Peru - Water Supply and Power Engineering Project

Document of The World Bank FOR OFFICIAL USE ONLY Report No. P-2277-PE REPORT AND RECOMMENDATION OF THE PRESIDENT OF THE INTERNATIONAL BANK FOR RECONSTRUCTION AND DEVELOPMENT TO THE EXECUTIVE DIRECTORS ON A PROPOSED LOAN TO THE REPUBLIC OF PERU FOR A WATER SUPPLY AND POWER ENGINEERING PROJECT October 18, 1978 This document has a restricted distribution and may be used by recipients only In the performance of their official duties. Its contents may not otherwise be disclosed without World Bank authorition.  CURRENCY EQUIVALENTS Currency Unit = Sol (S/.) Calendar 1977 October 10, 1978 US$1 = S/.80 179.10 S/. I - US$0.0125 0.0056 FISCAL YEAR January 1 to December 31 ABBREVIATIONS AID U.S. Agency for International Development COFIDE Corporacion Financiera de Desarrollo (National Development Bank) ELECTROLIMA Electricidad de Lima (Lima Power Company) ELECTROPERU Electricidad de Peru (National Power Company) ESAL Empresa de Saneamiento de Lima (Lima Water Company) IDB Inter-American Development Bank KfW Kreditanstalt fuer Wiederaufbau MVC Ministerio de Vivienda y Construccion (Housing and Construction Ministry)  FOR OFFICIAL USE ONLY PERU WATER SUPPLY AND POWER ENGINEERING PROJECT LOAN AND PROJECT SUMMARY Borrower: Republic of Peru. Beneficiary: Empresa de Saneamiento de Lima (ESAL) for the water supply component (US$4.9 million). Amount: US$8.8 million. Terms: Repayable in 10 years including 2-1/2 years of grace with interest at 7.35 percent. Each of the loan's two components would be refinanced by any future loan for a project prepared under that component. Relending Terms: The Government would onlend US$4.9 million to ESAL on the same conditions as the Bank loan. Moreover, the National Development Bank (COFIDE) -- which would, on behalf of the Borrower, be a party to the subsidiary loan agreement -- would receive a commission from ESAL of 0.75 percent per annum for administering the subloan and supervising a financial rehabilitation program for ESAL. ESAL would bear the foreign exchange risk. Prolect Description: The project would lay the basis for a long-term solution to Lima's water supply problems and update studies for a major hydropower plant. Its elements are: The ESAL Component Assessment of water resources and demand in the Lima Metropolitan area -- including a leak detection, correction and metering program; development of a water supply and sewerage master plan; preparation of a future water supply project; and strengthening of ESAL's organization, management and finances. The Mantaro Component Completion of studies for the Mantaro transfer and Sheque hydroelectric projects which would expand generating capacity in Peru's Central Region and assure Lima's water supply in the long term. I This document has a restricted distribution and may be used by recipients only in the performance I of their official duties. Its contents may not otherwise be discsed without World Bank authorization.  - ii - Special The project faces no special risks although ESAL would Risks: have difficulties in providing counterpart funds for the ESAL component and in servicing its sub-loan if water rates were allowed to decline in real terms. Special provisions in the Loan, Project and Subsidiary Loan Agreements are designed to assure that ESAL's revenues will remain at adequate levels. Estimated Costs: ------US$ million------ ESAL Component Local Foreign Total (a) Leak detection, correction and metering 0.41 1.98 2.39 (b) Water and Sewerage Master Plan 0.41 1.63 2.04 (c) Organization, management and financial studies; project management 0.10 0.40 0.50 0.92 4.01 4.93 Contingencies: Physical 0.09 0.40 0.49 Price 0.22 0.49 0.71 Subtotal 1.23 4.90 6.13 Mantaro Component Studies 0.80 3.20 4.00 Contingencies: Physical 0.08 0.32 0.40 Price 0.19 0.38 0.57 Subtotal 1.07 3.90 4.97 Total Project Cost 2.30 8.80 11.10 Financing Plan: Bank - 8.80 8.80 ESAL 1.23 - 1.23 Government 1.07 - 1.07 Total 2.30 8.80 11.10 Estimated Disbursements: Bank FY 1979 1980 1981 Annual 1.20 6.20 1.40 Cumulative 1.20 7.40 8.80  - iii - Rate of Return: Not Applicable Consultants: 1,100 man/months of technical and supporting personnel, including a project manager for the ESAL component. The average cost of consulting services, excluding contingencies, is estimated at US$7,000 per man/month. Appraisal Report: None   INTERNATIONAL BANK FOR RECONSTRUCTION AND DEVELOPMENT REPORT AND RECOMMENDATION OF THE PRESIDENT OF THE IBRD TO THE EXECUTIVE DIRECTORS ON A PROPOSED LOAN TO THE REPUBLIC OF PERU FOR A WATER SUPPLY AND POWER ENGINEERING PROJECT 1. I submit the following report and recommendation on a proposed loan to the Republic of Peru for the equivalent of US$8.8 million to help finance a Water Supply and Power Engineering Project. The loan would have a term of ten years, including two and a half years of grace, with interest at 7.35 per- cent per annum. The Government would relend part of the loan to Empresa de Saneamiento de Lima (ESAL) on the same terms and conditions as the Bank loan plus a commission of 0.75 percent per annum to the National Development Bank (COFIDE) for administering the loan. ESAL would bear the foreign exchange risk. In accordance with the normal procedure for preinvestment loans, the loan would be refinanced by any subsequent project loans arising out of this engineering project. PART I - THE ECONOMY 2. A report entitled "Economic Position and Prospects of Peru" (No. 655-PE) was distributed to the Executive Directors on March 3, 1975. A basic economic report on Peru is now being completed. The following para- graphs are based on this report and on the findings of several visits to Peru during the course of this year. Country data sheets are attached as Annex I. 3. Peru, the fourth largest country in Latin America, is divided by the Andes mountains into three distinct regions. The Costa, about 10 percent of the country's territory, is a narrow belt of dry plains, intermittently irrigated valleys and Andean foothills, where 46 percent of the population lives. Modern economic activity is concentrated in the Costa, particularly in Lima. The Sierra, with 44 percent of the country's population, encompasses the highlands above 2,000 meters which occupy about one-fourth of the country. The remaining two-thirds of the area is occupied by the sparsely populated Selva, vast tropical lowlands east of the Andes. The rugged topography limits trade between the three regions. 