Mexico - Fertilizer Sector Adjustment Loan Project

Document of The World Bank FOR OFFICIAL USE ONLY Report No. 13918 PROJECT COMPLETION REPORT MEXICO FERTILIZER SECTOR ADJUSTMENT LOAN PROJECT (LOAN 2919-ME) JANUARY 26, 1995 Mexico Country Operations and Environment Division Country Department II 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.  Currency Equivalents Currency Unit (until 12/31/92) = Mexican Pesos (Mex$) = 100 cents Currency Unit (beginning 1/1/93) = Mexican New Pesos (MexN$) = 1,000 old Pesos Average Exchange Rates 1984 US$1 = 167.8 1985 US$1 = 257.0 1986 US$1 = 611.8 1987 US$1 = 1,378.2 1988 US$1 = 2,273.1 1989 US$1 = 2,261.7 1990 US$1 = 2,821.0 1991 US$1 = 3,020.5 1992 US$1 = 3,094.7 1993 US$1 = MexN$ 3.1 1994 (June) US$1 = MexN$ 3.3 Abbreviations and Acronyms Used CNA Comisi6n Nacional del Agua (National Water Commission) EIA Environmental Impact Assessment FERTIMEX Fertilizantes Mexicanos FSAL Fertilizer Sector Adjustment Loan GOM Government of Mexico ICB International Competitive Bidding IMF International Monetary Fund PCR Project Completion Report PECE Pacto de Estabilizati6n y Crecimiento (Economic Stabilization and Growth Pact) PEMEX Petr6leos Mexicanos SAL Structural Adjustment Loan SDR Special Drawing Right SEDESOL Secretarfa de Desarrollo Social (Ministry of Social Development) SEDUE Secretaria de Desarrollo Urbano y Ecologfa (Ministry of Urban Development and Ecology) SEMIP Secretarfa de Energfa, Minas e Industria Paraestatal (Ministry of Energy, Mines and Parastatal Industry) SHCP Secretarfa de Hacienda y Credito Publico (Ministry of Finance and Public Credit) SOE State-Owned Enterprise TPY Tons per Year UAN Urea-Ammonium Nitrate  FOR OFFICLIL USE ONLY THE WORLD BANK Washington, D.C. 20433 U.S.A. Office of Director-General Operations Evaluation January 26, 1995 MEMORANDUM TO THE EXECUTIVE DIRECTORS AND THE PRESIDENT SUBJECT: Project Completion Report on Mexico Fertilizer Sector Adjustment Loan Project (Loan 2919-ME) Attached is the Project Completion Report on Mexico - Fertilizer Sector Adjustment Loan Project (Loan 2919-ME) prepared by the Latin America and Caribbean Regional Office. No Part II was submitted by the Borrower. The objective of the project was to restore competitiveness in the fertilizer sector. The project design was innovative. Based on extensive sector work, it combined sector policy reforms with investment for rationalization of operations. The policy program included elimination of price subsidies, closure of uneconomic plants, and reform of the fertilizer distribution system. The policy component was fully implemented, although with initial delays. As a result, production increased from about 1.6 million tons of nutrients in 1986 to 2 million in 1990. Despite sharp increases in prices, domestic demand remained at about 1.8 million tons, and the supply/demand balance showed a surplus during 1990-91. While not an original objective of the project, privatization started in 1991, and is about to be completed. The investment program was implemented with substantial adjustments to reflect changes of priorities during restructuring and privatization. The project outcome is rated as satisfactory, its sustainability as likely, and its institutional development impact as substantial. The PCR is of very good quality. It provides a full account of project implementation and outcomes, and includes detailed statistical evidence on sector development and beneficiary enterprise performance. An audit is not planned. Attachment 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.   FOR OFFICIAL USE ONLY PROJECT COMPLETION REPORT MEXtCO FERTILIZER SECTOR ADJUSTMENT LOAN (Loan 2919 ME) Table of Contents PREFACE . ....................................................... i EVALUATION SUMMARY ........................................... ii PART I: PROJECT REVIEW FROM THtE BANK'S PERSPECTIVE 1. Project Identity ............................................ 1 2. Background . ................................................. 1 World Bank and IMF Roles in Mexico's Adjustment ........................ 2 The Fertilizer Sector at Appraisal .................................... 3 Fertilizer Sector Development Following Loan Approval ..................... 4 3. Project Objectives and Description .................................. 5 Project Objectives . ............................................. 5 Project Description . ............................................. 5 4. Project Design and Organization ................................... 6 Project Design ................................................ 6 Project Coordination ............................................ 6 Organization of Rehabilitation and Investments Projects ...................... 6 Organization of Studies .......................................... 7 5. Project Implementation ......................................... 7 A. Policy Program Implementation .................................... 7 Implementation Schedule ......................................... 7 The Policy Program ............................................ 8 (a) Prices of Fertilizer ..................................... 8 (b) Prices of Fertilizer Raw Materials ........................... 9 (c) Links between PEMEX and FERTIMEX for Ammonia and Urea Production .......................................... 10 This document has a restricted distribution and may be used by recipients only in the performance of their officialduties. Its contents may not otherwise be disclosed without World Bank authorization.  (d) Plant Closure Program ................ ........ ....... ... . 10 (e) Withdrawal from Consignment and Retail Distribution Operations .10 (f) Fertilizer Imports . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 12 (g) Financial Restructuring .12 (h) Organizational Restructuring .13 The Privatization Process .15 B. Implementation of the Investment Components .17 (a) Completion of the Pajaritos Ammonium Nitrate Plant .17 (b) Plants Rehabilitation .18 (c) Maritime Terminals .19 (d) Wholesale Storage facilities . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 20 C. Environmental Aspects .21 D. Implementation of the Technical Assistance Component .23 E. Procurement .24 F. Total Project Costs .24 G. Financing .24 11. Disbursement Schedule .25 6. Project Results .26 (a) Policy Program Results .26 (b) Results of the Investments Components .27 (c) Financial Performance .27 7. Project Sustainability .28 Sustainability of the Policy Program and Privatization .28 Sustainability of the New Investments .29 Potential Sustainability of a Restructured FERTIMEX .30 8. Bank Performance .30 9. Borrowers Performance .30 10. Project Relationship .31 11. Consulting Services .31 12. Project Documentation and Data .31  PART III: STATISTICAL INFORMATION ............ .................. 32 1. Related Bank Group Operations .32 2. Project Timetable .33 3. Loan Disbursement .34 4. Project Implementation .35 5. Project Costs and Financing .37 A. Project Total Costs .37 B. Investments and Project Financing .38 C. Total Rehabilitation Costs and Financing .39 D. Costs and Status of Rehabilitation Sub-projects in Pajaritos Fosfatados ... ...... 40 E. Costs and Status of Rehabilitation Sub-projects in Lazaro Cardenas .... ....... 41 F. Bank Financing ........................................... 42 6. Project Benefits .......... 43 A. Direct Benefits ........................................... 43 Domestic Production of Fertilizer ................................ 43 Main Plants Production and Unit Consumption of Raw Materials .... ........ 44 National Fertilizer Demand .................................... 45 National Supply/Demand Balances ............................... 46 Fertimex Consignment Sales ................................... 47 B. Financial Impact .......................................... 48 International and Domestic Prices of Fertilizer and Fertilizer Raw Materials ... .. 48 Budget Transfers to FERTIMEX for Operation, Interest Payments and Investments . 52 FERTIMEX's Profitability .................................... 53 Profit and Loss Statements .................................... 54 Financial Performance ....................................... 55 C. Economic Impact of New Investment Projects ........................ 56 Pajaritos Ammonium Nitrate Plant ............................... 56 Maritime Terminals ........................................ 57 D. Studies ................................................ 58 7. Use of Bank Resources .......................................... 61 A. Staff Inputs ............................................. 61 B. Missions ..............................62  8. Status of Compliance with Legal Covenants ............................ 64 Annexes Annex 1 - Pajaritos Ammonium Nitrate, Economic Rate of Return Calculations Annex 2 - Maritime Terminals, Capital Costs Calculations Annex 3 - Divestiture of FERTIMEX's Production Units  PROJECT COMPLETION REPORT MEXICO FERTILIZER SECTOR ADJUSTMENT LOAN (Loan 2919 ME) PREFACE This is the Project Completion Report (PCR) of the Mexico Fertilizer Sector Adjustment Project for which Loan 2919-ME in the amount of US$265 million was approved by the Bank on March 15, 1988 and became effective on November 2, 1989. The Loan was closed on December 31, 1993 as planned during appraisal. Due to the acceleration of the privatization of Fertilizantes Mexicanos, S.A. (FERTIMEX) and to the resulting reduction in total financing requirements, US$19 million equivalent was canceled on July 9, 1992. The final disbursement took place on August 1, 1993. On August 10, 1993, the remaining balance in the Special Account in the amount of US$3.6 million was returned to the Bank, and on August 19, 1993 the remaining undisbursed balance of US$5.8 million was canceled, reducing the Bank Loan to US$240.2 million. The PCR was prepared by Daniel Crisafulli (Task Manager) and Charles Dahan (Consultant) and reviewed by David de Ferranti, Chief of the Mexico Country Operations and Environment Division of the Latin America and the Caribbean Country Department II and by Paul Knotter, Projects Adviser, Latin America and the Caribbean Country Department II (Preface, Evaluation Summary, Parts I and Part III). The Government provided extensive comments and statistical information during the Completion Mission which have been incorporated into Parts I and III of this report. Due to the privatization of the executing agency, the Government was not able to provide Part II of this report, "Project Review from the Government's Perspective". Preparation of the PCR, initiated during the final project supervision and completion mission to Mexico during June 1993, is based, inter alia, on the President's Report; the Loan, Project and Guarantee Agreements; the Fertilizer Sector Restructuring Program (sector report) prepared by the Bank (April 29, 1986); amendment letters; supervision reports; the Bank project files; and information prepared by FERTIMEX.   PROJECT COMPLETION REPORT MEXICO FERTILIZER SECTOR AD.lUSTMENT LOAN (Loan 2919 ME) EVALUATION SUMMARY Loan Objectives and Design i. This hybrid sector policy and investment loan was intended to support the implementation of the first phase of the Government of Mexico (GOM) and FERTIMEX five year program to put the fertilizer sector on a sound competitive basis and eliminate Government subsidies through: (i) implementation of major policy reforms; (ii) supporting rationalization investments; and (iii) carrying out studies required to assist in the implementation of the program. Major policy reforms included: (a) the elimination of price subsidies on fertilizer and fertilizer raw materials; (b) the closure of uneconomic plants; (c) the rationalization and liberalization of the fertilizer distribution system through withdrawal of FERTIMEX from retail and consignment distribution; (d) improvement in the organizational structure of FERTIMEX; (e) the financial restructuring of FERTIMEX; and (f) improvement in links between PEMEX and FERTIMEX for ammonia and urea production. ii. The project, as amended on February 4, 1990, consisted of three components: (i) US$150 million in Bank financing as set-asides in support of Mexico's debt reduction program, and US$50 million in Bank financing for imports of fertilizer and fertilizer raw materials; (ii) US$145 million, of which US$63.6 million was financed by the Bank, to undertake rationalization investments, including the rehabilitation of viable production plants, the completion of an ammonium nitrate fertilizer plant at Pajaritos, the construction of wholesale storage facilities, and the construction and or improvement of maritime terminals; and (iii) US$1.4 million in Bank financing for technical assistance for the restructuring of FERTIMEX. ImDlementation Experience The Policy Program iii. Substantial implementation delays occurred at the beginning of the project (particularly in price adjustments and withdrawal from distribution). The Fertilizer Sector Adjustment Loan (FSAL) suffered in 1988 and early 1989 from general price freezes decreed under GOM economic stabilization programs, and consequently: (i) the loan became effective over one year after the originally planned date (para. 5.1); (ii) the first tranche of the import and debt reduction component was disbursed 16 months behind estimates (para. 5.2); and (iii) the second tranche was released 15 months after the amended schedule and over 28 months behind appraisal estimates (para. 5.3). iv. After these initial delays, however, progress on the sectoral adjustment program was fully satisfactory. Early during implementation of the restructuring process of FERTIMEX, GOM and FERTIMEX's management embarked on an ambitious program aimed at the complete decontrol of the sector and total privatization of FERTIMEX. This program was implemented at an accelerated pace, and, in December 1992, the sector had been completely decontrolled, all production assets had been sold to private owners, FERTIMEX had stopped all distribution activities, and all other assets, including distribution assets, were being liquidated. This accelerated program was not contemplated  iii under the Loan and reflected policy decisions going beyond commitments in the Loan Agreement (Section 5). Privatiation of FERTIMEX v. While prepared as an option in the Bank's underpinning sector report for the project, the privatization of FERTIMEX productive assets which was not an original objective. Privatization started effectively on March 1991, with the sale of non-priority plants and was concluded 21 months later, in December 1992, with the sale of FERTIMEX's largest and most problematic industrial complex of Lazaro Cardenas. A total of 13 plants were sold individually in four phases by the Privatization Unit of SHCP assisted by financial agents, with some specialized assistance from the General Manager and the directors of FERTIMEX. Total revenues from the sale of all 13 plants were modest (about US$320 million), however, privatization permitted the creation of a competitive sector, avoided the formation of a private monopoly and eliminated GOM budgetary transfers to the fertilizer sector. Following privatization of all production facilities and the dissolution of the fertilizer marketing company, the Government appointed a liquidator to sell the remaining non-productive assets. Full liquidation of the company is expected to be completed during 1994 (para. 5.30). The Investment Program vi. The investment program was adjusted several times during project implementation to reflect changing priorities and constraints which arose during restructuring and privatization. The wholesale storage facilities were canceled in light of FERTIMEX's revised distribution strategy. On September 1, 1992, due to the acceleration of privatization, management decided to discontinue the construction of the Topolobampo and Altamira terminals and to sell them unfinished. Due to divestiture of the Pajaritos complex, all expenditures on the ammonium nitrate plant were suspended at the end of April 1992, although the plant was nearly completed. During implementation, a number of plant rehabilitation sub-projects were canceled and others were added to reflect changing priorities and accelerated pace of restructuring and privatization (para. 5.31). Project Results Policy Program Results vii. Total Decontrol of the Fertilizer Sector. The major objectives were: (i) total withdrawal of FERTIMEX from retail distribution; (ii) increase of fertilizer prices to 85% of their import/export parity; (iii) increases in raw material prices to approximate international parity; and (iv) increase in competition from imports. Not only were all these objectives fully achieved, but policy actions permitted the complete deregulation of the sub-sector, the complete withdrawal of FERTIMEX from all distribution activities, and facilitated the divestiture of plants (para. 6.1). viii. Divestiture of FERTIMEX's production facilities. The reorganization of FERTIMEX into decentralized regional business units, the rehabilitation investments, administrative and operational improvements, and staff reductions led to improved financial results and greater transparency in company accounts. This permitted the definition of packages of plants for divestiture, facilitating the privatization of FERTIMEX's production facilities (para. 6.2). ix. Impact on GOM Budget. Budget transfers to FERTIMEX were eliminated by 1993. Actual savings in budgetary transfers over the period 1988-92 are estimated at about US$1.0 billion  iv equivalent. These savings are somewhat lower than the US$1.3 billion equivalent expected at appraisal over the same period, but remain very substantial. Budget transfers for interest payments remained high (until 1990), due to the contracting of substantial additional short term debt to resolve critical liquidity problems (para. 6.3). x. Impact on Fertilizer Production and Use. Fertilizer production increased from about 1.6 million tons of nutrients in 1986 to about 2 million tons in 1990. This increase was in line with appraisal estimates (para. 6.4). Finally, production in FERTIMEX's urea plants increased by about 15%-20% above their 1986 level, as a result of better cooperation between FERTIMEX and PEMEX, and improved plant management. xi. Despite sharp increases in prices, domestic fertilizer demand did not decrease and remained at its 1986 level of about 1.75 million tons of nutrients (para. 6.5). This, however, was substantially lower than the 2.4 million tons projected at appraisal. At appraisal, the fertilizer deficit was expected to reach about 260,000 tons of nutrients in 1991 and 370,000 tons in 1992. Actually, the nutrient supply/demand balance showed a surplus of about 320,000 tons in 1990 and 230,000 tons in 1991. During and after the withdrawal of FERTIMEX from fertilizer production and distribution, domestic and imported fertilizer remained available to farmers, and no fertilizer shortages were reported. This was the result of the excellent preparation work performed by FERTIMEX before withdrawal from production and distribution. Results of the Investments Components xii. Performance in the implementation of project investments was mixed: (a) Plant Rehabilitation investments permitted improved operations and resulted in higher production and lower raw material consumption. In 1990, the consumption of raw materials reached levels consistent with those considered attainable during the sub-sector review and at appraisal; (b) implementation of Maritime Terminals was poor -- re-estimated rates of return on the Topolobampo and Altamira terminals are low, due to large cost overruns (para. 5.43). The new owners are likely to use these terminals for other products in addition to fertilizers, thereby raising the financial and economic viability of the facilities; (c) finally, with respect to the Pajaritos Ammonium Nitrate Plant, due to high capital costs and to low international prices of ammonium nitrate, returns on the plant are also low (para. 5.36). In addition, the international market for solid ammonium nitrate is limited and the domestic market is stagnant. Financial Performance xiii. Although FERTIMEX's gross operating margin (sales, minus costs of sales) eventually reached a positive value in 1991, reflecting the impact of plant rehabilitation and improved management, FERTIMEX's operating losses continued to increase (from about US$195 million in 1987 to about US$375 million in 1990 and US$ 281 million in 1991). These high operating losses were due inter-alia to temporary increases in distribution costs (para. 6.12). Except in 1990 and 1991, when price freezes caused serious liquidity problems, financial covenants were met. The Government assumed FERTIMEX's long term debt, as had been agreed. Project Costs and Procurement xiv. Many delays and procedural disagreements occurred early in the procurement of goods and works. All these problems were solved when sample International Competitive Bidding documents were agreed by the Bank and the Government for all Bank-financed projects in Mexico in mid-1989.  