GPOBA COMMITMENT PAPER – draft July 29 2007



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INDONESIA

GPOBA COMMITMENT PAPER

Project Name: Expanding Piped Water Supply to Surabaya’s Urban Poor (P105590)

Project Summary

The objective of the project is to increase and sustain access to piped water networks for poor households living in both formal and informal areas of Surabaya. The project will result in about 15,000 household connections to the utility’s piped water network and 500 household connections through a small number of innovative master meter schemes for informal communities not otherwise eligible for household supply. The total number of beneficiaries will be about 77,500 people (5 people per household).

The public water utility of Surabaya (PDAM) will be the implementing agency and ultimate recipient of the subsidy and the Grant Agreement will be signed with the Government of Indonesia. PDAM Surabaya will pre-finance, procure, and construct the systems. A City Government Committee headed by the Department of Public Works will act as the Scheme Manager to manage the project as a whole. In addition, a firm will be hired as the OBA Auditor to provide an annual assessment of progress and quality of works under the project; to undertake spot checks on connections made; and to certify the unit subsidies for extension connections and master meter schemes.

Total project size is $4.785 million of which $2.527 million is requested from GPOBA for subsidy payments, technical assistance, and Bank supervision. The project will be implemented over three years from 2008 to 2010 with a phased approach. In year 1 about 3,000 connections and three pilot master meter schemes will be provided. In years 2 and 3, the project will scale up. The 15,000 household connections will be a mix of in-fill connections to existing networks and expansion connections to new tertiary network subject to maximum average subsidy of $150 per household ($30 per person). In total about 7,500 in-fill and 7,500 expansion connections will be provided and about 10-15 master meter schemes.

Unit costs have been developed based on a random sample of recent PDAM contracts. They have been carefully verified by an independent consultant and compared with benchmarks. The unit cost per in-fill connection is set at $78 of which households will pay $33 (42%) and GPOBA will pay $45 (58%) for eligible connections. The unit cost for expansions schemes will vary according to length of tertiary pipe but is estimated at $283 on average of which households will pay $33 (12%) and GPOBA will pay $250 (88%) for eligible connections. However, assuming a 50 percent eligibility for reimbursement in expansion areas, GPOBA will only subsidize half of the network expansion costs. PDAM will bear the other half estimated at more than $1.5 million, in addition to all pre-financing costs. Unit costs for master meters have been developed in line with project practice for in-fills and expansions with a cap of $5,000 per scheme for the size of subsidy. All master meter and extension costs will be subject to review by the OBA Auditor prior to reimbursement.

Project beneficiaries will be targeted using proxy variables for income poverty. Specifically, the three eligibility criteria are: (1) building size < 60 m2, (2) road width < 6 m, and (3) formal installed electricity capacity < 1,300 VA (with a preference for households < 900 VA), or no formal connection.

Subsidy payment for eligible connections will only be made three months after the beneficiaries have gained access to piped water supply and the service has been delivered and paid for during that period. In addition, subsidies will be only disbursed provided the connection is new and made after signing of the Grant Agreement; the connection is of the approved specification; the connection is operational and in use at time of application for payment; and expansion and master meters schemes have been subject to the appropriate ex-ante and ex-post quality and unit cost reviews by the OBA Auditor.

Project Fact Sheet

Scope: Expanding piped water supply to low-income households in the city of Surabaya (East Java, Indonesia) through a combination of household connections to existing network, household connections to expanded network, and master meter schemes.

Total project costs: $4,785,000

Total GPOBA funding requested: $2,527,500

• Subsidy funding for connections = $2,212,500 (W3)

• Subsidy funding for master meters = $75,000 (W3)

• Independent auditor = $95,000 (W3)

• Recipient-executed special studies = $25,000 (W3)

• Supervision funding for World Bank = $120,000

The GPOBA funding will come from the Dutch contribution to GPOBA, and will meet requirement that subsidy per capita is less than or equal to $30, and that no more than 25% of Dutch contribution is allocated to non-SSA countries.

Additional funding sources: $2,257,500

• PDAM Surabaya Investment + Supervision = $1,587,500

• USAID ESP/ Eco Asia = $150,000

• User contributions for household connections = $495,000

• User contributions and NGOs for master meters = $25,000

Outputs:

• About 15,000 working household connections

• About 10-15 master meter schemes with 25-100 households each, target 500 households

Expected beneficiaries: 77,500 people (5 people per connection)

GPOBA subsidy “efficiency”: $30/person ($33/person with TA and Supervision costs)

Targeting: Households in poor areas that meet the three criteria established by the project as proxy variables for income poverty: (1) building size < 60 m2, (2) road width < 6 m, and (3) formal installed electricity capacity < 1,300 VA, or no formal connection.

Grant recipient: Government of Indonesia

Financial Management: GPOBA subsidies disbursed to incumbent service provider through designated account managed by the scheme manager. FM approach presented in this document has been prepared by FM team in Jakarta and will soon be cleared by the Regional Hub Leader (as part of process of finalizing the grant agreement).

Disbursement:

• Household connections = 100% after receipt of verified evidence of 3 months water service and paid bills

• Master meter schemes = 100% after receipt of verified evidence of 3 months water service and paid bills

Procurement:

• Cleared by Regional Hub Leader

• Competitive tendering of OBA Auditor through prior review

• Post review of PDAM works contracts in line with Output Based Disbursement (OBD) guidelines and the Country Procurement Assessment Report (CPAR) for Indonesia

Safeguards clearance:

• ISDS Concept Stage cleared by Regional Secretariat

• ISDS Concept Stage disclosed in Infoshop on July 31, 2007

• Project transferred to GPOBA for appraisal stage clearance

• Category B for environmental safeguards

• No other safeguards triggered

Government endorsement:

• City of Surabaya—Mayor’s Office, Planning Agency, Financial Management Agency

• Government of Indonesia—Ministry of Finance

Internal Rate of Return (IRR):

• Economic IRR is 45% with subsidy including expenditure, time and health benefits

• Financial IRR, even with subsidy, is -7 %

Exchange rate: IDR 9,000 per 1 USD

Panel of Experts’ Issues raised at Eligibility Stage (March 2007)

1. Household Contribution

The Panel of Experts asked if the tariff could cover at least O&M costs and if household contributions could be increased to more than the currently proposed $20.

➢ The tariff structure is set by the City of Surabaya, under regulations from the Ministry of Home Affairs, and cannot be adjusted for the project. Although some tariffs for residential customers do not cover O&M costs, the overall tariff structure (which contains a mix of different customer categories and consumption blocks) does cover both O&M and production costs. Such cross-subsidy schemes are common in Indonesia and accepted as a form of social redistribution.

➢ The project has increased the household contribution for in-fill or expansion connections to $33. This new figure is based on the results of a large survey of poor households which confirmed that 57% of poor households in selected project areas would be willing to pay Rp.300,000 ($33) or more for a PDAM connection. This new figure increases the efficiency of the GPOBA subsidy.

2. Project Buy-In

The Panel raised the issue of the project’s continuity in the event that the current managing director of the PDAM left.

