Peru - Irrigation Subsector Project

Document of The World Bank Report No. 13542-PE STAFF APPRAISAL REPORT PERU IRRIGATION SUBSECTOR PROJECT JUNE 27, 1996 Country Department III Natural Resources Development and Rural Povery Division Latin America and the Caribbean Regional Office  CURRE,NCY UNIT (AS OF JUNE 26, 1996) Currency Unit = Nuevos Soles USSI.00 = 0.4082 FISCAL YEAR January I - December 31 WEIGHTS AND M4EASURES The metric system is used throughout the report GLOSSARY OF ACRONYMlS AACH Autoridad Aut6noma de Automonous River Basin Authority Cuenca Hidrografica BN Banco de la Nacidn National Bank BNF Banco Nacional de Fomento National Bank for Development CCA Comisidn Consultiva Agraria Consultative Agricultural Board CFls Instituciones Financieras Commercial Financial Institutions Comerciales COFIDE Corporaci6n Financiera de Development Finance Corporation Desarrollo CONAMA Consejo Nacional del Medio National Environmental Council Ambiente DL Decreto Legislativo Legislative Decree DS Decreto Supremo Supreme Decree EPSA Empresa Publica de Servicios Public Enterprise for Agricultural Agropecuarios Services FAO/CP Organizacidn de las Naciones Food and Agriculture Unidas para la Agricultura y la Organization/Cooperative Program Alimentaci6n FONCODES Fondo Nacional de National Social Compensation and Compensacidn y Desarrollo Development Fund GDP Producto Bruto Intemo Gross Domestic Product GTZ Sociedad Alemana de Deutsche Gesellschaft fur Cooperacidn Tdcnica Technische Zusammenarbeit IDB Banco Interamericano de Inter-American Development Bank Desarrollo IDEA Instituto de Desarroilo Altermadve Development Institute Alternadvo IMP Fondo Monetario Intemacional Intemrational Monetary Fund INADE Instituto Nacional de Desarrollo National Institute for Development INTA Instituto Nacional de National Institute for Agricultural Investigacidn Agraria Research lNIAA Instituto Nacional de National Institute for Agricultural Investigaci6n Agricola y and Agroindustrial Research Agroindustrial INIPA Instituto Nacional de National Institute for Agricultural Investigacion y Promocion Research and Promotion Agricola INRENA Instituto Nacional de Recursos National Institute for Natural Naturales Resources MAG Ministerio de Agricultura Ministry of Agriculture MEF Ministerio de Economfa y Ministry of Economy and Finance Fina= NGOs Organizaciones No- Non-Govemmental Organizations Gubernamentales OECF Fondo de Cooperaci6n The Overseas Economic Economica a Ultramar (Jap6n) Cooperation Fund (Japan) ONA Organizaci6n Nacional Agraria National Agrarian Organization ONAA Oficina Nacional de Apoyo National Office for Food Assistance ALimentario OPA Oficina de Planificaci6n Agraria Agricultural Planning Office PCU Unidad de Coordinacion del Project Coordinating Unit Proyecto SAIS Sociedades Agricolas de Interds Social Agricultural Societies of Social Interest USADID Agencia para el Desarrollo United States Agency for Intemacional (Estados Unidos) Intemational Development WUO Junta de Usuarios / Comision Water User Association / Irrigation de Regantes District Commission  PERU IRRIGATION SUBSECTOR PROJECT Table of Contents LOAN AND PROJECT SUTMMARY ............................... i 1. BACKGROUND ........................................... 1 A. Country Overview ...................................... 1 B. The Agricultural Sector ................................... 2 C. The Irrigation Subsector .................................. 3 D. Environmental Sector .................................... 4 E. Lessons from Previous Bank Involvement ....................... 5 2. THE PROJECT ............................. 6 A. Project Objectives and Description ............................ 6 B. Irrigation Rehabilitation Component ........................... 6 C. Institutional Development and Strengthening of Users' Organizations Component ........................................ 7 D. Incentive Program for Technology Improvement Component ............ 8 E. Dam Safety Emergency Program ............................. 9 F. Project Administration and Monitoring ........................ 10 E. Project Environmental Aspects ............................. 10 3. PROJECT COST AND FINANCING ........... .................. 12 A. Summary of Project Costs ................................ 12 B. Project Financing ..................................... 13 C. Cost Recovery and Water Charges ........................... 13 4. PROJECT IMPLEMENTATION, PROCUREMENT AND DISBURSEMENTS ...... ....... .. ................... 16 A. National Level Organization and Management .................... 16 B. Management of Water User Organizations ...................... 17 C. Loan Funding for the Rehabilitation of Economically Viable Schemes ... .. 18 D. Accounts and Audits ................................... 20 E. Monitoring and Evaluation ................................ 20 F. Procurement ........................................ 21 G. Disbursements ....................................... 23 H. Retroactive Financing ................................... 24 5. BENEFITS, ECONOMIC JUSTIFICATION AND RISKS .... .. ......... 25 A. Benefits and Beneficiaries ................................ 25 B. Economic Analysis .................................... 25 C. Project Risks . ........................................ 26 6. SUMMARY OF AGREEMENTS REACHED AND RECOMMENDATION .... 28  ANNEXES ANNEX 1. Project Components by Year ............................. 31 ANNEX 2. Description of the Rehabilitation Works ...................... 32 ANNEX 3. Institutional Strengthening of Water Users' Organizations .... ....... 37 ANNEX 4. Incentives Program for Technology Improvement ................ 40 ANNEX 5. Financing of Irrigation Rehabilitation Works ................... 43 ANNEX 6. Emergency Dam Rehabilitation and Dam Safety Program .... ....... 49 ANNEX 7. Environmental Aspects ................................ 52 ANNEX 8. Financial and Economic Analysis .......................... 57 ANNEX 9. Implementation Plan .................................. 66 ANNEX 10. Supervision Program ................................. 70 ANNEX 11. Monitoring Indicators ................................. 71 ANNEX 12. Impact Indicators ................................... 72 ANNEX 13. Loan Disbursement Schedule ............................ 73 ANNEX 14. List of Documents in Project Files ......................... 74 MAP: IBRD 25955R1  PERU IRRIGATION SUBSECTOR PROJECT LOAN AND PROJECT SUtMMARY Borrower: The Republic of Peru Implementing Agency: Ministry of Agriculture Beneficiary WUOS Poverty NA Amount: US$ 85.0 million Terms: Standard variable interest rate for a LIBOR-based US dollar single currency loan, payable in 17 years, including a five-year grace period. Commitment Fee: 0.75 percent on undisbursed loan balances, beginning 60 days after signing, less any waiver. On Lending Terms: Funds for irrigation rehabilitation will be passed to WUOS via COFIDE, which will channel the funds to CFIs on-lending to WUOS. COFIDE will use a lending rate based on its normal rediscount on lending rate (as defined in para. 6.1 (f)) payable in a maximum of 17 years, including a grace period up to 5 years. CFIs will lend at commercial rates. Financing Plan: Local Foreign Total (US$ millions) Government --- --- 16.4 IBRD 63.5 21.5 85.0 Beneficiaries 6.0 5.0 11.0 OECF 49.4 10.6 60.0 Total 131.6 39.1 172.4 Environmental Classification: B Financial Rate of Return': 36.3% Economic Rate of Return': 38.7% Map: IBRD 25955R1 1 Estimated only for Irrigation Rehabilitation Component  I  ii PERU IRRIGATION SUBSECTOR PROJECT SUMMARY OF PROJECT COSTS (US$ MILLIONS) Component Local Foreinn Total % % Total Foreign Base Cost (US$ million equivalent) A. Rehabilitation of Irrigation and Drainage 89.1 13.3 102.4 13 65 Infrastructure B. Institutional Development/Training of WUOs 3.5 2.5 6.0 42 4 C. Incentive Program for Technology Improvement 1. Training and Extension Services 10.3 2.6 12.9 20 8 2. Incentives Fund 10.1 15.1 25.2 60 16 D. Project Administration and Monitoring 2.5 0.4 2.9 13 2 E. Emergency Dam Safety Program 4.2 2.8 7.0 40 5 Base Cost 119.7 36.7 156.4 24 100 Physical Contingencies 5.6 1.2 6.8 18 4 Price Contingencies 7.4 1.8 9.2 20 5 Total Project Cost 132.7 39.7 172.4 23 110 Financing Plan IBRD 63.5 21.5 85.0 OECF 49.4 10.6 60.0 Beneficiaries 3.7 7.3 11.0 Government of Peru 16.4 16.4 Total 133.0 39.4 172.4 Estimated Disbursements [ Bank Fiscal Year 1997" 1998 1999 2000 2001 2002 AnnualP 6.0 14.8 27.0 22.8 11.9 2.5 C umulative 6.0 20.8 47.8 70.6 82.5 85.0 Financial Rate of Return: 36.3%3' Economic Rate of Return: 38.7% l' Including US$0.5 million for retroactive financing. 2' Including initial deposits of US$4.5 million into two special accounts. Disbursements profile is structured to accomodate OECF parallel financing for rehabilitation works during the first two years of implementation. 2' Estimated only for Rehabilitation of Irrigation and Drainage Component.   PERU IRRIGATION SUBSECTOR PROJECT STAFF APPRAISAL REPORT 1. BACKGROUND A. Country Overview 1.1 Peru's twenty-two million people inhabit an area of 129 million hectares. About 10 percent of Per-u's area is located along a narrow coastal strip between the Pacific Ocean and the foothills of the Andes; 30 percent is mountainous (Sierra), made up of the valleys and western plateaus of the Andes; and 60 percent lies in the Amazon watershed (Selva), comprised of the valleys and eastern plateaus of the Andes (Ceja de Selva) and the Amazon jungle (Selva Baja). 1.2 - From the late 1960s until about 1990, economic policies in Peru were mainly characterized by heavy Government intervention and control. Only recently has the Govemment embarked on a program of widespread market-based reforms. 1.3 Starting in 1990, under the leadership of President Fujimori, the Government began implementing a series of broad-based reforms to restore long-term economic growth. These reforms were aimed at: (a) improving incentives policies so prices would better reflect their opportunity costs; (b) reducing government subsidies in order to control the budget deficit and inflation; (c) improving the regulatory environmen, o2 promote private investment; (d) and controlling violence and drug trafficking. More specifically, key reforms included: (a) Macroeconomic and trade policies which controlled public sector wages, brought prices of public goods more in line with international prices, and eliminated import duty exemptions and quantitative import restrictions; (b) Pricing and marketing policies which dismantled the costly guaranteed producer price mechanism and replaced it with a floor price mechanism implemented through use of import charges, eliminated consumer price controls, and significantly reduced Government intervention in marketing; (c) Rural finance reforms which eliminated preferential agricultural interest rates and allowed banks to freely set rates, liquidated the Banco Agrario (BAP), and created new second-tier institutions for lending to small businesses and farmers; (d) Coca eradication efforts which involve farmers in the design and execution of coca substitution programs and include complementary assistance for land registration programs, credit, institutional development, environmental preservation, interdiction, and human rights issues. 1.4 In agriculture, the Government began to implement many fundamental reforms. It moved to liberalize product, financial and land markets and to reduce the budgetary drain  caused by subsidies and price guarantee mechanisms. ECASA, the agricultural marketing agency, was liquidated, while ENCI, the agricultural import monopoly agency, was restructured and its monopoly removed. Preferential interest rates in agriculture were eliminated and the unprofitable Agricultural Bank liquidated. Land can now be more easily traded, leased or mortgaged. Maximum land holding limits were raised and land registration procedures simplified. The Government has taken major steps to remove the restrictions on the sale and lease of agricultural land. With some exceptions, agricultural land can now be freely traded or leased to any individual or legal entity, including foreign companies. Furthermore, the restriction on the use of agricultural lands as collateral for commercial bank loans has been eliminated. The Government is now beginning a program to provide registered titles to owners. There is a critical need to complete the registration of clear and definable titles so that the agricultural lands are capable of being transferred and used as collateral for borrowing. B. The Agricultural Sector 1.5 Peru is not fundamentally an agricultural economy. The potentially cultivable area is estimated at only 6 percent of the total area. An additional 14 percent of the area is suitable for pasture and 38 percent for forestry. The remaining 42 percent is either desert, mountains or protected land. Although the Costa is largely a desert strip, it holds 53 percent of the population, including that of greater Lima which accounts for about a third of the country's population. It has only 21 percent of the cultivable area, yet accounts for 60 percent of agricultural GDP. The region receives most of its water from 52 rivers that flow from the Sierra. In some areas, underground water is also available. Given the lack of rainfall, all cultivated land in the Costa is irrigated. The bulk of agricultural public investment has gone to finance large scale irrigation projects in this region. Many of the projects have been only moderately successful and some were never completed. Many have fallen into disrepair and are no longer functioning at full capacity. An estimated 200,000 to 300,000 hectares of land are adversely affected by salinity and waterlogging. 1.6 A natural constraint that limits the prospects for agricultural production is the availability of water resources. Although water resources are abundant in national terms, they are poorly distributed, both geographically and in terms of timing of availability. The bulk (98 percent) of the country's water supply is located in the Amazon basin where the potential for agricultural expansion is limited while the area of greatest potential expansion, the Costa, is entirely dependent on uncertain and highly variable seasonal supplies from rivers originating in the Sierra -- about 70 to 85 percent of the water flow occurs between January and April. Thus, despite its vast area, Peru's per capita availability of cultivable land is only 0.13 hectares, less than one-third the average for South America. 1.7 Peru's most important crops, in terms of value of production, are rice, cotton, sugarcane, eggs, milk, poultry and coffee. Of these, coffee, cotton and sugar have traditionally been Peru's most important export crops. Roughly one-fourth of the total value of agricultural production is in the form of poultry and livestock products; another one-third is in the form of fruits, vegetables and native crops such as quinoa; and the remainder is in the form of the major field crops such as white and yellow corn, rice, potatoes, beans, wheat, cotton, sorghum, sugar and coffee. In terms of cultivated area, white and yellow corn, potatoes and rice are the most important crops.  1.8 Peru has the potential to develop an export industry in non-traditional crops such as fruits and vegetables. These are grown almost exclusively in the Costa. They are well situated for export to northem hemisphere markets, both by virtue of being located on the coast where they can be exported easily, and because of the favorable climate and the fact that they can be produced in the "off-season" for northem markets. Currently, the most important of these specialty crops is high-quality fresh, frozen and canned asparagus which is shipped primarily to Northem European markets. Asparagus accounts for nearly 10 percent of the value of legal agricultural exports from Peru and has substantial growth potential. Another set of non-traditional products which Peru has successfully exported are several varieties of natural colorants including marigold flowers (used to produce an orange-yellow color) and cochineal (an insect product used to produce carminic acid) of which Peru produces 85 percent of the world's supply. Other crops which represent great potential but have yet to be more fully developed include flowers (in the Costa), palm oil (in the Selva), brazil nuts (in the Selva) and several varieties of beans. Peru also produces a number of other unique specialty products such as alpaca wool and several crops of the Incas (e.g., quinoa) which are found in the Andean region. 1.9 Peru's livestock sector is now dominated by the poultry industry which accounts for over 50 percent of the total volume of production in the subsector. Beef is the second most important meat product and constitutes 25 percent of the volume of meat produced in Peru, followed by pork (18 percent) and mutton (5 percent). Poultry production has been the most dynamic activity within the Peruvian agricultural sector over the last twenty years. The volume of poultry production has more than quadrupled since 1970. In contrast, production of beef and pork production has grown only marginally over the same period, while mutton production has declined. The poultry industry has expanded rapidly through the adoption of a vertically integrated, commercial input-intensive, production structure located along the Costa. C. The Irrigation Subsector 1.10 Irrigated areas are estimated to account for more than two-thirds of agricultural output. Except for a few modern irrigation schemes, most of the irrigation infrastructure is old and in need of extensive rehabilitation. Less than half of the irrigated lands have a reliable year-round water supply. Due to inadequate cost recovery, deferred maintenance, and inadequate management, water is used inefficiently in most of the irrigated areas. Moreover, many large irrigation schemes introduced in the coastal region of Peru since the early 1960s were not economically viable and too many projects were undertaken in relation to the fiscal resources available. Thus some of the projects that were begun in the 1960s are still not completed, while those that are completed suffer from inadequate funding for proper maintenance and repair. 1.11 The primary problem encountered in past public irrigation projects has been the lack of funds as well as of a sustainable operation and maintenance (O&M) program, resulting in the deferral of necessary maintenance and repair and the progressive deterioration of irrigation infrastructure. In relation to the shortage of funding for O&M, a proper system of water tariffs has also been lacking. Not only has the rate of collection been low in most of the irrigation systems but the tariffs themselves have been far from adequate. This can be seen from the level of O&M costs currently being recovered in the irrigation schemes to be  - 4 - rehabilitated under the project (between US$20 and 30 per ha), as compared to actual and future O&M requirements estimated to range between US$63 and US$138 per ha. Another constraint to effective irrigation within Peru has been the lack of a program to develop good management techniques and skills within the water user organizations that will enhance the effective management of the water supply infrastructure and promote sustainable maintenance. In an attempt to solve these problems, the government has transferred the responsibility for operation and maintenance of the systems to the water user organizations (WUOs). These WUOs should develop effective programs of maintenance including full cost recovery, or the rehabilitated systems will soon return to a state of deterioration. 1.12 Another limitation to the development of effective irrigation within Peru has been the lack of an effective technology transfer mechanism to provide incentives for farmers to learn about new methods of irrigation and agricultural practices and for the adoption of new and efficient practices. There is also a recurrent environmental problem of misuse of agricultural chemicals and subsequent water pollution. 1.13 The Government is presently contemplating measures to develop a system of water use rights. It has prepared a draft water law that would allow users to be allocated water rights and to buy and sell them on a free market. The rights could be traded separately from the land and would be recorded in a separate register. The water rights could also serve as collateral for loans. The objective of developing this system of water use rights is to bring about a more efficient allocation and use of water. The improved incentives to conserve water are also expected to reduce the problem of soil salinity and to better protect the environment. D. Environmental Sector 1.14 Despite the early recognition of the need for a central environmental planning authority dating as far back as 1972, Peru suffers from the absence of such an institution. It was not until the enactment of Decree Law (D.L.) No. 613 (C6digo del Medio Ambiente) in 1990 in which the National Environmental Agency, Sistema Nacional del Medio Ambiente (SINAMA) was created that a national coordinating unit was established. However, responsibility for the environment especially planning and management, remains fragmented. 1.15 In agriculture and renewable natural resources, the Instituto Nacional de Recursos Naturales (INRENA) has interpreted the environmental code to mean, among other tasks, the evaluation of the environmental and naturally renewable resources, monitoring and control of activities in which environmental risk is evident, establishment of effluent standards for agricultural activities, and the creation of a program to monitor pollution associated with agriculture activities. 1.16 The long-standing effort to create a central environmental authority may finally be coming to fruition. At present, there is a proposal in the legislature which calls for the creation of a Consejo Nacional del Medio Ambiente (CONAMA). The existing draft proposal would establish an autonomous agency under the Presidency. Among other responsibilities the council would be in charge of the developing national environmental standards, resolving inter-ministerial disputes, coordinating national, regional and local  government actions with respect to the environment and establishing criteria for zoning, environmental quality and impact assessments. 