Document of The World Bank Public Disclosure Authorized

Report No: 25718-PH

IMPLEMENTATION COMPLETION REPORT (TF-25191 SCL-44220)

ON A

LOAN

Public Disclosure Authorized IN THE AMOUNT OF US$23.3 MILLION

TO THE

DEVELOPMENT BANK OF THE PHILIPPINES

FOR AN

LGU URBAN WATER AND SANITATION PROJECT

Public Disclosure Authorized June 28, 2004

Urban Development Sector Unit East Asia and Pacific Region Public Disclosure Authorized CURRENCY EQUIVALENTS (Exchange Rate Effective June 15, 2004) Currency Unit = Philippine Peso 1 Peso = US$ 0.018 US$ 1 = 55.88 Pesos

FISCAL YEAR January 1 December 31

ABBREVIATIONS AND ACRONYMS

ADB Asian Development Bank APL Adaptable Program Loan BNWPP Bank-Netherlands Water Partnership Program CAS Country Assistance Strategy CAU Contract Administration Unit DBL Design Build Lease DBP Development Bank of the Philippines DENR Department of Environment and Natural Resources DILG Department of Interior and Local Government DOF Department of Finance EA Environmental Assessment EU European Union GOP Government of the Philippines LBP Land Bank of the Philippines LGU Local Government Unit LOI Letter of Intent LWUA Local Water Utilities Administration MWSS Metropolitan Waterworks and Sewerage System NDF Nordic Development Fund NEDA National Economic Development Authority ODA Official Development Assistance O&M Operation and Maintenance PAD Project Appraisal Document PHRD Policy and Human Resources Develeopment Fund PMO Project Management Office (at national level) PMU Project Management Unit (in each LGU) PPIAF Public-Private Infrastructure Assistance Facility PQ Prequalification Evaluation PSP Private Sector Participation PSR Project Status Report SLA Sub-loan Agreement TA Technical Assistance

Vice President: Mr. Jemal-ud-din Kassum, EAP Country Director: Mr. Robert Vance Pulley, EACPF Sector Director: Mr. Keshav Varma, EASUR Task Team Leader: Mr. Ming Zhang, EASUR

PHILIPPINES LGU URBAN WATER AND SANITATION PROJECT

CONTENTS

Page No. 1. Project Data 1 2. Principal Performance Ratings 1 3. Assessment of Development Objective and Design, and of Quality at Entry 2 4. Achievement of Objective and Outputs 5 5. Major Factors Affecting Implementation and Outcome 13 6. Sustainability 14 7. Bank and Borrower Performance 15 8. Lessons Learned 18 9. Partner Comments 19 10. Additional Information 20 Annex 1. Key Performance Indicators/Log Frame Matrix 21 Annex 2. Project Costs and Financing 22 Annex 3. Economic Costs and Benefits 24 Annex 4. Bank Inputs 26 Annex 5. Ratings for Achievement of Objectives/Outputs of Components 28 Annex 6. Ratings of Bank and Borrower Performance 29 Annex 7. List of Supporting Documents 30

Project ID: P039022 Project Name: LGU URBAN WATER & SANITATION Team Leader: Ming Zhang TL Unit: EASUR ICR Type: Core ICR Report Date: June 28, 2004

1. Project Data Name: LGU URBAN WATER & SANITATION L/C/TF Number: TF-25191; SCL-44220 Country/Department: PHILIPPINES Region: East Asia and Pacific Region Sector/subsector: Water supply (91%); Sanitation (6%); Flood protection (3%) Theme: Municipal governance and institution building (P); Other financial and private sector development (P); Municipal finance (P); Other urban development (P); Pollution management and environmental health (P)

KEY DATES Original Revised/Actual PCD: 10/08/1997 Effective: 05/27/1999 Appraisal: 06/04/1998 MTR: 03/12/2001 Approval: 12/15/1998 Closing: 09/30/2002 09/30/2003

Borrower/Implementing Agency: PHILIPPINES/DEVELOPMENT BANK OF PHILIPPINES Other Partners:

STAFF Current At Appraisal Vice President: Jemal-ud-din Kassum Jean-Michel Severino Country Director: Robert V. Pulley Vinay Bhargava Sector Manager: Keshav Varma Keshav Varma Team Leader at ICR: Ming Zhang Vijay Jagannathan ICR Primary Author: Josefina U. Esguerra; Ming Zhang

2. Principal Performance Ratings

(HS=Highly Satisfactory, S=Satisfactory, U=Unsatisfactory, HL=Highly Likely, L=Likely, UN=Unlikely, HUN=Highly Unlikely, HU=Highly Unsatisfactory, H=High, SU=Substantial, M=Modest, N=Negligible) Outcome: U Sustainability: L Institutional Development Impact: M Bank Performance: S Borrower Performance: S

QAG (if available) ICR Quality at Entry: U Project at Risk at Any Time: Yes 3. Assessment of Development Objective and Design, and of Quality at Entry 3.1 Original Objective:

Introduction.

In the late 1990s, only about 65% of the Philippines’ 28 million residents in large urban centers received piped water, and most were using open drains, septic tank and pit latrines to dispose of liquid and human waste. Public water supply and sanitation services in urban areas were being provided by three principal agencies: (a) the Metropolitan Waterworks and Sewerage System (MWSS) was providing service in Metro Manila; (b) in approximately 500 other large cities and towns, autonomous “water districts” provided water supply services; and (c) in some 1000 small towns, water supply was provided by line departments of local governments units (LGUs).

The Government of the Philippines' (GOP) objective for the water and sanitation sector was to ensure that at least 90% of the urban population had access to safe, reliable water supply with a reasonable period of time. The Bank's Country Assistance Strategy (CAS) emphasized strengthening infrastructure, facilitating private sector participation (PSP), and upgrading basic urban services in its towns so that GOP’s objective could be achieved. The Bank’s specific strategy for the water sector in the country had three elements: (a) assisting water utilities to improve operational efficiency and accountability to consumers; (b) facilitating PSP; and (c) leveraging private financial flows in the water and sanitation sector.

For the Philippines, three projects in the water and sanitation sector were approved in the late 1990s, corresponding to the three main providers of water discussed above: (a) the Second Manila Sewerage Project (Ln. 4019) approved in 1996 for MWSS; (b) the Water Districts Development Project (Ln. 4228) in 1997; and (c) the LGU Urban Water and Sanitation Program, approved in November 1998, as a three-tranche Adaptable Program Loan (APL). This ICR covers the first tranche of that APL.

Objectives of the Program: The overall development objective of the LGU Urban Water and Sanitation APL was to ensure that by 2007, approximately one-quarter of LGU-managed water utilities would be able to provide residents with water and sanitation services based on consumer demand, as enunciated in GOP’s strategy.

The objective of APL1, as stated in the Loan Agreement, was to assist selected LGUs to provide sustainable water and sanitation services and strengthen their institutional and technical capacity to manage water utilities. The objective was further clarified in the PAD as to test and fine-tune the set of institutional, technical and economic rules through which the national policies could be translated into concrete measures that would ensure better quality water supply and sanitation services in hundreds of small towns in the Philippines. The project’s development objective was to provide practical demonstration, through a reasonably large sample of LGUs, that with appropriate technical and financial designs, pricing rules and institutional incentives, water supply systems, irrespective of size, could be made both viable and sustainable. APL1 was developed in parallel with the Local Government Finance and Development Project (Ln. 4446, approved March 1999), which had available a significant technical assistance component for capacity building.

Assessment of Objectives

The objectives of the project were clearly stated and well understood by the various institutions involved, e.g., the participating LGUs, the Development Bank of the Philippines (DBP) as the borrower and lead

- 2 - implementing agency, and government policy-makers. The objectives were also discussed at a Philippines Water Supply Seminar sponsored by the World Bank Institute in June 1997. The statement of objectives benefited from the adoption of time-bound and quantitative triggers agreed upon by GOP, DBP and the Bank as conditions for moving to APL2.

The project’s objectives reflected very important but challenging reforms in the delivery of public services, reforms that were to advance recently adopted policies in decentralizing services and in private sector participation (PSP). Formulation of the right set of institutional, technical, financial and economic rules that would enable LGUs to better plan and implement water supply projects was important to various national government agencies, namely the Department of Finance (DOF), the Department of the Interior and Local Government (DILG) and the National Economic and Development Authority (NEDA), all of which supported the project during inception. The DILG in particular actively promoted the project during inception in order to generate a large sample of client LGUs that had already proven themselves successful in operating viable and sustainable water supply systems.

