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The World Bank

FOR OFF('IALt SE ONL Y

Report No. 10805-BR

STAFF APPRAISAL REPORT

BRAZIL

MINAS GERAIS WATER QUALITY AND POLLUTION CONTROLPROJECT

DECEM4BER 1, 1992

Infrastruicture DivisionCountry Department ILatin America and the Caribbean Regional Office

This document has a restricted distribution and mas be used bs recipients onJs in the performance oftheir official duties. Its contents mas not otherwise be disclosed without World Bank authorization.

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FOR OFFICIAL USE ONLYBRAZIL

MINAS GERAIS WATER OUALITY AND POLLUTION CONTROL PROJECT

STAFF APPRAISAL REPORT

Table of Contents

Page

Loan and Project Summary ............................................ i

I. INTRODUCTION .................................... 1.......... IA. Background .............................................. 1

II. WATER QUALITY MANAGEMENT ..................... 2A. Economic Managemcnt of Water Pollution ........................... 2B. Water Basin Management . ..................................... 3C. Water Quality and Pollution Control in Brazil ......................... 3D. Water Quality and Pollution Control in Belo Horizonte

Metropolitan Area ........................................... 5E. Strategies for Water Pollution Control .............................. 6

III. THE PROJECT ... ............................................ 8A. Background ............................................. 8B. Project Objectives and Rationale .......... ....................... 8C. Project Description . ........................................ 9D. Costs and Financing ......................................... 10E. The Borrower and Executing Agencies ............................. 11F. Status of Project Preparation ........... ......................... 12G. Financial and Economic Aspects of the Project ........................ 12H. Financial Status of the Borrower and the Beneficiaries .................... 14I. Poverty Aspects ........................................... 16J. The Environmental Impact . ........................... ........ 16K. Implications for Sector Policy . .................................. 18L. Project Implementation . ................................ 18M. Project Risks ............... ............... 22

IV. AGREEMENTS AND RECOMMENDATIONS .......... ................. 22

This report is based on the findings of an appraisal mission which visited Brazil from July 7 to 10,1992. The report was prepared by Emilio H. Rodriguez, Antonio Estache and Abel Mejia. ManuelMariflo (LATIE), Carl Bartone (INURD), Eduardo Abbott (LEGLA), William Partridge (LATEN),Beatriz Martinez, Salahuddin Ahmad (LAIIN), Ronaldo Seroa da Motta, Adrian de Maic, LeonTaylor, Victor Coelho, Vera Bazzanella and Leopoldo Bartolome (Consultants) participated in projectpreparation. Francisco Lobato of the Ministry of Social Welfare of Brazil coordinated projectpreparation by the Brazilian counterparts. Asif Faiz, Vahram Nercissiantz and Armeane M. Choksiare the managing Division Chief, Project Advisor, and Department Director, respectively, for theoperation. Carl Bartone and John Briscoe (INUWS) served as peer reviewers for the project.

This document has a restricted distribution and may be used by recipients only in the performanceof their official duties. Its contents may not otherwise be disclosed without World Bank authorization.

LUst of Tables

3.1 Project Cost Sumnmary3.2 Povery Groups Benefitting from the Projec3.3 Project Costs by Proc :rement Method

Uist of Annexes

Annex 1. Bank Loans to Brazil for Water Supply and SewerageAnnex 2. Project DescriptionAnnex 3. ResettlementAnnex 4. Industrial PollutionAnnex 5. Summary of CostsAnnex 6. Annual Investments/Investment Distribution by SourcesAnnex 7. Structure of CostsAnnex 8. Organizational StructureAnnex 9. Agreements and Financial FlowsAnnex 10. Cost/Benefit AnalysisAnnex 11. Notes and Assumptions for Financial ForecastsAnnex 12. Enviromnental Assessment SummaryAnnex 13. Obligations of the Executing AgenciesAnnex 14. Quarterly Project ExecutionAnnex 15. Monitoring IndicatorsAnnex 16. Bidding PackageAnnex 17. Loan Disbursement ScheduleAnnex 18. Rio das Velhas Water Basin Agency - Strategic PlanningAnnex 19. Selection Criteria for SubprojectsAnnex 20. Supervision PlanAnnex 21. Project File

Map No. IBRD 24157

BRAZILMINAS GERAIS WATER QUALITY AND POLLUTION CONTROL PROJECT

LOAN AND PROJECT SUMMARY

Borrower (Amount): State of Minas Gerais (US$145 million equivalent).

Guarantor: The Federative Republic of Brazil.

Terms: Repayment in 15 years, including five years of grace, with interest atthe Bank's standard variable rate.

Project Objectives

The principal project objective is to recuperate the environmentally deteriorated urban basinsof the Arrudas and Onca rivers in the metropolitan area of Belo Horizonte, the capital of the State ofMinas Gerais and one of the most congested industrial areas in Brazil. The project will also protect thedas Velhas river from effluents generated in the metropolitan area. Related objectives are: (i) to developinstitutional capabilities for environmentally sustainable management of these water basins particularlythrough the introduction of modern land use management, cost recovery mezhanisms, and an efficientlegal and regulatory framework; and (ii) to improve the quality of life of approxii'ately three millioninhxbitants of the two urban basins, through the rehabilitation and expansion of basic sanitationinfrastructure, i.e., sewers, solid waste collection and disposal, and drainage.

Project Description

The project consists of five main components: (i) flood control and urban drainage,including macrodrainage of all rivers and creeks in the water basin; (ii) municipal and industrial sewagecollection and treatment, which includes about 280 km of interceptors and sewers and two sewagetreatment plants; (iii) municipal and industrial solid waste collection and disposal, which includesimprovements in solid waste collection in the area and a sanitary landfill; (iv) urbanization, including thecreation of public areas, restoration of vegetation and resettlement; and (v) environmental protection andwaterbasin management, including studies for the protection of the das Velhas river and the control ofindustrial pollution in the area and institutional strengthening of the State Enviromnental Agency (FEAM).

Project Benefits

The principal project benefits are the restoration of water quality in the system of rivers,creeks and reservoirs in the metropolitan area of Belo Horizonte, and the improvement of the quality oflife in areas surrounding these water bodies. Water quality has a direct bearing on public health,biodiversity, use of water resources, and preservation of a safe and healthy environment. Quality of lifein the area will be enhanced by flood control, land reclamation, extension of sewerage and sanitationservices, and creation of parks and recreational areas.

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Project Risks

The main risks affecting the project are associated with the innovation of setting-up waterbasin authorities to integrate multi-institutional environmental efforts and responsibilities, and the socialand political complexities associated with population resettlement. To minimize these risks, the projectprovides for a well-staffed project unit in one of the leading development institutions in Brazil--Banco deDesenvolvimento de Minas Gerais. In addition, the executing agencies have a group of highly qualifiedtechnicians experienced in dealing with environmnental issues.

Pr-nject Costs (US$ million)

Flood Control and Urban Drainage 101.0Municipal and Industrial Sewage

Collection and Treatment 135.0Solid Wastes Collection and Disposal 4.7Environmental Protection 7.8Environmental Management 8.5Project Management 7.0Base Cost 264.0Physical Contingencies 13.2Cost at December 31, 1991 prices 277.2Price Contingencies 30-4Total Cost 307.6

Flnancing Plan (USS million)

Bank 145.0State of Minas Gerais 53.0COPASA-MG 78.9Municipality of Belo Hnrizonte 22.6Municipality of Contagem 8.Total Project Cost 307.6

Estimated Bank Disbursements (US$ million)

Bank Fiscal Year 1993 1994 1995 1996 1997Annual 32.3 35.0 42.6 24.8 10.3Cumulative 32.3 67.3 109.9 134.7 145.0

Rate of Return: 30 percent.

BRAZIL

MINAS GERAIS WATER QUALITY AND POLLUTION CONTROL PROJECT

Staff Appraisal Report

I. INTRODUCTION

A. Background

1.1 Traditional mining activities in the Belo Horizonte metropolitan area and the explosive urbangrowth and industrialization over the past several decades have been accompanied by increasing urbanenvironmental degradation in the area. One of the most critical environmental issues is the pollUtion ofrivers i...:d reservoirs close to the expanding city.

1.2 Water pollution results from two basic, and interrelated, reasons: (i) the environmentallyuncontrolled industrialization; and (ii) the inability to create appropriate urban and sanitationinfrastructure, particularly for the low income and favela population who invade vacant areas close to thewater bodies. Typically, the process starts with industries disposing untreated wastes into the naturaldrainage system, and with favelas invading hazard prone lands, located mostly on river banks and steepslopes, generally ill-suited for provision of basic infrastructure. Additionally, inadequate sectoralinvestments and unrealistic zoning practices have resulted in unmt.t demand for environmentalinfrastructure, especially for controlling floods and collecting and treating wastes The main waterpollution sources are: industrial and mining waste, municipal sewage, storm water run-o.f, uncontrolleddumping of solid wastes, erosion, and mudslides. Another important concern is flooding of denselyoccupied urban areas, as a consequence of increasing run-off, and shorter concentration times in thedrainage basin, with rainfall averaging 1,800 mm annually.

