Argentina - Water Sector Reform Project

Document of The World Bank Report No: 19258 PROJECT APPRAISAL DOCUMENT ON A PROPOSED LOAN IN THE AMOUNT OF US$30.0 MILLION TO THE ARGENTINE REPUBLIC FORA WATER SECTOR REFORM PROJECT IN SUPPORT OF THE FIRST PHASE OF THE WATER SECTOR REFORM PROGRAM May 10, 1999 Finance, Private Sector and Infrastructure Country Management Unit 5 Latin America and the Caribbean Regional Office  CURRENCY EQUIVALENTS (Exchange Rate Effective October 1998) Currency Unit = Argentine Peso ($) LC = US$1.00 US$1.00 = LC WEIGHTS AND MEASURES Metric System FISCAL YEAR January 1 - December 31 ABBREVIATIONS AND ACRONYMS APL - Adaptable Program Lending COFESA - Federal Council for Sanitation EIRR - Economic Internal Rates of Return ENOHSA - National Agency for Water and Sanitation Works GoA - Government of Argentina ICSID - International Center for Settlement of Investment Disputes IDB - Inter American Development Bank IFC - International Finance Corporation INDEC - the Census and Statistics Institute lpd - liter per capita per day NBI - unsatisfied basic needs NPV - Net Present Value OFWAT - Office of Water Services OSN - National Agency of Sanitary Works PMU - Project Management Unit POM - Project Operational Manual PSP - Private Sector Participation SOE - Statement of Expenditures SPIDES - Water Sector Information System UNICEF - United Nations Children's Fund Vice President: Shahid Javed Burki Country Manager/Director: Myrna Alexander Sector Manager/Director: Danny Leipziger Team Leader: Abel Mejia/Yoko Katakura  Argentina Water Sector Reform Project CONTENTS A Program Purpose and Project Development Objective ..........................................................2 1. Program purpose and program phasing .................................................................. 2 2. Project development objective ..................................................................2 3. Key performance indicators ..................................................................2 B Strategic Context ..................................................................2 1. Sector-related Country Assistance Strategy (CAS) goal supported by the project ......... 2 2. Main sector issues and Government strategy ..................................................................3 3. Sector issues to be addressed by the project and strategic choices .................................7 4. Program description and performance triggers for subsequent loans .............................8 C Project Description Summary .................................................................9 1. Project components ................................................................. 9 2. Key policy and institutional reforms supported by the project .......................................9 3. Benefits and target population .................... ..............................................9 4. Institutional and implementation arrangements ............................................................ 10 D Project Rationale ................................................................. 12 1. Project alternatives considered and reasons for rejection ............................................. 12 2. Major related projects financed by the Bank and/or other development agencies ....... 13 3. Lessons learned and reflected in the project design ............................................. ........ 14 4. Indications of borrower commitment and ownership . ................................................... 15 5. Value added of Bank support in this project ................................................................. I5 E Summary Project Analysis ................................................................. 15 1. Economic ................................................................. 15 2. Financial ................................................................. 16 3. Technical ................................................................. 17 4. Institutional ................................................................. 18 5. Social .................................................................. 20 6. Environmental assessment ................................................................. 22 7. Participatory approach ................................................................. 23 F Sustainability and Risks ................................................................. 23 1. Sustainability ................................................................. 23 2. Critical Risks ................................................................. 24 3. Possible Controversial Aspects ................................................................. 25  G Main Loan Conditions .............................................................. 25 1. Effectiveness Conditions .............................................................. 25 2. Other .............................................................. 25 H Readiness for Implementation .............................................................. 25 I Compliance with Bank Policies .............................................................. 25 Annexes Annex I Project Design Summary .............................................................. 26 Annex IA Key Performance Indicators - Utility Based ............................................. 28 Annex IB Key Impact Indicators - Program Based .................................................. 30 Annex IC Key Impact Indicators - Sector Based ..................................................... 31 Annex 2 Detailed Project Description .............................................................. 