Document o f

The World Bank

FOR OFFICIAL USE ONLY

Report No: 39801 - LK

INTERNATIONAL DEVELOPMENT ASSOCIATION

PROJECT PAPER

FOR A

PROPOSED ADDITIONAL FINANCING CREDIT

IN THE AMOUNT OF SDR26.3 MILLION (US$40 MILLION EQUIVALENT)

TO THE

DEMOCRATIC SOCIALIST REPUBLIC OF S R I LANKA

FOR THE

RENEWABLE ENERGY FOR RURAL ECONOMIC DEVELOPMENT PROJECT

May 15,2007

Energy and Infrastructure Unit South Asia Regional Office

This document has a restricted distribution and may be used by recipients only in the performance of their official duties. Its contents may not otherwise be disclosed without World Bank authorization.

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AU CAS CEB CPS DSM ESCOs ESD FMR GEF GOSL ICB IDA MOPE PCI PDO RERED S H S SPPA TA TERC VES

CURRENCY EQUIVALENTS (Exchange Rate Effective April 30, 2007)

Currency Unit = Sri Lankan Rupee 1 11.05 Rupees (Rs.) = US$1

US$ 1.525 = SDR 1

FISCAL YEAR July 1 - June 30

ABBREVIATIONS AND ACRONYMS

Administrative unit Country Assistance Strategy Ceylon Electricity Board Country Partnership Strategy Demand Side Management Energy Service Companies Energy services delivery Financial monitoring report Global Environmental Facility Government o f Sr i Lanka International competitive bidding International Development Association Ministry o f Power and Energy Participating credit institutions Project development objectives Renewable Energy for Rural Economic Development Solar home systems Standardized power purchase agreement Technical assistance Tsunami Emergency Reconstruction Credit Village Electricity Society

Vice President: Praful C. Pate1

Sector Manager: Salman Zaheer Country Director: Naoko Ishii

Task Team Leader: Mudassar Imran

FOR OFFICIAL USE ONLY

SRI LANKA

DEVELOPMENT ADDITIONAL FINANCING FOR A RENEWABLE ENERGY FOR RURAL ECONOMIC

TABLE OF CONTENTS

Page

I . INTRODUCTION .................................................................................. 1

11 . BACKGROUND AND RATIONAL FOR ADDITIONAL FINANCING ........................... 1

(a) Grid-Connected Renewable Energy., ...................................................... 2 (b) Solar P V Investments., ...................................................................... 2 (c) Independent Mini Grid ....................................................................... 2 (d) Energy Efficiency and Demand Side Management ...................................... 2 (e) Cross-sectoral Energy Applications ........................................................ 3 ( f ) Technical Assistance .......................................................................... 3

Rationale for Additional Financing ............................................................. 3

I11 . PROPOSED CHANGES ............................................................................. 4

I V . CONSISTENCY WITH CAS AND CPS ........................................................... 6

V . APPRAISAL OF SCALED-UP PROJECT ACTIVITIES .......................................... 6 Economic ........................................................................................... 6 Financial ............................................................................................ 6 Technical .......................................................................................... -7 Institutional ........................................................................................ -7 Procurement ....................................................................................... -7 Financial Management ............................................................................ 7 Environmental and social aspects. .............................................................. 8

V I . EXPECTED OUTCOMES ........................................................................... 8

VI1 . BENEFITS AND RISKS ............................................................................. 8

VI11 . FINANCIAL TERMS AND CONDITIONS FOR THE ADDITIONAL FINANCING .............. 9

This document has a restricted distribution and may be used by recipients only in the performance o f their off icial duties . I t s contents may not be otherwise disclosed without Wor ld Bank authorization .

SRI LANKA

DEVELOPMENT ADDITIONAL FINANCING FOR A RENEWABLE ENERGY FOR RURAL ECONOMIC

FY

PROJECT PAPER DATA SHEET

2008 2009 2010 201 1

Project Name: Renewable Energy for Rural Development, Additional Financing

ect ID: P101699 Borrower: Sri Lanka Responsible agency: Administrative Unit o f the DFCC Bank

Country Director: Naoko Ishii Environmental Category: B

Annual (Jan - Dec) (Jan - Dec) (Jan - Dec) (Jan - Jun) 10.0 12.5 12.5 5.0 - Cumulative I 10.0 *I 22.5 40.0

Current closing date: June 30, 2008

policies? o Y e s XNo Have these been approved by Bank management?

Revised project development objectives/outcomes.