For the DBP as a credit institution, these objectives were somewhat unrealistic. The DBP saw that promoting innovative water utility management schemes was in line with its development banking role and could have strategic value in terms of expanding its LGU client base. However, the project objectives implied policy reform and public sector intervention, making the project very complex. Implementing the reforms far exceeded the DBP’s mandate as a development bank, made the project quite demanding. Moreover, the product that DBP was to generate was a very specialized form of lending. It was beyond the proven capacity of DBP, which had no recent experience in dealing with subnational governments for capital-intensive infrastructure development. Achieving the objectives required technical inputs, such as rectifying construction defects, educating LGUs in commercial management of water systems, and promoting sanitation investments. These inputs were to be provided by specialized consultancy services financed by the project, and from other sources accessed through the Bank, but were at the same time, quite alien to DBP’s usual lending operations.

3.2 Revised Objective: Not Applicable.

3.3 Original Components: The project had a total of six components, three components of which were financed by the Bank. As the components of this project were to be demand-driven, the allocations were notional. Actual disbursements were expected to take place on the basis of demand for a subcomponent. The three components financed by the Bank were:

1) Water Supply (US$23.3 million) was to finance civil works, equipment and supervision for improved water supply systems for small towns that had traditionally been viewed as having "non-viable" and poorly functioning water utilities, managed by municipal agencies themselves. The component financed the construction of new systems and the rehabilitation and expansion of existing systems.

2) Sanitation Program (US$1.6 million) was to finance physical improvements in household toilets, on-site sanitation facilities including soakaway pits for septic tank effluents or the disposal of wastewater flows arising from augmented water supplies.

3) Urban Drainage Program (US$0.8 million) financed investments and consultant services in micro-drainage infrastructure.

- 3 - The project envisioned implementing this demand-based framework in about 35 LGUs. A trigger for moving to APL2 was completion of 10 fully operational, project-funded systems.

Three other components were included on the basis of parallel financing being offered by the European Union (EU), the Nordic Development Fund (NDF) and the Bank.

4) Water Utilities Private Sector Participation Facility (US$1.5 million). The EU funded concessional TA to help LGUs and Water Districts prepare information memoranda as a basis of bidding by private operators, to evaluate such proposals, and to identify the most appropriate form of more competitive private sector involvement.

5) Support for Preparation of the Next Batch of Projects (US$2.5 million). The NDF and other bilateral donors provided concessional TA to create a revolving fund from which LGUs could access resources for water supply or sewerage development.

6) Institutional Capacity Building Program (US$2.0 million). The NDF and the Public-Private Infrastructure Assistance Facility (PPIAF) provided TA to strengthen managerial and technical capacities of organizations and staff involved in (a) implementing the project; (b) regulating private operators; and (c) assisting LGUs in building institutional capacity and appropriate training program.

3.4 Revised Components: EU funding for component 4 was never utilized. Instead, a similar facility was included in a project financed by the Asian Development Bank (ADB) through the Land Bank of the Philippines.

3.5 Quality at Entry: Quality at entry is rated unsatisfactory.

Project development work correctly identified gaps in the government’s service delivery system and incorporated strategies that were aligned with the government’s evolving role in infrastructure development. The project was also well aligned with the Bank’s CAS objectives of strengthening the public sector by supporting reforms that would improve essential government services while maintaining public sector finances on a sustainable debt path. It was the first project that sought to build LGU capacity in establishing water utilities that could operate under commercial principles. The project was designed to respond to unmet demand for piped water systems in hundreds of middle and low-income municipalities where no Water Districts were operating. Tapping the private sector and amalgamating small water systems were also among the design innovations that added value to the project. The project implementation strategy incorporated new approaches for subproject planning and design, such as mandatory consultations with local communities and willingness-to-connect surveys, which sought to ensure that services provided to communities were based on what communities wanted and were willing to pay for.

For the DBP, the project represented its first opportunity to test the untapped LGU market for infrastructure services. There were no previous project experiences to guide implementation, and lending to small towns—particularly for water supply and sanitation facilities—was not common. The APL format provided GOP and DBP the opportunity to innovate and test the project concepts in APL1, while learning lessons that would be used to improve designs in subsequent phases.

However, with the benefit of hindsight, this very innovative project design also had a number of shortcomings. First, project preparation was not able to fully recognize and address the many risks in

- 4 - the LGU credit market which would lead to high dropout rates for LGUs. Had more thorough assessments been done, DBP could have had better recognition of the difficulties when committing to the project, and the national government agencies could have been asked to play a stronger role (e.g. coordinating competing lending windows).

Second, while the overall approach of encouraging PSP was valid, the assumption that the private sector would actively compete for LGU water utility operations seems to be too optimistic from hindsight, in light of the uncertain regulatory framework and unfavorable business enviornment for PSP. The project design should have offered more assistance to LGUs that were unable to secure private sector interest in operating their constructed systems, a constraint encountered during implementation.

Third, the triggers for APL2 should have included a disbursement criterion, so that APL1 would have been further along toward completion before APL2 became effective. Having such a criterion would have likely avoided the significant cancellation (79% of the Loan) from APL1 soon after APL2 became effective. More importantly, critical lessons from APL1 would have been better absorbed for APL2.

Fourth, the financial viability of using DBP as a financial intermediary for this type of operation could have been more thoroughly evaluated. DBP incurred net financial loss from the project as a result of a number of factors, including downward pressure of on-lending interest rate to LGUs, much higher transaction costs due to technical and political complexities, and the dropout of a number of large LGUs. In addition, the project’s technical issues proved quite challenging for DBP, which had no technical competence of its own.

Fifth, some of the feasibility studies of the individual subprojects were not of satisfactory quality (i.e. lacking in data, analysis not thorough), leading to some implementation delays and problems. This was largely a result of insufficient technical capacity by DILG and the LGUs to adequately review these feasibility studies.

Sixth, some of the first batch LGUs felt that their project-funded systems were overdesigned in terms of capacity, due mainly to unrealistic parameters for projecting demand. While the design standard for water demand projection in the Operations Manual is 100ml/day, actual demand for completed systems stayed at 50-80 ml/day. During preparation, the Bank team did suggest to have the coefficient lowered to 80 ml/day, but LWUA standard, which formed the basis of the Operations Manual, is 120 ml/day. So a middle value of 100ml/day was used. The parameters were lowered for subsequent subprojects.

Finally, more studies to determine demand should have been carried out for the sanitation component as little demand arose.

Some of these shortcomings are inevitable for APL1, since the objective of the phase is exactly to test and fine-tune the proposed approach. Many of these design weaknesses only became clear after project implementation progressed. Nevertheless, the ICR rates the overall Quality at Entry as Unsatisfactory because of the significant impact of the above factors on project implementation.

4. Achievement of Objective and Outputs 4.1 Outcome/achievement of objective: The project was able to make important achievements toward its development objectives. However, significant gaps still remained at the end of the project, and the overall achievement of project objectives is rated unsatisfactory.

- 5 - Before the advent of this Program, the available financing arrangements channeled resources exclusively to water utilities with strong local market potential, but excluded LGUs wishing to invest in reaching communities where the market for water was not developed. This project was successful in refining and testing new arrangements for the development, financing and sustainable management of water supply systems in secondary towns and cities.

Achievements

The project contributed considerably to the development of government policies and strategies for the development of water supply systems in small municipalities. For a financial institution such as the DBP, the project’s major accomplishment was not so much for market expansion as for development financing of investments that have strong social and economic value for rural LGUs. These achievements are outlined below.

Expanded Technical Options. Traditionally, residents in small municipalities relied on private vendors and/or low service levels from point sources such as handpumps, and communal faucets to meet their water needs. Through this project, the DBP offered small municipalities another alternative to providing universal house connections for any household willing to pay the agreed tariffs.

Financing Rules. Through the project, DBP exposed LGUs to borrowing long-term capital for infrastructure development. The project combined financial assistance with technical inputs to address the risks associated with the LGUs’ lack of experience and technical capacity in the construction and commercial operation of water supply systems. This is an important achievement considering the overall low level of infrastructure investments by LGUs.

