PROJECT INFORMATION DOCUMENT (PID)APPRAISAL STAGE

Report No.: AB695Project Name MX-Decentralized Infrastructure Reform and DevelopmentRegion LATIN AMERICA AND CARIBBEANSector Roads and highways (36%);Water supply and Sewerage

(40%);Housing construction (15%);Cross-sector Technical Assistance (9%)

Project ID P080149Borrower(s) BANOBRASImplementing Agency Banco Nacional de Obras y Servicios Públicos, S.N.C.

(BANOBRAS) - At the Federal levelAv. Javier Barros Sierra No. 515Col. Lomas de Santa FéMéxico, D.F. 01219Tel. (52-55) 5270-1200

Secretaría de Finanzas y Administración - At the State levelPaseo de la Presa No. 172, Guanajuato, Gto. 36000MéxicoTel. (52-473) 735-1510

Secretaría de Obra Pública (SOP) – At the State levelConjunto Administrativo Pozuelos Circuito Superior 5 Guanajuato, Gto. MéxicoTel. (52-473) 732-0334

Instituto de Vivienda del Estado de Guanajuato (IVEG) – At the State levelConjunto Administrativo Pozuelos Vialidad 1 S/NGuanajuato, Gto.MéxicoTel. (52-473) 732-5540

Comisión Estatal del Agua de Guanajuato (CEAG) – At the State levelAutopista Guanajuato – Silao Km 1,Guanajuato, Gto.MéxicoTel. (52-473)

Environment Category [ ] A [ ] B [ ] C [X] FI [ ] TBD (to be determined)Safeguard Classification [ ] S1 [ ] S2 [ ] S3 [X] SF [ ] TBD (to be determined)Date PID Prepared February 16, 2004Date of Appraisal December 10, 2003

AuthorizationDate of Board Approval May 18, 2004

1. Country and sector issues

Economic activity in Mexico is slowly recovering from the recession it went through and which was characterized by a 0.3 percent contraction of GDP in 2001, and a modest growth rates of 0.9 percent in 2002,1 and 1.3 percent in 2003. This reflected continued weakness of the U.S. economy and weak private investment due in part to limited progress on the administration’s legislative reform agenda, and declining private consumption2.

The country’s economic policy remains successfully focused on maintaining investor’s confidence, market access, and progressing towards financial and price stability. Monetary policy is geared toward achieving an inflation target of 3 percent in 2004. The government has not pursued a counter cyclical policy in order to avoid a deterioration of the public sector’s solvency or the perception thereof. On the contrary, the authorities largely maintained a neutral fiscal stance as public deficit targets are gradually reduced and lower-than-budgeted revenues have been compensated by expenditure cuts.

Reflecting the cuts, national investment shrunk in the last two decades as austerity programs reduced infrastructure investments from over 10 percent of GDP in the early 1980s to an estimated 3.3 percent in 2003. A turnaround in this trend will be essential to sustaining economic growth in the medium to long term. Closing the country’s widening infrastructure gap will also require major investments, with preliminarily estimated at US$20 billion per year over the next decade. Given the strong move to decentralized economic management mandated by the Mexican Constitution and legislation adopted in the 1990’s, policy makers and managers at sub-national levels will have to play a major role in closing this gap.

This implies consolidating macroeconomic gains and accelerate growth through enhanced competitiveness. An array of sound legal, regulatory, and institutional frameworks have been set in place in a number of infrastructure sector at the federal level, it is clear that bringing Mexico’s infrastructure to an adequate level will require further reinforcing them and changing the way the strategies and priorities of these sectors are conceived, managed, owned and regulated at federal and sub-national levels.

Slow growth, pent-up demand and institutional issues. Decentralization has been identified by the Government of Mexico (GoM) as a key element of the National Development Plan (Plan Nacional de Desarrollo, PND). The Six-year development plan issued in 2001, although it is still very much a work-in-progress as the combination of fiscal constraints, increasing political plurality, and a cautious policy outlook have left several components of the reforms incomplete.

1 On the basis of seasonally adjusted, quarter-on-quarter economic growth rates, it can be stated that the recession lasted for 6 quarters beginning the last quarter of 2000. The economic recovery started in the second quarter of 2002, though it lost speed during the next two quarters. 2 On the basis of seasonally adjusted, quarter-on-quarter economic growth rates, it can be stated that the recession lasted for 6 quarters beginning the last quarter of 2000. The economic recovery started in the second quarter of 2002, though it lost speed during the next two quarters.

Closely coordinated efforts between the federal, state and local government levels are needed in the infrastructure sectors. For example, to avoid a major water crisis in Mexico, measures are needed to gradually move to bulk and retail water tariffs that reflect scarcity, improve their collection and allocation of bulk water rights, and find the appropriate institutional arrangements responsive to the needs of decentralized development within a federalism framework. In the road transport sector, where efforts to enhance private participation were stymied by the failure of a road concessions program in the 1990s due to as poor financial design, new arrangements are to be structured to guide the processes of rationalization of the toll roads program, the establishment of a Road Maintenance Fund, institutional arrangements and the decentralization of the road network. In low-income housing, there have been advances in strengthening an integrated institutional structure at federal level to set the principles and parameters of the low-income housing strategy but this needs to be completed and state governments and their housing institutes have to adapt them to match the local conditions and regulations. These arrangements would foster the viability of longer-term finance, and bring greater private sector participation in service delivery and less costly concession programs. Annex 1 presents a more detailed examination of the main issues to be addressed in the infrastructure sectors considered at the national and state levels.