➢ The OBA Team at the PDAM is a dedicated team with 15 members from the various departments of the utility, including Planning, Customer Service and Consumption, and Research and Development. Active participation by PDAM staff in the project to date (from the concept stage to detailed preparation) ensures an institutional commitment to long-term service delivery to the poor, organizational learning as to how to design new schemes in the future, and a vested interest in maintaining water service beyond 3 months.

➢ In addition, the project team has met twice with the Mayor of Surabaya and multiple times with other city government agencies apart from PDAM. The involvement of a city agency as Scheme Manager now ensures that there is local support for the project beyond the PDAM. There is also support for the project from central government, including the Ministry of Public Works and the Ministry of Finance.

3. Grant Agreement

The Panel asked that the team clarify who the signatories to the Grant Agreement would be.

➢ Several options for implementation arrangements were explored including signing the Grant Agreement with the Government of Indonesia, with an NGO, and with the PDAM directly. However, due to Indonesian regulations, it was found that it is not possible to sign a Grant Agreement on behalf of the World Bank either directly with a city government or with a PDAM. As an alternative arrangement, discussions were held with leading NGOs in Indonesia. However, the option to work with an NGO was ultimately rejected in order to develop a national government model that would be scalable elsewhere in Indonesia, and because of limited interest from the NGOs themselves. As a result, the Grant Agreement will be signed by the Country Director of the World Bank (on behalf of GPOBA) and the Ministry of Finance (on behalf of the Government of Indonesia). Subsequently, an On-Grant Agreement will be signed by the Ministry of Finance and the City of Surabaya.

4. Mechanisms for Master Meter Tariff Collection

The Panel expressed some concern over the risk element of the master meter scheme. It felt that the design of a plausible mechanism to safeguard/ensure tariff collection would be important for replication.

➢ The master meter scheme has been designed such that subsidy disbursement for the portion of the costs of the system pre-financed by PDAM will be contingent on three months of billing and collection for the bulk meter. This is different from the concept stage in which 80% of the costs were to be reimbursed once the bulk meter was simply in place. In this new arrangement, PDAM’s reimbursement will thus be contingent on a successful tariff collection mechanism downstream of the bulk meter. This will put pressure on PDAM staff to take an interest in community mobilization and in the way the local NGO or CBO has designed the payment system, without putting such stringent safeguards in place that the project becomes a supply driven rather than a community driven scheme.

➢ Experience with similar schemes elsewhere, such as in Medan in Sumatra, Indonesia, has shown that there have not been any problems with revenue collection in either metered or non-metered downstream systems, and that in general community management does not appear to be an issue. To ensure that well-designed and sustainable tariff collection systems are in place, our project partners USAID ESP and ECO-Asia, both based in Indonesia, will work closely with local NGOs and have set aside significant funds to support them and transfer knowledge from Medan and elsewhere.

LIST OF ABBREVIATIONS

Bapemas City Poverty Agency

BI Bank Indonesia

BOQ Bill of Quantities

BPKP Government Financial Auditor

BRI Bank Rakyat Indonesia

CAS Country Assistance Strategy

CBO Community Based Organization

DG Directorate General

ESP Environmental Services Program

GOI Government of Indonesia

GPOBA Global Partnership on Output-Based Aid

Kelurahan Urban section/ward, comprising on average 10 RWs

Keppres Presidential Decision (Keputusan Presiden)

Kota Municipality

KPPN Local Office of National Treasury

KTP National Identity Card

MDG Millennium Development Goal

MoF Ministry of Finance

MoHA Ministry of Home Affairs

NGO Non Governmental Organization

NRW Non-Revenue Water

OBA Output-Based Aid

PIM Project Implementation Manual

PDAM Local Water Supply Company (Perusahaan Daerah Air Minum)

RPJM National Medium-Term Development Plan

RS Second Lowest Water Tariff for “Simple House” (Rumah Sederhana)

RSS Lowest Water Tariff for “Very Simple House” (Rumah Sangat Sederhana)

Walikota Mayor

1 USD = Indonesian Rupiah (IDR) 9,000

A. STRATEGIC CONTEXT AND RATIONALE

A.1. Country and Sector Issues

Indonesia

Indonesia is classified as a DAC III country although, from a World Bank perspective, it is an IDA/IBRD blend country. Some key national statistics are provided in the table below:

Table 1: Key Country Indicators

| |2005 |

|Population growth (annual %) |1.36 |

|Population, total (millions) |220.56 |

|Life expectancy at birth, total (years) |67.79 |

|Mortality rate, infant (per 1,000 live births) |28 |

|GNI (current US$) (millions) |278,236 |

|GNI per capita, Atlas method (current US$) |1,280 |

|GDP per capita (PPP US$) |3,600 |

|Population living below national poverty line (%) |16.6 (2007) |

|Population living below $2 per day (%) |49.9 |

|Prevalence of HIV, total (% of population ages 15-49) |0.13 |

Source: World Development Indicators Database, April 2007.

Indonesia has achieved remarkable economic development success over the past decade and was, until the Asian economic crisis struck, considered to be among the best performing East Asian economies. Indonesia grew at an annual rate of 7.1 percent between 1985 and 1995, and attained real Gross Domestic Product (GDP) growth of 7.8 percent in 1996. Between 1970 and 1996, the proportion of the population living below the official poverty line declined from 60 percent to an estimated 11 percent—about twenty-eight million people – reflecting the government's strong commitment to poverty reduction.[1]

During the 1997 financial crisis, GDP growth declined from 7 percent to negative 13 percent and inflation surged to nearly 60 percent. Since then, Indonesia has made a strong economic recovery and its transition to democratic governance and decentralization continues with President Susilo Bambang Yudhoyono making important reforms on several fronts. Indonesia has graduated from the IMF program, its macro economy has strengthened, and development spending and poverty levels have returned to pre-crisis levels. While governance issues remain an impediment to progress on some fronts, prospects of genuine reform are better now than in decades.[2]

Since mid 2006, Indonesia has been showing signs of a solid recovery from the dramatic fiscal and monetary policy adjustments in late 2005 which slowed the economy and increased poverty.[3] The 2005 economic slowdown was due in part to interest rate increases and in part to administered fuel price increases. Although the economic adjustments were designed to put Indonesia on a solid footing and were well received, the resulting slowdown was unfortunately accompanied by more natural disasters, including an earthquake in Yogyakarta, a tsunami in West Java (separate from the tsunami in 2004 that devastated Aceh), and a mud volcano in East Java south of Surabaya. Moreover, poverty rose from 16 percent to 17.75 percent between 2005 and 2006. The key economic challenge now facing the country is to turn the recent cyclical upturn into sustained growth, while addressing poverty and improving disaster preparedness.

The Urban Water Sector

The Indonesian water sector is in a precarious position. It suffers from, inter alia, tariffs set well below full cost recovery levels, low coverage, declining service ratios, high non-revenue water (especially from physical losses), poor levels of service, high indebtedness, political interventions and poor management capacity.[4] These problems have led to a vicious cycle of negative cash flows, underinvestment in assets, insufficient maintenance, increasing indebtedness and defaults/ arrears on loans. The situation has been exacerbated by the absence of any supporting national water strategy to accompany the 2001 decentralization of responsibility for service provision to local governments.

