Report No. 33483-MX Mexico Infrastructure Public Expenditure Review (IPER) October 24, 2005 Colombia Mexico Country Management Unit Finance, Private Sector and Infrastructure Unit Latin America and the Caribbean FOR OFFICIAL USE ONLY Document of the World Bank 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. ABBREVIATIONS AND ACRONYMS ADB Asian Development Bank AFORES Mexican private pension funds ANEAS National Association of Water and Sanitation Companies, (Asociacidn Nacional de Empresas de Agua y Saneamiento) APAZU Water Supply, Sewerage, and Sanitation Program in Urban Areas, (Programa de Agua Potable, Alcantarillado y Saneamiento en Zonas Urbanas) APIs Port Authorities Administration, (Administraciones Portuarias Zntegrales) B A N O B R A S National Development Bank for Public Works and Services, (Banco Nacional de Obras y Sewicios Ptiblicos) BLT Build-lease-transfer BOT Build-operate-transfer C A M M E S A Electric Wholesale Market Company of Argentina, (CompaAia Administradora del Mercado Mayorista Elkctrico, S.A. de Argentina) CAPUFE Federal road and bridges, (Caminos y Puentes Federales) CAS Subordinated Contribution Agreement, (Compromiso de aportacidn subordinada) CCA Water Advisory Council, (Consejo Consultivo de Agua) CCP Puebla Public toll roads, (Carreteras de Cuotas Puebla) CEA State Water Commission, (Comisidn Estatal de Agua) CEMCAS Training Mexican Center of Water and Sanitation, (Centro Mexican0 de Capacitacidn de Agua y Saneamiento) CENACE National Energy Institute, (Centro Nacional de Control de Energla) CEPAL Latin American National Economic Commission, (Comisidn Econo'mica para America Latina) CFE National Electric Commission, (Comisidn Federal de Electricidad) CNA National Water Commission, (Comisidn Nacional del Agua) CNBV National Banking and Securities Commission (Comisidn Nacional Bancaria y de Valores) CNSF National Bonds and Insurance Commission, (Comisio'n Nacional de Seguros y Fianzas) COFEPRIS Federal Commission for the Protection of Sanitary Risks (Comisidn Federal para la Proteccidn contra Riesgos Sanitarios) CONAE National Commission o n Energy Conservation, (Comisidn Nacional Ahorro de Energia) CONSAR National Commission o n the Retirement Savings System (Comisidn Nacional del Sistema de Ahorro para el Retiro) COPLADEs State planning committees, (El Comitt?de Planeacidn para el Desarrollo del Estado) CPS Country Partnership Strategy CRE Energy Regulatory Commission, (Comisidn Reguladora de Energi'a) DGCC General Directorate o f Road Maintenance Egresos Subsecretariat o f Spending EPA Environmental Protection Agency FOR OFFIcI[AE USE ONLY This document has a restricted distribution and may be used b y recipients only in the performance of their official duties. I t s contents may not be otherwise disclosed without W o r l d Bank authorization. FAIS Fund to support social infrastructure (Ramo 33) FARAC Trust Funds to Recover Roads Concessions, (Fideicomiso de Apoyo a1 Rescate de Autopistas Concesionadas) FINFRA Infrastructure Investment Fund, (Fondo de Znversidn en Znfraestructura) FISM Municipal Social Infrastructure Fund, (Fondo de Znfrastructura Social Municipal) FSA Financial Security Assurance GDP Gross domestic product HDM Highway Design and Maintenance Standards Model ICT Information and communication technology IDB Inter-American Development Bank EM Internal energy market IIE Electricity Research Institute, (Instituto de Znvestigaciones Electricas) IMCO Mexican Competitiveness Institute, (Znstituto Mexicano de la Competitividad) IMD International Institution for Management Development IMF International Monetary Fund IMP Mexican Petroleum Institute, (Instituto Mexicano del Petr6leo) IMTA Mexican Center for Water and Sanitation Training, (Instituto Mexicano de Tecnologia del Agua) INDEVAL Securities Institute, (Znstituto para el Depo'sito de Valores) INEGI National Institute o f Statistics, Geography and Computer Science, (Znstituto Nacional de Estadistica, Geografia e Znformdtica) INTERAGUA International Water Services IPER Infrastructure Public Expenditure Review IPP Independent power providers IRR Internal rate o f return LAC Latin America and the Caribbean LFC Power and Electricity o f the Center, (Luz y Fuerza del Centro) MDGs Millennium Development Goals MIGA Multilateral Insurance Guarantee Agency MW Megawatt NAFIN National Financing, (Nacional Financiera) NAFTA North American Free Trade Agreement NPV Net Present Value NRW Non-revenue water NSC N e w Concession Scheme NSIP Public Investment N e w System, (Nuevo Sistema de Znversidn Pu'blica) O&M Operation and maintenance OCALFA A l f a Highway Operator, S.A., (Operadora de Carreteras Alfa, S.A. de c.V.) OECD Organization for Economic Co-operation and Development 00s Water Utilities, (Organismos operadores) OPF Financed Public Works, (Obra Pu'blica Financiada) PAHO Pan-American Health Organization ... 111 PEMEX Mexican Petroleum, (Petrdleos Mexicanos) PER Public Expenditure Review PIARC World Road Association PIDIREGAS Projects with Deferred Impact in the Budgetary Registry, (Proyectos de Impact0 Dferido en el Registro de Gusto) PMI International Mexican Petroleum, (Petrdleos Mexicanos Internacional) PND National Development Plan, (Plan Nacional de Desarrollo) PNH National Hydraulic Plan POAs Annual Operative Programs PPI Private sector participation in infrastructure PPIAF Public-Private Infrastructure Advisory Facility PPP Public-private partnership PPPS Public-Private Projects, (Proyectos para la Prestacidn de Sewicios) PRODDER Water Rights Return Program, (Programa de Devolucidn de Derechos) PRODES The basin restoration program PROMAGUA Program for the Modernization of Water Utilities, (Programa para la Modernizacidn de Organismos Operadores de Agua) PROPIMI Pilot Program for Integral Maintenance, (Programa Piloto de Mantenimiento Integral) PROSSAPYS Program for Sustainable Drinking Water and Sanitation Services in Rural Communities, (Programa para la Sostenibilidad de 10s Servicios de Agua Potable y de Saneamiento en Communidades Rurales) PSBR Public Sector Borrowing Requirements PSP Private sector participation SAGARPA Ministry of Agriculture, Rural Development, Fishing and Food, (Secretaria de Agricultura, Ganaderia, Desarrollo Rural, Pesca y A 1imentacidn) SCT Ministry of Communications and Transport, (Secretaria de Comunicaciones y Transportes) SEDESOL Ministry of Social Development, (Secretaria de Desarrollo Social) SEMARNAT Ministry of Environment, (Secretaria de Medio Ambiente y de Recursos Naturales) SENER Ministry of Energy, (Secretaria de Energia) SFA Water Financial System, (Sistema Financier0 del Agua) SHCP Ministry of Finance and Public Credit, (Secretaria de Hacienda y Crkdito Pdblico) sP P I Investment Projects Information System, (Sistema de Informacidn de Proyectos de Inversidn) SNGs Subnational governments (states and municipalities) SOAPAP Water Utility Company o f the State of Puebla, (Sistema Operador de 10s Sewicios de Agua Potable y Alcantarillado del Municipio de Puebla) SPP Ministry of Budgeting, (Secretaria de Programacidn y Presupuesto) SPV Special purpose vehicle SSE Vice-Ministry of Expenditures, (Subsecretaria de Egressos) SSI Vice-Ministry of Income, (Subsecretaria de Ingresos) iv SUIBA Unified Basic Water System, (Sisterna Unifcado de Informacidn Bdsica del Agua) svv (Santiago-Valparaiso-Vi Aa) TAPSA Water Treatment of Puebla, S.A., (Traturniento de Agua de Puebla, S.A. de C.V.) TEU Twenty-feet equivalent unit UDIs Inflation-Linked Units UNICEF United Nations Children’s Fund U.S. United States WDI World Development Indicators WEF World Economic Forum wss Water Supply and Sanitation WHO World Health Organization WWTPs Wastewater treatment plants V Table of Contents . 1 AN OVERVIEW OF INFRASTRUCTURE SECTORS IN MEXICO ........................................... 1 A . Overview of Infrastructure Investments ..................................................................... 1 B. Transport ..................................................................................................................... 4 C . Electricity .................................................................................................................... 7 D. Water Supply and Sanitation .................................................................................... 10 2 . PERFORMANCE OF INFRASTRUCTURE SERVICES ............................................................ 15 A . Electricity.................................................................................................................. 17 Outcomes ................................................................................................................... 17 Tariffs and Cost Recovery ......................................................................................... 20 Spending .................................................................................................................... 25 B. Water Supply and Sanitation ..................................................................................... 26 Outcomes ................................................................................................................... 26 Tariffs and Cost Recovery ......................................................................................... 29 Spending .................................................................................................................... 32 C . Roads......................................................................................................................... 34 Outcomes ................................................................................................................... 34 Tariffs and Cost Recovery ......................................................................................... 36 Spending .................................................................................................................... 36 D. Railroads ................................................................................................................... 37 E. Ports........................................................................................................................... 39 F. Conclusion ................................................................................................................. 42 3 . BUDGETING, PLANNING, AND COORDINATION .................................................................. 43 A . Budget Cycle-Investment Planning, Annual Budget, Execution, and Evaluation .43 Common Elements..................................................................................................... 43 Transport .................................................................................................................... 47 Electricity ................................................................................................................... 56 Water Supply and Sanitation ..................................................................................... 59 Lessons from Multisector Evidence .......................................................................... 67 . . B. Intrasectoral Coordination......................................................................................... 68 Transport .................................................................................................................... 68 Electricity ................................................................................................................... 69 Water Supply and Sanitation ..................................................................................... 70 Financing ................................................................................................................... 72 C . Conclusions and Challenges ..................................................................................... 72 4 . FINANCING MEXICO’S FUTURE INFRASTRUCTURE INVESTMENTS .............. 75 A . How much? Meeting the Infrastructure Needs of Tomorrow ................................. 75 Simple Benchmarking ............................................................................................... 76 Costing Set Targets-Pricing Universal Service Access .......................................... 77 Sophisticated “Benchmarking”-Econometric, Macro Models ................................ 78 Sophisticated “Set Target”-Engineering-Economic Model Used b y Mexican Agencies .................................................................................................................... 79 vi Pulling i t All Together ............................................................................................... 80 Implications for Financing Needs .............................................................................. 83 B. W h o finances the Infrastructure? ............................................................................. 84 H o w to Maximize the Efficiency Impact of PPI ....................................................... 85 Levels o f Private Participation in Mexico’s Infrastructure........................................ 85 Forms o f Private Participation in Mexico’s Infrastructure ........................................ 86 Effects of Mexico’s Imbalanced Approach to the Use o f the Private Sector ............ 88 C. How Infrastructure I s Financed: Current Experience with Credit- Enhancement Schemes in Mexico ........................................................................................................ 89 Analyses o f Selected Existing Infrastructure Programs ............................................ 89 D. Recommendations ..................................................................................................... 94 Improving the Federal Government’s Instruments to Achieve Desired Infrastructure Outcomes with Sub-sovereign Projects ..................................................................... 95 Reducing Currency Risk and Mobilizing Long-term Financing through the Greater Use o f Local Financial Markets................................................................................. 96 Altering the Use and Design o f Guarantees .............................................................. 99 Migrating Toward More Balanced Market Structures in Electricity and Water .....100 Redirecting B A N O B R A S Activities toward Complementing the Market .............101 Improving Program and Product Design ................................................................. 102 5 . A WAY FORWARD FOR INFRASTRUCTURE FINANCE ..................................................... 104 A . Synthesis of Findings............................................................................................. 104 B. Integration o f Recommendations ........................................................................... 108 C . Prioritization o f Recommendations ....................................................................... 115 6 . . NWATER ANNEX A NATIONAL FEDERAL ORGANIZATIONS AND PROGRAMS I SUPPLY AND SANITATION ................................................................................................................. 120 7 . . ANNEX B PAYMENT FOR ENVIRONMENTAL SERVICES IN WASTEWATER TREATMENT-AN EXAMPLE OF PERFORMANCE-BASED TRANSFERS .............................. 123 8. ANNEX C. INTERNATIONAL EXPERIENCE IN THE USE OF THE PRIVATE SECTOR 124 9. ANNEX D. PUEBLA TOLL ROAD SECURITIZATION-THE USE OF SPECIAL- PURPOSE VEHICLES TO MOBILIZE SUB-SOVEREIGNFUNDS ................................................ 131 10. ANNEX E. THE PUEBLA BOT BUYBACK.......................................................................... 134 11. ANNEX F. CHILE TOLL ROAD CASE: USE OF MULTILATERAL GUARANTEES TO EXTEND TERMS AND ENTICE DOMESTIC PENSION FUNDS.................................................... 136 12. ANNEX G. TOLL ROAD TOLUCA-ATLACOMULCO-THE USE OF LIMITED CONTINGENT CREDIT LINES ............................................................................................................ 138 13. ANNEX H. GUAYAQUIL WATER AND SANITATION: USE OF A MULTILATERAL GUARANTEE TO COVER NEGATIVE CONTINGENCIES IN A MUNICIPAL WATER PROJECT .................................................................................................................................................. 140 14. ANNEX I . TLALNEPANTLA MUNICIPAL WATER COMPANY: A STRUCTURE FOR SUSTAINABLE FINANCING AT THE LOCAL LEVEL IN MEXICO ............................................ 141 15. BIBLIOGRAPHY....................................................................................................................... 144 vii List of Tables Table 1: Comparative Survey on the Quality o f Infrastructure. 2003. Selected Countries ........................................................................................................................................... x v Table 2: Quality o f Electrical Service. 1995-2003 .......................................................... xvi ... Table 3: Mexico’s Water and Sanitation Coverage i s comparatively High ..................xviii Table 4: Non-Revenue Water in Mexico compared to other countries ............................. x x Table 5: Water-Tariff Collection Efficiency ................................................................... xxv Table 6: Public Investment in Mexico. 1993-2003 ....................................................... xxix Table 7: Public Infrastructure Investment. 1998-2003 .................................................. xxix Table 1.1: Public Investment in Mexico. 1993-2003 .......................................................... 2 Table 1.2: Public Infrastructure Investment. 1998-2003 ..................................................... 3 Table 1.3: Estimate o f Subsidies for Electricity. 2003 ........................................................ 4 Table 2.1: Comparative Survey on the Quality o f Infrastructure. 2003 ............................ 15 Table 2.2: Mexico’s Electricity Coverage i s Comparatively High.................................... 17 Table 2.3: Quality o f Electrical Service. 1995-2003 ......................................................... 18 Table 2.4: CFE: Degree o f Cost Recovery. Price to Cost Ratios (%) ............................... 21 Table 2.5: International Electricity Prices for Households (U.S. dollars per kilowatt-hour) ........................................................................................................................................... 23 Table 2.6: International Electricity Prices for Industry (U.S. dollars per kilowatt-hour) ..23 Table 2.7: Mexico’s Water and Sanitation Coverage i s Comparatively High .................. 27 Table 2.8: Non-revenue Water in Mexico Compared to other Countries.......................... 29 Table 2.9: Collection Efficiency ........................................................................................ 31 Table 2.10: Road Network. in Kilometers. 2000 ............................................................... 35 Table 2.1 1: Railroad Efficiency Indicators ........................................................................ 38 Table 3.1: Evolution o f Resources for Highways in the Budget Process (Year 2003. in 1.000 millions o f Mexican pesos) ...................................................................................... 52 Table 3.2: Subsidies and Aprovecharnientos 1997-2003 ................................................... 57 Table 3.3: Level o f Water Abstraction Charges ................................................................ 60 Table 4.1: Different Approaches to Estimating Expenditure Needs in Infrastructure ...... 76 Table 4.2: A Simple Benchmarking Exercise: What Would i t Cost for Mexico to Achieve the Infrastructure Coverage o f Korea. the East Asia Median............................. 77 Table 4.3: Estimated Annual Investment “Needs” for Infrastructure. Based on Predicted Demand for Infrastructure Services-Fay and Yepes Approach ...................................... 79 Table 4.4: Annual Expenditures in Roads. Electricity. and Water and Sanitation Infrastructure - Past and Predicted ................................................................................... 3 2 Table 4.5: Conditions for FINFRA Financing................................................................... 90 Table 5.1: Principal Recommendations b y Sector and Theme ........................................ 109 Table 5.2: Mexico: PER-Prioritization o f Recommendations ..................................... 117 Table 5.3: MX: PER-Challenges in Implementing Longer-Term Recommendations 119 Table 8.1: A Sample o f Public and Private Contributions to Toll Roads in East Asia ...125 Table 8.2: Private Participation in Water Services in 2002 ............................................. 127 Table 8.3: Different Indicators o f Water Reforms........................................................... 128 Table 9.1: Transaction for the Securitization o f the V i a Atlixcayotl .............................. 131 ... Vlll List of Figures Figure 1: Annual Interruptions (minutes) per Electricity Connection ............................. xvi Figure 2: Electricity Distribution Losses (%) ................................................................. xvii Figure 3: Number of Electricity Connections per Worker in Distribution Segment ...... xvii Figure 4: Quality of Water Service in Mexico ................................................................ xix Figure 5: Quality of the Road Network. 2000 ................................................................. x x i Figure 6: Distribution of Electricity Subsidies by Household Decile ........................... xxiv Figure 7: Post Tariff for a 2. 800 Twenty-feet Equivalent Unit (TEU) Ship (thousand dollars) ........................................................................................................................... xxvi Figure 8: The Share of PPI Allocated to Greenfield Projects Has Been Particularly High in Mexico. 1990-2003.................................................................................................. xxviii Figure 1.1: Public Infrastructure Investment. 1998-2003 in MxPm. b y Sector .................. 3 Figure 1.2: Organization Chart of the Secretariat of Communications and Transport and other National Highway Institutions .................................................................................... 5 Figure 1.3: Structure of the Energy Sector .......................................................................... 8 Figure 1.4: Water Institutions ............................................................................................ 10 Figure 1.5: CNA Expenditures and Revenues 1998-2004 in M x P million ....................... 12 Figure 2.1: Annual Interruptions (minutes) Per Connection ............................................. 18 Figure 2.2: Distribution Losses (%) ................................................................................... 19 Figure 2.3: Number of Connections per Worker in Distribution Segment........................ 20 Figure 2.4: Prices of Electricity in Selected Latin American Countries. 2002.................. 22 Figure 2.5: Distribution of Subsidies. b y Household Decile ............................................. 24 Figure 2.6: Household Decile b y Total Income. 2002....................................................... 24 Figure 2.7: Investment in the Electricity Sector ................................................................ 25 Figure 2.8: Investments in Electricity as a Share of GDP-International Comparison ....26 Figure 2.9: Quality of Water Service in Mexico ............................................................... 28 Figure 2.10: Investment in Water as a Share of GDP - International Comparison ...........32 Figure 2.11: Estimated Funding o f Water and Sanitation Investment in 2004 ................. 33 Figure 2.12: Investment in Water and Sanitation by Subsectors. 1997-2002 (in constant prices) ................................................................................................................................ 33 Figure 2.13: Investment in Water and Sanitation by Urban and Rural Areas. 1997-2002 (in constant prices) ............................................................................................................. 34 Figure 2.14: Federal Investment in Roads (million pesos. constant 2003 prices) .............37 Figure 2.15: Railroad Tariffs Comparison ......................................................................... 39 Figure 2.16: Public and Private Investment in Railroads (million 2003 pesos) ................ 39 Figure 2.17: Port Tariff for a 2. 800 Twenty-feet Equivalent Unit (TEU) Ship (thousand dollars) ............................................................................................................................... 41 Figure 2.18: Public and Private Investment in Ports (million 2003 pesos) ....................... 41 Figure 3.1: 2001/2006 Program Original Goals and Expected Progress........................... 49 Figure 3.2: Planned Compared to Executed Highway Investments. A Sample of Projects ........................................................................................................................................... 54 Figure 3.3: Electricity Sector PIDIREGAS Investment Projects (million 2004 pesos) ....58 Figure 4.1 : Private Participation in Infrastructure Has Been Limited in Mexico. Relative to i t s Peers in Latin America. 1993-2002 .......................................................................... 86 ix Figure 4.2: P P I in Mexico has Disproportionately Favored Production and Generation Rather than Retail Utility. 1990-2003 ............................................................................... 87 Figure 4.3: The Share of PPI Allocated to Greenfield Projects Has Been Particularly High in Mexico. 1990-2003 ........................................................................................................ 88 Figure 4.4: Local Market and Institutional Investors Development (% o f GDP) .............97 Figure 4.5: AFORES’s Assets Under Management .......................................................... 98 Figure 4.6: Bonds as a Percent of Total Project Finance (1996-2004) .............................. 98 Figure 5.1 : Framework for Prioritization of Recommendations .................................... 116 Figure 9.1: Securitization of the Via Atlixcayotl Structure ............................................. 132 Figure 14.1: Tlalnepantla Municipal Water Structure ..................................................... 142 List of Boxes Box 3.1: Planning and Budget Integration: Past and Future Options ................................ 44 Box 3.2: Steps in Formulating the Federal Spending Budget ........................................... 45 Box 3.3: Procurement ........................................................................................................ 47 Box 3.4: Criteria Followed b y SCT for Setting Priorities for Road Investment ............... 5 1 Box 3.5: Pork-Barrel Spending.......................................................................................... 53 Box 3.6: Mexico’s System o f Water Abstraction Charges ................................................ 60 Box 3.7: Innovative Chiapas State Government Technical Assistance to Municipalities 62 Box 3.8: Decentralization of Water and Sanitation Services in Mexico ........................... 71 Box 4.1: The Growth Dividends of Better Infrastructure .................................................. 77 Box 4.2: Case Review: The Puebla BOT Buyback Compared to the Puebla Road Securitization ..................................................................................................................... 94 Box 4.3: Federal Influence to Improve Municipal Water Sector Policies ......................... 96 X Acknowledgments This report was prepared b y a team o f Bank staff led b y Gustavo Saltiel and Steven Webb, and structured on the basis o f specific sectoral inputs from Gabriela Elizondo Azuela (Electricity), Jose Barbero (Transport), and Manuel Schiffler (Water). Patricia Acevedo, Marianne Fay, Joshua Gallo, Jonathan Halpern, Ada Karina Izaguirre, Nicole Maywah, Jackson Morril, Jordan Schwartz, and Tito Yepes were also part o f the PER team. The study benefited from background papers prepared by the following consultants: Jose Luis Aburto and Ricardo Samaniego-Breach (Electricity), Luis Guerrero (Transport), Ruben Barocio and Arturo Jimenez (Water), Fausto Hernandez (Budget Institutions), and PROTEGO (Credit Enhancement Mechanisms). Coordination o f the PER chapters was organized in the following manner: Chapter 1: Gabriela Elizondo Azuela, Jose Barbero, Gustavo Saltiel, and Manuel Schiffler Chapter 2: Manuel Schiffler Chapter 3: Steven Webb Chapter 4: Jordan Schwartz and Marianne Fay with inputs f r o m Tito Yepes Chapter 5: Jonathan Halpern M a n y people in the Government o f Mexico, especially Dr. Luis Albert0 Ibarra (Chief o f the Investments Unit o f SHCP) and his team, in particular Jorge Castarih, Raul Flores, and Nicol6s Kubli, provided excellent guidance and collaboration in the preparation o f this report, as did the sectoral agencies involved in the infrastructure sectors reviewed (CNA for water, CFE for electricity, and SCT for transport). The report also benefited from the valuable comments o f Jose L. Irigoyen, Mary Morrison and the peer reviewers, William Dorotinsky, Robin Canuthers, and Caroline Van den Berg, whom we thank without implication for any errors that might remain. xi PREFACE Over the past five years, the W o r l d Bank has actively supported Mexico’s public finance reform agenda with lending and technical assistance. The main areas o f support have included tax and fiscal reform, fiscal sustainability, and fiscal management under decentralization. The Bank has also supported reforms in infrastructure through analytical work, which assessed the status and performance o f key infrastructure sectors, as well as the policy, regulatory, and institutional environment for involving the private sector in those sectors. A Public Expenditure Review, which analyzes the benefit incidence across households at different income levels and the geographic distribution o f federal spending in the states, was completed in 2004. This study was the initial piece o f programmatic analytical work on public spending in Mexico, as set forth in the Country Partnership Strategy (CPS) and continued with the present study. The previous studies gave some attention to public investment in infrastructure, but not in-depth analysis. Given the need to substantially improve the access t o and quality o f infrastructure services in a context o f tight public resources, a more thorough analysis o f public expenditures in infrastructure and other potential sources i s warranted. Therefore, the W o r l d Bank and the Ministry o f Finance and Public Credit (SHCP) agreed to prepare this Infrastructure Public Expenditure Review (PER) and, for this purpose, a close collaboration between the Bank team and the Investment Unit o f SHCP has been established. The PER supports three o f the four pillars o f the Mexico Country Assistance Strategy: Institutionality, Competitiveness, and Poverty Reduction. As part o f the analytic work on public finance, i t i s geared at improving the understanding o f critical governance and expenditure-allocation issues. Finally, given the multisectoral linkages o f infrastructure with poverty reduction, competitiveness, and growth, the study i s meant t o help clarify the agenda for the government’s strategy in all these subjects. The main objective o f the PER i s to present options for addressing infrastructure services needs in Mexico, including (a) improvements in program design and budget allocations, (b) efficiency gains in service provision, and (c) increased private sector participation and financing in a manner consistent w i t h the government’s goals for economic growth, and within i t s fiscal constraints. Three infrastructure sectors-water supply and sanitation, transport, and electricity- have been selected for inclusion in this PER for the following reasons: Impact on growth, trade, and competitiveness Social importance in terms o f poverty reduction Importance in the Government’s stated policy priorities. The study has been structured in five interrelated chapters as follows: xii Chapter 1 presents an overview o f the infrastructure sectors-agencies and aggregate spending-which sets the stage for the assessment o f the sectors’ performance and an in- depth analysis o f budgeting processes, planning, and coordination presented in subsequent chapters. Chapter 2 reviews the levels o f spending on the selected infrastructure sectors in Mexico, and existing cost-recovery mechanisms, and the related outcomes: quality and efficiency o f service, and extent of coverage being offered. T o explain these outcomes, Chapter 3 analyzes the processes o f planning, spending allocation, and coordination within and across subsectors. The role o f local governments and the nature o f incentives they face are also discussed. Chapter 4 discusses the effectiveness o f the existing programs in Mexico to encourage private participation and financing in the selected infrastructure sectors. The challenges for infrastructure development w i l l require new and different uses o f private sector financing and operations, and refined credit enhancement schemes to attract financiers, investors, and operators to Mexico’s infrastructure market, without placing unwarranted contingent liabilities on the government. Chapter 5 presents a series o f conclusions and recommendations to improve the efficacy o f Government’s interventions in the provision and financing o f infrastructure. Finally, since the study focuses principally on issues o f infrastructure spending and finance, i t does not address all facets o f infrastructure service delivery, nor does i t provide detailed roadmaps for implementation. Rather, this study should be viewed as a point o f departure for dialogue and consensus building on ways to better and more fully use current and potentially available resources in the provision o f basic infrastructure services. xiii Mexico: Infrastructure Public Expenditure Review (IPER) Executive Summary 1. In 2003, the Government o f Mexico spent about 1.2 percent o f gross domestic product (GDP) on infrastructure investment and maintenance (electricity, transport, water supply, and sanitation), and provided 0.7 percent o f GDP on untargeted consumption subsidies for the electricity sector. This i s a substantial amount o f resources, although not high by world standards, and yet the overall impact has been mixed. Mexico has a reasonable level o f coverage relative to Latin America (as i t should, given that i t i s one o f the richest countries o f the region); rail and port performance are reasonable by international standards, and some water utilities are well run. The quality and reliability o f infrastructure services, however, are generally below what could be expected o f an upper-middle-income country, and many poor Mexicans s t i l l lack access to basic services. In addition to hurting the standard o f living o f Mexican citizens, the poor quality o f infrastructure impedes competitiveness. 2. Looking forward, present spending levels may be sufficient for Mexico to achieve universal coverage in water and sanitation and electricity, t o modernize and complete i t s major transport corridors, and to improve the overall quality and reliability o f service. But this w i l l require substantially improved expenditure efficiency, a much more strategic use o f the private sector, and better targeting o f subsidies. Maintaining current government spending levels between 1 percent and 1.25 percent o f GDP, Mexico would remain around the Latin America average in both infrastructure coverage and expenditures, but i t would not reach the level o f infrastructure per capita o f the other OECD countries or faster-growing East Asian countries (such as Korea, which just a few decades ago trailed far behind Mexico in terms o f infrastructure endowments).' 3. A central message of this report is that the resources Mexico spends o n infrastructure could and should be better used. How the government uses i t s o w n resources i s one area for potential improvement: Public investment could be better focused on areas where private participation i s not likely to be forthcoming. Also, the public investment would generate higher social and economic returns if the process o f selecting and designing were improved. This would include focusing on relieving bottlenecks in the existing infrastructure networks and on creating new linkages. Greater expenditure efficiency could be achieved through improved coordination across agencies and levels o f government, the introduction o f multiyear planning and budgeting, and greater emphasis o n regular maintenance (as opposed to costly rehabilitation required because o f foregone maintenance). Better-targeted subsidies to help the poor would not only reduce the overall fiscal burden, but also avoid inflating demand (which in turn raises the need for further investments). A second area for potential improvement i s private sector participation in service delivery-increasing i t s volume, expanding its scope to include core utility services beyond the current confines o f greenfield up-stream production, and reducing i t s cost to Mexican tax payers by limiting the government In 1960 Korea had less than half Mexico's paved road density; today i t has 11 times more. In 1969, Korea had one-third the power infrastructure per capita o f Mexico; today i t has about three times as much. xiv guarantees to risks that private investors cannot control or predict (such as political intervention in the tariff- setting process). Finally, the resources o f both the public and private sector would have greater impact with the deployment o f mechanisms to foster greater transparency and accountability, including increased reliance on arms length regulation o f monopoly service providers. Coverage, Quality, and Efficiency: The Current Status of Infrastructure Services 4. Mexico has made steady progress in increasing the coverage o f roads, electricity, and water and sanitation over recent decades, reaching levels among the highest in Latin America. While there are s t i l l some gaps in access, notably in poor, rural, and indigenous communities, the main infrastructure challenges are in improving service quality and operating efficiency. Large industrial users ranked the average quality o f Mexico’s infrastructure somewhat below that o f most major Latin American and East Asian economies in a World Economic Forum survey (2004). The gap was widest for the quality o f electricity supply, and narrowest for ports and railroads (Table 1). Table 1: Comparative Survey on the Quality of Infrastructure, 2003, Selected Countries * “Overall Infrastructure” includes quality indicators from other sectors not shown above (that is, air transport and information and communication technologies). Note: Survey-based subjective evaluation on a scale from 1 - “underdeveloped and inefficient” to 7 - “as developed and efficient as the world’s best.” The higher the score, the better the quality. Source: WEF (2004). Electricity 5. The service quality o f Mexico’s main electricity provider, the Comisidn Federal de Electricidad (National Electric Company, CFE), has improved but s t i l l lags behind international standards and client expectations.* For example, when annual interruptions and distribution losses are compared to Latin American private distribution companies, * As measured by service interruptions and the number o f customer complaints. xv the CFE’s performance i s poor3 (Table 2 and Figures 1 and 2), and the service quality and operating efficiency o f the other electricity provider, Luz y Fuerza del Centro (LFC), are even worse. Table 2: Quality of Electrical Service, 1995-2003 - Not available. Sources: Data provided by CFE’s Subdireccih de Control Financiero, and LFC’s Subdireccih de Finanzas. Figure 1: Annual Interruptions (minutes) per Electricity Connection 250 - 200 - ~ ~ +CFE 150 - i Brazil ElectroPaulo +Argentina Edenor 100 - ~ +Argentina Edesur 0 1995 1996 1997 1998 1999 2000 2001 2002 2003 Sources: CFE financial data; and Andres, Foster, and Guasch (2005). N o data on annual interruptions have been reported for public utilities or public distribution companies. xvi Figure 2: Electricity Distribution Losses (%) 14 -I *CFE Totales 12 ,4 +Peru Edelnor 10 - +Peru Luz del Sur 8-l I -** Chile Chilectra 4' +Argentina Edenor +Argentina Edesur , 1995 1996 1997 1998 1999 2000 2001 2002 Note: CFE's data do not include natural phenomena, in which case values would be higher. Reliable comparative data for public utilities in other developing countries were not available. Sources: CFE financial data; and Andres, Foster, and Guasch (2005). 6. Labor efficiency indicators for electricity in Mexico have also slightly improved, but remain below international benchmarks. The total number o f permanent employees (including de confianza [managerial and thus nonunionized] and sindicalizados [unionized]) has remained almost constant, while electricity demand and production have grown. When compared to selected Latin American privatized distribution companies, however, CFE has s t i l l performed poorly (Figure 3). Figure 3: Number of Electricity Connections per Worker in Distribution Segment 3000 -, I P 2500 1 -+--PERU Edelnor 2000 1 I / -PERULuzdelSur &. - - ,+ . A- .---A --c.CHILE Chilectra 1500 - I -BRAZIL Electropaulo I 1000 j -ARGENTINA Edenor -m- ARGENTINA Edesur I 500 +COLOMBIA Codensa 0~ 1995 1996 1997 1998 1999 2000 2001 2002 2003 Sources: CFE financial data; and Andres, Foster, and Guasch (2005). xvii Water Supply and Sanitation 7. Access to water and sanitation in Mexico has steadily increased over recent decades, reaching levels significantly beyond the average o f the region and o f other developing countries (Table 3). Approximately 90 percent o f the population now has a water connection either in the house or nearby.4 Ninety percent had access to sanitation, including 63 percent that were connected to a sewer, 12 percent that had a septic tank, and another 15 percent that used sanitary latrines or evacuated their sewage through sewers discharging into the nearby environment. The poor and the extreme poor also benefited f r o m the increase in coverage: 58 percent of the extreme poor had access to a safe water supply in 2002, up from 38 percent in 1992.5 However, the coverage level drops sharply from more developed urban areas through the urban periphery and smaller towns to the more remote rural areas. Table 3: Mexico’s Water and Sanitation Coverage i s comparatively High Sources: Data from WDI (2003a) and C N A Water Statistics in Mexico (2004b). Sanitation data for Mexico are from the 2000 census. East Asia data are from World Bank (2004). 8. Service quality and operating efficiency clearly fall short o f the levels achieved in other OECD countries and upper-middle-income countries. The share o f municipal wastewater that receives some degree o f treatment i s more than twice as high as the Latin American average (30 percent compared to 14 percent): but it remains far below levels in OECD countries, and an unknown share o f treatment plants do not comply with norms for effluent discharge. According to the 2000 census, only 45 percent o f households connected to the water distribution network received a continuous supply; the remaining 55 percent experienced various degrees o f interruption to s u ~ p l y . ~ The incidence o f intermittent supply i s higher in smaller municipalities and for the poor* (Figure 4). This phenomenon puts Mexico clearly behind other OECD countries, where continuous water supply i s the norm. Improved water supply includes four categories: households with a piped supply in the house; households with a piped supply on the plot, but outside the house; public standpipes; and households that bring water from another house with a piped supply. World Bank (2004a), Poverty Assessment. C N A (2004a), “Situacih del Sub-Sector,” p. A-76 for Mexico. For Latin America average, see P A H O N H O (2001:24, 81). ’ Own calculation, based on census data quoted in Avila (2004), spreadsheet named Anexo I.CC-Agua. ’ Avila (2004) based on census data xviii Figure 4: Quality of Water Service in Mexico 100% h 90% 5 .- U e 80% P LI 70% 60% 50% 40% 30% 20% 10% 0% Poor people in cities Not poor people in Poor people in Not poor people in cities towns and rural towns and rural villages villages 9. Using non-revenue water’ as an indicator, operating efficiency levels in Mexico are far below the average level attained in developed countries, and below the level attained in the best-performing quartile o f utilities in developing countries, and even the levels of the best performers in Mexico (such as Monterrey, Tijuana, Leon, and Mexicali, among others). For example, while non-revenue water averaged between 20 and 30 percent in these better utilities, the average i s about 44 percent non-revenue water for all Mexico,10 (Table 4). Water staffing levels vary broadly in Mexico. The average staff per 1,000 connections among a sample o f 35 large Mexican utilities was 4.5 in 2000, ranging between 2.8 and 19.6.” These data imply ample scope for reducing excess staff at many water utilities. Non-revenue water i s the difference between water supplied and water sold as a percentage o f water supplied. loC N A (2004a), “Situaci6n del Sub-sector,” p. 42. Calculated based on a sample o f 157 service providers with reliable data. ’’The average for 38 utilities in the State o f Guanajuato was 4.4 in 2002. The average for a larger sample of utilities at the national level may be higher, since smaller service providers tend to have a higher staff ratio. xix Table 4: Non-Revenue W a t e r in Mexico compared to other countries Non-revenue Country (city) Year Water(%) . United Kingdom (average’, 2000 14 Sources: C N A (2004b342) for Mexican average; data on Mexican cities are from CNA: Ciudades Estratdgicas (2000) and Barocio (2004); for the Brazilian National Water Information System Diagndstico 2000; Malaysia and Asian cities from ADB Water in Asian Cities (2004); U.K. and U.S. from IB-Net (International Benchmarking Network); Latin American average from WHOLJNICEF (2000:25). Developing country sample average i s from Tynan and Kingdom (2002). Transport 10. In the transport sector, the need to improve quality i s most evident for roads. Under pressure f r o m growing traffic volumes, Mexico’s aging road network, particularly where run b y states and municipalities, i s in poor condition and badly in need o f repair. Expenditure on maintenance i s far lower than necessary, often resulting in the need for costly rehabilitation works. In contrast, structural reforms in Mexico’s railways and ports have permitted increased investments and improvements in the quality o f service. 11. As a result o f insufficient investment in maintenance and modernization, the condition o f many assets i s not satisfactory. Many federal, state, and local roads are old and require either renovation or replacement, particularly with steadily increasing traffic. Road use has risen significantly over the last decade, with road transport b y bus and truck currently accounting for 99 percent o f domestic commercial passenger traffic and more than 78 percent o f surface freight cargo. Following trucking deregulation in 1989, and the advent o f the North American Free Trade Agreement (NAFTA), trucking activity has grown by 32.5 percent, and the authorized weight o f vehicles was raised from 34 tons in 1960 to 66.5 tons in 1997.’* The number o f personal vehicles (mostly cars) i s growing at 7.6 percent per year, adding to the road infrastructure demand. 12. Considering 20 indicators o f road quality-including operational standards, traffic, design features, security, and maintenance-only 61 percent o f the highway l2The trucking industry has a relatively aged fleet (17.5 years on average). In addition, the large number o f owner-operators leads to inefficiencies and limits economies o f scale, while at the same time providing only modest service quality and efficiency. xx system can be considered modern, with 39 percent requiring improvement^.'^ Only one- fourth o f roads are in good condition, well below the almost 60 percent average for other OECD c o ~ n t r i e s (Figure '~ 5). Overall, the maintenance and improvement o f main federal corridors, although showing a positive trend, s t i l l lag behind demand. State and municipally controlled roads are in particularly bad condition, especially in rural areas.15 Figure 5: Quality of the Road Network, 2000 Quality of the Road Network, 2000 IUGood E SatisfactotyUDeficient I - trdia Canada Czech Denmark Hurigdy Mexicb New Portlgal South Africa SwedLn Switrerlahd Republic Zealand 13. Structural reforms, including privatization, have enhanced the quality and efficiency o f service o f Mexico's railroads and ports, although they s t i l l fall short of international best practice. The rail industry shows a diminishing a number o f accidents per kilometer, better use of assets (as shown by the higher number o f tons per locomotive), improved service quality (as indicated b y the lower number o f losses and claims), and a more efficient use o f fuel (Guerrero 2004). However, efficiency s t i l l falls short o f levels achieved in the United States and other OECD countries. The port industry has posted significant increases in containers per ship transferred per hour, reducing the time ships need to stay in port. One problem for ports i s the delays s t i l l experienced in moving cargo from terminal to rail or truck transportation. This i s due not 13 Communications and Transport Sector Program 200 1-2006. l4See Guerrero (2004). The source of data i s the PIARC. l5There i s very little data on the quality of roads at the subnational level, which might be symptomatic of larger issues of quality in the sector at that level. xxi only to a shortage o f physical infrastructure in port terminals, but t o weak trade facilitation procedures and user/agent behavior in managing their logistics chains.16 Tariffs, Subsidies, and Cost Recovery 14. Mexico lacks a coherent national policy framework for setting-and linking- infrastructure tariffs, subsidies, and cost-recovery goals. An office in the . SHCP Undersecretariat o f Revenue sets the electricity tariffs and the water abstraction charges owed b y the local water operators and those enterprises drawing water f r o m the source. The office strives to follow technical considerations o f each sector in setting the rates, but political factors loom large in the final determinations, and there is no multisector strategy to assure that an adequate package o f safety-net programs reaches the poor and not many o f the non-poor, and that the rates give appropriate incentives for conservation. Pursuit o f cost-recovery tariffs, which reduces the strain on public finances and facilitates private participation, would be more feasible if subsidies and tariffs were targeted to low- income groups. Moreover, although socially directed tariffs and subsidies can contribute to poverty reduction, through expanding access t o basic services and reducing charges, such subsidies are not usually the optimal way to help the poor. A s more efficient antipoverty programs, such as Oportunidudes, widen their coverage, Mexico could consider phasing out generalized utility tariff subsidies (as they already did with food subsidies) and shift to poverty targeting cash transfers. 15. The absence o f overarching subsidy policies -and the multiplicity o f federal, state, and municipal stakeholders involved-produces a wide variation in the degree o f cost recovery and subsidies across sectors and regions. Tariffs are set well below costs for some areas and users-even those who could pay. The most common form o f user subsidy in Mexico i s through l o w tariffs for certain consumer categories in electricity, water supply, and sanitation. These are usually financed directly or indirectly from the federal budget, but some subsidies are funded b y states and municipalities. One of the major subsidies-in electricity-is financed through the nonpayment o f uprovechamientos (levies) due by CFE to the Federal Government. Subsidies through the Fondo de Znversidn en Znfraestructura (Infrastructure Investment Fund, FINFRA) are indirectly paid by the Federal Government in the form o f foregone dividends for subordinated equity. 16. Subsidies for infrastructure services absorb significant public resources in Mexico and encourage inefficient resource use, but do not effectively target the poor. For example, subsidies (for operations and consumption) in the electricity sector amount to about 1.1 percent o f GDP and are highly regressive. Federal programs in the water and electricity sectors disproportionately benefit richer states, municipalities, and households, for which improved cost recovery and tax revenue mobilization could easily finance part of their infrastructure. l6For details, see Diagndstico General sobre la Plataforma Logistica del Transporte de Carga en MPxico, Instituto Mexican0 del Transporte, (2003, SCT). xxii 17. The Mexican Government has incorporated a modest degree o f poverty targeting in i t s transfers to subnational governments, mostly through a fund to support social infrastructure- FAIS (a budget category o f Ramo 33).17 In 2002, 44 percent o f the investments funded b y F A I S was used in the sectors considered in this report. About half of it went to water and sewerage, with the remainder split equally between rural roads and electricity distribution to rural and marginal areas (with wide variation in the pattern across municipalities). However, the majority o f federal infrastructure spending, subsidies, and transfers are not targeted for poverty reduction, and the distribution strongly favors the wealthier states and localities. Non-FAIS federal spending for water and sanitation in the wealthiest eight states in 2003 was two and a half times higher per capita than in the poorest eight states (Barocio 2005:71). 18. In the transport sector, toll-road tariffs are high b y international standards, despite recent reductions on federal routes. This diverts too much traffic to free roads and contributes to growing congestion problems. T o l l setting has been based mostly on financial needs, for which F A R A C debt weighs heavily, rather than economic considerations which incorporate demand patterns and country competitiveness concerns; the F A R A C technical committee i s currently looking at an overall review o f toll levels and structure.18 At major ports, which are commercial enterprises, and railways, which are largely privatized, charges cover the full costs o f good-quality service, demonstrating that such models can work in Mexico. Electricity 19. In electricity, average tariffs s t i l l fall short o f covering costs, despite steady nominal increases over the past 15 years. Substantial subsidies are applied in varying proportions to different categories o f users. Tariffs for commercial and industrial users are set near levels allowing full recovery o f the cost o f supplying these consumers. However, average residential and agricultural tariffs covered only 42 percent and 28 percent o f cost, respectively, during 1997-2003. The incidence o f residential subsidies stemming from current tariff structures i s regressive, benefiting mainly the upper-income households and richer states. 