1.3 A failure to institute sound pricing policies for bodi the provision of services and the use ofresources has contributed to poor environmental management and inadequate provision of infrastructure.In general, pollution control has been seriously cr.strained by inadequate leve:s of InveIIient, a lack ofappropriate cost recovery, ineffective technology, insufficient coordination between different levels ofGovernment,inadequate capacity to enforce environmental regulatiors and standards, and limitedinvolvement of users and NGOs.

1.4 The project provides for a comprehensive approach to water basin management, that will helpintegrate several sectoral functions and all three levels of government-federal, state and municipal aswell as the communiity in addressing water pollution issues in the Belo Horizonte metropolitan area bysupporting: (i) critical investments needed to recover the deteriorated environment and to raise standardsof living; (ii) necessary policy changes with increased reliance on market-based mechanisms and costrecovery; and, (iii) institutional reforms based on enhanced cooperation between state agencies and municipalities.

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1.5 t'e project area is located in the upper das Veihas river basin, and includes the two sub-basinscorres ling to the Arrudas and da Onca rivers. The upper das Velhas basin has 3,600 squarekilometcrs of drainage area and a population estimated at 4.5 million. The Arrudas sub-basin, with anarea of 200 square kilometers, has a population of 1.5 million. T'he da Onca sub-basin, with an area of212 square kilometeis, has a populariorn f 1.2 million. The project area corresponding to the BeloHorizonte metropolitan area is composed of eighteen municipalities including the municipalities of BeloHorizonte and Contagem. This area, in addition to being the state's political and economic nerve centerhas a important geomorphologic feature. Three of the most important rivers in Brazil have their springwaters in the vicinity of the Belo Horizonte metropolitan area: (i) the Parana river system, as the mainfluvial artery of southern Brazil, Paraguay, Uruguay, and Argentina; (ii) the Doce and Paraiba do Sulrivers-the main river system of the mid-Atlantic coast; and (iii) the Sao Francisco river, the mostimportant river in the northeast; whose watershed includes the das Velhas river basin, and the Arrudasand Onca sub-basins. (see Map No. IBRD 24157).

1.6 The remainder of this report is structured as follows. Chapter II summarizes the current stateof the water pollution control efforts in Brazil, and describes the water pollution control law and theconstraints on its implementation. It also highlights policy and market failures in the sector, and presentsa medium-term approach to water pollution management in metropolitan areas of Brazil. Chapter IIIdescribes the project, its objectives and main implementation features, in the context of the policy issuesraised in Chapter II. Finally, Chapter IV includes recommendations on the main agreements to bereached with Brazilian authorities.

II. WATER QUALITY MANAGEMENT

A. Economic Management of Water Pollution

2.1 Water pollution promotes disease and reduces the economic value of bodies of water.Misallocation of water uses, including uncontrolled pollution, arises beca4 se market prices fail to reflectsocial costs and benefits. When households and firms are left on their own, they will polluteindiscriminately. The Project will help the Brazilian authorities to design an effective Governmentregulatory framework to address these market failures, including the choice of policy instruments, theassignment of responsibilities within the Government administration and the extent and scope ofcoordination requirements for the successful implementation of policies when cross-jurisdictional issuesarise.

2.2 The economic instruments that can be relied on to ensure pollution control are assessed accordingto three ciiteria: (i) their cost effectiveness, both in terms of the conventional resources (labor and capital)for their implementation and the amount of information they require; (ii) their equity effects, on the basisof the benefits principle; and, (iii) the degree to which environmental management at a water basin scaleis likely to be endorsed by coalitions- between municipalitieb, between polluters, etc.--endowed witheiiough power to ensure effective enforcement of standards and regulations. The importance of the properassignment of instruments across government levels and across local jurisdictions to ensure the successof pollution control is paramount because of the potentially damaging effect of inte~rjurisdictionalcompetition on enviromment responsibilities.

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B. Water Basin Management

2.3 In order to attain effective management and control of water pollution, watfer resources must beassessed withi . the larger perspective of a water basin, which reflects the overall drainage patterns. Thegeographic, biological, and climatic features of a water basin form a relatively coherent ecological systemwhich makes it the basic natural unit for water resources management. For water quality management,given its localized nature, a sub-basin, a division of the water basin, can function as an adequate unit forplanning and management, as long as it is viewed as part of the entire water basin. The water basinapproach provides an adequate framework to plan and manage water pollution problems in heavilyurbanized areas in Brazil such as the 3elo Horizonte metropolitan area. Finally, long-term watermanagement stability of water basin authorities is closely linked to their administrative independence andfinancial autonomy, both of which are given critical consideration in the project.

C. Water Quality and Pollution Control In Brazil

Introduction

2.4 During the period 1940-1985, the urban population of Brazil grew by 83 million, increasing theurban tax base from 30 to 73 percent. Most of this population growth and the concomitant pace ofindustrialization (10.4 percent p.a. during the sevendes and early eighties) has been concentrated in ninecities mostly located in the southern part of the country. The accelerated growth of metropolitan areashas resulted in massive degradation of the limited natural resources, in particular the close-by watersources. As this metropolitan growth was not accompanied by adequate investment in environmentalinfrastructure and sanitation services, the environment and the quality of life in the metropolitan areashas deteriorated significantly.

Water Pollution - Related Services

2.5 Access to water supply improved significantly during the seventies and eighties; the percentageof urban population connected to public water supply systems increased from 50 percent to 86 percentover the 1970-1989 period. Indirect access to public water sources also increased over the same periodfrom 3 percent to 9 percent. As -egards sewage collection, the development has been modest; thepercentage of people connected to urban public sewerage increased from 25 percent to 42 percent. About50 percent of the population has relied on septic tanks and latrines-which is not necessarily undesirable-while 10 percent had no access to a sanitation facility at all. Sewage treatment is partiai at best as only10 percent of the sewage collected underwent some form of centralized treatment. In most locations, rawmunicipal sewage is discharged into rivers or the ocean. Industrial water pollution is not welldocumented, but available evidence suggests the importance of this type of pollution in 12 states. Whilecoverage of solid waste collection increased from 49 percent in 1981 to 60 percent in 1988, insufficientmunicipal solid waste collection remains a problem, leading to a combination of land, air and waterpollution. Furthermore, collected waste is disposed in open air dumps rather than sanitary landfills.Incineration or composting are seldom used; recycling is rare and informal.

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Polilies and Institutions

2.6 The Federal Government responsibilities for water quality management are discharged throughthe Environmental Secretariat (SENAM) under the Presidency, and relate mostly to issues of waterstandards and quality criteria. The Brazilian Institute o; the Environment and Renewable NaturalResources (IBAMA) is responsible for formu,ating and enfcrcing federal environmental regulationsderived from the National Policy for the Environment. Federal agencie are not presently involved inwater pollution control activities in the metropolitan area of Belc Horizonte.

2.7 The state leve' responsibilities include the execution of programs and projects and the control ofactivities that could adversely affect the environment. The states are also responsible for the preparationof norms and standards to complement those enacted by IBAMA. The technical agency responsible forwater quality planning and control in the State of Minas Gerais is the State Environmental Agency(Fundacao Estadual do Meio Ambiente, FEAM) while the S.Lte Council for the Environment (ConselhoEstadual do Meio Ambiente, COPAM), is responsible for the implementation of the National Policy forthe Environiment. FEAM includes as part of its duties, support to municipalities n s tting up localinstitutions and controls for the p. ,tection of environment. The constitution of the State of Minas Geraisstipulates that protection of environment (especially water resources) is a public function of shared interestamong municipalities, and falls under the purview of metropolitan management.

2.8 Brazil water pollution law (Law No. 6.938 of 31/08/81) relies mostly on ambient and effluentstandards and zoning regulations. Policy guidance and basic minimum norms are set by the Federalgovernment, normally adapted from U.S. standards. The standards adopted across states tend to beuniform, and only Rio and Sao Pauio have attempted to adjust limits taking into account the economiccost of pollution. Minas Gerais has adopted the Federal standards which define five classes of water,based on their main use. Quality objectives and, to some extent, emission limits are set accordingly.For every specific water class, the law limits or prohibits ceitain discharges. It also provides a moregeneral limitaticn by prohibiting any discharge that will result in the change of the classification of awater body. Public enterprises in charge of sewage disposal and treatment, however, are not requiredto achieve any pre-established level of reduction in the pollution load they discharge.

2.9 Licensing is require.i for all new investments and projects that could possibly cause environmentaldamage. This includes industries, housing developments and physical infrastructure. Environmentalimpact assessments (RIMA) have been mandatory for these projects since 1985 and are used by the statesto impose a combination of technological and emission standards, through the licensing procedure.Industries producing hazardous solid wastes are reouired by FEAM to comply with its program for thesafe disposai of these wastes. This program is *eing effectively managed by FEAM. The projectsupports the program by providing installations with environmental safeguards for the disposal ofhazardous solid wastes (Annex 2).

