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 inUrban Areas, (Programa de Agua Potable, Alcantarillado y Saneamiento en Zonas Urbanas) APIs Port Authorities Administration, (Administraciones Portuarias Zntegrales) BANOBRAS National Development Bank for Public Works and Services, (Banco Nacional de Obras y Sewicios Ptiblicos) BLT Build-lease-transfer B O T Build-operate-transfer CAMMESA Electric Wholesale Market Company of Argentina, (CompaAia Administradora del Mercado Mayorista Elkctrico, S.A. deArgentina) 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 CuotasPuebla) CEA State Water Commission, (Comisidn Estatal deAgua) CEMCAS Training Mexican Center of Water and Sanitation, (Centro Mexican0 de Capacitacidn deAgua 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) C N A NationalWater 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 FederalCommission for the Protection of Sanitary Risks (Comisidn Federal para la Proteccidn contra Riesgos Sanitarios) CONAE National Commission on Energy Conservation, (Comisidn Nacional Ahorro de Energia) CONSAR National Commission on 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 of Road Maintenance Egresos Subsecretariat o f Spending EPA Environmental ProtectionAgency FOROFFIcI[AEUSEONLY This document has a restricted distribution and may be usedby recipients only in the performance of their official duties. I t s contents may not be otherwise disclosed without World Bank authorization. FAIS Fundto support social infrastructure (Ramo33) FARAC Trust Fundsto Recover Roads Concessions, (Fideicomiso deApoyo a1 Rescate deAutopistas Concesionadas) FINFRA InfrastructureInvestment Fund, (Fondo de Znversidn en Znfraestructura) FISM Municipal Social InfrastructureFund, (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 ZnvestigacionesElectricas) IMCO Mexican Competitiveness Institute, (ZnstitutoMexicano 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 SanitationTraining, (InstitutoMexicano de Tecnologia del Agua) INDEVAL Securities Institute, (Znstitutopara el Depo'sitode Valores) INEGI National Institute of Statistics, Geography and Computer Science, (ZnstitutoNacional de Estadistica, Geografia e Znformdtica) INTERAGUAInternational Water Services IPER Infrastructure Public Expenditure Review IPP Independent power providers IRR Internal rate of return LAC Latin America and the Caribbean LFC Power and Electricity of 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 New Concession Scheme NSIP Public Investment New System, (Nuevo Sistemade Znversidn Pu'blica) O&M Operation and maintenance OCALFA Alfa Highway Operator, S.A., (Operadora de Carreteras Alfa, S.A. de c.V.) OECD Organization for Economic Co-operation and Development 0 0 s Water Utilities, (Organismos operadores) OPF Financed Public Works, (Obra Pu'blica Financiada) PAHO Pan-AmericanHealth Organization ... 111 PEMEX MexicanPetroleum, (PetrdleosMexicanos) PER Public Expenditure Review PIARC World RoadAssociation PIDIREGAS Projects with Deferred Impact inthe Budgetary Registry, (Proyectos de Impact0 Dferido en el Registro de Gusto) P M I International MexicanPetroleum, (Petrdleos Mexicanos Internacional) PND National Development Plan, (PlanNacional de Desarrollo) PNH National Hydraulic Plan POAs Annual Operative Programs PPI Private sector participation ininfrastructure PPIAF Public-Private Infrastructure Advisory Facility PPP Public-private partnership PPPS Public-Private Projects, (Proyectospara la Prestacidn de Sewicios) PRODDER Water Rights ReturnProgram, (Programade Devolucidn de Derechos) PRODES The basin restoration program PROMAGUA Program for the Modernization of Water Utilities, (Programa para la Modernizacidn de Organismos Operadores deAgua) PROPIMI Pilot Program for Integral Maintenance, (ProgramaPiloto de Mantenimiento Integral) PROSSAPYS Program for SustainableDrinkingWater and Sanitation Services in Rural Communities, (Programapara la Sostenibilidad de 10s Servicios de Agua Potable y de Saneamiento en CommunidadesRurales) 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 A1imentacidn) SCT Ministry of Communications andTransport, (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 FinancialSystem, (SistemaFinancier0 del Agua) SHCP Ministry of Finance and Public Credit, (Secretaria de Hacienda y Crkdito Pdblico) sP P I Investment Projects Information System, (Sistemade Informacidn de Proyectos de Inversidn) SNGs Subnational governments (states and municipalities) SOAPAP Water Utility Company of the State of Puebla, (SistemaOperador de 10s Sewicios deAgua 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) i v SUIBA UnifiedBasic Water System, (SisternaUnifcado 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-feetequivalentunit UDIs Inflation-LinkedUnits UNICEF UnitedNationsChildren's Fund U.S. UnitedStates WDI World DevelopmentIndicators WEF World EconomicForum wss Water Supply and Sanitation WHO World Health Organization WWTPs Wastewatertreatmentplants V Table of Contents 1 . AN OVERVIEW OF INFRASTRUCTURESECTORSINMEXICO ........................................... 1 A.Overview of Infrastructure Investments..................................................................... 1 B.Transport ..................................................................................................................... 4 7 D.Water Supply andSanitation.................................................................................... C.Electricity.................................................................................................................... 10 2. PERFORMANCE OF INFRASTRUCTURE SERVICES ............................................................ 15 A.Electricity.................................................................................................................. 17 17 Tariffs and Cost Recovery ......................................................................................... Outcomes................................................................................................................... 20 B.Spending 25 Water Supply and Sanitation..................................................................................... .................................................................................................................... 26 Outcomes................................................................................................................... 26 Tariffs and Cost Recovery ......................................................................................... 29 32 C.Roads......................................................................................................................... Spending.................................................................................................................... 34 34 Tariffs and Cost Recovery ......................................................................................... Outcomes................................................................................................................... 36 D.Spending ................................................................................................................... .................................................................................................................... 36 Railroads 37 E.Ports........................................................................................................................... 39 F.Conclusion................................................................................................................. 42 3. BUDGETING,PLANNING, AND COORDINATION .................................................................. 43 A.Budget Cycle-Investment Planning, Annual Budget, Execution, andEvaluation.43 43 Transport.................................................................................................................... Common Elements..................................................................................................... 47 Electricity ................................................................................................................... 56 Water Supply and Sanitation..................................................................................... 59 B.Lessons from Multisector Evidence .......................................................................... 67 Intrasectoral Coordination......................................................................................... . . 68 Transport.................................................................................................................... 68 Electricity................................................................................................................... 69 Water Supply and Sanitation..................................................................................... 70 C.Financing ................................................................................................................... 72 Conclusions and Challenges..................................................................................... 72 4. FINANCING MEXICO'S FUTURE INFRASTRUCTURE INVESTMENTS ............................ 75 A. How much? Meetingthe Infrastructure Needs of Tomorrow................................. 75 SimpleBenchmarking ............................................................................................... 76 Costing Set Targets-Pricing Universal Service Access .......................................... 77 Sophisticated"Benchmarking"-Econometric, Macro Models................................ 78 Sophisticated"Set Target"-Engineering-Economic Model Usedby Mexican Agencies .................................................................................................................... 79 vi Pullingit All Together ............................................................................................... 80 B.Implications 83 84 How to Maximize the Efficiency Impact of PPI ....................................................... Who finances the Infrastructure? ............................................................................. for Financing Needs.............................................................................. 85 Levels o f Private Participation inMexico's Infrastructure........................................ 85 Forms o f Private Participation inMexico's Infrastructure........................................ 86 C How Infrastructure I s Financed: CurrentExperience with Credit- Enhancement .Effects of Mexico's Imbalanced Approach to the Use of the Private Sector ............88 Schemes in Mexico........................................................................................................ 89 D.Analyses 89 Recommendations ..................................................................................................... o f Selected Existing InfrastructurePrograms ............................................ 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 of Local Financial Markets................................................................................. 96 Altering the Use and Design of Guarantees .............................................................. 99 Migrating Toward More Balanced Market Structures inElectricity and Water .....100 Redirecting BANOBRAS Activities toward Complementingthe Market .............101 Improving Program and Product Design................................................................. 102 5. A WAY FORWARD FOR INFRASTRUCTUREFINANCE ..................................................... 104 A. Synthesis of Findings............................................................................................. 104 B. Integrationof Recommendations........................................................................... 108 C. Prioritization of Recommendations ....................................................................... 115 6. ANNEX A NATIONAL FEDERAL ORGANIZATIONS AND PROGRAMS INWATER . SUPPLY AND SANITATION ................................................................................................................. 120 7. ANNEX B PAYMENT FOR ENVIRONMENTALSERVICESINWASTEWATER . TREATMENT-AN EXAMPLE OF PERFORMANCE-BASEDTRANSFERS .............................. 123 8. ANNEX C INTERNATIONALEXPERIENCE INTHE USEOF THE PRIVATESECTOR . 124 9. ANNEX D .PUEBLA TOLL ROAD SECURITIZATION-THE USEOF SPECIAL- PURPOSEVEHICLES TO MOBILIZE SUB-SOVEREIGNFUNDS ................................................ 131 10 ANNEX E THE PUEBLA BOT BUYBACK .......................................................................... 134 11.. ANNEX F ..CHILE TOLL ROAD CASE: USEOF MULTILATERAL GUARANTEESTO EXTEND TERMS AND ENTICEDOMESTIC PENSIONFUNDS .................................................... 136 12. ANNEX G TOLL ROADTOLUCA-ATLACOMULCO-THE USEOF LIMITED . CONTINGENT CREDIT LINES ............................................................................................................ 138 13. ANNEX H GUAYAQUIL WATER AND SANITATION: USEOF A MULTILATERAL . GUARANTEE TO COVER NEGATIVECONTINGENCIES INA MUNICIPAL WATER PROJECT .................................................................................................................................................. 140 14. ANNEX I .TLALNEPANTLA MUNICIPAL WATER COMPANY: A STRUCTUREFOR SUSTAINABLE FINANCINGAT THE LOCAL LEVEL INMEXICO ............................................ 141 15. BIBLIOGRAPHY ....................................................................................................................... 144 vii Listof Tables Table 1: Comparative Survey on the Quality of Infrastructure. 2003. Selected Countries ........................................................................................................................................... xv 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 inMexico compared to other countries ............................. xx Table 5: Water-Tariff Collection Efficiency ................................................................... xxv Table 6: Public Investment inMexico. 1993-2003 ....................................................... xxix Table 7: Public Infrastructure Investment. 1998-2003 .................................................. Table 1.1: Public Investment inMexico. 1993-2003 ..........................................................xxix2 Table 1.2: Public Infrastructure Investment. 1998-2003..................................................... 3 Table 1.3: Estimate of Subsidies for Electricity. 2003 ........................................................ 4 15 Table 2.2: Mexico's Electricity Coverage i s Comparatively High.................................... Table 2.1: Comparative Survey on the Quality of Infrastructure. 2003 ............................ 17 Table 2.3: Quality o f Electrical Service. 1995-2003 ......................................................... 18 Table 2.4: CFE: Degree of Cost Recovery. Price to Cost Ratios (%) ............................... 21 Table 2.5: InternationalElectricity Prices for Households (U.S. dollars per kilowatt-hour) Table 2.6: InternationalElectricity Prices for Industry (U.S. dollars per kilowatt-hour) ..23 ........................................................................................................................................... Table 2.7: Mexico's Water and Sanitation Coverage i s Comparatively High ..................23 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 2.11:Railroad Efficiency Indicators........................................................................ 38 Table 3.1: Evolution of Resources for Highways inthe Budget Process (Year 2003. in 1.000millions of Mexicanpesos)...................................................................................... 52 Table 3.2: Subsidies andAprovecharnientos 1997-2003................................................... 57 Table 3.3: Level of Water Abstraction Charges ................................................................ 60 Table 4.1:Different Approaches to Estimating ExpenditureNeeds inInfrastructure ......76 Table 4.2: A Simple Benchmarking Exercise: What Would it Cost for Mexico to Achieve the Infrastructure Coverage of 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 inRoads. Electricity. and Water and Sanitation Infrastructure- Past and Predicted................................................................................... 3 2 Table 4.5: Conditions for FINFRAFinancing................................................................... 90 Table 5.1: Principal Recommendations by Sector and Theme........................................ 109 Table 5.2: Mexico: PER-Prioritization o f Recommendations ..................................... 117 Table 5.3: MX: PER-Challenges inImplementing Longer-TermRecommendations119 Table 8.1: A Sample of Public and Private Contributions to Toll Roads inEast Asia ...125 Table 8.2: Private Participation inWater Services in2002............................................. 127 Table 8.3: Different Indicators of Water Reforms........................................................... 128 Table 9.1: Transaction for the Securitization of the Via Atlixcayotl .............................. 131 ... Vlll Listof Figures xvi Figure 2: Electricity DistributionLosses (%) ................................................................. Figure 1:Annual Interruptions (minutes) per Electricity Connection............................. Figure 3: Numberof ElectricityConnectionsper Worker inDistribution Segment......xvii xvii Figure 4: Quality of Water Service inMexico ................................................................ xix Figure 5: Quality of the RoadNetwork. 2000................................................................. xxi Figure 6: Distributionof ElectricitySubsidiesby Household Decile ........................... xxiv Figure 7: Post Tariff for a 2.800Twenty-feet Equivalent Unit (TEU) Ship (thousand dollars) ........................................................................................................................... xxvi Figure 8: The Share of PPIAllocated to GreenfieldProjectsHas Been Particularly High inMexico. 1990-2003.................................................................................................. xxviii Figure 1.1: Public Infrastructure Investment. 1998-2003inMxPm. by Sector ..................3 Figure 1.2: Organization Chart of the Secretariat of Communications and Transport and Figure 1.3: Structure of the Energy Sector.......................................................................... 8 other National Highway Institutions.................................................................................... 5 Figure 1.4: Water Institutions ............................................................................................ 10 Figure 1.5: CNA Expenditures and Revenues 1998-2004inMxP million....................... 12 Figure 2.1: Annual Interruptions (minutes) Per Connection ............................................. 18 19 Figure 2.3: Numberof Connections per Worker inDistributionSegment........................ Figure 2.2: DistributionLosses (%)................................................................................... Figure 2.4: Prices of Electricityin SelectedLatin AmericanCountries. 2002..................20 22 Figure 2.5: Distributionof Subsidies. by HouseholdDecile............................................. 24 Figure 2.6: Household Decile by Total Income. 2002....................................................... 24 Figure 2.7: Investment inthe Electricity Sector................................................................ Figure 2.8: InvestmentsinElectricity as a Share of GDP-International Figure 2.9: Quality of Water Service inMexico ............................................................... Comparison ....25 26 Figure 2.10: Investment inWater as a Share of GDP -International Comparison...........28 Figure 2.11: EstimatedFunding of Water and Sanitation Investment in 2004 .................32 33 Figure 2.12: Investment inWater and Sanitation by Subsectors. 1997-2002 (in constant prices) ................................................................................................................................ 33 Figure 2.13: Investment inWater and Sanitation by Urban and Rural Areas. 1997-2002 Figure 2.14: Federal Investment inRoads (million pesos. constant 2003 prices).............34 (inconstant prices)............................................................................................................. 37 Figure 2.15: Railroad Tariffs Comparison......................................................................... Figure 2.16: Public and Private Investment inRailroads (million 2003 pesos) ................39 39 Figure 2.17: Port Tariff for a 2.800 Twenty-feet Equivalent Unit (TEU) Ship (thousand dollars) ............................................................................................................................... 41 41 Figure 3.1: 2001/2006 Program Original Goals andExpected Progress........................... Figure 2.18: Public and Private Investment inPorts (million 2003 pesos) ....................... 49 Figure 3.2: PlannedCompared to Executed Highway Investments. A Sample of Projects Figure 3.3: Electricity Sector PIDIREGAS Investment Projects (million 2004 pesos) ....58 ........................................................................................................................................... 54 Figure 4.1:Private Participation in Infrastructure Has Been LimitedinMexico. Relative to its Peers inLatinAmerica. 1993-2002.......................................................................... 86 ix Figure 4.2: PPIinMexico has Disproportionately Favored Production and Generation Rather than Retail Utility. 1990-2003 ............................................................................... 87 Figure 4.3: The Share of PPIAllocated to GreenfieldProjects Has Been Particularly High Figure 4.4: Local Market and Institutional Investors Development (% of GDP) .............97 inMexico. 1990-2003........................................................................................................ 88 Figure 4.5: AFORES's Assets Under Management.......................................................... Figure 4.6: Bonds as a Percent of Total Project Finance (1996-2004).............................. 98 98 Figure 5.1: Framework for Prioritization of Recommendations.................................... 116 Figure 9.1: Securitization of the Via Atlixcayotl Structure............................................. 132 Figure 14.1: Tlalnepantla MunicipalWater Structure..................................................... 142 Listof Boxes Box 3.1: Planning andBudget Integration: Past andFutureOptions................................ 44 Box 3.2: Steps inFormulating the FederalSpending Budget ........................................... 45 Box 3.3: Procurement........................................................................................................ 47 Box 3.4: Criteria Followedby SCT for Setting Priorities for Road Investment ...............51 Box 3.5: Pork-Barrel Spending.......................................................................................... 53 Box 3.6: Mexico's Systemof Water Abstraction Charges................................................ 60 Box 3.7: Innovative Chiapas State Government Technical Assistance to Municipalities 62 Box 3.8: Decentralization of Water andSanitation Services inMexico........................... 71 Box 4.1: The Growth Dividends of Better Infrastructure.................................................. 77 Box 4.2: Case Review: The PueblaBOT Buyback Compared to the PueblaRoad Securitization..................................................................................................................... 94 Box 4.3: Federal Influence to Improve MunicipalWater Sector Policies......................... 96 X Acknowledgments This report was prepared by a team of Bank staff led by Gustavo Saltiel and Steven Webb, and structured on the basis of 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 of the PER chapters was organized inthe 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 from Tito Yepes Chapter 5: Jonathan Halpern Many people in the Government of Mexico, especially Dr. Luis Albert0 Ibarra (Chief of the Investments Unit of SHCP) and his team, in particular Jorge Castarih, Raul Flores, and Nicol6s Kubli, provided excellent guidance and collaboration in the preparation of 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 of 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. x i PREFACE Over the past five years, the World 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 of 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 of 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 to and quality of infrastructure services in a context of tight public resources, a more thorough analysis of public expenditures in infrastructure and other potential sources i s warranted. Therefore, the World Bank and the Ministry of 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 of the four pillars of the Mexico Country Assistance Strategy: Institutionality, Competitiveness, and Poverty Reduction. As part of the analytic work on public finance, it i s geared at improving the understanding of critical governance and expenditure-allocation issues. Finally, given the multisectoral linkages o f infrastructure with poverty reduction, competitiveness, and growth, the study is meant to help clarify the agenda for the government's strategy in all these subjects. The main objective of 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 with the government's goals for economic growth, and within its fiscal constraints. Three infrastructure sectors-water supply and sanitation, transport, and electricity- have been selected for inclusion inthis PER for the following reasons: Impact on growth, trade, and competitiveness Social importance interms of poverty reduction Importance inthe Government's stated policy priorities. The study has been structured in five interrelated chapters as follows: xii Chapter 1 presents an overview of the infrastructure sectors-agencies and aggregate spending-which sets the stage for the assessment of the sectors' performance and an in- depth analysis of budgeting processes, planning, and coordination presented in subsequent chapters. Chapter 2 reviews the levels of spending on the selected infrastructure sectors inMexico, and existing cost-recovery mechanisms, and the related outcomes: quality and efficiency of service, and extent of coverage being offered. To explain these outcomes, Chapter 3 analyzes the processes o f planning, spending allocation, and coordination within and across subsectors. The role of local governments and the nature of incentives they face are also discussed. Chapter 4 discusses the effectiveness of the existing programs in Mexico to encourage private participation and financing in the selected infrastructure sectors. The challenges for infrastructure development will require new and different uses of 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 of conclusions and recommendations to improve the efficacy of Government's interventions inthe provision and financing of infrastructure. Finally, since the study focuses principally on issues of infrastructure spending and finance, i t does not address all facets of infrastructure service delivery, nor does it provide detailed roadmaps for implementation. Rather, this study should be viewed as a point of departure for dialogue and consensus building on ways to better and more fully use current and potentially available resources in the provision of basic infrastructure services. xiii Mexico: Infrastructure Public Expenditure Review (IPER) Executive Summary 1. In 2003, the Government of Mexico spent about 1.2 percent of gross domestic product (GDP) on infrastructure investment and maintenance (electricity, transport, water supply, and sanitation), and provided 0.7 percent of GDP on untargeted consumption subsidies for the electricity sector. This i s a substantial amount of resources, although not high by world standards, and yet the overall impact has been mixed. Mexico has a reasonable level of coverage relative to Latin America (as it should, given that it i s one o f the richest countries of the region); rail and port performance are reasonable by international standards, and some water utilities are well run. The quality and reliability of infrastructure services, however, are generally below what could be expected of an upper-middle-income country, and many poor Mexicans still lack access to basic services. In addition to hurting the standard o f living of Mexican citizens, the poor quality of infrastructure impedes competitiveness. 2. Looking forward, present spending levels may be sufficient for Mexico to achieve universal coverage in water and sanitation and electricity, to modernize and complete its major transport corridors, and to improve the overall quality and reliability of service. But this will require substantially improved expenditure efficiency, a much more strategic use of the private sector, and better targeting of subsidies. Maintaining current government spending levels between 1 percent and 1.25 percent of GDP, Mexico would remain around the Latin America average in both infrastructure coverage and expenditures, but it would not reach the level of 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 interms of infrastructure endowments).' 3. A central message of this report is that the resources Mexico spends on infrastructure could and should be better used. How the government uses its own 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 of government, the introduction of multiyear planning and budgeting, and greater emphasis on 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 is private sector participation in service delivery-increasing its volume, expanding its scope to include core utility services beyond the current confines of greenfield up-stream production, and reducing its cost to Mexican tax payers by limiting the government In 1960 Korea had less than half Mexico's paved road density; today it has 11 times more. In 1969, Korea had one-third the power infrastructure per capita o f Mexico; today it 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 of both the public and private sector would have greater impact with the deployment of mechanisms to foster greater transparency and accountability, including increased reliance on arms length regulation of monopoly service providers. Coverage, Quality, and Efficiency: The Current Status of Infrastructure Services 4. Mexico has made steady progress in increasing the coverage of roads, electricity, and water and sanitation over recent decades, reaching levels among the highest in Latin America. While there are still some gaps inaccess, notably inpoor, 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 andrailroads (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 of Mexico's main electricity provider, the Comisidn Federal de Electricidad (National Electric Company, CFE), has improved but still lags behind international standards and client expectations.