20. Residential tariffs are well below the OECD average, while industrial tariffs are higher than the average o f OECD countries and the United States. Independent sources indicate that peak industrial electricity tariffs are more than four times higher than the costs o f producing electricity on-site with diesel-based thermal plants.” High industrial tariffs have led to an increasing trend toward self-supply b y industries during peak hours. Compared with the electricity tariffs in other Latin American countries, commercial tariffs are among the highest tariffs in the region, while industrial and residential tariffs are close to the regional average. Ramo 33 i s a budget allocation that aggregates all the earmarked transfers to subnational governments. ’*For an analysis o f road toll-setting criteria, see R. Carruthers and R. Basu, “The Theoretical and Practical Basis for Setting Road Tolls,” World Bank, Transport and Urban Development Department, 2004. l 9 Instituto Tecnol6gico de Estudios Superiores de Monterrey (2004), quoted in Samaniego-Breach (2005 :24). xxiii 21. Residential electricity subsidies are highly regressive: Upper middle income households (income deciles 6,7, and S), receive the majority o f the consumption subsidy (Figure 6). The electricity subsidies also go mostly to the regions that are already more economically developed. The vast majority o f the subsidy-over 90 percent-is not a lifeline for the poor and encourages inefficiency, especially in the hot areas in the summer, which benefit from highly subsidized rates. Poverty criteria are absent in the determination o f regional electricity tariffs, unlike in water, where some municipalities set lower tariffs in poorer neighborhoods. International evidence suggests that tariffs that are geographically differentiated on the basis o f even crude assessments o f marginality are m i l d l y progressive, while increasing-block tariffs,*' which are common in Mexico and in many other developing countries, benefit mainly the better o f f because the middle blocks are also subsidized and non poor households tend to consume more than the poor. Figure 6: Distribution o f Electricity Subsidies b y Household Decile 1 2 3 4 5 6 7 8 9 10 Decile Source: World Bank (2004c,d). Water 22. Water service providers also typically charge industrial and commercial users tariffs that are close to full cost recovery, and cross-subsidize residential users. The average tariff across users i s only about half the Latin America and the Caribbean (LAC) average (US$0.32 per cubic meter compared to US$0.65 per cubic meter). About 69 percent o f connections are metered and charged through increasing-block tariffs that charge reduced rates to low-volume users, but also large volumes o f subsidized water t o upper-income users. 2oWith an increasing-block tariff, consumers face a low volumetric per-unit price up to a specified quantity (or block), and then for any amount consumed over this quantity, they pay a higher price up to the limit o f the second block, and so on. xxiv 23. There are no reliable figures on total water and sanitation revenues in Mexico. Water tariff collections have been estimated at MxP14.5 billion (US$1.54 billion) in 2002. Billed revenues were estimated b y various sources at between MxP20.2 billion (US$2.14 billion) and MxP26.9 billion (US$2.9 billion) in the same year.21 On average, i t seems that the sector generates only a very modest cash surplus, which i s well below the financial performance achieved b y the top quartile o f utilities in developing countries (Tynan and Kingdom (2002:3). Moreover, this apparent modest surplus among Mexican utilities in part reflects shortfalls in essential spending on maintenance and modernization rather than financial viability. The aggregate figures also mask substantial variations in performance among service providers that depend on municipal subsidies for recurrent costs and those that self-finance substantial investments. This suggests that some service providers in Mexico achieve or exceed international good practice. 24. The level of collection efficiency in Mexico has been estimated at 72 percent, far below the levels achieved in developed countries, and even in many developing countries (Table 5). The wide variations within Mexico again show that high levels o f performance are achievable in the country. An increase in collection efficiency to 95 percent-close to the best utilities in Mexico-would mobilize more than MxP5 billion annually, without any increase in tariffs. This i s more than all federal subsidies outside Ram0 33 provided to the sector in 2003. Table 5: Water-Tariff Collection Efficiency OECD average 1996 95 Asian cities (average of 18) 200 1 88 Brazil (average) 2000 87 Mexico (Hermosillo) 1999 85 Mexico (average) 2002 72 rMexico (Matamoros) I 1999 I 45 -1 25. Thirty-one percent o f water customers are not metered and are charged a flat rate (cuota fija) independent o f consumption. In a few instances, flat rates are differentiated b y neighborhood, and sometimes sharply so. For example, in the Federal District the flat rate in the highest cadastral category is 20 times higher than in the lowest. Since the level o f water consumption does not vary that much among income groups, this type o f water tariff may have a progressive incidence. Geographically differentiated tariffs that are *’The lower figure i s taken from C N A (2003), “Situacibn del Sub-sector,” p. 38, and i s calculated from a sample o f 437 localities in all states. The higher figure i s taken from Barocio (2004), based on extrapolations made from a sample o f 192 localities from states for which data was deemed reliable. xxv even crudely based on poverty levels may reach the poor more effectively than increasing-block tariffs (Foster and Yepes 2005). Transport 26. Despite reductions in the late 1990s, high fares have kept the use o f many toll roads below capacity. Estimates suggest that toll tariffs would have to be reduced significantly to have a real impact on traffic patterns. This is largely due to many free roads that compete with toll roads for freight and passenger traffic. After the substantial reductions o f the 1990s-from 12 to 2 Mexican pesos per truck and kilometer in constant prices in the case o f roads owned b y Fideicomiso de Apoyo a1 Rescate de Autopistas Concesionadas (FARAC)-tariffs have been stable since 1998. 27. Costs for railway services are higher in Mexico than in Brazil or the United States, which i s partly explained b y cargo characteristics: in the United States and Brazil, minerals account for a majority o f the cargo that can be transported at a lower unit cost. In Mexico, due to the relatively l o w share o f cheap bulk cargo and the scattered origin and destination patterns, train operation i s necessarily more costly. Nevertheless, the lack o f competition among concessionaires, due to the ineffectiveness o f interchange rules and insufficient intermodal competition, also contribute to high tariff levels. 28. Port tariffs are generally higher than international benchmarks when all charges are considered. Tariffs for port infrastructure use include two main categories: charges to vessels and charges t o cargo. International comparisons are o f limited value, since these two concepts are not homogeneous across ports. Mexico charges l o w tariffs per transferred ton on ports (US$1.4 in Veracruz compared to US$6.68 in Los Angeles). However, tariffs are much higher when all charges are considered (like shore-to-terminal cargo handling or customs agent payments), as shown in Figure 7 . Figure 7: Post Tariff for a 2,800 Twenty-feet Equivalent Unit (TEU) Ship (thousand dollars) 300 250 200 150 100 50 0 Source: Instituto Mexican0 para l a Competitividad (2003). xxvi Private Sector Participation-Limited and Costly 29. Since 1994 private sector participation and financing in transport, electricity, water, and sanitation in Mexico while growing substantially over prior periods, remains lower than in its peers in Latin America (Argentina, Brazil, Chile, and Colombia). Mexico was one o f the first countries in Latin America to attract significant private participation in infrastructure (PPI), but after the collapse o f the road-concession program in the early 1990s, PPI decreased and has remained modest since. Compared to other relevant countries, Mexico has not had significant private investment in energy and water distribution services. The energy sector (electricity generation through the Proyectos de Zmpucto Diferido en el Registro de Gusto [Projects with Deferred Impact in the Budgetary Registry, PIDIREGAS]) has attracted the most private financing, followed b y transport, especially for railroads and airports. The very modest private investments in water supply and sanitation concentrated mainly on build-operate-transfer (BOT) schemes for wastewater treatment plants. 30. In addition, the approach to PPI in Mexico-particularly for the segments that provide service directly to retail consumers-has limited the efficiency gains that normally arise from private participation. PPI in Mexico has mostly been in upstream activities such as electricity generation and water-treatment plants and highways. In contrast, in the rest o f Latin America, PPI in roads, water and sanitation, and electricity has mostly taken the form o f concessions or divestitures for existing infrastructure and expansion o f networks to serve additional segments o f the population (see Figure 8). Mexico’s lack of reform o f existing service providers has limited the efficiency gains that usually occur from involving the private sector in the running o f infrastructure services (improvements in commercial and technical efficiency). Moreover, PPI involvement has typically taken the form o f “take-or-pay” agreements with substantial guarantees from the government. These implicit but costly forms o f fiscal support have been necessary because private producers could not be enticed to sell their output t o public utilities which were not, in and o f themselves, financially viable purchasers or if creditworthy, were subject to government controls which raised risk o f future payment capacity. xxvij Figure 8: The Share of PPI Allocated to Greenfield Projects Has Been Particularly High in Mexico, 1990-2003 Management and Lease Contract CS Greenfield Projects LAC Chile Mexico (Excl!~diiig Meam) Note: Chilean projects traced back to 1985; water data extends through 2004. Sources: World Bank PPI Database; Ada Karina Izaguirre, authors’ calculations. 31. This i s all the more surprising given Mexico’s good sovereign risk and credit ratings, i t s macroeconomic stability and general success in attracting foreign direct investments, and the depth o f local capital markets. Indeed, Mexico i s probably one o f the few developing economies today that could fairly easily attract substantial amounts o f private capital for infrastructure.22 The new private sector participation schemes being developed and implemented provide an opportunity to increase efficiency and reduce the scope of sovereign guarantees provided b y the Federal government. Investment: How Much i s Spent and Needed, for What, and Where? Overview of Infrastructure Investments 32. Public investment in Mexico has fluctuated substantially with the federal political cycles, with peaks in years o f Presidential elections (1 994, 2000) and Congressional elections (1997, 2003), as shown in Table 6, although the cycle i s less clear after 2001. Over and above the political cycle, public investment has increased some since the collapse after the 1994-95 crisis. ’*Private flows to infrastructure in Latin America have collapsed since the peak year o f 1997, partly because o f the economic crises in East Asia and Argentina, but also because much of the more attractive divestiture operations (mostly in telecommunications and power) have already taken place. xxviii Table 6: Public Investment in Mexico, 1993-2003 Billion 2003 Annual % GDP M x Pesos Growth 1993 226.9 3.76 1994 311.4 5.01 37.3 1995 214.0 3.75 -3 1.3 1996 182.4 3.00 -14.8 I997 200.8 3.10 10.1 1998 185.8 2.80 -7.5 1999 205.7 3.00 10.7 2000 257.6 3.59 25.2 200 1 246.7 3.60 -4.2 2002 288.5 4.24 17 2003 313.0 4.53 8.5 2004 324.4 4.76 3.7 Source: INEGI, National Accounts. 33. I t appears that infrastructure investment has not kept pace with the noted increase in overall public investment. In fact, the infrastructure share o f public investment declined from about 39 percent to 28 percent (Table 7).23 (PEMEX investments were increasing strongly.) Nevertheless, the absolute amount o f resources invested in the sectors covered in this report increased from MxP64 billion (2003 pesos) in 1998 to MxP83 billion in 2003, or from 1.1 percent o f GDP to 1.2 percent. Table 7: Public Infrastructure Investment, 1998-2003 1998 64 39% 1.06% 1999 64 36% 1.02% 12ooo I 69 I 31% 1 1.04% 1 200 1 68 32% 1.02% 2002 84 34% 1.26% 2003 83 28% 1.23% Source: World Bank calculations based on agency reports. 34. The modest increase in public infrastructure investment i s mainly attributed to roads and water supply and sanitation. In electricity, direct public investment declined, while quasi-public investment through PIDIREGAS increased until 2002, but dropped significantly in 2003. Chapter 2 discusses investments in each sector in more detail. 23 The report covers roads, ports, railroads, electricity, and water and sanitation. Schools, health infrastructure, urban transport, airports, irrigation, and gas are examples of sectors that are not included in this report. xxix Distribution of Spending 35. Across infrastructure sectors, public spending i s heavily weighted toward new construction and upgrading, while regular maintenance activities are underprovided. In roads, federal maintenance expenditures have been insufficient to keep the network in good condition. In the electricity sector, the approved budgetary resources for maintenance, operation, and repair have been on average 30 percent below the amount requested by CFE. In water and sanitation, investment favors new construction, and insufficient maintenance affects the quality o f service. This all points to substantial future investment requirements for rehabilitation, and highlights the need for better incentives and funding mechanisms to promote better management o f existing assets. 36. The Mexican Government does not calculate total public investment in infrastructure, but estimates done for this report suggest that public spending on investment and maintenance in roads, water and sanitation, and electricity was around MxP82 billion in 2003, about 1.2 percent o f GDP. This does not include the electricity subsidies, mentioned earlier, which are for consumption purposes, but i t does include the quasi-public financing for the electricity sector done through the PIDIREGAS financing scheme. About half of this investment is for the electricity sector, and a quarter is for roads. The remainder i s mostly for water, with a very small amount allocated to ports and rail. Future Investment Needs 37. Making estimates of future investment needs i s fraught with difficulties-it depends on sectoral goals in terms o f quality and coverage, and requires assumptions about future prices and demand growth. Nevertheless, the report offers a series o f estimates associated with different policy goals, building on Mexico's infrastructure agencies' estimates (see chapter 4 for details). 38. First, b y modestly increasing expenditures on maintenance and investment, Mexico should be able to improve the quality o f i t s infrastructure and achieve some key policy goals (such as universal coverage in water and sanitation and electricity, and the completion o f major road transport corridors). Indeed, investment and maintenance needs estimated by Mexico's infrastructure agencies (Secretaria de Energia [SENER], Comisio'n Federal de Electricidad [CFE], Secretaria de Comunicaciones y Transportes [SCT], and Comisio'n Nacional del Agua [CNA]) for electricity, roads, water, and sanitation, respectively) are modest at around MxP83 billion for 2006-1 5. Adding sufficient resources to adequately maintain networks and slightly accelerate the completion o f major policy goals (such as universal coverage in water and sanitation and electricity) increases this estimate somewhat to about MxP102 billion. Depending on GDP growth performance, this would represent 1 percent to 1.25 percent o f GDP. 39. Such a rate o f spending, however, would not allow Mexico to reach the level o f infrastructure per capita o f other OECD countries or faster-growing East Asian countries. Indeed, countries like the Republic o f Korea, which trailed behind Mexico in terms o f infrastructure coverage in the 1960s, invested over 3 percent o f GDP per year on average xxx in infrastructure over recent decades-as have China, Indonesia, Thailand, and other competitors that are catching up rapidly with Mexico in terms o f infrastructure quality and coverage. This highlights the urgency o f reallocating untargeted subsidies-such as the 0.7 percent o f GDP currently spent on electricity consumption subsidies-toward productive investment and maintenance, and o f improving expenditure efficiency more generally. 40. Looking at individual sectors, the primary financing challenge for the road sector w i l l be to ensure adequate funding for rehabilitation and maintenance of the existing network. While the new concession scheme and public-private participation program (known as the PPS) could hope to leverage private investment in the highway program, current annual levels o f financing w i l l have to increase b y 30 to 40 percent in order to fund maintenance and rehabilitation needs and bring all roads in the primary federal and state networks to fair-to-good condition. Longer-term and performance-based rehabilitation and maintenance contracts might help achieve this goal in a cost-effective manner. 41. For electricity, the challenge i s to find new financing instruments that w i l l mobilize large amounts o f money, given the shortcomings o f the current PIDIREGAS scheme (which w i l l probably decline as a source) and other structural constraints discussed below. 42. For water and sanitation, the highest priority w i l l be to use existing funding more efficiently, b y reducing unit costs and focusing more on rehabilitation and maintenance. A n y new additional funds should be used to increase service coverage, especially for the poor. Given Mexico’s presently high unit costs for connecting and serving households, the level o f resources and timing required to meet the social goals o f universal coverage are sensitive to the prospect o f improving (or not) the efficiency o f the use o f funds and the delivery mechanism for those resources. 43. Responding to the need for increased resources and, most important, increased efficiency in the use o f these resources, w i l l require new and different uses of private sector participation and refined credit-enhancement schemes to attract financiers, investors, and operators to Mexico’s infrastructure market in a more cost-effective manner. The principles that should be adhered to as the private sector i s sought to close the gaps above are as follows: e Government support-direct transfer o f funds or guarantees-is a subsidy to providers and users o f the infrastructure service from the taxpayer. I f the subsidy benefits a connected consumer (through, for example, support to the construction o f a water treatment plant) or a consumer with an automobile (through the building o f a non- toll road), that portion o f the subsidy transfer which i s greater than the value o f externality produced b y the investment (for example, better public health, active commerce) i s highly regressive. The rich use the services more and thus benefit more. In addition t o i t s impact on equity, the setting o f tariffs and user fees has both direct and indirect financing implications on infrastructure. Where average tariffs fail to xxxi cover operations and maintenance-as in Mexico’s water and sanitation sectors- subsidies are required just to sustain financially unviable utilities. Also, lower charges often simulate higher demand, which entails higher investment requirements. Moreover, guarantees and off-take agreements become particularly blunt instruments for providing support in which a flat taxpayer subsidy benefits special groups o f consumers. a Efficiency gains can be realized through competitive bidding for the provision o f sunk assets (such as electricity generation facilities) and for long-term arrangements for operations o f commercial services. For any o f these potential efficiency gains (due to lower operating costs and, possibly, capital costs), to be passed on to consumers b y public or private monopolies requires proper regulation or oversight. Institutional Challenges 44. Achieving better quality, access, and efficiency in infrastructure services w i l l require stronger institutional arrangements, with increased coordination and planning within and across sectors, and greater accountability. The role o f the Government in infrastructure planning has changed over time, shifting i t s focus from public investment programs to issues o f strategic direction, decentralization, private sector participation, and financial support. Central coordination i s essential, given the cross-cutting nature o f these issues and their economic and political impacts. Disjointed decisionmaking about funding allocations has contributed to sector outcomes not linked w i t h national development priorities. The process i s least fragmented in the electricity sector, which i s centrally managed. Central budget funding should be used to prioritize activities that pursue the government’s objectives o f enhancing competitiveness and reducing poverty. 45. Closer coordination between the planning processes o f national and state governments and the annual budget formulation process i s necessary to set more realistic and attainable goals. Across all sectors and national and subnational government agencies, policy planning and coordination should be better linked, especially for water and sanitation, and for important aspects o f transportation. One area t o focus o n i s increasing incentives and assistance for subnational planning that is critical in the transport and water and sanitation sectors. There should also be better horizontal coordination among the various municipalities within metropolitan regions. 46. T o strengthen planning and link i t more closely to budgeting (centrally and within sectors), the government could build on what i s already in the annexes o f the budget that project the future year outlays for individual investment projects, particularly in electricity and transport. From this, one could project multiyear resource envelopes for programs and sectors (not just individual projects), which would include debt service and ~ ~ envelopes would be indicative and need subsequent operations and m a i n t e n a n ~ e .Such 24 Annexes 4 and 6 o f the budget give projections o f investment outlays for several years of all electricity and road projects (hundreds) that are included in the budget for that year. Besides giving more detail than policymakers, Congress, or the public need to know, the annex tables do not give any indication of the expected flow o f future investment totals, because most individual projects w i l l end in the current fiscal year, so the future-year aggregates are always much less than half o f the present year. xxxii Congressional approval in each year’s budget. CFE already follows this approach and the Secretaria de Comunicaciones y Trunsportes (Ministry o f Communications and Transports, SCT) i s moving in that direction. The use o f multiyear resource envelopes also eliminates the need to divide larger projects into components that can be finished in a year or less, with the higher total costs that entails. 47. The government could also strengthen the authority o f the secretariats for transport and energy to allocate indicative multiyear budget ceilings within their sectors and monitor and disclose compliance with performance targets for the key agencies that report to them, to improve coordination among national-level agencies. For the sectors that involve several levels o f government, namely roads and water, experience in the United States and other federal nations in the OECD shows the value o f using matching grants, with multiyear projections and dependence on meeting performance standards. The revolving funds programs for water and wastewater in U.S. states provide good examples. 48. Being accountable and meeting performance standards requires systems for the evaluation o f large-scale federally funded programs, with respect to their efficacy and efficiency in achieving measurable quality and sustainability o f service outcomes. An ex post evaluation would provide valuable information on what strategies work and why- informing the design of future programs. Such evaluations can also help establish incentives for good performance and lead to greater transparency. The W a y Forward-A Better Use of Public and Private Resources 49. O f the seven recommendations o f this report, three apply to public sector funding, two to private financing, and two to the overall institutional environment. First, public investment needs to make more effective use of taxpayer resources and to refocus on areas that the private sector cannot finance. This means reducing the role o f the government in financing the electricity sector and toll roads, which have made substantial fiscal demands (many o f them off-budget or contingent) and for which there i s significant scope for increased private participation. B y the same token, i t implies improving the efficacy o f spending in traditional areas o f public finance such as water supply, sanitation, and non-toll roads. 50. Three sets o f policy instruments-competition, financial markets, and regulation,-could strengthen incentives for service providers to improve efficiency. Competition i s notably absent from the electricity sector due t o the statutory monopolies o f CFE and LFC. I t i s precluded f r o m the water and sanitation sector, due to the natural monopoly characteristics o f localized services. In transport, there are substantive competitive forces through intermodal choice, directly competing ports, and the presence of “free” roads in toll corridors. Private finance has been permitted in a few segments o f infrastructure, but the structure and coverage o f federal financial guarantees have muted the incentive impact o n operators’ performance, as discussed below. 5 1. Several interim measures could improve efficiency and strengthen accountability for performance, without major changes in industry organization. These include xxxiii programs to enhance the autonomy and service orientation o f public sector operators. For example, CFE's Corporate Transformation program would set up business units and transparent transfer pricing mechanisms, following on a prior pilot exercise. Municipal and state water companies in many localities also could be fully constituted as autonomous, commercial enterprises. In transport, efficiency gains could be obtained through better contracting o f highway maintenance, competitively outsourcing FARAC's toll-road maintenance, and restructuring Caminos y Puentes Federales (CAPUFE). 52. Second, the incremental public funding released through greater resource efficiency should focus on three areas: maintenance and rehabilitation, strategic bottleneck infrastructure segments, and extension of basic services to the poor. Additional resources need to be allocated on an ongoing basis to preventive maintenance and renovation, particularly for highways and electricity distribution, where the rate o f return t o such spending i s much higher than to new investments. Examples o f strategic segments o f networks include electricity transmission, bulk-water conveyance facilities, road links in the strategic corridors, and railhighway urban bypasses. Such investments need not be large, but have important strategic value, and in some cases could be co- financed with the private sector. 53. Devoting a greater share o f federal resources to infrastructure for poor households does not imply an absolute increase in spending. On the contrary, targeting retail subsidies in electricity and water to poor communities and poorer households in better-off urban areas would release substantial resources for other uses. Subsides should focus in the first instance on facilitating access o f the poor to the service and extending coverage in small localities. T o the extent that consumption o f these groups merits subsidization, i t should be limited to satisfying minimum basic needs. Moreover, delivering service to the poor need not be costly, and relaxing technical norms governing choice o f technology and billing methods have proven their worth in other countries. Examples include condominia1 systems for water and sanitation, and off-grid energy solutions for electricity. Finally, relaxing statutory monopoly rights o f the large public sector operators to permit small-scale providers to serve isolated communities in partnership with the network utility (or the municipality), offers substantial benefits to both the utility and to households with little or no service at present. 54. Third, better design of investment programs and selection of projects would improve outcomes. To improve the cost-effectiveness o f federally funded programs and thus reduce the magnitude o f subsidies from budget, closer coordination i s required along several dimensions: between sectoral agencies and the Ministry o f Finance and Public Credit (Secretaria de Hacienda y Crkdito Pu'blico, SHCP) to keep long-term sector development plans in line with budgetary and broader fiscal realities; between the SHCP and sector ministries to weed out projects o f questionable viability; among sectoral agencies to ensure balanced sector development (for example, gas-electricity in energy, and multimodal planning in transport); and across levels o f government (for example, regional transport planning and coordinating planning, service standards, and oversight in water and sanitation). Policy coordination i s crucial in water and sanitation, where local governments set most tariffs and governance conditions under which water companies xxxiv operate, while the Federal Government continues to provide the largest share o f concessional resources for investment. Hence, Mexican taxpayers, largely outside the local jurisdiction, bear the cost o f local pricing and investment decisions. 55. Even with limited competition, regulation, and financial market involvement, however, the government could s t i l l discipline operators’ performance b y making the size and type o f transfer dependent on the progress in realizing genuine improvements in efficiency and service. Such performance-based allocation could be applied in sharing expected toll-road efficiency gains between the SCT and SHCP, and in setting up the sistema financiero del agua (water financial system), which was stipulated in the recent modifications to the national water law but i s yet to be established. 56. For performance criteria to genuinely affect resource allocation decisions, future resource availability needs to be predictable, such as through multiyear resource envelopes and budget ceilings. This i s already done to some degree for large individual electricity projects and to a lesser degree for transport, but should be applied to entire programs. Even in the interim, as procedures and systems are established for performance-based budgetary allocation, multiyear budgeting for infrastructure would permit more effective planning and efficient program execution. 57. Fourth, private finance f o r infrastructure could b e mobilized to a much greater extent to leverage public resources. While the present outlook for rails, ports, and toll roads appears promising, this is not so for electricity and water supply and sanitation, even in segments that have historically attracted significant private finance, such as thermal power plants and wastewater treatment facilities. Concerns about operators’ present and future creditworthiness, the Federal Government’s future willingness to step in to cover subnational or public enterprise obligations, and the lack o f arms-length regulation strongly limit investor interest. Rather than having taxpayers assume s t i l l greater risks to attract private finance (as has been the case in power generation with the substitution of Optimal Power F l o w for IPP contracts), efforts should be directed at the source o f the uncertainty: namely the likelihood o f political interference in the capacity o f the purchasing distributor to pay for the service. The new concession scheme for state highways goes some way in this direction. Similar innovation i s needed in the electricity and water and sanitation sectors. 58. Fifth, federal credit enhancements w i l l b e required to attract sizable sums of private funding f r o m domestic and international sources, but their design and functioning need revision. T o date, projects under federal jurisdiction have generally been backed by full guarantees o f cash flow (for example, PIDIREGAS for electricity and the New Concession Scheme for transport) or equity returns (FINFRA). This requires the government to take o n more risks than necessary, and hence carry commensurately larger contingent liabilities. Since the Federal Government has an investment-grade rating on sovereign debt, i t could offer narrower types o f guarantees in the form o f negative covenants, such as insurance against political and regulatory risk. For subnational projects, negative covenants may also reduce financing costs, but the enhancements w i l l also require some kind o f security based on assets or cash flow. These xxxv could take the form o f state-level revolving funds for water and sanitation, transport, and other local infrastructure services. Such risk insurance and backstopping facilities should also help shift private finance toward distribution networks that interface with consumers. 59. Sixth, arms-length regulation of tariffs and service quality i s largely absent at present, and especially in electricity and water and sanitation it could improve the incentives for public sector providers and start creating the environment that would make good use o f private investment as legal opportunities for that are opened. Improving sector performance w i l l require greater clarity and coherency on policy goals and instruments, institutional responsibilities for establishing and regulating service providers, and pricing policies commensurate with those goals. The goals should make explicit the major policy decision, such as the desired levels o f access and service quality, the required levels o f investments and potential sources o f financing, and how noncompliance with regulations would be sanctioned. Although municipalities have primary jurisdiction for Water Supply and Sanitation (WSS) services, they have little technical capacity for policymaking and regulation, so state agencies might need to take this role. This would offer the advantages o f consistency in policy and investment planning across hydrologically and politically interdependent geographic areas, and o f administrative and financial capacity and the ability t o coordinate federal (and state) assistance. The Comisiones Estutules de Aguu are well placed to carry out planning and policymaking functions, and key regulatory, monitoring, and oversight functions. 60. Other modifications o f institutional arrangements should be considered. For investors and operators t o take on some risks now borne b y the government and Mexican taxpayers, they require greater predictability about future cash flows, which depend on how tariff and service standards are set and adjusted. For electricity, this implies empowering the Energy Regulatory Commission to function as a sector regulator, with oversight o f retail tariffs, service quality, and contracts between C F E and service providers, including private generators and gas suppliers. For water and sanitation, this implies building the capacity o f state water commissions and municipal agencies in performance monitoring, planning, and the revision o f retail tariffs. For railways, the SCT should clarify the rules for service access among carriers. For highways, the SCT should expand the current pilot program for multiyear, standards-based contracts for maintenance. 61. Seventh, moving forward on the above recommendations will require greater accountability and better information on performance outcomes. There i s little systematic information on whether projects have had good or bad results, and such information rarely has any budgetary consequences. While sectoral agencies and subnational governments are demanding greater autonomy in investment planning, execution, and financing, effective accountability should accompany autonomy. Indeed, without reliable, verifiable information on actual performance, i t i s risky to respond unconditionally to demands for more autonomy. Rather, increments to autonomy should depend on improvements in accountability. xxxvi 62. Better performance tracking and information disclosure w i l l require measures like the following: regular reporting b y subnational governments on the use o f federal transfers, especially Ram0 33FAIS; standardized reporting on performance o f water companies through an expansion o f C N A ’ s sistema de infomacidn nacional (national information system); and strengthening the Centro Nacional de Control de Energids (CENACE’s) and CRE’s capabilities for measuring and reporting on service quality in the electricity sector. Such measures do not require large sums of money, yet they do require building institutional capacities among the concerned sectoral agencies and subnational governments, and sustained political commitment to transparency. Proposal for a Short-Term Infrastructure Agenda 63. The immediate priorities for the government would be those measures that do not require new laws or additional resources, and preferably that w i l l use existing funds more efficiently, save money, or bring in more. Improving the selection o f public sector projects, shifting spending toward maintenance, setting up agencies (or granting autonomy to existing ones) for arms-length regulation, and improving transparency could all start immediately. 64. Improving institutions for transparency and accountability could also start immediately, but w i l l take time to bear fruit. Bringing more money in and improving targeting o f consumer subsidies b y raising water and electricity rates (closer to costs) on consumption b y non-poor households and putting more efficient tariff structures in place should be done as soon as politically possible, which might be immediately after the July 2006 Presidential election. However, significant efforts to improve collections of existing tariffs should start immediately. 65. Doing a multiyear financing plan for infrastructure (not just particular projects) w i l l probably have to wait for the new government in 2007, incorporating this into the next National Development Plan so that i t w i l l be a more practical guide for infrastructure budgeting. With such a plan and more resources coming in, i t would then be appropriate to organize a sustainable increase in infrastructure investment. 66. An improved regulatory framework w i l l make i t possible to attract more private sector participation without the sort o f exorbitant guarantees that are common now, fully covering revenue projections. The Government may replace these with partial-risk guarantee schemes to ensure, on one hand, that the private sector has an incentive to be efficient and innovative and, on the other hand, that the Government fulfills i t s responsibilities as a partner of the private sector. xxxvii 1. A N OVERVIEW OF INFRASTRUCTURE SECTORS IN MEXICO 1.1 Mexico’s infrastructure sectors are in transition. In the past they performed two competing functions: first, to provide infrastructure services, and second, to distribute rents accruing to the public sector in a way that assured political support for the governing party. Now, Mexico i s recognizing the need for more efficient provision o f infrastructure services in order to generate economic growth, improve international competitiveness, and reduce poverty. This w i l l require improving the efficiency o f investment allocation and generation o f additional resources through more effective institutional frameworks, efficient delivery o f infrastructure services, and adequate pricing policies. 1.2 Over the past decade, several policy instruments have been put in place in Mexico, improving the supply o f infrastructure with increasing private sector involvement. The outcomes s t i l l fall short o f what i s needed, however, and the programs in place have not proved to be the most efficient. As a result, building new and maintaining existing infrastructure in an efficient and sustainable manner have surfaced as important challenges for the Mexican Government. Moreover, the Government recognizes the need to review the institutional organization of the infrastructure sectors in order to develop more efficient ways t o finance infrastructure. 1.3 The institutional framework for infrastructure services provision in Mexico consists o f a complex set o f formal rules and informal practices among a large number o f organizations. These organizations often face constraints to their autonomy, and have widely different levels o f capacity, resources, and influence. M a n y infrastructure agencies are politicized, and the division o f roles and responsibilities among the different agencies i s often not clearly defined. 1.4 The structure and roles o f the agencies participating in infrastructure services planning, financing, and provision varies among sectors, and entail varying degrees o f complexity that depend on the specific sector and the interrelations o f functions and responsibilities at the three levels o f government. 1.5 This chapter provides an overview o f investments in infrastructure and describes the structure o f agencies and institutional arrangements in the infrastructure sectors, setting the stage for the review o f the sector performance and a profound analysis o f budgeting processes, planning, and coordination carried out in the following chapters. A. OVERVIEW OF INFRASTRUCTURE INVESTMENTS 1.6 Public investment in Mexico has fluctuated substantially with the federal political cycles, with peaks in years o f Presidential elections (1994, 2000) and Congressional elections (1997, 2003), as shown in Table 1.1, although the cycle i s less clear after 2001. Over and above the political cycle, public investment has increased some since the collapse after the 1994-95 crisis. 1 Table 1.1: Public Investment in Mexico, 1993-2003 Billion 2003 Annual % GDP M x Pesos Growth 1993 226.9 3.76 1994 311.4 5.01 37.3 1995 214.0 3.75 -31.3 1996 182.4 3.00 -14.8 I997 200.8 3.10 10.1 1998 185.8 2.80 -7.5 1999 205.7 3.00 10.7 2000 257.6 3.59 25.2 200 1 246.7 3.60 -4.2 2002 288.5 4.24 ‘7 2003 313.0 4.53 8.5 2004 I 324.4 4.76 3.7 Note: Election years in bold italics. Source: INEGI, National Accounts. 1.7 Information on investment expenditures in infrastructure was compiled for the purpose o f this report based on data provided b y sector agencies and on an estimate o f infrastructure expenditures under F A I S (Rarno 33’s fund to support social infra~tructure).~ A~ similar approach o f aggregating data from sector agencies has been used for subsidies.26 The reliability of the data thus i s equal to the reliability o f the underlying sector figures. 1.8 With these caveats in mind, i t appears that infrastructure investments have not kept up with the noted increase in overall public investment. In fact, the infrastructure share of public investment declined from about 39 percent to 28 percent (Table l.2).27 Nevertheless, the absolute amount o f resources invested in the sectors covered in this report increased from M x P 6 4 billion to MxP83 billion, or from 1.1 percent o f GDP to 1.2 percent. ~ 25 Public transport and airports are not included in the figures, since they are not covered by this report. In electricity PIDIREGAS were included, and in ports investments by Integral Port Administrations were included, since they are considered quasi-public investments. Maintenance and rehabilitation expenditures have in most cases been included b y the Mexican sector agencies (SCT, CNA, CFE, LFC) in the investment figures. The increase for water investments in 2002 i s partly due to the inclusion o f investments outside C N A programs that were not available for earlier years. 26 For roads, public investments are equated with subsidies. For water and sanitation, subsidies are equal to federal and state funding for investments as shown by CNA. For electricity, the subsidy figures are those shown in the financial statements o f CFE and LFC. 27 The report covers roads, ports, railroads, electricity, and water and sanitation. Schools, health infrastructure, urban transport, airports, irrigation, and gas are examples o f sectors that are not included in this report. 2 Table 1.2: Public Infrastructure Investment, 1998-2003 As a share of Billion 2003 Pub1 As a Share M x Pesos Investment of GDP (%) (%) 1998 64 39% 1.06% 1999 64 36% 1.02% 2000 69 31% 1.04% 200 1 68 32% 1.02% 2002 84 34% 1.26% 2003 83 28% 1.23% 1.9 The modest increase in public infrastructure investment is mainly attributed to roads and water supply and sanitation. In electricity, direct public investment declined, while quasi-public investment through Projects with Deferred Impact in the Budgetary Registry (Proyectos de Zrnpacto Diferido en el Registro de Gusto, PIDIREGAS) increased until 2002, but dropped significantly in 2003 (Figure 1.1). Chapter 2 discusses investments in each sector in more detail. Figure 1.1: Public Infrastructure Investment, 1998-2003 in MxPm, by Sector 100,000 1Railroads 90,000 80,000 Ports 70,000 60,000 Water and Sanitation 50,000 40,000 Roads 30,000 20,000 W Electricity (Pidiregas) 10,000 0 0 Electricity (CFE, LFC and 1998 1999 2000 2001 2002 2003 Munic .) I Source: World Bank estimate using data from Mexican sector agencies. 1.10 Subsidies for infrastructure services absorb significant public resources in Mexico and encourage inefficient resource use, but do not effectively target the poor. For example, subsidies (for operations and consumption) in the electricity sector amount to about 1.1 percent o f GDP (Table 1.3) and are highly regressive (see Chapter 2, Figure 2.5). The most important source of subsidies i s off-budget subsidies through CFE, financed primarily through the nonpayment o f statutory dividends (uprovecharnientos), amounting to M x P 4 9 billion in 2003, or 0.7 percent o f GDP. 3 Table 1.3: Estimate of Subsidies for Electricity,2003 financed byCFE(off- I 49 I 0 I 49 Other Subsidies (LFC operation and FAIS) 1 21 1 2.9 I 23.9 1 0.35% Total 70 2.9 72.9 1.08% B. TRANSPORT 1.1 1 Transportation i s the largest category o f public investment funded from the central budget. The roads subsector i s b y far the largest, with almost 90 percent of the budgeted public investment at the federal level. Transport i s partly decentralized, with participation f r o m all three levels o f government, but in roads the dominant actor i s the Federal Government. I t builds and maintains the main roads-toll and toll free-which are the skeleton and arteries o f the network to which local roads connect. Many roads now classified as state and rural roads were originally constructed b y the Federal Government and have been turned over to the states and municipalities in the past decade (World Bank 2003b). I.12 The Secreturiu de Comunicuciones y Trunsportes (SCT) handles the investment and maintenance o f non-toll federal roads. While the toll road agencies-Cuminos y Puentes Federules (CAPUFE) and the Fideicomiso de Apoyo a1 Rescute de Autopistus Concesionudus (FARAC)-are nominally under Federal Government control-CAPUFE under SCT and F A R A C under the Ministry o f Finance and Public Credit (Secreturiu de Hacienda y Crkdito Pu'blico, SHCP) via the Bunco Nucionul de Obrus y Sewicios Pu'blicos (BAN0BRAS)-they have considerable autonomy, and FARAC' s expenditures takes place outside the budget framework of SCT, as explained below. The ports have been concessioned to Integral Port Authorities (Administruciones Portuarias Integrules, APIs) that raise much o f their own revenue and financing, largely outside o f the federal budget, and are owned b y (and report to) the local and state governments and to federal representatives that comprise their boards o f directors. Intercity railroads were almost all privatized in the 1990s, and SCT now acts as regulator. Public funds co-finance some urban-rail interfaces and operate a small public system (Ferrocurril del Istmo de Tehuuntepec). N e w urban systems are being concessioned, and although no federal expenditure i s yet linked to this initiative, i t may have a future fiscal impact. Although airports and urban transportation are important parts o f subnational public expenditure, they are not analyzed in the PER. 4 Figure 1.2: Organization Chart of the Secretariat of Communications and Transport and other National Highway Institutions SHCP Secretary o f SCT : \ - Undersec. o f General Undersec. Undersec. Gen. .*' Infrastructure C o d of of of Coord. o f I Transport Commu- Ports and and SCT nications Merchant Centers ~ 1.13 Figure 1.2 shows the organization o f SCT and other units that are relevant for the roads subsector. The Undersecretary for Infrastructure deals with federal highways and rural roads, including a directorate for road construction (DG de Carreteras Federales), another for road maintenance (DG de Consewacidn), and a special unit for toll roads (Unidad de Autopistas de Cuota). Three other agencies are relevant for roads2*: SCT Regional Centers, located in multistate regions across the country, implement projects (contracting and supervising works) and link SCT with the states and municipalities. These local governments also have their o w n agencies to deal with highways (including their own toll roads in a few cases), urban and rural roads, and passenger transportation services. 1.14 CAPUFE started in the 1960s and holds the titles to t o l l bridges (including international ones) and toll roads (eventually about 1,000 kilometers) that the government built up to the early 1980s, financed with a m i x of o i l revenue and general government borrowing. I t had responsibility for maintaining and operating them (collecting tolls), and since it had no debt or capital cost, the collected tolls more than sufficed to cover expenses, and the remainder went to SHCP. This gave the agency incentives to collect money and perform good maintenance, but not to do i t efficiently. *' Trucking, regulated b y the Undersecretary o f Transport, i s an important complement to roads. Deregulation o f the trucking industry at the federal level in the 1990s greatly widened the range o f choices to haul cargo, and opened the way for rapid increases in the number o f individual owner-operators. From 1993 (after the reform) through 2000, tons transported by the trucking industry increased by one-third. The new regulations permitted the use o f bigger and heavier trucks, as well as a larger number. The Mexican Government i s planning further reforms to facilitate the movement o f the freight between the United States and Mexico. 5 1.15 In 1989, after recovering from the 1982 debt crisis, Mexico started building toll roads again (about 4,500 kilometers by 1994) under build-operate-transfer (BOT) agreements with private f i r m s . Construction took place between 1989 and 1994, with guarantees from the Federal Government. During the crisis o f 1995, they went bankrupt and the Federal Government took over the roads and the debt-worth almost US$6,000 million. T o keep the liabilities o f f the federal books, which were constrained b y an International Monetary Fund (IMF) program at the time, afideicomiso (trust) (FARAC) was created under B A N O B R A S to take over the debt and title to the roads. F A R A C had (and has) virtually no administrative structure or capacity, and hence i t contracted CAPUFE to operate and manage i t s network, in return for a flat rate o f 30 percent o f tolls collected. Thus, as long as costs do not go above the generous slice o f revenue, CAPUFE continues to lack incentives for efficiency. 1.16 With the general economic recovery since 1995, and especially the effects o f NAFTA, FARAC’s network has generated more than enough revenue to service the original debt. Rather than paying down this debt ahead o f schedule, however, FARAC has issued new debt to finance some new investment, and in 2002-03, to purchase the old network f r o m CAPUFE.29 With the latter transaction, F A R A C acquired title to the total federal toll network, including the parts with highest traffic, and CAPUFE became specialized in operations and maintenance. The new investment b y F A R A C has been modest thus far-mainly doing clearly needed modernization and connections. If i t gets more ambitious, however, i t w i l l face pressure to be linked with the wider technical and political process o f investment allocation. 1.17 Having an autonomous agency in charge o f toll roads i s consistent with international best practice, as in Spain, Italy, and France, but FARAC w i l l need more institutional capacity and appropriate institutional oversight if i t i s to fill this role. Also the system needs to give incentives for efficiency in operation and maintenance, including opening to competition and having a contract with better incentives for CAPUFE. 1.18 Railroads and ports are the two best-performing segments o f Mexico’s transport system, in terms o f quality and rate o f improvement in service and in terms o f service charges covering costs (see chapter 2 for more details). The restructuring o f the railroad system in the late 1990s entailed regional segmentation, with three main railroads under vertically integrated concessions. The three main networks and a number o f smaller lines were connected to shape the national system and rules for service exchange and rights to use different tracks established. Beginning in 1997, the government issued concession agreements that transferred responsibility for infrastructure and operation to vertically integrated companies. These private companies are in charge o f the railroad’s sector investments, and must follow the commitments for investment laid out in each concession agreement. The results have been generally positive, although the lack o f coordination among the companies prevents full interconnectivity among railroads. The 29 The money to purchase the roads from CAPUFE went to Federal Government coffers (as capital income), essentially enabling i t to borrow o f f budget, via FARAC, to finance spending other than toll-road investment. 