2.10 The implementation of pollution control measures in Minas Gerais is carried out by FEAM underthe oversight of COPAM. However, FEAM is institutionally weak, has no laboratory of its own andsuffers from understaffing. It finds it difficulty to cover the entire state, and resources art insufficientto conduct proper inspections on a regular basis. For the monitoring of water quality, FEAM uses thelaboratories and technical assistance of private and public institutions, especially the Technical Foundationof Minas Gerais (Fundacao Centro Tecnologico de Minas Gerais, CETEC). FEAM is also in charge ofthe inventory of pollution discharges and the licensing of new industries; tasks that are not carried outeffectively. Water quality monitoring of das Velhas and Paraopeba rivers has been carried out regularly

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by FEAM through CETEC, since 1977. There are 15 monitoring stations, where a characterization ofthe water quality is done with the analysis of relevant chemical and biological parameters. A waterquality index is calculated on the basis of nine of these parameters, following commonly acceptedprocedurus.

2.11 The water utiliLy of Minas Gerais (Companr&ia de Saneamiento de Mi".., Uerais, COPASA-MG)is respons.ble for water supply and sewerage services (including industiies) as an agent of mostmunicipalities in the State, including Belo Horizonte and Cont!-em. COPASA-MG, a well-structuredand adequately staffed water utility, is considered one of the leading institutions in the water sector inBrazil.

2.12 Under a legal framework that devolves environmental protection functons and rasponsib;litiesto municipalities in the State of Minas Gerais, Belo Horizents and Contageir have formaliy set upmunicipal-level institutions to look after environmental matters. Belo Horizonte has a MunicipalSecretariat for the Environnent established in 1983, responsible for planning, management and controlof the environment. In addition, in Belo Horizonte, there are numerous private organizations involvedii environmental activities. in Contagem, there is a municipal council (CODEMA) for protecting theenvi:onment, which has been created with technical assistance from FEAM. These institutionalarrangements, however, have not been effective in contro.ling water pollution in these municipalities,partly because of the serious magnitude of the problem.

D. Water Quality and Pollution Control In Belo Horizonte Metropolitan Area

2.13 In most parts of the Belo Horizonte metropolitan area-particularly in the das Velhas andParaopeba river basins--water quality does not meet the required standards At virtually all monitoringstations dissolved oxygen is substantially depleted and one or more quality parameters exceed thepermissible limit in 100 percent of the samples. Oiganic matter, phosphorous, toxic metals and cyanideare commonly in concentrations that do iot meet the quality requirements for these rivers.

2.14 Of an estimated population of 2,286,000 in Belo Horizonte, about i,839,000 (80 percent) areconnected to the sewerage network, through 238,518 connections. In Contagem, 267,000 out of apopulation of 551,000 (48 percent) are connected through 3 ', 9 64 connections. Raw sewage is dischargedinto the water bodies in the two municipalities; as a result, the Arrud. and Onca rivers are heavilypolluted and the Vargem das Flores and Pampulha reservoirs have suffer;.' om progressive degradation.

2.15 Water quality in metropolitan Belo Horizonte ranks among the worst in the state, as a result ofthe high level of domestic and industrial dis, r ,es and the low dilution capacity of the Arrudas and Oncarivers. The city now spreads over most of the catchment area and the river flow is totally composed ofcombined industrial and municipal sewage and storm water. Oxygen levels in these two rivers arenormally below 1 ppm in most stretches located inside the urbanized area compared to a minimumstandard of 5 ppm. This situation causes evident health hazards and loss of amenities (recreation, fishing,etc.) that adversely affect the areas along the rivers and the population settlements on their banks. Thedischarge of the Arrudas and Onca rivers further degrades the water of the already polluted das Velhasriver, and downstream of the discharge from Belo Horizonte metropolitan area presents long stretchesof river with low oxygen content and poor water quality. Annex 10 details current water qualityindicators corresponding to the Arrudas, da Onca and das Velhas rivers and compares these values toestablished Brazilian standards.

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2.16 Industrial activity in the region is based on mining, steel mills and metal processing (23 percentof the industr,es in Belo Horizonte and 28 percent in Contagem), although some important agroindustries(11 and 14 percent) and textile factories (20 and 3 percesit) are alo present. 'he importance of themetallurgical sector is explained by Lhe fact that more than 60 percent of the Brazilian iron-ore reservesand 99.7 percent of the production of iron is concentrated in the state of Minas Gerais, while 16 percentof the state reserves are located in the Belo Horizonte Metropolitan area. Sixty-Aight percent of Braziliangold reserves are in Minas Gerais and 95 percent of the State's gold production takes place in the BeloHorizonte metropolitan area. Most industries in Belo Horizonte ar.d Contagem are located in fourindustrial districts, although some of the large industrial sources of organic pollution (mainlyagroindustries and textile) are spread throughout the city. The Arrudas river receives the main part ofthe industrial discharges primarily from the metallurgical sector. Two enterprises, Mannesman and theCompanhia Siderurgica Belgo-Mineira, with discharges of 19,200 and 2,400 m'/d respectively, are majorpolluters of this river, with both organic and inorganic pollutant loads.

2.17 Accordiag to FEAM data, collected between 1980 and 1982, and COPASA-MG cadastre ofindustrial consumers, the total BOD5 load of the Arrudas and Sarane -Onca river basins can be estimated,using unitary discharge ratios, at around 24,000 kg/d. The suspended solids load discharged by theindustry in these river basins is estimated at 15,000 kg/d. Apart from the load of organic matter andsuspended solids discharged by industries, discharges of toxic substances in industrial efluents are alsoa major concern. Besides the impact on the quality of the receiving waters, and especially on their biota,the presence of toxics and heavy metals jeopardizes the effectivene&a of biological sewage treatrnent andrestricts the reutilization of the sludge which will be produced by primary sedimentation. In order to planfor the abatement of existing industrial discharges, the project includes a progratn for a detailed evaluationof the industrial discharges into the Arrudas and Onca rivers and the design of the necessary policyinstruments and investment plans to control the industrial effluents.

E. Strategies for Water Pollution Control

Government Strategy

2.18 The strategy developed by the Federal Government to address water pollution issues derives fromfour key considerations:

* The Federal Gcvernient recognizes that water pollution problems in Brazil are relatedto intense urbanization processes concentrated in major metropolitan areas within specifikwater basins.

O The Government rebognizas the need for implementation of multi-sectoral investmentprograms and appropriate policy instruments to address the pollutioi. ,.-blem.

* It also recoenizes the need to place project implementation responsibility on sub-nationalentities with strong institutional capacity, rather than relying on the limited capabilitiesof the Federal institutions.

* It acknowledges the need for cost recovery through the use of existing taxes and tariffsand new mechanisms based on different levels of consumption.

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Rationale for Bank Invo:vement

2.19 The Bank strategy in Brazil is to support policies and investments aimed at achievingenvironmentally-sustainable economic growth and social development in the context of macroeconomicstability. The primary emphasis is on efficient allocation of resources, increased efficiency andaccountability in the public sector, and the appropriate targeting and delivery of support services to thepoor. The project aims to promote these objectives through an integrated program of investment andinstitutional strengthening tot cost-effective water pollution control. The project will focus on (i) requiredpolicy changes, including an ir-.reased reliance on rnarket-based approaches and cost-recovery; and (ii)institutional strengthening, including cooperation across government levels. The Bank will assist theBrazilian authorities in designing an appropriate analytical framework f'r evaluating the costs and benefitsof pollution control to guide environmental policies and investment decisions.

Pas# Bank Involvement

2.20 The Bank has activelN participated in the development of'che Brazilian water sector. Since 1971,sixteen water and sanitation loans (US$1.9 billion) have been approved to support the national sanitationplan (PLANASA) objectives. (See Annex 2 for a list of projects) Although priority was given to watersupply, substantial investments were made for sewage collection, treatment and disposal, and fordrainage. These operations have helped to achieve: (i) decentralization of most water sectorresponsibilities to the states including establishmenit of strong state water companies (SWCs) (ii)application of sound economic principles for project investment; (iii) water tariff legislation permittinga satisfactory degree of financial viability of the sector at the state level; and (iv) formulation and use ofmodern financial and operational systems in the SWCs.

2.21 The Bank has recently approved a Water Sector Modernization Project (Loan 3442-BR) to assistBrazil in the reformulation of the sector's organization and objectives, with primary emphasis onimproved efficiency through the use of commercal practices and regulatory arrangements to fostercompetition. Additionally, the Banik has financed two industrial pollution control projects with majorbeneficial impacts on urban areas and is now processing a nation-wide program. Recent municipaldevelopment projects also include solid waste, sewerage, and drainage projects.

2.22 The Bank has only limited project experience in water pollution control. The Brazil WaterQuality and Pollution Control Project (Loans 3503, 3504 and 3505-BR), covering the states of Sao Pauloand Parana, was approved in july 1992. This is the Bank's first self-standing municipal water pollutioncontrol project based on a comprehensive water basin management approach. The proposed projectextends the Govermnent's water pollution control program to the State of Minas Gerais.

