Colombia - Water Sector Reform Assistance Project

Document of The World Bank Report No: 21868 CO PROJECT APPRAISAL DOCUMENT ON A PROPOSED LOAN IN THE AMOUNT OF US$40 MILLION TO THE REPUBLIC OF COLOMBIA FOR A WATER SECTOR REFORM ASSISTANCE PROJECT September 27, 2001 Finance, Private Sector and Infrastructure Department Mexico, Colombia and Venezuela Country Management Unit Latin America and the Caribbean Region  CURRENCY EQUIVALENTS (Exchange Rate Effective September 20, 2001) Currency Unit = Peso ($) $2342 = US$1.00 $1 million = US$427 FISCAL YEAR January 1 - December 31 ABBREVIATIONS AND ACRONYMS ACUACAR Aguas de Cartagena (The Water and Sewerage Company of Cartagena) AAA Acueducto, Alcantarillado, Aseo (The Water, Sewerage and Solid Waste Company of Barranquilla) BOD Biochemical Oxygen Demand CAR Corporacion Autonoma Regional (Local Environmental Authority) CARDIQUE Corporaci6n Autonoma del Canal del Dique (The Regional Environmental Authority in Cartagena) CAS Country Assistance Strategy CDF Country Development Framework CONPES Comisi6n Nacional de Poiftica Econ6mica y Social (National Comission for Economic and Social Policy) CRA Comisi6n Reguladora de Agua (Water Regulating Committee) DAPS Direcci6n de Agua Potable y Saneamiento (Water and Sanitation Directorate) DNP Departamento Nacional de Planeaci6n (National Planning Department) DDUPRE Direccion de Desarrollo Urbano y Proyectos Especiales DTF Deposito Termino Fijo (interest rate of a fixed term deposit) EIE Environmental Impact Evaluation EIRR Economic Rate of Return EMP Environmental Management Plan FINDETER Financiera de Desarrollo Territorial (a second tier financial intermediary for regional and local infrastructure investment established in 1990) FMS Financial Management Specialist Vice President: David De Ferranti Country Management Unit Director: Olivier Lafourcade Sector Management Unit Director: Danny Leipziger Task Manager: Menahem Libhaber  FNG Fondo Nacional de Garantias (National Guarantees Fund) ICN Ingresos Corrientes de la Nacion (Nation's Current Income) ICV Indice de Calidad de Vida (Quality of Life Index) INDEMUN Indice de Desarrollo Municipal (Municipal Development Index) IRR Internal Rate of Return Km Kilometer LACI Loan Administration Change Initiative LGU Local Government Unit M Meter MCM Million Cubic Meters Mm Millimeter MOE Ministry of the Environment M3/d Cubic meters per day M3/s Cubic meters per second MED Ministerio de Desarrollo Economico (Ministry of Economic Development) NBI Necesidades Basicas Insatisfechas (Unsatisfied Basic Needs) NGO Non Governmental Organization NPV Net Present Value PAOI Programa Anual de Obras e Inversion (Ainual Program of Works and Investments) PIU Project Implementation Unit PMR Project Management Report POI Programa de Obras e Inversion (Program of Works and Investments) POM Project Operation Manual PSP Private Sector Participation RPA Regional Procurement Adviser SEA Sectoral Environmental Assessment SEE Strategic Environmental Evaluation SIAS Sistema de Informacion Agua y Saneamiento (Sector Information System) SME Small and Medium Entrepreneur SOE Statement of Expenditures SS Suspended Solids SSPD Superintendencia de Servicios Publicos Domiciliarios (Superintendency of Domestic Public Services) TA Technical Assistance UFW Unaccounted For Water WSS Water and Sewerage Sector WSR Water Sector Reform WTP Willingness To Pay   Colombia Water Sector Reform Assistance Project CONTENTS Page A. Project Development Objective .........................................................1 1. Project development objective ..........................................................1 2. Key performance indicators ..........................................................1 B. Strategic Context ..........................................................1 1. Sector-related CAS goal supported by the project ....................................................1 2. Main sector issues and Government strategy ..........................................................2 3. Sector issues to be addressed by the project and strategic choices .............................6 C. Project Description Summary ..........................................................7 1. Project components ..........................................................7 2. Key policy and institutional reforms supported by the project ................................ 14 3. Benefits and target population ......................................................... 14 4. Institutional and implementation arrangements ...................................................... 14 D. Project Rationale ......................................................... 20 1. Project alternatives considered and reasons for rejection ........................................ 20 2. Major related projects financed by the Bank and/or other development agencies .... 21 3. Lessons learned and reflected in proposed project design ....................................... 21 4. Indications of borrower commitment and ownership .............................................. 23 5. Value added of Bank support in this project ......................................................... 24 E. Summary Project Analyses ......................................................... 24 1. Economic ......................................................... 24 2. Financial ......................................................... 25 3. Technical ......................................................... 26 4. Institutional ......................................................... 27 5. Environmental assessment ......................................................... 28 6. Social ......................................................... 30 7. Safeguard Policies ......................................................... 32 F. Sustainability and Risks ......................................................... 33 1. Sustainability ......................................................... 33 2. Critical risks ......................................................... 33 3. Possible controversial aspects ......................................................... 35 G. Main Loan Conditions ......................................................... 36 1. Effectiveness conditions ......................................................... 36  continued Page 2. Other ...................................................... 36 H. Readiness for Implementation ...................................................... 37 I. Compliance with Bank Policies ...................................................... 37 Annexes Annex 1. Project Design Summary ...................................................... 38 Annex IA.Key Performance Indicators ........................................... 41 Annex 2. Detailed Project Description ........................................... 43 Annex 3. Estimated Project Costs ...................................................... 56 Annex 4. Cost-Benefit Analysis Summary ....................................... 57 Annex 5. Financial Assessment of Revenue-Earning Project Entities . . 68 Annex 6. Procurement and Disbursement Arrangements . .......................................... 89 Table A. Project Costs by Procurement Arrangements . ............................................ 94 Table Al. Consultant Selection Arrangements ..................................... 95 Table B. Thresholds for Procurement Methods and Prior Review . . 96 Table C. Allocation of Loan Proceeds ......................................... 101 Annex 7. Project Processing Budget and Schedule . ............................... 102 Annex 8. Documents in Project File ........................................... 103 Annex 9. Statement of Loans and Credits ....................................... 106 Annex 10. Country at a Glance ................................................ 108 Annex 11. Eligibility Criteria for Participating Municipalities . ........................ 110 Annex 12. Sectoral Environmental Assessment Summary . ........................... 112 Annex 13. Social Assessment Summary ......................................... 120 Annex 14. Potential Participating Municipalities ...................................................... 131 Annex 15. Model of Private Sector Participation in Water Companies . ................. 135 in Colombia's Medium Size Cities Annex 16.The Constructor-Operator Model for Private Sector Participation ............. 144 in the Operation of Water Supply and Sanitation Systems in Small Municipalities Annex 17.Private Sector Participation in the Water Sector in Colombia . ................ 153 Annex I8.Private Sector Participation Experience in the Water Sector . ................. 164 in Latin America Annex 19.Comparison of the Performance of Private and Public Water . ................ 167 Utilities with Respect to Service Expansion to Low-Income Areas MAP IBRD 31321  COLOMBIA WATER SECTOR REFORM ASSISTANCE PROJECT Project Appraisal Document Latin America and Caribbean Region LCSFW Date: September 20, 2001 Team Leader: Menahem Libhaber Country Manager/Director: Olivier Lafourcade Sector Manager/Director: Danny M. Leipziger Project ID: P065937 Sector(s): WW - Water Supply & Sanitation Adjustment Lending Instrument: Specific Investment Loan (SIL) Theme(s): Poverty Targeted Intervention: N Program Financing Data [X] Loan [ I Credit [ ] Grant [ ] Guarantee [ ] Other: For Loans/Credits/Others: Amount (US$m): 40.00 Proposed Terms (IBRD): Fixed-Spread Loan (FSL) Grace period (years): 7 Years to maturity: 15 Commitment fee: 0.85% for the first 4 years, 0.75% thereafter. Financing Plan (US$m): Source Local Foreign Total BORROWER 15.00 0.00 15.00 IBRD 24.00 16.00 40.00 PRIVATE SECTOR AND MUNICIPALITIES 15.00 0.00 15.00 Total: 54.00 16.00 70.00 Borrower: REPUBLIC OF COLOMBIA Responsible agency: THE MINISTRY OF ECONOMIC DEVELOPMENT The Ministry of Economic Development, Directorate of Potable Water and Basic Sanitation Address: Calle 28, No. 13A-15, Piso 17, Edificio Bancafe, Bogota, Colombia Contact Person: Carmina Moreno, Director of Potable Water and Basic Sanitation Tel: 57-1-2826352 Fax: 57-1-2822329 Email: Cmoreno@sias.gov.co Estimated disbursements ( Bank FY/US$m): FY 2002 2003 2004 2005 2006 Annual 5.00 11.00 15.00 6.00 3.00 Cumulative 5.00 J 16.00 31.00 37.00 40.00 Project implementation period: November 30, 2001 to December 31, 2006 Expected effectiveness date: 11/30/2001 Expected closing date: 06/30/2007 OM8 PADI Ful Rl US) 2   Page 1 A: Project Development Objective 1. Project development objective: (see Annex 1) The development objectives of the project are: (i) to support water sector reform by facilitating the incorporation of the private sector into the management and operation of water utilities participating in the project for the purpose of creating an enabling environment for improving the efficiency and sustainability of these utilities, and by providing them with financial support to ensure their viability; (ii) expand the coverage of water and sewerage services in participating municipalities; and (iii) facilitate the access of populations in low income areas of participating municipalities to water and sewerage services. These objectives are expected to be achieved by providing: (i) technical assistance for incorporating private sector participation in the management and operation of the water and sewerage services in the utilities of about 3 medium size cities or regional associations of municipalities, with populations of up to about 300,000 inhabitants, as well as in the utilities of about 25 small municipalities with populations of up to about 12,000 inhabitants; and (ii) financial support to the utilities which have successfully incorporated the private sector; and which will be directed at benefiting the poor, as well as ensuring the financial viability of these utilities. Project activities will focus mainly on the Caribbean coastal region of Colombia,which consists of the Departments of Atlantico, Bolivar, Cesar, Cordoba, La Guajira, Sucre, Magdalena and San Andres, Providencia y Santa Catalina. The focus will be in this region because it suffers from the lowest coverage rates of water and sewerage in the country, as well as the lowest level of service, and the Govemment' s policy is to reduce these regional disparities. However, about 15% of project activities will be implemented in other parts of the country. The project might also provide technical and financial support to cities which have undertaken earlier reform processes involving private sector participation in the management of their utilities. The reform principles proposed by the project reflect the policy of the government and will be applied throughout the entire country, even while using other financing sources. 2. Key performance indicators: (see Annex 1) The main indicator for measuring the success of the program is the progress made in attracting PSP, both in the medium size cities and in the small municipalities. For those utilities which are successful in attracting a private operator, eight monitoring indicators will be used to track progress related to the objectives of the water supply and wastewater sector, which aim to improve efficiency, sustainability and service-to-all. The selected indicators are those agreed under the CDF, and form a "utility-based" set of indicators used to measure the operational and financial efficiency of water utilities (which will basically be the target indicators stipulated in the PSP contracts, i.e., coverage of services, reduction in rationing, productivity, financial performance etc.). Details on the performance indicators are provided in Annex IA. B. Strategic Context 1. Sector-related Country Assistance Strategy (CAS) goal supported by the project: (see Annex 1) Document number: 17107 CO Date of latest CAS discussion: 11/6/97 CAS Progress Report Report Number: 19805 Date of CAS Progress Report discussion: 11/18/99 The proposed project will support the CAS objective of Achieving Sustainable Growth, by Improving Infrastructure Services. Colombia's poor and deteriorating infrastructure has long been identified as a critical constraint to faster economic growth. The govemment's strategy to improve the quantity and quality of water supply, sewerage and sewage treatment infrastructure emphasizes increased private sector participation. The project is consistent with the CAS's emphasis that "The Bank intends to support rural and small cities water supply at the national level, with a special focus on private sector participation."  Page 2 2. Main sector issues and Government strategy: Sectoral Context. In 1986 the Decentralization Law transferred the responsibility for operating and managing the water and sewerage systems to the municipalities. Decentralization has been a major force in shaping the water and sanitation sector's structure. Colombia now consists of 1,091 municipalities and about 1,500 registered water and sanitation service providers, including municipal departments, utilities (public, private and mixed) and other authorized organizations. In 1991 a new constitution was installed in Colombia, in which the right of municipalities to provide water and sanitation services was confirmed, including the power to grant concessions or other forms of private sector participation in the provision of the water and sewerage services. The constitution provided the legal framework to introduce more aggressive reforms in the water sector by clearly separating service provision and policy making, and by allowing private sector participation (PSP) in the infrastructure sector. Law 142, enacted in 1994, established a legislative and regulatory framework for the sector that emphasizes efficiency of service provision through the introduction of competition and the promotion of PSP in the sector. The Ministry of Economic Development is responsible for the water sector. The responsibilities for the sector have been assigned to different institutions within the Ministry. The Potable Water and Sanitation Directorate (DAPS) oversees the water and sanitation sector, formulates sector policies and plans sector development. The Water Regulatory Commission (CRA) promotes competition among service providers, controls monopolies, defines tariff setting methodologies based on standard formulas and on investment plans submitted by the operating companies, and sets service quality and technical standards to be followed by utilities. In addition, the Superintendency of Domestic Public Services (SSPD) is responsible for monitoring and supervising the adequacy and efficiency of the operations, for establishing uniform accounting systems, supervising the administration of subsidies, and monitoring the general administration of public services companies. Environmental regulation is handled by Autonomous Regional Corporations (CARs). Colombia, with a population of about 40 million inhabitants, has made impressive progress in expansion of water and sanitation services in urban areas over the past decade. Approximately 84% of the urban population of about 28 million were connected to water supplies in 1997, as compared to 79%, the average for the LAC region. About 75% were either connected to public sewerage or had individual septic tanks in 1997. Rural coverage was lower with about 44% of the 11 million rural population connected to public water supply and only about 25% connected to sewerage systems. However, the increase in coverage rates masks shortcomings in the quality of service. Water rationing and intermittent supplies are common in most water supply systems. Only slightly less than 50 percent of all drinking water is treated and, as a result, the drinking water quality in many systems is sub-standard. Sufficient pressure in the water supply systems is lacking, adding to the risk of bacterial contamination. Sewage collection systems do not have sufficient hydraulic capacity to handle wastewater flows, especially in poor neighborhoods, resulting in overflow problems. The share of generated wastewater receiving any kind of treatment is about 5%, which is low for a middle income country such as Colombia. Private sector involvement in the water sector began in 1995 in Cartagena, with support from the Bank. Since then, some 15 large and medium size water companies, as well as about 35 smaller ones have