1.17 At present, there are other indicators of progress in meeting the country's environmental challenges which have direct relevance to proposed World Bank projects. In 1989, a Comision Nacional composed of the Instituto Nacional de Planificaci4n and other public and private institutions was created to develop a National Conservation Strategy (NCS) for the purpose of defining basic policies to guide development planning in promoting the sustainable development and use of natural resources. One of the priorities identified in the NCS was the development of an integrated watershed management program. The objectives of the program include planning and promoting the sustainable development of watersheds which would include river basin planning, erosion control, rehabilitation of small-and- medium scale irrigation systems, reforestation, and training and education in watershed management. A number of other programs could be supported through a watershed approach including a program of water quality monitoring, pesticide management and regulation, and control of dumping untreated wastes. E. Lessons from Previous Bank Involvement 1.18 This project would be the fifth irrigation project supported by the Bank in Peru. The first two loans (Loan 114-PE of 1955 and Loan 418-PE of 1965) financed irrigation works and land settlement in the San Lorenzo area. A third loan in 1986 (Loan 1403-PE) helped to rehabilitate and reclaim 40,000 ha in four coastal valleys; and the fourth, the Lower Piura Irrigation Rehabilitation Project (Loan 1771-PE), supported irrigation rehabilitation works on 34,000 ha in 1987 (credit suspended in 1987 for non-payment of arrears). Although the implementation of these projects was rated as satisfactory, cost recovery was inadequate. As a result, necessary maintenance and repair of irrigation schemes was indefinitely deferred. Following several years of virtually no public spending on O&M, by the early nineties, many schemes faced a high risk of failure. Arrangements for O&M under the current project take this lesson into account and build on the successful experience of WUOs. The project also includes a major component in the strengthening of the WUOs in this area, along with the rehabilitation so that the problem should not recur. Problems with project sustainability encountered in past projects are unlikely to recur, given the strong commitment to the program as shown by the WUO's willingness to assume full responsibility for operation and maintenance and the cost of the rehabilitation works. Bank experience worldwide already shows that decentralization of responsibility to water user associations, combined with institutional strengthening and incentives to adopt cost-effective technology, significantly improves water use efficiency, cost recovery and O&M of irrigation infrastructure. This project's components incorporate this lesson. Additionally, the project introduces a key innovation - WUOs under the project will assume full responsibility for rehabilitation investment costs by borrowing from commercial banks, with access to a line of credit under the project. A similar arrangement has been successful in the Bank supported Nepal Irrigation Line of Credit project, where participants cover a portion of the investment costs. More generally, Bank experience demonstrates that, where market-oriented macroeconomic and financial sector policies are in place, targeted credit can be an effective and successful development tool. Peru's economic and financial sector reforms, supported by the Bank and IDB, are exemplary. The current project ensures that subproject selection will be demand driven and participating banks will provide financing at market interest rates.  - 6 - 2. THE PROJECT A. Project Objectives and Description 2.1 Project Objectives. The proposed project is in line with the objectives of the Bank's strategy in Peru of redefining the role and structure of central Govemment institutions and promoting private sector and sustainable development. This would be accomplished by supporting agricultural policies and programs to rehabilitate and improve the management and sustainability of agricultural infrastructure. More specifically, the project would raise agricultural production and productivity by enhancing the sustainability and efficiency of existing public irrigation systems. The project will also help to reduce the role of the public sector in irrigation by: (i) strengthening the private sector through local management (including (O&M) by the water users' organizations; (ii) creating an Irrigation Rehabilitation Fund to provide a long-term commercial credit-line to implement irrigation rehabilitation schemes; and (iii) allowing the WUOs to define their investment priorities for the design and construction of these schemes. As such, the project emphasizes the Bank's water management policy through its efforts on decentralization and cost recovery for operation and maintenance as well as capital investment. To this aim, the project would strengthen the capabilities of the water users' organizations to assume full responsibility for operation and maintenance of the systems. Through the development of a water user training and extension program as well as a program to promote the adoption of innovative technologies for irrigation, the project would also expand the individual water user's capacity to efficiently manage his resources. 2.2 Project Description. The project will consist of five components: (a) rehabilitation of the infrastructure for approximately 25 public irrigation schemes, (65 percent); (b) institutional development and strengthening of water users' organizations and training of their management in the area of administration, finance, and operation and maintenance (4 percent); (c) an incentive program for technology improvement, including a training program for private technicians, extensionists and farmers in irrigation techniques and practices, fertilization and pesticide management, as well as a pilot matching-grant program to encourage adoption of modem irrigation technology (24 percent); (e) a nation- wide emergency dam safety program (5 percent) and (d) project administration and monitoring (2 percent). B. Irrigation Rehabilitation Component 2.3 The main component of the project would finance the rehabilitation of irrigation and drainage infrastructure in about 25 schemes or subprojects, covering an estimated area of over 200,000 ha and reaching over 50,000 farming families. Total investment would be about US$102 million (base cost), representing some 65 percent of total project costs. As a major innovative feature, rehabilitation works would be constructed by users who would repay 100 percent of the investment costs. To this end, the project would fund a credit line which will be channeled, through COFIDE, a second-tier bank, to retail lenders that would select the final borrowers (WUOs) and accept the attendant credit risk. 2.4 The rehabilitation component would be implemented on a program-type basis. It would include a first group of subprojects whose feasibility studies have already been  completed, as well as additional schemes to be prepared before and during project implementation. To be eligible, these schemes would have to meet a number of technical, institutional, financial, economic and environmental criteria satisfactory to the PCU and the first-tier financial institutions (CFIs). At negotiations the Government provided assurance that financing will only be used to fund those irrigation projects in which the users can demonstrate that they are able and willing to repay the costs of the project (para. 6. la). 2.5 Feasibility studies were prepared by local consultants, with financial and technical support from FAO as well as financial support from GTZ and PHRD, and are available for a first group of 10 subprojects. Out of these ten, the following seven are planned for implementation in the first year of the project: San Lorenzo (US$5.6 million), Chancay-Lambayeque (US$7.0 million), Huaral-La Esperanza (US$6.9 million), Santa Rita de Siguas (US$3.6 million), Yuramayo (US$0.9 million), La Joya Antigua (US$4.4 million and Huara-Santa Rosa (US$8.2 million). 2.6 The other three subprojects have a number of institutional problems which still need to be resolved: Chili Regulado (US$2.4 million), Santa-Lacramarca (US$14.1 million) and Sama (US$1.5 million). These problems are primarily difficulties in land titling within the projects and organizational problems within competing WUOs. The solution of these problems is underway and would be completed prior to implementation of these subprojects. 2.7 Feasibility studies were also prepared by a MAG technical team for six additional rehabilitation subprojects covering a total area of 45,900 ha and at an estimated cost of US$33 million; some of them could be implemented in the first year of the project; the six schemes include Chicama, Locumba, Camana, Pisco, Pativilca and Vitor. Most of the works being considered include the rehabilitation of canals, drains and water intakes. Detailed descriptions and costs for each sub-component are shown in Annex 2. C. Institutional Development and Strengthening of Users' Organizations Component 2.8 The proposed project includes a critical component for strengthening the WUOs, on a nation-wide basis, to obtain full recovery of the cost of operation and maintenance and assure long-term project sustainability. The cost of the component is estimated at US$6.0 million (base costs). WUOs are now responsible for operating, maintaining and administering irrigation systems in Peru. Those directly involved in the project will also be required to implement, either directly or by hiring private contractors, rehabilitation works for the systems for which they are responsible. Through this component, the project would strengthen WUOs' capacities in the area of administration (including the calculation and collection of new tariffs which reflect full cost recovery), finance and, most importantly, operation and maintenance of the irrigation systems. 2.9 In light of the various activities that WUOs, i.e., Irrigators' Commissions (Comisiones de Regantes) and Users' Boards (Juntas de Usuarios), have to perform, a four- year training program has been designed for each of the various groups within these organizations, namely: (i) organization leaders; (ii) "technical managers" and their assistants; (iii) extension workers; and (iv) administrative staff.  - 8 - 2.10 The training program will emphasize six important areas: (a) the best techniques for the planning, management and distribution of water resources; (b) the basic concepts for the proper maintenance of infrastructure and equipment, including preventive maintenance; (c) how to achieve sustainable and profitable agriculture, while protecting the environment; (d) cost recovery policies and water charge rate structures and collection; (e) efficient administration of financial resources; and (f) construction and contract management D. Incentive Program for Technology Improvement Component 2.11 This component would promote the adoption of technological innovations among all irrigation farmers, with a view to achieving greater efficiency in the use of water and soil resources, thereby enabling farmers to increase their competitiveness on both the domestic and foreign markets and to improve their income. In order to improve water productivity in the agricultural sector, farmers need to be made familiar with advanced technology so that they may adapt it to their production processes. This component would have two sub- components: (a) training technical specialists (extensionists) and financing their salaries, on a declining basis, during a three-year period to assist with access to new technology; and (b) one-time matching grants from the government for part of the investments made by beneficiary farmers to modernize their irrigation systems. Total base cost of this component is estimated at US$38.1 million, which includes a contribution from the beneficiaries equivalent to about US$11 million. 2.12 The first sub-component is a training program which would be put together for the extension workers who will be responsible for transferring irrigation and drainage technology to irrigation system users. The subject matter envisaged for the training provides extensive coverage of most of the know-how that these extension workers should have; it would also include training on environmental aspects, particularly where the use of agrochemicals is concerned, along with the mitigation of their environmental impact. In order to ensure that the trained professionals hired by the user organizations remain, they will be asked to sign a commitment to work with the hiring organization for a minimum of five years, or repay the salaries they have received during their training. These extension workers will be responsible for promoting the upgrading of irrigation technology and also for disseminating the financial incentive program to all farmers who can participate in this program, including the poorer farmers who might not otherwise avail themselves of the program. They will also use the irrigation systems put in place under the program to promote the adoption of irrigation technology, with the aim of encouraging farmers in the areas they serve to use more efficient irrigation systems. 2.13 The second sub-component (investment matching grants for the adoption of new irrigation technology) would provide incentives to boost investment in irrigation technology improvements. This program's potential beneficiaries would be the owners of irrigated farm land as well as the farmer organizations or associations that operate irrigation systems serving their members' farms and that are interested in modernizing in order to achieve more efficient use of water and soil resources. To ensure that all farmers are provided equal access to these grants, the funds made available will be allocated proportionately to the irrigated areas in the main valleys of the coast. In addition, to assure a greater impact upon more poverty-stricken farmers, the program will provide up to 80 percent matching grant to  - 9 - farmers with less than 15 hectares and a grant of no more than 50 percent to farmers with more than 15 hectares of land. 2.14 Since this program's aim is to promote improved irrigation technologies, only projects on land with water already supplied to the farm site will receive grants. The grant will be paid on the cost of studies to establish improved irrigation methods and also on the works and equipment needed to apply irrigation water and agricultural chemicals, including the necessary pumping equipment, in cases where pressurization is needed. In light of the market costs of the most common irrigation systems, such as sprinklers, gated pipes, drip and micro-irrigation, including pressurization and delivery of agricultural chemicals via irrigation systems, a ceiling on investment per hectare will be set at US$5,000, since higher investments will be difficult to recover. There will also be a ceiling on investment of US$150,000 per individual project or US$300,000 for projects undertaken by farmer's organizations or associations. To qualify for grants under the program, farmers will be required to participate in a competitive selection process, based upon technical criteria and cost-sharing capacity, organized by the PCU and designed to ensure that all farmers groups can benefit from the proposed grant scheme (para. 6. lb). 2.15 The maximum subsidy percentages are expected to gradually decrease over time, as the proportion paid by farmers increases. Since the competition rules will take into account the aim of achieving greater farmer participation in project costs, demand is also expected to increase as this type of incentive becomes known to farmers. Farmers benefitting from this program will be required to make access to the improved irrigation systems available to the region's extension specialists for use in demonstrations to other farmers (para. 6.1 c). 2.16 The grant will be paid once the works have been fully constructed and delivered to the satisfaction of the PCU and the Bank. To assist competing farmers and to enable them to secure at least a partial bank loan or to pay for part of the cost of the irrigation improvements, the PCU will award them "Subsidy Certificates for Modernized Irrigation" upon receipt of notification that they are winners of the auction. These certificates will become valid as soon as the works have been accepted to the PCU's satisfaction. The approval by the Bank of the final version of the Operational Manual for the Incentives Fund will be a condition of disbursements for the incentive program component (para. 6.4a). E. Dam Safety Emergency Program 2.17 This component refers to the development of an emergency rehabilitation program for critical problems with selected dams within the Pacific basin. The base cost of this component is estimated at US$7.0 million. It includes testing and necessary rehabilitation of control equipment, valves, gates, low-level drains and other outlet works, and generators in four major dams (Poechos, San Lorenzo, Tinajones and El Fraile) as well as completion of earth stabilization works at El Fraile dam. Storage reservoirs are an essential component of irrigated agriculture in Peru, and most of the existing irrigation schemes depend on them for their water supply. INADE, under arrangements satisfactory to the Bank, will cause the dams under the project, after their rehabilitation, to be periodically inspected (para. 6.le).  - 10- 2.18 A study was carried out during the preparation of the Irrigation Susbsector Project with the objective of evaluating present operating conditions of eight major dams in Peru. The analysis, which emphasized those aspects considered as high risk for the safety of the structures, also included a proposal for the development of a nationwide dam safety program (see Annex 6). A Dam Safety supervision committee has been already established in INADE to implement the dam safety emergency component. F. Project Administration and Monitoring Component 2.19 A financially autonomous Project Coordinating Unit would be established in MAG under supervision of the Minister of Agriculture. The PCU would be responsible for the intersectoral coordination arrangements and the implementation of the institutional development, the incentives program, and the training components. The PCU would also evaluate the irrigation schemes submitted by the WVUOs, on the basis of technical, financial, economic, and environmental pre-established eligibility criteria. 2.20 The project would use an information system managed by the PCU for monitoring the implementation of irrigation subprojects and assess progress in achieving other project objectives. The development of the system entails the creation of a base line information data and the procedures to capture key technical, financial and operational information. The PCU will design and establish the information and monitoring system before loan effectiveness (para 6.3e). Total base cost of this component, including the PCU costs and the monitoring system, is estimated at US$2.9 million. G. Project Environmental Aspects 2.21 As the Irrigation Subsector Project involves only the rehabilitation of small-to medium-sized infrastructure of existing irrigation schemes, it is unlikely that it will have any negative environmental impacts. All the irrigation schemes considered for rehabilitation work have been in operation for many years and face a range of environmental issues which include: low irrigation efficiency, high water loss, waterlogging and salinization, water quality issues and improper use of agrochemicals. Without the proposed rehabilitation work the environmental consequences of these irrigation developments would tend to increase since the infrastructure will continue to deteriorate and no other financial resources are available to address environmental issues. The project, on the other hand, would bring a range of beneficial environmental impacts since it would promote efficient water use by reducing water losses, improve drainage systems which have a direct impact on waterlogging and soil salinity, and address a broad range of environmental issues, including the use of fertilizers and pesticides, in its training component. 2.22 The future Water Management Project under preparation by the Government of Peru would address most of the environmental impacts resulting from irrigation developments in the coastal valleys of Peru which cannot be fully addressed without a broad multi-disciplinary approach which would deal with environmental issues at a watershed scale. Such an approach would have to focus on integrated watershed management. Its successful implementation would further necessitate the support of a national program (framework) designed to address environmental protection nationwide. Such a broad-based program would allow for a better assessment and evaluation of the range and magnitude of  - 11 - environmental impacts associated with irrigation developments in Peru. The knowledge that will be gained during the analysis of existing irrigation systems as part of the proposed Irrigation Subsector Project should greatly assist in such future environmental planning. 2.23 Although it is beyond the scope of the Project to address the entire spectrum of existing environmental problems, some specific measures will be adopted to minimize environmental degradation within the subproject's areas. The Project will focus on improving on current patterns of agro-chemicals use through the development of appropriate training modules for inclusion in the project's training componen.s. The reduction of current water losses throughout the conveyance systems, associated with the utilization of improved irrigation technologies such as sprinkler and drip irrigation, will reduce the incidence of water logging and salinization.  - 12 - 3. PROJECT COST AND FINANCING A. Summary of Project Costs 3.1 The total cost of the Project is estimated at US$172.4 million, including physical and price contingencies. More specifically, base costs are estimated as follows: (a) US$102.4 million for Rehabilitation of Irrigation and Drainage Infrastructure; (b) US$6.0 million for Institutional Development; (c) US$38.1 million for the Incentive Program for Technology Improvement; (d) US$2.9 million for Project Administration; and (e) US$7.0 million for the Emergency Dam Safety Program. Estimated local and foreign costs, as well as physical and price contingencies, are shown below. Note that, since costs have been estimated in US$ equivalent, price contingencies represent only foreign inflation estimated in accordance with the Bank's manufacturing unit value (MUV) index (on average 2.7 percent p.a. between 1994 and 1999). Summary of Proiect Costs Component Local | Foreign L Total % Total I ._________ I _________ Foreign Base Cost (US$ million equivalent} A. Rehabilitation of Irrigation and Drainage 89.1 13.3 102.4 13 65 Infrastructure B. Institutional Development/Strengthening 3.5 2.5 6.0 42 4 of WUOs C. Incentive Program for Technology Improvement 1. Training and Extension Services 10.3 2.6 12.9 20 8 2. Incentives Fund 10.1 15.1 25.2 60 16 D. Project Administration and Monitoring 2.5 0.4 2.9 13 2 E. Emergency Dam Safety Program 4.2 2.8 7.0 40 5 Base Cost 119.7 36.7 156.4 20 100 Physical Contingencies 5.6 1.2 6.8 17 4 Price Contingencies 7.4 1.8 9.2 20 6 Total Project Cost 132.7 39.7 172.4 23 110  - 13 - B. Project Financing 3.2 A Bank loan of US$85 million will help to finance foreign and local costs amounting to about to 49 percent of total project cost. OECF is expected to provide a loan of about US$60 million. The contribution of project beneficiaries will amount to US$11 million, while the remaining US$16.4 million will be provided by the Government. The parallel cofinancing funds will be used to finance specific irrigation rehabilitation works under the project. Farmers will partially finance the on-farm investments under the incentives program for technology improvement. GOP financing would likely to be used for the incentives fund sub-component and the project administration component. Loan effectiveness would be conditioned upon the allocation by the Government of adequate funds from its proposed fiscal year budget to be made available to MAG to implement the first year project activities (para. 6.3a). C. Cost Recovery and Water Charges 3.3 The existing legislation (Supreme Decree 003-90-AG, 1990) defines two classes of water tariffs, one for agricultural use and the other for non-agricultural use. In general, these tariffs do not reflect the actual cost of water. In the non-agricultural sectors, they are calculated on the basis of the general unit tax, Unidad Impositiva Tributaria (UIT), of which they represent very small proportions (from 0.05 percent for water supply, fisheries and energy to 0. 