Document of The World Bank

Public Disclosure Authorized FOR OFFICIAL USE ONLY

Report No: 35454-BR

PROJECT APPRAISAL DOCUMENT

ON A

PROPOSED LOAN

Public Disclosure Authorized IN THE AMOUNT OF US$35.9 MILLION

TO THE

STATE OF RIO GRANDE DO NORTE, BRAZIL

WITH THE GUARANTEE OF

THE FEDERATIVE REPUBLIC OF BRAZIL

FOR A

Public Disclosure Authorized RIO GRANDE DO NORTE INTEGRATED WATER RESOURCES MANAGEMENT PROJECT

August 13,2007

Brazil Country Management Unit Sustainable Development Department Latin America and the Caribbean Region

Public Disclosure Authorized 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

(Exchange Rate Effective July 2007)

Currency Unit = Brazilian Real Br$1.86 = US$1

FISCAL YEAR January 1 - December 31

ABBREVIATIONS AND ACRONYMS ADESE Serid6 Sustainable Development Agency (a civil society agency) ANA National Water Agency APL Adaptable Program Loan BP Bank Procedures CAERN RGN State Water and Sewage Company CAS Country Assistance Strategy CQ Consultant Qualifications criteria DNOCS National Department of Drought-Related Works EA Environmental Assessment EMATER RGN State Institute for Technical Assistance and Extension Services EMP Environmental Management Plan EMPARN State Company for Agricultural Research of RGN EPA Environmental Protection Area GDP Gross Domestic Product GOB Government of Brazil GoRN Government of Rio Grande do Norte IBRD International Bank for Reconstruction and Development ICB International Competitive Bidding IDA International Development Association IDB Inter-American Development Bank IDEMA RGN State Environmental and Economic Development Institute (within SEPLAN) IGAFW RGN State Institute for Water Management ISDS Integrated Safeguards Data Sheet IWRM Integrated Water Resources Management Kfw German Bank for Development M&E Monitoring and Evaluation MIS Management Information System NE Brazil’s Northeast NGOs Nongovernmental Organizations O&M Operation and Maintenance OD Operational Directive OP Operational Policy OPN Operational Policy Note PAPP Former name of the Rural Alleviation Projects financed by the Bank in FOR OFFICIAL USE ONLY Brazil PCN Project Concept Note PCPR Rural Project Alleviation Projects (financed by the Bank in the Northeast of Brazil) PDS Sustainable Development Plan PERH State Water Resources Plan (Plano Estadual de Recursos Hidricos) PID Project Information Document PMSS 11 Water Sector Modernization I1Project (Projeto de Modernizag6o do Setor Saneamento) PMU Project Management Unit POA Annual Operations Plan PROAGUA Federal Water Resources Management Project PY Project Year QBS Quality-Based Selection QCBS Quality- and Cost-Based Selection RGN State of Rio Grande do Norte RPRP Rural Development Projects RVP Regional Vice Presidency SAPE State Secretariat for Agriculture, Livestock and Fisheries SBD Standard Bidding Documents SEA Strategic Environmental Assessment SEMARH Secretariat of Environment and Water Resources SEPLAN Secretariat for Planning and Finance SEPLANRN State Secretariat for Planning and Finance SERHID Former State Secretariat of Water Resources SIAF Integrated Financial Administration System (Sistema Zntegrado para AdministrapTo Financeira) SIGMA Environmental Management Information System (Sistema de Informag6es Gerenciais do Meio Ambiente) SIL Specific Investment Loan STN National Treasury Secretariat TA Technical Assistance WRM Water Resources Management WUA Water Users Association

Vice President: Pamela Cox Country ManagerDirector: John Briscoe Sector Management Director: Laura Tuck Acting Sector Manager: Juan Carlos Belausteguigoitia Task Team Leader: Alvaro Soler

This document has a restricted distribution and may be used by recipients only in the performance of their official duties. Its contents may not be otherwise disclosed without World Bank authorization,

BRAZIL Rio Grande do Norte Integrated Water Resources Management Project

CONTENTS Page A .STRATEGIC CONTEXT AND RATIONALE ...... 1 1. Country and Sector Issues ...... 1 2 . Key State Development Issues...... 2 3 . Rationale for Bank Involvement...... 6 4 . Higher-Level Objectives to which the Project Contributes ...... 7 B. PROJECT DESCRIPTION ...... 8 1. Lending Instrument ...... 8 2 . Project Development Objective and Key Indicators...... 8 3 . Project Components ...... 10 4 . Lessons Learned and Reflected in the Project Design ...... 12 5 . Alternatives Considered and Reasons for Rejection...... 13 C . IMPLEMENTATION ...... 14 1. Partnership Arrangements.,, ...... 14 2 . Institutional and Implementation Arrangements ...... 14 3 . Monitoring and Evaluation of Outcomes/results ...... 15 4 . Sustainability and Replicability ...... 16 5 . Critical Risks and Possible Controversial Aspects ...... 16 6 . Loadcredit Conditions and Covenants ...... 17 D. APPRAISAL SUMMARY ...... 18 1. Economic and Financial Analyses ...... 18 2 . Technical...... 19 3 . Fiduciary ...... 20 4 . Social ...... 20 5 . Environment...... 21 6 . Safeguard Policies...... 22 7 . Policy Exceptions and Readiness ...... 23

Annex 1: Country and Sector Background ...... 24 Annex 2: Major Related Projects Financed by the Bank and/or other Agencies ..... 35 Annex 3: Results Framework and Monitoring ...... 36 Annex 4: Detailed Project Description...... 40 Annex 5: Project Costs ...... 50 Annex 6: Implementation Arrangements ...... 51 Annex 6. Appendix 1...... 57 Annex 7: Financial Management and Disbursement Arrangements ...... 59 Annex 8: Procurement Arrangements ...... 65 Annex 8. Attachment 1...... 69 Annex 9: Economic and Financial Analysis ...... 71 Annex 10: Safeguard Policy Issues...... 77 Annex 11: Project Preparation and Supervision ...... 81 Annex 12: Documents in the Project File ...... 83 Annex 13: Statement of Loans and Credits ...... 84 Annex 14: Country at a Glance ...... 88 Annex 15: Summary of the Social Assessment ...... 91 Annex 16: Summary of the Environmental Assessment ...... 96 Annex 17: Fiscal Analysis of NoGrande do Norte State Government ...... 108 Annex 18: Map...... 128 BRAZIL

NOGRANDE DO NORTE INTEGRATED WATER RESOURCES MANAGEMENT

PROJECT APPRAISAL DOCUMENT

LATIN AMERICA AND CARIBBEAN

LCSEN

Date: August 13,2007 Team Leader: Alvaro J. Soler Country Director: John Briscoe Sectors: Irrigation and drainage Sector ManagedDirector: Laura Tuck (70%);General water, sanitation and flood protection sector (30%) Themes: Water resource management (P);Other environment and natural resources management (S);Rural services and infrastructure (S) Project ID: PO89929 Environmental screening category: Partial Assessment

LendingY Instrument: SDecific Investment Loan

[XI Loan [ ]Credit [ ]Grant [ ]Guarantee [ ]Other:

For Loans/Credits/Others: Total Bank financing (US$m.): 35.90 Proposed terms: Fixed Spread Loan payable in 17 years including 4 years of grace and principal repayments linked to commitments.

Borrower: State of Rio Grande do Norte - Brazil

Responsible Agency: State Secretariat of Environment and Water Resources - SEMARH Rua Dona Maria Camara, 1884 - Capim Macio Natal, RN Brazil 59082-430 Tel: (55-84) 3232-2410 Fax: (55-84) 3232-2411 www. semarh.m. gov.br Project implementation period: Start December 1,2007 End: May 30,2012 Expected effectiveness date: January 15, 2008 Expected closing date: November 30, 2012 Does the project depart from the CAS in content or other significant respects? [ ]Yes [XINO Re$ PAD A.3 Does the project require any exceptions from Bank policies? Re$ PAD D. 7 [ ]Yes [XINO Have these been approved by Bank management? [ ]Yes [ IN0 Is approval for any policy exception sought from the Board? [ ]Yes [XINO Does the project include any critical risks rated “substantial” or “high”? [ ]Yes [XINO Ref:.I PAD C.5 Does the project meet the Regional criteria for readiness for implementation? [XIYes [ ]No Ref:.I PAD D. 7 Project development objective Re$ PAD B.2, TechnicalAnnex 3 The project development objective is to promote economic, social and environmentally sustainable development through the implementation of an integrated water resources management system.

Additionally, the project will support the preparation of a water sector strategy and long-term investment program that will pursue an adequate supply and an efficient use ofwater resources, key elements to support the State’s overall sustainable development and reduce the vulnerability ofthe rural poor to cyclical droughts. Regarding essential infrastructure, the project will focus mostly on water supply in poor rural areas, including rehabilitation and expansion ofboth drinking water supply networks and pilot interventions to improve irrigation schemes.

The results ofthe project’s interventions will be measured by the contributions made to three key areas: (i)the development of an improved legal framework and strengthened institutional setup for efficient WRM by the state; (ii)the development and satisfactory implementation of planning, information and operation instruments for WRM; and (iii)the promotion ofan optimized water resources supply through the rational use ofnatural resources and the expansion and improvement ofthe coverage ofthe water supply systems.

Project description [one-sentence summary of each component] Re$ PAD B.3.a, Technical Annex 4 1. Institutional Development and Water Resources Management Instruments Component: improve the State’s water resources management capabilities and develop adequate water resources management instruments, through: Improvement of the Legal and Institutional Framework; Water Sector Planing, Information, and Operational Instruments; and Studies and Special Projects. 2. Natural Resources Conservation and Protection Component: support the preservation of water quality; improve efficiency in water use; and generate water-saving technologies. 3. Water Infrastructure Component: provide technical and financial assistance to improve water availability, through: Rehabilitation and Maintenance of Existing Water Infrastructure; New Water Infrastructure; Water Supply Systems for Small Rural Communities; and Pilot Subprojects for the Rehabilitation and Modernization of Small Farmer Irrigation Schemes. 4. Project Management Component: responsible for overall project execution and M&E system, as well as the preparation ofthe Phase I1Bank Loan.

Which safeguard policies are triggered, if any? Re$ PAD 0.6, TechnicalAnnex 10 Environmental Assessment (OP 4.0 1) Natural Habitats (OP 4.04) Pest Management (OP 4.09) Safety of Dams (OP 4.37)

Significant, non-standard conditions, if any, for: Re$ PAD C. 7 Board presentation:

Loadcredit effectiveness :

Covenants applicable to project implementation:

A. STRATEGIC CONTEXT AND RATIONALE

1. COUNTRY AND SECTOR ISSUES

1. Economic Management. Brazil’s economic management remains strong. The country continues to operate the trio of fiscal balance, inflation targeting, and limited exchange rate intervention that it has been utilizing since January 1999 when the Real was allowed to float. There is no sign that Brazil’s commitment to this strategy will decrease.

2. The government continues to exceed fiscal targets (it has maintained an average primary surplus level of 4.47 percent’ of GDP since 2003, well above the 4.25 percent target) and reduce debt (the debt-to-GDP ratio fell below 50 percent in December 2006, down from 57 percent in 2003).

3. Likewise, monetary policy has succeeded in containing inflation (from 12.5 percent in 2002 to 3.1 percent in 2006), which has accordingly lowered real interest rates (from a peak of 19.75 percent in mid-2005 to 12.75 percent in March 2007) and encouraged investment.

4. Prudent fiscal and monetary measures have led to strong external performance by boosting exports (they have more than doubled between 2002 and 2006 to US$140 billion), the trade balance (from US$13 billion in 2002 to US$46 billion in 2006), and international reserves (totaling US$11 1 billion, an historic level, as of April 2007).

5. Despite these improvements, economic growth continues to be modest. Although revised national accounts data have increased GDP levels and growth rates for recent years (the 2006 growth rate was adjusted to 3.7 percent, up from 2.9 percent), the growth forecast for 2007-2008, based on the continuation of monetary easing and a favorable international economic climate, is expected to remain between 3.5 and 4 percent.

6. Income distribution and poverty reduction have steadily improved since 2004. The most recent National Household Survey showed a reduction in income inequality; the Gini index fell from 0.59 in 2002 to 0.57 in 2005 (the latest available). The poverty rate, which had risen to 34.1 percent in 2003, dropped to 29.1 percent in 2005 mainly due to higher economic growth in the poorest regions, well-targeted conditional cash transfer programs, as well as increases in labor income and a decline in unemployment.

7. Water Resources. There is more fresh water available per capita in Brazil than in other upper-middle income countries, but it is extremely unevenly distributed. Brazil has 5,700 km3of water availability, which is 12 percent of the world’s total. About 73 percent of Brazil’s fresh water is concentrated in the Amazon River Basin, while the semi-arid Northeast (NE), with 35 percent of the population, has only 3 percent of the country’s water resources. In the industrialized South and Southeast, which houses nearly 60 percent of the population, water pollution and availability problems are severe. Almost

All economic figures used in this section are from the International Monetary Fund.

1 all rivers crossing urban areas are highly polluted, affecting the health of poor populations, causing environmental damage, and increasing the cost of water treatment for downstream users.

8. In 1997, the National Water Resources Management System (SINGERH) was created with the main objectives of coordinating water management at the national level and developing a National Water Resources Policy. In addition, in 2000 the National Water Agency (ANA) was created and is responsible for the implementation of this policy as it relates to water resources management.

9. Since 1997, major achievements in the water sector have included: (i) development andor implementation of legal and institutional frameworks in the states to promote efficient water resources management; (ii)preparation of many important watershed plans, operational plans, feasibility studies, and engineering designs; and (iii) creation andor strengthening of several water users associations, water basin committees and national and state water resources councils, and water resources information systems.

10. Although good progress has been made, there is still a long way to go to achieve sustainable and efficient water resources management (WRM). Problems with water supply, sewage, and solid waste collection services affect many smaller towns with scant financial and managerial capacity to address them. Although overall access of Brazil’s urban households to water supply services is high at about 90 percent, coverage varies considerably from region to region and state to state; quality differs dramatically from one part of a city to another. Some 56 percent of urban households are connected to a sewage system and 16 percent have septic systems, but coverage is more uneven for sanitation than for water supply. Little of the collected wastewater is treated, which results in health hazards and environmental degradation, especially in urban areas. Water supply and sanitation coverage is highest in the relatively affluent South and Southeast and lowest in the poorer North and NE. A large part of the un-served population lives in peri-urban areas, slums (fuvelas), and smaller towns with mainly lower-income populations.

2. KEYSTATE DEVELOPMENTISSUES

11. The State of Rio Grande do Norte (RGN) has an estimated population of about 2.9 million. In recent years, the state’s economic structure has experienced a gradual reduction in the relative importance of the agricultural sector, although it remains the state’s largest consumer of water, with a parallel increase in the economic importance of the industrial sector, including agro-industries, tourism, and services. This has been accompanied by rapid urbanization with 75 percent of the state’s inhabitants now living in urban centers and another 25 percent, primarily poor farmers, residing in rural areas mostly in the South where serious droughts jeopardize their livelihoods.

12. The State of RGN has shown satisfactory economic performance with average GDP growth rates fluctuating between 5 percent and 7 percent per annum over the last 15

2 years or sow2Despite this, over 40 percent of the population lives in extreme poverty, illiteracy is at 30 percent, and infant mortality is above the national average. In relative terms, poverty is far worse in the southern region of Serid6, which is home to only about 10 percent of the population, but whose development potential is severely constrained by poor soils, an inadequate supply of water resources, poor management of the natural resource base of small farmers, and absence of technical assistance to promote sustainable development alternatives.

13. Water Resources. The State of RGN has one of the largest water resources deficits of all Brazilian states. It has a high risk of drought occurrence, with large intra- and inter- annual rainfall variations, high evapotranspiration, few perennial rivers, and serious water storage and management problems. With average annual rainfall of about 700 mm and annual per capita water availability of less than 1,200 m3,RGN fits the UN classification of being in a stress situation. In addition, there is a lack of basic information on the water resources sector, which is essential for making investment-related decisions.

14. Expansion of the tourist industry, with new developments close to Natal and along the adjacent coastal area, is creating additional demand for water and placing further pressure on groundwater resources, which are becoming an increasingly important source of water for human consumption and irrigation. In addition, economic growth and urban expansion are increasing the pollution of water resources, especially groundwater resources, largely as a result of sewage being discharged directly onto the land or into water courses. Sewage pollution is most severe in cities such as Natal, Mossorb, and Caic6 where only 27 percent, 17 percent, and 7 percent, respectively, of households are connected to sewage systems.

15. The irrigation sector also plays a large role in economic growth, but it too presents serious water use inefficiency. The sector is responsible for the direct creation of over 100,000 jobs and generates some US$50-60 million in annual exports, mostly from large commercial farmers. But efficiency in public irrigation schemes, where smallholder irrigation takes place, is generally low as is security of water availability.

16. In addition, the state’s groundwater resources, consisting primarily of three large aquifers, are being exploited without an adequate assessment of their potential and no clear strategy for their use. This has already resulted in overexploitation of some aquifers with the obvious risk of future depletion of reserves.

17. Cyclical droughts, which have occurred during ten of the last thirty years, are another threat to the state’s sustainable development. The table below shows the percentage increase in water deficit under normal climatic conditions and during droughts in the nine watersheds in RGN that are experiencing a deficit. Such significant variations make improved WRM a necessity in RGN, especially given its economic dependence on water resources.

For further information on the fiscal situation of the State, see Annex 18.

3 Water Deficit by Watershed

~ Deficit ( '000m3/year) % Watershed 1 Normal I Drought /-Change I Apodi-Mossor6 ! 51,9821 60,608 16.6:

18. State Efforts. To date RGN has shown great commitment to improving WRM and water infrastructure by heavily investing in the sector for more than a decade. In addition to State Secretariat of Environment and Water Resources (SEMARH), the water management system is composed of the RGN State Water and Sewage Company (CAERN) and the RGN State Institute for Water Management (IGARN), which are hierarchically under the former State Secretariat of Water Resources (SERHID-now SEMARH), but each has its own budget and enjoys financial and administrative autonomy, CAERN is responsible for operation and maintenance of water supply and sewage systems in RGN, and IGARN was established for bulk water management. Under the current administration, SEMARH is responsible not only for water resources management but also for environmental issues and protection. In this context, the Institute for Environmental Protection (IDEMA) has also been located hierarchically under SEMARH. These reforms to modernize the sector's institutional framework o have been accompanied by significant investments in infrastructure necessary to enhance water supply, especially with the support of the Bank-financed Federal Water Resources Management Project (PROAGUA) and state resources. Indeed, efforts have been primarily focused on infrastructure, sometimes neglecting management instruments as well as the consolidation of the system as a whole. Thus, further work is necessary to improve the management framework and to consolidate past efforts. The State of RGN is seeking additional long-term financing to continue the implementation of its water resources policies and programs to improve WRM and mitigate the effects of periodic droughts through a continuous flow of resources to the sector over the next decade. To this end, the water sector has been given precedence over other sectors in the economy for the allocation of potential external resources.

19. Some of the state's main efforts, as well as some of the work that needs to be done to consolidate them, are listed below. The State of RGN:

(a) has promoted several water infrastructure works such as the Bulk Water Transmission Pipelines System Program (Program das Adutoras);

4 (b) created the State Secretariat of Water Resources (SERHID) in the late 1990s; SERHID has also recently been given environmental protection responsibilities and was transformed into SEMARH, but is not yet fully staffed;

(c) established IGARN for bulk water management in the early 2000s; IGARN’s legal rules and regulations are not yet in place and thus it cannot hire staff or operate;

(d) has prepared the State Program for Sustainable Development and Drought Management through which it has already invested US$202 million in the construction of dams, bulk water transmission pipelines, and canals;

(e) has created a new legal and institutional water resources framework, which needs to be revised; (0 has developed the first phase of the State Water Quality and Quantity Monitoring Network and designed the State Water Resources Information System, both of which need to be updated and expanded;

(8) has carried out studies on water resources, including a conservation and maintenance survey of bulk water infrastructure and initial studies on several aquifers, although the state has yet to implement most of the recommendations of these studies;

(h) has created over than 130 water users associations (WUA), although many continue to need strengthening and a strategy for financial sustainability, while other areas have yet to establish WUA; and

(i) has promoted public-private sector partnerships for the development of new irrigation areas and attempted to transfer operation and maintenance (O&M) responsibility for some large irrigation schemes to WUA to make the irrigation sector more efficient. However, this has focused mainly on large irrigation schemes, leaving small farmers with no clear strategies for irrigation modernization and development.

20. State Infrastructure. The state currently owns and operates more than 1,000 km of water transmission infrastructure which benefit some 600,000 people and is organized in five large bulk water transmission pipeline system^.^ PROAGUNSemi-Aridprovided financial support for the construction of the Serra de Santana main and the very important Mossor6 sub-main. In addition, there are 45 state-operated dams each with a storage capacity of at least 5 million m3,about a third of which are devoted mostly to irrigation. However, most of the water infrastructure exhibits a variety of problems, from oversized and poorly maintained dams and underutilized irrigation infrastructure to heavy losses in the water distribution systems (combined physical and billing losses are estimated at 45 percent) and overall deficient O&M. These are compounded by a lack of basic

Monsenhor Expedito, Medio-Oeste, Jeronimo Rosado, Sertiio Central Cabugi, and Sema de Santana.

5 hydrological information and weak institutions on which to base an adequate WRh4 system.

3. RATIONALE FOR BANKINVOLVEMENT

21. Bank Approach to Sector Issues. The proposed project forms an integral part of the WRM strategy which the Bank has been pursuing in Brazil for over a decade through federal and state projects. This has helped states, most notably Bahia and Cear6 in the NE, to develop institutional capacity and improved infrastructure to manage their water resources efficiently. The water sector is crucial to the development of the NE, and of RGN in particular. However, RGN is characterized not only by water scarcity, but also by extremely unequally distributed water resources-the state’s water-scarce interior hampers development, particularly that of irrigation, while the coastal areas are comparatively rich in water resources but under pressure from intense development driven by the services sector.

22. The proposed project will continue this long-standing commitment to promoting equitable and sustainable water resources management by bringing Rio Grande do Norte’s WRM capacity up to par with that of the leading states in the region. It will foster the introduction of the successful WRM model implemented in those states, duly adapted to the specificities of RGN, and pave the way for the replication of similar efforts in neighboring states with similar characteristics. Increased WRM capacity will also prepare the state to better face the cyclical droughts to which it is prone and to better manage its infrastructure to improve water quality and security. Most importantly, it will improve the state’s investment planning capacity in the water sector and, through this, its ability to continue to drive and manage sustainable, even, and equitable economic growth.

23. The Government of Rio Grande do Norte (GoRN) has requested the Bank’s long- term commitment and financial support to the strengthening of the water resources sector in the state. Lessons learned from the Bank’s long-term involvement in the rural development and water resources sectors of Brazil and the Bank’s international and regional experience in implementing a diverse set of rural development projects, give the Bank a comparative advantage over other lenders to assist the GoRN with the implementation of an integrated WRM project. The Bank’s experience will also help strengthen the project’s links to state poverty reduction and economic growth policies. It can also help better define supply and demand interventions leading to the rehabilitation, improved maintenance and operation, and further development of critical infrastructure where it has the greatest efficiency and distributional impact.

24. Relevant Bank Experience. Over the past ten years, the Bank has implemented PROAGUNSemi-Arid, which finances WRM in all states in the region and was executed in RGN by SERHID and now by its successor, SEMARH, and the Rural Development Projects (RPFWs, formerly known as RDPsPAPPs) at the state level. Both have supported the state’s effort to improve the WRM system and the supply of water to small, scattered rural populations. In addition, the Bank has supported three WRM projects in Ceard (Urban Development and Water Resources Management Project, Water Pilot Project, and Integrated Water Resources Management Project) and a state project in

6 Bahia (Integrated Water Resource Management Project). The WRM systems developed in Cearh and Bahia are regarded as models in Brazil and have provided lessons learned to other NE states. The Bank has also financed the Sanitation Sector Modernization Project (PMSS) to modernize Brazil’s sanitation sector. Meanwhile, in the South, the Bank is supporting several projects whose implementation is providing important information regarding the consideration that must be given to land use changes as part of water resources planning. The proposed project would be an additional piece in a large mosaic of Bank assistance to WRM in the NE.

25. PROAGUNSemi-Arid’s Support to the State is Noteworthy. It resulted in the first big step toward more sustainable and integrated WRM in the state-markedly in relation to institutional development-which explains the state’s interest in continuing its efforts in the sector with a state project. However, although PROAGUNSemi-Aridhas helped the state to improve its WRM, its impact has necessarily been limited because of limited resources coupled with great demand by states and the Federal Government.

26. The Government of Brazil (GOB) will soon begin the preparation of PROAGUA National which will continue the work initiated by PROAGUNSemi-Arid. This project will support the state’s WRM as it relates to key instruments and civil works that are strategic for the Federal Government and more easily implemented with federal support than with state support alone. However, the impact of this project will be limited because of insufficient resources to meet all foreseen demands. Simultaneous state and federal projects have shown great results due to more effective resource allocation and sharing of experiences.

27. Activities of other Agencies. A strategic aspect of project design is the pursuit of complementarity with other initiatives being implemented in the state and the sector. A number of agencies are executing activities that deal with various aspects of WRM in the RGN. These include: (i)KfW which will soon begin implementation of an operation providing financing to expand Natal’s sewage system, aimed at preserving the groundwater quality of the coastal aquifer, currently affected by nitrates; and (ii)CEF, the Federal Government’s official bank, which is financing several CAERN activities, including the expansion of water supply systems connected to the Monsenhor Expedito pipeline, a program to control losses in water distribution systems, and an institutional development program designed to address CAERN’s institutional weaknesses in line with diagnostic studies financed by PMSS. Some of these activities will serve as project counterpart financing, thus allowing these investments to leverage necessary institutional strengthening activities.

4. HIGHER-LEVELOBJECTIVES TO WHICH THE PROJECT CONTRIBUTES

28. The project is framed within the State Government’s global strategy to ensure socially, economically, and environmentally sustainable development in the Semi- Arid. It will constitute a key element of the state’s efforts to strengthen its water management, a process in which it has invested some US$200 million over the last decade.

7 29. In addition, the project fits within the Bank’s WRM strategy for Brazil’s NE which promotes the sustainable use and participatory management of water resources and reliable and sustainable access to water, especially to small, scattered rural populations.

30. Moreover, the proposed project is fully consistent with the Bank’s strategy for sustainable development in Brazil as described in the current CAS. The project will contribute to the promotion of more equitable human capital and social development by “reducing extreme poverty, vulnerability and social exclusion”. With regard to increasing the sustainability of natural capital and local services, the project will support the CAS objectives through better water quality and WRM; more sustainable land, forest, and biodiversity management within the context of improved WRM; and more equitable access to local services. Through its infrastructure improvement activities, which will increase the efficiency of the water sector, the project will contribute to enhancing the state’s competitiveness through improved resource allocation. In addition, by increasing the role played by local water users associations and basin committees in WRM, the project will lead to better local-level governance.

B. PROJECT DESCRIPTION

1. LENDINGINSTRUMENT

3 1. The lending instrument will be a Specific Investment Loan (SIL). Although the original proposal called for a three-phase Adaptable Program Loan (APL), the GOB and the Bank reached an agreement during project preparation to implement the proposed project as a five-year SIL, followed by a possible six-year SIL, subject to the approval of the corresponding Cartu Consultu, building on the gains of this current project. As the sector changes over the course of this proposed first phase, this approach will allow for a better understanding of the long-term needs and prospects of the state’s water sector and more flexibility and targeting in designing a second phase. Bank support for the implementation of a second project will be conditional on results achieved during the first project regarding increased institutional, technical, and operational capacity.

2. PROJECT DEVELOPMENTOBJECTIVE AND KEYINDICATORS

32. The higher level objective of the project is to promote economic, social, and environmentally sustainable development through the implementation of an integrated water resources management system. Mostly by focusing on institutional strengthening and rehabilitation of key bulk water infrastructure, the proposed project will seek to consolidate this system, which the state has often overlooked in the past in favor of larger infrastructure investments.

33. The specific project development objective is to implement an integrated water resources management system that will support more environmentally sustainable use of water resources while also increasing access of poor families to reliable potable water and decreasing operational and maintenance costs of water allocation and distribution s ys tems.

8 34. The project will support the preparation of a water sector strategy and long-term investment program that will pursue an adequate supply and efficient use of water resources, key elements to support the state’s overall sustainable development and reduce the vulnerability of the rural poor to cyclical droughts. Regarding essential infrastructure, the project will focus mostly on water supply in poor rural areas, including rehabilitation and expansion of drinking water supply networks and pilot interventions to improve irrigation schemes.

35. The results of the project’s interventions will be measured by contributions made to three key areas: (i)development of an improved legal framework and strengthened institutional setup for efficient WRM by the state; (ii)development and implementation of planning, information, and operational instruments for WRM; and (iii)promotion of a rational use of natural resources and expanded and improved coverage of the water supply systems.

36. Project outcomes will be measured using the following outcome indicators:

(a) revision of state water resources legislation to define a new legal framework for the management of water resources in the state, incorporating the themes of water reuse and irrigation policies;

(b) consolidation of state water resources management system agencies through the implementation of SEMARH and IGARN Strategic Planning;

(c) development and satisfactory implementation of planning, information, and operational instruments for WRM, including a revised State Water Resources Plan, basin plans, public water resources emergency plan, monitoring and water resources information network, improved water licensing system, and long-term investment program for the sector;

(d) improvement and expansion of coverage, and sustainable operational model, of small rural community water supply systems;

(e) development of a model for the rehabilitation and modernization of public irrigation perimeters, and testing of natural resources management in microcatchments ;

(f) reduction of financial and physical losses in the water transmission and main distribution systems;

(g) rehabilitation and optimal operational condition of main bulk water infrastructure;

(h) development and implementation of an improved water tariff collection system.

9 3. PROJECTCOMPONENTS

37. See Annexes 3 and 4 for details on project components, activities, and outcomes. Total project costs have been estimated at US$59.8 million, which will be financed through a Bank loan of US$35.9 million and GoRN counterpart funds of about US$23.9 million. The project will finance four main components as follows:

Project Financing Matrix by Component (in US$ millions)

38. Component 1: Institutional Development and Water Resources Management Instruments (US$15.2M, 25.4 percent of project cost). The objective of this component is to improve the state’s WRM capabilities and develop adequate WRM instruments. Project activities will be directed mainly at consolidating the design and operation of an integrated WRM system, with effective stakeholder participation and the watershed as the basic territorial management unit, to ensure equitable and efficient development that is socially, economically, and environmentally sustainable. This component has five subcomponents: (1.1) Improvement of the Legal and Institutional Framework, (1.2) Water Sector Planning Instruments, (1-3) Information Instruments, (1.4) Operational Instruments, and (1.5) Studies and Special Projects.

39. Target groups include: public water agencies, including SEMARH, IGARN, and CAERN; other water users and their associations; and the State Secretariat for Planning and Finance (SEPLAN) and the GoRN.

40. Main outcome includes: improved institutional and legal framework for the water sector.

41. Component 2: Natural Resources Conservation and Protection (US$5. lM, 8.5 percent of project cost). This component will support the preservation of water quality; improve efficiency in water use by reducing water losses in state-owned public water supply infrastructure, improving water conservation in agricultural and industrial activities, and generating water-saving technologies, including using treated wastewater; and promote the adoption of sustainable agricultural practices on irrigated lands. There are five subcomponents: (2.1) Microcatchment Pilot Projects, (2.2) Prevention of Losses in the State’s Bulk Water Transmission Networks, (2.3) Prevention of Losses in the Public Water Supply System, (2.4) Uses of Treated Wastewater, and (2.5) Sediment Control.

10 42. Target groups include: water users in the pilot microcatchments and in the state as a whole; and public water agencies.

43. Main outcomes include: implementation of improved natural resources management interventions (pilot management plans in two microcatchments, sediment control and reuse of treated wastewater); and improved maintenance and operation of bulk water transmission systems.

44. Component 3: Water Infrastructure (US$35.4M, 59.2 percent of project cost). The objectives of this component are to enhance the state’s water management capabilities and to improve general water availability. Technical and financial assistance will be provided to: improve water availability through the rehabilitation of existing bulk water infrastructure; construct supplementary water infrastructure works to improve water supply for the population being served by the Monsenhor Expedito transmission main and for poor scattered rural populations; and implement pilot interventions for improved irrigation efficiency. There are four subcomponents: (3.1) Rehabilitation and Maintenance of Existing Water Infrastructure, (3.2) Expansion of Water Infrastructure, (3.3) Water Supply Systems for Small Rural Communities, and (3.4) Pilot Interventions for the Rehabilitation and Modernization of Small Farmer Irrigation Schemes.

