Peru - Lima Water Supply and Sewerage Project

Document of The World Bank FOR OFFICIAL USE ONLY Report No. 3744b-PE, PERU LIMA WATER SUPPLY AND SEWERAGE PROJECT STAFF APPRAI3AL REPORT April 14, 1982 Water Supply and Sewerage Division Latin America and the Caribbean Regional Office 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 authorization.  UNIT AND MEASURES 1 mm = millimeter = 0.04 inches 1 cm = centimeter = 0.39 inches 1 m = meter = 3.28 feet 1 km = kilometer 0.62 miles 1 1 = liter = 0.26 US gallons 1 m3 = cubic meter = 264 US gallons 1 m3/sec = cubic meter = 22.82 MGD = million US gallons per second per day 1 ha = hectare = 10,000 m2 = 2.25 acres 1/cd liters per capita per day lps = liters per second lpd = liters per day mg/l = milligram per liter CURRENCY EQUIVALENTS Currency Unit = Soles S/574 = US$1.00 (March 1982) FISCAL YEAR January 1 to December 31 . 4  FOR OFFICIAL USE ONLY ABBREVIATIONS AND ACRONYMS AIC - Average Incremental Cost CARE - Cooperative for American Relief Everywhere CEPIS - Pan American Center of Sanitary Engineering (Centro Panamericano de Ingenieria Sanitaria COFIDE - National Development Bank (Corporacion Financiera de Desarrollo) DGOS - General Directorate for Sanitary Works (Direccion General de Obras Sanitarias) DIS - Sanitary Engineering Directorate (Direccion de Ingenieria Sanitaria) IDB - Inter-American Development Bank INP - National Institute of Planning (Instituto Nacional de Planificacion) IRR - Incremental Rate of Return MVC - Ministry of Housing (Ministerio de Vivienda y Construccion) MTP - Mantaro Transfer Project ORDES - Regional Development Agencies (Organismo Regional de Desarrollo) PSU - Project Supervisory Unit SEDAPAL - Lima Water Company - Forrier ESAL (Servicio de Abastecimiento de Agua Potable y Alcantarillado de Lima) SEDAPAR - Arequipa Water Company - Former ESAR (Servicio de Abastecimiento de Agua Potable y. Alcantarillado de Arequipa) SEDAPAT - Trujillo Water Company - Former ESAT (Servicio de Abastecimienito de Agua Potable y Alcantarillado de Trujillo) SENAPA - National Water Supply and Sewerage Service (Servicio Nacional de Agnia Potable y Alcantarillado) UNICEF - United Nations Children's Fund 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 authorization.  I  PERU STAFF APPRAISAL REPORT LIMA WATER SUPPLY AND SEWERAGE PROJECT TABLE OF CONTENTS Page No. I. INTRODUCTION ......................................... l II. THIE SECTOR Population .. 1 Water Resources .. 1 Health Situation .. 2 National Sector Planning . .2 Sector Organization .. 3 Service Levels and Quality . . 4 Past Sector Investments .. 5 Sector Objectives .. 6 Manpower Aspects .. 6 Experience Under Previous Loans . . 7 III. THE BORROWER AND IMPLEMENTING AGENCY Background . . 7 Management and Personnel .. 9 Commercial .. 9 Planning, Budgeting and Accounting . .11 Data Processing ..12 Auditing . .12 Insurance ..12 Overall Assessment ..12 IV. POPULATION, SERVICE AND DEMAND IN THE PROJECT AREA Description of Project Area and its Population .13 Water Resources and Quality .13 Existing Water Supply and Sewerage System .14 Water Production and Consumption .17 Population and Demand Projections .18 This report is based on the findings of an appraisal mission which visited Peru during September 21 to October 14, 1981. The mission was comprised by Messrs. Jorge Culagovski, Economist; Bernardc Gomez, Financial Analyst and Adan Cajina, Engineer.  - II - Page No. V. THE PROJECT Genesis ............................................. 20 Objectives ......... 20 Service Standards .................. ................. 20 Project Description .. 21 Status of Designs .. 22 Least-Cost Analysis ................. ................ 22 Cost Estimates ................... ................... 23 Project Financing .................. ................. 25 Implementation .................... .................. 26 Procurement ..................... .................... 28 Disbursement .................... .................... 28 Retroactive Financing ............................... 31 Environmental Aspects .............. .. ............... 31 VI. FINANCIAL ANALYSIS Past Financial Performance and Present Position ..... 31 Revenues ......... ................................... 33 Users Contributions and Service Improvements ........ 34 Financial Projections ................................ 35 SEDAPAL's Investment and Financing Plan .............. 37 Monitoring and Evaluation Criteria ................... 40 VII. ECONOMIC AND SOCIAL ANALYSIS Introduction .42 Return on Investments .42 Long-Run Marginal Cost and Tariffs .43 Population Benefitted and Urban Poverty Impact 43 Affordability of Services by the Urban Poor .44 Project Sensitivity and Risks .44 VIII. AGREEMENTS REACHED DURING NEGOTIATIONS .45  - III - TABLE OF CONTENTS (Continued) LIST OF ANNEXES 1. Sector Reponsibilities 2. SEDAPAL's Organizational Structure 3. SEDAPAL Institutional Assessment of SEDAPAL 4. Rimac Average Monthly Flow at Atarjea Treatment Plant and Lima's Consumption Pattern 5. Raw Water Quality of Rimac River at Atarjea Treatment Plant 6. Projected Production, Sales and Instal'Led Capacity 7. Project Components 8. Detailed Project Cost Estimates 9. SEDAPAL Consultant Services 10. Implementation Schedule - Cumulative Completion 11. Notes on Financial Statements 12. Distribution of Consumers, Consumption and Billing by Consumption Level 13. Outline Terms of Reference for Tariff Study 14. Incremental Rate of Return 15. Long-Run Average Incremental Costs 16. Incremental Population Served 1982-86 17. Selected Documents and Data Available in Project File LIST OF TABLES 2.1 Water Supply and Sanitation Service Levels 4.1 1980 Water Supply in the Lima Metropolitan Area 4.2 Status of Metering of Water Connection.3 4.3 Population and SEDAPAL's Demand ProjecLions 5.1 Project Cost Estimate 5.2 Financing Plan for the Project 5.3 Allocation of Loan Proceeds 5.4 Loan Disbursement Schedule 6.1 SEDAPAL Selected Income and Cash Flow *Data 1978-81 6.2 Distribution of Consumers, Consumption and Billing by Category of Water Use 6.3 SEDAPAL Selected Income and Cash Flow *Data 1980-86 6.4 SEDAPAL Investment and Financing Plan 1982-86 6.5 SEDAPAL Monitoring Indicators MAP IBRD Map No. 16120 - Peru - Lima Water Supply and Sewerage Project  I  PERU LIINA WATER SUPPLY AND SEWE.RAGE PROJECT Staff Appraisal Report I. INTRODIJCTION 1.01 The Government of Peru has requested the continuation of Bank fi- nancial assistance for the expansion and improvement of water supply and sewerage services in Lima. The project was prepared by the Servicio de Abastecimiento de Agua Potable y Alcantarillado de Lima (SEDAPAL), formerly ESAL, with the assistance of consultants andi the Bank. It aims at solving Lima's most pressing short- to medium-term water supply and sewerage needs. The project, to be executed during the period 1982-86, would benefit about 1.0 million inhabitants, mostly in low-income areas. SEDAPAL is addressing longer term sector needs in Lima through the preparation of water supply and sewerage master plans 1/ which are being financed under Bank Loan S-11-PE. The total cost of the proposed project is estimated at US$92.8 million equivalent. A Bank Loan of US$40.6 million is recommended to finance part of the foreign exchange component and the front-end fee on the Bank Loan. US$7.7 million will be cofinanced from official and private sources. The Borrower and Executing Agency would he SEDAPAL. II. THE SECTOR 2/ Population 2.01 Results of the 1980 census are still incomplete. The mid-1981 population of the country was estimated on the basis of the last census at 18.2 million inhahitants, of which 66% lived in urban areas and 34% in rural areas (communities with less than 2,000 inhabitants). The population of Lima accounted for about 40% of the country's urban population. The total population is growing at an estimated annual rate of 2.7%. Migration to urban centers has resulted in a continued, albeit declining, increase in the proportion of urban population. It is forecast that by 1990 the urban population will reach about 17 million inhabitants, or 74% of the country's population. W7ater Resources 2.02 W4ater resources are abundant but geographically unbalanced. The Andes divide the country into two large watersheds. To the east, a complex 1/ Engineering Science's draft report on the Lima Water Master Plan is available in project files. 2/ A Sector Review, prepared by SEDAPAL in October 1981, is available in Project Files.  -2- and extensive river system flows into the Amazon Basin. This system's substantial water flows are for the most part untapped. To the west of the Andes, desert conditions are predominant and rainfall is less than 15 mm/ year. Some fifty rivers flow across the coastal region into the Pacific, supplying water for agriculture and urban communities in the coastal region. Most streams, however, are seasonal and require costly regulation to be fully utilized. Given the topography and subsoil characteristics of the Peruvian coast, groundwater is believed to be abundant although a com- prehensive assessment has not been made. Local studies in Lima and Trujil:Lo are being carried out to determine groundwater potential. Pre- liminary results indicate that these two aquifers are being used at close to their maximum safe yield. Water resources belong to and are admi- nistered by the public sector. 2.03 Water sources in Lima include surface water from the Rimac River and groundwater supplies. Since the aquifer is being depleted, groundwater extraction cannot be expanded to satisfy the needs beyond the early 1990's. A transfer of water from the Atlantic watershed, expected to be completed by 1987, would increase the flow of the Rimac River and provide enough water to satisfy Lima's long-term needs (para. 2.23). Health Situation 2.04 Health statistics in Peru are deficient. During the 1960s and 1970s, general mortality declined from 17.8 deaths per 1,000 in 1962 to 11.9 in 1977; infant mortality declined from 160 to 107 deaths per thousand live births in the same period. The downward trend in general and infant mortality rates is encouraging, but Peruvian mortality rates are among the highest in Latin America. In 1972, the mortality rate for water-related diseases was a high 79 per 100,000 inhabitants, which compares unfavorably with other countries of similar GDP in Latin America (Colombia, 70; Dominican Republic, 42). 2.05 Infectious diseases continue to have a high incidence in morbi- dity rates. Most diseases that are transmitted through inadequate water supply or sanitation have noticeably increased from 310 per 100,000 inhabi- tants in 1970 to 386 per 100,000 inhabitants in 1978. It should be noted, however, that part of the increase in morbidity rates might reflect im- proved health reporting rather than deteriorating sanitary conditions. National Sector Planning 2.06 The National Institute of Planning (INP) is responsible for pre- paration of national and sectoral development plans, and participates in the preparation of public sector budgets. INP is also in charge of orient- ing and coordinating the work of the sectoral planning departments of each ministry which, in turn, are responsible for formulating sector strategies, policies, investment plans and budgets. In spite of this planning struc- ture, no meaningful planning has taken place in the water supply sector, and sector investment plans have been no more than the sum of individual investment programs proposed by the various sector agencies.  -3- Sector Organization Urban Areas 2.07 The Ministry of Housing (MVC) determines national policies for the sector in urban areas. Up to mid-1981 the functions of planning, con- struction and operation of systems rested alternatively on local municipal- ities, regional development agencies (ORDES), regional branches of the General Directorate for Sanitary Works (DGCS-Ministry of Housing), and on semi-autonomous water companies (SEDAPAL in Lima, SEDAPAT in Trujillo, and SEDAPAR in Arequipa). However, responsibilities between the different agen- cies were not clearly defined and the capacity to plan and to execute pro- grams was inadequate. 2.08 In September 1981, the National Water Supply and Sewerage Service (SENAPA) was created. SENAPA assumed the responsiblity for sector plan- ning, financing, coordination and technical assistance for all water supply and sewerage systems in urban areas. SENAPA's involvement (through region- al branches) in construction and operation of local systems will be selec- tive, depending on the capabilities of the local institutions. A gradual and pragmatic decentralization process is expected to take place over the medium term. Water companies in the largest cities (Lima, Trujillo and Arequipa) have already become subsidiaries of SENAPA, enjoying a much Larger degree of financial and administrative autonomy than they originally had. Over the next few years, companies in medium size cities will be created as subsidiaries of SENAPA with a limited degree of autonomy which will increase as they develop acceptable teclnical and administrative capa- bilities. During this process of administrative decentralization, SENAPA will play a strong role in sector development. It will also continue to provide or to have a high degree of participation in the provision of water supply and sewerage services in cities or regions where the absence of suf- ficiently large populations makes the creation of independent companies hard to justify. SENAPA will also continue to define sector policies and priorities. In addition, it will be responsible for defining and putting iinto effect financial and tariff policies, identifying sector needs and im- plementing specific programs to satisfy them. SENAPA is now strengthening its organization and manpower resources to meet its responsibilities. Rural Areas 2.09 The Sanitary Engineering Directorate (DIS) under the Ministry of Public Health is in charge of planning and constructing water supply and sanitation works in rural areas. The operation and maintenance of rural systems is the responsibility of community councils that DIS helps to set up in each community. The organization of DIS is functional; it includes four departments: (Studies, Construction, Maintenance, and Programming) and regional offices. DIS has a permanent staff of about 200 persons, of which 180 are at its headquarters. In addition, it employs about 1,000 operators on a temporary basis to help operate systems at the local level. The Government plans to strengthen the regional offices to provide permanent assistance to local communities in the operation and maintenance  - 4 - of water systems and to promote effective sanitation programs. Additional staff are particularly required in the field of community development and health education. The functions of the sector institutions are summarized in Annex 1. Service Levels and Quality 2.10 It is estimated that by mid-1981, about 54% of the urban popula- tion had access to potable water through house connections and 14% through public standpipes. About 51% of the urban population was connected to a sewerage system and about 7% had septic tanks or latrines by the same date. Service levels for 1972 and 1981 are summarized in Table 2.1. 