Prior to the 2001 decentralization program, the Ministry of Finance (MoF) used to provide financing to the country’s hundreds of local water supply companies (PDAMs) by means of sub-loan agreements, bearing much of the risk and burden of any unpaid loans. Although fiscal accountability has now been transferred to local governments, the PDAMs remain heavily indebted to central government. Current PDAM indebtedness stands at around IDR 5.2 trillion ($570 million). Of the 338 PDAMs, less than ten percent are deemed financially “healthy.” Most generate insufficient funds to cover operating costs, let alone invest in network expansion and/or in service improvements to increase cash flows in order to service debts.

Currently, only 17 percent of households have access to piped water. For Indonesia to achieve its Millennium Development Goal (MDG) for water, sector investment must increase from IDR 450 billion ($50 million) to at least IDR 4.15 trillion ($450 million) per year until 2015. Unsurprisingly, Indonesia is below the coverage required to be on track to fulfilling the MDGs for both water and sanitation in 2015. Disaggregated data for urban and rural areas show that urban water coverage has fared particularly badly with coverage actually regressing from 1990 (92 percent) to 2004 (87 percent).[5]

In the absence of a connection to piped supplies, households rely on shallow and deep wells. Ongoing use of such sources is becoming increasingly unsustainable, particularly in urban areas. Lack of adequate sanitation has led to contamination of shallow groundwater sources and an increase in the associated incidence of water-borne diseases. The over-pumping of deep wells has led to salt water intrusion in coastal aquifers and ground subsidence. In addition to wells, poor households buy water from small-scale vendors and from neighbors with access to piped supply. Vended water costs many times more than piped water and poor households can spend more than 20 percent of their income on vendor-distributed water.

In general, ability and willingness to pay is not an issue in terms of water tariffs, but steep connection charges can, and often do, constitute a barrier to entry for the poor. There is evidence that most unconnected households that would like to connect are poor, with a large proportion of them being “very poor”[6]. A recent customer satisfaction survey of 12 PDAMs across the country revealed that nearly half of the unconnected poor would like to become PDAM customers if they could afford to.[7] Connection fees are typically USD $50, but are sometimes as high as USD $400—particularly in cities like Surabaya and Bandung where the price of new connections includes the cost of expanding the tertiary network in addition to the stated connection fee. Most poor people do not have the disposable income to pay such fees unless they are spread out over 3 to 5 years.

The Surabaya Water Supply Company (PDAM)

Unlike most of Indonesia’s public water utilities, PDAM Surabaya has a good reputation in the market and is in a stronger financial position with no arrears on its debts. In 2005, the utility’s annual operating and maintenance costs were USD $25 million and its total revenue $31 million.[8]

At its helm is a new director from the private sector who has shown commitment to efficiency improvements for existing customers and to system expansion for new customers. With the potential for several more years under the new director, the utility can be expected to continue its positive trends. In 2006 the utility reduced its non revenue water (NRW) by 1.3 percent to 36 percent through improvements in customer processing and faster response times to leakage complaints. Bill collection, which is outsourced to the private sector, reached an impressive 98% and the Customer Service Department was certified by ISO 9001.

Currently, coverage is 67% with approximately 360,000 domestic and commercial connections—but the City Government of Surabaya, which owns the PDAM, has given it ambitious expansion targets. In 2007, for example, the company is expected to connect an additional 20,000 residential customers.

As part of this push, PDAM Surabaya has shown a rare commitment to connecting the poor. In 2007, the utility set aside IDR 2 billion of its own budget ($220,000) for tertiary network expansion to the city’s poor neighborhoods. However, both its funds and know-how are limited. The current approach of the utility is to target the 3,000 households on the city’s waiting list. And while these households cannot afford the full costs of system expansion, they are not particularly poor. Moreover, these households on the waiting list are being assisted by a recent micro-credit program initiated by the PDAM with USAID’s Environmental Services Program (ESP) in Surabaya in coordination with a national bank (BRI). The poorest households, who do not qualify for micro-credit and are not on the waiting lists, are not being targeted.

Around 10-20% of Surabaya’s residents are estimated as officially poor.[9] In practice, many more live on less than $2 per day. Many of these poor households are unable to afford the steep connection fee which includes the cost of tertiary network expansion. In addition, some segments of the urban poor population are unable to furnish the legal paperwork required by the utility for the provision of individual household connections—documents such as land titles and national identity cards. In the absence of piped supply, these households are currently reliant on a combination of vended water from neighbors or small scale independent providers and free well water, much of it either expensive or contaminated.

In short, there is a clear need for increased investment to improve access for the poor, and there are limitations regarding their ability to pay for it. There is also a need for innovative solutions to the water problems of informal communities and for ways to deliver piped water to them.

A.2. Rationale for GPOBA Involvement

This project meets GPOBA operational criteria and the core OBA principles of:

• explicit use (i.e. targeting) of subsidies;

• increasing accountability of service providers;

• providing incentives for innovation and efficiency;

• enhancing sustainability; and,

• monitoring of results.

Replication

The project has great potential for replication both within Surabaya and across Indonesia. Within Surabaya, the active participation of PDAM staff of all levels in OBA project design and the formal establishment of an OBA Team by the Director in January 2007 shows strong institutional commitment to long-term service delivery to the poor. In addition, service expansion targets set by the city, including for poor households, suggest that both the Mayor and City Government will hold the PDAM accountable for service delivery to the urban poor. Given annual budget allocations by the city to the utility for system expansion, the OBA approach could in future years be adopted by the City Government and lead to a better definition of the relationship between the city and PDAM with regard to servicing low income households, to more transparency, and to better incentives for performance.

The project also puts forward a national model which other cities or donors may take up. Because this project targets a public sector utility and 337 out of Indonesia’s 338 water supply companies are still public, this scheme has the potential to have a powerful demonstration effect on the merits of output-based aid. Already during project preparation, the Ministry of Public Works and the National Planning Agency have expressed a keen interest in potentially expanding the OBA approach to other cities.

Innovation

The project will also demonstrate the potential of an innovative master meter approach for informal settlements when individual household connections are not viable. Providing service through bulk supply, whereby utility asset ownership stops at the entrance to the community, and enabling communities to manage their own distribution networks, metering, billing, and collection is a new approach to service delivery that has not been tested before in Surabaya. GPOBA subsidies will help test this innovative approach in the field. Successful implementation of these schemes could have a very powerful impact on city leaders and PDAM managers who remain skeptical of the ability of the poor to pay for service and wary of extending networks to poor and informal neighborhoods.

A.3. Higher Level Objectives to Which the Project Contributes

The proposed project fits well with existing high level development objectives and strategies developed by both the World Bank and by the Government of Indonesia. For example:

• The project supports the Bank’s latest Country Assistance Strategy (CAS) for 2004-2008, which focuses all lending and grant activity on two areas impeding rapid poverty reduction: (1) a weak investment climate; and (2) low quality service delivery to the poor. Within the goal of improving the climate for high quality investment, building Indonesia’s infrastructure is a key objective in the CAS. Within the goal of improving the quality of service delivery to the poor, Bank Group support is devoted to making providers more directly accountable to their clients.

