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1 Public Disclosure Authorized Public Disclosure Authorized Public Disclosure Authorized Public Disclosure Authorized Turkey Country Unit Infrastructure and Energy Sector Department Europe and Central Asia Region Document of The World Bank FOR OFFICIAL USE ONLY PROJECT APPRAISAL DOCUMENT ON A PROPOSED LOAN IN THE AMOUNT OF EURO MILLION (US$275 MILLION EQUIVALENT) TO ILLER BANKASI WITH THE GUARANTEE OF THE REPUBLIC OF TURKEY FOR THE MUNICIPAL SERVICES PROJECT May 27,2005 Report No: TR This document has a restricted distribution and may be used by recipients only in the performance of their official duties. Its contents may not otherwise be disclosed without World Bank authorization.

2 CURRENCY EQUIVALENTS Currency Unit = TL (Turkish Lira) - until December 31,2004 = YTL (Yeni Turkish Lirasi)- from January 1, YTL = 1,000,000 TL 1 Euro (e) = 1.29 US Dollar ($), using exchange rate on April 30,2005 FISCAL YEAR January 1 - December 31 ABBREVIATIONS AND ACRONYMS EU Bank BRSA CAS CFAA CPAR CQ ESW Debt Law FI FMR GDP IAS IB IC ICB IDF IFRS European Union World Bank Banking Regulation and Supervision Agency (BDDK in Turkish) Country Assistance Strategy Country Financial Accountability Assessment Country Procurement Assessment Review Consultant Qualifications Economic and Sector Work Law on Regulating Public Finance a md Debt Management Financial Intermediary Financial Monitoring Reports Gross Domestic Product International Accounting Standards Iller BankasYIller Bank Individual Consultant Intemational Competitive Bidding Institutional Development Fund Intemational Financial Reporting Standards ISA JICA MIS MoU LCS NCB OM PHRD PMU QCBS SA SBD SEE SIL SOE SPO TA UFW International Standards on Auditing Japan International Co-operation Agency Management Information System Memorandum of Understanding Least Cost Selection National Competitive Bidding Operational Manual Policy and Human Resources Development Fund Project Management 1Jnit Quality and Cost Based Selection Special Account Standard Bidding Documents State Economic Enterprise Specific Investment Loan Statement of Expenditure State Planning Organization Technical Assistance Unaccounted for Water Vice President: Country ManageriDirector: Sector Manager: Task Team Leader: Shigeo Katsu Andew N. Vorkink Sumter Lee Travers Sudipto Sarkar

3 ... TURKEY Municipal Services Project FOR OFFICIAL USE ONLY CONTENTS Page A. STRATEGIC CONTEXT AND RATIONALE Country and sector issues... 1 Rationale for Bank involvement... 6 Higher level objectives to which the project contributes... 7 B. PROJECT DESCRIPTION Lending instrument... 7 [If Applicable] Program objective and Phases... 7 Project development objective and key indicators... 7 Project components... 8 Lessons learned and reflected in the project design Alternatives considered and reasons for rejection C. IMPLEMENTATION Partnership arrangements (if applicable) Institutional and implementation arrangements Monitoring and evaluation of outcomes/results Sustainability Critical risks and possible controversial aspects Loadcredit conditions and covenants D. APPRAISAL SUMMARY Economic and financial analyses Technical Fiduciary Social Environment Safeguard policies Policy Exceptions and Readiness This document has a restricted distribution and may be used by recipients only in the performance of their official duties. Its contents may not be otherwise disclosed without World Bank authorization.

4 Annex 1: Country and Sector or Program Background Annex 2: Major Related Projects Financed by the Bank and/or other Agencies Annex 3: Results Framework and Monitoring Annex 4: Detailed Project Description Annex 5: Project Costs Annex 6: Implementation Arrangements Annex 7: Financial Management and Disbursement Arrangements Annex 8: Procurement Annex 9: Economic and Financial Analysis Annex 10: Safeguard Policy Issues Annex 11 : Project Preparation and Supervision Annex 12: Documents in the Project File Annex 13: Statement of Loans and Credits Annex 14: Country at a Glance MAP IBRD 33685

5 Date: May 27,2005 Country Director: Andrew N. Vorkink Sector Managermirector: Sumter Lee Travers Project ID: PO TURKEY MUNICIPAL SERVICES PROJECT PROJECT APPRAISAL DOCUMENT EUROPE AND CENTRAL ASIA ECSIE Team Leader: Sudipto Sarkar Sectors: General water, sanitation and flood protection sector (70%);Sub-national government administration (30%) Themes: Municipal finance (P);Other urban development (P) Environmental screening category: Financial Intermediary Lending Instrument: Specific Investment Loan Safeguard screening category: Financial Intermediarv Project Financing Data [XI Loan [ 3 Credit [ 3 Grant [ ] Guarantee [ ] Other: For Loans/Credits/Others: Fixed Spread Commitment Linked Loan Total Bank financing: 212,900,000 (US$275.0m equivalent) Proposed terms: (a) Term: FSL with 17 years maturity; (b) Grace: 5 years, level repayment of principal; (c) Front-end Fee: 100 basis points, less existing waivers; (d) Commitment charge: 85 basis points, for the first four years; thereafter 75 basis points, less any waivers in effect; and (e) Interest: LIBOR plus spread. BORROWER RECONSTRUCTION AND DEVELOPMENT (including Front-End Borrower: Iller Bank; Yeni Ziraat Mahali 14 Sokak, Diskapi; Ankara, Turkey Tel: Fax: Contact: Mr. Hidayet Atasoy, General Director

6 Remonsible Agencv: Treasurv is the Guarantor of the loan :Y I hual hmulative Does the project depart from the CAS in content or other significant respects? Re$ PAD A.3 Does the project require any exceptions from Bank policies? Re$ PAD D. 7 Have these been approved by Bank management? [s approval for any policy exception sought from the Board? Does the project include any critical risks rated substantial or high? Re$ PAD C.5 Does the project meet the Regional criteria for readiness for implementation? Re$ PAD D. 7 Project development objective Re$ PAD B.2, Technical Annex 3 [ ]Yes [XINO [ ]Yes [XINO [ ]Yes [ IN0 [ ]Yes [XINO [XIYes [ ]No [XIYes [ ]No Sumort sustainable environmental services in selected munichalities Project description [one-sentence summary of each component] Re$ PAD B.3.a, Technical Annex 4 The project will have the following three components: a) Municipal Development to support investments in the water, wastewater, and solid waste sectors; b) Municipal Technical Assistance to support preparation of feasibility studies, urban planning, preparation of bidding documents, and utility operational improvement plans; and c) Iller Bank Institutional Strengthening to increase the financial and technical capacity, suppor. incremental operating costs, and prepare audits Which safeguard policies are triggered, if any? Re$ PAD D. 6, Technical Annex 10 Environment Assessment Involuntary Resettlement (land acquisition only) Significant, non-standard conditions, if any, for: Re$ PAD C.7 Board presentation: June 23,2005 Loadcredit effectiveness: September 15,2005 Covenants applicable to project implementation: They are summarized in the PAD

7 A. STRATEGIC CONTEXT AND RATIONALE 1. Country and sector issues On December 17, 2004, the European Union (EU) invited Turkey to begin negotiations in October 2005 to be a member of the EU Union. This agreement is a significant event for the country and shows Turkey s commitment towards making sustainable economic, social, and political reforms. At the same time the country has recovered from the economic and financial crisis of The GNP has been growing at a fast pace in recent years (2002: 7.9%; 2003: 5.9%; 2004: 9.6%) and the current positive macroeconomic situation allows the policy makers to move from crisis management to systemic solutions in a number of areas that are relevant for EU accession. Environment investments related to EU accession will be large. In response to the EU decision to invite Turkey for accession negotiations, Turkey is considering institutional arrangements and realignment of laws to be in compliance with the EU directives. The total cost of compliance to meet the EU environmental directive is expected to exceed US$ 40 billion between 2005 and This cost includes a cost of over US$ 20 billion for the water, wastewater, and solid waste sectors. Rapid urbanization also leads to high investment costs and Turkey spends about 2% of GNP on an annual basis for capital investments at the local level, which represents about 50% of the local government expenditure. Currently, 70% of Turkish citizens live in urban areas and this urbanization rate is expected to increase to 85% before it stabilizes. This high urbanization leads to demand for core municipal services that include water, wastewater, and solid waste management, and transportation. Given this high rate of urbanization and the need to meet EU environmental directives, Turkey will have to sustain a high level of investments at the local level to develop the infrastructure. Further, it is also important for policy makers to ensure that quality services are sustained. This project will focus on water, wastewater, and solid waste investments and will contribute towards developing the infrastructure and promoting sustainable services. Some of the issues faced in the sector are summarized below: Watermastewater Cost coverage varies: The average water supply tariff is US$0.70 per cubic meter in metropolitan areas and around US$ 0.42 in non-metropolitan areas. In general, most medium sized to large municipalities (population > 100,000) are able to cover their costs. However, smaller and poorer municipalities have difficulties in fully covering the costs; Inefficient operations: The average Unaccounted for Water (UFW) is around 50% of production. This figure is high compared to some of the EU countries: Germany (1 0%); France (25%); England (around 25%); and Austria (10%). Thus, it is important to focus on reducing UFW through administrative measures and rehabilitation of pipes to prevent commercial and physical losses, respectively; and 1

8 e Policies on central government support for the sector are not fully in place: The nature of the water and wastewater business is such that it often requires public support for investments. The involvement of the public sector is often justified since the investments generate positive externalities such as better environment, reduction of water borne disease, and increased tourism. All EU countries have provided support for the development of the water and wastewater sector with a wide range of investment subsidy (3-24% of costs) and instruments (budget support, tax advantages to utilities, partial debt service coverage by the central government, and waiver of fees and charges due to the central government). The countries that joined the EU in May 2004 also receive investment subsidies in the form of EU cohesion and structural fund grants. Turkey will need to develop policies in providing assistance to the water and wastewater utilities, especially in the poorer areas of the country. The assistance from the central government should be: fiscally sound, based against pre-determined criteria to make objective decisions on the eligibility for assistance, and linked to improved operating efficiency. The type of instrument to be used should be determined based on a review of various methods used in the EU countries. Solid Waste Management e There is a shortage of proper sanitary landfills in the country: Most of the wastes generated in the country are disposed of in about 2,000 small scale and 50 large dump sites. The disposal is not controlled and the dump sites pose an environmental and health risk. There are about 11 sanitary and controlled landfills that serve about 20% of the population. To meet the EU directives on solid waste management, Turkey would have to construct more sanitary landfills. The issue of not having adequate landfills should be addressed urgently as the per capita solid waste generation is increasing: Between 1995 and 2002 there has been an annual increase of 3.5% of household waste generated in the country'. Currently the per capita waste generation is around 1 kg/day. However this number is expected to increase to 1.5 to 2.5 kg/day as income level rises. The increase in waste generation is a concern for policy makers and measures to dispose of the waste in an environmentally safe manner and reduce the volume of waste through recycling should be considered; and e Costs are not covered and are not linked to the service: The fees are not sufficient to meet costs, especially investments. A fee of around US$ 0.07 (fixed at 100,000 TL) per cubic meter of water sold is charged to water users. Linking a solid waste management fee to water consumption is not appropriate. The users should be charged separately for solid waste services and the level of fees should reflect the cost of service provision. Technical Assistance for Environmental Heavy Cost Investment Planning; ENVEST; September

9 Government Actions The government recognizes the importance of providing good quality municipal services and to start preparations to meet EU directives. To this end, it is pursuing activities related to municipal reform so that municipalities and their utilities have more resources, follow prudent financial management practices, and report on performance and financial matters to the central government on a regular basis. The government has also initiated reforms in Iller Bank (B), which transfers central government taxes to the municipalities on a monthly basis and provides technical assistance, loans, and grants to municipalities. Municipal Reform There are 3,225 municipalities that have a mandate to provide the basic infrastructure services - water, wastewater, transportation, solid waste management - which account for the bulk of their expenditures. Details of the revenues and expenditures of local govemments are provided in Annex 1. The sector faces the following challenges from the service delivery and investment perspectives: a e Financial resources are inadequate at the local level: In aggregate, there is a chronic financing gap at the local level given the amounts of financing and the levels of municipal expenditure. However, the situation is not uniform across the country. The metropolitan municipalities are financially better placed, in relative terms. On a per capita basis, the metropolitan municipalities receive more tax transfers from the central government compared to non-metropolitan municipalities; Financial management at the local level is limited: Municipalities often do not manage their limited resources prudently, contributing to the problem of a perpetual financing gap. Public expenditure management reforms have started in the country and the government is taking measures to implement the reforms at the municipal level; and a The municipal debt market is not developed: Long term capital, typically needed for municipal infrastructure development, is only available through government sources in the country, including loans from International Financial Institutions (IFIs) backed by a Treasury guarantee. This lack of long term capital and the inadequate financial resources and management at the local level have not allowed the municipal debt market to grow, which in tum has affected municipal development. The total local government borrowings from domestic banks are very small compared to the assets of the banking sector. At the end of 2003, total local government domestic borrowings were 1,336 trillion TL (1,129 trillion TL with Iller Bank; and 207 trillion TL with deposit money banks), which represents about OS%* of the entire banking sector assets. In the absence of long-term funds, municipalities use their current revenues and shortterm borrowings to finance investments. Reliance on hlly financing investment costs from current revenues is sub-optimal because it makes the current generation pay for the * Borrowings in Local Governments ; Messrs. Ferhat Emil and H. Hakan Yilmaz, September

