the indonesia water fund - assessment of feasibility

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THE INDONESIA WATER FUND ASSESSMENT OF FEASIBILITY

MoF 1

MTNs repayment

3 Indonesian investorsCIC Operations

2

PT. DanareksaFinance

Indonesian private banks

Indonesia Water Fund

partial guarantee

Guarantor

SEPTEMBER 2006

This publication was produced by Development Alternatives, Inc. for the United States Agency for International Development under Contract No. 497-M-00-05-00005-00

Illustration credit: ESP Jakarta. Image caption: The illustration of Financing Arrangements During Operations.

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THE INDONESIA WATER FUND

ASSESSMENT OF FEASIBILITY

Title: The Indonesia Water Fund Assessment of Feasibility

Program, activity, or project number: Environmental Services Program,

DAI Project Number: 5300201. Strategic objective number: SO No. 2, Higher Quality Basic

Human Services Utilized (BHS). Sponsoring USAID office and contract number: USAID/Indonesia,

497-M-00-05-00005-00. Contractor name: DAI. Date of publication: September 2006

TABLE OF CONTENTS

LIST OF FIGURE......................................................................................................................... I LIST OF TABLE .......................................................................................................................... I ABBREVIATIONS....................................................................................................................... I EXECUTIVE SUMMARY..........................................................................................................III 1. INTRODUCTION .............................................................................................................. 1

1.1. BACKGROUND ..........................................................................................................................................1 1.2. OBJECTIVE AND SCOPE OF WORK ...........................................................................................................1 1.3. STATUS AND CONTENTS OF THIS REPORT ..............................................................................................2

2. WATER AND SANITATION IN INDONESIA .............................................................. 4 2.1. SUMMARY ...................................................................................................................................................4 2.2. WATER.......................................................................................................................................................4 2.3. SANITATION...............................................................................................................................................8

3. DEMAND PROJECTIONS .............................................................................................. 11 3.1. SUMMARY ................................................................................................................................................ 11 3.2. POTENTIAL DEMAND FOR PIPED WATER SUPPLY.................................................................................. 12 3.3. POTENTIAL DEMAND FOR PIPED SEWERAGE......................................................................................... 15 3.4. ACTUAL DEMAND FOR PIPED WATER SUPPLY ...................................................................................... 16

4. FINANCING PIPED WATER AND SANITATION..................................................... 17 4.1. SUMMARY ................................................................................................................................................ 17 4.2. EXISTING FINANCING MECHANISMS...................................................................................................... 18 4.3. FUTURE FINANCING MECHANISMS ........................................................................................................ 22 4.4. CONSTRAINTS TO FINANCING PIPED WATER AND SEWERAGE SYSTEMS ........................................... 23

5. STRUCTURE AND ORGANIZATION OF THE IWF................................................. 25 5.1. SUMMARY ................................................................................................................................................ 25 5.2. SCOPE OF THE INDONESIA WATER FUND ........................................................................................... 27 5.3. IWF DESIGN CRITERIA........................................................................................................................... 29 5.4. STRUCTURE OF THE INDONESIA WATER FUND .................................................................................. 32 5.5. FINANCING ARRANGEMENTS ................................................................................................................ 35 5.6. SECURITY ARRANGEMENTS .................................................................................................................... 37

6. SERVICES OF THE IWF ................................................................................................. 40 6.1. SUMMARY ................................................................................................................................................ 40 6.2. ANALYSIS OF COMPETING SERVICES ...................................................................................................... 40 6.3. A DETAILED OVERVIEW OF THE IWF’S SERVICES.................................................................................. 42

7. FEASIBILITY ANALYSIS OF THE IWF ....................................................................... 45 7.1. SUMMARY ................................................................................................................................................ 45 7.2. METHODOLOGY FOR ASSESSING THE FEASIBILITY OF THE IWF.......................................................... 46 7.3. IMPACT OF IWF FUNDING AND MANAGEMENT COSTS ON THE EFFECTIVE INTEREST RATE ON INVESTMENT........................................................................................................................................................... 48 7.4. MINIMUM REQUIRED AVAILABILITY OF BILATERAL GUARANTEES ........................................................ 52 7.5. EFFECTIVE INTEREST RATE ON INVESTMENT UNDER FULL COST-RECOVERY...................................... 53 7.6. MINIMUM REQUIREMENTS FOR THE FEASIBILITY OF THE IWF ............................................................. 54

8. CONCLUSIONS AND RECOMMENDATIONS .......................................................... 56 8.1. SUMMARY ................................................................................................................................................ 56 8.2. BENEFITS OF THE IWF............................................................................................................................ 56

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8.3. RECOMMENDED ACTIONS TO FURTHER DEVELOP THE IWF CONCEPT............................................. 57 9. ANNEXES......................................................................................................................... 60

ANNEX 1. EXISTING PPPS IN THE WATER SECTOR ........................................................................................... 61 ANNEX 2. STATUS OF PDAM LOANS ................................................................................................................. 62 ANNEX 3. REVIEW OF PP54/2005....................................................................................................................... 63 ANNEX 4. BOND ISSUANCE COSTS..................................................................................................................... 66 ANNEX 5. ASSUMPTIONS FOR IWF FINANCING ................................................................................................ 67 ANNEX 6. IWF CASHFLOW PROJECTIONS......................................................................................................... 69 ANNEX 7. IWF HIGH-LEVEL MEETING REPORT................................................................................................. 71 ANNEX 8. REFERENCES ......................................................................................................................................... 73

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LIST OF FIGURE FIGURE 1. OVERVIEW OF FINANCING ARRANGEMENTS FOR A STRAIGHT BOND ISSUE8................................. VIII FIGURE 2. SECURITY ARRANGEMENTS DURING OPERATIONS*. .......................................................................... IX FIGURE 3. REPORT STRUCTURE.................................................................................................................................3 FIGURE 4. URBAN AND RURAL COVERAGE OF IMPROVED WATER SOURCES IN SELECTED SOUTH-EAST

ASIAN COUNTRIES (2002).......................................................................................................................5 FIGURE 5. HOUSEHOLD ACCESS TO WATER, BY TYPE OF SOURCE (2002).........................................................5 FIGURE 6. URBAN AND RURAL COVERAGE OF PIPED WATER SUPPLY, 2000-2015. ...........................................6 FIGURE 7. PIPED WATER CONNECTIONS AND PRODUCTION CAPACITY, 1995-2015. .....................................6 FIGURE 8. URBAN AND RURAL COVERAGE OF SANITARY FACILITIES IN SELECTED SOUTH-EAST ASIAN

COUNTRIES (2002)...................................................................................................................................8 FIGURE 9. URBAN AND RURAL COVERAGE OF SANITARY FACILITIES (2002).......................................................9 FIGURE 10. PDAM LOANS EXTENDED BY THE MINISTRY OF FINANCE, 1993-2005. ......................................... 20 FIGURE 11. PPP ARRANGEMENTS, 1993-2005. ...................................................................................................... 20 FIGURE 12. CHANNELING ARRANGEMENTS FOR A CONCESSIONAL LOAN. ....................................................... 34 FIGURE 13. OVERVIEW OF FINANCING ARRANGEMENTS DURING CONSTRUCTION......................................... 36 FIGURE 14. FINANCING ARRANGEMENTS DURING OPERATIONS......................................................................... 37 FIGURE 15. SECURITY ARRANGEMENTS DURING OPERATIONS*. ......................................................................... 39 FIGURE 16. PROJECT FINANCE LOAN TERMS COMPARED – IWF VS. COMMERCIAL BANKS.............................. 42 FIGURE 17. OVERVIEW OF SCENARIOS. ................................................................................................................... 50

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LIST OF TABLE TABLE 1. PARTIES INVOLVED IN THE INDONESIA WATER FUND...........................................................................VI TABLE 2. INDICATIVE TERM SHEET FOR A BOND ISSUE FOR PDAM XYZ. ....................................................... XI TABLE 3. WATER UTILTIES IN INDONESIA BY SIZE CLASS, 2004. .........................................................................8 TABLE 4. SERVICE LEVEL TARGETS FOR THE SANITATION SECTOR. .....................................................................9 TABLE 5. KEY FEATURES OF PIPED SEWERAGE NETWORKS IN INDONESIA. ..................................................... 10 TABLE 6. MDG#7 GOALS VS. CURRENT STATE OF AFFAIRS, PIPED WATER SUPPLY ONLY. ......................... 13 TABLE 7. COST ESTIMATES FOR PIPED WATER SUPPLY SYSTEMS, 2004-2015. ................................................ 13 TABLE 8. ASSUMED FUNDING SOURCES FOR PIPED WATER SUPPLY SYSTEMS, 2004-2015............................ 13 TABLE 9. OPPORTUNITIES FOR PUBLIC-PRIVATE PARTNERSHIPS IN THE WATER SECTOR.............................. 14 TABLE 10. MDG#7 GOALS VS. CURRENT STATE OF AFFAIRS, PIPED SEWERAGE ONLY ................................. 15 TABLE 11. ESTIMATED INVESTMENT REQUIREMENTS FOR PDAMS WORKING WITH ESP. ................................. 16 TABLE 12. INVESTMENT REQUIREMENTS VS. NET PUBLIC SAVINGS, SELECTED PDAMS.................................... 19 TABLE 13. SUMMARY OF CONSTRAINTS TO FINANCING WATER AND SANITATION. ...................................... 24 TABLE 14. FUNDING SOURCES AVAILABLE TO PROVIDERS OF PIPED WATER AND SEWERAGE. ...................... 29 TABLE 15. PREFERRED CREDIT TERMS OF PDAMS (INDICATIVE). ....................................................................... 30 TABLE 16. IMPLICATIONS OF IWF DESIGN CRITERIA. .......................................................................................... 31 TABLE 17. PARTIES INVOLVED IN THE INDONESIA WATER FUND....................................................................... 33 TABLE 18. CREDIT TERMS OF THE IWF VIS-À-VIS COMPETING LOAN PRODUCTS. ........................................ 41 TABLE 19. COMPLIANCE OF IWF DESIGN CRITERIA WITH FEASIBILITY REQUIREMENTS................................... 46 TABLE 20. KEY ASSUMPTIONS FOR CALCULATING THE EFFECTIVE INTEREST RATE ON INVESTMENT FOR AN

IWF LOAN TO ELIGIBLE WATER UTILITIES. ........................................................................................ 48 TABLE 21. EFFECTIVE INTEREST RATES ON INVESTMENT FOR IWF BORROWERS UNDER THREE SCENARIOS.49 TABLE 22. SENSITIVITY OF EFFECTIVE INTEREST RATES ON INVESTMENT TO CHANGES IN ASSUMPTIONS...... 51 TABLE 23. MINIMUM REQUIRED GUARANTEED AMOUNT TO MEET PROJECTED DEMAND FOR IWF PROJECT

FINANCING............................................................................................................................................. 52 TABLE 24. ANNUAL PROJECT PREPARATION COSTS OF THE IWF (INDICATIVE). ............................................. 53 TABLE 25. IMPACTS OF FIXED COSTS ON EFFECTIVE INTEREST RATES ON INVESTMENT. ................................. 54

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ABBREVIATIONS APBD Anggaran Belanja dan Pendapatan Dearah (local government budget) BAPEPAM Badan Pengawas Pasar Modal (Capital Market Supervisory Agency) BAPPEKKI Badan Pengkajian Ekonomi, Keuangan dan Kerjasama Internasional

(Institute for Economic and Financial Research and International Cooperation)

BAPPENAS Badan Perencanaan dan Pembangunan Nasional (National Planning Board)

BLU Badan Layanan Umum (public service agency) BPD Bank Pembangunan Daerah (local government development bank) BPP-SPAM Badan Pendukung Pengembangan Sistem Penyediaan Air Minum (Water

Supply Development Supporting Agency) BPS Badan Pusat Statistik (Central Bureau of Statistics) BUMD Badan Usaha Milik Daerah (local government-owned company) BUMN Badan Usaha Milik Negara (state-owned company) CIC Collective Investment Contract CLO Collateralized Loan Obligation DAK Dana Alokasi Khusus (General Allocation Fund) DAU Dana Alokasi Umum (Special Allocation Fund) DCA Development Credit Authority DG Directorate-General DPPP (DP3) Direktorat Pengelolaan Penerusan Pinjaman (Directorate for the

Management of Local Government Sub-loans) DPRD Dewan Perwakilan Rakyat Daerah (Local Parliament) EIRI Effective interest rate on investment ESP Environmental Services Program FOREX Foreign exchange GOI Government of Indonesia IDR Indonesian Rupiah IWF Indonesia Water Fund KIK-EBA Kontrak Investasi Kolektif–Efek Beragun Aset (Collective Investment

Contract – Asset-Backed Securities) LG Local government MDG Millennium Development Goal MoF Ministry of Finance MoHA Ministry of Home Affairs MPW Ministry of Public Works MTN Medium-Term Note NAP-CW National Action Plan on Clean Water NAP-S National Action Plan on Sanitation NGO Non-governmental organization O&M Operations and maintenance

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PDAM Perusahaan Daerah Air Minum (local government drinking water company)

PerMendagri Peraturan Menteri Dalam Negeri (regulation by the Minister of Home Affairs)

PERPAMSI Persatuan Perusahaan Air Minum Seluruh Indonesia (Association of Indonesian Water Companies)

PMK Peraturan Menteri Keuangan (Decree of the Minister of Finance) PP Peraturan Pemerintah (Government Regulation) PPP Public-private partnership RDA Regional Development Account RPJM Rencana Program Jangka Menengah (Medium-Term Development

Program) SLA Subsidiary Loan Agreement USAID United States Agency for International Development US$ United States Dollar UU Undang-undang (law) WHT Withholding Tax WTP Water Treatment Plant DEFINITIONS

Study Team The consortium of firms that was awarded consultancy service for the Project

Project Environmental Services Program (ESP) Local government A provincial government or district government (kabupaten or kota) EXCHANGE RATE

US$ = IDR 9,000

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EXECUTIVE SUMMARY At present, less than 18 percent of all households in Indonesia have access to piped water. The Government of Indonesia plans to increase coverage to 62 percent in 2015 by increasing the number of household connections from 6.3 million to over 25 million. The required investments are estimated at US$ 450 million per year, up from the current level of investment amounting to US$ 50 million per year. Water utilities (or their owners) have not had access to long-term financing since the Asian Crisis (1997) and, as a result, there is considerable pent-up demand for rehabilitation to existing systems and network expansion.


SUMMARY The USAID-sponsored Environmental Services Project (ESP) has proposed a mechanism to finance water, sanitation and related environmental services with third-party long-term loans and securitization offerings, referred to as the Indonesia Water Fund (IWF). ESP has developed the proposal with PT. Danareksa, a state-owned firm and the largest investment house in the country. PT. Danareksa has expressed its interest in participating in the IWF by entering into a formal Memorandum of Understanding (MOU) with ESP to further develop and operationalize the concept. The proposed arrangements have attracted the strong support of the MoF and other GOI agencies.

ORGANIZATION The Indonesia Water Fund is envisaged as an underwriting and co-financing facility, managed by PT. Danareksa Sekuritas, a wholly owned subsidiary of PT. Danareksa. A primary objective of the IWF is to mobilize 12-year project finance for the rehabilitation and expansion of water utility networks at affordable and fixed interest rates in local currency. The establishment of the IWF does not immediately require up-front capitalization from GOI, local governments or water utilities. It also does not require a change to existing laws, although the underwriting of projects with a financing requirement not exceeding IDR 150 billion requires some changes to existing (tax) regulations, which are already reflected in a draft revision to the income tax law. This means that it would be possible to establish the IWF at short notice.

ELIGIBLE WATER UTILITIES Initially, the IWF would underwrite the take-out of construction financing for projects undertaken by creditworthy water utilities. A water utility is deemed creditworthy if it meets two criteria:

1. The utility charges (or will soon charge) a full cost-recovery tariff. A utility meets this condition if total income covers the full cost of operations according to the latest available audited financial report. The full cost of

THE INDONESIA WATER FUND - ASSESSMENT OF FEASIBILITY

operations is defined as: operating cost + debt service + 10% of equity. A utility that does not meet this condition may be eligible for the IWF if it starts charging full cost-recovery tariffs before signing an underwriting agreement with the IWF.

2. The utility is capable to repay outstanding arrears (if any). This

condition is met if arrears on outstanding loans do not exceed IDR 1 million per connection according to the latest available audited financial report.

ELIGIBLE PROJECTS. The IWF would only underwrite a project if the water utility:

1. Maintains a DSCR of at least 1.5 throughout the term of the project financing. The Debt Service Coverage Ratio is defined as: [cash available from operations after all operating expenses including taxes have been met minus debt service] / debt service.

2. Complies with other general financing terms and security

arrangements. These are outlined in the term sheet attached to this Summary.

SERVICES. To assist with the mobilization of 12-year project finance for the rehabilitation and expansion of water utility networks, the IWF offers to underwrite the take-out of construction financing through a bond issuance in the domestic market. The contractor would be responsible for the organization of construction financing. PT. Danareksa considers IDR 150 billion as the minimum size for an individual bond offering (‘straight bond’). If the financing requirements of a water utility remains below this threshold, the IWF would issue a collateralized loan obligation bond (‘pooled bond’)*.

THE ROLE OF MULTILATERAL AND BILATERAL CREDIT AGENCIES. 1. Provide partial credit guarantees. It is proposed that multilateral and

bilateral credit agencies would provide guarantees to facilitate the mobilization of construction and operations financing by covering up to 35% - 50% of the exposure of IWF bondholders. To assist the contractor in organizing construction finance, it will be important for such agencies to signal the conditional availability of partial credit guarantees prior to the start of construction, at the time the contractor is selected by competitive tender and assumes responsibility for mobilizing its own construction finance. The conditional availability of the guarantees would trigger a conditional underwriting by PT. Danareksa Sekuritas.

* PT. Danareksa has indicated that, depending on market conditions, it may consider underwriting a

straight bond for water utilities with a financing requirement of less than IDR 150 billion. It is also willing to underwrite bond financing for the repayment of arrears of municipal water enterprises (PDAMs) on outstanding loans, with a maximum of IDR 10 billion per PDAM.

ENVIRONMENTAL SERVICES PROGRAM WWW.ESP.OR.ID IV


2. Co-finance bond issues and (optionally) co-finance construction. The Ministry of Finance is considering the utilization of a supporting loan from an international donor, with the proceeds of the loan channeled to PT. Danareksa to finance the purchase of 30% of IWF bond offerings and, optionally, to co-finance 30% of the construction cost of waterworks.

FINANCING ARRANGEMENTS

OVERVIEW OF FINANCING ARRANGEMENTS. The IWF would facilitate the financing of waterworks in two stages:

1. Construction of waterworks (for periods up to 2.5 years). At the start of this period, a water utility (‘the Borrower’) and a reputable contractor will agree upon a contract for the construction of waterworks (‘the Project’). The contractor will be responsible for completing the Project on agreed specifications at fixed-price, fixed-schedule terms. In addition, the contractor will be required to arrange the financing needed to undertake and complete the Project from its own financiers and under its own responsibility. While this arrangement obviates any requirement for PT. Danareksa to organize financing at this stage, the latter will be required to provide assurances to the contractor (and its financiers) that a take-out of construction finance is available once the Project is completed. To provide this level of comfort, PT. Danareksa Sekuritas, acting as financial advisor of the borrower, will issue a conditional underwriting of the permanent financing before construction starts (based on an initial credit review). The conditional underwriting will be replaced by a formal underwriting before Project completion.

2. Operations (for periods up to 10 years). Three months before the

expected date of completion of the Project, a full credit rating of the Borrower will be secured and the take-out of construction financing arranged through an underwriting by PT. Danareksa Sekuritas to be made available upon completion of the Project. PT Danareksa Finance will be empowered through formal agreements to make up to 10-year loans to each qualifying water utility, assuming full credit risk.

PRIMARY PARTNERS IN THE FINANCING ARRANGEMENTS. Implementing the financing arrangements described above requires to collaboration of the Ministry of Finance, PT. Danareksa, providers of partial credit guarantees and a Project Originator (this role is currently fulfilled by ESP). To facilitate pooled bond issues, the co-financing arrangements offered by a donor (international financing institution) are deemed essential (Table 1).

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Table 1. Parties Involved in the Indonesia Water Fund.

Partners Role in the IWF

PRIMARY PARTNERS (essential parties to the IWF)

Ministry of Finance (MoF) Executing Agency of the IWF; signs loan agreements with International Donor and PT. Danareksa Finance (Donor loan pro-ceeds employed to co-finance IWF projects).

PT. Danareksa Sekuritas Investment house; provides financial advisory and underwriting services to water utilities.

PT. Danareksa Finance* Co-finances construction loans from MoF loan Multilateral and bilateral credit agencies

Issues guarantee to domestic private investors extending up to 35% - 50% cover on exposure taken on operations finance.

Project Originator (USAID / ESP)

Identifies and analyses prospective projects

International Donor* Extends a loan to GOI (US$ 50 million equivalent), which is on-lent by MoF to PT. Danareksa Finance for the purpose of co-financing IWF projects.

