Peru - Lima Water Rehabilitation and Management Project

Document of The World Bank Report No. 13206-PE STAFF APPRAISAL REPORT PERU LIMA WATER REHABILITATION AND MANAGEMENT PROJECT NOVEMBER 1, 1994 LA3 Department Environment and Urban Development Division Latin America and the Caribbean Regional Office  Currency Equivalents Currency unit = sol US$1 = 2.16 soles (March 31, 1994) 1 figures in U.S. dollars unless otherwise noted Weights and Measures Metric Fiscal Year January 1 - December 31 Abbreviations and Acronyms CEPRI-SEDAPAL SEDAPAL's privatization committee COPRI Interministerial committee for privatization CORTAPA Former tariff-setting board FONAVI National Housing Fund SEDAPAL Servicio de Agua Potable y Alcantarillado de Lima (Lima Water and Sewerage Service Company) SENAPA Superintendencia Nacional de Agua Potable y Alcantarillado (former urban water agency) SLA Subsidiary loan agreement  Peru Lima Water Rehabilitation and Management Project Staff Appraisal Report Contents Loan and Project Summary ........................................ . v I. Water and Sanitation Sector Overview ................................... 1 A. Economic background ....................................... 1 B. Institutional and legal framework .1............................... . I C. Current sector issues ................................... 2 D. SEDAPAL ................................... 3 E. Lessons from Bank experience ................................. . 4 II. The Project .5 A. Objectives and rationale .5 B. Water demand .5 C. Description .6 D. Cost ..7 E. Economic evaluation ........................................8 F. Poverty alleviation and affordability .9 G. Financial analysis .10 H. Environmental impact .14 1. Risks . . . . . . . . . . .. .. . .. .. . . . . . . . . . . . . .. . . . . . . . .. . ... . . 14 III. Project Implementation .14 A. Arrangements .14 B. Subproject selection criteria .16 C. Project supervision .17 D. Procurement . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 17 E. Disbursement .18 F. Advance contracting and retroactive financing .18 G. Auditing arrangements .18 H. Reporting and monitoring .19 IV. Agreements Reached and Recommendation ........................... . 19 This report is based on the findings of an appraisal mission that visited Peru from April 26 to May 13, 1994. The mission was comprised of Messrs./Mmes. Abel Mejia, Yoko Katakura, Caroline Van Den Berg, Eid Nouhra (LA1IN), Alex Bakalian, Thelma Triche (TWUWS), Robert Taylor (LAIIE), Rudy Van Puymbroeck (LEGLA), Orville Grimes (LA1DR), Luz Maria Gonzales (consultant), and Makoto Nakao (OECF). Rita Cestti, Manuel Mariffo (TWUWS), Carlos Velez (LA1IN), Jerson Kelman, Dominique Berthon, Jean Louis Olivier, Roberto Chama, Eduardo Baso, and Eduardo Buroz (consultants) also participated in project missions. Carlos Olle from SEDAPAL coordinated project preparation. Juan Barandiaran, Ana Mendoza, Carlos Oyafuso, Alfredo Garcia, R. Rojas, E. Rojas, M. Sheen, and Carlos Paredes comprised the Project Preparation Team in Peru. Thelma Triche (TWUWS) and Walter Stottmann (EMTIN) are peer reviewers. Mr. Asif Faiz was the responsible Division Chief during project preparation and appraisal. The sector Division Chief, Projects Advisor, and Department Director are Messrs. Eugene D. McCarthy, Robert Crown, and Yoshiaki Abe.  - 1i - Tables 1. Project costs ............................................... . 8 2. Financing plan, 1994-2000 ..................................... . 11 3. Financial data, SEDAPAL, 1987-93 .............. .. ... ... .. ... .. .. . 12 4. Sensitivity analysis for two tariff rate structures ......... . .. . . . .. . . .. . . . . 13 5. Project costs by procurement method .............. .. ... ... .. ... .. .. . 18 Annexes .21 1. Bank Loans to Peru for Water and Sanitation Sector and Related Loans ..... . . . . . 23 2. Experience and Lessons Learned from Previous Projects ...... . . . . . . . . . . . . . . 24 3. Peru's Privatization Program ............ ... .. .. .. .. .. .. .. .. ... .. . 26 4. SEDAPAL Management Plan ........... .. .. .. .. .. .. .. .. .. .. . .. . . 28 5. SEDAPAL Investment Plan ............ ... .. .. .. .. .. .. .. .. ... .. . 30 6. Detailed Project Cost ........................................ . 38 7. Technical Assistance ................. .... ... .... ... ... .... ... . 43 8. Water Demand in Metropolitan Lima ......... . .. . . .. . . . .. . . .. . . . .. . 47 9. Cost Benefit Analysis: Methodology and Results ....................... . 55 10. Marginal Cost Pricing Analysis: Methodology and Results ...... . . . . . . . . . . . . 66 11 Financial Projections ................ ... ... .... ... ... ... ... .. . 74 12. Notes and Assumptions for Financial Forecasts ....... . . . . . . . . . . . . . . . . . . 77 13. Procurement Plan and Implementation Schedule ....... . . . . . . . . . . . . . . . . . . 84 14. Implementation Plan ................ ... ... ... ... ... ... ... .. . . 90 15. Project Flows: Legal, Financial and Technical ......................... . 95 16. Project Review . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 96 17. Guidelines for Evaluation of Subprojects ............................. 98 18. Supervision Plan. . ........................... 103 19. Monitoring Indicators. . . ......................... 104 20. Loan Disbursement Schedule . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 108 21. Selected Documents Available in Project File ........................ . 109 Maps .112 IBRD 26211 IBRD 26212 IBRD 26213  - iii - Peru Lima Water Rehabilitation and Management Project Staff Appraisal Report Loan and Project Summary Borrower: Republic of Peru. Beneficiary: Lima Water and Sewerage Service Company (SEDAPAL). Amount: US$150 million equivalent. Terms: Repayment in 17 years, including a grace period of five years, at the Bank's standard variable rate, with level repayment of principal. The Government will extend the loan to SEDAPAL under the same terms and conditions. SEDAPAL will bear the foreign exchange risk. Project objectives: The project's goal is to improve the efficiency of water and sanitation delivery in the Lima-Callao metropolitan area. The project will promote water conservation, support SEDAPAL's privatization, rehabilitate damaged water supply and sewerage systems, expand services to the urban poor in the pueblos jovenes, and support reforms in the legal and institutional framework of the water and sanitation sector. Project description: The project has four components. The water conservation component includes preparing a customer cadastre, reconstructing water meter boxes, and installing 406,000 water meters. This component will also initiate conjunctive use of surface and groundwater in three districts where groundwater is depleted and the risk of saline contamination is serious. The rehabilitation component will improve water supply and sewerage in the twelve districts that comprise 40 percent of SEDAPAL's water sales and 75 percent of total revenue. Wells will also be rehabilitated under this component. The pueblos jovenes component will expand and improve water and sanitation services for 600,000 of Lima's poor. The institutional strengthening component involves studies and technical assistance programs for SEDAPAL and the Superintendency of Sanitary Services. Poverty aspects: The pueblos jovenes component is targeted toward the poor. At project's end, 600,000 beneficiaries-about 26 percent of the total number of beneficiaries-will be the urban poor living in the outskirts of Lima. In addition, the water conservation component will install water meters in high-income households. Water savings obtained from this component will be directed to the pueblos jovenes. Environmental aspects: A detailed environmental assessment was prepared for the project. The project is classified as Category B under the Bank's rating system. Although construction impacts are expected from the rehabilitation, their effects on land use and ecological systems are expected to be minimal.  - iv - Project benefits: The project will provide 834,000 people with improved water supply and 788,000 people with improved sewerage. The pueblos jovenes component will provide an additional 600,000 low-income residents with both new and improved services. Other project benefits include savings from reducing unaccounted-for water and water consumption in high-income areas, health benefits from the pueblos jovenes component, increased reliability of water supply services, reduced water costs in low-income areas, and preservation of water resources. Project risks: The project's main risks include political opposition to the sectoral reform- including privatization-that may slow the reform process, ineffective execution of the project during the transition from public to private sector operation, insufficient counterpart funding, and non-acceptance of Bank funds by the concessionaire. The risk of political opposition is minimized by three factors. First, the new regulatory and institutional framework is the result of two years of consensus-building by the Government of Peru to advance reform. Second, the timing and social environment for privatization is favorable-the current administration wants to advance SEDAPAL's privatization before the April 1995 elections. Finally, successful privatization in other sectors and public utilities has created social support for privatization. The risk of ineffective execution of the project during the transition period is minimized by a management agreement to be signed between SEDAPAL and the government. This agreement defines key operational and investment performance objectives and will be evaluated every three months until the private operator assumes responsibility. If privatization is unsuccessful, terms for a second management agreement will be discussed with SEDAPAL and the government during the Project Review. Annual management agreements should be signed thereafter. If privatization is successful, a performance plan-as part of the concession contract-will be signed between the private operator and SEDAPAL. The risk of insufficient counterpart funding is minimized through the new tariff regulations, which allow for adequate levels of revenue and automatic adjustments based on five-year tariff formulas, and through the monitoring of investment decisions and operational efficiency through the management agreement (before privatization) and the performance plan (after privatization). The risk that the concessionaire may not enter into a subsidiary loan agreement with SEDAPAL for the use of the Bank funds, and hence the possibility of an early partial cancellation of the Bank's loan, is minimized by the fact that prequalified private operators have already shown considerable interest in the Bank loan which would finance urgent rehabilitation work. Table 1 Project costs (millions of U.S. dollars) Project component Foreign Local Total Rehabilitation 53.4 95.5 148.9 Water Conservation 22.2 22.0 44.2 Network Expansion 25.6 14.5 40.1 Institutional Development 3.4 15.4 18.8 Total Base Cost 104.6 147.4 252.0 Physical Contingencies 10.5 14.7 25.2 Price Contingencies 12.1 17.0 29.0 Total Project Cost 127.1 179.1 306.2  v - Table 2 Financing plan, 1994-2000 (millions of U.S. dollars) Bank-financed projecta SEDAPAL totad investnent plan Source of funds Amount Percent Amount Percent World Bank 150.0 49.0 150.0 22.6 Cofinancier 76.2 24.8 76.2 11.5 SEDAPAL 80.1 26.2 317.0 47.8 Other loansb 120.3 18.1 Total 306.2 100.0 663.6 100.0 a. Does not include US$40.5 million interest accrued during constnuction, to be financed by SEDAPAL's internal resources. b. A majority of these loans are provided by FONAVI and other domestic institutions for primnary and secondary works (US$66 million). Table 3 Estimated Bank project disbursements, 1995-2001 (millions of U.S. dollars) Bank fiscal year 1995 1996 1997 1998 1999 2000 2001 Annual 26.5 38.2 40.4 26.1 10.2 6.0 2.6 Cumulative 26.5 64.7 105.1 131.2 141.4 147.4 150.0 Rates of return: The internal economic rate of return of the project is estimated at 22 percent, and the financial rate of return at 17 percent.   