Document of The World Bank

FOR OFFICIAL USE ONLY Public Disclosure Authorized Report No: 41275-ID

INTERNATIONAL BANK FOR RECONSTRUCTION AND DEVELOPMENT Public Disclosure Authorized

PROGRAM DOCUMENT

FOR A PROPOSED

FIRST INFRASTRUCTURE DEVELOPMENT POLICY LOAN (IDPL 1) IN THE AMOUNT OF US$200 MILLION

TO Public Disclosure Authorized THE REPUBLIC OF

OCTOBER 3 1,2007

Sustainable Development Department Public Disclosure Authorized East Asia and Pacific Region

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. REPUBLIC OF INDONESIA - GOVERNMENTFISCAL YEAR January 1 - December 3 1

CURRENCYEQUIVALENTS (Exchange Rate Effective as of October 25,2007) Currency Unit Rupiah (Rp) US$1.oo 9,175 Rp

Vice President: James Adams Country Director: Joachim von Amsberg Sector Director: Christian Delvoie Co-Task Team Leader: Hongjoo Hahm Co-Task Team Leader: Michel Kerf

The Indonesia First Infrastructure Development Policy Loan was prepared by a World Bank team supervised and task managed by Hongjoo Hahm (EASIS) and Michel Kerf (EASOP), and consisting of Michael Warlters (EASOP), John Holdaway (EASIS), Maha J. Armaly (ECSSD), Timothy H. Brown (EASIS), Steven Charles Burgess (EAPCO), Sally L. Burningham (EASIS), Jeffkey John Delmon (FEU), Giovanna Dore (EASRE), Jan Drozdz (EASIS), Wolfgang Fengler (EASPR), Migara Jayawardena (EASTE), Charles J. Kenny (FEU), William Kingdom (EASUR), Blane D. Lewis (EASPR), Sulistiowati Nainggolan (EASIS), Isono Sadoko (EASIS), Imad Saleh (EAPCO), L. Panneer Selvam (EAPCO), Rajiv Sondhi (EAPCO), and Andri Wibisono (EASIS).

The team is working closely with David Hawes (AusAID), Alfred0 Pasquale (Asian Development Bank), Takehiro Yasui (Government of Japan), and Stephen Schwartz (IMF) to coordinate policy advice.

Ellis Juan (FEU), Christine Kessides (ECSSD) and Bambang Bintoro (Consultant) are the peer reviewers for the operation. The team is working under the overall guidance of Christian Delvoie (Sector Director, EASSD) and Joachim von Amsberg (Country Director, EACIF). FOR OFFICIAL USE ONLY

ABBREVIATIONS AND ACRONYMS ,\ 1\ iris \iical dnd isor! ,\cu\ities JICA Jdpdnesz Intzrndtional Caoperation Agenc) ADB Asian Development Bank KAI 1 Indonesian Railway Company I National Committee for the Acceleration of Infrastructure. APBD Sub-national Expenditure Budget ' velopment i APBN National Expenditure Budget putusan Menteri, (Ministerial Decree) i AMDAL Environmental Impact Assessment I Keppres ' Keputusan Presiden, (Presidential Decree) AusAID Australian Agency for International Development I KMK I Keputusan Menteri Keuangan, (MOF Decree) BAPPENAS National Development Planning Agency , KF'K 1 Anti-Corruption Commission .LpKpp GoodsiServices Procurement Policy Development. BI Bank Indonesia Institution BPK Supreme Audit Agency i LWG 1 Land Working Group BPKP Financial and Development Supervisory Board , MCIT Ministry of Communications and &fo-rmat!on Technology Control Board for Development of Drinking Water BPP-SPAM MDGs Millennium Development Goals Systems BPS National Statistics Agency , MOEMR Ministry of Energy and Mineral Resources BRTl Indonesian Telecommunications Regulatory Body MOE , Ministry of Environment BUMD Regional Government Enterprises 1 MOF Ministry of Finance CAS (PR) Country Assistance Strategy (Progress Report) I MOHA Ministry of Home Affairs CCT Conditional Cash Transfer MOPW Ministry of Public Works CDD Community Driven Development 1 MOSOE Ministry wed Enterprises CGI Consultative Group on Indonesia MOU Memora nderstanding CIDA Canadian International Development Agency ' MTEF Medium-Term Expenditure Framewoik CMEA Coordinating Ministry for Economic Affairs ' NAP-CW National Action Plan on Clean Water 1 CPI Consumer Price Index NCB National Competitive Bidding CPIA Country Policy and Institutional Assessment ; NJOP Assessment of Price for Land Tax CY Calendar Year i NPPO National Procurement Policy Office 1 DAK Special Allocation Grants OGM Operational Guidelines Manual , 1 DAL General Allocation Grants OPCS Operations nd Country Services DFlD Department for International Development I P2T Land Acqu ommittee DG Directorate General l PDAM Public Wat es DGH Directorate General of Highways 1 PEFA Public Expenditure and Financial Accountability DlPA Budget Activity Lists Pelni 1 National Sailing Corporation DPL PER Public Expenditure Review DPR Perpres Peraturan Presiden, (Presidential Regulation) DSF Decentralization Support Facility : PFM , Public Financial Management e-GP Electronic Government Procurement 1 PLN State Electricity Company EPP Economic Policy Plan Peraturan Menteri Keuangan, (MOF Regulation) ESW Economic and Sector Work National Community Empowerment Program FRAP Financial Restructuring Action Plan PP , Peraturan Pemerintah, (Government Regulation) FSL Fixed Spread Loan l PPIAF , Public Private Infrastructure Advisory Facility FY Fiscal Year PPITA Private Provision of Infrastructure Technical Assistance GDP Gross Domestic Product GF Guarantee Fund Government Financial Management and Revenue GFMRAP PSP Private Sector Participation Administration Project GHG Greenhouse Gas ' RKP Government's Annual Work Plan GNP Gross National Product ' RMU I &sk Management Unit GTZ German Technical Cooperation RPJM I Medium-Term Development Plan IBRD ~~~~~~e~tfor Reconstruction and Satker 1 Ministerial Working Unit ICB International Competitive Bidding ' SIA Social Impact Assessment ICT Information and Communications Technology SNG , Sub-national Government IDA International Development Association SOE State Owned Enterprise IFC International Finance Corporation ' TDL I Basic Electricity Tariff IG Inspector General TEU Twentyfoot Equivalent Unit IIF Indonesia Infrastructure Fund I TSA 1 Treasury Single Account IMF International Monetary Fund 1 UNDP ~ United Nations Development Program Inpres Presidential Instruction USAID United States Agency for Internat!onal

IPP Independent Power Producer ~ US0 Universal Service Obligation IRSDP I Infrastructure Reform Sector Development Program UU Law

JBIC Japanese Bank for International Cooperation WSS I Water Supply and Sanitation

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.

INDONESIA.FIRST INFRASTRUCTURE DEVELOPMENTPOLICY LOAN

I. INTRODUCTION ...... 6 I1. COUNTRY CONTEXT ...... 8 Recent Economic Developments ...... 8 Poverty Profile and Development Challenges ...... 15 The Government’s Development Strategy ...... 18 I11. THE GOVERNMENT’S INFRASTRUCTURE REFORM PROGRAM ...... 19 The Challenge ...... 20 The Government’s Infrastructure Agenda ...... 22 IV. BANK SUPPORT TO THE INFRASTRUCTURE REFORM PROGRAM ...... 30 Link to the Country Assistance Strategy ...... 30 Rationale for a New Policy Loan Series ...... 31 Relationship to Other Bank Operations ...... 32 Collaboration with Other Development Partners...... 33 Lessons Learned ...... 34 Analytical Underpinnings ...... 36 V . THE PROPOSED INFRASTRUCTURE DEVELOPMENT POLICY LOAN...... 36 Policy Area I: National Infrastructure ...... 40 Policy Area 11: Sub-National Infrastructure...... 44 Policy Area 111: Public-Private Partnerships...... 47 Policy Area IV: Land, Environment, and Fiduciary Responsibilities ...... 50 VI. OPERATION IMPLEMENTATION ...... 55 Poverty and Social Impacts ...... 56 Participation ...... 57 Implementation, Monitoring and Evaluation...... 57 Technical Assistance to Support Implementation ...... 59 Fiduciary Aspects ...... 60 Loan Administration ...... 61 Environmental Aspects ...... 61 Governance ...... 63 Risks and Risk Mitigation ...... 65 ANNEX 1 LETTER OF DEVELOPMENT POLICY ...... 70 ANNEX 2 INFRASTRUCTURE REFORMS PLANNED UNDER INPRES 6/2007,82 ANNEX 3 INDONESIA IDPL POLICY MATRIX ...... 88 ANNEX 4 IMF ASSESSMENT LETTER ...... 91 ANNEX 5 FIDUCIARY ASPECTS ...... 94 ANNEX 6 ENERGY ...... 108 ANNEX 7 WATER AND SANITATION ...... 114 ANNEX 8 TRANSPORT ...... 120 ANNEX 9 TELECOMMUNICATIONS ...... 136 ANNEX 10 SUB-NATIONAL GOVERNMENTS ...... 146 ANNEX 11 PUBLIC SERVICE OBLIGATIONS AND STATE ENTERPRISES ..... 153 ANNEX 12 PUBLIC-PRIVATE PARTNERSHIPS ...... 159 ANNEX 13 LAND ACQUISITION ...... 165 ANNEX 14 ENVIRONMENT ...... 169

... 111 ANNEX 15 GOVERNANCE ...... 173 ANNEX 16 ANALYTICAL UNDERPINNINGS ...... 178 ANNEX 17 INDONESIA AT A GLANCE ...... 180 ANNEX 18 INDONESIA MAP (IBRD MAP 33420) ...... 180

iv INDONESIA- FIRST INFRASTRUCTURE DEVELOPMENTPOLICY LOAN(IDPL 1)

Loan Program Summary

Borrower Republic of Indonesia

Implementing Ministry of Finance, Coordinating Ministry of the Economy, and Bappenas Agency

Amount The proposed operation would provide US$200 million in program assistance from IBRD.

Terms Commitment-linked payable in 20 years, including 5 years of grace and annuity principal repayment; at six-month LIBOR, plus fixed spread for Fixed Spread Loans (FSL) denominated in US$.

Tranching Single Tranche

Description This single-tranche IDPL - in the total amount of US$200 million - is the first in a proposed series of programmatic IDPLs to support a carefully selected subset of Indonesia’s broader reform agenda on infrastructure, focusing on: (i)central government infrastructure expenditures; (ii)sub-national government infrastructure spending; (iii)public-private partnerships; and (iv) cross-sector infrastructure support such as land acquisition, environment and procurement reform. It builds on and deepens the reforms undertaken by the Government of Indonesia as supported by other development partners.

Benefits The key benefits expected from the program are: 1 Increased, and enhanced efficiency of, Government spending on infrastructure resulting in improved infrastructure services at the national and sub-national level, conducive to sustained growth and poverty alleviation. 1 Increased private investment in infrastructure under a transparent, credible framework that maximizes the overall benefits of such investments. I Enhanced governance for infrastructure that ensures that the infrastructure reform program is conducted in an equitable and sustainable manner. 1 Effectiveness of the policy dialogue within a policy framework jointly developed and agreed upon by the Government and the main development partners (including ADB, the World Bank and JBIC).

Partnerships / IDPL 1 has been prepared in close coordination with ADB and JBIC. ADB and the Government Parallel of Japan have extended a policy loan to the Government in late 2006 to support the Government’s Financing infrastructure agenda. The IDPL series is designed to complement and converge in timing with the series of loans planned by ADB and the Government of Japan.

The operation and the Government’s reform program are subject to disruption based on several risks: . Government commitment and capacity to implement the reform program. The government’s ability to sustain infrastructure reform is subject to inter-related risks of political change of course and bureaucratic capacity. 1 Corruption. Indonesia is struggling with corruption and corruption could reduce the benefits that are expected from implementation of the reforms supported by the IDPL series. 1 Macroeconomic and political stability. An economic downturn in oil prices, natural disasters or serious political strife, for example, could negatively impact the reform process.

Operation ID P107163

V I. INTRODUCTION

1. The proposed Infrastructure Development Policy Loan (IDPL 1) to Indonesia for US$ 200 million is the first in a series of three single-tranche loans, planned over the 2007-20 10 period, supporting the Government’s ongoing medium-term infrastructure reform program. It is designed to support key components of Indonesia’s infrastructure reform agenda with a particular focus on cross-sector reforms aimed at increasing the transparency and efficiency of the Government’s infrastructure spending, at promoting public private partnerships, and at fostering good governance. Success in these areas is key to enhance the credibility and legitimacy the Government’s infrastructure reform agenda as a whole. Future loans in the series would support a deepening ofthese reforms.

2. Prior to the 1997 financial crisis, infrastructure investment over 6% of GDP contributed substantially to Indonesia’s good progress on growth and poverty reduction. The first priority of successive governments since the crisis has been to restore macro- economic stability; reducing inflation, stabilizing the rupiah, and reducing public debt as a share of GDP. The World Bank has recognized these substantial macro-economic achievements in a program of four annual policy loans, commencing in 2004 (DPL 1, DPL 2, DPL 3, and DPL 4).

3. While the priority lay with restoring macro-economic stability, infrastructure investment suffered, falling to a low of 2% of GDP in 2000, and reaching just over 3% of GDP in 2005 (Figure 1). Where 3.5 million new customers were connected to electricity in 1997, PLN now connects around 1 million new customers per year. The proportion of the population with access to piped water has fallen by 2% to 17%, because of the closure of some utilities and the growth of the population. Urban roads have become severely congested, and rural roads suffer from inadequate maintenance. Redressing the infrastructure investment backlog is now a key priority to sustain economic growth and poverty reduction.

Figure 1: Infrastructure Investment

7, 1 6 16.1 I

1 0 1997 1998 1999 2000 2001 2002 2003 2004 2005

National GoLernment ISub-national Govsmment ra SOEs IPriwte

Source: PER-IFA (2007), updated. Note: SOE data prior to 2000 are incomplete.

6 4. In 2004, the World Bank published a major study of Indonesia’s infrastructure, urging that infrastructure investment be increased by 2% of GDP, and providing recommendations for a host of reforms to promote investment and household access to services, and to improve sectoral governance. A significant group of recommendations, emerging from lessons of the crisis, focused on the need for a regulatory and institutional framework for infrastructure PPPs and for appropriate risk management of PPPs.

5. The Yudhoyono Government, elected in September 2004, recognized the importance of these recommendations, and set infrastructure as a major priority. PPP reforms are the highest profile elements of the Government’s infrastructure agenda. They are highly significant in governance terms - establishing principles of transparency and competition, and requiring reforms across a host of practices within government - as well as being part of the Government’s overall solution for addressing the country’s infrastructure investment needs. But the Government’s reforms extend well beyond PPPs, including reform of public sector financing for infrastructure, fiscal relations with sub- national governments, and broader governance issues.

6. An Infrastructure Summit was held in January 2005, offering 91 PPP transactions to the private sector. The reaction to these offerings was disappointing; many existing policy blockages remained to the preparation of bankable projects and many projects were not well prepared. The Government recognized these weaknesses, and has taken steps to address them. During the course of 2005, new regulations were put in place requiring competitive bidding of PPPs and appropriate risk management ofguarantees for PPPs. The Government prepared a wide-ranging “Infrastructure Policy Package” in 2006, aiming to encourage competition, to eliminate discriminatory practices that obstruct the private sector’s participation in infrastructure provision, and to redefine the Government’s role, including separating policy-making, regulatory and operational responsibilities. A second Infrastructure Summit was held in November 2006 where ten PPP “Model Projects” were identified to be the particular focus of efforts to improve the quality of project preparation. This year, the PPP initiatives to boost infrastructure investment were complemented with major increases in budgeted public spending, made possible by the Government’s improved fiscal situation. The Government also provided an updated policy package for reforms to be carried out during 2007 (Annex 2).

7. In support of the Government’s Infrastructure Policy Package, the Asian Development Bank (ADB) launched a program of policy loans in 2006, providing US$ 400 million in recognition of the first “sub-program” of policy reforms. Further ADB policy loans are planned for 2008, and mid 2010 depending on the Government’s progress. In early 2007, the Japanese Government joined the ADB in supporting the Government’s program, providing a US$lOO million loan in support of the first “sub- program”.

8. While the Government is clearly focusing on the need to tackle infrastructure issues and while a number of reforms have been initiated, concrete results remain modest. No major PPP transaction has yet been successfully brought to market under the new institutional and regulatory framework; tariff reforms in the power sector are hampered by political considerations; operational and financial problems continue to plague the urban water sector; and land acquisition processes for infrastructure projects remain cumbersome and often inequitable. 7 9. In order to help sustain the reform process, the Government has requested that the World Bank join the ADB and the Japanese Government in supporting the Government’s infrastructure program. The reforms that are the focus ofthe proposed IDPL series are set out in the Policy Matrix (Annex 3). Given that the reforms that have been initiated have yet to yield major benefits, the achievements recognized as “prior actions” by IDPL 1 are correspondingly modest. Progress is gradual, and the 2009 election poses the risk of a change of political direction. But the commitment of the current Government, the importance of infrastructure reforms in terms of governance, and the potential for significant contributions to economic growth and household access to basic services justify launching the IDPL series. Closer Bank involvement in the forward-looking reform agenda is likely to make a significant contribution to its success.

10. The proposed IDPL series has been designed in close coordination with the ADB and the Japanese Government. In addition, while the proposed IDPL series is commencing a year after the ADB’s series, it is intended that the two series will converge in substance and timing, so that the 2010 operation will coincide for all three development partners. The reforms that are the focus ofthe proposed IDPL series are set out in the Policy Matrix (Annex 3).

11. COUNTRY CONTEXT

11. Ten years after the East Asian financial crisis, Indonesia has emerged as a very different country. It has embraced political pluralism and participation, and is in a strong position to resume impressive levels of growth and poverty reduction. Prudent fiscal and macroeconomic policies, particularly low budget deficits, have been instrumental in Indonesia’s recovery, with the most dramatic improvement a reduction in debt levels from 80% of GDP in 2000 to 37% of GDP by mid-2007. Despite several shocks during the past three years (e.g., natural disasters, terrorist strikes in and , and global fuel price increases), the economy has performed well and has now overcome the impact of the slow down at the end of 2005 due to the large fuel price increases (and resultant inflation), and high interest rates.

12. The World Bank projects growth to surpass 6% in 2007, adding a boost to the Government’s poverty reduction efforts. While continuing prudent macroeconomic policies, the Government is pushing forward on broad structural and institutional reforms. These include efforts to improve governance and address endemic corruption. Given its improved fiscal position, Indonesia has the opportunity to improve the quality of education, expand healthcare, and close critical infrastructure gaps to improve the investment climate, reduce poverty, and build a sustainable and globally competitive economy. RECENTECONOMIC DEVELOPMENTS

13. Following an economic slowdown at the end of 2005, due to major increases in domestic fuel prices and higher interest rates, economic growth has been recovering steadily since mid-2006 (Figure 1). By 2407, year-on-year growth was up to 6.3% and is expected to rise further in 2Q07, despite recent turbulence in international financial markets (Figure 2). For 2007 as a whole, the Bank projects growth at 6.3% compared

8 with 5.5% in 2006. The main drivers of recent growth have been investment and exports, which have been running 74% and 8-10% per annum, respectively. The ratio of investment to GDP (nominal) increased from 19% in 2002 to 23.75% by mid-2007, and it looks likely to exceed 24% for 2007 as a whole.

.2%. 4.0% 91 1 P2 1 Q3 194 91 1 a2 I P3 194 Pl 192 1 '23 1 94 91 I 92 193 1 P4 91 1 92.- 2003 1 2004 I 2005 1 2005. 1 2001.

14. After many months of measured (25 or 50 basis points) policy rate cuts, Bank Indonesia (BI) held its key short-term policy interest rate steady since early July 2007. Bank Indonesia has indicated that this shift is consistent with rising volatility in international markets, inflationary developments and BI's inflation targeting regime (Figure 3).

15. CPI inflation, which dropped dramatically in the wake of the 2005 fuel price increases, had been running slightly below BI's targets for several months through May 2007. In June, it began to creep upwards; by August, it was running at 6.5%, near the middle of BI's target band (Figure 2). As with other countries in the region, since 2006 higher commodity prices have been feeding into food prices, thereby pushing up consumer inflation. By contrast, administered prices are currently holding down overall inflation (Figure 4). Excluding these volatile components, core inflation has been steady in the 5.5-6.0% range since late 2006.

Figure 3: Inflation and Bank Indonesia's Targets :::I Administered Goods

25% -

Food

5% .

0% 7 Jaw06 Apr-06 JuCO6 Ocl-06 Jaw07 Apr-07 JuL07 Source: BI, World Bank estimates

9 Figure 4: Inflation I:: Administered Goods

25% -

Food

5% -

0% 7 Jaw06 Apr-06 Jul-06 Oct-06 Jam07 Apr-07 JuC07 Source: BI, World Bank estimates

16. The Government's budget deficit is likely to widen a little. Over the past several years, budget deficits have been running below 1% of GDP (0.5% in 2005 and 0.9% of GDP in 2006), but look to widen in 2007, to 1.5% of GDP (compared with 1.1% in the Budget;). This larger deficit stems, in part, from lower-than-expected income tax collections and from large, one-off settlements of arrears in payment of VAT refunds. There has also been increased spending in a few priority categories in the 2007 revised budget, including infrastructure and disaster response. Notwithstanding this increased deficit, the ratio of government debt to GDP is projected to decline, from 40% in 2006 to less than 35% by end 2007, as the deficit remains relatively low and economic growth picks up.

17. The proposed budget for 2008 projects another small increase in the deficit to 1.7% of GDP versus a projected 1.5% in 2007 (Table 1). There will be a decline (relative to GDP) in revenues partly offset by limits on some categories of spending. Lower revenues are accounted for by lower oil and gas revenues (both tax and non-tax), as GDP growth outpaces increased oil and gas production. Another factor is a reduction in payments to the Government by BI that temporarily raised other revenues in 2007. On the spending side, fuel subsidies are assumed to decline due to fuel switching by PLN and the substitution of LPG for kerosene by consumers, but other subsidies increase. Among other spending items, transfers to regions decline; by contrast, central government social and capital spending (poverty programs and infrastructure, respectively) surges.

18. The 2008 budget increases the resources available and responds more closely to development needs. Good progress has been made over the past two years in reallocating inefficient spending (most notably, fuel subsidies) towards pro-poor programs. Fiscal space (for central and sub-national governments) increased from an estimated 6.3% of GDP in 2001 to 10.5% in 2007 (Figure 5).' Increased revenues (oil& gas revenues and taxes) and decreasing fuel subsidies, and payments on debt are the main factors for this increase in recent years.

' Fiscal space is defined here as discretionary spending (that is, total expenditures minus salary, interest payments, subsidies and transfers to regions). 10 Table 1: Government Budgets, 2006-08 -2006 -2007 2007 2008 (Actual) (Budget) (Projected) (Budget) Revenues 19.1% 19.1% 18.2% 17.7% Non-oil domestic tax 0.6% 12.0% 11.4% 2.2% oiw Non-oil & gas income tax 5.0% 5.8% 5.5% 6.1% olw VAT 3.7% 4.3% 4.0% 4.3% Oil & gas 6.0% 4.8% 3.9% 3.6% Other 2.5% 2.3% 3.0% 1.9% Expenditures 20.0% 20.2% 19.8% 19.4% Central Govt. 13.3% 13.6% 13.3% 13.3% Personnel 2.2% 2.7% 2.6% 3.0% Materials 1.4% 1.9% 1.6% 1.2% Interest Payments 2.4% 2.3% 2.2% 2.1% Subsidies 3.2% 2.7% 2.8% 2.2% Social Assistance 1.2% 1.4% 1.3% 1.6% Other Current 1.1% 0.5% 0.8% 0.7% Cap ita1 1.6% 1.9% 1.6% 2.4% Transfers to Regions 6.7% 6.6% 6.5% 6.1% Primary Balance 1.5% 1.2% 0.7% 0.4% Overall Balance -0.9% -1.1% -1.5% -1.7% Net Financing 0.9% 1.1% 1.5% 1.7% Bonds 1.7% 1.5% 1.9% 2.1% Official finance -0.8% -0.4% -0.3% -0.4% Assumptions (Actual for 2006): GDP growth (%) 5.5% 6.3% 6.3% 6.8% Inflation (YO) 13.1% 6.5% 6.5% 6.0% Exchange rate (Rp/US$) 9159 9300 9100 9100 Oil Price ($/bbl) $ 64.3 $ 63 $ 60 $ 60

19. There are significant increases budgeted for spending on infrastructure and social spending. The former is particularly welcome as total public infrastructure investment (public, state-owned enterprises and private sector combined) stands at 3.2% of GDP, still significantly below pre-crisis levels of around 56% of GDP. As a result, Indonesia has fallen behind most other countries in the region with some of the lowest rates of access to clean water, energy and sanitation services in the region.

11 Figure 5: Fiscal Space Widens '= 1

Fm7 Fw p1op Ma ml Fw2 rn My Fws Fws m7 ce-1 OPrnVrn 5rnwam Source: BI, World Bank estimates

20. Regional governments have become the dominant players in service delivery. Indonesia's move to decentralization in 2001 changed the fiscal fundamentals of the country and the regions are now spending almost the same amount as the central government. This has occurred because transfers from the central government to regions have increased in recent years, for example by almost 2 percentage points of GDP between 2005 and 2006. Despite small projected declines (in share of GDP) for 2007 and 2008, transfers dominate sub-national finances, particularly for district governments because own-source revenues are low. The General Allocation Fund (DAU) is likely to become even more dominant if shared revenues from oil and gas decline on lower oil and gas production and prices.

21. Today, the main fiscal policy challenge is not the need for additional financial resources but to spend effectively. Both central and regional governments are having difficulty spending their available resources with effectiveness. Indeed, regional governments have been saving major amounts of their revenues, for example their deposits in commercial banks reached 2.5% of GDP by March 2007. Recently, the growth in these deposits has slowed, but they are still increasing rising at some 10 to 15% annually, about the same as the increase in 2007 transfers over those in 2006.

22. Indonesia has a strong balance of payments with record exports. In 2006, the surplus on current account of the balance of payments reached US$9.9 billion, much higher than in 2004 (US$1.6 billion) and 2005 (US$0.3 billion). This significantly wider surplus was partly due to high commodity prices, which pushed exports over US$lOO billion for the first time. Imports increased at a more measured pace, reflecting the relatively slow pace of economic activity especially during 2006. These trends generally continued through the first half of 2007, although imports have accelerated. This strong performance in the current account has contributed to a sizable accumulation of official international reserves, which surpassed US$50 billion at mid-2007, providing Indonesia with a cushion against external shocks. Furthermore, the ratio of total external debt to GDP, a key external risk indicator, fell to 33% at end-2006 from the peak of 158% in 1998.

23. Looking ahead at the medium-term, economic growth is projected to rise slowly from 6.3% in 2007 to 7% by 2011 (see Table 2). With a supportive international

12 environment and continued reform momentum, investment growth is expected to push economic growth higher, with investment rising to 27% of GDP. Exports are also expected to remain strong, although some slowdown is expected in 2008 due to slower growth in world demand. Imports would tend to accelerate owing to rising economic growth, led by import-intensive investment spending. The current account would narrow progressively through the end of the forecast horizon. However, it should be noted that a precondition for sustained growth near 7% is more investment of a higher quality, both private and public. On the public side, this is within reach due to the increase in “fiscal space”, noted previously.

Table 2: Indonesia: Medium-term Outlook ------CY2006 CY2007 CY2008 CY2009 CY2010 CY2011

Growth Rates Real GDP 5.5% 6.3% 6.4% 6.6% 6.9% 7.0% Consumer Inflation 13.1% 6.5% 6.0% 4.5% 5.5% 4.5%

Central Govt. Budget (as ‘YOof GDP) Total Revenues 19.1% 17.5% 17.7% 17.9% 18.0% 18.2% Total Expenditures 20.0% 19.0% 19.4% 19.5% 19.5% 19.7% Deficit -0.9% -1.5% -1.8% -1.7% -1.6% -1.6% Total Govt. Debt 39.7% 34.5% 31.9% 30.1% 28.3% 27.2%

Balance of Payments Current Account Balance (US$ billions) $ 9.9 $ 10.8 $ 8.8 $ 7.1 $ 5.7 $ 4.3 (as % of GDP) 2.7% 2.5% 1.8% 1.3% 1.0% 0.7% Merchandise Exports (US$ billions) 103.5 116.1 125.8 136.8 151.1 167.7 (% change) 19.0% 12.1% 8.4% 8.7% 10.4% 11.0% Merchandise Imports (US$ billions) 73.9 83.3 93.7 105.4 120.0 137.0 (% change) 6.3% 12.8% 12.4% 12.5% 13.9% 14.1%

24. Inflation, projected to be 6.5% in 2007, is expected to decline slowly over the medium-term in line with Bank Indonesia’s inflation targeting framework (Table 2). An exception to this would be in 2010, when inflation is predicted to rise in line with a further reduction in government subsidies.

25. After widening a little in 2007 and 2008, the fiscal deficit is expected to remain around 1% % of GDP over the medium-term. This deficit is consistent with increased financing for public spending and continued declines in the government debt to GDP measure. In fact by the end of the forecast horizon, total government debt (foreign and domestic) would well below 30% by the end. Despite declining debt (in relation to GDP), the Bank projects the government’s gross financing needs to remain large over the medium-term. This reflects the anticipated increase in the deficit to finance increased public investment and allocations to priority sectors (such as education, health and infrastructure), as well as large principle repayments (Table 3).

13 Table 3 Indonesia: Government Gross Financing Needs, 2004-2008 (In billions of US$) -2004 -2005 -2006 -2007 -2008 APBN-P APBN Gross Financing 10.6 7.3 11.6 15.4 18.2 - Deficit 2.6 1.5 3.2 6.4 8.2 - Amortization 7.9 5.9 8.4 8.9 10.0 In Rupiah 2.7 2.0 2.7 2.9 3.4

In FIC 5.2 3.8 5.7 6.0 6.6

Notes: Deficit (as YOof GDP) 1.O% 0.5% 0.9% 1.5% 1.7% Rupiah/US$ 8939 9705 9159 9050 9100

26. There are however considerable risks to this outlook. On the external side, this assumes a limited impact on US and world economic growth of the US sub-prime housing situation. Clearly, there are additional risks involved in the current situation, although vibrant growth in domestic demand in the larger Asian economies, such as Indonesia, should insulate them somewhat. On the internal side, the forward-looking risks for Indonesia are more varied and include a loss ofreform momentum in the run up to the election, and increasingly binding infrastructure constraints. Another risk, linked to infrastructure and a favorable international environment is a surge in inflationary and import pressures.

27. The IMF has recently2 examined the sensitivity of their medium-term outlook to a series of exogenous shocks (including assumed policy responses and exchange rate changes) and finds the Indonesian economic and fiscal situation relatively robust to the assumed changes. . In one scenario in response to a lack of progress on reform, real growth falls to 5%; the fiscal deficit widens to more than 3% of GDP; inflation rises to over 7%; but despite this the ratio ofpublic debt to GDP continues to decline. . In another in response to a tightening of global liquidity, international reserves decline, but remain comfortably above adequate levels; the rupiah depreciates by about 15%; inflation rises above 7%; and GDP growth slips below 5%. . Debt is most sensitive to exchange rate fluctuations. The impact of growth and interest rate shocks are small. In particular, a one-time 30% real depreciation of the rupiah raises the public debt ratio by 10 percentage points, which then declines (over the period to 20 12) to an increase of 7-8% over the base case (expected to be around 26% of GDP at that time).

28. The IMF’s assessment of Indonesia’s macro-economic performance is set out in Annex 4.

* See Appendix Ito the Staff Report for the 2007 Article IV Consultation dated June 27,2007. 14 POVERTY PROFILE AND DEVELOPMENTCHALLENGES

29. Poverty declined significantly in 2007. Headcount poverty fell 1-1 percentage points to 16.6% of the population, after an unexpected increase of 1.5 percentage points in 2006. The number of poor fell by 2.1 million to 37.2 million in 2007 marking a resumption in the decline in poverty since the 1998 financial crisis (Figure 6).

Figure 6: Poverty Headcount

8 40 c 35 E ! 30 \ I 25 20 I: I P l5 I g! 10 2 51 0~'~'~'l'I'l'~'~1 1976 1980 1984 1988 1992 1996 2000 2004 -Old Method t Revised Method Source: SUSENAS, World Bank estimates

30. Strong growth, falling inflation, and targeted cash transfers all contributed to the decline in poverty between 2006 and 2007. The Indonesian economy performed well over the measurement period (approximately February to February) with real GDP growth close to 6% and private consumption growth of 4.7%. Moreover, inflation fell from a high of 18% in early 2006 (due to large fuel price increases) to 6.5% in early 2007. Concerns remain regarding rice prices, which rose a further 20%, although the rate of increase was far below the previous year's. The cash transfer program, providing 19 million households 300 thousand rupiah per quarter (around USD 30 dollars), compensated poor households for fuel price increases and, undoubtedly also helped reduce measured poverty in 2007.

31. In recent years, poor households have been benefiting less from growth than wealthier households. Real per capita consumption growth was between 2 and 5% for the two bottom quintiles, while growth ranged from 10 to 20% for the top quintile. As a result, inequality worsened and the Gini coefficient rose from 35.4 to 37.6. This continues a worrisome trend in which growth has become less pro-poor since 2002. An important cause for this may be continuing increases in the price of rice (see above) as 75% of the poor are net rice purchasers, and rice accounts for roughly 25% of poor households' expenditure.

32. A large percentage of the population remains vulnerable to poverty. Measurement of poverty in Indonesia is relatively volatile because of the large number of households clustered around the poverty line. For example, raising the poverty line 20% from roughly US$1.50 (approximately the government poverty line) to US$1.80 per capita per day would increase the poverty rate from 17 to 29%. Thus small price changes in goods

15 consumed by poor households have relatively large effects on the proportion of households classified as poor.

33. Vulnerability to poverty also comes from the fact that Indonesia is particularly prone to natural disasters. The December 2004 tsunami left 170,000 dead in and Nias. Post disaster reconstruction has picked up and as ofthe end of 2006, about 75% of the anticipated total reconstruction program had been allocated. The health and education sectors recovered rapidly to pre-tsunami levels, and the difficult housing sector also experienced an acceleration of reconstruction with an estimated 60,000 houses rebuilt by end-December. While Aceh’s record is strong compared to other tsunami-affected countries, the Yogyakarta reconstruction effort has set a new standard. Less than one year after the devastating earthquake in May 2006, almost 150,000 houses (more than half of the requirement) were rehabilitated, most of which at low-cost and with strong community participation. Natural disasters continue to plague Indonesia. Flooding in February 2007 in Jakarta claimed about 80 lives and forced the evacuation of more than 300,000 people. Several earthquakes also struck the Maluku and Nusa Tenggara regions. Despite the country’s perennial challenge of managing natural disasters, the Government has until recently focused more on responding to emergencies than on preparing for them. However, in March 2007, the Indonesian Parliament adopted long-anticipated legislation on disaster management. The new law establishes a National Disaster Management Agency that reports directly to the President to coordinate efforts to reduce disaster risks in advance and to provide leadership during an emergency. In addition, Indonesia has become the epicenter for Avian and Human Influenza (AHI) risks. The H5N1 virus has killed at least 189 people and sickened 121 more worldwide since it began ravaging Asian poultry stocks in 2003, according to the World Health Organization. Indonesia accounts for 79 of those deaths (or 42% of total) and 20 illnesses. The fatality rate among those infected has risen but the Government has launched a public awareness campaign that appears to be reaching the bulk of the country’s 240 million people and a recent consensus has emerged between government and international specialists on a detailed plan of action.

34. Large gaps remain between the poorer east and the more prosperous west. The incidence ofpoverty is highest in the eastern islands, including , Maluku, and Nusa Tenggara, reaching 41, 26, and 23%, respectively. In contrast, poverty rates are 16.5% in Java and . However, Java and Sumatra are the most populous regions, and contain over three quarters of the country’s poor. There is also a continuing disparity between urban and rural regions, with a poverty rate of 20% in rural areas, as opposed to 13% in urban areas. The urban-rural poverty gap remained constant between 2006 and 2007, as poverty fell by roughly 1.1 percentage points in each area.

35. Performance with regard to the MDGs has been mixed. Of the 8 goals listed in Table 4, 1 is already achieved and 3 are on track. It is encouraging that in 2006 the percentage of people living on less than US$1 a day was substantially below the MDG target of 10.3%. Net enrollment in primary schools remains high, under-five child mortality is steadily falling, and access to improved water facilities has dramatically increased. Other indicators are less positive, however. Declines in malnutrition have stagnated since 2002, and maternal mortality fell by only 20% between 1993 and 2005, which is insufficient to meet the target. Finally, despite recent improvement, access to improved sanitation also remains significantly short ofthe MDG target. 16 Table 4 Selected MDGs in Indonesia Goal Targets 2015 Value Asof On Target track 1. Eradicate Halve the proportion of people living under $1 per day 10.3 8.5 2006 Yes extreme poverty (indicator: proportion of people living under $1 a day) and hunger Halve the proportion of people suffering from hunger 19 25.8 2005 No (indicator: prevalence of malnutrition) 2. Achieve Ensure that all children can complete a full course of 100 93.2 2005 Yes universal primary education (indicator: net enrollment in primary primary school) education 3. Promote Eliminate gender disparities in primary and secondary 100 99.7 2005 Yes gender equality education, preferably by 2005, and in all levels of and empower education no later than 2015 (indicator: net women enrollment girls in primary school) 4. Reduce child Reduce by 213 the under-5 child mortality rate 33 46.0 2005 Yes mortality (indicator: no of U5M per 1,000 live births) 5. Improve Reduce by 3/4 the maternal mortality ratio (indicator: 105 307 2005 No maternal health MMR per 100,000 live births) 6. Combat HIV, Have halted, by 2015, and begun to reverse the spread Insufficient information Malaria and of HIV/AIDS and other major diseases other diseases (indicator: HIV/AIDS prevalence) Have halted, by 2015, and begun to reverse the Not 262 2005 Yes incidence of TB (indicator: TB prevalence per ava'lable 100,000) 7. Ensure Halve, by 2015, the proportion of people without 86 77 2004 Yes environmental sustainable access to safe drinking water (indicator: sustainability proportion of people with access to safe water) Halve, by 2015, the proportion of people without 73 55 2004 No sustainable access to basic sanitation (indicator; proportion of people with access to basic sanitation) By 2020, to have achieved a significant improvement Insufficient information in the lives of at least 100 million slum dwellers Integrate the principles of sustainable development Insufficient information into country policies and programs and reverse the loss of environmental resources 8. Develop a In cooperation with developing countries, develop and Not 30.6 2005 No global implement strategies for decent and productive work partnership for for youth. (indicator: youth unemployment rate) development

36. The government is scaling up spending on poverty through a National Community Empowerment Program. The program is expanded to over half of the nation's sub- districts in 2007, with full coverage planned for 2009. The community empowerment program builds upon Indonesia's accumulated experience with community driven development programs, in particular the World Bank funded Kecamatan Development Project and Urban Poverty Project. These programs focus on improving local governance and service delivery at the sub-district and village level, by encouraging participatory planning and providing block grants. Funds are generally used for rural roads, or education and health related projects. Previous evaluations show that projects provide internal rates of return of 39 to 68%, and are completed at substantially lower cost than comparable publicly funded projects.

37. Indonesia is also piloting two major conditional cash transfer (CCT) programs, one directed at households and the other at communities. The household

17 CCT is modeled after similar programs in Latin America, as well as the 2005-06 targeted cash transfer program. The household CCT provides poor households with an average transfer of about US$140 per year, conditional upon utilizing a basic set of health and education services. In the community CCT, which is an important component of the PNPM, communities receive a grant that is aimed at increasing utilization rates of the same basic services that are targeted by the household CCT. Facilitators guide the process of decision-making and provide technical advice on how to improve health and education outcomes. Conditionality is introduced in the form of financial incentives, by making a portion of the block grant in the second and subsequent years dependent on exceeding community-specific targets established in the initial year. THE GOVERNMENT’SDEVELOPMENT STRATEGY

3 8. The Government’s medium-term strategy (RPJM) represents the country’s medium- term development vision for 2004-09. It lays out three broad and multi-pronged goals: (i) a safe and peaceful Indonesia; (ii)a just and democratic Indonesia; and (iii)a prosperous Indonesia. It also incorporates the eight MDGs in order to frame medium-term targets as part of international commitments to be achieved by 2015. Each of these three broad goals contains more specific objectives in a number of sector-specific or theme-specific policy areas. With the policy pronouncements and emerging reform agenda articulated by the new President in October 2004, and given the likelihood that Indonesia would soon graduate from IDA, the new administration decided to incorporate the poverty reduction strategy into the RPJM and the Government’s mainstream planning processes.

Figure 7. Links between Indonesia’s RPJM, RKP, and SNPK RPJM 2001-2009 Medium-Term Development Plan (3 Objeclive addressing 33 Policy Areas)

A salt and peacefiil Indonesia A jus1 and democratic A prosperous Indonesia

I

Priori@ 2 Revitalised agriculture, fishery, forestry, and rural development I Pn’orify 3 Accelerated infrastructure development and energy management

Priority 4 Improved access and quality ofeducation and healthcare

Priority 7 Strengthened defense capability and stabilization ofdomestic security

Priority 8 Disaster management and mitigation, and improved treatment of avian flu

Note: Dotted boxes denote areas supported by the two DPL programs

18 39. For the past three years, the Government has further elaborated on the RPJM through the Annual Work Plan (RKP). Through the RKP, the Cabinet identifies priority areas and associated targets among the 33 policy areas found in the RPJM. The priorities of the annual RKP provide an umbrella guide to aggregate budget allocations in the state budget in order to respond to emerging challenges and to align spending, programs, policies, and activities to current development needs. This represents a recent break from a long tradition of incremental budgeting wherein allocations typically resembled those of the previous year and only new proposals were subjected to scrutiny and analysis. The development theme for the 2008 RKP is “acceleration of economic growth to reduce poverty and unemployment” and the 2008 W delineates eight national development priorities. The eight national development priorities are: (1) increased investment, export and employment opportunities; (2) revitalized agriculture, fishery, forestry, and rural development; (3) accelerated infrastructure development and energy management; (4) improved access and quality of education and healthcare; (5) improved effectiveness in poverty alleviation; (6) corruption eradication and acceleration of bureaucratic reforms; (7) strengthened defense capability and stabilization of domestic security; and (8) disaster management and mitigation, and improved treatment of avian flu. The 2008 executive budget proposal closely reflects these priorities, with significant increases in capital and social assistance spending. Capital expenditures are focused on areas with expected higher economic returns, such as the construction of roads, bridges, irrigation tracks, and transportation infrastructure and facilities. Underpinning the high priority placed on economic infrastructure and investment-led growth, significant increases are proposed in spending of the Ministry of Public Works (+33.1% in real terms) and the Ministry of Transportation (+54.8% in real terms). Figure 7 illustrates the links between Indonesia’s planning and strategy documents.

40. In July 2007 the Government issued an integrated economic policy package (Inpres 6/2007) building on the previous year’s set of policy packages. The package covers four broad areas: infrastructure; investment policy; financial sector reform and SME policy. The infrastructure elements of Inpres 6/2007 are set out in Annex 2.

19 111. THE GOVERNMENT’S INFRASTRUCTURE REFORM PROGRAM

41. The Government’s infrastructure reform program is a central element of the Government’s efforts to reduce poverty, providing an expected boost to economic growth, and directly improving household access to basic services. A backlog of necessary infrastructure investment has arisen as a result of low investment levels over the past decade. The Government has recognized this challenge, and is seeking to increase private infrastructure investment, remove policy blockages to public and private investment, and increase public investment. In addition, the Government is aiming to improve the efficiency of infrastructure expenditures, particularly through governance improvements. Donors are contributing to improve the effectiveness of infrastructure expenditure with substantial technical assistance and capacity building activities. THE CHALLENGE

42. As indicated in Figure 1 infrastructure investment fell from 5-6% of GDP before 1997 to a low of around 2% of GDP in 2000. A slowing in infrastructure investment was appropriate immediately after the crisis, given reduced growth of demand for infrastructure services and the need to achieve macro-economic stability. However by 2003 real GDP had surpassed pre-crisis levels. Infrastructure investment was not keeping pace with the resurgent economy, let alone addressing the needs ofthose who have never had access to infrastructure services. By 2005 infrastructure investment was still only 3.2% of GDP.

43. Demand for electricity has been growing at around 6% per year since 2000, but there has been no corresponding growth in available system capacity (Table 5). Peak demand has progressively approached available capacity, until reserve margins are now inadequate. Blackouts and load-shedding are occurring, particularly on the islands outside the inter-connected Java-Bali system. Annual demand growth of 7 to 9% is forecast in the next decade. Additional growth could be foreseen if greater progress is made in providing household connections to the third of the population currently without electricity access.

Table 5: PLN’s Electricity System Capacity vs Peak Demand 2000 2001 2002 2003 2004 Installed Capacity (MW) 23,949 24,246 24,359 24,475 24,920 PLN 20,762 21,059 21 ,I12 21,206 21,470 IPP 3,187 3,187 3,247 3,269 3,450 Available Capacity (MW) 21,853 22,077 20,841 22,048 21,494 Aggregated Peak Demand (Mw3 15,320 16,313 17,160 17,949 18,896 Reserve Margin based on total capacity (percent) 56.3 48.6 42.0 36.4 31.9 Reserve Margin based on available capacity (percent) 42.6 35.3 21.5 22.8 13.7

44. The efficiency of Indonesia’s cities is reduced by severe traffic congestion. Currently, 43% of the road network on Java is congested with related high travel times

3 As detailed peak load data are not available, aggregated peak demand is used. Although this does not reflect the actual situation of various systems which are not interconnected, it provides a reasonable indication ofthe overall demand and supply balance in Indonesia. 20 and costs. Congestion is expected to increase to 55% of the network by 2010. The total road network grew by 12% between 2000 and 2004.4 The proportion of paved roads has increased by 28% since 1998. In the same period, the number ofmotor vehicles per 1,000 persons increased by 80%. (Table 6).

Table 6: Increasing Road Congestion Indicators 1998 1999 2000 2001 2002 2003 2004 2005 %Chanae., 1998- 2005 Paved Roads, % of Total 47.3 57.1 57.1 58.9 57.6 58.3 .. 60.5 28% Motor Vehicles (per 1,000 87.8 89.5 92 100.1 108.5 118.7 133.2 158.2 80% persons) Source: CGI June 2006, Indonesia: Transport Sector Review (January 2006): Overview of Road Sector Findings

45. Freeways, including ring-roads for urban centers and inter-city expressways, would provide a major boost to growth. For the most part, however, these highways are only at planning stage. The quality of Indonesia’s national roads is relatively high, but too many sub-national roads are poorly maintained (Table 7).

Table 7: Road Quality Length (km) Condition (% Good-Fair) Surface Standard 2006 2000 2006 (% Paved) Freewaynoll Roads 649 100 National Roads 34,628 97 81 90 Provincial Roads 37,164 89 63 89 Kabupaten/Kota Roads 266,564 37 53 52 Total Kin of Roads 339,005 60.5

Source: DGH - Strategic Plan March 2005, MOPW

46. Indonesia’s 316 water utilities (PDAMs) are in crisis. Piped water provided by utilities is the long-term lowest-cost sustainable and safe solution for the provision of water in urban centers, but only 31% of the urban population and 17% of the total population have access to piped water. This is very low by regional standards (Table 8). Water quality and regularity of service delivery are declining, and few, if any, utilities supply potable water. Water losses, both physical and administrative, account for up to 60% of PDAM production. Indonesia also lacks adequate sanitation and waste-water treatment systems. The failure to treat waste-water leads to pollution of water sources and further raises the cost ofclean water production.

Table 8: Access to piped water Nationwide Capital Country Urban Rural Total city only Malaysia 95% 64% 84% 100% Philippines 60% 22% 44% 58% Thailand 80% 12% 34% 83% Vietnam 51 % 1% 14% 84% Indonesia 31 yo 5% 17% 51% Cambodia 31 % 1% 6% 84%

Source: Ministry of Transport. 21 Sources: UN Joint Monitoring Program (2004), ADB (2004), Water in Asian Cities

47. Restoring national infrastructure expenditure to a more appropriate level could be expected to give a substantial boost to GDP (Box 1).