More specifically, the project supports two of the Bank Group’s four stated “business platforms” from which CAS objectives are to be reached. These are: (1) the Community Driven Development Platform, (2) the Local Services Platform, (3) the Public Utility Platform, and (4) the National Lending Platform. About 40 percent of lending is allocated to the Local Service Platform to help create local accountability in service delivery, and about 15 percent of lending is allocated to the Public Utility Platform to support investments in both governance and efficiency in the water supply and energy sectors specifically.

• The project supports the recommendations of the World Bank’s 2006 policy report entitled Making the New Indonesia Work for the Poor. The report specifically states that existing targeting and subsidy mechanisms in the water sector are flawed and that mechanisms need to be put in place to target the poorest specifically. The OBA project supports several of the specific solutions outlined in the report, including geographic targeting (e.g. injection of subsidy into spatially defined poor areas), means testing (e.g. selection by income or other robust proxy variables), and lower service-levels (e.g. provision of stand pipes or other forms of bulk supply in order to increase access). The project also supports the stated need to encourage water utilities to institutionalize pro-poor approaches, reconsider service levels, develop pro-poor financing strategies, and target the needs of the very poorest households.[10]

• The project supports the attainment of the Millennium Development Goal (MDG) for water by specifically targeting those least able to afford connection fees and network extensions. This is important not only because coverage is behind schedule for the sector as a whole, but because the urban water sector is faring particularly badly. For example, the proportion of the urban population with access to sustainable water supply has actually decreased from 92 percent in 1990 to 87 percent in 2004.[11] Moreover, coverage for piped water supply is less than 20 percent. This means the majority of urban citizens with access to improved water supply are dependent on vended water and groundwater of increasingly poor quality, and well-organized projects are needed to reverse the declining trend so that Indonesia can get back on track to achieving the water MDG.

• Finally, the project supports the Government of Indonesia’s latest national medium-term development plan (RPJM) which aims to provide 40 percent of households with access to piped water by the end of 2009.[12] The National Action Plan on Clean Water (NAP-CW), issued by the Ministry of Public Works in 2004, supports the attainment of the MDG and proposes achieving this by improving access to piped water supply from 17 percent to 62 percent in 2015, and reducing dependency on other water sources. Among other things, this requires a major push for system expansion and increasing the number of household connections – both of which strategies are directly supported by the OBA project.

B. PROJECT DESCRIPTION

B.1. Project Development Objectives and Key Indicators

The main development objective of the project is to increase and sustain access to piped water networks for poor households living in both formal and informal areas of Surabaya. Achieving this objective should result directly in:

• access to affordable and clean water services;

• health benefits from reduced exposure to the environmental risks posed by contaminated water and associated water-borne diseases;

• economic benefits from a reduction in the cost of water, from a reduction in medical expenses and other coping costs associated with inadequate supply, and from a reduction in time spent collecting water;

• social benefits from more equitable access to clean water for poor households; and

• environmental benefits associated with a transfer of water supplies from wells to piped supply that will reduce excessive groundwater extraction and associated land subsidence.

This development objective will be measured primarily by (1) the number of eligible (low income) households with new access to piped water networks; and (2) the number of master meter schemes installed (see Annex 5).

Annual reports will be prepared that also assess the impact of the project on connected households using, at least, the following indicators: (1) change in water use in connected poor households; (2) change in expenditure on water by connected poor households; (3) change in average time spent collecting water by connected poor households, and (4) customer satisfaction with information provided, ease of application procedures, quality of service and cost of service (see Annex 5). Other, longer term impacts will have to be separately evaluated after the completion of the project.

B. 2. Project Components

Component 1 – New Connections

Three kinds of connections or “outputs” are proposed as a means to achieving the delivery of water service for the urban poor: in-fill connections to existing mains, expansion connections to previously unserved areas, and bulk supply or “master meter” connections for particularly poor, dense or informal communities not otherwise eligible for individual connections.

Unit costs for these three kinds of outputs are based on a random sample of recent PDAM contracts. These have been carefully verified by an independent consultant and compared with benchmarks, such as recent World Bank projects in Indonesia and local market prices. The review of contracts was based on: (1) a review of relevant Bills of Quantities (BOQ), (2) verification of the unit costs of all materials as specified in the above BOQs, (3) review of pipe laying costs of tertiary network from earlier works contracts, (4), review and analysis of other costs paid by the PDAM or by customer (e.g., road reinstatement), (5) analysis and justification of associated design and supervision costs, and (6) determination of an average all-inclusive cost of tertiary network per meter for several pipe diameters.

1. In-Fill Connections

The utility may connect the urban poor by means of an “in-fill” connection to an existing tertiary network. Normally, the utility would charge a customer a connection fee which ranges in price from IDR 600,000 ($66) to IDR 2,350,000 ($260) depending on the size of the building, the width of the street in front of the house, and the distance from the nearest tertiary pipe. Most poor households fall in the lower categories of this range. Adjusting for current prices, the actual average cost of materials and labor for connecting a poor household to an existing main is about IDR 700,000 ($78). The proposal thus takes $78 as the unit cost per in-fill connection.

2. Expansion Connections

The utility may connect the urban poor by expanding the tertiary distribution network to unserved areas. This is expected to reduce the most critical barrier to access for the poor since households in unserved areas of Surabaya must bear the prohibitive cost of network expansion in addition to an already considerable connection fee. The unit cost for an expansion scheme will be established in four steps. While the first step is a one-off citywide effort and has already been completed, the remaining steps are expansion specific and will need to be undertaken for each new expansion scheme.

In the first step, already completed, unit rates were established for two diameters of tertiary pipe. This agreed rate includes the cost of materials, labor, construction, and all other associated costs, and will be applicable citywide for the duration of the OBA project. As per the detailed cost analysis of recent PDAM network expansion contracts, the unit costs are:

• IDR 225,000 ($25) per meter of PVC pipe with an external diameter of 110 mm; and

• IDR 301,000 ($33) per meter of PVC pipe with an external diameter of 160 mm;

In the second step, during project implementation, the PDAM and the OBA Auditor will agree on the scope of the expansion, including the length of network required. The total length for each diameter pipe multiplied by the agreed unit costs will be the total cost of that extension.

In the third step, a tertiary expansion unit rate for each household residing in the area will be computed. This will be the total expansion costs divided by the total number of households (both poor and non poor). The total number of households is available from the head of the kelurahan and will be checked by the Auditor.

While the actual unit cost per extension scheme will vary, the average extension cost is estimated at about $205, excluding the connection cost. This average cost was calculated for the purpose of project planning and projected schedule of payments. It was calculated assuming a split of various pipe diameters in line with current PDAM network distribution (86% 100mm: 14% 150mm) and assuming 8 meters of tertiary pipe work per household.

In the fourth and final step, the unit cost of connecting the household to the network (the connection cost) must be added to the unit cost of network expansion (see Table 2).