Heterogeneity among states and need to customize. Historically, infrastructure development in Mexico has been very uneven among states and among sectors. Several (but not all) of the northern and central states have tended to be more proactive in reviewing the strategic issues surrounding the financially sustainable development of these sectors and attracting private sector participation to enable such development, whereas the southern states tended to pay less attention to these aspects, leading to a much more rudimentary state of sector development and performance. Poverty, access to necessary basic services, attention to maintenance and local priorities also vary considerably among states and local communities. Likewise, in some sectors such as telecommunications and electricity, more attention has historically been focused on putting in place economically and financially sustainable tariffs and appropriate cost recovery mechanisms, whereas the thinking and actions are at a much more initial stage in respect of the water and sewerage sectors in most states. Accentuating this trend is the fact that institutional capacity at the state and local levels varies widely amongst states. partly reflecting the different income levels and stages of development, but also the political environment and the consequent differences in the economic and sector policies.

Private sector participation and sub-contracting. Mexico has rightly sought over the past two decades to substitute public with private infrastructure investment. However, the private sector’s response has not materialized as fully as had been expected, and Mexico effectively is experiencing a depreciation of its capital stock. In order to correct this trend, a continued search for innovative methods of promoting public-private partnerships and other modes of private sector participation is needed. Also needed are appropriate long term funding instruments and continued regulatory reforms at varying degrees in the infrastructure sub-sectors at the three levels of government.

Responsibilities of federal, state and local jurisdictions. The division of responsibilities varies significantly amongst infrastructure services – for example; water and sanitation services and local roads are primarily the responsibility of local government whereas key elements of

telecommunications, major highways and electricity infrastructure are federally controlled and urban development and low income housing tend to be shared. Responsibilities for strategy making and priority setting amongst the three levels are often not well defined. Clarifying the strategies at the sub-national levels is a key ingredient of providing better access, quality and sustainability of infrastructure services.

2. Objectives

The unmistakable mandate provided by Mexico’s Constitutional amendments and corresponding legislation adopted in the 1990’s was to link firmly the country’s future economic and social development to a much more decentralized mode of economic management in most economic and service sectors. However, the majority of the states and local authorities do not yet have the institutional or technical capacities to undertake effectively the responsibilities implied in the strong move to decentralization or to formulate comprehensive economic and sectoral strategies to guide such a process. Institutional and strategic capacities of some of the national entities responsible for guiding the decentralization process in the respective sectors are also not yet well developed. Combined with the prospects for Mexico graduating from Bank lending in the coming decade or two, this makes it crucial for the Bank to engage firmly in this process at this time, so that the Bank could help leave behind in Mexico adequate capacities to manage the decentralized development process.

The Country Assistance Strategy (CAS) approved by the Board in 2001 identifies decentralized development and working at sub-national levels of Government as an explicit priority. The CAS envisages that the Bank program would help strengthen sub-national level performance and capacities to enable them to assume the economic management responsibilities assigned to them under Mexico’s Constitutional reforms of the 1990’s. As a step towards this objective, the Bank has previously provided analytical assistance to help in the establishment of a clearer fiscal decentralization framework and rules. Specifically, these incorporated hard budget constraints within which states will have to manage their fiscal program, reducing moral hazard in sub-national borrowing, increasing transparency and public accountability of sub-national fiscal and financial management and of the overall decentralization process and setting up pilot mechanisms to enhance efficiency in decentralized expenditures in the environment and health sectors. It was envisaged that further Bank interventions would help promote structural reforms and capacity building at the macro-management level and/or at individual sectors, depending on the specific circumstances faced by a state.

3. Rationale for Bank Involvement

The Bank can play an important role in helping Mexican states define coherent sector strategies and priorities and improving their institutional capacity and sustainability. Lack of access to basic infrastructure and public services is both a key dimension of poverty and of quality of life of the poor and underprivileged in Mexico. Both urban and rural poor neighborhoods experience striking deficiencies in access to potable water, sanitation, electricity and telephones. Poor water and sanitation services have been demonstrated to have direct effects on the health and productivity of population. Lack of access to roads is typically also a major impediment, hindering effective participation of poorer population segments in economic and commercial

activity, and limits their access to basic health care and education – in turn perpetuating poverty and low quality of life.

If pursued as part of an effective and well thought out strategy which appropriately reflects the state’s circumstances, priorities and capacities, decentralized infrastructure development can bring major improvements in and the quality and access to basic infrastructure, especially to the poorest segments. By bringing policymakers and final beneficiaries closer together, it can promote the design and implementation of strategies that are much more responsive to the local needs, priorities and characteristics. It can also redefine the role of the federal government entities into one that guides and catalyzes appropriate actions at the sub-national levels, and limiting its own direct action to only areas where it is needed.