32 Annex 2A Summary of Guidelines for Regulatory Models and Concession Contracts .......... 37 Annex 2B Potential Beneficiaries of the Program ..................................................... 40 Annex 2C Table of Content of the Project Operational Manual .................................... 44 Annex 3A. Estimated Project Costs .............................................................. 47 Annex 3B. Detailed Project Costs .............................................................. 48 Annex 4. Cost-Benefit Analysis Summary .49 Annex 5. Financial Summary for Revenue-Earning Project Entities .59 Annex 6. Procurement and Disbursement Arrangements .70 Table A. Project Costs by Procurement Arrangements .71 Table B. Thresholds for Procurement Methods and Prior Review .71 Table C. Allocation of Loan Proceeds .72 Annex 7. Project Processing Budget and Schedule .74 Annex 8. Documents in Project File .75 Annex 9. Statement of Loans and Credits .77 Annex 10. Country at a Glance .82 Annex 11. Letter of Development Program from the Government of Argentina ................. 84 Map  Argentina Water Sector Reform Project Project Appraisal Document Latin America and the Caribbean Regional Office LCC7C Date: May 10, 1999 Team Leader: Abel Mejia, Yoko Katakura Country Manager/Director: Myrna Alexander Sector Manager/Director: Danny Leipziger Project ID: ARPE-6046 Sector: Water Supply and Sanitation Lending Instrument: APL Theme(s): Reform Poverty Targeted Intervention: [ ] Yes [x] No Program Financing Data APL Indicative Financing Plan Estimated Ithplemnentation Borrower ______ - Period (Bank FY) IBRD Othersi Total Commitment Closing US$ m % US$m US $ m Date Date APL 1 30.0 64 17.1 47.1 7/31/1999 7/31/2002 The Argentine Republic APL 2 40.0 57 29.9 69.9 1/31/2002 1/31/2004 The Argentine Republic Total 70.0 60 47.0 117.0 Project Financing Data [x ] Loan [I Credit [ Grant [] Guarantee [ Other [Specify] For Loans/Credits/Others: Amount (US$m): 30.0 Proposed terms: [ ] To be defined [] Multicurrency [X] Single currency [ Standard Variable [ Fixed [xl LIBOR-based Grace period (years): 5 Commitment fee: 0.75% Years to maturity: 15 Front-end fee on Bank loan: l% Financing plan: [ 3 To be defined Source Local Foreign Total IBRD (Including front-end fee) 14.6 15.4 30.0 Utilities/Cooperatives 17.1 17.1 Total: 31.7 15.4 47.1 Borrower: The Argentine Republic Responsible agency(ies): The Secretary of Natural Resources and Sustainable Development Estimated disbursements (Bank FY/US$M): FY 2000 2001 2002 Annual 6.0 14.0 10.0 Cumulative 6.0 20.0 30.0 Project implementation period: 2 years Expected effectiveness date: August 31, 1999 Closing date: July 31, 2002 Implementing agency: ENOHSA Contact person: Dr. Jorge Rais E-mail ENOHSAI@INEA.COM.AR OCS APL PAD Form: February 28. 1999  A: Program Purpose and Project Development Objective 1. Program purpose and program phasing: (see Annex 1) The program seeks to support water sector reforms in medium-size cities with population of about 50,000, to 500,000, through the introduction of private sector participation in the operation and management of water utilities, adoption of appropriate regulatory frameworks, and institutionalization of tariff policies and tested investment alternatives to reach better poor consumers. While extending the reforms to these new medium-sized cities, the program also supports resolving the emerging issues of the earlier reform process in larger cities: weak economic regulation of utilities, slow expansion of services to the urban poor, and the lack of a well-defined framework to enforce environmental standards. The expectation is that this reform process will put this segment of Argentina's water and sanitation sector on a sound enough footing to attract private sector financing in combination with the appropriate role for the public sector. The program will be implemented in two phases over a 5-year period. The program will geographically expand the sector reform over time, by providing technical and financial assistance in medium-size cities. By the end of the program, it is expected that nearly half of the large and medium-size city water utilities (at least 22 utilities) will have completed PSP transactions, out of the universe of 58 large and medium- size cities, and 25 provinces and/or municipalities will have approved the sector regulatory frameworks. Of these, 9 will have been direct beneficiaries of the financial assistance provided under the program while almost all will have benefited from the technical assistance and training programs. Annex 2B provides details of utilities in large and medium-size cities, which would be the potential program beneficiaries. 2. Project development objective: (see Annex I) The development objective of the first phase of the proposed Water Sector Reform program is to pursue the program's objectives in about five medium-size municipal and provincial utilities (including two cooperatives). It is expected that these first five utilities will demonstrate the operational and financial viability of the program and set the stage for replication to other utilities in the later stages. The first project, thus, includes actions to continue to prepare the ground for the participation of other utilities, municipalities and provinces in subsequent stages. 