Mozambique - Second National Water Development Project (II)

Document of The World Bank Report No: 19131 MOZ PROJECT APPRAISAL DOCUMENT ONA PROPOSED CREDIT IN THE AMOUNT OF SDR 55.4 MILLION (US$ 75 MILLION EQUIVALENT) TO THE REPUBLIC OF MOZAMBIQUE FORA NATIONAL WATER DEVELOPMENT PROJECT II May 12, 1999 AFTUI AFC02 Africa Regional Office  CURRENCY EQUIVALENTS (as of May 12, 1999) Currency Unit: Mozambican Meticais US$ 1.00 = Mt 12,450 SDR 1.00 US$ 1.36 FISCAL YEAR Government & Public Enterprises January 1 to December 31 ABBREVIATIONS AND ACRONYMS AfDB = African Development Bank CAS Country Assistance Strategy CIDA = Canadian International Development Association COGEA Commisao de Gestao de Empresas de Agua (Commission for the Management of Water Services) CRA Conselho de Regulaqao do Abastecimento de Agua (Council for the Regulation of Water Supply) GOM = Government of Mozambique DASU = Departamento de Agua e Saneamento Urbano (Department of Urban Water and Sanitation) DN = Director Nacional (National Director of Water) DNA = Direc,ao Nacional de Aguas (National Directorate of Water) FCGD = F6mm Coordenador da Gestao Delegada (Stakeholder's forum) FIPAG = Fundo de Investimento e Patrimonio do Abastecimento de Agua (Asset and Investment Water Fund) HRD = Human Resources Development IPP International PriVate Partner MAE = Ministerio de Administraqao Estatal (Ministry of State Administration) MOPH = Ministerio das Obras PNiblicas e Habitac,o (Ministry of Public Works and Housing) MPF = Ministerio do Plano e Financas (Ministry of Planning and Finance) NDF = Nordic Development Fund NWD = National Water Development Program NWDP I = National Water Development I NWDP II = National Water Development II NWP National Water Policy PIM = Project Implementation Manual PL = Project Leader PSM Private Sector Management PSP = Private Sector Participation RWSS = Rural Water Supply and Sanitation UEP = Urban Environmental Project WRM = Water Resources Management Vice President: Callisto Madavo Country Director: Phyllis Pomerantz Sector Manager: Jeffrey Racki Team Leader: Jane Walker  Mozambique National Water Development II CONTENTS A: Project Development Objective ................................................................2 1. Project development objective ..................... ...........................................2 2. Key performance indicators ...............................................................2 B: Strategic Context ................................................................3 1. Sector-related Country Assistance Strategy (CAS) goals supported by the project .......3 2. Main sector issues and Government strategy ...............................................................3 3. Sector issues to be addressed by the project and strategic choices ............. ...................5 C: Project Description Summary ................................................................6 1. Project components ................................................................6 2. Key policy and institutional reforms supported by the project ................ ......................7 3. Benefits and target population ................................................................7 4. Institutional and implementation arrangements ............................................................ 8 5. Monitoring and Evaluation (M/E) ............................................................... 11 D: Project Rationale ............................................................... 12 1. Project alternatives considered and reasons for rejection .................. .......................... 12 2. Major related projects financed by the Bank and/or other development agencies .......... 13 3. Lessons learned and reflected in the project design ..................................................... 13 4. Indications of borrower commitment and ownership ................................................... 14 5. Value added of Bank support in this project ............................................................... 14 E: Summary Project Analysis ............................................................... 15 1. Economic .............................................................. 15 2. Financial .............................................................. 15 3. Technical .............................................................. 16 4. Institutional .............................................................. 17 5. Social .............................................................. 17 6. Environmental assessment .............................................................. 18 7. Participatory approach .............................................................. 18 F: Sustainability and Risks .............................................................. 19 1. Sustainability .............................................................. 19 2. Critical Risks: (reflecting assumptions in the fourth column of Annex 1) .................... 20 3. Possible Controversial Aspects .............................................................. 21  G: Main Loan Conditions ........................ 21 1. Conditions of Effectiveness .................. 21 2.Financial Covenants .................. 22 3.Dated Covenants .................. 22 H: Readiness for Implementation ........................ 22 I: Compliance with Bank Policies ........................ 23 Annexes Annex 1. Project Design Summary Annex 2. Detailed Project Description and Environmental Summary Annex 3. Estimated Project Costs Annex 4. Economic Cost-Benefit Analysis Summary Annex 5. Financial Summary Annex 6. Procurement and Disbursement Arrangements Table A. Project Costs by Procurement Arrangements Table Al. Consultant Selection Arrangements Table B. Thresholds for Procurement Methods and Prior Review Table C. Allocation of Loan Proceeds Annex 7. Financial Management Annex 8. Project Implementation Manual Table of Contents Annex 9. Project Processing Budget and Schedule Annex 10. Documents in Project File Annex I l. Statement of Loans and Credits Annex 12. Country at a Glance  Mozambique National Water Development Project II Project Appraisal Document Africa Regional Office AFC02 Date: May 12, 1999 Team Leader: Jane Walker. Country Director: Phyllis Pomerantz Sector Manager: Jeff-rey Racki Project ID: MZ-PA-52240 Sector: WW - Water Supply & Sanitation Adjustment Lending Instrument: Specific Investment Loan Theme(s): Private Sector Poverty Targeted Intervention: [ I Yes [XI No Project Financing Data I Loan [X] Credit ] Grant [] Guarantee [] Other ISpecify] For LoanslCredits/Others: Amount (US$m): 75.00 Proposed terms: [] To be defined [X] Multicurrency [] Single currency [I Standard Variable [] Fixed [ LIBOR-based Grace period (years): 10 Years to maturity: 40 Commitment fee: Not exceeding 1/2 of 1% Service charge: 0.75% A U Government 7.59 2.65 10.24 Cofinanciers (AfDB, Netherlands) 10.1I 19.49 29.60 IDA 19.18 55.82 75.00 Total: 36.88 77.96 114.84 Borrower: Government of Mozambique Guarantor: Government of Mozambique Responsible agency: Ministry of Public Works and Housing, Fundo de Investimento e Patrim6nio do Abastecimento de Agua, Direccao Nacional de Aguas Estimated disbursements Bank FY/US$M): Annual 1.49 10.30 17.28 18.60 15.94 11.39 Cumulative 1.49 11.79 29.07 47.67 63.61 75.00 Project implementation period: 5.5 years Expected effectiveness date: September 30, 1999 Expected closing date: September 30, 2005 Implementing agency: FIPAG, DNA Contact person: Americo Muianga, National Director, National Directorate of Water, Ministry of Public Works and Housing Address: Av. 25 de Septembro, 942, Maputo, Mocambique Tel: 420470 Fax: 302130/420469 E-mail: PNDA@virconn.com OCS PAD Form: October 9, 1998  Page 2 A: Project Development Objective 1. Project development objective: (see Annex 1) The main objective of the project is to improve the quality, reliability and sustainability of water services for the cities of Maputo, Beira, Quelimane, Nampula, and Pemba (target cities) through promoting greater private sector participation in the provision of these services. More specifically, the project seeks to: * Commence institutional and regulatory reform within the urban water sector with the introduction of commercial principles in the operation and management of water services through the use of a private sector operator * Accelerate capacity building and human resource development for the sector through training and demonstration effects within the context of the private operator contract * Provide an institutional framnework that improves the quality and sustainability of users services and acts as an operational model for water services, as these begin td be decentralized to municipal based management. 2. Key performance indicators: (see Annex 1) Outcome /Impact Indicators: * Mandated tariff policy that water pricing will be based on principles of full cost recovery. * Work towards the establishment of autonomous publicly owned water companies in the 5 targeted cities that are run on commercial principles of cost recovery and that are managed and run by private sector operators. - Assist in the devolution of the responsibility to provide water supply to the Local Authorities as municipalities take an increasing role in direction and ownership of the new water companies. * Creation of a water sector regulatory agency for urban water service provision. Output Indicators * In the target cities, the population with improved access to safe reliable water supplies would increase from the current level of 0.8 million to 1. lm by 2004. * FIPAG: Full cost recovery achieved by year: O&M +depreciation O&M +depr. +debt service FIPAG. Year 4 of Operations Year 5 of Operations September 2004 September 2005 * Reliabi lity of service i proves % of customers receiving <24 hrs supply/day Cities 09/99 09/02 09/04 Maputo 80 60 20 Beira 95 55 5 Quelimane 100 60 5 Nampula 100 50 5 Pemba 100 70 5 * Percentage of microbiological water quality samples meeting target values Il1 09/02 09/04 1 All cities 50% 95%  Page 3 B: Strategic Context 1. Sector-related Country Assistance Strategy (CAS) goal supported by the project: (see Annex 1) Document number: Report No. 17180-MOZ dated November 21, 1997; Date of latest CAS: discussed by the Executive Directors on December 18, 1997. The project would support the CAS objective ofpromoting sustainable economic growth bv. * Providing improved coverage, higher quality and