69927 Report on Three Potential PPP Water Projects in the Ministry of Public Works – BPP SPAM Based upon the review of previously prepare Tender Documents and Pre-Feasibility Studies 1. Background The reaction by bilateral and multilateral agencies, the private sector and the Government of Indonesia to the Infrastructure Summit was an important step toward developing transactions that can assist infrastructure development throughout Indonesia. However, the commitments made by Government to these agencies and the private sector has not yet come to fruition. Many of the projects selected and advertised during the Summit required significant inputs to be attractive to private sector. In addition, certain key provisions required to ensure mature, well-defined and bankable transactions were often missing. A meeting between the Minister of Public Works and a World Bank delegation recently concluded that Water Supply projects are now in a position to be tendered with the expected issuance of water extraction licenses and a further examination of water supply have shown that some of the projects can proceed. A team had been mobilized during 2005 to prepare five projects for PPP. The team developing those projects determined that four of the projects required issuance of a license to local government to allow them to extract raw water sufficient for project needs. Unfortunately, previous licenses granted to other authorities coupled with uncertainty on the use of river water made issuance of the license problematic. The Directorate General Water Resources of the Ministry of Public Works has recently been able to clarify river water usage and extraction to allow a license to be issued. The license has made it possible to tender projects for PPP. While the water issue was being resolved, the team assembled to develop the project was suspended but was to be later re-mobilized once it became clear that a license would be issued. The team before it was suspended developed tender documents and information memoranda for the projects. While the projects were developed the documents were not fully completed prior to being suspended. The review will entail three projects, two in Tangerang known as Sepatan and Benda. These projects are “Greenfield� water supply concessions where the private sector will be invited to build the entire water supply treatment and distribution and sell water to local residents. The third project is a BOT bulk water supply project in Kota Surakarta valued at approximately $5 million. At the end of June 2005 the project was proceeding but still required two municipal governments, Kabupaten Sukoharjo and Kota Surakarta to agree and sign an MOU prior to proceeding. While no problems were anticipated, local government approval processes were time consuming and the staff assigned was temporarily suspended pending the outcome of both Governments agreeing to an MOU to cooperate toward finalizing the project. That MOU has been signed. At present, most if not all issues have been resolved and tender documents are ready to invite private sector participation in developing water supply infrastructure. Limited funding has been provided by the World Bank to see if, on a pilot basis, the best of these project opportunities can be brought to conclusion. The Bank in cooperation with BPP- SPAM, the MPW regulatory and development arm, and the Project Management Unit of KKPPI would like to understand which of the projects is most ready to move forward. They have engaged a consultant to do a limited review of prior documents with the understanding that the benefits and impediments of each project will be reviewed, with an eye toward providing a recommendation based upon these documents and a clear understanding of constraints to ensure that the most beneficial project is recommended for further analysis. 2. Objective The overall objective of the Review of Water Project Tender Documents is to ensure that from the list of projects noted above the most likely project is chosen for further analysis. This future analysis will include an update of previously prepared Tender Documents and a complete Request for Proposal that the private sector can bid on and lenders will find bankable. The current analysis will look closely at objective issues such as the demand for water within the relative municipalities, subjective issues such as concerns over raw water extraction licenses and local government security and at Sovereign issues that affect project bankability. It must be pointed out, however, sovereign creditworthiness is essential for Project Finance. While the objective of this TOR is not to opine on Sovereign issues, reference shall be made to terms and conditions that may be examined to ensure that most of these Sovereign issues are addressed. This report is limited to examining existing tender documents prepared by the PPITA Ministry of Public Works team and offering direct suggestions for the project that has the highest probability of success. 