10 hll investment compared to a scenario where investment costs could be financed through loans repaid through imposition of user fees and taxes over the life of the assets financed. In 2004, the government submitted a number of laws to the Parliament related to public and local administration. These laws support proper allocation of responsibilities between the central and local administrations, elimination of unfunded mandates, an increase in accountability at the local level, and delivery of quality service. e e e in July 2004, the Parliament approved the Public Administration Framework Law which is the basic law that governs responsibilities of central and local authorities. This law, however, is not yet in effect; in July 2004, the Metropolitan Municipal Law was approved by the Parliament and the law is now effective. The law increases the physical areas to be covered by these municipalities by including the adjacent settlements under the jurisdiction of the metropolitan administration. This will increase the infrastructure development requirements of the metropolitan municipalities since the adjacent settlements often do not have the same level of infrastructure compared to the metropolitan area. The project includes three metropolitan municipalities; and in December 2004, the Parliament approved the Municipal Law (the law is in effect but is currently being examined by the Constitutional Court). The essence of this law is to enhance municipal financial management, strengthen the local institutional capacity, and increase local revenues. Also, the law emphasizes the need to provide quality service and the financial and service quality will be monitored on a regular basis. The Municipal Law outlines borrowing principles that will bring about financial discipline in the municipalities. The law also requires municipalities to submit their financial position on a quarterly basis to the Ministry of Interior, Ministry of Finance, State Planning Organization, and Treasury. Failure to comply with the law will lead to the application of the Turkish penal code on the responsible municipal officials. The government is now considering the revision of the Municipal Revenue Law that will increase the taxes and tariffs that were not updated since The Municipal Revenue Law also proposes to simplify the local revenue system by eliminating local taxes where administrative costs are higher than the collection. Furthermore, the law proposes to introduce a hotel tax that will help finance the infrastructure in areas that attract tourists. Iller Bank Reform In 1933, Iller Bank (IB) was established as a municipal bank with a purpose of providing financial resources to the municipalities and it carries out two essential hnctions: transfer central tax revenues to the local authorities on a monthly basis, and support infrastructure development at the local level through technical assistance, loans, and grants. Some key features of IB relative to municipal sector development are summarized below and details are provided in Annex 9. 4

11 0 IB has about 3,500 staff with expertise on technical, financial, accounting, and legal matters. About 55% of its staff are based in the eighteen regional offices throughout the country; 0 By law, all municipalities contribute towards the equity of the bank. Through a decision of the government in May 2004, the capital of IB was increased to 3 quadrillion TL to be gradually paid by municipalities before This capital can be increased further through a decision of the government. IB uses this equity as a primary source of capital for investments. It is not a deposit taking bank and has not raised funds from the market; 0 Traditionally, IB s total loans to municipalities have been in the range of US$ million annually. These loans have been for equipment, infrastructure development, and working capital. In terms of the entire banking sector, IB is not a significant player and its assets represent about 0.9% of the entire banking sector assets3. IB s share of financing the municipal sector is low, compared to the total capital investments at the local level which have been around US$ 4-5 billion per year in recent times. Most of the financing at the municipal level has come from the revenues rather than borrowings and there are no restrictions for private banks to lend to municipalities. The central government, however, would like IB to provide more loans in the future and to this end, reforms in the institution are being planned; 0 About 6% of national taxes are transferred back to all the municipalities through IB. This transfer represents the central government s share of financing municipal expenditures. By law, IB is able to intercept the transfers in lieu of debt service for an IB loan to a municipality, in case of debt service default by a municipality; 0 IB also transfers grants to municipalities for investments. Traditionally, about 10% of the investments supported by IB have been funded through grants; and 0 IB provides Technical Assistance to municipalities, especially the ones that are small and have limited institutional capacity. The TA includes preparation of surveys and construction supervision. Reforms in Iller Bank were identified in the Eighth Five Year Development Plan (covering 2001 to 2005), given the mandate of the institution to develop municipal infrastructure. Recently, the reforms in IB have taken on special significance as the institution will play an important role in implementing upcoming EU grant programs. To this end, the government is carrying out the following tasks: e it initiated the development of the Iller Bank Strategy under the leadership of State Planning Organization (SPO). The strategy has been drafted and is expected to be finalized by October The strategy includes the following objectives: (a) provide service to municipalities in a timely manner; (b) strengthen the banking function of IB; September 30, total banking assets: US$ billion; IB assets: US$ 1.81 billion. Source: Banks Association of Turkey ( tbb.orn.tr/enrzlishlbulten/3%2oavliwtoplumalitablolar/200409/tables-usd/default. htm) 5

12 (c) complete projects to meet the needs of municipalities; (d) ensure that proper technology is used; (e) improve the quality of staff in IB; and (f) ensure efficient use of public resources so that loans are repaid in a timely manner, the capital of the bank is utilized more economically, and the financial management of the bank improves. Among other things, the strategy specifically notes that IB has an ideal opportunity to be involved in helping municipalities meet EU directives; and that IB will play a key role in implementing environmental activities; and e it has drafted amendments to the Iller Bank Law. The main features of the law are to strengthen the financial and technical function of IB, and create an internal audit and a risk management unit as per the requirements of the Turkish banking legislation (Annex 9). The proposed amendments to the law are expected to be sent to the Parliament after the Iller Bank Strategy is finalized. 2. Rationale for Bank involvement The Country Assistance Strategy (CAS), dated October 2, 2003, aims at reducing the risk of reemergence of crisis in Turkey and helping the country address economic challenges of preparing for EU membership. The CAS presents four development themes: (a) sound macroeconomics and governance; (b) equitable human and social development; (c) attractive business climate and knowledge; and (d) strong environmental management and disaster prevention. At a policy level, the government and the EU expect that the Bank will assist Turkey in its EU accession process. Collaboration among the government, EU, and the Bank on this project is an example of this understanding. The project will support the government s plans to provide basic urban services and comply with EU environmental directives. Further, as an implementing agency of the project, IB s capacity to appraise and supervise Sub-projects will increase. This is relevant since the government is considering to use IB as an agency that will help in the implementation of the upcoming EU programs. The project is aligned with the fourth development theme since it will support environmental improvements at the municipal level. Specifically, the CAS mentions that the project will help to improve services. This will be achieved through the proposed investments and institutional strengthening components of the project. The Bank has been involved in the municipal sector in Turkey through a number of water and wastewater projects and through economic and sector work (ESW). The involvement of the Bank will be a continuation of the ongoing dialog between the Bank and the key stakeholders. Lessons learned from past activities have been incorporated in the project design. 6

13 3. Higher level objectives to which the project contributes The project contributes to the overall municipal sector development in the following ways: 0 Support Turkey s intent to meet EU s environmental directive: The investments will contribute towards meeting EU s directives on water, urban wastewater, and solid waste management. Further, through the project, IB will be strengthened and this is in line with the government s plan to use the institution as an implementing agency for upcoming EU programs; 0 Promote efficiency of investments: At the feasibility study stage, analysis will be carried out to ensure that viable investments are being supported and the procedures followed under this project could be replicated in other municipal investments. A debt-service coverage ratio (at least 1.2) will be used to test the affordability of investments; and 0 Promote efficiency of operations: Every Sub-proj ect will have an institutional component at the municipal level to promote operational efficiency and to increase the financial strength of utilities. The procedures followed under this project could be replicated in other municipal investments in Turkey. B. PROJECT DESCRIPTION 1. Lending instrument This project will be processed as a Specific Investment Loan (SIL). 2. [If Applicable] Program objective and Phases Program objective and Phases are not applicable for a SIL. 3. Project development objective and key indicators The objective of the project is to support sustainable environmental services in selected municipalities. To meet this objective the project will: 0 support the development of municipal infrastructure to improve the environment and quality of water, wastewater, and solid waste management services. This development will be measured by the following indicators: reduction in water losses, increased volume of wastewater treated, increased number of water and sewerage connections, and use of a sanitary landfill. Satisfactory output indicators will be a Sub-project financing eligibility criterion; 0 support the utilities to strengthen their financial position, improve operational efficiency, and prepare and implement projects. This would be measured by the following 7

14 indicators: improvement in working ratio, reduction of unaccounted for water, and successful completion of projects. An Operational Improvement Plan will outline the plans of municipalities and their utilities to improve their institutional and financial position and will be a Sub-project financing eligibility criterion; and a support the institutional strengthening of IB so that it is able to implement the project in a satisfactory manner. The above mentioned key indicators at the Sub-project level will be monitored through the Subloans and IB will report the performance of each Sub-project through the Project Progress Report. The overall project progress would be measured by the aggregated performance of individual Sub-proj ects. 4. Project components The project will have three components. The Bank loan will be denominated in Euros and will be equivalent to US$ 275 million. In components 1 and 3, the counterpart funds will be provided by the municipalities and IB, respectively. The front end fee will be borne by IB which will pass the cost to the municipalities. Preparation work has started through a PHRD grant of US$ 500,000 which was signed on May 4, Component 1 : Municipal Development - Eligible expenditures under this category would be for the water, wastewater, and solid waste sectors. Investments have been proposed by IB and the PHRD grant is financing feasibility studies in a number of municipalities to confirm the viability of the investments. Indicative investments are shown in Table 2. The project implementation arrangements outline Sub-borrower and Sub-project eligibility criteria (Annex 6). IB will carry out the due diligence on appraising each Sub-proj ect and will also be responsible for supervision. Without prior approval of the Bank, no other municipality will join the project and it would have to meet the Sub-borrower eligibility criteria. The municipalities that have been included in the project were short listed from the demand survey conducted by IB. In the survey, about ninety municipalities showed interest to participate in the project from which the fourteen municipalities shown below were chosen based on their current financial standing (no overdue payments to IB). These municipalities have all signed a Memorandum of Understanding (MoU) with IB through which an agreement has been reached that the PHRD grant will finance the feasibility studies that will help define the investments. 8

15 e Component 2: Municipal Technical Assistance - Eligible expenditures under this category will be for municipalities for the following purposes: (a) feasibility studies; (b) urban planning; (c) preparation of design and bidding documents; (d) Operational Improvement Plan related to institutional, technical, financial, and environmental matters. All Sub-projects will have an Operational Improvement Plan; and (e) construction supervision. The expenditures will be financed through Sub-loan proceeds from IB. e Component 3: Iller Bank Institutional Strengthening - Eligible expenditures under this category will include technical assistance to Iller Bank so that it is able to implement the project and the Action Plan (below) in a satisfactory manner. The expenditures will be financed fiom IB s own resources and the Bank loan. Eligible expenditures under this category will be: (a) increasing financial and banking capacity; (b) increasing technical capacity; (c) incremental operating costs; and (d) audits. 9

16 The project s Action Plan includes key items that increase transparency in operations and supports the needs of the municipalities. Satisfactory implementation of this Action Plan by IB is a covenant in the Loan Agreement. The institutional strengthening of IB will be in line with the ongoing government reforms of the agency. In this context, IB will share the Iller Bank Strategy and the proposed amendments to the Iller Bank Law with the Bank to allow exchange of views on these documents. Table 3 ACTION PLAN June 30,2005: Report loans and grants separately. They are currently accounted separately but reported jointly. Separation of the grants will also help with the upcoming EU programs June 30, 2005: Post IB s quarterly financial statements on the internet, updating it quarterly and explicitly showing overdue payments January 1,2006: Working with the SPO, develop explicit policies to provide assistance to small and poor municipalities and for water and wastewater investments with positive environmental externalities January 1,2006: Allow municipalities to access the following information via the internet: Debt service payments, tax transfers, and the level of intercepts January 1,2006: Complete the E-transformation process to provide better financial and technical information within IB January 1, 2006: IB will hire: a) financiabanking consultants for risk management, internal auditing, and training; and b) technical consultants for project appraisal from a technical and financial standpoint. 6 months after passage of new Iller Bank Law, IB will establish: a) an Internal Audit Unit; and b) a Risk Management Unit. 5. Lessons learned and reflected in the project design The Bank has been involved in the Turkish municipal sector for a number of years and the lessons learned from the various Implementation Completion Reports, audit reports, and sector reports are summarized below. Investment pipeline for projects should be strong: Very often in projects where the Bank s loan is administered by an implementing agency which provides Sub-loans to the final beneficiaries, the emphasis is on developing the procedures on the use of the Bank loan funds. This reduces the emphasis on the investment pipeline creating a risk of insufficient demand of the Bank loan funds. In this project, the Bank loan amount is based on preliminary assessment of the feasibility studies in pre-identified municipalities. In addition, IB has a pipeline of investments with other municipalities and will be able to rapidly prepare Sub-projects, if needed. Thus, the risk of a low demand for the Bank loan fund is modest; 0 Focus on improving the efficiency of operations and investments: While investments are necessary, there is a need to focus on operating efficiency. Thus, a satisfactory Operational Improvement Plan is a Sub-proj ect eligibility criterion through which efficiency gains will materialize - reduction of water losses, increase in bill collection etc. In addition, investment decisions have not always been economic in the past. The feasibility studies and subsequent Sub-project appraisal by IB and review by the Bank will ensure that the investments are economically justified; 10