SECONDARY PARTNERS (other relevant parties)

Water utilities Owners of construction waterworks; issue Bonds. Local governments (owners of water utilities)

Form part of the security arrangements (including the issuance of a Letter of Comfort).

Construction contractors Construct waterworks; arrange financing during construction period.

Domestic private banks Finance construction of waterworks. CIC-Operations* Collective Investment Contract; purchaser of CLO bond, the

proceeds of which are used to pay off the construction financiers. Trustee Acts on behalf of bondholders. Credit rating agency Rates Bond issue. Institutional investors Invest in Bonds issued by the Borrower.

Source: ESP * Essential partner for pooled bonds only ** Applies to pooled bonds only

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DETAILED FINANCING ARRANGEMENTS – STRAIGHT BONDS. Key parties to the proposed financing transactions are the Originator (USAID/ESP), PT. Danareksa Sekuritas, Indonesian private banks and other private financiers, construction contractors, credit rating agencies and water utilities. The following steps would be taken: Step 1. The Originator prepares a feasibility study for a project that may be financeable

through a bond offering. Step 2. The Originator delivers the feasibility study to PT. Danareksa Sekuritas (‘the

Underwriter’), if the Originator’s evaluation is positive. Step 3. If the Underwriter agrees, it enters into a formal mandate to mobilize operations

finance on behalf of the water utility on terms to be agreed. Step 4. The water utility (‘the Borrower’) selects a reputable construction contractor

(‘the Contractor’) through a transparent tendering process, in accordance with prevailing regulations, to construct a water utility network. The Contractor must be acceptable to the Underwriter and the agencies that issue a partial credit guarantee (‘the Guarantor’).

Step 5. A credit rating agency is selected to provide a preliminary review of the proposed Borrower’s potential credit rating in the context of its financial track record, the institutional arrangements in which it operates and the robustness of contractual undertakings (including the role of the various parties to construction, construction finance and operations) which form part of the proposed financing.

Step 6. Based on its independent credit appraisal as well as discussions with the credit rating agency, the credit agencies issue a certificate signaling its intent to provide a bondholder guarantee for 35% - 50% of the operations financing to take effect once the project works are successfully completed (on conditions to be negotiated between the Borrower, Contractor, the Underwriter and the Guarantor). Based on this guarantee, the Underwriter issues a certificate identifying similar terms and conditions under which it will provide a bond underwriting at the time the project works are completed.

Step 7. The Contractor and Borrower enter into a fixed-price, fixed-schedule construction contract pursuant to which the former mobilizes finance for the proposed Project.

Step 8. Assuming that the Project is implemented on schedule and according to contractually agreed specifications, a rating agency issues a formal credit rating of the Borrower.

Step 9. The Guarantor issues its partial guarantee(s) and the Underwriter its formal underwriting. Based on these, the Contractor’s financiers enter into an agreement with the Contractor to finance construction milestones (for details on the above steps, refer to the sample term sheet attached to the Executive Summary).

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project analysis

partial guarantee (conditional)

underwriting (conditional)

take-out arrangements (conditional)

project

identifi-cation

Originator (USAID/ESP)

contractor selection/ award of contract

construction conform international best practices

2

1

3

9

Guarantor

3

mandate

4 7

PT. Danareksa Finance


IWF (operations finance underwritten by PT. Danareksa Sekuritas)

Contractor

6

Water utility (Borrower)

Figure 1. Overview of Financing Arrangements for a Straight Bond Issue*. Source: ESP * Note: Step 6 (credit appraisal) and Step 8 (credit rating) not shown in exhibit.

DETAILED FINANCING ARRANGEMENTS – POOLED BONDS. The steps identified above would also apply to a pooled bond offering, although the placement of the bond would be organized differently. As mentioned earlier, PT. Danareksa considers IDR 150 billion as the minimum size for a bond offering. If the financing requirements of a water utility do not exceed this threshold, the take-out of the construction financing will be organized as follows:

1. PT. Danareksa establishes a Collective Investment Contract - Operations Vehicle (hereinafter also referred to as ‘CIC-Operations’). This is the formal name given to SPVs used in Indonesia for selling or purchasing securitization instruments.

2. Upon commissioning of the first of a series of ‘smaller’ waterworks projects (i.e. projects with a financing requirement below IDR 150 billion), CIC-Operations issues, in its own name, a Bond which will be the source of funding with which to take out the construction financing.

3. CIC-Operations then uses the Bond proceeds to extend a loan to the first of the ‘small‘ Borrowers against medium-term notes (MTNs) executed by the Borrower, with terms and conditions matching those of the Bond. CIC-Operations pledges the MTNs, along with other security, to the trustee designated to act on behalf of the Bondholders.

4. Using the same process, whenever a ‘small’ project is completed, bondholders are required to purchase the corresponding part of the issue to take out the construction financing of that particular project.

ENVIRONMENTAL SERVICES PROGRAM WWW.ESP.OR.ID VIII


SECURITY ARRANGEMENTS To provide security to financiers of construction loans, a contractor will be subject to strict fixed-price fixed-schedule performance standard and penalties for sub-standard performance. At the time of the take-out of construction financing, the Borrower (usually a PDAM) and its owner (usually a local government) are each required to set up a liquidity standby, amounting to 10% of the outstanding loan. Moreover, the owner is required to issue a letter of comfort that is backed by a partial credit guarantee. As a fourth layer of protection, the Borrower will pledge to create a lock-box arrangement for accounts receivables in the event of a default. Upon completion of the construction of a water supply project, these security arrangements would remain in place, except for contractor penalties. Finally, a sinking fund requirement, monitored by the trustee, will be imposed on the Borrower during the operations phase to ensure that the Borrower is sufficiently liquid to meet its debt service obligations (Figure 2).


CIC- Operations

Trustee Owner 3

1

2

water utility acc. receivable

liquidity standby (>10%)**

letter of comfort (partial credit guarantee)

Figure 2. Security Arrangements During Operations*. Source: ESP * Contractor penalties apply during the construction phase ** Also used to fulfill sinking fund requirements

FEASIBILITY OF THE IWF A detailed analysis of the costs of the various services provided by the IWF shows that the Fund would be able to offer 12-year project loans to water utilities at an average interest rate of approximately 14% to 15% p.a. For the issuance of a pooled bond, it is essential that the Ministry of Finance exempts CIC vehicles established by the IWF from withholding taxes on interest paid to holders of the CLO Bond issued by CIC-Operations. If MoF continues to double tax CIC vehicles, as is presently the case, the IWF is not feasible for projects with a financing requirement not exceeding IDR 150 billion (i.e. for CLO bond financings).

ENVIRONMENTAL SERVICES PROGRAM WWW.ESP.OR.ID IX


OUTSTANDING ISSUES STATUS OF THE PROPOSAL. To implement the IWF as discussed herein, it is necessary to secure the commitment of the primary partners, the status of which is:

• USAID: has expressed interest in providing partial guarantees and is funding the preparation of feasibility studies for selected PDAMs.

• The Ministry of Finance: has expressed commitment in principle to the proposal and has set up a task force to resolve outstanding issues.

• International Donor: has expressed interest to lend a US$ 50 million equivalent loan to GOI, the proceeds of which would be channeled to PT. Danareksa Finance to co-finance waterworks projects underwritten by the IWF.

• PT. Danareksa: has expressed commitment in principle to the scheme.

RESULTS OF A HIGH-LEVEL MEETING WITH GOI. At the invitation of the Director General of Treasury, the Study Team presented the proposed concept for the IWF to a number of high-level decision makers in the central government in a meeting that was held on 29 June 2006. During this meeting, GOI expressed its commitment in principle to support the establishment of the IWF at short notice and confirmed its intention to support the IWF by borrowing the equivalent of US$ 50 million from an international donor. The proceeds of this loan would be channeled as a Rupiah-denominated sub-loan to PT. Danareksa to finance the purchase of 30% of IWF bond offerings and, optionally, to co-finance 30% of the construction cost of waterworks.

THE NEED FOR A WAIVER ON WITHHOLDING TAX. Revenues from CIC issues are currently subject to withholding tax (WHT) on interest earned and interest paid. MoF has been approached to eliminate the double taxation related thereto of CIC. The justifications being used are as follows:

• WHT on interest levied on pooled bonds should be waived as they represent ‘double’ taxation. (CIC vehicles are ‘pass through’ vehicles and should not be taxed at both ends). Banks, pension funds and mutual funds are not similarly double taxed.

• WHT on the CLO instrument should be waived because the offering is supporting municipal infrastructure and should be considered the equivalent of a municipal bond.

USAID has verified that a draft revision to the income tax law, which the National Parliament intends to approve in 2007, already provides for the removal of double taxation. At the time of writing, the Ministry of Finance had not expressed on the proposed removal of WHT payable by holders of IWF bonds.

ENVIRONMENTAL SERVICES PROGRAM WWW.ESP.OR.ID X


Table 2. Indicative Term Sheet for a Bond Issue for PDAM XYZ. SUMMARY

Proposed transaction Take-out of construction financing through a bond issue (the “Bonds”) on the Surabaya Stock Exchange during [ ], the proceeds of which will be used to:

a. IDR [ ] To replace construction finance (Principal and Interest) organized by a construction contractor (the “Contractor”) pursuant to a fixed-price, fixed-schedule construction contract (the “Turnkey”) to undertake the implementation of approved water works (“the Works”).

b. IDR [ ] To establish liquidity standby reserves amounting to 20% of the Turnkey cost.

c. IDR [ ] To pay Bond issuance and underwriter’s fees. d. IDR [ ] To provide other working capital at commissioning of

the Works needed to implement household connection program as to generate revenues from sale of water needed to repay the Bonds.

Face value of Bonds IDR [ ] 100% Consisting of: - Construction take-out - Working capital

IDR [ ] [ ]% = a+b+c IDR [ ] [ ]% = d

Key participants - Borrower PDAM XYZ - Owner District government XYZ - Contractor Undesignated, First class Contractor to be selected through a

competitive bidding, with procedures to be agreed by Underwriter. - Underwriter PT. Danareksa Sekuritas, with conditional underwriting to be issued

prior to mobilization of construction finance. - Credit Enhancer Partial credit guarantee instrument [ ], covering up to [ ]% of

eligible bondholders’ exposure, with such instrument to be issued conditionally prior to the mobilization of construction finance.

Works [ ] Construction term 30 months: [ ] 20xx – [ ] 20xx, to include detailed engineering,

subject however to schedule accepted by Underwriter and Enhancer selected Contractor.

Timing of underwriting - Conditional [ ] 20xx - Formal [ ] 20xx

GENERAL FINANCING TERMS

Term of take-out financing

10 years from Disbursement in [ ] 20xx.

Repayment Balloon maturities at 5, 7 and 10 years from take-out with respectively 30%, 30% and 40% of face value falling due on each of such anniversaries.

ENVIRONMENTAL SERVICES PROGRAM WWW.ESP.OR.ID XI


GENERAL FINANCING TERMS (continued) Interest rate 14% estimated average, subject to market conditions. - Construction 8% rollup, 6% coupon payable semi-annually. - Operations 14% average on unpaid balances, subject to prevailing market at

Disbursement. Trustee Undesignated, to be selected from approved list of Custodians as

amended from time to time by Bank Indonesia. Terms of conditional underwriting

Take-out conditional upon following being met: Unqualified acceptance of Works by Borrower. Works deemed to have been completed on time, on schedule and according to specifications by independent engineer designated by Underwriter and Enhancer. Days Account Receivables not to exceed [ ] at Disbursement. Days Inventory, not to exceed [ ] at Disbursement. Comfort Letter by Owner and Borrower, as described hereunder. Tariff deemed to be at full cost-recovery, as per formula specified in conditional underwriting. Debt service coverage ratio of at least [1.5]. All other security arrangements in place.

SECURITY ARRANGEMENTS 1. Liquidity standby Borrower and Owner each create liquidity standby reserves with a

value of 20% of the outstanding loan amount at Disbursement. The liquidity standby reserves are to be controlled by the Trustee and held in secure, short-term fixed deposit investments, or other liquid instrument approved by Underwriter.

2. Letter of Comfort, backed by partial credit guarantee

Owner and Borrow issue a Letter of Comfort to the Trustee stating that it commits to maintain: 1. Full cost-recovery tariffs during the term of the Bonds, to include

an outcome at all times for a debt service coverage ratio of at least [1.5], the numerator of which is equal to cash available from operations after all operating expenses including taxes have been met minus debt service; divided by a denominator equal to the debt service.

2. Its liquidity standby reserves of at least 10% of the total borrowed amount from own revenues or national transfers. If the liquidity standby reserve is insufficient to make debt payments and the Owner is unable to meet debt payments, the partial credit guarantee would cover shortfalls up to [ ]% of principal of the total borrowed amount.

3. Water utility accounts receivables (lock-box arrangement)

Pledge to Trustee of cash in designated current account used by water utility customers to pay their monthly bills, to be enforced by Trustee as necessary and from time to time to secure payment for past due amounts.

4. Sinking fund Maintain sinking fund as per underwriting agreement Source: ESP

ENVIRONMENTAL SERVICES PROGRAM WWW.ESP.OR.ID XII

1. INTRODUCTION

1.1. BACKGROUND In 2002, the Government of Indonesia (GOI) committed itself to Millennium Development Goal #7 and pledged to halve, by 2015, the proportion of people without sustainable access to safe drinking water and basic sanitation. To achieve this goal, annual investments in piped water and piped sewerage would need to increase from approximately US$ 50 million to about US$ 500 million over the next ten years. To help the Government improve the delivery and financing of environmental services, USAID is funding a five-year technical assistance program under the leadership of Development Alternatives Inc., called ‘the Environmental Services Program’. ESP works with central government agencies, local governments1, municipal water utilities, private enterprises and other stakeholders to expand access to water and sanitation services. Unlike many other donor-funded programs, ESP provides:

• Integrated technical assistance in water resource management at two levels, namely: (i) at the watershed level, where quantity, quality, flow of water and its distribution amongst users are primary concerns; and (ii) at the water utility level, where bulk water supply, water treatment facilities, systems expansion and improvements in operational efficiency are primary concerns.

• Mobilization of corporate finance for water utilities and alternative finance for watershed management.

1.2. OBJECTIVE AND SCOPE OF WORK

1.2.1. OBJECTIVE. The primary objective of this study is to assess the feasibility of establishing a sustainable funding mechanism to leverage domestic public and private sector financing for investments in the water and sanitation sector. The purpose of this mechanism (hereinafter also referred to as the ‘Indonesia Water Fund’ or IWF) is to improve access to long-term financing to providers of water and sanitation services.

1.2.2. SCOPE OF WORK. To achieve the study objective, the Study Team has identified:

• A structure and organization for an IWF designed to: (1) respond to the needs of water utilities; (2) operate within the ambit of existing laws; and (3) addresses the

1 The term ‘local government’ refers to provinces (propinsi), municipalities (kota) and regencies

(kabupaten). The term ‘district government’ refers to kota and kabupaten only.


overarching policies of government, including its efforts to meet Millennium Development Goals (MDG).

• The services that would be offered by the IWF to augment the capacity of the Indonesian capital markets to improve the sophistication of the fixed income security markets.

• The (potential) competitors of the IWF in the offer of such services. • The pre-conditions that must exist to enable the IWF to achieve its objective,

with particular reference to the domestic capital market regulations.

1.2.3. GENERAL APPROACH OF THE STUDY TEAM. The Study Team has adopted a consultative and participatory approach to identify the best design options so that the resulting framework has evolved from deliberation among key stakeholders, the most important of which are:

• The Ministry of Finance (DG of Treasury and the Institute for Economic and Financial Research and International Cooperation)

• The Capital Market Supervisory Agency (BAPEPAM). • The Ministry of Public Works (DG of Housing and Settlements). • The National Planning Board (BAPPENAS). • The Ministry of Home Affairs (DG Regional Finance). • The Association of Indonesian Water Companies (PERPAMSI). • PT. Danareksa, a state-owned investment house. • International Donors

1.3. STATUS AND CONTENTS OF THIS REPORT

1.3.1. STATUS. This Final Report is a draft, to be reviewed by a USAID steering committee in Jakarta. The comments of the reviewers will be incorporated in the final version of the report, to be submitted in October 2006.

1.3.2. SUMMARY OF CONTENTS. Chapter 2 gives an overview of the water and sanitation sector in Indonesia. Chapter 3 contains demand projections for piped water and sewerage services, based on potential demand derived from GOI policy objectives, and actual demand identified by ESP. Chapter 4 gives an overview of available sources of funding that are currently available to finance the required investments. This chapter sets the stage for Chapter 5, which describes the structure and organization of the proposed IWF. Chapter 6 describes the services to be offered by the IWF in detail, and compares these services to those of competing financing mechanisms. Chapter 7 expresses an opinion on the feasibility of the Indonesia Water Fund. Chapter 8 presents conclusions and recommends actions that need to be taken to further develop the IWF concept.

ENVIRONMENTAL SERVICES PROGRAM WWW.ESP.OR.ID 2


SITUATIONAL ANALYSIS

Chapter 2 Water and Sanitation in

Indonesia

Chapter 3 Demand

Projections

Chapter 4 Financing Piped Water

and Sewerage


Chapter 5 Structure and

Organization of the IWF

Chapter 6 Services of the IWF

Chapter 8 Conclusions and

Recommendations

Chapter 1 Introduction

Chapter 7 Feasibility Analysis of

the IWF

Figure 3. Report Structure.



2. WATER AND SANITATION IN INDONESIA

2.1. SUMMARY At present, the proportion of households with sustainable access to safe drinking water and basic sanitation is substantially lower in Indonesia than in most other South-East Asian countries. In 2003, less than 20 percent of all households had access to piped water and less than two-thirds had access to improved sanitation facilities. To improve access to water and sanitation services, the Government of Indonesia has planned for a substantial increase in the coverage of piped water supply and sewerage systems, the main reasons being:

• Efficiency. Economies of scale allow a water utility to provide piped water at a far lower cost than a jet-pump or a private water vendor.

• Affordability. Piped water is five to ten times cheaper than water from alternative sources.

• Environmental benefits. The provision of piped water supply systems and sewerage networks with appropriate treatment facilities would allow the Government to mitigate the negative impacts of groundwater abstraction and wastewater discharge.

Most existing piped water supply and sewerage systems in Indonesia are managed by municipal water enterprises (PDAMs). It is likely that PDAMs (owned by individual local governments) will continue to play a major role in providing piped water supply services, primarily because local governments (LGs) are unwilling to give up managerial control of PDAMs. In addition, the private sector is reluctant to invest in ‘greenfields’ and in small and medium-sized towns, which are most in need of improved piped water services.

2.2. WATER

2.2.1. CURRENT SERVICE LEVELS. At present, about 50 percent of all households in Indonesia have access to improved sources of water2. Coverage levels are significantly lower than in most other countries in South-East Asia (Figure 4). Most local governments own a drinking water company (PDAM), which provides piped water to domestic and small-scale commercial users. In 2004, PDAMs and privately managed water utilities operated 6.4 million connections, which served approximately 17 percent of the population. Most households continue to rely on alternative sources of water, such as pumps, wells and rivers (Figure 5). In many areas,

2 Improved sources are located more than 10 meter from an excreta disposal site and include pumped water, packaged water, rainwater and water from a protected well or spring



especially in Java, groundwater abstraction has reached unsustainably high levels. Because of a continuing increase in industrial effluents and wastewater discharge, the quality of water resources is rapidly deteriorating.

URBAN RURAL

Malaysia 96% Malaysia 94%

Thailand 95% Thailand 80%

Philippines 90% Philippines 77%

Vietnam 93% Vietnam 67%

Indonesia 61% Indonesia 41%

Cambodia 58% Cambodia 29%

Figure 4. Urban and Rural Coverage of Improved Water Sources in Selected South-East Asian Countries (2002). Percentage of households with access to improved water sources Source: UN Joint Monitoring Program (2004), BPS (2003)

URBAN RURAL

Piped water 33% Piped water 6%

Other, improved 28% Other, improved 35%

Other, not improved

30% Other, not improved

28%

No access 9% No access 31%

Figure 5. Household Access to Water, by Type Of Source (2002). Percentage of households (Indonesia only). Source: BPS (2003)

2.2.2. DESIRED SERVICE LEVELS. In 2004, the Ministry of Public Works issued the National Action Plan on Clean Water, which contains a detailed investment plan to substantially increase access to safe drinking water. In accordance with MDG #7, GOI intends to provide 88 percent of all households with safe drinking water in 2015, up from 75 percent in 2000. The primary means to achieve this objective is to improve access to piped water services from about 21 percent to 62 percent (Figure 6) and reduce dependency on other water sources such as rivers, lakes and wells. This, in turn, requires a major increase in production capacity (through a combination of system optimization and system expansion) and in the number of household connections (Figure 7). ENVIRONMENTAL SERVICES PROGRAM WWW.ESP.OR.ID 5


URBAN RURAL

Projections Projections

34.2% 48.6%

58.8% 69.1%

6.8% 23.0%

38.4%

53.9%

2000 2005 2010 2015 2000 2005 2010 2015

Figure 6. Urban and Rural Coverage of Piped Water Supply, 2000-2015. Percentage of households with access to piped water Sources: BPS (2003); National Action Plan on Clean Water, MPW (2004)

PIPED WATER CONNECTIONS

(millions)

PRODUCTION CAPACITY

(‘000 liter/second)

Projections Projections

2.7 4.8

12.9

19.0

25.4

61 94

181 268

358

1995 2000 2005 2010 2015 1995 2000 2005 2010 2015

*

Figure 7. Piped Water Connections and Production Capacity, 1995-2015. Sources: PERPAMSI (1995), National Action Plan on Clean Water, MPW (2004) *PERPAMSI estimates total piped water connections in 2004 at 6.3 million, which is less than 50 percent of the total assumed for 2005 in the National Action Plan on Clean Water



2.2.3. INSTITUTIONAL ARRANGEMENTS FOR PIPED WATER SERVICES.

According to Law 32/2004 on Regional Autonomy, local governments are responsible for the delivery of clean water. In most local governments, piped water services are delivered by PDAMs. In a few cases, PDAMs operate piped water supply systems in partnership with private enterprises. The central government is encouraging the provision of piped water through public service agencies (Badan Layanan Umum or BLUs) and regional water utilities. PDAMS.