I. Water and Sanitation Sector Overview 1. Water and sanitation services in Peru have deteriorated because of poor management. A widespread, deadly cholera epidemic began in January 1991-reflecting the state of water and sanitation infrastructure, particularly in urban areas. Although structural reform has improved the sector's operation, the system requires considerable physical and institutional rehabilitation. Investment needs and weak institutional capacity led the Government of Peru to encourage private sector participation in the management of Lima's SEDAPAL-the country's largest water and sanitation services company. A. Economic background 2. Peru has long suffered from political and macroeconomic instability. Until recently, the government followed a state-led development strategy containing extensive legal controls. Government intervention in economic activities led to misallocated resources, fostered inefficient public enterprises, and hindered the development of social, economic, and physical infrastructure. Utility tariffs were politically influenced with little regard for costs. During 1985-90 the Garcia administration implemented expansionary fiscal policies, including targeted credits, subsidies, and reductions in taxes and public sector prices. These policies initially induced economic growth but eventually increased deficits, created hyperinflation, and aggravated resource misallocation. By mid- 1990 annual inflation peaked at nearly 36,000 percent. GDP had dropped to the 1960 level. Scarce resources were used inefficiently, and few were allocated to public utility systems. 3. The Fujimori administration introduced a macroeconomic stabilization and structural reform program in mid-1990. The stabilization program included a tight monetary policy, instituted temporary taxes, and increased public utility rates. Structural reforms promoted competition and private investment. An extensive privatization program seeks to privatize all major public holdings by mid-1995 (Annex 3). 4. Water and sanitation reform includes enactment of the Water and Sanitation Services Law in July 1994 and preparation of accompanying regulations, a draft Water Resources Law currently before Congress, a supervisory agency (the Superintendency of Sanitary Services) was created in January 1994, increased water and sewerage tariffs, restructured municipal water companies, and a privatization committee for SEDAPAL (CEPRI-SEDAPAL). 5. By mid-1991, water and sanitation infrastructure had deteriorated such that considerable rehabilitation was needed to guarantee its operation. Water resource management was also urgent, particularly in urban centers with limited water resources. The government requested the Bank's assistance in rehabilitating and privatizing the system, strengthening supervisory capacity, and supporting the creation of a Water Resource Management Authority in Lima. B. Institutional and legalframework 6. The institutional environment of the water and sanitation sector has changed considerably in the past five years. Until 1989 the Servicio Nacional de Agua Potable y Alcantarillado (SENAPA) provided service in urban areas. The Rural Sanitation Program of the Ministry of Health provided service in rural areas. Water sector operations were decentralized in 1989, and responsibilities were transferred to local governments. Except for the water utilities in Lima and Trujillo, all subsidiary companies and operational units were decentralized. 7. SENAPA was abolished in 1992, when the Ministry of the Presidency assumed responsibility for the water and sanitation sector. Policies favoring viable and autonomous water  - 2 - companies were developed, and CEPRI-SEDAPAL was established to promote private participation. The Superintendency of Sanitary Services was created to regulate the sector and to help develop efficient water companies at the municipal level. This agency reports to the Vice Minister of Infrastructure in the Ministry of the Presidency and is financed with water and sewerage revenues. A staff of 20 is formulating regulations and a strategy for sector development. There are currently about 30 local companies and more than 100 direct management municipal services. 8. Other supervisory institutions include the Ministries of Agriculture and Health. The Ministry of Agriculture has recently drafted a Water Resources Law emphasizing private water-use rights. The Ministry of Health oversees water quality standards; its responsibilities will be better defined once pollution control arrangements are developed through the Water Resources Law. 9. The Water Resources Law, presently in draft, introduces changes that facilitate water market development, promote private sector investment, and encourage water conservation. Water-use rights will be granted to private users, development and management decisions will be made at the lowest appropriate level, and resource coordination and management will be determined by river basin authorities. The concept of private water-use rights is different from the existing system, which grants substantial discretionary power to the public sector. 10. The Constitution adopted in 1993 affirmed that water and sanitation services are the responsibility of local government. The Water and Sanitation Services Law (Ley General de Servicios de Saneamiento) , defines institutional responsibilities for service provision and regulation. It also establishes a framework for private sector participation. It also uses transparency, financial viability, and social equity as basic principles for tariff setting. This is a departure from the previous tariff regime, in which water and sewerage tariffs were set by the Comision Reguladora de Tarifas de Agua Potable y Alcantarillado (CORTAPA) with little concern for transparency or financial viability. Regulations that specify the functions of the Superintendency of Sanitary Services have also been drafted. Tariffs are currently set on interim arrangements. In Lima, SEDAPAL proposes a tariff increase to the Ministry of the Presidency, which makes a decision after consulting with the Ministry of Economy and Finance. C. Current sector issues 11. Peru's water resources are geographically unbalanced. The sparsely inhabited East Andes have abundant and untapped water sources, while the western slopes, including Lima, have less than 15 millimeters of annual precipitation. Most of the country's population is concentrated in coastal urban centers. Water supply and sanitation services do not meet the demand in these areas-water rationing is a daily occurrence in Lima. Poor resource management has worsened the problem. The Rimac river-the main source of water for Lima-is polluted with untreated mining, industrial, and domestic waste. Lima's sewage is discharged into the sea or diverted for irrigation. In addition, underground water develops an alarming degree of contamination and salinity when the water table near the ocean drops. These factors-along with the network's poor condition-are responsible for the persistent cholera. 12. Service coverage. Peru's 1993 population was 22 million, with average annual growth of 2.2 percent. Urban areas (defined as population centers with more than 2,000 inhabitants) account for about 70 percent of the total population. Urban population is growing at an annual rate of 2.9 percent, while the rural population is growing at less than 1 percent. About 6.4 million people-29 percent of the country's population-live in the Lima-Callao metropolitan area. Urban migration accelerated in recent years as terrorism drove rural populations to the outskirts of Lima. Here they formed low-income communities called pueblos jovenes, and now account for 58 percent of Lima's population. By 2000 Lima's population is expected to reach 7.7 million. 13. Water and sanitation services have not kept up with population growth. In 1991 national service coverage was estimated at 58 percent for water and 42 percent for sewerage. In urban centers, the figures were 74 percent for water and 62 percent for sewerage. In Lima, the coverage  was 79 percent for water and 75 percent for sewerage at end-1993. These figures represent the population physically connected to the water supply and sewerage systems-not service quality. According to the Living Standards Measurement Survey conducted in 1991, 48 percent of Peru's population received water for less than 12 hours each day. Twenty-eight percent received less than six hours of service each day. Sewerage is also inadequate, with most domestic, industrial, and mining wastes discharged untreated into rivers and the ocean. 14. Sector investment. During 1985-89 investments in water and sanitation infrastructure represented just 0.15 percent of GDP. This is one of the lowest figures in Latin America. Countries with better service invested about 1.0 percent of GDP. For decades, policies ignored the economics of water supply and sewerage. Tariffs were set below cost and driven by political and social interests, making it impossible for revenues to cover investment. 15. Increasing coverage has taken priority over maintenance needs. In Lima maintenance of existing assets has been negligible. About 3 kilometers of water pipe were replaced during 1987 and 1989-in a system with more than 6,700 piped kilometers. Few investments were made in sewerage. National rehabilitation needs are estimated at US$400 million in the next five years. 16. Health impacts. Water availability has declined substantially, particularly in low-income areas. The true cost of inadequate supply was evident after the 1991 cholera outbreak. In the first ten weeks of the epidemic, Peru lost US$1 billion in exports, tourism, and emergency health expenditures. Poor hygiene conditions have also increased the incidence of diarrhea-in the pueblos jovenes, eight episodes of diarrhea per person are reported annually. Medical expenditures and lost wages put a heavy burden on the poor's household income. Improved water supply could contribute significantly to poverty alleviation. D. SEDAPAL 17. SEDAPAL provides service to the Lima-Callao metropolitan area. For more than a decade, it has suffered from low tariffs, high inefficiency, and increasing operating costs. The company did not generate positive net income between 1982 and 1992. Government intervention deprived the company of the ability to make its own investment and financial decisions. SEDAPAL has suffered a drastic decline in real revenue as a result of government policy keeping public utility prices low. Average tariffs were a mere US$0.10 per cubic meter in 1989, much lower than the unit operating cost. The company was unable to pay its suppliers, cover debt service, or maintain and expand service. It depended on user donations, government concessionairy loans (through FONAVI), and transfers to cover operating and investment costs. Government investments in SEDAPAL were minimal, since the government itself was on the verge of bankruptcy. 