* For example, when annual interruptions and distribution losses are compared to Latin American private distribution companies, * As measuredby service interruptions and the number o f customer complaints. xv the CFE's performance i s poor3(Table 2 and Figures 1and 2), and the service quality and operating efficiency of the other electricity provider, Luz y Fuerza del Centro (LFC), are even worse. Table 2: Quality of Electrical Service, 1995-2003 -Notavailable. 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: CFEfinancial data; and Andres, Foster, and Guasch (2005). No 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 of 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 still performed poorly (Figure 3). Figure 3: Number of Electricity Connections per Worker inDistribution Segment 3000 -, I 2500 1 P 2000 1 / -+--PERU Edelnor -PERULuzdelSur I 1500 - &.- -.,..,+A- .---A --c.CHILEChilectra I -BRAZIL Electropaulo 1000 jI -ARGENTINA Edenor I -m- ARGENTINA Edesur 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 of the region and o f other developing countries (Table 3). Approximately 90 percent of 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 from 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 is comparatively High Sources: Data from WDI (2003a) and CNA 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 of the levels achieved in other OECD countries and upper-middle-income countries. The share of 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 of treatment plants do not comply with norms for effluent discharge. According to the 2000 census, only 45 percent of 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 of 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. CNA (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). ''Avila Own calculation, basedon census data quoted inAvila (2004), spreadsheet named Anexo I.CC-Agua. (2004) basedon census data xviii Figure 4: Quality of Water Service in Mexico 100% 5 h 90% .-eP U 80% LI 70% 60% 50% 40% 30% 20% 10% 0% Poor people in cities Not poor peoplein Poor people in Not poor people in cities townsand 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 of 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 of water supplied. loCNA (2004a), "Situaci6n del Sub-sector," p. 42. Calculated based on a sample of 157 service providers with reliable data. ''The average for 38 utilities in the State of 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 Water in Mexico compared to other countries Country (city) Year Non-revenue Water(%) . United Kingdom (average', 2000 14 Sources: CNA (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 is from Tynan and Kingdom (2002). Transport 10. In the transport sector, the need to improve quality is most evident for roads. Under pressure from 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 of 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 of service. 11. As a result of insufficient investment in maintenance and modernization, the condition of 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. Roaduse has risen significantly over the last decade, with road transport by bus and truck currently accounting for 99 percent of domestic commercial passenger traffic and more than 78 percent o f surface freight cargo. Following trucking deregulation in 1989, and the advent of the North American Free Trade Agreement (NAFTA), trucking activity has grown by 32.5 percent, and the authorized weight of 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 of 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). Inaddition, the large number of owner-operators leads to inefficiencies and limits economies of 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 co~ntries'~ (Figure5). Overall, the maintenance and improvement of main federal corridors, although showing a positive trend, still lag behind demand. State and municipally controlled roads are inparticularly bad condition, especially in rural areas.15 Figure 5: Quality of the Road Network, 2000 Quality of the Road Network, 2000 IUGood ESatisfactotyUDeficient I - trdia Canada Czech Denmark Hurigdy Mexicb New PortlgalSouth Africa SwedLn Switrerlahd Republic Zealand 13. Structural reforms, including privatization, have enhanced the quality and efficiency of service of Mexico's railroads and ports, although they still fall short of international best practice. The rail industry shows a diminishing a number of accidents per kilometer, better use of assets (as shown by the higher number of tons per locomotive), improved service quality (as indicated by the lower number of losses and claims), and a more efficient use of fuel (Guerrero 2004). However, efficiency still falls short of 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 still experienced inmoving cargo from terminal to rail or truck transportation. This i s due not 13Communications and Transport Sector Program 2001-2006. l4See Guerrero (2004). The source of data is the PIARC. l5There is 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 to weak trade facilitation procedures and user/agent behavior in managing their logistics chains.16 Tariffs, Subsidies, and CostRecovery 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 of Revenue sets the electricity tariffs and the water abstraction charges owed by the local water operators and those enterprises drawing water from the source. The office strives to follow technical considerations of 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 of safety-net programs reaches the poor and not many of the non-poor, and that the rates give appropriate incentives for conservation. Pursuitof 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 to basic services and reducing charges, such subsidies are not usually the optimal way to help the poor. As 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 of federal, state, and municipal stakeholders involved-produces a wide variation in the degree of 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 low 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 by states and municipalities. One of the major subsidies-in electricity-is financed through the nonpayment of 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 of 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 of 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 of poverty targeting in its transfers to subnational governments, mostly through a fund to support social infrastructure- FAIS (a budget category of Ramo 33).17 In 2002, 44 percent of the investments funded by FAIS 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 of 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. Inthe transport sector, toll-road tariffs are highby international standards, despite recent reductions on federal routes. This diverts too much traffic to free roads and contributes to growing congestion problems. Toll setting has been based mostly on financial needs, for which FARAC debt weighs heavily, rather than economic considerations which incorporate demand patterns and country competitiveness concerns; the FARAC 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 of good-quality service, demonstrating that such models can work inMexico. Electricity 19. In electricity, average tariffs still fall short of 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 of the cost of supplying these consumers. However, average residential and agricultural tariffs covered only 42 percent and 28 percent of cost, respectively, during 1997-2003. The incidence o f residential subsidies stemmingfrom current tariff structures is 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 of OECD countries and the United States. Independent sources indicate that peak industrial electricity tariffs are more than four times higher than the costs of producing electricity on-site with diesel-based thermal plants." High industrial tariffs have led to an increasing trend toward self-supply b y industries duringpeak 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. '*Ramoan 33 is a budget allocation that aggregates all the earmarked transfers to subnational governments. For analysis of 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. l9 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 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 from highly subsidized rates. Poverty criteria are absent in the determination of 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 of even crude assessments of marginality are mildly progressive, while increasing-block tariffs,*' which are common in Mexico and in many other developing countries, benefit mainly the better off because the middle blocks are also subsidized and non poor households tend to consume more than the poor. Figure 6: Distribution of Electricity Subsidies by 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 of subsidized water to upper-income users. 2o With an increasing-block tariff, consumers face a low volumetric per-unit price up to a specifiedquantity (or block), and then for any amount consumed over this quantity, they pay a higher price up to the limit of the secondblock, 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 by 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, it seems that the sector generates only a very modest cash surplus, which is well below the financial performance achieved by the top quartile of 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 of 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) 2001 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 (cuotafija) independent of consumption. In a few instances, flat rates are differentiated by neighborhood, and sometimes sharply so. For example, in the Federal District the flat rate in the highest cadastral category is 20 times higher than inthe lowest. Since the level of water consumption does not vary that much among income groups, this type of water tariff may have a progressive incidence. Geographically differentiated tariffs that are *'The lower figure i s taken from CNA (2003), "Situacibn del Sub-sector," p. 38, and i s calculated from a sample of 437 localities in all states. The higher figure is taken from Barocio (2004), based on extrapolations made from a sample of 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 of 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 by 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 by 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 low share of 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 of 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 infrastructureuse include two main categories: charges to vessels and charges to cargo. International comparisons are of limited value, since these two concepts are not homogeneous across ports. Mexico charges low 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. Figure7: PostTarifffor a2,800 Twenty-feetEquivalentUnit(TEU) Ship (thousanddollars) 300 250 200 150 100 50 0 Source: InstitutoMexican0 para la Competitividad (2003). xxvi PrivateSector 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 of the first countries in Latin America to attract significant private participation in infrastructure (PPI), but after the collapse of 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 by 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 of Latin America, PPI in roads, water and sanitation, and electricity has mostly taken the form of concessions or divestitures for existing infrastructure and expansion o f networks to serve additional segments of the population (see Figure 8). Mexico's lack of reform of existing service providers has limitedthe efficiency gains that usually occur from involving the private sector in the running o f infrastructure services (improvements in commercial and technical efficiency). Moreover, PPIinvolvement has typically taken the form of "take-or-pay" agreements with substantial guarantees from the government. These implicit but costly forms of fiscal support have been necessary because private producers could not be enticed to sell their output to public utilities which were not, in and of themselves, financially viable purchasers or if creditworthy, were subject to government controls which raised risk of future payment capacity. xxvij Figure 8: The Share of PPIAllocated to Greenfield Projects HasBeenParticularly 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 is all the more surprising given Mexico's good sovereign risk and credit ratings, its macroeconomic stability and general success in attracting foreign direct investments, and the depth of local capital markets. Indeed, Mexico i s probably one of the few developing economies today that could fairly easily attract substantial amounts of 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 by the Federal government. Investment: How Muchis Spent and Needed,for What, andWhere? Overview of Infrastructure Investments 32. Public investment in Mexico has fluctuated substantially with the federal political cycles, with peaks in years of Presidential elections (1994, 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 of 1997, partly because of 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: PublicInvestmentinMexico, 1993-2003 Billion 2003 Annual M x Pesos % GDP 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 2001 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. It appears that infrastructure investment has not kept pace 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 7).23 (PEMEX investments were increasing strongly.) Nevertheless, the absolute amount of resources invested in the sectors covered in this report increased from MxP64 billion (2003 pesos) in 1998 to MxP83 billion in 2003, or from 1.1percent of GDP to 1.2 percent. Table7: Public InfrastructureInvestment, 1998-2003 1998 64 39% 1.06% 1999 64 36% 1.02% 1 2 o o o I 69 I 31% 1 1.04% 1 2001 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 is 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 in2003. 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 of 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 of GDP. This does not include the electricity subsidies, mentioned earlier, which are for consumption purposes, but it 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 is fraught with difficulties-it depends on sectoral goals in terms of 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, by modestly increasing expenditures on maintenance and investment, Mexico should be able to improve the quality of its infrastructure and achieve some key policy goals (such as universal coverage in water and sanitation and electricity, and the completion of 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 of major policy goals (such as universal coverage in water and sanitation and electricity) increases this estimate somewhat to about MxP102 billion. Depending on GDPgrowth performance, this would represent 1percent to 1.25 percent of GDP. 39. Such a rate o f spending, however, would not allow Mexico to reach the level of infrastructure per capita of other OECD countries or faster-growing East Asian countries. Indeed, countries like the Republic of 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 of infrastructure quality and coverage. This highlightsthe urgency of reallocating untargeted subsidies-such as the 0.7 percent of GDP currently spent on electricity consumption subsidies-toward productive investment and maintenance, and of improving expenditure efficiency more generally. 40. Looking at individual sectors, the primary financing challenge for the road sector will 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 of financing will have to increase by 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 will mobilize large amounts of money, given the shortcomings of the current PIDIREGAS scheme (which will probably decline as a source) and other structural constraints discussed below. 42. For water and sanitation, the highest priority will be to use existing funding more efficiently, by reducing unit costs and focusing more on rehabilitation and maintenance. Any 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 of resources and timing required to meet the social goals of universal coverage are sensitive to the prospect of improving (or not) the efficiency of the use of funds and the delivery mechanismfor those resources. 43. Responding to the need for increased resources and, most important, increased efficiency in the use o f these resources, will 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 of the infrastructure service from the taxpayer. If 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 of a non- toll road), that portion of the subsidy transfer which i s greater than the value of externality produced by 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 to its impact on equity, the setting of 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 of consumers. a Efficiency gains can be realized through competitive biddingfor the provision of sunk assets (such as electricity generation facilities) and for long-term arrangements for operations of commercial services. For any of these potential efficiency gains (due to lower operating costs and, possibly, capital costs), to be passed on to consumers by public or private monopolies requires proper regulation or oversight. Institutional Challenges 44. Achieving better quality, access, and efficiency in infrastructure services will require stronger institutional arrangements, with increased coordination and planning within and across sectors, and greater accountability. The role of the Government in infrastructure planning has changed over time, shifting its focus from public investment programs to issues of strategic direction, decentralization, private sector participation, and financial support. Central coordination i s essential, given the cross-cutting nature of these issues and their economic and political impacts. Disjointed decisionmaking about funding allocations has contributed to sector outcomes not linked with 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 pursuethe government's objectives of enhancing competitiveness and reducing poverty. 45. Closer coordination between the planning processes of 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 of transportation. One area to focus on 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. To strengthen planning and link it 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 operations and maintenan~e.~~Such envelopes would be indicative and need subsequent 24Annexes 4 and 6 of the budget give projections of 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 of future investment totals, because most individual projects will end in the current fiscal year, so the future-year aggregatesare always much less than half of the present year. xxxii Congressional approval in each year's budget. CFE already follows this approach and the Secretaria de Comunicaciones y Trunsportes (Ministry of Communications and Transports, SCT) i s moving in that direction. The use of 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 of 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 of 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 of 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 leadto greater transparency. The Way Forward-A Better Use of Publicand Private Resources 49. O f the seven recommendations of this report, three apply to public sector funding, two to private financing, and two to the overall institutional environment. First,public investmentneeds to make more effective use of taxpayer resources and to refocus on areas that the private sector cannot finance. This means reducing the role of the government in financing the electricity sector and toll roads, which have made substantial fiscal demands (many of them off-budget or contingent) and for which there i s significant scope for increased private participation. B y the same token, it implies improving the efficacy of 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 to the statutory monopolies of CFE and LFC. It i s precluded from the water and sanitation sector, due to the natural monopoly characteristics of 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 of infrastructure, but the structure and coverage of federal financial guarantees have muted the incentive impact on operators' performance, as discussed below. 51. 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 of 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 of 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 to such spending i s much higher than to new investments. Examples of strategic segments of 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 of 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 of the poor to the service and extending coverage insmall localities. To the extent that consumption of these groups merits subsidization, it should be limited to satisfying minimumbasic needs. Moreover, delivering service to the poor need not be costly, and relaxing technical norms governing choice of 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 of federally funded programs and thus reduce the magnitude of subsidies from budget, closer coordination is required along several dimensions: between sectoral agencies and the Ministry of 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 of concessional resources for investment. Hence, Mexican taxpayers, largely outside the localjurisdiction, bear the cost of local pricing and investment decisions. 55. Even with limited competition, regulation, and financial market involvement, however, the government could still discipline operators' performance by 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 sistemafinanciero 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 for infrastructure could be 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 of arms-length regulation strongly limit investor interest. Rather than having taxpayers assume still greater risks to attract private finance (as has been the case in power generation with the substitution of Optimal Power Flow for IPP contracts), efforts should be directed at the source of the uncertainty: namely the likelihood of political interference in the capacity of 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 inthe electricity and water and sanitation sectors. 58. Fifth,federal credit enhancements will be required to attract sizable sums of private funding from domestic and international sources, but their design and functioning need revision. To date, projects under federal jurisdiction have generally been backed by full guarantees of cash flow (for example, PIDIREGAS for electricity and the New Concession Scheme for transport) or equity returns (FINFRA). This requires the government to take on more risks than necessary, and hence carry commensurately larger contingent liabilities. Since the Federal Government has an investment-grade rating on sovereign debt, it could offer narrower types o f guarantees in the form of negative covenants, such as insurance against political and regulatory risk. For subnational projects, negative covenants may also reduce financing costs, but the enhancements will also require some kindo f security based on assets or cash flow. These xxxv could take the form of 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 of private investment as legal opportunities for that are opened. Improving sector performance will 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 of access and service quality, the required levels o f investments and potential sources of 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 of consistency in policy and investment planning across hydrologically and politically interdependent geographic areas, and of administrative and financial capacity and the ability to 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 of institutional arrangements should be considered. For investors and operators to take on some risks now borne by 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 of 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 of state water commissions and municipal agencies in performance monitoring, planning, and the revision of 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, it 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 will require measures like the following: regular reporting by subnational governments on the use of federal transfers, especially Ram0 33FAIS; standardized reporting on performance of water companies through an expansion of CNA'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 will use existing funds more efficiently, save money, or bring in more. Improving the selection of 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 will take time to bear fruit. Bringing more money in and improving targeting of consumer subsidies by raising water and electricity rates (closer to costs) on consumption by 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) will probably have to wait for the new government in 2007, incorporating this into the next National Development Plan so that it will be a more practical guide for infrastructure budgeting. With such a plan and more resources coming in, it would then be appropriate to organize a sustainable increase in infrastructure investment. 66. An improved regulatory framework will make it possible to attract more private sector participation without the sort of 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 its responsibilitiesas a partner of the private sector. xxxvii 1. ANOVERVIEW OFINFRASTRUCTURESECTORSINMEXICO 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 of infrastructure services in order to generate economic growth, improve international competitiveness, and reduce poverty. This will require improving the efficiency of investment allocation and generation of additional resources through more effective institutional frameworks, efficient delivery of 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 of infrastructure with increasing private sector involvement. The outcomes still fall short of 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 to finance infrastructure. 1.3 The institutional framework for infrastructure services provision in Mexico consists of a complex set o f formal rules and informal practices among a large number of organizations. These organizations often face constraints to their autonomy, and have widely different levels of capacity, resources, and influence. Many infrastructure agencies are politicized, and the division of roles and responsibilities among the different agencies i s often not clearly defined. 1.4 The structure and roles of the agencies participating in infrastructure services planning, financing, and provision varies among sectors, and entail varying degrees of complexity that depend on the specific sector and the interrelations of functions and responsibilities at the three levels of government. 1.5 This chapter provides an overview of investments in infrastructure and describes the structure of agencies and institutional arrangements in the infrastructure sectors, setting the stage for the review of the sector performance and a profound analysis of 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 of 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:PublicInvestment inMexico, 1993-2003 Billion 2003 Annual M xPesos % GDP 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 2001 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 inbold italics. Source: INEGI, National Accounts. 1.7 Information on investment expenditures in infrastructure was compiled for the purpose of this report based on data provided by sector agencies and on an estimate of infrastructure expenditures under FAIS (Rarno 33's fund to support social infra~tructure).~~ A similar approach of aggregating data from sector agencies has been used for subsidies.26 The reliability of the data thus i s equal to the reliability of the underlying sector figures. 1.8 With these caveats in mind, it 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 of resources invested in the sectors covered in this report increased from MxP64 billion to MxP83 billion, or from 1.1percent of GDP to 1.2 percent. ~ 25Public 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 by the Mexican sector agencies (SCT, CNA, CFE, LFC) in the investment figures. The increase for water investments in 2002 is partly due to the inclusion of investments outside CNA programs that were not available for earlier years. 26For 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 of sectors that are not included in this report. 2 Table 1.2: PublicInfrastructureInvestment, 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% 2001 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. Figure1.1:Public InfrastructureInvestment, 1998-2003inMxPm,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, LFCand 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 of 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), amountingto MxP49 billion in 2003, or 0.7 percent of GDP. 3 Table 1.3: Estimateof Subsidiesfor Electricity,2003 financed byCFE(off- I 49 I 0 I 49 Other Subsidies (LFC 1 1 I 1 operation and FAIS) 21 2.9 23.9 0.35% Total 70 2.9 72.9 1.08% B.TRANSPORT 1.11 Transportation i s the largest category of public investment funded from the central budget. The roads subsector i s by far the largest, with almost 90 percent of the budgeted public investment at the federal level. Transport i s partly decentralized, with participation from all three levels of government, but in roads the dominant actor i s the Federal Government. It builds and maintains the main roads-toll and toll free-which are the skeleton and arteries of the network to which local roads connect. Many roads now classified as state and rural roads were originally constructed by the Federal Government and have been turned over to the states and municipalities in the past decade (World Bank 2003b). I. TheSecreturiudeComunicucionesyTrunsportes(SCT)handlestheinvestment 12 and maintenance of 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 FARAC under the Ministry of 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 of their own revenue and financing, largely outside of the federal budget, and are owned by (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). New urban systems are being concessioned, and although no federal expenditure i s yet linked to this initiative, it may have a future fiscal impact. Although airports and urban transportation are important parts of subnational public expenditure, they are not analyzed inthe 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 o f o f Coord. o f I and SCT Transport Commu- Ports and Centers nications Merchant ~ 1.13 Figure 1.2 shows the organization of 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 own 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 toll bridges (including international ones) and toll roads (eventually about 1,000 kilometers) that the government built up to the early 1980s, financed with a mix of oil revenue and general government borrowing. It 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 it efficiently. *' Trucking, regulated by the Undersecretary of Transport, is an important complement to roads. Deregulation of the trucking industry at the federal level in the 1990s greatly widened the range of choices to haul cargo, and opened the way for rapid increases in the number of 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 of bigger and heavier trucks, as well as a larger number. The Mexican Government i s planning further reforms to facilitate the movement of the freight between the United States and Mexico. 