3. Community Creditworthiness In this section we will examine the ability of each community to offer security to allow the project to proceed as planned. Security takes on a number of forms and is not a guarantee of debt but a guarantee of the performance of local government and PDAM to live up to their commitments or make payments in accordance with the terms of their agreement with private sector. These commitments include increasing tariffs consistent with the tariff adjustment plan detailed in the investors’ proposal. Failure on the part of local government to approve recommended tariff increases will have a serious and adverse affect on project performance and ultimately debt servicing. Normally, an independent tariff regulator is established to relieve the burden of local government from adjudicating tariff adjustments. Such a regulator was established for DKI Jakarta but the regulator does not have the ability to approve tariff increases only local government can approve tariff increases. We will examine the ability of local government and its water utility to be able to offer any money backed security to subsidize the project directly if it becomes politically expedient to delay approval of tariff increases. By doing this, project creditworthiness is enhanced. Further security issues include land acquisition for facility development, granting of rights of way and ensuring that such rights of way are available, limiting local opposition and possibly reducing competing water sources such as groundwater from being extracted by local businesses and households. The perceived ability of local government to provide this security is key to project success and ultimately lower risk and cost. We must examine objectively whether local government is prepared to live up to their commitments and thus make finding a private sector partner easier. Below we look individually at each project and offer our opinion on the issues and likelihood of successfully completing this transaction by each local government and PDAM. Sepatan Sepatan is located in Kabupaten Tangerang. The PDAM that is responsible for water supply is known as PDAM Tirta Kerta Raharja. Kabupaten Tangerang is a community that is experiencing significant urban growth over the past few years. Population, which stood in total between Sepatan and Pasar Kemis at more than 300,000 at the end of 2000, is expected to grow at 4% per annum. It is clear from these figures that not only is service demand very high it will continue to grow significantly for the future. Existing water resources used by most people in the community come from groundwater. However, groundwater has begun to deteriorate due in part to heavy usage and is far below drinking standard. There is concern that with growth and pumping at the current rate groundwater will not recharge and will become scarce in years to come. The Pre-FS points out that there are many industrial plants in Pasar Kemis and a significant number of these businesses will purchase water from the new water company. Experience has shown that industrial water usage does not require high quality water. Industrial water usage is mostly process water, which does not need to be at drinking standard. Hence, groundwater is normally considered satisfactory for process usage. We suggest that a water demand survey needs to be conducted in Sepatan and Pasar Kemis to determine if there is sufficient high quality demand. Local government revenues are under Rp. 1 trillion annually. Despite the high revenue, Government has been running at a deficit since 2001. It is unlikely that local government will have the resources to provide subsidy payments should they default on tariff increases. PDAM does not currently operate any water supply in the area so their management in the area is not critical to the partnership. However, their ability to provide the land, rights of way and act as guarantor for tariff increases is vital. PDAM’s financial capacity is severely limited. The report notes that PDAM is in default of all loans and barely covers operating costs with revenue for water sales. It seems currently unlikely that PDAM is in any position to provide project support and project revenues are entirely dependent on tariff adjustments that must be granted through local legislature. This presents numerous problems for attracting a private partner. The report is silent on whether land will be provided for building the Water Treatment Plant. However, financial projections do not include the cost of land acquisition in its analysis, leading to the assumption that land and rights of way will be provided by PDAM at no cost to the Concessionaire. Since the report is silent on land for development, we have assumed that PDAM would be required to acquire the land, obtain building rights and provide rights of way. We believe that this is likely to be a major impediment to building the project on time and at a reasonable cost. PDAM currently does not have the resources to purchase the land and is unaware of the hurdle this creates for project progress. Benda Benda is located in Kota Tangerang. The PDAM that is responsible for water supply is known as PDAM Tirta Banteng. Kota Tangerang is a thriving suburb of DKI Jakarta with numerous industrial plants and service businesses. Generally Tangerang is a bedroom community of DKI Jarkata with a fairly high per capita income by Indonesian Standards. The project zone surrounds Jakarta’s international airport, which also provides income to Kota Tangerang. The area surrounding the airport is densely populated. In fact, it is one of the most densely populated regions in Kota Tangerang. Urban growth approximates 1.75% annually and will add to the density over time. PDAM Tirta Banteng currently served a small portion of this region principally serving the airport. The project anticipates that the private sector will provide approximately 50 l/s to PDAM Tirta Banteng for service to their existing constituency and the remaining 270 l/s to be under management of the private partner to sell water within certain areas of Kecamatans Benda, Periuk and Jatiuwung. The PDAM would continue to operate their existing system. While this seems inefficient, this scheme