4. Peru has abundant natural resources. These include the large deposits of varied minerals located mainly in the Sierra and the southern coast. Another major natural resource asset is the large fishing potential of the offshore waters, although the magnitude of this potential is subject to sharp fluctuations. In contrast to mining and fishing, agricultural land is limited. Most of the soils suitable for intensive agriculture (3.5 million ha or 3 percent of the country's total area) are already being farmed. The remaining land with good agricultural potential is concentrated in higher parts of the Selva, with high costs of access and clearance. It would also be possible to expand the arable land in the Costa, but this would require drainage and salinity control or high-cost irrigation schemes. Although  - 2 - Peru's water resources are abundant, their geographical and seasonal distri- bution is unbalanced. East of the Andes, an extensive river system carries an immense water flow into the Amazon basin. West of the Andes, most of the rivers are seasonal streams that swell in the summer months. Future manage- ment of water resources will require heavy investments to maximize the use of westward flowing rivers. 5. Since the military came into power in 1968, the Government has followed a development strategy directed toward linking economic growth with a transformation of society to achieve broader popular participation in the country's economic, social and political life. This strategy aimed at narrow- ing the sharp differences in wealth and opportunities between income classes and geographical regions. The Government has tried to correct these imbalances by expanding the role of the State in the economy, changing the pattern of asset ownership, reducing foreign ownership of national resources, orienting industry and agriculture toward producing essential goods for the domestic market, stimulating the deconcentration of economic activity out of Lima, and reforming the educational system to make it more responsive to local economic and social needs. Through nationalization and creation of new enterprises, the State has taken direct control of over 150 enterprises in key economic sectors, and its share in total capital formation has risen from less than one-fourth in 1968-70 to over one half in 1974-76. Finally, through complex legislation, the Government has imposed strict controls on the operations of the non-public sectors. 6. As a result of these actions, the pattern of asset ownership in the economy has changed drastically. Through nationalization, the share of assets owned by foreigners fell sharply. A sweeping land reform redistributed 45 percent of the country's best farmlands to workers' cooperatives benefit- ting some 25 percent of all rural families. Through other laws, the industrial workers were given shares in the firms which employed them and those in the mining sector a share in profits. The Government has also given a strong autarkic orientation to its agricultural and industrial sector policies and strenghened the incentives for industries outside of Lima. At the same time, the groundwork has been laid for an important reform of the educational system. 7. One of the most significant achievements of the Government was the promotion of the cultural and political integration of the country. Owing in great part to the land reform, the rural population has become better organized to communicate its priorities in a more forceful and articulate way. 8. While the Government's programs have benefitted large numbers of Peruvians, they have not reached the poorest half of the population which continues to live in abject poverty. It is estimated that 70 to 75 percent of rural families, including the "minifundistas" (those farming less than 2 ha) and the seasonal landless workers, have not been reached by social programs. The Government imposed controls on prices of a number of domestic- ally produced goods, and heavily subsidized imported petroleum and foodstuffs. Most of the subsidized products, however, were not important in the consump- tion basket of the poorest groups. Moreover, price controls in some cases hurt the poor as producers.  9. Through 1977, the Government followed expansionary fiscal and credit policies. The rapid increase in spending by the public sector was not matched, however, by a parallel increase in revenues. Pricing, interest rate and foreign exchange policies encouraged consumption and discouraged savings and exports. As a result of these policies, aggregate demand considerably exceeded aggregate supply. This excess demand, in turn, led to widening external gaps and to strong inflationary pressures, with a resulting loss of international reserves and a massive build-up of external debt. This imbalance was aggravated by circumstances beyond the control of the authorities. Anchovies, the fishing industry's principal catch, disappeared, and copper and sugar export prices dropped to extremely low levels. Furthermore, petroleum reserves turned out to be far less than expected and with high access cost, which made the rise in oil prices militate against and not for the Peruvian economy. 10. Public sector savings dropped steadily in relation to GDP from 4.6 percent in 1970 to dissavings of 2.8 percent in 1977. A major cause for this was a massive erosion of the tax base owing to excessive tax holidays, exemp- tions and weak enforcement. At the same time, there were rises in the budget- ary cost of subsidies for foodstuffs and petroleum products, and sharp increases in non-developmental expenditures. Much of public investment, furthermore, has been increasingly concentrated on capital-intensive projects with long gestation periods which have so far contributed little to the growth of output or employment. 11. Inflation acceierated from 5 percent per year in 1970 to 38 percent in 1977. Interest rates on domestic banking system loans, however, remained substantially negative in real terms, discouraging financial savings and stimulating capital flight. The exchange rate, furthermore, remained prac- tically constant between 1968 and 1975, thus contributing to the overall dis- equilibrium. National savings fell dramatically from 16 percent of GNP in 1970 to 8 percent in 1977, financing only about one-half the level of invest- ment in this last year. These trends inevitably exerted an effect on economic growth which progressively declined in real terms. Following a period of rapid expansion in 1968-74 during which GDP grew by more than 6 percent per year, the growth rate dropped progressively and became negative in 1977. 12. The growing disequilibrium described above was reflected in the balance of payments. The cumulative current account deficit averaged US$1.1 billion per year in 1974-77, equivalent to nearly 9 percent of GNP. To finance this deficit, Peru accumulated a massive external debt. Peru's total private and public external debt--including short-term debt-as of year-end 1977 was almost US$8.3 billion, equivalent to two-thirds of GDP and 4 times exports. Much of this debt was contracted on fairly short maturities. For example, three-fourths of the public sector long-term debt outstanding as of year-end 1977 was scheduled to be repaid over the 1978-82 period. 