45. Target groups include: the state’s poor rural population, including small farmers in the pilot irrigation schemes; water users throughout the state and their associations; and water management and supply entities throughout the state.

46. Main outcomes include: crucial state-owned WFW infrastructure rehabilitated and in optimal operational condition.

47. Component 4: Project Management (US$4. lM, 6.9 percent of project cost). This component will be responsible for overall project execution and the Monitoring and Evaluation System, as well as communications and dissemination, and preparation of the concept document for a possible second-phase project. There are four subcomponents: (4.1) Project Management, (4.2) Monitoring and Evaluation, (4.3) Support to Preparation of the Second Phase, and (4.4) Project Communication and Dissemination.

48. Target groups include: SEMARH (where the Project Management Unit, PMU, will be established); and water users and public water agencies throughout the state.

49. Main outcomes include: effective implementation, M&E, and dissemination of project actions; and second-phase project agreed and prepared.

50. Integration Activities. In addition to the development of an integrated approach to WRM, it was agreed with the GoRN that specific activities in Components 2 and 3 would be geographically concentrated in the Seridd. These activities will be implemented in accordance with the sustainable development plan prepared for the region under the leadership of the Serid6 Development Association (ADESE) and with ample participation of civil society.

11 5 1. Project activities framed within this plan, which seeks to improve the quality of life of its citizens in an environmentally sustainable manner, include: (i)the conservation and protection of natural resources activities of Component 2, including microcatchment pilot projects; (ii)improvement and expansion of water supply systems for small rural communities (subcomponent 3.3)-including drilling new wells, rehabilitation and installation of small water desalinization units-and the development and testing of a framework for their sustainable operation; (iii)testing of alternatives for the re-use of treated wastewater (subcomponent 2.4); and (iv) rehabilitation and modernization of irrigation schemes (subcomponent 3.4).

52. Through Component 1, the project will provide support to the State of RGN, through SEPLAN, in promoting the integration of state-level policies and in strengthening its management capacity to better design and monitor public expenditures and their impact on the reduction of poverty, particularly in the rural space. A system will be developed to strengthen the cross-sectoral integration, monitoring, evaluation, and results-based management of development efforts within the state.

53. Lessons learned from the activities to be implemented in the Seridb, along with the experiences gained from the monitoring of RGN public expenditure programs, through the SEPLAN activity, will help improve the design and implementation of future policy interventions.

4. LESSONSLEARNED AND REFLECTED IN THE PROJECT DESIGN

54. The aforementioned Bank interventions have been providing valuable lessons concerning effective measures to improve WRM at the state level and the financing of small-scale rural infrastructure, such as water supply systems for rural communities, and other investments that are identified and operated by poor rural communities. Drawing on lessons learned from long-term Bank involvement in the water and sanitation sector in Brazil, work supported by the PMSS project has confirmed many suspected weaknesses in the state’s water supply and sanitation sector, including CAERN debts in excess of 200 percent of annual revenues and a tariff structure inconsistent with a sound economic and fiscal situation.

55. The following lessons gleaned from the Bank’s projects in the region were considered in the project design:

Establishment of an integrated water resources management (IWRM) approach at the basin and local levels is essential to reconcile cross-sectoral water demands.

Government’s explicit commitment to the proposed activities assures efficient and smooth implementation. The project will leverage this commitment to ensure that the project achieves its development objective and sustainability.

Inter-sectoral water allocation is a sensitive issue involving high political costs and challenging decision-making issues. Facilitating consensus among the various

12 parties, conflict resolution mechanisms, and clearly delineated areas of authority and responsibility are crucial.

(d) When there are appropriate institutional, legal, and regulatory frameworks for water rights, Bank experience shows that rational water use can be promoted by establishing water rights, with water charges ensuring adequate cost recovery. In addition, effective collection of water charges depends on stakeholder participation and appreciation of the benefits to be derived from the system. Introducing water use charges prior to delivering demonstrable benefits to users inevitably results in controversy and inadequate collection. Experience points to the need for sound educational and public information programs to preempt such problems.

(e) Bank experience confirms the need to decentralize and promote stakeholder participation in WRM. Bank projects in the NE have demonstrated that, although firm government commitment to project objectives is absolutely essential to overcome institutional weaknesses, the stronger the participation of users and their sense of “ownership,” the more successful the project will be in achieving its development objectives and sustainability of its actions.

(f) Projects which focus solely on infrastructure works are often unsustainable, and it is important have clearly defined criteria for the eligibility of infrastructure works and to promote a balance between resource management and infrastructure to increase sustainability.

5. ALTERNATIVES CONSIDERED AND REASONS FOR REJECTION

56. The rationale of the proposed loan is to ensure the availability of necessary investments to achieve integrated water resources management within a sustainable development approach to reduce poverty and protect the environment.

57. One alternative considered was a proposal to deal strictly with water infrastructure, including rehabilitation and expansion of irrigation infrastructure, but which would not pursue an integrated approach to the whole sector. The Bank and GoRN also weighed short- versus long-term interventions. However, a decision was made to lay the foundation for and pursue an IWRM approach over the course of the next decade in order to build on the Bank’s experience in the sector and to better complement other projects in the sector.

58. Moreover, the project was originally planned as a three-phase APL with a relatively small loan (about US$l5.0 million) in each phase. Later, given the improved debt capacity of the state and focusing on greater flexibility in project design, the GOB agreed to a proposal by the GoRN to implement a five-year SIL, which, if successful, would pave the way for a possible six-year SIL building on the gains of the first loan as a better alternative. The proposed US$35.9 million loan constitutes the first phase in the implementation of this approach and will finance the development of the legal, institutional, and technical bases for the integrated management of water resources along

13 with the preparation of a long-term program for the water sector. Successful results from this first phase would make it possible to move on to a program focused on the full implementation of a basin-based water resources management mechanism and the implementation of larger infrastructure investments, which could be carried out during a six-year second phase supported by another loan.

C. IMPLEMENTATION

1. PARTNERSHIPARRANGEMENTS

59. One of the key strategic aspects of the project’s design is its pursuit of complementarity with other projects and programs being implemented in the state and the sector. As mentioned, the Bank, KfW, and CEF are all preparing or implementing projects that address water resources in RGN. In particular, the CEF is financing a number of CAERN programs, some of whose activities will be accepted as counterpart contributions. Specifically, CAERN will be involved in the implementation of (i) programs to combat losses in water transmission mains and distribution systems-the latter CEF-financed; (ii)automation and increased water production capacity in the Monsenhor Expedito water transmission main, and expansion of the distribution networks served-the latter CEF-financed; and (iii)specific studies. Actions of the proposed project and the CEF-backed programs will thus be coordinated to avoid overlap and to ensure complementarity. Moreover, the aforementioned CEF-financed investments will act as state counterpart funds. Thus, CAERN agreed to have the implementation of these activities monitored by the Bank, and procurement must be acceptable to the Bank before the investments are accepted as counterpart contributions.

2. INSTITUTIONAL AND IMPLEMENTATION ARRANGEMENTS

60. See risk matrix below in section C5 for related risks and mitigation measures. The Borrower will be the State of Rio Grande do Norte. The Secretariat of Environment and Water Resources (SEMARH) will be the project executor with the help of the State Secretariat for Planning and Finance (SEPLANRGN), the State Secretariat for Agriculture, Livestock and Fisheries (SAPERGN), the State Institute for Technical Assistance and Extension Services (EMATEIURGN), the State Company for Agriculture Research (EMPARNRGN), the State Institute for Water Management (IGARN), the State Water and Sewage Company (CAERN), as implementing partners. The capacities of these agencies were evaluated by Bank specialists, and actions required to overcome the institutional weaknesses detected are addressed in the institutional strengthening subcomponent (1.1). The bulk of activities will be implemented by SEMARH directly (see Annex 6, Appendix 1). The State Environmental and Economic Development Institute (IDEMA), under SEMARH, is the institution in charge of environmental licensing in RGN and will oversee and assist in environmental matters related to project implementation. SAPE will provide technical assistance for the project’s irrigation activities. Additionally, the Seridd Sustainable Development Agency (ADESE) will assist, under contract, in the participatory development of Models for Management of Water Supply Systems in Small Rural Communities in Component 1.

14 6 1. In addition to centralizing financial management and procurement activities, SEMARH will have overall responsibility for project implementation which is organized at three different levels: (i)a decision-making level, through a Project Management Council presided by SEMARH and including representatives of SEPLAN and SAPE plus the Project Manager (based in the PMU) who will act as the Council’s executive secretary (the Council, which will meet annually, will be responsible for the approval of the Operational Manual and the Annual Operation Plans [POA] as well as for the definition of policies); (ii)an advisory level, through an Executive Forum formed by one representative of each implementing partner and presided by the Project Manager, which will meet quarterly and deliberate on all operational aspects of the project’s day-to-day management (such as articulation of the participation of the various actors in project implementation, ongoing evaluation of project progress, and the resolution of conflicts that may exist among project participants); and (iii)a wholly managerial level, represented by the PMU, which will be established within SEMARH. The PMU will include six professionals who will be recruited from SEMARH or other State Government entities to hold key management positions, plus a full-time procurement officer and a group of technicians experienced in project implementation recruited from the private sector who will perform the technical/operational duties needed for the management of a project of this nature, when necessary. The PMU’s duties will include day-to-day management functions, management of the project cycle and activities, the administrative and financial management of the project, reports and audits, and coordination with the World Bank.

62. More details on the project’s institutional, financial, and procurement aspects are included in Annexes 6 (Implementation Arrangements), 7 (Financial Management and Disbursement Arrangements), and 8 (Procurement).

3. MONITORINGAND EVALUATION OF OUTCOMES/RESULTS

63. The Environmental Management Information System (SIGMA) will be used for project M&E. The Bank has approved this system as an appropriate information management tool for monitoring the implementation of projects. A review of the system determined that, with the integration of a few changes, SIGMA will be sufficient for the project’s mostly straightforward M&E.

64. Specific staff will be included as part of the PMU to develop and manage a project M&E module during PYOl to complement the capabilities of the SIGMA system. The system, which will be managed by the PMU, will record baseline data for each activity and monitor the list of performance indicators developed for the project. Indicators agreed cover, among others: (i)improved legal and institutional framework for WRM; (ii)satisfactory development and implementation of planning, information, and operational instruments; (iii)promotion of rational use of natural resources; and (iv) optimization of water supply.

65. Regular monitoring and evaluation will be the responsibility of the PMU, which will prepare semi-annual reports on implementation progress. These reports will include progress achieved in relation to the Operational Manual’s timetable and targets for

15 project activities, the Procurement Plan and schedule, and agreed POAs. The outputs of the M&E System, as will be indicated in the Operational Manual, will be used to assess the performance of project components and suggest improvements as necessary. An annual report will be prepared indicating project achievements, experiences, problems, and lessons learned for yearly discussions with stakeholders.

66. As required for all World Bank-financed projects, evaluations based on the agreed indicators will be carried out at midterm and at the end of project execution. The baseline and ex ante evaluation of the project will be prepared by the PMU during the first three months of project implementation. These evaluations will be the responsibility of the PMU with the assistance of independent consultants acceptable to all parties.

4. SUSTAINABILITY AND REPLICABILITY

67. Sustainabilitv. The main objective of the project is to improve the state’s existing WRM system, thus promoting rational investment decisions and allocation of resources to contribute to the sustainable development of the water sector. Furthermore, the planned pilot activities in irrigation development and natural resources management will contribute to the establishment of a sound basis for economically and environmentally sustainable development in these two areas.

68. Sustainability of the project’s actions depends on the existence of a clear, capable structure for the WRM and on the appropriate management and operation of the state’s water resources infrastructure. This will be ensured through: (i)institutional strengthening of the public entities and other stakeholders involved in water management in the state; (ii)improved management and operation of the state’s water resources infrastructure through the creation or strengthening of water users associations; (iii) dissemination of lessons, basin plans, and water resources information to increase the engagement of water users in decision making; and (iv) development of cost recovery mechanisms to ensure adequate administration and O&M of water infrastructure.

69. Redicabilitv. Once the IWRM system has been consolidated in RGN, the model could be replicated in other NE states facing similar challenges, such as Sergipe, Alagoas, and Pernambuco. In addition, lessons learned from the implementation of planned pilot activities in irrigation development, natural resources management, reuse of treated wastewater, etc., will facilitate their replicability in other areas of RGN and in other states.

5. CRITICAL RISKS AND POSSIBLE CONTROVERSIAL ASPECTS

70. The overall risk for the project is considered moderate. The main potential risks that may affect project success and their respective mitigation measures which were incorporated into project design are presented in the matrix below.

16 Risk Matrix

Rating w/ Risk Mitigation Mitigation If economic recovery continues at its present rate and the Lack of counterpart funds projections by the GoRN are confirmed, there is likely to Low delays implementation. be a sound fiscal situation during project implementation. Lack of central The consolidation of the leading role given to the State governmental commitment Secretariat of Environment and Water Resources to carry out the necessary (SEMARH) will facilitate the implementation of the institutional reforms to institutional reforms necessary for the successful Moderate implement an IWRM development and operation of an IWRM system. system and promote the sustainable use of natural resources. Weak institutional capacity Intensive training and capacity building at regional and for project execution. central levels by the project will minimize this risk. Moderate The project will work with a known client whose capacity in this regard is well tested. Moreover, the involvement of the implementation partners is limited to very specific activities and the bulk of the project will be implemented by SEMARH. In addition, both IGARN and CAERN are Project implementation part of the water resources system headed by SEMARH (a type of institutional arrangement supported by the Bank arrangements too Moderate institutionally complex. and being used successfully in other Brazilian states as well as in the Federal Government) which makes these arrangements less complex than they initially appear. Finally, Bank management is committed to working toward team continuity in the project, which has proven to be critical in other Bank projects with similar implementation arrangements. Overall Project Risk Moderate

7 1. No issues have been identified that might be controversial or pose reputational risks to the Bank.

6. LOANKREDITCONDITIONS AND COVENANTS

72. At present, no exceptional contractual clauses or conditions are foreseen for project effectiveness or implementation. Conditions of Loan effectiveness will include: (i)establishment of the Project Management Unit, including publication of the Decree creating the Project Management Council and the PMU, in a form and substance satisfactory to the Bank, and issuance of directives from the State Secretariat of Water Resources appointing the Project Manager, technical manager, and the four executive managers for the PMU; (ii)submission to the Bank by Recipient of Working Agreements, acceptable to the Bank, signed with implementation partners for project implementation as listed in Annex 6.

17 D. APPRAISAL SUMMARY

1. ECONOMICAND FINANCIAL ANALYSES

73. See Annex 9 for further information. Improved WRM is the key to promoting socially and environmentally sustainable economic development in RGN and, by its very nature, the impact of the project would be felt throughout the economy of the state and by all segments of society. Moreover, improved efficiency in water use would lead not only to direct economic benefits, but also to environmental benefits such as less pressure on water sources, which are not as easily quantified. Consequently, the project is not amenable to traditional cost-benefit analysis.

74. Thus, two different approaches were used to assess the project’s economic viability. For the Institutional Development and WRM Instruments component, some of the impacts that an improved WRM system could have on the state’s economy were selected as indicators of the likely returns of this type of investment. The economic viability of the Water Infrastructure component, on the other hand, was assessed using a traditional cost-benefit analysis, which was applied to a sample of investment proposals identified for implementation during PYOl , These analyses demonstrate the economic and financial viability of the project and its components.

75. Likely Impacts of Component 1: Institutional Development and WRM Instruments. This component’s activities will: a) strengthen WRM institutions and adopt an rwRM system to address both supply and demand issues; b) develop and implement WRM tools and instruments, including an integral water resources information system; c) rationalize water infrastructure investment decision making; d) improve O&M of existing and new water infrastructure; and e) influence water demand by establishing adequate water charges, combined with incentives schemes for small producers to improve water use efficiency in the irrigation sector.

76. Bank experience and economic literature4 point to important economic gains to be obtained from improved WRM projects which justify investment in this type of activity. Over the last ten years, average annual investment in the water sector has been around US$16.0 million. If the state maintains the same level of investment over the next decade, just a 10 percent efficiency gain, resulting from an improved investment decision-making process due to access to better information in the water resources sector, would represent a yearly benefit of about US$1.6 million. Likewise, each 10 percent reduction in water losses in the water supply network operated by CAERN, as a result of institutional strengthening and improved O&M, would translate into an annual benefit of about US$2.0 million. Finally, if losses in the agricultural sector due to droughts were reduced by 10 percent as a result of better management of water resources, annual benefits to small farmers would be around US$l.1 million. Considering that the annualized cost of Institutional Strengthening and WRM Instruments component during the life of the project is estimated at US$3.6 million, even on the basis of a partial list of conservatively

4 Cummings, et al., (1996); Rogers (1993); London Economics (1996); World Bank Project Appraisal Document, Brazil-Federal Water Resources Management Project (1 998).

18 estimated benefits, one could conclude that the proposed investment is economically viable. Improved efficiency in water use would lead not only to the direct economic benefits shown above, but also to environmental benefits, Le., less pressure on water sources such as the Lagoa Bonfim and aquifers, which have not been quantified and incorporated into the cost-benefit analysis of this component.

77. Traditional Cost-Benefit Analysis of ComDonent 3: Water Infrastructure. The economic viability of this component is based on the analysis of two interventions whose execution would start during PYOl and which represent over 50 percent of the total investment foreseen for this component. The selected interventions are: (i)the improved and expanded water intake of one of the large bulk water transmission mains, Monsenhor Expedito, which has an estimated economic rate of return of 16.7 percent, and, if water tariffs were collected at the present rate of R$1.76 per cubic meter, it would recover 100 percent of O&M cost and about 56 percent of capital cost whereby the remaining 44 percent of capital cost would be the state government’s contribution to investment, which is within the range of government contribution to this type of investment in the NE; and (ii)the Pilot Irrigation and Water Resources Management Project in Cruzeta whose models of production alternatives presented financial rates of return ranging from 18.5 percent to 31.8 percent and an overall economic rate of return of 33.4 percent.

2. TECHNICAL

78. The project is considered technically sound given that its design adequately identifies and addresses a major constraint to sustainable development in RGN: poor management of water and natural resources resulting in inefficient use and risk of their deterioration.

79. The proposed IWRM system will deal with surface and ground water resources and also with improved management and conservation of other natural resources in rural areas as part of water resources planning. It will provide the necessary capacity and instruments to implement such a comprehensive approach. The design provides a broad, strong framework for stakeholder participation to increase ownership by promoting the participation of water users in IWRM and in the investment process, and through activities to strengthen their associations. At the same time, the project will work to ensure that several other key cross-sectoral issues are included, such as provision of good quality and guaranteed fresh water for human consumption, reduced waste of water, conservation of aquifers, reduction of land degradation, etc.

80. Finally, the project will employ a demand-driven approach to promote the implementation of improved irrigation infrastructure and management of natural resources in irrigated areas, with larger participation and co-financing by the private sector to ensure sustainability.

19 3. FIDUCIARY

8 1. See Annexes 7 and 8 for more information. Financial management, including procurement, will be under direct responsibility of the financial manager and team iithe PMU.

82. Based on Bank guidelines, SEMARH, assisted by the PMU through its financial manager, will be responsible for the following actions: (i)coordination and monitoring of the flow of funds; (ii)management of the Financial Information System; (iii)preparation of financial reports to be submitted to the Bank; (iv) implementation of any necessary corrective measures of the financial management during project implementation; and (v) contracting an independent auditing company, using Bank procedures, for financial verification and control of financial records in accordance with Bank guidelines.

83. Financial Management Assessment. A financial management assessment was carried out in accordance with Bank guidelines. Its overall conclusion is that SEMARH and the PMU will have satisfactory financial management arrangements in place once the staff is adequately trained and the SIGMA system is installed and working in coordination with the state’s public financial management system, the Integrated Financial Administration System (SIAF). The financial management risk associated with the project has been assessed as moderate.

84. Flow of Funds. All procurement and financial management will be centralized in the PMU. Funds will be advanced, in local currency, from the Loan Account into a second operating account in Natal specially set up for loan funds. Upon instructions from the PMU, payments will be made to suppliers for all project components, including those implemented by other entities. In order to minimize interest expense, the Bank may advance, in accordance with the project’s budget and cash-flow forecasts, several tranches of the Bank’s share of expenditures for a given period.

85. Procurement Assessment. An assessment of SEMARH’s capacity to implement project procurement reviewed the organizational structure for project implementation and the interaction between project staff responsible for procurement and the Secretariat’s relevant central unit for administration and finance. Related concerns identified include: (i)a complex and time-consuming procurement process; (ii)lack of experience with a high volume of procurement transactions; and (iii)lack of a procurement management information system. The corrective measures agreed are: the updating of the SIGMA project management information system for SEMARH and raising the awareness of relevant authorities who have a role in procurement processing about procurement issues. The overall project risk for procurement is average.

4. SOCIAL

86. See Annex 16 for summary of Social Assessment. The State of Rio Grande do Norte ranks very low in a variety of social indicators including an HDI of 0.574, an infant mortality rate of 43.2 per 1,000 live births, and over 40 percent of its population living in extreme poverty. It has experienced significant out-migration in recent years due in part

20 to a lack of job opportunities and social services, including health and education. The socioeconomic challenges facing the state are exacerbated by the precarious situation of its water resources which is characterized by water scarcity, deficient water treatment and sanitation, deterioration of water tables and reserves, lack of wells, and deterioration of irrigation infrastructure.

87. Stakeholder Involvement. Project stakeholders will include: SEMARH, SEPLAN, SAPE, EMATERRN, EMPARN/RN, IGARN, ADESE, CAERN, NGOs, local development agencies, unions, civil society, and water users, including small farmers. Since the project will fund improvements to the operation of the state’s water supply and distribution infrastructure, all water users in the state will benefit from the project’s activities.

88. Prior to and during project preparation, numerous meetings were held with multiple stakeholders (e.g., private and public, NGOs, unions, civil society, water users, men and women). Throughout 2004 and 2005, the former SERHID, in conjunction with state and municipal government agencies, NGOs, the state university, unions, and local development agencies, has organized a series of stakeholder meetings designed to discuss local challenges and a pilot project in the Cobra River microcatchment in order to address local needs. Additional meetings were held in the target communities to discuss the proposal for the pilot.

89. The project will pay particular attention to strengthening, and creating when necessary, water users associations to empower users to play an active role in water resources management and in the resolution of their water use conflicts. Project beneficiaries will participate in the development and implementation of the pilot projects in the Cobra and Una River microwatersheds (Component 2) and the participatory design, implementation, and operation of the Cruzeta irrigation rehabilitation scheme (Component 3). In addition, they will manage water issues through water users associations established or strengthened by the project. Although the involvement of all levels of stakeholders increases the institutional complexity of project implementation, given the project’s goal of bringing the various parties together to manage water resources, a certain degree of complexity is required.

5. ENVIRONMENT

90. See summary of the EA in Annex 17 for more information. The project’s environmental impacts are expected to be largely positive and include the conservation of water and other natural resources by making their management more efficient.

91. In addition to a participatory Environmental Assessment (EA) and Environmental Management Plan (EMP) already undertaken during project preparation, the proposed project will undertake a Strategic Environmental Assessment (SEA) to assist the state in the review, updating, and approval of the State Water Resources Plan, which is now nearly a decade old. The SEA’S objective is to facilitate the focus on and integration of environmental and sustainability aspects in the planning process, thereby contributing to better decision making to achieve the project’s development objective.

21 6. SAFEGUARD POLICIES

Safeguard Policies Triggered by the Project Yes No Environmental Assessment (OPBP/GP 4.01) [XI [I Natural Habitats (OPBP 4.04) [XI [I Pest Management (OP 4.09) [XI [I Cultural Property (OPN 11.03, being revised as OP 4.1 1) 11 [XI Involuntary Resettlement (OPBP 4.12) [I [XI Indigenous Peoples (OD 4.20, being revised as OP 4.10) [I [XI Forests (OPBP 4.36) [I [XI Safety of Dams (OPBP 4.37) [XI [I Projects in Disputed Areas (OPBP/GP 7.60)* [I [XI Projects on International Waterways (OP/BP/GP 7.50) [I [XI

92. Environmental Rating. In accordance with OP4.01, the project has been classified as a Category B project for environmental impacts.

93. Environmental Assessment. An EA was carried out for the project in order to identify potential environmental impacts, recommend mitigation and compensatory measures for any negative impacts, and maximize the largely positive environmental impacts expected from the project. An EMP was developed as part of the EA and is fully incorporated into the project design in order to adequately address these issues during project implementation.

94. Natural Habitats. The Monsenhor Expedito water supply system will be implemented in a protected area established for the preservation of the Lagoa Bonfim. Thus, the environmental rehabilitation activities of the dam sites and the consolidation activities were evaluated following OP 4.04. Appropriate methodologies to deal with Natural Habitats are included in the EMP.

95. Pest Management. The predicted interventions for the improvement of small-scale irrigation perimeters were evaluated following OP 4.09. Appropriate methodologies to deal with pest management are included in the EMP, and Integrated Pest Management Plans will be prepared for irrigated areas involved in the project.

96. Cultural Property. The project does not trigger this safeguard. However, works to be carried out in PYO2-PYO5 will be undertaken in municipalities hosting archeological sites. Thus, these works will be assessed during the design of their related projects in compliance with Brazilian legislation and will include a consultation with the National Institute for Artistic and Archeological Heritage. The Environmental Manual for Construction, included as part of the EMP, provides guidelines to follow in the event that any object of cultural property is found.

* By supporting the proposed project, the Bank does not intend to prejudice the final determination of the parties’ claims on the disputed areas.

22 97. Involuntarv Resettlement. The project does not trigger this safeguard. The state and the Bank have agreed that the proposed project will not undertake any activities that involve resettlement. Nonetheless, since the Bank and the state have prepared a Resettlement Framework for other projects in the state, it is included in the EMP for the unlikely event that project actions require its use.

98. Safetv of Dams. The project proposes recovery actions and maintenance of 20 dams and reservoirs for multiple uses whose environmental conditions were evaluated in the EA. Of these dams, 11 are large scale and 9 are small or medium scale. Because project actions will not alter the storage capacity of the dams and reservoirs, no negative cumulative impact is expected. A Dam Safety Panel was contracted following OPBP 4.12 to address the issues of dam safety. It evaluated 8 dams foreseen to have interventions during PYO 1.

7. POLICY EXCEPTIONSAND READINESS

99. No policy exception is required to implement the proposed project, which meets regional criteria for readiness for implementation.

23 ANNEX 1: COUNTRY AND SECTOR BACKGROUND

Brazil - NoGrande do Norte: Integrated Water Resources Management Project

1. Country Background

1. The Brazilian economy is experiencing a cycle of modest growth, improved income distribution, and reduced poverty in a context of strict fiscal discipline, low inflation, and a very comfortable external situation which are reflected in the strong improvement of financial sustainability indicators.

2. Economic growth rates were modest. Even tough revised national accounts data have increased GDP levels and growth rates for recent years. Based on the data released in March 2007, the economy is about 10 percent larger than previously estimated. Brazil is now the 8th largest economy in the world (larger than Italy). The 2006 growth rate was revised to 3.7 percent, from 2.9 percent. The projected continuation of monetary easing and a favorable international economic climate is consistent with an economic growth forecast of 3.5-4 percent again for 2007. The government has prepared a Program of Accelerated Growth (released on January 22,2007) that emphasizes tax breaks and public investment increases, but excludes major policy reforms which would accelerate growth.

3. Income distribution and poverty reduction strongly improved in 2004 and 2005. The latest National Household Survey (PNAD) showed a reduction in income inequality; the Gini index fell from 0.59 in 2002 to 0.57 in 2005 (the latest available). The poverty rate, which had risen to 34.1 percent in 2003, experienced a strong drop to 31.7 percent in 2004 and to 29.1 percent in 2005. This drop was due mainly to higher economic growth in the poorest regions, well targeted conditional cash transfer programs (such as the Bolsa Familia), as well as increases in labor income (especially the minimum wage) and the decline in unemployment (from over 12 percent in 2003 to around 10 percent during 2005-06).

4. Meeting the primary fiscal surplus targets has been a main factor explaining the improvement in market sentiment, as reflected in improved credit ratings (see below). The government’s fiscal targets were designed to reassure financial markets and improve public debt sustainability. During 2003-06 the public sector primary surplus target has been 4.25 percent of GDP. The recorded primary fiscal surplus increased from 4.25 percent of GDP in 2003 to 4.8 percent of GDP in 2005. In 2006, an election year, the primary surplus was just above the target 4.32 percent of GDP.

5. There are increasing concerns regarding the sustainability of the fiscal path and the quality of fiscal adjustment. Fiscal adjustment has been accomplished through strong revenue increases and curtailing public investment. There is limited scope for further adjustment using these methods and the PAC would aim to slightly reverse these trends. The tax burden grew to over 37 percent of GDP in 2005 and Federal Government investment represented only about 0.5 percent of GDP. The discretionary portion of the

24 budget is limited to less than 20 percent of total spending. The growth of current expenditures, especially social security, represents a main source of fiscal risks and expenditure rigidity. Despite social security reforms in 1998, social security deficits and debt remain persistent and growing, and government announcements indicate that prospects for substantial reforms are remote through 2010.

6. The prudent fiscal stance contributed to a fall in public debt as share of GDP. The primary fiscal surplus, exchange rate appreciation, and positive GDP growth led public debt to fall from over 57.5 percent of GDP in 2003 to just below 50 percent of GDP in 2006. The authorities also have improved the composition of public debt.

7. The government has repeatedly shown a commitment to an inflation targeting regime. Inflation fell from 12.5 percent in 2002 to 3.1 percent in 2006. Consistent with this regime the Central Bank has consistently reduced the headline interest rate (SELIC) from a peak of about 19.75 percent in mid-2005 to 12.75 percent in March 2007.

8. Strong external sector performance has reduced external vulnerability. Exports more than doubled from 2002 to 2006, reaching US$140 billion, benefiting from high commodity prices. The Brazilian trade balance grew from US$13 billion in 2002 to US$46 billion in 2006. After more than a decade of deficits, the external current account surplus grew from 0.8 percent of GDP in 2003 to 1.4 percent of GDP in 2006. International reserves have reached US$11 1 billion in April 2007, an historic peak. This has supported an appreciation of the nominal exchange rate from just below R$4 to the US dollar in October 2002 to around R$2 in April 2007. The growing strength of Brazil’s external position allowed Brazil to make an early repayment of its entire outstanding obligations to the IMF in December 2005, with the Paris Club in 2006 as well as retiring its Brady Bonds in 2006. As a result, Brazilian public sector external net debt is negative.

9. Reduced external vulnerability improved Brazil’s external debt sustainability indicators that are now the strongest in 30 years. Strong exports reduced the interest payments-to-exports from 35 percent in 1999 to 10 percent in 2006. Similarly there was a significant decrease in the net debt-to-exports from the 350 percent in 1999 to 50 percent in December 2006. As a result, sovereign spreads have been dramatically reduced. Sovereign spreads fell from 2,400 basis points in October 2002 to less than 200 basis point in 2006 (155 basis points in April 2007, its lowest level).

2. State and Sector Background

10. The State of Rio Grande do Norte, which has a total area of 53,300 km2,borders the Atlantic Ocean to the north and east and the states of Paraiba and Cearii to the south and west, respectively. The state’s population, estimated at about 2.9 million inhabitants, has undergone a rapid process of urbanization in recent years. About 75 percent of the total population lives in urban centers, which is consistent with changes in the state’s economic structure which has experienced a gradual reduction in the relative importance of the agricultural sector, with a parallel increase in the importance of the industrial sector, including agro-industries, as well as that of tourism and services. The remaining 25 percent resides in rural areas and are mostly poor farmers, who are concentrated

25 largely in the rural south and are exposed to serious droughts that jeopardize their livelihoods. Since the early OS, droughts have caused average annual losses of over US$12.0 million in traditional small farmer crops, such as maize and beans.

11. From a climatic viewpoint, about 57 percent of the total area, mostly located in the northern part of the state, could be classified as predominantly semi-arid. The central and southern parts (18 percent of the total) are arid, while coastal areas of the east and the serranas areas of the interior (20 percent of the total) have a sub-humiddry climate. The humid climate encompasses the eastern coastal zone, including the cities of Natal, Siio Jose de Mipibu and Canguaretama, which represent 5 percent of the state’s area. Consequently, about 82 percent of the territory, which is located in the so-called Poligono das Secus, represents areas of high risk of drought occurrence, with large intra- and inter-annual rainfall variations, high evapo-transpiration, and serious problems of water storage and management. Together with Cearh, Paraiba and Pernambuco, Rio Grande do Norte is one of the Brazilian states with the largest deficit in water resources. The state has an estimated water availability of 1,200 m3/persodyear5, which is considered low, and is mostly concentrated in the coastal zone.

