May 21, 2004

Document of the World BankR

eport No. 29062-IR

Islamic R

epublic of IranEnergy-Environm

ent Review

Policy Note

Report No. 29062-IR

Islamic Republic of IranEnergy-Environment Review Policy Note

Water, Environment, Social and Rural Development DepartmentMiddle East and North Africa Region

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Currencv Equivalents (Exchange rate effective March 19,2004)

Currency Unit = Iranian Rial (Rls) US$l.OO = Rls 8,434.80

BAU CAS CBA CDM CEM CNG DOE EER ESI EU FA0 FY GEF GDP GHG GO1 INEA PCC Mboe MDG MNA OEP OFDA OPEC PCF PPP SEA T&D TPER TTERP UNDP UNEP UNFCC-COP voc WHO

Fiscal Year Iranian Fiscal Year ends March 20

Acronvms

Business As Usual Country Assistance Strategy Cost-Benefit Analysis Clean Development Mechanism Country Economic Memorandum Compressed Natural Gas Department of Environment Energy Environment Review Environmental Sustainability Index European Union Food & Agriculture Organization Fiscal Year Global Environment Facility Growth Domestic Product Greenhouse Gases Government of Iran International Nuclear Energy Agency Intergovernmental Panel on Climate Change million barrels oil equivalent Millennium Development Goal Middle East and North Africa Office of Energy Planning Office of Foreign Development Agency Organisation of the Petroleum Exporting Countries Prototype Carbon Fund Parity Purchasing Power Strategic Environmental Assessment Transmission and Distribution Total Primary Energy Requirement Tehran Transport Emission Reduction Project United Nations Development Program United Nations Environment Program United Nations Framework Convention on Climate Change - Convention of Parties Volatile Organic Compound World Health Organization

Vice President: Christiaan J. Poortman Country Director: Joseph P. Saba Sector Director: Letitia A. Obeng Sector Manager: Vijay Jagannathan Task Team Leader: Sherif Arif

1 Introduction ...................................................................................................................................... 1 Background to the Note ............................................................................................................. 1 1.1

1.2

1.3

Linkages to previous work ......................................................................................................... 2

Purpose of the Note ................................................................................................................... 3

2 Key Aspects ofthe Economy ofIran ................................................................................................ 4

3 Environmental sustainability in Iran ............................................................................................... 5 3.1 Political commitment ................................................................................................................. 5

3.2 Environmental issues ................................................................................................................. 6 Water scarcity and quality ................................................................................................. 6 Urban and industrial pollution ........................................................................................... 6 Untreated hazardous and municipal wastes ....................................................................... 7 Land degradation and deforestation ................................................................................... 7 Exposure to natural hazards ............................................................................................... 8 Trans-boundary and regional issues .................................................................................. 8 Institutional and legal framework ...................................................................................... 8

3.2.1 3.2.2 3.2.3 3.2.4 3.2.5 3.2.6 3.2.7 3.2.8 Summary o f issues ............................................................................................................. 9

The costs of environmental degradation .................................................................................... 9 3.3

4 The Energy Sector in Iran .............................................................................................................. 11 4.1 Energy supply and conversion ................................................................................................. 11

4.2 Energy demand ........................................................................................................................ 13

4.3 Energy trends ........................................................................................................................... 15

4.4 Implications for the environment ............................................................................................. 17

5 Assessment ofDamage Costs in the Energy Sector ....................................................................... 20 5.1 Methodology ............................................................................................................................ 20

5.2 Estimates of local environmental damage costs in 2001 ......................................................... 22

5.3

5.4 Forecasts of local damage ........................................................................................................ 25

5.5 Conclusions ............................................................................................................................. 27

Global damage from flaring of natural gas .............................................................................. 25

6 Policy Options ................................................................................................................................. 28 6.1 Price reform ............................................................................................................................. 28

6.2 Sectoral measures .................................................................................................................... 31 6.2.1 Modeling principles ......................................................................................................... 34 6.2.2 Impact on the environment of measures without price reform ........................................ 36 6.2.3 Impact on the state budget of measures without price reform ......................................... 36

6.3 Sectoral measures, combined with price reform ...................................................................... 38

6.4 Options for partial price reform ............................................................................................... 40

6.5 Conclusions ............................................................................................................................. 42

7 Conclusions and Recommendations .............................................................................................. 43 7.1 Findings ................................................................................................................................... 43

7.2 Recommendations: A New Energy-Environment Strategic Framework (2004-2014) ........... 45

7.3 Action Plan .............................................................................................................................. 47

7.4 Role o f the World Bank ........................................................................................................... 48

7.5 Conclusion ............................................................................................................................... 49

Figure 4.1: Production and export of crude oi l ....................................................................................... 11 Figure 4.2: Per capita energy consumption (in barrels of crude oil equivalent / year) ........................... 13

Figure 4.4: International comparison of energy intensity ....................................................................... 14 Figure 4.5: Subsidies to energy by fuel and sector (10 Rials) .............................................................. 15 Figure 4.6: Allocation of subsidies by fuel and sector (2019) ................................................................ 16 Figure 5.1: Emissions by sector .............................................................................................................. 22 Figure 5.2: Damage by fuel and sector in 2001 (10l2 Rials) .................................................................. 23 Figure 5.3: Damage cost by pollutant and sector in 2001 ( 10l2 Rials) ................................................... 24 Figure 5.4: The economic cost of fuel .................................................................................................... 24 Figure 5.5: Damage by fuel and sector in 2019 (10 Rials) .................................................................. 26 Figure 5.6: The evolution o f damage by pollutant .................................................................................. 26 Figure 5.7: The evolution o f damage by sector ...................................................................................... 27 Figure 5-8: Evolution of damage by fuel ................................................................................................. 27 Figure 6.1: Energy demand in three reform scenarios (mboe) ............................................................... 29 Figure 6.2: Damage costs by pollutant in selected years under reform ( 10l2 Rials) ............................... 30 Figure 6.3: Direct impacts on economic growth from price reform ........................................................ 31 Figure 6.4: Damage by pollutant over time: measures no price reform ................................................. 36

Figure 4.3: Energy demand in 2001 (mboe) ........................................................................................... 13

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12 Figure 6.5: Cumulative net benefits to Iran (10 Rials) ......................................................................... 37 Figure 6.6: Net financial flows to the state o f measures ......................................................................... 37

Figure 6.8: Cumulative economic benefits (10 Rials) .......................................................................... 39 Figure 6.7: Damage costs by pollutant: price reform plus measures ( 10l2 Rials) ................................... 39

Figure 6.9: Cumulative net cash-flow to the state (10 Rials) ............................................................... 40 Figure 6.10: Damage reductions for single fuel price increases (2019) ................................................. 41 Figure 6.11: Subsidy reductions for individual fuel price increases (2019) ........................................... 41

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Table 4-1: Impacts o f gas flaring (1994/95) ........................................................................................... 15 Table 4-2: Energy balance 2001 (entries in mboe) ................................................................................. 18 Table 4-3: Partial energy balance for 2019 (entries in mboe) ................................................................ 19 Table 5-1: Benefit values assumed for Iran ............................................................................................ 21 Table 6-1: Market prices and opportunity costs (2001) .......................................................................... 28 Table 6-2: Effect on consumer price index of price ref0 rm ..................................................................... 30 Table 6-3: Summary of sectoral measures ............................................................................................... 32 Table 6-4: CBA of sectoral measures ..................................................................................................... 34 Table 6-5: Key parameters o f the modeled policies ............................................................................... 35 Table 7-1: Main effects of price reform and sectoral measures .............................................................. 44

Acknowledgements

This sector note was prepared by Mr. Sherif Arif (Regional Environmental & Safeguards Advisor and Task Team Leader) and Mr. Nigel Lucas (Environmental Economist, Consultant). Mr. Vijay Jagannathan i s the Sector Manager, and Ms. Letitia A. Obeng i s the Sector Director.

The team would like to acknowledge the cooperation and support received from the Government of Iran, particularly H.E. Dr. Massoumeh Ebtekar, Vice-president and Head of the DOE, Dr. Yousef Hojjat, Deputy Head Human Environment (DOE), Dr. Majid Shafie-Pour, Senior Advisor to the Head o f DOE and Director of the EER Office in the Department of Environment (DOE), Dr. Mojtaba Ardestani, Project Coordinator, the Members of the DOE Steering Committee, as well as the staff members of the DOE EER Office. The team would also like to thank the Consultants at Electrowatt-Ekono, TERI and Ghods Niroo, especially Dr. Robert Zwahlen, Team Leader of Electrowatt-Ekono, and Mr. Michael Cupit, Environment Economist at the Environment Management Resources (ERM).

Messrs. Tjaarda P. Storm Van Leeuwen (Lead Financial Analyst, MNSIF), Victor B. Loksha (Energy Economist, ECSIE) were the peer reviewers and provided useful comments and feedback. Ms. Magalie Pradel desktopped and edited the report.

The team finally gratefully acknowledges the financial support provided by the Norwegian Government through a t rust fund to the study.

EXECUTIVE SUMMARY

The Government of Iran (GOI) has requested the World Bank assistance to integrate environment priorities into i t s energy sector, with the intention that some of i t s recommendations could be included in the 4” Five Year Development Plan (2005-2010). The mainstreaming tool for integrating environmental concerns into the energy sector i s an Energy-Environment Review (EER) into the energy sector, which i s called in the World Bank’s “Environment Strategy for the Energy Sector: Fuel for Thought”, approved by the Board on July 20, 1999. The results of the EER should be interpreted in the light of the objective o f the 4” Five Year Development Plan to achieve fast and sustainable growth and accelerate the transition to a market economy. In particular the suggested actions wi l l promote economic efficiency through a proper allocation o f scarce resources, including environmental resources, so as to achieve economic efficiency and environmental and social protection.

This Policy Note i s based on the Final Report o f the Environmental Energy Review (EER) prepared over two years with the full collaboration with the GO1 and the assistance of international and national consultants. The EER was financed by the Norwegian Trust Fund for Sustainable Development. The EER report comprises: (a) an analysis of the current situation with regards to energy generation and use; (b) an evaluation of the growth prospects with regard to energy generation and use; (c) the identification of the environmental issues induced by the generation and use of energy and estimation of the costs of the damages; (d) the evaluation of the extent o f contribution to the climate-change phenomenon through emission o f greenhouse gases; (e) the evaluation of the proposed mitigating measures for the previously identified environmental problems; (f) conclusions and recommendations; and (g) a proposal for an action plan.

The emphasis of the EER i s on air pollution, because it i s the most extreme and visible s ign of environmental damage, certainly in the large cities. This does not mean that other environmental issues are of secondary importance and should not be addressed. The EER describes a process and methodology for using damage-costs as a tool for engaging the GO1 into a policy dialogue into integrating environment concerns into the energy sector. Such process and methodology could be adapted and be used in the policy dialogue in other sectors such as water, land degradation. Other important issues are marine pollution from oi l spills and contamination of water from oi l production and processing. Marine pollution i s covered in the Note. Refinery issues are better treated by normal processes o f industrial pollution control. The policies recommended wi l l generally lead to more efficient use o f resources and a diminution of other environmental impacts and wi l l have no adverse effects on other media, such as water and soil.

The major source of air pollution i s the energy sector which i s key to the Iranian economy. It i s the main engine of future economic growth, a principal cause o f environmental pollution and damage and a major source o f market distortion.

Iran possesses substantial reserves of hydrocarbons. Iran i s OPEC’s second largest oi l producer. At the end of 2002 it possessed 12.3 billion tons o f proved reserves, amounting to 8.3% of global proved reserves. Oi l production peaked at over 6 million barrels per day (mbd) in 1990, but has since fallen and in 2002 was 3.3 mbd. Iran aims to raise i t s o i l production to 8 mbp by about 2025, and i s seeking foreign investment to this end.

Iran i s also well-endowed with natural gas. In 2002 there were 23 trillion cubic metres of proved reserves of natural gas in Iran, equivalent to 14.8% o f known world reserves and the second largest in the world after the Russian Federation. Production of natural gas in Iran that year was

i

64.5 billion cubic metres (bcm) giving it a reserves to production ratio of around 360 years, compared to 8.6 years in the U S and 81 years in the Russian Federation.

Other sources of primary energy in Iran include thirteen hydropower with a total capacity of 2,000 MW; which generated 6,908 GWh in 2000, equal to 7.4% of the national output Iran has a long-standing commercial nuclear program. In 1995 and 1998, i t signed agreements with Russia to complete the 1000 MW pressurised light water reactor at Bushehr. The power plant i s to be commissioned in 2004. The present aim i s to have 7000 MW of nuclear power installed by 2021. Despite i t s vast oi l and gas reserves Iran has also renewable energy programs in photovoltaics, wind, geothermal and biomass.

Per capita consumption of energy has risen from 2.0 boe per year in 1965 to 10 boe per year now The energy intensity value i s higher than that characterizing most industrial economies and also higher than more densely populated developing countries such as China and India.

Energy in the domestic market i s heavily subsidized; the EER estimates the total subsidy in 2001 at 118 ~ 1 0 ' ~ Rials ($ 15 billion) equal to 17.8% of the Iranian GDP. This practice not only distorts consumer choice and obscures state accounts, but i s the cause of high environmental damage. The present pricing policies o f the GO1 aim broadly to keep energy prices constant in real terms; if these policies continue to 2019 (the end of the 6" Plan) then the subsidy to the sector wi l l r ise to 2 8 8 ~ 1 0 ' ~ Rials (measured in Rials o f 2001) equal to 20% of GDP. Consumption of energy and emissions o f green-house gases wi l l more than double.

The Iran's Country Economic Memorandum for Iran of April 2003 made detailed studies o f the consequences on the state accounts and consumer prices of various schedules of energy price adjustment and the ways in which unwelcome impacts could be managed by compensation schemes. The Memorandum concluded that the preferable combination would be of a quick adjustment of energy prices in two to three years and a phased compensation scheme over 5-7 years. This procedure would allow time to develop the targeting mechanisms and institutional structures required to deliver the social safety measures and also allow the accumulation of the revenues to fund it.

On the basis o f the energy supply and demand, the EER assessed environmental damage from air- pollution in Iran using the ExternE study that has extended over 10 years and i s s t i l l in progress; it has been funded by the EU Commission and Member States'. Damage costs were transferred from Western European practice to the conditions of Iran by scaling according to GDP per capita measured in PPP terms.