3. Key performance indicators: (see Annex I) Three sets of performance indicators will be used to measure the success of the program. The first set is the "utility-based" indicators, which measure the operational and financial efficiency of participating utilities with PSP and cooperatives. The second is the "project-based" indicators, which measure the success of the reform program implemented through each project phase. The third set is the "sector- wide" indicators which are designed to measure the sector wide impact of reforms by establishing benchmarks such as total revenue generated, taxes paid, and investments made by the sector utilities. In addition to these impact indicators, a set of indicators was also developed to measure the effectiveness of the project executing agency. Specific indicators and their targets are presented in Annex 1. B: Strategic Context 1. Sector-related Country Assistance Strategy (CAS) goal supported by the project: (see Annex 1) Document number: No. 14278-AR Date of latest CAS discussion: May 15, 1997 Progress Report No. R98-36, March 17, 1998 and November 10, 1998 Consolidate and deepen structural reforms. The project would address an unfinished part of the CAS agenda at the sub-national level of government by focusing on the privatization of water utilities, and reduction of fiscal transfers to inefficient public utilities. The 1995 financial crisis in Argentina provoked  Page 3 by the Mexican peso devaluation opened a window of opportunity for accelerating reforms, supported by the Bank. This includes the provision of water and sanitation services in the provinces and municipalities. The proposed project would take full advantage of this by expanding the support available to provinces and municipalities willing to transfer the water utilities management to the private sector. The project will build on the technical assistance already being offered to subnational governments under the ongoing water sector loan (Ln. 3281-AR, Water Supply II) and the World Bank Institute to carry out privatization processes and regulate utilities, and provide financial support for initial and urgent rehabilitation/emergency investments in the privatized utilities and other forms of private participation. At the same time, the program supports the CAS goal of strengthening basic services and improving welfare by promoting the delivery of affordable water and sanitation services for the urban poor. 2. Main sector issues and Government strategy: Sectoral Context. The Secretary of Natural Resources and Sustainable Development has confirmed to the Bank that private sector participation (PSP) continues to underpin the government's strategy to improve the quality and efficiency of water and sanitation services in urban and rural areas'. While demand for privatization remains strong, however, the recent experiences in the sector have demonstrated how complex and difficult a process this is. Most provinces and a large number of municipalities and cooperatives are therefore increasingly requesting from the Federal Government technical assistance and financial support to open their utilities for competition, create regulatory agencies and avoid some of the mistakes of the past. Argentina's ambitious reform program of the water sector which included the 1993 concession for the metropolitan center of Buenos Aires, is under considerable stress and still lacks the institutional capacity to be sustainable. Emerging regulatory issues in Buenos Aires, the low level of investment in the oldest privatized utility of Corrientes (privatized in 1991), and the premature termination of the concession in TucumAn, to name just a few, reflect the nature of the problems that should be urgently addressed by the federal and provincial governments to make this shift to private operation work better. We know from practical experience in Argentina and research by the Bank and elsewhere that the water sector presents some of the greatest challenges in privatization, and that this sector has not been as successful as others, such as telecommunications, gas, transport and electricity. This is both because of the different characteristics of the sector and the trade-offs to be made in realizing social and financial objectives. Main sector Issues * Low coverage andpoor quality of water and sanitation services. Argentina has the lowest share of population with access to safe water and sewage collection, within its income category. According to the 1991 census, about 72 percent of the urban population was connected to a water network, and only 38 percent was connected to a sewerage network. By 1996, according to the sector information system (SPIDES) developed by the Secretary of Natural Resources and Sustainable Development, coverage indicators in urban centers improved to 81 percent for water and 51 percent for sewage collection. Only 17 percent of the five million rural population have access to safe water. Water rationing in summer months is a frequent occurrence in practically all major cities. Quality of drinking water is sub-standard for most systems supported by shallow aquifers. Existing sewage collection systems are insufficient to handle increasing flows as more households move from on-site disposal to conventional network system. This situation is being exacerbated by irrational consumption patterns and wastage of the vast majority of water supply systems in Argentina compounded by the lack of adequate tariffs based on metered consumption. The Buenos Aires concessionaire is facing major overflow problems in one of the four main sewage interceptors of the city because of these reasons. Moreover, sewerage collection, let alone any degree of treatment even in major urban centers, is at unacceptably low levels for a country of Argentina's income level. Policy Letter sent by the Secretary of Natural Resources and Sustainable Development, from the Ministry of Economy Public Work-s and Services July 1997. Confirmed by the Secretary of natural Resources and Sustainable Development, March 24. 