v Actual total Project costs amounted to US$320.12 million, versus US$346.4 million estimated at appraisal, i.e., 7.6% below appraisal estimates. The cost overruns of the Pajaritos ammonium nitrate plant (49%) largely offset the lower costs of: (i) the distribution infrastructure rationalization component (41 % below estimates); and (ii) the rehabilitation of the production plants (27% below estimates). Total Bank financing amounted to US$240.2 million, versus US$265 million estimated at appraisal, while counterpart funds amounted to about US$80 million, in line with appraisal estimates (para. 5.59). Environmental Aspects xv. The main environmental issues of this project were: (i) the impact of sea disposal of the gypsum produced in the phosphoric acid plant at Lazaro Cardenas; (ii) the impact of the gypsum water sea disposal at the Pajaritos phosphoric acid plant; and (iii) the impact of sulfur dioxide (SO2) emissions from the sulfuric acid plants of Pajaritos (para. 5.48). xvi. Lazro Cardenas. Since the commissioning of the plant in 1987, the gypsum sea disposal system has been plagued with a series of problems. During implementation of FSAL, the Bank accepted to finance two stand-by dilution water pumps; an Environmental Impact Assessment (EIA); and the design of the system recommended by the EIA. A preliminary EIA study concluded that the impact of gypsum disposal was not significant. After review, the Bank insisted on the need for a more complete follow-up study. After the disposal system was destroyed by an earthquake in 1992, contracting of the study was suspended. At the time of divestiture in December 1992, the phosphoric acid plants were not operating and the dispute with the Comisi6n Nacional del Agua (CNA or National Water Commission) over resolution of the environmental problems was still not determined. Prior to delivery of the plant, the new owner reached an agreement with CNA with a view to finding a permanent solution to this problem (para. 5.51). xvii. Pajaritos Fosfatados. (a) To address the Gypsum-contaminated water of the Pajaritos Fosfatados plant overflows to the Gulf of Mexico, the project included: (i) the rehabilitation of the phosphoric acid plants and (ii) a gypsum water recycle sub-project. The phosphoric acid units were rehabilitated and the operation of the settling ponds improved. However, FERTIMEX dropped the water recycle sub-project due to the acceleration of plant divestiture. The Bank requested that FERTIMEX prepare an EIA, which concluded that the impact of contaminated gypsum water disposal was minimal. Nevertheless, the new plant owner signed an environmental agreement with CNA which included the implementation of the water recycle project within three years. (b) In order to reduce SO2 emissions from the two single absorption sutfuric acid plants of Pajaritos Fosfatados, FERTIMEX added an ammonium sulfate solution recovery section to these plants. This project, which was started before appraisal, was completed and commissioned in 1990. Currently, one of the sulfuric acid plants has been definitively stopped and the second plant is not in operation (paras. 5.53 and 5.54). Proiect Sustainability Sustainability of the Policy Program xviii. The FSAL identified two major risks relevant to project sustainability: (i) a possible negative impact on the agricultural sector; and (ii) a possibility of future policy reversals. xix. Close linkage with the Agriculture Sector Adjustment Loan (AGSAL- Loan 2918-ME), reduced the risk of negative impact on the agricultural sector. Following implementation of the  vi AGSAL and AGSAL II (Loans 2918-ME and 3357-ME, respectively), the agricultural economy moved close to a market-pricing system, subsidies on agricultural inputs were reduced and arbitrary and costly trade restrictions on most agricultural products were abandoned. As a result, fertilizer prices increased, but domestic fertilizer consumption did not decrease and remained around its 1986 level (para. 6.4). xx. The policy reforms, as implemented, went far beyond commitments under the FSAL. This success was the result of strong GOM commitment to reform, particularly by the Salinas administration. Due to the success of the broad program of structural adjustment put in place during recent years, the risk of political reversal of the reform process is exceedingly low. In addition, although it is too early for a full evaluation, the privatized and deregulated fertilizer sector appears to function well. The private sector reacted quickly and positively to FERTIMEX's withdrawal from fertilizer distribution and full sectoral deregulation (para. 5.13). All sites are currently operating, with one exception. xxi. The last remaining distortion in the sector is now being removed: Mexican regulations have been revised to exclude ammonia from the list of products reserved for PEMEX, and to allow private sector participation in ammonia production. PEMEX has announced its decision to sell its ammonia plants in the near future (para. 7.4). Sustainabdity of New Investments xxii. The viability of the Topolobampo and Altamira maritime terminals could be improved following divestiture, if the new owners use them to handle other products in addition to fertilizers (para. 6. 10). Also, on a marginal cost basis, net cash flows of the Pajaritos ammonium nitrate plant remain positive and, if completed at low cost, the Urea-Ammonium Nitrate (UAN) solutions plant could offer the opportunity for market diversification (para. 5.37), thereby improving plant sustainability (para. 6.11). With respect to Lazaro Cardenas, low price obtained from the plant sale (about US$50 million together with the ROFOMEX mine of Baja California) confirms that the plant may only be financially sustainable when treating part, or all, past investment as sunk costs (PCR, Loan 1686-ME). Attempts are currently underway to improve the plant financial viability. Findines and Lessons Learned xxiii. There was clear over-compliance on the policy based component, although with significant initial delays. In comparison, the investment component performed rather badly with capital cost overruns and delays. The Bank played a major role in carrying out the underpinning economic and sector work, and contributed to project design and implementation. After negotiating the project with a FERTIMEX management team rather adverse to sector restructuring and a Government not fully committed to complete reform, the new Government's philosophy resulted in actions that were fully in line with the most far-reaching recommendations in the sector report. A number of lessons may be learned from implementation of the project and from the privatization process which took place in parallel. The most important are: Lessons from Restructuring xxiv. Government commitment to reform is essential for comprehensive sector restructuring. GOM was able to deal simultaneously with macroeconomic stabilization, structural adjustment and debt reduction. Consensus within the Government and the State-Owned Enterprise (SOE) regarding the need for price deregulation is particularly important. When this consensus is reached, the  vii implementation of pricing reforms can move faster and beyond original commitments. Timely pricing reform, in turn, is essential for the overall restructuring program para. 5.5). xxv. SOE management commitment to company restructuring is also indispensable. If management commitment is limited, as was the case at appraisal and the early stages of implementation, it may be advantageous for the Bank to accept a limited restructuring program which includes key studies that could provide the underpinning for more ambitious actions in the future. A limited program, well received by the borrower, may be more effective in initiating full restructuring than a more ambitious program which does not attract commitment (para. 5.19). A positive feature of the loan was the linking of tranche conditions to specific policy actions and phases of the studies needed to prepare later actions. The design of tranches with sufficient time lag between tranche disbursement ensures effective follow-up of policy implementation and avoids possible back-sliding when the loan is fully disbursed. xxvi. Price conditionality for fertilizer and fertilizer raw materials was superseded by GOM's overriding price stabilization programs early during implementation. In spite of close coordination between the Bank and GOM on stabilization and sector restructuring measures, it was not possible to avoid conflicting policy programs and negative impacts on FERTIMEX finances and restructuring efforts (para. 5.5). xxvii. Plant closure programs should be carefully assessed and should be flexible particularly when the viability of the plants to be closed-down depends on prices of international commodities in a depressed and volatile market (as the fertilizer market has been for many years) (para. 5.9). xxviii. New investments should not normally be part of a sector restructuring operation. They are not likely to be efficiently implemented until the company and/or sector has been completely restructured and, if privatization is the ultimate target, they will be better implemented by the new owner at lower cost to the Government. Well-implemented rehabilitation investments, however, may improve efficiency in preparation for liberalization or privatization; maintain an incentive for management and staff to optimize operations during the divestiture period; and enable the Bank to monitor the restructuring process and provide an important opportunity for the Bank to maintain a dynamic working dialogue with the company (paras. 5.31, 6.9). Lessons from Privatization xxix. Consolidation of divestiture activities in a central government interministerial unit, assisted by qualified agent banks for the management of sales, is an effective way of organizing speedy and efficient sales. Efficiency of the divestiture may be improved if specialized assistance is obtained from the company management as long as it is committed to divestiture (para. 5.27). xxx. Adequate packaging of assets for divestiture is very important: the sale of Pajaritos Fosfatados in combination with Pajaritos Nitrogenados and of the Rofomex phosphate mine in combination with Lazaro Cardenas greatly facilitated their divestiture (para. 5.25). xxxi. It is important to secure labor support, or at least prevent opposition, in advance of the restructuring and divestiture process. This can be achieved by preparing acceptable compensation schemes during lay-offs and by encouraging labor participation in bidding for the privatized entities (para. 5.28).  viii xxxii. If well prepared, public sector withdrawal from fertilizer distribution activities can be implemented quickly and easily. Critical factors are: management commitment, the establishment of incentives to attract the private sector, and prior pricing and trade deregulation (para. 6. 1). Lessons from Project Supervision xxxiii. High returns can be gained from time and resources invested in building a working dialogue with key decision makers and maintain an open and frequent communications. The close relationship which developed between the Bank, FERTIMEX management, and the GOM permitted a better understanding of problems encountered during the restructuring and privatization process and resulted in a continuous policy dialogue (para. 10.1). xxxiv. Intense project supervision by the Bank as well as continuity in Bank staff is especially important in this type of operations, and even more when local administrations overlap-- the task manager responsible for preparation, appraisal and negotiation should supervise the project at least during the initial critical phases to ensure continuity in the policy dialogue.   PRO.JECT COMPLETION REPORT FERTILIZER SECTOR ADJUSTMENT LOAN (Loan 2919 ME) PART I: PRO.JECT REVIEW FROM THE BANK'S PERSPECTIVE 1. Project Identity Name: Fertilizer Sector Adjustment Loan Loan Number: 2919-ME RVP Unit: Latin America & Caribbean Region Country: Mexico Sector: Industry Sub-sector: Fertilizer 2. Background 2.1 The Fertilizer Sector Adjustment Loan (FSAL) was prepared and appraised as an integral component of Mexico's broad economic and sectoral restructuring program during a time of rapid change in the macro and microeconomic policy environment in the country. The loan reflected the refocussing of the Bank's country assistance strategy in line with the shift in Government policy toward stabilization, macro adjustment, and sectoral reforms. 2.2 The crisis experienced by the Mexican economy during the first half of the 1980s, among the most severe that the country had experienced in its history, was the result of decades of inward- oriented development policies combined with negative external shocks. By 1970, Mexico had exhausted the easier possibilities for import-substitution industrialization which had generated an average 6.2% rate of economic growth from the 1940s to the 1960s. During the 1970s, central administrative controls were increasingly used to allocate the resources available to the economy. This economic control was extended through increasing regulation and direct state ownership of productive resources. State participation in the economy peaked at 1,155 firms in 1982 with the nationalization of the commercial banks. 2.3 The high rates of growth, although continuing at an average of 6.2% through the 1970s, masked a growing degree of inefficiency in the economy. Total factor productivity growth, for example, declined from about 4.5% per annum in the 1940s, to 1.0% in the 1950s and 1960s, and to zero growth in the 1970s. Following the financial and economic crisis of 1976, major oil discoveries led to an apparent quick economic recovery. Public external debt grew from US$40 billion in 1979 to US$78 billion in 1981. The ensuing prosperity lasted until 1982, when falling oil prices, rising world interest rates, and massive capital flight led external creditors to refuse to provide further finance to cover Mexico's deficits or to roll over its short-term debt. 2.4 The debt crisis of 1982 forced the incoming administration, which took office at the end of the year, to adopt a stringent stabilization program and to seek external debt relief. The program succeeded in reducing the fiscal and current account deficits and enabled a fragile economic recovery to begin in 1984-85. Initial steps toward trade liberalization, privatization, and structural reform were taken. Two major external shocks, the Mexico City earthquake of 1985 and the collapse of oil prices in 1986, however, disrupted this recovery.  2.5 Despite the worsening external environment in 1985-86, and in recognition of the limited results of earlier reform efforts, the Government deepened the program of structural adjustment. Major trade reforms, notably the signing of the General Agreement on Tariffs and Trade (GATT) in 1986, were undertaken to open the economy to international competition. 2.6 The macroeconomic situation continued to deteriorate, however, with annual inflation reaching 159% in 1987. In December of that year, the Government negotiated the Pacto (Economic Solidarity Pact), which combined fiscal and monetary austerity with agreed wage and price controls. The Government initially froze the dollar-peso exchange rate as a nominal anchor against inflation. Labor and business groups, in turn, negotiated a program of wage and price controls intended to curb the strong inertial components of inflation. 2.7 In December 1988, the Pacto was renewed as the Economic Stabilization and Growth Pact (PECE). The new agreement contained guidelines for price and wage adjustments and exchange rate movements in an effort to consolidate price stability. The well-balanced Pacrto/PECE strategy, which included Government, business, and labor efforts at stabilization, turned out to be successful, as inflation dropped to 52% in 1988 and an average of 20% during 1989-1992 while output and investment recovered quickly. 