Table 2: Unit Costs

| |Unit Cost of Network |Unit Cost of Household |Total |

| |Expansion |Connection |Unit Cost |

|In-Fills |n/a |$78 |$78 |

|Expansions |$205 (average) |$78 |$283 |

Household Contributions: In a large survey of 10,000 unconnected poor households, 57% of respondents were willing to pay more than IDR 300,000 ($33) for a connection fee. An additional 34% were willing to pay between IDR 150,000 ($17) - IDR 300,000. In order to maximize subsidy efficiency, make room for expansion connections, and ensure beneficiary ownership of the project, the household contribution has been set at $33. This price point is considered sufficient to capture enough households to support the proposed OBA program. In addition, PDAM will consider accepting this payment over a three month period, enabling more households from lower willingness to pay categories to accept this connection contribution.

Size of Subsidy: The size of the subsidy from GPOBA will be the unit cost of in-fill and expansions connections minus the household contribution (see Table 3). For in-fill connections, the subsidy will reimburse the estimated costs incurred by the PDAM in making an average connection less the pre-financing costs for the connection and the customer contribution. However, for expansion connections, PDAM will bear the cost of the tertiary network associated with all households not eligible for OBA subsidy reimbursement (either because households do not meet the targeting criteria, because specified outputs are not met, or because eligible households are not willing to connect). Assuming a 50 percent eligibility for reimbursement in poor areas, GPOBA will thus only subsidize half of the network expansion costs. PDAM will bear the other half estimated at more than $1.5 million (see Annex 1). In addition to this sizeable contribution, PDAM will also bear the costs of pre-financing the $250 per expansion connection not paid upfront by the household.

Table 3: Size of GPOBA Subsidy for Eligible Connections

| |Total Unit Cost |Household Contribution |Size of |

| | | |GPOBA Subsidy |

|In-Fills |$78 |$33 |$45 |

|Expansions |$283 (average) |$33 |$250 |

Mix of In-Fill and Expansion Connections: The utility will provide a mix of in-fills and expansion connections as it pleases as long as the average subsidy per household does not exceed $150 ($30 per head, 5 people per household). The mix of connections will thus vary according to PDAM planning. The mix assumed here of 7,500 extensions and 7,500 in-fills has been calculated in such a way as to reach 15,000 connections while maximizing the number of expansion connections and maintaining an average maximum subsidy of < $150 (see Annex 1). PDAM has the freedom to decide where to implement any in-fill connections or network expansion schemes. In order to determine area selection for the OBA project, PDAM has initially selected 25 kelurahan for survey work and where tertiary network expansion schemes might be implemented. These kelurahan are characterized by high demand (many households are on the waiting list) and low service coverage—but have good pressure and continuity of supply (see Annex 7).

Targeting: In the absence of a reliable database of poor households, project beneficiaries will be targeted using proxy variables for income poverty. Specifically, the three criteria are:

1. building size < 60 m2, and

2. road width < 6 m, and

3. formal installed electricity capacity < 1,300 VA (with a preference for households < 900 VA), or no formal connection[13].

After an extensive survey and subsequent analysis these have been taken as the best criteria available that are both rule-based and easily verifiable for the OBA Auditor. Together, they capture 67% of the 10,000 households in the survey although the expected capture rate per kelurahan is estimated at less than 50% because the survey targeted only “poor-looking” households. International experience with services for the urban poor suggests that building size and road width are generally robust proxy variables for poverty when income data are not easily available. The electricity criterion has been added to mitigate any errors of inclusion for non-poor households still living in smaller homes.

Outputs and Subsidy Disbursement: Subsidies for eligible connections will be disbursed provided:

i. the connection is new and made after signing of the Grant Agreement;

ii. the connection is of the approved specification;

iii. the connection is operational and in use at time of application for payment;

iv. the connection has been used for at least three months as evidenced by billing records; and

v. expansion connections have been subject to the appropriate ex-ante and ex-post quality and unit cost reviews by the OBA Auditor.

3. Master Meter Connections

For the third kind of connection, the project proposes to trial the innovative use of bulk meters or “master meters” to serve low-income communities. By regulation, PDAM cannot invest or lay pipes in any area that is (1) not zoned as residential in the Master Plan or (2) is zoned as residential but the residents lack legal land title—either because the land is government owned, private owned, or simply unclear. Although master meter connections cannot generally be provided to the first of these categories, they will be developed as a way to alleviate PDAM’s constraints in the second.

As this approach is experimental and targets the poorest of the poor, the utility will not be expected to co-finance the subsidy expenditure—although it will incur costs from pre-financing and from some community liaison activities required to make the scheme work. Significant co-financing will occur, however, from both household contributions for hardware and from NGOs for community mobilization. PDAM may also contribute through its Corporate Social Responsibility (CSR) fund as one-time subsidies not reimbursable by GPOBA.

Target Population: The target population for master meter schemes is clusters of poor households living in informal areas without the legal paperwork required to obtain individual household connections, but on land zoned as residential in the latest Surabaya Master Plan (unless the City Government gives explicit permission otherwise). This captures a fairly large potential customer base since many households lack the stringent combination of identity cards, land title, and tax receipts required by PDAM for household connections. While this is the target population, PDAM is free to install master meter schemes in other poor communities, on the premise that only truly poor communities would elect to have this level of service in the first place.

Upstream Construction: PDAM will pre-finance, procure, and construct the scheme upstream and inclusive of the master meter. This means, it will extend tertiary networks (if necessary), lay a short entry pipe, and install a master meter at the entrance to an informal community. Since PDAM cannot by regulation invest in informal communities downstream of the master meter, its asset will stop at the entrance to the community on the closest municipal land (e.g. the street).

Downstream Construction: The community would be responsible for designing, financing, and constructing the system downstream of the master meter. An NGO will have to be actively involved in facilitating this process as the broker between the community and the PDAM, and in forming a legal Community Based Organization (CBO) if one does not already exist. The NGO will bear the costs for this software component out of its own budget. Both PLAN International and ESP/ECO-Asia have agreed to fund this component for a certain number of schemes. PLAN has community facilitators in the field ready to work on mobilizing communities, and ESP/ECO-Asia has set aside funds to facilitate another local NGO doing the same.

Size of Schemes & Unit Costs: The project will target 500 households over three years, aiming for 10-15 schemes of around 25-100 households each. The upstream cost per scheme will vary but the project has set a cap of $5,000 per scheme, including any necessary tertiary expansion, for the size of subsidy from GPOBA. This amounts to a maximum subsidy average of $150 per household or $30 per capita, in line with the project as a whole. Unit costs for master meters, entry pipes, pipe tapping, and cost per meter of tertiary pipe have been developed in line with project practice for in-fills and expansions, and will be subject to auditing by the OBA Auditor prior to reimbursement.

The project estimates that downstream hardware costs will be approximately Rp.500,000 ($55) per household, more if an overhead tank is required. In some cases, households will be able to pay the full amount over several months. In other cases, when households are only able to pay the same connection fee charged to other OBA households of Rp.300,000 ($33) or even less, the remaining Rp.200,000 ($22) or more will have to come either as a grant from PDAM through its CSR fund or through a transitional financing plan to generate money from the community itself by running the master meter as a community tap for one year at vended prices above PDAM bulk supply cost but below market prices for vended water.