In 2004, 311 of 440 local governments in Indonesia owned a drinking water company (Perusahaan Daerah Air Minum or PDAM). PDAMs provide piped water to domestic and small non-domestic water users, but normally do not serve large-scale industrial users, who mainly depend on groundwater. Many PDAMs barely cover operating expenditures. Over 80% cannot service their loans or finance system rehabilitation. Since 1998, net new investment has been negative. PDAMs make an aggregate annual loss of about IDR100 billion. If assets were valued at replacement value (rather than historical cost), losses would be much higher. Many PDAM in rural areas do not possess the economies of scale required to be technically and financially efficient. The Ministry of Public Works estimates that 28% of PDAMs are in a ‘critical’ condition. PUBLIC-PRIVATE PARTNERSHIPS.

At present, about 15 piped water supply systems are managed by PDAMs in partnership with private enterprises, and another 15 to 20 PDAMs are negotiating proposals with private investors (Annex 1). Virtual all private investment in piped water supply services has taken place in large and metropolitan cities. Full privatization, which involves the sale of assets from the government to a private sector party, is unconstitutional in Indonesia. PUBLIC SERVICE AGENCIES (BADAN LAYANAN UMUM).

In June 2005, GOI issued Implementing Regulation 23/2005, which allows local governments to establish so-called Badan Layanan Umum (BLU). The purpose of such agencies is to provide public services along commercial lines but without a profit motive. (As such, a BLU is comparable to existing local government agencies, such as local hospitals and bus terminal operators.) REGIONAL WATER UTILITIES.

International experience suggests that the minimum size of a water utility is 50,000 to 100,000 customers (ADB, 1997). In 2004, there were 22 PDAMs in Indonesia that met this criterion. Most of the other 289 PDAMs in the country operate fewer than 25,000 connections (Table 3). Their networks usually consist of several smaller systems, many of them not serving more than a few hundred customers. The central government recognizes that regionalization of water utilities may result in significant economies of scale (especially in densely populated areas) and is therefore promoting re-grouping of PDAMs to create larger water utilities. Because most local governments have proven reluctant to give up ownership of their PDAMs, this strategy has thus far not been implemented.



Table 3. Water Utilties in Indonesia by Size Class, 2004.

Connections Size class (# connections)

Number of utilities Total ('000) % Total

> 50,000 22 2,877 45 25,000 - 50,000 30 1,038 16 10,000 – 25,000 103 1,612 25 < 10,000 150 812 13

Total 305 6,440 100

Source: PERPAMSI (excl. 6 PDAMs for which data were not available)

2.3. SANITATION

2.3.1. CURRENT SERVICE LEVELS. Indonesia has one of the lowest rates of off-site sanitation services in the world (Figure 8). At present, less than 2 percent of the population is connected to piped sewerage networks, which served about 200,000 urban households in 2004. About 60 percent of population relies on septic tanks and pit latrines for human waste discharge (Figure 9). Over ten million households are currently not served by some form of on-site sanitation. A large portion of the rural population, as well as most low-income households in urban areas, discharge human waste directly into rivers, lakes and open space. The resulting contamination of surface and groundwater has led to high incidences of faecal-borne diseases and environmental degradation of water sources, especially in densely populated areas. In 1999, the ADB estimated the economic cost of wastewater pollution in Indonesia at almost US$ 4.7billion per year.

URBAN RURAL

Malaysia 100% Malaysia 98%

Thailand 97% Thailand 100%

Philippines 81% Philippines 61%

Vietnam 84% Vietnam 26%

Indonesia 78% Indonesia 52%

Cambodia 53% Cambodia 8%

Figure 8. Urban and Rural Coverage of Sanitary Facilities in Selected South-East Asian Countries (2002). Percentage of households Source: UN Joint Monitoring Program (2004)



URBAN RURAL

Piped sewerage 1% Piped sewerage Nil

Septic tank, pit 77% Septic tank, pit 52%

Other 22% Other 48%

Figure 9. Urban and Rural Coverage of Sanitary Facilities (2002)

Percentage of households Source: BPS (2003)

2.3.2. DESIRED SERVICE LEVELS. In 2004, the Ministry of Public Works (MPW) published a National Action Plan on Sanitation, which contains a proposal for providing 75 percent of the population with improved sanitation facilities by 2015, up from 63 percent in 2002 (Table 4). The primary means to achieve this objective is to increase household coverage of piped sewerage services from about 2 percent in 2003 to almost 20 percent in 2015. The National Medium-Term Development Plan (RPJM) for 2004-2009 also contains quantitative targets concerning an increased in the utilization rates of waste treatment facilities and a reduction in the proportion of wastewater that remains untreated.

Table 4. Service Level Targets for the Sanitation Sector.

Source Service level target Coverage*

Millennium Development Goal

Halve, by 2015, the proportion of people without sustainable access to basic sanitation

75%

National Action Plan on Sanitation

Increase, by 2015, coverage of improved sanitation in urban areas to 80% and coverage in rural areas to 70%

75%

RPJM 2004-2009 No open defecation by 2009 100%

Sources: UNDP, MPW (DG Cipta Karya), BAPPENAS * Percentage of total population with access to improved sanitation

2.3.3. INSTITUTIONAL ARRANGEMENTS FOR PIPED SEWERAGE SERVICES.

According to a revision to PP25/2000, an implementing guideline to the Law on Regional Autonomy, local governments are responsible for the provision of sanitation services, except for piped sewerage services in large and metropolitan cities (which is a central government responsibility). At present, four of seven piped sewerage networks in the country are managed by a PDAM. The system in Jakarta is managed by a separate sewage utility (PD. PAL). Part of the sewerage system in Tangerang is managed by its sanitary engineering department. The system in Yogyakarta is managed by agencies from three different local governments (Table 5).



Table 5. Key Features of Piped Sewerage Networks in Indonesia.

Population served Local Government

Connections ('000) Total ('000) % Total

Sewerage system managed by

Existing

Kota Bandung 90.0 450 20 PDAM

Kota Cirebon 18.8 90 32 PDAM

DKI Jakarta 2.3 220 2.8 Dedicated BUMD*

Kota Medan 7.4 49 2.3 PDAM

Kota / Kab Tangerang

9.8 46 4 PDAM / LG agency

Kota Surakarta 8.0 70 13 PDAM

Kota Yogyakarta 10.1 85 10 Three LG agencies

Planned

Kota Denpasar NA NA NA (to be determined)

Kota Balikpapan 25.0 125 25 PDAM

Sources: Consultant, World Bank (2001) * Badan Usaha Milik Daerah (local government-owned enterprise)



3. DEMAND PROJECTIONS

3.1. SUMMARY There is strong evidence that demand for piped water services in Indonesia is high. In contrast, demand for piped sewerage systems is virtually absent, even though GOI encourages the development of such systems. Indications of potential demand for piped water and sanitation can be derived from GOI planning documents, the most important of which are:

• The National Action Plan on Clean Water (NAP-CW) and the National Action Plan on Sanitation (NAP-S), which were both prepared by the Ministry of Public Works and cover the period 2004-2015.

• The current National Medium-Term Development Plan (Rencana Pembangunan Jangka Menengah or RPJM), which was prepared by BAPPENAS and covers the period 2004-2009.

• ‘Water Supply PPP Investment Opportunities’, which was issued in 2005 by BPP-SPAM, a branch of the Ministry of Public Works. This document contains a list of 22 projects that may be of interest to private investors.

According to the National Action Plan on Clean Water, annual investments in piped water supply need to increase from US$ 50 million to US$ 450, in order to meet the Millennium Development Goal of supplying over 60 percent of all households with piped water by 2015. BPP-SPAM has identified 22 water supply projects that could be financed by the private sector. The estimated cost of these projects is approximately US$ 370 million. (The RPJM does not contain investment cost estimates, but is broadly consistent with NAP-CW and NAP-S.) According to the National Action Plan on Sanitation, annual investments in piped sewerage systems need to increase from virtually zero to about US$ 40 million per year, in order to meet the GOI target of supplying over 18 million households with piped sewerage by 2015 (up from 2 million in 2003). Evidence for actual (as opposed to potential) demand for piped water supply exists in the form of investment plans by 15 large PDAMs that are currently preparing feasibility studies with ESP assistance. The total cost of investment projects under consideration by these PDAMs is estimated at US$ 140 million.



3.2. POTENTIAL DEMAND FOR PIPED WATER SUPPLY

3.2.1. THE NATIONAL ACTION PLAN ON CLEAN WATER REQUIRED INVESTMENTS TO MEET MILLENNIUM DEVELOPMENT GOAL #7.

To halve, by 2015, the proportion of people without sustainable access to safe drinking water, Indonesia needs to invest at least IDR 45 trillion (or IDR 4.5 trillion per year) over the next ten years in piped water supply systems. According to a recent study by the Ministry of Public Works, investments in water infrastructure are currently in the order of IDR 450 billion per year (US$ 45 million), or just ten percent of the amount needed to achieve the stated goal (Table 6). Stated differently, the ‘financing gap’ in the piped water sector is estimated at US$ 400 million per year. COST ESTIMATES.

The NAP-CW estimates the total investment cost of the planned expansions at IDR 41.5 trillion (approximately US$ 4.5 billion). About IDR 2.8 billion, or 7 percent of the total amount, would be allocated in 2004-2005 to investments in system optimization (such as reduction in water losses and improvement of capacity utilization rates). The remaining 93 percent consists of investments in additional production capacity and household connections (Table 7). Because investment in 2004 and 2005 was negligible, the Study Team assumes that the amount of IDR 41.5 billion will need to be spent during 2006-2015. This amounts to an annual investment of IDR 4.15 trillion (or US$ 450 m). For three reasons, the actual cost is likely to be higher than the estimated cost:

• Cost estimates in the National Action Plan for Water Supply do not include price contingencies. This means, effectively, that investments in the NAP-CW are expressed in constant US Dollars.

• GOI has recently issued an implementing guideline (PP16/2005), requiring all water utilities to supply potable water by 2008. At present, few (if any) utilities meet this target. The cost of additional treatment facilities is not included in the NAP-CW.

• The NAP-CW is already outdated (for example, the number of household connections in 2004 was estimated by PERPAMSI at 6.3 million, or less than 50 percent of the number assumed by the plan).



Table 6. MDG#7 Goals vs. Current State of Affairs, Piped Water Supply Only. Indicator Current state

(2000) MDG goals (2015)

% Achieved (MDG#7 =100)

Population served (million) 42.1 152.2 28

Coverage ratio 20.7% 62.0% 33

Production capacity (‘000 m3) 94 358 28

Connections (million) 6.8 25.4 27

Investment (US$ million/year) 50 450 11

Source: National Action Plan on Clean Water, MPW (2004)

Table 7. Cost Estimates for Piped Water Supply Systems, 2004-2015. (IDR trillion)

2004-2005 2006-2010 2011-2015 Total

Optimization 2.8 - - 2.8

Expansion 6.4 15.9 16.4 38.7

Total 9.2 15.9 16.4 41.2

- of which urban 65% 51% 56% 56%

Source: National Action Plan on Clean Water, MPW (2004) FUNDING SOURCES.

The NAP-CW assumes that bilateral and multilateral development banks would finance over 60 percent of the planned investments (Table 8). Local government sources (including revenues from PDAMs) are expected to finance 18 percent of the total requirements. The remaining 22 percent would be funded by commercial loans (urban areas only), central government grants (mostly rural areas) and revolving funds. The targeted amount of commercial bank financing is IDR 4.5 trillion during 2006-2015, or US$ 50 million per year.

Table 8. Assumed Funding Sources for Piped Water Supply Systems, 2004-2015. (IDR trillion)

Funding source Urban Rural Total % Total

Commercial loans 4.5 - 4.5 11%

Soft loans* 13.2 12.2 25.4 61%

Central government grants 0.9 2.7 3.6 9%

Revolving funds 0.3 0.3 0.7 2%

Local governments** 4.4 3.0 7.5 18%

Total 23.3 18.3 41.5 100%

Source: National Action Plan on Clean Water, MPW (2004) * Multilateral and bilateral development banks ** Including revenues from PDAMs and other local-government owned enterprises



3.2.2. WATER SUPPLY PPP INVESTMENT OPPORTUNITIES PPP OPPORTUNITIES.

In 2005, BPP-SPAM identified 22 water supply projects that could be financed by the private sector (Table 9). The total cost of these projects is IDR 3.4 trillion (or US$ 370 million). Most proposed projects would be located in cities with a population of least 500,000, require an investment in the order of US$ 20 million, and require the PPP to manage a water supply system for a period of 20 years (either as a concession or under a BOT arrangement). At the time of writing, none of the 22 projects were awarded to a PPP, although Kab. Tangerang has started negotiations with a consortium of investors.

Table 9. Opportunities for Public-Private Partnerships in the Water Sector

Location PPP Modality* Planned increase in capacity (l/s)

Total investment (IDR b)

Kota Padang BOT 400 100

Kota Jambi BOT 400 150

Kota Pekanbaru Concession 500 300

Kab. Bengkalis Concession 300 200

Kota Dumai Concession 300 200

Kota Bandar Lampung BOT 500 200

DKI Jakarta BOT ** NA

Kab. Tangerang Concession 400 NA

Kota Tangerang Concession 250 NA

Kota Bekasi Concession 250 200

Kab. Bekasi Concession 200 200

Kab. Karawang Concession 200 200

Kab. Purwakarta Concession 200 200

Kota Bandung BOT ** NA

Kab. Bandung Concession 500 300

Kab. Pemalang Concession 100 100

Kota Tegal Management contract 100 75

Kab. Brebes Concession 100 100

Kota Semarang BOT 1,250*** 400

Kota Surakarta BOT 300 30

Kab. Gresik Concession 400 300

Kota Manado BOT 500 100

Total 7,150 3,355

Source: BPP-SPAM (2005) * BOT = Build Operate Transfer ** Transmission only (no new production capacity) *** Includes transmission mains with a capacity of 2,500 l/s



3.3. POTENTIAL DEMAND FOR PIPED SEWERAGE

3.3.1. THE NATIONAL ACTION PLAN ON SANITATION REQUIRED INVESTMENTS TO MEET MILLENNIUM DEVELOPMENT GOAL #7.

The Ministry of Public Works estimates that annual investments in piped sewerage systems need to increase from less than US$ 5 million to about US$ 40 million, in order to reach the objective stated in the National Action Plan on Sanitation of providing over 18 million households with piped sewerage by 2015 (Table 10). COST ESTIMATES.

For piped sewerage, the NAP-S assumes a constant investment cost of US$ 25 per household. Because GOI intends to provide 16 million households with piped sewerage connections, total investments are estimated at (16m x 25 =) US$ 400 million, or US$ 40 million per year. Actual costs may vary considerably by city, due to variations in geographical and hydrological conditions.

Table 10. MDG#7 Goals vs. Current State of Affairs, Piped Sewerage only

Indicator Current state (2000)

MDG goals (2015)

% Achieved (MDG#7 =100)

Population served (million) 2.0 18.3 11

Coverage ratio 1.0% 7.4% 13

Investment (US$ million/year) 5 40 12

Source: National Action Plan on Clean Water, MPW (2004) FUNDING SOURCES.

Unlike the National Action Plan on Clean Water, the NAP-S does not contain a financing strategy. The plan assumes that a local government will cover 100 percent of the full cost of a piped sewerage system, but does not indicate how it would finance the costs (The NAP-S also does not state how the central government would finance piped sewerage systems in large and metropolitan cities.) Studies have indicated that willingness-to-pay for piped sewerage is far lower than for piped water supply, even though the required per capita investment is substantially higher. For this reason, private investors are reluctant to invest in piped sewerage systems, because such systems cannot be operated on a financially feasible basis without government subsidies.



3.4. ACTUAL DEMAND FOR PIPED WATER SUPPLY

ESP.

Since 2005, ESP has assisted eleven PDAMs with the preparation of feasibility studies for the optimization and expansion of piped water supply systems. Eleven of these PDAMs are among the 25 largest water utilities in the country. The total investment cost of the proposed projects is estimated at IDR 1.3 trillion (US$ 140 million). Implementing these projects would add over 260,000 household connections to existing piped water supply systems (Table 11). This amounts to 5 percent of all household connections in the country.

Table 11. Estimated Investment Requirements for PDAMs Working with ESP.

PDAM Investment items* Potential new connections

Total investment (IDR b)**

Kota Bogor System Expansion 6,000 46

Kab. Bogor (East) System Expansion, WTP 13,000 78

Kab. Bogor (Central) System Expansion, WTP 11,000 87

Kota Medan System Expansion, WTP 50,000 58

Kab. Subang Bulk Water Supply 6,000 30

Kab. Subang System Expansion, WTP 9,000 50

Kota Surakarta System Expansion, WTP 27,000 79

Kab. Magelang System Expansion 4,012 35

Kab. Bandung WTP 26,000 206

Kota Bandung WTP 66,000 150

Kota Cirebon System Expansion 28,500 158

Kota Cirebon Bulk Water Supply NA 122

Kota Malang System Expansion 16,800 46

Kota Balikpapan** Various (Municipal Bond) NA 120

Total 263,312 1,265

Source: ESF (2006) * WTP = Water Treatment Plant ** All figures are preliminary and subject to change *** Local government OTHER INDICATIONS OF ACTUAL DEMAND FOR PIPED WATER SUPPLY.

Until the 1997 monetary crisis, central government grants and loans were a major source of long-term financing for PDAM investment programs. To replace these funding sources, which are now in short supply, many PDAMs have attempted to secure alternative sources of long-term financing, especially from multilateral donors and private investors. In recent years, the World Bank and the ADB have prepared investment projects with a total cost of several hundreds of millions of US Dollars. To date, none of these projects has been implemented.



4. FINANCING PIPED WATER AND SANITATION

4.1. SUMMARY To meet the Government’s stated development objectives, annual investments in piped water supply services need to increase by at least US$ 400 million per year over existing funding levels. The required increase an annual investments in piped sewerage is estimated at US$ 35 million. Local governments are responsible for providing piped water supply services. The responsibility for providing piped sewerage is shared by the central government (large and metropolitan cities) and local governments (other cities). EXISTING FINANCING MECHANISMS.

Because of political, social and budgetary constraints, most local governments are unable to finance investments in piped water systems and sewerage networks from tariffs, grants, central government loans or (increases in) own revenues. Although local governments have immediate access to internal revenues and (in some cases) to central government grants to finance such projects, the amounts available from these sources are far lower than those required to significantly improve such systems. Multilateral donors are currently experiencing difficulties in securing efficient channeling procedures through the on-lending facility in the Ministry of Finance. Private investment may grow into a major source of funding, but only for a small number of large and metropolitan cities, and mainly in areas where a proven demand for water already exists. The market for long-term loans from domestic banks is still in its infancy. FUTURE FINANCING MECHANISMS.

Central and local governments have shown limited interest in government-financed revolving funds for municipal investments. Such funds are time-consuming to establish and require substantial government regulation and up-front financial contributions. The market for municipal bonds will not take off until GOI has issued a set of ministerial decrees that are currently under preparation. With the exception of PALIJA (which manages a large water concession in Jakarta), no water utility has issued a corporate bond, primarily because the financing requirements of most PDAMs will not exceed the minimum size for an individual bond offering (IDR 150 billion). The constraints associated to existing and future financing mechanisms were taken into consideration during the design of the IWF, which is discussed in detail in Chapter 5.