6 United States, with a similar multiplicity of rail transport companies, has a good clearinghouse system that allows rail cars to move efficiently among networks owned b y different companies. 1.19 The amendment to the port law in 1993 made a profound reform in the port system following a landlord management structure b y creating Integral Port Authorities (APIs), which are public entities that engage private operators within the ports. A s the manager o f the Veracruz port explained, “it i s like a shopping mall, where the mall owner decides what range o f services are needed and rents (concessions) space to the highest bidder.”30 The arrangement opened the door for private investment in the construction and operation o f new terminals and expanded the range o f services provided. As with the railroad system, the result has been quite positive, with federal subsidies no longer required to support operation and maintenance: APIs cover their operation expenses, pay the government for the concession rights, and invest to improve and expand services. C. ELECTRICITY 1.20 Mexico i s the last major country in Latin America where one vertically integrated nationalized company, the Cornisio’n Federal de Electricidad (CFE), controls essentially the entire sector. As required by the Constitution, the electricity sector i s federally owned or controlled. Independent power producers and self-suppliers thus have to sell their (excess) output to CFE and cannot sell directly to users. The Metropolitan area o f Mexico City i s served b y Luz y Fuerza del Centro (LFC), which accounts for 23 percent o f national electricity distribution and 2 percent o f generation. A s shown in Figure 1.3, CFE, LFC, and Petr6leos Mexicanos (PEMEX, the federal o i l and gas company with a monopoly on that sector) report officially to the Secretary o f Energy. However, their strong traditions, politically appointed heads, o w n revenues, and powerful unions give them significant autonomy. 30 Interview 19 January 2005. 7 Figure 1.3: Structure of the Energy Sector Secretaria de Hacienda y Secretaria de Energia Crtdito Pdblico (SHCP) (SENER) FEDERAL LEVEL I I b 1 PEMEX I (incl. CENACE) Petr6leos Mexicanos Internacional (PMI) Centro (LFC) Instituto Mexican0 del Instituto de Petr6leo (IMP) Investigaciones Electricas (IIE) - I Instituto Nacional d t Compafiia Mexicana 4 de Exploraciones Investigaciones Nucleares Instalaciones Inmobiliarias Industrias (I11Servicios) STATE-OWNED Sources: Adapted from Manual de Organizacidn General de l a SENER, DF 19 Abril2004, COMPANIES AND and www.sener.gob.mx. INSTITUTES 8 1.21 Reforms passed between 1992 and 1995 allowed for private sector participation in electricity generation, provided that electricity is sold only to CFE. The same reforms introduced a regulatory agency, the CRE (Comisidn Reguludoru de Energiu). However, CRE’s main attributions are limited to specific functions related to the regulation o f electricity generation and gas supply by the private sector. Unlike in many other countries, the regulator does not regulate utilities. CFE and L F C thus are outside the scope o f CRE. 1.22 I t is considered good practice in the electricity sector to have an independent system operator in charge o f transmission and dispatching. In Mexico, however, CFE itself i s in charge o f the operation and administration o f the National Power System through one of i t s departments, the Centro Nucionul de Control de Energiu (CENACE). 1.23 In 1998, the Board of CFE created the Direccidn de Modernizucidn y Cumbio Estructurul (the Modernization and Structural Change Unit) to undertake a Program o f Corporate Transformation, which included the simulation o f the functional separation of CFE’s operating divisions-generation, distribution, and transmission-to create conditions of competition and to evaluate the economic and operational results o f the main cost centers. After those units were defined, C E N A C E began t o operate a virtual (simulated) internal energy market (EM), which takes into account external variables (like the prices o f fuels) and internal factors (like the thermal efficiency o f plants). Statistics o f the E M have been constructed since 2000 and helped in evaluating the effect o f potential bilateral contracts between divisions and C E N A C E on the stability o f electricity prices. T o give this analysis an operational effect, the idea was to reward administrators in proportion to their success in reducing losses, improving generation efficiency, and improving maintenance, relative to the alternative modeled. However, after seven years of operation, the Modernization and Structural Change Unit has not evolved as expected and today it i s only a small unit without a clear role. Moreover, i t s work i s hardly reviewed and taken into account b y internal CFE units or government entities such as CRE. Indeed, since C E N A C E is not an independent entity, i t s capacity to provide with transparent reliable information i s not clear under the current institutional arrangement. Likewise, the confluence o f restrictive administrative norms and union resistance to rescaling o f compensations based on unit’s performance, have further prevented the implementation o f the Program o f Corporate Transformation. 1.24 An important arrangement in the energy sector i s the PIDIREGAS scheme. This was created in 1997 as a way to increase economically necessary investment in an off-budget way, in order to stay within the IMF agreements of the time.31 T w o variants o f the scheme exist. The Direct PIDIREGAS scheme is a basic finance, build and transfer operation, whereby CFE commits t o purchase a specified asset, such as a generating plant that has been built b y a private contractor. During the construction phase, the contractor provides the financing required. U p o n completion, CFE purchases 31 The IMF agreed to the arrangement. Although the budget deficit only includes PIDIREGAS when, in the future, actual payments are made, SHCP since 2001 has been publishing the Public Sector Borrowing Requirement, a broader measure that includes the direct PIDIREGAS investments and accrued interest, net of amortization. The PSBR does not include conditioned PIDIREGAS, although the payments to operators are counted as outlays in the current budget. 9 the asset w i t h long-term financing mobilized b y either the private contractor or by CFE itself. Conditioned PIDIREGAS are independent power production (IPP) projects, whereby the private partner keeps the plant, and enters into a long-term service contract with CFE. The government commits to purchase the plant only if the private partner breaches the service contract, or under specific circumstances offorce majeure. Because o f this, conditioned PIDIREGAS become contingent liabilities to the government. More than a contractual agreement, the PIDIREGAS scheme i s a type o f guarantee instrument that supports off-balance sheet financing. 1.25 An office in the revenue sub-secretariat o f SHCP sets the electricity tariff schedules, which vary by sectoral usage and for the summer season b y region according to temperature (air-conditioning demand). For industrial users there are technically sophisticated cost-recovery tariffs that take account o f tension, interruptability, and peak- load demand. For residential and agricultural users, politics plays a large role in the setting of subsidized rates.32 1.26 Since the reforms introduced under the Nuevo Federalism0 in 1995, the responsibility for the planning and financing of grid extension and off-grid supply has been transferred from CFE and L F C to the states and municipalities. A substantial part o f these investments i s financed through FAIS. A similar share i s financed b y both the National Commission for Indigenous People and SEDESOL, focusing on grid extension. Once a system has been constructed, i t s assets and operational and financial responsibility are transferred to CFE. Today, rural electrification efforts are limited to non-economic costly grid extensions which are not accompanied b y other programs or initiatives that ensure rural economic development. The implementation o f sound economic and technical solutions such as off-grid solutions which integrate sustainability components and the participation of private service providers have so far been incipient. D. WATER SUPPLY AND SANITATION 1.27 Although water, like all natural resources in Mexico, is constitutionally the property o f the Federal Government, the water supply and sanitation sector i s much more decentralized than electricity. According to the Mexican Constitution, since the decentralization o f 1983 the primary responsibility for delivery o f water supply and sanitation services rests with local government, comprised o f 2,446 municipalities and almost 200,000 villages and hamlets. Municipalities and municipal water companies (organimos operadores, 00s) provide service t o most customers, and state water agencies handle the rest, including in municipalities (about 1,000 out o f 2,480) that are too small to have their own capacity. Other important sector responsibilities remain vested at the state and federal levels. A recent amendment o f the National Water L a w created the basin agencies (organismos de cuenca) with an important but yet undefined role in the sector. Thus, the functions o f institutions at various levels o f government overlap, as indicated in Figure 1.4. Figure 1.4: Water Institutions 32 See chapter 3 and World Bank (2004a,b) for more details. 10 Federd Level pzGGiiq...........I U t l L y B o a r d s Fbbirayors 1 Local h e 1 p l 6 rmnicipalities) .... I 1 1.28 The federal Comisidn Nacional del Agua (CNA) i s the apex institution of the sector. C N A i s formally under the authority of the Ministry of Environment (SEMARNAT), but enjoys considerable de facto autonomy. I t s Director General i s nominated by the President of the Republic. Created in 1989 with a staff of 38,000 at the time, i t now has 17,000 employees, most of who work in the agency's 13 regional branches and 20 state branches. C N A financed or undertook itself only about one-fourth of the investment in the sector, but i t s t i l l plays a key role in administering the financial flows of the overall sector, including water resources management, irrigation, and water supply and sanitation. 1.29 CNA's budget in 2004 was close to MxP12 billion, o f which about one third i s allocated to water and sanitation, while the remainder i s split between irrigation (hidroagricola), water resources management, flood protection and personnel services. Within the category water supply and sanitation, the largest spending item i s the operation and maintenance of bulk water supply systems, accounting for MxPl.85 billion (the largest of which i s the Cutzamala system serving the Mexico City metropolitan area). Although municipalities are required to pay for the bulk water supplied to them, most do not. As a result, CNA's expenditure on bulk water supply can be considered a recurrent subsidy, provided to one of the most affluent areas o f the country. CNA's main source o f 11 funding i s payments for water rights, amounting to MxP5.9 billion in 2002. These payments originate mainly from industries (76 percent o f payments in 2002) and from water service providers (17 percent) (CNA 2004b:87f.). The other key revenue item i s the sale o f bulk water (MxP1.2bn in 2003), complemented b y several other minor revenue items. A comparison of total CNA expenses and revenues for 1998-2004 i s shown in Figure 1.5 below. For details on the water rights system, see B o x 3.6. I t also gets revenue from federal budget transfers, external credits, and bulk water sales.33 Figure 1.5: CNA Expenditures and Revenues 1998-2004 in MxP million 18000 16000 14000 12000 - 10000 0 Revenues 8000 Expenditures 6000 4000 2000 0 I 1998 1999 2000 2001 2002 2003 2004 Source: CNA, National Water Statistics 2005. 1.30 The 2004 amendment o f the National Water L a w mandated the creation o f Basin Agencies (Organismos de Cuenca) that would strengthen the planning function at the basin level. However, the implementing decrees for the amended law remain to be disseminated and enacted. The Basin Agencies are supposed t o play a key role in the administration o f the Water Financial System (Sistema Financier0 del Agua, SFA) introduced through the recent amendment o f the Water Law.34 The directors o f the Basin Agencies, which are supposedly autonomous, w i l l be appointed by C N A . There i s considerable uncertainty about the scope, form, and timing o f the restructuring process and decentralization o f CNA, the creation o f Basin Agencies, and their role in administering the SFA. 1.31 State governments play an active role in the water and sanitation sector. They are involved in investment planning through six-year State Development Plans and the State Planning Committees, the Comite' de Planeacidn para el Desarrollo del Estado (COPLADE), with representatives from various line ministries and agencies. 33 Billed bulk water revenues were M x P l billion in 2002. I t i s not clear how much has been collected. The revenues originate essentially from the operation of the country's two largest bulk water systems: the Cutzamala system serving the Mexico City Metropolitan area, and the Uspanapa-La Cangrejera system, supplying industries in the South of Veracruz State. 34 The exact role o f the basin-level institutions in the SFA remains to be defined through the operating rules of the new system. 12 Institutional arrangements for planning and service provision vary substantially among the 31 states. 1.32 Almost all states have created State Water Commissions (Comisidn Estatal de Agua, CEA). The CEAs are autonomous entities that usually are under the authority o f the State Ministry o f Public Works. Their attributions differ widely among states. I n 19 states the State Water Commission has an explicit mandate to support municipalities in the provision o f services through technical assistance. In some states the CEA also monitors data on the performance o f service providers, but seldom are these data aggregated into a comprehensive information system. The CEAs are not regulators, since they do not approve tariffs, which are set at the municipal level or in some cases b y State Congresses. In at least 13 states, CEAs or state-owned public enterprises separate from the CEAs operate water distribution systems. In many states, the number o f municipalities served b y state-level bodies i s limited and the localities are small. However, in some states, state-level bodies provide services to the entire state or almost the entire state, such as in Querktaro and Puebla. In a few states with important bulk water supply systems, the C E A also operates these systems. All CEAs also have some authority and responsibility for water resources management. 1.33 At the local level, as a result o f different policies and programs, a variety o f institutional arrangements for service provision can be found. Broadly, they can be classified into four different categories: 0 Reformed service providers (organismos operadores), public or private utilities, defined as one that has achieved a significant degree o f financial and legal autonomy from the municipality and the state government. Examples include Saltillo (Coahuila) and Hermosillo (Sonora). 0 Unreformed but successful service providers defined as those that have achieved a level o f performance that i s close t o best practice, using the standard technical and financial indicators (see chapter 2.)35 Examples include the Public Service Commission o f Baja California and Aguas y Drenaje de Monterrey serving the State o f Nuevo Le&. 0 Unreformed and largely unsuccessful arrangements with limited commercial orientation and limited autonomy from the municipality or the state-estimated to occur in about 80 percent o f municipalities. This includes both service providers and direct provision b y municipalities. 0 Other arrangements, including cooperatives and private small-scale providers. 1.34 Most large cities and some smaller towns have created decentralized municipal service providers (organismos operudores) with varying degrees o f independence. While service providers have their own legal personality and board, in practice most are closely linked to the municipality, which typically appoints most board members and the service provider’s director. According to C N A estimates, general managers o f service providers hold their positions for an average o f 1.5 years (Kemper and Alvarado 2001:629), and 35This would consist o f a collection efficiency o f more than 90 percent, non-revenue water o f less than 30 percent, a working ratio o f less than 0.75, and a staff-per-1,000-connection ratio o f less than 5. 13 most commonly do not survive political changes, resulting in frequent reorganizations and changes in strategy, which immediately undo the potential effectiveness of the previous strategy. There often are close financial links between service providers and municipalities, such as the contracting o f debt and the payment o f bills b y the municipality on behalf o f the service provider. Accounts are usually held on a cash basis, not on an accrual basis, and are seldom audited. There are usually no performance targets for the service providers. 1.35 Nevertheless, there are a few notable exceptions o f service providers that are efficiently operated on a commercial basis. The best o f these service providers self- finance a substantial proportion o f their investments, have been rated b y credit rating agencies, and at least one-the service provider o f Tlanepantla-has even issued a local currency bond. 1.36 In most smaller municipalities, water and sanitation services are performed directly by a municipal department. The quality and efficiency o f services in smaller municipalities tend to be lower than in larger municipalities. Intercity service providers, which are a common institutional arrangement in some other countries to exploit economies o f scale in service provision among small towns or in large metropolitan areas, are almost nonexistent in Mexico. In rural areas, water services are provided directly b y local government or b y user groups, which sometimes take the form o f cooperatives. In some cases, the state water commission provides services in rural areas at the request o f villages or municipalities. 1.37 M a n y of the larger service providers are members o f the Asociacio'n Nacional de Empresas de Agua y Saneamiento (ANEAS), which represents its members at the national level. ANEAS plays an active role in discussing policies, and works in close collaboration with CNA. 1.38 Although the importance in the water sector o f the actors at the state and local level has been increasing over the past two decades, C N A remains the sector's dominant actor in terms o f determination o f policies, subsidy programs, and norms in water supply and sanitation. The existence o f such a strong national institution in the water and sanitation sector i s unusual compared to most other countries, where functions o f national or federal institutions in the water and sanitation sector are usually limited t o certain regulatory and normative tasks and are often fragmented among various institution^.^^ The concentration o f expertise and power in a single federal institution provides some advantages, but i t also means that checks and balances are limited, due to the lack o f expertise on the sector that i s independent o f CNA. 36Some smaller countries, in particular in Africa and Central America, do have single national agencies in charge of water and sanitation service provision, but nowadays these cases are exceptions. 14 2. PERFORMANCE OF INFRASTRUCTURE SERVICES 2.1 Mexico has made steady progress in increasing the coverage o f electricity, water, sanitation, and roads in recent decades, reaching one o f the highest levels in Latin America. While gaps remain, particularly in rural areas and among indigenous communities, the main infrastructure challenge i s not coverage, but insufficient service quality and poor operating efficiency. 2.2 Quality o f service and operating efficiency in the infrastructure sectors covered b y this report lag behind other middle-income countries, as shown in a 2003 W o r l d Economic Forum survey among large industrial users (Table 2.1). The gap i s lowest in ports and railroads, which have made the most improvements in recent years, followed b y electricity. Interestingly, the quality o f Mexico’s infrastructure in all o f these sectors does not match the infrastructure quality o f China, one o f i t s main competitors. Data in this report show that the gap in the quality o f services in water supply and sanitation, which was not covered b y the survey, may be even higher. The quality o f services o f roads-especially state and municipal roads-is estimated to be lower than in other Organisation for Economic Co-operation and Development (OECD) countries, since about 40 percent o f roads are in poor condition. All this confirms the conclusion that quality o f infrastructure services in Mexico does not match i t s achievements in the expansion o f coverage. Table 2.1: Comparative Survey on the Quality of Infrastructure, 2003 * “Overall Infrastructure” includes quality indicators from other sectors not shown above (that is, air transport and information and communication technologies). Note: Survey-based subjective evaluation on a scale from 1 - “underdeveloped and inefficient” to 7 - “as developed and efficient as the world’s best.” The higher the score, the better the quality. Source: WEF (2004). 15 2.3 Tariffs are below cost for residential users o f water and electricity, but they are close to or above cost for industrial and commercial users. I t i s estimated that the share o f the average electricity and water bill in expenditures o f an average household does not exceed 2.5 percent and 1.8 percent, respectively, well below thresholds at which tariffs are deemed unaffordable. Expenses to compensate for poor service quality-cisterns for storage, and purchases from tankers and bottles in the case o f water, and surge protectors in the case o f electricity-are estimated to be substantial and, in the case o f water, much higher than utility bills. I t i s likely that willingness to pay for a service o f good quality i s higher than current tariffs among most users. 2.4 All sectors exhibit a bias toward new construction and upgrading, while preventive maintenance i s neglected. In roads, the high share o f roads in poor condition i s a consequence o f insufficient maintenance. In the electricity sector, the approved budgetary resources for maintenance, operation, and repair have been on average 30 percent lower than the requested amount. In water and sanitation, assets are often deteriorated and investment i s biased toward new construction. 2.5 There i s no explicit policy to target subsidies for infrastructure services to poor households, or to target infrastructure investments at poorer regions. The 2004 Public Expenditure Review has shown that, overall, the poorest states receive as much federal transfers per capita as the average.37 Many but not all transfers are formula based. Ram0 33, a formula-based transfer to municipalities and states, strongly favors the poorest o f them. In 2002 at least 44 percent o f Ram0 33-created FAIS investments were estimated to have been used in the sectors covered in this report. This i s equivalent to 15 percent o f total investments in these sectors, with a concentration in water and sewerage. However, the poverty orientation o f F A I S is countered b y the distribution o f the 85 percent o f infrastructure investments that are financed outside FAIS. For example, in the water and sanitation sector the eight states with the lowest marginality received 2.5 times more investments per capita than the eight states with the highest marginality, excluding FAIS. This i s partly due to the nature o f some formula-driven programs such as the Water Rights Return Program (Programa de Devolucio'n de Derechos, PRODDER), which favors states with higher water scarcity, which are generally the states w i t h the lowest marginality. 2.6 The primary problem o f the poorest states, however, i s not the volume of resources at their disposal, but how the resources are used. This is also one o f the key findings o f the World Bank study Development Strategy for Mexico's Southern States, which recommended increasing federal resources only after improvements in performance have been achieved (World Bank 2002:4). 2.7 The remainder o f this chapter analyzes the performance o f the five sectors covered in this report along a common analytical framework focusing, first, on outcomes (coverage, service quality, and operational efficiency); second, on tariffs and cost recovery; and third, on the level and composition o f spending. 37 World Bank (2004c:74). This includes all transfers, including earkmarked uportuciones, non-earmarked participuciones, and sectoral programs. 16 A. ELECTRICITY Outcomes 2.8 Access to electricity in Mexico has steadily increased over recent decades, reaching levels significantly above the average for the region and o f other developing countries, with 95 percent o f the population connected to the electricity grid (Table 2.2) (World Bank 2004d:48). This coverage expansion has favored the extreme poor and rural dwellers. For example, 90 percent o f the extreme poor had access t o electricity in 2002, up from only 63 percent in 1992 (World Bank 2004a). 2.9 Nevertheless, rural areas and indigenous communities remain underserved. For example, electricity coverage in the predominantly rural Southern States (Chiapas, Guerrero, Oaxaca, Veracruz) reaches only half to two-thirds o f population centers. Unelectrified localities are mainly small indigenous communities, generally in extreme poverty, with populations below 1,000 inhabitants, located in remote rural areas.38 The lack of both appropriate mechanisms and a formal operational rural electrification program, which consider off-grid solutions, rural economic development and sustainability issues, are contributing to the persistence o f the l o w electricity coverage rate, especially in communities characterized by extreme poverty levels39. Table 2.2: Mexico’s Electricity Coverage i s Comparatively H i g h Sources: World Bank (2004) East Asia report; data for Mexico in electricity coverage from INEGI (2002). 2.10 According to official data, the quality o f electricity services has improved (Table 2.3). Customer interruptions caused b y operating events and customer complaints declined, while connection time decreased for both the National Electric Company (Comisidn Federal de Electricidad, CFE) and Luz y Fuerza del Centro (LFC). However, distribution losses increased moderately for C F E and massively for LFC-from 11 percent in 1994 to 27 percent in 2003. 2.11 Nevertheless, a gap remains between the major service providers, CFE and LFC, serving the metropolitan area o f the capital. The gap i s most marked in the connection time for new customers (1 day compared to 6 days) and distribution losses (27 percent compared to 11 percent) (Aburto 2004). 38 There are s t i l l 2,600 localities of between 100 and 10,000 inhabitants without electricity in this region. 39 Initiatives led by the Indigenous People Development Commission focus exclusively on costly grid- extensions which favor communities with more than 1,000 inhabitants. Essential factors such as cost- effectiveness; willingness to pay o f the communities and sustainability are generally not taken into account. 17 Table 2.3: Quality of Electrical Service, 1995-2003 1995 1998 2002 2003 Interruptionof CFE 242 225 124 121 Service LFC - 374 144 135 (min/customer) Complaints CFE 14 10.7 4.2 4.1 1 (no./l,OOO customers month) I 1 LFC - 1 6.7 1 4.4 1 4.3 1 Connection CFE I 2.3 1.4 1.2 1.1 time, new customers LFC - 10 5.5 6 (days) 2.12 Despite the gradual improvements in service quality, i t remains below the levels reached in many other countries in Latin America and East Asia. For example, when annual interruptions and distribution losses are compared to Latin American privatized distribution companies, the performance of CFE i s poor4’ (Figures 2.1 and 2.2). Figure 2.1: Annual Interruptions (minutes) Per Connection 250 - I 200 - I I +CFE 150 1 Brazil ElectroPaulo +Argentina Edenor 100 4 +Argentina Edesur 0 1995 1996 1997 1998 1999 2000 2001 2002 2003 Sources: CFE financial data; and Andres, Foster, and Guasch (2005). 40 N o data on annual interruptions have been reported for public utilities or public distribution companies. 18 Figure 2.2: Distribution Losses (%) l8 1 16 - 14 - -CFE Totales , -W- Peru Edelnor +Peru Luz del Sur --+-Chile Chilectra +Argentina Edenor 2 - +Argentina Edesur 0 , 1995 1996 1997 1998 1999 2000 2001 2002 Note: CFE's data do not include natural phenomena, in which case values would be higher. Reliable comparative data for public utilities in other developing countries were not available. Sources: CFE financial data; and Andres, Foster, and Guasch (2005). 2.13 There i s no independent verification of the quality o f service and operational performance data provided b y CFE and LFC. Independent verification increases the reliability o f data and i s o f great importance for regulatory purposes, for a balanced and transparent relationship between independent power producers and buyers o f electricity and for increasing the confidence of investors in the sector. 2.14 Insufficient investment in maintenance and modernization makes i t difficult to further improve service quality. The approved budgetary resources f o r maintenance, repair, and refurbishment o f assets are on average 30 percent lower than the level that CFE executives think i s required (and reflected in the amount requested initially b y CFE management every year)41. Neglect o f aging plants and distribution lines makes i t hard to maintain and almost impossible to further improve levels o f service quality and efficiency. 2.15 Labor efficiency indicators have also slightly improved, but remain below international benchmarks. The total number o f permanent employees (including de con.anza and sindicalizados) has been maintained almost constant, while electricity demand and production have grown. When compared, however, to other Latin American companies, the performance o f CFE is s t i l l poor (Figure 2.3). I s i s evident that the influence o f the unions has an effect on the overall economic and technical performance o f both CFE and LFC42. 41Interview with CFE management. 42For instance, the confluence o f restrictive administrative norms and union resistance to rescaling compensation based on the performance o f different operative units across segments has impeded improving the labor efficiency parameters. 19 Figure 2.3: Number of Connections per Worker in DistributionSegment43 3000 i 2500 1 -MEXICO CFE 2000 - +PERU Edelnor +PERU Luz del Sur 1500 ! ---t CHILE Chilectra +BRAZIL Electropaulo -ARGENTINA Edenor 1000 -ARGENTINA Edesur +COLOMBIA Codensa I 500 7 o i I 1 1995 1996 1997 1998 1999 2000 2001 2002 2003 Sources: CFE financial data; Andres, Foster, and Guasch (2005). Tariffs and Cost Recovery 2.16 CFE and L F C are required to provide electricity at tariffs set b y the Federal Government, including at tariffs below cost for certain categories o f users (Table 2.4). The subsidy implied in these tariffs i s financed in different ways in the case o f CFE and LFC. CFE does not receive transfers to finance the subsidies. I t s subsidies are primarily financed b y nonpayment o f a statutory rate o f return (uprovechamientos) o f 8 percent on CFE’s net fixed assets. In case uprovechamientos exceed user subsidies, CFE’s capital base i s strengthened through retained earnings, as was the original intention o f the government. However, CFE’s capital base i s currently being eroded because subsidies have exceeded uprovechumientos since 2000. User subsidies have been estimated b y CFE at MxP49 billion in 2003 (0.7 percent o f GDP), while uprovechumientos stood at MxP44 billion (0.6 percent o f GDP). The subsidized tariffs cause a loss o f federal revenues through the nonpayment o f uprovechumientos. In the case o f LFC, which i s not subject to uprovechumientos, the Federal Government transfers finance the excessive operational cost and the subsidy to consumers, totaling M x P 2 1 billion (0.3 percent o f GDP). Total subsidies to the electricity sector thus amount t o MxP70 billion, about 1 percent o f GDP, or 175 percent o f investments in the electricity sector in 2003. 2.17 According to CFE, the average tariff charged t o residential customers in 2003 covered just 42 percent o f costs, and the average tariff for agricultural use covered 28 percent o f costs. Industry paid 88 percent o f costs (Table 2.4). 43 In the case o f CFE, data includes only workers in the distribution segment 20 Table 2.4: CFE: Degree of Cost Recovery, Price to Cost Ratios (%) Source: Samaniego-Breach (2005) own calculations using CFE data. 2.18 The electricity tariff system remains very complex, with 112 different billing possibilities that draw from 7 basic tariffs, 2 seasons, and 8 billing options b y consumption level (World Bank 2004d: 139). All o f the tariffs contain non-linearities and discontinuities, and arbitrary criteria for applying them, which makes i t difficult to understand them and often leads to paradoxical results. Especially in the case o f LFC, political involvement in the process o f tariff setting b y the Finance Ministry has led t o rates that do not allow for cost recovery. 2.19 Residential tariffs are well below the OECD country average, while industrial tariffs are higher than the average o f OECD countries and the United States. Independent sources indicate that peak industrial electricity tariffs are at times higher than the costs o f producing electricity on-site with diesel-based thermal plants.44 High industrial tariffs have led to an increasing trend toward self-supply b y industries during peak hours. Compared with the electricity tariffs in other Latin American countries, commercial tariffs are among the highest tariffs in the region, while industrial and residential tariffs are close to the regional average (Figure 2.4). 44 Instituto Tecnoldgico de Estudios Superiores de Monterrey (2004), quoted in Samaniego-Breach (2005:24). High tariffs during peak hours might be the result of underinvestment in the transmission and distribution networks as well as the lack o f thermal plant availability. 21 Figure 2.4: Prices of Electricity in Selected Latin American Countries, 2002 2o Bindustrial 0 5 10 15 BCornrnercial Price of electricity (US$ cents per kWh) 0 Residential Sources: Foster (2004) and CFE. 2.20 A comparison o f tariffs with OECD countries and the United States shows that residential tariffs in Mexico are substantially lower than in the United States, Spain, and the OECD average (Table 2.5). Industrial tariffs in Mexico were lower than these comparators after the 1995 crisis, but are now higher due to tariff increases in Mexico and tariff decreases in comparator countries that have introduced competition (Table 2.6). Comparative data on industrial tariffs are sometimes contradictory, partly due to methodological problems.45 For example, some sources show that industrial tariffs in Mexico were 27 percent higher than in the United States in 2003, while others say the difference i s as high as 54 percent.46 Another source calculates that in 2003 the average implicit industrial tariff of CFE was 22 percent higher than in Arizona and 25 percent higher than in N e w Mexico, and the average implicit industrial tariff in California was 51 percent higher than for CFE (Samaniego-Breach 2005:27). 45 Methodological issues include the weighting among various industrial tariffs (medium and high voltage, peak and off-peak), the coverage and weighting o f the sample among utilities in one country, whether taxes were included, and the choice of the appropriate exchange rate (Purchasing Power Parity or straight exchange rate). 46 The former percentage i s calculated from tariffs in Table 2.6, while the latter percentage comes from a recent study by the Industry Association of the State o f Nuevo L e h , quoted in Samaniego-Breach (2005 :24). 22 Table 2.5: International Electricity Prices for Households (U.S. dollars p e r kilowatt-hour) n.a. = Not available. a. Electricity prices in the United States include income taxes, environmental charges, and other charges. However, the prices exclude the taxes collected for the convenience o f the States and “passed through” to the customer. Note: Energy end-use prices including taxes, converted using exchange rates. Source: Samaniego-Breach (2005 :27). Table 2.6: International Electricity Prices for Industry (U.S. dollars per kilowatt-hour) Mexico 0.042 0.027 0.033 0.041 0.038 0.042 0.051 0.053 0.065 Spain 0.078 0.076 0.074 0.061 0.057 0.049 0.043 0.041 n.a U n i t e d Statesa 0.048 0.047 0.046 0.045 0.045 0.044 0.046 0.050 0.051 2.21 Residential electricity subsidies are highly regressive: Upper middle income households (income deciles 6, 7, and S), receive the majority o f the consumption subsidy (Figure 2.5). The electricity subsidies also go mostly to the regions that are already more economically developed. The vast majority of the subsidy-over 90 percent-is not a lifeline for the poor and encourages inefficiency, especially in the hot areas in the summer, which benefit f r o m highly subsidized rates. Poverty criteria are absent in the determination o f regional electricity tariffs, unlike in water, where some municipalities set lower tariffs in poorer neighborhoods. 23 F i g u r e 2.5: Distribution of Subsidies, b y Household Decile I 1 2 3 4 5 6 7 8 9 10 Decile Source: World Bank (2004c,d). 2.22 According to the 2002 Household Survey the average share of electricity expenditures in household income was 2.65%, varying between 3.2% for the first decile and 1.9% for the tenth decile (see Figure 2.6).47 F i g u r e 2.6: Household Decile by T o t a l Income, 2002 3.5% 3.0% 2.5 % 2.0% 15% 1.0% 05% 0.0% I I I In N V VI w WI M X IEi Share of Expenditure in Electricity 4 Share of Expenditure in Water Source: World Bank calculations based on the National Survey on Household Income and Expenditure. 47World Bank calculations based on data from the 2002 National Survey on Household Income and Expenditure (ENIGH) by INEGI. 24 2.23 Agricultural electricity subsidies are also highly regressive, favoring the richer, Northern states that rely heavily on irrigation for climatic reasons. Poor farmers do not have access to the benefits o f the subsidy, because they practice very limited irrigation, if at all, again to a large extent because there i s no need for irrigation in the Southern states for climatic reasons. As a result, Chiapas received only MxP44 million o f subsidy (0.8 percent o f total electricity subsidy to agricultural customers), while Oaxaca received MxP18 million (0.3 percent), and Guerrero only MxP3.6 million (0.1 percent) (World Bank 2004~). Equally alarming, the subsidy and subsequently l o w tariffs for electricity creates a perverse incentive to over-pump aquifers, increasing already alarming water shortages. Spending 2.24 Total investment in the electricity sector was MxP39.9 billion in 2003, a marked decline from investment levels in the previous year (Figure 2.7).48 More than 90 percent of investments are carried out b y CFE and private investors, the remainder being accounted for b y LFC. CFE investments include i t s own budgetary investment, and “financial investments” in the form of Projects with Deferred Impact in the Budgetary Registry (Proyectos de Zmpacto Diferido en el Registro de Gusto, PIDLREGAS). PIDIREGAS investments constantly increased until 2002, but then declined abruptly in 2003. Total investment in electricity corresponded to 0.7 percent o f GDP in 2003, lower than other countries in Latin America (Figure 2.8). Figure 2.7: Investment in the Electricity Sector (million MxP 2004) 1 60,000 I 50r000 40,000 ~ 1 30,000 ~ 20,000 10,000 0 ~ 1998 1999 2000 200 1 2002 2003 ~ 1 7 Direct Investment byCFE 0 Pidiregas E k i Luzy Fuerza del Centro Note: Investmentsby municipalities, partly funded under FAIS, are not included. Sources: Secretaria de Energia, quoted in Samaniego-Breach(2005); World Bank calculations. 48This excludes FAIS, investments made by developers and “payments for BLTs and PIDIREGAS,” which are shown by some CFE statistics as “investments.” 25 Figure 2.8: Investments in Electricity as a Share of GDP-International Comparison I Total Investments in Electricity (as YO of GDP) 3.00% I 2.50% ~ 2.00% 1 1.50% 1.OO% I 0.50% 0.00% Mexico (2003) Argentina (2002) Chile (2001) Colombia (2001) Sources: World Bank calculation for Mexico; Calder6n and ServBn (2004) for other countries, 2.25 The reduction in investments i s largely due t o the deteriorating financial situation o f CFE, which in turn i s due to (a) increasing liabilities from earlier investments undertaken using the PIDIREGAS scheme, (b) increasing fuel costs, (c) and increasing pension obligations @assivo laboral). During 2000-02, CFE investments averaged 17 percent o f total budget, or MxP17.3 billion a year. Investments were even lower as a percentage o f total LFC’s budget, averaging approximately 10 percent o f total expenditures for 1998-2003. B. W A T E R SUPPLY AND SANITATION Outcomes 2.26 Access to water and sanitation in Mexico has steadily increased in recent decades, reaching levels significantly beyond the average o f the region and o f other developing countries (Table 2.7).49 Approximately 90 ercent o f the population now has a water connection either in the house or nearby.5 8 Ninety percent had access to sanitation, including 63 percent that were connected to a sewer, 12 percent that had a septic tank, and another 15 percent that used sanitary latrines or evacuated their sewage The through sewers discharging into the nearby e n ~ i r o n m e n t . ~ ~ poor and the extreme 49 While statistics show the level of sanitation coverage the same as the average for the region, this figure i s distorted by different definitions o f access to sanitation, since latrines are excluded from the definition used in Mexico, while they are included in many other countries. 50 Improved water supply includes four categories: households with piped supply in the house; households with piped supply on the plot, but outside the house; public standpipes; and households that bring water from another house with piped supply. 5 1 The 2000 census, as shown in spreadsheets provided b y Avila (2004). C N A includes only the first two categories in i t s statistics on access to sanitation (alcunturilludo), but does not publish statistics on sanitation coverage in the broader sense. 26 poor also benefited from the increase in coverage: 58 percent o f the extreme poor had access to a safe water supply in 2002, up from 38 percent in 1992 (World Bank 2004a). However, the coverage level drops sharply from more developed urban areas through the urban periphery and smaller towns to the more remote rural areas52. Table 2.7: Mexico’s Water and Sanitation Coverage i s Comparatively H i g h Sources: Data from World Bank (2003a) and CNA Water Statistics in Mexico (2004). Sanitation data for Mexico are from the 2000 census. East Asia data are from World Bank (2004b). 2.27 Service quality and operating efficiency clearly fall short o f the levels achieved in other OECD countries and upper-middle-income countries. The share o f municipal wastewater that receives some degree o f treatment i s more than twice as high as the Latin American average (30 percent compared to 14 percent),53 but i t remains far below levels in OECD countries, and an unknown share of treatment plants do not comply with norms for effluent discharge. 2.28 According to the 2000 census, only 45 percent o f households connected to the water distribution network received a continuous supply o f water; the remaining 55 percent experienced various degrees o f intermittent supply.54 The incidence o f intermittent supply i s higher in smaller municipalities and for the poor.55 (Figure 2.9) This phenomenon puts Mexico clearly behind other OECD countries, where continuous water supply i s the norm. 52 From 2000 census, as shown in spreadsheets provided by Avila (2004). According to CNA access to sewerage (alcantarillado) has increased to 77.5% (2004), though CNA does not publish statistics on sanitation coverage in the broader sense. 53 CNA (2004a:A-76). For Latin America average, see P A H O W H O (2001 :24,81). 54 Own calculation, based on census data quoted in Avila (2004), spreadsheet named Anexo I.CC-Agua 55 Avila (2004) based on census data. 27 Figure 2.9: Quality o f W a t e r Service in Mexico 100% 90% 80% 70% 60% 50% 40% 30% 20% 10% 0% Poor people in cities Not poor people in Poor people in Not poor people in cities towns and rural towns and rural villages villages 2.29 Water-related health indicators have shown a marked improvement, but s t i l l remain worse than those o f a few other upper-middle-income countries in Latin America.56 While there are very limited data on drinking water quality at the tap, the intermittency of supply i s likely to have a negative impact on drinking water quality, mitigating progress made in the disinfection o f water at the source, which has now reached 95 percent. A recent survey has shown that 16 percent o f Mexicans with connections receive water that does not contain the required level of residual chlorine at the tap.57 2.30 Using non-revenue water (NRW)58 as an indicator, operating efficiency levels in Mexico are far below the average level attained in developed countries, and below the level attained in the best-performing quartile o f utilities in developing countries (Table 2.8). For example, the average level o f NRW in Mexico i s estimated at 44 percent,59 while the best-performing quartile o f 123 utilities in 44 developing countries achieves less than 23 percent o f NRW (Tynan and Kingdom 2002). The average level in developed countries i s about 15 percent. The level o f NRW in Mexico varies substantially, showing that l o w levels o f NRW are achievable in Mexico. 56 For example, the mortality rate associated with intestinal infectious diseases in Mexico i s twice as high as in Argentina, four times as high as in Costa Rica, and 15 times as high as in Chile. See Background paper on water. 5' Comisidn Federal para la Proteccidn contra Riesgos Sanitarios (COFEPRIS), quoted in the Mexican press in January 2005. The study covered all Mexican states from January to December 2004. 58 Non-revenue water i s the difference between water supplied and water sold as a percentage o f water supplied. 59 C N A (2004a:42). Calculated based on a sample of 157 service providers with reliable data. 28 Table 2.8: Non-revenue Water in Mexico Compared to other Countries Bsico do Estado Sources: C N A (2004a:42) for Mexican average; data on Mexican cities are from CNA: Ciudades Estratkgicas (2000) and Barocio (2004); for the Brazilian National Water Information System Diagno’stico 2000; Malaysia and Asian cities from ADB Water in Asian Cities (2004); U.K. and U.S. from IB-Net (International Benchmarking Network); Latin American average from WHOLJNICEF (2000:25). Developing country sample average i s from Tynan and Kingdom (2002). 2.31 Water staffing levels vary broadly in Mexico. The average level o f staff per 1,000 connections among a sample o f 35 large Mexican utilities was 4.5 in 2000, ranging between 2.8 and 19.6.60 These data suggest that there is ample scope for improving the situation o f many overstaffed water utilities throughout the country. Tariffs and Cost Recovery 2.32 Tariff levels and structures in the water and sanitation sector display a wide regional variation, including service providers that fully recover their costs and others that fail to cover even their operating costs. The sector as a whole falls far short o f generating sufficient revenues to cover full costs.61 Water service providers typically charge tariffs close to full cost recovery to industrial and commercial users and cross- subsidize residential users. On average, water tariffs for industrial and commercial users are more than four times higher than for residential users.62 The average tariff across 6o The average for 38 utilities in the State o f Guanajuato was 4.4 in 2002. The average for a larger sample o f utilities at the national level may be higher, since smaller service providers tend to have a higher staff ratio. Estimates show that the sector generates a moderate “surplus” over operating costs. This does not take into account depreciation, debt service, and adequate maintenance. The accounting “surplus” thus i s an illusion. I N E G I (1999), ICenso de Captacibn, Tratamiento y Suministro de Agua. The average tariff i s M x P 1.62/m3 for residencial users, M x p 6.90/m3 for commercial users and M x P 6.76/m3 for industrial users. 29 users i s only about half the Latin America and the Caribbean (LAC) average (US$0.32 per square meter compared to US$0.65 per square meter).63 2.33 There are no data on average water tariff increases in Mexico, although anecdotal evidence suggests that average real tariffs remained flat or may have declined. In a few utilities, automatic tariff adjustment mechanisms are in place, linking a sector- specific price index to small tariff adjustments on a monthly basis. 2.34 Most cities do not charge for sanitation. In those cities where users pay for sanitation, it i s typically as a small percentage share o f the water bill. Given the substantial ongoing and planned increase o f investments in wastewater treatment, which w i l l go hand in hand with an increase in operating and maintenance costs, an effective cost-recovery mechanism for wastewater treatment i s urgently needed. This could be achieved through a system o f output-based transfers, similar to a Brazilian program under which the Federal Government pays utilities for the discharge o f adequately treated wastewater after independent verification (Annex B). 2.35 There are no reliable figures on total water and sanitation revenues in Mexico, Water tariff collections have been estimated at MxP14.5 billion (US$1.54 billion) in 2002. Various sources estimate billed revenues at between MxP20.2 billion (US$2.14 billion) and MxP26.9 billion (US$2.9 billion) in the same year.64 On average, i t seems that the sector generates only a very modest cash surplus, which i s well below the financial performance achieved by the top quartile o f utilities in developing countries (Tynan and Kingdom 2002:3). Moreover, this apparent modest surplus among Mexican utilities in part reflects shortfalls in essential spending on maintenance and modernization rather than financial viability. The aggregate figures also mask substantial variations in performance among service providers that depend on municipal subsidies for recurrent costs and those that self-finance substantial investments. This suggests that the some service providers in Mexico achieve or exceed international good practice. 2.36 Average collection efficiency in Mexico i s far below the levels achieved in developed countries, and even in many developing countries. The level o f collection efficiency in Mexico has been estimated at 72 percent (Table 2.9). The wide variations within Mexico again show that high levels o f performance are achievable there. An increase in collection efficiency to 95 percent-close to the best utilities in Mexico- would mobilize more than MxP5 billion annually, without any increase in tariffs. This i s more than all federal subsidies outside Ram0 33 provided to the sector in 2003. 63 For Mexico: Barocio (2004: 15); for Latin America: WHO/UNICEF (2000:18). The prices are not strictly comparable, because the regional figures refer to earlier years. A comparison with average 2003 tariffs in the region may show an even larger discrepancy. 64 The lower figure i s taken from CNA (2004:38) and i s calculated from a sample o f 437 localities in all states. The higher figure i s taken from Barocio (2004), based on extrapolations made from a sample o f 192 localities from states for which data was deemed reliable. 30 Table 2.9: Collection Efficiency I Country I Year 1 Collection / Billing (%) Mexico (Monterrev) I 2004 I 98 OECD average 1996 95 Asian cities (average o f 18) 200 1 88 Brazil (average) 2000 87 Mexico (Hermosillo) 1999 85 Mexico (average) 2002 72 Mexico (sample o f small cities) 20 Sources: C N A (2004); SMAPA (Tuxtla Gtz. 0.0.)interviews (2004); Capitol Advisors Ltd. Hermosillo Case Study (1999); IDB, the Brazilian National Water Information System, and OECD, Ciudades EstratCgicas (2000). 2.37 According to official estimates, 69 ercent o f Mexican water users are metered and are charged increasing-block tariffs. 6 9 However, from a poverty perspective increasing-block tariffs are questionable, as demonstrated b y a recent international study that shows that the benefits from increasing-block tariffs accrue mainly to the better off. 2.38 Thirty-one percent o f water customers are not metered and are charged a flat rate (cuota fija) independent o f consumption. In a few instances, flat rates are differentiated b y neighborhood, and sometimes sharply so. For example, in the Federal District the flat rate in the highest cadastral category i s 20 times higher than in the lowest. Since the level o f water consumption does not vary that much among income groups, this type o f water tariff may have a progressive incidence. Geographically differentiated tariffs that are even crudely based on poverty levels may reach the poor more effectively than increasing-block tariffs. 2.39 According to the 2002 Household Survey the average share o f expenditures for piped water supply in household income was 0.65%, varying between 1.0% for the first decile and 0.4% for the tenth decile (see Figure 2.6 above in the section on electricity showing the shares o f expenditures for both water and electricity).66 This share i s l o w in international comparison. 65 An analysis o f domestic water tariffs in 23 Mexican cities with increasing-block tariffs reveals that many utilities allow a broad lifeline consumption o f up to 30 cubic meters per month, or about 240 liters per capita per day. Such broad lifeline blocks defeat the purpose o f cross-subsidization among domestic users, because the great majority o f domestic users fall into the highly subsidized category. World Bank calculations based on data from the 2002 National Survey on Household Income and Expenditure (ENIGH) by INEGI. 