1 percent for industries and mines). 3..4 In the agricultural sector, the volumetric water tariff includes three components: (i) a so-called water user's association component (ingresos de la junta de usuarios) to meet their O&M expenses, to pay for the conservation and improvement of common irrigation infrastructure and to finance the operating budget of the Administrador Tecnico; (ii) a water levy or canon de agua component, representing 10 percent of the first component. Revenues from this levy are to go to the autonomous water basin authorities; and (iii) an "amortization" component, to recover the cost of public investment in storage infrastructure for irrigation purposes. This component will also represent only 10 percent of the water user association component, except when otherwise determined by "special" project authorities. 3.5 Irrigation water tariffs are proposed by the Administrador Tecnico to the water user association and, in case of disagreement, are decided by an ad hoc, informal committee. Except in a very few cases, these tariffs are unrealistically low (US$20-30 per ha)y' and do not provide for proper O&M of the irrigation systems (the "amortization" component is usually not recovered). Collection has generally been unsatisfactory, due to the fact that: in 5 It is estimated that this would require ahout US$75 per ha for cornmon irrigation infrastructure and S45 per ha for diversion structures.  - 14 - the past, the irrigated systems were inadequately maintained by the Government, so farmers did not see why they should pay for 0 & M, (responsibility has only recently been transferred to water user associations and several of these lack experience as yet). Moreover, the perception of the State as provider, frequent conflicted over the use of a resource which was not always available and minimal penalties in case of default. On average, it is estimated that 20 percent of farmers do not pay their water dues. 3.6 In addition, special water levies (cuotas) are collected by the association or irrigator commission as mandatory contributions from water users for specific works or activities in the irrigation system or sub-system. According to the existing law, these cuotas are used only to meet extraordinary expenses. In reality, they often constitute the only means for an irrigator or canal commission to operate and maintain its canal or subsector. Since the transfer of irrigation infrastructure O&M by the Government to water users in 1989, the payment of canal commission-controlled cuotas has helped to improve O&M of canals or specific parts of irrigation systems. 3.7 The system of low collection and poor maintenance has essentially been that of a vicious circle with the one leading to the other. For their part, low water tariffs have resulted in: (i) a lack of financial resources to operate and maintain the irrigation systems adequately, so that most of the irrigation systems are in an advanced stage of deterioration (some with a high risk of collapse); (ii) excessive water consumption at farm level due both to the lack of any price incentive to use water more efficiently, and to high conveyance losses; (iii) undue preference for crops (such as sugarcane and rice) with large water requirements; and (iv) limited incentives toward more efficient irrigation techniques such as sprinkler or drip irrigation. 3.8 More recent Government policy in the irrigation subsector has focused on improved efficiency, calling for: (i) complete take-over of responsibility by water users for O&M of their irrigation systems, and (ii) recovery of 100 percent of investment costs in deferred maintenance works, including for rehabilitation and modernization of existing irrigation schemes. 3.9 The above policy statements have met with enthusiasm by farmers, who are anxious to participate in the financing of works needed to restore the old irrigation systems which they have been using under ever-worsening conditions. Encouraged by prospects of financial support from Government, some of these farmers, through their water user associations, have already contributed to the implementation of feasibility studies for the rehabilitation of their irrigation systems. To finance rehabilitation costs, farmers' access to credit is to be facilitated and conditions of this credit eased by allowing reasonable grace periods for loan repayment. 3.10 The Government of Peru is strongly of the opinion that 100 percent recovery of the total investment for rehabilitation must be obtained from the WUOs. Consequently, the project is structured to attempt to do this. However, depending on the system and the nature  - 15 - and scope of the works required, small farmers under a few schemes may not always be able to repay the investment costs of rehabilitation, in addition to higher O&M costs. In these cases, a system of cross subsidiation by the more profitable farmers within the same WUO will ensure full cost recovery. 3.11 While 100 percent recovery of these investment costs is possible, given the fact that real guarantees will be used as collateral, it is much more important that recovery of O&M costs on a sustainable basis be achieved. The future sustainability of the WUOs and their ability to successfully function in a decentralized, self-governing manner will rely upon their ability to collect the full cost of ongoing O&M including sinking funds for the replacement of electrical and hydromechanical equipment in future years. The development of farmer-controlled WUO's to collect and manage the assessments and that are responsible for the operation and maintenance of the systems will be facilitated by the institutional component of the project.  - 16 - 4. PROJECT IMPLEMENTATION, PROCUREMENT AND DISBURSEMENTS A. National Level Organization and Management 4.1 A Project Coordination Unit (PCU) within the Ministry of Agriculture will be primarily responsible for the project's organization and management aspects, including supervising and ensuring effective implementation of the project's components. This unit, reporting directly to the Minister and Vice-Minister, would, however, be technically, administratively and financially autonomous. The Project Coordination Unit would be created, either by the Law for restructuring the agricultural sector currently under consideration by Congress or by a new law specific to the project. It would be established for the project period of five years, and its personnel, under the direction of a Project Coordinator, would be recruited for fixed periods of time according to project needs. The PCU would include: a technical unit headed by a water resource management specialist and comprised of a civil engineer (hydraulics and irrigation systems), an agricultural engineer, an agronomist and an economist; a financial unit (two professionals); a unit specifically in charge of supervising the training programs (with a lead coordinator and his assistant, plus one coordinator each for support to water user organizations for irrigation technology and for farmer training); and an administrative unit (one professional). In addition, support staff (five) would be required. 4.2 The PCU's principal functions would be as follows: coordination with the various executing agencies (COFIDE and the WUOs for the project's rehabilitation component NGOs and external consultants for the training and extension components and INADE for the Dam Safety Emergency Program) technical and financial supervision of project implementation by these agencies (while the PCU would be responsible for overall coordination and supervision, COFIDE, in coordination with and under the regulations established by the Superintendency of Banks and Insurance, would perform its normal role of monitoring first-tier institutions to which it lends); selection and recruitment of consultants to prepare feasibility studies for additional rehabilitation subprojects or for specific aspects such as legal expertise and audit; supervision of consultants' work and evaluation of feasibility studies; monitoring and evaluation of project activities; and supervision of a three-year technical maintenance audit of the subprojects subsequent to rehabilitation to assure their sustainability. Before effectiveness of the loan MAG would have staffed the PCU, with staff with experience and qualifications acceptable to the Bank (para. 6.3b). 4.3 Execution of Part A of the project would be responsibility of COFIDE. Its role would be primarily to monitor the overall performance and repayment capacity of CFIs and to supervise the use of project funds. Specifically, COFIDE would: (i) qualify and monitor the performance of CFIs according to the established qualification criteria; (ii) monitor compliance with the provisions of the Credit Manual; and (iii) allocate, disburse, repay and account for project funds. To this aim, COFIDE would: (i) ensure that subloans  - 17 - shall be made in accordance with the Credit Manual approved by the Borrower and the Bank; (ii) within six months after the project's closing date, COFIDE and MAG would prepare and execute a plan, acceptable to the Bank, for the future operation of part A of the project. (Para. 6.2a). B. Management of Water User Organizations 4.4 Water users within each of the country's 97 irrigation districts are grouped into Juntas de Usuarios (JU) which are comprised of various irrigators' commissions (Comisiones de Regantes, CRs) corresponding to irrigation "sectors" or "subsectors". Both the JUs and CRs have legal identity, and are entitled to establish O&M plans, operate and maintain irrigation infrastructure, and contract loans to carry out works and studies. Collection of water tariffs and administration of the district's funds are the responsibility of the JU. Each Junta is obliged by law to hire a technical manager with at least five years of professional experience in irrigation systems operations and soil and water resource management. Most of these WUOs are technically and administratively weak and not all employ an adequately experienced technical manager. They will require considerable institutional strengthening in technical, administrative and financial skills, particularly in the areas of construction and financial management, and systems operation and maintenance. 4.5 In practice, the situation is rather complex. Some of the irrigation schemes considered for rehabilitation under the project have several Juntas, some having been established by different groups of water users within the same irrigation district. This practice, which clearly contradicts the law, leads to frequent conflicts among users. In some cases, the legal existence of two Juntas (e.g., in Santa Lacramarca) has eventually been recognized by court decision. Conflicts also arise between a Junta and its irrigators' commissions, some of the latter being better organized and more dynamic than the Junta itself (e.g., La Esperanza in Huaral, north of Lima). 4.6 The WUOs involved in the project's rehabilitation component will be responsible for the implementation of all rehabilitation work under the Project using funds borrowed from the first-tier lenders (using irrigated land under the system, or any other real assets, as collateral). These WUOs will be responsible for contracting the rehabilitation or performing the work by force account. They will be responsible for procurement and disbursement of funds to pay for the work as well as the management of the construction. It is anticipated that most WUOs will use expert consultants for the actual management of rehabilitation work under the project. The WUOs will be fully committed to financing 100 percent of the rehabilitation costs and to adequately operating and maintaining the irrigation infrastructure and will sign collateralized a credit contract with the financial intermediaries, requiring each to fully service its debt. Subloans will not be released without such a contract.  - 18 - C. Loan Funding for the Rehabilitation of Economically Viable Schemes 4.7 Government would create a Rehabilitation Fund to provide a long-term- commercial-credit line to implement irrigation rehabilitation schemes. In this context, the WUOs would be allowed to define their investment priorities for the design and construction of these schemes. The Government would also provide technical support to the WUOs in the preparation of their credit applications. This should ensure that schemes to be financed will have adequate financial (as well as economic) rates of return. 4.8 As noted earlier, approximately US$102 million (base costs) would be utilized under the Project for the rehabilitation of about 25 existing irrigation schemes. COFIDE - a government owned second-tier financial institution- would be responsible for the management of the Rehabilitation Fund. To this aim, it would sign an Agreement with the Ministry of Economy, as the Government of Peru's financial agent. COFIDE's role would primarily be to monitor the overall performance of Commercial Financial Institutions, and to supervise the use of the Fund assets. COFIDE is financially sound and has adequate selection procedures, as well as organizational and staff capacity to carry out these responsibilities. Signature of the Agreement between MEF and COFIDE, including the Credit Operational Manual and the final version of the subsidary participation agreement between COFIDE and the CFIs, would be a condition for loan effectiveness (para. 6.3c). 4.9 CFIs that satisfy creditworthiness criteria, and comply with prudential regulations of the Superintendency of Banks and Insurance, would be eligible to drawn on the Rehabilitation Fund, after entering a Subsidiary Participation Agreement with COFIDE. COFIDE would charge the financial intermediaries no more than the average cost of funds of CFIs, as defined in the Credit Operating Manual, and no less than the cost of funds to the Borrower under the project, plus a commission (0.5 percent) to cover administrative costs. 4.10 The Rehabilitation Fund under the project, would be exclusively applied to finance 100 percent of rehabilitation subloans in US dollars. The funds required for various investments in irrigation rehabilitation under the Project would be channeled from COFIDE to CFIs, which will on-lend 100 percent of the required investment to the WUOs, at commercial rates. During loan negotiations, it was agreed that the proposed mechanism for financing rehabilitation will be evaluated by the Bank, the OECF, and the Government, as soon as the first US$10 million of the loan funds are committed, but no later that June 30, 1998, and adjustments satisfactory to the Bank, will be made to perfect such mechanism (para. 6.1g). 4.11 The recipient of the credit for irrigation rehabilitation investments would use real guarantees as collateral for such credit. The CFIs assuming the lending risk would be responsible for determining the acceptability of such collateral in each case. In most cases the collateral would be land, although alternative collateral acceptable to the Superintendency of Banks and Insurance would be eligible. To the extent feasible, complementary collateral  - 19 - water use concessions may be acceptable in the future once the new water law is passed by the Congress. 4.12 Participating CFIs would repay COFIDE in accordance with amortization schedules with WIUOs, and COFIDE in turn would transfer the Government what it recovers form CFIs. The Government would assume currency risks associated with the Bank loan (e.g., basket), and transfer to COFIDE in US dollars, while the CFIs would borrow US dollars from COFIDE and relend the same to WUOs, which would take a US dollar - Nuevo Sol currency risk. CFIs would bear the full credit risk on their loans to WUOs. 4.13 Eligible expenditures would include irrigation/drainage infrastructure, machinery and equipment, preparation of detailed construction designs, and supervision of construction. Eligibility for financing under the Fund would exclude transfer of assets such as land or farm purchases, or refinancing of existing indebtedness. The Credit Operating Manual would describe the eligibility of borrowers, the procedures for loan applications, the role of CFIs in investment evaluation, and the disbursement procedures. COFIDE would not make the first disbursement until a WUO has signed a subloan agreement with a CFI and a construction contract for the works. (The details of the on-lending arrangements are discussed in Annex 5). 4.14 The issue regarding the clarification and registration of land titles within the subproject areas needs to be resolved to the extent that the CFIs are satisfied as to the adequacy of the collateral provided by the borrowing WUOs and their members. These land titling and registration issues will be resolved under an IDB loan, already Board approved, which will support recent Government reforms, including new legislation designed to unify existing land registries, and to ensure simplified land registration procedures. 4.15 In coordination with the PCU, MEF will monitor the performance of COFIDE in managing the rehabilitation fund. To ensure that WUOs are maintaining the systems that are being rehabilitated with this loan in an adequate and sustainable manner and that they are collecting an acceptable water charge to recover the cost of O&M, the PCU would be responsible for hiring an independent technical auditor to monitor the O&M status of the subprojects on an on-going basis. This auditor (probably an engineering consulting firm) would review the irrigation infrastructure of the subproject every three years to determine that the ongoing operation and maintenance status is current and satisfactory and to recommend needed corrective actions. The WUO would then be responsible for complying with the auditor's recommendations within one year following the issuance of its report (para. 6.2i).  - 20 - D. Accounts and Audits 4.16 The PCU would maintain separate project accounts to record expenditures made under the project and for the special account, using a plan of accounts acceptable to the Bank. COFIDE would also maintain separate accounts for operations cofinanced with Bank funds. First-tier lending institutions would maintain records adequate to reflect their operations and their financial situation, in accordance with internationally accepted accounting principles consistently applied and properly audited based upon international standards. During loan negotiations, it was agreed by the Government that: (i) the PCU project accounts would be audited according to appropriate principles by independent auditors acceptable to the Bank; (ii) the auditor's report would include a separate opinion regarding the special account and the reliability of SOEs established to support withdrawals requests for loan funds, as well as a management report focusing on overall institutional performance and flow of funds efficiency under the project; and (iii) the audit reports would be submitted to the Bank within six months after the end of the fiscal year (paras. 6. li to 6. lk). During loan negotiations it was agreed by COFIDE that: (i) COFIDE's project accounts and financial statements would be audited in accordance with appropriate auditing principles consistently applied, by independent auditors acceptable to the Bank; (ii) it would furnish to the Bank no later than six months after the end of each year, the auditor's report in such detail as the Bank shall have reasonably requested; and (iii) it would furnish to the Bank any other information concerning said records, account and financial statements, as the Bank shall from time to time reasonably request (para. 6.2b). During negotiations, it was agreed that the terms of reference for selection and contracting of the auditors would be in accordance with Bank requirements and that those presented by COFIDE were, in principle, acceptable. (para 6.11). The plan of accounts and accounting procedures for the PCU and COFIDE would have been made operational before loan effectiveness (para 6.3d). E. Monitoring and Evaluation 4.17 The project would use an information system for monitoring the implementation of the large number of subprojects scattered across the peruvian coast. The monitoring plan, includes project performance indicators and targets, which would serve as the basis for overall monitoring of other project activities as well. During loan negotiations, the Government agreed that the PCU: (i) will prepare and submit for Bank's approval, not later that December 31, each year, an annual operating plan (POA), and (ii) will establish within the PCU and thereafter maintain during the period of execution of the project, a comprehensive information and monitoring system, satisfactory to the Bank and will issue within three months of each project semester, semi-annual reports on project implementation progress which will be submitted to the Bank; through the Minister of Agriculture (paras. 6. ln and 6. lo). Loan effectiveness would be conditioned upon making operational the agreed management information system for the project, at the PCU level (para. 6.3e).  - 21 - 4.18 Under normal circumstances, the Bank would undertake at least two missions annually to review project implementation performance. At least one of these would be used to review and establish annual investment plans and work programs. Additionally, in order to perfect the mechanism for financing rehabilitation, an evaluation of the performance of the credit line would be carried out by the Bank, the OECF, and the Government, as soon as the first US$10 million of the loan funds are committed, but no later than June 30, 1998. (para. 4.10). The PCU would furnish to the Bank, for its approval, not later than six months after the closing date a plan for the future operation of the project, and that thereafter, it would carry out said plan with due diligence and efficiency (para. 6. lp) F. Procurement 4.19 For the rehabilitation component the PCU would ascertain that all procurement of rehabilitation works and equipment by private entrepreneurs will be undertaken by the WUOs, in accordance with established commercial practices which have been reviewed and found acceptable to the Bank, ensuring high quality and competitive price. Contracts will be awarded based on the comparison of at least three proposals from eligible bidders. However, all rehabilitation contracts for civil works larger than US$5.0 million, and contracts for goods and equipment above US$250,000, would be awarded through International Competitive Bidding (ICB) following Bank guidelines. The technical staff of the WUOs would be assisted by the PCU in the implementation of their procurement process. Irrespective of the amount of the contracts, the documentation of the first contracts for construction of works and acquisition of equipment to be financed by each commercial bank would be subject to prior Bank review. 