12. The largest consumers of water in the state are agricultural activities, to which almost 70 percent of available water resources are dedicated; followed by the urban and rural sanitation sector which consumes approximately 20 percent of available resources; and the industrial sector which accounts for just under 10 percent.

13. The State of RGN has shown satisfactory economic performance during the 1990s and early 2000s, with average GDP growth rates fluctuating between 5 percent and 7 percent per annum. Despite these relatively high rates of growth, however, over 40 percent of the population is still living in extreme poverty, about 30 percent of the population over 15 years of age is illiterate, and infant mortality is still above the national average. In relative terms, the levels of poverty are far worse in the state’s southern Serid6 region. Although this region concentrates only about 10 percent of the population, its development potential is severely constrained by poor soils and an inadequate supply of water resources. These constraints are further aggravated by poor management of the natural resource base of small farmers and the absence of technical assistance to promote sustainable development alternatives.

14. Socio-economic indicators of the state as a whole are shown in the table on the following page.

?3etti et al. IntroduGtio ao Gerenciamento de Recursos Hidricos, ANA, 2001

26 Socio-economic Indicators

INDICATORS 19’70 1980 1990 1995 2001 2003 ~GDP(US$ million) I 1,023 I 2,736 I 5,608 I 6,859 I 9,834 I N/A I IGDP growth (%) I - I 10.34 I 7.44 I 4.11 I - I - I POPULATION (thousand) 1,550 1,898 2,415 2,634 2,776 2,896 PER CAPITA GDP (US$) 660 1,441 2,373 2,608 3,490 N/A ILITERACY RATE(% ofpop. over 15 yrs ofage) I 45.5 I 56.3 I 63.7 I 70.0 I 76.3 I 66.6 I INFANT MORTALITY (per ‘000 live births) 176.5 145.2 88.0 80.0 43.2 N/A WATER SUPPLY (% of households) - 25.9 48.0 51.4 88.5 N/A SANITATION (% of households) 2.1 3.2 7.1 12.0 15.5 N/A (POVERTY INDEX (% of families) I - I - I 46.0 I 43.0 I - I - I LIFE EXPECTANCY (years) 38.6 45.4 54.6 58.6 66.4 67.3

15. The economic structure of RGN has changed during the last century, from a period in which mining (mainly salt - 90 percent of the salt produced in Brazil comes from RGN), cotton and sugar cane farming, and extensive livestock production were the main sources of growth to the present where the agricultural sector contributes less than 7 percent of GDP and there is a strong predominance of the service sector. The relative importance of traditional crops, such as cotton and sugar cane, in the sector’s GDP is gradually being replaced by irrigated crops, mostly for export. A modern sector is developing in which agro-industries, agro-business export market-oriented irrigation projects, shrimp production and poultry farming play a central role. Despite the rapid expansion of exports of agricultural and agro-industrial products and their potential for the state’s economy, future development of these products could be jeopardized by poor management of water resources.

16. The low incidence of rainfall and the small number of perennial rivers have led to increasing water supply problems in most regions of the state. Expansion of the tourist industry, which has created new developments close to Natal and along the adjacent coastal area, is putting additional pressure on already scarce water resources. With economic growth and urban expansion, pollution of water resources is becoming a problem in RGN, largely as a result of sewage being discharged directly onto the land or into water courses. Sewage pollution is more severe in medium to large cities, like Natal, Mossor6 and Caic6, where only 27, 17 and 7 percent, respectively, of households are connected to sewage systems. Increasing amounts of untreated sewage and industrial effluents pose a threat to groundwater resources. This is particularly serious in the case of the aquifer that supplies Natal, which has a population of 1.1 million inhabitants.

17. Also plaguing the water sector are insufficient availability and inadequate delivery of water resources. The state owns and operates more than 1,000 km of bulk

27 water transmission mains organized in five major systems6 benefiting some 600,000 people. While around 90 percent of the population living in large and medium-sized urban centers has adequate water supply, this percentage decreases drastically as one moves to smaller urban centers and rural areas, particularly in the poorer regions of the south, such as Seridb.

18. This is partially a result of the various problems from which the state’s water supply infrastructure suffers, ranging from oversized and poorly maintained dams and underutilized irrigation infrastructure; heavy total losses in the water distribution systems (combined physical and billing losses are estimated at about 45 percent); and overall deficient operation and maintenance, all of which are compounded by a lack of basic hydrological information and weak institutions on which to base an adequate water resources management system.

19. Legal Framework. In 1996, the state approved its Water Law (no6.908) aimed at planning, developing and managing water resources in the state in an integrated, decentralized and participatory manner. It considers the instruments of Water Plan, Water Fund, water rights and charges. That same year, the State Secretariat of Water Resources (SERHID) was created with special responsibilities for water resources policies and management. The following year, the state regulated the water resources management system and the water rights and water infrastructure licensing procedures, and in 1998 the State Water Fund was regulated. Then, in 2002 the Rio Grande do Norte State Institute for Water Management (IGARN) was created to assist SERHID with bulk water management. Following approval of the State Water Law and the preliminary structuring of SERHID, water rights began to be formally granted (outorga de dgua) which guaranteed rights to water use. Finally, in January 2007, through a Special Law (lei Complementar 340), SERHID was also given environmental protection responsibilities and was changed into the State Secretariat of Environment and Water Resources (SEMARH).

20. Charging for water use is an instrument for the implementation of the State Water Law. With support from PROAGUNSemi-Arid, the state prepared a study on charges for water use which it intends to implement with support from the proposed project.

21, Institutional Framework. As mentioned, the state has shown great commitment to implementing reforms to modernize the institutional framework of the water resources sector. Over the last decade, the state Government has attempted to strengthen management and operation of its water sector by creating SERHID with special responsibilities for water resources policies and management, which has recently been transformed into the State Secretariat of Environment and Water Resources (SEMARH) and given, in addition to water resources management, also environmental protection responsibilities. Furthermore, the Rio Grande do Norte State Institute for Water Management (IGARN) was created in the late 1990s with the responsibility for the planning, informational and operational management instruments. However, thus far these efforts have met with mixed results, and while a new institutional setup for WRM is

Monsenhor Expedito, Medio-Oeste, Jeronimo Rosado, Sertao Central Cabugi, and Serra de Santana

28 in place, there is still considerable work to be done. The new SEMARH is yet to be fully staffed, and IGARN still does not have its legal Rules and Regulations in place and, therefore, can neither hire staff nor operate. In addition, operation and maintenance of water supply and sewage systems in the state is the responsibility of the Rio Grande do Norte Water and Sewage Company (CAERN). This mixed public and privately-owned company suffers from insufficient financial resources, poorly trained personnel and a weak overall management structure, which results in poorly maintained water distribution systems and high water losses. In order to overcome these institutional shortcomings, an institutional strengthening project, developed with the support of the Bank-funded Water Sector Modernization I1Project (Projeto de ModernizapZo do Setor Saneamento, PMSS IT),is currently being implemented with financial resources provided by the Caixa Econ8mica Federal (CEF).

3. The State’s Water Resources

22. Preparation of the State Water Plan began in 1996 and concluded in 1999. The Plan aims at providing policy and other elements needed for sound and efficient water resources management in the state. Since then, a variety of changes have taken place that need to be addressed in the Plan, including the creation of IGARN and the approval of a new state water law, and the creation of SEMARH.

23. The State Water Plan divided the state into 16 water regions, mainly composed of major river basins. Out of these, the Piranhas-Aqu is the only one considered to be a federal river basin and has hence received support from the Federal Government through ANA.

24. While there are many aquifers in the northern part of the state due to its porous and deep soils, the southern part, especially the Serid6, is characterized by pervasive water scarcity and shallow clayey soils over a rocky subsoil. The state’s surface and groundwater resources are described below.

25. Surface Water. Low rainfall and the absence of perennial rivers of any importance have led to increasing water supply problems in most regions of the state. Most of the main rivers7 are not perennial rivers and, although an important program to build water infrastructure has been implemented during the last three decades, it is not sufficient to store and manage these rivers’ water resources, even as water resources become scarcer. There are 45 state-operated dams with a storage capacity of at least 5 million cubic meters, about a third of which are devoted mostly to irrigation. Existing dams, which were constructed and operated by the National Department of Drought-Related Works (DNOCS) or SERHID, are facing gradual deterioration as a result of lack of maintenance. Moreover, a large number of municipal dams are no longer in operation due to salinity, sedimentation, lack of maintenance and other problems. Additionally, there is an urgent need to improve the operation of dams by incorporating integrated water supplies - including both surface and ground water - and planned schemes to maximize the use of

’ Including the ApodiNossorb, Piranhas, Boqueirao, Punad, Maxaranguape, CearB-Mirim, Doce, Potengi, Pirangi, Trairi, Jacu, Catu, Curimatali, Guaju and Serid6

29 stored volumes, by reducing evaporation, infiltration losses and the salinity potential of water. However, little monitoring information exists on the quantity or quality of the state’s water resources, which makes it difficult to plan a long-term strategy for addressing their management.

26. As presented in the table below, some information is available on the amount of water provided by the state’s dams, which have a relatively large storage capacity, but with a much reduced availability of regulated water flows because of inadequate operation and oor maintenance. In 1991, for example, the existing storage capacity was 7,217,954 hm P(included the planning units of Leste Potiguar, ApodUMossorci and PiranhadAcu shared by Paraiba) with an availability of only 1,992,788 hm3.

Surface Water in Rio Grande do Norte

Volume stored

27. In addition to insufficient water supply and inadequate infrastructure, the water sector also suffers from lack of coordination between the state and relevant private parties regarding resource use and delivery. In the past, a large number of small and medium- sized dams were constructed, without any regional planning or guidance, by private producers and investors attempting to address individual or local water demand problems, particularly in the area of the Cristalino Aquifer. These dams, which are independently operated, are sometimes located in the same watersheds as the larger state-operated dams and thus draw water from the same sources which, without proper coordination, makes the operation and management of larger dams even more difficult.

28. Groundwater Resources. The groundwater resources of the State of Rio Grande do Norte are limited to 6 main aquifers: Cristalino, Assu’, Jandaira, Barreiras, alluvial de osits and dunes deposits, with varying extraction capacities - ranging from 1.5 to 250 mP /h - and with salinity levels ranging from 200 to 2000 mg DM/1. However, they are under pressure from increasing demands exerted by existing irrigation projects and their expected expansion, and by increasing shrimp farming downstream.

29. Expansion of the tourist industry, which has created new hotel and resort developments close to Natal and along the adjacent coastal area, is putting additional pressure on these already scarce resources. Groundwater, in particular, is becoming an increasingly important source of water resources both for human consumption and for irrigation. In addition, groundwater resources are being utilized without an adequate

30 assessment of their potential and no clear strategy for their use. This has resulted already in the over-exploitation of some aquifers, risking the future depletion of reserves.

30. Moreover, urban expansion has resulted in the pollution of some aquifers. For example the DunasBarreiras aquifer system, which supplies water to the city of Natal, receives 46 million m3of sewage annually. Relatively high pluviometric averages (around 1,50Omm/year), associated with a homogeneous aeolic permeable sandy cover has guaranteed the recharging of the aquifer system. However, recent studies carried out by the state have revealed several contamination points and a growing number of contaminated wells.

3 1. The integrated management of surface and ground water could address potential water scarcity by significantly reducing the depletion of groundwater resources. Additionally, the identification of vulnerable pollution zones and the adoption of preventive and mitigation measures would assure more effective sustainable management of groundwater resources.

32. Water Sumlv and Basic Sanitation. The water supply services operating in Rio Grande do Norte provide water for nearly 90 percent of homes, but sewage and treatment services cover only 13 percent of households, compared with 19 percent in the Northeast and 37 percent for Brazil as a whole. Inadequate sewage and water treatment systems have resulted in a process of gradual pollution of water courses and aquifers.

33. CAERN is responsible for the operation and maintenance of the major water supply and sewage systems at the state level. It also operates the adduction pipes, constructed in the last two decades, which supply water to small cities and towns in the state’s interior. As a result of insufficient financial resources, operation and maintenance of the water supply network has been deficient. Resulting losses, which are estimated at more than 45 percent, have negative effects on the quantity and quality of water supplied for human consumption.

34. Irrigation Agriculture. There are about 90,000 farmers in the state occupying some 3.7 million hectares. About one-third of the land is devoted to livestock or mixed livestock-crop production, while an additional 30 percent is under natural forest and 10 percent is unproductive land. The remaining land is either under annual (11 percent) or permanent crops (4.5 percent), with some 6 percent fallow. Nearly three-quarters of farmers have less than 20 hectares and together account for only about 7.5 percent of the land. At the other end of the spectrum are large farmers, with more than 500 hectares each, who represent less than 1.5 percent of the total number of farmers yet occupy nearly 45 percent of the land.

35. Small farmers are usually engaged in low technology rain-fed subsistence agriculture and livestock production. Poor soils and unsustainable agriculture practices, combined with lack of the technical assistance and credit necessary to promote the adoption of more sustainable production systems, have resulted in increasing poverty of small farmers. Moreover, the poor management of already scarce water resources has resulted in an insufficient and uncertain supply of water for irrigation in poor rural areas

31 and, consequently, in little or no development of irrigated agriculture, which could offer a better alternative to subsistence farmers.

36. Although there are no precise figures, some estimates indicate that irrigation infrastructure covers about 28.000 ha8, and is located mostly in the Piranhas-Acu and Apodi-Mossorb watersheds, which would represent less than 2 percent of total land under crops. The construction of some of this public infrastructure, such as the Armando Ribeiro Goncalves Dam, has enabled not only the construction of the Lower Assu public settlement development (5,600 ha), but also the development of some 14,000 ha of private irrigation, a pattern common in irrigation development in Rio Grande do Norte during the last two decades.

Rio Grande do Norte Main Irrigation Developments

Source: DNOCS

37. Almost two-thirds of the state's irrigated area is under fruit cultivation (melon, banana, mango and papaya), followed by crops such as maize (4,500 ha), cotton (1,250 ha), beans (800 ha), and areas with a combination of crops, the latter characterizing public irrigation in settlements, particularly those located in the poorer and more arid regions of the south. Although the irrigation sector is responsible for the direct creation of over 100,000 jobs and generates some US$50-60 million in exports annually, irrigation efficiency is generally low as is security of water availability, except among large commercial farmers.

38. In order to improve the overall efficiency of the irrigation sector, the government has been attempting to transfer the responsibility for operation and maintenance of some of the existing large irrigation schemes to water users associations (Transferenecia da Gestao da Zrrigacao, TGI), while at the same time promoting public-private sector partnerships (Parceria Pu'blico-Privada, PPP) for the development of new irrigation areas. However, these measures have focused mainly on large irrigation schemes, thus leaving the important small farmer sector with no clear strategies for irrigation modernization and development.

* Lack of reliable statistics makes it difficult to obtain accurate estimates of irrigated agriculture.

32 4. Main Water Problems

39. Water scarcity along with the inadequate management of water and other natural resources - including fragile soils - are some of the main threats to the state’s sustainable development. In order to avoid the progressive deterioration of water resources resulting from their non-rational management, it is necessary to develop an integrated management approach for surface and groundwater in the context of a sustainable development program in the Semi-Arido. This program should be designed to achieve efficient use of the state’s water resources guaranteeing not only water for human and animal uses in future dry periods, but also to secure a stable development which could contribute to the reduction of rural poverty and the protection of natural resources.

40. Unfortunately, the state has no long-term strategy for the integrated management of its scarce water resources. The development of such a strategy will require: (i) improved preservation of water resources; (ii)a better understanding of the balances and combined management of surface and ground water supplies; (iii)an improved regulatory and legal framework to orient water resource and land use; (iv) more and better information on aquifers and spring water, erosion and sedimentation processes, and water availability and quality, in order to allow for better prediction of droughts, management of aquifers, and conservation of biodiversity and natural resources; (v) a plan to preserve estuaries and lagoons (due to their extreme vulnerability in the face of threats such as increasing shrimp faming); and (vi) and a strategy to tackle the issue of irrigation.

41. The increased groundwater extraction over the years and the increased levels of pollution in specific areas present the most serious challenges to groundwater management in the state. There is no clear definition of guiding principles in groundwater development nor are there criteria for evaluating policy responses to groundwater depletion and degradation. These guiding principles should consider: (i)basic research; (ii)groundwater monitoring and data collection; (iii)diagnosis of management instruments such as sector policies; water rights, institutional capacity regulatory framework, sector policies and public involvement; and (iv) focusing integrated management in strategic locations for more effective results. A more proactive approach to groundwater management, to complement institutional strategies, will also require technical options consisting of (i)conjunctive management, consisting of compensating measures for use such as artificial recharge mechanisms; (ii)conservation and protection measures; and (iii)improvement of irrigation efficiency.

42. Attention must also be given to the non-structural issues which impact on water availability and delivery, such as: the regularization of water rights and land tenure, administration of irrigated farms, organization of water users associations (including the strengthening of 103 existing ones), technical assistance and rural extension programs, technology application in irrigation, capacity building programs for water resource users and public personnel who deal with their delivery and control, and irrigated lands for agriculture,

33 5. State’s Commitment

43. In addition to the substantial work carried out in institutional and legal framework development, the State of Rio Grande do Norte has worked hard to improve the water supply for human consumption through the implementation of a variety of activities. They include: the construction of dams to allow perennial flow of rivers and the granting of the derived water for different uses, especially in adverse climatic situations, and the construction of pipelines to supply potable water to small populations with chronic water scarcity problems.

44. In addition, the former SERHID supported the creation of more than 130 water users associations, which are now responsible for the operation of more than 130 small sanitation systems built by that same State Secretariat. The new SEMARH also has a team that is promoting the organization of the water basin committees, the first of which will be responsible for the Piranhas-ASu River, a federal river.

45. Still, much work remains to be done to meet the social and development needs of the state, specifically as relates to poverty. In some areas of the state, the situation outlined here is even more dire due to the combination of water scarcity with fragile environmental conditions and a declining social economy. Thus, beyond the planned rehabilitation of the state’s water infrastructure system, the Bank’s involvement is necessary for this sustainable development program to continue in its efforts for the next 10 years. It is here that the Bank’s financial assistance and experience in institutional strengthening for SEMARH and other public services acting in the sector will be important, particularly since the results of the last state elections guaranteed the continuity of state government policies and programs regarding the water resources sector.

34 ANNEX 2: MAJOR RELATED PROJECTS FINANCED BY THE BANK AND/OR OTHER AGENCIES

Brazil - Rio Grande do Norte: Integrated Water Resources Management Project

Latest Supervision (ISR) Ratings Sector issue Project (Bank-financed ?rejects only) Implementation Development Progress Objective (DO) (IP)

Agency: IDB Sector Issue: Water Brazil - Social Action in Sanitation Program and Sanitation

35 ANNEX 3: RESULTS FRAMEWORK AND MONITORING

Brazil - Rio Grande do Norte: Integrated Water Resources Management Project

Use of Project Outcome PDO Project Outcome Indicators Information Implement an integrated water a fully operational water PY2-PY3: resources management system resources monitoring and (i) External evaluation of that will support more information network; Project implementation; environmentally sustainable 20% reduction in water loss from (ii)Mid-term review and use of water resources while three large water distribution adjustments in Project also increasing access of poor pipelines; strategy; families to reliable potable reduction in water loss from PY4: water and decreasing 20% - the water distribution systems of operational and maintenance (iii)Final project evaluation costs of water allocation and municipalities served by the and definition of strategies Monsenhor Expedito pipeline; distribution systems. for the preparation of the 3,000 additional families with next phase. access to reliable potable water; 20% increase in the economic efficiency of the Itans and Cruzeta irrigation perimeters.” Use of Intermediate Outcome Intermediate Outcomes Intermediate Outcome Indicators Monitoring Component 1: Institutional Outcome 1: Outcome 1: Development and Water Resources Management PY2-PY3: Instruments (i) Evaluation of the legal and . State Water Resources Legislation revised institutional strengthening Consolidation of the legal and and adopted, defining a new legal framework necessary for sustainability institutional framework and for the management of water resources in the of sector activities by the implementation of planning state; State and management instruments 1 SEMARH and IGARN’s Strategic Plans fully -PY4: necessary to expand state implemented; capacity for effective water (ii) Incorporate lessons and resource management . Water resource information network fully experiences from the operational. implementation and performance of the planning, information and operation instruments into the State’s a longer term sectoral program.

Component 2: Natural Outcome 2: Outcome 2: Resources Conservation and Protection -PY4: (i)Evaluate results of loss Optimize water supply through % loss reduction in the state large pipeline reduction activities in the the adoption of environmental systems infrastructure. pipelines and supply system recovery actions infrastructure, and of other practices and policies for the rational use of natural resources pilot plans for the definition of strategies and activities for the preparation of a longer term sectoral program.

36 Component 3: Water Outcome 3: Outcome 3: Infrastructure PY4: Increase access to water supply 1 % increased storage capacity of dams; - (i) Analyze results of pilot in the Semi-Arido region 1 % of rural water services supported by activities to assess scaling- project with sustainable management up with future sectoral 1 % increase in the economic efficiency of investments by the State. Itans and Cruzeta imgation perimeters

Component 4: Project Outcome 4: Outcome 4: Management

Efficient Project PY4: 1 PMU effectively facilitating project - Implementation implementation and providing all required (i)Evaluation of SEMARH’s technical, financial, monitoring and management capacity and evaluation reports assessment of any further strengthening needed for implementation of future sector activities.

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su 2 2 ANNEX 4: DETAILED PROJECT DESCRIPTION

Brazil - Rio Grande do Norte: Integrated Water Resources Management Project

1. Introduction

1. The proposed project forms an integral part of the WRM strategy which the Bank has been pursuing in Brazil for over a decade through federal and state projects which have helped states to develop institutional capacity and improved infrastructure to manage their water resources efficiently. This is particularly crucial in RGN since the state’s economic growth depends on the preservation of its scarce water resources and their more equal redistribution. The project will support the continuation of this long-standing commitment to ensuring equitable and sustainable water resources management by bringing Rio Grande do Norte’s WRM capacity up to par with that of the leading states in the region. It will foster the introduction of the successful WRM model implemented in those states, duly adapted to the specificities of RGN, and pave the way for the replication of similar efforts in neighboring states with similar characteristics. This increased capacity will also prepare the state to better face the cyclical droughts to which it is prone and to better manage its infrastructure to improve water quality and security. Most importantly, it will improve the state’s investment planning capacity in the water sector and, through this, its ability to continue to drive and manage sustainable, even and equitable economic growth throughout RGN.

2. Total project costs have been estimated at US$59.8 million, which will be financed through a Bank loan of US$35.9 million, and government counterpart funds of about US$23.9 million. To achieve its objectives, this five year project will be implemented through four components: (1) Institutional Development and Water Resources Management Instrument; (2) Natural Resources Conservation and Management; (3) Water Infrastructure; and (4) Project Management.

2. Project Objectives

3. The project development objective is to promote economic, social and environmentally sustainable development through the implementation of an integrated water resources management system. Mostly by focusing on institutional strengthening and infrastructure rehabilitation, the proposed project will seek to consolidate this system, which in the past the state has often overlooked in favor of larger infrastructure investments. The project will prepare a long-term water sector investment program that will enable an adequate supply and efficient use of the state’s water resources, both key elements to support the state’s overall sustainable development and reduce the vulnerability of the rural poor to cyclical droughts which have occurred in the state during ten of the last thirty years. With regard to essential infrastructure, the project will focus mostly on the: (i)rehabilitation and improvement of community drinking water supply systems; (ii)rehabilitation and improved operation of dams; (iii)pilot rehabilitation and modernization of two irrigation schemes; and (iv) improvement of the water intake of one of

40 the state’s large bulk water transmission mains, the Monsenhor Expedito, and an increase in the number of water distribution systems it serves.

3. Project Design 4. The proposed project, which will adopt an integrated water resources management approach, will include institutional development, water resources management instruments, infrastructure rehabilitation and construction, and natural resources management as some of its activities. These elements will constitute the basis on which to build a long-term sustainable development program for the water sector of Rio Grande do Norte.

5. The project was originally planned as a three-phase APL, with a relatively small loan (about US$15.0 million) in each phase. However, given the improved debt capacity of the state as well as the greater flexibility in project design afforded by a two-phase intervention, the GoRN and the Bank agreed to implement a five-year SIL to be followed, if approved, by a six- year SIL building on the gains of that first loan as a better alternative. This would imply, as a first phase, a project of US$59.80 million, supported by a loan of about US$35.90 million, to develop the legal, institutional and technical basis on which to build a long-term sustainable development program for the water sector of RGN. This long-term program will have as a starting point a consolidated IWRM system developed during the first phase, and will thus be able to focus on the full implementation of a basin-based WRM mechanism and the development of a more comprehensive infrastructure investment plan. Assuming the proposed first phase achieves the results necessary to move on to the second phase, a new Curtu Consultu would be prepared and, if approved, the program would be executed during a six-year second phase which would be supported by a new loan.

4. Project Outcomes and Outputs vor more details, see Annex 3)

6. The main expected project outcomes include:

(a) Legal and institutional framework for the effective management of water resources updated.

(b) Mechanisms to improve the coordination between elected officials, the private sector and urban and rural communities established, and their participation in water and other natural resources management decision-making processes increased

(c) lblicinstitutions and users involved in water resources management strengthened and trained for the implementation of public policies defined for the sector.

(d) Optimization of the water resources supply promoted through the adoption of measures to improve water use efficiency -development and satisfactory implementation of planning, information and operation instruments- and the implementation of selective new local and regional water infrastructure.

7. Project outcomes would be measured using the following outcome indicators:

41 (a) State Water Resources Legislation revised, defining a new legal framework of the management in the state incorporating the themes of water reuse and irrigation policies;

(b) implementation of SEMARH and IGARN Strategic Planning, consolidating the state water resources management system agencies;

(c) the development and satisfactory implementation of planning, information and operation instruments for WFW, including inter alia revised State Water Resources Plan, basin plans, public water resources emergency plan, monitoring and water resources information network, improved water licensing system and long-term investment program for the sector;

(d) improvement and expansion of coverage, and sustainable operational model, of small rural community water supply systems;

(e) model for the rehabilitation and modernization of public irrigation perimeters, and the management of natural resources in microcatchments tested;

(f) reduction of financial and physical losses in the water transmission and main distribution systems;

(g) main bulk water infrastructure rehabilitated and in optimal operational condition;

(h) development and implementation of an improved water tariff collection system.

5. Project Components

8. The proposed project will have four components:

9. Component 1: Institutional Development and Water Resources Management Instruments (US$15. lM, 25.2 percent of project cost). The objective of this component is to improve the state’s water resources management capabilities and develop adequate water resources management instruments. Project activities will be directed largely at strengthening the main institutions in the water sector and improving the legal framework for their operation; consolidating the design and operation of an integrated water resources management system, with effective stakeholder participation and using the watershed as the basic territorial management unit, to ensure equitable and efficient development that is socially, economically and environmentally sustainable; implementing an integrated water resources information system to improve the policy and investment decision-making process; and implementing new operation and management models, including improved tariff collection mechanisms, for large and small water supply systems.

(a) Target groups include: water management agencies, including SEMARH, IGARN and CAERN; water users and their associations; SEPLAN and the state government

42 (b) Main outcomes include: improved institutional and legal framework for the water sector, water rights system and water charges system implemented, consolidation of water users associations, water resources management plan, water resources emergency plan, water resources M&E network, studies related to water availability and use, and system to monitor implementation of the government’s public expenditures programs and assess their impact on poverty reduction.

(c) This component will be implemented through five subcomponents:

i. Subcomponent 1.1 - Improvement of the Legal and Institutional Framework: which would finance: (i)a review of the existing legal framework for water resources management and the presentation of eventual legal reforms, including the development and implementation of a water rights system, and an assessment of staffing requirements by SEMARH and IGARN to fully carry out their functions; (ii)institutional strengthening of the State Secretariat of Environment and Water Resources (SEMARH) and the Water Management Agency (IGARN), including the commitment by GoRN to fully staff them in accordance with the requirements determined by the aforementioned assessment; (iii)technical assistance to strengthen state policies and development strategies in the water resources sector, irrigation sector and reuse of treated wastewater; (iv) strengthening of 24 existing provisional water users associations (WUAs), the creation of 84 new WUAs, including the development of a system of water user fees to guarantee their financial sustainability, and the establishment of watershed management committees in the watersheds of four rivers: Apodi-Mossor6, Piranhas-ACu, Pitangi and Potengi to test a participatory approach to water resources management, using the watershed as the basic management unit; lessons learned during establishment and operation of these committees would be used in the design and implementation of the second phase project to contribute to the successful implementation of a basin-based WRM mechanism; and (v) training program, including formal and informal environmental education programs.

ii. Subcomponent 1.2 - Water Sector Planning Instruments: which would finance: (i)an updated State Water Resources Management Plan; (ii)the development of a methodology for the preparation of watershed-specific WRM plans, which would be applied to the preparation of at least three Water Resources Management Plans - for the watersheds of Apodi-Mossor6, Pitangi and Potengi-; (iii)preparation of an emergency plan to minimise the effects of droughts and other extreme climatic events on the state’s economy; (iv) preparation of an incentive scheme to promote the adoption of efficient irrigation technologies; (v) preparation of hydrological studies on groundwater resources and new water supply sources; which together with (vi) preparation of a land surface zoning for aquifer protection, would contribute to better

43 management of groundwater resources; and (vii) preparation of an Atlas of Water and Environmental Resources.

iii. Subcomponent 1.3 - Information Instruments: which would include: (i)an improved Integral Water Resources Information System, incorporated into a Geographical Information System; and (ii)a water resources monitoring and evaluation network, are expected to improve investment decision making by both the state government and private investors

iv. Subcomponent 1.4 - Operational Instruments: which would include: (i) development and operation of a water rights system, including a cadastral survey of current water users and their respective water rights; (ii) development of an efficient water tariff system, using as a basis the conclusions and recommendations of the PMSS-financed study on reforms of the current water tariff system ; (iii)development of an operational model, including an on-line information system, for state-run water infrastructure as well as (iv) a framework for the operation of water supply systems for small communities, which would benefit from the results of the analysis of alternative scenarios for WSS service provision in the state undertaken by PMSS.

v. Subcomponent 1.5 - Studies and Special Projects: which would provide support to undertake several water resources mwagement studies. The main studies already identified cover issues related to: (i)development of a framework for improved management of solid wastes, to build on the experience gained about carbon finance activities during project preparation; (ii)identification of resource conservation zones directly related to aquifer recharge areas; and (iii)other studies identified during project implementation, which would be evaluated on a case-by-case basis. Under “Special Projects”, the project would finance the design of a Monitoring and Evaluation System for State Government Programs and would provide technical assistance to SEPLAN for its operation; this would enable SEPLAN to have a central system to monitor the implementation of government programs, including investment programs in the water sector, and comprehensively evaluate their impact.

10. Component 2: Natural Resources Conservation and Protection (US$5. lM, 8.5 percent of project cost). This component will support the preservation of water quality; improve water use efficiency through reducing water losses in state-owned public water supply infrastructure, promoting better water conservation practices among users, and generating water- saving technologies, including using treated wastewater; and promote the adoption of sustainable agricultural practices on irrigated lands.

44 (a) Target groups include: water users in the pilot microcatchments and in the state as a whole, and public water agencies

(b) Main outcomes include: implementation of pilot natural resources management plans in two microcatchments; improved maintenance and operation of bulk water transmission pipeline, as well as billing and collection in water distribution networks to prevent physical and financial losses; potential uses of treated wastewater researched, and incentive schemes to promote its use designed and tested; construction of at least 350 small soil retention schemes in streams or brooks located in areas of heavy erosion to control sedimentation and improve water quality.

(c) This component will include the following 4 subcomponents:

i. Subcomponent 2.1 - Microcatchment Pilot Projects: The project would finance the participatory preparation and implementation of pilot projects in two microcatchments. The first one would be implemented in the watershed of the Cobra River in Serid6, which is characterized by severe environmental degradation. The second one would be implemented in the watershed of the Sal e Una River, located in the coastal areas of the eastern parts of the state, where native forest and vegetation are threatened by deforestation and unsustainable agricultural practices. The project will finance a participatory diagnostic of the present state of each microwatershed and the design and implementation of appropriate natural resources management plans to promote soil conservation practices as well as the recuperation of native vegetation and the adoption of a regulated use of agrochemicals.

ii. Subcomponent 2.2 - Prevention of Losses in the State’s Bulk Water Transmission Networks: Project activities would finance: (i)network maintenance; (ii)macro-measurements along the water transmission systems to monitor water losses; (iii)a program for the prevention of illegal network connections; (iv) a cadastral survey of water users; and (v) a program to improve the tariff collection system.

iii. Subcomponent 2.3 - Prevention of Losses in the Public Water Supply System: This subcomponent will consist of investments made through CAERN’ s CEF-financed institutional development program, of which approximately US$2.5 million will be accepted as project counterpart funding. Investments will be made in information processing equipment for billing and collections and for the installation of micro- and macro-measurement equipment.

iv. Subcomponent 2.4 - Uses of Treated Wastewater: This subcomponent will finance research on possible uses of treated wastewater and the design of incentive schemes to promote its appropriate use.