17 0 Focus on institutional aspects of Sub-projects: The past Bank projects were successful in completing the physical infrastructure but there were difficulties in meeting the institutional and financial objectives. Under the past projects, the Loan Agreements were between the municipalities and the Bank with the Treasury as the Guarantor. Under this project, the Borrower will be Iller Bank, a public agency that will on-lend the Bank loan proceeds to the municipalities. By having a public agency with considerable municipal expertise and experience as a Borrower, the government will be able to better implement its institutional and financial policies at the local level; and 0 Focus on institutional aspects for using EU funds: The absorption rate of EU grant funds for environmental investments has been low in countries that have recently joined the EU or are in the accession process. The main reason for delays in utilizing EU grant funds is inadequate institutional arrangement to prepare, appraise, and implement projects. To overcome this problem, the government is already making plans to strengthen IB so that it is able to implement the EU environmental programs. The project will support the plans of the government through the Iller Bank s Institutional Strengthening component. 6. Alternatives considered and reasons for rejection 0 Use commercial banks to on-lend to municipalities: The use of commercial banks, rather than IB, was considered. However, this option was not pursued for the following reasons: (a) the government requested the Bank to work with IB as the Borrower so that the institution gains experience in project appraisal and supervision. IB is a specialized public institution for local infrastructure development and the government plans to promote the role of the institution to address basic service needs at the local level in line with EU environmental directives; and (b) IB has a long standing relationship with all municipalities, which are its shareholders, and is well placed to implement the project. The institution has a core competency in the water and wastewater business, representing about 95% of its loan assets, that will simplify project arrangements since IB will be able to handle both technical and financial issues; 0 Completely restructure IB, prior to making the Bank loan: Completely restructuring IB - change in governance structure, separation of technical and financial functions, capitalizing the bank through the market, amending the Iller Bank Law - prior to making the Bank loan was considered. However, it was felt that these reforms would be medium term in nature and critical investments related to the environment should not be delayed if they can be justified. The government also wanted to follow a well thought out reform in the bank. To this end, it is now drafting a Iller Bank Strategy which will be the basis for the amendments to the Iller Bank Law; 0 Direct lending by Bank to municipalities: Direct lending by the Bank to municipalities was considered. However, reviewing the wide range of municipal demands, spread across the country, it was felt that it would be difficult for the Bank to directly prepare and supervise multiple activities. IB was chosen as the implementing agency as it has the 11

18 mandate and the capacity to develop municipal infrastructure and is fully supported by the central government; and Limiting sector focus: Municipalities are responsible for the provision of multiple infrastructure services but the project focuses on water, wastewater, and solid waste management. This decision was taken since these sectors represent the largest cost to meet EU s environmental directives. Further, these sectors are financed through tariffs that are under the control of municipalities and not backed by taxes that have competing demands and are not under the control of the municipalities. Under the Sub-projects, municipalities will be required to adjust tariffs to meet costs. C. IMPLEMENTATION 1. Partnership arrangements (if applicable) The government is planning to direct EU assistance towards IB, starting in 2006, so that the institution is well placed to implement EU programs in the future. To this end, the Bank will coordinate both with the government and EU to ensure that any assistance to IB is complementary in nature. 2. Institutional and implementation arrangements This operation supports public sector infrastructure development and IB, as an agent for the central government to serve local administration, will implement the project and use the Bank loan proceeds to lend to municipalities. The operation is not characterized as financial intermediary lending, where the Bank s Operational Policy 8.30 would apply, for the following reasons: IB s loans are effectively guaranteed by the central government by virtue of the ability of the institution to withhold central government tax transfers to municipalities in lieu of debt service. Municipal revenues, the source of the debt service for the loans made by IB, are heavily dependent on central government transfers. Currently, about 45% of municipal revenues originate from the central government; IB s capital mainly comes from legally mandated equity contributions from municipalities, which are its shareholders and borrowers. IB has not raised funds from the market and as a result it has no outstanding financial liabilities; The Sub-borrowers in the project have already been pre-identified and individual Subloans are subject to explicit approval of the Bank, based on Sub-proj ect eligibility criteria. IB has the capacity to implement the project and due to its central tax transfer function, the institution is in regular contact with all municipalities. It has specialized water and wastewater departments that currently appraise and finance projects. The institution also has eighteen 12

19 regional offices that will help to prepare and supervise projects. A Project Management Unit (PMU) within IB was established in April 2005 and will be responsible for co-ordinating activities and be the primary contact point for the Bank. The PMU comprises a Director and four staff members with technical and banking qualifications. The PMU Director and the staff are all employed by IB. The PMU will draw upon other staff within the bank, as needed. Apart from the PMU, IB s Project Appraisal Unit will help to prepare the project. Project supervision will be carried out by IB s Water Supply Department and Sewerage and Wastewater Department, both of which have staff based in Ankara and the regional offices. Municipalities that have been selected will have to meet the Sub-borrower eligibility criteria. IB will have to ensure that Sub-project eligibility criteria are met. The details of the on-lending conditions are presented in Annex 6. The Mid Term Review of the project will be carried out by September 30, Monitoring and evaluation of outcomes/results The parameters to measure outcomes on quality local service delivery will be outlined in the feasibility studies and included as benefits of the project. The Project Progress Report will provide information on: 0 success in meeting the environmental objective of the project measured through wastewater treated, water loss reduced, sewerage connections increased, and disposal of waste in an environmentally safe manner; e improvements in the financial position and operational efficiency through indicators like improvement in working ratio, and reduction of unaccounted for water; and 0 status of the technical assistance program in Iller Bank, including the status of the Action Plan. The Project Progress report will be submitted to the Bank on a semi-annual basis. On an annual basis, an independent auditor will audit IB as per international standards and the audit report will be made available to the Bank. 4. Sustainability The government is emphasizing the delivery of local services as seen through the passage and discussions of various laws related to municipalities and their services. The intent of Turkey to meet EU directives on environment has also created the need to look into municipal development in a more holistic manner. Thus, the assets created by the project are expected to be maintained for the provision of services. The project supports basic services such as provision of potable water and wastewater treatment. The risk of these services being discontinued is negligible. The financial analysis carried out as part of project preparation will ensure that tariffs are adequate to cover investment and operational costs. The technology used for the proposed investments is well tested and the risk 13

20 of operational failure is low. Further, the technology used will have to be justified as part of the Sub-project approval process. These factors will ensure the sustainability of investments. 5. Critical risks and possible controversial aspects Full development of the municipal sector will take time as it is related to efficient implementation of the public administration and municipal laws, some of which are still not effective. Further, changes would have to take place in the financial sector so that long term capital is available to support a municipal debt market. However, important environmental investments should not be delayed and should be completed if they can be justified on a case by case basis. The project takes this approach by selecting municipalities with relatively good financial standing and environmental needs. Prior review of investments by IB and the Bank will ensure that the investments are justified. All municipalities and investments will have to meet the Sub-borrower and Sub-project eligibility criteria. The risk of not meeting the project development objective is substantial since the overall governance structure of IB makes it subject to political interference. IB may be asked to grant favors to municipalities (debt forgiveness, collect less than what is due from municipalities, provide free services) that would affect the project. To mitigate this risk, the project design includes : e e A ring fenced approach where the project activities are separated from the rest of the operation of IB through technical and financial covenants in the Bank s Loan Agreement, some of which will also be reflected in the Sub-loan Agreement. Failure to implement the covenants in a satisfactory manner would lead to remedial actions, including suspension of the loan; and Assurance from the government that it would facilitate project implementation. This assurance will be sought through the Guarantee Agreement since the government has full administrative and financial control over IB. 14

21 Risk Mitigation Measure To Project Development Objectives IB may be asked to grant favors The project will be ring fenced - to municipalities. This may affect key technical, financial, and the project reporting requirements will be same for IB and the municipalities - v Risk Rating S The Guarantor will provide assurances that IB will be able to implement the project in a delayed due to lack of counterpart funds and political commitment; construction delays; and non-familiarity with Bank procurement procedures Sub-projects will ensure that the projects are viable, affordable, and simple. These factors are included as Sub-project financing criteria. The signing of Subloans by municipalities will indicate the commitment on the part of municipalities IB may not be able to effectively supervise the project due to lack of co-ordination among the involved departments The PMU is authorized to coordinate activities among various departments. Further, the PMU is adequately staffed and can draw on consultants as required Municipalities may want to Adequate planned expenditure on M minimize expenditure on Technical Assistance which would prevent planned and technical assistance and an Operational Improvement Plan will be a Sub-project financing sustained development criteria Implementation of the IB s In the Guarantee Agreement, M Technical Assistance delayed assurances will be provided by the government that it will facilitate satisfactory implementation of the project and implementation of the Action Plan Risk Rating: H = High; S = Substantial; M = Modest; N = Negligible or Low M 15

22 6. Loadcredit conditions and covenants Effectiveness Condition a a at least two Sub-loan Agreements signed; and satisfactory legal opinions on the Loan Agreement, Guarantee Agreement, and Sub-loan Agreement provided to the Bank. Loan Agreement Covenants IB will: hire an auditor in accordance with terms and conditions agreed with the Bank by November 30, International Financial Reporting Standards (IFRS) will be applicable for the financial statements of IB and the project. These statements will be audited annually as per international auditing standards; submit a Procurement Plan by October 1,2005; share the Iller Bank Strategy and the proposed amendments to the Iller Bank Law with the Bank to allow exchange of views on these documents; ensure that qualified and adequate staff are assigned to implement the project; select municipalities and municipal utilities based on the Sub-borrower eligibility criteria; appraise projects based on the Sub-project eligibility criteria; implement the Action Plan in a satisfactory manner; submit a Project Progress Report to the Bank semi-annually; submit a Financial Monitoring Report to the Bank on a quarterly basis; submit an updated Procurement Plan to the Bank on a semi-annual basis; open an escrow account where the debt service requirements for the Bank loan will be set aside; maintain a debt service coverage of at least 1.2 throughout the duration of the project; enter into Sub-loan Agreements satisfactory to the Bank and maintain such subsidiary agreements throughout the duration of the project; and 16

23 e use the Operational Manual of the project for guidance on the use of the Bank loan funds. The Financial Management Manual will be part of the Operational Manual. D. APPRAISAL SUMMARY 1. Economic and financial analyses The economic analysis of the investments will be conducted as part of the feasibility assessment of each Sub-project. The benefits of the investments will be compared against the costs. The financial analysis of the investments will also be conducted as part of the feasibility studies. The affordability of tariffs will be taken into account as part of the analysis. The feasibility studies are being conducted by consultants, financed by the PHRD grant, under the supervision of IB. The Bank s approval to the investments would be based on Sub-borrower and Sub-project eligibility criteria. Overall, the financial situation in IB is stable due to capital contributions by municipalities. At the same time, IB does not have financial liabilities since it has not raised hnds fi-om the market and it is not a deposit taking institution. Loans made by IB have a cash collateral as by law the institution can intercept the tax transfers in lieu of debt service payments. However, the interception is not always used uniformly which resulted in overdue payments to the institution (principal, interest, and penalties) at the end of In 2005, these overdue paymentsrepresenting about 28% of the equity of the institution - were restructured into 3 years loans. For purposes of the project, the ability of IB to service the Bank loan is assured through the use of an escrow account where the municipalities will deposit their debt service and through the liquidity of IB due to the capital contributions of municipalities. Key financial covenants for the Loan Agreement are: e Creation of an escrow account in IB where municipalities will deposit their debt service payments. Funds in this escrow account will be utilized to repay the Bank; and e The debt service coverage for IB and the municipalities will be at least Technical The techndlogy to be used under the project is standard and well tested. As part of the feasibility studies, the consultant will suggest technical solutions that are viable, cost efficient, and have minimal operating costs. IB has the capacity to review the work of the consultants carrying out the feasibility studies and also will be supported by an independent consultant - financed by the PHRD grant - during the review. The investments have to be technically viable as a Sub-project eligibility criterion. 17