31 2.40 Expenditures for water from tankers and bottled water are estimated to be many times higher than expenditures for piped water supply across income groups, for both households with and without access to piped water. These expenses have not been included in the census data. Households with access to piped water frequently suffer from intermittent supply, and do not trust the quality o f the water supplied. Therefore they frequently build cisterns, buy water in large bottles, boil or filter piped water, and buy water from tankers. These costs for coping with the poor quality o f piped water services have not been estimated for Mexico, but are thought to be several times higher than the current costs for piped water supply. Spending 2.41 Total investment in the sector was estimated b y the World Bank to be MxP16.6 billion (US$1.5 billion) in 2003, or 0.27 percent o f GDP.67This i s lower than investment levels in other countries o f the region (Figure 2.10). Investment in water supply and sanitation declined b y 45 percent in real terms from 1993 to 1996 due to the economic crisis, recovering only slowly. In 2003, i t again increased significantly, finally exceeding i t s pre-crisis level. The impact o f the low investment levels has been felt in the persistence o f poor service quality, and in l o w levels o f wastewater treatment. Figure 2.10: Investment in Water as a Share of GDP - International Comparison Total Investments in Water (as 9%of GDP) 1 00% U .WQ i 0 80% 0 60% 0.?648 0.38% i 0 40% u,L/ Yo 0 20% -- I 000% I I I I I Mexico Argentina Chile QOOI] Colombia Brazil (2002) I20033 (20021 eon11 Source: Calderdn and ServCn (2004). The Mexico 2002 figure has been calculated b y the World Bank, including investments under FAIS and by housing developers. 2.42 Federal subsidies (including Ram0 33) are estimated to account for 56 percent o f investment financing in water supply and sanitation in 2003, complemented b y state subsidies (13 percent) and a small share o f municipal subsidies (Figure 2.11).68 Internal cash generation and commercial credits account for only a small share o f investment 67 Based on a gross domestic product o f MxP6,245 billion in 2003 in current prices. Source: INEGI Web site. The investment figure includes an estimated MxP.5 billion of water and sanitation investments through FAIS, which are not included in C N A statistics. CNA statistics do not distinguish between municipal subsidies and internal cash generation b y municipal service providers, thus making it impossible to precisely establish the total level of subsidies to the sector. 32 financing (possibly 5 percent), although available data do not allow making a precise estimate. B y far the largest source o f investment funding for the sector besides the Federal Government is housing developers (22 percent), which construct water and sewerage systems within their developments and which increased their investments substantially as part o f large subsidized housing programs initiated in 2001. Figure 2.11: EstimatedFunding of Water and Sanitation Investment in 2004 Credits, Equity and Others Federal Program Housing Developers 22% 2.43 Before 2000, investments in sanitation were neglected compared to investments in water supply. Since then, this distortion has been corrected, in particular through a substantial increase of investments in wastewater treatment in response to federal pressure to comply with norms for wastewater treatment. Figure 2.12 shows the breakdown o f investments b y subsectors. Figure 2.12: Investment in Water and Sanitationby Subsectors, 1997-2002 (in constant prices) 6 5 4 3 u) e o m $2 0 1 0 1997 1998 1999 2000 2001 2002 Source: Barocio (2004), using CNA figures. This includes only investments under CNA programs. Figures for 2003 are not included, because they do include substantial investments outside CNA, and thus are not comparable to earlier years. 33 2.44 As can be seen in Figure 2.13, the share o f investments allocated to rural areas declined since 2000. In any case, a slight long-term decrease in the share o f investments allocated to rural areas may simply reflect the lower share o f the rural population in the total population. Figure 2.13: Investment in Water and Sanitation by Urban and Rural Areas, 1997-2002 (in constant pricesY9 6,000,000 5,000,000 4,000,000 3,000,000 2,000,000 1,000,000 0 1997 1998 1999 2000 2001 2002 ~ Source: Barocio (2004), using C N A figures. This includes only investments under C N A programs. Figures for 2003 are not included, because they do include substantial investments outside CNA, and thus are not comparable to earlier years. 2.45 The high average level o f non-revenue water in Mexico (discussed in chapter 1) and feasibility studies suggest that investments in the reduction o f distribution losses would be more cost-effective than investments in new bulk water supply i n f r a ~ t r u c t u r e . ~ ~ For example, a 1996 study estimated that the unit investment costs o f leakage reduction in Mexico City would be eight times lower than the unit investment costs o f additional bulk water supply (Ciudad de Mexico 1996).71 I t seems that despite a stated priority for investments destined to “increases in efficiency,” there i s s t i l l a preference for investments in bulk water supply as opposed to investments in leakage reduction. C. ROADS Outcomes 2.46 Mexico’s road network i s extensive. As shown in Table 2.10, about 16 percent of the roads are federal roads and the remaining 84 percent are state and municipal roads. About 11 percent o f the federal roads are toll roads. Mexico’s road network presents congestion problems around large cities, however, and still fails to link some rural areas 69 In 1,000 Mexican Pesos 70 While i t could be argued that the rapid increase o f access (see chapter 1) at a time o f declining investments during the 1990s could be interpreted as a sign o f efficiency, it appears that i t i s more the result of prioritizing coverage expansion over rehabilitation and wastewater treatment. 71 The unit costs were US$0.4 per cubic meter and US$3.17, respectively. 34 to major state and national highways. In Oaxaca, for example, 40 percent o f the state’s localities representing 15 percent o f the state’s population are not served b y a road (Fay 2004: 7). Table 2.10: Road Network, in Kilometers, 2000 Source: Sector Program 2001-2006, SCT. 2.47 As a result o f insufficient investment in maintenance and modernization, the condition o f many assets i s not satisfactory. Many federal, state, and local roads are old and require either renovation or replacement, particularly with steadily increasing traffic. Road use has risen significantly over the last decade, with road transport b y bus and truck currently accounting for 98.5 percent o f domestic passenger traffic and more than 85 percent o f surface freight cargo. Following trucking deregulation in 1989, and the advent o f the North American Free Trade Agreement (NAFTA), trucking activity has grown b y 32.5 percent, and the authorized weight o f vehicles was raised f r o m 34 tons in 1960 to 66.5 tons in 1997.72 2.48 Mexico’s road network i s in poor condition and badly needs repair. Based on an assessment o f 20 indicators that include operational standards, traffic, design characteristics, security, and maintenance, only 61 percent o f the highway system can be considered modern, with 39 percent requiring improvement^.^^ Moreover, only a fourth o f the roads are in good condition, well below the average o f a sample consisting mainly o f other OECD countries (59 percent).74 Overall, the main federal corridors s t i l l lag in maintenance and modernization, although there i s some recent improvement. 2.49 State and municipally controlled roads are in particularly bad condition, especially in rural areas.75 For example, in Chiapas, Guerrero, and Oaxaca, rural roads account for 73 percent o f the total roads, and are either (a) improved tracks (9 percent), not really suitable for vehicles, and not usually passable year round; (b) dirt or gravel roads (6 percent), which may or may not be passable year round; or (c) surface roads (58 percent). O f the paved highways, only 9 percent have more than t w o lanes.76 72 The trucking industry has been characterized b y a relatively aged fleet (17.5 years on average). In addition, the high number o f owner-operators l e d to inefficiencies and limits economies of scale, while at the same time providing only modest service quality and efficiency. 73 Communications and Transport Sector Program 2001-2006. 74 See Guerrero (2004). The source o f data i s PIARC. 75 There i s very l i t t l e data on the quality o f roads at the subnational level. This may be symptomatic o f larger issues o f quality in the sector at this level. 76 Fay (2004:9); and “Anuario Estadistico 2003,” SCT. 35 2.50 The efficiency o f road maintenance also does not meet OECD standards. The operation and maintenance costs for toll roads managed b y Caminos y Puentes FederaZes (CAPUFE) average US$80,000 per kilometer in the main highways, compared to US$40,000 to US$50,000 in most countries.77 In the maintenance o f free roads, suboptimal programming and the absence o f contractual incentives for better performance increase Tariffs and Cost Recovery 2.51 Despite reductions in the late 1990s, high fares have kept the use o f many toll roads below capacity. Estimates suggest that toll tariffs would have to be reduced significantly t o have a real impact on traffic patterns. This i s largely due to many free roads that compete with toll roads for freight and passenger traffic. After the substantial reductions o f the 1990s-from MxP12 to M x P 2 per truck and kilometer in constant prices in the case o f roads owned b y the Fideicomiso de Apoyo a1 Rescate de Autopistas Concesionadas (FARAC)-tariffs have been stable since 1998. 2.52 The decrease in tariffs for toll roads has led to increased usage, but the tariff levels are s t i l l high b y international standards. In the F A R A C network, the tariff i s estimated to be US$0.20 per kilometer for five-axle trucks. In the Mexicali beltway, which i s currently under negotiations for a concession, the tariff is estimated to be US$0.35 per kilometer for five-axle trucks. For one o f the most expensive roads in Brazil (Sgo Paulo-Ribeirao Preto), the tariff i s around US$O. 10 per kilometer.79 Spending 2.53 Federal road expenditures have fluctuated substantially (Figure 2.14), although with an increasing trend since 1998. The fluctuation i s most evident in the construction of new roads and in the upgrading (modernization) o f roads, reflecting political influences. The share devoted to maintenance and rehabilitation i s more stable, although at a l o w level.80 77 Income-Expenditure Structure in 2001, CAPUFE. 78 Regarding programming, until recently SCT was using a management program called SISTER to plan road maintenance. The program i s fairly old in many respects; the need to update planning with new management tools such as the HDM-4 i s essential. Regarding contractual incentives, so far fixed road segments were assigned to contractors at a flat rate, thus providing no incentives for improved performance. 79 Sources: Unidad de Autopistas de Cuota, SCT, and “Ancilisis de la Competitividad,” Instituto Mexican0 para la Competitividad (IMCO), septiembre de 2003. The budgetary process i s discussed i n Chapter 3, including an analysis of the impact of political agendas in altering overall flows of government funds to targeted investments that fall outside of sector plans issued by the SCT. 36 Figure 2.14: Federal Investment in Roads (million pesos, constant 2003 prices) 20,000 18,000 16,000 14,000 12,000 10,000 8,000 6,000 4.000 2.000 0 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 1 0 Building and Upgrading Maintenance and Rehabilitation Rural Roads Note: State and municipal investments are not included in this table. Source: “Tercer Informe de Gobierno.” 2.54 Expenditures for maintenance and rehabilitation are l o w b y international comparisons.81 They are estimated to have accounted for less than 0.15 percent o f GDP in 2000, compared to 0.3 percent to 0.4 percent o f GDP in other OECD countries (Guerrero, 2004).82 2.55 There are no reliable figures on state and municipal expenditures for roads. They are tentatively estimated to be almost M x P 7 billion per year, compared to federal road investments o f about MxP20 billion in 2003. Extrapolating from a sample o f 5 representative states (Oaxaca, Guerrero, Queretaro, Yucatin, and Sonora) to the 32 states, total state investment in roads i s estimated to be MxP4.4 billion. Municipal investments in rural roads are estimated to be almost entirely funded through FAIS. I t has been estimated, based on a survey o f mayors, that in 2002, o f the MxP23.5 billion in FAIS, MxP2.3 billion (or 10.5 percent) was used for rural roads. D. RAILROADS 2.56 Structural reforms have enhanced quality and efficiency o f service o f Mexico’s railroads, although they s t i l l fall short o f international best practice. The rail industry shows a diminishing number o f accidents per kilometer, better use o f assets (as shown b y 81 No breakdown i s available between maintenance and rehabilitation, which are accounted for under the same category in the SCT budget. 82 Preliminary Data. This comparison should be made with caution because the inclusion o f subnational expenditure in national figures i s not clearly stated. There has been a recent initiative to increase the level of road maintenance at the state level, the impact o f which i s not reflected in Figure 2.13. 37 the higher number o f tons per locomotive), improved service quality (as indicated b y the lower number o f losses and claims), and a more efficient use o f fuel (see Guerrero 2004). However, as shown in Table 2.1 1, efficiency s t i l l falls short o f levels achieved in the United States. In the World Competitiveness Survey major industrial users ranked the quality o f Mexico’s railways s t i l l fairly low, at position 57 out o f 102 countries. Table 2.11: Railroad Efficiency Indicators 3. Operation 1.3 0.7 0.8 4. Traction efficiency 56 100 180 5. Service quality 0.0044 0.0022 0.0004 6. Fuel efficiency 108 185 255 2.57 The Railway Service L a w establishes that tariffs are set freely b y the concessionaires. This policy i s based on the assumption that competition not only comes from other railways, but also from the trucking industry, and that interchange rules would be sufficient to promote competition among different concessionaires. Concessionaires are forced to register tariffs at SCT, and these tariffs then become maximum values; they may offer discounts to users in an equal and nondiscriminatory manner. SCT can establish the basis for tariffs when i t concludes that there i s no actual competition. 2.58 Costs for railway services are higher in Mexico than in Brazil or the United States, as shown in an analysis b y the Instituto Mexican0 para la Competitividad (Figure 2.15). This i s partly explained b y cargo characteristics: in the United States and Brazil, minerals account for a majority o f the cargo that can be transported at a lower unit cost. In Mexico, due to the relatively l o w share o f cheap bulk cargo and the scattered origin and destination patterns, train operation i s necessarily more costly. Nevertheless, the lack of competition among concessionaires, due to the ineffectiveness o f interchange rules and insufficient intermodal competition, are also contributing t o high tariff levels. 38 1 competition and decentralized port management.84 As part o f the reform in 1995, port service prices were no longer set b y the Government in order to encourage private investment, eliminate subsidies, and consolidate management and self-sustainable financial results. The chosen methodology in the port sector to determine infrastructure and services tariffs was total cost recovery. The system responds to an efficient cost structure in the long run, and reveals the productivity gains in the sector. Tariff updates depend on the request o f concessionaires and may take place every six months. In cases where competition i s not enough, a regulatory scheme based on maximum tariffs i s adopted. 2.61 Increased investment and structural reforms have enhanced the quality and efficiency o f service in Mexico’s ports, although-just as with railways-they s t i l l fall short o f international best practice. The port industry has posted significant increases in containers per ship transferred per hour, reducing the time ships need to stay in port. For example, in Veracruz-one o f Mexico’s busiest ports-productivity in handling containers doubled between 1995 and 2003.85 For other ports the productivity gain increases have been in the range o f 15 percent to 55 percent (see Guerrero 2004). However, in the World Competitiveness Survey, major industrial users s t i l l ranked Mexico’s ports fairly low, at position 62 out o f 102 countries. One problem for ports i s the delays s t i l l experienced in moving cargo from terminal to rail or truck transportation. This i s due to procedural and logistical factors not related to physical infrastructure. These include (a) the complex cargo review and inspection process, (b) the inability o f users to properly prepare the documentation and payments, and (c) the failure to coordinate logistics with land-based transport. 2.62 Since their inception in 1994, Administruciones Portuarias Zntegrules (Integral Port Authorities, AP1s)-which are allowed to freely set their tariffs-have been able to cover operational and capital costs. The three major ports o f Veracruz, Manzanillo, and L i z a r o Cirdenas show operational margins o f around 45 percent between 1995 and 2003.86 The success o f ports in covering costs i s likely attributable to an improved institutional arrangement that sets in place the correct incentives for maximizing investments and sustainability, and also an increase in demand for services. 2.63 Port tariffs are generally higher than international benchmarks when all charges are considered. Tariffs for port infrastructure use include two main categories: charges to vessels and charges to cargo. International comparisons are o f limited value, since these two concepts are not homogeneous across ports. Mexico charges l o w tariffs per transferred ton on ports (US$1.4 in Veracruz against US$6.68 in Los Angeles). 84 Chapter VI1 o f the Port Law established the legal framework for tariff setting. I t states that SCT w i l l set up in the concession agreement the basis for tariff setting as regards ports, terminals, and other related services when there i s no effective competition. The regulation w i l l stand as long as the conditions for i t s existence exist. Under the regulation, Integral Port Authorities were created as autonomous entities for the management and operation o f ports. “Coordinacih General de Puertos y Marina Mercante,” SCT. I t increased from 43 containers to 86 containers per hour. 86 Financial Statements, 2003. Only in the case o f one smaller port (Puerto Madero) does the Federal Government make limited transfers. 40 However, tariffs are much higher when all charges are considered (like shore-to-terminal cargo handling or custom’s agent payments), as shown in Figure 2.17. Figure 2.17: Port Tariff for a 2,800 Twenty-feet Equivalent Unit (TEU) Ship (thousand dollars) 300 250 200 150 100 50 0 Source: IMCO (2003). 2.64 The creation o f APIs in 1993 has led to a significant increase in investment since 1996 (Figure 2.18). The total investment in ports from 1994 to 2003 was financed b y the APIs (21 percent), private port operators (69 percent), and the federal and state governments (10 percent). Since 1999, federal funding has been limited to the few remaining fully government-owned ports. Figure 2.18: Public and Private Investment in Ports (million 2003 pesos) 7,000 6,000 5000 4000 3.000 2,000 1 000 n 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 OPubhc WAPIs QPnvate Source: “Tercer Informe de Gobierno” (2003). 41 F. CONCLUSION 2.65 This chapter has examined the quality o f service, extent o f coverage, and levels of spending in transportation, electricity, and water and sanitation infrastructure in Mexico. It also included a comparison o f Mexico’s performance characteristics with those o f other middle-income and OECD countries. While Mexico has made steady progress in increasing coverage over the past decades, and has reached levels higher than the averages for Latin America, access to infrastructure services s t i l l remains below that o f other O E C D countries. Also, quality o f service and operating efficiency lag behind other middle-income countries. 2.66 The degree o f cost recovery varies substantially among sectors, but remains very l o w in two key segments: household and agricultural electricity users, and household users o f water supply and sanitation services. Furthermore, the existing user subsidies are poorly targeted, with evidence in the electricity sector showing that most benefits accrue to the better off. Collection efficiency i s very l o w in water supply and sanitation, exacerbating the problem o f low tariffs, but also providing an opportunity to improve cost recovery without necessarily raising tariffs. The financing o f subsidies occurs through direct transfers from both the federal and state governments, and through the nonpayment of uprovechumientos b y CFE. 2.67 The main challenge i s to improve the quality o f services and operating efficiency, and to increase access to the remaining unserved areas, particularly in smaller cities, rural areas, and among indigenous communities. The next chapter reviews how institutions influence current spending patterns, efficiencies, and service quality, and explores options for institutional reforms that would foster achieving the goals o f increased quality, efficiency, and access o f infrastructure services. 42 3. BUDGETING, PLANNING, AND COORDINATION 3.1 An examination o f the institutions in the infrastructure sectors shows a fragmented process o f spending planning and allocation, and insufficient coordination within and across subsectors. In an overall context o f tight constraints on central budget funding, we find two sorts o f differential access to funds. First, some areas receive effective priority through their access to off-budget spending and to revenue from cost recovery, which i s convenient but not necessarily in line with overall national priorities. Second, central budget funding tends to be distributed with a little for everyone, which ends up underfunding relative to needs in some areas that should be prioritized according to the government’s objectives of competitiveness and poverty reduction. 3.2 Institutions are important for understanding and improving these outcomes, because they affect the structure and incentives for decisionmaking. The budget cycle o f planning, annual budgeting, execution, and evaluation i s at the core o f the expenditure institutions within each agency. After discussing the budget cycle within each sector, this chapter considers issues of intrasectoral coordination, and the flows o f money that are effectively decided outside the regular budgeting process-private financing and service charges. The lack o f coordination among all agencies in each sector contributes to the ineffective prioritization in the overall allocation o f resources. A. BUDGET C Y CLE-INVESTMENT EXECUTION, ANNUALBUDGET, PLANNING, AND EVALUATION Common Elements 3.3 The budget cycle starts ideally with a planning process, assessing the needs of the society and the funding that w i l l be available. The plan usually focuses on investment needs, but i t should also consider the associated requirements for current spending (salaries, maintenance, and so forth) and the availability o f current revenue to pay for them. Next, the spending must be budgeted, annually in Mexico, to carry out a year o f the plan, Then the budget must be executed, w i t h procurement o f construction, management o f personnel, and adjustments t o reflect deviations o f revenues and costs from the budget projections. Finally, monitoring and evaluation should report on the quality and efficiency of the spending, and the evaluation should guide decisions in the next round o f planning and budgeting. 3.4 In Mexico, the formal planning process b y federal and state governments i s done once every six years, at the start o f each new presidential or gubernatorial term (which are not coterminous). These national and state development plans make statements o f intent, unaccompanied b y financing plans (or even cost estimates in most cases), indicative budget allocations, or effective prioritization. Hence, in the absence o f 43 a revenue boom (oil), parts o f the plans are immediately found financially unachievable, and as the sexenio progresses, they generally become obsolete. The annual budget formulation process, where real money i s allocated, makes some reference to the development plans, but the links become more tenuous over time. Nonetheless, as shown in B o x 3.1, the electricity sector and the federal roads subsector have some planning that i s linked with budgeting. Box 3.1: Planning and Budget Integration: Past and Future Options T o properly plan investment, centrally or within individual sectors, one needs to think in terms o f a multiyear resource envelope within which to allocate the outlays for multiyear projects, along with the subsequent needs for debt service and operations and maintenance. Prior to the early 1990s, planning and budgeting in Mexico were done in a single secretariat-the Secretaria de Programacidn y Presupuesto (SPP)-which was separate from Finance. Even though the National Development Plan did not include an explicit financing plan, the SPP developed the plan with a good understanding o f the financing requirements, and with some incentive not to produce a plan that they would not be able to carry out. Then, SPP was merged with the Secretariat o f Finance to become the Secretaria de Hacienda y Crkdito Pliblico (Ministry of Finance and Pubic Credit, SHCP), so that the budgeting and spending activities would better take into account the availability o f revenue. After the SPP was converted into the Subsecretariat o f Spending (Egresos, SSE) within SHCP, n the 1990s i t was done the location of the planning function was not institutionally specified. I by SSE, sometimes with good results. In the current administration, the Plan Nacional de Desarrollo (PND) was done within the Presidencia, with the objective of elevating its priority. The effect, however, was to leave the actual allocation o f resources (by SHCP and the line ministries) out of touch with the plan; rather, the budget emerges from an interaction among sector ministries, each pushing i t s own agenda-with Congress and the SHCP-and SHCP trying to maintain fiscal discipline. T o strengthen planning and better link i t with budgeting, other OECD countries have had success with a decentralized strategy, rather than a recentralization strategy, such as recreating the SPP or giving the Subsecretaria de Egresos an explicit mandate to do planning. The Cabinet or Central Executive, in coordination with the Ministry of Finance, sets the priorities for overall resource allocation and gives each sector agency i t s corresponding multiyear resource envelope, which i s budgeted for the first year and i s reflected in a rolling indicative plan for the next three to five years. Within these envelopes, the sectors develop their detailed plans, with allocations fo1 investment and current spending categories. I n Mexico, CFE already follows this rolling multiyear approach, and SCT i s moving in that direction. 3.5 Box 3.2 lists the steps in formulating the federal spending budget, embodied in the annual Ley de Zngresos. In the budget formulation and execution, the Secretaria de Hacienda y Crkdito Pziblico (Ministry o f Finance and Public Credit, SHCP) plays a central role, particularly in enforcing spending restraint, which became an overriding priority after the financial crises in the 1980s and mid-1990s. I t does not act in isolation, however, and the parts in italics indicate where political negotiations are particularly important. 44 3.6 F o r investment budgeting, new processes are currently being introduced. The SHCP Unidad de Inversiones (Investment Unit) developed a Nuevo Sistema de Inversi6n Pdblica (NSIP) in 2003; the implementation for all public investment i s just starting. The N S I P requires technical, economic, and environmental assessments as prerequisites to set a code number for each project, which i s mandatory for a project to enter into the budgeting process. The NSIP i s looking for a more careful assessment o f projects; for large investment proposal, the NSIP requires a third-party expert opinion. The originating agency selects and pays the expert; however, if SHCP selected and paid for the expert, the opinion would tend to be more independent and neutral. 3.7 For investments executed with in the federal budget, the expenditure-control process i s structured directly b y SHCP through the Cuenta de la Hacienda Pu'blica Federal, which registers the flows granted and executed in all government programs on a yearly basis. I f irregularities arise, the Auditoria Superior de la Federacidn (a body that reports directly to Congress) i s in charge of sanctions. In 2004, SHCP developed a new mechanism to make the process quicker and more transparent-the Sistema de Informacidn de Proyectos de Inversidn (SIPPI), housed in SHCP. SIPPI w i l l allow for online portfolio management of all government projects, automatically linking the budget allocation o f funds with their current execution. Within SIPPI, SHCP i s developing a module that w i l l allow for the consultation o f the cost-benefit analysis o f the projects and their ex post evaluation, which was previously unavailable. Box 3.2: Steps in Formulating the Federal Spending Budget 1. SHCP sends main guidelines to sectoral agencies. 2. Sectoral agencies prepare first draft Annual Operative Programs (POAs), with sector priorities. a. States and municipalities (subnational governments [SNGs]) exert influence. 3. SHCP reviews draft POAs, negotiates with sectors, and sets the fiscal envelope for each sector. 4. Sector agencies develop definitive POAs and deliver them to SHCP. 5. SHCP integrates sector POAs into a consolidated draft federal budget and delivers i t to Congress. 6. SHCP and Presidencia negotiate budget with Congress. a. Sector agencies lobby Congress. b. SNGs exert influence with their Deputies and Senators. 7. Congress approves budget, with modifications. 8. Sector agencies revise POAs to be consistent with the approved budget. 9. Sector agencies execute the budget, subject to cuts required during the year b y SHCP. a. SNGs and sector agencies exert influence. Note: The parts in italics indicate where political negotiations are particularly important. 45 3.8 Some important spending in each o f the infrastructure sectors i s outside o f the regular federal spending budget, under the headings o f Fideicomiso de Apoyo a1 Rescate de Autopistas Concesionadas (FARAC), Proyectos de Impact0 Diferido en el Registro de Gasto (Projects with Deferred Impact in the Budgetary Registry, PIDIREGAS), and the subnational governments, as noted in the section on agency structure and elaborated below in the sector-specific contexts. PIDIREGAS, nonetheless, are being brought into the budget process: the borrowing with PIDIREGAS does have to be approved b y Congress within the revenue budget; the outlays for interest and amortization o f previous years’ PIDIREGAS are in the spending budget; and the l i s t o f new projects to be financed with this scheme are presented. The borrowing and spending b y FARAC remains outside the budgeting process. O f course, the borrowing b y organismos operadores (00s)and municipalities for local water works i s completely outside federal budgeting and control mechanisms, although the funding i s mixed with federal transfers from Ram0 33, and the federal participaciones are sometimes the collateral for the local borrowing. 3.9 Usually, the sectoral ministries or agencies are in charge o f project identification, selection, and development. The rationale i s that these ministries or agencies have more experience than others in aligning their projects with the national development plan and sectoral programs, and that eventually the Ministry o f Finance would refuse projects that are not consistent with macroeconomic or budgetary constraints. This approach i s not always effective, however, since some agencies are motivated b y private interests, and the Ministry o f Finance i s not always politically able to turn down bad projects. I t i s important to mention that, in accordance with the legal framework associated with the budget, i t i s the Congress who ultimately approves the issuing o f new PIDIREGAS. 3.10 The implementation o f projects, including procurement, i s under the individual management o f the relevant secretariat or agency. In procurement, Mexico has made considerable progress in standardizing the process and making i t more transparent. As discussed in B o x 3.3, however, it does not effectively assure that the most cost-effective bids are selected. Other aspects o f implementation and subsequent evaluation are handled in a more ad hoc manner, with substantial variation across sectors. 46 Box 3.3: Procurement Although Mexico has made important progress in improving procurement practices, there s t i l l remain substantial deficiencies in transparency and achievement o f the objective o f getting good value for public money, especially for infrastructure investment in many areas. Mexico’s e- procurement system-COMPRANET-has succeeded in becoming the almost universal venue for advertising opportunities for contracting at the federal level, although not yet at state and municipal levels. For the subsequent step of bidding, however, COMPRANET i s slow and cumbersome, and i s therefore essentially never used for bidding c i v i l works, even at the federal level. Infrastructure investment contracts were bid with a two-envelope system until 2005, so that bids evaluated on non-price dimensions to get a short list, and then only they are evaluated on the basis o f prices, which had been concealed in the second envelope. The time officially allowed for bid preparation i s typically short-10 to 30 days-whereas 40 days or more are normally needed. Thus bids are rarely well prepared unless a bidder can access insider information. In practice, in some cases, this allows a few f i r m s to collude and overprice their bids, because they obtain critical information through informal channels to prepare the bid, and more competitive bids are disqualified on technical grounds. Allowing more time for bid preparation (according to size o f project), making projects o f optimum size (usually larger), and switching to a one-envelope system would improve the procurement process. Single-envelope bids, with price and technical quality revealed from the start, would make collusion more difficult by making i t s cost clearer. Congress passed a new procurement law in 2005, making some important reforms, including the one-envelope system for bidding, a requirement of clearer and more objective award criteria, and an allowance for contracting beyond the fiscal year, with approval of SHCP. Other problems with procurement are the crush of completing most contracting near the end o f the fiscal year, with a rushed schedule to finish a project that only has a budget assured for a single year. This also means that what should be larger projects get fragmented into pieces that can be finished in a year or less-but at higher total cost-problems also observed in other countries in the region, where future budget commitments (vigencius fiturus) have become sources of corruption and budget rigidity. Getting a guaranteed budget for enough years to finish a project would therefore increase efficiency in the allocation and use o f public resources. An improved procurement system w i l l have a significant impact on both national investment rates and long-term growth rates. Regulation and implementation are the important next steps, for which good practices could be learned from Canada, the United States, and some European countries. Transport 3.11 The analysis here o f the transport expenditure process concentrates on roads, due to the sector’s dominant size, and because railroads and ports have been privatized or made to operate on a commercial basis. Thus they are largely outside the federal budget allocation process. The policy guidelines and project identification for highway investment result in a top-down process with two stages: the overall sector strategy, and the identification and prioritization o f specific projects. 47 3.12 Three considerations, in addition to technical factors, have shaped the highway strategy in Mexico: First, since around 1990 the Federal Government has largely followed the policy o f not constructing new toll-free highways. Second, the toll-road system i s expected to generate enough revenue to cover i t s current and capital-service cost. Thus new federal highway investment only goes where there i s demand sufficient for a second highway to make substantial revenue with tolls, although each segment does not need to be financially s e l f - ~ u f f i c i e n t . ~ ~ rest o f federal highway spending (over The half) goes t o upgrading existing highways, often substantially, and to maintenance. Third, highway investment ranks among the most visible and politically salient federal infrastructure spending. Thus i t i s not surprising to see the three-year political cycles reflected in Figure 2.13, with peaks in the congressional (and presidential) election , years-1991, 1994, 1997,2000, and 2003. Sector Strategy Formulation Recommendations 3.13 Sector planning i s especially important for transport, because o f the network interdependency. The public sector involvement in transport includes the provision o f basic infrastructure (by itself or through agreements with private operators). The infrastructure i s usually integrated in networks, therefore requiring physical coordination (planning) for i t s optimal development. There are also many externalities associated with infrastructure. The market has a strong role in transportation (in services and infrastructure operations), but some public planning remains essential, to assure complementarity. 3.14 Planning should consider all modes o f transport and the different levels o f government involved, but the tendency in Mexico i s to approach transport planning mode b y mode and government b y government, disregarding the links. The main transport network-that is, the road network-and services are split among national, state, and municipal jurisdictions. Therefore, public planning should be undertaken at all levels, and in many cases i t should coordinate vertically (primary and secondary networks) and horizontally (several municipalities within metropolitan regions). Best practices currently look for strategic planning. Although models are required to perform sound plans, a high-level strategic policy exercise should precede the technical exercise. The European Union, Canada, the U.K., and the U.S. Department o f Transportation provide good examples o f strategic planning. 3.15 The Plan Nacional de Desarrollo (PND) 2001/2006 constitutes the general framework, and i s the basis for the transport Sector Program 2001/2006. These documents are produced at the beginning o f the Presidential term; the Sector Program i s based on the Secretaria de Cornunicaciones y Transportes (Ministry o f Communication and Transport, SCT) research, a consultation process (Foros de Consulta Ciudadana), and previous programs. I t defines the key strategies and goals for the period, estimating 87 The Constitutional clause mandating “free mobility” i s sometimes interpreted to mean that the government may not construct a toll road on a route for which there i s not also a toll-free highway. Due to the density o f the existing highways, however, i t is rare that the government cannot construct a toll road because a non-toll connection i s lacking. 48 the required resources. For highways the Sector Program 2001/2006 includes two main pillars: (a) the modernization o f 89 percent of the length o f the established 14 key corridors o f Mexico’s federal roads b y 2006, and (b) the achievement of a goal o f 90 percent o f paved roads in good or acceptable condition by the same year. Although overall resource needs are estimated at this stage, there i s no financial planning or budget allocation, and therefore no guarantee that the goals established could actually be achieved. 3.16 Figure 3.1 shows the original goals o f the PND and the actual progress in the two key programs. Seventy-one percent of the highway corridors were modernized b y 2003 (widened, straightened, and so forth), and an 83 percent goal i s likely to be attained b y 2006. Toward the goal of improving road conditions, 69 percent of the road surfaces were brought up to good condition b y 2003; at this execution pace, approximately 78 percent i s expected to be completed b y 2006. Although the six-year program establishes goals and estimates resource needs, it i s the yearly budgetary process that allocates funds and sets the pace for actual achievement of the goals. Figure 3.1: 2001/2006 Program Original Goals and Expected Progress (a) Modernization of M a j o r Highway Corridors 100% , 0 20% 0% 7 1994 1996 1998 2000 2002 2004 2006 49 (b) Road Condition Good or Acceptable 100% 80 % 60 % 40 % 20 % 0% 2000 2001 2002 2003 2004 2005 2006 3.17 Setting goals and measuring achievements in this open manner i s a step in the right direction. Figure 3.1 .a measures the share o f roads with designs that were upgraded, with straightening, widening, and so forth. Figure 3.1.b looks at road condition. International experience has also shown the benefits o f measuring the cost per kilometer o f achieving this, and o f external performance audits to verify the achievements, and this would be a good next step for Mexico. 3.18 Project Identification and Ranking. The Unidad de Autopistas de Cuota takes the lead in evaluating the projects to be included in the investment program, both toll and free roads, because it has the best technical capacity. I t i s organized with particular emphasis on regional coordination, including the participation o f states in several regional working groups and active input from the SCT regional centers. The objective o f federal integration in defining investment needs i s reinforced b y regional agreements between several states and the Federal Government, and b y bilateral agreements between i t and some particular states. In these agreements, states assume some responsibilities for the projects, mainly the liberation o f the right o f way, and eventually co-financing works. 3.19 The working groups appointed b y the Unidad de Autopistas de Cuota review the regional portfolios that the SCT Regional Centers develop in discussion with the states in their areas, check the progress in projects development, and finally set a l i s t o f priorities based on established criteria. These criteria-presented in B o x 3.4-reflect a multi-criteria analysis aimed at balancing technical, economic, financial, and environmental aspects with political interests and agreements. The first four criteria are the most relevant: they reflect the strategic objective o f concentrating efforts in the 14 key corridors, allow for the continuity o f multiyear projects, avoid the budgeting o f projects without adequate preparation, and reflect local authorities’ preferences. When rigorously emphasized, these provide a solid technical basis for selectivity. When the main criteria are interpreted loosely and mixed with the secondary criteria, almost any ordering o f projects i s possible, and the actual selection may be political and with little 50 technical or economic justification. Box 3.4: Criteria Followed b y S C T for Setting Priorities for Road Investment Main Criteria: Location within the 14 major corridors. Work in progress. Level of project preparation. RegionaVstate preferences. Secondary Criteria: Socioeconomic impact. Potential for private finance. Contribution to other projects. Environmental impact. Co-financing with states. Scope of the project benefits. Impact on poor and marginal communities, and other existing commitments within the state. 3.20 The cost-benefit analysis i s barely a preliminary one. Cost estimates are based on standardized unitary costs; benefits are based on existing traffic flows when the projects are improvements o f existing roads (even though the presumed result would be more traffic), and on origin-destination studies when they are new links. N o network model i s used as a support o f project evaluation. The multi-criteria mechanism can be seen as a compromise between technical considerations and political bargaining. According to experts, project evaluations usually yield an internal rate o f return (RR) that i s barely above the minimum threshold established b y SHCP (12 percent), which indicates the weakness o f the portfolio, since even a slight worsening of the economic context would put the R R below the threshold for most o f the projects. 3.21 The program for planning maintenance focuses o n bringing the whole federal highway system up to adequate standards b y 2006. After severe deterioration o f the system due to lack of sufficient funds during the 1990s, the government has launched a program for highway maintenance that w i l l total US$309 million." The program was set as a priority in the budget and the Sector Program 2001/2006 after the diagnosis o f the condition o f highways. 3.22 Budget Preparation, Negotiation, and Approval. The negotiation and approval o f the SCT budget involves mainly SCT, SHCP, and the Congress, as described in B o x 3.2. SCT also prepares an additional l i s t o f projects beyond their main submission o f Annual Operative Programs (POAs), in case more resources become available. Highway resources in Mexico result f r o m the overall budgeting process, because there is no specifically earmarked road fund. An incipient Fondo Carretero was recently implemented, aimed exclusively at financing the public component o f the private-public agreements under the new toll-road concessions scheme. Investment in construction and 88 The World Bank finances US$218 million o f this program. 51 maintenance of free roads uses exclusively budget resources. 3.23 In recent years the Congress has introduced major changes to the highway budget proposal submitted b y SHCP. For example, in 2003 the Congress raised investment resources to 3.4 times the request from SHCP, and maintenance resources to double the request (Table 3.1); SCT and subnational entities lobbied the Congress to get the budget increase. In some cases, the money put back in b y Congress goes to fund projects initially (reviewed and) proposed by SCT, but increasingly Congress has proposed to fund projects without any prior technical analysis.89 B o x 3.5 on pork-barrel spending discusses this. The Congress did this for the 2005 budget on an even larger scale, leading to a Presidential veto and some Constitutional uncertainty. A decision of the Supreme Court in spring 2005 seems to have resolved the issue in favor o f giving the executive priority in budget details, like which project to do, and letting the Congress decide on broader issues, like spending ceiling for sectors and subsectors. Table 3.1: Evolution of Resources for Highways in the Budget Process (Year 2003, in 1,000 millions of Mexican pesos) Source: DG de Prograrnacidn, Organizacidn y Presupuesto, SCT. Values rounded. 89 SCT submits to SHCP an additional l i s t o f projects that would be worth doing if unforeseen funds became available through, for instance, a rise i n o i l prices. 52 Box 3.5: Pork-Barrel Spending benefits, most o f the benefits are relatively local, as are the employment effects o f building them. Consequently, as in many countries, road building i s a principal ingredient o f pork-barrel politics; state delegations in Congress are always inclined to push for more funding than i s in the national interest, which i s better represented by the Federal Executive. I n Mexico, transport i s the largest investment sector outside of energy, and most transport investment goes for roads. I n looking at institutions for road budgeting, one must ask not only how well the budget process constrains the appetite for pork, but also how well the Executive uses the distribution o f projects to achieve i t s other political and policy objectives. T w o or three decades ago, in the heyday of PRI hegemony, pork was an important currency for maintaining party discipline and supremacy. Since the end o f a one-party majority in Congress in 1997, the politics and practice of budgeting has changed. T w o o f the new developments have probably made the process less efficient in terms of political bargaining to achieve national objectives. First, Congress i s earmarking more o f the investment budget for specific geographic destinations, which shows up particularly in transport. This makes the process more transparent but also more rigid. In the 1990s and before, the Executive often made unwritten agreements with governors and legislators, promising public investment in return for votes on one issue or another. In 2001-02 these promises were often unfulfilled, and regional interests in Congress reacted by putting them into the annual budget law. The second development i s a less-united front o f the Executive Branch. For, example, in 2003 the SCT requested a budget o f MxP12 million for 2004, SHCP put barely a third o f that in the budget request to Congress, and then SCT lobbied with state interests in Congress to get the transport budget back up to 90 percent o f the original request. The same pattern was repeated in 2004 for the 2005 budget, but the 2005 Supreme Court decision may reduce the problem for the future. The government could also continue i t s practice o f listing technically approved projects that did not fit into the proposed budget, in order for Congress to have a feasible slate to choose from. One would expect Congress to add some politically motivated, but it would be more politically efficient if their distribution were used to achieve some other national-interest reform on the President’s agenda-labor, energy, fiscal, and so forth-rather than just to advance one sectoral interest within the Cabinet. 3.24 Budget Execution and Control. Once the SCT yearly program i s defined and the budget approved, projects start (or continue) b e i n g implemented. At an aggregate level, allocated resources are almost a l l expended. In 2003, of the M x P 2 4 . 4 billion approved f o r the transport sector in the federal budget, M x P 2 4 . 2 was spent, accounting for 99 percent. The same can b e said for the roads subsector, with M x P 2 1 . 4 b i l l i o n approved in the budget and MxP21.2 spent, again accounting f o r 99 percent of the total. 3.25 L o o k i n g at the project level, the picture i s quite different. A sample illustrates significant variations, with an average 8 percent increase, with cases of up to 33 percent, and a l l o f them showing costs higher than approvedg0 (Figure 3.2). If the project evaluation w i t h the original costs was hardly above the minimum IRR threshold, cost overruns this size m a y m o v e them b e l o w the threshold; this m a y b e exacerbated if traffic 90 An increase in expenditures o f up to 25 percent can be approved without a project review. 53 (and therefore benefits) i s less than forecast when the project was submitted for approval. Since the whole o f investment spending stays within the sector ceiling, some projects must have been dropped or substantially underexecuted (Figure 3.2). If the projects that turn out to be more problematic and less worthwhile are the ones dropped, then concentrating on the better projects i s not so bad. Thus, it would be useful to review the rationale for dropping projects. Figure 3.2: Planned Compared to Executed Highway Investments, A Sample of Projects 1 E l Planned 0 Observed 1 Tota Enr.onq,e La Escona oa Ap zaco-L m ies Tlax PLeo Rosar 0.V a Un on Enir nq-e El Granare Escarcega-Crer-ma Reforma Agrar a Desv ac on a Ma an,a L oram e r i o ae C,abi a More a --as F ores Actopan-lxq 0 , pan Ce aya Sa arranca Em E Tapcne Co E i t Aeropdre-o Ja: Paso a aesn ve Aameaa 00. 200. 4O0c 6OC- 800. 100". 1200; 140'0 Source: Unidad de Autopistas, SCT. 3.26 The fragmentation into annual pieces of what should be multiyear projects becomes even more problematic in the implementation phase, because budget uncertainties and the (re-) bidding process delay the release o f funds and completion o f works. T o help address this problem, the N e w Concession Scheme (NSC) was instituted as a highway subaccount within Fondo de Znversidn en Znfraestructuru (Infrastructure Investment Fund [FINFRA], a fiduciary fund for infrastructure, administered b y BANOBRAS, like FARAC), which operates as a Fondo Carretero in the sense that funds put there can remain into the next fiscal year with earmarking for highway investment. During 2003, FINFRA received enough contributions to allow for a multiyear budget and a variety o f projects because the resources available surpassed MxP$14 billion. However, due to the lack o f capacity to implement more than three or four important projects at the same time b y the Unidad de Cuotu and BANOBRAS, and the complications found b y the private investors for taking part in the NCS, funds have been only partially used. Once allocated in FINFRA, resources are managed outside the budget, which has advantages for manageability (that is, carry over), but i t needs to be done in a transparent manner. 3.27 Maintenance o f federal roads i s carried out mainly b y third parties on contract. T w o chief players on the government side do the contracting: CAPUFE and the SCT's General Directorate o f Road Maintenance (DGCC). CAPUFE handles maintenance in the toll-roads system, the ownership o f which i s gradually being transferred totally to 54 FARAC. D G C C i s in charge o f maintenance for the non-toll federal highways. 3.28 F o r the toll roads, the rules o f concessions require guarantees o f adequate funding for maintenance (SCT 2003:26). M i n o r maintenance i s done directly b y CAPUFE; F A R A C reimburses the funds on a weekly basis for those services for which CAPUFE can provide evidence o f execution. In major maintenance, CAPUFE outsources the works to contractors through a bidding process; FARAC reimburses CAPUFE for the works proven to be done. Problems sometimes arise because CAPUFE does not provide any performance indicators, making it difficult t o evaluate i t s efficiency. FARAC lacks the capacity to properly monitor CAPUFE, especially to avoid gold-plating behavior (that is, speculative behavior in which those activities that generate the largest profit are selected), which i s tempting, given FARAC's off-budget income. Auditing and monitoring b y FARAC are weak: the unit has only 20 people to supervise 23 major concessionaires. 