managed to incorporate the private sector through various types of models, mainly mixed capital, concession and management contracts. The most important examples of PSP processes in the water sector are in Cartagena, Barranquilla, Santa Marta, Tunja, Monteria, Palmira, Girardot, Riohacha and in some smaller municipalities. The performance of all these utilities has improved. Some of them, especially the ones which were first to incorporate the private sector like Cartagena, Barranquilla and Tunja, are now well run utilities and enjoy a high degree of customer satisfaction. In spite of a favorable government policy, private sector participation in the water sector is still not widespread and is far lower than has been expected. The reasons for the slower than expected spread  Page 3 of PSP are twofold: first security problems of the country deter foreign operators and investors; second, carrying out PSP processes is complex and difficult, and needs government technical assistance and financial support in order to be successful. Main Sector Issues and Government Strategy: Poor Utility Performance. The main reason for poor utility performance is inadequate management capacity, which is a result of political intervention in management, political nomination of managers and their frequent replacement for reasons not related to their performance. Poor utility performance is reflected in the low quality of service provided and in inadequate commercial systems, low billing and collection, as well as inadequate maintenance. As noted in B2, coverage rate values do not reflect the real quality of service. A better performance indicator is the effective water service coverage, which takes into account continuity of service and water quality, in addition to physical coverage. The effective water service coverage in Colombia, which reflects coverage of 24 hours per day with water quality that complies with drinking water standars, is shown below: The Effective Water Coverage in Colombia as Indicator of Level of Service (Data for 1997) Major Cities I Medium Cities Small Municipalities National Average 82% 46% 27% < 50%?? Source: ACODAL, Estado del Sector de Agua y Saneamiento en Colombia, Julio 24 de 1998 These data indicate that (i) utility performance in the country, on average, is less than satisfactory; (ii) utility performance in medium and small municipalities is deficient; and (iii) there are great disparities between major cities and the rest of the country. Large Regional and Urban - Rural Disparities in Service Coverage. It is estimated that 10 million Colombians (of a total of 40 million) do not have access to piped water and about 15 million lack access to adequate sanitation systems. The Atlantic Coast (Caribbean region), Orinoquia and Amazonia regions present the lowest coverage rates for both services. Larger cities tend to have better coverage indicators (both in quantity and quality) than small cities and rural areas. The rural population, which accounts for about 30 % of the national total, has the lowest coverage rates, at 44% for piped water and 25% for sewerage. High Investment Needs. Total investment required for implementing the four year water and sanitation plan (1998-2002) is US$ 1.9 billion or approximately US$ 475 million per year. These figures do not provide for any investment in wastewater treatment. In the past, funding of almost 60% of the sector investments has come from Government resources, but given the current economic situation the Government can no longer continue to provide such a level of support. Consequently, there is a need for increasing cash generation from utilities and for attracting private sector investment. Low private Capital Investments and Credit to the Sector. In spite of expectations, little private investment has been channeled to the water and sanitation sector (3.4% of total private investments in recent years). Most lending for the sector is made through FINDETER with little private participation. Limited Subsidies to the Poor. Cross subsidies are part of the design of the tariff structure in Colombia and have proven to be an effective mechanism for income redistribution in large urban areas. However, as the number of municipalities in which the entire population classified in the  Page 4 lower income strata has grown, the cross subsidy mechanism became less effective. A specific mechanism, the Solidarity Funds,was proposed to allow a better service to low-income groups while helping utilities achieve financial sustainability, by providing an additional direct subsidy to the service provider. However, these funds are supposed to be financed with municipal resources. Because of budget shortfalls, the municipalities do not have resources and the Solidarity Funds concept has not been put to practice. Low Wastewater Treatment Coverage. Only about 5% of the wastewater generated in the country undergoes any kind of treatment, while the rest is discharged without any treatment, thereby contaminating a significant part of the natural water resources. Contributions from the central government for water quality control are normally assigned as a result of difficult negotiations between regional and central authorities and there is no clear mechanism for financing municipal wastewater treatment plants. Weaknesses in the Regulatory System. The regulatory and supervising agencies (CRA and SSPD) have regulatory monitoring oversight responsibility for over 1500 service providers in the country. This situation makes the regulatory activity costly and inefficient. Large utilities serving over 6 million inhabitants like Bogota are regulated in the same way as those serving 2,000 inhabitants. Current regulation is based on tariff setting formulas that were designed to provide incentives for efficient services, but have not been fully successful in promoting efficiency. Tariff levels are in most cases still too low due to political considerations that override sector incentives. During May-June, 2001 several legislative initiatives to reform Law 142/1994 have been presented in the Congress. The purposes of those initiatives are diverse and range from proposing to instate caps on tariffs to the elimination of the SSPD. Changes in the regulatory and legal framework do not provide comfort to potential private investors and constitute an obstacle to the efforts of consolidating the reform started in 1994. The government, established a high level commission to address the concerns of the legislature. Limited Coordination Among Central GovernmentAgencies. There are many institutions in the sector, some with overlapping functions in certain areas. Under such circumstances, coordination effort are a must. Utilities frequently complain about the large amount of information requested by the government, and about the costs associated with generating it. On the Positive Side the following can be mentioned: Adequate Sector Policy Framework. The Government of Colombia has always been a pioneer in adopting correct sector policies in the water sector. The decentralization policy was enacted long ago, and promotion of PSP is a key sector policy. These are advanced policies which provide opportunities for improvements in sector performance. The government has also steadily provided financing to the sector and continues to do so. Satisfactory Service in the Large Cities. The water and sewerage services in the five large cities (Bogota, Medellin, Cartagena, Barranquilla, Bucaramanga), which serve a population of about 12 million inhabitants, are good, although not always the most efficient. The exception is Cali, which is currently undergoing a crisis in the water and sewerage services. Successful Performance of Utilities with PSP. The experience with the privatized utilities (Cartagena, Barranquilla, Santa Marta, Tunja, Monteria, Palmira, Girardot, Riohacha and more) is encouraging. The performance of all of them has greatly improved, customer satisfaction is high and they provide good examples for resolving the water sector problems. Consequently PSP is emerging as a methodology which tends to be adopted by mayors who are interested in improving the water sector performance.  Page 5 Government Strategy In recent years, the government of Colombia has embarked on a water sector reform program aimed at incorporating the private sector into the management and operation of public water utilities. About 50 Colombian municipalities of various sizes have already adopted the private sector participation (PSP) concept and are managed by private operators. The performance of these utilities has significantly improved after transferring their management to the private sector (see Annex 17 for details regarding performance before and after PSP in some of the utilities). Experience in Colombia also shows that, contrary to the common perception which holds that the private sector serves better the rich and neglects the poor, if PSP processes are adequately structured, utilities managed by private operators serve low income areas better than the best public utilities in the country, as demonstrated in Annex 19. The government's strategy is based on four key policy objectives aimed at improving the sector performance: (i) strengthening the regulatory framework; (ii) implementing technical assistance programs; (iii) providing financial support to promote modernization and efficient management as well as to subsidize the poor; and (iv) rationalizing the institutional framework at the national level to improve coordination in the sector. Strengtltening the Regulatory Framework. This policy aims at achieving a stable and transparent regulatory framework that: (i) takes into account differences in local markets; (ii) makes economic regulation (CRA's responsibility) and its monitoring and enforcement (SSPD's responsibility) compatible; (iii) harmonizes efficiency and social objectives; (iv) promotes efficient operation and investment; (v) encourages investment by private sector; and (vi) allows cost recovery. Implementing Technical Assistance Programs. This policy objective aims to assist in sector improvement through technical assistance which will be provided by MED in three main areas: (i) utility modernization to improve efficiency and service quality, both to public and private utilities of different sizes, (ii) sector planning, at the sub-national level, to Departmental govemments, and (iii) improving the sector information system. Providing Financial Support. This policy objective aime at achieving sector self sustainability by promoting the concept that financing of sector utilities would be mainly based on income generated by collection of bills. When required, municipalities could subsidize the tariff of low income customers or subsidize part of the investments using the revenue transfers of Law 60. When warranted and when the previous resources are not sufficient, the government will make available to individual utilities, under strict conditions, additional resources from the national budget to solve structural problems, generally through PSP. Rationalizing thte Institutional Framework. This process would allow to: (i) Strengthening the coordination capacity of MED. Coordination at the national level would be fostered through the strengthening of the MED. (ii) Coordination of environmental policies. To achieve a balance between environmental and public services legislation, the MED and the Ministry of the Environment (MOE) would regulate the retributive charges in the water sector and fix these charges to cover the costs of improving the quality of water resources. They would also stipulate the priorities for applying these charges to different user groups. (iii) Coordination of actions in rural areas. With the objective of integrating rural policy with water sector policy, the MED would coordinate actions with other national entities, Departments and municipalities.  Page 6 3. Sector issues to be addressed by the project and strategic choices: Sector issues to be addressed by the project: The proposed project would be the first Bank-financed project to directly support implementation of the government's sector reform agenda. It would support several key PSP operations, targeting improvement of efficiency and expansion of water and sanitation services in two types of utilities: (i) medium-size cities or regional associations of municipalities (with populations of up to about 300,000 inhabitants); and (ii) small municipalities (with populations of up to about 12,000 inhabitants). In doing this, the project will address the following sector issues: * Poor utility performance * Disparity in service coverage between large cities and between medium and small cities * High investment needs * Low private capital investments and credit to the sector * Subsidies to the poor Sector strategic choices: (i) Publicly v. privately managed utilities: The program reflects the strategic choice already made by the government of Colombia, supported by the Bank, to move from public ownership and management of water and sanitation services to a model in which management and operation are led by the private sector. Continued support to public utilities, aimed at improving their performance, was not accepted and PSP was selected as the preferred institutional strategy because of performance improvement that has been achieved in utilities which have incorporated the private sector in their management, such as in Cartagena, Barranquilla and Tunja. (ii) Focus on small and medium-size utilities: Large utilities have historically received the greatest share of support from the central government and financial support from the Bank. Through the proposed project, the Bank will be providing technical assistance and financing investments in small and medium size utilities that choose to incorporate the private sector in their management. It will focus on a segment of the sector which suffers from the greatest backlog in investments and which has not received significant Bank support in the past. (iii) Promote PSP in small municipalities : Conventional wisdom suggests that it is not feasible to privatize small enterprises, because the private sector has no interest in utilities which serve less than 300,000 inhabitants. However, experience shows that in Paraguay, and to a smaller extent in Colombia and in other countries, there are some successful examples of small-size private operators in the water and sanitation sector, managing utilities without any government support. There is enough evidence to indicate that in Colombia it would be possible to find small private entrepreneurs interested in operating water and sanitation services in small municipalities. (iv) Promote the development of a market of small entrepreneurs to serve as operators of utilities in small municipalities: The number of small municipalities targeted by the project amounts to about 25, while the supply of operators which can currently handle these utilities is far smaller than the number required. The project aims to promote the development of small entrepreneurs in the water and sanitation industry, targeting small and medium construction companies or associations of such construction companies with small consulting firms, to become water operators in small municipalities. The idea is that, through competitive bidding, small and medium size construction companies will compete for the construction and/or rehabilitation of the systems in small municipalities and the winning bidder would commit to operate the system for a period of ten years from the date of signing the contract. This type of contract has been denominated "Constructor- Operator" contract. The MED will provide technical assistance to these small entrepreneurs for the management of water utilities.  