PERU NATIONALRURAL WATER SUPPLY AND SANITATION PROJECT (Loan No. 7142-PE) PROPOSEDAMENDMENTAND RESTATEMENTOF THE LOANAGREEMENT , PART I -BACKGROUND 1. PRONASARis aUS$80 millionproject supportedby an IBRD loan (7142-PE)ofUS$50 million, which was approved on August 29, 2002 and became effective on March 12, 2003. The Project is designed to increase the sustainableuse of water supplyand sanitationfacilities in rural areas andsmall towns while emphasizing improvements in hygiene practices and training in operation and maintenance. To achieve this objective, the loan includes the financing of the following four components: (i) US$40.9 million for the rehabilitation and expansion of existing water and sanitation systems (80% of the component)and the constructionof new systems (20% of the component) in rural areas; (ii) US$2.6 million for the improvement of service quality, rehabilitation and expansion of water supply and sanitation systems in small towns; (iii) US$1.6 million for consultant services to enhance public sector capacityin the rural water and sanitation sector; and (iv) US$2 million for project management, supervision, monitoring, evaluation and audits for MVCS. The project's closing date is December 31,2008. 2. To date, approximatelyUS$6 million (12%) of the loan has been disbursed (the original disbursement estimate through January 2006 was 65% of the loan amount), with total commitmentsof US$9.1 million (19%).The key constraintsin project implementationinclude: Institutional changes in Peru: FONCODES was establishedin 1991as an autonomous public entity, with independent governance and administrative systems. In June 2003, after loan effectiveness, FONCODES was transferred to MIMDES which required that the social fund assume the Ministry's complex and highly centralized administrative and fiduciary procedures thereby constraining the agency's ability to effectively implement the project. Under, new budgetary processes, yearly Execution Agreements between FONCODES and MVCS were required to authorize disbursementsunder component 1 of the project. Signing annual Execution Agreements, however, delayed implementationbetween 4 to 8 months in each of the first 3 years of project's execution, severely limiting the implementationprogress of the component. Also in 2003, in the context of the Government of Peru's decentralization agenda, central government transfers toFONCODES were reduced while transfers to sub- national governmentswere increased. Lack of adequate resources and capacity for the implementation of Component 1 by FUNCODES: Under the original project design, FONCODES would use own resources for the management and supervision ofComponent 1. However, due to changes in the intergovernmental transfer system, the social fund was unable to assign adequate budget to project management activities. Additionally, FONCODES staff assigned to the project implementationdid not have adequatecapacity andexperience. Resistance to change in FONCODES: PRONASAR's innovativeproject cycle was designed to address issues of sustainability and rehabilitation of deteriorated systems built by FONCODES under previous administrationsthrough enhanced community participation and improved project preparation. However, the focus FONCODES of staff during implementation has remained on the execution ofworks with minimal consideration for community capacity building and participation. FONCODES staff continues to view the c project's emphasis on social activities, a longer pre-investment period and communityand district municipality co-financingas unnecessary. Diffusion of responsibilities: Implementation ofComponent 1by two agencies,under two different Ministries, has resulted in unduly cumbersome implementation procedures and slowed project execution. The presence of multiple executing agencies has also generated an atmosphere of rivalry and lack of accountability making it difficult to identify and correct problems. Atomized procurementarrangements: The initial tenderingprocess was designedin small lots that were ultimately unattractiveto local private firms. Many lots failed to attract any bids at all. The initial tendering process was also delayed due to the lack of counterpart familiarity with Bank norms and procedures. This situation was partially corrected for the second tenderingprocess, wherenew contractswere designedwith a larger scope. Lack of financial resources for training at all levels, including district municipalities, consultants, and central government officials: The capacityof water userassociations,district municipalities and of the regional officials of FONCODES was significantly overestimated during project preparation and hence the need for intensive training and capacity enhancement was not incorporated into the original project design. It was only during implementation that the scope of the capacitygapsbecame apparent. Additionally,the Government did not consider it appropriateto use loan proceeds to finance training activities, concentrating instead on physical works. The lack of adequate training resources hampered the ability of both FONCODES and MVCS to invest in improvedstaff capacityto takeon the challenges impliedunder the new project cycle. Implementation status was downgraded in October 2004 due tothese factors. The Bank team has subsequently been working with the authorities to develop different approaches to improve project implementation including an independent institutional assessment which made, recommendations on alternativeapproachesfor improved implementation. During the Mid-Term Review (September2005) the Bank team reached an agreement with the Government onthe need to find an alternative to FONCODES for the implementationof Component 1.The team and the Government subsequently engaged in detailed discussions on alternative implementation arrangementsand the draftingand negotiation of the attachedrevised loan agreement. 