4.20 On-farm irrigation equipment under the Matching Grant Program for Technology Improvement will be also procured by private farmers or farmer's organizations, in packages as large as possible, following local established commercial practices acceptable to the Bank, and would be awarded on the basis of comparison of bids from at least three eligible suppliers. 4.21 The rest of the project components would involve public procurement and would be implemented by INADE (Dam Safety Program) and the PCU, contracts for civil works larger than US$3 million, and contracts for goods and equipment above US$250,000 would be procured through International Competitive Biddings (ICB) following Bank guidelines. In the procurement of goods and works through ICB, the WUOs and the public agencies will use the relevant standard bidding documents issued by the Bank. Other contracts for civil works (up to an aggregate amount equivalent to US$3.4 million), and goods (up to an aggregate amount equivalent to US$1.4 million) would be procured following local competitive bidding (LCB) procedures in accordance with standard bidding documents agreed with the Bank. Miscellaneous equipment and materials required by the project, totalling some US$0.6 million, and estimated to cost less than US$20,000 per contract, would be awarded on the basis of evaluation and comparison of price proposals invited from at least  - 22 - three suppliers, in accordance with procedures acceptable to the Bank. The Guidelines for Use of Consultants by World Bank Borrowers and the World Bank as Executing Agency shall apply for the selection and contracting of consulting services, totalling some 115 man- years for technical assistance, training and special studies. Public civil works contracts estimated to cost over US$3 million, goods over US$250,000 and consultant contracts above US$50,000, for individual consultants, and above US$100,000 for consulting firms would be subject to prior Bank review of procurement documentation. With these thresholds, prior Bank review would involve about 30 contracts over a period of about five years and is expected to cover about 50 percent of total contracts with Bank fnancing. During supervision, the Bank would randomly check contracts not subject to procurement. During negotiations, the Government would provide assurances that the procurement procedures described above would be followed and that established commercial practices in the sector, consistent with Bank basic procurement principles, will be used. Procurement arrangements are summarized in the table below. Procurement Arrangements Procurement Method Project Element ICB LCB Other N.B.F.Y Total Civil Works WUOs contracts 12.5 41.1 60.1 113.7 (12.5) (38.5) (51.0) Public contracts 3.4 3.4 (3.4) (3.4) Goods and Equipment WUOs contracts 0.5 15.3 11.5 27.3 (0.5) (9.4) (9.9) Public contracts 2.7 1.4 0.7 4.8 (2.7) (1.4) (0.7) (4.8) Consultants and Other 13.8 13.8 Services (13.8) (13.8) Operating Costs 9.4 9.4 (2.1) (2.1) Total 15.7 4.8 80.3 71.6 172.4 (15.7) (4.8) (64.6) (85.0) Note: Figures in parentheses represent amounts to be financed by the Bank loan. 2 N. B. F: Not Bank Financed. To be procured in accordance to cofinancier regulations, in conformity with para. 1.4 of World Bank Guidelines.  - 23 - G. Disbursements 4.22 The proceeds of the proposed loan would be disbursed as follows: (a) 95 percent against project expenditures made for the subloans under the rehabilitation component; (b) 100 percent for consultants and 100 percent of foreign and 85 percent of local costs, for goods under the Institutional Development component; (c) 100 percent of foreign and 85 percent of local costs for goods, 100 percent for consultants, 40 percent for extension services and 50 percent for matching grants under the Incentive Program for Technology Improvement component; (d) 100 percent of foreign and 85 percent of local costs for goods; 100 percent for consultants; and 75 percent up to US$350,000, 50 percent between US$350,000 and US$700,000 and 25 percent between US$700,000 and US$1,020,000 for operating costs under the Administration and Monitoring component, and (e) 100 percent of foreign and 75 percent of local costs for civil works, 100 percent of foreign and 85 percent of local costs for goods, and 100 percent for consultants under the Dam Safety component. Disbursements for civil works contracts not exceeding US$3 million, contracts for goods and equipment not exceeding US$250,000, and consultant contracts below US$50,000 for individual consultants and below US$100,000 for consulting firms, training and technical assistance costs, and operating expenses would be made against Statements of Expenditure (SOEs) prepared by either the executing agency or WUOs with technical support from the PCU. In the case of initial payments required by contractors to begin implementation of works under the rehabilitation component, disbursements would be made against contracts signed between WUOs and commercial banks. Supporting documentation for such expenditures and contracts would not be submitted to the Bank, but would be made available for inspection by Bank supervision missions.  - 24 - IRRIGATION SUBSECTOR PROJECT DISBURSEMENTS (Expressed in US$ equivalent) CATEGORY AMOtNT of % of Expenditures to be Financed the Loan Allocated Subloans 46,300,000 95 % of amount disbursed by COFIDE under Subloans Goods 4,170,000 100% of foreign expenditures and 85 % of local expenditures Consultants' Services 13,030,000 100% Agricultural extension services under 2,730,000 40% Part C of the Project Matching Grand under Part C of the 7,300,000 50% Projec Operating expenses under Part D of 1,020,000 75% up to $350,000 equivalent; 50% thereafter the Project up to an aggregate of $700,000 equivalent; and 25% thereafter Civil works under Part E of the 2,400,000 100 % of foreign expenditures and 75 % of local Project _ expenditures Unallocated 8,050,000 Total 85,000,000 4.23 In order to reduce the interval during which the Government would finance the Bank's share of project costs with its own resources, two Special Accounts in US dollars would be established in commercial Banks acceptable to the Bank. The first one would cover COFIDE's expenditures and would be opened with an initial deposit of US$3.0 million. The second one would cover PCU's expenditures and would be opened with an initial deposit of US$1.5 million. The amounts deposited in the special accounts could be increased or decreased by the Bank as required for project execution. The Bank would replenish both Special Accounts for the amount of withdrawals on account of eligible expenditures at the request of the PCU on the basis of Statements of Expenditures (SOEs). Disbursements are expected to occur over about a six-year period, as shown in the estimated disbursement schedule (Annex 13). H. Retroactive Financing 4.24 The Government of Peru has requested retroactive financing up to an amount of US$500,000 to finance expenditures in respect to the institutional strengthening program to be executed by the PCU. Because of the immediate need to carry out this program, retroactive financing, would be limited to costs incurred prior to the date of the loan Agreement. These funds would be used to fund consultant services and operating expenses,  - 25 - and would be conditioned on the application of the World Bank's procurement guidelines for the procurement of goods and for the contracting of consultants and services. 5. BENEFITS, ECONOMIC JUSTIFICATION AND RISKS A. Benefits and Beneficiaries 5.1 The Project's main benefits would be: (a) increased agricultural productivity and production through increased efficiency in the use of water and agricultural inputs such as fertilizers and pesticides; (b) increases and greater stability in incomes for project beneficiaries; (c) improved conservation and management of water resources; (d) sustainable O&M of water storage, delivery and drainage systems on a full cost-recovery basis; and (e) sustainable infrastructure development by strengthening the private sector through promotion of local water use management and private financing. There will also be some associated, indirect, general benefits such as improved flood control, environmental enhancement and improved publicly used roads. 5.2 More specifically, by rehabilitating an estimated 25 existing irrigation schemes, the project would increase the availability of water to project beneficiaries which would help to: (i) raise incomes by an estimated 30 percent for project beneficiaries!'; (ii) increase water use efficiency by an estimated 10-15 percent for project beneficiaries; (iii) increase irrigated areas and agricultural productivity by an estimated 20-50 percent; (iv) as a result of the training and incentives programs, enhance the institutional, technological, administrative, and O&M capabilities of water users and their representative organizations. 5.3 In addition, rehabilitation of existing schemes will significantly reduce water losses and improve water conservation, thereby improving the environment. Training oriented towards more efficient use of pesticides and fertilizers should also alleviate deteriorated environmental conditions. Finally, the project will reduce the Government's subsidy role in the irrigation sector and encourage increased private sector participation on two fronts: (i) design, construction, supervision, administration and maintenance of irrigation infrastructure; and (ii) expanded extension of formal credit in long-term irrigation and agriculture sector investments. B. Economic Analysis 5.4 While ten subprojects have already been identified and feasibility studies prepared for them, it is anticipated that under the project an additional 15 subprojects will be undertaken during project implementation. As such, the project is somewhat unique relative to more traditional irrigation projects. Consequently, financial and economic analysis has only been carried out for the first ten subproject areas on expenditures covering the rehabilitation of existing irrigation infrastructure. Individual financial rates of return for subprojects range from 12-50 percent, while the overall return is around 36 percent. In general, given Peru's improved macroeconomic situation and the existence of few significant financial price distortions, the resulting economic rates of return are similar to the financial 3 See Financial and Economic Analysis Annex for details.  - 26 - rates of return. Individual economic rates of return range from 18-50 percent with an overall return of about 39 percent. 5.5 Sensitivity analyses have also been carried out for the referenced ten subprojects. The analysis tests the scheme's viability under adverse scenarios. Switching values have been used to determine the percentage of changes in key variables required to reduce the ERR to the opportunity cost of capital. The sensitivity of individual schemes to changes in benefits and costs varies significantly due to the relative diversity of the schemes and their specific cropping patterns. In general, the results show that the schemes are relatively insensitive to cost overruns and reduced benefit from lower production. The schemes are only slightly more sensitive to decreases in benefits due to commodity price reductions. Such relative insensitivity is the result of farm models being prepared with conservative production assumptions and considerations of market demand, which allowed for a narrower range of sensitivity tests. Additionally, historical trends strongly suggest that the rained water supply estimated under the subprojects is virtually guaranteed. Finally, delays in implementing the rehabilitation works will not be a major consideration since the works are generally not complicated and their investment costs are relatively small. (Details of financial and economic analysis are provided in Annex 9). C. Project Risks 5.6 There is a risk that first-tier lender institutions will participate only partially in the financing of the subprojects, thus delaying rehabilitation of the irrigation schemes. Inefficient State-owned development banks have kept these lenders out of the sector for almost thirty years and many do not have experience with group lending, preferring to concentrate their operations with a few select clients. Continuing improvements in macro- economic conditions and Bank and IDB supported reforms in the financial sector, which will increasingly allow more efficient institutions to compete more aggressively for financing such as that proposed under the project, will help attract commercial lenders. Moreover, after the first year of implementation the mechanism for financing rehabilitation could be perfected after its performance evaluation by the Bank, the OECF, and the Government. 5.7 The institutional and technical capabilities of the WUOs to organize themselves to identify and implement the irrigation schemes could affect the speed and quality of project implementation. To minimize this risk, technical assistance will be provided to strengthen the WUOs involved in project designs and implementation. Delays in starting project execution should be averted since final designs for first-year investments were completed prior to appraisal. The risk that some water users may find difficulties in repaying their loans will also be minimized by the pressure from other members of the water users organization. Participating private financial institutions, in combination with the project coordination unit will also ensure that the proposals for investments under the project are financially viable. The scope of the MTR will include a performance evaluation of the irrigation rehabilitation fund and the impact of the rehabilitation works and other project's components, on both the irrigation system and agricultural production. 5.8 Since formal credit will be extended, real guarantees will be demanded from WUOs eligible to receive the credit. This will provide a significant incentive for WUOs to repay the loans for two reasons: (a) land is perhaps their ,nly real immovable asset, and (b)  - 27 - non-payment of long-term credit, resulting in potential transfer of land ownership, would reduce access to short-term credit. Furthermore, since loans will be extended to WUOs as a whole, group pressure will minimize poor repayment by individual members. Barring unlikely and unforseen significant changes in macroeconomic conditions and or a reversal of the improvement in real interests rates, it is reasonable then to expect a high rate of recovery of the investment costs. Considering the importance of land, it is noteworthy that, while strengthening the regulatory framework is still underway, the Government, backed by IDB support, has made significant land titling and registration progress to date. Recent legislation unifies the two existing registries and simplifies related procedures. None of the initial subprojects have significant land problems and complications for others are being resolved. 5.9 Although some of the WUOs under the first ten subprojects are already recovering some of the O&M costs, there is a history among WUOs of generally establishing water tariffs at low levels which do not reflect the real costs of O&M. Full recovery of even these lower tariffs has generally not been achieved. Major emphasis must be placed upon the full recovery of O&M costs if the subprojects are to be sustainable over the long term. This will be achieved through current and ongoing improvements in the regulatory framework. As the new water law and regulations are put in place in the near future, the water tariff should more closely reflect the true cost of water use and WUOs would have recourse to effectively cut off water supply to water users who do not pay the full water tariff. 5.10 Finally, to ensure that WUOs are paying an acceptable water charge for recovering the cost of O&M, the PCU would be responsible for contracting an independent technical auditor to monitor O&M completed by WUOs. On a three-year basis, this auditor (probably an engineering consulting firm) would review the irrigation infrastructure rehabilitation under the project to determine whether O&M actions have been completed and recommend needed additions or changes. The WUOs would then be responsible for complying with the auditor's recommendations within one year following the issuance of its report. Since works under the rehabilitation component will be implemented within the first three years of the project, it is not likely that any serious operations and maintenance problems will arise prior to the end of the overall project implementation period. However, since the rehabilitated irrigation schemes will have a longer economic life, there will be a need to ensure that WUOs adequately operate and maintain them well beyond the project implementation phase. Two elements of project design should help ensure this: (a) WMOs themselves are financing the rehabilitation - this will give them ample incentive to properly maintain the rehabilitated schemes; and (b) WUOs will be professionally trained under the project, especially in operations and maintenance, as well as finance and administration. Finally, during the course of project supervision, post-project remedies will be considered. For example, following on the technical auditor arrangements described above, in the event that the WUO does not comply with auditor recommendations, the PCU or CFIs could be permitted to comply with the auditor's recommendations by subcontracting a firm(s) to complete the necessary O&M work. The cost of this work would then be incorporated into the amortization schedule for the irrigation investment credit.  - 28 - 6. SUMMARY OF AGREEMENTS REACHED AND RECOMMENDATION 6.1 During loan negotiations, the Bank and the Borrower agreed: (a) that financing will be only provided for the rehabilitation of those irrigation projects in which the users can demonstrate that they are able and willing to repay the costs of the project (para. 2.4); (b) to qualify for subsidies under the incentives matching grant program for adoption of technological innovation, farmers will be required to participate in a competitive selection process acceptable to the Bank organized by the PCU and designed to ensure that all farmer groups can benefit from the proposed Grant scheme (para. 2.14); (c) that farmers benefitting from the incentive program will be required to make access to the improved irrigation systems available to the region's extension specialists for use in demonstrations to other farmers (para. 2.15); (d) that INADE, under arrangements satisfactory to the Bank, cause the dams under the project, after their rehabilitation, to be periodically inspected (para. 2.17); (e) that COFIDE would charge the CFIs an adjustable interest rate at prevailing market rates which will not exceed the average cost of funds of CFIs, as defined in the Credit Opeating Manual, and not be less than the sum of the interest rate and other charges on the Bank loan, plus a commision (0.5 percent) to cover administrative costs. (para. 4.9); (f) that the mechanism for financing rehabilitation would be evaluated by the Bank, the OECF and the Government, as soon as the first US$10 million of the loan funds are committed, but not after June 30, 1998, and adjustments satisfactory to the Bank will be made to perfect such mechanism (para. 4.10); (g) that each WUO under the project will be responsible for complying with the O&M technical auditor's recommendations within one year following the issuance of the audit report (para. 4.15); (h) that PCU accounts would be audited by independent auditors acceptable to the Bank (para. 4.16); (i) that the auditor's report would include a separate opinion regarding the special account, and the reliability of SOEs established to support withdrawals request for loan funds (para. 4.16); (j) that the audit reports would be submitted to the Bank no later than six months after the end of each fiscal year (para. 4.16);  - 29 - (k) the plan account and accounting procedures for the PCU and on the terms of reference for selection of the auditors will be in accordance with Bank requirements (para 4.16); (1) on the monitoring plan, including project performance indicators and targets (para. 4.17); (m) that PCU will prepare and submit to the Bank, not later than December 31 each year, project annual operating plans (para. 4.17); (n) that PCU will establish within the PCU and thereafter maintain during the period of execution of the project, a monitoring system, acceptable to the Bank, and will submit to the Bank within three months of each project semester, semi- annual reports on project implementation progress (para. 4.17); (o) that MAG would furnish to the Bank, based on guidelines acceptable to the Bank, not later than six months after the closing date a plan for the future operation of the project and exchange views with the Bank on said plan (para. 4.18). 6.2 During loan negotiations, COFIDE agreed: (a) that: (i) it would ensure that subloans shall be made in accordance with the Credit Manual approved by the Borrower and the Bank; (ii) within six months after the project's closing date, COFIDE and MAG would prepare a plan, based on guidelines acceptable to the Bank, for the future operation of part A of the project and exchange views with the Bank on said plan (para. 4.3). (b) that it would: (i) have its accounts and financial statements audited in accordance with appropriate auditing principles consistently applied, by independent auditors acceptable to the Bank; (ii) furnish to the Bank no later than six months after the end of each year, the auditor's report in such detail as the Bank shall have reasonably requested; (iii) furnish to the Bank any other information concerning said records, account and financial statements, as the Bank shall from time to time reasonably request (para. 4.16); (c) COFIDE shall constitute, and operate therafter, a reserve fund to grant short- term loans, with an amortization period not to exceed one year, to CFIs in the event of defaults by WUOs on Sub-Subloans, in order to provide liquidity to such CFIs while collection measures are bein taken. Such reserve fund shall be established and be operated under the criteria and procedures set forth in the Irrigation Project Credit Manual. Whenever not required for the above purposes, the proceeds of the reserve fund shall be utilized for the financing of irrigation rehabiliation projects and other agricultural capital investments under similar terms and conditions as those provided under this Agreement for Part A of the Project and as further described in the Irrigation Project Credit Manual.  - 30 - 6.3 Conditions for loan effectiveness would be that: (a) The Government would have allocated adequate funds from its proposed fiscal year budget and made them available to MAG to implement the project activities for 1996 (para. 3.2); (b) the Borrower would have staffed the PCU with staff with experience and qualifications acceptable to the Bank (para. 4.2); (c) MEF and COFIDE would have signed the Subsidiary Agreement for the establishment and management of the Rehabilitation Fund (para. 4.8); (d) the plans of accounts and accounting procedures for the PCU and COFIDE would have been made operational (para. 4.16); and (e) a monitoring system, acceptable to the Bank, would have been made operational at the PCU level (para. 4.17). 6.4 Conditions of disbursements would be that: (a) for the Incentive to the Adoption of Technological Innovations component, the PCU would have adopted the final version of the Incentives Fund Manual, acceptable to the Bank (para. 2.16). RECOMMENDATION 6.5 Subject to the above agreements and conditions, the proposed Project would be suitable for a US dollar single currency Bank loan of US$85.0 million with a term of 17 years, including a 5 year-grace period LIBOR-based.  PERU IRRIGATION SUBSECTOR PROJECT Table 1: Project Components by Year (US$ tlhousand equivalent) Components Year I Year 2 Year 3 Year 4 Year 5 lTotal Costs % FE A. Rehabilitation of irrigation Ilnfrastictiure 18,873.2 35,560.7 4R,020.0 -- 102,453.9 13 B. Institutional Dcvelopmciit Strcngthcning (Training of WUOs) 1,650.9 1,460.8 841.7 997.1 1,002.1 5,952.6 50 C. Incentive Program for Tcchnology Improvenicnt 1. Training of Extensionists 1,652.9 1,325.0 1,325.0 1,325.0 1,291.1 6,919.0 40 2. Participation to Cost of Extensionist and Matcrials 3,600.9 1,599.4 799.7 -- -- 6,000.0 10 3. incentivcs for Technology Improvement 3,300.0 4,100.0 4,900.0 5,700.0 7,200.0 25,200.0 60 Subtotal 8,553.8 7,024.4 7,024.7 7,025.0 8,491.1 38,119.0 39 D. Project Administration and Monitoring 1. Project Coordination Unit 624.1 624.1 611.6 520.3 520.3 2,900.4 2 2,900.4 Subtotal 624.1 624.1 611.6 520.3 520.3 2 E. Complementary Programs 1. Emergency Dam Safety Program 7,000.0 -- -- -- -- 7,000.0 40 Subtotal 7,000.0 -- - - - 7,000.0 43 Total bascline Costs 36,702.0 44,670.0 56,498.0 8,542.4 10,013.5 156,425.9 20 Physical Contingencics 1,610.3 2,065.1 2,697.6 220.4 218.9 6,812.3 18 Price Contingencics 895.1 1,959.1 3,963.6 957.3 1,416.6 9,191.2 20 Total Project Costs 39,207.4 48,694.2 63,159.2 9,720.1 11,449.0 172,429.4 ,T1  - 32 - ANNEX 2 PERU IRRIGATION SUBSECTOR DESCRIPTION OF THE REHABILITATION WORKS 1. The main characteristics of the subprojects that will be implemented during the first two years of the Project are summarized in Table 1. A brief description of the rehabilitation works, as well as the critical aspects related to each subproject, are presented below: 2. San Lorenzo. This subproject is located in the northern part of the Peruvian Coast. The main source of water is the Quiroz river which provides most of the water used in the irrigated area. A 22 km conveyance canal (60 rn/sec), including 8.7 km of tunnels (8.7 km), connects the river with the San Lorenzo reservoir (total capacity of 258 hm3). The current irrigated area is 32,140 ha, which includes some 6400 ha incorporated into the system by 2700 unauthorized users who use uncontrolled water in the upper portion of the Quiroz canal and consume more than 20 percent of the total water used in the project. 3. The main works to be undertaken by the users' organizations are: (a) rehabilitation of the sand trap, including the access road and the control gates in the diversion structure; (b) rehabilitation of the Quiroz canal and the Culqui tunnel; installation of irrigation farm gates on the Quiroz canal to improve the control of water used by the unauthorized users; (c) repairing of the Quebrada Totoral diversion structure, and construction of irrigation intakes to control water used by unauthorized users; (e) repairing of the diversion dike on the Chipillico River, and rehabilitation of its related works; (f) rehabilitation of the Yuscay canal and improvement of the conveyance system; and (g) acquisition of machinery and equipment for system maintenance. 4. After completion of the rehabilitation works, the water availability in the irrigation system will increase by about 197 hm3 which will help to improve the cropping pattern and increase the irrigated area by 595 ha. 5. Chancay-Lambayeque. This sub-project is also located in the northern part of the Peruvian Coast; the main sources of water are the Conchano, Chotano and Chancay Rivers. Surface-regulated water is guaranteed for only 46 percent of the total project area (86,664 ha). Under these circumstances the users need to use groundwater to at least partially complement, the water deficits. Therefore, the main objective of the rehabilitation works, is to increase the amount of surface water available for irrigation. 6. The main works under this subproject, are a complex network of canals and tunnels which convey water from the Conchano and Chotano Rivers to the Chancay River, and then to the Tinajones reservoir (320 hm3). A conveyance system distributes the water to irrigate an average of 40,200 ha. Additionally, 885 unauthorized users in the upper part of the system irrigate an area of 4,747 ha without a proper license or permit. In the lower irrigated valley there is a need to improve the drainage system which is the main factor contributing to water logging and soil salinity. Since most of these problems are due to the  - 33 - large area planted with rice, the project also envisages changing the cropping pattern in order to reduce water consumption and water losses. 7. The more important actions to be executed by the users' organizations are: (a) rehabilitating the Chotano y Conchano tunnels; (b) repairing of the diversion gates in Raca- Rumi; (c) rehabilitating the connection canals; (d) repairing the main related works of the Tinajones reservoir; (e) rehabilitating of the Taymi canal; and (f) rehabilitating the drainage system. 8. The investment in rehabilitation works under the Project, is fully justified in order to reduce the risk of total failure of the system. Although the investment per hectare under the Project is low, the financial analysis shows that small farmers may have difficulties in repaying 100 percent of the rehabilitation costs. However, cross subsidies managed by the users' organization, as well as favorable credit rates and terms, should mitigate this. 9. Huaral-La Esperanza. This is a small highly productive subproject with 3,475 ha on which farmers grow fruits and vegetables at high productivity levels. The main objective of the works envisaged by the Project will be the improvement of the conveyance system to reduce water losses and obtain more water to satisfy full water demand for crops, thereby increasing the production yields. No significant implementation or cost recovery problems are expected in this subproject. 10. The works to be carried out for the rehabilitation of the project will be: (a) lining 17,048 m of existing conveyance earth canals; repairing 55,055m of lined canals; (c) constructing a 27,500 m3 pond; (d) constructing 859 small structures in the canal network; (e) rehabilitating two wells and building a new one; and (f) repairing the main roads. 11. Santa Rita de Siguas. This is also a small subproject, located in Arequipa, in the southern region of the country. It covers an area of 1,447 ha, irrigated with water from the Siguas River. The irrigation system is very simple, consisting of a direct diversion work, a main canal of 33.7 kin, and a secondary canal network of 36.7 km. 12. The rehabilitation works will consist mainly of the construction of a new diversion structure to obtain more water from the river; to clean and reduce cracks in the main canal; and lining the secondary canal network. By means of these works, more water will be available and a new area of 700 ha will be irrigated; additionally, the water distribution system will be improved with communication and water measurement equipment; the application efficiency is also expected to be improved. Considering the users' qualifications and the average size of the irrigated plots, greater than 15 ha, no financial or technical problems are expected during project implementation. 13. Yuramayo. This subproject is also located in the region of Arequipa, in the southern part of the Peruvian coast. The rehabilitation works are intended to double the irrigated area which currently amounts to some 1,020 ha. The irrigation system is simple and consists of a direct diversion of water from the Yura River; a main canal of 29.9 km; and a secondary distribution network of 47.72 km. The irrigated area is divided into four different sections, located on sloped hills. Under these conditions, irrigation is a very difficult task that has forced the users to build an impressive system of terraces to facilitate water application.  - 34 - 14. The rehabilitation works will aim to improve the conveyance system by repairing the water intake structure, protecting the first 4 km of the main canal, reducing cracks and constructing 185 structures, including 175 on-farm control gates to improve water delivery to users. 15. A conflict exists with the Vitor irrigation scheme, located downstream from the Yuramayo project, since both systems share the same water source. It will therefore be necessary to clarify the water rights available to each area before deciding on the increase of new irrigated area. 16. La Joya Antigua. This sub-project forms a part of the Chili River system which is regulated by several dams in the upper basin, including the Fraile and Aguada Blanca reservoirs. Since the 4,000 ha irrigated area is located in the lower part of the Chili Regulado system, it receives the residual waters originating in the different types of hydraulic developments located in the upper portion of the river, including sewage from Arequipa and runoff from the Cerro Verde and Santa Rosa mines. 17. The irrigation infrastructure consists of a diversion dam on the Chili River, a main canal of 43.3 km with several tunnels, 23 water intakes for irrigation and 3 other intakes for non-agricultural purposes, and a secondary distribution network composed of 75 km of canals. Due to poor maintenance practices, the main canal is unable to transport all the water demanded for irrigation during peak periods. 18. The rehabilitation activities will include the following: (a) repairing the gates and sand trap structure in the diversion dam; (b) repairing the main canal and tunnels to increase their capacity; (c) constructing a new canal to consolidate the operation of 23 existing gates under one control structure; (d) constructing 107 small structures; and (e) repairing the service roads. 19. Since 1991, La Joya's irrigation is managed by two users' organizations (La Joya Antigua and La Joya Nueva). Taking into account that the proposed rehabilitation works will also benefit a sector controlled by the La Joya Nueva subsystem, an agreement between the users of the two Juntas should be reached to share the repayment obligations generated by the construction of such works. 20. Huaura-Santa Rosa. This subproject located to the North of city of Lima uses water from the Huaura River. The total irrigated area is composed of 7 different irrigation systems plus 26 independent small irrigation subsystems. The proposed rehabilitation works affected only three of the main systems: Santa Rosa (5,594 ha), Quipico (3,290 ha), and San Felipe (9,704 ha). Conveyance efficiency will substantially improve after construction of the rehabilitation works; as a consequence, land use intensity will increase in the affected areas. 21. The main works considered for these systems are: (a) rehabilitation of the main canal and the service roads in the Santa Rosa system; (b) construction of a new diversion structure on the Huaura River (including the installation of electrical control gates), a sand trap structure and a large number of small related structures in the Quipico system; and (c) construction of a new diversion structure on the Huaura  - 35 - River, a 2,262 m new lined main canal, and rehabilitation of the total conveyance network in the San Felipe system. 22. The users' organizations that will be responsible for the implementation of the works are the Comisiones de Regantes (Irrigators' Comissions) of Santa Rosa, Quipico and San Felipe. Therefore, each of these comissions would also assume responsibility for the repayment of the investments required for the rehabilitation of each specific system. 23. Chili Regulado. This subproject, located in Arequipa, is a multipurpose water system. It forms part of the Chili River hydraulic development system, which is regulated by several reservoirs in the upper basin. The diversion and conveyance works provide domestic and industrial water for the Arequipa region as well as irrigation water for the Zamacola project. 24. The principal component of the Chili Regulado system is the Zamacola-Arequipa canal which takes water directly from the Charcani II hydroelectric plant. Due to poor maintenance, water losses in this canal represent about 34 percent of total conveyed water. 25. The rehabilitation works to be implemented by the users' organization include repairing and lining the Zamacola canal and tunnels, and the construction of a new water intake on the Chili River. The increased water availability will allow the JU's to increase the project's irrigated area and improve crop yields because of more timely water application. 26. Currently non-agricultural users such as SEDAPAR, which provides drinking water for the city of Arequipa, Rio Seco Industrial Park developments, are not members of the users' organization; therefore, their participation as active members must be resolved before project implementation begins. 27. Santa Lacramarca. This subproject located 450 km north of Lima, uses water from the Santa River to irrigate 16,766 ha. The valley is divided into two subsystems, Santa and Irchim, each managed by a different users' organization. 28. The main components of the existing irrigation systems are: three diversion works on the Santa River; two main conveyance canals, two distribution networks and a drainage system in the lower portion of the irrigated areas. Conveyance efficiency in the canals is very low due to poor maintenance. 29. The rehabilitation works under the Santa subsystem include the construction of a new diversion structure on the Santa River; lining of 22 km of the Chimbote main canal, lining of 25.7 km of secondary canals, construction of 371 small structures in the conveyance network, and the rehabilitation of the service roads. In the case of the Irchim subsystem, the users' organization asked for the construction a new diversion structure (25 m3/sec capacity) and the purchase of machinery and equipment for the subsystem's maintenance. As a result of these investments, more water will be available to improve land use intensity and crop yields; the operation and maintenance of both systems will also be substantially improved.  - 36 - 30. Sama. This irrigation subproject (1,274 ha) is located in the Southern part of the Peruvian Coast. The main source of water is the Sama River, subject to periodic droughts. Moreover, water quality is nearly unacceptable in accordance with Laboratory standards due to high saline content. Despite these adverse constraints, local farmers have managed to develop very efficient irrigation methods and relatively high yields for alfalfa, since livestock is the main production activity in the project area. 31. The irrigation system consists of several rustic diversion structures along the river and a canal network of 127 Km, only 34 percent of which is lined. The proposed works, to be undertaken by the users' organization, involve the rehabilitation of the entire irrigation network in order to increase land use intensity in the project area. 32. A large number of small farmers are members of the users' organization; the cash flow analysis prepared for these small farmers shows that they will not be able to repay 100 percent of their share of the rehabilitation costs. Therefore, some kind of cross subsidy managed by the organization's board will be established by the JUs, in order to guarantee full recovery of the investments required by the construction of the rehabilitation works. 33. A summary of six additional subprojects is presented in the table below. The feasibility studies for these subprojects have been also prepared by a MAG technical group and cover an area of 39,040 ha. The estimated cost of the proposed rehabilitation works amounts to US$27.1 million. Table: New Subprojects Investment Cost No. Subproject Area US$ US$/ha I Vitor (*) 1,556 1,635,153 1050.9 2 Chicama (*) 5,684 2,983,920 525.0 3 Locumba 2,800 2,500,000 892.9 4 Pativilca 8,000 5,000,000 625.0 5 Camana 7,000 8,000,000 1142.9 6 Pisco 14,000 7,000,000 500.0 TOTAL 39,040 27,119,073 694.7 (*) Study already completed.  - 37 - ANNEX 3 PERU IRRIGATION SUBSECTOR PROJECT INSTITUTIONAL STRENGTHENING OF WATER USERS' ORGANIZATIONS A. Introduction 1. An important element of the Irrigation Subsector Project is the strengthening of users' organizations, all of which are responsible for operating, maintaining and administering irrigation systems in Peru and some of which will soon be required to hire contractors to rehabilitate the irrigation systems for which they are responsible. 2. The project will finance a technical assistance program aimed at training the users' organization leaders; the technical managers; the irrigation system's operating staff and administrative/accounting officers, as well as the users themselves, although the latter will be given information on the new form of administration of the systems in question rather than training as such. There are at least four important areas that would be covered by the training: (i) efficient administration of financial resources; (ii) advanced techniques for the planning, management and distribution of water resources; (iii) the basic concepts for proper maintenance of infrastructure and equipment, including preventive maintenance; and (iv) strategies for achieving sustainable and profitable agriculture while protecting the environment. In the specific case of users' organizations that will rehabilitate the irrigation systems for which they are responsible, more extensive training will be needed in commercial procurement practices and construction management systems. B. Organization of the Training 3. The PCU will invite local qualified consultants (including universities and NGOs) to submit proposals to carry out training activities. International consultants from universities, institutes or consulting firms specializing in this type of training will also be contracted to support local institutions. The PCU will also monitor the activities carried out by these institutions. 4. Local institutions responsible for the training program must demonstrate their experience in several of the following areas: (a) water management, operation and maintenance of irrigation works, administration of financial and human resources, infrastructure construction and rehabilitation, operation of heavy equipment; and (b) modem technology for handling and administering irrigation water and knowledge of and ability to hire experts in these fields who are familiar with electronic data processing methods so that they can advise users' organizations on the use of this type of equipment, which will give them greater efficiency in administering both water and work equipment. The local institutions must also demonstrate that they have adequate physical and human resource capacity to carry out the training. International consultants, for their part, will be required to  - 38 - demonstrate their experience in conducting agricultural training programs, with emphasis on irrigation water management, irrigation techniques and methods for training institutions or agencies responsible for managing and administering water irrigation and drainage infrastructure. 5. The training program will take into account the need for leaders and technical/administrative staff of the users' organizations to give priority to the maintenance of irrigation and drainage infrastructure, machinery and equipment, vehicles and electronic and communications equipment for which they are responsible, since one of the main reasons for the need to rehabilitate the works and purchase machinery and equipment has been the absence of such maintenance, and of preventive maintenance in particular. 6. The training will also address issues of environmental protection issues. The following topics would be included in the environmental training: soil degradation through marshlands formation, salinization caused by poor management of irrigation water, improper maintenance of the works and indiscriminate use of agrochemicals, including fertilizers and pesticides. 8. Finally, computer technology training will be included for technical and administrative personnel. This will enable enhanced management and control of human resources (user lists, payroll, etc.), financial resources (accounting, stock accounting, salaries, etc.), water resources (use planning, irrigation scheduling, water distribution, hydrometric statistics, etc.) and physical resources (inventories of infrastructure and materials, monitoring of maintenance, scheduling of activities, etc.). 