Page 7 (v) Focus on the Atlantic Coast Region (the Caribbean Region): Because of an investment backlog in the Caribbean region, this region suffers from the lowest coverage of water and sanitation services, as well as the lowest quality of its utility management. The government has now decided to give investment priority to the Caribbean region through an infrastructure program, Plan Caribe. The project will support Plan Caribe in an attempt to reduce the regional disparity in water and sanitation services. C. Project Description Summary 1. Project components (see Annex 2 for a detailed description and Annex 3 for a detailed cost breakdown): Basic Project Concept Introduction: The project seeks to support water sector reforms both in medium size cities or regional utilities ( serving populations of up to about 300,000 inhabitants) and in small municipalities (populations of up to about 12,000 inhabitants) by facilitating the incorporation of the private sector in the management and operation of the water and sanitation services in the utilities of participating cities and municipalities and by providing financial support to these utilities, while ensuring provision of services to the poor. Based on experience in Colombia, as well as elsewhere in the LAC region (Annexes 17 and 18) it is assumed that once the private sector gets involved in managing the utilities, the level of the water and sanitation services will improve, the services will become more efficient and more reliable, their coverage will expand and the access of poor consumers to these services will increase. The project reflects the Government's policy to provide targeted assistance to utilities which choose to incorporate the private sector in management and operation of the water and sewerage services, since the PSP approach is believed to be the best way to improve the performance of the water utilities and the level of service which they provide to the customers. Consequently, the project is demand driven and will assist municipalities which choose to participate and: (i) agree to private sector participation in their water utilities; and (ii) reach an agreement with MED regarding a tariff increase which will elevate the tariffs to a level which, as a minimum, will cover operation, maintenance and depreciation costs, and as higher than that as socially and politically possible. For the purposes of the project, PSP is defined as transferring full management and operational responsibility to the private sector and provision of investments by the private sector in an amount compatible with the agreed level of tariffs. For the purpose of helping to diminish disparities, the project will focus on supporting: (i) medium size cities and small municipalities, which suffer from investment backlog and low level of services; and (ii) municipalities in the Caribbean region, in which the water and sanitation services are less developed than in other parts of the country. The aforementioned priorities would result in providing support to population of scarce resources, since most of the population in the medium size cities and small municipalities of the Caribbean region is of low income. Lists of the medium size cities and small municipalities in the Caribbean region, which are potential candidates to participate in the project, are presented in Annex 14. The preferred option in PSP in the water sector is to reach an agreement on a full concession, under which the concessionaire commits to provide all the investments required during the contract period. However, under the conditions in medium size cities and small municipalities in Colombia, it would be difficult to reach full concession agreements. Most of these cities suffer from significant infrastructure backlogs and need high investments, while the current tariffs are quite low. It is estimated that in most medium size cities and certainly in all small municipalities, even with tariffs increased to a socially acceptable maximum level, it would not be possible to finance all the works required in the next 10-30 years (the contracts period range) just from tariffs. Consequently, the private sector, which will be hired to manage a utility, will invest up to a level that can be recovered  Page 8 from tariffs, whereas the rest of the investments would need to be provided by the public sector (national and/or local government) in the form of subsidies or loans to service users. Two different mechanisms were developed during project preparation to facilitate the incorporation of the private sector in: (i) medium size cities or regional associations of municipalities with populations of up to about 300,000 inhabitants; and (ii) small municipalities with populations of up to about 12,000 inhabitants. The differentiation result from the fact that, from the private sector's standpoint, the business is different in the two size ranges of municipalities, and the required type of operator is different in both, i.e., for medium size cities only an experienced operator with proven credentials in operating utilities of comparable size can be hired, while for small municipalities proven experience in operating comparable systems is not required, but rather the capacity to operate them. The cut off number of 12,000 was selected because it defines reasonably well the limit between the two types of municipalities and because it coincides with an administrative division in Colombia. For both types of municipalities, model bidding documents have been developed, which include the terms of reference, specifications and draft contract. For each municipality, engineering and financial consultants will be hired to prepare the required investment program (Plan de Obras e Inversion - POI) and the financial projections of the new privately managed utility, respectively. The PIU at the Ministry of Economic Development, in cooperation with the municipal authorities, would then incorporate the investment and financial data in the model bidding document and will produce a specific set of bidding documents for each participating municipality. Private operators hired under the project will be required to provide water of a quality which complies with the national drinking water quality standards. Medium size cities: The operators for medium size cities must be private companies or joint ventures which have proven experience in operating similar size water and sewerage systems and are financially solid enterprises which can mobilize the required funds for investment. The contract for the medium size cities, which defines the proposed model, is denominated "operation contract". The investment commitment of the private operator of each city will depend on the level of tariffs agreed upon with municipal authorities. In one extreme, where the tariff level can support only operation, maintenance and depreciation, it would be a management contract (operation without investment); in the other extreme under which the tariffs can support all the investments, it would be a full concession (operation plus commitment to provide all the required investment). In most cases, however, it is expected to be an operation contract under which the operator would commit to provide part of the required investment while the rest will have to come from the public sector, either the municipality or the government or both. If the maximum tariff level acceptable to the municipal authorities does not cover the operation and maintenance cost of the utility, the participation of the city in the project will be rejected, since the utility is financially nonviable and the private sector cannot operate under such conditions. The basic principle of the operation contract is that it only commits the operator to provide an investment compatible with the level permitted by the authorized tariff. The financing of any additional investment is the responsibility of the public sector, and, under the project, it will be attempted to provide to participating utilities the amount of support requested in each case by the private operator. However, funding restrictions might limit the availability of funds for each city, in which case the public sector would commit to provide an investment at a level which will at least ensure that the rate of return to the private operator of the entire transaction will be attractive enough'. This will be done by defining in the bidding documents a cap on the amount which the public sector would provide. The cap value will be derived from a financial model which will be prepared for each participating utility prior to initiation of the bidding process for selecting the private operator, so as to ensure the achievement of an adequate rate of return for the private 1 The value of the rate of return for each case will take into account the specific risks of the municipality in question and may vary in the range of 12% to 25%.  Page 9 enterprise. The operation contract stipulates the investment program over time (the POI) required to bring the system to optimal conditions, as proposed by the winning bidder, and including a commitment of the operator to finance and construct the part of it which corresponds to him according to his proposal. When public funding is required, its use and allocation will be derived from the POI. MED and the municipal authorities will reach an agreement with the operator regarding the works and/or goods of the POI, which be financed by the government subsidy. The criterion for selection of the winning bidder is simple and transparent: the contract would be awarded to the bidder who requests from the public sector the lowest capital investment subsidy in order to complete the works of the POI and bring the system to the optimal state, as well as operate and maintain the water and sanitation system. No operation subsidies are involved and the maximum amount that the government is ready to pay (the subsidy cap) will be stipulated in the bidding documents. The performance indicators targets (metas del contrato) will be stipulated in the draft contract which forms part of the bidding documents, will be compatible with the subsidy cap, and will also ensure an adequate service to the poor. Each bidder will submit his own POI, which may be different from the POI proposed by the engineering consultant, since the POI is essentially a technical proposal and it is advisable to let the private sector introduce its own ideas and innovations. Each bidder will provide in his proposal a detailed annual scope of works and related dollar amount which he commits to carry out each year. The winning bidder will agree that, once he has received from the government an agreed set of works whose value is equivalent to the amount of subsidy which he requested, he will reach the target indicators value over time, as stipulated in the contract, i.e., the operator will commit to attain the target indicators corresponding to the total level of investments provided (private plus public investments). The yearly work program can be changed in mutual agreement with the mayor but the operator would have to comply with the total amount of the annual investment program. The amount which the public sector has committed to provide will not be made available to the operator, for his discretional use, but will be rather used to finance part of the infrastructure works stipulated in the POI, which will be proposed by the operator (i.e., works considered by him as high priority works) and approved by the municipal authorities and the MED. In this way, the private operator will not receive a financial contribution from the government, but rather the right to operate additional infrastructure which is provided by the government as a grant and is owned by the municipality, and whose value is equivalent, or close, to the amount of the subsidy which he requested in his proposal. In this manner, the government, in effect, finances additional infrastructure for the city residents and not the provision of funds to the operators, a concept more acceptable to the public. In each city, the works financed by the government will be designed by the private sector managed utilities and the executing agency of each subproject will be the privatized water utility of the city. This arrangement will ensure that the infrastructure provided by the government will be totally satisfactory to the private operator and will meet his requirements. The works and goods financed with Bank proceeds will be procured through public bidding processes in accordance with the Bank procurement guidelines. The supervision and control of the PSP contract will be the responsibility of the contracting agency, i.e., the municipality, which may hire an individual consultant or a consulting firm, on a full or part time assignment, to carry out that task and determine if the performance targets are achieved by the operator. The duration of the operation contracts would be in the range of 20-30 years, which is the time required to recover investments in these type of contracts. If the authorized tariff level is sufficient to cover all the investment program (with no need for financing support from the public sector), the contract would then be awarded to the bidder who offers the highest reduction in the authorized tariff (i.e., the lowest tariff). Additional details regarding the proposed model for medium size cities are presented in Annexes 2 and 15.  Page 10 Recently, the water utilities of several medium size cities in the Caribbean region have been privatized under various PSP models, utilizing technical assistance provided by the government. The government has also offered financial support to the privatized utilities but has encountered difficulties in providing it. It requested, therefore, that these utilities be eligible to access financing under the proposed project. Such utilities could become eligible to project financing under the following conditions: (i) the private operator has been elected through a competitive bidding process acceptable to the Bank; (ii) the agreed tariff levels are adequate and coincide with the principles of the proposed project, or, in case they are inadequate, the operator and the municipal authorities agree to bring them to adequate levels; (iii) the municipal authorities are ready to contribute matching financial resources from government transfers or other sources; and (iv) when necessary, the private operator and the municipal authorities agree to modify the performance indicators stipulated in the operation contract, add to it indicators for low income areas and incorporate in it other amendments, as required by MED and the Bank. During project preparation, PSP processes based on the described model were prepared for several cities (Cucuta, Maicao, Sincelejo, Corozal, Quibdo, Flandes, Espinal, Duitama, Popayan and others) as well as for several regional schemes (Acuavalle, composed of 33 municipalities, ERAS composed of Cerete, Sahagun, Cienaga de Oro, San Carlos and San Pelayo, and ARATT composed of Arjona Turbaco and Turbana). Three bidding process were initiated, like those in Cucuta, ERAS and Maicao. One process, in the city of Maicao, was completed successfully and has been awarded to a private operator. Unfortunately, in the other two, no proposals were submitted. The reasons for that are: (i) the bidding processes coincided with the end of the term of mayors in Colombia in late 2000, which hindered the processes by allowing only a short time of about three weeks for submission of proposals; (ii) security problems in the regions of the two cities; and (iii) the impact of the water pollution taxes "tasas retributivas" and other environmental contingent liabilities (financial impact of possible future more stringent environmental norms), which were mentioned by potential private operators as a reason for finally deciding not to submit a proposal. Small municipalities: The contract with private operators in small municipalities is denominated "Constructor-Operator" contract. The concept of incorporating the private sector in the management of utilities of small municipalities, with populations of up to 12,000 inhabitants, is perhaps the most significant innovation of the project. Common perception suggests that it is impossible to privatize small utilities, because the private sector does not have interest in utilities which serve less than 300,000 inhabitants. However, experience has shown that in Colombia (see Annex 17), as well as in other countries, there are successful small-size private operators in the water and sanitation sector, managing utilities without any government support. The basic assumption of the "constructor-operator" concept is that big operators have an interest in managing utilities of large and medium size cities, while small utilities attract small operators. The concept was developed during project preparation and was adopted by the government It is the first time that any government in Latin America supports PSP in a large number of small municipalities with a population of less than 12,000 inhabitants each. The concept of the "constructor-operator" model in small municipalities is that through competitive bidding small and medium size construction companies, possibly in association with small consulting firms, will compete for the construction and/or rehabilitation of the water supply and sewerage systems in a small municipality and the winning bidder will have to commit to operate the systems for a period of 10-15 years from the date of signing the contract. No prior experience in operation of water systems is required from the bidders. It is assumed that construction companies that have the capacity to construct the systems, also have the technical and management capacity to operate them after minimal training, since the systems are quite small and simple. The winning bidder will receive training in management of water utilities as well as written material and management software, from the PIU. Although it might appear that the bidding process for selecting the Constructor-Operator is similar to that for selecting a constructor for small works, it is in fact a process for selecting a private operator,  Page 1 1 in which the selection criterion of the winning bidder is the lowest subsidy that is required to construct, operate and maintain the specified water and sewerage infrastructure in the municipality. Bidders will estimate the present value of surplus operating revenue and determine how much they can contribute from future income to finance the works, and how much they request as public sector (government and municipality) subsidy. The winning bidder will be required to establish a special purpose company with, separate accounts, to construct and operate the water and sewerage systems of the municipality. The Constructor-Operator model is basically a concession tailored for small municipalities, in which the government finances, in the form of a subsidy, most of the required water and sewerage infrastructure investment in the participating small municipalities. The requirement for a high level of government subsidy results from the fact that small municipalities suffer a significant backlog in infrastructure while the population does not have the capacity to finance this backlog through tariff increases. The Constructor-Operator model is, in fact, similar to that of the operation model in medium size cities, with three differences: (i) in small municipalities the operator is also the constructor, and this was required for the creation of the operators market; (ii) the level of government subsidy will most probably be greater (in terms of percent of total investment) in small municipalities; and (iii) the duration of the contracts in small municipalities is 10-15 years while the duration of the contracts in medium-size cities is 20-30 years. Although initially constructors may not find such an operation attractive, they might agree to be responsible for system operation and management because of their interest in the construction portion of the contract. After operating the system he himself constructed for ten years, the Constructor-Operator will most probably recognize the benefits of performing as a system operator, i.e., benefiting from a stable, reliable and continuous source of income, while performing a relatively simple task. It is expected that this will convince the entrepreneur to remain an operator on a permanent basis. In that manner, through the concept of constructor-operator, it is expected that the market of private operators for small municipalities will be created. Additional details regarding the proposed "Constructor-Operator" model for small municipalities are presented in Annexes 2 and 16. During project preparation, a pilot PSP processes based on the "Constructor-Operator" model were prepared in