4.2. EXISTING FINANCING MECHANISMS

4.2.1. USER CHARGES PIPED WATER SUPPLY.

For political reasons, many PDAMs charge tariffs that are far below full recovery-levels and are barely able to cover their operating expenditures. (This is especially the case for smaller PDAMs. Two-thirds of PDAMs with more than 25,000 household connections reported working ratios of at least 100 percent.) In 2004, over 80 percent of PDAMs were unable to service their outstanding loans or finance the replacement of existing systems (see Annex 2 for an overview of PDAM debts). Some PDAMs are no longer operational. In most cases, substantial tariff increases would be required to allow PDAMs to finance replacement expenditures. Because this process will take many years, tariff revenues cannot be considered as a significant source of funding for expansion of piped water systems in the short and medium term. PIPED SEWERAGE.

Worldwide, few governments impose full cost-recovery tariffs for the usage of sewerage networks, partly in recognition of substantial positive externalities (such as health and environmental benefits). In view of political of social implications, it is not realistic to expect local governments to introduce full cost-recovery tariffs any time soon. At best, local government may be prepared to impose tariffs that cover O&M costs. This means that a local government would need to mobilize additional funding sources to cover the investment cost and, at least initially, part of the cost of operations and maintenance.

4.2.2. LOCAL GOVERNMENT REVENUES Most local governments heavily depend on central government transfers, of which shared tax revenues and the general allocation (Dana Alokasi Umum or DAU) are the most important. In 2003, revenues from local taxes and service charges accounted for less than 10 percent of total receipts. Borrowings and other revenues were negligible. Local governments allocated, on average, about 70 percent of total revenues to finance routine expenditures (such as wages and maintenance). The remainder (estimated at IDR 27 trillion, or US$ 3 billion) was available to finance development expenditures, including new investments in water and sanitation services. Many local governments report significant year-end cash balances. At first sight, it seems that local government may finance a major portion of the required investments in piped water and sewerage systems. For various reasons, this is unlikely to be the case:

• Water and sanitation services compete with other sectors for scarce funds, so that only a portion of the IDR 27 trillion would be available for these services. The cost of piped water supply projects often exceeds 50 percent of funds available for development expenditures (Table 12). Few local parliaments will approve an investment of such a magnitude.

• As long as water and sewerage tariffs remain below cost-recovery levels, local governments would be required to subsidize these services; this provides a disincentive to expand existing systems (and would also lead to an immediate



increase in routine expenditures, thereby automatically reducing funds available for new investment).

• Positive cash balances are partly a result of the uncertainty related to the timing and amount of certain central government transfers (shared revenues and earmarked grants). In addition, many local governments lack the capacity to efficiently prepare and manage investment projects.

Table 12. Investment Requirements vs. Net Public Savings, Selected PDAMs.

Local government NPS* in 2003 (IDR b)

PDAM investment required (IDR b)

PDAM investment as % of NPS

Kota Bogor 142 46 32%

Kab. Bogor 436 165 38%

Kab. Subang 189 80 42%

Kota Surakarta 144 79 55%

Kab. Magelang 109 35 32%

Kab. Bandung 398 206 52%

Kota Bandung 352 150 43%

Kota Cirebon 98 280 286%

Kota Malang 113 46 41%

Sources: MoF (2004), ESF (2006) * NPS = Net Public Savings (non-earmarked revenues minus obligatory expenditures)

4.2.3. CENTRAL GOVERNMENT LOANS AND GRANTS PIPED WATER SUPPLY.

Until the mid-1990s, central government grants were a major source of funding for PDAM investment programs. In addition, the center provided loans to PDAMs through the Rekening Pinjaman Daerah (RPD) in the Ministry of Finance. Since the advent of the monetary crisis in 1997, these sources are no longer widely available, primarily because budget constraints have forced the central government to limit spending on investment programs in all sectors, including the water sector. As long as the Government has not formulated a clear financing policy for the sector, this situation is likely to remain unchanged.

The Central Government cannot close the financing gap on its own

In 2003, MPW spent US$ 20 million on watershed management in East Java and provided US$ 1.5 million in grants to PDAMs in that province. For comparison, the total cost of a pipeline from Umbulan Springs to the Greater Surabaya area is estimated at US$ 180 million.

PIPED SEWERAGE.

Most sewerage systems in Indonesia were either constructed in colonial times or financed from central government grants (many of these grants were, in turn, financed from multilateral loan proceeds). Because the central government has traditionally assigned a low priority to sanitation infrastructure, public investments in sanitation have remained at very



low levels. Although the Ministry of Public Works intends to increase investments in piped sewerage from US$ 5 million in 2005 to US$ 15 million in 2006, it is unlikely that central government grants can be relied upon to close the financing gap. MULTILATERAL BANK LOANS.

Development banks, such as the World Bank and the ADB, have repeatedly expressed their interest in financing a substantial portion of the financing gap through long-term loans. Current regulations allow GOI to borrow for improvements in piped water supply and sewerage systems, and to pass on the loan proceeds as sub-loans to local governments through the Regional Development Account (RDA) in the Ministry of Finance (MoF). Because of regulatory and operational uncertainties and the delay by MoF to produce realistic rescheduling procedures for loans of heavily indebted PDAMs, few sub-loan agreements have been executed since 2000 (Figure 10).

36 38

18

46 59

32

11 4 (nil) (nil) (nil) (nil) (nil)

‘93 ‘94 ‘95 ‘96 ‘97 ‘98 ‘99 ‘00 ‘01 ‘02 ‘03 ‘04 ‘05

Figure 10. PDAM Loans Extended by the Ministry of Finance, 1993-2005. Number of sub-loan agreements in redemption by year Source: Ministry of Finance

4.2.4. PRIVATE SECTOR FINANCING Since 1990, the private sector has invested about US$ 650 million in the piped water supply sector, of which over US$ 450 million in Jakarta. (No private sector investment was recorded in piped sewerage.) Because of legal and regulatory uncertainties and limited access to long-term financing, private investment in the water sector has come to a virtual standstill since 1998 (Figure 11).

2

1

2 2

3

4

1 1

(nil) (nil) (nil)

2

1

‘93 ‘94 ‘95 ‘96 ‘97 ‘98 ‘99 ‘00 ‘01 ‘02 ‘03 ‘04 ‘05

Figure 11. PPP Arrangements, 1993-2005. Number of agreements concluded by year Source: BPP-SPAM (2005)



FOREIGN INVESTMENT.

Foreign private investors are interested in larger BOT-type arrangements (with an initial investment of at least US$ 10 million), preferably in areas with an established demand for water. Some foreign investors do not wish to consider water supply systems with a service area population below 500,000 as this would not allow them to recoup due diligence project preparation costs. Moreover, they are discouraged by high levels of price distortion and the absence of a credible regulatory environment. The risk that local governments will not approve pre-agreed tariff increases is of particular importance, especially because water and sanitation systems are long-term investments without an ‘exit option’. Unlike most of their domestic counterparts, foreign investors have access to offshore commercial bank loans. Foreign capital is expensive, however, mainly because of high country risk (which is partly reflected in high FOREX risks), and past experience suggests that foreign investors require a return on equity in the order of 25%-30% per year. Few projects meet this criterion. DOMESTIC INVESTMENT.

Although the domestic private sector is willing to finance smaller projects than overseas investors, they are also concerned with high project preparation costs and the risk that tariffs will not be increased to contractually agreed levels. Moreover, most domestic private investors do not have access to long-term project finance. In recent years, some local governments have signed multi-year turnkey contracts with domestic contractors to expand piped water supply systems. However, such arrangements cannot be considered as genuine private sector investment, as the local government effectively procures water infrastructure on installment. DOMESTIC COMMERCIAL BANK LOANS.

Commercial banks (private or state-owned) are unable to match long-term loans with long-term deposits, and therefore unwilling to extend loans with maturities beyond 5 to 7 years. They are, in any event, reluctant to lend to PDAMs or local governments without a guarantee. However, according to a recently issued Government Regulation (PP54/2005), a kabupaten or kota is by law not allowed to issue guarantees nor can it offer its revenues or assets as collateral to a bank. In addition, few banks have experience with financing water or sanitation infrastructure. Having access to commercial credit is particularly important for direct investments in PDAMs or indirect investments through public-private partnerships (PPPs). The ability of PDAMs to borrow commercially is also important for the implementation of smaller projects that, in any case, can be implemented more readily and often with less adverse impacts on the tariff structure if debt resources are available.



4.3. FUTURE FINANCING MECHANISMS

REVOLVING FUNDS.

A revolving fund is a financial mechanism that uses its own resources (including reflows from loan repayments) to co-finance infrastructure projects. The National Action Plan on Clean Water assumes that revolving funds would finance IDR 700 billion (or US$ 80 million) of required investments in piped water supply until 2015. At present, such funds do not exist in Indonesia3. In recent years, foreign donors have attempted to introduce two models:

• The state bank model. Under this model, a foreign lender would extend long-term loans, denominated in a foreign currency, to the Ministry of Finance, which would on-lend the proceeds to a state-owned bank. The bank would re-lend in Rupiah to local governments and manage the loan portfolio in return for a fee (and bear the resulting FOREX risks). This model, which is currently being promoted by KfW and the ADB, is attractive to state banks because it provides the banks with access to long-term loans at attractive terms of credit. The state bank models are essentially mechanisms for the disbursement of multilateral loans without (actively) involving DPPP in the management of the loan portfolio. The state banks would, in principle, be able to lend to all local governments in the country to finance investments in a variety of sectors.

• Dedicated revolving funds. Such funds are set up to finance investments in a

specific sector or in a specific local government. Two dedicated funds are currently under preparation (coincidentally both supported by Dutch water utilities): (1) the Botabek Water Revolving Fund; and (2) the Eastern Indonesia Water Fund. Both funds intend to use bilateral donor grants and credit risk guarantees to leverage domestic capital.

Thus far, none of the models has been implemented, possibly because MoF (which is responsible for capital market regulation) is reluctant to license a competitor to the Regional Development Account that is managed under its auspices. The Study Team also learned from discussions with central government officials and PDAMs that establishing a revolving fund is likely to be time-consuming because of substantial regulatory requirements. Moreover, central and local governments are generally unwilling to invest in such a fund. MUNICIPAL BONDS.

The Ministry of Finance is encouraging the development of a municipal bond market and has recently issued new implementing guidelines in response to change in the law of fiscal decentralization (see Annex 3 for details). Because domestic financiers and local governments do not have experience with municipal bonds, and because access to the municipal bond market is likely to be restricted to a small number of financially sound local governments (such as Jakarta and Surabaya), this financing mechanism will remain beyond the reach of most providers of piped water and sewerage systems.

3 Although the Regional Development Account (RDA) in the Ministry of Finance was established as a

financially sustainable fund, it cannot be classified as a genuine revolving fund, as receipts from loan repayments are either left dormant on an account in the central bank or allocated to the state budget for activities unrelated to infrastructure finance.



CORPORATE BONDS.

Capital market regulations allow local government-owned companies to issue a corporate bond. Thus far, no PDAM has attempted to issue a bond, the main reasons being:

• Lack of experience. This argument does not only apply to PDAMs, but also to financiers and underwriters (the recent successful bond issue by PALYJA is likely to be an exception for some time).

• Limited project size. The financing requirements of most PDAMs will not exceed IDR 150 billion, which PT. Danareksa considers the minimum size for an individual bond offering.

• High perceived risk. As long as many PDAMs remain in arrears, financiers will demand a high premium (estimated at 300 basis points) to compensate for default risk.

4.4. CONSTRAINTS TO FINANCING PIPED WATER AND SEWERAGE SYSTEMS

PIPED SEWERAGE.

Because piped sewerage systems are costly and because willingness-to-pay for such systems is low, GOI acknowledges that the full cost of such systems cannot be covered from user charges. This means that the government (in the collective sense) must subsidize the service. The National Action Plan on Sanitation does not indicate how central and local governments would finance the required subsidies. It is clear, however, that few local governments are willing to invest heavily in systems that are widely regarded as a luxury product. In addition, the presence of a significant ‘subsidy gap’ will discourage private investors and commercial banks to finance piped sewerage services. PIPED WATER SUPPLY.

While piped sewerage needs to be subsidized, it is realistic to charge full-cost recovery tariffs for piped water supply services. Indeed, a guideline of the Ministry of Home Affairs (Decree 2/98) states that PDAMs should cover the full cost of their operations from tariff revenues. Because of political constraints, many local governments do not allow PDAMs to charge full-cost recovery tariffs. Approved tariffs usually only cover (a portion of) operations and maintenance costs. PDAMs that offer piped water supply services at tariffs that are substantially lower than the full cost of the service will not be able to attract private investment or commercial bank loans. Alternative sources of funding, such as subsidized loans and local or central government grants, are scarce or no longer available.



Table 13. Summary of Constraints to Financing Water and Sanitation. Funding source Constraint

User charges Absence of political willingness to increase tariffs to full cost-recovery levels. Limited willingness-to-pay (especially for piped sewerage).

Local government revenues

Water and sanitation compete with other sectors for scarce development expenditures.

No financial incentive to provide new services that must be subsidized as long as water and sanitation tariffs remain below cost-recovery levels.

Limited project preparation capacity.

GOI grants Central government budget constraints.

GOI loans Central government budget constraints. Unwillingness of GOI to lend to local governments. Legislative uncertainty. Uncertainties concerning debt and arrears rescheduling.

Private sector investment

High country risk. High legal and regulatory risk. Limited access to domestic commercial bank loans.

Commercial bank financing

Limited experience with the water and sanitation sectors. Inability of local governments to provide collateral. Inability to match long-term loans with long-term deposits.

Revolving funds Significant regulatory requirements (time-consuming). Limited interest from central and local governments to provide up-front

financial contributions.

Municipal bonds Only available to large and metropolitan cities. Regulatory delay (awaiting issuance of MoF Decree).

Corporate bonds No experience. High perceived risk. Minimum bond offering (IDR 150 billion) exceeds financing requirements of

most water utilities.

Source: ESP



5. STRUCTURE AND ORGANIZATION OF THE IWF

5.1. SUMMARY ORGANIZATION.

The Indonesia Water Fund is envisaged as an underwriting and co-financing facility for creditworthy water utilities. It would be managed by PT. Danareksa, a wholly owned subsidiary of the Ministry of Finance. The design of the IWF incorporates credit enhancers and security arrangements that are deemed sufficient by private financiers and allow the Fund to offer credit terms that are acceptable to and affordable by water utilities. The detailed design was prepared in close consultation with PT. Danareksa. OBJECTIVE.

A primary objective of the IWF is to mobilize 12-year project finance for the rehabilitation and expansion of water utility networks at affordable and fixed interest rates in local currency. The establishment of the IWF does not immediately require up-front capitalization from GOI, local governments or water utilities. It also does not require a change to existing laws, although the underwriting of projects with a financing requirement not exceeding IDR 150 billion requires some changes to existing (tax) regulations, which are already reflected in draft revision to the income tax law. This means that it would be possible to establish the IWF at short notice. FINANCING ARRANGEMENTS.

The IWF would facilitate the financing of waterworks in two stages:

1. Construction of waterworks (for periods up to 2.5 years). At the start of this period, a water utility (‘the Borrower’) and a reputable contractor will agree upon a contract for the construction of waterworks (‘the Project’). The contractor will be responsible for: (i) completing the Project on agreed specifications at fixed-price, fixed-schedule terms; and (ii) arranging the financing needed to undertake and complete the Project from its own financiers and under its own responsibility. (PT. Danareksa may choose to co-finance, at its own risk, up to 30% of the construction cost from an international donor loan, channeled to PT. Danareksa by MoF.) PT. Danareksa will be required to provide assurances to the contractor (and its financiers) that a take-out of construction finance is available upon completion of the Project. To provide this level of comfort, PT. Danareksa Sekuritas, acting as financial advisor of the borrower, will issue a conditional underwriting of the permanent financing before construction starts (based on an initial credit review). The conditional under-writing will be replaced by a formal underwriting before Project completion.



2. Operations (for periods up to 10 years). Three months before the expected date of completion of the Project, a full credit rating of the Borrower will be secured and the take-out of construction financing arranged through an underwriting by PT. Danareksa Sekuritas to be made available upon completion of the Project. PT Danareksa Finance will be empowered through formal agreements to make up to 10-year loans to each qualifying water utility, assuming full credit risk.

CREDIT ENHANCEMENTS.

Partial credit guarantees, issued by multilateral or bilateral credit development agencies, would be used to facilitate the mobilization of construction and operations financing. According to PT. Danareksa, such guarantees would be especially important during the construction phase, where risks are normally higher than during the subsequent operations phase. To further improve terms of credit, it is proposed that the IWF would blend domestic private financing with low-cost funds provided by an international donor to finance the purchase of 30% of IWF bond offerings and, optionally, to co-finance 30% of the construction cost of waterworks. SECURITY ARRANGEMENTS.

To provide security to financiers of construction loans, a contractor will be subject to penalties in case of late delivery or not meeting pre-agreed quality standards. Next, a Borrower (usually a PDAM) and its owner (usually a local government) are each required to set up a liquidity standby, each amounting to 10% of the outstanding loan at the time of the take-out of construction financing. If required, the liquidity standbys would be used to: (i) meet debt payment obligations in case of a default by the Borrower; and (ii) replenish a sinking fund that the Borrower is required to establish to meet its financial obligations to the IWF. In addition, owner of the utility is required to issue a letter of comfort that is backed by a partial credit guarantee. As a fourth layer of protection, the Borrower will pledge to create a lock-box arrangement for accounts receivables in the event of a default. Upon completion of the construction of a water supply project, these security arrangements would remain in place, except for contractor penalties. STATUS OF THE PROPOSAL.

To implement the IWF as discussed herein, it is necessary to secure the commitment of the primary partners, the status of which is:

• USAID: has expressed interest in providing partial guarantees and is funding the preparation of feasibility studies for selected PDAMs.

• The Ministry of Finance: has expressed commitment in principle to the proposal and has set up a task force to resolve outstanding issues.

• An International Donor has expressed interest to lend a US$ 50 million equivalent loan to GOI, the proceeds of which would be channeled to PT. Danareksa Finance to co-finance waterworks projects underwritten by the IWF.

• PT. Danareksa: has expressed commitment in principle to the scheme.



5.2. SCOPE OF THE INDONESIA WATER FUND

REVIEW OF THE STUDY OBJECTIVE.

The primary objective of this study is to assess the feasibility of establishing a sustainable funding mechanism to leverage domestic public and private sector financing for investments in the water and sanitation sector. The purpose of the mechanism is to improve access to long-term financing to providers of water and sanitation services. The results of situational analysis (Chapters 2, 3 and 4) impose two limitations to the scope of the IWF:

• Limitations to sectoral scope. To achieve Millennium Development Goal #7, GOI promotes investment in two sub-sectors: piped water supply and piped sewerage. In order to address the overarching policies of the Government, the IWF will aim its services at providers of these services.

• Limitations to scope of services. Because the objective of the IWF is to leverage both public and private sector financing for investments in piped water supply and sewerage systems, services aimed at improving access to long-term sources of public financing are outside the scope of the Indonesia Water Fund.

5.2.1. LIMITATIONS TO THE IWF SCOPE OF SERVICES A TYPOLOGY OF FUNDING SOURCES.

Providers of piped water and sewerage services have access to three types of funding sources:

• Internal sources. These consist mainly of user charges (tariff revenues).

• Public external sources. These consist of central government loans and grants, and contributions of local governments (usually in the form of equity investments, grants or subsidies).

• Private external sources. At present, these consist of private sector investments and domestic commercial bank loans. Municipal bonds and corporate bonds constitute additional sources of private financing, that local governments and PDAMs may be able to access in the near future. (The Study Team does not expect that revolving funds for water and sewerage services will be established any time soon. Such funds are therefore ignored in the remainder of this report.). Mobilizing external sources of private capital is the primary focus of the Indonesia Water Fund.

COMMERCIAL BANK LOANS AND CORPORATE BONDS.

As argued in Chapter 4, providers of piped sewerage services are unable to attract private financing, because of the substantial ‘subsidy gap’ that exists in the sector. The same argument applies to water utilities that sell piped water services at tariffs that are far lower than full cost-recovery tariffs. Because data on full-cost recovery tariffs for piped water supply are scarce and unreliable, this report assumes that a water utility is (in principle) able to access the domestic capital market if it meets two criteria:



1. The utility charges (or will soon charge) a full cost-recovery tariff. A utility meets this condition if total income covers the full cost of operations according to the latest available audited financial report. The full cost of operations is defined as: operating cost + debt service + 10% of equity. A utility that does not meet this condition may be eligible for the IWF if it starts charging full cost-recovery tariffs before signing an underwriting agreement with the IWF.

2. The utility is capable to repay outstanding arrears (if any). This condition is met if arrears on outstanding loans do not exceed IDR 1 million per connection according to the latest available records of the Ministry of Finance. To qualify for the services of the IWF, an eligible water utility would need to mintain a DSCR of at least 1.5 throughout the term of the project financing, and cmply with other general financing terms and security arrangements (as outlined in the term sheet attached to the Executive Summary).

MUNICIPAL BONDS.