9. There will be four major groups of trainees in the users' organizations, as follows: (i) technical managers and their assistants; (ii) organization leaders; (iii) administrative staff; and (iv) Users in general. Technical managers and their assistants. Since these will be the technical staff responsible for the operation and maintenance of the irrigation works, they would be expected to already have general knowledge in areas relating to water use/management and works upkeep/maintenance, and also of administrative matters. Their training would include: (a) general framework, including institutional organization, water legislation, irrigation rights, and organization of users; (b) water planning and management, including estimating water supply availability for planning purposes, and water demand (irrigation requirements by crop; effects of water shortage on crop yields, calculation of unit irrigation requirement rates); water distribution programs; methods for distributing water according to scheduled demand, methods of delivery by turns; estimating conveyance loss and its components, i.e., evaporation, infiltration, leakage and management-related; estimating loss factors for irrigation scheduling, using water control points; (c) general knowledge of irrigation scheduling and methods, farmland drainage, problems caused by marshlands formation and soil salinization and how to combat them; fertilizer application and use, pesticide use problems; preparation of programs for the proper use of agrochemicals in agriculture; problems of pollution caused by agrochemicals; (d) upkeep and maintenance of the irrigation works, including preparation of the inventory of works, schedules for upkeep and maintenance; estimating work volume; upkeep cycles; methods of upkeep and appropriate equipment; unit performance of equipment under different operating circumstances, methods of scheduling works, unit costs and integration of program costs; program monitoring; and methods for maintaining special hydraulic equipment such as valves, gates and electromechanical equipment in general, maintenance of storage and  - 39 - diversion dams; maintenance of heavy equipment, vehicles, electronic equipment, computers, etc.); administrative aspects including the preparation of budgets for the ope,.ition and maintenance of works. C. Organization Leaders 10. The training of leaders would be in the form of seminars which clearly present, the general principles of the same topics as those taught to the technical managers and their assistants, without going too deeply into technical details. Emphasis will be placed on the following areas of particular importance for the sound administration of irrigation systems: (a) legal framework; (b) institutional organization; (c) irrigation rights and water legislation; (d) methods of water distribution and the importance of water measuring for equitable water distribution; (e) environmental impact of the works and their operation and maintenance. Special attention must be drawn to the effect of the use of polluted water for crop irrigation, to pollution caused by agrochemicals, particularly those that have been banned in other regions and countries, and their effect on plants, wildlife and human health; and other aspects of environmental abuse such as water erosion caused by improper water management, marshlands formation and soil salinization, with their effects on resource productivity; (f) principles of operation and maintenance of equipment and works; (g) financial aspects, including estimating irrigation tariffs and their components; analysis of the organizations' financial and capital status; and interpretation of income statements, budgets and balance sheets; (h) general information on equipment needs and management methods that will lead to greater operating and administrative efficiency, including the need to purchase computers, communications equipment and explanation of the features and advantages of support software; and (j) general aspects of organization for efficient management and its relationship to the operation, maintenance and administration of the works. In the specific case of users' organizations that will rehabilitate the systems for which they are responsible, more extensive training will be needed in all organizational, managerial and financial aspects. D. Administrative Staff 11. Administrative staff would be trained primarily in cost accounting methods, including allocation of costs among different categories of services; financial planning and cost revenue forecasting; personnel management and administration; estimating and collecting water charges; budgetary techniques; legal administrative aspects; and inventories of physical resources. Training will focus on estimating tariffs which directly relate the cost of water to the amount of water used. As such it will cover treatment of capital, public and private investment, variable costs (operation, maintenance and administrative costs); and distribution of costs between direct and indirect beneficiaries. E. Cost of the Component 12. The total cost of the institutional strengthening of the user's organizations component is approximately US$6.0 million.  - 40 - ANNEX 4 PERU IRRIGATION SUBSECTOR PROJECT INCENTIVES PROGRAM FOR IRRIGATION TECHNOLOGY IMPROVEMENT A. Introduction 1. The incentive program would consist of two components: (a) assistance with access to technology and (b) Govemment subsidies based on investments made by farmers to modemize their irrigation systems. B. Assistance with access to technology 2. To gain access to technology, users' organizations need to hire technical specialists who are familiar with technology and who are capable of transferring it to users interested in adopting it. However, a sufficient market for these technical specialists does not yet exist. Additionally, while the IDB is supporting the Govemment in creating a market-oriented extension system, these efforts focus on individual producers for productive activities, not for irrigation and not for groups such as the WUOs . As such, this sub- component will finance a training program for private extensionist (US$7.2 million) and will provide financial assistance to users' organizations by paying on a declining basis, part of the salaries of the extensionists hired by the organizations (US$7 million). This financial assistance would be phased out over three years, after which farmers would pay technical specialist salaries in full. More specifically, it is estimated that 60 percent of the specialists' salaries would be financed under the sub-component during the first year, 40 percent during the second year and only 20 percent during the third year, after which the users will pay 100 percent of this cost. 3. The number of specialists per irrigation commission will vary based upon the number of users in each commission. The total requirement is estimated at around 480, based upon the current number of users throughout the coast of Peru. This would result in the annual distribution by department shown in Table I below. 4. Selection would be made in accordance with earlier referenced criteria for providers of technical assistance under the water user training sub-component. In order to ensure that the trained professionals hired by the users' organizations will remain, they will be required to sign a commitment to work with the hiring organization for a minimum of five years, or repay the salaries they have received during their training.  - 41 - Table 1. Number of Extension Specialists by Department DEPARTMENT USERS TECHNICAL COSTS (US$) SPECIALISTS No. No. 1 2 3 TOTAL TUMBES 3619 9 45360 31240 15120 90720 PIURA 52165 96 483840 322560 151280 967680 LAMBAYEQUE 51349 72 362880 241920 120960 715760 LA LEBERTAD 33880 69 347760 231840 115920 695520 ANCASH 11396 20 100800 67200 33600 301600 LIMA 40624 76 383040 255360 127680 766080 ICA 29354 71 357840 238560 119280 715680 AREQUIPA 22675 42 211680 141120 70560 423360 MOQUEGUA 3292 8 40320 26880 13440 80640 TACNA 6554 13 65520 43680 21840 131040 TOTAL 254908 476 2399040 | 1599360 | 799680 4798080 5. The project will finance the cost of training private extensionists who will be hired by the users' organizations to provide technical assistance to farmers in the areas of on- farm water management, agricultural production, marketing and environmental protection. The training program was designed by a group of international experts and will place emphasis on the adoption of new irrigation technologies under the particular conditions of the Peruvian coast (including the evaluation of all technical and socio-economic factors that influence the selection of the most appropriate irrigation methods). C. Investments Subsidies to Improve Irrigation Technology 6. Equally as important as training is the inclusion of incentives to promote technological innovation in irrigation (US$16 million), with a view to achieving greater efficiency in the use of water and soil resources, thereby enabling farmers to increase their competitiveness on both the domestic and foreign markets and also to improve their income. Project subsidies would complement beneficiaries' investment in on-far irrigation equipment and works, amounting to about US$11 million. To ensure that all farmers are provided equal access to these subsidies, the funds made available will be allocated proportionately to the irrigated areas in the main valleys of the coast. Since the program's aim is to promote modernized irrigation, only projects on land with water already supplied to the farm site will receive subsidies.  - 42 - 7. Legal support for these incentives comes from Legislative Decree No. 653 of July 30, 1991, i.e., the Law Promoting Investments in the Agricultural Sector, which, in paragraph E of Article 2, refers to guarantees for the development of agricultural activities, as well as Supreme Decree No. 0048-91 of October 30, 1991, which, in Article 106, indicates that the Government, through the Ministry of Agriculture will, promote the improvement and technical modernization of irrigation systems. Furthermore, since the funds for the incentives are part of the loan negotiated by the Peruvian Government with the World Bank, approval of said Credit by the Executive Branch by Supreme Decree is legally valid. 8. The subsidy will be paid on the cost of studies to establish improved irrigation methods and also on the equipment needed to apply irrigation water and agricultural chemicals, including the necessary pumping equipment, in cases where pressurization is needed. In light of the market costs of the most common irrigation systems, such as pressurization, spraying, drip and micro-irrigation, including pressurization and delivery of agricultural chemicals via irrigation systems, a ceiling on investment per hectare has been set at US$5,000, since higher investments will be difficult to recover. There will also be a ceiling on investment per individual project of US$150,000 or US$300,000 for projects undertaken by farmer organizations or associations. The farmers benefitting from this program will be obliged to make improved irrigation systems available to the region's extension specialists of the region for use in demonstrations to other farmers. 9. The Government will allocate funds to two groups of users, who will be identified as "small," in the case of individual farms under 15 ha in area, and "large," in the case of farms over 15 ha in area, a maximum farm size also being set at 30 ha. -- or up to the investment ceiling, in the case of associated farms -- for entitlement to the subsidy. The funds available for the program will be divided equally between these two groups. In the case of the "small" farmer group, the Government may subsidize up to a maximum of 80 percent of project cost, while in the case of the "large" farmer group the ceiling will be set at 50 percent of project cost. 10. To qualify for these subsidies, farmers will be required to take part in public competitions organized by the Ministry of Agriculture. Invitations to participate will be published in a daily national newspaper or in "El Peruano," the Official Gazette, specifying the conditions for participation and the procedures to be used in selecting the winning projects. 11. The projects entering the competition will be analyzed from a technical, financial and legal standpoint by the PCU's Central Coordination Unit of the PCU under the Ministry of Agriculture. The subsidy will be paid once the works have been fully constructed and delivered to the satisfaction of PCU.  - 43 - ANNEX 5 PERU IRRIGATION SUBSECTOR FINANCING OF IRRIGATION REHABILITATION WORKS OPERATING MANUAL A. New Investment Funding and Recovery Arrangements 1. To implement the rehabilitation component, the Government intends to change the system traditionally employed to finance irrigation infrastructure, which until very recently was tied to the central government's budget. The existing system envisages the recovery of public investments through a system of water charges and tariffs (Executive Order 17,752, section 18, and Decree 003/90, section 14). To address problems associated with delayed repayment, several mechanisms will be utilized. First, CFIs may require WUOs to establish a reserve Fund within the CFI, equivalent to about one year's repayment. In the event of WUO default, the CFI can access this reserve. Once the reserve is depleted, if the WUO remains in default, the CFI will have full power to initiate judicial action against the delinquent party, including execution of guarantees. Finally, a second reserve Fund will be established within COFIDE and funded by the interest differential between COFIDE's cost of borrowing and on-lending under the project. CFIs can access this reserve once the WUO reserve is depleted and evidence is produced that the CFI has initiated actions to execute WUO guarantees. Operational details for these reserve funds and the WUO guarantees are described in the Credit Operating Manual. 2. Central to the new approach is active private-sector involvement in project identification through the WUOs, as well as recovery of investment costs through the use of a targeted credit line. To encourage private institutions to participate in the agricultural sector, the Government has eliminated investment ceilings and overregulation, as evidenced, for instance, by Legislative Decrees 653 (Agricultural Sector Development Act), 757 (Legal Framework for the Promotion of Private Investment), and 758 (Regulations for the Promotion of Private Investment in Public Utilities Infrastructure). It has also ended various types of subsidies. 3. The primary advantages to channeling the rehabilitation funds through the financial sector include: (i) capacity to work directly with Project beneficiaries; (ii) efficiency and flexibility in distribution of funds for rehabilitation investments (a key element given the immediate need to rehabilitate existing irrigation schemes); and (iii) encouragement of formal private credit relationships channeled to the agricultural sector. 4. To enable irrigation infrastructure users to rehabilitate their systems, the Government will assist them with financing generated from the proceeds of external borrowing and government funds. WUOs will now be fully responsible for operation and management of their systems, thus enhancing the potential for more efficient use and operation of the irrigation infrastructure. As such, WUOs will have a greater incentive to also undertake and recover their own investment in rehabilitation. Principles, conditions, rights and obligations of the parties have been clearly spelled out in the system of contracts adopted to transfer infrastructure to WUOs.  - 44 - B. Proposed financing arrangements 5. To finance the costs of irrigation rehabilitation works, the Government will use the banking and finance system, with funds to be administered by the second-tier bank, COFIDE. Under the Peruvian banking legislation, a second-tier bank is a financial institution whose mandate is to support investments in various productive sectors, with financing to be provided exclusively through financial intermediaries. After a set of formal requirements has been satisfied, the latter institutions receive the funds and bear the full risk of the lending operation, and therefore require borrowers to satisfy their particular lending requirements. 6. The Government will make long term financing available for the remaining 100 percent of the investment costs by channelling funds through COFIDE to first-tier lenders (e.g., commercial banks), which will on-lend to WIUOs. The latter will then acquire the goods and services needed for the project through private contractors, following standard commercial procedures consistent with Bank procurement guidelines. Specialized firms will be hired to prepare detailed engineering designs and supervise the implementation of the rehabilitation works. In shifting financial and contractual service delivery to the private sector, the PCU in MAG will be intentionally kept as small as possible, playing more of a supervisory and regulatory role. C. Governance 7. The line of credit established within COFIDE for financing the rehabilitation works, heretofore referred to as the Fund, will be governed by the following provisions: (i) Article 76 of the Peruvian Constitution: "Contracts for every service and project of the import and value specified in the Budget Act shall be let through an open call for tenders; (ii) the terms of loan agreements entered into by and between the Government of Peru and (a) the World Bank and (b) the Government of Japan; (iii) the Operating Regulations for the project; (iv) the Budget Act of Peru; (v) The National Oversight System Act (Executive Order 26,162, section 4); (vi) Executive Order 25,907/92 authorizing departments and agencies of the public sector to deposit their funds in any Peruvian bank or finance corporation; and (vii) for all matters not covered by the aforesaid laws and provisions, the pertinent provisions of Legislative Decree 770, Chapter IV, Subchapter IX; the Banking Institutions and Finance Corporations Act, and the Civil Code, Book XII, Chapter IV. In addition, participating first-tier lenders, in verifying the legal status of WUOs which apply for loans, will determine that they are legally established and represented and ascertain their membership and geographic sphere of operation, in accordance with the following legislation: (i) Executive Order 653/91, section 59, which requires that water users in each irrigation district be organized into Irrigators' Committees for each irrigation sector or subsector, and into Users' Associations for each irrigation district; (ii) Supreme Decree 048/91 (Regulations E.O. 653), section 113, which defines an irrigation district as a continuous geographic territory comprising one or more drainage basins or sub basins or a portion thereof and falling under the jurisdiction of a District Technical Administrator; (iii) Decree 037/89, section 1, which defines a water user as every individual or corporation which is licensed to use water and is registered as a water user; (iv) Decree 037/89, section  - 45 - 22, which requires Users' Associations to have a cross-sectoral membership; (v) Decree 048/91, section 121, which requires every Users' Association to have a technical manager with a degree in agricultural science, expertise in water delivery systems and water and soil management, and at least five years' experience. D. Eligibility of Financial Intermediaries 8. In order to participate in the project, first-tier financial lenders would have to comply with a series of technical, financial, institutional and operational criteria. These criteria are incorporated in the Credit Operating Manual and include: financial and prudential criteria established by COFIDE and the Superintendency of Banks and Insurance (e.g., regarding profitability, liquidity, risk, solvency, reserves, etc.); experience in financing irrigation investments, experience in financing investments in the agriculture sector (both long-term and working capital or other short term investments) and proximity to, and nature of relationships with potential clients. E. Eligibility of Beneficiary WUOs 9. W'UOs participating in the project will have to comply with at least the following criteria: (i) completion of feasibility study satisfactory to the PCU; (ii) establishment as a legally constituted user association; (iii) existence of a census of association members; (iv) approval by the members to request the financing under the project; (v) expressed consent by members to provide real guarantees in the form of water rights, land, and or other guarantees as required by participating financial intermediaries for financing the subprojects; and (vi) demonstration of approved operating regulations and effective administrative capacity. Additionally, prior to receiving a loan from a participating first-tier lender, each WUO will have to demonstrate, to the satisfaction of the lender, the following: (i) suitable legal, administrative, and financial capacity; (ii) sufficient financial quality of subproject feasibility study, including demonstration of a rate of return no less than 12%; and (iii) sufficient real guarantees to obtain the loan. F. Terms and Conditions of Funds to Government and COFIDE 10. The Government will borrow from the World Bank and the cofinancier, on separately negotiated terms, funds to cover the rehabilitation investment costs under the project. The Government will provide 100 percent to WUOs as long term financing flowing from the Government through COFIDE, which will establish a separate account for administering the funds. The costs of the funds to COFIDE will be determined by the Government's cost of borrowing under the project. The amortization will be consistent with those established for loans to WJUOs under the project.  - 46 - F. Terms and Conditions of Loans to Financial Intermediaries 11. Funds lent by COFIDE to first-tier lenders will be provided for the purpose of rehabilitating existing irrigation schemes, as identified under the project. Loans to the first- tier institutions will be denominated in American dollars at an interest rate no more than the average const of funds of CFIs, as defined in the Credit Operating Manual, and no less than the cost of funds to the Borrower under the project, plus a commission (0.5 percent) to cover administrative costs. A penalty for delayed repayment will be assessed, following Central Bank procedures and regulations. The terms of the loans will be established in accordance with the requirements of the subprojects, but not exceed a maximum of fifteen years, including a maximum of four years grace. G. Terms and Conditions of Loans to WUOs 12. Loans from first-tier lenders to WUOs will be provided for the purpose of rehabilitating existing irrigation schemes, as identified under the project. Loans will be denominated in American dollars at market-determined commercial lending rates (the current relatively high inflation imputed in local currency interest rates does not favor long-term finance). These rates will be either variable or fixed, depending on the requirements of participating WUOs and lenders. The terms of the loans will be established in accordance with the requirements of participating WUOs and their subprojects, but not exceed a maximum of fifteen years, including a maximum of four years grace. H. Disbursement 13. In accordance with the disbursement procedures described in paragraph 4.23 of this Staff Appraisal Report, for 95 percent of the rehabilitation investment costs, COFIDE will on-lend to first-tier financial institutions. COFIDE will only on-lend out of proceeds generated by external borrowing (e.g., from the World Bank and OECF) under the project, as disbursed from the overall project's Special Account and deposited in a separate account within and maintained by COFIDE. Disbursements to first-tier lenders will be made by directly crediting the lender's account in the Central Bank, or other bank deemed acceptable by COFIDE, against a promissory note issued by the first-tier lender to COFIDE, identifying it as the on-lending source of the funds under the project. Finally, first-tier lenders will disburse to WTUOs an advance, equivalent to 30% of the total cost of each works contract (e.g., for mobilization, initial working capital, etc.), at such time that a loan contract is signed between the two parties. The advance would be rolled over as on-going disbursements are made in accordance with statements of expenditure submitted by WUOs during implementation of works. I. Loan Recovery 14. Participating first-tier lenders will be required to repay COFIDE 100 percent of the funds they receive, which COFIDE will in turn transfer to the Government. Amortization schedules will be consistent with those established for the individual subprojects. Repayments will be made by directly debiting the first-tier lender accounts in  - 47 - the Central Bank, or other bank deemed appropriate by COFIDE. At any time, the first-tier lender can provide early repayments. All loan recovery, including principal and interest, will be repaid to the Government in accordance with the referenced amortization schedules. Finally, the beneficiary WUOs will be required to repay to their lenders under the project 100 percent of the funds they receive. Amortization schedules will be established in accordance with the requirements of the WUOs and their subprojects. In the case of delayed repayment, the lender will have full power to initiate judicial action against the delinquent parties, including execution of guarantees. J. Risks 15. The Government will assume the risks associated with transferring funds through COFIDE to CFIs. The WUOs will be responsible for the dollar-nuevo sol risk (the first-tier lenders under the project will likely pass on the dollar-sol risk to WUOs since the latter will be taking loans in American dollars). First-tier lenders will assume full credit risk for the loans they provide to participating WJUOs. K. Security Arrangements 16. Real guarantees will be provided by WUOs to obtain loans for financing the rehabilitation investment costs under the project. These guarantees will include, at a minimum, land and water use. Other guarantees may be used as well, in accordance with the requirements and flexibility of participating first-tier lenders. L. Lnstitutional Responsibilities 17. The Government will make the funds under the project available through its public expenditure budget. For the rehabilitation funding, a credit line will be established within COFIDE through an agreement between the Ministry of Economy, as the Government of Peru's financial agent, and COFIDE. The PCU within MAG will be responsible for supervision of the overall project, while COFIDE will directly supervise participating first- tier lenders. 