2.11 It is estimated that by mid-1981, about 19% of the rural popula- tion had access to safe water (2% through house connections and 17% through standpipes) and only 1% had access to sanitary means of waste disposal. There is no information on the use of latrines in rural areas, but indica- tions are that existing facilities do not comply with minimum requirements to avoid health hazards. 2.12 The 1972 census and 1981 estimates indicate that water supply coverage has varied little. Since population has grown rapidly, the ab- solute number of people lacking water services has been increasing steadi- ly. By 1981, about 9 million people in the country lacked access to safe water supplies. Some progress in the provision of sanitation services was made from 1972 to 1981, but by the latter year, some 11 million people still lacked adequate means of waste disposal.  TABLE 2.1: WATER SUPPLY AND SANTATION SERVICE LEVELS Water Suipply Sanitation 1972 1981 1972 1981 1. Total Country Population (million) 13.5 18.2 13.5 18.2 Population served (million) 6.2 9.3 3.9 7.0 (house connections (mill.)) (4.3) (6.4) (public standpipes (mill.)) (1.9) (2.9) Service Level (%) 46 51 29 39 2. Urban Population Population (million) 8.1 12.0 8.1 12.0 Population served (million) 5.7 8.2 3.9 7.0 (house connections (mill.)) (4.1) (6.5) (public standpipes (mill.)) (1.6) (1.7) Service Level (%) 70 68 48 58 3. Rural Population Population (million) 5.4 6.2 5.4 6.2 Population served (million) 0.5 1.2 0.1 0.1 (public standpipes) Service Levels (%) 9 19 1 1 2.13 Control of water quality is under the Ministry of Health. Water quality in both urban and rural areas is erratic, and in some cases defi- cient. It is estimated that about 20% of L.ima's and all of Trujillo's and Ica's, water supplies are not chlorinated. Water service in many urban centers is intermittent and constitutes a potential health hazard, as water supplies can be contaminated through leaky joints by infiltration from sewer pipes or septic tanks. In most municipal and rural water systems, water quality is not regularly monitored. SENAPA, SEDAPAL, SEDAPAT and SEDAPAR are initiating programs to overcome the major water quality problems in urban centers. Past Sector Investments 2.14 Over the 1971-80 period, a total of US$330 million (in 1981 prices) was invested in the sector, or an average of US$33 million per year. External financing has supported all major investment programs. Lenders have been IDB, KfW, CARE, UNICEF and, since 1976, IBRD. 2.15 The limited increase in service levels between 1972 and 1981 is a consequence of the low investment levels in the sector over the same pe- riod. On a per capita basis, investments iuring the decade were among the  - 6 - lowest in Latin America. This can be explained in part by the lack of ade- quate tariffs and by the weakness of sector institutions. 2.16 In the past, urban areas have received investments at a higher proportion than the share of its population in the total population of the country. This has been the result of the relatively stronger absorptive capacity of the institutions dealing with the sector in urban areas. It is noteworthy that contributions of cash, labor and materials from local communities have made up about 12% of total investments in rural areas. Sector Objectives 2.17 The country's sector goals for 1990 include the provision of (a) potable water to 85% of its urban population and 50% of its rural popula- tion; and (b) sanitation services to 75% of its urban and 30% of its rural population. Although these goals are short of those of the International Water Decade, which aim at complete coverage for both urban and rural areas, they are highly ambitious in view of present low service levels and the investments required to reach the targets. They should, however, serve as a guide for the executing entities, which are preparing specific five- year investment programs. SEDAPAL has established service level goals for Lima for 1990, when it expects to serve 90% of Lima's population with water supply and 85% with sewerage. 2.18 Achieving the 1990 targets in water supply and sanitation will require a much higher level of investment than in the past. Assuming aver- age per capita investment costs similar to those of works under execution, and required investments for rehabilitation and maintenance of existing systems of US$20 per capita, total required investments for 1982-1990 would amount to about US$2,000 million in 1981 prices. These investments corre- spond to an average of US$220 million per year, compared to the average of US$33 million (both in 1981 prices) invested during the past decade. Manpower Aspects 2.19 In 1979, the major sector institutions in urban areas had a per- manent staff of about 6,700 persons. The rural sector employed about 1,500 persons, including about 1,000 temporary local operators. About 10% of sector employees were professionals, 31% were technicians and the remaining 59% unskilled or semi-skilled. The average ratio of employees per thousand water supply connections in urban areas was 10, which is considered high compared with efficient companies in Latin America, which have a ratio of 4-5 employees per thousand connections. 2.20 Since 1975, the proportion of skilled labor to total personnel employed by sector institutions has been declining. The uncompetitive levels; of renumeration have made it difficult for sector institutions to hire aind retain adequately qualified staff. SENAPA authorities are, there- fore, developing a plan of action for increasing the competitiveness of the salaries in the sector. In addition, they are considering the establish- ment of a national training program, which would be based on the recommen- dations of a study made by the Pan American Center of Sanitary Engineering  - 7 - (CEPIS) in November 1980. The study is available in Project Files. 2.21 Several universities in Peru provide training in engineering and administration. The foremost of these is the National Engineering Univer- sity of Lima. Technicians are trained by the National Training Service and by the Public Health Training Center. In 1979, the Government of Peru re- ceived a grant from IDB to develop, through CEPIS, a training program for the sector. This program is expected to provide technical training to about 500 persons over a three-year period. Experience Under Previous Loans 2.22 The Bank is participating in the financing of a water supply and sewerage component of the Urban Sites and Services Development Project (Loan 1283-PE, signed in October 1976). "his component, with a cost of US$13.0 million, of which the Bank is financing US$6.5 million, provides for the extension of water supply and sewerage services to low-income areas (Pueblos Jovenes) of southern Lima. It is being executed by SEDAPAL and is expected to be completed by June 1982. 2.23 The Bank is also participating in the financing of the Water Sup- ply and Power Engineering Project (Loan S-11-PE, signed in December 1978). The project includes the preparation of feasibility studies for the Mantaro Transfer Scheme to meet long-run water supp'y and power needs for Lima, and a water supply component. The cost of the water supply component being executed by SEDAPAL is US$6.1 million, of which the Bank is financing US$4.9 million. This project component includes the preparation of Lima's Water Supply and Sewerage Master Plan, SEDAPAL's institutional improve- ments, macro water metering, and leak detection and control programs. The lengthy process of selecting consultants arLd cumbersome procurement proce- dures delayed the start of implementation. As of March 31, 1982, 87% of the funds allocated to SEDAPAL had been committed but only US$2.4 million had been disbursed. SEDAPAL, however, took appropriate remedial actions and implementation accelerated during the last semester of 1981 and the first quarter of 1982. Project implementation is now expected to be com- pleted during the last quarter of 1982, and the Bank has extended the Loan's closing date from December 31, 1981 to December 31, 1982. SEDAPAL is complying with all loan covenants. III. THE BORROWER AND IMP-EMENTING AGENCY 3.01 SEDAPAL will be the Borrower and implementing agency. The Na- tional Development Bank (COFIDE) will be SEDAPAL's financial agent. SENAPA, owner of SEDAPAL'S equity, and the authority which must approve tariffs for services provided by SEDAPAL, should also be part of the con- tractual arrangements with the Bank in order to ensure compliance with loan conditions. Background 3.02 Between 1970 and 1981, the instil:ution responsible for planning, constructing and operating all water supply and sewerage services in the  Greater Lima Metropolitan Area was ESAL an autonomous public entity, under the Ministry of Housing. In September 1981, ESAL became subsidiary of SENAPA and its denomination was changed to SEDAPAL. Both, SENAPA and SEDAPAL's By-Laws 1/ provide the latter with a degree of financial and ad- ministrative autonomy which allows for an effective operation. Assurances were obtained during Loan negotiations that there would be no changes in SEDAPAL's legal status without Bank's concurrence. 3.03 Legislative Decree No. 150 which created SENAPA, and SENAPA's By- Laws provide for the establishment of a sector investment fund, which would be partly funded by surpluses from the operation of its subsidiary com- panies after deduction of requirements for their own reinvestments. Assur- ances were obtained from SENAPA during negotations that SEDAPAL's generated revenues would only be transferred when the funds are projected to exceed the requirements of SEDAPAL's investment program for the following five- year p,eriod as approved by SEDAPAL's Board of Directors (para. 6.20 b). 3.04 SEDAPAL is governed by a six-member Board of Directors appointed by the President of Peru. One of the members of the Board is a represen- tative of the Ministry of Health, and another a Representative of the Muni- cipality of Lima. The other four members represent the President. The General Manager who is the Chief Executive Officer, and the two managers reporting to him are appointed by SEDAPAL's Board. 3.05 SEDAPAL's organizational structure is presented in Annex 2. Two departments report to the General Manager: (a) Technical--responsible for operation and maintenance of SEDAPAL's water and sewerage systems, engineering studies and projects, and implementation and supervision of cons- truction programs; (b) Administrative--responsible for personnel management, com- mercial activities, procurement, financial management and accounting. Seven units also report to the General Manager. These units are in charge of planning, data processing, legal advice, public relations, organization and methods, works inspection and corporate affairs. 3.06 SEDAPAL's organizational structure, procedures, and control were not considered fully adequate for its operational needs, and are being res- tructured through an institutional improvement program financed under Loan S-ll-PE. The program is being carried out by SEDAPAL and the management consulting firm of Price Waterhouse. The consultant's assignment includes 1/ Both documents are available in project files.  - 9 - the analysis of SEDAPAL's management practices (completed in mid-1980) 1/ and the implementation of the resulting recommendations. The implementa- tion began in March 1981 and is currently scheduled to be completed by the last quarter of 1982. Management and Personnel 3.07 SEDAPAL's present General Manager, a civil engineer specialized in hydrology, has extensive experience and is well qualified to handle overall responsibility for the institution. The key managerial positions under the General Manager are currently filled by qualified personnel. In the past, SEDAPAL found it difficult to hire and retain high-level qual- ified staff because of low salary levels. The problem has been alleviated by a recent increase of SEDAPAL's managerial salaries. In addition, SEDAPAL's Board of Directors has committed itself to continue to monitor the competitiveness of SEDAPAL salary levelE. 3.08 In June 1981, SEDAPAL's permanent staff totalled 3,060, or 8.1 employees per thousand connections. This raEtio is high compared with other water utilities in Latin America (5.6 in Bogota and 3.7 in Santiago). Un- skilled and semi-skilled job categories are overstaffed, but those requir- ing highly qualified personnel are understaffed. SEDAPAL's goal is to operate with 5.7 employees per thousand connections by 1986. -_Specific targets to be included in the project monitoring indicators-have been agreed upon (Table 6.5). 