Box 1: The Importance of Infrastructure Reform

The World Bank’s 2004 study, “Averting an Infrastructure Crisis” provided rough estimates suggestive of the difference to GDP that could be made by addressing (or failing to address) Indonesia’s infrastructure challenges. US$ million % of GDP (2002) Cost of 100 hours of electricity outage per year (failure to 2,000 0.99 expand capacity to meet growing demand) Benefit of connecting 1 million new electricity consumers per 150 0.07 year Benefit of increasing water tariffs by SO%, increasing efficiency 1,752 0.88 by 20%, and reinvesting proceeds in new household connections Net savings generated by increasing annual road maintenance 773 0.39 from Rp. 4 trillion to Rp. 6.5 trillion Economic return on annual road investment of $270 million 108 0.05 following JARNS priorities Total 4,783 2.39

I I THE GOVERNMENT’SINFRASTRUCTURE AGENDA

48. The Government’s infrastructure strategy has evolved over the past three years. Initially, great emphasis was placed on attracting private investment, reflecting the Government’s constrained fiscal position at the time, and an optimistic assessment of the ease with which private investment could be attracted. As this optimism became tempered by experience, attention was also given to removing policy blockages and improving the overall climate for infrastructure investment. Most recently, as the Government’s fiscal position has improved, budget allocations for public infrastructure investment have been increased. Much remains to be done, but there is by now a substantial body of achievements and a strong forward reform agenda addressing infrastructure investment constraints to economic growth, household access to basic services, and issues of sectoral governance.

49. Immediately after its election in 2004, the Yudhoyono government set infrastructure as a major priority, recognizing the lack of investment as an important constraint to growth. An Infrastructure Summit was held in January 2005, offering 91 transactions to the private sector. The reaction to these offerings was disappointing: investor confidence was inevitably affected by the post-crisis renegotiation of infrastructure projects; many existing policy blockages remained to the preparation of bankable projects; and in practice the projects were not well prepared by the government. None ofthe projects has reached financial closure.

50. Following the Summit, the KKPPI (Ministerial Committee for the Acceleration of Infrastructure Investment), was given responsibility for advancing infrastructure reform.

22 In February 2006 the KKPPI released an extensive Infrastructure Policy Package, detailing a series of 156 policy reforms to be achieved during 2006. The objectives of this program include encouraging competition, setting tariffs at cost-recovery or alternatively using explicit PSO subsidies to reconcile affordability and commercial viability, elimination of discriminatory practices that obstruct the private sector’s participation in infrastructure provision, and a redefinition of the government’s role, including the separation of policy-making, regulatory and operational responsibilities. A further policy package was released, in the form of Inpres 6/2007 (see Annex 2), covering planned reforms to the end of 2007.

51. The 2006 and 2007 policy packages provide important, but not exhaustive, statements of the Government’s agenda. The following discussion provides an overview of the main themes of infrastructure reform in the country. Budget Allocations for Infrastructure

52. Indonesia’s improved fiscal position has permitted increases in public investment in infrastructure. Total national public expenditure (all levels of government) was Rp. 536 trillion (about US$ 60 billion) in 2005. The reduction in fuel subsidies, increases in revenues, and lower debt service payments permitted a US$ 15 billion increase in Indonesia’s public expenditures in 2006, and further increases in total spending are planned for 2007. The additional fiscal space has permitted an increase of over 30% in the budget allocations for capital expenditures in 2008 by the Ministry of Public Works and the Ministry of Transport. These are the national ministries responsible for the bulk of Government infrastructure investment. It is intended to maintain this higher level of investment beyond 2008.

Electricity

53. The Government’s reform agenda in the electricity sector can be grouped into three broad areas: system expansion, household access, and environmental sustainability. An overview of the electricity sector is provided in Annex 6.

54. In the area of system expansion, planning and investment were thrown into disarray in 2003 when a new law restructuring the industry was found to be unconstitutional. As demand has continued to grow, the challenge has been to combine rapid project development with a coherent least cost expansion plan. The pre-2003 plans for market restructuring are no longer priority reform issues. Much attention is being given to the process of project development, including the investment climate for independent power plants. The relationship between the natural gas and electricity sectors also needs to be addressed: many combined cycle gas turbine electricity plants are currently being operated on expensive diesel for want of relatively modest investments in connection to the gas network. Sectoral financing is ultimately dependent on tariff levels, but here the Government is unwilling to reform until at least the next election, having regard to the economic impact of the 2005 reduction in fuel subsidies.

55. The pace of electrification is affected by PLN’s commercial incentives, with tariffs and subsidies playing critical roles. With tariffs set below cost, and therefore providing PLN with a commercial disincentive to connect new customers, the government’s

23 subsidy policy is central to the access agenda. Although electricity subsidies are large, they are not well targeted either to the poorest electricity consumers or to those who are not yet connected. The Government is reviewing its overall PSO strategy, as discussed in Annex 11. One of the features of electricity supply in Indonesia is large variation in its cost of supply across different regions. This opens up another avenue for expanding household access to electricity, through regionally differentiated electrification strategies, supported financially by local governments.

56. The Government is also beginning to develop a low carbon action plan. As host of the 2007 Climate Change Conference, Indonesia has a special incentive to improve its performance on environmental issues. The Government intends to initiate a switch to greater reliance on natural gas and renewable fuels in the production of electricity.

Water and Sanitation

57. Following decentralization reforms in 2001, the Government took a largely “hands- off’ approach to management of water and sanitation, relying on sub-national governments to ensure adequate delivery of services. As sector performance has gradually declined, the Government has become increasingly aware that it needs to take a more active role in policy development and monitoring.

58. The National Action Plan on Clean Water (NAP-CW) sets targets in support of the Millenium Development Goal of halving the proportion of people without sustainable access to safe drinking water and basic sanitation. The goals for 2015 include access to safe drinking water for 88% of households, piped water for 62% of households, and access to improved sanitation for 75% of households. The Plan also aims to reduce dependence on protected water sources, such as rivers, lakes, and wells.

59. To achieve the NAP-CW’s targets around US$ 4.6 billion will be required during 2004-20 15. The Government intends that loans from international financial institutions would constitute more than 60% of the finance required. But no such loans have been approved in the past ten years. Regulations prohibit borrowing from foreign sources by PDAMs which have arrears, or whose owning local governments have arrears, on debt to the Ministry of Finance. Over two hundred PDAMs are affected.

60. The Government places high priority on resolving the arrears of PDAMs, but it is equally necessary to ensure that any new lending does not result in a recurrence of repayment arrears. The Government’s first effort in this area was the Financial Recovery Action Plan (FRAP) for PDAMs, launched in 2000. Under the FRAP, detailed action plans are developed to improve the management and operational performance of individual PDAMs. The FRAP was supplemented with legislation introduced in 2005 permitting restructuring and forgiveness of PDAM debt to the Ministry of Finance, contingent on participation in the FRAP and other measures. The underlying principles of these initiatives are appropriate, but their practical application is too slow, delaying for years the time it will take for most PDAMs to access new debt finance. The Government is now looking to revise the regulations to permit a more rapid resolution of the debt arrears problem.

24 61. More detail on the Government’s program in water and sanitation is provided in Annex 7.

Roads and Other Transport

62. The national road network needs to be expanded. Severe congestion is prevalent in Java and Sumatra, and Indonesia needs an expressway network. Currently there are only 600 km of controlled access toll roads. But before new roads are built, the highest priority is ensuring full maintenance of the existing network. Sub-national roads in particular are poorly maintained, reducing rural communities’ access to services.

63. A sector strategy that sets realistic and prioritized targets for network expansion and maintenance as well as a plausible and actionable set of tools and sources for financing will underpin any long-term improvement in the development impact ofthe roads sector. In particular, ensuring adequate financing of the investment needs and ensuring full maintenance of the existing network are key concerns. Recognizing the complexity of securing financing through PPP projects, and the limited scope in the current environment for dedicating tax revenues to the transport sector, the Government is now examining the full range of potential financing sources. Options include greater reliance on the “Jasa Marga” model (toll-road SOE) funded by budget allocations, sale or securitization of assets, borrowing, and road user fees.

64. In recent years policy development in the road sector has focused on establishing a new legal regime for toll roads and attracting private investment. The new UU 38/2004 and the subsequent PP 15/2005 on Toll Roads addressed these issues. In August 2005, the Ministry of Public Works (MOPW) issued Kepmen 374/2005, which enables the toll- road tariffs to be set on the basis of a bidding process. The Indonesian Toll Road Authority (BPJT) was established in October 2005. Its responsibilities include developing business plans and feasibility studies for toll-road projects; conducting bidding, facilitating land acquisition, and recommending tariffs for such projects; and supervising implementation of toll-road concessions. The short-term challenge is to fully operationalize the authority.

65. As the pace of private investment in the sector has been slower than initially anticipated by the Government, attention has shifted to public financing. The government has responded with a doubling of its roads investment budget for 2008 from about US$1.1 billion equivalent in 2007 to about US$ 1.9 billion equivalent planned for 2008. There is still a need, however, to better define revenue sources, including tolls, road user charges, fuel levies, or national budget.

66. Masterplans were developed during 2006 for land transportation safety, railways development, and sea transportation. In the road sector, basic routings and engineering designs have been prepared for expressways development, but the financing arrangements remain to be developed in detail. More detail on the transport reform agenda is set out in Annex 8.

25 Telecommunications

67. The Government’s overall policy objective in telecommunications, as per UU 36/1999 on Telecommunications and the 1999 Sector Blueprint, is to facilitate competition and promote a level playing field. Specific reform commitments include introduction of cost-based interconnection and introduction of a call traffic clearing system (SKTT); tariff rebalancing; readjusting the national numbering plan; early termination of exclusive rights on the domestic and international fixed network (and associated compensation payments to the incumbents); introduction of modern telecommunications licenses; radio spectrum management reform, including 3 G licensing; launch of a Universal Service Obligation (USO) program; and reorganization of the Ministry and empowerment of the independent regulator (BRTI). More details on the Government’s telecommunications agenda are set out in Annex 9. Sub-National Governments

68. Decentralization of public expenditure has created new challenges in meeting Indonesia’s infrastructure needs. Sub-national governments are responsible for sub- national roads, and water and sanitation services, and could potentially play a greater role in expanding household access to electricity.

69. Following the 2001 decentralization reforms fiscal transfers to the regions have increased from 19% of central government expenditure in 2000 to 34% in 2007. Sub- national governments have used the extra funds to increase their spending on personnel, and their reserve holdings of bank deposits, but have not increased their infrastructure spending correspondingly. The reasons for these trends include weaknesses in both national and sub-national budget processes, and weakness in sub-national capacity to plan for and effectively spend on infrastructure. In addition, Indonesia does not yet have the sorts of matching grants seen in many federal countries to encourage infrastructure development. The Government is now looking to enhance the incentives for sub-national governments to better address infrastructure needs.

70. It makes sense for sub-national governments to leverage their budgets with borrowings, enabling development spending to be brought forward. This is particularly important for infrastructure investments, which require large up-front capital investments. But, scarred by the consequences of the 1997 financial crisis, Indonesia’s fiscal authorities have taken a strict approach to managing sub-national debt. Reforms occurred in 2005 setting out the legal basis for sub-national borrowing, including bond issuance. One ofthe criteria is an absence ofarrears on debt payments, and this has proven to be a practical barrier to new sub-national borrowing, affecting both sub-national governments and their public enterprises (particularly PDAMs). The Government is developing a program to reduce arrears, through debt restructuring, debt write-offs, and interception of fiscal transfers to enforce debt repayment.

71. More detail on the reform of sub-national governments’ infrastructure is set out in Annex 10.

26 Public-Private Partnerships

72. The Government is strongly committed to developing PPPs, recognizing the importance of the PPP agenda not only for the infrastructure investment objectives, but also in terms of governance. The framework for infrastructure PPPs that has been put in place over the past few years is one of the most important governance improvements since the fall of the New Order regime. Under President Suharto, there was little competition in the award of infrastructure projects, and the State bore excessive downside risk. With annual private investment in infrastructure greater than 2% of GDP, the sums of money and the scope for corruption were huge. Every IPP constructed prior to 1997 was co-owned by a member ofthe Suharto family or the ruling elite. Following the crisis, all IPP contracts needed to be cancelled or re-negotiated. In stark contrast, the new framework embodies principles of transparency, competition, and appropriate risk management.

73. A major effort has been made to ensure appropriate project preparation, selection of operators, and allocation of public support for PPP projects. Perpres 67/2005 requires competitive bidding in the award of infrastructure PPPs, provides guidance on the minimum terms of PPP contracts, and authorizes the Ministry of Finance to approve or reject requests for direct or contingent government support of PPP projects. PMK 38/2006 sets out the sorts of guarantees the Government may give, and a Risk Management Unit has been established to ensure that appropriate forms and levels of government support are given to individual projects, and to ensure that the overall level of contingent support is consistent with sound fiscal management.

74. A second area of focus is financing of PPPs. The Government has set aside funds to provide direct public support, such as land acquisition, or to serve as a backstop for the issuance of government guarantees. The next step in the risk management reforms is the establishment of a proposed Guarantee Fund, which will be available to honor government guarantees in the event they are called. The amount of money available in the fund will cap the level of contingent liabilities the Government may assume through infrastructure guarantees. Professionally invested, the Guarantee Fund can be grown over time, allowing the Government to commit to a higher level of guarantees, and facilitating greater levels of private infrastructure investment. To address weaknesses in local capital markets, the Government is also creating the Indonesia Infrastructure Fund, which will mobilize funds in order to provide the long-term local currency debt required for PPP projects. The World Bank is closely involved with the IIF initiative and is planning to support the Government in its design, in mobilizing initial equity investors, and arranging subordinated debt.

75. Much activity within infrastructure ministries and SOEs has been devoted to the preparation of PPP transactions. But the Government is struggling to balance the desire to prepare projects quickly against the need to prepare thoroughly. Without adequate preparation, PPP projects receive few bidders, and are unable to proceed to financial closure. The KKPPI is charged with facilitating project preparation. A network of specialist PPP Units is being developed within the KKPPI Secretariat and infrastructure line ministries and SOEs. Infrastructure summits were held in January 2005 and November 2006, to attract potential private investors. Particular attention is now being given to ten “model” PPP projects, which the Government intends to be the focus of

27 careful project preparation. IFC Advisory Services are negotiating with the Government over the terms of a mandate as investment adviser to prepare one ofthe model projects, a coal-fired power plant in .

76. Finally, as part of the Infrastructure Reform Packages developed by the KKPPI in 2006 and 2007, legislation is being prepared to remove SOE monopolies in railways and ports, and to separate regulatory responsibilities from policy development and SOE service provision. These measures will expand the potential scope for private participation in infrastructure.

77. While the PPP agenda continues to be subject to setbacks (for various reasons, including constrained capacity and political interference), progress is being made. New institutions are being put in place and lessons are being learned, but it will take time for these new arrangements to bear fruit in terms ofprivate investment.

78. More detail on the Government’s PPP reforms is set out in Annex 12.

Land Acquisition

79. The government has recognized that the land acquisition process has been a significant bottleneck to the rollout of infrastructure - particularly in the road sector. Perpres 36/2005, amended by 65/2006, was created to provide clearer guidance on land acquisition, including a principal of market-based compensation levels and a central role for dissemination of information. A National Land Agency Implementation Guideline (3/2007) is designed to address inconsistencies between this new presidential and existing ministerial guidelines covering land acquisition. Further reforms seek to strengthen the land acquisition process including improved rules governing expropriation and compensation.

80. More detail on the Government’s land acquisition system is set out in Annex 13.

Environment

8 1. The Government’s RPJM indicates that the problem of declining environmental quality as a result of disasters or environmental destruction as well as the improvement of natural resource management and environmental preservation will both be priorities. Initiatives to improve environmental management include controlling/handling environmental pollution, controlling and reducing smoke and haze from forest and land fires, conservation of natural resources, improving spatial planning process and developing environmental data and information. As planned in 2008, overall environmental spending would have more than doubled in three years. Further reforms will strengthen environmental processes specifically related to improved environmental impact assessment.

82. More detail on environmental issues related to infrastructure is set out in Annex 14.

28 Governance

83. A wide ranging governance reform effort since the 1997 crisis has altered the constitution, introduced decentralization and considerably changed financial management processes. Infrastructure has been a part of the reform process with widespread corporatization and privatization. More recently, the government’s 2006 Infrastructure Policy Package separated policy, regulatory and operational responsibilities of government while leveling the playing field for private provision. The Government recognizes that significant issues of governance remain in the sector, however, and a number of the reforms outlined above - regarding institutional structures in roads, water and power, as well as the rollout of improved mechanisms for introducing PPPs and financing reform - will have a significant impact on the quality of governance in infrastructure.

84. Keppres 8012003 on public procurement promotes the basic principles of procurement: transparency, open and fair competition, economy, and efficiency. It covers all areas of procurement that use public funds and contracting entities at all levels of government. The decree meets most of what is generally regarded as accepted international practice. A new Keppres has been drafted that, if issued, will establish a fully independent regulatory body as Goods/Services Procurement Policy Development Institution (Lembaga Pengembangan Kebijakan Pengadaan Pemerintah - LPKPP). The planned institution will report directly to the President. The possible establishment of an independent LPKPP would be an important step to push the reform agenda in public procurement. There are several initiatives for reform that are currently led by the current National Public Procurement Office (NPPO) in Bappenas such as drafting of a new procurement law, development of standard bidding documents, e-procurement, certification programs etc. However progress has been slow mainly due to the limited staffing at the current NPPO and the lack of Government priority to the reform agenda.

85. The Government has also improved audit arrangements, particularly the external audit function carried out by BPK. The enactment of the new audit law in 2004 clarified BPK’s mandate while a 2006 law lays down internal and external governance arrangements for BPK. BPK has issued a series of internal implementing regulations as well as a new set of Government Auditing Standards that are substantially in line with comparable international standards (INTOSAI). On the other hand, the internal audit function - carried out, among other entities, by the Inspectorate General (IG) in each spending ministry - continues to be a weak link in governance. The Inspector General’s Office of the Ministry of Public Works has declared an intention to modernize and improve auditing methods at the level of the line ministry. Capacity building is required to introduce systematic risk assessments aimed at identifying the most acute problem areas and to ensure that audit reports include recommendations on how to address systemic failures.

86. More detail on governance and infrastructure in Indonesia is set out in Annex 15.

29 IV. BANK SUPPORT TO THE INFRASTRUCTURE REFORM PROGRAM

LINKTO THE COUNTRY ASSISTANCESTRATEGY

87. The CAS embraces four main areas of development assistance: improving the investment climate; making service delivery responsive to the needs of the poor, improving governance, and disaster risk management. The CAS explicitly identifies infrastructure as one of the key factors involved in the improving the investment climate, but it is also central to improvements in service delivery for the poor and a critical area for governance reform.

88. The CAS, prepared in 2003, notes that inadequate investment in infrastructure is a major threat to Indonesia’s economic prospects, and commits the Bank Group to confronting the challenge through analytical and advisory services and financing. In addition to sectoral initiatives in energy, transport, communications, water, and sanitation, the CAS indicates that the Bank would support a strategic framework for infrastructure. The CAS refers to the major infrastructure strategy prepared by the Bank, completed at the end of 2003, which would guide the Bank’s national-level policy dialogue and engagement. Four years later, the Infrastructure Strategy has led to the Government’s infrastructure reform program, for which the Government is requesting recognition in the form ofa policy loan.

89. While infrastructure reform fits squarely within the CAS objectives, the launching of a new policy loan series raises issues in terms of the level of policy lending and the timing of the proposed series. The CAS Progress Report (CAS PR), approved in September 2006, envisaged US$ 600 million for policy lending in FY08, and mentioned that an Infrastructure DPL could be included within this total, alongside the planned DPL 4 operation. The Bank now proposes to increase the envelope for policy lending in FY08 beyond that envisaged in the CAS PRYto US$SOO million, of which US$ 600 million would be allocated to DPL 4 and US$ 200 million to IDPL 1,

90. There is a strong case for increasing the level of policy-based lending beyond that envisaged in the CAS PRYnotwithstanding that this was only recently approved by the Board. In essence, Indonesia is a well-performing middle income country, with strong desire to increase programmatic borrowing, and where such borrowing poses no great risks in exposure for either the Government or the Bank.

91. The Government has made clear progress on key policy areas since the start of the CAS period. There is mutual desire by Government and the Bank to deepen and broaden the policy dialogue in key areas that would be supported by policy-based lending. There is strong Government demand as reflected in its emerging medium-term borrowing strategy to shift away from multiple, stand-alone projects towards programmatic lending. The Government seeks to scale up spending in line with its medium-term strategy and objectives. Finally, despite a recent increase in fast disbursing program loans, the Bank estimates that there will be little impact on total indebtedness and Bank exposure/risk, both of which have undergone a steady reduction in recent years (see Table 9).

30 Indonesian debt to IBRD has been declining since 2001 and is expected to continue to decline from US$9.78 billion at end-2003 to US$6.36 billion in 2008.

Table 9: Indonesia’sDebt and Bank Exposure (US$ billion) 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 Debt to World Bank 11.9 10.7 11.4 12.1 12.4 12.2 11.5 10.7 9.9 9.1 8.7 Total government debt 55.3 50.9 70.7 135.5 132.0 122.5 138.5 143.5 139.0 133.9 148.9 External 55.3 50.9 58.2 65.5 63.9 60.3 65.7 70.7 71.1 70.8 72.1 Domestic 0.0 0.0 12.5 70.1 68.1 62.2 72.8 72.8 67.9 63.1 76.8 GDP 227.4 215.7 95.4 140.0 165.0 164.1 200.1 238.5 256.9 287.0 365.2

World Bank debt Percent of GDP 5.2% 5.0% 11.9% 8.6% 1.5% 7.4% 5.8% 4.5% 3.9% 3.2% 2.4% Percent ofGovt. debt 21.5% 21.0% 16.1% 8.9% 9.4% 9.9% 8.3% 7.4% 7.2% 6.8% 5.9% Percent of Govt. 21.5% 21.0% 19.6% 18.5% 19.4% 20.2% 17.5% 15.1% 14.0% 12.9% 12.1% - external debt

92. Plans for the remaining loans of the IDPL series will be integrated into preparation of the new CAS, which starts in FY09. RATIONALE FOR A NEWPOLICY LOANSERIES

93. It has become impossible to do full justice to the infrastructure reform agenda within the confines of the existing DPL series. For many years after the Asian crisis, a priority of the Government has been to improve the macroeconomic situation. The Indonesia DPL program was primarily conceived to support the Government’s efforts in that respect. Now that substantial macroeconomic progress has been achieved, inadequate infrastructure has emerged as one of the main factors that could prevent Indonesia from reaching its full growth potential. The Government is committed to addressing an infrastructure agenda that is complex, technically detailed, and challenging.

94. Consideration will be given to continuing the DPL series in the new CAS period, in part to address the Government’s desire for regular budget support. While measures to strengthen the framework for infrastructure provision have been included in the existing DPL program since its inception, providing meaningful support to the emerging infrastructure agenda cannot be done as just a - relatively minor - part of the DPL program, especially at a time when this program is being relied upon to support an increasingly broad range of measures including for example a deepening agenda in public financial management. A separate IDPL series also provides the flexibility to adjust the timing of operations to actual progress in relatively risky infrastructure reform. The timing of the DPL series on the other hand is somewhat more predictable, and thus better suited to meet the Government’s desire for regular budget support.

95, Infrastructure investment operations, even when they are designed to further policy reforms (as is the case of APLs for example), are important, but not sufficient instruments to support the infrastructure agenda of the Indonesian Government. The main reason is that key elements of the infrastructure agenda are cross-sectoral in nature. This is true of issues pertaining to financing, PPPs, inter-governmental fiscal relations, governance, and the environment for example. Infrastructure development in Indonesia, even within individual sectors, requires strengthened coordination across government agencies, including line ministries, SOEs, and the central ministries of Finance, Planning, and

31 Economic Affairs. The range and nature of these challenges extend well beyond the sorts of policy reforms that could be addressed through infrastructure investment operations.

96. Establishment of a new IDPL series responds to strong country demand. The Minister of Finance especially has been forceful in requesting the launching of a new infrastructure series in addition to the existing DPL series and the Ministry of Finance is centrally involved in most of the cross-sector reforms recognized in this first IDPL. The Government as a whole recognizes the importance of Bank support in advancing key reforms within the bureaucracy, as well as the intellectual leadership and assistance the Bank can provide on the details ofparticular reforms.

97. The launching of a new infrastructure series provides a strong signal of Bank support for the infrastructure policy loans of the ADB and JBIC. The policy loans provide a platform for all three development partners to work together in support of the Government’s infrastructure program.

98. Finally, it is worth noting that the co-existence of two DPL series in one country has precedents elsewhere, such as in Brazil for example. RELATIONSHIPTO OTHER BANKOPERATIONS

99. The IDPL series builds upon reforms initially recognized in the DPL series, and complements the Bank’s infrastructure investment operations.

100. The DPL series contains four broad policy pillars: “macroeconomic stability and credit-worthiness”, “improved investment climate”, “improved financial management and anti-corruption”, and “making services work for the poor.” Since DPL 2, infrastructure reforms have been supported under the investment climate pillar. The infrastructure-related measures in past DPL operations have focused on developing a policy framework for PPPs, managing the risks associated with guarantees given to PPPs, and developing sources of long-term finance for private investors in infrastructure.

101. With the launching of the IDPL series, two subjects that had been planned as triggers for DPL 4 have been removed from the DPL 4 policy matrix and are now addressed in the IDPL policy matrix. These DPL 4 triggers addressed (i)the establishment of the Indonesia Infrastructure Fund; and (ii) the framework for restructuring local government debt and debt work-out for 10 PDAMs or local governments. These matters are now addressed in the IDPL policy matrix.

102. In addition to the migration of triggers from the DPL series to the IDPL, the two operations interact in the areas ofbudgeting and inter-governmental fiscal relations. Implementation of a medium-term expenditure framework (MTEF) with a system of clear forward estimates for the 2008 budget is a trigger for DPL 4, and is judged to be fulfilled with the development of macro-economic forecasts of revenues and expenditures for a period ofthree years. Further development of the MTEF requires bottom-up estimates of revenues and costs by line ministries. The IDPL series includes a trigger calling for the development of these estimates by the Ministry ofPublic Works in respect ofnational roads.

32 The DPL series is also concerned with the borrowing framework for sub-national governments. This is of central importance for infrastructure, since the major purpose of sub-national borrowing will be for capital expenditure, and the bulk of this will be for infrastructure investment. The DPL 4 policy measures interact with IDPL triggers dealing with sub-national debt restructuring and the development of performance incentives in the inter-governmental fiscal framework.

103. The IDPL series is complemented by existing and proposed World Bank Group infrastructure investment operations which, in addition to expanding infrastructure networks and promoting household access to services, address high priority sector- specific institutional issues: The road sector is currently supported by two ongoing investment operations. In addition to financing important links in the country’s transport networks in eastern Indonesia, and Java and Sumatra, the operations address matters including decentralization of planning and management for sub-national road, quality of works procurement, and institutional development. An investment project is currently under preparation addressing institutional capacity for maintenance and budget operations in western Indonesia. 0 In the water and sanitation sector a programmatic loan promotes rural household access to safe water, basic sanitation and improved hygiene. Loans currently under preparation would pilot PDAM arrears restructuring and strengthen PDAM management; protect the main source of drinking water for Jakarta, and support the transition to network sewerage and treatment in Batam. In the energy sector, an investment loan focuses on the expansion of the gas distribution system and capacity building for the gas utility, PGN, and earlier institutional reform was supported through the Java-Bali Power Restructuring project. The Bank is also preparing projects to address geo-thermal power and rural electrification. The Bank also finances two large-scale community-driven development programs focused on rural and urban communities. A large element of these programs is associated with the delivery of community-determined infrastructure. The Bank proposes to support a fusing of the two programs, and their enlargement to cover the entire country, in a project to be delivered in 2008.

COLLABORATION WITH OTHER DEVELOPMENTPARTNERS

104. The Bank, the ADB, and the Government of Japan are all supporting the Government’s infrastructure reform program, and there is close coordination between all three development partners. Through separate policy loans, the ADB and the Government of Japan are focusing on a large subset of the Government’s reforms. The reforms being recognized through the Bank’s IDPL series are a smaller subset of the Government’s reforms, focused on areas of high priority to the Government, and where the Bank is closely involved in dialogue with the Government.

105. Cooperation between the three development partners in respect of the Government’s infrastructure reforms can be traced back at least as far as the first Infrastructure Summit in January 2005, when the three development partners cooperated to produce a series of policy notes for seven infrastructure sectors. Following the first

33 Summit, the ADB took the lead in discussions with the Government which resulted in February 2006 in the formulation of the KKPPI’s Infrastructure Policy Package, which listed reforms implemented in 2005 and planned for 2006. These discussions also helped extend the reform agenda to 20 10. The mutually agreed short- and medium-term reform agenda has been the basis for ADB’s “Infrastructure Reform Sector Development Program” (IRSDP), a cluster of three policy-based sub-program loans. The World Bank and the Government of Japan were both closely involved in preparation of the IRSDP, and the IRSDP policy matrix incorporates suggestions from the Bank and the Government of Japan. The ADB’s first sub-program loan of US$ 400 million was approved in November 2006. The Government of Japan adopted the ADB’s policy matrix, and provided a parallel US$ 100 million policy loan in March 2007.

106. Despite differences in form and scope, the Bank and ADB’s policy matrices reinforce and complement each other in supporting the Government’s overall reform agenda. For example, the IRSDP policy matrix highlights sector strategy design, development of a framework for private sector participation and support for the implementation of Perpres 67/2005, preparation and execution of model PPP projects, the creation of an infrastructure fund and improved land acquisition. The policy matrix recognizes 63 reform achievements under the first sub-program and has 99 indicative triggers for the second sub-program. In identifying a more limited set of conditions, the Bank has focused on certain elements of the Government’s program that either reinforce the ADB’s matrix or extend it, including greater emphasis on public spending at national and sub-national levels and environment. As discussions and operations go forward the Bank will seek to have these areas incorporated into the IRSDP matrix for the ADB’s second and third sub-programs, to ensure that there is a single “broad” matrix supported by all development partners, with the Bank focusing its support on a critical subset of reforms.

107. Timing of the IDPL series and the policy loans of the ADB and the Government of Japan will be synchronized and will depend on policy reform progress. Assuming adequate progress, the intervals between ADB’s three sub-programs are roughly 21 months each, with the second sub-program likely to go to the ADB Board in mid-2008, around six months prior to the proposed timing for the second World Bank operation. Both ADB and World Bank third operations are forecast to go to their respective boards in mid-20 10. LESSONSLEARNED

108. The 2005 OPCS Review of World Bank Conditionality stresses the importance of broad ownership of policy reforms undertaken in DPLs. The review suggests that policy lending should only support policies and programs where there is clear evidence of broad-based domestic support, including parliament and civil society.

109. The action items identified in the policy matrix have strong champions - the Ministry of Finance has played a key role in identifying actions where it is confident of being able to advance reforms. And the objectives sought enjoy broad popular support. One area where ownership could be questioned is that of PPPs. A transparent and competitive approach to PPP procurement is not universally supported, even within Government. This is clearly recognized as one ofthe key risks ofthe operation, but it also

34 provides an important motivation for undertaking the operation - the Minister of Finance considers that the Bank’s support through the IDPL will strengthen the reformist position.

110. The OPCS review also stresses the importance of a coordinated accountability framework tailored to the country’s circumstances. The thematic areas ofthe IDPL policy matrix are all drawn from the Government’s own program. Monitoring indicators on budget allocations, household access to electricity and water, and road length and condition are all matters on which the Government routinely collects information. While less routine, the monitoring indicators in respect of PPPs are matters of keen interest to the Government. Only in respect of land acquisition, environment, and procurement has it been necessary to work with the Government to agree on special IDPL-related monitoring indicators.

1 1 1. Finally, the OPCS review recommends focusing on actions critical for achieving results as conditions for disbursement and conducting transparent progress reviews conducive to predictable and performance-based financial support. In order to maintain the required focus, the IDPL series contains a limited number of triggers overall. In addition, an effort was made, for IDPL 1 (and in some cases for IDPL 2), to identify the first steps critical to the launch of specific reform processes. IDPL 2 and 3 triggers were then designed to sustain and deepen these processes over time. The IDPL series identifies the main features of the Government’s reform program to be supported by three distinct operations over a period of several years. Progress toward implementation ofthis reform program (and achievement of indicators that have already been agreed upon) will be reviewed at regular intervals with Government counterparts. To further increase overall transparency and predictability, these progress reviews will be coordinated very closely with ADB and JBIC. This coordination will be facilitated by the fact that the IDPL series itself has been designed in close coordination with ADB and JBIC to ensure that it complements, and progressively converges with, the infrastructure policy operations that these two development partners are jointly undertaking.

1 12. Experience gained with the Indonesia DPL series has provided particular lessons in respect of risk analysis, assessment of environmental aspects, and consultation mechanisms. 0 The IDPL risk analysis distinguishes between contextual risks (eg disasters) and those directly related to the operation and hence amenable to alleviation measures; and indicates the relative likelihoods of different risks. 0 Environmental aspects are explicitly integrated into the IDPL policy matrix, and the Country Environmental Assessment currently underway provides a platform for assessing the impact of infrastructure reforms. 0 The Government has, through its Infrastructure Summits, made significant efforts to inform the public about its reform intentions. The Bank is actively encouraging the Government to undertake additional consultation measures, as discussed in the section on Consultation.

1 13. A recent Bank review of infrastructure lending over the past twenty years5 notes the centrality of governance under both public and private provision. The past decade has

Infrastructure at the Crossroads: Lessons from 20 Years of World Bank Experience 35 demonstrated that involving the private sector is not a panacea, and that no other actors can compensate for government weaknesses in sector strategy, investment and expenditure prioritization, regulation, and risk management. There is also greater understanding of the importance of understanding the political economy of private participation, and appreciation that institutional reform and capacity building is a complex, long-lived process demanding long-term engagement.

114. The IDPL program is all about governance, and the program’s balance between public and private sectors recognizes the international lessons. In respect of the PPP elements, the reform targets are conservative - financial closure ofjust two transactions in a period of five years (2005-2010). Great efforts have been made to cap the liability of the central government for contingent liabilities from PPPs, reflecting the lessons learned from Indonesian PPPs in the 1990s. And efforts are being made to mobilize greater domestic capital to provide long-term finance for PPPs - reflecting political economy concerns about foreign investment as well as currency risk lessons from the 1990s. ANALYTICAL UNDERPINNINGS

115. The IDPL policy matrix indicates the Bank’s assessment of the key policy constraints affecting infrastructure development, grounded in practical experience of reform realities. This assessment reflects a wealth of analytical work, including analysis performed by World Bank staff in collaboration with the Government and other development partners, as well as analysis conducted in the context of technical assistance to the Government. Annex 16 sets out some of the key World Bank analytical efforts related to the IDPL reforms.

36 V. THE PROPOSED INFRASTRUCTURE DEVELOPMENT POLICY LOAN

116. The proposed IDPL aims to reduce poverty by addressing infrastructure constraints to economic growth, and by encouraging the direct provision of basic services to households - including electricity and water. The IDPL program builds on the sound macro-economic foundation that has been re-established in recent years, and opens a new area for detailed policy dialogue between the Government and the Bank. The program is grouped around four policy areas: (i)(i) central government infrastructure expenditures; (ii)sub-national government infrastructure spending; (iii)public-private partnerships; and (iv) cross-sector infrastructure support such as land acquisition, environment and procurement reform. These four policy areas combine to support the Government’s objectives of increasing public infrastructure spending while enhancing the impact of these additional investments.

117. The Policy Matrix in Annex 3 sets out the elements of the Government’s program being addressed through the IDPL series. The program involves three operations. The “prior actions”, which are conditions of disbursement of this first IDPL, have all been fulfilled. The policy matrix also sets out “indicative triggers” for IDPL 2, to be achieved by September 2008. Indicative triggers for IDPL 3 are intended to be satisfied by the middle of 2010. The indicative triggers are intended to be flexible, potentially being adjusted in timing and content to match the Government’s reform progress. This is particularly true for IDPL 3, which will be prepared following the next Presidential election in 2009.

118. The policy matrix cross-references the elements of the Government’s program that are set out in Inpres 6/2007 (Annex 2). It should be noted, however, that Inpres 612007 only covers reforms to the end of 2007, while the elements ofthe Government’s program recognized by the IDPL series extend until 2010.

119. The policy matrix also contains cross references to related elements of the ADB’s policy matrix. The IDPL policy matrix covers a carefully selected subset of the Government’s broader reform agenda. Policy actions or triggers were designed to maximize: (i)focus on reforms that are seen as key priorities by the Government; (ii) linkage to fiscal management; (iii)potential for near term impact; (iv) locking-in and providing support to important reforms.

National Infrastructure

120. The first policy area of the matrix focuses on public expenditures on national government infrastructure, supporting increased public spending and refinements to existing financing strategies that will improve the efficiency ofpublic spending. 0 Budget allocations for capital expenditure by the Ministry of Transport and the Ministry of Public Works will be increased. 0 A medium term expenditure framework will be developed for the national road network, permitting refinements of the financing strategy, including for maintenance.

37 In the electricity sector, areas for attention include refocusing PSO subsidies and rural electrification.

121. This part of the matrix builds on elements (2.1, C.2, and C.6 of Inpres 6/2007. These elements call for improvements in electricity access in rural areas, a review of PSO policy (particularly important in respect of electricity), and improvements in road maintenance. It also supports triggers 39,40, 41, 45 and 47 ofthe ADB’s IRSDP matrix. Sub-National Infrastructure

122. The second policy area in the matrix deals with the infrastructure of sub-national governments. Sub-national annual investment in infrastructure (around 1% of GDP) is almost entirely budget-funded, with very little debt being undertaken to finance investment. Borrowing is central to efficient financing of infrastructure investment, but the accumulated stock of sub-national government debt is less than 0.2% of GDP.

123. There are various legal and institutional impediments to sub-national borrowing, the most important of which is a prohibition on new borrowing when a government is in arrears to the national government on existing debt. Notwithstanding the low level of overall debt, arrears are widespread, with the practical effect that currently 107 out of 384 local governments, 16 out of 32 provinces, and 189 out of 320 PDAMs may not legally borrow. On the institutional front, INPRES 6/2007 B2 program emphasizes the need to allocate responsibilities between the Central and Regional Governments in infrastructure development. The need to clarify the authorities and responsibilities amongst the different levels of government is clearly needed to respond to the new decentralized environment to ensure improved capital and maintenance expenditures on municipal infrastructure such as water, sanitation, local roads, and possibly expansion of power services.

124. There are three elements involved in the Government’s response to this issue. The first is to restructure existing debts so that sub-national governments and their PDAMs are no longer in arrears on their payments. The second is to put in place a system of sanctions to ensure no recurrence of arrears. The final element is to provide a system of positive incentives to increase sub-national spending on infrastructure and ensure that it is used effectively. In addition, it is necessary to finalize and come to an agreement on the amounts of debt of PEMDAs and PDAMs to come to full closure on this issue. The Ministry of Finance efforts on this front could be strengthened as part ofthe restructuring and monitoring.

125. This part of the matrix supports element B.2 of Inpres 6/2007, which calls for a revision and clarification of the allocation of responsibilities between central and regional governments in infrastructure development. It also supports triggers 59, 60 and 61 of the ADB’s IRSDP matrix.

Public-Private Partnerships

126. The PPP agenda has been at the forefront of the Government’s infrastructure initiatives over recent years. Progress is gradual, but real. The Government has made great strides in establishing a new governance regime for private investment in

38 infrastructure. Developments of the legal and institutional framework have been recognized in the DPL series. The test of these developments is whether the new arrangements will deliver private investment in infrastructure.

127. PPP project preparation is complex, and rigid timetables are likely to be counter- productive. Nevertheless, over the next three years, substantial progress should be made in developing a few transactions that will serve as models for subsequent PPP project preparation, and signal Indonesia’s readiness for private investment. The major elements that need to be put in place include careful project preparation, the provision of government support and management of the Government’s risk exposure, and long-term finance available to private investors. Substantial capacity building will be required in all three areas.

128. In order to attract more private financing in infrastructure, the overall credibility of the PPP program must be enhanced. The Policy Matrix supports the Government’s PPP efforts by focusing on three main areas: (i)clarification of the legal ambiguities surrounding potential public support to sub-national PPP projects and projects that are non-compliant with Perpres 67/2005; (ii)mobilization of sustainable sources of PPP financing through establishment of the IIF and the GF; and (iii)preparation and implementation of a few initial demonstration PPP projects.

129. This part of the Policy Matrix supports elements B.l, B.4 and C.4 of Inpres 6/2007, which call for capacity building to prepare PPPs, the establishment of non-bank financial institutions for infrastructure financing, and the provision of operational guidelines for PPP projects. It also supports triggers 3,4, 69 and 70 ofthe ADB’s IRSDP matrix.

Land, Environment, and Fiduciary Responsibilities

130. Actions are needed to enhance the transparency and sustainability of infrastructure reforms. The Policy Matrix supports government efforts in four areas: (i)strengthening of existing guidelines and processes for land acquisition, (ii)enhancing of environmental safeguard processes, (iii)expanding procurement-related capacity building; and (iv) strengthening the Inspectorate General (IG) ofthe Ministry ofPublic Works.

13 I. Land acquisition is executed on the basis of provisional engineering plans (in part because ofinadequate financing for design), requiring frequent plan revisions and delays. Institutional responsibilities are unclear and overlapping. There are too many participants in the land acquisition process at every level. No specific portion of project budget that the Ministry of Public Works receives from the Ministry of Finance is allocated to land acquisition. The Ministry of Public Works has a fragmentary organization which lacks clear responsibilities for acquisition, and the role for the Ministry vis-a-vis local governments regarding national projects is unclear. Acceleration of infrastructure rollout and improved social outcomes will require a clearer framework covering responsibilities and financing for all stages of land acquisition as well as progress towards a standardized template for calculating compensation, including compensation for indirect effects. The IDPL series involves a series of triggers to support movement to such a regime.

39 132. The Government is preparing legislation on solid waste management (currently in draft and under public socialization by the Ministry of Environment). Through this law, the Government aims to create an incentive system whereby individuals will be encouraged to reduce the generation of solid waste, while local governments and businesses will be given incentives to improve the management and disposal of solid waste.

133. The AMDAL process for environmental assessment is also being strengthened to allow for greater public participation, earlier review for environmental concerns, project adjustment for mitigation, and follow up monitoring and reporting. While not guaranteeing full success across all issues, fuller implementation of the AMDAL process (with adequate resources, capacity, and public scrutiny) would have an important potential impact on environmental outcomes.

134. A number of actions catalogued elsewhere have significant governance components. Nonetheless, a number of challenges remain, particularly in the area of procurement in the Ministry of Public Works. Public Financial Management (PFM) is at the heart of governance reforms. Although but one facet of good governance and PFM, public procurement is targeted as being in particular need ofreform not least based on the finding of significant cases of corruption in infrastructure procurement processes under World Bank projects. Furthermore, disbursement in respect of development projects is slow and one reason for this appears to be a lack of capacity among procurement practitioners. With decentralization, infrastructure projects are frequently managed, either in full or in part, at the provincial or kabupaten (district) level, thereby requiring the participation of provincial and kabupaten staff in the procurement process, where capacity is particularly limited. Expanding procurement capacity and extending e- procurement should help to address these problems.

135. Audit capacity is important to monitor and improve the success of procurement policies and broader practices designed to ensure the provision ofquality infrastructure at the lowest price. At the moment, the capacity of internal audit bodies at the line ministry level, including in the Ministry of Public Works, is weak. Audits are not targeted on a risk-based approach, and audits focus on fault-finding rather than the analysis of systemic design related to issues uncovered. In part as a result, audit recommendations are not always acted upon. A reform program initiated by the IG of the Ministry of Public Works should help to address these problems.

136. This part of the Policy Matrix supports element C.3 of Inpres 6/2007, which calls for the acceleration of land acquisition processes for the public interest. It also supports triggers 5 and 36 ofthe ADB’s IRSDP matrix. POLICY AREAI: NATIONALINFRASTRUCTURE

Objective: Increased quantity and eflciency of Central Government spending on infrastructure through improved subsidy/PSO policy, and expenditure planning and budgeting.

40 Budget Increases

Prior Action: H Increased proposed 2008 APBN allocation for national infrastructure (capital expenditure buy the Ministry of Public Works and Ministry of Transport) by 30% over the 2007 level.

Indicative Trigger for IDPL 2: Maintain proposed 2009 APBN allocation for national infrastructure at least 30% over 2007 level.

Indicative Trigger for IDPL 3: Maintain proposed 201 0 APBN allocation for national infrastructure at least 15% over 2007 level.

Monitoring Indicator: Actual spending on national infrastructure increased by 25% over 2006 level by 201 0.

137. A central recommendation of the World Bank’s 2004 study “Averting an Infrastructure Crisis” was that total infrastructure investment should be increased by at least 2% of GDP, with increases desirably coming from both public and private investment. The Government is promoting PPP projects in order to increase private investment, and is examining the use of fiscal incentives and other financing mechanisms to encourage sub-national governments to increase their infrastructure investment. Investment by SOEs is likely to increase significantly in the coming years, particularly as PLN expands its capacity.

138. The element of infrastructure investment the Government can directly control is that which occurs through the national budget (APBN). Among Government ministries, the Ministries of Transport and Public Works are responsible for almost all infrastructure investment. The budget proposal put forward by the Government, but not yet approved by Parliament, increases their total budgets by 54.8% and 33.1% respectively. Within this total budget, the Government intends to increase annual capital expenditure (ie investment) by at least 30% compared to the 2007 level, through to 2009. For 2010, the Ministry of Finance at this stage prefers to keep spending promises limited to a 15% increase over the 2007 investment level, in order to provide spending flexibility for the incoming Government.

139. The desired outcome from the budget proposals put to the Parliament by the Government is an increase in actual expenditure. Rapidly increasing budget allocations may stretch implementation capacity in the ministries concerned. The Ministry of Finance will report on the actual capital expenditures achieved by the Ministry of Public Works and Ministry of Transport.

Roads

Indicative Trigger for IDPL 2:

41 . Adoption of a medium-term expenditure framework and performance based budgeting by the Ministry of Public Works for the national road network.

Indicative Trigger for IDPL 3: 80% of required maintenance/preservation budget received and applied to national roads by 201 0.

Monitoring Indicator: . 84% of national roads in goodfair condition by 2010 (compared with 81% in 2006); increase in national road lane-km as a result of new road construction by IO00 lane-km between 2007 and 2010.

140. The Government seeks to increase both road maintenance and expansion of road network capacity. It needs not only to increase budgetary allocations, but also to develop new revenue sources, and to match its future spending plans with the available resources. While high rates of returns can be expected for most roads projects currently envisaged, sound financial planning is required to mobilize revenues for the highest priority projects.

141, The Government took an important step towards the development of a Medium Term Expenditure Framework this year, with aggregate revenue and expenditure forward estimates developed for the 2008 Budget, based on macro-economic projections for two out years (2009 and 2010). (This was a trigger for DPL 4, and has been satisfied). The next steps in development of a full budget-wide MTEF is the development by line ministries of bottom-up estimates of the costs of carrying out existing and new policies, and a reconciliation between these costs and the aggregate resource envelope. The Ministry of Public Works will be one of the first line ministries to provide estimates of forward expenditures based on multi year commitments, foreseeable future implications of present spending (for example maintenance costs resulting from road construction), and planned program targets for out-years.

142. In further development of the financing framework, the Government intends to estimate the finances needed to fully maintain the national road network, taking account of plans for network expansion. The estimates may distinguish between routine maintenance and periodic maintenance. The Government further intends to ensure that the Budget provides at least 80% ofthese financing needs by 20 10.

143. To monitor the success of these initiatives, the Ministry ofPublic Works will report on the proportion ofnational roads that are in good or fair condition (currently 8l%), and the expansion ofthe national road network in terms of lane-km.

Power

Prior Action: Publication of a breakdown of the 2006 PLN PSO compensation payment by region and customer category (updated based on audit by Supreme Audit Agency).

Indicative Trigger for IDPL 2:

42 w Issuance of an integrated PLN 3-year PSO plan in consultation with Ministry of Energy and Mineral Resources, Ministry of Finance and Ministry of State-Owned Enterprises; and adoption of policy framework for regional electrification and rural access by Ministry of Energy and Mineral Resources in consultation with PLN, Ministry of Finance, and BAPPENAS.

Indicative Trigger for IDPL 3: Review of basic electricity tariff(TDL) and level and coverage of subsidy.

Monitoring Indicator: 60% of population with access to electricity by 2010 (compared with 55% in 2003).

144. The national electricity tariff structure is set below the level of PLN’s costs. Consequently, PLN has weak commercial incentives to extend network coverage: new customers increase PLN’s losses. To ensure that PLN remains financially viable, the Government provides a “public service obligation” subsidy, which covers the difference between the tariff and the estimated cost of different consumer classes. This subsidy is not currently targeted to the poorest consumers nor directed towards expanding coverage.

145. The first step in redirecting subsidies is publication of the beneficiaries of the subsidy, across regions and classes of users. The World Bank has already provided some preliminary analysis on this issue, but Government publication of these figures will provide greater Parliamentary and public scrutiny, helping to build support for further reform.

146. By the middle of 2008, the Government intends to develop a medium term strategy addressing PLN’s power development and expansion targets with better integration of the PSO, tariff policy, and corporate responsibility reforms. The aim is to ensure that electrification capacity and connection targets established by the Ministry of Energy are consistent with the established tariffs, and that any shortfall is provided through the PSO in a predictable manner. Integration is also intended to ensure that the Ministry of State- Owned Enterprises, which is the corporate shareholder of PLN, would support the necessary financing required to undertake the planned expansion.