18. COFIDE will be required to comply with its responsibilities as defined in the referenced agreement for establishing the credit line. These will include provision of financing to first-tier lenders for WUO subprojects, supervision of these lenders, and submission of quarterly progress reports to the PCU in MAG. 19. In coordination with the PCU, MEF will monitor the performance of COFIDE in managing the rehabilitation credit line. The first-tier lenders will be required to comply with their responsibilities as defined in contracts signed with COFIDE. They will also be responsible for providing assistance to WUOs in preparing loan requests and documentation, evaluating the viability of WUOs and their subprojects for their financing, supervising the use of funds by WUOs to whom loans are provided under the project, seeking loan recovery, maintaining an adequate financial information system for their own obligations and WUO subloans, and providing the Bank or COFIDE or the PCU with any related information which may be reasonably requested.  - 48 - M. Effectiveness of Operating Manual 20. The definitions, procedures and requirements described in this Manual wilU become effective at such time that the credit line is established within COFIDE for the purpose of financing rehabilitation of existing irrigation schemes, as defined under the project. COFIDE may modify the Manual, with approval from the PCU, and as satisfactory to the Bank, with the objective of adapting to changing circumstances during project implementation and ensuring the success of the overall project. Any changes made will be immediately communicated to participating first-tier lenders.  - 49 - ANNEX 6 PERU IRRIGATION SUBSECTOR PROJECT EMERGENCY OF DAM REHABILITATION AND DAM SAFETY PROGRAM 1. The western region of the Peruvian Andes is characterized by limited and irregularly distributed precipitation. As a consequence, storage dams become an essential element in increasing and ensuring timely distribution of water supply to cities and irrigation schemes on the coast. These reservoirs are usually located in the Sierra (above 2,000 m msl) where precipitation is abundant. The stored water is then conveyed to the consumption centers and distributed by gravity to users in the lower coastal valleys. Many of the irrigation schemes being considered for rehabilitation works as part of the Irrigation Subsector Project (San Lorenzo, Santa Rita Siguas, La Joya Antigua and Chili Regulado, among others) depend on these reservoirs for their water supply. 2. Due to the essential role of storage reservoirs as an integral component of existing irrigation developments, a well-respected international expert carried out a dam safety evaluation study of eight major dams in Peru (see attached Table I for details). The assessment of these dams' current operating conditions identified the following problems: (i) inexistence of a government agency responsible for the operation, maintenance and safety of dams; (ii) lack of maintenance and operational guidelines; (iii) lack of qualified personnel for operation and maintenance; (iv) problems with data collection systems (some of the monitoring equipment does not work and data are not analyzed); (v) problems with gates, valves, spillways and other outlet works; (vi) deficient power generators; and (vii) structural problems (El Fraile reservoir). Most of the problems with the hydromechanical equipment and outlet works are the result of poor maintenance. 3. The appraisal mission confirmed that, among the eight reservoirs inspected, four require immediate rehabilitation works. The cost estimate for these works has been prepared on the basis of the above-referenced dam safety study and additional cost information regarding the necessary rehabilitation works of the Quebrada El Cazador (El Fraile reservoir) obtained from the Ministry of Agriculture's Regional Office in Arequipa. Due to the multiplicity of users affected by the reservoirs, and the deferred maintenance of the works, the Government has agreed to take responsibility for the cost of rehabilitation. It will also be responsible for administering related operation and maintenance, either directly or by contracting out. Ultimately, however, operation and maintenance costs would be covered on a pro-rated basis among the various users of the reservoirs. 4. The proposed emergency works are briefly described below and a more detailed budget is presented in Table II in Table 1 of this Annex. Poechos Dam: (a) Testing and necessary maintenance of control equipment for the operation of gates, valves and other outlet structures; (b) replacement of the gasket seals in gates; (c) maintenance of low-level drains and outlet works; and (d) maintenance and/or replacement of electric generators.  - 50 - San Lorenzo Dam: (a) Testing and necessary maintenance of control equipment for the operation of gates, valves and other outlet structures; (b) maintenance of low-level drains and outlet works; and (c) maintenance and/or replacement of electric generators. Tinajones Dam: (a) Testing and necessary maintenance of control equipment for the operation of gates, valves and other outlet structures; (b) replacement of seals of radial gates; and (c) maintenance and/or replacement of electric generators. El Fraile Dam: (a) Implementation of a data collection system; (b) study to investigate stability of the concrete structure and abutments; (c) testing and necessary maintenance of control equipment for the operation of gates, valves and other outlet structures; (d) maintenance of low-level drains and outlet works; (e) maintenance and/or replacement of electric generators; (f) communication equipment; and (g) complete maintenance works with the objective of improving the stability of the Quebrada El Cazador by reducing seepage, improving drainage and controlling erosion. 5. The project will retroactively finance all costs associated with studies, construction and maintenance and procurement of equipment for emergency dam safety to be executed by INADE and the Ministry of Agriculture between the date of the appraisal mission and the date of loan effectiveness for the Project. Retroactive financing, amounting to about US$2.5 million, will be limited to the works described and will be conditioned to the application of the World Bank's procurement guidelines for the procurement of goods and for the contract of consultants and services. It would be also contingent upon the establishment of a unit responsible for the management of the dam safety program and for the follow-up activities of operation and maintenance (O&M) of the reservoirs, in INADE.  Emergency Dam Safety Program Budget Estimate US$ (1,000) DAM STUDIES GENERATORS COMMUNICATION SPILLWAY GATES & VALVES & OTHER TOTAL l_______ EQUIPMENT CONTROL CONTROL Poechos 150 250 300 250 300 1,250 San 80 250 100 300 730 Lorenzo en Tinajones 100 250 150 300 800 El Fraile 420 250 50 150 300 3,050' 4,220 | TOTAL 750 1,000 50 300 650 1,200 3,050 7,000 1/ Rehabilitation works at Quebrada El Cazador.  - 52 - ANNEX 7 PERU IRRIGATION SUBSECTOR PROJECT ENVIRONMENTAL ASPECTS A. Environmental Sector 1. The absence of a central environmental planning authority in Peru has contributed to an institutional vacuum, resulting in the fragmentation of environmental responsibility among ministries, with the creation of small ministerial environmental units which often suffer from lack of personnel and financial resources. The existence of these ministerial-based environmental units, while potentially valuable as a counterpart to a central environmental agency, have contributed to ineffective environmental management through institutional overlap, poor coordination, and duplication of efforts. 2. The institutional failure is also largely due to differing interpretations of the term autoridad competente (responsible authority) as provided for in the environmental code (Codigo del Medio Ambiente), enacted in 1990. In agriculture and renewable natural resources, the Instituto Nacional de Recursos Naturales (INRENA) has interpreted the environmental code to mean, among other tasks, the evaluation of environmental and natural renewable resources, monitoring and control of activities in which environmental risk is evident, establishment of effluent standards for agricultural activities, and the creation of a program to monitor pollution associated with agricultural activities. 3. Despite the constraints noted above there is evidence that the situation may be changing for the better. First, in at least one ministry (Ministry of Mines), the environmental unit is being strengthened (with support from the World Bank's EMTEL project). This has resulted in substantial progress, including the development of a registry of mines, publishing of emission standards, and the establishment of a rudimentary monitoring program dependent on self-monitoring with supervisory oversight contracted out to the private sector. More recently the Government has created the Consejo Nacional del Medio Ambiente (CONAMA) as an autonomous agency under the Presidency; among other responsibilities the council would be responsible for the development of national environmental standards, resolution of inter-ministerial disputes, coordination of national, regional, and local government actions with respect to the environment, and the establishment of criteria for zoning, environmental quality and impact assessments. 4. Presently, there are other indicators of progress in meeting the country's environmental challenges which have direct relevance to proposed World Bank projects. In 1989 a Comisi6n Nacional comprised of the Instituto Nacional de Planificaci6n (ONERN) and other public and private institutions was created to develop a National Conservation Strategy (NCS) for the purpose of defining basic policies to guide development planning in promoting the sustainable development and use of natural resources. One of the priorities identified in the NCS recommended the development of an integrated watershed management program. The program's objectives include planning and promoting the sustainable development of watersheds which would include river basin planning, erosion control,  - 53 - rehabilitation of small- and medium-scale irrigation systems, reforestation, and training and education in watershed management. A number of other programs could be supported through a watershed approach including an environmental sanitation program (water quality monitoring, pesticide management and control, and dumping of untreated wastes). 5. In addition, the proposed new Water Law presents the opportunity for the establishment of instream flows for ecological purposes which, in effect, are "environmental water rights" to be established during the initial allocation process. Other important aspects that may be addressed in the new law are the prohibition of alterations to water quality which would be harmful to human health, plants and wildlife and provisions for river bank protection as well as other measures as required to protect the watersheds. 6. Moreover, interest in supporting Peru's environmental management capacity continues to grow. In the near future, the Interamerican Development Bank (IDB) will be providing support through trust funds to strengthen both INRENA and CONAMA. Regarding the former, support is being provided to INRENA to build capability in environmental impact assessments (EIA) and environmental audits and in the establishment of Maximum Permissible Emission Limits for contaminants in agricultural and agro-industrial activities. In addition, the IDB will support the development of a renewable natural resource monitoring system for the establishment of policies and guidelines. This monitoring system will include the creation of a surface water quality monitoring network in six to eight of the country's critical river basins. B. Environment and Irrigation 7. Irrigation developments in Peru are associated with a series of environmental issues which include: (i) waterlogging and salinization; (ii) water quality; (iii) erosion and siltation; (iv) alterations to ground water hydrology; (v) changes in stream morphology; (vi) minimum instream flows; and (vii) inappropriate use of agro-chemicals, among others. Many of the environmental impacts resulting from irrigation developments in the coastal valleys of Peru cannot be fully addressed without a broad and multidisciplinary approach which would deal with environmental issues at a watershed scale. Such an approach must focus on integrated watershed management. Its successful implementation would further necessitate the support of a national program (framework) designed to address environmental protection nationwide. In this context, the Irrigation Subsector Project would allow for a better assessment and evaluation of the range and magnitude of environmental impacts associated with irrigation developments in Peru, derived from the knowledge that will be gained during the analysis of existing irrigation systems to be included as part of the project. The subprojects included in the rehabilitation program are small pieces of a large puzzle (watershed) which includes a much wider range of water uses, and conflicts, and related environmental impacts. Those aspects related to integrated watershed management and a nationwide environmental protection program will be addressed in the Bank's forthcoming Land and Water Management Project. 8. The Irrigation Subsector Project, which involves only the rehabilitation of small-to-medium-sized infrastructure of existing irrigation schemes, will have a positive environmental impact. This is not to say that some of the irrigation schemes to be rehabilitated under the project have no environmental impacts. However, all the irrigation  - 54 - subprojects considered for rehabilitation works have been in operation for many years facing a variety of previously-mentioned environmental issues. Without the proposed rehabilitation works, the environmental impacts of these irrigation developments will tend to increase since the infrastructure will continue to deteriorate and no other financial resources are available to address environmental aspects related to existing irrigation systems. The project, on the other hand, will bring a range of environmental benefits since it will promote efficient water use by reducing water loses, improve drainage systems which have a direct impact on waterlogging and soil salinity, and address a broad range of environmental issues, including the proper use of pesticides, herbicides and fertilizers, in its training component. 9. Although it is beyond the scope of this project to address the entire spectrum of existing environmental problems, there nevertheless there remains the need to evaluate such problems and to adopt some specific measures to minimize environmental degradation within project areas. Among the major environmental issues related to the irrigation subprojects to be rehabilitated are the following: (a) Waterlogging and Salinization. Waterlogging and salinization is a serious problem in irrigation projects in Peru. It is estimated that 40 percent of the total cultivated land in the coastal valleys is affected, to some extent, by soil salinization. The issues of soil salinization and waterlogging, which are particularly intense in schemes in the northern part of the country, will be partially addressed by improvements in water delivery and distribution systems and drainage systems associated with proposed rehabilitation works. Increased risks of waterlogging and salinization, possibly associated with expansion or irrigated areas stemming from water surpluses generated by improved efficiency, will be minimum. Most of the additional water that will be available for irrigation is the result of reducing current losses throughout the conveyance systems, which is one of the causes of the waterlogging and salinization problems facing these projects. Utilization of improved technologies such as sprinlder and drip irrigation will also reduce the incidence of water logging and salinization. (b) Inappropriate Use of Agro-Chemicals. There is no effective program to monitor or control the importation, production, manufacturing or application of agro-chemicals in the country.' This has resulted in widespread use of products which have been banned in many countries for human health reasons (e.g., DDT, mercury-based fungicides, organochlorides, etc.) and inappropriate applications of pesticides, primarily in terms of over-application and/or use of inappropriate mixtures. While there is no national monitoring program, site-specific studies provide evidence of pesticide accumulation in agricultural products and animals. The results of these studies, together with indirect evidence of existing patterns of pesticide use in areas in proximity to most of the proposed irrigation schemes, provide a sufficient basis to recommend appropriate mitigation measures be included in the project. The project will focus on improving current pesticide use patterns through the In recognition of the problem a legal ban was placed on the importation of 12 organo-chlorides in 1991. In November 1992, the Servicio Nacional de Sanidad Agraria (SENASA) was created and given the responsibility of developing national atandards for the importation and use of pesticides. In July 1993 the Comisi6n Nacional de Plaguicidas waa created to develop new legislation to control pesticides. None of these actions appear to have been effective in promoting changes in patterns of uwe at field level.  - 55 - development of appropriate training modules for inclusion in the project's training component. Emphasis will be placed on the "training of trainers", through short courses, development of appropriate audiovisual materials, environmental guidelines and other tools. (c) Increased Water Consumption - Watershed Hydrology. One of the environmental issues of direct concern to the project is the rehabilitation of water withdrawal structures which raises the possibility of higher water intake. Possible impacts associated with this aspect will be limited by maintaining the existing distribution system's capacity in the primary canals which will not be enlarged under the project. The purpose of rehabilitating these withdrawal structures is not necessarily to promote the withdrawal of larger amounts of water but rather to permit timely and efficient water distribution when it is most needed in the irrigation fields. It is further expected that, following the implementation of the proposed new water law, any expansion of the amount of water used for irrigation will be a function of non-allocated available water resources within each watershed. It is also expected that minimum instream flows for environmental purposes will be established during the initial allocation of water rights. (d) Water Quality. There is no national water quality monitoring program from which an adequate assessment can be made to determine the status of existing surface waters used in the country's irrigation projects. A review of results obtained from the most recent national water quality sampling program indicated the presence of heavy metals in concentrations exceeding human safety standards. The statistical significance of these results is uncertain since they were derived from a short-term monitoring program with limited area- wide coverage. Nonetheless, they are a matter of concern. 10. Many of the subprojects are dependent on water intakes located downstream from other irrigation schemes which drain into a shared river system. Excessive pesticide concentrations were also recorded in the 1982-83 national water quality monitoring program. Furthermore, the dumping of untreated municipal waste and mine tailings at sites upstream from irrigation schemes also represents a significant water quality concern. 11. While it is clear that it is beyond the scope of the project to address the range and magnitude of the water quality problems identified above, there nevertheless remain specific actions which could initiate a process leading to the required improvements in surface water quality. In the short term, these actions include the development of a training module for the proper use of agro-chemicals designed to reduce the use of highly toxic materials in project supported areas. The Government can benefit from the development of such a training module by extending its application to areas not supported by the project. Over the medium term, the Bank will support, through a Japanese PHRD Grant, the development of a water quality monitoring program for high-risk watersheds as part of the preparation of the forthcoming Land and Water Management Project. Data collected from this monitoring program, in addition to data obtained from a similar IDB-financed program, could be used as a partial basis to develop a watershed management strategy, and facilitate the identification of possible interventions designed to mitigate water use conflicts in the follow-on Land and Water Management Project. Finally, in the medium to long term it is  - 56 - expected that provisions included in the proposed new water law that prohibits alterations of water quality which are harmful to human health, wildlife and plants will allow for the development of mechanisms to punish polluters and contribute therefore, to the overall improvement of the quality of surface and ground waters.  - 57 - ANNEX 8 PERU IRRIGATION SUBSECTOR PROJECT FINANCIAL AND ECONOMIC ANALYSIS A. Introduction 1. Financial and economic analysis has been undertaken for the Project's major component, the Rehabilitation of Irrigation and Infrastructure. The analysis focuses only on the first ten subprojects planned under the project, for which detailed engineering and feasibility studies have been prepared and reviewed. The project is actually program- oriented. As such, future irrigation rehabilitation subprojects are expected to be prepared, reviewed for feasibility using the same rigorous criteria as used for the first ten subprojects, and implemented under the project. Additionally, the analysis does not cover the other components of the project since the activities proposed at this stage are not necessarily project-specific and would impact beneficiaries outside the immediate project area. B. Target Population 2. It is estimated that the project would ultimately benefit over 50,000 farming families covering an area over 200,000 ha. This includes an estimated 34,000 farms and 130,000 ha in the area covered by the first ten subprojects (see Table I, attached). The majority of the land under the first 10 subprojects is privately held, resulting in significant variation in land holding size in these areas. More than one-third are less than 3 ha while another third are between 10-20 ha. About 5 percent are more than 20 ha and the rest are between 3-10 ha. Not all land is privately held. Sizeable portions of land distribution are the result of the Agrarian Land Reform, resulting in land titling ambiguities. Even outside land reform settlements, not all farmers have title to the land they farm, often as a result of disputes over inheritance. Nevertheless, the success of initial and ongoing land titling efforts should resolve this issue. C. Financial Analysis 3. Financial analysis has been carried out at the farm level in order to determine the financial viability of the project for farmers who would be project beneficiaries. More specifically, the financial analysis assesses these farmers' capacity to recover the investment in rehabilitation works and to fully pay the operation and maintenance costs related to irrigation rehabilitation.  - 58 - Assumptions for Financial Analysis 4. Financial analysis has been carried out on the basis of sixty-four farm models which represent the present and future agriculture scenarios of the different project areas5'. Approximately one-half of the models represent crop development and livestock activities while the other half show only crop development. Cropping intensity and water use efficiency at the outset of the project reflect current practices. With few exceptions, the specific crop models used as the basis for the aggregated farm models assume a constant present situation in terms of production and inputs. While this is a conservative assumption, it is reasonable in that it allows the analysis to focus on project benefits related to irrigation enhancements and not speculative advances in agriculture development. 5. The prices used in the referenced models were those prevailing in December 1992. Using a cost and price index, prices have been adjusted to reflect 1994 data. 6. For each subproject, farm models represent farmers who benefit primarily from irrigation improvement. In most cases, increased production value results from increasing the irrigated area while maintaining relatively constant cropping (and livestock) patterns. However, in some cases, the potential for enhanced agriculture development in high-value crops (e.g., fruits and vegetables) is currently hindered primarily by poor irrigation. Thus, it is assumed that the development of such potential under the project is directly related to irrigation improvement (as opposed to new agricultural development practices). The models show an evolution over a twenty-year period, the expected useful life of the irrigation; however, full development would be reached in year four of the project. Each model differs based upon current and expected cropping patterns for a given area and its size. 7. In all cases, under the with-project situation of improved irrigation, crop area, cropping intensity and water use efficiency are expected to increase, resulting in increased yields, production values, and incomes (although neither equally nor significantly in all cases). Also in all cases, under the without-project situation of unimproved irrigation, a declining capacity to realize agricultural potential is expected, which would result in falling yields, production values and incomes. More specifically, without-project benefits have been estimated to decrease at the following rates: 1 percent per year over ten years for Santa Rita de Siguas and Huaral-La Esperanza; 2 percent for San Lorenzo and Chancay-Lambayeque, Sama, Santa Lacramarca, and Huara-Santa Rosa; and 3 percent for Yuramayo, La Joya Antigua and Chili Regulado. The justifications for the above are the following: (a) Cases in which lack of rehabilitation would not have significant impact on current production/farmer incomes: Huaral-La Esperanza and Santa Rita de Siguas. In these subprojects, the assumption is a without-project situation declining by no more than 1 percent per annum. Minor rehabilitation works are planned, with minimal risk of failure. 5 Feasibility studies were prepared under FAOITCP/PER/2254 for 10 subprojects expected to be implemented in Years I and 2 under the project. The results of these studies were subsequently adjusted by Bank mission members. The studies and adjustment estimates are located in Project Files.  - 59 - (b) Cases in which lack of rehabilitation would modestly impact current production/farmer incomes (also taking into account the fact that, without the Project, some type of small rehabilitation works would be undertaken from time to time): San Lorenzo, Chancay-Lambayeque, Huaral-Santa Rosa, Santa Lacramarca and Sama. In these subprojects, the assumption is a without- project situation declining by some 2 percent per year. Significant rehabilitation works are planned but the existing irrigation infrastructure would not collapse entirely without them. Even without the project, some of the rehabilitation would be undertaken anyway to "sustain" the existing irrigation system, particularly in the case of larger subprojects such as San Lorenzo and Chancay-Lambayeque. (c) Cases in which the lack of rehabilitation would seriously impact the sustainability of existing infrastructure as well as current production/farmer incomes: Yuramayo, La Joya Antigua and Chili Regulado. Here, the assumption is a without-project situation declining by 3 percent per annum. By way of example, Yuramayo's infrastructure is threatened by the risk of landslides, which would be mitigated by the completion of the rehabilitation works planned under the Project. Similarly, La Joya Antigua and Chili Regulado both have tunnels which may collapse without the rehabilitation works planned under the Project. 8. Since most of the subprojects involve mostly small-and-medium sized farmers, not involved in agro-industry, income tax is not applicable through the year 1999 (Peruvian Tax Law: Legislative Decree 771, Article 116 and Legislative Decree 2/80, Article 4). While there is no guarantee that the existing Law will change after 1999, a conservative assumption is made that as of post-1999 (e.g., Year 6 of the Project), income taxes would be applicable according to rates currently established under the Law for agribusinesses and related enterprises. These rates range from about 6 percent for annual incomes of less than US$4,000 to 30 percent or higher for annual incomes over approximately US$20,000. 9. Regarding debt service, requirements for both long-term credit for off-farm rehabilitation works, as well as short-term credit for on-farm investments are estimated. Long-term credit for civil works is estimated as the share of costs that each farmer in a given farm model would be required to pay. Other credit is broken down between on-farm' investment (about 70 percent, generally targeted toward fruit development) and working capital requirements to cover the costs of fertilizer and pesticides. The parameters assumed for long-term credit are: a total repayment period of 12 years', including a maximum of four years' grace period. Those for on-farm investment are: a maximum of 7 years repayment, including 4 years grace. However, few models incorporate on-farm investment and those that do represent producers who have limited access to quasi-governmental, export oriented financing. Working capital credit is estimated on an annual payback basis, with no grace. Finally, two interest rates have been tested for purposes of calculating debt service: 12 percent and 15 percent.  - 60 - Fmancial Results 10. Based on the above, financial rates of return for after-debt service have been calculated (see Table II, attached). These rates are reflective of the 12 percent interest rate as a conservative estimate, although the long-term debt will ultimately be extended at a rate slightly lower than 12 percent. Present values and switching values have also been calculated for net incremental income, investments and other operating costs. 11. Due to the variability in farm sizes and incomes within the Project (more than one-third fall below 3 ha while another third are between 10-20 ha), the financial returns also vary significantly from one subproject to another. Individual subproject's financial returns range from about 12 percent to over 50 percent; however, in general, farm models with lower returns tended to represent a higher number of actual farms under the project than models with higher returns. As such, the overall financial return for the project is estimated at approximately 36 percent. Similarly, increases in beneficiary incomes are variable (see Table II, attached). At full development, increases in incremental income (after payment of higher O&M costs, taxes and debt service related to the rehabilitation works) range from less than 5 percent to over 50 percent, depending on the subproject area. For the same reasons applicable to the financial returns, the overall increase is substantial but not exceedingly high, an estimated 30 percent. Despite this variability, it is noteworthy that no subproject as a whole suffers from cash flow problems, although some farm models within subprojects do reflect minimal cash flow difficulty. This is evident particularly in the Chancay-Lambayeque and Sama subproject areas. However, due to relatively close proximity to urban areas and access to other economic activities, off-farm income, which is not incorporated in the farm models, will help offset potential cash flow problems. 12. Regarding the seemingly high financial returns, rehabilitation projects in general, and the current one which is no exception, have the characteristic that much of the "returns" benefit not only from the incremental investment but also existing investments that are "sunk" - i.e., have been made in the past and have a very low alternative use (opportunity cost) without the proposed project investment. As such, financial returns will almost always appear to be high because the benefits are often high compared to relatively small incremental investment costs. Given this "mathematical quirk", it therefore becomes critical, to focus on reasonable estimates of the "without-project case" as well as the sustainability of the enterprises or beneficiary associations involved. For this reason, discussion herein (above) has been devoted to the issues of what the water user associations would do without the current Project and how the incomes and cash flows of beneficiaries are affected over time with the Project. D. Water Charges and Cost Recovery Water Tariffs 13. The existing legislation (Supreme Decree 003-90-AG, 1990) prescribes two classes of water tariffs, one for agricultural use and the other for non-agricultural use. In general, these tariffs do not reflect the true cost of water. In agriculture, the water tariff includes three elements:  - 61 - (a) A so-called water user association component to meet association O&M expenses and to finance the Technical Manager's operating budget (5 percent of the amount collected). (b) A water levy component, representing 10 percent of the first component. Revenues from this levy are to go to regional agricultural development funds (Fondeagros) or to large-scale "special" irrigation projects. (c) An "amortization" component to recover the cost of public investment in diversion structures for irrigation systems. This component is also to represent only 10 percent of the water user association component, except when otherwise determined by "special" project authorities. 14. Irrigation water tariffs are proposed by the Technical Manager to the water users' association and, in case of disagreement, are decided by an ad hoc, informal committee. Except in very few cases, these tariffs have been unrealistically low (US$20-30 per ha) and have not provided for proper O&M of the irrigation systems (the "amortization" component is usually not recovered). Collection has generally been unsatisfactory, due to various factors: poor organization of users' associations, perception of the State as provider, frequent conflicts over the use of a resource which is not always available, and minimal penalties in case of default. On average, it is estimated that 30 percent of farmers have not paid their water dues. 15. In addition, special water levies are collected by a given association or irrigators' commission as mandatory contributions from the water users for specific works or activities in the irrigation system or subsystem. According to the existing law, these levies are only used to meet extraordinary expenses. In reality, they often constitute the only means for an irrigator or canal commission to operate and maintain its canal or subsector. Since the transfer of irrigation infrastructure O&M by the Government to water users in 1989, the payment of canal commission-controlled levies has helped to improve O&M of canals or specific parts of irrigation systems. 16. Low water tariffs in the past have resulted in: (i) a lack of financial resources to operate and maintain the irrigation systems adequately, so that most of the irrigation systems are in an advanced stage of deterioration (some with a high risk of collapse); (ii) excessive water consumption at farm level due both to the lack of any price incentive to use water more efficiently, and to high conveyance losses; (iii) undue preference for crops (such as sugarcane and rice) with large water requirements; and (iv) limited incentives to use more efficient irrigation techniques such as sprinkler or drip irrigation. Current Cost Recovery Policies and Payment of Water Charges 17. More recent Government policy in the irrigation sub-sector has focused on improved efficiency, calling for: (i) complete take-over of responsibility by water users for O&M of their irrigation systems, and (ii) full recovery of irrigation investment costs, including for rehabilitation and modernization. The Peruvian Government, as well as irrigation water users, deserve full credit for taking these measures and, since this is the first  - 62 - time in the world in which farmers are willing to finance 100 percent of irrigation investment costs, they should be strongly supported by the Bank in implementing the new policy. 18. The current Project supports recent Government policy to shift responsibility to water users for O&M and investment costs for irrigation infrastructure. However, both Government policy and the Project demonstrate recognition that the objective to recover 100 percent of O&M and investment costs is ambitious. Consequently, consideration has been given to the fact that not all beneficiary farmers and water users' associations possess the same financial capacity. However, the existing Law regarding income taxes (referred to above), coupled with relatively favorable loan terms planned under the Project, would enable even those with low financial capacity to benefit from the Project. Thus, the with-project situation demonstrates that in virtually all cases, the higher expected production and revenues would more than cover both the amortization of credit for irrigation investments and the increased water charge for operation and maintenance costs. Economic Analysis 19. As in the case of the financial analysis, economic analysis has been carried out for the first ten subproject areas on costs and benefits relating to the rehabilitation of existing irrigation infrastructure. In general, given the improved macroeconomic situation regarding price distortions in Peru, the economic analysis yields results similar to those of the financial analysis. Assumptions for Economic Analysis The assumptions underlying the economic analysis are the following: (a) Economic prices have been calculated for key outputs (e.g., cotton, rice, maize, and sugarcane) and inputs (e.g., Urea and triple phosphate). Additionally, "conversion factors", taking into account updating of original data to 1994 terms, have been applied to financial prices for all other outputs and inputs, including fertilizers and pesticides. (b) The without-project situation is the same as for the financial analysis. (c) Rehabilitation investment costs include mission estimates for physical contingencies. Other on-farm investment costs are based upon feasibility studies prepared by local consultants. All costs are estimated to be equivalent in economic and financial terms. (d) An economic return for the overall rehabilitation component has been estimated taking into consideration the costs of the Project Coordinating Unit (36 percent) and administrative costs (3 percent) which would apply to the Rehabilitation component.  - 63 - (e) Cost phasing is as follows: (i) rehabilitation investment costs in Years 1 and 2 of the Project, with related works to be completed in their respective years; (ii) Project Coordinating Unit and administrative costs are only applied in Years 1 and 2 as these are the years in which works for the first ten subprojects are expected to be implemented. Benefit streams are those applicable only to the first ten subprojects. E. Economic Results 20. The results show economic returns for each subproject similar to those of the financial returns. In general, economic retums are higher than financial returns, as a result of applying the referenced conversion factors to financial prices. Where the economic return is lower than the financial retum, economic prices for certain key commodities have been estimated to be lower than financial prices. Again, there is significant variability among subprojects for the same reasons which applied under the financial analysis. Economic returns range from about 18 percent to over 50 percent, depending on the subproject. The overall economic return is estimated to be about 39 percent (see Table II, attached). 21. A sensitivity analysis has been carried out on the subprojects to account for declining trends in world market prices of outputs. The analysis tests the viability of the schemes under adverse scenarios (e.g., decreases in benefits ranging from 10 percent to 15 percent). Switching values have also been calculated to determine the percentage of changes in key variables required to reduce the economic return to the opportunity cost of capital. The sensitivity of individual schemes to changes in benefits and costs varies significantly due to the relative diversity of the schemes and their specific cropping patterns. In general, however, the results show that the subprojects are relatively insensitive to cost overruns and reduced benefits from either lower production or commodity price reductions. Such relative insensitivity is the result of farm models being prepared with reasonably prudent production assumptions and consideration of market demand.  -64 - ANNEX 8 Table 1 PERU IRRIGATION SUBSECTOR PROJECT SUBPROJECT COSTS SUBPROJECT Area (ha) No. Users Investment Investment/ha O&M with Projec; O&M w/o Project, (US$ 000) (US$) (USS/ha) lUS$/hal Year 1 San Lorenzo 32805 5692 5,556.4 1 69.4 63 29 Chancay Lambayecue 47500 15148 6,975.0 146.8 84 26 Hiuaral La Esperanza 3476 565 6,867.6 1,957.7 72 52 S. Rita de Siguas 2147 97 3,607.5 1,680.3 109 80 Yururnayo 2217 175 879.8 396.8 94 21 Subtotal 88145 21677 23,886.3 4,351.0 422 208 Year 2 I'Ka Joya Antigua 3598 535 4,387.4 1,219.4 97 30 Hua,a S. Rosa 18588 6763 8,1 70.2 439.5 115 25 Chili Regulado 1941 677 2,381.0 1,226.7 82 21 S. Lacramarca 16766 3857 14,090.2 840.4 65 18 Sama 1247 259 1,519.6 1,193.0 138 15 Subtotal 42140 12091 30,548.4 4,919.0 497 109 OVERALL TOTAL 130285 33768 54,434./ 9,270.0 919 317 NI7E Numbers m,ay not caculate prec,sely due to roundinrg  - 65 - ANNEX 8 Table 2 PERU IRRIGATION SUBSECTOR PROJECT SUBPROJECT RETURNS SUBPROJECT FRR ER.R Average Incremental Income Average Income at Full Development increase (US$iyearl Year 1 San Lorenzo > 50 > 50 2333.0 49.0 Chancay Lambayecue 1 2.0 21.8 37C.0 < 5 Huaral La Esperar.z3 20.7 35.I i103.0 8.0 S. Rita de Siguas > 50 11.2 7490.0 > 50 Yurumayo > 50 > 50 583 .0 > 50 Year 2 La Joya Antigua > 50 > 50 4232.0 4C 37 Huara S. Rosa > 50 > 50 r808.0 > 50 Chili Regulado > 50 > 50 I4730 > 50 S. Lacramarca 29.7 42.5 343.0 35.0 Sama 1 2.0 17.3 151.0 < OVERALL 36.3 38.7 2257.0 30.4 NOTES: i ) All calculations are based uDon models prepared by consultants and adjusted by *he Bank. The results reflect 'he tact that subprojecs with lower financial and economic returns include larger numbers of smaller farms than other subprojects which show higher returns. The results also reflect expected value calcuistions based upon three scenares: the base case and oenefits reduction of 10% and 15%. 21 Incremental income = with projec- net income lafter higher O&M costs shown in 7able i less the sum of: without project net income, deoc service, and taxes. 31 Full develomernt actually occurs at Year 4 of the Project, at which time incremental income is in all cases significantly higher than the results above. However. long-term debt service payment does not begin until Year S ano current Peruvian Law ooes not require small-medium size farmers to pay income tax until 1999 (Year al. To be realistic, then, the above results are reflective of Year S. 41 The % increase in incremental income w/Droiect net income I w/O project net income  r 4- . >-3 4 - > - - - -. -r -. L S - - u * ! S . . -. . -, , .- ......................................................................................................................................... ........... . ................................ ................ . ........... ................. -u , If . Ci -~~~~~~~~ ~~~~~~ - - I -- - - a - .''''''''''''' '' ' '';'''''''''' t .~~~~~~~S ,1 -,a 4 '3-t~ o Ce S _ # , M4I r 14-i ' Z Z, "'2... .. .... . - - -F ... '' .... ' . .. . .. 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