Institutional Arrangements. The LGUs that did borrow through the project are now applying commercial principles in the operation of their water supply systems. Contrary to common perception, only one of the operational water systems hesitated to issue disconnection notices to delinquent customers. Enterprise-based financial management systems are maintained separately from the general operating fund. Financial performance is reported regularly and financial targets are driving their collection policies and market promotion strategies.

Private Sector Partnership (PSP) Arrangements. Through the project, DBP played a key role in helping to promote more PSP for the water sector by educating LGU officers about the advantages of having a private operator for their water systems. Clustering LGU sub-projects under a single PSP contract was pursued to increase cost efficiency in managing small systems, per the government’s policy of amalgamating small water systems. Integrating a construction contract with a lease contract under a single Design-Build-Lease Contract (DBL), enabling a prospective operator to control a system’s technical performance, was also a new contracting arrangement developed under the project.

Transparency. Part of institutional development is to strengthen selected LGUs and national agencies in the preparation and management of water and sanitation facilities. In the course of implementation, the project helped government to design procurement rules and bid documents to competitively and transparently select PSP companies. The DBP can be credited with consistently applying the competitive bidding process despite the resulting disbursement setbacks.

However, the overall outcome is rated unsatisfactory because it did not meet its objective of providing practical demonstration, through a reasonably large sample of LGUs, that appropriate technical and

- 6 - financial designs, pricing rules and institutional incentives, water supply systems regardless of size, can be viable and sustainable.

The project result also did not pass the “litmus test on whether this demonstration exercise has succeeded”, which is “the extent to which the private sector is willing to invest its time, effort and finances in supporting the water utilities in these towns”, as stated in the Project Appraisal Document (PAD). One out of nine water systems built (Kalilangan Bukidon) actually went into commercial operation by a private sector operator, while another (Lantapan, Bukidon) is due for takeover by a private operator. The private sector lost interest due to the risk of low revenues and the uncertain policy environment for water, particularly when one of two concession contracts for the Metropolitan Waterworks and Sewerage System (MWSS) faced very difficult circumstances.

A critical fact that affected development outcome is that many LGUs eventually withdrew their interest, despite that more than 100 prospective LGUs submitted letters of intent (LOI) before Board approval. The reasons for the dropouts include: (a) DBP’s interest rate was higher than the prevailing market rates and was not lowered promptly; (b) national government did not provide clear and consistent policy guidance on LGU financing, which drove most LGUs to seek grant financing from various other sources even when there was actually none; and (c) political change at LGUs after the elections, which resulted in reversal of LGU commitments. This downward pattern of LGU interest was exacerbated when the first batch of LGUs was unable to demonstrate immediate benefits due to technical, procurement and financial issues that delayed activities.

4.2 Outputs by components:

Component 1: Water Supply

This component is rated unsatisfactory. The PAD indicated that approximately 35 municipalities would be covered under APL1, but only 10 municipal water supply systems were financed and constructed when the loan was closed. As a result, only $6.63 million out of $23.3 million loan allocation was disbursed. These ten municipalities were all from the first batch of participating LGUs, whose water supply systems were already performing well technically. The second and third batches of LGUs were bidded out and had signed subloan agreements, but were unable to go into construction.

Assessment of Constructed Water Supply Systems

Of the ten systems in the first batch, nine are operational, and providing 24-hour, satisfactory water quality service to connected households. Of the three systems in Bukidnon Province, the systems in Kalilangan and Lantapan encountered several technical problems during construction, problems which could have been partly avoided if the feasibility studies had been better executed and more closely supervised. In addition, the water supply source of the Lantapan system provided a lower yield than estimated because of disruptions caused by an earthquake. Work is nearing completion to tap an alternative water source to meet the municipal demand and this work is being undertaken with LGU resources. The following table summarizes the implementation status of the first batch of municipal water systems.

- 7 - Implementation Status of Batch 1 Water Systems

Total cost in Bank financing Municipality million Pesos US$ million Status as of Feb 2003 LAGUNA, Magdalena 24.22 0.49 Completed & operational ISABELA Aurora 17.21 0.30 All six water systems in the Cabatuan 27.37 0.50 Isabela cluster are complete Luna 11.60 0.21 and operational Mallig 11.10 0.20 Quezon 22.74 0.54 San Mateo 29.45 0.41 BUKIDNON Kalilangan 12.58 0.28 Completed and operational Lantapan 35.15 0.62 Completed and partially operational Cabanglasan 1.02 0.03 10% completed, transferred to APL2

In communities where the subprojects went into construction, the project provided the appropriate infrastructure to provide good quality water service. It enabled private firms to be contracted for all detailed engineering design and civil works. The civil works were supervised by the construction supervision consultants hired by DBP and were monitored closely by the LGU Project Management Units. (These were teams of LGU officers who were designated to oversee project implementation in each municipality).

The quality of operation and maintenance (O&M) of the water systems was initially unsatisfactory, but LGU administrations, DBP and DILG undertook measures to improve the technical and financial performance of the water systems. LGU waterworks staff reported that training inputs provided by the project through the DBP were quite useful in developing their ability to manage the water utilities. Although all participating LGUs are now subsidizing the debt repayments of their water systems, the Batch 1 LGU water systems have the potential to become commercially viable.

The quality of the construction work met the standards set out in the design and bidding specifications in the Magdalena and Isabela clusters while the technical performance of the Bukidnon cluster has yet to achieve its design parameters. Poor execution of the feasibility studies of the Bukidnon cluster caused considerable delays in completing their sub-projects.

Reasons for Low Disbursements

The most important factor for the overall low disbursement for the component is the lack of firm commitments from LGUs. LGUs frequently drop out after completion of their feasibility studies for a variety of reasons. A significant element was the absence of clear policy direction from the national level on PSP and access to subsidized credit. For example, some LGUs, such as Iligan City in Lanao Norte and Malaybalay City in Bukidnon withdrew from the project and decided to "go-it-alone" on the mistaken assumption that the feasibility study by itself was adequate to attract private sector financing. These two intended subprojects alone, if implemented, would have increased the usage of the loan by $10.4 million.

- 8 - Other LGUs were concerned about the high interest rates at a time when the 91-day T-bill in the Philippines was well below 10% (as opposed to 15% in the project). DBP was not able to lower the interest rates quickly enough in response to market change, and lost some LGUs during the time. Yet other LGUs were hoping to access funding from subsidized credit or use their political connections for construction (although none was forthcoming). For example, a number of municipalities applied to a JBIC-financed facility in the Land Bank of the Philippines, another government financial intermediary, that was offering similar municipal credit services but had much less demanding fiduciary or safeguards requirements and no requirements for PSP.

Another important factor is procurement irregularities at subproject level, for which DBP strongly insisted on remedies by the LGUs. The most important case in this aspect involved the six Isabela towns in the second batch. After three years of efforts, these subprojects (with estimated costs $3.2 million) were not implemented eventually, because the lowest qualified bidder was not chosen to be awarded despite the numerous efforts by DBP and WB in urging the authorities to correct the situation. Elected officials outside these municipalities were also involved in the prolonged procurement case. At one point, the LGUs were to approach the Land Bank to finance these subprojects after DBP cancelled the SLAs as a result of procurement failure. But DBP intervened and informed Land Bank of the reasons of procurement failure. The case not only voided all the preparation and implementation work done for the towns, but also slowed the pace of implementation in other LGUs as many bidders and mayors with projects in the pipeline waited on the sidelines to see how these conflicts were managed and resolved by the DBP. The case preoccupied the PMO and Bank for many months and greatly impaired subproject processing.

A final factor responsible for the low disbursement was the better financing terms offered under APL2, as a Fixed Spread Loan in Japanese Yen (a new IBRD product). The effective cost of borrowing for DBP under APL2 is much lower than that from APL1 (Single Currency Loan in US Dollar). As a result, DBP requested to cancel the undisbursed balance of APL1, rather than seeking its full utilization, and transferred the three ongoing subprojects under APL1 to APL2.

Component 2: Sanitation Program

Funding for this component was never implemented and is thus rated unsatisfactory. It is important to note that households have invested private funds to improve their sanitation facilities upon completion of the water supply subprojects. This did not happen systematically, but rather on a piece-meal basis, as and when the household decided to improve indoor plumbing. Credit was offered to households for sanitation but there were no takers.