3.29 For the federal free roads, the expenditure-control process is better structured directly f r o m SHCP through the Cuenta de la Hacienda Pu'blica Federal, which registers the flows granted and executed in all government programs on a yearly basis, as noted above. Maintenance o f the free federal highways looks more efficient than for toll roads, although the funding i s less generous due to budget constraints. M i n o r and major maintenance i s entirely outsourced b y D G C C following a fairly transparent bidding process-mostly through COMPRANET, the federal e-procurement program-and controlling execution. However, in this case contracts are assigned w i t h conventional bidding for certain works (rather than longer-term contracts for maintenance up to a certain standard), which implies high administrative costs and lack o f incentives for efficiency. Recently the government attempted t o broaden the scope o f maintenance and grant the contracts in an integral, multiyear, and output-based manner. T o this end, the Programa Piloto de Mantenimiento Integral (PROPIMI) was conceived. P R O P I M I seems to be working adequately; D G C C regional units have increased i t s magnitude from US$20 million to US$60 million for 2005. SCT, SHCP, contractors, and some states have agreed to have multiyear budgeting in a few cases. Nevertheless, i t would be more effective to determine explicitly the process for multiannual budgeting, which then could be used generally, instead o f having particular agreements for particular projects. 3.30 State and municipal authorities develop plans t o fill gaps in connecting users with the national network and within urban areas. Quality o f this planning and i t s coordination with SCT planning varies widely and depends heavily on the local political cycles, which are not synchronized with each other or w i t h the national cycle. Some states and municipalities plan and execute substantial projects, but there i s rarely continuity across administrations (no reelection), which is especially problematic for the municipalities, with only three years for each administration. Some states complain that their own needs and planning are not factored into the federal planning, making the allocation o f federal road funds less efficient. 55 Electricity 3.31 C F E has the most advanced planning system o f any infrastructure agency in Mexico. In the 1960s, with support from other large utilities and international associations, CFE began to develop integrated power-systems planning. Mathematical models were implemented for capacity expansion o f generation and transmission, as well as for system reliability, hydroelectric operations, and maintenance scheduling. Initially, the planning framework was limited to a power systems engineering perspective. Later, between 1977 and 1988, the planning system integrated other disciplines, mostly economics, statistics, and finance, into the planning function. Demand-forecasting models were developed, along with models for productivity analysis, financial planning, marginal costs, and tariff design. Also, a methodology was put in place for the systematic formulation and evaluation o f investment projects. After 1991, however, the financial portion o f the planning system was reallocated to the Financial Office o f CFE, losing some o f the integration and coordination that had previously been achieved. Since 1994, b y law, CFE updates i t s rolling 10-year plan for investment and maintenance every year. The CFE budget for each year follows from the updated plan. The planning o f investment with budget and non-budget (PIDIREGAS) resources i s fully integrated within CFE, in contrast to the other infrastructure sectors where the investment with resources from outside the federal budget i s largely separate. 3.32 All CFE and L F C income and outlays are formally within the national budget, which i s anomalous for electric utilities, and to some extent politicizes their finances. With i t s own substantial revenues, CFE depends substantively on the national budgeting process mainly for the borrowing for new investment that i t does directly, with important effects discussed below. Although i t s current spending and investment are all in the federal budget and formally approved there, the large o w n revenues and payments for fuel charges to Petrdleos Mexicanos (PEMEX) are in-and-out transactions that happen automatically without substantive consideration in the federal budgeting. Despite the implicit subsidy, the actual cash flow between CFE and the Treasury has been minimal every year since the reform o f CFE in 1986. 3.33 As a public enterprise, CFE should make profits and pay taxes and dividends to the government (and distribute profit sharing to i t s workers), and so each year since 1986 CFE has made a corresponding bookkeeping transfer (aprovechamiento) to the government, equal to 8 percent o f the net valuation o f assets. Then the government makes a bookkeeping transaction o f approximately an equal amount to cover the cost of the politically mandated price subsidies to residential and agricultural consumers. (The cost o f inefficiencies at CFE also gets folded in here.) During 1997-99, payments o f aprovechamientos to the government exceeded the level o f subsidies received b y CFE. The utility was thus generating a small net transfer to the Federal Government. This situation reversed in 2000, when consumer subsidies f r o m CFE grew substantially and exceeded the aprovechamientos, as shown in Table 3.2. Since then, CFE has been eating into i t s own capital, b y cutting investment and not fully replacing equipment as i t depreciates. Older capital also has higher operating costs, contributing to making CFE’s cost o f service higher than international comparators. 56 Table 3.2: Subsidies and Aprovechamientos 1997-2003 1997 1998 1999 2000 2001 2002 2003 Aprovechamiento, MxP1,OOO million 23.7 25.4 31.8 35.6 37.8 38.9 43.8 Consumer Subsidies, MxP 1,000 million 20.5 21.4 29.9 40.5 43.2 41.3 56.5 Difference 3.2 4.0 1.9 -4.9 -5.4 -2.4 -12.7 3.34 Thus, in practice, CFE has to make do with the revenue i t collects. I t does not control i t s output prices and has limited control over costs; hence, the main adjusting variable i s i t s own investment in generation, which has declined over the past decade and i s now clearly less than needed to meet demand. T o fill even partially the investment gap, CFE has relied increasingly on PIDIREGAS for investment in generation and transmission. 3.35 PIDIREGAS have remained and grown in amount (PEMEX has them for about four times the amount o f CFE), even though the original rationale i s gone; now SHCP fully discloses them and counts them as part o f the overall public sector debt and borrowing. In 2003 they were 1.1 percent o f GDP, almost half o f the total Public Sector Borrowing Requirement, 2.5 percent o f GDP. The amortization o f old PIDIREGAS debt equaled over one-tenth o f the new investment in the budget, and the amortization burden is projected to grow. Figure 3.3 shows the growth o f direct (CFE buys the PIDIREGAS- funded plant upon completion, Optimal Power Flow) and indirect PIDIREGAS (which provide guarantees for backing power purchase agreements with independent private providers [IPPs]). IPPs in electricity generation now account for about one-fifth o f installed capacity and almost all o f new generation. 57 Figure 3.3: Electricity Sector P I D I R E G A S Investment Projects (million 2004 pesos) 35,000 - 30,000 25,000 20,000 15,000 10,000 5,000 0 1 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 Source: SHCP (2004), from Aburto (2004). 3.36 One should not confuse PIDIREGAS with true private investment ( s t i l l largely potential) in the electricity sector. With true private sector participation, the f i r m s would make investment decisions and bear the full risk. N o w public sector s t i l l makes most o f the decisions and bears most o f the risk o f loss, while f i r m s get relatively secure profits, although they do bear some risk, mostly in the construction phase. The public sector bears many risks; with build-transfer operations i t ends up with an asset, in other cases, not. N o w that Mexico has no external restrictions on access to the financial markets, the only potential benefit of PIDIREGAS to the public sector i s that the private execution o f the investment could be more efficient, although the government could always have a simple contract for construction and operation b y the same firms, unlinked t o financing. I t seems unlikely that the firms can get lower-cost financing f r o m the market than the government could get directly, and the government’s guarantee o f the PIDIREGAS debt counts against i t s credit rating. The main problem with current arrangements that involve the private sector i s not the form o f the PIDIREGAS scheme, but rather the institutional setting in which CFE i s a monopsony buyer f r o m generation facilities. As discussed further in Chapter 4, private participators would probably only need a partial guarantee against the possibility that the regulated price would not adjust to keep up with changes in fuel cost and the overall price inflation. 3.37 LFC operates in a different budget and financial regime from CFE. I t i s considerably less efficient than CFE, due mainly to excessive labor costs and l o w productivity, and i t does not even have a bookkeeping obligation to pay uprovechumientos t o the Federal Government. I t has lost most o f i t s generation capacity and mandate, and i t mainly distributes power generated b y CFE and i t s licensed private producers. To stay in operation, L F C requires about MxP17,OOO million per year in outright cash subsidy f r o m the Federal Government budget. 58 3.38 Rural electrification, while nominally under the purview o f CFE, i s actually carried out b y states and municipalities, in general matching funds f r o m the federal transfer (in Ram0 33) for the Fondo de Znfrastructura Social Municipal (Municipal Social Infrastructure Fund, FISM) with those available from the Indigenous People Development Commission (CDI) and SEDESOL. In 2003, about 13 percent o f FISM went for rural electrification projects (INEGI survey, Annex 2). Rural electrification initiatives have almost exclusively focused on grid extensions at very high costs. Water Supply and Sanitation 3.39 Most investment for water and sanitation in Mexico i s not done directly b y the Federal Government, but b y organismos operadores (OOs), municipalities, state governments, and private housing developers, although most o f the money for public investment ultimately comes from the federal government. About 25 percent o f water and sanitation investments are paid with federal funds channeled through the Comisidn Nacional del Agua (National Water Comission, CNA), mostly as transfers to the local agencies plus some CNA investments in i t s own (non-emergency) structures for bulk water supply. Municipalities receive considerable resources (a total o f 0.8 percent of GDP, which i s about three times the relevant budget o f C N A ) through F I S M in Ram0 33. Municipal contributions to investment in water supply and sanitation come from F I S M and from federal tax sharing (untied funds via participaciones), but there are not systematically available data on the amount o f funding from these sources for water and sanitation. The municipalities also have to pay for their use o f water resources, as described in Box 3.6. 59 Box 3.6: Mexico’s System of Water Abstraction Charges In Mexico, since 1989, all users who abstract water directly from a river or the ground have to pay a water abstraction charge (called a water right, or derecho) to the Federal Government through the Ministry o f Finance. The level o f the abstraction charge i s differentiated according to nine geographic zones and six user categories, resulting in about 40 different rates. Users in water- scarce areas pay substantially higher charges than users in water-abundant areas (Table 3.3). Likewise, self-supplied industries (uso general) pay charges that are more than 30 times higher than for utilities. The largest water user by far, irrigated agriculture, was initially exempt from the charges.* The system was thus designed with both fiscal and political motives, often conflicting, and with little consideration of environmental economics, which would have suggested the use o f uniform charges for all user categories. n 2001, total revenues from abstraction charges were MxP5 billion. Eighty-six percent of the I charges were paid by industries, 7 percent by CFE for its hydropower plants, and 7 percent by utilities. Final water users supplied through the network-whether residential or industrial- ultimately are the ones that pay for charges levied on utilities, although water bills to final users do not identify abstraction charges separately. Table 3.3: Level of Water Abstraction Charges Source: Asad and Garduiio (2004:7), on the basis o f the Federal Rights Law. Initially, cash-strapped utilities refused to pay the water abstraction charges. To remedy thi: problem the Federal Government initiated a program to return these revenues to utilities subject t c certain conditions, in a program called the Programa de Devolucidn de Derechos (Water Right! Return Program, PRODDER). The conditions include that for each peso returned, the utilities havr to invest that much plus another peso from other sources. The program has led to a substantia increase in investment and in the collection efficiency (recaudacidn) o f abstraction charges, anc PRODDER now has become the largest federal subsidy program for water supply and sanitation The program, which i s administered b y CNA, caused abstraction payments by utilities to more thar double, accounting for 18 percent o f payments in 2002 compared to 7 percent the previous year. Abstraction charges paid directly by industries remain with the Federal Government and are not returned to users. *Since 2003 agricultural water users that [are discovered to] exceed the abstraction amount specified in their license have to pay a nominal fee for the amount used in excess o f the licensed amount. Likewise, utilities that abstract more than 300 liters per capita per day have to pay a surcharge to provide a disincentive for self- supplied industries to switch to network supply. 60 3.40 Most o f CNA’s funding to municipalities and states i s provided on a matching fund basis through the Programa de Agua Potable, Alcantarillado y Saneamiento en Zonas Urbanas (Water Supply, Sewerage, and Sanitation in Urban Areas, APAZU), which has successfully stimulated more state and local investment in water and sanitation. The first APAZU program varied the percentage matching requirement according to the marginality index of the locality, to help the poorer areas, but APAZU I1 abandoned this practice. Poorer areas do get more FISM funds, in accord with the formula, and there i s evidence that rural municipalities and smaller urban ones use a larger share o f their F I S M for water and sanitation investments. PRODDER funding follows f r o m collections b y organismos operadores (00s)in the previous year, and thus favor richer municipalities, on average. 3.41 For water, planning at the central level seems less important than planning at the state and local levels. The six-year state development plans supposedly set priorities for water investments, for which states and municipalities seek federal co-funding. These plans are monitored b y the Comites de Planeacidn para el Desarollo (COPLADEs). At the federal level, the budget envelope for federal subsidies i s set annually with no multiyear resources envelope (except for donor-funded programs such as Frontera Norte and the Programa para la Sostenibilidad de 10s Sewicios de Agua Potable y de Saneamiento en Communidades Rurales [Program for Sustainable Drinking Water and Sanitation Services in Rural Communities, PROSSAPYS]). The lack o f coherence between the annual budget cycles at the state and local levels makes planning at these levels extremely difficult. The need for coordination in the water sector thus i s mostly “vertical” between the federal, state, and local governments. 3.42 Local governments do most o f the planning and budgeting for water and sanitation. Some o f the better institutions are in the more economically advanced states, l i k e Nuevo Leon, Baja California, and Guanajuato, but some poor states like Chiapas also have good programs in place (Box 3.7). C N A has an elaborate electronic system for cataloging, categorizing, and tracking individual projects. I t was intended to reflect national programmatic priorities, but the results are usually t o give a few projects to each water region. The overlapping planning and budget cycles and multitude o f norms at the federal, state, and local levels make investment planning in Mexico’s water sector complex and difficult. Most investments in water and sanitation are co-funded through one or more federal programs, the state government, the municipal government, and sometimes municipal service providers. Economic planning i s rudimentary, in the sense that cost-benefits analyses are routinely conducted, but often without much rigor or consideration of alternatives. C N A gives some help and technical assistance for local planning, for example, as part o f the Programa para la Modernizacidn de Organismos Operadores de Agua (Program for the Moderniziation o f Water Utilities, PROMAGUA), although implementation o f this program has been slow. 61 Box 3.7: Innovative Chiapas State Government Technical Assistance to Municipalities The State o f Chiapas has some of the poorest water service quality in Mexico, with no single urban municipality receiving water on a continuous basis. Investments have been haphazard and poorly planned, creating problems in system operation. Maintenance i s poor, and billing efficiency low. T o remedy this situation, the state government-through i t s Water Commission-in 200 1 initiated a municipal water and sanitation program (Agua Potable y Saneamiento en Cubecerus Municipules y Zonas Urbanas) to create autonomous municipal utilities and to assist in planning investments o n a long-term basis. Participating municipalities produce diagnostic studies covering technical, social, financial, and human resources aspects o f system modernization. The studies are fully paid for by the municipalities, and they are carried out by consultants from within the state, selected from a l i s t o f 24 qualified consultants prepared by the Water Commission. Participating municipalities commit to create autonomous operating entities. The program also foresees the creation of citizen councils (Consejos Consultivos Ciudadanos) in the participating municipalities to communicate citizen concerns to municipal decisionmakers. The councils also disseminate information about water and sanitation investments and planned changes such as metering and volumetric tariffs to citizens. So far 37 municipalities have signed a contract (convenio de coordinucio'n) with the state Water Commission under this program, and 14 municipalities are in the process of conducting the diagnostic studies. Some have undertaken investments funded through the federal APAZU program and municipal resources from FAIS. 3.43 M u l t i y e a r investment plans exist at each level o f government, but are often not coherent with each other. At the federal level, CNA produces a National Hydraulic Plan (PNH) that coincides with the Presidential t e r m and feeds into the Plan Nacional de Desarrollo (National Development Plan, PND).91 The multisectoral Development Plans States, mentioned above, coincide with the six-year gubernatorial terms and thus not with the Presidential terms o r PNHs. At the local level, there are multisector M u n i c i p a l U r b a n Development Plans that usually cover 20 years, but these are not connected t o concrete actions, and the M u n i c i p a l Development Plans cover o n l y the three-year terms o f local governments. M o s t water utilities do not engage in formal long-term planning f o r their systems, w h i c h expand ad hoc, f o l l o w i n g the pattern of urbanization and in response to the fluctuating availability o f funds from federal programs. Investments in wastewater treatment are mostly driven by pressure to c o m p l y with legal deadlines f o r environmental norms, w h i c h often ignore the financial and technical capacity of service providers to operate and maintain these assets adequately. Finally, maintenance and rehabilitation- the step-children of water investments-are usually neglected. Some o f the better utilities have established Master Plans, i n c l u d i n g investment plans covering varying periods (5 to 15 years). Investment projects need to b e approved by the municipal council, w h i c h usually does not have a long-term perspective and favors piecemeal system expansion over maintenance. 91 The PNH for 2001-06 includes targets for investment, but these targets are not binding. 62 3.44 The federal allocation for various water investment programs is determined year by year in negotiations among CNA, SHCP, and Congress. After approval o f the annual budget, adjustments are frequently made throughout the year, generally within the initial envelope. CNA’s budget i s detailed, distinguishing among four types o f expenditures and 36 budget lines in three subsectors. Each budget line usually corresponds to a national program and sometimes to a regional program.92 In rare cases, Congress specifically introduces individual projects as line items in CNA’s budget.93 Thus the agency has to go back to SHCP for every reallocation, even to achieve the initial goals with the same overall resource allocation. 3.45 In recent years, Congress has regularly increased the budget envelope proposed b y SHCP f o r C N A b y 8 to 10 percent (Barocio 2005:25). Congress has also intervened to modify the structure o f expenditures, substantially increasing the envelope for water supply and sanitation, while reducing i t for irrigation and water resources management. Actual expenditures implemented, however, are usually identical to or slightly lower than what Congress approved. The numerous budget modifications during the year o f execution do not affect overall expenditures or allocations for major subsectors. The envelope for federal investment programs varies significantly f r o m year to year. The overall federal contribution to investments in water supply and sanitation declined significantly during the second half o f the 1990s, but has increased since 2001, as recommended b y the PNH. 3.46 The availability o f funds at the federal, state, and local levels not only varies considerably, but usually does not coincide with spending needs during the year. This either leads to delays or forces state and local governments to advance funds that ought to be paid b y the Federal Government, t o be later reimbursed when the funds become available. The delays in the availability o f federal funds sometimes result from the difficulty in complying with all relevant administrative, norms, and in other cases the delays come at the subnational levels. 3.47 The administrative norms for public investment projects at various levels of government are so complex that they delay investments and are often ignored, opening space for politically motivated decisions and favoritism. The complexity o f the norms discriminates against funding for states and municipalities-usually poorer ones-that do not have the capacity to comply with all the norms. SHCP’s administrative norms are defined in the budget law, the manual o f budget norms, and i t s annexes, and in guidelines for operating rules for federal programs. In addition, states and municipalities have, of course, their own administrative norms. A detailed analysis o f these norms i s beyond the scope of this review. While some norms are needed to ensure economic efficiency, 92 The only regional projects in the 2003 and 2004 C N A budgets were a water project and a sanitation project for the Valle de Mexico, a project for the Lerma-Chapala Basin to protect the environmentally sensitive Chapala Sea through measures in several states, and the water supply project for Guadalajara and Le6n. 93 This was the case o f the Water Supply Project for Guadalajara and L e h , located in the States o f Jalisco and Guanajuato, respectively. The project has a single line item. 63 environmental sustainability, and transparency o f investments, the norms are overly complex and could be streamlined without sacrificing the original objectives. 3.48 To assess the degree o f satisfaction o f service providers with various federal programs, a federal water association conducted a survey in 2004, evaluating the programs using the following criteria: 0 The perception o f the service providers participating in the programs; 0 The existence o f incentives for generating co-funding; 0 The existence o f incentives to improve efficiency; 0 The degree o f flexibility in the use o f funds at the local level; 0 The degree o f discretion in the allocation o f funds to specific states and cities and the concomitant risk o f pork-barrel spending and favoritism; 0 The administrative burden o f the programs, in particular concerning the relationship between state and federal budget cycles; 0 The degree o f poverty targeting; and 0 Quality assurance, monitoring, and evaluation mechanisms. The survey found that most participating service providers are satisfied with the programs, although the extent varies b y p r ~ g r a m . ’ ~ 3.49 All the federal programs require some co-funding b y states, municipalities, and utilities, which has effectively motivated increased investment funding from the local level, especially for those programs that are administratively relatively uncomplicated and provide a large degree o f local discretion for use of the funds. For instance, in the Water Rights Return Program (PRODDER), municipalities and utilities can reclaim the amount they paid in water abstraction charges to the Federal Government, provided they fulfill certain limited conditions and invest an equal sum financed b y state, municipal, or utility funds. The program contributed to increasing the municipal (and utilities) contribution to C N A programs from 10 percent (in 1998) to 22 percent (in 2003) (Barocio 2005). 3.50 On the other hand, the existing programs have not brought about improvements in operating or economic efficiency, despite the intentions o f some programs to do so. 94 The Mitofsky survey was conducted b y the Asociacidn Nacional de Empresas de Agua y Saneamiento (ANEAS) among 191 respondents. Quoted in the ANEAS journal Agua y Saneamiento, Year 3, No. 13, 3rd quarter, 200454-56; and in Barocio (2005), various pages. Among respondents participating in the respective programs, the share o f those declaring to be satisfied or very satisfied are as follows: PROMAGUA 67 percent, A P A Z U 86 percent, PROSSAPYS 88 percent, and PRODDER 98 percent. The rate o f participation among those interviewed i s also varied: PROSSAPYS 31 percent, PROMAGUA 53 percent, APAZU 55 percent, and PRODDER 82 percent. Many o f those not participating have a negative view o f the programs. 64 For example, P R O M A G U A was specifically created to improve efficiency through the elaboration of Master Plans and the introduction o f Private Sector Participation (PSP). In the five years o f the program, however, i t has not led to any case o f introducing PSP, and disbursements have been far below expectations. Few o f the existing programs tie the level o f subsidies to past improvements in efficiency. Indeed, PROMAGUA even provides higher federal subsidies for service providers with lower efficiency, probably to offset their inability to raise co-funding, but this encourages inefficiency. 3.51 Flexibility in the local use o f funds has made various programs more attractive to service providers. For example, PRODDER, the largest federal subsidy program in the sector, has very few strings attached. Since service providers refused to pay water abstraction charges before the introduction o f the program, there seems to be an implicit acknowledgment that these funds “belong” to them and their use should thus not be much restricted. Correspondingly, service providers have expressed great satisfaction with this program. However, the program does not provide any incentives t o improve efficiency. FAIS, a multisector fund under Ram0 33, also has n o strings attached. The importance o f FAIS for the sector i s significant. While the exact amount o f water and sanitation investments under F A I S are not well known, i t has been estimated based on a survey o f mayors that the total volume o f federal subsidies channeled to the sector through F A I S i s more than twice as high as all federal subsidies under CNA-administrated programs, Finally, none o f the federal programs-FAIS or the CNA-administrated programs-is conditional on changes in the governance structure o f utilities or on policy/regulatory changes at the state level. 3.52 The degree o f discretion in the allocation o f funds to states and municipalities varies substantially among programs. For example, the discretion in the case o f PRODDER i s practically zero, since funds are “earmarked” for service providers corresponding to the amount they have paid in water abstraction charges. On the contrary, discretion in APAZU-the second-largest program in the sector, which has recently been significantly expanded-seems to be considerable, which has led to charges of political favoritism, despite the formal existence o f detailed operating rules that are apparently not always respected. Programs funded by international donors, such as the rural water supply and sanitation program PROSSAPYS, funded b y the Inter-American Development Bank and the US.-funded Fronteru Norte program, may entail a somewhat lower degree o f discretion due to the external supervision o f the programs. 3.53 The administrative burden o f the programs varies considerably. For example, some states and service providers complain about the heavy administrative burden o f APAZU, while there are few, if any complaints, about PRODDER or PROSSAPYS. In particular, the mismatch between the federal and state budget cycles poses a significant problem, coupled w i t h the allocation o f federal subsidies on an annual basis despite the multiyear nature o f infrastructure investments. Federal budget allocations are usually determined so late that i t becomes impossible for state and municipal governments to plan appropriately. The complexity o f programs may make access by states and service providers with limited administrative capacity more difficult. A simplification o f operating rules may reduce that bias. However, the solution to that problem ultimately 65 lies in the strengthening o f local capacity through continuity o f managerial staff and better insulation of service providers from undue political interference at the municipal level. 3.54 There i s no poverty targeting in any o f the federal subsidy programs for the water sector, except for the rural water and sanitation program PROSSAPYS. Actually, some o f the programs favor the more affluent parts o f the country. For example, the Frontera Norte program i s only available to localities within 300 kilometers o f the border with the United States, which happen to be the areas with the lowest degree o f marginality in Mexico. PRODDER, the largest federal program, i s heavily tilted in favor o f the Northern states as a result o f the technical characteristics o f the program. The water abstraction charges are set at much higher levels in the arid, Northern parts o f the country, so that service providers in these usually richer localities both pay more and receive more funds through this program95. This bias in favor o f richer localities i s partly compensated b y FAIS, a multisector fund under Ram0 33, the importance o f which for the sector has been emphasized further above, which i s allocated according to a formula that heavily favors poorer municipalities and states. 3.55 There are only limited effective quality assurance and monitoring mechanisms in the federal programs. The program with the largest impact on investments in the sector, FAIS, has no reporting requirements, no screening mechanism, and no evaluations. In the CNA-administrated programs cost-benefit analyses are pro forma exercises, which are o f limited effectiveness as screening tools, despite quality control o f CBAs exercised b y SHCP. E x post evaluations are rare and, if done, usually lack independence and critical assessment. There i s no effective requirement for reporting the allocation or monitoring the effectiveness o f these funds. The attempts at monitoring outcomes, both at the federal level and in some states, are hampered b y the poor quality o f financial and technical data collected by service providers, the lack o f incentives to improve the quality o f data, and the lack o f links o f reporting formats to specific investments or programs. Information i s reported voluntarily to the national statistical agency, with a substantial lag and without a standard format. The L a w o f Ram0 33 requires the states to report the destination o f these resources, but there are no standards for this or sanctions for not doing it at all. This hinders both accountability t o the local clientele and planning at the state and national levels. 3.56 The lending b y B A N O B R A S for local water investment has recently increased, starting from a very l o w level. High overhead costs, passed o n to borrowers, and cumbersome procedures make the B A N O B R A S option less attractive than i t should be, given its access to low-cost international funding. For large and well-managed localities, the market has filled the financing gap or could do so, especially with links between debt service and tariff collection. Small localities, on the other hand, typically lack financing, even from BANOBRAS. ’’I t must be noted however, that PRODDER has been designed to stimulate payment by all water service providers. 66 Lessons from Multisector Evidence 3.57 Infrastructure planning and investment require a long preparation period, and that i s one of the reasons why sound policy planning and coordination i s a critical factor in infrastructure development. As noted, Mexico does national-level planning episodically, but i t i s not linked with budget ceilings or allocations, (a problem common to all sectors in the budget and planning process), and i s not linked w i t h planning b y governments and agencies at the subnational level, which handle most of the household water and sanitation infrastructure, and some important parts for transportation. There are insufficient incentives and help for good subnational planning, which are critical in transport and water and sanitation. 3.58 The CFE's 10-year rolling plans, linked integrally with the annual budget, could be a model for the other infrastructure sectors, perhaps with a shorter time horizon, say three to five years. This would be a logical next step from the current practice o f having multiyear budgets only for individual projects, and toward the concept o f a complete multiyear budget and fiscal projection (see World Bank 2004c, chapter 4). 3.59 The transport and water and sanitation sectors in Mexico went through significant changes during the last decade. T o varying degrees, these sectors reformed their policies and institutions, particularly in regard to privatization and decentralization, but the policy and planning functions do not seem to have adapted to the new circumstances. At a macro level, government plans are inconsistent with budget allocations because the plans give a lot o f emphasis to investment projects, but in practice investment funding comes as a residual after funds are allocated for salaries, debt service, transfers to local governments (formula based), and other current spending. 3.60 In order to implement the planned national strategy with policies and programs for the infrastructure sectors, the government should have strong policy planning and coordination functions at the center. SHCP takes into account the resource constraint, but usually has neither concern nor technical know-how to set the priorities among different projects coming from competing agencies. This requires technical reviews-including feasibility, economic analysis, and environmental and social impact-for which SHCP could develop some capacity, for the largest projects and when the impact i s multisectoral. Most of the technical review and prioritization, however, would need to be done at the sector level, b y the secretariat that has responsibility for all agencies in the sector-the Secretaria de Comunicaciones y Transportes (SCT), the Secretaria de Energia (SENER), and Secretaria de Agricultura, Ganaderi'a, Desarrollo Rural, Pesca y AlimentacidnlComisidn Nacional del Agua ( S A G A R P N C N A ) in the sectors studied here. 3.61 The strong impulse for fiscal control b y SHCP within the budget context has increased the relative attractiveness o f infrastructure spending that can be financed outside the regular budget ceilings, even if these investments are nominally counted in the budget. The electricity and road transport sectors each has some parts o f spending that are subject to relatively rigid budget constraints, and some parts that are more or less 67 outside the budgeting process, and thus much less constrained, although the latter are s t i l l using public resources, including credit, guarantees, and creditworthiness. This observation does not apply so much to water. It seems that CNA has considerable clout and thus has substantial discretion in determining i t s budget. SHCP i s relatively inactive in water and focuses basically on the fiscal ceilings, and Congress only adds a few pet projects to serve local interests. The use o f guarantees in the water sector seems limited and below their potential. 3.62 The federal matching-grant investment programs in the water sector, especially APAZU, have been relatively successful in terms o f securing local contributions through matching funds. Such experience might help in the roads and rural power sectors to motivate a clearer and more constructive division o f labor and to further the impact o f other water programs that do not currently require subnational co-funding. This i s needed because the extreme dependence o f Mexico’s local governments on transfers from the center both reflects and reinforces the culture o f lobbying for projects and funding f r o m the federal level, rather than raising own resources with accountability to local taxpayers and clients. COORDINATION B. INTRASECTORAL 3.63 Mexico’s infrastructure sectors traditionally played a large role in distributing rents and political patronage, so the appointment o f the agency heads and the development of the unions have tended to follow political considerations. Hence, the agencies tend to become bureaucratically isolated silos, (that is, they are closed, with no interaction with other agencies), without incentives for the intrasectoral coordination that i s often needed to improve the quality and efficiency o f service delivery. Multisector planning, linked seriously with budget allocations, does not exist, and even within the sectors the coordination across agencies i s increasingly rare, because the unofficial mechanisms o f coordination through a monopoly political party have become inoperative in the 21st-century context o f political competition. Transport 3.64 Most o f the information and decisionmaking for transport stays within the institutional silos o f free roads, toll roads, railroads, and ports. This leaves the intermodal infrastructure underdeveloped, and the modes themselves inefficiently used. Better intersectoral, that is, intermodal, coordination in transport could contribute importantly to making Mexican business more ~ o m p e t i t i v e . ~ ~ Several European countries, such as Spain and France, and the U.S. Department o f Transportation, provide good examples. 3.65 Transportation i s partly decentralized, but there i s relatively good information sharing within each subsector-toll roads, free highways, railroads, and ports. Transport has some coordination in theory, with the priority for 14 road corridors, but in practice 96Logistics cost about 18 percent o f GDP in Mexico, which i s 40 to 75 percent above most OECD countries, although still better than the other large L A C countries (World Bank 2004). 68 the directorates in SCT that handle highways, ports, airports, and railroads each has effective autonomy in i t s own area. The regional centers mainly channel requests for roads from the state and municipal governments and do not realize their potential to work with multiple local governments to develop integrated regional transport plans that would govern the investment plans o f all other SCT directorates, plus FARAC and the port administrations. The lack o f coordinated information and management i s especially severe around the intermodal connections between the transport subsectors. Individual large corporations make their own arrangements-often with state-of-the-art efficiency and government cooperation-but small and medium enterprises have to rely on the substandard public sector connections and are left at a disadvantage. 3.66 SCT, which i s the logical place for accountability, i s not in fact accountable for the performance o f the transport system as a whole, nor does it currently have authority to manage the whole sector. For instance, the unclear accountability and reporting relationship o f F A R A C and the multiple roles o f B A N O B R A S (especially as supervisor o f F A R A C as well as sectoral financier) are institutional problems that need addressing. Also, the transfer o f the responsibilities for the development o f local transportation infrastructure to local governments makes i t more difficult to have the essential policy planning and coordination between the federal and subnational governments. Electricity 3.67 The reforms o f CFE in the late 1980s and 1990s have led to better public information and indicators o f performance for that part o f the sector. L F C i s still more under the control o f unions, and lacks accountability for service or fiscal balance. Within the narrowly defined electric power sector, CFE and LFC generally coordinate adequately, with the production and transmission o f CFE linking well w i t h LFC’s distribution system, which i s all that i s left o f the company. Aside from a pricing issue mentioned above, the inefficiency and fiscal problems o f L C F are relatively independent o f i t s relationship to CFE. 3.68 The arms-length relationship between SHCP and CFE causes several problems. Agreeing on budget allocation and annual expenditures requires a number o f meetings during which CFE finds i t difficult to convince SHCP on ways to prioritize expenditures to maximize the technical performance o f the company. For instance, as the number o f transmission and distribution lines increase, CFE needs approval to buy more equipment or additional vehicles to conduct maintenance; Hacienda often does not approve on the grounds that i t s economic impact i s not clear. Thus, information asymmetries distort the allocation o f resources, because SHCP does not or cannot trust information f r o m CFE about the status o f assets in terms o f efficiency or needs for maintenance expenditure. Ideally, CFE would have autonomy t o follow the most cost-effective way t o meet performance standards, and SHCP and other central agencies would focus o n ex post monitoring o f performance. Given CFE’s monopoly position and political clout, however, SHCP does not have much ability t o impose ex post enforcement, so the emphasis remains on ex ante controls that leave little incentive for managerial and technical improvements. The lack o f autonomy prevents the implementation of more aggressive strategies at the regional level (for example, competition with other utilities 69 through international interconnections and other commercial practices or strategic behavior). CFE has no incentive to improve i t s efficiency, and no CRE regulations can in practice be imposed on CFE. 3.69 There i s poor coordination between CFE/LFC and the rest o f the energy sector, especially w i t h PEMEX on gas. Shifting technology and the financing pressures to rely on smaller plants (independent power producers, IPPs) that can be financed with PIDIREGAS i s making gas ever more important for generation. This should lead to incentives for producing more gas (of which Mexico has substantial unexploited reserves), but the internal organization o f PEMEX-monopoly controller o f gas as well as oil-prevents an appropriate response to the demand for gas. As a result, Mexico i s becoming increasingly dependent on liquefied natural gas and other high-cost sources, and i s locking this in with long-term contracts. The Secretary o f Energy traditionally has not been able to coordinate the activities o f these two giant institutions, which carry great political weight through the political appointment o f their heads and the strength o f their unions. The IPPs for electricity generation often make their own contacts and deals with PEMEX-Gas. Due to political pressures and constitutional constraints, neither market incentives nor the Energy Secretariat can reallocate resources within the sector or bring in private sector investment as needed to efficiently meet the growing energy needs o f the economy. Water Supply and Sanitation 3.70 Overall policies in the Mexican water and sanitation sector seem more or less appropriate. The National Hydraulic Program and the Water L a w emphasize the need for greater operational efficiency, financial autonomy o f service providers, and the protection of water resources through environmental awareness (referred to as a “culture o f water”; see Annex A). The challenge lies not so much with the basic principles o f the policies adopted b y the Federal Government, but rather in the implementation o f these policies, which are hampered b y weaknesses in the institutional framework (as mentioned above), overlapping planning and budget cycles at various levels o f government, and complex administrative norms including the operating rules of some o f the programs that have been put in place to implement these policies. As a result, most water utilities in Mexico s t i l l lag behind their peers in other Latin American countries and even the good performers in Mexico in terms o f technical and commercial efficiency and capacity to recover costs. 3.71 The water sector i s the most decentralized, with the great majority o f spending decisions taken at the local levels, and i t has recently seen a few important innovations, mostly local. B o x 3.8 gives some history on decentralization o f water in Mexico. Although the sector i s inherently decentralized, the technically logical pattern o f decentralization for water service does not usually match the pattern o f political decentralization in Mexico. The new arrangements that stem f r o m the Water Law, however, and the requirements o f a reliable supply o f water services b y sectors o f the economy (that is, the tourist industry) mandate more coordinated planning. C N A has 70 appropriate and necessary roles in setting national standards f o r water service, collecting information, and distributing financial resources derived f r o m national taxation. Box 3.8: Uecentralization of Water and Sanitation Services in Mexico Until the decentralization initiated by President de la Madrid in 1983, most water and sanitation services in Mexico were provided by federally owned agencies (Juntas Federales de Agua) under the supervision o f a Federal Ministry. Planning, financing, and operation were federal responsibilities without involvement of state or municipal governments. The s t i l l common belief that water i s a responsibility o f and a gift from the Federal Government i s rooted in the policies of that period. In 1983, as part of a broader decentralization process, municipalities were entrusted with providing water and sanitation services, with the assistance o f state governments where necessary. However, municipalities received neither the necessary financial resources nor technical assistance to fulfill their new responsibilities. As a result, the quality o f services apparently deteriorated where it was entrusted to municipalities. Many state governments decided that municipalities did not have the capacity to provide services. Thus, in 1988, 21 state governments were responsible for service provision, and only 10 states had devolved responsibility to the municipalities. In 1989, the Salinas government, recognizing the weaknesses o f earlier efforts, decided to support the creation o f municipal service providers with legal and financial autonomy from the municipality. The newly created service providers were supposed to be under the authority of a Board that included non-political members, and which would have the authority to approve tariff increases, instead of having tariffs approved b y State Congresses or the Municipal Councils. The newly created CNA was given the task o f defining federal policies to strengthen service providers, providing them with technical assistance, and administering federal programs aimed at funding them. As a result, 11 more states transferred service provision to municipal service providers, bringing the total to 21 states in 1996. I n addition, many state water laws were amended. The amendments granted service providers tariff autonomy and stipulated that revenues had to be used exclusively for service provision instead o f being diverted to other municipal activities. These policies were essentially continued after 2000 by the Fox administration. Despite the appropriateness o f the federal policies to strengthen service providers, the autonomy o f many service providers remains limited. Moreover, the quality o f services and the degree of cost recovery have not significantly improved 16 years after the policies were introduced, making the search for more effective and sustainable models of local service provision more imperative. Source: Pineda (2002). 3.72 Traditionally, three groups o f institutions in the sector have needed to coordinate activities-CNA, the Comisio'n Estatal de Agua (State Water Commissions, CEAs), and the municipalities and organismos operadores ( 0 0 s ) . Some of this happens, but coordination remains inadequate. Investment planning i s carried out by the municipalities and the OOs, and sometimes by the CEAs, w h i l e CNA administers federal subsidies, including technical assistance. T h e functions o f the C E A s d i f f e r w i d e l y among states, some being in charge of investment planning, and operation and maintenance, w h i l e others provide technical assistance, and at least one operates a benchmarking 71 system. Furthermore, C N A and the new basin agencies have a potentially valuable role in issuing (and controlling) permits for the development o f new sources and wastewater discharge. Regulations are needed to realize this value. Financing 3.73 SHCP also needs to improve the coordination o f i t s own interaction with the sectoral agencies, especially if i t wants to move more toward multiyear budgets. As the sector ministries develop multiyear financing plans to go with their sector investment and operations plans, these w i l l need to be coordinated with the expected future fiscal envelopes, which are the responsibility o f Planeacidn Hacendaria (fiscal planning) in the Subsecretariat of Public Credit for aggregate allocations, and the responsibility o f the Subsecretariat o f Expenditure for sectoral allocations. This also needs coordination with cost recovery plans (where the Subsecretariat for Revenue has the lead role in setting tariffs), with the anticipated future needs to borrow (Subsecretariat o f Public Credit), and the accumulation o f contingent liabilities (Subsecretariat o f Public Credit). Even if SHCP does not get involved in the choice o f particular projects and lines o f spending within the sectors, it needs to take an active role in developing the financing plans for the sectors and setting standards for making projections o f spending and contingent liabilities. 3.74 T o achieve this, the various parts o f SHCP-the Unidad de Inversiones in the Subsecretarka de Egressos (SSE), the DGs o f Planeacidn Hacendaria and Public Credit, and the tariff-setting units in the Subsecretaria de Ingresos (SS1)-will need to work with each other and with their counterparts in the sectoral ministries and in the states. This w i l l challenge the traditional tendency o f each subsecretariat and even directorate to operate as a silo, with which others neither interfere nor coordinate. c. CONCLUSIONS AND CHALLENGES 3.75 The two main institutional problems for Mexican infrastructure are: (a) inadequate transparency and accountability; and (b) insufficient coordination o f investment planning, not only among agencies within each infrastructure sector, as just noted, but also at the macro policy level. 3.76 Transparency and accountability. Fragmented information systems and decisions about monetary allocation have led to disparate sector outcomes-some bad, some good-but not linked to the national development outcomes. The process i s least fragmented in the electricity sector, which i s almost all managed from the center, but there i s also less experimentation. Innovations o f the 1990s in CFX left a legacy o f institutional strength, but as problems emerged since then i t has been hard to motivate change. In the other sectors, all three levels o f government are involved, especially municipalities in water and sanitation, and multiple federal agencies are involved with transport, but generally the various actors do not share information well, which i s often a 72 tactic to avoid accountability, 3.77 The present system authorizes individual projects and budget envelopes annually, w i t h little reference to the effectiveness and efficiency o f sectoral spending, but rather on the basis o f notional, largely historical unit costs and ex ante cost-benefit studies. There i s little systematic information on whether results are good or bad, and such information rarely has budgetary consequences. While sectoral agencies and subnational governments are demanding greater autonomy in investment planning, execution, and financing, there i s not the effective accountability that should accompany autonomy. Indeed, without reliable, verifiable information on actual performance, i t i s risky to respond positively to demands for more autonomy. Rather, increments to autonomy should depend on improvements in accountability. 3.78 Currently, SHCP does not receive timely, objective information on whether funds were provided t o the executing unit as planned, whether they were used for the purposes intended, or whether their application translated into improved services, and at what cost. Without such information, i t i s difficult to determine what could have been done better. There i s n o regular reporting b y subnational governments on the use o f federal transfers, especially unconditional transfers such as Ram0 33/FAIS, which are a growing source o f finance for WSS, urban and state roads, and electrification; nor is there standardized reporting o n performance o f WSS companies (organismos operadores). 