MoF has informed the Study Team that local governments are allowed to issue municipal bonds to finance projects that are not full cost-recovery, as long as these projects generate revenues that accrue to the local government budget. This means that local governments may issue bonds to finance piped water and sewerage projects that are not financially feasible. Local governments could, in principle, also finance financially healthy PDAMs from the proceeds of a municipal bond issue. For two reasons, this is not recommended:

• There is some uncertainty about the operational requirements for a municipal bond offering. It is expected that this uncertainty will be resolved when the Minister of Finance issues an implementing decree to a recently issued Government Regulation on local government borrowing (PP54/2005). For a detailed analysis of this regulation, refer to Annex 3.

• PP54/2005 imposes restriction of municipal bonds that do not apply to corporate bonds. For example, the PP rules out the private placement of bonds, which prevents the IWF to act as a bond bank.

PRIVATE INVESTMENT.

Because private investors are themselves in need of access to long-term financing (which is usually supplied in the form of commercial bank loans), private investment can be seen as an ‘indirect’ funding source. As long as the private sector does not have access to long-term financing, private investment in piped water will remain insignificant. For this reason, the IWF considers private investors as consumers of long-term financing, not as suppliers thereof.

5.2.2. SCOPE OF IWF SERVICES – SUMMARY. • Primary focus. Initially, the IWF would seek to provide improved access to

commercial bank loans and corporate bonds to PPPs and PDAMs that meet basic liquidity criteria (Table 14).

• Secondary focus. In a later stage, the IWF would assist local governments and other PDAMs with providing access to the municipal bond market to finance projects that are not full cost-recovery.

The remainder of this report exclusively discusses the primary focus of the IWF.



Table 14. Funding Sources Available to Providers of Piped Water and Sewerage. (black areas indicate the primary focus of the IWF; dark grey areas indicate the secondary focus)

Piped water supply providers

Funding source PPPs PDAMs, no

subsidy gap* PDAMs with subsidy gap

Piped sewerage providers

Internal

User charges √ √ √ √

External, public

Local gov. revenues √ √

GOI grants √ √

GOI loans √ √ √ √

External, private**

Private investment √ √

Commercial banks √ √

Municipal bonds √ √ √

Corporate bonds √ √

Source: ESP * PDAMs that: (i) have arrears of less than IDR 1m per household connection; and (ii) charge a full

cost-recovery tariff ( [Operating Cost + Debt Service + 10% of Equity] > Total Income) ** Excludes revolving funds (which are unlikely to be established in the short term)

5.3. IWF DESIGN CRITERIA

5.3.1. GENERIC DESIGN CRITERIA. • Financial sustainability. To make a long-term impact on the water and

sanitation sector in Indonesia, the IWF must utilize its resources in a financially sustainable manner. This means that interest rates charged by the Fund should fully cover its funding and management costs. It also implies that the IWF should not rely, in the long run, on grants from foreign donors or the central government, and that water utilities that do not meet basic creditworthiness criteria would not be able to participate.

• Participatory planning. Because the IWF seeks to address the concerns of a large number of stakeholders (including GOI, local governments, commercial financiers and private investors), consultation with key stakeholders is essential to ensure long-term commitment to the successful operation of the IWF. The support of the central government is especially important, as GOI remains responsible for the regulation of financial institutions (BAPEPAM) and water utilities (Ministry of Home Affairs), and compliance with national development targets (BAPPENAS) and technical standards for water and sanitation services (MPW).



Table 15. Preferred Credit Terms of PDAMs (Indicative).

Credit term Stated preference Relative importance

Annual interest rate Below 15% p.a. High

Type of interest rate Fixed High

Loan term At least 10 years High

Grace period Construction period Medium

Grace on interest During construction period Medium

Type of loan Consistent with cashflow projections Medium

Loan processing time First disbursement during current financial year High

Basis for assessing creditworthiness

Based on project cashflows, not on local government revenues

High

Minimum equity required Zero Medium

Other terms No risk of takeover by private investor High

Source: ESP

5.3.2. DESIGN CRITERIA ARISING FROM THE SPECIFIC NEEDS OF BORROWERS.

• Acceptability to service providers. Markets surveys indicate that PDAMs

(and their owners) are unwilling to accept arrangements that risk the transfer of managerial autonomy to a private sector party (Table 15). They are furthermore unlikely to accept variable interest rates or loan agreements that are secured by local government revenues (and therefore automatically subject to the DAU intercept mechanism).

• Affordability. The IWF must offer credit terms that prospective borrowers can

afford. PDAMs assisted by ESP accept interest rates up to 15 percent p.a. and loan terms of at least 10 years. Perhaps surprisingly, few PDAMs have attempted to negotiate these credit terms. This may reflect the difficulty of obtaining long-term financing in general.

DESIGN CRITERIA ARISING FROM THE SPECIFIC NEEDS OF LENDERS.

At present, commercial financiers feel that the expected return of investing in piped water systems is not commensurate with risk. The design of an IWF would therefore need to include:

• Professional management. Poor management of many government agencies suggests that private financiers may be reluctant to channel funds through a fund that is managed by a public entity.

• Availability of credit enhancers. Multilateral guarantees and credible security

arrangements (such as reserve funds or pre-agreed revenue intercepts) are examples of means that reduce risks to private financiers.



Table 16. Implications of IWF Design Criteria.

Criterion Implication Approach taken

General

Financial sustainability No long-term reliance on grants, funding and management costs fully covered by interest rates

ESP currently provides support to PT. Danareksa; cost of support to be included in interest rates thereafter

Participatory planning GOI approval necessary Intensive consultation with key stakeholders

Specific to borrowers

Acceptability (PDAMs) No risk of takeover by private investors, short processing times of project proposals, no reliance on local government borrowing capacity, fixed interest rates

Structuring of financing arrangements to meet PDAM requirements

Affordability Maximum interest rate 15% per year, minimum loan term 10 years

Financial engineering, use of low-cost donor funds to lower average interest rate

Specific to lenders

Professional management

IWF not managed by GOI Management by professional investment house

Availability of credit enhancers

Need for guarantees and other security arrangements

Multilateral guarantee available to financiers, strict security arrangements

Source: ESP IMPLICATIONS OF IWF DESIGN CRITERIA.

Based on the design criteria (Table 16), the Study Team recommends that the IWF be established as a fund managed by PT. Danareksa, the largest investment house in Indonesia and a wholly owned subsidiary of MoF. The design of the IWF incorporates credit enhancers and security arrangements that are deemed sufficient by private financiers and allow the Fund to offer credit terms that are acceptable to and affordable by water utilities. The detailed design was prepared in close consultation with PT. Danareksa.



5.4. STRUCTURE OF THE INDONESIA WATER FUND

ORGANIZATION.

The Indonesia Water Fund is envisaged as an underwriting and co-financing facility, managed by PT. Danareksa Sekuritas, a wholly owned subsidiary of PT. Danareksa. A primary objective of the IWF is to mobilize 12-year project finance for the rehabilitation and expansion of water utility networks at affordable and fixed interest rates in local currency. The establishment of the IWF does not immediately require up-front capitalization from GOI, local governments or water utilities. It also does not require a change to existing laws, although the underwriting of projects with a financing requirement not exceeding IDR 150 billion4 requires some changes to existing (tax) regulations, which are already reflected in draft revision to the income tax law. This means that it would be possible to establish the IWF at short notice. SUMMARY OF FINANCING ARRANGEMENTS.

The Indonesia Water Fund finances water utilities in two stages:

1. Construction of waterworks (for periods up to 2.5 years). At the start of this period, a water utility (‘the Borrower’) and a reputable contractor will agree upon a contract for the construction of waterworks (‘the Project’). The contractor will be responsible for: (i) completing the Project on agreed specifications at fixed-price, fixed-schedule terms; and (ii) arranging the financing needed to undertake and complete the Project from its own financiers and under its own responsibility. (PT. Danareksa may choose to co-finance, at its own risk, up to 30% of the construction cost from the proceeds of an international donor loan, channeled to PT. Danareksa by MoF.) PT. Danareksa will be required to provide assurances to the contractor (and its financiers) that a take-out of construction finance is available once the Project is completed. To provide this level of comfort, PT. Danareksa Sekuritas, acting as financial advisor of the borrower, will issue a conditional underwriting of the permanent financing before construction starts (based on an initial credit review). The conditional underwriting will be replaced by a formal underwriting before Project completion.

2. Operations (for periods up to 10 years). Three months before the

expected date of completion of the Project, a full credit rating of the Borrower will be secured and the take-out of construction financing arranged through an underwriting by PT. Danareksa Sekuritas to be made available upon completion of the Project. PT Danareksa Finance will be empowered through formal agreements to make up to 10-year loans to each qualifying water utility, assuming full credit risk.

4 PT. Danareksa has indicated that, depending on market conditions, it may consider underwriting a

straight bond for water utilities with a financing requirement of less than IDR 150 billion. It is also willing to underwrite bond financing for the repayment of arrears of municipal water enterprises (PDAMs) on outstanding loans, with a maximum of IDR 10 billion per PDAM.



Table 17. Parties Involved in the Indonesia Water Fund.

Partners Role in the IWF

PRIMARY PARTNERS (essential parties to the IWF)

Ministry of Finance (MoF) Executing Agency of the IWF; signs loan agreements with International Donor and PT. Danareksa Finance (Donor loan proceeds employed to co-finance IWF projects).

PT. Danareksa Sekuritas Investment house; provides financial advisory and underwriting services to water utilities.

PT. Danareksa Finance* Co-finances construction loans from MoF loan

Multilateral and bilateral credit agencies

Issues guarantee to domestic private investors extending 35% - 50% cover on exposure taken on operations finance.

Project Originator (USAID / ESP) Identifies and analyses prospective projects

International Donor* Extends a soft loan to GOI (US$ 50 million equivalent), which is on-lent by MoF to PT. Danareksa Finance for the purpose of co-financing IWF projects.

SECONDARY PARTNERS (other relevant parties)

Water utilities Owners of construction waterworks; issue Bonds.

Local governments (owners of water utilities)

Form part of the security arrangements (including the issuance of a Letter of Comfort).

Construction contractors Construct waterworks; arrange financing during construction period.

Domestic private banks Finance construction of waterworks.

CIC-Operations* Collective Investment Contract; purchaser of CLO bond, the proceeds of which are used to pay off the construction financiers.

Trustee Acts on behalf of bondholders.

Credit rating agency Rates Bond issue.

Institutional investors Invest in Bonds issued by the Borrower.

Source: ESP * Essential partner for pooled bonds only ** Applies to pooled bonds only Rationale for the proposed structure.

1. Construction (for periods up to 2.5 years). The risks associated with an infrastructure project are substantially higher during construction than during the operations phase, and therefore require different risk mitigation measures.

2. Operations (for periods up to 10 years). PT. Danareksa believes that the

Indonesian bond market is able and willing to purchase securitization instruments with a maturity of ten years and in some cases, longer.



The role of multilateral and bilateral credit agencies.

1. Provide partial credit guarantees. It is proposed that multilateral and bilateral credit agencies provide guarantees to facilitate the mobilization of construction and operations financing by covering up to 35% - 50% of the exposure of the bondholders. To assist the contractor in organizing construction finance, it will be especially important for such agencies to signal the conditional availability of partial credit guarantees prior to the start of construction, at the time the contractor is selected by competitive tender and assumes responsibility for mobilizing its own construction finance. The conditional availability of the guarantees would trigger a conditional underwriting by PT. Danareksa Sekuritas.

2. Co-finance bond issues and (optionally) co-finance construction. The

Ministry of Finance is considering borrowing the equivalent of US$ 50 million from an international donor to support the IWF, with the proceeds of the loan channeled to PT. Danareksa to finance the purchase of 30% of IWF bond offerings and, optionally, to co-finance 30% of the construction cost of waterworks.

PROPOSED CHANNELING ARRANGEMENTS FOR A CONCESSIONAL LOAN BY AN INTERNATIONAL DONOR.

The proceeds of a concessional soft loan would be channeled to PT. Danareksa as follows (Exhibit 5.5):

1. On behalf of the Government of Indonesia, the Ministry of Finance (MoF) signs a loan agreement with an international donor. The donor disburses funds to the MoF.

2. The MoF signs a sub-loan agreement with PT. Danareksa Finance, and on-lends

funds from the soft loan in Rupiah. This means that all FOREX risks will be borne by the MoF. PT. Danareksa Finance pays the MoF a surcharge on the interest to cover FOREX risk management costs.

3. PT. Danareksa Finance utilizes sub-loan proceeds to co-finance 30% of IWF

Bonds (and, optionally, 30% of the construction cost of IWF projects), assuming full credit risk of each sub-loan.


IWF

Indonesian investors

InternationalDonor

2

3

1 Ministry of Finance

Source: ESP

Figure 12. Channeling Arrangements for a Concessional Loan.



5.5. FINANCING ARRANGEMENTS

5.5.1. PHASE 1: CONSTRUCTION. During this phase, key parties to the proposed financing transactions are USAID / ESP, PT. Danareksa Sekuritas, PT. Danareksa Finance, Indonesian private banks and other private financiers, construction contractors, credit rating agencies and water utilities. The following steps would be taken: Step 1. The Originator prepares a feasibility study for a project that may be financeable

through a bond offering.

Step 2. The Originator delivers the feasibility study to PT. Danareksa Sekuritas (‘the Underwriter’), if the Originator’s evaluation is positive.

Step 3. If the Underwriter agrees, it enters into a formal mandate to mobilize operations finance on behalf of the water utility on terms to be agreed.

Step 4. The water utility (‘the Borrower’) selects a reputable construction contractor (‘the Contractor’) through a transparent tendering process, in accordance with prevailing regulations, to construct a water utility network. The Contractor must be acceptable to the Underwriter and the agencies that issue a partial credit guarantee (‘the Guarantor’).

Step 5. A credit rating agency is selected to provide a preliminary review of the proposed Borrower’s potential credit rating in the context of its financial track record, the institutional arrangements in which it operates and the robustness of contractual undertakings (including the role of the various parties to construction, construction finance and operations) which form part of the proposed financing.

Step 6. Based on its independent credit appraisal as well as discussions with the credit rating agency, the credit agencies issue a certificate signaling its intent to provide a bondholder guarantee for 35% - 50% of the operations financing to take effect once the project works are successfully completed (on conditions to be negotiated between the Borrower, Contractor, the Underwriter and the Guarantor). Based on this guarantee, the Underwriter issues a certificate identifying similar terms and conditions under which it will provide a bond underwriting at the time the project works are completed.

Step 7. The Contractor and Borrower enter into a fixed-price, fixed-schedule construction contract pursuant to which the former mobilizes finance for the proposed Project.

Step 8. Assuming that the Project is implemented on schedule and according to contractually agreed specifications, a rating agency issues a formal credit rating of the Borrower.

Step 9. The Guarantor issues its partial guarantee(s) and the Underwriter its formal underwriting. Based on these, the Contractor’s financiers enter into an agreement with the Contractor to finance construction milestones (for details on the above steps, refer to the sample term sheet attached to the Executive Summary).



project analysis

partial guarantee (conditional)

underwriting (conditional)

take-out arrangements (conditional)

project identification

Originator (USAID/ESP)

contractor selection/ award of contract

construction conform international best practices

2

1

3

9

Guarantor

3

mandate

4 7



IWF (operations finance underwritten by PT. Danareksa Sekuritas)

Contractor

6


Figure 13. Overview of Financing Arrangements During Construction.

Source: ESP * Note: Step 6 (credit appraisal) and Step 8 (credit rating) not shown in exhibit.

5.5.2. PHASE 2: OPERATIONS (THE BOND ISSUE). The steps identified above for a straight bond offering would also apply to a pooled bond offering, although the placement of the bond would be organized differently. As mentioned earlier, PT. Danareksa considers IDR 150 billion as the minimum size for a bond offering. If the financing requirements of a water utility do not exceed this threshold, the take-out of the construction financing will be organized as follows (Figure 14):

1. PT. Danareksa establishes a Collective Investment Contract - Operations Vehicle (hereinafter also referred to as ‘CIC-Operations’). This is the formal name given to SPVs used in Indonesia for selling or purchasing securitization instruments.

2. Upon commissioning of the first of a series of ‘smaller’ waterworks projects (i.e. projects with a financing requirement below IDR 150 billion), CIC-Operations issues, in its own name, a Bond which will be the source of funding with which to take out the construction financing.

3. CIC-Operations then uses the Bond proceeds to extend a loan to the first of the ‘small‘ Borrowers against medium-term notes (MTNs) executed by the Borrower, with terms and conditions matching those of the Bond. CIC-Operations pledges the MTNs, along with other security, to the trustee designated to act on behalf of the Bondholders.

4. Using the same process, whenever a ‘small’ project is completed, bondholders are required to purchase the corresponding part of the issue to take out the construction financing of that particular project.



MoF

1

MTNs repayment

3Indonesian investors

CIC-Operations

2 Guarantor



Indonesia Water Fund

optional repayment of arrears (up to IDR 10 billion)

partial guarantee

Source: ESP

Figure 14. Financing Arrangements During Operations.

5.6. SECURITY ARRANGEMENTS OVERVIEW.

To provide security to financiers of construction loans, a contractor will be subject to strict fixed-price fixed-schedule performance standard and penalties for sub-standard performance. In addition, a Borrower (usually a PDAM) and its owner (usually a local government) are each required to set up a liquidity standby, amounting to 10% of the outstanding loan at the time of the take-out of construction financing. Moreover, the owner is required to issue a letter of comfort that is backed by a partial credit guarantee. As a fourth layer of protection, the Borrower will pledge to create a lock-box arrangement for accounts receivables in the event of a default. Upon completion of the construction of a water supply project, these security arrangements would remain in place, except for contractor penalties. Finally, a sinking fund requirement, monitored by the trustee, will imposed on the Borrower during the operations phase to ensure that the Borrower is sufficiently liquid to meet balloon payments at the end of the fifth, seventh and tenth year after commissioning of its project (for details, refer to the sample term sheet attached to the Executive Summary).

5.6.1. PHASE 1: CONSTRUCTION CONTRACTOR PENALTIES.

Upon signing a financing agreement, a Borrower is required to contract a reputable company, which is acceptable to the financiers, to construct a water utility network (lenders will be given the right to approve contractors short-listed by the Borrower). Contractors must have a demonstrated track record in constructing water supply systems at internationally acceptable standards on a fixed-price, fixed-schedule basis and participate in a competitive tender for the right to build works strictly on fixed-price, fixed schedule contracts. Finally, contractors must be financially capable to pay penalties for sub-standard performance. These penalties will amount to at least 15% of the contract value.



5.6.2. PHASE 2: OPERATIONS Upon completion of the construction of a water supply project, contractor penalties would be replaced by the following set of security arrangements (Exhibit 5.8): 1 – LIQUIDITY STANDBY.

A financing agreement with IWF requires the water utility to create a liquidity guarantee with a value of 10 percent of the outstanding loan amount before the take out of the construction financing is effected. The same requirement applies to the owner of the utility (usually a local government). PT. Danareksa has indicated that it is willing to finance the liquidity guarantee of the utility and its owner (effectively providing up to 120% of project financing). The liquidity standbys would be controlled by a trustee and held in secure, short-term fixed deposit investments or other liquid instrument.

2 – LETTER OF COMFORT BACKED BY A PARTIAL CREDIT GUARANTEE.

As part of a financing agreement between the IWF and a Borrower, the owner of the water utility is required to issue a Letter of Comfort. This letter would state that the owner:

• Pledges to approve full cost-recovery tariffs including a debt service coverage ratio of at least 1.5.

• Has a moral obligation to maintain its liquidity guarantee at at least 10% of the total borrowed amount from local revenues or national transfers (if the owner is not a local government, other arrangements would apply).

If the liquidity standby is insufficient to make debt payments and the local government is unable to meet debt payments, the partial credit guarantee would cover shortfalls up to the guarantee ceiling of up to 35% – 50% of principal of the total borrowed amount, depending on the credit agency. (The Study Team has studied the option of intercepting central government transfers, but concluded that prospective lenders would not consider this as a credible credit enhancement mechanism.) Resistance to the DAU revenue intercept

Law 33/2004, as well as its predecessor Law 25/1999, states that the central government will deduct any arrears on local governments from central government transfers ‘...in the event the Regional Government fails to repay the Regional Loan to the Government’. Even though over 80 percent of local governments have been in arrears since the laws were issued, the central government has never used the intercept mechanism, nor has it issued the implementing guidelines required to operationalize the mechanism.

3 – WATER UTILITY ACCOUNTS RECEIVABLES.

In the event that the trustee is required to submit a claim to the issuer of the partial credit guarantee, it will be able to access the Borrower’s accounts receivables as a lock-box arrangement5. This arrangement would remain in place until:

• All outstanding arrears to construction financiers or (during the operations phase) bondholders have been paid.

5 The Study Team has verified with the legal department of PT. Danareksa that this type of

arrangement is legal and enforceable in Indonesia.



• The multilateral or bilateral credit development agency has been compensated in full for any claim payments made under its partial credit guarantee periodically throughout the year.

4 – SINKING FUND REQUIREMENT.