147. The Ministry of Energy and Mineral Resources (MOEMR) will also produce a policy framework on regional electrification and rural access by the middle of 2008. The policy framework is intended to encourage sub-national governments and PLN to cooperate on electrification at the regional and district level. Already under development, it consolidates present laws and policies that enable sub-national electrification options, indicates the planning and design process through which PLN and the sub-national governments can develop solutions, and highlights how they may obtain central government support in terms of technical assistance, planning, possible subsidies, and access to financing. Once the Policy Framework is implemented, PLN and local governments could agree through a memorandum of understanding (MoU) the electrification needs in the area as well as the responsibilities ofeach stakeholder in terms of implementing the agreed solution. The signing of MoUs would indicate that the electrification plan in a given region goes beyond a simple target, and that there is a concrete expansion plan with a commitment to fund and implement it. Such an effort is 43 already being supported by the MOEMR in four regions in Indonesia with the support of the World Bank.

148. Ultimately, tariff reform is required to set the electricity sector on a sound financial footing, and providing clear commercial incentives to expand household access. The Government is aware of this, but having substantially reduced fuel subsidies in 2005, has been reluctant to increase prices before the next election, due in 2009. The Government will review the tariff after the election. This review could provide an opportunity to redirect subsidies to provide stronger incentives for electrification.

149. Based on PLN’s figures for connections, 55% of the population currently has access to electricity. There are alternative measures, based on survey evidence, which report a higher level of access. For monitoring purposes PLN’s figures will be used to determine the total level of access. by 2010. POLICY AREA11: SUB-NATIONALINFRASTRUCTURE

Objective: Improved sub-national infrastructure services through increased sub-national government spending and an improved incentives framework

Sub-National Governments

Indicative Triggersfor IDPL 2: w Implementation of sub-national government debt restructuring, including possible use of intercept mechanism. Formulation of a strategy to incorporate performance incentives into the intergovernmentalframework.

Indicative Trigger for IDPL 3: Implementation of performance incentives in the intergovernmental $financial framework.

Monitoring Indicator Increase in sub-national budget (APBD) capital expenditures by 20% over 2005 level by 201 0.

150. The Government has a three-pronged strategy for increasing the level and effectiveness of sub-national governments’ infrastructure expenditures. Debt arrears will either be restructured or extinguished, in order to remove legal impediments to new borrowing. New sanctions will be introduced to ensure that sub-national governments do not again fall into arrears. And fiscal incentives will be introduced to encourage greater and better spending on infrastructure.

15 1. The Government has begun to restructure the debt of sub-national governments and PDAMs, under a legal framework established by a 2005 Perpres, and KMKs issued in 2005 and 2006. But the current case-by-case approach, with individual deals being negotiated for each entity with arrears, could take many years. Recognizing the likely delays, the Ministry is now seeking to develop revised regulations which would permit the restructuring ofdebts for entire classes of entities.

44 152. The national Government could resolve the issue of arrears, and provide strong incentives to prevent their recurrence, by withholding a proportion of annual “balance fund” transfers. The balance fund (DAU) is a system of block transfers, comprising about half of sub-national governments’ revenues. Legislation already exists that would permit the “interception” of funds being transferred under the DAU. But the Government has been hesitant to use the intercept, partly out of concerns for the political impact.

153. The Government took a first step in June 2006 when the Ministry of Finance delayed DAU transfers to five local governments that had not submitted their 2006 budgets to the ministry as required. Within two weeks all five governments had complied. By 2008, the Government will begin using the intercept regularly to recover arrears in respect of any debt incurred since 2001.

154. Removing legal impediments to borrowing will not be a panacea. Many sub- national governments lack the capacity to plan for large infrastructure investment, or have misaligned incentives to direct spending to other uses, such as excessive administration budgets. While not a complete solution, the Government intends to develop a system of fiscal incentives, such as matching grants, to encourage sub-national infrastructure expenditures. The process will begin with a review of the existing incentives as well as international experience. The Government seeks to have a new system of incentives in place by the middle of2010.

155. The new incentive framework to be incorporated in the intergovernmental financial framework is expected to lead to increased sub-national budget allocations for capital expenditure which in turn will assist in addressing sub-national infrastructure deficiencies.

PDAMs

Indicative Trigger for IDPL 2: I Adoption of revised DG Treasury Decree 53/PB/2006 and related regulations to facilitate and accelerate PDAM debt work-out and implementation of the Financial Restructuring Action Plans.

Indicative Trigger for IDPL 3: Implementation of work-out of debt of 60 PDAMs and provision of long-term loans to 25 PDAMs.

Monitoring Indicator 35% of urban population with access to piped water by 2010 (compared with 31 % in 2006).

156. Around US$ 4.6 billion of investment will be needed during 2004-2015 to meet Indonesia’s targets for clean water. The Government envisages that around 60% of the finance needed for piped water systems will be provided through loans from international financial institutions. But not a single such loan has been approved in the past ten years. A major obstacle to the provision ofnew loans is the existence of arrears on debt owed to

45 the Ministry of Finance. Currently, 213 PDAMs have arrears, or are owned by local governments with arrears, and are not permitted to access debt finance from foreign organizations. To improve the flow of funds from financial institutions to meet the Government’s targets, progress is required on INPRES 6/2007 B2 which emphasizes the need to clarify responsibilities between central and regional governments in infrastructure development - also emphasized in ADB and other DPLs.

157. The Government initiated a process of debt restructuring, debt forgiveness, and management reforms for individual PDAMs in 2005. The legal foundation for debt restructuring is established by Ministry of Finance through PMK 107/2005, with implementing guidelines set out in DG of Treasury Regulation PER-53/PB/2006. As a pre-condition for debt restructuring PMK 107/2005 requires that PDAMs participate in the Financial Restructuring Action Plan (FRAP), which is designed to improve the operational performance of PDAMs through changed management, and commercial or technical improvements.

158. Under the terms of DPL4, the Government had committed to implement the work out of debt of at least 10 PDAMs and/or local governments. Although this target has been met, the current approach to the development of action plans for individual PDAMs is time-consuming, delaying the beginning of negotiations on debt restructuring. PMK 107/2005 delays debt forgiveness until two years of restructuring have been attempted. It also provides debt restructuring opportunities to the weakest PDAMs only. DG of Treasury Regulation PER-53/PB/2006 for its part includes requirements (such as having three years of unqualified audit reports) which are likely to prevent some PDAMs from participating in the FRAP. DG of Treasury Regulation PER-53/PB/2006 also creates some perverse incentives (for example, it links the extent of debt forgiveness to PDAMs’ ability to generate cash, thereby prompting PDAMs to manipulate their accounts).

159. The Government intends to revise the regulations by the end of 2008, to streamline and accelerate the process. The new approach will open the debt restructuring process to all PDAMs and permit forgiveness ofpenalties for debt arrears as soon as a PDAM, local government, and the Ministry of Finance reach agreement on actions to be taken to improve the PDAM’s operations, such as timely repayments of arrears to the Ministry of Finance and implementation oftariff increases.

160. Improved operations and debt restructuring would enable PDAMs to access long term finance, which in turn would enable the investments needed to undertake improvements in service including increases in the number of household connections. The Government expects to be well-advanced in the implementation ofthese reforms by the end of 2010, with the restructuring of the debts of 60 PDAMs, and 25 PDAMs having moved on to the stage ofactually accessing long-term loans.

161. Opening up long term financing sources to PDAMs financing through debt restructuring, combined with improved operations (as well as fiscal incentives for local governments to invest in infrastructure services as discussed above), should pave the way for increased access to piped water. The monitoring indicator indicates not only success in improving PDAM operation and managing the debt restructuring process, but also that new investments in water distribution have taken place. Improving access to long term financing requires resolution ofthe amounts of debt for each PEMDA/PDAM, as well as 46 clarification of investment and implementation authorities and responsibilities among the different levels of government. POLICY AREA111: PUBLIC-PRIVATE PARTNERSHIPS

Objective: Increased private investment in infrastructure through the establishment of a fiscally sound, credible and transparent PPP framework.

Transactions

Indicative Trigger for IDPL 2: 8 Initiation ofpre-feasibility studies for 6, feasibility studies for 4 and tendering for 2 PPP projects in full compliance with Perpres 67/2005 requirements.

Indicative Trigger for IDPL 3: 8 Initiation of feasibility studies for 4, tendering for 2 and award and financial close of 2 PPP projects prepared and tendered in compliance with Perpres 6 7/2005.

Monitoring Indicator: 8 PPP transactions tendered in compliance with Perpres 67/2005 attract at least 3 responsive bids on average.

162. The Government had hoped to make more rapid progress in attracting private investment in infrastructure. In reality the enabling environment is only partially established. The last few years have demonstrated that non-transparent deals made by political insiders do not provide a means of accelerating infrastructure investment. Instead, careful project preparation is required, following the criteria set out in Perpres 67/2005 , with feasibility studies, transparency, and clarity concerning the Government support required.

163. The Government has recognized the inherent difficulties. Where the January 2005 Infrastructure Summit announced 9 1 transactions for potential private investment, the December 2006 Infrastructure Summit focused its attention on ten transactions intended to serve as models ofgood project preparation.

164. Progress on particular transactions would be a major advance, because of the signal it would send to investors, and also because of the precedent value for all agencies involved in preparing PPP transactions. International experience and Indonesia’s recent experience suggest caution in setting progress on transactions as triggers for policy lending. Nevertheless, progress on transactions is the real test of the entire institutional development, and so it is appropriate to include this as a trigger for future operations. The IDPL triggers focus on supporting the development of a pipeline ofprojects prepared in a way that is consistent with the legal and institutional regime established by the Government, with two projects having reached financial closure by 2010.

165. The monitoring indicator focuses on the number of bids received when calls for PPP proposals are made. There are many potential PPP projects for which the economic fundamentals should permit mutual benefit to the Government and private investors. The

47 level of investor interest is thus a market indication of whether the Government has adequately prepared the projects.

Non-Compliant Projects

Prior Action: H No allocation of Government support for any PPP project that is not compliant with Perpres 67 since the issuance of Perpres 67, absent a special andproject- specijk Perpres allowing non-compliance with Perpres 67 for that project in particular.

Indicative Trigger for IDPL 2: 8 Adoption of (i) a legal instrument specifiing the conditions and procedures for seeking government support for already awarded PPP projects not compliant with Perpres 67/2005 and (ii) a legal instrument to clarifi eligibility of PPPs promoted by SOEs or sub-national entities for public support.

Indicative Triggersfor IDPL 3: Implementation of new legal framework for non-compliant projects.

Monitoring Indicator Financial close/termination, by 2010, of all toll road concessions signed prior to August 17, 2007.

166. It was initially intended that the KKPPI would act as a filter on project quality, and that only well-prepared projects would pass to the RMU to be considered for public support. But the KKPPI has been slow to establish capacity within its Secretariat, with the result that line ministries have taken their requests directly to the RMU. The RMU has had difficulty managing the influx of requests in respect of poorly prepared projects seeking government guarantees.

167. As private investment has been slow to materialize, pressure has mounted for the RMU to authorize guarantees for projects which do not comply with Perpres 67/2005. To its credit, the Ministry of Finance has resisted these pressures, and this achievement is recognized as a significant “prior action”.

168. Recognizing the desirability of giving guarantees to at least some of these projects, in order to kick-start private investment, but also seeking to avoid undermining Perpres 6712005, the Government intends to develop a one-off process for resolving the backlog of non-compliant projects. To receive public support, a non-compliant project awarded before November 2005 must have (i)confirmation from Bappenas that it is classified as a strategic project, (ii)a request from a supporting line ministry to the RMU indicating the amount of government support sought, and (iii)an assessment by the RMU that government support represents value for money and that the required government support fits with the available funding envelope. Projects awarded after November 2005 but before 17 August 2007 must also have a Perpres indicating a waiver of Perpres 67/2005 requirements. All other projects must be fully compliant with Perpres 67/2005 in order to receive government support.

48 169. Another avenue for limiting the number of poorly prepared projects is to reduce the legal ambiguities. Whether the RMU can provide government support to PPPs promoted by SOEs or sub-national entities is currently unclear under Perpres 67/2005. The Government intends to clarify that government support may be provided to such projects, facilitating for example PPP initiatives by local government in water and sanitation, rural electrification, ferry ports, and other infrastructure.

170. The issue of non-compliant projects is of particular concern in the toll-road sector where concessionaires have failed to obtain financing for their projects or to commence construction, and uncertainty over their legal rights constrains the development or reallocation of these projects. The Government has announced that it will require all such projects to either achieve financial closure by 2010, or else they will be terminated under the new legal regime established in 2008. The resolution of non-compliant toll-road concessions will serve as an indicator of the practical effectiveness ofthe new regime.

PPP Financing

Prior Actions: Allocation of Rp. 3.0 trillion in proposed 2008 APBN for the Indonesia Infrastructure Fund (IIF), the Guarantee Fund, and land acquisition. . Submission of draft Government Regulation to the President to establish the IIF to support development of local currency long-term infrastructure financing.

Indicative Triggers for IDPL 2: Production of draft package of legal documents needed to establish the Guarantee Fund. . Mobilization of equity and debt from multilateral, bilateral, and private investors to the IIF; IIF to be fully staffed and operational.

Indicative Trigger for IDPL 3: . Operationalization of Guarantee Fund with clear procedures and a shadow rating.

Monitoring Indicator: Private sector financial commitments to private infrastructure projects increase to 0.75% of GDP by 201 0 (compared with 0.5% in 2005).

171. Various forms of Government support are likely to be needed in order for PPP transactions to achieve financial closure. The Government is establishing the Indonesia Infrastructure Fund to address a shortage of long tenor limited recourse debt in local financial markets. The Guarantee Fund will facilitate the provision of Government guarantees against particular risks in PPP projects. And the Government can substantially lessen the risks faced by private investors by purchasing the land required for particular projects.

172. The Government has set aside in the draft 2008 Budget Rp. 3 trillion (over US$ 300 million) to use in establishing the IIF and the Guarantee Fund, and for purposes of land

49 acquisition. In addition, the the necessary regulations to establish the IIF have been approved, and are now awaiting Presidential approval. The legal work, the mobilization of funds, and the operationalization of the IIF and the Guarantee Fund will continue through to 2010.

173. The monitoring indicator, which seeks an increase in private sector financial commitments to private infrastructure projects, serves not only to indicate the success of PPP financing measures, but indeed of all of the measures associated with PPP development. POLICY AREAIv: LAND,ENVIRONMENT, AND FIDUCIARYRESPONSIBILITIES

Objective: Enhanced governance for infrastructure through improved land acquisition, environmental protection, and procurement and audit processes within the Ministry of Public Works. Land

Prior Action: Issuance of a KKPPIKMEA decree to establish an inter-ministerial Land Working Group to address land acquisition issues with active participation of BPN.

Indicative Triggers for IDPL 2: Adoption of an action plan by the Land Working Group to accelerate land acquisition processes and ensure fair compensation and rehabilitation measures to project affected persons. Adoption of Ministry of Public Works decree, in agreement with Ministry of Finance, on allocation of land acquisition and compensation costs as project costs in budget allocation for each Ministry of Public Works/Directorate-General of Highways national roads project.

Indicative Trigger for IDPL 3: 8 Implementation of Land Working Group’s action plan.

Monitoring Indicator: Collection of data on delays and level of compensation paid for land acquisition for all national roadprojects in 2009 and 201 0.

174. The main objective of the IDPL is to accelerate investment in infrastructure projects and to ensure that this be achieved without adverse impacts on the livelihoods of affected persons. In order to achieve these objectives it is imperative that the Land Working Group is established under KKPPI with core membership of representatives of CMEA, BAPPENAS, DGH, Jasa Marga, Ministry of Home Affairs and BPN and with other floating members as required to develop an action plan to address land acquisition constraints that have slowed financing in infrastructure projects in the past and lead efforts at coordination of land acquisition policy going forward.

175, .The inconsistencies that characterize current land acquisition practices and implementation procedures in Indonesia are partially due to the lack of uniform

50 implementation guidelines supporting the existing legal framework. Procedural issues are largely focused on land expropriation, compensation and the appeals process. The Land Working Group will be tasked with producing an action plan by January 2008 to set the reform agenda on land acquisition. It is intended that the recommendations of the Land Working Group will feed into the IDPL 2 and 3 triggers for 2008 and 2010 respectively. The action plan will include, but will by no means be limited to, recommendations on: Legal framework and exercise of eminent domain: The prevailing regulations and laws that govern land acquisition in Indonesia force all acquisitions to go through a complicated negotiation process prior to land expropriation. Negotiations are often lengthy and, as the law is currently situated, allow for a grievance process that may continue until land rights must be revoked through an act of the President. The Land Working Group will review the prevailing laws and regulations, assessing potential need for amendments, new legal instruments or other changes with respect to expropriation powers and the eminent domain process. 0 Implementation guidelines: Land expropriation procedures and guidelines are still in conflict between different institutions leaving the most vulnerable project- affected-persons - such as squatters, share-croppers and other non-titled inhabitants - without clear rights. The Land Working Group will oversee harmonization ofthe guidelines and ensure these issues are addressed.

0 Institutional setup: Multiple stakeholders participate in the land acquisition process at many levels. MOPW, MOF and the national P2T (Panitia Pengadaan Tanah, Land Acquisition Committee) are all empowered to contribute to the process at the national level. The effectiveness and the activities of local level P2T committees, including the balance of between local and non-local voices, vary from kabupaten to kabupaten. The result is non-uniform implementation of what should be a standardized land acquisition process, with the method of implementation in each project largely determined by the makeup of local P2T committees. The Land Working Group will make recommendations on the ideal institutional arrangement that will allow land to be acquired on behalf of all government agencies and line ministries. 0 Negotiations resolution: The current negotiation based process leads to excessive delays and price escalation due to the lack of a fair and independent mechanism for the valuation of land. The Land Working Group will explore the possible role of an independent land valuer in the land acquisition process and design a new process to exploit the advantages that this offers.

176. The lack of funding transparency complicates and slows the land acquisition process. No specific portion of project budget that the MOPW/ DGH receives from the MOF is allocated to land acquisition. This leaves DGH to internally determine what portion of project budget to use for land acquisition, in a less transparent, more ad hoc manner. Inclusion of land acquisition as a separate project cost in national roads projects undertaken by DGH will ensure that the required funds are available and utilized in a more efficient manner.

177. Collection of data on delays and level of compensation paid for land acquisition for all national road projects would constitute a real step forward as the Government does not collect such information at present.

51 Environment

Indicative Trigger for IDPL 2: . Submission to Parliament of revisions to Law on Waste Management to reduce the generation and improve the handling of solid waste.

Indicative Trigger for IDPL 3: . Submission to Parliament of amendments to Law 23/1997 on Environmental Management to improve the implementation and enforceability of the AMDAL process.

Monitoring Indicators: . Improvement in the quality of AMDALs and capacity to conduct AMDALs at national and local level. Decline in the open-dump disposal of solid waste.

178. Many environmental issues are being addressed by the Government, but not all of these are relevant to infrastructure and most will be accomplished outside the IDPL document and process. The rationale for including environmental issues in the matrix is to raise issues and recognize key targets for improving the Government’s environmental management program in conjunction with its developing infrastructure program.

179. The proposed triggers focus on waste management and environmental management because it is a key area of intervention where the Government could make progress to improve environmental outcomes on infrastructure projects using existing institutional frameworks, and human resource capacity.

180. The Law on Solid Waste Management (currently in draft and under public socialization by the MOE) aims to create an incentive system whereby individuals will be encouraged to reduce the generation of solid waste, while local governments and businesses will be given incentives to improve the management and disposal of solid waste. The draft law requires for example that local governments develop closed waste management facilities (Le., sanitary landfills) and cease the use of open dumping within 5 years of the passage of the law. The law also governs partnerships and creation of user groups to improve solid waste management at the level of district or city government. Significantly, citizens’ groups that believe they have been harmed by poor solid waste management practices have the right to bring a class action suit for redress and compensation.

18 1. The MOE will complete draft revision of Law on Environmental Management (UU Pengelolaan Lingkungan Hidup, update of UU 23/1997, which includes EINAMDAL process). The final version will include improved climate change and law enforcement features, especially concerning AMDAL, the Indonesian EIA process. Associated PP are also in the process of being revised. It is expected that these revisions will improve the application, implementation, and enforceability of the AMDAL process.

52 182. Implementation ofthe new law of Solid Waste Management is expected to lead to a decline in the open dump disposal of solid waste and to an increase in the proportion of solid waste that is recycled, recovered, composted or disposed of in a sanitary landfill. Strengthening of the AMDAL process should result in more effective public consultations, higher quality environmental management and monitoring plans, and abidance by local governments to minimum standards of operation.

Procurement

Prior Action: . Use of MOP W semi-e-procurement system for all national roads works contracts used in Java and Sumatra valued above Rp. 10 billion.

Indicative Triggers for IDPL 2: . Expand the use of the semi-e-procurement system for all national roads works contracts used in Java and Sumatra and to two other provinces. Establishment of Procurement teamhit in DGH staffed, funded and mandated to provide support to procurement committees in terms of advice, capacity building, review and streamlining of procurement procedures and promotion of standardized bidding documents.

Indicative Triggers for IDPL 3: . Implementation of full transaction-based e-procurement system for all MOP W national level procurement. . Expand the scope of the Procurement teamhit to other directorates in the MOP w.

Monitoring Indicator: . 80% of construction/works contracts funded by APBN are awarded within 45 days of bid opening.

183. A twin approach of expanding the use of the current semi e-procurement in the MOPW and creating a procurement team/unit(s) is supported under this program. It is envisaged that the Ministry will expand the use of the semi e-procurement to two additional provinces by 2008 while the trigger for 2010 will be the use of a full procurement system in all provinces. In parallel, procurement units will be established to strengthen procurement capacity in DGH as a trigger for 2008 and will be expanded to other directorates by 2010.

184. The MOPW and the City of Surabaya have both been at the forefront in the development of e-Government Procurement (e-GP) technology. Although they are independent e-GP systems, they are similar to some extent. The Ministry’s system is referred to as a semi e-procurement system as it includes bidding process up to the point of submission of bids which have to be done in hard copy and continues as a manual process. Until LPKPP is established, Bappenas has been taking the lead on behalf of the Government for implementation of e-GP in Indonesia at a national level. Currently, the focus is on developing policy and legislation for the validity of e-GP including electronic documents and signatures. Eventually the Ministry will need to decide whether to adopt

53 the national system in its entirety or ensure that its own system will integrate with it. Currently, the MOPW system is used for national road works contracts valued at more then 10 billion IDR in Java and Sumatra. For IDPL 2, the Ministry should expand the system for use all road contracts in Java and Sumatra in addition to two other regions. Ultimately, the IDPL 3 trigger for 2010 would be the use of a full e-procurement system in all provinces.

185. Unlike personnel from the central MOPW who are involved in numerous complex infrastructure procurement packages on a day-to-day basis, the capacity and confidence of such staff sourced from provinces and districts is expected to be much weaker. Therefore, it is proposed that the Ministry, which is responsible for most infrastructure projects, establish a central ministerial procurement office/unit/team in DGH and staffed by competent procurement specialists, preferably certified to a high level of experience, to be set up and piloted initially within DGH by September 2008 as a trigger for IDPL 2. The purpose of such a central procurement unit will be; (a) First, being centrally located within MOPW DGH Jakarta, it would liaise with the newly established LPKPP so as to ensure that the Ministry in general, and DGH in particular, procurement processes are (i)in accordance with national laws and regulations (currently UU 18/1999 on Construction Service and Keppres 80/2003) and (ii)are consistent with central Government public procurement policies and reforms. Where possible, the team will work to simplify current process and increase transparency. (b) In particular, the unit /hub would ensure that MOPW / DGH standard bidding documents and any other Ministry or DGH procurement manuals are updated, consistently used at all levels and are in accordance with national standards and international best practice. The team should also consider customizing the harmonized standard bidding documents for multilateral agencies for use in all of its externally financed projects for ICB. This will mean less work for DGH staff in dealing with these projects on a case by case basis and more efficiency/ consistency for bidders and evaluation committees alike. (c) that DGH staffs involved in procurement are trained to a basic level of competence with specialist expertise in highways, and, where procurement complaints / grievances related to highways are directed to the relevant project management unit, provide impartial expert advice to assist in their resolution. Second, the unit would provide a “pool of expertise” or a “knowledge resource” for tender committees to “tap into” when undertaking procurement for highways should the committees feel it lacks the capacity and/ or confidence to undertake a particular procurement. Knowing that such a resource or pool of expertise is available will help instill confidence and, hopefully, overcome concerns regarding potential liability.

186. Having piloted this procurement unit within DGH since September 2008, it is envisaged that the MOPW would expand it into all other Directorates General within the Ministry by mid 20 10 as a trigger for IDPL 3. The structure for such expansion would be left to the Ministry. The unit could be taken out of DGH and become a centralized hub within the Ministry as a whole, perhaps under the Secretary General, with additional specialist expertise added to assist the other respective DGs, or, alternatively, additional specialist procurement units could be created within every DG

54 187. One measure of success of these procurement reforms - on which the monitoring indicator focuses - is a reduction of the time needed from bid opening to contract award by the MOPW.

Audit

Indicative Trigger for IDPL 2: I Adoption of an action plan to strengthen staff capacity at Inspectorate General of Ministry of Public Works and introduce modern risk-based methodology and practices to provide assurance on the Ministry of Public Works ’ internal control systems and compliance.

Indicative Triggersfor IDPL 3: Implementation of the action plan and clearly demonstrated adoption by the Inspectorate General of modern methodology and practices.

Monitoring Indicator: Production by the Ministry of Public Works Inspectorate General of relevant and effective internal audit reports - including identijication of weaknesses in control systems and recommendations to the management for improvements and sanctions - and timely implementations of the reports’ recommendations.

188. While progress has been made in addressing key weaknesses of the central audit functions, internal audit within individual line ministries remains quite weak. The goal of the IDPL is to extend the process of audit reform from the central audit agencies to the line ministry level in the MOPW. The Inspectorate General office in the Ministry is proposing a pilot reform agenda, to be supported under the IDPL, to improve audit performance. In particular, the Inspectorate General will move away from a system of unfocused audit effort towards a risk-based selection procedure and away from a focus on fault-finding to an analysis ofrequired systemic reforms brought to light by audit cases.

189. Production by the Inspectorate General office of high quality audit reports focusing on systemic recommendations combined with a more systematic implementation ofthese recommendations by the Ministry would demonstrate the success ofthese reform efforts.

55 VI. OPERATION IMPLEMENTATION

POVERTY AND SOCIAL IMPACTS

190. In order to systematically analyze the link between proposed policy reforms and the associated poverty and social impacts, a Social Impact Assessment (SIA) will be carried out prior to IDPL 2. The assessment will identify the range ofpositive and negative social impacts and examine the distributional impacts of the reform program on different stakeholders, with a particular focus on the poor and vulnerable. The scope of the SIA will be worked out in consultation with the Government and other development partners, particularly the Asian Development Bank.

19 1. The welfare effects of many of the IDPL policy reforms are likely to take a decade or more to be realized. Many of the policies are intended to improve governance over the next few years, which will induce new investment plans, which in turn will induce infrastructure construction. The process of construction may yield some social dislocation. Only when construction of new infrastructure is completed do the benefits begin to be realized.

192. All of the reforms embodied in the IDPL are intended to provide a boost to economic growth and aggregate welfare. The extent to which the poor participate in the benefits of growth has varied over time in Indonesia. Given the public good nature of many infrastructure services, it is possible that infrastructure-derived growth could be more pro-poor than other sources of growth in Indonesia’s recent history.

193. International experience indicates strong linkages between infrastructure service provision and poverty reduction. Reliable, affordable and cost-effective provision of infrastructure services can help in improving health and education outcomes (reducing levels of child mortality from water borne diseases, respiratory illnesses, better access to schools and clinics) and indirectly in reducing the fiscal burden of governments to create space for other expenditures. Improved access to reliable infrastructure services can increase the general welfare of poor households through reductions in the opportunity costs (both time and money) associated with finding imperfect alternatives to meet essential needs.

194. Several IDPL reforms are focused on directly increasing household access to services, including rural electrification and access to piped water. Access to such services is currently highly regressive. Network expansion is likely to reduce this regressivity, although international experience suggests that the poorest sections of the community are usually the last to be connected. Policies addressing sub-national governments’ incentives to invest in infrastructure may, in time, improve the provision of rural roads. Rural roads typically have significant effects on the reduction ofpoverty.

195. The timing of changes, if any, to electricity subsidies and pricing has not been specified in the IDPL reforms, but measures calling for their review have been included with the aim of reducing their regressive impact. In 2005, the Government provided Rp. 11 trillion of subsidies to the electricity industry. The poorest 10% of Indonesians benefited from an estimated Rp. 900 billion of subsidies, while the richest 10% received

56 Rp. 1.3 trillion. Upward electricity tariff revisions would adversely affect those who already have connections, but would help to expand the rate of connection, particularly in the eastern provinces where poverty rates tend to be higher.

196. Notwithstanding the many social benefits of improved infrastructure, there may be some social costs associated with expanded infrastructure investment. In particular, land acquisition associated with road construction may have adverse social consequences. Indonesia’s current standards of compensation do not meet World Bank standards, particularly in respect of loss of livelihood. Those without formal title receive no compensation for relocation. The IDPL reforms which envisage improved compensation standards may help to mitigate the adverse social consequences. PARTICIPATION

197. The Government has an active “socialization” program as part of its infrastructure reform agenda. It engages regularly with a variety of business, religious, and civil society organizations. Particular highlights in recent times include the two highly publicized infrastructure summits held in 2005 and 2006. As well as being a forum for soliciting private investment, the summits were used by the Government to communicate its infrastructure reform plans to the broader public.

198. The Government regularly seeks feedback from the business community, including through business forums in oil and gas, mining, transport, roads, energy and other sectors, various bilateral and multilateral chambers of commerce. The Government is currently planning several events to promote private participation in infrastructure, including a conference to promote PPPs in transport and a business forum to attract investors in the proposed Palapa Ring National Telecommunications Backbone.

199. While the Government’s communication with the private sector is strong, the role of broader civil society in the decision-making process remains minor. With that in mind, design of the IDPL package includes an important component focusing on increasing the quality of infrastructure through increased civil society oversight (e.g. PSO transparency, procurement reform, environmental reform). Furthermore, as part of the preparation process of the loan, socialization meetings have been organized by the Bank with several local non-governmental, religious and civil society organizations and senior staff of the World Bank. Some of the largest and most influential organizations have participated, including Nahdlatul Ulama the Centre for Strategic and International Studies (CSIS), the Habibie Center, and the Institute for Development of Economics and Finance (Indef). The World Bank’s ongoing relationship with civil society will serve to reinforce the reforms supported by the IDPL and ensure their continuing success.

IMPLEMENTATION, MONITORINGAND EVALUATION

200. The over-arching objectives ofthe operation are to: (a) increase, and enhance the efficiency of, Government spending on infrastructure resulting in improved infrastructure services at the national and sub-national level; (b) increase private investment in infrastructure under a transparent, credible framework that maximizes the overall benefits of such investments; and (c) enhance governance for infrastructure that ensures that the infrastructure reform program is conducted in an equitable and sustainable manner.

57 201. Following through the results chain, indicators closely link to the achievement of these objectives include: (i)the level of public and private infrastructure investment and expenditure; (ii)the level of access to services such as electricity and water; (iii)the quality of provision (such as the quality of the road network for example); (iv) measures of the quality and timeliness of land acquisition, environmental assessment, procurement and auditing processes. Progress toward achieving these indicators will be reviewed at regular intervals with Government counterparts and in very close coordination with ADB and JBIC. Table 10 lists: (i)the specific targets or indicators that will be used to assess reform progress; (ii)the current situation or baseline pertaining to each of these indicators; and (iii)the Government partners primarily responsible for monitoring progress toward each ofthe indicators.

Table 10: Monitoring and Evaluation Framework b Indicators I Objectives Baseline (Monitoring)

...... s were in goodfai were 74,000 nationa

Capital expenditure by the Ministry of Public Works (Rp. 14.1 trillion) and Ministry of Transport (Rp. 4.7 trillion). ’ 2005 capital expenditure estimated at 50% of total sub-national development expenditures; new budgeting system will permit direct calculation of capital expenditures by 2010. All preconditions to first drawdown of debt fulfilled or waived.

58 Table 10: Monitoring and Evaluation Framework Indicators Objectives (Monitoring) Baseline ~nvitmmenta1 Protection, - Improvement in the quality of AMDALs and capacity to - Limited actions to address existing AMDAL and Procurement and audit conduct AMDALs at national and local level' (MoE). known weaknesses, and lack of technical and processes within Ministry ofPub,ic Works,the Decline in the open-dump disposal of solid waste (MoE). for review, and - monitoring of AMDAL functions at local level; %pres - C.31 IO - Open dump waste disposal is 53% in large and ...... gmedium-size cities, and 85% in small cities. 'I - 80% of constructiodworks contracts funded by APBN - Very few constructiodworks contracts funded are awarded within 45 days of bid opening (MoPW). by APBN were awarded within 45 days of bid ...... oPK!in~...ifl.20!6.:...... - Production by the MoPW IG of relevant and effective - Audit reports of the MoPW IG tend to lack internal audit reports - including identification of systemic recommendations on how to deal with weaknesses in control systems and recommendations to weaknesses in control systems, and focus instead the management for improvements and sanctions - and on recording individual lapses or failures. timely implementation of the reports' recommendations

TECHNICALASSISTANCE TO SUPPORT IMPLEMENTATION

202. Considerable donor technical assistance has been, and will continue to be, provided in support of the Government's PPP reforms. World Bank staff have been closely involved in the development ofthe PPP institutional and regulatory framework, including the KKPPI Secretariat, PPP Unit, Risk Management Unit, Guarantee Fund, and the Indonesia Infrastructure Fund. The World Bank regularly provides rapid response policy notes to assist the Government as it develops the PPP framework and transactions. Trust funds are used to build capacity and to develop operational procedures for the Risk Management Unit, and to help design the Guarantee Fund. A World Bank technical assistance loan, PPITA, has been used to aid in making the PPP Unit operational, and to fund international experts to assist line ministries to prepare PPP transactions. IFC Advisory Services are negotiating with the Government over the terms of a possible mandate to prepare the transaction for an independent power plant in central Java. AusAID has provided a recognized infrastructure expert to work directly with the Ministry of Finance in dealing with strategic reform issues. The ADB has established a project development facility focused on developing ten PPP transactions intended to serve as models of good practice.

203. The intergovernmental and sub-national reform agenda is supported by a plethora of donor technical assistance activities. Donors participating in the Bank-managed Decentralization Support Facility (DSF) include DFID, AusAID, CIDA, GTZ, USAID, and UNDP. Activities are concentrated most heavily in the three thematic areas of service delivery, planning and budgeting, and financial management/procurement. Under the DSF, the Bank is leading the design and implementation of activities dealing with: 0 Restructuring of sub-national government and PDAM debt; 0 The regulatory framework for sub-national bonds; 0 a regulatory framework for sub-national public bankruptcy and insolvency;

' Improvement is defined by: (i) better definition of the objectives and expected outputs of public involvement/consultation in AMDAL; (ii) strengthening of existing procedures for RKLRPL by requiring a detailed SPDL to be produced within the first year of operation; and (iii) progress to establish minimum standards of operation for local governments covering institutional, human resources, and budgetary requirements, linked to incentive systems for good performance. "' Ref to World Bank. 2006. AMDAL Reform and Decentralization: Opportunities for Innovation in Indonesia. Discussion Papers, East Asia and Pacific Environment and Social Development Unit. Washington D.C. I' Statistics from the Ministry of Environment State of the Environment Report 2006 59 training for Ministry of Finance staff involved in cost-benefit analysis of local infrastructure projects; 0 development ofthe fiscal incentive framework for sub-national governments; and development of institutional framework clarifying roles and responsibilities among the different levels of government based on international experience and Indonesia’s circumstances.

204. The Bank is also organizing trust-funded technical assistance to support implementation ofthe PDAM debt restructuring process, including: 0 Reviewing the legal framework to identify necessary amendments to Perpres 53 and related legislation; 0 Helping the PDAMs to prepare FRAPs; and 0 Assisting the Ministry of Finance to contract out the review of FFUPs and restructuring to accelerate the review process.

205. An AusAID trust fund administered by the Bank will finance several activities in support ofthe IDPL program, including: 0 Development of a fiscal incentive scheme for infrastructure investment by sub- national governments and improvement oftheir borrowing capacity; 0 Review of land acquisition issues and development of solutions; 0 Environmental management capacity and needs assessment for the Ministry of Public Works; 0 Implementation of the policy framework for regional electrification and rural access;

206. The Bank will also provide technical assistance to support the Ministry of Public Works in developing a medium term expenditure framework. FIDUCIARYASPECTS

207. The foreign exchange control environment is assessed to be generally satisfactory. The country is no longer subject to the Extended Arrangement from the IMF. Bank Indonesia (BI) was last subject to the transitional procedures under the Fund’s safeguards assessment policy in 2002. That assessment recommended remedial actions to address a number of vulnerabilities in the audit arrangements for the central bank. The main recommendations have been implemented, including the establishment of an independent audit committee at BI and the publication of BI’s audited financial statements. Audited financial statements for Bank Indonesia for the year 2006 have been reviewed. The audit report issued by BPK, the State Audit Board, contained an unqualified audit opinion.

208. Reform of public fiscal management is addressed in the DPL series, and is not a subject of conditionality in the IDPL series. Indonesia has taken many steps in recent years to establish a sound legal and administrative framework for fiscal management. Annex 5 describes the reforms already undertaken, and sets out the challenges remaining. Known weaknesses in financial management and accountability are gradually being addressed in a program of reform, supported by the DPL series, the GFMRAP project, and other donor supported initiatives. No additional fiduciary arrangements are proposed for this operation.

60 LOANADMINISTRATION

209. Borrower and Credit Amount. The Borrower is the Republic of Indonesia and this operation is a single-tranche IBRD loan ofUS$ 200 million that would be made available upon loan effectiveness, as all policy actions supported by the loadcredit would have been completed prior to Board presentation. For the IBRD loan, the Government has confirmed that Indonesia would borrow this amount as a Fixed Spread Loan (FSL) in US$ currency with annuity repayment schedule linked to commitments.

2 10. Disbursement Arrangements and Use of Funds. The loan disbursement will follow the standard Bank procedures for Development Policy Lending. The loan amount will be disbursed into a foreign currency account of the Borrower at Bank Indonesia that forms part of Indonesia’s official foreign exchange reserves. The equivalent Rupiah amount will immediately be transferred to the General Operational Treasury (SBUN) account of the Borrower that is used to finance budget expenditures, as the loan is intended to be used to support the general government budget. The Borrower will provide to the Bank a written confirmation that this transfer has been completed, and provide to the Bank any other relevant information relating to these matters that the Bank may reasonably request. Disbursements of the loan will not be linked to any specific purchases and no procurement requirements have to be satisfied, except that the Borrower is required to comply with the standard negative list of excluded items that may not be financed with Bank loan proceeds. Ongoing discussions with the Government on the overall reform program in the infrastructure being supported by this DPL will form the basis for reporting on substantive policy issues. ENVIRONMENTALASPECTS

21 1. Many of the reforms supported by the IDPL will help improve environmental outcomes in priority areas, such as sanitation and energy efficiency. For example, power sector investments and reforms have the potential to increase energy efficiency and promote alternative energy sources that could be environmentally beneficial in the medium term. Investments in water supply, quality and access have the potential to improve sanitation and environmental health outcomes for affected populations

212. The operation has been designed to help mitigate or strengthen the Government’s capacity to address potential negative environmental impacts. Efforts have been made, for example, to: Include and strengthen social safeguards in the infrastructure investment process. Recognize and strengthen the GOI’s own efforts to improve implementation and enforceability ofthe AMDAL/EIA framework. Improve transparency in the governance of the infrastructure financing and investment process.

2 13. However, with regard to the scale up of infrastructure, there is still a need to ensure that improved environmental management capacity is integrated into the Government’s infrastructure investments and PPP institutions. In particular, adequate resources and follow up monitoring should be allocated to ensure that:

61 Infrastructure departments and agencies establish, train and equip environmental safeguards and compliance units (equivalent to the Directorate for Roads environment unit) Checks and balances are established to ensure that the Government’s environmental procedures (AMDAL review, mitigation, public consultation, follow up compliance monitoring) are followed (for national and sub-national projects). Ongoing monitoring (including by third party institutions) is carried out to assesdensure that future infrastructure projects allocate sufficient budget to support environmental mitigation at both national and sub-national level. Regional/local government capacities and standards of performance are also upgraded appropriately for the roles and responsibilities under the infrastructure investment program.

2 14. The implementation ofthe IDPL will be accompanied by the provision of technical assistance to help the Ministry of Public Works improve its environmental performance. The first step will involve the conduct of an assessment of the capacity and needs of the Ministry to carry out environmental assessments of infrastructure projects. The proposed work will build on the existing work done on AMDAL at national and local level and will be led jointly by the Ministry of Environment and the World Bank. It is expected that this assessment will inform a complementary capacity building effort to ensure that projects comply with the existing environmental legislation (and that which is in the process of being updated) at planning, construction and implementation stages. 2 15. The challenges of reforming AMDAL to improve its effectiveness and adapting it to regional autonomy include the need to clarify the functions of local government; increase bureaucratic capacity and efficiency; deepen local level transparency and accountability; and stimulate learning and innovation. The prospect of increasing the efficiency of AMDAL by streamlining bureaucratic procedures, presents one of the most significant potential benefits; where there is greater capacity for environmental management decentralization could present real opportunities for promoting environmentally sustainable economic growth. In relation to transparency and accountability, expectations have been raised that the business of government will be more responsive to local needs in the future. This force for change presents the prospect that environmental issues can become more politicized at local level and therefore of higher priority. Existing evidence indicate that increasing public scrutiny and access to information is already having an impact on the sense of accountability felt by environmental and other officials in some local authorities, leading to better environmental outcomes. However existing regulations and guidelines that govern public participation in EIA would benefit from being more discreetly focused on the identification and analysis of project-related impacts, but also to be less prescriptive in terms ofmethods. National and local authority must find ways to make innovation a more integral part of the process. This implies measures to allow greater flexibility with the way in which AMDAL rules and procedures are applied, particularly within jurisdictions with higher than average environmental management capacity. It also implies building a better understanding of home grown good practice in AMDAL and disseminating this information widely among practitioners. There is a delicate balance to be struck here between encouraging innovation without undermining the overall integrity of the system,

62 recognizing also that bureaucracies are risk averse favouring gradual increments of change.

216. In addition, the IDPL policy dialogue provides an important opportunity to introduce and encourage adoption of “best practice” standards for environmental review, public consultation, and follow up monitoring within the national infrastructure investment agencies, the proposed PPP institutions, and the Indonesia Infrastructure Facility (IIF). The IDPL policy dialogue is already serving to raise awareness and communication about these critical needs among key agencies of the Government and directly with the Ministry of Finance, which makes important resource allocation decisions. The IDPL process can serve a useful role in continuing to raise these issues and provide venues for their discussion and resolution among involved Government agencies. GOVERNANCE

2 17. Good governance covers a number of crosscutting Government functions that relate to supporting increased efficiency, improving performance and fighting against corruption. Learning from the lessons of the Asian financial crisis of 1997, Indonesia embarked on a wide-ranging governance reform program. Decentralization, public administration and financial reform, reallocation of government power, and judicial reform are just a few of the many wide-ranging and radical governance reforms that the Government has targeted initially.

218. In the area of infrastructure in particular, Indonesia has moved to commercialize, corporatize and -in some instances-privatize the delivery and management of public infrastructure beginning in the early 1980s. The reforms included the creation of subsidiaries and the sale of stakes in both parent and subsidiary enterprises. This process covered power, gas, telecoms, airports, seaports, railways and toll roads.

219. It is worth noting that public roads and water and sanitation services remain outside this reformed environment, and governance problems in these sectors remain particularly acute -one reason that institutional reforms in these sectors are a focus of attention in this IDPL. Nonetheless, there have been reforms in these sectors as well. For example, UU 7/2004 on water resource and subsequent regulations clarified the terms for private sector participation in the sector, ended BUMD monopolies and established a National Water Regulatory Agency. The Infrastructure Reform Sector Development Program supported by the ADB and JBIC further supports the development of long-term planning in the sector and greater managerial autonomy of PDAMs. The new Road Law, the Toll Road Authority and the separation of regulatory and operational functions of the Jasa Marga should all improve the situation regarding governance oftransport.

220. More recently, in February, 2006, the government released an Infrastructure Policy Package reporting on 206 policy outputs that had been completed or would be completed within the year designed to encourage competition, eliminate discriminatory practices that obstruct private sector participation in infrastructure, and ensure a separation of policy making, regulatory and operational responsibilities.

63 221. In turn, the World Bank has been supporting the development of approaches that are likely to reduce the impact of corruption in delivery of community road and water and sanitation projects. These include community-driven approaches as well as output-based models covering water infrastructure rollout in Jakarta and Surabaya. The Bank’s focus on anti-corruption plans within projects has also involved institutional approaches designed to increase probity and efficiency ofprovision.

222. The 2003 business environment survey suggested that Indonesia’s infrastructure sector is comparatively free of corruption - less than 5% of firms reported payments to get a water, telephone or electricity connection, less than 5% reported bribes to obtain a construction permit. This matches broader results from the survey which suggested below-average levels of corruption in the country. Having said that, there is considerable evidence that corruption remains a significant problem in infrastructure, perhaps especially in the road sector, including cases involving World Bank projects.

223. In areas where private participation is further advanced, the more significant governance problems regard regulation and the management of public-private partnerships. Final tariffs are frequently set very late in the process (after construction is complete in the case of toll roads), and regulatory independence is limited. A number of ‘abandoned’ transport projects signed under a non-competitive and opaque PPP process in 1997 may be revived. The government has also been under pressure to exempt specific projects from the new governance regime covering PPPs (Perpres 67/2005) and to date two exemptions have been issued (the MW 10,000 coal-fired power generation crash program and the Jakarta ).

224. Decentralization has increased the number of actors with discretion over water and roads budgets while capacities in areas such as procurement and audit remain particularly weak at the local level. Progress is being made in strengthening detection and prosecution through institutions such as the Supreme Audit Institution and the Anti- corruption Commission, but there is additional work to be done in the areas of improved risk-focusing of physical audits, greater transparency of procurement, heightened sanctions and revised staff incentives. In both water and transport, there remains an unclear division of responsibilities within and between central and local government. In water in particular, there are limited tools for central government to influence adoption of national policies at the local level, and excessive local government interference in the management of PDAM operations. Collusion in procurement in the road sector remains endemic and sanctions against guilty parties remain weak. There are an increasing number of ‘unqualified opinions’ in PDAM performance audits and lack of adherance to national government directives.

225. While significant challenges remain, the reform agenda is ongoing. Other parts of this note describe a number of reforms in the institutional structures governing infrastructure that should improve governance and reduce the scope for corruption to derail infrastructure rollout in Indonesia. Not least, the Government has launched an aggressive reform program to introduce transparency and competition in PPP transactions through Perpres 6712005 and PMK 38/2006. It intends to implement a mechanism to address non-compliant projects, in particular those holding up development of the trans- Java transport corridor. In addition, in the urban water sector, the legal framework has been revised to affect reform in PDAMs, and Perpres 6/2007 directs clarification of 64 responsibilities covering WSS between central and regional governments as well as improved regulation of regional WSS enterprises. In energy, the greater clarity surrounding public service obligations for PLN will improve the incentives to reduce waste and corruption within the enterprise.

226. At the national level in roads, the medium term expenditure framework should reduce the scope for opportunistic addition of investments designed to maximize rent- extraction rather than economic return at the expense of maintenance of the existing infrastructure stock and projects with higher benefit-cost ratios. DGH is moving towards the use of standard bidding documents, expanding the use of e-procurement, the disclosure of contract information, and looking towards enhanced and standardized processes for land acquisition and environmental specifications. These standardized acquisition processes should not only speed the rollout of infrastructure, but also reduce the role of discretion on behalf of individual assessors in terms of the scale of payments to be made -this should reduce corruption. Again, as noted above, a number of triggers in the IDPL should help to improve the governance of sectors -in particular water and roads.

RISKSAND RISK MITIGATION

Government commitment (moderate risk)

227. In the area of PPP, the reforms championed by the Minister for Finance and the KKPPI move Indonesia to a system of transparent and competitive bidding for PPP projects, with an appropriate allocation of risks between the private sector and the State. The transition is not secure, however, and there remain strong political pressures to circumvent competitive bidding pressures, to bring projects to market before they are adequately prepared, or to support the bankability of PPP projects with inappropriate government guarantees. Such pressures to operate outside the transparent and competitive processes recently put in place might stem from well-meaning but ultimately misdirected attempts to accelerate the implementation of PPPs or from inappropriate rent-seeking. In other parts of the infrastructure agenda, questions about the Government’s commitment can also be raised. Reforms of sub-national financing and of the incentive framework for delivery of sub-national infrastructure are at an early stage, and land acquisition and anti- corruption reforms will be subject to resistance by vested interests.

