Financing of Water Resources Sector Reform

A Note on Some Financing Options for Decentralized Water Resources Development and Management in Indonesia

Background

I Economic and Financial Principles

II The Decentralization Law and Reform of Intergovernmental Fiscal Relations (Perimbangan Otonomi Daerah.)

III Financial Mechanisms to Support the New Water Resources Policy

1. National

2. Regional/Provincial

3. Large Strategic River Basins

4. Smaller river basins crossing kabupaten boundaries

5. River basins and irrigation systems wholly within kabupaten boundaries

6. Irrigation systems and sub-systems to be transferred to WUA and WUAF

Diagrams

Example 1

Example 2

Annexe A – An Overview of Water Resources Decentralization in Indonesia

Annexe B Financial Principles

Annexe C: The Decentralization Law and Reform of Intergovernmental Fiscal Relations (Perimbangan Otonomi Daerah.)

A Note on Some Financing Options for Decentralized Water Resources Development and Management in Indonesia

Background

For many years the system for the management and financing of water resources in Indonesia was GOI (Government of Indonesia) directly provided the finance for almost all capital investment as well as heavy subsidies for operation and maintenance. This was accomplished through budgetary allocations to capital and routine budgets. In theory, a consultative process was responsible for allocation between and within sectors. For investment projects, funds were provided through DIPs (Daftar Izin Proyek – or budget “authorization”) which were covered by domestic revenues and/or donor and development bank loans. The earmarked subsidies for O&M were provided in a similar way. In PJPI ( the first 25-year development plan) , finance was treated as an input to an agricultural production process, with little consideration of the potential advantages of using financial contracts, prices, and incentives to achieve efficiency and effectiveness in the use of government resources.

Recent years, both pre and post-Suharto, have seen progress in the design of new institutions, incentives and financing mechanisms for infrastructure. These innovations have, however, been largely restricted to the water supply sector rather than to broader water resource management. An exception is the Jasa Tirta BUMN (Badan Usahah Milik Negara – a nationally owned state enterprise), which has been a laboratory case for developing a new type of river basin institution. Water supply (a user sector) has always been largely handled through public enterprises (e.g. BUMD such as a PDAM) and has even been financed through loans (e.g. the Regional Development Account.) However command allocation of investment resources and direct and indirect subsidies predominated. In addition, some cities have started to adopt market oriented municipal finance strategies as a means of improving the quality of investment decisions and services. This approach, managed by PUOD, has focussed on helping local governments and their enterprises get credit ratings based on debt capacity and hence access to bank credit and the bond market. Continued difficulties in producing a service culture within existing PDAMs have led to privatizations through concession arrangements (the assets remain the property of the kabupaten/ kotamadya.)

Investment in irrigation infrastructure, at both the user and main system level has continued to be delivered by central government managed “Proyek” which are financed by DIPs. When completed systems are eventually transferred (often after many rounds of rehabilitation), they are handed over for O&M to a vertical line ministry at the province (Dinas Pengairan.) At present, responsibilities for O&M are being transferred to newly formed Dinas Pengairan at the kabupaten level, supplemented by continued central government and provincial management of larger systems traversing kabupaten boundaries. One such administrative entity is the Balai (PSDA) which is still being financed as a project in several river basin locations throughout Indonesia. Attempts to devolve responsibility for O&M to provincial governments in the past have failed to improve water use efficiency and physical infrastructure has continued to deteriorate at a rapid rate. Fundamental flaws in the implementation of the ISF program have led to its abandonment in its original form – changes which will maximize farmer responsibility and self financing of O&M are already underway.

Under the leadership of the DPU, a new approach to water resources management has been advocated – largely a product of interest engendered by the Cisarua Conference of 1992. This conference marked the acceptance by GOI of the broad international consensus that water resources must be managed on the basis of river basins (DAS) rather than by hierarchies of public administration. Cisarua (and its incorporation in the GBHN for PJP II) advocated adoption of international policy commitments such as the Dublin Declaration and Agenda 21. Thus at a conceptual level, the government apparatus of Indonesia is well equipped to provide the technical engineering leadership for implementation of the new policy. Explicit options for financial and managerial devolution have received less attention but are now being highlighted by the economic crisis. It is evident that, for the foreseeable future, there will be a dramatically smaller central government financial commitment to the water sector in general and irrigation in particular. Investment in new schemes will likely be severely curtailed, as extensification is not only very expensive, but will have only a marginal effect on production in times of severe drought.