eight small municipalities (Puerto Escondido, Los C6rdobas, Mofiitos, San Bernardo del Viento, Cumaral, Nataga, Palermo, and Tello). Because of government budget restrictions to finance the related investments, the bidding processes were carried out for only five municipalities; of these, two processes have been successfully completed for the municipalities of Cumaral and Nataga and the respective contracts have been awarded and signed. The others were negatively impacted from the fact that the bidding processes coincided with the end of the term of mayors in Colombia, in late 2000, which is the reason that no proposals were submitted for the other municipalities. Destination of Bank Proceeds: The Bank funds will be lent to the government of Colombia, which will use them mostly as subsidies to finance public investments in water and sanitation infrastructure in medium size cities and small municipalities. In addition, part of the Bank funds will be used to finance the technical assistance activities which will be provided to each participating municipality for incorporating the private sector in the management and operation of the services, as well as for other technical assistance activities included in the project. Ensuring the Provision of Services to the Poor: In medium size cities: in order to ensure services in poor neighborhoods of medium size cities, two sets of pre-established performance targets, varying over the years, will be stipulated in the operation contracts, one for the entire city and one for the low income neighborhoods. The operators will commit to achieve both sets of targets, thus ensuring the provision of services to the poor in the medium size cities. In small Municipalities: the eligibility criteria will provide a screening mechanism which will ensure that only municipalities with a high portion of low income population will be able to participate in the project. This will be done through  Page 12 use of the social indicator INDEMUN2 (Indice de Desarrollo Municipal - Municipal Development Index) which is determined annually by DNP for each municipality. Only municipalities with an index value of up to 5, which reflects low income municipalities, will be eligible to participate in the project. This value will ensure that most of the population in the participating small municipalities is of low income. Subsidy Policy: The tariffs for each stratum will be structured in such a manner that high income consumers in strata 4, 5 and 6 will pay their share in the investment program through the tariff and will not receive any subsidies. As a result, all the investment subsidies financed by the Bank will benefit only consumers in strata 1,2 and 3, i.e., population residing in low income areas. This approach is a requirement of Law 142 and also a project objective of supporting the poor. Eligibility Criteria: Although there are some differences between the eligibility criteria of small municipalities and medium size cities for participating in the project, the criteria in both cases are quite similar. The main eligibility criteria are: (i) the water coverage rate in the municipality is lower than a pre-established value; (ii) the mayor and the municipal council agree to PSP and accept the proposed PSP model; (iii) the mayor and the municipal council agree to new tariffs at a level which will ensure coverage of, at least, the operation, maintenance and depreciation costs, and as high as socially and politically possible; (iv) the mayor and municipal council agree to contribute to the investment program a certain percent (between 8 to 20%, to be established specifically for each case) of the Law 60 municipal transfers or other municipal resources; (v) the mayor commits to carry out a campaign aimed at informing the community about the reform, the PSP model and the tariff adjustment involved (vi) the investment per capita is capped and cannot exceed a pre-determined value; and (vii) the proposed works will not include resettlement. Additional details regarding the eligibility criteria of small municipalities and medium size cities are presented in Annex 11. Project Components The proposed project will help to incorporate the private sector in the management and operation of about 3 water utilities in medium size cities and in about 25 water utilities in small municipalities. It will also provide financial support for infrastructure investments in the utilities which have been successful in incorporating the private sector. The main project components are: (i) the provision of financial support for investments in water utilities of medium size cities and small municipalities; and (ii) technical assistance for PSP and project management. Additional project components include sector environmental capacity strengthening and rural water and sanitation policy development. The project components are summarized in the following table, which includes the estimated cost of each component and sub-component. 2INDEMUN is a territorial development indicator which reflects in each municipality a set of social indicators (coverage of education, coverage of public services, health, unsatisfied basic necessities) as well as financial indicators (tributary and non-tributary income per capita and expenses per capita). The INDEMUN indicator has 8 categories. Category I reflects the least developed municipal level and category 8 the most developed. Category 5 was selected as the cut off category of the indicator in order to be inclusive enough, while on the other hand not to include in the project municipalities with too high a level of development and too low a level of poverty.  Page 13 Project Components and Estimated Cost Indicative Bank- % of Component Sector Costs % of financing Bank- ______(US$M) Total (US$M) financing A. Investments in Subprojects in 61.8 88.3 31.8 79.5 Medium Size Cities and Small Municipalities Al. Loan investments in W&S Urban Water 15.0 21.4 15.0 37.5 works in medium size cities in Supply the Caribbean region A2. Loan investments in W&S Urban Water 16.8 24.0 16.8 42.0 works in small municipalities in Supply the Caribbean region A3. Government counterpart Urban Water 15.0 21.4 0.0 0.0 funds for investments in Supply medium and small municipalities in the rest of the country A4. Private Sector and Law 60 Urban Water 12.5 17.9 0.0 0.0 investments in medium size Supply cities A5. Private Sector and Law 60 Urban Water 2.5 3.6 0.0 0.0 investments in small Supply municipalities B. Sector Environmental Environment 0.8 1.1 0.8 2.0 Management Capacity Adjustment Strengthening C. Rural Water and Sanitation Rural Water 0.9 1.3 0.9 2.2 Policy Development Supply & Sanitation D. Project Management and 6.5 9.3 6.5 16.3 Training, PSP Technical Assistance, Studies and Supervision of Works Dl. Project Management and Urban Water 2.5 3.6 2.5 6.3 Training Supply D2. TA for PSP in medium Urban Water 1.0 1.4 1.0 2.5 size cities and supervision of Supply works D3. TA for PSP in small Urban Water 3.0 4.3 3.0 7.5 municipalities and supervision Supply of works Total Project Costs 70.0 100.0 40.0 100.0 Total Financing Required 70.0 100.0 40.0 100.0 (Note: The Borrower shall pay the Bank a front-end fee equal to US$400,000 no later than 60 days after effectiveness date of the Loan).  Page 14 2. Key policy and institutional reforms supported by the project: The proposed project will support the following reforms: * Promotion of private sector participation in the management and operation of medium-size water utilities. * Promotion of private sector participation in the management and operation of water utilities in small municipalities. * Incorporation of a poverty strategy in PSP contracts. * Promotion of reform of environmental regulations, especially in regard to effluent discharge regulations. * Development of a policy for increasing water and sanitation coverage in the rural sector. 3. Benefits and target population: Project benefits are related to the reform of the water and sanitation sector in Colombia. They include efficiency gains expected from private sector management of sector operations; increased and more efficient investments to rehabilitate and expand infrastructure--within the incentives of private sector decision making--to meet clearly defined operational and service targets; and fiscal gains from increased tax revenues. Improved operational and investment efficiency translates into: (i) More reliable water and sanitation services; (ii) The elimination of water rationing and intermittent water supply during the summer months; (iii) Reduction of wastage of water by establishing a metered- based tariff regime; (iv) Improved water quality for human consumption to meet international standards; (v) Reduction of water pollution, within a defined framework of environmental regulations; (vi) Better services to the poor by the establishment of service and coverage targets in poor areas within PSP arrangements; and (vii) Better sizing, timing and technology choice of sector investments through the incentives of private sector rationale. Furthermore, the project's benefits are expected to extend beyond the direct beneficiaries and the 5-year implementation period. In the medium term, the project is expected to improve the sector's access to the private capital markets by establishing a track record for well designed privately operated contracts. The project will also provide credible and acceptable PSP models which will be tested during the implementation period and which could be adopted by utilities in other countries. Finally, the project would provide assistance to the impoverished Caribbean region, which has the lowest service coverage and lowest quality of service, as well as an average income below the national average, so as to attempt to reduce regional disparities. Targeted population: an estimated population of about 700,000, a large portion of which is of low income (when measured in terms of unsatisfied basic needs-NBI, about 40% of the Caribbean population is living in poverty and about half of that population is living in misery, see Annex 13), residing in small municipalities, is expected to benefit from improved water and sanitation services as a result of the project. Of the eight departments included in the project area (Atlantico, Bolivar, Cesar, Cordoba, La Guajira, Magdalena, Sucre and San Andres, Providencia y Santa Catalina), all except one (Atlantico) have a higher incidence of poverty and lower water and sewerage coverage rates than the national averages, as shown in Annex 13. It is noteworthy that, of all departments in the country, the highest misery levels are found in Cordoba and Sucre, when measured in terms of unsatisfied basic needs (NBI). When using the quality of life index (ICV) to measure poverty, again Bolivar, Cordoba, Magdalena and Sucre are, after Choco (which is a department not located in the Caribbean region), among the poorest departments in the country. 4. Institutional and implementation arrangements: Implementation period: FY 02-FY07 (5 years) Borrower and Executing Agencies: The Borrower is the Government of Colombia. The ministry in charge is the Ministry of Economic Development (MED). The executing agency of the TA  Page 15 component of the project is the Project Implementation Unit (PIU) in the Directorate of Water Supply and Basic Sanitation (Direccion de Agua Potable y Saneamiento Basico) in the Ministry of Economic Development. The executing agency of each investment subproject will be the utility of the municipality, managed by a private operator. The PIU will control and monitor the performance of the executing agency of each subproject and will ensure that when using Bank funds, the executing agencies will comply with the Bank's guidelines. Project management and coordination: Overall project management and coordination will be carried out under the guidance of the Director of Water and Basic Sanitation in MED, who will also be responsible for policy issues and overall coordination with municipal and departmental governments. The Director will be assisted by the PIU in MED, which will be the implementation and coordination agency of the project. The PIU will supervise the implementation of subprojects and manage all the technical assistance activities through a team of consultants financed under the Loan. This team has already been working in the implementation of component E of Loan 3336-CO, which supported the preparation of the proposed project, and has gained valuable experience in structuring PSP processes, in social aspects related to PSP and in Bank procedures. One of the most important tasks to be carried out by the PIU during project implementation is the "socialization" of the PSP process in each municipality. First of all, this would entail convincing the mayor to participate in the project. Secondly, the PIU would assist the Mayor to secure support from other important actors such as the municipal council, community organizations, the business community and NGOs. Then it would assist the mayor to carry out public information campaigns and community consultation. A detailed description of the PIU functions and responsibilities in implementing the project is included in the Project Operational Manual (POM), which is being prepared with Bank assistance. Oversight of project management will be provided by an inter-institutional committee created specifically for this project. This committee, called "Comite Coordinador Interinstitucional DNP- MDE", is made up of representatives of MED and of two units of the National Department of Planning (DNP), namely DDUPRE (Direcci6n de Desarrollo Urbano y Programas Regionales Especiales), which is a unit in charge of the water sector; and the Caribbean Plan Program. Learning and Feedback Arrangements: The PIU in MED will also serve as a focal point for exchanging experiences (best practices and lessons learned), training, and an information data- base for sector reform. To that end, the PIU will do three things. It will organize periodical workshops with the participating municipalities to exchange experiences. It will also prepare training programs for small operators and decision makers as well as for community representative groups, and it will maintain the sector information system which would be available to the public, including potential investors and lenders. Legal Agreement: The Loan Agreement will be signed between the Bank and the Government. In addition, the government will sign contracts with two Assistance Entitities which will assist it in administrating the Loan funds. One Assistance Entitity will administer the investment funds and the other wil administer the TA funds. For each subproject, an agreement of financial support, Convenio de Apoyo Financiero, will be signed by the government, through the MED, and the respective municipality. This agreement would: (i) describe the works to be financed by the government; (ii) stipulate the commitment of the municipality to use the Bank procurement guidelines for executing the works and to employ the selected private operator as the executing agency of the works; (iii) establish the funding obligations of the municipality (contribution of Law 60 transfers or other sources); and (v) specify any additional conditions and issues associated with the contribution of investment funds by the government.  Page 16 Decision flow and processing steps: The project will be demand driven. MED will inform medium size and small municipalities located in the project area about the project, and interested municipalities will initiate the contact with MED. The main eligibility criterion for participating in the project is the agreement of the municipal authorities to PSP. Additional eligibility criteria are presented in Annex 11 and are included in the POM. Mediun size municipalities in the project area, which have previously carried out PSP processes in their water utilities (not in the framework of the project) may be eligible to participate in the project, subject to two conditions. The first condition is that the hiring process for the private operator and the subsequent contract are found satisfactory to the Bank. The second condition is that procurement of any goods or works by the municipality should follow Bank guidelines. In each municipality the process starts with signing a technical assistance agreement (Convenio de Asistencia Tecnica) between the municipal government and MED. In this agreement, the municipality expresses interest in participating in the project, it agrees to PSP, and also agrees to adjust tariffs as well as provide partial financing for investments from Law 60 resources. The TA activities are somewhat different in medium size and small municipalities, being simplified in small municipalities. However, in both cases, the TA includes the preparation of a works and investment plan (Plan de Obras e Inversiones-POI) with service/quality targets, a tariff regime and bidding documents, including a draft PSP contract. All these are prepared by qualified consultants hired by the PIU. Before the bidding process for selecting the private operator is initiated, the PIU conducts a detailed review of the material prepared by the consultants, especially of the proposed tariffs and subsidy, as well as of the bidding documents, in order to assess the technical/financial/economic viability of the proposed subproject. The most important aspects of this review are the proposed tariffs, investment subsidy and financial projections. This will be done using a financial model agreed upon with the Bank. Once the PIU has decided on the proposed tariffs and subsidy cap, which will be proposed to the mayor, it will send the information to the Bank for no objection. After obtaining the Bank's comments and no objection, negotiations with the municipal authorities will then take place and the resulting agreement on tariffs and subsidy cap will be sent again to the Bank for no objection. Before initiating the bidding process, an agreement of financial support (Convenio de Apoyo Financiero) will be signed between MED and the municipality, as described above. Once a PSP contract is awarded, the utility becomes eligible for receiving financial support from the national government in the form of a subsidy, the amount of which will be a result of the bidding process