Selecting Communities: Communities are not likely to self-select and PDAM will need assistance in rolling out this scheme. Therefore, the project will partner with ESP/ECO-Asia and with the Surabaya office of the NGO PLAN International to select communities, test the idea within the community, and if there is genuine demand, propose the area to PDAM. Other NGOs and the PDAM are free to do the same, but the project will need ESP and PLAN to generate momentum and elicit demand.

Institutional Arrangements: The PDAM contract for a master meter will be signed with a CBO as a legal entity. There will not be a connection fee paid directly to PDAM, since all of its hardware costs associated with this scheme will be repaid by GPOBA. Instead, communities will pay either a portion or the full costs of the hardware downstream of the master meter—which effectively amounts to a connection fee payable to the CBO or NGO. The PDAM can choose when to invest in the system in order to limit the financing costs—for example, it may wait to see purchase of materials by the community prior to construction upstream. NGOs and CBOs will liaise between the community and the PDAM to ensure the transfer of information in the crucial initial stages. They will also mobilize the community downstream of the master meter and assist in generating demand and in designing the scheme.

Bulk Tariff: PDAM has yet to agree on a tariff for bulk supply, but it will either be the lowest social tariff, which is a flat rate charged for public taps, or the low-income (RSS) tariff depending on a new regulation for master meter bulk supply. The project has stressed that the tariff should not be more than the current average tariff in the RSS bracket and that it cannot be the actual RSS bracket which would be highly regressive at a bulk sale level (due to the rising block design of the tariff schedule).

Downstream Billing: Downstream of the master meter, each community would have to organize themselves in such a way as to pay for their own use and cover the monthly bill from PDAM. This could either be through a flat fee or through individual household meters, plus a premium to cover the operations and maintenance costs associated with managing the master meter scheme.

Outputs and Subsidy Disbursements: GPOBA reimbursement will be contingent on two outputs: (1) three months of billing and payment of the bulk supply bill, and (2) a signed contract between a CBO and the PDAM. This limits the PDAM’s responsibility to the master meter but requires actual service to households in order for reimbursement to occur, and therefore obliges PDAM to take an interest in the downstream activities. Subsidy disbursements will be subject to auditing in the same fashion as for other kinds of connections, including quality control checks.

Lessons Learned: The project team visited Medan in Sumatra, Indonesia where similar schemes have been implemented by the PDAM. Lessons learned and incorporated in project design include:

• contributions as high as IDR 350,000-500,000 are not a problem for the majority of poor households if payable over time, but subsidies are required to cover the costs of the upstream hardware (including any tertiary network extension) and of community mobilization;

• there have not been any problems with revenue collection in either metered or non-metered schemes, and in, general, the community management does not appear to be an issue;

• PDAMs can play an active mobilizing role in the development of the schemes downstream of the master meter; and

• quality assurance is vital both by an auditor upstream of the master meter and by an NGO or CBO downstream of the master meter in order to avoid problems such as inadequate pressure at the level of the master meter or the purchase by the community of cheap household meters which may result in inadequate revenue collection due to under registration of consumption.

Component 2 – Technical Assistance for Project Implementation

To support the project implementation, two external auditors will be used.

(1) An OBA Auditor (a firm) will be hired by the Scheme Manager at an estimated cost of $95,000 over three years. The role of the OBA Auditor is to monitor implementation and payment of subsidies, and can be broken down as follows:

• On an ongoing basis, the OBA Auditor will monitor the quality of expansion schemes and connections, by making spot check while connections are being made and pipes are being laid, and by conducting some ex-post assessments on a random basis (including detailed reviews of as-built documentation, interviews with installation teams/supervisors/customers, and, if necessary, opening connections made).

• On a 3 month basis, the OBA Auditor will receive claims from PDAM through the Scheme Manager, and then certify whether these claims are (or are not) eligible for reimbursement. The Auditor will do so (1) by examining the billing records of PDAM to ensure three months supply, billing, and payment, and (2) by ensuring the households are eligible according to the rule-based and auditable targeting criteria specified in the project manuals, and (3) by agreeing on the unit cost for expansion connections by verifying the length of pipe of various diameters required to expand the network to that area and verifying the total number of households living in that area, and  (4) by verifying any claims and associated unit costs for master meters schemes. The OBA Auditor will also report on any deviations from the project scope or approach if discovered during the assessment.

• On a 6 month basis, the OBA Auditor will submit a report measuring (1) the number of eligible connections made, (2) the number of eligible households within expansion scheme areas who could connect to the network at a later date, and (3) the number of completed expansion schemes (see Annex 5).

• On an annual basis, the OBA Auditor will in addition to the end of year 6-month report also evaluate the impact of the project to date. Based on a random sampling of 10% of households  that benefited from the scheme, the Auditor will provide his assessment of the impact of the project on connected households using, at least, the following indicators: (1) change in average water use in connected eligible households (water use per capita per day); (2) change in expenditure on water by connected eligible households; (3) change in time spent collecting water by connected eligible households; (4) customer satisfaction with ease of application procedures, quality of service and cost of service; and (5) change in utility incentives to connect low-income households, measured by number of OBA connections made as a percent of all connections made by PDAM (see Annex 5).

(2) A Financial Auditor will also be hired by the Scheme Manager to carry out an annual financial audit of the OBA Designated Account and of project financial management. In line with standard Bank practice in Indonesia for World Bank financed projects, the project will use the Government’s Financial and Development Supervisory Board (Badan Pengawasan Keuangan dan Pembangunan, or BPKP). The cost of this audit will be borne by the Government and thus no TA funds are requested from GPOBA for financial audits.

The Financial Auditor will conduct audits of the project as designated in the Grant Agreement and in accordance with Indonesian Regulation Government Accounting Standard Perpres No. 24/2005. The aim is to give a true and fair view of the operations during the year and of the financial position of the project at the end of the year (see Annex 2 for more on financial management and internal controls).

The Financial Auditor will examine corporate governance aspects and the use of resources, and will provide the necessary information stipulated in the TOR, including, but not limited to:

• Project Financial Statements that include a Summary of Funds received, showing the GPOBA and possible counterpart funds separately; a Summary of Expenditures; and a Balance Sheet showing Accumulated Funds of the project, bank balances, other assets of the project, and liabilities, if any;

• a schedule listing individual Statements of Expenditure withdrawal applications and the total withdrawals under the SOE procedure;

• an opinion as to the degree of compliance with the Bank's procedures and the balance of the Designated Account;

• a separate paragraph commenting on the accuracy and propriety of expenditures withdrawn under SOE procedures and the extent to which the Bank can rely on SOEs as a basis for grant disbursement; and

• a management letter, including comments and observations on the accounting records, systems, and controls; identified deficiencies and areas of weakness in systems and controls and relevant recommendations; a report on the degree of compliance of each of the financial covenants on the Grant Agreement and comments, if any; report of matters that have come to attention during the audit which might have a significant impact on the implementation of the project; and any other matters that the Auditor considers pertinent.