1998.  Page 4 * Low investments. The backlog of investment needs is large, particularly for those related to collection and safe disposal of sewage and delayed preventive maintenance of water supply facilities2. Current annual investments (1995 and 1996) of about US$300 million (including US$200 million in Buenos Aires) are still low. Per-capita investments in Buenos Aires and Corrientes of about US$22/year are below the targets set in the concession contracts in Argentina. Investment requirements to reach 90% coverage of piped-water supply and 70% of collection-not including any eventual treatment of sewage--in urban centers has been conservatively estimated at US$5.3 billion3. To achieve this target in 8-10 years, more than US$500 million a year of investments in constant terms would be required. In the past, sector investments have been heavily subsidized, as the revenue generated by utilities has been insufficient to meet highly inefficient sector operations. Moreover, sector investments under public utilities are subject to strong political pressures which generally lead to inefficient--and frequently oversized--investment decisions. The problems of capital investments are compounded by the costs of switching from individual shallow wells and septic tanks to network facilities4, which are generally borne by customers. These costs are typically out of reach of the poor customers, and are resisted by more wealthy customers who do not see the rationale for switching to the network. As Argentina progresses and eventually faces the problem of sewerage treatment, this gap between investment needs and capital availability and willingness to pay will only increase. * Inadequate revenues, internal cash generation, and efficiency. Average revenue per connection in Buenos Aires is about US$150/year, for both water and sanitation services. It compares unfavorably with other utilities of the region (Sao Paulo, Rio, Lima), about US$300/year. The problem is exacerbated by the prevailing culture of no-payment for water and sanitation services: even if tariff levels in aggregate are adequate (albeit not efficient nor progressive), low collection rates and high water losses works against achieving a reasonable level of cash flow. Sector operations are also highly inefficient. Public utilities are plagued with aging and unmotivated personnel with a labor productivity index of 150 connections per employee, or lower5. Unaccounted for water is unknown since the majority of connections are not metered, but presumably is higher than 40%, given the fact that per-capita water production and treatment capacity in most cities exceeds 400 liters per person/day. Because of all of these factors, water utilities in Argentina are not able to generate the cash needed to support a substantive investment program, nor are they able to attract reasonable levels of equity and/or debt financing that match their investment needs. * Weak institutionalframework. The legacy of the inefficient OSN (National Sanitation Agency) system, dismantled in the early eighties, left the sector in disarray. Ten years later, in the early nineties, the dismal quality of water and sanitation services in most of the country and the major overhaul of the public sector provided conditions to initiate the reform of the water utility sector. To that end, the concession of water and sanitation services in Buenos Aires had a catalytic effect and provided the overall direction to the reform of the sector. In parallel, the public sector assumed a new and challenging--but largely unknown--role as a regulator of public utilities. Under the new sector arrangement, the capacity of the federal and provincial governments to formulate sector policy is still embryonic. There is no institutional capacity in the government or professional organizations to provide the normative framework required by water and sanitation activities. Sector apex institutions are subject to frequent changes of direction, and the institutional priority assigned to water and sanitation is low, when compared with other utility sectors. Reform Issues 2The World Bank. Argentina. Managing Environmental Pollution: Issues and Options. October 16, 1996. Pan American Health Organization. Country Report, 1995. 'Connecting a new household to the water and sewerage network cost about US$1000. In addition, the in-house cost to receive the improve service could be as high as US$3,000. Water Concession in Buenos Aires: Issues and Propositions. July 1997. Thomas-Olivier Nasser. The World Bank. ' In the largest utilities of Colombia and Pera, the labor productivity index oscillates between 400-500 per employee. In Brazil, this index ranges 100-200. at best.  Page 5 * Lack of transparency in privatization processes. Some of the earlier privatization attempts in the sector faced difficulties because of the lack of transparency in privatization processes. Complex and subjective bid award criteria, changes in selection criteria midway through the bidding process, and ill-defined award criteria contributed to long delays in PSP processes in Cordoba and Mendoza, and it is one of the defining factors in the failed concession in Tucuman. * Weak and expensive regulatory institutions and inefficient tariff regimes. The existing regulatory agencies are, in general, weak, overstaffed with former public utility employees, and without clear regulatory processes for dispute resolution. They charge regulatory fees ranging from 1% to 7% of tariff revenue, compared with 0. 