3.79 Coordination o f planning. Federal ministries, agencies, and local governments have been relatively isolated in the planning and implementation o f infrastructure spending. Coordination has been lacking between the subsectors and modes in each sector, because the President and secretaries do not insist on it, but rather grant autonomy to powerful appointed heads o f subsector agencies that operate as silos. The powerful unions reinforce the autonomy o f the subsector agencies, usually at the expense o f efficiency. A Comisidn Intersecretarial and the C o m i t h de Evaluacidn de Proyectos, established under Unidad de Inversiones in SSE, are theoretically in charge o f intersectoral coordination, but they do not have decisionmaking powers, and sometimes these commissions are only forums for the exchange o f information. 3.80 T o a large extent, the requirements for infrastructure planning have changed, shifting the focus from public investment programs to strategic planning in Mexico, reorganization o f the infrastructure sectors, decentralization, private sector participation, pricing and subsidies, and financial support. Clearly, some central coordination i s important for setting the medium-term allocation o f resources in a way consistent with the national economic and political priorities. Even with such sectoral resource envelopes, set b y the President, Cabinet, and SHCP, there s t i l l needs to be some sectorwide planning that covers all agencies within each sector. While this could be accomplished with a return to the old centralized planning model that Mexico had with the SPP, the newer, more promising route in many countries i s to have a lead sectoral agency, like SENER and SCT, do the planning for all federal agencies in the sector and to use performance standards and conditional transfers, especially with co-funding, to provide incentives for other levels o f government to go along with the national strategy. 73 3.81 Achieving a reunification o f planning and budgeting within each sector w i l l require not only coordination within the sectors, but also improved coordination among the various parts o f SHCP that are responsible for budgeting and financing, setting prices in the sectors, and controlling the accumulation o f budget and contingent liabilities. 74 4. FINANCING MEXICO’S FUTURE INFRASTRUCTURE INVESTMENTS 4.1 This chapter considers three questions with regard to the financing o f Mexico’s infrastructure: (a) how much i s needed, (b) who should finance it, and (c) how to best structure the financing. Answering the first question requires agreeing on what the goal of financing is. I s i t high-income OECD-country levels o f coverage? A reasonable expansion and guarantee o f minimum quality of service? These questions are reviewed in Section A, which discusses infrastructure investment needs and how they vary according to objective. I t reviews the estimates generated b y Mexico’s infrastructure agencies, and provides a sectoral analysis o f the size, structure, and timing of the investment needsg7 4.2 While infrastructure investments must eventually be paid for b y either the taxpayer or the user, answering the question o f who should finance investments and how to best structure investment schemes i s much more complex. Section B looks at the potential role o f the private sector in financing infrastructure needs, and argues that Mexico has not made a very effective use of private finance-first because o f the modesty o f the investment, and second because this financing has gone almost exclusively to upstream activities (generation o f electricity, wastewater treatment plants) and not to the downstream ones at the retail level. Section C reviews the way in which public mechanisms have promoted private financing o f roads, water, and electricity, and discusses ways to make these credit enhancement schemes more effective. Section D concludes b y offering recommendations on how the Government o f Mexico could better leverage existing sources o f financing in the provision o f infrastructure. A. H O W MUCH? THE INFRASTRUCTURE NEEDS MEETING OF TOMORROW 4.3 There are several ways o f estimating expenditure “needs” in infrastructure, each o f which gives different answers, depending on the objectives (Table 4.1). The first issue i s whether a benchmarking approach is adopted, or a set target defined. The IPER treats the investment trends and credit enhancements used in the electricity, water, and sanitation sectors, and the transport subsectors o f roads, railroads, and ports. I t does not analyze housing, urban transport, telecommunications, or airports. The model built to anticipate the future investment needs o f Mexico’s core infrastructure sectors includes roads (federal and state level), electricity and water supply, and sanitation. Wastewater treatment i s not included in the model, nor are the other subsectors o f transport, which already receive the vast majority o f their financing from the private sector. 75 Table 4.1: Different Approaches to Estimating Expenditure Needs in Infrastructure “Benchmarking” Set target Example: Example: - Stock target: What would i t cost to -MDGs: What would it cost for Mexico to get Mexico’s infrastructure (per achieve universal service coverage in water capita, per unit o f GDP, per km2) to and sanitation, electricity, and access to all the level o f the L A C leader; or to the year-round roads. level o f the East Asia median? - Flow target: How does Mexico’s expenditures on infrastructure compare to peers? Econometric: - Engineering-Economic Models: Growth: What level of These are “set” targets inasmuch as the target infrastructure coverage i s needed to is a particular level o f coverage and quality achieve x percent growth and reduce as defined through engineering-economic inequality by z percent? Model models developed by Calder6n and ServCn - Power sector: Well-defined (2004) could be used for this. international methodology, applied by CFE Demand: What level of in Mexico, which estimates the investment infrastructure coverage w i l l be needed to maintain the integrity o f the demanded b y firms and consumers network and satisfy predicted expansion in for given growth projections? This i s demand. the approach followed in Fay and - Waterhanitation: Financial model thai Yepes (2003). estimates investment needed to attain the coverage goals set in the National Hydraulic Plan. - Roads: Well-defined methodology foi rehabilitatiodmaintenance expenditures combined with road sector expert opinion 01 definition o f major corridors and investmen needs for their completion. Simple Benchmarking 4.4 Benchmarking can be done through a simple costing exercise. Looking at infrastructure stocks, for example, what would i t cost for Mexico to reach the infrastructure density o f a country deemed an appropriate comparator or goal? (See Box 4.1 for an illustration.) An even simpler approach i s to benchmark Mexico relative to i t s peers, in terms o f how much i t spends on infrastructure. This was done in chapter 2, showing that while Mexico’s investment in infrastructure i s low, the levels o f the past two years are comparable to that o f most o f i t s Latin American peers. 76 Box 4.1: The Growth Dividends of Better Infrastructure Calderdn and ServCn (2004) carefully analyze the impact that infrastructure might have on growth. They find that it i s significantly positive, and that improved coverage, notably o f services with social impacts such as water and sanitation, also contribute to reducing inequality, making growth even more pro-poor. In the case o f Mexico, their results imply that raising infrastructure coverage and quality to the level of the Republic o f Korea, the East Asia median, would entail a growth payoff o f an additional 3.2 percentage points per year. H o w much investment would be required to achieve this growth payoff? This simple benchmarking exercise i s done in Table 4.2, relying on international average costs: Mexico would have to invest 52 percent o f GDP, or 2.6 percent o f GDP over 20 years, to achieve the level of coverage o f Korea. Some additional resources would be needed to improve quality. I s this a pie-in-the-sky ambition? Not at all: Similar increases were in fact achieved by Korea (as well as China, Indonesia, and Malaysia) over the 20-year period from the late 1970s to the late 1990s. Indeed, Korea’s infrastructure endowments 25 years ago were substantially worse than Mexico’s at the time. The implication o f this exercise i s not, of course, that were Mexico to double i t s annual expenditures on infrastructure i t would become the next Korea. In fact, Korea i s a much more densely populated country, so i t i s not even obvious that it would be desirable for Mexico to aim for a similar road density. Nevertheless, this exercise illustrates the fact that most countries that have grown fast over long periods o f time have invested substantial amounts o f resources in developing their infrastructure. I t also highlights the fact that substantial progress in infrastructure coverage does not come cheap. I Table 4.2: A Simple Benchmarking Exercise: What Would it Cost for Mexico to Achieve the Infrastructure Coverage of Korea, the East Asia M e d i a n (% GDP) 16% 34% 2% 52% Note: Korea i s the East Asian median country in terms o f infrastructure density for the three services covered in the table. Costs used are US$1,900 per kilowatt o f generating capacity, US$400 per mainline, and US$lSO,OOO per kilometer o f roads (paved and unpaved). Source: Bank staff calculations based on data from C a l d e r h and Servtn (2004). Costing Set Targets-Pricing Universal Service Access 4.5 As for targets, a possibility i s t o price the cost o f achieving the Millennium Development Goals (MDGs) or some similar universal coverage goal. In the case of Mexico, the cost o f reaching universal coverage in electricity and water and sanitation b y 77 2015 would be a rather modest 0.17 percent o f gross domestic product (GDP), o f which 0.13 percent of GDP would be for water and sanitation, and 0.04 percent for electricity (0.03 percent rural and 0.01 percent urban). Unfortunately, data were not available to estimate the cost o f ensuring universal access to a year-round passable road, which would be the equivalent universal service access measure for transport. 4.6 This estimate i s modest partly because i t relies on alternative technologies in circumstances where the price o f a connection to the grid or the network would become prohibitive. For electricity, i t assumes an average price o f US$l,OOO per new connection, which implies that households too far from an existing network to be connected at a rice inferior or equal to US$l,OOO would be served b y alternative off-grid technologies! In the case o f water and sanitation, i t also assumes that households in low-density areas would not have access to sewerage connections, but to alternative sanitation systems (such as latrines), and that a proportion o f households would have access to water, but not necessarily in-house connections. 4.7 The 0.13 percent of GDP estimate for water relies on Mexican prices, but would be almost 25 percent lower (0.10 percent o f GDP) assuming Latin America and the Caribbean (LAC) average costs. These numbers do not include the cost o f maintaining or rehabilitating the existing system. Sophisticated “Benchmarking”-Econometric, Macro Models 4.8 More sophisticated approaches can use either macro, econometric models, or micro, engineering-economic models. The macroeconometric models can estimate what might be needed in several ways. One looks at the infrastructure coverage needed to achieve a particular growth objective, assuming given levels o f other inputs. This has not actually been done, but an approximation can be obtained using the work o f Calder6n and ServCn (2004), as described in B o x 4.1. Another sophisticated form o f benchmarking, developed in Fay and Yepes (2004) assumes that as economies grow and populations get richer, both f i r m s and individuals demand a greater level o f infrastructure coverage. 4.9 The growth approach described in B o x 4.1 suggests that Mexico could gain substantial growth payoffs from increasing its infrastructure coverage but this would require investing substantially more than Mexico currently invests. The approach o f Fay and Yepes’s (2004), on the other hand, suggests that Mexico would need to spend about 0.5 percent of GDP more on new investments in water and sanitation, roads, and electricity to satisfy the additional demand implied b y a modest growth performance o f about 2.5 percent per year.99 About the same amount would be needed for maintenance 98 Since there are s t i l l some households to be connected that are relatively close to existing grids and could be connected at lower prices (say US$500 or so), the price that determines a switch to alternative off-grid technologies could be somewhat above US$l,OOO. However, what i s certain i s that an average price of US$l,OOO per connection would not allow universal connection to a grid. 99 This i s GDP, not GDP per capita, growth. The projection used for Latin America as a whole i s similar, at 2.6 percent per year. 78 of existing assets.100 The equivalent estimate for LAC i s 1.58 percent o f GDP (Table 4.3). Table 4.3: Estimated Annual Investment “Needs” for Infrastructure, Based on Predicted Demand for Infrastructure Services-Fay and Yepes Approach Electricity Roads Water and Total Sanitation Sophisticated “Set Target”-Engineering-Economic M o d e l Used by M e x i c a n Agencies 4.10 Mexico’s sectoral agencies have used the engineering-economic approach, which builds on micro-level data and sector-specific engineering-economic models. In the power sector, the Comisio’n Federal de Electricidad (National Electric Company, CFE) has adopted a well-recognized methodology that estimates the investment needed to maintain the integrity o f the network and satisfy predicted expansion in demand (CFE 2003). This yields an estimate o f MxP$52 billion, or 0.63 percent o f GDP (Table 4.3). I t does not include universal service coverage, which, considering i t i s mostly rural, should be funded with Ram0 33/FAIS resources. Adding the cost o f universal coverage in rural areas (0.03 percent o f GDP, as mentioned earlier) would raise the estimated investment need slightly to MxP54 billion, or 0.62 percent o f GDP, shown in Table 4.4 as “augmented government projections”. 4.1 1 Similarly, in the roads sector, the Highway Design and Maintenance Standards Model (HDM) can help estimate maintenance and rehabilitation needs for a network, while traffic data and transport network models can identify key corridors and possible needs for expansion. With this approach, the Secretaria de Comunicaciones y Transportes (Ministry o f Communications and Transport, SCT) estimates that MxP6.7 billion i s needed for the maintenance o f the federal network, and MxP12 billion for the modernizationhpgrading o f major corridors, for a total of about MxP18.7 billion per year during 2006-1 1 (Table 4.4). This represents a 31 percent increase in expenditure on the federal network relative to 2001-03. N o equivalent estimation was found for state feeder roads. Adding our own estimates o f maintenance and rehabilitation costs o f the state lw Maintenance i s estimated as 2 percent o f the value o f the stock per year for roads and electricity, and 3 percent for water and sanitation. 79 feeder network increases the total required for the road sector to MxP26 billion per year, equivalent to 0.29 percent o f GDP, as shown in the “augmented Government projections.” 4.12 Calculating the investment needs and even tracing the expenditures in Mexico’s water and sanitation sector are challenging exercises, given the decentralized, multilayered, fragmented organization o f the sector. Nevertheless, the CNA estimates that MxP12.3 billion a year i s required to finance sector needs during 2006-29, slightly less than what i s estimated to have been spent during 2001-03. I t covers the cost o f expanding access through major bulk water supply and wastewater treatment projects, but at a slow pace, since universal service coverage would only be reached in 2029. W e estimate, instead, the cost o f reaching universal service coverage b y 2015 (which i s not a particularly ambitious goal for a country o f the income level and existing water coverage o f Mexico) and add to it the estimated maintenance cost o f the existing system. This yields a slightly higher estimate than CNA’s: close to M x P 2 1 billion, or about 0.23 percent o f GDP, as shown in the “augmented Government projections” for the water sector in Table 4.4. This amount does not include any o f the rehabilitation that i s surely needed. Pulling it All Together 4.13 The exercise above implies that the agencies have made reasonable estimates o f expenditure needs in their sectors. In fact, at about 1 percent o f GDP, these estimates are probably on the l o w side, since they do not include socially desirable and affordable targets, such as universal service coverage in electricity and water and sanitation b y 2015. They may also underestimate somewhat what i s needed in terms o f maintenance and rehabilitation. This may be particularly true in the water sector, which i s well known to have suffered from years o f poor maintenance, but for which i t i s impossible to estimate the exact cost o f the rehabilitation and upgrades needed to ensure better quality of service. As such, even the “augmented” government projections, at 1.14 percent o f GDP, are also likely to be lower-bound estimates. Note, however, that these estimates are fairly sensitive to the GDP growth projections made-slower GDP growth implies a higher burden. 4.14 These estimates also compare reasonably well w i t h what could be derived from the various benchmarking exercises. Indeed, b y spending between 1 percent and 1.25 percent o f GDP, Mexico w i l l remain around the Latin America average in terms o f both infrastructure coverage and expenditures. However, such a level o f spending would not allow Mexico to reach the level o f infrastructure per capita o f other OECD countries or faster-growing East Asian countries (such as the Republic of Korea, which ’ust a few decades ago trailed far behind Mexico in terms o f infrastructure endowments). ldl ~~ ~ In lo’ 1960, Korea had less than half Mexico’s paved road density; today i t has 11 times more. In 1969, Korea had one-third the power infrastructure per capita o f Mexico; today it has about 3 times as much. 80 4.15 Nevertheless, spending 1 t o 1.25 percent o f GDP on these infrastructure sectors would have a much greater effect if also accompanied b y efficiency gains. In particular, i t appears that unit costs in the water sector could be lowered quite substantially. Similarly, studies have shown that rural electrification in Mexico i s often done at extremely high costs, because o f an excessive reliance on grid connections. Finally, much of the need for rehabilitation in roads, water and sanitation, and electricity i s due t o insufficient maintenance over the last decade. And i t i s well known that rehabilitation i s much more costly than regular maintenance. 81 c1 s x z c1 10 1 m 2 0 s r! c1 0 0 - 0 2 g 8 - g 0 s 8 3 0 I? I? A Implications for FinancingNeeds 4.16 The analysis above suggests that the primary financing challenge for the road sector w i l l be to ensure adequate funding for rehabilitation and maintenance o f the existing network. While the new concessioning and Proyectos para la Prestucidn de Sewicios (Public-Private Projects, PPPs) program hold out considerable hope for the leveraging of private sector investment in the highway program, current annual levels o f financing w i l l have to increase by 30 to 40 percent in the years ahead in order to fund maintenance and rehabilitation needs and bring all roads in the primary federal and state networks into fair to good condition. Longer-term and performance-based rehabilitation and maintenance contracts might offer the most efficient procurement mechanism to help achieve this goal in a cost-effective manner. 4.17 In the electricity sector, the challenge is to find new financing instruments to mobilize large amounts o f money, which w i l l be complex, given the shortcomings o f the current Proyectos de Zmpucto Diferido en el Registro de Gusto (Projects with Deferred Impact in the Budgetary Registry, PIDIREGAS) scheme and other structural constraints discussed later in this chapter. 4.18 For water and sanitation, the highest priority w i l l be to use existing funding more efficiently to reduce per-unit costs and to focus more on rehabilitation and maintenance. A n y new additional funds should be directed to increasing service coverage, especially o f the poor. Given Mexico’s currently high unit costs for connecting and serving households, the level o f resources and timing required to meet the social goals o f universal coverage are highly sensitive to the prospective improvement (or not) in the efficiency of the use o f funds, and the delivery mechanism for those resources. 4.19 Responding to the need for increased resources and, most important, increased efficiency in the use o f these resources, w i l l require new and different uses o f private sector participation, and refined credit enhancement schemes t o attract financiers, investors, and operators to Mexico’s infrastructure market in a more cost-effective manner. Using the private sector to close the gaps noted should recognize the following principles: e Government support-direct transfer o f funds or guarantees-is a subsidy t o providers and users o f the infrastructure service f r o m the taxpayer. I f the subsidy benefits a connected consumer (through, for example, support to the construction of a water treatment plant) or a consumer with an automobile (through the building o f a non- toll road), that portion o f the subsidy transfer which i s greater than the value o f externality produced b y the investment (for example, better public health, active commerce) i s highly regressive. The rich use the services more and thus benefit more. e In addition to i t s impact on equity, the setting o f tariffs and user fees has both direct and indirect financing implications on infrastructure. Where average tariffs fail to cover operations and maintenance-as in Mexico’s water and sanitation sectors- subsidies are required just to sustain financially unviable utilities. Also, lower charges 83 often simulate higher demand, which entails higher investment requirements. Moreover, guarantees and off-take agreements become particularly blunt instruments for providing support in which a flat taxpayer subsidy benefits special groups o f consumers. Efficiency gains can be realized through competitive bidding for the provision o f sunk assets (such as electricity generation facilities) and for long-term arrangements for operations o f commercial services. For any o f these potential efficiency gains (due t o lower operating costs and, possibly, capital costs), to be passed on to consumers b y public or private monopolies requires proper regulation or oversight. B. WHO FINANCES THE INFRASTRUCTURE? 4.20 Infrastructure services are always paid for b y either general revenues or user fees. There are two choices when trying to finance an investment project: ask users t o pay a tariff that covers operations and maintenance and debt service, and allows for a sufficient return on investment (under credible willingness and ability to pay assumptions); or commit public funds to compensate for insufficient user fees. A third choice could, o f course, be to revisit the scope of the original project and reduce or eliminate the planned investments. 4.21 While the ultimate funding can come only from taxpayers or users, the financing to shift the payment to the future can come from a variety o f sources-public or private-through federal or state transfers, municipal budgets, state or federal guarantees, bond issuances, special non-budgetary funds, tariffs and rate charges, private banks, or private equity investors. And, since taxpayers or users always end up paying the bill or repaying the loan, infrastructure financing decisions should fully consider the risk to them. That i s not to say that those agencies, investors, and financiers involved with mobilizing finance are not assuming risk. Indeed, since tariffs in some combination w i t h tax revenues cannot be counted on with perfect assurance to match the ongoing financing requirements o f infrastructure provision, there i s a risk premium on long-term capital. 4.22 Over the past decade, Mexico introduced a number o f policy instruments to foster increased private sector participation in infrastructure (PPI), but the performance i s disappointing when compared with the international experience with private sector provision (reviewed in Annex C). The amount o f private financing mobilized has been low, especially compared to peers in Latin America. Even more important, the mechanisms through which PPI has occurred in Mexico have not made the most efficient use of the private sector’s capital or operational expertise. 84 How to Maximize the Efficiency Impact of PPI 4.23 Mexico’s ability to improve the coverage and quality o f i t s infrastructure and to sustain those improvements without unduly taxing public resources w i l l require better use o f PPI. This w i l l entail greater levels o f competition in service provision, and better regulation, oversight, and contractual adherence. Competition can be achieved in infrastructure provision in several ways, with increasing degrees o f impact on rates and qu,ality of service: 0 Competition for the right to build (for example, power plants, water and wastewater treatment plants); 0 Competition for the right to provide service (for example, water utility concessions); 0 Competition from yardstick benchmarking derived by contrasting the performance o f local monopoly service providers; and 0 Competition for actual service provision in unbundled sectors (for example, merchant power plants selling into a power market; independent suppliers o f electricity and gas and retail rights over existing networks). A program’s ability to achieve efficiency in service provision and capital expenditure relates to i t s use of all available forms o f competition. In this regard, Mexico i s behind i t s regional peers. To date, Mexico has primarily used the first form o f competition-for the right to build-in the power and water sectors, with a small degree o f competition for the right to serve (concessions) in water. Competition among service providers i s not possible, since it relies on yardstick benchmarking-which in turns requires a plethora o f independent service providers at the commercial service level, and an institution with authority for monitoring and sanctioning relative performance. Finally, competition in actual service provision (mostly in electricity) would require market restructuring and the development of independent distribution f i r m s with the right to choose their sources o f generation. Levels of Private Participation in Mexico’s Infrastructure 4.24 When viewed as a percentage o f investment per capita, Mexico has made little use of the private sector in infrastructure compared to most o f i t s Latin America competitors (Figure 4.1). In order for Mexico to attain more competitive mechanisms, greater and better use o f the private sector w i l l be required in the future. 85 Figure 4.1: Private Participation in Infrastructure Has Been Limited in Mexico, Relative to its Peers in Latin America, 1993-2002 16700 1993-1997 1998-2002 Note: Includes all energy sectors (including gas), telecommunications, water and sanitation, and transport (roads, ports, railways, and airports). Source: World Bank PPI Database. 4.25 The limited use o f PPI i s all the more surprising in light of Mexico’s good sovereign risk and credit ratings, i t s macroeconomic stability and general success in attracting foreign direct investments, and the depth o f local capital markets. Indeed, Mexico i s probably one o f the few developing economies today that could fairly easily While PPI may indeed attract substantial amounts o f private capital for infrastructure. lo2 increase in Mexico with the new PPPs and concessioning programs, careful attention should be given to new schemes in order to increase PPI’s impact on efficiency. This i s described in more detail below. Forms of Private Participation in Mexico’s Infrastructure 4.26 The benefit from private sector participation i s generally related to the degree o f interface between the private sector and domestic consumers o f infrastructure services. While Mexico appears to have achieved fairly l o w per-unit costs at the upstream end (for generation development, for example), most utility inefficiency i s found downstream, at the retail level: line losses from undermaintained assets, poor customer and consumption data, distorted tariff structures, lack o f metering, and theft in tandem with lack o f incentives for disconnection. 4.27 In Mexico’s case, the most sensitive areas o f utility-consumer interface-water supply and electricity supply-have seen very little private sector participation. Although a significant portion o f CFE’s financing for generation may be mobilized b y private power plant developers, and several water and wastewater treatment plants around lo*Private flows to infrastructure in Latin America have collapsed since the peak year of 1997, partly because o f the economic crisis in East Asia and Argentina, but also because much of the more attractive divestiture operations (mostly in telecommunications and power) have already taken place. 86 Mexico are built and operated b y the private sector, few end consumers o f those services see the private sector as their service provider and bill collector. Figure 4.2 illustrates this point. Figure 4.2: PPI in Mexico has Disproportionately Favored Production and Generation Rather than Retail Utility, 1990-2003 100% f .- loo% f .- g : 80% 80% e n L .- .- t 60% - $j 60% 2 L 3 u 5 .- .- - 40% ti 40% 1 Distributionand/or transmission t i ; r r m Distribution and generation 20% 20% Generation e: b 0% 0% I p LAC (Excluding Chile Mexico LAC (Excluding Chile Mexico Mexico) Mexico) I J I I Note: Chile data extend back to 1985 to capture their early PPI initiatives. Water data extend through 2004. Source: World Bank PPI Database; A. Karina Izaguirre, authors’ calculations. 4.28 The degree to which Mexico has limited private sector involvement to production, and continued to rely on public agencies as service deliverers, has been remarkable compared to the rest o f Latin America. Less than 20 percent o f Mexico’s water projects with private participation, and n o electricity projects, have assumed some form o f retail risk (Figure 4.2). B y contrast, nearly half o f Chile’s power projects and over 80 percent of their water projects have included a “retail” element that transferred commercial risk t o the private sector. Mexico’s reluctance to bring the private sector t o i t s citizens in the areas o f water and electricity i s a response to political constraints. But whatever the motivation, the result i s lower levels of competition, fewer opportunities for efficiency gains, and a lack o f incentive for the implementation o f effective regulation. 4.29 A related characteristic o f Mexico’s private programs in water, electricity, and roads can be found in i t s preference for greenfield projects. While this may be changing with the new PPPs toll-road initiatives and a few water concessions, t o date, the vast majority o f projects have been for the construction and operation o f new production facilities (Figure 4.3). 87 Figure 4.3: The Share of PPI Allocated to Greenfield Projects Has Been Particularly High in Mexico, 1990-2003 U LAC Chile! Mexico (Exduditig Piled@ Notes: Chilean projects traced back to 1985; water data extend through 2004. Source: W o r l d Bank PPI Database; A d a Karina Izaguin-e, authors’ calculations. Effects of Mexico’s Imbalanced Approach to the Use of the Private Sector 4.30 There are several results o f the stark preference for using the private sector in greenfield and production projects. The first, as mentioned above, i s the decreased opportunities for efficiency because existing service providers are not exposed to competitive pressures, new management, technology, outside sources o f financing, or procurement approaches. In addition, the motivation for establishing legal and institutional arrangements that separate out political, operational, and economic decisionmaking i s reduced. As a result, the degree o f regulation and independent oversight in Mexico’s utility and road sectors remains underdeveloped, while tariff setting remains the purview o f political forces. 4.31 The dominant use of private funds in greenfield projects and the imbalance between private sector participation in production/generation versus retail operations also places a disproportionate burden on taxpayers. That is, under current arrangements municipal water utilities must offer steep take-or-pay agreements in order t o secure private financing for water, and wastewater treatment plants. If the publically owned utilities themselves were financially viable purchasers, the guarantees for these agreements would be lower, cheaper, or altogether unnecessary. 4.32 In addition to shifting risk from users to taxpayers, the implied subsidy i s mostly regressive, since only connected consumers benefit. The costlier the subsidy, the 88 higher the regressive tax against those who are either unconnected, underserved, or receiving poor-quality service. C. HOW INFRASTRUCTURE I S FINANCED: CURRENT EXPERIENCE WITH CREDIT- ENHANCEMENT SCHEMES I N MEXICO 4.33 Even assuming political commitment at the federal, state, and municipal levels, i t w i l l take several years for Mexico to move toward the types o f market structure described in Section 4.2. While those structures may reduce or eliminate the need for off-take agreements, some public credit enhancements that fall into the general category of guarantees and insurance-that is, indirect subsidies that create contingent liabilities- may continue to serve as useful elements in a strategy to leverage private sector participation in infrastructure. This section summarizes the role o f the primary credit enhancement schemes currently in use in Mexico in order to help refine their role and improve the efficacy o f their delivery. 4.34 Mexican experience with credit enhancement has changed over time, and the degree o f success varies across sectors and programs. This section thus reviews trust funds, guarantee and transfer programs which defy a simple institutional categorization, and focuses on an overview o f the primary issues related to the major credit enhancement schemes affecting those infrastructure sectors. Analyses of Selected Existing Infrastructure Programs Infrastructure Investment Fund (Fond0 de Inversi6n en Infraestructura, FINFRA) 4.35 After the 1995 Mexican crisis, FINFRA was one o f the first programs to promote private investment in different infrastructure sectors. Created as Trust Number 1902 in Banco Nacional de Obras y Sewicios Pu'blicos (BANOBRAS), i t was specifically designed to finance infrastructure projects with high social return. Private participation in the provision o f infrastructure i s encouraged (providing public resources results in a greater national and foreign private participation in infrastructure). The program has gone through several changes over the years. Currently, the program can provide financing for building water supply, sanitation, roads, ports, airports, urban transport, and public utilities. 4.36 Projects are awarded to the contestant that requests the least government funding. For example, in the case o f roads, the government sets the tariffs and the contractors bid for the project on the basis o f lower subsidies (Table 4.5). 89 Table 4.5: Conditions for FINFRA Financing Type of Contribution Authorized Limit Venture capital Up to 35% of equity Subordinated capital Up to 40% of total investment Venture and subordinated capital Up to 49% o f total investment Aggregate public share of capital Up to 49% of total investment Total aggregate public share Up to 2/3 of total investment Commitment in one single project Up to 20% of the Fund's equity 4.37 The following analysis of FINFRA i s focused on two subsectors, toll roads and wastewater treatment plants, where FINFRA has been most active within the sectors covered b y this study. 4.38 FINFRA's Federal Toll-roads Concessions: In the early 1990s, the Mexican government embarked on an ambitious toll-road concession program. While the program resulted in the construction o f many new roads, a majority o f the concessions failed after the macroeconomic crises o f 1995, and were ultimately rescued b y the g~vernment."~ The early program was so ambitious that it not only included the few toll roads justified b y the traffic volumes o f that time, but also included most o f the links that might be attractive for private participation according to today's traffic levels. Nonetheless, over the last two years the Government has begun to pursue the concessioning of new toll roads, two o f which are under construction, seven o f which are now being tendered, and another seven o f which are s t i l l in the planning stages. 4.39 The new road concession program represents an effort to identify and assign risks among participants in a rational manner. I t also recognizes the need for public- private partnerships. The mechanism recognizes that there are certain projects for concessioning that may not have positive revenue for the private sector, and thus require government intervention. Some key elements o f the program are: 0 Federal resources are channeled through FINFRA, establishing maximum l i m i t s for each project. FINFRA's funding w i l l serve as a matching grant o f the concessionaire's risk capital. 0 The initial federal contribution i s a nonrecoverable transfer. 0 Once the concessionaire has recovered the initial investment and a certain return, i t w i l l share with FINFRA the net income from the road until the end o f the concession contract. lo3 Sales, Sclar, and Videgaray (1999) offer a description and analysis o f the early program and i t s financial failure. 90 4.40 The bidding i s open to national and international consortiums integrated b y investors and operators that must demonstrate their operating experience. With the goal of avoiding conflict o f interest, given that i t i s both the investor and the constructor, there w i l l be mechanisms that guarantee the risk capital: 0 The concessionaire must take into consideration in i t s proposal the obligation to supply at least 25 percent o f the total project value. 0 A project bond w i l l be established for the concessionaire to cover the risk that the project might have to be prematurely terminated, or there are out-of-budget costs for which the concessionaire i s responsible. 0 A similar bond w i l l be established against authorities and called in the event they breach their part of the contract. 4.41 The new concession mechanism relies on debt financing (domestic and international). In order to mitigate risks to debt holders, FINFRA commits to providing subordinated contributions if needed to cover debt service (cornpromiso de aportacidn subordinada, CAS). The maximum amount o f this government commitment i s established in pesos in the concession documentation. If called, repayment of the CAS is subordinated to project debt, but remains senior to project equity. The concession i s assigned to the bidder that requires the lowest amount o f the sum o f federal grants for construction and the present value o f the requested CAS. The maximum time span of a concession w i l l be 30 years. 4.42 The main objective o f the new program i s to increase the supply o f roads through a combination of fiscal subsidies and market financing backed b y tolls. In this manner, the government i s leveraging the private sector to supply infrastructure services that produce positive externalities. 4.43 Although this new approach to concessioning Mexico’s toll roads i s a marked improvement upon the earlier approach, the market has responded with modest levels o f enthusiasm. This may be a result o f the lack of traffic guarantees provided in the program. While i t i s an improvement that those direct forms o f contingent liabilities are not absorbed b y the taxpayers, the Government may be able to guarantee against negative contingencies such as the construction o f alternative routes. The CAS addresses these issues for debt holders, but magnifies the problem for equity holders that become subordinated to CAS recovery. 4.44 A second financing challenge i s the unavailability of long-term currency swaps and Unidad de Znversidn (Inflation-Linked Units, UDIs) (that is, inflation-adjusted, fixed- rate bonds) to floating-rate peso swaps. Given the long-term nature o f the projects, the lack o f long-term currency swaps i s a limit on external financing options. UDUpeso swaps could be helpful in mitigating currency risks, given that the source o f payment (tolls) i s indexed to inflation, and therefore UDI finance i s the best asset-liability match. Unfortunately, there i s not yet a long-term market for such swaps, and in contrast with other sectors (that is, low-income housing), the government i s not willing to provide the swaps. 91 4.45 O n the impact on Federal Government finances, and thus on the taxpayer burden, the bid design illustrates how much more valuable a real subsidy i s to a contingent payment, since bids to date have evidently preferred the up-front subsidy. In effect, the parametric formula equates the cost of the guarantee as one-to-one with the direct subsidy. In addition, the lack o f currency and UDI swaps increases the vulnerability of the concessions to macroeconomic risk, which can lead to costly bailouts. 4.46 Aside from the currency mismatch concerns and the bid bond requirements, the l o w levels o f interest to date could be the result o f the wariness o f private road operators to return to Mexico. However, the dominance o f new road construction (including a focus on difficult-to-project ringroads and bypasses) rather than concessions over existing roads with some proven traffic makes the program that much riskier f r o m the investors' perspective. 4.47 FINFRA 's Wastewater Treatment Plants: Municipal wastewater treatment i s a priority area o f investment for FINFRA. In 2004 alone, nine wastewater treatment plants (WWTPs) received FINFRA support, under build-operate-transfer (BOT) mechanisms. The standard capital structure for a WWTP BOT includes a FINFRA subsidy o f up to 40 percent o f the investment, debt financing o f about 30 percent (provided b y B A N O B R A S or other sources), and the remaining 30 percent in equity from the concessionaire. The public water utility (state or municipal) i s the off-taker for treated wastewater. Off-take payments are monthly, comprising charges for equity return and debt service (Tl), fixed expenses (T2), and variable costs (T3). T1 i s a take-or-pay obligation. 4.48 T o mitigate payment risk, B A N O B R A S sets up a contingent credit line that covers from three to six months o f payments, and the credit line i s in turn backed up b y federal transfers: if the utility does not pay, the concessionaire calls the credit line and gets the payment from BANOBRAS; then B A N O B R A S can collect i t s payment from the federal transfers targeted to the local government. Although the nominal amount o f the credit line i s limited to three to six months, it i s a revolving line. Given the strength o f the federal transfers guarantee, the revolvency risk i s minimal so, de facto, the complete stream o f payments i s backed b y federal transfers for the l i f e o f the concession. See B o x 4.2 for a comparison o f Puebla case studies in the use o f credit enhancement design. Annexes D (Puebla Toll Road Securitization) and E (the Puebla BOT Buyback) contain more detailed information about these individual cases. 4.49 The need for municipal wastewater treatment i s evident, and FINFRA- sponsored projects have been instrumental in increasing coverage. There i s no doubt that the program has been effective in addressing the negative externalities caused b y residual discharges. However, the following are key weaknesses: 0 Many local utilities and governments have reservations about the mechanism, and this has limited its impact. Reservations stem mainly from four factors: (a) wastewater treatment i s not a political priority; (b) regulations mandating wastewater treatment before discharge into federal water bodies have no credible 92 enforcement; (c) the B O T increases utility expenditures; and (d) federal transfers are the main collateral available for local governments, and there may be other demands for the limited quantity. These factors decrease the effectiveness o f the FINFRA matching grant incentive. 0 While wastewater treatment plant BOTs have worked well in utilities that are financially healthy, in cases where the utility i s in bad financial standing the BOT makes things worse b y adding to expenses. Typically this increases dependence on transfers from the parent government if tariffs cannot be increased to cover the wastewater treatment plants. 0 The B A N O B R A S contingent credit line basically transforms off-taker risk into debt-like risk backed b y federal transfers. In this context, requiring a capital structure with 30 percent equity is inefficient, and offers a risk-return arbitrage opportunity to private participants. Unfortunately for the purchasers and sponsors, this increases costs significantly. The fact that all bids for wastewater treatment plant BOTs attract strong interest from operators and banks is, therefore, n o surprise. 0 The accounting treatment o f the contingent credit line, due to i t s revolving nature, does not reveal the true size o f the T1 take-or-pay liability. BOTs are often marketed as schemes that do not create debt, which i s true only from an accounting perspective. T 1 i s not a conditional obligation, and i s strongly guaranteed b y an intercept on federal transfers, so i t s present value should be acknowledged when debt i s assessed. 0 Bidding rules and procedures are quite intricate and prone to controversy. WWTP BOTs have become so appealing to private participants, that bidding has become contested and litigious. Some projects are delayed for months due to bid controversies, and others have been cancelled (that is, Pachuca’s project). 93 Box 4.2: Case Review: The Puebla BOT Buyback Compared to the Puebla Road Securitization A comparison o f the Puebla toll road securitization and the Puebla water BOT demonstrates how credit enhancement design affects risk allocation and the financial sustainability o f projects. In the case o f the Puebla toll road, a partial guarantee was offered, which forced the market to understand the underlying risk and absorb a meaningful part o f it. Moreover, it i s based on an underlying financially viable asset (the road), and a structure that achieved an A+ rating without the guarantee. In addition, the true sale structure gives control to the investors o f critical variables related to payment capacity, including tariff levels. There i s no backing o f federal transfers, and the government has no responsibility for making any payments. In contrast, the contingent line in the BOT was a full guarantee (disguised as partial through the revolving-line device), so the investors did not have to make any analysis or absorption of the underlying risks, such as the utility’s payment capacity. I t was based on federal transfers, not a financially viable asset (the utility) or credit structure. Finally, investors had absolutely no control o f critical variables affecting payment capacity, such as tariffs. Although the arrangements for moral hazard and the electoral cycles are the same in both cases, the fundamental differences in the design o f the credit enhancement instrument deliver a different level of sustainability in each arrangement’s financial structure. I n the road’s case, the risk and full control over critical variables were transferred to the investors and the guarantor. By contrast, basically all risk and control o f critical variables stayed with the state government in the BOT’S case. Annexes D (Puebla Toll Road Securitization) and E (the Puebla B O T Buyback) contain more detailed information about these individual cases. D. RECOMMENDATIONS 4.50 The f o l l o w i n g recommendations to improve the design o f federal infrastructure programs that increase decentralization and private participation come f r o m a review o f international experiences and the analysis o f Mexico’s current financing arrangements, existing credit-enhancement programs, and alternative cases. The overriding objective i s to protect the government’s macroeconomic stability by limiting the government’s fiscal exposure to infrastructure investment wherever possible. This must b e done in the context of awareness o f the growing need for infrastructure investment in real terms. T h e recommendations have three objectives: 0 Reducing risks where possible; 0 Rebalancing risk allocation away from taxpayers and toward providers and users; and 0 I m p r o v i n g the structure o f credit-enhancement mechanisms and improving the efficacy of agencies involved in financing of infrastructure. 4.5 1 The first step toward limiting the government’s fiscal exposure to infrastructure expenditures i s to reduce total risk. Risk-political, economic, regulatory, or project- specific-translates i n t o higher costs o f capital in project finance and fewer bids on 94 competitive project transactions (reduced auction benefits). These risks may be reduced through stronger regulation, oversight, and accountability-in particular in the transfer o f federal subsidies to sub-sovereign entities, municipalities, and public service providers. The greater use o f local capital markets w i l l also reduce currency risk, and may reduce project risk b y fostering closer alignment between long-term investor interests and operational performance o f the service provider. 4.52 T o rebalance the allocation o f risk away from taxpayers, guarantees should be offered only to the extent necessary to get market participation, and should allocate to the private sector or public utility i t s fair share o f risk. This means that when guarantees are employed, the government needs to shift away from revenue, traffic, or volume guarantees, and to use guarantees against negative contingencies, such as failure o f tariffs to keep pace with input prices. This w i l l require strengthening regulation and the financial and technical performance o f service providers through increased private sector participation focused on retail operations. Conversely, if a project requires a significant guarantee o f cash flow in order to be bankable, the project should be reevaluated. Finally, in cases where credit-enhancement mechanisms are indispensable, given growing expenditures in infrastructure, the Government should design the enhancement to protect i t s own fiscal exposure and to assure that, when transfers or guarantees are made, the agencies involved are acting effectively and efficiently. The discussion here focuses on the public infrastructure bank for subnational projects (BANOBRAS), the Government’s largest off-balance-sheet financing scheme (PIDIREGAS), the future approach to public- private project design (PPPs), and federal-municipal matching grants. Improving the Federal Government’s Instruments to Achieve Desired Infrastructure Outcomes with Sub-sovereign Projects 4.53 T o reduce political risk, i t i s important to understand the decentralization process and the agency problem i t generates. The agency problem arises because o f the different incentives o f the Federal and subnational governments. The Federal Government has two main sets o f instruments to achieve long-term goals in the provision of sub-sovereign infrastructure: transfers and penalties. Transfers are in the different programs to promote local government and private participation. Although penalties and fines are established in the Mexican laws (for example, in the Federal Water Fees Law), the Federal Government i s only using the first set o f instruments, which local governments understand, diminishing their incentives to abide b y the rules. 4.54 Moreover, in a repeated interaction, municipalities and local governments perceive that they not only w i l l avoid penalties, but w i l l receive subsidies in the future if efficiency i s not attained. This produces perverse behavior, which, in the end, i s more costly to society as a whole. I t i s important to break this structure o f perverse incentives that lead to inefficient outcomes. B o x 4.3 shows some examples o f how the Federal Government’s failure to enforce the rule o f law leads to counterproductive incentives in the infrastructure sectors. 95 Box 4.3: Federal Influence to Improve Municipal Water Sector Policies Constitutional reforms starting in the 1980s established the municipalization of water in Mexico. This opened up opportunities for new partnerships in water programs. However, the decentralization of water supply and treatment to municipalities has proven problematic. Exacerbating the lack o f long-term planning endemic to the three-year administration terms of local government, the water programs generally do not match the incentives of municipalities with the incentives o f the Federal Government. Some o f the highest risks for the water programs come from the local government or utility freezing tariffs. Moreover, local government may decrease tariffs for political reasons, which makes current and future revenue collection difficult. T h i s i s aggravated by the short-term horizon o f municipal administrations. Since the key issue o f these programs i s to promote efficient water charging, the whole scheme may be vulnerable if tariffs are not increased or are susceptible to government changes. Even if they are not included in the programs, some water systems have made it part of their operational rules to update tariffs to reflect changes in costs and inflation. In general, the federal water programs need improvement. Municipal participation has been scarce, and the private sector i s being attracted only through strong federal guarantees.’ However, the Federal Government rarely penalizes municipalities for deficient provision of sewerage and treatment, or uses i t s fiscal powers to recover water fees from the municipalities. Most programs focus on benefits for municipalities, but little i s done to enforce the law. This type o f behavior sends the wrong signal to municipalities. Municipalities do not have the incentives to correctly charge and pay for their water, because the Federal Government does no1 penalize them if they do not pay their fees. Moreover, there i s little incentive for sewerage and sanitation because the municipalities perceive a very low probability o f receiving a fine from the Federal Government for not complying with discharge standards.’ Given the decentralization oi the water sector, the Federal Government has two tools to promote proper water supply sewerage, and sanitation: support through water spending programs and the enforcement o f law To date, i t i s using only the first. 1. Mainly by the use of the contingent credit line used i n the FINFRA projects. 