Document of The World Bank FOR OFFICIAL USE ONLY Report No.: 2621 I PROJECT COMPLETION NOTE (LOAN 4528-MK; CREDIT 3536-MK) ONA PROPOSED LOAN IN THE AMOUNT OF US$l6.2 MILLION AND CREDIT IN THE AMOUNT OF SDR 10.3 MILLION (US$13.1 MILLION EQUIVALENT) TO THE!, MACEDONIA FOR A WATER UTILITY IMPROVEMENT PROJECT March 15, 2004 Infrastructure and Energy Department South East Europe Country Unit Europe and Central Asia Region This document has a restricted distribution and may be used by recipients only in the performance of their official duties. Its contents may not otherwise be disclosed without World Bank authorization. CURRENCY EQUIVALENTS (Exchange Rate Effective as of March 15,204) Currency Unit = Macedonian Denar MKDl = US$O.O19732 US$l = MKD 50.680 FISCAL YEAR January - December ABBREVIATIONS AND ACRONYMS AAA Analytical and Advisory Services CAS Country Assistance Strategy IBRD International Bank for Reconstruction and Development IDA International Development Agency KH Komunalna Higiena oc Operating Company PSP Private Sector Participation SDR Special Drawing Rights Unaccounted for Water Vice President: Shigeo Kat su, ECAVP Country Director Orsalia Kalantzopoulos, ECCU4 Sector Manager Sumter Lee Travers, ECSIE Task Team Leader/Task Manager: Sudipto Sarkar, ECSIE PROJECT COMPLETION NOTE MACEDONIA WATER UTILITY IMPROVEMENT PROJECT (Loan 4528 -MK; Credit 3536 -MK) Background 1. This is a Project Completion Note for the above project which was approved by the Bank's Board on June 26, 2001. The Loan and Credit Agreements for the project were not signed as of December 26, 2002 due to reasonsexplained below. As per Bank's policy, since the project did not come into effect within 18 months of Board approval, the Loan and Credit Agreements lapsed. 2 The project cost was estimated to be US$ 42.4 million which was to be financed from the following sources: a) International Development Agency (IDA) Credit of SDR 10.3 million (US$ 13.1 million equivalent); b) International Bank for Reconstruction and Development (IBRD) Loan of US$ 16.2 million; c) Skopje Vodovod (water and wastewater utility) contribution of US$ 8.1 million; d) Skopje Komunalna Higiena (solid waste collection company) contribution of US$ 1.0 million; and e) Government contribution of US$4.1 million. Project Objectives 3. The project had two objectives: Improve the operational efficiency of Skopje Vodovod, the largest water and ivastewater utility in the country, to enable it to provide quality service at affordable prices to the population; and Provide a sound basis for the future development of the solid waste sector in Skopje. 4 The first objective was to be met through a Subsidiary Loan Agreement to be signed between Macedonia and Skopje Vodovod for a project estimated to cost US$ 36.6 million that had the following components. Implementation of these components was to be ensured through the Project Agreement between the Bank and Skopje Vodovod: a> Initial Investments (US$ 9.8 million) that would address urgent water network and sewerage rehabilitation needs. Preliminary preparation for these investments were completed prior to Board approval and bidding documents were prepared for US$ 2.1 million worth of investments. b) Operating Fund (US$ 21.9 million) that would finance (i) water network efficiency improvements; (ii) rehabilitation of the water, sewerage, and stormwater network; and (iii) extension of water services in the outskirts of Skopje. The Operating Fund was to be used after an Operating Company (OC) - joint public private partnership - was put in place. 2 c>Vodovod Restructuring (US$ 2.8 million) that would provide technical assistanceto the Vodovod and the city of Skopje to select a private operator for the OC and to effectively supervise the OC; and d) Project Management and Implementation support (US$ 0.4) to implement the project and carry out public awarenesscampaigns and customer surveys. 5 The second objective was to be met through a Subsidiary Loan Agreement to be signed between Macedonia and Skopje Komunalna Higiena (KH) for a project estimated to cost US$ 4.5 million that had the following components. Implementation of these components was to be ensured through the Proiect Agreement between the Bank and Skopie KH: a> Technical Assistance (US$ 0.3 million) that would finance the development of an implementation plan to improve solid waste collection in Skopje and monitor the Drisla landfill; and b) Urgent Investments (US$ 4.2 million) that would replace the solid waste collecting vehicles that were old and subject to constant breakdowns that affected the quality of service. The investments would also allow KH to expand services in poorer under-served areasand outside the city limits. 6 The Government as a Borrower had obligations to ensure proper implementation of the Subsidiary Loan Agreements, meet financial management requirements, and refinance the Project Preparation Facility which was used to support feasibility studies. To this end US$ 1.2 million was expected to be spent by the Government under the project. Project Design 7 Apart from investments that were expected to support the rehabilitation needs of the city, the project also supported policy and institutional measures. During project preparation, the following issues were identified in the Skopje Vodovod and addressedunder the project to make the company run more on a commercial basis and improve service efficiency. * High Unaccounted for Water (UFW): A combination of administrative and physical losses led to high UFW? About 45% of the water produced was not accounted for and was not billed. l Low Bill Collection Rate: In spite of low tariffs, bill collection rates were low. About 70% of the bills would be collected on a current basis. Using a combination of the high m (billing of 55% of the water produced) and low bill collection rate (70%), the Skopje utility would collect cash for only about 38% of the water it produced. Enforcement such as disconnection to non-paying customers was not common due to social considerations. 