45 v. Subcomponent 2.5 - Sedimentation Control: This will finance the construction of about 350 small soil retention schemes in streams or brooks located in areas of heavy erosion, as a means of controlling sedimentation and improving water quality.

11. Component 3: Water Infrastructure (US$35.1M, 58.8 percent of project cost). The objectives of this component are to enhance the state’s water management capabilities and to improve general water availability. Technical and financial assistance will be provided to: improve water availability through the rehabilitation of existing infrastructure; construct supplementary water infrastructure works to improve water supply for the population being served by the Monsenhor Expedito transmission main and for poor scattered rural populations; and implement pilot interventions for improved irrigation efficiency. There are four subcomponents: (3.1) Rehabilitation and Maintenance of Existing Water Infrastructure; (3.2) Expansion of Water Infrastructure; (3.3) Water Supply Systemsfor Small Rural Communities; and (3.4) Pilot Interventions for the Rehabilitation and Modernization of Small Farmer Irrigation Schemes.

(a) Target groups include: the state’s poor rural population, including small farmers in the pilot irrigation projects; water users and their associations throughout the state; and water management and supply entities throughout the state

(b) Main outcomes include: rehabilitation, maintenance and improved operation of at least 20 existing dams and reservoirs for multiple use; improved capacity of the Monsenhor Expedito Water Transmission System thereby improving the reliability of water supply to the population of about 160,000 people currently served by the system; rehabilitation and improvement of small water supply systems to supply drinking water to about 160 communities that currently live without adequate water supply in rural areas; and rehabilitation and modernization of small farmer irrigated production systems and improved water resources management system in the Serid6 region through participatory pilot interventions.

(c) This component will be implemented through four subcomponents:

i. Subcomponent 3.1 - Rehabilitation and Maintenance of Existing Water Infrastructure: which will finance approximately US$3.5 million in feasibility studies, designs and implementation of rehabilitation and maintenance works, and the development and implementation of improved operation plans of at least 20 dams and reservoirs. The reservoirs to be rehabilitated, with a capacity of over 5 million cubic meters each, were prioritized according to the degree to which they are structurally compromised. Additionally, the project would update the technical information on the remaining 25 of the 45 total state-run dams. These 25 dams would be rehabilitated during the second phase project.

46 ii. Subcomponent 3.2 - Expansion of Water Infrastructure: which will improve the Monsenhor Expedito Water Transmission System that serves a population of 160,000 people in the center of the state. The Bank-financed improvement of the system -approximately US$8.7 million- will concentrate on upgrading its intake to expand capacity so the water supply can reliably meet the population’s current and future water demand and simultaneously protect the Lagoa Bonfim -one of the systems water resources. It will also include the automation of the pipeline operation and a macro measurement system to enhance control of the distribution of the water volume. In addition, it will expand service to seven municipalities and connect them to the distribution system to provide a reliable water supply to a population of about 10,000 not currently connected to the water transmission network. This latter activity will be non-Bank financed; it will be financed through a CEF- financed CAERN program, and approximately US$9.1 million will serve as part of project counterpart. iii. Subcomponent 3.3 - Water Supply Systemsfor Small Rural Communities: the project will finance approximately US$8.2 million for works, equipment and training for the rehabilitation of approximately 60 small desalinization units as well as the construction of 35 new ones and the improvement of at least 60 new small water supply systems, to reliably supply drinking water to disperse rural population without adequate water supply in some 30 municipalities. iv. Subcomponent 3.4 - Pilot Interventions for the Rehabilitation and Modernization of Small Farmer Irrigation Schemes: the project will finance works, equipment and technical assistance to rehabilitate two irrigation schemes in the Serid6 and promote, with beneficiary co-financing, the adoption of modern irrigation technology and sustainable production systems by beneficiaries of the pilot intervention, who are largely poor small farmers. Additionally, the project will promote the adoption of an improved water resources management system in these areas, with strong participation of beneficiaries in the decision-making process and in the management of the irrigation main network, managed so far by DNOCS. This subcomponent will also support the participatory design, implementation and operation of the proposed pilot irrigation rehabilitation projects. Implementation of this component will begin during the first year with the implementation of the pilot in the Irrigation Scheme of Cruzeta. A second pilot irrigation rehabilitation project will be identified and implemented in subsequent years. Lessons learned from implementation of these pilot projects are expected to be used for the design of irrigation sector rehabilitation and modernization program to be implemented during the second phase project.

47 12. Component 4: Project Management (US$4.1M, 6.9 percent of project cost). This component will be responsible for overall project execution and the operation of the Monitoring and Evaluation System, as well as the preparation of the second phase investment program. There are four subcomponents:

(a) Subcomponent 4.1 - Project Management: which will finance PMU staff and technical assistance required for project implementation.

(b) Subcomponent 4.2 - Monitoring and Evaluation: which will carry out the design and operation of the Project’s Monitoring and Evaluation System.

(c) Subcomponent 4.3 - Support for Preparation of the Second Phase: which will finance the preparation of the second phase project.

(d) Subcomponent 4.4 - Project Communication and Dissemination: which will design and implement the Project Information and Communication Program providing the basis for the transfer of knowledge, exchange of experiences and dissemination of lessons learned. It would include the sharing of information both within and outside the project in order to increase awareness of water resource constraints in the state and of the project’s actions.

(e) Target groups include: SEMARH (where the PMU will be established); water users and public water agencies throughout the state and the region

(0 Main outcomes include: PMU established and implementing project; project M&E system in operation; project Information and Communication Program functioning; and second phase project agreed and prepared.

13. Integration Activities. In addition to the development of an integrated approach to WRM, it was agreed with the GoRN that specific activities in components 2 and 3 would be geographically concentrated in the Seridd. These activities will be implemented in accordance with the sustainable development plan prepared for the region under the leadership of the Seridd Development Association (ADESE) and with ample participation of civil society.

14. Project activities framed within this plan, which seeks to improve the quality of life of its citizens in an environmentally sustainable manner include: (i)the conservation and protection of natural resources activities of Component 2, including microcatchment pilot projects; (ii) improvement and expansion of water supply systems for small rural communities (subcomponent 3.3) -including drilling new wells, rehabilitation and installation of small water desalinization units - and the development and testing of a framework for their sustainable operation; (iii)testing of alternatives for the re-use of treated wastewater (subcomponent 2.4); and (iv) rehabilitation and modernization of irrigation schemes (subcomponent 3.4).

15. Through Component 1, the project will provide support to the State of RGN - through SEPLAN - in promoting the integration of state-level policies and in strengthening its

48 management capacity to better design and monitor public expenditures and their impact on the reduction of poverty, particularly in the rural space. A system will be developed to strengthen the cross-sectoral integration, monitoring, evaluation and results-based management of development efforts within the state.

16. Lessons learned from the activities to be implemented in the Serid6, along with the experiences gained from the monitoring of RGN public expenditures programs - through the SEPLAN activity - will help improve the design and implementation of policy interventions, including those that would be carried out during a possible second phase.

49 ANNEX 5: PROJECT COSTS

Brazil - Rio Grande do Norte: Integrated Water Resources Management Project

Project Cost By Component andor Activity (US$ '000) Foreign Local Total Institutional Development and WRM Instruments 6,240.3 7,306.2 13,546.6

Conservation and Protection of Natural Resources 2,496.6 2,175.8 4,672.4

Water Infrastructure Component 15,829.6 14,949 .O 30,778.6

Project Management 1,479.5 2,137.4 3,616.9

26,046.0 26,568.4 52,614.4

Physical Contingencies 1,616.9 1,975.7 3,592.6 Price Contingencies 1,220.0 2,373.1 3,593.1

TOTAL PROJECT COST' 28,793.1 30,917.2 59,800.1

Identifiable taxes and duties are US$7.1 million, and the total project cost, net of taxes, is US$56 million. Therefore, the share of project cost net of taxes is 88 percent. Including US$35.9 million of Bank loan.

50 ANNEX 6: IMPLEMENTATION ARRANGEMENTS

Brazil - Rio Grande do Norte: Integrated Water Resources Management Project

For risks and mitigation measures related to project implementation arrangements, see the Risk Matrix in section C5 of the main text of this document.

1. Project Implementation Structure 1. The Project’s operational structure will include three complementary levels: (i)a decision-making level composed of a Management Council formed by three state Secretaries; (ii)an advisory level composed of an Executive Forum for discussion and advisory services, formed by representatives of all of the Project’s executing and co- executing agencies; and (iii)a fully executive level formed by a Project Management Unit (PMU), linked to SEMARH and staffed by a mix of state public servants and private sector consultants.

2. Organizational Chart for Project Implementation

51 SEMARI:

EXECUTIVE PROJECT FORUM MANAGER

pn I TECHNICAL MANGEMENT ADVISORY SERVICES

WATER PROTECTION & INFRA- ADMINISTRAT1V:Z MANAGEMENT CONSERVATION STRUCTURE AND FINANCIAL MANAGEMENT MANAGEMENT MANAGEMENT

MANAGEMENT CONSERV AT10 STRUCTURE COMPONENT COMPONENT

3. Decision-Making Level - Management Council

2. The Management Council will be composed of three state Secretaries: the State Secretariat of Environment and Water Resources (SEMARH) which will also preside over the Council, the State Secretariat of Planning and Finance (SEPLAN), and the State Secretariat of Agriculture, Livestock and Fisheries (SAPE) as well as the Project Manager who will act as the Council’s Executive Secretary.

3. The Management Council will meet at least once a year. Its duties will include: (i) functioning as a forum to integrate the project with state development policies; (ii)approving the Project Operational Manual; (iii)approving annual POAs; (iv) defining the project’s annual budget categories; (v) defining the project’s major strategic areas; (vi) evaluating the project’s progress and making relevant recommendations; (vii) ensuring stakeholder participation during project implementation; (viii) performing an ex-post review of contracts for project execution; (ix) approving accords, agreements, and other instruments to be signed by SEMARH and project implementation partners; (x) creating the mechanisms and instruments needed for proper implementation of the project; and (xi) other duties envisaged in the Management Council’s by- laws.

52 4. At the first meeting of the Management Council, the following instruments should be approved and endorsed: (i)the first year’s POA; (ii)the Project Implementation Plan with the First-Year Procurement Plan; (iii)the Council’s By-laws; (iv) the Executive Forum’s By-laws; (v) the agreements and covenants signed by SEMARH and other project participants; (vi) the program’s Operational Manual; and (vii) other instruments.

5. Conditionalities regarding the initial drafts of these instruments will be decided during the Appraisal mission.

4. Advisory Level - Executive Forum

6. The Executive Forum will be presided by the Program Manager and composed of representatives of all partner agencies executing or co-executing the program. It should meet on a quarterly basis with the following agencies: (i)SEMARH; (ii)SEPLAN; (iii)IDEMA; (iv) EMATERAW; (v) EMPARNRN; (vi) IGARN; (vii) ADESE; and (viii) CAERN. For information on specific responsibilities of these entities, see section 8 below.

7. The Executive Forum’s duties will be to: (i)articulate the participation of various actors who will participate in project implementation; (ii)evaluate the project’s progress on a frequent and ongoing basis; (iii)make the necessary decisions for effective project management; (iv) resolve any conflicts and controversies that may exist among project participants; (v) ensure proper execution of the project through the effective use of existing technical instruments; (vi) facilitate the participation of other institutions andor agencies which, as determined by the Management Council, in the future may become a an integral part of the project; and (vii) other duties to be proposed in its by-laws.

5. Executive Level - Project Management Unit (PMU)

8. The PMU, to be created and structured by State Decree, will be located within SEMARH. It will be structured around the project’s components and will make use of expertise in SEMARH in those areas where it already exists. When this is not the case, it will contract outside technical support. The PMU will act as a technical group for the project and will be responsible for ensuring the technical and managerial quality of actions carried out by the project. The publication of the Decree creating the PMU will be a condition for the signing of the Loan Agreement. The Project Manager will be appointed by a Directive of the State Secretary of Water Resources. Other PMU managers will be appointed in the same manner.

9. In addition to functioning as the Executive Secretariat of the Project Management Council and as General Coordinator of the Executive Forum, the PMU’s duties will also include: (i)managing overall project execution; (ii)managing the execution of the pilot interventions under the responsibility of SEMARH; (iii)coordinating the execution of other subcomponents; (iv) preparing the annual POA proposals; (v) articulating with relevant state agencies to ensure the proper and timely provision of financial resources for the project, both those from the loan and those from counterpart contributions; (vi) providing the means and conditions needed to obtain technical support for analyzing and monitoring actions, proposals, and products related to

53 project execution; (vii) coordinating and administering activities related to the contracting of various planned activities and actions; (viii) coordinating and administering activities related to project financial, disbursement, and auditing issues; (ix) preparing accounting statements in accordance with the Loan Agreement; (x) establishing and operating the Project’s monitoring and evaluation and providing information to the World Bank and the Government of Rio Grande do Norte as requested; (xi) promoting the broad dissemination of the project and its components; and (xii) other duties indicated in the project Operational Manual.

10. The PMU will be staffed with technicians with previous experience in the management of programs and projects. The six managerial posts within the PMU will be staffed by technicians recruited from the Rio Grande do Norte public sector. They will include the Project Manager, the technical advisory manager, and the four executive managers for the areas of water management, protection and conservation of water resources, infrastructure, and administration and finance. The other technicians who will provide services in the PMU will be recruited from the private sector through a single contract with a consulting firm for project management support. This arrangement, known locally as a “bunco de horus”, takes the form of a contract -procured according to Bank rules- with a consulting firm which, through predefined profiles of the various technicians who will form the team, will make them available to the PMU according to agreed work loads.

11. This contract is expected to make available a maximum of 22 people at higher levels of program execution. Thirteen of those will be high level technicians, including: 1 legal adviser, 1 water resources adviser, 1 technical adviser, 3 administrative and financial specialists, 1 full-time procurement officer, 3 specialists in the monitoring and control of works and physical undertakings, 2 water resources management specialists, 1 institutional development specialist, and 1 specialist in the conservation and protection of water resources. The other team members, numbering no more than 8, will be mid- or support-level technicians in the areas of secretarial, data processing, financial and administrative support, and general services.

6. Procurement

12. As agreed by the State of RGN and the Bank, all procurement processes under the Project - most of them for the contracting of consulting services - will be centrally managed and monitored by the PMU, on behalf of SEMARH. SEMARH’s capacity to carry out procurement processes -evaluated by the Bank’s team procurement specialist - was found to be appropriate. Several training activities were recommended to update the skills of technicians involved in procurement processes in RGN. Annex 8 defines the procurement guidelines under which the project will operate.

7. Financial Administration and Flow of Funds

13. As agreed by the State of RGN and the Bank, the program’s financial administration will be centrally handled by the PMU’s Administrative and Financial Management Office, and there will be no transfer of funds to the implementation partners. Financial provisions were included in

54 the State Executive Office’s Budget Proposal (SEMARH and FERH categories) for calendar year 2007, both for the use of loan resources and for the counterpart guarantee. More details on financial management, disbursements, and audits are available in Annex 7.

8. Implementation of Components and Subcomponents

14. SEMARH, through the PMU, will be responsible for the project’s overall management. Component 1 (Institutional Development and WRM Instruments), which includes mostly studies to be contracted to local and/or international consulting firms, will be under the sole responsibility of the PMU in SEMARH, except in the case of the development of several water resources management instruments, for which it will be assisted by IGARN, and by ADESE in the promotion of water users associations and the development of a model for the sustainable macro-operation of water supply systems for small communities. In the case of the M&E system for state programs under subcomponent 1.5, SEMARH will pass along this responsibility to SEPLAN.

15. In the case of Component 2 (Natural Resources Conservation and Protection), EMATER, with technical assistance from EMPARN, will manage the microcatchment activities, CAERN will be in charge of the activities dealing with water losses, and SEMARH, through the PMU, will manage the activities dealing with the re-use of water and with sedimentation control.

16. Component 3 (Water Infrastructure) will be executed by SEMARH through the PMU. Ln the case of Water Supply Systems in Small Communities and Extension of the Desalinization Network (activities 3.3.2 and 3.3.3, respectively), the PMU will be assisted by an NGO - to be determined - in the macro-operation of those systems. EMATER and EMPARN will provide support to subcomponent 3.4 - Pilot Interventions for the Rehabilitation and Modernization of Small Fanner Irrigation Schemes

17. Component 4 will be fully executed by SEMARH through the PMU.

9. Legal Instruments for Project Institutional Arrangements

18. Given that the program’s financial administration will be centrally handled by the PMU: (i)all loan and counterpart resources will be budgeted under SEMARH categories; (ii)all contracts will be signed between SEMARH and suppliers, service providers, and contractors; and (iii)the relationship between SEMARH and project implementation partners, will be governed through Working Agreements.

19. Thus, SEMARH shall sign an Agreement with each of the implementation partners such as IDEMA, EMATER, EPARN, etc. These Agreements shall specify the responsibilities of both parties. Submission of a draft of these Agreements, acceptable to the Bank, will be an effectiveness condition. The goods and services to be transferred to implementation partners, under the Institutional Strengthening component, will become effective based on Commodatum Agreements, signed by them and SEMARH. The other legal instruments generated by the project

55 will be contracts to be signed by SEMARH and suppliers of goods, providers of general and consulting services, and works contractors.

10. Institutional Strengthening

20. During project preparation, institutional assessments were made of all participating project institutions, generating a set of institutional demands to strengthen them, both for general purposes and for the project’s specific purposes. An institutional assessment of the State Water Resources Management System was also performed to enable the verification of ownership of various investments under implementation or the improvement of water resources management instruments, as indicated in Component 1 of the project.

21. The evaluation of the Management System, which because of the lack of more suitable indicators to evaluate water resources management was based on an identification and qualitative assessment of the various water resources management instruments existing in the State of RGN, confirmed the needs and demands identified and addressed in Component 1.

22. The institutional demands that will actually make up the Legal and Institutional Aspects subcomponent of the Water Resources Management Component will be agreed upon during the Appraisal mission.

56 ANNEX 6, APPENDIX 1

Implementation Responsibilities

The table below summarizes the responsibilities of the project's implementing partners by project activity.

Activities Implementing Partners

4= Overall Responsibility for Activity X = Primary Implementer # = Implementing Partner 4+ = Executing Agency under contract

1.1.1 Institutional, Planning and Legal Studies I+x I /#I I 1.1.2 Institutionalization of Water Reuse Policy +X 1.1.3 Institutionalization of Irrigation Policy +X #

~ 1.14 Training Programs +X 1.1.5 Support for Creation & Strengthening of Basin Committees & +X WAS 1.1.6 Information Plan +X 1.1.7 Program for Rational Use of Water +X 1.1.8 Institutional Strengthening I +X I ,I ,,I! Subcomponent 1.2 - Water Sector Planning Instruments 1.2.1 Update State Water Plan I+x I

1.3.1 State Water Quality and Quantity Monitoring Network I+x I I#/ I 1.3.2 State Water Resources Information System I+x I /#I#/ I

1.4.1 Regularization and Control of Water Use Rights +X # 1.4.2 Identification Studies of Funding Sources for WRM +X

57 stems in Small

I Component 3 - WATER INFRASTRUCTURE Subcomponent 3.1 - Rehabilitation and Maintenance of Existing Water + x Infrastructure Subcomponent 3.2 - Expansion of Water Infrastructure 4x #

3.3.1 Small Underground Water Reservoirs I+x I I# 3.3.2 Maintenance and Expansion of DesalinationNetwork +X 3.3.3 Installation of Water Supply Systems in Small Communities +X # Subcomponent 3.4 - Pilot Interventions for the Rehabilitation and + x # # Modernization of Small Farmer Irrigation Schemes

Subcomponent 4.1 - Project Management +X Subcomponent 4.2 - Monitoring and Evaluation. +X Subcomponent 4.3 - Support to Preparation of the Second Phase +X Subcomponent 4.4 - Project Communication and Dissemination +X

58 ANNEX 7: FINANCIAL MANAGEMENT AND DISBURSEMENT ARRANGEMENTS

Brazil - Rio Grande do Norte: Integrated Water Resources Management Project

1. Financial Management Assessment

1. A financial management assessment of the project was carried out in accordance with OPBP 10.02 and the Manual for Financial Management Practices in World Bank-Financed Investment Operations issued by the Financial Management Sector Board on November 3,2005.

2. The assessment was carried out jointly with staff from SEMARH, including the person who, in principle, will be responsible for financial management issues, and the state’s Budget Coordinator, from SEPLAN.

3. The assessment included: (i)the discussion with staff of project design and its consequences on the flow of funds and financial management and disbursement arrangements; (ii)evaluation of the state’s public financial management system - SIAF Sistema Zntegrado para Administraglo Financeira - and the Ministry of Environment’s monitoring system - SIGMA, which is expected to be installed for the technical monitoring of the program; (iii)discussions with regard to the acquisition of a new system for monitoring, financial and technical, of the project, as an alternative to SIAF and SIGMA; (iv) review of minimum staffing requirements, including training and qualifications; (v) review of internal control mechanisms in place; (vi) agreement on the format and content of financial monitoring reports (FMRs), and the option for report-based disbursements versus transaction based disbursements; and (vii) review of internal and external audit arrangements.

4. The overall Financial Management Assessment conclusion is that RHID, and the PMU that will be created to that effect, will have, satisfactory financial management arrangements in place to meet OP/BP 10.02, once the staff is adequately trained and the SIGMA system is installed and working in coordination with the SINsystem. The financial management risk associated with the project has been assessed as moderate.

2. Implementing Entities

5. The project will be coordinated and supervised by a PMU within SEMARH. The PMU, which has not yet been created, will report directly to the Secretary of Water Resources and will have an administrative management structure (Ger2ncia Administrativa) to handle financial management matters, including disbursements, and procurement issues. The PMU will also benefit from the support of other SEMARH departments, namely regarding the state’s SIAF system and SIGMA, as it is currently the case for the PROAGUA project.

59 6. In addition to the PMU, other implementing agencies will include IGARN, EMATER and CAERN. SEMARH, where all financial management issues will be centralized and monitored, will be involved in the implementation of all project components. IGARN, CAERN and EMATER will also participate in components 1,2 and 3 respectively.

3. Financial Management System

7. Project financial data will be recorded by the PMU in two, separate systems: (i)SIAF, the state’s budgetary and accounting system, where all public expenditures are budgeted for, committed and recorded, and through which all payments are made; and (ii)SIGMA, the Federal Government’s environmental Management Information System (MIS).

8. While SIAF will focus on financial management aspects, with good embedded control mechanisms, SIGMA-which is not yet installed-will be more geared to technical monitoring of the project. SEMARH has decided that, given the complementarities between these two systems, it will be more cost effective to utilize SIAF and SIGMA instead of developing a new system from scratch. Despite the fact that some gaps will have to be filled in and reconciliations between data in SIAF and SIGMA will be necessary, namely in order to report in a format acceptable to the bank, the financial assessment endorses the client’s decision to work with the two existing systems.

9. SIAF will provide reliable financial information, which will be the basis for the financial module of the financial monitoring reports; SIGMA, once installed and staff adequately trained will provide technical data for project monitoring and the FMRs.

10. Within SIAF, a new separate managing unit (Unidude Gestoru)-a specific cost center for the project in the state’s public financial management system-will be set up for the project as agreed with SEPLAN facilitating the identification of project expenditures and its sources of funding. Accordingly, the state’s system was found to comply complies with Bank minimum financial management requirements, and, with some additional work, the PMU and SEMARH’s financial management staff will be able to produce reliable FMRs in a timely manner.

11. Staffing. Financial management staff will consist of a financial coordinator, an accountant and not less than two administrative persons. As project implementation progresses, additional staff, from SEMARH and to be recruited, will join the PMU.

12. Reporting. Agreement has been reached with the PMU with regard to the format, content, and periodicity of F’MRs/IFRs. Reporting will be in local currency only, taking into account the flow of funds. The fourth quarter FMR/IFR, showing the cumulative figures for the period, should be submitted to the auditor for review under the annual external audit to be prepared by a private independent auditing firm.

13. The following reports formats will be available in SIAF and should be furnished to the Bank not later than 45 days after the end of each calendar quarter, as well as be sent along with other disbursement forms when requesting loan withdrawals:

60 61 14. Financial Reports include:

(a) FMR 1A - Sources and Uses of Funds, by disbursement category, cumulative (project-to-date, year-to-date, and for the period) and Cash Flow Disbursement Forecast.

(b) FMR 1B - Uses of Funds by Project Activity-Components, cumulative (project-to- date, year-to-date, and for the period, and a variance analysis of actual versus planned expenditures) and by financing source.

(c) FMR 1C - Uses of Funds by Project Activity-Components; Cumulative (as in 1B) indicating physical implementation progress.

(d) FMR 1D - Reconciliation of Special (Designated) Account.

(e) FMR 1E - Contract above Thresholds (TTL and Procurement officer).

(f) FMR 2 - Performance Monitoring Indicators (TTL).

(g) FMR 3 - Procurement Report (Procurement Officer).

15. Supervision. Financial management supervision will take place at least once a year and will include (i)review of quarterly FMRs; (ii)review of the auditors’ reports and follow-up of issues raised by auditors in the management letter, as appropriate; (iii)follow up on any financial reporting and disbursement issues; (iv) update of the financial management rating in the Implementation Status Report (ISR); and (v) review of internal control arrangements, including internal audit.

16. Disbursements and Flow of Funds. SEMARH has decided to use Report-based Disbursements (FMRs/IFRs) for loan withdrawal purposes. Funds will be advanced from the loan account into a special bank account (designated account), in local currency (Reais), to be held in a commercial bank acceptable to the Bank in Natal, RN for the exclusive use of the Rio Grande do Norte Integrated Water Resources Management Project. SEMARH will be responsible for opening and managing the special bank account including, and not limited to, producing monthly bank reconciliations and submitting to the Bank the necessary documentation attached to each withdrawal application. SEMARH will also be responsible for the preparation cash flow/disbursement forecast for the loan.

17. As disbursements will be based on un-audited financial reports (FMRs/IFRs), all expenditures supporting documentation will be retained at SEMARH for at least one year after receipt of the audit report for the period, and all records of the expenditures will be available for examination by the Bank if considered necessary.

62 18. In order to minimize interest expense, the Bank would provide an advance of loan funds for the bank’s share of eligible expenditures for a given reporting period. This advance would be based on: (i)the project’s budget and implementation progress; and (ii)cash flow forecasts.

19. SEMARH will centralize financial management and disbursements for project activities. Upon instructions from SEMARH, payments will be made to suppliers for all project components, including those implemented by other agenciedentities. Payments made for contracts above the Bank’s prior review thresholds will be fully documented, with adequate supporting documents, as part of the financial report in a summary sheet format.

20. Accounting and Auditing. Annual project financial statements and FMRs will be prepared in accordance with consistently applied accounting standards, acceptable to the Bank, on a cash accounting basis, in compliance with law 4.320/64.

21. Project financial statements will be audited by independent auditors, satisfactory to the Bank, in accordance with acceptable auditing standards. The auditor’s report will be submitted to the Bank no later than six months after the closing of the borrower’s fiscal year. It is recommended that the Bank finance project audit costs.

22. The external audit will be conducted in accordance with Terms of Reference acceptable to the Bank, which will address specific risk areas, as outlined in the financial management risk assessment table. Auditors will be required to issue an opinion on project financial statements, as per the guidelines “Annual Financial Reporting and Auditing for World Bank-financed activities”, of June 30, 2003, and will produce a management letter, identifying any internal control weaknesses, or areas of improvement.

4. Financial Management Risk Assessment

23. The Risk Assessment Matrix below presents the items of potential risk for the project from a Financial Management standpoint.

Risk HS ML Mitigation Measures i.Country specific X ii.Sub-national level X This will be only the second IBRD loan to the State of RGN iii.Entity specific X iv. Project specific X Several entities involved: pilot sub-projects (eligibilitj flow of funds) to be detailed in a Operations Manual

63 i.Implementing Agency X Some experience with the federal project PROAGUA however, as implementing agency this will be a much larger and more complex program; training in Bank procedures, FM, Procurement will be required ii.Flow of Funds X Arrangements for pilot interventions to be defined iii.Staffing X Need to retain an FM coordinator with previou experience with Bank procedures and familiarity with SIAF and SIGMA; most staff to be hired or retained by the PMU; Bank to provide training iv. Accounting procedures X v. InternaExternal Audit X Need to retain a satisfactory independent audit firm or explore other alternatives vi .Reporting & Monitoring X SIGMA not installed - condition of Loan signing vii. Information Systems X Same as above H-High S-Substantial M-Moderate L-Low

24. The financial management risk associated with the project has been assessed as moderate.

64 ANNEX 8: PROCUREMENT ARRANGEMENTS

Brazil - Rio Grande do Norte: Integrated Water Resources Management Project

1. General

1. Procurement for the proposed project would be carried out in accordance with the World Bank’s “Guidelines: Procurement under IBRD Loans and IDA Credits” dated May 2004 and revised October 2006; and “Guidelines: Selection and Employment of Consultants by World Bank Borrowers” dated May 2004 and revised October 2006, and the provisions stipulated in the Legal Agreement. The general description of various items under different expenditure category is described below. For each contract to be financed by the loadcredit, the different procurement methods or consultant selection methods, the need for prequalification, estimated costs, prior review requirements, and time frame are agreed between the Borrower and the Bank project team in the Procurement Plan. The Procurement Plan will be updated at least annually or as required to reflect the actual project implementation needs and improvements in institutional capacity.

2. Procurement of Works: Works procured under this project would include: small works for restoration of dams, expansion of existing pipelines and restoration and expansion of small water plants. The procurement will be done using the Bank’s Standard Bidding Documents (SBD) for all ICB and National SBD agreed with (or satisfactory to) the Bank.

3. Procurement of Goods: Goods procured under this project would include: computer equipment, software packages, printing services of educational materials, meteorological stations, satellite images, water flow meters. The procurement will be done using Bank’s SBD for all ICB and National SBD agreed with (or satisfactory to) the Bank.

4. Procurement of Non-consulting Services: Non-consulting services to be procured under the Project include training logistics (hotel services, catering, travel), workshops, etc. Contracts estimated to cost US$500,000 or more will be procured following ICB procedures. Contracts with values below US$500,000 per contract may be procured using National Competitive Bidding (NCB) procedures using bidding documents agreed by the Bank. Contracts estimated to cost below US$lOO,OOO may be procured on the basis of quotations obtained from three qualified contractors in response to a written invitation.

5. Selection of Consultants: Consulting services from firms and individuals required for the project include: legal and institutional studies regarding use of water resources; Information Technology master plan for SEMARH; review and update of the state’s water resources master plan; studies for development of a monitoring tool for the use of water resources; operational studies regarding use of water resources; engineering designs; and support for project management and implementation. Short lists of consultants for services estimated to cost less than US$500,000 equivalent per contract may be composed entirely of national consultants in accordance with the provisions of paragraph 2.7 of the Consultant Guidelines.

65 6. The design of the project indicates that EMATER and EMPARN, which are government agencies, will implement subcomponent 2.1 for pilot plans and projects for restoration of water microbasins as co-executing agencies. Each agency will be responsible for executing around US$710,000 in project activities.

7. Furthermore, it was agreed that the Serid6 Sustainable Development Agency (ADESE) will be hired on a sole-source basis to implement activity 1.4.4, which refers to the development of a model for the sustainable operation of water supply systems in very small communities scattered through the State of Rio Grande do Norte. In addition, an NGO to be determined during project implementation will be hired to implement and help evaluate said model.

Table 1: Procurement Summary

category I (US$

500 2 5 10,000 NCB All processes Works 5 500 Shopping First process >500 Goods and Non- ICB All processes consulting 500p 5 100 Services NCB All processes (incl. training, Iloo communication) Shopping First process >500 I QCBS/QBS 1 All processes Consulting 500S<200 1 QCBSLCS (Allprocesses (firms) 100 5 200 QCBSLCS All processes I100 CQLCS First process for each selection method. Consulting Section V in All cases above US$50,000 (individual) the Guidelines Direct All cases regardless of the amounts involved Contracting Agreements All cases regardless of the amounts involved

8. The thresholds will be reviewed when the PIU gains experience in Bank’s rules and regulations. All single-source selection of goods and works, regardless of the amount of the contract, will be subject to prior review by the Bank.

66 2. Assessment of the Agency’s Capacity to Implement Procurement

9. Procurement activities will be carried out by the State Secretariat of Environment and Water Resources (SEMARH). The procurement unit of the agency is staffed by five procurement officers.