228. The 2009 legislative and presidential elections might heighten some of these commitment risks. Pressures to show quick results before the election might induce the Government to try to accelerate infrastructure development by eschewing competitive and transparent processes. Coalition politics in the run up to the elections could complicate the implementation of the Government’s program. Finally, a new administration much less committed to the types of reforms supported by the IDPL series could take over after the elections.

229. On the whole the present Government appears strongly committed to the reform program. And the forthcoming elections hold promises as well as risks: a number of politicians and bureaucrats are pushing to complete the current reform agenda in order to position themselves for roles in the next government. The likelihood of continuity in Government also provides a positive incentive to push ahead with reforms.

65 230. In addition, the launch of the IDPL series is itself aimed at mitigating commitment risks since future loans will be delayed if the reform agenda stalls. An additional risk mitigation mechanism is the fact that the IDPL policy matrix is focused on items of the Government’s program where the Ministry of Finance (whose commitment to reform is strong) can influence policy. Overall, the Minister for Finance considers that the Bank’s support strengthens the Government’s ability to sustain a consistent course of infrastructure reform and to resist political pressures to backtrack.

Government capacity (high risk)

23 1. The Government’s infrastructure reform program is undoubtedly complex and it is clear that the relatively slow pace of progress so far is due at least in part to capacity constraints. The fact that ill-prepared PPP projects are brought to market is likely due to a misguided desire to accelerate processes as mentioned above but also to an inability to meet the standards of project preparation that major private investors require. Difficult institutional issues hinder progress on the access agenda with respect to both rural electrification and expansion of PDAM coverage. Delays in procurement affect the Government’s ability to deliver on its investment program.

232. The Government is well aware of these issues and the Government’s request for Bank support through the IDPL series is aimed in part at enlisting Bank’s assistance in this regard. The Bank is supporting a large number of technical assistance activities - described above - to promote, inter alia, the PPP agenda, effective involvement of local governments in infrastructure development, the PDAM debt restructuring process, rural electrification, telecommunications access, land acquisition, and environmental management. These activities are designed in coordination with and to complement the TA initiatives supported by other development partners such as ADB and JBIC.

233. Even with substantial technical assistance, achieving within the next three years all the reform objectives supported by the IDPL will constitute a real challenge. It is quite possible that the indicative triggers for IDPL 2 and 3 might require some revision and that the timeframe for implementation of the whole reform program might need to be extended. But the Government firmly believes that the Bank’s assistance in building the capacity required to implement the reform program will greatly contribute to the ultimate success of the program.

Corruption (high risk)

234. Indonesia is struggling with issues of corruption, and corruption could certainly have an impact on the success of the IDPL series. To the extent that Indonesia is successful in increasing the level of infrastructure investment, it is possible that the absolute amount of funds diverted away from infrastructure spending for corrupt purposes would increase. Association with high absolute levels of corruption poses reputational risks for the Bank.

235. There is no simple mitigation strategy. The Bank is pursuing multiple anti- corruption initiatives in Indonesia, including in respect of infrastructure. There are anti- corruption initiatives in multiple Bank infrastructure projects, and the procurement 66 reforms set out in Policy Area IV are part of the anti-corruption effort. More generally, IDPL prior actions and triggers support greater transparency and accountability through the development of sector strategies and clarity in the allocation of responsibilities between levels of government alongside greater competition and transparency in the development of PPPs.

236. There is a moderate risk that the PPP governance reforms may be subverted by private interests, undermining a key policy area of the IDPL series. There is a tension within Government between those who champion transparent and competitive processes, and those who favor project preparation which is less thorough and which leaves substantial risks best managed by well-connected insiders. If insiders were to gain the vast majority of PPP contracts, there would be suspicions of corruption. In addition, the objective of obtaining substantial new investment could be defeated.

237. The Bank’s mitigation strategy involves capacity building and analytical support. The IDPL is itself part of the mitigation strategy, signaling the Bank’s support for transparent and competitive processes.

Macroeconomic stability (moderate risk)

238. Macroeconomic performance is subject to multiple risks, of varying likelihood and gravity:

External shocks and balance of payments vulnerabilities. A capital account shock or a global growth slowdown would lead to a temporary slowdown in activity, but the economy should be able to withstand moderate shocks. Factors limiting the potential impact of external shocks include diversity of exports (geographically and with respect to products), limited external debt exposure, and adequate reserve levels.

Natural disasters and civil disturbance. In recent times Indonesia has suffered the Aceh tsunami, the Yogyakarta earthquake, flooding in Jakarta, and terrorist attacks in Bali and Jakarta. The Government is seeking to improve its preparedness for such shocks. Under the new Law on Disaster Management a National Disaster Management Agency will be established to reduce risks through improved national development programming and to lead and coordinate responses to disasters.

Fiscal sustainability. Government revenues are linked to the fortunes of the macro-economy, and are thus vulnerable to all forms of macroeconomic shocks. Oil and gas revenues deserve particular mention, as they provide almost 30% of central Government revenues. At present, marginal changes in world petroleum prices are budget neutral. Significant price increases, accompanied by further domestic fuel price increases, would generate a terms of trade advantage and provide the Government with more resources, since Indonesia is a net exporter of oil and gas. Significant price decreases would be largely neutral on the central government budget, but would have an impact on local government revenues as transfers from the central government to the regions decline. This is a medium

67 term concern as local governments have built up substantial cash reserves which would allow them to adjust gradually to a lower level oftransfers.

0 Debt sustainability. Debt sustainability is unlikely to pose problems for macro- economic stability. Outstanding Government debt stood at US$I39 billion in 2004 and US$137 billion in June 2006 (41% of GDP) with the decline being caused by debt repayments and also by depreciation of the yen. The government debt-to-GDP ratio is projected to fall to below 3 1% ofGDP in 2010.

0 Exchange rate risks. Indonesia operates a managed float exchange rate regime. In recent times, Indonesia’s strengthening macro-economy has attracted significant, though volatile, portfolio inflows, resulting in appreciation of the rupiah. Allowing the rupiah to appreciate supports macro-economic stability; improving inflation prospects, creating room for lower interest rates, and weakening incentives for further inflows.

0 Monetary risks. The primarily market-determined exchange rate supports the inflation-targeting framework. The Bank projects inflation of 3% by 2010. The Bank of Indonesia’s success in reducing inflation, following the 2005 reduction in fuel subsidies, suggests that the central Bank will continue to be a stabilizing influence on the macro-economy.

0 Policy stability. As the 2009 Presidential election approaches it is possible that politically difficult decisions will be deferred, slowing the pace of structural reforms. On the upside, growth could be higher than projected if the pace of structural reforms is accelerated.

0 Financial sector risks. Banking sector indicators have improved in recent times, in line with macroeconomic performance. The profitability ofbanks has improved as interest rates have fallen. IMF analysis of market pricing for listed banks suggests a historically low probability ofdefault for banks. A remaining source of vulnerability is the high share of state banks, with generally inferior credit quality, and a high share of nonperforming loans.

0 Corporate sector risks. Major corporate sector vulnerabilities have been addressed in recent years. Excessive foreign borrowing and lending by banks to related companies were significant problems in the 1997 financial crisis. Non- bank private sector cross-border borrowing has declined as a proportion of Indonesia’s foreign exchange reserves, from 194% in 1997 to 56% in 2006. Sectoral reforms have separated banks from their related corporate groups.

239. Overall, the potential risks to macro-economic stability which are most likely to be realized are shocks over which the Government has little or no control (natural disasters, the world economy). The mitigation strategy is to improve the Government’s overall fiscal and monetary management, to improve the economy’s resilience.

68 Political Stability (low risk)

240. The next Presidential election is due in 2009. Approaching elections may lessen the commitment to difficult policy reforms. The President is particularly associated with anti- corruption initiatives. The Vice President, a possible election rival, is closely associated with infrastructure development. The reform agenda may be sensitive to coalition politics, and tensions between partners may grow as the election nears. While such concerns may affect the details of particular policies, there seems to be only low risk of any reversal ofthe past decade’s democratic reforms.

24 1. There have been numerous security concerns in recent years, including separatist violence in Aceh, and terrorist strikes in Bali and Jakarta. There seems only low risk that these or other security issues could threaten overall political stability over the next few years.

242. Such risks are outside the control of the Bank’s country dialogue. The mitigation strategy for dealing with such risks relies on the fact that IDPL proposed series of loans will only be approved as long as the policy reforms yield the agreed upon achievements.

69 ANNEX 1 LETTER OF DEVELOPMENT POLICY

Ref: S-115/M.EKON/ 10/2007 Jakarta, Indonesia, October 3 / 2007 Ref : S-508/~.08/2007

Mr. Robert Zoellick President The World Bank Washington DC

Mr. Waruhiko Kuroda President Asian Development Batik Manila, Philippines

Dear Mr. Zoellick, Mr. Kuroda,

On behalf of the Government of Indonesia, we would like to present recent economic and reform developments iii Indonesia and request your continued support tlirough a Development Policy Loan and an InfrastructureDevelopment Policy Loan this year. Since taking office, this Governnient has focused its energies on accelerating economic growth, reducing poverty and regional disparities, and improving governance. To achieve this end, we have pursued a broad reform agenda designed to improve the investment climate, public fiiiancial management and governance, and service delivery. Tliese efforts are based on our Medium-Term Development Plan (RPJM), annual Government Action Plans (RIG') and each ministry's own work program (Renstra). This year has also seen another reform package that takes a comprehensive approach to reform iii the areas of investment, the financial sector, and infrastructure, while also adding elements designed to assist small and medium enterprises. We have worked hard to meet our coininitments to reduce poverty and impmve economic outcomes and governance, despite a series of coiitiiiuing natural disasters. We believe we are succeeding: deinocracy continues to take root through direct local elections (including in the capital Jakarta this year); regions and communities destroyed by lsunamis and earthquakes are rebuilding; reform momentum continues to build; and economic growth is starting to accelerate.

DEVELOPMENTPOLICY ASSISTANCE Once again we wish to convey our appreciation to the World Bank, the Asian Development Balk and the Japanese Government for their support through tliese Development Policy Loans (DPLs) and to the World Bank for reinforcing the development partner comrnonity's support for our infrastructure refonn agenda, begun last year with the ADB and the Japanese Government through an Infrastructure Development Policy Loan (I' DPL). The ability to work with our key development partners across these areas reinforces reform priorities while providing a source of reliable financing. This year brings some synergies and some challenges as we process the DPL and the I-DPL simultaneously. In general, we would like to continue our engagement with you on the development policy agenda, i.e. tl~e iiivestiiient climate, public financial management and governance, and service delivery. However, infrastructure is now such a high priority that separating it and focusing on a series of key refonns will allow us to reinforce last year's Infrastn~ctureRefonn Sector Development Program. We believe that the policy agendas laid down in both areas are proceeding well and that we have met, or will shortly meet, virtnally all ofthe polioy actions. Due to large domestic and foreign repaynionts and ai1 increase in the budget deficit, gross financing needs remain large in 2007. Thus this letter is in support of a request to the World Bank to approve a Development Policy Loan of US$600 inillion and an Infrastructure Development Policy Loan of US$200 million, aid to the Asian Developlilelit Bank to approve a third Development Policy support Loa11 @PSP 3) ofUS$200 million.

70 MACROECONOMIC STABILITY Deginiiiiig in 2006, the Government and its development partners mutually agreed to reduce the focus on macroewnoniic stability by eliminating this pillar of our engagement, while increasing the focus 011 improving service deliveiy. The results in 2006 and 2007 thus for would appear tojustib this decision. Our macroeconomic position continues to improve rapidly. Growth in 2006 was 5.5 percent despite the economic slowdown in response to dramatic policy tneasures taken in the latter half of 2005 (fuel price and interest rate inCrenses). Growth in 2007 was 6. I percent in the first half and indicators have been picking up since then. We feel confident that Uie budget estimate for growth of 6.3 percent for the year should be acliieved and this will be by far the highest growth outcome in ten years. Inflation is n little higher tlinn we would like, although down substantinlly froin last year. After spiking in the aftermath of the fuel price increases, inflation returned to within Bank Indonesia’s target range of 5 to 7 percent by the end of 2006 and was 6.9 percent at the end of September. We now anticipate that it will end the year within the target range. Other indicators are strong as well. The Govwnmant’s debt- to-GDP ratio has continued to fall, reaching 39 at tlie end of 2006, and is expected to fall below 35 percent at the end of 2007. We have dramatically increased our raerves, to over US$50 billion. Exports remaiii strong and growing at over 9 percent mid-year (over one year enrlier), after growing 9 percent in 2006 as well. We have seen a pick-up io investment including foreign direct and portfolio. Io the first half of this year, real investment was running at over 7 percent higher than a year ago. Direct investinelit approvals (domestic and foreign) as measured by the National Investment Coordinating Board (BKPM) are higher by 59 pcrcent and 212 percent, respectively, than last year. These improvements have not goiie unnoticed, and the Indonesian stock market has been one of die world’s best performing and our sovereigii ratings continue to improve, most recently with the October 19,2007 upgrade ofour foreign currency rating to Ba3 by Moody’s. Still, we can not afford to be complacent. With reforms, hard work and good coordination we believe that we can iiicrease growth beyond the current 6 to 6.5 percent range and continue to reduce inflation. Thus we ate projecting next year’s budget at 6.8 percent growth aid inflation at 6.0 percent. Higher growth and lower inflation are needed to deliver real income increases, job growth and poverty reduction. This requires pushing ahead with investment climate reforms especially infrastructure investment. This year has also seen a desired reversal in recent increases in poverty and unemployment but again there is niiicli more to be done. We niust improve public services generally, but especially services that improve tlie lives of the poor and the vulnerable. Our 2008 budget subinissioii to llie DPR captures the agendas’ under discussion. We continue to use increased fiscal space to expand poverty programs including scaling up the poverty reduction program (PNPM) in 2008 and the current piloting of a conditional cash transfer program (PKH). We are proposiiig increased infrastructure budgets, especially for the Ministries of Public Works and Transport. We also note that we have inciwsed the budget deficit to 1.5 percent in 2007 and anticipate a budget a deficit of 1.7 percent for 2008. We believe that the improving macro picture justifies an increase iii spending and especially on spending for critical priorities designed to accelerate growtli, jobs and poverty reduction, including poverty programs and lnfrastmcturt. The recent turmoil in international capital markets is another reminder that we winot afford to be complacent. We do not anticipate a major slowdown in global markets, but we are watching the situation carefully and preyariiig for the eventuality of capital outflows, lower growth and a reversal in commodity prices. We believe that our fiscal and monetary situation is stronger than it lips been for seine time and that we are. now in a better position to deal with external shooks than in the recent past. Nonetheless, history teaches us how a crisis, wlieii it strikes, can be worse than planned and we are working to iiiiprove the policy and iiistitutional base needed for couiitercyclical policy. We have continued to press ahead in areas that we believe will improve our ability to prevent or react to crises. In pnrticular we note the ongoing changes at the Ministry ofFinance. The Fiscal Policy, Debt Managenient, Asset Mniiagement and Inter-Regional Fiscal Affairs Agencies and Directorates General are fully Functioning. The Fiscal Policy Office Risk Management Unit is essessi~lginfrastructure projects requiring Government support ps agreed last year. In addition, it has developed and published the first ever fiscal risk statement as part ofour budget document With this we expect that we Cali better understand and anticipate a range of wlltiligent nnd i~nplicit liabilities. The establishment of the Inter-Regional Fiscal Affairs DG has allowed us to ilnprove our focus 011 the intergovernmental fiscal framework but it has also allowed us to provide incentives to regional governnrents not meeting their reporting obligations, i.e. tlirougli the use of financial

71 intercepts. The debt management unit also continues to develop well. The Govcniient’s domestic bond market continues to deepen and extend throilgll continued monthly auctions and buy-backs, the very sucoessful issuance of retail bonds and, most recently, T-bills. We have requested DPLs in the form of fixed-spread loans (FSL) from the Bank iii recent years, allowing us the option of hedging currency risk.

INVESTMENTCLIMATE, Sustained macroeconomic stability is a necessity for investment. However, in a competitive interlocking world we must compete for quality iiivestments at home and abroad, especially as our economic base becomcs more sophishted and diversified. We appreciate that this in turn requires enacting and implementing key measures with respect to the investment climate, an effort prioritized by the President aid the Cabinet. In particular, higher growth and increased investment require simple and low-wst entry for new firms, a low-cost operating eilviroliinent for existing firms, simpler and more transparent tariff-setting, reliable infinstructure, efficient financial markets (bank and especially non-bank), and special altentioii to smdl and medium enterprises (SMEs). The most recent of tliese packages is the Policy Package (Inpres No. 6/2007) issued in June. This Inpres inandstes the Coordinating Minisler for the Economy, the Governor of the Central Bank, 19 other miiiisters, three heads of non-departmental government institutions (LPND), as well as all governors, regents, and mayors to implement policies to accelerate development and empower SMEs. The policies iii the Inpres detail programs, actions, and outputs with clear, time-bound targets and specify the institutions and individuals responsible for implementation. This package puts into one place previously separate infrastructure, investment, finance and SME packages thus providing more focus and coherence. Generally, progress on Uie investment climate has been more difficult and slower than we would have liked, but progress is accelerating as we learn better how to focus priorities and addiess problans. Working closely with Parliament, we also passed two critical pieces of legislation this year: a new Investment Law and the first of three tax laws, on tax administration procedures. These constitute landmark pieces of legislation clarifying important arcas of investor wncern and should provide an impetus to investment. We are now working with Parliament on iiicoine and value added tax laws, and would like to reach an agreement that would begin the process of cutting marginal corporate and personal tnx rates to 25 percent and 30 percent, respectively, by next year. One area where we have not made as much progress as we would have liked is 111 job creation and labor regulations. As noted, the unemployment rate fell this year, which is welcome. However, jobs, especially good jobs, are not being created as fast as we would like. To address tile especially difficult issues in severance pay and put the system on a sustainable basis we have been holding tripartite meetings with labor and employers to develop solid proposals that would bettw share the burden. We hope that this process will result in a solution that allows us to accelerate employment growth in the years ahead.

In our engagenieiit witli.you we propose to focus on four critical invcstnleiit climate areas (not including infrastructure, which is considered separately). All ofthese reflect areas of investor conceni: Regulatoiy reform Tax and ciistoms reform The financial sector SbengUieniiig small businesses

Going forward we would propose that we retain the focus of our engagement within these areas, as each is a critical elemwit of the larger investment climate reform agenda This consistelicy helps US to focus, drive slid dcepen reforms.

Regrilatory reforiii lniproved investmelit procedures have become a benchlnark for investors and a measure of tbe Government’s ability to institute regulatory reform. Thus we are pleased that we were able to pass a new Investment Law this year. This law had originally been submitted to Parliament in 2006 but, due to a iiuinber of contentious issues, it had not progressed well, We arc pledthat we were able to work with Parliament to develop a wnsensus that we believe will promote investment while finding a balance between foreigii and domestic investors. The law emphasizes the equal treatment of foreign and domestic investmait, removes Uie forced divestment and limited duration of foreign investment in the old law, lengthens the time horizon to hold land, liberalizes some immigration procedures, and

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72 allows for international arbitration. Associated with the law are a series of critical govemlnent regulations. Regulations on inveshnent incentives, cenbal and local government responsibilities, and tlie iiegative list are now complete. The incentives regulation allows for accelerated deprsciation, loss Cariy forward and investmelit tax credits. Tlie negative list lays out tlie procedures and guidelines for iiivestmeiit (including foreign investment) more clearly than before. There has been some criticism of sectors in wliicli foreign investment shares llave been reduced but, agai~i, we believe that this regulation strikes a balance while providing tlie transparency foreign investors need. We also note that existing investors will be grandfathered in sectors where the rulas have changed. We have also taken a number of steps to addr’ess problems aid simplify regulations to reduce the time it takes to start a business. We expect tlintihe effective implementation of these steps will improve our standing on this measure next year. Tie passage of laws and regulations is not sufficient to deliver improved performance. To reinforce investment and trade reforms we have reinvigorated tlie National Team on Accelerating lnvestnieiit and Exports (PEPI). PEP1 reporls to the President under tlie guidance of the Coordinating Ministry for tile Economy and is charged with coordinatioii and follow-up on investment and export issues generally. Over the next year we phito iise this vehicle to formalize our engagement with tile private sector iii tlie development of investment policy, simplifying business licenses, initiating an investor problem-solving function, and addressing the remaining issues and ambiguities around the Investtneiit Law and Uie negative list. To iiionitor tlie iiaprovements we have been making to the investment climate we also plan to improve our reporting in critical areas such as the time to start a business, the time to process tax refunds and tlie import clearance time. Finally, we propose to begin the development ofa pilot scheme designed to provide on-line information @idinvestment licensing in the year ahead.

Tnxes, crrstoins md trnde reJorni

Reducing the operating costs and increasing certainv for existing finns is an equally impomit objective. Taxes and customs, in particular their administration, are consistently listed & investor conceriis. AS noted, this year lias seen the passage of a new Tax Administration Law. We believe that this law incorporates importaiit procedural breakthroughs. First it was developed through a process of sustained engagenient wltli Uie private business sector, and second, similar to the Investment Law, it also profited from nn effective engttgement with Parliament. Tlie final product goes a long way toward addressing the concerns raised by the private sector, especially as regards the issue of tax assessments and self-assessment, and associated concerns about the right to pay the self-assessed amount.

We have also addressed tax related issues that do not require the passage of a law, iiicluding accelerating VAT refunds and clarifying the riglits and procedures of taxpayers undergoing an audit. Thus we settled VAT refund arrears to the private sector amounting to over Rp 10 trillion. At the same time we are continuing to roll out modern taxpayer offices to medium and small taxpayers (most recently a medium taxpayer ofice io Bandung). This should increase the share of taxpayers with access to computerized systems not only improving taxpayer satisfaction but also broadening the tax base, which is of considerable impitmice given the plan to cut tax rates in the pending income tax law. Another very important measure has been the National Single Window WSW) iiicluding a single adniinistrative document for hiporters mid exporters. Tliis measure, a commitment to ASEAN, a6 well as part of our owti reform agenda, has wnsistently been cited by the private sector as central to reducing costs, time and governance wiicerns. We rolled out a pilot in Batam at the e11d of 2006, conipleted a roadmap for the extended system in August 2007 and will introduce a pilot at our biggest poit (Tanjung Prick) in December, Trade policy is another area where consistency is important for firms, both doniestic and foreign, as the stnicture of tariffs, non-tariff barriers and standards directly affect investment and output choices. This year has seen continued steps designed to ilnprove the iiistitutioiial basis of tariff-setting by Team Tariff (the inter-ministerial team responsible for tariff- setting). The inandrde of this inter-ministerial team has beell extended and now includes explicit . reference to a secretariat and research teams - the key to building further capacity. The Ministry Of Trade has begun to improve its trade analytical capacity, including through a recent exercise on effective protection.

Going forward we propose to continue our emphasis on trade facilitation by choosing an operatiollal model and operator for tlie National Single Window, including through engagillg key private sector

4 I

73 stakeholders in the process. We will follow on from the recent Tax Administration Law with tlie regulations required to implement it mid by monitoriiig the tax depaiimeiit's response to a audits aud objectioiis. Finally, we intend to push ahead with the harmonization of tariffs, transparelicy io tariff- setting procedures and the developmelit of Team Tariff. We also believe that it is an appropriate time to look more deeply at trade policy formulation, especially trade in services, but also standards and product quality. We propose to begin developing improved institutions and capacity building in tliese areas.

Tlrefiiiniicbl sector ' The past year has seeii the end of one more legacy or the crisis. The Deposit Guarantee Agency (LPS) completed the sliminalioii of the blanket bank deposit guarantee introduced in 1998, with a reduction of the final guarantee ainouiit to Rp 100 million per account in March. The Financial Sector Stnbility Forum, where issues of systemic risk can be addressed, is now formally in place although not yet staffed or operational. Bank Indonesia has pushed ahead with efforts to improve good corporate governance and risk management in the banking system through new regulatioiis and guidelines that clarify the roles and responsibilities of Boards of Commissionen and Directors and mandates independent commissioners and better disclosure of developnieiits that could affect shareholders' rights. Bank Negara Indonesia (BNI) was partially privatized in July when 20 percent of its shares were sold through a secondary offering and we intend to continue tliese state-owned bank rights offerings. We propose to continue to develop the Financial Sector Stability Forum going forward. Recent events in international capital markets remind us once again of the potential for international shocks to spill over into domestic markets, thereby threatening financial stability. The Forum has as its mandate addressing systematic financial sector failures, as well as anticipating and avoiding them. AS mentioned, our non-bank financial markets have begun to grow mora rapidly and this is a welcoiiie development. We will continue to focus on developing a more diversified financial sector with greater emphasis on non-bank financial institutions as well as on institutions that can assist in niobilizing aiid sllocating long-term domestic finoiicial resources for development, particitlarly for infrastructure projects. We also believe that our insurance markets should be able to grow faster, tlirls reducing risk aversioii and making longer-term capital availablo. In particular, it is impoilant to address some fundamental underlying risks for this to happen - risks asscciated with a lack of a policy-holder protection scheme.

$ME dcveloprnenr

An area where we are committed to do more is 011 the environment for our mall and medium enterprises that have played such an important role in creating jobs and increasing our economic resilience in recent years. We would like them to play an incidrole in entrepreneurship, Le. as an incubator of larger firms. Thus we are pleased that this year we were able to include a set of comprehensive measures designed to assist SMEs (Inpres No. 6/2007). This package focuses on issues of importance to SMEs, particularly access to finalice and the implementation of last year's Warehouse Receipts Law, which allows small famers and businesses to use these receipts as collateral. Warehouse receipts systems are now being put in place (in Banyumas, for example). The Government has also recapitalized Aksrindo and Peruin Smna (creditlinsuranw guarantee firms) to enable an iiicrease in lending to SMEs. In the next year we propose to rationalize the operations of the many fin~iclng/niicrofinaiicing sclieines offered by line ministries and stateowned enterprises to improve the effectiveness aid transparelicy of fiiianciiig to SMEs.

PUBLIC FINANCIAL MANAGEMENT AND GOVERNANCE The government reforin agenda in public fiilancial managemait (PFM) and goveillaice has also been progressing well. Last year we broadened the agenda beyond conventional PFM to include civil service reform and progress has continued there as well. The overall budget reforms begtui in 2005 continue. This year again saw the budget prepared and DIPAs issued 011 time. Difficulties remain but minislries and agencies continue to improve their

3

74 understanding of tlie new procedures and systems, and disbursements this year appear to be ahead of those in 2006. However, problems in capital budgetingand procurement remain. Perhaps tlie biggest change has been the allocation of spending. Tie large reduction iti subsidies in 2006 increased resources for other priorities. We started tlie process of reallocating these resources in last year's budget (this year's spending) beginning with an expansion ofthe national poverty reduction prograni (PNPM) aid piloting a conditioiial cash ttansfer program (PKH). The budget reallocation process accelerated this year. Continuing the commitment last year, PNPM will be soaled up in 2008 (ainiirg at iiational coverage by 2009). However, the Cabiiiet also agreed to strengthen the link from priorities to spending on poveity reduction and economic infrastructure. This is as outlined in our annual work prograiii (RKP) and lias necessitated reductions in budgets for other sectors. Tlie 2008 budget proposal includes sigiifionnt increases in capital and social assistance spending. We proposed to Parliament to increase capital spending by 27 percent compared with 2007 (revised budget) with this spending focused 011 investments with higher economic returns, such as roads, bridges, irrigation tracks, and transportation infrastructureand facilities. We are also increasing spending on education, health and other social services. Having the budget better reflect government priorities (the RKP) is a positive step and one that we will build on. Tlie RKP also includes our reform priorities in tlie PFM area and in our engagement with you we have been focusing on reforms in tliree areas: Budgeting, controls, and transparency in finaiicial management,

0 The procurement process Civil service refonn.

Burlgefhg, controls nrzd Iransynrecrcy in financial macmngetnent Our program addresses the many elenieiits in PFM reforms from planning, to budgeting, to disbursement, to accounting and auditing. We are committed to deepening these reforms across Uie eotlre budget cyole. Reforms have advanced in a nuniber ofawas, including those where we have been engaged with you, but also through the continued provision of timely government accounting statements and improved semester outcomes. The Fiscui Polioy Office has developed and published a fiscal risk statement aa part of our aniiual budget submission, which looks at the impact of niacroeconomic assumptions, and contingent and implicit liabilities. We are conimitted to extending it in the years to come to include such areas 89 pension liabilities. Underpinning our cominitmont to tlie impleinentatioti of a modernized budget system, we have also establislied structural units in the DO Budget and the DG Treasury that are charged with developing improved procedures and systems, and driving change in the years ahead. Finally, Treasury modernization has made lieadway with die introductioii of a simplified and accelerated business process for the settlement of payment orders in selected treasury offices (KPPN Percontohan). In our engagement with you we have focused on three areas: (i)improved budgeting iiicluding tlirwrrgfi the addition of a medium-term expenditure framework (MTEF) and performance-based budgeting; (ii) tlie extension of the Treasury Single Account (TSA); and (iii) improved transparency around the RDVRDA on-lending accounts (to state-owned enterprises, local governments and water utilities). We liave made good progress in all of these areas. The 2008 budget provides two-year forward estimates for aggregate revenue and expenditure categories as a first step toward an MTEF. Meanwhile, performance-based budgeting (PBB) has advanced, inoluding a review of budget foiins aimed at strsngtliening performance inforniation. The 2008 budget document submitted to Parliarneat In August includes a chapter elaborating expenditure policies and speoifying tlie expected outpiits of our most critical spending programs. This year also saw the enactment of the Cash Management Regulation that provides tlie needed legal underpinning for the Treasuiy Single Account, in particular the ability to bring into compliance off-budget accounts (the legal right to close existing accounts and prior MOF approval to open new ones). We have continued tlie expansion and extension of the TSA old, in October, the system was expanded to ewer all expenditure accounts of all treasuiy offices in the counby. Improving Uic existing situation and developing transparent acwuntability tumngements for RDI and RDA accounts has proven rather more difficult than we had anticipated. Nonetheless, we have now computerized and reconciled a large number of these accounts. Government RegulationNo. 8/2007 lays out tlie principles for improved management and procedures for investments and is supplemeiitd by detailed operating procedures.

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75 We propose to continue to work in most of these Arne areas, as well as introduce some change in emphasis. Thus we intend to continue to focus budget reforms over the next year on tlie introduction and monitoring of improved PBB and to extend the MTEF at the program level to selected ministries (including tlie Ministry of Finance and Bappenas). We also intend to wntiiiue the engagement on the TSA with its extension to tlie revenue side and to begin intensive preparation for the introduction of tlie new budget nnd treasury system (SPAN) in 2009. We also want to improve a long-standing problem with the budget disbursement pnttern, namely, tlie extent to which it is heavily back-loaded during the fiscal yew. To address this problem we intend to change some procedures for multi-year projects to allow for the continued appointmuit of project teams and parallel processing for procurements. We have also mads progress in introducing modified accrual accounting, but there continue to be challenges in making the government financial statements reliable due to a lack of integratioii between Treasury accountiiig systems and accounting systems in line ministries. We intend to address this through a review of line ministry systems aid procedures this year. Finally, we intend to forinulate a strategy for budget reform covering the short, medium and long term. Tlie strategy will build on the experiences gained in tiie pat few years and encompass the introductioii of a programmatic MTEF, PBB, eiilianced appraisal and budgeting for large multi-year investment projects and links to audit aid civil service reforms.

Inryroveciprociirenieiif processes and oritconies Iniproving public procureinont has been a priority for years now. We have continued to work to improve llie procurement regulatory framework through tiie drafting of a new procurement law, providing improved tools through drafting D new set of standard bidding documenls, improving the procurement capacity and e-procurement systems. However, as we indicated last year, continued progress in this difficult and technical area will require an institution with a sustained focus on procurement policy. Last year we had decided to strengthen the National Public Procurement Office (NPPO) by creating an Echelon 1 level position within Bappenas. However, before we finished tlie legal framework, a consensus developed that it would be better if such an agency were independent and reporting directly to tlie President. Thus, afier some delay, we are now creating such an agency. This process will be accelerated by making use of the existing unit in Bappenas and staff from the Ministry ofFinance to get the new ngency off Ute ground quickly. Next year will see this new agency, the LPKPP (Lembnga Pengembangan Kebijakan Pccigadaan Pemerintah), as an independent effective procurement office. It will play a strong role in procurement policy, including through a revision to Keppres No. 80 to update and simplify the regulation to reflect tlie lessoiis learned so far, the discmiriation of standard bidding documents, and developiog a strategy for capacity building and tools to monitor the performance of public procurement throughout the country. With the delays in the formation of the new agency the development of a new procurement law has been put on hold. However, in the medium twin, we envisage proposing a procurement law to Parliament to streiigtlieii the legal frainework, in particular to ensure the enforceability of a common procurement framework at all levels of government.

Govcriiwice nnd Civil Service ReJomis One of our key priorities is improved governance through civil service reform. To improve governance broadly we have piit in place an institutional framework to better detect, investigate, nnd prosecute cases of corruption. Tlie Commission for the Eradication of Corruption established in 2004 lias achieved a solid track record in bringing to couit a number of high level cases, But one of !he lessons we have learned is the critical need for more productive incentives and more efficient institutional design in the civil service, Civil service reform will be a long term effort but we have now stnrted: first we have made a systematic assessment of the compensation packages of high level civil servaiitS and second, we have launched a comprehensive pilot reform in the Ministiy of Finance. Both coniponents have progressed well. We have completed a job classification exercise resulting in job descriptions for higli level civil service positions and used to determine pay grades for llie entire government. Beginning late last year, we developed a road map to a jobbased remuneration system at tlie Ministry of Finance that provides better differentiation based on coniplexity and workload, on responsibility and on performance criteria. With tlie approval of Parliament we began putting this system in place on September I. 2007. On the institutional Front, tlieru ha been a

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76 reorganization of the Secretary General's ofice to improve human resource planning, and provide better support for the Minister and Uie Ministry's refam agenda "liese reforms are still very much iii their infancy and we are inonitoring the situation closely. The Parlianient agreed to extend these mfonns to four other agencies (the Commission for Eradication of Corruption (KPK), the Siipreine Audit Board (BPK), tlie Supreme Court and the State Minister for Administration (MenPAN) as well as llie Ministry of Finance) as a first step towards a indium aid longer term institutional and civil service reform strategy. We are also proposing to push the reform agenda deeper at the Minisby of Finance with an overview of both institutional and HR reforms. On tlie institutional side this,would involve looking longer term at shuctural issues designed to improve efficiency such as creating agencies for certain administration functions and on tlie HR reforms to follow up on current agenda with a special emphasis on assessments of how improved incentives have impact on performance.

PUBLIC SERVICE DELIVERY This represents the second year hat we have focused on improved public service delivery, especially in the area of poverty related programs. The main focils is on scaling up our lieadline poverty prograni (PNPM), as well as increasing spending on infrastructure, health aid education in order to increase access aiid service delivery. But we are also consideriiig future poverty propnming with the introduction of conditional cash traiisfer programs. This increased spending is designed lo deliver more jobs and poverty reduction as part of our pledge to achieve the RPJM and MDGs for 2009 and 2015, respectively. Last year, in the aftermath of the scoiiomic adjustment to higher fuel and rice prices, we witnessed an up-tick in poverty levels from 16 percait to 17.8 percent. In 2007, growth was sufficient to bring the overall headcount in poverty back to 16.6 percent - belter, but still f& from what we would like. Consequently, poverty and regional disparities will have to be addressed with more effective instruments. This, in tun), requires better targeting, better information on the performance of programs, and using such information to improve the focus and implementation of public interventions. Thus, starting from last year and with your support we have continued to push ahead with our flagship poveity reduction progroln (PNPM) aiming for the program to cover all of Indonesiaby 2009. At the same time we liave begun to pilot individual conditional ash transfer and community-based conditional cash transfer progrruns (PKH) that will together cover close to one milliori households. Tlie unconditional cadi transrer program in 2006 was successful in preventing poverty from rising further, but it was a crash program. Now, we would like to have better targeting of poor households to improve education and health outconles. These conditional inteiventions require significantly greater monitoring capacity aid sectoral interventions, therefore we are piloting new programs in this area.

To deliver oii our public service agenda we have been focusing 011 three broad areas: (i)strengthelid effectiveness and pro-poor targeting of publio programs; (ii) community-driven development; and (iii) improved service delivery.

SN.engthened efledveness mid pro-poor tiargetiiig of publicprosroiirs Wlien we first began to cut untargeted fuel subsidies and reallocate the resources to more targeted educatioci, health and village infrastructure we were unable to assess how well these programs were doing. Tlie initial and subsequent assessriients liave convinced us of tlie importance of better evaluations of poverty programs and Government spending niore generally. This year has seen a real breakthrough. As part of the development of PNPM, Bappenas conducted an assessment of more than 14 community poverty reduction programs implemented by various agencies. Many of these progranis duplicate each other, use different methodologies and create inefficiencies. We are now nioviiig to assess best practice in the ama and consolidate our own and development partner programs. At the sane time we have requested support for deeper analyses and rigorous evaluations of several key poverty and public services programs. We have also created baselines for both PNPM and PKH to allow for improved evaluation in the fnture. Most importantly, we are institutionalizing these assessments tlirough guidelines on how evaluations are to be pcrfonned and througli the creation of a new Echelon 1 level positioii at Bappenas. These will improve our capacity to deliver the kind of solid evaluations and empirical evidaice needed to shift in programs and resoiircds. In order to ensure that the planning and budgeting frameworks became real instruments of change we have identified, among other actions, the need to reinforce and institutionalize the use of evaluation

0 /w

77 arid assessment tools as a permanent practice in the policy formulation and budgetary allo~atioii processes. The iiitent is to promote a more adequate generation and systematic use of public- performance information iii decision-making, while stiaiigtlieiiiiig effective accountability, both within the goveiiiment and control ngeiicies, and among citizens. However, well-targeted social programs require a good targeling system. Currently, various poverty programs (Raskin, BLT, Askeskin) each use their owii system, creating wnfusion aid inefficiency. This year we propose to begin the development of a consolidaled national database flexible enough to serve multiple poverty and social programs. Finally, decentinlization has put regional governments in charge of many of the areas critical to improved pro-koor service deliveiy and recent budget changes have increased the resources available to these local governments. Thus the tliird area of focus for us is an effort to improve our leverage on pro-poor spending by facilitating llie engagement of sub-national governments through better procedures and apacity.

Coiriitririri~y-rln'vr,rdeeeloynreitt I Filially, a iiuinber of policy support measures are needed to make PNPM successful as it moves I forward. 111 effect tliese programs operate on a different basis tlirui typical government pingrains, as they are executed by communities that directly plan, manage, and execute their self-identified programs either through contracts or tlieir own labor, We have now produced an operating manual for PNPM that clarifie ways in which tliw villages can use simplified procurement procedures. Since the the cany-over of spending from one year to tlie next doe not comply with the prevailing laws, we now plan to allow communities to use un-disbursed fiinds fiom one year in the following year, using the revised budget process. We are working to facilitate more continuity in multi-year projects and this will also assist in addressing problems with niulti-year spending at the coininunity level. First, as we move ahead with the PNPM program to cover the entire country, we will have to ensure tliat sufficient funds are allocated to die program in order to have a significant poverty reduction and employnient impact. Second, wo will need to eiisure proper coordination aniong different liiie ministries so that essential services to lielp the poor, SLICIIas education and health, are mobilized to complement and support PNPM efforts. This will involve improved coordiiiatioii and aiignnient of interventions. Third, the Government must be vigilant to ensure that funds are used for their intended purposes, wliicli will require improved nianagement, greater financial and programmatic supervision, and the promotion of accountability and information transparency mechanisms for citizens.

Service cIeIivery Under our decentralization framework most service delivery is now the responsibility of regional governments. These goveninients have more resources to deliver tliesa services but many, including water, sewerage, roads etc require large upfront investments io infrastructure that geiierally require borrowing. However, soins countries have run into fiscal problems through poor borrowing decisions on the part of regional governments. Thus one ofour objectivw lias been to develop a clear framework for subnational borrowing that provides access to finaiice but also incentives to encourage wise borrowing. This framework, including guidelines on how to issue bonds, 1i&s now been developed and placed on the Ministry of Finance website. However, this is the beginning and not the end of the process, and we will be monitoring the access of local governments and local government enterprises to capital markets going forward. Other elements of support for sub-national governments that we have committed to, (for instance, working out the arrears of water enterprises and local governments) have become the natural focus of our efforts in the InfrastructureDPL and are disoussed thsro. Universal access and quality of education services remain on top of our agenda Our education strategy outlined in tlie Ministry of National Education's five-year strategic plan (Renstra) is founded on three pillars: (i)equity and expansion of access; (ii)quality, relevance and competitiveness; and (iii)goveriiance and accountability. Under (i) equity and expansion of access, we address both supply and demand barriers to education. One key program in this area is the Operational Aid to Schools (knowo as BOS). Borne out of the oil subsidy reduction compensation fund, BOS is being used to eliminate school fees for basic education. In (ii)quality, relevance and competitiveness, the focus is placed on staiidards and includes the establishment of the National Education Standard Agency (BSNP). Teacher quality is a high priority and all teachers wIII need to demonstrate colnpetelicy io order to obtain the newly required teacher ccrtitication. For (iii)governance and accoantability, we are placing special einpliasis on improving key systems including the ilnplemenktion of a Financial Management System, improved audits, arid intensification of preventive measures by the Inspectorate

9

78 General. In particular we am pleased to have advanced our central effort to improve teaclier stslidards and certification this yea in line with our commitment last year.

We remain committed in our focus 011 education, a sector that lias seen a substantial increase in finalicing in recent years. Using these increased resources well is one of the government's main priorities and we will look into the efficiency, equity and distribution of education spending. In Uia coming year, we propose to begin to deal with tile problem of the mimatcli between teacliers and schools with solile areas over-served and otliers under-served. To begin to address this problem we propose to implement a i'egulation (PP) that requires teachers (ohthan head teaclieix) to be assigned a minimum of 24 hours class time per week in order to receive tlie professional allowance (for certified teachers) and/or tlie special area allowance (for tewhers working in hardship areas).

INFRASTRUCTURE Tlie infrastructure agenda has now become the top government priority. To sustaiii growth, substantially increased investment ill supporting infinstructiue is required. We have begun lo substantially increase our national spending on iiifrastructure; but we are also planning to increase spending by sub-national governments in tlieir areas of responsibility; and by the private sector, through public-private partnerships (PPPs). In addition, we are pmuiiig critical cross-cutting issues, includiiig faster land acquisition, better waste and general environmental inaiiageinent and improved procurement in the Ministry of Public Works.

Nntioitnl iitfrnshcture We have moved forward 011 two areas in our engagenient on national illfrostructure this year. First, the Government has increased annual infmstructure spending in the state budget (APBN) for 2008 by 30 percent. A mqior part of the higher APBN infrastructure development spending will be used to increase the capaoity and upgrade the standard of the non-tolled national highway network. Substantial spending increases are also being provided for several otiier forms of national transport infrastructure, including most notably the railway system. Second, we have also increased tile transparency of the compensation payments to the state electricity company (PLN). PLN is required to provide power to the public at tariffs set by the Government and in return PLN receives compensation from the APBN budget for the full costs of its public service cbllgatlon (PSO). Beginning this year, PLN has begun to post information on its website to show how tlie 2006 PSO compensation payment translates into subsidies to consumers by region and by customer category. PSO payments to PLN currently accouiit for a very substantial propoition of total APBN spending, and we accordingly consider it veiy inipoitant that tlie public be informed on the beneficiaries oftlie PSO. Looking ahead, we intend to maintain the increase in infrastructure spending in 2009 and into tlie medium terni with actual annual infrastructure spitding averaging at least 25 percent above 2006 levels. But we also need to use Uiese increnses in spending wisely and the key to this involves the preparation of MTEFs and PBBs. This is now commencing in a number of sectors and the Government attaches a high priority to preparing ai Initial MTEF and PBB for national highways by mid-2008. Our priority in the PSO area is to better integrate the assessment of PSO compensatioii needs into PLN's medium-term planning processes. This will enable tlie likely costs of alternative performance targets - including for increasing the household electrification ratio - to be carefully considered by the key stakeholder ministries (Ministries of Energy and Mineral Resources, State- Owned Enterprises, and Finance) before final planning decisions are laken. Consideration will also be given to refining the design of the cuiwnt PSO scheme so as to better align it with PLN's corpolQJe structure and to reduce tlie scope for re-emergence of distorting cross-subsidies. These tasks will provide us with the foundations for analyzing and assessing possible avenues for reducing tile overall level of PSO compensation for electricity supply and for better targeting subsidies to the most needy, including through reviewing tlie basic electricity tariff.

Sub-tmtiorrnl in/nrslr.uctrrre Regional autonomy has rcdefilied responsibilities for infrastructure provision, with subnational goveninients now being fully responsible for managing urban water supply, sanitation and local roads. Tile central government's supporting role in sectors where provision authority Iias been decentralized

10

79 is now primarily to empower and enable regional governments to obtain adequate financing and to create appropriate incentives for thein to invest effectively and efficiently. For a vnriety of reasons, infrastructure expendituiw by sub-national governments ond regional enterprises have remained stubbornly low. This is of particular concern in water and sanitation and, to a lesser extent, iii urbui and rural roads. In some instances, low spending is attributable to fiscal constraints, while in others, the issue appears to be the institutional capacity to prepare and implement work programs. For many regions, arrears on debt-seivice payments to central government preclude local governments and/or their water utilities (PDAMs) from seeking new loans. Accordingly the Governiiient’s iiiimediate objective is to tackle the arrears issue. This will involve restructuring the debts of local governments and PDAMs and, thereabr, employing Uie ‘intercept mechanism’ provided by the taw on Fiscal Balance to prevent recurrences. In order to provide improved incentives for local governments to invest in high-priority infrastructure, the Governnient will embed appropriate perfoimance-based meohanisnis within the existing inter-governmental finalicing framework. Tiis will include improving the functioning of the current matching grant scheme (the DAK) and incorporating performance-based incentives in the Financial Restructuring Action Plans for PDAMs. We are aiming by 2010 to implement debt work-out schemes for at least 60 PDAMs and to ennble at least 25 PDAMs to access new long-term debt.

Piiblic-privnfe pnrfitersliips The Government is also looking to private investors to contribute not only substantial additional financing but to drive mucli needed improveinents in efficiency and service standards. For this reason, we moved quickly after taking office to establish an improved governance regime for publieprivate partnership projects and to identify an initial set of promising transactions. Tlie new regime, which is set out in a Presidential Regulation (Perpres) No. 67/2005, empowers the Government to provide support for economically sound projects that would otlienvise iiot be ‘bankable’, aid we have subsequently created a Risk Management Unit (RMU) within the Ministry of Finance to inanage associated fiscal risks. Our experiences over the past two years have highlighted that we still need to do much more if we are to attract the level and quality of private sector illvestment in infrastructure. Near-term priorities include: strengthening the capacity of contracting agencies to prepnre and tender projects to besl practice standards; resolving ambiguities concerning provision of Government support for projects that are to be contracted by sub-national agencies or that do iiot comply fully with the preparation and tendering provisions ofPeipm No. G7)2005; * establishing an lnfrastructurc Gunrantee Fund to increase the credit enhancement value of Government support and to facilitate prudent management of fiscal risks; and establishing an Infrastructiire Investment Fund to assist in the mobilization of financing for PPP projects, in particular long-term local currency financing. By 2010, we expect the above measures to result in financial closure on at least two major PPP projects that are fully compliant with the requirements of Perpres No.67/2005 and in a considerable strengthellingof well-prepared PPP projects in the pipeline. We will be issuing a regulation in 2008 to specify sound and transparent procedures and criteria for dealing with the backlog of PPP projects that have already been awarded but that have not been prepared and tendered in full compliance with Perprcs No. 67/2005. Projects that are not deemed to be compliant with Perpres No, 67/2005 will not be eligible for Government support unless explicitly provided for by a presidential regulation.

Oflrer cross-crtt:iiig issues Our experiences over the past two yews have also highlighted the need to address a range of policy and process issues that have the potential to undennine the legitimacy, sustai~lability,8Ild publl~ acceptability of major infrastructure projects. The most important of these relate to land ncquisitiotl, environmental protection, and procurement.