2.23 Past Bank experience in pollution control projects in Brazil is summarized as follows: (a) Bank-supported projects have employed only a limited selection of cost recovery instruments, relying almostentirely on tariffs; (b) Bank-supported projects overestimated industrial demand, basing needs onestimated pollution loads; with high tariff levels, consumer demand diminished considerably, andindustries relied, instead, on in-house sewage treatment plants (although monitoring andcontrol/enforcement of industrial discharges was questionable); (c) pollution control projects should havetaken an integrated approach to accommodate municipal, agricultural, and industrial sources; (d) pastproject approaches to pollution control have relied on political, administrative or managerial units, ratherthan dealing with the water basin--the natural environmental unit. The Project addresses the above issues,and will help establish sound policies including carefully-designed charges for services.

III. THE PROJECT

A. Background

3.1 The decertralization of responsibilities for infrastructure services decreed in Brazil by the newConstitution has spawned innovative local initiatives to provide water and sanitation services. In thiscontext, groups of municipalities have started to develop associations to prepare proposals, seek financingand execute water resource management and pollution control projects.

3.2 During 1990, some state governments and the Sanitation Secretariat at the Ministry of SocialWelfare (MAS) started to discuss with the Bank the possibilities of Bank support for some of the aboveregional initiatives. Since then, a process of screening and prioritizing water pollution problems has takenplace, based on the economic and social costs involved in each state proposal, the local willingness to actand the degree of project preparation. The Bank is participating in the financing of two local initiativesto protect the Guarapiranga reservoir in the Sao Paulo metropolitan area and the Upper Iguazu river inmetropolitan Curitiba, Parana (Loans 3503, 3504 and 3505-BR). This project extends the programn tothe Arrudas, da Onca and das Velhas rivers in Belo Horizonte.

3.3 The Project was identified in February, 1991. Three Bank missions, in June and September,1991, assisted MAS and concerned State institutions in project preparation. The project was appraisedin July 1992. Loan Negotiations took place from November 9 to 13, 1992.

B. Project Objectives and Rationale

3.4 The main goal of the project is to recuperate the environmentally deteriorated urbarn basins of theArruda and Onca rivers. The Project will also help start the program for improving water quality in thedas Velhas river. Specific objectives are twofold: (i) develop institutional capabilities to manage thewater basin in an environmentally sustainable way through the introduction of modern land use incentives,cost recovery mechanisms, and an efficient legal and regulatory framework; and (ii) improve the qualityof life of approximately 2.7 million inhabitants of the two urban basins mentioned above, through therehabilitation and expansion of basic sanitation infrastructure, i.e., sewers, solid waste collection anddisposal and drainage in two municipalities (Belo Horizonte and Contagem) as well as housingimprovement and park development.

3.5 To develop the institutional capabilities for water basin management, the project will address somekey needs, namely: (i) clarifying state and municipal responsibilities for laws and regulations concerningenvironmental protection at a water basin scale; (ii) setting up an institutional framework to integrate stateand municipal participation in the inter-disciplinary management of the water basin; (iii) developingmarket mechanisms to control environmentally damaging land use; (iv) introducing innovative costrecovery instruments; (v) establishing mechanisms for industrial pollution control; (vi) strengthening ofthe state environmental agency (FEAM); (vii) promoting NGO participation to enhance projecteffectiveness and encourage envirommental education; and (viii) introducing adequate water qualitymonitoring programs and environmentally sound operations and maintenance practices.

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3.6 To improve the quality of life of the mostly low-income and favela population living in the twomunicipalities within the water basin, the project will: (i) support COPASA investment program toexpand sewers and interceptors within the two urban basins, and to build the first phase of two seweragetreatment plants on the Arrudas and Onca rivers. These investment projects are part of a larger COPASAprogram to depollute the Arrudas and Onca rivers; (ii) complete the macrodrainage system for floodcontrol, and rehabilitate the basic drainage infrastructure at the water basin and urban levels; (iii) improvesolid waste collection and final disposal in the two municipalities; (iv) implement a resettlement programfor favela and low-income population livii,g in hazard-prone areas, unsuitable for basic infrastructureprovision; (v) reforest heavily eroded areas affecting river flow and slope stabilization; and (vi) developrecreational parks to enhance the living environment in the Belo Horizonte Metropolitan area.

3.7 The project will foster a new approach for water basin management, based on effectivecoordination among the sectoral institutions. This coordination would feature the two municipalities,COPASA, the water company, and FEAM, the state environmental agency. During preparatorymeetings, the need for cross-sectoral and cross-governmental integration was emphasized as aprecondition fo, project success. The local authorities were responsive and, agreed to create a singleintegrated project execution unit at the Minas Gerais Development Bank (BDMG). During the first twoyears of project implementation, the executing unit will prepare the supporting studies and obtainapprovals for the establishment of a Belo Horizonte Metropolitan Water basin Management Authority.A mid-term review after two years of project implementation will review the status of the proposed waterbasin management authority.

3.8 Long-term water basin management stability is closely linked to administrative independence andfinancial autonomy. These two conditions are R critical element to guarantee project success.Accordingly, a surcharge for the Belo Horizonte Metropolitan water use and wastewater discharges iscurrently under consideration, among other revenue mechanisms, to internalize environmental water basinmanagement costs.

3.9 Traditional approaches to land use management, ;.:lely based on regulation are insufficient tohandle the complex dichotomy of urban expansion and environment degradation. The project will presentpractical solutions to one of the most critically polluted water basins in Brazil, relying on existing andwell-performing sectorial agencies and municipalities and their recent willingness to integrate efforts atthe water basin level. Among the specific proposals envisaged to reduce distortions in land use pricingare adequate pricing policies for resources and services, which will promote environmentally safeactivities in the metropolitan area with increased land values and potential revenue yields, and thedevelopment of recreational areas and parks to protect the most critical and damaged area.

C. Project Description

3.10 The project to be implemented over five years consists of five main components: (i) floodcontrol and urban drainage; (ii) municipal and industrial sewage collection and treatment; (iii) municipaland industrial solid waste collection and disposal; (iv) environmental protection and urbanization; and,(v) water basin management. Project description is given in Annex 2. Resettlement is detailed in Annex3 and the industrial pollution control plan in Annex 4. Detailed description of each project componentis in the Project File. A summary description of the project is given below:

0 The flood control and urban drainage component (39 percent of project cost) includes:(i) 6 km of a flood control channel on the Arrudas river; and (ii) approximately 10 km

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of main channels, to complete the urban macrodrainage systems for the Sarandi,Ferrugem, and Onca rivers;

* The municipal and industrial sewage collection and disposal component (50 percent ofproject cost) includes: (i) 77 kms of interceptor and pressure mains, (ii) 210 kms ofnetwork expansion and 14,000 new sewer connections; and (iii) two primary treatmentplants able to treat a total 8.8 m3/s of sewage;

* The municipal and industrial solid waste collection and disposal component (2 percent ofproject cost) is designed to improve solid waste collection in both municipalities,including the establishment of the Perobas sanitary landfill in Contagem, making specialprovision for the disposal of hazardous wastes;

* The environmental protection and urban land use component (3 percent of project cost)includes: (i) restoring river bank vegetation, development of public areas, andrecreational facilities along the Arrudas and Onca rivers; (ii) developing the PampulhaReservoir ecological and recreational park; and (iii) the resettlement of about 1,600families (Annex 3); and

e The water basin management component (4 percent of project cost) includes: (i)preparation of studies and organization of the public and government consultation processneeded to develop a proposal for the Belo Horizonte Metropolitan Water basin Authority;(ii) preparation of an environmental master plan for the Arrudas and Onca water basinsto integrate sectoral plans for land use, sewerage, solid waste, industrial and miningdevelopment, and water quality; (iii) training programs for water basin environmentalmanagement, technical and financial support to NGOs and technical assistance to the twomunicipalities to meet their local environmental planning and management needs; (iv) anenvironmental management information system and consultant services for projectmonitoring and technical audit!' ig; (v) water quality and pollution control studies for dasVelhas river; (v) studies for inLustrial pollution control (Annex 4); and (vi) institutionalstrengthening of the state environmental agency (FEAM).

D. Costs and Financing

3.11 The total cost of the project is estimated at about US$307.6 million equivalent. Project costs aresummarized in Table 3.1 and detailed in Annex 5. Annex 6 shows annual investments and thedistribution by source of financing; and Annex 7 contains a breakdown of project costs in civil works,materials and equipment and consultant services. The foreign exchange requirement is estimated at aboutUS$70.0 million (23 percent of total). Costs based on December 30, 1991 prices, and including fivepercent physical contingencies for equipment, works and services, amount to US$277.2 million. Pricecontingencies of US$30.4 million, or 11 percent of the December, 1991 project costs, are based on anestimated average international inflation rate of 3.9 percent per annum during the project implementationperiod. Due to high local inflation rates, costs estimates were prepared in cruzeiros (Cr$) and thenconverted to US dollars. Costs include indirect taxes (about US$30 million). Even though the exemptionfrom import duties for materials procured under international financing has been cancelled, such dutiesare not considered, based on the assumption that the executing agency will be able to obtain a waiver.Interest during construction is not included.