10. An assessment of the capacity of the Implementing Agency to implement procurement actions for the project was carried out by the Bank during project preparation. The assessment reviewed the organizational structure for implementing the project and the interaction between the project’s staff responsible for procurement and the Secretariat’s relevant central unit for administration and finance.

1 1. Concerns related to project procurement have been identified and include complex and time consuming procurement processing, lack of experience with a high volume of procurement transactions and lack of a procurement management information system. The corrective measures which have been agreed are rolling out SIGMA (a project management information system) for SEMARH and discussion with the relevant authorities that have a role on procurement processing. The overall project risk for procurement is moderate.

3. Procurement Plan

12. The Borrower has developed a Procurement Plan for project implementation which provides the basis for the procurement methods. This plan was agreed between the Borrower and the Project Team on May 8,2007 and is available at SEMARH with Ms. Joana D’Arc Medeiros. It will also be available in the Project’s database and in the Bank’s external website. The Procurement Plan will be updated in agreement with the project team annually or as required to reflect the actual project implementation needs and improvements in institutional capacity. See summary below.

67 Table 2: Summary of Procurement Action Plan

# Action Timeframe 1 Prepare a General Procurement Plan for the life of the Before negotiations. project and a detailed Procurement Plan for the first eighteen months of project implementation for each of the participating agencies. 2 Training all the participating agencies procurement and Not later than technical staff on Bank-procurement policies. effectiveness. 3 Maintain procurement expertise available within the project Include in the TORS management unit during the life of the project. of the project management firm that will support the operations of the project management unit. 4 Include a section on procurement in the operations manual By negotiations. including a detailed description of all procurement methods allowed when applying the national law, especially the “preggo eletr6nico”and “pregiio presencial” and restrictions on its use. 5 Implement a procurement monitoring system covering all At the latest two executing agencies capable of capturing and consolidating all months after relevant procurement information. -effectiveness. -

4. Frequency of Procurement Supervision

13. In addition to the prior review supervision to be carried out from Bank offices, the capacity assessment of the Implementing Agency has recommended annual supervision missions to visit the field to carry out post review of procurement actions.

68 ANNEX 8, ATTACHMENT 1

Details of the Procurement Arrangement Involving International Competition

1. Goods, Works and Non-consulting Services

(a) List of contract packages which will be procured following ICB and direct contracting:

Review Bid Estimated Procurement Domestic Description Prequalification by the opening Cost (USD Method Preference Bank ‘000) Date Works for expansion of the capacity of existing ICB pipeline networks 1,558 Supply and No Yes Prior 0713 112008 (Hydro-mechanical Installation Equipment) ICB Equipment for 632 Supply and No Yes Prior 03/28/2008 hydrometric stations 1 1 Installation 1 1 1 1

(b) ICB Contracts estimated to cost more than US$350,000 for goods and US$5 million for works per contract and all direct contracting will be subject to prior review by the Bank.

2. Consulting Services

(a) List of Consulting Assignments with short-list of international firms:

Expected Estimated Cost Selection Review by the proposal Description (USD ‘000) Method Bank opening date Implementation of State Water Quality and Quantity Monitoring Network and monitoring and operation system for the State’s water resources infrastructure 1,048.32 QCBS Prior 01/28/2008

O&M of the network: Implementation of the M&E System for government programs Works for expansion of the capacity of existing pipeline networks (project execution and 685,37 QCBS Prior 07/05/2007 supervision of works) Component 4 - Project Management: Specialized .30 QCBS Prior 03/06/2007 Consultancy

(b) Consultancy services estimated to cost more than US$200,000 per contract and all single source selection of consultants (firms) will be subject to prior review by the Bank.

69 (c) Short lists composed entirely of national consultants: Short lists of consultants for services estimated to cost less than US$500,000 equivalent per contract may be composed entirely of national consultants in accordance with the provisions of paragraph 2.7 of the Consultant Guidelines.

70 ANNEX 9: ECONOMIC AND FINANCIAL ANALYSIS

Brazil - Rio Grande do Norte: Integrated Water Resources Management Project

1. Introduction

1. The main objective of the project is to promote social and environmentally sustainable economic development through the strengthening of the technical, institutional, legal and operational framework and the rehabilitation and construction of some essential infrastructure required for the successful implementation of an integrated water resources management system. The improved water resources management system would be a key factor to promote sustainable development in the State of Rio Grande do Norte and, by its very nature, the impact of the project would be felt throughout the economy of RGN and by all segments of society. Consequently, project benefits will be difficult to measures ex-ante and, by the same token, this type of project is not amenable to traditional cost-benefit analysis.

2. Under these circumstances, two different approaches were used to assess the project’s economic viability. For the water resources management-related component, some of the impacts that an improved water resources management system could have on the state’s economy were selected as indicators of the likely returns on investment in this type of activities. The economic viability of the infrastructure component, on the other hand, was assessed using traditional cost benefit analysis, which was applied to a sample of investment proposals that have been identified for implementation during the first year of the project.

2. Likely Impacts of Component 1: Institutional Development and WRM Instruments

3. Project activities under this component are oriented toward building the state’s technical, institutional and operational capabilities and developing adequate management tools and instruments to implement an integrated water resources management system, which is expected to result in a more efficient, equitable and sustainable use of scarce water resources in Rio Grande do Norte. This component would in particular: a) strengthen existing institutions dealing with water resources management issues and adopt an integrated water resources management system that will deal with both supply and demand issues, with effective stakeholder participation and using the watershed as a basic territorial management unit; b) develop and implement water resources management tools and instruments, including an integral water resources information system; c) rationalize water infrastructure investment decision making; d) improve O&M of existing and new water infrastructure; e) influence water demand through the establishment of adequate water charges, combined with incentives schemes for small producers to promote improved efficiency in water use in the irrigation sector.

4. Strong Institutional Framework would result in better planning and implementation of water sector investment programs, as well as a more efficient project design and implementation,

71 reduced cost overruns and more efficient use of existing infrastructure. By improving the quality of the water resources information system, the project would have also a positive impact on the quality of investment decisions both by the public sector and private investors, as has been demonstrated in other parts of the worldg.

5. From Water Supplv to Water Demand Management. The integrated water resources management approach promoted by the project would result in a shift in emphasis in policy and program decisions from purely supply-oriented water resources development projects to both supply- and demand-oriented activities. With the implementation of an improved water charges collection system, a more rational use of water would be promoted, which will in turn result in less pressure for water supply development initiatives and a larger contribution of water users toward the economic cost of water consumed. A strong education program for water users and the promotion of their participation in water resources management at the river basin level would lead to a more rational management of water resources as well as the long-term sustainability of these resources. Education, combined with incentives to improve efficiency in water use in the irrigation sector as well as the adoption of adequate land management practices would contribute toward the promotion of sustainable production systems, particularly among small farmers.

6. Improved Operation and Maintenance. The adoption of an improved O&M system for water infrastructure would contribute not only to a longer economic life of the works but also to a reduced need for rehabilitation, which are traditionally the result of deferred maintenance and poor operation practices. Improved O&M would contribute to a reduction in both financial and physical losses in the various water distribution systems. Furthermore, improved operation of water infrastructure would also contribute to mitigate the negative impacts of droughts on the state’s economic activities, particularly on agriculture.

7. Bank experience and data derived from economics literature”, would indicate that there are important economic gains to be obtained from improved water resources management, and that these gains would more than justify investment in this type of activities.

8. Since these benefits cannot be quantified in monetary values with any precision, the approach used here focuses on the measure of some economic impacts that this component would have on the water sector and which would indicate that investment in this component is likely to be economically feasible .While one could formulate a comprehensive list of possible benefits created in the water resources sector, the ability to measure them in monetary terms is more limited, therefore, the estimated possible benefits that might reasonably be expected from the Institutional Development and WRM component will be conservative, and only a few values that are both relevant for the discussion and quantifiable were selected.

“The quality of investment decisions is positively related to the quality of [hydrological] data used in the decision making process” (Cummings, Ronald, Ariel Dinar and Douglas Olson (1996), “New Evaluation Procedures for a New Generation of Water-Related Projects”, World Bank Technical Paper Nr. 349, (Washington, D.C.: The World Bank). A similar conclusion was reached in London Economics (1994), India: National Hydrology Project, An Economic Appraisal, 24 pp plus appendices, Report to the World Bank: September. IO Cummings, et al., (1996); Rogers (1993); London Economics (1996); and World Bank (1998).

72 9. Average annual investment in the water sector has been around US$16.0 million over the last 10 years. Assuming that the state maintains, at least, the same level of investment during the next decade, a 10 percent efficiency gain, as a result of an improved investment decision-making process due to access to better information on the water resources sector, would represent a benefit of about US$1.6 million per annum. Likewise, every 10 percent reduction in water losses in the water supply network operated by CAERN, as a result of institutional strengthening and improved O&M, would translate into an annual benefit of about US$2.0 million. Finally, if losses in the agricultural sector produced by droughts were to be reduced by 10 percent as a result of better management of water resources, annual benefits to small farmers would be around US$l-1 million. Considering that the annualized cost of Component 1 (Institutional Strengthening and WRM Instruments), during the life of the project, is estimated at US$3.6 million, even on the basis of a partial list of conservatively estimated benefits, one could conclude that the proposed investment is economically viable.

10. Improved efficiency in water use would lead not only to direct economic benefits, as shown above, but also to environmental benefits, i.e. less pressure on water sources such as the Lagoa Bonfim and aquifers, which have not been quantified and incorporated into the benefit- cost analysis of the component

3. Traditional Benefit-Cost Analysis of Component 3: Water Infrastructure

11. The economic viability of this component is based on the analysis of two pilot interventions whose execution would start during the first year of the project, and which represent over 50 percent of the total investment foreseen for this component. The selected projects are the expansion of one of the large bulk water transmission mains, Monsenhor Expedito, and the Pilot Irrigation and Water Resources Management Project in Cruzeta. Details of the economic analysis of these two projects are given in the sections below.

12. Monsenhor Expedito Water SuDPlY Infrastructure Pilot Intervention. The main objective of this investment proposal is to develop a system that could meet the population’s current and future demand for water while at the same time protecting the water resources of the Lagoa Bonfim. Previous environmental studies determined that the level of the lake could not go below 39 meters if irreversible environmental damaged was to be prevented. This limit was almost reached during the last severe drought. The system is currently extracting 228 l/s directly from the lake and 176 l/s from wells drilled close to the lake, which would result in a combined extraction from the lake’s water resources of 404 l/s.

13. Project activities in the water supply sector would improve the supply of drinking water, both in terms of quantity and quality, to benefit some 300,000 people, of which about 50,000 are currently not connected to the water supply network and the rest are receiving insufficient and unreliable supply of water. Except for two towns of between 15,000 and 20,000 inhabitants each, the beneficiaries are rural poor living either in some of the 28 small villages or 48 dispersed communities.

73 14. Under the proposed pilot intervention, total level of (direct and indirect) extraction form the Lagoa Bonfim would be reduced to 230 l/s to guarantee that, even under extreme droughts, the lake would be preserved. The rest of the water resources required to meet the expanded future demand would come from wells drilled in areas that do not pose any threat of negative environmental impacts.

15. However, apart from the environmental benefits, the investment proposal is also financially and economically viable. For the purpose of the economic and financial analysis, water consumption levels and water prices were estimated on the basis of field work carried out in 2004. Benefits were assumed to come from both savings by current consumers from changing to a cheaper source of water supply and increased consumption of water at a lower price by both current and new consumers. Benefits were quantified by simulating a “with project’’ situation with the help of the SIMOP Simulation Software, which estimates demand curves and incremental consumer surplus derived from greater water availability for different population groups ’ ’ . Four water consumer groups were identified, with their respective consumption patterns and sources of supply. The price elasticity assumed for each of the four groups was derived from a water demand function for the Northeast, which had been estimated on the basis of field work carried out in 1997’2. Conversion factors obtained from a PMSS-financed study13 were applied to financial prices of labor, materials and equipment to obtain economic costs. On the basis of these assumptions, the economic rate of return to investment in the expansion of the Monsenhor Expedito Water Supply Infrastructure was estimated at 18.7 percent.

16. The long-term marginal cost of water was estimated at R$2.93/cubic meter, which is the level at which water tariffs would have to be set to guarantee full capital cost and O&M cost recovery. At their present level of R$1.76/cubic meter, water tariffs would recover 100 percent of O&M cost and about 56 percent of capital cost; the remaining 44 percent of capital cost would be the state government contribution to investment, which is within the range of government contribution to this type of investment in the Northeastern states in Brazil.

17. Pilot Irrigation and Water Resources Management Proiect. The area identified for the first proposed pilot project is Cruzeta. The second pilot project would be identified during the first year of project implementation. Cruzeta was taken as representative of the two pilot projects to be implemented under the project and used as a basis for assessing the economic viability of Component 3.4 (Modernization of Small Irrigation Schemes).

18. Cmzeta is a small irrigation scheme, located in the Serid6, with some 110 hectares under irrigation infrastructure that are cultivated by 23 poor small farmers when irrigation water is

11 Powers, Terry A.and Carlos AsValencia,(1978), Modelo de Simulacidn de Obras P6blicas (SIMOP). Manual del Usuario, (Washington, D.C.: Inter-American Development Bank, IDB). I’ PBLM- Consultoria Empresarial S/C Ltda. (1997), Excecuqao de Servicios TCcnicos sobre a Demanda de Agua no Nordeste, Relatorio Final, (Banco do Nordeste). l3Cecilia Menon Moita et ai., (1998), Metodologia de Avaliaqao EconBmica e Financiera de Projetos: a esperiencia do PMSS 11, (Brasilia: IPEA).

74 ,-

available. Irrigation efficiency is low, as these farmers apply surface irrigation and use low technology cultivation methods. The irrigation scheme, which has a main canal with a capacity of 400 Us, was designed to irrigate about 142 hectares. However, during 8 of the last 15 years, when rainfall was below normal, the area that was actually irrigated was less than 60 hectares. Droughts were certainly an important factor in the decline of the area under irrigation, but the situation was made worse by the low efficiency of the irrigation method used and the poor management of water resources stored in the dam. Farmers have an average of 4.8 hectares under canal, where they cultivate mostly tomatoes, beans, maize, and some papaya (mamao). Additionally, they have just under 12 hectares each suitable for rainfed agriculture and livestock production, a situation that is characteristic of most small farmer irrigation schemes that can be found in the poor rural areas of Serid6.

19. The operation and maintenance of the irrigation main scheme is the responsibility of National Department of Drought-Related Works (DNOCS), while the water users association (Associa$io dos Irrigantes do Perfmetro Irrigado Cruzeta - APICR UZ) manages the secondary network up to the farms’ intakes. The cost of O&M is about US$335 per month, but no water charges are currently being collected and, therefore, hardly any maintenance is being carried out. Farmers used to receive technical assistance from DNOCS, but responsibility for hiring specialists to provide technical assistance was given to the APICRUZ, which, given its precarious financial situation, has not been providing any technical assistance to its members. Under the project, farmers will receive financial support to cover O&M, including technical assistance, on a declining scale basis, starting with 100 percent project financed O&M in Year 1, 75 percent support in Year 2,50 percent in Year 3 and 25 percent in Year 4. By Year 5, farmers will be financing 100 percent of O&M cost. Additionally, under the project farmers are expected to contribute about one-third of capital cost.

20. The proposed pilot project would finance works, equipment and technical assistance to rehabilitate the present irrigation scheme in Cruzeta; promote the adoption of modern irrigation technology and sustainable production systems by project beneficiaries; and improve the operation and management of the dam. Lessons learned from the implementation of the pilot project are expected to provide a basis for the design of sustainable production systems and water resources management schemes that are applicable to the rest of the small farmer irrigation schemes in the state.

21. On the basis of a participatory design, three models were chosen as representative of the type of cropping patterns that could be adopted in the “with project situation”, in which the security of irrigation water would improve, as a result of an improved management of the dam; irrigation efficiency at the farm level would increase substantially, thanks to the adoption of modern irrigation technologies; and productivity would increase with the provision of technical assistance to farmers. All three models are assumed to keep about one hectare under traditional crops, such as beans, and forage (capim), but with improved surface irrigation and higher yields than under the “without project” situation. The cropping patterns selected by beneficiaries as possible production alternatives under the project were: (a) tomatoes, combined with watermelons, in double cropping, and papaya; (b) high specialization in tomatoes, combined

75 with watermelons in double cropping; and (c) a more diversified production system, which includes tomatoes, always in double cropping with watermelons, combined with papaya and coconut: reflecting both different attitudes toward specialization and risk aversion by potential beneficiaries. These production systems were utilized to build the three farm models that were used to analyze the financial and economic viability of the pr~posal’~.Financial rates of return of the models ranged from 18.5 percent to 31.8 percent; and the overall economic rate of return of the proposal was estimated at 33.4 percent. Farmer’s annual income increased from an average of about R$5,000, in the “without project” situation, to about R$17,000 at full development of the project.

l4Details of costs and production estimates used in the three models can be found in SERIHD (2005), RecuperaqFio e Modernizaqtio de Perimetros Irrigados. Projeto Piloto Perimetro Irrigado de Cruzeta, (Natal: SERHID); and in E. Floto, F. Pizarro and VSilvestri (ZOOS), “Rehabilitacidn y Modemizacidn del Perimetro de Riego. Algunas hipdtesis de trabajo”, Working Paper, (Roma: FA0 Investment Centre).

76 ANNEX 10: SAFEGUARD POLICY ISSUES

Brazil - Rio Grande do Norte: Integrated Water Resources Management Project

1. Overview

1. The safeguard policies that have been triggered for this project include: Environmental Assessment; Natural Habitats, Pest Management, and Safety of Dams.

Environmental Assessment (EA): An EA was undertaken for the project following OP/BP/GP 4.01.

DamSafety Panel: The component on rehabilitation and conservation of dams for multiple uses foresee actions on infrastructure rehabilitation and operational improvement in approximately 20 existing dams and reservoirs that are strategic to water resources management in the state. A panel of experts has been contracted to ensure the safety of dams in this project. The panel includes specialists in hydrology, hydraulics, structure, and geo-technology of dams. The general objective of the panel is to provide technical assistance to the project management teams during project preparation and during project implementation. The panel's report can be found in the Project File.

2. Relevant Safeguard Policies

Safeguard Policies Triggered by the Project Yes No Environmenta1 Assess ment (OP/B P/GP 4 .O 1) [XI [I Natural Habitats (OP/BP 4.04) [XI [I Pest Management (OP 4.09) [XI [I Cultural Property (OPN 11.03, being revised as OP 4.1 1) [I [XI Involuntary Resettlement (OPBP 4.12) [I [XI Indigenous Peoples (OD 4.20, being revised as OP 4.10) [I [XI Forests (OPBP 4.36) [I [XI Safety of Dams (OP/BP 4.37) [XI [I Projects in Disputed Areas (OP/BP/GP 7.60)* [I [XI Projects on International Waterways (OP/BP/GP 7.50) [I [XI

2. Environmental Rating: In accordance with Bank Safeguard Policy OP4.01, the Project has been classified as a Category B project for environmental impacts.

3. Environmental Assessment

3. An environmental assessment (EA) has been carried out for the project in order to identify potential environmental impacts, recommend mitigation and compensatory measures for

* By supporting the proposed project, the Bank does not intend to prejudice the final determination of the parties' claims on the disputed areas

77 any negative impacts, and maximize the largely positive environmental impacts expected from the project.

4. An Environmental Management Plan (EMP) was developed as part of the EA and was fully incorporated into the project design. In addition to the EA, the project triggered Safeguards related to Natural Habitats, Pest Management and Safety of Dams. These have been adequately addressed in the course of project preparation, included in the EA, and reflected in the project design. The Terms of Reference for the Environmental Assessment were reviewed by qualified Bank staff.

5. In addition to an Environmental Assessment (EA) and Environmental Management Plan (EMP) already undertaken, the proposed project will consider undertaking a Strategic Environmental Assessment (SEA) to assist the state in the review, updating and approval of the State Water Resources Plan (PERH), which is now nearly a decade old. The SEA’S objective is to assist in the determination of which options are best-suited to achieving the project’s development objective with regard to environmental and sustainability concerns and in order to minimize negative impacts on either environmental resources or on sustainable development. It, therefore, is aimed at facilitating the focus on and integration of environmental and sustainability aspects in the planning process, thereby contributing to better decision making.

6. The revision of the PERH should take eight months and include the following elements, which were defined in the original plan:

(a) Update the diagnostics and base studies of the state’s watersheds;

(b) Update planning studies;

(c) Update the programming of actions; and

(d) Dissemination program for the State Water Resources Plan.

4. Environmental Management Plan

7. The project’s EMP includes the following activities:

(a) A Social Communication Program to provide strategic support for implementation of project actions and to prepare the project Communication and Dissemination Plan;

(b) an Environmental Education Program to carry out educational actions aimed at water users and project intervenient agents to sensitize, create awareness and train technicians and workers;

(c) EPA Bonfim-Guaraira Regulation Support Program to support the establishment of environmental zoning and EPA management;

78 (d) Monsenhor Expedito System Loss Control Plan to promote actions for the reduction of current losses from 46 to 25 percent;

(e) Environmental Program for Water Infrastructure Regularization to implement actions and measures required for the environmental regularization of the water infrastructure in the state, starting with the expansion of interventions undertaken in the scope of the project;

(f) Monitoring Program to monitor changes in the quality and quantity of waters from the water courses and reservoirs:

(g) Environmental Construction Manual to serve as a guide of appropriate environmental practices, including guidelines, procedures and technical specifications to be adopted in all stages of the implementation of water infrastructure. Finally, the EMP includes an

(h) Environmental Management System to organize and coordinate actions of a socio- environmental nature of the Program’s components; supervise the implementation of programs of institutional nature; identify and evaluate the relevant levels of environmental impacts, and establish improvement targets and guide the operations to achieve these goals.

8. Natural Habitats: The Monsenhor Expedito water supply system will be implemented in a protected area established for the preservation of the Lagoa Bonfim (Bonfim Lake). Thus, the environmental rehabilitation activities of the dam sites and the consolidation activities were evaluated following OP 4.04. The adoption of appropriate methodologies to deal with Natural Habitats was included in the EMP.

9. Pest Management: The predicted interventions for the improvement of small scale irrigation perimeters were evaluated following the OP 4.09. The adoption of appropriate methodologies to deal with Pest Management was included in the EMP, and Integrated Pest Management Plans were prepared for irrigated areas involved in the project.

10. Cultural Property: The project does not trigger the Cultural Property Safeguard. However, works to be carried out in PYO2-PY05 will be undertaken in municipalities hosting archeological sites. For this purpose, these works will be assessed during the design of their related projects in compliance with Brazilian legislation, and will include a consultation with the National Institute for the Artistic and Archaeological Heritage (IPHAN). The Environmental Manual for Construction, included in the EMP, includes guidelines to follow in the event of the chance find of any object of cultural property.

11. Involuntarv Resettlement: The project does not trigger the Involuntary Settlement Safeguard. There is an agreement between the state and the Bank that the proposed project will not undertake any activities or pilot interventions that involve resettlement. Nonetheless, given that the Bank and the State of Rio Grande do Norte have prepared, agreed and updated a

79 Resettlement Framework for other projects in the state, this document has been included in the project file in the extremely unlikely event that project actions require its use.

12. Safety of Dams: The project proposes recovery actions and maintenance of at least 20 dams and reservoirs for multiple uses which are considered strategic to the state, in order to facilitate their more efficient operation. The EA evaluated the environmental conditions of these dams and reservoirs which are utilized primarily to supply water for human use and regional development with a focus on rural-population activities, including irrigation and weanling livestock production. Of these dams, 11 are large-scale and 9 are small or medium-scale. As project actions will not alter storage capacity of the dams and reservoirs, no negative cumulative impact is expected. A Dam Safety Panel was contracted following OP/BP 4.12 to address the issues of dam safety. During project preparation, 8 dams, predicted to have interventions executed during the lStyear of project implementation were evaluated.

5. Public Consultations (for more information on the project’s public consultation process, see Annexes 16 and 17)

13. Prior to and during project preparation numerous meetings were held with multiple stakeholders (e.g. private and public, nongovernmental organizations, unions, civil society, water users, men and women). These include series of consultations with all categories of project stakeholders for the development of project actions as well as with government entities to discuss possible environmental impacts of project interventions.

14. SEMARH, in conjunction with state and municipal government agencies, nongovernmental organizations, the state university, unions, and local development agencies, has organized a series of stakeholder meetings, including both men and women, designed to discuss local challenges and a pilot project in the Cobra River microcatchment designed to address local needs. Additional meetings were held in the target communities to discuss the proposal for the pilot. The Una River pilot will be developed in the same participatory manner.

15. During project preparation, several consultations and meetings were carried out with participation of state entities, including a technical meeting about the project components, which included a discussion of the expansion of the Monsenhor Expedito Pipeline since it involves environmentally sensitive issues. This technical meeting included the presence of members from the State Water Resource Council and the State Environmental Council and licensing authorities from the State of Rio Grande do Norte (IDEMA) and Brazil’s Public Prosecutor’s Office. In addition, a final public consultation process about this activity was carried out in November 2005.

80 ANNEX 11: PROJECT PREPARATION AND SUPERVISION

Brazil - Rio Grande do Norte: Integrated Water Resources Management Project

Planned Actual PCN review 06/23/2004 06/23/2004 Initial PID to PIC 07/30/2004 07/30/2004 Initial ISDS to PIC 07/30/2004 07/30/2004 Appraisal 12/0 1/2005 1 2/0 1/2005 Negotiations 0211 512006 07/02/2007 Board/RVP approval 091 18/2007 Planned date of effectiveness 0 1/ 15/2008 Planned date of mid-term review 03/30/20 10 Planned closing date 11 /30/20 12

16. Key institutions responsible for preparation of the project: International Bank for Reconstruction and Development (World Bank), Secretariat of Environment and Water Resources (SEMARH), United Nations Food and Agriculture Organization (FAO) and State Secretariat for Planning and Finance (SEPLAN).

17. Bank staff and consultants who worked on the project included:

Name Title Unit Alvaro Soler Task Manager: Sr. Rural Dev. Spec. LCSAR Luis Correa Noronha Consultant: Water Res. & Inst. Spec. LCSAR Edgardo Floto Consultant: Economist LCSEN Dana Frye Jr. Professional Assoc. LCSAR Fernando Pizarro Land &Water Dev. Engineer FAOICP Pablo Anguita Consultant: Water Res. Specialist FAOICP Luiz Gabriel Azevedo Civil Engineer (Sector Leader) LCSSD Juan David Quintero Sr. Environmental Spec. LCSEN Alexandre Fortes Consultant: Environmental Spec. LCSEN Dorte Verner Sr. Social Economist LCSEO Judith Lisansky Sr. Anthropologist LCSEO Jose Janeiro Sr. Finan Mgmt Spec. LCOAA Luis Prada Procurement Spec. LCOPR Alexandre Borges Procurement Spec. LCOPR Catarina Portelo Sr. Counsel LEGLA Isabella Micah Drossos Sr. Counsel LEGLA Mariana Montiel Sr. Counsel LEGLA Alejandro Alcala Legal Consultant LEGLA Fernando Blanco Economist LCSPE Martin Gambrill Sr. Water Engineer LCSFW Werner Kornexl Sr. Environmental Spec. LCSEN Paula Pedreira de Freitas Operations Analyst LCSEN Gloria DeHaven Language Program Assistant LCSSD

81 Karen Ravenelle-Smith Language Program Assistant LCSSD Matthew Cummins Jr. Professional Assoc. LCSEN 18. Bank funds spent to date on project preparation:

(a) Bank resources: US$294,000

(b) Trust funds: US$7,000

(c) Total: US$301,000

19. Estimated Approval and Supervision costs:

(a) Remaining costs to approval: US$40,000

(b) Estimated annual supervision cost: US$90,000

82 ANNEX 12: DOCUMENTS IN THE PROJECT FILE

Brazil - Rio Grande do Norte: Integrated Water Resources Management Project

1 Project Document for Programa de Desenvolvimento Sustentiivel e ConvivCncia com o Semi- Arido Potiguar

2. Dam Safety Panel’s Report

3. Environmental Assessment

4. Social Assessment

5. Environmental Management Plan

6. Resettlement Framework

7. Banco do Nordeste (1997), Execucao de Servicios TCcnicos sobre a Demanda de Agua no Nordeste, Relatorio Final,

8. Cecilia Menon Moita et al., (1998), Metodologia de Avaliacao EconGmica e Financiera de Projectos a experiencia do PMSS 11, (Brasilia: IPEA)

9. Cummings, Ronald, Ariel Dinar and Douglas Olson (1996), “New Evaluation Procedures for a New Generation of Water-Related Projects”, World Bank Technical Paper Nr. 349, (Washington, D.C.: The World Bank)

10. PBLM- Consultoria Empresarial S/C Ltda. (1997), Excecucao de Servicios Tecnicos sobre a Demanda de Agua no Nordeste, Relatorio Final, (Banco do Nordeste)

11. Powers, Terry A. and Carlos A. Valencia 1978), Modelo de Simulacih de Obras Pliblicas (SIMOP). Manual del Usuario, (Washington, D.C.: Inter-American Development Bank, IDB)

12. World Bank, 2004, Brazil: Irrigated Agriculture in the Brazilian Semi-Arid Region: Social Impact and Externalities, Washington, D.C. Report No. 28785-BR

13. World Bank, 1998, Project Appraisal Document for the Federal Water Resource Management Project (PROAGUA), Washington, D.C. Report No. 1745 1-BR.