The participating LGUs largely realized the importance of sanitation investments, but were unwilling at this juncture to engage directly in a credit operation for individual households. LGU planners are of the opinion that government involvement in providing for household sanitation was not a priority because households themselves were investing in onsite facilities. LGUs in these urbanizing municipalities saw their role as one of using their regulatory powers to enforce local ordinances and building codes as a means of promoting household sanitation rather than providing resources directly. This view was shared by NEDA who was not seriously concerned by the lack of disbursements under this component.

Component 3: Urban Drainage Program

This component is not rated because the Environmental Management Plans in the completed subprojects did not call for drainage infrastructure. In keeping with the demand-driven approach for this component,

- 9 - no disbursements were made.

Component 4: Water Utilities Private Sector Participation Facility

This component is rated satisfactory. The idea of putting up a revolving pre-investment fund to finance a TA program to help LGUs prepare information memoranda and evaluate bids was endorsed by GOP. However, instead of using EU funds as originally envisioned, GOP chose instead to establish a similar facility with the LBP, with financing from the ADB.

The project moved very efficiently in developing bid documents and in conducting preparations for bidding activities. This work resulted in the adoption of specific rules for PSP in the construction and operation of water systems. The work also developed a practical format for amalgamating small water systems by tendering LGU contracts as a cluster. This amalgamation allowed the operation to be awarded to a single contractor who could, in turn, benefit from some economies of scale by operating within a given province. Another important achievement is the preparation of bidding documents for the Design-Build-Lease arrangement for water systems under the second batch of LGUs. These bidding documents addressed some of the private sector’s concerns that had discouraged them from participating in the project.

Component 5: Support for Preparation of Next Batch of Projects

This component is rated satisfactory. The project worked with a pipeline of about 110 prospective LGUs (mostly with less than 2000 connections each), of which 95 had completed a feasibility study for a water system.

The number of feasibility studies generated by this component was very high and most were completed early enough to give the LGU lead time for local consultations. Learning from the negative experience with the first batch of LGUs prepared under the PHRD grant, the subsequent feasibility studies and detailed engineering designs financed by this component were evaluated by the DBP’s Construction Supervision Consultant before sub-project approval to ensure the quality of data and analysis used to select appropriate options by LGUs and appraisal by DBP. The Nordic Development Fund facility became operational only after APL1 closed, and so did not contribute to this component.

Component 6: Institutional Capacity Building:

This component is rated satisfactory. This component was to be financed by the Nordic Development Fund facility, which became operational only in January 2003. Instead, the project used funds from the Public-Private Infrastructure Assistance Facility (PPIAF) and the Bank-Netherlands Water Partnership Program (BNWPP). The PPIAF financed the following: (a) drafting the regulatory legislation for water utilities; (b) developing the implementing rules and regulations for the Contract Administration Unit (CAU), in assisting LGUs to rebid lease contracts; and (c) testing out new approaches, such as Output-Based Aid.

4.3 Net Present Value/Economic rate of return: The project’s net present value could only be computed for the water systems that are fully operational and able to generate actual data on revenues and costs. Hence, the economic cost-benefit analysis could not be computed for the Bukidnon cluster since none of those three sub-projects is fully operational yet. Among the LGUs in the Isabela cluster, the San Mateo system was not included in the analysis in view of the 6-month gap in financial data while the system was under private sector contract management.

The project has an EIRR of 19.56% for the Isablela cluster and 145.4 % for the Magdalena system. The

- 10 - project generated benefits for the users in terms of better quality of service at lower cost. Those who were purchasing water from vendors were able to realize substantial savings with water from their new system, particularly in Magdalena. Those who had their own wells as their exclusive source of water, as was the case in Isabela, now have a water source that is reliable, convenient and safe.

Although the overall EIRR is high, the sub-project benefits were lower than the levels expected in the Feasibility Studies, mainly because of the lower than expected usage by their beneficiaries. In the Isabela cluster, the LGU systems have yet to reach the number of connections obtained during the willingness-to-connect surveys. In Magdalena where almost all houses in the service area are connected to the system, the average level of consumption is less than half the estimated level during the planning stage hence bringing down user benefits by the same proportion.

4.4 Financial rate of return: In financial terms, the Magdalena system is the most viable with an FIRR of 7.3 % and a net present value of P315.8 million (discounted at 15%). The FIRR for the Isabela cluster is 3.2% and the average NPV is negative P17.2 million. Among the LGUs in the Isabela cluster, Quezon has the highest financial viability indicators with an FIRR of 16.2% and was the only system that generated a positive NPV at P0.67 million (discounted at 15%). The rest of the water systems in the Isabela cluster have lower financial indicators than Quezon.

For the same reason that the level of water usage among the residents in the service coverage area is lower than expected, the FIRR for all the sub-projects is lower than estimated in the feasibility studies. Household connections in Isabela are below design levels mainly because some residents opted to use their own wells than pay the monthly minimum charge for the system. Those households who are connected to the system consume much less volume than the average household in urban areas.

The water systems are all under LGU management and, as expected, collection efficiency varies greatly. Magdalena has excellent rates of collection efficiency and has every indication that the present management team is sustainable. In Isabela, the average collection efficiency is only 64%; however all of the waterworks management teams are mounting a campaign to improve collection to ease the LGU debt service burden.

4.5 Institutional development impact: This section discusses institutional impact on three groups of agencies involved in the implementation of the project: LGUs, DBP and DILG. The overall impact is rated modest.

The project has had a significant institutional development impact on the first 10 LGUs that had gone into construction and operation. They have learned to make strategic investment decisions to develop their water systems and access long-term financing within the bounds of existing policies that aim at rationalizing national government subsidies for water sector projects. The project was able to introduce to LGUs the approach of using PSP so that this mode is now generally preferred over direct waterworks administration by LGU staff. The LGUs learned and are employing new skills in waterworks project development, construction, and operation. In order to cope with the additional financial obligations, LGUs are now forced to practice sound financial management policies and are benefiting from more active participation of their finance officers in investment decisions. It should be noted that the many LGUs that received preparation assistance but did not utilize the loans still benefited from the project in institutional development through technical assistance provided for subproject preparation. Therefore the institutional development impact on LGUs reached far beyond the participating LGUs.

- 11 - Towards the end of the project period, after learning its experience with project implementation, DBP put in place a new PMO that works exclusively to provide LGU clients with project packaging and credit re-lending operations for LGU Urban Water Supply Project services. Through this new PMO, which differs from the original set-up, the DBP is able to operate more effectively as a financial intermediary for LGUs and to respond to the other nonfinancial needs of waterworks systems development and operation. The highlights of this new arrangement are shown below:

Highlights of New Institutional Arrangements for Project Implementation in DBP

Initial Reorganized Organizational Structure The PMO reported to the Industrial The PMO now reports to Project Research and Restructuring Management Department; It Department which was also absorbed key staff of the LGU implementing other ODA-funded Department who are quite adept and programs more experienced at dealing with LGU clients Loan Packaging and Credit Loan packaging was done Loan packaging and credit operations Operation exclusively by the PMO at head are integrated into the functions of office while credit operations were the PMO; Only PMO Head is done by the LGU Department responsible for meeting target disbursements Project Promotion and Heavy reliance on the work of DILG DBP PMO now takes the lead in Information Dissemination Water Supply and Sanitation PMO project development and promoting for dealing with LGUs during the project among prospective LGUs project development with consistent information on DBP lending rules and procedures Role of DBP Branch Branch offices had no knowledge of Loan disbursements are booked at Offices the project and had no role in credit the branch office. Branch offices are evaluation and operation. motivated to develop strategy for Loan disbursements of the LGUs targeting clients with strong credit are credited to Head Office where potential. They help the PMO the PMO is located promote the project with LGUs.

The new PMO structure manifests DBP’s renewed commitment to turn around its poor performance in LGU infrastructure lending for water supply and sanitation and to compete for LGU clients more aggressively. Unfortunately the new structure came very late in the project, and the impact of these changes is accruing to succeeding phases of the program.

The DILG, which is mainly responsible for LGU capacity building, is now able to offer LGUs more technical, financial and PSP options, allowing them to pursue their plans to expand water supply service. Its role in promoting LGU water supply investments is now well defined, as LGUs actually demonstrated a need for technical advice during subproject development, tendering of contracts for PSP, up to formally signing a loan agreement with the DBP or other financial intermediary.

In summary, the project has had substantial institutional development impact for the participating LGUs, DBP, and DILG. However, because the number of LGUs participating in the project is much less than what was expected, the overall impact is rated modesst.