more sustainable water services for major urban areas which will improve the quality of life and enhance productivity of individuals and households; * Ensuring more efficient and cost-effective service delivery for domestic, commercial and industrial enterprises; * Promoting principles of cost recovery, self-sufficiency and demand led growth to ease the fiscal burden at the municipal and Central Government level. The project would support the CAS objective of capacitv building and development of human resources primarily through the promotion of private sector-led service delivery by: e Introducing private sector participation in the provision of water supply services in the five cities; = Laying the foundation of wider institutional reform covering all cities by fostering options for the private sector participation in the provision of urban water services; - Demonstrating to GOM and the municipalities a wide range of efficient and cost-effective management practices that result in better service delivery; - Strengthening sector human resource capacity through employment and training under modem private sector management practices; - Implementing demand led market based principles that will result in the involvement of a wide range of stakeholder including municipalities, commercial and industrial users, private sector groups and NGOs. Providing for and promoting new institutions for professional sector oversight, management and regulation. The project would support the CAS objective of strengthening development partnerships: The project provides a framework within which: * Donors are working closely together and in a coordinated manner, for the first time in the urban water supply subsector, to support GOM in its efforts to plan and implement a program of sustainable development. * Partnerships between GOM and the newly elected municipalities. * Partnerships between GOM and the private sector. 2. Main sector issues and Government strategy: Sector Issues: Water resources management and source protection: Improving environmental management is urgently required in Mozambique and increasingly becoming an issue. The country's natural resources form the basis of its economy and are the principal sources of income and future economic growth. The majority of Mozambique's water resources are those of its major rivers, almost all of which arise in other countries. Over the last three decades, upstream riparians have diverted much of the yield of several of these rivers for irrigation and other consumptive uses. From 1991 to 1996, Mozambique faced severe water shortages, with insufficient water for irrigation requirements, saline water intrusion into estuaries, and significant water supply interruptions in different parts of the country. Arrangements for more equitable sharing of water between the riparian countries are important to ensure that Mozambique will have sufficient safe water sources for the provision of adequate potable water for communities.  Page 4 Urban water and sanitation service delivery: The urban population of Mozambique is growing rapidly and represents 38% of the national total. Since 1990, the annual growth rate in urban population averaged over 7%, partially due to the effects of the prolonged civil war. The huge influx of immigrants has overwhelmed water and sewer systems designed for much smaller populations. The current potable water supply service is inadequate and is characterized by low levels of coverage and very poor quality and reliability. Only about 30 % of the urban populations have access to safe water. Inadequate sanitation and drainage further contribute to the deteriorated conditions for urban populations. These deficiencies, in tum, have led to very poor health statistics and a degraded quality of life resulting in lower individual and household productivity and poverty entrenchment. Sector management capacity and sustainabilitv: Both water resources and potable water are managed through central govermment authorities, while the sanitation services (including the majority of sewerage) is the responsibility of municipal govemments. The public administration responsible for the service delivery is extremely weak, and is characterized by underskilled and poorly trained and paid staff. Management capacity is extremely scarce. Cost recovery for water services is low, which in part reflects the low efficiency of the service. User fees for sewerage and sanitation are minimal or non-existent. Much of these fees are not retained for service provision but are used for other municipal purposes. Government Strategy: Background and Overview: The Government of Mozambique is addressing the multiple sector issues within the water and sanitation sector with a range of innovative polices and strategies. In August 1995, GOM adopted a comprehensive sector strategy document entitled the National Water Policy (NWP). The policies to which GOM committed itself include: increased beneficiary participation, recognition of water as an economic as well as a social good; decentralized autonomous and financially self sustaining provision of water supply and sanitation services, integrated water resources management taking environmental impacts into account; multi-objective investment planning; a greater focus on capacity building; and an increased role for the private sector. GOM has prepared and approved a National Water Development Program (NWD Program) to implement the above polices. The achievement of these polices' objectives is found in three broad initiatives, as follows: Water Resources Managment, Rural Water Supply, and Institutional Reform: The first component of the NWD Program financed by IDA and co-financed by Nordic Development Fund (NDF) and CIDA supported National Water Development I Project (NWDP-I, Cr. 3039-MOZ), which became effective in June 1998. Under the credit, Mozambique is participating in studies of transboundary rivers; increasing its capacities to support the international technical negotiations that are required to reach agreements, as well as its water resources management capacities; reforming its approach to the provision of rural water supply services with the objective of implementing a demand oriented approach; and developing a strategy for water resources management and the management of bulk water for irrigation and other purposes. The project also includes significant support for capacity building within the Direccao Nacional de Aguas (DNA). Urban Water Reform and Management: Under the program, GOM has decided to undertake a sweeping refonn of the urban water supply provision. The program starts with institutional reform at the very heart of service delivery to move away from central management, and towards more deregulated management involving better regulation and financial planning. Specifically, GOM has taken steps to provide for: (i) full private sector management for water supply services in 5 major cities with an expected follow-on for 8 further towns; (ii) tariff reforms that aim at full cost recovery; and (iii) the establishment of a Regulatory Board (Conselho de Regulacao do Abastecimento de Agua - CRA) for the sector. The Program for urban water supply also includes investments in rehabilitation and extension of systems. The proposed NWDP-II is poised to support the urban water supply component of the NWD program in association with the African Development Bank and Dutch bilateral support.  Page 5 Urban Sanitation and Related Urban Services: With respect to sanitation and sewerage services, the major component of the GOM long term program of public and municipal sector reform is decentralization. This is seen as a means to make the provision of sanitation and sewerage services, along with related infrastructure services - especially drainage, more efficient and more accountable to the users. Devolution of authority and resources to municipal government is already advanced. However, institutional capacity at the municipal level is extremely weak. The proposed IDA-supported Municipal Development Project is being developed to address major issues in the delivery of urban services. The project is taking a long-term view (10- 15 years) in which significant upgrading of the capacity of local governments is expected to be achieved. Specific investment in wastewater and sanitation are programmed within this proposed credit. 3. Sector issues to be addressed by the project and strategic choices: Staged Initiatives: The proposed project comprises one component of a broader program of total water supply sector management and development for Mozambique. Given the known limited institutional capacity of the country as a whole and in the sector particularly, a strategic choice was made by IDA to support the ambitious water reform program in a set of three specific sub-sector initiatives, as follows: (i) water resources, rural water and capacity building (NWDP-I - 1998); (ii) urban water (NWDP-II - 1999); and (iii) urban services, including sanitation and drainage (Municipal Development Project - 200 1). For example, during most of the preparation phase, the NWDP-I project and the proposed NWDP-II project were being prepared as a single large and complex project. In July 1997, GOM and the Bank together made a decision to split the project into two. The result is simpler, more manageable projects. Nevertheless, while capacity strengthening, particularly in project management within DNA, is on-going; the implementation of some components under DNA's control has been slow. DNA acts as a project executing agency for NWDP I and will act as the executing agency for a small component of NWDP II. Use of Private Sector Management: Of the main sector issues outlined above within the water sector, one of the most important is the inadequate provision of urban water supply to the major cities of Mozambique. Complementary and essential to this lack of provision, is the problem of the implementation capacity to achieve improved services and the sustainability of service delivery to consumers at a reasonable cost and in a reasonable timeframe. Specifically, GOM undertook a strategic decision to augment the management and operational efficiency of the water companies in the cities of Maputo, Beira, Quelimane, Nampula, and Pemba by contracting out to a private sector operator through a competitive bidding process while retaining oversight through the creation of a regulator. An autonomous public sector body (Fundo de Investimento e Patrim6nio do Abastecimento de Agua - FIPAG) will hold all state water assets in the five towns and contract with the private operator for services through a range of contracting options. The decision reflects wider GOM public management reform which focus on a more results oriented public service where scarce public sector resources are devoted to oversight and regulation while permitting the private sector to operate a range of services under a regulated environment. Multi-donor Participation: In support of the significant demand for investment in rehabilitation and extension of the five cities systems, IDA has encouraged a strategy that will allow participation by a range of donors. Over the medium term, there is scope for additional investments, mainly for expansion works in the core secondary cities. This is in addition to current funding committed by IDA, AfD)B, and the Dutch Government which supports some expansion of the systems, but is mainly focused on rehabilitation. Other donors including the French and Germnan governments and the European Union have already expressed interest in participating in the project. It is expected that most of the bi-lateral funding will be in the form of grants. Further, there is considerable scope for additional funding within the overall urban water program, which is wider than the 5 cities covered with the project.  