11

80 The Government recognizes that timely land acquisition, through procedures that ensure those affected receive fair compensation and access to appropriate rehabilitation measures, is essential for the efficient implementation of toll-road and many other infrastructure projects. Shortcomings in the current procedures for land acquisition have continued to cause significant slippages and escalation of costs despite our recent efforts to address them. In addition, tlie implementation ofcapital works on some national highway projects has suffered delays as a result ofthe current practice of requiring local governments to contribute to project costs by funding land acquisition. Tlie Government has recently established a high-level Working Group to develop an action plan for implementing, in a socially responsible manner, (116, eminent domain procedures available under the 1961 Law on Land Aquisilion, and intends that this will be implemented by 2010. In addition, we will be mending existing regulations during 2008 so as to enable the costs of land acquisition for the construction and upgrading of national highways to be funded from the APBN budget. We are very conscious of the need to ensure that tlie potential environmental impacts of infrastructure development and use, including impacts on climate change, are carefully identified and assessed, and that appropriate management, mitigation and monitoring measures are adopted. hi addition, we are also aware of the need to put in place improved policies and standards for waste management, which we view as an increasingly vital form of public infrastructure. The needed refonns will require changes to existing legislation, and we accordingly plan to submit drafts of new laws on waste management and environmental management to the Parliament before the end of tlie Government’s term. Considerable efforts have already been expended by successive administrations to enable effective and transparent competition for infrastructure projects tlirough the improvement of procurement policies and proceduiw, and througli skills and systems upgrades in ministries that manage high-value procurements. We view e-procurement as an Important tool for increasing competition, transparency and efficiency. The Ministry of Public Works has already taken an Important first step by implementing ‘semi-e-procurement’ for all national road works contracts in Java and Sumatra and expects full impiementatioii of transactionsbased e-procurement for all national road works procurements by 2010. During 2008, the Ministry will establish acentral procurement unit to drive the further development of procedures, systems, and documentation and to provide support and guidance to individual procurement committees. To complement md reinforce these and other measures designed to improve the governance of infrastructure provision, we are also now taking concerted steps to increase die effectiveness of the internal audit function within key ministries, Once again, tlie Ministry of Public Works is pilotirig new approaches and has already adopted improved procedures for technical audits. As the next step, the Ministry will during 2008 prepare and adopt a plan for improving the audit riietliodology used by the InspectorateGeneral to align with international best practice.

CONCLUSION This has been a year of solid progress for our economy and our reform programs to improve the investment climate and public financial management and governance. Our improved fiscal position continues to translate into increased spending on poverty, social programs and infrastructure, and we welcoine the increased emphasis in these areas. In closing we reiterate our cominitnient to the ambitious reform agenda we have laid out and thank you for your contintied engagement and support

~ Minister of Finance Republic of Indonesia

Sri Mulyaiii Indrawati

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0 ANNEX 4 IMF ASSESSMENT LETTER

Indonesia-Assessment Letter for the World Bank Group September 11, 2007

Staff Assessment of Developments and Policies

Recent Developments and Short-Term Prospects

Economic growth reached 5% percent in 2006 as the dip in activity following the late 2005 fuel price and interest rate hikes proved shallow. Strong exports compensated for weak domestic demand. Notwithstanding heightened risk3 to the outlook from a possible slowing ofU. S. growth, staff still projects GDP growth at around 6 percent in 2007 with some shift from external to domestic demand. Inflation has remained broadly stable around 6 percent in 2007-the middle ofthe 2007 target range of 5-7 percent-allowing Bank Indonesia (BI) to lower its policy rate further to 8% percent. The external current account surplus is projected to narrow from 2% percent of GDP to around 1% percent in 2007 as lower global growth and commodity prices reduce exports. The central government deficit increased modestly to 1.0 percent of GDP in 2006. For 2007, staff projects a somewhat higher deficit of around 1.6-1.8 percent of GDP.

Along with other emerging markets, Indonesia’s equity and bond markets were hit by the recent turmoil in global financial markets. The extent of the sell-off was relatively high in a regional comparison, but it followed a prolonged period ofincreases, driven by the abundant global risk appetite as well as domestic factors such as declining interest rates and perceptions of reduced vulnerability and improving economic prospects. Portfolio capital flows mirrored these developments as foreign investors increased their positions in Indonesian securities during most of 2007, then reduced exposure since mid-July. After appreciating in May vis-a-vis the U.S. dollar in response to portfolio inflows, the rupiah has subsequently fallen by around 7 percent (3% percent since the Article IV consultation in mid-July), but remains within a range consistent with external competitiveness and macroeconomic stability.

Banking sector indicators have strengthened, although the impact on balance sheets from the recent market turmoil has yet to be fully assessed. Over the past year, bank profitability has improved. The banking system is well capitalized and nonperforming loans are low for private banks. State banks’ non-performing loans have fallen significantly but still remain higher. Overall, with the improving indicators, the banking system appears to be in a relatively good position to weather the recent global financial market turmoil. Direct exposure to collateralized debt obligations (CDOs) or other structured credit products appears minimal and Indonesian financial markets have so far remained sufficiently liquid during periods of market pressure.

91 2

Similarly, external vulnerability indicators have improved over the past year, helping the economy to weather recent volatility. Fiscal deficits are modest and public debt is declining, the external current account is in surplus, and the exchange rate is broadly market- determined, with some symmetric market intervention to smooth volatility and automatic purchases ofthe government’s foreign exchange receipts. The ratio oftotal external debt to GDP is expected to decline to less than 20 percent ofGDP by 2012, from 35 percent in 2006, while government debt (including domestic debt) is projected to decline from 39 percent of GDP to 26 percent over the same period. A steady build-up ofreserves and lower external borrowing have increased the ratio of reserves to short term debt to more than 150 percent.

Nonetheless, downside risks remain to the positive outlook, in particular related to the global financial market turmoil arid its impact on global growth. While reduced vulnerabilities have put the Indonesian economy in a good position to weather moderate external shocks (see adverse macro scenarios in the 2007 Article IV staff report), a sharper than expected slowdown in global economic growth and a sustained reduction in risk appetite could have a significant negative impact on the Indonesian economy. The main risks arise from potentially lower export demand and commodity prices, reduced access to financing and higher financing costs, and possible balance sheet impacts oflower asset prices and a depreciated rupiah.

RiIacroeconomic and Structural Policies

The government continues to implement its comprehensive reform agenda to boost growth over the medium term. Key elements ofthe strategy include policies to strengthen financial intermediation, improve the business climate, and increase infrastructure investment. While substantial progress has been achieved, including passing of a new investment law and several fiscal reforms, other measures, particularly with respect to the labor market, have encountered resistance.

With respect to monetary policy, Bank Indonesia (BI) has responded flexibly to shocks to inflation and output, while building the credibility of its newly established inflation targeting framework. The last two policy meetings saw a pause in the current rate-cutting cycle, in response to the recent weakening in the rupiah, a slight increase in headline inflation, and uncertainty over the fall-out from the global financial turmoil. Staffjudge that room for further rate cuts will remain limited, particularly since the full effect ofrecent rate cuts is likely still to be felt and the currency has shown some renewed weakness in recent months.

In the staffs view, the recent relaxation of prudential regulations to encourage lending is not likely to have much impact on lending growth. At the same time, the steps represent a departure from international standards and risk having an adverse signaling effect on supervisors and banks alike. With bank lending already

92 3

increasing, in the staffs view BI should reconsider the appropriateness ofthe measures as soon as possible. Moral suasion to encourage banks to lend to specific sectors could result in credit misallocation and should also be avoided. Instead, staff has encouraged the authorities to strengthen efforts to promote the development of capital markets and instruments of longer-term financing and to develop a strategy on the future role of state banks.

0 The authorities’ projected fical stance is appropriate. The modest relaxation in deficit targets for 2007 and 2008 provides some room for additional development spending while ensuring further declining debt ratios. Further improvements in tax administration, some new tax measures, and the streamlining of expenditures, including through greater flexibility of energy prices, could create additional space for priority spending, such as infrastructure, health, and education. Enhancing the implementation capacity of local government would also contribute to this effort.

0 The authorities have made good progress in fiscal reform. Recent achievements include the restructuring of the tax agency and the adoption ofa key tax reform bill. The planned introduction of a fiscal risk statement and the medium-term fiscal framework in the 2008 budget should help to further strengthen fiscal management.

0 Structural reforms have advanced with the recent passage of the investment law and the presentation of a new economic policy pacliage. While publication ofthe negative list for foreign investors raised some concerns in the foreign business community, the law retains a broadly open investment regime and clarifies existing ownership limits, which were previously opaque. The privatization process has also been restarted, with the sale ofa minority stake in a major state owned bank in July. However, progress on the difficult issue oflabor market reform remains limited.

Status of IMF Relations

0 The 2007 Article IV consultation was completed on July 18,2007.

0 The next Fund mission is scheduled for November/December, 2007. The next Article IV mission is scheduled for mid-2008. Technical assistance missions from the Fiscal Affairs Department, covering tax and treasury administration, and from the Monetary and Capital Markets Department, covering banking supervision, will be in the field in the interim.

93 ANNEX 5 FIDUCIARY ASPECTS

Background and Analytical Underpinnings

1. The funds from this operation will essentially flow to provide general budget support to the Government. The management of the Government’s budget is influenced to a large degree by the on-going Public Financial Management (PFM) reforms. This note summarizes the direction and progress of these reforms to help determine the attendant fiduciary risks to these funds.

2. This assessment of fiduciary aspects of this loan has drawn upon several studies on public financial management and accountability that have been completed over the last 12 months, both internally within the Bank and those undertaken by donor partners. Studies undertaken internally by the Bank include a Public Expenditure Review completed this year. We have also considered specific inputs and advice from donor partners, including a Sector Report on Accountability & Audit in Indonesia (ADB: January 2007), a Statement of Fiscal Risks (IMF: 2006), Report on Budget Reform Priorities (joint World Bank and IMF: April 2007) and a Report on Observance of Standards and Codes on Fiscal Transparency (IMF: October 2006). This assessment has also taken into account a review of the progress made in implementing actions agreed under the third DPL approved in year 2006 and results of recent supervision missions to assess progress in implementing the World Bank-financed Government Financial Management and Revenue Administration Project (GFMRAP) that became effective in October 2005. These reports and documents provide the analytical underpinnings for this assessment. An exercise to measure PFM processes based on the PEFA’ methodology is currently under way and is likely to be completed by November 2007.

3. Deficiencies in Indonesia’s PFM systems have been well documented in recent years and a reform strategy to address these was formulated by the Government in their White Paper on Public Financial Management reforms that was prepared in 2003. This strategy covered a broad spectrum of public financial management, from budget formulation to budget execution, accounting and reporting and external oversight. These reforms directly influence the environment in which public expenditure is planned, budgeted, executed and accounted for across all levels of Government. A more detailed commentary on the progress in implementing these reforms is given below to help identify the attendant risks arising from the borrower’s capacity to receive and manage this loan and help determine the fiduciary arrangements for this operation.

4. There is also a need to boost public investment in infrastructure, both at the national and sub-national levels. In this context, the fiduciary environment in which public finances are managed becomes particularly relevant. In the initial years, the focus of on- going PFM reforms has been understandably at the Ministry of Finance, which is leading the reform process. But the scope of PFM reforms is gradually expanding to line

I Public Expenditure & Financial Accountability: A Performance Measurement Framework

94 Annex 5 Fiduciary Aspects ministries such as Ministry of Public Works, who share a clear responsibility for maintaining acceptable levels of accountability for public expenditure. Budget Allocations

5. A recent analysis by the Bank’ has concluded that prudent macroeconomic policies, particularly the extremely low budget deficits, have been instrumental in Indonesia’s recovery from the last crisis. Over the past 10 years, there has also been a remarkable transformation in the way public resources are managed and allocated. As a result, Indonesia can expect to have significant additional fiscal resources, or “fiscal spacey’- almost of the magnitude of the revenue windfall seen during the oil-boom of the mid- 1970s.

6. The composition of public investment has changed substantially since decentralization. When Indonesia decentralized, sub-national governments increased their share of resources. Sub-national governments now manage about half of total public investment. At the same time, the sectoral composition of expenditures changed as well. The overall shares of education and administrative expenditures have increased substantially, while infrastructure has declined, particularly since 2003. Yet some key indicators of government budget performance have not improved so far, particularly budget out-turn indicators. Actual central government expenditure has consistently deviated from initial plans. Subsidies tend to be underestimated, while capital spending has been consistently lower than the budgeted amount. At the same time, other parts of the budget - most notably public investments and central government personnel spending - show under-spending. Public Financial Management Reform Strategy

Some key elements of the reform strategies articulated in the past included the following: Modernizing an outdated legal environment for PFM, by issuing a modern set of laws and implementing regulations; Reforming an opaque and inefficient budget formulation process, by discontinuing the separate recurrent and development budgets, and introducing performance budgeting systems and forward estimates; Reforming budget implementation, in particular the inefficient payments system and weak monitoring and accountability arrangements; Modernizing management of the Government Treasury, to consolidate fragmented cash management and make government banking arrangements more efficient; Introducing modem Government Accounting Standards and accounting practices to improve the reliability of Government financial reporting; Reforming arrangements for government auditing, in particular strengthening the mandate and capacity of Supreme Audit Institution (BPK), addressing overlaps

2 Extracts from Indonesia Public Expenditure Review 2007: Spending for Development

95 Annex 5 Fiduciary Aspects between external and internal audit agencies and clarifying their respective roles and responsibilities. e Modernizing the institutional and regulatory framework for public sector procurement. Summary of implementation experience on PFM Reforms

7. Successive Indonesian governments in the last several years have embarked on reforms in the budget and public financial management system, with support from various donor^.^ These followed the important political reforms that have been introduced since 1998-including “big-bang” decentralization and the direct election of the President. Key areas ofprogress so far include the following.

Adopting a new legal framework for planning, budgeting, treasury management, and external audit. New laws were adopted by Parliament during 2003-04 and many government implementing regulations were issued thereafter. Restructuring the Ministry of Finance. A first restructuring occurred in 2004, when the Directorate General (DG) of Treasury was established, separate from DG Budget. A second restructuring occurred in 2006, when a new Fiscal Policy Office was established with a focus on macro-fiscal policies and projections, and a new DG Debt was created by splitting off two directorates from DG Treasury, with external and domestic debt management consolidated in one DG. Unifying the previous routine and development budgets. As from the 2005 annual budget, a new economic and functional classification was introduced for budgetary expenditures, based on the IMF’s Government Finance Statistics Manual (GFSM 2001) ~ystem.~ Beginning a process of rationalizing government bank accounts and improving cash managemenL5 A principal objective is to establish a treasury single account (TSA) and to close government accounts outside the DG Treasury’s control. PP 24/2005 prescribes modified cash government accounting standards, as a transition towards full accrual standards at a later date. Templates for accounting statements to be used by central and local governments have also been issued. Finalizing plans to introduce a new treasury system (the SPAN project). The World Bank’s Government Financial Management and Revenue Administration Project (GFMRAP) focuses particularly on computerization of treasury operations through the treasury system. The GFMRAP also includes components to support change in the budget system-within the Ministry of Finance and BAPPENAS- as well as for improving parliamentary involvement and oversight of the budget approval processes.

3 The main technical assistance providers are the World Bank, Asian Development Bank, the IMF, The Dutch Government, European Community and the Government of Australia. 4 Indonesia: Treasury Modernization and Related Reforms, (IMF, April 2005), and Report on the Government Finance Statistics Mission, (IMF January 11-24,2006). 5 Indonesia: Improving Cash and Debt Management, by I.Lienert et. a1 (IMF, March 2007).

96 Annex 5 Fiduciary Aspects

0 Keppres 80/2003 introduces many improvements in the procurement regime in Indonesia and lays out a plan for establishing a national policy formulation and oversight agency. An omnibus procurement law is envisaged for consolidating, clarifying and simplifying the numerous procurement rules and regulations. This law, currently under preparation, would further strengthen the legal foundation for modernizing public procurement. 0 Strengthening the mandate of and funding for external audit institution. The State Audit Law legislated in 2004 lays out the broad legal framework for the operation on the country’s supreme audit institution, BPK6, to reinforce its position and mandate as an external audit institution reporting to Parliament. A separate law (BPK Law) has recently been passed to cover the institutional arrangements for the management and oversight of BPK. BPK has seen a significant increase in its budgetary financial resources. 0 Enhancing parliamentary oversight of budget processes. Parliamentary commissions have become particularly active in scrutinizing and amending the government’s draft annual budget. However, this has become more intensive and detailed than is the case in many countries. There would be a need for a more strategic and less instructive approach to their involvement. 0 The government published the IMF fiscal transparency report7 and undertook its socialization throughout Indonesia. The public availability of fiscal information is already improving and the government has published a fiscal risk statement with the 2008 budget. Experience in Implementing budget reforms

8. The fiscal roles of the executive and legislative branches are now defined in law and evolving in practice. Fiscal relationships between the government and legislature are defined in the UU 17/2003 on State Finances. The House ofRepresentatives (DPR) is the principal legislative body and it plays a significant role in shaping the budget and fiscal policy. The budget is passed in agreement between the president and the DPR. The process involves an examination by DPR of both the macroeconomic framework and macro-fiscal policies and the detailed budget allocations. The relative roles of the executive and legislative branches in this area are evolving.

9. The laws governing budget management clearly specify the responsibilities of the minister of finance and comprehensive regulations have been developed. While the President, as head of government, has overall authority to exercise national fiscal management, UU 17/2003 clearly delegates the responsibility of overall fiscal management of central government finances to the Minister of Finance as chief financial officer. The law also assigns responsibilities to individual ministers, governors and other local authorities for financial management and accountability in their jurisdictions.

Badan Permeriksa Keuangan 7 Indonesia: Report on Observance of Standards and Codes-Fiscal Transparency Module, IMF Country Report No. 061330, September 2006.

97 Annex 5 Fiduciary Aspects

10. Provisions of the new regulations are under implementation. The budget classification is largely consistent with contemporary international standards. The Ministry of Finance is developing plans for a medium-term expenditure framework (MTEF) to guide budget policy. Forward estimates at the aggregate level have been introduced for 2009 and 2010 with the budget for 2008. However, much more work needs to be done to fully operationalize the MTEF approach. Reforming Budget Execution

11. Indonesia still spends 50% of its total capital expenditure in the final quarter of the year*. For the past five years, spending has always started slowly and then accelerated at the end of each year. This spending pattern raises concern as project implementation is disrupted by an adverse cycle. Moreover, under-spending in capital expenditures constrains increases in infrastructure investments. Slow and back-loaded disbursements are symptoms ofmore severe challenges that are encountered at each stage of the public expenditure management cycle.

12. The government maintains a comparatively rigid budget execution process. Detailed input controls aim at ensuring that the composition of the budget complies with political priorities and that the budget will not be altered during execution. Spending warrants (DIPAs), while now issued at the beginning ofthe fiscal year, contain excessive amounts of detail leaving little flexibility for adjustments in the composition of inputs needed to carry out a given activity. Re-allocations across DIPAs from delayed programs to better performing ones that could enhance satisfactory implementation of the overall expenditure program require a lengthy revision process, sometimes involving the parliament (DPR). Such inflexibility creates practical difficulties and inefficiencies.

13. With expanding fiscal space, public investment is increasing, putting additional pressure on the Public Financial Management (PFM) systems. Planning and executing public investment is inherently more demanding than current or mandatory expenditure.

14. Basic internal control procedures are in place to ensure that expenditures across all spending agencies strictly follow approved budgets. Spending units’ DIPAs are the key documents required to authorize government spending and form the basis for expenditure control and these are now issued more timely than in the earlier years. Ministry of Finance regulations have been issued to cover various aspects of budget execution. The Treasury records expenditure transactions at the payment stage. The expenditure control system does not provide for central recording of commitments. Operational control over expenditure stages such as commitment and verification of delivery ofgoods and services are undertaken by budget users. Treasury and Cash Management

15. Transparency is clouded by a multitude of bank accounts. The Treasury itself maintains multiple bank accounts, both in Rupiah and in foreign currency, at Bank

8 Indonesia: Public Expenditure Review 2007: Spending for Development

98 Annex 5 Fiduciary Aspects Indonesia. There are also an unknown number of extra-budgetary bank accounts maintained by budget users. External audit reports have placed these at over 1300 bank accounts that have not been reported to the central Treasury.

16. Regulations associated with UU 1/2004 will address this weakness and provide for: (i)the installation oftreasury single account (TSA) at Bank Indonesia; (ii)the conversion of operational bank accounts at commercial banks into zero-balance transit accounts; and (iii)a mandatory review at the Ministry of Finance of bank accounts of all state agencies outside treasury oversight, with a view to close those that do not serve the public interest. Pilot runs for testing zero-balance arrangements with commercial banks have been successful. It is planned to complete the consolidation of all government cash balances into the TSA by end-2007.

17. The cash based accounting system generates timely records of revenue and expenditure transactions, but does not track monthly arrears. Transaction records are electronically transmitted to the directorate of accounts at treasury headquarters for consolidation and generation of periodic reports on budget execution. The cash-based treasury system does not track payment arrears on a monthly basis; although DG Treasury’s plans to move towards an accrual recording system would make it possible.

18. Treasury cash management and payment modernization will be supported by the planned computerized treasury system (SPAN) under the World Bank GFMRAP project. The implementation of the treasury component of GFMRAP has been delayed. DG Treasury has not mobilized for project implementation and the procurement process has been ongoing for more that 18 months. Procurement Reforms

19. The last few years have witnessed improvements in the public procurement environment. Keppres 80/2003 provided a national public procurement regulation that meets most of what is generally regarded as accepted international practice including basic principles: transparency, open and fair competition, economy, and efficiency. This decree also requires that a national public procurement office (NPPO) be established as a regulatory body for public procurement. With the introduction of Keppres 80/2003, a previous Certification (“Pre-qualification”) process for the suppliers/ providers of goods and services was, in most instances, abandoned by GOI. This has previously led to segmentation of the market and especially at the provincial levels. Keppres 80/2003 also established a basis for sanctions, complaint handling and requirements for certification of users.

20. However, the public procurement system still has significant deficiencies at the regulatory, and more importantly, implementation aspects. These are mainly the delays in establishing a strong regulatory body; slow progress in development of procurement regulation anchored by a law, slow progress in development of standard tools in terms of bidding documents and users manuals; weakness in procurement capacity in implementing agencies, especially at the provincial and district levels; collusion and

99 Annex 5 Fiduciary Aspects corruption practices in the bidding process and concerns on the efficiency of anticorruption and sanctions measures.

21. A new Keppres has been drafted that, when issued, will establish a fully independent Goods/Services Procurement Policy Development Institution (Lembaga Pengembangan Kebijakan Pengadaan Pemerintah [LPKF'P]). The planned institution will report directly to the President and will be chaired by an appointee from the civil service (non-political), who may be assisted by a Committee comprised of procurement experts sourced from both inside and outside government. The establishment of LPKPP, in itself, should not be regarded as reforming public sector procurement. Rather, it should be perceived as the first crucial stepping stone to enable focus on a wider public procurement reform program.

22. Laws enacted since 2000 that impact on, or make reference to, public procurement are Construction (governing civil works), State Finance, Treasury, Audit, and Small Scale Business. The pace of Indonesia's commendable decentralization reforms has had an impact on public sector procurement at different levels of government with ministers, governors, and even mayors being able to issue their own decrees, regulations, and instructions. The plethora ofregulations is often inconsistent with one another and many do not meet accepted international practice. As a consequence, national procurement reforms and the need for national procurement policies and standards became urgent.

23. Indonesia's legal framework for public sector procurement can best be strengthened by anchoring it with an overarching consolidated and comprehensive national public sector procurement law at the highest level that (i)establishes the fundamental principles and procedures applicable to all public sector procurement, (ii)allows for the imposition of sanctions where the principles and procedures, and particularly those relating to good governance and ethics, are not met, (iii)amends other laws that refer to public sector procurement, and (iv) ensures that such a law will have the necessary authority in a decentralized environment. Drafts of a new high-level law and associated subordinate regulations are being finalized and are expected to be ready by end of 2007.

24. Standard bidding documents: currently there are no national standard bidding documents in Indonesia. Some implementing agencies (such as Ministry of Public Works) have developed standard bidding documents for their own use. However, there is no evidence that such documents are consistently used at all levels of government in the country. The NPPO, through the support of ADB, has drafted eight National Model (Standard) Bidding Documents being (1) An Explanatory Guide, (2) Goods with Pre- qualification, (3) Goods with Post-qualification, (4) Works with Pre-qualification, (5) Works with Post-qualification, (6) Other Services with Pre-qualification, (7) Other Services with Post-qualification, and (8) Consulting Services, and which are now available in a draft form in the Indonesian language only. The use ofthese documents is still not mandatory and in fact there is still no strong push from NPPO to enforce their use at the national level. NPPO preference is to try these documents on a pilot basis. While Keppres 80/2003 provides the basic requirements to be included in general conditions of contract, a standard general conditions of contract has yet to be produced

100 Annex 5 Fiduciary Aspects

25. Capacity Building and Certification: There has been growing concern, both by the Government and the Bank, on the pace of projects implementation. Significant delays and slow disbursement seem to occur across the entire PFM cycle. Projects reported delays and difficulties in budget preparation and approval, budget execution, and implementatiordprocurement. Specifically, there are concerns on implementation /procurement capacity of government staff and absence of incentives for project managers/procurement committees. Added to this, concerns of prosecution has also affected projects due to the reluctance of officials to take actions amid growing fear of being prosecuted under anti-corruption legislation even when it comes to minor mistakes.

26. On capacity building, Keppres 80/2003 required the Government to adopt an examination system and certification for procurement practitioners within Government contracting entities to ensure that their level of competence is indeed consistent with their level of responsibilities. So far, the rate of staff passing the basic procurement certification is very low (12%). It is evident that there is need for a strategic approach to capacity building. The future LPKPP will consider creating a Professional Procurement Training and CertiJication Board in order to develop and integrate a cost-effective procurement capacity building program.

27. Corruption, Sanctions and Independent Appeals Mechanism: despite improvements in the public procurement system, there are still concerns about corruption and collusive practices. Several cases under Bank projects have come to light. While addressing this requires an overall governance strategy, there are several important elements in the procurement system that can support such strategy such as an independent complaints mechanisms, effective sanctions mechanism and improving transparency in the procurement process through the use of e-procurement.

28. Keppres 80 requires the establishment of a complaint handling mechanism. However, this is not set up independently but within each implementing agency. As part of the ongoing CPAR, options will be explored for having independent complaints handling mechanism under the “umbrella” but independent of LPKPP, or possibly as totally independent body comprising persons from private sector professional organizations as well as civil servants with expertise in public sector procurement and procurement law.

29. E-procurement: The Ministry of Public Works and the City of Surabaya have both been at the forefront in the development of e-Government Procurement (e-GP) technology. NPPO has been taking the lead on behalf of the Government for implementation of e-GP in Indonesia at a national level. Currently, the focus is on developing policy and legislation for the validity of e-GP including electronic documents and signatures. NPPO has also established an electronic bulletin board for advertising national procurement opportunities. NPPO is considering adopting a national e-GP system, similar to that adopted by the City of Surabaya and pilot the e-Tendering functionality as a first step. Eventually the Ministry will need to decide whether to adopt

101 Annex 5 Fiduciary Aspects the national system in its entirety or ensure that its own system will integrate with it. Currently, the Ministry’s semi e-system is used for national road works contracts estimated as more then 10 billion IDR in Java and Sumatra. Generally the Ministry system provides most ofthe online functionalities for e-Tendering that would be required by international standards. However, submission of bids onwards is till being done manually due to the absence of the legislation to allow the full process as indicated above. Accounting and reporting on budget execution

30. The aggregate Government Annual Financial Statements have been prepared in a timely manner for 3 years now (2004, 2005 and 2006). Although the timeliness is a significant achievement, there are serious concerns about their reliability. The external auditors (BPK) have for three years issued a “Disclaimer” opinion on these financial statements due, among various factors, to serious shortcomings in the control environment ion which these were prepared and due to scope limitations.

3 1. The aggregate annual financial statements present revenues, expenditures and transfers, surpluddeficit, and financing aggregates, as compared with budget provisions. A balance sheet and a cash flow statement are also presented, along with a full statement of government accounting policy.

32. The recent development of Government Accounting Standards is a step forward to improve financial reporting, though the requirement of the State Treasury law of the complete introduction of accrual accounting by 2008 is very ambitious and may not be realistic. The Accounting Standards Committee (KSAP) has been in operation for a few years now during which time they have put in place a due process for development of Government accounting standards that are well aligned with comparable international standards (IPSA’S). Technical capacity constraints limit the pace at which these accounting standards can be implemented at all levels of government, including at line ministries and sub-national governments.

33. Monthly and quarterly reports on budget realization are produced by each Ministry monthly and sent to the Ministry of Finance for consolidation. The Ministry of Public Works has been timely in submitting its financial reports to the Ministry of Finance. A mid-year un-audited report on budget realization is presented to the DPR in July and is available to civil society.

34. There are no systematic and publicly available reports of the government’s contingent liabilities, tax expenditures or quasi fiscal activities. Data on central government debt are regularly published, but there are lags in public reporting of its total debt, and there are concerns about reliability of external public debt. Information on government financial assets is published annually.

35. Although commendable action has been taken to improve government financial reporting, there continue to be serious challenges in making the government financial statements reliable, as reported by external auditors in their annual audit report for 2006.

102 Annex 5 Fiduciary Aspects

This reflects the immense challenges that lay ahead in an environment where accounting capacities at the grassroots are weak and the accounting processes not yet integrated or fully automated. External Audit

36. Indonesia has made significant progress' to address deficiencies in the audit sector over the last few years. The enactment ofthe Audit Law in 2004 clarified BPK's mandate as the sole external audit agency in the country, giving them extensive right of audit over public finance, generally in line with international standards (Lima Declaration). In practice, however, some restrictions continue to apply.

37. Another 'BPK Law' was passed by Parliament in 2006 lays down internal and external governance arrangements for BPK as an organization, on matters such as appointment of BPK Board members and financial and administration independence. BPK has issued a series of internal implementing regulations for these laws and has also recently issued a new set of Government Auditing Standards that are substantially in line with comparable international standards (INTOSAI). BPK has completed a comprehensive study on its organizational structure in comparison to fully developed Supreme Audit Institutions of other countries, and has also prepared a medium term Strategic Development Plan. Significant increases in budgetary financial resources have also been granted to BPK for their operation a1 needs.

38. A peer review of BPK was completed in 2004, and this showed serious weaknesses in capacity. Since then, improvements are gradually being made to the organization, with new hires and training. Spending agencies generally respond well to audit findings reported by BPK.

39. Audit Reports of BPK are submitted semi-annually to the Indonesian Parliament within legally mandated time. These reports certify the financial statements of the audited reporting entities, and in addition comments on any irregularities or inefficiencies in budget execution that may have been noted. However, there appears to be little systematic follow up by DPR on BPK reports and no formal reporting of this. A recent study by ADB" has highlighted the need for capacity building at the DPR Secretariat to handle audit reports and information constructively. Public disclosure of all BPK audit reports is now mandatory. Internal Controls and Internal Audit

40. The internal audit framework of the government is extensive but scope and organization do not match needs. Ironically, even with (or perhaps because of) multiple internal audit agencies in existence, the internal audit function continues to be a weak link in governance. The internal audit function is carried out at central government

9 Sector report on Accountability & Audit in Indonesia (ADB January 2007) IO Report on Capacity Building needs of DPR Secretariat on Review of BPK Reports. (Dr. Sherlock ADB May 2006).

103 Annex 5 Fiduciary Aspects through three institutions: IGs in each spending ministry; the BPKP, reporting to the President’s office, with government-wide jurisdiction; and Bawasda at each local government.

41. This institutional structure is complex and the mandates and division of labor between the various internal audit institutions are unclear. The IG represents the principal internal audit apparatus of a ministry. The scope of IG audit activities is generally limited to technical compliance audits. The IGs therefore operate as individual institutions corresponding to the number of ministries. Professional backgrounds of IG staff therefore normally include technical qualifications and not accounting or auditing. Audits by IGs are not conducted on a risk based methodology. Local governments maintain their own internal audit units (Bawasda’s).

42. BPKP’s staffing levels do not reflect a reduced mandate. Although its mandate has been significantly reduced, it maintains fully staffed decentralized offices in 26 provinces in the country. They do not have a formal role in internal audit now, except to provide audit services to line ministries upon request.

43. Each line ministry plays the role of program executing agency and is therefore principally responsible for maintaining internal controls. It is responsible for performing and achieving the objectives stated in budget allotment documents. In order to strengthen the responsibility and accountability over the appropriated budget by the line ministries, the function of payment order issuance has been transferred to the line ministries, resulting in a better segregation of functions of verifying transactions and issuing payments. While this segregation of duties is well designed, implementation experience has not been entirely satisfactory in the absence of clearly defined standards of accounting evidence, verification procedures and well-staffed prepayment audit units in the spending agencies. Reforming Regional Public Financial Management

44. Decentralization provides local governments with large resources and authority, which requires an adequate regulatory framework and financial management capacity at the local level. The financial management reforms stipulated in the decentralization and subsequent finance and treasury legislation would modernize the regional financial management system and improve accountability if efficiently implemented, but it is vast in scope and the concepts are fairly sophisticated.

45. The regulatory framework for regional public financial management reforms is largely in place and includes mechanisms for fiscal transfers to local governments. After decentralization, the central government has passed comprehensive legislation for financial management reforms at the regional level, to mirror similar changes being made at the Centre.

104 Annex 5 Fiduciary Aspects 46. However, most regions are lacking adequate technical and human resources to implement the reforms and the central government has not yet provided the required support. The unclear division of tasks between the Ministry of Finance and Ministry of Home Affairs has resulted in inconsistent and contradictory legislation with regards to regional financial management and caused confusion among most local governments. While sub-national governments are obligated by law to report certain fiscal and financial information to the central government, many do not (the data may be missing or simply withheld voluntarily). Sub-national governments are not obligated to publicly disclose pertinent fiscal and financial information. State Owned Enterprises

47. Indonesia has a sound legal framework for corporate governance and monitoring SOE operations. First, the SOE law (UU 19/2003) sets a clear ownership policy as the state is not allowed to be involved in the day-to-day management of SOEs and must allow them full operational autonomy. Second, a 2002 ministerial decree clearly details ., corporate governance responsibilities, including the need to: (i)submit each quarter the SOEs’ Financial Statements to the MSOE and to the appropriate line ministry; (ii) prepare annual financial statements that must be audited internally and by an independent auditor; and (iii)publish SOE annual reports in a timely manner.

48. Existing laws and regulations governing SOEs are not effectively implemented. Long delays still occur in auditing and publishing SOE financial statements. SOE annual reports are only regularly and systematically made public mostly in the case of companies that have accessed the local capital markets with listed instruments.

49. The planned use of PPPs to accelerate investment will create fiscal risks that merit disclosure. The government has taken steps to mitigate fiscal risks from PPPs. Perpres 67/2005 emphasizes careful project preparation and the selection of bidders in an open, competitive tender and gives the Minister of Finance the right to approve or reject requests for government support. Debt Management

50. Two major initiatives in debt management have been launched. Despite recent improvement in debt indicators, risks to the government’s budget remain substantial, and further improvements in debt management are essential to avoid future debt distress. The Ministry of Finance has made good progress in this regard. Two specific examples are the development and publication of a comprehensive debt management strategy in September 2005, and the decision to create a DG for Public Debt Management. Government is working on a more formal debt sustainability analysis for the first time. Governance and Anti Corruption

5 1. The Anti-Corruption Commission (KPK) has become operational and performs its duties and authority independently, free from any influence. It coordinates with other entities combating corruption, conducts investigations and prosecutions against corrupt acts, performs preventative actions against corruption, and monitors state governance. It has initiated and signed memoranda of understanding with some provincial and local

105 Annex 5 Fiduciary Aspects governments to establish and support good governance at the sub-national level. Although its capacity to carry out prosecutions is limited to a few cases per year, its focus is on high-level large-scale corruption.

52. Based on past experience, the Ministry of Public Works is vulnerable to fraud and corruption particularly in procurement, contract management and internal controls. These are areas where strong action is needed to reduce fiduciary risks and some specific actions in these areas will be supported in this operation. Improvements in procurement administration are included as an action item under the Governance policy trigger in this operation. The Ministry’s IG has recently been provided technical assistance under a Bank project to develop manuals for technical audits. Further work to expand this technical assistance to conducting audits on procurement and contract implementation, under a coherent risk based annual audit program of the IG, is now included as an additional item in the action matrix. Key Areas for Future Attention

53. In the period ahead, progress of the following key on-going PFM reforms will need to be closely monitored. 0 Ensuring coherence and drive in public financial management reform. 0 Deepening the reforms ofthe central government budgetary sector, along the lines discussed above; 0 Ensuring greater integrity and more effective management of public funds through the implementation of a Treasury Single Account, automating the treasury payments system, and institution of measures to prevent the proliferation of off-budget bank accounts. 0 Strengthening internal audit institutions, by establishing synergistic relationships between them and removing overlaps; 0 Implementation of a new treasury system, extending implementation of Government Accounting Standards and reengineering of underlying business processes at spending agencies to ensure reliable financial reporting. 0 Widening the reforms to all of Government. Extending modern financial accountability and management processes to sub-national governments in a coordinated manner and bringing these fully in line with emerging national standards.

54. Many of these are being actively considered and prioritized implementation plans are being developed by the Government. A capability to centrally monitor these and other reforms has recently been established at the Secretary General’s Office of Ministry of Finance. The on-going work on PEFA indicators will also assist the Government in setting benchmarks and monitoring progress.

Management of Foreign Exchange

55. The foreign exchange control environment is assessed to be generally satisfactory. The country is no longer subject to the Extended Arrangement from the IMF. Bank

106 Annex 5 Fiduciary Aspects Indonesia (BI) was last subject to the transitional procedures under the Fund’s safeguards assessment policy in 2002. That assessment recommended remedial actions to address a number of vulnerabilities in the audit arrangements for the central bank. The main recommendations have been implemented, including the establishment of an independent audit committee at BI and the publication of BI’s audited financial statements. Audited financial statements for Bank Indonesia for the year 2006 have been reviewed and we note that the audit report issued by BPK, the State Audit Board, contained an unqualified audit opinion. Conclusion

56. Following initial years of analytical work, Indonesia has taken impressive steps in recent years to build upon this and establish a sound legal and administrative framework for modern financial management. Changes in the legal and regulatory architecture are now largely complete and the momentum has shifted towards implementation of new financial management practices.

57. Known weaknesses in financial management and accountability continue to be gradually addressed through the PFM reform program discussed above. The donor community is actively engaged in this process. Key elements ofthe reforms are supported by the DPL triggers as well as the GFMRAP project and other donor supported initiatives. Much remains to be done, however. It will clearly take time to realize the full impact of these reforms and attain high standards in every element of sound public financial management.

58. In the meanwhile, some fiduciary risks will arise for this operation. Although the pace of implementing the planned reforms has been somewhat slow over the last year, the trajectory of reform is in the right direction and the current Government continues to demonstrate a commitment to continue the task of completing the planned reforms in public financial management. Taking these into consideration, we do not propose putting in place any additional fiduciary arrangements for this operation.

59. Since this operation is targeted specifically to support policy reforms at the infrastructure sector, policy reforms to enhance governance at the Ministry of Public Works are included in the policy matrix. Among the measures included are specific actions to help enhance the capacity of the internal audit institution (Inspectorate General) and the establishment of a procurement guidance unit at the Ministry. More details ofthese measures are included in the Program document.

107 ANNEX 6 ENERGY

1. Electricity supply-demand imbalances could undermine economic growth. Power demand growth has been on the rise recently responding to an economy that is growing at around 6% each year. Forecasts indicate that this trend will continue with demand expected to rise between 7-9% in the Indonesia Power Demand Projections coming year. PLN, the state-owned electricity utility, has struggled to Indonean electrlclty demand projectlons increase generation capacity, improve ~-N2006-201Splan(Growth 85%lyr) reliability, and manage the rising demand. Some generation capacity is being added, but very few new projects have been started that could be commissioned beyond 2007. OC ,,....,...,,,....,..,.., I Consequently, the reserve margins are 1996 2000 2004 2008 2012 2016 2020 expected to deteriorate until new Annud GOP mMh PtN7 3WkrZ-BX6 B~sipitudy5Wf~rX02.2~5,NdsNdy6%forXm2m5 Source: PLN, Nexant, Beicip Franlab capacity is added, risking the reliability of the power supply system in the interim. There are even indications that captive power producers facing rising fuel costs may want to revert back to PLN, and could add further pressure on the national power system. Indonesia risks undermining its resurgence as a result since economic growth is heavily energy dependent.

2. Low access to electricity contributes to economic and social disparities. Over 70 million people in Indonesia, mostly the poor, still do not have access to electricity. About 80% of those without electricity access live in rural areas and over half live outside ofthe dominant economic centers of Java and Bali. Given that 3 out of 4 Indonesian’s poor reside in rural areas and outer islands, increasing electricity access in Indonesia is an important consideration for inclusive growth that will improve the quality of life of the poor. Comparatively, Indonesia has fallen behind other countries in the region in terms of electrification. For example, Vietnam, which had lower Electrification Rate by Major Island (2004) electrification coverage than Indonesia in 1994, has substantially greater access levels today.

3. Stop-gap measures have been taken to reduce legal ambiguity resulting from the annulment of the 2002 Electricity Law. The Electricity Law, before it was revoked by the COnStitUtiOnal court of Indonesia Source, The World Bank in 2004, provided a long-term

108 Annex 6 Energy vision for developing the power sector in a financially and environmentally sustainable manner by relying on competition (where feasible and gradually to avoid disruption), modern regulation, regionalization and private sector involvement among others. Needless to say, there was a significant void after the court’s ruling, as the sector reverted to being governed by the electricity law that was previously enacted in 1985. The Government moved quickly to issue several interim regulations to temporary address shortcomings and inconsistencies due to the reinstatement of a significantly outdated law. The Government issued a new Energy Law, which is expected to serve as guiding principles for the entire energy sector, and has elements that impact the power sector. As for the new electricity law, Ministry of Energy and Mineral Resources (MOEMR) has submitted a draft to the Parliament for debate. It will be important to issue a robust law that will provide a clear direction for the sector. Putting in place a comprehensive framework for the power sector, on the other hand, will take time, and the Government will need to develop and implement it with a sound overall strategy and a long-term approach.

4. A Public Service Obligation (PSO) subsidy is being provided by the Government to make up PLN’s financial shortfall due to rising cost of supply and inadequate tariffs. The national electricity tariff (TDL) in Indonesia applies a uniform tariff structure throughout the country despite significantly varying costs. It is also highly politicized and is established by presidential decree. PLN, which is obliged to apply the TDL, has struggled in recent times to recover its costs. Given that PLN is also required to make a profit, such conflicting mandates undermine its ability to expand connections as well as capacity. When the fuel subsidy to PLN was removed in 2005, the cost of supply skyrocketed in the heavily diesel reliant energy mix and severely threatened the utilities’ financial solvency. The Government, which used to provide a targeted electricity subsidy to small consumer, expanded coverage of the PSO to include all consumers where cost recovery was undermined by the government regulated tariff’. This resulted in PSO payments, which were around $400 million in 2004, skyrocketing to over $3.5 billion by 2007. The present PSO does provide greater financial predictability to PLN’s operations although the Government has been working to further improve its mechanism. The IDPL is also expected to enhance the transparency ofthe PSO. However, the PSO has proved to be a poorly targeted subsidy with every electricity consumer in Indonesia receiving some level of public support. Furthermore, it provides little incentive for PLN to improve its efficiency. Therefore, it is important that the PSO policy be accompanied by the rationalization of electricity tariffs based on economic fundamentals that will enable the subsidy to be targeted towards protecting the poor and needy. Since implementing such a policy is bound to take time, it is useful the considerable preparation that is required begin as soon as possible.

5. PLN has revised its expansion plan (RUPTL) several times recently in light of slow progress in implementation. Its fluctuating financial fortunes have been a major reason

The present PSO policy is based on the State-Owned Enterprise Law, which requires PLN to make a profit, and for the Government to compensate them when their cost-recovery is undermined due to government policy, as in the case of the regulated TDL.

109 Annex 6 Energy PLN has had difficulty fully realizing its investment plans. The financial uncertainty led many potential private investors in the power sector to request further Government assurances, while it also limited PLN’s ability to implement its own expansion. PLN’s corporate structure is in a state of flux since they have stopped in mid-stride many measures they had begun to undertake to comply with the annulled electricity law. Consequently, PLN no longer has a dedicated planning department and have also experienced delays in implementing projects where financing has been secured. The IDPL attempts to reduce the conflicting mandates faced by the utility by bringing together the key Government stakeholders in respect of PLN - the Ministry of Energy, the Ministry of Finance, and the Ministry of State-Owned Enterprise - to support PLN’s expansion plans2. Given the potential for a looming power crisis, PLN will now have to take rapid action to address the immediate concerns while also taking prudent action for long term development ofthe sector to support the growing economy.

6. Energy savings measures provide opportunities for relatively quick and cost effective options for reducing capacity expansion needs, and some efforts are already underway. It is estimated that Demand-Side Management (DSM) that are already being considered or implemented to some degree Potential for Scaling-Up Energy Savings has the potential to reduce power from DSM Programs On-going Programs Potential 2,500 MW. Is these programs are scaled- Savings up and realize their full potential, this Efficient lighting (CFL, FTL) 730 MW would be tantamount to expanding Street lighting 160 MW generation capacity. International Partnership for industrial and building energy 760 MW experience suggests that DSM measures conservation Energy labeling for appliances 910 MW are most successful when complemented otal Reduction of Ca aclty Requirements 2,560 MW

7. Efforts are being taken to mobilize financing to the power sector, but a clear strategy that optimally allocates public finances to leverage private investments is needed. The power PLN Investment Estimates 200615 sector faces momentous investment needs, and PLN $ 27 billion estimates that about $40 billion in generation, $5 billion transmission, and distribution investment is needed in $8 billion order to keep pace with power demand growth and to $40 billion maintain system reliability. The public sector will have

2 In many instances in the past, the electrification target established by MOEMR and the tariff they propose, and the support given by MoF does not always reconcile towards an expansion plan that would result in a profit as required by the MSOE.

110 Annex 6 Energy to play a key role in this expansion, which will call for improving PLN’s operational efficiency as well as their financial position. A program to develop 10,000 MW of coal- fired power plants have been initiated by the Government and PLN has responded by issuing a $1 billion international bond to raise a portion of the financing. But, it remains questionable whether this expansion can be adequately financed by PLN without some form of assistance from the Government. Private investments in the power sector have also been in a global decline since the 1990s. and it has almost been negligible in Indonesia in recent years. Yet the private sectol L~ZII XIVG LU ~U~I~IGIILGritically needed investments, but it will be important for PLN to develop a few model transactions with a strategy for managing risks that would be seen as credible by investors. Several IPP projects have been tendered, but due to the various associated risks deemed unacceptable by investors, they have yet to achieve financial closure. The Government, with assistance from the World Bank Group and the Asian Development Bank, is now developing two “model” IPP projects that are expected to be tendered to private investors. Its success will be a key determinant ofthe viability ofPLN’s IPP program.

8. The Government hopes to improve the fuel mix to enhance efficiency. Indonesia has an abundance of many types of energy resources that Fuel Mix in Select Countries can be utilized for Dower Powr Gmlralon Fuel Mk(PLN Plan 2006-2015. IEA2W5) generation, yet the fuel mix is dominated by fossil fuels. Among fossil fuels, PLN is heavily dependent on diesel which has significantly increased its cost of supply and hdoneui Indonema Chin. lndu Brad1 US6Csn.d. OECD The World impacted the company’s 2W4 2015(PLN) Europe finances. Government Source: International Energy Agency, PLN subsidies for petroleum Note: Data for Indonesia is 2004 data. Data for other countries are 2002 data. products, on the other hand, have stymied investment in alternative energy. The Government has proposed a switch away from diesel based power generation towards greater utilization of coal, natural gas, and renewable energies. In order to realize this goal in an environmentally sustainable manner, the Government will need to address several key aspects:

0 Develop reliable supplies of natural gas. PLNhas already Gas-fired plants utilizing diesel Capacity Generation constructed nearly 3,500 MW instead in Java Bali 2005 (MW) 2005 (GWh) of combined cycle gas Grati Block 1&2 (CCGT) 764 2,067 turbine (CCGT) power plants Tambak Lorok (CCGT) 6 Units 61 6 3,879 Sunyaragi Gas Turbine 60 196 based on an earlier strategy, Gresik Block 1&2 (CCGT) 1,052 5,676 and have been unable to Muara Tawar Block 1&2 (CCGT) 920 5,552 secure gas supplies for them. Total 3,412 17,370 % of Java Bali total in 2005 13.5% 18% As a result, they are presently utilizing diesel, which is a key factor in their high cost of supply in Java-Bali. In 2005, these power plants

111 Annex 6 Energy produced nearly 20% of PLN’s generation, and based on current prices, the cost differential of the lack of gas supplies could result in a total subsidy expense of as much as $1.5 billion. The World Bank has communicated this issue to the Government as a part of the on-going sector dialogue, and some initial agreements have been reached on gas supplies for several power plants. Resolving the gas supply shortage will be a key issue for Government to tackle if it is to begin switching away from utilizing diesel for power generation.