World wide experience suggests that decentralization should best be carried out within a coherent overall national strategy and with adequate institutional infrastructure at lower levels of government. The proposed Program and Project aims to achieve this. The overall challenge is to make decentralization process fully sustainable. To this end, the previous Mexican Administration sought to ensure sustainability by promoting legislation to impose hard budget constraints on states and municipalities. This was achieved by the Government by renouncing, in the federal budget for 2000, its own powers to hand out discretionary transfers, and by establishing a regulatory link between capitalization requirements for bank loans to sub-nationals and these borrowers’ independently determined credit ratings. These reforms have started to show their positive influence by making states and municipalities focus more attention on the fiscal sustainability of their programs. To get their full beneficial impact, however, sub-national governments will need to formulate and implement medium and long term comprehensive sector strategies comprising an array of actions that go from infrastructure investment to regulatory reform and improvements in institutional capacities at state and local levels.

Sub-national sector strategies will undoubtedly be smaller in scale than traditional investment operations at federal level, but larger in the scope of the activities involved. Moreover, infrastructure investments at sub-national level are usually financed by pooling funds from federal and sub-national levels along with commercial and development bank financing. The combination of this factors would favor Bank financing through a Sector Wide Approach (SWAp), whereby comprehensive sector strategies including a variety of actions are prepared and put forward by sub-national governments to receive Bank financing under the proposed Program. It is anticipated that this mechanism will provide sufficient degrees of freedom for participating states to include within a sector strategy the optimal mix of investment and reform-orientated actions that would then be financed as a single unit.

A SWAp could provide a mechanism to lessen the difficulty of financing strategies that involve a large scope of activities financed by a pooling of funds. A natural consequence of this financing instrument is an increased reliance in country/state systems, and extending the positive externalities derived by applying “best practice” standards to sector strategies as a whole. Moreover, given the extent of consistency between Bank Safeguard policies and those of the SoG coupled with the high existing level of capacity for management of environmental and social issues within existing state institutions and sectoral agencies, a SWAp in this context offers an excellent opportunity for piloting reliance on existing country “Safeguards” systems

within select sectors. Thus, this project provides the chance to truly promote the objectives of a SWAp, including promoting country ownership, strengthening country systems and capacity, reducing transaction costs and the “hassle” factor, and ensuring a greater focus on project results.

4. Description

(a) Lending Instrument

World Bank (WB) support would be made available to address the issues discussed above through financing of a Program being mounted by BANOBRAS to support comprehensive infrastructure sector strategies undertaken by states. The actual Bank support would take the form of a series of independent state-by-state loans via BANOBRAS. Candidate states would be those that are taking reform and development measures to catalyze and promote efficient and fiscally and financially viable infrastructure development in priority sectors, with poverty responsiveness and access of public services to the poorest segments of the population. The proposed US$ 107.76 million loan to BANOBRAS to support SoG is the first of a series of loans under the DIRD to be considered.

(b) Program objective and Phases

The proposed Program is designed to improve the performance of infrastructure services throughout the territory of Mexico while operationalizing the decentralization objectives of the national government, thereby enabling and catalyzing the efficient and sustainable development of selected infrastructure sectors at the sub-national level. It also serves as the first “Safeguards Pilot” in the Latin America and the Caribbean Region (LCR), in which the Bank will rely on existing country systems for management of environmental and social issues within the context of the project.

In the long run, it is expected that the Program will help Mexico to build an effective and sustainable model to channel finance to support development of different sectors at sub-national levels, and help create the requisite institutional capacities. However, in order to avoid undue complexity in its initial stage and to facilitate learning which could be incorporated in further stages of the Program, support in the first stage of the Program would focus on three key infrastructure sectors, namely: (a) roads including highways and rural roads; (b) water and sanitation (including wastewater treatment); and (c) urban and low-income housing. Based on the initial experience, and applying any lessons learned from the first stage, the Program could be extended to additional priority sectors. During the first stage, the Program will be available only to states, although direct support could be extended to municipalities in later stages. Municipal and local administrations could also benefit even during the first stage because an important part of the state strategy might involve providing catalytic support to municipalities and utility operators to induce reforms and sustainable development of services at the local level in line with state priorities, for example, by using loan proceeds to provide Technical Assistance (TA) or institution building.

Program Features. The overall Program modality would be to provide long term finance, via loans granted to BANOBRAS3, which would on-lend to participating states to finance one or more sector strategies for infrastructure reform and development. States would be invited to articulate and submit a comprehensive sector strategy for the sector(s) for which they seek support under the Program, outlining investments in infrastructure, policies, structural or institutional reform actions and other sector development initiatives which they intend to implement over the next 2-4 year period. These would be accompanied by a specific investment program, calendar of actions and monitorable indicators to be achieved during that period which would be enabled by the sector strategies. As sector strategies are prepared by the states it is expected that they would be custom-tailored to reflect the stage of development of the sector, priorities and needed reform actions and hence could vary significantly from one state to another.