2.8 Following the inauguration of the Salinas administration in December 1988, the privatization program of the Government was expanded and accelerated. Although the sale of state enterprises began in late 1982, only 108 small and medium-sized SOEs had been privatized by the start of 1989, raising US$1.67 billion in revenue. The expanded program under the Salinas administration raised US$20.23 billion during 1989-1992, as the bulk of the remaining SOEs were sold or liquidated. World Bank and IMF Roles in Mexico's Adjustment 2.9 The Bank role in Mexico began to shift during the mid-1980s as a result of i) the Government's increasing commitment to profound structural reform and ii) recognition of the severity of the country's problems. The Bank began to work more closely with the Government on trade issues during 1984; by 1985, the Bank began to play a central role in the dialogue between the Government and international commercial creditors via the developing program of structural reform and financial support. 2.10 The Government, while fully committed to structural reforms, did not want a formal Structural Adjustment Loan (SAL) for political reasons. The Bank consequently agreed to address the long-term structural issues through a series of sector adjustment loans, which taken together, covered thoroughly the major elements of a SAL program. The two Trade Policy Loans (FY87 and FY88 for US$500 million each) were the first such operations and were followed by sector adjustment loans in the Fertilizer Sector (Loan 2919-ME, FY88, US$265 million); Agriculture Sector (FY88 and FY91, US$300 million and US$400 million, respectively); Steel Sector (FY88, US$400 million); Financial Sector (FY89, US$500 million); Industrial Sector (FY89, US$500 million); Public Enterprise Reform (FY89, US$500 million); Road Transport and Telecommunications (FY90, US$380 million); Interest Support (FY90, US$1.26 billion); and Export Sector (FY91. US$300 million). These operations formed a policy package to build the framework for the increase in private investment necessary to spur growth. 2.11 Since 1982, the IMF has supported Mexico with an extended arrangement for SDR 3.4 billion, a special emergency drawing for SDR 291 million following the 1985 earthquake, a stand-by agreement for SDR 1.4 billion in 1986, a drawing of SDR 453 million in 1989 under the  compensatory facility and a further extended arrangement of SDR 2.8 billion. The final extended financing facility was completed successfully in May 1993. 2.12 During the design and implementation of the program of sector restructuring, the Bank and IMF were in close coordination to ensure policy compatibility. The Bank and IMF also worked closely with the Government in negotiation of the 1989 debt reduction agreement with international commercial banks. This agreement resulted in an immediate drop in nominal interest rates, lengthening maturities for public debt and massive private capital inflows. The Fertilizer Sector at Appraisal 2.13 Until recently, the fertilizer industry had been viewed by the Government of Mexico as a strategic industry in the context of its overall objective to make effective use of its energy resources and to achieve self-sufficiency in basic grains and cereals. Annual consumption, which in 1987 amounted to 4.7 million tons of products (about 1.9 million tons of nutrients) had been growing by 6% per year since 1975. With the exception of small quantities of ammonium sulfate and specialty fertilizers, all fertilizer production in Mexico was in the public sector. All ammonia (the main raw material in the production of nitrogenous fertilizers) was produced by Petroleos Mexicanos (PEMEX). All other fertilizer intermediates and solid finished products were produced by FERTIMEX, which was also the primary agency responsible for fertilizer marketing and distribution in Mexico. 2.14 During the 15 years preceding appraisal in April 1987, the major objective of FERTIMEX had been to implement the Government policy of increasing domestic use and production of fertilizer, and to deliver it to farmers at subsidized prices (which in 1986 averaged about half of import parity). At appraisal, FERTIMEX total production capacity amounted to 6.0 million tons of finished products and 5.4 million tons of intermediates and consisted of 56 plants in 12 different locations. FERTIMEX production in 1987 totalled about 4.4 million tons of product. It was estimated then that twenty nine of these plants (accounting for about 28% of total product capacity and 11 % of total intermediate capacity) which started operation prior to 1970 were unlikely to become economically viable. With appropriate revamping and efficient operation, the remaining plants could become economically viable at the then projected international input and output prices. 2.15 FERTIMEX reached its distribution objective of widespread fertilizer availability at uniform, subsidized prices at very high distribution cost (about US$45/ton in 1986) due to: (i) excessive reliance on consignment; (ii) the obligation to deliver to about 2600 sales points; (iii) excessive reliance on truck transport; and (iv) high volumes transported and stored in bags in more than 1,000 warehouses with excessive inventories totalling about 4 million tons (about 10 months' sales). 2.16 FERTIMEX was operating in an environment of Government policies and regulations which were not conductive to optimum production, financial and economic efficiency. The major constraints to improving efficiency in the sector were: (a) The pricing system: The GOM set one uniform, subsidized price which was paid by farmers and distributors at the nearest railway station. This price was determined by the government's agricultural policy and was related neither to FERTIMEX's production and distribution costs nor to international prices: in 1986, revenues from sales covered only 44% of total costs including interest charges. Budgetary transfers amounted to US$386 million equivalent, and in addition FERTIMEX received about US$130 million equivalent in indirect subsidies from PEMEX in the form of low ammonia prices.  (b) Poor Financial situation of FERTIMEX: As of December 1987, FERTIMEX's debt amounted to US$1,032 million and total annual debt service (on the medium and long term debt) totalled US$185 million. (c) Lack of competition: FERTIMEX was a defacto production monopoly and, for all practical purposes, an import and distribution monopoly. (d) FERTIMEX Management Autonomy. Organization and Business Orientation: Due to FERTIMEX's high dependence on budgetary funding, government intervention in its management remained very heavy in spite of the newly enacted law on parastatal enterprises. The company continued to operate more as a Government department under SEMIP's supervision than as a commercial enterprise. Management was very centralized with over 3,500 headquarter employees out of total personnel of 13,000. Cost control was not a priority. (e) Non-integration of Ammonia and Urea Plants. Throughout the world fertilizer industry, ammonia and urea plants are integrated to maximize efficiency. In Mexico, due to prevailing legislation, ammonia plants were and still are, owned and operated by PEMEX, while the downstream urea plants were owned and operated by FERTIMEX. 2.17 Because of the escalating cost of subsidies to the national budget, the Government started to consider sector restructuring to minimize costs of both production and distribution. In 1985, for the first time in ten years of Bank involvement in Mexico's fertilizer sector, the GOM requested Bank assistance in the definition of an overall strategy for the sector. During 1986 and 1987 FERTIMEX already took a number of steps to improve its efficiency. These included: (i) decentralization of limited functions to the regional level; (ii) development of systems to support such decentralization; (iii) closure of 12 plants in five locations. These steps were part of the measures recommended by the Fertilizer Sector Restructuring Program report prepared by the Bank (April 29, 1986). Although indispensable, these measures fell far short of the reforms needed for FERTIMEX to carry out the medium and long term strategy spelled out in the 1986 Bank sector report, the GOM Sector Policy Statement (para. 3.1), and the policy program agreed during negotiations as part of the Project (section 5). Fertilizer Sector Development Following Loan Approval 2.18 Following approval of the loan in March 15, 1988, implementation of the agreed policy program experienced significant early delays. Effectiveness was achieved only in November 1989, as compared to the expected date of September 1988. Delays were due to the changes in Government administrations and, concurrently, in FERTIMEX management and to the price constraints imposed on raw materials and fertilizer prices under the Pacto and the PECE (paras. 2.6 and 2.7). 2.19 After these initial delays, progress in implementation of the program was satisfactory. The Government and FERTIMEX took the agreed actions in fertilizer and raw materials pricing, reorganization, and withdrawal from retail distribution. Moreover, GOM and FERTIMEX's management moved further and faster than had been anticipated. They embarked on an ambitious program which led to the complete deregulation and privatization of the fertilizer sector within about two years. Although complete privatization of the sector was not specifically envisioned in the FSAL, it was the preferred of the proposed options in the Fertilizer Sector Restructuring Program proposed in the Bank's sector report. However, at the time of appraisal, achieving this objective was considered to be unrealistic in the short to medium term. As of June 1993: (i) all production facilities had been sold and delivered to their new owners; (ii) FERTIMEX had withdrawn completely  from retail and wholesale distribution; (iii) all remaining personnel had been released as of December 31, 1992; (iv) all remaining assets including distribution facilities were being sold by a liquidator appointed by the Government; and (iv) the sector was completely deregulated. 3. Proiect Objectives and Description 3.1 Project Objectives: This hybrid sector policy and investment loan was intended to support the implementation of the first phase of the Government-FERTIMEX five year program to put the fertilizer sector on a sound competitive basis and eliminate Government subsidies through: (i) implementation of major policy reforms; (ii) investment to rationalize operations; and (iii) studies to assist in the implementation of the program. Major policy reforms were incorporated in the Sector Policy Statement, dated February 25, 1988 and in a contract between the Government and FERTIMEX which was signed before Loan effectiveness. These policy measures included: (a) the elimination of price subsidies on fertilizer and fertilizer raw materials according to a four-year program of price increases; (b) the closure of uneconomic plants; (c) the rationalization and liberalization of the fertilizer distribution system through withdrawal of FERTIMEX from retail and consignment distribution over a four year period; (d) improvement in the organizational structure of FERTIMEX; (e) the financial restructuring of FERTIMEX; and (f) improvement in links between PEMEX and FERTIMEX for ammonia and urea production. 3.2 Project Description: At approval, the project consisted of three components with a total cost of US$346.4 million: (a) US$200 million in Bank financing for imports of fertilizer and fertilizer raw materials (US$150 million) and other imports (US$50 million) in support of the sub-sector policy reforms; (b) US$145 million, of which US$63.6 million was financed by the Bank and US$81.4 million by the Government, to undertake rationalization investments in the production and distribution infrastructure. They included: (i) the rehabilitation of viable production plants; (ii) the completion of an ammonium nitrate fertilizer plant at Pajaritos; (iii) the construction of wholesale storage facilities (14 bulk fertilizer warehouses and 4 ammonia spheres); and (iv) the construction of two maritime terminals in Topolobampo and Altamira and improvement of existing bulk facilities in five ports; and (c) US$1.4 million for the financing of technical assistance to assist in the restructuring of FERTIMEX. This technical assistance included: (i) an overall organization study of FERTIMEX; (ii) a distribution study to define the modalities of FERTIMEX's withdrawal from retail and consignment operations; (iii) a phosphate study to develop a method of comparative economic evaluation of various phosphate rock types; and (iv) systems to upgrade the planning capabilities of FERTIMEX. 3.3 The Loan Agreement and the Guarantee Agreement were amended on February 4, 1990 to allow GOM to use US$150 million1' from the proceeds of the Loan as set-asides in support of Mexico's debt reduction program (see PCR, Interest Support Loan, Report No. 11640). The lLThe proceeds of the first tranche (US$100 million) and an additional US$50 million from the second tranche of US$100 million originally.  component for import of fertilizers and fertilizer raw materials was therefore reduced to US$50 million. However, the allocation of a large part of the loan proceeds for debt reduction purposes did not affect the objectives nor the implementation of the FSAL, since the imports which were originally to be financed out of these proceeds were financed from Mexico's own resources. 3.4 The Loan and Project Agreements were also amended on February 16, 1990 to permit the financing from the proceeds of the loan of: (i) urgent rehabilitation investments in Lazaro Cardenas; and (ii) studies to assess the environmental impact of gypsum and contaminated water ejected to the sea in Lazaro Cardenas and to design and engineer the recommended systems necessary to minimize such impact. 4. Project Design and OrEanization 4.1 Project Design. Based on the extensive sector work carried out during the preparation mission (November 1985) and summarized in the Fertilizer Sector Restructuring Program proposed by the Bank, and on the findings of the pre-appraisal and appraisal missions, the conceptual foundations for the project were clear and appropriate. The project objectives as reflected in the design were shared by parties relevant to the project. Designed as part of the GOM's overall economic restructuring strategy then under implementation, the project was timely. The design was innovative, combining sector policy reforms with investment for rationalization of operations. The roles, objectives, and responsibilities of the institutions and agencies involved were clear. The important conditions of effectiveness, unusual for an adjustment loan, and the linking of tranche conditions to specific policy actions proved instrumental in policy implementation. The policy reforms planned under the project were a prerequisite to FERTIMEX's complete withdrawal from retail and wholesale distribution and the divestiture of its production and distribution facilities (para. 6.2). The conceptual aspects of the rationalization investments program had been developed by FERTIMEX with inputs from Bank staff. However, this investment program had to be adjusted several times during project implementation to reflect priorities and constraints identified while implementing restructuring plans, and later on as a result of the accelerated privatization program implemented by the GOM and FERTIMEX. 4.2 Project Coordination. Except for the implementation of new investments, the FERTIMEX Planning Department was very effective at coordinating all Project activities. The Planning Department was also an effective channel of communication between the different agencies involved in project implementation, including the Bank, NAFIN, SEMIP, and SHCP. Through continuous informal contacts, support of Bank supervision missions, and timely progress reports, the Planning Department provided valuable assistance to Bank follow-up of policy reforms and the investment program, and of the restructuring and privatization processes. 4.3 Organization of Rehabilitation and Investments Projects. The plant rehabilitation components were successfully carried out by the decentralized production units. However, the new investment projects (completion of the ammonium nitrate plant and the construction of the two terminals of Topolobampo and Altamira), whose management remained centralized at Headquarters, were poorly implemented. Despite the restructuring of the company, FERTIMEX investment implementation capabilities at Headquarters remained limited. The Bank insisted on the contracting of outside consultants to support sub-project local implementation teams in planning, control, expediting, irspection, and reporting. However, FERTIMEX appointed with its own funds the same company for all three sub-projects, and only after construction had started. While costs overruns and implementation delays were not as severe as under the two previous Bank-financed projects  (FERTIMEX I and II), and despite the Bank's recommendations and supervision efforts FERTIMEX was not able to avoid recurrence of project implementation problems experienced under these past operations. Only when an experienced project manager was placed on site at the Pajaritos ammonium nitrate plant did the pace of construction improve. Reasons for delays and overruns were: poor project management organization including some modification of project scope during implementation without Bank agreement; lack of multi-annual investment budgets for the project; and a complete lack of incentives to maintain project implementation within budget and schedule. 4.4 Organization of Studies. The Organization and Distribution studies were consolidated and carried-out by Booz Allen & Hamilton of Mexico (BAH), jointly with FERTIMEX's management and with extensive participation of FERTIMEX's General Manager and Directors. The phosphate study was carried out by ATFER Fertilizer Consultancy of France. Finally, the impact assessments of the gypsum sea discharge at Lazaro Cardenas and of sea discharge of liquid effluent from the gypsum deposit at Pajaritos were carried out by EPAC Consultores, S.C., of Mexico. 5. Project Implementation A. Policy Program Implementation Implementation Schedule 5.1 The FSAL, which was approved on March 15, 1988 and signed on June 13, 1988 initially encountered serious implementation delays and became effective only on November 2, 1989, i.e. over a year after the originally planned date. The delays resulted from: (i) measures under the macro- economic stabilization programs (Pacto and PECE) which froze fertilizer and fertilizer inputs prices and made adherence to the originally agreed price increase schedule impossible; (ii) frequent management changes in FERTIMEX; and (iii) the plant closure program included in the restructuring agreement between the GOM and FERTIMEX (Convenio) submitted to the Bank as a condition of effectiveness which did not include the agreed-upon list of plants. Due to these events effectiveness was not declared, and the FSAL conditions were renegotiated in mid-1989 with consideration given to the constraints imposed by the Government's program of macroeconomic stabilization. The resulting amendments of the loan, guarantee, and project agreements preserved the objectives and integrity of the sub-sector adjustment program and was approved by the Board and signed on September 26, 1989. The amendments included: (a) a revised schedule for input and output price increases; (b) the establishment of conditions for release of the first tranche of the import component!'; and (c) revised covenants for implementation of the plant closure program allowing the continued operation of three ammonium sulfate plants originally intended for closure, under certain conditions (para. 5.9). 