5 1.15 In 1989, after recovering from the 1982 debt crisis, Mexico started buildingtoll roads again (about 4,500 kilometers by 1994) under build-operate-transfer (BOT) agreements with private firms. Construction took place between 1989 and 1994, with guarantees from the Federal Government. During the crisis of 1995, they went bankrupt and the Federal Government took over the roads and the debt-worth almost US$6,000 million. To keep the liabilities off the federal books, which were constrained by an International Monetary Fund (IMF) program at the time, afideicomiso (trust) (FARAC) was created under BANOBRAS to take over the debt and title to the roads. FARAC had (and has) virtually no administrative structure or capacity, and hence it contracted CAPUFE to operate and manage its network, in return for a flat rate of 30 percent of tolls collected. Thus, as long as costs do not go above the generous slice of revenue, CAPUFE continues to lack incentives for efficiency. 1.16 With the general economic recovery since 1995, and especially the effects of NAFTA, FARAC's network has generated more than enough revenue to service the original debt. Rather than paying down this debt ahead of schedule, however, FARAC has issued new debt to finance some new investment, and in 2002-03, to purchase the old network from CAPUFE.29 With the latter transaction, FARAC 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 by FARAC has been modest thus far-mainly doing clearly needed modernization and connections. If it gets more ambitious, however, it will face pressure to be linked with the wider technical and political process of investment allocation. 1.17 Having an autonomous agency in charge of toll roads i s consistent with international best practice, as in Spain, Italy, and France, but FARAC will need more institutional capacity and appropriate institutional oversight if it 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 of Mexico's transport system, in terms of quality and rate of improvement in service and in terms of service charges covering costs (see chapter 2 for more details). The restructuring of 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 of 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 of coordination among the companies prevents full interconnectivity among railroads. The 29The money to purchase the roads from CAPUFE went to Federal Government coffers (as capital income), essentially enabling it to borrow off 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 by 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 by creating Integral Port Authorities (APIs), which are public entities that engage private operators within the ports. As the manager of the Veracruz port explained, "it i s like a shopping mall, where the mall owner decides what range of 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 of new terminals and expanded the range of 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 is 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 of Mexico City i s served by Luz y Fuerza del Centro (LFC), which accounts for 23 percent of national electricity distribution and 2 percent of generation. As shown in Figure 1.3, CFE, LFC, and Petr6leos Mexicanos (PEMEX, the federal oil and gas company with a monopoly on that sector) report officially to the Secretary o f Energy. However, their strong traditions, politically appointed heads, own 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 Secretariade 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) - t Compafiia Mexicana I Instituto Nacional d 4 de Exploraciones Investigaciones Nucleares Instalaciones Inmobiliarias Industrias (I11Servicios) STATE-OWNED Sources: Adapted from Manual de Organizacidn General de la 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 LFC thus are outside the scope of CRE. 1.22 It is considered good practice in the electricity sector to have an independent system operator in charge of transmission and dispatching. In Mexico, however, CFE itself i s in charge o f the operation and administration of the National Power System through one of its 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 of Corporate Transformation, which included the simulation of 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 of the main cost centers. After those units were defined, CENACE began to operate a virtual (simulated) internal energy market (EM), which takes into account external variables (like the prices of fuels) and internal factors (like the thermal efficiency of plants). Statistics o f the EMhave been constructed since 2000 and helped in evaluating the effect of potential bilateral contracts between divisions and CENACE on the stability of electricity prices. To 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, its work i s hardly reviewed and taken into account by internal CFE units or government entities such as CRE. Indeed, since CENACE is not an independent entity, its capacity to provide with transparent reliable information i s not clear under the current institutional arrangement. Likewise, the confluence of restrictive administrative norms and union resistance to rescaling of compensations based on unit's performance, have further prevented the implementation of the Program of Corporate Transformation. 1.24 An important arrangement in the energy sector is 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 Two variants of the scheme exist. The Direct PIDIREGAS scheme is a basic finance, build and transfer operation, whereby CFE commits to purchase a specified asset, such as a generating plant that has been built by a private contractor. During the construction phase, the contractor provides the financing required. Upon completion, CFE purchases 31 The IMFagreedto the arrangement. Althoughthe budgetdeficitonly includesPIDIREGASwhen, inthe future, actual payments are made, SHCP since 2001 has been publishing the Public Sector Borrowing Requirement, a broader measure that includes the direct PIDIREGAS investmentsand accrued interest, net of amortization. The PSBRdoes not include conditionedPIDIREGAS, although the paymentsto operators are countedas outlays inthe current budget. 9 the asset with long-term financing mobilized by 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 of this, conditioned PIDIREGAS become contingent liabilities to the government. More than a contractual agreement, the PIDIREGAS scheme i s a type of guarantee instrument that supports off-balance sheet financing. 1.25 An office in the revenue sub-secretariat of SHCP sets the electricity tariff schedules, which vary by sectoral usage and for the summer season by region according to temperature (air-conditioning demand). For industrial users there are technically sophisticated cost-recovery tariffs that take account of 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 LFC to the states and municipalities. A substantial part of these investments i s financed through FAIS. A similar share i s financed by both the National Commission for Indigenous People and SEDESOL, focusing on grid extension. Once a system has been constructed, its 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 by other programs or initiatives that ensure rural economic development. The implementation of 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 SUPPLYAND SANITATION 1.27 Although water, like all natural resources in Mexico, is constitutionally the property of 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 of water supply and sanitation services rests with local government, comprised of 2,446 municipalities and almost 200,000 villages and hamlets. Municipalities and municipal water companies (organimos operadores, 00s) provide service to most customers, and state water agencies handle the rest, including in municipalities (about 1,000 out of 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 Law created the basin agencies (organismos de cuenca) with an important but yet undefined role in the sector. Thus, the functions of institutions at various levels of government overlap, as indicated inFigure 1.4. Figure 1.4: Water Institutions 32See chapter 3 and World Bank (2004a,b) for more details. 10 FederdLevel pzGGiiq...........IUtlLyBoardsFbbirayors 1 Localh e 1 p l 6 rmnicipalities) .... I 1 1.28 The federal Comisidn Nacional del Agua (CNA) is the apex institution of the sector. CNA i s formally under the authority of the Ministry of Environment (SEMARNAT), but enjoys considerable de facto autonomy. Its Director General i s nominated by the President of the Republic. Created in 1989 with a staff of 38,000 at the time, it now has 17,000 employees, most of who work in the agency's 13 regional branches and 20 state branches. CNA financed or undertook itself only about one-fourth of the investment in the sector, but it still 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, of which about one third is allocated to water and sanitation, while the remainder is split between irrigation (hidroagricola), water resources management, flood protection and personnel services. Within the category water supply and sanitation, the largest spending item is the operation and maintenanceof bulk water supply systems, accounting for MxPl.85 billion (the largestof which is the Cutzamala system serving the Mexico City metropolitan area). Although municipalities are required to pay for the bulk water suppliedto 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 of the country. CNA's main source of 11 funding is 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 of 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 Box 3.6. It also gets revenue from federal budgettransfers, external credits, and bulk water sales.33 Figure1.5: CNA ExpendituresandRevenues1998-2004inMxPmillion 18000 16000 14000 12000 - 10000 0Revenues 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 of the National Water Law mandated the creation of 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 to play a key role in the administration of the Water Financial System (Sistema Financier0 del Agua, SFA) introduced through the recent amendment of the Water Law.34 The directors of the Basin Agencies, which are supposedly autonomous, will be appointed by CNA. There i s considerable uncertainty about the scope, form, and timing of the restructuring process and decentralization of CNA, the creation of 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. 33Billedbulk water revenues were MxPl billion in 2002. It is 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. 34The exact role of the basin-level institutions inthe 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 of the State Ministry of Public Works. Their attributions differ widely among states. In 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 of 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 by 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 of municipalities served by 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 CEA 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 of different policies and programs, a variety of 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 of 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 to best practice, usingthe standard technical and financial indicators (see chapter 2.)35 Examples include the Public Service Commission of 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 of municipalities. This includes both service providers and direct provision by 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 of 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 CNA estimates, general managers o f service providers hold their positions for an average of 1.5 years (Kemper and Alvarado 2001:629), and 35 This would consist o f a collection efficiency of more than 90 percent, non-revenue water of less than30 percent, a working ratio of 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 of debt and the payment of bills by the municipality on behalf of 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 of service providers that are efficiently operated on a commercial basis. The best of these service providers self- finance a substantial proportion of their investments, have been rated by credit rating agencies, and at least one-the service provider of 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 of 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 by local government or by user groups, which sometimes take the form of cooperatives. In some cases, the state water commission provides services in rural areas at the request of villages or municipalities. 1.37 Many of the larger service providers are members of 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 of the actors at the state and local level has been increasing over the past two decades, CNA remains the sector's dominant actor in terms of determination of policies, subsidy programs, and norms in water supply and sanitation. The existence of 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 to certain regulatory and normative tasks and are often fragmented among various institution^.^^ The concentration of expertise and power in a single federal institution provides some advantages, but it also means that checks and balances are limited, due to the lack of expertise on the sector that i s independent of 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. PERFORMANCEOFINFRASTRUCTURESERVICES 2.1 Mexico has made steady progress in increasing the coverage of 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 of service and operating efficiency in the infrastructure sectors covered by this report lag behind other middle-income countries, as shown in a 2003 World 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 by electricity. Interestingly, the quality of Mexico's infrastructure in all of these sectors does not match the infrastructure quality of China, one of its main competitors. Data in this report show that the gap in the quality of services in water supply and sanitation, which was not covered by the survey, may be even higher. The quality of services of 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 of roads are in poor condition. All this confirms the conclusion that quality of infrastructure services in Mexico does not match its achievements in the expansion of 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 of water and electricity, but they are close to or above cost for industrial and commercial users. It i s estimated that the share of the average electricity and water bill in expenditures of an average householddoes 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 inthe case of electricity-are estimated to be substantial and, in the case of water, much higher than utility bills. It i s likely that willingness to pay for a service of 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 of roads in poor condition i s a consequence of 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 of them. In 2002 at least 44 percent of 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 of total investments in these sectors, with a concentration in water and sewerage. However, the poverty orientation of FAIS is countered by the distribution of the 85 percent of 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 of 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 with 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 of the key findings of 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 of this chapter analyzes the performance of 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 of spending. 37 World Bank (2004c:74). This includes all transfers, includingearkmarkeduportuciones, non-earmarked participuciones, and sectoralprograms. 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 of other developing countries, with 95 percent of 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 of the extreme poor had access to 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 of 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 of the low electricity coverage rate, especially in communities characterized by extreme poverty levels39. Table 2.2: Mexico's Electricity Coverage is Comparatively High Sources: World Bank (2004)East Asia report; datafor Mexico inelectricity coverage from INEGI (2002). 2.10 According to official data, the quality of 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 CFE 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 (1day compared to 6 days) and distribution losses (27 percent compared to 11percent) (Aburto 2004). 38There are still 2,600 localities of between 100and 10,000 inhabitants without electricity in this region. 39Initiatives 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 of the communities and sustainability are generally not taken into account. 17 Table 2.3: Quality of ElectricalService, 1995-2003 1995 1998 2002 2003 Interruptionof CFE 242 225 124 121 Service (min/customer) LFC - 374 144 135 Complaints CFE 14 10.7 4.2 4.1 1 (no./l,OOO customers ILFC 1 - 6.7 1 1 4.4 1 4.3 1 month) 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, it 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 150 +CFE 1 Brazil ElectroPaulo 100 4 +Argentina Edenor +Argentina Edesur 0 1995 1996 1997 1998 1999 2000 2001 2002 2003 Sources: CFE financial data; and Andres, Foster, and Guasch(2005). 40No dataon annual interruptionshavebeenreportedfor public utilitiesor publicdistributioncompanies. 18 Figure 2.2: DistributionLosses (%) l81 16 - 14 - , -CFE Totales -W- PeruEdelnor +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: CFEfinancial data; and Andres, Foster, and Guasch(2005). 2.13 There i s no independent verification of the quality of service and operational performance data provided by CFE and LFC. Independent verification increases the reliability of data and i s of great importance for regulatory purposes, for a balanced and transparent relationship between independent power producers and buyers of electricity and for increasing the confidence of investors inthe sector. 2.14 Insufficient investment in maintenance and modernization makes it difficult to further improve service quality. The approved budgetary resources for maintenance, repair, and refurbishment of assets are on average 30 percent lower than the level that CFE executives think i s required (and reflected in the amount requested initially by CFE management every year)41. Neglect o f aging plants and distribution lines makes it hard to maintain and almost impossible to further improve levels of 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 of CFE is still poor (Figure 2.3). I s i s evident that the influence of the unions has an effect on the overall economic and technical performance of both CFE and LFC42. 41Interview with CFE management. 42For instance, the confluence of restrictive administrative norms and union resistance to rescaling compensation basedon the performance of different operative units across segments has impeded improving the labor efficiency parameters. 19 Figure2.3: Numberof Connectionsper Worker inDistributionSegment43 3000 i 2500 1 -MEXICO CFE 2000 - +PERU Edelnor +PERU Luz del Sur 1500 ! ---t CHILE Chilectra +BRAZIL -ARGENTINAElectropaulo Edenor 1000 -ARGENTINA Edesur +COLOMBIA Codensa 500 7I o i I 1 1995 1996 1997 1998 1999 2000 2001 2002 2003 Sources: CFE financialdata; Andres, Foster,and Guasch (2005). Tariffsand CostRecovery 2.16 CFE and LFC are required to provide electricity at tariffs set by the Federal Government, including at tariffs below cost for certain categories of users (Table 2.4). The subsidy implied in these tariffs i s financed in different ways in the case of CFE and LFC. CFE does not receive transfers to finance the subsidies. Its subsidies are primarily financed b y nonpayment of a statutory rate of return (uprovechamientos) of 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 of the government. However, CFE's capital base i s currently being eroded because subsidies have exceeded uprovechumientos since 2000. User subsidies have been estimated by CFE at MxP49 billion in 2003 (0.7 percent of GDP), while uprovechumientos stood at MxP44 billion (0.6 percent of GDP). The subsidized tariffs cause a loss of federal revenues through the nonpayment of 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 MxP21 billion (0.3 percent of GDP). Total subsidies to the electricity sector thus amount to MxP70 billion, about 1 percent o f GDP, or 175 percent of investments inthe electricity sector in 2003. 2.17 According to CFE, the average tariff charged to residential customers in 2003 covered just 42 percent of costs, and the average tariff for agricultural use covered 28 percent of costs. Industry paid 88 percent o f costs (Table 2.4). 43Inthe case of CFE, data includesonly workers in the distributionsegment 20 Table 2.4: CFE: Degree of Cost Recovery, Priceto 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 by consumption level (World Bank 2004d: 139). All of the tariffs contain non-linearities and discontinuities, and arbitrary criteria for applying them, which makes it difficult to understand them and often leads to paradoxical results. Especially in the case of LFC, political involvement in the process o f tariff setting by the Finance Ministry has led to 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 of OECD countries and the United States. Independent sources indicate that peak industrial electricity tariffs are at times higher than the costs of producing electricity on-site with diesel-based thermal plants.44 High industrial tariffs have led to an increasing trend toward self-supply by 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 of thermal plant availability. 21 Figure 2.4: Prices of Electricity in Selected LatinAmerican Countries, 2002 0 5 10 15 2o Bindustrial BCornrnercial Price of electricity (US$ cents per kWh) 0Residential Sources: Foster (2004) and CFE. 2.20 A comparison of 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 higherthan inNew Mexico, and the average implicit industrial tariff in California was 51 percent higher than for CFE (Samaniego-Breach 2005:27). 45Methodological issues include the weighting among various industrial tariffs (medium and high voltage, peak and off-peak), the coverage and weighting of 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). 46The former percentage is calculated from tariffs in Table 2.6, while the latter percentage comes from a recent study by the Industry Association of the State of Nuevo L e h , quoted in Samaniego-Breach (2005:24). 22 Table 2.5: International Electricity Prices for Households (U.S. dollars per 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 of 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: InternationalElectricity 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 United 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 of 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 from highly subsidized rates. Poverty criteria are absent in the determination of regional electricity tariffs, unlike in water, where some municipalities set lower tariffs in poorer neighborhoods. 23 Figure 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 Figure 2.6: Household Decile by Total Income, 2002 3.5% 3.0% 2.5 % 2.0% 15% 1.0% 0 5% 0.0% I II In N V VI w WI M X IEi Share of Expenditure inElectricity 4 Share of ExpenditureinWater 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 of subsidy (0.8 percent of 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 low 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 by CFE and private investors, the remainder being accounted for by LFC. CFE investments include its 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 of GDP in 2003, lower than other countries in Latin America (Figure2.8). Figure 2.7: Investment in the Electricity Sector (million MxP2004) 160,000 I 50r000 40,000 ~ 130,000 20,000 ~ 10,000 0 1998 1999 2000 2001 2002 2003 ~ 1k7 Direct Investment byCFE 0 Pidiregas EiLuzyFuerzadel Centro ~ Note: Investmentsby municipalities, partlyfunded underFAIS, are not included. Sources: Secretaria de Energia, quotedin Samaniego-Breach(2005); World Bank calculations. 48 This excludes FAIS, investmentsmadeby developersand "payments for BLTs andPIDIREGAS," which are shown by some CFE statistics as "investments." 25 Figure2.8: InvestmentsinElectricity as a Shareof GDP-International Comparison I Total Investmentsin Electricity(as YOof 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 to the deteriorating financial situation of 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 of 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 of total expenditures for 1998-2003. B.WATER SUPPLYAND SANITATION Outcomes 2.26 Access to water and sanitation in Mexico has steadily increased in recent decades, reaching levels significantly beyond the average of the region and of other developing countries (Table 2.7).49 Approximately 90 ercent of 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 through sewers discharging into the nearby en~ironment.~~The 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 of access to sanitation, since latrines are excluded from the definition used inMexico, 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. 51 The 2000 census, as shown in spreadsheetsprovided by Avila (2004). CNA includes only the first two categories in its 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 of 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 is Comparatively High 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 of the levels achieved in other OECD countries and upper-middle-income countries. The share of 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 it remains far below levels inOECDcountries, 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 of water; the remaining 55 percent experienced various degrees o f intermittent supply.54 The incidence of 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. 52From 2000 census, as shown in spreadsheetsprovidedby Avila (2004). According to CNA access to sewerage (alcantarillado) has increasedto 77.5% (2004), though CNA does not publish statistics on sanitation coverage in the broader sense. 53CNA (2004a:A-76). For Latin America average, see PAHOWHO (2001:24,81). 54Own calculation, based on census dataquoted in Avila (2004), spreadsheetnamed Anexo I.CC-Agua 55Avila (2004) basedon census data. 27 Figure 2.9: Quality of Water Service in Mexico 100% 90% 80% 70% 60% 50% 40% 30% 20% 10% 0% Poor people incities 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 still remain worse than those of 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 of water at the source, which has now reached 95 percent. A recent survey has shown that 16 percent of Mexicans with connections receive water that does not contain the required level of residual chlorine at the tap.57 2.30 Usingnon-revenue water (NRW)58as an indicator, operatingefficiency levels in Mexico are far below the average level attained in developed countries, and below the level attained in the best-performing quartile of utilities in developing countries (Table 2.8). For example, the average level of NRW in Mexico i s estimated at 44 percent,59 while the best-performing quartile of 123 utilities in 44 developing countries achieves less than 23 percent of NRW (Tynan and Kingdom 2002). The average level in developed countries i s about 15 percent. The level of NRW in Mexico varies substantially, showing that low levels of NRW are achievable inMexico. 56 For example, the mortality rate associated with intestinal infectious diseasesin 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 is the difference between water supplied and water sold as a percentage of water supplied. 59 CNA (2004a:42). Calculated based on a sample of 157 service providers with reliable data. 28 Table 2.8: Non-revenueWater inMexico Compared to other Countries Bsico do Estado Sources: CNA (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 of staff per 1,000 connections among a sample of 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 of 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 of 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 of 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. 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. INEGI (1999), ICenso de Captacibn, Tratamiento y Suministro de Agua. The average tariff is M x P 1.62/m3 for residencial users, Mxp 6.90/m3 for commercial users and MxP 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 of the water bill. Given the substantial ongoing and planned increase of investments in wastewater treatment, which will 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 of output-based transfers, similar to a Brazilian program under which the Federal Government pays utilities for the discharge of 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, it seems that the sector generates only a very modest cash surplus, which i s well below the financial performance achieved by the top quartile of 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 of collection efficiency in Mexico has been estimated at 72 percent (Table 2.9). The wide variations within Mexico again show that high levels of 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. 63For 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. 