83 ANNEX 13: STATEMENT OF LOANS AND CREDITS

Brazil - Rio Grande do Norte: Integrated Water Resources Management Project

Difference between expected and actual Original Amount in US$ Millions disbursements

Project ID FY Purpose IBRD IDA SF GEF Cancel. Undisb. Orig. Frm. Rev’d PO82328 2005 BR-Integ.Munic.Proj.-BetirnMunicipality 24.00 0.00 0.00 0.00 0.00 24.08 0.00 0.00 PO80829 2005 BR 1st. PRL. for Environmental Sustainab. 502.52 0.00 0.00 0.00 0.00 502.52 0.00 0.00 PO83533 2005 BR TA-Sustain. & Equit Growth 12.12 0.00 0.00 0.00 0.00 12.12 0.00 0.00 PO877 11 2005 BR Espirito Santo Wtr & Coastal Pollu 36.00 0.00 0.00 0.00 0.00 36.00 0.00 0.00 PO60573 2004 BR Tocantins Sustainable Regional Dev 60.00 0.00 0.00 0.00 0.00 60.00 5.00 0.00 PO80830 2004 BR Maranhao Integrated: Rural Dev 30.00 0.00 0.00 0.00 0.00 30.00 1.15 0.00 PO83013 2004 BR Disease Surveillance & Control APL 100.00 0.00 0.00 0.00 0.00 100.00 0.00 0.00 2 PO877 13 2004 BR-Bolsa Familia 1st APL 572.20 0.00 0.00 0.00 0.00 572.20 0.00 0.00 PO541 I9 2003 BR BAHIA DEVT (HEALTH ) 30.00 0.00 0.00 0.00 0.00 28.67 4.67 0.00 PO70827 2003 BR-2nd APL BAHIA DEV. 60.00 0.00 0.00 0.00 0.00 42.99 18.10 0.00 EDUCATION PROJECT PO49265 2003 BR-RECIFE URBAN UPGRADING 46.00 0.00 0.00 0.00 0.00 44.99 4.95 0.00 PROJECT PO58503 2003 GEF BR Amazon Region Prot Areas 0.00 0.00 0.00 30.00 0.00 26.3 1 0.00 0.00 (ARPA) PO80400 2003 BR-AIDS & STD Control 3 100.00 0.00 0.00 0.00 0.00 91.85 11.15 0.00 PO76977 2003 BR-Energy Sector TA Project 12.12 0.00 0.00 0.00 0.00 12.12 3.42 0.00 PO74171 2003 BR-Municipal Pension Reform TAL 5.00 0.00 0.00 0.00 0.00 4.90 3.90 0.00 PO57665 2002 BR-FAMILY HEALTH EXTENSION 68.00 0.00 0.00 0.00 0.00 50.81 36.81 0.00 PROJECT PO5 1696 2002 BR SA0 PAUL0 METRO LINE 4 209.00 0.00 0.00 0.00 0.00 163.99 119.09 0.00 PROJECT PO57653 2002 BR- FUNDESCOLA IIIA 160.00 0.00 0.00 0.00 0.00 205.51 -22.78 0.00 PO55954 2002 BR GoIAS STATE HIGHWAY 65.00 0.00 0.00 0.00 0.00 36.80 35.80 0.00 MANAGEMENT PO6022 1 2002 BR FORTALEZA METROPOLITAN 85.00 0.00 0.00 0.00 0.00 111.47 54.02 0.00 TRANSPORT PROJ PO74085 2002 BR Sergipe Rural Poverty Reduction 20.80 0.00 0.00 0.00 0.00 5.13 -0.85 0.00 PO43 8 69 2002 BR SANTA CATARINA NATURAL 62.80 0.00 0.00 0.00 0.00 60.07 17.45 0.00 RESOURC & POV. PO73 192 2002 BR TA Financial Sector 14.50 0.00 0.00 0.00 0.00 9.30 5.48 0.00 PO70552 2002 GEF BR PARANA BIODIVERSITY 0.00 0.00 0.00 8.00 0.00 8.23 5.73 0.00 PROJECT PO66 I70 2002 BR-RGN 2ND Rural Poverty Reduction 22.50 0.00 0.00 0.00 0.00 14.98 6.58 0.00 PO73294 2001 BR Fiscal & Fin. Mgrnt. TAL 8.88 0.00 0.00 0.00 0.00 6.74 5.78 0.00 PO59566 2001 BR- CEARA BASIC EDUCATION 90.00 0.00 0.00 0.00 0.00 73.50 -16.50 0.00 PO50772 2001 BR LAND-BASED POVRTY 202.10 0.00 0.00 0.00 58.13 151.01 152.74 0.00 ALLEVIATION I(SM) PO50875 2001 BR Ceara Rural Poverty Reduction 37.50 0.00 0.00 0.00 0.00 12.34 5.59 0.00 Project PO50880 2001 BR Pemambuco Rural Poverty Reduction 30.10 0.00 0.00 0.00 0.00 18.58 13.78 0.00 PO57649 2001 BR Bahia Rural Poverty Reduction 54.35 0.00 0.00 0.00 0.00 8.39 -0.35 0.00 Project PO5088 1 2001 BR PIAUI RURAL POVERTY 22.50 0.00 0.00 0.00 0.00 9.98 7.98 0.00 REDUCTION PROJECT PO06449 2000 BR CEARA WTR MGT PROGERIRH 136.00 0.00 0.00 0.00 0.00 70.52 44.65 1.56 SIM PO47309 2000 BR ENERGY EFFICIENCY (GEF) 0.00 0.00 0.00 15.00 3.29 9.00 11.17 2.47 PO35741 2000 BR NATL ENV 2 15.00 0.00 0.00 0.00 2.32 5.61 7.93 7.93 PO39199 2000 BR PROSANEAR 2 30.30 0.00 0.00 0.00 6.40 22.29 28.69 22.29 PO50776 2000 BR NE Microfinance Development 50.00 0.00 0.00 0.00 0.00 30.15 -19.85 0.00 PO626 19 2000 BR INSS REF LJL 5.05 0.00 0.00 0.00 0.00 0.36 -0.14 0.67 PO50763 1999 BR- Fundescola 2 202.00 0.00 0.00 0.00 0.00 17.29 17.29 0.00 PO48869 I999 BR SALVADOR URBAN TRANS 150.00 0.00 0.00 0.00 0.00 85.95 85.95 0.00 PO58129 1999 BR EMER. FIRE PREVENTION (ERL) 15.00 0.00 0.00 0.00 0.00 5.46 5.46 -0.22 PO35728 1998 BR BAHIA WTR RESOURCES 51.00 0.00 0.00 0.00 0.00 5.84 5.84 -0.16 PO06559 1998 BR (BF-R)SP.TSP 45.00 0.00 0.00 0.00 0.00 3.88 3.88 0.00 POW74 1998 BR LAND MGT 3 (SA0 PAULO) 55.00 0.00 0.00 0.00 10.00 37.17 47.17 18.48 PO579 10 1998 BR PENSION REFORM LIL 5.00 0.00 0.00 0.00 0.50 1.48 1.98 0.88 PO42565 1998 BR PARAIBA R.POVERTY 60.00 0.00 0.00 0.00 0.00 11.16 11.16 0.00 PO43420 1998 BR WATER S.MOD.2 150.00 0.00 0.00 0.00 125.00 19.33 144.30 2.78 PO4342 1 1998 BR RJ M.TRANSIT PRJ. 186.00 0.00 0.00 0.00 27.78 92.74 120.52 0.00 PO38895 1998 BR FED.WTR MGT 198.00 0.00 0.00 0.00 40.00 54.67 94.67 16.35 PO43873 1997 BR AG TECH DEV. 60.00 0.00 0.00 0.00 0.00 15.24 15.24 15.24 PO06532 1997 BR FED HWY DECENTR 300.00 0.00 0.00 0.00 50.00 61.51 11 1.51 111.51 PO34578 1997 BR RGS Highway MGT 70.00 0.00 0.00 0.00 0.00 35.07 35.07 35.07 PO43868 1997 BR RGS LAND MGTPOVERTY 100.00 0.00 0.00 0.00 0.00 12.95 12.95 12.95 PO062 10 1996 GEF BR-NATL BIODIVERSITY 0.00 0.00 0.00 10.00 0.00 1.79 2.59 0.90 Total: 4,626.34 0.00 0.00 63.00 323.42 3,135.04 1,266.72 248.70

Statement of IFC’s Held and Disbursed Portfolio (in US$ millions)

Committed Disbursed IFC IFC FY Approval Company Loan Equity Quasi Partic. Loan Equity Quasi Partic 200 1 AG Concession 0.00 15.00 15.00 0.00 0.00 14.07 0.00 0.00 1996197 Algar Telecom 0.00 8.17 0.00 0.00 0.00 8.17 0.00 0.00 2002 Amaggi 25.71 0.00 0.00 0.00 25.71 0.00 0.00 0.00 2002 Andrade G. SA 30.00 0.00 10.00 20.00 30.00 0.00 10.00 20.00 2001 Apolo 7.61 0.00 0.00 0.00 5.1 1 0.00 0.00 0.00 1998 Arteb 20.00 7.00 0.00 18.33 20.00 7.00 0.00 18.33

85 1999 AutoBAn 24.35 0.00 0.00 19.41 24.35 0.00 0.00 19.41 1998 BSC 1.54 0.00 0.00 0.66 1.46 0.00 0.00 0.66 1993196 BUNGE CEVAL 0.00 2.31 0.00 0.00 0.00 2.31 0.00 0.00 1996 Banco Bradesco 1.69 0.00 0.00 2.50 1.69 0.00 0.00 2.50 1994196 CHAPECO 1.78 0.00 0.00 5.26 1.78 0.00 0.00 5.26 2002104 CN Odebrecht 25.00 0.00 0.00 0.00 25.00 0.00 0.00 0.00 2003 CPFL. Energia 0.00 0.00 40.00 0.00 0.00 0.00 40.00 0.00 1992 CRP-Caderi 0.00 0.32 0.00 0.00 0.00 0.32 0.00 0.00 2004 Comgas 45.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 1997100 Coteminas 0.00 0.39 0.00 0.00 0.00 0.39 0.00 0.00 1980192 DENPASA 0.00 0.12 0.00 0.00 0.00 0.12 0.00 0.00 1998 Dixie Toga 0.00 15.00 0.00 0.00 0.00 15.00 0.00 0.00 1997 Duratex 7.29 0.00 0.00 11.19 7.29 0.00 0.00 11.19 1999 Eliane 21.33 0.00 13.00 0.00 21.33 0.00 13.00 0.00 1998 Empesca 5.00 0.00 10.00 0.00 5 .OO 0.00 10.00 0.00 2001102 Escola 0.00 0.25 0.00 0.00 0.00 0.25 0.00 0.00 2000104 Fleury 20.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 1998 Fosfertil 6.06 0.00 0.00 26.02 6.06 0.00 0.00 26.02 1998 Fras-le 6.67 0.00 10.00 0.00 6.67 0.00 6.70 0.00 1994 GAVEA 1.88 0.00 5.50 0.00 1.88 0.00 5.50 0.00 GP Cptl Rstrctd 0.00 8.70 0.00 0.00 0.00 8.59 0.00 0.00 2001 GPC 9.00 0.00 0.00 0.00 9.00 0.00 0.00 0.00 1997 Guilman-Amorim 21.88 0.00 0.00 33.53 21.88 0.00 0.00 33.53 1998 Icatu Equity 0.00 14.00 0.00 0.00 0.00 12.60 0.00 0.00 1999 lnnova SA 13.75 5.00 0.00 35.00 13.75 5.00 0.00 35.00 1980187197 Ipiranga 23.62 0.00 0.00 39.75 23.62 0.00 0.00 39.75 1999 Itaberaba 0.00 5.34 0.00 0.00 0.00 5.34 0.00 0.00 2000102 Itau-BBA 103.63 0.00 0.00 0.00 64.08 0.00 0.00 0.00 1999 JOSAPAR 7.57 0.00 7.00 0.00 2.57 0.00 7.00 0.00 1995 Lojas Americana 4.00 0.00 0.00 0.00 4.00 0.00 0.00 0.00 1992199 MBR 15.00 0.00 0.00 0.00 15.00 0.00 0.00 0.00 2002 Macae 45.25 0.00 10.00 37.50 45.25 0.00 10.00 37.50 Macedo Nordeste 0.00 0.00 2.50 0.00 0.00 0.00 2.50 0.00 2002 Microinvest 0.00 1.25 0.00 0.00 0.00 0.12 0.00 0.00 2002 Net Servicos 0.00 3 1.74 0.00 0.00 0.00 3 1.74 0.00 0.00 1994 Para Pigmentos 10.75 0.00 9.00 0.00 10.75 0.00 9.00 0.00 1996 Perdigao 4.38 0.00 0.00 0.00 4.38 0.00 0.00 0.00 1994100102 Portobello 0.00 1.15 0.00 0.00 0.00 1.15 0.00 0.00 2000 Puras 3 .OO 0.00 0.00 0.00 3 .OO 0.00 0.00 0.00 2003104 Queiroz Galvao 0.60 0.00 0.00 0.00 0.08 0.00 0.00 0.00 Randon Imp1 Part 4.20 0.00 3.00 0.00 4.20 0.00 3.00 0.00 1997103 SP Alpargatas 30.00 0.00 0.00 0.00 5.00 0.00 0.00 0.00 1994197 Sadia 6.9 1 0.00 4.33 43.79 6.91 0.00 4.33 43.79 2002104 Salutia 0.00 0.08 0.00 0.00 0.00 0.08 0.00 0.00 1997 Samarco 7.20 0.00 0.00 0.00 7.20 0.00 0.00 0.00 1998 Saraiva 4.62 3.00 0.00 0.00 4.62 3.00 0.00 0.00 2003 Satipel 13.93 0.00 10.00 0.00 13.93 0.00 10.00 0.00 2000 Sepetiba 26.93 0.00 5.00 0.00 11.93 0.00 5.00 0.00 1999 Sudamerica 0.00 15.00 0.00 0.00 0.00 15.00 0.00 0.00 199019 1 Suzano Bahia SUI 0.00 0.53 0.00 0.00 0.00 0.53 0.00 0.00 200 1 Synteko 16.71 0.00 0.00 0.00 16.71 0.00 0.00 0.00 1996 TIGRE 3.85 0.00 0.00 0.00 3.85 0.00 0.00 0.00 1998104 Tecon Rio Grande 8.10 0.00 0.00 8.10 0.00 0.00 0.00 0.00 2001103 Tecon Salvador 0.00 0.56 0.00 0.00 0.00 0.55 0.00 0.00 2002 UP Offshore 11.60 10.00 0.00 30.00 0.00 3.00 0.00 0.00 2002104 Unibanco 20.00 0.00 0.00 0.00 14.80 0.00 0.00 0.00 1999 Vulcabras 8.33 0.00 0.00 0.00 8.33 0.00 0.00 0.00 1999 Wiest 0.00 0.00 8.00 0.00 0.00 0.00 8.00 0.00 Total portfolio: 675.72 144.91 162.33 331.04 498.17 134.33 144.03 292.94

Approvals Pending Commitment F/ Approval Company Loan Equity Quasi Partic. 2000 BBA 0.01 0.00 0.00 0.00 2002 Banco Itau-BBA 0.00 0.00 0.00 0.10 1999 Cibrasec 0.00 0.01 0.00 0.00 2004 Comgas 0.00 0.00 0.00 0.05 2002 Net Servicos 2 0.05 0.00 0.00 0.00 2002 Suape ICT 0.01 0.00 0.00 0.00 2004 TermoFortaleza 0.06 0.00 0.01 0.11 2004 TriBanco Brazil 0.01 0.00 0.00 0.00 2002 Unibanco-CL 0.00 0.00 0.00 0.15 Total pending commitment: 0.14 0.01 0.01 0.41

87 ANNEX 14: COUNTRY AT A GLANCE

Brazil - Rio Grande do Norte: Integrated Water Resources Management Project

88 Latin Lawcr. Mca middk- Brszil &Carib. iffime

$86 4 55 1 2,475 Lfe expectancy 3.400 4.009 1.PI8 8450 2.210 4,747

I .4 1. .4 10 .8 2.2 14

ga( Tf 50 71 72 Ti? 32 27 33 7 12 Access tc imwured water source $0 $1 82 as 90 m 14f 119 r 14 145 121 '115 f37 117 113

fW5 1945 2004 222.B 704.2 m.0 794.1 19 2 22.3 21.3 19.3 12-2 7.7 dB.0 22.5 24 4 205 =.a 28.1 18.0 1P.5 23.2 22.4 -02 -2.6 t .9 2.5 35 1.2 2.0 48.5 225 28.8 39 '1 3BI 47.8 3.e .. 232.9 Indebledmess 2W4 2003 2QKv-03

49 2.3 35 35 0.9 2.7 $50 2a.Q 12-6

STRUCTURE of the ECONOMY 1485 1945 2004 2905 Growth of capital and GDP ("a) (% or GDPj ~'gficutlure 11 5 Q.0 to.4 T lndustq 453 387 I Manufaauring 337 235 Serrces 431 543 Househc c hnal comumptcon expewdrme 656 588 Gmeral gcrr fin3 cmwmpoon expenditure QP lee Imports of gcacs and seavices 71 0 5

1985-95 1995-05 2004 ma5 (aWnepeannual grnwthj A~iUJ~re 21 42 5.3 2.7 Industry 03 12 6.2 27 Manufacturing -1 1 13 Services 23 05 4.5 -6 0

Hcuseho Q hnal ccnsumprrion expenditure 28 03 4.3 0.8 General govt finr conv~mpbcnexpenditure 13 37 0.7 56 Smss captal fornaban 23 D1 f4.3 -7 B Irnpom of gocos and sesvicees QP 0.7 14.3 a6

89 PRICES and GOMRNMENT FINANCE 1985 1995 2004 28305 Domesfbpr&es tX cSMu*7ef Consumer prices 200.0 68.0 5.8 69 lnvplicrt GDP defllatw 231 7 77.6 8.2 72 f3awmmenz finam (74 of GDP, ifichtdes wmf grants) CURW~~revenue 9.8 10.6 Cumnt budge? balance -0.7 -1.5 Overall sum us:defai -1 3

TRADE 13us $395 2004 ma5 $65 mtfhom) Taal expcrrls (fob: 25,63.8 46.506 8 1.46C 17 8.396 ron ore, manganese 1.eM 2-746 4.758 Soybeans ?.E45 3620 5,395 Manuladures 13.356 29720 52.948 i1.112 Taal impom ICT) 15.753 49872 62.802 75.~135 Food . 3.514 T ,058 Fuel and energy 6.176 2587 10.317 Capital goods 2.@D 19.891 12,132 25.t14 Exp& price index (2M@=fOO) 78 103 105 $17 Import pr~eindex [NOO=fCW) 47 85 97 Tmsof base f20Ort=fOO) Wi 121 120 $20

BAtAMCE or PAYMENTS 1985 1995 2004 m5 (us$tTllkff5I Expects d WdsJ~G SewfirS 27,715 48.544 iw.050 142.055 Impom of gcuds and 5micc5 15.~~658~50 80,069 w.403 Resouwe balance 30.785 -9206 239,896 48,452 We7 nme -11.2t3 -12,741 -20,520 -28.$$0 Ne4 CURmt mb;cnSkI3 $6 3.873 3,268 50 Cumnt acmwt balance 412 -17.973 1 Z ,738 18,822 Finmans ttems ineai -HI 30842 -1 5.377 -3.478 Chnaes in net rerenres 511 -12.869 3,639 -18.546 Memo: Sewrves including goa (US3 &ions] 11,mig 51 540 Ccnversion rate ID€&, IbCafrWSS) 2 28E-R ii.9

EXTERNAL DEBT and RESOURCE FLQWS 1W5 1995 2004 2005 (USb mirfmns) Taat debt at5tJndiiq and d sbumed IDJ,~~?100.515 222 02e leua 5.2'74 6.038 8,668 8.083 IDA D 0 0 0 Taal debt sewfoe 11.471 21.576 53,710 iew 796 1.868 1.843 1.335 IDA 0 0 0 0 Gcmpcsssraion af net resourn flows Oficial grant5 54 65 93 Official maicrs W6 -1.714 -2,938 Pnvate creditors aw 10.925 4,614 Forergn direct inwstment inel Mw#s) 1,443 K859 18.166 Po& o e~urty(nef inYmsj 0 2.775 2.08 i F 144.454 rN'orld Bank program Commiments 1,525 404 t.215 0 sbwsements 7e5 638 1.447 775 Principal repayments W 1.3T7 t.564 1,028 Net Rws 3s -539 -115 -255 Interest pammts 387 491 230 ?.UT Net trmskrs -33 -1 031 -w -5a

The Wwld Bank Gmup This table was prepared by mbyuna slaff, figures may dser fmm crthw Wand Bank pukahw daia. &"12/06

90 ANNEX 15: SUMMARY OF THE SOCIAL ASSESSMENT

Brazil - Rio Grande do Norte: Integrated Water Resources Management Project

1. Introduction

1. A social assessment of the project area was undertaken and is based on multiple secondary data sources and stakeholder consultations carried out both before and during project preparation. The focus of the social assessment was on: (i)providing a socio- economic profile of the state and the Serid6 region; (ii)determining the principle challenges to be confronted in the management of water resources; (iii)outlining beneficiary participation in each component; (iv) presenting an evaluation of past projects implementing similar measures as the proposed project; and (v) recommending possible beneficiary mobilization strategies. The full Social Assessment can be found in the project file.

2. State Background Information. Rio Grande do Norte has a population of almost 3 million inhabitants, 73 percent of which reside in urban or provincial urban areas. The Human Development Index for the state is 0.574, ranking it 21" out of the 26 Brazilian states. Although social indicators have improved significantly in recent decades, the state is still characterized as predominantly poor, and numerous challenges remain such as a 24 percent illiteracy rate and an infant mortality rate of 43.2 per 1,000 live births.

3. One of the main challenges facing Rio Grande do Norte, as in other states in the Northeast Region of Brazil, is the availability and sustainable use and management of its water resources. The majority of the state's territory is characterized as either semi-arid or arid, and desertification is increasing. In addition, periodic droughts are a major challenge.

4. Rio Grande do Norte's economy was long characterized predominantly by small- scale agriculture and land extensive ranching. However, the overall economy of the state is in the midst of a transformation, with further development of more modernized irrigated agriculture, agro-industrial activities, textiles, tourism and diversification of the service sector. Currently Rio Grande do Norte leads Brazil in the production of salt, farm- raised shrimp and some fruits (particularly melons) produced with irrigation. It rates second in terms of Brazilian oil production.

5. The majority of socio-economic challenges facing the state relate to water resources such as water scarcity, deficient water treatment and sanitation, deterioration of water tables and reserves, lack of wells, deterioration of irrigation infrastructure, and other problems. Poor soil and water management by users is also common and is related in part to deficiencies of policies, regulatory and legal instruments, uncertain land tenure . situations, and insufficiencies of technical assistance and extension for issues including conservation, management and maintenance of irrigation systems, alternative production techniques as well as deficiencies in credit, commercialization and storage, and training,

91 among others. The proposed project would address many of these issues, and the social implications for the priority area and subcomponents most focused on water users and communities are described in more detail below. Many of the project activities would include socio-economic diagnostics and further consultation with stakeholders (private and public, civil society, men and women) designed to increase stakeholder participation and ownership.

6. Priority Area: Seridd Region. The semi-arid Serid6 region (comprised of 28 municipalities) was selected as the high priority area for many project activities due to its low incidence of rainfall, chronic water shortages and ecological fragility. It is a region largely characterized by poverty and environmental degradation, both of which are exacerbated by traditional livelihood practices such as clear-cutting, grazing, clay extraction and firewood collection. Considerable out-migration occurs as people leave due to droughts and lack of livelihood and employment opportunities.

7. There is a deficit in coverage of basic sanitation services in the region, with 34.9 percent of households lacking an adequate water supply and 52.4 percent of sewage installations being inadequate. With regard to health services, although advances have been made in recent years, the Serid6 is still confronted by an insufficient number of health installations, doctors and preventive policies.

8. Most municipalities in the Serid6 rank below 0.50 in HDI and in 1991 the region’s overall illiteracy rate was 37.9 percent, 3 percentage points higher than that in the state as a whole. In addition, in 1991, 72.5 percent of the population was considered poor, defined as receiving equal to or less than one-half minimum salary per capita.

2. Stakeholder Consultations

9. Prior to and during project preparation numerous meetings were held with multiple stakeholders (e.g. private and public, nongovernmental organizations, unions, civil society, water users, men and women). See below for further details. An evaluation of previous efforts to install water supplies for small rural communities was carried out, and numerous consultations with stakeholders and potential beneficiaries were carried out for the development of the Cobra River pilot. Stakeholder concerns are briefly outlined below in the descriptions of the subcomponents with high stakeholder involvement.

10. Activity 1.1.5 - Support for the Creation and Strengthening of River Basin Committees and Water User Associations. Previous experience in Rio Grande do Norte since 1996 and in other Northeastern states demonstrates the actual and potential importance of water user organizations for improved participatory, decentralized and sustainable management of water resources. Initial work in Rio Grande do Norte has already been carried out with a broad spectrum of stakeholders both public and private, including men and women, in the Piranhas-Acu River Basin with a focus on the microwatershed of the Serid6 River.

92 11. The project plans to strengthen 103 existing water users associations, formalize some 20 others, and create at least 150 new water users associations in the Apodi- Mossoro, Piranhas-ACu and Potengi watersheds. It also plans to help set up river basin committees for the Pitimbu, Apodi-Mossoro and Potengi Rivers.

12. To this end, the SEMARH is adopting the participatory management methodology of the state of Cearii, which has significant experience in incentive programs to the formation of water users associations.

13. Lessons learned from this and other models show that decentralized, integrated water management can only be achieved with the participation of water users. However, it is important to note that existing associations have struggled with water use conflicts, generally arising from differences in the interests of small and large irrigators, fishermen and those who seed crops in receded sections of rivers and lakes in the dry season. These are usually resolved through the establishment of water use agreements, which prioritize supplies for human use and for weaner animals.

14. Activity 1.1.6 - Program of Rational Use of Water. The National Water Resources Policy (Law 9.433, January 8, 1997) asserts that the rational and integrated multiple uses and management of water resources requires well informed participatory approaches that involve government, water users and all citizens. In line with this participatory approach and building on previous activities in the state, this subcomponent would support decentralized environmental education activities for target audiences including multiple water resource stakeholders including, among others, irrigation users, small farmers, fishermen, salt producers, recreational users and the general population.

15. Activities would include, among others, socio-economic and environmental diagnostics of involved municipalities, creation and facilitation of municipal forums to discuss local water problems, mediation of conflicts among water users, training for community leaders and teachers, and development of school didactic materials as well as broader dissemination efforts. Goals include, among others, sensitizing municipal authorities to water and sanitation issues, formation of multiplier agents (e.g. teachers, leaders), and community mobilization such as for the management of desalinization systems.

16. Subcomponent 2.1 - Microcatchment Pilot Proiects: Cobra River Microwatershed Pilot. The Cobra River is located in the Serid6 in a semi-arid area characterized by intense environmental degradation, including the increasing substitution of the original habitat (caatinga) with agriculture and ranching, extraction of clay from alluvial areas, and firewood extraction. It is considered an area with a high risk for desertification. In recent years, local producers seeking to generate income have exacerbated the environmental problems by greatly increasingly ceramic production.

17. Since January 2004, SEMARH, in conjunction with other governmental (state and municipal) agencies, nongovernmental organizations, the state university, unions, and local development agencies, have organized a series of stakeholder meetings, including both men and women, designed to discuss local challenges and a possible pilot project

93 designed to address local needs. After several meetings, the municipality of Parelhas (three communities - Cachoeira, Santo Antonio da Cobra and Juazeiro - with a total population of 1,567 people comprising 391 families) - was selected for the pilot due to its concentration of ceramic activities, high degree of environmental degradation and the interest of relatively well organized civil society organizations.

18. Additional meetings were held in the target communities to discuss the proposal for the pilot. Local concerns included the need to: (i)discuss all interventions widely with the communities; (ii)implement small works to improve rational water use and soil conservation; (iii)recuperate gallery forests along the river; (iv) establish legal reserves; (v) seek economic alternatives for local workers; and (v) train and strengthen civil society organizations in the communities. These concerns are being incorporated into the planning of the pilot. In addition, a timetable was agreed to continue discussion about the details of the pilot activities to be implemented under the project. Lastly, the state university agreed to develop and monitor social, economic and environmental indicators for the pilot.

19. Subcomponent 2.1 - Microcatchment Pilot Proiects: Una River Microwatershed Pilot. The Una River microwatershed is located in a transition region between coastal and semi-arid. This region is the source of three rivers (the Una, Salto and Piquiri) which constitute the principal water supplies for the municipalities of VBrzea, Espirito Santo, Passagem and Santo AntGnio. The microwatershed is home to remnants of Atlantic Forest vegetation but suffers from an elevated degree of degradation along the banks of its rivers due to unsustainable agriculture and livestock practices.

20. The pilot, which is foreseen for implementation in PY02, would indirectly benefit some 40,000 people and is expected to have the following objectives: (i)recover permanent protected areas; (ii)carry out environmental education workshops; (iii)map the Piquiri-Una protected area which suffers from unmonitored timber extraction; and (iv) complete an environmental diagnostic of the pilot area. It would be developed in a participatory manner similar to that of the Cobra River pilot.

21, Subcomponent 3.4 - Rehabilitation and Modernization of Irrigation Schemes. This subcomponent would support the recuperation and modernization of irrigated perimeters of the Itans and Cruzeta reservoirs in the Serid6 region. Irrigated agriculture in the Serid6 produces primarily beans, corn, tomatoes, and bananas and other fruit. However, due to inefficiencies, old technologies and lack of maintenance, these irrigated areas have become less sustainable, and are using even more water than the cities nearby.

22. Preliminary diagnostics carried out in the perimeters of Itans and Cruzeta have identified the potential beneficiary families and some of their concerns, such as lack of technical assistance. It was also noted that there is a relatively high degree of social capital, in terms of local associations, and a high degree of local interest in increasing the efficiency of production, particularly with respect to modernization of irrigation techniques.

94 23. Activity 3.3.1 - Small Underground Water Reservoirs. This subcomponent would seek to disseminate knowledge of and assist farmers and ranchers in semi-arid areas with the construction of small works designed to decrease erosion and improve soil management, such as rock barriers and underground water reservoirs, the latter to promote small-scale sustainable agriculture and in order to abandon aggressive clay extraction and processing activities. The activities would be developed together with beneficiary communities and small farmers, in conjunction with local governments, and the technical assistance of EMATER (extension services). Areas targeted for priority actions are those with the greatest threat of desertification in the Serid6 and Alto Oeste regions, beginning with communities that indicate interest in participating.

24. Activity 3.3.3 - Installation of Water Supply Systems in Small Communities. In recent years, the state has mounted an ambitious program to assure water supplies to areas with chronic shortages, especially in the Serid6 region. The challenge has been assuring water for small rural communities that are geographically dispersed, which has been addressed primarily by the construction of wells. In 2002, sixty-one communities that had received small water supply systems from a variety of programs were surveyed in an evaluation of work done to date. It was concluded that while most communities reported an improvement in quality of life, only 43 percent of the installed water supplies functioned satisfactorily, the main problems being the quantity and quality of the water obtained as well as time required to fetch water.

25. Under the current project, 77 communities in situations of extreme water shortages in the Seridd region in the Piranhas-Asu river watershed were selected for installation or improvement of water supplies. Meetings were held in many of the communities, where there was strong interest in improving water supplies. In order to avoid the above-mentioned problems experienced by previous projects, the proposed project would combine various approaches as a framework to address the different aspects related to water supply, including desalinators, domestic distribution, cisterns, wells and public water fountains. The goal of this management model will be to provide sustainability to the operation and maintenance of the installed water supply systems.

95 ANNEX 16: SUMMARY OF THE ENVIRONMENTAL ASSESSMENT

Brazil - Rio Grande do Norte: Integrated Water Resources Management Project

1. Introduction

1. The project will support strategic approaches to the management of the state’s water resources in order to: (i)establish mechanisms that will result in the more efficient use and conservation of available water resources; and (ii)create the political, legal, institutional, technical and operational conditions for the appropriate management of the water resources in an integrated manner, thus fomenting the social, economic and environmentally sustainable development of the Potiguar semi-arid region in the State of Rio Grande do Norte.

2. The project will include non-structural and structural actions. Non-structural actions are related to institutional and legal issues and to the modernization of water resources management tools and capacity building within government agencies. Structural actions will finance works and activities to improve and rehabilitate existing water supply systems, and the construction of new supply systems in small communities. A higher concentration new supply systems will be constructed in the Serid6, which, given its levels of poverty, is a priority region for the project.

3. Environmental issues associated with the rehabilitation of existing water infrastructure and the construction of new small water supply systems in poor communities are expected to be of low magnitude. Impacts will be localized and therefore easily managed through the application of sound siting criteria and construction procedures. Therefore, the first phase of the project has been categorized as B for environmental purposes according to the World Bank’s OP 4.01 Environmental Assessment.

4. This document summarizes the findings of (i)the environmental assessment carried out by the Borrower; and (ii)the reports on dam safety by a panel of experts which inspected all dams to be rehabilitated under the project.

2. Environmental and Social Conditions

5. Poverty. The state of Rio Grande do Norte has 166 municipalities and a population of 2,852,800 inhabitants, 73 percent of which live in urban areas. The state is ranked 21st among Brazilian states with respect to the HDI15 and is in 4th place among Brazil’s northeastern states. In terms of education, 30 percent of the population over 15 years of age is illiterate. In the public health sector, the worst indicators are: infant mortality, limited access to basic sanitation, and poor nutritional condition of children under 5 years of age. These indicators are related to poor sanitary conditions, in particular, lack of access to potable water.

Human Development Index

96 6. The state economy is undergoing a re-structuring process, in which the traditional agriculture model has been giving way to ago-industrial activities (irrigation projects), modernization of the textile industry, growth of the tourism and oil industries and the service sector.

7. Water Resources. The state’s two major water basins, the Piranhas-Ap and the Apodi-Mossorb, are in the semi-arid area and occupy 60 percent of the state territory. The crystalline terrains are impermeable, which result in the rapid transformation of rain into flowing water, and sets conditions for the rivers’ intermittency. The only way to accumulate water is by using the extensive network of dams built in the region. Figure 1 shows the watersheds in the state.

8. The state’s water infrastructure is formed by a set of 45 major permanent reservoirs, with a capacity of over 5 million cubic meters, and by a water distribution system connecting all basins which extends for approximately 1,200 km over 7 major water transmission pipelines. Some portions of the intermittent rivers are turned into permanent-flow rivers by these dams, the most important of which are: Armando Ribeiro GonGalves, Umari, Santa Cruz, Passagem das Trairas, Boqueiriio de Parelhas and Itans.

Figure 1 - Watersheds in Rio Grande Figure 2 - Serid6 Region - Project Priority Area

9. The largest portion of the state is located in the northeastern sert6o (hinterland), an area vulnerable to cyclic droughts, with the frequent occurrence high salinity waters, thus complicating water availability issues. The priority region for the project’s action is the Seridb-Potiguar.

10. In most critical areas, the demand for potable water in both urban and rural areas is being met, although precariously. Major deficits in the availability of treated water and sanitary facilities are exacerbated by pollution and waste. Potential contamination of underground water sources either by agricultural chemicals in the rural areas or by urban wastewater effluents can jeopardize important water resources in the state.

97 11. Priority Area of Intervention - Seridd Region. The total population of the Serid6 is 294,000 inhabitants, which represents some 11 percent of the state’s population, and has been decreasing in recent decades.

12. The Serid6 Region, shown in figure 2, is in the inlands of the Semi-Arid Northeast, in an area of extremely low soil fertility. It suffers from scarce and unequal distribution of rains, which is characteristic in the Brazilian northeast, with the occurrence of total or partial droughts that can last from one to many years.