Page 6 C: Project Description Summary 1. Project components: (see Annex 2 for a detailed description and Annex 3 for a detailed cost breakdown) A. Private Sector Management of water supply systems for five cities. * Lease Contract B.P.* * Management Contract 5.71 5.71 * Rehabilitation & New Connections 14.67 14.16 * Program Management 2.30 2.30 Management Components A and B B.I. 13.31 11.25 by FIPAG Human Resources Development and 0.80 0.80 Training Total A 36.79 32 34.21 46 B. Water Supply Works. W.U. Water Supply Works 49.07 20.33 Design and Supervision 5.00 5.00 Total B 54.07 47 25.33 34 C. Urban Water Supply Policy & B.I. Strategy. Equipment for CRA 0.30 0.30 TA for the CRA 1.50 1.50 Urban Water Supply Strategy 2.00 2.00 Peri-Urban Pilot .40 .40 Project Management .40 .40 Total C 4.60 4 4.60 6 Total 95.46 83 64.14 86 Project Costs (with contingencies) 112.20 98 75.00 100 Interest during construction 2.65 2 0 0 **Total Project Costs 114.84 100 75.00 100 *Note: The cost of Lease Contract (est.US$24.5m) is not included in the Project Costs as this cost will be financed by the Customer Tariff and will be the responsibility of the Private Operator. **Note: Totals may not add due to rounding.  Page 7 2. Key policy and institutional reforms supported by the project: Policy Reforms: * Autonomy and financial viability of urban water services through the creation of a public water institute, FIPAG, as a transition to greater decentralization of service provision; * Greater participation by municipalities through their role in the Stakeholders Forum (F6rum Coordenador da Gestao Delegada - FCGD) and through their assistance in the selection of the Board of FIPAG, and eventual devalution of FIPAG into several municipally based utilities; * Use of private sector provision of urban water services through the contracting out of the operations of the water companies to the private sector; * Pricing of water service based on economic cost of water through the national Decree of the water Tariff Policy; * Full consumer participation in the key institutions (the CRA and FIPAG), and through programs for participatory decision-making on major system extensions. Institutional Reforms: * Creation of FIPAG and the transfer of ownership and operation of the state water companies, which cease to exist, to FIPAG; X Evolution of FIPAG into municipal based water companies with decentralized ownership; * Creation of the Independent Regulator (CRA). 3. Benefits and target population: The project will directly benefit an estimated 1.1 million people, representing about 47% of the consumers in the five cities. Of those already served by connections (about 800,000 people, or about 35% of all potential consumers), whether through house or yard connections or public standpipes, most currently receive supplies for only a limited number of hours per day. Of these, many also receive supplies of poor microbiological quality, at low pressure, and not every day of each month. To those consumers who are already connected but are poorly served, the project will bring services that are close to continuous and meet national standards of pressure and microbiological quality. These consumers will pay higher prices. Of the families and individuals who are not currently connected to the formal systems, most are poor, most pay more per cubic meter for their supplies than those currently connected (e.g. in Beira, in early 1998, 32% of households had direct connections to the formal water supply system and paid an average of US$0.091M3, while 30% purchased vended water at an average price of US$2.20! M3), and many must walk long distances to fetch water, a burden that falls disproportionately upon women. Some 300,000 people will receive formal services, through direct connections or standpipes, for the first time. For these improved and more reliable services, most of those who have been using vended water will pay lower unit prices, but improved metering and tariff policies, and options to choose between the forms of service, will allow most of them to adjust the balance of convenience, quantity consumed and monthly total paid, to match their own budgets. Improvement in the management of the services, both operationally and financially, will allow increased reliability and sustainability of the systems. Further poor and unreliable water services in the five cities are a constraint on operations by commercial and industrial enterprises increasing their operating costs and making these enterprises less competitive. Improved service levels, particularly reliably, will reduce constraints and promote confidence and increased investment. The increased skills of personnel involved in the sector, the improved framework of investment management, regulation and sector policy, and the experience gained in managing private sector management operators, will establish a base upon which to continue to improve and expand urban water services, both within these initial five cities and within other cities as the deregulated management model of the water sector expands.  Page 8 4. Institutional and implementation arrangements: For Components A and B: * Executing agency: FIPAG under MOPH; * Coordinator: Chairman of the Board of FIPAG through the CEO (Chief Executive Officer) of FIPAG. For Part C: * Executing agency: Direccao Nacional de Aguas (DNA) under the MOPH; * Component Coordinator: Head of Departamento de Agua e Saneamento Urbano (DASU) under the guidance of the National Director of Water Affairs (ND). Implementation period: September 1999 through March 2005 Project Co-ordination: Maior Institutions and Roles: FIPAG. All water supply fixed assets, presently at the disposal of state water companies in the five cities will be vested with the new FIPAG, created by decree number 73/98 dated December 23, 1998. A Stakeholders Forum will be formed as a consultative body on the Private Sector Program (PSP) for the Minister of MOPH. It will nominate members for appointment to the Board of FIPAG. This forum will be presided over by a representative of the MOPH and will include members appointed by Minist6rio de Plano e Financas (MPF) and Ministerio de Administraqao Estatal (MAE), as well as representatives of the CRA and FIPAG. Representatives of the local authorities will be consultative members but they will be entitled to vote on all matters related to the water supply systems in their area. The Board of FIPAG will consist initially of 5 professionally qualified individuals. FIPAG will have a professional chief executive officer (CEO) responsible for daily management of the institute, who will be recruited by the MOPH. The CEO will be assisted by a professional group of managers representing the following competencies: utility management, investment program management and financial management. Environmental expertise will also be located in FIPAG to ensure that correct environmental practices as set out in the Environment Action Plan (EAP) are implemented. An accountant will also be part of the FIPAG management team, as well as advisory legal services. The FIPAG professional team will be supported by a substantial technical assistance budget. FIPAG will be responsible for the implementation of components A&B of the project. Full job description of the professional staff and managers of FIPAG, as well as the operational policies and norms of FIPAG, are to be set out in the PIM. FIPAG will be the Employer (signatory to the contracts) of the Private Operator (PO), who will replace Agua de Maputo. FIPAG will also take over duties and obligations for water service delivery for the four water companies of Beira, Quelimane, Nampula and Pemba and enter into Management Contracts with the PO on the operations of water supply in these cities. As part of the GOM strategy to devolve responsibilities to the Local Authorities in a gradual and deliberate way, new public companies with both state and municipal ownership will be created in the four cities over the course of the project. The authority and responsibilities of FIPAG include: i) investment and financial management for rehabilitation and expansion of water supply assets; ii) maximization of efficiency and return on existing assets; and iii) contract management, monitoring and enforcement of its contractual obligations of the selected PO. FIPAG will review and approve the Strategic Business Plans and reports prepared by the PO. Until the new public companies are established, FIPAG will also be the formal employer of the employees of the former four northern water companies and support working capital requirements. Authority and responsibilities of FIPAG are outlined in a Performance Contract with the Ministry of MOPH. Private Operator (PO). FIPAG will contract technical and commercial operations of the water supply service to a PO. The PO will be a company incorporated in Mozambique. Between 70% and 85% of its equity will be owned by an International Professional Partner (IPP) and the remainder by private Mozambican interests. The working capital to be brought by the Private Operator has been set at US$3 million equivalent minimum.  