Using this approach, the EER assessed the total health damage from air-pollution in 2001 at about 5 6 ~ 1 0 ' ~ Rials ($7 billion); equivalent to 8.4% o f nominal GDP. In the absence of rice reform and control policies, the EER estimated that damage in Iran wi l l grow to 155x10 Rials ($19 billion) by 2019, in the money of 2001. This i s equivalent to 10.9% of nominal GDP, i.e. a larger percentage o f a larger GDP. O f this total, 1 0 7 ~ 1 0 ' ~ Rials ($8.4 billion) comes from the transport sector. The damage cost to the global environment from the flaring o f natural gas assessed on the basis o f a carbon price of $10/ton COz, and found to be approximately $600 million per year.

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Full details o f the methodology o f ExtemE, the results for all fuel-cycles and the applications to Member States can be

ii found on www.exteme.jrc.es.

This i s equal to a little less than 1% of current GDP. There are large costs associated with recovery and use of such gas, but equally there are large potential benefits.

The EER investigated the policy options to control and decrease the damage costs. I t examined separately price reform policies and/or sectoral measures. By sectoral measure i s meant an intervention that aim to cause a specific behavioural change, e.g. through targeted financial incentives and standards for equipment and appliances. The EER examined three scenarios for price reform in which subsidies were eliminated by: (a) 2009 at the end of the Fourth Year Economic and Social Development Plan (4' Plan) a fast price reform, to be close to the recommendations to the CEM; (b) the end of the 5fi Plan in 2014; as an intermediate price reform to consider a less acute public reaction and lower pressure of the CPI; and (c) by the end o f 6' Plan; as very slow price reform; this scenario would require price increases phased over 15 years and could be difficult to sustain. The EER conducted also detailed cost-benefit analyses on thirteen sectoral measures that could be taken to reduce the environmental impacts of the energy sector.

The challenge therefore i s to recommend the necessary policy reforms and sectoral measures that wi l l substantially reduce the damage costs from 8.4% o f GDP in 2001 and from 10.9% of GDP in 2019, in the case that no reform or measures are introduced. In order better to define the options and their impacts, a total of twelve scenarios were analyzed, characterized by a combination of four price reform scenarios and three different sets of measures. The main results can be summarized as follows:

(a) Compared to 2001, in a Business as Usual (BAU) Scenario, primary energy requirement and final energy consumption would more than double till 2019, with the corresponding detrimental effects on the amount paid as subsidies, on emissions and on damage costs. Subsidies and damage costs would not only increase in absolute terms, but also as percentage of GDP. Fast price reform by 2009, as proposed in the CEM, would decrease the damage costs by half. I t would increase overall financial benefits to the state and bring bigger environmental benefits in the intervening period 2004 - 2019, however it would have stronger impact on the consumer price index.

(b) Elimination of energy subsidies in 20 14 without sectoral measures would reduce energy consumption by half from 1556 mboe to 789 mboe, and result in a 50% decrease of damage costs from 10.9% of GDP to 5.7% of GDP. However, both energy consumption and damage costs (8 1 trillion Rials or US$ 1 1 billion) would s t i l l be higher than in 2001.

(c) Applying sectoral measures without price reform would lead in 2019 to a certain, although not very substantial, reduction in energy consumption and damage costs from 10.9% o f GDP to 7.6% o f GDP.

(d) The combination o f price reform and sectoral measures would bring energy consumption in 2019 almost to the level of 2001, and would actually result in a decreasing environmental impact, and therefore in reduced damage costs as compared to 2001 from 8.4% o f GDP to 3.9% of GDP. The effects are the same for all price reform scenarios, because of the assumption o f immediate adjustment to price.

(e) If price reform strategies cannot be comprehensive, then targeting transport fuels i s the best .compromise. There i s a double gain in avoided subsidy and avoided damage. Roughly, these benefits are comparable in magnitude.

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The major conclusions form this analysis are that: a) rapid price reform i s the best strategy for the environment. The policies proposed in the CEM for energy price reform are entirely coherent with those that the ERR shows most benefit the environment; b) only a combination o f price reform plus appropriate sectoral measures can keep damage costs by 2019 below those assessed for 2004; c) if price reform i s delayed past 2009 then the Iran can improve i t s financial cash-flow by providing financial incentives to the efficient use of energy and to the substitution o f fuel-oil by natural gas. These measures create a cash-flow to the state as a consequence o f avoided subsidy. Some of this positive cash-flow can fund other environmental control measures where the costs are not easily assigned to the polluter.

The EER shows that reform o f prices to the level of opportunity costs wi l l bring significant benefits, but wi l l s t i l l leave substantial environmental impacts that wi l l increase thereafter as a consequence o f increased energy use arising from continued economic growth. Price reform in itself i s not enough. Prices could be increased above the level of opportunity cost by taxes as i s done in many industrialized countries; such measures are normal driven by a combination of fiscal and environmental motives. Taxation should be borne in mind as a long-term option, but in the short-term the price reform needs to be supplemented by targeted sectoral measures to control emissions at source.

Based on a vision o f sustainable development anchored in a thriving market-based economy with efficient institutions and strong regulatory oversight, this policy note puts forward a four-point strategy with the proposed actions: a) to improve human health and the quality of life of the population through a reduction in the prevalence of respiratory diseases brought about by specified environmental control measures; b) to price energy resources efficiently to stimulate energy efficiency and competitiveness of the economy; c) to improve the productivity and sustainability o f the country’ s energy capital by investment in clean technology; d) to improve the institutional and legal framework and strengthen information dissemination and public awareness-raising.

The policy note also proposes an Action Plan to implement the main sectoral policies described above aiming at improving the environmental situation as far as it i s related to the energy sector. This Action Plan wi l l have to be developed further, and changed where required, since it can only be implemented within a coherent framework of Iranian environmental, energy and economic policies, which need to be defined and adopted by the Iranian Government. Therefore the Action Plan, as presented in the EER report, should be considered as a basis for the ongoing discussion with the GOI, which in any case must be continued for the further implementation o f work that has been initiated by the EER.

This Action Plan should be the basis for continuing discussion between the Bank and the GOI. The DOE has already established an Energy-Environment Review (EER) Office and has also formed an EER Steering Committee. Both should continue to function until the Policy Support Unit which i s envisaged under the World Bank co-financed Environment Management Support Project become fully operational with staff and resources. Later, the High Council of the Environment should oversee the Action Plan with the PSU acting a secretariat for monitoring, evaluating and coordinating the policy options executed and implemented by various agencies.

On the basis of the strategic actions, the role of the World Bank wi l l be to assist Iran in developing tools for meeting i t s MDG target # 7 on environment sustainability, in particular: a) to mainstream environment into target policies, programs and projects at the national and local levels; b) to promote sustainable development in the energy sector. This approach requires strong

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commitment and involvement from all departments and levels of government, including civil society and the private sector.

The policy note proposes that the Bank wi l l use five main tools in i t s support for the implementation of the EER: a) assisting DOE and the key energy Ministries o f Oil, Energy, Transport, and Environment in setting environmental priorities and in improving their environment management capacity; b) assisting the DOE and other relevant institutions of government to strengthen capacity in environment and social assessment; c) integrating environment into Bank’s instruments through the environment-energy priorities expressed in the CAS, sector work, and program and project design in the energy sector; d) building the capacity of key sector ministries, local governments, and municipalities in technical and managerial matters, as well as policy planning and evaluation; e) promoting regional cooperation in combating marine pollution from oi l and gas, and protection of marine resources in i t s Shatt El Arab waterway with Iraq and Kuwait and i ts downstream zone of influence in the Persian Gulf.

Since the year 2000, the Bank has been the major environment policy interlocutor in Iran. I t s presence i s needed now, even more than in the past, to play i t s catalytic role of addressing the root causes o f inadequate environmental management and in integrating environmental concerns into decision making and the management o f the economy, providing tools for environmental policy analysis and linking project preparation to investment. The EER i s the beginning of a process. Accompanying Iran in this process of environmental sustainability i s a challenge that the Bank has accepted to assume in order to help Iran improve the quality of life of the Iranian people now and in the future.

V

1 Introduction

1.1 Background to the Note

1. The Government of Iran (GOI) has requested the assistance of the World Bank to integrate environment priorities into i t s energy policy, with the intention that recommendations can be integrated into the fourth five year development plan (2005-2010). The aim of the GO1 i s to improve the protection o f the environment without hindering the economic development of the country. Economic growth i s required to improve the living standard of the population and to reduce poverty, but also to correct bad environmental practice and to address environmental issues that are not restricted to the energy sector.

2. The mainstreaming tool for integrating environmental concerns into the energy sector i s found in the World Bank Group “Environment Strategy for the Energy Sector: Fuel for Thought”, which was approved by the Board on July 20, 1999. The main objectives in th i s strategy are: (a) to facilitate more efficient use and substitution o f traditional fuels; (b) to protect the health of urban residents from air pollution due to fuel combustion; (c) to promote environmentally sustainable development of energy resources; (d) to mitigate potential impacts of energy use on global climate change; and (e) to develop capacity for environmental regulation, monitoring and enforcement. The strategy sets a course of action using three key instruments: policy assistance, knowledge management and targeted investments. I t also emphasizes that local, regional and global problems are excellent opportunities for developing countries to address environmental problems at all levels.

3. The objective of the EER i s to assist countries to better integrate energy sector development and investments with their environmental objectives. The preparation of an Energy-Environment Review (EER) i s one tool proposed by Fuel for Thought for providing recommendations on environmental mainstreaming in the energy sector; the strategy also identifies options and opportunities for the reduction of emissions of greenhouse gases (GHG) through the Clean Development Mechanism (CDM) of the Kyoto Protocol.

4. This diagnostic tool was therefore used to help identify gaps and priorities for assisting the GO1 to move closer to i t s sustainable development objectives. The EER of Iran uses a systematic analytical framework founded in cost-benefit analysis (CBA) and a participatory process to recommend a set o f priority investments and policy reforms. The results o f the EER should be interpreted in the general framework o f promoting economic efficiency through a proper allocation of scarce resources, including environmental resources, as to achieve economic efficiency and environmental and social protection (see paragraphs 91 and 92). Support to GO1 i s consistent with:

The Bank’s commitment to assist i t s clients in achieving their Millennium Development Goals (MDGs). In the case of environment, the MDG #7 related to environmental sustainability calls for mainstreaming the environment in policies and programs, reversing the losses of environmental resources, and improving access to environmental services;

The Banks environmental strategy to mainstream environment into policies, programs and projects for improving the quality of life, the quality o f growth and quality o f global commons;

The Interim CAS of Iran (June 2001) by supporting i t s sector reform agenda on environment, water and waste-water management, housing and social sectors;

The MNA’s regional strategy to strengthen policy reform and institution building that lead to poverty reduction through the appropriate combination o f lending and knowledge.

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5. This Policy Note i s based on the Final Report of the Environmental Energy Review (EER) prepared over two years with the full collaboration with the GO1 and the assistance of international and national consultants'. The EER was financed by the Norwegian Trust Fund for Sustainable Development. The EER report comprises: (a) an analysis of the current situation with regards to energy generation and use; (b) an evaluation of the growth prospects with regards to energy generation and use; (c) the identification of the environmental issues induced by the generation and use of energy and estimation o f the costs o f the damages; (d) the evaluation of the extent of contribution to the climate-change phenomenon through emission of greenhouse gases; (e) the evaluation of the proposed mitigating measures for the previously identified environmental problems; and (f) conclusions and recommendations, and a proposal for an action plan.

6. The EER-Iran was carried out under the guidance and leadership of the Department o f Environment (DOE), which i s the national authority for environmental protection in Iran. A special Energy-Environment Office was established in the DOE under the leadership of the Senior Advisor to the Head o f DOE, who also i s a Vice-president of the Islamic Republic of Iran. The EER Office included full time staff who participated in the study and worked closely with the Consultant, receiving on-the-job training in the process. A Steering Committee was appointed by the Head o f DOE to oversee and review the work, interface with Bank staff and support the Consultant. The Steering Committee was formed with representatives of all those Ministries that have responsibilities within the environment - energy nexus. Along with the Offices o f the DOE (EER Office, Climate Change Office, World Bank Coordination Office), the following ministries were represented in the Steering Committee: Ministry of Oil, Ministry of Energy, Ministry of Industry and Mining, Ministry o f Housing and Urban Development, Ministry o f the Interior, Ministry of Health and Medical Education, Management and Planning Organization, Atomic Energy Organization.

7. Four training workshops were organized by the EER through which 130 participants attended courses on energy and environmental issues in Iran, cost benefit analysis techniques and economic evaluation o f damage costs. A fifth workshop was held in February 2004 in conjunction with the presentation of the Final Report and chaired by the Vice-president o f Iran.

1.2 Linkages to previous work

8. The principal documents consulted for the EER were:

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The Energy Balance Report published by the Office o f Energy Planning (OEP), Ministry o f Energy The Third Five-year Development Plan of the GO1 The Final Report o f the Tehran Transport Emissions Reduction Project (TTERP), implemented by the World Bank with joint financing from GEF and the Municipality of Tehran 1993-1997 The Study on an Integrated Master-Plan for Air Pollution Control prepared by JICA in 1997 that deals also with air quality in Tehran The Greenhouse Report of Iran's Initial National Communication to UNFCCC-COP The Environment Strategy Study o f Iran, prepared with the assistance of the World Bank in 1995

' Environmental Energy Review; Final Report by Electrowatt-Ekono group in association with TERI and Ghods-Niroo, February 2004

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The World Bank report of 1999 on Economical Aspects of Increasing Energy Prices to Border Price Levels The Iran: Medium Term Framework for Transition, Converting Oil Wealth to Development, Country Economic Memorandum, World Bank, April, 2003 The Environment Management Support Project, World Bank, June 2003.

1.3 Purpose of the Note

9. This Policy Note reports the process and achievements of the EER in Iran with special reference to the use o f cost-benefit analysis as a tool for diagnosis, communication and the framing of solutions. I t identifies the value of the methodology as a means of communicating with government about the level of environmental damage, in establishing priorities for environmental policy and in the detailed design of such policies. I t makes recommendations for actions to be taken by the government, i t draws implications for the World Bank programs and it proposes studies to strengthen the methodology. The main focus i s on air pollution because this i s the most important generic impact of energy use. Other important issues are marine pollution from oi l spills and contamination of water from oi l production and processing. Marine pollution i s covered in the Note. Refinery issues are better treated by normal processes of industrial pollution control. The policies recommended wi l l generally lead to more efficient use of resources and a diminution of other environmental impacts and wi l l have no adverse effects on other media, such as water and soil.