13. Beginning in 1975, successive economic teams made several efforts to cope with the mounting economic crisis. A major stabilization program was initiated in June 1976, when the Sol was devalued from St. 45 to S/. 65 per U.S. dollar and fiscal and credit policies were tightened. While this program was initially successful in reducing the fiscal deficit and the loss  - 4 - of foreign exchange, it was abandoned later in the year. Further attempts to stabilize the economy were initiated in March, July and September 1977. A stand-by arrangement was negotiated with the IMF and approved on November 18, 1977, but its targets were not met. While these successive efforts were not fully carried through, they succeeded in reducing, somewhat, the gap between national savings and investment from a peak of 11.5 percent of GNP in 1975 to 8.5 percent in 1976 and 7.4 percent in 1977. 14. By mid-1978 the economic crisis had reached grave proportions. The drop in GDP had intensified, inflation had further accelerated to an annual rate approaching 60 percent, the private sector was finding it increasingly difficult to open letters of credit for new imports, the banking system's net international reserves had dropped to a negative level of US$1.2 billion and it had become clear that the public sector was fast approaching the point where it would no longer be able to fully service its external debt. 15. To deal with this worsening situation, a new economic team was named in May to manage the crisis. During the past five months the Government has adopted a number of important measures aimed at strengthening public finances, stimulating exports and stemming the loss of international reserves. The exchange rate was moved from S/. 130 to S/. 150 to the U.S. dollar and a system of frequent small devaluations was instituted. Most subsidies were eliminated, thus closing an important drain on public savings. As a result of this action, prices for edible oils were increased by 130 percent, for dairy and wheat products by 40 to 65 percent, and for petroleum products by an average of 60 percent. The prices of a wide range of other products and services sold by the public sector were raised as well. In addition, a number of tax measures were adopted, including a 10 percent import surcharge on most goods, an increase of 2.5 percentage points in the tax on traditional exports, and increases in the value-added and automobile registration taxes. Austerity measures were adopted to restrain the growth of government expenditures and interest rates on bank loans were raised from 24 to 36 percent per year. Peru also reached agreement with foreign commercial banks to reschedule US$185 million of principal payments due in July/December 1978 until January 1979. Finally, it negotiated a new stand-by arrangement which was approved by the IMF on September 15. 16. To lay the basis for future economic recovery, the Government is in the process of formulating a medium-term development program. This program, which will complement the stabilization effort already underway, is expected to (i) further strengthen public finances through tax reform; (ii) redirect public investment toward projects with high economic yields and short gesta- tion periods; (iii) stimulate recovery of private savings and investment; (iv) facilitate the growth of non-traditional exports; and (v) improve resource allocation and stimulate the growth of output and employment. 17. As part of the economic recovery program, the Government is seeking to reschedule or refinance part of its debt service obligations in 1979 and 1980. As regards the public sector medium- and long-term debt owed to foreign commer- cial banks, Peru is seeking to refinance 90 percent of the principal payments due in 1979 and 1980 (equivalent to approximately US$350 million each year)  - 5 - plus the US$185 million of principal payments originally due in 1978 but rescheduled for 1979. Altogether, the debt relief sought from commercial banks amounts to some US$880 million. Peru has also requested a convening of the Paris Club in early November to consider its request for refinancing 90 percent of the principal payments due on bilateral loans and insured suppliers' credits in 1979 and 1980. This is equivalent to some US$230 million each year. Successful completion of these debt relief operations, plus some refinancing of Peru's short-term debt (estimated at over US$2 billion) would be essential to the viability of the stabilization program. Finally, Peru has requested the Bank to support its development program with a program loan. This request is currently under consideration. 18. The strong measures adopted since May 1978 have begun to have beneficial effects on the country's financial situation. If Peru succeeds in the implementation of the difficult stabilization program, in obtaining the debt relief it seeks, and in formulating and implementing a sound economic recovery program, its creditworthiness would gradually be restored. 19. The proposed loan because of its small amount, would not add materially to the Bank's exposure in the country or to Peru's external debt burden. PART II - BANK GROUP OPERATIONS IN PERU Bank Operations 20. The Bank has made 33 loans in Peru for a total amount of US$552.3 million, net of cancellations; of these, US$308 million, had been disbursed as of August 31, 1978. About 40 percent of the Bank lending to Peru has been for transportation (mainly highways and ports), 19 percent for agriculture, 19 percent for electric power, 14 percent for mining and industry, and about 8 percent for an education project and a sites and services project. In the past, the main problem affecting World Bank projects has been Peru's weak implementation capacity. Given current fiscal difficulties, lack of counter- part funds has begun to hamper project execution; the Government is, however, making a special effort to provide adequate allocations for Bank projects. The Bank is monitoring this situation closely. Annex II contains a statement of Bank loans as of August 31, 1978, and notes on the execution of ongoing projects. 21 IFC commitments to date have been US$24.0 million (US$15 million to the Southern Peru Copper Corporation for the Cuajone Copper Mining Project) of which US$13.0 million is held by the Corporation. A summary statement of IFC investments as of August 31, 1978 is presented in Annex II.  - 6 - 22. The main objectives of Bank lending to Peru have been to assist in (a) the creation of a physical and social infrastructure capable of sustaining and fostering development; (b) the expansion of productive capacity in crucial sectors; (c) the consolidation of structural and institutional changes, parti- cularly land and educational reforms; and (d) the strengthening of agencies to implement and operate projects effectively. In the past, Bank lending has concentrated on infrastructure in the transportation and power sectors. More recently, in the face of mounting economic difficulites, the Bank's emphasis has shifted to more directly productive fields -- mining, agriculture and industry -- to aid Peru in surmounting the current balance of payments problem. 23. In addition to this loan, project preparation is continuing so as to maintain a pipeline which could be reactivated when economic conditions permit a resumption of normal lending. Future project lending would give priority to agriculture to help increase food production, raise the living standard of the rural poor and strengthen the relatively weak institutions operating in this field. Rural development and irrigation rehabilitation projects are now being prepared for this purpose. Bank lending would also be designed to address the problem of the explosive growth of Peru's cities. In the past, the Bank has made one loan for slum upgrading and two for power distribution in urban areas; further urban development projects are planned. In addition to preparing an expansion of electric generating capacity, the proposed engineering loan will lay the groundwork for dealing with Lima's long-term water supply problems which are particularly acute in the slums. Future small scale industries lending would be designed to provide employment to the urban poor, while a rural development program in the Andean highlands would aim, inter alia, at mitigating rural flight to the cities. 24. Bank loans to Peru constituted about 7.4 percent of total outstand- ing debt, including undisbursed, at the end of 1977, and absorbed about 3.7 percent of the country's external debt service in 1977. Assuming improved economic management, a successful debt-relief operation and increased re- course to long-term bilateral and multilateral aid, by 1985 the Bank's share in the country's outstanding public foreign debt could reach 12 percent and its share in debt-service would be around 8 percent. 25. The other principal aid agencies lending to Peru--IDB, AID and KfW-- are expected to continue giving special attention to agriculture with IDB emphasizing agricultural credit, AID rural development and KfW irrigation projects. Total loan commitments to date by the principal agencies are summarized in the following table:  -7- IBRD IDB AID KfW /1 --------- (US$ millions) -------- Transport and Telecommunications 219.2 54.0 15.2 14.6 Agriculture 107.5 112.9 103.0 34.1 Power 102.5 46.9 5.8 - Industry and Tourism 37.5 76.3 4.3 - Mining 40.0 39.4 - 41.0 Water Supply and Health - 75.9 - 16.6 Housing and Urban Development 21.6 36.6 23.2 - Others 24.0 82.9 18.0 6.7 Total 552.3 524.9 169.5 113.0 /1 Converted to US$ at exchange rate prevailing at time of loan approval. PART III - THE WATER SUPPLY AND POWER SECTORS THE WATER SUPPLY SECTOR Background 26. In the past 25 years, Peru's population more than doubled from 7.3 million in 1950 to 15.4 million in 1975. Demographic growth is expected to slow down somewhat in the future but Peru's population is still expected to be over 23 million inhabitants by 1990. The problem of rapid population growth is even more pronounced in the cities, particularly Lima. The urban population grew from 3.3 million in 1950 to 8.7 million in 1975 and is projected to reach 15.6 million in 1990. Metropolitan Lima alone nearly quadrupled its population over the last 25 years to 4.1 million in 1977. Projected growth rates for Lima's population vary widely but they indicate that the capital's population will increase to at least 6 million and possibly as many as 9 million people by the end of the next decade. Supplying water to this rapidly expanding population has proved difficult in the past and even more serious problems lie ahead as easily accessible water resources are being exhausted. Organization and Service Levels 27. The Ministry of Housing and Construction (MVC) determines national policies for the water supply and sewerage sector. Until now, rural water supply was the responsibility of the Ministry of Health, but its functions in the sector are being transferred to MVC. The majority of urban water and sewerage systems are owned and operated directly by MVC. There are also, however, about 40 independent municipal systems. In the country's three largest cities--Lima, Arequipa and Trujillo,--semi-autonomous, government-owned companies provide water and sewerage service. Four of their six board members and their general managers are appointed by MVC.  - 8 - 28. In 1975, service levels for the urban areas of Peru were 72 percent for water supply (56 percent with house connections and the rest with access to standpipes) and 51 percent for sewerage. Service levels in the rural areas are considerably lower and are estimated by MVC to be 15 percent for water and less than 2 percent for sewerage. 29. Investment in water supply and sewerage systems operated by MVC has totalled US$112.2 million since 1962. Another US$21 million has been invested in rural water supply during the same period. Nonetheless, there is a consider- able backlog of investment requirements and most systems are inadequate and poorly maintained. The problem is most pressing in the Lima metropolitan area, which is threatened by serious water shortages. 30. Sector deficiencies have been primarily due to institutional prob- lems -- poor planning and operational difficulties -- owing, in great part, to excessive concentration of sectoral responsibilities in Lima. This has been exacerbated by inadequate government investment funds and by low tariffs, which have made it difficult to raise the large capital sums needed for new works. Water Supply in Lima 31. The Empresa de Saneamiento de Lima (ESAL) was created in 1970 and is the institution responsible for providing water and sewerage in the Greater Lima Metropolitan area. ESAL, a government agency, is under the aegis of MVC, which approves its annual budget, tariffs, number of employees, and salary levels. It has a degree of freedom in its day-to-day operation but little autonomy otherwise. Its financial management and interdepartmental liaison need to be strengthened and its staff, 2700, is large in relation to the number of connections. In addition, tariffs have been too low to allow ESAL to operate efficiently and maintain its water supply/sewerage network while meeting its financial obligations. Measures would be taken under the proposed project to strengthen ESAL, particularly in the area of financial management (paragraphs 45 and 56). 