Page 9 The Private Operator will enter into five contracts with FIPAG, consisting of a 15 year "Lease Contract" for Maputo, and four identical five year "Management Contracts" for the four other cities. Under the Lease Contract for Maputo, the PO will be responsible for operating and maintaining FIPAG facilities, billing customers and collecting the Customer Tariff, at its o- .n commercial risk. The PO will retain part of the Customer Tariff, the Operator Tariff, and use the difference to pay a Rental Fee to FIPAG and a Regulation Fee to the CRA. The Operator Tariff will be fixed for five years, but regularly adjusted according to a contractual cost index formula during this period. The PO will be responsible for financing its own operating equipment, inventories and working capital from the Operator Tariff. The Operator Tariff will be entirely covered by the Customer Tariff. In addition, the PO will be responsible for implementing the rehabilitation and extension program related to secondary and tertiary distribution, connections and meters, (the Delegated Works). The PO may also act as the agent of FIPAG in the procurement, implementation and acceptance of all works under the control of FIPAG that are not part of the lease and management contracts (the Non-delegated Works). Under the five year Management Contracts for the four other cities, the PO will be responsible for operating and maintaining FIPAG facilities, billing customers and collecting the Customer Tariff, on behalf of FIPAG. FIPAG will pay the PO a Management Fee, part of which will be linked to the PO's collection and operational performance. FIPAG will also finance the supply of the PO's operating equipment and inventories for these four cities. Direc,cao Nacional de Aguas (DNA) of Ministerio das Obras Puiblicas e Habitaqao (MOPH), in particular Departamento de Agua e Saneamento Urbano (DASU) and Departamento de Gestao de Recursos Hidricos (DGRH) plays a key role in the monitoring and management of water resources and supplies. The formal responsibility for planning and implementation of urban water supply projects will be transferred from DNA to FIPAG, starting with the five cities under the project. DNA's executive functions regarding domestic water resources management (mainly bulk water supply) will eventually be phased out when all the five ARAs (Administracao Regional de Aguas) are operational. However, DNA professional personnel will be used on a consultative basis by FIPAG. DNA will also support the MOPH on assessing the implementation of the Performance contract to be signed with FIPAG. The ongoing NWDP I Project Unit of DNA will remain the interface between DNA and NWDP II. It will be used to provide specialized services such as procurement and accounting to the Component C of NWDP II. Component C will be implemented and coordinated under the direction of the National Director (DN) who will be assisted by the Department Head responsible for urban water supply and sanitation (DASU). Project oversight and policy guidance: The policy guidance and project oversight will be provided by the Minister, the National Director (DN) of DNA and the FIPAG Board. Sector Regulation: Conselho de Regulacao do Abastecimento de Agua (CRA). A three member regulatory board for the water supply sector has been created as a Public Corporation. The Decree number 74/98, dated December 23, 1998, to that effect has been passed by the Cabinet. The CRA will regulate water supply operations and issue instructions for FIPAG and the Operating Company in particular with regard to consumer tariffs, quality of services and network expansion programs. New tariffs proposed by FIPAG will be only effective after approval by CRA. CRA will act also as a forum for hearing of views and complaints from customers and municipalities, and for pre-arbitration between FIPAG and the Operating Company. Further, it may be noted that institutional arrangements of the project are designed in reference to the new Decentralization Law (Decree number 72/98, dated December 23, 1998) to provide for progressively increased involvement of Local Authorities through participation in the Stakeholders Forum, and a consultative role in relation to the CRA.  Page 10 Accounting, financial reporting and auditing arrangements: (The outline of the financial management strategy is set out in Annex 7) FIPAG to IDA: FIPAG's main tasks are: (a) to manage the lease contract for Maputo and the four management contracts for the 4 cities; and (b) to oversee the investment programn (capital works) for the Maputo lease contract and the capital works plus operation and maintenance program for the 4 cities. FIPAG will administer project accounts related to Components A and B for IDA. FIPAG will be structured to provide efficient procurement, financial management, reporting and administration. Financial procedures will be developed to cover intemal financial controls and compatibility with other Government reporting requirements. For example, ideally, FIPAG will maintain accounting records in respect of 4 bank accounts: (a) Current Account in Meticais (Part 1 Account) at a commercial bank acceptable to IDA to which drawdowns from the Special Account and the Project Account (Part 2 account, see (b)); (b) Project Account in Meticais (Part 2 Account) at a commercial bank acceptable to IDA to which Counterpart Funding by Government will be deposited; (c) Special Account in US Dollars/Meticais at a commercial bank acceptable to IDA; and (d) IDA Loan Account (Washington) in US Dollars/ Meticais /SDR. As FIPAG commences operations, highly skilled accounting and financial management staff will be recruited. In the first years of the project the management of FIPAG will be assisted by a team of experts, including a Financial Manager. These experts are to be engaged in conjunction with the Private Operator commencing operations. At this juncture in the start-up stage in the establishment of FIPAG's financial management system, FIPAG will not immediately begin with the PMR-based disbursements, as discussed in the World Bank's Loan Administration Change Initiative Handbook (LACI, September '98). Thus, in the short-term, existing disbursement procedures, as outlined in the World Bank's Disbursement Handbook, will be followed (i.e. Direct Payment, Reimbursement and Special Commitment). However, the development of FIPAG's financial management system, in accordance with the Financial Management Action Plan (presented in the PIM), is expected to facilitate the introduction of PMR-based disbursements within 18 months of credit effectiveness. Further details are set out in Annex 7. Tlhe PIM, referred to above, will include Procurement and Financial Manuals that will be followed in the project implementation by FIPAG. In addition, provision has been made to include a selective and intensive training program to enhance skills, especially in areas of Bank procurement procedures, compatibility with Bank's special accounts, SOEs and disbursement procedures. Financial statements will be produced on a quarterly and annual basis for IDA and the FIPAG Board. DNA to IDA: With respect to DNA's financial management of Component C, this will be straitforward. Component C consists of mainly engineering studies and consultancies. Payments made for these expenditures will be by direct payment by IDA and/or reimbursement. DNA will use a spreadsheet to monitor these transactions and there will be quarterly reports. Accountancy practices of DNA have been found to be consistent with and acceptable to the Association. Both FIPAG and DNA will have an annual audit undertaken by external auditors acceptable to the Association. Private Operator (PO) to FIPAG: The PO will provide extensive reports to FIPAG. These are set out in TITLE IX of the draft Contract Agreements and include, but are not limited to: TITLE Frequency - | Annual Reports - Technical and Financial Within 3 months of the end of the GOM fiscal year and then annually Market Survey 3 Months prior to the submission of the Strategic Business Plan (SBP) Strategic Business Plans(SBP) After 12 months, after 4 years and after nine years Annual Detailed Investment Plans After 12 months and annually thereafter Collection and Costs Summary Tables Quarterly Audited and Working Accounts Annually  Page 1 1 Procurement and Disbursement Arrangements: (full details are set out in Annex 6) Procurement: The majority of the procurement under the project will be undertaken under the auspices of FIPAG. Some procurement mainly for studies and consultancies will be undertaken by DNA for Component C of the project. Further, the Lease and Management contracts contain selected construction works and procurement of goods that were bid as a part of the procurement process for these contracts. Consequently, the winner of this competitively bid contract (the Private Operator) will not be required to follow WB guidelines for the procurement of these items. Such items are referred to as "Delegated Works". The Private Operator will be required to procure goods, works and consultancy services for the "Non-Delegated" component of the project under World Bank guidelines. Most consultant selections will be addressed through competition among qualified short-listed firms in which the selection will be based on Quality-and-Cost-Based Selection (QCBS) by evaluating the quality of the proposal before comparing the cost of the services to be provided. For some low cost assignments (less than US$50,000), the Consultant Qualification (CQ) method may be used. Technical assistance for procurement will be in the form of hiring of individual consultants or through contracts with consulting companies. Contracts less than $100,000 each may be awarded on a sole source basis subject to adequate justification and prior review by IDA. Training (total value US$0.8m) will primarily comprise hiring of individual short term consultants and support for training programs. Disbursement: Disbursement of IDA funds will be made on the basis of incurred eligible expenditures. For FIPAG, IDA will make advance disbursements from the proceeds of the Credit by depositing funds into a Special Account to expedite program implementation. The Special Account operated by FIPAG in the amount of US$ 1,000,000 is proposed. It is also proposed that a Project Account is established by the Borrower for FIPAG, that will be funded at least 3 months in advance by the GOM. The initial deposit will be US$ 250,000, with subsequent quarterly deposits of US$ 175,000 until US$ 2,000,000 is reached. The purpose of these funds is working capital to be provided by the GOM in the first 4 years of FIPAG's operation. Additional counterpart funding for capital works and other expenses is estimated at US$ 1.58 million. For component C, which is administered by DNA, funds will be disbursed from the credit only by direct payment and/or reimbursement. It is expected that the majority of payments will be direct payments from the credit to a third parties for goods and services upon the Borrowers request. 