The loan amount granted to each participating state to support sector strategies would be assessed by the Bank individually, and would be based on the size of financial gap that results from deducting all available funding sources from the total investment needs over the period covered by the medium term sector program (typically 3-4 years), the quality of the sector strategies and the efforts toward achieving sustainable strategies by each state.

In screening candidate states BANOBRAS would verify that the fiscal affairs of the state in question are being managed in a responsible way and that the finances of the state are sustainable in the medium term. These may be based on assessments to be made by BANOBRAS of: the current and projected net fiscal balances of the state, the structural consistency and efficiency of expenditures, sustainability of the debt levels, and the quality of the internal financial management practices. As part of its assessment, BANOBRAS will also take into account the credit ratings obtained by the state by an independent credit rating agency. BANOBRAS would also verify that candidate states have prepared a satisfactory, coherent and well integrated strategy for each sector for which they seek financing.

The Bank, in collaboration with BANOBRAS would assess the sector strategies proposed. In addition, in collaboration with relevant state and sectoral agencies, the Bank would assess the existing safeguards-related legal and institutional frameworks and capacities in the sectors. To promote adequate long-term investment levels in the sectors, the Program will place special emphasis to support sector strategies that comply with specific sector eligibility criteria as described in the Program’s Operating Regulations, including amongst other: (i) promote access to services to the poorest segments of the population; (ii) incorporate market-based solutions that support the maximum level of private sector participation - whenever feasible - through an appropriate overall sector structure, regulatory and competition frameworks, suitable tariff and cost recovery policies; (iii) include the requisite attention to maintenance of infrastructure facilities and operational efficiency; and (iv) promote the strengthening of state environmental and social management capacity within key sectors. To assist states in the formulation of the sector strategies, the Program’s Operating Regulations also include sector best practice guidelines. The proposed sector strategies would also have to be consistent with the national sector development strategy, as articulated by the respective national sector entities4. As part of the vetting process, BANOBRAS and the participating state would agree on any refinements 3 See Partnership Arrangements4 Comisión Nacional del Agua (CNA) in the case of the water and sanitation, Secretaría de Comunicaciones y Transportes (SCT) in the case of a

state roads program and the Secretaría de Desarrollo Social (SEDESOL) in case of urban development and low-income housing.

and/or institutional strengthening measures that may need to be incorporated in the proposed sector strategy. If agreement is reached between the Bank, BANOBRAS and the state, financial support to sector strategies would be codified in the form of a loan from BANOBRAS to the candidate state.

Since the Program has been designed as a SWAp, the set of rules governing participation and execution would be applicable to all expenditures incurred under the corresponding medium term sector strategy supported, regardless of the funding source. Thus participating states or municipalities would agree to apply the same rules and guidelines to investments and other expenditures financed by other domestic or external sources, federal government transfers as well as their own budget resources.

Disbursements under a loan would be based on accomplishments of agreed output benchmarks that reflect key elements of the strategy and corresponding unit costs. The specific triggers would be aimed at ensuring adequate additional progress or “value added” vis-à-vis the current situation and stage of development of the sector. Overall, these disbursement triggers would reflect the state’s priorities, needs and performance and output objectives. Their achievement would be closely monitored during Program execution by the Bank and BANOBRAS.

The Program’s Operating Regulations would govern the execution of the Program, covering all the operational aspects governing all loans under the Program. This includes Program sector eligibility criteria, fiduciary and safeguards requirements, sub-loan terms, conditions and on-lending arrangements, procurement (following agreed guidelines between the Bank and GoM), disbursements and financial management arrangements (to provide full transparency of outputs and expenditure accounting and auditing) and overall Program management. The Bank’s formal loan documentation would specifically require Program execution to comply with these Operating Regulations.

The Program serves as a “Safeguard Pilot”, with the Bank relying on country systems for management of environmental and social safeguards-related issues. Several of the investments included in the sector strategies financed under the Program could have significant environmental and/or social impact. In order to ensure that the Bank’s environmental and social safeguards are adequately addressed, a generic Environmental and Social Management Framework (ESMF), is incorporated into the Operating Regulations of the Program. Consistent with the SWAp, ESMF allows for substantial reliance on country/state systems and describes the process by which participating states will assess, minimize and mitigate- the environmental or social risks of each sub-component of the sector strategy, through specific institutional arrangements and reporting requirements. The ESMF calls for an assessment of the existing institutional capacity at state level, and makes recommendations for strengthening that capacity so as to ensure compliance with existing national and state laws.

(c) Project development objective and key indicators

The first Bank loan under the proposed DIRD Program would be a [US$ 107.76] million specific investment loan extended to BANOBRAS to support the sector strategies of SoG for the following sectors: road transport, water distribution and sanitation, and low-income housing. SoG has expressed strong interest in participating in the Program. Based on a full assessment by

the Bank and BANOBRAS, the three sector strategies submitted have been determined to meet the sector eligibility criteria, and are consistent with the sector best practice guidelines as described in the Operating Regulations.