The project development objectives (PDOs) are: to improve the quality o f rural l i fe by increasing access to off-grid renewable energy technologies and providing energy services to remote communities; and promote private sector participation in grid based power generation f rom renewable energy resources. There are n o changes to the project development objectives since the additional financing would fund similar activities as the original Renewable Energy for Rural Development (RERED) Project.

In line with the intended outcomes o f the RERED project, additional financing will seek to achieve increases in incomes o f households gaining access to electricity; greater private sector investment and participation in generating and distributing electricity with emphasis on renewable sources o f energy; growth o f a vibrant energy industry based o n commercial principles and transparent rules; and the integration o f renewable sources o f energy into the nations energy development program. The outcomes o f the Additional Financing project would be measured on the basis o f the fo l lowing key performance indicators: (i) measurable increases in incomes o f households gaining access to electricity (to be assessed through periodic monitoring and evaluation); (ii) sustainability o f renewable energy businesses as measured by the annual financial performance o f the companies operating in Sri Lanka; (iii) installation o f an additional 50 MW o f grid-connected electricity power generation capacity; and (iv) direct electricity access to an additional 60,000 households and 500 rural small and medium enterprises and public institutions directly through off-grid systems (solar, community hydro and biomass). Does the scaled-up or restructured project trigger any new safeguard policies: N o P

For Additional Financing

Source Borrower/Government o f Sr i Lanka IDA additional financing IDA balance from RERED GEF balance from RERED Sub-borrower PCIS

Local Foreign Total 0.0 32.0 1 .o 0.0 5 .O 21.2

5.5 40.0 3.2 1.1 29.5 23.2

*I 43.3 I 59.2 I 102.5 -

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I. INTRODUCTION

1. This Project Paper seeks the approval o f the Executive Directors to provide an additional Credit in an amount o f US$40 million (equivalent) for the Sr i Lanka Renewable Energy for Rural Economic Development Project [RERED P 10 1699; Credit number 3673-CE].

2. The additional financing would be used for the implementation o f activities which would scale-up the impact and development effectiveness o f the RERED project. I t i s expected to yield significant positive impacts in terms o f increases in power generation capacity with active private sector involvement, improvements in energy access in rural areas, and socioeconomic developments reflected in the creation of income generation activities and raising income levels. A vibrant industry spearheaded by the private sector created under the RERED project would be enhanced further. Furthermore, the project would achieve further reductions in carbon emissions by reducing financing barriers to renewable energy development, while contributing to Sr i Lanka’s targets of achieving 10% share o f non-conventional renewable sources o f energy in the grid by 2015 (Currently, non-conventional sources o f energy supply only 3.5% of the power sector output).

3. Presently, well over 100,000 rural homes are electrified through off-grid renewable energy solutions, mostly through solar home systems, and (to a lesser degree) independent mini grids powered by community based micro hydropower schemes. These account for about 2% of households in Sri Lanka accessing electricity services through the World Bank and GEF-funded Energy Services Delivery (ESD) and the RERED Projects. Sr i Lanka’s National Energy Policy o f GoSL envisages that 6% o f remote rural households will be electrified through off-grid solutions by 20 10.

4. major changes are being proposed.

The additional financing follows the same project design as the RERED project. No

5. There are no multi- or bi-lateral agencies co-financing the project. However, over the additional financing implementation period, the project would utilize the roughly US$ 1.1 million o f unutilized GEF funds carried forward from the RERED project.

11. BACKGROUND AND RATIONALE FOR ADDITIONAL FINANCING

6. The RERED project was approved on June 20, 2002, with an original credit amount of SDR 59.3 million (US$ 75 million equivalent), and a Global Environmental Facility (GEF) grant amount o f SDR 6.4 million (subsequently re-denominated to US$ 8 million). The Asian Tsunami which badly affected Sr i Lanka on December 26, 2004 resulted in the Government urgently seeking funds for emergency rel ief and reconstruction. The IDA portfolio was restructured to release a large portion o f uncommitted funds, amounting to US$ 75 million, from the existing portfolio to finance Phase I o f IDA’S response to the Tsunami in late January 2005. A portion of the uncommitted funds from RERED, amounting to approximately SDR 4.6 million, was transferred to the f i rs t Tsunami Emergency Reconstruction Credit (TERC). This paper relates to the additional financing provided for RERED, which does not affect the part o f the Credit diverted to TERC and therefore the TERC i s not covered or discussed in this paper.