18. As part of the 1991 sectoral reform, SEDAPAL went through a drastic restructuring. The number of employees was reduced from 3,769 in 1988 to 1,965 in 1993 through a voluntary retirement plan. Management was streamlined to five operational divisions. A Chairman of the Board, also a member of the CEPRI-SEDAPAL privatization committee, was appointed in November 1992. The Government has increased the water and sewerage tariff-to an average of US$0.28 per cubic meter in May 1994. Increased tariffs and decreased costs generated positive net income in 1993 for the first time in more than a decade. 19. SEDAPAL's operational efficiency has room for improvement. The company's reported unaccounted-for water (the difference between water produced and billed) was 38 percent of production in 1992. This figure, however, is underestimated. Only 4 percent of connections are billed on the basis of metered consumption, and actual consumption and billed volumes are often different. The remaining 96 percent of connections are billed at notional consumption levels in most cases that are higher than actual consumption. A district-by-district study revealed that unaccounted- for water at end-1993 was about 46 percent-30 percent from physical losses (leakage) and 16 percent from commercial losses (consumed but not billed). This level of loss is unacceptable in a water-scarce environment.  - 4 - 20. Privatization. The Government's strategy for SEDAPAL is consistent with its overall approach to privatization. CEPRI-SEDAPAL, the committee for SEDAPAL's privatization, hired advisors in June 1993 to examine options for increasing private sector participation. A team of technical and financial advisers was hired in late 1993 to assist CEPRI-SEDAPAL in preparing and implementing privatization. The first task was the assessment of the various options for privatizing. Several options were analyzed: sale of shares, sale of assets, management contract, lease arrangement, concession contract, and build-operate-own and build-operate-transfer arrangements. The consultants recommended the concession approach, in which a private operator makes a long- term commitment to invest and operate water and sanitation services. This option for private management of public services is widely used in France and Spain, and it was the option adopted in the privatization of Buenos Aires' water utility in 1993. The operator assumes all financial risks, and is responsible for capital expenditures (such as rehabilitation and expansion). Pricing and service obligations are also specified. A price cap is used to adjust tariffs. Ownership of SEDAPAL assets remains with the Government. The concession would be awarded through public bidding. 21. The interministerial committee for privatization (COPRI) approved a 30-year concession strategy in March 1994. Three international operators were prequalified prior to loan negotiations. During loan negotiations CEPRI-SEDAPAL provided the Bank with draft bidding documents for the privatization, including terms of the subsidiary loan to the concessionaire, draft concession contract, and performance plan. Interested bidders will require about three months to prepare their proposals. The public tender process, selection of the private operator, and finalization of the contract will take another nine to twelve months. A timetable for the privatization is in Annex 3. 22. Privatization has several benefits. A private operator would improve service quality and operational efficiency. This would reduce production requirements, delay the need for investment in new water supplies, and facilitate lower water rates. A private operator would also bring the capital needed to rehabilitate and expand the Lima water and sanitation network. 23. Public sector management. Private sector participation is not guaranteed. If it fails, SEDAPAL will continue under public sector management-in a policy environment that has clear performance incentives. The new regulatory framework for water and sanitation introduced marginal cost pricing, managerial autonomy, and accountability. These are essential for efficient utility management, public or private. SEDAPAL's institutional capacity should be strengthened by clearly defining its responsibilities and relationships with other public sector entities. Management agreements should be used to clarify objectives and define responsibilities among the different entities overseeing SEDAPAL management. A summary of SEDAPAL's management plan and specific targets for management agreements are in Annex 4. E. Lessonsfrom Bank experience 24. Most water and sewerage projects in Latin America have fulfilled their physical objectives, but not their institutional ones. Regional experience indicates that water and sanitation projects are subject to poor macroeconomic performance and frequent management changes and lengthy implementation compromise objectives. In addition, physical and institutional objectives should be linked, project scope and design should be simple, better demand and productivity forecasting is needed, and projects should emphasize cost recovery, operational efficiency, and internal contribution to investment. 25. Since 1976 the Bank has made three loans for water and sanitation projects in Peru, all in Lima. These loans amounted to US$55.9 million. Earlier projects had objectives similar to this project: expanding service, particularly in low-income areas, improving resource management, and strengthening SEDAPAL's managerial, technical, and financial capabilities. The projects failed to achieve their objectives because of political and economic constraints, macroeconomic instability, and the lack of institutional reform.  - 5 - 26. This project, the Bank's first in ten years in Peru's water and sanitation sector, takes these lessons into account. The Bank's assistance with regulatory and institutional reform has helped ensure sustainability-both the Government and SEDAPAL are committed to reform. The macroeconomic environment is now considered stable. Institutional reform is underway-and will be advanced with private sector participation, also supported by the project. 27. The proposed project is needed whether SEDAPAL is privatized or remains publicly managed. The Bank-financed project is a small portion-less than 20 percent-of the capital expenditure required for the Lima water and sanitation system in the next decade, but contributes to establishing direction for further system improvement. The bulk of investment will be undertaken by the private operator under the concession contract. II. The Project 28. The project was conceived and designed by the Vice-Ministry of Infrastructure and by SEDAPAL. The Bank helped design and implement a new institutional framework and improve SEDAPAL's efficiency. Achievements during project preparation include: * Creating and strengthening CEPRI-SEDAPAL. * Creating the Superintendency of Sanitary Services and eliminating SENAPA and CORTAPA. * Preparing the Water and Sanitation Services Law. * Increasing tariffs by more than 100 percent and gaining consensus on long-term marginal costs as a basis for tariff setting. * Hiring international consultants to assist with SEDAPAL's privatization. * Preparing a management plan for SEDAPAL that will guide management during the transition to privatization. 3 Training Peruvian officials through seminars and study tours. - Administering a Japanese Policy and Human Resources Development (PHRD) grant that evaluated rehabilitation requirements of the water and sewerage network, appraised alternatives for disposal and reuse of domestic sewage, and assessed hydrological data from the Rimac river basin and the environmental impacts of the entire investment. A. Objectives and rationale 29. After Peru resumed its debt service payments to the Bank in 1990, the Bank's lending strategy included an adjustment program supporting macroeconomic stabilization and structural and sectoral reform. During 1992-93, four loans were approved: the Structural Adjustment Loan (3452- PE), the Trade Reform Loan (3437-PE), the Financial Sector Reform Loan (3489-PE), and the Privatization Adjustment Loan (3595-PE). The Bank has also supported reforms with technical assistance-principally through the Privatization Technical Assistance Loan (3540-PE) and a series of PHRD (Japanese) grants. Now that economic stability and initial sectoral reforms have been achieved, the Bank is promoting economic development and poverty alleviation. As stated in the Country Assistance Strategy, discussed by the Board on April 20, 1993, and in the May 2, 1994 draft version, the Bank's objectives are sustaining macroeconomic stability, developing institutional capacity, improving income distribution, alleviating poverty, rehabilitating critically damaged infrastructure, and supporting privatization. 30. This project pursues these goals. It will expand water and sanitation services in the pueblos jovenes, rehabilitate Lima's damaged water supply and sewerage system, and support SEDAPAL's privatization. Privatization will be facilitated by onlending of the Bank's loan for emergency investments that will be made soon after the concession is granted. If privatization does not succeed, the project will assist further in the modernization and reform of SEDAPAL, a process initiated during project preparation.  -6 - B. Water demand 31. Water demand projections are based on estimated population growth, SEDAPAL's planned increase in coverage, and trends in per capita consumption. The population of the Lima-Callao metropolitan area will increase from 6.4 million in 1993 to 8.7 million in 2005. By 2005, 90 percent of the population should have direct access to piped water because of system expansion in the pueblos jovenes. 32. Per capita water consumption is the key variable in demand projection. Despite rationing, domestic water consumption in the Lima-Callao metropolitan area is high. Average consumption in September 1993 was 169 liters per day, compared with 236 liters per day in June 1987. These data are not directly comparable because of the impact of seasonality on consumption-1993 data were collected during the dry season, when rationing is more stringent. Still, although average household incomes had dropped and water rates had increased since 1989, it is mainly rationing that is responsible for lowered demand. Without rationing and excluding seasonality, the demand forecast assumes that consumers would have consumed 236 liters per capita per day. 33. Water consumption levels differ substantially within the Lima metropolitan area. This is mainly caused by the degree of rationing, which differs among districts. Income level also plays a role. Water consumption forecasts are based on district averages rather than systemwide consumption estimates. Demand forecasts for the districts are presented in Annex 8. 