2. CNA i s the responsible fiscal authority to enforce the different regulations. Reducing Currency Risk and Mobilizing Long-term Financing through the Greater Use of Local Financial Markets 4.55 The achievement o f macroeconomic stability, along with a sustained decline in inflation and interest rates has, in recent years, l e d to the r a p i d development of Mexico’s domestic financial markets. In real terms, medium- and long-term private securities more than doubled from 2000 to 2004 (Figure 4.4). 96 Figure 4.4: Local M a r k e t and Institutional Investors Development (% of GDP) 2.50 2.00 1.50 1.oo 0.50 t Institutional Investors* t Medium and Long Term Pnvate Secuntles *SIEFORES, Insurance Companies (pension, health, and life), Mutual Funds (fixed-income, variable income, and capital markets), and Savings and Credits Societies. Sources: CNBV, CONSAR, CNSF. World Bank (2003), and Banco de MCxico (with data from Instituto para e l Dep6sito de Valores [INDEVAL]). 4.56 At the project level, two indications o f the development o f local financial markets are the long-term securitization o f mortgages and the financing o f a toll road, at the end o f 2004, with maturities o f 30 years and 25 years, re~pectively."~Moreover, due to demography and the defined contribution reform of the Mexican pension system, there i s a sustained growth in the amount o f assets managed b y Mexican private pension funds (AFORES). As of December 2004, AFORES managed assets in excess o f MxP469 billion (US$41.9 billion), an amount equivalent to 6.3 percent o f Mexico's GDP (Figure 4.5). This figure i s expected to reach 20 percent o f GDP b y 2015 (Sales, Solis and Villagomez 1996). These two processes have created a capital market for long-term securities, where states and municipalities are demanding long-term financing and the AFORES are willing to invest their resources in long-term projects. '04 Both transactions are denominated in UDIs (Inflation-Linked Units). GMAC-Hipotecaria Su Casita securitized mortgages with a 30-year maturity. On the other hand, the Toll Roads Organism o f Nuevo Le6n securitized the Monterrey-Cadereyta highway to obtain 25 years' maturity. 97 Figure 4.5: AFORES’s Assets Under Management (as of December of each year, billions of pesos) 450 393 400 315 242 200 159 150 104 100 50 1999 2000 2001 2002 2003 2004 Source: CONSAR. 4.57 The market has also benefited f r o m two wider accomplishments in the financial sector in recent years: 0 Mexico has had full access to global debt markets after obtaining investment- grade ratings from Fitch, Moody’s, and Standard & Poor’s. 0 The development o f the Mexican bond market has allowed the government to access financing in the local market, converting the majority o f i t s debt from foreign currency (mostly U.S. dollars) to p e s d e n o m i n a t e d debt, thereby reducing the existing currency mismatch. I t has also led to unusually high levels o f reliance on bonds for project finance, as demonstrated in Figure 4.6. Figure 4.6: Bonds as a Percent of Total Project Finance (1996-2004) g 100% a I 0 90% 8 80% ~ Latin Am. (Excluding Mexico) @. 70% -0ECD Countries -***.<****AllDeveloping Countries 60% I 50% Y 40% e .7 n c 30% ,” 20% f 10% 0 m 0% 1996 1997 1998 1999 2000 2001 2002 2003 2004 Note: Represents voluntary reporting b y financiers. Source: Project Finance League Tables; Stephan von Klaudy, authors’ calculations. 98 0 In banking, the Comisidn Nucionul Bu,ncuria y de Vulores (CNBV) has recently enacted new rules for the creation o f reserves at credit banks. The amount o f these reserves depends on the bank’s credit ratings, effectively forcing states and municipalities to demonstrate significant financial soundness, and to create the required financial structures in order to gain access to credit. This recent regulatory change in banking reserves represents an important step toward a more solid and certain credit market for subnational governments. 4.58 Mexico is, today, in better shape to finance long-term infrastructure projects. It can obtain financing in pesos that match the maturity term o f infrastructure development. Consequently, the design o f the mechanisms o f intervention should encourage the use o f local long-term financial markets, including banks and bonds. A long-term goal should be to use foreign funds as complements to local financing. 4.59 Domestic pension funds w i l l grow over the next decade to be ten times the size of Mexico’s yearly infrastructure investment and maintenance needs. In order to leverage these pension funds, certain measure could help t o initiate them into the long- term investment opportunities: 0 Preparing projects to meet their particular investment requirements b y boosting credit ratings with multilateral guarantees. (See Chile T o l l Road Case Study in Annex F). 0 Providing set-asides for minority blocks o f shares prior to final transactions for infrastructure PPPs. This would give the AFORES the chance to value each opportunity and lock in a long-term investment (if they find it feasible or attractive) without having to bid or team w i t h strategic investors. Since they generally prefer to be passive investors, they may not care to marry with other equity investors in advance o f a sale. For the competitive portion o f the transaction held subsequent t o the AFORES sale, having the AFORES in position could provide the market with a strong indicator o f financial feasibility, and reduces the equity contribution required for a bid. Altering the Use and Design of Guarantees 4.60 I t may be difficult for projects to cover internally the cost o f risks associated with proper Government behavior, given the weak institutional and regulatory frameworks in Mexico’s infrastructure sectors. However, uncertainty o f government behavior might be partially mitigated through negative covenants in contracts, conflict resolution mechanisms, and design o f proper guarantees. 4.61 Government intervention in the provision o f infrastructure creates i t s own problems. When the private sector has invested in a large “sunk” project, the specific asset creates asymmetrical opportunity for Government interference (for example, in tariffs), or even expropriation. Mechanisms to mitigate those risks might include: 99 0 Establishing a Guarantee Facility with a line o f credit from a multilateral organization, which focuses on Partial Risk Guarantees for infrastructure projects. Such a facility could be administered b y BANOBRAS. This would allow for the facility’s design and standard products to be tailored to Mexican capital markets, laws, and regulatory peculiarities. Given that guarantees are not valued fully against the borrowing capacity o f the Government, this might be an effective way to bring the strength o f a multilateral agency’s credibility into the infrastructure sector without the full cost o f sector loans. T o improve the perceptions o f the private investment environment, the Mexican Government could consider joining the Multilateral Investment Guarantee Agency (MIGA), a World Bank Group organization. MIGA was formed in 1988 to encourage foreign direct investment in developing countries b y providing political risk insurance against such risks as transfer restriction, expropriation, breach o f contract, and war and c i v i l di~turbance.”~ MIGA could help the Government avoid self-induced risks, and i t does not require a sovereign guarantee. 0 Guarantees for government self-induced risks, wherever they are based, should transfer the risk to the party best able to handle it. The guarantees can be in the form o f contingent government debt securities, linked to negative covenants. Since the Federal Government has already reached investment grade, there i s no apparent need to structure the guarantees through specific cash flows or assets. 0 At the subnational level, project costs can be lowered and financing markets improved when negative covenants are backed up b y specific assets or cash flows. The “Toluca-Atlacomulco” project, described in Annex G, used a contingent credit line only to back up the State’s negative covenants-a relatively efficient way to address the appropriation risk at the sub-sovereign level. Migrating Toward More Balanced Market Structures in Electricity and Water 4.62 The imbalance between private sector participation in production compared to retail operations places a disproportionate burden o n Mexico’s taxpayers. Under current arrangements, CFE and municipal water utilities must offer take-or-pay agreements in order to secure private financing for power generation and water and wastewater treatment plants. If the utilities themselves were financially viable purchases, the guarantees for these agreements would be lower, cheaper, or altogether unnecessary. Given the correlation between income and utility connection, these guarantees are highly regressive. The only long-term solution i s to have financially viable utilities and independent entities involved in the distribution or retail activities and deciding on a competitive basis how to procure their production or generation needs. With proper ‘05 Membership in MIGA i s open to all member countries o f the World Bank. A country must (a) sign the MIGA Convention; (b) deposit its instrument o f ratification; and (c) subscribe to the shares of the Agency’s capital stock allocated to the country, and pay in full to the Agency the subscription amounts. 100 regulation, public sector ownership could remain on a commercial basis, although private ownership has usually been the best solution in other OECD countries This, in turn, requires a clear separation o f roles and responsibilities among policymakers, regulatordtariff approval authorities, and operators. 4.63 If the municipal water utilities and their regulatory arrangements are not currently strong enough to attract investors willing to mobilize capital, partial-risk guarantees from multilateral agencies might serve as a mitigant for political and regulatory risk. For example, for the water utility concession o f Guayaquil, MIGA offered political and contract breach insurance to protect a performance bond issued b y the investor-operator. The value of the guarantee was a small portion o f the investment obligations o f the concessionaire, but was sufficient to bring the project to financial closure. (See Annex H for a description o f the case.) 4.64 In roads, the use o f the private sector in the rehabilitation and operations o f existing assets w i l l help minimize the need for revenue or traffic guarantees, given the importance o f proven traffic levels to financial backers. In these cases, even partial coverage o f cost with tolls helps to reduce the need for full budgetary transfers or guarantees. Redirecting BANOBRAS Activities toward Complementing the Market 4.65 B A N O B R A S i s the most important government institution for promoting infrastructure in sectors such as water and roads. However, the bank’s activities could be reoriented to enhance i t s impact: 0 Complement marketfunctions. BANOBRAS, as a development bank, should play a facilitator role in the market. The bank should represent a complement to the market and compete in the market only in limited cases. 0 Leverage competitive characteristics. In spite o f its structural challenges (for example, high payroll, l o w return on assets), B A N O B R A S has valuable competitive advantages that could be used under a new business model: o Important brand recognition among states and municipalities; o The largest origination capacity in Mexico; o A better capacity than commercial banks to take long-term risks; and o Capacity .to provide technical assistance. 4.66 Consequently, a business model oriented to make B A N O B R A S play a catalyst role w i l l require the bank to considerably expand i t s credit-enhancement activities for market transactions, as i t did (in a pilot mode) in the Puebla-Atlixco toll-road securitization. Guarantee provisions can maximize the social impact of BANOBRAS’s capital. Since guarantee products have a wide flexibility to support individual client requirements, B A N O B R A S should use the strength o f local capital markets and the bank’s competitive advantages. A special guarantee line o f products focused on 101 government negative covenants can be o f great value to the market. This would build on BANOBRAS’s role in securitizing projects, such as with the Puebla-Atlixco T o l l Road (see Annex D), for which BANOBRAS provided a partial guarantee to bondholders. Improving Program and Product Design 4.67 Mexico’s macroeconomic stability has been recognized b y the international rating agencies as a key element in the promotion o f private participation in the provision o f infrastructure. This stability is, without doubt, a fundamental prerequisite for financing o f infrastructure with spreads that contain reasonable premiums for country, regulatory, and project risk. Consequently, program and product design must consider the impact o n public finances. Widespread intervention mechanisms could result in important contingent liabilities that eventually weaken the program’s and government’s fiscal stance. The long-term impact o f PIDIREGAS-and o f the market structure o f the electricity sector as a whole-shows up in this context. Likewise, PPPs could prove to be a new source o f uncertain liabilities for the Government if they are not evaluated from a public expenditure perspective and commitments for transfers are not assigned rationally. Finally, federal matching grants to municipalities need to be evaluated and probably redesigned to improve the incentives o f the sub-sovereign participants. 0 PZDZREGAS: T o approve a PIDIREGAS project i s supposed to generate sufficient revenues to pay for itself, but this requirement i s not always respected. For example, although transmission lines do not generate revenues in integrated utilities, a substantial number o f PIDIREGAS are for this type o f infrastructure. Furthermore, independent power providers (IPPs) have been documented selling power below production costs, creating a claim for public transfers under the power-purchase agreements. Whereas the water sector i s considered a much riskier sector than power in project finance, there are cases in Mexico where even water utilities have raised bonds based on revenue streams (see Annex I). If reliance on self-generated revenues to finance production or wastewater treatment i s possible for municipal or state water companies in Mexico, finding comparable arrangements in power generation should be possible for a national utility. PPS Evaluation and Debt Management: In the case o f PPPs, the future commitments o f the Federal Government could be significant, making it important to assess the intertemporal effects o f this intervention mechanism. T o assure proper long-term management, the Ministry o f Finance should carry out a global assessment. Currently, only the Undersecretariat o f Expenditures o f the Ministry o f Finance participates in the selection process o f PPPs. The Public Credit Unit (in the Public Credit Undersecretariat) should participate fully in the evaluation and assignments o f PPPs, since the Unit already must comment on the long-term implications o f the PPPs’ program from a public-debt-management 102 perspective. Moreover, it should keep a register of all future contingent obligations. '06 0 Matching Grant Programs: Program design should consider the political incentives of subnational governments. In the case o f municipalities, there are some infrastructure sectors (like sewerage and wastewater treatment) that do not represent a high priority for many local governments. In this case, regular matching grant schemes do not work. One possible mechanism i s to tie grants for politically attractive sectors to conditions around clear performance and financial targets in high-social-impact but low-priority infrastructure sectors. According to the Presidential Decree o f April 9, 2004, only the Public Investment Unit and the Budget lo6 Control and Policy Unit of the Expenditure Undersecretariat participate in this process. 103 5. A WAY FORWARD FOR INFRASTRUCTURE FINANCE 5.1 This chapter draws out the broad lines o f action flowing from the analysis o f performance and financing o f infrastructure o f the prior chapters. I t identifies common approaches and mechanisms, indicating the impact o f each, and provides a time frame for their implementation. I t concludes b y illustrating the nature o f the challenges to be addressed in operationalizing those considered o f high priority. I t should be reiterated that being a review principally of expenditure and finance issues, the recommendations do not address all facets o f infrastructure services, nor does i t provide a detailed roadmap for implementation. Rather, this review aims to stimulate dialogue and consensus building on ways to better and more fully use current and potentially available resources for basic infrastructure services. A. SYNTHESIS OF FINDINGS 5.2 The main conclusions o f the preceding chapters can be summarized as follows: 5.3 While important access gaps remain, particularly in smaller cities and rural areas, and especially among indigenous communities, Mexico’s key infrastructure challenges lie in improving the quality, reliability, and efficiency o f service. Chapter 2 examined the quality o f service and extent o f coverage, as well as levels o f spending in transportation, electricity, and water and sanitation infrastructure in Mexico. I t also includes a comparison o f Mexico’s performance characteristics with those o f other middle-income and Organisation for Economic Co-operation and Development (OECD) countries. I t concluded that Mexico has made steady progress in increasing coverage in recent decades-higher than the averages for Latin America, but below those o f OECD countries. 5.4 The quality o f infrastructure services strongly determines the extent to which enterprises can lower costs, expand market opportunities, and, with it, productivity and investment, which drive economic growth. Progress on improving service quality in Mexico has been uneven. Mexico’s road network i s a case in point. Though an important part of the network i s in good or fair condition, s t i l l about 40 percent of roads (especially state and municipal roads) are in poor condition. Expenditures on maintenance are far lower than in other OECD countries, contributing to more rapid deterioration, which has in turn necessitated more costly road rehabilitation. In contrast, structural reforms in railways and ports have permitted increased investment, which have enhanced the quality and efficiency o f service. Service quality b y the main electricity provider, the Comisidn Federal de Electricidad (National Electric Company, CFE), has improved, but still remains below international standards in terms o f transmission and distribution losses and thermal plant availability, with outage rates higher than official figures would indicate. In contrast, the Mexico City electricity operator, Luz y Fuerza del 104 Centro (LFC) presents performance characteristics well below that typically found in a middle-income country, and is functionally bankrupt. 5.5 The prevailing price-setting regimes-with large subsidies for some users and tariffs covering or exceeding full costs for others-lead to distortions o f usage and underinvestment. Retail tariffs for electricity, Water Supply and Sanitation (WSS), and toll roads are set b y a wide array o f agencies based on a m i x o f economic, financial, and political criteria. Most do not cover full costs, and subsidies tend to benefit better-off residential and agricultural users in the case o f water supply and electricity. While industry and commerce are least subsidized, electricity tariffs for these users are higher in Mexico than international benchmarks, as are those for toll roads, despite recent reductions. This i s not the case for WSS, where extensive underpricing places Mexico even below the Latin America and the Caribbean (LAC) averages in terms o f average tariffs-a worrisome phenomenon given that water scarcity i s most acute in Mexico. Subsidies through federal programs dedicated to WSS also disproportionately benefit richer states and municipalities, which could well finance part o f their infrastructure through improved cost recovery. 5.6 Current levels o f public expenditure on the infrastructure sectors considered in this study are broadly appropriate if Mexico i s to remain around the Latin American average in terms of coverage and quality o f infrastructure. No solid estimate o f public infrastructure investment i s available, but this report calculates public spending on investment and maintenance in roads, water and sanitation, and electricity to have been around MxP82 billion in 2003, amounting to about 1.2 percent o f GDP (not including an additional 0.7 percent o f GDP for electricity consumption subsidies). This i s in line with estimates o f what is needed during 2006-15 (MxP83 billion t o MxP102 billion) to adequately maintain networks and achieve the completion o f major policy goals (such as universal coverage in water and sanitation and electricity, and to complete major road transport corridors). This should amount to somewhere between 1 percent and 1.25 percent o f gross domestic product (GDP), depending on growth performance. This does not include the cost o f rehabilitation in water and sanitation infrastructure, much o f which i s in poor condition, but for which n o estimates are available. While these estimates are probably on the l o w side, they could help improve both coverage and quality if well spent. 5.7 Such a level o f spending would not, however, allow Mexico to reach the level o f infrastructure per capita of other OECD countries or faster-growing East Asian countries. Indeed, countries like the Republic o f Korea, which trailed behind Mexico in terms o f infrastructure coverage in the 1960s, invested over 3 percent o f GDP per year on average on infrastructure over the last decades-as have China, Indonesia, Thailand, and other competitors that are now fast catching up w i t h Mexico in terms o f infrastructure quality and coverage. This suggests the urgency o f the need to reallocate untargeted subsidies-such as the 0.7 percent of GDP currently spent o n electricity consumption subsidies-toward productive investment and maintenance, and the need t o improve expenditure efficiency, more generally. 105 5.8 The current l o w levels o f quality o f service could be reverted through substantial reallocation of spending to rehabilitation and maintenance, at the same time developing better incentives and funding mechanisms to promote better upkeep o f existing assets. Allocation o f public funding to water supply and sanitation should focus more on rehabilitation o f water distribution networks for improving continuity o f service, whereas for roads, the priority i s on highway maintenance and upgrading the secondary network. In electricity, as long as CFE remains a public monopoly, the priority for public funding should be upgrading transmission capabilities, and maintenance and renewal o f distribution networks to reduce losses. 5.9 Improving the efficacy and efficiency of fiscal support for infrastructure requires better coordination and planning within and across sectors, and greater accountability. T o a large extent, the requirements for infrastructure planning have become more complex, shifting in focus from traditional public investment programming to strategic planning, decentralization, private sector participation, and credit enhancement. Fragmented decisionmaking regarding funding allocations has contributed to disparate sector outcomes. Better coordination is essential, given the cross-cutting nature o f these issues and their economic and political impacts. The process i s least fragmented in the electricity sector, which i s centrally managed. Central budget setting should prioritize areas that meet with the government’s objectives of competitiveness and poverty reduction, while detailed planning would be done b y respective sectoral agencies in consultation with subnational agencies, as appropriate. 5.10 Greater coordination between the national and subnational government planning process and the annual budget formulation process i s necessary to present more realistic and achievable goals. Across all sectors, national and subnational government agency policy planning and coordination need to be linked, especially for water and sanitation, and for important parts for transportation. One area to focus on i s increasing incentives and assistance for subnational planning critical t o the transport and water and sanitation sectors. There should also be increased horizontal coordination between the several counties within metropolitan regions. Water attempts to do this with the Basin Councils. 5.1 1 Multiyear resource envelopes should be used to strengthen planning and better link i t with budgeting, centrally and within sectors. This includes outlays for multiyear projects and with debt service operations and maintenance. CFE already follows this approach, and the Secretaria de Cornunicaciones y Transportes (Ministry of Communications and Transport, SCT) i s moving in that direction. The use o f multiyear resource envelopes would also avoid the need to fragment larger projects into pieces that can be finished in a year or less, and the accompanying higher total costs. This would be a logical next step from the present practice o f having multiyear budgets only for individual projects, toward the concept o f complete multiyear budgets and fiscal projections. The government could strengthen the authority o f the relevant secretariats for transport and energy to allocate multiyear budget ceilings within their sectors, and enforce compliance with performance targets for the key agencies that report to them, to achieve more coordination among national-level agencies. For the sectors that involve several levels o f government, namely roads and water, experience in the United States 106 and other federations in the OECD shows the value o f using matching grants, with multiyear projections and dependence on meeting performance standards. 5.12 Accountability and achieving performance standards require systems for evaluation. This means building into the design o f federally funded programs reporting systems with respect to efficacy and efficiency o f such programs in achieving measurable outcomes in terms o f quality and sustainability o f service. An ex post evaluation would provide valuable information on what measures work and why-and thus valuable input for the design o f future programs. Such evaluations can also provide a basis for providing incentives for good performance, and would lead to greater transparency. The government should also consider strengthening enforcement measures t o complement subsidy-based incentives. 5.13 In order for Mexico’s service provision to become more efficient and accountable, greater and better use o f the private sector w i l l be required in the years to come. When viewed as a percentage o f investment per capita, Mexico has made little use o f the private sector in infrastructure compared to most o f its Latin America competitors. Given Mexico’s sovereign risk and credit ratings, macroeconomic stability, general success in attracting foreign direct investment, and depth o f local capital markets, this i s a lost opportunity. While these l o w levels o f private participation may change with the new Proyectos para la Prestacidn de Sewicios (Public-Private Projects, PPPs) and concessioning programs, the form of private involvement in infrastructure w i l l have to be carefully monitored so that maximum benefits in efficiency are achieved through more aggressive forms o f competition. 5.14 In Mexico’s case, the most sensitive areas o f utility-consumer interface-water supply and electricity supply-have seen very little private sector participation. Although a significant portion o f CFE’s financing for generation may be mobilized b y private power plant developers, and several water and wastewater treatment plants around Mexico are built and operated b y the private sector, few end consumers o f those services see the private sector as their bill collector and service provider. The degree to which Mexico has used public agencies as service deliverers while limiting private sector involvement in water and electricity t o production is extraordinary for the Latin America and Caribbean region. 5.15 Mexico’s difficulties in bringing the private sector to its citizens in the areas o f water and electricity may be considered a response to political constraints rather than a result o f the economic arguments put forth above. Whatever the motivation, the result i s lower levels o f competition, fewer opportunities for efficiency gains, and lack o f incentives for the implementation o f effective regulation. 5.16 Mexico also uses the private sector primarily to fund the construction o f greenfield projects rather than to address the inefficiencies or capital shortfalls o f existing assets. While this may be changing with the new PPPs toll-road initiatives, and a few water concessions, to date, the vast majority o f projects have been for the construction and operation o f new production facilities. The results o f this stark preference for using the private sector in greenfield and production projects include: 107 0 Decreased opportunities for efficiency gains, because existing service providers are not exposed to competitive pressures, new management, technology, outside sources o f financing, or procurement approaches. 0 Reduced pressure to establish legal and institutional arrangements that separate out political, operational, and economic decisionmaking. Hence, Unnecessarily high cost o f private participation because CFE and municipal water utilities must offer steep take-or-pay agreements in order to secure private financing for power, water, and wastewater treatment plants. If the utilities themselves were financially viable off-takers, the public guarantees for these agreements would be lower, cheaper, or altogether unnecessary, lowering the cost, in general, and the burden on taxpayers, in particular. 0 Regressive transfers because connected consumers benefit most from any public support to utilities. 5.17 To the degree that guarantees w i l l continue to be required to cover risks in infrastructure investment, their design should be oriented toward negative contingencies. Instead o f using full and revenue guarantees, this study advocates for more partial risk guarantees and other measures. On one hand, this w i l l better ensure that the private sector has an incentive t o be efficient and innovative, and, on the other hand, that the Government i s fulfilling i t s responsibilities as partner. In the same vein, Banco NacionaZ de Obras y Servicios Pziblicos (BANOBRAS) and other Mexican development banks should shift the focus o f their guarantee coverage from broad revenue and volume or traffic bases to more breach-of-contract and expropriation coverage. I t i s also advisable that BANOBRAS, as the most important government institution for promoting infrastructure in sectors such as water and roads, consider separating out i t s roles as direct financier, originator, and guarantor. 5.18 Beyond credit enhancement, there are other fiscally positive measures which should be taken to mobilize increased private financing, such as increasing project viability, enhancing the self-financing ability o f projects, strengthening the user-fee market structure, and credible regulation. Greater use could be made o f Mexico’s growing long-term debt markets t o finance infrastructure projects, including banks and bonds. This would reduce currency or exchange rate devaluation risks. The Mexican private pension funds (AFORES) could be an important source o f this local funding. B. INTEGRATION OF RECOMMENDATIONS 5.19 In this section, the findings o f the preceding chapters are translated into recommended actions, and integrated into a strategically oriented agenda for infrastructure in Mexico. I t indicates how the various recommendations impact different infrastructure sectors and themes. Although many o f the recommendations may appear 108 quite subsector specific, they interrelate with one another in a number o f ways to support increased competitiveness and improved social welfare. These are presented in Table 5.1. Table 5.1: Principal Recommendations by Sector and Theme Improving Public Finance: Institutions, Service Efficiency All Credit Information, and Quality Pro Accountability, Coordination Zlectricity Ramp up multiyear Permit electricity ursue options to permit (CENACE). subsistence levels. -educeburden on ,uyers and sellers choice: PSBR. lower markets with Options for reversing nultiple distribution CFE's zompanies (public or decapitalizationand xivate) and independent subsidy financing xansmission company. mechanism (aprovechamiento). Consider options for introduction of private management and capital ir distribution companies. wss Strengthen Incorporategreater Shift credit support Strengthen capacity of state poverty targeting in from up-front intergovernmental water commissions existing urban transfers to partial coordination in policy, in planning, programs. contingent guarantee planning, financial performance mechanisms to participation, and service monitoring, and Establish program to improve risk standards. tariff review. address unique allocation. circumstances of Increase coverage, depth, Institutionalize small citiedlarge Focus guarantee and relevance of the financial and towns. schemes on sistema de informacidn operational financially solid nacional. autonomy of water Make transfers utilities, secured by operators. conditional to actual tariff revenues, not Strengthen municipal performance unconditional federal accountabilities for use of Review technical improvements. transfers. unconditional transfers norms to promote (PRODDER, FAIS). sustainability i n Performance-based service provision. transfers formalized Review options to through national improve efficacy of sistema financiero discharge permits and del agua. levies. 109 Improving Public Finance: Private Finance and Service Efficiency Allocation and Credit and Quality Program Design Enhancement Strengthen coordination imong model agencies to acilitate efficiency gains ?om multimodal *ompetition. Clarify rules for Continue tripartite service access to :o-financing o f urban facilitate exchange bypasses. traffic. Strengthen oversight o f API’s planning to ensure port facilities and operations best meet future demand. Use multiyear, Continue to Establish systematic ex standard-based strengthen planning post evaluation at project contracts to processes; demand and program levels. increase and cost estimates; maintenance allocate resources on Strengthen tripartite efficiency. technical criteria. Coordination at regional Level through regional Reinforce asset road councils. management capacities o f states and municipalities. Permit F A R A C to Devise multiyear 2romote state PPPs Establish systematic ex outsource O&M to STC-SHCP :New Concession post evaluation at project private firms. agreement on Scheme). and program levels. allocation o f Restructure efficiency gains from Strengthen tripartite CAPUFE FARAC network. coordination at regional (regionalization level through regional and outsourcing). road councils. Institutionalize [ncentivize private Strengthen oversight multiyear budgeting pension fund capacity o f subnational based on approved participation in long- government, and financing plans and term finance, making accountability for use o f future budget use o f multilateral unconditional transfers. ceilings. guarantees and permitting AFORES Establish systematic ex Streamline budgetary a stake before post impact evaluation as release procedures competitive bidding. a basis for future funding and synchronize with and program revision. local government Rebalance PPP and budget cycles. credit guarantees Strengthen vertical toward underserved coordination in planning, Continue to subsectors (e.g., financing, and regulation. modernize public distribution). procurement rules Improve coordination (more specificity- Reduce reliance on among sector agencies anc team discussion). full federal SHCP on financing guarantees, shift to policies, investment Increase reliance on partial off-take and priorities, and budget user fees and/or risk guarantees. negotiations with 110 Improving Public Finance: Private Finance and Service Efficiency Allocation and Credit and Quality Program Design Enhancement Coordination statellocal own Congress. revenues. F o r local infrastructure, establish state revolving funds for PPPs, disbursed on performance criteria. Revisit B A N O B R A S business model: separate retail financing role from origination and guarantees. 5.20 There i s an urgent need to refocus public investment on areas that the private sector cannot finance, and to make more effective use o f taxpayer resources. This means reducing the role o f the government in financing the electricity sector and toll roads, which have made substantial fiscal demand (many o f them off-budget or contingent) and for which there i s significant scope for increased private participation. B y the same token, i t implies improving the efficacy o f spending in traditional areas o f public finance such as water supply, sanitation, and (non-toll) roads. 5.21 Three broad sets o f policy instruments can be brought t o bear to impose discipline or incentives on service providers to improve efficiency: competition, regulation, and financial markets. Competition i s notably absent f r o m the electricity sector due to the statutory monopolies granted to CFE and LFC. I t i s precluded from the water and sanitation sector, due to the natural monopoly characteristics o f localized services. In transport, there are substantive competitive forces through intermodal choice, directly competing ports, and the presence o f “free” roads in t o l l corridors. As to regulation, arms-length regulation o f tariffs and service quality is the exception rather than the rule, largely absent in WSS and electricity, at present. Finally, financial markets are indeed a source o f funding in those segments o f infrastructure where private finance has been permitted, though the structure and coverage o f federal financial guarantees have muted the incentive impact on operators’ performance. This i s discussed below. 5.22 Short o f changes in industry organization, there are several interim measures that could be taken to improve efficiency and strengthen accountability for performance. These include programs to enhance the autonomy and service orientation o f state operators. One example i s CFE’ s Corporate Transformation program, which should operationalize the prior pilot exercise o f constituting business units and transparent transfer-pricing mechanisms. Municipal and state water companies in many localities should be more fully constituted as autonomous, commercial enterprises. In transport, efficiency gains could be obtained through better contractual vehicles for highway maintenance, outsourcing Fideicomiso de Apoyo a1 Rescate de Autopistas Concesionadas (FARAC) toll road maintenance, and restructuring Caminos y Puentes Federales (CAPUFE). 111 5.23 The incremental public funding released through greater resource efficiency should focus on three areas: maintenance and rehabilitation, strategic bottleneck infrastructure segments, and extension o f basic services to the poor. Additional resources need to be allocated on an ongoing basis to preventive maintenance and renovation, particularly for highways and electricity distribution, where the rate o f return to such spending is much higher than to new investments. Examples o f strategic segments o f networks include electricity transmission, bulk-water conveyance facilities, road links in the strategic corridors, and railhighway urban bypasses. Such investments need not be large, but have important strategic value, and in some cases could be co-financed with the private sector. 5.24 Devoting a greater share o f federal resources to infrastructure for poor households does not imply an absolute increase in spending. On the contrary, targeting retail subsidies in electricity and water to poor communities and poorer households in better-off urban areas would release substantial resources for other uses. Subsides should focus in the first instance on facilitating access o f the poor to the service and extending coverage in small localities. T o the extent that consumption o f these groups merits subsidization, i t should be limited to satisfying minimum basic needs. Moreover, delivering service to the poor need not be costly, and relaxing technical norms governing choice o f technology and billing methods have proven their worth in other countries. Examples include condominia1 systems for water and sanitation, and off-grid energy solutions for electricity. Finally, relaxing statutory monopoly rights o f the large public sector operators to permit small-scale providers to serve isolated communities in partnership with the network utility (or the municipality), offers substantial benefits to both the utility and to households with little or no service at present. 5.25 Better outcomes can be obtained by introducing changes in the manner in which investment programs are designed and projects selected and funded. Coordination across agencies, resource allocation criteria, and budgetary procedures interact and impact the cost-effectiveness o f federally funded programs, and b y extension the magnitude o f subsidies and demands on Mexican taxpayers necessary to sustain services. Infrastructure, b y nature, has important spillover effects, involves multiple stakeholders, influences economic outcomes in varied ways, and therefore requires a good deal o f coordination. In Mexico, closer coordination i s required along several dimensions: among sectoral agencies and the Secretaria de Hacienda y Crkdito Pziblico (Ministry o f Finance and Public Credit, SHCP) to keep long-term sector development “plans” in line with budgetary and broader fiscal realities, and in dealing w i t h a newly empowered Congress to weed out projects o f questionable viability; among sectoral agencies to ensure balanced sector development (for example, gas-electricity in energy, and multimodal planning in transport); and across tiers o f government (for example, regional transport planning and coordinating planning, service standards, and oversight in WSS). Policy coordination i s crucial in WSS-it i s largely local governments that set tariffs and governance conditions under which water companies operate, while the Federation continues to provide the largest share o f concessional resources for investment. Hence, 112 Mexican taxpayers, largely outside the local jurisdictions, bear the impact o f local pricing and investment decisions. 5.26 Across sectors, federal budgetary resources tend to be allocated annually b y formulas, and for large projects based on ex ante cost-benefit calculations undertaken b y the project proponents. Given the limited reliance on competition, regulation, and financial markets to discipline operator performance, one o f the few levers available to government is conditioning provision o f resources to achievement o f efficiency and/or service delivery targets. This means dimensioning the magnitude and type o f transfer to the pace o f progress in realizing genuine service improvements. Such performance-based allocation mechanisms could be applied, for example, in the yet to be established sistema financier0 del q u a , as stipulated in the recent modifications to the national water law, and in the sharing o f efficiency gains between SCT and SHCP, in the FARAC highway network. 5.27 For performance criteria to genuinely affect resource allocation decisions, future resource availability needs to be predictable, such as through multiyear resource envelopes and budget ceilings. This i s already done to some degree for large individual projects for electricity, and to a lesser degree for transport, but should be applied t o entire programs. And, even in the interim, as procedures and systems are established to support more performance-based budgetary allocation processes, multiyear budgeting should be applied across infrastructure to permit more effective planning and efficient program execution. 5.28 Mobilizing private finance for infrastructure will be essential given the likely restricted fiscal envelope available. While the outlook for rails, ports and, to some degree, toll roads, appears promising, this i s not so for electricity and water supply and sanitation, even in segments that have historically attracted significant private finance, such as thermal power plants and wastewater treatment facilities. Concerns about operators’ present and future creditworthiness, the Federation’s future willingness to step in t o cover subnational or state-owned enterprises’ obligations, and the lack of arms-length regulation strongly limit investor interest. Rather than having taxpayers assume s t i l l greater risks to attract private finance, (as has been the case in power generation with the substitution o f Obra Publica Financiada [OPF] for independent power provider [IPP] contracts), efforts should be directed at the source of the uncertainty: the capacity o f the off-taker t o pay for the service without political interference. The new concession framework for state highways goes some way in this direction. Similar innovation i s called for in the electricity and WSS sectors. 5.29 Federal credit enhancement w i l l be required to attract sizable sums o f private funding from domestic and international sources, but their design and functioning are due for revision. T o date, projects under federal jurisdiction have generally been backed b y full guarantees o f cash flow (for example, electricity-PIDEREGAS, transport-New Concession Scheme) assets (for example, PPS), or even equity returns (FINFRA). This places the government in a position o f assuming a wider spectrum o f risks than may be called for, and hence carries commensurately larger contingent liabilities. Having 113 obtained an investment-grade rating on sovereign debt, the risk coverages the Federation offers could be narrowed and recast in the form o f negative covenants, that is, political (and regulatory) risk insurance and other forms o f contingent risk coverage. In the case of subnational projects, reliance on negative covenants may also reduce financing costs, but w i l l require some kind o f asset or cash-flow-based security, which could take the f o r m o f state-level infrastructure revolving funds for WSS, transport, and other local services. Such risk insurance and backstopping facilities should also be geared in part to rebalancing the allocation o f investment finance from greenfieldoff-take facilities to distribution networks. 5.30 Arms-length regulation of tariffs and service quality i s largely absent at present, and especially in electricity and water and sanitation it could improve the incentives for public sector providers and start creating the environment that would make good use o f private investment as legal opportunities for that are opened. Improving sector performance w i l l require greater clarity and coherency on policy goals and instruments, institutional responsibilities for establishing and regulating service providers, and pricing policies commensurate with those goals. The goals should make explicit the major policy decision, such as the desired levels o f access and service quality, the required levels o f investments and potential sources o f financing, and how noncompliance with regulations would be sanctioned. Although municipalities have primary jurisdiction for Water Supply and Sanitation (WSS) services, they have little technical capacity for policymaking and regulation, so state agencies might need to take this role. This would offer the advantages o f consistency in policy and investment planning across hydrologically and politically interdependent geographic areas, and administrative and financial capacity and the ability to coordinate federal (and state) assistance. The Comisiones Estatales de Agua are well placed to carry out planning and policymaking functions, and key regulatory, monitoring, and oversight functions. 5.3 1 Other modifications o f institutional arrangements should be considered. For investors and operators to take on some risks now borne b y the government and Mexican taxpayers, they require greater predictability about future cash flows, which depend on how tariff and service standards are set and adjusted. For electricity, this implies empowering the Energy Regulatory Commission t o function as a sector regulator, with oversight o f retail tariffs, service quality, and contracts between CFE and service providers, including private generators and gas suppliers. For water and sanitation, this implies building the capacity o f state water commissions and municipal agencies in performance monitoring, planning, and the revision o f retail tariffs. For railways, the SCT should clarify the rules for service access among carriers. For highways, the SCT should expand the current pilot program for multiyear, standards-based contracts for maintenance. 5.32 Moving forward on the above recommendations will require greater accountability and better information on performance outcomes. At present, the federal authorities, particularly SHCP, face a conundrum. The present system o f authorizing individual projects and budget envelopes annually, o n the basis o f notional, largely historical unit costs, and conjectural, ex ante cost-benefit studies says little about 114 how effective and efficient sectoral spending is. At the same time, sectoral agencies and subnational governments are demanding greater autonomy in investment planning, execution, and financing. The flip side o f autonomy i s accountability. In the absence o f reliable, verifiable information on actual performance, it is risky to respond positively to such demands. At present, SHCP does not have at its disposal timely, objective information on whether the application of the funds provided to the executing units translated into improved services, or at what cost. And, without such information, it i s difficult to determine what could have been done better. In order to reduce the information gap, the Investments Unit o f SHCP is currently developing a methodology for program impact evaluation. 5.33 Other elements o f performance tracking and information disclosure that would enhance accountability and decisionmaking for federal resource allocation include: regular reporting by subnational governments on the use o f federal transfers, especially unconditional transfers such as Ram0 33/FAIS, which are a growing source o f finance for WSS, urban and state roads, and electrification; and standardized reporting on performance o f WSS companies (organismos operudores) through an expansion of CNA’s sistemu de informacidn nucional. In the electricity sector, efforts have begun to establish an objective basis for measuring and reporting on service quality, and this should be followed through b y strengthening CENACE’s capabilities in this area, as well as CRE’s. Progress in these areas would help f o r m the basis for performance-tracking systems, which would facilitate several o f the major recommendations discussed above. These include introducing multiyear performance-based allocation mechanisms for federal funds, and credit-enhancement instruments, better-informed economic regulation and oversight, and, more generally, greater coherency in policy formulation, planning, and execution o f sectorwide investment programs. These measures do not require large sums o f money, but they do require building institutional capacities among the concerned sectoral agencies and subnational governments, and sustained political commitment to transparency . c. mIORITIZATION OF RECOMMENDATIONS 5.34 T o provide some prioritization among the recommended actions, a difficulty versus impact analysis was undertaken. The recommendations are mapped into a two- dimensional space according to whether they are likely to have high or l o w impact, and whether they entail high or l o w levels o f difficulty in their implementation. Recommendations are considered to be o f higher impact if they are likely to produce substantial results either in terms o f saving taxpayer resources, leveraging private finance, or addressing a critical infrastructure bottleneck or social priority. Recommendations are considered to be more difficult to implement to the extent that they present either challenges that are conceptual (in their designhnstrumentation), financial (in terms o f necessitating large increases in public spending), legal (where new legislation may be required), or political (strong vested interests). 115 5.35 The recommendations discussed above are assigned to four situations. Group I corresponds t o high-impactllow-difficulty measures that appear in the top-right quadrant o f Figure 5.1; these are high-priority measures in the short-run. Group I1corresponds to the high-impacthigh-difficulty measures that appear in the top-left quadrant o f the two- dimensional mapping: these are high-priority measures, and hence should be acted on in the short term. However, given their difficulty, i t i s not realistic to expect results until the longer term. Group I11corresponds to low-impactllow-difficulty measures that appear in the lower-right quadrant o f the figure. Although l o w priority, they could be undertaken rapidly if so desired. Last, group I V corresponds to the low-impacthigh-difficulty measures, which are (or should be) o f limited interest as a practical matter. 