64The lower figure is taken from CNA (2004:38) and is calculated from a sample of 437 localities in all states. The higher figure i s taken from Barocio (2004), based on extrapolations made from a sample of 192 localities from states for which data was deemed reliable. 30 Table 2.9: CollectionEfficiency I Country I Year 1 Collection / Billing (%) Mexico (Monterrev) I 2004 I 98 OECD average 1996 95 Asian cities (average of 18) 2001 88 Brazil (average) 2000 87 Mexico (Hermosillo) 1999 85 Mexico (average) 2002 72 Mexico (sample of small cities) 20 Sources: CNA (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 of 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 by a recent international study that shows that the benefits from increasing-block tariffs accrue mainly to the better off. 2.38 Thirty-one percent of water customers are not metered and are charged a flat rate (cuota fija) independent of consumption. In a few instances, flat rates are differentiated by 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 of water consumption does not vary that much among income groups, this type of 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 of expenditures for both water and electricity).66 This share i s low in international comparison. 65An analysis of domestic water tariffs in23 Mexican cities with increasing-block tariffs reveals that many utilities allow a broad lifeline consumption of up to 30 cubic meters per month, or about 240 liters per capita per day. Such broad lifeline blocks defeat the purpose of cross-subsidization among domestic users, becausethe great majority of 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 of 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 of 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 by the World Bank to be MxP16.6 billion (US$1.5 billion) in 2003, or 0.27 percent of GDP.67This i s lower than investment levels in other countries of the region (Figure 2.10). Investment in water supply and sanitation declined by 45 percent in real terms from 1993 to 1996 due to the economic crisis, recovering only slowly. In 2003, it again increased significantly, finally exceeding its pre-crisis level. The impact o f the low investment levels has been felt in the persistence o f poor service quality, and inlow levels of wastewater treatment. Figure2.10: InvestmentinWater as aShare of GDP InternationalComparison - Total Investments inWater (as 9%of GDP) 1 00% U.WQ 0 80% i 0 60% i 0 40% u,L/ Yo 0.?648 0.38% 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 by 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 of investment financing in water supply and sanitation in 2003, complemented by state subsidies (13 percent) and a small share of municipal subsidies (Figure 2.11).68 Internal cash generation and commercial credits account for only a small share of investment 67 Based on a gross domestic product of MxP6,245 billion in 2003 in current prices. Source: INEGIWeb site. The investment figure includes an estimated MxP.5 billion of water and sanitation investments through FAIS, which are not included in CNA statistics. CNA statistics do not distinguish between municipal subsidies and internal cash generation by 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 of 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 of large subsidized housingprograms initiated in 2001. Figure2.11: EstimatedFundingof Water andSanitationInvestmentin2004 Credits, Equityand Others FederalProgram 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 by subsectors. Figure2.12: InvestmentinWater and Sanitationby Subsectors, 1997-2002(inconstant prices) 6 5 4 3 u) m $ 2 e o 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 investmentsoutside CNA, and thus are notcomparable to earlier years. 33 2.44 As can be seen in Figure 2.13, the share of investments allocated to rural areas declined since 2000. In any case, a slight long-term decrease in the share of investments allocated to rural areas may simply reflect the lower share of the rural population in the total population. Figure 2.13: InvestmentinWater and Sanitationby 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 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. 2.45 The high average level of 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 infra~tructure.~~ For example, a 1996 study estimated that the unit investment costs of leakage reduction in Mexico City would be eight times lower than the unit investment costs of additional bulk water supply (Ciudad de Mexico 1996).71 It seems that despite a stated priority for investments destined to "increases in efficiency," there i s still 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 of 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 it could be argued that the rapid increase of access (see chapter 1) at a time of declining investments during the 1990s could be interpreted as a sign of efficiency, it appears that it i s more the result of prioritizingcoverage expansion over rehabilitation and wastewater treatment. 71 The unit costs wereUS$0.4 per cubic meter and US$3.17, respectively. 34 to major state and national highways. In Oaxaca, for example, 40 percent of the state's localities representing 15 percent of the state's population are not served by a road (Fay 2004:7). Table 2.10: RoadNetwork, inKilometers, 2000 Source: Sector Program 2001-2006, SCT. 2.47 As a result of insufficient investment in maintenance and modernization, the condition of 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 by bus and truck currently accounting for 98.5 percent of domestic passenger traffic and more than 85 percent o f surface freight cargo. Followingtrucking deregulation in 1989, and the advent of the North American Free Trade Agreement (NAFTA), trucking activity has grown by 32.5 percent, and the authorized weight of vehicles was raised from 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 of 20 indicators that include operational standards, traffic, design characteristics, security, and maintenance, only 61 percent of the highway system can be considered modern, with 39 percent requiring improvement^.^^ Moreover, only a fourth of the roads are in good condition, well below the average of a sample consisting mainly of other OECD countries (59 percent).74 Overall, the main federal corridors still 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 two lanes.76 72 The trucking industry has been characterized by a relatively aged fleet (17.5 years on average). In addition, the high number of owner-operators led to inefficiencies and limits economies of scale, while at the same time providingonly modest service quality and efficiency. 73Communications and Transport Sector Program 2001-2006. 74See Guerrero (2004). The source of data i s PIARC. 75There is very little data on the quality of roads at the subnational level. This may be symptomatic of larger issues of quality in the sector at this level. 76Fay (2004:9); and "Anuario Estadistico 2003," SCT. 35 2.50 The efficiency of road maintenance also does not meet OECD standards. The operation and maintenance costs for toll roads managed by 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 of free roads, suboptimal programming and the absence of contractual incentives for better performance increase Tariffs andCost Recovery 2.51 Despite reductions in the late 1990s, high fares have kept the use of 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 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 MxP2 per truck and kilometer in constant prices in the case of roads owned by 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 still high by international standards. In the FARAC 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$0.35 per kilometer for five-axle trucks. For one of the most expensive roads in Brazil (Sgo Paulo-Ribeirao Preto), the tariff i s around US$O. 10per 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) of roads, reflecting political influences. The share devoted to maintenance and rehabilitation i s more stable, although at a low level.80 77 Income-ExpenditureStructurein 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 is 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: UnidaddeAutopistasde Cuota,SCT, and "Ancilisisde la Competitividad," Instituto Mexican0 para la Competitividad(IMCO), septiembre de 2003. The budgetaryprocess i s discussed in Chapter 3, including an analysis of the impact of political agendas in altering overall flows of governmentfunds to targetedinvestmentsthat fall outside of sector plans issued by the SCT. 36 Figure2.14: FederalInvestmentinRoads(millionpesos,constant2003 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 0BuildingandUpgrading Maintenance and Rehabilitation Rural Roads Note: State and municipal investments are not included inthis table. Source: "Tercer Informe de Gobierno." 2.54 Expenditures for maintenance and rehabilitation are low by international comparisons.81 They are estimated to have accounted for less than 0.15 percent of GDP in 2000, compared to 0.3 percent to 0.4 percent of 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 MxP7 billion per year, compared to federal road investments of 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. It has been estimated, based on a survey of mayors, that in 2002, of 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 of service of Mexico's railroads, although they still fall short o f international best practice. The rail industry shows a diminishingnumber o f accidents per kilometer, better use of assets (as shown by 81 No breakdown is 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 of subnational expenditure in national figures is not clearly stated. There has been a recent initiative to increase the level of road maintenance at the state level, the impact of which is not reflected inFigure 2.13. 37 the higher number of tons per locomotive), improved service quality (as indicated by the lower number of losses and claims), and a more efficient use of fuel (see Guerrero 2004). However, as shown in Table 2.11, efficiency still falls short of levels achieved in the United States. In the World Competitiveness Survey major industrial users ranked the quality of Mexico's railways still fairly low, at position 57 out of 102countries. 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 Law establishes that tariffs are set freely by 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 it 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 of the cargo that can be transported at a lower unit cost. In Mexico, due to the relatively low share of 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 to hightariff levels. 38 1 competition and decentralized port management.84 As part of the reform in 1995, port service prices were no longer set by 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 of 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 still fall short of 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 of 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 of 15 percent to 55 percent (see Guerrero 2004). However, in the World Competitiveness Survey, major industrial users still ranked Mexico's ports fairly low, at position 62 out of 102 countries. One problem for ports i s the delays still experienced in moving cargo from terminal to rail or truck transportation. This is due to procedural and logistical factors not related to physical infrastructure. These include (a) the complex cargo review and inspection process, (b) the inability of 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 of Veracruz, Manzanillo, and Lizaro Cirdenas show operational margins of around 45 percent between 1995 and 2003.86 The success of 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 of limited value, since these two concepts are not homogeneous across ports. Mexico charges low tariffs per transferred ton on ports (US$1.4 in Veracruz against US$6.68 in Los Angeles). 84Chapter VI1of the Port Law established the legal framework for tariff setting. I t states that SCT will set up in the concession agreement the basis for tariff setting as regards ports, terminals, and other related services when there is no effective competition. The regulation will stand as long as the conditions for its existence exist. Under the regulation, Integral Port Authorities were created as autonomous entities for the management and operation of ports. "Coordinacih General de Puertos y Marina Mercante," SCT. It increased from 43 containers to 86 containers per hour. 86Financial Statements, 2003. Only in the case of 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 inFigure 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 of 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 by 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-ownedports. Figure 2.18: Public andPrivate InvestmentinPorts (million 2003 pesos) 7,000 6,000 5000 4000 3.000 2,000 1000 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 of service, extent of coverage, and levels of spending in transportation, electricity, and water and sanitation infrastructure in Mexico. It also included a comparison of Mexico's performance characteristics with those o f other middle-income and OECD countries. While Mexico has made steady progress in increasingcoverage over the past decades, and has reached levels higher than the averages for Latin America, access to infrastructure services still remains below that of other OECD countries. Also, quality of service and operating efficiency lag behind other middle-income countries. 2.66 The degree of cost recovery varies substantially among sectors, but remains very low in two key segments: household and agricultural electricity users, and household users of 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 low in water supply and sanitation, exacerbating the problem of low tariffs, but also providing an opportunity to improve cost recovery without necessarily raising tariffs. The financing of subsidies occurs through direct transfers from both the federal and state governments, and through the nonpayment of uprovechumientos by CFE. 2.67 The main challenge i s to improve the quality of 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 of increased quality, efficiency, and access of infrastructure services. 42 3. BUDGETING,PLANNING,AND COORDINATION 3.1 An examination of the institutions in the infrastructure sectors shows a fragmented process of spending planning and allocation, and insufficient coordination within and across subsectors. In an overall context of tight constraints on central budget funding, we find two sorts of 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 of the expenditure institutions within each agency. After discussing the budget cycle within each sector, this chapter considers issues of intrasectoral coordination, and the flows of 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 inthe overall allocation o f resources. A. BUDGETCYCLE-INVESTMENT PLANNING, ANNUALBUDGET,EXECUTION, AND EVALUATION CommonElements 3.3 The budget cycle starts ideally with a planning process, assessing the needs of the society and the funding that will be available. The plan usually focuses on investment needs, but it should also consider the associated requirements for current spending (salaries, maintenance, and so forth) and the availability of 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, with procurement of construction, management of personnel, and adjustments to reflect deviations of 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 of planning and budgeting. 3.4 In Mexico, the formal planning process by federal and state governments is done once every six years, at the start of each new presidential or gubernatorial term (which are not coterminous). These national and state development plans make statements of intent, unaccompanied by 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 of the plans are immediately found financially unachievable, and as the sexenio progresses, they generally become obsolete. The annual budget formulation process, where real money is allocated, makes some reference to the development plans, but the links become more tenuous over time. Nonetheless, as shown in Box 3.1, the electricity sector and the federal roads subsector have some planning that i s linked with budgeting. Box 3.1: PlanningandBudgetIntegration:Past andFutureOptions To properly plan investment, centrally or within individual sectors, one needs to think in terms of 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 of 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 of Finance to become the Secretariade Hacienda y Crkdito Pliblico (Ministryof Finance and Pubic Credit, SHCP), so that the budgetingand spending activities would better take into account the availability of revenue. After the SPP was converted into the Subsecretariat of Spending (Egresos, SSE) within SHCP, the location of the planning function was not institutionally specified. Inthe 1990s it was done 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 of 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 its own agenda-with Congress and the SHCP-and SHCP trying to maintain fiscal discipline. To strengthen planning and better link it 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 its 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. In Mexico, CFE already follows this rolling multiyear approach, and SCT i s moving inthat 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 of 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. It does not act in isolation, however, and the parts in italics indicate where political negotiations are particularly important. 44 3.6 For 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 sjust starting. The NSIP requires technical, economic, and environmental assessments as prerequisites to set a code number for each project, which is mandatory for a project to enter into the budgeting process. The NSIP is looking for a more careful assessment of 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 by 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. If 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 will allow for online portfolio management of all government projects, automatically linking the budget allocation of funds with their current execution. Within SIPPI, SHCP i s developing a module that will allow for the consultation of the cost-benefit analysis of the projects and their ex post evaluation, which was previously unavailable. Box 3.2: Steps inFormulatingthe 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 (subnationalgovernments [SNGs]) exert influence. 3. SHCP reviews draft POAs, negotiates with sectors, and sets the fiscal envelope for each sector. 4. Sector agenciesdevelop definitive POAs and deliver them to SHCP. 5. SHCP integrates sector POAs into a consolidated draft federal budget and delivers it to Congress. 6. SHCP and Presidencianegotiate 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 agenciesrevise POAs to be consistent with the approved budget. 9. Sector agenciesexecute the budget, subject to cuts required duringthe year by 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 of the infrastructure sectors i s outside of the regular federal spending budget, under the headings of 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 by Congress within the revenue budget; the outlays for interest and amortization of previous years' PIDIREGAS are in the spendingbudget; and the list of 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 by organismos operadores (00s)and municipalities for local water works i s completely outside federal budgetingand 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 of 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 of 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 by private interests, and the Ministry o f Finance i s not always politically able to turn down bad projects. It i s important to mention that, in accordance with the legal framework associated with the budget, it i s the Congress who ultimately approves the issuingof new PIDIREGAS. 3.10 The implementation of projects, including procurement, i s under the individual management of the relevant secretariat or agency. In procurement, Mexico has made considerable progress in standardizing the process and making it more transparent. As discussed in Box 3.3, however, it does not effectively assure that the most cost-effective bids are selected. Other aspects of 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 still remain substantial deficiencies in transparency and achievement of the objective of 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 civil 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 of prices, which had been concealed in the secondenvelope. The time officially allowed for bidpreparation is typically short-10 to 30 days-whereas 40 days or more are normally needed. Thus bidsare rarely well prepared unless a bidder can access insider information. In practice, in some cases, this allows a few firms 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 of project), making projects of 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 its cost clearer. Congress passeda 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 of 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. Gettinga guaranteed budget for enough years to finish a project would therefore increase efficiency inthe allocation anduse of public resources. An improved procurement system will have a significant impact on both nationalinvestment 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 of not constructing new toll-free highways. Second, the toll-road system i s expected to generate enough revenue to cover its 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 self-~ufficient.~~The rest of federal highway spending (over half) goes to upgrading existing highways, often substantially, and to maintenance. Third, highway investment ranks among the most visible and politically salient federal infrastructure spending. Thus it 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 of the network interdependency. The public sector involvement in transport includes the provision of basic infrastructure (by itself or through agreements with private operators). The infrastructure i s usually integrated in networks, therefore requiring physical coordination (planning) for its 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 of transport and the different levels of government involved, but the tendency in Mexico i s to approach transport planning mode by mode and government by 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 it 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 of 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 of the Presidential term; the Sector Program i s based on the Secretaria de Cornunicaciones y Transportes (Ministry of Communication and Transport, SCT) research, a consultation process (Foros de Consulta Ciudadana), and previous programs. It defines the key strategies and goals for the period, estimating 87 The Constitutional clause mandating "free mobility" is sometimes interpreted to mean that the government may not construct a toll road on a route for which there is not also a toll-free highway. Due to the density of the existing highways, however, it 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 of 89 percent of the length of the established 14 key corridors o f Mexico's federal roads by 2006, and (b) the achievement of a goal of 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 planningor budget allocation, and therefore no guarantee that the goals established could actually be achieved. 3.16 Figure 3.1 shows the original goals of the PND and the actual progress in the two key programs. Seventy-one percent of the highway corridors were modernized by 2003 (widened, straightened, and so forth), and an 83 percent goal i s likely to be attained by 2006. Toward the goal of improving road conditions, 69 percent of the road surfaces were brought up to good condition by 2003; at this execution pace, approximately 78 percent i s expected to be completed by 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 ExpectedProgress (a) Modernization of Major Highway Corridors 100% , 0 7 20% 0% 1994 1996 1998 2000 2002 2004 2006 49 (b) RoadConditionGood 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. Figure3.1.a measuresthe share of 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 of measuring the cost per kilometer of achieving this, and of 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. It i s organized with particular emphasis on regional coordination, including the participation of states in several regional working groups and active input from the SCT regional centers. The objective of federal integration in defining investment needs i s reinforced by regional agreements between several states and the Federal Government, and by bilateral agreements between it and some particular states. Inthese agreements, states assume some responsibilities for the projects, mainly the liberation of the right of 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 list of priorities based on established criteria. These criteria-presented in Box 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 of concentrating efforts in the 14 key corridors, allow for the continuity o f multiyear projects, avoid the budgeting of 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 of projects i s possible, and the actual selection may be political and with little 50 technical or economic justification. Box 3.4: Criteria Followed by SCT for Setting Priorities for Road Investment MainCriteria: Location within the 14major corridors. Work inprogress. Level of project preparation. RegionaVstatepreferences. 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 andmarginal 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. No 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 of return (RR) that i s barely above the minimum threshold established by 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 on bringing the whole federal highway system up to adequate standards by 2006. After severe deterioration of the system due to lack of sufficient funds during the 1990s, the government has launched a program for highway maintenance that will 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 of highways. 3.22 Budget Preparation, Negotiation, and Approval. The negotiation and approval of the SCT budget involves mainly SCT, SHCP, and the Congress, as described in Box 3.2. SCT also prepares an additional list o f projects beyond their main submission o f Annual Operative Programs (POAs), in case more resources become available. Highway resources in Mexico result from 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 88The World Bank finances US$218 million of 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 by 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 by 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 Box 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 of 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 Highwaysinthe Budget Process (Year 2003, in 1,000 millions of Mexicanpesos) Source: DG de Prograrnacidn, Organizacidn y Presupuesto, SCT. Values rounded. 89 SCT submits to SHCP an additional list of projects that would be worth doing if unforeseen funds became available through, for instance, a rise in oil prices. 52 Box 3.5: Pork-BarrelSpending benefits, most of the benefits are relatively local, as are the employment effects of buildingthem. Consequently, as in many countries, road buildingis a principal ingredient of pork-barrel politics; state delegations in Congress are always inclined to push for more funding than i s in the national interest, which is better representedby the Federal Executive. InMexico, transport is the largest investment sector outside of energy, and most transport investment goes for roads. Inlooking 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 of projects to achieve its other political and policy objectives. Two or three decades ago, in the heyday of PRI hegemony, pork was an important currency for maintainingparty discipline and supremacy. Since the end of a one-party majority in Congress in 1997, the politics and practice of budgeting has changed. Two of 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 of 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 of the Executive Branch. For, example, in 2003 the SCT requested a budget of MxP12 million for 2004, SHCP put barely a third of that inthe budget request to Congress, and then SCT lobbied with state interests in Congress to get the transport budget back up to 90 percent of 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 its practice of listing technically approved projects that did not fit into the proposed budget, in order for Congressto 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) being implemented. At an aggregate level, allocated resources are almost all expended. In 2003, of the MxP24.4 billion approved for the transport sector in the federal budget, MxP24.2 was spent, accounting for 99 percent. The same can be said for the roads subsector, with MxP21.4 billion approved in the budget and MxP21.2 spent, again accounting for 99 percent of the total. 3.25 Looking 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 all o f them showing costs higher than approvedg0 (Figure 3.2). If the project evaluation with the original costs was hardly above the minimum IRR threshold, cost overruns this size may move them below the threshold; this may be exacerbated if traffic 90 An increase inexpendituresof up to 25 percentcan be approvedwithout aproject review. 53 (and therefore benefits) i s less than forecast when the project was submitted for approval. Since the whole of 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. Figure3.2: PlannedComparedto ExecutedHighway Investments,A Sample of Projects 1 El Planned 0 Observed 1 Tota Enr.onq,e La Escona oa Ap zaco-L m ies Tlax PLeo Rosar 0.V a Unon Enir nq-e El Granare Escarcega-Crer-ma Reforma Agrar a Desv ac on a Ma an,a L oram erio ae C,abi a More a --as Fores 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: Unidadde 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 of funds and completion of works. To help address this problem, the New 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 by 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. During2003, FINFRAreceived enough contributions to allow for a multiyear budget and a variety of projects because the resources available surpassed MxP$14 billion. However, due to the lack of capacity to implement more than three or four important projects at the same time by the Unidad de Cuotu and BANOBRAS, and the complications found by 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 it needs to be done in a transparent manner. 