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Table 3. 1Project Cost Summary

(US$ million)

Project Component Base Cost

Flood Control and Urban Drainage 101.0

Municipal and Industrial Sewage Collection and Treatment 135.0

Municipal and Industrial Solid Waste Collection and Disposal 4.7

Environmental Protection 7.8

Environmental Management 8.5

Project Management 7.6

Sub-Total 264.

Physical Contingencies 13.2

Price Contingencies 3G.4

Total Cost 307.6

3.12 Cost estimates for equipment, materials and works of the water and sewerage component arebased on existing basic engineering designs and unit prices of similar recent works and acquisitionscarried out by the executing agencies. About 632 man months of consulting services are included forstudies and technical assistance; 712 for completing project preparation and supervision; and 136 forproject management. The consultants' average cost is estimated about US$12,500 per man-month, andrepresents rates as currently billed to include salaries, social costs, and the firms' overhead and profits.

3.13 A Bank loan of US$145.0 million equivalent will help finance all foreign exchange and somelocal costs, amounting to 47.1 percent of the estimated project cost. The loan will have a term of 15years, including five years of grace at the Bank's standard variable interest rate. The balance would beprovided as follows: (i) US$53.0 million (17.2 percent of total project cost) by the State of MinasGerais; (ii) USS78.9 million (25.7 percent) by COPASA; (iii) US$22.6 million (7.3 percent) by themunicipality of Beio Horizonte; and, (iv) US$8.1 million (2.6 percent) by the municipality of Contagem.The loan guarantor will be the Government of Brazil. The state of Minas Gerais will guarantee the fullamount of counterpart financing needed.

E. The Borrower and Executing Agencies

3.14 The Borrower is the State of Minas Gerais, which will execute the project through a special unitUnidad Gereiiciamiento do Programa' >UGP) at the BDMG. UGP will have full responsibility forproject management and will be composed at a minimum of a project manager, a financial analyst, anenvironmental engineer, a procurement officer, and a sociologist (to advise on resettlement issues). Aqualified manager from BDMG was appointed as project manager during project preparation. UGP will

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coordinate project execution with four sectoral agencies: COPASA, the municipality of Belo Horizonte,the municipality of Contagem, and FEAM. It was agreed during Loan Negotiations that themunicipalities of Belo Horizonte and Contagem may delegate to the State the execution of works underPart A of the Project. The four executing agencies, have proven experience in carrying out similarprojects and have qualified staff. They will execute the project under the supervision and control ofUGP. Each agency has appointed a coordinator io channel all project matters to and from UGP. Afterproject execution is completed, the water basin will be managed by a unit to be established under theproject. It is foreseen that this unit will serve as the embryo organization for the das Velhas River BasinAuthority. Annex 8 contains the organization chart of the project. Annex 9 shows the institutionalagreements and financial flows.

F. Status of Project Preparation

3.15 A project coordinating unit, created at the Minas Gerais Planning Secretariat (SEPLAN), assistedby qualified consultants, conceived and designed the project. During the preparation period, fourmeetings with all the participating institutions and two workshops (one on procurement and another onresettlement) took place. In addition, there were hearings with concerned NGOs. A five volume projectevaluation report is in the Project File. The Environmental Impact Assessment (EIA) required by theBrazilian law, RIMA, has been completed and approved by the State authorities. A summary of this EIAhas been distributed to the Board. The risks of delayed project start and slow disbursement of Loan fundsafter signature have been minimized as the State of Minas Gerais submitted at Loan Negotiations: (i)final designs representing in aggregate value 20 percent of the project cost; (ii) terms of reference forUGP; (iii) the list of coordinators for each executing agency; (iv) terms of reference for all studies to becarried out under the project; (v) terms of reference for management consultants (vi) final draftdocuments for project institutional agreements; (vii) final draft standard procurement documents andstandard letter of invitation for consultants; (viii) project operational manual; (ix) a plan for theinstitutional strengthening of FEAM; (x) final designs for resettlement; (xi) terms of reference for a studyto evaluate expected improvements in living standards; (xii) evidence of completion of legal actions forland expropriation; and (xiii) assurances of timely funding for the required land expropriations andhousing projects. In addition, it was agreed during Loan Negotiations that the contract with consultantsin charge of the preparation of an industrial pollution control plan (Annex 4) be formalized before LoanEffectiveness. The terms of reference for this plan have been agreed during Loan Negotiations.

G. Financial and Economic Aspects of the Project

Introducdion

3.16 The evaluation of the project includes: (i) the identification of both major polluters in the waterbasin and project beneficiaries, (ii) an assessment of financial and economic returns, and (iii) a discussionof cost recovery options. As measurement of pollutant loads are not available, pollution estimates arebased on standard characteristics of the polluters' output or, in some cases, inputs. Benefits are mostlyassociated with improved environmental conditions brought about by improvements in the overallinfrastructure surrounding the water basin. Other benefits are identified from an analysis of the activityand use of resources in each sub-basin prior to the environmental degradation of the sub-basin. Thefinancial rate of return is calculated for those investments that generate a flow of market priced goodsand services. Since many of the project benefits do not have a market value directly associated with the

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costs involved, the financial cost-benefit analysis (CBA) only gives a lo wer-bound value for the economicreturn of the project. The economic CBA internalizes other benefits which are assessed through theiropportunity cost or the willingness-to-pay for environmental services by the affected population. The costrecovery analysis includes all financial flows accruing to the agencies responsible for projectimplementation. The analysis also includes the identification of potential additional revenues to enhanceproject cost recovery.

Sources of Pollution

3.17 Domestic and industrial wastewater and uncontrolled runoff are the main sources of pollution ofthe Arruaas and da Onca r:vers. As provision of sewerage and sewage treatment facilities has not keptpace with the urban growth in the Belo Horizonte metropolitan area, a large volume of raw sewage isdischarged directly into the two rivers. Most of the urban growth in the metropolitan area has beenassociated with the development of heavy industry and mining during the economic boom of the 1970s.Many industries are located upstream, in Contagem, where effluents are discharged freely into the rivers.

3.18 Matrices showing pollution sources and estimated discharges for each sub-basin with and withoutthe project are presented in Tables 1 and 2 of Annex 10. As shown in Table 1, domestic sewage is themain pollutant, although industrial pollution is also significant. The indicators shown in the tables includeBOD, suspended solids, nitrogen and phosphorus, but do not include heavy metals--the basic determinantsof toxicity of industrial discharges. Metal contamination of the water bodies is expected to be significantgiven the concentration of mining and metallurgical activities in the sub-basins. In recognition of thisfact, the project provides for the preparation of an industrial pollution control plan (paras. 3.15 and 3.35and Annex 4). The prevalence of sewage as the main source of water pollution suggests that, domesticand industrial water tariffs could provide a large share of the cost recovery for the project. According:y,it will be an important objective of the project to identify, characterize and connect industries to publicsewerage. Table 2 of Annex 10 shows the project's pollution abatement benefits.

3.19 Pollution abatement measures under the project are confined to the Arrudas and da Onca waterbasins which practically coincide with the Belo Horizonte metropolitan area. Most pollutants dischargedinto the rivers will be intercepted and conveyed downstream to two sewage treatment plants locatedabove the das Velhas river. The present discharge of the tributaries into das Velhas sharply depletes thedissolved oxygen in the main river and creates poor environmental conditiosis in a 40 mile stretch of dasVelhas river. The concentration of sewage discharges into das Velhas at two points resulting from theproject's sewage interception and conveyance would further deteriorate water quality if no sewagetreatment was provided. The two primary sewage treatment plants will reduce pollution loads in termsof BOD by about 40 percent. As a result, substantial environmental degradation will be avoided and abasis for future protection programs will be established. As no data were available during projectpreparation to evaluate the economic benefits of further cleaning up the affected 40-mile stretch of theriver, the project provides for carrying out studies or, das ielhas water quality and the economicfeasibility of additional pollution abatement and control measures. These studies will take into accountwater pollution from intensive mining activities concentrated upstream of the metropolitan area. Thesestudies are critical for affective environmental management of the das Velhas river.

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Project Benefits and Benefidaries

3.20 The principal project benefits are flood control in heavily urbanized areas, the restoration of waterquality in the rivers, creeks and reservoirs in the Belo Horizonte metropolitan area, and improvement ofquality of life in areas surrounding these water bodies. Water quality is associated with improvedhygienic conditions (decreased infant mortality and -educed incidence of water borne diseases),preservation of biodiversity, improvements in health and quality of life, and preservation of a safe andclean urban environment. Table 3 in Annex 10 lists the project benefits, which include, inter-Ai, thepreservation of water supply sources, flood control, land reclamation and improved land use in hazardousareas, extension of sewerage services, and creation of recreational areas. Other project benefits are theenhancement of water uses in the das Velhas river, the financial strengthening of COPASA and themunicipalities, and the development of water basin management capabilities. Table 4 in Annex 10 showsestimates of the population that will benefit from each project component.