32. In 1977, ESAL provided water and sewerage services to about 2.9 million people, or 71 percent of the Greater Lima population, through 295,200 house connections. About 230,000 people in surrounding communities and the main industrial areas of the city are served by private wells not incorporated into the ESAL system. An. estimated one million people do not have access to piped water or sewerage services and depend on water delivered by trucks or from public standpipes. 33. Between 1973 and 1976, ESAL invested about US$70 million in its water supply and sewerage system. At present the water distribution network is being extended into Lima's slums with the help of a US$12.3 million equiva- lent credit from KfW and a US$14.5 million component of the Bank's sites and services loan of October 1976 (1283-PE). Despite these efforts, the water supply system is not expected to keep pace with population growth and the number of people without adequate water and sewerage services is likely to grow by 1980.  -9- 34. In 1976, Metropolitan Lima was supplied with approximately 20 m /sec of water. Of this amount, 14.4 m3/sec were supplied by ESAL mainly from the Rimac river (9.1 m3/sec) and from groundwater (5.3 m3/sec). The rest was provided by approximately 900 private wells about which little is known and estimates of supply from this source are subject to a wide margin of error. Accounted for water consumption is considerably lower than production. ESAL's sales amounted to only 7.0 m3/sec or 48 percent of its estimated supply; the rest was lost either through leakage in the distribution system or through illegal use. 35. Lima's rapidly expanding population will lead to a vast increase of water consumption. If, for instance, supply were to grow at the same pace as population, and if there were no improvements in the efficiency of distribution, about 40 m3/sec would have to be provided by 1990, and ESAL's supply would have to approximately double to around 30 m3/sec. Supply from existing sources, on the other hand, is approaching its limit. The Rimac river's average flow at Lima during the dry season reaches only 10 m3/sec in years of below average precipitation, while falling water tables at many wells suggest that groundwater sources will have to be carefully exploited in future. 36. To head off a water crisis, the Government has explored a number of long-term solutions. Storage of surplus flows during the wet season, diversion of other coastal rivers, reuse of treated sewage, and de-salting of sea water were considered. But two studies carried out in 1970 and 1976 by Binnie & Partners, a British consulting firm, with financing by grants from the British Overseas Development Ministry concluded that transfer of the waters of the Mantaro river across the continental divide to Lima (see map and plan following Annex III) would, if combined with a hydroelectric project, be the most economic way of obtaining large amounts of additional water. In the shorter term, however, existing resources may well be able to supply the city's growing needs if they are used optimally. A preliminary groundwater survey suggests that it is possible to increase production from wells. Wells have so far been dug where water was needed, without regard to an optimal use of groundwater, leading to sinking water tables in some industrial and resi- dential districts. However, the aquifers have not been tapped in many areas of the Metropolitan region. Another means of obtaining additional water is by reducing losses in the distribution system. Finally, unified control of water resources could result in more rational water management and in significant further savings. Thus, the city could be supplied primarily from surface water from November to May, the rainy season, when the Rimac carries an average of over 40 m3/sec, allowing groundwater resources to build up. Wells, on the other hand, might provide most of the water supply during the dry months when the Rimac's flow is insufficient to meet Lima's water demand. THE POWER SECTOR Organization 37. The Ministry of Energy and Mines determines national power sector policies, whereas operations fall under the responsibility of Electricidad del Peru (ELECTROPERU), the national power company, and several local power  - 10 - companies owned by ELECTROPERU but operating with varying degrees of independ- ence. In addition, the large mining companies maintain captive power plants which are usually independent of the public systems. Peru does not possess a national power grid but the many isolated systems are beginning to grow into regional networks. Among these, the Central System--with Lima at its hub--is by far the most important, accounting for about 65 percent of the country's generating capacity and 70 percent of consumption. The Lima Metropolitan area is served by ELECTROLIMA, a large and well-managed public utility. Lima Power Supply Situation 38. Until recently, ELECTROLIMA supplied the capital's power needs from its own hydropower stations on the Rimac and its tributaries (see Map following Annex III). During the 1966-76 period, demand in the Lima system grew at an average of 8.4 percent and new generating plants were built in time to meet demand. The Bank supported ELECTROLIMA's expansion programs with five loans totalling US$100.4 million. ELECTROLIMA's largest hydropower plant, built in the early sixties (financed by Loans 260-PE and 365-PE), already depends partly on water which is diverted by the Transandean Tunnel across the con- tinental divide to the Santa Eulalia river, a tributary of the Rimac. With the creation of ELECTROPERU in 1972, ELECTROLIMA relinquished responsibility for development of new generating capacity to the national power company. ELECTROPERU today supplies about one third of ELECTROLIMA's electricity needs from its 455 MW Mantaro power plant, 200 km to the southeast of Lima. 39. Additional generating units will raise the capacity of the Mantaro plant to 800 MW over the next two to three years, assuring Lima's supply until the early 1980s. A planned 217 MW extension of Mantaro, the Restitucion hydro- power station, should be completed by 1983. But additional generating capacity will have to be brought into operation by 1984 or 1985, at the latest, to ensure continued supply to the central region, which by then will be inter- connected with the industrial areas along the northern coast. Since construc- tion of a large hydropower project in the Peruvian Andes requires at least five to six years, it is likely that some thermal capacity will have to be installed to meet demand in the interim. 