3 0 High Employment costs: The cost share of employees was around 60% of the total operating costs. In well run utilities, employee expenses are less than 25% of the operating expense reflecting the excessive labor force in Skopje Vodovod. 8 . The policy measure supported under the project was the preparation of new Law of Water Supply, Drainage, and Treatment of Urban Wastewater. Submission of the draft law to Parliament was a condition of negotiations. Key features of the law included: simplifying the process of disconnecting services to non-paying consumers; requiring that utilities that function as municipal departments be registered as commercial enterprises. 9 The key institutional aspect of the project was to introduce an OC which would have a lease contract with Skopje Vodovod to provide water and wastewater services. The OC would be a public private venture and the private party was to be selected through a competitive process. The introduction of the private sector was supported by the City Council at that time since it would bring about a paradigm shift away from the traditional fully owned public sector model. The paradigm shift was expected to change the incentives for the service provider so that the problems of efficiency described above would be addressed. Introduction of the private sector was also in line with the Country Assistance Strategy (CAS) in effect at that time. 10 To allow the City Council to make an informed decision on the nature of Private Sector Participation (PSP) an analysis was completed which looked into the following three options: a) service contracts where the Vodovod's function would not change significantly but it would outsource some of its activities; b) a management contract where the private sector would be contracted by the Vodovod and would provide the water and wastewater services for a fee. The commercial and the investment risks would be borne by the Vodovod; and c) a lease contract through which Vodovod, on behalf of the city, would contract an OC for the provision of water and wastewater services. In this case, the OC would take on the commercial risk of operations. The Vodovod would retain the network assets and investment responsibilities such as implementing the Bank project. 11. In December 2000, the City Council selected the lease contract given that the benefits of this option were the largest and since it would boost the performance of service through the involvement of an experienced private operator. Further, as part of the options analysis, a market survey was conducted and the city was assured that a number of operators showed interest to be involved through the lease contract option. The term sheet for the lease contract and the shareholder's agreement were also developed prior to negotiations of the project. At negotiations the City confirmed the proposed institutional arrangement and subsequently a consultant was also hired to start the bidding process to select an operator. Negotiations were also confirmed by the Government through a letter dated May 29,200l to the Bank. 4 Chronological Events 12. A significant event that affected the project was the political unrest and the internal strife that started in the country in March 2001. The political unrest was flagged as an issue in the Project Appraisal Document which stated that this was a controversial aspect which created a political risk for the project. 13 Between July and December 2001, both the central Government and the City Council were busy coping with the problems related to the internal strife. There was an influx of refugees into Skopje that diverted the attention of the City Council and the Government was pre-occupied with internal security issues. In this period, there were travel restrictions to the country which limited directed interaction between the Bank headquarters staff and the Macedonian counterparts, although phone calls and electronic mail were used to communicate. The Bank's Skopje office also played an active role in interacting with the Government and the City Council with an objective to getting the legal agreementssigned as soon as possible. 14 In January 2002, after the political situation in the country stabilized, the Parliament approved the legal documents and authorized the Government to sign the Loan and Credit Agreements. Under the project, there were four legal agreementsthat were to be signed by the Bank and the Macedonian counterparts: a) Loan Agreement between Macedonia and the Bank; b) Credit Agreement between Macedonia and the Bank; c) Project Agreement between the Bank and Skopje Vodovod; and d) Project Agreement between the Bank and Skopje KH. In addition, the Government was to sign the Subsidiary Loan Agreements with Skopje Vodovod and Skopje KH. 15. After the Parliamentary approval and before the national elections, the Government was prepared to sign documents a) and b) mentioned above, but the City Council of Skopje showed reluctance to authorize the Skopje Vodovod to sign the Project Agreement. This was a reversal in the position of the City Council that had earlier negotiated the Project Agreement. Unwillingness to sign the Project Agreement by the City Council prevented the other legal documents from being signed. 16. The change in the position of the city could be attributed to the social and political unrest that had started in March 2001 that led to a change in the priorities of the Council which felt that the creation of the OC would lead to a reduction of jobs in the utility, although it was overstaffed. The creation of the OC was seen as a form of private sector participation that could potentially lead to loss of jobs in the Vodovod. Under the socio-economic situation present at that time, the Council did not want to create a situation that would be perceived to increase unemployment. In this period the Bank repeatedly explained to the City Council that the project did not require lay-offs. The staff in the OC were to be drawn from the Vodovod and those that were not selected (from the Vodovod) would continue to be a staff of the municipality. 