Develop fossil based fuels in a sustainable manner. The Government has instructed PLN through a keppres to diversify its fuel mix by expanding the utilization of coal for power generation. Coal fired power generation for based load could be justified provided that the environmental impacts of such expansions are thoroughly assessed and mitigation measures are implemented in accordance with environmental laws and regulations. Clean coal technologies should be progressively promoted whenever they are feasible and economically justified. This is particularly important since Indonesia has one of the fastest rising COz emission rates in the world while increasing use ofcoal for power generation also leads to localized pollution such as acid rain.

Promote the development of abundant renewable energy resources. Indonesia is rich in renewable energy resources, and could benefit from increasing the share of renewable generation. It has nearly 40% of the world potential geothermal resources, which could be a viable complement to coal-fired base-load generation. Geothermal generation can be developed at a scale that would be economically feasible, especially if coal prices keep rising. Biomass and hydro resources are abundantly available in most of the outer islands, and can be attractive options for switching away from the largely diesel-based generation in many of these locations. In order to exploit these resources, however, there is a need to develop a strategy and action plan to address technical, policy, and commercial barriers that presently hinder progress. The World Bank is assisting the Government to implement a set of policy reforms that would address the key barriers that currently hinder the development of geothermal power. It is further assisting PLN with a carbon transaction on a geothermal power project in order to reap the benefits of this clean energy through the Clean Development Mechanism (CDM). The ADB and JBIC have also been actively engaged in the geothermal area as well as other renewable energies.

112 Annex 6 Energy

Primary Energy Reserves and Production in Indonesia

8 IPapua 64 I 24 2 1 24,974 I 6,814

exploited with more development Source Ministry of Energy and Mineral Resources, Indonesia

9. The Government has set a target of electrifying 90% of the population by 2020 recognizing the low levels of access to electricity in the country. Approximately 1.3 million new connections are needed each year if Indonesia is to achieve this target. Despite this ambitious target, there is little in terms of a comprehensive plan for achieving this goal, as the pace of electrification by PLN has substantially slowed during recent years. With PLN’s present rate of rural electrification, it is unlikely that the Government will be able to meet its target. Despite PLN’s slow-down in expansion, they still connect nearly one million customers per year. Most of this expansion has been concentrated in Java and Bali where, before they faced unsubsidized fuels prices, PLN was able to recover its costs. If PLN is to refocus on expanding connections throughout the country, it is essential that Indonesia reform its electricity pricing in combination with improved cost-efficiency and well targeted subsidies to assist the poor when necessary. Sub-national solutions are increasingly becoming a way forward for increasing access in the absence of significant sector reforms at the central level. Many of these schemes are designed to augment PLN expansion efforts mostly through cost sharing mechanisms or implementing options for cost recovery. These decentralized solutions could be a viable complement to PLN if they were to be replicated in a systematic way at a greater scale where access to electricity is desired. In response, the Government is preparing a Policy Framework for Regional Electrification and Rural Access, which is being supported by the World Bank. The aim is to provide an enhanced investment climate where sub- national entities and PLN can work together to develop customized local solutions to meet their electrification needs and contribute to achieving the Government’s target. Achieving the 2020 Access Target Year Population (mil) 218 245 216 Pop. wlo Access (mil) 73 48 28 Households wlo Access (mil) 15 10 6

# new connections (mil) 10 10 % of population wl access

113 ANNEX 7 WATER AND SANITATION

1. Household access and quality of water and sanitation services are among the lowest in East Asia, and the situation is worsening. The national Government recognizes that a more active role in policy leadership is required in the water and sanitation sector than has been provided in recent years. Sector Performance

2. Provision of piped water services is inadequate, and treatment of human waste is almost non-existent in Indonesia. The percentage of the urban population served by piped water had reached 40% by 1997, but had declined to 33% in 2002. Only 18% of the total population has access to piped water. Access to “improved” water (a United Nations definition which includes among other sources water from covered wells - possibly from contaminated sources - but excludes bottled water sold by water vendors) has declined from 90% in 1995 to 87%. The environmental consequences of access through large scale private unregulated wells are high. Land subsidence, higher costs of reaching drinkable well water and proximity to septic tanks pose high environmental and health risks. An indicator of the problems is the high incidence of water-borne diseases, disproportionately affecting the poor. Over 96% ofhuman waste is not treated prior to disposal. Network sewerage reaches about 1.3% ofthe urban population. Access to private sanitation is 62% for the country (53% rural with a quarter connected to septic tanks; and 73% urban of which two-thirds have septic tanks) but the manner of operation of these system’s frequently risks contamination of ground and surface water.

3. Poor management structures and limited access to finance have resulted in deteriorating quality of service from water utilities (PDAMs). No PDAM offers water of drinking quality, and very few offer 24 hour services. The high incidence ofunaccounted water (up to 50% losses), low pressure, and lack of repair leaves a high toll on the system and increase breakage and inefficiencies. PDAMs have postponed maintenance in an effort to reduce costs, and few PDAMs use the required chemical dosages for water treatment. Inefficiencies in management and operations have impaired the opportunity to improve services to existing and new customers. Administrative costs are typically high, and salary costs excessive by comparison with international experience.

4. In sanitation, an absence of formal public or private networks and infrastructure is the norm. Almost 73% of urban households rely on on-site sanitation in the form of septic tanks, many of which are not functioning effectively. There is no effective complementary public investment in drainage, collection and disposal or even oversight. Widespread contamination of surface and ground waters has resulted in local epidemics and high incidence of fecal borne disease and other environmental impacts. With virtually no regulation or enforcement, most septic tanks are not appropriately designed

114 Annex 7 Water and Sanitation or maintained. Collection and disposal is not controlled. Unregulated contractors simply dump waste into nearby streams and public drains. National Plans and Targets

5. The National Medium-Term Development Plan (RPJM), prepared by Bappenas in 2004, took stock ofthe problems besetting the sector: Decline in investment in piped water supply, with most PDAMs barred from new borrowing because of existing debt arrears and in poor financial position to borrow in any case; Generally low quality PDAM management, resulting in poor operational and financial performance; Tendency of newly created local governments to establish new PDAMs, undermining the economies of scale possible from cooperating with neighboring jurisdictions; Water tariffs set below cost recovery, undermining any attempts at operational or financial recovery. Inadequate sanitation collection, transport, treatment, and disposal; Treatment plants that are not adequately operated and maintained; A decline in the proportion of urban residents who receive adequate sanitation services.

6. The RPJM set national targets for water access and sanitation, to be achieved by the end of 2009. For piped water the RPJM target is 40% ofthe population (66% ofthe urban population, and 30% of the rural population). The plan does not set targets for provision of non-piped water, nor did it address issues of the quality of water. For sanitation, the RPJM targets include; access to private or communal sanitation facilities for all households; 60% capacity utilization of sewage and sludge treatment plants; halving the volume of untreated domestic wastewater; and the commencement of piped sewerage systems in large cities.

7. These targets are supplemented by the National Action Plans on Clean Water (NAP-CW) and Sanitation (NAP-S), issued by the Ministry of Public Works in 2004, in support of the Millennium Development Goal No. 7; halving the proportion of people without sustainable access to safe drinking water and basic sanitation by 2015. The plan aims to achieve access to safe drinking water by 88% ofhouseholds (compared with 75% in 2002), 62% access to piped water, and 75% access to improved sanitation (compared with 63% in 2002). The Plan also aims to reduce dependence on protected water sources, such as rivers, lakes, and wells. Without changes in policies and incentives, these targets will not be achieved however.

8. Reforms for 2007 are set out in Inpres 6/2007 (See Annex 2). The Ministry of Home Affairs is to formulate regulations addressing the allocation of responsibilities between central and regional governments; and regulation of regional owned enterprises (BUMD). The lack of clarity on responsibilities for infrastructure development and reduces the scope for improved governance. The Ministry of Public Works is to develop guidelines for management of dams and reservoirs and the establishment of national and

115 Annex 7 Water and Sanitation regional water resource boards. In urban sanitation, pilot programs are being conducted in six cities with the intention of learning lessons that can be applied nationally.

Table 7 - 1: Piped water service targets 2000 2005 2010 2015 Service coverage targets - Urban (% total) 34.2% 48.6% 58.8% 69.1% - Rural (YOtotal) 6.8% 23.0% 38.4% 53.9% Capacity requirements - Connections (million) 4.8 12.9 19.0 25.4 - Production capacity ('000 I/s) 94 181 268 358 Sources: BPS (2003); National Action Plan on Clean Water (2004)

Financing

9. The NAP-CW targets will require investment of about US$ 4.6 billion over 2004- 2015. Only about US$ 50 million of investment occurred, primarily in rural community schemes using central government or foreign grant financing. To increase investment in urban water services to the necessary level, the Government's strategy includes: generating internal funds through productivity improvements, cost-covering tariffs, and improved corporate management; 0 providing access to long-term debt finance, by removing administrative barriers to donor financing, and enhancing PDAM credit-worthiness; and 0 ensuring that the transfer of investment funds from the central government provides incentives for improved commercial and operational performance, and for achievement of access targets.

Table 7 - 2: Cost estimates for piped water systems (US$ million) Type of improvement 2004-2005 2006-201 0 201 1-2015 Total

Optimization...... X 310 - - 310

Expansion...... W 710 1,770 1,830 4,300

Total...... c 1,020 1,770 1,830 4,610 - of which urban 65% 51% 56% 56% Source: National Action Plan on Clean Water (2004)

10. The NAPCW assumes donors will finance 61% of planned investments, and commercial banks will provide 11% of the financing. But no loans from international financial institutions have been approved in the past ten years, and few PDAMs meet commercial credit-worthiness standards.

11. Under current regulations, PDAM debt arrears to the central government provide a practical barrier to any borrowing from international financial institutions. Any such borrowing must be by the Ministry of Finance, which on-lends to the local government concerned, and which in turn on-lends to the PDAM. PDAMs are not permitted to borrow

116 Annex 7 Water and Sanitation in this way if either they or their owning local government have arrears to the national Government. As a consequence, 189 out of 2 13 PDAMs are legally precluded from this source of finance.

Table 7 - 3: Funding sources for piped water systems (US$ million) Funding source Urban Rural Total % Total IF1 1,470 1,350 % ...... Vloans 2,820 61 la 490 340 830 Local...... 7 governments 18%

Commercial...... loans ......

Central...... government ...... 9% volving funds 2% ...... Total 2,590 2,030 4,610 100% Source: National Action Plan on Clean Water (2004) la USD = IDR 9,000 Ib Provinces, kabupaten and kota (includes revenues from PDAMs and other local government-owned enterprises)

12. The arrears problem began with the 1997 financial crisis, and was exacerbated when the decentralization reforms in 200 1 transferred responsibility to local governments for certain PDAM debts incurred in respect of investment decisions made by the national Government. Some local governments have resisted repayment of these debts. Eighteen% penalties for non-payment have further contributed to the level of arrears. Total arrears increased by 37% between 2004 and 2006, and now constitute 67% of outstanding PDAM debt. Arrears on penalties represent 25.6% of total arrears, and 16.9% of outstanding debt to the Ministry of Finance. All parties recognize that a solution is needed.

13. The national government’s initial efforts to address PDAM debt was the Financial Recovery Action Plan (FRAP), a rescue program initiated in 2000. The FRAP may recommend management, commercial or technical improvements. A weakness of the FRAP has been the absence of finance to permit implementation of recommended actions to control costs (reduce leaks) or improve revenues (increase connections).

14. As experience revealed that the FRAP was insufficient for the Ministry of Finance to recover arrears, a legal basis for debt restructuring was established by PMK No. 107/PMK.06/2005. Implementing guidelines for the regulation were promulgated by the Director General of Treasury (No. PER-53/PB/2006). As a pre-condition for restructuring of debts with the Ministry of Finance, PMK No. 107PMK.06/2005 requires that PDAMs participate in the FRAP; the development of action plans for individual PDAMs is time-consuming, delaying the possibility of entering into debt restructuring discussions. Debt restructuring proceeds in two stages: (i)“conditional” which permits only rescheduling of debt; and (ii)“absolute” which permits reductions in penalties and interest if conditional restructuring has not been sufficient over two years. The cumulative effect is that under current regulations it would take many years before successful rescheduling of debt arrears for the majority of PDAMs could be completed, and then even more time before financing could be arranged and physical works commenced.

117 Annex 7 Water and Sanitation

15. The current restructuring regime also provides various perverse incentives. Under PMK No.107/PMK.06/2005, PDAMs that are regarded as performing well (as defined by Ministry of Home Affairs Decree 47/1999) are not permitted to participate in the restructuring program. Director General of Treasury Regulation No. PER-53/PB/2006 links rewards (more debt forgiveness) to the ability to generate cash, providing incentives to manipulate accounts. A system which rewards regular repayment would provide incentives that are better aligned with the ultimate objective.

16. By the end of 2008 the Government intends to revise the regulations on debt restructuring, including agreement on amounts of PEMDA and PDAM debts. The aim is to provide a more rapid mechanism for resolving PDAM arrears, and to provide a system of incentives for timely debt repayment to ensure that the problem of arrears does not recur. Sectoral Governance

17. Although most responsibility for PDAMs was transferred to local governments in 2001, the role of the central government remains unclear and at times not in line with decentralization. The central government still has an important role to play in setting policies and incentives and monitoring adherence to national regulations and strategies. The role of central government in selecting, preparing and implementing local government infrastructure investments should be limited in a decentralized environment. Clarification of roles and responsibilities, as emphasized in INPRES 6/2007, will contribute to improved governance and facilitation of infrastructure investments. The proposed approach to PDAM debt restructuring, recognizing the importance of ensuring adequate financing to achieve sectoral targets, illustrates a growing awareness by central government of this remaining policy responsibility. The national Government is also planning to revise its fiscal transfer system to provide stronger incentives for delivery of sub-national infrastructure services - the reforms are discussed in Annex 10.

18. The national government also plays a role in sectoral regulation. Although tariff levels are determined by local governments, tariff structures follow central government recommendations. Industrial and commercial entities pay higher rates, and tariffs are based on consumption levels. The national Government has also established a Control Board for Development of Drinking Water Systems (BPP SPAM) responsible for providing advice on all aspects ofthe provision of drinking water.

19. Local government responsibility for water provision is associated with the typical water utility management problems which affect many developing countries but are magnified in Indonesia given low coverage, enormous capital needs, and lack of a coherent sector strategy. There are political incentives to keep tariffs below cost and to employ excessive staff, undermining the financial viability of PDAMs. Indonesia’s decentralization process has added to these difficulties, with the creation of new local governments leading to the splitting of PDAMs. This exercise has undermined economies of scale and consumed time and resources in valuing and splitting assets and liabilities. And Indonesian local governments tend to use their ownership rights to declare

118 Annex 7 Water and Sanitation

“dividends” which are paid to the owners, even where PDAMs are making losses. Improvements in corporate governance are required, to provide stronger commercial focus for PDAM management.

119 ANNEX 8 TRANSPORT

Introduction

1. The road sector accounts for the major share of domestic freight and inter-urban passenger land transport in Indonesia, with railways accounting for less than 1% of the country’s freight traffic and less than 10% of total passenger traffic. Railway operations are limited to predominantly passenger services in Java and three separate networks in Sumatra that carry mainly cargo such as coal and cement. The aviation sector is well developed and expansion has been dramatic in recent years. Ports and airports are of particular importance to regional cooperation and integration as Indonesia is an archipelago, however there is very little intra-island coastal shipping, even of low value bulk commodities.

Road Transport

2. Current status. Since roads account for the major share of domestic freight and interurban passenger land travel in Indonesia, their coverage and condition are crucial to supporting economic growth and social development. The efficiency of Indonesia’s cities is reduced by severe traffic congestion. Currently, 43% ofthe road network on Java, and a higher proportion in Jakarta, is congested causing long travel times and higher costs. The expressways network comprises only about 650 km of high-grade toll roads. Expressways, including ring-roads for urban centers, would help relieve some of the congestion and, by enhancing inter-city linkages, provide a boost to growth. For the most part, however, these highways are only at the planning stage. Improved public transport solutions are needed to relieve road congestion in urban centers. In Jakarta, a system of dedicated bus lanes started operating in January 2004 and, by March 2006, the number of passengers per day had reached about 120,000. However, despite this gridlock remains a daily fact of life in the city. Additional bus lanes and a monorail mass rapid transport system are also being introduced or under development in Jakarta.

3. The quality of Indonesia’s national roads is relatively high, however too many sub- national roads are poorly maintained. Compared with other countries in the region a relatively high proportion (around 60%) of Indonesia’s roads are paved. While the proportion of national roads maintained in good-to-fair condition has declined since 2000, it is still over 80%. The condition of the sub-national road network is substantially poorer than that of the national roads (provincial roads 63% good /fair and kabupaten roads 50% good/fair’). Some of the poorest areas of eastern Indonesia, where population densities and traffic demand are low, still do not have all-season access.

’ Sub-national roads are fkded by the sub-national governments out of their transfers ftom the national government. The transfers are not tied to particular inf?astructure expenditures

120 Annex 8 Transport

Table 1. Key road sector statistics Statistic Notes Length of national roads 34,628 km 80% in good/ fair condition + 650 km toll Length of provincial roads 37, 164 km 63% in goodtfair condition Length of district roads 266,564 km 50% in goodtfair condition Rural access indicator 94% percentage of the population within 2 km of an all weather road Source: Directorate General of Highways

4. Investment needs. The road sector represents one of the main areas where investment has been significantly lower than that needed to keep pace with the increase in demand and economic growth, and where transport demand generally exceeds GDP growth rate. Construction of major inter-city expressways and new ring-roads for major cities will require a significant increase in road investment. Construction ofthe trans-Java highway connecting Jakarta and Surabaya with about 870 km of new expressways is estimated to cost Rp 50 trillion (about US$ 5 billion equivalent), of which land acquisition may account for Rp 5 trillion. A similar expressway system will be needed for Sumatra. The Government also recognizes the need to ensure continued good condition of the national road network and to improve the condition of the sub-national network and the roads ministry is concerned that the maintenance budget be protected. National roads have generally been maintained in good condition (currently about 80% in good and fair condition). However this is lower than the previous level of 87% in 2000. Rehabilitation and maintenance are also critical to achieving the Governments targeted level of quality for the national roads (84% good, 0% bad).

5. Budget. While investments in road network upgrading and expansion were substantial in the 1980s and 1990s, sector expenditures decreased sharply after the Asian financial crisis. The result has been increasingly severe congestion especially on key national roads, as capacity expansion has fallen short of real needs. Government has responded with a doubling of its investment budget for 2008 for national roads to 16,638,778 million (about US$ 1.8 billion equivalent) of which Rp 4,348,849 million (about US$ 0.47 billion equivalent) or about 26% will be spent on “Investment” and Rp 1 1,867,424 million (about US$1.30 billion equivalent) will be spent on “Maintenance”. The Directorate General of Highways (DGH) defines “Maintenance” to include betterment, periodic, and routine maintenance. If the “routine maintenance” budget is assumed to cover the whole of the national road network of 34,628 km then this amounts to about US$ 1,230 per km per year. If the “periodic maintenance” budget is assumed on a 5 year cycle then this amounts to about US$ 36,000 per km. In the official published budget there is currently no budgeting mechanism which separates out the “routine maintenance” budget from the overall “Maintenance” item. In terms ofthe “Investment” cost - while costs vary extensively from about US$ 1 million per km for capacity expansion assuming this then about 500 km of road development will be undertaken in FY08.

121 Annex 8 Transport

Table Nation; Road Budget and Performan e Targets 200f 2010 FY 2006 FY 2007 FY 2001 FY 2009 FY 2010 Description Rp million Rp million % Rp million Rp million Rp million -% Maintenance 3,772,901 10,426,968 78 11,867,424 12,149,470 14,399,932 59 Road Betterment 647,120 4,565,777 6,588,583 5,642,35 1 4,425,626 Periodic Maintenance 2,260,003 1,203,290 1,671,457 4,087,101 Routine Maintenance 426,459 391,598 446,72 1 532,840 1,180,955 Bridge Betterment 65,551 275,802 688,934 730,270 774,087 Rehabilitation 2,602,639 2,802,811 2,612,703 3,225,728 3,932,162

Investment 2,911,735 2,423,456 18 4,348,849 7,037,839 9,242,984 38

Non-Physical 808,960 567,263 811,101 797,312 3 Total 7,493,596 13,417,687 e16,638,778 19,998,410 24,440,228

Source: Directorate General of Highwqs

6. Financing sources. Indonesia’s road investments are largely funded through the regular budget (including support from bi-lateral and multi-lateral banks). The recent significant Government budget increases (the national road budget has been doubled to US$ 1.8 billion for 2008) will go a way to address the investment needs. Although the fuel price has increased significantly the continuing subsidizing of fuel means that price is not used either as an effective demand constraint mechanism or as a means for road users to finance ongoing maintenance of the road assets. Vehicle acquisition and ownership taxes accrue to the local jurisdiction and not to the national budget and are thus not available for any national road maintenance (although they could be applied to local road maintenance). Moreover, the Ministry of Finance considers a road fund unacceptable and prefers that financing be provided directly through the regular budget. It is however, not clear that the full required budget to ensure preservation ofthe network is being provided. The Road Law does clearly provide priority to maintenance funding and a mechanism for ensuring this in the budget is being discussed. Indonesia is also pursuing private sector involvement in the road sector through both institutional reforms and active PPP initiatives. These are primarily focused in the “Trans Java”- a 870 km expressway proposal which unfortunately has been mired in difficulties for several years now. The current PPPs are complicated by the fact that private firms were contractually awarded some sections of the route prior to 1998, but have been unable to achieve financial closure. Financial closure will require the resolution of a variety of issues,

122 Annex 8 Transport including arrangements for land acquisition and the nature and level of Government support.

7. Institutional reforms for private sector participation. The new UU 38/2004 on Roads and the subsequent PP 15/2005 on Toll Roads reformed the legal framework and are facilitating greater PSP2. Responsibilities have been unbundled by separating the regulatory functions from the main state owned enterprise (SOE), Jasa Marga; calling for the establishment of a new regulatory body; ending Jasa Marga ’s monopoly on toll-road development; and allowing private investors to bid for new build-operate-transfer or concession projects in competition with Jasa Marga. In August 2005, the Ministry of Public Works issued Decree No. 374/2005, which enables the toll-road tariffs to be set on the basis of a bidding process. At the same time, tariffs for existing toll roads were increased by 15%-50% to ensure financial sustainability of their operation. The Government technically allows “viability gap” funding (or Government “support”) however the transactions have not been structured in this way - in fact the private sector is required to also finance the land acquisition.

8. As stipulated by the new legal framework, the Indonesian Toll Road Authority BPJT was established in October 2005. Its responsibilities include developing business plans and feasibility studies for toll-road projects; conducting bidding, facilitating land acquisition, and recommending tariffs for such projects; and supervising implementation of toll-road concessions. The authority, which reports to the minister of public works, comprises a chairperson and four members from the Government, road association, universities, and other stakeholders. To ensure complementarity of toll roads with other parts of the road network, the toll-road authority works closely with MPW’s Directorate General of Highways. The short-term challenge is to fully operationalize the authority. In the medium term, separating its contracting and regulatory functions, and making the latter fully independent ofMinistry ofPublic Works, should be considered.

9. Institutional capacity in the road sector needs enhancement. While national asset management capacity is being strengthened, capacity building for development planning and operation and maintenance is needed. Regional agencies vary considerably in capacity and performance, and interagency coordination is weak. Heavy vehicle overloading is prevalent, road preservation costs are increasing significantly, and road safety is poor. The implementation of road works is often expensive and of low quality, and collusion among contractors is a problem. The business practices and performance of national agencies and the construction industry need to be improved and capacity of the regional agencies built up. Regulatory enforcement to reduce vehicle overloading needs strengthening and a comprehensive road safety program implemented. Ministry of Public Works (MPW), together with the Ministry of Transport (MOT) and with assistance from the World Bank, is preparing two initiatives in these areas: a pilot road safety program in and a pilot testing of performance-based contracts for road maintenance, including vehicle loading control, in central Java.

* To date, the private sector has been involved in the development of24% of the 650-km toll road network.

123 Annex 8 Transport 10. While the Directorate General of Highways (DGH), the Directorate in the Ministry of Public Works responsible for national roads, “executed” a US$ 1.1 billion budget in 2007, there are concerns that procedural and organizational issues (rather than policy issues) are constraining implementation, in particular on donor funded projects. Steps that DGH is taking will lead to improved implementation, for example DGH is moving towards the use of standard bidding documents (on NCB this is now standard for both foreign and domestic funded, and on ICB the harmonized document is being introduced), expanding the use of e-procurement, disclosure of contract information on official websites, and looking towards enhanced and standardized processes for land acquisition and environmental specifications (in the DGH Environment and Social Unit). DGH is also interested in exploring options to create a “facility” within DGH to provide “on call” management support for all DGH funded activities including those that are domestically funded- currently this works well for each foreign funded “project” whereby DGH contracts a management consultant to assist them with all management activities related to implementation. There is also a need to address corruption concerns. The adoption of standard bidding documents and of an e-procurement system for all road contracts will help. Moving forward, a comprehensive action program of anticonuption measures in the areas of procurement, transparency and accountability, auditing, and human resources will be needed.

Civil Aviation

Domestic Sector

1 1. The growth in domestic air passenger travel has been little short of startling since the sector was opened up to private operators in 1999. Prior to that, it was as sector dominated by public sector scheduled operators and a few non-scheduled private operators. There had been fairly steady growth in traffic until the financial crisis in 1997. Passenger numbers then fell dramatically, from 13.5 million in 1996 to 7 million in 1999. From 1999, passenger traffic has surged from 7 million to 34 million in 2006, almost a fivefold growth in seven years.

12. Growth has been led by the entry of a large number of private sector operators, offering domestic air travel at low fares. From half a dozen scheduled operators in 1998, there are now over 20 scheduled domestic air carriers, with a further 14 licenses issued. Given the geographical dimensions of Indonesia, numerous islands spread over 5,000 kms, the expansion in opportunities for low cost air travel has to be accepted as a major consumer advance, providing both social and economic benefits.

124 Annex 8 Transport

Figure 1 Indonesian Air passenger traffic

1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006

13. Such rapid growth is always likely to result in strains within a sector used to much lower traffic levels3. While the private sector has been able to react quickly to market liberalization, the public sector components of civil aviation have been much slower in providing the additional capacity necessary. There is intense competition within the sector and the new operators are able to keep fares low through the use of low cost leased aircraft (primarily B737s). One ofthe private airlines stated that between 80 - 90% of the domestic airline fleet is more than 10 years old. Such aircraft can be operated quite safely but require more maintenance attention and tighter and more frequent airworthiness control. There have been suggestions that the planes are not receiving the maintenance required and certainly the number of airworthiness inspectors has not kept pace with the growth in the sector (only 10% additional inspectors have been employed since 200 1).

14. Indonesia has had a number of serious fatal accidents in the domestic airsector: 0 2004 Lion Air, Boeing MD82, Solo, 25 dead 0 2005 PT Mandala Airlines, B737, Medan, 149 dead 0 2007, Adam Skyconnection, B737, Sulawesi, 102 dead 0 2007 Garuda, B737, Yogyakarta, 25 dead

15. While there were no catastrophic accidents during 2006, there were at least 15 serious incidents with a total of 14 fatalities. The rate of fatal civil aviation accidents is 15 times the world average. In the three years to March 1, 2007, there were 3.77 fatal

India has also seen a very rapid growth in domestic civil aviation with many new operators. Shortages of pilots, air traffic controllers, terminal capacity are now being experienced and there is growth concern being expressed about the safety of the system.

125 Annex 8 Transport accidents/million takeoffs, compared with the global rate of 0.254. The poor safety record led the EU to ban all Indonesian Airlines from flying to Europe (though none were operating services to Europe). A Government report in March, 2007, indicated that none of Indonesia’s airlines were fully compliant with international safety standards. The seven lowest rated airlines were given three months to improve or face having their licenses suspended.

16. The Government has taken action during 2007 to improve the safety of the civil aviation sector. A new Minister ofTransport was appointed, together with a new Head of Civil Aviation. Plans were announced for US$2 billion to be spent on upgrading the infrastructure by 2009 and more stringent controls over domestic airlines standards enforced. The new Minister has also proposed that there should be a ban on the purchase of aircraft more than ten years old and also possibly the introduction of Government established minimum fares.

International Sector

17. Traffic growth in international air traffic to/from Indonesia has been more modest, increasing from 3.8 million departures in 1998 to about 5.5 million passengers in 2006, an annual growth of about 5%. Indonesia has substantially more international flights than similar sized countries in Asia, but its pattern of flights is heavily influenced by the proximity of air hubs at Bangkok and Singapore. An analysis of international air passenger services, as reported in the ABC system, showed that Indonesia received more than twice the number of international flights operating to Pakistan and more than four times the services operated to Bangladesh. A significant majority of Indonesia’s international flights are within South East Asia, over 25% of its total services connect with either Bangkok or Singapore. Indonesia has also far more services to China and the Far East, but far fewer to the Middle East and Europe and no direct services to the USA. The tourist industry in Indonesia has generated a significant number of services to/from Australasia.

18. The other noticeable feature of Indonesia’s international civil aviation sector is the less important role played by the national carrier. Garuda operated 30% of the international flights to/from Indonesia, while the national carriers in Bangladesh and Pakistan operated significantly more than half the services.

The Maritime Sector

Shipping

19. Ports and shipping are key to national economic integration as well as important for passenger movements, especially between neighboring islands. Over the last 20 years, there has been a considerable increase in domestic sea freight as well as international

4 Unfortunately, the alternative for inter-island travel, sea, is no safer. In the last week of2006, at least five passenger boats sank, including the Senopati Nusantara ferry with the loss of more than 400 people

126 Annex 8 Transport imports and exports, although both domestic freight and exports are now regaining the levels reached in the mid-1990s, and imports have still to regain the levels reached before the financial crisis of 1997. However, draft limits vessel size to 3,000 - 3,500 Twenty- foot Equivalent Units (TEU) and few mainline ships call at Indonesian ports. Deficiencies in basic infrastructure and handling equipment include limited draft in some ofthe strategic ports that inhibit their ability to receive large vessels and ports like Jakarta are simply feeder ports to Singapore (given that Singapore is so close and an international hub). Inadequate equipment is the main cause of generally low port productivity in terms of average berth occupancy rate, turnaround time, and containerization rate. Overall, operational performance and service provision have not met client expectations and international performance standards. In particular, performance in container terminal operations is considered unsatisfactory by port users.

Figure 2 Indonesian Sea Freight (1988-2005)

pl- 1 180 I 160 ' IL -= 140 .-0 E 120 - -+-Imports - -+-Exports Domestic

-

0, 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005

20. Java dominates the maritime sector with international traffic slightly more important than domestic traffic and a significant inward imbalance in traffic: the ratio of inward to outward flows is approximately 2: 1. United Nations Conference on Trade and Development (UNCTAD) publishes an annual index of liner shipping connectivity combines fleet assignment, lines services as well as vessel and fleet sizes. It provides a comparative indication of the level of shipping service, table 3. China and Hong Kong have the highest connectivity. Indonesia has a rather lower connectivity than either Malaysia or Thailand, but higher than either the Philippines or Vietnam. While, however, the connectivity of Malaysia and Thailand is increasing, that of Indonesia is static or falling.

127 Annex 8 Transport

Table 3 UNCTAD: Liner Shipping Connectivity Index (Maximum score 2004 = 100) Rank Country 2004 2005 2006 200612005 % change 1 China 100.0 108.3 113.1 4.8 2 Hong Kong 94.4 96.8 99.3 2.5 3 Singapore 81.9 83.9 86.1 2.2 4 United States 83.3 87.6 85.8 1.9 5 United Kingdom 81.7 79.6 81.5 -1.8 10 Malaysia 62.8 65.0 69.2 4.2 18 India 34.1 36.9 42.9 6.0 20 Sri Lanka 34.7 33.4 37.3 4.0 22 Thailand 31.0 31.9 33.9 2.0 32 Indonesia 25.9 28.8 25.8 -3.0 38 Pakistan 20.2 21.5 21.8 0.3 49 Philippines 15.4 15.9 16.5 0.6 54 Vietnam 12.9 14.3 15.1 0.8 109 Bangladesh 5.2 5.1 5.3 0.2

21. Indonesia’s pattern of general cargo shipping is dominated by its proximity to Singapore, which has the world’s third highest level of liner shipping connectivity. Over 60% of the international containers are carried by feeder vessels to/from Singapore. The rest of the international traffic is on direct calls on the shorter Asian routes - Hong Kong, Taiwan, Japan and Korea. There are very few direct services to either Europe or the US. The main Indonesian container ports have limited drafts and cannot handle vessels much larger than 3,00OTEU, much smaller than the present size of the mainline mother vessels. Even if, the ports could handle much larger vessels, it is doubtful whether there would be a significant shift in the pattern of operations or whether Indonesia would gain much economically from substituting relatively infrequent mainline services in medium sized vessels, possibly calling at many ports for a very short feeder trip and frequent mainline service on very large vessels.

22. In terms of total container traffic, Indonesia has a large and growing traffic, substantially lower than either Malaysia or Singapore (whose traffic is distorted by transshipment) but higher than, for example, the Philippines or Thailand, Table 4. International freight is carried almost entirely in foreign flagged vessels, while domestic freight is handled by Indonesian vessels. Government does not permit foreign vessels to carry domestic cargo, thus preventing foreign lines from developing integrated feeder line services. Domestic lines (both state owned and private) have a large fleet of cellular container vessels, in the 200 - 400 TEU range, for domestic services.

Table 4 Total Container Traffic (million TEU) Country 2002 2003 2004 Singapore 17.0 18.4 21.3 Malaysia 8.7 10.2 11.3 Indonesia 4.5 5.2 5.6 Philippines 3.3 3.5 3.7 Thailand 3.8 4.2 4.9

128 Annex 8 Transport 23. While domestic container traffic has developed, it has a rather different pattern to international container traffic. Almost all international containers are shipped door-to- door and are thus moved inland to the final destination (though that may be close to the port area). Domestic containers are shipped generally on a port-to-port basis and stuffedlstripped at the ports and the contents moved inland on smaller trucks. Domestic container movement was initially stimulated by “free use”, under which international lines would give domestic free use of the containers if they were delivered to the locations where they were needed to load export cargo. There is very little intra-island coastal shipping, even for fuels. Attempts have been made to start such services around Java but they have not succeeded and were withdrawn.

Ports

24. Java dominates the general cargo market in Indonesia and three ports dominate the general cargo market in Java. All three ports have container terminals. Jakarta (Tanjung Priok) is by far the largest international container port in Indonesia and a major world container port, presently ranked 24th , with total traffic of 4.2 million TEU (2005), which has been growing rapidly in the last few years (about 16% annually). It is quite possibly the largest container port largely dependent on feeder services. Surabaya (Tanjung Perak) is also a major container port, in the east of Java, with an annual traffic of over 1.6 million TEU and about the 50th busiest container port in the world (2003). Tanjung Priok is primarily the gateway for international traffic while Tanjung Perak also has a substantial role in domestic container traffic, and handles significantly more domestic containers than Tanjung Priok and is the main hub port for the islands (excluding Java and Sumatra) international trade.

Table 5 Market share of Indonesia’s ports Port Market share Container Terminal Jakarta 52% Hutchison Surabaya 38% P&O (DP World) Semaran E 8% Pelindo

Table 6 Port Activity: Domestic Freight 2006 (million tonnes) Unloading Loading Total Belawan 7.0 0.5 7.5 Tanjung Priok 14.0 6.0 20.0 Tanjung Perak 10.7 10.5 21.2 Balikpapan 8.6 10.1 18.7 Makassar 3.2 2.6 5.8

25. Tanjung Perak is the major domestic traffic port in Indonesia, Table 6. In terms of total traffic, it is closely followed by Tanjung Priok and Balikpapan. There are very different patterns among the ports: a broad balance of loading and unloading at Tanjung Priok, Balikpapan and Makassar, but considerable imbalances at Belawan and Tanjung Priok, with far more imports than exports.

129 Annex 8 Transport 26. Indonesia has, not unnaturally, a large number ofports which are organized under by four state corporations (Pelindos). These have a large degree of autonomy and are, in most cases, financially self sufficient. There are also a number of private ports/terminals for bulk cargo, e.g. Cilacap and Cigadeng.

27. Government gave up trying to direct sea freight through a four tier network in the 1990s and has been trying to open up the sector to private investment but in a rather piecemeal and erratic fashion, certainly not in a manner consistent with accepted best practices. Government still controls port tariffs; this is perhaps not unexpected, given that many/most of the ports have substantial geographic monopoly power and there has been no attempt to develop intra-port competition. Unfortunately, the tariffs are generally too low to attract significant private sector interest.

28. In 1999, international port operators bought into the container terminals at Tanjung Priok (Hutchison, with a 51% shareholding) and Tanjung Perak (P&O, with a 49% holding). It is thought that the sales were linked more to raising finance for Government, in the aftermath of the financial crisis, than to raising port productivity. These joint ventures mix the role of the landlord and operator and have not been unbridled successes. There have been reports that Government would like to buy out the private port management companies, accusing them of not achieving the objectives of operating performance and attracting mainline services rather than acting as feeder ports for hub ports, primarily Singapore. While port productivity has improved since 1999, the improvement has been relatively modest (compared with the improvements that the private sector has brought about at other ports) and productivity is still modest by international standards.

29. Despite the relatively limited success of private participation at the two main container ports, the container terminal at the port of Makassar (850 meter berth with 11 meter draft and traffic of 245,000 TEU in 2005) was sold to ICTS is 2006. Eight private companies (including six foreign companies, such as Hutchinson, Maersk and PSA) are competing to build a new international port in Western Java, as part of Government’s plan to develop 25 international ports. In addition to the private sector’s participation in container terminals, the general cargo berths at Tanjung Priok were allocated to 11 stevedoring companies, each having 2 - 3 berths. But the labor was still effectively employed by the national dock labor pool, thus limiting management control and labor loyalty. Moreover, the leases were only for five years, too short a period for significant private sector investment.

Public Private Partnership Potential in Aviation and Maritime Sectors

30. The current legal framework5 defines the various categories of ports and airports; specifies that management of all general ports and all airports is the responsibility of the

Maritime Law 2 1/1992, Government Regulation 69/2001, and the implementing ministerial decrees 53, 54, 55, and 5612002 for ports; and Aviation Law 1511992, Government Regulation 70/2001, and the implementingministerial decrees 44,45, and 48/2002 for airports.

130 Annex 8 Transport

Government, which can delegate it to a state-owned enterprise (SOE); and allows private sector participation only through a cooperation agreement with an SOE. Based on this framework, the Government identified groups of ports and airports that are considered commercial (Le., generate operating profits or have the potential to do so), and allocated their management and development to six SOEs: (i)111 ports to four Indonesian port corporations (PELINDO I to IV), and (ii)23 airports to two airport corporations (Angkasa Pura I and 11). In reality these portfolios contain a mix of profitable and unprofitable assets, arranged in geographic proximity. The SOEs exercise monopoly rights over the ports and airports in their portfolios, managing all aspects of operation, development, and private sector participation. They also act as a regulator in their domain, setting tariffs for the use of portlairport infrastructure and for portlairport services in consultation with Ministry ofTransport.

3 1. Port tariffs are low, allowing full cost recovery only in larger ports and reducing the incentive for private sector investment. With the introduction ofthe International Ship and Port Security Code in July 2004, all Indonesian international ports face the challenge of implementing strict security measures; receiving ports can reject docking of ships with cargo from ports that do not meet the code requirements 32. While the capacity of the airside facilities is sufficient in the main airports, terminals and aprons are sometimes inadequate. The same is true for many secondary and tertiary airports. Air traffic security also needs to be addressed. Domestic airport tariffs are kept artificially low and do not allow cost recovery for services provided to passengers and air carriers. As a result, only major airports with significant international traffic are able to break even in their operations. The initiative for proposing increases in airport tariffs lies with the airport operator. However, the operator is required to consult with users, local Governments, and the Ministry of Transport. Experience with tariff increases indicates that they are difficult to implement due to strong resistance usually expressed during the consultation process. As with ports, security of strategic airports needs to be enhanced to deal effectively with security concerns.

33. Both ports and airports have good potential for PSP, but actual PSP is low given the lack of a clear and predictable regulatory and investment environment, and the lack of a level playing field providing equal access and opportunities to all investors. In the port sector, three of the four PELINDOs have formed joint ventures with private operators. These deal structures, with the PELINDOs acting as both landlord6 and operator, deter further private sector participation, as potential investors in new port terminals will not expect fair treatment from a landlord with a financial stake in an existing operator. Private sector participation in the airport sector has been very limited, and generally taken the form of subcontracts for selected landside services. Another impediment to PSP has been uncertainty caused by regional autonomy legislation, which confers authority over

6 Landlord functions in ports and airports include berthkerminal assignment, allocation of shed and warehouse space, control of all vehicles that enter and leave the ports/airports, cleaning and maintenance of infrastructure, and collection offees.

131 Annex 8 Transport public works, including ports and airports, to local Governments. This has created a potential for conflict with the PELINDOs and Angkasa Puras.

Railways

34. Despite, the low level of investment funding the railway receives and despite having to compete against a subsidised road sector, it is a well run operation with good productivity. The railway sector in Indonesia is limited to Java and Sumatra. The very extensive network of narrow gauge lines have closed and most of the network is Cape gauge (3 ft 6in). There is a relatively extensive network on Java which provides broad coverage throughout the island, including two east-west corridors and inter-connecting links; the network is 3,700 km, almost 75% of Java’s total railway length. There are three small, unconnected rail systems on Sumatra.

35. The organizational structure of the railway sector in Indonesia is unusual for a developing country and follows the European Union model of separating infrastructure and operations. 0 The state owns and maintains the fixed infrastructure, though PT Kereta Api (the Railway Corporation) will actually undertake the work 0 PT Kereta Api only owns the moving assets 0 The state is obligated to pay PT Kereta Api for the maintenance of the track as well as a PSO payment for non-commercial services 0 PT Kereta Api, for its part, pays track access charges to the Government on the services operated

36. While the principles provide the basis for transparent financial arrangements, the reality is more opaque. The payments made by Government for the maintenance of the track have been substantially below the levels agreed and it is not clear that the payments have been used for track maintenance. PT Kereta shows a small profit, on paper, but depreciation provision is well below the levels required to fund the necessary renewals of assets.

37. In terms of total size, the network in Indonesia is dwarfed by Chinese and Indian Railways but it is rather larger than most railways in East and South Asia. Track productivity is well below that achieved on Chinese and Indian Railways but is comparable with that achieved on the other railways, including railways in the European Union. In terms of labour productivity, Indonesian Railways is well above other railways in the region and only slightly lower than railways in the European Union but broadly equivalent to Thai or Indian Railways. In view of the reported average age of the locomotive fleet, locomotive availability is very high as is the reported kilometer utilization ofthe locomotive fleet (800 kms/locomotive/day).

132 Annex 8 Transport

Table 7 Indonesian Rail Network Size and Productivity Route-kms Traffidkm Traffidstaff Locomotive (million) (‘000) Availability China 71,897 27.7 1,165 na European Union Na 3.6 69 1 na Indonesia 5,040 4.0 610 90% Thailand 4,044 3.2 548 75% India 63,465 12.9 537 84% Malaysia 1,667 1.4 472 na Pakistan 7,79 1 3.3 3 10 67% Sri Lanka 1,170 3.8 270 68% Bangladesh 2,855 1.7 141 76% Vietnam 2,67 1 2.3 124 94%

38. Functionally, there are five distinct rail networks in Indonesia: e Jabotabek rail network: commuter services idaround the Jakarta Metropolitan region. An electrified network, using EMUS, some/all purchased second-hand from Japan a Java rail network: primarily a passenger rail system but carrying some freight e : generates 20% ofthe total rail revenues, 90% freight a : generates 2% oftotal revenues, 100% freight a : generates 3% oftotal revenues, 60% freight. With the exception ofthe Jabotabek network, the rail networks are all diesel systems.

39. The distribution of traffic, on the various networks, in 2006, is shown in Table 8. The passengers using the Jabotabek network are relatively short distance commuters (about 350,00O/day). In terms of total passenger-kms, traffic on the rest of the Java network is considerably higher, consisting ofmedium and long distance travel.

Table 8 Indonesian Rail Traffic 2006 (millions) Passengers Freight Tons Jabotabek 104.5 Other Java 51.6 3.9 Total Java 156.1 3.9 Sumatra 3.4 13.4 Total Indonesia 159.5 17.3

40. Traffic on Indonesian Railways, both passengers and freight grew substantially until the late 1990s and then both passenger and freight declined significantly, the consequence of the financial crisis and increased competition from low cost airlines. Traffic levels appear to have stabilized from about 2004. While down from their peak levels, passenger numbers are now about three times higher than in 1990, and freight is about 40% higher, Figure 3.

133 Annex 8 Transport

Figure 3 Indonesian Railway Traffic (1987-2006)

250

~ 301 25 -- e -- 200

E -- Yg 20 ._5 = 15 -- -'E E -2 10 -- E LL 5 --

0,1i!i II/III1III ///I!,0

4 1. The separation of infrastructure and its maintenance from railway operations should place road and rail on an equal competitive basis. However, this depends on equal treatment with respect to track access charges. These are paid for rail services, but fuel is subsidized and it is clear that road user charges are well below both short and long run road user costs. The extent ofthe distortion would require further review.

42. There have been announcements that Government will shortly allow both Indonesian and foreign private companies to invest in the railway sector. The structure of the sector, with the separation of infrastructure and operations, and the accepted principle of track access charges would allow conceptually the provision of third party train services, though a third party might well have to pay a trackage charge which covered both train control on the infrastructure (to PT Kereta) and track maintenance (to Government). However, it was made clear that PT Kereta Api's monopoly would be largely maintained. It was further suggested that private sector involvement in passenger services would be limited to a minority shareholding in the national railway company and would not be allowed to operate their own trains.

43. Worldwide, there has been relatively little private sector interest in investing in passenger services, which are mainly loss-making. However, medium and long distance express passenger services can make money, and there may be opportunities in Java for such services. There may be opportunities to for further refodrestructuring in the sector, to build on what appears to be a reasonably competent if non-commercial operation.

44. JBIC is financing engineering services for the development of a planned mass transit rail line in Jakarta with 10.5 km of elevated track and 4.0 km of subway. This development appears to be outside the realm of the present railways. There are also

134 Annex 8 Transport reports of the construction of a new rail line and port terminal in Southern Sumatra, costing US$260 million to be financed through the sale of coal, timber and crude oil (Times of India, 13/07/2007). There have been no recent reports, however, with respect to major changes to the main passenger network on Java which, in most respects, is the core of Indonesian Railways,

Participation of multilateral and bilateral funding agencies

45. The World Bank has been engaged in the road sector in Indonesia for more than 30 years with a focus on support to preservation of assets of both rural and inter-city roads. Engagement in other transport sectors has been limited with support to the Railway sector reform project, which closed in December 2005, being the last major area of support. There is ongoing support to shipping in the Malacca Straits which is a multi- country project.

46. Current World Bank support to the road sector includes the ongoing Eastern Indonesia Region Transport Project (first part of which closed in June 2006 Loan 4643 US$ 200 million, the second part of which is ongoing, Loan 4744 US$ 200 million) which focuses on rehabilitation and preservation ofnational, provincial and district roads. More recently attention has turned to supporting capacity expansion in Java and Sumatra under the Strategic Roads Infrastructure Project (approved July 2006, US$ 208 million Loan 4834). The Bank also supports the Public Private Partnership agenda and provides technical assistance on the institutional developments needed for toll roads through the PPITA loan. Support to roads below the district level is provided through the extensive CDD-style Kecamatan Development Program. There are presently two other proposed World Bank supported projects in the transport sector pipeline for Indonesia, namely the proposed National Roads Improvement Project funded in parallel with AusAID and the proposed Freeways Project aimed at supporting the freeway/expressway development in JavdSumatra by developing an expressway plan, financing land and supporting the transparent award ofconcessions.

47. Other major donors active in the transport sector include Asian Development Bank (ADB), JBIC and more recently AusAID. Bilateral donors such as JICA, the French Embassy, and KFW are also providing support. The ADB had been active in the ports sector. The Bank provides technical support to the French Embassy railways studies.

135 ANNEX 9 TELECOMMUNICATIONS

Introduction

1. Improving access to telecommunications infrastructure in Indonesia is important for several reasons: reducing regional inequality, facilitating faster and more efficient service delivery and business transactions, and enhancing competitiveness. Indonesia’s telecommunications sector is becoming more dynamic and diverse, evidenced by the dramatic growth in wireless and fixed-wireless telephony over the past five years. Investment in telecommunications infrastructure is overwhelmingly private-sector driven. The role of government (and potentially of development assistance) in this sector is to: (a) facilitate the development of telecoms infrastructure in rural and remote areas that are not commercially attractive, (b) facilitate the roll-out of high-speed data transmission networks (backbone) through private-public partnerships, including catalytic hnding where appropriate; (c) ensure that the legalhegulatory environment promotes competitive behaviour, reflects changes in technology, protects consumers and continues to encourage new investment.