- 12 - 5. Major Factors Affecting Implementation and Outcome 5.1 Factors outside the control of government or implementing agency: The East Asian crisis of 1997 affected many companies with the rapid drop in the value of the Peso and contraction of investments as private and foreign investors deferred plans for business expansion. Though the crisis occurred before project approval, its full impact was felt and better recognized only during the project implementation period. Many private companies became very conservative in their business decisions; some that had won contracts for water supply operations eventually backed out. The only private company that stayed with the project (in the Bukidnon cluster) was carefully checking all aspects of the system to ensure that the project breaks even throughout the concession period.

Geological problems also slowed project implementation. In the Laguna sub-project, two wells were drilled but did not yield satisfactory water quality, thus increasing construction costs. The yield of the Lantapan, Bukidnon water source declined unexpectedly after an earthquake hit during construction. These developments increased construction costs and delayed completion by several months. While these geological problems could not have been anticipated during subproject design, the problem revived local debate about whether the project approach was right for their water supply needs, particularly when local governments were shouldering all the risks.

5.2 Factors generally subject to government control: Poor coordination of governnment credit operations. The market for LGU financing made little progress towards its commercial orientation goal because LGUs continually believed that grant financing or subsidized credit would be available from the central government. Although subsidized credit was discouraged by policy-makers, investments coursed through the Municipal Development Fund, the Local Water Utilities Administration (LWUA), and subsidized credit from senators and congressmen offered LGUs financing that was cheaper than borrowing from DBP.

Frequent changes in LGU decisions posed problems for the PMO whose resources were too limited to keep in frequent contact with all the participating LGUs. Many LGUs dropped out of the project after newly elected officials, with very little background information, decided to seek cheaper financing sources. Since the government did not enforce a penalty for LGUs who pulled out of the project after signing a loan agreement (or even after signing a contract), DBP had to bear most of the pre-implementation costs of these cancelled subprojects.

Weak regulatory framework. The appeal of PSP in the water sector suffered considerably from inherent weaknesses in the Philippines’ indeterminate regulatory framework governing PSP contracts. The rules governing PSP arrangements for the water sector were enforced through individual lease contracts for each water system (or cluster). Under ideal arrangements, a sound, transparent regulatory framework can insulate the private sector from risks arising from changing rules, varying interpretations of those rules, and legal challenges from competing firms. Further, the unsatisfactory experiences with the MWSS concession during the life of this project did not bode well for similar prospects with LGUs. GOP moved very slowly and was not able to pass the regulatory legislation that would have put in place a more lasting and credible solution to these policy issues.

Weak LGU demand for sanitation and drainage components. The weak LGU demand for sanitation investments was another factor that negatively affected project outcome for both the sanitation and drainage components. Though these components were to be demand-driven, demand may have been greater with more forceful environmental education and if DENR had enforced environmental standards more

- 13 - consistently.

The key point is that the national government did little to coordinate its credit operations. The diverse lending possibilities led LGUs to defer borrowing decisions and explore alternative financing for their water subprojects.

5.3 Factors generally subject to implementing agency control: There were three factors under DBP control that affected project outcome. DBP was not able to reduce its interest rates when in fact market rates had already been declining for several months. The DBP eventually reduced its interest rates from 15% to 11% effective March 2002, and brought it down further to 9% effective January 2003, but by this time valuable project time had been lost.

The capacity of the PMO in DBP initially was not equipped to deal with complicated, fast-changing LGU credit market for water supply. It could not stay on top of implementation issues arising from having to deal with such a multiplicity of inexperienced clients. DBP planned to address this weakness by tapping into its branch network, but this arrangement could not immediately solve implementation issues that had already been mounting since construction started in 1999. In the meantime, DBP lost most of its prospective LGUs that had lined up for the second and third batches, and had to face difficult governance problems in Isabela province. At the later stage of the project, however, DBP reorganized its PMO to streamline business process and increase its capacity.

Another factor was that DBP was not able to produce an appropriate lending instrument that could put into motion the planned LGU sanitation investments. DBP did not see a need to move quickly on this component in view of the delayed implementation of the water supply component in the first batch of LGUs. Furthermore, DBP called for establishing new arrangements for on-lending for the sanitation investments through a local financial intermediary, for which it never initiated any ground work.

5.4 Costs and financing: The total project cost at appraisal was estimated at US$31.9 million with Bank financing of US$23.3 million for civil works and for technical assistance (TA) for construction supervision. Financing for a PSP revolving fund, for preparation for subsequent batches of subprojects, and for institutional capacity building was to be obtained from a concessional TA from the Nordic Development Fund (NDF).

Upon cancellation of the remaining balance of the Loan in March 2003, the total project cost amounted to US$8.65 million, or 27 % of the estimated cost at appraisal. The water supply component that had been given the highest allocation fell far short of its target of constructing 35 LGU water systems, undertaking only 10 in the first phase. As a result, this component accounted for only US$6.63 million or 28 % of the estimated cost. The two other components for drainage and sanitation facilities did not materialize at all and the allocation of US$2.4 million for these two components went unspent. US$1 million was disbursed for the Institutional Capacity Building Component, representing only 50% of the estimate made at appraisal. GOP opted to defer disbursements against the NDF loan, in order to fully utilize the PHRD grant which had been made available for subprojects under APL2.

6. Sustainability 6.1 Rationale for sustainability rating: Sustainability overall is rated Likely.

The individual LGU water supply systems implemented under the first batch are likely to be sustainable because they are delivering much higher quality water services than before the project. Analysis of the

- 14 - income profile of the communities shows that in most areas served by these water systems, the monthly water bill is well within the households’ capacity to pay, even for families with monthly incomes below P5,000.

The financial sustainability of the water systems is likely because the municipal governments have collected user charges not only to cover O&M cost, but also part of the debt repayment obligations. This financial result, though short of original expectation, is much better than an average LGU water system in the country where user charge is not sufficient even to cover O&M cost. LGUs are ready to absorb a part of the loan amortization costs, although this was not envisaged during preparation (when the lease fee was expected to cover full amortization costs). So far, the LGUs have encountered virtually no resistance from newly elected officials or members of local development councils in appropriating funds for loan amortization during the annual budget process. In one LGU (Aurora, Isabela) the financial burden of debt repayment is even being shared by the barangay, the village level unit of the local government. With multi-year financial programming, most LGUs can subsidize debt payments for the initial period of operations and scale these down over time as water consumption grows.

DBP’s lending operations in the LGU water sector is being sustained and continued under APL2. Towards the end of the project in October 2002, the PMO received much needed administrative strengthening, and the DBP management made major improvements in implementation quality. The new PMO absorbed key personnel from the LGU Unit of the DBP, hence infusing the PMO with the skills and experience needed to effectively deal with LGUs and the DBP branch offices nationwide. The LGU loans were added to the loan portfolio of the branch, whereas before they were recorded as part of central office operations. The immediate change was apparent in the active role of the DBP branch representatives in targeting prospective LGU clients with good financial positions and in using their resources for consultations during the project preparation and negotiation phases.

The financial sustainability of the project from the DBP’s standpoint is depends on the implementation progress of the succeeding APLs. Because a second and third batch of subprojects never materialized under APL1, the DBP was not able to recoup all its costs. For instance, payment for consultancy services for construction supervision amounted to P46.73 million of which only P6.59 million was recovered from the client LGUs. It paid a front-end fee of P8.87 million while the LGUs paid only P2.11 million. Financial sustainability of the DBP’s lending operation for LGU water systems can only be assured if the business under the succeeding APLs accelerates and large amount of loan cancellation can be avoided. The important task for DBP is to expand the coverage of the program to more LGUs in order to recoup its costs, particularly as the interest rate spread has narrowed.

6.2 Transition arrangement to regular operations: Not Applicable.

7. Bank and Borrower Performance Bank 7.1 Lending: Bank identification and preparation assistance are rated satisfactory. This project was strategically designed to mobilize resources from LGUs and the private sector to address a critical financing gap in developing municipal water and sanitation systems in the Philippines. Bank identification missions provided insights that allowed GOP to consider innovative elements offering the possibility of both a more sustainable means of water service delivery and forward-looking reforms. The Operations Manual prepared in consultation with the DILG featured a long-term financial planning model that showed LGUs the different options available for investing in infrastructure over the long-term. It also spelled out a new

- 15 - strategy for attracting PSP for the commercial operation of the water systems. It offered a new approach for infrastructure investment for smaller urbanizing municipalities that were in need of water supply. Before the project, this field was the exclusive business of the Local Water Utilities Administration (LWUA), which was facing financial difficulties and was unable to offer its programs to small LGUs.