10. In this Note, Chapter 2 resumes some of the salient features of recent economic development and the immediate priorities. Chapter 3 analyses the main environmental aspects of sustainable development, the major environmental issues, and the evidence for the political commitment o f the GOI. Chapter 4 reviews the pertinent characteristics of the energy sector, summarizes the supply and demand structure and the level and allocation of subsidies and identifies present trends. Chapters 5 and 6 form the core of the note; Chapter 5 comprises an account of the approach and methodology used in the EER to determine the damage cost of air pollution to the economy; Chapter 6 assesses the likely impact of specific policies o f price reform and sectoral measures for reducing air emissions. Chapter 7 summarizes the conclusions and recommendations, provides a proposal for an Action Plan and draws some implications for programs of the World Bank.

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2 Key Aspects of the Economy of Iran

11. The Iranian economy i s now at i t s most stable since the Revolution. External and internal balances have improved significantly and large surpluses have appeared. The current external balance in 1991/92 was in deficit by $10.2 billion and in 2002/03 was in surplus by $3.5 billion. The trade balance was in deficit by $6.5 billion in 1991/92 and in surplus by $3.9 billion in 2002/03'. Inflation has been systematically reduced from around 20% per annum in 1997 to 11.6% by 2001/02.

12. The country has a population of 64.5 million (2002) and a GDP of US$ 114 billion, Economic growth in 2001/02 i s estimated at 5.7%; this i s the highest rate o f growth since 1992. Nominal GDP per capita in 2002, according to the World Bank World Development Indicators, was 1710 US$/capita (115" place in the world); in PPP measures it was 6340 US$/capita (89" place). The total size o f the economy was US$ 107 billion (34" place) and in a PPP measure was US$415 billion (21" place).

13. The improved oi l prices in 1999 and 2000 were responsible for much o f the recent recovery. The country s t i l l faces severe economic problems. Average unemployment i s about 16% and much higher in some provinces. Because of high fertility rates in the past, the rate of growth of labor supply i s about 5% per year. An enhanced participation o f women in the labor market and continued high fertility rates w i l l sustain this oversupply. Unemployment has been recognized by the leaders o f the country as the greatest economic challenge that they face. The extensive subsidies applied across the economy and especially to energy not only lower efficiency by distorting the perceived value o f factor inputs they also obscure important aspects of government finance. Mineral rents do not appear in the state accounts because they are passed straight through to the consumer in low energy prices. If these adjustments are made, then the implied public sector budget i s around 42% of GDP compared to the 23.5% in the official presentation. This i s double the typical size of a middle income country and even higher than the European average.

14. The World Bank has recently issued a Country Economic Memorandum (CEM) on Iran, entitled Medium Term Framework for Transition: Converting Oil Wealth to Development. The Memorandum concludes that Iran i s about 10% of GDP off an economic equilibrium that would reduce unemployment and improve welfare by converting oi l wealth into sustainable development. The Memorandum estimates that the country i s about 10% of GDP short in the additional savings and investment needed to attain the growth that wi l l reduce unemployment. The CEM also estimates that the optimal management o f the non-renewable resources o f Iran requires that i t allocates about 10% more of GDP to savings and investment and less to consumption. Thirdly, the Memorandum estimates that the 10% adjustment can come from the reform o f the energy subsidy system.

15. The CEM expects the average growth of labor supply to decline from the current level, but calculates that with an annual improvement in labor productivity of 2.4% per year, i t wi l l require an average growth rate of 6.5% to maintain unemployment at 16%; or 8% GDP growth to bring unemployment down to 10% by 2010. Proper economic policies that put the mineral rents to effective use could achieve th is level of growth. These revised economic policies must go hand-in-hand with proper environmental policies to ensure part o f the nominal growth i s not destroyed by disproportionate environmental damage.

* Iran Medium Term Framework for Transition, World Bank Country Economic Memorandum, April 2003.

4

3 Environmental sustainability in Iran

3.1 Political commitment

16. Iran has made a strong political commitment to sustainable development. The Iranian National Committee on Sustainable Development i s the key institution. The Committee i s chaired by the Head of the Department of the Environment who i s a Vice-president of the Islamic Republic o f Iran; it includes members from the President’s Office, the Department of Environment, the Meteorological Organization, the Management and Planning Organization, the Academy o f Sciences, the Ministries of Culture and Higher Education, Oi l and Energy, Housing and Urban Development, Mines and Industry, Telecommunication, Foreign Affairs, Jihad-Agriculture, and Health. Iran participated in the recent Johannesburg Summit.

17. Article 50 of the Constitution of the Islamic Republic of Iran states that “ in the Islamic Republic, it is considered a public duty to protect the environment where the present and jkture generations are to have a thriving social life. Thus, any form of activity, whether economic or otherwise, that causes pollution of or irreparable damage to the environment is prohibited”. Political uncertainties and the Iran-Iraq war prevented the proper implementation of this constitutional provision during the early years after the Islamic Revolution. In recent years, the constitutional backing has been reinforced and supplemented by the reform process that the Iranian Government has implemented. Official statements recognize the need: a) to mainstream environmental considerations into policy making and planning; b) to strengthen the national environment apparatus; c) to enhance regulatory standards; d) to provide for more efficient monitoring; and e) to foster greater public education and public awareness.

18. The recognition by the GO1 o f the need to better manage the environment i s slowly translating into improved policies. In Chapter 12 o f the Law of the Third Plan for Economic, Social and Economic Development, the Government introduced measures “to protect the environment and to secure sustainable exploitation of the country’s natural resources”. The Law recognized for the f i r s t time the polluter-pays principle and required al l polluters to comply with appropriate standards and guidelines. It also established in i t s Executive By-laws a dual system of fines for polluters as well as tax exemption for establishments that invest in pollution control and prevention or in energy conservation and efficiency. In Chapter 18, pertaining to urban and rural development, the Law requires cost recovery for waste water and a system of fines in the event that establishments do not comply with appropriate treatment. Cost recovery for treated waste water has been introduced in Tehran. Full cost recovery for the disposal of municipal waste wi l l be initiated in Tehran as a f i r s t step that could be expanded in other major cities. The fines and tax incentive systems have not yet been made operational, but the process indicates an active engagement by the Legislature, Executive and Judiciary to develop a proper regulatory structure. The fourth Economic and Social Development Plan i s expected to further emphasize sustainable development as the core o f economic growth.

19. However, there i s a long way to go to reach th is objective. The Environmental Sustainability Index (ESI)3 based on a number o f indicators, puts Iran in the rank of 104 o f a total o f 122 countries with an ESI index of 38.4, indicating a low sustainability.

’ Esty and Comelius, World Economic Forum Publication, 2002.

5

3.2 Environmental issues

20. The pattern of socio-economic development, linked to the physical character of the country and the geo-political context, has engendered a variety of environmental problems that are structurally integrated into the development process and have been difficult to treat. They include:

0 Water scarcity and quality 0 Urban and industrial pollution 0

0 Land degradation and deforestation 0 Exposure to natural disasters 0 Trans-boundary and regional disputes

Untreated hazardous and municipal wastes

3.2.1 Water scarcity and quality

21. The renewable water resource available annually i s about 2150 m3 per capita. Access to water i s unevenly distributed, in part because of policies that allocate 90 percent o f the water resources in Iran to agriculture in an attempt to increase self-sufficiency in food. Chronic deterioration of water quality aggravates the scarcity. The main causes of the deterioration are the disposal of untreated municipal wastewater, industrial wastewater and contaminated drainage water from agriculture to groundwater, combined with a decreasing flow. Twenty five rivers out of thirty five are heavily polluted and out of thirteen groundwater tables, ten show medium to high levels of pollution4.

22. So far, only isolated and scattered sampling and analysis o f water quality have been made and the monitoring infrastructure in place i s too slow (and insufficiently reliable) to provide an adequate basis for intervention. As a part of a World Bank-financed Environmental Management Support Project (US$ 20 million), i t i s planned to carry out a large scale monitoring program o f the Karun river, which i s one o f the largest and most important rivers. Waste water quality i s expected to improve as result of the water supply and waste water projects co-financed by the World Bank in Tehran, Ahwaz and Shiraz.

3.2.2 Urban and industrial pollution

23. The rapid and uncontrolled expansion o f the main cities, particularly Tehran, Mashhad, Isfahan, Tabriz and Ahwaz, coupled to growth in heavy industry with little environmental control, has seriously damaged air quality. The life of motor vehicles in dry countries like Iran i s long and the capital stock in Iran i s aged. Vehicle performance i s characterized by old technology, poorly maintained. The high altitude o f the country reduces combustion efficiency. Roads are congested, vehicle speeds are low. Consequently, the impact of the transport sector on air pollution i s substantial; emissions of carbon monoxide alone are estimated at 5 million tonnes per year across the country of which 1.5 million tonnes are in Tehran.

24. Some initiatives have been taken to reduce vehicular emissions in Tehran, Shiraz, Mashhad, Isfahan and a few more of Iranian megacities; Compressed Natural Gas (CNG) has been introduced and recently the GO1 has required that all imported vehicles and all new locally assembled and manufactured vehicles must be equipped with catalytic converters. Unleaded gasoline was also introduced. The consumption of natural gas by taxis and passenger cars reached 1976 million m3 in

Compilation by the Department of Environment in Iran.

6

2000. A sustained switch from gasoline or gas-oil to CNG i s expected. Metallurgical industries, refineries, cement works and electroplating also contribute to air pollution, especially when they bum high sulfur fuel oil. Low prices for energy weaken the incentives to industry to convert to clean and efficient natural gas.

25. The topography of the country causes wind speeds to be low, so pollution i s not blown away and the aridity much of the year means that pollutants are not washed out. Residence times are long. Standards for ambient air are stringent, but frequently exceeded. Key pollutants such as PMlo, SO,, N O , and Volatile Organic Compounds (VOC) exceed WHO guidelines by between 30-350%. Air pollution i s estimated to cause over 4,000 deaths per year in Tehran alone. The Tehran Transport Emission Reduction Project (TTERP) assessed the cancer risk from the exposure to mutagenic substances, taking the NO, concentrations as a proxy for these; it estimated 3500 cases a year might be attributed to air pollution.

26. Schools are occasionally closed and residents are asked to remain indoors because o f the health r isks o f heavy air pollution. In November 2002, residents of Tehran were advised to remain at home because air pollution, particularly carbon monoxide, had reached emergency levels. Detailed air pollution reduction strategies for Tehran and Isfahan have been completed, but implementation i s problematic.

3.2.3 Untreated hazardous and municipal wastes

27. Approximately 15 million tonnes of municipal solid waste i s generated annually, o f which about 2.5 million come from Tehran5. Industries in Iran generate about 100,000 tonnedyear of hazardous waste. Hazardous waste, agricultural and hospital wastes are mixed with municipal waste in open dumps. No appropriate sanitary landfills exist. The GO1 and the World Bank are preparing a municipal solid waste management project for Tehran which wi l l set forth the institutional, legal and financial framework for an integrated solid waste management system and wi l l finance the f i r s t sanitary landfill in Iran.

3.2.4 Land degradation and deforestation

28. I t i s estimated that between 1.5 and 8 million tonnes o f soil a year are lost from erosion. The loss comes from poor irrigation, poor road construction and overgrazing. The poor irrigation practice causes a build-up of salts in the soil which, combined with water-logging, leads to an estimated loss of 2.5 percent in agricultural productivity. A joint study by the FAO, UNDP and UNEP estimated that 45 per cent o f agricultural land i s affected by light to moderate water erosion. Overgrazing i s a consequence of population pressure and social change, particularly urbanization and the eventual pressures on marginal lands.

29. The total forested area of the country has reduced, over the past 57 years, from 19.5 million ha. to 12.4 million ha.6; this corresponds to an annual loss o f 120,000 ha. of forest or a daily loss o f 340 ha. The World Bank and the Government of Iran are preparing a project on integrated land and water management (US$ 120-140 million) to enhance current GO1 efforts to achieve sustainable land and

Organization o f Waste Recycling and Composting (OWRC), Tehran.

Department o f Environment, Private Communication, 2003.

7

water management in the Alborz river basin. The project includes a large component on watershed and forestry management.

3.2.5 Exposure to natural hazards

30. Iran experiences periodic droughts, floods, dust storms, sandstorms and earthquakes along the western border and in the northeast. The last major earthquake occurred in December 2003 in the city o f Bam in which 30,00040,000 people died. An earthquake in 1990 was equally disastrous. In 2000, according to the OFDNCRED International Disaster Database, 37 million people were affected by drought and 25 million people in the following year. Severe floods in 1980 and in 2001 affected around 1 million people on each occasion.

3.2.6 Trans-boundary and regional issues

31. Iran i s one of the littoral countries of two international water bodies; the Persian Gulf in the South and the Caspian Sea in the North. The National Strategy for Environment and Sustainable Development has estimated that a total of 1.5 million tons of oi l were discharged to the waters of the Persian Gulf in the period of 1980 to 1989. The Caspian Sea i s also vulnerable to discharges from oi l production and transport. Producing two percent of global greenhouse gas emissions, Iran i s a significant contributor to climate change. Per capita carbon dioxide emissions increased by almost 25 percent between 1990 and 1999, and per capita energy use increased by 50 percent; the discrepancy between the two figures i s a consequence of the importance of natural gas in the incremental fuel mix.

3.2.7 Institutional and legal framework

32. The Constitution of the Islamic Republic of Iran requires the protection of the environment. Despite th is constitutional support it has proved difficult to elaborate an effective legal framework. The Environment Protection and Enhancement Act was passed in June 1974 and created the Department of the Environment (DOE) as an entity affiliated to the Prime Minister's Office. This affiliation was later transferred to the Office o f the President. The President chairs the Council and a Vice-president heads the Department. Much of the activity of the Department i s concemed with the conservation aspects of the environment and the operation of national parks and protected areas. There are 28 provinces in Iran; each has a DOE provincial directorate that monitors all aspects of environmental protection and the implementation of Department programs.