24 3. Fiduciary Procurement The overall procurement risk is rated high since IB and the municipalities are not familiar with the Bank s procurement procedures. However, this rating can be revised in the future as IB and the municipalities get more familiar with Bank s procurement processes. IB has significant procurement capacity on Turkish procedures and it is expected that it would be able to quickly and satisfactorily follow Bank procedures. The IB Institutional Strengthening of the project allows for procurement training of IB staff on this matter. Over the years, IB has developed substantial capacity in preparation of bidding documents, launching of contracts, record keeping, and supervising contracts as the bank carried out procurement activities on behalf of municipalities. This experience will be useful for IB to supervise procurement activities and assist municipalities, if needed, under this project. For works contracts less than US$ 5 million, IB will have the option to use the Bank s sample bidding document for National Competitive Bidding (NCB) with the Bank s procurement procedures. IB will also be given an option to use local NCB documents and procedures stipulated in the Public Procurement Laws (Law No: 4734 & 4735) under certain provisions required by the Bank (Annex 8). Based on the performance of the PMU, the threshold for NCB may be increased one year after the loan is effective. Financial Management The financial management assessment of IB has been completed and the overall rating is satisfactory (Annex 7). The assessment of the implementing entity, fund flow arrangements, staffing, accounting policies and procedures, reporting and monitoring, and information system was satisfactory. IB does not perform internal audits and amendments to the Iller Bank Law propose to create an internal audit department along with a risk management department. On external audits, IB is audited by auditors acceptable to Banking Regulation and Supervision Agency (BRSA) in accordance with Accounting and Auditing standards also published by BRSA. IB is also audited by the Higher Audit Board and the report is sent to the Parliament. IB has agreed that it will hire an external auditor to carry out the annual audits of the institution and the project as per International Financial Reporting Standards (IFRS). The Terms of Reference of the audit have to be acceptable to the Bank. IB will prepare financial statements and maintain records to ensure appropriate accounting of the loan funds. The Financial Monitoring Reports (FMR) will be prepared quarterly and will be submitted to the Bank no later than 45 days after the end of the quarter. The format and the content of the FMRs are outlined in the Operational Manual. 18

25 4. Social The public will be consulted on the investments as per the Environmental Framework and information on the project will be disclosed. In case of land acquisition, a Land Acquisition Framework has been developed for the project which will ensure that the property and inheritance rights of the public will be respected, the public will be fully informed, the land acquisition process will be transparent, and the expropriation price will be fair. Further, the Bank financing will take place only after the land acquisition process is completed satisfactorily and the municipality has ownership of the land, in line with the framework. The Bank loan will not finance investments that require resettlement. Affordability of tariffs is a Sub-project eligibility criterion and will be considered as a key element in determining the size of the investments. This will help mitigate any social risks associated with high tariffs. 5. Environment The project is expected to bring about environmental benefits through the treatment of wastewater, reduction of water losses, collection of wastewater, and improving solid waste management practices. The benefits of the investments will be analyzed during the feasibility studies and baseline information on the environment will be collected. To measure the progress of the project, environmental parameters - such as number of sewerage connections or volume o f wastewater treated -will be used. As per the Bank s Operational Policy 4.01, the environmental category of Financial Intermediary (FI) will be applicable for this project. An Environmental Framework has been developed for the project that will be implemented by IB which will be responsible for screening projects based on the Bank s environmental categories of A, B, and C. The municipalities will carry out the environmental assessments and IB will submit the necessary information to the Bank seeking financing for the investments. The framework also outlines the procedures for public consultation and information disclosure on environmental matters. 6. Safeguard policies During project implementation, IB will supervise municipalities to ensure that the Environmental Framework and Land Acquisition Framework are being followed. These frameworks have been discussed in Turkey and have been posted on IB s internet site. The Environmental Framework and the Land Acquisition Framework have been sent to the Bank s Infoshop on January 24,2005 and March 22,2005, respectively. The selected Sub-project sites are either located adjacent to the Mediterranean Sea, Black Sea, and Aegean Sea or on national rivers that discharge to these seas. For these sites, a Sub-project eligibility criterion is that the activities of the project will not adversely affect the quality and quantity of water flow and will be in compliance with Turkey s commitments under the 19

26 Bucharest and Barcelona Conventions. Each Sub-project will require the Bank's review and approval for financing under the Bank loan. A Sub-project criterion will be used for Sub-projects located on trans-boundary waters. The criterion requires that for such sites, investments should only be for ongoing schemes, involving additions or alterations that require rehabilitation, construction, or other changes that (i) will not adversely change the quality or quantity of water flows to the other riparians; and (ii) will not be adversely affected by the other riparians' possible water use. In accordance with this criterion, it is required that investments will only involve minor additions or alterations to the ongoing scheme which will not cover works and activities that would exceed the original scheme, change its nature, or so alter or expand its scope and extent as to make it appear a new or different scheme. Safeguard Policies Triggered by the Project Yes ' No Environmental Assessment (OP/BP/GP 4.01) [XI [I Natural Habitats (OP/BP 4.04) [I [I Pest Management (OP 4.09) [I [I [I Cultural Property (OPN 11.03, being revised as OP 4.1 1) [I Involuntary Resettlement (OP/BP 4.12) [XI [I Indigenous Peoples (OD 4.20, being revised as OP 4.10) [I [I Forests (OP/BP 4.36) [I [I Safety of Dams (OP/BP 4.37) [I [I Projects in Disputed Areas (OP/BP/GP 7.60)* [I [I Projects on International Waterways (OP/BP/GP 7.50) [I [I 7. Policy Exceptions and Readiness The project does not require any exceptions to Bank policies. implementation as indicated through the following: The project is ready for e e e Fiduciary arrangements - financial management and procurement - are satisfactory and in place; The PMU in IB is fully operational and it has been successful in carrying out project preparation, drawing on help of consultants and the rest of the bank as needed. The effectiveness of the PMU is expected to continue during project implementation where consultants and relevant departments o f IB will continue to provide support to the unit; The bulk of the counterpart funds required for the project will come from the municipalities and they have indicated their willingness to contribute towards the project by signing the MoU with the IB to initiate the feasibility studies. The project is included ' By supporting the proposed project, the Bank does not intend to prejudice thejkal determination of the parties' claims on the disputed areas 20

27 in the government s public investment program and the process to finalize the investment amount, through a review of the feasibility studies by SPO, is underway; e a Feasibility studies for the participating municipalities started on December 1, 2004 and the detailed investment program will be defined by June 2005, allowing for a timely implementation of the project; and As per the Bank s policies, environmental and land acquisition frameworks have been prepared and are satisfactory to IB and the Bank. 21

28 Annex 1: Country and Sector or Program Background TURKEY: Municipal Services Project Municipal Sector Background Turkey has 81 provinces covering the territory of the whole country. Governors head each province which are sub-divided into sub-provinces headed by a sub-governor. Within a province, there are four types of local authorities: Budget Municipalities. There are 3,225 municipalities that have been established in areas which have more than 2,000 inhabitants. They cover about 75% of the country s land mass and the average municipality has a population of 15,000. Each municipality is headed by a directly elected mayor and governed by an elected municipal council. Metropolitan Municipalities. In 16 of the main urban areas in Turkey, the municipalities are organized under umbrella organizations referred to as a metropolitan municipality that is responsible for the provision of services for all its constituent district municipalities. All metropolitan municipalities have a separate water and wastewater utility. In September 2004, the Metropolitan Municipality Law was amended which increased their area of coverage. Villages. Turkey has about 35,000 villages that are governed by a Muhtar (head man). The average village has a population of about 500. Special Provincial Administrations (SPAs). There are 81 SPAs, one in each province, covering urban areas and villages. The local authority functions within an SPA are carried out by the provincial administration under the province Governor. An overview of the local government budget is shown below in the table. The budget deficit in the local government sector has been financed by the central government through loans or allowing central government receivables from the local government to grow. Municipalities account for more than 80% of the local government budget. While overall there is a budget deficit, typically the revenues and expenditures balance in the larger municipalities. The figures mentioned below are derived from the paper entitled Assignment of Local Functions and Expenditures in Turkey (prepared by Messrs. Baki Kerimoglu and H. Hakan Yilmaz, September 2004). 22

29 LOCAL GOVERNMENT BUDGET (YO share of GNP) I 1999 I 2000 I 2001 I 2002 I 2003 REVENUES Tax revenues 2. Non-tax revenues Of which domestic borrowine Y Of which external bonowing 3. Factor Incomes I I I I I EXPENDITURES I 4.69 I 5.17 I 3.80 I 3.89 Note: 2003 figures are estimates Revenues: Municipalities have three sources of financing: Tax revenues: Taxes represent about 60% of the revenues of the local government. Central novernment sources: On average, about 75% of the tax revenues are from central government sources with the smaller municipalities being more dependent on central government resources. 6% of general taxes collected by the central government are distributed to the municipalities based on population. In addition, the metropolitan municipalities receive 3-6% of the central taxes collected within the region with the percentage being decided by the Council of Ministers. The transfer mechanism is not complicated and brings about certain level of predictability on the level of local government income. However, the large share of central transfers de-links taxation and spending at the local level. Further, transfers are not linked to actual service levels and extra transfers to metropolitan municipalities generally allow them to have additional resources in relative terms; and Local taxes: About 25% of the taxes are generated from local taxes and duties. The main local tax is the real estate tax. Locally raised revenues are centrally controlled and while there are many taxes, the collection rates are low and the proliferation of local taxes and fees makes them costly to administer. Non-tax revenues: About 18% of local government revenues are generated from non-tax revenues that include duties, contribution to investments (represents less than 2% of municipal revenues), fees based on revenues generated from mineral enterprises within a municipality or museum entrance fees. Further, municipalities are allowed to establish 23

30 commercial enterprises such as shops and 54% of the profits of these enterprises are a source of local government revenue; and Borrowings (short and long term) are included in the non-tax revenues but they constitute a small portion (5%) of the cash inflow to the municipalities. About 3.5% and 1.5% of the cash inflow to municipalities are from foreign and domestic sources, respectively. The low borrowings are largely due to lack of creditworthiness of municipalities and unavailability of long term funds in the country. Factor incomes: About 22% of the local revenues are generated from commercial enterprises and utility services such as water, sewerage, and transportation. These incomes are based on tariffs that are decided by the local authorities. In metropolitan municipalities the waterhewerage services and transportation services are provided through municipal companies. In other municipalities, the accounts of these services are merged with the rest of the municipal operations. Generally speaking, the water and wastewater services result in operating surplus and they often subsidize other municipal operations. Expenditures: Municipalities have the following expenditures: a) Current expenditures: About 40% of municipal expenditures correspond to current expenditures. This cost is mainly related to personnel expenditures that constitute about 75% of the current expenditures. b) Investment expenditures: This corresponds to about 35% of municipal expenditures and includes machinery, equipment, and construction costs. The municipalities would like to increase their investment expenditures but are constrained by limited resources and inability to reduce current expenditures. c) Current transfers: About 20% of the expenditures correspond to transfers from the municipalities to the central government for taxes, social security payments, and debt service. In percentage of GNP terms, there has been a decline in the payments since 1999 and this is due to the fact that less than 20% of the social security payments are made by the municipalities. Further, municipalities have overdue payments to the tax office and other public institutions. d) Expenditure on assets: About 3% of the expenditures are due to debt service on various investments. A large portion of the domestic municipal debt is held by Iller Bank. Municipalities - especially the large ones - may also have debt to International Financial Institutions, backed by Treasury guarantees. e) Capital transfers: All municipalities are shareholders of IB and by law they are required to contribute towards the equity of the bank. Transfer payments, corresponding to about 2% of the municipal expenditures, are made to IB on a regular basis. The municipalities are current on this payment to IB. 24

31 Municipal Debt There are two fimdamental constraints in the municipal debt market. Long term financing - needed for municipal infrastructure development - is not currently available. The situation is however getting better with the declining interest rates as described earlier. However, in the short term, it is unlikely that municipalities will have access to long-term credit that is necessary to finance local public infrastructure that requires a long payback period; and Municipalities have limitations on the resources that they can mobilize from taxes and have limited flexibility in reducing expenditures. However, they do have some flexibility in raising water and wastewater tariffs. Municipalities rely heavily on the central government to finance their operations. This is done through maintaining high levels of payables and debt to the central government. At the end of 2003, the local government debt held by the central government was around 18.3 quadrillion TL or around 5.6% of the GNp4 (shown below in the table). This high level of debt is a concern for the central government that is in the process of reforming the municipal sector (next section). The debt due to Treasury is for guarantees that have been called and paid by Treasury. The amounts paid by Treasury, on behalf of municipalities, become municipal debt and accounts for about 56% of the municipal debt held by Treasury. The remaining Treasury debt stock is due to contingent liabilities of Build Operate and Transfer projects (24%) and loans (20%). These loans have been mainly made by Intemational Financial Institutions. The liabilities to the public institutions are mainly the local government payables to the Social Security Administration and the Tax Office. Iller Bank debt is also included in the entire municipal debt stock. Under Turkish regulations, the loans made by Iller Bank are backed by cash collateral since, by law, the institution is able to intercept tax transfers in lieu of debt service payments. Local government borrowings from domestic banks are very small compared to the assets of the banking sector. At the end of 2003, total local government domestic borrowings were 1,336 4 Borrowings in Local Government; Messrs. Ferhat Emil and H. Hakan Yilmaz; September 2004 Borrowings in Local Governments ; Messrs. Ferhat Emil and H. Hakan Yilmaz, September

32 trillion TL (1,129 trillion TL with Iller Bank; and 207 trillion with deposit money banks), which represents about 0.5% of the entire banking sector assets. This low utilization of local commercial banks illustrates the above-mentioned issues of lack of long-term hnds and municipal creditworthiness. 26