14% for the UK's OFWAT. In addition, in most provinces there is a tendency to replicate the federal model by creating costly single-sector regulatory institutions6. The prevailing tariff regimes are rigid, do not encourage efficiency, nor address equity issues effectively. The tariff regime for the Buenos Aires Concession is undergoing a major review to correct this problem. * Poor choice of Award Criteria. When the privatization of the metropolitan water service of Buenos Aries took place in 1993, it was done on the basis of the greatest reduction being proposed to the government in average water tariffs, in lieu of any payment or cannon to the government for the concession rights. At the time, this was heralded as an extremely innovative and highly progressive way to award a concession, putting the interests of the consumer ahead of the fiscal goals of the government. However, in actual practice, this method was shown a major flaw in that it has not been able to be sustained over time. Because the company's cash generation capacity did not turn out to be as expected, the concessionaire was forced to seek tariff increases-albeit remaining below the original, pre-privatization level-to finance the investment program. This has severely eroded the public support and confidence for water privatizations as the promised benefits have not been realized. More recent water concessions and those being promoted under the proposed program revert to a more traditional approach, awarding concessions on the basis of the highest cannon, while respecting the required operational and investment targets. Lack of clear strategy andfeasible models to expand services to the urban poor in the context of PSP. Most existing private water concession contracts establish service coverage increase as contractual targets. However, few of them explicitly require service extension to the poor areas. As a result, private concessionaires tended to leave out the poor areas. Furthermore, those private concessionaires which attempted to extend services to the poor urban areas have faced difficulties because of: (i) the high personal costs which were to be borne by the new consumers for the connections and internal house remodeling needed; and (ii) the lack of any sort of financial support for these new connections. Nor was there any effort by the concessionaires to reach out to the communities to understand what they could afford to pay, test out alternatives which might lower the costs, or seek joint agreements on how the communities, who had not paid in the past to pay or to use and maintain the systems in the future. * Limited participation of risk capital by private investors in water and sanitation utilities. Since the award of the first water and sanitation concession in 1991, the private sector has shown limited interest in mobilizing financial resources to the sector. Investments in water and sanitation projects are frequently lumpy with long amortization periods, when compared to investments in telecommunications, gas and power. Even the best case for water privatization-the metropolitan area of Buenos Aries, with some 10 million consumers-has not been able to attract sufficiently long term financing from private sources and is depending on financing from IFC and the IDB. Smaller concessions, with a much lower revenue base, are clearly going to be less attractive to private sources. Thus, concessionaires largely rely on their internal cash generation, which is weak, to finance investments resulting in unacceptably long periods before targets for services levels are to be reached. " Argentina. Reforming Provincial Utilities. Issues. Challenges and Best Practice. A. Estache, Et Al. The World Bank. Januarv 22, 1996.  Page 6 * LLack of well-defined contracts and regulatory frameworks for existing cooperatives. More than 300 water systems are managed by cooperatives. These cooperatives are private concessions awarded by the municipalities, but often do not operate under a well-defined contract or a regulatory framework, and are often subject to political interference. Cross-sector issues * Fragmented water resources management system. Urban water and sanitation services form part of a large, complex system of water resource management in Argentina, as elsewhere. In the case of Argentina, river basin management across political boundaries is constrained by the current legal framework since water resources belong to the provinces in their respective jurisdictions. Inter- provincial conflicts related to the use of shared resources are increasingly frequent, particularly in the provinces of Mendoza, La Pampa, Chaco and Santa Fe. * Complex framework of environmental institutions and regulations affecting the sector. Environmental management in Argentina is to a large extent a provincial responsibility. However, under certain circumstances, the national government can assume authority for specific environmental issues. Normally, the Federal Government enacts laws, and invites provinces to adhere. The province is free to adopt the law in total or in part, and determines how the law is going to be enforced. The complexity of the system makes policy formulation and enforcement of environmental regulations practically impossible to coordinate. * Lack ofapolicyframework to address poverty issues. Argentina does not have an integrated and coherent strategy to provide basic urban services to the poor. Each sector is dealt with separately, with notable advances in the area of education to upgrade public facilities for poor neighborhoods. However, investment in municipal level infrastructure-roads, side walks, street lighting, garbage pick-up and disposal-are left in the hands of