complies with the desires of PDAM. The Kota appears to be solvent with significant revenue increases over the last 4 years. However, evaluating the Kota’s financial condition is difficult as the Pre-feasibility study does not provide sufficient detail on expenses and surpluses or deficits. However, revenue growth has been dramatic increasing a full 58% in the past 4 years. GDP is growing as well led the industrial sector, which grew at a rate of 12.8 per annum since 1999. While we lack sufficient detail to render an opinion on whether Kota Tangerang has the financial resources to support a private project it appears from the revenue growth and continuing prospects for the community that it is likely the Kota can provide external assurance that commitments will be guaranteed. Likewise PDAM appears to be improving dramatically. Since the PDAM’s inception in 1995 it incurred losses yearly until 2002. In 2003, PDAM was marginally profitable but by 2004 PDAM achieved significant results returning it to financial health. While they continue to have retained deficits, with tariff increases in 2004, it is likely that PDAM will continue to show healthy profits in the near term. Tariffs are generous by Indonesian standards averaging just under Rp2,900/m3. While PDAM cannot guarantee the commitments of Kota in agreeing to regular tariff increases, if the current trend continues it can provide a source of security for any delays in agreed tariff increases. Further projected tariffs of the new water enterprise are not materially in excess of current tariffs in Kota Tangerang. As of yet it is unclear if any Regulator has been established, however it is hoped that one can be established to provide comfort that tariff changes can be professionally determined and avoid political processes that can slow down approval. However, should such security for tariff adjustments be warranted, then both local government and PDAM have the capacity if not the resources to provide security. Land acquisition and rights of way will continue to be an issue. The report is generally silent on land issues. The financial analysis, however, does not cost land acquisition. By implication this means that local government or PDAM will purchase the land. This must be made absolutely clear prior tender. In addition land must be suitable for the WTP, offices, intakes, pump stations, etc, to ensure that project can proceed. Surakarta and Sukaharjo During the original analysis the project was intended to provide assistance to both Surakarta (Solo) and Sukaharjo. However, the analysis pointed out that Sukaharjo’s current production was capable of satisfying its communities need for at least the following five years. Surakarta needed new capacity to satisfy its growing population and supply was already at maximum. Unfortunately, water quality in the Bengawan Solo River adjacent to both communities was of such poor quality near Surakarta that an alternative source was needed. Effluent from textile plants in Surakarta contaminates the River to the point that treatment is both difficult and not cost effective. The result is that an intake downstream from the factories is needed to ensure that treatable water is available. Solo has requested that Sukaharjo agree to allow a private firm construct an intake in Sukaharjo to provide water for treatment. At PPITA’s suggestion, Sukaharjo agreed provided the private investor also agree to build an intake larger than specified for Solo to accommodate future Sukaharjo needs. At the time the PPITA analysis was suspended, an agreement had been reached but not yet approved by each local parliament. It is understood that this approval has been reached and the project is ready to proceed. Evidence of approval is required before funds should be expended for this project. This approval shall be affixed as an addendum to any contract between the parties. While the government of Sukaharjo and its PDAM are not at present a party required to secure the contract with the exception of the agreement, it should be noted that the financial condition of both Kabupaten Sukaharjo and PDAM Sukaharjo are precarious. Reform efforts are absolutely necessary before they can envision entering into a contract for BOT water supply. We encourage the MPW to assist PDAM Sukaharjo in these reform efforts and encouraging financial discipline coupled with realistic tariff increases. The government of Kota Solo has stable and increasing revenues owing to its more than 12% annual growth in GDP. Textiles and other industries have spurred local development and increasing incomes. Increasing income for local government has led to increased public spending on development project but with fiscal constraint. Government has maintained a surplus and funds available for future expansion. PDAM Solo is reasonably well managed with tariff increases in 2004 allowing PDAM to return to profitability. With over 55,000 connections PDAM Solo serves almost half its population. Water line losses of almost 30% are a cause for concern. A further reduction in this non-revenue water would improve both profitability and the PDAMs ability to achieve beneficial success with a private sector agreement. PDAM is somewhat highly leveraged with debts of about 2.5 times equity. With continued repayment of its debt, reductions to more manageable levels are possible. A major cause of PDAMs debt profile includes the development of wastewater treatment, which remains significantly unprofitable. It is our opinion that PDAM Solo is a creditworthy partner for cooperation with private sector but would benefit from improving