but would not exceed the agreed cap. During the construction period, the PIU will supervise each subproject, with the assistance of technical/financial consultants and external auditors, to ensure that the agreed rules and regulations are complied with. The supervision and control of each PSP contract is the responsibility of the corresponding municipality, which might hire consultants to provide it with assistance in evaluating the operator's compliance with the target indicators of the PSP contract. Procurement: When implementing works financed wholly or partly by Bank funds, the subprojects' implementation agencies, namely private operators, will adhere to the Bank procurement guidelines. This means that works and goods will be procured in accordance with the Bank's "Guidelines for Procurement under IBRD Loans and IDA Credits" (published in January 1995; revised in September 1997 and January 1999). When using their own funds for financing investments which they have committed to provide, other procurement procedures may be used. For the technical assistance components, consulting services, either wholly or partly financed by IBRD, will be procured in accordance with the Bank's "Guidelines for Selection and Employment of Consultants by World BankBorrowers" (published in January 1997, revised in September 1997 and January 1999). Goods will be procured in accordance with the Bank's Guidelines for Procurement under IBRD Loans and IDA Credits mentioned above. For works implemented in medium size cities, the executing agency of each investment subproject (i.e., the utility of each municipality, managed by a private operator) will use Standard Bidding Documents published by the Bank, for works and goods to be procured under International Competitive Bidding (ICB). Works implemented in small  Page 17 municipalities under the Constructor-Operator model, will be procured using model bidding documents which have been specially prepared and authorized to be used for that purpose, and are the same bidding documents used for selection of the operator. Standard documents for Requests for Proposals and consulting services contracts will be used under the technical assistance components of the project. Detailed project procurement arrangements are given in Annex 6. A procurement capacity assessment of the PIU has been carried out and the overall procurement risk was assessed as average. An action plan for strengthening the skills of the PIU has been agreed upon, including hiring a high level procurement specialist and sending additional procurement staff to Bank procurement training seminars. The PIU will provide procurement training for each of the individual subproject executing agencies and will monitor their performance to ensure that they comply with Bank procurement guidelines. Flow of funds: Financial management will be the responsibility of the PIU. All Loan funds will be deposited by the Bank, upon request of the PIU, in a special account in Banco de la Republica. Investment funds for works and goods in medium size cities and small municipalities under component A will be withdrawn by the PIU from the special account and deposited in an Administrator Account. The Administrator, which will be in charge of handling these funds, will be an Assistance Entity (Entity 1), which is an entity established by an international organization of countries, of which Colombia is a member, and which has the expertise, facilities and personnel required to carry out on behalf of the PIU certain activities under the project, such as administrating funds, contracting services and entering into respective agreements. Advances from the special account to the Administrator account will be documented within 30 days from the date the special account is debited. Bank funds will be used only to finance investments in the Caribbean region. When used to finance works in subprojects of medium size cities, Bank funds will be transferred from the Administrator account to subsidiary trust accounts managed by local fiduciary agencies. The funds of each subproject will be handled by one local fiduciary agency which will be hired to manage the funds of the respective subproject, and which will receive, in addition to the Bank funds also the input from the corresponding municipality (mainly Law 60 funds). Each local fiduciary agency will realize payments to constructors and service providers, upon authorization from the PIU. For payments of taxes and duties, the local fiduciary agencies will use the funds contributed by the municipalities. The local fiduciary agencies will sign the contracts with constructors and service providers on behalf of the respective municipalities. When used to finance works in subprojects of small municipalities, Bank funds will be transferred from the Administrator account of the Assistance Entity directly to the bank accounts of the respective Constructors-Operators. In such cases, a local fiduciary agency is not necessary since each subproject has only one works contract. Technical Assistance funds, which will be used to finance all activities under components B, C and D and will be fully financed by the Bank, will be transferred by the PIU from the special account to a designated account for financing technical assistance activities, which will be administered by another Assistance Entity (Entity 2), which is the same type of entity which will manage the investment funds. From the designated account managed by Entity 2, payment will be made to consultants and service providers, according to instructions of the PIU. Entity 2 will sign the consulting contracts on behalf of the government. MED is reviewing the performance of the Assistance Entities available in Colombia, and will sign, before the effectiveness date, agreements with the two which will be selected for the project. MED might decide to sign both agreements with a single Assistance Entity, which will be in charge of both tasks and open the two accounts (the Administrator account for investments funds under component A and the Designated account for TA funds under components B, C and D). The costs associated with the agreements of hiring these entities are not eligible for Bank financing. Nevertheless, the Entities need to be acceptable to the Bank. Government counterpart funds will be used to finance investments in all parts of the country, mostly out of the Caribbean region, but they can be used also for investments within that region. The counterpart funds will be managed directly by MED and will be deposited by the treasury in the  Page 1 8 project account, which is an account in a commercial Bank which will be opened by MED for this purpose. From this account the funds will flow in an identical fashion to that of the Bank funds, i.e., when used to finance works in subprojects of medium size cities, they will be transferred from the project account to the subsidiary trust accounts in the local fiduciary agencies, and when used to finance works in subprojects of small municipalities, counterpart funds will be transferred from the project account directly to the bank accounts of the respective Constructors-Operators. If, for some reason, the described flow of funds route from the special account to the accounts managed by the Assistance Entities is interrupted, other routes acceptable to the Bank, such as reimbursement of the Borrower for eligible payments made for the project and direct payment by the Bank to service providers, may be used. Direct deposits from the Bank into the Administrator account and Designated account managed by the Assistance Entities may also be done. A diagram detailing the flow of funds scheme is presented in Annex 6. The PIU will be responsible for sending withdrawal applications to the Bank and for reporting on the use of funds. The PIU will also be responsible for management of the counterpart funds contributed by the government, and for timely replenishment of the counterpart funds' project account. Financial management, reporting and auditing: Both the accounting and financial management of the project will be the responsibility of the PIU. A financial management assessment of the project was carried out by a LAC Financial Management Specialist (FMS). The FMS concluded that the PIU needs to be strengthened. An action plan was drawn up and it was agreed to hire two financial management experts for the PIU. The PIU will be responsible for consolidating project accounts and information, budgeting, preparing financial reports, establishing internal controls and contracting independent audits for the project. A new accounting, planning, monitoring and supervision software, compatible with LACI, will be purchased. A year after project initiation and after installing an integrated project financial system, the PIU shall prepare and submit to the Bank quarterly project management reports (PMRs) linking project expenditures to key monitoring indicators of activities carried out during each quarter. The formats and basis to produce those reports would be in accordance with the Bank Financial Management Manual and LACI procedures. Participating water utilities would follow accounting procedures and financial reporting outlined in the POM. Twice a year, (March 31 and September 31) summary progress reports of the operational/financial performance of the utility, and the implementation of the subprojects, would be presented by each participating utility to the PIU according to guidelines and formats included in the POM. An independent accounting firm acceptable to the Bank will be hired annually, in accordance with terms of reference approved by the Bank, to carry out the covenanted yearly audits of the special accounts, project account, and of the SOEs. Monitoring and evaluation arrangements: Monitoring and evaluation would be done by the Bank and by qualified consultants hired by the Bank. Participating utilities will submit summary reports to the PIU, following formats included in the POM. The PIU will submit the Bank consolidated progress reports on the performance of the project at the end of each semester ending April 30 and October 30. The Bank would carry out at least two full supervision missions and one partial supervision mission a year. Project's Operational Manual: The POM is an essential tool for project implementation. It has been designed to maintain the institutional memory of the project throughout its implementation life. Therefore it includes all relevant information regarding the project and procedures to guide the PIU (detailed information on subproject evaluation, reviews and approval, instructions for document flows, standards for progress reports, procurement and disbursement procedures, operational agreements between the participating agencies, and a detailed description of the PIU functions). The POM is currently under preparation and its completion is a condition of Loan Effectiveness.  Page 19 Counterpart funds: The proposed loan has already received Congressional approval (aprobacion Comisi6n Interparlamentaria) and Executive Branch approval through a CONPES document (CONPES 3001 de abril 1998, "Autorizaci6n de la Naci6n para contratar creditos externos hasta por US$ 296.5 millones con destino a completar la financiaci6n de las estrategias para la gente Caribe- Es Caribe). Nevertheless, both approvals authorize the use of loan proceeds only for works and activities implemented in the Caribbean region. When DNP first requested Bank support, the request referred only to the Caribbean region. Bank management responded that it was agreeable to initiate project preparation on condition that it would be a national project, and an APL, and accepted that the first phase would focus on the Caribbean region, but insisted that the project provide assistance also to the rest of the country. Given these constraints, the Bank project team and the government team (i.e., representatives of DNP and MED) reached a compromise which responds to the requirements of both the government and the Bank. The loan proceeds, in the amount of US$ 40 million, will be used only to finance works and activities implemented in the Caribbean region. The Government will provide counterpart funds in the amount of US$ 15 million from its budget, which will be used to finance works and activities in other regions of the country, mainly works under Constructor-Operator schemes, and to a smaller extent, works in medium size cities. Taxes and duties associated with project activities will be financed for each subproject from the contributions of the municipalities, mainly Law 60 transfers. When necessary, taxes could be financed also from counterpart funds. However, the project concept, principles and conditions will be the same for the Caribbean region and for the rest of the country, and the same implementation unit will manage project activities in the entire country. The total amount of project counterpart funds includes, on top of government's contribution from its budget, also private sector contributions, as well as some Law 60 contributions, at an estimated amount of US$ 15 million. This brings the total project counterpart fund to about US$ 30 million. Retroactive financing: The proposed project is expected to become effective in November 2001. An estimated US$150,000 will be required to maintain the services of the PIU from January 1, 2001, until the proposed loan becomes effective. These services have been financed by the proceeds of Loan 3336-CO until December 31, 2000, when the loan was closed. The total amount of retroactive financing would not exceed 10% of the loan amount, i. e., US$ 4 million and it would be used to finance works and services which have been executed within a period not exceeding 12 months prior to loan signing, and whose contracting has been carried out in accordance with the Bank procurement guidelines.  Page 20 D. Project Rationale 1. Project alternatives considered and reasons for rejection: * A conventional investment lending project with institutional strengthening. This approach was rejected for medium size utilities because experience from the Colombia Water and Sewerage Sector Project (Loan 2961-CO) demonstrated that this approach was not successful in terms of institutional development. For small-size utilities, a conventional strengthening of public utilities was considered, by providing technical assistance aimed at improving performance. However, this approach has not yielded satisfactory results in larger municipalities and it is doubtful that it will work better for smaller utilities. On the other hand, there is evidence that small private operators entering the sector have been successful in some Colombian regions as well as in other countries, such as Paraguay. * A technical assistance project. Limit Bank activity to providing intellectual leadership and financing consultants to prepare PSP transactions. This alternative was discarded since the government recognized that even in concessions for major urban areas, non-recourse financing was not feasible (even in the case of Buenos Aires, Argentina). It is also not realistic to expect that, in medium size and small utilities, all the required investments can be financed simply through tariffs. Consequently public investment would still be needed. * A sector reform project. With the requirement of incorporating the private sector in the management and operation of the water and sewerage utilities, a sector reform project has been selected as the preferable approach. In the past, the government invested large amounts in strengthening public utilities without achieving positive results. In contrast, the performance of several water utilities which have recently incorporated the private sector in their management, has significantly improved. The govemment therefore considers the PSP alternative, combined with financing part of the investments through public sector funding, as the best alternative given the current condition of the sector in Colombia. The participation of the Bank is perceived by the private sector as a key stabilizing factor. * An APL program. At first there was an attempt to reach an agreement with the government on an adaptable lending program as an instrument for the sector reform. This alternative was discarded because a condition for APL was that a medium and long term strategy, acceptable to the Bank, which can be implemented under one umbrella, needed to be agreed upon with the government. An agreement on such strategy could not be reached. Moreover, with the support of another financing agency, the government has initiated the preparation of programs similar to the one supported by the project (the government strategy is to diversify financing sources so it did not favor long term agreements with one lender). Also, uncertainties regarding regulatory and legal framework reforms, as well as the unstable security conditions in the country are not compatible with the APL concept.  Page 21 2. Major related projects financed by the Bank and/or other development agencies (completed, ongoing and planned). Latest Supervision Sector Issue Project (PSR) Ratings (Bank-financed projects only) Implementation Development Bank-financed Progress (IP) Objective (DO) Water Supply & Sanitation 2470-CO: Cucuta Water Supply & S U Sewerage Project-(completed in 1995) Water Supply & Sanitation 2637-CO: Barranquilla Water Supply HU HU Project-(cancelled in 1991) Water Supply & Sanitation 2512-CO: Fourth BogotA Water Supply S S Project-(completed in 1993) Water Supply & Sanitation 2961-CO: Water Supply and Sewerage S S Sector Project-(completed in 1996) Water Supply & Sanitation 3952-CO/3953-CO: Santa Fe I Water S S Supply and Sewerage Rehabilitation Project (ongoing) Water Supply & Sanitation 4345-CO: Urban Infrastructure Services S S Development Project (ongoing) Water Supply & Sanitation 3336-CO: Municipal Development S S Project, Component E, Water Utilities Modernization Water Supply & Sanitation 4507-CO: Cartagena Water Supply, S S Sewerage and Environmental Management Project (ongoing) Urban Environment 3973-CO: Urban Environment Technical S S Assistance Project (ongoing) Technical Assistance 16260-CO, Regulatory Reform Technical S S Assistance Project Other development agencies IDB Financed, Water Supply & Sanitation Cartagena Sewerage Project IDB Financed, Private Sector Devdopment Privatization and Concessions in Infrastructure IDB Financed, Technical Assistance Technical Assistance - PSP Water and Sanitation in Bucaramanga IDB Financed, Technical Assistance Technical Assistance - Support to Regulation in the Water and Sanitation Sector IDB Financed, Water Supply & Sanitation National Water Plan, US$ 60 million, under preparation, aimed at supporting all the regions of the country and expected to be effective in 2002 IP/DO Ratings: HS (Highly Satisfactory), S (Satisfactory), U (Unsatisfactory), HU (Highly Unsatisfactory) 3. Lessons learned and reflected in the project design: Since 1975, the Bank has made 13 loans totaling approximately US$707 million for water supply and sewerage development in Colombia. The Bank's overall experience in Colombia's water and sanitation sector has been mixed, with satisfactory achievement of physical objectives but inadequate progress towards the institutional and financial performance goals set at appraisal. The main lessons that emerge are summarized below.  