3.27 Maintenance of federal roads i s carried out mainly b y third parties on contract. Two chief players on the government side do the contracting: CAPUFE and the SCT's General Directorate of Road Maintenance (DGCC). CAPUFE handles maintenance in the toll-roads system, the ownership of which i s gradually being transferred totally to 54 FARAC. DGCC is incharge of maintenance for the non-toll federal highways. 3.28 For the toll roads, the rules of concessions require guarantees of adequate funding for maintenance (SCT 2003:26). Minor maintenance i s done directly by CAPUFE; FARAC reimburses the funds on a weekly basis for those services for which CAPUFE can provide evidence of 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 to evaluate its efficiency. FARAClacks 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 from 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. Minor and major maintenance i s entirely outsourced by DGCC following a fairly transparent bidding process-mostly through COMPRANET, the federal e-procurement program-and controlling execution. However, in this case contracts are assigned with 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 to broaden the scope o f maintenance and grant the contracts in an integral, multiyear, and output-based manner. To this end, the Programa Piloto de Mantenimiento Integral (PROPIMI) was conceived. PROPIMI seems to be working adequately; DGCC regional units have increased its 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, it would be more effective to determine explicitly the process for multiannual budgeting, which then could be used generally, insteadof having particular agreements for particular projects. 3.30 State and municipal authorities develop plans to fill gaps in connecting users with the national network and within urban areas. Quality o f this planning and its coordination with SCT planning varies widely and depends heavily on the local political cycles, which are not synchronized with each other or with 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 of federal road funds less efficient. 55 Electricity 3.31 CFE 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 of 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 of investment projects. After 1991, however, the financial portion of the planning system was reallocated to the Financial Office of CFE, losing some o f the integration and coordination that had previously been achieved. Since 1994, b y law, CFE updates its rolling 10-year plan for investment and maintenance every year. The CFE budget for each year follows from the updated plan. The planning of 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 LFC income and outlays are formally within the national budget, which i s anomalous for electric utilities, and to some extent politicizes their finances. With its own substantial revenues, CFE depends substantively on the national budgeting process mainly for the borrowing for new investment that it does directly, with important effects discussed below. Although its current spending and investment are all in the federal budget and formally approved there, the large own 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 of 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 its 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 of 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 of inefficiencies at CFE also gets folded in here.) During 1997-99, payments o f aprovechamientos to the government exceeded the level of subsidies received by CFE. The utility was thus generating a small net transfer to the Federal Government. This situation reversed in 2000, when consumer subsidies from CFE grew substantially and exceeded the aprovechamientos, as shown in Table 3.2. Since then, CFE has been eating into its own capital, by cutting investment and not fully replacing equipment as it depreciates. Older capital also has higher operating costs, contributing to making CFE's cost of service higher than international comparators. 56 Table 3.2: SubsidiesandAprovechamientos 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, MxP1,000 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 it collects. It does not control its output prices and has limited control over costs; hence, the main adjusting variable i s its own investment in generation, which has declined over the past decade and i s now clearly less than needed to meet demand. To 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 of CFE), even though the original rationale i s gone; now SHCP fully discloses them and counts them as part of the overall public sector debt and borrowing. In 2003 they were 1.1 percent of GDP, almost half of the total Public Sector Borrowing Requirement, 2.5 percent of GDP. The amortization o f old PIDIREGAS debt equaled over one-tenth of the new investment in the budget, and the amortization burden is projected to grow. Figure 3.3 shows the growth of 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 of installed capacity and almost all o f new generation. 57 Figure 3.3: Electricity Sector PIDIREGAS 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 (still largely potential) in the electricity sector. With true private sector participation, the firms would make investment decisions and bear the full risk. Now public sector still makes most of the decisions and bears most of the risk of loss, while firms 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 it ends up with an asset, in other cases, not. Now 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 of the investment could be more efficient, although the government could always have a simple contract for construction and operation by the same firms, unlinked to financing. It seems unlikely that the firms can get lower-cost financing from the market than the government could get directly, and the government's guarantee of the PIDIREGAS debt counts against its 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 from 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. It is considerably less efficient than CFE, due mainly to excessive labor costs and low productivity, and it does not even have a bookkeeping obligation to pay uprovechumientos to the Federal Government. It has lost most o f its generation capacity and mandate, and it mainly distributes power generated by CFE and its licensed private producers. To stay in operation, LFC requires about MxP17,OOO million per year in outright cash subsidy from the Federal Government budget. 58 3.38 Rural electrification, while nominally under the purview of CFE, i s actually carried out by states and municipalities, in general matching funds from 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 of FISM went for rural electrification projects (INEGI survey, Annex 2). Rural electrification initiatives have almost exclusively focused on grid extensions at very highcosts. Water Supply and Sanitation 3.39 Most investment for water and sanitation in Mexico is not done directly by the Federal Government, but by organismos operadores (OOs), municipalities, state governments, and private housing developers, although most of the money for public investment ultimately comes from the federal government. About 25 percent of 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 its own (non-emergency) structures for bulk water supply. Municipalities receive considerable resources (a total o f 0.8 percent of GDP, which is about three times the relevant budget of CNA) through FISMinRam0 33. Municipal contributions to investment in water supply and sanitation come from FISM and from federal tax sharing (untied funds via participaciones), but there are not systematically available data on the amount of funding from these sources for water and sanitation. The municipalities also have to pay for their use of water resources, as described in Box 3.6. 59 Box 3.6: Mexico's System of Water Abstraction Charges InMexico, since 1989,alluserswho abstractwater directly fromariverorthe groundhavetopay a water abstraction charge (called a water right, or derecho) to the Federal Government through the Ministry of Finance. The level of the abstraction charge is 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 of uniform charges for all user categories. In2001, total revenues from abstraction charges were MxP5 billion. Eighty-six percent of the 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 AbstractionCharges Source: Asad and Garduiio (2004:7), on the basis of 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 tc certain conditions, in a program called the Programa de Devolucidn de Derechos (Water Right! ReturnProgram, PRODDER). The conditions include that for eachpeso 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) of abstraction charges, anc PRODDER now has become the largest federal subsidy program for water supply and sanitation The program, which is administered by CNA, caused abstraction payments by utilities to more thar double, accounting for 18 percent of 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 of 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 of CNA's funding to municipalities and states is 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 of their FISM for water and sanitation investments. PRODDER funding follows from collections by 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 of the planning and budgeting for water and sanitation. Some o f the better institutions are in the more economically advanced states, like Nuevo Leon, Baja California, and Guanajuato, but some poor states like Chiapas also have good programs in place (Box 3.7). CNA has an elaborate electronic system for cataloging, categorizing, and tracking individual projects. It was intended to reflect national programmatic priorities, but the results are usually to give a few projects to each water region. The overlapping planning and budget cycles and multitude of 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. CNA gives some help and technical assistance for local planning, for example, as part of the Programa para la Modernizacidn de Organismos Operadores de Agua (Program for the Moderniziation of Water Utilities, PROMAGUA), although implementation of this program has been slow. 61 Box 3.7: Innovative Chiapas State Government Technical Assistance to Municipalities The State of 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. To remedy this situation, the state government-through its Water Commission-in 2001 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 on a long-term basis. Participating municipalities produce diagnostic studies covering technical, social, financial, and human resources aspects of 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 list of 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 Multiyear investment plans exist at each level of 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 term 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 or PNHs. At the local level, there are multisector Municipal Urban Development Plans that usually cover 20 years, but these are not connected to concrete actions, and the Municipal Development Plans cover only the three-year terms o f local governments. Most water utilities do not engage in formal long-term planning for their systems, which expand ad hoc, following the pattern of urbanization and in response to the fluctuating availability of funds from federal programs. Investments in wastewater treatment are mostly driven by pressure to comply with legal deadlines for environmental norms, which 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 of the better utilities have established Master Plans, including investment plans covering varying periods (5 to 15 years). Investment projects need to be approved by the municipal council, which usually does not have a long-term perspective and favors piecemeal system expansion over maintenance. 91The PNHfor 2001-06 includestargets for investment, but these targets are notbinding. 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 of 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 Inrecent years, Congress has regularly increased the budget envelope proposed by SHCP for CNA by 8 to 10 percent (Barocio 2005:25). Congress has also intervened to modify the structure of expenditures, substantially increasing the envelope for water supply and sanitation, while reducing it 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 from 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 recommendedby the PNH. 3.46 The availability of 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 by the Federal Government, to be later reimbursed when the funds become available. The delays in the availability of 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 of 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 budgetlaw, the manual o f budget norms, and its 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 of these norms i s beyond the scope of this review. While some norms are needed to ensure economic efficiency, 92The only regional projects in the 2003 and 2004 CNA 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. 93This was the case of the Water Supply Project for Guadalajara and L e h , located in the States of Jalisco and Guanajuato, respectively. The project has a single line item. 63 environmental sustainability, and transparency of investments, the norms are overly complex and could be streamlined without sacrificing the original objectives. 3.48 To assess the degree of satisfaction of service providers with various federal programs, a federal water association conducted a survey in 2004, evaluating the programs usingthe following criteria: 0 The perception of the service providers participating in the programs; 0 The existence of incentives for generating co-funding; 0 The existence of incentives to improve efficiency; 0 The degree of flexibility inthe use of funds at the local level; 0 The degree of discretion in the allocation of funds to specific states and cities and the concomitant risk of pork-barrel spendingand favoritism; 0 The administrative burden of the programs, in particular concerning the relationship between state and federal budget cycles; 0 The degree of 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 by pr~gram.'~ 3.49 All the federal programs require some co-funding by 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 of 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 limitedconditions and invest an equal sum financed by state, municipal, or utility funds. The program contributed to increasing the municipal (and utilities) contribution to CNA 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 of some programs to do so. 94The Mitofsky survey was conducted by 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 of those declaring to be satisfied or very satisfied are as follows: PROMAGUA 67 percent, APAZU 86 percent, PROSSAPYS 88 percent, and PRODDER 98 percent. The rate of participation among those interviewed i s also varied: PROSSAPYS 31 percent, PROMAGUA 53 percent, APAZU 55 percent, and PRODDER 82 percent. Many of those not participating have a negative view of the programs. 64 For example, PROMAGUA 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 of the program, however, it has not led to any case of introducing PSP, and disbursements have been far below expectations. Few of the existing programs tie the level of 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 of 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 of 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 to improve efficiency. FAIS, a multisector fund under Ram0 33, also has no strings attached. The importance o f FAIS for the sector i s significant. While the exact amount of water and sanitation investments under FAIS are not well known, it has been estimated based on a survey o f mayors that the total volume of federal subsidies channeled to the sector through FAIS i s more than twice as high as all federal subsidies under CNA-administrated programs, Finally, none of the federal programs-FAIS or the CNA-administrated programs-is conditional on changes in the governance structure of 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 of 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 ledto 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 by the Inter-American Development Bank and the US.-funded Fronteru Norte program, may entail a somewhat lower degree of discretion due to the external supervision of 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 of 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 with the allocation of federal subsidies on an annual basis despite the multiyear nature of infrastructure investments. Federal budget allocations are usually determined so late that it 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 of operating rules may reduce that bias. However, the solution to that problem ultimately 65 lies in the strengthening of local capacity through continuity of 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 of 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 of the country. For example, the Frontera Norte program is only available to localities within 300 kilometers of the border with the United States, which happen to be the areas with the lowest degree of marginality in Mexico. PRODDER, the largest federal program, i s heavily tilted in favor of the Northern states as a result of the technical characteristics o f the program. The water abstraction charges are set at much higher levels in the arid, Northern parts of 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 of richer localities i s partly compensated by FAIS, a multisector fund under Ram0 33, the importance of 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 of limited effectiveness as screening tools, despite quality control of CBAs exercised by SHCP. Ex 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 of these funds. The attempts at monitoring outcomes, both at the federal level and in some states, are hampered b y the poor quality of financial and technical data collected by service providers, the lack o f incentives to improve the quality o f data, and the lack of links of 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 Law of Ram0 33 requires the states to report the destination of these resources, but there are no standards for this or sanctions for not doing it at all. This hinders both accountability to the local clientele and planning at the state and national levels. 3.56 The lending by BANOBRAS for local water investment has recently increased, starting from a very low level. High overhead costs, passed on to borrowers, and cumbersome procedures make the BANOBRAS option less attractive than it 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. ''Itmust be notedhowever, that PRODDER has been designedto stimulatepayment 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 it 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 with planning by 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 of 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. To 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 of 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, by 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 (SAGARPNCNA) in the sectors studied here. 3.61 The strong impulse for fiscal control by 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 still 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 its 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 of 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 of 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 of labor and to further the impact of other water programs that do not currently require subnational co-funding. This is needed because the extreme dependence of Mexico's local governments on transfers from the center both reflects and reinforces the culture of lobbying for projects and funding from the federal level, rather than raising own resources with accountability to local taxpayers and clients. B.INTRASECTORAL COORDINATION 3.63 Mexico's infrastructure sectors traditionally played a large role in distributing rents and political patronage, so the appointment of 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 of 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 of coordination through a monopoly political party have become inoperative inthe 21st-century context of political competition. Transport 3.64 Most of the information and decisionmaking for transport stays within the institutional silos of 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 of 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 96 Logistics cost about 18 percent of 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 its 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 of 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 of 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 of FARAC and the multiple roles of BANOBRAS (especially as supervisor of FARAC as well as sectoral financier) are institutional problems that need addressing. Also, the transfer of the responsibilities for the development of local transportation infrastructure to local governments makes it more difficult to have the essential policy planning and coordination between the federal and subnational governments. Electricity 3.67 The reforms of CFE in the late 1980s and 1990s have led to better public information and indicators of performance for that part of the sector. LFC i s still more under the control of 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 of CFE linking well with LFC's distribution system, which i s all that i s left of the company. Aside from a pricing issue mentioned above, the inefficiency and fiscal problems of LCF are relatively independent o f its 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 of meetings during which CFE finds it difficult to convince SHCP on ways to prioritize expenditures to maximize the technical performance of the company. For instance, as the number of 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 its economic impact i s not clear. Thus, information asymmetries distort the allocation of resources, because SHCP does not or cannot trust information from CFE about the status of assets in terms of efficiency or needs for maintenance expenditure. Ideally, CFE would have autonomy to follow the most cost-effective way to meet performance standards, and SHCP and other central agencies would focus on ex post monitoring of performance. Given CFE's monopoly position and political clout, however, SHCP does not have much ability to impose ex post enforcement, so the emphasis remains on ex ante controls that leave little incentive for managerial and technical improvements. The lack of 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 its 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 of the energy sector, especially with 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 of PEMEX-monopoly controller of 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 of Energy traditionally has not been able to coordinate the activities of these two giant institutions, which carry great political weight through the political appointment of their heads and the strength of 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 bringin private sector investment as needed to efficiently meet the growing energy needs of 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 Law emphasize the need for greater operational efficiency, financial autonomy of service providers, and the protection of water resources through environmental awareness (referred to as a "culture of water"; see Annex A). The challenge lies not so much with the basic principles of the policies adopted by the Federal Government, but rather in the implementation of these policies, which are hampered by weaknesses in the institutional framework (as mentioned above), overlapping planning and budget cycles at various levels of government, and complex administrative norms including the operating rules of some of the programs that have been put in place to implement these policies. As a result, most water utilities in Mexico still 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 of spending decisions taken at the local levels, and it has recently seen a few important innovations, mostly local. Box 3.8 gives some history on decentralization of water in Mexico. Although the sector i s inherently decentralized, the technically logical pattern of decentralization for water service does not usually match the pattern of political decentralization in Mexico. The new arrangements that stem from the Water Law, however, and the requirements of a reliable supply of water services by sectors of the economy (that is, the tourist industry) mandate more coordinated planning. C N A has 70 appropriate and necessary roles in setting national standards for water service, collecting information, and distributing financial resources derived from national taxation. Box 3.8: Uecentralization of Water and Sanitation Servicesin Mexico Untilthe 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 of a Federal Ministry. Planning, financing, and operation were federal responsibilities without involvement of state or municipal governments. The still common belief that water i s a responsibility of 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 of 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 of 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. In1989,theSalinasgovernment, recognizingtheweaknesses ofearlier efforts, decidedto support the creation of municipal service providers with legal and financial autonomy from the municipality. The newly created service providers were supposedto 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 by State Congresses or the Municipal Councils. The newly created CNA was given the task of 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. In 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 of being diverted to other municipal activities. These policies were essentially continued after 2000 by the Fox administration. Despite the appropriateness of the federal policies to strengthen service providers, the autonomy of many service providers remains limited. Moreover, the quality of 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 is carried out by the municipalities and the OOs, and sometimes by the CEAs, while CNA administers federal subsidies, including technical assistance. The functions of the CEAs differ widely among states, some being in charge of investment planning, and operation and maintenance, while others provide technical assistance, and at least one operates a benchmarking 71 system. Furthermore, CNA and the new basin agencies have a potentially valuable role in issuing (and controlling) permits for the development of new sources and wastewater discharge. Regulations are needed to realize this value. Financing 3.73 SHCP also needs to improve the coordination of its own interaction with the sectoral agencies, especially if it 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 will need to be coordinated with the expected future fiscal envelopes, which are the responsibility of Planeacidn Hacendaria (fiscal planning) in the Subsecretariat of Public Credit for aggregate allocations, and the responsibility of the Subsecretariat of 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 of Public Credit), and the accumulation of contingent liabilities (Subsecretariat of Public Credit). Even if SHCP does not get involved in the choice of particular projects and lines of 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 of spending and contingent liabilities. 3.74 To achieve this, the various parts of SHCP-the Unidad de Inversiones in the Subsecretarka de Egressos (SSE), the DGs of 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 will challenge the traditional tendency of 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 of 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 it has been hard to motivate change. In the other sectors, all three levels of 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, with little reference to the effectiveness and efficiency of sectoral spending, but rather on the basis of notional, largely historical unit costs and ex ante cost-benefit studies. There is 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, it 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 to 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, it i s difficult to determine what could have been done better. There i s no regular reporting by subnational governments on the use of 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 on performance o f WSS companies (organismos operadores). 3.79 Coordination of planning. Federal ministries, agencies, and local governments have been relatively isolated in the planning and implementation of 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 of subsector agencies that operate as silos. The powerful unions reinforce the autonomy o f the subsector agencies, usually at the expense of efficiency. A Comisidn Intersecretarial and the Comith de Evaluacidn de Proyectos, established under Unidad de Inversiones in SSE, are theoretically in charge of intersectoral coordination, but they do not have decisionmaking powers, and sometimes these commissions are only forums for the exchange of information. 3.80 To a large extent, the requirements for infrastructure planning have changed, shifting the focus from public investment programs to strategic planning in Mexico, reorganization of 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 of resources in a way consistent with the national economic and political priorities. Even with such sectoral resource envelopes, set by the President, Cabinet, and SHCP, there still 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 of government to go along with the national strategy. 73 3.81 Achieving a reunification of planning and budgeting within each sector will require not only coordination within the sectors, but also improved coordination among the various parts of SHCP that are responsible for budgeting and financing, setting prices inthe sectors, and controlling the accumulation of budget and contingent liabilities. 