its collection of fees for wastewater treatment. Current legislation allows PDAM to disconnect both water and wastewater for any delinquency in wastewater fees. This should allow PDAM to collect fees and ensure continued profitable operations. In addition, we would strongly recommend that continued reform be encouraged to reduce non-revenue water, lower staff per connection ratios and provide rewards and incentives for employees to participate in company growth. The project envisaged as a BOT water supply project will require some level of security for on-going payments to the BOT operator. The security is likely to take the form of an escrow fund, bank guarantee, letter of credit or other security device that will allow the Operator to draw funds if PDAM fails to pay. PDAMs current cash reserves may not be adequate to provide this security and any analysis must include a review of methods for securing future payments. Land for development of the WTP is included in the analysis and factored into the cost. PDAM will own that land but the full cost is factored into the BOT price. Rights of way are likely not to be an issue since the project is a BOT and does not require access to local property. Defining interconnection points and metering should be the only issue regarding land or rights of way. Rights for the transmission pipeline should likewise be incorporated in the agreement between Solo and Sukaharjo. Conclusions Rating these potential projects we must look upon this analysis to determine which locale is easiest and most difficult to accomplish a PPP. Working backwards, it is clear that Sepatan has the lowest level of community creditworthiness. PDAM and local government do not appear to be well financed or managed and significant land acquisition and right of way issues continue. Benda has the second most demanding community creditworthiness. This is a result of the form of partnership envisaged. Local government and PDAM are both well financed and managed but land acquisition issues and rights of way make this project somewhat problematic. In our opinion, the most creditworthy community is Solo. While concluding a PPP deal with Sukaharjo would be very difficult, assuming that the agreement between Solo and Sukaharjo addresses both parties concerns adequately to engage a private partner will allow the PPP to proceed with Solo. Solo’s local government and PDAM are adequately financed and managed properly. Concerns remain regarding wastewater treatment but we believe that this can be overcome and PDAM could afford to pay for water provided through new connections. It is essential, however, that new connections for consumers be prioritized by PDAM to generate adequate revenue to pay for water supply. 4. Form of Partnership We have included the form of partnership in our analysis as it is our opinion that certain partnership formats are easier to accomplish than others. Further creative approaches can enhance the partnership format to encourage private sector to participate while allocating all risks to private sector will discourage participation. Sepatan The Form of Partnership envisioned for Sepatan is a “Greenfield� Concession. In this form of partnership a private sector firm assumes all commercial risk for developing a new water system in a community. The trouble with this form of partnership is that there is great uncertainty that revenues and new connections will materialize. While the PPITA study indicates that the demand is there it still remains a considerable risk. No revenue will flow until the entire system is built and new connections are installed. We are concerned that this option may be unattractive to private investors without substantial support from government. Of further concern is the request on the part of local government that the Concessionaire guarantee that it will connect nearly 32,000 homes by 2010. Clearly it is in the interest of the Concessionaire to connect as many homes and businesses as possible. New connections equate to new sources of revenue. To place this condition on the Concessionaire clearly reflects the poor understanding that local government and PDAM have concerning PPP. It is interesting to note that PDAM has some 88,000 connections in mainly the most prime area of the Kabupaten. A major portion of PDAM’s income derives from BOT water sales to DKI Jakarta and others. It is our opinion that this form of partnership is very difficult and is likely to be unattractive for private partners. We suggest that local government explore the possibility of a complete delegated management of PDAM. In a delegated management concession, private sector would assume all water supply management duties of current PDAM staff. In addition, the Concessionaire would be required to invest in new supply and new distribution in areas like Sepatan. However, this would be attractive to private sector in that they would have immediate income, would work on improving performance and concentrate on new investment. Banks would be more inclined to lend to an on- going business rather than a high-risk venture. Benda Benda desires to enter into a combined project with a 50 l/s BOT combined with a 270 l/s Concession contract. The one benefit from this form of partnership is that from the date of operation, revenue for 50 l/s is virtually guaranteed, clearly enhancing the project risk profile. However, the remaining project depends on a “Greenfield� concession that is dependent upon local demand. Once again PPITA studies indicate that substantial demand exists, it still contains considerable risk. In this project there are