5.2 The first tranche of the import component was released on December 14, 1989, and fully disbursed in February 1990, after the Loan and Guarantee Agreements were amended to allow GOM to use part of the proceeds of the Loan for set-asides in support of Mexico's debt reduction program (para. 3.3). All revised conditions for the release of this first tranche had been met by October 1989, one month before loan effectiveness, as follows: (i) fertilizer prices were increased by 18.8% in nominal peso terms on July 26, 1989; (ii) the price of sulfur was increased to at least export parity on 2/ Later it was agreed to use the entire first tranche as set-aside in support of Mexico's debt reduction program (para. 3.3).  July 31, 19892'; (iii) all studies were initiated; and (iv) FERTIMEX had begun withdrawal from retail distribution. 5.3 The conditions for the second tranche release were all met by mid-July 1991, and the tranche was released in September 13, 1991, about 15 months behind the amended schedule date (March 1990) and 26 months behind the originally scheduled date (April 1989). The main causes of this delay were: (i) some delays in fertilizer price increases due to PECE negotiations during the first part of 1990; (ii) slower-than-expected withdrawals from consignment and retail distribution4'; (iii) delays in the completion of the distribution study; and (iv) the original investment program presented by FERTIMEX for 1991 was not acceptable to the Bank because it included a financing gap and the completion of uneconomic ammonia spheres and warehouses investments. 5.4 After these initial delays, progress on the overall program of sectoral adjustment was fully satisfactory. Early in the implementation of FERTIMEX's restructuring, GOM and FERTIMEX's management embarked on an ambitious program aiming at the complete decontrol of the sector and the total privatization of FERTIMEX. This program was implemented at an accelerated pace, and, as of December 1992, the sector had been completely decontrolled, all production assets had been sold to private owners, FERTIMEX had stopped all distribution activities, and all other assets were being liquidated. This accelerated program was not contemplated in the Project and reflected policy decisions going beyond the commitments under the Project. The Salinas administration, which took office in December 1988, had more ambitious goals in sector and economic restructuring and was instrumental in accelerating and enlarging this program of sectoral reform. The Policy Program 5.5 The Policy Program supported under the FSAL aimed at financial self-sufficiency for FERTIMEX by the end of 1993, through a program of price increases and physical, organizational, and financial restructuring. The main measures of this program were implemented as follows: (a) Prices of Fertilizer 5.6 Over a period of four years (1989-1993) the Program called for: (i) an increase in the weighted average of controlled fertilizer prices by at least 18.8% in nominal Peso terms by September 30, 1989; and (ii) increases of 12.3% per year in constant end-1987 US Dollar terms, beginning in 1990 and ending when prices had reached import parity or FERTIMEX had achieved financial self- sufficiency. Financial self-sufficiency was defined as fertilizer list prices sufficient to cover production, distribution and marketing, administrative overhead, all financial charges, and an 8% return on equity invested in all new projects. After initial delays in 1988 and early 1989 (para. 5.1), the agreed fertilizer price increase of 18.8% in nominal pesos was implemented as of July 26, 1989. In 1990, fertilizer prices were increased by 20% on May 28, by another 20% on September 1, and by 3/ Effective September 5, 1989, it was agreed that the price of sulfur was to be automatically adjusted in line with export parity whenever the international reference price varied by more than 5%. 4/Due to the withdrawal of the Banco Nacional de Cr6dito Rural (BANRURAL) from fertilizer distribution, FERTIMEX consignment sales increased from 40% of total sales in 1987 to 60% in 11/89/90. As a result of the increase in consignment sales, the target for withdrawal established for the second tranche, which represented a modest 10% of 1987 total sales (430,000 tons), was increased to 30% of total sales in 1990 (1.5 million tons).  - 9 - a further 13% on November 16. Fertilizer prices increased by about 30% in end-1987 dollar terms during 1990, far exceeding the 12.3% per year real increase specified in the Loan Agreement for the year. These increases were sufficient to cover most of the required increases for 1991 as well. At the end of 1990, the average domestic fertilizer price reached about 90% of import (or export) parity as compared with 47% in April 1987, 69% at the end of 1987 and 59% at the end of 1988. As of October 30, 1991, a new fertilizer pricing system was introduced. In this pricing system, (i) prices for FERTIMEX were set at plant gate, based on international prices, and were differentiated by plant; (ii) controlled prices for each of the 198 primary warehouses, whether operated by FERTIMEX or the private sector, to which FERTIMEX limited its deliveries (para. 5.12), were set based on plant gate prices plus transport and handling costs; and (iii) prices to final consumers were left to market forces and only suggested by FERTIMEX. In addition, private producers were free to determine their prices. Also as an incentive to attract the private sector to retail and wholesale distribution, FERTIMEX introduced payment conditions with a 10% down payment and the balance due at 150 days. By the end of 1991 and during 1992, wholesale prices were 12-15% higher than their international parity. This margin was necessary to FERTIMEX to compensate for the financial cost of generous payment conditions. This fertilizer pricing system functioned well until FERTIMEX withdrew completely from fertilizer distribution early in 1993. Therefore, the covenant requiring price increases to the level of import parity was fully met. Domestic prices of fertilizers and their international parity, actual and as estimated at appraisal, are presented for the period 1986-92 in Part III, para. 6.B.1. (b) Prices of Fertilizer Raw Materials 5.7 The Policy Program also stipulated that controlled prices of domestic sulfur paid by FERTIMEX should reach export parity before September 30, 1989 and thereafter be maintained at this level; and ammonia prices paid by FERTIMEX to PEMEX should reach 80% of the export price by the end of 1993 according to an agreed program. International and domestic prices of raw materials, actual and as projected at appraisal, are compared in Part III, para. 6.B. 1 for the period 1987-93. Implementation was as follows: (i) The price of sulfur was increased above export parity on July 31, 1989; beginning October 10, 1989, prices were regularly adjusted to remain in line with export parity whenever the international reference price of sulfur varied by more than 5%. Finally, on August 3, 1990, prices were fully decontrolled, resulting in overcompliance with the conditions set in the guarantee agreement; and (ii) The nominal peso price of ammonia remained frozen at the end-December 1987 level as part of GOM economic stabilization program. In current dollar terms, the price of ammonia decreased to about US$44 per ton (40% of export parity by the end of 1988, and US$38 (51 % of export parity) at the end of 1989. On June 1990 the price of ammonia paid by FERTIMEX to PEMEX was increased by 20% in nominal peso terms to reach 56% of export parity and was increased by 75% in November 1990 to about US$72 equivalent, or 65% of its export price, thus meeting the 50% and 60% of export parity stipulated in the loan agreement respectively for end-1990 and end-1991. The price then remained unchanged until April 1992, when it was set at export parity, with monthly revisions, taking advantage of the very low export price of 1992 (US$74.5 FOB Coatzacoalcos). Export parity was defined ex-Cosoleacaque as the published price for Tampa, Florida less US$20 transport and handling cost. Prices for all other Mexican locations were based on the above price plus domestic transport and handling costs. In 1993, after divestiture of all FERTIMEX's production facilities, PEMEX decided to set ammonia prices at the full Tampa price, thus increasing prices in Mexico by US$20. The new private fertilizer producers complained and obtained a US$5 price concession through  - 10 - negotiations with PEMEX. Overall, the increases for the price of ammonia exceeded the conditions set in the Loan Agreement in terms of both timing and amount. (c) Links between PEMEX and FERTIMEX for Ammonia and Urea Production 5.8 On November 15, 1988, as a condition of Loan effectiveness, an agreement was signed between PEMEX and FERTIMEX including procedures to facilitate closer operating coordination of ammonia and downstream urea plants and to ensure more rational planning of new investments. Following this agreement, the operation of FERTIMEX's urea plants improved significantly, minimizing the inefficiencies which had arisen from the lack of integration of ammonia and urea plants (para. 6.9 and para. 6.A.2 of Part III). Since the divestiture of FERTIMEX, PEMEX and the new private producers negotiate prices directly. (d) Plant Closure Program 5.9 In 1986 and 1987, before the loan was approved, FERTIMEX closed a total of 12 plants on five production sites with a total capacity of 788,000 tons of finished products and 429,000 tons of intermediates. The Policy Program under the loan included an additional closure program for 1988 and 1989 involving the closure of 938,700 tons of finished product capacity and 178,550 tons of associated intermediate product capacity. Accordingly, the phosphoric acid plant of Coatzacoalcos, the small Tecun Uman complex fertilizer plant (66,000 tpy) owned by FERTIMEX in Guatemala, and the sulfuric acid plants 1 and 2 of Guadalajara were closed in February/March 1988. The phosphoric acid plant of Monclova was closed in June 1990, six months behind schedule (subsequently, the plants of Tecun Uman and Guadalajara were sold early in 1992). As already commented (para. 5.1) the plant closure program was amended before Loan effectiveness to allow the continued operation of the ammonium sulfate plants of Queretaro, Guadalajara, and Coatzacoalcos under continuous monitoring, as long as specified input/output international price ratios did not fall below agreed plant-specific levels. Until November 1990 the operation of these plants showed input/output ratios above those specified for either close monitoring or closure. Between November 1990 and August 1991, the operation of the three plants showed ratios lower than the specified and their viability was thus closely monitored and reported by FERTIMEX. The fertilizer plant of Coatzacoalcos was sold in March 1991 and is reported to have completely stopped operations. Finally, input/output price ratios improved again in August 1991 and the operation of Guadalajara and Queretaro remained marginally justified until they were sold, respectively, in March and July 1992. It is reported that these ammonium sulfate plants are currently operating at reduced capacity due to competition from imports of ammonium sulfate by distributors, resulting in the suspension of operations of the large two- thousand-ton capacity sulfuric acid plant of Queretaro. (e) Withdrawal from Consignment and Retail Distribution Operations 5.10 An important objective of the FSAL was the rationalization of the distribution system to reduce state participation and to attract private sector investment. For this purpose it was agreed that FERTIMEX would: (i) withdraw completely over five years from retail and consignment distribution and reduce operations and supervision activities from about 2,600 sales outlets to no more than 120 wholesale warehouses, except in marginal areas; (ii) carry out and complete before March 15, 1990, a two-phase distribution study to define a plan of action for FERTIMEX's withdrawal and design a system of incentives to motivate private distribution agents to take charge of distribution and storage at the retail level; (iii) initiate the withdrawal from consignment and/or retail operations by October 15, 1989; and, by February 28, 1990, withdraw from consignment and/or retail operations of an aggregate volume equivalent to more than 10% of all FERTIMEX sales of solid fertilizer in 1987;  - 11 - and (iv) complete the implementation of the defined plan of action by no later than December 31, 1992. 5. l By the end of 1989 FERTIMEX began a slow and gradual process of withdrawal from secondary distribution services by withdrawing from the provision of bulk-blended materials to Ingenios Azucareros and to the Mexican Coffee Institute. Withdrawal from retail and consignment operations remained insignificant until early 1991, due to: (i) the withdrawal of BANRURAL from fertilizer distribution, which increased FERTIMEX's consignment operations from 40% of total sales in 1987 to 60% in 1989/90 (para. 5.3, footnote 4); and (ii) delays in the distribution study, which was completed on September 30, 1990 as part of an integrated distribution and organization study. However, early in 1990, FERTIMEX management decided to disengage from primary distribution as well as from secondary distribution, and, with the assistance of BAH, initiated an ambitious program to (a) define the strategy and systems necessary for an orderly withdrawal; (b) identify solutions to problems that might arise from withdrawal; (c) prepare and negotiate direct sales contracts in substitution for consignment sales; (d) prepare and negotiate contracts for the transfer of consignment inventories; and (e) articulate a system of prices and margins that would permit withdrawal from retail distribution and help attract the private sector to both production and distribution during the transition period until subsidies are eliminated. The Bank strongly supported these actions and pressed GOM to rapidly implement the pricing system, which was proposed by FERTIMEX as a prerequisite to withdrawal from distribution and divesture of production and distribution facilities. This pricing system consisted of the following: (i) ex-plant prices equivalent to international prices; (ii) controlled, subsidized prices set at 198 ex-primary warehouses, whether operated by FERTIMEX or private agents, and differentiated regionally to reflect differences in transport costs, with downstream prices left to market forces; and (iii) margins sufficient to provide incentives for the operation of primary warehouses by the private sector. 5.12 By the end of 1990, FERTIMEX stopped all new consignment operations, and started to sign direct sales contracts with private distributors and began to limit deliveries to the 198 primary warehouses. Because of the excellent preparation work done by FERTIMEX, the number of such direct sales contracts increased from 8 in December 1990 to 85 in April 1991 (for about 1 million tons per year). In addition, 102 contracts had been signed by then to transfer about 540,000 tons of consignment inventories. By mid-1991: (i) FERTIMEX was limiting deliveries exclusively to 198 primary warehouses, of which only 28 were operated by FERTIMEX; (ii) sales through the 28 FERTIMEX agencies represented less than 20% of total sales for the first semester of 1991; and (iii) consignment sales, which represented 41% of total sales in 1987 and 58% in 1990, accounted for less than 2.5% of sales in the first semester of 1991 and 1% for the whole year. FERTIMEX's total and consignment sales for 1986-92 are presented in Part III, para. 6.A.5. 5.13 During the period between October 1991, when GOM approved a pricing system in which ex- FERTIMEX prices were set at plant gate, based on international prices (para. 5.6), and the end of 1992, when all FERTIMEX's production plants were divested, FERTIMEX owned 51 primary warehouses out of 198 nationwide, but, operated directly only 17. Sales through these 17 warehouses ac-ounted for less than 20% of total FERTIMEX domestic sales. By the end of 1992, only 10,000 tons of consignment inventories remained out of about 1.15 million tons in 1989. Early in 1993, after divestiture of all its production facilities, FERTIMEX withdrew completely from all distribution  - 12 - activities, including secondary, primary, and the operation of the small marketing company created to regulate the fertilizer market during a limited transition period. This complete withdrawal from distribution represented overcompliance with the condition set in the Project Agreement. The private sector reacted quickly and positively to FERTIMEX's withdrawal from fertilizer distribution and the now fully decontrolled fertilizer sector. During FERTIMEX's withdrawal from production and distribution, domestic and imported fertilizer remained available to farmers and no shortages were reported. This was the result of the excellent preparation work made by FERTIMEX before starting its withdrawal. (f) Fertilizer Imports Tariffs 5.14 Although the project Guarantee Agreement obliged the Government to maintain tariffs on major fertilizers at their December 15, 1987 level of 0%, these duties were increased to 10% as part of a broad tariff harmonization program supported by the Bank. Since this increase was motivated by the desire to harmonize tariffs across sectors and since the 10% tariff was below the then prevailing weighted average Mexican tariff, the Bank accepted to waive the respective condition and the Guarantee Agreement was amended consequently on December 10, 1991. However, as anticipated in the President's Report, as soon as prices reached their international level, fertilizer distributors started importing product in response to increases in fertilizer prices above international prices attempted by the new plant owners, and to take advantage of depressed international prices. Also, as of mid-1993, some new producers temporarily had stopped the operation of their intermediate fertilizer plants, and were using imported fertilizer intermediates to take advantage of low international prices for sulfuric and phosphoric acids. (g) Financial Restructuring 5.15 To ensure that FERTIMEX could operate on a sound financial basis and reach financial autonomy by 1992, GOM agreed to assume the equivalent of US$880 million, or 85% of FERTIMEX's long term debt, over the three-year period 1988-1990. Also, to strengthen FERTIMEX's financial performance, the restructuring agreement between FERTIMEX and the GOM (Convenio), the Project Agreement, and the Guarantee Agreement included the following financial targets: a long term debt/equity ratio of no more than 40/60; a current ratio of no less than 1.1 in 1988, 1.2 in 1989, 1.3 in 1990, 1.4 in 1991 and 1.5 in 1992 and beyond; and a projected long term debt service coverage ratio of not less than 1.0. 