3.09 SEDAPAL's training activities need to be expanded. Most of the training is on the job. During 1976-80, 250 employees participated in seminars. During the same period, SEDAPAL sent 110 employees to short-term courses. A new, adequately staffed administrative unit, being set up by SEDAPAL with the help of consultants, will be responsible for determining training needs, and for developing and implementing the corresponding pro- grams. Furthermore, the assistance of local universities and technical institutes is being sought to develop courses and seminars. Commercial 3.10 The Commercial Division is in criarge of installing new connec- tions, keeping the customers' files, metering water consumption, and bil- ling and collecting charges for SEDAPAL's services. Performance of this Division has been poor, but SEDAPAL is taking remedial action with the aid of the consultants. The Division, currently under the Administrative Manager, will become a Department reporting directly to SEDAPAL's General Manager. Qualified personnel are being hired for key functions, and the quality and coverage of the commercial computerized operations are being increased. The reorganization is scheduled to be completed by mid-1982. 1/ The consultant's report on SEDAPAL's management practices is available in project files.  - 10 - 3.11 SEDAPAL's customer files are unreliable and incomplete. They contain a significant number of closed and incorrectly classified connec- tions, and do not include up-to-date information on those customers who re- ceive water and sewerage services and those receiving water services alone. As a consequence, only one tariff scale is applied to both groups of customers (para.6.06). SEDAPAL and its consultants are developing new procedures and computer programs to keep the customer files up to date. At the sELme time, consultants are devising more effective internal control procedures. In addition, the users' survey programmed for 1982 as part of the proposed project (para. 5.05) would allow the collection of reliable information on the current status of connections to the SEDAPAL system, including the type of service provided (water, or water and sewerage). The survey will be based on the results of the pilot survey carried out by SEDAPA:L and its consultants under Loan S-ll-PE. 3.12 The number of SEDAPAL's billed connections as of June 1981 was 381,000. An estimated additional 83,000 connections were not being billed for water used. This total includes about 53,000 connections located in new urban developments where water and sewerage networks were installed by developers who have not complied with SEDAPAL's technical or administrative regulations. The remaining 30,000 connections are listed as closed. 1/ SEDAPAIL is currently implementing a program to add the estimated 83,000 connections to its billing system. About 12,000 of such connections were already incorporated into SEDAPAL's billing system between July and September 1981. The program is scheduled to be completed by mid-1984 as some minor works are required to comply with SEDAPAL's technical regula- tions. Specific targets included in the project inatnKug iidicators have been agreed upon (Table 6.5). 3.13 As of June 1981, only 35% of all connections were effectively metered, since a substantial portion of the meters in place are out of or- der or are not read (Tables 4.2 and 6.5). The lack of reliable consumption and production metering has resulted in unreliable assessment of unac- counted-for water (paras. 4.14 and 4.17). The proposed project will con- tinue to support the metering program financed under Loan S-11-PE as it in- cludes the purchase and installation of production and consumption meters, and equipment for SEDAPAL's meter repnar s'l-op (para. 5.05). 3.14 Meters are read every month by independent contractors. The number of meter readers employed by contractors and SEDAPAL's control over meter reading appear to be insufficient. Actions recommended by SEDAPAL's consultants to correct the situation are being implemented. 3.15 The billing process is slow (consumers are billed within 30 to 40 days of meter reading), because of the inadequacy of the computer program. A new program to accelerate the process is being prepared. Customers may make their payments at SEDAPAL's offices, commercial banks or drug stores. At present, late payments are automatically postponed to the next billing 1/ This is the estimated number of connections receiving water out of a total of 50,000 closed connections.  late payments have not been introduced. The new billing program provides for effective implementation of a policy of water shut-offs and of charges for late payments. As of June 1981, accounts receivable from water sales amounted to a high 4.5 months of sales, and accounts more than six months overdue amounted to 10% of the total. A significantly large number of un- usually old and poorly documented accounts will have to be written off. SEDAPAL's financial projections include a provision to that end (para. 6.13). Targeted reductions in accounts receivable were agreed with SEDAPAL's management and included in the project monitoring indicators (Table 6.5). This agreement was confirmedl during Loan negotiations and included in the Loan Agreement. Planning, Budgeting and Accounting 3.16 SEDAPAL, with the help of consultants, is implementing a new planning system well suited to its needs. The system integrates long-term objectives and annual operating budgets. The operating budgets are directly related to responsibility centers. 3.17 SEDAPAL is currently testing a new computerized accounting system, scheduled to be fully implemented by the second quarter of 1982. The system includes integrated financial, cost and budget accounting well suited to SEDAPAL's needs. 3.18 SEDAPAL's fixed assets were recent:ly inventoried and valued. As- surances were obtained during negotiations that SEDAPAL will continue to revalue its fixed assets annually using the official indexes established by the Government in compliance with Legislative Decree 21694 . Those indexes have been found satisfactory to the Bank. -f there are changes in the com- position or application of the indexes which, in the Bank's opinion, sig- nificantly affect the value of the required asset revaluation in any given year, an alternative index, such as the consumer price index, acceptable to the Bank should then be applied. Data Processing 3.19 SEDAPAL's computer equipment (IBM--4331) is adequate, but the Data Processing Center's performance has been poor. The computer programs available are limited and obsolete. SEDAPA]. has also experienced difficul- ties in hiring and retaining qualified personnel for the Center. Recent salary increases (para. 3.07) have somewhat alleviated the problem. A qualified Data Processing Director was appoLnted and some analysts and pro- grammers were hired with the advice of SEDAl'AL's consultants. New computer programs supporting SEDAPAL's reorganization are being prepared and SEDAPAL's management has assigned high priority to the improvement of the Center.  - 12 - Auditing 3.20 Peru's Government auditing agency (Contraloria) is responsible for the external audit of public entities. Since the auditing of all pub- lic entities is a task that goes beyond the capability of the Contraloria, the normal practice in public revenue earning enterprises, including SEDAPAL, has been to appoint private auditing firms selected by Contraloria and paid for by the enterprises. Terms of reference for the work of the external auditors are drafted by the enterprises and reviewed by Contra- loria. This arrangement would be acceptable to the Bank provided that draft terms of reference (including required qualifications for the audit firm) are timely submitted to the Bank for prior review and approval. SEDAPAL's 1980 financial statements were audited by Giraldo, de la Torre y Cia., a firm of competent independent auditors, which is acceptable to the Bank. Their report contain an unqualified opinion on SEDAPAL's financial statements and relevant comments on SEDAPAL's internal controls. SEDAPAL is in compliance with the covenant on external auditing under Loan S-11-PE. Assurances were obtained during Loan negotiations that SEDAPAL's annual financial statements will continue to be audited by competent independent auditors, in accordance with generally accepted accounting principles, and that a copy of their report will be presented to the Bank not later than April 30 of the corresponding following year. 3.21 The Peruvian laws require that SEDAPAL's internal auditor re- ports, to SEDAPAL's Board of Directors and Management and to the Contra- loria. The functions of the Internal Auditing Unit and its staffing are satisiFactory. Some problems have arisen, however, because of lack of com- munication between the Unit and other departments within SEDAPAL. SEDAPAL is taking remedial actions, including the issuance of a more detailed job description, which would permit better management control. Insurance 3.22 SEDAPAL carries fire and casualty insurance on plant and equip- ment. It also carries fidelity bonds and insurance for third party liabil- ity, professional risks and goods in transit. SEDAPAL's insurance policy has not, however, been subject to a thorough analysis. Assurances were ob- tained during negotiations that SEDAPAL would submit to the Bank for com- ment, before December 31, 1982, an insurance program to be put into effect no later than June 30, 1983. Overall Assessment 3.23 Since the start of the technical assistance program financed under Loan S-11-PE, SEDAPAL has made considerable progress in identifying its organizational weaknesses and in taking actions to correct them. Suc- cessful completion of the reorganization process will require SEDAPAL's continuing commitment. The present Board and Management have both the wil- lingness and ability to continue the process. Bank supervision of project execution should closely monitor progress made toward compliance with the implementation targets. Annex 3 summarizes the institutional assessment of  - 13 - SEDAPAL and highlights the weaknesses that 3hould be addressed during pro- ject supervision. IV. POPULATION, SERVICE AND DEMAND IN THE PROJECT AREA Description of Project Area and its Population 4.01 The Lima Metropolitan Area includes the cities of Lima and El Callao, and a number of smaller communities located in river valleys within the jurisdiction of Lima and El Callao Provinces.l/ Its population was 4.6 million 2/ as of June 30, 1981, and it is expected to increase to about 9.1 million by the year 2000. Urban expansion to accommodate this population increase tends to occur within the narrow river valleys and adjacent desert areas located north and south of downtown Lima. The Metropolitan Area re- presents about 26% of the country's population. It plays a leading role in the economic activity of the country by generating about 60% of the GDP and 70% of the country's industrial output (1979). 4.02 It is estimated that 41% of the 1981 population of Lima belonged to low-income families earning less than two minimum salaries per family. The majority of the low-income population lives in high-density develop- ments (Pueblos Jovenes) located on the outskirts of the central urbanized area. An estimated 13% of the low-income pDpulation lives under extremely poor sanitary conditions within downtown Lima. Water Resources and Quality 4.03 Metropolitan Lima area is traversed by the Rimac, Chillon and Lurin Rivers. The main water sources for the area are the Rimac River and groundwater aquifers. Both resources are fed from heavy rainfall and snow- melt in the upper reaches of the Andes Moun:ains. Rainfall in the coastal areas is almost non-existent (10-20 mm per year). 4.04 The Rimac River's average annual flow at the Atarjea Water Treat- ment Plant (Map 1) is estimated to be 21 m3/s, with monthly averagesfluc- tuating between 53.0 and 11.6 m3/s, as shown in Annex 4. This flow in- cludes about 3 m3/s from trans-Andean watersheds and is used for power gen- eration in the upper reaches. River regulation is not economically feasi- ble as the river valley is narrow and steer, and seismic activity is sig- nificant. During periods of low flow, the Rimac River can meet only part of the Lima's urban water needs. Some Df the urban demand is met by limited groundwater sources. The proposed project is aimed at meeting short- to medium-term needs by developing groundwater sources to be used in conjunction with existing water sources. Lcng-term urban needs are planned 1/ Other definitions of greater Metropolitan Lima might differ. 2/ Based on preliminary results of the 198C census.  - 14 - to be met by the Mantaro Transfer Project (MTP) which will address both power and water supply needs. 1/ 4.05 The raw water quality (Annex 5) of the Rimac River is affected by high levels of suspended solids from landslides during the rainy season and moderate bacterial contamination from small upstream communities. The Atar;jea Water Treatment Plant, which includes a raw water reservoir, has been adequate to handle the pollutants and delivers water that meets Peruvian and WHO drinking quality standards. The Peruvian Water Law is avaiLable in project files. Groundwater quality varies but is generally adequate, except in some coastal areas where sea water intrusion has in- creased salinity to unacceptable levels. Existing Water Supply and Sewerage System 4.06 In 1980, the Rimac River provided 9.5 m3/s (52%) of a total urban water supply of about 18.2 m3/s (Table 4.1). The remaining 48% was sup- plied from groundwater sources and minor springs. During the dry season (June to November) the river's flow decreases substantially and the use of grourndwater resources has to be increased to meet demand. Even during the high flow period, groundwater resources are presently required because of the limited capacity of the Atarjea Water Treatment Plant (10 m3/s) and because distant users cannot be economically served by this source. 4.07 Groundwater is supplied from about 215 SEDAPAL wells and about 260 industrial and private wells independent of SEDAPAL's water system. In some city areas, particularly where industry is concentrated, groundwater is being mined at a rate of about 2 meters per year. At this rate, many of the existing wells are drying up and need to be deepened or replaced. 4.08 It is estimated that more efficient combined use of groundwater and the Rimac River could meet Lima's water demand through the late 1980s. Use of existing water resources would have to be improved by permitting greater replenishment of the aquifer whenever flows in the Rimac River are high enough (January-March) to allow increased use of groundwater when the Rimac flow is low. To this end, SEDAPAL is now constructing a second treatment facility at Atarjea (5 m3/s capacity). A comprehensive ground- water management program and deep well construction program is included in the proposed project. 