5. Monitoring and Evaluation (M/E) For FIPAG, the responsibility for meeting the performance targets and outputs specified for the urban water supply will be the FIPAG Board and implemented by the CEO. For the DNA components of the project, this will be the day to day responsibility of DASU with the DN responsible for meeting performance targets and outputs.. The overall implementation of the project will rest with the Ministry of Public Works and Housing (MOPH). M/E will be steered by the Project's Design Summary Matrix (Annex 1), the Project Implementation Manual, and the corresponding Project Implementation Plan. MIE will be implemented through a variety of activities including: (1) the annual meeting of the Stakeholders Forum for FIPAG; (2) reports and meetings of the CRA, which represent consumer groups and beneficiaries; (3) IDA supervision missions; (4) quarterly and annual financial reports; plus the annual audit reports - Annex 7 sets out financial reporting requirements; (5) mid-term review (MTR) of project implementation jointly with IDA and other donors no later than 30 months after effectiveness; and (6) key performnance indicators at dated implementation milestones as provided in the implementation plan. FIPAG and DNA will provide IDA with progress reports on project implementation and outcomes, using the format agreed at negotiations. An Implementation Completion Report will be prepared within six months after the credit closes. GOM will contribute to the ICR with its own evaluation of the project.  Page 12 D: Project Rationale 1. Project alternatives considered and reasons for rejection: Within the overall framework of policy and institutional reform of the water sector, the GOM undertook to change the management of the water companies of the cities of Maputo, Beira, Quelimane, Nampula, and Pemba by contracting with the private sector. Within the design of the project to include private sector participation, the following project alternatives were considered: Forms of PSP (Private Sector Participation) management: To achieve improvement of the performance of the water supply companies, the possible options ranged from technical assistance, through commercialization, to the various forms of private sector management (PSP). The PSP options included management contracts with or without performance incentives, affermage/lease options, and full concessions. Evaluations of the relative effectiveness of this range of options suggested that those involving technical assistance and corporatization are unlikely to result in rapid performance improvement. A risk analysis concluded that transferring the commercial risk to a private sector operator appeared to be appropriate for Maputo, but this was not considered feasible for the other cities until the market for water supply services is better assessed, and there is an opportunity to assemble more complete information on their financial and service performance. Accordingly, a lease option was decided for Maputo, and management contracts with performance incentives for the remaining four cities. Cities to be targeted. The number of cities and their locations to be targeted under the initial PSP management option began a strategic decision making process. Options ranged from Maputo only, through to Maputo plus all 12 provincial cities. At one extreme, Maputo, with the country's largest urban water supply system, appeared to offer an attractive opportunity for private sector management and associated investment to benefit a large number of people. Confining the reform to Maputo, however, would be contrary to the Government's decentralization and investment policies, which for reasons of providing for economic growth, poverty reduction, and of encouraging wide participation of civil society in the process of devolution of municipal services, requires major reforms and investments to confer benefits more widely than in the rapidly growing Maputo area. At the other extreme, an attempt could be made to place all 13 city water systems at once under private sector management. This options was considered too risky due to difficulties of communication, coordination, regulation, and the limited capacities available to manage a project of such scale and complexity. It was decided that the cities to be included in the PSP management initiative would be Maputo, Beira, Quelimane, Nampula and Pemba, the largest urban complexes in Mozambique. These same cities participated in the Local Government Reform and Engineering Project (PROL, Cr. 2530). In these cities work, supported by the project, centered on the strengthening of local government, the upgrading of other municipal services, and the development of structure plans. Building on lessons from this project, a second urban project Municipal Development Project (MDP) is proposed. Investment priorities: This set of decisions also led to the choices of investments in urban water supply systems to be included in the sequence of two IDA projects: the NWDP I and NWDP II projects. While all five of the water supply systems will require continuing investment over many years, especially in rehabilitation of existing networks and construction of extensions into new service areas, most of this investment should be undertaken within an environment of policies and management that will assure sustainability, and the NWDP II will help assure that the process of policy reform started under NWDP I is supported and strengthened. However, some facilities in the headworks of some water supply systems are in poor condition, with significant risks of failure. It was agreed that NWDP I should include such works for Beira, Nampula and Pemba as are necessary to secure reliable supplies into the cities, and the planning and design of the larger scale works that are likely to be required for Quelimane. Design of these works is now under way under the NWDP I project. Considerable institutional strengthening of one of the executing agencies of the NWDP II project, the DNA, is ongoing under NWDP I.  Page 13 2. Major related projects financed by the Bank and/or other development agencies: (completed, ongoing and planned) Implementation Development Progress (IP) Objective (DO) Bank-financed National Water Development I (MZ- S S PE-3039) Rural Rehabilitation (Cr.2479) S S Local Government Reform and Engineering Project (PROL, Cr. 2530). S S Municipal Development Project (under preparation) Other development agencies: Netherlands, Swiss Development Cooperationomv. (SDC), Agence Frangaise de Developpment (AFD), Italy, UNDP, Denmark, European Union (EU), Portugal, SIDA, ,... CIDA, AfDB. IP/DO Ratings: HS (Highly Satisfactory), S (Satisfactory), U (Unsatisfactory), HU (Highly Unsatisfactory) 3. Lessons learned and reflected in the project design: Accountability and autonomy: T'he current institutional, regulatory and ownership framnework for the public sector water agencies mn Mozambique is not conducive to sound financial performance nor to the provision of efficient services. There is currently no accountability nor autonomy for the financial operations and no incentive structure for staff to improve efficiency of service delivery. Previous capital investments, mainly donor provided, were not linked to performance outputs. Most of the focus of these investments was on engineering issues. A lesson learned in the sector is that sustainable improvements in urban water service delivery are unlikely to be solved through project based investments alone. An investment program should always be linked to a substantial reform program involving institutional and economic (pricing) reform. Full Stakeholder Ownership: The introduction of a substantial reform program in the water sector must have full stakeholder ownership, both government and consumers. This is particularly important with the introduction of the international private sector as a key partner in the sector. A program of information and consensus building with all stakeholders is a critical part of the project design. Communitv Based Programs for Peri-Urban Areas: The reform of water utilities and the strengthening of their capacity is at the heart of the drive to extend water and sanitation services to the poor and to address mounting urban environmental problems. Further, regional evidence shows that conumunity-based programs are a necessary complement to larger central and municipality based water and sanitation systems. These types of programs play a key role in the provision of appropriate sanitation services and related hygiene education, and in meeting the water needs of peri- urban settlements by providing a framework for joint action with the central providers - the utilities. Under the proposed NWDP II, it was agreed to incorporate a peri-urban pilot project covering water supply, sanitation, and hygiene education services. While this pilot will be managed by DASU and it will call upon work being developed under the Sanitation Study as part of NWDP I, the development of the pilot will be  Page 14 closely associated with the private operator (PO) who will be managing central water services. The pilot project will draw on regional donor experience in the peri-urban sector, including that of the Bank's Regional Water Supply and Sanitation Group based in Nairobi. African Experience with Private Sector Participation (PSP): PSP in the urban water sector in Africa has established a track record. SODECI, a privately operated water company, in Cote d'Ivoire, has been in business for over 40 years and successfully provided water for over 325,000 customers located throughout the country. Guinea, Senegal, Ghana and South Africa also have privately operated water and wastewater schemes that are currently in operation. Cameroon, Congo, Tanzania and Zambia are developing private sector arrangements. A review of regional experience has recommended the need for an independent "regulator" and for the private sector operator to take as much "commnercial" risk in the transition as possible. The hierarchy of preferred options are: (1) a lease contract; (2) a performance based management contract; and (3) a fee for service management contract. African experience has also demonstrated that proper pricing has the power to manage demand, and thus the importance of designing a tariff structure to allow access of lower income groups to improved piped water services. This experience has also shown that if tariffs are kept too low, most of the poor will never be provided with adequate water services at reasonable prices. 