7. The RERED project has consistently been rated Satisfactory on implementation and achievement o f development objectives, and has met all relevant World Bank disbursement, procurement and fiduciary obligations. Key project data i s tabulated below:

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Key Project Data Effectiveness Date: 10/07/2002 Closing date: 06/30/2008 Project Age: Four years, four months

Project Performance Development Objectives: Satisfactory Implementation objectives: Satisfactory Risk flags: None

8. The key components of the project are described as follows:

(a) Grid-Connected Renewable Energy: This will enable continuation of the refinancing support for commercially available renewable energy sources - mini-hydro, wind and biomass projects. As a result, grid-connected small-scale renewable energy will provide more than 5% o f al l o f Sr i Lanka’s main grid capacity by 2010, a figure that would be higher than for most other countries. All grid connected renewables will come under the purview of the standardized small power purchase agreement and tariff developed under ESD. However, the agreement may need some changes in order to accommodate wind and biomass and this will be addressed during project implementation.

(b) Solar PV Investments: The installation of solar systems i s expanding rapidly and a successful market has been created under the ESD and the RERED projects. This will continue to provide refinancing and grant support for solar PV investments for household, commercial, and institutional use. In particular, the project will provide refinance, grant (now phased out to cover only very small systems), and Technical Assistance support (TA), as well as indirectly support the Sri Lanka’s solar subsidy program that i s managed by the Administrative Unit o f DFCC. The market will also be expanded to other applications such as: (i) smaller systems accessible to a poorer market segment; (ii) community applications for health clinics, schools, street lighting, etc.; and (iii) commercial systems for water pumping, and telecom. In this way, the project will both build economies o f scale to solidify the market and increase outreach and awareness building to cater to access for poorer families.

(c) Independent Mini Grid Systems: This would again build on accumulated experience through RERED and other donor-funded activities, and would support further commercialization o f village hydro and other community-based independent grid systems through: (i) refinancing and grant support for investments; (ii) project preparation support; and (iii) TA to address such issues as use o f daytime supply for income generation activities, stranded cost, etc. The status o f independent grids within the sector reform agenda will also be emphasized in the broader sector technical assistance. The indicative target i s access to 3000 new household connections through independent grids (village hydro projects, as well as projects based on biomass and other technologies).

(d) Energy Efficiency and Demand Side Management (DSM): The project intends to provide TA for further development o f energy efficiency service delivery in the private sector and development of a framework for sustainable implementation of energy efficiency and renewable energy development programs through the proposed Sustainable Energy Authority that will succeed the Energy Conservation Fund. It i s envisioned that responsibility of policy and regulatory issues related to DSM as well as the implementation of public policy type DSM programs will rest with the government, regulator, or utility, while private sector enterprises such

3

as Energy Service Companies (ESCOs) wil l implement commercially viable energy efficiency projects.

(e) Cross-sectoral Energy Applications: To help rural communities realize the direct and indirect economic benefits o f electrification, the Project would provide rural enterprise credit support for larger systems. It would also provide service institutions TA for the development of standardized energy packages to create awareness and to integrate energy provision into improved service delivery; and TA aimed at mainstreaming productive uses in off-grid systems.

(f) Technical Assistance: In addition to the component-specific T A described above, TA under the Project i s being envisaged for the following: (i) project administratiordpromotion; (ii) subproject promotiorddevelopment support; (iii) technology/market introduction/promotion/ capacity building; (iv) rural development; (v) sustainability; and (iv) monitoring and evaluation.

Rationale for Additional Financing

9. Sr i Lanka has made strong progress in terms o f promoting private investments in renewable and rural energy. However, the limited availability o f long-term investment capital to the private sector remains a major constraint. Developments of domestic capital markets that wil l permit private banks to raise a l l the required capital on their own account seem remote in the near and medium term. Therefore, in the absence of certainty about the availability o f additional financing of the type provided under the RERED project (after the closing o f this project), Participating Credit Institutions (PCIs) are expected to either postpone loan approvals for new projects, and/or offer shorter term (4 year) loans, which wi l l effectively render projects unviable. At present the Administrative Unit o f the DFCC Bank, which i s implementing the project has imposed a restriction on approving loans for grid connected projects and these applications are being placed in a queue. This has already resulted in a slow down o f the applications for projects. Any further delay in signaling the availability o f additional finance to the industry could slow- down the momentum built up. This threatens to interrupt the development o f the pipeline of future renewable energy investments, compromising the country’s objective of improving access to clean, renewable sources o f energy.