33. the following:

There are legal provisions for levies, taxes and charges on polluting enterprises. These include

0

0

Fines on polluters that exceed the national standards set out in the executive by laws o f the 31d Plan. The fines collected from the city of Ahwaz amounted to US$5.0 million in the f i r s t year; Revenues from the law known as law 1/1000" which mandates that enterprises should deposit l/lOOO' of their sales revenues in an escrow account for expenditures on improvement o f environmental conditions in accordance with a plan which should be approved by DOE. Such expenditures would be deducted from their taxes on their net income; The revenue from 1% o f the CIF costs of all automotive parts and vehicles. At present, the revenue goes to the Ministry of Finance. The newly passed law in 2003 merged th is 1% with all other sales taxes amounting to a total of 3% and the generated revenue goes to the treasury.

0

34. In general scope and orientation, the environmental legislation o f Iran i s comprehensive; it covers the main environmental issues and defines appropriate standards; when specific Iranian standards are not defined, international standards are adopted. The problems l i e so much in the scope o f the

8

legislation, but in the regulatory principles adopted and in the provisions for implementation and capacity for enforcement of the legislation.

35. The Environmental Management Support Project wi l l provide technical assistance to the DOE and selected provinces to strengthen capacity in policy formulation, to enhance the legal framework, to monitor and enforcement of water and air quality and to reinforce public information, and dissemination.

3.2.8 Summary of issues

36. There is evidence of strong commitment to sustainable development at the highest levels of government in Iran. Despite th i s political support and many appropriate actions, there i s s t i l l inadequate s ign o f success on the ground. Among the reasons for this are:

0

0

There i s no comprehensive environmental policy other than the provisions of the Economic and Social Development Plans; The Environmental Protection and Enhancement Act o f 1974 for Improved Environmental Protection, within existing Legal Framework much needs to be updated to introduce modern principles of environmental regulations; There i s insufficient sustainable finance for environmental services and investments. There i s some revenue to the DOE from fines and taxes and the GO1 wi l l provide in the 4" Economic and Social Development Plan for an environmental fund; There i s a lack of sufficient analytical capacity to assess the economic and financial costs and benefits o f policies, programs and projects; Mainstreaming o f environmental concerns into line Ministries i s not yet effective; Massive price distortions in the economy, if they persist, wi l l be incompatible with sustainable development.

0

0

0

0

37. As Iran struggles with i t s longstanding environmental problems, it must consider i t s response in the context o f two main economic challenges: (i) domestic economic liberalization, as it i s committed to market-based economic reforms; and (ii) entry into the global economy. I t must foster economic growth while properly managing i t s natural resource base and remaining competitive in international and domestic markets. As Iran moves forward with trade liberalization, private sector development, and privatization, the challenge for the World Bank i s to assist them in these transitions.

3.3 The costs of environmental degradation

38. The World Bank i s preparing an assessment o f the cost of environmental degradation in Iran that wi l l be completed in FY 05. Meanwhile, the GO1 has requested Bank assistance to develop a strategy to better integrate environmental concerns into policy for the energy sector. The energy sector i s the key to the Iranian economy; it i s the main engine o f future economic growth, a principal cause of environmental pollution and damage, and a major source o f market distortion. Within the scope of t h i s immediate assistance, there i s a focus on air pollution, which i s an important and direct impact of energy use on the environment, and the one affecting most people, especially the inhabitants o f the large cities, with Tehran in the forefront.

39. A critical tool for mainstreaming the environment into energy policy i s a mechanism to identify the strategic political priorities. A systematic approach i s needed to ensure that a) environmental considerations enter the development planning process at an early stage, b) there i s a multi-sectoral and long-term vision of development; c) there i s efficient allocation o f the Government's scarce resources o f

9

time and capital. Several methodologies are available for th is purpose. The tool selected for the EER i s cost-benefit analysis (CBA).

40. Cost-benefit analysis quantifies the benefits of environmental control and compares them to the costs. To do this requires an effective means o f assessing the cost of environmental degradation. Methodological choices are inevitable. The choice made by the EER i s to represent the damage from any pollutant by a cost per physical unit that i s applied to all emissions of that type. This procedure constitutes the f i rs t step towards economic valuation of environmental benefits. The results from the study o f environmental degradation in Iran now in process may help refine the valuation. Specifically, damage cost assessments can serve as an instrument to:

0

0

0

Identify the environmental impacts that impose the largest cost on society; Identify the environmental impacts that most undermine the social and economic development process; Provide a basis for integrating environmental issues into the financial and economic evaluation of investment projects and sector and economy-wide policies and regulations; Provide an economic basis for the allocation o f scarce private and public resources towards environmental protection.

41. The emphasis of immediate concern on air pollution does not mean that other environmental issues such as water and land degradation are o f secondary importance and should not be addressed. Rather, this Policy Note describes a process and methodology for using damage-costs as a tool for engaging the GO1 into a policy dialogue for integrating environmental concerns in the energy sector. Such process and methodology could be adapted and be used in the policy dialogue in other sectors such as water, land degradation.

10

4 The Energy Sector in Iran

42. The purpose of th is Chapter i s to provide a quick overview of the energy sector in Iran; it presents the information that i s necessary to understand how the environmental issues link back into the structure of energy supply and use. The Chapter f i rst reviews the supply and conversion activities in the sector, then surveys the historical trends in demand; from these analyses it develops energy balances for 2001 and future years. Finally, conclusions are drawn about the implications for the environment.

4.1 Energy supply and conversion

43. Iran has large resources of hydrocarbons that provide an opportunity either for prodigal use and environmental destruction or for a sound and sustained development. Iran i s OPEC’s second largest oi l producer; at the end of 2002 it possessed 12.3 billion tons of proved reserves, amounting to 8.3% of global proved reserves. The Figure 4.1 shows crude oi l production and export over the last 30 years in million barrels o i l equivalent (mboe). Oi l production was much higher in the 70’s than in recent years (over 2000 mboe/yr). The most recent peak in production was around 1993 to 1995 (close to 1500 mboe/yr), but has since fallen and in 2002 was about 1300 mboe/yr. Iran aims to raise production to close to 3000 mboelyr by about 2025, and i s seeking foreign investment to t h i s end.

Figure 4.1: Production and export of crude oil

Crude Oil Production and Exports 1 2500 I

0 Production W Export

44. Production o f oi l in 2001 was 1,274 million barrels; 775 million barrels were exported and the remainder was refined domestically. Iran has nine refineries with a nominal capacity of 1.35 mbd. Many of these refineries were established in the 1970s. The substitution of heavy fuel o i l by gas in power generation has created a surplus of heavy fuel oi l that i s exported; exports were around 80 mboe in 2001. Because of the rapid increase in the ownership of private cars there i s now a substantial import of gasoline, around 17 mboe in 2001 and rising steadily.

Some have since been upgraded.

45. In 2002, there were 23 trillion cubic metres of proved reserves o f natural gas in Iran, equivalent to 14.8% o f known world reserves and the second largest in the world after the Russian Federation. Production of natural gas in Iran that year was 64.5 billion cubic metres (bcm) giving it a reserves to production ratio of around 360 years, compared to 8.6 years in the U S and 81 years in the Russian Federation.

11

46. O f the 64.5 bcm of natural gas produced in 2002, around 21.1 bcm was re-injected into the reservoirs and 10 bcm was apparently vented or flared. Venting and flaring are economically wasteful and environmentally damaging procedures. About 14.7 bcm per year of natural gas are used in power generation and 12.9 bcm in the residential and commercial sectors. There i s little international trade o f gas at present, but there i s no doubt that Iran wi l l become a major exporter of natural gas in due course. In the meantime, the good availability of natural gas provides an important opportunity for environmentally sound development.

47. Thirteen hydropower schemes operate in Iran with a total capacity of 2,000 MW; they generated 6,908 GWh in 2000, equal to 7.4% of the national output. Under the Third Plan, 3,773 MW i s being added to the present hydroelectric capacity and by the end o f 2004 the total hydroelectric capacity wi l l reach 5,776 MW. Eight large hydropower projects are now under construction. These are expected to add 8,000 MW of capacity by 2006. The theoretical potential for power generation from unconstrained hydropower development projects in Iran i s estimated at 42,000 MW.

48. Coal has been produced since the early sixties but, because of the abundance of oil and gas, has played only a minor role in the economy. A large new underground mine, o f 3.5 million tonnes per year, may be developed at Tabas. The project needs access roads, water pipelines, railways and an airport and would impact seriously on the environment.

49. Iran has a long-standing commercial nuclear program. In 1995 and 1998, Iran signed agreements with Russia to complete the 1,000 MW pressurized light water reactor at Bushehr. The power plant i s to be commissioned in 2004 and has been approved by the International Nuclear Energy Agency (INEA). A 10-year agreement has been signed with Russia for fuel. The nuclear waste w i l l be handled under the supervision of the INEA, and brought to Russia for disposal. The present aim i s to have 7,000 Mw of nuclear power installed by 2021. The EER did not consider th is expansion of nuclear capacity in i t s forecasts as the abundant natural gas and good quality hydropower appear to offer cheaper and less environmentally problematic alternatives for power.

50. Despite i t s vast oi l and gas reserves Iran has also renewable energy programs in photovoltaics, wind, geothermal and biomass. These were investigated within the EER. They are generally not competitive with electricity from natural gas-fired combined cycle plant, but they do have global environmental benefits and were considered within the EER as candidates for the Clean Development Mechanism and related schemes.

51. Iran has an installed electricity generation capacity of 34,200 MW of which 92.6% i s thermal and the rest hydroelectric. The total annual production in 2002 was 130,083 GWh. Thermal plants bum natural gas (70.8%) and fuel oil, but conversion of the remaining fuel-oil plants i s underway. Only the more recent gas plants are combined cycle. There are plans to convert these to combined cycle. The 3rd Five Year Plan seeks to add 12,600 MW of capacity and to increase the average efficiency from 33.8% to 36%. A capacity of 96,000 MW i s planned for 2020.

12

4.2 Energy demand

52. now. Figure 4.2 shows the trend.

Per capita consumption of energy has risen from 2.0 boe per year in 1965 to 10 boe per year

Figure 4.2: Per capita energy consumption (in barrels of crude oil equivalent / year)

I Per Capita Energy Consumptlon

I ” * 1

53. Gas i s widely, but not universally available in Iran. Of the urban population of 42 million, 30 million were covered by the year 2000. There i s a strong consumer preference for natural gas as it i s cheaper than other domestic fuels. Electricity consumption has increased from 59,102 GWWyr in 1990 to 121,332 GWWyr in 2000, at an average annual growth rate of 7.7%. Per capita consumption grew at an average rate of 5.8% per year. The tar i f fs for electricity sales (US 1.5 cent/kw) offer substantial subsidies to residential consumers, especially the smallest.

54. Tables, the designation “ResComm” refers to the combined residential and commercial sectors.

Energy demand in Iran in 2001 i s summarized in the Figure 4.3. Here, as in other Figures and

Figure 4.3: Energy demand in 2001 (mboe) I

5 f

E

al

al 0 a

300

250

200

150

100

50

0 Agriculture. RescOmn Industry Transport Others

Eec’y Lffi Fueloil Gasoil Kerosene Gasoline Natural Gas Solid fuels

Source: Energy-Environment Review and Energy Balance 2001, Ofice of Energy Planning

13

55. The Country Economic Memorandum made independent assessments of the energy balance. There are slight differences in the figures reported by the CEM and those calculated by the OEP. The differences arise in the use o f different base years and in different conventional treatment of primary sources such as hydro. There are no substantial divergences.

56. Figure 4.4 compares the energy intensities of Iran and selected developed and developing countries. The figure suggests that Iran i s less efficient than other countries. The energy intensity value i s higher than that characterizing most industrial economies and also higher than more densely populated developing countries such as China and India

Figure 4.4 International comparison of energy intensity I 0 3

0.25 n k 0 2 8 2 0 1 5

5 0.1

0.05

0

57. Energy in the domestic market i s heavily subsidized. The target increase in energy price of 10% per annum i s lower than inflation (1 1.4 % in 2001). The EER estimated the total subsidy in 2001 at 1 1 8 ~ 1 0 ' ~ Rials (US$ 15 billion). The Figure 4.5 shows how the subsidies are distributed by fuel and sector. The Office of Energy Planning (OEP) has independently estimated that subsidies in 2000 were 1 1 4 ~ 1 0 ' ~ Rials. Total GDP in nominal Iranian Rials in 2001 i s calculated by the IMF to be 6 6 2 ~ 1 0 ' ~ Rials. Energy subsidies therefore amount to 17.8% of the Iranian GDP'. Such a level o f subsidy inevitably leads to huge distortion in consumer choice and indirectly to high environmental damage.

58. The environmental damage occurring from the production and use of energy should not be seen in isolation from other distortions in the economy. Environmental damage i s one special case o f a systemic misuse of resources arising in part from poor price signals. The widespread subsidy o f energy prices not only causes damage to the environment from profligate use, but at an economic level also reduces economic growth and the medium-term capacity to create modem jobs. There i s concem that sudden increases in energy prices wi l l cause pressure on prices, short-term unemployment and local hardship. The resources freed by proper pricing wi l l more than compensate for this short-term social impact, but appropriate safety measures and institutional structures to target affected groups need to be found.

' The CEM estimated a somewhat lower value o f subsidy at around 11% o f GDP. The difference arises from consistently lower assumptions about the border price o f fuels. This can in tum be traced to fluctuations in o i l prices.

14

Figure 4.5: Subsidies to energy by fuel and sector ( 1OI2 Rials) 1

Source

Hot flaring

Ventinglcold flaring

Total flaring

C02 equivalent

Natural Elect Gaso- Kero- Gasoil Fuel LPG Gas line sene Oil

co2 (kt) Cl& (kt) Total

31,537 492 32,029 (kt C02 eq.)

93 1 93 1

31,537 1,423 32,959

31,537 29,883 6 1,420

Source: Energy-Environment Review

59. The Islamic Republic of Iran signed the United Nations Framework Convention on Climate Change at the Rio de Janeiro Earth Summit in 1992 and ratified the Convention in 1996 as a Non- Annexl-Party. I t has submitted i ts First National Communication to the COP o f UNFCCC recently. Iranian annual GHG emissions are estimated to have been 405,000 Gg C02 eq., or 6.7 tons per capita in 1994. The contribution of Iran to the global C02 emissions i s about 2%. This i s similar to some important industrialized countries such as Canada or France.