5.16 The assumption of the long term debt took place in the agreed amounts and at the agreed dates, i.e. 25% in November 1988, 50% in June 1989 and 25% in June 1990. As a result, FERTIMEX achieved a very low long term debt/equity ratio, as the long term debt/equity ratio decreased from about 40/60 in 1987 to a low level of 2/98 in 1990. However, the expected positive impact on FERTIMEX liquidity resulting from the low level of long-term debt and FERTIMEX's cost reduction efforts were canceled out in 1989, due to delays in Government operating bridge term transfers and delays in price increases (due to the PACTO/PECE defacto price freeze). At end of 1989, FERTIMEX's liquidity situation became very poor with a current ratio of only 0.7, down from I. I at the end of 1988, and much below the 1.2 level FERTIMEX should have maintained during 1989 under the Project and Guarantee Agreements. This deterioration was due to insufficient and late operational budget transfers during 1989 and to delays in price increases which forced the company to contract substantial additional short term debt from commercial banks (para. 5. 1). 5.17 FERTIMEX's current ratio improved in 1990 and 1991, from 0.67 at the end of November 1990 to 0.91 at the end of December 1990, 1.13 at the end of June 1991, and 1.66 at the end of  - 13 - December 1991, exceeding the current ratio covenant of 1.4 specified for 1991. This important improvement in FERTIMEX's liquidity was the result of: (i) the restructuring of Mex$420 billion of short term debt to long term debt with BANAMEX (equivalent to about US$135 million); (ii) domestic price increases; (iii) greater efficiency in distribution due to FERTIMEX's withdrawal to only 198 primary distribution warehouses (para. 5.12); (iv) significant fertilizer exports at higher prices; (v) sales of consignment inventories at prices higher than their book value; (vi) divestiture and/or closing of uneconomic plants; and (vii) better plant capacity utilization and efficiency. After the restructuring of FERTIMEX's short term debt, the debt/equity ratio increased to 8/92, but remained well below the agreed level (40/60). 5.18 On June 16, 1992, the GOM assumed most of the remaining long-term liabilities of FERTIMEX to facilitate its complete privatization. These liabilities included: (i) all FERTIMEX liabilities to the Bank (US$62 million) including US$40 million under this loan; and (ii) all FERTIMEX long-term liabilities to BANAMEX. Following this additional debt assumption and the divestiture of all FERTIMEX's productive assets, the Debt/Equity ratio decreased to 0.2/99.8 and the current ratio increased to 1.69 at the end of December 1992 and to 1.81 at end of April 1993. Both ratios remained well within the agreed levels for 1992 and 1993. The status of compliance with the financial covenants for the debt/equity ratio and current ratios is summarized in para. 6.B.4 of Part 111. (h) Organizational Restructuring 5.19 An important objective of the FSAL was to define how FERTIMEX should be organized to efficiently carry out its new medium and long term strategy. Under the project it was agreed that FERTIMEX would formulate a 5-year strategic plan, carry out a study to review various organizational options and determine the optimum organizational structure necessary to efficiently fulfill its revised functions, and carry out this plan and implement the study's recommendations. As indicated in paras. 4.4 and 5.55 (i), in light of the accelerated progress made by GOM and FERTIMEX in defining the options for the restructuring program and their decision to disengage from primary as well as secondary distribution, the organization study was consolidated with the distribution study into a "Structural Change and Re-Dimensioning study (Cambio Estructural y Redimensionamiento). 5.20 Assisted by BAH, FERTIMEX quickly selected a sector restructuring option by mid-1989. The objective of the proposed option was to divide FERTIMEX into four independent regional companies which would eventually attract private participation in production and distribution. This objective was to be reached within a three year period in several steps: (i) the creation of four autonomous regional companies selling their output at equivalent import prices minus a distribution fee to cover part of distribution overhead cost, and paying international prices for inputs; (ii) the simultaneous creation of a marketing company, mainly to administer the fertilizer subsidy until it was eliminated and import parity of controlled prices was achieved; (iii) the maintenance of a small corporate headquarters responsible for strategic and financial planning; (iv) the privatization of a few smaller, less important plants and subsidiaries; (v) the withdrawal from secondary distribution and the possible involvement of the private sector in primary distribution as well; and (vi) the participation of the private sector in the establishment of new plants. Furthermore, the proposed option considered a second phase in which: (a) headquarters would disappear, leaving four completely independent and competing regional companies; and (b) the marketing company would disappear once prices had been deregulated and fertilizer subsidies eliminated.  - 14 - 5.21 The Bank analyzed the above program and shared its comments and suggestions with FERTIMEX management. This initial restructuring proposal was already significantly beyond the commitments under the FSAL. However, early in 1990, FERTIMEX submitted a far reaching revised proposal to the interministerial Comision de Gasto y Financianiento (Comission for Expenditures and Financing) for review and approval. FERTIMEX management presented this proposal to the Bank for comments prior to finalization. In this revised proposal, FERTIMEX proposed the complete privatization of all FERTIMEX activities (production as well as distribution) within a three-year period in two major phases: (i) a first phase consistent with the option proposed earlier of restructuring FERTIMEX into four regional production companies and a marketing company, the rehabilitation of the production capacity, the creation of a pricing system based on international prices for the production companies, and a system of commissions for distributors designed to cover distribution costs and prices ex-distributors which were to be controlled initially but differentiated to reflect freight differentials; and (ii) a second phase in which FERTIMEX would divest all its production and distribution infrastructure. During this period prices would be liberalized, but the marketing company would retain a presence in distribution as a regulator. The Bank and FERTIMEX considered the fertilizer subsidy was the main bottleneck to privatization efforts and advocated a rapid move to market prices. In addition, the Bank felt that the immediate removal of the subsidy would eliminate the need for a marketing agency. The Bank was concerned that the establishment of such a large public marketing agency could have the following potential drawbacks: discouraging private sector participation in production, increasing risks of inefficiency due to its monopolistic position, and continuing the lack of transparency in the administration of the subsidy. 5.22 FERTIMEX, assisted by BAH, advanced well in the process of reorganization and restructuring before and during the process of divestiture. The following measures were implemented: (a) Four regional production companies were created, new managers appointed, and most headquarters functions were decentralized. However, the legal constitution of the regional companies was not completed because: (i) privatization proceeded faster than originally anticipated; (ii) distribution of assets and liabilities between companies and individual plants proved more difficult than anticipated; and (iii) application of the 10% asset transfer tax on transactions between affiliated companies. (b) Marketing activities were decentralized into seven regions. By the end of 1992, after divestiture of all productive assets, the Government created a small marketing company to regulate the fertilizer market during a limited transition period. However, in April 1993, the Government dissolved this entity in light of the positive reaction of the sector to market forces (para. 5.13). (c) Major staff reductions in production and marketing activities were implemented. Total staff at FERTIMEX headquarters was reduced to 650 by 1993 from a 1989 level of 2,400. In 1990, FERTIMEX also carried out a job grading exercise of plant personnel, including a revision of salary scales and job definitions. (d) The number of union contracts was reduced and contracts were renegotiated. (e) Cost accounting systems were improved and separate financial statements prepared for each plant.  - 15 - (f) FERTIMEX prepared for the first time in 1990 a plan outlining the company's detailed strategy for reaching efficiency and restructuring goals. (g) Internal performance agreements between central FERTIMEX management and each production and distribution region were prepared which included financial incentives for goals reached. 5.23 Due to the GOM and FERTIMEX management decision to accelerate the second phase of the program, including privatization of the entire fertilizer sector, the first phase of the agreed reorganization program was not fully implemented (para. 5.21). However, the planning process played an essential role in the preparation of FERTIMEX for divestiture, providing the basis for a quick and orderly withdrawal from fertilizer distribution and the rapid divestiture of all productive assets. The Privatization Process 5.24 The privatization of FERTIMEX productive assets began during March 1991 and proceeded quickly and was concluded 21 months later, in December 1992. The plants were sold for cash prior to complete rehabilitation, free of any liabilities. Current assets were sold separately from productive facilities, with preference given to the plant purchaser. The bidding procedure was well-defined and transparent, and was designed to attract purchasers with management skills necessary for efficient operation of the facilities. 5.25 The first plant to be sold was the ammonium sulfate plant of Torreon in March 1991. The program concluded in December 1992 with the sale of FERTIMEX's largest and most problematic industrial complex, Lazaro Cardenas. A total of 13 plants (including one in Guatemala) were sold individually in four phases. The first group included the so-called "non-priority" small plants of Coatzacoalcos, Torreon, Monclova, Guadalajara, Salamanca and Tecun-Uman. The second group included the medium-size plants of Bajio, Camargo and Queretaro. The third group included the two large plants of Pajaritos Fosfatados and Pajaritos Nitrogenados, which initially were sold as a package to facilitate the sale of the older plant, Pajaritos Fosfatados.5' The fourth and final group included the Minatitlan complex and the Lazaro Cardenas complex. The latter was sold as a package with the problematic ROFOMEX phosphate mine in Baja California. Detailed information on the divestiture of each plant is presented in Annex 3. including plant production capacity, date of start-up, date of divestiture, new owner and sale price. The privatization of the fertilizer plants started with the sale of small and medium units (whose sale is simple and politically low risk) and moved to larger and more complicated units after learning-by-doing and when prices of fertilizer and ammonia were already deregulated. 5.26 The Privatization Unit (Unidad de Desincorporacion) of SHCP has been responsible for the coordination, supervision and sale of all FERTIMEX productive units. Final decisions, however, rested with the interministerial Comision de Gasto y Financiamiento. Banco International (10 plants) and Banco SERFIN (3 plants) were appointed as financial agents to handle the sales. The financial agents based the financial valuation of the plants on three valuation methods which were (i) net present value (NPV), (ii) book value, and (iii) asset value. The valuation study provided a technical reference price, which was used as a secret benchmark to evaluate the offers. Following the 5lFollowing privatization, the new owners sold the phosphate fertilizer plant of Pajaritos Fosfatados to another group.  - 16 - financial valuation and the preparation of prospectuses for each plant, offers were invited through a closed competitive bidding mechanism. Negotiations were held with the highest bidder to determine the final contract. All plants were sold after a first round of bids with the exception of Guadalajara, Salamanca and Tecun-Uman. The first bids received for these three plants did not reach the pre- established reference price and required a second round of bids. 5.27 FERTIMEX involvement in the privatization process was in principle limited to the provision of information needed for the preparation of prospectuses and assistance during plant visits by prospective purchasers. In fact, the General Manager and the directors of FERTIMEX, using their knowledge of the sector, provided specialized assistance to the Unidad de Desincorporacion and to the financial agent for the definition of the sales strategy, the packaging of plants, the identification of potential buyers, and the international and domestic promotion of sales. However, the divestiture of FERTIMEX plants did not attract foreign companies for the following possible reasons: (i) chronic overcapacity and low prices in the international fertilizer sector, which has remained depressed since the mid-1980s; (ii) the low efficiency and poor condition of FERTIMEX plants; and (iii) ammonia production was still reserved for PEMEX (para. 7.4). 5.28 No significant opposition from labor took place during the reorganization and divestiture of FERTIMEX. This absence of opposition allowed the reorganization and privatization programs to proceed smoothly and quickly. This lack of conflict was the result of: (i) the acceptable compensation package paid to personnel at termination and the timing of layoffs, most of which took place during the reorganization phase and before divestiture; (ii) the protection of labor interests through the strict application of union rights of first refusal, which under the state enterprise law allows the unions to acquire a company undergoing privatization by matching the highest bid;@ and (iii) the excellent relationship between FERTIMEX's general manager and the unions. 5.29 The privatization of FERTIMEX productive assets generated a modest US$320 million in cash from the sale of all 13 plants, including substantial balances of current assets, reflecting limited private sector interest. All FERTIMEX liabilities, totalling US$ 523 million, were assumed by the Government prior to divestiture. The Lazaro Cardenas complex was sold for about US$50 million (including the ROFOMEX phosphate mine), compared to a project base cost of US$646 million (total financing cost, including interest charges and working capital, amounted to US$ 801 million) as estimated in 1987. However, privatization eliminated the GOM budgetary transfers to FERTIMEX for operations and capital expenditures, which averaged US$192 millionper annum during 1986-91. In addition, the restructuring resulted in an open, competitive sector, avoided the formation of a private monopoly, and greatly reduced the likelihood of future policy reversals (para. 6.1). 5.30 Following the privatization of all production facilities at the end of 1992, the Government appointed a liquidator to sell the remaining non-productive assets, including inventories and distribution facilities consisting of 42 warehouses, 20 ammonia spheres, and 2 maritime terminals. Since April 1993, the liquidator has assumed full management responsibility for FERTIMEX. The full liquidation of the company is expected to be completed during 1994. All FERTIMEX personnel was laid-off on December 31, 1992; those remaining were contracted on a short term basis by the liquidator. As of July 1993, 438 staff remained with FERTIMEX, including 28 staff employed directly by the liquidator. The liquidator is responsible for managing the sale of all non-productive 6LUnder this provision, Camargo and Bajio were sold to Sindicato de la Industria Quimica, Petroquimica, Carboquimica y Conexos (Union of the Chemical Industry) for US$8.2 million and US$31.5 million, respectively.  - 17 - assets within pre-defined norms. The final approval of any condition outside the established norms rests with the Comision de Apoyo al Liquidator (Liquidation Support Committee) composed of representatives from: (i) the Comptroller General (SECOGEF); (ii) SEMIP; (iii) Directorate of Norms of SHCP; (iv) the Privatization Unit of SHCP; and (v) the Directorate of Expenditures of SHCP. The valuation of buildings, warehouses and terminals is the responsibility of the Commission for the Valuation of National Goods (CABIN). The liquidator appointed Banco Internacional as sales and financial agent to value all assets not under the mandate of CABIN (including spare parts, equipment) and define the sales strategy for each package. Bids are invited in accordance with Mexican competitive bidding norms. The liquidator anticipated some problems in the sale of the remaining assets due to: (i) the high degree of specificity of certain assets (e.g., spare parts for plants already sold); (ii) unsettled legal titles for many pieces of land with distribution facilities; and (iii) PEMEX current distribution and concession policy for ammonia sales for direct application, which impacts the sale of assets used in ammonia distribution. B. Implementation of the Investment Components 5.31 The investment program financed under the Loan was adjusted several times during implementation to reflect changes in priorities identified during implementation of policy action plans and the restructuring and privatization process. The implementation and status of each investment component are described below. (a) Completion of the Pajaritos Solid Ammonium Nitrate Plant 5.32 In 1984, FERTIMEX initiated the construction of a 600,000 tpy Urea-Ammonium Nitrate solution (UAN) plant within the Pajaritos fertilizer complex, with the objective of exporting nitrogen fertilizer solutions. This new nitrogen fertilizer production facility included the construction of a 40,000 tpy concentrated nitric acid plant. In 1986, when world market prices fell, FERTIMEX decided to: (i) add a solid ammonium nitrate (SAN) plant with a capacity of 270,000 tpy and the necessary product storage and handling to satisfy the domestic market needs; and (ii) delete the nitrogen solutions and concentrated nitric acid production plants. At FSAL appraisal, the investment was about 30% completed, but completion was being held-up since 1986 due to lack of financing. The anticipated appraised economic rate of return for this subproject in April 1987 was 21% and plant production was expected to replace output lost due to the plant closure program and meet the expected increase in market demand. The completion cost of this subproject, estimated to cost US$48.3 million at appraisal was financed under the Loan. Commercial operation was expected to start by April 1990. 5.33 In mid-1990, during supervision, the Bank discovered that FERTIMEX had restarted the construction of the UAN and concentrated acid plants, and that these plants were being built at a level of capacity which was would absorb the entire output of upstream plants. This was an unnecessary and expensive duplication of finished product capacity. At the request of the Bank, the construction of these plants was suspended at the end of 1990, and full priority was given to the completion of the Pajaritos SAN plant. 5.34 The subproject was subject to cost escalations and delays, as compared to appraisal estimates of April 1987, for the following reasons: (i) the very poor initial project management and control (para. 4.3); (ii) the lack of multi-year investment budgets; and (iii) the decision to change the project scope again during implementation. Only when an experienced project manager was brought on board did the pace of implementation improve. Subsequently, FERTIMEX management decided to  - 18 - stop all expenditures effective end-April 1992 due to the divestiture program of the entire Pajaritos complex, although the Pajaritos SAN plant was nearly completed. The diluted nitric acid unit began operation in May 1992, about 27 months behind schedule and about 10 years after the construction the project had started; the ammonium nitrate solution unit was completed and being prepared for start-up; the prilling unit was 99% completed; the product handling, bagging and storage facilities were completed and tested; and the construction of the concentrated nitric acid and UAN units, not financed by the Bank, were also well advanced. It is estimated that remaining works (excluding UAN and concentrated nitric acid plants) could have been completed in less than one month at a cost of about US$300,000. At the end of June 1993, during the PCR preparation mission, the new owner had not yet restarted construction. However, he indicated his intention to complete and operate the plant, pending availability of necessary funds for working capital and investment for project completion. 5.35 Investment cost since appraisal (April 1987) amount to US$72.9 million, 51% above appraisal estimates. Total costs of this plant since 1984, when construction started, amount to US$97 million, excluding costs of the UAN and concentrated nitric acid plants which were not part of the Bank project. A large part of these cost overruns was due to the lengthy implementation delays and to the sharp real peso appreciation that had occurred during the period 1988-91. 5.36 Because of the high costs and of the much lower currently projected prices of ammonium nitrate than estimated at FSAL appraisal, the economic rate of return of the subproject is estimated at approximately 1.9%. This level is far below the 21 % return expected at FSAL appraisal. If all costs incurred until appraisal are considered as sunk-costs, and only completion costs since appraisal are considered, the economic rate of return would increase to 4.4%. If in addition prices of ammonium nitrate were to increase by 20%, the economic rate of return would reach about 11 %. Had international prices of ammonia and ammonium nitrate risen as projected at appraisal, the economic rate of return of the total project would have been 10.7%. Under this price scenario, the economic rate of return would reach 15.5% when cost incurred prior to appraisal is considered as sunk cost. A sensitivity analysis is presented in para. 6.C of Part III and detailed calculations of ERR are shown in Annex 1. 5.37 In 1992 domestic sales of solid nitrogen fertilizer remained at their 1987 level of about 1.3 million tons of nutrient, while at appraisal demand had been projected at 1.76 million tons of nutrient. At the time of appraisal, the 1992 supply/demand balance of nitrogen nutrients was projected to show a deficit of more than 300,000 tpy. Instead, a surplus supply has accrued, amounting to 155,000 tpy in 1991. If the solid ammonium nitrate plant had been in operation, this surplus could have increased to about 245,000 tpy. During the past few years, the domestic market for solid ammonium nitrate was depressed and the export market was limited. Given the weak market for solid ammonium nitrate, the new owner will face difficulties in marketing the total potential SAN output of the plant. The completion of the UAN solution plant suspended earlier may represent a viable diversification into the export market. The new owners of the plant indicated that negotiations are currently underway with Norsk Hydro of Norway to create a joint venture to complete and operate the UAN plant. (b) Plant Rehabilitation 5.38 The plant rehabilitation program financed under the loan was adjusted several times during implementation. A number of sub-projects were canceled and others added as priorities changed and  - 19 - the pace of restructuring and privatization accelerated.2' Total rehabilitation expenses amounted to US$14.6 million, or about 73% of estimated costs. The cancellation of many sub-projects would have resulted in even lower expenditures; however, the rehabilitation of Lazaro Cardenas, added to the FSAL in 1990, offset some of these savings (para. 3.4). Key events during implementation included: (i) the rehabilitation of the phosphoric acid filters and the installation of Sanicro tubes in the evaporator heat exchanger in Pajaritos Fosfatados, leading to increased capacity and efficiency even when domestic phosphate rock is used; (ii) the cancellation of the gypsum water recyclation sub- project in Pajaritos Fosfatados (para. 5.53); (iii) the rubber lining of the phosphoric acid reactors, which eliminated a frequent cause of work stoppages at Lazaro Cardenas; (iv) the installation of contaminated water pumps in Lazaro Cardenas to partly reduce the impact of gypsum sea disposal (para. 5.49); and (v) the completion of the TSP plant in Lazaro Cardenas, which allowed diversification of production. The rehabilitation projects proved to be economically justified (para. 6.9). (c) Maritime Terminals 5.39 To increase the efficiency of fertilizer transport, the project included the construction of two maritime terminals at Topolobambo and Altamira and the retrofitting of dedicated existing bulk facilities in five ports. Two of these port projects were canceled: (i) the Guaymas terminal became uneconomic due to the port authority's decision to change the warehouse site; and (ii) the San Carlos terminal was no longer justified in light of revised FERTIMEX distribution plans. 5.40 The construction of the three remaining small terminals was concluded before July 1989 (para. 4, Part III), six months ahead of appraisal schedule. However, due to an indefinite strike in the contractor's workshop, FERTIMEX was obliged to cancel procurement of handling equipment, which was already 83% completed. Although this issue is currently being settled in court, no major financial losses to FERTIMEX are expected. In addition, FERTIMEX minimized the impact of this cancellation on the normal operation of these maritime terminals by contracting external handling services. 5.41 Upon opening of tenders for the first International Competitive Bidding (ICB) for the two large terminals of Topolobampo and Altamira, costs were found to be very substantially higher than estimated at appraisal. At these costs, the projects were no longer economically or financially viable. The Bank recommended, and the FERTIMEX agreed, to declare void the first round of ICB and revise the design of the terminals to make them consistent with the simple, economical design agreed at appraisal. Tenders in response to a second ICB were opened on November 30, 1990. After final clearance of the project design by Puertos Mexicanos, construction started on March 12, 1991 for Topolobambo (under a contract equivalent to US$9.96 million), and on May 15, 1991 for Altamira (under a contract equivalent to US$10.67 million), about 21 months and one year behind the respective Bank appraisal estimates. Under the contracts, the construction of both terminals was expected to be completed before the end of July 1992. However, the construction of the Altamira terminal soon fell behind schedule due to adverse weather conditions in the region and problems with suppliers. 7/Tlhe status and costs of all plant rehabilitation investments are summarized and compared with appraisal estimates in Part III, Para 5 C. Investment costs and the status of each component for the Pajaritos Fosfatados and the Lazaro Cardenas plants are given in Part III, Para 5 D and E.  - 20 - 5.42 As of September 1, 1992, due to large cost overruns in the construction of the maritime terminals of Topolobampo and Altamira and to the acceleration of the FERTIMEX privatization program, management decided to discontinue the construction of both terminals and to sell them unfinished. Construction of Topolobampo was about 87% complete while Altamira was estimated to be 80% complete. 5.43 Although the construction of the Guaymas and San Carlos terminals was canceled, total costs of the remaining maritime terminals sub-project amounted US$31.2 million, about 10% higher than appraisal estimates for all maritime terminals. Although actual costs of the smaller terminals were lower than expected, high overruns occurred in the construction of the Altamira and Topolobampo terminals. Total costs until construction was discontinued reached US$15.5 million for the Altamira terminal, and US$14.0 million for Topolobampo. It is estimated that total completion costs will amount to US$17.5 million for Altamira and US$15.7 million for Topolobampo. In current U.S. dollar terms, these costs represent escalations of 47% and 83% over appraisal estimates for Altamira and Topolobampo, respectively. They also represent 64% and 58% increases above the original contract amounts. They are the result of: (i) the sharp real peso appreciation that had occurred during the period 1987-91, as explained in the following paragraph; (ii) the need to finance off-site facilities originally to be provided by the port authority (access railroad, provision of potable water, access roads, and electrical connections), which amounted to about US$2 million; (iii) contract price escalations well above general inflation; (iv) design changes after contract signature made without Bank agreement which resulted in important variations in contract amounts; (v) construction of piers designed for 30,000 ton ships versus 10,000 tons as agreed at appraisal; and (vi) contract cancellation costs. At these levels, the two terminals are hardly economical -- the economic rate of return would decrease from 13% estimated at appraisal to 4.7% for Topolobampo, and from 17.7% estimated at appraisal to 9.2% for Altamira. Actual and appraisal estimates for capital costs, benefits, and economic rates of return for Altamira, Topolobampo and the entire maritime terminals sub- project are summarized in Part III, para. 6.C.1. 5.44 Appreciation of the peso explains the cost escalation for construction of the two maritime terminals in relation to appraisal estimate made in April 1987. Actual maritime terminal cost when adjusted to 1987 real peso terms using the national price index, and converted to US$ at end-1987 exchange rate, are US$7.4 million and US$8.1 million, respectively for Topolobampo and Altamira. The resulting cost is in line with appraisal estimates in 1987 terms for Topolobampo. It is even lower for Altamira, due to the important design simplification of the warehouse, included at Bank request in the final design specification (para. 5.41). Despite the execution of the projects in line with appraisal estimates (in 1987 dollars), actual cost in relation to the contract signed in 1990 exhibited large escalations (in constant end-1990 peso terms) remain about 32% higher than initial contract amounts for both terminals. These overruns are due to the already mentioned unforeseen need to provide for off-site facilities that had been assumed to be provided as public infrastructure, changes in design after contract signature, and contract cancellation costs. (d) Wholesale Storage facilities 5.45 Consistent with the policy to withdraw from retail operations and to maintain inventories in a maximum of 120 primary storage facilities, the project included the financing of 14 bulk storage facilities and four storage spheres for ammonia. These facilities formed part of FERTIMEX's program to construct 71 new solid fertilizer warehouses and 20 ammonia storage spheres. 5.46 However, early during the implementation of the project (in early 1990), in light of its revised distribution strategy (which foresaw the involvement of the private sector in primary as well as retail  - 21 - distribution), FERTIMEX decided to cancel its plans to construct and operate all new warehouses, except for the three most critical ones. Later on, at the end of 1991, as a result of withdrawal from primary distribution of fertilizer and of the accelerated privatization process of all its plants, FERTIMEX also canceled the construction of these three warehouses. The cancellation of the Oaxaca warehouse took place after the Bank had given its no objection for the signing of the contract. 5.47 By mid-1990, it had been decided that the ammonia spheres would not be built, for the same reasons as for the warehouses, and because revised costs estimates presented by FERTIMEX were far above appraisal estimates, jeopardizing their economic viability. This decision proved even more justified when, in April 1992, ammonia distribution for agricultural use was removed from the exclusive domain of FERTIMEX and PEMEX started to distribute ammonia for agricultural use directly from its own ammonia storage in quantities as small as 1,000 tons per year. This development makes the ongoing efforts to sell FERTIMEX's existing large ammonia (3,000 tons) spheres more difficult. C. Environmental Aspects 5.48 The nitric acid and ammonium nitrate plants financed under the Loan were designed to meet emission standards satisfactory to the Bank. Since the 1970s FERTIMEX had designed all new plants to comply with national standards or the standards of the US Environmental Protection Agency (EPA). In general, all plants built prior to the 1970's were designed with much lower standards than those now in effect. However, the FERTIMEX plant closure program included those plants built prior to the 1970's, thereby removing most of the plants in non-compliance with pollution standards. The main environmental issues of this project were: (i) the impact of sea disposal of gypsum produced by the phosphoric acid plant at Lazaro Cardenas; (ii) the impact of the gypsum water sea disposal at the Pajaritos phosphoric acid plant; and (iii) the impact of sulfur dioxide (SO2) emissions from the sulfuric acid plants of Pajaritos. The Lazaro Cardenas Plant Gypsum Disposal 5.49 The Lazaro Cardenas (LC) phosphate fertilizer complex was financed by the Bank (Loan 1686-ME). The potential negative environmental impact of this project was recognized from the beginning and measures were introduced to reduce pollution effects to acceptable levels by selecting modern processes. Initially, the project design included land disposal of the gypsum produced in the phosphoric acid plants. However, early during the implementation of the LC project, after the 1979 earthquake, for seismic and economic reasons FERTIMEX changed this arrangement and designed and built the plant with the gypsum (after dilution by the plant liquid effluent) discharged into the sea about 1.2 kilometers from the shore. Following the commissioning of the plant in 1987, this system was plagued with a series of problems, ranging from the rupture and plugging of the pipes to the malfunctioning of the contaminated water dilution pumps (see Project Performance Audit Report No. 10259 and Project Completion Report, Loan 1686-ME). The change from land to sea disposal method never received the approval of the Bank, which insisted from the outset on the need and urgency to find and implement a permanent solution to this important pollution problem. In a letter dated March 11, 1988 sent to the Bank prior to the approval of the FSAL, FERTIMEX committed itself to take steps to resolve this pollution control problem, including through the installation of new dilution pumps and a thorough reevaluation of the sealines to determine the appropriate measures to be taken to ensure their proper functioning. 5.50 During a supervision visit to LC in October 1989, the Bank learned of the difficulties encountered by FERTIMEX in solving the problem of gypsum and contaminated water disposal to the  - 22 - sea. Both gypsum pipes had remained broken since start-up, and the contaminated water dilution pumps were not installed. The gypsum was ejected through one of the pipes at about 100 meters from the beach and the contaminated water was still being discharged to the sea through the plant's drainage canal. To help FERTIMEX solve this problem, the Bank accepted to finance under the loan two stand-by dilution water pumps, taking into account (i) the important data base accumulated from observations and regular monitoring by FERTIMEX and the Secretarfa de Desarrollo Urbano y Ecolog(a (SEDUE or Ministry of Urban Development and Ecology); and (ii) the difficulties experienced by FERTIMEX in the construction and operation of this kind of disposal system. The Bank recommended that the following two studies also be financed under the loan: (a) an Environmental Impact Assessment (EIA) to be carried-out by a specialized consultant, to assess the actual impact of gypsum and contaminated water sea disposal and recommend and define the needed system; and (b) a study by an engineering firm specialized in undersea construction to design the system recommended by the environmental consultant. The financing of the pumps and of the above studies was included in the amendment to the Loan and Project Agreements, dated February 16, 1990 (para. 3.4). 