74 4. FINANCINGMEXICO'S FUTUREINFRASTRUCTURE INVESTMENTS 4.1 This chapter considers three questions with regard to the financing of 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 it high-income OECD-country levels of coverage? A reasonable expansion and guarantee of minimum quality of service? These questions are reviewed in Section A, which discusses infrastructure investment needs and how they vary according to objective. It reviews the estimates generated by 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 by either the taxpayer or the user, answering the question of who should finance investments and how to best structure investment schemes i s much more complex. Section B looks at the potential role of 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 of 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 of roads, water, and electricity, and discusses ways to make these credit enhancement schemes more effective. Section D concludes by offering recommendations on how the Government of Mexico could better leverage existing sources of financing inthe provision of infrastructure. A. HOW MUCH? MEETING INFRASTRUCTURE NEEDS TOMORROW THE OF 4.3 There are several ways of estimating expenditure "needs" in infrastructure, each of 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 of roads, railroads, and ports. I t does not analyze housing, urban transport, telecommunications, or airports. The model built to anticipate the future investment needs of 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 of transport, which already receive the vast majority of their financing from the private sector. 75 Table 4.1: DifferentApproachesto EstimatingExpenditureNeedsinInfrastructure "Benchmarking" Set target Example: Example: - Stock target: What would it cost to -MDGs: What would it cost for Mexico to get Mexico's infrastructure (per achieve universal service coverage in water capita, per unit of GDP, per km2)to and sanitation, electricity, and access to all the level of the L A C leader; or to the year-round roads. level of 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 is needed to is a particular level of 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 usedfor this. international methodology, applied by CFE Demand: What level of in Mexico, which estimates the investment infrastructure coverage will be needed to maintain the integrity of the demanded by 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 of major corridors and investmen needsfor their completion. SimpleBenchmarking 4.4 Benchmarking can be done through a simple costing exercise. Looking at infrastructure stocks, for example, what would it cost for Mexico to reach the infrastructure density of a country deemed an appropriate comparator or goal? (See Box 4.1 for an illustration.) An even simpler approach is to benchmark Mexico relative to its peers, in terms of how much it 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 of most of its Latin American peers. 76 Box 4.1: The Growth Dividendsof 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 of services with social impacts such as water and sanitation, also contribute to reducing inequality, making growth even more pro-poor. In the case of Mexico, their results imply that raising infrastructure coverage and quality to the level of the Republic of Korea, the East Asia median, would entail a growth payoff of an additional 3.2 percentage points per year. How much investment would be required to achieve this growth payoff? This simple benchmarkingexercise i s done inTable 4.2, relying on international average costs: Mexico would have to invest 52 percent of GDP, or 2.6 percent of GDP over 20 years, to achieve the level of coverage of Korea. Some additional resources would be neededto 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 of this exercise is not, of course, that were Mexico to double its annual expenditures on infrastructure it would become the next Korea. In fact, Korea is a much more densely populated country, so it is 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 of time have invested substantial amounts of resources in developing their infrastructure. It 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 Median (% GDP) 16% 34% 2% 52% Note: Korea is the East Asian median country in terms of infrastructure density for the three services covered in the table. Costs used are US$1,900 per kilowatt of generating capacity, US$400 per mainline, and US$lSO,OOO per kilometer of roads (paved and unpaved). Source: Bank staff calculations based on data from Calderh and Servtn (2004). Costing Set Targets-Pricing Universal Service Access 4.5 As for targets, a possibility is to price the cost of achieving the Millennium Development Goals (MDGs) or some similar universal coverage goal. In the case of Mexico, the cost of reaching universal coverage in electricity and water and sanitation by 77 2015 would be a rather modest 0.17 percent of gross domestic product (GDP), of 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 of 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 it relies on alternative technologies in circumstances where the price of a connection to the grid or the network would become prohibitive. For electricity, it assumes an average price of 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 by alternative off-grid technologies! In the case of water and sanitation, it 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 of 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 of GDP) assuming Latin America and the Caribbean (LAC) average costs. These numbers do not include the cost of 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 of other inputs. This has not actually been done, but an approximation can be obtained usingthe work of Calder6n and ServCn (2004), as described in Box 4.1. Another sophisticated form of benchmarking, developed in Fay and Yepes (2004) assumes that as economies grow and populations get richer, both firms and individuals demand a greater level of infrastructure coverage. 4.9 The growth approach described in Box 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 by a modest growth performance of about 2.5 percent per year.99 About the same amount would be needed for maintenance 98Since there are still some households to be connected that are relatively close to existing grids and could be connected at lower prices (say US$500or so), the price that determines a switch to alternative off-grid technologies could be somewhat above US$l,OOO. However, what i s certain is that an average price of US$l,OOO per connection would not allow universal connection to a grid. 99This is GDP, not GDP per capita, growth. The projection usedfor Latin America as a whole is 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 Model Used by Mexican 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 of the network and satisfy predicted expansion in demand (CFE 2003). This yields an estimate o f MxP$52 billion, or 0.63 percent of GDP (Table 4.3). It does not include universal service coverage, which, considering it i s mostly rural, should be funded with Ram0 33/FAIS resources. Adding the cost of 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 of 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 of Communications and Transport, SCT) estimates that MxP6.7 billion is needed for the maintenance of the federal network, and MxP12 billion for the modernizationhpgrading of 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 of maintenance and rehabilitation costs of the state lw Maintenance is estimated as 2 percent of 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 of 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 of 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. It covers the cost of 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. We estimate, instead, the cost of reaching universal service coverage by 2015 (which i s not a particularly ambitious goal for a country of the income level and existing water coverage of Mexico) and add to it the estimated maintenance cost of the existing system. This yields a slightly higher estimate than CNA's: close to MxP21 billion, or about 0.23 percent of GDP, as shown in the "augmented Government projections" for the water sector in Table 4.4. This amount does not include any of the rehabilitation that i s surely needed. Pullingit All Together 4.13 The exercise above implies that the agencies have made reasonable estimates of expenditure needs in their sectors. Infact, at about 1percent of GDP, these estimates are probably on the low side, since they do not include socially desirable and affordable targets, such as universal service coverage inelectricity and water and sanitation by 2015. They may also underestimate somewhat what i s needed in terms of maintenance and rehabilitation. This may be particularly true in the water sector, which i s well known to have suffered from years of poor maintenance, but for which it i s impossible to estimate the exact cost of the rehabilitation and upgrades needed to ensure better quality of service. As such, even the "augmented" government projections, at 1.14percent of 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 with what could be derived from the various benchmarking exercises. Indeed, b y spending between 1 percent and 1.25 percent of GDP, Mexico will remain around the Latin America average in terms of both infrastructure coverage and expenditures. However, such a level of 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 ~~ ~ lo'In 1960, Korea had less than half Mexico's paved road density; today it 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 1to 1.25 percent of GDP on these infrastructure sectors would have a much greater effect if also accompanied by efficiency gains. In particular, it appears that unit costs in the water sector could be lowered quite substantially. Similarly, studies have shown that rural electrification in Mexico is 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 to insufficient maintenance over the last decade. And it i s well known that rehabilitation i s much more costly than regular maintenance. 81 c1 x z c1 s 10 10 m 2 s r! c1 0 0 -2 0 g g 8 0 - 3 0 s8 I? AI? Implicationsfor FinancingNeeds 4.16 The analysis above suggests that the primary financing challenge for the road sector will be to ensure adequate funding for rehabilitation and maintenance of 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 of financing will 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 of money, which will be complex, given the shortcomings of 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 inthis chapter. 4.18 For water and sanitation, the highest priority will be to use existing funding more efficiently to reduce per-unit costs and to focus more on rehabilitation and maintenance. Any 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 of resources and timing required to meet the social goals of universal coverage are highly sensitive to the prospective improvement (or not) inthe efficiency of the use of funds, and the delivery mechanismfor those resources. 4.19 Responding to the need for increased resources and, most important, increased efficiency in the use o f these resources, will 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. Using the private sector to close the gaps noted should recognize the following principles: e Government support-direct transfer of funds or guarantees-is a subsidy to providers and users of the infrastructure service from the taxpayer. If 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 buildingof a non- toll road), that portion o f the subsidy transfer which i s greater than the value of externality produced by 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 its impact on equity, the setting of 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 of consumers. Efficiency gains can be realized through competitive biddingfor the provision of sunk assets (such as electricity generation facilities) and for long-term arrangements for operations of commercial services. For any of these potential efficiency gains (due to lower operating costs and, possibly, capital costs), to be passed on to consumers by public or private monopolies requires proper regulation or oversight. B. WHOFINANCESTHEINFRASTRUCTURE? 4.20 Infrastructure services are always paid for by either general revenues or user fees. There are two choices when trying to finance an investment project: ask users to 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, of 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 of 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 riskto them. That is not to say that those agencies, investors, and financiers involved with mobilizing finance are not assuming risk. Indeed, since tariffs in some combination with tax revenues cannot be counted on with perfect assurance to match the ongoing financing requirements of infrastructure provision, there i s a risk premium on long-term capital. 4.22 Over the past decade, Mexico introduced a number of 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 of 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 of its infrastructure and to sustain those improvements without unduly taxing public resources will require better use o f PPI. This will entail greater levels of competition in service provision, and better regulation, oversight, and contractual adherence. Competition can be achieved in infrastructure provision in several ways, with increasing degrees of impact on rates and qu,alityof 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 of electricity and gas and retail rights over existing networks). A program's ability to achieve efficiency in service provision and capital expenditure relates to its use of all available forms of competition. In this regard, Mexico i s behind its regional peers. To date, Mexico has primarily used the first form of competition-for the right to build-in the power and water sectors, with a small degree of 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 of 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 firms with the right to choose their sources of generation. Levels of Private Participation inMexico's Infrastructure 4.24 When viewed as a percentage of investment per capita, Mexico has made little use of the private sector in infrastructure compared to most o f its Latin America competitors (Figure 4.1). In order for Mexico to attain more competitive mechanisms, greater and better use o f the private sector will be required in the future. 85 Figure4.1: PrivateParticipationinInfrastructureHasBeenLimitedin Mexico, Relativeto itsPeersinLatinAmerica, 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 of PPI i s all the more surprising in light of Mexico's good sovereign risk and credit ratings, its macroeconomic stability and general success in attracting foreign direct investments, and the depth of local capital markets. Indeed, Mexico i s probably one of the few developing economies today that could fairly easily attract substantial amounts of private capital for infrastructure. lo2 While PPImay indeed 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 inMexico's Infrastructure 4.26 The benefit from private sector participation is generally related to the degree of interface between the private sector and domestic consumers of infrastructure services. While Mexico appears to have achieved fairly low 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 of metering, and theft in tandem with lack of incentives for disconnection. 4.27 In Mexico's case, the most sensitive areas of utility-consumer interface-water supply and electricity supply-have seen very little private sector participation. Although a significant portion of CFE's financing for generation may be mobilized by 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 of 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 by the private sector, few end consumers of those services see the private sector as their service provider and bill collector. Figure 4.2 illustrates this point. Figure 4.2: PPIin Mexico has Disproportionately Favored Production and Generation Rather than Retail Utility, 1990-2003 100% .-f loo% .- fe 80% t : 80% n g.-.- L 2.- 60% -Lu $j 60% ti 5 40% .-3 40% 1 Distributionand/or transmission r - t i r m Distributionand generation 20% ; 20% Generation e:b 0% p 0% LAC (Excluding Chile Mexico LAC(Excluding Chile Mexico Mexico) Mexico) I 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 of Latin America. Less than 20 percent of Mexico's water projects with private participation, and no electricity projects, have assumed some form of retail risk (Figure 4.2). B y contrast, nearly half of Chile's power projects and over 80 percent of their water projects have included a "retail" element that transferred commercial risk to the private sector. Mexico's reluctance to bring the private sector to its citizens in the areas of 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 of incentive for the implementation of effective regulation. 4.29 A related characteristic of Mexico's private programs in water, electricity, and roads can be found in its preference for greenfield projects. 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 (Figure 4.3). 87 Figure 4.3: The Share of PPIAllocated to GreenfieldProjects HasBeenParticularly High inMexico, 1990-2003 U LAC Chile! Mexico (Exduditig Piled@ Notes: Chilean projects traced back to 1985; water data extend through 2004. Source: World Bank PPI Database; Ada Karina Izaguin-e, authors' calculations. Effects of Mexico's Imbalanced Approach to the Use of the Private Sector 4.30 There are several results of 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 of 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 of regulation and independent oversight in Mexico's utility and road sectors remains underdeveloped, while tariff setting remains the purview of political forces. 4.31 The dominant use of private funds in greenfield projects and the imbalance between private sector participation in production/generationversus 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 to 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 is 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 INFRASTRUCTUREI SFINANCED: CURRENTEXPERIENCE WITH CREDIT- ENHANCEMENT SCHEMESINMEXICO 4.33 Even assuming political commitment at the federal, state, and municipal levels, it will take several years for Mexico to move toward the types of 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 of 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 of 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 of 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), it 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 of roads, the government sets the tariffs and the contractors bid for the project on the basis of lower subsidies (Table 4.5). 89 Table 4.5: Conditionsfor FINFRA Financing Type of Contribution Authorized Limit Venture capital Up to 35% of equity Subordinatedcapital Up to 40% of total investment Venture and subordinatedcapital Up to 49% of total investment Aggregatepublic share of capital Up to 49% of total investment Total aggregate public share Upto 2/3 of total investment Commitment inone singleproject 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 by 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 of many new roads, a majority of the concessions failed after the macroeconomic crises of 1995, and were ultimately rescued by the g~vernment."~ The early program was so ambitious that it not only included the few toll roads justified by the traffic volumes of that time, but also included most of 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 of which are now being tendered, and another seven of which are still 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. It 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 of the program are: 0 Federal resources are channeled through FINFRA, establishing maximum limits for each project. FINFRA's funding will serve as a matching grant of 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, it will share with FINFRA the net income from the road until the end of the concession contract. lo3 Sales, Sclar, and Videgaray (1999) offer a description and analysis of the early program and its financial failure. 90 4.40 The bidding i s open to national and international consortiums integrated by investors and operators that must demonstrate their operating experience. With the goal of avoiding conflict of interest, given that it i s both the investor and the constructor, there will be mechanisms that guarantee the risk capital: 0 The concessionaire must take into consideration in its proposal the obligation to supply at least 25 percent of the total project value. 0 A project bond will 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 will 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 of 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 of the sum of federal grants for construction and the present value of the requested CAS. The maximum time span of a concession will be 30 years. 4.42 The main objective of the new program i s to increase the supply of roads through a combination of fiscal subsidies and market financing backed by 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 of the lack of traffic guarantees provided in the program. While it i s an improvement that those direct forms of contingent liabilities are not absorbed by 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 is 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 of 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 of payment (tolls) i s indexed to inflation, and therefore UDIfinance 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 On the impact on Federal Government finances, and thus on the taxpayer burden, the bid design illustrates how much more valuable a real subsidy is 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 of 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 low levels o f interest to date could be the result of the wariness of private road operators to return to Mexico. However, the dominance of 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 from the investors' perspective. 4.47 FINFRA's Wastewater TreatmentPlants: Municipal wastewater treatment is a priority area of 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 of up to 40 percent of the investment, debt financing of about 30 percent (provided b y BANOBRAS 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 To mitigate payment risk, BANOBRAS sets up a contingent credit line that covers from three to six months of payments, and the credit line i s in turn backed up by federal transfers: if the utility does not pay, the concessionaire calls the credit line and gets the payment from BANOBRAS; then BANOBRAS can collect its payment from the federal transfers targeted to the local government. Although the nominal amount of the credit line i s limited to three to six months, it i s a revolving line. Given the strength of the federal transfers guarantee, the revolvency risk i s minimal so, de facto, the complete stream of payments i s backed by federal transfers for the life of the concession. See Box 4.2 for a comparison of Puebla case studies in the use of 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 by 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 BOT 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 of the FINFRAmatching 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 by 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 BANOBRAS contingent credit line basically transforms off-taker risk into debt-like risk backed by 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, no surprise. 0 The accounting treatment of the contingent credit line, due to its revolving nature, does not reveal the true size of 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. T1 i s not a conditional obligation, and i s strongly guaranteed by an intercept on federal transfers, so its 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 Box4.2: Case Review: The PueblaBOTBuybackComparedto the PueblaRoad Securitization A comparison of the Pueblatoll road securitization and the Puebla water BOT demonstrateshow credit enhancement design affects risk allocation and the financial sustainability of projects. In the case of the Puebla toll road, a partial guarantee was offered, which forced the market to understand the underlying risk and absorb a meaningful part of 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 of critical variables related to payment capacity, including tariff levels. There i s no backing of 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. It was based on federal transfers, not a financially viable asset (the utility) or credit structure. Finally, investors had absolutely no control of 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 of the credit enhancement instrument deliver a different level of sustainability in each arrangement's financial structure. Inthe 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 of critical variables stayed with the state government in the BOT'S case. Annexes D (Puebla Toll Road Securitization) and E (the Puebla BOT Buyback) contain more detailedinformation about these individual cases. D.RECOMMENDATIONS 4.50 The following recommendations to improve the design o f federal infrastructure programs that increase decentralization and private participation come from 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 is to protect the government's macroeconomic stability by limiting the government's fiscal exposure to infrastructure investment wherever possible. This must be done in the context of awareness o f the growing need for infrastructure investment in real terms. The recommendations have three objectives: 0 Reducing risks where possible; 0 Rebalancing risk allocation away from taxpayers and toward providers and users; and 0 Improving 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 into 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 of local capital markets will also reduce currency risk, and may reduce project risk by fostering closer alignment between long-term investor interests and operational performance o f the service provider. 4.52 To rebalance the allocation of 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 its fair share of 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 of tariffs to keep pace with input prices. This will require strengthening regulation and the financial and technical performance of 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, incases where credit-enhancement mechanisms are indispensable, given growing expenditures in infrastructure, the Government should design the enhancement to protect its 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. Improvingthe Federal Government's Instruments to Achieve Desired Infrastructure Outcomes with Sub-sovereign Projects 4.53 To reduce political risk, it i s important to understand the decentralization process and the agency problem it generates. The agency problem arises because of 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, diminishingtheir incentives to abide by the rules. 4.54 Moreover, in a repeated interaction, municipalities and local governments perceive that they not only will avoid penalties, but will 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. It i s important to break this structure o f perverse incentives that lead to inefficient outcomes. Box 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 Influenceto 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 of 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 of the Federal Government. Some of 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. This i s aggravated by the short-term horizon of municipal administrations. Since the key issue of 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 its fiscal powers to recover water fees from the municipalities. Most programs focus on benefits for municipalities, but little is done to enforce the law. This type of 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 ifthey do not pay their fees. Moreover, there is little incentive for sewerage and sanitation becausethe municipalities perceive a very low probability of 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 of law To date, it is usingonly the first. 1. Mainly by the use of the contingent creditline used inthe FINFRA projects. 2. CNA is the responsiblefiscal authority to enforce the differentregulations. Reducing Currency Risk and MobilizingLong-termFinancingthrough the Greater Use of LocalFinancial Markets 4.55 The achievement o f macroeconomic stability, along with a sustained decline in inflation and interest rates has, in recent years, led to the rapid development of Mexico's domestic financial markets. Inreal terms, medium- and long-term private securities more than doubled from 2000 to 2004 (Figure 4.4). 96 Figure 4.4: Local Market and Institutional Investors Development (% of GDP) 2.50 2.00 1.50 1.oo 0.50 tInstitutionalInvestors*tMediumandLongTermPnvateSecuntles *SIEFORES, Insurance Companies (pension, health, and life), Mutual Funds (fixed-income, variable income, and capitalmarkets), and Savings andCredits Societies. Sources: CNBV, CONSAR, CNSF. World Bank (2003), and Banco de MCxico (with data from Instituto parael Dep6sitode Valores [INDEVAL]). 4.56 At the project level, two indications of the development of local financial markets are the long-term securitization of mortgages and the financing of a toll road, at the end of 2004, with maturities of 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 by Mexican private pension funds (AFORES). As of December 2004, AFORES managed assets in excess of MxP469 billion (US$41.9 billion), an amount equivalent to 6.3 percent of Mexico's GDP (Figure 4.5). This figure i s expected to reach 20 percent of GDP by 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 of Nuevo Le6nsecuritizedthe Monterrey-Cadereyta highway to obtain 25 years' maturity. 97 Figure 4.5: AFORES's Assets Under Management (as of December of each year, billionsof pesos) 450 400 393 315 242 200 159 150 104 100 50 1999 2000 2001 2002 2003 2004 Source: CONSAR. 4.57 The market has also benefited from 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 of the Mexican bond market has allowed the government to access financing in the local market, converting the majority o f its debt from foreign currency (mostly U.S. dollars) to pesdenominated debt, thereby reducing the existing currency mismatch. It has also led to unusually high levels of reliance on bonds for project finance, as demonstrated in Figure 4.6. Figure 4.6: Bonds as a Percentof Total Project Finance(1996-2004) g 100% a I 0 90% 8 80% Latin Am. (Excluding Mexico) ~ @. 70% -0ECD Countries -***.