local municipalities most of which do not have the financial or institutional capacity to handle the upgrading needed in these services. Water and sanitation is in the hands of provincial utilities without any explicit poverty goals and housing is largely financed through federal transfers to provinces for essentially lower-middle income groups (who have formal employment). On the other hand, there are numerous programs funded by different development financing agencies (IDB, UNICEF, etc.) which extend water and sanitation services to the poor, but with no formal coordination mechanisms. Many of these programs take a paternalistic approach, where water (often low quality) is provided for free to the poor. There is no common policy framework for cost recovery, and, as noted earlier, the issue of poverty is frequently neglected in PSP arrangements. Government Strategy The government's strategy recognizes that it has an extremely long road ahead of it to be able to provide the level and quality of water and sanitation services, especially for the poor, that the country needs. This strategy must balance the goals of universal service, with due regard to equity, affordability, and fiscal responsibility. This calls for putting in place the right incentives for conservation, caring for the environment, and attracting private risk capital. The first part of the strategy is to promote private operation and management as the key step in restoring efficiency in the sector. The proposed program, along with what has been done to date, are clear reflections of that strategy. To achieve efficiency and investment goals in the sector the governments intends to maximize competitive forces. In the medium-term, the government expects a majority of water utilities --serving seventy percent of the country's population-- to be opened to for-the-market competition and subject to comparative regulation through Concessions, leases and management contracts. In relation to cooperatives, the government would promote adjustments to their corporate  Page 7 structure and regulatory arrangements to introduce competitive pressures on the utilities. A few relatively well-run publicly managed utilities will remain subject to the same regulatory arrangements as those for privately managed utilities. The government's vision for sector organization is summarized as follows: * Long-term concessions in cities greater than 50,000, in about 46 urban centers with a total population of about 22 million (including 9.1 million in Buenos Aires). * Management or lease arrangements for cities between 10,000 and 50,000, in about 100 small cities and towns with a total population of about 3.5 million. * Cooperatives in cities with long tradition of such organizations in charge of public utility services with a population of about 2.5 million. * Public sector managed utilities in a few relatively well-run provinces and municipalities with a population of about 1.5 million. * Operational contracts with the private sector for small and medium-size towns with a population between 2,000 and 10,000, in about 350 towns with a total population of 2 million. * Rural population, dispersed and concentrated (about 4.5 million) will rely on cooperatives and users' associations with a back-stop technical assistance provided by private firms financed by local and provincial governments. The second part of the strategy is oriented to modify the existing and highly inefficient pricing system for water and sanitation services in order to get the signals right, especially to attract future private risk capital. The government is guided by the following principles: universal metering, two-part tariff with adequate consideration to the allocation of capacity costs and demand differentiation, automatic adjustments to account for inflation, and periodic multiyear reviews to address revenue-adequacy requirements to meet expansion costs and changes in environmental regulation. The Government also aims at: (i) developing a transparent cross-subsidy system--with minimum price distortions--to achieve clearly defined poverty and environmental objectives; and (ii) promoting provincial regulatory entities-- preferably multi-sector--following consistent principles dictated by a federal law. At the same time, the government intends to incorporate explicitly the needs of the poor in the new concessions and tariff regimes. This will be done, on the short run, by adopting a social tariff, which caps water and sewerage tariffs for the poor at 5 percent of estimated family income. For typical poor families in Argentina, with monthly incomes of about $ 120-150, this means water and sanitation bills of about $ 7.50 per month. It will also ensure that there are means (mainly through sur-charges) to cover the costs of connections and possibly to offset the costs of internal house renovations. On the longer term, the government hopes to evolve a more coherent approach to basic urban services for the poor. The part of this strategy is being addressed as part of a poverty assessment presently being conducted by the Bank. The final part of the government's strategy is to work gradually on the issues of water resource management, starting with analytical work supported by the Bank. These issues should be integrated progressively into the agenda for water shed management, irrigation and environmental developments in the sector. 