Bank appraisal was unsatisfactory. Some key Quality at Entry issues (trigger design, risk assessments, and balance of PSP approach) could have been better assessed by the Bank during appraisal. The Bank underestimated implementation risks. The appraisal mission did not anticipate that competition from other sources of funds would weaken LGU interest in the project even as it was aware that a number of other LGU credit programs were offering different loan-equity-grant financing mixes and subsidized interest. The project could also have been designed to tap into GOP’s important role in rationalizing municipal credit policies and to obtain more efficient outcomes from competition among government financial institutions. Other quality at entry issues are discussed in section 3.5 above. On the other hand, appraisal of the fiduciary and safeguards issues was satisfactory.

7.2 Supervision: The Bank’s performance in supervision is Satisfactory. The project was thoroughly supervised and the content of Bank discussions with the DBP correctly identified weaknesses in implementation during every supervision mission. Supervision missions monitored project progress not only with respect to programmed levels of expenditures but also against the triggers for APL2. Bank specialists in finance and environment based in Manila were able work very closely with DBP on more specific approaches to solving the problem of slow disbursements. Because of their easy access to the borrower, these Bank staff were able to follow up on agreed actions and provide assistance when necessary.

Bank supervision tracked implementation of each LGU water system in detail. Intensive assistance was provided to the Borrower and the LGUs in a number of critical areas, including PSP design, development of the bidding documents for Design-Build-Lease, resolving various technical difficulties faced during subproject implementation, reorganization and strengthening of the PMO, and guidance on some of the very difficult procurement issues that DBP was facing. The Bank supervision team also helped draw lessons from the initial batch of subproject which were being applied in the processing of succeeding batches or subprojects to improve their performance. The supervision missions called the attention of DBP to the need for program adjustments (lowering its interest rate, strengthening the PMO) to allow the project to accelerate. Supervision of fiduciary (procurement and financial management) and safeguard aspects was also well conducted. The Bank management (Sector Director, Country Director and Country Manager) was actively involved and provided direct assistance to the team in addressing difficult implementation issues. While the Bank team did recognize and highlight the major project risks (LGU dropping out, procurement irregularities) in its mission documents, rating in the PSR could have been more realistic to alert the issues earlier. The project was rated satisfactory throughout the implementation period except toward the end of the project life.

7.3 Overall Bank performance: Bank performance overall is rated marginally satisfactory. Despite some of the deficiencies of project design and unexpected difficulties, the Bank team and management have actively worked with the Borrower in resolving the issues throughout the implementation phase.

Borrower 7.4 Preparation: DBP’s performance in prepration is not rated because it did not play a substantial role. This phase was initially led by the DILG working closely with LGUs. This arrangement proved very difficult for the DBP

- 16 - who, as Borrower and implementing agency, was unable to control the quality of the feasibility studies and needed more than the expected time to complete loan appraisals for the individual LGUs. DBP continued to rely on the DILG for information dissemination and consultations with the next batches of LGUs, while focusing on credit operations and loan disbursements. On the technical aspects of the next batches of LGUs, the construction supervision consultant of the DBP was tasked to evaluate the feasibility studies, detailed engineering designs and analysis of options before presenting them to the LGUs and as a condition for sub-project approval.

7.5 Government implementation performance: The central government’s performance in implementation is rated unsatisfactory. The national government’s leadership in pushing for the needed policy reforms was hardly felt during implementation of APL1. The DILG was the most active national agency pushing for water sector policy review and reform, but its staffing situations do now allow it to be more technicially equipped, and it was a minor player relative to DOF and NEDA who could have pushed more aggressively for the needed policy improvements. As a result, the policy framework for PSP in the water sector remained indeterminate, and the project stakeholders (i.e. LGUs, PSP companies) were very much exposed to the risk of changing rules and politics at the local government level. Also, the Government approved later other credit / grant facilities to LGUs financing similar activities under this project, but with different (or no) policy or fiduciary requirements. For the implementing local governments, overall most LGUs took their responsibilities seriously.

7.6 Implementing Agency: The DBP’s performance is rated marginally satisfactory. While the overall outcome of the project is unsatisfactory, and DBP had control over a number of measures that could have improved project performance (see Section 5.3), DBP has made very extraordinary efforts in implementing the project. As discussed in Section 3.5, project design and preparation have quite a number of shortcomings which made the project very difficult to implement successfully. A number of factors outside DBP’s control also signficantly affected project implementation and outcome (Sections 5.1 & 5.2). The project is the first time that DBP entered into the LGU credit market to implement water supply projects. The technical and political skills needed to manage LGU infrastructure financing proved to be more challenging than most, if not all, the other activities that DBP has been financing. The problem was compounded by the fact that other financing programs were competing for the same LGU clients. The project has been a very valuable learning experience for DBP, and it has made adjustments and improvements over the implementation period. As noted before, PMO reorganization was completed toward the end of the implementation period to strengthen its operations. This showed the determination by DBP management to continue the APL program, even though the financial and physical outcome from the first phase is far from satisfactory. Particularly to be commended is DBP PMO’s integrity during project implementation phase. It has refused to give in to political pressure to compromise on procurement procedures, even though such a stance led to slower project implementation and the loss of clients for DBP.

7.7 Overall Borrower performance: On balance, the performance of the various government agencies is rated marginally satisfactory. The Borrower has made significant efforts in implementing the project, though there are a number of areas that the borrower, including the government agencies, could have done better toward achieving more satisfactory results.

- 17 - 8. Lessons Learned As the first tranche of an APL, the project was continuously yielding lessons during implementation which were then used to evolve the project’s implementation strategy. Indeed, in some ways APL1 carried some of the hallmarks of a Learning and Innovations Loan (LIL), in that its objective was “to test and fine-tune” a set of rules to translate national policy into concrete measures. Key lessons learned from the project include: A consistent national policy on LGU financing, particularly with regard to grant subsidies, is needed. The national government gives high priority to financing decentralized public services, and as a matter of policy and fiscal reality, prefers that such funds be channeled through GFIs such as the DBP as loans. However, the implementation of such policy suffers from the implementation of other programs that provide untargeted subsidies for LGU investments, often as grants with little condition. This caused many LGUs to reconsider and eventually drop out of the program with the perception that more advantageous financing sources were available. Involvement of the private sector in water requires improvements in the overall regulatory environment. When PSP companies decide to venture into infrastructure projects, they do so with apprehension about the viability of the subprojects, given the long-term nature of the investment and the uncertain effects of political developments. The project’s design tried to address this by crafting PSP contracts that would effectively bind all stakeholders to long-term arrangements that would insulate the subproject from the noncommercial risks of doing business in municipal water and sanitation services. The project demonstrated that such contract-based regulations cannot fill the need for a well established national regulatory system in the water sector. Until such a regulatory system is in place, PSP goals have to be very conservative and accompanied by adequate legal and administrative arrangements for conflict resolution. In the meantime, project support should include strong assistance to small local public utilities in cases where the private sector interest does not materialize. Careful assessments of project demand and risks are important for credit line facilities. Market demand analysis and marketing strategy formulation should have been given stronger emphasis during the project preparation phase and during the feasibility study phase of each of the subprojects. Commitments from LGUs need to be confirmed and formalized as early as possible. Moreover, market demand analysis could have generated an objective assessment of whether the LGUs were prepared to go into sanitation and drainage investments. More realistic targets should be set for a first phase APL where the main objective is to test a new approach. The project basically achieved its stated objectives of testing and fine-tuning rules but missed its target for providing ample demonstration through a reasonably large sample of subprojects by a wide margin. Under an APL activity where the rules are still evolving and market response has yet to be fully tested, targets for subproject investments could perhaps be set initially at conservative levels. Intensive technical assistance to LGUs are needed for such infrastructure projects. LGUs have little technical capacity in undertaking such projects, and this has exerted stronger needs for technical competence at the implementing agency to be able to respond to LGUs effectively. This has inevitably led to high transaction cost for the financial intermediaries. Technical assistance therefore should have been financed separately and the cost should at least be partly borne by the national government.