5.51 At the request of SEDUE, FERTIMEX contracted the Mexican consulting firm EPAC, using FERTIMEX funds, to carry-out the EIA. The study concluded that the impact of gypsum disposal was limited to 200 meters around the discharge point (which was 100 meters from the shore), without important ecological impact. No accumulation of gypsum was reported due to the strong currents and surf in the region. After review of the final EPAC report, the Bank insisted on a more complete follow-up EIA, to be carried out by a consulting firm with experience in gypsum sea discharges to be financed under the loan. The terms of reference for this second study, the list of consulting firms and the evaluation report were reviewed by the Bank. However, contracting was suspended by FERTIMEX for the following reasons: (i) the Secretarfa de Desarrollo Social (SEDESOL or Ministry of Social Development, successor to SEDUE) decided to carry out a global environmental study for the area and asked FERTIMEX to participate in said study; and (ii) due to another earthquake, both discharge pipes were completely broken in September 1992, and the phosphoric acid units were stopped. FERTIMEX initiated repairs on one of the discharge pipes, but did not complete the work prior to the divestiture of LC in December 1992. 5.52 Before taking delivery of the plant, the new owner of LC reached an agreement with Comisi6n Nacional del Agua (CNA or National Water Commission) to operate the phosphoric acid plants with one of the gypsum discharge pipes repaired to a length of 70 meters. Under the same agreement, the new owner was allowed two years to construct a pipe discharging at 300m from the shore. This agreement also obliged the new owners to conduct a full EIA following completion of the 300m gypsum pipe and to carry out any further works recommended by the study. The progress on environmental issues made since privatization of LC, following years of delay, indicates that CNA and SEDESOL may be more effective in enforcing compliance with private firms than with SOEs. The Pajaritos Fosfatados Plant Gypsum Water Sea Disposal 5.53 At the Pajaritos Fosfatados plant, by-product gypsum from the phosphoric acid units is slurried with sea water and pumped to settling ponds in the Carolino Anaya Laguna. This slurrying water, contaminated with phosphoric acid, fluorine, and solid gypsum, overflows to the Gulf of Mexico. At appraisal, the efficiency of the phosphoric acid plants was very low and the operation of the gypsum settling ponds was unsatisfactory, resulting in high phosphoric acid and gypsum content in the rejected water. To address this environmental issue and improve raw materials recovery, the project included: (i) the rehabilitation of the phosphoric acid plants to improve efficiency (rehabilitation of the filters and replacement of the heat exchangers); and (ii) a sub-project to recycle  - 23 - contaminated water as process and cooling water and to improve the settling ponds to reduce water percolation and evaporation. The rehabilitation of the phosphoric acid units has been implemented and they are now operating at an acceptable level of efficiency. The operation of the settling ponds was also improved and the content of solids in the gypsum water was reduced to acceptable levels. However, FERTIMEX decided not to implement the water recycle sub-project due to high cost and the acceleration of the Pajaritos Fosfatados plant divestiture. The Bank requested that FERTIMEX prepare an EIA of the rejection of gypsum-contaminated water to the sea. This study was carried out by the Mexican consulting firm EPAC and completed before the plant was delivered to its new owner. The EPAC study concluded that the impact of contaminated gypsum water disposal was minimal and limited to 60 meters around the discharge point. However, the new plant owner signed an environmental agreement with CNA which requires the implementation within two years of the recycling project described above. Therefore, the solution envisaged under the project is expected to be implemented by the private sector. S02 Emissions from the Sulfuric Acid Plants of Pajarntos Fosfatados 5.54 The two sulfuric acid plants of the Pajaritos Fosfatados complex are based on the single absorption process and therefore have less than 97% sulfur recovery. To improve their efficiency and reduce SO2 emissions, FERTIMEX added an ammonium sulfate solution recovery section to these plants based on the exhaust gas scrubbing and stripping process. This project, which was started before appraisal, was completed and commissioned in 1990. As of mid-1993, one of the sulfuric acid plants was permanently closed and the second plant was not in operation due to the new owner's decision to import sulfuric acid and/or phosphoric acid to take advantage of the currently depressed international prices. D. ImpIementation of the Technical Assistance Comoonent 5.55 The status and impact of each study are presented in Part III, para. 5, D and are summarized below: (i) In light of the early progress achieved in the definition of the options for restructuring and the decision to disengage FERTIMEX from primary as well as secondary distribution, the distribution and reorganization studies were consolidated into one study (Cambio Estructural y Redimensionamiento), later followed by a complementary study to assist FERTIMEX in the implementation of the proposed organization. The study provided the basis for FERTIMEX's ambitious restructuring and privatization program. It also allowed FERTIMEX to define the strategy for an orderly withdrawal from distribution. (ii) Even though FERTIMEX did not procure phosphate rock under ICB, the Bank considered that the phosphate study was still worth carrying out, as it could provide FERTIMEX with an optimization methodology for rock purchases. The study presented a diagnostic of all phosphate fertilizer plants along with recommendations for the optimization of operations. In addition, the consultant provided computer software for the evaluation of phosphate rock. However, the main objective of the study, which was to prepare a bid evaluation methodology for inclusion in bidding documents for rock purchases, was not fully achieved. (iii) The EIAs for Lazaro Cardenas gypsum sea disposal and the Pajaritos Fosfatados gypsum- contaminated water sea disposal system are commented in detail in paras. 5.49 and 5.53 respectively.  - 24 - (iv) The improvement in planning systems was not implemented. 5.56 The total cost of the technical assistance component was about US$1.4 million, in line with appraisal estimates. Actual and estimated costs of each study are presented in Part III, para. 5 B. E. Procurement 5.57 Many delays and misunderstandings occurred early in the procurement of goods and works due to: (i) the initial lack of agreed bidding documents in accordance with Bank guidelines; and (ii) the implementation of rehabilitation sub-projects by the four newly-created regional production companies, which lacked any experience in the use of Bank procedures. These problems were solved in mid-1989 when sample International Competitive Bidding documents were prepared jointly by the Bank and the Government for all procurement under Bank-financed projects in Mexico. FERTIMEX claims that adoption of these procedures was satisfactory and resulted in lower prices and better quality of the procured equipment and works. However, a two-stage bidding process may have proven more effective for contracting the construction of the maritime terminals. A two-stage process may also have helped avoid the delays and problems encountered during construction of the Altamira terminal. 5.58 From the US$50 million remaining import component, US$20.1 million was used to finance direct procurement of phosphate rock in 1988 and 1989 as specified in the loan agreement, and about US$ 30 million went to procurement through ICB of potassium chloride and sulfur. FERTIMEX complained that: (i) prices obtained through ICB for sulfur were US$3 per ton higher than the price obtained by concurrent direct negotiations; and (ii) prices obtained for potassium chloride were substantially higher than could have been obtained through direct negotiations. However, these lower prices for potassium chloride were from Eastern European countries, which were not eligible for ICB at that time. F. Total Project Costs 5.59 Actual total Project cost amounted to US$320.12 million, versus US$346.4 million estimated at appraisal and the revised estimate of US$341.93 million made in 1991 (following the inclusion of the Lazaro Cardenas rehabilitation and cancellation of the warehouses and the implementation of the water recycle project in Pajaritos). The actual foreign exchange component is estimated to US$260.5 million, in line with appraisal estimates. The major deviations from the original and revised estimates are presented in Part III, para. 5.A and are summarized in Table 1 below. 5.60 Actual total project cost is 7.6% below appraisal estimates. The cost overruns of the Pajaritos SAN plant (49%) more than compensated for the lower costs of: (i) the rationalization of the distribution infrastructure component (41 % below estimates due to the cancellation of the warehouses and ammonia spheres); and (ii) the rehabilitation of the production plants (27% below estimates as already commented in para. 6.9) G. Financin2 5.61 Total Bank financing amounted to US$240.2 million, versus US$265 million estimated at appraisal. This shortfall was due exclusively to the reduced investment program, not to the policy and technical assistance programs. Counterpart funds amounted to about US$80 million, in line with  - 25 - Table 1 Proied Total Cods (US$ miUion) Appraia Edimates Revised Actual Cods % Chane fro Costs Edimates Total Local Forei2 Total Total Local Foreign SAR Revised Impor and Debt Reduction - lmports 200.0 0.0 200.0 50.0 50.0 0.0 50.0 (75.0) 0.0 - Debt 0.0 0.0 0.0 150.0 150.0 0.0 150.0 - 0.0 Sub-total 200.0 0.0 200.0 200.0 200.0 0.0 200.0 0.0 0.0 Rationalization Investrnents Amnu. Nitrate 48.7 26.9 21.9 65.3 72.9 35.5 37.4 49.5 11.6 Plants Rehab. 20.1 7.5 12.5 29.1 14.6 6.2 8.5 (27.1) (49.8) Distribution 76.2 46.5 29.7 33.0 31.2 17.7 13.4 (59.1) (0.1) Sub-total 145.0 80.9 64.1 127.4 118.7 59.5 59.2 (18.LU 68 Investments Technical 1.4 0.5 0.9 1.9 1.3 0.2 1.2 (3.5) (29.9) Aaisttance Non-allocated - - - 12.6 - TOTAL COST 346.4 81.4 265.0 341.9 320.0 59.6 260.4 &4) appraisal estimates, and were financed by GOM transfers. Total actual, estimated and revised project costs and financing are summarized (i) by project components in Part III, para. 5.B; and (ii) by category in the loan agreement in Part III, para. 5.F. A further breakdown of costs and financing of investments and technical assistance is provided in Part III, paras. 5.C, 5.D and 5.E. H. Disbursement Schedule 5.62 Substantial delays in disbursement occurred during 1988 and early 1989 due to the economic stabilization program. Effectiveness was delayed more than one year (para. 5.1); the first tranche of the import and debt reduction component was disbursed 16 months behind estimates (para. 5.2); and the second tranche was released 15 months after the amended schedule and over 28 months behind appraisal estimates (para. 5.3). After these initial delays, the pace of disbursement remained in line with appraisal estimates. Actual, estimated and revised cumulative loan disbursements are provided in Part III, para. 3. 5.63 Total loan disbursements reached US$240.2 million. NAFIN requested the cancellation of US$19 million on July 9, 1992 due to the cancellation of the warehouses, the ammonia spheres and of part of the rehabilitation sub-projects. On August 10, 1993 NAFIN reimbursed the remaining Special Account balance of US$3,605,869 to the Bank, reducing the total loan disbursement to US$240.2  - 26 - million, equivalent to 90.6% of original loan amount. NAFIN requested the cancellation of the remaining loan balance of US$5,800,692.45 on August 19, 1993. 6. Project Results (a) Policy Program Results 6.1 Total deregulation or the Fertilizer Sector. The main project objectives were: (i) total withdrawal of FERTIMEX from retail distribution; (ii) increase of fertilizer prices to 85% of their import/export parity; (iii) increases in raw material prices to approximate their international parity; and (iv) increase in competition from imports. All these objectives were fully achieved as the GOM implemented a complete deregulation of the fertilizer sub-sector. Partly due to depressed prices on the international market, implementation of stipulated price increases resulted in domestic prices reaching international parity much sooner than expected. GOM took that opportunity to completely deregulate prices of both inputs and outputs (Part III, para. 6.B. 1). Price deregulation also permitted the complete withdrawal of FERTIMEX from all distribution activities and facilitated the divestiture of the large plants. 6.2 Divestiture of FERTIMEX's production facilities. Critical factors in the success of FERTIMEX privatization included: (i) the reorganization of FERTIMEX into decentralized regional business units; (ii) the improvement in plant operations through rehabilitation investments and improved plant management and supervision (Part III, para. 6.A.2); (iii) staff reductions and the renegotiation and reduction in the number of union labor contracts; (iv) improvements in cost accounting systems; and (v) preparation of separate financial statements for each plant. FERTIMEX's restructuring improved operational and financial results while increasing the transparency and usefulness of financial accounts. This restructuring made possible the valuation of FERTIMEX facilities as distinct operating units, thus facilitating privatization. 6.3 Impact on GOM Budget. Savings in budgetary transfers over the period 1988-92 are estimated at about US$1.0 billion. No transfers occurred after 1992. These savings are somewhat lower than the US$1.3 billion expected at appraisal over the same period, but remain substantial. While transfers for operations progressively declined, and transfers for investments remained about even until 1991, transfers for interest payments remained high (until 1990) in spite of the assumption by GOM of most of FERTIMEX's long term debt outstanding at appraisal. This was due to the contracting of substantial additional short term debt to resolve critical liquidity problems resulting from delays in price increases and late budget transfers during 1988 and early 1989. Details on actual and estimated budget transfers are presented in Part III, para. 6.B.2. 6.4 Impact on Fertilizer Production and Use. Fertilizer production increased from about 1.6 million tons of nutrients in 1986 to about 2 million tons in 1990. This increase was in line with appraisal estimates (Part III, para. 6.A. 1). In terms of tons of product, 1990 production was about 8% higher than appraisal estimates. Because several ammonium sulfate plants which were supposed to close remained in production (para. 5.9), the average nutrient content of products sold in 1991 was 39%, about the same as in 1986 and well below the 46% expected at appraisal. Finally, production in FERTIMEX's urea plants increased by about 15%-20% from the 1986 level as a result of improved plant management and better cooperation between FERTIMEX and PEMEX. 6.5 Despite sharp increases in prices, domestic fertilizer demand did not decrease, remaining at the 1986 level of about 1.75 million tons of nutrients (Part III, para. 6.A.3). This level of  - 27 - consumption, however, was substantially lower than the 2.4 million tons projected at appraisal. Fertilizer prices set at international parity provided an incentive for more efficient use of fertilizer while eliminating the illicit export of subsidized Mexican product. 6.6 At appraisal, based on a projected 5% per annum growth of fertilizer demand, the fertilizer deficit was expected to reach about 260,000 tons of nutrients in 1991 and 370,000 tons in 1992. In fact, the actual nutrient supply/demand balance showed a surplus of about 320,000 tons in 1990 and 230,000 tons in 1991. Furthermore, this surplus does not take into account the production of the new ammonium nitrate plant, which was not yet in production during mid-1993. 6.7 Impact on Fertilizer Availability. As discussed in para. 5.13, during and after the withdrawal of FERTIMEX from fertilizer production and distribution, domestic and imported fertilizer remained available to farmers, and no fertilizer shortages were reported. This was the result of the excellent preparation work performed by FERTIMEX under the guidance of the consultant contracted for the restructuring and distribution study prior to withdrawal. 6.8 Fertilizer Tariffs. The Bank insisted on full compliance with tranche conditions prior to release, with the exception of the increase in fertilizer tariffs from 0% to 10% (para. 5.14). This increase formed part of a broad tariff harmonization program and, as such, was accepted by the Bank. (b) Results of the Investments Components 6.9 Plant Rehabilitation. Plant rehabilitation components permitted improved operations and resulted in higher production and lower raw material consumptions. In 1990, the consumption of raw materials reached levels consistent with those considered attainable during the sub-sector review and at appraisal (Part III, para. 6.A.2). The rehabilitation of the Prayon filters of Pajaritos Fosfatados resulted in much lower consumption of raw materials and reduced pollution; the operation of the Lazaro Cardenas plant improved and reached about 80% of nominal capacity; however, the gypsum sea disposal problem remained unsolved (para. 5.49). 6.10 Maritime Terminals. At estimated completion costs, the two terminals are barely economically viable. The economic rate of return of Topolobampo is 4.7% versus 13% estimated at appraisal and that of Altamira is 9.2% versus 17.7% estimated at appraisal (para. 5.43). However, following the privatization of these facilities, the new owners will probably use these terminals to handle other products in addition to fertilizer. This diversified use should improve their financial and economic viability. 