13. The Serid6 was deemed the region most affected by the desertification process. The area hosts the “Serid6 Desertification Nucleus”, one of four in the country being assessed by the Ministry of Environment and by national and international research institutes.

14. The main consequences of the environmental alterations in the Seridd region include degradation of soils, elimination of native vegetation cover, silting of water reservoirs, depletion of the water table, biodiversity loss, reduction of development options, and impoverishment and migration of rural men.

15. Water resources are characterized by their relative scarcity. The demand of the Seridd region is being very precariously met. The supply and demand balance reinforces the need to increase the water supply and improve its distribution, management and conservation. Only 0.2 percent of the rains that fall in the Serid6 region filter into the soil, 3.8 percent accumulate in dams, 5 percent return to the sea from the rivers and 91 percent evaporate.

3. Description of Proposed Project

16. The main goal of the five-year project is to support the state in achieving integrated water resources management in a participatory way, by respecting equity and sustainability from the technical, social, environmental and financial perspectives, and having the watershed as its management unit.

17. The project will include:

(a) Consewation and rehabilitation of dams: consisting of studies, civil works and equipment for the maintenance and rehabilitation of some 20 strategic dams within the state, as well as promotion of improvement activities to manage the multiple use reservoirs.

(b) Recovery and modernization of irrigation schemes: adaption of the Itans and Cruzeta irrigation schemes to the best conservation techniques and irrigation practices, thereby reducing water resources demand and increasing productivity within an institutional arrangement that enables self sustainability of these systems.

(c) Expansion of the Monsenhor Expedito Pipeline System: expansion of the pipeline’s productive capacity and construction of three new complementary

98 pipelines, thus expanding the services to seven municipalities that have no adequate source of supply.

(d) Hydro-environmental Works: construction of approximately 32 small underground reservoirs to accumulate water in alluvial beds for underground water storage and microbasin preservation.

(e) Desalinization Network: rehabilitation and establishment of new desalinization systems in small communities where the underground water sources have high levels of salinity, thus increasing the water supply meant for economic and social development.

(f) Small communities supply system: rehabilitation and improvement works of surface and underground water collection and distribution systems, borehole perforation, in at least 60 small communities of the Serid6 region.

4. The Project and IBRD Policies

18. The following table shows the World Bank’s main Operational Policies that directly or indirectly affect the sub-components assessed in this Environmental Assessment.

World Bank’s Operational Policies Triggered

Interventions Anticipated 14.01 4.04 4.09 4.12 4.10 4.37 I .. I Conservation and rehabilitation of dams i 11 iii iv Recovery and modernization of irrigation V vi vii schemes Expansion of the Monsenhor Expedito ... viii ix Pipeline System Hydro-environmental Works X Desalinization Network xi Small communities supply system xii State Review of the Water Resources Plan - xiii PERH

19. In order to meet the triggered safeguards, the following reports were prepared:

(a) OP 4.01 - Environmental Assessment. An Environmental Assessment (EA) was prepared per the Bank’s environmental policies applicable to Category “B” projects. The Report evaluates the interventions related to production increase and expansion and to the treated water supply networks; establishment of desalinization units in small communities and improvement of the existing ones; establishment of water supply simplified systems; and other investments such as the recovery of multiple use reservoirs in the region.

99 (b) Mitigating actions to address the adverse impacts were included in an EMP - Environmental Management Plan, containing associated costs, responsibilities for its implementation and time schedules. These actions are detailed in the EA and will become an integral part of project implementation.

(c) OP 4.04 - Natural Habitats. Actions related to improvements in existing dams and irrigation schemes could potentially affect conditions of preservation areas (e.g. the reservoir buffer zones). In addition, interventions aimed at the expansion of the Monsenhor Expedito Pipeline will take place in the BonfidGuaraira Environmental Protection Area (EPA). The project will include compensatory measures to support the project in the regulation and effective establishment of the EPA. The EPA is a sustainable use conservation unit that ensures the proposed activity.

(d) OP 4.09 - Pest Management. The Bank’s OP requirements will be fully complied with in the following interventions: (i)dam rehabilitation and conservation - regarding the eventual need to control pests in areas with vegetation cover surrounding the reservoirs; and (ii)recovery and modernization of the irrigation systems at the time of definition of the support mechanisms for the development of agricultural activities. Integrated Pest Management Plans will be prepared for irrigated areas involved in the project.

(e) OP 4.10 Indigenous Peoples. No interventions were identified for the 1st year of works with existing quilombolas, traditional populations of the state, and no occurrence is expected for the 2nd through to the 5th years.

(f) OP 4.12 - Involuntary Resettlement. Although involuntary resettlement of families was not identified, a Resettlement Framework has been included as part of the EA. The framework is the one developed for PROAGUA with the support and approval of the Bank, and already endorsed and in use in the state. It contains guidelines to be observed in the remote case that resettlement of families is needed at a later stage for the undertaking of project interventions.

(g) OP 11.03 - Cultural Property. No relevant interventions were identified in the activities and works for the first year of the project. However, the works of the 2nd through the 5th years will be undertaken in municipalities hosting archeological sites. For this purpose, the assessment of these works will be undertaken during the design of the projects in compliance with current Brazilian legislation, and will include a consultation with the IPHAN - National Institute for the Artistic and Archaeological Heritage. The Environmental Manual for Construction includes guidelines to follow should an object of cultural heritage be accidentally discovered during project implementation.

(h) OP 4.37 Safety of Dams. This policy is applicable to Component 3 - Water Infrastructure, sub-component 3.1 - Conservation and Rehabilitation Program for the State Water Infrastructure. The proposed project aims to rehabilitate 20

100 strategic dams in operation throughout the state. Eleven of these are large size dams and nine are of medium or small size.

20. Eight dams were selected for the safety assessment, three of which were 15 meters or higher (thus considered of large-scale) and five were medium or small-scale and had 15 meters or less (these will undergo project interventions during the first year of the project).

21. A panel of experts on dam safety was created for the large size dams. Safety reports were assessed and approved by the World Bank on the Rodeador, Passagem das Trairas and Itans dams. For the smaller dams, the inspection was undertaken by SEMARH experts, who used a methodology recommended by the Ministry of Integration (MI) and completed the Formal Inspection Sheet for earth dams.

22. Recommendations from these inspections have been included in project designs.

Summary of Safeguard Instruments

OP Response by the Project EA / EMP Preparation OP 4.01 - Environmental Assessment Public Consultations Program to Support the Consolidation of the Bonfim-Guaraira OP 4.04 Natural Habitats EPA - Loss Control Plan for the Monsenhor Expedito Pipeline System Integrated Pest Management Plan within the Irrigation Schemes OP 4.09 - Pest Management Modernization Pilot Projects Although not triggered, the project will adopt a Resettlement OP 4.12 - Involuntary Resettlement Framework approved by the Bank for the PROAGUA OP 4.20 Indigenous Peoples Not triggered Dams Panel of Experts - dams over 15 meters high Safety inspection - small and medium size dams OP 4.37 Safety of Dams Bank-approved Dam Inspection Guidelines prepared for

PROAGUA~ ~~ Procedures to “chance findings” in the Environmental Manual OPN 11.03 - Cultural Property for Construction

5. Environmental Assessment of Components

23. Rehabilitation of Existing Dams. An environmental assessment of the selected dams and reservoirs was carried out taking into account the following aspects: (i)overall conditions of operation and maintenance; (ii)land use and occupation in the Permanent Protection Area - PPA; (iii)conditions of the vegetation in the surrounding area of the reservoir; (iv) water use; (v) environmental licensing and water grants status; and (vi) water quality.

24. The assessments showed generalized deficiencies in the environmental management of the dams involved. They all had a high to medium degree of eutrophication, whose causes were only partially identified and require further studies. Untreated domestic sewage from urban areas, leather factories and slaughterhouses as

101 well as agricultural run-off, contribute to eutrophication. Recent research undertaken in the Serid6 region by the Instituto de Pesquisas Agricolas do Rio Grande do Norte (Rio Grande do Norte Agricultural Research Institute) point to the possible existence of high levels of phosphorous in regional rocks and soils. Hence, an in-depth study on the nutrient contributions to the dams assessed is required to help understand the determinant conditions of their eutrophication process.

25. Expansion of Water Structures - Monsenhor Expedito Pipeline System. The assessment carried out took into consideration the current situation of the existing system (area and population assisted, physical-operational system, and operational conditions of the system) and the expansion proposal involving the legal and technical aspects (environmental licensing and compliance with Brazilian laws and regulation).

26. The most sensitive technical issue is related to the impact of increased water pumping from the aquifer and its effects on the lagoon system, particularly in the Lagoa do Bonfim, because of the interdependency between the surface and groundwater systems. Studies carried out at the time of inception of the current pipeline system confirm that the intended expansion will not jeopardize the environmental conditions of the lagoon system.

27. The environmental licensing of the current system (preceded by the EIA/RIMA) underwent an intense public discussion on preserving the Lagoa do Bonfim’s environmental conditions and of the guarantees to be offered by the system’s operator (CAERN/SEMARH). As a result, a TAC-Terms of Adjustment in Conduct (as defined by Brazilian legislation)-was signed with the Public Prosecution Department and established the minimum level for the Lake at 39 meters, below which intake may not occur. The assessment concluded that the operation of the systems has met the environmental conditions established in that agreement.

28. Water demand is further exacerbated by inefficiencies in the system. According to operational information from 2004, the physical losses in the Monsenhor Expedito System are estimated to be of 46.1 percent. (The regional average is about 55 percent).Under the project, these losses are expected to be reduced to 25 percent through a Loss Control Plan.

29. The expansion of the water intake will take place in the BonfirdGuaraira Protected Area. The project will contribute to the management of this Conservation Unit, in particular the urgent need to establish criteria and parameters for the control of use and soil occupation of the several existing human activities in the areas near the Lagoon.

30. The expansion of the distribution system will involve the construction of new water pipes. This construction will take place along the right-of-ways of the existing road network. Environmental issues relating to this activity are expected to be minor and will be managed by an Environmental Manual for the Construction of Water Pipes which was prepared under the Bank-funded PROAGUA project.

102 3 1. Water Supply Systems in Small Communities. The Establishment of Water Supply Systems in Small Communities is meant to meet the needs of rural populations- usually not considered as users of the conventional systems-by supplying quality water (in physical-chemical and bacteriological terms), having as its basic principle the decentralized and participatory management by the communities affected. This involves: (i)hydro-environmental works; (ii)maintenance and expansion of the desalination network program; and (iii)establishment of water supply systems in small communities.

32. These are occasional interventions represented by the construction of underground reservoirs and the employment of human resources from the municipalities and micro-basins benefited. The promotion of rational and efficient use of the soils and waters and the use of hydro-environmental techniques is sought, particularly in the rural communities of the semi-arid region.

33. The focus of the environmental assessment was on the priority criteria review for the selection of construction sites and on the implementation strategy for the hydro- environmental works proposed.

34. Restoration and expansion of Desalination Network. SEMARH currently operates a network of 110 desalinators. These systems are included in an efficient maintenance program that distinguishes the condition of this equipment from others in the state.

35. Regarding the wastewater from these small plants, the project recommends its use in evaporation tanks, aquiculture, and even in household cleaning and laundry. The proposal for the expansion, recovery and maintenance of the state network is relevant and socially justifiable, given the possibility to supply potable water to the benefited communities.

36. Regarding recovery actions for existing systems, it is recommended that the systems be resized for storage and final waste disposal in order to avoid the inappropriate disposal in the region’s water bodies.

37. SEMARH will require more staff and the expansion of its structure in order to manage the new desalinators. One of the activities foreseen is training in preventative and corrective maintenance to capacitate operators to do minor repairs in the systems.

38. Water Supply Systems in Small Communities - Seridd Region. The assessments carried out in the small rural communities confirm the positive social impact of the system, given the major need for the works foreseen in the project as these will result in an increase of the water supply, better health and life conditions of the population, and an opportunity for the development of system management.

39. However, the success of these initiatives is highly dependent on the implementation of a management model for the operation and maintenance of these systems based on community participation. ADESE, with the support of ANA (the National Water Agency) has outlined the engineering projects and proposed a management model for the operation and maintenance of the simplified systems. The

103 management model proposed will be reviewed during project implementation and may be improved to achieve the operational sustainability of the systems over the years.

40. Modernization of Irrigation Schemes. The objective of this activity is to upgrade the irrigation schemes of Itans and Cruzeta to the best conservation techniques and practices, thus reducing the demand for water resources and increasing productivity within an institutional arrangement that enables the self-sustainability of the systems based on water resources management mechanisms appropriate for the state.

41. The main conclusions of the assessment were: (i)the current technologies are inadequate-the use of furrow irrigation increases water losses-which proves the need for modernization of procedures and techniques in order to obtain greater efficiency gains; (ii)soil salinization due to inappropriate irrigation management; (iii)loss of water in the hydric structures, hence the need for recovery and maintenance; (iv) use of pesticides without agronomic prescription, reflecting the need to conform to control regulations and integrated pest management; (v) deficiency in technical assistance and safety; and (vi) inexistence of efficient water allocation and environmental licensing systems.

42. strategic Studies: Review of the State’s Water Resources Plan. The review, updating and approval of the State’s Water Resources Plan foreseen in the project shall consider the undertaking of a SEA (Strategic Environmental Assessment) to be defined in the Terms of Reference included in the Environmental Assessment.

6. Overall Assessment of the Project

43. The environmental assessment undertaken proved the consistency of the proposed interventions and activities with Brazilian environmental legislation, in particular those related to environmental themes and water resources management, as well as the overall conformity of these interventions with IBRD’s Safeguards Policies.

44. After implementation of the non-structural actions, expected positive impacts that will reflect in different levels include:

(a) of institutional nature: improvements in the control and administration systems held by the state in terms of the water resources issues, thus reflecting in environmental protection issues such as the reinforcement of monitoring actions, uses control, and losses reductions, among others foreseen;

(b) of legal nature: a review of the existing legal instruments for water resources management will result in improvements to issues related to the environment, since integration actions should be anticipated, including legal issues related to water use control and legal actions for the protection of water sources used for public supply;

(c) of technical nature: the implementation of a Strategic Environmental Assessment aimed at the revision of the State Water Resources Plan will result in

104 significant environmental gains to be incorporated into the works and activities resulting from the Plan; and

(d) of social nature: resulting in a more representative participation of organized civil society in the water resources management process, by the establishment of Basins Committees and Water Users Associations.

45. Most proposed works are of small size and hence generate localized negative impacts that are temporary, easily reversible and common to the execution of water and sanitation works. These impacts would be properly mitigated with the adoption of measures recommended by the Environmental Management Plan.

46. As an overall conclusion, it is worth noting that positive impacts of major significance and magnitude will occur in extremely needy regions and communities and they will become permanent. These interventions and the important non-structural actions of the project shall generate the conditions to foment complementary actions aimed at the regional sustainable development that will equally result in significant benefits to the population affected by the project.

7. Project Environmental Management Plan

47. The project EMP involves the following activities to be implemented:

(a) Environmental Management System: the objectives are to organize and coordinate actions of a socio-environmental nature of project components; supervise the implementation of programs of institutional nature (social communication, environmental education and monitoring); identify and evaluate the relevant levels of environmental impacts, and establish improvement targets and guide the operations to achieve these goals.

(b) Social Communication Program: The objective is to provide strategic support for implementation of the project’s actions and includes the preparation of a Communication and Dissemination Plan, whose theme will be “the water resource in all its forms of use”. Estimated costs: R$100,000.

(c) Environmental Education Program: aims to contribute to a participatory ’ management policy of the state water resources, based on educational actions meant for water users and project intervenient agents. This will be an additional specific measure to sensitize, create awareness and train technicians and workers involved in these interventions for the adoption of environmentally friendly procedures related to the works, occupational health and safety and neighboring community relations. Estimated costs: R$250,000.

(d) EPA Bonfim-Guaraira Regulation Support Program: aims to support the establishment of the environmental zoning and EPA management plan through the allocation of resources from a Technical Cooperation Agreement signed between SEMARH and IDEMA for the elaboration of the works. For that purpose, Terms of Reference can be outlined by IDEMA and contracted by the

105 project. It is recommended that a Technical Evaluation Commission be established involving representatives from the state agencies to coordinate the works and technical evaluation of proposals. The estimated cost for this activity is R$240,000.

(e) Monsenhor Expedito System Loss Control Plan: aims to promote actions for the reduction of current losses from 46 to 25 percent. An estimated amount of R$lOO,OOO has been allocated for its elaboration.

(f) Environmental Program for Water Infrastructure Regularization: involves the actions and measures required for the environmental regularization of the water infrastructure in the state, starting with the expansion of interventions undertaken in the scope of the project. Estimated costs: R$450,000.

(g) Monitoring Program: meant to monitor changes in the quality and quantity of waters from the water courses and reservoirs, it is required in view of the potential of interventions to trigger qualitative alterations in the natural conditions of water bodies. Estimated costs for the Water Quality Monitoring: R$77,000; and for the Salinization and Eutrophication Control Program: R$350,000. Total estimated costs: R$427,000.

(h) Environmental Construction Manual: a guide of the appropriate environmental practices, including guidelines, procedures and technical specifications to be adopted in all stages of the implementation of water infrastructure. These procedures shall be observed by the contractors hired for the works and engineering services execution and involve: (i)Environmental Supervision of the Works and Environmental Requirements to Contract Companies; (ii) Environmental Planning of the Works; (iii)Establishment and Management of the Works; and (iv) Plan to Control and Recover disposal sites and Recovery of Areas used for the Construction Yard.

48. The EMP is estimated to cost R$1,567,000 to be allocated during the five years of duration of the 1st stage of the project. Other actions proposed will have their costs allocated in the corresponding components and sub-components.

8. Public Consultation

49. During the preparation stage of the Project, consultations, contacts and meetings (“scoping” process) were held with representatives of state government entities. A technical meeting took place on September 05,2005, to discuss the production system expansion of the Monsenhor Expedito Pipeline since it involved environmentally sensitive issues. A final public consultation was held on November 3, 2005. All consultations had the appropriate support documentation thus contributing to a significant decision making process.

106 50. The main aspects discussed with the entities’ representatives during the public consultations relate to uncertainties and considerations over the expansion of the Monsenhor Pipeline System with regard to the following aspects: (i)loss indexes in the pipeline system and actions aimed at the minimization of this issue; (ii)population to be assisted by the new system; and (iii)environmental assessments aimed at the protection of the Lagoa do Bonfim region and of the Bonfim-Guaraira Environmental Protection Area.

5 1. The project foresees the following actions and measures to address the abovementioned issues, among others: (i)environmental assessments to support the management framework of the EPA by the IDEMA; (ii)environmental education actions aimed at creating awareness about the importance of protecting the water resources of the state, in particular the Lagoa do Bonfim region; and (iii)investments in the loss control and elaboration of a Loss Control Plan for the System.

52. The creation of a website for the community to follow the progress of the project was requested during the EA presentation consultation, including the opening of a discussion forum with the public about the main themes addressed.

107 ANNEX 17: FISCAL ANALYSIS OF RIO GRANDE DO NORTE STATE GOVERNMENT

Brazil - Rio Grande do Norte: Integrated Water Resources Management Project

1. Summary

1. During the period 2000-2004*, the fiscal performance of Rio Grande do Norte state government was very sound. Responsible fiscal behavior enabled the state government to achieve substantial positive primary balances in the last five years. The large primary surplus and low indebtedness of Rio Grande do Norte allowed the state to obtain positive nominal and total balances, a very rare case among Brazilian states.

2. The good fiscal performance resulted from the combination of the control of current expenditures and the permanent increase of tax revenues which allowed Rio Grande do Norte to generate large current account surpluses that financed its investment requirements and to cover its financial obligations.

3. As a result of its sound fiscal performance, Rio Grande do Norte complied with all the fiscal limits established by the Fiscal Responsibility Law (FRL) since its enactment in 2000. Even more important, the FRL indicators have improved as a consequence of the continuous strong fiscal discipline. Net consolidated debt, used for compliance with the Fiscal Responsibility Law, plummeted from 65 percent of net current revenue in 2000 to 39 percent of net current revenue in 2004, well below the legal ceiling for state governments of 200 percent. Other FRL indicators are also well below the limits established by law: since 2000, the highest level for credit operations was 1 percent (against the FRL ceiling of 16 percent of net current revenue). Given the high interest payments and amortizations that allowed the reduction of consolidated debt, debt services represented in average 7.5 percent of net current revenue (against the FRL ceiling of 11.5 percent of net current revenue). Finally, in 2000-2004, personnel costs varied between 57 and 60 percent of net current revenue, very close to the FRL ceiling of 60 percent which constitute a source of vulnerability that the state needs to address in the future.

4. In addition to the Fiscal Responsibility Law requirements, the Rio Grande do Norte state government achieved all the targets of the Fiscal Adjustment Program agreed with the National Treasury Secretariat (STN) for 2000-2004.

5. As mentioned above, in the last years, it was observed an impressive progress in tax collection efficiency that allowed the state to increase by 25 percent its tax revenues and to generate current savings that financed its investment expenditures. The good performance of own tax revenue collection made Rio Grande do Norte less dependent from Federal Government transfers. In 2000, federal transfers represented 50 percent of

* Studies show that the results of the indicators during 2005 and 2006 confirm the same tendency of the 2000-2004 period.

108 Rio Grande do Norte current revenues while in 2004 this dependency fell to 45 percent. In any case, this ratio continues to indicate a strong dependence on federal transfers. However, as most of them are constitutionally or legally sanctioned, the risk associated to this dependence is lower than it seems at first sight.

6. On the expenditure side, despite its comfortable situation, as mentioned above, the major source of vulnerability of the state finances is the personnel expenditures. In particular, the upward trend of pensiodsocial security benefits for retired public employees needs to be contained. The state employees’ social security system is a pay as you go system and presented an actuarial deficit of R$10.5 billions at 2004, or 390 percent of net current revenues. This indicates potential increase on personnel expenditures that can deteriorate the financial situation with the need of decrease on other current expenditures or investment expenditures. At this respect, it is important to mention that the state is implementing a reform on the State Employee Social Security Institute system that can be considered best practice among Brazilian states. It is expected, the reform could at least contain the deficit of the state social security system.

7. The substantial fiscal balances obtained over the past few years, together with projections based on realistic assumptions, indicate that Rio Grande do Norte state government has sufficient capacity to repay its debt. Projections for the fiscal accounts and the indebtedness capacity for the next ten years show that the state government could assume the new loan from the World Bank without risking the fiscal health of the state government. Projection exercises for the period 2005-201 5, depict a favorable evolution for the main fiscal and financial indicators showing that the continuity of the responsible fiscal behavior should guarantee the debt sustainability.

8. The sensitivity analysis shows that the guarantee of fiscal sustainability depends on the continuity of tax revenue efficiency collection and the perseverance of the tight control of personnel expenditures.

9. In summary, through compliance with Fiscal Responsibility requirements and successful implementation of the adjustment program agreed with the National Treasury Secretariat (STN), the Rio Grande do Norte state government has demonstrated its commitment with a responsible fiscal stance to guarantee sustainability.

10. This fiscal analysis contains six sections. The first describes the evolution of the fiscal balances and fiscal revenues and expenditure for the period 2000-04. The second section analyzes the evolution and composition of the state debt. The third relates the evolution of the main Fiscal Responsibility Law indicators of Rio Grande do Norte and the accomplishment of the state fiscal accounts with the legal ceilings and the targets of the Fiscal Adjustment Agreement agreed with the STN. The fourth part contents the projection exercises which depict scenarios for the evolution of fiscal accounts and estimate the impact of the World Bank lending operation on the state fiscal accounts. The fifth section performs a sensitivity analysis to illustrate the effects of changes in the determinants of fiscal accounts on them. The final section summarizes the main overall findings and makes a number of policy recommendations.

109 2. Rio Grande do Norte State Government Fiscal Balances, Revenues and Expenditures, 2000-2004

11. Fiscal Balances. During the period 2000 to 2004, Rio Grande do Norte state government fiscal accounts presented a very solid position expressed in the generation of substantial fiscal balances.. The primary balance grew from 5 percent in 2000 to 15 percent in 2002-2004. In terms of current balance, during the period of analysis Rio Grande do Norte generated substantial surpluses larger than 20 percent of net current revenue which enabled it to finance investment expenditures and deficits on capital account and to meet the interest payments from the state debt. Consequently, Rio Grande do Norte obtained positive nominal balances during the entire period of analysis. Even more impressive, with the exception of 2001, the state obtained positive total balances during the period, which is a very rare occurrence in the public finances of Brazilian states.

12. Table 1 also shows that the sound fiscal stance of Rio Grande do Norte was based on the increase of current revenues and the stagnation of capital expenditures. The decrease of capital revenues and the growth of current expenditures forced the state government to reduce capital expenditures.

Table 1: Rio Grande do Norte State Government - Fiscal Balances. 2000-2004" I 2000 I 2001 I 2002 I 2003 I 2004

Current Revenues I 2,611,703 2,989,817 3,220,911 3,089,156 3,452,326 Capital Revenues - I1 2 16,967 27,605 31,582 37,436 27,330 Total Revenues 111 = I + I1 2,828,670 3,017,422 3,252,493 3,126,592 3,479,656

Deductions IV 109,961 64,576 59,056 71,650 49,172 Interest Revenues IVa 20,29 1 36,97 1 35,142 44,316 26,623 Credit Operations Revenues IVb 28,717 20,033 17,334 4,535 2 1,033 Debt amortization IVc 0 7,572 575 1 1 Asset Sales IVd 60,953 0 6,005 22,798 1,515