- 18 - 9. Partner Comments (a) Borrower/implementing agency: Development Bank of the Philippines (DBP) Comments:

The Implementation Completion Report is acceptable. Though majority of the ratings are unsatisfactory the report recognized the efforts done to improve the project implementation.

1. Per ICR report first paragraph, page 14, DBP was not equipped to deal with complicated, fast changing LGU credit market for water supply. It could not stay on top of implementation issues arising from having to deal with such municipality of inexperienced clients. DBP planned to address this weakness by tapping into its branch network. In the meantime DBP lost most of its prospective LGUs.

I think the above mentioned premise is not accurate, the PMO are equipped to deal with complicated LGU credit market. The reason why we tapped the services of the branches is just to assist us in marketing and booking of the LGU accounts. The decision to tap the services of the branches is not because the PMO is not efficient. The PMO is still on top of the management of the program.

It is also acknowledged in this report that for the DBP the project objectives were somewhat unrealistic. Majority of the problems encountered in the implementation of the program is beyond the control of DBP. For instance the key performance indicators as part of project implementation is beyond the control of DBP. The project design called for a partnership between the Government of the Philippines and DBP in order to achieve the objectives. It needs the complementation of Department of Finance (DOF), Department of the Interior and Local Government (DILG) and National Economic and Development Authority.

2. On the Achievement of Objective and Outputs, last paragraph, page 6, wherein it was mentioned that “none of the water systems actually went into commercial operation by a private sector operator”

To date, the municipality of Kalilangan, Bukidnon is operated by a private operator. For the municipality of Lantapan, Bukidnon, the water systems project is due for take over by the private operator. Initial meeting between the LGU and the Operator for the turn-over is scheduled on July 2, 2004.

Department of Interior and Local Government (DILG) Comments:

On page 6, paragraph 8: There are (2) two water systems on commercial operation by a private operator instead of none. These are the Water Utilities in the Municipalities of Lantapan and Kalilangan, Province of Bukidnon.

On page 7, paragraph 1:The reason for the LGU dropout in the project should include the lack of appreciation of some LGUs for private sector participation

On page 7, 4.2 Outputs by Components: APL 1 covered only nine municipalities of which 9 water supply facilities were also completed. All nine facilities instead of 7 are providing 24-hr satisfactory water service to connected households.

- 19 - On page 7, table on Implementation Status for Batch 1 Water Systems, Cabanglasan Bukidnon has dropped out from the project. Therefore, the municipality may be taken out from the list.

The above comments have been incorporated into the revisions of the ICR. (b) Cofinanciers: Not applicable as the Nordic Development Fund was not operationalized until APL2 (c) Other partners (NGOs/private sector): Not Applicable

10. Additional Information Not Applicable

- 20 - Annex 1. Key Performance Indicators/Log Frame Matrix

Outcome / Impact Indicators: 1 Indicator/Matrix Projected in last PSR Actual/Latest Estimate 1. Ten systens are completed and operational 1. Nine systems were completed 1. Nine systems are functioning. according to appraised design specifications 2. Twelve lease contracts were bidded out 2. Seven lease contracts have been 2. Devolution of operation, management and successfully redrafted with greater LGU participation, and revenue collection responsibilities under rebidded with support from the LGUs long-term commercial arrangements in 12 LGUs 90% of LGU residents receive reliable water These are sector related goals expected to be Not applicable supply, at least 16 hours per day achieved by 2020 90% of urban population has access to safe drinking water At least 80% of wastewater in the 20 largest cities outside Metro Manila is collected and treated

Output Indicators: 1 Indicator/Matrix Projected in last PSR Actual/Latest Estimate Water supply systems in project towns Completed In Lantapan an earthquake has reduced the constructed, with the Project Operational flow of water from the source, necessitating a manual guidelines followed new source development financed by APL2

30% of the participating LGUs successfully ALL participating LGUs successfully 70% of the first batch of LGUs are able to completed project implementation (i.e. completed project implementation provide reliable supply of water within the provide the planned quality water supply to service area communities

One-third of the LGUs contract with the All nine LGUs received PSP bids, although 7 30% of the LGUs have signed lease private sector to operate and maintain the of them did not reach contract perfection agreement with PSP partner. The rest of the newly constructed stage first batch LGUs are to tender their system operation shortly

Ten systems are completed and operational Nine systems were completed Nine systems are completed and seven of according to approved design specifications these systems are fully operational in by negotiation accordance with specifications

Project Management Office in DBP PMO in DBP was operational, but could not Project Management Office placed under operational by October 1, 1998. manage the drop-out rate problem, new management on October 2002 particularly after the difficulties experienced in Isabela

1 End of project

- 21 - Annex 2. Project Costs and Financing

Project Cost by Component (in US$ million equivalent) Appraisal Actual/Latest Percentage of Estimate Estimate Appraisal Component US$ million US$ million Water Supply 23.30 6.63 28 Sanitation 1.60 0.00 0 Drainage 0.80 0.00 0 Water Utilities PSP Facility 1.50 0.00 0 Project development for water supply & sanitation 2.50 1.01 40 Institutional Capacity Building 2.00 0.94 47 Total Baseline Cost 31.70 8.58 Price Contingencies 0.20 Total Project Costs 31.90 8.58 Front-end fee 0.20 0.23 100.00 Total Financing Required 32.10 8.81 a) PHRD grant of US$1.015 million was used for project feasibility studies for succeeding batches of LGUs b) Actual/latest estimate of project cost for each component include only costs incurred by the project in cash and does not include cost to government in the form of services of local staff and other operating expenses for the implementation of these components

Project Costs by Procurement Arrangements (Appraisal Estimate) (US$ million equivalent) 1 Procurement Method Expenditure Category ICB 2 N.B.F. Total Cost NCB Other 1. Works 0.00 22.20 2.10 0.00 24.30 (0.00) (19.90) (1.80) (0.00) (21.70) 2. Goods 0.00 0.00 0.00 0.00 0.00 (0.00) (0.00) (0.00) (0.00) (0.00) 3. Services 0.00 0.00 1.40 6.00 7.40 (0.00) (0.00) (1.40) (0.00) (1.40) 4. Miscellaneous 0.00 0.00 0.00 0.00 0.00 (0.00) (0.00) (0.00) (0.00) (0.00) 5. Front end fee 0.00 0.00 0.20 0.00 0.20 (0.00) (0.00) (0.20) (0.00) (0.20) Total 0.00 22.20 3.70 6.00 31.90 (0.00) (19.90) (3.40) (0.00) (23.30)

Project Costs by Procurement Arrangements (Actual/Latest Estimate) (US$ million equivalent) 1 Procurement Method Expenditure Category ICB 2 N.B.F. Total Cost NCB Other 1. Works 0.00 6.63 0.00 0.00 6.63 (0.00) (5.75) (0.00) (0.00) (5.75)

- 22 - 2. Goods 0.00 0.00 0.00 0.00 0.00 (0.00) (0.00) (0.00) (0.00) (0.00) 3. Services 0.00 0.00 0.94 1.01 1.95 (0.00) (0.00) (0.94) (0.00) (0.94) 4. Miscellaneous 0.00 0.00 0.00 0.00 0.00 (0.00) (0.00) (0.00) (0.00) (0.00) 5. Front end fee 0.00 0.00 0.23 0.00 0.23 (0.00) (0.00) (0.23) (0.00) (0.23) Total 0.00 6.63 1.17 1.01 8.81 (0.00) (5.75) (1.17) (0.00) (6.92) Project disbursement for hiring of Construction Supervision Consultants was US$938,324. Disbursements for the preparation of new batches of feasibility studies amounted to US$1.015 million during the first phase. 1/ Figures in parenthesis are the amounts to be financed by the Bank Loan. All costs include contingencies. 2/ Includes civil works and goods to be procured through national shopping, consulting services, services of contracted staff of the project management office, training, technical assistance services, and incremental operating costs related to (i) managing the project, and (ii) re-lending project funds to local government units.