It is envisaged that the straight bond (or the MTNs issued against a CLO bond) will mature at 5, 7 and 10 years from take-out with, say, 30%, 30% and 40% of face value falling due on each of such anniversaries. The precise structure of the maturities would vary by project. To ensure that the Borrower is sufficiently liquid to meet its repayment requirements, the Borrower will be required to establish a sinking fund and replenish this fund periodically in accordance with a schedule agreed in the formal underwriting agreement.


CIC- Operations

Trustee Owner 3

1

2

water utility acc. receivable

liquidity standby (>10%)**

letter of comfort (partial credit guarantee)

Figure 15. Security Arrangements During Operations*.

Source: ESP * Contractor penalties apply during the construction phase ** Also used to fulfill sinking fund requirements



6. SERVICES OF THE IWF

6.1. SUMMARY

6.1.1. POTENTIAL COMPETITORS OF THE INDONESIA WATER FUND.

The IWF offers 12-year project financing to water utilities that charge full cost-recovery tariffs (or tariffs approaching full cost-recovery levels), with arrears on outstanding loans not exceeding IDR 1 million per household connection. In theory, commercial banks and the Ministry of Finance offer comparable services, but these services are currently not operational or not tailored to PDAM requirements. Few PDAMs are able to afford loans offered by commercial banks, whereas lending by Ministry of Finance (even through local governments) is moribund. Even if the Ministry of Finance would re-open its on-lending window to PDAMs, it is unlikely that many PDAMs (or their owners) would like to utilize this facility, primarily because of extremely long loan processing times, variable (as opposed to fixed) interest rates, and the requirement that a local government must borrow on behalf of its PDAM6. This means that competition for the proposed IWF services is, at present, negligible

6.1.2. OVERVIEW OF IWF SERVICES. The services of the IWF would be delivered by subsidiaries of PT. Danareksa, except for marketing and project preparation, which are currently provided by ESP at no cost. PT. Danareksa Sekuritas would underwrite a financing facility to the Borrower that consists of a ‘straight’ or collateralized loan obligation (CLO) bond to be issued in the domestic bond market. In addition, PT. Danareksa Finance would co-finance 30% of the Borrower’s financing requirements during the operations phase (and, optionally, during construction).

6.2. ANALYSIS OF COMPETING SERVICES

6.2.1. COMPARISON OF CREDIT TERMS. The IWF would offer 12-year project financing to privately managed water utilities and PDAMs that meet basic creditworthiness criteria. To qualify for IWF funding, a proposed project must be financially feasible. Commercial banks and the Ministry of Finance offer comparable services. The RDA offers loans with a variable interest rate (currently 10% p.a.)

6 Since 2001, MoF no longer allows a PDAM to borrow against project cashflows or against its own

borrowing capacity.



with maturities of up to twenty years. Commercial bank loans are more expensive and normally not available for periods longer than 5 to 7 years (Table 18). Table 18. Credit Terms of the IWF VIS-À-VIS Competing Loan Products.

Credit term Ministry of Finance (RDA) Commercial banks IWF*

Annual interest rate

Variable, 10%-11% Variable, 16%-18% Fixed, below 15%

Maximum term 20 years 5-7 years 12 years

Maximum grace period

5 years 1 year Construction period

Grace on interest allowed?

Sometimes 1 year Partly (borrower to pay a reduced rate during construction)

Type of loan Level principal Level principal Negotiable

Loan processing time

12-18 months Up to 3 months Up to 6 months

Basis for assessing creditworthiness

Local government revenues Local government revenues

Project cashflows, availability of liquidity standby

Minimum cash contribution required

Usually 20%-30% (equal to the cost of items not eligible for multilateral bank financing)

(no data) 0%

Eligible project cost

Usually 70%-80% Negotiable 100% of investment cost and up to IDR 10 billion to refinance arrears on MoF loans

Eligibility criteria Project is full cost-recovery, LG participates in donor-funded program, LG creditworthy, no PDAM/LG arrears

(no data) DSCR > 1.5, full cost-recovery tariffs charged, no PDAM arrears in excess of IDR 1m per connection

Source: ESP * Indicative and subject to verification

6.2.2. THE ABSENCE OF GENUINE COMPETITION. At present, competition for IWF services is negligible. Few PDAMs are able to afford loans that are offered by commercial banks (Figure 16), whereas the Ministry of Finance has not signed a sub-loan agreement with a PDAM (or its owner) since 2000. Even if the Ministry of Finance would re-open its on-lending window to PDAMs, it is unlikely that many PDAMs would like to utilize this facility, primarily because of unusually long processing times, variable interest rates and the and the requirement that a local government must borrow on behalf of its PDAM. In general, PDAMs favor:

• Short loan processing times. PDAMs seek project financing that can be disbursement during the current financial year. The preparation of a RDA-financed loan requires many months, and preparation periods of three years have not been uncommon.



• Fixed interest rates. PDAMs and local governments strongly favor fixed interest rates. Since 2003, MoF offers variable interest rates only.

• The basis for assessing creditworthiness. PDAMs prefer to borrow against project cashflows rather than local government revenues, as required by MoF. (Indeed, since 2001 MoF no longer lends directly to PDAM, but insists that local governments borrow on behalf of PDAMs.) Local governments strongly oppose the DAU intercept mechanism that the Ministry of Finance may apply in the event of default.

16-18% 13-15%

Interest rate (% p.a.)

IWF Current market

conditions

5-7 yrs 12 yrs

Loan term

IWF Current market

conditions

Source: ESP

Figure 16. Project Finance Loan Terms Compared – IWF vs. Commercial Banks. (IWF terms indicative and subject to verification)

6.3. A DETAILED OVERVIEW OF THE IWF’S SERVICES

6.3.1. IWF SERVICES BY PHASE. From the point of view of a water utility, the Indonesia Water Fund offers a straightforward product: a 12-year loan at a fixed Rupiah interest rate with a pre-agreed repayment schedule. To be able to deliver this product, the IWF provides a series of services that may not be apparent to the utility. These services are:

• Project preparation, which consists of the preparation of project feasibility analysis and the marketing of the IWF.

• Phase 1: Arranging of construction financing. During this phase, PT. Danareksa Finance may invest its own funds (channeled from an international donor through the MoF) to finance 30% of the construction cost, should the contractor wish to utilize this facility.

• Phase 2: Arranging of operations financing. Once the IWF portfolio accumulates exposure to commissioned projects of IDR 150 billion or more, PT. Danareksa will set up a second special purpose vehicle (‘CIC-Operations’) to issue a collateralized loan obligation (CLO) bond.

The remainder of this chapter describes the services delivered by the IWF during the two phases. (Project preparation is not described.)



6.3.2. ARRANGING OF CONSTRUCTION FINANCING ISSUE A CONDITIONAL UNDERWRITING FOR IWF BOND OFFERINGS.

Co-finance construction cost (optional). On behalf of the Government of Indonesia, the Ministry of Finance (MoF) is considering a soft loan agreement with an international donor. The MoF would then sign a sub-loan agreement with PT. Danareksa Finance, and on-lend the proceeds of the soft loan in Rupiah (in a single disbursement upon signing of the agreement). PT. Danareksa Finance would utilize the sub-loan proceeds to co-finance 30% of the ‘straight’ and collateralized loan obligation (CLO) bonds (and, optionally, 30% of the construction financing). It is proposed to structure the loan as a 10-year annuity with a 2-year grace period on principal and interest.

Funding cost of PT. Danareksa Finance

The Study Team has assumed that the conditions of the sub-loan agreement would be identical to the conditions of the loan agreement between GOI and the international donor, with the exception of the interest rate. Because MoF will assume the FOREX risk for PT. Danareksa Finance, the latter will need to compensate MoF for hedging costs. Because GOI normally channels foreign loans to state-owned enterprises (such as PT. Danareksa) are in foreign exchange, there is no regulation that stipulates a ‘swap premium’ for BUMNs. For this reason, the Study Team has assumed that the premium stipulated in PMK 83/2005 applies. According to this decree, a surcharge of 5.03% is added to the interest rate on foreign-funded loans that are channeled as Rupiah-denominated sub-loans to local governments. PT. Danareksa has indicated that it intends to add a premium of at least 500 basis points to cover credit risks (which are not assumed by MoF). Assuming an interest rate of 0.75% p.a. from the donor, the total cost of funding of PT. Danareksa Finance is therefore (0.75 + 5.03 + 5.00 =) 10.78% p.a.

Arrange a partial credit guarantee. The Development Credit Authority (DCA) of the U.S. Treasury has expressed its commitment to offer a guarantee to encourage the mobilization of private capital for at least one project (expansion of a water utility network proposed by PDAM Kabupaten Bogor). The guarantee would cover at least 35% of all losses to domestic private financiers of the IWF throughout the 12-year financing term, and form part of a wider set of security arrangements (which are described in detail in Chapter 5). PT. Danareksa Sekuritas would arrange a partial credit guarantee whenever it concludes a financial arrangement with an individual borrower and make the guarantee available to domestic private financiers of IWF Bond offerings. The partial credit guarantee would not apply to the construction financiers.

Guarantees as a means to reduce risk

Risk is a particular problem for water infrastructure projects, which are long-term investments without an ‘exit option’. To be able to attract ‘limited recourse’ or ‘non-recourse’ financing, a financier would need a high level of confidence in the public party. A guarantee or equity participation of a multilateral agency, whether provided to the IWF itself or to an individual financier, is a powerful instrument to reduce project risk and thereby attract sufficient project financing at a reasonable cost of capital. At present, multilateral bank (such the IFC or the ADB) as well as several bilateral donors (notably the US-sponsored Development Credit Agreement or DCA) offer such guarantees. However, such guarantees only protect a financier against credit risk and not against interest rate risk (which is significant, given the long payback period of a typical water supply project and the inability of domestic banks to raise long-term sources of capital).



6.3.3. ARRANGING OPERATIONS FINANCING ISSUE A PERMANENT UNDERWRITING FOR IWF BOND OFFERINGS.

PT. Danareksa has provided the Study Team with a detailed overview of services that it provides for the issuance of a Bond (see Annex 4). An up-front underwriting fee of 2.5% applies. Other up-front fees account for 0.23% of the total offering. In addition, PT. Danareksa would charge annual fees amount 0.02% of the bond value (to cover registration fees and annual reviews by Pefindo, a rating agency). CO-FINANCE IWF BOND OFFERINGS.

PT. Danareksa would utilize the proceeds of the MoF sub-loan to co-finance 30% of IWF bonds. It is expected that the guaranteed sale of a significant portion of the issue, implicitly backed by GOI, would assist in obtaining a higher rating than would otherwise be given by a credit rating agency. HIRE A TRUSTEE BANK.

The main task of the trustee is the monitoring and (if required) execution of security arrangements. The annual cost of a trustee bank is estimated at 0.03% of the total value of the assets under its management.



7. FEASIBILITY ANALYSIS OF THE IWF

7.1. SUMMARY

7.1.1. CONCLUSIONS. A detailed analysis of the costs of the various services provided by the IWF shows that the Fund would be able to offer 12-year project loans to water utilities at an interest rate of approximately 14.6% p.a., provided that the Ministry of Finance exempts CIC vehicles from withholding tax (WHT) on interest earned from CLO Bonds vehicles. If this condition is met, the IWF is deemed feasible as long as PT. Danareksa co-finances at least 20% of the financing requirements during the construction and operations phase. If MoF continues to double tax CIC vehicles, as is presently the case, it would not be feasible for the IWF to take out the construction financing of waterworks through a CLO Bond issue. This is highly relevant, as the financing requirements of most utilities are unlikely to exceed IDR 150 billion, which is considered the minimum size for a straight bond.

7.1.2. THE NEED FOR A WAIVER ON WITHHOLDING TAX. Revenues from CIC issues are currently subject to withholding tax (WHT) on interest earned and interest paid. MoF has been approached to eliminate the double taxation related thereto of CIC. The justifications being used are as follows:

• WHT on interest levied on pooled bonds should be waived as they represent ‘double’ taxation. (CIC vehicles are ‘pass through’ vehicles and should not be taxed at both ends). At present, banks, pension funds and mutual funds are not similarly double taxed.




7.2. METHODOLOGY FOR ASSESSING THE FEASIBILITY OF THE IWF

7.2.1. IWF DESIGN CRITERIA. As explained in Chapter 5, the design of the IWF is based on three sets of criteria:

• General design criteria. The IWF should be financially sustainable and enjoy the support of the Government.

• Borrower-specific criteria. The IWF should offer services that are both acceptable and affordable by eligible water utilities.

• Lender-specific criteria. The IWF should be professionally managed and offer credit enhancements to mitigate risks to bondholders.

The Study Team has assumed that the IWF is feasible if all these requirements are met (Table 19).

Table 19. Compliance of IWF Design Criteria with Feasibility Requirements

Criterion Implication Compliance with feasibility requirement?

General

Financial sustainability No long-term reliance on grants, funding and management costs fully covered by interest rates

Temporarily; ESP provides currently support to PT. Danareksa at no cost; cost of support to be included in interest rates thereafter

Participatory planning GOI approval necessary Yes, GOI has expressed its support for the establishment of the IWF

Specific to borrowers

Acceptability (PDAMs) No risk of takeover by private investors, short processing times of project proposals, no reliance on local government borrowing capacity, fixed interest rates

Yes, financing arrangements are structured to meet key requirements of eligible water utilities

Affordability Maximum interest rate 15% per year, minimum loan term 10 years

Yes, provided that GOI exempts CICs from withholding tax on interest earned

Specific to lenders

Professional management

IWF not managed by GOI Yes, IWF managed by professional investment house (PT. Danareksa)

Availability of credit enhancers

Need for guarantees and other security arrangements

Temporarily; multilateral guarantee available to financiers, but subject to USAID budget constraints

Source: ESP



7.2.2. FULL COMPLIANCE WITH FEASIBILITY REQUIREMENTS. The design of the IWF already complies with three of the abovementioned design criteria. The fund is supported by GOI, would be managed by a professional investment house and offers services that are acceptable to eligible PDAMs and other water utilities. Temporary or contingent compliance with feasibility requirements.

• Financial sustainability. The variable costs of the IWF consist of funding and management costs, which are fully covered by interest rates charged to the Fund’s borrowers. The fixed costs of the IWF consist of consist of marketing and project preparation costs. At present, these costs are borne by ESP. It is uncertain if the IWF would remain affordable to eligible water utilities if the fixed costs of its operations would also be passed on to its prospective borrowers.

• Affordability. PDAMs have indicated that they are unwilling to accept (fixed Rupiah) interest rates exceeding 15% p.a. As will be shown in the remainder of this Chapter, the IWF will not be able to meet this requirement unless GOI exempts CICs established by the Fund from withholding taxes (WHT) on interest earned.

• Availability of credit enhancers. Several multilateral and bilateral credit development agencies have expressed an interest to support the IWF by offering a partial credit guarantee to domestic private financiers of the Fund. Because such agencies normally absorb part of the cost of issuance of such guarantees, the number of projects that could be financed by the IWF would be restricted by the availability of multilateral and bilateral budgets for support to the Fund. The Study Team has assumed that the multilateral and bilateral agencies would guarantee at least US$ {X} million per year, from 2007 to 2009.

7.2.3. CRITICAL SUCCESS FACTORS OF THE IWF. In the long run, the feasibility of the IWF may be negatively affected by three factors: (1) limitations to the ability of the IWF to charge borrowers interest rates that cover the full cost of its operations; (2) the obligation of CIC vehicles to pay withholding taxes on interest earned and interest paid; and (3) the limited availability of credit enhancers. To better understand the potential impact of these factors on the feasibility of the Fund, the Study Team has first estimated the interest rate on investment7 that the IWF would need to charge to cover its funding and management costs. Next, it is shown how constraints in the availability of partial credit guarantees would affect the lending volume of the IWF. This analysis is followed by an assessment of the impact of adding fixed costs to the full cost-recovery interest rate on investment.

7Investment is, in this context, defined as the total construction cost, including the cost of detailed

engineering designs, construction supervision and interest during construction, but not including financing and management costs.



7.3. IMPACT OF IWF FUNDING AND MANAGEMENT COSTS ON THE EFFECTIVE INTEREST RATE ON INVESTMENT

DEFINITION OF THE BASE CASE SCENARIO.

This scenario, hereinafter also referred to as ‘Partial Taxation’, assumes that: (i) the IWF would take out the construction financing of a series of waterworks projects through the issuance of a CLO bond; and (ii) MoF would exempt the CIC vehicle, which would issue the bond, from a 20% withholding tax on interest earned. For two reasons, the Study Team has selected Partial Taxation as the base case:

1. A planned revision to the income tax law, to be approved by the parliament in 2007, already provides for the removal of double taxation.

2. The issuance of a straight bond does not require the establishment of a CIC vehicle that would potentially be subject to double taxation. Stated differently, the Partial Taxation scenario also applies to straight bonds8.

EFFECTIVE INTEREST RATE ON INVESTMENT UNDER PARTIAL TAXATION.

Under this scenario, the effective interest rate on investment that is required to cover the funding and management costs of the IWF is estimated at 14.63% p.a. This estimate is based on a assumptions that the Study Team has verified with PT. Danareksa and other financial institutions (Table 20)9. The rate of 14.63% is slightly lower than the maximum interest rate that PDAMs are prepared to pay (15% p.a.). Table 20. Key Assumptions for Calculating the Effective Interest Rate on Investment for

an IWF Loan to Eligible Water Utilities.

Credit term PT. Danareksa Finance Private investors

Share in project financing 30% 70% Interest rate Fixed, 10.78% p.a. Fixed, 14% p.a. Fixed costs covered* 0% 0% Loan term 10 years (annuity) 10 years (with bullet payment upon

maturity) Grace period 2.25 years (on principal and

interest) 2.25 years (on principal and partly on interest)**

Up-front fees (none) 1% on construction loans, 2.73% on Bond issues

Partial credit guarantee fees (not applicable) 1% up-front fee, 0.75% annual utilization fee***

Sources: ESP, PT. Danareksa * Marketing and project preparation costs ** Reduced interest rate of 6.0% applies, the remainder to be rolled-up during construction *** Indicative (fee rate vary by credit development agency)

8 PT. Danareksa has indicated that the bond issuance costs (as a percentage of the issued value are the same for ‘straight’ bonds and CLO bonds.

9 See Annex 5 for detailed assumptions. Annex 6 contains cashflows projections.



7.3.1. SENSITIVITY ANALYSIS

SENSITIVITY OF THE PARTIAL TAXATION SCENARIO TO CHANGES IN KEY ASSUMPTIONS.

Under Partial Taxation, the effective interest rate on investment remains below the cut-off rate of 15% unless: (1) PT. Danareksa Finance reduces its co-financing share from 30% to less than 20%; or (2) if the assumed coupon rate of the CLO Bond increases from of 14% p.a. to 15% p.a. (Table 21). This means that:

• PT. Danareksa should co-finance at least 20% of the financing requirements of a project in order to offer a water utility an affordable interest rate, even though this does not appear desirable because increasing the Danareksa co-financing share increases GOI’s dependency on foreign-funded loans and restricts PT. Danareksa Finance to leverage its funds to attract private sector financing.

• PT. Danareksa may need to increase its co-financing share if the coupon rate on

IWF Bonds is higher than expected rate of 14% p.a. in order to maintain the interest rate on IWF loans below the 15% cut-off rate.

Table 21. Effective Interest Rates on Investment for IWF Borrowers Under Three

Scenarios. (dark grey areas indicate feasible combinations)

SCENARIO Assumption

Double Taxation Partial Taxation Full Exemption

Base case 16.69% 14.63% 12.92%

Danareksa co-financing share: 40% 16.07% 14.24% 12.73%



Danareksa credit risk premium: 6% p.a. 16.96% 14.90% 13.21%

Danareksa credit risk premium: 4% p.a. 16.44% 14.36%* 12.64%*

Coupon rate on Bonds: 15% p.a. 17.41% 15.22% 13.41%

Coupon rate on Bonds: 13% p.a. 15.96% 14.02% 12.42%

Source: ESP Note: Double Taxation applies to CLO bonds only (straight bonds do not require a CIC vehicle) * Not acceptable to PT. Danareksa (which demands a risk premium of at least 5% on the sub-loan

interest rate charged by MoF) DEFINITION OF ALTERNATIVE SCENARIOS.

In several countries (including Canada, India and the United States), interest paid to municipal bondholders is exempt from withholding taxes as a means to promote private investment in municipal infrastructure services. Against this background, GOI is considering to grant a full exemption on withholding taxes on interest earned and interest paid by CICs established by the Indonesia Water Fund. This scenario is hereinafter referred as ‘Full Exemption’ (Exhibit 7.4). For comparison, the Study Team has also estimated effective interest rate on investments if GOI would not grant a full or partial exemption on



withholding tax liabilities of CICs. This is the ‘Double Taxation’ scenario, which reflects the current state of affairs10.