3. Implementation progress has been satisfactory for component 2, which is executed directly by the MVCS. This component aims to delegate the provision of water and sanitation services to specialized operators in 12 smalltowns (district municipalities) in Peru. The decentralizationprocess has generated an increased demand for technical and investment support from district municipalities to further improve basic services. During appraisal it was expected that services in district municipalities neededonlymarginal investments, thus the component represented only 5% of the total project amount. However, a detailed assessment of municipal water and sanitation services in a sample of municipalities carried out by MVCS has found that the water and sanitation situationin most towns is far worse than expected. PART 11-PROPOSED AMENDMENT 4. After the proposed amendment,the project will continue to support two of the pillars in the CAS: Equity and socialjustice, including access to basic services, and the support of a more decentralized state. Increased and sustainableaccess to water and sanitation servicesin rural and small towns where poverty is heavily concentrated is in line with the strategic objectives of the CAS related to having a direct impact on the lives of the poor. The proposed implementation arrangements will enhance the role of district municipalities in project planning, financing and implementation,thus supportingongoing decentralizationeffortsby the Government. 5. The changes needed to improve project implementationinvolve a major amendmentand restatement of the Loan Agreementincluding: Implementation Arrangements. The proposed amendment will concentrate full implementationresponsibility for project execution within the MVCS, the Ministryin charge' of the water and sanitation sector in Peru. The MVCS will be responsible for all procurement' and fiduciary processes related to the project including payments, financial transfers, contracting and no objectionrequests. The Ministry's procurementand financialmanagement capacity has been assessed by the Bank, as it currently executes other components. Improvements to streamline its processes will be introduced as part of theRevised OperationalManual. Reallocation of loan proceeds among components. This amendment includes the reallocation of loan proceeds among components in the followingway: (i) increasing financing under Component 2, Water supply and Sanitation inSmall Towns, by US$3.7 million, with the objective of meeting the demand from 15 additional small towns willing to delegate the provision of water and sanitation servicesto autonomous, specializedoperators; (ii) increasing financing by US$1.1 million for Component 4, Project management, monitoring, evaluation, audits and supervision to enable MVCS to effectively implement Component 1; and (iii) using US$2.4 million from the unallocated category and a reduction of US$2.4 million from Component 1 to pay for the increased expenditures under Components 2 and 4. The Government's decision to reduce the scope of the rural component is also informed by availability of donor resources for water and sanitation in rural areas. However, PRONOSAR is the only current source offinancein the sector for small towns. Modifyprocurement arrangements.The amendment will provide an opportunity to use the updated Bank Procurement Guidelines (May 2004) which allow for increased flexibility and faster implementation. Additionally,the ceiling for goods and services, other than consultant service contracts using national competitive bidding, has been increased to US$ 350,000 based on current cost estimates and MVCS' enhanced experience in procurement management. 0 Introduce training as a disbursement category. The introduction of a training category will help improve quality of project implementation.The proposed amendment would allow the use of loan proceeds for the training of community beneficiaries, water boards, municipalities, sector professionals and government officials to enhance the skills and knowledgenecessary to implementprojects based on communityparticipationmethodologies and the use of appropriateengineeringdesignsto achieve sustainabilityof the interventions. 0 Update performance indicators to reflect major changes to the loan agreement. The restructuring of the Loan has required a reassessment of project scope and targets based on current costs and demands from district municipalities. Based on this reassessment, the expectednumber of project beneficiarieshas been revised modestly from 875,000 to 81 1,000, of which 686,000 will benefit from the rehabilitation and construction of rural water and sanitation systemsunder component 1and 125,000will benefit from improved servicesunder the small towns component. 6. Updateeconomic analysisandloan closingdate. The revised economic feasibilityof the project was based on an analysis of a sample of subprojects and presents a positive net present value of US$22 million and an internal rate of return of 22%. The original closing dateof December 31, 2008 will remain the same; with project implementation expected to catch up, due to parallel implementation in different provinces andimproved procurement arrangements that will allow for acceleratedand more effectiveimplementation. 7. Conditions of Amendment Effectiveness. The following conditions were identified by the project team and approved by the Government during technical discussions,as necessary for the Amendmentto become effective.Theyhave been includedin the attachedAmendment: The Revised Operational Manual is satisfactory to the Bank. MVCS has already submitteda draft operations manual, and it is anticipated that a Manual acceptable to the Bank will be finalizedprior to effectiveness. All existing contracts with specialized consultant firms are amended by FONCODES and by the MVCS. The Ministry has initiated negotiations with the firms to transfer contracts from FONCODESto MVCS. An Execution Agreement between FONCODES and MVCS for 2006 is signed. The Agreementhas been prepared, signedby MVCS and ispendingthe signatureof MIMDES. The Annual Implementation Program for 2006 (including the Annual Procurement Plan) is, prepared and satisfactory to the Bank.This conditionhas been met. A legal opinion is produced that is satisfactory to the Bank, showing that the proposed Amendment has been duly authorized and delivered on behalf of the Borrower andis legally binding upon the Borrower in accordance with its terms;and all the existing contracts mentioned above have been duly amended and executed, and are legally binding upon FONCODES, PIU and contractorsin accordancewith their terms.