60. Very large volumes of natural gas are flared or vented in Iran at the present time. The Iranian submission to the UNFCC estimates the greenhouse gas emissions from venting and flaring in 1994 to be about 60 mt of CO2eq. Full realization of the flare gas recovery project as included in the 3rd Plan would result in a reduction o f about 180,000 Gg CO2eq. Several projects have been implemented or are in construction, others are at the design or concept stage. The net impact of these efforts on the volumes of gas flared i s reduced to some extent by flaring from new sites as new production facilities are developed. The Go1 intends to eliminate flaring by the end of the 4th Economic and Social Development Plan.

Table 4-1: Impacts of gas flaring (1994/95) 1

4.3 Energy trends

61. The EER provides forecasts of energy use and associated environmental damage up to 2019 in the absence of intervention. I t then assesses the potential impacts on these trends o f energy price reform and sectoral measures. The starting point for this analysis i s a forecast of the energy balance in future years and th is in turn i s based on the historic energy balance for 2001 shown in the Table 4.2. This

15

balance has been constructed from the Iran Energy Balance Report, 2001 o f the Office of Energy Planning and the Iran Statistical Yearbook, 2002.

t

62. The base-case forecast i s a Business As Usual (BAU) scenario where current policies and trends are assumed to continue. The Government o f Iran has instructed that nominal energy prices should increase by 10% per year during the period of the 3rd Plan and must rise thereafter in such a way as to maintain the real price of energy constant. The Office of Energy Planning (OEP) in the Ministry of Energy has projected energy demand up to the year 2021 on the basis of these assumptions and the EER adopts this work as the basis o f i t s reference scenario.

0 Industry ResComm

63. The forecast for power generation assumes that cost-effective hydropower developments proceed. The forecasts further assume that the use of fuel oil for power generation i s phased out by 2014 and no new fuel oi l powered plant i s built. All incremental generation, apart from that from new hydro and renewable plants, comes from natural gas burnt mainly in combined cycle plants.

Y a 40 , Ull Agriculture 'b 20

0

N

7-

64. The energy balance for 2019 so calculated i s shown in Table 4.3. The balance i s simplified compared to that calculated for 2001, by removing condensate and solid fuels, for which the EER had no estimates of future supply or demand and for which it proposed no policies, and also by removing the productive activities that do not have environmental impacts addressed by any o f the policies treated in the EER. In this base-case scenario, the total primary energy requirement at the end o f the 6th Plan in 2019 i s estimated at 1947 mboe, compared to the 878 mboe recorded in 2001. This i s an increase of 122% or 4.5% per year on average. This rate o f growth in primary energy demand i s a little higher than the 4% rate of growth in GDP that i s envisaged from 2005 to 2021. The relative growth rates imply an income elasticity of 1.1.

65. Under present pricing policies, the subsidy to the sector wi l l have risen to 2 8 8 ~ 1 0 ' ~ Rials by 2019, measured in Rials of 2001. The OEP projections assume 6% GDP growth to the end of the 3rd Plan and 4% thereafter. If achieved, th i s would result in a GDP in 2019 of 1 4 2 0 ~ 1 0 ' ~ Rials of 2001. Energy subsidies therefore wi l l amount to 20% o f GDP. The allocation o f subsidies by fuel and sector i s shown in Figure 4.6. Domestic energy, especially electricity, gas-oil and gasoline dominate.

Figure 4.6: Allocation of subsidies by fuel and sector (2019) I

Natural Elect Gaso- Kero Gasoil Fuel LPG Gas line Oil

16

4.4 Implications for the environment

66. The analysis shows that if energy demand continues to grow in line with historic trends then consumption wi l l more than double by the end o f the 6* Plan. Iran has the resources to permit th i s extravagance, but i t w i l l jeopardize future generations, put huge stresses on the economy and exacerbate what i s already extreme environmental damage.

67. investigates the impacts o f price reform and sectoral measures to control emissions.

The next Chapter describes the methodology used to estimate damage costs and then Chapter 6

17

5 Assessment of Damage Costs in the Energy Sector

68. Estimation of damage costs i s a key step in the cost-benefit analysis (CBA) of environmental policies. CBA i s the usual tool for policy assessment in many developed countries, especially in the EU and i t s Member States. I t i s by no means a determinant of policy, but it provides the fundamental methodology for the screening and diagnosis o f policies and standards. The estimation of damage costs i s one way among several to estimate willingness to pay for environmental improvement. If this willingness to pay can be established at different levels of environmental impact then the set of values forms a demand curve for environmental improvement. When combined with a marginal cost abatement curve, that i s essentially a supply curve for environmental improvement, we can establish in principle what actions and policies conform to consumer valuations of the environment.

5.1 Methodology

69. There are two approaches to the identification o f health damage costs for Iran:

1. The creation and characterization of a detailed impact pathway approach for Iran. This would require the identification and characterization of the five steps by which economic activity creates contingent damage, namely determination of: (i) activity data; (ii) emission factors; (iii) dispersion processes; (iv) dose-response functions; and (v) economic valuations. Such work i s demanding of time and resources and it was not possible within the EER to perform such a study, mainly because of unavailability o f reliable air quality data.

2. Transfer of existing values derived outside Iran, but calibrated to the Iranian case. This approach was used by the EER.

70. Damage costs are one way of determining a demand curve for environmental improvement. An assessment of damage costs requires characterisation o f the pathway along which pollutants travel from the source to the receptor. I t requires that the emissions associated with a process or activity be known, that the mechanism of dispersion in the atmosphere and any subsequent chemical recombination can be described, that the response of a receptor to the received dose i s known and determined and that the response can be valued. A great deal of work has been done on establishing damage costs. A major reference for the assessment o f damage from air pollution i s ExternE, a project launched a decade ago by the Commission o f the European Community. The techniques have been widely used both in the formulation o f EU Directives and also by Member States for national legislation. Work to date has concentrated on air pollution from power generation and transport, but it i s in the process o f extension to other media.

The other principal approach i s to ascertain the Willingness to Pay.

Results have been used to support EU legislation concerning: 0 legislation concerning incineration, 0

0

0

0 the Emission Ceilings Directive, 0

0 the Auto-Oil programme, 0 and much other work.

the Large Combustion Plant Directive, the EU strategy to combat acidification, the National Air Quality Strategies,

proposals under the UNECE multi-pollutant, multi-effect protocol,

20

The damages considered within the scope o f th is work include damage to health (mortality and morbidity), buildings, crops and eco-systems. The loss of economic output from health impacts tend to dominate. On the assumption that the value of these impacts i s roughly proportional to the income o f the community concerned the values derived for the EU have been scaled by GDP to provide f i r s t order estimates for Iran. Evidently the application of the full impact-pathway analysis would be preferable, and the possibility of such research should be considered, but the resources to make these direct estimates were not available to the EER. The benefit transfer approach was therefore adopted. The limitations of the methodology should though be borne in mind.

PMlO

so2

7 1. The values obtained when this conversion was applied to the ExternE values are shown in the Table 5.1. Only a restricted set of local pollutants, PMlo, SOX, NOx and CO was included in the EER, but these are the pollutants that cause most of the total damage. Other pollutants such as VOCs are important in specific localities, but were not included for the sector appraisal. Ozone i s a product of chemical reactions initiated by NOx and the damage costs for NOx include these secondary impacts. Lead was not considered as it i s being phased out at present. The values in the Table are not of course precise. Taking into account the ranges quoted for the original estimates and some of the uncertainties in the benefit transfer it i s likely that the range o f estimates i s within 50% and 200% of the mean. These ranges are shown. They offer some indication o f the likely robustness of cost-benefit calculations made using these values. Although there i s th is substantial degree of uncertainty regarding the exact damage costs, the errors wi l l tend to be consistent over time and therefore time trends wi l l be unaffected.

low medium high

34,400 2,150 4,300 8,600

14,600 912 1,825 3,650

72. For global pollutants, a range of damage cost values was used. A low estimate was based on the value of trades in the Prototype Carbon Fund (US$ 3/tonne C02 equivalent); a medium estimate was based on anticipated values in the future EU carbon trading scheme (US$ lO/tonne C02 equivalent) and a high estimate was based on damage cost assessment made by the PCC (US$ 80/ tonne C02 equivalent).

NOx

co COZ

Table 5-1: Benefit values assumed for Iran 1

4,800 300 600 1,200

1,500 94 188 376

24 3 10 80

Pollutant I (kRiaVton) I I ($/tonne> I

73. I t i s clear that calculating values of damage costs on the basis of a single value for each tonne of emissions i s a gross simplification. In reality, the link between the quantity o f emissions and the eventual damage costs i s complex. Many factors wi l l affect the damage costs caused by a unit of emissions, including:

0

0

Weather conditions (wind speed and direction, air pressure, whether i t i s raining, etc.). The height and velocity of emissions to air.

21

e

e e

e

e

74.

The population eventually affected (number, distribution by age and income, proportion o f vulnerable people, etc.). The existence of other chemicals in the atmosphere. The retention of the pollutants in the atmosphere. Pollutants stay in the air for longer in Iran than in Western Europe. There i s little rain and average wind speeds tend to be low. The impact of a ton of pollutant i s therefore higher in Iran than in temperate zones. The EER made no allowance for this. Saturation effects. The nature of marginal impacts differs at higher ambient levels of pollutants. In areas of high concentrations, marginal reductions can have a significant benefit for the environment. The effects were not calculated in the EER, so the damage costs may under-estimate total value. Different economic preferences. Valuation of the environment may shift with income. There i s evidence that with wealth there i s a disproportionate increase in perception of environmental benefits. The analysis did not make th is adjustment because there i s no obvious basis for estimating the income elasticity of environmental values in Iran.

In practice, there i s a range o f damage costs for unit emissions of each pollutant. The EER made no attempt to establish th i s range. The weaknesses in the available data on the geographical distribution of emissions and the fuel used, coupled with the lack of data on air pollution outside the major cities and on epidemiological studies throughout Iran, means that assigning values within ranges i s difficult. As the understanding of the derivation and application of these values increases in Iran, it may be possible to assign different values dependent on location and activity. This could be a relatively simple way of improving the analysis.

5.2 Estimates of local environmental damage costs in 2001

75. From the energy balance for 2001 shown in Table 4.2, the EER estimated the emissions to air from each transformation and consumption activity as well as the corresponding damage costs. A summary o f the calculated emissions and their origin by sector i s shown in the Figure 5.1. The Figure shows the percentage o f emissions of each pollutant that arise from each sector. The numbers underneath the designation o f the pollutants are the annual emissions in kilotonnes, or in the case of CO2, megatonnes.

Figure 5.1: Emissions by sector

PMlO sox co NOx C02 (131 kt) (1349 kt) (5435 kt) (1106 kt) (352 mt)

ResComm

I PowerGen

22

76. B y applying the unit damage costs presented in Table 5.1 to the emission balances described above, the environmental damage by fuel, sector and pollutant can be assessed. The annual sum of damage from all sources in 2001 was estimated to be about 3 8 ~ 1 0 ' ~ Rials ($4.7 billion); this i s equivalent to 5.7% of nominal GDP. This i s a large figure, but not out-of-line with estimates made elsewhere. The World Bank Technical Paper No. 508 on Urban Air Quality Management cites damage from air pollution of up to 10% of urban income in Bangkok, Kuala Lumpur and Jakarta. The large discrepancy between nominal and PPP measures of GDP in Iran also impacts on th is percentage figure. Because the damage costs have been adjusted to reflect PPP estimates of per capita GDP, it i s perhaps more reasonable to compare them to PPP estimates of national GDP in t h i s case the estimated damage falls to 1.6%.

77. The origin of damage by sector, fuel and pollutant i s shown in the Figures 5.2.and 5.3. These figures show the percentage contributions of the different sectors respectively to the total damage associated with each fuel and pollutant. The numerical entries attached to each bar are the total damage from that fuel or pollutant calculated in 10l2 Rials. I t can be seen that transport i s by far the largest contributor to damage and power generation i s the second. Most damage from transport occurs from low-level emissions o f particulates, carbon monoxide and oxides of nitrogen. Local damage from the power sector i s mainly from oxides of sulfur. The substitution of natural gas for fuel oil in power generation i s proceeding rapidly and this can be expected to take care of much of the environmental damage arising from this activity. The transport sector i s clearly the proper focus for future effort.

Figure 5.2: Damage by fuel and sector in 2001 ( 10l2 Rials) I

100%

80%

60%

40%

20%

0% NatGas (1.1) Crude (2.9) Gasoline (9.0) Gasoil (9.5) Fuel Oil (14.5) Total (37.7)

Damage by fuel loi2 Ws: $1 bn = 8 x 10l2 Ws

23

Figure 5.3: Damage cost by pollutant and sector in 2001 ( loi2 Rials) I 100%

80%

60%

40%

20%

0% m10 (4.5) SO2 (19.7) Nox (5.3) co (8.2)

Damgecostin1012FUs:$l bn=8x 1012Rls

Others

Industry 0 Res” 0 Agriculture m Power generation

Oil refining

Transport

78. Figure 5.4 shows the damage cost by fuel compared to the market price and the opportunity cost. The total height o f the bar indicates the full economic cost o f the fuel under the present conditions of use. The large damage cost arise of gasoline reflects the huge emissions o f carbon monoxide from old, inefficient and badly maintained cars. If the technology were to be improved then the economic cost of the fuel in th is sense would fall.

8

7

6

5

z 4 a 3

2

1

0

1 Natural Gas Gasoline Gasoil FuelOil

Damage cost Subsidy Market price

24

5.3 Global damage from flaring of natural gas

79. The EER estimates the damage cost to the global environment from the flaring of natural gas. The C02 equivalent of 60 million tonnes equals 15% of the GHG inventory of Iran. The damage, assessed on the basis o f a carbon price of $10/ton C02, i s around $600 million per year. The volume of gas flared in 1998 was 13.2 bcm'; if i t could have been brought to market for power generation or industry it would have had a value based on i t s opportunity cost of about 5 . 7 ~ 1 0 ' ~ Rials per year ($700 million per year). This i s equal to a little less than 1% o f current GDP. There are large costs associated with recovery and use o f such gas, but equally there are large potential benefits.