Primary Revenues V = I11 - IV 2,718,708 2,952,846 3,193,437 3,054,942 3,430,484

~~~~~~~ ~ ~ ~ ~ ~ ~~ Current Expenditure VI 2,269,290 2,563,309 2,637,895 2,5753 15 2,833,3 14 Capital Expenditure VI1 503,683 474,982 376,578 296,965 402,944 Total Expenditure VI11 = VI + VI1 2,772,974 3,038,291 3,014,472 2,872,280 3,236,258

Deductions IX 155,185 156,453 191,306 182,154 177,470 Interest Payments IXa 7 1,076 69,27 1 80,904 7 1,808 61,417 Amortizations IXb 84,109 87,182 110,402 110,346 116,053

Primary Expenditures X = VI11 - IX 2,617,789 2,881,838 2,823,166 2,690,126 3,058,788

110 Primary Balance XI = V - X 100,920 7 1,008 370,27 1 3 64,8 16 371,696

Current Account Balance XI1 = I - VI 342,413 426,508 583,O 16 513,841 619,012

Nominal Balance XI11 = I11 - IVb -1Vc - VI11 + IXb 50,135 38,708 324,509 337,324 336,902

Total Balance XIV = 111 - VI11 55,696 -20,868 238,021 254.312 243.398

Memo Items Net Current Revenue (NCR) 2,039,630 2,366,888 2,448,409 2,324,105 2,639,452

Primary Balance / NCR 4.9 3.0 15.1 15.7 14.1 Current Account Balance / NCR 16.8 18.0 23.8 22.1 23.5 Nominal Balance / NCR 2.5 1.6 13.3 14.5 12.8 * Thousands of Reais in 2004 as IPCA as deflator

13. The Evolution of Fiscal Revenues. As mentioned above, the responsible fiscal stance followed by Rio Grande do Norte was based on the good performance of current revenues. Table 2 shows that from 2000 to 2004, current revenue grew by 32 percent. The net current revenues, which measure the real availability of fiscal resources by the state, increased in real terms by 29 percent. As Brazil's accumulated GDP growth 9.5 percent during 2000 to 2004 was of 9.5 percent, Rio Grande do Norte available revenue grew 20 percent above GDP during this period. On the contrary, capital revenues experienced a decline as credit operations and capital transferred were maintained at around R$30 billion'6.

14. The growth of net current revenues mainly resulted from the enhancement of tax collection efficiency and the strong increase of other current revenue^'^. Current transfers exhibited a more modest performance. Tax revenues grew by 28 percent while current transfers increased by 17 percent. Other revenues experienced a strong growth of 300 percent, however as they are smaller, the impact of their growth on the state available revenues was limited.

15. The most important state tax, the ICMS" increased by 25 percent during the period of analysis. IPVA19 and the remaining taxes increased by 19 and 23 percent respectively. User charges exhibited a very good performance with an accumulated growth of 39 percent.

16. Constitutional transfers from the Federal Government grew by 28 percent while other current transfers fell by 30 percent. The growth of constitutional federal transfers

l6Extraordinary revenues and asset sales led to a high level of capital revenues of R$217 bi in 2000. " The consolidation of the accounts of the State Social Security Fund into the state accounts in 2002 explains the large increase of other current revenues. A VAT collected by the states. Automobile property tax.

111 can be explained by the introduction of the transfer from SUS in 2001 and the CIDE transfer that began to be transferred in 200420.

17. Overall, given the better performance of tax revenues vis a vis of the current transfers, the state dependence on transferred resources was reduced. In 2000, current transfers represented 50 percent of current revenue while in 2004 the dependence on transfers fell to 45 percent. It is important to remark that in 2000, the transfers corresponding to the SUS and CIDE did not exist. As in 2004, they represented 16.9 percent of current transfers, if these transfers were not in included, the dependence on federal transfers would fall to less than 45 percent.

18. The current revenue composition represent a risk in the sense that reductions on intergovernmental transfers can have a significant impact on the Rio Grande do Norte fiscal situation, as the state has a strong dependence on this revenue source. However, the constitutional nature of most of the federal transfers reduces the vulnerability of state finances on transferred resources. Overall, the continue increase in tax revenue should reduce the dependence of federal transfers and will make state finance less vulnerable.

Table 2: EoGrande do Norte State Government - Revenue Structure, 2000-2004" 2000 2001 2002 2003 2004 Current Revenues 2,611,703 2,989,817 3,220,911 3,089,156 3,452,326 Tax revenue 1,204,964 1,298,243 1,353,769 1,363,957 1,506,219 Taxes 1,165,310 1,255,370 1,292,941 1,312,866 1.45 1,236 ICMS 1,116,610 1,204,170 1,240,537 1,262,863 1,393,621 IPVA 47,301 49,588 50,841 47,946 55,887 Other taxes 1,398 1,613 1,563 2,057 1,728 User Charges 39,654 42,872 60,829 5 1,090 54,983 Social Contributions 104,176 103,9 15 108,175 Current Transfers 1,315,841 1,470,684 1,553,994 1,363,292 1,543,432 Federal Government Transfers 1,154,683 1,249,470 1,464,677 1,338,388 1,479,25 1 WE 848.4 1 1 934,499 1,066.4 10 967,086 1,000,020 IPI - exp 4,500 6,851 7,112 6,944 5,883 Lei 87/96 - ICMS 13,128 9,329 9,235 SUS (Health Unique System) 23,036 2 1,524 95,322 FUNDEF 186,592 196,387 204,645 181,536 180,3 16 Other Federal transfers 115,181 11 1,733 150,346 151,968 188,475 Non-constitutional transfers 161,157 221,213 89,3 17 24,904 64,181 Other Current Revenues 90,898 220,89 1 208,972 257,992 294,500 Financial Revenues from state assets 20,291 36,971 35,142 44,316 26,623 Revenue from State Services 42,603 45,266 22,367 35,897 32,502 Other 28,005 138,654 15 1,464 177,779 235,375

Deductions 572,073 622,929 772,502 765,051 812,874

*' SUS (Health Unique System - Sisterna Unico de Sazide) is a transfer to health assistance done by the state government. It is a program of decentralization of health provision from Federal Government to lower levels of government. CIDE (ContribuigGo de Intervenpio no Dominio EconGrnico) is an economic contribution charged by the Federal Government over the commercialization and importation of oil and its derivatives, natural gas and its derivatives and alcohol, that was created on 2001 (Constitutional Amendment n. 33, 2001) and its revenue collection is being shared with states and municipalities since 2004.

112 Social Security Contributions 104,176 103,9 16 108,175 Constitutional Transfers 317,575 347,566 362,895 371,329 399,729 Deduction for FUNDEF 254,498 275,363 305,431 289,806 304,970

Net Current Revenues 2,039,630 2,366,888 2,448,409 2,324,105 2,639,452 Capital Revenues 2 16,967 27,605 31,582 37,436 27,330 Credit Operations 28,717 20,033 17,334 4,535 21,033 Capital Transfers 7,413 8,448 4,78 1 Asset Sales 60,953 6,005 22,798 1,515 Debt amortization 7,572 575 1 1 Other 127,297 256 1,654 * Thousands of Reais in 2004 as IPCA as deflator

19. On the capital account, table 2 shows that capital revenues suffered a strong reduction from 2000 to 2004 - 87 percent at constant prices. However it is important to mention that the capital revenues in 2000 were extraordinarily high due to asset sales and other extraordinary capital revenue. Credit operations were reduced by 27 percent, and have been very small in all the years due to severe limitations on new credit operations imposed by the Fiscal Adjustment Program, agreed with the National Treasury Secretary, and by the National Monetary Council controls on credit supplied by financial institutions to public sector.21 Capital transfers partially compensated the fall of credit operations, while other capital revenues were insignificant, except in 2000. After privatization, asset sales had reduced its importance as a revenue source.

20. The Evolution of Expenditures. The improvement of the fiscal situation of Rio Grande do Norte was the result of a lower increase in expenditures compared with the very good performance of revenues described in the previous section. From 2000 to 2004, total expenditures increased by 16 percent at constant prices. This increase resulted from a strong expansion of current expenditures of 25 percent and the reduction of capital expenditures of 20 percent.

2 1. Personnel expenditures, the most important component of current expenditures, increased by 47 percent. Constitutional transfers to municipalities grew by 29 percent while other current expenditures and interest payments fell by 10 and 14 percent, respectively.

22. The strong increase of personnel expenditures maintained the Fiscal Responsibility Law indicator of personnel expenditure on net current expenditures fluctuating around the legal ceiling of 60 percent, despite the favorable performance of revenues.

23. The evolution of personnel expenditures deserves special attention as they seem to be the most important source of risk for the state public finances. In particular, the increasing trend of deficits of the State Employees Social Security Institute (IPE) deficits would threat the comfortable fiscal situation. The state Treasury has covered the deficit of IPE that in 2004 achieved almost R$400 million. At July 2004, the IPE actuarial deficit

21 National Monetary Council Resolutions No. 2827 limit bank exposure to the public sector to 45% of equity. Further CMN resolutions strongly limited the domestic credit to public sector entities.

113 achieved R$10.5 billion or 3.9 of net current revenue which implicates that increase in the future level of personnel expenditures (contributions to social security or retiree personnel) is very likely.

24. The imbalances in the social security system are a major preoccupation affecting the financial health of all three administrative levels -central, state and municipal-in Brazil. Over the past few years, two Constitutional Amendments22were introduced in an attempt to reduce this imbalance by modifying the rules governing social security. The 2003 Constitutional Amendment for example established the possibility of levying social security contributions on retirement and pension benefits, subject to certain lower thresholds.

25. At the same time, the state is implementing a reform in its social security system with the creation of a financial fund to finance the benefits for the retired employees, their survivals and active employees older than 50 years in as pay as you basis and a social security fund for the new entrants and active employees younger than 50 years old in a fully funded basis. This reform would contain the increasing path of the state social security system deficit.

Table 3: Rio Grande do Norte State Government - Expenditure Structure, 2000-2004" 2000 2001 2002 2003 2004

Total Expenditure 2,772,974 3,038,29 1 3,014,472 2,872,280 3,236,258

Current Expenditures 2,269,290 2,563,309 2,637,895 2,575,315 2,833,314

Personnel 1,167,040 1,376,210 1,631,771 1,602,855 1,7 19,025 Employees 958,355 1,126,973 1,142,092 1,101,019 1,197,334 Social security benefits 208,685 249,238 489,679 501,837 521,691 Interest Payments 7 1,076 69,271 80,904 71,808 61,417 Constitutional Transfers to Municipalities 318,579 327,013 375,774 386,77 1 41 1,136 Other Current Expenditures 712,595 790,814 549,446 513,881 64 1,736

Capital Expenditures 503,683 474,982 376,578 296,965 402,944 Investments 315,683 308,781 190,028 98,107 196,180 Debt Amortization 84,109 87,182 110,402 110,346 116,053 Financial Investments 103,89 1 79,019 76,147 88,512 90,7 11

Memo Items

Net Current Revenue 2,039,630 2,366,888 2,448,409 2,324,105 2,639,452

** .Constitutional Amendment no. 20 (1998) and Constitutional Amendment no. 41 (2003).

114 Personnel Expenditure under FRL concept 1,152,402 1,331,642 1,459,321 1,413,056 1,535,818 Personnel Expenditure / Net Currrent Revenue 56.50 56.26 59.60 60.80 58.19 Fiscal Responsibility Law Ceiling: 60%

Debt Service (Interest Payments + Debt Amortization) 155,185 156,453 191,306 182,154 177,470 Debt Services / Net Current Revenue 7.61 6.61 7.81 7.84 6.72 Fiscal Responsibility Law Ceiling: 11,5% * Thousands of Reais in 2004 as IPCA as deflator

26. The second most important component of current expenditure corresponds to the category of other current expenditures which embraces the operating expenditures, mainly good and services purchases and maintenance expenditures. To compensate the strong increase of personnel expenditures and constitutional transfers to municipalities, this category was downward adjusted. On the same direction, interest payments fell by 14 percent as the state indebtedness was reduced.

27. As personnel expenditures, constitutional transfers and interest payments are rigid expenditures, their evolution are out of the government control, the expenditure increase was alleviated through the control of capital expenditures. In fact, capital expenditures suffered a strong reduction of 20 percent from 2000 to 200423.

28. Most of this reduction was due to a decrease on direct investment expenditures which fell by 38 percent. Debt amortization experienced the highest increase among all the expenditure categories (40 percent) which also explains the compression of investment expenditures. Other capital expenditures which comprise capital transfers and financial investment also were reduced as part of the expenditure control in a context in which of obligatory expenditures (personnel, constitutional transfers and debt amortization) experienced a significant increase.

29. Debt service (interest payments plus amortizations) increased by 14 percent. However, its level shows a very comfortable financial situation as the ratio debt service to net current revenue has been below the ceiling established by Federal Senate Resolution n.43/2001, in attendance of the Fiscal Responsibility Law. The legal ceiling is of 11.5 percent of net current revenue and the Rio Grande do Norte has been fluctuating around 7 percent in all years from 2000 to 2004.

30. In summary, the evolution of the state expenditure composition was not favorable. The increase of current expenditures and debt amortization reduced the space of state investment expenditure. As a result, the evolution of the different expenditure categories shows that the quality of state expenditures was worsened. The increase of rigid current expenditures constrained the state to expand public investment expenditures fostering the regional economic growth.

23 It is important to remark that capital expenditures were extraordinarily high given the extraordinary capital revenues obtained by the state in this year.

115 2. Consolidated Debt and Indebtedness Capacity

31. As a result of the tight fiscal policy, from 2000 to 2004, Rio Grande do Norte consolidated debt decreased by 16 percent or R$224 million at constant prices24.The net consolidated debt, which is the consolidated debt minus state financial assets, used for compliance of the Fiscal Responsibility Law, decreased by 23 percent or R$301 million at constant prices.

32. The reduction of the debt stock and the strong increase of net current revenue led to a strong fall of the net consolidated debt to net current revenue ratio 65 percent of net current revenue to 39 percent, well below the ceiling of 200 percent established by the Fiscal Responsibility Law, implying a larger indebtedness capacity. As a result of the debt reduction and the expansion of net current revenue, the space for additional indebtedness allowed by the FRL expanded from R$2.8 billion to R$4.2 billion at constant prices.

33. In terms of components of state debt, domestic debt represents 95 percent of consolidated debt while external debt share is 5 percent. Domestic debt fell by 17 percent or R$231 million at constant prices, while external debt increased by 29 percent or R$14 million at constant prices. This pattern reflects the lack of access to domestic credit operation and the use of this form of financing in substitution to domestic credit operations. Exchange rate devaluation was also responsible for the increase of state external debt.

Table 4: Rio Grande do Norte State Government - Consolidated Debt* 2000 200 1 2002 2003 2004 Consolidated Debt 1,435,329 1,466,675 1,622,936 1,311,310 1,210,619 Domestic Debt 1,345,113 1,371,119 1,491,038 1,212,833 1,113,424

Federal Government - National Treasury 1,285,859 1,309,203 1,150,852 1,06 1,970 1,405,068

Federal Banks 59,254 61,916 6 1,980 5 1,454 85,970

Judiciary Debt - Precatbrios - after 5/2000 40,017 33,354 34,8 19 32,664 38,352

External Debt 50,199 62,201 63,658 64,53 1 93,546

Deductions = Financial Assets 108,618 154,853 43,117 185,098 4,803

24 It is important to stand out that during this period the Federal Government, through the National Monetary Council, imposed controls for public sector credit supply, which restricted the space for new credit operations with government owned banks, the most important source of public sector credit supply.

116 Net Consolidated Debt 1,326,711 1,311,821 1,618,132 1,268,193 1,025,521

Other obligations Floating debt 97,609 116,381 67,354 186,936 208,230 Memo Items: Net Current Revenue 2,039,630 2,366,888 2,448,409 2,324,105 2,639,452 Net Consolidated Debt / Net Current Debt 0.65 0.55 0.66 0.55 0.39 Fiscal Responsibility Law ceiling: 2.0 Space forhrther indebtness 2,752,549 3,421,955 3,278,686 3,380,017 4,253,383

34. In terms of indexation composition, Rio Grande do Norte state government debt is well diversified. The debt with the National Treasury (STN)25 which is mostly indexed to the Wholesale Price Index (IGP-DI and IGP-M) represents 5 1 percent, debt linked to exchange rate represents 23 percent and the debt indexed to the Rate of Reference (TR), used by federal financial institutions, contributes with 19 percent. The remaining 7 percent of Rio Grande do Norte state debt is indexed to different indices used for correct social security contributions in arrears (the Central Bank monetary policy rate (SELIC) and the long run interest rate TJLP.

35. The diversified composition of the state debt does not imply low vulnerability of debt to macroeconomic shocks. In particular, the strong correlation between the Wholesale Price Index and the exchange rate makes the state debt vulnerable to external shocks as 70 percent of it is directly or indirectly linked to the exchange rate.

Figure 1: RN State Government Consolidated Debt Composition by Index, 2004

Other Exchange rate 7% 23%

4. Fiscal Responsibility Law (LRF) and Fiscal Adjustment Program Compliance

25 Brazil’s Federal Government set up three bailout operations in ten years, reflecting the weak fiscal discipline of state governments in the eighties and nineties. At constant prices of 2004, in 1989 the Federal Government assumed R$22 billion of state’s external debt which represented 1.4% of GDP. In 1993, the National Treasury assumed R$89 bi or 7.2% of GDP of state’s debt with federal financial institutions. Finally, in 1997, the Federal Government restructured state’s bond debt by R$200 bi or 11.7% of GDP. Rio Grande do Norte state government debt was rescued in the three operations. In the first operation, National Treasury rescue a debt of R$97 million, the second bail-out operation achieved R$715 million. In the last one, the Federal Government rescued Rio Grande do Norte bonds amounted at R$58 million. As a result, the most important creditor of the state is the National Treasury from which Rio Grande do Norte has a debt of R$1.1 billion of 2004.

117 36. As a result of its sound fiscal performance, the state government has complied with most of the fiscal limits established by the Fiscal Responsibility Law (FXL). As mentioned above, net consolidated debt as a proportion of net current revenue, used for compliance of the Fiscal Responsibility Law, fell from 63 to 38 percent, far below the legal ceiling of 200 percent.

37. Table 5 shows that Rio Grande do Norte state government has kept within the other limits laid down by the Fiscal Responsibility Law (FRL). However, the state had difficulties in reducing the personnel expenditures to net current revenue ratio which fluctuated around the FXL ceiling of 60 percent.

38. The percentage of credit operations and debt servicing as a proportion of the net current revenue was lower than 1 percent while the legally-imposed limit of 16 percent. The ratio of debt service payments to net current revenue varied around 7 percent, while the FRL ceiling is 11.5 percent.

39. As part of its fiscal adjustment, the Rio Grande do Norte state government subscribed in 1999 contract governing the refinancing of its debt with the National Treasury. In exchange, the Federal Government undertook to carry out a Restructuring and Fiscal Adjustment Program (FAP)26.

40. The targets established in the FAP are very similar to the Fiscal Responsibility Law requirements. In addition to the personnel and indebtedness indicators, the FAP covers targets for primary surplus, own revenue collection and investment expenditures.

41, Up to now, the good fiscal performance of Rio Grande do Norte allowed to meet comfortably most of the requirements set in the four FAPs signed by the state government with the National Treasury.

Table 5: State Government ComDliance to Fiscal Remonsibilitv Law Limits* 2000 2001 2002 2003 2004

Net Current Revenue 2,039,630 2,366,888 2,448,409 2,324,105 2,639,452

Net consolidated Debt 1,326,7 11 1,311,821 1,6 18,132 1,268,193 1,025,521 % Net Current Revenue 1 65% 1 55% 1 66% 1 55% 1 39% Space for further Indebteness I 2,752,549 I 3,421,955 I 3,278,686 I 3,380,017 I 4,253,383

Credit Operations 20,268 15,106 14,175 4,254 21,033

% Net Current Revenue 1 .O% 0.6% 0.6% 0.2% 0.8%

26 The FAP agreed with 26 state governments under the Debt Restructuring Program was an additional tool used by the Federal Government to reinforce fiscal discipline for sub-national governments.

118 Space for further credit operations 306,073 363,596 377,570 367,603 40 1,279

Debt Service 155,185 156,453 191,306 182,154 177,470 % Net Current Revenue 7.6% 6.6% 7.8% 7.8% 6.7%

Space for further Debt Service 79,372 115,739 90,261 85,118 126,067

Personnel Expenditures** 1,152,402 1,33 1,642 1,459,321 1,4 13,056 1,535,818 % Net Current Revenue 57% 56% 60% 61% 58% * Thousands of Reais in 2004 as IPCA as deflator ** FRL definition of Personnel Expenditures excludes social security benefits that are financed by the State Social Security Fund

42. In summary, by meeting the key requirements of the Fiscal Responsibility Law and implementing the Fiscal Adjustment Program, Rio Grande do Norte state government has demonstrated that it genuinely seeks to continue its trajectory of sustainability. As described in the above sections, there is no real evidence of fiscal imbalances during the entire period under analysis. Between 2000 and 2004, the Rio Grande do Norte state government consolidated its sound fiscal performance.

5. Projected Fiscal Situation (2005-2015)

43. In this section, the fiscal situation of Rio Grande do Norte state government will be projected from 2005 to 2015 in order to evaluate the impact of the World Bank credit operation of US$49.3 million under the project Viver Melhor ZZ. Also the projection exercise permit to assess the repayment capacity of the state to meet the financial obligations to be generated by the proposed lending operation. The main assumptions of the basic scenario are on Table 6 below.

44. The projected fiscal situation of Rio Grande do Norte state government during the period 2005 to 2015 indicates the continuance of a comfortable fiscal situation which will allow the state to meet its financial obligation derived form the World Bank lending operation Viver Melhor ZZ. The projection exercise shows a very limited impact of the proposed operation on fiscal balances, indebtedness and the Fiscal Responsibility Law indicators.

45. Besides the Fiscal Responsibility Law indicators, two others indicators which evaluate the cash flows generation of the state will be analyzed. The first is interest coverage, which represents current account cash flow without interest payments, the flow of saving funds generated before interest payments, divided by the interest payment. The second is investment coverage, which represents the amount of investment financed with cash flow (current account balance). The minimum level recommended for the first indicator is 1.5 while for the second is 30 percent. The projection exercise shows that these two requirements will be complied in each of the years projected.

119 Table 6: Assumptions for Financial Projections Variables Assumptions Base year figures- 2004 Macroeconomiddemographic Population growth 1.35% in 2005 decreasing uniformly to 1.05% in 2015. Rio Grande do Norte population average growth was 1.4% for 2000-2004 by IBGE. GDP growth 3.5% per year, from 2005 to 2014 Inflation rate 5.2% in 2005 and 4.5% thereafter Exchange rate Central Bank Market Expectations for 2004 and 2005, varying with inflation afterwards Revenue ICMS Increase with GDP growth and inflation IPVA Increase with population growth and inflation Social Contributions Increase with personnel expenditures Others Increase with GDP growth and inflation

Transfers

State Participation Fund - F'PE Increase with GDP growth and inflation Unified Health System - SUS Increase with population and inflation Other federal transfers Increase with inflation Multigovernmental transfers Increase with population and inflation Fundef Increase with inflation

Other Current Revenues Increase with inflation

Capital Revenues Credit Operations Obtained from Fiscal Adjustment Program 2003-2005 agreed with the National Treasury Capital Transfers Increase with inflation

Expenditures Current Expenditures Personnel, including social SecurityIncrease with population growth and inflation. benefits Goods and Services Increase with population growth and inflation Transfers to municipalities Increase with GDP growth and inflation Interest payments Obtained from Debt Department of SEFAZ Rio Grande do Norte Capital expenditures Investment Increase with GDP growth and inflation Capital transfers Increase with inflation Amortizations Obtained from Debt Department of SEFAZ Rio Grande do Norte IBRD Loan US$57 million, grace period 5 years, maturity 15 years

Annual interest rate of 4% (including other fees)

46. In the base case scenario depicted in Table 6, and assuming that half of the nominal balance will finance additional investment expenditures and the other half will be accumulated as financial assets and that credit operations will be maintained at 2 percent of net current revenues, Rio Grande do Norte will maintain its comfortable fiscal situation in the future. As Tables 7 and 8 below show that given the increase in investment, the primary balance will decline from the current 14 percent to around 10

120 percent in the next years. Current balance will be maintained at the 24-25 percent of net current revenue. A reasonable assumption for growth (annual rate of 3.5 percent) and the control of current expenditures guarantee this comfortable fiscal scenario.

47. During the period of the World Bank program implementation (2005-2008), it is expected an increase in investment expenditures that would reduce the projected primary balance in an annual amount of about R$50 million of 2004. This amount will represent about 10 percent of projected investment expenditures of the state during the implementation period and will reduce the primary surplus in 2 percent of the projected net current revenue.

48. Given the declining trend of indebtedness, even with the operation the projected consolidated debt of Rio Grande do Norte will fall in 2006 when the disbursement is expected to be low. In 2007 and 2008 the proposed operation will increase the debt by 2 percent of net current revenue. After that, the net consolidated debt to net current revenue will resume its decreasing path.

49. With relation to the credit operation requirement, the highest annual disbursement of the loan operation will happen in 2007, representing only 1.5 percent of the projected net current revenue for this year. The additional financial obligations originated by the World Bank proposed operation are not significant when compared with the projected debt service payments without this operation. On the contrary, the projection exercise shows that the state debt service payments will continue to fall reaching 4 percent of net current revenue, making Rio Grande do Norte compliant with regard to the FlU requirement of 11.5 percent before 2015.

50. The projection for the personnel expenditures to net current revenue ratio shows a decreasing trend reaching a level lower than 50 percent in 2008. This result strongly depends on the assumption of a low population growth and a higher GDP growth that would affect revenues.

5 1. The projection for the interest coverage and the investment coverage indicators, confirms the sustainability of the healthy fiscal situation of Rio Grande do Norte as both are very high compared with the recommend levels and will exhibit increasing path until 2015.

52. In summary, it is evident that the realization of the project will not compromise the financial sustainability of the state.

121 m $1 6. Sensitivity Analysis

53. The purpose of the sensitivity analysis in this section is to identify the most important sources of risk for the future fiscal performance of Rio Grande do Norte state government and to assess the sensitiveness of the main fiscal variables to each of these potential risks.

54. The financial performance will be measured by the six financial indicators analyzed in section D. The first is the net consolidated debt to net current revenue ratio that should not be higher than the FRL ceiling of 200 percent); the second is the credit operations to net current revenue ratio that should be kept below the FRL ceiling of 16 percent; the third is the debt service to net current revenue ratio that has a FRL ceiling of 11.5 percent; the fourth is the personnel expenditures to net current revenues ratio with a maximum FRL ceiling of 60 percent; the fifth is the interest coverage which should be higher than the recommended level of 1.5 and the sixth is the investment coverage with a minimum recommended level of 30 percent.

55. The potential risks analyzed are changes on: ICMS revenue, Federal Government transfers, personnel expenditures, other current expenditures (including goods and services), population and state GDP growth rates and the exchange rate. To show the sensitiveness to these variables it will be calculated the change on each of these variables that would make Rio Grande do Norte not compliant with the Wrecommended levels of the financial indicators above during the projection period of 2005-2015.

56. The most important source of risk are: the ICMS tax collection on the revenue side and the personnel expenditures on the expenditure side. The importance of ICMS tax revenue on the revenue structure of the state is the reason why the fiscal soundness of the state is highly sensitive to the performance of ICMS revenue.

57. Personnel expenditures constitute the most important risk for the Rio Grande do Norte state government. More specifically, expenditures with retirement benefits and pensions is an important source of risk. According to the actuarial evaluation, at July 2004, the technical deficit, on actuarial terms amounted R$10.5 billion, or 390 percent of net current revenues. In this sense, an increase in the future level of personnel expenditures (contributions to social security or retiree personnel) is very likely. And as this is an important item of expenditure, financial health is very sensitive to it.

58. Federal Government transfers and other current expenditures can be considered as of moderate risk. On the other hand, state GDP and population growth rates and exchange rate are variables that represent low risk to the financial sustainability of the state. The results of the sensitivity analysis are shown in the Sensitivity Analysis Exercises below.

59. ICMS Revenue - Risk: High. Tax revenue has a direct impact on revenue and the state VAT, the ICMS represents 93 of Rio Grande do Norte state tax revenue. According to the sensitiveness exercise, ICMS collection could be 7 percent lower than the projected level on the base case scenario and still Rio Grande do Norte would comply with all

124 financial indicators considered in this analysis. In this sense, tax revenue changes represent a high risk for the financial health of the state.

60. Federal Government Transfers - Risk: Moderate. Federal Government transfers must be 10 percent smaller than on the base case scenario to imply that at least one of the indicators will achieve a personnel expenditures to net current revenue higher than the FRL ceiling of 60 percent.

61. Personnel Costs - Risk: High. Personnel expenditures only 3 percent higher than projected levels would imply the non-compliance of the personnel expenditures to net current revenue ratio required by the FRL. Personnel costs here included active personnel expenditures and social security benefits-retirement benefits and pension payments- which represents 30 percent of total personnel expenses. According to Actuarial Evaluation Report of April 2005, the social security fund had a technical deficit of R$10.5 billion. As a result, we should expect an increase in retirement and pension payments and on social security contributions for the next years. In the basic scenario, the hypothesis was that the increase in personnel expenses, at constant prices, with population growth. In this sense, we classified personnel costs variable of high risk to Rio Grande do Norte’s public finances.

62. Social security imbalance is a concern for the financial situation of all the levels of federation in Brazil. In the last years, two Constitutional Amendments27 tried to reduce this imbalance, changing social security rules. The reform of 2003, allowed the collection of social security contributions charged over retirement and pension benefits, but with a floor of benefits that could be charged. This floor is the same for federal, state and municipal governments. This represented an advance to the Federal Government, which had been trying to charge this contribution without success, but, for state and municipalities, the measure will have a limited impact.

63. Other Current Expenditures - Risk: Low. Other current expenditures must be 30 percent above the assumptions to imply non-compliance of at least one of the financial indicators analyzed. Although financial sensitivity to this variable is not weak, other current expenditures represents less risk, since the government can have more control on it. In this sense, we classify its risk as moderate.

64. State GDP Growth - Risk: Low. The growth rate of Rio Grande do Norte GDP needs to be lower than -5 percent (negative) during the entire projection period to make the state non compliant to at least one of the financial indicators. As this hypothesis is not likely to occur, the state GDP fluctuations do not represent a serious risk for the state fiscal accounts.

65. Population Growth - Risk: Low. According to our hypothesis, population growth has an impact on operating expenditures. The base case scenario considered a growth rate from 1.35 to 1.05 percent per year, according to Brazilian Geography Institute estimates for Rio Grande do Norte. A very large population growth rate more than 10 percentage

*’Constitutional Amendment n. 20, from 1998 and Constitutional Amendment n. 41 from 2003.

125 points (a growth rate which is very unlikely) would imply the non compliance of at least one of the indicators. Thus, the financial situation is not sensitive to population growth.

66. Exchange Rate - Risk Low. Exchange rate depreciation has a direct impact on dollar indexed debt and an indirect impact on general price index (IGP) indexed debt, since this price index is very sensitive to changes on exchange rate. We assumed a general price index (IGP) additional variation of half of the real depreciation of the exchange rate. Given the low indebtedness of Rio Grande do Norte and the composition of state debt, only a very large exchange rate devaluation (more than 200 percent) will make Rio Grande do Norte non compliant to the FRL on net consolidated debt to net current revenue FRL requirement.

7. Conclusions

67. During the period 2000-2004, the fiscal performance of Rio Grande do Norte state government was very sound. Large primary surpluses and low indebtedness of Rio Grande do Norte allowed the state to obtain positive nominal and total balances, a very rare case among Brazilian states.

68. The good fiscal performance resulted from the combination of the control of current expenditures and the permanent increase of tax revenues which allowed Rio Grande do Norte to generate large current account surpluses that financed its investment requirements and to cover its financial obligations.

69. As a result of its sound fiscal performance, Rio Grande do Norte complied with all the fiscal limits established by the Fiscal Responsibility Law (FRL) since its enactment in 2000. Even more important, the FRL indicators have improved as a consequence of the continuous strong fiscal discipline. Net consolidated debt, used for compliance with the Fiscal Responsibility Law, plummeted from 65 percent of net current revenue in 2000 to 39 percent of net current revenue in 2004, well below the legal ceiling for state governments of 200 percent. Other FRL indicators are also well below the limits established by law: since 2000, the highest level for credit operations was 1 percent (against the FRL ceiling of 16 percent of net current revenue). Given the high interest payments and amortizations that allowed the reduction of consolidated debt, debt services represented in average 7.5 percent of net current revenue (against the FRL ceiling of 11.5 percent of net current revenue). Finally, in 2000-2004, personnel costs varied between 57 and 60 percent of net current revenue, very close to the the FRL ceiling of 60 percent which constitute a source of vulnerability that the state needs to address in the future.

70. In addition to the Fiscal Responsibility Law requirements, the Rio Grande do Norte state government achieved all the targets of the Fiscal Adjustment Program agreed with the National Treasury Secretariat (STN) for 2000-2004.

71. As mentioned above, in the last years, it was observed an impressive progress in tax collection efficiency that allowed the state to increase by 25 percent its tax revenues and to generate current savings that financed its investment expenditures. The good

126 performance of own tax revenue collection made Rio Grande do Norte less dependent from Federal Government transfers. In 2000, federal transfers represented 50 percent of Rio Grande do Norte current revenues while in 2004 this dependency fell to 45 percent. In any case, this ratio continues to indicate a strong dependence on federal transfers. However, as most of them are constitutionally or legally sanctioned, the risk associated to this dependence is lower than it seems at first sight.

72. On the expenditure side, despite its comfortable situation, as mentioned above, the major source of vulnerability of the state finances is the personnel expenditures. In particular, the upward trend of pensiodsocial security benefits for retired public employees needs to be contained. The state employees’ social security system is a pay as you go system and presented an actuarial deficit of R$10.5 billion at 2004, or 390 percent of net current revenues. This indicates potential increase on personnel expenditures that can deteriorate the financial situation with the need of decrease on other current expenditures or investment expenditures. At this respect, it is important to mention that the state is implementing a reform on the State Employee Social Security Institute system that can be considered best practice among Brazilian states. It is expected, the reform could at least contain the deficit of the state social security system.

73. The substantial fiscal balances obtained over the past few years, together with projections based on realistic assumptions, indicate that Rio Grande do Norte state government has sufficient capacity to repay its debt. Projections for the fiscal accounts and the indebtedness capacity for the next ten years show that the state government could assume the new loan from the World Bank without risking the fiscal health of the state government. Projection exercises for the period 2005-201 5, depict a favorable evolution for the main fiscal and financial indicators showing that the continuity of the responsible fiscal behavior should guarantee the debt sustainability.

74. The sensitivity analysis shows that the guarantee of fiscal sustainability depends on the continuity of tax revenue efficiency collection and the perseverance of the tight control of personnel expenditures.

75. In summary, through compliance with Fiscal Responsibility requirements and successful implementation of the adjustment program agreed with the STN, Rio Grande do Norte state government has demonstrated its commitment with a responsible fiscal stance to guarantee sustainability.

127

IBRD 34420

60° 40° 38° 37° 36° 35°

R.B. DE GUYANA VENEZUELA SURINAME BRAZIL French Guiana (Fr) STATE OF RIO GRANDE DO NORTE RORAIMA HYDROGRAPHIC BASINS DIVISION 0° 0° ATLANTIC OCEAN COLOMBIA Area Of Map Areia AMAZONAS PARÁ Branca CEARÁ RIO GRANDE DO NORTE 5° 15-115-1 15-215-2 TOCANTIN 5° BRAZIL MARANHAO PARAÍBA PIAUÍ 15-315-3 São Bento ACRE PERNAMBUCO RONDÔNI Baraúna do Norte ALAGOAS Galinhos SERGIPE Macau Guamaré A S MATO BAHIA Pedra Grande PERU GROSSO Serra do Mel Mossoro BRASILIA Touros

s Parazinho BOLIVIA GOIÁS a n h 15-415-4 MINAS a MATO r 03 16-116-1 20° GERAS 20° i GROSSO ESPÍRITO P Alto do PARAGUAY SANTO o DO SUL SÃO i Rodrigues Carnaubias R PAULO RIO DE Jandaíra CHILE JANEIRO 04 PARANÁ Governador 16-216-2 SANTA Dix-Sept Rosado Pureza RIOCATARINA ARGENTINA GRANDE ATLANTIC Ipanguaçu Alfonso Bezerra Pedro Avelino 05 Maxaranguape DO SUL OCEAN João Câmara Acu Pedro URUGUAY Felipe 01 Preta 16-316-3 80° 60° Guerra Poco Branco Tairu Upanema Ceará Mirim Apodi Angicos Jardim de Bento Lajes Angicos Fernandes 07 16-416-4 Severiano Melo São Gonçalo Caraubas Parú 06 do Amarante Rodolfo NATAL Fernandes Augusto Macaiba CEARÁ Severo Ryu Barbosa São Paulo 08 Racho do Potengi Parnamirim da Cruz Olho D´Água 16-516-5 Tabuleiro Dos Borges Santana Barcelona São Tomé Bom Grande do Matos Jesus Janduis Sen. Elôi 09 6° Umarizal Lagoa Vera 6° Portalegre de Souza Jucurutu Cerro Cora de Velhos Cruz Messias São José de Mipibu Martins Targino Pres. 02 Cerro Cora Lagoa Monte Pau Dos Ferros Patu Juscelino Nísia 16-616-6 Dr. Florânia Salgada Alegre Severiano Encanto Almino Floresta Frutuoso Sen. Georgino Afonzo Lagoa Agua Gomez Januário de Pedras Avelino São Tangará Brejinho Arés Nova Cicco Miguel Rafael São Vincente Tibau do Sul Antônio Santa Cruz Coronel Fernandes s Campo Redondo Martins a 16-716-7

h

R João Pessoa R Passagem Goianinha

Marcelino n Currais Serrinha i

i R u o Vieira a o i c

José da ir Novos o

10 Santo Ja Vila Flor P São Bento 11 Penna o do Trairí Antõnio i Baía R São Cel. 12 Luís S Formosa Fernando e Elequiel Serra de Lagoa D' Gomez r id Monte das São Bento Anta Canguaretama Alexandria Jardim ó Cruzeta Pedro São José Jaçanã Gameleiras Pasa e Fica de Piranhas Acari Velho do Seridó Japi 16-816-8 Parana Caico Nova Cruz 13 Montanhas 14 2 HYDROGRAPHIC BASINS DRAINAGE AREA (Km ) Carnaúba MAIN RIVERS Jardim dos Dantas 1 APODI/MOSSORÓ 14,276.0 do Seridó 2 PIRANHAS/AÇU 17,498.5 BASINS LIMITS Serra Negra 3 BOQUEIRÃO 250.5 do Norte RESERVOIRS 4 PUNAÚ 447.9 Ouro Branco Parelhas 5 MAXARANQUAPE 1,010.2 São João 12 MAIN BASINS 6 CEARÁ-MIRIM 2,635.7 do Sabugi 15-2 SECONDARY BASINS 7 DOCE 387.8 8 POTENGI 4,093.0 Ipueira Santana URBAN AREA 9 PIRANGI 458.9 do Seridó 0 10 20 30 40 50 10 TRAIRI 2,887.4 MAIN ROADS KILOMETERS 11 JACU 1,805.5 SELECTED CITIES AND TOWNS 12 CATU 208.5 This map was produced by the Map Design Unit of The World Bank. 13 CURIMATAÚ 830.5 STATE CAPITAL The boundaries, colors, denominations and any other information 14 GUAJU 150.6 shown on this map do not imply, on the part of The World Bank PARAÍBA Group, any judgment on the legal status of any territory, or any 15 NORTH COAST 5,736.4 STATE BOUNDARIES endorsement or acceptance of such boundaries. 16 EAST COAST 649.4 37° 36° 35°

DECEMBER 2005