Page 22 Successfulperformance of utilities with PSP. Experience with privatized water utilities in Colombia is encouraging (see Annex 17). There is also positive experience with PSP in water utilities in other countries in Latin America such as Chile, Argentina and Bolivia (see Annex 18), and in other parts of the world. On the basis of this experience, a commitment of each participating municipality to sector reform based on incorporating the private sector in the management of its utility is a fundamental aspect of project design. Front-loading institutional reform. The most important lesson is that key institutional reforms should be front-loaded. This is reflected in the design of the present project. PSP is a condition for participating in the project and each utility will have to sign an operation contract with a private operator in order to access the loan funds. Safeguards against political interference. Past and present Bank experience in Colombia show a consistent pattern of political interference in the WSS sector. Consequently, there is an overriding need to protect the privately operated utilities in participating municipalities against political interference from future local government authorities. To this end, the agreements governing the transfer of government funds to the participating utilities, which will be signed between the MED and each municipality, will include the obligation of the municipal authorities to maintain private sector participation in the provision of the water and sewerage services in accordance with the signed contract. Violation of this condition will result in withdrawal of government financing. The agreement of financial support will be in effect also after the loan closing date. Even if a municipality violates the mentioned condition after the closing date, the government will still have the power and means to protect the operator, if he is mistreated by future mayors. Needfor Adequate Tariffs and subsidies. Past experience shows a need to restructure tariff systems and to improve public awareness on the true cost of water and sewerage services, while targeting social subsidies in such a manner that they directly benefit the poor. An important principle in preparing the PSP processes under the proposed project consists, therefore, of reaching an up-front agreement with each mayor regarding the tariff level in his municipality, ensuring that it will cover operational and maintenance costs as well as part of the investment costs. Also, the subsidy policy will directly benefit the poor and only the poor. Needfor utilizing appropriate design standards. On a technical level, past Bank projects in the sector have often fallen victim to chronic overestimation of water demand and frequent implementation delays, which, in an inflationary environment, have resulted in cost overruns for most of the projects. The focus on careful design through a strategy of minimum cost that is protective of the environment, and with a private operator in charge of design, will minimize the risk of over-design in the proposed project. Community consultation. Recent experience in the Philippines with a similar project highlights the importance of community acceptance of tariffs during the project preparation process. In the Philippines project, it was required that 60% of households agree to the proposed tariff. Community consultation also helps filter out investments for which there is not adequate demand. Notwithstanding these benefits, it is considered that for the proposed project in medium size cities, it would be impractical to seek agreement from such a high percentage of the population. Community consultation would be carried out in participating municipalities, but this would be done during project implementation rather than as an eligibility condition, since the willingness to pay is related to service improvement which occurs gradually. Experience gained with structuring PSP processes during project preparation. During project preparation, several PSP processes were completed both for medium size cities and for small municipalities. The lessons learned are summarized below.  Page 23 Providing Flexibility to add and drop municipalities . This is required since political commitment of mayors may change during implementation. Allocating adequate time for rebidding. Each municipality is different with its own peculiarities, so that a high level of flexibility must be maintained to reach a successful conclusion to the bidding process. Because of the high risks involved, flexible design has also to be accompanied by allocating adequate time for re-bidding in order to provide the appropriate incentives to attract bidders. Using a single consultantfor structuring a PSP process. Experience has shown that it is preferable to award just one consulting contract for preparing a PSP process, which will include the responsibility for all the activities involved, rather than dividing the preparation activities between two contracts: (i) preparing the program of works and investments; and (ii) preparing all the rest (financial projections, legal aspect, bidding document). Also, because of the complexity of the processes, consulting firms do not have the capacity to prepare more than 2-3 processes for medium size cities simultaneously. Hence, it is important to clearly define the distribution of responsibilities between the PIU and the consulting firms in a manner that would improve efficiency and productivity. The PIU should carry out the "Socialization" processes. The PIU needs to be the main actor in the "socialization" of the PSP process in each municipality; this responsibility cannot be delegated to consultants. The need to use model bidding documents and standardfinancial models. In order to ensure quality and standardized processes, it is advisable to request all consulting firms to use a standard financial model for the analysis of the new private sector managed utilities and to use model bidding documents and a PSP contract for preparing the transactions. Low capacity in small municipalities to contribute to investments. Contributions to investments in small municipalities are low. In better off municipalities they can be as high as 20%, whereas in municipalities with a high portion of low- income inhabitants it is much less. The government, therefore, needs to continue to be a fundamental stakeholder in financing the water and sanitation sector in small municipalities. Providing continuous support to newly privatized utilities. The signing of a PSP contract is only the start of a complex transaction process that requires several years to consolidate. The government, therefore, needs to provide continuous support to the privatized utilities in technical, financial and political aspects. 4. Indications of borrower commitment and ownership: The Central government is fully committed to the sector strategy supported by the project as indicated in the document "Cambio para Construir la Paz". This document has been approved by Congress, and outlines the key principles for reform of the water and sanitation sector in Colombia. Commitment to the project is also reflected by the following: * The government amended the Municipal Development Project Loan Agreement (Loan 3336-CO) and created a new component for water utilities' modemization, reallocating US$ 5 million, which have been used for the sector policy reform program; * The govemment fully adopted the sector reform program which now forms the basis of a national water sector policy; * The government has established a Project Implementation Unit staffed by a high quality multi- disciplinary team;  Page 24 * The government has disseminated extensively information regarding its policy, which resulted in generating an impressive demand by mayors for participating in the project; * PSP processes in about 15 medium size cities are underway as part of project preparation. One of them, in a city located in the Caribbean region, has been awarded and is expected to be signed shortly. * PSP processes in a pilot of 8 small municipalities has been carried out during project preparation and the government will finance from its own resources, in the form of subsidies, the main part of the investment programs in two municipalities which have managed to sign PSP contracts. 5. Value added of Bank support in this project: * Brings Bank experience and intellectual leadership with private participation in the water, sanitation and other sectors, gained in the region and elsewhere in the world. * Introduces transparency to the privatization process. * Brings techniques and experiences in extending water and sanitation services to the poor on a large scale. * Brings management discipline to the project. + Bank financing will act as catalyst for private sector financing. * Brings credibility to the project, thereby promoting participation of private operators. E. Summary Project Analysis (Detailed assessments are in the project file, see Annex 8) 1. Economic (see Annex 4): [X] Cost-Benefit Analysis: NPV= US$ 11.74 million; ERR= 28.12% (see Annex 4) []Cost Effectiveness Analysis [ ] Other A cost-benefit analysis which was carried out to determine the economic and financial viability of the project demonstrates that it is beneficial to the economy as a whole, as well as to each of the stakeholders, as detailed in Annex 4. A sample of the following 10 municipalities from all around the country was initially considered to be representative for the economic analysis: the medium size cities of Maicao, Cucuta, Sincelejo, Corozal, Quibd6, Flandes and Espinal, the regional system of ERAS, and the constructor-operator schemes of Cumaral and Nataga. At a later stage, the proposed loan was downsized to its current level and the project focus shifted to the Caribbean region. However, since a previous analysis on an extended sample had already been carried out, its results are presented in this PAD even though part of the medium size municipalities included in it are located out of the Caribbean region. The results of the cost-benefit analysis of the projects included in the extended sample analyzed show that 90% of the projects were economically feasible and their expected net impact on the economy is substantially positive. Only one project, in the municipality of Corozal, had a negative economic return. In this particular case, works could be redesigned to ensure that the investment financed and the incorporated efficiency gains would result in a desirable economic impact. The sample considered representative for the project includes 5 municipalities: Maicao and Sincelejo (medium size cities in the Caribbean region-CR), the regional system of ERAS (CR), and the municipalities of Cumaral and Nataga, located outside the Caribbean region, but still eligible to participate in the project because they are small municipalities. The results of the economic analyses of the utilities of the sample municipalities show that all the respective projects are viable, with EIRR values in the range 15 to 47%.  Page 25 Once the overall viability of the proposed reform in the sample utilities was verified, a distributive analysis was carried out to assess the impact of the reform on each of the stakeholders, which include the government (fiscal impact) and service users. The impact analysis on direct beneficiaries focussed on assessing the net impact on the poor. Finally, risk and sensitivity analyses were conducted to assess the impact of changes in critical assumptions on the economic viability of the reform in the sample utilities. Detailed results of these analyses are presented in Annex 4. 2. Financial (see Annex 4 and Annex 5): NPV=US$ 5.06 million; FRR= 16.0% (see Annex 5) A financial assessment of a sample of 5 utilities, which would potentially participate in the project, was carried under assumed conditions of future private operation. The main objective of carrying out the financial analysis was to develop a methodology which could be used during project implementation to ensure that only financially feasible transactions will be included in the project and to train the PIU staff in using that methodology. The specific objectives of the financial assessment of each municipal utility were to: (i) assess the financial feasibility of each of the proposed PSP contracts included in the sample municipalities, which have been prepared with the help of privatization consultants; (ii) assess the debt service capacity of the potential operators and their eligibility for obtaining commercial loans; and (iii) determine the main risk factors and the sensitivity of the overall feasibility of the operation contracts to these factors. The cost-benefit analysis described above determined the viability of the project on an incremental basis (net benefits from reform, i.e., the difference between "with" and "without" reform scenarios). The financial assessment then determined the viability of the operation contracts structures from the point of view of the investors and lenders. A privately operated company is financially viable, when: (i) NPVs of the utility operations (cash flow) and the returns to the shareholders are positive; and (ii) the main financial indicators (debt service coverage, debt equity ratio, and liquidity ratio) of the utilities are expected to remain sound throughout the lifetime of the operation contract. Financial assessment and projections were prepared for a sample of five municipal utilities under assumed conditions of future private operation. Three of the utilities correspond to the medium size municipalities of Maicao, Sincelejo and ERAS with populations of between 100,000 and 250,000 inhabitants; while the other two correspond to the small municipalities, Cumaral and Nataga, with less than 12,000 inhabitants each. The sample of municipalities on which the financial analysis was carried out is smaller than the sample used for the economic analysis and it includes only five municipalities out of the 10 included in economic analysis sample. The reason for the difference in the samples size is that the preparation of the financial analysis only began after reducing the loan amount and modifying the project focus to include medium size cities only from the Caribbean region while maintaining the all-country focus for small municipalities. At that stage, there was no reason to carry out a financial analysis of the medium size utilities located out of the Caribbean region, so only the utilities of Maicao, Sincelejo, Corozal and ERAS were maintained in the sample, as well as the small utilities of Cumaral and Nataga. It was decided to discard the utility of Corozal from the sample since it did not pass the economic analysis threshold, so the sample was finally established as including the five aforementioned municipalities. This is a reasonable sample size for the current project magnitude. The utilities included in the sample were found to be financially viable only when a government investment subsidy was included in each transaction. Using the tariffs proposed in the draft bidding documents, the average IRR of the sample, in real terms, was found to be 16% for the enterprise and 17% for investors. The net benefit is US$ 4.7 million for investors and US$ 5 million for the enterprise. The total government subsidy required was US$ 15 million. It was also found that when some adjustment were made in tariffs and in service targets in relation to the values used by the privatization consultants, the results improved: total profit for investors reaches US 9.3 million with an internal rate of return of 21% in real terms, while the results for the enterprise increased to US$ 9 million, achieving an IRR of 18% in real terms. The required subsidy decreased to US$ 10  Page 26 million. In the case of Sincelejo, the utility became financially viable even without requiring a government subsidy. For small municipalities the required government subsidy is estimated at about 70% of investment cost which corresponds to a subsidy of about US$ 300 per connection, or about US$ 60 per person served. For medium size cities the required government subsidy is estimated at about 15% of investment cost which corresponds to a subsidy of about US$ 100 per connection, or about US$ 20 per person served. The sensitivity and risk analyses show that the viability of the operation contracts is largely dependent on: (i) tariff level; (ii) rate of return expected by the investors; (iii) government and municipal subsidies; (iv) investment costs; and (v) bill collection rates. According to the results of the financial risk analysis, the variables who have the highest impact on the project's financial results are: (i) government subsidy; and (ii) investment cost overrun. The risk associated with the availability of subsidy funds will be mitigated by obtaining, before signing each operation contract, a clear government commitment to provide the required subsidy, using for that purpose the Bank loan funds. The risk associated with investment cost overruns should be mitigated by good management control of the private operator. Fiscal Impact: The net fiscal impact of the project is yet unknown since it depends on the municipalities participating in the project, which are unknown up front in a demand driven project. It is estimated that in the poorer municipalities, which require higher subsidies, the fiscal impact would probably be negative, while in the better off municipalities it may be positive. The Government gains from: (i) increased income from income tax paid by private operators; and (ii) increased VAT income due to increase in investment and materials purchases. However, under the proposed project the government provides capital investment subsidies to the consumers and it is estimated that in poor municipalities, the value of the collected taxes is unlikely to be high enough to compensate for the subsidies provided. The net fiscal impact on the government from the utility reform in the sample of 5 municipalities which were used for the financial analysis (Maicao, ERAS, Sincelejo, Cumaral and Nataga) is estimated to have a positive value of about US$3.5 million. However, this positive value is driven by the high positive fiscal impact of Sincelejo, which is the largest city in the group and the only one with a positive impact (of US$ 7.39 million). 