As part of this TA component, and in addition to the hiring of an OBA Auditor, a small ($25,000) unallocated amount is included for miscellaneous consulting services that may arise during the implementation of this GPOBA scheme e.g. for additional focused studies to assist the scheme manager to deliver the project successfully. This amount will only be utilized by the Scheme Manager with the written permission of the World Bank task manager.

Component 3 – World Bank Supervision

World Bank staff will need to provide routine support to PDAM Surabaya and the Scheme Manager during project implementation. Staff will periodically (2-3 times a year) visit the sites to review progress with local authorities and assist in revising any project components or procedures, if necessary. Staff will also devote considerable time from Washington, DC and from Jakarta, Indonesia to monitor progress. Some of this budget will be used for training by World Bank staff to build capacity of the implementing agencies, for example of the OBA Scheme Manager in procurement.

B.3. Project Costs

Component 1 for new connections is estimated as follows:

|Item |Estimated Cost |

| |(USD) |

|Subsidy for Mix of In-Fills & Expansion |$2,212,500 |

|Connections | |

|Subsidy for Master Meters |$75,000 |

|Total Component 1 |$2,287,500 |

Component 2 for recipient executed Technical Assistance is estimated as follows:

|Item |Estimated Cost |

| |(USD) |

|OBA Auditor in 2008 |$30,000 |

|OBA Auditor in 2009 |$30,000 |

|OBA Auditor in 2010 |$35,000 |

|Unallocated special studies |$25,000 |

|Total Component 2 |$120,000 |

Component 3 for World Bank Supervision is estimated as follows:

|Item |Estimated Cost |

| |(USD) |

|Supervision in 2008 |$40,000 |

|Supervision in 2009 |$40,000 |

|Supervision in 2010 |$40,000 |

|Total Component 3 |$120,000 |

In addition, co-financing during implementation is expected as follows:

|Item |Estimated Cost |

| |(USD) |

|USAID/ESP Co-Financing |$150,000 |

|PDAM Supervision |$50,000 |

|PDAM Network Investment |$1,537,500 |

|HH Connection Contributions |$495,000 |

|HH/NGO Master Meter Contributions |$25,000 |

|Total Co-Financing |$2,257,500 |

B.4. Economic and Financial Analysis

Economic Analysis

The economic analysis of the project is based on the standard methodology for calculation of Net Present Value (NPV) and economic Internal Rate of Return (E-IRR), using a “with and without GPOBA subsidy” scenario.

The analysis has been done for 15,500 households (15,000 individual connections and 500 to be connected via master meters). Information from a socio-economic survey carried out in the target districts and Surabaya PDAM’s tariff structure (increasing block tariff) has been used to calculate household consumption, expenditures on water, and household willingness to pay for improved access to water supply services.

Costs include investment and operation and maintenance costs, and are based on PDAM Surabaya’s estimates for the project (i.e. O&M costs are 1.5 % of capital costs).

Economic benefits are confined to expenditure savings, time savings as a result of lower collection and wait time, and health savings in the form of productive days gained and cost savings on treating water-borne diseases. All benefits, other than those in the form of productive days gained, are quantified based on primary information obtained from the household survey of target households. Productive days gained are valued based on adjusted World Health Organization (WHO)[14] estimates.

The methodology assumes one productive adult wage earner per household and minimum wages as the opportunity cost of time. The minimum wage is also adjusted downward for the high proportion of self and low-wage contractual employment among the target households.

The project has an economic Net Present Value of $ 8,170,659 and an economic Internal Rate of Return (E-IRR) of 45 percent. The E-IRR is 25 percent with only expenditure savings taken into account. It increases to 30 percent when time savings are added and to 45 percent with value of health benefits added. As a percentage of total benefits, expenditure savings account for 56 percent, time savings for about 11 percent and health benefits for 33 percent (see Table 4).

The analysis uses a 12 percent discount rate and the useful life of the project is assumed to be 15 years.

Table 4: Economic Analysis

|No. of Households |E-IRR |E-NPV |% Benefits | % Benefits |% Benefits |

| | | |(Expenditure) |(Time) |(Health) |

|15,500 |45% |$ 8,170,659 |56% |11% |33% |

Financial Analysis

The financial analysis takes into account the investment costs for connecting the 15,500 households (individual and master meter connections) and operating costs that are directly linked to the increased access to services. Of the total investment costs, OBA subsidy accounts for 51 percent and user contribution for about 12 percent. The project has a negative financial IRR even with the OBA subsidy. This is considered acceptable for reasons below.

The low F-IRR indicates the lack of commercial incentives for connecting unserved urban poor households in Surabaya. This is because the tariff for low-consumption and low-income customers who are the sole beneficiaries of this project does not cover O&M costs. However, unlike most of Indonesia’s public water utilities, PDAM Surabaya is in a strong financial position with no arrears on its debt. It is a profitable utility earning acceptable returns from the mix of higher consumption residential and higher tariff commercial customers across its service area. As with many water utilities with high service ratios, there are significant diminishing marginal returns on connecting poor, un-served households (areas), but the impact is diluted across hundreds of thousands of non-poor customers who are not beneficiaries of this project and therefore not included in the F-IRR calculation.

The economic analysis demonstrates clearly the social benefits of the subsidy, with expenditure and health benefits constituting a relatively bigger proportion than time benefits.

C. IMPLEMENTATION

C. 1. Milestones for Project Implementation

|Milestone |Expected completion |

|Formal GPOBA Approval |September 2007 |

|Completion of Implementation Manuals |September 2007 |

|Training of Scheme Manager and PDAM |September – October 2007 |

|Grant & On-Grant Agreements Signed |October – November, 2007 |

|Tender process for OBA Auditor |October – December 2007 |

|Implementation begins |January 2008 |

|(once Auditor is hired and in place) | |

|First claim made by PDAM |April 2008 |

|(minimum 3 months after first connection) | |

|Subsidy disbursement ends |December 2010 |

C.2. Partnership Arrangements

The project is supported by USAID’s Environmental Services Program (ESP) and Environmental Cooperation-Asia (ECO-Asia) who have provided extensive support in Indonesia and provided considerable financing. For example, ESP financed a small pre-survey to estimate the total eligible population for an OBA project in Surabaya and ECO-Asia financed a large survey of 10,000 non-connected poor households. ESP has also contributed substantially to the design of the project, especially the master meter schemes. Going forward, ESP and ECO-Asia will continue to provide on the ground technical assistance for the project as a whole and significant support for master meter schemes, including identifying possible locations and funding NGOs to work on community mobilization downstream of the master meter. The expected co-financing from ESP and ECO-Asia is estimated at $150,000.

C.3. Institutional and Implementation Arrangements

General Implementation

One of the purposes of the GPOBA project is to demonstrate an arrangement that could be used by the City of Surabaya as a permanent arrangement to maximize the efficiency of public subsidies by linking these to outputs. For this reason, it is considered preferable to embed this project within existing government structures used to deliver services to citizens. This increases the likelihood of long term sustainability and of replication both in Surabaya and elsewhere in Indonesia.