The proposed loan would support SoG to achieve sustainable investment levels in and efficient operation of three infrastructure sectors, with enhanced basic services for the poorest population segments and financial sustainability: road transport, water and sanitation and provision of low-income housing. It will follow the Program’s Operating Regulations and would be output based in its major investment components. The sector strategies included both investment, reform-oriented and institution building sub-components for each sector. Annex 3 presents the development indicators to monitor the performance.

(d) Project components

The three sector strategies, together with cross-sector TA program to improve state government processes are, hereinafter referred to as ‘Project Components’, derive from SoG’s “Plan Estatal de Desarrollo” - a long-term plan prepared on the basis of a systematic consultation process. A description of the main sector issues faced by SoG is included in Annex 1, along with the strategies designed by the state agencies to address them. A brief summary of each sector strategy to be supported by the Bank is presented here. Further details on the sub-components and costs estimates are in Annexes 4, 5, and 15.

Component I: Implementing the Road Transport Sector Strategy

The three-year sector strategy proposed by SoG, to improve overall performance of the road transport sector includes both investment and institutional strengthening actions with an estimated cost of around US$163 million, of which US$60 million will be covered by the Bank loan. The main sub-components under this are:

(i) Institutional strengthening: Improving the investment planning and the Planning Programming Budget (PPB) cycle, introducing performance maintenance contracts, designing a program for the transfer of the federal roads, development of pavement management systems and development of an improved framework for private sector financing of road projects;

(ii) Preventive and routine maintenance and rehabilitation of the existing road network: This is a high priority program covering about 2071km state managed network. It would be based for the first time on a network assessment to derive the maintenance and rehabilitation priorities for optimally allocating resources;

(iii) Expansion of the state managed network. This includes building 600 new km of roads;

(iv) Improvement of bridges and elimination of bottlenecks: Road grade separation overpasses and improvement of unsafe or restricted spots along the federal/ or state roads;

(v) Construction of toll roads: Completing six projects; and (vi) Improvement and construction of rural roads.

Component II: Implementing the Water Distribution and Sanitation Sector Strategy

This component addresses the problems faced by the Government of the State of Guanajuato (GoSG) in water and sanitation service provision. This strategy is fully consistent with the national development plan and the state’s hydraulic program for 2001-2006, and covers both the investment and institutional strengthening needs through four sub-components. The estimated cost for the water distribution and sanitation component is US$94 million, of which US$38.4 will be covered by the Bank loan:

(i) Water resources management: Establishing a Hydraulic Planning System, efficient measurement of hydrological cycle and introduction of participation mechanisms for water management systems;

(ii) Uses of Water: Increase coverage of water supply and sanitation in rural and urban areas, increase wastewater treatment in large communities5. A substantial element of this item is the Program to Improve Efficiency and financial sustainability of service providers, e.g. TA to service providers and municipalities to achieve cost effectiveness and a satisfactory level of tariff recovery; further development of benchmarking models for service providers; and

(iii) Institutional Strengthening of Comisión Estatal del Agua de Guanajuato (CEAG): Improve the regulatory framework, process certification, staff training, promote technological transfers.

Component III: Implementing the Low-Income Housing Strategy

(i) Institutional Strengthening(a) Establish adequate prudential financial criteria suitable for

decentralized or autonomous non-bank financial intermediaries engaged in housing finance, efficient loan recovery mechanisms and provisions policy thereof;

(b) Formally approve the legal framework applicable to the sector to incorporate item (a) above and to make Instituto de Vivienda del Estado de Guanajuato (IVEG) financially sustainable in the medium term and able to preserve its capital in real terms; and

(c) Implement item (b) above and improve the information and supervision systems to enable it.

(ii) Increase supply of low-income housing for the poorest segments of the population through three main products: financing of materials self-construction, financing gradual improvement and rehabilitation of housing, and financing of urbanized lots ready for housing construction.

Completion of the institutional strengthening sub-component, satisfactory to the Bank, would be a disbursement condition to begin withdrawals under item (ii).

Component IV: Technical Assistance to Cross-Sector Areas5 The wastewater treatment element of the strategy is part of a national program directed by CNA, however several deficiencies have been

identified by CEAG and the Bank regarding the financial and operational sustainability of these investments. As part of the proposed loan, CEAG is developing additional screening criteria to bolster their effectiveness and promote sustainability, which could eventually be used by other states of the Program.

In response to the State’s request and in order to implement the necessary reforms as suggested by the Bank’s assessments for the state, a TA component of US$2 million has been designed to strengthen existing capabilities within the state in order to achieve full compliance with the Program’s Operating Regulations. The subjects covered include are cross-sectoral and would have a positive impact beyond the sector strategies proposed for Bank financing. Specifically this includes:

(i) Strengthening of the mechanisms to screen, prioritize and monitor public investments;

(ii) Strengthening of the existing consultation and participation mechanisms at state, municipal and community levels;

(iii) Enhancing the safeguard policies and methodologies applicable to investments undertaken by the state entities;

(iv) Strengthening of procurement policies and practices; and(v) Optimization of the existing financial management and audit systems and processes.