Financial Cost-Benefit Analysis

3.21 The estimates of financial benefit cost ratios (B/C ratios) and internal rates of return (IRR) forthe project are based on: (i) additional revenues from industrial and domestic sewerage tariffs, municipalproperty tax (IPTU) and municipal property transfer tax (ITBI); (ii) savings in the cost of water treatmentand solid waste collection, health care, flood related damages, and maintenance of the Pampulhareservoir; and (iii) licensing and park entrance fees. Estimates are calculated under two assumptions: fi)with current industrial output and existing tariffs (assumption A); and (ii) taking into account industrialgrowth and tariff increases (assumption B). The discount rate is 12.0 percent. Under assumption A, thebenefit-cost ratio is 0.57 and the IRR., 6.0 percent. Under assumption B, the B/C ratio is 0.71 and theIRR, 8.2 percent. Tables 5 and 6 in Annex 10 detail the B/C ratios and IRRs for each project component.

Economic Cost-Benefit Analysis

3.22 Four groups of benefits are taken into account in the economic CBA: water supply, floodcontrol, sewerage services and recreation. For evaluating benefits from water suipply, the opportunitycost method was used. For the other three sources of benefits, a crude version of willingness-to-paymethod was used. The details of the procedures and calculations are in the Project File. Estimates werecalculated under two assumptions: (i) accepting the legal valuation of property as market value(assumption A) ; and, (ii) assuming that the legal valuation is 60 percent of the market value (AssumptionB). The discount rate is 12.0 percent. Under assumption A, for the project as a whole the B/C ratio isestimated at 1.34 and the IRR, 29.8 percent. Under assumption B, B/C ratio reaches 1.68 and the IRR,45.2 percent. Tables 7 and 8 in Annex 10 show the B/C ratio and IRR for each project component.

H. Financial Status of the Borrower and the Beneficiaries

3.23 The Bank loan for the State of Minas Gerais of US$145.0 million equivalent accounts for 47.1percent of the total project cost. Counterpart funds will be provided as follows: (i) State Government ofMinas Gerais US$53.0 million; (ii) Minas Gerais water company (COPASA) US$78.9 million; (iii)Municipality of Belo Horizonte US$22.6 million, and; (iv) Municipality of Contagem US$ 8.1 million.

3.24 A review of the finances of the State of Minas Gerais and the other executing agencies revealsthat the project does not require additional financial resources beyond those needed by these institutions

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for their ongoing investment plans. Documentation in the project files details the financial status of theBorrower and the beneficiary agencies, and includes historical and projected financial data. COPASA,which has the most significant financial participation in the program (US$78.9 million), will providecounterpart funding througl. internal cash generation as follows: (a) increasing the average water andsewerage tariff from US$0.37 per m3 to US$0.50 per m3 at the end of 1993, and by maintaining it atthat level thereafter, in dollar terms; (b) reducing the level of unaccounted for water from 36 percent to30 percent; (c) increasing water metering from 87 percent to 92 percent of total water connections, inboth. the metropolitan Belo Horizonte area and the other municipalities served by COPASA, beginningin 1993; (d) revaluating fixed assets under the legal requirement of 12 percent return on investment; and(e) changing the tariff structure to reflect marginal costs of services in the different cities throughout theState. During Loan Negotiations, COPASA agreed to carry out the Management Improvement Planshown in Annex 11.

3.25 COPASA's ambitious investments program for the 1992-1997 period is US$1.2 billion,representing an average of US$180.4 million per annum. The project's annual investments represent,on average, US$13.1 million, or 7.2 percent of COPASA's total investment program. The allocation ofresources for investments takes into consideration the following criteria: (a) increase of internal cashgeneration as a result of increased tariffs and cost savings (reflected in an improved operating ratio, from0.85 to 0.75); (b) reasonable allocation of Caixa Economica Federal (CEF)'s funds for 1992; (c) financialrehabilitation of the State Water and Sewerage Fund (FAE), and (d) equity investments by the stategovernment as part of its pluri-annual development plan.

Financial Projections for the State of Minas Gerais

3.26 Financial projections for the period 1992-1997 assume a real growth of 5 percent in fiscalrevenues and expenditures. Average annual revenues amount to US$5.5 billion. Fiscal revenues amountto 66.5 percent of the total revenues, with a 95 percent share of sales taxes (ICMS). Federal transfersaccount for 19 percent of total revenues, and 14.5 percent from credit operations. Projected Stategovernment expenditures are as follows: 49.6 percent--state payroll and other operating expenses; 33.8percent--interest and amortization of domestic and foreign debt; and 7.2 percent--planned investments forthe period, which represent an annual average investment of US$289 million (totalling US$1.7 billionsduring the whole period). T'hese expenditures will be mainly allocated to investments in transport, urbaninfrastructure, basic sanitation, and environment. The project represents 10 percent of total stateprojected investments, of which 7.5 percent is financed by the Bank and 2.5 percent by direct statetransfers. The State of Minas Gerais has a stable financial situation, with low discretionary transfers anddebt. Although project costs represent 52 percent of total revenues, they will be maintained at that levelthroughout the 1992-1997 period.

Financial Projections for the Municipality of Belo Horizonte

3.27 The financial projections for the municipality of Belo Horizonte are based on the municipal masterplan, which is currently under review by the municipal legislature. Revenue projections take intoconsideration the following factors: (a) fiscal reform under the new Constitution, which benefitted themunicipalities by increasing state and federal transfers of municipal participation funds and sales tax(ICMS), as well as the incorporation of new taxes, specifically ITBI (property transfer tax), IPI exporttax and the fue! tax (liquid and gas); (b) fiscal municipal reforms, including a new schedule forassessment of IPTU (property tax). Currently the municipality is self-financing improvements to itscadastre and the updating of the service tax.

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3.28 Based on an estimated real annual growth of one percent from 1992 onwards, the annual revenueforecast for the 1992-1997 period is US$627 million. Annual fiscal revenues are estimated at US$298million, or 48 percent of total revenues. The main municipal taxes are IPTU and ISS, accounting for 43percent and 36 percent respectively of the total fiscal revenue. Federal and state transfers to themunicipality are 37 percent of the total revenues, the ICMS being the most significant transfer, accountingfor US$125 million annually, or 20 percent of the total revenues. The Bank's project represents, onaverage, an annual investment of US$3.8 million, which correspond to just 2 percent of the municipality'sinvestment program forecasted for 1992-1997. Furthermore, the financial analysis reveals that themunicipality of Belo Horizonte has the capacity to increase its debt, providing interest expenmes andamortization do not exceed 8 percent of total revenues.

Financial Projections for the Municipality of Contagem

3.29 Financial projections for the Municipality of Contagem take into account the fiscal reforms underthe new Constitution. These projections assume an annual growth of 3.8 percent for revenues, and 5.5percent for costs. The municipality depends heavily on state transfers (ICMS), which during 1992-1997are estimated to average US$57 millions annually, or 68 percent of total revenues. Current liabilitiesduring the period will average US$66.4 million per year, equivalent to 76 percent of total revenues. Theparticipation of the Municipality of Contagem in the Bank project (US$28 million) is not very significantin relationship to the municipality's budget.

I. Poverty Aspects

3.30 Table 3.2 shows an estimate of the poverty group (comprising families earning three minimumsalaries or less) who will benefit from the Project. Sewerage flood control and resettlement componentsof the project will directly improve the living conditions of a substantial group of poor living in theproject area. The reallocation of families living on risk-prone river banks to specially designed housingprojects will improve the living environment of an important segment of the poor people benefitting fromthe project. The creation of parks and the upgrading of areas along the rivers will provide recreationareas for the poor, who usually do not have access to such facilities. Finally, the improved reliabilityof water sources to the metropolitan area will significantly enhance water and sanitation services to thepoor.

J. The Environmental Impact

3.31 The project will improve environmental conditions in the Belo Horizonte metropolitan area andin a 40 km stretch of the das Velhas river receiving run off and sewerage discharges from the area. Allproject components are designed to help upgrade existing deteriorated conditions and to create thefoundations for sustainable environmental management in the area. The project will enhance water usesin most of the water bodies in the metropolitan area and improve the quality of life in the surroundingareas, through flood control and proper disposal of wastes--including toxics, and by controlling land usein hazardous areas, and providing basic sanitation services and recreational facilities.