4.09 The bulk of Lima's water supply is distributed through the public water system managed by SEDAPAL (Table 4.1). Private industry is the next largest urban supplier, followed by miscellaneous private water develop- ments, domestic well supplies and minor surface water extractions. 1/ M[antaro Transfer Project Feasibility Study by Binnie and Partners is available in project files.  - 15 - TABLE 4.1: 1980 WATER SUPPLY IN THIE LIMA METROPOLITAN AREA Estimated Quantity Source of Supply M3/s X Public Supply (SEDAPAL) 85 Atarjea Treatment Plant 9.2 Wells 5.8 Infiltration Galleries 0.4 Private Supplies 15 Industrial Wells 2.0 Industrial Surface W4ater Diversion (on Rimac) 0.3 Private Water Wells and Springs 0.5 18.2 100 4.10 The Atarjea Treatment Plant consi,ts of: an intake structure and a grit basin; a primary sedimentation reEiervoir with a capacity of 500 thousand m3 which allows large turbidity peaks to be bypassed; and primary and secondary sedimentation, filtration and chlorination facilities. The new treatment plant (para. 4.08) being constructed adjacent to the existing facility (expected to be commissioned by early 1983) will expand treatment capacity by about 50%. 4.11 About 85% of SEDAPAL's wells operate continuously to keep up with demand. Many of SEDAPAL's wells are in poor condition because of the lack of proper maintenance and spare parts, and because of the lack of suffi- cient stand-by capacity to allow the wells to be shut down for repair. Most of the groundwater extracted is not chlorinated. Inadequate design, construction techniques and supervision are also causes of the poor perfor- mance and low yield of most wells. Prival:e wells have the same construc- tion deficiencies, but their operation and maintenance practices are some- what better because they are not in continuous operation and because they have stand-by capacity. The proposed project includes a technical assis- tance component to develop additional extraction capacity and to improve the operation of existing wells. This component also includes the imple- mentation of improved technical specifLcations for construction and equipment of wells, and provision of chlorination facilities. 4.12 The existing water distribution system covers an area of approxi- mately 25,000 hectares with about 4,500 km of pipeline and 200 storage tanks (340,000 m3 of storage capacity). Pipeline sizes range from 75 mm to 1,800 mm. About 255 km are 250 mm in diameter or larger. Because the five pressure zones in the distribution system have not been properly bound by valves, system pressure in some service areas is low. Periods of zero pressure occur frequently in high-altitude areas during the summer months. SEDAPAL has an ongoing program to complete installation of valves needed to  - 16 - equalize system pressure zones. Seventy percent of the program has been executed and completion is expected by 1983. Drilling of additional deep wells under the proposed project would help restore normal pressures in the water system. The treatment plant under construction (para. 4.10) would also help to improve system pressures. 4.13 In 1980, unaccounted-for water was estimated at 50% of water pro- duction. Investigations carried out under Loan S-11-PE revealed that dis- tribution system leakages, old pipelines, improperly tapped house connec- tions and malfunctioning valves are the cause of about 34% of the unaccoun- ted-for water. Illegal connections and underestimated consumption may account for the remaining 66% of the unaccounted-for water. A leak detec- tion and repair program is being financed under Loan S-ll-PE and will be permanently established within SEDAPAL's operations. 4.14 A pilot water house-connection survey carried out by SEDAPAL during late 1980 (para. 3.11) indicated a high incidence of unmetered con- nections and malfunctioning meters. Results of this survey are shown in Table 4.2 below. TABLE 4.2: STATUS OF METERING OF WATER CONNECTIONS (as of December 1980) Number of Connection Category Connections 1/ % (000) Domestic: Not metered 106 27 Metered, not read 179 45 Metered and read 112 28 397 100 Commercial/Industrial: Not metered 8 28 Metered, not read 14 48 Metered and read 7 24 29 100 All Customers: Not metered 114 27 Metered, not read 193 45 Metered and read 119 28 426 100 1/ Includes billed and closed connections; does not include unbilled connections in new urban developments (para. 3.12)  - 17 - A metering program for industrial and commer-cial establishments was started in 1980 with Bank financing under the Loan S-11-PE. The program would be broadened under the proposed project to inzlude domestic meters and rein- force SEDAPAL's meter maintenance practices and facilities. The objective of the proposed program is to increase mete- coverage to 71% of connections by 1986. The metering program, combined wi:h the leak detection and repair program (para. 4.13) and supported by the users' survey for water and sew- erage connections (para. 5.05), is expected to reduce unaccounted-for water to about 30% by 1986 (Table 6.5). 4.15 SEDAPAL's sewerage system, of about 4,000 km of collectors and interceptors serves approximately 90% of the population served by the water supply system. New urban developments cn the outskirts of Lima still depend on individual latrines for sewage disposal. All of the city's waste-water, except for that of a small seriice area, is discharged without treatment into the ocean and nearby rivers. Industries connected to SEDAPAL's sewerage system produce significant amounts of pollutants, in- cluding some toxic materials. Beaches in t:he immediate vicinity of sewage discharges are polluted, as are the lower reaches of the Rimac River. 4.16 The sewerage Master Plan being prepared under Loan S-ll-PE pro- vides for the development of a system under the following guidelines: (i) discharges into local rivers will be intercepted and di- verted to the central sewerage system in order to reduce pollution of water sources; (ii) wastewater not diverted For reclamation and reuse will receive pretreatment only and be discharged into the ocean via three outfalls; and (iii) wastewater from communities not connected to the central collection system will be treated in oxidation ponds and discharged into nearby rivers. Water Production and Consumption 4.17 As shown in Table 4.3, in 1980 SEDAPAL produced an estimated 485 million m3 (15.4 m3/s) to supply the city's needs. As water production metering in most of SEDAPAL's facilities is not adequate and well produc- tion is estimated only by occasional spot checks, the above figure is not completely reliable. 4.18 Consumption by SEDAPAL customerE in 1980 was estimated at about 243 million m3/year. Monthly consumption varied seasonally from a low of about 84% of average to a high of 114% duAing the summer months (February peak). Water consumption was distributed as follows: 74% for residential use and 26% for industrial, commercial, and public uses. About 95% of SEDAPAL's domestic consumption in 1980 was consumed by households in the middle-and high-consumption brackets, representing 70% of the population served.  - 18 - 4.19 The present average domestic consumption is about 204 1/cd. Middle- and high-consumption groups use about 330 I/cd, while low- consumption groups use about 56 1/cd. The population served through stand- pipes and water trucks consumes about 20 1/cd. Wastage is encouraged by the high proportion of unmetered connections and damaged meters (Table 4.2). SEDAPAL has measured night-time wastewater flows in downtown Lima's interceptors at an average of 80% of the 24-hour average flow. Since groundwater infiltration in Lima is nil, this high level of nigh-time wastewater flows is a strong indication of wastage caused by faulty plumbing and carelessness. Population and Demand Projections 4.20 Metropolitan Lima's population of 4.6 million in 1981 increased at a rate of 3.8% p.a. in the last decade; population is projected to in- crease at a rate of 3.8% p.a. in 1981-1990 and 3.5% p.a. in 1990-2000. The 1990 population of the metropolitan area would reach 6.4 million or 28% of the country's total population. This projection is based on urban zoning regulations, which induce urban growth north and south of downtown Lima and encourage large industries to settle in development areas outside Lima. 4.21 Water demand projections take into account projected population growth, SEDAPAL's planned increase in service levels and decreasing per capita consumption. SEDAPAL's institutional improvements in operation and maintenance and in the metering program are expected to decrease demand in high-consumption groups to about 300 1/cd by 1986 and to about 280 1/cd by 1990. Low consumption customers are assumed to maintain present consump- tion Levels. Population, service levels and demand projections are shown in Table 4.3. The projected water demand and available supply are pre- sented graphically in Annex 6.  TABLE 4.3: POPULATION AND SEDAPAL'S DEMAND PROJECTIONS Population Service Unaccounted Population Served level Water Supply for water (Million) Production Consumption Total Per Total Per Water Sewerage Million Capita Million Capita Water Sewerage __ _ m3/yr lpd m3/yr lpd % 1980 4.43 3.37 1/ 3.06 76 69 485 484 242 241 50 1981 4.60 3.50 1/ 3.17 76 69 498 478 264 253 47 1983 4.96 3.70 3.47 75 70 543 396 331 246 39 1985 5.34 4.45 4.16 83 78 573 354 396 244 31 1986 5.54 4.76 4.40 86 79 597 344 418 241 30 1990 6.44 5.79 5.41 90 84 697 330 488 231 30 1995 7564 -.8 69 490 85 778 310 545 217 30 2000 9.10 8.2 7.83 90 86 864 290 605 203 3O 1/ About 600 thousand people are estimated to be illegally connected (para. 3.12).  - 20 - 4.22 Water production, based on the above estimates, is expected to grow at a rate of about 4% during the current decade to achieve a service level of 86% by 1986 and 90% by 1990. To meet the goals for 1986, ground- water extraction would have to be increased and groundwater management prartices would have to be improved to allow the combined use of ground- water and surface water in 1983 and beyond. V. THE PROJECT Genesis 5.01 Since 1978 the Bank has been assisting SEDAPAL with the assess- ment of Lima's water resources and strengthening SEDAPAL's management and operational abilities through Loan S-ll-PE. The proposed project was iden- tified by a Bank mission in January 1981. Since then the Bank has been as- sistilng SEDAPAL with project preparation. 5.02 SEDAPAL's low level of investment in the past and the rapid growth of Lima's population have resulted in a pressing need for water and sanitation which requires immediate solution. The proposed project is aimed at meeting Lima's short- and medium-term water supply and sewerage needs. It is consistent with the strategy being incorporated in the water and sewerage master plan financed under Loan S-il-PE. Lima's long-term needs are to be met through the development and transfer of water from the Atlantic watershed. Feasibility studies for this solution were prepared and financed under Loan S-ll-PE; final designs would be financed under the Bank's proposed Sixth Power Loan. Objectives 5.03 The overall objective of the project is to improve health and living conditions in Lima, in particular those of the low-income popula- tion, through the improvement and extension of the water supply and sewer- age facilities. Specific project objectives are: (i) to improve and extend water and sewerage services to highly populated areas where most of Lima's low-income population lives (Pueblos Jovenes); (ii) to improve water and sewerage services in several areas of Lima under the general framework of the master plan; (iii) to improve the management of the Lima's ground and surface water resources; and (iv) to continue strengthening SEDAPAL's management capability through the implementation of measures to improve SEDAPAL's financial, commercial and maintenance functions. Service Standards 5.04 Water services will be provided through house and courtyard con- nections. Sewerage services will be provided through house discharges to  - 21 - the sewerage system. These standards are in accordance with the popula- tion's expectations and ability to pay. They also conform to the Govern- ment's and SEDAPAL's objectives of expanding water and sewerage services in the metropolitan area. Existing groundwater facilities will be upgraded to extend their useful lives and expanded to me2t the need for higher service levels of a growing population. The project. includes the construction of waterborne sewerage systems in the densely populated low-income areas to be served by the water systems. It is not considered economically feasible to extend service by house connections or waterborne sewerage connections to scattered and low-density settlements within the service area. These areas will continue to be served by standpipes or water trucks and by pit latrines. Project Description 5.05 The project would directly benefit about 370,000 inhabitants with water and sewerage services by 1986. It would also develop water sources to permit some 610,000 additional inhabitants to be incorporated to the water system by the same date. SEDAPAL's sewerage system would, with only minor works, be sufficient to incorporate thE population to be served from the newly developed water sources. (i) provision and improvement of water and sewerage services to low-income areas through: (a) construction of about 463 km of water distribution networks, transmissior mains (including 5 km pipe- line to Canto Grande (para. 5.22)) and storage tanks, and about 43,00D house connections; and (b) construction of about 430 km of sewage collector networks, 10 km of sewage interceptors and about 46,000 house discharges; (ii) development and improvement of groundwater sources to in- crease water production by 4.4 m3/sec to permit the incor- poration of about 120,000 addlitional connections and allow more efficient operation and maintenance of existing