3. Technical: It is expected that by the end of the project, about a third of the water utilities in medium size cities in the Caribbean region, (about 20 cities), will have completed PSP transactions. This includes some cities which have already signed PSP contracts without project support. Likewise, it is expected that about 15 out of the I 10 small municipalities in the Caribbean region, as well as about 10 small municipalities in other parts of the country, will have incorporated small private entrepreneurs in the management and operation of their water systems. As a result of the project, the management of the water services for a significant part of the population in the Caribbean region will be better shielded from political interference in their operation, and the way will be paved to improving the level of service for this population through the management expertise of the private sector. It is expected that such a widespread level of PSP will change the sector characteristics and mode of performance, not only in the Caribbean region but in the entire country, by encouraging continuation of similar reform activities. The main portion of the project funds will be used to finance civil works and equipment for improvement of water supply and sanitation services in about 3 medium size cities and in about 25 small municipalities. These investments are expected to comprise generally routine upgrades and rehabilitation to the existing systems. In the medium size cities, the scope of works will be determined by the private operators, as part of the POIs (programs of works and investments) which they will submit. The detailed designs will also be prepared by them. The works and goods will be procured by the private operators, in accordance with Bank guidelines. The supervision of works will be carried out by consulting firms which will be hired for that purpose, while the adherence to the Bank procurement guidelines will be the responsibility of the  Page 27 PIU. In the small municipalities, the works will be designed by consultants hired by the PIU, and will be carried out by the private operators, "constructors-operators". The supervision of works in small municipalities will be carried out by consulting firms hired for that purpose. 4. Institutional: 4.1 Executing agencies: The executing agency of the TA component of the project is the Project Implementation Unit (PIU) in the Directorate of Water and Basic Sanitation (Direccion de Agua Potable y Saneamiento Basico) in the Ministry of Economic Development. The executing agency of each investment subproject will be the utility of the municipality, managed by a private operator. It is assumed that these private operators will have the capacity to manage and execute their investment programs. The PIU will control and monitor the performance of the executing agency of each subproject and will ensure that when using Bank funds, they comply with the Bank's guidelines. The PIU will also provide appropriate training to the executing agencies. 4.2 Project management: Overall project management will be carried out under the guidance of the Director of Water and Basic Saanitation in MED, who will also be responsible for policy issues and overall coordination of municipal and departmental governments. The PIU in MED will be the implementation agency of the project. It will supervise the implementation of subprojects and manage all the technical assistance activities through a team of about 17 consultants financed under the loan. This team has already been working on the implementation of component E of Loan 3336-CO. Component E supported the preparation of the proposed project, and the team has gained valuable experience in structuring PSP processes, in social aspects related to PSP and in Bank procedures related to procurement, disbursement, reporting and auditing, all of which will help it manage the project successfully. A detailed description of the PIU functions will be included in the Project Operational Manual. Being a unit in a government ministry, the PIU suffers from limitations typical to such units, exacerbated by frequent changes in the Minister of Economic Development. Changes in its staffing are therefore likely. In order to minimize the risk of disruption in project management, the Bank will organize periodic training sessions for the PIU on various aspects of project management, in conjunction with supervision missions. Oversight of project management will be provided by an inter-institutional committee, "Comite Coordinador Interinstitutional DNP-MDE", formed specifically for this project. This committee comprises representatives from MED and two units of the National Department of Planning (DNP): (i) DDUPRE; and (ii) the Caribbean Plan Program. 4.3 Procurement issues: When implementing works financed with Bank funds, the subproject implementation agencies, the private operators, will adhere to the Bank procurement guidelines. When using financing investments which they have committed to provide, or while using municipal resources, other procurement procedures may be used. The PIU will provide procurement training to the executing agencies and will control and monitor their performance and ensure that they comply with the Bank procurement guidelines. For the technical assistance components, which will be implemented under the responsibility of the PIU and financed by the Bank, Bank procurement guidelines will be used for hiring of consultants and for purchasing goods.  Page 28 4.4 Financial management issues: Financial management will be the responsibility of the PIU. Administration of funds will be carried out through a fiduciary agency, which will open two accounts: one 9the special account) for depositing the loan funds from the Bank and the other (the project account) for depositing the govemment counterpart funds. The PIU will receive withdrawal requests from the participating executing agencies and will authorize them as warranted, instructing the fiduciary agency to transfer corresponding amounts to the service providers of the executing agencies. Each executing agency will report to the PIU on the use of funds at the subproject level. The PIU will also instruct the fiduciary agency to execute payments to consultants, goods and service providers, in conjunction with activities under the TA components which will be managed directly by the PIU. The PIU will be responsible for reporting to the Bank as well as sending withdrawal applications to the Bank. 5. Environmental: Environmental Category: B (Partial Assessment) 5.1 Summarize the steps undertaken for environmental assessment and EMP preparation (including consultation and disclosure) and the significant issues and their treatment emerging from this analysis. Since most investments financed by the project will be used for rehabilitation of existing water systems, the project will not have any significant negative environmental impacts. Moreover, positive environmental and social impacts are envisioned as water service level, coverage and quality improvements in participating municipalities. The project, however, will ensure proper environmental screening and enforcement measures to guarantee that all investments pay appropriate attention to environmental issues and comply with existing environmental norms and procedures in the country. Water and sewerage rehabilitation projects will not entail any resettlement of population, and specific eligibility criteria for municipalities will establish that projects entailing resettlement will not be accepted. An environmental assessment of the water and sanitation sector (SEA) carried out during project preparation, identified key legal and institutional issues related to environmental management in the sector. Colombia has severe environmental pollution problems. These problems have been exacerbated by intense urbanization rates and industrialization, an inadequate environmental regulatory framework and a long-standing backlog in sanitary and waste treatment infrastructure. Only about 5% of collected sewage receives any kind of treatment, well below regional levels. Fragmentation of institutional responsibilities and lack of coordination have led to an uneven and often confusing regulatory and institutional framework for environmental management as it pertains to the water and sanitation sector. Regional environmental institutions (Corporaciones Regionales), with which the municipalities benefiting from the project will have to deal, are weak (with a few exceptions). Environmental licensing processes for private operators may become cumbersome and the capacity to monitor environmental conditions at the regional level is almost non-existent. Environmental regulation of the water and sanitation sector in Colombia is the responsibility of weak institutions of the national and local governments. The responsibilities of different sectoral ministries and local entities are often overlapping. Wastewater treatment levels and effluent discharge standards do not allow for cost-effective solutions even if the existing law hints that proper consideration be given to receptor body assimilation capacity. Non-domestic discharges to sewerage networks lack a proper regulatory framework and definition of institutional responsibilities for their management and control.  Page 29 5.2 What are the main features of the EMP and are they adequate? The environmental assessment proposes an action plan, to be financed by the project, that will: (i) strengthen the legal and institutional frameworks through revision of existing laws and regulations and redistribution of tasks among responsible institutions; (ii) strengthen the capacity of the regulatory and enforcement agencies, clarifying roles, responsibilities and budget requirements and taking into account economic and financial analysis of environmental regulations; (iii) prepare environmental guidelines for design and construction of civil works and for environmental auditing procedures of existing works; (iv) clarify environmental requirements for the private operators and determine environmental liabilities; (v) prepare an environmental annex for bidding documents for use in the selection of private operators; and (vi) monitor compliance, ensure enforcement and proper reporting of environmental issues in the sector. Specific outputs of the SEA are already available, including: (i) a detailed set of environmental specifications and requirements to be included in all bidding documents and contracts; (ii) a methodology for environmental impact assessment criteria and procedures for water and sanitation projects; (iii) draft environmental guidelines for the construction of water and sewerage systems; and (iv) an institutional strengthening program to improve environmental management capabilities in water and sanitation sector agencies. During project preparation, agreements have been reached among the main stakeholders (Ministry of Economic Development, Ministry of the Environment and DNP) in regard to cooperation during project implementation aimed at working towards the resolution of the described problems and supporting the implementation of the proposed project. The cooperation activities will focus on: (i) implementation of the Environmental Management Plan of the project; (ii) harmonizing the inconsistencies within the current legislation (mainly between Decrees 1594 and 901); (iii) improving procedures (including institutional responsibilities) for issuing environmental licenses for water projects; (iv) evaluation of environmental risk and identification of mitigation mechanisms which would be included in operation contracts; and (v) involving the CRA in effort to establish mechanisms that would enable the inclusion the tasas retributivas in the water tariffs. An inter-institutional task force (the environmental task force), which will include representatives of the Ministry of Economic Development and the Ministry of the Environment, will be constituted before project effectiveness to work on all the mentioned issues, build consensus on environmental aspects, mitigate the risk to the project resulting from the current legislation and resolve during project implementation ad-hoc problems related to specific subprojects, in cooperation with the respective regional environmental authority. 5.3 For Category A and B projects, timeline and status of EA: Date of receipt of final draft: December 31, 2000 The SEA report has been finalized and reviewed by the Bank. After consultation with relevant stakeholders, a final draft has been sent to the Bank before appraisal. 5.4 How have stakeholders been consulted at the stage of (a) environmental screening and (b) draft EA report on the environmental impacts and proposed environment management plan? Describe mechanisms of consultation that were used and which groups were consulted? The SEA has been subjected to intensive institutional and public consultation with the participation of the Ministry of Environment, Ministry of Development, National Department of Planning, Regional Environmental Agencies, water sector Regulatory agencies, private operators, academics, professional associations, NGOs and public defense groups. A national level workshop took place prior to appraisal. The project will finance an environmental component to support the implementation of the most critical activities identified in the sectoral action plan defined in the SEA.  Page 30 5.5 What mechanisms have been established to monitor and evaluate the impact of the project on the environment? Do the indicators reflect the objectives and results of the EMP? For the PSP processes, environmental requirements, guidelines and targets are being written into the operation contracts. As part of the long-term strategy for improved environmental management in the water and sanitation sector in Colombia, the project will support the EMP for the water and sanitation sector described above. Environmental management capacity will be strengthened in key sectoral agencies, especially the Water and Sanitation Division of the Ministry of Economic Development, so as to improve its capacity to supervise subprojects. 6. Social: 6.1 Summarize key social issues relevant to the project objectives, and specify the project's social development outcomes. A Social Assessment study was carried out to analyze the key social issues of the project and guide the design of mitigation measures of negative impacts. The key social issues relevant to project objectives include: (i) socio-economic burden of water cost before and after project; (ii) consensus building and community participation strategy; and (iii) labor force reduction and measures for mitigation of its impact. The expected social development outcome of the project is to achieve at least 80% of household water connections in low income areas (defined as connections for strata 1, 2 and 3) in each participating municipality. The social assessments study was carried out on a sample of six municipalities: the five used in the financial analysis plus the municipality of Quibdo, which was considered to be of interest because it is one of the poorest in the country. A summary of the social assessment study is presented in Annex 13. The project targets the Caribbean region where about 40% of the population is below the poverty line and about half of this poor population lives in conditions of misery. The level of water and sanitation services in medium size cities and small municipalities, which are potential participants in the project is currently quite low. Nominal average water coverage in the project area is estimated at about 75% for water and about 50% for sewerage. However, the effective water coverage, taking into account continuity of supply and water quality, is only about 45% in medium cities and less than 30% in small municipalities. Also, service delivery is focused on providing water to high income areas. The poor and unreliable water and sanitation services, especially in low income areas, have significant negative social implications. The project will have a positive impact on improving the living conditions of the population in the participating municipalities, and especially of those residing in low income areas, by expanding the coverage of water and sewerage services, improving water quality and incrementing service continuity. Considering the project targets with respect to improving the coverage and the level of services, as well as the subsidy policy applied under the project, it is expected that its impact on household expenses on water will vary, depending on the pre-project level of services as follows: (i) if the current service is extremely poor and forces households to buy water from alternative suppliers, it is expected that the social impact of the project will be remarkably positive for all the socio-economic strata; water consumption will increase and the expenses on purchase of water will decrease (by as much as 13% in stratum I in Maicao); (ii) if the current service already reaches a reasonable coverage rate and quality, the project's social impacts are also expected to be positive. However, it would provide different benefits to different socio-economic strata: the poor, who in general receive services of lower quality, will benefit from improved services, while the wealthier will continue to receive good services. Under this scenario, the consumers in all socio-economic strata will spend more on the purchase of water, however, the  Page 31 increase in the expenses on water purchase will not be higher than 5.1% (stratum 2 ERAS) and smaller in the other municipalities. This level of increase in expenses will not have a significant effect on the households socio-economic conditions. (iii) For consumers in all the socio-economic strata, in both scenarios the monthly expenses on purchase of water after the project (i.e., the monthly water bills) will not exceed, on average, 8% of monthly household income and in most cases it will be lower than that (in the range of 4 to 8%). The project aims at supporting 2-3 medium size water utilities and about 25 small municipalities. The estimated total number of employees in the medium size utilities would be between 300 to 500, while the total number of employees in the small municipalities is estimated at 100-150. In the worst case scenario, the number of employees in the medium size utilities would be reduced by half under private operation, whereas in the small municipalities it is not expected to be reduced. The labor issues associated with the project are spread over a large area. Through the project, significant funds will be invested in each municipality, of which about 35% will be directed to creation of new jobs. Most of the remaining 65% will be applied to material, mainly of local origin, which contributes to the local economy. Several mitigation measures will be incorporated into the project to ease these labor problems. These measures include voluntary separation programs and retrenchment training and activities. 