4. Indications of borrower commitment and ownership: In August 1995, GOM approved the NWP, including the private sector management of the five water companies of Maputo, Beira, Quelimane, Nampula, and Pemba. To implement the policy, the Government established an interministerial commission, COGEA (Commission for the Management of Water Services), chaired by the National Director, DNA, to oversee: (i) the formation of the Private Sector Operation and Management Contracts, (ii) the preparation of decrees for the implementation of the institutional arrangements, and (iii) draft tariff policies. Significant progress has been made in all areas. Most recently, in April, 1999 increases and improvements to urban tariffs were approved by GOM. Previously, GOM approved the following policy and legal documents: * Legal framework for PSP (private sector participation); * Decree on creation of FIPAG (Asset and Investment Water Fund) and its statutes; * Decree on creation of CRA (Regulatory Board) and its statutes; * Decree adjusting the Investment Law to cater for PSP; * Resolution on Water Tariff Policy. Official bidding documents were issued in October 1998 for the lease contract for Maputo and the management contract for the four remaining cities. Three bids from POs for the private sector management were received in January 1999 and were evaluated. IDA has given its official no objection for the GOM to negotiate with the lowest bidder. The decision to nominate a winning bidder and its fornal announcement, a condition of negotiations, has been met. The signed and executed contract between FIPAG and the PO is a condition of effectiveness. 5. Value added of Bank support in this project: IDA has been active in the development of the water sector in Mozambique since the mid 1990s and has been a keen supporter of the GOM's National Water Policy which was promulgated in 1995. The National Water Development I Project, supported by IDA, SDC, SIDA, CIDA and NDF was designed to support the implementation of this comprehensive policy. A number of bilateral and multilateral development agencies and a number of NGOs have been providing Mozambique with assistance for many years in the sector, with European bilateral agencies dominant in urban water supply. Dutch technical assistance has been significant. The World Bank group however has added value by supporting the private sector approach to urban water supply reform as designed under NWDP II. Within the donor community,  Page 15 IDA has unrivalled experience with a range of PSP efforts in the sector and within the region. Further, the Bank Group is particularly well-placed, given its world wide experience in similar type operations, to call on its large body of knowledge and expertise to capture international lessons learned and best practices in support of the project. The project, however, will rely on a multi-donor approach, particularly the AfDB and Dutch assistance at the commencement of the Credit. Wider donor assistance, as in the first project, is expected. E: Summary Project Analysis: 1. Economic: (see Annex 4) [X] Cost-Benefit Analysis: NPV=US$ 76.49 million; ERR= 35.3% The econormic analysis is based on the evaluation of the costs and benefits of the project to the population of the five cities where the project will be implemented. The benefits identified under the project and used for the calculation of the Project's economic rate of return are: (a) cost savings for not having to buy water from private vendors; (b) cost savings for time saved by not having to fetch water; (c) cost savings for not having to boil water; and (d) consumer surplus on the increased quantity of water used. The project would improve water supply coverage and service to communities of the five cities through private sector management of the city water supply systems, and investments in the water supply infrastructure (primarily rehabilitation). The immediate impacts of the project would be safer and more reliable water supply services for about 1.1 million people living in urban and peri-urban areas. The project would also provide additional water supply to serve industrial, institutional and commercial users. Furthermore, the project would help to strengthen the institutional capacity in the sector aiming at optimizing the use of existing infrastructure and local water sources, improving planning and project design capacity, increase productivity and efficiency, and reduces water losses and waste. 2. Financial: (see Annex 5) To evaluate the financial viability of the Project, FIPAG's operations and financial statements over 15 years have been projected and analyzed. The financial model has the following base assumptions: * On-lending. The capital expenditures and other costs in the five cities will be co-financed through a combination of sources from the IDA, AfDB, and the Dutch Government. To support the commercial principles of FIPAG, IDA funds for capital works are to be onlent at 6.25% with a repayment period of 22 years including a grace period of 5 years. * Operating costs. Projections only take into account the operations under the new project and do not include revenues, operating costs, assets and liabilities of the ongoing operations. An evaluation of the utilities' assets will be undertaken in the first year of the proposed project to help ascertain the actual value of FIPAG's starting assets. * FIPAG's revenues. Are based on the fixed and variable rental fees it expects to receive from Maputo's lease operator, the connection fees and earnings before interest depreciation and tax for each of the utilities. Since the cost of the management contract has only been provided in a lump sum for all four cities, this amount is deducted from total revenues of FIPAG and not from individual utilities incomes. * Sales of water. (FIPAG's revenues) are derived from averaging high and low case estimates of water collections. The low case was taken from Halcrow/Banque Paribas' financial evaluation report, and the high case was taken from the low bidder's collection estimates. The derived base case collection  Page 16 ratios used in the financial projections are expected to rise from actual levels of 26%-33% (depending on the city ) to 75-85% in year 5 of operations. Based on the above assumptions, FIPAG is able to generate a positive income after the third year of operations. An initial cash injection of about $2.5 million will be required during the first year of operations to cover working capital requirements for new works. Additional cost estimated at about $2.0 million will be needed to fund current liabilities of the former utilities. These funds will be sourced mainly from current revenues, government cash contributions and donor support. Provided that the collections are maintained at the projected level, FIPAG is expected to start repayment of its debt to the Government in year five, and shortly after, to generate enough funds to reinvest in new assets if required. FIPAG could show robust enough future cash flow projections for it to raise funds directly on the market. Annex five provides detailed financial statements for FIPAG during the first fifteen years of operations. 3. Technical: Capital works program: Preparations included a study entitled "Provincial Towns Water Sector Study", GOM, August 1995, fimded by the Netherlands and IDA, which assessed the condition of all water supply and sewerage assets, human resources capacities, and the available financial information, and proposed a capital works program to remedy deficiencies in the water supply and sanitation infrastructure. The needs for, and priorities, timing and cost estimates of works to remedy the major deficiencies were also identified by the study. The proposed works program was checked and updated by two independent engineering consultancies. The provisions made in the project capital works program are generally consistent with and are sufficient to cover the independent estimates provided in the bids for the private sector management contracts. WZater resources: * Water for Maputo comes from the Pequenos Libombos reservoir on the Umbeluzi River, which will be adequate for the period of the project but may become insufficient within 7 to 10 years. Sufficient additional resources are available from other rivers in the vicinity, including the Incomati River. A possible transfer scheme, not requiring a dam was identified in the early 1 990s to fulfil this need. The project accordingly will support feasibility and design studies to determine and develop the optimum scheme for providing additional water resources. * Beira receives its supplies form the Pungue River. Quantities are adequate, but supplies have been interrupted during dry seasons due to saline intrusion. A re-sited pumping station is being designed, with support from NWDP-I, to overcome this problem, and funds are provided for its construction under this project. Exploration work is under way with KfW support to identify adequate groundwater resources for Quelimane. If successful, this would enable a less costly form of water treatment (saving both operational costs and the capital costs of rehabilitation of the treatment works) and would also avoid the costs of developing additional surface water supplies, which exist but would require surface water regulation works. Adequate water resources are available for the Nampula and Pemba, but a study is programmed to identify the next steps of expansion of water resources for Pemba. Meadworks: For Maputo and Nampula, no additional headworks are required during the project. For Beira, headworks capacity will be adequate once the new pipeline electrical system is completed (funds available under NWDP-I) and tank capacity is increased. Quelimane and Pemba suffer from supply outages due to pipeline bursts for Quelimnane and lack of access due to access road flooding in Pemba. The replacement of the pipeline in Quilemane is included in the project.  