SCENARIO 1 – DOUBLE TAXATION

Financier (receives 64)

CIC (receives 80, pays 80)

Borrower (pays 100)

WHT (20%) WHT (20%)

SCENARIO 2 – PARTIAL TAXATION



Borrower (pays 100)

WHT (20%)



Borrower (pays 100)

SCENARIO 3 – FULL EXEMPTION

Source: ESP

Figure 17. Overview of Scenarios. EFFECTIVE INTEREST RATE ON INVESTMENT UNDER THREE SCENARIOS.

• Double Taxation. The effective interest rate on investment (EIRI) that the IWF must charge to cover its funding and management costs is estimated at 16.7% p.a. (Exhibit 7.3). Changes to key assumptions do not result in a rate below the cut-off rate of 15% p.a. Note that Double Taxation only applies to CLO bonds, as a straight bond issue does not require the establishment of a CIC that may be subject to double taxation.

• Partial Taxation. Removal of withholding taxes on interest earned lowers the EIRI to 14.6% p.a., which is marginally lower than the cut-off rate. To further reduce the EIRI, it is necessary to increase the co-financing share of PT. Danareksa Finance (which is not desirable) or to lower the coupon rate on the Bond offering (which is not realistic).

• Full exemption. Removal of WHT on interest earned and interest paid reduces to EIRI to 12.9%. Changes to key assumptions do not result in a rate that is

10 Note that even under Double Taxation, interest earned on loans extended by PT. Danareksa Finance

would not be subject to WHT, because this income is derived from a foreign-funded loan and therefore already tax-exempt under prevailing regulations.



higher than the cut-off rate of 15% p.a. This means that, under this scenario, IWF project financing is considered affordable to water utilities (except for a reduction in the credit risk premium; PT. Danareksa has indicated that it requires a premium of at least 5 percent on sub-loan proceeds channelled to prospective Borrowers). Perhaps surprisingly, Full Exemption also results in affordable interest rates if the Danareksa financing share is reduced to zero, although the EIRI increases from 12.9% p.a. to 13.4% p.a. This means that a soft loan to GOI is not a necessary pre-condition for the establishment of the IWF if the Government would fully exempt CIC vehicles from withholding tax.

SENSITIVITY OF EFFECTIVE INTEREST RATE ON INVESTMENT UNDER THREE SCENARIOS.

Exhibit 7.5 shows the percentage change of EIRIs arising from a 1% change in the value of a key assumption. (For example, a change in the Danareksa co-financing share from 30% to 31% results in a reduction of the EIRI by 0.04% p.a. under Partial Taxation.) The sensitivity indicators show that:

• The EIRI is most sensitive to changes in the coupon rate on the Bond offering, followed by changes in the credit risk premium charged by PT. Danareksa Finance and changes in the assumed interest rate charged by the construction financiers. As expected, the EIRI is relatively insensitive to changes in the Danareksa co-financing share (because the interest rate charged by PT. Danareksa Finance is only marginally lower than the rate on construction loans and Bonds).

• The EIRI is more sensitive to changes in key assumptions under Double Taxation than to equal changes under Partial Taxation or Full Exemption.

Table 22. Sensitivity of Effective Interest Rates on Investment to Changes in Assumptions

(% change in interest rate as a result of a 1% change in the value of the underlying assumption)

SCENARIO Assumption (varied by +1% from base case) Double Taxation Partial Taxation Full Exemption

Danareksa co-financing share (30%) -0.06 -0.04 -0.02

Danareksa credit risk premium (5%) 0.27 0.27 0.29

Interest rate on construction loans (14%) 0.21 0.19 0.17

Coupon rate on Bonds (14%) 0.72 0.59 0.49

Source: ESP



7.4. MINIMUM REQUIRED AVAILABILITY OF BILATERAL GUARANTEES

ASSUMED DEMAND FOR IWF PROJECT FINANCING.

The attractiveness of the IWF to prospective borrowers largely depends on its ability to respond to demand for project financing. As described in Chapter 3, ESP has already identified financing requirements for water utility networks of approximately IDR 1.3 trillion (or US$ 140 million). The Study Team has assumed that the IWF would finance this amount during the five-year period of 2007-2011. This means that the IWF would mobilize project financing of (140/5=) US$ 28 million per year. It should be emphasized that the figure of US$ 140 million is used as a minimum estimate of the IWF project financing volume only. It does not imply that the IWF would finance all projects that have been identified by ESP. REQUIRED FUNDING SOURCES TO MEET DEMAND FOR IWF PROJECT FINANCING.

To provide project financing of US$ 28 million per year, the IWF would need to secure private financing of (70% x 28=) US$ 19.6 million. Because interest would accumulate during construction, the exposure of private financiers would rise to approximately US$ 21.5m by the end of the construction period (Table 23)11. This is the minimum amount that, every year, would need to be guaranteed by multilateral and bilateral credit development agencies to ensure that the IWF is able to meet projected demand for project financing. At the time of writing, these agencies had not indicated to what extent it would be able to finance these requirements, except the Development Credit Authority (DCA) of the U.S. Treasury, which has committed itself to issue partial credit guarantee to financiers of a piped water supply project proposed by PDAM Kabupaten Bogor. Preliminary discussions suggest that donors would be willing to guarantee any amount not covered by the DCA. Table 23. Minimum Required Guaranteed Amount to Meet Projected Demand for IWF

Project Financing

Average amount (per year)

Total amount (2007-2011)

Assumed demand US$ 28.0m US$ 140m

Financed by PT. Danareksa Finance (30%) US$ 8.4m US$ 42m

Financed by other investors (70%) US$ 19.6m US$ 98m

Adjustment factor for guaranteed amount* 1.095 1.095

Minimum required guaranteed amount US$ 21.5m US$ 107m

Available guaranteed amount NA NA

Source: ESP * Adjustment required to account for interest during construction

11 See Annex 6 for detailed cashflow projections.



7.5. EFFECTIVE INTEREST RATE ON INVESTMENT UNDER FULL COST-RECOVERY

7.5.1. FIXED COSTS OF THE IWF. Estimates of effective interest rates on investment presented earlier in this Chapter do not include the fixed costs of the IWF. These costs are presently borne by ESP, and consist of:

• Marketing (preparation of presentation materials and briefings to interested water utilities).

• Project preparation (preparation of feasibility studies, including associated

activities such as consultations with PDAMs and local parliaments).

7.5.2. ESTIMATES OF FIXED COSTS. The Study Team estimates the marketing costs at US$ 150,000 per year, consisting of:

• Salaries of two full-time consultants (24 x US$ 5,000 = US$ 120,000).

• Travel and other costs (US$ 30,000). Project preparation costs are estimated at US$ 300,000 per year (Table 24). This assumes that the IWF would finance, on average, three projects per year with an average cost of (28/3 =) US$ 9.3 million. Total fixed costs account for approximately ([0.15 + 0.3] / 9.3 =) 4.8% of the average project cost.

Table 24. Annual Project Preparation Costs of the IWF (Indicative).

Number of projects per year, financed by the IWF 3

Feasibility studies implemented (success rate) 50%

Feasibility studies required 6

Unit cost of feasibility study US$ 50,000

Project preparation cost US$ 300,000

Source: ESP

7.5.3. CHARGING BORROWERS FOR FIXED COSTS. The IWF would eventually need to pass on marketing and project preparation costs to its borrowers in order to remain financially sustainable. The Study Team has assumed that PT. Danareksa Sekuritas would increase its Bond issuance fee to cover the additional cost. Because proceeds from Bonds would only cover 70 percent of the total financing requirements, the up-front fee would need to be increased by (4.8/70% =) 6.9%.



7.5.4. EFFECTIVE INTEREST RATE ON INVESTMENT UNDER THREE SCENARIOS.

The increase in the Bond issuance fee from 2.7% to 9.6% would result in an increase of the effective interest rate on investment of about 1.0 p.a. % under all scenarios (Table 25). The effective interest rate on investment under Partial Taxation increases from 14.6% p.a. to 15.6% p.a. This means that the IWF would not be able to pass on the full costs of its operations to its borrowers without affecting the feasibility of the Fund, unless: (i) PT. Danareksa Finance increases its co-financing share (to about 40%) to compensate for the required increase in the interest rate; or (ii) the fixed costs of the IWF would continue to be funded by USAID or other foreign donors after 2009. It also indicates that the support of ESP represent a significant cost reduction to the IWF’s services.

Table 25. Impacts of Fixed Costs on Effective Interest Rates on Investment.

SCENARIO Effective Interest Rate on Investment Double Taxation Partial Taxation Full Exemption

Base case (variable costs only) 16.69% 14.63% 12.92%

Full cost-recovery (including fixed costs) 17.68% 15.58% 13.85%

EIRI differential 0.99% 0.95% 0.93%

Source: ESP

7.6. MINIMUM REQUIREMENTS FOR THE FEASIBILITY OF THE IWF

7.6.1. COMPLIANCE WITH DESIGN CRITERIA. The IWF is deemed feasible if it meets six design criteria. At present, it already meets three of these criteria. The fund is: (1) supported by GOI; (2) managed by a professional investment house; and (3) offering services that are acceptable to eligible PDAMs and other water utilities. In addition, the IWF is likely to: (4) remain financially sustainable, even if it would need to charge borrowers the cost of marketing and project preparation (that are currently borne by ESP), by increasing its co-financing share; and (5) have access to partial credit guarantees to provide at least US$ 140 million in project financing during 2007-2010. The sixth design criteria – affordability – will only be met if GOI would exempt CICs established by the IWF from withholding tax on interest earned. The feasibility of the IWF would be dramatically enhanced if GOI would also exempt CICs on withholding taxes on interest paid to financiers of the Fund.

7.6.2. THE NEED FOR A WAIVER ON WITHHOLDING TAX. Revenues from CIC issues are currently subject to withholding tax on interest earned and interest paid. MoF has been approached to eliminate the double taxation related thereto of CIC. The justifications being used are as follows:



• Withholding tax (WHT) on interest levied on pooled bonds should be waived as they represent ‘double’ taxation. (CIC vehicles are ‘pass through’ vehicles and should not be taxed at both ends). Banks, pension funds and mutual funds are not similarly double taxed.




8. CONCLUSIONS AND RECOMMENDATIONS

8.1. SUMMARY There is presently a large and unfulfilled demand for long-term financing for piped water supply services in Indonesia, estimated at US$ 400 million per year. Demand is driven by the central government, which has committed itself to halve, by 2015, the number of people without access to safe drinking water, as well as by over 400 local governments, which have been responsible for the provision of water and sanitation since the implementation of Law 22/1999 on Regional Autonomy in 2001. This report has argued that the Indonesia Water Fund, as proposed in this report, is uniquely suited to leverage domestic private capital to finance much-needed investments in piped water supply systems. This concluding chapter summarizes the opportunities that favor the establishment of an Indonesia Water Fund, and actions that need to be taken to further develop the concept.

8.2. BENEFITS OF THE IWF

8.2.1. THE IWF HELPS THE CENTRAL GOVERNMENT TO ACHIEVE ITS STATED OBJECTIVES.

In 2002, the Government of Indonesia committed itself to Millennium Development Goal #7 and pledged to halve, by 2015, the proportion of people without sustainable access to safe drinking water and basic sanitation. To achieve this goal, annual investments in the water and sanitation sector need to increase from US$ 50 million to US$ 450 million over the next ten years.

8.2.2. THE IWF PROVIDES TANGIBLE BENEFITS TO LOCAL GOVERNMENTS.

The direct benefits to participating local governments are:

• Opportunity to leverage internal revenues. Because the liquidity standby, that forms part of the IWF security arrangements, protects private financiers against losses from non-performing loans, commercial banks would be willing to extend loans that exceed the standby by a sizable margin. This benefit is all the more important as water utilities presently have no access to long-term financing. As described in Chapter 6, commercial banks and the Ministry of Finance offer comparable services, but there are currently not operational or not tailored to PDAM requirements. Few PDAMs are able to afford loans offered by commercial banks, whereas lending by MoF (even through local governments) is moribund.



• Access to commercial bank financing. The availability of a partial credit guarantee further limits credit risk to domestic private investors. The IWF would use the instrument to attract construction financing at attractive terms and issue bonds with maturities up to ten years. In addition, the IWF is able to consolidate many smaller loans into a size that is more readily marketable and adaptable to the domestic credit markets.

• Attractive terms of credit. Interest rates on IWF loans would be lower than interest rates charged by commercial banks, as: (1) credit risk guarantees would lower credit risks; (2) the IWF would enable financiers to better match assets and liabilities; and (3) because of its access to low-cost funds (to be provided by an international donor), the required return on IWF capital is lower than the return required by commercial financiers, so that blending the two sources lowers the average cost of capital. In addition, the economies of scale of the financial transactions of the IWF lowers the management and administration cost per unit of amounts borrowed.

• Access to the domestic bond market. The IWF is able to place bonds with lower coupon rates and longer maturities than most individual water utilities.

• Access to supporting services. Through ESP, the IWF provides technical assistance for the preparation of feasibility studies.

8.2.3. THE IWF PROVIDES ACCESS TO DOMESTIC COMMERCIAL BANKS TO ACCESS THE MARKET FOR MUNICIPAL INFRASTRUCTURE FINANCE.

In recent years, domestic commercial banks have repeatedly expressed their interest to access the market targeted by the IWF, but have been reluctant to do so for various reasons (primarily because of their inability to raise matching funds for long-term capital). The IWF’s credit enhancements would enable commercial banks to extend long-term loans at an acceptable risk.

8.3. RECOMMENDED ACTIONS TO FURTHER DEVELOP THE IWF CONCEPT

8.3.1. RESULTS OF A HIGH-LEVEL MEETING WITH GOI. At the invitation of the Director General of Treasury, the Study Team presented the proposed concept for the IWF to a number of high-level decision makers in the central government in a meeting that was held on 29 June 2006. During this meeting, GOI expressed its commitment in principle to support the establishment of the IWF at short notice and confirmed its intention to support the IWF by borrowing the equivalent of US$ 50 million from an international donor. The proceeds of this loan would be channeled as a Rupiah-denominated sub-loan to PT. Danareksa to finance the purchase of 30% of IWF bond



offerings and to co-finance 30% of the construction cost of waterworks, should contractors wish to avail of this facility.

8.3.2. REQUIRED ACTIONS TO FURTHER DEVELOP THE IWF. On 30 June 2006, the Ministry of Finance invited the Study Team to join the IWF Technical Team and prepare a prioritized list of actions to be taken by the team. The proposed actions are:

1. Waiver for WHT on interest earned by KIK-EBA (avoid double taxation). Action 1.1: Prepare draft circular letter for MoF (DG of Taxes) to avoid double

taxation on CICs as ‘pass-through’ vehicle. Action 1.2: Discuss draft circular letter with the Director General of Taxes with

the aim of obtaining a decision in favor of avoiding double taxation before September 2006.

2. Channeling of international donor loan proceeds to PT. Danareksa in

Rupiah. Action 2.1: Prepare draft request for loan proceeds for inclusion in Blue Book. Action 2.2: Request a donor to confirm ‘in principle’ interest in signing a loan

agreement with GOI for on-lending to PT. Danareksa. Action 2.3: Request PT. Danareksa to submit application for the donor’s funds

to BAPPENAS for inclusion in Blue Book. Action 2.4: Analyze legal requirements for channeling of loan proceeds in

Rupiah to PT. Danareksa. Action 2.5: Assess realistic surcharge to the donor’s interest rate that would

need to be paid by PT. Danareksa Finance to cover FOREX risks assumed by MoF.

Action 2.6: Prepare draft circular letter (or other required legal documents) for channeling loan proceeds in Rupiah to PT. Danareksa Finance, with reference to the surcharge on the interest rate.

Action 2.7: Discuss draft circular letter (or other required documents) with DG of Treasury with the aim of obtaining a decision before Sep ’06.

Action 2.8: Prepare timetable for loan negotiations between GOI and the donor. Action 2.9: Facilitate loan negotiations between GOI and the donor.

3. Waiver for WHT on interest paid by KIK-EBA (exempt municipal

bonds). Action 3.1: ESP and PT. Danareksa to analyze legal requirements for exempting

interest earned on IWF bonds from WHT. Action 3.2: Prepare draft regulation (or other required legal documents) to for

removal of WHT paid on interest earned on IWF bonds. Action 3.3: Discuss draft regulation with the Sekretaris Negara (SekNeg) with

the aim of obtaining a decision before September 2006.

8.3.3. PROGRESS TO DATE (30 SEPTEMBER 2006). 1. Waiver for WHT on interest earned by KIK-EBA. USAID has verified

that a draft revision to the income tax law, which the National Parliament intends to approve in 2007, already provides for the removal of double taxation.



2. Channeling of International Donorloan proceeds to PT. Danareksa in Rupiah. PT. Danareksa has prepared an application for a US$ 50 million equivalent soft loan from an international donor, for inclusion in the Government’s short-list for foreign loans (known as the BAPPENAS Blue Book).

3. Waiver for WHT on interest paid by KIK-EBA. At the time of writing, the Ministry of Finance had not expressed on the proposed removal of WHT payable by holders of IWF bonds.



9. ANNEXES

ANNEX 1. EXISTING PPPS IN THE WATER SECTOR ANNEX 2. STATUS OF PDAM LOANS ANNEX 3. REVIEW OF PP54/2005 ANNEX 4. BOND ISSUANCE COSTS ANNEX 5. ASSUMPTIONS FOR IWF FINANCING ANNEX 6. IWF CASHFLOW PROJECTIONS ANNEX 7. IWF HIGH-LEVEL MEETING REPORT ANNEX 8. THE US-JAPAN CLEAN WATER FOR

PEOPLE INITIATIVE ANNEX 9. REFERENCES



ANNEX 1. EXISTING PPPS IN THE WATER SECTOR PPP Modality / Location*

Production capacity (l/s)

Total invest-ment (US$m)

Concession period Investor

BOT Medan 200 5 25 years (2000-2025) Lyonnaise des Eaux

Batam Concession 1,600 100 25 years (1996-2021) Cascal BV & PT. Bangun Cipta Sarana

BOT Jambi 200 2 25 years (1996-2021) PT. Noviantama

BOT Palembang 80 5 25 years (1998-2023) PT. Bangun Cipta Sarana

BOO Serang Utara 150 5 25 years (1993-2018)

West-Jakarta Concession

6,200 225 25 years (1997-2022) PT. Palyja

East-Jakarta Concession

6,500 225 25 years (1997-2022) PT. Thames PAM Jaya

JO Cisedane 3,000 NA 25 years (1998-2023) Tirta Cisedane

BOT Serpong 50 2.5 25 years (1997-2022) Bintang Jaya

BOT Lippo Karawaci

120 10 25 years (1999-2024) Lippo Karawaci

BOO Bintaro Jaya 100 10 1990 Pembangunan Jaya

BOT Cikampek 60 0.5 25 years (2000-2025) PT. WATTS

BOO Bekasi 50 10 1993 PT. Kemang Pratama

BOO Hunday Industrial Estate

50 5 1994 PT. Hunday

BOO Kota Legenda

25 2.5 1995 PT. Cikarang Permai

BOT Bukit Indah Cikarang

150 10 1998 PT. Bukit Indah

BOT Bawen 250 10 2004 APAC Inti

BOT Sidoarjo 100 2.5 25 years (1998-2023) PT. Vivendi

BOT Denpasar 300 10 25 years (1995-2020) PT. Tirta Artha Buana

BOT Samarinda 400 5 25 years (2004-2029) PT. WATTS

BOT Banjarmasin 500 5 25 years (2005-2030) PT. Adi Karya

Source: BPP-SPAM (2005) * BOT = Build Operate Transfer; BOO = Build Operate Own; JO = Joint Operation



ANNEX 2. STATUS OF PDAM LOANS OVERVIEW OF THE PDAM LOAN PORTFOLIO. According to the Ministry of Finance, arrears on PDAM loans increased from IDR 1.66 trillion in December 2003 to IDR 2.75 trillion in December 2004, a year-on increase of 65 percent. Non-performing loans are in a progressive state of deterioration, as they slip into higher categories of arrears (Tabel A1.1). PDAMs with more than IDR 5 billion in arrears will probably need serious restructuring. On 31 December 2004, there were 87 such PDAM, up from 41 one year earlier. Most of these PDAM serve highly urbanized areas.

Exhibit A2.1 Classification of Pdam Arrears at 31 December 2003/04

(IDR billion)

0 0-0.5 0.5-1 1-5 5-10 10-20 > 20

December 2003 25 48 14 86 14 17 10

December 2004 24 32 13 62 47 17 23

Change 2003-04 -1 -16 -1 -24 33 0 13

Source: Direktorat Penerusan Pinjaman Pemerintah (2005) UNCERTAINTIES CONCERNING THE RESCHEDULING OF LOCAL GOVERNMENT ARREARS. According to current regulations, the proceeds from a multilateral bank loan can only be channeled to a PDAM through the local government that owns the utility. A local government is not allowed for to sign a sub-loan agreement with the Ministry of Finance if it has outstanding arrears on central government loans, including loans to its PDAM. According to MoF data, over one-third of 440 local governments had outstanding arrears in excess of IDR 5 billion, primarily because of arrears on PDAM loans. On 23 September 2005, the Director-General of Treasury, who is responsible for the administration of central government loans to local governments, issued a letter, which states that local governments are no longer allowed to reschedule arrears. If a local government wishes to borrow for water supply (or any other sector), it needs to repay any outstanding arrears in one tranche. In view of high levels of indebtedness of PDAMs, many local governments are politically or financially unable to do so.