wells, through: (a) construction of about L km of infiltration galleries and improvement of existing galleries; and (b) drilling and construction of, and provision of equipment, for about 76 deep wells, and rehabilita- tion of about 80 wells; (iii) improvement in the operation of the water distribution system and reduction of unaccounted-for water through:  - 22 - (a) provision and installation of about 180 master meters in existing wells and in the principal water mains. (b) acquisition and installation of about 164,000 house meters, rehabilitation of 136,000 meters, and im- provement of SEDAPAL's meter repair shop; and (c) provision of additional water quality control labo- ratory equipment and purchase of about 190 operating vehicles; (iv) technical assistance for: (a) a users' survey of water and sewage connections to incorporate unregistered connections into the com- mercial system, and to permit better planning for the expansion of services; and (b) management and control of water resources including groundwater recharge, and operation and maintenance of deep wells. Status of Designs 5.06 SEDAPAL has retained qualified engineering consultants for the final design of project components. Final designs, including bidding docu- ments, for components representing almost 40% of project costs were com- pleted by March 31, 1982. Completion of all final designs and tender docu- ments is expected by September 1982. SEDAPAL has invited international competitive bidding for the financing and construction of 50 deep wells (out a total of 76 included in the project). It would include the design, drilling and equipping of wells. SEDAPAL's consultants have been assigned the task of determining the location of the wells and designing connections to the existing distribution system. Least-Cost Analysis 5.07 Selected project components correspond to the least-cost techni- cally feasible alternative (13% discount rate). Water supply and sewerage networks to serve low-income areas are being designed in conformity with satisfactory engineering standards and at reasonable per capita consumption levels. Construction of new wells, rehabilitation of existing wells and construction of additional infiltration galleries were found to be the most efficient means of developing new production. The metering program is desiLgned to meter medium- to high-consumption customers to achieve a target of 71% of total connections by 1986. The purchase of vehicles and equip- ment is intended to improve SEDAPAL's operating capacity at a lower cost than leasing. Improvement of the existing water and waste discharge labo- ratory would strengthen SEDAPAL's role in surveillance of water quality and would improve the accuracy of data required for the design of future sewage  - 23 - treatment and disposal facilities. The technical assistance component is aimed at improving SEDAPAL's water resource management and commercial practices. Cost Estimates 5.08 The estimated total cost of the project is US$92.76 million with a total foreign exchange cost of US$45.25 million (49%), as shown in Table 5.1. In addition, interest during construction is estimated to be US$9.57 million and the front-end fee is US$0.60 million. Detailed cost estimates are provided in Annex 8. 5.09 Cost estimates were prepared by SEDAPAL's Engineering Depart- ment. They are based on recent bids for similar civil works, materials and equipment, updated to March 31, 1982 prices, Cost estimates are exclusive of taxes. The average allowance for physical contingencies is 13.5% and varies from 10% for well-defined components to 15% for works at the design stage. Price contingencies are based en a 4-1/2 year construction schedule. International inflation forecast at 8.5% in 1982, 7.5% for the years 1983 through 1985, and 6% in 1986 was applied to the foreign com- ponent. Domestic inflation rates applied to local components are 50%, 40%, 30%t 25%, and 20%, for the years 1982, 1983, 1984, 1985 and 1986, 1/ res- pectively. Variations of the exchange rate were assumed to compensate for the difference between the local and international inflation rates. L/ Average annual domestic inflation was 59' in 1980 and 65% in 1981.  - 24 - TABLE 5.1: PROJECT COST ESTIMATE Local Foreign Total Local Foreign Total ------S/ million -------- -------US$ million-- Water supply and sewerage works Water supply 3,955 4,286 8,241 6.89 7.47 14.36 Sewerage 6,754 2,657 9,411 11.77 4.63 16.40 Water sources New wells 2,269 3,656 5,925 3.95 6.37 10.32 Rehabililtation 514 1,471 1,985 0.90 2.56 3.46 Galleries 444 734 1,178 0.77 1.28 2.05 Metering program 2,629 3,059 5,688 4.58 5.33 9.91 Equipment Vehicles 235 1,728 1,963 0.41 3.01 3.422 Laborato-ry 26 48 74 0.05 0.08 013 Technical assistance Users' survey 630 267 897 1.10 0.46 1.56 Groundwater management 270 316 586 0.47 0.55 1.02 Engineering supervision 1,563 269 1,832 2.72 0.47 3.19 Base cost 1/ 19,289 18,491 37,780 33.61 32.21 65.82 Physical contingencies 2,603 2,495 5,098 4.53 4.35 8.88 Total cost in June 1981 prices 21,892 20,986 42,878 38.14 36.56 74.70 Price contingencies 2/ 21,666 19,859 41,525 9.37 8.69 18.06 Total Project Cost 43,558 40,845 84,403 47.51 45.25 92.76 Front-end fee on Bank Loan -- 344 344 -- 0.60 0.60 Total financing required 43,558 41,189 84,747 47.51 45.85 93.36 1/ At March 1982 prices and exchange rate. 2/ Variation of the exchange rate is assumed to compensate the difference between the local and foreign inflations. NOTE: Figures have been rounded.  - 25 - 5.10 Consultant and engineering services are estimated at US$5.77 mil- lion for a total of 2,766 man-months, of which 616 are for professional and technical staff and 2,150 for support staff. The average man-month cost, (including salaries, international travel and subsistence) for ex- patriate technical staff is US$10,000 (76 man-months), the average cost for locally hired professional staff, including salaries and administrative costs, is US$2,380 (540 man-months) and the average cost of local support staff is US$1,720 (2,150 man-months) inclucing salary and administrative cost. Supervision of construction is estimated at US$3.19 million and in- cludes 1,450 man-months of technical and su'port staff. The cost of the users' survey is estimated at US$1.56 million and includes 1,170 man-months of technical and support staff. The cost of the groundwater management program is estimated at US$1.02 million and includes 146 man-months of technical and support staff. Detailed conEultant costs and manpower re- quirements are presented in Annex 9. P'roject Financing 5.11 Financing required for the project, excluding interest during construction and the front-end fee on the proposed Bank loan, is estimated to be US$92.76 million equivalent (S/84,403 million). The proposed Bank loan of US$40.6 million would finance the estimated direct and indirect foreign exchange costs of the project, excliding the cost of construction of 50 deep wells, for which a US$7.70 million credit (parallel financing) is being sought. The front-end fee on the Bank Loan (US$0.60 million) would be capitalized and also financed under the proceeds of the proposed loan. Cash to be internally generated by SEDAPAL would provide US$54.63 million to finance local costs as well as interest luring construction. A break- down of project costs and financing is presented in Table 5.2  - 26 - TABLE 5.2: FINANCING PLAN FOR THE PROJECT Sl million US$ million Requirement Project Cost: Foreign exchange 40,845 45.25 44 Local currency 43,558 47.51 46 Sub-Total 84,403 92.76 90 Front--end fee on Bank Loan 344 0.60 1 Interest during construction 9,779 9.57 9 Total Cost 94,526 102.93 100 Sources Bank loan 42,596 40.60 39 Cofinancing 6,634 7.70 8 Internal cash generation 45,296 54.63 53 Total Sources 94,526 102.93 100 Implementation 5.12 The project will be executed by SEDAPAL during the period July 1982-December 1986 in accordance with the construction schedule shown in Annex 10. Most of the bidding process will be carried out during late 1982 and early 1983, and the bulk of project construction is likely to start during 1983, except for some works in Pueblos Jovenes which are ex- pected to start during 1982 (para. 5.22). The project is expected to be completed by December 31, 1986. 5.13 The Project Supervisory Unit (PSU) created in 1979 to coordinate and supervise the engineering project financed under Loan S-11-PE will be strengthened to continue to perform similar activities under the proposed Loan. PSU will be responsible for: (i) coordination of consultants to advise SEDAPAL's Ground- water Management Division on the optimal use and operation of existing water resources; (ii) supervision of consultants in charge of the users' survey; (iii) supervision of construction under the proposed project; (iv) supervision of ongoing consulting assignments financed un- der Loan S-11-PE; and  - 27 - (v) control of project supervision, including control of moni- toring indicators and preparation of semiannual reports to be submitted to the Bank (para. 6.21). The manager, deputy manager and three depertment directors, who will be provided by a consulting firm to head PSU, and short-term consultants for project supervision would be entirely finEnced under the proposed Loan. 'Professional and support personnel to staff the PSU and to supervise con- struction will be provided and paid for by SEDAPAL. Assurances were ob- tained from SEDAPAL during negotiation that it would hire qualified consul- tants for the PSU under Terms of Reference acceptable to the Bank and that it would provide at all times the required staff, funds and equipment for its effective operation. The proposed Loan would also finance 40% of con- sultant's services required for the cadastral survey and management of groundwater resources. The following tasks should be completed by SEDAPAL to the Bank's satisfaction as a condition of Loan effectiveness: reorgani- zation of PSU; definition of its functions; and appointment of its manager and deputy manager. 5.14 Project implementation in a four-and-a-half year period is con- sidered to be achievable by SEDAPAL consider[ng that: (i) equipment and materials to be procured are standard goods in the international and local water supply and sewerage industry. Civil works do not present major technical dif- ficulties and are well within the technical capability of the local construction industry; (ii) SEDAPAL's institutional absorptive capacity has been im- proved as a result of the technical assistance program, financed under Loan S-11-PE, and key PSU staff has ac- quired adequate experience in project management; (iii) significant improvements of SEDAPAL's finances during 1981 give reasonable confidence in the timely availability of local counterpart funds; (iv) SEDAPAL's investment plan has been staged according to the urgency of need and to its Implementation capability. The project corresponds, thus to the first stage of SEDAPAL's investment plan; (v) project works have been carefully identified to allow si- multaneous construction of riost components; (vi) bidding procedures would be streamlined by adopting stand- ard bidding documentation for most civil works and goods; and (vii) final designs being prepared by consultants are in an ad- vanced stage of preparation and are expected to be com- pleted during the course of 1982 (para. 5.06).  - 28 - 5415 Three supervision missions (24 man-weeks) a year, for the first two years and two per year (16 man-weeks) for the following years, are planned. Procurement 5.16 Procurement will be made in accordance with the Bank's procure- ment guidelines which have been discussed and agreed upon with SEDAPALe Contracts would be grouped in appropriate bidding packages to make them at- tractive for international competitive bidding (ICB). Proposed major con- tracts for civil works and for materials and equipment purchase are listed and scheduled in Annex 8. Civil works in excess of US$1.5 million will be procured under ICB. Materials and equipment in excess of US$200,000 would also be procured on the basis of ICB. Civil works contracts of less than US$1.5 million or contracts for materials of less than US$200,000 are not likely to interest foreign bidders. These contracts will be awarded under local bidding procedures which are acceptable to the Bank. The aggregate amount of contracts so awarded shall not exceed US$6.0 million. Contracts for goods and services costing less than USS50,000 would be procured on the basis of price quotations obtained from not less than three suppliers and would be subject to a maximum aggregate of US$500,000. No works under force account or services provided under statement of expenditures proce- dures are anticipated. 5.17 Foreign suppliers are expected to win most of the equipment5 large diameter pipe and well construction contracts. Given the development of the civil works construction industry in Peru, most civil work contracts are expected to be won by local contractors. Due to the technical capa- bility of local consulting firms, moderate expatriate personnel input in the form of short and specialized consulting assignments is expected for supervision of construction, the users' survey, and management of ground- water resources. A draft of the general conditions for all ICB and local procurement tender documents would be prepared for the first bid and, upon Bank approval, would be used for subsequent bids. Contracts subject to ICB (inc]Luding copies of bidding documents, bid analysis report and recommen- dation for award), expected to account for about 90% of total project cost, will be made available to the Bank for prior review and approval. Con- tracts awarded under local bidding would be submitted to the Bank for expost review; disbursements will be made only after the Bank is satisfied with this review. In the evaluation of international bids, both, domestic and regional preferences would apply. Local suppliers would receive a margin of preference of 15 percent or the prevailing duty, whichever is lower. For purposes of comparison among foreign suppliers, bids from sup- pliers which are members of the Cartagena Agreement (or any other such re- gional trade agreement acceptable to the Bank) would be accorded a prefer- ence representing the difference between the prevailing duty actually ap- plicable and the duty applicable to goods imported from non-member coun- tries, or 15 percent, on the C.I.F. price, whichever is lower.  -- 29 - Disbursement 5.18 The project would be completed by December 31, 1986 and the closing date would be June 30, 1988. The proposed allocation of the loan proceeds and the disbursement percentages are: TABLE 5.3: ALLOCATION OF L.OAN PROCEEDS Amount of the Loan Allocated % of Expenditures to Category (US$ million) be Financed 1. Civil Works 17.0 36% of total expen- ditures 2. Materials and equipment 15.0 100% of foreign expenditures and 54% of local expendi- tures 3. Consulting Services 2.0 a) Management staff 100% of total expen- Project Supervisory ditures Unit and short-term consultants b) Users' Survey and -- 40% of total expen- groundwater management ditures 4. Front-end fee on Bank Loan 0.6 100% of total expen- ditures 5. Unallocated 6.0 Total Loan 40.6 5.19 Bank financing of the foreign component of civil works (34%) will be achieved by disbursing 36% of all payments to contractors, except for the repayment of the 5% retention withheld from civil works contractors during the guarantee period, and paid for following the completion of works.Civil works contracts which include the supply of materials would be reimbursed for the corresponding portion of materials and civil works in accordance with the respective categories of the Loan proceeds. Total Bank financing of the technical assistance component corresponds to the estimated value of the foreign exchange cost. Disbursements for this com- ponent would be made according to the categoiies shown in Table 5.3 above. All disbursements will be made against fully documented withdrawal applications. 5.20 A schedule of expected disbursements by quarter is presented in Table 5.4. Disbursements for the project would be completed by the pro- posed closing date (June 30, 1988).  - 30 - TABLE 5.4: LOAN DISBURSEMENT SCHEDULE (US$ million) Bank Fiscal Year Quarterly Cumulative Cumulative and Quarter Ending Disbursement Disbursement % 1983 September 30, 1982 0.6 0.6 1 December 31, 1982 0.4 1.0 2 March 31, 1983 0.4 1.4 3 June 30, 1983 0.4 1.8 4 1.8 1984 September 30, 1983 1.4 3.2 8 December 31, 1983 1.4 4.6 11 March 31, 1984 2.2 6.8 17 June 30, 1984 2.2 9.0 22 7.2 19435 September 30, 1984 2.6 11.6 29 December 31, 1984 2.6 14.2 35 March 31, 1985 3.6 17.8 44 June 30, 1985 3.6 21.4 53 12.4 1986 September 30, 1985 3.4 24.8 61 December 31, 1985 3.4 28.2 69 March 31, 1986 2.2 30.4 75 June 30, 1986 2.2 32.6 80 11.2 19837 September 30, 1986 2.0 34.6 85 December 31, 1986 2.0 36.6 90 March 31, 1987 1.2 37.8 93 June 30, 1987 1.2 39.0 96 6.4 1988 September 30, 1987 0.6 39.6 98 December 31, 1987 0.6 40.2 99 March 31, 1988 0.2 40.4 99 June 30, 1988 0.2 40.6 100 1.6 5.21 The 6-year disbursement profile for the project is supported by improvements in SEDAPAL's institutional capacity and project management practices (para. 5.14). The proposed Loan is therefore expected to be dis- bursed more rapidly than the average disbursement experience disclosed for  - 31 - similar projects in Latin America and for 3ank-financed projects in Peru (about 8 years). Retroactive Financing 5.22 The Canto Grande project component (about 5 km of water transmis- sion pipeline and one 200 lps pumping staticn) represents the continuation of a program being financed under Loan 128`-PE and undertaken by SEDAPAL and the Ministry of Housing to satisfy pressing water demands. Canto Grande is a low-income, densely populated a.rea with about 120,000 inhab- itants. Water is provided from existing wells through standposts and water trucks. It is severely rationed, creating serious health hazards. Con- struction of a proposed water transmission main would remedy the present rationing. The estimated cost of this component is US$1.6 million equiva- lent. Final designs and bidding documents have been completed by SEDAPAL and agreed upon with the Bank. Construction is expected to be initiated by May 1982 and implementation would take abou: six months. In order not to delay the solution of this pressing problem, retroactive financing of up to a maximum of US$0.5 million for expenditures incurred for the construction of this component, after April 30, 1982, is proposed. Environmental Aspects 5.23 The project will have positive effects on the environment by im- proving the sanitary conditions of low-income areas on the outskirts of Li- ma. There would be, however, an increase in the volume of sewage dis- c:harged into the already polluted receiving bodies. The sewage pollution problem is being carefully assessed under the water and sewerage master plan for Metropolitan Lima financed under Loan S-11-PE. This plan will de- fine, inter alia, solutions to treat and recLaim sewage flows and their fi- nial disposal into nearby rivers and the ocean. SEDAPAL's monitoring and control of industrial discharges, water trealment and water quality will be enhanced by the project through the provision of new laboratory equipment. VI. FINANCIAL ANALYSIS A. Past Financial Performance and Present Position 1978-81 Results 6.01 SEDAPAL's financial performance in 1978 and 1979 was unsatisfac- tory, with operating losses in both years. This was mostly the result of delays in taking action on the approval anc. implementation of tariff in- creases in line with inflation. Monthly tariff increases starting in 1980 significantly improved SEDAPAL's finances. [nternal generation of funds in 1980 allowed SEDAPAL to cover working capi:al requirements, debt service and part of its investment program as required by the financial covenant under Loan S-1l-PE. Estimated financial results for 1981 are encouraging, showing an internal generation of funds of S/4.46 thousand million (US$10.6 million). SEDAPAL's debt to equity ratio (estimated at 9% by the end of  - 32 - 1981) and the debt service ratio (16) are highly conservative and would allow SEDAPAL to substantially increase its borrowing level in the future. 6.02 SEDAPAL's tariffs were increased by 30% in September 1980, and by an additional 5% a month during the last quarter of that year. In March 1981, SEDAPAL's tariffs were increased by another 20%. Additional 5% monthly tariff increases between April and December 1981 were fully imple- mented. The net result was an increase in average revenue per m3 sold from S/15 in 1979 to an estimated average revenue of S/46 in 1981, or a 17% in- crease in real terms. 1/ SEDAPAL's program of tariff increases was the first step taken to finance a significant part of its expanded capital expenditures program. Other actions taken in 1981 include the updating of connection fees (para. 6.08) and Government authorization to SEDAPAL to manage Metropolitan Lima's groundwater resources and to charge tariffs for private well water usage (para. 6.07) 2/. 6.03 Key income and cash flow data, extracted from SEDAPAL's financial statements for years 1978-81 (Annex 11), are summarized in Table 6.1. TABLE 6.1: SEDAPAL SELECTED INCOME AND CASH FLOW DATA 1978-81 (Current S/OO0 million) 1981 1978 1979 1980 (Estimated) a! Net income (loss) (.79) (.64) (1-54) (.98) Operating ratio (%) 98 84 87 81 Internal cash generation (.36) .77 1.21 4.46 Working capital needs .73 .68 .89 1.42 Investment program .54 2.26 2.72 6.39 Borrowings 1.63 2.17 2.40 4.13 a/Annual data for 1981 was estimated on the basis of unaudited financial statements for the first semester. 6. 04 In the past, SEDAPAL and other public service entities have been exempted from taxes on net income, equity and surplus from asset revalua- tion. For the year 1981 and thereafter, no legally binding exemption has been granted for net income and equity taxes. Legislative Decree 21694, however, exempts SEDAPAL from taxes on asset revaluation (para. 6.15). 1/ Average inflation rates were 59% in 1980 and 65% in 1981. 2/ Legislative Decree (No. 148 of June 15, 1981) giving this authority to SEDAPAL is available in project files.  - 33 - B. Revenues General 6.05 SEDAPAL's operational and non-operational revenues include tar- iffs for water and sewerage services, contributions from users, and ser- vice improvement fees. In the past, SEDAPAL's tariffs and other charges were set by the Ministry of Housing on the basis of SEDAPAL's request. Under the new sector arrangements (para. 2.0), SENAPA has the authority to set tariffs and charges for services provided by SEDAPAL. Tariffs 6.06 Revenues from tariffs represent vittually all SEDAPAL's operating revenues. In spite of recent tariff increases, average revenues for water supply and sewerage services are below the combined long-run marginal cost for both services. Revenue targets under the proposed project would be reviewed under a tariff study (paras. 6.09 and 7.07) taking into consider- ation how they relate to estimated long-run marginal costs. SEDAPAL's tariff structure assigns consumers to three categories according to water use: domestic, commercial and industrial. Distribution of consumers, consumption and revenues is given in Table 6.2 below: TABLE 6.2: DISTRIBUTION OF CONSUMERS, CONSUMPTION AND BILLING BY CATEGORY OF WATER USE Category Consumers Consumption Billing (Percentage) a/ Domestic 94.26 73.58 46.43 Commercial 5.28 13.45 17.71 Industrial 0.42 3.06 11.93 Industrial connected to sewer system only 0.04 9.91 23.93 TOTAL 100.00 100.00 100.00 a! Average for April, July and October 1980, and January 1981. The minimum consumption level is 10 m3 per month for domestic customers and 15 m3 for other customers. Consumers in the lowest consumption category pay a flat tariff while intermediate- and high-level consumers pay tariffs per m3 which are progressive with respect to water consumption. Progres- siveness in tariffs is slight, however, and consumers in the lowest  - 34 - consumption levels pay a higher unit price for actual consumption than con- sumers in the intermediate consumption levels (annex 12). Connections re- ceiving only water services (about 10% of all connections) are charged for both water and sewerage services. Industrial customers connected only to the sewerage system (users of water from private wells) pay a tariff for sewerage equivalent to about 60% of the combined tariff for water and sewerage.l/ Issues such as the appropiate degree of tariff progressiveness and the required separation of charges for water and sewerage services will be addressed in a comprehensive tariff study to be undertaken by SEDAPAL during the first year of project implementation (para. 6.09). 6.07 The charges for private use of groundwater resources are applica- ble starting in February 1982. They are intended to cover the opportunity cost of water production and transmission and were initially set at 20% of the combined water and sewerage tariffs charged to customers connected to SEDAPAL's system. 2/ This level of tariffs will be reviewed within the first year of project implementation, in connection with the proposed tariff study (para. 6.09) and taking into account the average long-run marginal cost of water resources for Lima. Users Contributions and Service Improvements 6.08 Users' contributions to capital costs include donation to SEDAPAL of networks installed by developers and consumer payment for house connec- tion costs. Low-income users pay a fixed charge to defray the cost of net- works installed directly by SEDAPAL. Customers are also charged fees (canones) for the right to use the system. These fees have not been re- vised since they were established in 1965 and, thus contribute little to revenues. Service improvements fees introduced in August 1981 have essen- tially replaced connection fees. Since these service improvement fees are indexed to Lima's minimum wage, they are protected from inflation. New connections in low-income areas are exempted from payment of this fee. These approaches to obtaining capital contributions from customers are generally effective and do not preclude the provision of services to low- income areas. Practical application is, cumbersome, however, and will be reviewed under the tariff study (para. 6.09). 6.09 Issues affecting tariffs and other charges mentioned above will- be addressed in a comprehensive tariff study to be undertaken by SEDAPAL during the first year of project implementation. Assurances were obtained from the Government, SENAPA and SEDAPAL during negotiations that: 1/ In practice, however, the relationship between the tariff for indus- trial sewerage and the full tariff is uncertain, as there is no metering of water consumption from private wells. Charges are assessed on production estimates based on the technical specifications of wells and on usage. In turn, this estimate is adjusted downwards by 20%. 2/ Supreme Decree (No. 008-82-VI of February 16, 1982) establishing this tariff level is available in project files.  - 35 - (a) SEDAPAL would complete a study of the tariff structure and other revenue sources (operational and non-operational) by March 31, 1983 under terms of reference and in accordance with an implementation schedule satisfactory to the Bank (draft terms of reference are included in Annex 13); and (b) the results of the study, subject to prior comments of the Bank and SENAPA, would be [mplemented according to the agreed upon schedule, starting not later than July 1, 1983. C. Financial Projections Income Statements 6.10 A summary of SEDAPAL's 1980 income statement and projected income statements for the years 1981-86 is presented in Table 6.3 below. Detailed financial projections and underlying assumptions are presented in Annex 11. TABLE 6.3: SEDAPAL SELECTED INCOME AND CASH FLOW DATA 1980-86 a/ (Current S/000 Millions) 1980 1981 1982 1983 1984 1985 1986 Operating revenues 7.35 15.94 32.34 53.88 78.63 105.51 133.88 Operating costs b/ 6.40 12.91 21.76 34.11 44.82 59.28 74.18 Operating ratio .87 .81 .67 .63 .57 .56 .55 Service Improvements fees - .25 1.08 1.83 2.68 5.73 5.25 Internal Cash generation 1.21 4.46 13.56 19.93 32.96 46.06 54.57 Debt service ratio c/ 3.22 16.40 13.56 13.94 8.37 10.04 5.50 Debt/equity + debt (X) 8.39 8.70 9.42 19.40 29.41 33.90 34.78 Revenue covenant (%) - - 2.0 3.5 4.0 4.0 4.0 Rate of return (v) - - 1.9 3.0 5.5 6.0 6.2 a/ Actual results for 1980; projections for 1981-86. b/ Before depreciation charges. c/ Not including payments on the planned borrowing for SEDAPAL's contribu- tion to the Mantaro Transfer Scheme cLnd for sewage treatment and disposal works to be undertaken in 1984 and beyond.  - 36 - 6.11 SEDAPAL's projected financial performance is satisfactory and feasible. Average water and sewerage tariffs would increase in real terms by 28% during the period 1982-86 (1982-16%; 1983-5%; 1984-86-2% a year) from the estimated 1981 average level of S/46 per m3 sold (US$0.11/m3) to S/59 per m3 sold (US$0.14/m3) in 1981 prices. Industrial sewerage tariffs would increase from S/152 to S/196/m3 equivalent in 1981 prices. Revenues from charges to users of water from private wells have been projected con- servatively at US$40 million during the 1982-86 period. In addition, the recently approved service improvement fees (para. 6.08) should provide SEDAPAL with revenues representing 3-4% of total water and sewerage tariff revenues. 6.12 SEDAPAL's operating ratio would drop from the high 1980 level of 87% to a satisfactory 55% in 1986. The current ratio would be maintained at satisfactory levels above 2. SEDAPAL's capitalization is expected to remain conservative with the debt-to-total capitalization remaining below 35% during the forecast period. The debt service ratio reached a high 16.4 in 1931, and would gradually drop to a satisfactory 5.5 in 1986, despite payments due on the proposed loan, suppliers/official credit, the current portion of Loan S-ll-PE and the current KfW Credit.The estimated debt service does not include payments on the long-term borrowing to be secured to complete SEDAPAL's contribution to the Mantaro Transfer Scheme and to finance sewage treatment and disposal investments scheduled for 1984 and thereafter (paras. 6.17-18). As the amounts, terms, and conditions of these borrowings would have significant impact on SEDAPAL's finances, agreeraent was reached during negotiations that SEDAPAL would not incur any new long-term debt without the Bank's agreement, unless the net revenues before interest and depreciation for the fiscal year preceding such incur- rence or for a later 12-month period ended prior to such incurrence, which- ever amount is the greater, are more than 1.5 times the maximum debt service requirements for any succeeding fiscal year on all debt to be incurred, included the debt proposed. 6.13 Forecasts of operating costs take into account increases in vol- umes of water produced, increases in salaries (15% in 1982-86) and energy costs (25% in 1982-86) in real terms, and required increases in the use of chemicals and materials for the upgrading of operation and maintenance. Three percent of total billing was projected to be written-off each year as uncollectable. Unaccounted-for water is targeted to be reduced from 47% in 1981 to 30% in 1986 and thereafter, as a result of the upgrading of the Commercial Division (paras. 3.10-3.15), the metering program under the pro- posed project and the leak control program initiated under Loan S-11-PE. 6.14 A revenue covenant was agreed upon during negotiations which specif'ies that revenues should cover operating and maintenance costs, taxes, depreciation or debt service, whichever is higher 1/ and provide a contribution toward SEDAPAL's capital expenditure requirements. The con- tribution is expressed as a perc~entage of revalued net fixed assets plus 1/ Depreciation is higher than debt service during all the years covered by the financial projections because of SEDAPAL's relatively low debt service requirements during these years.  - 37 - revalued work in progress and revalued SEI)APAL's share of the Mantaro Transfer capital costs. The agreed upon percentages (2.0% in 1982, 3.5% in 1983, and 4.0% in 1984 and thereafter) will allow SEDAPAL to finance during the project construction period about 40% of the cost of its investment program (Table 6.4). Based on current financial projections, this covenant would produce a satisfactory financial performance (a rate of return of 2.0% in 1982, 3.0% in 1983, 5.5% in 1984, and 6.0% or more in 1985 and thereafter). It is also designed to deal withi the potential problem of the still uncertain cost of the large Mantaro Water Transfer Scheme exceeding the current feasibility study estimate. If such a cost increase occurred, SEDAPAL might meet the targets of a standard rate of return covenant, but not generate sufficient revenues to cover its capital investment require- ments. On the other hand, the agreed revenue covenant would, on an annual basis, take into account SEDAPAL's revenue requirements in light of the cost of the Mantaro project and would thus provide greater assurance that these requirements would be satisfactorily met. 6.15 SEDAPAL was legally exempt from taxes on income, equity and sur- pyLus on asset revaluation through 1980. Future taxation of SEDAPAL is un- certain and the financial projections have been prepared on the basis of continued tax exemption. The projections indicate that SEDAPAL's finances would improve substantially with the projected tariff increases for the 1982-86 period (28% in real terms), which are additional to the recently introduced charges on private wells and on service improvement fees. In the event SEDAPAL is taxed at some future date, its capacity to contribute to capital expenditures could be reduced, and the Government might find it difficult to authorize further tariff increases to compensate for the tax payments. Therefore, the Government may have to make equity contributions to SEDAPAL in order to compensate for any shortfall in internal cash generation. D. SEDAPAL's Investment and Financing Plan 6.16 SEDAPAL's investment and financing plan during project implemen- tation is summarized in Table 6.4. Details a-e presented in Annex 11.  - 38 - TABLE 6.4: SEDAPAL INVESTMENT AND FINANCING PLAN 1982-86 US$ Application of Funds Current Million Proposed project 93 21 Current projects 15 3 Other works 1/ 54 12 Interest during construction 21 5 Working capital 26 6 SEDAPAL Investment Program 209 47 Estimated contribution to Mantaro Transfer 235 53 investment 2/ Total Applications 3/ 444 100 Sources of Funds Internal cash generation for: SEDAPAL's investment program 118 27 Contribution to Mantaro transfer investment 2/ 57 13 Internal Cash Generation 175 40 IBRD loan 4/ 37 8 Suppliers/official loan 8 2 Other loans for SEDAPAL's investment program 5/ 46 10 Total borrowing for SEDAPAL investment program 91 20 Additional financing required for Mantaro Transfer investment 2/ 178 40 Total Sources 444 100 1/ Includes sewage treatment scheduled for 1984-86; as well as minor expansion and renovation of water distribution and sewage collection networks. 2/ Based on preliminary cost estimates and a 50% contribution by SEDAPAL to the Transfer costs. Does not include interest during construction. 3/ Net of networks built by developers and donated to SEDAPAL, estimated at US$60.0 million during the period. 4/ An additional US$4 million would be disbursed in 1987-8. 5/ Loans being disbursed to finance current investment projects (US$8 mil- lion) and loans to be identified for sewage treatment and disposal (US$39 million). 6.17 SEDAPAL's investment program represents a turning point from past years, when investments were kept at levels insufficient for a much needed increase in service coverage. Financial feasibility is based on:  - 39 - (a) obtaining increased revenuec from tariff increases, from the new charges for private water consumption (para. 6.11), and from new service improvement: fees (para. 6.08); and (b) securing foreign and local borrowing. The proposed level of borrowing (US$269 million) is adequate, as SEDAPAL's level of capitalization is forecast to remain high with the debt-to-total capitalization reaching a maximum of 35% in 1986. SEDAPAL's borrowing plan includes: the Bank and suppliers/official loans for the proposed project; and additional loans to complete the financing of its estimated share of the costs of the Mantaro Transfer Scheme, and to undertake the programmed sewage treatment and disposal investments. 6.18 SEDAPAL would complete its contribution to the cost of the Mantaro Transfer Scheme by assuming long-term debt to be incurred by the Peruvian Government. The amount and the terms of the debt to be assumed by SEDAPAL will be defined during preparation of that project, 1/ and when: (a) cost estimates based on en,ineering designs are completed; and (b) sources, terms and conditioas for the financing of construc- tion of the Scheme are defiaed. 6.19 A Government resolution has been issued authorizing SEDAPAL, sub- ject to the approval of SENAPA, to increase tariffs periodically during 1982. These increases should be equivalent to monthly increases in SEDAPAL's average revenues per m3 of water sold of at least 4.5% for 1982. Implementation of this program should be monitored carefully. The first increases (5.0% effective January 1982 and 15% effective in March 1982) have taken place and quarterly increases of approximately 15% in June and September are envisaged by SENAPA and SEDAPAL. If inflation in 1982 is greater than the expected 50%, the future quarterly tariff increases would have to be higher to ensure that projected tariff increases in real terms (16% over 1981 level) are maintained. 6.20 To protect the execution of the financing plan and SEDAPAL's fin- ancial viability, and in addition to the revenue covenant (para. 6.14), agreement was reached during negotiations on the following: (a) SEDAPAL would submit to SENAPA and the Bank, before August 31 of each calendar year, a proposed schedule of tariff ad- justments for the following year designed to assist it in achieving the respective revenue covenant. This proposal should be based on a reviSed five-year financing plan for SEDAPAL and on an estimate of the value of taxes to be paid by SEDAPAL the following year (para. 6.15); and 1/ Engineering designs to be financed under the Bank Proposed Sixth Power Loan and to be completed by mid-1982.  - 40 - (b) SEDAPAL would exchange views with the Bank, before August 31 of each calendar year, on its five-year investment plan to be taken into account for purposes of the annual proposed schedule of tariff adjustments. Monit:oring and Evaluation Criteria 6.21 SEDAPAL would submit to the Bank semi-annual reports (due on February 28 and August 31 of each year) on the progress of project imple- mentation and on its operating and financial performance during the pre- ceeding semesters ending on December 31 and June 30, respectively. Specific targets agreed upon during negotiations and comparisons with actual performance should be included in SEDAPAL's semi-annual reports to the Bank. These targets would include, inter-alia, a comparison of pro- jected and actual project construction schedules, disbursements, revenue covenant, rate of return, water production and sales, metered and unmetered connections, revenues per m3 of water sold, number of employees per thousand connections, operating ratio, and revenues from charges to private well users. Table 6.5 includes the agreed upon monitoring indicators. 6.22 Agreement was reached during negotiations that SEDAPAL would pre- pare within the six months following project completion a Project Com- pletion Report, which would evaluate the extent to which the project achieved its objectives and the efficiency of its execution. The report should conform to guidelines to be provided by the Bank.  TABLE 6.5: SEDAPAI. MONITORIMCT INDTCATORS 1980 2/ 1981 1982 1983 1Q84 1985 1986 1987 Population I/ Population (000) 4,432 4,600 4,775 4,957 5,145 5,341 5,544 5,744 7 Served Water 3/ 61.3 61.Q 67.5 74.1 80.0 83.3 85.6 87.0 7 Served Sewerage 3/ 55.4 55.8 61.7 68.4 74.6 78.0 79.0 82.3 Water Production and Sales Water Produced (million T3) 485 49R 517 543 565 573 597 627 Water Sold (million m3) 243 264 295 331 368 396 418 439 lnaccounted-for water (%) 50 47 43 39 35 31 30 30 Industrial Sewerage (a3 million equivalente) 25 25 25 25 25 24 24 24 Water-usage through Private Wells Subject to ESAL Charges (million m3) -- - 25 40 50 50 50 50 Operations I/ Total Connections (000) 4' Water 364 381 430 487 545 5888 629 661 Sewerage 328 344 393 450 508 551 592 624 Of which, Domestic: Water 340 356 403 450 515 556 595 626 Sewerage 307 321 368 424 480 521 560 591 Metered Conniections (000) 119 133 155 219 300 382 446 476 Metered Connections (7) 32.7 34.9 36.0 45.0 5S.) 65.0 71.0 72.0 Consumption/Connection (m3 month) 55.6 57.7 57.2 56.6 56.2 56.1 55.4 55.3 Employees per 1000 Connections 7.q 8.() /.I h. b. 6.1 5- S Financial Water and Sewerage Tariff (S/ m3 sold- 1981 prices) 38 46 53 56 57 58 54 S9 Industrial Sewerage Tariff (SI m3 - 1981 prices) 120 152 176 185 189 193 196 196 Private well tariffs (S/ m3 - 1981 prices) -- -- 57 6(1 61 63 64 64 Water and Sewerage average Revenue per m3 Sold by SEDAPAL and Consumed through Private Wells (1981 Prices). 5/ 50 61 70 71 72 73 74 74 Operating Ratio (%) 87 81 67 63 57 56 55 53 Debt Service Ratio 3.2 16.4 13.6 13.9 8.1+ 10.0 5.5 4.6 Revenue Covenant Target -- -- 2.0 3.5 4.) 4.0 4.0 4.0 Rate of Return (7) -- -- 2.0 3.0 5.5 6.0 6.0 6.5 7 Debt (Debt/Debt + Equity) 8.4 8.7 9.4 19.4 29.i 33.9 34.8 32.5 Water and Sewerage Accounts Receivable (Months Sales) 4.5 3.7 3.5 2.5 2.5 2.5 2.5 2.5 1/ Yearly averages 2/ Actual 3/ It includes only population served by billed connections. 4/ It includes only billed connections. Connections non-billed and receiving water as of June 1481 are targeted to be incorporated to SEDAPAL's billing system as follow: 31,0O0 in 1981-82; 32,000 in 1982-83; and 20,000 in 1983-84. 5/ Revenues include: water and sewerage revenues, industrial sewerage revenues, service i provement fee; and private wells charges.  - 42 - VII. ECONOMIC AND SOCIAL ANALYSIS Introduction 7.01 The proposed project has been conceived to meet the short- to medium-term water supply and sewerage needs of Lima's population. Its ob- jectives are consistent with existing urban upgrading programs and with the preliminary recommendations of the water supply and sewerage master plan, which is now being completed. The project will help to improve the living conditions in extensive areas of the city, where lack of safe water and sanitation are causing health hazards. All project components are interre- lated, and they interact to provide the services at the lowest possible cost. Development of new groundwater sources will be accompanied by the rehabilitation of existing wells and the redistribution of water production from areas where inadequate metering has caused excessive water wastages to areas lacking service. The project will also provide sewerage services to the same areas benefitted by provision of water supply. 7.02 The project places special emphasis on the application of sound technical and financial policies as a means to increase efficiency in the allocation of water resources and to permit an accelerated increase in ser- vice coverage on the outskirts of Lima, where most of the low-income po- pulation lives. Return on Investments 7.03 Since most of the incremental population to be served will re- ceive! both water supply and sewerage, a combined incremental rate of return (IRR) was calculated. It also included the cost of project components de- signed to improve SEDAPAL's efficiency in the provision of services such as water metering, transportation and laboratory equipment, the users' survey and technical assistance for the management of groundwater resources. Minor complementary investments to be undertaken hy SEDAPAL during the project construction period were estimated and included in the calcula- tions. The estimated IRR is 16X, which compares favorably with the estimated opportunity cost of capital of 13%. 7.04 The IRR was calculated by comparing costs and benefits of water consumption and sewerage services "with the project" with the situation "without the project." Two-thirds of the increase in water consumption due to reduction in unaccounted-for water were excluded from the calculation of benefits since it is estimated that it corresponds to water already being consumed, although not paid for. As such, they are not economic benefits. Benefits were valued using expected revenues as a proxy for economic bene- fits. Since positive externalities and consumers' surplus are not fully reflected in revenues, the resulting rate of return is bound to under- estimate the project's economic benefits. In order to better reflect costs and benefits to the economy, a shadow-exchange factor (from 1.07 in 1982 to 1.10 in 1985 and thereafter) and a shadow wage rate (0.6) for unskilled labor were used. A summary of costs and benefits and underlying assump- tions is included in Annex 14.  - 43 - 7.05 The 16% return on the investment program is fully satisfactory and is the result of a thorough analysis undErtaken by SEDAPAL to limit its investment program to the most cost effective components. Each project component was analyzed separately and its zontent, timing and magnitude were compared to different alternatives to make sure that the overall net benefits of the project could not be increased by deleting or redesigning any of them. Long-Run Marginal Cost and Tariffs 7.06 Long-run marginal costs for water supply and sewerage were esti- mated by calculating the long-run Average Incremental Cost (AIC) at a 13% discount rate. The resulting AICs at June, 1981 prices and exchange rate aLre: water supply: US$0.21/m3; sewerage: US$0.06/m3 equivalent. The com- bined AIC of US$0.27/m3 equivalent is substantially higher than both the 1981 average tariff (US$0.11/m3) and the average unit cost of the short-term investment program (US$0.13/m3). These increasing long-run costs are caused by significant investments required to develop new and dlistant water sources and by the need for tle development of sewage treat- ment and disposal facilities. A summary of AIC calculations is included in Annex 15. 7.07 The recent introduction of service improvement fees and of tariffs for private water usage will permit SEDAPAL to meet its financial requirements by increasing its tariffs in real terms by approximately 28% cluring the project's construction period. Since average tariffs are still projected to remain below the estimated AIC, SEDAPAL will undertake a com- prehensive tariff study, which will include a detailed analysis of long-run miarginal costs, their implications on resource allocation, and their rela- tion with SEDAPAL's financial targets (paras. 6.09 and Annex 13). Tariff structures will then be adjusted to reflect as closely as possible the cost to the economy of meeting increasing water supply and sewage collection needs, as well as the cost of solving emer,ing sewage treatment and dis- posal problems. Tariffs for consumption above basic requirements will be set at levels at least equal to its respective long-run marginal cost. Population Benefitted and Urban Poverty Impact 7.08 The project would directly benefit about 370,000 inhabitants by -1986 through water and sewerage connections. In addition, it would develop new water sources to permit the connectior to the water system of some 610,000 additional inhabitants. It would also, by improving water pres- sures, eliminate rationing, which presently affects numerous districts of Lima. It is estimated that by 1986, coverages in water supply and sewer- age will increase 86% and 79%, respectively. Coverages will continue to :increase beyond the completion date of the proposed project to reach the targeted coverage of 90% and 85% in water supply and sewerage, respectively by 1990. 7.09 About 560,000 beneficiaries of water supply (57% of total benefi- ciaries) and 220,000 beneficiaries of sewerage (59% of total beneficiaries) are estimated to belong to families earning Less than two minimum salaries,  - 44 - equivalent to about one-third of per capita GNP. This low-income group of the population will increase its access to water supply and sewerage in the period 1982-86 from 61% to 80% and from 49% to 71%, respectively. A table presenting the impact of the project on poverty groups is included in Annex 16. 7.10 Of the low-income beneficiaries mentioned in the paragraph above, about 370,000 project beneficiaries (37% of total beneficiaries) and 150,000 project beneficiaries (40% of total beneficiaries) in water supply and sewerage, respectively, are estimated to belong to the absolute poverty group (earning less than one-fourth of per capita GNP). 1/ 7.11 About US$39 million in June 1981 prices, or 52% of the total pro- ject cost will directly benefit areas on the outskirts of Lima (Pueblos Jo- venes), where most of the low-income population lives. Affordability of Services by the Urban Poor 7.12 Projected water supply and sewerage tariffs for low-income con- sumers (less than 10 m3/month) would result in charges of S/241/family/ month in June 1981 prices. In addition, maximum monthly installments for the payment of the connections and contribution to investment fees are projected at S/2,100. Total payments would thus reach S/2,340/family/ month, which represents about 3.2% of monthly family earnings for the lowest income group. Services are, thus, affordable to all segments of the population. 7.13 Total charges for water supply and sewerage, including tariffs and fixed charges are estimated to be about the same amount that the low-income population is presently paying to purchase about 4.5 m3/month of unsafe water from private vendors. The project will help to alleviate healtlh hazards by providing to these consumers up to 10 m3/month of safe water and sewerage services without an excessive burden on their budgets. Project Sensitivity and Risks 7.14 The effect of variations in selected cost and benefit variables was tested. The IRR would still be equal to the estimated opportunity cost of capital according to the following switching values: Variable Switching Value Water and Sewerage Tariffs - 12% Incremental Demand - 16% Delays in Realization of Benefits 2 years Construction Costs + 20% Operating Costs + 48% 1/ Population with incomes that are insufficient to ensure minimum con- sumption levels (Urban Development Study based on "Encuesta Nacional de Hogares de Propositos Multiples").  - 45 - 7.15 As shown in the above table, the project's worth is fairly sensi- tive to changes in revenues; however, revenues are not expected to deviate significantly from those projected since: (a) projected tariffs, including increases in real terms, are well within the capacity of Lima's population to pay. Fur- thermore, tariff increases for 1982 (16% in real terms) are already being implemented (para. 6.19); (b) incremental demand has been projected on the basis of de- creasing per capita consurmption, paying due attention to the likely effects of increased metering and tariff adjustments; and (c) a substantial delay in the realization of project benefits is not anticipated given the advanced stage of final designs and the conventional nature of works, which are well within SEDAPAL's and the local contreactors' capabilities. 7.16 Construction or operating costs Eare not likely to exceed those projected by percentages as high as their respective switching values since projections were based on actual costs of similar works being undertaken by SEDAPAL and on present unit operating costs. Projections of the latter anticipate increases in real terms accounl:ing for the stregthening of SEDAPAL's operational and maintenance practices. The project is considered to be of high priority by the Government and SEDAPAL authorities, who are committed to ensuring its successful and timely implementation. The fail- ure of Government authorities to continue authorizing periodic tariff adjustments would jeopardize SEDAPAL's financial viability, and consequent- ly it would jeopardize compliance with the project's objectives. These tariff adjustments are highly sensitive. They are, however, a necessary condition for SEDAPAL's financial self-sufficiency and for sector develop- ment. A continuous dialogue between the Government authorities, SEDAPAL's management and the Bank on the need to permit SEDAPAL to finance the local c ontribution to SEDAPAL investments withoul: resorting to the Government budget should ensure timely implementation of required tariff adjustments. Overall project risks are average and will be reduced by close supervision and monitoring by the Peruvian authorities, SEDAPAL and the Bank. VIII. AGREEMENTS REACHED DURIENG NEGOTIATIONS 8.01 During Loan negotiations assurances were obtained as follows: From the Government and SFNAPA tha: (a) periodic tariff adjustments would be timely approved (paras. 6.15 and 6.20 (a)); (b) SEDAPAL surpluses would only be transferred to SENAPA after making provision for SEDAPAL's five-year investment program (para. 3.03);  - 46 - (c) SEDAPAL would be authorized to implement the recommenda- tion of the tariff study (para. 6.09); and (d) There would be no adverse changes in SEDAPAL's legal status (para. 3.02). From SEDAPAL that: (a) it would comply in each calendar year with the revenue covenant (paras. 6.14 and 6.15); (b) it would submit to SENAPA and the Bank each year a pro- posal for tariff adjustments (para. 6.20 (a)); (c) it would prepare not later than Mlarch 30, 1983 a compre- hensive tariff study and implement, the recommendations of the study, starting not later than July 1, 1983 (para. 6.09); (d) it would exchange views with the Bank each year on its five-year financing plan (para. 6.20(b)); (e) it would not incur in any new long-term debt without the prior Bank's concurrence, unless its debt service ratio exceeds 1.5 in any calendar year (para. 6.12); (f) its accounts receivable would not exceed 3.5 months of billing by year end 1982, and 2.5 by year 1983 and thereafter (para. 3.15 and Table 6.5); (g) it would revalue its fixed assets annually (para. 3.18); (h) its financial statements would be audited annually (para. 3.20); (i) it would carry out a study on the adequacy of its insurance practices (para. 3.22); (j) it would hire qualified consultants, for the technical assistance under the users' survey and the management and control of groundwater resources components of the pro- posed project (para. 5.05 (IV) and 5.13); (k) it would hire qualified consultants for the PSU and it would maintain it adequately staffed and funded (para. 5.13); (1) it would submit to the Bank semi-annual progress reports (para. 6.21); and (m) it would prepare before six months after project completion, a Project Completion Report (para. 6.22).  - 47 - 8.02 The following special condition of effectiveness would be in- cluded: SEDAPAL would complete the following l-asks to the Bank's satisfac- tion: reorganization and definition of functions of its Project Supervisory Unit, and appointment of its manager and deputy manager (para. 5.13). 8.03 Retroactive financing from April 30, 1982, for up to US$0.5 million is recommended (para. 5.22). 8.04 Provided the foregoing conditions are met, the proposed project would be suitable for a Bank loan of US$40.6 million. The Loan would be repayable over 17 years, including 4-year grace period.  - 4& - ANNEX 1 PERU LIMA WATER SUPPLY AND SEWERAGE PROJECT Sector Responsibilities Function Urban Areas Rural Areas National Policies and National Planning INP Intersectorial Priorities Institute (INP) Sectorial Planning and -Ministry of Housing (MVC) Ministry of Health (MS) Intrasectorial Priorities -National Institute for Water Supply & Sewerage (SENAPA) Definition of Investment -MVC Sanitary Engineering Programs -SENAPA Dept. of MS (DIS) Project Identification and SENAPA, SEDAPAL, SEDAPAT, DIS Project Preparation SEDAPAR Project Construction Private Contractors DIS Project Execution SENAPA, SEDAPAL, SEDAPAT, DIS Supervision SEDAPAR Systems' Operation and SENAPA, SEDAPAL, SEDAPAT, Community Boards Maintenance SEDAPAR  PERU LIMIVA WATER SUPPLY AND SEWERAGE PROJECT SERVICIO DE AGUA POTABLE Y ALCANTARILLADO DE LIMA Organizational Structure BOARD OF DIRECTORS I .._ _ _ _ J Legal Advisor _ Office Internal Auditing Office l _ _ _, Technical Assistance Program Office _ GENERAL MANAGER J Legal Matters Office sinnng Off ice Works D t_ _ _ _ _ ___ Pcb_ _ _ _ _ _ _ _ _ _ _ _ Relations Affairs Organization a6nd ADMINISTRATIVE DEPARTMENT TECHNAICL DEPARTMENT L