Both users (WUA/WUAF) and local governments (at the provincial and kabupaten levels), will have to raise the finance needed to fix the problems of the sector (through rehabilitation) and cover O&M costs by user fees or explicit subsidies funded through kabupaten budgets. It will not be possible for Central Government to decree what the level of these subsidies will be. There must be much more emphasis on user charges, increased use of local property taxation and the discretionary use of Central Government block grants by local governments, as sources to fund water resources development. Even these resources will be inadequate in many circumstances and the public sector will have to form partnerships with the private sector, and/or look to the financial markets as a source of long-term funding. Local government access to these sources will depend on their credibility as clients and partners – their so called creditworthiness or credit rating.

The urgency engendered by political conditions and economic crisis requires a much more rapid and committed implementation of the type of decentralization outlined in PJP II. Short, medium and long-term strategy, and corresponding “action programs” require the clarification and dissemination of economic and financial principles, to which GOI is already committed at a policy level. The fiscal environment in which implementation of these principles must be achieved has also changed, with the imminent submission of new laws, which devolve many current central government functions, tax bases, and management authority to autonomous local governments. These local governments will receive a much larger proportion of national budgetary resources in the form of formula driven block grants. Not only will kabupatens decide how these funds will be used, but also decisions would be subject to the directives of, and accountability to, democratically elected councils (DPR) as well as the conditions imposed by the capital market.

This note comprises four sections: -

A summary of the basic economic and financial principles underlying current international thinking on the financing of water resources;
The preliminary outline of forthcoming legislation on decentralization and intergovernmental fiscal relations;
Financing Mechanisms for various levels of water resource management
Two diagrams to illustrate the principles enunciated in III. These diagrams and the accompanying text explain how demand based financing mechanisms would work. Both examples try to make a direct link between investment demand (as expressed by users willingness to pay as well as social priorities) and a financial response. This contrasts with the current supply-led approach which is implemented through central government’s annual budgeting of projects.

I Economic and Financial Principles[1]

The following principles are derived from theory and international and national experience over the last five decades:-

Management institutions for water use and overall resource management should not be line ministries (Dinas) but autonomous financial entities, not bound to the budgetary cycle, able to borrow money, collect fees, and use budget transfers for both O&M as well as investment in new infrastructure.
The potential gains from diligent O&M are significantly higher than the costs. Farmers, however, will not be willing to pay O&M fees if they are not used properly and the benefits are not forthcoming.[2]
Economically, increased funding of maintenance, provided it actually leads to proper maintenance, is usually justifiable by the savings from having to do less frequent rehabilitation.[3]
Charges for O&M should be in the form of direct contracting of service for fees at the farmer level, and not via taxes which disappear into the local or national government tax coffers. [4]
Government subsidies to adjust for externalities, to address equity issues and to “seed” new institutions are better delivered in the form of equity grants, whose use has to be accounted for in subsequent accounting periods.
The deterioration of assets (e.g. physical structures and environmental resources) must be captured within the accounting framework used by water resource institutions.
Concessions which are subject to both regulation and periodic performance review, are often a satisfactory substitute for full privatization;
Using development banks and other financial institutions as sources of both short and long-term finance will only improve the quality of investment decisions if the bank’s operational management is both independent and accountable to its directors for the use of capital.
Government loan guarantees create moral hazard and project loans should be made on the basis of an evaluation of the creditworthiness of the borrower.
Decisions should be devolved to the lowest level possible.
If the willingness to pay of customers is too low allow a profit to be made then any subsidy given should be transparent – it should not for instance be hidden in providing credit at well below market rates. This produces undesirable distortions in financial markets.

II The Decentralization Law and Reform of Intergovernmental Fiscal Relations (Perimbangan Otonomi Daerah.)

Indications from early drafts of forthcoming legislation for decentralization of central government functions, are dramatic and imply:-

Direct assignment of 25% of government revenues to provincial and kabupaten governments plus additional increased shares of resource taxes and specific investment funds (extending the existing INPRES system.)
Central Government responsibilities to be limited to foreign relations, security and defense, justice, monetary policy and an as yet undefined category of “national strategic policy
Most reassignments would be directly to the kabupaten/ kotamadya governments with accompanying block grants based on, as yet to be defined criteria related to population, economic potential and “need.”
The province would have authority over matters which transcend kabupaten boundaries with the explicit mention of public works, communications, transport, mining, forestry, estates and strategic regional policy.
Local governments will be able to access funds both from the national budget, donors, the foreign and domestic private sector and from the local revenue base;
Provincial and local governments will be free to allocate these funds as well as their own source revenues (pendapatan asli daerah)
Both provincial and kabupaten governments would be free to restructure their dinases and kabupatens may, individually or in cooperation with other kabupatens, transfer responsibilities to local government enterprises (BUMD), private enterprises or joint government-private partnerships