3. Sector issues to be addressed by the project and strategic choices: The proposed project would be the first Bank-financed project to directly support implementation of the Government's sector reform agenda. It would support the second generation of PSP arrangements targeting the improvement of efficiency and expansion of water and sanitation services in medium-size cities of the country (population between 50,000 and 500,000). In doing this, the program will address: * The high risks and commensurate lack of private sector financing for smaller urban centers during the critical start-up phase of the new concessions (first five years)  Page 8 * The lack of a coherent approach to tariffs, cost recovery, and financing of service expansion, especially for the poor * The lack of viable alternatives for serving the poor * The lack of consistency and transparency in the regulatory framework and concession contracts * The institutional weaknesses and lack of technical support for the provincial and municipal authorities in charge of this process * The absence of a national strategy towards a more integrated approach to water resource management, especially environmental regulations, water quality targets and standards. The program reflects the strategic choice already made by the government and supported by the Bank in the past to move from public ownership and management of water and sanitation to a privately led model of operation. While the past privatizations have demonstrated some flaws, the choice of reverting to public operation was not seriously considered, choosing rather to improve on the private model. The key strategic decisions were how to adapt and improve the original approach. What was needed is an approach which is robust enough to accommodate the multiplicity ofjurisdictions, structures and circumstances found in the water sector in Argentina, yet one that introduced new rules of the game and standards based on the lessons learned from the earlier experiences. Another major strategic choice had to be made on how fast to modernize the sector. Public expectations, particularly on the rate at which services would be improved and upgraded by the new operators, have been very high from the outset. In part this was a consequence of how the authorities were able to gain popular support for the initial privatizations (of all sectors) in the early 1990s. Unfortunately, these expectations, which are slow to being realized in the case of water and sanitation, are not matched with willingness-to-pay. Nor were they matched by the private sector's willingness to take risks. The result is that a strategic choice had to be made to defer and delay investments, particularly in the case of sewerage, and to seek more cost effective ways of expanding service, especially for the poor. Nevertheless, there are still a number of long-run strategic choices to be made in the sector, especially as regards to financing if service levels are going to be significantly improved. 4. Program description and performance triggers for subsequent loans: The water sector reform program is a US$117 million program, which consists of two phases over a five- year period. Phase I (APL 1): The first phase consists of: (i) financial support to medium-size provincial and municipal utilities and cooperatives (about 5 utilities), which successfully completed the reform process (PSP contract signed and/or regulatory framework established); (ii) technical assistance for the reform process of provincial and municipal utilities to be financed by APL 2; and, (iii) support to existing private utilities and regulatory agencies, including: (a) a pilot program to extend water and sanitation services to the urban poor under private concession; (b) a training program for the water utility regulators; and, (c) technical assistance to establish sector environmental guidelines. Phase 11 (APL 2): The second phase will continue the support started by APL I and extending support to additional municipalities and provinces. Lessons learned from APL I will be incorporated in the design of PSP contracts, as precisely detailed in the minutes of negotiation for the APL I loan:extension of services to the poor, and design of regulatory framework. APL 2 will be triggered when: (i) 70 % of APL I is committed (through, for example sub-loan contracts signed with utility operators); (ii) 5 provinces and/or municipalities enact sector regulatory and environmental frameworks and have an operating regulatory or other agency; and  Page 9 (iii) 3 provinces and/or municipalities (in cities with population of more than 50,000) sign PSP contracts acceptable to the Bank and awarded according to competitive procurement procedure acceptable to the Bank A long list of participating provinces and municipalities to be counted towards trigger events will be agreed upon negotiations of each APL. Annex 2B provides details of utilities included in the program C: Project Description Summary 1. Project components: (see Annex 2 for a detailed description and Annex 3 for a detailed cost breakdown) Indicative Bank- % of Component Category Csts % of financing Bank- (US$M) Total (US$M) financing Investment Physical (new 30.0 63.7 18.0 60.0 concessions) Physical (other PSP 10.5 22.2 5.5 52.0 arrangements and cooperatives) Institutional Institution Building 5.2 11.0 5.2 100.0 Environmental Institution Building 1.0 4.2 1.0 100.0 Total Project Costs 46.8 99.0 29.7 63.5 Front-end fee 0.3 1.0 0.3 100.0 Total Financing Required 47.1 100.0 30.0 63.7 2. Key policy and institutional reforms supported by the project: The reforms supported by the project are: * Private sector participation in the management of provincial and municipal water utilities. - Establishment of sector regulatory frameworks at appropriate levels. - Establishment of independent regulatory agencies (single- or multi-sector) at provincial level.