Project Financing by Component (in US$ million equivalent) Percentage of Appraisal Component Appraisal Estimate Actual/Latest Estimate Bank Govt. CoF. Bank Govt. CoF. Bank Govt. CoF. Water Supply 21.00 2.30 5.75 0.87 27.4 37.8 Sanitation 1.40 0.20 0.00 0.00 0.0 0.0 Drainage 0.70 0.10 0.00 0.00 0.0 0.0 Water Utilities PSP 0.00 1.50 0.00 0.0 0.0 Project Development 0.00 2.50 0.00 1.01 0.0 0.0 Institutional Cap Bldg 0.00 2.00 0.94 0.0 0.0 Front End Fee 0.23 0.23 100.0

- 23 - Annex 3. Economic Costs and Benefits

Economic Analysis Financial Analysis Net Benefit (Pm) Rate of Return NPV (Pm) Rate of Return Magdalena 315.791 145.4 % -13.439 7.3 %

Aurora 1.944 17.7 % -15.983 -5.5 %

Cabatuan 20.255 27.9 % -25.058 -6.0 % Luna 3.804 21.6 % -10.152 -3.0 % Mallig -3.984 2.7 % -10.584 -6.2 % Quezon 18.382 27.9 % -14.146 5.1 %

Present Value of Flows Economic Analysis Financial Analysis Magdalena Appraisal Latest Estimate Appraisal Latest Estimate Cost (NPV) Pm 30.45 50.93 Benefit (NPV) Pm 346.24 37.49 Net Benefit PM 315.79 -13.44 Rate of Return 145.4 7.3 Aurora Cost (NPV) Pm 12.98 13.78 26.94 Benefit (NPV) Pm 27.43 20.79 10.96 Net Benefit Pm 10.87 1.94 12.23 -15.98 Rate of Return 33.28 17.70 21.17 -5.54 Cabatuan Cost (NPV) Pm 26.19 27.35 Benefit (NPV) Pm 61.43 20.11 Net Benefit Pm 20.26 19.38 -25.06 Rate of Return 27.88 21.01 -6.02 Luna Cost (NPV) Pm 9.91 10.46 19.63 Benefit (NPV) Pm 20.60 14.26 9.48 Net Benefit Pm 7.94 3.80 8.52 -10.15 Rate of Return 30.59 21.62 21.34 -2.98 Mallig Cost (NPV) Pm 9,630 10.00 18.64 Benefit (NPV) Pm 11,143 6.02 8.05 Net Benefit Pm 59 -3.98 8.17 -10.58 Rate of Return 15.15 2.74 21.36 -6.17 Quezon Cost (NPV) Pm 20.30 38.04 Benefit (NPV) Pm 38.68 23.90 Net Benefit Pm 18.38 18.34 -14.15 Rate of Return 27.88 21.13 5.09

- 24 - Notes:

1. Economic Analysis

The computation of economic benefits was based on the assumptions made on consumer surplus that were estimated in the feasibility studies of the sub-projects. The values reflect the cost savings to households in a service area (the price of water without the project was based on the price of water sold by vendors or imputed from the cost of operating existing deep wells and other water sources). The economic analysis also computed the benefit gained from a higher consumption of safe drinking water that was otherwise not enjoyed because of the high cost before the system was completed.

Economic costs were based on actual cost of the project and the operation and maintenance expenses. For the economic benefits, the relevant variables are price and consumption. The actual price of water in all the sub-projects was close to the price computed and adopted in the feasibility studies. Consumption levels based on most recent estimates are, however, only about 40% to 50% of the levels assumed in the feasibility studies. The recomputation of economic benefits accounted for this lower level of consumption to determine the adjusted level of direct user benefits and consumer surplus.

2. Financial Analysis

The financial cost-benefit analysis was based on financial records obtained from the first batch of LGUs to determine actual operating costs and revenues of completed systems. The analysis was done for all operational water systems except for San Mateo, which turned over the system to a private operator in 2002 and was unable to monitor operating costs and revenues during this period.

The approach for computing the financial rates of return used the model developed by the project through Mr. George Calderon, World Bank financial specialist. Some adjustments were made to take the context of the entire project investment rather than the relatively limited stake of a private operator. The lease fee was merely a transfer from the private operator to the LGU and hence was not used in the analysis of revenues. The project cost-benefit analysis also included the salvage value of the assets of each sub-project.

- 25 - Annex 4. Bank Inputs (a) Missions: Stage of Project Cycle No. of Persons and Specialty Performance Rating (e.g. 2 Economists, 1 FMS, etc.) Implementation Development Month/Year Count Specialty Progress Objective Identification/Preparation

June 1997 4 Water & Sanitation Specialist & TM (1); Financial analyst (1); Water & Sanitation Engineer (1); Economist

Appraisal/Negotiation May - October, 9 Water & Sanitation 1998 Specialist & TM (1); Financial analyst (1); Water & Sanitation Engineer (1); Economist (2); Environmental Specialist (1); Social Scientist (1); Engineer (1); Legal Counsel (1);

Supervision

06/13/1999 4 TTL/WATER SUPPLY & S S SANITATION SPECIALIST (1); PROJECT ENGINEER (1); FINANCIAL ANALYST (1); SOCIAL SCIENTIST (1) 03/04/2000 4 PRIN. WATER & SAN SPEC S S (1); WATER & SAN. SPEC. (1); SOCIAL SCIENTIST (1); ENVIRONMENTAL SPECIALI (1) 08/03/2000 5 TASK TEAM LEADER/ECO S S (1); ENGINEER (1); FINANCIAL MANAGEMENT S (1); PROCUREMENT SPECIALIST (1); ENVIRONMENTAL SPECIALI (1) 03/27/2001 5 TTL/WATER SUPPLY & S S SANITATION SPECIALIST(1); PROJECT ENGINEER (1); PROCUREMENT SPECIALIST (1); FM SPECIALIST (1); LGU LIAISON (1) 03/03/2002 3 TT/WATER SUPPLY & S U SANITATION SPECIALIST (1); PROJECT ENGINEER (1); FM

- 26 - SPECIALIST (1) ICR July 2002 8 TTL/WATER SUPPLY & U U SANITATION SPECIALIST (1); PROJECT ENGINEER (1); PROCUREMENT (1); FINANCIAL MANAGEMENT (1); ENVIRONMENT (1); COMMUNITY PARTICIPATION (1); CONSULTANTS (2)

(b) Staff:

Stage of Project Cycle Actual/Latest Estimate No. Staff weeks US$ ('000) Identification/Preparation 125.3 495.9 Appraisal/Negotiation 42.1 80.6 Supervision 85.3 245.7 ICR 3 26.0 Total 256.2 849.2 Costs incurred up to and including FY99 were increased 15% to take into account the differences in the new accounting system begun in FY00.

- 27 - Annex 5. Ratings for Achievement of Objectives/Outputs of Components (H=High, SU=Substantial, M=Modest, N=Negligible, NA=Not Applicable) Rating Macro policies H SU M N NA Sector Policies H SU M N NA Physical H SU M N NA Financial H SU M N NA Institutional Development H SU M N NA Environmental H SU M N NA

Social Poverty Reduction H SU M N NA Gender H SU M N NA Other (Please specify) H SU M N NA Private sector development H SU M N NA Public sector management H SU M N NA Other (Please specify) H SU M N NA The project's major failure has been the low disbursement rate. The reasons have been explained in the main text of the ICR. Apart from the problems created by Isabela province in procuring operators for an important cluster of projects, and the decline in interest of Mayors because of the large differential between the onlending rates and prevailing market rates an important factor in low disbursements has been a depreciation of over 20 per cent of the peso against the dollar. Overall, the project was designed as the first phase in a learning and innovation loan with fairly ambitious goals in terms of sectoral reforms. What it has accomplished is the following: l innovative financing arrangements involving GFIs l continued interest of LGUs to encourage private operators to participate in the Philippines water business l GOP follow-up actions in restructuring LWUA to take advantage of the changed ways of doing business in LGUs. l Highlighted the urgent need for regulatory reforms.

- 28 - Annex 6. Ratings of Bank and Borrower Performance (HS=Highly Satisfactory, S=Satisfactory, U=Unsatisfactory, HU=Highly Unsatisfactory)

6.1 Bank performance Rating Lending HS S U HU Supervision HS S U HU Overall HS S U HU

6.2 Borrower performance Rating Preparation HS S U HU Government implementation performance HS S U HU Implementation agency performance HS S U HU Overall HS S U HU

- 29 - Annex 7. List of Supporting Documents Mid-term evaluation of Performance of APL1 (2001) Project Appraisal Document for LGU Urban Water and Sanitation Project APL2 J. Esguerra: Evaluations of water supply systems in Isabela towns and Magdalena (2003)

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