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Tabl 3.2Poverty Groups Benefitting from the Project

(Hab)

Project C'omponent Area Number ofPoor

Beneficiaries

Sewerage services "Vargem das Flores" sub-basin 1,700

'da Onca" sub-basin 15,000

Macrodrainage and Interceptors "Arrudas" sub-basin 36,000

"da Onca" sub-basin 45,000

Recreation/Parks 146,000

Water Supply 78,300

Resettlement 9,000

3.32 The project is designed to prevent the occurrence of potentially negative impacts associated withthe disposal of wastes in sanitary landfills, disposal of sludge from the sewage treatment plant, and-esettlement of population. Installations for soliu waste and sludge disposal will be designed to controlpercolation of leachates in the ground. In addition, safeguards to achieve environmentally acceptableclosure of existing landfills and for disposal of solid wastes are described in Annex 19. The resettlementplans proposed by the Borrower were found to be satisfactory. Community involvement starts early inthe process; project objectives and features are discussed in private meetings with NGOs and throughpublic hearings and field visits with the families targeted for resettlement. The affected families areoffered four options for resettlement: (a) cash compensation (at replacement value) upon presentation ofa sales agreement for a replacement house elsewhere; (b) a house plot and construction materials to builda new dwelling in exchange for the present house; (c) a plot and project-constructed house for which theaffected family pays 50 percent of the difference in value between the present house and the replacementhouse; and (d) cash compensation (at replacement value) and free transport to a destination in another cityor town (Annex 3). Adequate resettlement a-eas near the affected favelas have been identified andacquired, and additional lands elsewhere have been identified as backup should they be needed. Theorganizational capacity for implementation of the resettlement program is impressive. The professionalsresponsible include engineers from the Development Department of the Belo Horizonte Municipality(SUDECAP) and the Department for Community Development of Contagem (SUDECOM), and socialworkers, social scientists and engineers fTom a non-governmental organization, the Urbanization Agencyof Belo Horizonte (URBEL), which has more than a decade of experience in this area. Theimplementation methodology involves working with existing neighborhood organizations to carry outinformation campaigns, population and property inventories, valuation of property, negotiation ofcompensation, selection of appropriate resettlement options, development of new sites, mobilization andtransfer, and issuing titles. Intensive follow-up over a 6-month period by social workers and monitoringover a five-year period during which replacement assets may not be sold are included in the resettlementprogram. The proposed resettlement is an extension of ongoing policies and programs throughout the

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city directed at improving living standards and public health conditions in favelas. The Project'sOperational Manual will include a detailed schedule of the resettlement subcomponent. At negotiationsthe Bank and the Borrower agreed on terms of reference for an independent evaluation of anticipatedimprovements in living star.ards and public health under the project (para. 3.15). The evaluation willinclude project beneficiary families as well as resettled families.

3.33 The project has been classified as "A" under O.D. 4.01. The Environmental Impact Assessment(EIA) conducted by SEEBLA (consulting firm) and submitted to the Bank on April 30, 1992, wasreviewed and found satisfactory. A summary has been distributed to the Board (Annex 12); the fullreport is available in the Project File. Each sub-project eligible for Bank financing shall comply with EIArequirements. The Borrower will present to the state authorities before implementation of each subprojectevidence of compliance with EIA recommendations.

K. Inplications for Sector Policy

3.34 The project changes a single sector orientation to water pollution control, and provides for amulti-disciplinary approach involving institutional integration within the boundaries of a water basin. Theproject provides for extensive studies, equipment and other facilities to strengthen water pollutionmonitoring and control in the Arrudas and Onca river basins and to provide a basis for water qualitymanagement in the das Velhas basin. Finally, the project promotes the consideration of alternative costrecovery instruments (Annex 10, Tables 3A and 3B, list existing and potential cost-recovery instruments)in order to expand the financial resources available for water pollution control in Brazil. Agreement wasreached during Loan Ncgotiations on the establishment of water basin management unit and a water usesurcharge to finance its opera.ions prior to September 30, 1994.

L. Project Implementation

Principal implementation Features

3.35 The project will be implemented over a five-year period and is expected to be completed byNfarch 31, 1997. It includes a variety of sub-projects that have been appraised on the basis of feasibilitystudies and preliminary engineering designs and found satisfactory. Final Bank approval of sub-projectswill be given during project implementation. To this effect, the Borrower will submit to the Bankevidence of sub-project compliance with the eligibility criteria shown in Annex 19. Eligibility criteriaincludes, n=-Ii1g, least-cost analysis, marginal cost pricing, and an environmental impact analysis. Amid-term review is scheduled by March 1994 to examine progress made, assess the relevance of allproject objectives and actions and, if necessary, recommend necessary revisions. In addition, duringproject implementation, two workshops will be held for purposes of orientation and explanation of Bankprocedures; the first not later than two months after loan signature and the second not latei han May 30,1994. The project includes studies and data collection, training and technical assistance and formulationof policies to support the establishment of a water basin management unit. The studies will be carriedout by consultants under the supervision of UGP. As most of the studies pertain to water basin operationand management, which is critical for the achievement of project objectives, these actions are scheduledduring the first two years of project implementation with study recommendations to be discussed duringthe mid-term review. Another series of studies and technical assistance relate to industrial pollutioncontrol (Annex 4). Follow-up actions on industrial pollution control will be considered at the mid-term

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review. Annex 14 shows a schedule of project execution by quarters. Annex 18 outlines the strategicplanning for the water basin management unit, including studies and technical assistance for operationand management of the water system.

3.36 Implementation a-ia institutional arrangements for the project will be formalized by the followingdocuments:(i) Loan Agreement between the Bank and the Stdte; (ii) Guarantee Agreement between theBank and the Federative Republic of Brazil; (iii) Subsidiary Agreements between the State and theexecuting agencies; (iv) onlending agreements between the State ard executing agencies;and (v )agreement between the State and the financial intermediary (BDMG).

3.37 Bank funds will flow from the Brazil Central Bank to BDMG, which will also receive theeounterpart funds from the state government and the executing agencies. Counterpart funds will bedisbursed by BDMG, at the request of each executing agency.

Project Supervision

3.38 Sub-projects will be carried out by the executing agencies, assisted by consultants, under theoverall guidance and control of UGP, which will be staffed by qualified professionals and assisted bymanagement consultants financed under the Loan. Project implementation re.quirements and procedures,including monitoring indicators and key project events will be detailed in an Operation Manual (Manualde Operacoes), under preparation by UGP. These arrangements would permit Bank supervision to bemaintained at a reasonable level and focusea on the development of studies related to water basinmanagement, and on critical and innovative projects such as industrial sewage and solid waste disposaland resettlement operations. Despite the above supervision arrangements, the project because of itsinnovative character and complex institutional features, will require more than customary supervision bythe Bank. The supervision plan is presented in Annex 20.

Reporting and Monitoring

3.39 Progress reports, prepared in accordance with the format given in the Operational Manual, willdescribe and compare past achievements with appraisal estimates; review compliance with the monitoringindicators detailed in Annex 15, and provide a critical assessment of p,.oblems and issues arising duringproject execution. The guidelines will also propose adjustments and remedial actions in case ofunsatisfactory progress. A set of physical, operational, environmental and financial monitoring indicatorswill constitute the basis for project review and supervision, including the mid-term review 'jpara. 3.35).The environmental impact of the project will be reported annually on the basis of the methodologyincluded in the Operational Manual. A final report analyzing the Project's key issues and containing aretrospective assessment of the Project's implementation from the Borrower's own perspective will besubmitted to the Bank not later than six months after the Loan's closing date.

Procurement

3.40 Civil works represent about 70 percent of the total project cost; equipment and materials, about23 percent; and consultant services, including studies, technical assistance, completion of engineeringdesigns, supervision and management, about 7 percent. All contracts for equipment and materialsestimated to co3t the equivalent of US$250,000 or less, and for civil works estimated to cost theequivalent of US$5.0 million or less, will be procured on the basis of local competitive biddingprocedures satisfactory to the Bank. Foreign firms will be allowed to participate in the bidding. Above

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these limits, procurement will be carriew: out on the basis of ICB, under Pank guidelines. Project costsby procurement method are presented in Table 3.3. Annex 16 details a a seliminary packaging of bidsfor procurement purposes. During Loan negotiations, it was agreed that standard bidding documents andcontracts for civil works and services under ICB and LCB approved recently for Loans 3504-BR a: d3505-BR will be used for procurement under the Loan. Engineering and project supervision services andtechnical studies will be procured in accordance with Bank guidelines for the use of consultants (August1981). Proposals will be invited from foreign and local consultants. A draft letter of invitation andcontract for consultant services is also under preparation (para. 3.15, [vii]). With the exception of priorreview of terms of reference, Bank ex-post review will be used for hiring consultants for engineeringdesign and supervision for assignments amounting to less than US$100,000 equivalent, and in theagg;egate value not to exceed the equivalent of US$1.0 million.

Table 33Proiecc Cost by Procurement Method

(USS million)

Project Elements ICB LCB Other Total

Civil Works $ 235.6 $ 29.9 $265.5(98.9) (12.6) (111.5)

Equipment $ 15.6 $ 8.0 -. $ 23.6(12.9) ( 3.4) ( 16.3)

Engineering and Tecinical Assistance -- -- $ 18.5 $ 18.5-_- (17.2) (27.2)

Total $251.2 $ 37.9 $ 18.5 $307.6(111.8) (16.0) (17.2) (145.0)

()Bank Loan.

3.41 All procurement under ICB (about 86% of total project cost) will be subject to prior Bank reviewof advertising, bidding documents, bid evalL 4tion, and contract awards. In the interest of expeditingproject execution, all procurement under LCB will be subject to ex-post review by sampling. However,in order to ensure that ade4uate procurement procedures are followed, the Bank will review and approve,irrespective of the amount, the first two contracts under LCB for goods and for works. If the Bankdetermines in the review by sampling that procurement is inconsistent with agreed procedures, the Bankwould revise the contract review procedures, and no expenditures for ;uch items will be financed out ofthe proceeds of the loan. Furthermore, the Bank may cancel an equivalent amount of the loan. Inaddition, the Bank reserves the right to review the following two LCB contracts.