5. Financing

Source: ($m.)BORROWER 212.70INTERNATIONAL BANK FOR RECONSTRUCTION AND DEVELOPMENT

107.76

Total 320.46

6. Implementation

Partnership arrangements

BANOBRAS, Mexico’s principal national development bank charged with the responsibility for federally sponsored development lending to states and municipalities, especially in infrastructure areas, is the agency designated by GoM to implement the Program. In the initial stages of Program implementation, the Bank expects to work closely with BANOBRAS in discharging its functions of assessing the proposed sector strategies, in particular checking compliance with the Program’s sector eligibility criteria and general rules governing execution as described in the Program Operating Regulations. The expectation for possible future loans under the Program is that BANOBRAS will increasingly assume responsibility for these functions, accompanied by a gradual transition of Bank involvement from direct participation in assessments to provision of technical and advisory assistance to BANOBRAS and the states.

Institutional and implementation arrangements

Borrower, Implementing Agencies and Channeling Arrangements. BANOBRAS would be the Borrower of the proposed Bank loan, with guarantee provided by United Mexican States. We have been informed by the Borrower that would be a USD fixed spread loan, and are waiting to receive confirmation of exact terms of the loan within the available options. We are also waiting

for the formal action by BANOBRAS for the approval of the Program Operating Regulations and ESMF.

Funds from BANOBRAS to SoG would be initially channeled through the state’s Finance Secretariat and would be passed on by it to the concerned state executing agency, including SOP (for road transport), CEAG (for water and sanitation), IVEG (for low income housing) and other government entities for the cross-sector TA. Funds from BANOBRAS are expected to be made available to SoG at terms comparable to the Bank’s own maturities, bearing interest rates in pesos which are expected to be at CETES or TIE, covering the funding cost for BANOBRAS and administrative and other spread. The responsible entities in the state will keep track of the details of the costs, financing and outputs, and make them available to Secretaría de Finanzas y Administración (SFA) and through them to BANOBRAS who will act as the liaison with the Bank on financial and procurement matters.

Procurement. In order to ensure that the Bank fiduciary obligations are met, BANOBRAS will have to sign a formal sub-loan contract or a Memorandum of Understanding (MoU) with SoG, covering most of the conditions described above, including the channeling arrangements, procurement and disbursement conditions and the rules under the Operating Regulations. The MoU will define the thresholds for prior reviews, allow for bidders from all countries to participate in local biding; it also will define the obligation for a rolling 18-month Procurement Plan that would identify contracts to be financed by the Bank. In order to allow retroactive finance, procurement carried out before each MoU is signed will have to use the already approved Standard Bidding Documents (SBD) for Bank financing. In order to review all procurement activities below the prior review threshold BANOBRAS should have adequate procurement and Financial Management (FM) staff.

Financial Management. WB loan funds will flow from the loan account, to a Special Account (SA) in the central bank managed by BANOBRAS. Funds will be disbursed from BANOBRAS to the states based on performance information provided by the states, and in accordance with applicable processes of states and sub-national entities that may be involved in the program. States will be allowed to receive up to 20% of their loan as an initial advance, after which further disbursements must be triggered by output achievements. Once states provide the required information demonstrating the achievement of certain output and performance targets, BANOBRAS will carry out relevant verification processes and then disburse the appropriate amount of funds to the states, (States are responsible for transferring funds to other sub-national entities such as municipalities). After disbursing to the state, BANOBRAS will draw down the appropriate amount from the SA, and then submit a replenishment application to the Bank.6

Counterpart funds will be represented by the funds that states have included in the investment programs partially financed by the Bank/BANOBRAS loan.

Safeguards. So as to ensure that Safeguard issues are adequately addressed within the context of this pilot that tests reliance on existing country safeguards systems, the Bank, BANOBRAS and the relevant state and sectoral agencies have agreed to an ESMF. This ESMF lays out the required environmental and social work for each type of sectoral project financed through the Program, institutional arrangements to ensure that this environmental and social work is

6 In Mexico all expenditures are pre-financed by the government or the financial agency, and then reimbursed from the SA.

adequately undertaken, reporting mechanisms to ensure that the Bank is flagged in instances of potentially significant environmental and/or social impact, and a strengthening program to ensure that sufficient state capacity exists to ensure compliance with existing relevant state and national laws.

7. Sustainability

Specifically, the more commonly faced challenge in the majority of the states is not an overall fiscal management breakdown, but rather a need to address structural, performance or economic efficiency problems experienced in a number of individual sectors. The Program described, that has been designed by GoM and BANOBRAS in close consultation with the Bank to address problems faced in key infrastructure sectors, directly responds to this challenge. Support to investment needs, structural reforms and sustainable development of key infrastructure sectors can be expected to yield substantial benefits in terms of economic growth, productivity and competitiveness as well as improvement of basic services to the poor, their standard of living and ability to participate more effectively in economic activities. In addition, sector strategies supported by the Bank under the Program will be prepared by each candidate state ensuring ownership as they respond to the local needs and priorities as identified by the State government in consultation with their population. In addition, sector strategies would give high priority to those reforms or investments needed to achieve sustainability in each sector (e.g. rehabilitation and routine maintenance of roads, maintenance of infrastructure to avoid water losses, financial sustainability of water service providers through efficient billing and collection systems, etc.).