Page 17 4. Institutional: By developing the NWP and using it effectively to support implementation of the first steps of tariff reform and private sector management of the urban water sector, and initiating a reform path for the RWSS and WRM subsectors, MOPH and DNA have demonstrated strong abilities to formulate a reform-oriented policy agenda. However, in spite of recent improvements, sector agencies are still weak in technical skills in their key specialties, and in financial and human resources management capacities. This is one of the major reasons for the selection of private sector management as the strategy for the five city water supply systems. Additional measures included in the project to redress these weaknesses include incorporation of the procurement function in the PSP contracts, support for human resources development activities in FIPAG and the CRA, and for the foreign costs of training of Mozambican water company personnel. The strategies for funding of the FIPAG and CRA include levies which have first call on the Operator Tariff for the Maputo Water Supply System, and development of their capacities using technical assistance and consultancies initially. The pace of the development of their capacities is matched to the expected timing of the requirements for the calls upon the various skills and capacities required. This indicates a rapid build- up of capacities in FIPAG to full capacity during year one, but for CRA the build up will be paced to reach full capacity in year two. 5. Social: Sustainability and Beneficiary Assessments. Experience in Mozambique and elsewhere has demonstrated that beneficiary preferences (type, location, and management of water sources), and existing informal vendors influence the sustainability of new water investments. Determining investments based on consultation with consumers and assessment of the incentives of existing vendors, helps to increase residents' sense of ownership of the assets, willingness to pay the cost or contribute time towards operations and maintenance and to refrain from vandalism. Preparations for NWDP II therefore included beneficiary assessments (BAs) of both urban and peri-urban communities of the five cities, to gain an understanding of their priorities for water improvements and willingness to pay for those priorities. These assessments also touched upon the impact that the current, and future, tariff structure would have on poorer peri-urban residents. In general, the BAs concluded that if the proposed project results in greater volumes of water delivered as planned, this will reduce informal market water prices which the poor are most likely to pay. At the same time, the proposed tariff increases typically fell well below the current informal market prices and therefore would only cause undue hardship if there were no improvements in service level and informal vendors therefore increased prices. The BAs also demonstrated that the poor were most likely to suffer higher prices and lower service levels as a result of the current low tariffs and poor management. Taking account of social issues during implementation. Implementation of the proposed project will also include BAs, to identify demand for specific services in specific neighborhoods, to characterize the social context of communities and stakeholder groups, to assist in the design of consultation mechanisms to ensure that improvements correspond to consumer demand, and that decision-making by the local water company and by FIPAG and CRA is well structured and fully informed. BAs and consultations so far have highlighted the diversity of communities in terms of strength or weakness of social networks and community organizations, income levels, and cultural preferences for organization of water management, even within peri-urban areas, and therefore the need for a demand-driven, menu-based approach to the provision of water supply investments and management schemes. The BAs have also consistently showed a high level of willingness to pay for improved service levels and better management from the water companies, even among low-income groups, largely because of the comparatively high cost of informal market alternatives.  Page 18 6. Environmental assessment: Environmental Category [ ] A [X] B [ ] C An environmental assessment (EA), covering the NWDP I and NWDP II Projects jointly was completed in July 1996. Following public display, discussion and comment in the five cities, relevant comments and updated information were incorporated in a second edition dated August 1997. No adverse comments were received about the components of this project. A review and update of the EA was undertaken in earlyl999, aimed at ensuring that issues and further developments during subsequent preparation which may have environmental significance are fully taken into account and responded to. The EA contains an Environment Management Plan (EMP) which provides guidance on the main actions to be taken to ensure good environmental performance of the project. Resettlement. While no specific cases of resettlement as a result of works in this project were identified during project preparation, the project provides an allocation of US$500,000 for any possible resettlement. Drainage and sanitation. During preparation of the EA, the beneficiary assessments and other consultations and studies, the most significant potential environmental issue raised was the effect of improved water supplies generating increased wastewater in the cities. This will be managed through a combination of measures outlined in Annex 2. Management and monitoring. DNA will establish a full time Environmental Assessment Advisor, with the role of advising the ARAs, FIPAG and the Operator/manager on the implementation and monitoring of the EMP, and establishing an ongoing reporting program and data base. The project provides support for the provision, as technical assistance, Environment Manager within FIPAG for the first two years of the project, to supervise the Operator/Manager's implementation of and compliance with the EMP. 7. Participatory approach: Private sector management. Participation in decision-making on the desirability of, and optional forms for, private sector management of urban water supply systems included: (i) workshops with water company managers and financial personnel, municipal mayors and administrative chiefs; (ii) public meetings in five cities in association with the Environment Assessment; (iii) parliamentary debates, with accompanying media exposure; and (iv) consultation with trade union representatives. Existing and fture consumers. The direct beneficiaries of the proposed project, existing and potential new customers of the formal water supply systems (domestic, commercial and industrial), have been consulted through participatory discussion groups and quantitative interviews through the BAs on their preferences for service improvements, including management improvements and on their perspective on privatizing management of the water companies. In addition, consumers' participation will be essential to the water companies' future success in devising solutions to eradicate problems such as vandalism of public water points and meters, the proliferation of illegal connections, and poor payment levels. Therefore, bidders for the lease and management contracts were required to submit their customer consultation strategies (methods, framework, procedures). A potential resource for such work includes over 80 municipal, water company, public health, and NGO staff in the cities concerned who have been trained on how to undertake participatory discussion groups during the BA process. Peri-urban areas. In peri-urban areas in particular, where there are a wider variety of possible service levels (house connection, yard tap, standpost) and water sources (resale from yard tap, yard wells in addition to direct connections), it will be important that consumers participate in decisions on service level and management arrangements for public water points. Beneficiary assessments have shown the variety of management arrangements that currently exists, as well as numerous suggestions for improvement which vary depending on the locale, community and specific cultural norms. For example, in inner peri-urban areas of Beira where high crime and low community cohesion exist, customers have devised their own strategy to deal with the non-functioning of public standposts; they have invented rotating payment schemes among 2 or 3 families which pool resources for a semi-private yard tap. Such schemes were not in place in outer peri-urban neighborhoods of the same city where more cohesive communities lived and standposts  Page 19 functioned better. A peri-urban pilot project, as discussed in section, D.3 on lessons learned, is included in the project. Consultaiion during implementation. During implementation, the Operator/manager will be obliged to undertake surveys as part of its preparation of the business plans for each water company, and in its planning of system enhancements and extensions. These surveys would be designed to demonstrate the level of consumer demand and consumer preferences (location, management, type) of specific investments planned. Monitoring whether the Operator/manager is consulting consumers, and using proper methods to do so, both in planning investments and on other issues which concern them, would be the responsibility FIPAG as the primary manager of the contracts. In cases where conflicts or problems had developed between the private operator and consumers, CRA would play a role in pre-arbitration. These roles are defined in the formal decrees setting up FIPAG and the CRA. F: Sustainability and Risks 1. Sustainability: The degree of Project sustainability is mainly dependent on: * how successful the new institutional arrangements will be in capturing the efficiencies gained as a result of the lease and management contracts providing a private sector-type environment of performance incentives, and in passing the benefits on to the beneficiaries, and * ensuring adequate on-going maintenance of the works completed under the Project. T1he fee structure in the Maputo Lease contract is such that the financial gains resulting from operating and collection efficiency gains, beyond the Operator's tariff, are paid to FIPAG in the form of a variable fee. It is estimated that within 36 months after the project has become effective, tariff level will be high enough and the collection rate improved enough to cover all costs of FIPAG before interest and taxes. Provision is made for the management contracts for the other four cities to be re-bid after the initial 5 years, to enable the capturing of the efficiency gains made in the first 5 years. Options include progressing towards a lease contract for Beira and possibly Nampula. These will be reviewed at mid-terrn. For Maputo, more than sufficient cash flow will be generated to adequately provide for on-going maintenance. Further, provisions made under the project capacitate FIPAG to generate enough cash flow from the Maputo operation, and later in the project Beira, to cover routine maintenance and to provide for enough depreciation to cover replacement of the assets over the long run. To ensure maximum success in collection, the tariff increases have been projected taking into account the findings of the beneficiary assessment about the customers' willingness and ability to pay for safe water.  