6.11 Pajaritos Ammonium Nitrate. Due to high costs of capital investment and reduced international prices for ammonium nitrate, returns on the ammonium nitrate plant are small. The economic rate of return of the project is now estimated at about 1.9%, much lower than the 21% expected at appraisal (para. 5.36). In addition, the international export market for solid ammonium nitrate is limited and its current domestic market is stagnant. Domestic demand for nitrogen fertilizer in 1992 remained at the 1987 level of about 1.3 million tons of nutrient, far below the 1.76 million expected at appraisal. (c) Financial Performance 6 12 FERTIMEX gross profit (sales less the cost of sales) decreased in 1988 and 1989 as a result of two factors: the fertilizer price freeze under the country's economic stabilization program, and the start-up of the highly unprofitable plant of Lazaro Cardenas. Profitability improved in 1990, and for  - 28 - the first time since 1982 it reached a positive value in 1991, reflecting the impact of price increases, plant rehabilitation, and improved management. Nevertheless, FERTIMEX operating losses increased substantially, from about US$195 million in 1987 to about US$375 million in 1990, although they decreased in 1991 to US$ 281 million. These high operating losses were mainly due to increases in distribution costs resulting from: (i) the withdrawal of BANRURAL from fertilizer distribution; and (ii) increases in rail transport costs. However, except in 1988, total cash flow after financial expenses and before budgetary subsidies and principal payments on debt remained positive over the period 1987-91 despite the start-up problems of Lazaro Cardenas. Details are provided in Part III, para. 6.B.3. 6.13 Compliance with financial covenants has already been analyzed in para.5.17 and results are presented in Part III, para. 6.B.4. 7. Project Sustainability Sustainability of the Policy Program and Privatization 7.1 The FSAL identified two major risks during implementation: (i) the possible negative impact on agricultural production if changes in output prices did not compensate for increased fertilizer costs; and (ii) the possibility of policy reversals once the loan was fully disbursed. 7.2 Close linkage with the Agriculture Sector Adjustment Loan (AGSAL, Loan 2918-ME), reduced risks of a negative impact on the agricultural sector. During the implementation of the AGSAL, and the successor project AGSAL II (Loan 3357-ME), prices for all agricultural products were liberalized (except for four basic products prices for which prices have been historically above international prices), subsidies on agricultural inputs were reduced, and trade restrictions on agricultural products greatly reduced (again, except for four basic products). Rising agricultural prices compensated for fertilizer price increases, as expected at appraisal. As indicated in the AGSAL PCR dated February 15, 1994, it is too early to fully evaluate the effects of agricultural reform. As stated above, domestic consumption of fertilizer nutrients did not decrease between 1986 and 1992 (para. 6.5). 7.3 The policy reforms actually implemented went well beyond commitments under the Loan. This success was the result of strong commitment to reform, particularly by the current Mexican administration. The risk of political reversal of the reform process is now very low, due to the administration's success in stabilizing and restructuring the economy and the implementation of international trade accords including the North American Free Trade Agreement (NAFTA). In addition, although it is early for a complete evaluation, the privatized and deregulated fertilizer sector appears to function well: (a) The private sector reacted quickly and positively to FERTIMEX's withdrawal from fertilizer distribution (para. 5.13), and to the complete sectoral deregulation. Fertilizer remained available to farmers at international prices, as distributors imported products following the new plant owners' decision to increase fertilizer prices above international levels (para. 5.14). In light of this positive reaction, GOM dissolved the small marketing company created to regulate the market only a few months after its creation. Future Government involvement in fertilizer distribution is unlikely.  - 29 - (b) All fertilizer plants are currently in operation with the exception of Coatzacoalcos, which has been stopped. The new producers have already demonstrated the capacity to quickly react to market forces: some producers have suspended production of fertilizer sulfuric and phosphoric acid as a result of low international prices (para. 5.14); and they have been able to organize a producers association to negotiate ammonia prices with PEMEX and to lobby GOM for higher fertilizer tariffs. However, in light of the decision to divest ammonia plants in the near future, PEMEX is not likely to accept less than the export parity price for ammonia. SEMIP has indicated that the GOM will not accept higher tariffs except in cases of demonstrated dumping. 7.4 Until recently, Mexican regulations have granted exclusive rights for ammonia production to PEMEX. This provision has resulted in a major distortion to the fertilizer sector because ammonia and urea plants are normally integrated to ensure a constant and economic supply of carbon dioxide to the urea plant. These regulations have now been revised to exclude ammonia from the list of products reserved for PEMEX, and to allow private sector participation in ammonia production. PEMEX has announced the decision to sell all ammonia plants in the near future. The terms of the privatization will be critical for the viability of the privatized urea plants. The dependence on external carbon dioxide and ammonia supplies remains problematic principally for Pajaritos Nitrogenados and Minatitlan, since their ammonia supply (from Cosoleacaque) can be exported. Export of ammonia from the other ammonia plants (Bajio and Camargo) is more difficult. 7.5 The Project Completion Report and the Audit Report of the Fertilizer II Project (Loan 1686- ME) concluded that the Lazaro Cardenas plant could only be financially sustainable when treating part, or all, of capital investment as sunk cost (total financing required as of 1987 was about US$800 million). This was confirmed by the very low price obtained from the plant sale (about US$50 million together with the ROFOMEX mine of Baja California). Attempts are being made by the new owner to improve the financial viability of this plant, including (i) the use of low-cost imported sulfuric acid, (ii) negotiation of a long-term supply contract for by-product sulfuric acid with Mexicana de Acido Sulfurico, and (iii) the study of possible operational improvements in processing of ROFOMEX phosphoric rock. Sustainability of the New Investments 7.6 As indicated in para. 5.41, the economic viability of the Topolobampo and Altamira maritime terminals could improve following privatization if the ports are used to handle other products in addition to fertilizer. However, during divestiture, attention should be paid to ensuring that the Lazaro Cardenas and Pajaritos fertilizer plants continue to have access to them under the same conditions offered to foreign fertilizer products. 7.7 Due to much higher completion costs, lower prices, limited export markets for solid ammonium nitrate, and the stagnant domestic market, the Pajaritos ammonium nitrate plant has a low estimated rate of return (para. 6. 11). However, on a marginal cost basis, net cash flows remain positive. If completed at low cost the UAN solutions plant, which was not part of the Project, could offer an opportunity for market diversification (para. 5.37) thus improving plant sustainability.  - 30 - Potential Sustainability of a Restructured FERTIMEX. 7.8 FERTIMEX cash flow!' remained positive over the period 1987-91, with the exception of 1988 (para. 6.B.3 of Part III). This confirms that after restructuring, the operation of the existing facilities by FERTIMEX could have been sustainable on marginal cost basis. Furthermore, if FERTIMEX could have withdrawn from retail distribution prior to 1991 and if the maritime terminals had then been in operation, distribution costs could have been reduced by about US$20 per ton of fertilizer (in 1987 constant terms) as expected at appraisal. This would have resulted in much lower operating losses and higher cash flow. Under this hypothetical scenario, FERTIMEX would still have experienced operating losses in 1991. These losses would have been far lower than historic losses (in constant 1987 pesos converted to 1987 U.S. dollars) and would have been in line with FERTIMEX operating losses as projected at appraisal for the same year (US$ 44.4 million). However, as already indicated, FERTIMEX was unable to improve its capacity to implement new investment projects. 8. Bank Performance 8.1 Bank performance during project identification, preparation, appraisal and supervision was generally thorough and effective. During project preparation, the Bank conducted extensive sector work which addressed the important issues of the fertilizer sector and developed options for restructuring. The principal options identified included both the partial and complete privatization of FERTIMEX production and distribution facilities. Although the latter option was the preferred by the Bank, complete privatization was not considered possible in the short term at the time of FSAL appraisal. However, the Bank recommendations did form the basis of the GOM/FERTIMEX medium and long term management strategy. 8.2 Implementation of the project was intensively supervised by the Bank. Thirteen supervision missions were fielded over five years (two per year in 1988, 1989 and 1992 and three per year in 1990 and 1991), consisted of two persons per mission, and averaged 9-10 days. The combination of policy-based and investment lending required frequent supervision due to: (i) the need to continuously monitor compliance with policy conditionality; (ii) the need to maintain a dialogue with the GOM and FERTIMEX on sectoral policy and strategy issues and to provide support for restructuring and privatization; (iii) the need to closely monitor project implementation and propose remedial actions in a timely manner; and (iv) the large quantity and diversity of investment sub- projects and the need to adjust the program several times to reflect changing priorities during restructuring and privatization. The Bank demonstrated substantial flexibility during project implementation, quickly adjusting the investment and policy programs in response to the evolving Government strategy for macroeconomic stabilization, sectoral restructuring, and privatization. However, despite this intensive supervision the Bank was not able to bring about major improvements in FERTIMEX's ability to implement new investment projects. 9. Borrowers Performance 9.1 The strong commitment of the Salinas administration to structural reform resulted in rapid deregulation and privatization of the fertilizer sector, going well beyond the commitments under the 8/After financial expenses and before budgetary subsidies and principal payments on debt.  - 31 - loan agreement. To achieve this goal, the GOM appointed a highly competent General Manager to FERTIMEX along with a management team which was fully committed to reform. 9.2 FERTIMEX management was able to efficiently implement the difficult measures required for regionalization and reorganization of the company and its preparation for divestiture (para. 5.22). Furthermore, jointly with the Unidad de Desincorporaci6n of SHCP, FERTIMEX management actively participated in the privatization process of the productive assets (para. 6.2). However, during the construction of the maritime terminals and of the Pajaritos Ammonium nitrate plant, FERTIMEX investment implementation capabilities at headquarters remained limited. Although weaknesses remained, project implementation delays and cost overruns experienced were less severe than those experienced under the two previous Bank-financed projects (para. 4.3). 9.3 NAFIN took a much more active role in the implementation of the FSAL than in the previous two loans. NAFIN managed the Special Account, was the official channel of communication between FERTIMEX and the Bank, and reviewed the procurement documentation and provided extensive comments prior to submission to the Bank. 10. Project Relationship 10.1 The success of the FSAL was strongly supported by the high degree of professionalism of all the parties involved and the close and strong working relationship which developed between the Bank and Government. The reorganization and distribution study benefitted from the constructive collaboration between FERTIMEX and the consulting firm BAH. The excellent relationship between the Bank and FERTIMEX management, particularly during the Salinas administration, facilitated close contact and frequent communication throughout the restructuring process, providing the opportunity for frequent informal consultations on important policy and strategic issues. 11. Consulting Services 11.1 FERTIMEX contracted with BAH for the reorganization and distribution study (para. 4.4). BAH performance was very good. The study, which was prepared in close cooperation with FERTIMEX, provided a strong basis for defining and implementing the restructuring and privatization program. 11.2 During the implementation of the maritime terminals and the ammonium nitrate plant, FERTIMEX contracted a specialized Mexican firm with its own resources to assist field teams in project management. FERTIMEX has reported performance problems under this contract. 12. Project Documentation and Data 12.1 The legal documents of the project were adequate for achieving the project objectives. The Sector Restructuring Program, the Staff Appraisal Report, the supervision reports and the documentation in the Project File provided adequate background for the review of project implementation. A few weeks before the final supervision and PCR preparation mission in June 1993, the Bank requested FERTIMEX to prepare the project related information needed for the preparation of the PCR. All the requested information was provided and discussed during the mission. Furthermore, FERTIMEX provided a draft of the internal corporate project completion report.  - 32 - PART III: STATISTICAL INFORMATION 1. Related Bank Group Operations Loan Loan in Proiect Namc Year of Approval Status Million USS 1. I Bank Operations in the Fertilizer Sector Loan 1112-ME 50.0 Fertilizer I Project 1975 Closed: Januaiy 20, 1982 PCR issued December 1984 Loan 1686-ME 80.0 Fertilizer II Project 1979 Closed: Dec.31, 1983 Completion: Dec. 1986 PPAR/PCR issued December 1991 Loan 2919-ME 265.0 Fertilizer Sector 1988 Closed: Dec.1993 Adjustment Loan 1.2 Proiects in Related Sectors Loan 2918-ME 300.0 Agriculture Sector 1988 Closed: Nov. 15, 1990 Adjustment Loan Completion: Nov. 15, 1990 PCR issued February 1994 Loan 3085-ME 500.0 Public Enterprise Reformn 1989 Closed:June 30,1992 Completion: June 30, 1990 PPAR/PCR issued June 1992 Loan 3087-ME 500.0 Industrial Sector Policy 1989 Completed PCR issued August 1993 Loan 3357-ME 400.0 Agriculture Sector 1991 Second tranche released in Adjustment Loan 11 December 1993 PCR under preparation Comment: Since the 1940s, the Bank has made the agricultural sector the leading sector in its lending to Mexico. To support this strategy and help improve productivity, the Bank approved two operations in the fertilizer sector. The first fertilizer project was signed on May 20, 1975 (Loan 1112-ME). It financed the construction of two urea plants in Bajio and Pajaritos and an insecticide plant in Salamanca. The second fertilizer project (Loan 1686-ME) was signed on May 18, 1979 to finance the construction of a phosphate fertilizer complex at Lazaro Cardenas. The Fertilizer Sector Adjustment Loan formed part of a series of sector adjustment loans approved between 1987 and 1990 aimed at stimulating private sector investment and growth.  - 33 - 2. Project Timetable Item Date Date Date Planned Revised Actual - Identification Mission (i) 06/85 - Preparation Mission(ii) 09/85 10/85-11/85 - Pre-appraisal Mission 04/86 11/86-12/86 - Appraisal Mission 04/86 04/87 04/87 - Loan Negotiations 07/87 02/88 - Board Approval 09/87 03/15/88 - Loan Signature 06/13/88 - Loan Effectiveness (iii) 09/12/88 02/15/89 11/02/89 07/31/89 11/15/89 - Loan Closing 12/93 12/93 - Loan Completion 06/93 06/93 8/93 Comments: (i) The need for comprehensive restructuring of the fertilizer sector was identified during a public sector investment program review in the fertilizer, secondary petrochemical and pharmaceutical branches of the chemical industry in May-June 1985. An in-depth diagnostic of the industry was undertaken by the Bank during a preparation mission in November 1985. A diagnostic report on possible restructuring options was forwarded to the GOM in April 1986. Several Bank follow-up missions subsequently visited Mexico to discuss the findings of this review. (ii) The preparation mission was postponed due to the Mexico City earthquake. (iii) The FSAL initially encountered serious implementation delays and became effective over a year after the originally planned date. Essentially, it suffered in 1988 and early 1989 from measures under the macro-economic stabilization programs (Pacto and PECE), which rendered impossible the scheduled fertilizer and fertilizer inputs price increases; from frequent management changes in FERTIMEX; and from disagreements over the treatment of the plant closure program in the Restructuring agreement between GOM and the FERTIMEX (Convenio), submitted to the Bank as condition of effectiveness (para. 5.1 of Part I).  - 34 - 3. Loan Disbursements (US$ million) Cumulative Loan Disbursements Bank Fiscal Year and Semester Appraisal Formally Actual as % Actual as % Endini Estimate Revised Actual Of Estimated Of Revised Estimates at Appraisal Estimates 1988 - Mar 88 2.5 0.0 0.0 0.0 - Jun 88 10.0 0.0 0.0 0.0 1989 - Dec 88 45.0 0.0 0.0 0.0 - Jun 89 120.0 0.0 0.0 0.0 1990 - Dec 89 190.0 6.0 6.0 3.2 100.0 - Jun 90 227.0 156.8 156.8 69.1 100.0 1991 - Dec 90 237.0 163.9 164.0 69.2 100.1 - Jun 91 244.0 227.0 173.2 71.0 76.3 1992 - Dec 91 251.0 245.0 229.8 91.5 93.8 - Jun 92 257.0 257.0 239.6 93.2 93.2 1993 - Dec 92 261.0 261.0 243.8 93.4 93.4 - Jun 93 264.0 264.0 243.8 92.3 92.3 1994 - Dec 93 265.0 265.0 240.2 90.6 90.6 Loan Disbursements Estimated, Revised and Actual 280 1 260- -. 240 220 f 200, , 180 / 160 0 140 1200 / 80 - / 60 40- 20 -