10. In line with the objectives of the RERED project, the additional financing project would continue to address the long-term funding constraints of the local capital markets, by providing a maturity period that matches the pay-back period o f renewable energy investments (7-9 years). This would facilitate the development of the renewable energy sector thereby contributing to Sr i Lanka’s renewable energy development goals. The time during which the additional finance i s being disbursed could be used to structure, and develop long term financing instruments (such as the Renewable Energy Bond presently under consideration) for sustaining renewable energy investments over the long term in the absence o f external financing. The additional finance wil l fill the gap in the short term.

11. IDA financing for the original RERED project amounted to US$75.0 million, o f which US$7 million was reallocated to the tsunami emergency, leaving a balance o f US$68 million for the original project purposes. As of May 15, 2007, US$26.9 million (or about 30% of revised credit amount) remains unexpended.’ In 2006, actual expenditures averaged about US$3.5

There has been a significant depreciation o f the US Dollar vis a vis the SDR since project approval in June 2002. At today’s exchange rates, the original project amount i s equivalent to US$90 million, an increase o f approximately 20%. While the unexpended amount includes the balance in the special account, it does not include expenditures to date during 2007.

1

13. TtX' pizrtod under the addit io i I? d i ca presented in the ~ o l l ~ ~ ~ ~ ~ ~ table:

Iechriical assistance 1 3.8 1 3.7 1 0.0 I 0.2 I 0.6 I 0.0 1 0.0

? ts of

__ - Projected IDA Balance* &om

Additional RERED as o f Financing 12/3 1,O7

Percentage of

financed 40 Ot! ni l W O or'rinoi.nt3

Amount in US$ Amount in US$ expenditure to be Expenditure Category (millions) (millions)

disbursed in respect o f ~ ~ ~ ~ ~ ~ n s

I

6

approving grid-connected projects wil l then be lifted, and the existing pipeline of projects wil l be accepted for commitment and disbursement, along with new projects.

17. on30 June2011.

The additional financing operation wi l l be completed on 31 December 2010 and closed

Other Proposed Chanves

18. Financial terms and conditions would change as discussed in paragraph 35, below.

19. The RERED project has been reviewed for the Bank’s Operational Policy (OP) 8.30 and the following changes have been proposed to improve the effectiveness of additional financing: (i) over the additional financing implementation period, the Government would prepare a strategy for the development of long term financing market for renewable energy development. (This work has already been initiated under the ongoing Capital Market Study); (ii) the rate at which the Government o f Sr i Lanka on lends funds to participating credit institutions (PCIs) would be increased. The current practice o f linking these rates with the average weighted cost o f deposits would be replaced with a rate established on the basis of the average weighted cost o f deposits and the average weighted cost o f fixed deposits (these rates would be reviewed in one year, and revised as necessary); and minor adjustments to the PCI eligibility criteria would be made to improve the effectiveness o f this OP, notably: (a) the current maximum permissible non performing loan (NPL) ratio o f 20% (infection ratio) would be lowered to 10%; and (b) the cash collection ratio o f 80% (total as well as for principal) would be raised to 85%.

IV. CONSISTENCY WITH CAS OR CPS:

20. There i s strong evidence that access to modern energy services (particularly electricity) has positive impact on the lives of the people, demonstrated through i t s beneficial impacts on heath, education, productivity, and general well being o f the people. These objectives are consistent with the country assistance strategy of Sr i Lanka and the broader goals of reducing poverty.

v. APPRAISAL OF SCALED-UP PROJECT ACTIVITIES

21. Economic: The additional financing would enhance the economic impact o f the RERED project and i s justified on economic grounds in a number of ways including: First, by deepening the involvement o f the private sector it broadens the range of electrification options, thereby creating alternatives to monopolistic, state-led provision o f electricity services. Second, this operation has strategic relevance for the Bank in the sense that it provides opportunities for strengthening our involvement in sector reform and efficiency. Finally, economic analysis, under standard assumptions for typical projects, demonstrates positive economic rates o f returns on investments, especially for mini hydro projects where the rate o f return exceed 20%. For village hydro the economic rate of return ranges between 7- 40% depending on whether the households already own TV and batteries; and for solar home systems (SHS) it i s about 5%. Even though the returns for SHS are low, they are s t i l l the least-cost alternatives in areas with dispersed populations and/or where grid extension i s expensive.

22. Financial: The financial rates o f return based on the financial analysis o f a typical project under standard assumptions are as follows: grid-connected mini hydro: 20% to the developer; off-grid village hvdro: in the range o f 3-31% for a typical 10 kW project (depending

7

on whether or not the households already own TV and batteries; and solar home systems about 3% (for household that already use a battery and TV).