6.2 Participatory Approach: How are key stakeholders participating in the project? Activities to promote community participation will be undertaken by a multidisciplinary team (engineers, PSP and social specialists), which forms part of the PIU. This team will be responsible for participation, taking advantage of the lessons learned from the pilot project implemented during preparation, as well as of the experience of private operators in Colombia. The form of stakeholder participation is different in small municipalities and in medium size cities. It also depends on the project phase and is different in the first phase of PSP preparation and in the second phase in which the services are operated by the private sector. In medium size cities stakeholder participation will involve representatives from the public and private sector, including municipal authorities, municipal council, commerce and industry associations, engineers associations, environmental authorities and licensing entities, NGOs, community organizations, press and media, etc. The local community as a whole will be informed about the reform through a media campaign (press, radio, TV). In small municipalities, stakeholder participation will directly involve the residents, through their community organizations, neighborhood representatives, user entities, local leaders, religious leaders, etc., on top of all other relevant public or civil society organization existing at the municipal level. To promote participation of small municipalities in the project, as well as community acceptance, it was considered advisable for the PIU to associate with a strategic partner which would support the "socialization" process. The Regional Autonomous Corporations (CRAs), which are the regional environmental authorities, could serve as strategic partners, since they share the common goal of improving sanitation services and safe wastewater disposal. During the first phase of the sector reform, the duration of which might be 6 to 12 months, the participatory process will be intensive. This phase will successfully conclude when the proposed reform obtains a favorable public opinion. Without such support, mayors will be reluctant to proceed with the reform. During the second phase, namely the phase of operation and management of the systems by the private sector, public participation will take the form of creation and operation of the "veedurias populares". These "veedurias populares" are public committees whose task is to act as independent public reviewers of the performance of the private operators, and to provide information to the public, as a means of ensuring utility accountability to consumers.  Page 32 Finally, after a detailed analysis it was decided not to seek an up front formal commitrnent from a significant portion of the community in each municipality regarding the acceptance of the increased tariffs. Achievement of such a commitment in medium size cities is practically impossible, because of the large number of consumers. It might be possible in small municipalities. However, since the improvement in service will come gradually, and since the willingness to pay is related to the service improvement, the up front community approval approach was not considered advisable. 6.3 How does the project involve consultations or collaboration with NGOs or other civil society organizations? The participatory and consultation program will involve NGOs and civil society organizations as part of the strategy of strengthening community adherence to the project. 6.4 What institutional arrangements have been provided to ensure the project achieves its social development outcomes? Provision of services to the poor will form part of the contracts with the private sector. The use of Bank funds to subsidize the poor will form part of the Loan Agreement. 6.5 How will the project monitor performance in terms of social development outcomes? The percentage of households in low-income areas connected to the water network, which is the performance indicator for social development outcome, will be stipulated in the PSP contract of each participating municipality and will be monitored by the municipal authorities as part of the PSP contract control, and also by the PIU. 7. Safeguard Policies: 7.1 Do any of the following safeguard policies apply to the project? Policy Applicability Environmental Assessment (OP 4.01, BP 4.01, GP YES 4.01) Natural habitats (OP 4.04, BP 4.04, GP 4.04) No Forestry (OP 4.36, GP 4.36) No Pest Management (OP 4.09) No Cultural Property (OPN 11.03) No Indigenous Peoples (OD 4.20) No Involuntary Resettlement (OD 4.30) No Safety of Dams (OP 4.37, BP 4.37) No Projects in International Waters (OP 7.50, BP 7.50, No GP 7.50) Projects in Disputed Areas (OP 7.60, BP 7.60, GP No 7.60) 7.2 Describe provisions made by the project to ensure compliance with applicable safeguard policies. Local screening studies undertaken for the environmental analysis certify that the nature of required investments for water and sanitation services improvement, which include existing infrastructure rehabilitation and extension, should not entail population displacement. Eligibility criteria for subproject financing include the screening for population displacement. In case a specific subproject requires population displacement, it would not be eligible for participating in the project.  Page 33 F. Sustainability and Risks 1. Sustainability: The main factors that support the sustainability of the project are: * Institutional reform supported by the project promotes incorporation of the private sector in the management and operation of the utilities. PSP is considered the key instrument in ensuring project sustainability. * Participating municipalities will have to complete the PSP process prior to obtaining access to project financing, so the institutional reform will be implemented up-front. * Selection of the private operators will be achieved through transparent competition for the market, on the basis of one clearly defined economic criterion. + In medium size municipalities the project will finance utilities with a 20-30 year operating and planning horizon and a well-defined and realistic investment plan which would be formulated by the operators, with designs having also been prepared by them. * In small municipalities, the works will be carried out by the operators, who will have the incentives to construct them to the highest quality standard possible, since they themselves will have to operate the installations for the duration of the operation contracts. * The tariff level at the time of the award of each operation contract will be agreed upon with the mayor and will be communicated to the community prior to the PSP process. i A proactive strategy and a credible mechanism to address the issue of expanding services to the poor will be implemented. 2. Critical Risks (reflecting the failure of critical assumptions found in the fourth column of Annex 1): Risk Risk Rating Risk Mitigation Measure From Objective to Goal Interest from local and international operators in S Flexible design of the program to adjust to the pace the W&S sector in Colombia declines. of private operators interest, allocating time and funds for rebidding. Government has no capacity to ensure sector M Through sector dialogue, Bank management will policies are maintained during an extended period. try to convince the government to maintain the right policies. Continuity of policies depends also on local governments and their multiplicity provides The newly proposed regulatory framework (which S safegard against complete change of policies. is planned to be innovative and based on Hiring of local private operators, which is a target deregulation of all system components except supported by the project, contributes to continuity. water supply and sewage networks) does not Successful performance of the private operators is provide credibility and deters private operators. the most significant factor in ensuring continuity in policy. The Bank is working with the CRA and provides TA, under another project (Regulatory Reform Technical Assistance Project, 1 6260-CO). in an effort to help the CRA come up with a credible regulatory framework. A Bank supported workshop was held to review the implications of the new framework and support the CRA in taking responsible decisions. Utilization of independent public disclosure of service performance will be practiced as a means of ensuring CRA's and utility accountability to consumers. From Outputs to Objective  Page 34 Risk Risk Ratinq Risk Mitigation Measure Support to PSP from future local governments and S Carrying out adequate promotion of the reform community is not provided. prior to PSP, and an information campaign, social and community participation and consultation activities. Applying realistic initial assumptions and moderate expectations. Inconsistency in environmental legislation and M It is expected that the activities under project weakness of environmental institutions have component B (Strengthening Sector Environmental negative impact on activities and financial Management Capacity) will assist in resolving the situation of participating utilities. legislation inconsistency issue and contribute to relaxation of too stringent environmental requirements. An inter-institutional environmental Task Force which will be established under the project will also work with the respective CARs to resolve issues of specific PSP processes, establishing appropriate levels of treatment based on the uses of the specific receiving body and considering a waiver of contamination tax or modification of schedule of payment as warranted. Utilization of independent public disclosure of the performance of the environmental authorities will be practiced as a means of ensuring responsible performance and accountability. The legal and regulatory framework established M The government established a commission by Law 142 is changed by Congress. composed by the Ministers of Economic Development, Mines and Energy and Communications, the Directors of the three Regulatory Commissions (energy, communications and water), the "Superintendente de Servicios Puiblicos" and two Congress members, whose purpose is to analyze the current situation of the public services sector and to provide an adequate response to existing problems which triggered the legislative initiatives for change, but without modifying Law 142. From Components to Outputs Insufficient political support to PSP from local S Matching contribution of central government grants government. to construct infrastructure would provide incentives for local governments to participate in the project and provide the necessary support to it. Initial tariffs authorized by local governments are S Tariff negotiations will be based on financial too low. projections and adequate tariffs will be an eligibility criterion Insufficient interest from private operators in H Flexible design of the project to adjust to the pace project supported utility privatizations. of private operators interest. Creating the interest of small operators through the Constructor- Operator approach. Allocating adequate time for rebidding. Delays and corruption in the procurement of PSP S Transparency in PSP procurement processes and  Page 35 Risk Risk Ratinp Risk Mitigation Measure contracts. contracts awards, which would be based on one clear, easily defined economic criterion, close supervision of procurement processes and timely Bank support. Frequent management changes in related S The project is consistent with government strategy, govemment agencies. is expected to enjoy continuity, and be relatively immune from management changes. Currency devaluation and interest rates exceed the S Macroeconomic stability will have to be maintained forecasted values and cause cost overruns. by the government. In case of cost overruns, the government will need to provide the additional required funds to complete the public sector support obligations. Otherwise, less works financed by the public sector will be implemented. Delays in availability of financial resources of the S Only financially viable private operators will be private operators and in provision of counterpart eligible for contract award. Agreements with funds by municipalities. government agencies regarding counterpart funds and with municipalities regarding Law 60 transfer contributions will be reached up front and will form part of the Loan Agreement. Delays in provision of funds by the private sector and municipalities will trigger a halt in provision of Bank funds. Works in the Caribbean region, totally financed by Government will delay the provision of funds for H the Bank, would be financed in tranches. The works in parts of the country out of the Caribbean trigger for financing each tranche will be the region, which need to be totally financed by corresponding financing of a tranche of works out government resources. of the Caribbean region, financed by the government. Risk mitigation out of reach General security status in the country and in H project areas continues to deteriorate, resulting in deterrence of private operators. Overall Risk Rating H Risk Rating - H (High Risk), S (Substantial Risk), M (Modest Risk), N(Negligible or Low Risk) 3. Possible Controversial Aspects: The three main following potential controversial aspects were identified: (i) planned increases in tariffs; (ii) labor force reduction; and (iii) environmental legislation related to the water sector. Tariff increases: One of the basic concepts of the project is to reach agreements with the mayors of participating municipalities regarding tariff increases, so as to improve the attractiveness of municipal utilities to PSP. Tariff increases are always controversial and unpopular. Mitigating measures will be implemented through public information campaigns, community participation and consultation events, contact with community representatives, NGOs, municipal councils and politicians to explain and promote the project concepts and justify the tariff increases.  Page 36 Labor force reduction: One source of inefficiencies in ailing public utilities is a higher than required number of employees. Private operators will certainly tackle this issue and reduction in the number of employees of the utilities in the participating municipalities is expected and will be a controversial issue. This issue, and the related mitigation measures, are discussed in the Social section of the Summary Project Analysis. Current environmental legislation related to the water sector: The current environmental legislation (mainly Decrees 1594 and 901), which sets water quality standards and tasas retributivas for water contaminant discharges, reflect priorities that need to be harmonized with the water sector policies and priorities which the project aims to support. The existing inconsistencies in legislation coupled with the institutional weakness of regional environmental authorities (CARs) who are in charge of law enforcement, and rigidities in the water sector legislation with respect to the transfer through water tariffs of pollution costs to consumers, send mixed messages to the water utilities and generate confusion and resistance to comply with the current legislation. The existing situation thus constitutes an unstable regulatory environment regarding the environmental legislation and obligations, posing a potential risk to the proposed privatization program supported by the Water Sector Reform Project. G. Main Loan Conditions 1. Effectiveness Conditions e The Project's Operation Manual, satisfactory to the Bank, has been completed. e PIU maintained fully operational, with an adequate team of experienced professionals, including a new procurement specialist and two new financial management specialists (a financial coordinator and a public accountant). * The Model of Technical Assistance Agreement (between the government and a municipality), satisfactory to the Bank, has been prepared. * The Model of Subproject Agreement (between the government and a municipality), satisfactory to the Bank, has been prepared. * The Environmental Task Force, comprising representatives of the Ministry of Environment and the Ministry of Economic Development, has been established. * A Project Agreement (Project Agreement 1), acceptable to the Bank, in respect of the subprojects components of the project, has been signed with an Assistance Entity.