2. Indonesia faces two main “access” challenges: (a) adequate supply of basic communications (telephony and data services) at the village level; (b) nationwide development of high-speed communications backbone/broadband infrastructure which is needed to facilitate real growth of Internet in Eastern Indonesia and Western Indonesia at the kabupaten (kota) level, and support multiple applications in different sectors. Adequate and affordable Internet bandwidth is not only a prerequisite for the future development of the telecoms sector itself. For example, more widely available, affordable and reliable telecommunications infrastructure in Indonesia will help to: Improve communications between central ministries and sub-national governments 0 Enable delivery of government services online (e.g. business registration, e- procurement, access to information about services) 0 Promote delivery of financial services, ranging from mobile phone-based micro- payments (e.g. transfer offunds from overseas workers) to Internet banking Stimulate development of e-commerce and contribute to trade facilitation. Facilitate communication between small enterpriseshural producers and suppliers and markets.

3. The Government has issued a National ICT strategy that envisages more widespread development of ICT applications in various sectors. However, implementation depends critically on adequate infrastructure and sound regulations being in place. The Government has begun to address the main regulatory challenges. Reforms are ongoing in such areas as interconnection, licensing and spectrum management. The government is also developing a new universal service policy and program. It is also starting to address” second generation” issues, e.g. unified access and service licensing (allowing all operators in the sector to provide the same kinds of services rather than restricting licenses by technology), and the implications of convergence of telecommunications and medidbroadcasting technologies (e.g. introduction ofIP-TV).

136 Annex 9 Telecommunications

Telecommunications Infrastructure: Current Status and Challenges

4. Current situation. Access to basic telephony is growing as a result of substantial private investment in wireless networks. In 2006-2007 we have seen continued growth in wireless and fixed-wireless telephony’ and the launch of third-generation (3G) wireless services (permitting fast data downloads/mobile Internet access) while the number of fixed lines (traditional copper wires) stagnated. At the end of 2006, fixed teledensity (including fixed lines and fixed wireless) was around 6%, and mobile teledensity was around 29% as shown in Table 9-1.

Table 9-1. Telecommunications Access, end-2006. Subscribers (millions’, 2004 2006 Fixed lines in service 8.5 9.1 Fixed wireless 2.0 5.0 Wireless (GSM) 29.5 65.0 Wireless 3G 0.0 1.o Internet subscribers 11.2 23.4 of which, broadband 0.1 0.5

5. Overall Internet penetration is relatively low at around 11% (2006 estimate), overwhelmingly via dial-up connections. New broadband or high-speed Internet access technologies (e.g. fixed DSL and cable, and broadband wireless access such as WiFi “hotspots” in urban areas, and WiMAX over longer distances) are also slowly becoming available, offering not only access to the Internet but also to Voice over Internet Protocol (VoIP) telephony, and multi-media services, e.g. TV. However, broadband is still very limited, with at most 500,000 subscribers as of end 2006. Rollout of broadband is still very constrained by limited network capacity (bandwidth), particularly in Eastern Indonesia, but also at the kabupaten level in Western Indonesia, and also by lack of supporting regulations. At the moment, the main provider is PT Telkom through its DSL “speedy” service. 3G Wireless is the fastest alternative.

6. Outlook2. Access to basic voice telephony, particularly wireless, is projected to improve in the medium-term, boosted by strong demand, particularly for prepaid services. Our projections suggested that wireless teledensity will reach at least 40% by 2010, 3G 13%, while fixed lines and fixed wireless would reach 17% and 36% of households respectively, with distribution of demand strongest in Java-Bali, Sumatra and Kalimantan. The most significant medium-term trend is the growing demand for

’ The main wireless (mobile) technology used in Indonesia is GSM (Global System for Mobile Communications). Fixed-wireless uses CDMA (code division multiple access), e.g. CDMA 2000 and CDMA 450 depending on frequency, and offers limited mobility, typically within a single area code, until recently at prices on par with fixed-line services. The term “3G” refers to third-generation wireless networks with high-speed data transmission capability. 2 The demand projections are based on Indonesian socio-economic data, industry analysis and benchmarking under the aegis of an ongoing World Bank//PPIAF study on development of national communications backbone networks in Indonesia. .

137 Annex 9 Telecommunications advanced data communications (Internet, multimedia) and particularly for broadband access. By 2020, the demand for broadband Internet is expected to surpass all other types of telecommunication services, reflecting the convergence of technologies, accounting for 86 of communication network capacity (bandwidth) demand. Details are shown in Figures 9-1 and 9-2.

Figure 9-1: Projected Demand for TelecommunicationdICT Services

Figure 9-2: Projected Bandwidth Demand (percentage of total capacity)

2010 2020

4 I. rn a Wireless (GSM-2G)

2 0 Wireless (3G) 23 ~Na~owband(dial-up) Internet rn Broadband Internet

32 0 Internet Protocol (IP) TV

7. Whilst these developments are encouraging, and consistent with global trends, Indonesia still suffers from a significant “digital divide.” The main access challenges that the government therefore needs to address, in partnership with the private sector, are village-level telephony-public access, and broadband Internet at the national and sub- national level.

Village-Level Basic Telephony.

8. In Western and Central Indonesia, regional and rural-urban disparities in telecommunications network infrastructure provision are gradually being eroded. Mobile operators in particular are now targeting less commercially attractive rural areas of Java- Bali, Sumatra and Kalimantan, and starting to extend beyond urban areas of Sulawesi and Nusa Tenggara. A key technical/cost consideration is that these Western and Central

138 Annex 9 Telecommunications regions are accessible to terrestrial “backhaul” networks (microwave, and some fiber- optic links).

9. On the other hand, while wireless telecommunications network coverage is increasing in these areas, access remains uneven. Up to 85% of Indonesia’s population are technically under the wireless “footprint.” However, public access to these networks is still very limited, Farticularly in the more economically disadvantaged districts at the desa (village) level. Two thirds of Indonesia’s villages lack a public phone. As with other infrastructure, rates vary considerably by region, with public phone access only available in 19% of Southeast Sulawesi’s villages, for example (PODES 2005). In addition, many areas of Eastern Indonesia-Maluku and Papua-remain “beyond the market”, due to very high logistical costs of service provision and relatively low purchasing power of consumers. Major technical constraints to rollout of wireless networks in Maluku and Papua include: lack of terrestrial “backhaul” infrastructure, hence reliance on high-cost satellite backhaul, as well as lack of roads and power supply.

10. The role of government would therefore be to: facilitate access to telecommunications networks, particularly in marginal areas (e.g. just beyond mobile “signal coverage”) facilitate public access in areas where there is mobile “signal coverage” but where people cannot yet afford private phones stimulate rollout of telecommunications infrastructure as well as public access in the most remote and poorest parts of the country that are very difficult to reach using available technologies, overcoming major technical constraints - the “true access gap.

11. The government intends to address these issues through its Universal Service Obligation (USO) program: a 0.75% tax on operators’ net revenues (already collected for 2005 and 2006) to finance a subsidy to operators to provide access in designated blocks of villages. As noted above, due to substantial private investment, the challenge is not “signal coverage” but public access. The Directorate-General of Post and Telecommunications is charged with implementing the US0 program, under PP 28/2005. The program entails issuance of competitive tenders for the subsidized provision of telecommunications access in designated villages.

12. Key considerationdrecommendations in this regard are: (a) the program should focus on public access facilities (e.g. pay phones) rather than network infrastructure so that subsidies do not finance network rollout in areas where private operators have already invested; and (b) the program should not establish special tariffs for “USO” areas. Under Minister of Communication and Information Technology Regulation No. 11 /PEIUM.KOMINF0/04/2007 operators bidding for service in “USO” areas would be

“Network coverage” means that a “signal” is available. However, only those with handsets can access the network. In several countries, telecom operators have partnered with entrepreneurs to provide public access mobile phones or “village phones.” Such programs are entirely feasible in Indonesia, but have not yet been developed.

139 Annex 9 Telecommunications required to offer tariffs at fixed-line tariff levels. This would act as a disincentive to wireless operators to participate as they would have to refit their billing systems (designed for millions of subscribers) to meet the needs of a few tens of thousands of customers. Moreover, demand-side analysis suggests that consumers are willing to pay at mobile tariff rates (they are already paying for satellite service at high rates in areas out of current mobile network range, for example).

13. If the US0 program is implemented before end-2007, the government should be able to reach an access target of at least one public phone in 80% of population centers of over 1,000 inhabitants by 2010.

Broadband Internet at the National and Sub-National Level.

14. The key access gap is the absolute lack of terrestrial backbone networks in Eastern Indonesia (mainly in Maluku, Papua, Nusa Tenggara Timur), and the limited reach of backbone networks beyond major population centers in Western Indonesia, as illustrated in Figure 3. This means that Internet access in these areas is costly and inefficient. An additional constraint to affordable Internet access has been the high cost of leased lines which was recently regulated downwards (2006).

orks in Indonesia, 2007

Kcandisi Saat hi...

15. To meet the growing demand for Internet services, the government has submitted for investor interest the proposed “Palapa Ring” project. This now comprises two elements: (a) Eastern Ring: construction and operation of a new fiber-optic terrestrial network in Eastern Indonesia which currently has only satellite backbone infrastructure, (b) Western Ring: more efficient and coordinated utilization of existing proprietary backbone infrastructure, and construction of fiber-optic backbone extensions to the kabupaten (kota) level. For the Eastern Ring, the government has attracted a seven- member consortium of 5 operators and 2 investors who signed a Memorandum of Understanding in June 2007. For the Western Ring, as some of this infrastructure is

140 Annex 9 Telecommunications already in place, the government will be looking to investors to support the kabupaten extensions.

16. The recommended role of Government for stimulating broadband Internet is threefold:

(a) supportive regulations to create a more competitive environment for provision of “access” to these backbone networks. In other words, permit multiple operators (fixed and mobile) to provide broadband services in addition to PT Telkom which is offering very limited DSL (fixed broadband) services, and none at the sub- national level. Three key steps to be undertaken in this regard are: 0 issuance of WiMAX (long-range wireless transmission) licenses. These will allow new players to provide wireless broadband, and compete with PT Telkom. The government has already indicated its intention to issue WiMAX licenses in 2007; 0 allowing the use of 900MHz spectrum for 3G mobile telephony (longer range for rural areas). The government has been revising its spectrum allocation policy throughout 2006-7; this would be an additional measure; and 0 removing infrastructure and service restrictions on existing telecoms licenses-i.e. allowing all operators to provide all types of telecom services through the phased introduction of Unified Access (and Service) Licensing. This would require a step-by-step approach since it entails recalculation of spectrum pricing, review of all existing licenses, numbering systems and tariffs, in close consultation with the industry.

(b) mobilizing concessional financing for less commercially viable sections of “backbone”, e.g. from development partners or through partial risvcredit guarantees. Analysis of the NPV of different sections of the fiber-optic backbone and estimation ofthe likely financing gap is still ongoing.

(c) Establishing and maintaining competition safeguards for development and utilization of fiber-optic infrastructure to ensure that new network capacity is accessible to all potential users on fair and transparent terms. In this regard, investors in fiber-optic network infrastructure will require: regulatory certainty, and a reasonable return on investment. Competitors will require fair and non- discriminatory access to services and facilities. Consumers want: strong price competition between operators, and access to cheap, reliable and plentiful bandwidth. Types of safeguards include: break-up of overlapping economic interests between consortium and downstream carriers, agreement on effective access regimes for bottleneck facilities; operational separation; Government participation as “honest broker” or possibly through an equity investment4.

4 Equity stake have the downside of closely involving Government in the consortium business affairs - and expose Government to future capital calls

141 Annex 9 Telecommunications General Policy and Regulatory Developments

17. Indonesia is heading in the direction of a more competitive market, but it is questionable whether there is as yet sufficiently robust competition in all market segments to help realize this potential. The sector policy and regulatory reform agenda needed to facilitate competition is comprehensive. Moreover, regulatory decisions need to be fully depoliticized and made subject to technical/professional review. The government has made numerous reform commitments. Its overall policy objective, as per UU 36/1999 on Telecommunications and the 1999 Sector Blueprint, is to facilitate competition and promote a level playing field. Specific reform commitments include: introduction of cost-based interconnection and introduction of a call traffic clearing system (SKTT) ; tariff rebalancing; readjusting the national numbering plan particularly for domestic long distance, international direct dialing and VoIP; early termination of exclusive rights on the domestic and international fixed network (and associated compensation payments to the incumbents); introduction of modern telecommunications licenses; radio spectrum management reform, including 3G licensing launch of a Universal Service Obligation (USO) program updating the 1999 Blueprint, and reorganization of the Ministry and empowerment of the independent regulator (BRTI).

18. Progress has been incremental. Principal developments in 2005-7 may be summarized as follows.

(a) Interconnection. Resolving this difficult issue has important implications for revenue-sharing among operators, retail pricing, and market entry, including for VoIP service providers. The existing arrangements and practices have been a major deterrent to facilities-based competition, for example. Following a detailed cost modelling exercise and consultative process, an Interconnection Decree was issued in February 2006, to become effective in January 2007. The timetable for implementation is still in progress in particular as the two major operators, Telkom and Indosat have concluded bileratal interconnection agreements, based on revenue-sharing. However, operators have been instructed to submit reference interconnection offers. The SKTT traffic clearing system was established but is not operational, due to the lack of enabling regulations, and some resistance from operators.

(b) Targs. Changes to call tariffs have proved politically sensitive, hence implementation has been partial. In January 2002, the government announced a plan to increase fixed line tariffs by an average of 45.49% by January 2005; the first 15% increase was implemented in 2002. The 2003 increase did not take place due to lack of approval by the legislature. In March 2004 the government announced that it would allow operators to rebalance their tariffs, with the

142 Annex 9 Telecommunications resulting weighted average of tariffs increasing by 9%. Since then, local tariffs have increased about 28%, while long-distance tariffs have fallen around 10%. Wireless operators and customers have resisted increases in local call tariffs as the mobile-fixed interconnection charge is currently about 50% of the local call charge. The issue of wholesale Internet tariffs and international bandwidth pricing is also being addressed, with the revision of regulations on leased lines 03/Per/M.Kominfo/ 1/2007,

Numbering. Fixed-wireless licenses have been granted for domestic local service, allowing operators to provide service within specified area codes (without roaming). Calling rates are required to be comparable with fixed rates. The implementation of new access codes (3-digit for domestic long distance, and international direct dialing, and 5-digit for VoIP) has been approved. Implementation is to be phased in over a five-year period.

Licenses. Under the 1999 law, existing licenses for telecommunications services are to be replaced by “modern licenses” including mandatory obligations for license holders (construction, service, network performance, US0 contributions). Three license categories were introduced in the 1999 law: for telecom networks, services, and special telecom operations. The transition arrangements for existing licenses are unclear. A related issue is whether or not the existing duopoly arrangement for fixed-line services (Telkom and Indosat) will continue to 2010 as previously envisaged, given the entry of wirelesdfixed-wireless competitors, and alternative networks. Compensation payments for early termination of Telkom and Indosat’s exclusive rights in their respective sub-sectors (Telkom domestic fixed and Indosat international) have been budgeted and the first installment paid. The government has indicated that it intends to issue a third international license, and phase in Unified Access Licenses and commensurate revisions of regulations for spectrum, numbering, tariffs).

Radio Spectrum Management. Spectrum is a scarce and valuable public resource and its management attracted substantial media attention in 2005-6. The government has been revising its radio spectrum management policies in light of new entry (3G mobile), and new technologies (broadband wireless access). The main issues are: (i)the allocation of equal 5MHz spectrum “blocks” to all five 3G operators-the two licensed in 2004, and the three subsequently licensed after the February 2006 auction; (ii)the need to reallocate spectrum previously assigned to CDMA operators’ for 3G; and (iii)the proposed licensing and allocation of high- frequency bands for broadband wireless. To date, (i)and (ii)have been completed. With regard to other spectrum issues, the government declared that the 2.4 GHz band would be license-exempted (Ministry of Transportation’s Ordinance on the use of 2.4 GHz for high-speed Internet). This was an important decision that has allowed WiFi services to expand as noted above.

5 The government required CDMA fixed-wireless operators to migrate from the 1900MHz band so this could be allocated for 3G, at some cost to the operators.

143 Annex 9 Telecommunications

(f) Sector Institutions. The sector ministry was reorganized in 2005. The Ministry of Communications and Information Technology, has oversight powers across the full range of telecommunications and media, effective February 2005. It has primary responsibility for telecommunications sector reform and development- incorporating the directorate-general of post and telecommunications (DG-Postel) in addition to existing res onsibilities for ICT applications and broadcastinghnformation services. ?The sector regulator has become increasingly active, though full regulatory independence has not been achieved. The Indonesian Telecommunications Regulatory Body (Badan Regulasi Telekomunikasi Indonesia, or BRTI), established in July 2003 , became effective on January 4, 2004. BRTI consists of the telecommunications regulatory committee (KRT), and is chaired by the Directorate General of Post and Telecommunications (DGPT). BRTI is ostensibly responsible to issue licenses and resolve disputes and advise government on telecoms policy issues. However, BRTI’s responsibilities vis-a-vis DGPT are not clearly-defined. BRTI is not fully independent of DGPT, and the 1999 Telecommunications Law is unclear about its degree of independence. Since DGPT became part of MCIT in June 2005, BRTI effectively operates under the ministry’s umbrella. BRTI’s decisions are issued in the form of DGPT decrees. It is chaired by the Director-General, Postel. A further constraint to BRTI’s effectiveness is its limited staff and resources which constrains its ability to operate independently.

19. Overall, while there has been some progress in the reform agenda, a number of regulatory issues remain unresolved. The cumulative effect of this lack of clarity and slow implementation is a regulatory drag on investment and service diversification ,

20. Moroever, on top of this unfinished agenda, a second wave of policy/regulatory issues looms ahead in view of the market trends and technological changes described above. Adjusting to convergence of telecommunicationshroadcasting: for example, ensuring that regulations do not hinder “triple-play” of voice, video and data services;

6 MCIT now consists of three Directorate Generals (DGs): Directorate General of Posts and Telecommunications (formerly in the Ministry of Communications, and officially absorbed into MCIT in June ZOOS), Directorate General of Information Technology (IT) Applications, and Directorate General of Broadcasting and Information Dissemination, reflecting the converging nature of the sector. Other government institutions involved in telecommunications sector development include: (a) the Coordinating Ministry for Economic Affairs which chairs the telecommunications sector restructuring team (Tim Koordinasi Telematika Indonesia, appointed by Keppres 9/2003 and covering infrastructure, applications, legal structures, human resources, finance and investment, standardization and e-government); (b) Bappenas, is interested in overall sector structure and competition policy and has commissioned a study on the structure of the telecoms market, post-duopoly; (c) the State Ministry of State Enterprises (holds government shares in Telkom and Indosat); (e) the Ministry of Finance is interested in sector financing, revenue-generation, as well as government ICT applications that could benefit fiom greater diffusion of communications infrastructure.

144 Annex 9 Telecommunications

0 Supporting new technologies that lead to the development of packaged-value- added services; Facilitating a more dynamic and competitive wireless market: licensing of mobile virtual network operators (MVNOs); mobile number portability, for example.

Development Partner Activities.

2 1. There are numerous development organizations, foundations and NGOs supporting various aspects of ICT development and use in different sectors. Initiatives have proliferated and include, for example, development of ICT strategy (UNDP) financing for telecentres (UNDP, Korea, IDRC/CIDA), ICT in education initiatives, ICT in agriculture, e-government (Korean pilot project) for example.

22. With regard to infrastructure and regulation-the two foundational elements of ICT development-the Asian Development Bank, the World Bank and the International Telecommunications Union have been the main players.

23. ADB, through the IRSDP, is assisting the government in implementing private- public partnership for infrastructure development. In the case of telecoms, the project supported the government in the development of new regulations on interconnection. Japan (JICA) has provided some advisory assistance on telecommunications policy and regulation. ITU has a program of workshops and advisory support on key regulatory topics, both regional (regulatory toolkit, with the World Bank’s infoDev department) and country-specific.

24. The World Bank has advised the government on development of a new business model for universal service (USO) through the Global Partnership on Output-Based Aid, on competition policy (through PPITA), and is actively assisting the government with technical, economic and legal/institutional analysis on the “Palapa Rings” project (through PPIAF), and possibly with catalytic financing/guarantees. In addition, the World Bank’s is advising the regulator (BRTI) on transition to unified access licensing and will shortly be commencing analysis on public service delivery through e-government opportunities.

145 ANNEX 10 SUB-NATIONAL GOVERNMENTS

Background and Context

1. In 200 1, Indonesia launched an ambitious program of decentralization. The effort had its genesis in two laws, both promulgated in May 1999: UU 22/1999 on local government and UU 25/1999 on fiscal balance. In December 2000, UU 34/2000, an additional and essential piece of decentralization legislation on regional government taxation was passed by parliament (DPR). These three laws were supplemented by a large number of implementing regulations and ministerial decrees.

2. In late 2004, Indonesia initiated a re-design of its basic decentralization regulatory framework by issuing revisions to the two major pieces of legislation, UU 32/2004 on local government and UU 33/2004 on fiscal balance. Many of the basic lower order legislative instruments related to these two laws have also now been completed, although a few remain to be produced. Draft amendments to UU 34/2000 have also been finalized and are now being reviewed by DPR.

3. Implementation of decentralization has been uneven, at best. Among other problems, key sub-national infrastructure services appear to be in a state of disrepair. Local governments are responsible for provision of water services, sanitation, and rural roads. Sub-national governments could also play a greater role in the expansion of household electricity connections. Across the country, service standards in these sectors are poor. Issues and Challenges

Borrowing

4. Sub-national borrowing is commonly viewed as the most efficient and equitable means of financing local infrastructure for service delivery. Historically, Indonesian sub- national governments and water enterprises (PDAMs) have not, however, borrowed significant amounts for public capital development. The cumulative amount borrowed through on-lending mechanisms from 1975 through 2004 (the last year for which comprehensive and reliable data are available) was Rp 5,792 billion in nominal terms or Rp 26,168 billion in constant 2004 terms; these figures represent about 0.2% and 0.9% of 2004 GDP, respectively. Sub-national borrowing peaked in the mid-1990s, declined precipitously along with the East Asian financial crisis (which started in mid-1997), and has not recovered since. Borrowing since decentralization has been especially meager (Lewis, 2006) (Figure 10-1).

146 Annex 10 Sub-National Governments

Figure 10-1: Sub-National Borrowing, 1975-2004 (Rp. Trillion, constant 2004 prices)

40 A ,

_.

25

10

15

10

05

00

5. An important constraint on sub-nationals attempting to access sources of finance concerns their poor repayment of past loans. According to current regulations (UU 33/2004 and PP 54/2006), sub-national governments may not borrow if they have arrears on past loan repayments and PDAMs may not borrow if either they or their associated local governments have repayment arrears. Insisting that potential borrowers be free of arrears before they are allowed to borrow is a useful pre-condition from the point of view of encouraging sub-national creditworthiness but it does restrict the pool of potential borrowers. Nearly half of the total sub-national loan repayments that have fallen due are in arrears. As of 2004, 332 out of 431 sub-national borrowers were in arrears on their loan repayments to central government, including 143 out of 218 sub-national government borrowers and 189 out of 213 PDAMborrowers (Table 2).

Table 2: Subnational Borrowing and Repayment 1975-2004 (Rupiah Blns) Number of Number of Amts Borrowers Outstanding Borrowers Borrowed with Arrears Arrears Principal Kab/Kota 192 1,052.3 127 560.4 714.0 Provinces 26 962.4 16 121.9 343.2 PDAM 213 3,777.0 189 2,75 1.O 3,121.0 Total 43 1 5,791.7 332 3,433.3 4,178.2

Spending and the Accumulation of Reserves

6. The recurrent resources that sub-national governments have at their disposal have not been used well either. Sub-national government spending has been arguably allocatively inefficient. Sub-national government expenditure on administration, for example, is very high. In 2004, provinces and kabupatedkota spent 32% of their combined budgets on administrative activities. Best practices from more developed countries suggest that a figure of around 5% should be sufficient to cover administrative needs. By contrast sub- national governments spent only 17% of their budgets on infrastructure. See Table 3 for the details.

147 Annex 10 Sub-National Governments

Table 3: Sub-National Government Spending (2004) Province Kabupatenmota Consolidated Rp (Bn) Percent Rp (Bn) Percent Rp (Bn) Percent Administration 12,327 38.0 35,529 29.9 47,856 31.6 Education 3,815 11.8 39,805 33.5 43,620 28.8 Infrastructure 8,321 25.7 17,147 14.4 25,468 16.8 Other 1,399 4.3 11,728 9.9 13,127 8.7 Health 3,000 9.3 8,108 6.8 11,108 7.3 Agriculture 1,823 5.6 4,201 3.5 6,024 4.0 Environment 619 1.9 1,233 1.o 1,852 1.2 Trade 479 1.5 681 0.6 1,160 0.8 Labor 426 1.3 452 0.4 878 0.6 Mining 195 0.6 74 0.1 269 0.2 Total 32,404 100 118,958 100 151,362 100

7. Sub-national governments have also under-spent resources at their disposal and have accumulated large reserves. At the start of decentralization, sub-national governments held about Rp 7 trillion in reserve funds. Through the end of May 2007, provinces and kabupatedkota had accumulated about Rp. 100 trillion in unspent balances. Figure 10-2 provides the details of the accumulation of sub-national bank deposits, a reasonable proxy for reserve funds. The aggregate figure amounts to just over 3% of2006 GDP. An accumulation of reserves of this magnitude is excessive. It represents a significant forgone opportunity to increase spending to support infrastructure service delivery.

Figure 10-2: Sub-National Government Bank Deposits Since Decentralization

Incentives, Mandates, and Sanctions

8. Many argue that poor sub-national government fiscal and service delivery performance is a direct function of the lack or misuse of incentives, mandates, and sanctions in the intergovernmental fiscal system. Incentives have played a dubious role in the allocation of the general purpose grant (DAU) and the spending of those funds, for example. The DAU is the most important source of funds for sub-national governments. It makes up approximately one half of total sub-national revenues and nearly two-thirds of local government revenue budgets. The pool of finance for the DAU is 26% of net domestic revenues. In 2006 the DAU reached nearly Rp 146 trillion (48% of GDP). From the total pool of finance, a portion sufficient to cover the entire regional wage bill is

148 Annex 10 Sub-National Governments hived off and allocated to the regions as a function of their respective salary needs. The remainder ofthe DAU pool is distributed across regions according to a fiscal equalization formula. In 2006 about 50% of the DAU was allocated to fund sub-national civil servant wages.

9. The stated rationale (in UU 32/04) for covering sub-national salary payments from the DAU is to ease the local fiscal planning burden associated with the regular transfer of staff among regions or between the center and regional governments. Most analysts have argued that from the local perspective, however, the DAU allocation scheme serves as a disincentive to rationalizing sub-national civil service employment. (Why bother firing excess staff as long as the center is paying their salaries?) Any disincentive that does exist, however, is somewhat diluted by the fact that regions do not have complete control over the hiring and firing of their civil servants. Much of this authority is reserved by agencies of the central government. In the current context, the easiest way for regions to rationalize their stock of personnel is through attrition, a mechanism of rather limited scope. All things considered, however, the DAU allocation scheme still probably does serve as some disincentive to reducing excess personnel at the sub-national level.

10. The best known spending mandate in Indonesia relates to the education sector. The Constitution stipulates that 20% of both central and sub-national government spending must be allocated to education activities. Furthermore, recent law (UU 2012003) specifies that teacher salaries are not to be included in the 20% calculation. Sub-national governments currently spend about 29% of their budgets on education. But 80% of such spending is devoted to teacher salaries, leaving just 6% of sub-national budgets devoted to non-personnel education spending. In order to reach the 20% requirement, sub-national governments would need to allocate an additional Rp 21 trillion to education, thereby making the share of education (including teacher salaries) about 45% of total budgets. The budget shares of other sectors would need to be reduced commensurately. This suggests the distinct possibility that attempts to realize the education spending mandate might well crowd out spending in other sectors, including infrastructure.

1 1. Most sanctions in the Indonesian intergovernmental system revolve around delaying or cutting regional “balance funds” (Le. intergovernmental revenue sharing and DAU transfers). The center may delay payment of balance funds to a sub-national government that fails to report its finances to the Ministry ofFinance as required by law, for example. Or it may cut (“intercept”) a sub-national’s balance funds if the latter does not repay a loan taken from the central government on time or in full. Until recently (see below) the government has been reluctant to employ potentially useful sanctions ofthis type.

Government Initiatives

Borrowing

12. Government has recently revised the regulatory framework for borrowing with a view to increasing availability of finance for sub-national infrastructure development. On- lending procedures have been revamped (see especially PP 2/2006, PerPPN 5/2006, PMK

149 Annex 10 Sub-National Governments 52/2006, and PMK 53/2006). And sub-national governments are now permitted to issue bonds (UU 33/2004, PP 54/2006, PMK 147/2006).

13. With a view to cleaning up the arrears problem and increasing the pool of potential borrowers, government has embarked upon an agenda to restructure sub-national debt. Government has issued a regulation (PP14/2005) that provides the overall framework for PDAM and sub-national government debt restructuring. And the Ministry of Finance has finalized detailed decrees (PMK 107/2005 and PerDJ 53/2006) that provide a structure to work out PDAM debt. The ministry is now preparing comparable decrees for sub- national governments. One potential problem with the nature of the emerging regulatory framework concerns the case-by-case approach that has been adopted. The concern is that, given the large number of sub-nationals with arrears, such a method will take a significant amount oftime, perhaps many years, to successfully implement.

Spending and the Accumulation of Reserves

14. The government has finally issued the long-awaited regulation on the assignment of service responsibilities across levels of government (PP 38/07). Clarification of functional roles and responsibilities should help to focus sub-national government spending on core services.

15. With a view to further improving the allocative efficiency of sub-national expenditures, the Ministry of Home Affairs (MoHA) is currently organizing the development of minimum service standards for core sub-national functions; the approach has been codified in a recent government regulation (PP 65/2005). Minimum service standards are at varying stages of readiness across the full range of sectors in which they are being developed. Those for education and health are in a relatively advanced state, while those for infrastructure are not yet far along.

16. This is government’s second attempt at developing a system of minimum service standards. An examination of the standards set for local public education, developed during the first phase, revealed that they were excessive in number, confusingly mixed in type (Le. input, output, and outcome), and internally inconsistent. More generally, the fiscal viability of achieving standards in education and other sectors was judged to be more than a little dubious.

17. While round two of the government’s efforts on developing minimums service standards might result in better outcomes, this is far from a foregone conclusion. A recent study of Indonesia’s current overall approach to setting minimum service standards concludes that prospects of successful implementation are doubtful (Ferrazzi, 2005). Impact can only be determined after sufficient time has elapsed, of course, presuming that the effort is actually implemented this time. But at present the most likely outcome would appear to be one ofunrealistic, unfunded, and unenforceable directives. As such, it would not be expected that minimum service standards would have much success in focusing sub-national expenditures on priority tasks, as intended.

150 Annex 10 Sub-National Governments

Incentives, Mandates, and Sanctions

18. As stipulated in law (UU 33/2004 articles 32 and 107) the government will eliminate the so-called hold harmless provision attendant to DAU allocations starting in 2008. (The hold harmless condition guarantees each sub-national government that it will not receive a DAU allocation in one year that is less than it was the year before.) The removal of the provision effectively means that some sub-nationals (i.e. especially those with significant natural resource revenues) may not receive an amount of DAU funds sufficient to cover staff costs. As such, removal of the hold harmless will weaken-but not remove entirely-the existing disincentive in the allocation scheme to rationalize civil service employment. It does not appear, however, that government is at this time willing to completely eliminate the disincentive by explicitly refusing to automatically cover the sub-national civil service wage bill of all sub-nationals (i.e. especially those without significant funds from other sources). Still, government is interested in exploring the proper use of incentives in a more pronounced and systematic way in other areas of the intergovernmental fiscal system.

19. As noted above, until recently, the government had proved disinclined to employ balance fund sanctions. But in June of 2006, the Ministry of Finance delayed DAU transfers to five local governments (three in Papua, one in , and one in Central Java) that had not submitted their 2006 budgets to the ministry, as required. Within one week, four of the five local governments had complied with the budget submission obligation and within two weeks the remaining kabupaten had also turned in its budget.

20. Despite this success, many officials inside the central government apparently remain hesitant about the use of this type of sanction as related to loan non-repayment. One stated reason for their lack of enthusiasm concerns the uncertainty about whether the intercept may be applied to loans taken out before it was legally introduced (UU 25 was issued in 1999 and began implementation in 2001). But at least four local governments that took out loans from the central government after 1999 (two of which borrowed after 2001) are currently in default. The center could apply the intercept to these cases without concern about the timing issue but has so far at least chosen not to do so.

Initiatives of Other Stakeholders

Borrowing

21. The World Bank has supported government initiatives to improve the regulatory frameworks for on-lending and for sub-national bonds via the DPL series and linked technical assistance. USAID has provided technical assistance on the bonds framework, as well, and has been instrumental in assisting individual sub-national PDAMs in preparing bond issuances. WB is supporting legal due diligence work related to USAID efforts on individual bond preparations. ADB has expressed interest in the provision of partial credit guarantees and JICA has noted its interest in co-financing capital

151 Annex 10 Sub-National Governments developments associated with the issuance of individual PDAM and sub-national government bonds.

22. The World Bank is currently providing technical assistance to the Ministry ofFinance in developing regulations for restructuring sub-national government and PDAM debt. In addition, the Bank is working with Ministry of Finance to explore the needs and requirements associated with developing a regulatory framework for sub-national public sector bankruptcy.

Spending and the Accumulation of Reserves

23. The ADB IRSDP includes a trigger to support the completion of the regulation on the assignment of expenditure responsibilities across levels of government; as noted above, the government has now issued the regulation (PP 38/2007). GTZ and CIDA are currently assisting the Ministry of Home Affairs in preparing regulations on minimum service standards and GTZ is working with the Ministry of Health to develop standards for the sector. The Bank is carrying out analytical work for the Ministry of Finance on estimating the costs of achieving minimum service standards in the health and education sectors.

24. The Bank is working with Bank Indonesia, Ministry of Finance, Ministry of Home Affairs, and Bappenas on various issues related to the sub-national accumulation of reserves. The agreed upon agenda is to: document in as detailed a manner as possible the buildup of sub-national reserves since decentralization; determine the causes of large increases in surplus and reserves through analytical and field work; develop guidelines for the proper accumulation and use of reserves; and develop mechanisms to better monitor surplus and reserves in real time.

Incentives, Mandates, and Sanctions

25. The Bank is doing preparatory work for the Ministry of Finance on incorporating incentives into the intergovernmental system. To start, the Bank is drafting a paper for the ministry that will: examine the current system of incentives, mandates, restrictions, and sanctions in the Indonesian intergovernmental framework; review the literature on the use of incentives in intergovernmental systems worldwide; and recommend a course ofaction for Indonesia to make better use of such incentives, especially in the context of encouraging increased spending on infrastructure (via borrowing and improved use of recurrent funds). The paper will be finalized by the end ofthe calendar year.

152 ANNEX 11 PUBLIC SERVICE OBLIGATIONS AND STATE ENTERPRISES

Background

1. Indonesia’s Constitution requires Government to ensure that basic goods and services are provided to the public at affordable prices.’ In the years following independence, this led to State-Owned Enterprises (SOEs) being assigned monopoly or dominant roles in key infrastructure sectors such as telecommunications, electric power, railways, ports and shipping, and civil aviation. Tariffs for basic services were regulated by Government at sub-commercial levels, and SOE managements were generally accorded very limited operational and financial autonomy.

2. By the mid-1980s it was evident that economic growth was being constrained by the poor performance of key SOEs, including those in the infrastructure sectors. This led Government to embark on a program of sector restructuring and SOE unbundling, corporatization, and privatization within a broader framework of economic deregulation. Nonetheless, several important infrastructure SOEs still retain monopoly powers under existing sector laws (notably PLN, the State electricity company) or are otherwise required to act as agents of Government in delivering basic services at sub-commercial tariffs (e.g. KAI, the State railway company, and PELNI, the State inter-island shipping company).

3. Until recently, the cost to SOEs of providing such ‘non-commercial’ services was funded indirectly through two main mechanisms, namely input subsidies and internal cross-subsidies.2 Input subsidies were pervasive, with important channels including: Supply of energy at subsidized prices (e.g. PLN and KAI obtained fuel from Pertamina at Government administered prices, while KAI also obtained power from PLN at a special low rate); Free use of Government-owned assets (e.g. Government owned the railway infrastructure but did not charge the KAI for its use) Injection of capital assets as equity (e.g. PELNI received a fleet of passenger vessels, KAI received carriages and railcars, and PPD (a State owned transport company) received buses); 0 On-lending of concessional loans (e.g. early World Bank and other donor loans were on-lent to PLN in rupiah). 4. Cross-subsidies were particularly significant for PLN, where the uniform national electricity tariff policy resulted in cross-subsidies from customers on Java-Bali to those in the Outer Islands and from large to small customers.

1 Article 33: Sectors of production which are important for the country and affect the lives of the people shall be controlled by the State. Article 34: The State has the obligation to provide sufficient medical and public service facilities. 2 The one notable exception was Pertamina, which received direct compensation from the APBN budget for the losses incurred in supplying hels to the domestic market at prices set by Government.

153 Annex 11 Public Service Obligations 5. In general, subsidies were not well targeted, their costs were not measured, and there were no ‘drivers’ for efficiency improvement. Moreover, input subsidies and cross- subsidies tended to blur accountability and to distort decision-making by SOE managements and service userse3

6. The first step towards addressing these problems was taken in the late 1990s as part of a comprehensive reform plan for the railway sector. This included establishing a scheme under which KAI would be compensated directly from the State Budget (APBN) for losses incurred in providing economy class passenger services at the tariffs set by G~vernment.~In 2001, a similar scheme was established for the power sector under which PLN would be compensated for the costs of supplying power to its very smallest customer^.^ More recently, PELNI has been allocated a fixed annual amount to compensate it for operating losses incurred on its inter-island passenger shipping services.

The Public Service Obligations (PSO) Policy

7. Implementation problems encountered with these pilot schemes were attributable in part to the absence of an umbrella framework for channeling subsidies through SOEs. This was addressed in 2003 with the enactment of UU 19/2003 on State Enterprises, which states (in Article 66) that Government may, with the approval ofthe shareholders, require an SOE to carry out a special task of public benefit. The Elucidation to the Law stipulates that Government must provide compensation for all associated costs plus a margin if the special task is not financially viable.

8. These provisions are elaborated in PP 45/2005,6 with Article 65 stipulating that: 0 the plan for a proposed PSO task must be jointly reviewed by the SOE, the Minister for SOEs, the Minister for Finance and the Technical (Sector) Minister assigning the task; 0 each PSO task must be approved by the Shareholders’ General Meeting (for limited liability Persero enterprises such as PLN, KAI or Pelni), or by the Minister for State Enterprises for less autonomous ‘Perum’ enterprises;

3 For example, the managements of the railway and bus companies could blame poor equipment availability on maintenance problems attributable to Government procurement decisions. In the power sector, the combination of cross-subsidies and the low administered price of oil bels encouraged private businesses to invest in captive plants. 4 The railway scheme was not implemented as designed, however, and in practice KAI received a fixed annual amount intended to represent the sum of its PSO compensation plus the costs incurred in maintaining and operating the railway infiastructure on behalf of Government, less a nominal payment for track access. The three schemes were collectively known as PSO-IMO-TAC 5 Namely those with connections of 450VA and a monthly consumption ofup to 60kWH. 6 The Elucidation to the Government Regulation uses the term ‘Public Service Obligation’ (Kewajiban Pelayanan Umum or KPU) to describe the assignment to an SOE of a ‘function of public benefit’ involving delivery of ‘certain goods and services which are greatly needed by the community’ (Note: in some Government documents, the term PSO is used to denote government’s broader obligation to provide certain non-commercialservices to the pub1ic)c.

154 Annex 11 Public Service Obligations

SOEs undertaking PSO activities for Government must maintain separate accounts for their PSO and non-PSO activities; 0 the Directors of SOEs undertaking PSO activities must provide a report on their implementation to the Shareholders’ General Meeting / Minister of State Enterprises and to the Technical Minister. 9. Implementation of the new policy commenced in 2005 but in the infrastructure sectors has so far focused primarily on PLN. To date, there have been no significant changes in the legacy PSO schemes for KAI and PelnL7 The current PLN PSO arrangements are described in Box 1.

Box 11-1: The PLN PSO The current procedures for managing PSO payments to PLN are contained in Minister of Finance Regulation PMK 12612006, issued in December 2006, which stipulates that::

0 electricity subsidies are to be channeled through PLN to electricity consumerS in those tariff categories for which the average selling price is below the cost of supply;

0 the amount of the subsidy is calculated as the negative difference between the applicable tariff for each tariff category less the cost of supply at the applicable supply voltage level (low, medium, high), multiplied by the volume of sales for each tariff category. PLN’s total costs of supply are allocated to the three supply voltage levels using rules set by the Ministry of Energy and Mineral Resources. All of PLN’s main cost items are eligible for in the calculation: purchases of electricity, including leasing of generators;

0 costs of fuels and lubricants;

0 costs of maintenance, including materials and services;

0 personnel costs;

0 administration costs; depreciation of fixed assets in operation;

0 costs of borrowing related to electricity supply. To date, the margin on costs has been set at 0%. However, Government is currently considering providing a positive margin so as to enable PLN to earn a profit. PMK 12612006 also stipulates how compensation payments are to be made to PLN. Interim payments are made each month based on the amount of the budget allocation and are subject to a final adiustment Davment based on audit,

10. PSO budget allocations are included in the APBN budget under the heading ‘Subsidies’. A summary of the initial (APBN) and amended (APBN-P) allocations for PLN, KAI and PELNI for 2005-2007 is presented in Table 1. As can be seen, PSO compensation for PLN rose sharply from the initial APBN allocation of Rp.3.363 trillion

7 Increased oil prices, coupled with Government’s decision not to raise power tariffs, necessitated expansion of the original PLN targeted subsidy scheme for small customers. In 2006, electricity supply to all customers became a PSO for PLN.

155 Annex 11 Public Service Obligations in 2005 through to the amended allocation of Rp. 31.246 trillion for 2006,8 reflecting increases in world crude oil prices and the removal of the oil fuel input subsidy for PLN under the October 2005 fuel price pa~kage.~The budget allocations for KAI and PELNI are rounded amounts. Unlike the current policy for PLN, which reflects the intent of UU 19/2003, these are not adjusted based on actual costs of PSO service delivery.

Table 1: APBN Subsidy/PSO Allocations 2005-2007 (Rp. Trillion)

2005 2006 2007 APBN APBN-PI APBN-P2 APBN APBN-P APBN Infrastructure Enterprises PLN 3.363 4.110 12.511 15.000 31.246 25.838 KAI 0.200 0.200 0.270 0.350 0.350 0.375 PELNI 0.250 0.250 0.355 0.400 0.400 0.450 Sub-total - Infrastructure 3.81 3 4.560 13.136 15.750 31.996 26.663 Pertami n a 19.000 76.515 89.194 54.276 64.212 61.838 Rice, fertilizer and other 8.483 15.562 16.759 9.484 11.420 14.423 Total Subsidies 31.296 96.637 119.089 79.51 0 107.628 102.924 Source: MOF Issues and Challenges

11. UU 19/2003 and PP 45/2005 represent an important first step in moving from a regime characterized by hidden input subsidies and cross-subsidies to one based on providing explicit compensation payments to SOEs from the APBN budget for financial losses incurred in delivering specific services or outputs as instructed by Government. As indicated above, implementation is still at a very early stage and many inter-related issues have yet to be addressed.

12. Definition of PSO objectives and targeting. Most existing PSOs have evolved over time and are not clearly linked to the provisions of sector laws and regulations or to government policy statements. For example, the electricity laws and subordinate regulations identify a role for Government in ensuring electricity is made available at affordable prices to the poor and to less developed regions. While the original targeted PLN PSO scheme aligned with this objective, the present scheme is not targeted and channels subsidies to all PLNcustomers in all regions.

8 The actual subsidy payment for 2006 was Rp.32.909 trillion, which reflects the removal of the cap on PSO amounts. PLN would have received a larger PSO payment had it been able to achieve the aagreed system losses target. 9 Although the 2007 APBN allocation is lower than the amended 2006 allocation, it is evident that the latter will need to be increased significantly in the APBN-P budget as the schedule for substituting oil by gas at key combined cycle plants on Java has suffered delays.

156 Annex 11 Public Service Obligations

13. In the absence of clear objectives and careful targeting, it is possible to assess whether subsidies are providing value for money." For example, the design of the original targeted PLN scheme would be appropriate if its objective was to ensure affordability of a minimum quantum of electricity use. However, if the objective was to expand access to electricity, it would likely have been more effective to provide increased subsidies for connection charges.

14. Stranded Businesses. The PSO mechanism is intended as a means for delivering subsidies to targeted end-users through SOEs. In practice, some PSO schemes are funding what have now become stranded businesses. For example, demand for Pelni's inter-island passenger services, which are operated by a fleet of large and fairly modern vessels, has been greatly reduced following the emergence of low cost air carriers in the wake of deregulation. Efficient delivery of subsidized economy class inter-island passenger services in the changed environment-if still justified--would require extensive fleet and route restructuring. Continuing to provide PSO payments in the absence of such restructuring is likely result in ineffective use ofbudget resources.

15. Short-term perspective: PP 45/2005 has introduced the concept of PSO Plans (Rencana Penugasan Khusus). In practice, however, decisions on PSO allocations are still taken annually on the basis of SOE draft annual work plans and budgets. While this may be appropriate for SOEs whose PSO activities are a minor adjunct to its core commercial business, a longer term approach is needed for most infrastructure SOEs. Thus, for example, the future level of PLN PSO payments will be greatly influenced by near-term decisions on its system expansion plan and on new long-term fuel supply contracts. In the absence of a sound medium-term framework, Government will find itself issuing a series of annual blank cheques. Likewise, SOEs that would need to invest in special purpose assets to provide the required services will rightly seek assurances as to Government's commitment to continuation of PSO services.

16. Capital injection and PSO compensation. Government capital injection (PMN) and annual PSO compensation can both be used to support the delivery of non-commercial services by SOEs. For example, in the absence of PSO margins and long-term PSO contracts, a prudent profit-oriented SOE would not wish to invest its own internally generated funds in specialized assets needed to provide a PSO service. However, past practices whereby Government departments have supplied SOEs with equipment--such as buses or railcars - as equity injections have generally proved unsatisfactory. l1 Government capital injection, rather than PSO compensation, may also be the appropriate channel for financing the restructuring of stranded PSO businesses. The PMN and PSO mechanisms accordingly need to be viewed as complements, with careful consideration being given to their respective roles on a case-by-case basis.

loTo place the PLN PSO subsidy in perspective, the 2006 APBN-P amount was more than double the budget for the Ministry ofHealth and around 50% more than the budget for the Ministry of Public Works. I1 SOEs commonly argued that Government departments procured inappropriate equipment with consequential operation and maintenance problems.

157 Annex 11 Public Service Obligations 17. PSOs for local services. Some SOEs, including KAI and Damri (a State-owned bus operator), provide some basic services that are local in character. Regional governments are naturally keen to see such services expanded, particularly if the associated costs would be borne by central Government. Following decentralization, some sector laws and regulations have been amended to open the possibility of regional governments sharing PSO compensation burdens. This remains a grey area, however, and ground rules have yet to be developed.

18. Costing of PSOs. The costing of PSOs for individual SOEs should desirably follow common guidelines addressing topics such as: 0 eligibility of costs to be included in the PSO calculation; 0 allocation of indirect and joint costs; valuation of capital costs;12 0 use of efficient versus actual costs; and 0 setting of PSO margins

19. Budgeting and payment procedures. The budget allocations and payments for some PSOs (e.g. KAI) are currently lump sum contributions that do not reflect estimated or actual costs. This is inconsistent with the intent of UU 19/2003 regarding compensation for full costs, and may have significant consequences for the financial performance of SOE’s whose input costs are subject to significant fluctuation.

20. The timeliness of PSO payments can be very important for SOE cash flows, and there is scope for further improving payment arrangements and, in some cases, for reducing unnecessarily cumbersome procedures for verifying progress payments.

21, Reporting. PP 45/2005 requires SOEs to report on the implementation of their PSO tasks. However, to date reporting has focused narrowly on costs and little or no information is available on who benefits from PSO compensation payments. Next Steps

22. The Government is in the process of preparing a road map for the further refinement and implementation of subsidy policy for the infrastructure sectors. This is scheduled to be published by December 2007.13 The road map will include activities designed to improve the design of subsidies for services infrastructure services delivered directly by Government agencies or contracted out to private operators as well as those involving the further refinement and implementation of the SOE PSO policy.

l2 An important issue here concerns asset valuation. If assets have not been revalued, as is the case with KAI, computed PSO payments will be low but Government will inevitably face future requests for large capital injections as depreciation charges are insufficient to finance replacement assets. 13 See Inpres 6/2007 concerning Policies for the Acceleration of Real Sector Development and Empowerment of Micro, Small and Medium Enterprises.