23. Technical: Grid-connected as well as off-grid biomass power generation projects are technical interventions relatively new to Sr i Lanka that wi l l be implemented under the project. While the technology utilized has a proven track record in other countries and as such poses no major technical issues, it wi l l be tested for the f irst time in Sr i Lankan conditions. Generally, off- grid village hydro sites and SHS beneficiaries are selected following a review of Ceylon Electricity Board’s (CEB) grid expansion plans and the distance of the sites from the nearest power line. However, some unplanned sites do get developed and in these cases the beneficiaries are free to seek grid supply and forgo the off-grid system.

24. Institutional: There are no major institutional issues; the institutional arrangements under the RERED Project have worked well and wil l be continued in the additional financing operation. The Administrative Unit (AU) o f the DCFF Bank - a private licensed specialized bank, which has successfully managed the implementation o f the RERED project wi l l continue to manage project implementation. The AU i s well staffed and professionally managed under the leadership of a Senior Vice President o f DFCC Bank. Recently, a finance company capable of providing micro credit to support off-grid investments such as solar home systems has joined as another PCI. This wil l improve rural access to micro finance and increase competition among off- grid credit providers.

25. Procurement: There are no procurement issues. The project wi l l follow the established arrangements o f the RERED Project, which i s being satisfactorily implemented. In addition to new sub-projects, the additional financing wil l finance sub-projects developed under the RERED Project pipeline. Since this i s a financial intermediation project, there i s no major direct procurement o f goods and works. The only significant procurement under International Competitive Bidding (ICB) procedures in respect o f goods and works wi l l be by the private sector project developers of grid-connected wind, hydro and biomass sub-projects. These wil l follow Bank guidelines stipulated under the RERED project: “Guidelines for Procurement under IBRD Loans and IDA Credits”, January 1995 and revised in January and August 1996, September 1997 and January 1999 for goods and works; and “Guidelines: Selection and Employment o f Consultants by World Bank Borrowers”, January 1997 and revised in September 1997 and January 1999 for consultant services. Compliance wil l be ensured through ex-post reviews and audits, except in cases where the procurement i s of value greater that prior-review thresholds. In the case o f TA, only small outlays for goods are envisioned. In respect o f services and training, the TA wil l be administered by DFCC AU using both grant and credit funds.

26. Financial manapement: The implementing entity, DFCC Bank, has a proven track record of good financial management and sound project operating guidelines under the ongoing RERED Project. The DFCC Bank has demonstrated capacity in submitting project audit reports and informative quarterly project management reports to the Bank on a timely basis. The Project wi l l be using a Financial Monitoring Report (FMR) based disbursement process, and the quarterly FMRs wil l include both physical and financial progress information.

27. The AU at DFCC Bank wi l l continue with on-going risk mitigation measures that include: independent physical verification o f assets, due diligence by PCIs on procurement practices of beneficiaries, use o f Project Auditors to perform validation checks at solar companies in respect o f granthbsidy claims on solar home system installations, operation of a computerized system for validating and processing the GEF cofinancing grant and government subsidy for solar home systems, and operation of a computerized project accounting system.

8

28. Environmental and social aspects: There are no modified, expanded or new activities that have any safeguard implications under the additional financing. Therefore, the Environmental and Social Assessment and Management Framework (the Framework) prepared for the RERED project i s applicable. There will be no new safeguard policies triggered. The project has been classified as a Category B project since the project will have substantial positive environmental and social effects, with potential adverse impacts limited to small scale mini- hydro, biomass and wind energy plants. The Framework will serve as a template for potential sub-project developers to undertake sub-project specific environmental and social safeguards assessments. Monitoring safeguards would be effected both through country-based enforcement and project based community oversight mechanisms, which have been very successful under RERED. While the Framework has been publicly disclosed in 2002, it will be placed in the public domain once again.

VI. EXPECTED OUTCOMES

29. As noted above, the project i s expected to yield significant development outcomes reflected in increases in incomes o f households gaining access electricity; greater private sector investment and participation in generating and distributing electricity with emphasis on renewable sources of energy; growth of a vibrant energy industry based on commercial principles and transparent rules; and the integration of renewable sources of energy into the nations energy development program also yielding carbon offset benefits.. These outcomes are supported by several quantifiable outputs. Specifically, over the additional financing implementation period, the project would: (i) increase the grid-connected capacity by a further 50 M W through renewable energy technologies by the private sector (ii) provide energy access to 60,000 additional households in rural areas through off-grid electricity services; and (iii) provide access to an additional 500 rural micro and small scale enterprises.