Page 20 2. Critical Risks: (reflecting assumptions in the fourth column of Annex 1) IFrom Outputs to Objective M.aacroeconomic and Political instability Mds Lack of political will to complete implementation of LwPeatinincludes full evaluation of the benefits of private participation in private sector management (PSM) PSP and dialogue on the proposal with stakeholders in of water companies, with good market based entry. Mozambique. Bidding for the PSP contracts was competitive and evaluation and award will be based on World Bank procurement guidelines Backtracking on tariff policy for water Substantial Continued policy dialogue between the Bank and GOM. Once a PSP contract for the water supply systems of the five cities is in place, contractual penalties and other adverse effects on customers and governments tend to discourage tariff backtracking. GOM's well structured internal dialogue on tariffs, which has built a succession of decisions on the NWP, has increased commitment. Budget allocations lower than agreed levels, and High The project provides for an initial provision of disbursements to DNA/ FIPAG from MPF are delayed or working capital from GOM to the four northern cities, lower than the approved budget. and some subsidies until the collections exceed costs. At the planned tariff levels, rental payments from the lease contract for Maputo will be sufficient to generate most counterpart funds after year 2. Under NWDP-I, the budgeting and financial management capacities of DNA are being significantly improved. Inadequate management capacity on the part of DNA to Low Appointment of managers for finance and HRD from implement the project successfully. NWDP-I , as well as NWDP-I extensive support for HRD and procurement training. Inadequate management capacity due to the creation of a Substantial Strong TA incorporated in design of implementation; new management institution, namely FIPAG. some support to be available from DNA. Lessons learned from other African experiences. Regulatory risk: (i) CRA will be a new institution with High (i) TA support to CRA; (ii) project and contractual limited initial capacity, (ii) there is a significant risk that incentives are provided to encourage full payment of government institutions may continue to avoid payment of accounts by government institutions; (iii) government water accounts; (iii) regulatory arrangements may be has endorsed a strong national tariff policy which insufficient to ensure the maintenance of tariffs at builds in automatic escalations due to inflation and appropriate levels. other factors. From Components to Outputs Water Supply Works: Lack of adequate sewerage and Modest Rehabilitation of mains and connections will reduce drainage to deal with increased wastewater generated as a leakage. Drainage and sanitation in Beira and result of rehabilitation and extension of water supply Quelimane to be included in IDA Urban Environment system. project now in preparation. In Maputo and Nampula drainage and sanitation to be designed and implemented as part of this project concurrently with water supply extensions. House connections to be strictly limnited where sewerage not available. Overall Risk Rating IH_igh l Risk Rating - H (High Risk), S (Substantial Risk), M (Modest Risk), N (Negligible or Low Risk)  Page 21 3. Possible Controversial Aspects: Private Sector Participation: The Government's program of privatization has become controversial in Mozambique. This has increased the scrutiny which the public is giving to the proposal for private sector management of the water companies, and the sensitivity of the public to concern which may be expressed about it. The GOM has emphasized publicly that the water sector proposals are receiving very thorough and careful preparation, and that the proposal differs from most previous privatizations in Mozambique in that (1) the operator(s) will be subject to strong regulatory oversight; (2) the Government will retain ownership of the assets, and the Operators will be contracted managers; and (3) the due to the incorporation of construction work into the contracts, and to the fact that the water companies are not heavily over-staffed, loss ofjobs will not be a problem in this initiative. GOM is carrying out a public information campaign in all five cities. Public exposure of the components of this project during the Environmental Assessment process, did not bring to light serious adverse concem on the part of the public, although some were concemed about the influx of foreigners that Private Sector Management would bring, and the likely increase in tariffs. A public education and consultation prograrn for the five cities is being conducted. Controversy, if any, other than about Private Sector Operators, may be generated by (1) stakeholders within the public sector who may see themselves adversely affected by the reforms proposed, and (2) illegal users of water, as water resources management and urban water supply management improve and prevent or penalize illegal use. Lack of Comprehensive Strategies for Wastewater and Sanitation Managaement within the proiect Immediate environmental impact strategies have been identified within the project to mitigate possible environmental concems with regard to increased water supply volumes. - mainly the provision of adequate drainage and rehabilitation of certain sewage facilities - on a site specific basis. The main thrust of the GOM and IDA's strategy to deal comprehensively with urban sanitation, wastewater and sewerage problems is housed in the follow-on Municipal Development Project. The main reason for this split in responsibilities is two fold. Firstly is the lack of institutional capacity at the municipal level; and second, and some what related, is the comprehensive approach to capacity building at the municipal level that the Urban Project intends to take . The building up of capacity in a "piecemeal" approach for certain urban services, in this case sanitation and drainage may not be as effective or efficient as the more inclusive approach that is currently in preparation. G: Main Loan Conditions 1. Conditions of Effectiveness * CEO of FIPAG appointed, CEO FIPAG to have qualifications acceptable to IDA. * Contrato Programa (between the Government and the FIPAG), acceptable to IDA, specifying FIPAG's performance targets and obligations for reporting, has been executed. * Subsidiary Loan Agreement (between the Government and the FIPAG), acceptable to IDA, specifying on-lending conditions from the Government to FIPAG has been executed. * FIPAG has entered into the Lease Contract and the Management Contracts with the winning bidder for the management of city water supply systems of Maputo, Beira, Quelimane, Nampula and Pemba. * A completed Project Implementation Manual satisfactory to IDA. * Accounting services available in DNA (for Component C) and appropriate start up financial arrangements for accounting services available for FIPAG. * AFDB loan agreement and Dutch Bi-lateral Grant agreement have been executed and are ready to be declared effective. * A legal opinion satisfactory to the Association, confirming that: (i) The Development Credit Agreement has been duly authorized or ratified by the Government of Mozambique and is legally binding upon the GOM in accordance with its terms; (ii) The Project Agreement has been duly authorized or ratified by FIPAG, and is legally binding upon FIPAG in accordance with its terms; and (iii) The Subsidiary Loan has been duly authorized or ratified by FIPAG, and is legally binding upon FIPAG and the Government in accordance with its terms.  Page 22 2. Financial Covenants * the DNA and FIPAG will maintain, in accordance with sound accounting practices, records and accounts reflecting the basic information for the preparation of the statement of expenditures. * F][PAG will collect detailed information on the utilities' operating costs, production volumes, technical and commercial losses and collection ratios. This information will be part of the quarterly reports submitted to IDA under the requirements of the Bank's LACI system. * the GOM will ensure that the tariffs will reflect the principles of full cost recovery and be sufficient to cover operating expenses, depreciation and cost of capital, and tariff levels will be reviewed during the Mid Term Review to assess their ability to recover all costs. * the Government will ensure that measures are taken to improve collection rates such that enough revenues are collected to produce a positive rate of return before debt service requirements. * within one year after effectiveness the GOM will settle all its outstanding arrears to the utilities covered under the Project. * no later than 12 months after the effective date of the project, 100% of all outstanding receivables of all utilities (except Maputo) are settled. - F.IPAG will not incur any additional debt unless a reasonable forecast of the revenues and expenditures of FIPAG shows that the projected net revenues of FIPAG for each fiscal year during the term of the debt to be incurred shall be at least 1.5 times the projected debt service requirements. 3. Dated Covenants