III Financial Mechanisms to Support the New Water Resources Policy

The emphasis should be on flexibility and variation in financial planning – both in the goals set for different regions and in the assessment of kabupaten - level capacity, as well as different transition paths from present to future arrangements. Regional and kabupaten governments, not the central government, will set goals and objectives. Although the banking system is presently in crisis, banks will be re-capitalized and this presents an opportunity to strengthen infrastructure financing by supporting suitable, “healthy” banks with access to a long-term line of credit. Finance should no longer be considered a direct input to a production process, with quantification in the form of DIPs and associated targets for “realization.” The abandonment of detailed sectoral investment goals by central government, and the substitution of targeted reforms in governance and institutions mean a drastically reduced role for government. There will be much more use of market-based financing mechanisms and increased political participation in decision making by the citizenry. The new framework would put the onus for demonstrating performance on the regions themselves; how will the different regions’ public and private sectors make use of the facilities offered?

The options for financing mechanisms are outlined below, with most of the substance of reform and restructuring representing a move away from national and provincial financing through DIPs. This requires development of new institutions in the form of river basin corporations for large systems, and some adapted form of BUMD or a corporation for smaller basins. These institutions would be either standalone within a kabupaten, or a cooperative venture between several kabupatens. They would perform the functions presently carried out by the Dinas. While the irrigation dinas will survive in some kabupaten, particularly in more isolated and undeveloped areas, new institutions are required to manage irrigation systems and river basins along more transparent and accountable lines, especially in human resource allocation and finance.

1. National

During the transition period there will continue to be Government DIPs to complete projects and to fund the ongoing technical and regulatory functions of a drastically streamlined DGWRD. Consideration might even be given to transferring irrigation O&M to agriculture so as to integrate agricultural and irrigation functions. The goal is to get Central Government out of direct financing of infrastructure and to transfer directorate responsibilities for planning and supervision to newly formed provincial directorates or to the kabupaten level. Other financing mechanisms at the Central level might include:-

Mega-projects – direct GOI equity participation may be considered for strategic reasons but would preferably involve participation by the domestic and foreign private sectors.
Targeted foreign/domestic funding of central projects for key national management functions e.g. to establish networked water resource databases, monitor implementation of national policy at provincial level, training, management and leadership training for newly formed water authorities/ water BUMD staff.
Capitalizing an independent national apex infrastructure development fund or development bank. This would be an alternative to DIPs, and a way of facilitating infrastructure investments. The governance and regulation of such an institution could be addressed in the broader context of the reform of local government finance, state enterprises and banking. Other sectors will face similar problems of access to capital under new conditions of fiscal decentralization.

2. Regional/Provincial

The eventual goal should be to limit provincial functions to technical oversight and policy implementation, and leave financial audit/supervision to the appropriate specialist departments. In the interim, there may be partially completed projects, started with DIP funding, that should be completed. In many outer island locations, it is unrealistic to expect any immediate change in the system of dependence on the center. The financial implications of decentralization are that the way in which projects are identified, formulated and then financed should be from the “bottom up”, and depend very much on responsive financial mechanisms which are institutionalized at a local level. This accommodating financial system must be more market-based and responsive, providing rapid access to centrally sourced funds but outside of the budgetary framework. In highly developed Java, Bali, parts of Sumatra and Sulawesi, it can be expected that there will be future large scale water resources projects which are identified by the province but which are then financed through some combination of financial instruments, such as:-

Equity contributions from kabupaten;
Debt from a central infrastructure fund, with repayment guaranteed by the provincial government, or by kabupaten/kotamadya themselves if they can achieve good credit ratings by demonstrating debt capacity over time;
Debt from the independent provincial development bank (BPD[5]) that are “healthy”, and which would either have a line of credit to a central infrastructure fund, and/or its own funds. Access would be conditional on satisfying transparent conditions such as:- a) the financial health of the bank as rated by Bank Indonesia regulators; b) the credit rating of the borrower and c) the nature of the investment to be funded. The Ministry of Finance and BAPPENAS would also be relieved of the burden of micro-managing infrastructure investment;
Debt provided by the private banks – in the short-term this is likely to be in short supply, and Indonesian debt markets are very shallow anyway. Indonesian banks have never been able to provide much long-term finance and even “development banks” such as the BPDs have been forced to concentrate on short-term commercial sector working-capital loans. Healthy private banks should also have access to an infrastructure fund, with funding at rates determined by the markets in long term and in the short term by central government (Ministry of Finance/ Bank Indonesia.)
Cash flow from operations.

Given the concentration of banking and financial institutions in the capital cities of the larger provinces, and that major river-basin authorities would cover many kabupaten, project financing can be shifted towards the province. Lower levels of government will now have more control over capital/equity funds in the form of central government block grants. This will make their participation more meaningful than in the past when Jakarta institutions monopolized project finance