34. A major goal of this project is reducing water use and water losses. The project uses two tools to achieve water conservation (demand management). It will manage demand through the installation of water meters. And it will reduce physical losses through rehabilitation of the supply network. These two measures will be supplemented with a conjunctive use program that will optimize surface and groundwater use to increase water supplies. Rehabilitation has two major impacts. Reducing unaccounted-for water will increase the available supply. Since the current water supply system is characterized by rationing, this will result in higher consumption. But the introduction of water meters will offset this increase. The use of reliable water meters has an impact similar to a real rate increase. Instead of paying a minimum consumption level, households pay for actual consumption-resulting in higher water bills. The impact of higher rates was estimated using an average price elasticity of demand -0.30-a value comparable to that used in recent studies by the Superintendency of Sanitary Services. Based on this value, per capita domestic water demand will decline from 236 liters per day in 1994 (without rationing) to 188 liters per day in 2005. Because service coverage will increase by 2005, total domestic water consumption will rise to about 17 cubic meters per second. 35. Non-domestic water demand is expected to increase in line with population growth-about 2.5 percent a year. Total non-domestic water consumption will increase to about 5 cubic meters per second by 2005. Physical losses currently account for about 31 percent of total water production. Because of the limited scope of the rehabilitation program, these losses will decline only to about 29 percent in 2005. Total production capacity in 2005 will therefore increase to nearly 32 cubic meters per second. Population projections and water demand methodologies are explained in Annex 8. C. Description 36. Until this project was prepared, SEDAPAL's investments were based on annual reviews of the public expenditure budget in conjunction with other government institutions. With Bank assistance, SEDAPAL developed an investment plan for 1994-2000. This plan follows SEDAPAL's water and sewerage master plan from the early 1980s, financed by a previous Bank loan. This plan is still valid because of low investment in the past decade. Neglected maintenance during this period increased investment requirements. The Bank-financed project-totalling US$306.2 million-is part of the US$663.6 million investment plan for 1994-2000.  37. Investment priorities. Improving infrastructure and SEDAPAL's commercial base are the top priorities. Operational assets have priority for reducing water losses and improving service quality. The commercial base will be improved by updating the customer cadastre and installing water meters. The conjunctive use of surface and groundwater will optimize the use of existing water resources. Investment in a major trans-basin scheme could be postponed, since major water source expansion will not be required before 2003 (according to the demand forecast). Studies should be completed in the next five years to determine the least-cost solution for long-term water supply. A means of sewage disposal should be implemented after studies determine the best wastewater management scheme for Lima. Engineering for sewage disposal could be financed through the Bank project. Studies to evaluate wastewater management will be financed through a Japanese Policy and Human Resources Development (PHRD) grant, already approved by the Peruvian Government. 38. Project components. The project consists of a water conservation program, rehabilitation of existing water and sewerage infrastructure, expansion of water supply and sewerage networks to low-income areas (pueblos jovenes), and technical assistance for institutional development. These components are described in detail in Annex 5. 39. The water conservation component (18 percent of total project cost) has two subcomponents. The first is a program for reducing unaccounted-for water, including the preparation of a customer cadastre, reconstructing substandard water boxes, and installing 406,000 new water meters for 56 percent of SEDAPAL's customers. The second develops conjunctive use of surface and groundwater in three areas of Lima where groundwater is depleted and saline contamination is a threat. This subcomponent provides secondary network pipes, nine reservoirs, rehabilitation of wells, and reinforcement of 35 kilometers of primary network pipe to accommodate additional flow from the treatment plant. 40. The rehabilitation component (59 percent of total project cost) has three subcomponents. The first will rehabilitate water supply networks in twelve districts. This involves replacing or repairing 42 kilometers of primary pipes and 622 kilometers of secondary pipes, reconstruction of 117,000 house connections, rehabilitating 129 unused reservoirs and repairing 156 defective ones, and supplying basic maintenance equipment. The second subcomponent will rehabilitate sewer networks in these same districts, replacing 77 kilometers of concrete pipes and 616 kilometers of secondary lines. This subcomponent will also repair 123,000 house connections and 12,300 manholes. The final subcomponent will rehabilitate 39 wells with diminished yields and provide equipment for 85 new wells. 41. The service expansion component (16 percent of total project cost) will provide works to serve up to 600,000 low-income people in the pueblos jovenes. Works include transmission lines, pumping stations, reservoirs, interceptors, and wastewater treatment plants. Engineering for these projects does not involve complex technical solutions. Cost estimates are based on recently executed projects of similar complexity. Priorities will be set through a participatory process that mobilizes potential beneficiaries. 42. The institutional strengthening component (7 percent of total project cost) includes about 1,500 staff-months for consultant services, training, equipment, and logistical support in six subcomponents: management assistance, modernization of financial management, assistance with SEDAPAL's transformation from direct service provider to contract administrator, capacity-building for the Superintendency for Sanitary Services, baseline studies to support a water basin authority in the region, and feasibility studies for wastewater disposal and the Chillon water treatment plant. D. Cost 43. The total cost of the project is estimated to be US$306.2 million. Project costs are summarized in Table 1 and detailed in Annexes 5 and 6. The foreign exchange requirement is estimated to be US$127.1 million (41.5 percent of total project cost). Costs are based on end-1993  - 8 - prices, and include physical contingency allowances of US$25.2 million-10 percent of equipment, works, and services. Price contingencies of US$29.0 million-10 percent of the December 1993 project costs-are based on estimated international inflation of 2.5 percent per year during project implementation. Cost estimates are expressed in U.S. dollars because of high local inflation. Table 1 Project costs (millions of U.S. dollars) Project component Local Foreign Toal Rehabilitation 95.5 53.4 148.9 Water conservation 22.0 22.2 44.2 Network expansion 14.5 25.6 40.1 Institutional development 15.4 3.4 18.8 Total base cost 147.4 104.6 252.0 Physical contingencies 14.7 10.5 25.2 Price contingencies 17.0 12.1 29.0 Total project cost 179.1 127.1 306.2 44. Cost estimates for equipment, materials, and works for the rehabilitation and conservation components are based on engineering designs and unit prices of similar recent works. The rehabilitation component is based on a least-cost solution. Its engineering has been evaluated and found satisfactory. The network expansion component does not yet have detailed engineering- appraisal was based on engineering and cost estimates from similar recent works. Engineering for this component will also be financed based on a least-cost solution, and will require intense coordination with beneficiary communities. Conditions for individual subprojects in the pueblos jovenes are presented in Annex 17. Institutional development estimated are based on the terms of reference for each subcomponent and on current consultant fees. E. Economic evaluation 45. Each project component generates different benefits. Water conservation and rehabilitation will increase the available water supply. Rehabilitation will also reduce production costs, provide 834,000 people with improved water supply and 788,000 people with improved sewerage, and extend the lifetime of the network-postponing the need for new investment. Service expansion will either provide or improve access to water supply and sewerage for 600,000 low-income residents- improving hygiene and generating health benefits. And institutional strengthening will improve the management and efficiency of Lima's water resources. 46. Data limited the benefits that could be quantified. Project benefits have been limited to direct-use benefits and exclude those from capacity-building, reduced pollution, and postponed new investment. Project benefits also include an estimate of the consumer surplus. Calculating the consumer surplus is difficult because of the lack of data on water consumption behavior in Lima (see Annex 9). Based on investment costs, projected operating and maintenance costs, and economic benefits, the internal economic rate of return is 22 percent. The net present value is US$209 million and the benefit-cost ratio is 1.85. 47. Subproject analysis. A separate cost-benefit analysis was prepared for the water meter program, water supply network rehabilitation, and expansion of the water supply and sewerage network in the pueblos jovenes. The water meter program will install 406,000 water meters in districts with excessive consumption. Assuming an average price elasticity of -0.30, per capita water consumption in these districts will decline from 292 liters per day in 1993 to 200 liters per day when the project is implemented. Billing efficiency should also improve with the use of reliable meters. Commercial water losses should decline from nearly 16 percent of total production in 1993  - 9 - to 10 percent in 2005. The internal economic rate of return of this component is 119 percent. The net present value is US$213 million and the benefit-cost ratio is 6.06. 48. Savings generated from rehabilitation of the water supply network will amount to 1.3 cubic meters a second when this component is complete. Rehabilitation will cost US$47 million (adjusted for taxes and subsidies and excluding price contingencies). Based on these costs, the internal economic rate of return of this component is 13 percent. The net present value is US$9 million and the benefit-cost ratio is 1.19. 49. The number of beneficiaries from water supply and sanitation network expansion is 600,000. Of these, 276,000 will receive improved service. The rest will receive direct access to the system. This component has direct-use benefits in the form of reduced rationing. Households that currently depend on indirect water supply (such as vendors and standpipes) consume about 30 liters a day per capita-and pay high prices for water. Once households are connected to the piped water system, it is likely that the decline in prices will be accompanied by an increase in consumption. Analysis indicates the internal economic rate of return of this component is 43 percent. The net present value is US$143 million and the benefit-cost ratio is 2.88. 50. Tariff analysis. SEDAPAL's current water and sewerage rates do not reflect actual costs. Long-run marginal costs of water and sewage are estimated at US$0.45 per cubic meter-the current average is US$0.28 per cubic meter. An analysis of SEDAPAL's marginal cost structure is in Annex 10. 