33 Annex 2: Major Related Projects Financed by the Bank and/or other Agencies TURKEY: Municipal Services Project A list of recent Bank projects in the sector is shown below. The lessons learned from these projects have been incorporated in the design of this project. Name I Closing Date 1 OED Rating The Bank has been involved in the municipal sector in Turkey through a number of water and wastewater projects and through economic and sector work (ESW). Through these activities the Bank has assisted in the development of the infrastructure and provided policy advice. The involvement of the Bank will be a continuation of the ongoing dialog between the Bank and the key stakeholders. Lessons learned from past activities have been incorporated in the project design. Some of the recent activities are: a a a In the last twenty years, the Bank financed water and wastewater projects in the municipalities of Istanbul, Ankara, Bursa, Izmir, Antalya, and Cesme-Alacati. In the Bursa project, there was a solid waste component which assisted the city to construct a landfill and promote recycling of wastes. The Bank also financed the Cukurova Urban Development Project where IB was involved; In the last three years, the Bank prepared a Municipal Sector Review and an Urban Water and Wastewater Sector Review. These ESW outline the issues in the sectors and make recommendations which have been considered under the project; and The Bank s Institutional Development Fund supported the development of a Performance Monitoring System. Through the system, the operational and financial performance of 129 pilot municipalities (including all of the 122 municipalities that have a population more than 100,000) are made public through the internet. The government plans to expand this performance monitoring to other municipalities as it is being promoted under the current decentralization efforts. The Project Status Report at project closure rates both the IP and DO as satisfactory. 27

34 Annex 3: Results Framework and Monitoring TURKEY: Municipal Services Project Results Framework I PDO Support sustainable environmental services in selected municipalities One Der ComDonent Component One: Municipal Development Component Two: Municipal Technical Assistance Component Three: Iller Bank Institutional Strengthening Outcome Indicators Quality local services provided in participating municipalities Results Indicators for Each Component Component One: These results will be Sub-project specific and will include: - Wastewater treated - Water loss reduced - Sewerage connection increased - Solid waste disposed in sanitary landfill Component Two : - Feasibility studies, design, and construction supervision carried out efficiently - Operational Improvement Plan implemented Component Three: Project implemented satisfactorily Use of Outcome Information Determine the progress made in supporting the urbanization trend in Turkey Use of Results Monitoring Component One: Establish and implement policies on providing quality service Component Two : Allow for planned and sustained municipal development Component Three: A strengthened IB will help the development o f the municipal sector 28

35

36 Description of Proposed Investments Annex 4: Detailed Project Description TURKEY: Municipal Services Project The proposed investment projects that have been identified are listed below. PHRD grant financed consultants are currently concluding feasibility studies that analyze the projects from an economic, financial, technical, and environmental perspective. In order to qualify for Bank financing the proposed Sub-borrowers must meet all Sub-project eligibility criteria. a Antalya Metropolitan Municipality: (2000 census population is 675,000 in the winter and double that level in the summer.) The project comprises the construction of a sewerage system in the eastern part of the city and in 11 municipalities that have been attached to the Antalya Metropolitan Municipality. The project also includes building a wastewater treatment plant for the additional flow and to a marine outfall to protect the environment in this city that depends on its large tourism industry. Implementation could be expected to start early since the proposed Sub-borrower, ASAT, is experienced with Bank projects after executing a large Bank-financed water supply and sewerage project in the year a Bergama: (Population of 52,000). The project consist of the constructing a sanitary landfill that would replace the present practice of dumping garbage in an unsanitary and temporary site. The tourism industry is important and continuing the present improvised disposal system would risk perpetuating the associated health and environmental hazards. a Cankiri (Population of 63,000). The municipality seeks financing to build a water transmission line from the existing Giildiircek dam and to construct a potable water treatment plant in order to alleviate the supply problems with insufficient water and low service pressure. These investments should be complemented with a plan to improve operations and reduce unaccounted water, possibly be replacing old and leaking segments of the existing water supply network and introducing demand management programs. 0 Elbistan: (Population 77,000). The project aims at upgrading the existing water transmission lines, storage tanks and water distribution network. The construction of a wastewater treatment plant is also included. Currently untreated wastewater is being discharged in the Ceyhan river, creating a threat to public health and the environment. 30

37 e Gelibolu: (Population 22,000). The project comprises construction of a sanitary landfill to discontinue the present unplanned and unsanitary disposal of solid waste. The proposed new landfill site is about 6 kilometers inland and only domestic waste (not hazardous) will be disposed in the site. Any generated leachate will be sufficiently treated - as per Bank guidelines and applicable national standards - and discharged on land. e Giimiigova (Duzce) (Population ). The project proposes to construct a water treatment plant to eliminate the turbidity in the water. Water is presently supplied from karstic springs and the turbidity in the water rises above acceptable levels whenever it rains. The exact causes and suggested corrective measures would be determined under the project. e Ilica: (Winter population 17,000; summer population70,000). The municipality is located in the tourism growth pole between Antalya and Manavagat. At present, the town relies on septic tanks to accept the wastewater. Due to the local impervious clays the individual tanks cannot absorb the wastewater that rises to the surface and constitutes a pubic health danger. The project would construct a sewerage network. Kutahya: (Population 170,000). The project objectives are (i) to rehabilitate the major share of the existing water supply network that is approaching the end of its usehl life; (ii) to begin building a stormwater drainage system; (iii) to build a sanitary landfill; and (iv) to rehabilitate the existing wastewater treatment plant. Given that the city has proposed multiple investments there is a need to prioritize them to ensure that the activities supported under this project are affordable. The project would improve environmental and health conditions within the city and improve the quality of water discharged from the city. e e e Mersin Metropolitan Municipality: (Population 545,000). The application of the new Metropolitan Municipal Law has expanded the jurisdiction of the metropolitan municipality. Present service is inefficient with unaccounted water approaching 55% of water produced. The project proposes to rehabilitate the water network by replacing leaky distribution network segments with highdensity polyethylene pipe. Mugla: (Population 44,000). The project proposes to develop sewerage network and construct a wastewater treatment plant. Currently untreated wastewater is discharged underground which creates the potential of groundwater contamination and seepage of wastewater to the nearby Aegean Sea. Odemig (Population 62,000). The project proposes to construct a wastewater treatment plant. Currently, untreated wastewater is discharged to a nearby stream which eventually reaches the Aegean Sea. 31

38 e Polatli: (Population 80,000). The town suffers from excessive hardness in its present water supply. The project proposes to build a water treatment plant to soften the hardness of the water. e Samsun Metropolitan Municipality: (Population 363,000). Due to the application of the new Metropolitan Municipal Law, the jurisdiction of the metropolitan municipality has increased. The municipality proposes to rehabilitate the water network. Although the present water supply will be sufficient for the city s projected needs for the foreseeable future the high levels of unaccounted water of 50% justifies a program of demand management and selective upgrading of the present water distribution network. The project would need to create an information system of the existing water supply system, possibly on the basis of a Geographic Information System (GIs). e Serik Tourism Infrastructure and Environment Union: (Population 170,000 residing in the Union of Serik, Kadriye, Belek, Karadayi, Belkis, Yeni Kocayatak, Candir, Bogazkent, Tasagil municipalities). The union is located between Antalya and Manavgat in a region that relies on agriculture and tourism. Insufficient and inadequate water service has prompted the union to request the rehabilitation and expansion of its water distribution network. The project may well include a program of demand management and measures to reduce unaccounted for water. 32

39 Iller Bank Institutional Strengthening Under Component 3 of the project, there will be Technical Assistance (TA) for IB. The objective of the TA will be to strengthen the institutional capacity of Iller Bank. The TA will cover: strengthening of financial and banking capacity; and strengthening of technical capacity, audit, and incremental operating costs. The TA for Iller Bank will include the following: Increasing financiavbanking capacity: By January 1, 2006, IB will hire three financialbanking consultants who will provide advice and report to the PMU. The TA will strengthen IB s capacity of risk management and internal auditing and also strengthen IB s capacity to implement the upcoming EU programs. The Terms of Reference for the consultants are included in the Operational Manual; Increasing technical capacity: By January 1, 2006, IB will hire three technical consultants (financial specialist, engineer, procurement specialist) who will provide advice and report to the PMU. The TA will enable IB staff to provide efficient technical and utility management solutions to the municipalities. It will also strengthen IB s capacity to implement the upcoming EU programs. The Terms of Reference for the consultants are included in the Operational Manual; Audit: On an annual basis, IB will complete an audit as per international accounting standards (Annex 7); and Incremental Operating Costs: The incremental operating costs include salaries of consultants working in the PMU, staff per diems, lodging and travel costs for field trips related to the implementation of the project, seminars and workshops, and equipment - hardware and software. 33

40 Annex 5: Project Costs TURKEY: Municipal Services Project Project Cost By Component and/or Activity 1. Municipal Development 2. Municipal Technical Assistance 3. Iller Bank Institutional Strengthening Local Foreign Total US $million US $million US $million Total Project Costs (with contingencies) Front-end Fee Total Financing Required

41 Annex 6: Implementation Arrangements TURKEY: Municipal Services Project The implementation arrangement of the project is schematically shown below. There will be the following legal agreements for the project (i) a Loan Agreement between the Bank and IB; (ii) a Guarantee Agreement between Treasury and the Bank; and (iii) Subloan Agreements between IB and the participating municipalities. The Operational Manual of the project will provide guidance to IB on the use of loan funds and reporting arrangements. PROJECT SCHEME SUB-LOAN AGREEMENT VK/ /" Account Loan Conditions: The loan to IB will be made in Euros with the following conditions: (a) Term: Fixed Spread Loan with 17 years maturity; (b) Grace: 5 years, with level repayment of principal; (c) Front-end Fee: 100 basis points, less existing waivers; (d) Commitment charge: 85 basis points, for the first four years; thereafter, 75 basis points, less any waivers in effect; and (e) Interest: LIBOR plus fixed spread. On-lending terms: The Sub-loans will be made in Euros and the exchange risk will be borne by the municipalities. This has been a policy of the government for all foreign loans directed towards municipalities. Guidelines for on-lending arrangements from IB to the municipalities will be as follows: (a) The term will be 17 years and the grace period for Sub-loans will end on the day the grace period for the loan to IB from the Bank ends; (b) Front end Fee: same charge to IB due to the Bank loan; (c) Commitment charge: same as the charge to IB due to the Bank loan; (d) Interest rate: interest rate due to the Bank loan plus a spread of 100 basis points to cover IB's cost; and (e) Guarantee Fee: 25 basis points that will be charged by Treasury and passed to the municipalities by IB. 35

42 Escrow account: To secure debt service, IB will require municipalities to deposit the interest and principal repayments in an escrow account. IB will use the funds in the escrow account to service the Bank loan. The municipalities will deposit the funds in the escrow account 15 days prior to the repayments due from IB to the Bank. As per the law, IB is authorized to use the tax intercept also as collateral for a Sub-loan. Project Management: In April 2005, a Project Management Unit (PMU) was created which is authorized to carry out project preparation and supervise implementation. Preparation and supervision will be carried out by other relevant units in IB with the PMU playing a co-ordinating role. The PMU comprises a Director and four staff members with technical and banking qualifications. The PMU Director and the staff are all employed by IB. The PMU will draw upon other staff within the bank - financial, technical, procurement, environmental, legal etc. - on an as needed basis. The PMU will be the primary contact point for the Bank. Currently, the PMU is also supervising three consultants (financial, technical, and procurement) that are financed by the Policy and Human Resources Development Fund (PHRD) grant. These consultants are providing training to the IB staff (in the PMU and in other departments) and assisting with project preparation. Project Appraisal: Within the Planning Department, comprising 110 staff, a Project Appraisal Unit, comprising 8 staff, has been formed. This unit will be responsible for appraising the projects in consultation with the PMU. Out of the 8 staff, 7 of them are technical and 1 of them is a financial specialist. The financial capacity of this unit needs to be strengthened and IB will support the Project Appraisal Unit in the following manner: a) utilize the financial consultant, funded by the PHRD grant; b) draw on other financial specialists in the bank; and c) hire additional financial staff for the project. Under the proposed amendment to the Iller Bank Law, the Planning Department will be converted to a Project Development Department and the Project Appraisal Unit will be converted to a Project Appraisal Department. The experience gained under the project will be beneficial for other appraisal work to be carried out by IB. Project Supervision: IB will carry out project supervision of the Sub-loan Agreements. The water projects will be supervised by the Iller Bank s Water Supply Department, which has about 90 staff. The wastewater and solid wastewater management will be supervised by the Sewerage and Wastewater Department, which has about 70 staff. These units are based in Ankara and the units will draw upon the capacity of the regional offices for the supervision. Project Design and Construction Supervision: All design work and construction supervision will be conducted by consultants. These consultants would be employed either by the municipalities or by Iller Bank on behalf of the municipalities if the capacity of a municipality is inadequate. Role of Regional Offices: IB has an extensive regional representation through its 18 Regional Directorates where 55% of the staff are located. These regional offices will play an important role in preparing and supervising the projects. During preparation, the 36