Guanajuato’s proposed sector strategies are the product of an extensive consultation process undertaken in 2000. They describe the expected goals to be achieved during the 2004-2006 period and are consistent with the sector strategies at federal level. In particular, the proposed strategies are the second-phase of the six-year plan that GoSG launched in 2001. Although there have been lags in several areas relative to the original commitment that GoSG had, in general all of the priority areas have been tackled. Also the design of the Programmatic framework allows for a substantial amount of flexibility for the State to achieve the output results.

8. Lessons Learned from Past Operations in the Country/Sector

The Bank’s experience with decentralization projects shows that while there is no fixed decentralization agenda that can be applied to all cases and country situations, inclusion of certain key features flagged below would be critical to the success of the decentralization programs.

Importance of capacity building at sub-national agencies. Decentralization of investment responsibility to lower levels increases accountability and typically improves service quality. Bank and other experience shows that decentralization of responsibilities can succeed only if accompanied by commensurate increasing the capacity of local agencies to strategize, plan, monitor and implement programs that fulfill their new responsibilities. Previous projects that began with a decentralized or demand driven model without an adequate capacity building element have had poor operational results characterized by slow disbursements and low quality investments. Moreover, the impact of decentralization upon public sector efficiency depends on

the country’s ability to prevent lower-level governments from mis-managing their debt. 7 The basic criteria under the proposed Program are designed to ensure that participating states have a track record of prudential fiscal, financial and environmental and social management, and that capacity building is tackled as an integral part of the state sector programs.

Establishing clear criteria for sub-project selection. Experience with previous decentralization projects in Mexico highlight the importance of establishing clear criteria for choosing sector priorities and sub-projects selection, in order to eliminate uneconomical projects, which could be selected by states or municipalities with little or no experience in prioritization and project evaluation.8 Sustainability and impact are increased through the establishment of clear rules of the game in relation to subsidies and cost recovery policies, need to minimize market distortions, clarity on expected results, etc. The proposed Program applies these rules and results- based disbursement to accomplish this. Previous projects have demonstrated that developing a cost recovery strategy, combined with clear targeted subsidies where needed, are critical to the sustainability of investments. Most project components ensure that investments are supported by cost-recovery tariffs or explicitly budgeted upfront subsidies.

Importance of community participation in planning and implementation and Program ownership. Previous projects show that the benefits from decentralizing urban service provision helps to develop strong local ownership of the projects. In some cases ownership went deep enough to ensure smooth transfers of the projects between adversaries at times of political succession9. Community participation in project design and implementation facilitates cost recovery tariffs, ensures accountability of government agents and is a way to ensure that priorities reflect the population needs. Country experience highlights the importance of using the existing planning and participation mechanisms for consultation, strengthening them whenever necessary. The proposed Program incorporates local stakeholders into the investment identification and priorization process and will provide support to build capacities at state and municipal levels.

9. Safeguard Policies

Social

The project is a safeguard pilot, testing for the first time in LCR reliance on existing country systems for oversight of environmental and social safeguards-related issues. This pilot approach proposes to address safeguards issues using an ESMF, included in Annex 18. This ESMF approach calls for Bank oversight procedures to ensure that national and local capacity exists to adequately manage environmental and social aspects of subprojects. Implementation of ESMF is designed to ensure that Mexican laws, regulations and procedures related to safeguard issues adequately reflect the “spirit” of Bank safeguard policies, that there is sufficient capacity to enforce those laws, regulations and procedures, and that any deficiencies are remedied through strengthening programs. In limited areas, additional procedures are recommended to ensure that subprojects with significant environmental and/or social risk are flagged to the Bank so that: 1)

7 Decentralization and the challenge of hard budget constraints, Poverty Reduction & Economic Management (PREM) Notes 21597.8 Evaluation Report: Decentralization and Regional Development (US$500m), August 1994l, Report No. 13032-ME9 Brazil Impact Evaluation Report, Learning form Best Practice in Five Urban Projects, Report No. 167736, June 1997

the Bank can target these subprojects during supervision; and 2) monitor whether existing gaps between GoM regulations and Bank policy make a difference in project outcome.

ESMF was applied to Guanajuato for the select sectoral strategies. The result of this exercise is included as Annex 10, which details the agreed institutional arrangements for overseeing safeguards-related issues, describes the results of the capacity assessments, and sets forth a proposed strengthening program to ensure that relevant state and municipal agencies are able to guarantee compliance with relevant Mexican standards for all projects in the key sectors (roads, water and sanitation, and urban housing)

As described in ESMF, social safeguards issues will be generally addressed as follows:

Involuntary Resettlement. Resettlement activities will be conducted in accordance with a state-defined procedure, with one agency or institution charged with overseeing the process, under institutional arrangements adequate for ensuring compliance with Mexican resettlement policies. This procedure should ensure that all projects requiring significant resettlement (more than 200 households) are flagged to the WB early on to allow prior review, comment and supervision by Bank staff. In Guanajuato, the agency charged with overseeing resettlement would be the Social and Human Development Ministry (Secretaría de Desarrollo Social y Humano - SDSH), who would coordinate any resettlement activities undertaken by the SOP and/or municipalities under the terms of binding agreements established under the ESMF. The SDSH would be responsible for preparing progress reports for Bank review and for flagging projects requiring significant resettlement (more than 200 households), as described above.