51. SEDAPAL's water rate schedule is complex, with different rates for residential, commercial, industrial, public, and social customers. Since meter reading is rare, the rate structure has been effectively replaced by a flat rate equal to a notional monthly consumption. The rate schedule has a high level of cross-subsidization-commercial and industrial customers pay rates that subsidize social and residential consumers (Annex 10, Table 5). Cross-subsidies seriously impair efficient resource allocation-industries and commercial enterprises often use their own groundwater sources to avoid paying high rates. A lower level of cross-subsidization could increase the number of commercial and industrial users in the system, reducing the strain on groundwater sources. The current tariff structure makes no distinction between water and sewerage costs. 52. The Water and Sanitation Service Law-enactment of which was a condition for loan negotiations-should make the tariff structure meet basic financial requirements and satisfy social equity concerns. New tariff regulations should be approved by executive decree prior to loan effectiveness. The following criteria are expected: * Marginal costs will be used as a reference value in rate structure and levels. * A distinction will be made between water and sewerage rates to improve the transparency of tariff-setting procedures. * The rate structure will be simplified by reducing the number of consumption blocks from seven to three. The range of these consumption blocks will be set according to current consumption levels. The first block will cover the minimum volume of water needed by a typical household. The second block will cover the volume that is still not considered excessive--25 to 30 cubic meters a month. Consumers that go beyond this upper limit will be considered excessive users. Such users should pay at least the marginal cost of water supply and sewerage to induce more rational water use. * Cross-subsidization will be limited to the lowest residential consumption block. * Tariffs will be set so that SEDAPAL can finance operating expenses, debt service, and investment. * The tariff schedule will include an adjustment formula to avoid real tariff declines, while promoting efficiency and the financial sustainability of SEDAPAL.  - 10 - F. Poverty alleviation and affordability 53. In Lima 79 percent of the population has access to piped water, and 75 percent has access to sewerage. The remainder relies on standpipes, group taps, or vendors. Improving service and access for low-income households will increase water consumption and sewage collection. This will be offset by lower water consumption in districts with high-volume use-where meters will be installed. 54. It is difficult to determine the capacity to pay for water and sewerage. SEDAPAL is preparing a study to determine willingness to pay. Since these studies are not yet available, the affordability of water and sewerage services was determined using ability-to-pay indicators. 55. SEDAPAL applies a minimum water consumption level of 22 cubic meters a month to low- income households connected to the network.' This level is high compared with minimum standards in other countries. The minimum consumption level should provide enough water to satisfy basic needs and maintain minimal hygienic conditions. The minimum monthly consumption rate is equal to 1.0 percent of monthly household income for poor households and 1.9 percent for extremely poor households.2 Water vendor costs range from 2 percent to 13 percent of monthly household income (depending on season and distance) for a daily per capita use of 30 liters.3 Households that purchase water from vendors pay 12 to 24 times more per unit of water than households connected to the piped water network. 56. Total charges for water supply and sewerage also include connection costs. Connection charges are high in Lima because they include the investment costs of secondary works. The average connection cost in the pueblos jovenes is estimated to be US$850. Residents can apply for short-term loans at FONAVI. FONAVI loans have a repayment period of five years and a monthly interest rate of 1.5 percent. Based on these rates, total charges for water supply and sewerage (including monthly installments for the payment of the connections) amount to 8.3 percent of monthly household income for the poor and 16.2 percent for the extremely poor. For households without a connection, such high entry costs mean piped water is not a viable option. 57. The rate structure could be further adjusted to favor low-income households. The monthly minimum consumption level should be reduced from 22 cubic meters to 10 cubic meters-a level sufficient for maintaining minimal hygienic conditions. To reduce the impact of connection costs, a more liberal credit system should be introduced. A loan with a repayment period of ten years and a monthly interest rate of 1.5 percent would reduce connection costs to 6.2 percent of monthly household income for the poor and 12.1 percent for the extremely poor. Another option is incorporating connection costs in the water rate. If the marginal cost of water was applied, the cost of water would be 3.1 percent of monthly household income for the poor and 6 percent for the extremely poor. This would lower dramatically the barriers to piped water access. The Ministry of the Presidency will submit to the Bank a proposal that incorporates these changes prior to loan effectiveness. In the second phase of project implementation, SEDAPAL will start to finance the secondary network, and these costs will be incorporated into water and sewerage tariffs. 1. SEDAPAL's rate structure has six rate categories, but only five are used. District income level determines which rate is applied. The rate categories range from 22 to 65 cubic meter a month. 2. Poverty thresholds at the end of 1993 were S/ 1,549 (about US$707) per capita per year for the poor and S/ 791 (about US$361) per capita per year for the extremely poor. These data are based on the October 1991 poverty threshold in Lima (World Bank data) and adjusted for GDP and exchange rate trends. 3. According to a survey of water vendors in December 1993, water costs range from SV. 0.80 to S/. 1.50 for a cylinder of 200 liters. Average monthly household use is 5 cubic meters, which corresponds to daily per capita use of 30 liters.  - 11 - G. Financial analysis 58. A Bank loan equivalent to US$150 million will help finance foreign and local costs amounting to about 49 percent of total project cost (Table 2). A cofinancier--the Overseas Economic Cooperation Fund--is expected to provide a loan of about US$76 million for specific project subcomponents. The remaining US$80 million will be provided by SEDAPAL. Table 2 Financing plan, 1994-2000 (millions of U.S. dollars) Bank-financed projecta SEDAPAL total investment plan Source offunds Amount Percent Amount Percent World Bank 150.0 49.0 150.0 22.6 Cofinancier 76.2 24.8 76.2 11.5 SEDAPAL 80.1 26.2 317.0 47.8 Other loansb 120.3 18.1 Total 306.2 100.0 663.6 100.0 a. Does not include US$40.5 million interest accrued during construction, to be financed by SEDAPAL's intemal resources. b. A majority of these loans are provided by FONAVI and other domestic institutions for primary and secondary works (US$66 million). 59. SEDAPAL's financial perfonnance, 1987-93. SEDAPAL's financial performance has been affected by Peru's unstable macroeconomic environment. During 1986-92, Peru experienced hyperinflation-reaching 7,650 percent annually in 1990. Financial performance has also deteriorated because of poor financial management and inefficient operations. As a result, SEDAPAL has not been able to maintain its physical assets, leading to rapid deterioration of service quality. Financial statements with notes and assumptions are in Annexes 11 and 12. 60. SEDAPAL's net internal cash generation turned negative in 1988. As liquidity worsened, the company stopped paying its debts and delayed payments to suppliers. By end-1993 SEDAPAL had US$45 million of external debt in arrears. This debt was assumed by the Government according to agreements reached at the Paris Club and other bilateral meetings. But SEDAPAL still carries this debt as an obligation to the Government. The company has depended increasingly on state transfers and user contributions to cover minimal investment and working capital needs. With scarce financial resources, SEDAPAL's investment stagnated between US$15 and US$26 million in the past several years-much lower than the level required to maintain service quality. 61. Restructuring SEDAPAL. Financial performance started to improve in 1991 as inflation abated and restructuring began. Tariffs increased from a low of US$0.10 per cubic meter in 1989 to US$0.28 per cubic meter in May 1994-still lower than the estimated marginal cost of US$0.45 per cubic meter. A voluntary retirement plan reduced the number of employees by 33 percent between 1987-93, and personnel costs dropped from 75 percent of operating costs in 1987 to 40 percent in 1993. The number of employees per 1,000 water connections improved from 6.38 in 1987 to 2.74 in December 1993 (Table 3). This figure compares favorably with water companies of similar size elsewhere in Latin America. Because of increased tariffs and decreased operating costs, SEDAPAL generated positive net income in 1993 for the first time in more than a decade. 62. SEDAPAL's financial management systems have considerable room for improvement. Medium- and long-term investment and financial planning has not been done until recently. Monthly financial statements take three or four months to process. And the commercial system needs improvement. In late 1993 SEDAPAL launched a billing and collection program that seeks to reduce by 40 percent the amount of bills uncollected after three months past due. If successful, accounts receivable would be reduced to 75 days of revenue by 1995. The program has not been as  - 12 - effective as expected because of a recent tariff increase. In addition, SEDAPAL's fixed assets (US$432 million at end-1993) have not been revalued sufficiently in the last several years, and are thought to be significantly undervalued. Table 3 Financial data, SEDAPAL, 1987-93 1987 1988 1989 1990 1991 1992 1993 Financial indicators Water and sewerage tariff (per cubic meter) 0.21 0.13 0.10 0.15 0.21 0.20 0.21 Operating revenue (millions of U.S. dollars) 82.4 53.0 41.3 60.1 85.6 91.0 101.8 Operating expenses (millions of U.S. dollars) 66.3 64.7 62.5 59.2 77.4 74.0 69.4 Net income (millions of U.S. dollars) -27.7 -128.5 -98.6 -115.1 -23.4 -14.9 20.2 Working ratio (percentage) 80.5 122.1 151.3 98.6 90.4 81.2 68.2 Operating ratio (percentage) 119.4 261.3 291.6 209.7 120.5 99.5 79.0 Investment (millions of U.S. dollars) 15.0 17.8 20.2 18.9 26.4 18.1 39.5 Operational indicators Accounts receivable comparator (days) 78 116 100 116 90 100 119 Employees per 1,000 water connections 6.38 6.35 5.79 5.44 4.81 3.49 2.74 63. Projected financial perfonnance, 1994-2000. The financial projections presented in Annex 11 assume operational efficiency and investment that could be attained by a reasonably well- managed public utility in Latin America. These conservative projections assume that: SEDAPAL will increase water service coverage to 88 percent by 2000 (from 79 percent in 1993), there will be no Government transfers, the average water and sewerage tariff will increase to US$0.37 per cubic meter, and SEDAPAL will refinance its external debt in arrears and repay its obligations to the Government. 