43 regional offices will support the PMU and the Project Appraisal Unit in providing relevant information in a timely manner and co-ordinating with the municipalities and the municipal utilities. During implementation the regional offices will supervise the project jointly with the Water Supply and Sewerage and Wastewater Department. Supervision reports will be provided to the PMU. During Preparation IB will be responsible for identifying eligible Sub-borrowers and ensuring that the Subproject eligibility criteria are met. Sub-borrower Eligibility: Municipalities or municipal utilities eligible to receive the Bank loan for investments and technical assistance will have met the following criteria. e e No overdue payments to the Treasury or IB; Debt service coverage throughout the duration of the project should be at least 1.2; and 0 Satisfactory institutional arrangements for a Sub-project to be carried out effectively. For the project, the municipalities have been pre-identified. Preliminary assessment indicates that these municipalities will be able to meet the above criteria and this will be verified through the ongoing feasibility studies. Sub-project Eligibility. IB will ensure that the following Sub-project eligibility criteria are met. IB will work with the municipalities to appraise a Sub-project that will be based on feasibility studies. IB will submit viable Sub-projects to the Bank for proposed financing. A Sub-project will be eligible to receive loan fimds if the following criteria are met satisfactorily: e e e e Environmental Benefits: There should be an environmental benefit to justify the investments; Economics; The Sub-project should be justified on economic grounds through a cost benefit analysis. Wherever possible, the cost benefit analysis will be quantified; Technical: The Sub-proj ect should be technically feasible and cost effective; Financial: (i) the projected tariffs should cover all costs related to operations and investments; and (ii) the projected household bills should be at socially affordable levels for the services provided under the Sub-project; 37

44 e Operational Improvement Plan: There should be a satisfactory Operational Improvement Plan at the municipal or utility level. The success of the plan would be measured through financial improvements (e.g. decrease in working ratio) or efficiency gains (e.g. reduction of water losses); e Water Quality/Quantity Issues: IB will confirm the following and their judgment will be substantiated with analysis for the review of the Bank: (a) For Subprojects on trans-boundary waters, investments should be for ongoing schemes, involving additions or alterations that require rehabilitation, construction, or other changes that (i) will not adversely change the quality or quantity of water flows to the other riparians; and (ii) will not be adversely affected by the other riparians' possible water use. This applies only to minor additions or alterations to the ongoing scheme and it does not cover works and activities that would exceed the original scheme, change its nature, or so alter or expand its scope and extent as to make it appear a new or different scheme; and (b) For projects located adjacent to the Mediterranean Sea, Black Sea, or the Aegean Sea or on national rivers that discharge to the seas, investments should not adversely affect the quality and quantity of water flow and should in line with Turkey's commitment under the Bucharest and Barcelona Conventions; and e Social: (a) no physical resettlement of people should be needed due to the project; and (b) the land expropriation process, if required, should be completed prior to signature of a Sub-loan in a satisfactory manner in line with the Land Acquisition Framework and the municipality should be the owner of the land. During Implementation Through the Sub-loan Agreement the municipalities will agree with IB to carry out the following: e e e e e implement the project in a sound technical and financial manner; adjust tariffs to meet operating and investment costs; implement the Operational Improvement Plan satisfactorily in each municipality; set up an escrow account in which amounts that correspond to 6 months of debt service will be deposited 15 days prior to their due date to repay IB which will also have the right to intercept tax transfers in lieu of debt service by the municipalities; implement the Environmental Framework Agreement in a satisfactory manner. This will include environmental activities during project preparation and implementation involving appropriate level of public consultation and information disclosure; 38

45 e e implement the Land Acquisition Framework Agreement in a satisfactory manner, if required; and provide necessary technical and financial information to IB in a timely manner. Reporting Every six months, IB will provide a status report to the Bank through Project Progress Report that will include the following. e Project Summary: (a) status of individual Sub-project on physical investments; (b) status of improvements in service quality and institutional arrangements in each Sub-project; (c) status of Operational Improvement Plan of each Sub-project; (d) status of reforms in IB, including the implementation of the Action Plan; (e) reporting of the Outcome and Results Indicators as per the project; e Fiduciary/Safeguard: Summary information on (a) procurement progress, including an updated procurement plan; (b) disbursements which will include loan committed amounts, actual disbursements, and upcoming disbursements for a year; (c) financial management, including the submission of audits, once a year; (d) status of implementing the Environmental Framework; and (e) status of implementing the Land Acquisition Framework; and e Comments: Any special concerns or suggestions to streamline project implementation should also be provided. Apart from the Project Progress Report, IB will submit to the Bank a Financial Monitoring Report on a quarterly basis and a Procurement Plan on a semi-annual basis. 39

46 Annex 7: Financial Management and Disbursement Arrangements TURKEY: Municipal Services Project FINANCIAL MANAGEMENT 1. Summary of the Financial Management Assessment An assessment of the adequacy of the project financial management system at IB was undertaken in February The current financial management arrangements for the project are satisfactory to the Bank. The detailed financial management assessment questionnaire is included in the project files. A summary of financial management assessment and conclusions follows: FINANCIAL MANAGEMENT ASSESSMENT ' COMMENTS Iller Bank Law an Internal Audit unit Country Issues A Country Financial Accountability Assessment (CFAA) for Turkey was carried out in The CFAA report identified some weaknesses in the Turkish financial accountability, in both the public and the private sector. However, since then, the financial management environment in Turkey has improved. The 1999 Banks Law established the Banking Regulation and Supervision Agency (BRSA) which has the authority to determine the accounting and auditing requirements applicable to the banks under its supervision. Banks must submit non-audited monthly prudential returns to the BRSA, and publish audited annual financial statements. Only auditors approved by the BRSA may carry out such audits. All changes in auditor must also be approved, and a change can be imposed by BRSA if the performance of an auditor is not satisfactory. The external auditor is required to report to the BRSA on banks' internal control and risk management systems and on issues which may negatively affect the operation of a bank. 40

47 The BRSA issued a new comprehensive regulation on accounting standards for banks in July 2002, which brings these standards in line with IFRS. However, the BRSA regulation does not require full application of International Accounting Standards (IAS) 27 (consolidation of subsidiaries), as banks are required to consolidate the statements of only their financial subsidiaries. For non-financial subsidiaries, separate financial statement disclosure is mandated. The statements of such non-financial subsidiaries are not IAS-based, however, and thus their disclosure will not allow the user to consolidate the statements with the IAS-based consolidated statements of the parent bank and its financial subsidiaries. The BRSA also regulates external audit of bank financial statements and auditors have to be approved by the BRSA. The Regulation on Principles for Independent Auditing and the Regulation on Authorization of the Auditing Institutions and Permanent or Temporary Withdrawal of their Authorities are the applicable regulations for the external audits and they are broadly in line with International Standards on Auditing (ISA). IB is governed by the Iller Bank Law and the BRSA regulations. BRSA recognizes that IB is not fully in compliance with the prudential regulations due to the absence o f a) an Internal Audit unit; and b) a Risk Management unit. The BRSA has not considered this to be a serious breach and not issued any warnings to IB. Remedial actions are being taken by the government and the proposed amendments to the Iller Bank Law include the creation of an Internal Audit and a Risk Management unit. Financial Management Assessment Implementing Entity: The project will be implemented by IB which has two core functions: a) support infrastructure development at the local level through technical assistance, loans, and grants; and b) transfer central tax revenues to the local authorities. Through these function, IB is in regular contact with all municipalities and has the capacity to implement the project. To manage the project, a Project Management Unit (PMU) has been established at IB. The PMU is staffed with experienced management and staff and it will co-ordinate project activities and will be the primary counterpart for the Bank. The risk associated with the implementing entity is assessed as negligible. Funds Flow: There will be a Special Account in a bank, acceptable to the World Bank. Funds from the loan will be made available to municipalities following submission of payment documents (invoices for the goods purchased and completion reports for construction activities) to IB. This information will be collected and controlled by IB to ensure compliance with the Sub-loan conditions. The risk associated with funds flow is considered as negligible. 41

48 Staffing: Staff currently working in the PMU will continue to work during project implementation. The qualifications and experience of these staff are satisfactory to the Bank. Since IB will be responsible for controlling the documents that will form the basis for payments, additional staff from relevant departments will support the PMU during project implementation. The risk associated with staffing is considered as negligible. Accounting Policies and Procedures: The financial management capacity at IB is satisfactory. The Bank has qualified personnel and adequate manuals and guidelines to conduct efficient financial management. The accounting and reporting systems at IB are geared toward producing statements and information as required by Turkish laws and regulations. Currently, the Iller Bankasi Bilgi Islem Sistemi (IL BIS) is being implemented which is a web based management information system linking all the departments of the institution. Considering that IB has adequate accounting and reporting systems all project related activities will be integrated into the existing system of the institution. Financial Monitoring Reports (FMR) will also be produced by the system. All accounting policies and procedures for the loan will be documented in the Financial Management Manual, which is a part of the Operational Manual for the project. The risk associated with accounting policies and procedures is assessed as negligible. Reporting and Monitoring: IB will maintain records and will ensure appropriate accounting for the loan funds. Financial statements for the project will be prepared by IB. The new information system of IB installed within the IL BIS is capable of producing the Financial Monitoring Reports (FMR) which will be prepared quarterly and will be submitted to the Bank no later than 45 days after the end of the quarterly period. The Bank and IB have agreed on the formats of the FMRs and they include the following reports: Project Sources and Uses of Funds, Use of Funds by Loan Term, Uses of Funds by Sub-loan, Special Account Statement, Project Balance Sheet, Investment Monitoring Report, Uses of Funds by Procurement Category, Sub-loan Distribution According to Regions, Sub-loan Distribution According to Investment Type, Sub-loan Drawdown Status, Quarterly Financial Reports (covering interest received and terms o f Sub-loans). The risk associated with reporting and monitoring is assessed as negligible. Information Systems: IB is currently implementing the IL BIS project which is a web based secure application that will link all departments of the institution allowing it to execute, monitor, and report using the same data source. By June 2005, it is expected that the system will be fully fbnctional and the regional offices will also be connected to the system. The project s accounting and monitoring will be carried out by the IL BIS. The risk associated with information systems is assessed as negligible. Supervision Plan: During project implementation, the Bank will supervise the project s financial management arrangements in two ways: (i) review the project s quarterly FMR, 42

49 and the annual audited financial statements and auditor s management letter; and (ii) during the Bank s supervision missions, review the project s financial management and disbursement arrangements to ensure compliance with the Bank s requirements. As required, a Bank-accredited Financial Management Specialist will assist in the supervision process. 2. Audit Arrangements Internal Audit. Iller Bank does not have an intemal audit department as explained in the Country Issues section. The amendments to the Iller Bank Law propose to create the Intemal Audit unit. External Audit. Currently IB has its accounts audited in accordance with Accounting and Auditing standards published by BRSA by independent auditors acceptable to BRSA. The current auditors of IB have issued unqualified audit opinion on the financial statements of IB for the year ended December 31, During project implementation, the annual audit of IB will be completed by an independent auditor, approved by BRSA and acceptable to the Bank, as per IFRS and ISA. The TOR of the audit firm will cover the audit of the project accounts and the Special Account in addition to the audit of IB s IFRS financial statements. The audited project financial statements will include: project balance sheet, sources and uses of funds and the Special Account statement. The auditor s TOR will also address the issue of whether the State of Expenses (SOEs) submitted during the fiscal year, together with the procedures and intemal controls involved in their preparation, can be relied upon to support the related withdrawal applications. IB is also audited by the Higher Audit Board on an annual basis. The 2002 Higher Audit Report was reviewed by the Bank and there are no recommendations relating to financial management. The risk associated with external audit is assessed as substantial since the audit firm is not yet engaged. However, this risk will be addressed through the hiring of an external audit firm by November 30, Financial Risk Analysis From a financial management perspective, the overall rating risk rating of the project is moderate. A summary of the risk assessment for the project follows: 43

50 INHERENT RISK 1. Country Financial Management Risk 2. Project Financial Management Issues Overall Inherent Risk CONTROL RISK RATING High Moderate High RATING COMMENTS Based on CFAA report COMMENTS BRSA regulations. IFRS financial statements for IB are currently not available. However, the audit report of the 2005 financial statements will Country financial management risk. The CFAA identified some weaknesses in the Turkish financial accountability, in the public, private and the banking sectors. However, IB is in compliance with the BRSA prudential regulations with the following exceptions - it needs to create an Intemal Audit unit and a Risk Management unit. These units are expected to be created through an amendment to the Iller Bank Law. Although IB currently does not use IFRS, under the project IB will submit its IFRS based audited financial statements to the Bank in addition to its audited financial statements prepared in accordance with the BRSA accounting standards. DISBURSEMENT ARRANGEMENTS The loan hnds will be disbursed through Bank procedures on direct payments and Statement of Expenditures (SOEs). Supporting documentation for SOEs, including completion reports and certificates, will be retained by IB and made available to the Bank during project supervision. Disbursements for expenditures above the SOE thresholds will be made against presentation of full documentation relating to the expenditures. The following shows the allocation of loan proceeds. 44