VII. BENEFITS AND R I S K S

30. Recently there has been a move from avoided cost based tariffs to technology based cost plus tariffs. Although this was an outcome o f stakeholder consultation, some mini hydro promoters now view this as a disincentive reducing their cost recovery. This perception may lead to a decline in their interest in minihydro investments. The Government of Sr i Lanka has not yet given a clear indication of the sustainability o f the funding gap in the event the technology based tariff i s higher than the avoided cost tariff. The government i s presently refining the price structure and it i s anticipated that the concerns of promoters would be addressed. On the other hand, the new tariff structure will benefit the more expensive technologies such as biomass and wind, which are presently not viable on the avoided cost based tariff.

3 1. The sustainability o f the grid-connected small power industry will depend upon further refinements to the standardized power purchase agreement (SPPA) between the CEB and the power generators. The existing SPPA represented a major breakthrough for renewable energy, and has been demonstrated to form the basis for sustainable mini-hydro investments. I t should be noted that there i s a need for some refinements to the SPPA to ensure sustainability o f continued mini-hydro development and that the SPPA i s accommodated in the power sector reform process.

32. Since a distorted or unstable macroeconomic environment could undermine the realization of project objectives, OP 8.30 stipulates that a line of credit be considered only in the context o f a satisfactory macroeconomic framework. Available information from the Sr i Lanka Development Forum Report (dated January 12, 2007) indicates that, except for the chronic fiscal

9

deficit and a sudden jump in inflation caused mainly by steep rise in o i l prices, the macroeconomic environment remains reasonably satisfactory. To illustrate, the Sr i Lankan economy has posted impressive gains in the post-tsunami period, with a 6% growth rate in 2005 followed by 7.8 % growth during the first three quarters o f 2006. Higher growth has been accompanied by the decline in unemployment rates - from 8.1% in 2004 to 6.4% in the first nine months o f 2006 (excluding the North and Eastern parts o f the country). With per-capita income rising above US$l,OOO in 2004 Sri Lanka i s on a steady path to achieving status o f a middle- income country. The Government has also developed a strategy to reduce the fiscal deficit.

33. Despite the escalation o f conflict in Sri Lanka over the last 18 months, particularly in the North and East, project activities have been progressing reasonably well (as o f the end o f 2006). Approximately 24% o f the solar home systems sold under RERED has been installed in rural households in the North and East over the past five years. The data also shows that in all eight conflict affected districts, sales o f solar home systems have not been interrupted, although there i s slow down o f purchases in 2007, due to the escalation in the conflict. This i s a significant achievement. The terrain in the North and East i s such that there i s low potential for grid connected or off-grid hydro power projects, therefore there i s l i t t le likelihood o f hydro projects being developed in the North and East. The escalation o f the conflict may have an adverse impact on solar home systems being financed by the PCIs due to the security risks. Since many years o f conflict have resulted in slow expansion o f the national grid, there i s bound to be a demand for solar home systems when the situation normalizes in the North and East. At that time it i s expected that the PCIs would be willing to resume lending for solar home systems since the security risks will be lower. A complete cessation o f fighting may not be necessary for this to happen as demonstrated by the continued sales o f solar home systems in the conflict affected areas during 2006.

34. The RERED project has performed well, however, the long term sustainability o f the sector, in the absence o f RERED type financing depends on a satisfactory state o f the financial sector which would make it possible for the project to have continued access to strong and competitive PCIs to finance renewable energy projects. While the RERED project has limited leverage to influence reforms in the financial sector the additional financing provides an opportunity for the government to develop a strategy for addressing the long-term financing market issues for renewable energy sector. The options considered in the Capital Market Study under preparation (by consultants on behalf o f the government), such as the renewable energy bond could form the basis for implementing such a strategy. This would also provide a next step in reducing the necessity o f long-term financing to commercial banks from IDA for energy projects.

VIII. FINANCIAL TERMS AND CONDITIONS FOR THE ADDITIONAL FINANCING

35. The financial terms o f the additional financing wil l be those currently offered to Sr i Lanka, being IDA hardened lending terms for IDA gap countries, specifically a ten year grace period and twenty year maturity, with principal repayable at ten percent per year for years 11-20, and zero interest payments. Project conditionality will remain the same as for the original credit in terms o f implementation requirements.