17 A Bank management team also visited Skopje in April 2002 to discuss the project and fadilitate its effectiveness. Subsequent to the mission, on April 30, 2002, the Bank sent a letter to Government and the Skopje city officials mentioning its concern about the delays in making the Loan and Credit Agreements effective. The Bank informed the officials that the IDA resources 5 allocated for the project would be lost if the legal agreements were not signed on time. Further, to allay the concerns about the OC, the Bank clarified that the public sector could have majority ownership in the company. This would allow the city to have a significant influence on the operations of the OC. The Government or the City Council did not respond to this letter. 18 . In a run-up to the September 2002 national elections, the local authorities were not able to take a decision on the Project Agreement, although the central Government at that time was still willing to move forward with the project. Prior to the elections, the Government officials and also the opposition had assured the Bank that a decision - one way or the other - would be taken soon after the elections. A new Government came to power in November 2002 which had majority representation from the same coalition that controlled the City Council and was part of the national opposition party prior to the elections. 19 The Bank sent a letter on December 3, 2002 informing the newly appointed Government and the City Council that the deadline to sign the legal documents was December 26, 2002, 18 months after Board approval. Failure to sign the documents would lead the Loan and the Credit Agreements to lapse. In this letter, the conditions to meet the effectiveness conditions were also reiterated. These conditions were the execution of the Subsidiary Loan Agreements and the appointment of the auditor. Progress had been made on these two fronts soon after Board approval. The Subsidiary Loan Agreements were drafted and an auditor had been selected. Given the concerns related to the institutional arrangements, the Bank again clarified in this letter that the public sector would retain majority control of the OC. The letter also mentioned that the Bank would be willing to consider changes in the institutional arrangements of the project as long as it did not require an amendment to the legal agreements. 20 On December 25, 2002, the Government responded to the Bank by saying that based on a l review, it decided to not support the project anvmore. The views of the Citv Council on the proiect objectives and structure were cited as reasons for withdrawing the support Government support for the project. 21 On January 10, 2003 the Bank replied by expressing its disappointment with the Government decision, especially since the project was prepared with full consultation and agreement with the previous Government and the City Council and that the project was approved by the Parliament. The Bank also mentioned that it had been very responsive to the needs of the City Council and the Government during project preparation, that the decision to not proceed with the project was a surprise, and that the country forfeited the availability of concessional IDA financing. 22. The Bank was pro-active in interacting with the Government and the City Council with an objective to making the Loan and Credit Agreement effective as soon as possible. Due to the delays in effectiveness, the project was categorized as `unsatisfactory' in the Project Status Reports which brought about a significant institutional attempt to sign the legal documents as soon possible. Staff from the Bank's headquarters and the Skopje office regularly interacted with the Government and the city officials to urge them to make the Loan and Credit Agreements effective. The Bank management also met with the officials and exchanged letters in an attempt to sign the legal documents. 6 Conclusion 23 As per the Bank's policy (OP 13.00), due to the 18 month delay in effectiveness, the Loan and Credit Agreements lapsed. The approach taken by the City Council to focus on institutional aspectswas correct and as a result it was reflected in the project design. However, the willingness to implement the institutional reform waned as the socio political situation in the country changed with the internal strife. Priorities and political alliances shifted after the Board approval which was the primary causefor the Loan and Credit Agreements to lapse. 24. Even if the OC was not included as part of the project design, without the political willingness, it would be difficult to bring about efficiency improvements in the water utility. Commitment from the city would be required to reduce unaccounted for water, increase tariffs and bill collection rates, improve employee productivity etc. BY not agreeing to sign the Project Agreement the City Council demonstrated that they were not ready to addressthese difficult issues. 25. In a recent assessmentmade by the Government, urban poverty remains as a key priority. There are about 100 slum settlements in the country where citizens lack accessto safe drinking water and sanitation and environment :ally friendly solid waste management services. Skopje accounts for 27 of these slums settlements. Potentially some of these areas could have been covered by the project through the Operating Fund. Although there is recognition of the need to improve the situation, the efficiency of services is still not high given the institutional constraints that have not been addressedproperly. The Bank expects to be engaged in the urban sector through an Analytical and Advisory Services (AAA) that outline a comprehensive urban upgrading strategy which would include measures to improve the efficiency of water and wastewater services. The implementation of this strategy would, however, depend on the willingness of the Government to carry out reforms.