51 Expenditure Category Works Goods Consultant Services and Training Incremental Operating Cost Project Cost Front End Fee TOTAL Total Cost Financing Bank Financing (US$ million) (US$ million) Bank I Counterpart % of total cost % of total cost % of the total cost o 1.o 100% of the portion to be financed by the Bank NIA % of the total cost The Bank financing in Euros as mentioned in the Loan Agreement for the above categories is as follows: (a) Works - 188,000,000; (b) Goods - 7,540,000; (c) Consultant Services and Training - 15,500,000; (d) Incremental Operating Cost - 775,000; and (e) Front End Fee - 1,085,000. Retroactive financing of 10,000,000 is made available for Works, Goods, and Consultant Services and Training. The above financing percentage is based on the note entitled Turkey: Country Financing Parameters that was sent to the Bank s Board on January 27,2005 by Bank management (SecM ). The note mentions that in general, the cost sharing is expected to not exceed 87%. However, the note also mentions that the Bank may finance up to 100% of the costs of individual projects, but will only do so after considering the context of the operation, availability of counterpart funds, and implications for the overall portfolio. In this particular project, the overall financing of the Bank is around 90% which is reasonable given that counterpart funds are not readily available at the local level. Further, the investments to be supported under the project have high positive externalities due to the environmental, health, and social benefits but the cost recovery period is long. Thus, a high percentage of Bank financing will help with the cash flow of the utilities, reducing the pressures to increase tariffs beyond unaffordable levels. Use of Statements of Expenditures (SOEs): The reimbursement of expenditures made from the Special Accounts (SA) may be made on the basis of certified SOEs, for the following items: (a) contracts for goods valued at less than Euro (e) 400,000; (b) contracts for works less than 4,000,000; (c) consulting contracts with firms valued less than 200,000 and with individuals valued less than 50,000; (d) incremental operating costs; and (e) training. Expenditures above these thresholds will be fully documented. Special Account (SA): IB will establish, maintain, and operate a Special Account in a bank, acceptable to the World Bank. The account will be denominated in Euros. The maximum Authorized Allocation for the SA will be 20 million. During the initial stages of the project, the deposits will be limited to 10 million. When more than 35 million of the loan is disbursed, the deposits will be increased to the maximum Authorized Allocation. 45

52 Annex 8: Procurement TURKEY: Municipal Services Project This section covers the procurement assessment and procurement arrangements for the project. PROCUREMENT ASSESSMENT In October 2004, the Bank carried out a procurement assessment of IB. Meetings were held with (a) department dead of IB responsible for procurement and operations (b) division manager of IB responsible for procurement (c) head of the PMU for the project and his procurement staff and consultant financed by the PHRD grant. The findings of the Country Procurement Assessment Report (CPAR) and the experience gained in the use of the PHRD grant for this project have been taken into account while completing this assessment. The overall procurement risk is rated high since IB and the municipalities are not familiar with Bank s procurement procedures. However, this rating can be revised in the future as IB and the municipalities become more familiar with Bank s procurement processes. It should be noted that IB has significant procurement capacity and it is expected that it would be able to quickly and satisfactorily follow Bank procedures. Project Management IB will be the Borrower for the project and on-lend to municipalities. IB has created a Project Management Unit (PMU) in April The PMU is authorized to carry out project preparation and supervise the implementation of the municipalities on behalf of IB. The PMU is staffed by a Director and four staff with technical and banking qualifications. The Director of the PMU and the staff are employed by IB. In addition, a procurement consultant is providing support to the PMU. IB has significant procurement capacity and is knowledgeable on Turkish procurement procedures since it carried out this function for municipalities over a number of years. The PMU will draw upon other staff in IB for procurement assistance, if needed. IB has an extensive regional coverage through its 18 Regional Directorates. These regional offices will also play an important role in supervising the project which will have three components: e Component 1 : Municipal Development; 0 Component 2: Municipal Technical Assistance; and e Component 3 : Iller Bank Institutional Strengthening. For components 1 and 2, procurement will be implemented and contracts will be signed by the municipalities. Contracts will be signed by IB for component 3. The role of the PMU on procurement matters will be to: 46

53 assist the municipalities in preparing bidding documents and Terms of References for consulting assignment; supervise municipalities to ensure that procurement arrangements, as agreed under the project, are being followed. The PMU will also ensure that IB is following the agreed procurement procedures of the project; prepare a Procurement Plan for each Sub-loan in co-ordination with the project municipalities. The Procurement Plan for all Sub-loans and activities to be undertaken in IB will be aggregated by the PMU. This overall Procurement Plan will be updated on a regular basis; facilitate the implementation of the project at the municipal level and provide technical assistance, as required; prepare Project Summary Report that will include the overall status in project implementation, updated procurement plans, and performance of municipalities to meet the progress benchmarks; make payments to the contractors and consultants employed by the municipalities against completed works or delivered goods; and maintain procurement records for review and audit by Turkish authorities. This record keeping will also help with the procurement supervision of the Bank, including the post review of procurement procedures. IB follows Public Procurement Law No.4734 and Public Procurement Documents law No The new Public Procurement Law became effective in January 1, 2003 and incorporates comments provided by the Bank and the EU. This law aims to provide a more competitive and transparent environment on procurement matters. The Bank is also providing assistance - through a grant - where Turkish officials are receiving technical assistance to implement the new law. The Bank has reviewed the Turkish procurement processes in detail and wherever possible local procedures will be used. Recommendations IB has been supporting municipalities on procurement matters over a number of years. The institution is familiar with Turkish procurement procedures and the procurement capacity within the institution is high. The bank also has its own legal department that can provide advice on procurement matters and can draw on consulting help if necessary. However, IB s experience with World Bank procurement procedures is limited and to this end, the following recommendations will be implemented during project preparation: a the PMU will seek the assistance of procurement and legal experts within IB, on a as needed basis. If required, the PMU will hire consultants; 47

54 e e record keeping and filing will be conducted with due diligence and be systematic to facilitate rapid document retrieval; and the PMU and project municipalities procurement staff will receive training on Bank procurement procedures. The training of the procurement staff in the PMU should be continued throughout the duration of the project. PROCUREMENT ARRANGEMENTS A. General Procurement for the proposed project would be carried out in accordance with the World Bank s Guidelines: Procurement Under IBRD Loans and IDA Credits dated May 2004, Guidelines: Selection and Employment of Consultants by World Bank Borrowers dated May 2004, and the provisions stipulated in the Loan Agreement. During project implementation, IB will develop the specific investment plan in each municipality. The processes to be followed to develop a Procurement Plan based on the investments are outlined below. Procurement of Works: Eligible investments under this category would be for water, wastewater, and solid waste sectors. For International Competitive Bidding (ICB), the Bank s Standard Bidding Documents (SBD) will be followed. NCB procedures will be followed for works contracts to cost less than Euros ( ) 4,000,000. Any ambiguity regarding documentation on NCBs will be overcome by using the Bank s sample NCB documents for ECA Region for Works and Goods. IB will also be given the option to use local NCB documents and procedures stipulated in the Public Procurement Law (Law No: 4734 & 4735) with certain modifications (Attachment 1 to this annex). Based on the implementation of the contracts, the Bank may increase the NCB thresholds to 5,000,000 one year after the effectiveness of the project. Procurement of Goods: Goods procured under this project would include equipment and materials needed for the eligible investments for the water, wastewater, and solid waste sectors. For ICB, Bank s SBD will be followed. NCB procedures will be followed for goods manufactured in the country, readily available in the local market, and costing less than 400,000. Any ambiguity regarding documentation on NCBs will be overcome by using the Bank s sample NCB documents for ECA Region for Works and Goods. IB will also be given the option to use local NCB documents and procedures stipulated in the Public Procurement Law (Law No: 4734 & 4735) with certain modifications (Attachment 1 to this annex). Shopping procedures will be followed for goods and small works that cost less than 80,000. Selection of Consultants: Consultants may be hired by IB or the municipalities for: (a) preparation of bidding documents including the detailed design drawings, technical specifications and bills of quantities and for the construction supervision of the eligible municipal infrastructure works; (b) feasibility studies; (c) urban planning; (d) 48

55 improvements in the municipality or municipal utility. These improvements relate to institutional, technical and financial matters including the water leak detection and reduction techniques and other efficiency improvement programs; (e) technical assistance to IB to implement the Iller Bank Strategy, the Action Plan, and the project - training; seminars; consultants on technical, financial, procurement matters; and audits. The consultant procedures to be followed are: Quality and Cost Based Selection (QCBS), Consultant Qualifications (CQ), Least Cost Selection (LCS), and Individual Consultants (IC). Short lists of consultants for services estimated to cost less than 200,000 equivalent per contract, may be composed entirely of national consultants in accordance with the provisions of paragraph 2.7 of the Consultant Guidelines. Prior Review Thresholds: The following prior review thresholds will apply for the project: (a) all ICB for goods and works; (b) first two NCB works and Goods and Shopping (Minor Works, International Shopping and National Shopping) contracts; (c) all consultant contracts with firms that are valued at 200,000 or more; (d) all individual consultant contracts valued at 50,000 or more; and (e) all single source contracts for services and direct contracts for goods. Post review ratio: Contracts not subject to Bank s prior review will be post reviewed by Bank s supervision missions and procurement specialists. At a minimum, 1 out of 5 contracts will be chosen for post review. The frequency of procurement supervision will be every six months. B. Procurement Plan As the investment plan under each Sub-project is not yet defined, a Procurement Plan, which outlines the procurement methods, has not been prepared. However, by October 1, 2005 IB will submit a Procurement Plan to the Bank since the investments under the project will be defined by then. The Procurement Plan will include the procurement to be conducted by the municipalities and IB. The Procurement Plan, satisfactory to the Bank, will be available at the PMU and at the Bank s external database and website. IB will revise the Procurement Plan on a semi-annually basis to reflect the updated implementation status of the project. 49

56 Attachment 1 Local NCB documents and procedures can be used with the following modifications: Eligibility: Bidding should not be restricted to domestic bidders. No restriction shall be applied to foreign bidders who wish to submit a bid. Procedures: The Open Procedure, as defined in the Public Procurement Law, shall be followed in all cases. Invitations to bid shall be advertised in the Official Gazette and in at least one widely circulated national daily newspaper or at the web site of the public procurement agency allowing a minimum of 30 days for the preparation and submission of bids. Assessment of the bidder s qualifications: In the procurement of goods and works, where pre-qualification is not used, the qualifications of the bidder, recommended for award of contract, shall be assessed by post-qualification using the following: minimum experience; and technical and financial requirements. These criteria will be explicitly stated in the bidding documents and a pass/fail method (not a merit point system) will be used. Participation by government-owned enterprises: Government-owned enterprises in the Republic of Turkey are eligible to participate in bidding only if they can establish that they are legally and financially autonomous, operate under commercial law, and are not a dependent agency of the government. Further, they will be subject to the same bid and performance security requirements as other bidders. Participation by joint ventures: Participation shall be allowed from joint ventures on the condition that such joint venture partners are jointly and severally liable under a Contract. Bidding documents: Procuring entities shall use the appropriate standard bidding documents for the procurement of goods, works or services, and shall contain draft contract conditions, acceptable to the Bank. Bid evaluation: Evaluation of bids shall be made in strict adherence to the monetarily quantifiable criteria declared in the bidding documents. A merit point system will not be used. Extension of bid validity will be allowed once only for not more than 30 days. The Bank has to provide prior approval of extensions beyond the first one. Contracts shall be awarded to the qualified bidder that submits the lowest evaluated and responsive bid. No domestic preference will apply under NCB procedures. Price adjustment: Civil works contracts of long duration (e.g. more than eighteen (18) months) will contain an appropriate price adjustment clause. 50

57 e e e Rejection of all bids: All bids will not be rejected and new bids solicited without prior approval of the Bank. Contracts: All contracts will be in writing and they should be signed and stamped by authorized signatories of the Purchaser and the Supplier and contain identical terms and conditions of contract to those included in the tender documents. Securities: Bid Securities should not exceed 3% (three percent) of the estimated cost of the contract. Performance Securities should not exceed more than 10% (ten percent) of the value of the contract. No advance payments will be made to Contractors without a suitable Advance Payment security. The wording of all securities will be included in the bidding documents and has to be approved by the Bank. 51