80. Cost-benefit analysis of the options for gas recovery requires information on: a) the location of sites where gas i s vented or flared, b) the volume and composition o f the gas and c) the location of potential consumers. This information has been assembled by the National Iranian Oi l Company (NIOC) and discussions have been held with the Global Gas flaring Reduction Public-Private Partnership (GGFR) program o f the World Bank. There appears to be considerable potential for projects to recover flared gas that are cost-effective on a commercial basis as a consequence of normal technical optimisation. There may be others that wi l l require additional support through credits for carbon saved. The GGFR has proposed to NIOC and the Go1 that NIOC should prepare summary descriptions for some of the more problematic projects and that these should be reviewed along with experts from private companies and Bank staff to identify to what extent non-conventional funding sources should be sought and what options could be available.

5.4 Forecasts of local damage

81. Using the energy forecasts presented in Table 4.3 as a reference scenario, the EER estimated how damage would increase if nothing were done to control it. Valuation o f the environment increases with income so to provide estimates o f unit damage costs in future years the values for 2001 were scaled according to the growth in per capita GDP. The consequence o f this procedure i s that the unit damage costs in 2019 are roughly double those of 2001. This i s because people value a reduction in damage more when they are better off. Adopting these assumptions on unit costs, combined with the forecasting work described earlier, the EER estimated that damage would grow to 9 4 ~ 1 0 ' ~ Rials ($12 billion) by 2019, in the money o f 2001. This i s equivalent to 6.6% o f nominal GDP, i.e. a larger percentage o f a larger GDP. O f this total damage, an amount of 5 0 ~ 1 0 ' ~ Rials ($6.2 billion) arises from the transport sector. If the relationship between PPP and nominal GDP were maintained to 2019, then the damage as a percentage of PPP GDP would be 1.8%. Figure 5.5 shows how this damage originates by sector and fuel. The Figure shows the percentage share of the damage for each fuel by sector. The numbers associated with each fuel are the damage from the fuel in 10l2 Rials; the allocation by sector i s somewhat similar to that in 2001 for the case of all fuels except fuel-oil, on which the penetration of gas into the power sector has a significant effect. The dominant contribution of transport to the damage i s even more marked in 2019 than in 2001 as a consequence o f the penetration of gas into power generation and industry.

Iran Statistical Yearbook, 2001.

25

Figure 5.5: Damage by fuel and sector in 2019 (lo'* Rials)

100%

I 80%

Transport 60% w Industry

0 Rescomn 40% Agriculture

m Fbw erGen 20% e Oil refining

"," r NatGas (5.3) Crude (8.5) Gasoline (30.7) Gasoil (29.8) Fuel Oil (17.9)

Damage cost 10l2 Rls ($US1 bn = 8xlOl2 Rls)

82. Figures 5.6 to 5.8 show how damage grows over time in terms of pollutants, sectors and fuel-type. Oxides o f sulphur are the biggest source of damage, arising from diesel and fuel-oil use in industry. CO i s also significant; the unit damage cost for CO i s not as high as for other pollutants, but it i s produced in huge volumes. Figure 5.7 shows transport to dominate among the sectors in i t s contribution to damage because of the contributions to oxides of sulphur and carbon monoxide. Figure 5.8 shows gasoil and gasoline to be the biggest sources of damage by fuels.

Figure 5.6 The evolution of damage by pollutant I 100

80

11 60

3 40 3

h u) E % r x Qo

t 20 9 0 r

0 2001 2004 2009 201 4 201 9 I

26

Figure 5 .7 The evolution o f damage by sector 1 1 00

80

60

40

20

0 2001 2004 2009 2014 201 9

m Others Transport Industry ResComm Agriculture PowerGen Oil refining

Figure 5-8: Evolution of damage by fuel I 100

80

60

40

20

0 200 1 2004 2009 2014 2019

5.5 Conclusions

83. Present policies and behavior are not sustainable. The environmental damage in 2019 i s a larger proportion of a larger GDP than in 2001. This deterioration occurs despite the good fortune that natural gas substitutes for all use o f fuel oi l in power generation by 2019. Transport i s the main source of damage and the obvious priority for policy.

84. o f price reform and sectoral measures that bring also economic benefits.

The next Chapter examines how th i s great deterioration might be controlled by policies

27

6 Policy Options

Price (kRlslboe)

84

85. This Chapter investigates the policy options available to the GO1 to control environmental damage. The EER examined the consequences of price reform policies and sectoral measures, separately and in combination. By a sectoral measure i s meant an intervention that aim to cause a specific behavioral change, e.g. through targeted financial incentives and standards for equipment and appliances.

Subsidy Annual Annual Annual (% of OC) increase to increase to increase to

2009 (%) 2014 (%) 2019 (%)

68% 25% 12% 8%

6.1 Price reform

Gasoil

Furnace O i l

86. The Table 6.1 below compares market prices for fuels in Iran with opportunity costs and shows the annual percentage increases necessary to bring the prices to an economic level by the end of the 4th, 5th and 6th plans. The reform o f energy price to reflect international levels would be beneficial to the economy at large and to the environment.

217

108

Table 6-1: Market prices and opportunity costs (2001) 1

44 I 79% 136% I 17%

(kRlslboe)

11%

Gasoline

Kerosene

217

162

11% 2% 1% 1%

78% 35% 16% 10%

Natural Gas (Industry)

Gasoil (Industry)

Natural Gas (ResComm)

CNG (Transuort)

Electricity (Agric) 1 Electricity (ResComm) Electricity (Industry)

Electricity (Others)

19 191% I 63% I 28% I 18%

22 I 90% I 58% I 26% 1 16%

17 1 85% I 45% I 20% I 13%

23 167% 125% 112% 18%

I lo% 19 1 75% I 32% I 15%

17 I 86% I 48% I 22% 1 14%

18 I 98% I 122% I 49% I 31%

118 I 88% 152% 123% I 15%

87. The CEM for Iran studied the impact on the state accounts and consumer prices of various schedules o f energy price adjustment and the ways in which social consequences could be managed by compensation schemes. The Memorandum concluded that the preferable combination i s a quick adjustment of energy prices in two to three years and a phased compensation scheme over 5-7 years. This procedure would allow time to develop the targeting mechanisms and institutional structures required to deliver the social safety measures and also allow the accumulation o f the revenues to fund them.

28

88. The EER examined three scenarios for price reform with end dates:

0

0

0

2009: end of 4th Plan; fast price reform. This i s close to the recommendations o f the CEM, given the time that i s likely to elapse before reform i s implemented. 2014: end o f the 5" Plan; this date has some political attractions in terms of less acute public reaction and lower pressure on consumer prices, but requires sustained political will. 2019: end of 6th Plan; slow price reform; this scenario would require price increases phased over 15 years and could be difficult to sustain.

The price reform scenarios have been modeled using the reference scenario taken from OEP. This scenario is based on constant prices in real terms. The EER then constructed demand curves for each fuel in future years using own-price elasticities derived by OEP.

89. The predicted effect of price reform on the energy sector i s dramatic. Figure 6.1 shows final energy demand in 2001,2004, 2009, 2014 and in 2019 under the three scenarios. For each subsequent snap-shot year, there i s a group o f four bars showing the composition of final demand. The labels within each group, @e. None, -09, -14, -19) show the year reform i s completed. If prices equaled opportunity costs then the TPER in 2019 would be 1030 mboe, compared to 878 mboe in 2001 and to 1947 mboe in 2019 if there i s no price reform. The TPER in 2019 i s the same regardless of when reform i s achieved, because the simple elasticity model assumes immediate adjustment. The emissions o f C02 in 2019 with price reform wi l l be 358 mt compared to 708 mt without price reform and to the 325 mt emitted in 2001.

Figure 6.1: Energy demand in tbree reform scenarios (mboe) I 1800

1 600

1400

1200

8 1000

E 800

600

400

200

0

2009 201 4 201 9

90. The environment improves under price reform as a consequence o f the energy saving. These improvements are shown in Figure 6.2. With price reform, the total damage cost in 2019 i s 48x 10l2 Rials ($US6 billion) compared to 9 4 ~ 1 0 ' ~ Rials ($US 12 billion) under the reference scenario. This damage cost i s s t i l l higher than that o f 2001. Price reform w i l l avoid annual environmental damage by 2019 o f 4 6 ~ 1 0 ' ~ Rials ($US6 billion). All price reform scenarios show

29

the same annual saving by 2019, but of course in the slow price reform scenarios there i s higher damage in earlier years. Price reform i s not sufficient to bring damage in 2019 back to the value of 2004. Note that the damage costs that are experienced in 2019 represent a lower level of physical damage than in 2004. Because o f higher valuations by the public, these lower physical damages represent a higher economic cost.

Figure 6.2: Damage costs by pollutant in selected years under reform (10” Rials) I 1 00

80

60

40

20

0 2004 No -09 -14 -19 NO -09 -14 -19 NO -09 -14 -19

2009 201 4 201 9

Price reform in the energy sector wi l l increase the level o f prices to consumers directly through the energy bill and indirectly through the impact on other goods and services. The likely upper level of impact on the consumer price index i s shown in Table 6.2.

Table 6-2 Effect on consumer price index of price reform 1 Reform by: Increase in CPI

(% per year)

13.9% I2014 I 6.7% ._

2019 I 4.4% I 91. The CEM made estimates o f the impact o f various price reform policies on consumer prices and these are broadly consistent with the EER. The CEM made a substantial analysis of the various compensation schemes that government could use to offset the impacts of price reform. The CEM estimated that without offsetting action by government households would experience a 30.5% loss in consumer surplus. I t i s necessary to ensure that t h i s large shock does not affect the vulnerable. The CEM suggests that part of the oi l revenue now used to subsidise energy consumption should be invested to create jobs. After an extensive analysis of three principal options the CEM concluded that the share of the appropriate compensation in the three

30

cases would be between 35% and 47% of the loss in consumer surplus. In other words the government can easily afford to compensate vulnerable groups and s t i l l keep a large part o f the surplus released.

92. The export o f oi l released by the price reform wi l l add to national income. Figure 6.3 shows the estimated impacts on growth from the reform strategies. It i s a lower bound because the extra revenues wi l l allow more investment that wi l l stimulate growth. The y axis shows the extra growth each year. With fast reform, there i s an extra 2-3% growth over 5 years, with medium paced reform the benefits are around 1 - 1.5%, but spread over ten years and with slow reform the benefits are about 1 - OS%, but spread over 15 years. The discontinuities in the Figure arise from discontinuities in the growth assumptions o f the National Planning periods.

Figure 6.3: Direct impacts on economic growth from price reform I 3.00

I 2.50 5 1 :::: 1 0.00

z 1.00 c (0

0.50

I 2000 2005 201 0 201 5 2020

+ 2009 +2014 e 2 0 1 9

6.2 Sectoral measures

93. Price reform i s not the only, or indeed the most direct way of controlling emissions to air. The EER conducted detailed cost-benefit analyses on the sectoral measures that might be taken to reduce the environmental impacts of the energy sector. The CBA valued energy at opportunity costs and included local and global damage costs. Where sectoral measures save energy, there i s a financial benefit to the state budget from avoided subsidies. The cost-benefit analysis in these cases has been used to estimate the net cash-flow to the state. The short-list of sectoral measures analyzed by the EER was composed from a long-list that in turn was compiled from study o f the reports of previous technical assistance projects and in consultation with representatives o f relevant Iranian institutions. The short-list i s shown in Table 6.3. Activities in some of these areas have already begun. There i s legislation regarding the requirement for catalysts on new vehicles and programmes have been initiated in energy efficiency, demand-side management and for the inspection and maintenance of vehicles. The inclusion o f these measures in th is l i s t does not necessarily suggest that there i s no ongoing activity, but that what activity has begun needs to be sustained and possibly strengthened. The Iranian Fuel Conservation Organization (IFCO) in the Ministry of Petroleum i s addressing energy efficiency in a broad sense. IFCO programs cover four areas: transport, industry, commercial & residential and CNG. The focus of their activities is building design, household appliances, fuel switching (adoption of CNG technologies in car manufacture and construction of CNG distribution stations) as well as cofinancing urban transport investments such as expressways and the extension of the metro system. However IFCO does not include environmental benefits in their cost-benefit analysis o f investments.

31

I No. I Enerw Cvcle

7 8 9

Geothermal) Requiring investment in Flue Gas Desulphurisation equipment at power plant. Improving emissions performance o f refineries (fugitive and energy related) Reduction o f Transmission and Distribution Losses in electricitv

Production Production TransDort

10 11

- . - - -. .. - . Reduction in Losses from oil and gas network Price reform for Energy Products

Transport Consumption

17 18

Measures blocked in grey in the Table have been evaluated qualitatively. Measures blocked in black have been evaluated based on case-studies. Other measures were evaluated quantitatively with CBA.

Taxis) Energy Efficiency fund for the industrial sector Energy efficiency fund for the residential and commercial sectors

Consumption

94. The benefidcost ratios calculated for specific projects within a measure cover a range as would be expected and there are always issues as to what extent a project i s typical o f i t s class. I t i s therefore inappropriate to quote exact B/C ratios for each measure. Measures were classified in the following groups:

19 20 21

0

0

0

0 D: Measure i s not cost-effective 0

A: Measure i s win-win: i t has both net economic benefits (when damage costs are excluded) and also reduces local damage B: Measure i s cost-effective only when local damage savings are included C: Measure i s cost-effective only when global damage savings are incorporated; suitable for CDM activities

X: Either insufficient data i s available to conduct a CBA or the topic does not lend i tse l f to the methodology.

Demand Side Management Program Consumption Building efficiency standards Consumption Standards and labeling for amliances ConsumDtion

32

95. The results o f t h i s analysis are presented in the Table 6.4. The classifications do not indicate the cost-effectiveness o f the activity, but of the promotion of the activity by government, so promoting the switch to natural gas in the residential sector i s not cost-effective because the substitution i s very attractive under present conditions and no policy incentives are needed. The shaded cells indicate the measures that were included in the subsequent forecasting exercise, because they could be quantified and modeled. The l i s t contains no measures to promote major public transport systems such as new rail lines and metros. Some projects o f this nature were examined, but the environmental benefits are normally only a small part o f the benefits o f such a project; the main benefit i s generally the saving in congestion. This i s not to say that the public transport has insignificant benefit to the environment, merely that the environmental benefits are generally not sufficient to justify such projects on environmental grounds alone. The damage costs savings f rom public transport savings should certainly be quantified and credited to the project. This task falls within the Mainstreaming measure. The appropriate Ministry should liaise with the Department o f Environment to agree a methodology that ensures the environmental benefits are represented in the analysis of such projects.

33

Table 6 4 CBA of sectoral measures I IMeasure I Class I I Mainstreaming the environment I X I I c awareness raising I x I I Reduction o f flaring I C I I ~ e m e n t o f drilling mud I fluids I X I 1 Flue Gas Desulphurisation at power plant. I I Reducing fugitive emissions at refineries I

I Reduction in losses from o i l and gas network I

I Congestion management for transport I I Enhancing public transport I

I Building efficiency standards I

I Promotion o f the switch to gas in residential & commercial sectors I I Switching from diesel to electric pumps for ground water I

6.2.1 Modeling principles

96. Price reforms and sectoral measures are not mutually exclusive. The EER frrst created scenarios of price reform. The scenarios were modeled through constant annual percentage increases in price over a defined period and a behavioral response governed by a price-elasticity. Onto those price-reform scenarios were then imposed selected .sectoral policies. The key

Major public transport projects tend only to be cost-effective when other extemalities are incorporated in the CBA, mainly congestion costs.

34

parameters o f the sectoral measures included in the model are summarized in the following Table 6.5. A detailed cost-benefit analysis of each measure i s given in the Final Report of the EER. The account for each policy includes:

Measure Objective

Promote renewables (Wind, land-fill gas, biomass)

0

0

0

Specification of the costs and performance of investments induced by the measure. The benefitkost ratios of investments under market prices and opportunity costs. An assessment of the technical potential.

Potential Costing basis Comment

5 GW $900 per kW, net o f Installed progressively capacity savings on the grid

The Table includes a reference to the appropriate section of the Annex to the Final Report of the EER.

Promote Demand Side Management

Promote appliance and equipment standards

Convert to natural gas in industry

I Table 6-5: Key parameters of the modeled policies 1

Reduction o f 5% o f total $200 I k W o f peak demand electricity consumption saved

Reduction o f 8% o f total $200 I k W o f peak demand electricity consumption saved

50% o f furnace o i l use As described in detailed CBA

Over the period

Over the period

Over the period

Create incentives for energy efficiency in industry

Oblige catalysts on new cars

Reduction o f 5% o f total electricity generation I CBA I As described in detailed Over the period

21 % o f industrial energy According to scenario use

All new cars $250 per car Introduced from 2005

Over the period

Require inspection and maintenance o f existing vehicles

Reduce S content o f middle distillates

Create incentives for energy 10% o f residential natural Payback 2.5 years Over the period r efficiency -- in households gas use I

A l l vehicles $10 per vehicle per year Introduced from 2005

100 ppm in diesel As described in detailed CBA

Introduced from 2009

$785 per car plus I infrastructure costs Over the period Convert vehicles to CNG 20% o f vehicles I

97. four price-reform scenarios and three sets of measures. These options for measures are:

Twelve scenarios were examined. This set i s formed from the possible combinations of

0 Nomeasures 0 All measures 0 No class C measures, i.e. measures only justified by avoided global damage.

The price-reform scenarios require that prices shall be brought to opportunity cost by the end o f 2009, 2014 or 2019. There i s also a scenario with no price reform, but constant prices at their present level. The combination of no price reform and no measures i s the reference scenario.

35

6.2.2 Impact on the environment of measures without price reform

98. The EER estimated how the sectoral measures would change energy demand. The TPER in 2019 i s 1835 mboe, compared to 1947 mboe in the reference case. The impact on emissions i s greater. The estimated annual damage cost savings induced by sectoral measures by 2019 i s around 2 9 ~ 1 0 ’ ~ Rials ($US3.5 billion). The Figure 6.4 shows the composition o f damage by pollutant. Sectoral measures by themselves are only partially effective. Damage continues to grow and i s higher in each o f the snapshot years than in 2004.

Figure 6.4 Damage by pollutant over time: measures no price reform

100

80

60

8 40

n VJ - z F Y c u)

aa p 20

0

2004 No Yes No Yes No Yes

2009 201 4 201 9

0 co 0 NOx

so2 PMI 0

6.2.3 Impact on the state budget of measures without price reform

99. The net economic performance of the measures i s shown in Figure 6.5, as the discounted cumulative net flow of economic costs and benefits. The curve “without damage” shows the cumulative opportunity cost saving, net of the cumulative investments, required by the measures. The curve “with damage” includes also the savings in damage costs. The package o f measures pays back to the country in about 4 years, if the damage costs are not included, and in 2 years if damage i s included. Discounting in the EER i s performed at a discount rate of 10%. A dominant part o f the economic benefits and environmental improvement comes from the win-win measures o f class A.

36

Figure 6.5: Cumulative net benefits to Iran (lo'* Rials)

+ Without damage + With damage

100. the first eight years of a program of measures without price reform.

I t i s instructive to look at the net financial flow to the state. The Figure 6.6 shows this for

Figure 6.6: Net financial flows to the state of measures I 30

25

20

u) 15 E 2 10 P

5

0 2

-5

+Outlay

+ Energysubsidy savings

+Net balance (undiscounted)

37

The outlay has been calculated by dividing the measures into three groups:

0

0

Those fully funded by the private sector Those partially funded by the state (i.e. efficiency and fuel conversion funds) Those fully funded by the state (i.e. T&D losses and renewable energy); this group i s effectively state funded because the investments wi l l be made in the power sector and electricity prices are determined by the price reform schedule so there i s no possibility of incremental revenue to the power sector to cover the incremental costs.

The outlay then comprises all investments in the third group and an appropriate proportion of the investments in the second group. The maximum accumulated deficit in the state outlay i s 1 . 4 ~ 1 0 ' ~ Rials or around $US170 million. This then i s the approximate amount required as start-up capital for a fund to implement these measures. We note that there has been some discussion within government o f the possibilities o f funded incentives to energy efficiency and fuel substitution from avoided subsidies. The status of the proposed fund i s not at present clear, but the forgoing analysis c o n f m the essential merit of the concept.

The state breaks even in three years.

6.3 Sectoral measures, combined with price reform

101. The EER models price reform by 2009, 2014 and 2019. The Figure 6.7 shows the damage costs by pollutant in each of the snap-shot years 2009, 2014, 2019 for the three price reform scenarios including sectoral measures. The combined effect reduces damage substantially below the 2004 value by 2009 in all three cases. Even by 2019 the damage i s less than in 2004. A comparison with the price reform case (Figure 6.2) and the sectoral measures case (Figure 6.4) shows that only the combination of measures and price reform wi l l achieve a cleaner environment in 2019 than now. Price reform by 2009 plus sectoral measures provides the cleanest environment over the period.

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Figure 6.7: Damage costs by pollutant: price reform plus measures (lo'* Rids) 1 100

90

80

70

60

50

40

30

20

10

0 ~

2004 No -09 -14 -19 No -09 -14 -19 No -09 -14 -19 2009 2014 201 9

co NOx so2 PM10

102. The Figure 6.8 shows the cumulative net economic benefits of the measures in the case of price reform by 2014. This i s composed of the benefits of the energy saved measured at opportunity cost net o f the cost of the measures. Two curves are shown one with the environmental damage added to the benefit stream. The cumulative net benefit by 2019 i s around 50 x 10l2 Rials ($US 6.2 billion).

Figure 6.8: Cumulative economic benefits ( 1012 Rials) I 60

50

40

30

20

10

0 2

-1 0

+Without damage -With damage

9

39

103. The Figure 6.9 shows the cumulative net financial flow to the state. The example i s for price reform achieved by 2014. The state effort i s paid back in about six years and cumulative benefits are a maximum in 2012. After that date because the reform has brought prices close to opportunity costs there are no benefits in avoided subsidies and the cash-flow to the state fails. The logic o f self-funding programs breaks down when price reform i s achieved.

Figure 6.9: Cumulative net cash-flow to the state ( 10l2 Rials)

40

30

20

10

0 2

-1 0

-20

+Outlay

+ Energysubsidy savings

+Net balance (undiscounted)

6.4 Options for partial price reform

104. Price reform requires political will. The inflationary impacts of price reform and the resentment of consumers might prevent the introduction of cost-effective prices even by 2019. The EER considered what energy prices should be addressed in a partial reform process. Figure 6.10 shows how environmental damage in 2019 fal ls as the price o f fuels increases. The x axis shows the annual increase in price to 2019 and the y axis shows the damage in 2019. Gas-oil and gasoline give the most environmental benefit for a specified rate of price increase.

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Figure 6.10: Damage reductions for single fuel price increases (2019) I 1 00

90

80

70 0% 5% 10% 1 5%

annual %price increase

-t- Gasoline --e Kerosene -A- Gasoil ++ FO + NatGas -e- Elec (resicdntial)

105. The Figure 6.11 shows for each fuel the damage saved as a function of the avoided subsidy in 2019. Each point on the curve shows an increment of 2.5% in the annual percentage price increase applied to the fuel. So the end point of the gasoline trajectory, for example, represents a 7.5% per annum increase in fuel price between 2004 and 2019. This would bring a benefit by 2019 of 9 x 10l2 Rials ($US 1.1 billion) of avoided damage and 28 x 10l2 Rials ($US 3.5 billion) o f avoided subsidy. Transport fuels have good damage avoidance per unit of subsidy saved.

I Figure 6.1 1: Subsidy reductions for individual fuel price increases (2019) I

+Gasoline +Kerosene +- Gasoil + FO ++ NatGas +Elm (residential]

0 10 20 30 40 50 subsidy trillion Rials

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106. If price reform strategies cannot be comprehensive, then targeting transport fuels appears to be a sensible compromise. There i s a double gain in avoided subsidy and avoided damage. Roughly, they are comparable in magnitude. Such a strategy has some other advantages, namely that there i s relatively l itt le substitution of other fuels in transport, so leakages into other fuels not subject to price reform would be small. The most likely substitution would be an enhanced used of natural gas in transport, which i s in any case a policy with much to recommend it. Moreover, natural gas i s fairly abundant in Iran and electricity as a product of natural gas i s also easily available. There i s some justification in focusing price reform on fuels that are locally scarcer.

6.5 Conclusions

107. There are conclusions to be drawn from this work regarding both methodology and substance. In terms of methodology, the analysis shows the significant potential of the CBA technique for:

0

0

0

Dialogue with government concerning the magnitude of environmental damage and the political priority that it deserves Assessment of the contingent environmental benefits from price reform Analysis, prioritization and design of sectoral policy instruments for environmental control.

108. limitations in t h i s application include:

I t would be wrong not to recognize the weaknesses and limitations o f the method. The

0

0

0

The lack of country specific information on emission factors and damage costs Inadequate differentiation in the costs of different emissions, e.g. by location and altitude Excessively simple sectoral models, especially in transport.

The appropriate treatment o f these limitations i s not to abandon the methodology, but to carry out the work needed to make it more robust and reliable. Given the interest shown by the GOI, Iran may offer an opportunity for a case-study that would have wider application in other middle- income arid countries, especially in the MNA region.

109.

0

0

0

In terms of substance the analysis shows:

Rapid price reform as recommended by the CEM for economic reasons i s also the best strategy for the environment Price reform by 2009 plus appropriate sectoral measures wi l l rapidly improve the environment and keep damage below the damage experienced in 2004 up to 2019 and beyond Only price reform plus appropriate sectoral measures can keep damage costs by 2019 below those assessed for 2004 If the political wi l l to fully reform prices i s not present, then the best strategy for the environment i s to load price increases onto transport fuels.

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7 Conclusions and Recommendations

7.1 Findings

110. The main findings from the analysis of Chapter 6 are that:

0 The environmental damage of air pollution from the energy sector in Iran in 2001 was estimated to be 3 8 ~ 1 0 ’ ~ Rials ($4.7 billion), which i s equivalent to 5.7% of nominal GDP (1.6% o f GDP in PPP terms).

0 In the absence o f price reform and policy intervention the damage wi l l grow to 9 4 ~ 1 0 ’ ~ Rials ($12 billion) by 2019, equivalent to 6.6% of nominal GDP (1.8% of GDP in PPP terms). O f th is total, 5 0 ~ 1 0 ’ ~ Rials ($6.2 billion) arises from the transport sector.

0 The most important measures to reach the objectives of improving energy performance and the environment i s the elimination of subsidies in a suitable time frame, taking into consideration the political feasibility and social suitability of the energy reform. Energy sector measures are accompanying options in the case that no or only partial price reform i s undertaken, however the effects on the reduction of damage costs i s limited and wi l l not exceed 30% from the base line scenario.

0 If price reform and sector reform strategies cannot be comprehensive, then targeting transport fuels i s the best compromise. From the environmental point of view, gas oi l and gasoline give by far the most environmental benefit for a specified rate o f price increase. Fuel oi l i s rather price insensitive and i s being substituted anyway by natural gas. The environmental impacts are declining naturally. Electricity price increases give rather l itt le local environmental benefit because it i s made in the main from natural gas.

111. The challenges therefore i s to recommend the necessary policy reforms and sectoral measures that wi l l substantially reduce the damage costs from 5.7% of GDP in 2001 (1.6% in PPP terms) and from 6.6% o f GDP in 2019 (1.8% in PPP terms), in the case that no reform or measures are introduced. In order to better define the options and their impacts, a total o f twelve scenarios were analyzed, characterized by a combination of four price reform scenarios and three different sets o f measures. The price reform scenarios were: no price reform or price reform implemented by 2009, 2014 or 2019 (end of 4th, 5th or 6th Plan). The different sets o f measures were: with no measures, with all sectoral measures, or with only Class A (“win-win”) and Class B (justified by local damage) measures i.e. omitting Class C measures, (only cost-effective when global damage i s included). The main results are shown in Table 7-1. They can be summarized as follows:

e Compared to 2001, in a Business as Usual (BAU) Scenario, primary energy requirement and final energy consumption would more than double till 2019, with the corresponding detrimental effects on the amount paid as subsidies, on emissions and on damage costs. Subsidies and damage costs would not only increase in absolute terms, but also as percentage of GDP.

0 Applying sectoral measures without price reform would lead in 2019 to a certain, although not very substantial, reduction in energy consumption and damage costs from 6.6% of GDP to 4.6 % o f GDP (1.8% to 1.2% in PPP terms).

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e Elimination of energy subsidies in 2014 without sectoral measures would reduce energy consumption by half from 1556 mboe to 789 mboe, and result in a 50% decrease of damage costs from 6.6% of GDP to 3.3% of GDP (1.8% to 0.9% in PPP terms). However, both energy consumption and damage costs (47 trillion Rials or US$ 6 billion) would s t i l l be higher than in 200 1.

Year I 2001

The combination of price reform and sectoral measures would bring energy consumption in 2019 almost to the level of 2001, and would actually result in a decreasing environmental impact, and therefore in reduced damage costs as compared to 2001 from 5.7% o f GDP to 2.2% of GDP (1.6% to 0.6% in PPP terms). The effects are the same for all price reform scenarios, because of the assumption of immediate adjustment to price.

Reference Year 2019

Table 7-1: Main effects of price reform and sectoral measures 1 Scenario I BAU I Sectoral I Elimination I Elimination

and sectoral measures

(mboe)

(mboe) out of which - Natural gas - Gasoline - Gasoil - Fuel o i l - Electricity Emissions (kt) - co* - so2 - NOX - co - PMlO

Domestic energy consumption

Subsidies 10lL Rials

Subsidies in % of GDP Damage Costs 10” Rials

bn US$

I measures I Primary energy requirement I 878 I 1,947 I 1,835 I 1,030 I 962

720 1,556 1,460 789 737

242 575 588 300 3 10 99 198 160 117 94 160 294 294 92 92 73 98 41 66 31 60 197 183 120 114

352,00 708,000 649,000 358,000 332,000 0 1,436 812 753 530 1,349 2,161 1,578 1076 747 1,106 10,790 7,67 8 5967 4135 5,435 228 214 80 72 131 118 288 267 0 0 15 36 33 0 0 17.8 20.3 18.8 0 0 37.7 94.3 65.2 47.5 31.0 -

bn US$ I 4.7 I 11.8 I 8.2 I 5.9 1 3.9 Damage Cost in % of GDP I 5.7 I 6.6 I 4.6 I 3.3 I 2.2 (nominal) Damage Cost in % of GDP I 1.6 I 1.8 I 1.2 I 0.9 I 0.6

112. Fast price reform by 2009, as proposed in the CEM, would increase overall financial benefits to the state and bring bigger environmental benefits in the intervening period 2004 - 2019, but would have stronger impact on the consumer price index. Generally, the interests o f the environment are congruent with the recommendations o f the CEM. In the case that such rapid

44

price reform i s not envisaged, the EER studied a package of price reform by 2014 and sectoral measures.

0 Phasing out of energy subsidies by the end of the 5th Plan (i.e. 2014) with the provision o f a social safety net for reducing the impact of the measure on the poorer segment of the population.

0 Implementation of sectoral policies alongside the subsidies reduction, since the combination of both provides the best environmental and economical effects.

7.2 Recommendations: A New Energy-Environment Strategic Framework (2004-2014)

113. While initiating i t s transition towards a market economy, Iran has opted for sustainable development in i t s 4" Economic and Social Development Plan. The option o f a market economy i s now seen as the key vehicle for achieving both sustained economic growth and significant environmental improvements. The economic reform process i s aimed at deregulating the economy and creating an enabling framework for private sector participation, focused on fiscal, trade, and price reforms, as well as the elimination o f subsidies, and the introduction o f cost recovery measures. To ensure good management of the environment, these reforms should be coupled with changes in incentives structures and the strengthening o f environmental management institutions.

114. The EER points to the need for clear articulation between environmental policies with overall economic policy. In this regard, environmental benefits wi l l flow f i r s t from the deregulation o f the economy, and which was aimed at dismantling the system o f administrative management o f the economy, including price and fiscal reforms, trade and foreign exchange liberalization, removal of subsidies, and adopting energy sector measures that are financially attractive. The environment should not be considered as a separate concem, but rather as a part of a system o f distorted resource use.

115. Based on a vision of sustainable development anchored in a thriving market-based economy with efficient institutions and strong regulatory oversight, the EER puts forward a three- pronged strategy for getting there (more details are given in the document itself). The package comprises a mix o f price reform and sectoral measures. The EER clearly shows that reform o f prices to the level of opportunity costs wi l l bring significant benefits, but w i l l s t i l l leave substantial environmental impacts that wi l l increase thereafter as a consequence o f increased energy use arising from continued economic growth. Price reform in itself i s not enough. Prices could be increased above the level of opportunity cost by taxes as i s done in many industrialised countries; such measures are normal driven by a combination of fiscal and environmental motives. Taxation should be bome in mind as a long-term option. The price reform needs to be supplemented by the targeted sectoral measures described above to control emissions at source. These measures may be divided into two groups: one group that imposes certain minimum standards for example on vehicle performance; a second group that provides financial incentives to environmentally favourable investments in energy efficiency and fuel substitution. This last group can in tum be subdivided into two sub-groups: one sub-group o f financial measures that aim to correct market distortions based in poor access to information and unrealistic perceptions of risk and a second sub-group that compensates for distorted prices o f energy in absolute and relative terms (second-best solutions). The lifetime of this latter group o f measures would normally be limited to the transitional period o f price reform and would be withdrawn once price reform was complete.

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a) the prevalence of respiratory diseases, through:

Improve human health and the quality of life of the population through a reduction in

0

0

0

0

0

Better prevention and control o f air pollution from industrial sources; The promotion of natural gas as the main domestic fuel; The faster substitution of natural gas in industry and the power sector; The promotion of CNG in vehicles together with the inspection and maintenance of other vehicles; Decrease of the sulfur content o f middle distillates to 100 ppm from 2009.

b) Price the energy resource efficiently as to stimulate energy efficiency and competitiveness of the economy, through:

Making the subsidies to petroleum products explicit in the budget as recommended by the CEM; Raising the prices of petroleum products other than kerosene to international levels by 2014. Fuel-oil should be included in th is program because the substitution by natural gas in industry i s governed by the price differential and this i s at present not high enough; Simplifying the electricity tariff structure to channel subsidies exclusively to the genuinely poor. Bringing electricity prices for other consumer categories to opportunity cost by 2014; Initiating a s imi la r process to make gas subsidies explicit and to reform gas prices starting from 2010.

Improve the productivity and sustainability of the country’s energy capital, through:

Sustainable demand side and supply side management, using participatory and community driven approaches, with strong linkages to electricity, natural gas, and transport fuels; Bringing an end to cold flaring, reducing fugitive emissions in refineries, reducing T&D losses in electricity and from the oi l and gas sector, and switching from diesel to electricity in groundwater pumps; Establishing an energy efficiency fund for the industrial and commercial sectors as such fund are financially rewarding to Iran because of the large savings in the opportunity costs o f energy which i s not reflected in market prices; Promoting renewable energy (either directly or through guarantee by the State o f power purchase agreement). This should be pursued within the Clean Development Mechanism (CDM) and the Prototype Carbon Fund (PCF) under the Kyoto Protocol; Financing system improvements for a combined energy policy in the oil, gas and electricity sectors. A mechanism to be considered i s to recycle the avoided subsidies into funds to promote efficiency and substitution o f natural gas into industry and provide financial incentives for energy efficiency in households and for conversion of vehicles to CNG. The Fund should terminate when price reform i s complete.

Improve the institutional and legal framework in energy and environment and strengthen information dissemination and public awareness-raising through:

0 Undertaking an assessment o f the roles, functions and responsibilities o f the Ministries of Oil, Energy, Transport and the Department o f Environment and determine specific

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actions in the short, medium and long-term for the integration of environmental concerns in the policy formulation and implementation process in the energy and transport sectors. Updating the legal and regulatory framework to implement modem concepts in environmental management namely the polluter-pays, and precautionary principles; public participation and disclosure, environmental liability, market based and voluntary mechanisms, environmentally-oriented permitting systems, and cooperation among stakeholders. The revision should also encompass an update of quality standards for air pollution, including the development of procedures and guidelines for compliance and enforcement. Formulating a comprehensive program for creating and enhancing environmental public awareness. This should not be limited too narrowly to the environment-energy interface. On the contrary, at th i s level, it should envisage a very comprehensive approach to the subject, namely informing people about the policy options, the actions that would be undertaken under each and the long-term benefits expected to accrue to the economy from such measures. This wi l l help in reducing the public antipathy towards the costs that it i s expected to shoulder in the course of the policy time frame. Building capacity and enhancing knowledge in damage cost analysis, policy design, training and adequate information pertaining to the best and clean technologies to require o f polluting industries, their application, costs and performance.

0

0

0

7.3 Action Plan

116. An Action Plan was prepared for the implementation of the main sectoral policies described above aiming at improving the environmental situation as far as i t i s related to the energy sector. This Action Plan wi l l have to be developed further, and changed where required, since it can only be implemented within a coherent framework o f Iranian environmental, energy and economic policies, which need to be defined and adopted by the Iranian Government. Therefore, the Action Plan, as presented in the EER report, should be considered as a basis for the ongoing discussion with the GOI, which in any case must be continued for the further implementation of work that has been initiated by the EER. The Action Plan also indicates entities which should be involved in, or responsible for, implementing and monitoring of specific activities. An overview of the action plan i s attached. There i s an emphasis on air quality, because th is i s the most widespread and acute environmental impact of energy use. Other important issues are marine pollution from oi l spi l ls and contamination of water from oi l production and processing. Marine pollution i s covered in the Action Plan. Refinery issues are better treated by normal processes o f industrial pollution control. The policies recommended wi l l generally lead to a more efficient use o f energy and a diminution o f other environmental impacts also.

117. Executing agencies named in the Action Plan are generally the Ministry responsible for the sector to which the policy i s related. However, there wi l l be a few instances where the measure wi l l be cross-cutting across more than one ministry. For example, a policy of reducing subsidy on gasoline may directly relate to the Ministry o f Oil, but wi l l also have relevance to the Ministry o f Finance because of i t s repercussions for the state finances and budget. I t i s thus proposed to set up a Task Force for each component policy with members drawn from the concerned ministries and other bodies, but functioning under one particular ministry so that the accountability i s fixed. The Task Force should also have a member from the implementing agency to provide insights into what kind of mechanism i s required to actually put the policy in place. But since the overall objective o f the EER i s to improve the state of the environment in the country, one overall executing agency responsible for overseeing and monitoring the action plan

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i s also recommended. The DOE has already established an Energy-Environment Review (EER) Office and has also formed an EER Steering Committee. Both should continue to function until the Policy Support Unit which i s envisaged under the World Bank co-financed Environment Management Support Project become fully operational with staff and resources. At a later stage, whenever the decision of the Government wil l be to undertake substantial policy reforms in the energy sector, the High Council of the Environment, which i s responsible for the state o f environment in the country should be responsible for overseeing the Action Plan with the PSU acting as a secretariat for monitoring, evaluating and coordinating the policy options executed and implemented by various agencies.

7.4 Role of the World Bank

118. The Role of the World Bank wi l l be to assist Iran in developing tools for meeting i t s MDG target #7 on environmental sustainability. The World Bank wi l l focus on mainstreaming environment into target policies, programs and projects at the national and local levels to promote sustainable development in the energy sector. This approach requires strong commitment and involvement from all departments and levels of government, including civil society and the private sector.

119. The Bank wi l l propose five main tools in i ts support for the implementation o f the EER:

a) Priority Setting: Through assisting DOE and the key energy ministries o f oil, energy and transport, and Environment in setting their own environmental priorities and in improving their environment management capacity. Particular attention wi l l be given to building a local capacity for understanding linkages between energy and environment, and to improving and disseminating methods for the economic evaluation of environmental externalities. In addition, Bank support i s expected to further emphasize the environmental benefits o f continued deregulation o f the economy, the use of economic and market based instruments, trade policy, sound natural resource management, and efficient public expenditures and service delivery with the highest impact on poverty reduction.

b) Strengthening Due-Diligence Capacity: Through assisting the DOE and other relevant institutions of government to strengthen capacity in environment and social assessment. The EER i s a strategic environmental assessment (SEA) o f the energy sector. This SEA should be followed up by a structured learning program aimed at building in-country capacity for upstream integration of environmental considerations into planning and sectoral decision making.

c) Integrating Environmental Concerns into the Bank’s Instruments. Through primarily supporting the environmental energy priorities through the Country Assistance Strategy (CAS), sector work, and program and project design in the energy sector. Particular emphasis wi l l be through technical support on demand side management, energy conservation and efficiency, reduction of gas flaring and undertaking analytical work for establishing a National Environmental Protection Fund. The Global Environment Facility (GEF), the Clean Development Mechanism and the Prototype Carbon Fund (PCF) should be further explored as potential financial mechanisms for such support.

d) Capacity Building. This wi l l be achieved through strengthening the capacity o f key sector ministries, local governments, and municipalities in technical and managerial matters, as well as policy planning and evaluation. The Environment Management Support Project wi l l

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establish the Policy Support Unit and wil l focus on strengthening the institutional and legal framework as well the monitoring of air quality.

e) Regional Couperution in combating marine pollution from oi l and gas, and protection o f marine resources in i ts Shatt El Arab waterway with Iraq and Kuwait and i t s downstream zone o f influence in the Persian Gulf. This wi l l be undertaken through a design and implementation of a regional project that could be co-financed by GEF for the sustainable use and realization o f the full economic and social benefits o f the waterway

7.5 Conclusion

120. The success o f implementing the EER wi l l require more than the proposed Bank assistance, which, although catalytic, i s quite modest compared to the scope and severity of air pollution in Iran. In the end, GO1 should take the lead for a sustainable reform program on which much o f the environmental improvements wi l l depend. This wi l l require time, patience and perseverance. However, because environmental sustainability requires a long-term view and an integrated systematic approach, i ts greatest benefits wi l l happen in the longer term. I t would be shortsighted to try to justify the continuation of Bank's assistance based only on i t s expected immediate tangible benefits, important as these may be. Since the GO1 and the Bank are committed to environmental sustainability, Bank assistance should therefore continue to be a long-term, forward-looking program that would help build the country's capacity by providing knowledge and the best intellectual and professional resources available to assist in addressing priority emerging and longstanding environment issues in the energy sector.

After all, Iran i s publicly committed to sustainable development.

121. Since the year 2000, the Bank has been the major environment policy interlocutor in Iran. I t s presence i s needed now even more than in the past to play i ts catalytic role of addressing the root causes of inadequate environmental management and in integrating environmental concerns into decision making and the management of the economy, providing tools for environmental policy analysis and linking project preparation to investment. The EER i s therefore the beginning of a process. Accompanying Iran in this process of environmental sustainability i s a challenge that the Bank has accepted to assume in order to help Iran improve the quality of life of the Iranian people now and in the future.

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0 m