158 ANNEX 12 PUBLIC-PRIVATE PARTNERSHIPS

1. Over the course of 2005 and 2006, the Government put in place a legal and institutional framework to support infrastructure public-private partnerships (PPPs). Key features of this framework include: a A Perpres and Ministry of Finance (MOF) implementing PMK which require competitive bidding for infrastructure PPPs, set requirements for the procurement process and provide for Government support to PPPs. a The empowerment of an inter-ministerial committee (KKPPI) to resolve problems in the development ofPPP projects. e The creation of PPP Units to prepare projects. a The establishment of a Risk Management Unit (MU) to cap the Government’s overall exposure to contingent liabilities, and to provide for Government support to PPPs.

2. Challenges facing the Government over the next few years include: a Building capacity in the new institutions; e Preparing transactions for release to the private sector, and achieving financial closure on PPP deals; a Establishing a Guarantee Fund to support the work ofthe RMU; a Establishing an Indonesia Infrastructure Fund (IIF) to provide long-term finance for use in infrastructure investment.

Legal Environment

3. Perpres 67 was issued in November 2005 to provide a comprehensive legal framework for PPPs. Perpres 67/2005 (along with its implementing regulation - KMK 38/2006) describes in detail the rules and procedures for the bidding process. PPP projects may be identified and prepared either by the Government or the private sector, but the sponsors must be selected through open and transparent bidding. Tariffs must be set at full cost recovery level, and if tariffs exceed consumers’ ability to pay, the difference is to be compensated by a subsidy from the Government. Decisions on financial support from the Government are managed by the RMU ofMOF. Under Perpres 67/2005, public support can only be provided to projects that comply with Perpres 67/2005.

4. Unfortunately, the drafting af Perpres 67/2005 is unclear in various respects. It is not clear whether Perpres 67/2005 was intended to apply to projects promoted by SOEs or sub-national entities. There are questions about the application of Perpres 67/2005 to projects for which calls for proposals were issued prior to Perpres 67/2005. Finally, Perpres 67/2005 requires that projects achieve financial close within 12 months of project award. This is an important mechanism to ensure that unviable projects or unable concessionaires cannot block infrastructure development in Indonesia. But there is ambiguity about which projects are subject to this clause and about the definition of “financial closure”. These legal ambiguities have encouraged project proponents to seek

159 Annex 12 Public -Private Partnerships government support outside the requirements of Perpres 67/2005. The Government is seeking an effective process to resolve the issue of non-compliant projects.

KKPPI

5. The KKPPI is an inter-ministerial committee that forms the lynchpin of all infrastructure policy reform and is the lead actor in the field of PPP. It is supported by two secretariats - one in BAPPENAS and one in CMEA - that help to disseminate know- how related to developing PPP projects, assist line ministries and SOEs when designing and developing PPP projects, create standard form documentation to be used with PPP projects, and review proposed projects in support ofthe RMU.

PPP Units

6. A Central PPP Unit is to be established within the KKPPI Secretariat as a resource center from which review and standard best practice processes originate, including standard contract documents and bid submission and tracking. The Central PPP Unit will be complemented by and receive well prepared proposals from technically staffed “PPP Nodes” housed in the respective KKPPI line ministry members. All of the functional groups belonging to this framework are either currently being staffed or are making steps towards final establishment with some standard operating procedures having already been adopted via ministerial decree and others being written in close coordination with donor assistance.

7. With the execution of the PPP transactions devolved to the line ministries, the Central PPP Unit will be responsible for ensuring policy consistency, quality control and transparency by establishing standards and principles that all transactions must follow, and by monitoring the execution for compliance. Given the massive investment needs against limited capital resources, another important responsibility ofthe Central PPP Unit will be to prioritize PPP projects according to their development impact and readiness for implementation. Procurement is currently underway for a consultant funded by the Private Provision of Infrastructure Technical Assistance (PPITA) loan provided by the World Bank to complete the establishment ofthe Central PPP Unit.

8. The establishment of PPP nodes and some ofthe capacity to be created within the Guarantee Fund and IIF will be used to compensate for the limited success achieved by KKPPI. Each key line ministry and SOE will need to create a PPP node in order to ensure projects submitted to the KKPPI and RMU are assessed for suitability for public support are well prepared and comply with all standard operating procedures for the submission of projects including all social and environmental requirements. To date, neither MOT nor MOPW have succeeded in operationalizing their PPP nodes. The MOT PPP node has been legally established via a Kepmen, however, it still requires staffing and the allocation of a budget before it can begin to function. At present, MOPW does not intend to establish new institutions to fulfil the role envisioned for the PPP nodes. Regulatory bodies for roads and water have been established (BPJT and BPP-SPAM) and are operating however there is disagreement within MOPW as to whether they can

160 Annex 12 Public -Private Partnerships function as PPP nodes concurrently; in both cases, but especially in the case of water, the resources devoted explicitly for PPP are insufficient and capacity to carry out their envisioned role in the PPP framework remains low.

9. The Government has identified the development of Operational Guideline Manuals for the PPP nodes in the Ministry of Transportation and the Ministry of Public Works in its Inpres 6/2007 and procurement is underway for a PPITA funded consultant to establish the PPP node in the Ministry ofTransportation.

Risk Management Unit

10. Efficient financing ofPPP projects can involve the use of government guarantees, to ensure that the Government bears risks which it can better manage than private investors. In addition, particularly where infrastructure projects have large public externalities, some level of direct financial support from the Government may be appropriate.

11. The Risk Management Unit (RMU) has been established within the Ministry of Finance to manage the provision of government support, including guarantees. The RMU determines the type and level of government support for PPP projects. It may review PPP project proposals to determine whether the proposed contract represents an appropriate allocation of risk between the Government and private investors. The RMU is also responsible for managing the Government’s total exposure to contingent liabilities, in principle rationing guarantees to their highest value uses while ensuring that the Government is exposed only to manageable levels of risk. The RMU is now fully staffed.

Guarantee Fund

12. A Guarantee Fund is being developed in support ofthe risk management function. The basic idea is to have a fund ofliquid assets that can be rapidly mobilized in the event that a contingent liability is realized. The Government Fund will be a state-owned enterprise, with its own balance sheet, removed from the annual budget cycle, and benefiting from independent governance. The Fund will be used to: 0 ring fence budget allocations intended for government support ofPPP projects, reduce the likelihood ofdiversion of such funds for inefficient use, 0 limit liabilities for government support provided to PPP projects to the value of the Guarantee Fund, reassure the public that government liabilities in the face of PPP projects are less likely to have catastrophic consequences improving the credit enhancement function of government support, and therefore help the government in their risk management of contingent liabilities (increasing efficiency and targeting of guarantees and ring-fencing government contingent liabilities).

161 Annex 12 Public -Private Partnerships 13. Shifting contingent liabilities to a separate entity with its own capital and limited liability will help to ensure there are no hidden risks in the government accounts, and that the government’s exposure is limited by its equity in the fund.

14. A final policy paper setting out the framework for the Guarantee Fund is to be completed in August 2007 and the Ministry of Finance PMK on the establishment of the Fund is to be completed by November 2007.

15. In 2006 the Government set aside Rp. 800 billion for use as government support for PPP projects. It is intended that the Government will continue to set aside funds each year, to contribute to the capitalization of the Guarantee Fund.

Indonesia Infrastructure Fund

16. The Government is establishing the Indonesian Infrastructure Fund (IIF) to address weaknesses in the domestic capital market. Indonesian banks have limited experience in complex project appraisal, risk assessment for structured financings and in particular managing construction risk. Even the most experienced local banks possess only limited exposure to infrastructure projects, for example providing 3-5 years corporate finance loans to infrastructure companies. Despite the attraction of long-term infrastructure investments for pension funds and insurance companies, regulations currently largely restrict their long-term assets to bond issues with 1-10 year maturities (shorter than the life of most infrastructure projects). Although institutional investors control assets worth more than 7% of GDP, over half are invested in bank deposits.

17. The IIF will mobilize local currency financing for PPP projects by intermediating in the local bank and capital markets and providing a vehicle for institutional investors who could not invest directly in projects. The IIF will be a financial institution, with a minority Government participation (potentially financed by a loan from the Bank and other donors) and leveraged by private resources.

18. The Facility will be a private financial institution with commercially oriented private sector governance, mandated and equipped to mobilize local currency private financing of the right tenor, terms and price for the development of creditworthy, strategic infrastructure projects in Indonesia by: 0 Using its good credit rating to borrowing from the private debt market, in particular from institutional investors. It will then lend these funds to individual projects on terms appropriate for infrastructure projects. Providing financial products to enhancing the credit of the project and thereby mobilize additional private financing. By providing the riskiest tranche of debt, or otherwise reducing the risk of the project, the IIF will enable the project to attract the balance of its debt requirements from the local financial markets on terms appropriate to infrastructure projects.

19. A Perpres on infrastructure financing is due by July 2007 and the PP on government participation for the establishment of the Indonesia Infrastructure Fund is to

162 Annex 12 Public -Private Partnerships be completed by August 2007. The Government has already allocated Rp. 600 billion in the 2006 budget year to the IIF. IFC, ADB, KFW, and other donors have expressed interest in making equity contributions. Debt is to be provided in part by donors: The World Bank is currently preparing a $100-200 million loan, while the participation of other donors is unconfirmed.

Project Preparation in Practice

23. At the January 2005 Infrastructure Summit, the Government offered 91 projects totaling $22.5 billion to the private sector. The expectations raised by this major offering were not met. By the end of 2006,prequalification and bidding had been undertaken for two batches oftoll roads comprising a total of 17 projects, three gas pipeline projects, and one power project. Prequalification was ongoing for another six power projects. Participation in bidding has been generally low. Contracts have been awarded for the three gas pipelines and one power plant, as well as for three toll roads, but no deal has yet achieved financial closure.

24. Learning from this experience, the Government held a second Infrastructure Summit in December 2006, in which attention was focused on just ten candidate projects, intended to serve as models ofgood project preparation.

25. The inability to interest investors and financiers can be attributed to poor project preparation. Projects have been released for bidding without adequate feasibility studies, risk analysis, project packaging, or bankable draft concession agreements. In addition, no provision has been made for Government support in the bidding documents, despite major risks perceived by investors with regard to land acquisition for toll-road projects and PLN’s creditworthiness for power projects.

20. Poor project preparation can in turn be traced to tensions within Government between those who desire rapid results and those who counsel more thorough preparation. In reality, poorly prepared projects do not achieve financial closure, but as the delays have lengthened, pressure has mounted to find shortcuts in the project preparation process. The situation has been aggravated by the slowness of the KKPPI to establish capacity within its Secretariat capable of reviewing PPP project proposals, and by lack of clarity in the legal framework.

2 1. There are also pressures to short-circuit carefbl project preparation for reasons of old-fashioned rent-seeking. The Ministry of Finance has come under significant pressure to provide Government support for non-compliant projects. Specific Keppres have been issued authorizing Government guarantees in respect of the Jakarta Monorail and a program of investments in 10,000 MW of coal-fired power generation.

22. Another source of delay in the development of PPP projects is the presence of pre-existing projects which are unable to reach financial closure, but which constrain the possibility for new projects. Ofparticular concern are site specific projects like toll roads and geothermal power projects which, once allocated, specifically constrain infrastructure

163 Annex 12 Public -Private Partnerships development of those allocated projects. In the toll-road sector, the Government is requiring all existing concession holders to reach financial close by 2010, and is developing a new legal regime to implement this.

164 ANNEX 13 LAND ACQUISITION

Background

1. In order to achieve the objectives ofthe IDPL prior actions must be taken to address constraints that have prevented increased financing in infrastructure projects in the past. One of the largest of these constraints is the current land acquisition process. Many project delays are attributable to land acquisition and resettlement planning and implementation procedures. Although amendments have been made to the existing laws and regulations in order to streamline the process, many problems persist. The key land acquisition issues and problems that have been identified, among others, include: (a) Lack of clarity in the legal and regulatory framework governing acquisition of assets and resettlement; (b) Inconsistency in asset valuation procedures (c) Land titling and tenure issues (d) Absence ofa reliable dispute resolution mechanism (e) Institutional capacity and set-up

Current Land Acquisition Practices and Implementation Procedures

Existing Legal and Regulatory Framework

2. Current practice of land acquisition in Indonesia has its origin in the Home Affairs Kepmen No. 154975 concerning Land Acquisition Procedures; No. 2/1976 concerning Land Acquisition Procedures for Public Purpose by Private Sector; and No. 2/1985 concerning Land Acquisition Procedures for Development Projects in Sub-District (Kecamatan) Area. These regulations were enacted to facilitate private investments, especially real estate development. Following widespread dissatisfaction among affected land owners, however, President Soeharto issued Keppres 55/1993, which specified the limits to government powers in acquisition of assets while retaining the core principle of facilitating private investors’ interests. Key features ofthe Decree included: (a) limitation of the definition of public purpose to only public goods (thus clarifying and limiting the scope for the taking of private land); and (b) specification of the Land Price Assessment for Land Tax (NJOP) as a proxy value for calculation of compensation for land appropriation. The vague language of Keppres 55/1993 allowed local governments flexibility in its implementation and, as a consequence, also led to large variations in interpretation depending upon the capacity and intentions ofthe implementing authority.

3. Keppres 55/1993 also reiterated previous land acquisition policy that linked ultimate responsibility for the act of land expropriation through the powers of eminent domain directly to the President (initially established under UU 20/1961). UU 20/1961 concerning Expropriation Right on Land and Other Assets is still valid.

4. Keppres 55/1993 was succeeded by Perpres 36/2005, which streamlined responsibility for land acquisition by pegging it to the scale of project being undertaken and provided for direct negotiations on compensation and system of redress. Perpres

165 Annex 13 Land Acquisition 36/2005 was further amended by Perpres 65/2006. Perpres 65/2006 provided clearer guidance on land acquisition regarding compensation and transparency. Key provisions included the establishment ofmarket price as the basis for compensation and requirement for dissemination of information on anticipated area and impact ofthe project to affected communities. However, Perpres 65/2006 reconfirms the expropriation responsibility of the President from UU 20/196 1, perpetuating a system where national level political risk must be factored into expropriation decisions. Because the language of Perpres 36/2005 and Perpres 65/2006 gives wide space for interpretations and because they are not fully consistent with previously issued ministerial level regulations and operational guidelines, new ministerial level implementation guidelines were necessitated. The BPN (National Land Agency) has now issued the Implementation Guidelines No. 3/2007 for Perpres 36/2005 and Perpres 65/2006 which hopefully will address the inconsistencies and gaps that have existed in the past. Current Land Acquisition Practices

5. Current land acquisition practices and implementation procedures in Indonesia are characterized by inconsistencies, due to the lack of uniform implementation guidelines supporting the existing legal framework - itself ambiguous on certain issues (as detailed above). The implementation ofland acquisition in projects is made further difficult due to complex land title issues, institutional setup, lack of capacity in many local governments and budgetary constraints.

6. The following provides a list ofthe main issues encountered in practice:

Sequencing in technical design and land acquisition. Land acquisition is often executed on the basis of incomplete/provisional engineering designs. Definitive site plans are rarely ready until very late in the project process, often due to budget constraints during the project preparation stage. This results in delays, the need for constant revision of inventory and repeated visits to the site with different land acquisition requirements.

Impacts on income and employment are not recognized. Economic losses are not paid due attention at the inventory preparation stage and no provisions are made to mitigate impacts on livelihood and employment. This lack of attention to the economic implications of displacement often leads to partial failure of otherwise sound relocation policy, and affected people end up worse off due to the projects.

No recognition to project affected persons without tenure securiw. Squatters or owners without tenure security and proof of ownership (informal or traditional, tenants) either receive significantly reduced compensation for lost assets or are not compensated at all. Impacts such as loss or restriction of access to public facilities and services (health, education, etc.) are often not given any consideration and not documented. With the exception of agricultural tenants, other tenants are not compensated, despite provisions to do so in UU 50/1960.

166 Annex 13 Land Acquisition

Absence of land records. Absence of proper land records, including digital database, land parcel records and ownership data in most provinces is a major hurdle to the acquisition of land. Absence of reliable records also allows for improper manipulation.

Compensation assessment procedures. The weakness of the current process of determining compensation is that the level of compensation is not only low, but also highly arbitrary. Compensation for land with valid title certificates varies from less than NJOP to more than double NJOP'. Although there has been some improvement in the land compensation standards over the past three years, this is limited to some projects in Java. Often the amount of compensation and other entitlements depends on the bargaining strength of affected households and the local government's available financial resources.

0 Absence of relocation assistance. Provision of relocation assistance, particularly the provision of replacement land and/or house, varies from one project to another. Similarly, only a few projects provide transport allowances to affected households.

0 Funds for design. The funds for technical designs are often allocated together with the budget for implementation. Therefore, the implementing agencies are generally reluctant to spend sufficient fund for finalizing the design unless there is certainty of implementation, which depends on how the land acquisition proceeds in a project. On the other hand, land acquisition cannot proceed without technical design and definitive site plans. Additionally, project implementation agencies are often not given timely allocation of budget for land acquisition and resettlement.

0 Budgetary constraints. In projects sponsored by the central or state level governments, local governments are often expected to bear the entire cost of land acquisition and resettlement as their contribution towards the project. Many local governments, particularly those with limited resources of their own, find it difficult to mobilize adequate resources to carry out land acquisitionhesettlement in accordance with the agreed plan.

0 Institutional setup. Many implementing agencies do not have sufficient and/or skilled staff to address social impacts adequately. Within the Ministry of Public Works, the complex and fragmented organizational setup does not provide for clear roles and lines of responsibility regarding the planning and implementation of land acquisition. The problem of institutional setup is further exacerbated by overlapping responsibilities and lack of coordination between different ministries and departments.

'. NJOP is the value of a property determined by the Ministry of Finance for taxation purposes. Property owners tend to get a lower valuation of their property to save on taxes. Further, the assessed value is not revised at regular intervals. NJOP generally tends to be 50% lower than the actual market value.

167 Annex 13 Land Acquisition

Government Reform Program

7. Given the complexity of the problems facing land acquisition for public and private infrastructure projects in Indonesia, the Government has decided to establish an inter- ministerial Land Working Group under the KKPPI to take the lead on the reform agenda. This Group will publish an action plan to address, among others, the following issues: (a) Delegation of the role of the President in land expropriation. The Land Working Group will determine the legal instrument required to achieve this objective and determine whether UU 20/1961 needs to be amended or replaced, or if just new implementing regulations are required. (b) Exploration of the feasibility of eminent domain in Indonesia. Most countries allow construction to occur concurrently with negotiations by placing compensation funds in escrow while negotiations occur to avoid delays. The Land Working Group will evaluate the feasibility of this arrangement for Indonesia in the current legal context. (c) Design an appropriate institutional framework. The Land Working Group will determine the party or parties that have ultimate responsibility for land acquisition and establish clear reporting lines to cut down on bureaucratic delays associated with inter-agency negotiations over land. (d) Design appropriate guidelines for the entire land acquisition process to ensure equitable compensation for affected persons. The Land Working Group will draft regulations for land acquisition that recognize the rights of the most vulnerable affected persons including squatters, sharecroppers, and those who do not necessarily hold legal title to their land. These regulations should be accepted by all relevant agencies.

8. In addition, the Government recognizes that an agreement must be reached between the Ministry of Finance and line ministries, starting with the Ministry of Public Works, on allocation of land acquisition and compensation funding as an integral part of project cost. In the past, any increases in land acquisition cost would come straight out of the budget for design and other vital project components leading either to delays while extra funding was sought, or poorly designed projects. This budget practice will not only facilitate land acquisition, it will also increase the transparency of Ministry of Finance budgeting.

168 ANNEX 14 ENVIRONMENT

Context and Issues

1. Natural resources are an important contributor to Indonesia’s GDP and the Government’s budget. As Indonesia returns to political stability and robust economic growth, the time is right to begin considering ways to improve the quality of growth by addressing environmental and equity issues in the broader context of improved transparency and accountability of governance. Agriculture, forestry, and mining contribute about 25% of Indonesia’s GDP and about 30% of overall government budget revenue. Yet, Indonesia’s macroeconomic policies appear to favor resource depletion over sustainable use as they reward district governments on resource revenue as opposed to performance or stewardship.

2. Energy policy, forest sector practices and climate change issues are intricately linked in Indonesia. Fossil fuels dominate energy consumption in both rural and urban areas, and Indonesia is gradually increasing the proportion of energy produced from coal. Indonesia is also the second-largest Green House Gas emitter among developing countries in the region - it generates nearly one-tenth of the world’s greenhouse gases, mostly from logging and foresthwamp fires. National energy policies propose to increase reliance on renewable energy sources, but at the same time the Government also plans a large scale-up in the use of coal to reduce Indonesia’s dependence on oil imports - a move that could lead to significant negative environmental impacts.

3. Poor environmental management is hurting both the poor and the economy. The costs of pollution and inadequate waste management to the Indonesian economy are high: total economic losses attributable to limited access to safe water and sanitation are conservatively estimated at 2% of GDP annually. Annual costs of air pollution to the Indonesia economy have been calculated at around US$400 million a year. The economic cost of the health effects of pollution in Jakarta alone is estimated at US$700 million a year. These costs are typically borne disproportionately by the lowest income groups because they are more likely to be exposed to pollution and less likely to be able to afford mitigating measures.

4. Water quality is declining and access to safe water and sanitation remains limited. Indonesia has one of the lowest coverage for water and sanitation in the region: some 43 million people still have no access to safe water - 30 million of these people live on Java. Primary sources of water are deteriorating due to lack of recharge of urban groundwater and increased pollution levels of surface and groundwater. Urban air quality is poor and resulting in increased health problems and productivity losses. Jakarta has higher levels of fine particulates and C02 than most other cities in Asia; although some progress has been made through the elimination of the use of leaded gasoline in 2006. Solid waste generation is increasing and impacting water and air quality. Solid waste generation has increased significantly over the past five years. In 2000, Jakarta alone was generating 24,000 m3 of garbage daily, which is estimated to double by 2010. Only about 50% of solid waste is actually being collected, with the poor areas of the

169 Annex 14 Environment cities generally underserved or not served at all. Between 1520% of waste is properly disposed across the country; some of the remainder ends up in rivers and canals, exacerbating the flooding problem.

5. Indonesia’s administrative and regulatory framework for environmental management is improving, but remains weak at the level of implementation and enforcement. Environmental institutions, and their roles and responsibilities, are fragmented and coordination mechanisms at national and local levels are poorly defined. Technical capacity - human, financial and technical resources - is limited, especially at the local level, which has an important share of environmental management responsibilities under the decentralization framework. Under decentralization, sub- national governments feel less strongly bound by national guidelines, which creates another hurdle for environmental management, since many of these duties have been devolved to provincial and district levels. Thus, regulatory bodies in many provinces and districts now fall directly under the command of the governor or district head, who is often also the proponent of the projects or activities that must be regulated. Many provinces and districts are reinterpreting existing rules or adopting new regulatory procedures; while some of these innovations strengthen environmental controls, many relax them or seek to bypass national standards.

6. There are signs of improvement in the budgetary resources needed to improve environmental assessment and management. The Government’s Medium-Term Development Plan indicates that two general environmental issues will be addressed. First is the problem of declining environmental quality as a result of disasters or environmental destruction, which puts pressure on development everywhere. Second is the improvement of natural resource management and environmental preservation in the direction of providing economic benefits, including environmental services. Implementation of these priorities and actions is being facilitated by increasing budgetary allocations to environmental management activities, most of which are not based in the Ministry of Environment, which has institutionally led policy-making, coordinating, and oversight efforts on environment country-wide. Government spending on environmental issues has been increasing in recent years and, if all goes as planned in 2008, overall environmental spending will have more than doubled in three years. Yet, it remains unclear whether or not the current level of funding is adequate and/or efficiently allocated across key priorities. The budget documents also noted that a Special Allocation Fund (DAK) for Environment has been instituted since 2006, with funding nearly tripling in 2007. Indonesia’s Response to Climate Change

7. In 2007, global environmental attention has been riveted on the issue of climate change, emissions of greenhouse gases (GHG), and the need to adapt to the adverse effects resulting from global warming. In Indonesia, this attention and scrutiny has been heightened, as well, by the decision to host the Conference of the Parties of the UN Framework Convention on Climate Change in Bali in December 2007. In the run-up to the Bali event, Indonesia is undertaking a number of studies and preparations, including work on the 2nd National Communication (supported by UNDP) and preparation of a

170 Annex 14 Environment proposal/initiative on carbon payments for Reduced Emissions from Deforestation and Degradation (REDD), supported by the World Bank, DFID, and AusAID. Concern over Indonesia’s carbon emissions and development path is justified. Recent summaries have shown that forest and land use change are very large contributors to Indonesia’s GHG emissions profile. Potential carbon payments through a REDD mechanism may be able to provide the incentives needed to continue to expand these efforts, as Indonesia has the potential to gain hundreds ofmillions of dollars through such mechanisms.

8. The Ministry of Environment has developed a draft National Action Plan for Mitigation and Adaptation to Climate Change. This effort will result in a national development plan and strategy for key issues, areas and sectors that relate to mitigation and adaptation needs; this plan will also be a venue for integrating policies across agencies of the Government. The Ministry will also be preparing other analyses and policy documents, including an analysis of climate variability, trends and changes, and their implication in Indonesia. Most of these documents are expected to be produced in advance of the Bali Conference of Parties to the UN Framework Convention on Climate Change in December 2007. In addition to these efforts, the Minster of Finance has agreed with UNFCCC to host a parallel meeting of Finance Ministers on December 11, 2007, in Bali. This meeting will be a major opportunity to mainstream climate change issues into continuing international dialogue about impacts and financing needs. In preparation for that meeting, the Minister has requested logistical assistance, an assessment of the fiscal and financial policy instruments needed to mitigate and adapt to climate change, and a longer-term study for development of a national low-carbon strategy and associated financing needs. Environmental Issues in IDPL

9. Many of the reforms supported by the IDPL will help improve environmental outcomes in priority areas, such as sanitation and energy efficiency. For example, power sector investments and reforms have the potential to increase energy efficiency and promote alternative energy sources that could be environmentally beneficial in the medium term. Investments in water supply, quality and access have the potential to improve sanitation and environmental health outcomes for affected populations

10. The operation has been designed to help mitigate or strengthen the Government’s capacity to address potential negative environmental impacts. Efforts have been made, for example, to: Include and strengthen social safeguards in the infrastructure investment process. Recognize and strengthen the GOI’s own efforts to improve implementation and enforceability ofthe AMDAL/EIA framework. Improve transparency in the governance ofthe infrastructure financing and investment process.

11. However, with regard to the scale up of infrastructure, there is still a need to ensure that improved environmental management capacity is integrated into the Government’s infrastructure investments and PPP institutions. In particular, adequate resources and follow up monitoring should be allocated to ensure that:

171 Annex 14 Environment

Infrastructure departments and agencies establish, train and equip environmental safeguards and compliance units (equivalent to the Directorate for Roads environment unit) Checks and balances are established to ensure that the Government’s environmental procedures (AMDAL review, mitigation, public consultation, follow up compliance monitoring) are followed (for national and subnational projects). 0 Ongoing monitoring (including by third party institutions) is carried out to assesdensure that future infrastructure projects allocate sufficient budget to support environmental mitigation at both national and subnational level. 0 Regional/local government capacities and standards ofperformance are also upgraded appropriately for the roles and responsibilities under the infrastructure investment program.

12. The implementation ofthe IDPL will be accompanied by the provision of technical assistance to help the Ministry of Public Works improve its environmental performance. The first step will involve the conduct of an assessment of the capacity and needs of the Ministry to carry out environmental assessments of infrastructure projects. The proposed work will build on the existing work done on AMDAL at national and local level and will be led jointly by the Ministry of Environment and the World Bank. It is expected that this assessment will inform a complementary capacity building effort to ensure that projects comply with the existing environmental legislation (and that which is in the process of being updated) at planning, construction and implementation stages.

13. In addition, the IDPL policy dialogue provides an important opportunity to introduce and encourage adoption of “best practice” standards for environmental review, public consultation, and follow up monitoring within the national infrastructure investment agencies, the proposed PPP institutions, and the Indonesia Infrastructure Facility (IIF). The IDPL policy dialogue is already serving to raise awareness and communication about these critical needs among key agencies of the Government and directly with the Ministry of Finance, which makes important resource allocation decisions. The IDPL process can serve a useful role in continuing to raise these issues and provide venues for their discussion and resolution among involved Government agencies.

172 ANNEX 15 GOVERNANCE

Sector Reform and Procurement

14. Good governance covers a number of crosscutting Government functions that relate to supporting increased efficiency, improving performance and fighting against corruption. Learning from the lessons of the Asian financial crisis of 1997, Indonesia embarked on a wide-ranging governance reform program. Decentralization, public administration and financial reform, reallocation of government power, and judicial reform are just a few of the many wide-ranging and radical governance reforms that the Government has targeted initially.

15. Infrastructure has been a part ofthe reform process with widespread corporatization and privatization. In the area of infrastructure in particular, Indonesia has moved to commercialize, corporatize and-in some instances-privatize the delivery and management of public infrastructure beginning in the early 1980s. The reforms included the creation of subsidiaries and the sale of stakes in both parent and subsidiary enterprises. This process covered power, gas, telecoms, airports, seaports, railways and toll roads. The water resource UU 7/2004 and subsequent regulations clarified the terms for private sector participation in the sector, ended BUMD monopolies and established a National Water Regulatory Agency. The new Road Law, the Toll Road Authority and the separation of regulatory and operational functions of the Jasa Marga should all improve the situation regarding governance oftransport.

16. The 2003 business environment survey suggested that Indonesia’s infrastructure sector is comparatively free ofcorruption -less than 5% of firms reported payments to get a water, telephone or electricity connection, less than 7% reported bribes to obtain a construction permit. This matches broader results from the survey which suggested below-average levels of corruption in the country. Having said that, there is considerable evidence that corruption remains a significant problem in infrastructure, perhaps especially in the road sector.

17. In sectors where reform has moved further, the more significant governance problems regard regulation and the management of PPPs. For example, a number of ‘abandoned’ transport projects signed under a non-competitive and opaque PPP process in 1997 may be revived. The government has also been under pressure to exempt specific projects from the new governance regime covering PPPs (Perpres 67) and to date two exemptions have been issued (the MW 10,000 coal-fired power generation crash program and the Jakarta Monorail).

18. Decentralization has increased the number of actors with discretion over water and roads budgets while capacities in areas such as procurement and audit remain particularly weak at the local level. Progress is being made in strengthening detection and prosecution through institutions such as the Supreme Audit Institution and the Anti- corruption Commission, but there is additional work to be done in the areas of improved risk-focusing of physical audits, greater transparency of procurement, heightened

173 Annex 15 Governance sanctions and revised staff incentives. In both water and transport, there remains an unclear division of responsibilities within and between central and local government. In water in particular, there are limited tools for central government to influence adoption of national policies at the local level, and excessive local government interference in the management of PDAM operations. Collusion in procurement in the road sector remains endemic and sanctions against guilty parties remain weak. There are an increasing number of ‘unqualified opinions’ in PDAM performance audits and lack of adherence to national government directives.

19. While significant challenges remain, the reform agenda is ongoing. The IDPL program embraces a number of reforms in the institutional structures governing infrastructure that should improve governance and reduce the scope for corruption to derail infrastructure rollout in Indonesia. Not least, the Government has launched an aggressive reform program to introduce transparency and competition in PPP transactions through Perpres 67/2005 and KMK 38/2006. It intends to implement a mechanism to address non-compliant projects, in particular those holding up development of the trans- Java transport corridor. In addition, in the urban water sector, the legal framework has been revised to affect reform in PDAMs, and Perpres 6/2007 directs clarification of responsibilities covering WSS between central and regional governments as well as improved regulation ofregional WSS enterprises.

At the national level in roads, DGH is moving towards the use of standard bidding documents, expanding the use of e-procurement, the disclosure of contract information, and looking towards enhanced and standardized processes for land acquisition and environmental specifications. These standardized acquisition processes should not only speed the rollout of infrastructure, but also reduce the role of discretion on behalf of individual assessors in terms of the scale of payments to be made -this should reduce corruption.

20. Nonetheless, a number ofproblems remain, particularly in the area of procurement in the Ministry of Public Works. Public Financial Management (PFM) is at the heart of governance reforms. Although but one facet of good governance and PFM, public procurement is targeted as being in particular need of reform not least based on the finding of significant cases of corruption in infrastructure procurement processes under World Bank projects. Furthermore, disbursement in respect of development projects is slow and one reason for this appears to be a lack of capacity among procurement practitioners. With decentralization, infrastructure projects are frequently managed, either in full or in part, at the provincial or kabupaten (district) level, thereby requiring the participation of provincial and kabupaten staff in the procurement process, where capacity is particularly limited. The Government intends to address these challenges by taking action on two fronts: building capacity and rolling out transparent electronic procurement processes.

174 Annex 15 Governance Audit

21. The government recognizes a need to boost public investment in infrastructure, both at the national and sub-national levels. In this context, the fiduciary environment in which public finances in the country are managed becomes particularly relevant. The focus of on-going PFM reforms has in the initial years understandably been at the Ministry of Finance, which is leading the reform process. In addition, PFM reforms now need to be gradually extended to line ministries, such as Ministry of Public Works, who clearly share the responsibility for maintaining acceptable levels of accountability for public expenditure.

22. Public Sector auditing in Indonesia presents such an opportunity for extending on- going PFM reforms. Past analytical work done by the Bank indicated serious deficiencies in this sector, including weak institutional capacities, a multiplicity of organizations engaged in auditing with overlapping mandates and use ofoutdated methodologies.

23. Indonesia has made good progress’ towards addressing some of these deficiencies over the last few years, mainly to strengthen external audit arrangements. The enactment ofthe Audit Law in 2004 clarified BPK’s mandate as the sole external audit agency in the country, giving them almost unrestricted right of audit over public finance, generally in line with international standards (Lima Declaration). Another ‘BPK Law’ was passed by Parliament in 2006 which lays down internal and external governance arrangements for BPK as an organization, on matters such as appointment of BPK Board members and financial and administration independence. BPK has issued a series of internal implementing regulations for these laws and has also recently issued a new set of Government Auditing Standards that are substantially in line with comparable international standards (INTOSAI). Audit reports by BPK contain an audit opinion on the central government’s financial statements, as aggregated by the Ministry of Finance, are submitted to Parliament in a timely manner and are available to public.

24. On the other hand, the internal audit framework of the government is extensive, but scope and organization do not match needs. Ironically, even with (or perhaps because of) multiple internal audit agencies in existence, the internal audit function continues to be a weak link in governance. This institutional structure for internal audit is complex and the mandates and division of labor between the various audit institutions are unclear.

25. The internal audit function is carried out through three institutions: Inspectorate General (IG) in each spending ministry; the BPKP, reporting to the President’s office, with government-wide jurisdiction; and Bawasda at the local government level. Each line ministry plays the role of program executing agency and is therefore principally responsible for maintaining internal controls. It is responsible for performing and achieving the objectives stated in budget allotment documents. Under recently implemented PFM reforms, the function of payment order issuance has been transferred to the line ministries, in order to strengthen the responsibility and accountability over the

Sector report on Accountability & Audit in Indonesia (ADB January 2007).

175 Annex 15 Governan c e appropriated budget by the line ministries. In this context, IGs at line Ministries play a particularly significant role in ensuring that internal control systems operate as intended.

26. The Ministry of Public Works is one of the largest ministries in terms of the national budget as well as in terms of the number of infrastructure projects that involve substantial procurement of goods, works and services that are particularly subject to fiduciary risks. Past experience in several Bank financed operations has shown a consistent pattern of lapses in control systems at this Ministry.

27. Factors that often contribute to fiduciary lapses at the Ministry are weaknesses in internal control systems and in poor compliance with operating policies and procedures. Prior experience with donor projects indicates management ineffectiveness in monitoring systems and/or detecting lack of compliance with rules and procedures and good practices. The modernization and strengthening of the IG to perform routine internal audit functions is therefore important to build institutional capability for a systematic and risk based review of control systems, with in-built learning. The increased demand for accountability from within the institution is also a good way of conveying the right messages from the top and enhancing the soft controls incorporated in the COS02 framework.

28. The broad mandate of the Ministry of Public Works IG is to conduct an internal audit function to help ensure that the agency’s expenditure of public funds are spent wisely and in accordance with regulations; that development programs of the Ministry achieve their intended objectives; and that areas of corruption, collusion, nepotism, waste, fraud and efficiency are identified and eliminated. Since the government plans to significantly increase budgetary allocations for infrastructure, the Ministry’s management has articulated the following specific priorities: 0 Minimize budget leakage 0 Improve quality ofpublic works financed by the budget 0 Provide support for good practices in project management by Ministry staff

29. The department’s audit teams cover up to 40% of the 881 Satker (working units) within the Ministry of Public Works. Priorities are given to i) Satker with budget allocation higher then IDR 50 billion; ii) Satker with strategic activities and iii) Satker with multi year contracts. 20% of the Satkers spent 90% of the Ministry’s annual budget, therefore the coverage of the internal audit is considered high. However, the Ministry’s IG recognizes the needs to improve its audit methodology towards modern internal audit practices. Capacity building is required to introduce systematic risk assessments to help guide the IG audit staff in their work.

30. The IG of the Ministry of Public Works has indicated the intention to develop its department into a good practice example. An initial step in this direction is the development of a manual for technical audits to be undertaken by the Ministry’s IG. The

COSO: Committee of the Sponsoring Organizations of the Treadway Commission on internal audit.

176 Annex 15 Governance next step planned is to train its audit staff in modern methods and risk based approaches to provide reasonable assurance to the Ministry’s management on how well its internal control systems are functioning and to improve information technology support for the IG.

3 1. These reform efforts should yield improvement in quality ofinternal audit work that will be reflected primarily in reports produced by the IG. These reports should include clear identification of weaknesses in control systems and constructive recommendations to the management for improvement and sanctions.

177 ANNEX 16 ANALYTICAL UNDERPINNINGS

1. The 2004 flagship report, Averting an Infrastructure Crisis: A Framework for Policy Action provided a cross-sectoral analysis of Indonesia’s infrastructure challenges, addressing issues including planning, inter-governmental relations, corruption, promotion of PPPs, commercialization, regulation, and financing. It included four annexes focusing on the details of energy, transport, water and sanitation, and telecommunications. The report provided a ready focus for the new Government in 2004, and the analytical background for most ofthe infrastructure reforms over recent years.

2. The 2007 Indonesia Public Expenditure Review, Spending for Development - Making the Most of Indonesia s New Opportunities found that Indonesia’s recent increase in fiscal space provides opportunities unprecedented since the 1970s, and recommended that, among other matters, these resources be used to increase infrastructure expenditures. The report also provides an analysis ofthe equity and geographic breakdown of access to infrastructure service, and includes an analysis of the fiscal cost and regressive distribution of electricity subsidies. The PER is complemented by separate regional public expenditure reports, in Aceh and Papua.

3. In addition to analytical work pursued as part of project development, several reports have been prepared dealing with particular infrastructure sectors. Electricity for All: Options for Increasing Access in Indonesia focused on critical barriers to extending access including tariff and subsidy policies. Towards an EfJicient Fuel Products Market in Indonesia: Achieving an Equitable and Sustainable Policy addresses both fuel pricing and subsidy policy. Framework for Introducing Performance-Based Maintenance Contracts to Indonesia provides a blueprint for the introduction ofimproved maintenance systems for the country’s road network. Aspects of transport planning, including financing, environmental and social aspects, were addressed in the context of separate technical assistance activities delivered to Bappenas and sub-national governments in 2003. Rural roads were an area of particular focus in the cross-sectoral 2006 Rural Investment Climate Assessment, which reported on the development impact of limited infrastructure rollout in rural areas. Indonesia: Enabling Water Utilities to Serve the Urban Poor focused on what PDAMs could do to extend services to the 50 million urban poor unconnected to piped water, also discussing the barrier that low tariffs create to such service rollout. Analytical work in the telecommunications sector has been provided as part of direct technical assistance to the Government, on subjects including universal service, competition policy, the Palapa Rings national broadband network, access licensing, and e-government opportunities.

4. Decentralizing Indonesia: A regional public expenditure review report, prepared in 2003, forms the backdrop to the Bank’s work on issues of decentralization. It sets out the agenda to be addressed in making decentralization work, including the assignment of functions over levels of government: local capacity to implement the functions; the intergovernmental fiscal system; and accountability at the local level. The report has been supplemented subsequently with numerous policy papers provided in the form of technical assistance to the Government.

178 Annex 16 Analytical Underpinnings

5. Work on the details of PPP reform has been provided as part oftechnical assistance to the Government. The PPITA loan has been used to develop the governing institutions for PPPs, including the KKPPI Secretariat, Central PPP Unit, and Risk Management Unit, and to develop a strategy for dealing with “non-compliant” projects. PPIAF grants have been used to develop many of the important details of the risk management regime, as well as dealing with various issues of land acquisition, public support for IPPs, and development ofthe Guarantee Fund.

6. An internal review ofland acquisition issues in Bank projects identified many ofthe issues that need to be addressed through policy reforms. AMDAL Reform and Decentralization - Opportunities for Innovation (2006) provides an analysis of and recommendations for the country’s environmental impact assessment system, including recommendations taken up under this operation.

179 ANNEX 17 INDONESIAAT A GLANCE

Indonesia at a qlance 9/18/07

East Lower Key Development Indicators Asia & middle Age distribution, 2006 Indonesia Pacific income (2006) Male Female

70 74 Population, mid-year (millions) 224 1,900 2,276 Surface area (thousand sq. km) 1,860 16,300 28,549 60-64 Population growth (Oh) 1.3 0.8 0.9 50 54 Urban population (Oh of total population) 48 42 47 40-44 30 34 GNI (Atlas method, US$ billions) 316 3,539 4,635 20-24 GNI per capita (Atlas method, US$) 1,410 1,863 2,037 10 14 GNI per capita (PPP. international $) 3,950 6,821 7,020 0.4 15 10 5 0 5 10 15 GDP growth (Oh) 9.4 8.8 5.5 percent GDP per capita growth (Oh) 4.0 8.6 7.9

(most recent estimate, 2000-2006) Under4 mortality rate (per 1,000) Poverty headcount ratio at $1 a day (PPP, %) 8.5 9 Poverty headcount ratio at $2 a day (PPP, %) 50 37 100, Life expectancy at birth (years) 67 71 71 Infant mortality (per 1,000 live births) 30 26 31 Child malnutrition (Oh of children under 5) 29 15 13

Adult literacy, male (% of ages 15 and older) 94 95 93 Adult iiteracy, female (% of ages 15 and older) 87 67 85 Gross primary enrollment, male (% of age group) 118 115 117 Gross primary enrollment, female (Oh of age group) 116 113 114 1990 1995 2000 2005 Access to an improved water source (YOof population) 79 79 81 Access to improved sanitation facilities (Oh of population) 60 51 55 0 Indonesia 0 East Asia 8 Pacific

Net Aid Flows 1980 1990 2000 2006 Growth of GDP and GDP per capita (Oh) (US$ miiiions) Net ODA and official aid 94 1 1,716 1,654 2,524 Top 3 donors (in 2006): l5T Japan 350 868 970 1,223 Australia 48 77 72 185 Netherlands 65 190 144 176

Aid (Oh of GNI) 1.3 1.6 1.1 0.9 Aid per capita (US$) 6 10 8 11

90 95 00 05 Long-Term Economic Trends

-4-GDP -GDP Consumer prices (annual % change) 9.5 7.5 3.7 13.1 percapita GDP implicit deflator (annual % change) 31 .O 7.7 20.4 13.6

Exchange rate (annual average, local per US$) 627.0 1,842.8 8.421.8 9,159.3 Terms of trade index (2000 = 100) 63 100 76 1980-90 1990-2000 2000-06 (average annual growth %) Population, mid-year (millions) 148.3 178.2 206.3 223.9 1.8 1.5 1.4 GDP (US$ millions) 78,013 114,426 165,021 364,459 6.1 4.2 4.9 (% of GDP) Agriculture 24.0 19.4 15.6 12.9 3.6 2.0 3.1 Industry 41.7 39.1 45.9 47.0 7.3 5.2 4.0 Manufacturing 13.0 20.7 27.7 28.0 12.8 6.7 5.1 Services 34.3 41.5 38.5 40.1 6.5 4.0 6.5

Household finai consumption expenditure 51.4 58.9 60.7 62.0 5.2 6.6 4.5 General gov't final consumption expenditure 10.5 8.8 6.5 8.6 4.6 0.1 8.3 Gross capital formation 24.1 30.7 22.2 24.6 7.7 -0.6 5.4

Exports of goods and services 34.2 25.3 41 .O 30.9 2.7 5.9 7.7 Imports of goods and services 20.2 23.7 30.5 26.1 1.2 5.7 9.0

Note Figures in italics are for years other than those specified. 2006 data are preliminary. .. indicates data are not available. a. Aid data are for 2005.

Development Economics, Development Data Group (DECDG)

180 95° 100° 105° 110° 115° 120° 125° This map was produced by the Map Design Unit of The World Bank. The boundaries, INDONESIA colors, denominations and any other information shown on this map do not imply, on SELECTED CITIES AND TOWNS the part of The World Bank Group, any judgment on the PROVINCE CAPITALS legal status of any territory, 15° or any endorsement or NATIONAL CAPITAL acceptance of such boundaries. INDONESIA RIVERS MAIN ROADS MYANMARMYANMAR RAILROADS VIETNAM PHILIPPINES PROVINCE BOUNDARIES 10° 10° INTERNATIONAL BOUNDARIES THAILANDTHAILAND Sulu Sea 135° 140°

Banda Aceh L A Y 5° A BRUNEI 5° 1 S Natuna Talaud Medan M Besar I Celebes Is. Tarakan PACIFIC OCEAN PematangsiantarPematangsiantar A Sea Simeulue 2424 1919 Morotai 2 SINGAPORE 2323 Manado Nias Tanjungpinang PekanbaruPekanbaru 2525 Ternate Halmahera Waigeo 0° 3 Pontianak KALIMANTANKALIMANTAN 2626 Gorontalo 0° M Lingga 2020 Samarinda Manokwari e Padang 3030 Biak n PaluPalu SorongSorong t 4 Balikpapan Peleng ObiObi a Siberut 5 JambiJambi Bangka 2121 w Misool Yapen a Pangkalpinang PalangkarayaPalangkaraya SULAWESISULAWESI Sula Is. 3232 Jayapura i SUMATERASUMATERA Mamuju CeramCeram 9 Belitung 2222 FakfakFakfak IRIANIRIAN JJAYAAYA I s PalembangPalembang 2727 AmahaiAmahai . 6 2828 7 Bandjarmasin 2929 Kendari BuruBuru 3333 (PAPUA)(PAPUA) Bengkulu Ambon A Parepare TimikaTimika PuncakPuncak JayaJaya 8 (5030(5030 mm)) E

5° Muna Kai N BandarBandar Java Sea Makassar I Enggano 1111 Baubau Banda 3131 Is. A LampungLampung U

JAKARTA U SerangSerang Sea Aru 0 200 400 Kilometers P Is. G 1212

Madura

BandungBandung SemarangSemarang A 1010 1313 Wetar PAPUAPPAPUA SurabayaSurabaya Babar W 0 100 200 300 400 Miles Tanimbar

1616 E JAWA Yogyakarta Lombok Sumbawa Alor Moa Is. 1515 BaliBali RabaRaba Flores NEW GUINEAN 1414 Merauke NEW GUINEA 95° 100° 105° Denpasar MataramMataram 1818 Ende TIMOR-LESTE Arafura Sea 1717 Sumba PROVINCES: 10° Waingapu Timor 10° Kupang 1 NANGGROE ACEH DARUSSALAM 12 JAWA BARAT 23 KALIMANTAN TIMUR 2 SUMATERA UTARA 13 JAWA TENGAH 24 SULAWESI UTARA 3 RIAU 14 D.I. YOGYAKARTA 25 GORONTALO 4 SUMATERA BARAT 15 JAWA TIMUR 26 SULAWESI TENGAH 5 JAMBI 16 BALI 27 SULAWESI BARAT INDIAN OCEAN

6 BENGKULU 17 NUSA TENGGARA BARAT 28 SULAWESI SELATAN IBRD 33420R1 NOVEMBER 2006 7 SUMATERA SELATAN 18 NUSA TENGGARA TIMUR 29 SULAWESI TENGGARA 8 LAMPUNG 19 RIAU KEPULAUAN 30 MALUKU UTARA 15° 15° 9 BANGKA-BELITUNG 20 KALIMANTAN BARAT 31 MALUKU 10 21 KALIMANTAN TENGAH 32 IRIAN JAYA BARAT AUSTRALIAA U S T R A L I A 11 D.K.I. JAKARTA 22 KALIMANTAN SELATAN 33 PAPUA (IRIAN JAYA) 115° 120° 125° 130° 135° 140°