58 Annex 9: Economic and Financial Analysis TURKEY: Municipal Services Project The economic and financial appraisal of Sub-projects will be carried out as part to the feasibility analysis. They have to be satisfactory for the Bank to provide the no objection to the financing of investments. The discussions below provide the following: a) background information on Iller Bank (IB); b) government actions regarding IB; and c) financial projections of IB. 1. BACKGROUND In June 1933, IB was established as the Municipalities' Bank pursuant to the Law No with the purpose of providing financial resources to the municipalities. In June 1945, pursuant to the Law No. 4759, the Bank changed its name to Iller Bank with expanded tasks and organization as a development and investment bank for the local authorities. Its capital has been increased periodically, and through a law dated May 18, 2004 the bank received an authorization to increase its capital to 3 quadrillion TL. Although IB is classified as a bank and is regulated by BRSA, it functions as a central government agent providing assistance to municipalities. It is not a deposit taking bank but functions as a public sector institution with a mandate to develop local infrastructure. Institutional Structure The institutional structure of IB is as follows: 0 General Assemblv: IB 's shareholders are classified into three groups: provincial administration, municipalities, and village administration. These three groups are represented in the General Assembly. In addition, there is representation from Treasury, and the ministries of Finance, Interior, Public Works and Settlement, Education, Agriculture, Forest and Rural Affairs, Health, and Industry and Trade. The General Assembly meets in April each year. 0 Board of Directors: The highest executive unit in IB is the Board of Directors that comprises five people: a chairman and four members. The General Manager of IB is also the chairman of the Board. Three members are nominated by the Ministry of Public Works and Settlement while the fourth is nominated by the Ministry of Finance. 0 Management: The highest level of management is the General Manager and four Deputy General Managers who are based in Ankara, which is the headquarters of IB. This management team is supported by other managers in Ankara and eighteen regional offices. The Council of Ministers nominates the General Manager and the President of the Republic approves the nomination. There are 52

59 laws that provide guidelines on the required qualification for the management and the current management team meets the requirement of the law. At the end of 2003, IB had a total of 3,552 personnel who are based in Ankara and the eighteen regional offices. The decentralization of staff is high and about 56% of the personnel are based in the regional offices. Compared to 2002, there has been a slight decline in staff. The administrative staff includes the ones that carry out non-technical activities and includes accounting professionals. The technical staff are primarily the engineering experts that have supported municipalities in the past on surveys, feasibility studies, detailed design, and procurement. Staff Classification Administrative Technical support TOTAL As of Dec. 31,2003 As of Dec. 31,2002 1,513 1,685 1,251 1, ,552 3,815 Operations As per the 1945 Law No. 4759, IB has two core functions: a) support infrastructure development at the local level through technical assistance, grants, and loans; and b) transfer central tax revenues to the local authorities. Infrastructure Development The bank carries out the following hnctions: 0 provide investment loans to local administration for public improvements in cities, towns, and villages; 0 provide short term loans to local administration; 0 prepare maps and surveys and conduct studies - such as urban planning - to support development at the local level; 0 supervise construction, on behalf of municipalities; 0 sell or lease local assets, on behalf of local administration; 0 arrange insurance for local assets, on behalf of local administration; and 0 provide equipment that is necessary for construction at the local level. While IB has multiple functions, its core business has been in the provision of loans for the water and wastewater sector (shown below in the table). To help the country meet 53

60 EU environmental directives, the institution intends to strengthen this core business and also assist municipalities with their solid waste management needs. IB also channels central government grants to municipalities and about 10% of the investments supported by IB have been grant funded. No. of activities Other civil works Geotechnical studies Tax Transfers In addition to infrastructure development function, IB also has a core function to act as the agent for the central government to transfer taxes to the local authorities on a monthly basis. About 6% of national taxes collected in the country are directed to local authorities based on population. IB has the infrastructure to carry out this activity for the 3,225 municipalities on a monthly basis. In 2003, the total transfers amounted to TRL 2.9 quadrillion. Investments and Financing In 2004, IB invested around 458 trillion TL (around US$ 300 million) in the municipal sector. The proposed investment and financing of IB are shown as Attachment 1 of this Annex. Traditionally, IB has been able raise its capital from the equity contribution from municipalities. As per the Iller Bank Law, 5% of actual municipal net income of the previous year is transferred by the municipalities to IB as an equity contribution to the IB. The institution does not take deposits and has not raised funds from the market and as a result, there are no financial liabilities. The capital infusion through equity contribution from municipalities will continue due to the requirements of the Iller Bank Law and IB plans to use this capital and the Bank loan to support municipal infrastructure development in the medium term. In lieu of debt service on loans made by IB to municipalities, IB is authorized to deduct 100% of the tax transfers to the municipalities. However, the method of loan recovery through interception of tax transfers as a last resort enforcement measure has not been uniformly applied. Sometimes, there is political pressure on IB to intercept lower than the maximum amount to not hamper the tax revenue flows to financially-constrained municipalities. 54

61 2. GOVERNMENT ACTIONS IB was created in 1933 and the conditions then were different from the challenges faced today by the municipalities. Recognizing that IB can play an important role in developing municipal infrastructure, the government intends to strengthen the technical and financial function of the institution. To this end, the government has started two key activities: 0 Preparing the Iller Bank Strategy, under the leadership of SPO. This strategy is expected to be completed by October 2005; and 0 Amending Iller Bank Law taking into account the key recommendations of the Iller Bank Strategy. The amendments to the Iller Bank Law are expected to be sent to the Parliament after the strategy is finalized. Iller Bank Strategy On July 7, 2003 a governmental decision was taken to prepare the Iller Bank Strategy under the leadership of the State Planning Organization (SPO). A draft strategy was prepared in November 2004 which recognizes that IB has been providing key local government services since 1933 and that the bank has an important role to play in the future, especially taking into account the rapid urbanization in Turkey. The strategy defines the mission of IB as contribute to sustainable urbanization through the development of projects at international standards, providing loans, consultancy, and technical assistance to meet the needs of the local administration. To meet this mission, IB has defined the following seven specific actions, along with benchmarks: (a) provide service to municipalities in a timely manner; (b) strengthen the banking function of IB; (c) complete projects to meet the needs of municipalities; (d) ensure that proper technology is used; (e) improve the quality of staff in IB; (f) support development of projects in other countries; and (g) ensure efficient use of public resources so that loans are repaid in a timely manner, the capital of the bank is utilized more economically, and the financial management of the bank improves. The strategy notes that special assistance will be required for the medium and small sized municipalities. Out of the 3,225 municipalities in the country, 2,838 municipalities have a population less than 20,000 and there are 182 municipalities with a population between 20,000 and 50,000. The strategy outlines some of the recent steps taken within IB: 0 As of January 1, 2004 IB is no longer involved in procurement of works, goods and services on behalf of municipalities. This decision was taken through Regulation on Amendment to the application regulation of Iller Bank Law (Official Gazette No ); 0 On March 18, 2004 a decision was taken by Ministry of Public Works and Settlement to adopt the Regulation on Construction Supervision Services of Iller 55

62 Bank (Offcia1 Gazette No ) on the role of IB in supervision of contracts. Through this decision Iller Bank will be able to provide technical assistance to municipalities, if requested; and a In December 2003, the Department of Project Development and Appraisal was created and guidelines for project appraisal were established. The strategy also notes the following priorities of IB in the coming years: a Protect seas, lakes, rivers, and fresh water sources. IB will receive funds for the protection of water sources, given the national importance of such activities; 0 Be more responsive to the needs of municipalities. The transfer of procurement to the municipalities is an important step in this regard; a Provide supervision of contracts as support to municipalities, if requested; 0 Be an implementing agency for the upcoming EU programs, as Turkey gets ready to upgrade its water and wastewater systems in line with the EU environmental directive; a E-transformation of IB through which the decisions will be well documented and available to relevant parties, including the regional offices. The E-transformation process was launched in the bank on April 29,2004 and the process is expected to be completed by end December 2005; and 0 Create a database on the service needs of all municipalities so that future investment programs can be developed. The data collection process has been completed and the information now needs to be stored in a database that will be regularly updated. Iller Bank Law Draft amendments to the law have been prepared and circulated among related ministries for comments. It is expected that the key recommendations of the strategy will also be incorporated in the amendments which will be sent to the Parliament after the Iller Bank Strategy is finalized. A major feature of the proposed amendment (November 2004 version) is the institutional restructuring of IB through the separation of the following functions: service, consulting, supervisory, and ancillary units. 0 Service units - departments of Loan, Banking Services and Fund Management, Urbanization, Project Development, Project Assessment, Infrastructure Implementation, Superstructure Implementation, and Accountancy. These service units will help to bring more focus on banking and technical functions; 56

63 0 Consulting units - departments of Legal Consultancy, and Press and Public Relations Consultancy. The consultancy is expected to be fee based and as a result they have to be competitive with the private sector; 0 Supervisory units - Internal Audit unit and Risk Management unit to be in compliance with BRSA regulations; and 0 Ancillary units - departments of Human Resources and Back-up Services. 3. FINANCIAL PROJECTIONS The financial projections of Iller Bank are shown below which indicate that the institution will be able to maintain profitable operations and satisfactorily carry out the project. The projections take into account the proposed changes in IB, indicated in the draft Iller Bank Strategy and amendments to the Iller Bank Law. These projections were reviewed by Treasury as part of its due diligence process to provide the sovereign guarantee under this project. Assumptions 0 The results from the third quarter 2004 financial data (as of September 2004) were extrapolated to estimate the projections; 0 The projections are in nominal terms, based on inflation and exchange rate expectations indicated below. These assumptions were provided by Treasury to B; Inflation YTLNS$ US$/Euro Onward 8% 5 YO 4% 4% Annual YTL devaluation of 4% As of January 1,2005, Turkey has re-denominated its currency. The new currency unit is Yeni Turk Lira (YTL). TL 1,000,000 is equal to YTL 1. The financial statements and tables have been adjusted accordingly; 0 From 2006, IB will apply the following real interest rates for its local currency loans: 4% for 3 year maturity (equipment loans); 3% for 5 year maturity (construction loans for investments that are in the program of SPO or IB); and 5% for short-tenn loans (working capital loans); 57

64 0 Annual investments were forecasted according to the demand survey conducted by IB in 2004; 0 Fees associated with the Bank loan will be passed on to the borrowing municipalities. The interest rate for municipalities will be the Bank s interest rate plus a 1% margin to be charged by IB; and 0 Table of selected financial indicators are shown below. Income Statement In 2003, after taxes, IB registered a net profit of 158,946 billion TL which represents a net margin of 32%. As IB will start to charge a positive real interest rate from 2006, the net margin is expected to rise to 37-41% level; The decrease in revenue in 2003, compared to 2002, is primarily due to the loss of other revenue, which originated from the procurement and final design services provided by IB that were discontinued from However, it is planned that IB will provide technical consulting services on a fee basis to municipalities, especially the smaller ones. A steady increase in technical services is assumed between 2004 and 2009 where the fees are expected to grow from 3% of total revenue in 2003 to 8% of total revenue in 2015; Interest revenues represented about 90% of the total revenues in Lending will remain as the main revenue source and the percentage of interest revenue to total revenue is expected to be around 85% during the projection period; On the expenses side, the main cost is the personnel. IB plans to check this cost by not increasing the total number of staff after The total personnel cost is assumed to increase by 2% annually in real terms, caused by the change in mix of technical, financial and banking staff. The financial and banking staff are paid at a higher pay scale compared to other technical staff as stipulated in the Civil Servant Law; The cost of inflation corrections, associated with introduction of inflation adjusted accounting, was about the same amount as other expenses in This high 58

65 level of corrections in 2003 was due to the fact that IB did not adjust the value of its assets with inflation in a timely manner; and a Debt Service Coverage Ratio (net income/debt service) will be maintained at high levels since IB has low debt service requirements compared to its net income. The primary sources of finds for investments will be: collection on loans outstanding, net income, and the Bank loan (shown in the Funds Flow Chart). The projected resources in liquid assets will be adequate to service the Bank loan. Balance Sheet 0 In the past, political interference hindered IB in filly collecting its loan assets from the municipalities, which led overdue payments. Total overdue loans at the end of 2004, including accrued interest and penalties, accounted for 28% of IB s total equity. However, as of January 1, 2005, all overdue loan assets have been restructured into three year loans with monthly repayments and they are being closely monitored. The current regulations prevent IB from provisioning overdue loans which results in over-reporting of income and consequently a higher tax liability, compared to a situation of adequate loan provisioning; a a a Paid-in capital is expected to grow from TRL 749 trillion in 2003 to YTL 3 billion by mid This is due to the May 2004 decision of IB s Board to increase the capital of IB through equity contributions by municipalities; 18% of the total assets were held in short term money market accounts in These are typically the tax resources held by IB over a short period (around 10 days), prior to the transfer to the municipalities. In 2003, the total amount that was transferred to the local authorities was TL 2.9 quadrillion. The money market and securities accounts are expected to stay consistent over the project period; IB will follow a conservative financial policy that maintains its repayment capacity. Current Ratio (current assetdcurrent liability) will be maintained above 1.5 throughout the projection period; 0 The short and long-term loans constitute about 65% of the assets during Short-term loans were mainly short term advances which are not in the investment program. In line with the increasing emphasis to support infrastructure investments in municipalities, the short-term loans are projected to gradually decrease. Correspondingly, the long-term loans will increase and the total loan assets are expected to be around 75% of total assets during the project period; and a The main liability arises from the tax transfers to be made to municipalities, which constitute about 60% of all liabilities in 2003 (miscellaneous short term liabilities). Currently, there are no credit liabilities. Even as the credit liability will increase due to the Bank loan, the Gearing Ratio (liabilitiedequity) will be decreasing from around 44% in 2003 to 16% in 2015 due to the projected increase 59

66 in equity. The lowering Gearing Ratio and Debt Service Coverage Ratio above 2 suggest that IB has the capacity to take on more debt, if required. 60

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