5.36 The results o f mapping Figure 5.1: Framework for Prioritization of Recommendations recommendations b y impact and difficulty are presented in Table 5.2. The bulk o f the recommendations fall into the high-priority upper-right and upper-left quadrants o f Figure 5.1, with very few in the low-impact/long-term b U IL I d lower-left quadrant. Those in the right a quadrants represent some o f the “quick z e HIGHPRIORITY, LONG TE&l HIGHPRIORITY, SHORT TERM wins” either because the necessary s e course o f action i s already well defined, because they can be implemented on the basis of existing legal or c administrative instruments, or because U N. m a d the associated financial costs are z LOWPRIORITY, LOW PRIORW, modest. Most of these actions could be 3 0 LONGW SHORTTERM A addressed forthwith, with efforts focusing on those in the upper-right quadrant. HIGHDIFFICULTY LOWDIFFICULTY 116 Table 5.2: Mexico: IPER-Prioritization of Recommendations More Difficult Less Difficult High Priority MULTIPLE SECTORS: yIULTIPLE SECTORS: [nstitutionalize multiyear budgeting. streamline budgetary release procedures. Establish systematic ex post impact strengthen subnational government evaluation. iccountability for use of federal transfers. Strengthen vertical coordination in planning, mprove horizontal coordination among sector financing, and regulation. igencies and SHCP. Shift BANOBRAS’s guarantee coverage to 5stablish state revolving funds for PPPs, breach of contract. iisbursed on performance criteria. Shift from full debt service guarantees to 5ncourage private pension fund participation in partial off-take and risk guarantees. ong-term finance. Rebalance PPP and credit guarantees to Separate BANOBRAS retail financing role from underserved subsectors. rigination and guarantees. Options to access private pension funds for long-term finance. ZLECTRICITY: 3educe transmission and distribution losses ELECTRICITY: hrough modernizationand maintenance. Address LFC functional bankruptcy. Empower CRE to function as sector regulator: Develop power markets options with multiple iversight of tariffs, service quality, and distribution companies (public or private) and :ontract% independent transmission company. Target consumption subsidies to poor Introduce private finance in distribution. households. Reduce reliance on OPF in favor of long-term wss: service contracts. Institutionalize financial and operational autonomy of water operators. TRANSPORT Incorporate greater poverty targeting in Permit FARAC to outsource O&M to private existing urban programs. firms. Establish programs for small citiedlarge Use multiyear, standard-basedcontracts to towns. increase maintenance efficiency. Make sector transfers conditional to actual Promote federal and state PPPs (New performance improvements and formalize i n Concession Scheme). sistema financier0 del agua. Shift credit support from up-front transfers to wss: partial contingent guarantee mechanisms to Build capacity in state water commissions. improve risk allocation. Expand sistema de informacidn nacional. Focus guarantee schemes on financially solid TRANSPORT: utilities, secured by tariff revenues. Implement institutional reform of toll road management. Complete modernizationof key highway corridors. 117 Lesser Priority Continue modernizing public procurement rules. Increase reliance on user fees and/or state/local own revenues. Increase flexibility of long-term PPAs to reduce risks to CFEFederation. Contain scope of PIDEREGAS and review structure to reduce burden on PSBR. OperationalizeCFE Corporate Transformation Program. Review technical norms to promote sustainability in service provision. Strengthen intergovernmentalcoordination in policy, planning, financial participation, and service standards. Restructure CAPUFE. Clarify rules of service exchange in railways. 5.37 Regarding electricity, while sector “reform” i s commonly characterized as a “Constitutional” issue and therefore politically complex, there are several types o f actions that can be taken in the short and medium term to improve performance without legislative action. For WSS and transport, there do not appear to be overriding legal or political obstacles. Rather, they require changes in the way institutions interact with each other and with private sector contractors and financiers. Examples include sorting out FARAC/CAPUFE responsibilities and financing terms for highway maintenance; oversight o f tariffs and service quality among CFE, SHCP, and CRE; and service oversight, investment planning, and financing among C N A and subnational governments. Others present financial hurdles, including rebalancing toll-road tariffs, increased funding o f maintenance and renewal o f electricity distribution networks, and highway maintenance. 5.38 Nonetheless, to obtain broad, sustained gains in overall sector performance, a significant proportion o f the recommendations in the upper-left quadrant (Group 1 1) should be addressed. These are characterized as longer-term, high-impact measures. Implementation o f these recommendations requires first addressing certain challenges. Table 5.3 identifies the nature o f the challenges to be addressed f o r each. Given their complexity, preparatory work for many o f these actions should be initiated in the near term. For those actions identified as conceptually complex (for example, refocusing federal guarantees, poverty targeting, program impact evaluation), work should be initiated to explore specific options in depth, and to develop more detailed recommendations. Relatively few o f the actions in this group appear to require legal changes, and those that do are concentrated in the electricity sector. The current administration has prepared draft legislation and enabling regulations (reglamentos) for this purpose, and they should be reviewed to ascertain the scope for further improvement. Similarly, relatively few face significant financial hurdles. Those that do, require further refinement to devise practical solutions (for example, BANOBRAS-guaranteed coverages and modification o f PIDEREGAS and FINFRA risk-coverage mechanisms). Finally, where the challenges involved are largely political, i t will be necessary to 118 continue to consult with stakeholders and build consensus around the need for and direction o f change. Table 5.3: MX: IPER-Challenges in ImplementingLonger-Term Recommendations finance. ELECRICITY I Address LFC functional bankruptcy. X X X Introduce private management and capital in I X X distribution. Develop power markets options with multiple X X distribution companies (public or private) and independent transmission company. wss Institutionalize financial and operational autonomy of X Incorporate greater poverty targeting in urban X programs. Strengthen municipal accountabilitiesfor use of ? ? unconditional transfers. Establish programs to address unique circumstances of small citiedlarge towns. Make transfers conditional to actual performance ? X improvements. Performance-based transfers formalized through ? national sistemafinanciero de agua. Shift credit support from up-front transfers to partial X contingent guarantee mechanisms to improve risk allocation. TRANSPORT Implement institutional reform of toll road Complete modernizationof strategic highway X 119 ANNEXES 6. ANNEX A. NATIONAL FEDERAL ORGANIZATIONS AND PROGRAMS IN WATER SUPPLY AND SANITATION 6.1 The Consejo Consultivo de Agua (CCA) i s a high-level advisory body to the Comisidn Nacional del Agua (National Water Commission, CNA) created in 2000 to promote a cultura del qua-“a culture o f water”-in Mexican society. I t has formed five committees covering the following strategic issues: economy and finance, education and communication, legal framework, technologies, and environmental management. I t recently initiated a comparative analysis o f water-related policies and their impact on water productivity and on sectors and socioeconomic groups in the society as part o f W o r l d Bank studies on the economic assessment o f policy instruments in the water sector. This analysis focuses on water resources management and irrigation. In addition, in 2002 the CCA initiated a 10-year media campaign on the culture o f water. These are everyday water conservation ideas for the layperson to minimize water use, such as using one glass o f water to brush one’s teeth. 6.2 Created in 1986, the Mexican Water Technology Institute (Znstituto Mexicano de Tecnologia del Agua, IMTA), under the authority of the Ministry o f Environment (SEMARNAT), i s in charge o f research, development, and transfer o f water technologies. 6.3 The Mexican Center for Water and Sanitation Training (Centro Mexicano de Capacitacidn en Agua y Saneamiento, CEMCAS), established in 2000 with French assistance, i s a national training center for the staff o f water and sanitation service providers. The Center i s governed b y a board presided over b y CNA. 6.4 Most larger service providers are members o f the Asociacidn Nacional de Empresas de Agua y Saneamiento de M h i c o (ANEAS). Founded in 1992, A N E A S represents the interests o f service providers in the national political arena, promotes the exchange o f experiences among service providers, strives to strengthen the autonomy of service providers, and promotes the culture o f water. 6.5 Water resources management and land-use planning, which are closely linked to investment planning, should ideally be undertaken at the level o f the hydrographic region (basin), because o f the numerous environmental externalities within a basin. In Mexico, this has been recognized in principle through the establishment o f 25 Basin Councils (Consejos de Cuenca), since 1993, each covering one or several basins. In practice, however, the Basin Councils have had little influence on investment planning and relevant policies. Therefore, the 2004 amendment o f the National Water L a w mandated the creation o f Basin Agencies that would strengthen the planning function at the basin level. The implementing decrees for the amended law remain to be implemented and enacted, however, and only three basin agencies have been created so far. The Basin Agencies and Councils are supposed to play a key role in the administration o f the Water 120 Financial System (Sistema Financier0 del Agua, SFA), introduced through a recent amendment t o the Water Law.lo7 6.6 There are 25 Basin Councils covering almost the entire national territory. The Basin Councils’ functions are, in principle, to formulate and execute activities to improve water resources management, and to develop water infrastructure in their respective basins.”’ Most Basin Councils were recently created, the first one having been created in 1993 in the Lerma Basin, and most others after 1999. M o r e than half the members o f the Basin Councils represent various levels o f government, while up to half represent users and “society.” The Basin Councils (Organismos de Cuenca) are expected t o guide, together with CNA, the work o f the basin agencies. 6.7 The directors o f the Basin Agencies are supposedly autonomous, but w i l l be appointed by CNA. I t i s not clear if or to what extent the Basin Agencies w i l l integrate the functions and the personnel o f CAN’s regional and state offices. The number o f Basin Agencies i s also not clear. Thus there i s considerable uncertainty about the scope, form, and timing o f the restructuring process and decentralization o f CNA. 6.8 Drinking Water for Urban Areas (Agua Potable en Zonas Urbanas, APAZU) i s directed at urban areas, and used to be CNA’s largest program. Created in 1990, it i s the oldest o f the current C N A programs and was initiated b y the World Bank. I t has continued to be funded b y the Federal Government after the closure o f the last corresponding World Bank loan. 6.9 The Water Rights Return Program (Programa de Devolucidn de Derechos, PRODDER) was created in January 2002. I t i s funded b y water rights payments b y municipalities on the basis o f the Ley Federal de Derechos. 6.10 The Program for the Northern Border (Programa de Atencidn a la Frontera Norte) i s targeted at the six Mexican states bordering the United States. The U.S. government makes grants t o this program through i t s Environmental Protection Agency (EPA). 6.11 The smallest C N A program, Clean Water (Agua Limpia), i s directed at increasing the level o f chlorination o f drinking water. 6.12 The Program for Sustainable Drinking Water and Sanitation Services in Rural Communities (Programa para la Sostenibilidad de 10s Sewicios de Agua Potable y de Saneamiento en Communidades Rurales, PROSSAPYS) is exclusively devoted to rural areas and i s partially financed b y the Inter-American Development Bank. The exact role of the basin-level institutions in the SFA remains to be defined through the operating rules o f the new system. ‘Os The territory, covered by several Basin Agencies (such as the Lerma Basin), covers up to five states, while on the other hand, some states (such as Sonora) include territory covered b y up to five Basin Agencies. 121 6.13 B A N O B R A S (Banco Nacional de Obras y Sewicios Pu'blicos) lends to municipalities and utilities and administers the federal grant program, Program for the Moderniziation of Water Utilities (Programa para la Modernizacidn de Organismos Operadores de Agua, PROMAGUA), jointly with CNA. BANOBRAS credits to service providers and municipalities are channeled through three multisectoral credit lines with different objectives and conditions. The BANOBRAS contribution to PROMAGUA comes from the Fondo de Inversidn en Znfraestructura (Infrastructure Investment Fund, FINFRA), which i s described further above. 6.14 The Secretaria de Desarrollo Social (SEDESOL) administers 11 different programs that are focused on the poor, and include some investments in water supply and sanitation."' The best-known o f these programs are Opportunities (Oportunidades, formerly PROGRESA) and HABITAT (the United Nations' program), large programs that have small activities in water supply and sanitation. Each o f the 11 programs has i t s own criteria and conditions. Most of these programs focus on poor households in marginal urban and rural areas. lo9 Avila (2004:34-70. The programs are Oportunidades, Microregiones, HABITAT, Oportunidades Productivas, Coinversidn Social, Atencidn a Jornaleres Agricolas, Programa de Capacitacidn y de Fortalecimiento Institucional, Iniciativa Ciudadana 3x1, Programa para el desarrollo de 10s Pueblos Indigenas, Programa Estatales por Demanda, and the Programas Regionales para Zonas de Alta Marginacidn. No breakdown o f the water and sanitation investments among these programs i s available. 122 7. ANNEX B. PAYMENT FOR ENVIRONMENTAL SERVICES IN WASTEWATER TREATMENT-AN EXAMPLE OF PERFORMANCE-BASED TRANSFERS'" 7.1 Financing and cost recovery for urban sanitation, consisting o f sewerage and wastewater treatment, i s a challenge throughout the world. Many utilities do not levy separate tariffs for sanitation, and where such charges exist they are usually insufficient to finance operation and maintenance costs, not to mention capital costs. This problem i s particularly acute in countries that embark on ambitious investment programs to increase the coverage o f wastewater treatment. There i s thus considerable agreement that subsidies are needed for sanitation, at least during a transition period. The challenge i s to devise programs to channel these subsidies, while promoting efficiency and operational and environmental sustainability. 7.2 In 2001 Brazil introduced a program that meets these criteria. Under the basin restoration program (PRODES), the Federal Government essentially pays service providers for treating wastewater based o n certified outputs, instead o f financing inputs such as c i v i l works. Up to half the investment costs for wastewater treatment plants are eligible to be reimbursed over three to seven years, provided that the quality o f the wastewater discharged meets the norms. If the norms are not met in one trimester, a warning i s issued. If they are not met in the following trimester, the payment i s suspended. I f the norms are s t i l l not met in the next trimester, the service provider i s excluded f r o m the program. This provides strong incentives to properly operate and maintain plants. In short, the program does not fund promises, but results. 7.3 The program enhances the financial viability o f utilities, and thus increases their ability to access commercial credit, through development banks (such as the Cuixa Economics Federal) and commercial banks. The operational risk i s clearly assigned to the service provider, which i s best able t o manage that risk. T o prevent overinvestment, the treatment plants have to be included in basin plans adopted b y water basin agencies as a necessary condition to be eligible for financing under the program. 'loSources: AgCncia Nacional de Aguas, www.ana.,nov.br, and World Bank. 123 8. ANNEX C. INTERNATIONAL EXPERIENCE IN THE USE OF THE PRIVATE SECTOR 8.1 This annex summarizes some elements in the design o f private participation in the financing and building o f infrastructure in developing countries-particularly middle- income countries. The objective i s to highlight some lessons that may be useful in evaluating and improving programs in Mexico. The common theme among the three sectoral analyses i s the relationship between success and the introduction o f the private sector in existing assets and retail operations. Toll Roads 8.2 Although the public protests in Cochabamba and the struggling water concession o f Buenos Aires might capture the headlines, toll roads represent a particular challenge in the areas o f project finance and public-private partnerships. In many cases, private finance i s sought for greenfield roads, which means that there is no proven traffic demand to back project finance. Motorists are notoriously fickle about valuing their time and paying fees even for existing non-toll roads, so willingness and ability to pay for studies o f this area o f infrastructure have often proven unreliable. To exacerbate the problem o f demand uncertainty and price inelasticity, the public good nature o f road networks has resulted in widespread laws that prohibit private toll roads from operating where alternative roads are not available. 8.3 As a result, toll roads stand out from the World Bank’s database o f Private Participation in Infrastructure (PPI) as the subsector with the highest percentage o f canceled projects. The PPI database counts 2,7 16 private infrastructure projects that came to financial closure between 1990 and 2003 in the developing world. O f those projects, only 91-about 3 percent-were canceled outright due to project failure or political disillusionment. I n contrast, o f the 359 toll roads that were signed into agreement during that same period, 3 1 have been canceled, representing nearly 9 percent o f all projects. I f any country knows the difficulties o f managing a successful toll road program, i t i s Mexico. Over half o f the world’s individually canceled toll roads were in Mexico, and the recent initiatives to introduce a more nuanced risk-sharing mechanism into the bidding system for the second round o f toll roads reflects that learning curve. 8.4 Despite the challenges, there have been hundreds o f successful toll roads in the developing world, particularly in Latin America (155 out o f 359 toll roads) and East Asia (157 out o f 359). W h a t distinguishes successful toll-road projects from Mexico’s early experience i s the dominance of the use of existing roads and the blending of public and private funds right from the outset of the projects. In Asia, only 28 percent of toll roads have been greenfield construction. The rest have been concessions or outright divestitures. 124 8.5 Table 8.1 shows how different countries in East Asia have leveraged private risk capital with public contributions. This does not include minimum traffic or revenue guarantees, which were used to further limit private risk. Table 8.1: A Sample of Public and Private Contributions to Toll Roads in East Asia private Finance Private Finance at Risk* 18% 73% 76% 48% Public Funds or Contributions in Kind 25 % 27 % 16% 23% *All figures in US$ Billions Note: Does not include contingent liabilities from minimum traffic or revenue guarantees. Source: Adapted from ADB (2000). 8.6 As with East Asia, in Chile-where US$6 billion was generated for 22 private toll-road projects between 1994 and 2003-16 o f the projects (nearly three-fourths o f all toll roads) were concessions o f existing roads. Chile has further used a bidding method-least Net Present Value (NPV)-that fixes all politically sensitive variables and allows for the concessionaire to “hold onto” the rights to collect tolls for as long as i t takes to achieve the winning NPV. Electricity 8.7 Many developing countries have attempted t o liberalize their energy markets and to replace rigid state controls with private initiative and ownership. As mentioned, this has often involved the use o f the private sector for the assumption o f commercial and retail risk (investment in distribution) and construction risk in generation. O f the 340 electricity projects undertaken in upper-middle-income countries between 1990 and 2003, 115 involved distribution and/or transmission. These projects with retail or commercial risk were valued at slightly over half o f the U S 1 0 3 billion mobilized for the sector’s private projects. Aside f r o m the financing that was brought in, the literature indicates that the greatest benefits have accrued from increased coverage levels, lower costs, and higher quality driven b y competition and more independent regulation. Despite the recent shock and tension between the Argentine Government and the country’s 62 federal concessionaires, the formation o f Argentina’s power market represents a successful attempt to introduce market forces into a lethargic and underfunded power sector. 125 8.8 T o underpin the energy reform program, Argentina’s government made a concerted effort to attract foreign private investment to the sector, emphasizing competition among providers. In 1992 the Argentina Bilateral Investment Treaty was signed with the United States, granting U.S. companies the privilege to invest in Argentine enterprises under terms no less favorable than those applied to domestic companies. B y 1993, new regulations had removed all remaining restrictions on foreign investment, allowing investors to own as much as 100 percent o f privatized entities. In addition, full repatriation o f profits was allowed. 8.9 During the reform period o f the mid-l990s, roughly 10,000 megawatts (MW) o f Argentina’s total installed capacity o f 18,300 M W was sold, and Argentina’s four large federal electricity companies were unbundled and a 51-percent share of each o f the three resulting federal distribution companies was sold to private investors.’ ’’ Now, over 90 percent o f Argentina’s transmitted power i s carried b y private entities. 8.10 Argentina conducted the restructuring process in a way that would facilitate competition in the electricity sector. Assets were unbundled through a process that separated the functions o f vertically integrated federal electricity utilities prior to their sale. Transmission was separated from distribution, and the wires were separated f r o m the retail function. In addition, cross-ownership restrictions were implemented. Generators were legally restricted to a market share o f 10 percent or less o f the national electricity sales volume. Generating companies were not allowed to own a majority share in any transmission facility. 8.11 The wholesale market was created to establish a competitive market for generation, with merit order dispatch, such that the lowest-cost generator i s dispatched first. One entity, Compaiiia Administradora del Mercado Mayorista Ele‘ctrico, S.A. (CAMMESA), i s responsible for dispatch and for settlements. C A M M E S A i s a nonprofit, independent organization. Though i t i s owned b y the government and the power generation companies, i t i s governed b y a board composed of two representatives each f r o m the generating companies, the national government/Secretariat o f Energy, the distribution companies, the transmission companies, and large users. Competition i s encouraged b y open access to the wholesale market that i s guaranteed b y law. 8.12 Argentina’s federalist form o f government, in which much autonomy i s granted to the provinces, has provided a complicated context for restructuring and privatization. While the privatization o f federal electric utilities has been largely successful, privatization at the provincial level has not always proceeded as well. Delays in provincial sales have been due t o concerns over unemployment and conflicts at the provincial level. In addition, there have been conflicts between the agendas o f the national and state governments that have delayed transactions in several cases (ADB 2000). 11‘ According to the Secretaria de Energia, Mexico’s effective electricity capacity for 2003 was 49,672 MW. Of this total, 23.9 percent (11,872 MW) was from independent producers. 126 8.13 Despite the federalist challenges, the estimated average price o f electricity o f EDENOR, EDELAP, and EDESUR, (private distribution concessionaires for the Buenos Aires metropolitan area), fell 10.8 percent during the period under analysis, with average household rates dropping about 8, percent, and high-consumption consumer rates 70 percent . 8.14 The lessons from Argentina’s experience are clear: Competition i s a powerful tool for achieving market rates and better performance o f service providers. The Argentine experience also shows that privatization at the subnational level might be more challenging than previously thought. Water Supply, Sewerage, and Sanitation 8.15 The private sector plays an important role in the water sector o f many developed economies, as shown in Table 8.2. In developing economies, however, the levels o f private investment participation in water supply, sewerage, and sanitation are far below those observed in other infrastructure sectors. Water supply, sewerage, and sanitation accounted for just 5 percent o f global private investment in infrastructure in developing economies between 1990 and 2001. Moreover, i t has been declining: private flows for water supply and sanitation did not reach US$1 billion in 2003, down from US$8.4 billion in 1997. Build-operate-transfer (BOT) water and wastewater projects represent less than one-third o f all water projects b y value and b y number. Again, in most countries, the private sector has been invited to take on commercial risk and to interface with consumers as the service provider. Table 8.2: Private Participation in Water Services in 2002 United States Source: CNA “Masons Water Yearbook 2002-2003.” 8.16 The state o f the water sector in the developing world remains challenging for investors. For example, in many countries there is a lack o f knowledge about the location and condition of the underground networks, which represent on average 70 percent o f the value o f the utilities’ assets. Moreover, water i s often considered a free or deeply discounted public good, despite the costs o f treatment and retail supply. Thus, there i s often an ill-informed community constraint against private sector involvement in water supply. While this has led to several high-profile concession renegotiations and even cancellations, the evidence suggests that municipalities in the region have generally benefited from the role o f the private sector in retail water systems. 127 8.17 Mknard and Shirley (2002) compare the content and outcomes of six water system reforms initiated during 1988-93: the concession system in Buenos Aires, Argentina; service contracts in Mexico City; state ownership and operation in Lima, Peru (where a concession was planned but not implemented); and Santiago, Chile; and leases in Abidjan and Conakry, Africa. Initial conditions in the six cities are summarized in Table 8.3. Connection rates were lowest for the two African cities, which were also the poorest and fastest growing. Water stress (unsustainable resources) was most severe in Lima and Mexico City. Table 8.3: Different Indicators of Water Reforms Buenos Mexico Indicator Santiago Abidjan Con Aires City Year reform started 1993 1993 1992 1989 1988 1989 Type of Reform Planned Concession Management Contract Concession Sale Leasea Lease Implemented Concession Contract State Owned State Owned Lease Lease Population in service area at start of reform 8.7 8.4 6.4 4.6 2.0 1.o (millions) National GDP per capita at start of the 8,861 7,647 3,462 7,101 1,582 1,398 reform (US. Dollars) Population connected at start of the reform (percent) b Water 70 97c 75 99 60 38 Sewerage 58 86 70 88 35 10 Annual population growth, 198695 1.5 3.1 2.4 1.8 5.1 5.6 (percent) Annual Water production at start of 1402 1113 527 47 8 67 163 reform (million cubic meters) a. Before reform, the lease in Abidjan had characteristics similar to a management contract. b. Includes private taps in yards of dwellings. These were predominant in Abidjan and Conakry, important in Mexico (20 percent of connections) and probably Lima, and minimal in Santiago and Buenos Aires. c. 1990. d. Includes people with access to standpipes or neighbors’ taps. e. 1980-91. Source: MCnard and Shirley (2002). 8.18 Competition emerged only through competitive bidding in Buenos Aires, Abidjan, and Conakry. With a concession contract, regulation in Buenos Aires attempted to impose a fuller range of financial risks on the operator (investor) than did the other systems. Every city, excluding Santiago, provided cross-subsidies from high-volume to 128 low-volume customers. In the analyzed cases, none o f the regulatory regimes had a very strong or formal institutional structure (commitment devices, regulatory neutrality, enforcement mechanisms, consumer representation). Nevertheless, Santiago had the best system, which, perhaps ironically, was state-owned and operated. 8.19 Changes in economic welfare after the reforms-combining the effects to government, consumers, workers, and domestic investors-were estimated and compared to a counterfactual (no reform) scenario. For the cases with available data, MCnard and Shirley (2002) found that per capita welfare gains are estimated to be largest in Buenos Aires (US$150 in 1996 prices), followed b y Santiago (US$64) and Conakry (US$12). 8.20 The short-term results o f reforms were estimated comparing before and after indicators o f efficiency and other performance measures. After reforms, labor productivity (measured in employees per connection) increased and operating costs dropped in every city (with operating costs falling below revenues everywhere except Mexico City). In addition, water and sewerage coverage expanded everywhere except Lima. N e w connections grew at a faster pace in every city except Lima, where the growth rate remained the same. The unaccounted-for water-a measure combining physical losses (due to poor maintenance) and commercial losses (due to poor financial management or illegal use)-fell significantly in Buenos Aires, Lima, and Santiago, but the improvement was less evident in the other three cities (Kessides 2004). 8.21 The experiences in Chile and Argentina are particularly interesting for the rest of Latin America, and particularly for Mexico. In 1988, Chile put in place a new regulatory regime for water and sanitation, allowing rates t o reflect the actual cost o f providing services. The Chilean Government then reorganized the sector under 13 state- owned regional water companies and started to partially privatize some o f them. Privatization was followed b y renewed investment b y the privatized companies, but also b y more apparent limitations o f their public counterparts. While private companies invested 70 percent more in 2001 than in 1998, public companies invested almost 70 percent less. The decline for public companies reflected the growing difficulties the public sector had in financing their operation. 8.22 Sharp differences between the two groups o f companies also emerged in price behavior. During 1998-2001, private companies’ rates rose 20 percent more on average than did public companies’ rates. Most o f the difference in price behavior stems from the fact that privatized companies invested more, in part to add new services (mostly in sewerage and sanitation). Nevertheless, fees charged b y private companies are still 40 percent lower on average than those charged b y their public counterparts. The explanation for this difference might lie in the fact that the public sector kept the highest- cost companies, especially those in northern Chile, which has one o f the world’s driest climates (Bitran and Valenzuela 2003). 8.23 In Argentina in the early 1990s, a series o f important provincial water utilities were privatized. As protection against devaluation risk, most contracts included clauses adjusting tariffs automatically to the U.S. dollar. This type o f clause combined with 129 international arbitration clauses and the active role o f the World Bank, the Inter- American Development Bank, and the European Investment Bank in syndicating these loans (mostly under N B loan structures), made the financing o f these concessions possible despite the fragile macroeconomic situation o f the country, and an unstable legal and fragile regulatory framework. The shortcomings o f these structures, and the little protection that the contractual clauses afforded to the lenders, became apparent with the economic collapse o f the country, which led to the failure o f the majority o f the concessions. 8.24 Some conclusions can be drawn from this brief review. First, private participation in the water sectors o f developing countries i s a reality, although it has been declining as large international operators continue to retrench. Second, privatization often improves performance, although i t i s not the only way to foster efficiency, as the case of Santiago (which remained in public ownership during the period studied b y MCnard and Shirley [2002]) demonstrates. Third, macroeconomic risks are extremely important and should be mitigated (the failure o f a considerable percentage o f Argentina’s concessions illustrates the point). Fourth, the financial and governance credibility o f municipal governments i s central to the success o f most water public- private partnerships, given the decentralized nature of the service. 130 9. ANNEX D. PUEBLA TOLL ROAD SECURITIZATION-THE USE OF SPECIAL-PURPOSE VEHICLES TO MOBILIZE SUB- SOVEREIGN FUNDS 9.1 On 27 August 2004, the State o f Puebla toll-road company, Curreterus de Cuotus Puebla (CCP), issued a municipal bond backed b y the future flows coming from the collection o f tolls o f the Via Atlixcdyotl, a state-owned toll road connecting the cities o f Puebla and Atlixco. Proceeds were used to finance the construction o f a new toll road in the same state. Table 9.1 summarizes the key elements o f the transaction. Table 9.1: Transaction for the Securitization of the Via Atlixcayotl Bond Type: Trust-preferred, inflation-protected, interest-bearing, municipal bond (Certifcados Bursa'tiles) Amount Issued: 15 1,680,000 UDIS (Mexican Inflation-linked Units), equivalent to MXN519,989,073 at the issue date (27 August 2004) Maturity: 5,460 days (approximately 15 years) Credit Ratings: AAA(mex) FitchRatings; mxAAA Standard & Poor's Interest Rate: Fixed at 6.40% Payments: Semiannual Debtor: Caminos de Cuota de Puebla (CCP) Trustee (bond issuer): Nacional Financiera (NAFIN) Credit Enhancement: Banco Nacional de Obras y Servicios Pliblicos (BANOBRAS) 9.2 The deal was structured b y creating a special-purpose vehicle (SPV) to issue the municipal bonds and manage the structure's cash flows. Under the legal agreement endorsed b y CCP, the SPV not only possesses the right to receive all income collected from the tolls, but also the right to collect the tolls itself. The transaction was in fact structured as a true sale o f the assets to the Trust. Transaction Background 9.3 The Via Atlixcdyotl i s a regional 18-kilometer toll road that connects the capital city o f Puebla and the city o f Atlixco. This road was constructed in the late 1980s and has been operational since 1989. Since then, the Via Atlixcdyotl has enjoyed solid and growing revenue, thanks to the continuous growth o f the region, which has resulted in additional traffic (mainly cars). 9.4 During the past few years, the government of the State o f Puebla has continued to build much-needed road infrastructure. While some o f these projects have benefited from federal grants, most o f them have been financed b y the state. 131 9.5 The Governor o f the State of Puebla, together with the Board of Directors o f CCP, decided to monetize the Via Atlixcciyotl in order to release resources to finance additional toll-road infrastructure. 9.6 CCP set up an SPV at NAFIN which, acting as the trustee o f this private trust, issued the MxP520-million inflation-linked municipal bond. The bond i s backed b y the future cash flows from the collection o f tolls on the Via Atlixcciyotl. The transaction i s also backed by a line of credit (irrevocable, contingent, and unconditional) provided b y BANOBRAS, which would cover any shortfall in the debt service (principal and interest payments) of up to the peso equivalent of 53 percent o f the transaction's original principal amount o f 151.7 million Unidud de Znversidn (Inflation-Linked Units, UDIs), or approximately 80.4 million UDIs. 9.7 Figure 9.1 shows the structure o f the security reform. Figure 9.1: Securitization of the Via Atlixcayotl Structure Chart: S e c w i h t i a n o f the "Via A ~ ~ y a t l " s t r u c t u w TOLL- R OAD 0 PERAT0 R -13 " I 4 ..................... TOLL-ROAD 7 USERS 2 6 OPERATING AND MA1NTENANCE EXPENSES 2-J 1 1 TOLL-ROAD 2 PROJECTS IN CCP THE STATE OF PUEBLA Transaction Innovations and other Highlights 9.8 The Via Atlixcdyotl bond deal i s an innovative transaction in the Mexican market due to the following reasons: 132 0 I t is the first toll-road securitization in Mexico with both partial credit enhancement and credit enhancement from a local provider. BANOBRAS provided a credit line (53 percent o f the original principal amount) to the trustee to back principal and interest payments in the event that the operating cash flows from the toll road are insufficient to service the bonds. In this sense, while the credit enhancement provides additional security to the bondholders, i t calls for reliance on the creditworthiness o f the toll road itself. This allows for a more efficient use o f capital than under a full-wrap from an international AAA provider, because the Mexican local currency market benchmarks the spreads against the sovereign (mxAAA) rather than against a global AAA. From the issuer perspective, a local partial enhancement lowers the cost o f the transaction compared to a global full-wrap. 0 I t i s the first bond enhancement b y BANOBRAS. The transaction marks BANOBRAS’s entry into the bond enhancement market. As a lender, B A N O B R A S has financed a sizeable part of Mexico’s infrastructure. This transaction signals an encouraging shift in BANOBRAS’s approach to market development, supporting issuers and investors, rather than competing against them. This i s a very positive development for infrastructure financing in Mexico. 0 This if the first Mexican toll-road securitization (excluding fully-wrapped) t o receive local “AAA” ratings from FitchRatings and Standard & Poor’s. Previous toll-road securitizations had received ratings o f AA to AA+ (local scale) thanks to their structures, which included sunk-fund provisions and other reserve accounts, among other particularities. This transaction was the first one to receive a AAA rating (local scale), which allowed Puebla’s government to increase the maturity o f the bond to 15 years, and upsize the deal to MxP520 million. Other issuers might benefit in the future from stronger structures, similar to the one used in this deal. 133 10. ANNEX E. THE PUEBLA BOT BUYBACK 10.1 In January 1999, the water utility company o f the State o f Puebla (SOAPAP) and the private company Tratamiento de Agua de Puebla, S.A. de C.V. (TAPSA), currently an affiliate o f Undeo Degremont (Suez), signed a 20-year agreement to build, operate and maintain four water-treatment plants. The structure was a standard build- operate-transfer (BOT), with Fondo de Inversidn en Znfraestructura (Infrastructure Investment Fund, FINFRA) support, including the contingent credit line backed b y an intercept on federal transfers to guarantee timely payments from the off-taker, SOAPAP. 10.2 In the original plan, SOAPAP was supposed to increase user tariffs to fund the payments to the concessionaire. However, after a change o f State o f Puebla administration, SOAPAP no longer considered the tariff increase a viable option. As a result, the monthly payments for the B O T severely affected SOAPAP’s financial standing-so much so that i t eventually stopped making payments. Once that happened, TAPSA called the contingent credit line, and B A N O B R A S collected payment from the state government. Because SOAPAP continued to argue that i t did not have the means to absorb the BOT tariffs, the State Government continued to make the monthly payments through the contingent credit line (the state was not in a position to stop payments, given the pledge on i t s federal transfers). 10.3 Finally, in 2004, after more than two years o f paying for the BOT, the state government realized i t could significantly lower i t s monthly payments b y substituting the T1 (off-balance) liability with straight (on-balance) debt. Therefore, in January 2005, SOAPAP refinanced the T1 with an anticipated buyback o f the plants, for an amount equal to MxP665 million, part o f which was used to prepay the Banco Nacional de Obras y Sewicios Ptiblicos (BANOBRAS) long-term loan. SOAPAP financed the acquisition through a long-term loan in pesos f r o m a commercial bank, w i t h monthly payments significantly lower than the former T I payments. The Net Present Value of the savings i s approximately MxP400 million. These savings were possible largely because T1 included an equity component which was completely substituted for debt. Along with the buyback, SOAPAP contracted the operation and maintenance o f the plant with the former concessionaire, Undeo Degremont. 10.4 The Puebla buyback illustrates the following: 0 A B O T structure can aggravate the fragile financial standing o f a local water utility if the source o f funds t o make the monthly payments was not properly secured. In this structure, there was no binding obligation to increase tariffs. When this happens, the financial burden i s likely passed on to the state. 0 The contingent credit line implemented b y B A N O B R A S effectively prevented what could have been a case o f outright quasi-rent appropriation. The credit line 134 forced the State government to step in, and the concessionaire did not miss a single payment. 0 O n the other hand, the fact that the credit line was a three-month revolving loan implied the State and SOAPAP registered a debt amounting to only three months o f payments. However, as the state learned after more than two years of consecutive draws on the credit line, the true liability was much higher than the three months o f payments that appeared on i t s books (since the buyback was financed with debt, now the full liability-which i s lower than the original-is disclosed). 0 The strong guarantee o f the state’s pledge o f i t s federal transfers under the original BOT structure made i t possible to lower the capital cost to the off-taker b y increasing leverage (in fact, paying out equity). I t made little sense to continue paying equity returns when the risk to the concessionaire was debt-like, and when 100 percent debt refinancing was possible. 135 11. ANNEX F. CHILE TOLL ROAD CASE: USE OF MULTILATERAL GUARANTEES TO EXTEND TERMS AND ENTICE DOMESTIC PENSION FUNDS Transaction Background 11.1 In order to secure domestic long-term financing"* for the Santiago-Valparaiso- V i n a (SVV) toll road concession, a co-guarantee o f the multilateral Inter-American Development Bank (IDB) and Financial Security Assurance (FSA), a private sector monoline financial guarantor with local capital market financing rated, was used. The financing was structured for placement among local pension funds and insurance companies restricted to high-investment grade, primarily national-scale, AAA-rated issues. Without such credit enhancement, capital-intensive infrastructure projects such as S V V would not be able to secure debt financing from the large pool o f local capital controlled by the pension funds and insurance companies. 11.2 The use o f the co-guarantee structure enabled IDB to overcome underwriting limits o f the private sector window o f the institution o f the lesser o f US$75 million, or 25 percent o f project costs. Because the S V V concession does not have a fixed term, the financing incorporates a mandatory prepayment provision, should the term o f the concession be shorter than the stated tenor o f the bond issue. This transaction, the largest guaranteed local currency issue to date in Chile, represents the first example o f cooperation between a multilateral institution and a private sector monoline financial guarantor. I t i s also noteworthy because the financing attained the lowest fixed-coupon rate and longest maturity to date for a local currency infrastructure financing. 11.3 I f a long-dated transaction is not rated high investment grade, primarily AAA on the local scale, i t probably w i l l not be salable among the pension funds and insurance companies that comprise the term local capital markets in Chile. International capital market financing, especially for long-dated issues typical in infrastructure financing with local currency revenue, exposes both investors and the issuer to foreign exchange risks. While the Government o f Chile has attempted to solve this issue through use o f a foreign exchange collar, the perception o f risk among investors would most likely preclude a successful launch. 11.4 Innovation o f Project: Foreign exchange risk is mitigated through financing in the local capital markets. The risk that the rating o f the transaction would not be sufficient for term capital market investors in Chile is mitigated through use o f the IDB financial guarantee product, where the IDB guarantee up to i t s underwriting limits enabled the financing to attain investment-grade ratings. This was then wrapped b y the 'I2The project i s financed through the issuance o f a local currency bond for approximately the equivalent of US$306 million, with 5.8 percent interest and 23-year maturity. 136 co-guarantor FSA (private mono-line guarantor) into AAA-rated financing that was well received by local capital market investors.' l3 '13 Source: Structured Credit International Inc. 137 12. ANNEX G. TOLL ROAD TOLUCA-ATLACOMULCO-THE USE OF LIMITED CONTINGENT CREDIT LINES Transaction Background 12.1 In March 1993, the Ministry o f Communications o f the State o f Mexico and the private company Operudoru de Curreterus Alfa, S.A. de C.V (OCALFA) signed a five- year concession to operate, administer, and maintain a 55-kilometer highway connecting the cities o f Toluca and Atlacomulco, in exchange for financial compensation to the State o f Mexico. T w o years later, in September 1995, the agreement was extended for 12 more years. 12.2 Six years after the initial agreement, in March 1999, the State o f Mexico negotiated a substitution o f the dealer and some modifications o f the terms and conditions o f the concession, in the following manner: 0 OCALFA, in exchange for an indemnity paid b y the State o f Mexico, transferred the rights o f the concession to a Trust established in the Bunco Nucionul de Obrus y Sewicios Pziblicos (BANOBRAS). The term o f the concession was extended for 20 years. The Trust obtained debt collateralized with the future revenues o f the toll road from BANOBRAS. Proceeds were used to pay the indemnity to OCALFA, and the remaining funds were paid to the State o f Mexico in compensation for the extension o f the concession. 0 Also in 1999, a revolving, irrevocable, contingent credit line was signed b y the State o f Mexico, which i s secured with a pledge on federal transfers. The credit line i s triggered only i f (a) the State o f Mexico does not update toll-road fees in accordance with the terms and conditions o f the concession; (b) if income decreases due to the crossing o f users free o f charge (with passes granted b y the State o f Mexico) in numbers that exceed the levels agreed; and (c) the collection o f the tolls i s suspended for more than 24 hours due to social or political circumstance or any other circumstance attributable to the local government. Transaction Innovations 12.3 The main strength o f the transaction was that the contingent credit line was not provided to secure the debt service, but rather t o guarantee that the State of Mexico would not take actions that could adversely affect the collateral o f the debt obtained b y the trust. This guarantee has the following characteristics: 0 I t ,i s partial, forcing the market to understand the underlying risk and absorb a meaningful part o f it. 138 0 I t i s based on an underlying financially viable asset (the road) and structure, which achieved an underlying A+ rating without the guarantee (and i t has no backing o f federal transfers). 0 The true sale structure gives control to the investors o f critical variables related to payment capacity, including tariff levels. 12.4 Moreover, b y focusing only on negative covenants, i t i s an efficient tool to address the issue o f quasi-rent expropriation. The contingent credit line has never been triggered and, in December 2004, the structure was extended for 25 years. 139 13. ANNEX H. GUAYAQUIL WATER AND SANITATION: USE OF A MULTILATERAL GUARANTEE TO COVER NEGATIVE CONTINGENCIES IN A MUNICIPAL WATER PROJECT Transaction Background 13.1 The Interagua-Guayaquil Water and Sanitation Project remains one o f the more innovative water transactions to come to closure in Latin America.'14 In October 2000, the Government o f Ecuador publicly tendered the administration, operation, rehabilitation, and expansion o f the potable water, sewerage, and drainage system for the Canton of Guayaquil (the Concession Area), with approximately 2 million inhabitants. In December 2000, the government awarded the 30-year concession to International Water Services (INTERAGUA). A performance bond backed b y US$18 million o f political risk insurance helped close the deal. 13.2 INTERAGUA i s a subsidiary o f the International Water Group o f the Netherlands. I t operates the potable water, sewerage, and drainage system in accordance with the Concession Contract, and has started necessary rehabilitation and expansion projects. The company i s working to upgrade services and operating performance b y reducing unaccounted-for water and increasing cash collection. The concession agreement calls for tariff increases to be linked to predetermined improvements in the quality o f water and service, and to increases in the number o f potable water and sewage connections (by about 30 percent and 40 percent, respectively). 13.3 The capital expenditure program contemplates investments of about US$500 million over the 30 years o f the concession. The concession term is divided into six five- year periods. Based on the information gathered during the first year of operation, INTERAGUA has been able to assess the capital expenditure program needed to improve quality of services and to achieve the requirement o f 55,238 new water and wastewater connections b y 2006. As a result, the capital expenditure program currently contemplated i s estimated to reach approximately US$146 m i l l i o n for 2002-06. The Project's Innovation 13.4 In the absence o f a strong regulatory framework, such as in Guayaquil, offsetting performance requirements were built into the contract between the concessionaire and the government. The concessionaire assured i t s commitment to service expansion and improvement through a performance bond. T o mitigate the risk of the government calling the bond unduly-and to insure against expropriation, civil disturbance, and war, the Multi-lateral Insurance Guarantee Agency (MIGA) provided a guarantee. The presence o f MIGA provided sufficient assurance for the deal to reach financial closure. '14 This information i s extracted from an Inter-American Development Bank project report, a Multilateral Insurance Guarantee Agency report, and press reports. 140 14. ANNEX I.TLALNEPANTLA MUNICIPAL WATER COMPANY: A STRUCTURE FOR SUSTAINABLE FINANCING AT THE LOCAL LEVEL IN MEXICO Background 14.1 The year 2001 witnessed the rebirth o f the Mexican municipal bond market after more than 90 years o f inactivity. Mexico, although a federal country, was politically and economically centralized for most o f i t s modern history. A cornerstone in the decentralization process was the US$600 million World Bank structural adjustment loan o f 1998. The loan set up a series o f criteria for disbursement that were designed to foster fiscal decentralization and to spark the sub-sovereign credit market. Today, all 32 states and over 70 municipalities and decentralized entities are rated, making Mexico, in a six-year period, the second-largest country in terms o f municipal ratings (after the United States and before Canada). 14.2 These reforms have led to the increasing participation o f states and municipalities in meeting the large demand for infrastructure. The growth o f assets under pension fund management has further accelerated this development. Assets under management grew from MxP40 billion in July 1998 t o more than MxP414 billion in April 2004. Pension funds are under growing pressure to diversify their assets in high- quality papers. 14.3 Tlalnepantla i s a municipality o f approximately 800,000 habitants. It i s strategically located in the metropolitan area o f Mexico City, which makes i t a major commercial and industrial hub of a region o f more than 24 m i l l i o n people. One o f Tlalnepantla’s top investment priorities was the construction of a MxP9.5 million wastewater treatment plant to treat domestic sewage for industrial reuse. 14.4 The challenge o f securing water supply to populations and businesses i s particularly acute in the metropolitan area o f Mexico City due t o its topography (high altitude, l o w precipitation) and high population density. The scarcity o f water i s further aggravated b y a long history o f inappropriate incentives, such as allowing the use o f potable water for industrial processes. Under the leadership o f the municipal government, Tlalnepantla decided to remedy this situation. 14.5 The operation closed on June 30, 2003. Bunco Suntunder Mexicuno acted as a trustee of a private trust and issued a bond for MxP95 million. The bond i s backed b y the payment obligations under a loan agreement between the trust and the municipality o f Tlalnepantla and i t s municipal water company, acting as joint obligers. 14.6 Dexia provided a letter o f credit to cover any shortfall in the debt service, up to the pesos equivalent o f approximately US$8 million. The International Finance 141 Corporation, in turn, covers 36.56 percent o f Dexia's payment obligation. Figure 14.1 describes the structure o f this arrangement. Figure 14.1: Tlalnepantla Municipal Water Structure I Transaction Innovations 14.7 The Tlalnepantla bond issue was a landmark transaction for the Mexican market for the following reasons: 0 I t was the first time that a municipality did not use federal transfers as collateral for the financing. This represents an important departure f r o m the traditional scheme for financing states and municipalities in Mexico, because i t places additional reliance on the creditworthiness o f the local government. 0 I t was the first financing using the water fees as the primary repayment source, and thereby created an important precedent for investment in the water sector in Mexico. 0 I t was the first credit enhancement for a bond issued b y a state or municipality. The enhancement i s partial, so that the enhancers w i l l be sharing the risk w i t h the investors. The presence o f Dexia and the IFC was crucial in convincing the investors that the risk was acceptable. 14.8 In addition, the structure o f the transaction addresses some o f the challenges for the intervention o f international financial institutions in the financing o f local infrastructure. The financing i s in local currency, thereby avoiding that a public utility (and i t s users) take the currency risk. 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