With this approach, the Implementing Agency will be PDAM Surabaya. The PDAM will be free to develop project planning as it chooses provided its claims for reimbursement meet the agreed conditions and the average subsidy does not exceed $150/HH. PDAM will also be responsible for organizing pre-financing to support new service connections and extensions.

The Scheme Manager will be a City Government Committee headed by the Department of Public Works (Dinas Bina Marga dan Pematusan, literally the Department of Roads and Drainage). Located within the City Government, the Department will act on behalf of the City to manage the project as a whole.

Specifically, the role of the Scheme Manager is:

• To hire the OBA Auditor. This will be done in compliance with World Bank procurement guidelines. The World Bank will assist in this one-time exercise, for example by training the Scheme Manager in procurement.

• To receive claims from PDAM for reimbursement for working connections. Upon completion of new expansion schemes and of household connections to tertiary network in areas of its own choosing, PDAM will submit its claims to the Scheme Manager.

• To submit claims to the OBA Auditor for their review and certification. The OBA Auditor will monitor the quality of the connections made by PDAM, appraise expansion schemes, and check that the payment requests made are correct. The OBA Auditor is responsible for certifying these claims, which must then be returned to the Scheme Manager. The Scheme Manager will review the certification documents for completeness and consistency before approving for payment.

• To review and approve payment requests made by the OBA Auditor for services rendered under their contract.

• To approve and submit requests for payment to the City of Surabaya and later the local treasury unit of the Ministry of Finance (KPPN) based on the claims certified by the OBA Auditor, and to ensure payment is received both by PDAM for certified claims and by the OBA Auditor for services rendered. The Scheme Manager should follow up with KPPN if needed when payment is delayed.

• To report to GPOBA in Washington DC, including (1) to submit to them the 6-monthly and annual reports prepared by the OBA Auditor, and (2) to request additional disbursement of funds into the special account on a 6 monthly basis as and when existing funds are used.

• To provide all necessary documentation to support the work of the Financial Auditor each year.

The OBA Auditor will be a firm hired by the Scheme Manager. Its role has been outlined in Section B.2 but in summary the OBA Auditor will: (a) provide an annual assessment of progress and quality of works under the project; (b) undertake spot checks or audit on connection made; and (c) certify the unit subsidies for extension connections. A detailed TOR will be provided in the Project Implementation Manual (PIM) for the Scheme Manager.

The Financial Auditor will be the Government Auditor BPKP. It will carry out an annual financial audit of the project as outlined in Section B.2 and in Annex 2. A detailed TOR will be provided in the Project Implementation Manual for the Scheme Manager.

Grant Agreements and Fund Flows

The Grant Agreement will be signed by the Country Director of the World Bank (on behalf of GPOBA) and the Ministry of Finance (on behalf of the Government of Indonesia). Due to Indonesian regulations, it is not possible to sign a Grant Agreement directly with the City of Surabaya or with the PDAM. The Grant Agreement will outline the roles and responsibilities of the various agencies involved in implementation through ancillary agreements annexed to the main document.

Subsequently, an On-Grant Agreement will be signed by the Ministry of Finance and the City of Surabaya, most probably by the Mayor.

Thereafter, the implementation of the grant will be governed by the Project Implementation Manuals (PIMs). The grant will only become effective once the City of Surabaya has adopted the Scheme Manager Manual and the PDAM Board has adopted the PDAM Manual.

Project funds will be held in a designated account in the Bank of Indonesia. Funds will flow directly from GPOBA to the designated account, and then from the account to the PDAM and to the OBA Auditor (see Annex 2 for Funds Flow Diagram). No project funds will be received by either the Ministry of Finance or the City of Surabaya.

C.4. Monitoring and Evaluation of Results

The outputs of the project upon which GPOBA subsidies will be disbursed are:

• working household connections; and

• working master meter schemes.

Each output will be certified by the OBA Auditor hired by the Scheme Manager. The projected outputs are presented in Annex 5 along with a description of additional M&E activity that will be collected annually to provide assessments of:

• Change in average water use in connected OBA households;

• Change in expenditure on water by connected OBA households;

• Change in time spent collecting water by connected OBA households;

• Change in incentives to connect low income households; and

• Customer satisfaction.

C.5. Sustainability

Sustainability has been factored into the project design in several ways:

• Subsidies are one-off investments that represent the most critical hurdles for improved access and are not for ongoing consumption. Although tariffs for low-income consumers do not cover O&M costs, the overall tariff regime of PDAM Surabaya (which reflects its mix of customer categories) does cover both O&M and production costs.

• Subsidies are paid after verification of payment of bills for at least three months, indicating that service is likely to continue in the future.

• The chosen utility is committed to efficient service delivery and sustainable supply. Its Customer Service Department is ISO 9001 certified and collection of payments is 98 percent.

• The active participation of PDAM staff of all levels in OBA project design and the formation of an OBA Team by the Director ensures an institutional commitment to long-term service delivery to the poor, and organizational learning as to how to design new schemes in the future.

• Service expansion targets set by the city, including for poor households, suggest that both the Mayor and City Government will hold the PDAM accountable for service delivery to the urban poor.

C.6. Critical Risks

|Risk |Risk Mitigation Measures |Rating with Mitigation |

|Low affordability and willingness |Setting the connection fee at an acceptable point: According to the household |Low |

|to pay by customers |survey conducted during project preparation, nearly 60% of all respondents were| |

| |willing to pay IDR 300,000 ($33) or more for a PDAM connection. | |

| | | |

| |Using the PDAM’s tariff structure to advantage: | |

| |PDAM’s current tariff structure results in cost savings of between IDR 7,000 | |

| |($0.77) and IDR 144,000 ($16) per household per month as compared to existing | |

| |alternative supplies. | |

|Low sustainability of project |Creation of an in-house OBA Team at utility; |Modest |

| |Active participation by PDAM staff in the project (from the concept stage to | |

| |detailed preparation through to implementation) ensures knowledge transfer and | |

| |a vested interest in maintaining water service beyond 3 months. | |

| | | |

| |Involvement of the Mayor in several meetings: | |

| |The Mayor is very supportive of the project, and service expansion targets set | |

| |by the City Government suggest it will hold the PDAM accountable for service | |

| |delivery to the poor. | |

|Inability of PDAM to pre-finance |Assurance of PDAM financial capacity: |Low |

|outputs |The PDAM has the cash in hand to pre-finance the project. | |

|Lack of community involvement |Absence of supply-driven planning downstream of master meters and voluntary |Low/Modest |

| |participation in program: | |

| |Active NGO or CBO involvement in the master meter scheme will ensure | |

| |communities receive schemes they want and are able to pay for. Participation in| |

| |the OBA scheme for expansions and connections will be voluntary. | |

|Quality of connections fails to |Risk transfer to PDAM and an OBA Auditor: |Low |

|fulfill the requirements |PDAM bears the financial risk, which motivates them to pay attention to the | |

| |quality of the connections they wish to reimbursed for. Random quality control | |

| |by the OBA Auditor will also encourage PDAM to pay attention to quality. | |

Risk ratings: High (>75%), Substantial (50-75%), Modest (25-50%), Low/Negligible ( ................
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