fewer industrial customers envisaged there by depending to a much greater degree on household connections and the willingness of local citizens to convert from their existing water source to the newly formed water company. While we are certain demand exists, there still remains significant risk. Unlike Sepatan there is no requirement for achieving a certain level of connections by any specific date. However, PDAM operates its water supply network in the same region offering a competitor for private sector. We are of the opinion that PDAM is generally well managed but to encourage investment by private operators, they should consider offering the PDAM’s existing network in Benda and surrounds to have one larger contiguous system. It would provide immediate income for the investor with a requirement that they develop further capacity and connections. Surakarta and Sukaharjo This form of partnership is a BOT bulk water supply scheme with PDAM Solo purchasing all of the operator’s production. It provides immediate income from the date of operation. It is by and large a simpler form of partnership and income for the PDAM to pay for production fees is generated from new connections resulting from additional water supply. We would encourage PDAM make every effort to ensure the non-revenue water be reduced as much as possible. By so doing, PDAM will be able to take maximum advantage of the new supply available. Incidentally, normal project finance generally is more applicable for BOT scheme and usually not available for Concession or delegated management contracts. In a BOT there is assured income while with Concession forms, due to the increase in risk, project finance would likely be unavailable. Project finance is generally more highly leveraged and hence less equity is needed for this scheme. Conclusions The form of partnership is critical to project success. Here we assess the benefits of each form of partnership as a method for assessing which project has the highest degree of success. Once again in descending order, we feel that Sepatan’s form of partnership is by far the most difficult. As a “Greenfield� concession it offers lower immediate revenue potential, contains the highest degree of commercial risk and further requires a specific number of connections within a specific time period, which may or may not be achievable. Benda would be our second choice in part due to the BOT element that allows for a certain level of income immediately available for the Operator. However, we feel that this opportunity would be greatly enhance to make it our likely first choice if PDAM Tirta Banteng’s entire Benda operation were included in the Concession Agreement. Solo’s form of partnership is clearly the most straightforward. It offers a simple agreement with a take or pay contract and immediate income at the moment operations begins. We believe that this project can be more highly leveraged as a result of the cash flow from income generated by the continuing water sales. We must believe that this would be our first choice in comparison with its form of partnership. 5. Technical Considerations In this section we review the technical elements of each project. We will look at the type of project needed, the expected investment, operating issues and other elements of a technical nature that will be a factor in determining which of the projects is most beneficial and favorable for investment. Table 1 below presents a series of factors for review. Factor Sepatan Benda Solo/Sukaharjo Total Investment in Rp. 145 billion Rp.185 billion Rp. 49 billion Rupiah Total Investment in $ 16 million $20.5 million $5.4 million US Dollars New Connections 31,900 10,600 38,000 Population Served 158,000 50,000 190,000 Factor Sepatan Benda Solo/Sukaharjo New Production 320 400 200 Capacity (l/s) Intake Capacity 350 424 330 (l/s) Land Investment None Stated None Stated Rp. 2 billion Required (PDAM) Targeted continuity 24 24 24 (hrs./day) Initial avg. Tariff Rp. 3,150 Rp. 3,800 Rp. 1565 (per m3) Raw Water Source Cisadane–Uncertain Cisdane – Uncertain Bengawan Solo – no SIPA issued no SIPA issued SIPA available Reviewing the technical data we have the following comments. Sepatan Development of Sepatan would require an outlay of some $16 million. While this is substantial the number of new customers is quite significant, almost 160,000 people would receive a piped supply of clean water where in the past water may not have been as plentiful or as pure. The tariff envisaged is reasonable and only slightly higher than the tariff provided to existing customers. The tariff benefits from the anticipated use of water by industrial users who cross subsidize those households in the area. Benda The cost to develop Benda is the most expensive at over $20 million. This high cost is a result of the disparate nature of the service area. It is not contiguous and requires the laying of a significant amount of distribution pipe to cover this fairly large area. While we do not have information regarding combining this with the existing piped system in the area, it would almost certainly gain from economies of scale should the existing pipe network be expanded rather than developing a brand new network unlinked to existing customers. Tariffs at current prices are about 40% above tariffs in Kabupaten Tangerang presently. If this new system was developed there is concern that many would complain and force the government to rescind the agreed tariff or the government would be forced to subsidize the project. Finally the project connects only 10,600 households. This appears a meager sum for such an