ANNEX 3. REVIEW OF PP54/2005 INTRODUCTION.

On 9 December 2005, the President of Indonesia signed a new implementing guideline on regional borrowing in response to changes in the laws on regional autonomy and fiscal decentralization (Law 32/2004 and Law 33/2004, respectively). The new guideline, better known as PP54/2005, is highly relevant for the development of municipal credit markets as it contains specific regulations on regional borrowing in the form of bank loans and municipal bonds. This Annex summarizes the key features of PP54 and its implications for the establishment of a water fund. SCOPE OF THE REGULATION.

PP54/2005 regulates loan transactions undertaken by provinces, kabupaten and kota. Article 1.9 defines a regional loan as: “a transaction to enable a region to receive money or benefits of monetary value from a third party with the obligation on the part of the region to repay [the money or benefits received]”. The guideline classifies regional loans as follows:

• Short-term loans (with maturities not exceeding one year). • Medium-term loans (with a maturity of at least one year, but which must be

repaid in full before the end of the five-year term of the Head of the Region who signed the loan agreement).

• Long-term loans (with a maturity of at least one year, but not subject to the restriction that applies to medium-term loans).

• Municipal bonds. This Annex discusses long-term loans and municipal bonds only, as loans with maturities of five years or less are not relevant to the needs of the water and sanitation sector. REGULATIONS PERTAINING TO LONG-TERM LOANS

Restrictions on long-term borrowing from a foreign national. Article 3.1 explicitly forbids regions to borrow directly from a foreign national (pihak luar negeri), except in the form of a municipal bond issue. Loans extended by a foreign national (such as a multilateral bank) must be approved by BAPPENAS and channeled through the Ministry of Finance. PP54/2005 does not disallow a region to borrow from an Indonesian national in currencies other than Rupiah. This implies that multilateral banks may channel US$-denominated loans to region governments through a domestic commercial bank. Restrictions on long-term loan guarantees. Article 4.1 explicitly forbids regions to guarantee loans extended to third parties, including regional enterprises such as PDAMs. Article 4.2 disallows regions to collateralize regional government revenues or property owned by a region (except for municipal bond issues). Projects eligible for long-term loan financing. Regional governments must use the proceeds of long-term loans to finance ‘investment projects that generate revenues’. According to Article 7.3 of PP54/2005, a project is considered ‘revenue-generating’ if two conditions are met: (i) the project generates revenues directly; and (ii) these revenues accrue to the regional government budget.



Global regional lending limits. According to Law 17/2003 on State Finances, net public debt must not exceed 60 percent of GDP. PP54 states that the Minister of Finance will issue a cumulative lending limit for regional governments in August of every year, and prepare a manual for assessing the limit (Art. 10). Experience suggests that both the preparation of the manual and the issuance of a regional lending limit will be delayed. This, in turn, may result in delays in central government approval of long-term loan proposals submitted by regional governments. Individual regional lending limits. Apart from the global lending limit, which applies to all regions in the country, an individual regional government must meet four criteria to obtain central government approval for a long-term loan (Art. 12):

1. Total outstanding loans < 75% non-earmarked revenues in the previous fiscal year. 2. Debt service coverage ratio (DSCR) > 2.5. 3. No arrears on outstanding loans from the central government. 4. Formal approval of the regional parliament (DPRD).

According to the interdepartmental working group that was responsible for preparing PP54/2005, arrears on sub-loans to regional government enterprises are not considered when assessing regional lending limits. DPPP, however, has recently indicated that it does not wish to conclude a sub-loan agreement with a regional government before it has repaid all its arrears, including arrears (if any) on loans to its PDAM. Central government approval for long-term loans. Regions must obtain central government approval for all long-term loans. As shown inTable A3.1, the evaluation and approval procedures vary by source of finance. The Minister of Finance is responsible for the approval of all long-term loan proposals financed by the central government. In recent years, most approved loans to regional governments were financed from the proceeds of IBRD and ADB loans. The Minister of Finance will only evaluate regional loan proposals that on list of ‘priority projects for foreign loans and/or grants’ (Daftar Rencana Prioritas Pinjaman dan/atau Hibah Luar Negeri or DRPPHLN). This list is prepared by BAPPENAS, based on the advice of technical ministries such as MPW. The Minister of Home Affairs is responsible for approval of long-term loans financed from non-governmental sources. It appears that many regions do not report long-term proposals to MoHA to avoid a lengthy evaluation and approval process.

Table A3.1 Evaluation and Approval of Long-Term Loan Proposals by Regions

Funding source Responsible for evaluation Responsible for approval*

Central government (foreign sources)

BAPPENAS, technical ministries, Ministry of Finance

Minister of Finance, based on advice of Minister of Home Affairs

Central government (domestic sources)

Ministry of Finance Minister of Finance

Other sources Ministry of Home Affairs Minister of Home Affairs

Source: ESP, based on PP54/2005 * Subject to compliance with the global regional lending limit issued by the Minister of Finance REGULATIONS PERTAINING TO MUNICIPAL BONDS

General restrictions on municipal bond issues. Municipal bonds must be issued on the domestic capital market and comply with prevailing capital market regulations. In addition, a municipal bond must be denominated in Rupiah and issued at 100 percent of face value



(discounted bonds and index bonds are explicitly disallowed). The proceeds of a municipal bond issue can only be used to finance revenue-generating projects. Restrictions on guarantees to municipal bondholders. Article 4.3 of PP54/2005 limits regional government guarantees to bondholders to revenues of a bond-financed project government property that forms an integral part of that project. Article 23 states that the central government does not guarantee municipal bond issues. Restrictions on bond issues for non-revenue generating projects. Regional governments must use the proceeds of municipal bonds to finance ‘public sector investments that generate revenues’. The Ministry of Finance informed the Study Team that local governments are allowed to issue municipal bonds to finance projects that are not financially feasible, as long as these projects generate revenues that accrue to the local government budget (APBD). It also informed the Team that a minimum cost-recovery rate would apply, although MoF had not yet determined this rate. Central government approval. Regions must obtain approval of the local government (DPRD) and the Minister of Finance to issue a bond. The evaluation and approval process will be regulated by a ministerial decree that is expected to be issued in the first half of 2006. IMPLICATIONS FOR THE ESTABLISHMENT OF THE IWF

Continued dependence on MoF as a conduit for multilateral loans to regional governments. Although the IWF is intended as a financially self-sustaining entity, it is expected that multilateral banks will support the fund by providing sub-loan financing for investments in participation certificates of central and regional participants. The PP suggests that approval of such loans would be time-consuming, as it would require the involvement of the Ministry of Public Works, BAPPENAS, the Ministry of Finance and the Ministry of Home Affairs. To make matters worse, the disbursement of such loans would be managed by DPPP, which requires up to 12 months to prepare a sub-loan agreement. The new requirement of the annual issuance of a global lending limit for regional governments may result in further delays. Uncertainty about the status of a revolving fund as a conduit of multilateral loans. PP54/2005 disallows regional governments to borrow from a foreign national. It does, however, allow regions to borrow from an Indonesian national (upon approval of the Minister of Home Affairs). The PP does not clarify if multilateral loans channeled to regional government through the IWF, to be established as an Indonesian legal entity, would constitute ‘borrowing from a foreign national’. Limited availability of credit enhancements. PP54/2005 severely restricts the ability of regional governments to provide credit enhancements.

• Long-term loans. Regional governments are not allowed to guarantee loans to their own enterprises (such as PDAMs), or to collateralize regional government revenues or public property for the purpose of guaranteeing a long-term loan.

• Municipal bonds. A regional government may only issue a municipal bond to finance a projects with cost-recovery rate below 100% but above a yet to be determined rate. Project revenues and regional government contributions to the project may be offered to bondholders as credit guarantees. GOI does not guarantee municipal bond offerings.



ANNEX 4. BOND ISSUANCE COSTS

Table A4.1 Estimated Issuance Costs for A 5-Year Bond of IDR 1 Billion

(IDR million)

Year 1 Year 2 Year 3 Year 4 Year 5

Up-front costs

Underwriter 25,000

Notary 50

Legal consultant 400

Public accountant 400

Printing 250

Public expose 250

Pefindo rating:

- General obligation* 60

- Bonds issuance 800

BES listing fee** 50

KSEI joining fee 15

Subtotal 27,275

Annual costs

Annual Pefindo review 100 100 100 100

Trustee bank fee 800 800 800 800

BES annual fee 50 50 50 50

KSEI annual 20 20 20 20 30

Subtotal 20 970 970 970 980

TOTAL 27,295 970 970 970 980

(as % of issued value) 2.73% 0.10% 0.10% 0.10% 0.10%

Source: PT. Danareksa



ANNEX 5. ASSUMPTIONS FOR IWF FINANCING

Table A5.1a Assumptions for IWF Financing

Int’l Donor loan to GOI

Loan size ($ Million) 50

Interest rate (% p.a.) 0.75%

Commitment fee (% undisbursed) 0.25%

Grace period (years) 10

Repayment period (years) 30

GOI loan to Danareksa

$ / Rupiah 9,000

Loan size (Rupiah billion) 450

MoF surcharge (% p.a.) 5.03%

Rupiah interest rate (% p.a.) 5.78%


Grace period (years) 10

Repayment period (years) 30

Financial structure

Danareksa loan (% fin. requirement) 30.0%

Participation other lenders (% fin. requirement) 70.0%

Danareksa loan

Danareksa surcharge (% p.a.) 5.00%

Rupiah interest rate (% p.a.) 10.78%


Construction loans

Interest rate charged (% p.a.) 14.0%

Interest paid during construction (% p.a.) 6.0%

Interest rate accumulated during construction (% p.a.) 8.0%

Up-front fee on construction loans (% nominal value) 1.0%

Bond issue

Coupon rate, 10-year bonds (% p.a.) 14.0%

Up-front fee (% nominal value) 2.73%

Annual fee (% nominal value) 0.02%

Minimum bond size (IDR billion) 150

Sources: ESP, PT. Danareksa



Tablet A5.1b Assumptions for IWF Financing (Continued)

Partial credit guarantee

Up-front fee (% nominal value) 1.00%

Annual fee (% nominal value) 0.75%

Other assumptions

Trustee fee 0.03%

Average construction period (years) 1.75

Number of projects per year 4

Average financing requirement (IDR billion / project) 100

WHT tax on interest earned, straight bond 0.0%

WHT tax on interest earned, pooled bond 20.0%

WHT tax on interest paid 20.0%

Sources: ESP, PT. Danareksa



ANNEX 6. IWF CASHFLOW PROJECTIONS INTRODUCTION. Chapter 7 presents effective interest rates on investment (EIRIs) that the IWF would need to charge to its Borrowers to cover its funding and bond issuance costs (but excluding marketing and project preparation costs). This Annex presents cashflow projections for a project with a cost of IDR 100 billion (excluding interest during construction) and a construction period of nine quarters (2.25 years). It first describes the assumed funding sources and the methodology used to calculate the EIRI for the base case under Partial Taxation. FUNDING SOURCES. It is assumed that IWF would, at least initially, arrange the financing of waterworks projects from the following sources (refer to Annex 5 for detailed assumptions):

1. A loan from PT. Danareksa Finance. This loan would finance 30% of the total cost. The loan amount of (30% x 100=) IDR 30 billion would be disbursed in five equal installments at the end of quarters 1, 3, 5, 7 and 9. No interest would be payable during the construction period. Upon commissioning of the project, the Borrower will repay the loan as an annuity in forty quarterly installments (10 years). An annual interest rate of 10.78% applies.

2. A construction loan. This loan would be extended to the contractor (and

not to Borrower) to finance 70% of the total cost. The loan amount of (30% x 100=) IDR 70 billion would be disbursed in five equal installments, also at the end of quarters 1, 3, 5, 7 and 9. Conform prevailing market conditions, part of the interest (charged at an annual rate of 14%) is payable during the construction phase, at the end of every quarter. It is assumed that the contractor would need to pay 6% during construction; the remainder would be accumulated.

3. A Bond. To take out the construction financing, CIC-Operations would issue a

serialized bond with a nominal value equal to the construction loan including accumulated interest. An annual coupon rate of 14.0% applies. Interest is payable at the end of each quarter. Principal would be repaid in three balloon payments at 5, 7 and 10 years from take-out with respectively 30%, 30% and 40% of face value falling due on each of such anniversaries.

4. Medium-Term Notes (MTNs). CIC-Operations would issue the Bond

against MTNs executed by the Borrower. Because the terms and conditions would match those of the Bond, the cashflows associated are ignored in the cashflow projections. (To simplify the presentation, it is implicitly assumed that the Borrower would pay directly to the Bondholders; in reality, these payments will ‘pass through’ the CIC vehicle.)



METHODOLOGY. To calculate the EIRI for the base case of the Partial Taxation scenario, two steps were taken: Step 1. Calculate quarterly cash inflows (disbursements) to the Borrower and cash

outflows (debt service charges, including bond issuance costs, the cost of guarantees and other charges) from the Borrower for funding sources: (i) the PT. Danareksa loan; (ii) the construction loan; and (iii) the Bond. MTNs were ignored, because the net impact of cash inflows and cash outflows of this instrument would not affect the EIRI.

Step 2. Calculate the IRR of all 49 quarterly cashflows during construction and operations. This rate is the interest rate that the IWF would need to charge on investment to cover its funding and management cost.

PT. Danareksa has indicated that it will charge the same issuance fee for ‘straight’ bonds and CLO bonds, so that the cashflow projections would apply to both types of bonds (Table A6.1).

Table A6.1 CASHFLOW PROJECTIONS FOR A IDR 100 BILLION IWF FINANCING (EXAMPLE)

(IDR billion) Net cashflows to Borrower Quarter Danareksa Loan Construction Loan Bond TOTAL

1 6.000 14.474 20.474 2 0.000 -0.231 -0.231 3 6.000 13.550 19.550 4 0.000 -0.459 -0.459 5 6.000 13.316 19.316 6 0.000 -0.698 -0.698 7 6.000 13.073 19.073 8 0.000 -0.945 -0.945

CO

NST

RU

CT

ION

PH

ASE

9 6.000 12.820 -2.136 16.684

10-13 -5.738 -11.580 -17.319 14-17 -5.738 -11.580 -17.319 18-21 -5.738 -11.580 -17.319 22-25 -5.738 -11.580 -17.319 26-29 -5.738 -35.053 -40.792 30-33 -5.738 -8.106 -13.845 34-37 -5.738 -31.579 -37.318 38-41 -5.738 -4.632 -10.370 44-45 -5.738 -4.632 -10.370

OP

ER

AT

ION

S P

HA

SE

46-49 -4.304 -35.929 -40.233

Source: ESP



ANNEX 7. IWF HIGH-LEVEL MEETING REPORT

Office : Jakarta Region : NATIONAL Subject : Workshop on Indonesia Water Fund Financing Scheme Site(s) : Hotel Borobudur Participants : DG of Treasury MoF, Director of Subloan Management (DP3), DG of

Taxes, BAPPEKI, BAPEPAM, BAPPENAS, Ministry of PW, Director of Regional Income and Investment (MoHA), PT. Danareksa, ESP/USAID.

Date : 29 June 2006 PURPOSE

The purpose of the workshop was to make a presentation on the Indonesia Water Fund and get a commitment to go forward through additional ESP and Government efforts. MEETING NOTES

1. Mr. Mulia Nasution, the DG of Treasury (MoF) chaired the workshop. Andre Oosterman from ESP-USAID delivered the presentation in Bahasa Indonesia on IWF, followed by Mr. Lin Chi Wei, President Director of PT. Danareksa.

2. Four outstanding issues were the focus of ensuing discussion: (i) confirmation of channeling arrangements for soft loan proceeds; (ii) confirmation of MoF’s preference for risk sharing; (iii) confirmation of one-time disbursement and programmatic approach; and (iv) waiver for WHT on interest earned and paid by CIC.

3. With regard to issue (iv), Mr. Petrus from DG of Taxes, MoF informed that there was at one time a tax exemption facility for government bonds but it has been eliminated. Granting a tax exemption for one investor would probably raise similar demands from others. However, since a new UU for Taxation is still being discussed, a couple of points could be brought up: (1) whether the double withholding tax for CIC-ABS has been identified as an issue in the UU; (2) if this issue could be accommodated in a Peraturan Pemerintah or Peraturan Menteri Keuangan; and (3) if the government either waive or subsidize the tax.

4. Mr. Teguh from DP3, MoF – regarding issue (i) and (ii): Based on the Circular on on-lending, there is no regulation for channeling foreign funding to an executing bank such as Danareksa. However, DG Treasury indicated that the government would be interested in borrowing foreign funds for this purpose and channeling them to Danareksa and that they would be willing to absorb the foreign currency risk. The type of channeling is not regulated but it could be accommodated.

5. Mr. Basah from BAPPENAS: The proposal for foreign financing is not yet included in Blue Book. Danareksa (as allowed by PP 2/06) should submit the proposal immediately.

6. Regarding issue (iv), Mr. Mulia suggested that a BLU (public service entity) be created to avoid taxes, managed by Danareksa. Mr. Lin Chi Wei did not support this idea as creating a BLU would adversely affect market discipline.



7. Outcomes/Conclusions: Issues no 1-3 could be solved, while no.4 needs intensive follow up. Mr. Mulia announced to the audience that a tim teknis (task force) needed to be set up to resolve outstanding issues, comprised of one representative from each ministry to resolve. The contact person will be Mr. Widjanarko, DG Treasury (APHLN).

The contact person of the technical team requested ESP the following morning to identify a prioritized list of actions to be taken by the technical team.

1. Waiver for WHT on interest earned by KIK-EBA (avoid double taxation). Action 1.1: Prepare draft circular letter for MoF (DG of Taxes) to avoid double

taxation on KIK-EBA as ‘pass-through’ vehicle Action 1.2: Discuss draft circular letter with DG of Taxes with the aim of obtaining

a decision in favor of avoiding double taxation before Sep 2006

2. Channeling of Int’l Donor loan proceeds to PT. Danareksa in Rupiah. Action 2.1: Prepare draft request for soft loan proceeds for inclusion in Blue Book. Action 2.2: Request donor to confirm ‘in principle’ interest in signing a loan

agreement with GOI for on-lending to PT. Danareksa. Action 2.3: Request PT. Danareksa to submit application for donor funds to

BAPPENAS for inclusion in Blue Book. Action 2.4: Analyze legal requirements for channeling of soft loan proceeds in

Rupiah to PT. Danareksa. Action 2.5: Assess realistic surcharge to interest rate that would need to be paid by

PT. Danareksa to cover FOREX risks assumed by MoF. Action 2.6: Prepare draft circular letter (or other required legal documents) for

channeling soft loan proceeds in Rupiah to PT. Danareksa, with reference to the surcharge on the interest rate.

Action 2.7: Discuss draft circular letter (or other required documents) with DG of Treasury with the aim of obtaining a decision before Sep 2006.

Action 2.8: Prepare timetable for loan negotiations between GOI and donor. Action 2.9: Provide support to GOI and donor to facilitate loan negotiations.

3. Waiver for WHT on interest paid by KIK-EBA (exempt municipal bonds). Action 3.1: ESP and PT. Danareksa to analyze legal requirements for exempting

interest earned on municipal bonds from WHT. Action 3.2: Prepare draft regulation (or other required legal documents) to for

removal of WHT paid on interest earned on municipal bonds. Action 3.3: Discuss draft regulation with the Sekretaris Negara (SekNeg) with the

aim of obtaining a decision before Sep 2006.



ANNEX 8. REFERENCES ____, Keputusan Menteri Keuangan Nomor 35 Tahun 2003 tentang Perencanaan, Pelaksanaan / Penatausahaan dan Pemantauan Penerusan Pinjaman Luar Negeri Pemerintah Kepada Daerah

____, Undang-Undang Republik Indonesia Nomor 32 Tahun 2004 tentang Pemerintahan Daerah

____, Undang-Undang Republik Indonesia Nomor 33 Tahun 2004 tentang Perimbangan Keuangan antara Pemerintah Pusat dan Pemerintahan Daerah

____, Peraturan Pemerintah Republik Indonesia Nomor 54 Tahun 2005 tentang Pinjaman Daerah

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BAPEPAM, Indonesian Capital Market Master Plan 2005-2009, Jakarta, August 2005

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Peterson, G., Bank or Bonds? Building a Municipal Credit Market, The Urban Institute, Washington D.C., 2002

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Tel. +62-21-720-9594 Fax. +62-21-720-4546

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the indonesia water fund - assessment of feasibility

Documents

piped water supply

contract number

potential demand

dai project number

demand projections

actual demand

strategic objective

executive summary