Indigenous Peoples. Projects that could potentially affect indigenous peoples, either positively or negatively, should be evaluated on a case-by-case basis by GoM and WB staff to ensure that projects benefit those groups, or to mitigate any potential negative impact. Oversight of this issues in Guanajuato would be the responsibility of the state Indigenous Peoples Committee, in accordance with arrangements detailed in the ESMF.

Environment

ESMF lays out the agreed institutional arrangements for overseeing safeguards-related issues, describes the existing capacity to manage those issues, and sets forth a strengthening program to ensure that relevant state and municipal agencies are able to guarantee compliance with relevant Mexican standards for all projects in the key sectors (roads, water and sanitation, and urban housing)

As described in ESMF, environmental safeguards issues will be generally addressed as follows:

Environmental Assessment (EA). All types of subprojects included in the sectoral strategies to be supported through the project have been pre-screened for risk, and specific institutional arrangements, procedures and reporting requirements have been set forth for those subproject types. These due diligence procedures are designed to ensure that existing Mexican law, deemed to be adequate in the Guanajuato context, is systematically applied to all subprojects in the select sectors. They call for the state environmental agency, Instituto de Ecologia Guanajuato (IEG), to

oversee application of EA laws and regulations. In addition to ensuring that applicable EA laws are complied with, IEG will be responsible for flagging high risk projects to the Bank (Type III projects; see Annexes 10 and 18), and guaranteeing that additional EA procedures (site screening) are implemented in those high-risk projects. IEG will also be responsible for providing updates to the Bank.

Natural Habitats. IEG is responsible for ensuring that no development impacts any critical natural habitat areas (as per OP 4.04, these include existing and officially proposed protected areas, as well as other sites of high conservation value). This is done within the context of a very strong state protected areas system, including 16 such areas legally established (including a RAMSAR site) with an additional six under development. This protected areas system is considered adequate to mitigate any long-term cumulative impacts associated with the state’s infrastructure development program on other non-critical natural habitats areas. Additionally, all subprojects representing significant potential environmental risk (Type III projects) will be screened to ensure that their design minimizes and/or mitigates any such impact to non-critical natural habitats.

Safety of Dams. CNA and CEAG are responsible for overseeing the development of all dams within the state of Guanajuato. Given their capability to ensure adequate oversight of dam safety-related issues, the Bank will oversee only dam projects greater than 15m in height. The existing state procedures are considered adequate for smaller dams (<15m).

Cultural Property. Cultural property-related issues will be addressed using existing state systems, as they are considered highly adequate. In Guanajuato, cultural property is addressed through the SOP’s restoration unit (Dirección de Restauración de Monumentos), which is responsible for identifying and mitigating any potential infrastructure-related impact on cultural property. In case of chance findings SOP will ensure that INAH is promptly notified and involved in the protection processes.

Safeguard Policies Triggered by the Project Yes NoEnvironmental Assessment (OP/BP/GP 4.01) [X] [ ]Natural Habitats (OP/BP 4.04) [X] [ ]Pest Management (OP 4.09) [ ] [X]Cultural Property (OPN 11.03, being revised as OP 4.11) [X] [ ]Involuntary Resettlement (OP/BP 4.12) [X] [ ]Indigenous Peoples (OD 4.20, being revised as OP 4.10) [X] [ ]Forests (OP/BP 4.36) [ ] [X]Safety of Dams (OP/BP 4.37) [X] [ ]Projects in Disputed Areas (OP/BP/GP 7.60)* [ ] [X]Projects on International Waterways (OP/BP/GP 7.50) [ ] [X]

10. List of Factual Technical Documents

* By supporting the proposed project, the Bank does not intend to prejudice the final determination of the parties' claims on the disputed areas

World Bank. -- Aide Memoire and Back to Office Report of Identification and Preparation Mission (February 2003, March 2003, September 2003).---- Procurement Capacity Assessment, 2004, Lea Braslavsky ---- Financial Management Capacity Assessment, 2004, Daniel Boyce ---- Environmental Assessment, 2004, Juan David Quintero ---- Operating Regulations, March 2004

11. Contact Point

Contact: Krishna ChallaTitle: Sector LeaderTel: 5782+4257Fax: 5782+4222Email: Kchalla@worldbank.orgLocation: Mexico City, Mexico (IBRD)

12. For more information contact:

The InfoShopThe World Bank1818 H Street, NWWashington, D.C. 20433Telephone: (202) 458-5454Fax: (202) 522-1500Web: http://www.worldbank.org/infoshop