expensive project. Sepatan anticipates providing over 30,000 connections and providing water for 160,000 people. In Benda that total is only 10,000 and 50,000 new customers. It should be noted that the sale of 50 l/s to PDAM under a BOT arrangement will provide for a number of new customers but the report is unclear as to how many new customers would be connected. Surakarta and Sukaharjo The number of connections stated above may be significantly overstated. The Pre-FS team had explored a number of scenarios that included and excluded Sukaharjo. As stated above, after careful consideration, Sukaharjo was eliminated from consideration at least initially because it was felt that Sukaharjo did not have the financial capacity to complete a private transaction and by reducing non-revenue water from approximately 50% to a more manageable 35% sufficient water could be made available to meet current needs. Finally, household tariffs at 2004 prices would be below the cost of the bulk water. Hence the project would best sell water directly to Solo and once Sukaharjo reached a critical level and tariffs increased sufficiently they could contract directly with the investor. Unfortunately the Financial Analysis was a version that includes both Solo and Sukaharjo. Therefore the total number of new connections noted in the Pre-FS is materially different from the number of connections that will be realized. It should be noted that the cost of water supplied by the investor is likely low enough to be of interest to PDAM Solo. Current tariffs average almost Rp. 1,800/m3. While the margin is small at the moment, tariff increases over time will afford PDAM to make profit on water sold and distributed. It is understood that land will need to be acquired to site the WTP. However, this should not present major problems as PDAM has agreed to acquire the land and will assign its use to the private sector for project development. Conclusion Rating each project based upon technical merits is entirely subjective. However, to be fair the project that promoted the most connections in our opinion should be the highest rated project. Because of the inability to assess fairly the number of connection for Solo, we have reduced the connections by one-third to project approximately 25,000 connections. From this measure we can see that Benda is the least attractive, Solo second and Sepatan first. We had originally thought of assessing the cost per connection as a way of comparing projects. However since Solo is a BOT and no reticulation is involved in the project it would clearly unfairly prejudice the analysis. Finally, in terms of total cost, which would make each project more or less attractive to bankers, the larger the project the more interesting the project would be. By that measure Benda is clearly the largest. However, in a project the size of Solo, it could just be small enough for private investors to take an interest. First, by PPP standards, it is a simple design, the investment is reasonably easy to arrange and could become a good working model for other such developments throughout Indonesia. One of the conundrums of development is that it takes almost the same amount of money to develop a small project as it does a larger one. The same reports, pre-qualification criteria, request for proposal and contract development must be entertained. 6. Recommendations From the analyses above we can draw certain conclusions. However to recapitulate the scoring for projects we present the following: Factor Sepatan Benda Solo/Sukaharjo Creditworthiness 3 2 1 Partnership 3 2 1 Technical 1 3 2 Average 2.33 2.33 1.33 From the analysis it can be seen that the Solo project would be the most beneficial. However, we continue to feel strongly that by modifying Benda to include a concession for the entire region of Benda and it surrounds the project can combine the existing system and customer base along with new development to meet customer needs in the entire area. Despite the arithmetical analysis, we must explore intangibles in order to render a final opinion. Benda has such a low number of connections for such a high cost we are fearful that without altering the structure this project would not succeed. It is the project that would most benefit from restructuring the deal. Sepatan could succeed along with other areas such as Ciparens if a complete delegated management concession was offered. This would be extremely attractive to private sector and would be financeable partly through existing cash flows. Of course this form of partnership is the most complex and would require participation from the Ministry of Finance as well as local government. We strongly urge all parties to examine this potential closely. Ultimately, by restructuring management through private sector means, current debts could be paid, additional water can be supplied to the community and unserved areas can receive water for the first time. We understand that there is some resistance to cooperation between Solo and the private sector. We feel that this resistance stems from a lack of understanding of the nature of the cooperation. In this instance, a well-managed PDAM would only purchase bulk water from a supplier and existing funds can be more effectively used in expanding distribution and coverage. The income generated by expanding PDAM coverage can be reinvested in further development until coverage stands at 100%. Discussion and presentations to local government and the community would go a long way toward explaining the benefits of this approach and articulate the win-win nature of this form of cooperation.