Disbursements

3.42 The loan would be disbursed as follows: (i) 100 percent of foreign expenditures for importedequipment and materials; (ii) 42 percent of expenditures for civil works, equipment and materials; (iii)

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100 percent of expenditures for services of foreign consultants; and (iv) 85 percent of expenditures forservices of consultants with offices in Brazil. In order to expedite project execution, a Special Accountin the amount of US$10 million will be established in a commercial bank to cover project expenditures.Disbursements against civil works contracts below the equivalent of US$5.0 million and for goodsequivalent to US$250,000 will be made under the Statements of Expenditure procedure prepared andcertified by UGP. Detail documentation will be retained by UGP for inspection during supervisionmissions and for audit by external auditors. No force account works are envisaged. The estimatedschedule of disbursement (Annex 17) provides for Loan disbursement in six years. The closing date willbe September 30, 1997.

Advanco-1 Contracting and Retroactive Flnancing

3.43 The Loan will finance works to be carried out during the period 1992-1997. Work onresettlement and expenditures for consultants services will need to start in 1992 to have theimplementation of selected project tasks completed by mid-1994. In view of these needs, the projectwould provide for the following: (i) advanced contracting as of July 1, 1992, amounting to US$20millIon, and (ii) retroactive financing as of the same date, amounting to US$5 million. Advancecontracting and retroactive financing will be subject to the following conditions: (i) UGP's fully staffedand a Letter of Intent signed between UGP and the executing agency; and (ii) Bank procurementguidelines used for all applicable contracts.

Audit

3.44 All project accounts and statement of expenses submitted by UGP and the Special Account shallbe audited by external auditors. In addition, all executing agencies will submit audited financialstatements to UGP to be forwarded to the Bank. Audit reports for the previous year will be submittedtc the Bank every year by June 30 at the latest.

Management of the Water basin

3.45 Efficient management of the water basin will center around two elements: 'i) a set of policyinstruments to permit environmentally sustainable development in the area; and (ii) an autonomous andmodern water management unit to implement the policies. For the preparation of the above managementsystem, the project includes extensive data gathering and preparation of sectoral plans for the area, whichwould be followed by the design of alternative integrated schemes for the environmental regulation andcontrol of the area. During the project's mid-term review, scheduled for May, 1994, agreement wouldbe sought oni the selected alternative for establishing the water basin authority and the required changesto environmental policies and the implementation schedule of required actions. When designing andestablishing the project management unit, special attention would be given to the following items: legalarrangements to ensure the needed autonomy and enforcement powers, provision for the generation ofadequate resources and use of modern management systems, and agreement on a sector strategyemphasizing: (i) industrial pollution control (Annex 4); (ii) environmental sanitation; and, (iii) land usemanagement. Annex 13 shows key events for the establishment of the das Velhas river water basinauthority.

3.46 The State Environmnental Agency (FEAM) will exercise an important role during projectimplementation until the water basin authority is created. A program fo. strengthening FEAM--financedby the Loan--has already started. A plan for effective monitoring of the industrial pollution is being

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prepared by FEAM assisted by specialized consultants (para. 3.15) Another group of consultants willassis. FEAM in preparing studies for the upper das Ve:has river pollution control and monitoring.

Key Implementation Actions

3.47 In order to minimize project implementation telays, the following agreements on keyimplementation actions were reached during Loan Negotiations: (i) formalization of all Loan/Projectdocuments before effectiveness (para. 3.36); (ii) the staffing of UGP and formalization of Letters of Intentbefore committing retroactive funding (para. 3.34); (iii) the eligibility criteria for subprojects (para. 3.35and Annex 19); (iv) terms of reference for studies for the establishment of a water basin management unit(para. 3.34); (v) the approval of a water use surcharge (para. 3.34); (vi) monitoring indicators (para. 3.34and Annex 15); (vii) COPASA's financial plan (Annex 11); (viii) a plan of action for industrial pollutioncontrol and strengthening of FEAM (para. 3.10 and Annex 4); and (ix) timely submission of satisfactoryaudits (para. 3.44), and progress reports and PCR (para. 3.39). In addition, agreement was reached onthe decision that no disbursement for the two sewage treat,nent plans will be made until completion ofthe industrial pollution control studies. Fiially, the approval of subprojects related to the disposal ofhazardous solid wastes will be subject to the provision of satisfactory safeguards.

M. Project Risks

3.48 The main project risk is associated with the project's innovative character and the requiredinstitutional integration at the state and municipal levels. This risk was carefully assessed early on inproject preparation and the Loncerned project institutions decided to create UGP at the state level inBD' ., for overall project supervision and coordination with the executing agencies. The executingagencies have highly qualified staff widi experience in implementing Bank-funded projects.

3.49 Resettlement represents another risk beset by many social and political hazards. Advancedpreparation of detailed plans by the two municipalities for the first two years of project execution, willhelp minimize these risks.

3.50 Finally, there is a risk in introducing modern policy instruments for water pollution control inBrazil. Though the need for these policy changes is broadly recognized at the technical level, theirimp!ementation might encounter political difficulties. Even if implementation of needed reforms isdelayed, the project will be instrumental in helping Brazilian authorities in developing appropriatetechnologies for overcoming widespread water pollution problems.

IV. AGREEMENTS AND RECOMMENDATIONS

4.1 During Loan Negotiations, agreement was reached on the following:

(a) final designs representing in aggregate value 20 percent of project costs (para. 3.15(i);

(b) terms of reference for the UGP (para. 3. 15(ii));

(c) the list of coordinators for each executing agency (para. 3.15(iii));

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(d) terms of reference for studies to be carried out under the project (para. 3. 15(iv));

(e) terms of reference for management consultants (para. 3.15(v));

(f) final draft documents for project institutional agreements (para. 3. 15(vi));

(g) final draft standard documents and standard letter of invitation for consultants (para.3.15(vii));

(h) the Operational Manual (para. 3.15(viii));

(i) a plan for the institutional strengthening of FEAM (para. 3.15(ix));

() final designs for resettlement (para. 3.15(x));

(k) terms of reference for a study to evaluate expected improvements in living standards(para. 3.15(xi);

(I) evidence of completion of legal actions for expropriations (para. 3.15(xii)); and

(m) timely funding for the required land expropriations and housing projects (para.3.15(xiii)).

(n) CCPASA's financial plan (para. 3.24).

4.2 In addition, the Bank reached agreement with the Borrower on the following:

(a) the establishment of a water basin unit (para. 3.34);

(b) the establishment of a water use surcharge (para. 3.34);

(c) mid-term review and workshops (para. 3.35);

(d) the eligibility criteria for subprojects (para. 3.47(iii));

(e) monitoring indicators shown in Annex 15 (para. 3.47(vi));

(f) the timely submission of satisfactory audit reports, progress reports and ProjectCompletion Report (para. 3.47(viii)).

4.3 Prior to Loan Effectiveness, the Borrower should:

(a) have signed the contract with consultants for the preparation of the industrial pollutioncontro! plan (para. 3.15); and

(b) have signed all subsidiary loan agreements (para. 3.47(i).

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4.4 Prior to incurring retroactive expenses the Borrower should:

(a) fully staff UGP (para. 3.49(ii)); and

(b) ensure that a letter of intent has been signed between UGP nd the concerned executinrgagency (para. 3.43(i)).

4.5 Prior to disbursement of Loan funds to an individual subproject the Borrower should submitevidence to the Bank of the subproject's compliance with the eligibility criteria (para. 3.35).

4.6 Prior to disbursement of Loan funds to subprojects for the construction of the Arrudas and DaOnca sewage treatment plants, the Borrower should complete an industrial pollution control plan (para.3.47).

4.7 Subject to the above conditions, the proposed project is suitable for a Bank Loan of US$145million equivalent to the State of Minas Gerais. The Loan is to be repaid over a period of 15 years,including a five-year grace period, at the Banks standard variable rate. Advanced contracting for up toUS$20 million and retreactive financing for up to US$5 million for expenditures incurred after July 1,1992, is recommended (para. 3.43).

MINAS GERAIS - WATER QUALITY AND POLLUTION CONTROL PROJECTARRUDAS AND ONCA INATER BASINS R THEBELO HORIZONTE METRO'OLITAN AREA

Bank Loam to Brail for Watbr Supply and Sewage

WM ]LOM NO.AMOUNT BORROWER PURPOSE Simils - of W.111011 COoM(USe Wit ~~~~~~~~~~~~~~~~Cesannab. I Olebor.

1971 757-BR 22.0 City Watr Co. Sao Pauo water disribution and storage. 100% 100% Proed Peromance Audit Report (PPR) dated 04/04/80.1971 75B-BR 12.0 City Water Co. Sao Paulo sewage colection and disposal. 100% 100% Idem. Loan wrount reduced1om US$15.0 million.1974 100P-BR 36.0 BN