64. Under this base-case scenario, operating and financial performance will improve gradually. By 2000, SEDAPAL will reduce its unaccounted-for water level to about 41 percent (from 46 percent in 1993). Employee productivity will improve further, to 1.96 employees per 1,000 connections, through a gradual reduction of SEDAPAL's staff. With decreased personnel costs, SEDAPAL will maintain a working ratio of less than 60 percent and an operating ratio of 75 percent, while increasing needed maintenance costs. Commercial efficiency should reduce the accounts receivable to about 75 days of revenue by 1995, thereby increasing funds for investment. SEDAPAL will generate sufficient cashflow to pay its debts and cover a substantial portion of projected total investment (US$664 million, not including capitalized interests). By 2000, SEDAPAL's internal cash will cover more than 50 percent of investment, including 26 percent of the Bank project. 65. Sensitivity analysis. A sensitivity analysis was conducted on key variables to determine their impact on SEDAPAL's internal cash generation and the level of investment that could be executed between 1994 and 2000. This analysis highlighted the importance of operational efficiency and tariff increases to SEDAPAL's financial performance and to timely execution of the investment program. Three efficiency scenarios and two tariff structures were used to determine possible impacts on SEDAPAL's investment capacity. The "private sector" scenario estimates efficiency under private management. The "improved public sector" scenario, which includes the base case scenario described above, assumes that SEDAPAL's operational efficiency will improve to the level of a reasonably well-managed public utility elsewhere in Latin America. The "business-as-usual" scenario assumes no improvement. Each scenario is analyzed under two tariff structures-a gradual increase to US$0.37 per cubic meter and the May 1994 level of US$0.28 per cubic meter. Internal investment sources were calculated for each combination to determine the level of investment afforded under each scenario (Table 4).  - 13 - Table 4 Sensitivity analysis for two tariff rate structures Gradual increase to Efficiency scenario US$0.37 per cubic US50.28 per cubic meter meter Private sector (lowers unaccounted-for water to 30 percent) Investnent level (millions of U.S. dollars) 752 541 Maximum working ratio (percent) 57 65 hnproved public sector (lowers unaccounted-for water to 41 percent) Investment level (millions of U.S. dollars) 664 474 Maximum working ratio (percent) 60 73 Business as usual (unaccounted-for water remains at 46 percent) Investment level (millions of U.S. dollars) 633 450 Maximum working ratio (percent) 64 78 66. Under the private sector scenario, at tariffs of US$0.37 per cubic meter, investment would be US$752 million-10 percent more than planned. The financial performance of the company could improve even further under this scenario, since the Government will likely assume all or part of SEDAPAL's debt obligation once a concession is awarded. Under the improved public sector scenario, with increased tariffs, the total investment program (US$663.6 million) will be completed in seven years. With no tariff increase, investment would be limited to about US$541 million-83 percent of what is planned. Under the business-as-usual scenario, with a tariff increase, internal cash generation and investment will fall short of what is planned. Without a tariff increase, SEDAPAL would be able to execute only about 68 percent of total investment. The investment program in this case would be delayed by more than four years, which defers the net incremental benefit of the investments. Under the business-as-usual scenario, the internal financial rate of return of the project is reduced to 10 percent, compared with 17 percent under the base-case scenario. Details of the assumptions and results are presented in Annex 12. 67. To strengthen SEDAPAL's financial standing, assurances were obtained during loan negotiations that SEDAPAL will: * Generate sufficient cashflow to cover 30 percent of the total investment program. * Revalue its fixed assets and incorporate the study's recommendations into 1995 end-year financial statements in a form acceptable to the Bank. * Improve employee productivity-the number of employees per 1,000 water connections-to less than 2.5 by end-1995, and less than 2.0 by end-2000. * Maintain a debt service coverage ratio no lower than 1.5. * Sign annual management agreements to contain physical, operational, and financial performance targets. In addition, the Government and SEDAPAL should agree on a timetable for settling SEDAPAL's external debt in terms acceptable to the Bank, before the closing of the concession contract. If privatization is successful, the Government should cancel at least the overdue portion of SEDAPAL's external debt (US$45.8 million at end-1993). SEDAPAL could then pay on the current portion of the debt. If privatization is unsuccessful, the Government and SEDAPAL should agree on a debt refinancing plan, and possibly a debt cancellation scheme tied to the second management agreement. H. Environmental Aspects 68. The project is classified as Category B under the Bank's environmental guidelines. An Environmental Impact Assessment has been carried out for the project and is available in the project  - 14 - files. Temporary adverse impacts are the disruption of road traffic during construction and increased wastewater from connections in the pueblos jovenes. The first impact will be mitigated by careful scheduling of construction. The second will be addressed by the comprehensive wastewater management project whose preparation is partly financed by this project. Since the project emphasizes rehabilitating existing infrastructure, conserving water, and expanding service to low- income areas, it will deliver significant environmental benefits. These benefits include improved health, quality of life, and supply reliability and reduced flooding, odor, and groundwater depletion and contamination. L. Risks 69. The project's main risks are political opposition to the sectoral reform-including privatization-that may slow the reform process, ineffective execution of the project during the transition from public to private sector operation, insufficient counterpart funding, and non- acceptance of Bank funds by the concessionaire. The risk of political opposition is minimized by three factors. First, the new regulatory and institutional framework is the result of two years of consensus-building by the Government of Peru to advance reform. Second, the timing and social environment for privatization is favorable-the current administration wants to advance SEDAPAL's privatization before the April 1995 elections. Finally, successful privatization in other sectors and public utilities has created social support for privatization. The risk of ineffective execution of the project during the transition period is minimized by a management agreement to be signed between SEDAPAL and the Government. This agreement defines key operational and investment performance objectives and will be evaluated every three months until the private operator assumes responsibility. If privatization is unsuccessful, terms for a second management agreement will be discussed with SEDAPAL and the Government during the Project Review. Annual management agreements should be signed thereafter. If privatization is successful, a performance plan-as part of the concession contract-will be signed between the private operator and SEDAPAL. The risk of insufficient counterpart funding is minimized through the new tariff regulations, which allow for adequate levels of revenue and automatic adjustments based on five-year tariff formulas, and through the monitoring of investment decisions and operational efficiency through the management agreement (before privatization) and the performance plan (after privatization). The risk that the concessionaire may not enter into a subsidiary loan agreement with SEDAPAL for the use of the Bank funds, and hence the possibility of an early partial cancellation of the Bank loan, is minimized by the fact that prequalified private operators have already shown considerable interest on the Bank to finance urgent rehabilitation work. III. Project Implementation 70. The borrower is the Republic of Peru. The executing agency is SEDAPAL. The project will be managed by a project management unit within SEDAPAL. The project management unit will be responsible for overall management of the project, and will ensure consistency in the application of Bank guidelines and compliance with the loan agreement, the subsidiary loan agreements, and project agreement conditions. A. Arrangements 71. Although the project is a conventional Bank project-with an investment component and an institutional component-project implementation is linked to SEDAPAL's privatization process. The Loan Agreement will be signed by the Republic of Peru (represented by the Ministry of Economy and Finance) and the Bank. A Project Agreement will be signed by SEDAPAL and the Bank to directly execute the project during the transitional period before privatization, and through the private contractor after privatization. SEDAPAL, representing the Government of Peru, will sign a concession contract with the private operator.  - 15 - 72. First phase. Project implementation will have two phases. The first phase, expected to last up to 12 months, corresponds to the project execution period while privatization takes places, and ends with a comprehensive project review. During this phase, up to 20 percent of the project-about US$56 million-would be committed by SEDAPAL. Operational indicators and investment goals will be monitored and managed by a management agreement to be made between SEDAPAL and the Government of Peru, in a form satisfactory to the Bank. As condition of effectiveness, the Government and SEDAPAL will sign the management agreement for 1995. 