40. A comprehensive survey of the country's hydro power potential is currently underway supported by a German Government grant and funds from the Bank's most recent power loan (1215-PE). This survey's conclusions will be used in the preparation of a power sector master plan to determine an optimal sequence for investment in new generating and transmission facilities. Financing for the master plan is also provided under Loan 1215-PE. The contract for the plan's preparation was recently signed and its results should become available in 1980. One project which is being considered in the master plan is the Sheque hydropower station (600 MW) on the upper reaches of the Santa Eulalia river (see map and plan following Annex III),-for which feasi- bility studies, financed by Loan 511-PE, were prepared in the early 1970s. Sheque would require increased flows through the existing Transandean Tunnel which would have to be obtained by pumping water from the Mantaro river, a tributary of the Amazon. If this scheme were selected, the water transfer from the Mantaro river would also ensure Lima's water supply until at least the end of the century.  - 11 - PART IV - THE PROJECT 41. The objective of the proposed project would be to lay the groundwork for a long-term solution to Lima's water supply problems and for an expansion of the electric generating capacity in Peru's central region. The project evolved from preparations for a Lima Water Supply Project which was separated into an engineering and a construction component after it became clear that project preparation would be too large a task, in terms of time and cost, to be easily accommodated in the framework of a single project loan. Since 1976, various Bank missions have visited Peru in connection with the Lima Water Supply Project; the engineering loan was prepared by a mission in January 1978. Negotiations were completed in Washington on September 8, 1978. The Peruvian delegation was headed by Mr. Ulises Montoya Alberti, Deputy Director of Public Credit and by Ing. Augusto Bedoya Reyes, President of ESAL and of the Mantaro Commission. It included representatives of the Government, the National Development Bank (COFIDE) and ESAL. There is no separate appraisal report for this project. Annex III contains a supplementary Project Data Sheet. Project Description 42. The project would achieve its objective (i) through studies and programs which would lay the groundwork for a more effective water distribution and sewerage system for Lima; and (ii) by determining the technical and economic feasibility of transferring water from the Mantaro river across the continental divide to Lima. Effective distribution of water resources would be the objective of the project component which would be the responsibility of ESAL. How to supply the needed amounts of water -- through optimal use of existing resources and eventually by opening up new sources of water -- would be studied under the project's Mantaro component for which the inter-sectoral Mantaro Commission would assume responsibility. ESAL Component 43. The first part of this component would consist of studies which would assess the volume of water available from all the existing sources in the Lima Metropolitan Area, including those sources presently under private control. Since neither production nor use by large consumers is measured at present, large water meters would be installed to provide this information. A survey would be made of the distribution network to identify losses of water from defective pipes or unauthorized connections. ESAL would also carry out a leak repair program. 44. A second part would aim at producing a water supply and sewerage master plan for Lima. Drawing on the results of the water optimization study (see paragraph 47) the plan would propose a framework for the expansion of Lima's water distribution and sewerage system. Detailed engineering would be prepared for priority improvements in Lima's water distribution network, sewerage system and basic sanitation. These improvements would constitute the core of a possible future Bank project.  - 12 - 45. A third part would consist of studies to identify the organiza- tional and financial measures which are needed to enable ESAL to administer water resources effectively and to carry out a major expansion program. In the financial area, where ESAL is particularly weak, consultants would assist the company in improving its accounting system and financial reporting. In the process, they would help update ESAL's financial statements and projec- tions. 46. A project manager to coordinate the different elements of the ESAL component would be financed under the proposed loan. A candidate, satisfac- tory to the Bank, has already been identified for this position and attended the loan negotiations. Mantaro Component 47. The Mantaro Component would address the question of how Lima's long- term water needs could best be met. An optimization study would explore possibilities for stretching existing water resources by such means as unified management of surface and groundwater and reuse of sewage. But it is expected that the bulk of future needs will have to be met from new sources. Earlier studies have pointed to the Mantaro Transfer (see paragraph 36) as the most economical source of large amounts of additional water. The transfer would entail pumping of up to 32 m3/sec from the Mantaro River through the existing Transandean Tunnel to the Santa Eulalia river where it would be used for power generation and to supply water to Lima. Several studies exist for the transfer and for the Sheque hydroelectric plant but they will have to be revised and in some cases expanded since they do not yet provide adequate elements for an investment decision. The question of scale and timing, for instance, will have to be reviewed based on the results of the optimization study and of the investment needs in the power sector. Other issues which will have to be addressed include ecological aspects (particularly control of the Mantaro's heavy pollution from mine water discharges) and the impact on existing and proposed power stations downstream on the Mantaro, Santa Eulalia and Rimac rivers, which together account for the bulk of the country's hydroelectric capacity. Additional geological investigations at the project sites and more detailed design of some components should, finally, allow firmer cost estimates. 48. Since the Mantaro water transfer would be closely interrelated with development of the power sector in the Central Region, an investment decision on the transfer would have to be taken in the context of the power sector's overall development. The German and Bank-financed power master plan mentioned in paragraph 40, which would be developed simultaneously with the Mantaro studies, would help provide this context. So far, work on a hydropower survey, whose findings would be incorporated in the master plan, is advancing satisfactorily, but there were delays in engaging consultants who would carry out surveys of other energy sources, of transmission needs, and of existing facilities to prepare a complete investment plan for the power sector. A contract for these studies was, however, recently signed and their results should be available in 1980.  - 13 - Prolect Execution 49. ESAL would execute its component with the assistance of consultants and under the supervision of COFIDE (Sections 2.04a and 2.03 of the draft Project Agreement). Satisfactory terms of reference for each of its elements are being drawn up by ESAL with Bank assistance. To assure sdequate coor- dination and supervision of the component, ESAL would hire, on terms and conditions satisfactory to the Bank, the project manager referred to in paragraph 46 (draft Project Agreement, Section 2.05). The proposed loan would provide funds for this purpose. Hiring of the project manager is a condition of effectiveness of the Loan Agreement (draft Loan Agreement, Section 6.0ib). 50. Peruvian legislation entrusts jurisdiction over all groundwater use to the Ministry of Agriculture, but the Ministry agrees that ESAL should have control over all non-agricultural use of water in the Lima area. The Government has, therefore, committed itself to grant, at ESAL's request, to the water supply company the exclusive right to drill new wells and to revoke concessions of existing private wells in ESAL's favor whenever the company wishes to assume management of these (draft Loan and Project Agreements, Sections 4.04). Control would be transferred gradually district by district as ESAL builds up its capacity to exercise this new function. In the meantime, a decree will give ESAL's representatives the right to visit and inspect existing private wells. This will assure that the studies under the project can be carried out. Passage of such a decree is a condition of the loan's effectiveness (draft Loan Agreement, Section 6.01(c)). 51. The Mantaro transfer studies would be carried out by consultants under the supervision of the Mantaro Commission which was created within MVC. The Commission, which is chaired by the President of ESAL and includes the Presidents of ELECTROPERU and ELECTROLIMA as well as representatives of various ministries, reflects the project's multisectoral character. Its main task so far has been to select consultants to carry out the studies. The selection was recently completed and the British firm which did the original Mantaro studies, Binnie & Partners, has been selected to carry out the transfer studies which this loan would finance. Contract negotiations are currently underway. 52. Until recently the Mantaro Commission has depended on staff seconded to it from other public agencies for specific tasks. As preparation work is expected to begin soon, however, the Commission is now setting up a project unit to supervise execution of the studies (Section 3.03 of the draft Loan Agreement). Its staff would be complemented, as necessary, by personnel from the two power companies, ELECTROPERU and ELECTROLIMA. Before authorizing disbursements for the Mantaro component, the Bank would satisfy itself that the project unit is adequately staffed for supervising the consultants (draft Loan Agreement, Schedule 1, para. 4b). 53. Since the two project components are interdependent but are being executed by different agencies, working groups would be set up to assure adequate coordination on the studies' different aspects. These working groups, which would be constituted by January 31, 1979, would include the ESAL Project Manager and representatives of the Mantaro project unit and of COFIDE (Section 3.02 of the draft Loan Agreement).  - 14 - 54. The Government has selected COFIDE to act as financial agent for the project and to administer the proposed loan on its behalf. Since COFIDE will likely be involved in financing the projects expected to grow out of the engineering loan, the Government decided to associate it with this operation at an early stage. For these reasons, COFIDE would also be a party to the Project Agreement. 55. Part of the proposed loan (US$4.9 million) would be on-lent by the Government to ESAL under a subsidiary loan agreement which would be concluded between COFIDE, acting on the Government's behalf, and ESAL. The subloan would carry the same terms as the Bank loan and ESAL would bear the foreign exchange risk. For its services, COFIDE would receive a fee of 0.75 percent p.a. of the amount on-lent to ESAL. 56. As was mentioned in paragraph 31, ESAL's finances require improvement. In the past the company's revenues have been insufficient to service debt and properly maintain the existing water/sewerage system. The subloan to ESAL would, therefore, be tied to a financial rehabilitation program requiring the company to meet from revenues (i) its normal operating and maintenance expen- ditures; (ii) debt service payments; and (iii) the counterpart funds needed for the ESAL component (para. 5(i) of Schedule 2 to the draft Project Agree- ment). Since the financial studies envisaged under the ESAL component would also be important for the restructuring needed for ESAL to eventually carry out the large water supply project to be prepared under this engineering loan, the hiring of consultants to help ESAL strengthen its financial management would take place no more than 60 days after the signing of the subsidiary loan agreement (para. 5(ii) of Schedule 2 to the draft Project Agreement). COFIDE would supervise the execution of the financial program. To this end, it would monitor the adequacy of ESAL's financial performance on a quarterly basis (Section 4.03(i) of the draft Project Agreement) and the Government has committed itself to approve water tariff increases requested by ESAL if these quarterly reviews point to any shortfall in revenue (Section 4.03 of the draft Loan Agreement). 57. COFIDE is the Government's principal development finance institu- tion and assists both public and private firms in Peru. It has had wide experience in raising and channeling external resources to support projects in diverse sectors. COFIDE received a US$35 million development banking loan from the Bank in 1977 (Loan 1358-PE). In connection with that loan, COFIDE's capabilities for resource allocation and supervision were analyzed and found to be satisfactory (Report 1195-PE of December 6, 1976). Since then, al- though the Sol has undergone a rapid devaluation and economic conditions have deteriorated, COFIDE's performance has continued to be satisfactory. At the end of 1977, its total assets stood at about US$400 million equivalent and its financial structure was within the 5:1 debt-equity limit agreed with the Bank when Loan 1358-PE was made. With a qualified professional staff of more than 150, COFIDE has demonstrated its ability to administer a large and varied loan portfolio and is considered capable of supervising the financial rehabili- tation of ESAL.  - 15 - Cost and Financing 58. The project's total cost, net of taxes and duties, is estimated at US$11.1 million. Foreign exchange costs are estimated at US$8.8 million. The proposed Bank loan would cover the foreign exchange component. The Government would contribute US$1.07 million through MVC's budget to cover local costs for the Mantaro component. The balance of the project's local costs, US$1.23 million, would be provided by ESAL through its internal cash generation. Price contingencies were based on a disbursement profile of thirty-four months starting in early 1979. Worldwide inflation was estimated to reach 8 percent in 1979, 7.5 percent in 1980 and 7 percent in 1981. A higher price contingency (16, 15 and 14 percent for 1979, 1980 and 1981 respectively) was provided for local costs to provide a margin of safety in case exchange rate adjustments lag behind domestic inflation. Procurement and Disbursement 59. Expenditures for consultants are expected to account for about US$9.4 million or 85 percent of project costs. ESAL and the Mantaro Commission would retain an estimated 1,100 man/months of consulting services at an esti- mated cost of US$7,000 per man/month excluding contingencies. Studies under the project would be carried out by qualified consultants selected in accord- ance with Bank guidelines. Foreign firms, possibly associated with local consultants, are expected to be selected for all major studies. 60. The remainder of project costs, US$1.7 million, would consist of equipment purchases (US$1.3 million) and civil works (US$0.4 million) in connection with the water metering and leak repair programs under the ESAL component. Equipment and meters would be procured under international com- petitive bidding, except in cases, such as pipes and fittings for the leak repair program, where contracts would be too small to make international bidding practical. When international bidding is used, local manufacturers would be allowed a margin of preference of either 15% of the CIF price or the applicable import duty, whichever is lower. Contracts of less than US$50,000 equivalent would be awarded according to ESAL's normal procurement procedures, which require at least three quotations. Such directly procured items would be subject to an aggregate maximum of US$500,000. Civil works for leak repair have to be carried out in close coordination with the leak detection program and with operation of the water system. Since it would be difficult to use contractors efficiently under these circumstances, they would be executed by ESAL's own maintenance crews under force account procedures. These civil works would not entail foreign exchange expenditures and would not, therefore, be financed under the Loan. 61. Disbursements from the loan account -- expected to be spread over a period running from February 1979 to December 1981 -- would be made against: (a) the foreign cost of consultant services including the cost of professional services by Peruvian consultants; (b) the cost of equipment and materials purchased from abroad; and (c) 63 percent of expenditures for materials and equipment purchased locally such as pipes and fittings, which corresponds to their estimated foreign content. The Bank would refinance each of the loan's components with any future loan for a project arising out of that component.  - 16 - Project Justification and Risks 62. The proposed loan would help lay a sound basis for long-term solutions to Lima's needs in the water supply and power sectors and prepare two projects -- the expansion of Lima's water supply system and the Mantaro Transfer -- for possible Bank financing. It would also support organizational and financial improvements in ESAL which are preconditions for urgently needed investments if Lima's growing population, particularly in the slums, is to be adequately supplied with water and sewerage services. 63. The Mantaro transfer, including its power component, would be both a technically complex and a large project -- total costs could be in the order of magnitude of US$800 million -- and the government has indicated that it intends to look to the Bank for direct financing and for help in assembling its financial package. Given the number of issues involving various sectors which have to be considered in reaching an investment decision, preparation is more complex than is usual for power or water supply projects. Bank involve- ment at an early stage through the proposed loan would play a useful role in assisting this preparation effort. 64. The local cost of the project's first component would be borne by ESAL whose finances would have to improve for it to fulfill the financial obligations arising from the project. The success of the financial reform of ESAL, therefore, constitutes a special risk. The financial conditions in COFIDE's subsidiary loan agreement with ESAL and in the Loan Agreement, which are described in paragraph 56, are considered adequate to protect the Bank from this risk. The execution of a subsidiary loan agreement, satisfactory to the Bank, by ESAL and COFIDE, acting on the Government's behalf, would be a condition of effectiveness (draft Loan Agreement, Sec. 6.01a). PART V - LEGAL INSTRUMENTS AND AUTHORITY 65. The draft Loan Agreement between the Bank and the Republic of Peru and the draft Project Agreement between the Bank, ESAL and COFIDE and the Report of the Committee provided for in Article III, Section 4(iii) of the Articles of Agreement are being distributed to the Executive Directors separately. 66. The draft Loan and Project Agreements do not differ from the usual pattern and do not impose unusual obligations on the parties. Special condi- tions of effectiveness of the loan will be the hiring of a project manager by ESAL (paragraph 49), issuing of a decree granting ESAL's representatives the right to visit and inspect private wells (paragraph 50) and the execution of a subsidiary loan agreement between COFIDE, on behalf of the Government, and ESAL (paragraph 64). In addition, a condition of disbursement for the Mantaro component is the setting up of an adequately staffed unit to supervise the Mantaro transfer studies (paragraph 52). 67. I am satisfied that the proposed loan would comply with the Articles of Agreement of the Bank.  - 1 7 - PART VI - RECOMMENDATION 68. I recommend that the Executive Directors approve the proposed loan. Robert S. McNamara President Attachments October 18, 1978 Washington, D.C.   ANNEX I TABLE 3A PERU - SOCIAL INDICATORS DATA SHEET Page 1 LAND AREA (THOU KM2) -----------------------------------_-----____ --------------- PERU REFERENCE COUNTRIES (1970) TOTAL 1285.2 MOST RECENT AGRIC. 369.1 1960 1970 ESTIMATE CHILE MEXICO SPAIN** __