<****AllDeveloping Countries I 60% 50% 40% .7 n 30% Ye c ," 20% f 10% m 0 0% 1996 1997 1998 1999 2000 2001 2002 2003 2004 Note: Representsvoluntary reporting by financiers. Source: Project Finance League Tables; Stephan von Klaudy, authors' calculations. 98 0 In banking, the Comisidn Nucionul Bu,ncuriay de Vulores (CNBV) has recently enacted new rules for the creation of reserves at credit banks. The amount of 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 of the mechanisms of intervention should encourage the use of 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 will 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 to initiate them into the long- term investment opportunities: 0 Preparing projects to meet their particular investment requirements by boosting credit ratings with multilateral guarantees. (See Chile Toll 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 with strategic investors. Since they generally prefer to be passive investors, they may not care to marry with other equity investors in advance of a sale. For the competitive portion of the transaction held subsequent to 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 Designof Guarantees 4.60 It may be difficult for projects to cover internally the cost of risks associated with proper Government behavior, given the weak institutional and regulatory frameworks in Mexico's infrastructure sectors. However, uncertainty of 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 its 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 of credit from a multilateral organization, which focuses on Partial Risk Guarantees for infrastructure projects. Such a facility could be administered by 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 of the Government, this might be an effective way to bring the strength of a multilateral agency's credibility into the infrastructure sector without the full cost o f sector loans. To improve the perceptions of 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 by providing political risk insurance against such risks as transfer restriction, expropriation, breach of contract, and war and civil di~turbance."~ MIGA could help the Government avoid self-induced risks, and it 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 of 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 by 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 inElectricity and Water 4.62 The imbalance between private sector participation in production compared to retail operations places a disproportionate burden on 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 `05MembershipinMIGA is open to all member countries of the World Bank. A country must (a) sign the MIGA Convention; (b) deposit its instrument of ratification; and (c) subscribe to the shares of the Agency's capital stock allocatedto the country, andpay in full to the Agency the subscriptionamounts. 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 of 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 of Guayaquil, MIGA offered political and contract breach insurance to protect a performance bond issued by 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 Hfor a description of the case.) 4.64 In roads, the use of the private sector in the rehabilitation and operations of existing assets will help minimize the need for revenue or traffic guarantees, given the importance of proven traffic levels to financial backers. In these cases, even partial coverage of cost with tolls helps to reduce the need for full budgetary transfers or guarantees. Redirecting BANOBRASActivitiestoward Complementingthe Market 4.65 BANOBRAS i s the most important government institution for promoting infrastructure in sectors such as water and roads. However, the bank's activities could be reorientedto enhance its impact: 0 Complementmarketfunctions. 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 of its structural challenges (for example, high payroll, low return on assets), BANOBRAS has valuable competitive advantages that could be used under a new business model: o Important brandrecognition among states and municipalities; o The largest origination capacity inMexico; o A better capacity than commercial banks to take long-term risks; and o Capacity.toprovide technical assistance. 4.66 Consequently, a business model oriented to make BANOBRAS play a catalyst role will require the bank to considerably expand its credit-enhancement activities for market transactions, as it 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, BANOBRAS should use the strength of local capital markets and the bank's competitive advantages. A special guarantee line of products focused on 101 government negative covenants can be of great value to the market. This would build on BANOBRAS's role in securitizing projects, such as with the Puebla-Atlixco Toll Road (see Annex D), for which BANOBRAS provided a partial guarantee to bondholders. ImprovingProgramandProductDesign 4.67 Mexico's macroeconomic stability has been recognized by the international rating agencies as a key element in the promotion of private participation in the provision of infrastructure. This stability is, without doubt, a fundamental prerequisite for financing of infrastructure with spreads that contain reasonable premiums for country, regulatory, and project risk. Consequently, program and product design must consider the impact on 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 of PIDIREGAS-and of the market structure of the electricity sector as a whole-shows up in this context. Likewise, PPPs could prove to be a new source of 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 of the sub-sovereign participants. 0 PZDZREGAS: To 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 of 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 inpower generation should be possible for a national utility. PPS Evaluation and Debt Management: In the case of PPPs, the future commitments of the Federal Government could be significant, making it important to assess the intertemporal effects of this intervention mechanism. To assure proper long-term management, the Ministry of Finance should carry out a global assessment. Currently, only the Undersecretariat of Expenditures of the Ministry of Finance participates in the selection process of PPPs. The Public Credit Unit (in the Public Credit Undersecretariat) should participate fully in the evaluation and assignments of PPPs, since the Unit already must comment on the long-term implications of 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 of 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 is to tie grants for politically attractive sectors to conditions around clear performance and financial targets in high-social-impact but low-priority infrastructure sectors. lo6 According to the Presidential Decree of April 9, 2004, only the Public InvestmentUnit and the Budget Controland Policy Unit of the Expenditure Undersecretariatparticipateinthis process. 103 5. A WAY FORWARDFORINFRASTRUCTUREFINANCE 5.1 This chapter draws out the broad lines of action flowing from the analysis of performance and financing of infrastructure of the prior chapters. It identifies common approaches and mechanisms, indicating the impact of each, and provides a time frame for their implementation. It concludes b y illustrating the nature of the challenges to be addressed in operationalizing those considered of high priority. It should be reiterated that being a review principally of expenditure and finance issues, the recommendations do not address all facets of infrastructure services, nor does it provide a detailed roadmap for implementation. Rather, this review aims to stimulate dialogue and consensus buildingon ways to better and more fully use current and potentially available resources for basic infrastructure services. A. SYNTHESIS OFFINDINGS 5.2 The main conclusions of 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 of service. Chapter 2 examined the quality of service and extent of coverage, as well as levels of spending in transportation, electricity, and water and sanitation infrastructure in Mexico. It also includes a comparison of Mexico's performance characteristics with those of other middle-income and Organisation for Economic Co-operation and Development (OECD) countries. It concluded that Mexico has made steady progress in increasing coverage in recent decades-higher than the averages for Latin America, but below those of OECD countries. 5.4 The quality of 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, still 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 of transmission and distribution losses and thermal plant availability, with outage rates higher than official figures would indicate. Incontrast, 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 of usage and underinvestment. Retail tariffs for electricity, Water Supply and Sanitation (WSS), and toll roads are set by a wide array of agencies based on a mix of 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 of 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 of 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 of public expenditure on the infrastructure sectors considered in this study are broadly appropriate if Mexico is to remain around the Latin American average in terms of coverage and quality o f infrastructure. No solid estimate of 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 of what is needed during 2006-15 (MxP83 billion to 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 of gross domestic product (GDP), depending on growth performance. This does not include the cost of rehabilitation in water and sanitation infrastructure, much of which i s in poor condition, but for which no estimates are available. While these estimates are probably on the low 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 of infrastructure per capita of other OECD countries or faster-growing East Asian countries. Indeed, countries like the Republic of Korea, which trailed behind Mexico in terms of 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 with Mexico in terms of infrastructure quality and coverage. This suggests the urgency of the need to reallocate untargeted subsidies-such as the 0.7 percent of GDP currently spent on electricity consumption subsidies-toward productive investment and maintenance, and the need to improve expenditure efficiency, more generally. 105 5.8 The current low levels of quality of 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 of public funding to water supply and sanitation should focus more on rehabilitation of water distribution networks for improving continuity of service, whereas for roads, the priority is on highway maintenance and upgrading the secondary network. Inelectricity, as long as CFE remains a public monopoly, the priority for public funding should be upgrading transmission capabilities, and maintenance and renewal of 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. To 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 of 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 by respective sectoral agencies inconsultation 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 to 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. 5.11 Multiyear resource envelopes should be used to strengthen planning and better link it 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 of 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 of 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 of government, namely roads and water, experience in the United States 106 and other federations in the OECD shows the value of 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 of federally funded programs reporting systems with respect to efficacy and efficiency of such programs in achieving measurable outcomes in terms of quality and sustainability of service. An ex post evaluation would provide valuable information on what measures work and why-and thus valuable input for the design of 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 to complement subsidy-based incentives. 5.13 In order for Mexico's service provision to become more efficient and accountable, greater and better use of the private sector will be required in the years to come. When viewed as a percentage of investment per capita, Mexico has made little use of the private sector in infrastructure compared to most of its Latin America competitors. Given Mexico's sovereign risk and credit ratings, macroeconomic stability, general success in attractingforeign direct investment, and depth of local capital markets, this i s a lost opportunity. While these low levels of 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 will have to be carefully monitored so that maximum benefits in efficiency are achieved through more aggressive forms of competition. 5.14 InMexico's case, the most sensitive areas of utility-consumer interface-water supply and electricity supply-have seen very little private sector participation. Although a significant portion of CFE's financing for generation may be mobilized by private power plant developers, and several water and wastewater treatment plants around Mexico are built and operated by 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 to 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 of water and electricity may be considered a response to political constraints rather than a result of 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 of effective regulation. 5.16 Mexico also uses the private sector primarily to fund the construction of greenfield projects rather than to address the inefficiencies or capital shortfalls of existing assets. While this may be changing with the new PPPs toll-road initiatives, and a few water concessions, to date, the vast majority of 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 of financing, or procurement approaches. 0 Reduced pressure to establish legal and institutional arrangements that separate out political, operational, and economic decisionmaking. Hence, Unnecessarily highcost of 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, ingeneral, 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 will continue to be required to cover risks in infrastructure investment, their design should be oriented toward negative contingencies. Instead of using full and revenue guarantees, this study advocates for more partial risk guarantees and other measures. On one hand, this will better ensure that the private sector has an incentive to be efficient and innovative, and, on the other hand, that the Government i s fulfilling its responsibilities as partner. Inthe same vein, Banco NacionaZ de Obras y Servicios Pziblicos (BANOBRAS) and other Mexican development banks should shift the focus of their guarantee coverage from broad revenue and volume or traffic bases to more breach-of-contract and expropriation coverage. It 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 its 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 of projects, strengthening the user-fee market structure, and credible regulation. Greater use could be made of Mexico's growing long-term debt markets to 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 of this local funding. B. INTEGRATIONOFRECOMMENDATIONS 5.19 In this section, the findings of the preceding chapters are translated into recommended actions, and integrated into a strategically oriented agenda for infrastructure in Mexico. It 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. Table5.1: PrincipalRecommendationsby Sector andTheme Improving PublicFinance: Institutions, ServiceEfficiency All Credit Information, and Quality Pro Accountability, Coordination Zlectricity Rampup multiyear Permitelectricity ursueoptions to permit (CENACE). subsistence levels. -educeburdenon ,uyers and sellers choice: PSBR. lower marketswith Options for reversing nultiple distribution CFE's zompanies (public or decapitalizationand xivate) andindependent subsidy financing xansmissioncompany. mechanism (aprovechamiento). Consider options for introductionof private management andcapitalir distributioncompanies. wss Strengthen Incorporategreater Shift credit support Strengthen capacity of state povertytargetingin from up-front intergovernmental water commissions existingurban transfers to partial coordinationinpolicy, in planning, programs. contingent guarantee planning, financial performance mechanismsto participation,and service monitoring, and Establishprogramto improve risk standards. tariff review. addressunique allocation. circumstancesof Increasecoverage,depth, Institutionalize small citiedlarge Focus guarantee andrelevanceof the financial and towns. schemes on sistema de informacidn operational financially solid nacional. autonomy of water Maketransfers utilities, securedby operators. conditionalto actual tariff revenues, not Strengthenmunicipal performance unconditional federal accountabilitiesfor use of Review technical improvements. transfers. unconditionaltransfers norms to promote (PRODDER,FAIS). sustainabilityin Performance-based serviceprovision. transfers formalized Review optionsto throughnational improveefficacy of sistemafinanciero dischargepermitsand del agua. levies. 109 Improving Public Finance: Private Finance and Service Efficiency Allocation and Credit and Quality ProgramDesign Enhancement Strengthencoordination imong model agencies to acilitate efficiency gains ?om multimodal *ompetition. Clarify rules for Continue tripartite service access to :o-financing of urban facilitate exchange bypasses. traffic. Strengthen oversight of 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 programlevels. increase and cost estimates; maintenance allocate resources on Strengthen tripartite efficiency. technical criteria. Coordination at regional Levelthrough regional Reinforce asset road councils. management capacities of states and municipalities. Permit FARAC 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 FARACnetwork. 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 of 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 programrevision. local government Rebalance PPP and budget cycles. credit guarantees Strengthen vertical toward underserved coordination inplanning, 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. For local infrastructure, establish state revolving funds for PPPs, disbursed on performance criteria. Revisit BANOBRAS 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 of taxpayer resources. This means reducing the role of the government in financing the electricity sector and toll roads, which have made substantial fiscal demand (many of them off-budget or contingent) and for which there i s significant scope for increased private participation. B y the same token, it implies improving the efficacy of spending in traditional areas o f public finance such as water supply, sanitation, and (non-toll) roads. 5.21 Three broad sets of policy instruments can be brought to bear to impose discipline or incentives on service providers to improve efficiency: competition, regulation, and financial markets. Competition i s notably absent from the electricity sector due to the statutory monopolies granted to CFE and LFC. It i s precluded from the water and sanitation sector, due to the natural monopoly characteristics of localized services. In transport, there are substantive competitive forces through intermodal choice, directly competing ports, and the presence of "free" roads in toll corridors. As to regulation, arms-length regulation of 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 of funding in those segments of infrastructure where private finance has been permitted, though the structure and coverage of federal financial guarantees have muted the incentive impact on operators' performance. This i s discussed below. 5.22 Short of 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 of state operators. One example i s CFE's Corporate Transformation program, which should operationalize the prior pilot exercise of 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 a1Rescate 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 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 of return to such spending is much higher than to new investments. Examples of strategic segments of 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 of 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 of the poor to the service and extending coverage in small localities. To the extent that consumption of these groups merits subsidization, it should be limited to satisfying minimumbasic needs. Moreover, delivering service to the poor need not be costly, and relaxing technical norms governing choice of 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 by extension the magnitude of subsidies and demands on Mexican taxpayers necessary to sustain services. Infrastructure, by nature, has important spillover effects, involves multiple stakeholders, influences economic outcomes in varied ways, and therefore requires a good deal of coordination. In Mexico, closer coordination is required along several dimensions: among sectoral agencies and the Secretaria de Hacienda y Crkdito Pziblico (Ministry of Finance and Public Credit, SHCP) to keep long-term sector development "plans" in line with budgetary and broader fiscal realities, and in dealing with a newly empowered Congress to weed out projects of questionable viability; among sectoral agencies to ensure balanced sector development (for example, gas-electricity in energy, and multimodal planning in transport); and across tiers of 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 localjurisdictions, bear the impact of local pricing and investment decisions. 5.26 Across sectors, federal budgetary resources tend to be allocated annually by formulas, and for large projects based on ex ante cost-benefit calculations undertaken by the project proponents. Given the limited reliance on competition, regulation, and financial markets to discipline operator performance, one of the few levers available to government is conditioning provision of resources to achievement of efficiency and/or service delivery targets. This means dimensioning the magnitude and type of transfer to the pace of 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 to 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 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 Federation's future willingness to step in to cover subnational or state-owned enterprises' obligations, and the lack of arms-length regulation strongly limit investor interest. Rather than having taxpayers assume still greater risks to attract private finance, (as has been the case in power generation with the substitution of Obra Publica Financiada [OPF] for independent power provider [IPP] contracts), efforts should be directed at the source of the uncertainty: the capacity of the off-taker to 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 inthe electricity and WSS sectors. 5.29 Federal credit enhancement will be required to attract sizable sums of private funding from domestic and international sources, but their design and functioning are due for revision. To date, projects under federal jurisdiction have generally been backed by full guarantees of 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 of 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 of negative covenants, that is, political (and regulatory) risk insurance and other forms of contingent risk coverage. In the case of subnational projects, reliance on negative covenants may also reduce financing costs, but will require some kind of asset or cash-flow-based security, which could take the form of 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 of investment finance from greenfieldoff-take facilities to distribution networks. 5.30 Arms-length regulation of tariffs and service quality is 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 of private investment as legal opportunities for that are opened. Improving sector performance will 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 of access and service quality, the required levels of investments and potential sources of 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 of 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 of institutional arrangements should be considered. For investors and operators to take on some risks now borne by 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 of 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 of state water commissions and municipal agencies in performance monitoring, planning, and the revision of 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 of authorizing individual projects and budget envelopes annually, on the basis of 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 of autonomy i s accountability. In the absence of 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 of SHCP is currently developing a methodology for program impact evaluation. 5.33 Other elements of performance tracking and information disclosure that would enhance accountability and decisionmaking for federal resource allocation include: regular reporting by subnational governments on the use of federal transfers, especially unconditional transfers such as Ram0 33/FAIS, which are a growing source of finance for WSS, urban and state roads, and electrification; and standardized reporting on performance of 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 by strengthening CENACE's capabilities in this area, as well as CRE's. Progress in these areas would help form the basis for performance-tracking systems, which would facilitate several of 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 of sectorwide investment programs. These measures do not require large sums of 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 To 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 low impact, and whether they entail high or low levels o f difficulty in their implementation. Recommendations are considered to be of higher impact if they are likely to produce substantial results either in terms of 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 of 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 to 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 of the two- dimensional mapping: these are high-priority measures, and hence should be acted on in the short term. However, given their difficulty, it 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 of the figure. Although low priority, they could be undertaken rapidly if so desired. Last, group IV corresponds to the low-impacthigh-difficulty measures, which are (or should be) of limited interest as a practical matter. 5.36 The results of mapping Figure 5.1: recommendations by impact and Framework for Prioritization of Recommendations difficulty are presented in Table 5.2. The bulk of the recommendations fall into the high-priority upper-right and upper-left quadrants of Figure 5.1, with very few in the low-impact/long-term b U lower-left quadrant. Those in the right d IL I HIGHPRIORITY, HIGHPRIORITY, quadrants represent some of the "quick LONGTE&l SHORTTERM wins" either because the necessary zaese course o f action i s already well defined, because they can be implemented on the basis of existing legal or administrative instruments, or because c U m the associated financial costs are a d N. z LOWPRIORITY, LOW PRIORW, modest. Most of these actions could be 3 L O N G W SHORTTERM 0 addressed forthwith, with efforts A focusing on those in the upper-right quadrant. HIGHDIFFICULTY LOWDIFFICULTY 116 Table 5.2: Mexico: IPER-Prioritization of Recommendations MoreDifficult LessDifficult High Priority MULTIPLE SECTORS: yIULTIPLE SECTORS: [nstitutionalizemultiyearbudgeting. streamlinebudgetaryrelease procedures. Establishsystematicex post impact strengthensubnationalgovernment evaluation. iccountabilityfor use of federal transfers. Strengthenvertical coordinationin planning, mprovehorizontalcoordinationamong sector financing, andregulation. igenciesand SHCP. Shift BANOBRAS's guarantee coverageto 5stablish state revolving funds for PPPs, breachof contract. iisbursedon performancecriteria. Shift from full debt serviceguarantees to 5ncourage privatepensionfundparticipationin partialoff-takeand risk guarantees. ong-termfinance. RebalancePPP and creditguaranteesto SeparateBANOBRAS retail financingrole from underservedsubsectors. rigination and guarantees. Options to access privatepensionfunds for long-termfinance. ZLECTRICITY: 3educe transmissionanddistribution losses ELECTRICITY: hroughmodernizationandmaintenance. AddressLFC functionalbankruptcy. EmpowerCREto function as sector regulator: Developpower marketsoptionswith multiple iversight of tariffs, service quality, and distributioncompanies(public or private) and :ontract% independent transmissioncompany. Target consumption subsidies to poor Introduceprivatefinance in distribution. households. Reduce relianceon OPFin favor of long-term wss: servicecontracts. Institutionalizefinancial andoperational autonomy of water operators. TRANSPORT Incorporategreater povertytargetingin PermitFARAC to outsourceO&M to private existingurbanprograms. firms. Establishprograms for small citiedlarge Use multiyear, standard-basedcontracts to towns. increasemaintenanceefficiency. Make sector transfers conditionalto actual Promotefederal and state PPPs (New performanceimprovements and formalize in ConcessionScheme). sistemafinancier0 del agua. Shift credit support from up-front transfers to wss: partialcontingent guarantee mechanismsto Build capacity in state water commissions. improverisk allocation. Expandsistema de informacidn nacional. Focusguarantee schemes on financially solid TRANSPORT: utilities, securedby tariff revenues. Implementinstitutional reformof toll road management. Complete modernizationof key highway corridors. 117 Lesser Priority Continuemodernizingpublic procurement rules. Increasereliance on user fees and/or state/local own revenues. Increaseflexibility of long-termPPAsto reduce risks to CFEFederation. Contain scope of PIDEREGASandreview structure to reduceburden on PSBR. OperationalizeCFE CorporateTransformation Program. Reviewtechnicalnorms to promote sustainabilityin serviceprovision. Strengthenintergovernmentalcoordinationin policy, planning,financial participation,and service standards. RestructureCAPUFE. 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 of 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 of tariffs and service quality among CFE, SHCP, and CRE; and service oversight, investment planning, and financing among CNA and subnational governments. Others present financial hurdles, including rebalancingtoll-road tariffs, increased funding of maintenance and renewal of electricity distribution networks, and highway maintenance. 5.38 Nonetheless, to obtain broad, sustained gains in overall sector performance, a significant proportion of the recommendations in the upper-left quadrant (Group 11) should be addressed. These are characterized as longer-term, high-impact measures. Implementation of these recommendations requires first addressing certain challenges. Table 5.3 identifies the nature of the challenges to be addressed for each. Given their complexity, preparatory work for many of 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, it will be necessary to 118 continue to consult with stakeholders and build consensus around the need for and direction of change. Table5.3: MX: IPER-Challenges inImplementingLonger-TermRecommendations finance. ELECRICITY I AddressLFC functional bankruptcy. X X X Introduceprivatemanagementandcapitalin I X X distribution. Developpower marketsoptionswith multiple X X distributioncompanies (public or private) and independenttransmissioncompany. wss Institutionalizefinancial andoperationalautonomy of X Incorporategreater povertytargetingin urban X programs. Strengthenmunicipal accountabilitiesfor use of ? ? unconditionaltransfers. Establishprogramsto addressuniquecircumstances of smallcitiedlarge towns. Make transfers conditionalto actualperformance ? X improvements. Performance-basedtransfers formalizedthrough ? nationalsistemafinanciero de agua. Shift credit support from up-front transfers to partial X contingent guaranteemechanismsto improverisk allocation. TRANSPORT Implementinstitutional reformof toll road Complete modernizationof strategichighway X 119 ANNEXES 6. ANNEX A. NATIONALFEDERAL ORGANIZATIONSAND PROGRAMSINWATER 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 in2000 to promote a cultura del qua-"a culture o f water"-in Mexican society. It has formed five committees covering the following strategic issues: economy and finance, education and communication, legal framework, technologies, and environmental management. It recently initiated a comparative analysis of water-related policies and their impact on water productivity and on sectors and socioeconomic groups inthe society as part of World 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, in2002 the CCA initiateda 10-year media campaignon the culture of water. These are everyday water conservation ideas for the layperson to minimize water use, such as using one glass of water to brushone'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 of Environment (SEMARNAT), i s incharge of research, development, and transfer of 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 by a board presided over by CNA. 6.4 Most larger service providers are members of the Asociacidn Nacional de Empresas de Agua y Saneamiento de Mhico (ANEAS). Founded in 1992, ANEAS represents the interests of service providers in the national political arena, promotes the exchange of experiences among service providers, strives to strengthen the autonomy of service providers, and promotes the culture of water. 6.5 Water resources management and land-use planning, which are closely linked to investment planning, should ideally be undertaken at the level of the hydrographic region (basin), because of the numerous environmental externalities within a basin. In Mexico, this has been recognized in principle through the establishment of 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 Law mandated the creation of 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 of the Water 120 Financial System (Sistema Financier0 del Agua, SFA), introduced through a recent amendment to 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. More than half the members of the Basin Councils represent various levels of government, while up to half represent users and "society." The Basin Councils (Organismos de Cuenca) are expected to guide, together with CNA, the work o f the basin agencies. 6.7 The directors of the Basin Agencies are supposedly autonomous, but will be appointed by CNA. It i s not clear if or to what extent the Basin Agencies will integrate the functions and the personnel of CAN's regional and state offices. The number of Basin Agencies i s also not clear. Thus there i s considerable uncertainty about the scope, form, and timing of the restructuring process and decentralization of CNA. 6.8 DrinkingWater for Urban Areas (Agua Potable en Zonas Urbanas, APAZU) is directed at urban areas, and used to be CNA's largest program. Created in 1990, it i s the oldest of the current C N A programs and was initiated by the World Bank. It has continued to be funded by the Federal Government after the closure of the last corresponding World Bank loan. 6.9 The Water Rights Return Program (Programa de Devolucidn de Derechos, PRODDER) was created in January 2002. It is funded by water rights payments by 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) is targeted at the six Mexican states bordering the United States. The U.S. government makes grants to this program through its 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 of drinkingwater. 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 of the new system. `OsThe 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 by up to five Basin Agencies. 121 6.13 BANOBRAS (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 is 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 of 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 of the 11programs has its 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 of the water and sanitation investments among these programs i s available. 122 7. ANNEX B. PAYMENTFORENVIRONMENTALSERVICES IN WASTEWATER TREATMENT-AN EXAMPLEOF PERFORMANCE-BASEDTRANSFERS'" 7.1 Financing and cost recovery for urban sanitation, consisting of 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 of 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 on certified outputs, instead of financing inputs such as civil 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 is suspended. If the norms are still not met in the next trimester, the service provider i s excluded from 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 is clearly assigned to the service provider, which i s best able to manage that risk. To prevent overinvestment, the treatment plants have to be included in basin plans adopted by 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 EXPERIENCEINTHE USEOF THE PRIVATE SECTOR 8.1 This annex summarizes some elements in the design of private participation in the financing and building of 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 of the private sector inexisting 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 of 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 of this area of infrastructure have often proven unreliable. To exacerbate the problem of demand uncertainty and price inelasticity, the public good nature of 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 of 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. In contrast, of the 359 toll roads that were signed into agreement during that same period, 31have been canceled, representing nearly 9 percent of all projects. If any country knows the difficulties of managing a successful toll road program, it i s Mexico. Over half of the world's individually canceled toll roads were in Mexico, and the recent initiatives to introduce a more nuanced risk-sharing mechanism into the biddingsystem for the second round of toll roads reflects that learning curve. 8.4 Despite the challenges, there have been hundreds of successful toll roads in the developing world, particularly in Latin America (155 out o f 359 toll roads) and East Asia (157 out of 359). What distinguishes successful toll-road projects from Mexico's early experience is 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 minimumtraffic or revenue guarantees, which were used to further limit private risk. Table8.1: A SampleofPublicandPrivateContributionsto Toll RoadsinEastAsia privateFinance PrivateFinanceat Risk* 18% 73% 76% 48% Public Fundsor Contributions in Kind 25% 27% 16% 23% *All figures inUS$ Billions Note: Does not includecontingent liabilitiesfrom minimumtraffic or revenueguarantees. 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 of the projects (nearly three-fourths of 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 it takes to achieve the winning NPV. Electricity 8.7 Many developing countries have attempted to liberalize their energy markets and to replace rigid state controls with private initiative and ownership. As mentioned, this has often involved the use of the private sector for the assumption of commercial and retail risk (investment in distribution) and construction risk in generation. O f the 340 electricity projects undertaken inupper-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 of the U S 1 0 3 billion mobilized for the sector's private projects. Aside from 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 by competition and more independent regulation. Despite the recent shock and tension between the Argentine Government and the country's 62 federal concessionaires, the formation of Argentina's power market represents a successful attempt to introduce market forces into a lethargic and underfunded power sector. 125 8.8 To 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 of privatized entities. In addition, full repatriation of profits was allowed. 8.9 Duringthe reform period of the mid-l990s, roughly 10,000 megawatts (MW) of Argentina's total installed capacity of 18,300 MW was sold, and Argentina's four large federal electricity companies were unbundled and a 51-percent share of each of the three resulting federal distribution companies was sold to private investors.' '' Now, over 90 percent of Argentina's transmitted power i s carried by 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 of vertically integrated federal electricity utilities prior to their sale. Transmission was separated from distribution, and the wires were separated from the retail function. In addition, cross-ownership restrictions were implemented. Generators were legally restricted to a market share of 10 percent or less of the national electricity sales volume. Generating companies were not allowed to own a majority share inany 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), is responsible for dispatch and for settlements. CAMMESA i s a nonprofit, independent organization. Though it i s owned by the government and the power generation companies, it i s governed by a board composed of two representatives each from the generating companies, the national government/Secretariat of Energy, the distribution companies, the transmission companies, and large users. Competition i s encouraged by open access to the wholesale market that i s guaranteed by law. 8.12 Argentina's federalist form of government, in which much autonomy i s granted to the provinces, has provided a complicated context for restructuring and privatization. While the privatization of 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 to concerns over unemployment and conflicts at the provincial level. In addition, there have been conflicts between the agendas of 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 of 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 of service providers. The Argentine experience also shows that privatization at the subnational level mightbe 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 of 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 of global private investment in infrastructure in developing economies between 1990 and 2001. Moreover, it has been declining: private flows for water supply and sanitation did not reach US$1billion in 2003, down from US$8.4 billion in 1997. Build-operate-transfer (BOT) water and wastewater projects represent less than one-third of all water projects by value and by 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 Participationin Water Servicesin 2002 United States Source: CNA "Masons Water Yearbook 2002-2003." 8.16 The state of the water sector in the developing world remains challenging for investors. For example, in many countries there is a lack of knowledge about the location and condition of the underground networks, which represent on average 70 percent o f the value of the utilities' assets. Moreover, water i s often considered a free or deeply discounted public good, despite the costs of 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 Indicatorsof Water Reforms Indicator Buenos Mexico Aires City Santiago Abidjan Con 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 Populationin service area at start of reform 8.7 8.4 6.4 4.6 2.0 1.o (millions) NationalGDP per capita at start of the reform 8,861 7,647 3,462 7,101 1,582 1,398 (US.Dollars) Populationconnectedat start of the reform(percent) Water b 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 productionat start of reform 1402 1113 527 478 67 163 (million cubic meters) a. Before reform, the lease inAbidjan hadcharacteristics 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) andprobably Lima, and minimal in Santiago andBuenos Aires. c.1990. d. Includespeoplewith accessto standpipesor neighbors' taps. e.1980-91. Source: MCnardand Shirley (2002). 8.18 Competition emerged only through competitive bidding in Buenos Aires, Abidjan, and Conakry. With a concessioncontract, regulation inBuenos 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 by Santiago (US$64) and Conakry (US$12). 8.20 The short-term results of 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. New 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 inthe 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 to reflect the actual cost of providing services. The Chilean Government then reorganized the sector under 13 state- owned regional water companies and started to partially privatize some of them. Privatization was followed by renewed investment by the privatized companies, but also by more apparent limitations of 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 of companies also emerged in price behavior. During 1998-2001, private companies' rates rose 20 percent more on average than did public companies' rates. Most of 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 by private companies are still 40 percent lower on average than those charged by 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 of the world's driest climates (Bitran and Valenzuela 2003). 8.23 In Argentina in the early 1990s, a series of 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 of 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 of the country, and an unstable legal and fragile regulatory framework. The shortcomings of these structures, and the little protection that the contractual clauses afforded to the lenders, became apparent with the economic collapse of the country, which led to the failure of the majority of the concessions. 8.24 Some conclusions can be drawn from this brief review. First, private participation in the water sectors of developing countries i s a reality, although it has been declining as large international operators continue to retrench. Second, privatization often improves performance, although it i s not the only way to foster efficiency, as the case of Santiago (which remained in public ownership during the period studied by MCnard and Shirley [2002]) demonstrates. Third, macroeconomic risks are extremely important and should be mitigated (the failure of a considerable percentage of Argentina's concessions illustrates the point). Fourth, the financial and governance credibility of municipal governments i s central to the success of most water public- private partnerships, given the decentralized nature of the service. 130 9. ANNEX D. PUEBLA TOLL ROAD SECURITIZATION-THE USEOFSPECIAL-PURPOSEVEHICLES TO MOBILIZESUB- SOVEREIGNFUNDS 9.1 On 27 August 2004, the State of Puebla toll-road company, Curreterus de Cuotus Puebla (CCP), issued a municipal bond backed by the future flows coming from the collection of tolls o f the ViaAtlixcdyotl, a state-owned toll road connecting the cities of Puebla and Atlixco. Proceeds were used to finance the construction o f a new toll road inthe same state. Table 9.1 summarizes the key elements of the transaction. Table 9.1: Transaction for the Securitization of the Via Atlixcayotl BondType: Trust-preferred, inflation-protected,interest-bearing, municipalbond (Certifcados Bursa'tiles) Amount Issued: 151,680,000 UDIS (MexicanInflation-linked Units), equivalent to MXN519,989,073 at the issue date (27 August 2004) Maturity: 5,460 days (approximately15 years) CreditRatings: AAA(mex) FitchRatings; mxAAA Standard & Poor's InterestRate: Fixedat 6.40% Payments: Semiannual Debtor: Caminosde Cuotade Puebla (CCP) Trustee (bond issuer): Nacional Financiera (NAFIN) CreditEnhancement: Banco Nacional de Obrasy Servicios Pliblicos (BANOBRAS) 9.2 The deal was structured by creating a special-purpose vehicle (SPV) to issue the municipal bonds and manage the structure's cash flows. Under the legal agreement endorsed by 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 of the assets to the Trust. Transaction Background 9.3 The ViaAtlixcdyotl i s a regional 18-kilometer toll road that connects the capital city of Puebla and the city of 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 of the region, which has resulted in additional traffic (mainly cars). 9.4 During the past few years, the government of the State of Puebla has continued to build much-needed road infrastructure. While some o f these projects have benefited from federal grants, most of them have been financed by the state. 131 9.5 The Governor of the State of Puebla, together with the Board of Directors of 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 NAFINwhich, acting as the trustee of this private trust, issued the MxP520-million inflation-linked municipal bond. The bond i s backed by the future cash flows from the collection of tolls on the Via Atlixcciyotl. The transaction i s also backed by a line of credit (irrevocable, contingent, and unconditional) provided by 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 Unidudde Znversidn (Inflation-Linked Units, UDIs), or approximately 80.4 million UDIs. 9.7 Figure 9.1 shows the structure of the security reform. Figure 9.1: Securitization of the Via Atlixcayotl Structure Chart: Secwihtian o fthe "ViaA ~ ~ y a t l " s t r u c t u w TOLL-ROAD -13 " 0PERAT0R I 4..................... TOLL-ROAD USERS 7 2 6 OPERATINGAND 1 1 MA1NTENANCE 2-J EXPENSES TOLL-ROAD CCP 2 PROJECTS IN THE STATE OF PUEBLA Transaction Innovations and other Highlights 9.8 The ViaAtlixcdyotl bond deal is an innovative transaction in the Mexican market due to the following reasons: 132 0 It 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 of 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, it calls for reliance on the creditworthiness of the toll road itself. This allows for a more efficient use of 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 Itis the first bond enhancement by BANOBRAS. The transaction marks BANOBRAS's entry into the bond enhancement market. As a lender, BANOBRAS 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) to receive local "AAA" ratings from FitchRatings and Standard & Poor's. Previous toll-road securitizations had received ratings of 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 of 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 inthis deal. 133 10. ANNEX E. THE PUEBLA BOT BUYBACK 10.1 In January 1999, the water utility company of the State of 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 by 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 of Puebla administration, SOAPAP no longer considered the tariff increase a viable option. As a result, the monthly payments for the BOT severely affected SOAPAP's financial standing-so much so that it eventually stopped making payments. Once that happened, TAPSA called the contingent credit line, and BANOBRAS collected payment from the state government. Because SOAPAP continued to argue that it 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 its federal transfers). 10.3 Finally, in 2004, after more than two years of paying for the BOT, the state government realized it could significantly lower its monthly payments b y substitutingthe T1 (off-balance) liability with straight (on-balance) debt. Therefore, in January 2005, SOAPAP refinanced the T1 with an anticipated buyback of the plants, for an amount equal to MxP665 million, part of 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 from a commercial bank, with 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 of the plant with the former concessionaire, Undeo Degremont. 10.4 The Puebla buyback illustrates the following: 0 A BOT structure can aggravate the fragile financial standing of a local water utility if the source of funds to 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 BANOBRAS 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 On 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 of payments that appeared on its 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 of the state's pledge of its federal transfers under the original BOT structure made it possible to lower the capital cost to the off-taker by increasing leverage (in fact, paying out equity). It made little sense to continue paying equity returns when the risk to the concessionaire was debt-like, and when 100percent debt refinancing was possible. 135 11.ANNEX F. CHILETOLLROADCASE: USEOF MULTILATERAL GUARANTEESTO EXTENDTERMS AND ENTICEDOMESTICPENSIONFUNDS Transaction Background 11.1 In order to secure domestic long-term financing"* for the Santiago-Valparaiso- Vina (SVV) toll road concession, a co-guarantee of 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 SVV would not be able to secure debt financing from the large pool of local capital controlled by the pension funds and insurance companies. 11.2 The use of the co-guarantee structure enabled IDB to overcome underwriting limits of the private sector window of the institution of the lesser of US$75 million, or 25 percent of project costs. Because the SVV concession does not have a fixed term, the financing incorporates a mandatory prepayment provision, should the term of the concession be shorter than the stated tenor of the bond issue. This transaction, the largest guaranteed local currency issue to date in Chile, represents the first example of cooperation between a multilateral institution and a private sector monoline financial guarantor. It 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 If a long-dated transaction is not rated high investment grade, primarily AAA on the local scale, it probably will 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 of Chile has attempted to solve this issue through use of a foreign exchange collar, the perception of risk among investors would most likely preclude a successful launch. 11.4 Innovation of Project: Foreign exchange risk is mitigated through financing in the local capital markets. The risk that the rating of the transaction would not be sufficient for term capital market investors in Chile is mitigated through use of the IDB financial guarantee product, where the IDB guarantee up to its underwriting limits enabled the financing to attain investment-grade ratings. This was then wrapped b y the 'I2The project is financed through the issuance of a local currency bond for approximately the equivalent of US$306million, 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 '13Source: StructuredCredit International Inc. 137 12. ANNEX G. TOLL ROADTOLUCA-ATLACOMULCO-THE USEOFLIMITED CONTINGENT CREDIT LINES Transaction Background 12.1 InMarch 1993, the Ministry of Communications of the State of 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 of Toluca and Atlacomulco, in exchange for financial compensation to the State of Mexico. Two 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 of Mexico negotiated a substitution of the dealer and some modifications of the terms and conditions of the concession, inthe following manner: 0 OCALFA, in exchange for an indemnity paid by the State of Mexico, transferred the rights of the concession to a Trust established in the Bunco Nucionul de Obrus y Sewicios Pziblicos (BANOBRAS). The term of the concession was extended for 20 years. The Trust obtained debt collateralized with the future revenues of 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 of the concession. 0 Also in 1999, a revolving, irrevocable, contingent credit line was signed by the State of Mexico, which i s secured with a pledge on federal transfers. The credit line i s triggered only if (a) the State o f Mexico does not update toll-road fees in accordance with the terms and conditions of the concession; (b) if income decreases due to the crossing of users free o f charge (with passes granted by the State of Mexico) in numbers that exceed the levels agreed; and (c) the collection of 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 of the transaction was that the contingent credit line was not provided to secure the debt service, but rather to guarantee that the State of Mexico would not take actions that could adversely affect the collateral of the debt obtained by the trust. This guarantee has the following characteristics: 0 It,is partial, forcing the market to understand the underlying risk and absorb a meaningful part of it. 138 0 It is based on an underlying financially viable asset (the road) and structure, which achieved an underlying A+ rating without the guarantee (and it has no backing of federal transfers). 0 The true sale structure gives control to the investors of critical variables related to payment capacity, including tariff levels. 12.4 Moreover, by focusing only on negative covenants, it i s an efficient tool to address the issue of 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. GUAYAQUILWATER AND SANITATION: USEOF A MULTILATERAL GUARANTEETO COVERNEGATIVE CONTINGENCIES INA MUNICIPALWATER PROJECT Transaction Background 13.1 The Interagua-Guayaquil Water and Sanitation Project remains one of the more innovative water transactions to come to closure in Latin America.'14 In October 2000, the Government of Ecuador publicly tendered the administration, operation, rehabilitation, and expansion of 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 by US$18 million of political risk insurance helpedclose the deal. 13.2 INTERAGUA is a subsidiary of the International Water Group of the Netherlands. It 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 by reducing unaccounted-for water and increasing cash collection. The concession agreement calls for tariff increases to be linked to predetermined improvements in the quality of 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 of the concession. The concession term is divided into six five- year periods. Based on the information gathered during the first year of operation, INTERAGUAhas been able to assess the capital expenditure program needed to improve quality of services and to achieve the requirement of 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 million for 2002-06. The Project's Innovation 13.4 In the absence of 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 its commitment to service expansion and improvement through a performance bond. To 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 of MIGA provided sufficient assurance for the deal to reach financial closure. '14This information is extracted from an Inter-American DevelopmentBank project report, a Multilateral InsuranceGuarantee Agency report, andpressreports. 140 14. ANNEX I.TLALNEPANTLA MUNICIPAL WATER COMPANY: A STRUCTURE FOR SUSTAINABLE FINANCINGAT THELOCALLEVELINMEXICO Background 14.1 The year 2001 witnessed the rebirth of the Mexican municipal bond market after more than 90 years of inactivity. Mexico, although a federal country, was politically and economically centralized for most of its modern history. A cornerstone in the decentralization process was the US$600 million World Bank structural adjustment loan of 1998. The loan set up a series of 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, makingMexico, in a six-year period, the second-largest country in terms of municipal ratings (after the United States and before Canada). 14.2 These reforms have led to the increasing participation of states and municipalities in meeting the large demand for infrastructure. The growth of assets under pension fund management has further accelerated this development. Assets under management grew from MxP40 billion in July 1998 to 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 of approximately 800,000 habitants. It is strategically located in the metropolitan area of Mexico City, which makes it a major commercial and industrial hub of a region o f more than 24 million 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 of securing water supply to populations and businesses i s particularly acute in the metropolitan area of Mexico City due to its topography (high altitude, low precipitation) and high population density. The scarcity of water i s further aggravated b y a long history of inappropriate incentives, such as allowing the use of 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 by the payment obligations under a loan agreement between the trust and the municipality of Tlalnepantla and its municipal water company, acting asjoint obligers. 14.6 Dexia provided a letter of 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 of Dexia's payment obligation. Figure 14.1 describes the structure of this arrangement. Figure 14.1: TlalnepantlaMunicipalWater Structure I Transaction Innovations 14.7 The Tlalnepantlabond issue was a landmark transaction for the Mexican market for the following reasons: 0 It was the first time that a municipality did not use federal transfers as collateral for the financing. This represents an important departure from the traditional scheme for financing states and municipalities in Mexico, because it places additional reliance on the creditworthiness of the local government. 0 It 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 It was the first credit enhancement for a bond issued by a state or municipality. The enhancement i s partial, so that the enhancers will be sharing the risk with the investors. The presence of Dexia and the IFC was crucial in convincing the investors that the risk was acceptable. 14.8 In addition, the structure of the transaction addresses some of the challenges for the intervention o f international financial institutions in the financing of local infrastructure. The financing i s in local currency, thereby avoiding that a public utility (and its users) take the currency risk. 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