73. Second phase. The second phase will be initiated after the project review. Two scenarios are possible. If privatization is successful, SEDAPAL, representing the Government of Peru, will sign a concession contract with the private operator. SEDAPAL will continue to exist as the owner and administrator of the concession contract. Its project management unit will be responsible for institutional development and the investment component of the project accepted by the private concessionaire. Once privatization occurs, however, SEDAPAL's statutes will have to be adjusted to allow for such arrangements. Bank staff provided comments on the draft revised statutes during loan negotiations. SEDAPAL's project management unit would continue to manage the institutional development component of the Project, handle all disbursement requests, and if so agreed with the concessionaire, it would carry out the procurement for the investment component of the Project accepted by the concessionaire. This would facilitate the application of the Bank's requirements with respect to procurement as stipulated in the Project Agreement. The concessionaire may elect to carry out all procurement itself. If it elects to receive the benefit of the terms of the Bank loan by entering into a subsidiary loan agreement with SEDAPAL, it will have to agree to assume all obligations of SEDAPAL for the execution of the investment component of the Project under its Project Agreement with the Bank--including the Bank procurement rules. A draft of the subsidiary loan agreement will be included in the bidding documents of the concession. Because it is possible that the plans of the concessionaire may call for a somewhat different execution or a different timing of the urgently needed rehabilitation measures described in the Project Description in the Loan Agreement, a comprehensive project review would be carried out jointly by the Bank, the Government, SEDAPAL, and the concessionaire prior to the closing of the concession transaction to determine to what extent the Loan Agreement, the Project Agreement, and the first Subsidiary Loan Agreement (SLA-1) would have to be changed, if at all, including possibly the cancellation of a portion of the Bank loan. The second Subsidiary Loan Agreement between SEDAPAL and the concessionaire (SLA-2) would incorporate, by reference, all the relevant obligations of SEDAPAL under the revised Loan and Project Agreements. The performance obligations of the operator will then be monitored by the Bank until the project is completed. If privatization is unsuccessful, the project will still be modified at Project Review, with institutional strengthening expanded as needed. Annual management agreements between the Government and SEDAPAL, approved by the Bank, would ensure monitoring of project implementation during the second phase. In both scenarios, the Bank loan would be fully recovered through tariffs. 74. Project management. The project management unit will report to a project committee at SEDAPAL chaired by the general manager. This unit is responsible for overall project execution, including all bidding processes, preparation of disbursement requests, management of project accounts, and preparation of progress reports. It will be composed of at least a project manager, a financial analyst, a sanitary engineer, and a procurement officer. The project manager was appointed prior to loan negotiations. The project management unit will be assisted by management consultants to be firnanced through the project. The project management unit will carry out the project directly during the first phase of implementation, investing up to 20 percent of the Project. The remaining 80 percent of the proceeds of the Bank Loan, or the amount accepted by the concessionaire, will be used for the procurement of works, goods and services through the concessionaire applying Bank rules on procurement. The institutional component will also be assessed at Project Review to reflect the outcome of the privatization process. Terms of reference for the project management unit were agreed on during loan negotiations, with staffing concluded by loan effectiveness. The main functions of the project management unit, the project committee, and the management consultant are outlined in Annex 14. As condition of effectiveness, SEDAPAL will have formally established the project management unit and the project consultative committee and  - 16 - will have staffed the PMU as agreed at negotiations. Agreement was reached with SEDAPAL to operate and maintain the unit and the committee during project implementation with functions and responsibilities satisfactory to the Bank. 75. Legal documents and conditionality. Project legal documents include a loan agreement between the Republic of Peru (represented by the Ministry of Economy and Finance) and the Bank, a subsidiary loan agreement (SLA-1) between the Ministry of Economy and Finance and SEDAPAL, and a project agreement between SEDAPAL and the Bank to execute the project. Financing terms and conditions are the same in the subsidiary loan as in the Bank loan, with foreign exchange risk borne by SEDAPAL. There is a second subsidiary loan agreement (SLA-2) between SEDAPAL and the concessionaire for any parts of the project carried out by the concessionaire using the proceeds of the Bank loan. Terms and conditions of the SLA-2 must be satisfactory to the Bank, and will be stipulated in bidding documents for the concession. The concessionaire could decline to take the subsidiary loan, and any part of the Bank funds not accepted by the concessionaire will be canceled. The Government of Peru will countersign the SLA-2 to confirm its agreement. Agreement was reached during loan negotiations that the project will be carried out in accordance with the management agreement prior to Project Review. After the Project Review, the project must be in accordance with the concession contract and SLA-2 or, if privatization fails, the project will be carried out in accordance with the second management agreement and subsequent annual agreements (as approved by the Bank). A summary of the legal documents and institutions involved is in Annex 15. 76. Special account. A Special Account will be established in U.S. dollars in a commercial bank acceptable to the Bank. The authorized allocation-sufficient for about four months of expenditures-will be US$8.0 million. It was agreed during loan negotiations that the authorized allocation will be limited to US$4.0 million until the aggregate amount of withdrawals exceed US$20.0 million. The threshold under which use of this account is obligatory is US$800,000. The Bank will replenish the special account upon receipt of disbursement requests from the Government. SEDAPAL's project management unit will control the special account and be responsible for disbursement requests. Requests will be submitted monthly, or when the account balance is 67 percent of its initial deposit, whichever comes first. SEDAPAL will also establish a separate account in local currency. Counterpart funds will be deposited at regular intervals to match requirements for each component under execution, according to a schedule to be presented every three months. Both accounts will be managed in accordance with international accounting standards. 77. Project review. Once the results of the privatization process have been published by the Government of Peru, a Project Review involving the Government, the Bank, and the private operator will occur prior to the second phase of the project. This review is essential to project implementation. A draft terms of reference for the review was discussed during appraisal and agreed to during loan negotiations (Annex 16). Prior to Project Review, SEDAPAL should have reached a final agreement with the Government on settling its external debt and submitted proposals to the Bank for modification of the loan agreement, project agreement, and subsidiary loan agreement, if necessary. If privatization is successful, the Project Review will accommodate, to the extent possible, the proposed investment and financing plan proposed by the concessionaire and determine any amendments to the legal documents--including any cancellation of a portion of the loan--as necessary. If privatization is unsuccessful, and SEDAPAL remains as the service provider, the Project Review will adjust the institutional support component to strengthen SEDAPAL's institutional and management capacity, particularly in financial and commercial areas. The Project Review will take place either ninety days within the award of the concession, or not later than December 31, 1995, or when aggregated loan disbursements amount to US$40 million, whichever comes first, in the event that the concession has not been previously awarded. In addition to the Project Review, two workshops will be held to explain Bank procedures. The first will be held at the beginning of the first phase of project implementation, and no later than two months after loan signature. The second will be held after Project Review to initiate the second phase of project implementation.  - 17 - B. Subproject selection criteria 78. There are two types of subprojects related to water supply and sanitation service in Lima-rehabilitation and expansion. Rehabilitation subprojects will be selected based on technical criteria agreed on during project preparation relating to maintenance urgency, district location, and pipe material. Expansion subprojects in the pueblos jovenes will be chosen based on two principles. First, districts are prioritized based on service demand-the community is responsible for preparing and submitting subproject proposals. Second, project management should be limited to defining and disseminating the "rules of the game" (technical and financial criteria for feasibility) and quality control. A more detailed description of the selection criteria for subprojects is in Annex 17. C. Project supervision 79. SEDAPAL's project management unit will supervise all project components, including SEDAPAL's compliance with the Project Agreement. A project implementation manual prepared by SEDAPAL contains basic project management procedures. An acceptable version of this manual was agreed to during loan negotiations, and the final version will be formally adopted prior to loan effectiveness. Project reviews and supervision will be based on well-defined and measurable institutional, physical, operational, and financial indicators developed during appraisal. Monitoring indicators were agreed with the Government during loan negotiations (Annex 19). 80. The project will require considerable Bank supervision-20 staff-weeks have been allocated for the first phase of implementation (Annex 18). The Project Review will be a key instrument of Bank supervision. Supervision will be based on SEDAPAL's 1994-2000 investment and financial plan, performance indicators and targets in the concession contract, the set of project monitoring indicators indicated above, and the targets in the management agreement between SEDAPAL and the Government. During loan negotiations, agreement was reached that SEDAPAL and the Bank will conduct annual reviews of the progress in the implementation of the project based on an annual operating plan presented by SEDAPAL, including a review of the implementation schedule, monitoring indicators and budget for the incoming year. These reviews will take place not later than October 31 of each year. Progress in the implementation of the Project will be based on the indicators in Annex 19. D. Procurement 81. Civil works represent about 83 percent of total project cost. Equipment and materials used in civil work contracts account for 25 percent of this percentage. Consultant services (studies, supervision, management, technical assistance, and engineering designs) account for 9 percent of total project cost, and equipment and materials, 8 percent. All equipment and materials contracts estimated to cost less than US$250,000 up to an aggregate amount of US$2.0 million, and civil works estimated to cost less than US$3 million up to an aggregate amount of US$42.9 million, could be procured under local competitive bidding. Above these limits, procurement will be carried out through international competitive bidding, using Bank's standard bidding documents for goods and works. Seventy percent of works will be procured under international competitive bidding (Table 5). Draft standard bidding documents for local competitive bidding are being prepared taking into consideration the most recent Country Procurement Assessment Report, which concludes that regulations for local competitive bidding procedures in Peru are not entirely consistent with Bank procedures. Consultant services, including engineering, supervision and technical studies will be procured according to Bank Guidelines. Supervision and engineering designs amounting to more than US$50,000 for firms and US$20,000 for individuals will require prior Bank review. The Procurement Plan and Implementation Schedule is in Annex 13, including a preliminary bidding package.  - 18 - Table 5 Project costs by procurement method (millions of U.S. dollars) Internatonal Local compedtve Project ekment competitive bidding bidding Other Total Civil works 210.0 42.9 252.9 (69.8) (30.6) (100.4) Equipment and materials 22.4 2.0 24.4 (22.4) (1.4) (23.8) Consulting services 28.9 28.9 (25.8) (25.8) Total 232.4 44.9 28.9 306.2 (92.2) (32.0) (25.8) (150.0) Note: Figures in parentheses are amounts financed by the Bank loan. 82. International bidding will be subject to Bank review of advertising, bidding documents, bid evaluation, and contract awards. To expedite project execution, only local bidding for works exceeding US$500,000 and US$100,000 for goods will be subject to ex ante review. These prior review arrangements would result in a coverage of above 85 percent of Bank finance of contracts for goods and works. If the Bank determines that procurement is inconsistent with agreed procedures, said expenditures cannot be financed by the loan and the Bank may cancel an equivalent amount of the loan. E. Disbursement 83. The loan will cover 100 percent of foreign expenditures for consultants, works and goods, 85 percent of local expenditures for consultants, and 66 percent of local expenditures for civil works, equipment, and materials. Funding will be disbursed through the special account to expedite project implementation. Disbursements for civil works contracts of less than US$500,000 and goods of less than US$100,000, and also for consulting contracts with firms and individuals costing US$100,000 and US$20,000 respectively, will be made under the statements of expenditure procedure prepared and certified by SEDAPAL's project management unit. Documentation will be retained by the management unit for inspection during supervision missions and for auditing. No force account works are envisaged. The estimated schedule of disbursement (Annex 20) lasts six years, ending on December 31, 2000. The closing date will be June 30, 2001. F. Advance contracting and retroactive financing 84. The loan will finance works between 1994 and 2000. Some emergency rehabilitation and consultant services have already been funded to allow full implementation by mid-1995. Advance contracting-about US$20 million-began on May 15, 1994, and retroactive financing-about US$10 million-will be provided for eligible expenditures incurred since that day. Advance contracting and retroactive financing must follow Bank procurement guidelines. To ensure a prompt project start and loan disbursement, SEDAPAL provided the Bank with bidding documents for subprojects expected to be eligible for retroactive financing and terms of reference for selected studies and technical assistance. G. Auditing arrangements 85. During loan negotiations the Bank and SEDAPAL agreed that external auditors will perform an annual audit of SEDAPAL's project accounts, statements of expenditure, the special account, and financial statements. Each year's audit report will be submitted to the Bank by June 30 of the following year.  - 19 - H. Reporting and monitoring 86. Quarterly progress reports, as described in the project implementation manual, will describe and compare project progress with the progress envisaged at appraisal, review compliance with the monitoring indicators in Annex 19, and assess problems and issues arising during project execution. The reports will also propose adjustments and remedial action in case of unsatisfactory progress. Agreement was reached during loan negotiations that progress reports will be submitted to the Bank by March 31, June 30, September 30, and December 31 of each year. A final report analyzing key issues and containing the borrower's assessment of the project will be submitted to the Bank within six months of the loan closing date. IV. Agreements Reached and Recommendation 87. During loan negotiations, SEDAPAL agreed: a. To generate sufficient internal funds to cover at least 30 percent of the total investment program throughout the project execution period (para. 67). b. To revalue its fixed assets and incorporate the study's recommendations into 1995 end-year financial statements in a form acceptable to the Bank (para. 67). The asset revaluation study, satisfactory to the Bank, would be completed by no later than December 31, 1995. c. To improve employee productivity-the number of permanent employees per 1,000 water connections-to less than 2.5 by end-1995, and to less than 2.0 by end-2000 (para. 67). d. To maintain a debt service coverage ratio no lower than 1.5 (para. 67). e. On the contents of the terms of reference for the project management unit (para. 74). f. To carry out the project in accordance with the first management agreement prior to project review. After the Project Review, the project must be in accordance with either the concession contract and second subsidiary loan agreement or, if privatization fails, the second management agreement and subsequent annual management agreements (para. 75). All agreements are subject to Bank approval. g. On the selected indicators and targets to be monitored during project implementation (para. 79). h. To hold with the Bank annual reviews on the implementation of the Project. These reviews will take place not later than October 31. Progress in the implementation will be based on the indicators in Annex 19. i. That external independent auditors, satisfactory to the Bank, will perform an annual audit of project accounts, statements of expenditures, the special account, and SEDAPAL's financial statements. Each fiscal year's audit report should be submitted to the Bank by June 30 of the following year (para. 85). j. That quarterly progress reports will be submitted to the Bank by March 31, June 30, September 30, and December 31 of each year (para. 86). k. To hold a Project Review in accordance with the timing and terms of reference as described in annex 19 (para. 77). 1. To establish and maintain a project account for purposes of depositing the necessary counterpart funds in accordance with schedules to be presented to the Bank on March 31, June 30, September 30 and December 31. m. To prepare and present to the Bank, not later than November 30 each year, an annual operating plan with a review of the implementation schedule, monitoring indicators and budget for the incoming year (para.80). 88. During loan negotiations, the Government of Peru and SEDAPAL agreed: a. To submit proposals for modification of the loan agreement, project agreement, and subsidiary loan agreement to the Bank before Project Review (para. 77). b. On the terms of reference for the Project Review (para. 77).  - 20 - c. To amend SEDAPAL's Bylaws, in a form satisfactory to the Bank, to adapt such Bylaws to the Water and Sanitation Services Law (para. 73). 89. Prior to loan effectiveness: a. New tariff regulations should be approved by an executive decree as part of the regulations of the Water and Sanitation Services Law (para. 52). b. The Ministry of the Presidency should submit to the Bank a proposal satisfactory to the Bank for financing secondary works in accordance with the Water and Sanitation Services Law (para. 57). c. SEDAPAL has formally established the project management unit and the project consultative committee and has staffed the project management unit according to the terms of reference agreed at negotiations. d. SEDAPAL should formally adopt the project implementation manual (para. 79). e. The Government of Peru and SEDAPAL have executed the subsidiary loan agreement. f. The Government and SEDAPAL have executed the management agreement for 1995. g. SEDAPAL has opened the project account. 90. An agreement between the Superintendency of Sanitary Services and SEDAPAL, satisfactory to the Bank, will be a condition to disburse the institutional straightening subcomponent of the Superintendency. 91. Recommendation. Subject to the above conditions, the project is suitable for the Bank loan of US$150 million equivalent, to be repaid over 17 years, including a grace period of five years, at the Bank's standard variable rate.  - 21 - PERU LIMA WATER REHABILITATION AND MANAGEMENT PROJECT STAFF APPRAISAL REPORT ANNEXES  - 22 -  PERU ANNEX 1 LIMA WATER REHABIUTATION AND MANAGEMENT PROJECT BANK LOANS TO PERU WITH WATER AND SANITATION COMPONENTS Status as of April 30, 1994 .,,,,- -- ... .moi,rn . Bo1wer: ..,.... , ,. ' ""'' . , ' ' ' ' 'C 1976 1283-PE 21.6 Banco de la Urban Sites and Services 100% The project did not achieve its cost recovery objectives. Vivienda Development 1979 S-1 1-PE 8.8 Republic Water Supply and 93% 7% of the loan was cancelled. There were initial delays of Peru Power Engineering due to non-compliance with legal and financial conditions of the Loan Agreement. .... .... tSA - Up_ niPply-........ .: . :f pt o e :Iui c l w : . . . . . . . . . . .'. . . . . . . . . ... . ... 1983 2204-PE 10.2 Republic Public Sector 99% 1 % of the approved loan amount was cancelled. The of Peru Management project was designed to improve overall performance of Government. 1985 2451-PE 60.1 Republic Lima Metropolitan 40% 60 % of the approved loan amount was cancelled. The of Peru Development erosion of sectoral institutions and policies led to the suspension of loan disbursements in May 1987. 1993 3540-PE 30 Republic Privatization 10% Various options have been assessed for privatizing of Peru Technical Assist SEDAPAL. The recommendation by the consultants is to pursue the concession approach. 1993 3595-PE 250 Republic Privatization 30% The successful privatization of the government's telecom of Peru Adjustment holdings has given an enormous boost of confidence I___ __ ____ _ ____ __ _____ I __________ I___ to the privatization strategy of the country. 1 Only one project sector specific has been approved in Peru.  - 24 - Annex 2 Bank Experience and Lessons Learned 1. Most water and sanitation projects provide substantial economic and health benefits. Since the 1960s-when Bank lending in this sector began-projects have become larger, with many involving assistance to multiple entities under one operation. Some operations relied on intermediaries to control implementation and to provide assistance. Many operations aimed to consolidate water entities. The main lessons from this experience are: * Achieving institutional and cost recovery objectives is slow and difficult. * Adequate project preparation, early land acquisition, and manageable procurement procedures are essential to avoid project implementation delays. * The quality of Bank supervision during project implementation is a key factor in achieving objectives. * Sound management and adequate maintenance are important to avoid endangering the sustainability and benefits of new facilities. * Attention should be paid to wastewater disposal in densely populated areas. * More attention should be given to the high levels of unaccounted-for water that are commonly observed in water companies throughout Latin America. Experience in Latin America 2. Most water and sewerage projects in Latin America have met their physical objectives-and in some cases surpassed them-but have suffered from implementation delays (averaging about two years longer than estimated during appraisal) and failure to meet their institutional objectives. The main lessons from the regional experience are: