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2 1. Bali 2. Bangka-Belitung 3. Banten 4. Bengkulu 5. Daerah Istimewa Yogyakarta 6. Daerah Khusus Ibukota Jakarta 7. Gorontalo 8. Irian Jaya Barat 9. Jambi 10. Jawa Barat 11. Jawa Tengah 12. Jawa Timur 13. Kalimantan Barat 14. Kalimantan Selatan 15. Kalimantan Tengah 16. Kalimantan Timur 17. Kepulauan Riau 18. Lampung 19. Maluku 20. Maluku Utara 21. Nangroe Aceh Darussalam 22. Nusa Tenggara Barat 23. Nusa Tenggara Timur 24. Papua 25. Riau 26. Sulawesi Selatan 27. Sulawesi Tengah 28. Sulawesi Tenggara 29. Sulawesi Utara 30. Sumatera Barat 31. Sumatera Selatan 32. Sumatera Utara

3 Averting an Infrastructure Crisis: A Framework for Policy and Action

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6 THE WORLD BANK OFFICE JAKARTA. Jakarta Stock Exchange Building Tower II/12th. Fl. Jl. Jend. Sudirman Kav Jakarta Tel: (6221) Fax: (6221) Website: THE WORLD BANK H Street N.W. Washington, D.C , U.S.A. Tel: (202) Fax: (202) / feedback@worldbank.org. Website: A copublication of the World Bank East-Asia Infrastructure Department and Indonesia Country Program Printed in June 2004 Cover and book design: Arif Wicaksono - Grha Info Kreasi All photographs used in this publications are from Jez O'Hare Photography, except photos on page 12 and 41 (World Bank collection) and some photos on the cover (see below) Cover photographs: Power Line; Jez O'Hare. Bus Passenger; Jez O'Hare. The photographs of children, old woman, and telephone-man are from World Bank collection. This volume is a product of the staff of the World Bank. The findings, interpretations, and conclucions expressed herein do not necessarily reflect the views of the Board of Executive Directors of the World Bank or the governments they represent. The World Bank does not guarantee the accuracy of the data included in this work. The boundaries, colors, denominations, and other information shown on any map in this work do not imply any judgment on the part of the World Bank concerning the legal status of any territory or the endorsement or acceptance of such boundaries.

7 Foreword Countries around the world are again recognizing the crucial role of infrastructure in promoting development. Strong infrastructure programs spur economic growth, create jobs, and help improve the quality of life. Neglect of infrastructure, in contrast, acts as a drag on growth and job creation, and perpetuates poverty. In today s Indonesia, due to the economic crisis of and other factors, the state of infrastructure is a hindrance rather than a help to development. Risks of power outages are discouraging investors in new factories, traffic congestion is eroding the quality of urban life, and longer travel times are making businesses uncompetitive as they seek to get their goods to market. Forty seven percent of households are still not connected to the grid, and 6,000 villages lack electricity altogether. Forty five percent of households suffer unsanitary conditions and 22 percent have no access to safe water. As a result health conditions and worker productivity compare unfavorably with comparator countries. The good news is that Indonesia is well positioned to reverse this situation. Recent macroeconomic successes imply that financial shortages are easing, and new legislation and policies offer the possibility of better managed infrastructure and a renewed role for private investment in the sector. This report Averting an Infrastructure Crisis: A Framework for Policy and Action has been prepared to support the Government s efforts to take advantage of this opportunity. It has been developed in close collaboration with Bappenas and other key agencies. It complements the Infrastructure Book, developed under BAPPENAS to provide a long term infrastructure development scenario that encompasses all major infrastructure sectors. The path ahead will not be easy. Policy reforms will need to be implemented firmly, and investment in infrastructure will need to be increased by an amount equivalent to 2 percent of GDP per year. Money cannot substitute for policy and institutional reforms, or vice versa. Both are required, and both public and private sectors will need to play a larger role. The report provides options rather than blueprints. The main report addresses cross-cutting issues that affect all infrastructure sectors. Background reports are available on roads, telecommunications, electric power, water supply and sanitation. The World Bank is privileged to work in partnership with the Government as it works for deeper and more equitable development. We stand ready to further support the efforts of the Government to implement an ambitious infrastructure reform agenda. Finally, the report attempts to provide an integrated approach to infrastructure development that goes beyond sector-specific issues. This cross-sectoral analysis forms the first part of the report (first six chapters). It draws on a study of four specific sectors namely telecommunications, power, water supply and sanitation, and roads, which are presented in the second part of the report (four background sector reports). Similar approaches are being undertaken for other Asian countries. In addition, a thematic infrastructure strategy report undertaken in collaboration with JBIC and the ADB, will also cover the emerging challenges facing the whole East Asia region. We hope that this effort will enhance our understanding of infrastructure issues in East Asia and thus help policy makers throughout the region. Andrew D. Steer Country Director, Indonesia East Asia and Pacific Region Christian Delvoie Director, Infrastructure Department East Asia and Pacific Region v

8 Acknowledgment This report was prepared by a core team led by Ani Dasgupta and consisting of Michel Kerf (co-team leader), David Hawes, and Andre Bald. The following people formed the larger team and contributed to or drafted parts of the report: Migara Jayawardena, Phil Gray, Bill Paterson, Peter Roberts, Mohammad Farhandi, Geoffrey Read, Tenzin Norbhu, Peter Smith, Phil Lam, Demetrios Papathanasiou, Ann Thomas, Janelle Plummer, Jan Drozdz, Menno Pradhan, P S Srinivas, Naseer Rana, and Jonathan Walters. The report was prepared under the overall guidance of Christian Delvoie, Director, East Asia and Pacific Infrastructure Department and Andrew Steer, Country Director, Indonesia. The report benefited from consultation and advice from numerous reviewers including: Antonio Estache, Jenifer Wishart, Christina E. Malmberg Calvo, Vivien Foster, C. Fallert Kessides (as peer reviewers); Bert Hofman, Jit Bajpai, Keshav Varma, Juinhui Wu, Joel Hellman, Rick Pollard, Yoichiro Ishihara, Albert Wright, John Besant Jones, Jonathan Halpern, Cecilia Briceno, Axel Baumler, Barbara Lee, Homi Kharas, Arvind Gupta, Jeffrey Gutman, Michel Bellier, Baher El Hifnawy, Hatim Hajj, Alberto Nogales, Luiz Tavares, Songsu Choi, Raja Iyer, Hiroaki Suzuki, Ming Zhang, Noureddine Berrah, Robert Taylor, Barry Trembath, Elisa Muzzini, Abhas Kumar Jha, and Mark Baird. Editorial and production support was provided by Melissa Morris. We would like to thank the Norwegian Trust Fund for Private Sector and Infrastructure for financial support for this project, and Marianne Bergstrom for her good natured support. This report was developed in close collaboration with Bappenas and Committee for Acceleration of Infrastructure Investments (KKPPI) in Indonesia. Many staff from these departments provided invaluable advice, and we would like to especially thank Suyono Dikun, Deputy Minister for Infrastructure, BAPPENAS; Jinny Katuuk, Deputy Minister for Fiscal and Economic Decentralization and Infrastructure Development, Coordinating Ministry for Economic Affairs; and Bambang Susantono, Assistant Deputy for Communication and Telecommunication, Coordinating Ministry for Economic Affairs for their support and guidance. This report complements the Infrastructure Indonesia: before, during and after the crisis, (2003), edited by Mr Dikun and developed by BAPPENAS which seeks to provide a long term infrastructure development scenario and encompasses all major infrastructure sectors. KKPPI organized four workshops to discuss the background sector papers with a diverse group of sectoral experts. We would like to acknowledge the contribution from all of the participants of these workshops. Our understanding of each sector was greatly enhanced by their candid examination of the bottlenecks and solutions from a variety of perspectives. These events brought together over 100 of the leading experts from government agencies, the private sector, the NGO and academic communities, and the press. The background sector papers are included at the end of this report. The discussion from these workshops shaped our report, and the positive feedback prompted us to co-host with KKPPI a larger national conference to share and discuss the cross-cutting policy issues emerging from our analysis of Indonesia s infrastructure. Conclusions and comments from this conference shaped the main report. We want to thank Mr Susantono for taking the initiative to arrange these events and Hardini Puspasari and Sri Oktorini for handling the logistical details. vi Averting an Infrastructure Crisis: A Framework for Policy and Action

9 Table of Content Foreword Acknowledgment Overview Introduction 1 The Problem 2 Towards a Solution 4 Need for Action on Multiple Fronts 6 The Way Forward 15 Chapter 1 Achievements, Challenges, and Opportunities Introduction 17 The Infrastructure Challenge 18 Public Management of Infrastructure 26 Business Environment for Infrastructure 27 Corruption 28 Financing Challenge 29 Chapter 2 Improving Public Management of Infrastructure Introduction 31 Commercializing, Corporatizing and Privatization 32 Making Decentralization Work 34 Evolving Role of the Center 39 Recommendations 43 v vi Chapter 3 Restoring Private Participation Introduction 49 Private Infrastructure Investment in the 1990s 52 The Promise of Private Service Provision 53 Setting Objectives 54 Ensuring the Financial Sustainability of Service Provision 55 Maximizing Competitive Discipline 57 Balancing Users and Operators Interests through Adequate Regulation 62 Allocating and Managing Risks 64 Public Support for Private Projects 67 Recommendations 73 Chapter 4 Getting a Grip on Corruption Introduction 75 Anatomy of Corruption in the Infrastructure Sectors 76 Recommendations 85 Chapter 5 Mobilizing Finance for Infrastructure Development Introduction 89 Financing Gap 90 Options for Bridging the Financing Gap 91 Targeting Public Finances to Protect the Poor 98 Recommendations 102 Chapter 6 The Way Forward: Prioritizing Reforms Introduction 105 International Comparisons 106 Estimated Impacts of Certain Reforms 107 Prioritizing Reforms 110 List of Abbreviations 229 End Notes 231 Bibliography 239 vii

10 Table of Content List of Figures Figure 1. Total Infrastructure Expenditures ($US Billions, nominal) 2 Figure 2. Access to Infrastructure by Income for 'Safe Water' 3 Figure 3. Central Government Development Spending (US$ Billions) 4 Figure 4. Private Participation in Infrastructure ($US millions) 8 Figure 5. Filling the Gap - Infrastructure Spending (% of GDP) 11 Figure 6. Infrastructure Spending as a % of GDP) 11 Figure 1.1. Fewer firms are set up (percentage in total companies) 21 Figure 1.2. Growth and Infrastructure Investment (% of GDP) 21 Figure 1.3. Household Access to Safe Water by Income (%) 22 Figure 2.1. Improving Government Performance 46 Figure 3.1. Private Participation in Infrastructure ( ) 52 Figure 3.2. Private Participation in Infrastructure ( ) 52 Figure 3.3. Process for Deciding Whether to Provide Fiscal Support 68 Figure 5.1. Infrastructure Investment (% of GDP) 90 Figure 5.2. Structural Change (% of Economic Activity) 90 Figure 5.3. Central and Local Development Spending on Infrastructure as a % of GDP (Current 1993) 92 Figure 5.4. Local Government Development Spending by Sectors, Figure 5.5. Central Development Spending on Infrastructure as a % of GDP (Current) 93 Figure 5.6. Central Government Development Spending (US$ Billions) 93 Figure 5.7. Fiscal Consolidation 94 List of Tables Table 1. Infrastructure Performance 2 Table 2. Sector Issues 3 Table 1.1. Infrastructure Service Delivery Power and Telecom 18 Table 1.2. Infrastructure Service Delivery Water, Sanitation and Roads 18 Table 1.3. Urbanization in East Asia 22 Table 3.1. Main Forms and Potential Benefits of Infrastructure Privatization 53 Table 3.2. Options Most Likely to Address Government Objectives 70 Table 6.1. Business Environment 106 Table 6.2. Estimates of Cost and Benefits of Reforms 107 List of Text Boxes Box 1. taking action on Public Management 7 Box 2. taking action on Restoring Private Participation 10 Box 3. taking action on Tackling Corruption 11 Box 4. taking action Mobilizing Finance for Infrastructure Development 14 Box 1.1. Infrastructure and the Business Climate 20 Box 2.1. Box 2.2. Box 3.1. Box 3.2. Box 3.3. Financing Schemes to Pursue National Objectives in Decentralized Contexts: The State Revolving Fund Model 36 Financing Schemes Using Apex Institutions to Select Good Projects - The case of FINDETER in Colombia 37 Achieving Economies of Scale in Water and Sanitation in Brazil 61 Assessing the Fiscal Impact of Colombian Government Guarantees 71 South Africa Taking into Account Public Expenditure Impact of Public-private Partnerships in Infrastructure 72 Box 4.1. Procurement in the Second Sulawesi Urban Development Project 79 Box 4.2. Year-end moves to protect budgets 83 Box 5.1. Using Pension Funds in Chile to Finance Infrastructure 96 Box 5.2. Malaysia: The Case of the Employees Provident Fund 97 Box 5.3. Cross-subsidizing New Connections Under the Buenos Aires Water and Sanitation Concession 100 Box 5.4. Output-based Aid Scheme to Extend the Teledensity in Chile 101 viii Averting an Infrastructure Crisis: A Framework for Policy and Action

11 Table of Content Background Sector Report I Electric Power Introduction 121 Policy and Institutional Framework 124 Sector Structure and Ownership 126 Investment Needs and Financing 129 Sector Performance 131 Main Sector Issues 133 The Way Forward 137 Annex I.1 Cost Benefit Analysis Electric Power 140 Background Sector Report II Telecommunications Introduction 149 Policy and Institutional Framework 150 Sector Structure and Ownership 151 Investment and Financing 153 Sector Performance 154 Main Issues 156 The Way Forward 158 Annex II.1 Cost Benefit Analysis Telecommunications 160 Background Sector Report III Road and Road Transport Overview 171 Policy and Institutional Framework 173 Sector Structure and Ownership 174 Investment and Financing 175 Sector Performance 178 Main Issues 180 The Way Forward 182 Annex III.1 Cost Benefit Analysis Road and Road Transport 190 Background Sector Report IV Water Supply and Sanitation Overview 193 PART A: WATER SUPPLY Policy and Institutional Framework (Water) 195 Sector Structure and Ownership (Water) 196 Investment and Financing (Water) 199 Sector Performance (Water) 200 Main Sector Issues (Water) 202 PART B: SANITATION Policy and Institutional Framework (Sanitation) 204 Sector Structure and Ownership (Sanitation) 204 Investment and Financing (Sanitation) 205 Main Sector Issues (Sanitation) 208 The Way Forward ( Water and Sanitation) 209 Annex IV.1 Legislation relevant to water supply and sanitation service provision 216 Annex IV.2 Principal agencies involved in policy formulation and implementation 217 Annex IV.3 The Jakarta Concessions 218 Annex IV.4 Financial Recovery Action Plan (FRAP) 219 Annex IV.5 Corporatization of PDAMs 221 Annex IV.6 Cost Benefit Analysis Water Supply 222 ix

12 Table of Content List of Figures Figure II.1. Indonesian Telecommunications Sector Structure 153 Figure Annex II Model simulation - Price elasticity 162 Figure Annex II Local Market Price vs. Time 163 Figure Annex II Local Market Quantity Demanded over Time 164 Figure Annex II Local Market Change in Consumer Surplus over Time 164 Figure Annex II National Long Distance Market Price over Time 165 Figure Annex II National Long Distance Market Quantity Demanded over Time 166 Figure Annex II National Long Distance Market Change in Consumer Surplus over Time 166 Figure Annex II International Long Distance Market Price over Time 167 Figure Annex II International Long Distance Market Quantity Demanded over Time 168 Figure Annex II International Long Distance Market Change in Consumer Surplus over Time 168 Figure Annex II Aggregate Change in Consumer Surplus over Time 168 Figure III.1. Public Expenditure on National, Provincial and District Roads (current prices) 175 Figure III.2. Public Expenditure on National, Provincial and District Roads (constant 2002 prices) 175 Figure III.3. Adequacy and Allocation of Resources for Road Preservation 180 Figure III.4. Economically Warrented Road Capacity Expansion Program for Java Strategic Network Figure Annex III Figure IV.1. Sector Structure and Ownership 196 Figure IV.2. Key Issues for future action in the water sector 202 Figure IV.3. Key Issues for future action in the sanitation sector 208 List of Tables Table I.1: Main Legal and Regulatory Provisions 124 Table I.2: Electrification Rates (%) 131 Table I.3. Quality of Electricity Supply (Scale of 1-7), Table I.4. Transmission and Distribution Losses (%) 132 Table I.5. The Way Forward 141 Table Annex I Cost to sector due to power shortage 145 Table II.1. Key Reforms Introduced by Law 36/ Table II.2. Allocation of Policy and Regulatory Responsibilities 151 Table II.3. Telkom and Indosat Transition to two Full-Service Providers 151 Table II.4 Investment in KSO Regions 152 Table II.5. ICT Expenditures as a Share of GDP in Selected Countries 153 Table II.6. Teledensities in Selected Countries 155 Table II.7. Internet Use in Selected Countries Table II.8. Telephone Faults per 100 Lines per month 155 Table II.9. Telephone Main Lines per Employee 155 Table II.10. Fixed and Analog Cellular Fees Table II.11. Fixed and Analog Cellular Fees as Percentage of Per Capita GNI Table II.12. The Way Forward 159 Table Annex II NPV of the Change in Consumer Surplus by Segment (in Millions) 160 Table Annex II % Change in Price for Local Segment 163 Table Annex II Model Result - Local Market Segment 163 Table Annex II Local Market Average Total Call Minutes 164 Table Annex II Local Market Change in Consumer Surplus (in Millions) 164 Table Annex II % Change in Price for National Long Distance Segment 165 Table Annex II Model Result DLD Market Segment 165 Table Annex II National Long Distance Market Average Total Call Minutes 166 Table Annex II National Long Distance Market Change in Consumer Surplus (in Millions) 166 Table Annex II % Change in Price for International Long Distance Segment 167 Table Annex II Model Result - ILD Market Segment 167 Table Annex II International Long Distance Market Average Total Call Minutes 167 Table Annex II International Long Distance Market Change in Consumer Surplus (in Millions) 167 Table Annex II Aggregate Change in Consumer Surplus (in Millions) 168 Table III.1. Classification of Roads and Allocation of Responsibilities for Development and Maintenance 172 Table III.2. Main Legal and Regulatory Provisions 172 Table III.2. Main Legal and Regulatory Provisions 172 x Averting an Infrastructure Crisis: A Framework for Policy and Action

13 Table III.3. Allocation of Policy and Regulatory Responsibilities 173 Table III.4. Length of the Public Non-Tolled Road Network (Km) 174 Table III.5. Regional Shares of Classified Road Network, Land Area and Population, 2000 (%) 174 Table III.6. Governmental Expenditures on Roads, 1984/ / Table III.7. Total Road Network 178 Table III.8. Paved Roads as % of Total Road Length (including District roads) 178 Table III.9. Condition of the Kabupaten Road Network by Construction Type, Table III.10. Road Accident Fatalities, Table III.11. Condition of the National and Provincial Road Network by Region, 2001 (%) 179 Table III.12. Government Expenditure on Roads, Millions 1999 USD 180 Table III.13. Projected Road Agency and Road User Costs by Budget Level 180 Table III.14. The Way Forward 188 Table Annex III NPV of the Change in Consumer Surplus by Segment (in Millions) 190 Table Annex III Projected Road Agency and Road User Costs Assuming 80% Efficiency 191 List of Text Boxes Table of Content Box I.1. Integrating Captive Power Plants (CPPs) in the Power Sector 127 Box I.2. What About Using Captive Power to Increase Reliability? 135 Box I.3. Indonesia IPP Debacle 136 Box Annex IV Targets vs. achievements in the two concession areas 218 Table IV.1. Estimated distribution in urban areas 197 Table IV.2. Estimated distribution in rural areas 197 Table IV.3. Coverage Statistics for PERPAMSI Member PDAMs 197 Table IV.4. Sewerage Coverage 204 Table IV.5. The Way Forward - WATER 214 Table IV.6. The Way Forward SANITATION 215 Table Annex IV Legislation relevant to water supply and sanitation service provision 216 Table Annex IV Water Supply 217 Table Annex IV Sewerage 217 Table Annex IV Summary of Model Results (US$ Millions) 224 Table Annex IV % Change in Tariffs Needed to Cover Costs 224 Table Annex IV Inputs and Assumptions 225 Table Annex IV Model Outcomes 226 Table Annex IV Scenario 1 - Status Quo: Maintain current service level 227 Table Annex IV Scenario 2 - Partial Reform: Maintain current service level 227 Table Annex IV Scenario 2 - Partial Reform: Reinvest additional revenue to expand access 227 Table Annex IV Scenario 3 - Full Reform: Maintain current service level 227 Table Annex IV Scenario 3 - Full Reform: Reinvest additional revenue to expand access 227 Table Annex IV Sensitivity Analysis Comparison 228 Table Annex IV Summary of Model Results (US$ Millions) 228 Table Annex IV % Change in Tariffs Needed to Cover Costs 228 xi

14 overview Averting an Infrastructure Crisis: A Framework for Policy and Action

15 Indonesia is turning a corner, from crisis management towards growth. For the first time, after the crisis, Indonesia is able to focus on longer-term development policies. Reversing the trend of deteriorating infrastructure is one of the top priorities. How did Indonesia, a country that had successfully used infrastructure development as a path out of poverty and towards economic growth, find itself struggling in almost every infrastructure sector? Infrastructure played a key role in driving growth and poverty reduction in the 30 years prior to the 1997 crisis. But following the crisis, the government had to focus on fixing more immediate problems such as currency devaluation, capital flight, and an unstable political and social environment. The government had to reduce development spending, and infrastructure suffered across the board. Indonesia s infrastructure quality ranks among the lowest in the region and is affecting growth, poverty reduction, foreign investment, and the environment. Indonesia has recovered from the crisis, and the government is well positioned to refocus on infrastructure. Recent progress such as fiscal consolidation, political stability, and some improvement of the regulatory framework sets the stage for Indonesia to move beyond the current infrastructure impasse. To avert a major infrastructure crisis, further action is urgent. Additional infrastructure investments of about 2% of GDP are required in the short and medium-term. But additional spending alone is not enough, the government will also have to address the longer term issues of improving public management, the regulatory environment, and working out the complications from decentralization. Public infrastructure investment has dropped sharply since the crisis from $8 billion USD in 1994, to $1.5 billion in

16 Averting an Infrastructure Crisis: A Framework for Policy and Action The Problem Additional infrastructure investments of $5 billion USD (2% of GDP) is required annually to reach a 6% medium-term growth target. Poor infrastructure is impeding Indonesia s growth and poverty reduction efforts. While the extent that growth drives infrastructure, or that infrastructure drives growth, is unclear, the strong associations between GDP and the availability of telecommunications, power, paved roads, and access to safe water are well known as are the benefits of growth for the poor (Dollar and Kraay 2001). Indonesia s current GDP growth (4 percent) is limited by investment and several business climate surveys have identified poor infrastructure as a key bottleneck. Current consumption led growth has its limits, and to reach the government s 6 percent growth target, more investment is needed. Figure 1. Total Infrastructure Expenditures ($US Billions, nominal) Infrastructure is a key production function for improving health, gender equality, education, and the environment all components of the MDGs, and poverty reduction Private Public Indonesia has lost competitiveness and now ranks near the bottom among its neighbors for most infrastructure indicators (Table 1). The Word Economic Forum s survey, the Global Competitiveness Report captures Indonesia s slide in overall infrastructure quality. In 1996 Indonesia outranked Thailand, Taiwan, China, and Sri Lanka. By 2002, they all surpassed Indonesia which finished 64 th out of 80 countries surveyed. Table 1. Infrastructure Performance Indicator Indonesia Regional Ranking Electrification Rates (%) out of 12 Fixed Telephone lines (%) 4 12 out of 12 Mobile Subscribers (%) 6 9 out of 12 Access to Improved Sanitation (%) 55 7 out of 11 Access to Improved Water (%) 78 7 out of 11 Road Network (Km per 1,000 pop) out of 12 Coverage and quality are poor. Over 6,000 villages mostly in rural areas outside of Java-Bali still do not have electricity connections Infrastructure service coverage and quality are low. Roughly 90 million people are not have a electricity connection, the vast majority of whom are the poor. Only 14 percent of the population is serviced through water utilities and only 1.3 percent have access to a sewerage network. Indonesia s fixed-line teledensity (4 percent) reduces its competitiveness, and the lower rural coverage is increasing development disparities. Congestion has increased on the road network but little capacity has been added. Maintenance of existing stock is neglected, particularly on the district network where almost 50% of the roads are classified as in poor or bad conditions. 2

17 Overview Table 2. Sector Issues Water and Sanitation Telecommunications Water access is low 22% of the population do not Fixed line access is the lowest in the region have access to improved water, and only 14% only 4% of the population, mostly in urban areas, are connected to PDAMs is covered Sanitation service is lacking only 1.3% of the Massive investment is needed, but funding is population are reached by a sewerage network a challenge raising teledensity 1% will cost PDAMs are struggling over 2/3 operate in the $330 million red, unaccounted for water is over 40%, and The mobile sector continues to expand, tariffs are well below costs averaging 77% annual growth since 1995 Power Roads and Road Transport Access is low - 43% of population is without power Spending has declined from 22% of the national (roughly 90 million people, of which 90% are poor) development budget in 1993, to 11% in 2000 Connection costs are 33% higher in rural areas Maintenance is lacking the proportion of road Investment needs are high an estimated budget for maintenance reduced from 30% to US $15-17 billion is required before 2012 for below 10% from 1985 to 2000 an additional 9,700 MW of capacity, expanded Congestion is a problem significant capacity transmission, and distribution for 1.6 million connections annually expansion is needed, but little has been added, and urbanization trends will only increase the problem Infrastructure is critical to support rapid urbanization trends. More than 60 million people (from 80 million in 2000 to 140 million in 2020) will be added to Indonesia s urban population in the next two decades. The primary urban areas in the country already suffer from lack of clean water, sanitation and adequate urban transportation. Yet, urban areas are the key drivers of the economy contributing 70 percent of non-oil. Additionally, providing basic services to the large numbers of urban poor (over 13 million were below the poverty line in 2002) must be a focus of Indonesia s poverty reduction strategy. Poor infrastructure has reduced the quality of life and the environment. The lack of sewerage systems and solid waste facilities have caused widespread contamination of surface and ground water, as well as the destruction of sensitive eco-systems. During the dry season, 10% of the river flow of the Brantas river (the direct source of Surabaya s water supply) consist of untreated industrial wastewater. Further, about half of Surabaya s solid waste and most of the human waste are dumped into the river. These conditions are common throughout Indonesia, and are the prime reason Indonesia has the highest incidence of typhoid in East Asia. By 2020, Indonesia s urban population will grow by six times the size of Jakarta today. An ADB study estimates the annual social and economic cost of sanitation related health impacts at US$ 4.7 billion (2.4% of GDP), roughly Rp 100,000 per household per month. The poor have the worst access to services. Just over half of the population lives under $2 per day and not surprisingly their access to infrastructure services is markedly low. Figure 2 shows that access, in this case for safe drinking water, decreases sharply as household income declines. Coverage across sectors is generally even lower in rural areas, where 23 percent of the population lives below the poverty lines, versus 7.5 percent in urban areas. Adding to this, the poor have fewer choices and pay more through alternative providers, often for lower quality services. Figure % 80% 60% 40% 20% 0% Source: SUSENAS 2002 Access to Infrastructure by Income for 'Safe Water' Income Quintiles 3

18 Averting an Infrastructure Crisis: A Framework for Policy and Action The economic crisis contributed to the severity of Indonesia s infrastructure woes. Immediately after the economic crisis, many planned private and public infrastructure projects were suspended by, and the financial viability of active private projects was eroded by the Rupiah s plunge. Overall, public spending on infrastructure has dropped by 80 percent from pre-crisis levels. In 1994, the central government spent almost $14 billion USD on development, 57 percent of this for infrastructure. By 2002 development spending had plunged to less than $5 billion, of which only 30 percent was for infrastructure. Private investment in infrastructure also plummeted by over 90 percent from its peak in 1996, to its low in Figure 3. Central Government Development Spending (US$ Billions) * a.) Tourism, Post, & Telecom b.) Housing & Settlement, c.) Irrigation, d.) Transportation, Meteorology & Geophysics, e.) Regional Development Source: Ministry of Finance Towards a Solution Indonesia s projected economic outlook is bright showing increased growth, declining government debt, and reduced deficits The economic troubles of the late 90 s are not the sole explanation for the current infrastructure problems. Before the crisis hit, services such as water, electricity, roads and telecommunications suffered from poor institutional and regulatory frameworks, and corruption went unchecked. A prosperous economy provided little impetus for the government to take needed reforms. The financial crisis has now been overcome. With a stable macroeconomic situation and the reforms initiated in various infrastructure sectors, and IPP and KSO settlements, Indonesia is well positioned to address its infrastructure problems. However, financing needs are significant to adequately maintain existing assets and to increase capacity. Annual investments of $2-3 billion over the 2010 period are needed to meet even modest growth in electricity demand; the road sector could easily absorb $ million more per year for maintenance, betterment and expansion; investments of $600 million per year are considered a conservative estimate of what is needed to meet the Millennium Development Goals in the water and sanitation sector; and raising telecommunication density by one percentage point costs about $300 million. 4

19 Overview Infrastructure has been an integral part of the agenda for policy makers in the past few years. This has resulted in various reform initiatives, including the following: a modern electricity law was adopted in 2002, implementing regulations have been prepared, electricity tariffs have been increased substantially, and contentious issues with the Independent Power Producers have been settled; a new oil and natural gas law was passed, that introduced downstream competition and market pricing; the water sector has seen progress in implementing a debt work out program to strengthening PDAMs finances; and in telecommunications, a new law adopted in 1999 paved the way for the progressive introduction of competition in all market segments, and dramatic growth in the number mobile subscribers since 1997 has been accompanied by solid increases in the number of fixed lines in service, public payphones, teleshops, and internet shops. Despite the significance of the reforms, the resulting overall impact has been rather limited. A key impediment is the lack of an overall government strategy for infrastructure and predictable policies in these critical infrastructure sectors. For example, most of the key laws that were passed still do not have implementing regulations. In addition, credibility of public policies from the point of view of the private investors remains historically low. 5

20 Averting an Infrastructure Crisis: A Framework for Policy and Action Indonesia must address the various facets of this policy-credibility issue in order to attract the financial resources that its infrastructure sectors currently lack. In particular, more efficient management of public infrastructure assets will help contain costs and optimize use of public funds; with progressive implementation of cost-covering tariffs, internally generated funds could be made available for investment; and an overall environment more conducive to private participation would help rekindle the interest of private financiers for Indonesian infrastructure. Such reforms will take time, however, and a substantial financing gap is likely to remain. In order to fill this gap, government spending on infrastructure will have to increase. In addition, steps can be taken to promote greater mobilization of domestic savings for infrastructure investment, and better targeting of public resources towards the poor. Need for Action on Multiple Fronts Improving Public Management of Infrastructure Most of Indonesia s infrastructure is still developed and managed by the public sector, and this will remain the case for some time to come. Hence, better public management of infrastructure will have by far the most positive impact. However, the role played by the public sector will change in three major ways. First, Indonesia has moved to commercialize and corporatize delivery and management of key public infrastructure, hence, the role is changing from provision to regulation (discussed in the next section). Second, Indonesia has launched an ambitious decentralization program that has transferred many responsibilities relating to infrastructure provision to sub-national entities. Third, and in part as a consequence of the above two changes, the role of central agencies with respect to infrastructure is evolving, thus requiring the Government to rethink how it coordinates policy and strategic planning. Rethinking the Role of Central Authorities Today, responsibilities for infrastructure provision and operating decisions are widely dispersed between a proliferation of special purpose coordination committees several of which have overlapping roles. In the road sector, for example, what is needed is an effective National Roads Strategy. A strategy that is understood by all, with a clear financing plan, clear articulation of responsibilities, clear links between planning, new investments, management of use and maintenance, and a clear path ahead for capacity building and institutional reform. To do this, the central government will have to quickly readjust its role to the post decentralization environment. In addition to decentralization, many government agencies will now have to move from being a service provider to a facilitator, as greater corporitization and privatization is introduced. Emphasis is needed on policy formulation and support to local authorities rather than on design and implementation of civil works, or on direct provision of services. These new functions need to be defined with precision for each of the main sector ministries, and organizational structures and staffing needs will need to be reviewed accordingly. Indonesia also faces the challenge of redefining its mechanisms for coordinating policy and strategy for infrastructure development in an environment with more dispersed roles. In the past, Bappenas prepared the national five-year development plans and, along with the Coordinating Ministry for the Economy and Industry (EKUIN), also coordinated Indonesia s policy development and reform initiatives. Currently, Bappenas, whose powers are now more circumscribed, functions as a planning advisor for those committees, and the Coordinating Ministry of Economic Affairs (EKUIN s successor) focuses more on short 6

21 Overview term implementation matters. A key challenge for Indonesia is to craft a framework for coordinating policy and strategic planning in an environment with a much wider dispersion of responsibilities than in the past. Making Decentralization Work In 2001, Indonesia launched a big bang decentralization program. The legislative and regulatory provisions needed to implement such a program are still incomplete. In the infrastructure sectors, decentralization has created uncertainty as to which level of government is responsible for the provision of various services. The situation is exacerbated by the fact that some decentralization implementing regulations are inconsistent with others, as well as with existing national sector regulations. Capacity within the local governments also needs to be developed so that they can effectively provide services commensurate with their new responsibilities. The way in which financial resources have so far been transferred to decentralized authorities is unsatisfactory. First, the current allocation of resources between regions tends to exacerbate rather than reduce regional inequalities. Modifying the current allocation of resources is political and difficult but in the present situation, many poorer regions receive just enough to pay wages and are left with little funding for infrastructure or other types of expenditures. In addition, the central government lacks instruments to promote the pursuit of national objectives by local authorities. Funds available for matching grant schemes are very limited. In addition, at present two distinct matching grant mechanisms, with different application and evaluation criteria, and different terms and conditions are in use, these need to be harmonized. Finally, the current framework for regional government borrowing is unduly restrictive. Local governments should be encouraged to borrow from the market. This will require, among others, modern financial management at the local level and institutions that can rate local government credit worthiness. This is much needed, as constraints on financial transfers from the center and on borrowing opportunities have already led some regional governments to impose arbitrary fees and taxes that tend to introduce economic distortions and conflict with national legislation. Coordinating between the 400 local governments and municipalities will necessitate empowering provincial governments to have a larger role. Decentralization has exacerbated regional inequalities budget receipts per capita for rich regions are 30 times higher than the poorest regions. Box 1. Taking action on Public Management The role, organization and staffing of main sector ministries need to reflect the new decentralized environment. Overall policy planning and coordination functions also need to be strengthened. The government needs to expand its efforts to operate on a commercial basis. PDAMs especially need attention to be more transparent, and to operate more autonomously from local governments. UU22/1999 and earlier sector laws should be amended to better define the role and responsibilities between the levels of government, and for infrastructure provision. The provinces need to be empowered to play a much stronger coordinating role vis-à-vis municipalities. Procedures for on-lending of foreign loans need to be streamlined by amending KMK.35. (the policy that governs local borrowing) The current bottom-up process is complex, and has the potential to impede the channeling of funds for urgent and justified infrastructure at the sub-national level. Restoring Private Participation Indonesia needs to mobilize private investments for infrastructure if it wants to rapidly improve service coverage, maintain international competitiveness, and support the expanding economy. There has been a substantial decline in private participation in infrastructure in Indonesia after a dramatic increase in the first half of the 1990 s, (Figure 7

22 Averting an Infrastructure Crisis: A Framework for Policy and Action 4). Private participation will bring much needed financial resources and expertise. Indonesia can become substantially more competitive for private infrastructure funds by: ensuring the introduction of commercial principles in publicly managed infrastructure; financial sustainability of infrastructure services; enhancing competition between operators; implementing regulations to balance public and private interests; and optimizing the allocation of risk among stakeholders. Figure 4. Private Participation in Infrastructure ($US millions) Source: WB PPI database Commercializing, Corporatizing and Privatizing Increasing commercial discipline by transforming infrastructure department agencies into state-owned corporations, or limited liability companies has produced significant performance gains. A few examples are Telkom and Indosat (telecom), PLN and PGN (power), and Jasa Marga (roads). Requiring compliance with stock disclosure and auditing procedures, as well as appointing more professionally qualified and independent commissioners all had positive impacts. But not all service providers have similarly improved efficiency. PDAMs function with little autonomy, often relinquishing dividends to local governments who are notorious for applying pressure to keep tariffs artificially low. Commercial principles are also lacking in the road sector, were empirical findings suggests the quality of works is declining, while collusion in contract awards is increasing. Moving towards cost covering tariffs has directly contributed to PLN s improved financial sustainability other sectors should prudently follow. Ensuring Financial Sustainability of Service Provision The government s ability to apply cost-covering tariffs is an important precondition of private sector investment, which is not met at present in many infrastructure sub-sectors in Indonesia. The government has supported remarkable tariff increases in the power sector from below 2.5 cents per kwh in 1997 to the current rate of 7 cents (approximately same as cost of production), and achieved significant improvements in the financial condition of the sector. By contrast, the water sector is in disarray, as insufficient tariffs compel PDAMs to limit their expansion as well as cut back on maintenance. The transport sector also needs to improve its financial viability to fund much needed expansion works as well as cover the cost of maintenance. An appropriate method would be to remove ineffective subsidies on gasoline and diesel, restructure road user charges to reflect actual usage, and earmark 8

23 Overview these funds to cover sector expenditures. Charges for international telecommunications are expected to decrease due to enhanced competition in the sector but the price of local calls are currently below costs and will have to rise in the future. It is important that any future tariff increases in infrastructure sectors be phased in cautiously with corresponding improvements in services. Ensuring social acceptance of these reforms, where the rationale and timing are clearly articulated to the public, is also critical for the long-term success in the sector. Maximizing Competition Indonesia has not fully taken advantage of the benefits of competition, yet the intensity of competitive pressures is one of the most important determinants of performance in infrastructure service provision. The scope for head to head competition in the market where consumers can choose their supplier, and suppliers compete to serve them varies. However, the one market where competition is easily feasible, telecommunication, it has been postponed. Similarly in power, Indonesia Power and PLN continue to operate more as partners than head-to-head competitors. Consequently, power is more costly than it would be with competition. Indonesia s new 2002 electric power law does however recognize the potential for competition in generation and supply, and provides for its progressive introduction on a regional basis. Indonesia s mobile phone market is the best example of competitiveness (and consequently private investment), and consumers have benefited from better technology, more choices, and lower prices. When direct, head-to-head competition is not feasible, competition for the market (e.g. franchise bidding) can be used to select operators. However, numerous opportunities have been lost in Indonesia: water supply concessions have been awarded through direct negotiations; numerous unsolicited IPP projects were also negotiated quickly and nontransparently; and the same practices are widespread in the toll road sector. The cost for the Indonesian economy has been enormous when a number of IPP projects were finally competitively tendered, the offered tariff was well below the previously negotiated one for similar projects. Finally, competitive discipline can be derived from yardstick competition, whereby regulators use comparative performance data from other similar enterprises to regulate monopoly network industries. This is a tool that has been used effectively by various countries, especially in sectors characterized by the existence of multiple operators holding monopolistic positions in different regions. Some fragmented efforts have been made in Indonesia to introduce yardstick competition in the water distribution sector, but much more systematic efforts should be undertaken in that sector and elsewhere. Establishing Adequate Regulation Sound regulation is needed for private participation as it promotes economic efficiency, fosters innovation, and creates incentive for system expansion. A credible regulatory body, however, needs autonomy and independence to perform its function. This can be achieved by providing regulators with distinct statutory authority, appointing them for fixed-terms, preventing their removal except in predefined circumstances, and providing funding through levies on the regulated industry. Laws have been passed in both the telecommunication and energy sector that enables the creation of regulatory entities. Indonesia is at an early stage in developing its regulatory agencies and more effort is needed to develop adequate, independent regulatory bodies. To move forward, the government must appoint the regulators, issue and implement the regulations stated in the laws, and provide these agencies with adequate resources so that they can begin to establish a track record. Regulation by contract will have to be the norm in the interim. 9

24 Averting an Infrastructure Crisis: A Framework for Policy and Action Indonesia ranked 138 th out of 146 countries in the 2002 World Investment Report for Foreign Direct Investment. Allocating and Managing Risk Rewards for investors are commensurate with risks but Indonesia s reputation as a country, filled with red tape, a weak judicial system, arbitrary taxes, and corruption has made many investors reluctant to invest. Their reluctance also stems from political and economic events beyond their control. But if these services were to be provided by the public sector instead, the government would, in fact, be implicitly bearing all of the risks. Therefore, the government should develop a framework for identifying and assessing various investment risks, and a methodology to help determine which are acceptable to undertake. Involving the Ministry of Finance in this process would also better ensure that the expected fiscal exposure of risk sharing arrangements are properly evaluated and financially feasible. Box 2. Taking action on Restoring Private Participation Amendments to Keppres 7 (or a similar regulation) need to be completed, and supplemented with a sound policy framework on public support for private projects, including a framework for realistic risk allocation between public and private sector. Develop a comprehensive plan to restore tariffs to cost-reflective levels, and improve on socializing tariff changes to the public. Develop sector-by-sector plans for restructuring and promoting competition with the adoption of competitive tendering as the norm for all PPI projects, and benchmarking mainstreamed as a means to pressure local monopolies Indonesia ranked 122 out of 133 countries on the Corruption Perception Index (CPI) But curbing corruption is not impossible by increasing competition with improved complaint mechanisms and advertising, a recent World Bank infrastructure project in Bali has saved almost 20% of the government owner s estimate in procurement. Tackling Corruption Corruption remains pervasive in Indonesia, and despite the government s attempts to address the issue, little progress has been made. The post-soeharto and post-decentralization environment is often perceived to have made matters worse, as corruption is more diffused, and even less effective in producing intended results. Corruption is a major factor determining investor confidence. Indonesia s ranking, well below its neighbors (China, Thailand, Philippines, and Vietnam) in Transparency International s Corruption Perception Index (CPI), illuminates some of the reasons for its lagging investment climate. Infrastructure presents opportunities for rent seekers at every stage, from project identification and negotiation, to implementation and operation. The results are costly a significant amount of public funds are lost annually through corrupt procurement practices in Indonesia. Eliminating corruption requires fundamental changes in the accountability framework that will take considerable time to design and implement. However, there are significant opportunities for reducing corruption in the infrastructure sectors in the short term these require limiting rent-seeking opportunities, improving detection, increasing the consequences of being caught, and creating incentives for non-corrupt behavior. Box 3. taking action on Tackling Corruption Considerable effort has gone into improved procurement regulations for central and regional government by replacing Keppres 18/2000 with Keppres 80/2003. The new regulation establishes an Institution for Development of Public Procurement Policy (LPKPP), requires procurement certification for bid committees, removes pre-qualification for contracts below $6 million, and introduces integrity pacts for suppliers and contractors. Keppres 80 a positive step but the government needs to work out the many unresolved details to ensure implementation and enforcement are carried through. The revision to Kepress 7/1998 on Public Private Partnerships for Infrastructure Provision is overdue. This is needed to improve guidelines for project identification and more transparent and competitive solicitation of private partners. 10

25 Overview Mobilizing Finance for Infrastructure The reforms discussed above will help address, to some extent, the lack of financing that currently affects the provision of infrastructure. Cost covering tariffs, in particular, are ultimately key to ensure financial sustainability. But all such reforms will take time and there will therefore remain, a significant financing gap. This can, in part, be filled from three sources: increased government spending, greater mobilization of domestic savings, and better targeting of public resources towards the poor. In 1996 Indonesia invested 7% of GDP in infrastructure, the figure has dropped to 3% Increasing Government Spending The Government projects a growth rate of 6 percent or above for the year 2006 (GOI PJM ). Based on international comparisons as well as on comparisons with levels of government spending before the crisis infrastructure investments will need to reach at least 5 percent of GDP to sustain a growth rate of 6 percent per year. In 2002, overall spending on infrastructure amounted to around 3 percent of GDP only (see Figure 5.). This is low compared to Indonesia s past infrastructure spending levels. With limited prospects of substantial private investments in the short term, the gap needs to be closed, to a large extent, by public authorities. Local government spending in infrastructure increased significantly in the years following decentralization. Today local governments share of public investment in infrastructure is almost equal to that of central government (Figure 6). The most promising avenue for further increasing the contribution of local governments to infrastructure financing lies in enhancing their capacity to borrow. However, the institutions needed to make municipal borrowing possible and profitable for municipalities and creditors alike are severely underdeveloped in Indonesia and correcting this will, at best, be a slow process. In the short to medium term, increased public spending on infrastructure can therefore come only from the central government. This has been recognized by the authorities: from 2002 to 2003, infrastructure allocation by the central Government was increased by US$ 0.75 billion to bring infrastructure spending to US$ 2.5 billion, these figures remain low, however, when compared, for example, to the 1994 level of spending mentioned above. A combination of the following measures could possibly address the problem in Figure 5. Filling the Gap - Infrastructure Spending (% of GDP) Indonesia needs to increase infrastructure spending an additional 2% of GDP ($5 billions) annually to reach its 6% medium-term growth target 4.5% Figure 6. Infrastructure Spending as a % of GDP) Overall spending has declined, but the district's share has increased following decentralization 8% 4.0% Central 7% 6% Total Spending Indonesia needs to fill the gap by an additional 2% of GDP 3.5% 3.0% 5% 2.5% 4% Government 2.0% 3% 1.5% 2% Private Sector 1.0% District 1% 0.5% 0% %

26 Averting an Infrastructure Crisis: A Framework for Policy and Action the medium term. First, the central government needs to increase its overall revenue envelope, especially through increased compliance. Second, existing allocation in nonperforming sectors could be directed towards infrastructure (for example, various fuel subsidies account for nearly 2 percent of GDP). Finally, the impressive fiscal consolidation of the last few years has created some space for increased borrowing. Indonesia s debt to GDP ratio is steadily decreasing and the deficit has been kept to a bare minimum. This discipline has resulted in upgrades by investment rating agencies. Government can borrow at below 7 percent in the market today and, as discussed in the next section, the domestic market is relatively un-tapped for infrastructure related borrowing. However, before borrowing from the market, the Government should maximize the use of cheaper donor funds first. Mobilizing Domestic Finance Domestic funds are the key to the long-term health of infrastructure finance. Three large retirement funds (for police and defense personnel, for civil servants, and for employees in the private sector and in SOEs), several hundreds of funds established by individual employers for their employees and the life insurance sector have combined assets of about Rp. 100 trillion contributed by almost 26 million participants. Various steps can be taken to increase the flow of domestic fund to infrastructure. International experience shows that contractual savings institutions, notably pension schemes (which are allowed to invest in non-governmental assets) are essential instruments to channel domestic savings into infrastructure financing. Pension funds and insurance companies have long-lived liabilities denominated in local currency, making them particularly suited for investing in infrastructure instruments that provide returns in local 12

27 Overview currency over long periods of time. The Indonesian Government should therefore consider modification of the investment regulations that govern institutions such as the pension funds and insurance firms in order to enable such institutions to invest in infrastructure securities. It cannot be overemphasized, however, that an attractive investment climate for infrastructure is a precondition for tapping domestic capital markets; institutional reform in the capital markets alone will achieve little. It is also absolutely crucial that fund managers have incentives and be free to make investment decisions on the basis of commercial rather than political considerations. To develop products that these funds can invest in, the central Government may consider using public resources to strengthen the capacity of sub-national entities especially municipalities to borrow on the local markets. The Government of Colombia, for example, created a municipal finance institution, Findeter, designed to promote long term lending from commercial banks to municipalities. A bank that made a long term loan to a municipality can borrow from Findeter up to 85 percent of the loan at subsidized rates. This facilitates access by municipalities to commercial loans while relying on the project appraisal skills of commercial banks (banks are liable to Findeter if their borrowers default). To the extent possible, government schemes for municipal finance should involve the financial sector in allocating credit and sharing risk. This in turn requires that local banks possess sufficient capacity in assessing the expected returns of projects. Finally, municipal finance schemes can only be viable if municipalities have a positive and roughly predictable revenue stream through taxes, services charge, ect. To bring together supply and demand, the Government will have to focus on creating or upgrading certain aspects of financial market infrastructure. Establishing a sound government bond market in which sovereign issues in domestic currency of various maturities are issued at predictable regular intervals is another important aspect of market infrastructure: a well functioning government debt market allows the creation of benchmark bond prices which would then form the basis on which instruments of different risks can be priced. Lastly, a sound legal framework and credible dispute resolution mechanisms are key to attracting long-term investments from private sources. Sound and credible credit rating institutions which would provide an independent assessment to investors of the risks and returns offered by the bonds are important players in this process. Protecting the Poor Cross-subsidization between users of infrastructure services is very common in Indonesia. However, current cross-subsidization schemes in Indonesia present major drawbacks; they are not well targeted at the poor and tend to subsidize the already low variable consumption costs of existing users while the poor often have no access to the service; they entail rather large resource transfers and therefore introduce important allocation distortions, and they force a given service provider to operate transfers between different categories of its own users, therefore requiring that monopolistic arrangements be maintained to prevent new entrants from stealing the customers who are currently over-charged and who provide the source of the cross-subsidies. Cross-subsidization schemes should be better targeted at the truly poor e.g. existing users could contribute part of the costs of expanding the system to reach new users. In addition, to breaking up monopolies, the government could impose a uniform levy on all companies participating in the market and redistribute those resources to the operators who provide services to the poor. 13

28 Averting an Infrastructure Crisis: A Framework for Policy and Action Output-based schemes link the payment of the subsidy to the effective provision, by an operator, of the service that qualifies for obtaining the subsidy. Among the mechanisms that rely on taxpayers to subsidize certain services, output-based subsidies can be most precisely targeted at poor users. Since service providers receive the subsidy only after actual delivery of the desired services, such schemes enhance the operators incentives to perform. Indonesia has started to explore such schemes in the power sector. It should also design such schemes in ways that maximize competitive pressures between operators. This can be done by organizing competitive bidding processes to identify, on the basis of the lowest subsidy required, the operator that will have the right to provide the subsidized services. The Government could also establish a system of portable subsidies, whereby operators compete for customers and any operator that provides the agreed upon service to the targeted population receives a pre-determined subsidy. Box 4. Taking action Mobilizing Finance for Infrastructure Development Indonesia needs to increase investments in infrastructure by about 2 percent of GDP. In the short/medium term, increased spending by the central government will be required to bridge this gap. This would be possible through a combination of: improved tax collection, re-allocation of unproductive spending, and increase in borrowing made possible by the impressive fiscal consolidation. Steps should be taken to tap domestic savings for infrastructure investments. To the extent that cross-subsidy schemes remain necessary in the short term to enable the poor to have access to infrastructure, they should be more limited and better targeted at the truly poor It is imperative for Indonesia to press forward on the path of reform if infrastructure is to foster rather than hinder its fragile economic recovery and its efforts to tackle poverty. The Way Forward Indonesia has already started to undertake ambitious reforms in infrastructure. At the same time, the severity of current and potential future problems can not be underestimated. The reform agenda is potentially huge and no government can possibly address all issues simultaneously. There are limits, for example, to the number of new laws that can possibly be simultaneously drafted and then considered by the DPR. Also, tariffs cannot be increased all at once given the strain that it would put on household budgets. In addition, the Government has already committed to give high priority to an ambitious agenda of policy and legal reform measures included in the White Paper. In light of these constraints, this report attempts to prioritize between reform measures. There are no simple solutions ahead. But we believe that any strategy will need to focus on three pillars: First, better public management, planning and consistent policies for infrastructure development will be key to reestablish credibility, service provision and impact on the population. The new decentralization agenda lends added complexity to this agenda. Second, while the public sector is likely to remain dominant in many infrastructure sectors, steps will need to be taken to re-attract the private sector in order to provide vital expertise, foster competition (or appropriate regulation) to improve efficiency, and because the financing constraints will remain large for some time. Finally, efficiency in implementing public projects will be key to improve impacts. This will require a consistent drive to improve transparency, competitive bidding and root out corrupt practices, which are prevalent in infrastructure projects throughout the world and also in particular in many sectors in Indonesia. Over the short to medium term, we envisage a financing gap of around two to three percent of GDP to fully reestablish infrastructure expenditures to the level required to 14

29 Overview both support growth prospects, and to expand the provision of basic infrastructure services to the population. This is a conservative estimate, but we believe it is within reach with appropriate policies and improved efficiency. Indonesia has made impressive progress in fiscal consolidation over the last few years, and additional measures are identified to reach this goal. While increased public spending will be key, especially to reach the poor and lagging areas, this should not be considered a substitute for policy reforms, but a complement. In addition, this should also provide a good platform to develop more sustainable forms of mobilizing long term funding from domestic financing sources. Without minimizing the challenges ahead, we are therefore optimistic about the future. A feasible path exists, and the government is aware of what needs to be done. The report does not attempt to provide a blueprint for such a path, as searching for this path, including sequencing of actions, priorities for investments, and building constituencies for reforms, is by nature a political exercise. Rather, it tries to highlight key issues that the decision makers may want to consider when preparing and implementing their next steps. Key in this regard will simply be a consistency of signals and determination in forging ahead. We are honored to have been associated to this effort through this report and stand ready to assist in implementing it. 15

30 chapter 1 Achievements, Challenges, and Opportunities

31 Indonesia s past economic achievements are commendable. The economy grew impressively for 30 years until the 1997 financial crisis. The poverty headcount during the period of 1975 to 1995 declined from 64.3 to 11.4 percent. Despite the hardships endured as a result of the financial crisis, the fiscal consolidation policies that followed are widely viewed as sound. The infrastructure sector was a significant factor that paved the way for poverty reduction and economic development. Given Indonesia s dependence on infrastructure to reduce poverty and develop in the past, one must ask why the infrastructure sectors are substantially lagging behind today? Infrastructure was significant for Indonesia's gains in poverty reduction and economic development. It would be inaccurate to blame the financial crisis as the sole reason for the current state of the infrastructure sector in Indonesia. The issues in the sector arise from a complex set of issues rather than a single unique incident. The sector has required substantial structural and institutional improvements for quite some time, but the economic boom prior to the crisis overshadowed the urgency of the reforms. Adequate public policies on infrastructure were never put in place and as a result, the sector is now unable to attract the necessary investments. With the economy now poised to rebound, Indonesia s infrastructure sector is at a cross roads, and its actors face a unique opportunity to implement the much needed reforms in time to sustain the recovery. This report analyses the sector and suggests that the lack of quick progress across the infrastructure sectors will affect Indonesia s ability to achieve economic growth targets and further reduce poverty. It recognizes the considerable progress made thus far, but contends that reforms have The past economic boom overshadowed the urgency for infrastructure sector reforms. 17

32 Achievements, Challenges, and Opportunities been insufficient, scattered, and uncoordinated. Hence, the overall benefits from these reforms are limited with little generated momentum. The report calls for a large scale, well coordinated reform effort to overcome the current infrastructure challenges. Although the authorities now recognize the importance of improving the sector, the true scale of the challenge may not be clear, especially at different levels of government. Hence, the solutions are not discussed and deliberated at the appropriate levels. The issues are usually still dealt with a single sectoral view that produces short-term, uncoordinated solutions with artificial boundaries. There are common issues facing all infrastructure sectors that can be addressed through cross sectoral solutions. A close examination reveals that there are many similar issues across the infrastructure sectors, therefore requiring cross sectoral solutions. Common issues that transcend individual infrastructure sectors include a lack of credibility to mobilize private investments, poor public management, insufficient user charges, inadequate financing, difficult decentralization challenges, and weak governance. The government now faces an opportunity to press forward with an organized effort to address these cross-cutting issues which will help a majority of the sectors to reap synergistic benefits. This report strives to identify and analyze these cross-sector issues, and to present the policy maker with recommendations to confront and solve them. The concluding chapter illustrates the way forward by identifying the most pressing cross-sector reforms that are needed. In addition, the final chapter summarizes the key sector-specific improvements discussed in four separate reports that accompany this report, which are specifically focused on electric power, road and road transportation, water and sanitation and telecom-munications. Indonesia's infrastructure performance lags behind the region. The Infrastructure Challenge Improving Access and Quality of Service Indonesia faces major challenges in its infrastructure sectors as it seeks to consolidate and accelerate its still fragile economic recovery, improve its international competitiveness, and increase access to basic public services. Symptoms of these challenges are found in every infrastructure sector. Roads in and around major cities are heavily congested throughout the day, while many inter-urban and rural roads are in poor and deteriorating condition. Jakarta s urban transport system is severely stressed, with poorly-maintained and highly overloaded buses jostling for scarce road space, while its sparse suburban railway system is underutilized. The prospect of imminent power shortages hangs over Java while many outer island regions are suffering regular outages. PLN has recently been adding new customers at rates exceeding 1 million per year but has so far managed to connect only slightly over half of all households, although many more have informal connections via neighbors. Far fewer household have access to piped potable water, let alone to public sewage systems. While the picture is brighter in the telecommunications sector, which has seen explosive growth in mobile phone use since the market opened, Indonesia s teledensity lags well behind that of its neighbors and low internet connectivity carries with it the threat of being left on the wrong side of the digital divide. Summary comparative performance indicators in the four sectors are presented in Table 1.1 and Table 1.2 below. In seeking to address these challenges through mobilizing the required investment, the Government is forced to confront the sensitive issue of tariffs. Tariffs in many sectors have long been well below the level needed to support new investment, and the Rupiah s sharp decline in value in and subsequent rise in inflation made the situation worse. In 18 Averting an Infrastructure Crisis: A Framework for Policy and Action

33 Chapter 1 Table 1.1: Infrastructure Service Delivery Power and Telecom Power Telecom Electrification Quality of Transmission Main Mobile Telephone Rates (%)* Electric and Distribution Lines Subscribers Subscribers Supply Losses (%) per 100 per 100 per 100 (Scale 1-7)** People*** People*** People*** Australia India Philippines Sri Lanka Thailand Indonesia China Vietnam Malaysia Singapore Korea Mongolia Indonesia Rank out of 12 out of 11 out of 11 out of 12 out of 12 out of 12 * Source: International Energy Agency, Philippines NEA, Estimates for Korea and Australia ** Source: World Economic Forum s Global Competitiveness Report *** Source: International Telecommunications Union Power shortages are imminent in Java, while outer island regions already suffer regular outages. Table 1.2: Infrastructure Service Delivery Water, Sanitation and Roads Water and Sanitation Roads (%) Pop (%) Pop Total Road Paved Road Fatalities w/access to w/access to Network Roads Fatalities per 100,000 Improved Improved (Km per 1,000 per Total Land per 100,000 Vehicles** Sanitation)* Water* People)* (km per sq ft)* People** Australia India Philippines Sri Lanka Thailand Indonesia China Vietnam Malaysia Singapore Korea Mongolia Indonesia Rank out of 11 out of 11 out of 12 out of 12 out of 9 out of 9 * Source: WDI ** Source: International Road Federation some sectors, the Government has shown strong political resolve by implementing tariff reforms while facing significant public opposition. Most notably, the average electric power tariff has been raised from below US2 cents per kwh in 1998 to close to its pre-crisis level of around US6.7 cents. The tariff increases have been structured so that the impact is borne more by larger consumers, with many manufacturers now complaining that their electricity Tariffs in most sectors are insufficient to cover maintenance costs or support new investments. 19

34 Achievements, Challenges, and Opportunities rates are higher than elsewhere in the region (see Box 1.1 for business concerns regarding infrastructure). The Government has also moved to assist the poor by simultaneously implementing an output based subsidy scheme where PLN is compensated for providing power to very small users at sub-commercial rates. But further tariff increases will likely be necessary to finance the massive investments required to serve a projected doubling of demand by 2010, especially if PLN is unable to conclude new gas sales agreements quickly and is forced to burn more oil. However, with elections scheduled for 2004, the final quarterly power tariff increase planned for 2003 has been cancelled. Concerns about possible social unrest have previously led to the postponement or restriction of tariff increases for other services, including water, phone, and rail transport. The poorest urban dwellers nonetheless pay much more per liter for their water than do those who are much better off. For many cash-strapped operators, continuing low tariffs have necessitated substantial cut-backs in maintenance and deferral of well justified new investments. This in turn is translating into poorer and sometimes less safe services for those who already have access and, of course, into longer waits for those who don t. Box 1.1: Infrastructure and the Business Climate Indonesia s business and investment climate is increasingly being perceived to be less competitive than its ASEAN neighbors since the boom-years before the 1997 economic crisis. The tenuous legal environment, uncertain political climate, lack of security, growing competition from China and Vietnam, concerns over taxes, customs, and labor issues have all contributed to Indonesia s decline as a premier business location. But among these issues, infrastructure remains on the mind and in the investment calculus of local and foreign businesses. The Jakarta Japan Club (JJC) whose membership includes almost 400 businesses working in Indonesia identified the key issues that were necessary to conduct business and increase foreign investment in Indonesia through a survey of Japanese companies. Of the JJC s ten priority areas ranging from security (#1), taxes (#2) labor issues (#4), and human resources (#10) two concerned infrastructure. Improving the Energy Supply (#7) was a critical step, notably expanding and increasing supply, implementing distribution facility development plans, and reliability. Improving Industrial Infrastructure (#8), specifically access roads from production centers to harbors and airports, as well as correcting the expensive harbor fees (identified as the most expensive and noncompetitive among ASEAN countries) was also a key priority. The JJC does not speak for Indonesia s diverse business community, but its concerns are in-line with those of local businesses. A recent series of focus group discussions conducted by the World Bank (Oct 2003) with the private sector throughout East Java highlighted similar concerns. While policy issues such as licensing and labor were identified as the top business constraints, infrastructure was also a priority. Like the JJC survey, large enterprises identified poor road maintenance, issues of access to industrial estates, insufficient power supply, and expensive but insufficient water supply as their main infrastructure problems. Small businesses identified the impacts of road congestion on transporting goods, as well as the need for businesses to supply their own captive power to compensate for unreliable supply. Source: JJC survey and WB Jakarta FGD survey results (draft) But even with a firm resolve on tariffs and cost recovery, it will take time to accelerate the flow of new investment to needed levels. Public budgets are tightly constrained and Government has to strike a careful balance between fiscal prudence and expanded investment. And it must do this at a time when it is still striving to improve the implementation of a rapidly planned and implemented decentralization program that has radically shifted functional responsibilities and expenditure assignments. Restoring private investment in infrastructure on a significant scale holds the promise of relieving the burden on public financing. High priority needs to be given accordingly to measures for improving Indonesia s stubbornly poor investment climate and, within this, to the difficult task of improving the attractiveness of infrastructure investment. But such efforts will not bear fruit overnight, in 20 Averting an Infrastructure Crisis: A Framework for Policy and Action

35 Chapter 1 part because many prospective investors and lenders have been adversely impacted by the crisis, in part because domestic capital markets are not yet equipped to finance large infrastructure projects, and in part because of the sharp global decline in foreign direct investment in emerging market infrastructure projects. Consequently, Indonesia will in the near term face continuing capital shortages that will require Government to make very tough investment choices, including at times choosing between investments that will support economic growth and those that will more directly enhance social welfare by improving access to services. Developing Infrastructure to Achieve Growth and Reduce Poverty There is widespread recognition that infrastructure plays a key role in economic growth. Currently, private consumption remains the engine of Indonesia s growth, accounting for 91 percent of GDP growth in 2002, and 83 percent in the first three quarter of Consumption led growth has its limits and the next push for growth has to come from investments. Investments have remained very low however over the past three years, the number of newly established businesses has declined while the number of businesses that scaled down or closed increased (see Figure 1.1). Several studies have concluded that infrastructure is one of the key bottlenecks. The investment climate survey carried out by ADB and World Bank identified the lack of infrastructure as a critical barrier to improving the investment climate. Another study, conducted by Danareksa Research, shows that business leaders acknowledge macroeconomic consolidation, but an ineffective judiciary and lack of infrastructure have negated increases in business confidence, and in turn growth. Numerous empirical studies have demonstrated the close correlation between growth and the quality and quantity of infrastructure. The extent that growth drives infrastructure investment, or that infrastructure drives growth is unclear. However, the strong associations between GDP and the availability of telecommunications, power, paved roads, and access to safe water are well known. Figure 1.2 shows the relationship that appears to exist in Indonesia between growth and infrastructure investments both showing a downward trend over the last decade. Lack of infrastructure is a critical barrier to improving the investment climate. There is a strong link between infrastructure, economic growth, and poverty. Figure 1.1. Fewer firms are set up (percentage in total companies) Figure 1.2. Growth and Infrastructure Investment (% of GDP) % % 0% -5% -10% Total Infra Spending* Gov Infra Spending** Private Infra Spending*** Growth Rate 0.0 new down-scaled closed Source: staff calculation based on BPS industrial census data -15% * Equals Gov Infra Spending and Private Infra Spending ** Gov Spending as a percentage of GDP includes infrastructure categories housing, telecom, transportation, reg dev, and water and irrigation - Source MoF *** Source: World Bank PPI database 21

36 Achievements, Challenges, and Opportunities Inadequate infrastructure has a greater impact on the poor. Less than 20% of the poorest population in Indonesia have access to 'safe' drinking water, versus over 80% for the richest. Inadequate infrastructure services also tend to affect the poor more than the better-off. Access is directly linked to income, and not surprisingly the poor have the lowest coverage. Less than 20 percent in the poorest quintile have access to a safe water source, versus over 80 percent coverage for the richest quintile (see Figure 1.3). According to the 2002 Susenas survey, 23 percent of the rural population is below the poverty line, versus 7 percent in urban areas but providing infrastructure in rural areas where the majority of the poor live is difficult. Roughly 11 million people living in remote areas are not reached by a road network. Similarly for power, over 6,000 villages lack access to electricity. Insufficient infrastructure coverage, or poor service quality is more prevalent in areas where the poor are concentrated. This may be due to the fact that areas with high incidence of poverty are not attractive to infrastructure providers because of the perception that the poor do not have sufficient resources to pay for the services. In many cases though, the poor are willing and able to pay for infrastructure, but it is the operators who lack the resources and incentives to expand or improve networks. The fundamental problem is a poor business and regulatory framework that keeps infrastructure tariffs below costs and provide few incentives for operators to increase efficiency. Compounding this, the poor have traditionally no way of getting their preferences heard when decisions are made on infrastructure investments. Figure 1.3. Household Access to Safe Water by Income (%) Improving service provision is critical to improving the lives of the poor. Global experience has illustrated infrastructure s role as a production function for improving health, gender equality, education, and the environment all components of the Millennium Development Goals (MDGs) - and poverty reduction in general. Indonesia has made some gains towards meeting the MDGs. Child mortality rates have declined from 91 births per 1,000 to 45 births per 1,000 between 1990 and Already the prevalence of child malnutrition (% of children under 5) has reduced from 35% in 1995 to 25% in Towards gender equality, the ratio of girls to boys in education has increased from 90.7 to 97.8 percent between 1990 and Youth literacy rates have improved from 95 to 97.9 percent during the same period. There have also been modest gains in overall access to water and sanitation. However, unchecked development has impacted the environment CO2 emissions have increased from.9 to 1.2 metric tons per capita and the percentage of forested areas has decreased from 65.2 to 58 percent of total land area between 1990 and If Indonesia is to continue its overall progress towards reaching its MDGs, it will have to target infrastructure investments towards the poor. 100% 80% 60% 40% 20% 0% Income Quintiles Source: Susenas 2002 Tackling the Impact of Greater Urbanization Indonesia s economic growth as well as its population growth is expected to be largely centered around cities. Indonesia s urban population in 2001 was over 90 million, only second to China in the region. This was a result of an average annual growth rate of 4.2% in the second half of the nineties (see table 1.3). Currently the urban population in Indonesia makes up 42% of the total population. However, the forecasted growth in urbanization in Indonesia is one of the fastest: Indonesia s urban population is expected to reach nearly 64% of the total population by Jakarta is expected to have the largest population of any city in the East Asia region as early as 2015 with over 17 million inhabitants. 22 Averting an Infrastructure Crisis: A Framework for Policy and Action

37 Chapter 1 Table 1.3: Urbanization in East Asia Urban Urban Urban Urban Urban Population Ratio Population Population Ratio Growth Forecast 2030 (Mill.) (% of total pop.) (% of total pop.) (%) (Mill.) Cambodia China Indonesia Mongolia Philippines Vietnam Indonesia's rapidly growing urban population, which was 90 million in 2001, was second in the region only to China. Source: Webster (2002) and World Bank, various. Indonesian cities are already experiencing the impact of this fast growing urban population. Urban lifestyles, with their proximity to markets and easier access to information, may be much more conducive to participation in the expanding industrial and service sectors. However, there is also a corresponding pressure on the economic and social fabric of urban areas. For example, cities in Indonesia, especially Jakarta, experience greater levels of traffic congestion as a result. Pressures on the water system can also be exacerbated, as seen by the depletion of the northern Jakarta aquifer. Low levels of initial access to sewage collection coupled with the increased demand compel residents to utilize on-site sanitation which is unsuitable for areas that are densely populated. The result, in many instances, is a water contaminated through improperly disposed sewage, which poses significant health risks for those living in urban areas. Preventing Environmental Degradation Indonesia s poor infrastructure has direct impacts on the environment. The problems are most acute in urban areas, where rapid population and industrial growth has far exceeded the capacity of existing water, sanitation, and road networks. Indonesia has one of the lowest rates of sewerage and sanitation coverage in Asia. In addition to human waste, unchecked industrial expansion with little supporting infrastructure for treatment and disposal of waste has caused widespread contamination of surface and groundwater. Industrial effluents, such as phenol, detergents and nitrate, have been observed in shallow aquifers in the Jabotabek area. The health implications are severe, considering that water from most PDAMs as well as the majority of self provided water in urban areas is not potable. The ecological impacts are also high the entire coral reef in the Jakarta Bay has been destroyed by untreated waste, and major rivers in urban areas (such as the Brantas in Surabaya) are effectively dead. Inefficient and insufficient road networks have also contributed to poor air-quality. Idling cars stuck in gridlock, along with antiquated transit systems are key sources of localized air pollutants that include lead, particulates, CO, NOX, HC, SO2, and CO2. In the early 1990s, the UNEP ranked Jakarta as the third most polluted mega-city in the world. In the 1990's, Jakarta ranked as the third most polluted city in the world. 23

38 Achievements, Challenges, and Opportunities Lack of infrastructure is not the only issue poorly planned or inappropriate road expansion has the propensity to impact previously undeveloped areas. There is a real need to increase road access to poor and remotely located communities. However, road development can accelerate environmental degradation by increasing opportunities for exploitation by illegal loggers and miners. Further, coastal roads and the ensuing development often impact sensitive ecological areas. Underlying Factors The economic crisis led to a sharp decline in public spending on infrastructure. Indonesia s geography and uneven distribution of population resources complicate the task of infrastructure provision. Inter-island shipping, river transport, and civil aviation necessarily play crucial and complementary roles in a complex domestic transport system that serves densely populated Java, the rugged and sparsely populated terrain of Papua, and the hundreds of populated small islands in the Malukus and Nusatenggaras. Electricity supply systems outside the large interconnected Java-Bali grid are highly fragmented, while the most important of Indonesia s abundant primary energy resources are located far from its main demand centers. The economic crisis has also contributed significantly to the severity of Indonesia s current infrastructure woes. Public spending had to be reduced sharply in real terms and many committed and planned private infrastructure projects were suspended by Government decree. The financial viability of private projects that were already in operation or allowed to proceed was quickly eroded by the Rupiah s sudden plunge. Subsequent efforts to restore private infrastructure investment and the viability of public enterprises have been undermined by uncertainties created by political upheaval, social unrest, and regional conflict. While geographical factors have necessarily impacted efficiency and increased costs in some sectors, most observers agree that the main causes of Indonesia s infrastructure problems are elsewhere. While it is convenient to blame the economic crisis for Indonesia s current infrastructure woes, it would be more accurate to portray it as having exposed and compounded pre-existing weaknesses. Many of these had been recognized long before the crisis struck, but a booming economy served to dissuade the Government from taking necessary but difficult remedial measures. Indonesia s infrastructure sector is now at a critical point where the Government needs to chart a strategy for the future. The Government is at a cross roads needing to determine whether they will implement the long overdue reforms 24 Averting an Infrastructure Crisis: A Framework for Policy and Action

39 Chapter 1 in the sector or potentially make infrastructure a constraint to economic revival. The path to reform is complex and there is no single policy measure that can solve the challenges facing the sector. The Government will also have a set of policy options at their disposal, and will have to carefully analyze and determine the most appropriate instrument that can achieve the intended outcome. Policy makers will constantly have to balance between the difficult measures needed to improve the sector with the potential hardships that arise as a consequence. The reforms will also take time to implement and achieve results. The remainder of the chapter highlights several areas that the Government can begin to reform in order to build the credibility of the sector so that there will be increased investments improving the quality and quantity of services in order to sustain the economic recovery. 25

40 Achievements, Challenges, and Opportunities Public Management of Infrastructure Decentralization has altered the roles of infrastructure provision across all levels of government. The quality of public management differs markedly across the sectors. PLN is a technically competent and reasonably sophisticated corporation whose reports have long been audited by international firms. Its main weaknesses are in the areas of finance and treasury management, where it is already striving to make needed improvements. It has been able to manage quite successfully rapid system expansion across Indonesia s diverse regions, connecting over 1 million new customers a year during the 1990s. As with any large public monopoly there is scope for improving efficiency, but PLN is nonetheless a well managed public utility. The road and water sectors are composed of a large number of agencies whose technical capacities and governance regimes are far weaker than PLNs. In telecommunications, the private sector plays the larger role, where one SOE (Indosat) is now majority privatized, and the other (Telkom) is listed on the NYSE and LSE (although having problems with the former), and where technological convergence is deepening competition. Decentralization has added a new dimension by assigning sector government functions to regions that previously had no role in these sectors. While the regions have long had public works units to plan and implement road programs, they do not yet have units to handle newly assigned functions, for example, for power (some licensing and planning responsibilities) and for small ports and airports. While the PDAMs are corporations, it would not be appropriate in terms of managerial capacity or performance to group many of them with PLN, PGN or Telkom. In the case of the regional public works units, large expenses have been incurred to build capacity, but this is not reflected in the quality of planning or implementation of works due to poor incentive and widespread corruption. 26 Averting an Infrastructure Crisis: A Framework for Policy and Action

41 Chapter 1 The counterpart Law on Fiscal Decentralization (Law 25/1999) seeks to ensure regional governments will have the financial resources that are necessary to implement their expanded roles. Aggregate local revenue generation capacity of regional governments is relatively small, however, with around 90 percent of regional government spending financed through central government transfers. Most regions are searching for new revenue sources, with some imposing taxes and levies that are inconsistent with prevailing laws and regulations. 1 But with large regional disparities and an equalizing block grant mechanism (DAU) that is not yet functioning as intended, many regions have limited funds available for infrastructure provision after meeting their wage bills. A conditional special purpose capital grants program (DAK), which is partially intended to finance small infrastructure investments, is being implemented for the first time in 2003 and offers a potentially important means of using central government resources to improve expenditure prioritization and governance at the local level. However, the amount of funding now being transferred through the DAK is small relative to the total amount conveyed through the DAU and other revenue sharing arrangements from such sources as the exploitation of natural resources and property taxes. In the meantime, Government is still working to operationalize procedures for on-lending and on-granting of foreign loans that were introduced by Minister of Finance Decree KMK.35 in January These procedures are complex and delays with their implementation could impede the timely flow of donor resources to the regions for infrastructure and other programs. Local government spending on infrastructure increased following decentralization, and is now equivalent to central government levels. In this environment, integration of planning and coordination of implementation poses formidable challenges. These are most evident in sectors where responsibilities are divided both horizontally and vertically, as with roads. During the Soeharto era, Bappenas played a key role in inter-agency coordination as well as in national development planning. Today, the picture is less clear. Bappenas still has responsibility for national development planning while the Coordinating Minister for Economic Affairs is responsible for coordinating overall implementation of the economic program. In addition, several Ministerlevel committees have been established to coordinate activities in specific areas. These include the Committee on Policy for the Acceleration of Infrastructure Development (KKPPI), sector-specific committees on power and telecommunications, and a cross-sector committee on rural infrastructure development. This already complicated situation is set to change further, with the recently enacted State Finance Law having defined away key planning roles of Bappenas and with a proposed law on national development planning now under discussion. Business Environment for Infrastructure The institutional and regulatory environment pertaining specifically to infrastructure is not conducive to efficient service provision by private operators. Deep-rooted institutional and regulatory problems can be traced to the 1945 Constitution, which requires productive activities that impact the lives of the public to be controlled by the State. This was long interpreted to mean that infrastructure services must be provided exclusively by the public sector. Laws gave wide-ranging monopoly powers to State-owned enterprises (SOEs) and consequently made little provision for economic regulation. Authority to set tariffs was typically vested with the President and entirely discretionary, while sector departments commonly combined the roles of policy-maker, regulator and shareholder representative. In the absence of any form of competition, many enterprises became not surprisingly inefficient, unresponsive, corrupt, and heavily dependent on government for their financing. Private infrastructure investors find the current business environment too risky. 27

42 Achievements, Challenges, and Opportunities And Government in turn appeared to be more concerned about protecting these enterprises than the public they serve. This regulatory and institutional framework was ill-suited to accommodate for the entry of the private sector when the need was first recognized in the mid-1980s. Adjustments were made, but typically in a manner that assigned government functions to SOEs and provided very limited modalities for private investment. Partial privatization proceeded in the telecommunications sector, but Government was reluctant to relinquish control. For the most part private investors cooperated with incumbent public enterprises through concessions, BOT, BOO, and other contractual arrangements. The governance framework was weak, facilitating the flood of unsolicited and often ill-conceived project proposals involving politically connected local partners that characterized the latter years of the Soeharto era. During the mid-1990s, unsolicited projects shaped sector planning and programming rather than vice-versa, with many contracts embodying risk allocations that created large contingent liabilities for the public sector. The subsequent dramatic failure and consequent large public costs of such projects has led many elements of civil society to demand a return to the original interpretation of the Constitution. Government is now seeking to restore private investment in infrastructure, but the response thus far has been fairly muted except in the telecommunications sector. Pre-crisis concerns relating to the regulatory framework and absence of a functioning eminent domain mechanism for land acquisition remain. Confidence in the sector has further eroded after the crisis due to renegotiation of IPP contracts, persistent disputes with water concessions and contracts, and the failure of local courts to execute an international arbitration award. In the present climate, investors are also reluctant to participate in infrastructure provision because of the poor credit-worthiness of SOE off-takers coupled with Government s understandable reluctance to provide guarantees. International investors, lenders and insurers, in particular, are less interested in infrastructure projects in emerging markets than they were during the mid-1990s. The bursting of the 3-G telecom s bubble, coupled with the collapse of Enron and the sharp decline in the share values of other leading infrastructure companies, has led many overseas firms to refocus on consolidating in their home markets and divesting overseas portfolios. Indonesia, with its stubbornly high country risk rating, is currently attracting very little foreign direct investment, even in sectors that offer rapid payback, let alone in infrastructure. At the same time, high domestic interest rates coupled with difficulties in mobilizing long-term finance pose problems for prospective local infrastructure investors. Corruption Indonesia ranks at the bottom of the Transparency International's Corruption Perception Index. Indonesia still has to tackle corruption, collusion, and nepotism effectively. According to the latest Corruption Perception Index published by Transparency International (TI), Indonesia ranks 122 nd out of 133 countries. With a rating of 1.9 out of 10, Indonesia has the lowest score in East Asia except for Myanmar. While post-soeharto governments have accorded high priority to eradicating corruption, their efforts appear to have been unsuccessful: in 2001 Transparency International assigned an identical score of 1.9 to Indonesia. In fact, while there is a perception among households that the overall level of corruption has remained more or less the same over the past few years, the view in business circles tends to be that corruption is becoming more diffuse and less effective at delivering the intended outcomes following the recent moves toward decentralization. 28 Averting an Infrastructure Crisis: A Framework for Policy and Action

43 Chapter 1 In an environment where corruption is rife, infrastructure sectors are typically affected very heavily. Opportunities for extracting rents are abundant at all stages of infrastructure projects, from project identification and negotiation through to implementation and operation. The costs to the economy are very high and unsustainable: Government and state enterprises together are currently procuring about $7 billion total per year with infrastructure accounting for a major share and there are indications that up to 30 percent of the amount may be stolen through corrupt practices. Financing Challenge PLN has estimated a need for annual power sector investments of US$2-3 billion during the period up to 2010 to meet what would, relative to past trends, be modest growth in demand. The capital costs of providing new phone lines continues to fall, but raising teledensity is still expected to cost more than US$300 million per point. The road sector could easily absorb US$ million per year for maintenance, betterment and expansion of the classified public network, with additional funding needed to develop toll roads in densely trafficked corridors. Massive investments will also be needed in the water and sanitation sector if Indonesia is to reach its Millennium Development Goals, with US$ 600 million per year being considered a conservative estimate. Overall investments need are in fact likely to be higher, because the above estimates do not fully take into account factors such as the rapid rate of urbanization in Indonesia. Massive investments are required across infrastructure sectors. The energy sector alone requires US$ 2-3 billion annually. Effectively tackling the issues mentioned previously will progressively help to bridge the financing gap. Lower corruption levels, clearer allocation of responsibilities, and an improved institutional and regulatory framework for infrastructure combined with improved public management practices would reduce the costs of infrastructure service provision and would go some way toward providing private investors with the confidence that they need to consider re-investing in Indonesia s infrastructure. As mentioned previously, these reforms will take time, and therefore, measures need to be implemented to mobilize funding the for sector in the short-term. Furthermore, structural reforms in the sector are not a substitute for a well designed long-term finance strategy. In the near-term the Government can resort to increased spending in the infrastructure sector and upgrading key features of the financial markets. In the long-run, however, the sector will have to rely on mobilizing domestic capital, especially savings, towards the sector in addition to attracting back foreign investors. As long as the Government is financing the infrastructure sector, it would be useful to achieve poverty related objectives by channeling resources in a manner that ensures affordable access to the poor. 29

44 chapter 2 Improving Public Management of Infrastructure 30 Averting an Infrastructure Crisis: A Framework for Policy and Action

45 The majority of Indonesia s infrastructure continues to be developed and managed by the public sector, although private sector participation has increased in recent years. The manner in which infrastructure is maintained and operated, however, varies among sectors. Over the past two decades, three major transformations have been taking place which have diminished the roles of the central sector ministries and departments but also greatly increased their complexity and the need for effective interagency coordination. Most of the infrastructure services will remain in the hands of the public sector in the near future. Indonesia has moved to commercialize, corporatize and in some instances privatize the delivery and management of public infrastructure beginning in the early 1980s. Some forms of infrastructure that were previously provided directly by sector departments or departmental agencies (Perjans) were transformed into state-owned corporations (Perums) while more recently many Perums have been transformed into profitoriented limited liability state-owned companies (Perseros). 2 National and regional monopolies are being unbundled in some instances, as a part of a wider SOE reform and privatization program. The reforms have included the creation of subsidiaries (e.g. PLN and Pelindos II and III) and the sale of stakes in parent or subsidiary enterprises (e.g. Telkom and Indosat, and container terminal subsidiaries at Jakarta and Surabaya ports). 31

46 Improving Public Management of Infrastructure The Government has moved to complement reforms by separating responsibilities for sector policy formulation, regulation, and SOE ownership. In 1997, a Ministry of State Enterprises (MOSE) was established to take over the ownership of SOEs or shareholder functions that had previously been handled by sector ministries on behalf of the MOF. Although the process was interrupted when MOSE was abolished and then re-established, progress has been made in improving corporate governance as well as their corporate cultures. More recently, the enactment of Law 22 on Oil and Natural Gas in 2001 has enabled the Government to establish non-ministerial bodies to assume the regulatory functions previously handled by Directorate Generals for the sectors. Three such agencies currently exist, namely the downstream oil and gas regulatory agency, the electricity market supervisory agency, and the telecommunications regulatory agency. None of the entities are adequately staffed and fully functional, however. Furthermore, there is a lack of clarity between the responsibility and authority of the regulatory agencies and the various General Directorates. Indonesia has decentralized many of the functions and responsibilities related to infrastructure provision that were previously handled by central sector departments. While limited transfer of responsibilities was made during the 1990s in areas such as road and traffic transport, Indonesia began to implement a large scale big bang decentralization effort in January 2001 with the application of its laws on regional autonomy. 3 The actual magnitude of the changes has varied considerably between sectors. In the case of telecommunications, the scope of decentralized authority is very limited while sectors such as power, ports, and airports have devolved considerable responsibilities to the regions. In other sectors such as roads, regional governments already had considerable authority, and long established agencies (Dinas) have adequate capacity to assume additional obligations. This chapter assesses briefly how these major changes have impacted the development and performance of the infrastructure sectors, and considers how the Government may consolidate and build upon recent achievements. It also explores the changing role of Bappenas and its implications for coordinating policy and strategic planning. Commercializing, Corporatizing and Privatization Most of Indonesia s main infrastructure services are no longer provided and managed directly by central or regional government departments or agencies. 4 The most significant sectors are now corporatized and managed by Persero enterprises. They include 5 : PT PLN (power) PT PGN (gas transmission and distribution) PT Telkom and PT Indosat (basic telecoms) PT Angkasa Pura I and II (the major airports) PT Pelindo I-IV (the major seaports) PT KA (railway services) PT ASDP (ferry terminals and services) PT Jasa Marga (toll roads). Many of these Perseros transformed from Perums during the mid 1990s, and a key precondition was to be operationally profitable. Perseros have greater managerial autonomy, but must also conform to tougher financial management requirements. They are also able to better compete with the private sector for qualified workers since they can now offer market-based compensation. 32 Averting an Infrastructure Crisis: A Framework for Policy and Action

47 Chapter 2 As Perseros, the performance of these enterprises and the responsiveness to customers appear to have improved significantly. 6 The improvements are most evident in enterprises that have been partly privatized or permitted to access the domestic capital market, in part because of the more stringent audit and disclosure requirements of the stock exchange. 7 Telkom, Indosat, PLN, PGN and Jasa Marga are all traded in the stock market. Although they fall short of being world class, these Perseros have enhanced their performance and have a steadily improving record of corporate governance. In contrast, the enterprises in the transport sector lag in performance, due to their low regulated tariffs or poor past investments as well as the limited pressure they have faced to implement reforms. For example, the organizational structure of PT KA which was initially a Perjan but later transformed to a Perjan and then to a Persero during the 1990s has changed very little since the era of the steam locomotive. 8 In the absence of clearly defined profit centers or business units, the company has continued to maintain railway lines and to operate services that are commercially unviable. The performance and responsiveness of Persero enterprises have improved significantly. During the 1980s and early 1990s, sector departments often viewed SOEs under their jurisdiction as sources for supplementing their budgets and for providing jobs for senior staff. SOEs were commonly expected to finance activities such as the overseas travel of ministers and their staffs, conferences and workshops, and office equipment. Boards of Commissioners were frequently filled by senior officials from sector departments, while less senior officials were regularly appointed to full-time director level positions. Therefore, it would be common, for example, for the Director General for Electricity to be Chairman of the Board of Commissioners for PLN or for the DG of Land Transport to hold the equivalent position in PT KA. These practices are being gradually phased out by MOSE, which is seeking to make companies fully accountable for their financial performance and to make Boards of Commissioners more professionally competent and independent. Privatization has reinforced this effort, as many private shareholders require that business professionals be appointed to Boards of Commissioners and to key director level positions (particularly finance). Progress made thus far is encouraging, although a significant further effort is still needed in this regard. The situation is different in the water and sanitation sector, since these services are provided by regional utilities. The public road network is also administered at the state level and it constitutes one of the State s largest physical investments. The sector, however, is not managed on a commercial basis. There has been very little progress in making road users pay for the costs they impose, or towards earmarking proceeds to provide a stream of operational revenue, despite many years of discussions regarding these issues. Instead, heavy commercial vehicles that are more prone to damage roads receive implicit financial support for their road use in the form of subsidized fuel or relatively low vehicle taxes. Responsibilities for asset management in the sector are divided among central, provincial, kabupaten and kota governments. While Indonesia has developed an impressive set of road asset management tools for the different parts of the network, it is apparent that these are not being utilized effectively and that allocation of funds across networks, regions and works programs is consequently sub-optimal. 9 Since governance in the sector is weak, there is evidence of poor quality of works and pervasive collusion in contract awards.. In recent years, Government has begun to explore the possibility of establishing a system of road funds and road boards as a means of commercializing the management of road assets and also to increase stakeholder involvement. While this effort is promising, strong leadership and very effective coordination of the large number of agencies and involved stakeholders will be needed to move forward. 33

48 Improving Public Management of Infrastructure Prior to granting more autonomy to the regions, about 90 percent of government revenues accrued at the central level. The Big Bang decentralization gave regions the responsibilities for all sectors except foreign affairs, defense and security, justice, monetary and fiscal affairs, and religion. Making Decentralization Work Prior to granting more autonomy to the regions in January 2001, Indonesia was a multitiered but highly centralized state. Around 90 percent of total government revenues accrued to the central government, while its agencies and deconcentrated regional offices (Kanwils) were responsible for over 80 percent of the public expenditure. Powers were heavily concentrated in central ministries and agencies, who had little accountability to local communities. Local consumers also had a limited ability to influence central authority decisions regarding public service provision. As a result, there were increasing calls for revenue sharing between the central, regional, and local governments for some time. In 1999, Laws on Regional Governance and on Fiscal Balance between Central and Regional Governments were drafted and enacted in little over one year, and important supporting regulations were rapidly implemented during the following eighteen months to stay on schedule. Predictions that the extremely ambitious agenda and timetable will result in catastrophic breakdown in service delivery proved unfounded, and overall, the implementation proceeded smoothly. Nevertheless, numerous problems have arisen, and various aspects of the decentralization process require further rethinking and refinement. 10 Law 22 provides for autonomous regions to be responsible for government functions in all sectors except for foreign affairs, defense and security, justice, monetary and fiscal affairs, and religion. The central government, however, retained the responsibility for macro policy on planning and control of national development and a number of other areas. 11 It further confers responsibility for eleven sectors including public works (which encompasses roads) and communications (which if defined by the span of control of MOC encompasses air, land and sea transport, and telecommunications), to the kabupatens and kotas. 34 Averting an Infrastructure Crisis: A Framework for Policy and Action

49 Chapter 2 Notable in Law 22 is the very limited powers accorded to provinces vis-ŕ-vis the kabupatens and kotas. Provinces are given a dual role of being deconcentrated representatives of the center as well as being autonomous regions in their own right. However, their roles as autonomous regions are comparatively narrow and weak, and are limited mainly to functions and responsibilities that span the boundaries of the kabupatens and kotas in their territories. There are compelling arguments for strengthening their responsibilities in some areas, and in particular for empowering provinces to play a more pro-active role in promoting and facilitating inter-kabupaten /kota cooperation in fields such as urban transportation and solid waste management. Providing the provinces greater decision-making authority regarding the transfer of funds is a method that can broaden their influence on local governments. Government Regulation 25 of 2000 (PP25/2000) elaborates the provisions of Law 22 by defining the functions that are assigned to the center and to the provinces, with all other functions being deemed to belong to the kabupatens and kotas. The specificity and clarity regarding how functions are devolved to different levels of government varies among sectors. In the case of telecommunications, the center s functions are defined simply as regulation of the national telecommunications system. By contrast, the equivalent function in the transport sector is specified as setting standards, issuing licenses, setting tariffs, etc. The assignments specified in PP25/2000 are also not entirely consistent with the provisions of Law 22, and in many instances differ considerably from the assignments stipulated in the respective sector laws. In several instances, this ambiguity is exacerbated by the different terminologies employed for regional and sector regulations. In moving forward, it is important that the Government further clarify the functions that would better serve the population when provided through a decentralized mechanism, and ensure that these responsibilities are transferred to the appropriate decentralized level. The degree of decentralization or the level of government with responsibility for a particular infrastructure service would need to be determined by the specific characteristics in the sector such as the economies of scale and exclusivity of markets. The potential impact of decentralization varies among infrastructure sectors. In the case of telecoms, primary authority continues to reside in the center, although the succinct manner in which PP 25/2000 defines its role could be interpreted to leave kabupatens and kotas with some scope for entry. There has been comparatively little change in the allocation of functions for public water supply and sanitation inasmuch as the kabupatens and kotas have long had significant responsibilities in this area. 12 While decentralized authorities have likewise long played a significant role in the provision and maintenance of road infrastructure and in the management of road traffic and transport, their powers and obligations have been considerably expanded by Law 22 with kabupatens and kotas now having authority to decide spending priorities for their respective networks. 13 The regions, and in particular the kabupatens and kotas, have also been assigned important new responsibilities in the power sector, while they have been granted authority for small ports and airports for the first time. With the exception of the power sector, these changes are yet to be reflected in new or amended sector laws. 14 In several instances, such as for small ports and airports, central departments have expressed concern about the lack of local capacity to assume newly decentralized responsibilities and the required transfers of authority have stalled as a result. It is important to ensure technical support for local governments so that they are able to provide services commensurate with their new responsibilities. As a result, national assistance may be necessary to assist local entities to develop their capacity. Various 35

50 Improving Public Management of Infrastructure public-private partnerships can also be useful to transfer expertise in infrastructure service provision, in addition to relying on experts currently employed by the central ministries. Administrative boundaries encourage investments that focus at the local level, but are sub-optimal from a wider regional or national perspective. Law 22 on decentralization stipulates that local governments must have adequate funding to implement the functions transferred to them. The complexity of Indonesia s decentralization is compounded by the large number of kabupatens and kotas and by the continued division of existing regions. 15 Administrative boundaries tend to encourage investment decisions that, while perhaps rational at the local level, are sub-optimal from a wider regional or national perspective. For example, a kabupaten may not view improving a particular road or irrigation and drainage works as a priority, but the main beneficiaries of these actions may be located in adjacent regions. In principle, such boundary effects should be addressed by the provinces or the central authorities, but the limited roles of the provinces and the sheer number of regions greatly compounds the challenge. At the same time, there is also a threat of over investment, with individual regions each wanting to build or upgrade ports or airports in their own areas rather than rely on those in adjacent regions. As previously mentioned, stronger provincial influence, especially through the financial transfer mechanisms, can help reduce these investment inconsistencies. It is also generally the central government s role to ensure that there is consistency in quality and quantity of infrastructure provision across the country. Law 22 stipulates that autonomous regions must not only be empowered to implement the functions transferred to them, but also be ensured adequate funding to implement these responsibilities. In reality, the ability of regional governments to raise taxes or impose levies is highly circumscribed, as is their capacity to borrow. Nevertheless, it is important to progressively develop this capacity so that future infrastructure needs will be adequately financed, and central government support is critical. A revolving fund, as described in box 2.1, could help local governments gain greater access to capital at a lower cost of borrowing. When financial markets are more developed, an option such as an apex financing institution, as described in box 2.2, may be viable. Box 2.1. Financing Schemes to Pursue National Objectives in Decentralized Contexts: The State Revolving Fund Model Indonesia s big bang approach to decentralization offers a unique opportunity to mobilize local private capital to finance infrastructure. A key implication of effective fiscal decentralization (market based borrowing coupled with hard budget constraints) is that pooling of project risk along with layers of credit enhancement can result in enhanced opportunities for mobilizing domestic investment in infrastructure. The State Revolving Fund model offers a useful instrument to lower borrowing costs and increase access to private capital for local governments by leveraging central government grants. This provides the smaller municipalities, which lack the requisite creditworthiness and expertise to access the market on their own, the economies and efficiencies of the municipal finance market. In 1984, in connection with the Federal Clean Water Act, the US Federal Government set up state revolving funds (SRFs) for wastewater and water projects in the US. The federal government makes capital grants to the state government, matched by a contribution from the state (currently at 20%). Several states use these subsidies to create dedicated reserve funds to collateralize pooled bond flotation to support the financing needs of local governments within the state. The pooled SRF bonds of New York state are AAA rated even when many participating local governments have lower ratings or are not rated at all. US bond banks typically provide a number of credit enhancements like debt service reserve funds and state transfers payment intercept provisions to provide additional comfort to lenders and thereby lowering the cost of borrowing. In emerging markets like Indonesia, where default rates may be higher, private borrowers may require higher levels of comfort through layers of credit enhancements in addition to debt service reserves like intercepts of central government transfers, multilateral lines of credit, and partial risk guarantees. Over time, the SRF model can play a crucial role in deepening and widening local capital markets, enhancing private financing of infrastructure and diversifying local investment portfolios. 36 Averting an Infrastructure Crisis: A Framework for Policy and Action

51 Chapter 2 Despite the potential for improved future borrowing at the local level, approximately 90 percent of regional government revenue is currently obtained through transfers from the center. 16 Law 25 defines three main forms of central government transfers, namely revenue sharing (bagi hasil), the general allocation fund (DAU), and the special allocation fund (DAK). Nearly 90% of regional government revenue is currently obtained from the center. Revenue sharing arrangements transfer funds accrued to the central government through royalties and production sharing from natural resource exploitation, and from land and property taxes. The adopted formulae are designed to ensure funds return to the region in which it was generated so that regional authorities can determine the most appropriate use of the revenue. The principal beneficiaries of these revenue sharing arrangements tend to be regions with extensive oil and gas development, mining and forestry resources, and those with large cities. Box 2.2. Financing Schemes Using Apex Institutions to Select Good Projects - The case of FINDETER in Colombia In Colombia, political decentralization started in 1968, with elected mayors in 1986 and then governors in 1991, came after spending had been substantially delegated to the local levels. The subsequent reforms reduced the national government s discretion in the distribution of transfers. The increased transfers and the assignment of oil royalties gave sub-national entities about half of public sector current revenues. This had the effect of creating stable and predictable revenues for municipalities which had a crucial bearing on the subsequent success of Colombia s municipal credit institution, Financiera de Desarrollo Territorial (Findeter), which was set up as a part of the political decentralization process. Findeter discounts loans by private sector and state-owned commercial banks that also appraise the projects, and monitor performance. The institution is owned by the Ministry of Finance (86 percent) and regional governments (14 percent). A bank that makes a long-term loan to a sub-national agency can borrow from Findeter up to 85 percent of the loan value with the same maturity (up to 12 years, with up to 3 years of grace). In addition to its capital and retained earnings and loan reflows, Findeter also relies on external borrowing (mainly semi-commercial loans from IBRD and IDB) and issuance of bonds on the domestic market. These unguaranteed bonds offer commercial yields. Findeter lends to commercial banks in pesos at a variable rate, pegged 2.5 percent above the market average rate for fixed-term deposits. It also charges a 1 percent up-front fee. Several measures are taken to reduce credit risk: Banks are liable to Findeter if their borrowers default; municipal revenue, pledged as collateral, can be used to repay Findeter s loans; municipalities that have defaulted to Findeter are not eligible for fresh loans. The percentage of municipal revenue that can be pledged is capped and there are lower bounds for debt to service coverage ratios. Since it was set up in 1990, Findeter reached almost two-thirds of Colombia s 1000 municipalities. Water, sanitation and roads account for 75 percent of Findeter s portfolio. However, Findeter s market share of infrastructure investment has been steadily shrinking, with local governments increasingly preferring access to commercial banks directly. The largest cities have begun financing their projects by directly accessing the bond market. While this is a concern for the institution, it is also a good sign indicating the mainstreaming of access to private capital markets by local governments. Alavardo and Gouarne (1994) offer three lessons for countries seeking to replicate Findeter s experience19: To the extent feasible for each country, government schemes for municipal credit should involve the financial sector in allocating credit and sharing risk. Findeter s program is viable because most Colombian local governments and utilities have a positive and roughly predictable cash flow that can legally be pledged as collateral; and because Colombian banks possess basic lending skills and incentives. Similar instruments may not work in countries where these conditions do not apply. Municipal investment lending is not a magic bullet that can trigger dramatic institutional change at the local level. 37

52 Improving Public Management of Infrastructure General purpose grants (DAU), in its current form, tends to exacerbate regional inequalities. Conditional grants (DAK) are insufficiently funded and are still mostly allocated for maintenance backlogs rather than new investments. No foreign financing has yet been processed using the onlending arrangements in KMK.35. The DAU is a general purpose unconditional equalization grant, required to equal 25 percent of APBN receipts in aggregate from domestic sources (net of revenue sharing). In total, revenue sharing measures and the DAU represent approximately one-third of APBN receipts from domestic sources. The DAU is intended to provide an equalized amount of funding so that regional governments can provide basic public services to a nationally consistent standard. However, the manner in which it is currently applied tends to exacerbate rather than reduce regional inequalities. 17 As a result, many of the poorer regions, who also face incompressible wage bills, have very little discretionary funds available to finance infrastructure and other needs. These spending needs can be considerable since many regions inherited poorly maintained infrastructure (e.g. roads) and other facilities (e.g. schools and health centers) which require substantial investments to restore. The DAK is a special purpose conditional grant implemented in 2003, whose funding is still comparatively small. 18 The central government identifies the regions for receiving the grants and also determines the purpose of its use. The DAK, by law and regulations, is intended to fund investment activities, particularly those that have spill-over benefits. The grant is restricted from being used for recurrent and administrative expenses. In order to obtain DAK grants, regions are required to provide counterpart funding, which is currently 10 percent of the grant amount. In 2003, the major part of the DAK funding was allocated for funding maintenance backlogs, with around two-thirds of the total being allocated to the road and irrigation sectors. The DAK is not intended to be a substitute for a properly implemented DAU, and in any case is not funded to a level that would enable it to fulfill such a role. The shortcomings in the intergovernmental fiscal transfer system are compounded by constraints on regional government borrowing as well as on-lending procedures of foreign loans to the regions. The on-lending procedures are stipulated in MOF decree KMK.35 issued in January 2003, which is still in the process of being implemented. In the past, a considerable part of Government s borrowing from multilateral and bilateral lenders had been channeled to the regions for infrastructure projects, particularly for roads and water supply. KMK.35 has the laudable aim of making on-lending demand driven, with regions being required to submit extensively documented project proposals for review by a central evaluation team. In addition to defining the procedures and criteria for on-lending, the decree also establishes an on-granting channel for projects that are deemed to be economically sound but not commercially viable via cost recovery. KMK.35 states that regions must contribute counterpart funds from their discretionary resources, with the amount varying according to the financial capacity of the region. This creates in effect a parallel channel to the DAK, raising the possibility that the central government could be offering two matching grant mechanisms for similar types of investments, but with different application and evaluation criteria and varying terms and conditions. Up to this point in time, no foreign financing has been processed utilizing the KMK.35 procedures. For future application, there is also a need for clarity regarding how investments will be classified as either cost-recoverable or not. Regions will lose the opportunity to finance infrastructure projects through this mechanism until the governing policies and procedures are further clarified. The above constraints create strong pressures for regions to mobilize additional revenues from local sources. While desirable in principle, this is leading to the arbitrary imposition of distortionary or inappropriate fees and taxes that conflict with the provisions of Law18/ Law The impact of such practices is already evident as some regions impose a form of 38 Averting an Infrastructure Crisis: A Framework for Policy and Action

53 Chapter 2 VAT on mobile phone calls and many others impose transport levies including fees on the movement of goods through their territories. Evolving Role of the Center The fundamental changes mentioned previously in this chapter are reshaping the challenges by redefining the duties and functions of central sector departments. They also require the Government to rethink how it coordinates strategic planning and policy formulation in an era in which it has far less direct control over investment and operating decisions. In order to perform their evolving roles effectively, the key sector departments MSRI, MOC and MEMR will need to redefine their missions, adapt their staffing levels and skill mixes, and adjust their organization structures accordingly. The extent and nature of the changes will vary considerably between departments as well among sectors. In principle, MSRI which was previously the Ministry of Public Works (MPW) faces the most complex challenges. Initially created as a construction department, MPW developed strong planning and programming capacities and the previous scope of its activities encompass spatial planning as well as numerous other sector development planning credentials. Decentralization, however, has both diminished its role as an organization that implements civil works and also reduced its authority as a planning entity. The department has already undergone a radical restructuring effort, eventually being transformed into MSRI. During this transition, MSRI managed to align its structure to operate in the current decentralized environment, while many of its staff were distributed better by being assigned to functional pools. It is important to note that this transformation occurred despite various proposals over the years to abolish the department and distribute its functions to other entities. For example, it has been suggested that the agency responsible for roads (Bina Marga / DGRI) could be a part of MOC and the agency responsible for water resources and irrigation (DGSDA) could join the Department of Agriculture. Such options will likely be considered again as Indonesia contemplates the overall structure of the central government before the appointment of the next Cabinet in The Ministry of Energy and Mineral Resources has also undergone some reorganization in recent years to adapt to decentralization. The ministry now has a reduced role in the mining sector, while they are anticipating further changes resulting from the implementation of the new electricity and oil and natural gas laws. 20 Further adjustments within Directorates General are likely to be needed as, for example, the Electricity Market Supervisory Agency becomes operational and the new bottom-up arrangements for preparing national electrification plans (RUKN) are implemented. Furthermore, it would be prudent to expand the role of the Center for Energy Information into that of a comprehensive central energy policy unit. 21 The MOC has arguably faced the greatest change in role and responsibilities of the three core infrastructure departments. The creation of MOSE has resulted in the elimination of MOC s oversight responsibilities for some 20 diverse infrastructure SOEs 22. Likewise, the mandate for decentralization calls for the transfer of responsibilities for the hundreds of small ports and airports that have been managed by MOC s directorate generals. In the telecommunication sector, the creation of a non-ministerial regulatory agency will narrow the role of the DG for Posts and Telecommunications. 23 Moreover, there may also be compelling reasons to establish non-ministerial regulatory agencies for the transport sector in the future. The role of the MOC is also changing in other aspects. Globalization necessitates Key sector departments will have to adapt to their changing roles, by redefining their mission, adjusting their structure, and transforming their staffing needs. The MOC has faced the greatest change in their roles and responsibility. 39

54 Improving Public Management of Infrastructure rapid improvements of the communication and logistical infrastructure, which will require MOC to be a nimble policymaker and facilitator. Decentralization, on the other hand, is creating demand from regional governments for guidance and assistance in areas such as urban transport management and planning. These challenges are daunting because while there have at various times been proposals for radical restructuring of the MOC, the actual changes implemented over the past two decades have been comparatively minor. 24 Policy coordination will also have to evolve with a redefined framework and a strategy for infrastructure development. In addition to rethinking the role and organization of the individual sector ministries, Indonesia also faces the challenge of redefining its framework for coordinating policy and strategy for infrastructure development. Responsibilities for infrastructure provision and operating decisions are now far more widely dispersed than they were in the past while globalization and democratization require that infrastructure services must be far more responsive to the evolving demands of users. Under the Soeharto regime, Indonesia was among the most centrally managed countries. Bappenas, given overall oversight, guided and coordinated the development of national fiveyear development plans and sector development programs (REPELITAs). They were also responsible for approving individual projects and annual development budgets. Sector departments were given guidelines for preparing proposals for programs and projects, which were then submitted to Bappenas for review, amendments, and consolidation. Regional governments previously had very little discretion over infrastructure provision, with the exceptions being in the roads and water supply sectors. With very little revenue from their own sources, the regions depended on loans and grants from the center to fund investments in these sectors. By far the major portion of such investments were financed by foreign loans or purposespecific Inpres grants. Bappenas had overall authority to decide allocations to sectors, individual regions, and individual projects, while sector departments managed and oversaw the detailed planning and design. In other sectors, infrastructure was provided exclusively by one or more SOEs (e.g. electric power, telecoms) or by a combination of SOEs and government agencies (e.g. railways, ports, airports). Until the late 1990s, the infrastructure Perums were heavily dependent on GOI for their investment financing, with assets typically being financed from the APBN development budget and transferred as an increase in the State s equity participation. Regional entities were not permitted to borrow internationally without the consent of GOI or through one of its transfer mechanisms. Regional governments also had very limited scope for securing financing from domestic banks and capital markets. These limitations were relaxed during the 1990s 40 Averting an Infrastructure Crisis: A Framework for Policy and Action

55 Chapter 2 when many Perums transformed into Perseros. Those who were financially stable such as Telkom and PLN were permitted to issue bonds and borrow from domestic banks, or to make primary share issues as part of privatization transactions. In the early days of the Soeharto era, Bappenas also coordinated Indonesia s policy development and reform initiatives. However, as the reform agenda became more complex, this role was shared with the Coordinating Ministry for the Economy and Industry (EKUIN). A series of major cross-agency reforms were embodied in complex Deregulation Packages 41

56 Improving Public Management of Infrastructure (Paket Deregulasi), each of which involved the preparation and issuance of many new regulations and decrees by several agencies. The first and perhaps most radical of these was Inpres 4 of 1985, which was designed to improve the flow of goods through major ports and whose major provision was to remove the authority of the customs office to process large import shipments. The package comprised three Government regulations, five Presidential Decrees and instructions, several joint ministerial decrees, and more than twenty decrees of the Minister of Finance and Minister of Communications, all of which were issued in a period of one week. Bappenas powers are significantly circumscribed since the Soeharto era. The landscape is now changed and Bappenas powers are much more circumscribed. The REPELITA has been replaced by PROPENAS, which is less specific in its program prescriptions and target-setting, while DIP project documents no longer require Bappenas approval. The 2003 State Finance Law, which provides for consolidation of routine and development budgets and for medium term expenditure frameworks to supplant the current form of national development planning, does not define or indicate the future role of Bappenas. The role of EKUIN s successor, the Coordinating Ministry of Economic Affairs (CMEA), has also been changing. There is a now an increased need for effective interagency coordination and interaction, but achieving this goal has proved to be difficult. Recognizing the need for more collaborative processes, there has been a proliferation of special purpose coordination committees. These include, for example, the Committee on Policy for Accelerating Infrastructure Development, a Committee on PLN Rehabilitation and IPP Renegotiation, and a Committee on Rural Infrastructure Development, all chaired by the Coordinating Ministers. Bappenas tends to oversee the overall functions of many of these Committees while CMEA itself tends to focus more on short term implementation matters. Several of the committees have potentially overlapping roles, and the sheer number of them and bureaucratic territoriality tends to complicate their effective functioning. 42 Averting an Infrastructure Crisis: A Framework for Policy and Action

57 Chapter 2 Recommendations While implementing regulations have yet to be issued, the State Finance Law would appear to pave the way for the Ministry of Finance to play a more pro-active role in decision-making on matters relating to infrastructure sector restructuring and regulatory reform. Government should be seeking ways to reduce the State s fiscal exposure in the infrastructure sectors, through promoting structural reforms and private participation arrangements that lead to increased private investment, and to the transfer of commercial risks to private parties. However, it would be unrealistic to expect sector ministries or utilities to make fiscal exposure a major criterion for choosing between alternative market structures or alternative forms of private participation. South Africa provides an interesting model in this context by having established a Private Participation in Infrastructure Unit in its National Treasury. This ensures that the ministry with overall fiscal oversight is also responsible for driving implementation of private participation in infrastructure. Private participation has been brought into the ambit of the country s medium term expenditure framework (MTEF), and sector ministries are expected to demonstrate how risks are to be managed, performance measured and value for money maximized in their large infrastructure projects and programs, if they are to be approved in their MTEF budgets. This in turn has required sector ministries to optimize risk allocation between private and public parties at the planning stage of infrastructure projects. The key conclusions and recommendations stemming from the above are that: Government s efforts to commercialize, corporatize and privatize the provision of infrastructure services and to separate responsibilities for policy formulation, regulation and ownership of public enterprises have had a positive impact overall and should be consolidated and expanded. Decentralization has irreversibly changed the manner in which Indonesia is governed, but further actions are needed to better define the responsibilities of the different levels of government, to improve the implementation of financial transfers from the center, to promote effective inter-region cooperation, to build the capacities of regional agencies, and to prevent imposition of inappropriate taxes and levies. The task of the central government has changed dramatically over the last decade or so, with the reduction in its ability to directly manage infrastructure provision. The government should now review the roles and organization of individual sector ministries and rethink the arrangements for coordinating policy and strategic planning. Commercialization and Corporatization The most important infrastructure sector from the standpoint of pressing ahead with commercialization and corporatization is roads, where there are compelling arguments for the progressive introduction of a soundly based user-pays regime for infrastructure use and the establishment of a system of road funds and road boards. MSRI has already undertaken considerable preparatory work in this area, and there is scope in the near term for moving ahead with pilot schemes pending the implementation of desirable legal reforms. A draft road sector law is currently in Parliament. More generally there are considerable opportunities for deepening the commercialization and corporatization of infrastructure SOEs, particularly in the transport sector. For example, the railway sector should move to rationalize the business of PTKA. An initial step in this 43

58 Improving Public Management of Infrastructure direction would be to exit from businesses such as some freight services that clearly lack commercial viability, and restructure itself on line-of-business principles. Likewise, Jasa Marga should be relieved of its toll road authorization function and restructured so it operates as a commercially oriented toll road corporation. These changes should also be supported by further strengthening of MSOE s shareholder capacity, continuing the attempts to further improve the professional capacities of SOE Boards of Commissioners, and the establishment of a credible non-ministerial regulatory authority. At the regional level, there is a pressing need to corporatize the PDAMs and to improve the governance framework within which they operate. A new law on regional enterprises (BUMDs) is currently being drafted which will provide an opportunity to implement policies that will enable and require PDAMs to operate at arms length from DPRDs and regional governments in a professional, transparent and fully accountable manner. An improved regulatory arrangement for water supply is also urgently needed to further support this effort. Privatization is a useful means of improving enterprise performance, but infrastructure reforms in this regard need to be carefully designed and implemented. The overarching goal of privatization should be to support efforts to provide expanded and better public services in a more efficient and sustainable manner. Therefore, the objectives of privatization should be clearly defined and then articulated to consumers in an effort to socialize the reform measures. It is also desirable that any restructuring and rehabilitation needed to enable more effective competition along with adequate regulatory arrangements be instituted prior to privatizing SOEs. Decentralization The Government has recognized the need better define roles and responsibilities of the different levels of government, including those related to infrastructure sectors. Preparations are underway to amend UU22/1999 and its implementing regulations and to replace a number of earlier sector laws, including those for roads, road traffic and transport, railways, ports and shipping, and civil aviation. 25 It will be important to consider expanding the role of provinces as autonomous regions, as a part of this process. This would include, for example, the functions related to the management of small ports and airports, and to planning activities in the power sector. Providing more discretion to provinces on how financial transfers are made can increase their influence with local governments. The central government and the provinces will have to take greater responsibility in ensuring the consistency of infrastructure service provision across the country as well. There should also be an effort to increase the technical capacities of various local entities so they can better select and implement investments, and improve the quality of services to consumers. Central government support will be crucial, especially for local governments that have limited technical capacity and also lack adequate accountability. Partnerships with the private sector, through joint ventures, investments, or twinning arrangements can be useful for upgrading local capacity. Specialists that are currently based in central ministries can play a critical role in this process. Government has also recognized the need to increase the fiscal capacity of regional governments to implement their assigned functions, whether through enhancing their powers to collect taxes and charges or through improvements to the intergovernmental fiscal transfer system. While the key changes needed such as improving the DAU formulation are 44 Averting an Infrastructure Crisis: A Framework for Policy and Action

59 Chapter 2 properly outside the scope of this report, there are three topics that merit mention in the specific context of improving the delivery of infrastructure services. The first two relate to the mechanisms for on-lending / on-granting of foreign loans and channeling of special grants (the DAK) and are to some extent related, while the third relates to the imposition of inappropriate taxes and levies. The on-lending procedures established by MOF Decree KMK.35 are designed among others to discourage imprudent borrowing by the regions. While it incorporates many desirable features, the complex bottom-up process adopted has the potential, if applied rigidly, to impede the channeling of funds for urgent and well justified infrastructure and other investments at the sub-national level. Moreover, there are also questions concerning the appropriateness of its on-granting mechanism inasmuch as this creates a special purpose conditional grants channel that parallels the DAK, but with different procedures and terms. Government has acknowledged the need to amend KMK.35 and there is a strong case for streamlining procedures for dealing with loans that would finance projects with components in many regions and for integrating its on-granting channel with the DAK. Given the limited discretionary financing capacities of most regions, the DAK potentially has a critically important role to play in funding infrastructure development at the regional level and in promoting improved efficiency in infrastructure management. There are compelling arguments for increasing the volume of funding allocated for the DAK, and for making the allocation process more bottom-up in line with the intent of PP104/2000. The most promising avenues for increasing DAK funding would be to shift deconcentrated funding currently being channeled through sector departments for what are properly regional government functions, and to use the DAK as the mechanism by which GOI transfers the proceeds of foreign loan and grant proceeds as special purpose grants under KMK.35. There is also considerable scope for using the DAK as a means of promoting improvements in the efficiency of infrastructure spending at the sub-national level. In particular, the DAK should be used to stimulate investments for projects (e.g. flood control) whose benefits are likely to be enjoyed in significant measure by those in neighboring regions, and to foster inter-region cooperation in fields such as solid waste management where consequent scale efficiencies could be expected to significantly reduce costs. There are also compelling arguments for using the DAK to finance much-needed institutional development and capacity building at the kabupaten / kota level, although this would likely require amendment to PP 104/2000. The imposition of inappropriate taxes and charges by regional governments can adversely impact the efficient provision and use of public infrastructure. Law 34/2000 empowers the Minister of Finance to revoke regional government regulations (Perdas) that are deemed to be inconsistent with the public interest or to conflict with higher level regulations (and specifically Law 18/1997). Regional Governments are required to submit Perdas establishing new taxes and charges to the center for review within 15 days of their ratification, with the center then having the right to reject these within a period of one month. In practice, neither side has been able to comply with these time limits, with the result that the Minister of Finance was in December 2002 revoking Perdas that had been issued more than a year earlier. Many of the 173 Perdas that had been canceled up to December 2002 involved charges on truck operators for the use of road infrastructure. However, feedback from infrastructure providers suggests that regional governments continue to find innovative new charges sooner than MOF can review and make decisions regarding them, and that regions are not complying promptly when ordered to revoke inappropriate regulations. 45

60 Improving Public Management of Infrastructure Such inappropriate charges can deter new infrastructure investment and lead to increased tariffs for existing services, and therefore, an effort to prevent their proliferations is needed. Rethinking the Center While the state remains central to economic development, its role is increasingly that of partner, catalyst and facilitator. Democratization, globalization and other factors are imposing relentless pressures for improved performance in the area of governance, compelling Indonesia to rethink its processes for policy making, planning and budgeting. The challenges of improving government performance are shown schematically in Figure 2.1. Indonesia has already responded to these evolving challenges through the enactment of the State Finance Law, which heralds a significant shift from the national development planning model that served Indonesia well through the 80s and early 90s. Detailed plans Figure 2.1. Improving Government Performance Globalization Increased competition for mobile resources Volatile Capital Open Markets Democratization Increased role of parliament Coalition gov s Participation Democratization Increased role of regions Local initiatives Diversity Fiscal Pressures Large debt Deficits Donor Financing Transparency & Accountability Less tolerance for corruption Demand for Gov. performance ROLE OF INDONESIA S GOVERNMENT Risk Political disintegration Macroeconomic instability Opportunities Better government services Higher growth INSTITUTIONAL CHANGE Processes Policy Formulation Planning Budgeting Legislation Roles & Responsibilities Planning Legislative Cabinet Civil Society Organizations MoF Bappenas Line Agencies Local Government Incentives Definition of results Reporting requirements Rewards & sanctions Legal Framework IMPROVED GOVERNMENT PERFORMANCE Source: Indonesia: Public Spending in a Time of Change. World Bank, Averting an Infrastructure Crisis: A Framework for Policy and Action

61 Chapter 2 for implementing the new law are now being prepared, with particular attention being given to integrating improved processes for strategic policy formulation and development planning with the preparation of medium-term expenditure frameworks and annual agency work programs and budgets. As indicated above, it will be important to position the management of public risks associated with private provision of infrastructure within these processes. This definition of processes will in turn provide the basis for deciding the responsibilities of individual agencies. While there are no ready-made solutions for addressing these issues, many other countries have shifted from centrally planned to market-driven economies in recent years, and Indonesia can likely benefit from their experience. With a new Cabinet expected to take office in October 2004, there is now an opportunity to start identifying and assessing possible options with a view to having preliminary proposals available for consideration by the incoming President. 47

62 chapter 3 Restoring Private Participation 48 Averting an Infrastructure Crisis: A Framework for Policy and Action

63 In December 2002, Government sold a further 42 percent stake in the international and mobile telecommunications operator, PT Indosat, to Singapore Technologies Telemedia (STT), bringing the level of private ownership to 85 percent. STT s bid valued Indosat s shares at around 50 percent above their current price on the Jakarta and New York Stock Exchanges, with the total payment being around US$627 million. Coming just two months after the Bali bombing and following a competitive process that had been explained in the press, there were reasonable grounds for Government to anticipate some praise for this transaction. Instead it came under heavy criticism for selling a strategic national asset, lack of transparency, and its choice of buyer. Private sector is weary of investing in Indonesia, but their expertise and funding is badly needed in the infrastructure sector. Just a short distance from Indosat s head office is a building that symbolizes Indonesia s ambivalent attitude toward the private sector. PT Sarinah is a strategically positioned but visibly run-down department store. Owned by the State, it has stagnated while modern privately owned stores have mushroomed around it. Although long an obvious privatization candidate the retail market is booming while Sarinah under-performs and plays no special social role 26 reasons continue to be found for keeping it under public ownership. Not surprisingly, resistance to private participation on the commanding heights of the infrastructure economy is considerably stronger. 49

64 Restoring Private Participation There are several reasons for this. First, many interpret Indonesia s constitution to require that basic infrastructure be provided directly by the State through government or public enterprises. Second, the legacy of the 1990s has led the public understandably to equate private participation with crony participation and corruption. Third, and linked with this, the public has little trust in the capacity of public institutions to contract with and regulate private operators. While surveys also reveal general distrust of key State institutions, public provision nonetheless tends to be seen better option than private provision. In short, there are currently few political champions of private participation while those who oppose it enjoy strong and vocal support. 27 In seeking to attract private infrastructure investors, Indonesia will need to understand and respond to their expectations and concerns. Infrastructure presents particular challenges insomuch as initial investments tend to be large and lumpy, growth in capacity utilization is often slow with correspondingly long pay-back periods, and tariff increases are generally socially sensitive. Special measures are needed to reconcile these features with private investors desire for predictable and secure returns. International experience has shown that, with sound policies, regulatory frameworks and competent institutions, risks can be reduced and appropriately allocated so as to make infrastructure projects attractive even for conservative investors such as pension funds. But private funding will be scarce and financially prohibitive where these conditions are not met. Viewed in this context, Indonesia s infrastructure sectors are unattractive for many investors because risks are perceived to be too high. The underlying causes for this include: Regulatory arrangements and tariff policies are not conducive to private investment. By way of example, power and phone tariffs are decided by Government in consultation with the DPR, with decisions being significantly influenced by political considerations. Likewise, initial tolls for toll roads are confirmed until construction is complete, while automatic toll adjustment has not been permitted. Institutional capacities are weak and procedures are cumbersome. Together these translate into high up-front and operating costs. For example, it took several years to complete the Terms of Agreement for Indonesia s first independent power producer (IPP), with the cost of technical, legal and financial advisors for preparatory work amounting to several million dollars. Private providers of infrastructure have also complained for years about the difficulties acquiring land and securing right-of-ways. At the sub-national level, many agencies have insufficient expertise to promptly negotiate credible concession agreements with private groups. Domestic financial institutions can contribute little. Domestic capital markets and banks are unable to mobilize long-term Rupiah financing for major infrastructure projects, and international financing poses exchange rate risks except in cases where revenues are also denominated in foreign currency. The judicial system is corrupt. The judicial system in Indonesia, which is the avenue of final recourse, has a very poor reputation as a fair arbiter in solving disputes. A recent decision not to execute an international arbitration award has exacerbated overseas investor s concerns regarding the credibility of the judiciary. 50 Averting an Infrastructure Crisis: A Framework for Policy and Action

65 Chapter 3 Public off-takers are considered poor credit risks. Even before the crisis, Pertamina and its production sharing contractors required gas sales agreements with PLN to be backed by stand-by letters of credit on State-owned banks. The subsequent renegotiation of PLN s IPP contracts, which were backed only by comfort letters, has prompted prospective investors to seek more robust backing for payment obligations. Consequently, many investors, lenders, and insurers remain cautious about the infrastructure sector despite potentially attractive business opportunities. Other countries are perceived to have stronger government commitments and offer environments for infrastructure investment that are less risky. Furthermore, there are other non-infrastructure investment opportunities in Indonesia that offer more secure returns. Many Indonesians expect infrastructure services to be provided by the public sector, and view private participation with skepticism. The Indonesian Government recognizes these challenges and is moving to address them. This chapter first reviews Indonesia s past achievements in attracting private sector interest in infrastructure. It then discusses the benefits that the country could derive from a resurgence of private investors and operators in the sector. Finally, it identifies the steps that Indonesia can take to progressively establish an environment more conducive to private participation in infrastructure so that overall welfare benefits of their participation can be maximized. 51

66 Restoring Private Participation Private Infrastructure Investment in the 1990s Indonesia was one of East Asia s infrastructure success stories with over $24 billion in private funds invested in 62 projects. Indonesia was one of East Asia s private infrastructure success stories of the 1990s, with over $24 billion of private funds invested in 62 projects. Indonesia attracted the second highest share (27%) of private sector infrastructure investment after the Philippines (28%). Its energy and telecom sectors captured the majority of investment, followed by transport, and water and sanitation (Figure 3.1). Figure 3.2 shows the peak in annual investments totaling $6.5 billion in 1996 with the period between 1995 and 1997 representing the highpoint of investments flows. However, investments plunged following the crisis with only $1.4 billion in Subsequent flows have remained low. The modalities for large scale private participation in Indonesia have varied from sector to sector. In the power sector, private investments aimed at serving public needs have been channeled exclusively through IPP generation projects with PLN as the sole off-taker. By contrast, the Government s initial moves in the telecommunications sector included partial privatization of Indosat and Telkom, with 85 percent and 49 percent respectively of these companies now in private hands. All three national GSM mobile operators are majority privately owned, while local fixed services in two of Telkom s seven operating regions are operated by private consortia under revenue sharing agreements. 28 In the water sector, private participation has taken the form of concessions designed to rehabilitate, expand and operate, while in the road sector private companies have developed toll roads with Jasa Marga as a junior partner. In the natural gas sector, an international consortium has taken a strategic stake in PGN s gas transmission subsidiary, while in the ports sector international operators have bought stakes in concession companies created to operate and develop container terminals at the public ports of Jakarta and Surabaya. At the other end of the spectrum, small and medium enterprises, cooperatives and the informal sector also play important roles. This is particularly true of the water supply, Figure 3.1. Private Participation in Infrastructure ( ) Figure 3.2. Private Participation in Infrastructure ( ) Water/Sanitation Transport Energy Millions US$ Telecom ,000 4,000 6,000 8,000 10,000 12,000 Millions USD Source: WB PPI database Source: WB PPI database 52 Averting an Infrastructure Crisis: A Framework for Policy and Action

67 Chapter 3 sanitation and solid waste sectors, where the informal sector is an active service provider. Likewise small enterprises and cooperatives also participate in the power sector, including in micro generation and local distribution. The Promise of Private Service Provision Indonesia needs private sector participation in infrastructure because they bring vital resources and expertise. In addition, and perhaps more importantly, the conditions for effective service provision by any operator, public or private that have been discussed in chapter 2 are more likely to be met under private provision. This is because attracting the private sector requires the Government to credibly commit to developing the type of business environment that is needed, by any operator, for efficient service provision. In particular, private provision can help establish an arm s length relationship between service providers and public authorities, thereby relieving political pressures that impede efficient service delivery. This arrangement often results in stronger government commitments to cost covering tariffs which give operators an better opportunity for financial sustainability. In the absence of such a commitment, private companies would be reluctant to participate in a market where they are exposed to commercial and investment risk. Private provision of infrastructure services can be useful, however, since private managers operate under commercial principles, with greater flexibility in staffing and increased diligence in efficiency gains such as improved collections and greater cost savings. These improvements stimulate further private capital investment, foster management expertise, and encourage technology adoption. Private provision can also offer improved services through greater competition, as well as an opportunity to better allocate risks between public and private sectors. The scope of the potential benefits of private participation mentioned previously varies depending upon the specific option that is selected ranging from management contracts to full divestiture. Management contracts theoretically result in the fewest benefits, while divestiture of state owned enterprises can achieve the full range of benefits from private sector involvement. The key characteristics of each form of private participation and its potential benefits are presented below and summarized in Table 3.1. Table 3.1. Main Forms and Potential Benefits of Infrastructure Privatization Upstream Downstream Management Lease BOT/ BOT/ Contract concession concession Divestiture Management expertise X X X X X Tariff discipline X X X Access to private capital X X X Capital market development X X X Potential capital revenues X Note: Management Contract. Under a management contract, a private firm manages the operations of a state-owned business without committing investment capital or accepting commercial risks. If the firm is empowered to implement reforms and given incentives for good performance or penalties for bad performance, management capacity will develop so as to maximize profitability. Leases. Under a lease, a private firm operates and maintains a state-owned business at its own commercial risk, with income being derived directly from tariffs. Except for agreed maintenance obligations, the lessee is not required to commit investment capital. This format has the merit of requiring governments to impose tariffs that more than cover operations and maintenance costs and of providing incentives to reduce costs and improve payment collection. It can help achieve improved utilization of existing assets but will not assist in expanding capacity. 53

68 Restoring Private Participation Upstream BOT/Concession. 29 Under an upstream contract, a private firm (e.g. power generator or bulk water supplier) takes commercial risk and accepts investment obligations to build or rehabilitate as part of an agreement to supply to a downstream off-taker. Predictable revenue flows, sound management, and adequate separation from public authorities can facilitate access to private capital. Such schemes can be attractive to operators insofar as they are one step removed from end-users and the collection of tariffs. While the upstream operator has an interest in ensuring that the downstream off-taker performs efficiently, its financial insulation makes it less concerned to see cost-covering end-user tariffs, especially if the off-taker s payments are guaranteed by the government. Downstream BOT/Concession. Under a downstream contract, a private operator is involved in supplying a service such as power or water directly to end-users. Although contractually comparable to upstream contracts, such schemes force governments to commit to tariff discipline because the private operator s financial viability is dependent primarily on cost-covering tariffs. Without such commitment, private operators will not participate. Divestiture involves the sale of Government s shares in a state-owned enterprise and is arguably the strongest form of private participation. Sales of stakes to strategic partners will normally have the merits of bringing specialized technology and managerial expertise. IPOs on the other hand brings the disciplines of stock exchange listing, including stringent reporting and disclosure requirements, and can distribute individual share ownership broadly across the population While privatization has been on Indonesian Government s agenda since the late 1980s, there has been limited progress in infrastructure sectors except telecommunications. In the case of Indosat and Telkom, the Governments decision not only to privatize, but list the companies in the New York Stock Exchange has resulted in considerable gains. This has subjected the two companies to stringent international reporting and disclosure standards, with both companies consequently being rated as among the best managed firms listed on the Jakarta Stock Exchange. In other sectors notably ports and gas transmission privatization has so far been limited to the sale of stakes in subsidiary concession companies and strategic partners, although preparations are now underway for an IPO in PGN by the end of Upstream BOT/BOO/concession contracts are the most common form of private participation in Indonesia, mostly in the power and water sectors. There is considerable scope for expanding the use of downstream contracts, including in the water sector, so as to promote operational efficiency as well as tariff discipline. Downstream contracts are currently used in the toll road sector but tolls have not increased to cover costs in the absence of such a contractual provision. It will be desirable in this context to ensure that government agencies and public enterprises are well informed of the different contractual models and their respective advantages and disadvantages. Setting Objectives As a first step in its effort to attract private sector interest, the Government will need to clearly define its objectives for promoting private participation and articulate this to consumers. It will then need to demonstrate to potential investors that it can establish an environment conducive to private participation while assuring a skeptical public that it has the capacity to prevent any abuse of market power, by providing credible regulations and enabling effective competition. Once objectives are determined and a strategy is agreed upon, a public information effort to socialize the impact is essential. Several Governments Northern Ireland is an example - have opted to use the internet for such purposes. Some countries have gone still further to recognize the link between PPI and public expenditure reform, making PPI programs explicit, key components of these reform programs. The South African Government, for example, has established a PPI Unit in its National Treasury, thereby ensuring that the ministry with overall fiscal oversight is also responsible for driving implementation of PPI. PPI has been included in the country s medium term expenditure framework (MTEF), and sector ministries are expected to demonstrate how 54 Averting an Infrastructure Crisis: A Framework for Policy and Action

69 Chapter 3 risks are to be managed, performance measured and value for money maximized in their large infrastructure projects and programs, before they are approved in their MTEF budgets. This in turn has required sector ministries to incorporate PPI options for infrastructure projects at the planning stage, many of which have moved into procurement and implementation phases as PPI models. As sector ministries have become more comfortable with the approach, private participation has expanded from traditional infrastructure projects to include social programs in sectors such as health and education. These lessons could be highly relevant for Indonesia as it moves to implement the 2003 State Finance Law. It must also be recognized that the opportunities for sound private participation opportunities in infrastructure should not be limited to large investments. As previously noted, Indonesia has demonstrated extensive and effective small scale private involvement in sectors such as water supply and sanitation, and should look to harness such entrepreneurial resources to support other sectors such as rural electrification. Ensuring the Financial Sustainability of Service Provision A sufficient level of tariffs is essential for sustaining infrastructure services. Private enterprises pay particular attention to tariff levels since they are vital for earning an adequate return on their investments. In most infrastructure sectors in Indonesia, there is a need to raise tariffs so that service provision can be financially sustainable. For many consumers, however, tariff increases will create hardship by further raising the substantial share of income they already spend on infrastructure services. In Indonesia, decisions on key tariffs continue to be made by Government rather than by regulatory agencies. Recently the central government implemented needed tariff increases, most notably for power and fuel, despite substantial public opposition. However, several other previously approved increases, of telephone tariffs and fuel prices scheduled for January 2003 and of power tariffs scheduled for October 2003, were postponed. This has caused concern among existing and potential investors regarding the government s commitment towards financial sustainability in the infrastructure sector. Therefore, it is important to implement a carefully planned set of tariff reforms while clearly articulating to consumers the need for the reforms and addressing consequent social and distributional impacts. Financial viability is critical for providing efficient infrastructure services to consumers. Therefore, service providers need to recover their costs, ideally by charging those who use the services. Alternatively, costs can also be recovered through general tax revenues or international donor funds implicitly paid by domestic tax payers or international tax payers respectively. In order to be financially sustainable, it is important to have users or tax payers pay for maintenance and operations at a minimum. It is likely that service providers will cutback on maintenance and/or expansion in the absence of such financing, which will eventually lead to access constraints and a degradation of service quality. The situation is most alarming in the water supply sector, where most PDAMs are financially fragile. Current tariffs are too low to cover recurrent operation and maintenance costs, and the financial situations in many PDAMs are too weak to fund network expansion. The financial situation is further undermined by the fact that many local governments continue to extract funds from utilities through dividends in advance. As a result, many PDAMs have reduced their spending on operations and maintenance which has contributed to high levels of unaccounted for water that average between 40 and 50 percent. The quality 55

70 Restoring Private Participation PDAMs finances are weakened by low tariffs, making network expansion difficult. of water service has also deteriorated. In some instances, PDAMs have reduced the amount of chemicals they use to treat water, which has increased the possibility of water-borne diseases. Most PDAMs have ceased servicing their debts to Government, which has limited their access to new funding for required investments. The poor access and service of many PDAMs, therefore, require nearly 80% of the population to rely on self-provisioning or the informal sector obtain water. PLN has made substantial improvements since the crisis, although its financial condition remains fragile. The utility has attained a low debt-equity ratio which reduces its interest charges, while arrangements have been made to obtain Government compensation for charging mandated low tariffs from small customers 30. Recent tariff increases have greatly improved the cash flow situation, enabling PLN to finance a new circa 800 MW gas turbine plant using its own reserves. The current tariff level of about US 6.7 cents/kwh was reached after ten consecutive quarterly increases bringing it to a pre-crisis level. The current tariff level is close to being sufficient to cover long-run marginal costs in the sector. It will be important to consolidate recent reforms, and issue the implementing regulation for the new Electricity Law. One important aspect of the regulations should be a mechanism for automatic tariff adjustment. The situation in the telecommunication sector is more complex. Operators are reasonably efficient and profitable, and are able to finance their expansion by mobilizing bank loans or bonds. Tariffs for international services are high in comparison with other countries, and there is scope for considerable price reductions. The removal of exclusivities enjoyed by Telkom and Indosat, however, have already prompted them to offer services with sizeable discounts. 31 The situation is different for domestic long charges, which tend to be high, while charges for local service are quite low. This is a consequence of the Government s implicit policy of requiring those who could afford long distance calls to cross-subsidize monthly subscription charges and local calls. This was easily managed when Telkom enjoyed exclusivity on domestic fixed access and long distance services. However, the introduction of a duopoly system seen as the first step in a move towards full competition in the market requires tariffs to be rebalanced in order to make investments in fixed access networks more attractive. The Government initially made a provision to address this by announcing a 15 percent average tariff increase in January 2003, but then subsequently deferred its implementation. In the mobile telecommunication sector, growth is strongest in the pre-paid card segment, since it is difficult for individuals to obtain post-paid accounts without additional financial guarantees. Willingness to pay is nonetheless high, notwithstanding the fact that pre-paid rates are higher than post-paid charges, and that the less welloff are therefore paying higher rates for their calls. The situation of informal and community-based infrastructure services is quite different since there is less direct interference from public authorities. These services tend to be driven by consumer demand and are consequently responsive to users needs. Therefore, communities are often willing to contribute to construction costs and support cost covering tariffs. This reinforces feedback from consumer organizations that indicates users willingness to accept significant tariff increases provided that: (i.) the justification is convincing; (ii.) the provider is perceived to be efficient and not corrupt; (iii.) the provider 56 Averting an Infrastructure Crisis: A Framework for Policy and Action

71 Chapter 3 shows commitment to improving service quality; and (iv.) the increases are announced well ahead of their implementation and phased-in progressively so that household budgets can be adjusted. The recent series of substantial power tariff increases was accepted in part because of an effective media campaign and in part because Government required PLN to improve its performance and publish information on its achievements. Maximizing Competitive Discipline Private participation yields best results where there is effective competition among providers. In the economist s ideal world, constant market pressures ensure efficient delivery of quality products and services to consumers at prices that are just enough to enable producers to earn a sufficient return on their investments. Less efficient firms will exit the market while others with potential to succeed will enter. The mobile phone market provides a good example of how intense competition among manufacturers can result in rapid technological innovations and cost reductions. It also exemplifies how competition among retailers can lower prices for consumers. Private participation yields best results when there is competition among providers. The infrastructure sectors have characteristics including very high fixed costs that make them generally less amenable to intense competition. However, recent advances in technology have enabled competition to be introduced in such sectors that were previously seen as natural monopolies. The scope for head to head competition in the market where consumers can choose their supplier, and suppliers compete to serve them - varies within sectors as well as between market segments. Such competition tends to feasible in sectors and markets segments where: variable costs are high relative to fixed costs, thus limiting economies of scale; services are excludable, thus making it possible to charge for them; there are few externalities, positive or negative associated with the provision of the service; political and strategic concerns are limited. Carefully designed sector restructuring, driven and overseen by government, can maximize the scope for head-to-head competition by unbundling market segments with different characteristics and thereby maximize the potential benefits of private participation. For example, many countries have unbundled their power sectors so as to enable head-tohead competition in power generation and in retail supply to small customers. However, infrastructure markets are more complex and require careful design and proper regulation. A competitive power generation market, for example, requires a sufficient number of players, a robust transmission system, clearly defined market rules, and competent professional institutions to manage system operations and payments. Likewise, head-tohead competition among mobile phone operators also needs to be supported by interconnection arrangements and cross-payment systems. In many sectors and segments economies of scale preclude head-to-head competition between service providers. Notable examples include pipes and wires businesses such as power and gas transmission and distribution, and urban water supply. In many cases, it does not make sense to duplicate highly capital intensive networks, and therefore, these natural monopolies are relegated to the public sector. There is still a scope, however, to 57

72 Restoring Private Participation achieve some of the benefits of private participation, which can be attained through competition for the market. For example, franchise bidding 32 can enable periodic competitive discipline through the bidding out of rights to operate services under concessions or other forms of agreements. The public sector can also be reluctant to relinquish direct control and select operators through competitive processes. The selection of projects and operators prior to the crisis was in fact particularly opaque and non-competitive. While the attendant risks were acknowledged by the economic ministries, it was not until January 1998 when the private sector interest in further infrastructure investments waned that Keppres 7 of 1998 was issued to establish some basic rules of the game. A requirement of this decree is that all proposed for private participation be subject to thorough technical, economic, and financial pre-feasibility studies. It also requires that private participation will also be solicited on a competitive basis. Key decision-making roles in the procurement process were accorded to the Government s Procurement Evaluation Team (TEP) for national projects and to provincial Governors for regional projects. Subsequent changes in the Government department structure, including the decentralization of public responsibilities and the disbanding of the Procurement Evaluation Team, have cast doubt on the continuing validity of Keppres 7. The KKPPI Committee was tasked two years ago with drafting a revised Decree, but progress is delayed due to issues related to the draft s consistency with existing sector laws. In the meantime, there are indications of a return to practices that characterized the Soeharto era, with some private groups again proposing unsolicited infrastructure projects of questionable merit and some government agencies again showing interest to negotiate deals directly with them. While the desire to complete such deals is understandable, it will likely undermine the Government s broader efforts to build public trust in a credible and transparent private infrastructure program. There are compelling reasons for adhering to a firm policy of requiring competition in private participation at this stage of Indonesia s economic recovery, despite mixed views as to how best to handle unsolicited proposals. Investments should be selected based on sound pre-feasibility studies and also be identified as high priority in sector development plans. Such processes should provide comfort to investors and government agencies, who will be better able to refute claims that contracts were secured through corrupt practices. 58 Averting an Infrastructure Crisis: A Framework for Policy and Action

73 Chapter 3 59

74 Restoring Private Participation Conversely, investors who seek to conclude deals through direct negotiation with the Government must recognize the possibility of their contracts coming under intense scrutiny in the future. The telecom sector in Indonesia leads the field in competition and private investment, with benefits to both users and investors. Competitive discipline can also be derived through yardstick competition, whereby regulators use comparative performance data from other similar enterprises to regulate monopoly network industries. 33 Yardstick competition applies pressure to under-performing service providers by comparing them with other suppliers of the same service using various measures of performance and efficiency (i.e. price, maintenance cost per km of main, leakage levels, etc.). In unbundled sectors, it gives companies incentives to check the performance of their suppliers. Shareholders and customers also have better information about company performance. Such comparative assessments exert pressure on managers to improve their company s performance. Although no service provider operates under the same circumstances and the process requires reliable data, yardstick competition may increase performance and efficiency of service providers in Indonesia. 34 The telecommunications sector has been least affected by physical and administrative boundaries and by social sensitivities regarding tariffs. Consequently, in Indonesia as in other countries, it leads the field in terms of competition and private investment, with benefits to both users and investors. Since the mid-1990s, three national GSM operators, 35 all now fully or majority privately owned, have been competing head-to-head in the cellular mobile market. Their efforts to increase market share have contributed to explosive growth. From around 2000, VOIP operators began to encroach on the Indosat-Satelindo international call duopoly, while the impending termination of exclusivities promises far more intense competition and downward pressure on tariffs as Telkom enters the market. 36 The ending of exclusivities will enable the newly merged Indosat and Satelindo to become a competitor with Telkom on domestic local and long-distance services, although this may take some time. 37 Perhaps more significantly, technological convergence is quickly blurring the distinction between mobile and fixed services, with GSM operators now complaining about unfair competition from Telkom s new radio-based fixed access service, which offers high data transmission speed and voice quality and provides various value-added services at the same tariff as the conventional fixed-line service. The broadband cable and ISP markets are also competitive, with Telkom and Indosat again being major players but with other operators having significant shares in specific niches or regions. At the other end of the spectrum, the organization of urban water distribution services has been shaped by administrative limitations, while bulk water supplies have been shaped by watershed boundaries. In some large metropolitan cities, such as greater Surabaya, responsibility for water distribution is shared among several PDAM s. There are limited prospects for economies of scale due to the over 300 PDAMs in existence. Each PDAM functions as a poorly regulated local monopoly making inefficiency inevitable. Opportunities for introducing efficiency-enhancing competition have been foregone as water supply concessions were awarded to private consortia through direct negotiations, including notably the two concessions awarded in Jakarta. Efforts to benchmark performance are fragmented. Faced with similar problems, the UK during the 1970s restructured its many small municipally organized water and sanitation utilities into 10 regional water and sanitation authorities organized around river basins. This generated significant scale economies and also paved the way for yardstick competition. Box 3.1 highlights the experience in Brazil, where municipal authorities continue to have constitutional responsibility for provision of water 60 Averting an Infrastructure Crisis: A Framework for Policy and Action

75 Chapter 3 and sanitation services, and where many have opted to delegate upwards to a state-level water company which provides services to numerous municipalities. 38 Box 3.1. Achieving Economies of Scale in Water and Sanitation in Brazil In Brazil, until the 1970s, municipalities were responsible for the public provision of water supply and sanitation. Suppliers were municipal water and drainage companies, each with different financial and administrative structures. Insufficient supply and a weak institutional structure in terms of organization, financial resources, and planning plagued municipal water companies, and made it difficult to increase supply and meet increasing demands. These problems led to the creation and implementation of Brazil s National Water and Sanitation System in the early 1970s, which consisted of the National Water Supply and Sanitation Plan (Planasa), the National Housing Bank, and the Employment Guarantee Fund. Concurrently, Brazil s State Water and Sanitation Companies (CESBs) were set up in every Brazilian state and were responsible for construction, operation, and maintenance. In order for CESBs to operate in their respective states, they had to obtain municipal concessions to run the services under long term contracts because the Brazilian Constitution states that the power to grant water and sanitation concessions belongs to the municipalities. The larger system and resulting economies of scale, along with the favorable performance of the economy, increased amount of funds available, and practice of cross subsidies, all helped services expand quickly. In 1980, Planasa covered 42 percent of Brazil s total population. By 1990, even though the total population increased by 23 percent, Planasa s coverage rose to 57 percent. Source: Brazil Ministry of Foreign Relations. The toll road sector can claim Indonesia s first significant private infrastructure project, the Ciawi Tanjung Priok link of Jakarta s inner ring road, which was constructed in the mid-1980s. Like many projects that followed, however, this was directly negotiated with a group linked to the Soeharto family. The Government subsequently decided that all toll roads should be developed by the private sector, but stopped short of requiring competitive solicitation and selection. Although efforts were made later in the Soeharto era to establish competitive bidding procedures, these were not implemented in a transparent manner. Politically connected groups continued to secure approval for their unsolicited projects. A recent study, funded by PPIAF, 39 has developed comprehensive recommendations for restructuring the toll road sector, including proposals for improved project packaging and competitive tendering, with the specific goal of promoting sustainable private investment. The Power sector has experienced the highest cost in terms of foregone competitive opportunities. Indonesia started to explore options for power sector restructuring in 1990 as it was embarking on solicitation of proposals for its first IPP project, Paiton 1. At that time a further five IPP projects had been identified for competitive tendering based on PLN s least-cost expansion plan, and selection processes had commenced when in 1992 Presidential Decree (Keppres) 37/1992 opened the door to a flood of unsolicited proposals. Politically connected local partners were able to ensure that their projects were negotiated quickly, although aggregate capacity commitments quickly exceeded PLN s projected needs and plant locations were not consistent with transmission system capacity. In the absence of competitive tendering, tariffs were high relative to those achieved in countries that adopted more transparent processes. This was demonstrated when a number of Java IPP projects were finally tendered, with the offered tariff for Tanjung Jati A being well below those previously negotiated for other similar projects. By foregoing competitive practices, the power sector in Indonesia missed many opportunities to lower power purchase costs. While the merits of sector restructuring to enable head-to-head competition in generation and in retail supply were recognized, little progress was made and some decisions that 61

76 Restoring Private Participation were taken with regards to the sector have arguably complicated the next steps in the process. In 1994, PLN s Java-Bali generation plants were transferred to two subsidiary companies (now Indonesia Power and PJB) with a view to their early privatization. Fortunately the privatization did not proceed as international experience has shown, among others, that: (i.) having two dominant generation companies will not enable effective competition; (ii.) restructuring and privatization should desirably start with downstream retail supply businesses so as to ensure credit-worthy buyers for the Genco s bulk power; and (iii.) restructuring of partly privatized businesses is usually more difficult than restructuring of full SOEs. 40 Indonesia Power and PJB continue to be fully owned by PLN and in practice continue to operate more as partners than head-to-head competitors. Indonesia s new electric power law, Law 20/2002, recognizes the potential for competition in generation and supply, and provides for its progressive introduction on a regional basis as circumstances allow. It also reflects a sound understanding of the principles that should guide sector restructuring and specifies preconditions that must be met before a region can be declared open to competition in generation. These include among others, adequacy of retail tariffs to provide a commercial return, adequacy of competition in primary energy supply, presence of sufficiently capable and reasonably balanced generators, and adequacy of other parts of the system to support competition. The law also permits regional unbundling, which needs to be implemented with careful consideration to the trade-off that exists between better accountability to consumers and a reduction of economies of scale. Government s program for implementing the new law is contained in its Blueprint published in April This outlines a strategy for unbundling the key Java-Madura-Bali (JAMALI) grid into generation, transmission distribution and other businesses so as to enable limited generation-side competition to commence from September PLN for its part has conducted detailed modeling studies to assess how the unbundling and regrouping of JAMALI generation assets might best be handled, although there is as of yet no consensus on the precise nature and sequencing of the steps to be taken or their timing. Properly designed and implemented, the efficiency benefits of restructuring should be considerable. 43 In summary, Indonesia has so far taken very limited advantage of the benefits that competition can deliver in its infrastructure sectors. While the opportunities for expanding head-to-head competition are fairly limited, especially in the near term, it is useful to progressively move towards such a system. In the meantime, competition for the market should replace direct negotiation wherever feasible, while benchmarking should be mainstreamed as a mechanism for exerting pressures on incumbent local monopolies to improve their performance. Balancing Users and Operators Interests through Adequate Regulation Competent and transparent regulation is a prerequisite for successful private participation in infrastructure, particularly in those sectors and business segments where head-to-head competition is possible. Regulation is needed to promote economic efficiency and to correct for market failures stemming from participants having excessive market power. Good regulatory institutions improve the investment climate of the sectors they oversee by promoting broader participation, fostering innovations in service provision, and creating incentives to expand access to customers. 62 Averting an Infrastructure Crisis: A Framework for Policy and Action

77 Chapter 3 The overarching challenge of regulatory policy is to balance economic efficiency and social equity in the provision of services. On the one hand, sustainable provision in infrastructure services requires pricing regimes that allow for reasonable returns on investment. On the other hand, ignoring social concerns will risk consumer discontent. Regulators accordingly require a degree of independence from political influences, but need to also respond to policies of an elected government. In order to achieve this balance, a number of countries have successfully applied formal arrangements that include: providing the regulatory agency with a distinct statutory authority, free of ministerial control; prescribing in advance the criteria for appointments and mandating the participation of both the executive and legislative branches of government in the appointment process; appointing regulators for fixed periods and prohibiting their removal, except for clearly defined due causes; funding the agency s operation with user fees or levies on the regulated industry at a level that allows adequate remuneration of regulators and their staff. Measures for holding regulators accountable and their actions transparent include: specifying the duties, responsibilities, rights and obligations of regulatory agencies in laws; allowing for judicial review of regulatory decisions; mandating reporting and monitoring procedures by legislative oversight committees; requiring publication of decisions and allowing for reviews by interested parties. The use of well-specified contracts for service provision allows for the gradual development of regulatory capabilities. Discretion can be limited initially, with emphasis placed on monitoring and enforcement functions. Explicit policies governing the behavior of infrastructure operators in a sector, the scope for competition, and the setting and adjustment of tariffs on the basis of clear and simple formulas, all can narrow the scope of regulation, reduce regulatory discretion, and prepare the ground for transferring broader responsibilities to regulatory bodies as their capacity increases. In the near term, it is evident that regulation through contract will be the likely option in Indonesia, in part because there will be comparatively little scope for head-to-competition outside the telecommunications sector. In sectors such as toll roads and water supply, regulation through contract should be considered. It is important that contracts be carefully designed to facilitate the regulatory function and allow for expanded competition in the future. Indonesia is still in the very early stages of establishing regulatory institutions for its infrastructure sectors. The first infrastructure sector law to include reference to non-ministerial regulation was the 1999 Telecommunications Law. The law itself is silent on the matter but the Elucidation, which is considered part of the law, permits the Minister to delegate his regulatory powers to a regulatory body without providing further elaboration. There has been strong pressure from the DPR and the industry to establish an embryonic regulatory agency on the basis of this law, particularly because of the acknowledgement by the Director General of Posts and Telecommunication that it lacks the capacity to regulate the industry in its current form. As a result, the Indonesia Telecommunication Regulatory Agency was established by ministerial decree in July The agency is a hybrid entity which is headed by the Directorate Generals of Posts and Telecommunications and includes a small Indonesia is still in the very early stages of establishing regulatory institutions for its infrastructure sectors. 63

78 Restoring Private Participation committee of industry professionals. Its powers are limited and there would appear to be no provision for funding needed to employ specialist staff and consultants. The 2001 Oil and Natural Gas Law and the 2002 Electricity Law in contrast both have explicit provisions for the creation of regulatory agencies along lines that are fully consistent with the principles listed above. In the oil and natural gas sector, the downstream regulatory body (referred to as Batur) has already been established. The agency, however, is not yet functioning as the Law s implementing Government Regulation on downstream businesses which will define the licensing and other rules the agency will oversee has not yet been issued. Its duties include ensuring competition in the supply of petroleum fuels a daunting task in the absence of any move to restructure Pertamina s present absolute monopoly as well as regulating the transportation of gas by open-access pipeline and the setting of gas prices for small consumers. In the power sector, the Government Regulation on the Electricity Market Supervisory Agency (EMSA) has just recently been established but appointments are not expected to be made until early This agency will have regulatory jurisdiction only in regions declared open to competition, while regulatory authority for non-competition regions will be shared among the different levels of government. As for oil and natural gas, the implementing Government Regulations that will define EMSA s duties and powers in more detail have still to be issued. For both sectors, a priority should be to issue and implement the regulations, and enable the regulatory agencies to recruit competent professionals so they can begin to establish a track-record. Regulation in water and sanitation poses particular challenges because the sector is fragmented. To be effective, a regulatory system should have a clear demarcation of responsibilities among national, provincial or municipal regulators, and sector ministries. When attempting to identify a proper balance between regional and central regulatory authority, careful consideration should be given to factors such as the technical sophistication required, the availability of local expertise at reasonable cost, and the increased likelihood of industry capture as an agency s jurisdictional scope becomes more limited. The creation of a single economic regulatory authority for water and sanitation across the country would greatly simplify the regulatory function. Decentralized actors such as municipal governments should preferably be responsible for monitoring performance, setting local standards, dealing with customer complaints, and more generally, for ensuring accountability to local citizens. In the event that there are multiple agencies, a clear assignment of responsibilities and jurisdictions is needed to ensure that various regulatory aspects are consistently regulated by the same agency. The World Investment Report by Foreign Direct Investment (FDI) ranks Indonesia's risk profile at 138th out of the 146 countries surveyed. Allocating and Managing Risks Investors and lenders seek rewards commensurate with perceived risks, but projects become untenable when these risks are too high. Infrastructure projects pose particular risks that are compounded by an unfavorable overall investment climate. Following the onset of the economic crisis, Indonesia has been viewed as a high risk country, with a performance ranking at 138 th out of 146 countries surveyed in the 2002 World Investment Report for Foreign Direct Investment (FDI). Investors main concerns include bureaucratic red-tape, a dysfunctional judicial system, excessive increases in minimum wages, arbitrary imposition of taxes and levies by local governments, and pervasive corruption. Banks have remained risk averse and have shown only limited interest in new corporate lending including financing infrastructure projects. 64 Averting an Infrastructure Crisis: A Framework for Policy and Action

79 Chapter 3 The Government of Indonesia is committed to improving the investment climate, as illustrated by the measures included in the IMF exit White Paper. But, changing investor perceptions will take time and efforts will be needed in the interim to reduce risks at the sector and the project levels. Previous sections have identified the importance of improving the regulatory environment as well as promoting greater transparency in the project award process. These reforms should be complimented with better allocation and mitigation of investment risks. The guiding principle in this process is that risks should generally be borne by the party best able to assess, control, and manage them (or by the party with the best access to hedging instruments, greatest ability to diversify the risks, or lowest cost of bearing them). During the Soeharto era, there was a tendency for the public sector to assume too much risk in its contracts with private providers. However, before discussing this aspect further it is important to understand the nature of the risks in the individual sectors. The prospective investors and lenders for the first IPP projects on Java faced formidable challenges. PLN had the monopoly on supplying power to the public, but no control over its retail tariff. It was subject to direction by Government on its investment planning and also depended on the public sector for much of its investment financing. PLN did control plant dispatch, but had a vested interest in maximizing the use of their own generation plants. Consequently, IPP developers insisted on robust take-or-pay agreements as a precondition for undertaking investments due to concerns that PLN may: (a) over-estimate future demand growth and commit to excess new generation capacity; (b) fail to sufficiently develop the transmission system to fully utilize the new generation capacity; and (c) fail to prioritize plant dispatch based on economic merit. Developers also insisted that tariff payments to them be denominated in US dollars. This measure was taken because investors had to rely on foreign financing since the domestic financial markets were unable to mobilize funding at the required scale. Another reason was the fact that the primary energy source in many instances were either internationally traded (e.g. coal) or priced in foreign currency (e.g. geothermal steam). If the Government had insisted on tariffs being computed directly in Rupiah, as would seem to be implied by Keppres 37/1992, it is unlikely that these projects would have been financed by private investors. Financial closure on Paiton I had already taken over a year to finalize after the PPA was signed. The Government, during this time, was firm in resisting pressure from developers to provide an explicit sovereign guarantee for PLN s payment obligations, but instead agreed to sign a support letter compelling PLN to meet their contractual obligations. Could the Government or PLN have negotiated better terms? The tariffs could have most certainly been better negotiated, by relying on more competitive practices instead of entertaining unsolicited proposals by politically connected investors. It may have been difficult, however, to arrange for a more favorable risk sharing arrangement since Paiton I was the first such project. However, it can be argued that the Government should have negotiated better terms for subsequent projects instead of relying on the Paiton I agreement as a model. Although PLN subsequently sought to improve the risk allocation on some deals, politically connected project developers were generally effective in being able to obtain favorable terms similar to earlier agreements. 65

80 Restoring Private Participation Although an electricity law has been passed, the implementing regulations and a credible regulatory agency have yet to be established. Investment prospects in the toll road sector appear promising despite high risks. As the Government seeks to restore private infrastructure investment, it is useful to assess the current risks that exist in different sectors. In the power sector, there is evident private interest in new IPP projects and in supply of gas to PLN. No IPP projects have yet been offered through competitive tender but direct negotiations are in progress on a number of new expansion projects. The overall country risk environment remains less favorable than in the mid-1990s and PLN s financial situation, though much improved, is still fragile. Passage of the new electricity law is viewed positively by investors, but in the absence of implementing regulations and a credible functioning regulatory agency, there is considerable uncertainty regarding its likely impact. Meanwhile, the cancellation of the previously agreed 2003 fourth quarter power tariff increase has raised concerns about Government s ability to implement tariff increases that may be needed in the future. The renegotiation of existing IPP contracts have also made investors nervous. As a result, developers and lenders for new IPP projects are seeking more robust support for PLN obligations than was provided in the past. Therefore, the question arises as to which risks the Government should bear? There is also a need to identify the type of support the MOF would be willing to provide to directly negotiated projects in the absence of a framework and strategy for financing investments in the sector. Securing early agreement on private financing for a major new generation plant would undoubtedly help Indonesia s efforts to avert possible near term power shortages and perhaps also encourage other investors to return. On the other hand, the absence of competitive tendering may provoke justifiable public concerns that power prices will again be inflated due to non-transparent and politically motivated arrangements. In the telecommunications sector, the risk situation is more straightforward as there is less government intervention. Investors will determine their expansion needs based on business segments that offer the most attractive and secure returns. This is also based on an expectation that tariffs will remain unchanged in the near-term. Although investments into the sector are expected to continue, it is unlikely that the pace will be sufficient to close the teledensity gap with neighboring countries. It is likely that investments into rural areas where returns are lower, will also be slow to develop. Investment prospects in the toll road sector, especially from domestic private investors, appear promising despite the high risks. The Government, however, will have to carefully select projects and proceed to address some of these crucial risks. Key issues include the regulatory risks related to the setting of initial tariffs and their subsequent adjustment, and to the multiple roles of Jasa Marga. Land acquisition also poses serious risks in the absence of an effective eminent domain mechanism. Financing risks could be reduced by packaging the development of new links with concessions to operate adjoining links that already generate a solid cash flow. It will also be important to award contracts through transparent and competitive tendering as the toll road sector in Indonesia is perceived to be corrupt. The water supply sector presents the most complex challenges. Regional governments continue to extract cash from PDAMs in the form of dividends in advance despite most utilities incurring losses. PDAMs are best able to assess, control, and manage operational risks since they are closest to the end user but they bear only a small part of the cost of poor performance. Their main source of financing is in the form of loans from the central government, and over 60 percent of the more than 400 loans are in arrears. The central government retains all the contingent liabilities which gives PDAMs and regional governments little incentive to manage in a financially sustainable manner. In such circumstances, private investors will be extremely reluctant to accept commercial risks, and therefore, would not be keen to enter into downstream contracts. 66 Averting an Infrastructure Crisis: A Framework for Policy and Action

81 Chapter 3 Public Support for Private Projects Public support for private infrastructure projects can improve economic efficiency by remedying market failures, including those attributable to Government s own actions, and by helping to achieve distributional objectives such as extending services to poor communities. 44 As used here, public support involves the provision of some form of direct or indirect subsidy from a government budget whose level is just sufficient to enable a service to be provided on a commercially viable and sustainable basis by an efficient private operator. Such public support should be distinguished from forms of public participation that are expected to yield satisfactory financial returns for the providing entity. Indonesia has often viewed infrastructure services as being provided exclusively by either the public sector or through private providers. The basic road network is seen as a public good and has been financed entirely from government budgets, while toll roads are seen as private and are expected to be financed entirely by the private sector. The concept of publicprivate partnerships recognizes, however, that there can be merits in involving private investors and operators in the provision of public services. These options may not be commercially viable, and therefore may not attract private financing or be sustainable through user tariffs. By way of example, two options for increasing road capacity in an already heavily congested arterial corridor may be to either widen the existing public road or to develop a new restricted access road. Analysis may show that building the more costly new road is preferable on economic grounds when all externalities are considered, but 67

82 Restoring Private Participation that this would not be a financially viable investment for a private toll road developer who receives only toll revenues. In such circumstances, there may be compelling arguments for some form of carefully designed public support scheme that would suffice to induce a competent private operator to invest and thereby free public funds for other uses. Deciding whether to provide public support requires careful consideration of objectives, benefits and costs. Figure 3.3 below illustrates a decision framework that governments can utilize in order to make such decisions. Note that one of the first questions that the government should consider is whether a change of policies might enable infrastructure projects to take place and government objectives to be met without the need for any fiscal support. In some cases, there are very clear links between the speed at which market liberalization measures can be implemented and the extent to which government support will be necessary to attract private investments. In Indonesia, this is particularly evident in the power sector: as long as the public incumbent, PLN, remains the only purchaser of wholesale electricity, potential private power producers are likely to require government support before committing investments to the sector. In a liberalized market where independent power producers can sell directly to distribution companies and other major clients, the need for government support is likely to disappear. Although a liberalized market would require less government intervention, the drawback of faster reforms should also be taken into consideration before proceeding. There is a multitude of public support methods, and Indonesia has employed different forms at various times. Some of these options are outlined below. Figure 3.3. Process for Deciding Whether to Provide Fiscal Support Receive request for fiscal support Clarify government s objectives Yes Would nonfiscal policy changes achieve objectives at no cost? No Identify the most promising instruments, considering their targeting and transparency Yes Do benefits of best instrument justify its cost? No Decline request for fiscal support; change policy Provide fiscal support Decline to provide fiscal support Source: Timothy Irwin, Public Money for Private Infrastructure: Deciding When to Offer Guarantees, Output-Based Subsidies, and Other Fiscal Support, World Bank Working Paper No. 10, July 2003, p Averting an Infrastructure Crisis: A Framework for Policy and Action

83 Chapter 3 Output-Based Aid (OBA) 45 Indonesia has long supported the delivery of public services by subsidizing inputs to their production. PLN and public transport operators continue to benefit from subsidized fuel, while the state-owned rail and bus companies have previously depended on the Government to provide rolling stock and vehicles as equity. Such subsidies have been largely ineffective in achieving many of their objectives, partly because they were poorly targeted towards the intended beneficiaries. These subsidies also reduced the incentive for more efficient operations. For example, the subsidy on diesel has mostly benefited private truckers rather than poor consumers. Cheap fuels also reduce incentives for better engine maintenance. Moreover, some input subsidies have caused significant market distortions, such as PLN s preference to utilize highly subsidized diesel fuel instead of more economically efficient fuels. Many governments are now turning to output-based subsidies to achieve their developmental objectives and Indonesia has also started to move down this path. The compensation paid to PLN for supplying power to very small customers at sub-commercial tariffs is one example. Another is the public service obligation (PSO) scheme adopted for PTKA s economy class passenger services, although this is not yet fully implemented. In order to derive maximum benefits from output-based subsidy schemes, public authorities must design them properly. In particular, the intended beneficiaries must be clearly identified and the service to be provided must be very precisely defined. It is essential that competition be introduced between the different service providers. Monitoring and evaluation arrangements must also be carefully designed to ensure payments are made on the basis of contracted outputs that are actually delivered to consumers. These points will be discussed again in Chapter 5 when highlighting the government s financial interventions in favor of poor infrastructure users. Output-based subsidies support PLN charge sub-commercial tariffs for very small electricity customers. Capital Contributions One of the simplest means by which Government can support an investment project is by contributing capital as an equity infusion or by providing a loan at market or subsidized rates. By participating in financing the investment, the government takes a direct stake in its success, which in turn may help reinforce tariff discipline. However, caution is needed to ensure that private equity investors provide a sufficient proportion of the financing so as to fully commit to the success of the venture. Making up-front capital contributions to private infrastructure investments will be politically difficult for Indonesia in the current budget-constrained environment given the competing claims of other sectors. While Government could in principle raise money through capital markets, such public sector borrowing may crowd out other private investments by raising interest rates. It could also resort to borrowing from international financial institutions, with the incurred sovereign debt being invested as equity or on-lent as a project loan. However, this would also squeeze out borrowing for other purposes at the margin. Contingent Financing Infrastructure developers often look to Governments to share the risk burden of investments. Such requests most commonly concern risks related to Government s own political or regulatory actions, such as expropriation or refusal to implement a tariff adjustment in accordance with contractual provisions. For Indonesia, PLN payment risk has long been a key issue for both IPPs and gas suppliers. Elsewhere, project developers have sought and obtained traffic guarantees for toll roads and other transport infrastructure projects. 69

84 Restoring Private Participation The Government of Indonesia has rightly been extremely cautious in providing any form of sovereign guarantee. As previously noted, it declined to guarantee PLN s payment obligations under existing IPP contracts, although it did sanction political risk insurances taken out by some developers to provide security against expropriation. It has also permitted state-owned banks to provide stand-by letters of credit for PLN s payment obligations under gas supply agreements. In the future, the most compelling case would be for the Government to guarantee implementing its own commitments such as tariff increases. However, any such guarantees must be properly assessed for the expected costs before decisions are taken. 46 More generally, it will be important to avoid creating unintended precedents and there should desirably be no discussion of guarantees at the level of an individual project until there is a sound overall policy framework in place that includes sunset provisions. Nonetheless, Government must recognize that the PLN monopsony in the wholesale power market creates payment risks for generators. Guaranteeing off-take is the price the State pays for retaining the monopsony. This creates a contingent liability for the State which could only be avoided by greater liberalization of wholesale power. MoF accordingly needs a basis for comparing the fiscal exposure associated with: (i) the PLN monopsony for IPPs; (ii) private generation with some liberalization of wholesale power; and (iii) traditional public investment in generation. Other Instruments of Government Intervention There are various other means by which governments can induce private investment in the provision of public services. One option is to provide in-kind grants, such as free use of land for toll road or other transport projects or of radio spectrum for telecommunications services. Permitting publicly owned land to be used for non-core activities such as advertising or gas station and restaurant areas may augment revenues and further enhance viability. Some countries have provided various tax incentives for private infrastructure projects, but these schemes pose risks and any proposals should be very carefully assessed to ensure that they are consistent with overall public finance and tax policy in the country. Table 3.2 below reviews the different forms of support mentioned above and assesses the extent to which the different instruments may be effective in achieving government objectives. Table 3.2. Options Most Likely to Address Government Objectives Guarantees Guarantees Instrument Output-based Capital of risks under of risks not under Objective cash subsidies contributions the government s the government s control control Internalizing externalities in infrastructure markets Overcoming failures in markets for financing infrastructure Mitigating political and regulatory risks Circumventing political constraints on prices or profits Redistributing resources to the poor via infrastructure = Possibly Well Targeted = Possibly Well Targeted & Relatively Transparent Source: Timothy Irwin, Public Money for Private Infrastructure: Deciding When to Offer Guarantees, Output- Based Subsidies, and Other Fiscal Support, World Bank Working Paper No. 10, July 2003, p Averting an Infrastructure Crisis: A Framework for Policy and Action

85 Chapter 3 In addition to assessing the accuracy and transparency of different instruments, governments also need to be able to estimate their costs. Estimating the overall cost of providing support to infrastructure projects may present some degree of difficulty when such support does not take the form of a cash subsidy (to calculate the cost of in-kind grants, one needs to assess their opportunity costs for example), when support is pledged for a long period of time (questions may arise as to the appropriate value of the discount rate), and when the actual level of support needed depends upon uncertain events (for example, in order to assess the cost of a capital contribution by the government, one has to estimate the expected returns on the capital invested; the cost of a government guarantee, for its part, will depend upon the probability that the risk will be called). In addition, once a decision has been made to provide a given form of support, government accounting processes are usually ill-designed to track the cost of that obligation over time. Indonesia s budget, for example, will reflect the expected cost of direct cash subsidies. In the absence of accrual accounting, it will not, on the other hand, reflect the opportunity cost of in-kind grants or the expected cost of uncertain forms of support such as guarantees. A variety of techniques have, however, been developed to estimate the cost of such obligations. The cost for the government of providing debt to a project can be calculated by comparing the conditions of the loan with those that are imposed by commercial lenders for similar projects; the cost of an equity contribution can be estimated by using models, such as the capital-asset pricing model (CAPM), that estimate the appropriate compensation for bearing risk; and since granting a guarantee is generally equivalent to granting a put option to the beneficiary, the cost of such instruments can be estimated through the use of option pricing techniques. Some countries, such as Columbia, are using such techniques to estimate the cost of public support to infrastructure projects and are incorporating the results in their budget processes, as described in more detail in Box 3.2. Box 3.2. Assessing the Fiscal Impact of Colombian Government Guarantees In the mid 1990s, the government of Colombia undertook an innovative project to measure the expected fiscal costs of the risks it bore in three private infrastructure projects: the El Cortijo El Vino toll road, a telecommunications joint venture, and a power-sector project. Using techniques developed to price financial options, the study simulated possible outcomes in each project, by making assumptions about the way the key variables evolved over time (for example, do they roughly follow a random walk or do they have a tendency to revert to a mean), the expected growth rates of those variables, and their variability. In the case of the toll-road, for example, the government had given a guarantee that would top-up the private operator s revenue if traffic fell below a certain level. By making assumptions about the evolution of traffic volumes, their expected growth, and volatility, the study estimated that the government could expect to pay about $3 million as a result of the guarantee. The study also identified that the government bore some construction-cost risk in the toll-road project and estimated that the government could expect to pay about $1 million as a result. In the power-sector project, on the other hand, the government s biggest exposure to risk came from guaranteeing the obligations of a financially precarious state-owned utility that had agreed to purchase the output of the private generator. If retail electricity prices were too low to pay for the wholesale power, the government would have to step in. The study estimated the expected cost of these obligations at about $52 million. Since then, the government has introduced a general policy requiring the identification and quantification of guarantee obligations, and government agencies entering into guarantees must now make up-front payments to a contingent fund to cover the estimated cost of the liabilities. The Colombian debt-management office must approve the method used to quantify the liabilities. Source: Timothy Irwin, Public Money for Private Infrastructure: Deciding When to Offer Guarantees, Output- Based Subsidies, and Other Fiscal Support, World Bank Working Paper No. 10, July 2003, p

86 Restoring Private Participation Finally, the identity, incentives and information of those in charge of making decisions on public support will be key determinants of the quality of such decisions. It is important, for example, to ensure that those who have an interest in minimizing the costs of government support are involved in the decision-making process alongside those who have an interest in ensuring that a particular project is undertaken. It is important as well to ensure that key tradeoffs between different forms of support are considered prior to taking decisions. This in turn means that decision makers must have the authority to consider such trade-offs (e.g. to determine whether policy reforms alone could enable a valuable project to go forward, or whether fiscal support is needed and if so what specific instrument would be most appropriate) as well as expertise on a wide range of options that is needed to make informed decisions. One practical recommendation for Indonesia would be to ensure that the Ministry of Finance which has incentives to minimize the cost of government support to infrastructure and the broad perspective needed to assess trade-offs between different options - is involved in key decisions affecting the support that the Government provides to infrastructure projects. South Africa, for example, has implemented such a model, as described in Box 3.3 below. Box 3.3. South Africa Taking into Account Public Expenditure Impact of Public-private Partnerships in Infrastructure Some countries have recognized the links between private participation in infrastructure (PPI) and public expenditure reform, and made PPI programs explicit and important components of their broader public expenditure reform programs. The South African Government, for example, has established a specialist PPI Unit in its National Treasury, thereby ensuring that the ministry with overall fiscal oversight is also responsible for driving implementation of PPI. In fact, PPI has been brought into the ambit of the country s medium term expenditure framework (MTEF), and sector ministries are expected to demonstrate how risks are to be managed, performance measured and value for money maximized in their large infrastructure projects and programs, if they are to be approved in their MTEF budgets. Increasingly, this has meant that sector ministries have had to incorporate PPI options for infrastructure projects at the planning stage, many of which have moved into procurement and implementation phases as PPI models. Interestingly, as the sector ministries have become more comfortable with the approach, private participation has expanded from traditional infrastructure projects to include social programs in sectors such as health and education. Source: Michael Schur, World Bank 72 Averting an Infrastructure Crisis: A Framework for Policy and Action

87 Chapter 3 Recommendations If Indonesia is to develop its infrastructure at the pace needed to support rapid economic growth, maintain international competitiveness, and quickly improve service coverage and access, it will need to mobilize large scale private sector participation in the key sectors on a sustainable and efficient basis. This will require concerted and carefully coordinated efforts to develop and implement a sound over-arching strategy. The key elements of such a strategy should ideally include: Defining, publishing and socializing basic goals and policies for private participation; Developing sector-by-sector plans for restructuring and promoting competition, with competitive tendering being adopted as the norm for all new PPI projects and benchmarking being mainstreamed as a means of pressuring local monopoly businesses to improve their performance; Completing the process of sector law revision, accelerating the issue of implementing regulations, and moving ahead with establishing and empowering non-ministerial regulatory agencies; Developing a carefully prioritized and systematic plan for reducing risk perceptions, which include streamlining procedures, a better documenting and communicating policy, and regulatory achievements. Completing and issuing the amended Keppres 7 and supplementing it with a sound policy framework on public support for private projects. Such a framework should ensure that the implications of all possible alternatives (including the adoption of policy and market reforms that might eliminate the need for public support) are duly considered. This in turn requires that the authorities with the mandate and incentives to carefully consider such issues are key participants in the decision-making process. Finally, the cost of government support needs to be adequately estimated and reflected in budgets. Developing a comprehensive plan to restore tariffs to cost-reflective levels and to explain the rationale for increases to the public. Investing in building capacity as part of the process of empowering government agencies to respond to the challenge of dealing efficiently with private infrastructure developers, and communicating effectively with the public regarding PPI issues. 73

88 chapter 4 Getting a Grip on Corruption 74 Averting an Infrastructure Crisis: A Framework for Policy and Action

89 Transparency International s (TI) latest Corruption Perceptions Index, published in October 2003, ranks Indonesia in 122 nd place out of 133 countries assessed. Its rankings are based on survey data from business people, academics and risk analysts in various countries. Singapore was ranked 5 th, Hong Kong was ranked 14 th, Malaysia 37 th, China 66 th, Thailand 70 th, Philippines 92 nd, and Vietnam 100 th. In short, Indonesia compared poorly with regional competitors. TI s 2003 complementary International Global Corruption Barometer (GCB) survey 47 of 47 countries indicates that almost 80 percent of Indonesians believe corruption affects political life very significantly. When asked to nominate just one of eleven institutions from which they would most like to eradicate corruption, an overwhelming 33 percent selected the judicial courts. A further 16 percent identified political parties, while 11 percent indicated public utilities, and 10 percent suggested the police force. Over 55 percent of Indonesians perceived that corruption affects the culture and values of society in a significant manner, and 33 percent said that it affects their personal and family life. Interestingly only 16 percent viewed corruption affecting the business environment in a significant way, suggesting their perception that businesses manage to pass on these costs to consumers. This assessment is broadly in line with various surveys reported in the domestic press and with anecdotal information. Although the country-specific data are not available, the GCB survey also confirms that the poor suffer disproportionately as a result of corruption. Those surveyed in Indonesia did feel optimistic, however, that the situation would improve, with about 55 percent expecting corruption to decrease in the future. Almost 80 percent of Indonesians surveyed believe corruption has significant impacts on political life. 75

90 Getting a Grip on Corruption After decentralization, corruption is perceived as more diffused and pervasive. Infrastructure has long been fertile territory for corruption. While post-soeharto governments have accorded high priority to eradicating corruption, collusion and nepotism (KKN), there is little indication that their efforts to date have had any significant impact. Indonesia s corruption score of 1.9 in the TI 2001 Corruptions Perception Index did not improve in the 2003 survey, and very few countries scored lower. There is a clear perception among business professionals that corruption is becoming more diffused and less effective in terms of it providing protection or delivering intended outcomes. It appears that corruption during the Soeharto era was more structured and systematic as compared with the present decentralized environment in which many different agents extract rents from businesses. Many have looked to decentralization as a means of promoting increased accountability. Decentralization brings those responsible for public service delivery much closer to users, thus increasing the scope for users to discipline decision-makers for poor performance or corruption. It is much too early to assess whether this will happen in Indonesia and the information currently available does not provide a clear and consistent assessment. Many press reports as well as the central government often suggest that local officials are using their new responsibilities towards corrupt ends. This is confirmed by BPK audit results, which suggest a worrisome trend in both local and provincial levels. However, the Governance and Decentralization Survey (GDS), conducted by Gajah Mada University in mid-2002 in 177 regions, showed that a large majority of households believes that the level of theft, bribes and, illegal levies has remained the same as before decentralization. However, this may simply reflect trends in bribes paid by households rather than by investors. This survey also showed that the general public perceives the incidence of corruption to be highest in government procurement. The infrastructure sectors have long been fertile territory for corruption in both developed and developing countries. While public interest tends to be most easily captured by reports of malfeasance in the implementation of mega-projects, opportunities for extracting rents are abundant and exploited in most facets of infrastructure provision. The costs to the economy and society can be enormous and unsustainable. This chapter provides a brief description of corruption as it affects the infrastructure sectors in Indonesia and outlines what Government is and could be doing to address these issues. The latter discussion focuses on remedial actions that are reasonably specific to infrastructure provision and does not delve into broader fields such as reform of the judicial system. 48 This chapter is limited to describing practices that provide opportunities for corruption and to illustrating how these have been exploited. In describing such generic practices or activities there is no intention to suggest that any specific project that might fit within the broad characterizations has been subject to corrupt activity. Anatomy of Corruption in the Infrastructure Sectors Opportunities for corruption arise at most stages of the infrastructure project cycle, starting with project identification and continuing through the implementation and operation phases. While the modalities can differ in some respects depending on whether the project developer is public or private, the basic practices are broadly similar. 76 Averting an Infrastructure Crisis: A Framework for Policy and Action

91 Chapter 4 Identifying Projects Infrastructure projects should be properly identified, defined and prioritized through soundly based planning and programming processes. In practice, project identification can provide opportunities for corruption in both public and private sector projects. In the public sector, the most significant opportunities involve procurement by SOEs and government agencies of highly specialized products from overseas. Local agents often offer inducements to generate orders, while suppliers arrange for the necessary financing. Once such supplier driven orders are approved, deals can be made at marked-up prices since the combination of narrow technical specifications and financing tied to the suppliers preclude effective competition. Such schemes are most easily arranged in sectors, such as railways, power and telecommunications, which utilize highly specialized mechanical and electrical equipment whose specifications can be tailored to fit the products of a particular supplier. They can be particularly inefficient since they tend to result in over-purchasing as well as over-pricing. By providing financing for important but weak domestic industries, donor/ exporters may be inadvertently facilitating such corrupt practices. There are some indications that such practices may be declining among SOEs that are subject to meaningful market pressures. This is particularly the case among those SOEs that have been partly privatized or permitted to seek financing from banks and the domestic capital market. The series of SOE performance audits commissioned by MOF may also have contributed by highlighting deficiencies in the planning and project identification processes. However, anecdotal information suggests that the problem still persists and that domestic banks may now be playing a larger role in financing such schemes. In the case of private provision, unsolicited proposals provide clear opportunities for corruption, as developers define the project they wish to undertake. During the Soeharto era, a local partner s political connections or financial pay-offs would often ensure that its proposal would be quickly approved. Where formal review procedures existed, for example in the power sector, these normally would be followed. Thus, for example, sponsors of a number of unsolicited IPP projects were able during the mid-1990s to secure Letters of Preliminary Approval notwithstanding objections from some senior ministers. It should be noted in this context that the interest of connected local firms to participate in projects promoted by international developers may be enhanced by carried interest arrangements under which the international developers would finance the equity participation of the local partners and be repaid from the project s dividend stream. Unsolicited proposals for infrastructure development tend to be driven by private interests rather than the common good of the public. In principle, unsolicited proposals can contribute to sound infrastructure development programs by enabling the private sector to provide innovative solutions for meeting infrastructure needs. Many countries have explicit procedures for handling such proposals within their planning processes. However, a number of unsolicited proposals submitted for power, transport and water supply projects in Indonesia have not included any special innovative merit while many have been inconsistent with current sector and spatial development plans and policies. Awarding and Negotiating Contracts Indonesia s public procurement system, which encompasses the processes of preparing specifications, inviting bids, selecting winners, and negotiating contacts, is widely believed to be the principal source where public funds are illegally extracted. Infrastructure procurement make up a major share of the approximately $7 billion total annual goods, 77

92 Getting a Grip on Corruption Infrastructure make up a major share of the US$7 billion annually procured by the public sector - making it a prime target for corrupt practices. The current Presidential Decree (Keppres 18/2000) governing procurement is an improvement over previous decrees, but is still weak in promoting competition. works and services procured by government and state enterprises. The amount that is extracted through corrupt practices may be as high as 30 percent. Indonesia s current public procurement regulations are defined in Keppres 18/2000, which applies to purchases under all government budgets. In addition the 1999 Construction Law includes provisions that relate specifically to procurement of civil works and related consulting services. There is no single organization that is formally responsible for development and implementation oversight of procurement policy, but by default this role has been shared by Bappenas and Kimpraswil. Government procurement is managed by Project Managers (Pimpros), who are selected by a senior official of the implementing agency (e.g. the Secretary General of a sector department). Pimpros in turn appoint Tender Committees to manage the procurement process from its inception through to contract award. The positions on these ad hoc committees, which usually have 5 or more members, are generally filled by staff from the more junior ranks of the civil service. 49 Keppres 18/2000, while an improvement on previous decrees, is weak in several important respects. Perhaps most importantly, it facilitates a restricted level of competition because it: calls for fair competition among firms of equal standing, thereby allowing subjective judgments to be made on which firms will qualify; permits preferential treatment for local small and medium enterprises for contracts below certain values, thus contravening the one-country : one-market principle and precluding the benefits of nation-wide competition; provides considerable discretion to use less-than-fully-competitive procurement methods such as shopping and direct contracting ; establishes soft requirements for advertising or announcing tenders (or contract awards). Keppres 18/2000 also fails to establish procedures to handle complaints from aggrieved bidders or apply mandatory sanctions for firms and officials found guilty of colluding or partaking in other malpractices. Public procurement is administered in an environment that provides limited rewards for efficiency and honesty or penalties for corruption. Collusion between officials and contractors is widespread, with the more commonly employed practices being: Restrictive specifications. As noted earlier, specifications for certain types of public procurements can be tailored to fit those of a particular manufacturer s product. This is most easily done for complex and highly specialized equipment where a carefully written specification might effectively rule out all but a favored supplier. For example, requiring a particular processor configuration for railway or traffic signals may greatly constrain the number of bidders. However, there have also been instances of government agencies issuing technical guidelines for commonly purchased items, such as vehicles, that have been taken directly from a particular manufacturer s brochure. It is also possible to structure the specifications for straightforward civil works packages so as to create opportunities for corruption. This may involve deliberately under-scoping certain types of work so as to create opportunities for profitable contract amendments during implementation. 50 Restricting bidders. Many techniques have been used to discourage or prevent meaningful competition in the bidding process and thereby facilitate collusion between officials and one or more 78 Averting an Infrastructure Crisis: A Framework for Policy and Action

93 Chapter 4 favored bidders. The more common practices include dividing works or procurements for example, sections of road works, into very small packages, limiting or otherwise manipulating bid advertising, shortening bid submission periods, and manipulating pre-qualification processes. Thus, for example, road works are commonly sliced up into small sections so as to discourage or preclude large contractors from bidding, while the World Bank has many times received copies of procurement notices supposedly placed in phony newspapers. Likewise pre-qualification has commonly been employed as a pre-registration system for limiting participation to a small group of colluding bidders. Such practices allow all bidders to submit over-priced bids, with the winner sharing its excess profits with the project management and other bidders. Recent investigations have shown that local branches of business associations, such as the Contractors Association (Gapensi), often play an ambiguous role in such collusive efforts. Fixing the evaluation. When some of the previously mentioned practices are not successful, tender committees may find themselves under pressure to reject one or more firms that have under-bid the favored contractor. This should in principle be difficult under procedures where the firm submitting the lowest priced conforming bid is declared the winner. However, there have been numerous instances when tender committees disqualify low bids as being unresponsive for inconsequential typing and other minor errors and omissions. While many such attempts have been thwarted, especially under foreignfinanced projects, it is likely that many others are undetected and cost the government substantial amounts of money. An illustration of the systematic nature of such practices is provided in Box 4.1, which summarizes pertinent findings of a recent fiduciary review by the World Bank of the Second Sulawesi Urban Development project. 51 Box 4.1. Procurement in the Second Sulawesi Urban Development Project: A fiduciary review of the procurement processes for a sample of 26 contracts financed by the World Bank under the Second Sulawesi Urban Development Project revealed evidence of manipulation designed to give the appearance of competition. The winners appear to have been pre-selected in most cases. The review findings, which covered procurements in four cities, included : The participation of a large number of companies within a single ownership cluster suggests the creation of shell companies. A shell company involves the appointment of nominal directors who are without any real organizational powers or functions, and merely sign documents on behalf of the company. The similarities between the bid proposals of the winning and losing bidders are consistent with the possibility of government officials having pre-arranged winners. Certification from the industry association, GAPENSI, was a condition of participation in the bidding process and all bidders were indeed GAPENSI members. Similarities between bid prices were indicative of the bidders having access to the unit price details of the Owner s Estimate in advance of preparing their bids. The contents of the bid documents indicate that bidders were not individually represented at the prequalification or bid selection meetings but rather that a single representative acted for multiple companies. This is consistent with the finding that companies from the same ownership cluster submitted the winning and losing bids for the same package. Instances were noted where the most competitive bidder was excluded from further evaluation. This is consistent with the possibility that administrative or weak technical grounds were found to exclude competitive bidders from the selection process. World Bank Office, Jakarta 79

94 Getting a Grip on Corruption The contract for Tanjung Jati, a 1,300 MW power plant, was awarded through a competitive process, and yielded a significantly lower tariff than other unsolicited investments. As noted in Chapter 3, Indonesia has comparatively little experience in soliciting and evaluating competing proposals for private sector participation projects since most of these in Indonesia have been unsolicited or directly negotiated. There have, however, been a number of important exceptions including in the power and toll roads sectors where proposals have been solicited through reasonably well-designed processes on the basis of carefully prepared bidding documents. One notable example was the Tanjung Jati A 1,300 MW coal-fired IPP project, which attracted bids from several international consortia and yielded a tariff significantly lower than those for similarly sized plants that were not awarded through fully competitive processes. 52 It is worth noting in this context that raising the tariff for a large IPP base-load plant by just one-tenth of a US cent per kwh will increase its annual revenues by several million US dollars. 53 In the absence of effective competition, those negotiating on behalf of the public sector often have no meaningful benchmarks on which to assess the minimum feasible tariff level. The challenges are far more complex, for example, in investments such as integrated urban toll roads and light rail projects than for an IPP plant for which some indicative capital cost and tariff benchmarks are available. As the scope for inflating prices increases, opportunities for corrupt practices also expand. Financing the Investment For conventional public sector projects, the source of funding can have an important bearing on the opportunities for corrupt practices inasmuch as it may influence the scope for effective competition and increase or diminish the prospects for stringent supervision. Thus, for example, at the sub-national level, it may be easier to inhibit competition when a project is financed entirely from the region s own discretionary APBD resources than when it is financed with, say, conditional Special Allocation grants (DAK) from the APBN. Thus, under the DAK, recipients are required to follow technical guidelines set by the respective sector ministries, with project implementation also being subject to monitoring and evaluation by the center. In the case of road projects, the 2003 DAK conditions require the use of nationally approved planning and implementation guidelines and standards, while the education sector has gone much further by requiring public participation and oversight of school rehabilitation works through the involvement of regional education boards in project prioritization and school committees and local communities in project implementation. 80 Averting an Infrastructure Crisis: A Framework for Policy and Action

95 Chapter 4 Involvement of external financiers can have both positive and negative impacts. International agencies such as World Bank and ADB have fiduciary obligations that require them to use their best efforts to ensure that all project components are designed appropriately and that goods, works and services are procured competitively and transparently and implemented properly. This task is relatively straightforward for projects involving, for example, the construction of high voltage power transmission lines but extremely challenging in the case, for example, of projects involving large numbers of small and geographically scattered urban infrastructure investments. Thus, the former might involve just a handful of large value packages with precise performance specifications capable of attracting intense 81

96 Getting a Grip on Corruption international bidding while the latter could involve hundreds of packages, with each being awarded locally by different agencies under conditions conducive to collusion. Intensive supervision has nonetheless made such practices more risky for those involved and there have been numerous instances of multilateral lenders rejecting efforts by tender committees to disqualify valid low bids without proper grounds. However, there has usually been little follow-up in such cases by the responsible government agencies to sanction those responsible. Any form of external financing that limits the prospects for meaningful competition necessarily brings attendant risks in the form of increased scope for price mark-ups. Indonesia s experience is that projects financed by export credits and tied bilateral financing have tended to be more expensive, on the basis of whole-life costs than projects financed from sources that require meaningful bidding competition. By way of example, PLN was recently required by Government to renegotiate prices for a number of extra high voltage transmissions packages funded by export credits after international competitive bidding for a similar package funded from another source had resulted in a much lower price. 54 The issues are somewhat different for private infrastructure projects as both investors and lenders should, in principle, have a common interest in minimizing costs and risks. However, a quest for profit during construction has in many instances created perverse incentives and considerable opportunities for corrupt practices. This practice involves marking-up construction costs with a view to obtaining debt financing for, say, 75 percent of the nominal total cost that would in practice more than cover the full efficient construction cost. The loop is then closed by awarding the construction contract to an affiliated contractor. No equity is actually contributed by the developer and, if the project is unsuccessful, the lenders often state-owned in Indonesia s case would bear all of the risk. Such practices which would have involved collusion with banks appear to have been most prevalent in the toll road sector, where investors and lenders were well aware that tariff and other risks would make projects essentially un-bankable. Yet demand among local investors for toll road projects during the mid-1990s was buoyant to the extent that, when the crisis struck, Government through Keppres 39/1997 postponed a total of 37 private toll road schemes. 55 The phenomenon of profit during construction is not unique to Indonesia or the toll road sector and indeed many international banks have been exposed due to weak due diligence procedures. Implementing the Project The core objective during the implementation of public projects should be to ensure that the contractor delivers the works, goods and services to the specified standards at the agreed upon price in a timely manner. The opportunities for corruption are again abundant and most commonly involve under-supplying on quantity or quality. Thus, for example, the asphalt overlay on a road project may be thinner than specified or the base course aggregates may be outside the specifications. While such practices should be detected by the supervision consultant, in practice there is often collusion between the project manager, contractor and the consultant. They collude by 82 Averting an Infrastructure Crisis: A Framework for Policy and Action

97 Chapter 4 approving over-invoiced charges and providing certificates for completion of unsatisfactory work. There are many examples of poorly constructed works failing prematurely and resulting in enormous costs to the State. There have also been many examples of officials and contractors colluding during project implementation to create unjustified amendments to contracts. The late release of budget funds can also encourage corruption by creating perverse incentives for agencies to lock in resources that would otherwise be lost at the year-end. Typically, this is accomplished by transferring funds to other bank accounts outside the control of government and by falsifying documentation on project progress. This presents an opportunity for misappropriation. Box 4.2 below highlights some of the Bank s findings on corrupt budgeting practices. Box 4.2. Year-end moves to protect budgets Recent World Bank supervision missions to a development project in one city showed that, for 16 civil works contracts, a majority of the payments to contractors were processed by Government treasury offices in December, just days before the fiscal year-end and often on the last day of the contracts. The mission also noted the following pattern: Minutes were attached to payment vouchers (SPM), duly signed by project managers, stating that work was 100% complete. However, detailed back-up calculations were either not attached, or were attached but not certified by independent engineering consultants. Site visits revealed that progress was well below 100%. Payment of counterpart (GOI) funding, normally representing 20% of project costs, was transferred to bank accounts in the regional development banks owned by regional governments. The balance 80% was generally paid out to contractors bank accounts in private banks. During discussions, representatives of KPKN, the treasury office, acknowledged that they often resorted to this practice at fiscal year-ends, where funds were shifted to regional treasuries, to protect unspent but committed balances under centrally budgeted projects. It was not clear how these protected funds, now outside the central treasury system, were actually used or controlled. The same pattern was observed in one other city. Approved national budgets for these cities were received by the project offices as late as July, leaving only 5 months to complete procurement, implementation and payment of the said project packages. The inflexibility of the budget system provides incentives for project staff to falsify documents certifying project progress and exposes government and donor funds to risk of misuse. Source: World Bank, Indonesia In principle, private investors and lenders should have every incentive to ensure their projects are built to the highest commercial standards. This appears to have been the case where projects were well conceived and the contractual arrangements provided suitable incentives for minimizing costs. However, construction quality has been poor where profit during construction appear to have been a primary objective. The Operations Phase When it becomes operational, an infrastructure project typically becomes part of a larger network or system, making opportunities for corruption more diffuse as they are more likely to occur at the system or business wide level. Since a detailed discussion of such practices is beyond the scope of this report, this section will highlight three practices that may occur frequently: Although heavy vehicles are notoriously overloaded and creat significant road preservation costs, offenders are rarely sanctioned. 83

98 Getting a Grip on Corruption Failure to protect infrastructure. Some types of infrastructure, particularly road pavements, can be damaged through improper use. In Indonesia, over loading is estimated to increase road preservation costs by percent. 56 Many roadside weighbridges, however, manage to identify few offenders. It is estimated that between 30 and 100 percent of heavy vehicles are overloaded the most serious offenders being trucks carrying logs, aggregates and other bulk products. It has been recognized since the early 1980s when all of Indonesia s weighbridges were ordered to be shut down for a lengthy period that the underlying problem is corruption. Weighbridge operators accept bribes from small operators while larger ones employ military or police security to exempt themselves from inspection. In fact trucks operated by the army and police cooperatives are among the offenders in many instances. Failure to optimize infrastructure use. Sometimes even relatively small scale corruption can have a large impact on the efficiency of infrastructure provision. For example, traders pay small bribes to enforcement officials to allow them to operate stalls and kiosks in areas that contribute to roadside friction and cause significant congestion. Likewise, route licensing practices that force bus and pick-up operators to use public terminals where legal and illegal levies are collected can also cause intense congestion in urban centers. Failure to optimize revenue collection. Unaccounted for output is a major issue for Indonesia s PDAMs, many of which are able to collect payments from customers for only percent of the treated water they put into the distribution system, and for PLN, which estimates that it loses 84 Averting an Infrastructure Crisis: A Framework for Policy and Action

99 Chapter 4 approaching Rp. 1 trillion per year as a result of power theft. In both instances, part of the unaccounted for output is attributable to corruption as opposed to technical losses and simple theft. For example, there have been many cases of PLN technicians being paid by customers, large and small, to arrange wiring so as to partially by-pass meters or otherwise impede proper metering. During the mid-1990s, a number of high profile cases involving large scale theft by factories owned by politically influential players were identified where the level of involvement went much higher than the installation technician. Power theft is estimated to cost Rp 1 trillion per year, with many cases of collusion between operators and consumers. Audit as the last line of defense In the absence of effective oversight or any requirement for public disclosure, audits are the last line of defense against corruption in public projects. In recent years, both the Supreme Audit Board (BPK, which reports to Parliament) and the Government s internal audit agency (BPKP, which reports to the President) have documented extensive irregularities and leakages. Yet both agencies have publicly complained that their reports are largely ignored and that little or no action is taken against offenders. In recent years, MOF has also commissioned special performance audits of a number of SOEs, agencies and special funds by private auditors to complement routine financial compliance audits. These audits have benchmarked procedures and practices as well as efficiency and productivity levels against various comparators. They have also highlighted areas where there were strong indications of procurement or other irregularities. Although a number of the audited organizations, including PLN, have responded positively by implementing the auditors recommendations, no prosecutions have resulted from the findings. It is clear that Indonesia lacks both the political will to prosecute civil servants involved in corrupt practices, and an effective enforcement mechanism. Recommendations As noted in Combating Corruption in Indonesia, 57 eliminating corrupt practices will require fundamental changes in the accountability framework that will take considerable time to design and implement. Nonetheless, there are significant opportunities for moving ahead quickly to reduce corruption in the infrastructure sectors. The four main avenues involve restricting the opportunities for corruption to occur, increasing the likelihood of its being detected, raising the probable costs of being caught, and creating positive incentives for non-corrupt behavior. Effective competition is one of the best means of narrowing the scope for corruption, and considerable effort has gone into developing improved procurement regulations to replace Keppres 18/2000. The key features of the new Keppres, which was signed by the President in November 2003, include: Establishment of an Institution for Development of Public Procurement Policy (LPKPP). The new institution, which will report to the President, is to be established by January Bappenas is tasked with coordinating the actions needed to establish the new institution and with undertaking some of its tasks on an interim basis. Introduction of a requirement for project managers and members of bid committees to be certified in procurement. This will be phased in over a period of three years. 85

100 Getting a Grip on Corruption Removal of restrictions which required that bidders be certified by business associations and / or be domiciled within the region making the procurement. Removal of the requirement for pre-qualification for contracts below Rp. 50 billion (about $6.2 million). Introduction of a requirement for suppliers, contractors and consultants to sign integrity pacts. Introduction of explicit prohibitions against collusive practices, along with the specification of minimum sanctions. Clearer definition of conflicts of interest and expanded definition of information disclosure requirements. The provisions of the new Keppres apply to procurements by both central and regional governments. The Government is also preparing a new Keppres to replace Keppres 7/1998 on Public- Private Partnerships for Infrastructure Provision. This is expected, among others, to establish sound guidelines and procedures for the identification of projects to be offered for private participation and for the transparent competitive solicitation of private partners. Expanded information disclosure, coupled with expanded public participation and improved financial compliance, technical and performance auditing, offer the best prospects for increasing the probability of detecting corruption. While a major part of infrastructure expenditures are now managed by regional governments and public enterprises, central 86 Averting an Infrastructure Crisis: A Framework for Policy and Action

101 Chapter 4 government can play a vital role, for example, by establishing stringent information disclosure requirements for procurement activities and by publishing information on information disclosure compliance. Publication might be pioneered appropriately by posting on the internet expanded information on the implementation of projects financed by DAK grants so as to supplement the basic data on grant allocations provided by MOF. Such additional data could provide the basis for benchmarking the transparency of planning and implementation performance and might usefully include the results of inspections and technical audits. These measures need to be complemented by tough sanctions for those found to have engaged in corrupt practices, together with effective procedures for ensuring that such sanctions are properly applied and published. Creating positive incentives to eliminate corruption from the infrastructure sectors will require Government to rethink the way it operates. One avenue that merits consideration would involve publishing examples of best practices for example of expanded procurement information disclosure on the internet. Consideration might also be given to establishing competitions for good practice, for example in the planning and implementation of DAK grants. In some instances there may also be opportunities for restructuring the implementation of government functions so as to facilitate their implementation by the private sector under arrangements that provide soundly designed financial incentives for effective and transparent performance. One example of such an approach now being piloted in Sumatra involves the private operation of road-side weighbridges under a scheme that allows enforcement performance to be evaluated against secure weigh-in-motion data. 87

102 chapter 5 Mobilizing Finance for Infrastructure Development 88 Averting an Infrastructure Crisis: A Framework for Policy and Action

103 The reforms discussed in the preceding chapters will progressively improve the investment climate for infrastructure in Indonesia, and as a result help mobilize financing for the sector. The effects of these reforms, however, will not be felt immediately, and therefore a substantial financing gap is expected to remain in the medium-term. This chapter first identifies the gap in financing. It stresses that a carefully designed long-term financing strategy is needed. At the same time, it is important to note that increased spending alone is not a sustainable way of improving infrastructure services. Instead, a coordinated effort where expenditure complements sector reforms is needed to revive the sector. The chapter then reviews potential funding sources, including both international and domestic sources. Options for mobilizing domestic financing are discussed in more detail. Finally, the chapter discusses how the increased financing can be best spent by government to achieve its development objectives, including pro-poor growth. While detailed technical recommendations will call for more analysis than can be provided in the present report, a broad outline of the steps that could be taken in these three areas is presented below. 89

104 Mobilizing Finance for Infrastructure Development Public infrastructure investment has dropped sharply since the crisis from $8 billion USD in 1994, to $1.5 billion in Additional infrastructure investments of $5billion USD (2% of GDP) is required annually to reach a 6% medium-term growth target. Financing Gap The Government of Indonesia projects a growth rate of 6 percent or above for the year 2006 (GOI PJM ). In the decade preceding the 1997 financial crisis Indonesia grew at an average of 7 percent per year. This was associated with fixed capital formation of an average of 26 percent of GDP and infrastructure spending of around 6 percent of GDP. By contrast, in 2002, fixed capital formation was at 20 percent and overall spending on infrastructure amounted to no more than 2 percent of GDP: private spending in infrastructure has picked up a little since 2000 but is still below 0.5 percent of GDP; local government expenditure on infrastructure was around 0.75 percent; and central government expenditure was only slightly above that. This is low by international standards (see Figure 5.1). It is possible that the structure of the Indonesian economy in the next decade may be different from what it was during the two decades preceding the crisis, hence the historical relationship between growth and infrastructure spending might not hold. In 1960 manufacturing accounted for 15 percent of the economy and agriculture for about 50 percent. By 1980, agriculture had shrunk to 24 percent of the economy and manufacturing had grown to nearly 42 percent, making infrastructure even more important to growth. The decade ahead may see the economy moving away from manufacturing and more towards services, but this evolution is likely to be slow: between 1990 and 1997, services did grow from 34 percent of the economy to about 40 percent but the share of manufacturing kept growing to about 44 percent (see Figure 5.2). In any case, given the poor condition of existing infrastructure and severe backlog, it is fair to assume that infrastructure investments will remain a critical issue for growth in the coming years. Estimates by World Bank staff With labor growth and total factor productivity remaining at historical levels suggest that infrastructure investments of about 5 percent of GDP are needed to sustain a 6 percent medium term economic growth target. Given that the current level of infrastructure spending is about 3 percent of GDP, there would need to be an inceease of US $5billion (2 percent of GDP). It should be noted, however, that this is a conservative estimate since it does not fully take into account factors such as the impact of rapid urbanization. Figure 5.1. Infrastructure Investment (% of GDP) Figure 5.2. Structural Change (% of Economic Activity) Agriculture Private Public Indonesia Albania Russia Cambodia Kazakhstan Services Industry Note: Latest data available - Indonesia (2002), Albania (2000), Russia (2000), Cambodia (2001) Sources: World Bank PPI Database, World Bank Public Expenditure Reports Source: Indonesia: Rapid Growth, Weak Institutions. forthcoming. Hofman, Bert, et all. 90 Averting an Infrastructure Crisis: A Framework for Policy and Action

105 Chapter 5 Options for Bridging the Financing Gap There are four main sources through which infrastructure development can be financed : User charges that are reinvested; International capital markets; Public financing, through government budgetary resources; and Domestic capital markets. User charges are a key source of infrastructure financing, particularly in well developed utilities. In many mature private utilities, internally generated funds can account for up to 70% of investment funds. 58 In order to generate those funds, tariffs must be set at adequate levels, which is not the case at present in Indonesia. As mentioned earlier, tariffs will need to be raised. But, the impact of such reforms on the capacity of utilities generate funds needed for investment will only be felt progressively. Tariff increases will indeed have to be gradual to take into account residential users capacity and willingness to pay and to ensure that commercial and industrial consumers remain internationally competitive. Infrastructure can also be financed through international capital via private investors and lenders as well as international development agencies. Private financiers have been reluctant to finance infrastructure in Indonesia after the difficulties they faced in the aftermath of the crisis. Many infrastructure projects in Indonesia have been renegotiated, and the weak legal system creates little recourse for investors 59. Indonesia s international credit rating while improving is still below investment grade. In addition, foreign investment in infrastructure projects in developing countries has been declining globally as perceived risks in emerging market investments have increased. In the last two years, however, Indonesia has experienced a small increase in inflow of private capital. Although this trend is expected to continue, a lack of policy and regulatory predictability will be an impediment from significant financial flows into infrastructure. Therefore, sector reforms are critically needed if Indonesia is to rely on international capital markets for infrastructure finance, and such reforms will take some time. Multilateral and bilateral development agencies, such as the IBRD, ADB, and JBIC, can be a useful source of loans during the reform period, but can only cover a minor portion of the infrastructure requirements. Public spending on infrastructure will need to increase in the short-term if Indonesia is to reach its growth target. Foreign investment in infrastructure projects in developing countries has declined globally. Since the two options just discussed will not mobilize sufficient financing to meet infrastructure demand, Indonesia will have to resort to fulfilling the investment funding needs through other means. This can include gaining maximum leverage from increased government spending in the short-term, and seeking to mobilize greater domestic capital for the future. These two potential sources are discussed in the next sections. Increasing Public Financing Local government spending in infrastructure increased in the years following decentralization. Today local government s share of public investment in infrastructure is almost equal to that of central government (see Figure 5.3). In the last three years for which data is available, local governments allocated approximately 50 percent of their revenue for infrastructure compared to about 30 percent for central government (see Figure 5.4). This allocation is unlikely to increase substantially. Interestingly, there is some evidence of under spending by local governments, but once again, more systematic budgeting and implementation would only increase local government spending After decentralization, local governments share of public investment in infrastructure is almost equal to the central government s. 91

106 Mobilizing Finance for Infrastructure Development 5,0% Figure 5.3. Central and Local Development Spending on Infrastructure as a % of GDP (Current 1993) 4,0% 3,0% 2,0% 1,0% 0,0% Source: Indonesia: Rapid Growth, Weak Institutions. forthcoming. Hofman, Bert, et all. Figure 5.4. Local Government Development Spending by Sectors, Politic, Information, Communication, Mass Media Law 2002* Religion Health, Social Welfare, Women Participation, Children and Teenagers Education, National Culture, Faith to One God, Youth and Sports Regional Development and Settlement Mining and Energy Trade, Regional Business Development, Regional Finance and Cooperative Water Resource and Irigation Industry 0% 5% 10% 20% 30% 40% 50% Share * 2002 data from 318 out of 348 local government Sources: MoF 92 Averting an Infrastructure Crisis: A Framework for Policy and Action

107 Chapter 5 on infrastructure marginally. The most promising avenue for increasing the contribution of local governments to infrastructure financing lies in increasing their capacity to borrow. However, the institutions needed to make municipal borrowing possible and profitable for both municipalities and lenders are severely underdeveloped in Indonesia and correcting this will, at best, be a slow process. Infrastructure development in the short to medium term will require increased public spending from the central Government. The Government has now recognized the need for additional development spending, which rose from, from 44 trillion Rp in 2002 to 65 trillion Rp in The share of infrastructure within the budget also increased from 28 percent to 30 percent amounting to an increase of US$ 0.75 billion. This brings the yearly allocation to US$ 2.5 billion or about 1.2 percent of GDP (see Figures 5.5 and 5.6). However, these are historically low figures, in both relative and absolute terms. In the years before the crisis, for example in 1994, the central Government allocated nearly 60 percent of its development budget for infrastructure amounting to 4 percent of GDP (nearly US$ 8 billion), and the private sector, for its part, invested more than US$ 2 billion. There are a number of steps that the central government could take to increase infrastructure spending. First, the government could improve its public finances through improved revenue collection. This would increase overall development expenditure, or alternatively a higher proportion could be channeled to infrastructure spending. The Government has currently undertaken a program to reform its revenue collection as Indonesia s performance lags behind other countries in the region. This effort appears to be working as government income has been rising in the range of 0.3 to 0.5 percent of GDP per year. The Government may want to allocate more of this funding towards infrastructure development. A second source of funding could be to direct existing funding for non-performing sectors towards infrastructure. For example, nearly 2 percent of GDP is utilized for funding fuel subsidies. This allocation of over $4 billion dollars could be more effectively utilized through other investments such as infrastructure. Although this subsidy includes funding for kerosene, commonly used by the poor, a major portion of it could be phased out and the funding Recent fiscal consolidation has created opportunities for increased government borrowing. Figure 5.5. Central Development Spending on Infrastructure as a % of GDP (Current) 5% Figure 5.6. Central Government Development Spending (US$ Billions) 16 4% Other Items 3% 2% (US$Billions) Infrastructure Items* 1% 0% Estimate % 28 % 30 % 1994 Expenditures 2002 Expenditures 2004 Approved budget Sources: MoF * a.) Tourism, Post, & Telecom b.) Housing & Settlement, c.) Irrigation, d.) Transportation, Meteorology & Geophysics, e.) Regional Development Source: Ministry of Finance. 93

108 Mobilizing Finance for Infrastructure Development reallocated to other priority sectors. Finally, the fiscal consolidation of the last few years, highlighted in Figure 5.7, has created some space for increased government borrowing. Indonesia s debt to GDP ratio is steadily decreasing and the deficit has been kept to a bare minimum. This discipline has resulted in upgrades by investment rating agencies. It is estimated that the government could borrow at 7 percent in the market today and, as discussed in the next section, the domestic market is scarcely utilized for infrastructure related borrowing. The government would however have to re-evaluate its fiscal policy if it were to borrow additional funds, since it is currently targeting a balanced budget. Mobilizing Domestic Finance Funding infrastructure through increased government spending is not sustainable in the long-term Indonesia will need to access capital markets. Although it may be possible to mobilize infrastructure funding through increased government spending, it is not a sustainable strategy in the long-term. Therefore, Indonesia should look to access domestic capital markets to finance infrastructure, in addition to implementing reforms to attract international private investors as already discussed in this report. Many nations with mature market economies have a fairly long history of domestic infrastructure finance. Moreover, an increasing number of developing countries are developing the institutions and the instruments needed to take advantage of local capital market financing for infrastructure. Relying on bank loans can be one way of financing infrastructure through the domestic capital markets. There are drawbacks however. First, it may be difficult for most commercial banks to provide sufficiently long term loans since they need, for prudential reasons, to maintain a match between the duration of their assets and liabilities (commercial bank deposits in Indonesia are not of sufficiently long maturities to provide such financing). Second, the large volume of loans required for such investments makes them highly risky, and commercial banks are often unwilling to lend in such situations without additional guarantees from the government. Third, commercial banks are usually not able to finely price risk, through interest rate variations across different types of risks. 60 Capital markets beyond the banking system therefore represent the major potential source of financing. Capital market instruments help to allocate resources to their most profitable uses, and provide a mechanism for the pricing of risk in situations where this may be Figure 5.7. Fiscal Consolidation Projections show increased growth......declining government debt... (Debt as a percent of GDP)...and deficits. (budget deficit as a percent of GDP) Percent 7,0% 6,0% 5,0% 4,0% 3,0% High Case Scenario Base Case Scenario % 90% 80% 70% 60% 50% 40% 30% 20% 10% 0% Actual Projection under the Base Case Scenario % 5% 4% 3% 2% 1% 0% 4.8% Budgeted 1.4% 3.7% Actual 2.7% 2.5% Revised Budget 1.7% 1.8% 1.9% 1.2% Sources: staff estimates Sources: staff estimates Sources: Ministry of Finance 94 Averting an Infrastructure Crisis: A Framework for Policy and Action

109 Chapter 5 important and potentially difficult. Many advanced countries have made use of capital markets for the financing of their infrastructure requirements, through both bond and equity issues. In recent years, a growing number of developing countries have also developed the securities markets and long-term savings institutions which have allowed them to tap domestic markets for infrastructure finance. Indonesia has yet to exploit these markets to their full potential. It cannot be overemphasized, however, that an attractive investment climate for infrastructure is a precondition for accessing domestic capital markets. Therefore, reforms discussed in the previous chapters are an important component of the strategy to generate infrastructure finance through the domestic markets, and they need to be implemented simultaneously. The Role of Contractual Savings Institutions Indonesia has a pool of long-term domestic funds that it could tap for financing its infrastructure requirements if sector and policy reforms ensured a more certain return for investors. Indonesia has three large retirement funds ASABRI (pension fund for the police, civilian and military defense personnel), TASPEN (pension fund for civil servants), and JAMSOSTEK (provident fund for employees in the private sector and in SOEs) created in 1966, 1969, and 1992 respectively. In addition, over 300 employers in Indonesia have retirement funds for their employees. As of December 2002, the combined assets of these retirement funds totaled approximately Rp. 73 trillion. The life insurance sector in Indonesia is another source of long term domestic resources, and had assets of about Rp. 26 trillion as of December These institutions have a combined total of 26 million participants with assets amounting over Rp. 100 trillion that can be potentially mobilized for investments including infrastructure. These assets are likely to grow further in value in the future given that participation in many retirement programs are mandatory, and that the relatively young labor force in Indonesia is unlikely to draw on these accounts soon. Indonesia has a pool of longterm domestic funds that it could tap for financing, but it will need to implement sector and policy reforms to attract these investors. 95

110 Mobilizing Finance for Infrastructure Development These resources have not always been well managed. The governance, regulation and supervision, and investment policies of pension funds have been poor and not tied in to the overall development priorities of the country. Both TASPEN and ASABRI are poorly funded relative to their benefit obligations, and hence, are proving to be increasing drains on the national budget instead of being sources of long-term capital. 61 ASABRI is controlled by the Ministry of Defense, TASPEN is overseen by the Ministry of Finance, while JAMSOSTEK is under the purview of the Ministry of Manpower and Transmigration. The first two entities are effectively unsupervised, while JAMSOSTEK and the employers pension funds are supervised by the Ministry of Finance. All pension funds have suffered from a lack of transparency and disclosure, weak management information systems and internal corporate governance, and political influence over their investments. The vast majority of the assets in these retirement funds are invested in short-term bank deposits a clearly sub-optimal use of these funds. A relatively small proportion of these assets is invested in the capital markets and other private securities. There has been almost no involvement of these funds in financing infrastructure. The life insurance sector has faced similar problems that have been compounded since the financial crisis. Indonesia has over 60 life insurance firms most of them small and poorly capitalized. The investments of these firms were adversely affected by the crisis, but many weak firms continued to operate since their premium payments were able to cover any claims. These firms have also faced criticism similar to private banks for poor governance. Investments of these firms are also in short-term assets exposing them to asset-liability mismatches and roll-over risk. Regulation and supervision of insurance companies has been historically weak. Box 5.1. Using Pension Funds in Chile to Finance Infrastructure To increase investment in infrastructure during the early 1990s, Chile's government introduced a concession program to attract private capital into the transport infrastructure sector, covering roads and highways, bridges, tunnels, and airports. The program has managed to attract over US$3.6 billion in private investment for infrastructure. Chile was the first Latin American country to allow pension funds to be invested in infrastructure projects. In 1981, Chile had replaced its bankrupt pay-as-you-go retirement system with a fully funded system of individual retirement accounts managed by the private sector. By 2001, more than 95 percent of Chilean workers had joined the system; the pension funds have accumulated $36 billion in assets; and the average real rate of return has been 10.9 percent per year. Initially, pension funds were legally constrained from investing in infrastructure projects. In particular, the lack of investment grade rating for bonds or other financial instruments issued by concession companies was an obstacle. In order to facilitate investments from pension funds and insurance companies legal changes to financial and infrastructure regulations were introduced between during the mid-90s. These reforms, among other things, enabled pension funds and insurance companies to invest in bonds without history. As a result of these reforms, a new long-term financial instrument, the Infrastructure Bond, was created. The typical infrastructure bond offered a 20-year fixed rate bond denominated in Unidades de Fomentos (UFs) an inflation-adjusted unit of account used in Chile with a AAA local rating and a monoline guarantee. The bonds are sold exclusively to local private investors, including local pension funds, and they have been continuously oversubscribed. Of the 16 toll road concessions awarded, 11 have opted for the alternative of Infrastructure Bonds, 3 have financed through bank loans and 2 concessions have not yet decided their financing structure. The development of the infrastructure bond market was assisted by the fact that in 1995 Chile achieved an A- credit rating, creating an opportunity for monoline insurance of bond issuances. In November 1998, the consortium handling the upgrade of the Talca-Chillan stretch of the nation's main thoroughfare, Route 5, issued the first US$150 million in infrastructure bonds. Till mid-2002, a total of US$963 million of infrastructure bonds had been issued in five offerings. The concession program is now being expanded to fund private investment in jails and urban infrastructure. 96 Averting an Infrastructure Crisis: A Framework for Policy and Action

111 Chapter 5 Chile and Malaysia are two developing countries that have been able to successfully mobilize their domestic capital markets to help fund infrastructure projects (see Boxes 5.1 and 5.2). One key enabling factor, in both of these cases, was the development of contractual savings institutions, notably pension schemes, that were allowed to invest in non-governmental assets. Given the long-term liabilities of pension schemes (the pension benefits of retirees), and the fact that this liability is in domestic currency, it is important to develop these institutions to mobilize local currency instruments for financing infrastructure. The experiences of Chile, Malaysia and other emerging economies also illustrate some pre-conditions that are critical before financing from contractual savings institutions can be readily accessed. These conditions include, for example: (i) the existence of appropriately designed and funded social security systems, which do not crowd out the development of contractual saving institutions, where individuals participate in government funded retirement schemes expecting a greater pay-off; (ii) regulatory regimes that encourage innovation and efficiency, and avoid widespread mistrust between contractual savings institutions and their customers; (iii) existence of borrowers and market makers who can underwrite and repackage complex financial offerings to allow contractual savings institutions to participate in infrastructure transactions; and (iv) stable macroeconomic conditions which support the predictability of the operations of pension funds and insurance companies. Contractual savings institutions, such as pension funds, can be a useful source of long-term domestic finance for infrastructure. Box 5.2. Malaysia: The Case of the Employees Provident Fund Malaysia has also actively encouraged the state-run provident fund the Employees Provident Fund (EPF) to participate in infrastructure development. EPF was created in order to establish a social security and pension system for employed workers and provide old-age, survivor and disability benefits. The Fund receives its contributions from the employee (9% of earnings) and the employer (12% of payroll). As of December 2002, EPF controlled total assets of RM 208 billion. Malaysia s local market investors, and in particular EPF, have been very active in infrastructure projects, since the early 80s, when the government allowed private participation in infrastructure, and launched a divestiture program to reduce budgetary and management obligations and to promote competition. The US$8.0 billion Kuala Lumpur International Airport, sold $2.2 billion in Islamic bonds. These bonds, and also the ones for the Shah Alam expressway (US$510 million) were placed mainly with local institutional investors. The YTL power project was the first IPP contract awarded in Malaysia. The YTL project was financed in its entirety by local markets. The company borrowed RM 3.1 billion (US$967 million) in two tranches: (i) A RM 1.5 billion fixed rate 10% 10-year bond subscribed by EPF (which purchased the bond issue in its entirety). The bonds were rated AA3 by the Rating Agency of Malaysia, based on the project s contractual arrangements and feasibility. (ii) RM 1.6 billion floating rate term loan underwritten by Bank Bumiputra and United Malaysian Banking Corp. Project equity, which was financed 100% by YTL during the construction period, was then partially sold off to a number of local investors, including Tenaga. Other major projects that raised significant resources from local sources include the Lumut Power project and the North- South Expressway. EPF has also invested in the Sikap Power project, Kuala Lumpur City Centre Twin Tower, and the Light Rail Transit. In 2000, Malaysia raised almost $2.6 billion in domestic bonds for project finance. Similar amounts are estimated to have been raised annually since. The Government also worked on creating an enabling environment for financial institutions to undertake investments in infrastructure. It created a liquidity facility Cagamas Berhad in 1986 that allowed financial institutions to dispose of their housing loan portfolios and raise liquidity, a part of which, in turn was invested in infrastructure. It initiated a process of issuing long-dated government debt securities through regular auctions, thereby enabling the creation of benchmarks for pricing. The Rating Agency of Malaysia (RAM) was also established and regulations on the issuance of securitized debt offerings required that acceptable ratings be obtained. 97

112 Mobilizing Finance for Infrastructure Development Upgrading Key Features of the Financial Markets Infrastructure Many of the steps outlined to marshal domestic finance may take some time to take effect as noted earlier. Improving many of the features of the financial markets is also a long term proposition, and a detailed analysis of the needed reforms are beyond the scope of this report. However, several key measures can be taken in the near-term to improve the efficiency of domestic capital markets and facilitate the mobilization of domestic savings for finance infrastructure projects. One such measure would be to enforce accounting, auditing and disclosure standards. The establishment of credible credit rating institutions would also be valuable to investors as this would give them access to independent assessments of risks and returns offered by bonds. Enabling greater tradability of shares in infrastructure companies is another step that can enhance resource flows into the sector. In addition, mandatory disclosure of reliable information about financial intermediaries may enhance investor participation in equity markets. Other longer-term financial market upgrades can include implementing regulations that instill investor confidence in brokers and other capital market intermediaries in order to encourage investment and trading in the stock market. Establishing a sound government bond market is another important step. This may involve concentrating debt maturities in a small set of standardized and liquid benchmark issues, moving to an auction-based system run according to internationally accepted principles rather than syndicated issues, setting a predictable issuing calendar, and establishing futures contracts on government debt. A well functioning government debt market allows the creation of benchmark bond prices, which would then form the basis on which instruments of different risks can be priced. The tax regime can also significantly influence the accumulation and flow of private capital. Stamping and withholding taxes, as well as related registration fees, can often discourage new issuance and can create barriers to entry for trading on the secondary market. Lastly, a sound legal framework and credible dispute resolution mechanisms are key to attracting long-term investments from private sources. Targeting Public Finances to Protect the Poor Chapter 1 describes the disproportional impact of inadequate infrastructure on the poor. The Government in Indonesia has a unique opportunity now to channel the investments it will make in the infrastructure sector to ensure that the poor have expanded access to 98 Averting an Infrastructure Crisis: A Framework for Policy and Action

113 Chapter 5 improved services. It will be crucial, however, to make sure that government efforts in that area do not undermine the efficiencies gained through other reforms. The remainder of the chapter identifies measures that can help the government achieve this balance. Contributions by Better-off Users In theory, targeted lump-sum payments collected through general taxation should distort consumption patterns less than cross subsidies between users. In practice, however, tax and subsidy reform is often a long-term endeavor, and generally requires considerable policy coordination between government agencies. In such cases, cross-subsidization between users may represent the best near-term option, albeit on a temporary basis. In the 99

114 Mobilizing Finance for Infrastructure Development Cross-subsidies are common in Indonesia, but are not well targeted towards assisting the poor. long run, however, an adequate tax and subsidy policy would almost certainly be economically more efficient. Cross-subsidization between users of infrastructure services is very common in Indonesia. In the WSS sector, for example, tariff structures are usually based on consumption blocks, with large users cross-subsidizing smaller ones. The situation is similar in the electricity sector with small residential users charged about US 3.5 cents per kwh while large residential users tariffs can be as high as 10.1 cents per kwh. Finally, in the telecommunications market, long distance services cross-subsidize monthly subscription charges and local calls, both of which are priced below costs. Cross-subsidization arrangements, as currently implemented in Indonesia, present major drawbacks however. First, they are not well targeted towards assisting the poor. Instead, the cross-subsidies described above reduce the costs of consumption for all existing small users, rather than for the truly poor among them. The subsidy also benefits existing users, who tend to be better off, while many of the poor do not have access, often because of financially prohibitive connection charges. For example, the cost of a 450 VA connection can be higher than electricity usage charges for an entire year. Telephone connections in rural areas can cost about US$220. As a result, many of the poor are not connected to infrastructure networks and do not benefit from cross-subsidization arrangements. A second drawback of existing cross-subsidization arrangements in Indonesia is that they entail rather large resource transfers and therefore introduce important allocative distortions. Indeed, poorly targeted consumption subsidies entail continuous transfers of resources to a relatively large number of users (as opposed to targeted connection subsidies that would only entail one-time transfers to the truly poor). A third drawback of existing schemes is that because they force a given service provider Telkom or PLN for example to operate transfers between different categories of its own users, they require that monopolistic arrangements be maintained (as new entrants would steal the users who are currently over-charged thereby depriving the incumbent of the source of the cross-subsidies a process known as cream-skimming ). Box 5.3. Cross-subsidizing New Connections Under the Buenos Aires Water and Sanitation Concession Lyonnaise des Eaux was awarded a 30 year concession contract in 1992 to provide water and sanitation services in Greater Buenos Aires. Under the terms of this concession, coverage rates had to reach 100% for water and 90% for sewerage by the end of the 30 year period. Most of the new connections were to be made among poor socioeconomic groups with household income as low as US$200 to $245 per month. In comparison with these resources, access charges initially established under the terms of the concession were high: from US$251 to 637 per household for water, and from US$856 to 891 for sewerage. The concessionaire was required to allow customers to spread the access charges over a two year period, but this still represented an average cost of US$44 per month, or a fifth of the income of a poor household. The high level of charges generated hostility from customers and a crisis point was reached in After new negotiations, the US$44 monthly access charge was reduced to US$4. In addition, a monthly universal service and environmental improvement fee of US$3 each for water and sewerage was imposed upon all customers whether existing customers or newly connected ones connected to the water and/or to the sewerage networks. This amounted to a cross-subsidy between existing and new customers. Because existing users were more numerous than new ones the modest US$3 (or US$6) charge was sufficient to help the operator cover the cost of new connections. And because existing users were from better-off groups, the change did not provoke serious opposition. Source: Estache, Foster, and Wodon, Accounting for Poverty in Infrastructure Reform Learning from Latin America s Experience, World Bank Institute, Averting an Infrastructure Crisis: A Framework for Policy and Action

115 Chapter 5 In the future, cross-subsidization schemes could therefore be devised so that existing users contribute part of the costs of expanding the system to reach new users. This is precisely the type of cross-subsidization arrangement that emerged after some trial and error in the context of the Buenos Aires water and sanitation concession (see Box 5.3). In addition, in order to avoid the cream-skimming issue, the Government (or the regulatory authority) can impose a levy on all firms operating in the market, and redistribute this income to companies who connect new users in order to enable those firms to subsidize the cost of connection. This approach is being widely used to increase access in the telecommunications sector for example. Contributions by Taxpayers Various forms of government support to infrastructure projects are already discussed in Chapter 3. Among these different options, output-based subsidies stand out as a mechanism that can most precisely target the benefits towards the poor. Indonesia has already begun to implement such schemes: the Government s provision of targeted subsidies to compensate PLN for the cost of supplying electricity below cost to very small consumers is one example. Output-based schemes constitute attempts at targeting subsidies at the poorest. They also enhance operators incentives to perform by linking payment of the subsidies to actual delivery of the desired services. Indonesia has however failed, so far, to structure outputbased schemes in ways that would provide further efficiency incentives to operators by Output-based subsidies can be effective in reaching the poor, but Indonesia has had little success due to limited competition between operators. Box 5.4. Output-based Aid Scheme to Extend the Teledensity in Chile In 1994, in an effort to increase access to public telephones in the rural and low income areas, the Chilean government set up a Telecommunication Development Fund. The fund is financed by the national budget and administered by the Council for the Development of Telecommunications, chaired by the Minister of Telecommunications. This Council makes annual decisions about which projects are eligible for subsidies. Project profiles typically comprise installing one public phone in each community within a given territory. Concessions were awarded, without exclusivity rights, for a period of thirty years, to bidders requiring the lowest subsidies to install those public phones over a given territory. While the bidding documents contain service obligations, maximum tariffs, interconnection and maximum amounts of available subsidies, the choice of technology, network structure, specific location of the phones, and the option to provide additional telecommunications services, are left to the operators discretion. Before the start of this initiative, about 15 per cent of the population had no access to public phones; by the end of 2000, only 1 per cent of the population remained in that situation. In addition, the total subsidies committed by the Fund amounted to only $21.8m which is essentially 0.3 per cent of the total telecommunications revenues over the period, while private companies invested $30m in public payphones and another $109m for the provision of other telecommunications services in rural areas. A summary table follows below. No. of localities covered by the scheme 6,059 Total subsidy required $21.8m Total no. of beneficiaries 2.2m Subsidy per telephone $3,598 on average (compared with $20,000 required by the incumbent to install a public phone prior to the launch of the scheme) Subsidy per inhabitant $10 on average The success of this initiative can be attributed to the effective identification of demand by involving local groups; limiting and clearly defining the obligations of the operators, while allowing them leeway to find the most cost efficient method to provide telecom services; and, the disbursement process for the subsidies - the operators received all or at least a significant part of their subsidy in a lump sum, without indexation, after the facilities were completed, which gave them clear incentives to ensure that the telephones would become operational as soon as possible. The commitment by senior government officials as well as competent implementation, were all also key factors for the success of this venture. 101

116 Mobilizing Finance for Infrastructure Development maximizing competitive pressures. Such competitive pressures can be introduced by organizing competitive bidding processes to identify, on the basis of the lowest subsidy required, the operator that will receive the public subsidy in exchange for providing the service. Processes of this type have been used to promote expansion of the telecommunications network in Chile (see Box 5.4). It is also possible to structure output-based aid schemes in ways that maximize direct competition between operators. In order to achieve this objective, public authorities need to establish a system of portable subsidies, whereby any operator that provides the agreed upon service (e.g. establishment of an electricity connection) to members of the targeted population receives a pre-determined subsidy (e.g. pre-determined amount per electricity connection actually installed). Australia, for example, has launched two regional pilot schemes whereby new telecommunications operators can compete directly with the incumbent, Telstra, for access to funds earmarked for the provision of pre-determined loss-making services. In these two regions, users are thus able to choose among competing universal service providers. Recommendations Indonesia needs to increase infrastructure investments by about 2 percent of GDP in order to sustain growth rates of 6 percent per year. Closing this gap is undoubtedly a difficult challenge. We argued above that in addition to the measures discussed in previous chapters aimed at improving the public management of infrastructure, restoring private participation, and combating corruption - the Government should explore the three following options: increasing government spending on infrastructure, promoting greater mobilization of domestic savings, and targeting public resources more accurately towards the poor. In the short-medium term, a substantial part of the infrastructure financing gap can only be bridged by increased central Government spending. In order to achieve this objective, the central government could take the following steps: (i) increasing the overall revenue envelope; (ii) redirecting unproductive subsidies towards infrastructure financing; and (iii) increasing government borrowing to finance infrastructure a policy made possible by the impressive fiscal consolidation that Indonesia has successfully implemented over the last few years. As far as promoting the mobilization of domestic savings is concerned, an essential precondition is to establish an attractive investment climate for infrastructure. Beyond this, the Government should consider whether specific measures may promote the effective involvement of contractual savings institutions in the financing of infrastructure projects. Such steps might include: (i) checking whether the investment regulations that govern pension funds and insurance firms should be modified in order to enable such institutions to invest in infrastructure securities; (ii) designing social security systems that do not crowd out the development of contractual saving institutions; (iii) adopting regulatory regimes that protect those who entrust their savings to contractual savings institutions; and (iv) maintaining stable macroeconomic conditions. On the demand side, the central Government may consider using public resources to 102 Averting an Infrastructure Crisis: A Framework for Policy and Action

117 Chapter 5 strengthen the capacity of sub-national entities especially municipalities to borrow on the local markets. Finally the Government will need to focus on creating or upgrading certain aspects of financial market infrastructure, including: setting up sound and credible credit rating institutions; developing a sound government bond market; and establishing credible dispute resolution mechanisms. The government should also aim at targeting scarce public finance more accurately towards increasing access by the poor to infrastructure. At present, Indonesia relies mostly on cross-subsidies to try to improve infrastructure access among the poor. However, the current system could be much improved by targeting such subsidies more accurately to truly benefit the poor (e.g. existing users could contribute part of the costs of expanding the system to reach new users). In addition, cross-subsidization could be made compatible with competitive market structures by funding the scheme through a levy imposed on all companies participating in the market. Alternatively, subsidies can be funded by taxpayers. In both cases, the key is to ensure that providers have strong incentives to deliver services efficiently. Indonesian authorities could meet this objective by disbursing subsidies only when outputs have actually been delivered to targeted beneficiaries and by promoting competition between various service providers. 103

118 chapter 6 The Way Forward: Prioritizing Reforms 104 Averting an Infrastructure Crisis: A Framework for Policy and Action

119 The preceding chapters (as well as the sector-specific chapters presented at the end of the present study) propose a detailed menu of reforms. It is clear, however, that not all proposed reforms can be carried out in parallel. First, some of the proposed reforms involve public expenditures (e.g. to relieve congestion in the transport network) and public funding is limited. Second, some of the proposed reforms are politically challenging (e.g. price increases in water; or elimination of the fuel subsidy) and there is a limit to the number of politically challenging reforms that can be undertaken at any given time. Finally, there is a limit to the capacity of public authorities to manage multiple reform processes. Therefore, this chapter attempts to provide a framework that can be useful in setting priorities. The prioritizing process can be guided by the following three criteria: (i) international comparisons that can provide insight as to where Indonesia s performance lags behind that of regional competitors; (ii) estimates of the overall economic impact of the proposed reforms; and (iii) estimates of the distributional impacts of the reforms among different categories of stakeholders. It is important to realize that none of these criteria should be used as the sole basis on which to justify undertaking a particular reform or investment. At the most, taken together, they provide indicative inputs that policymakers can use for choosing priorities. The following is a short description of the three criteria, including a brief mention of their respective limitations: If Indonesia s businesses are to be internationally competitive, Indonesia s infrastructure should be broadly on par with that of its regional competitors. However, improvements to infrastructure standards should be carried out only to the extent that they are relevant for Indonesia s growth and the well being of its people. The objective should not be to solely attempt to measure-up to other countries without regard to the local context. For example, low level of access to improved water sources may not be a significant criteria where abundant high quality fresh water is available. 105

120 The Way Forward: Prioritizing Reforms Estimates of the overall economic impact of the proposed reforms are based on a cost-benefit analysis. The exercise was carried out for each of the four infrastructure sectors discussed in the report. It is important to note that this analysis considers only a limited number of relatively simple reform scenarios and that it relies on the available data that is imperfect. Furthermore, it does not take into account the benefits of some of the more cross-cutting reform measures such as tackling corruption for example, which are difficult to quantify. Used with caution, however, such analysis can provide some indications as to which reforms are likely to have the largest overall economic impact. Besides the overall economic impact of the reforms, it is useful to identify the specific beneficiaries of the reforms as well as who will pay for them. Estimating the impact on various stakeholders can also provide insight as to who may support the reform effort and who may oppose it. As with the cost-benefit analysis, it is difficult however to quantify the impact on various stakeholders with a high-level of precision, especially the effect of some of the broad based cross-cutting reforms. International comparisons between Indonesia and its neighbors are briefly presented in the next section. The following section discusses both the overall economic impact and the distributional effects of proposed reforms. The last section of the chapter then draws on this analysis to suggest some possible priorities. International Comparisons Chapter 1 provides a detailed description of how Indonesia s infrastructure standards measure against regional competitors. It is clear that Indonesia lags behind most of the countries in the region based on these infrastructure indicators. Electrification rates and teledensity are particularly low (service providers in these two sectors are however connecting new users at a fast pace). The situation of the WS&S sector is also worrying with relatively low access to networks and utilities in extremely poor financial conditions. Table 6.1 shows that Indonesia also compares badly with regional countries in the areas of local governance and corruption. Table 6.1. Business Environment Helpfulness of Helpfulness of Efficiency of Gov Takes Corrupting as Frequency of Loc. Gov in Loc Gov in Local Gov in into account Constraint to Irregular Additional Doing Business Doing Business Delivering voice of Operation and Payments to Get in 2000 in 1997 Services Business Growth of Business Things Done (1 very Helpful, (1 very Helpful, (1 very efficient, (1-always, (1 no obstacle, (1 always, 6 very unhelpful) 6 very unhelpful) 6 Very Inefficient) 6 never) 4 major obstacle) 6 never) China Malaysia Indonesia Singapore Philippines Thailand Cambodia Indonesia Rank 7 out of 7 7 out of 7 7 out of 6 7 out of 7 4 out of 6 5 out of 6 Source: World Business Environment Survey (WBES), Copyright 2000, The World Bank Group 106 Averting an Infrastructure Crisis: A Framework for Policy and Action

121 Chapter 6 Estimated Impacts of Certain Reforms This section reviews the results of the cost-benefit analysis conducted to estimate the overall economic impact of certain reform scenarios in the four specific infrastructure sectors analyzed in this report. It also discusses who gains the most from the reforms and who will pay for them. The reform scenarios and the results of the cost-benefit analysis are summarized in Table 6.2. As pointed out above, the analysis only covers a limited number of reform scenarios and the data on which it relies is imperfect. Results should therefore be viewed as rough estimates and more detailed analysis would be needed to refine the numbers as well as to consider additional and/or more complex reform measures. Electric Power This analysis provides an estimate of the benefits of investing in the electricity sector in Indonesia. Such benefits arise mainly in two forms: (i) as avoided costs of electricity interruptions for customers already connected to the power grid (industrial, commercial, residential), and (ii) as welfare benefits for new customers that could with further system expansion become connected to the grid and enjoy electricity services. Aggregate estimates of such benefits are subject to the uncertainties of statistical averaging of a broad range of costs and limited information on customers willingness and ability to pay. Nevertheless, conservative estimates for electricity shortages only are at a level of about 0.1 percent of GDP, but a figure of 0.8 percent of GDP is not unreasonable. Moreover, such electricity interruption costs are sensitive to system reliability, which in Table 6.2. Estimates of Cost and Benefits of Reforms Sector Reforms Cost/Benefit ($) Cost/Benefit (% of GDP) Electric Power Investments in the sector do US$ billion annually % keep up with projected rate of in avoided costs of unsupplied growth of demand electricity Water Supply PDAM tariffs increase About US$ 850 million average About 0.6% by 50%, increase in consumer surplus PDAM efficiency and PDAM profit per year increases by 20%, over 5 years PDAM bill collection (about US$ 669 million first year, increases by 20% US$ 1,316 million fifth year) Water tariffs decrease by 10% for users not served directly by PDAMs Roads Increase annual budget About US$ 1,600 million About 1.1% constraint from Rp. 2 trillion average increase in cost savings to Rp. 6 trillion, and economic returns per year Expand road network as over 10 years identified under the Java (about US$ 1,200 million first year, Arterial Road Network Study US$ 1,800 million tenth year) Telecom Tariffs meet international About US$ 2,200 million average About 1.5% levels in 5 years increase in consumer surplus per year over 5 years (about US$ -9 million first year, US$ 7,400 million fifth year) 107

122 The Way Forward: Prioritizing Reforms turn is directly related to overall investments in the sector. Should investments in the sector not keep up with the rate of growth for projected electricity demand, system reliability is bound to deteriorate resulting in considerable costs that will likely adversely impact the country s investment climate and macroeconomic conditions. If, on the contrary, reliability in the system is improved as a result of the reforms and investments proposed, this will directly benefit existing consumers, and more broadly, the economy as a whole. The envisaged increase in access at a rate of about 1 million new connections annually (a figure consistent with the performance achieved over the past few years), will, for its part, most likely benefit the rural poor who are now lacking access to the grid. Water The analysis reveals a NPV gain in consumer surplus and PDAM profit of about US$ 1,752 million over 5 years (or an average of US$ 350 million per year) if PDAMs increase tariffs by 50 percent, efficiency by 20 percent, and bill collection by 20 percent. An additional gain of about US$ 500 million per year in consumer surplus results if water prices decrease by 10 percent for the 85 percent of the population not directly served by PDAMs. Thus, the potential, cumulative annual gain is in the order of US$ 850 million (US$ 350 million + US$ 500 million). In this model, the change in consumer surplus is cumulative (i.e. it is computed by comparing consumer surplus during any given year with consumer surplus prior to the reforms). As the model assumes that additional profits are reinvested to expand the network, new connections bring additional profit and the change in consumer surplus reaches higher levels every year. Based on the currently regressive shortage of access, it can be inferred that a significant number of the new connections will be to those consumers who are in the bottom two income quintiles. Therefore, it can be estimated that the poorest income groups can benefit from as much as 60% of the new connections. Existing consumers, for their part, bear the cost of higher tariffs (but may benefit from improvements in service quality). It is important to recognize that the analysis ignores some significant elements and requires numerous assumptions. First, the consumer surplus analysis only takes price changes into account. It does not consider the impact (on health, consumer surplus etc.) of the substantial improvement in water quality and service that users enjoy as they move from alternative sources of water to a PDAM direct connection. Second, it also does not consider the potential benefits of reform in the sanitation sector. Finally, PDAMs performances vary significantly and the figures used in the analysis are only best estimates of representative figures. Roads The cost-benefit analysis conducted in the road sector shows that increasing the annual preservation budget constraint from Rp. 2 trillion (US$ 215 million) to Rp. 6 trillion (US$ 644 million) saves about US$ 1,150 million of agency and user costs. Those who use secondary and tertiary roads stand to benefit the most from improved maintenance, since these roads are those that suffer most from insufficient maintenance. Moreover, expanding the road network as advised in the Java Arterial Road Network study (JARNs) results in an additional US$ 450 million of economic gains. These gains increase annually as new investments are made every year and each investment yields a given rate of return. The majority of the gains result from reducing the cost of future congestion (for more detail on the costs of congestion, please refer to the Strategic Expenditure Planning Model (SEPM) and the JARNs study). 108 Averting an Infrastructure Crisis: A Framework for Policy and Action

123 Chapter 6 The main beneficiaries of the priority expansion works identified in the report are expected to be the users of the main arteries and primary networks. It is important to note, however, that most of these expansions will need to be funded by tax payers, and proper selection of projects will be key to maximizing the benefits. Telecom The telecom cost benefit analysis quantifies the change in consumer surplus resulting from tariff changes and steady state growth in the local, national long distance, and international long distance segments. The analysis reveals an average annual gain of about US$ 2,200 million if tariffs reach international levels in five years. Given that Indonesian international long distance tariffs are significantly higher than the international standard, the international long distance segment accounts for the overwhelming majority of the gain in consumer surplus. Consumers who use international long distance services will stand to benefit the most, with increases in consumer surplus of up to US$ 14 billion over five years, depending on the level of reforms. Users of domestic long distance services stand to gain as much as US$50 million to US$300 million in consumer surplus. Consumers who now use local telephone services, on the other hand, will face tariffs based on economic costs, and as a result, their current benefits may be reduced by as much as US$4 billion. Note that over time, technological change would likely reduce telecom tariffs even in the absence of any reforms. However, the model considers that changes in tariffs are entirely due to reform. It is likely, therefore, that the model overestimates the (positive) impact of reforms. 109

124 The Way Forward: Prioritizing Reforms Prioritizing Reforms The international performance comparisons and the estimates of overall and distributional impacts of reforms discussed above can shed some light on the areas that appear to deserve priority attention: Indonesia suffers from a very poor investment climate characterized by unclear allocation of responsibilities among public authorities, insufficient strategic planning and coordination capacity, high political and regulatory risks, and high levels of corruption. Despite rapid increases in the number of residential and commercial connections, access to electricity still compares unfavorably with that of other countries. In addition, brownouts and blackouts, whose costs for the economy are very large, are becoming more widespread and the situation will deteriorate fast if nothing is done urgently to increase generation capacity and remedy transmission and distribution bottlenecks. The WSS sector is in very poor condition and substantial welfare benefits would be gained both from increasing the number of house connections and from improving, even marginally, the efficiency of service provision for the large majority of the population that will remain unconnected to the main network in the near future. The performance of the road sector, at present, is relatively good when compared to the situation in neighboring countries. The enormous welfare benefits that would be derived from the implementation of an aggressive expansion program do reveal, however, that addressing congestion issues is becoming an urgent issue. Finally, Indonesia is also lagging behind its neighbors in telecommunications access and the benefits derived from catching up with international best practice would be considerable. However, important steps have already been taken (not least the introduction of vibrant competition in the mobile market) that increase the likelihood that the rapid improvements that have been witnessed in the past few years will be sustained in the future. For each of the areas listed above, the present report suggests a number of priority reform measures. This prioritization effort is informed by the discussion of the various prioritization criteria presented above. In addition, an attempt is made at taking into account the degree of political and technical complexity associated with specific reforms in order to try to devise a reform agenda that is realistic. This agenda remains very ambitious, however, and appropriate phasing and coordination will be very important. Also, the need to adequately explain to the population at large why the reforms are needed well ahead of implementation, rather than after the event, cannot be over-emphasized. Note that, according to the proposed reform agenda, public financial resources would be spent primarily in the power, WSS and road sectors while overall price increases would be targeted mainly to the WSS - and to a lesser extent to the road sector. Cross-sector Issues Six areas require priority attention: 1. The Government of Indonesia needs to take steps to tackle some of the issues associated with the decentralization process: The allocation of responsibilities between different levels of government needs to be clarified: the assignments specified in the different regulations that implement 110 Averting an Infrastructure Crisis: A Framework for Policy and Action

125 Chapter 6 the decentralization program are not always fully consistent and further inconsistencies exist between these regulations and the sector regulations. The provinces need to be empowered to play a much stronger coordinating role vis-ŕ-vis municipalities. This is all the more urgent since the number of separate local governments is steadily increasing, which in turn raises the number of externalities and coordination issues that need to be addressed. Effective capacity building at the local level is required, especially in the road and power sectors where local authorities have been given substantial additional responsibilities. Procedures for on-lending of foreign loans need to be streamlined and process harmonization is needed as far as on-granting mechanisms are concerned, as there are at present two distinct processes with different application and evaluation criteria and different terms and conditions. There are, in addition, powerful arguments for increasing the volume of resources allocated by Government grant funding in order to increase the flow of resources to the poorest regions and to promote inter-region cooperation for infrastructure projects characterized by high externalities (at the regional level) and by high economies of scales. At the same time, there is a need to intensify efforts to prevent the proliferation of illegal taxes by regional governments. 2. Indonesia needs to rethink the role of central authorities in two main respects: The role, organizational structures and staffing needs of the main sector ministries need to be reviewed, with emphasis on policy formulation and support to local authorities rather than on planning and implementation of civil works and direct provision of services. A conceptual framework needs to be developed for coordinating policy and strategic planning in an environment characterized by much wider dispersion of responsibilities than in the past. 3. In order to re-attract private investors and operators in infrastructure and in order to maximize benefits from private participation the following measures would be needed: Priorities, for improving the overall investment climate, include the difficult task of reforming the legal system (in particular to reduce the incidence of corruption), and to facilitate the securing of land and rights of way by private operators. Tariff increases are most urgent in the WSS sector. In the road sector, road user charges need to be restructured to reflect actual road usage more closely as well as earmarked to cover road expenditures, and the current subsidy on gasoline and automotive diesel oil will need to be eliminated. In the power sector, implementation of a comprehensive gas sector strategy is crucial to ensure access to reasonably priced gas for electricity generation if the need for substantial electricity retail price increases is to be avoided in the future. Finally, in the telecommunications sector, fixed local tariffs will need to be progressively raised to better reflect costs. All price increases will however need to be phased in progressively, and they should be accompanied by improvements in service quality as well as by an effective information campaign to explain the reasons for the increases to the public. 111

126 The Way Forward: Prioritizing Reforms Head to head competition should be introduced without delay in fixed telecommunications, it should be introduced as planned in electricity generation, and it should be encouraged between small scale providers in all infrastructure sectors. When head to head competition is not feasible, competition for the market should, as a rule, be used to select operators. Finally, competitive discipline can be derived from yardstick competition, whereby regulators use comparative performance data from other similar enterprises to regulate monopoly network industries. Indonesia has so far taken only timid steps toward creating adequate regulatory institutions for infrastructure. Substantial reforms are needed to turn the embryonic telecommunications agency that exists at present into a competent and autonomous regulator. And while the 2001 Oil and Natural Gas Law and 2002 Electricity Law both provide for the creation of full-fledged regulators, a regulatory body has been established but is not yet functioning in the oil and natural gas sector and one still remains to be established in the electricity sector. The WSS sector, for its part, still lacks a comprehensive and consistent regulatory framework. Indonesia also needs to adopt a sound policy framework on public support for private projects. Decision makers need to be able to assess the pros and cons of all possible alternatives (including the adoption of policy and market reforms that might eliminate the need for public support). They also need to be able to estimate the cost of such support and ensure that such cost is adequately reflected in public accounts. Among other measures aimed at meeting such objectives, Indonesia might want to consider involving the Ministry of Finance which has incentives to minimize the cost of government support to infrastructure and the broad perspective needed to assess trade-offs between different options - in key decisions affecting the support that the Government provides to infrastructure projects. 4. While steps have already been taken and while the task is undoubtedly daunting, the Indonesian Government has no choice but to redouble efforts to defeat corruption: New procurement regulations have been adopted in November Additional regulations, currently in preparation, are now needed to promote the transparent competitive selection of private partners for private infrastructure projects. The elimination of barriers to entry into infrastructure markets and further reliance on direct competition between providers of infrastructure services would also narrow the scope for corruption. Additional steps could be taken as well to promote information disclosure. These measures need to be complemented by the effective implementation of tough sanctions for those found to have engaged in corrupt practices. 5. Indonesia needs to increase investments in infrastructure by about 2 percent to sustain projected growth rates of about 6 percent per year. The various measures listed above would go some way toward bridging that financing gap. Implementation will take 112 Averting an Infrastructure Crisis: A Framework for Policy and Action

127 Chapter 6 time however and the gap is therefore likely to remain at least in the short-medium term. The Government of Indonesia could take steps on two additional fronts to mobilize additional resources for infrastructure: The Government should consider increasing spending in infrastructure. In fact, in the short-medium term, much of the infrastructure financing gap will need to be covered by increased investments by the central Government. Improved tax collection, an area where Indonesia performs badly compared to neighboring countries, would help. So would the re-allocation of some unproductive spending (e.g. on fuel subsidies) to infrastructure. Finally, the impressive fiscal consolidation of the last few years characterized by declining debt and budget deficit - has created some space for increased borrowing. Steps should also be taken to tap domestic savings for infrastructure investments. An essential precondition is the establishment of an attractive investment climate for infrastructure where profitable investment opportunities do exist in the sector and where investors are free to make decisions on the basis of sound commercial criteria. Additional measures might include: (i) considering whether the regulatory framework applicable to contractual savings institutions might need to be modified in order to enable such institutions to effectively contribute to infrastructure financing; (ii) designing social security systems that do not crowd out the development of contractual saving institutions; (iii) adopting regulatory regimes that protect those who entrust their savings to those institutions; and (iv) maintaining the macroeconomic stability which supports the predictability of operations of contractual savings institutions. The Government may also consider using public resources to strengthen the capacity of sub-national entities especially municipalities to borrow on the local markets. To the extent possible, government schemes for municipal finance should involve the financial sector in allocating credit and sharing risk. Finally, the Government would also have to focus on creating or upgrading certain aspects of financial market infrastructure, for example by establishing adequate credit rating institutions, a sound government bond market, and credible dispute resolution mechanisms. 6. It is essential to devise mechanisms that will enable the poor to have access to infrastructure services: To the extent that cross-subsidy schemes remain necessary in the short term, they should be more limited and better targeted at the truly poor (e.g. existing users could contribute part of the costs of expanding the system to reach new users). In addition, they need to be restructured to be compatible with competitive market structures (e.g. instead of relying on the incumbent to cross-subsidize the provision of services to different categories of users, the government could impose a uniform levy on all companies participating in the market and redistribute those resources to the operators who provide services to the poor). The Government could opt to channel more of the subsidies intended to help the poor access and consume infrastructure services through output based mechanisms. It should also design such schemes in ways that maximize competitive pressures between operators (e.g. by organizing competitive bidding processes to identify, on the basis of the lowest subsidy required, the operator that will have the right to provide the subsidized services). 113

128 The Way Forward: Prioritizing Reforms Electric Power 1. The most pressing priority in the electric power sector is to adopt implementing regulations for the 2002 Electricity Law including credible tariff regulations, establishment of the regulatory authority, and adoption of licensing procedures. 2. Given the imminent shortage of natural gas for generating power, the Government also needs to issue regulations related to the 2001 Oil and Gas Law and develop a comprehensive gas sector strategy that includes a rational gas pricing policy (access to reasonably-priced gas is essential to limit the cost of electricity generation and stave off the need for substantial retail price increases in the future). 3. The Government should be commended for having already started the process of partially privatizing PGN. PLN restructuring should proceed according to the Government s sector blueprint. 4. In addition, steps could be taken immediately to enable auto-generators and other small electricity producers to distribute to third parties and to establish an appropriate framework to enable them to sell power to PLN or to gain non-discriminatory access to PLN s grid to deliver power to other customers as the producers choose. 5. Determining the speed at which market liberalization should take place is one of the main issues facing decision-makers today, and one that will require further careful analysis and consideration. Trade offs exist between, on the one hand, the risks associated with a hasty implementation of complex reform measures, and, on the other hand, the costs incurred because of the reduced incentives for efficiency and the Government liabilities generally associated with monopolistic market structures. 6. Further study is also needed to better ascertain the potential of existing captive capacity and to determine which policies and regulatory framework would maximize the contribution that captive power can make to the development of the sector as a whole. Water Supply and Sanitation Priorities regarding water supply include: 1. Developing an enabling framework to revitalize the sector. Two key objectives would be to revise the allocation of responsibilities in the sector, and to promote the progressive adoption of sustainable, cost-covering, tariffs (e.g. a national body could be set up to provide and publish - advice to local governments on price setting issues). 2. Carrying out a widespread program of PDAM reform, which would include: the restructuring and rescheduling of PDAM debt; corporatization; merging unviable PDAMs; and promoting private sector involvement especially by local operators inter alia through the development of adequate regulatory arrangements. 3. Expanding network coverage to meet growing urban demands. Additional resources (including multi-lateral and bi-lateral funding) will need to be passed on to reformminded PDAMs and local governments to help achieve agreed targets by Capitalizing on the potential of alternative water providers. The elimination of PDAMs exclusivity rights, the effective prohibition of anti-competitive practices by PDAMs and by existing vendors, capacity building initiatives aimed at supporting small-scale operators, and improving the interface with formal utility provision would all contribute to achieving this objective. 114 Averting an Infrastructure Crisis: A Framework for Policy and Action

129 Chapter 6 5. Encouraging community-managed provision. The policy framework developed through WASPOLA needs to be disseminated, an appropriate financing strategy aimed at increasing access for the poor in rural areas needs to be developed, and capacity building initiatives need to be implemented at the local level. 6. Regulating household self-provision. This would include the establishment of an adequate regulatory regime to ensure quality and minimize environmental impact, as well as the development of a strategy enabling a future transition to the network system. Priorities regarding sanitation include: 1. Developing a nation-wide sanitation campaign. This would include measures aimed at securing political will, a strategy to ensure that the public is aware of the benefits of improved sanitation, and the development of a national sanitation policy and strategy. 2. Developing the institutional and policy framework. This framework will need, inter alia, to clarify responsibilities at the central and at the local level, with emphasis at the central level on establishing appropriate standards, mobilizing funding, and assisting local governments, and at the local level on developing a multi-provider strategy, establishing a local regulatory framework, maintaining political will, andbuilding implementation capacity. 115

130 The Way Forward: Prioritizing Reforms 3. Ensuring pro-active interventions by public authorities, in particular to address the present chronic under-investment, to regulate on-site sanitation and prepare the transition from on-site to network sewerage in large cities, to enhance and replicate community initiatives, and to capitalize on and regulate the activities of smallscale private providers. Roads 1. While tax revenues are limited, a strong case can be made for adequately funding high return capacity expansion projects in the road sector. A recent study of Java s arterial road network identified a program of upgrading projects whose first year economic rate of return would be 20 percent or more. The investments required would exceed past levels of funding however (the study s recommended expenditure program for the period foresaw an increase from Rp. 0.5 trillion in 2002 to 1 trillion in 2007 and a stabilization of expenditures at that level through 2010). Improved access to remote communities is a priority as well. Given the high costs, these developments cannot compete with other investments in the road sector on the basis of economic returns and other criteria need to be developed to identify priority projects and conditions for government support. 2. Road maintenance, for its part, must progressively become financially self-sustaining. This requires that the current subsidy on gasoline be eliminated and that road user fees be restructured to reflect actual road usage more closely and earmarked to finance the maintenance of the road network. Road funds, and road boards, should be established to finance and manage the maintenance of the existing network. The allocation of road expenditures for maintenance work needs to be improved, inter alia through more effective use of existing tools such as the Indonesia Road Management System. Finally, steps need to be taken to ensure that road works yield better value for money (e.g. road funds need to rely on competitive and transparent procurement processes, independent technical and financial audits should become mandatory, and outputbased contracting should be introduced). 3. The institutional and regulatory framework for toll roads needs to be strengthened: Regulatory and operational roles of Jasa Marga should be separated to allow it to operate as a viable company; a national Indonesian toll road authority should be established that is responsible for concession agreements; an appropriately structured formula should enable the automatic adjustment of toll rates; transparent and competitive procedures need to be implemented for soliciting bids for toll road projects; issues of land acquisition and rights of way need to be addressed; and 116 Averting an Infrastructure Crisis: A Framework for Policy and Action

131 Chapter 6 sound policies are needed to determine the conditions under which government support should be extended to toll road projects. Provision for many of these changes will need appropriately reflected in the draft amendments to the 1980 Road Law now being prepared by MSRI, and in a new Government Regulation on Toll Roads that will replace GR 8/ Law 13/1980 on Roads and Law 14/192 on Road Traffic and transport are currently being amended. Preparation of a comprehensive roadmap for the road and road transport sector should be prepared to identify with precision the policy and institutional reforms that should be reflected in the new laws. It is essential, in particular, that the new laws provide a more conducive environment for private participation, inter alia by introducing an improved framework for the development and operations of toll roads and by creating the legal basis for the introduction of road funds. Telecommunications 1. A first priority is to intensify and entrench pro-competitive policies in the sector. Telkom s and Indosat s remaining exclusive rights should be eliminated as soon as possible and the Government might want to take specific steps to increase competition in basic telephony services. To facilitate increased competition in the local market, the rebalancing of local and long distance tariffs needs to take place (the Government should, in particular, fully implement the 45% tariff increase over 3 years already agreed with the DPR). Establishing an adequate interconnection regime and improving the licensing and radio spectrum management are other important pro-competition measures that need to be adopted. 2. The existing regulatory body needs to be substantially strengthened. BRTI needs to be protected from undue government and industry pressure. It also needs to receive the resources required to recruit highly qualified professionals and to engage world class professional advisors as needed. 3. In order to increase access to telecommunications services in rural areas, the Government should rely on output-based schemes rather than on direct public investments. 4. The 1999 sector blueprint should be reviewed to emphasize the importance of competition and autonomous regulation, and reflect the adopted policies on tariffs, interconnection, universal service obligations, and radio spectrum management. A new telecommunications law could be drafted afterwards, in line with the revised sector blueprint. 5. Finally, institutional reforms are needed to ensure that the measures identified above (the importance of which has been recognized for a long time by Indonesian public authorities) are effectively implemented. One approach would be to use an existing or new ministerial-level interdepartmental committee, chaired by the Coordinating Ministry for Economic Affairs, to begin implementation planning. The committee would need to be given instructions, resources and target dates to review telecommunications development policies and issues, undertake consultations, and begin development of specific plans to implement the key reforms identified above. 117

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133 ReportsI-IV Background Sector

134 sector I Electric Power 120 Averting an Infrastructure Crisis: A Framework for Policy and Action

135 The ultimate soundness of a power sector is measured by its ability to supply electricity to all customers reliably and efficiently. In the case of Indonesia, the sector also needs to expand power rapidly to the remaining 40% of the population without it 90 % of whom are poor. Despite the Government s commendable efforts over the past few years which have resolved some of the key sector issues, Indonesia s power sector at this juncture can still make significant strides in all three areas reliability, efficiency and access. Reliability Overall, the reliability is borderline; while the economy will not slow to any great degree or grind to a halt due to power supply interruptions, the system would surely benefit from a comfortable, safe margin of reliability. This assessment is based on relatively rigorous analyses of how the system will function as demand increases. Based on these analyses, Indonesia s sporadic power shortages will persist, particularly in the outer islands, but major, long duration blackouts are not imminent unless investment halts completely over the next three-four years (which is unlikely). If such blackouts do occur, they will most likely be due to inadequate or insufficient physical infrastructure resulting from an inability to meet financing needs. An additional threat to increasing reliability is the constraint on delivery of natural gas to the sector. It is estimated that demand will grow by an average of 6% per year between This corresponds to a total of US$16-US$18 billion in investment needs: US$12-US$12.5 billion for generation, US$2.5-US$3.5 billion for transmission and US$1.7-US$2 billion for distribution. A failure to meet these needs will result in insufficient or inadequate physical infrastructure and decreased reliability. 121

136 Electric Power The bulk of funds will have to come from private sector (domestic or international) rather than PLN s internal cash reserves or multilateral/ bilateral lending and guarantees. PLN s finances are precarious, despite 10 consecutive quarterly tariff increases, which has brought the average rate to 7 cents/kwh. This level is unlikely to rise next year, due to elections. Even after the election, it would be difficult to hike the average tariff much more. Given the tariff increase limitation and other constraints discussed in the text, PLN s contribution from its own resources could not be more than US$3 billion from Second, multilateral/bilateral contributions to PLN s capital investments from will be an estimated US$2-US$2.5 billion (this is in addition to the ongoing and committed projects). Thus, the balance will need to come from the private sector, either domestic or international. However, Indonesian investors have not been major contributors to the energy sector in the past, partly because the domestic capital market is underdeveloped. Thus, it is estimated that domestic capital will account only for US$1-US$1.5 billion from The bulk (about US$10- US$11 billion) will have to be international capital, but two obstacles exist. First, investors globally have pulled back from the energy sector, and second, they insist on full Government guarantees, which the Government is reluctant to provide. To break this impasse, Indonesia must develop a new framework for sharing the risks. The first step is to more accurately understand investors expectations about risks and risk-sharing. Also, the Government needs to expedite to create the regulatory agency and to promulgate the new regulations, and provide clear signals on the future direction of the sector structure including for outside Java-Bali; these actions will substantially reduce investors estimates of the risks. With US$ 14 billion in contingent liabilities, Indonesia s priority should be to minimize future contingent liability by unbundling the risks the Government assumes, and by devising mechanisms by which some of these risks can gradually shift to the private sector. The Government should offer performance guarantees when needed to overcome perceived country risk problems (associated with the projects) but not for risks that are purely commercial. Another threat to increasing reliability is the constraint of natural gas delivery to the power sector. It is expected oil use will decline to about half its current level by As the oil consumption in the power sector declines, coal and natural gas consumption will rise. While coal will continue to play an increasingly important role in the power sector, the main issue is the availability of natural gas. Although the country has large reserves of gas, its domestic use has been constrained, most importantly due to the flawed price structure. Under the present cost-value price structure, major distortions exists which have slowed the growth of the gas industry and are a disincentive for producers to supply gas to the domestic market. Efficiency While it is difficult to determine if PLN s inefficiencies stem from its practices or Government actions/policies, PLN consultants found that ample room exists for improvements as is true of other utilities in the region. PLN s inefficiencies reportedly were US$600-US$800 million a year. Responding to the consultants report, PLN began an Efficiency Drive Program three years ago to review its operations and has since improved some of its practices. Power sector efficiency is also measured by examining the losses; PLN s losses are 12%, which is in the mid-range for the utilities in the region. Increasing efficiency is also possible through sector reform. In September 2002, Indonesia passed its first modern electricity legislation (Law No. 20) that provides for a market-based operation that takes into account environmental, energy conservation, safety and diversification issues within a competitive market. Also, the law states that an independent regulatory agency (EMSA) be established within one year of its enactment (by September 2003), funded by the Government and fees from licenses. The EMSA s proposed structure and responsibilities seem sound, although it has not yet been established. PLN, a limited liability company, is partially unbundled. Recent restructuring included (a) placing new plants under a new (third) generation subsidiary; (b) dividing the transmission company (P3B) into two separate units; and (c) creating PLN IPP Trader company to handle all IPP matters, as well as a proxy for a single-buyer model (SBM). To further unbundle and corporatize its activities, PLN arranged (a) binding contracts between the two subsidiaries and the single buyer (SB) unit, (b) transmission service agreements between the transmission company and the SB unit, and (c) a bulk power supply agreement between the SB unit and distribution companies. Given PLN s organizational changes and the law s provisions, broadly, two alternatives can be envisioned for the sector s structure: The singlebuyer model (SBM), or multi-buyer, multi-seller (MBMS) model, with the possibility of an interim wholesale competition (WSC). Considering the array of the requirements for moving to what appear to be a MBMS model under the Law, it is difficult to see how they could be met in the next foursix years. When all elements are taken into account, a practical (and likely) approach for now would be to insure (a) an effective SBM is established with the necessary regulations issued, (b) the EMSA is up and running, and (c) the sector experiments with a small-scale MBMS model, and gradually develops a more mature one over the next several years. Access Overall, the country s rate of electrification is about 53%, which means some 90 million people still do not have access to electricity. Per capita annual consumption at 380 kwh is among the lowest in the region and the share of biomass in total energy is about 32%, one of the region s highest. Although the low rate of electrification is a major problem, and calls for an accelerated plan to expand the residential supply, meeting the demand of the remaining unserved population in Indonesia will be difficult largely due to the country s geography and the location of rural populations. In Java Bali, where over 96% of the villages are electrified, expansion mainly involves intensification within the existing network, and 122 Averting an Infrastructure Crisis: A Framework for Policy and Action

137 the pace of electrification is faster than outside Java-Bali. If PLN continues connections at the present pace, Java-Bali s electrification will approach 95%-98% in about years. However, outside Java-Bali, only about 70% of villages are electrified, and it will take significantly longer to provide residents with power. Further, connections costs for outside Java-Bali are, on average, about 33% higher than for Java-Bali. Therefore, it is not expected that Indonesia will approach 100% electrification any time soon. Background Sector Report I Expansion in rural areas outside Java Bali (and some of the rural areas within Java Bali), need and should not rely entirely on PLN s grid connections. Once a clear power sector structure for outside Java Bali is designed, and regulations are issued for grid and tariff codes, together with recent decentralization laws, several options will exist with which to accelerate electrification in the rural areas outside Java-Bali. To assess these options, a rural electrification strategy must be devised which would establish optimal electrification schemes and targets, particularly for areas that cannot be supplied through grids for many years. Self-generated (captive) power plays an important role in supplying electricity to various sectors of the economy. While estimates vary, Indonesia has about 15,000 MW of installed self generation capacity which produce about GWh electricity. Although theoretically this could supplement the country s electricity supply significantly, a closer look at the structure of the captive power capacity and utilization presents major technical and business-philosophy issues that limit the extend that these plants can be expected to supply power to national grid. Nonetheless, the captive power s role in the sector will continue and therefore it is important that Indonesia prepare a strategy to integrate them into the sector. The Way Forward The most pressing issue is for the Government to promulgate the implementing regulations for the 2002 Electricity Law, since these are key to resolving most pending issues. The draft has been in an advanced stage for over a year. While all eight regulations need to be promulgated in the near future, the most critical are those that establish the regulatory agency (Electricity Market Supervisory Agency EMSA), set tariffs (including the wheeling charges) and adopt licensing procedures. Once EMSA is established, the Government should immediately fund and staff the agency and appoint its top staff which was supposed to have occurred by last September. Given the imminent shortage of natural gas for generating power, the Government should issue regulations related to the 2001 Oil and Gas Law. Also, it needs to develop a comprehensive gas sector strategy that would include (a) introducing a rational gas pricing policy, and (b) restructuring and partially privatizing PGN. (Studies on both these topics are on-going and should be available in the next six months). Once tariff regulations are issued, policy makers and regulators need to address three tariff issues. These include: (a) providing a more accurate and quantifiable definition for the term economic value as it applies in the Law to the sale price of electricity (tariff); it must also define the term reasonable profit ; (b) providing a formula to automatically adjust electricity prices and a firm date to apply it; (c) resolving the matter of the two major cross-subsidies (from high and medium to low voltage consumers, and from Java-Bali to outside Java-Bali consumers). With regard to the first cross-subsidy issue, the Government needs to articulate its policy and, together with the regulators and PLN, agree on a permanent mechanism to handle it. With the second, since the law provides for applying a levy for this purpose (to the transmission and distribution systems in areas where competition exists, in order to build systems in less developed areas), the Government and regulators must issue the necessary regulations and, together with PLN, create mechanisms for applying them. PLN must develop an investment plan, including a core plan, for between now and 2012, along with criteria for forecasting demand, funding requirements, sources of funds (particularly from PLN s internal cash), and the implications if goals are not met. Additionally, the Government/ PLN must finalize settlement on the remaining five IPPs, settle litigation with the Karaha Bodas IPP, and assess the lessons from the Indonesian IPP program, so as to incorporate them when preparing the risk-sharing policy. To close the gap with private investors, Government must hold the agreedupon meetings with the private sector/stakeholders together with WBG, ADB and JBIC so as to (a) detail recent progress in the power sector, (b) provide a realistic assessment of the sector including the regulations and regulatory agency, and the structure both within and outside Java-Bali and (c) more fully understand the private sector s concerns. Government must (a) unbundle the risks associated with future PPAs and adopt a formal risk allocation/sharing policy along the lines recommended in the report, to minimize contingent liability, and (b) begin devising policy on the treatment of contingent liability in the national account. To improve sector efficiency, PLN must update its efficiency program, describing its accomplishments and the timeframe for resolving remaining issues identified by its consultants, in a format that can be quantified and monitored. Furthermore, Government must set clear guidelines consistent with the Law, implementing regulations and the current direction of the sector, including existing and firmly planned infrastructure about its intent on the medium and long term structure of the sector, with respect to the single-buyer (SBM) or multi-buyer, multi-seller market model (MBMS), and a timeframe for introducing them. It must also articulate policy for the electricity sector outside Java-Bali, where widespread commercially viable operations are not envisaged in the near future. This report s recommendations with respect to the structure of the sector for Java-Bali is to ensure that (a) an effective SBM, with regulations to support it, is established, and that the regulatory agency is functioning (SBM must be regulated with respect to bulk supply tariffs and the least-cost solution for transmission and generation); also, that (b) the sector experiments with a small-scale MBMS model, and subsequently develop a mature MBMS over the next several years provided that in the meantime PLN moves aggressively to improve its efficiency, fully unbundling and corporatizing its functions. With respect to timeframe, Indonesia s transition to a MBMS 123

138 Electric Power proposed incentives for renewable energy development), government funding (e.g. for renewable energy research and development), and application of emissions trading. market can indeed be accelerated. The most critical step is establishing EMSA, promulgating the rules, and completing the southern 500 kv transmission line. While the Government should continue rationalizing tariffs and subsidies, liberalizing primary fuel prices, and integrating IPPs into the market, these measures can be introduced at the same time as it moves towards a MBMS market. It is in the best interests of Government to continue fostering competitive conditions now rather than later, thereby reaping the benefits of competition sooner and lessening the sector s fiscal burden and corresponding contingent liability. To increase access, the Government/PLN, taking account of the regulations, sector structure and cross subsidies, must prepare a rural electrification strategy that will include an investment program, source of funds, and timeframe to maximize the country s electrification. The Government, PLN and the regulators must articulate a policy for integrating self-generated power into national electricity supply system (consistent with the law and regulations), and an appropriate framework should be established to enable them to sell electricity to PLN or to gain non-discriminatory access to PLN s grid to deliver power to other customers, as the producers choose. Policy and Institutional Framework The power sector is in the early stages of what will be a complex and lengthy transitional process that is outlined in the recently-passed law, draft regulations and the April 2003 Blueprint. 62 The Blueprint, which is intended to be a dynamic document, sets out several ambitious, near and long term targets for sector development and highlights challenges that will need to be addressed in order to meet them. The targets include: Meeting electricity demand: solve all electricity crises outside Java by early 2004; achieve 90% household electrification by Improving financial independence of electricity supply: settle all IPP disputes by June 2003; raise electricity tariffs to levels that cover operating and capital costs and provide an adequate return by 2005; introduce an automatic tariff adjustment mechanism by Increasing efficiency of electricity supply: implement limited generationside competition in Batam in 2004; implement limited generation side competition for the Java-Madura-Bali (JAMALI) by 2007; finalize proposals by end-2003 for establishing a transmission company that will perform the functions of system operator, market operator and transmission owner for JAMALI. The policies set out in the Blueprint give high priority to ensuring environmental sustainability, including through business regulation (e.g. through non-fossil fuel and energy utilization improvement obligations), certification (e.g. energy efficiency standards for equipment), taxation (e.g. Table I.1: Main Legal and Regulatory Provisions Legal Instrument Key provisions Law (22/2001) on Oil Downstream competition and market and Natural Gas pricing (implementing regulations are pending) Upstream production (implementing regulations are pending) Law (20/2002) on Electricity Progressive introduction of competition initially for large consumers, later at retail level, on a region-by-region basis (a number of implementing regulations are pending) Establishment of Electricity Market Supervisory Authority (EMSA) by September EMSA will regulate and supervise power enterprises operating in competition regions In non-competition regions authority for issuance of business and operating licenses is decentralized to regional and local authorities, and in some cases to the Minister. Tariffs for competition areas to be at a level that enables cost to be covered and fair return to be earned (implementing regulation pending on interpretation of fair returns). EMSA responsible for supervision of tariffs Transmission and distribution recognized as natural monopolies to be operated in a non-discriminatory manner, to be offered to State enterprises Allows for different types of private enterprises in the electricity sector: generation, transmission, distribution, retail, sales agent, power market manager, power system manager Imposes levies on transmission and distribution in competition regions to finance network extensions to less developed regions Presidential Decree 37 (1992) Allows private entities to be involved in power Keppres 37/1992 generation, transmission and distribution Keppres 39/1997; Establishes a Minister-level team to guide Keppres 139/1998; and oversee PLN s financial rehabilitation Keppres 169/1999; and IPP renegotiations Keppres 133/2000 PLN authorized to conduct renegotiations for IPPs Keppres 76/2000 Empowers heads of regional governments to issue licenses for geothermal power exploitation Government Regulation Covers policies on foreign investment 20/1994 Pending the issue of implementing regulations for the new Electricity Law (Law 20/2002), the Ministry of Energy and Mineral Resources through its Directorate General of Electricity and Energy Development (DGEED) continues to have primary responsibility for regulation and licensing as well as for sector policy making and strategic planning. The Ministry of State Enterprises is involved in the sector through its 124 Averting an Infrastructure Crisis: A Framework for Policy and Action

139 role as shareholder of PLN, and has primary responsibility for overseeing PLN s performance and guiding its corporate restructuring and privatization. Regional governments have until recently had no role in the sector and few have yet started to undertake functions that are assigned to them under the new law. Background Sector Report I Until the regulations are promulgated, Authority to set the basic electricity tariff (TDL) remains with the President. During the Suharto era the President s authority was absolute, but decisions are now taken only after extensive discussion within Cabinet and consultation with the DPR. Prior to the crisis the level of the average retail tariff was determined primarily by financial covenants on World Bank and ADB loans, and specifically a requirement to achieve an 8% rate of return (ROR) on revalued fixed assets in operation. Policies and procedures for private participation in the sector were defined by Presidential Decree 37 of 1992 (Keppres 37/1992), which stipulated that private entities could be involved in power generation, transmission and distribution. 63 This decree paved the way for unsolicited project proposals, gave preference to the build-own-operate (BOO) model, required tariffs to be expressed in Rupiah and approved by the Minister, and prohibited Government from guaranteeing invested equity or debt service obligations. Keppres 76/2000 empowers heads of regional government to issue licenses to exploit geothermal resources. The key change to be introduced by Law 20/2002 is that its transitional provisions stipulate that at least one region should be applying competition in generation within five years and that an Electricity Market Supervisory Agency (EMSA) should be established within one year. The law stresses that EMSA will be independent, funded through a Government-allocated budget and fees from licenses. The decision for a region to shift to a competitive market structure is required to be made by Government Regulation and to have regard to region-specific factors such as adequacy of retail tariffs to provide a commercial return, adequacy of competition in primary energy supply, presence of sufficient capable and reasonably balanced generators, and the capacity of other parts of the system to support competition. The EMSA is required to be in place and the market rules and codes adopted before competition can commence. The wires businesses of transmission and distribution are recognized as natural monopolies that must be operated in an open and non-discriminatory manner, and are required to be offered in the first instance to State enterprises. Any enterprise wishing to participate in the supply of electricity to the public is required to hold a business license (IUPL). Seven main business types are identified, namely: generation, transmission, distribution, retail, sales agent, power market operator, and power system operator. 64 Enterprises wishing to provide power for their own use are required to obtain an operating license (IO). Law 20/2002 s provisions with respect to planning, licensing, regulation and supervision differ for competition and non-competition regions. The EMSA will be responsible for regulating and supervising power enterprises operating in competition regions. Its duties will include preventing unhealthy competition, regulating retail tariffs for customers with low voltage connections, regulating tariffs for transmission and distribution system use, issuing business licenses, arranging public consultation and establishing complaints handling procedures, facilitating dispute resolution, supervising implementation of business license conditions, and imposing administrative sanctions for license violations. It will also be responsible for defining the boundaries of competition areas and for establishing market rules and the transmission grid code. The EMSA will be accountable to the President, with its members being appointed by the President with the approval of the DPR. In non-competition regions, authority for licensing and regulation will be divided among the different levels of government. A bupati (district head) /walikota (mayor) may issue business and operating licenses for enterprises whose activities are located entirely within the kabupaten (district) / kota (municipality) and not connected to the national grid. Likewise a governor may issue licenses for enterprises whose activities span kabupaten or kota boundaries but are located entirely with a province and not connected to the national grid. Authority to issue licenses for enterprises whose activities span provincial boundaries and / or are connected to the national grid will continue to reside with the minister. 65 For competition regions, Law 20/2002 provides for the price of bulk power supplied to consumers connected at high and medium voltage to be set by fair competition, with EMSA having the role of market supervisor. However where there is a single buyer structure, the EMSA is required to regulate tariffs for all consumer categories. In non-competition regions, tariffs are to be set by central or regional government according to their licensing authority. In regulating power prices or tariffs, the responsible entity is required to consider factors including production costs, enterprise efficiency, quality and reliability of supply, industry and commercial norms, scarcity and characteristics of primary energy sources used, and affordability. Overall responsibility for sector strategic planning is vested in government. Regional governments are required to prepare Regional Electrification Plans (RUKD) and central Government is required to prepare a National Electrification Plan (RUKN) based on the RUKDs and inputs from civil society. More detailed Power System Development Plans (RPSTL) are required to be prepared by the Power System Manager (PSM) in the case of competition regions and by the responsible State enterprise in the case of non-competition regions. Law 2/2002 includes provision for imposition of levies on transmission and distribution facilities in competition regions and requires that the proceeds be used to finance the development of transmission and distribution networks in less developed regions. 66 The law also stipulates that Government and regional governments shall provide funds for the development of power supply facilities to assist the less privileged, to serve less developed and isolated areas, and to support village electrification. 125

140 Electric Power Sector Structure and Ownership PT Pelayanan Listrik Negara (PLN) PLN is a Persero (a limited liability, almost-integrated utility), consisting of PLN Pusat (its holding company), two wholly owned subsidiaries that are generation companies (Indonesia Power and PJB), one strategic business unit (SBU) that is a transmission company (P3B) and five SBUs that are distribution companies. Retail operations are run through retail business units. This organization was designed to separate policy and strategic decision making from operations. The former is conducted through a Board of Directors consisting of five directors (one each for generation, transmission and distribution, retail and commercial, finance and human resources) as well as the president of the company. PLN is accountable to the (a) Ministry of State-Owned Enterprise, which is the Government s designated corporate owner of PLN, (b) Ministry of Energy and Mineral Resources, which makes energy policy and issues regulations, and (c) Ministry of Finance, which is the financial owner of PLN. The Government s daily oversight of PLN is conducted by a Board of Commissioners whose members include representatives of the three ministries and others. Further features of its structure include the following: (a) in preparing for future multi-generation companies, PLN is placing the new plants under a new (third) generation subsidiary; (b) the transmission company (P3B) is divided into two units: One owns, operates and maintains the transmission assets, while the second deals with system operations, including dispatch and scheduling; and (c) PLN has created an IPP Trader company, as well as a proxy for a single-buyer model (SBM) for administering the contracts with the two generation subsidiaries and for billing the five distribution units. To move forward to full corporatization of its generation, transmission and distribution, PLN has arranged (a) binding contracts between the two subsidiaries and the single buyer (SB) unit, (b) transmission service agreements between the transmission company and the SB unit, and (c) a bulk power supply agreement between the SB unit and distribution companies. However, licenses for generation, transmission, distribution and the SB companies/units have not yet been issued: The regulation for licenses needs to be issued first, and EMSA is not in place yet. PLN s installed generating capacity has grown from less than 800MW in the mid 1970s to around 20,800MW by end The public supply has been augmented over the past four years by the commissioning of IPP plants with capacity totaling around 3,050MW. The JAMALI grid accounts for around 18,600MW, including around 2,850MW of IPP capacity. The Independent Power Producer (IPP) Program In 1990 Indonesia solicited bids for its first IPP projects, Paiton I and Paiton II in East Java, with both bidders ultimately being awarded contracts. The Power Purchase Agreement (PPA) for Paiton I was signed in February 1994 and financial closing was achieved some fourteen months later, just days after the signing of the PPA for Paiton II. In the interim Keppres 37/ 1992 had unleashed a flood of unsolicited project proposals, enabling 26 PPAs and Energy Sales Contracts (ESCs) to be signed by the time the crisis struck in mid These agreements covered some 10,800 MW capacity and a projected investment of circa US$13-US$14 billion, with developers securing support letters under which Government committed to cause PLN to meet its contractual obligations. 68 A declining step tariff structure was adopted for Paiton I and several of the 11 geothermal IPP plants, while agreements for other plants provided for fully levelized tariffs. Power purchase tariffs typically comprised four components: capacity, fixed operation and maintenance, energy, and variable operation and maintenance. Expressed as a composite, the lowest tariff was around US 5.75 cents for the competitively solicited Tanjung Jati A (coal, 1,320 MW). At the other end of the range, initial period tariffs for Paiton I and most geothermal plants with declining step structures were above US 8 cents (and hence well above the prevailing average retail tariff, even before account was taken of system losses). When the Rupiah commenced its sharp decline, the Government moved quickly to postpone or put on hold many major power and other infrastructure projects. Keppres 39/1997, issued in September 1997, allowed 9 power projects to proceed in accordance with their PPAs / ESCs but caused others, in whole or in part, to be postponed or subject to review. 69 PLN later announced its intention to renegotiate all contracts with IPPs and in the interim to make payments at a pre-crisis rate of Rp. 2,450 to the US$. As of March 2003, PLN had reached agreement on amended tariffs and terms and conditions with 14 IPPs, of which seven have operating plants. Five of these Paiton I (Coal, 1230 MW), Paiton II (Coal, 1220 MW), Gunung Salak (Geothermal, 197 MW), Drajat (Geothermal 72MW) and Cikarang (CCGT, 348 MW) are on Java, while two Sengkang (CCGT, 135 MW) and Pare Pare (Diesel, 60MW) are on Sulawesi. Renegotiated tariffs are mostly in the range US cents, with the exception being the diesel-fueled Pare-Pare plant at around US 5.5 cents. In at least one instance, an amended agreement provides for extension of the original concession period while several include provision for payment of accrued arrears. The Tanjung Jati B project (Coal, 1320 MW), whose construction was halted by the crisis, is a special case and has been restructured as a build, lease and transfer scheme with PLN as operator and with Government providing support through a liquidity facility. This plant now is scheduled to come on stream in Negotiations have been concluded for a further five geothermal IPPs of which Wayang Windu (Java, 110MW) is in operation and Dieng (Java, 60MW) is close to being in operation. Field exploration and development has commenced at the other three, namely Patuha (Java), Sarulla (North Sumatra), and Bedugal (Bali). However, final steps to complete the process have yet to be taken. Seven contracts have been closed out and one is in process of litigation Averting an Infrastructure Crisis: A Framework for Policy and Action

141 Captive Power Indonesia has substantial supply of captive power. Unfortunately, a consistent set of reliable data and information regarding the capacity of the captive power plants (CPPs) and their utilization do not exit, partly because more than 60% of the plants are small and scattered around the country (in about 10,000 companies). However, it is estimated that the country s installed capacity of CPPs in 2003 was about 15,000 MW, and that the plants generated about 44,000 GWh of electricity. 72 A CPP is constructed by an industry or commercial entity to produce power for its own use. These plants developed in Indonesia because various sectors particularly manufacturing found that electrical power from the grid was either unavailable or unreliable(although the price of diesel oil was heavily subsidized, this incentive factor did not play an important rule in the growth of CPPs). Industrial sector began to install diesel generators during 1980s. CP capacity grew by 4%-5% a year during this decade. By the end of the decade and into the early 1990s, as industrial output soared and PLN s power shortages became more frequent, CP grew even more rapidly, at an average rate of 9% a year. Since 1994, their growth dropped to 3.5% 4% a year, largely because PLN s supply had become more reliable. Where more plants were constructed, it was largely due to increase in co-generation capacity, which produce both power and heat at a very competitive price. In fact, it is expected that while the relative importance of captive power will decline, companies will continue to build co-generation plants. However, CPPs will, for many reasons, continue to play an important role in the sector. First, it is expected that manufacturing will continue to expand, and industries will use CPPs, particularly in co-generation. Second, a realistic future scenario will almost certainly present a restructured power sector, with open access to new entrants as well as regulations for wheeling charges to sell to a third party, and to trade electricity in a multi-buyer, multi-seller (MBMS) market. In such a market, some of the larger CPPs might choose to spin off and form electricity supply subsidiaries to their industrial parent companies. Last, some of the geographical areas in the country will still not have access to PLN s grid in the foreseeable future, and could use the CPPs to meet their electricity needs. All these factor will give new momentum to the CPPs, which can then act as catalysts opening the sector to more competition and accelerating the development of the MBMS market. Therefore, it is important that Indonesia prepare for a future that includes CPPs, devising a strategy to incorporate them into the sector (see the Box I.1). Primary Energy Supply Indonesia is richly endowed with fossil fuels and with hydro, geothermal, and other renewable energy resources. While the most abundant resources are located in the outer islands, Java nonetheless has significant oil, natural gas, hydro and geothermal resources. The pattern of primary energy use by the power sector has been significantly influenced by Government policies, and in particular by the pricing of petroleum fuels. These have favored the use of oil for power generation and in 2001 some 37% of PLN s installed capacity was oil-fueled. Background Sector Report Box I.1. Integrating Captive Power Plants (CPPs) in the Power Sector It is important that Indonesia devise a strategy to integrates CPPs into the sector. This will require (a) obtaining a better understanding of their physical and operational status, (b) preparing well-defined policies to integrate them into the sector; and (c) issuing the regulations for the CPPs (which include those for the wheeling charges, a vital step for the CPPs to sell their excess electricity to the grid). Such policies must respond to the CPP owners concerns, including mechanism to share the risk if fuel becomes unavailable, and reasonable provisions for wheeling, transmission and distribution loss charges for CPPs that sell their excess electricity. Equally important, the policies must consider the impact of the CPPs on the sector. Some of the issues they must address are (1) concern about the reliability of the CPP power supply to the grid as a source of firm power, given their small size and industrially-geared operations, (2) the environmental impacts of the CPPs, given the type of fuel they use (i.e. mainly diesel) and the high emissions per unit of production compared to larger plants, and (3) the revenue impact on the sector, since CPPs are mostly in manufacturing, which produces higher revenues for the utility due to higher tariffs and less administrative work (ie. more efficient billing and collection systems). Fortunately, the recently-enacted electricity law includes provisions for own interest generation: It formalizes the present liberal licensing policy by allowing prospective CPP owners to apply for operating licenses from the regents, mayors, governors and the Ministry of Energy and Mineral Resources (MEMR), depending on their size and location. The law also allows those who hold operating licenses in competition areas to sell excess electricity by obtaining licenses from the regulatory agency; in the non-competition areas, excess electricity can be sold by obtaining licenses from authorized provincial officials, or from the MEMR, as indicated above. Further, the law states that transmission and distribution grids must be open to all. Thus, in principle, no laws prevent the CPPs from supplying their excess electricity to PLN through the grid, or to third parties, either through PLN s grid or through an independent transmission line. However, rules and regulations which have not yet been developed must clarify important issues. These include wheeling charges, transmission and distribution losses, limits on the CPPs capacity (if any), cost recovery for connecting to the grid, banking electricity, and providing guidelines/price for the firm and unfirm supply. Some of these issues have far-reaching implications and must be addressed by the regulatory agency that has not yet been created. For example, should wholesale consumers/distributors be allowed to have their own generation plants and thus avoid transmission charges? If the answer is yes, it would increase the potential for stranded costs (see section VII.2.b). Also, allowing major customers to build generation plants would not be fully in line with the single buyer model (see section VII.2.b). Thus, the Bank recommends that the Government initiate a study to review and update the information related to the country s CPPs. Once this is accomplished, the Government should sharpen and better articulate the policies so they are compatible with the recently-passed law and issue the necessary regulations with respect to own-interest power generation. I 127

142 Electric Power Currently, the various sources of energy used to generate power are natural gas (34%), coal (31%), oil (22%), hydro (10%), and geothermal/others (3%). It is expected that the use of oil will gradually decline to about half its current level by 2010 because (1) Indonesia will be a net importer of oil by 2010 and (2) subsidies of petroleum products will be fully phased out (this has and will increase PLN s fuel costs substantially). As the oil consumption in the power sector declines, coal and natural gas consumption will rise. Oil - Indonesia s proven and potential (probable plus possible) oil reserves stood at 5.1 and 5.5 billion barrels respectively in 2001, just slightly higher than their levels in Exploration expenditures have fallen in recent years, however, and new acreage offered in 2002 generated little interest. Production of crude and condensate has been declining, falling from 1.58 million bpd in 1997 to 1.34 million bpd in 2001 and to about 1.2 million bpd in Pertamina has typically accounted for around 10% of total production while Production Sharing Contractors (PSCs) have accounted for the remainder. 73 Many large fields are already mature, and production at some is being maintained by use of steam flood and other enhanced recovery techniques. Decisions on further investments at many such fields are on hold pending the issue of the upstream regulations for the 2001 Law on Oil and Natural Gas (Law 22/2001) which inter-alia are needed to establish a legal basis for PSC extensions. After dipping in 1998, domestic fuel sales have grown steadily despite the economic crisis and a series of large price increases, rising from around 50 billion liters in 1997 to around 56 billion liters in Oil currently accounts for around 60% of Indonesia s total primary energy consumption and around 21% of PLN s power generation. With an annual production to proven reserves ratio of below 12, Indonesia confronts the prospect of becoming a net oil importer in the medium term. Pending implementation of Law 22/2001 s downstream provisions, which require competition and market pricing, Pertamina remains the sole domestic supplier of petroleum fuels and Government continues to set their prices. 74 Government has committed to phasing out the fuel subsidy by 2004, and is well on track to achieve this. The next step, which was introduced from January but quickly put on hold, will be to price all fuels except household kerosene at 100% of their Singapore ex-refinery prices plus a handling charge and applicable taxes. Natural Gas - Indonesia has very substantial natural gas resources, with proven and potential reserves standing at 90 and 87 trillion cubic feet (tcf) respectively at end Sumatera accounts for 51.1% of the proven reserves, East Kalimantan for 28.7%, Papua for 12.7%, Java for 6.8%, and Sulawesi for 0.7%. Reserves in producing fields account for around 37% of total reserves and 42% of proven reserves, with East Natuna and Tangguh accounting for the major part of the proven but non-producing reserves. 128 Averting an Infrastructure Crisis: A Framework for Policy and Action

143 Proven reserves have increased significantly in recent years and it is likely that considerably more gas will be discovered as the market develops and investments in pipeline infrastructure encourage increased exploration. Background Sector Report I Natural gas production has ranged between tcf per year between 1995 and 2001, with the highest levels being recorded in 1996 and Pertamina has been producing about 10% of the total while six PSCs account for most of the remainder. Around 20% of total production is accounted for by the producer s own use, flaring and re-injection. In 2001, sales totaled around 6.2 billion cubic feet per day (bcfd) of which two thirds went for export as LNG or LPG. Power generation accounted for about 0.6 bcfd, or 30% of total domestic consumption. The pattern of domestic consumption has been greatly influenced by Government directions on gas pricing, with Pertamina in the past having been required to supply gas at very low prices to industries notably steel and fertilizer that were deemed to be of strategic importance. PLN s main gas supplies are priced in the vicinity of US$ 2.50 per MMBTU inclusive of pipeline tariff. Most domestic contracts provide for a flat tariff over time, and only one major domestic contract (for the Duri steam flood enhanced oil recovery project) provides for indexation to the price of crude. Securing supplies of natural gas for power generation is urgently required for the cost-efficient operation of PLN s power plants and to re-invite private investments for power generation. According to its own estimates, PLN is incurring extra costs at the rate of Rp. 342 per kwh by using diesel instead of natural gas as a fuel in its power plants. According to PLN, switching the fuel for the existing power plants that currently run on diesel to natural gas, would results in annual savings of Rp trillion. If the additional capacity being planned for in West Java is also taken into account the costs of inadequate gas supply are substantial and have a further negative impact to PLN s financial standing. Coal - Indonesia s coal reserves are estimated to exceed 38 billion tons, much of which is low grade lignite that will not be economically workable in the foreseeable future. Mine-able reserves, which are located mainly in South Sumatera and East Kalimantan, totaled around 5.4 billion tons at end-2001, with low-sulphur sub-bituminous grades accounting for 4.6 billion tons and bituminous / anthracite grades for 0.8 billion tons. Production has increased dramatically over the last decade, reaching 92 million tons in 2001 of which 64 million tons was exported. Virtually all production is now from open pit mines, with most of the large mines being in East Kalimantan. Illegal mining has been a growing problem, and in the absence of effective enforcement mechanisms several coal producers have been forced to reach accommodations with illegal operators exploiting their production areas. Power generation accounts for more than two thirds of domestic coal consumption, with the main users being PLN s Suralaya plant (3,400 MW) and the PLN and IPP plants at the Paiton complex (3,250MW). Supplies for Suralaya are sourced mainly from the State-owned Bukit Asam mine in South Sumatera while coal for Paiton comes mainly from Kalimantan. Domestic prices are basically set by the international market, although in some regions small producers do not have the option of exporting and are essentially captive to PLN. Coal will continue to play an increasingly important role in the power sector. Indonesia, which is the third largest exporter of coal, will have an ample supply for domestic use, as long as PLN pays competitive prices to obtain it. We expect the percentage of coal used to generate power will increase from its current level (31%) to 38%-40% by 2010/2012. Geothermal - Indonesia s ring of fire volcanic belt contains over 200 prospective locations for geothermal energy development. Total geothermal energy potential is estimated at 19.7GWe. Java accounts for over a quarter of total potential, most of the proven reserves of 1.8GWe, and all but 22MW of the 790 MW of installed capacity. Hydro - Indonesia has an estimated 75 GWe hydropower potential, 95% of which is off-java. Total installed capacity of hydropower plants was around 4.2 GW in 2000, with PLN accounting for around 3 GW. Investment Needs and Financing To estimate the finances required in the sector, it is necessary to forecast growth in demand and the criteria for a comfortable/safe margin of reliability, and then determine the required sector investment. 75 Demand Forecast PLN s installed capacity at the end 2002 was 20,800 MW, which included 3,050 MW from the IPPs. Java Bali had a capacity of 18,600 MW (including 2,850 from the IPPs), and the balance was outside the area. Peak capacity at the end of 2002 was 13,850 MW. These numbers do not include a reported 13,000-15,000 MW of self-generated (i.e., captive power). Prior to the regional crisis, electricity sales in Java-Bali grew 12%-16% a year, and the elasticity of demand was While the crisis first dampened demand (-1.4% in 1998), peak load bounced back in 1999 and 2000, growing by 12% and 11%, respectively. This was mainly due to the suppressed demand resulting from cutbacks related to the initial shock, particularly in industry. In 2001 and 2002, demand growth stabilized at about 6%-7% a year, partly as the result of ten quarterly tariff hikes, which dampened industrial demand again. PLN has a fairly elaborate system for forecasting demand, which includes estimating electricity sales to the residential, commercial, industrial and public sectors, and to each major region (eg. West Java and East Java), and then aggregates these estimates to obtain total demand. Sales for each sector are forecast from the historical elasticity between estimated annual energy sales and annual growth of sectoral aggregate expenditures. To these figures are added the estimated 129

144 Electric Power energy sales to new customers in each sector, using the historical relation between the number of new customers and sectoral GDP. This total forecast is then converted into system peak-load demand through an estimated load factor which historically has moved between a narrow range of 70%-71.5%. In one approach, the Bank s GDP forecast was applied to PLN s methodology: Peak load growth averaged about 7% for a base case and 10% for the high case, for the period. 76 In another, a low estimate was developed assuming PLN s financial constraints would limit its customer connections to about to 650,000 per year, and gradually increase to one million by the end of Under a high scenario, it was assumed that PLN would reach the pre-crisis level of 1.7 million connections a year, beginning in The peak load average growth was about 5.3% and 8.7% respectively. For the purpose of this analysis, a composite value of 6% average growth between was used as the base case forecast (i.e. which was drawn from among several sources and scenarios). Peak load demand growth for each year was also calculated. Allowances were made for de-rated capacity, long-term outages and constrained capacities in order to arrive at the necessary installed capacity and corresponding additional generation requirements. 77 This approach is not a substitute for a model that would include some of the post-crisis recovery efforts and other factors that will continue to affect electricity demand for the next few years, such as suppressed demand, captive power, and absolute/relative movements in energy product prices. Besides, forecasting demand in Indonesia is complicated by several factors, such as that (a) industries and some businesses switch back and forth between using their own captive power (i.e. self-generated power) and grid power, and (b) it is difficult to make a strong correlation between energy sales and GDP growth in Indonesia since the post-crisis economy does not necessarily offer a realistic indicator of demand growth. However, the forecast based on the above analysis should still offer a reasonably accurate picture of the low, high and base cases when considering the overall supply/demand balance. Investment Needs Using a base case forecast, the new generation capacity needed to secure the system is estimated at about 14,000 MW between now and The estimated cost is about US$12-US$12.5 billion. To expand the transmission network, the investment needed assuming that all existing projects will be completed and their funds secured between now and 2012 is an estimated US$2.5-US$3.5 billion. To expand the distribution system with about 1.6 million connections a year, the investment needed is an estimated US$1.7-US$2 billion between now and Therefore, the above components will require total investments from now to 2012 of about US$16-US$18 billion. 78 Investment Financing Three sources could be tapped to finance such an investment program: (a) PLN s internal cash reserves; (b) multilateral/bilateral lending and guarantees; and (c) private sector investors, either through domestic or international markets. PLN s Internal Cash Reserves - PLN s finances continue to be precarious and several elements must hold together for it to start earning a rate of return of 5%-6% by 2005/2006 (from about 2.5% expected by the end of 2004). These involve a stable tariff of about 7 cents/kwh and a continuing Government subsidy for users below 450 VA (to whom power is sold below production costs). For PLN to achieve an appreciably higher rate of return, the tariff must be increased substantially. As will be discussed in the following sections, this will not be easy to achieve. Recent improvements in PLN s finances, particularly in its capital structure, are due to several one-time actions, such as converting about $3 billion in interest it owed to the Government into equity, converting about $500 million in unpaid principals into a new 20-year loan, and a major revaluation of its fixed assets which added $11 billion book-value to its equity. Further, the Government paid it a targeted subsidy, totaling about $1 billion, from These actions sharply improved PLN s debt-toequity and debt-service-coverage ratios. However, the improved capital structure would only allow PLN to borrow more, and the fundamentals on the real revenue and expenditure remain unchanged. PLN will not be able to generate enough finances to contribute significantly to capital investments for some years to come. For example, by the end of 2002, operating losses were about US$800 million, and net losses before taxes were US$660 million. While operating expenditures included substantial amounts for depreciation due to the revaluation of its fixed assets, there were also gains from foreign exchange transactions and a one-time windfall due to IPP renegotiations. Prospects for Tariff Increase - Prospects for a substantial tariff increase are minimal. Immediately after the crisis and the devaluation of the rupiah, the average tariff was about 2.5 cents/kwh. But, due to 10 consecutive quarterly increases, it is now 7 cents and it is unlikely the rate will rise next year (due to elections). Even after the election, it would be difficult to hike the average tariff much more. The Law provides that the tariff in competition areas is to be set by fair competition, 79 and in the noncompetitive areas to be set by the central or provincial governments. In practice, this will be accomplished by putting a levy on the transmission and distribution tariff in the competitive areas, to subsidize the development costs of transmission and distribution in the non-competitive areas. This implies a major cross subsidy in the tariff structure. Further, the tariff structure is distorted in another way, in that the small consumers pay significantly lower tariffs than the average rate (consumers below the 450 VA band in residential areas pay about 3.5 cents, but those above 3.3 KVA band pay about 11 cents). It would be difficult to justify increasing the lower band tariff above 3.5 cents in a country where over 50% of the population of 220 million live on less than US$2 a day. At the same time, to increase the tariff for the higher band users (mainly industries), would push them to self-generation schemes and also may affect their competitiveness. 130 Averting an Infrastructure Crisis: A Framework for Policy and Action

145 Therefore, given (a) the imperative nature of the two cross subsidies for the near-to-medium term, (b) that the 7 cents is more or less at the right level to cover long-run marginal costs, and (c) the political perceptions associated with expensive IPPs and the inefficiency and corruption of PLN, it is difficult to see how the average tariff could be raised significantly (above 7 cents). Background Sector Report I Subsequently, considering the expected tariff limits, PLN s contractual obligation to the IPPs over the next 30 years in dollar-denominated payments, and the increased price of fuel (when the subsidy is fully removed), PLN s contribution from its own resources could not be more than $3 billion between 2004 and 2012, mostly after 2007 if several elements hold together; this contribution will most likely be used mainly for investment in the distribution sector. Multilateral/bilateral funding - It is estimated that multilateral/ bilateral contributions to PLN s capital investments between will be about US$2-US$2.5 billion (this is in addition to what has already been committed); the highest share will come from Japan, followed by the ADB and WBG. Japan s funding is expected to be mainly for generation and some for transmission. The WBG s are expected to fund rural electrification projects through direct loans, and new generation capacity through partial risk or partial credit guarantees. The use of MIGA s political risk guarantees should be encouraged, because they do not create contingent liabilities for the Government. Private investors - The balance of the investments will need to come from the private sector, either domestic or international. The performance of Indonesia s economy over the past few years has been better than expected. Growth has been 3%-4%, the currency has been relatively stable, inflation dropped to about 6%-7% and Moodys and S & P recently raised Indonesia s rating (from B3 to B2, and from B- to B). Nevertheless, the investment climate continues to be weak: Investment in energy is down by about 11%, particularly in the oil and gas sector, and overall, investment licenses issued in 2003 were substantially fewer than in With regard to domestic investors, although the level of domestic savings increased since the crisis and is now 23% of GDP, a figure similar to the East Asian average of 25%, Indonesian capital has not been a major contributor to investment in the energy sector in the past. 80 Reasons include an underdeveloped capital market and a lack of financial instruments the main one is the banking system, which is weak. Therefore, it is estimated that domestic capital will invest only US$1-US$1.5 billion for the period , mostly in partnership with international companies investing in generation. Thus, the lion s share (about US$10-US$11 billion) will have to come from international capital, but two factors prevent the sector from attracting it. First, investors globally have pulled back from the energy sector, and second, they insist on a full Government guarantee, which the Government refuses to provide, in part reflecting its negative experience over the past decade with the independent power producers (IPPs). This gap with investors is further discussed in the sections 6 and 7. Sector Performance Access and Service Coverage In 2001 PLN sold a total 84.5 TWH to some 30 million customers. Java- Madura-Bali (JAMALI) accounted for two-thirds of the customers and slightly over 80% of sales. Residential connections accounted for 93.5% of total customers, with business accounting for 3.9%, industry for 0.2%, and social for the remainder. Although small in terms of customer numbers, industry accounted for 42% of sales while residential customers accounted for 39%. The household electrification rate has increased from 7% in 1980 to its present level of around 57%. Table I.2 provides a comparison of electrification rates in East Asia. The economic crisis caused PLN s sales growth rate to slow significantly, with sales to industrial customers falling in While the industrial sector has since remained in the doldrums, there has been increase in new connections and sales for the business sector. Sales growth in the residential sector has also remained strong at 10% per year. This is more than double the growth rate for new residential connections, suggesting that existing customers are increasing their consumption. Despite financial constraints and a desire to limit the numbers of new connections to low tariff small user categories, PLN has continued to connect over 1 million customers annually. Table I.2: Electrification Rates (%) Country Vietnam Thailand Singapore Philippines Myanmar 10 5 Mongolia China Indonesia Malaysia Cambodia Source: ADB, IEA, Philippines NEA While impressive, PLN s sales growth over the last two decades has been from a low base. Thus while Indonesia s rate of growth in power consumption per capita has been far higher than for regional comparators, its reported 1999 level of 345 kwh per capita per year places it alongside India and within reach of the Philippines but well behind neighbors such as Malaysia and Thailand

146 Electric Power Efficiency In terms of transmission and distribution losses, as well, it has made creditable improvements since the mid-1980s, and while higher than other regional competitors such as China or Korea, Thailand or Malaysia, does better than the Philippines or Vietnam in terms of losses. Over the last three decades Indonesia has allocated considerable resources to its rural electrification program. By end-2000, 98% of villages in Java and 75% of villages off-java were electrified. All Java provinces had village electrification ratios above 95%, while outside Java ten provinces had ratios above 80% and 4 had ratios below 50% (with Papua being the lowest at only 18%). The total number of rural customers was 19.2 million, representing around 75% of PLN s residential customer base. PLN Quality of Service PLN s overall quality of service, as measured in terms of outages and voltage stability, has improved significantly over time but still varies very considerably from region to region. Customers main concern is with power outages, which accounted for one third of all complaints received by PLN during the period The next most significant causes for complaint were errors in meter reading (circa 23%), and delays in making new connections (14%). Voltage fluctuations accounted for a small (5%) but growing proportion of complaints, with many customers reporting consequent damage to household equipment. Quality of service is generally poorer outside JAMALI. In January 2003, PLN listed 14 critical regions as having peak loads significantly in excess of their available generating capacity. These include much of Sumatera, East and West Kalimantan, North Sulawesi and Gorontalo, and West Nusatenggara, with rolling power cuts now being needed in the peak period. Such problems are imminent for several other outer island systems and in many areas, shortage of generation capacity is also compounded by transmission and localized distribution bottlenecks. Indonesia s quality of electricity service in relation to other countries, as indicated by a survey, can be seen in the Table I.3 below. Table I.3. Quality of Electricity Supply (Scale of 1-7), 2002 Country Rating Singapore 6.6 Australia 6.4 Korea (Rep.of) 6.2 Malaysia 5.7 Thailand 5.3 Philippines 3.1 Indonesia 3.4 China 4.6 Viet Nam 3.0 Survey question asked to business leaders: The quality of electricity supply in your country in terms of lack of interruptions and lack of voltage fluctuation is 1-worse than most other countries, 7-equal to the highest in the world Source: World Economic Forum Table I.4. Transmission and Distribution Losses (%) Country Australia China Indonesia Korea, Rep Malaysia Myanmar Philippines Singapore Thailand Vietnam Source: World Bank Tariffs, Subsidies, and Affordability Historically, the setting of tariffs for individual consumer categories was guided by the twin principles that tariffs should be uniform throughout the country and that large consumers should pay higher rates than small consumers. PLN was accordingly required to manage significant crosssubsidies between JAMALI and other island groups and between large and small consumers, but received no explicit subsidies from Government. 82 Until the early 1990s, the basic electricity tariff (TDL) was reviewed every two or three years with the resultant increases being large and sometimes creating social unrest. In 1994 the average tariff was increased to approximately US 7 cents per kwh and an automatic tariff adjustment mechanism established to maintain its real value relative to PLN s costs. This provided for quarterly adjustments to be made by the Minister on the basis of changes in the consumer price index, costs of primary energy, costs of power purchases, and the Rupiah to US$ exchange rate. This mechanism worked reasonably well through to the start of the crisis when the magnitude of the needed quarterly adjustments caused it to be suspended. The Rupiah s sharp depreciation caused the average retail tariff to fall from close to US 7 cents in mid-1997 to below US 2 cents in 1998 and left PLN unable to meet its payment obligations. Government agreed to suspend debt service payments on on-lent loans and to provide cash flow support to enable essential payments to be made. As part of the adopted sector recovery strategy, it committed to restoring the tariff to US 7 cents per kwh by The 6% per quarter increases approved for 2003 coupled with increases in previous years put this target within easy reach. 83 The burden of higher tariffs fell initially on large and medium consumers, but rates for smaller consumers will increase during While cash flow support has ceased, 132 Averting an Infrastructure Crisis: A Framework for Policy and Action

147 Government is now providing explicit targeted subsidies for very small consumers with connections not exceeding 450VA. The amount of the subsidy is calculated as the difference between the cost of supplying these consumers and the revenues received from them. 84 Government proposes to reintroduce automatic adjustment once tariffs have reached their economic level. 85 Background Sector Report I At present, Indonesia s average tariff is relatively blow compared with other countries in the region, but by the end of the year it should be broadly in line with levels in Malaysia, Thailand and China. The average tariff disguises considerable variation in the rates for different consumer categories. At one end of the range, a small residential consumer with a 450VA connection and a consumption of 50kWh per month currently pays around Rp. 16,000 per month or US 3.5 cents per kwh. At the other, a large residential consumer with a connected capacity of 16,500VA and monthly consumption of 2,000 kwh currently pays the equivalent of around US 10.1 cents per kwh. 86 Recent information indicates that small customers have tended to increase their electricity consumption in the wake of the crisis while at the same time spending a smaller proportion of their total household expenditure on power. For many prospective electricity consumers, the level of monthly payments is of lesser concern than the cost of securing a connection, which for a 450 VA connection could be more than the cost of a full year s electricity usage. Main Sector Issues The ultimate soundness of a power sector is measured by its ability to supply electricity to all customers reliably and efficiently. In the case of Indonesia, the sector also needs to expand power rapidly to the remaining 40% of the population without it. This is imperative, for the obvious reasons that the cost of frequent or long-lasting interruptions to supply is huge, the system s inefficiencies take a heavy toll on consumers and/or public resources, and lack of service to nearly half the population carries high economic costs, particularly for the poor, who represent 90 % of the unserved. Despite the Government s commendable efforts over the past few years which have resolved some of the key sector issues (a modern electricity law was passed, implementing regulations were prepared, tariffs were increased substantially, and contentious issues with the Independent Power Producers have been settled), Indonesia s power sector at this juncture can still make significant strides in all three areas reliability, efficiency and access. 133

148 Electric Power Reliability Although it is difficult to assess the reliability of Indonesia s power system without a more accurate definition for reliability, it can be said that the reliability at this juncture is borderline. That is, while the economy will not slow to any great degree or grind to a halt due to power supply interruptions, the system would surely benefit from a comfortable, safe margin of reliability. This assessment is based on an evaluation of how the system will function as demand increases in relation to maximum available system capacity as well as available and targeted capacity margin. Indonesia s sporadic power shortages will persist, particularly in the outer islands and, during peak period, in distant residential suburbs but major, long duration blackouts are not imminent unless investment halts completely over the next three-four years (which is unlikely). However, even sporadic interruptions have substantial accumulated economic costs; and, if the country is to avoid them and, particularly potentially higher costs in future, it must resolve the reliability issue, now. Three possible areas from which future interruptions could stem are (a) operating and maintenance practices and budgetary problems; (b) organizational and sectoral changes; and (c) inadequate physical infrastructure. With PLN, operating and maintenance practices and related budgetary issues would be an unlikely source of major interruptions, since its staff have many years experience operating and maintaining the generation plants, transmission system and distribution network, and have done so relatively competently and effectively. Further, despite PLN s financial problems, the core budget for O&M has always been protected, both by PLN and the Government. In fact, PLN managed to continue the electricity supply even during the difficult period following the 1997 economic crisis. Organizational and structural changes to PLN and the sector except for the possible impact of the decentralization discussed below would also be unlikely sources; under almost all scenarios, a PLN will continue to exist in some form for the next decade or so. Further, the structure that probably will be fashioned over the next 8-10 years is that of a quasi single-buyer model (SBM), a rough proxy of the current structure. However, as decentralization evolves, it could cause localized supply problems in the context of the new electricity law. Until the new law was passed, PLN was expected to meet the Government s electrification targets. With the new law, some responsibility for power supply will pass to provincial governments, kabupatens, private companies, and even community-based cooperatives, and licenses for non-competition areas including off-grid electricity power will be issued by local mayors or governors. At present, no clear implementing regulations nor a comprehensive rural energy strategy exist to adopt the changes in areas where it is uneconomic for PLN to extend the network. Therefore, this is a potential supply problem. However, it would be limited to specific geographic areas, and only be of concern until the Government applies a mechanism to support decentralized power provision and defines the sector structure outside the Java-Bali area. In this respect, the Government is encouraged to move rapidly on both fronts: issuing the implementing regulations and formally adopting a policy for operations outside the Java Bali power sector structure. Thus, the area with the most potential for causing major power interruptions is inadequate/insufficient physical infrastructure. Thus, to the extent that Indonesia will be able to raise the funds to meet existing needs and growth in demand will determine whether it will experience blackouts. An additional threat to increasing reliability is the constraint on delivery of natural gas to the power sector. An issue related to the adequate level of infrastructure in Indonesia s power sector is the country s substantial capacity of CPPs. While theoretically it is possible to supplement the country s electricity supply significantly and do much to relieve the potential power shortages through using captive power, a closer look reveals that the CPPs structure and the unwillingness of the CPP owners to participate in electricity business effectively limit CPPs contributions to the country s grid supply (see Box I.2). 87 Securing the Financing to Meet Demand PLN s Finances - Although PLN has recently made great strides in improving its finances, it is still in a precarious financial state and several elements must hold together for it to start earning a 5-6% rate of return by 2005/2006 and to make significant contributions towards investment needs of the sector. As described in section 4, many of the recent improvements are due to one time actions rather than a change in business fundamentals. PLN must continue with the implementation of its Efficiency Drive Program to improve its finances, and the Government needs to reinstate the automatic tariff adjustment formula to prevent the tariff from sliding back again. Private Investment Gap - The majority of investment financing (about US$10 billion) will have to come from international capital. However, investors globally have pulled back from the energy sector. They insist on a full Government guarantee, which the Government refuses to provide, in part reflecting its negative experience over the past decade with the independent power producers (IPPs). 88 Clearly, these two positions present obstacles to investment in the sector. For example, there is no indication that the private sector is willing to invest in Indonesia in a major way without a Government guarantee. Also, it would be difficult for the Government to justify a full faith and credit guarantee to the private sector to supply power to a viable market, given the negative effects of past guarantees (see box below). To break this impasse, Indonesia must develop a new framework for sharing the risks. Constraints on Natural Gas It is expected that the use of oil in the power sector will gradually decline to about half its current level by 2010 because (a) Indonesia will be a net importer of oil by 2010 and (b) subsidies of petroleum products will be fully phased out (this has and will increase PLN s fuel costs substantially). As the oil consumption in the power sector declines, coal and natural gas consumption will rise. Indonesia, which is the third largest exporter of coal, will have an ample supply for domestic use, as long as PLN pays competitive prices to obtain it. Natural gas, on the other hand, poses a more difficult scenario. 134 Averting an Infrastructure Crisis: A Framework for Policy and Action

149 Box I.2. What About Using Captive Power to Increase Reliability? In 1998, the Bank conducted a preliminary survey, using the information from DGEEU, PLN and BPS regarding captive power. After making some statistical adjustments, it concluded that the country s total CP installed capacity was about MW (representing 40% of the country s total installed capacity at the time), and that the plants generated 39,000 GWh (representing about 35% of the country s electricity generation). It is estimated that the installed capacity of CPPs in 2003 had reached to about MW, generating about GWh electricity. With respect to type of plant, diesel-driven CPPs represented about 60% of installed capacity and 42% of the electricity the plants generate. Steam plants represent 22% and 29% respectively, followed by gas turbines (11% and 17%), and hydro plants (6% and 11%). Co-generation plants represent about 25% of the CP installed capacity. About 35% of CPPs are connected to the PLN grid and 65% are not. Manufacturing uses about 75% of the power the CPPs produce, followed by oil and gas (17%), mining (6%) and commerce (2%). Within manufacturing, the paper industry uses the highest share 20% of the capacity. By any measure, this amount could theoretically be a major source of electricity supply. However, a closer look at the CPPs structure regarding the type of plants (ie., diesel, steam, gas and hydro), the type of fuel used (ie., oil, gas or coal), and the type of service performed (ie., whether they are the main or supplemental source or power, or if they are of co-generation type) presents major technical and business-philosophy issues that severely limit (a) the extent that CPPs can be expected to supply power to a national grid (ie., CPPs selling power to PLN through its grid system, or selling power to a third party, either through PLN s system or through an independent transmission line); and (b) the degree to which the CPP owners wish to be involved in such activities. Until now, the CPPs contribution to grid supply been negligible (i.e., less than 1% of the total CPP generation). Several factors have contributed to this limitation: First, excess capacity mostly exists in the diesel plants which are mostly small units but collectively they represent about 60% of the CPP s installed capacity. Such excess capacities do not insure that these small plants are appropriate sources for a major grid. In many cases, economies of scale are an issue. Further, the electricity supply needs to be stable with respect to its quality and quantity, and subject to appropriate regulations. While some of these plants may indeed produce excess power, it may not be available on a regular basis, or may not be economic. Second, in the Bank s survey, numerous CPP owners said they were unwilling to supply power to the PLN, mainly because they did not want to lose focus from their primary business; nor did they want to be responsible for what they considered cumbersome procedures for billing and other aspects. Given the first and the second above, many of the smaller diesel plants can be eliminated as potential suppliers, although as noted above they represent over 60% of the CPPs installed capacity. Third, while it would thus appear that the larger CPPs (steam plants, gas turbines, hydro plants) meet many of the qualifications to sell excess electricity to the grid (i.e., relative size, reliability, cost effectiveness and ability to adhere to regulations), there are again serious limitations. For example, while two large hydro-based plants produce substantial power, given their high utilization factor, there is virtually no excess capacity that could produce electricity to sell to a grid. As for plants run by gas turbines, over 50% are in the oil and gas sector, which again have very little excess capacity. With regard to large steam plants, while they have potential for excess capacity, given that they are mostly of cogeneration type, the production of electricity is a function of the production of heat. Finally, there is an issue with PLN s willingness to buy power from the CPPs, possibly with the objective of taking over some of the CPPs. However, Bank s analysis indicates that there is a considerable limitation to the number of the CPPs that can be taken over by PLN. Therefore, the main conclusion that emerges from these statistics is that the quantity of electricity that can be sold by the CPPs to the grid is significantly less than would at first appear possible; namely, estimated about 1,000MW supply to the grid, under optimal condition. Background Sector Report The main issue is the availability of natural gas because although the country has large reserves 50 years proven, based on current levels of production its use in the domestic market has been constrained due to several factors: (a) the flawed price structure for natural gas, (b) the inadequacy of laws governing natural gas production until now, and in that context, the role of Pertamina which was an inefficient monopoly and negatively affected the upstream gas industry until about two years ago when the new law was passed, (c) the vertically integrated structure of the downstream gas industry which worked against greater private sector participation until recently, and (d) due to all these, the infrastructure needed to support a fully developed gas market was never built. 89 Efficiency The issue of efficiency is somewhat less complicated than reliability; ample room exists for PLN and the sector to improve efficiency as is also the case with other utilities in the region. Broadly, the issue of efficiency involves PLN s operations and the sector s structure. PLN Operations While it is difficult to fully separate whether inefficiencies stem from PLN s practices or Government actions/policies, based on past reviews by PLN s consultants, some features can be described. For example, PLN is following best practices with regard to its collections, asset loading, on-line monitoring, overhead line maintenance, and employee training. However, several important areas can be improved, such as its planning, procurement and implementation for capital investments. According to its consultants report, of its average investment from (before the crisis) of about US$3.5-US$4 billion a year, opportunities existed to save up to 40% of the total through better planning and evaluation, better timing of the use of funds, and avoiding cost over-runs and delays. However, only half of these lost opportunities were under PLN s control (the rest were controlled by other stakeholders). Nonetheless, PLN s share of inefficiencies according to the report amounted to some US$600- US$800 million a year. In response to the consultants report, PLN began an Efficiency Drive Program about three years ago to review most of its operations and take steps to improve efficiency. Unfortunately, it is difficult to measure the extent to which PLN has succeeded with the program, since, after the crisis, capital investments were substantially reduced. At the least, however, it would be useful if PLN could quantify the achievements to date, and offer a timeframe for addressing and resolving the remaining issues. I 135

150 Electric Power Sector Structure Much has been written about restructuring and reforming the power sector globally to enhance efficiency and promote private sector development. In Box I.3. Indonesia IPP Debacle During the 1990s, escalating electricity demand and limited public resources throughout East Asia left many countries little choice but to invite foreign investment in power plants. While the programs brought positive results by reducing (or in some cases eliminating) power shortages, and while it is difficult to quantify the cost of power shortages had the IPP programs not been implemented, they also created serious problems that were exacerbated by the regional crisis. (a) In some countries, costly power shortages were reduced, but in many cases more capacity was added than was needed, and some corruptly benefited from lucrative transactions. (b) Governments often protected the IPPs against market risks (and sometimes fuel supply risks) through long-term take-or-pay contracts, thereby creating huge contingent liabilities for the countries, particularly since the currency risks were often covered by indexing power purchase prices to hard currencies. (c) While subsidies for capital costs were reduced, the IPPs sometimes increased the State-owned utilities supply costs, often through uncompetitive bidding practices. (d) Although IPP programs were intended to break up sector monopolies, the terms of their power-purchase-agreements (PPAs) often created rigidities that caused the systems to operate inefficiently and complicated the sector s further liberalization. These issues were particularly pronounced in Indonesia, where 26 primarily US$-denominated PPAs were signed between the IPP sponsors and PLN for about US$18 billion, which added roughly 11,000 MW of capacity. Funds for these IPPs were secured from international sources, but predominantly from unsolicited proposals. Although the Government did not issue explicit guarantees, letter of supports were given to the IPPs through which the Ministry of Finance (MOF) or the Ministry of Mines and Energy (MEMR)required PLN to perform its obligations. As the result of the crisis and devaluation of the rupiah, the Government faced with huge debt postponed some IPP projects and directed PLN to reimburse only part of its obligations to the operating IPPs. Investor response was mixed, depending on whether each took a short or long-term view of its involvement; in the most extreme cases, the Government was sued and in one, an international arbitration panel ruled in favor of the IPP. The Government has settled or renegotiated all the disputes with the IPPs, excluding the case mentioned above, and has done a commendable job keeping its commitment and protecting the contracts. However, at least two aspects of the agreements have created serious problems - (a) They have produced a huge contingent liability for the Government and (b) the PPAs have captured, for the next 30 years, a sizeable share of the power market under a set tariff and dispatchability level which heavily affects the future market. the region, Indonesia s power sector has been one of the most analyzed. Based on those analyses, it is clear that reform strategies must be tailored to each country s unique conditions. In Indonesia, the task is complex and will require substantial time, given the sector s precarious finances, the newness of the law and regulations and the problems created by the existing IPPs, which restrict the reforms that can be adopted. Any sector restructuring will have to be consistent with the recent law and the soon-to-be issued regulations, and take into account the (a) present direction of PLN s organization; (b) PLN s finances and the sector s financial viability; (c) validity of existing IPP s contracts; and (d) geographical features with respect to Java Bali and outside the area. (see VII.2.b for more detailed discussion). Access Overall, the country s rate of electrification is about 57%, which means some 90 million people still do not have access to power. This rate is lower than the world average (74%), and even less than that of developing countries (65%). Per capita annual consumption, of 380 kwh, is among the lowest in the region and the share of biomass use in total energy is about 32%, one of the region s highest. Although this low rate of electrification is a major issue and calls for a more accelerated plan to expand the residential supply, meeting the demand of the remaining unserved population in Indonesia will be difficult largely due to the country s geography and the location of the rural population. As of September 2003, PLN had 29.6 million residential customers, of which 70% were in Java-Bali. Almost 80% of the electricity sold is consumed in Java-Bali, with the industrial sector accounting for 42% of the total, residential 40%, commercial 13%, and the public sector 5%. However, about two-thirds of the population without power live in rural areas, and 65% of these are outside Java-Bali. The cost of connecting this group is, on average, about 33% higher than connecting residents inside Java-Bali. In fact, this estimate is low, since it is based on (a) an average cost that combines rural and urban connections and (b) rural areas that are accessible and already served by PLN. However, in a country with roughly 15,000 islands and a length and width of 5,000 and 1,800 kilometers, the cost of supplying power to outlying rural areas, particularly the remote islands, is much higher: In Java Bali, power is generated by larger and more efficient base-load power plants, transmitted through high voltage backbone transmission grids and distributed through a well-developed distribution sector which reduces losses. In the outer islands, however, the grids use lower transmission voltages and are powered from much smaller generation plants, which causes higher losses. In Java Bali, where over 96% of the villages are already electrified, connecting those without power mainly involves intensification, which means expanding within the existing supply and distribution network. As the result, the pace of electrification is much faster: If PLN (or its successor) continues connections at the present pace, Java-Bali s electrification rate will approach 95%-98% in about years. However, outside Java- Bali, where only about 70% of villages are electrified, the task will take significantly longer. Thus, it is expected the country s overall electrification will not approach 100% any time in the near future. 136 Averting an Infrastructure Crisis: A Framework for Policy and Action

151 The Way Forward The most pressing issue is for the Government to promulgate the implementing regulations for the 2002 Electricity Law, since these are key to resolving most pending issues. The draft has been in an advanced stage for over a year. While all eight regulations need to be promulgated in the near future, the most critical are those that establish the regulatory agency (Electricity Market Supervisory Agency EMSA), set tariffs and adopt licensing procedures. Only after implementation of Law 20/2002 will significant progress be made towards increasing reliability, efficiency, and access. Increase Reliability Securing Financing to Meet Demand Improve the tariff structure. With regard to tariffs, the Government is encouraged to (a) issue the necessary regulation for setting the rates; (b) develop and issue an unambiguous and quantifiable definition of economic value including a definition of fair return; (c) develop an automatic price adjustment formula and set a firm date for applying it; (d) issue a regulation on the context and application mechanism for the cross subsidy (levy) between the competitive and non-competitive markets; and (e) better articulate its policy with regard to cross subsidies between the high/medium voltage and the low voltage consumers, in terms of a more permanent mechanism to handle this cross subsidy and/or timeframe to phase it out. Close the gap with private investors. The first step to address the issue is to obtain a more accurate understanding of the investors expectations with regard to the risks and risk-sharing. The ongoing initiative by the three multilateral institutions (WBG, ADB and JBIC) and the Government s agreement to hold stakeholder consultation meetings will offer an appropriate initial forum for the Government to better articulate its achievements thus far and its commitment to further sector reform. It will also offer different types of investors the opportunity to express their expectations and underlying concerns. Since the meetings will occur in the presence of the three largest lenders, this will offer an element of impartiality that will help all involved to pinpoint the most important problems and find ways to resolve them. For its part, the Government also needs to expedite the promulgation of the regulations, create a regulatory agency and provide a clear signal on the future direction of the sector structure; these actions are prerequisites to viable and active private sector involvement. By doing so, the Government will substantially reduce the price the investors put on the risk package. In 2003, the contingent liability of the power sector alone was about US$ 14 billion; in fact, the figure could be much higher when the entire performance of the IPPs for the duration of the 30-year contract is taken into account. As mentioned above, MOF and MEMR issued letters of support to the IPPs that cause PLN to perform its obligation under the agreement through which all capacity payments must be in foreign exchange, and, in most cases, US dollars. While these letters appear to have created implicit contingent liability (as opposed to explicit), the arbitration court found the lines between implicit and explicit to be blurred, and ruled that the Government was liable under the contract. Background Sector Report The lack of explicit contractual obligations associated with contingent liability (i.e., an event which may or may not happen), makes its treatment on government balance sheets very difficult. As in many countries, Indonesia has not adopted a clear standard or appropriate methodology on how to treat contingent liabilities in its national accounting system. Ways do exist to account for these liabilities in the budget, although describing them is outside the scope of this report. Thus, for the purpose of this discussion, Indonesia s priority should be to minimize future contingent liability by unbundling the risks the Government assumes, and by devising mechanisms by which some of those risks will gradually (upon improvement of the country s performance) shift to the private sector. Not only would this lower the Government s contingent liability, but it would also provide a standard through which incorporating it in the Government s books can be facilitated. The crux is unbundling and reallocating some of the risk. To do so, the country could follow the approach the Bank has recommended in other countries. For example, Indonesia could provide guarantees that protect the investors rights (such as against expropriation) and assure that basic rules upon which the viability of a project depends will not be arbitrarily changed. In addition, it could guarantee the foreign exchange convertability and transfer risks, although it could charge a fee for this (the fee could gradually increase as the Government s credit rating improves). However, market and fuel supply risks should form an integral part of the project agreement say, between PLN and the project sponsors and such an agreement should be drawn strictly on a commercial basis. Nonetheless, after carefully assessing the market, the Government could also consider offering added incentives during the early years of credit-building, by agreeing to guarantee the amount that may be awarded to the project sponsors pursuant to arbitration under the project agreement. This, as with the foreign exchange guarantee, could be phased out once the country meets certain credit thresholds. In other words, the Government should offer performance guarantees when needed to overcome perceived country risk problems (associated with the projects), but not for risks that are purely commercial. Removing Constraints on Natural Gas Delivery Indonesia needs to devise a coherent and market-integrated strategy for developing its gas sector. Such a strategy must address the problems noted in section 6, as well as establish a sustainable structure for delivering gas to the power sector, given the critical role of this fuel due to its substantial economic and environmental benefits in power generation. A key prerequisite for economic utilization of gas is for the Government to promulgate the necessary regulations associated with the new oil and gas law, along with Pertamina s changed role and functions. Lacking such regulations, gas development and utilization will be severely hampered, given the size of the sector investment requirements and the need for private sector participation. I 137

152 Electric Power Adopting and implementing a rational gas pricing policy is the most critical factor in mobilizing natural gas. Until now, the domestic price of natural gas in Indonesia has been problematic. The price of some of the energy products for which the gas could substitute are too low for gas to be competitive. At the same time, the price at which natural gas is sold to consumers is below its economic value (ie., netback value), which means producers have little interest in developing this resource. A rough estimate indicates that the average (economic) cost of supplying natural gas in Indonesia ranges from US$1.90-US$2.25 per mmbtu, while its weighted average wholesale price is about US$2 per mmbtu. Conversely, the economic value of gas on average is estimated at US$3.00-US$3.75 per mmbtu. Under such a cost-value price structure, (a) the selling price of gas to some consumers is lower than its cost of supply while to others it barely covers the costs, and (b) a substantial amount of economic rent to the Government (the difference between the cost of supply and the netback value) is unrealized. Further, despite Indonesia s relatively large gas resources, it should not be considered a gas surplus country, particularly given East Asian countries appetite for LNG. To redress this, the cost of supplying gas, in addition to the average incremental cost of production and transport, should include an appropriate amount for the depletion premium. When the total cost of gas supply is compared to the current weighted average wholesale price of natural gas and the netback value of gas, major distortions clearly exist. These have slowed the growth of the gas industry and are a disincentive for producers to supply gas to the domestic market. At present, PLN pays an average of about US$2.50 per mmbtu for its gas supply, including the cost of pipeline transmission. This is substantially below the economic value of gas in the power sector (i.e.,us$3.00-us$3.75 per mmbtu), where natural gas achieves its highest economic value when used as fuel to generate electricity. Although because of this under-pricing PLN currently benefits, even if PLN were to pay the full economic value of gas for its supply, the cost to PLN would still be less than that of internationally-priced diesel oil which is currently consumed by PLN. Therefore, PLN suffers from the fact that the existing price distortions limit the amount of gas that is being produced. This cost (to PLN) is substantial, representing the difference between the price PLN pays for diesel oil and what it would pay for natural gas, if it was available. Given PLN s difficult financial condition, the limits on tariff increases, and the sector s large investment needs, such saving would go far to resolving some severe financial problems. Increase Efficiency PLN Operations PLN must update its achievements thus far in implementing the Efficiency Drive Program, describing its accomplishments up to now and the timeframe for resolving remaining issues identified by its consultants, in a format that can be quantified and monitored. 138 Averting an Infrastructure Crisis: A Framework for Policy and Action

153 Sector Structure Broadly, two alternatives can be envisioned for the sector s structure: The single-buyer model (SBM), or multi-buyer, multi-seller (MBMS) model, with the possibility of an interim wholesale competition (WSC). An extensive body of information exists on these alternatives, in general, and several studies are available specifically on Indonesia. Since PLN consultants have already analyzed the pros and cons of the two in the Indonesian context, this report does not cover the merits of the two. Instead, it describes the law s provisions with respect to the two models, the main issues that need to be addressed or steps taken to move towards one or the other, and the time required to move to a functioning MBMS market. The recent Law is dormant on the issue of SBM. It provides that within a maximum period of five years, there shall be the region applying competition limited to the generation aspects. But Article 15 states the designation of region applying competition should be conducted gradually under a government regulation, and then lists eight requirements for designating the region in which to adopt electricity competition. These requirements include tariffs reaching their economic value, the condition of a system that allows the application of competition, competition of primary energy sources, preparation of rules required in the application of competition, and the necessary infrastructure. Analyzing the above requirements, serious obstacles must be overcome if competition of the sort envisioned in the MBMS model is to develop in a major region say, in the Java-Bali system. These include; Implementing Regulations. The top priority is for the sector to establish the regulatory agency (EMSA), which can issue the regulations needed and build the capacity of the EMSA and its staff. While the recent law provides a broad framework for the sector to operate competitively, it leaves important gaps that must be addressed by the regulator. Such gaps include for the EMSA to (1) finalize decisions on licensing, to create businesses involving generation, transmission, distribution, Sales Enterprise, Sales Agents, Market operators and System operators in the areas subject to competition ; (2) issue licenses to captive power owners that want to sell their excess electricity; (3) supervise the electricity sale price for generation, as well as for high and medium voltage customers; (4) determine the electricity price for low voltage customers, as it does for transmission/distribution grid prices (i.e., wheeling charges), and (5) supervise or establish safeguards and safety regulations. The required regulations need to be unambiguous, be flexible enough to deflect and/or incorporate external market changes and tested under different sensitivities. Since it takes quite a while to incorporate regulations, the effort should begin as soon as possible. PLN s corporate restructuring. The plan should be finalized and the final draft should be discussed/agreed with the main players. Sensitive issues such as the number of generation companies, as well as the extent of separation/integration of functions such as transmission, System and Market operations need to be clearly defined. Further, PLN s role outside Java-Bali must be determined. Tariffs and primary fuel. Some of these involve (1) more precisely defining their economic value (as stated in the law), (2) applying the automatic adjustment formula, and (3) determining the mechanism for Background Sector Report applying/implementing subsidies. Liberalizing primary fuel prices, particularly rationalizing the price of natural gas, is closely related. The IPPs. If Indonesia s electricity market is to be genuinely competitive, a plan must be developed to integrate existing IPPs into the market. As discussed earlier, this task is difficult since existing IPPs have long-term contracts (eg. 30 years) that often include minimum prices and minimum capacity (to be used) requirements. Under these conditions, options are limited, since the Government should not force the IPPs to integrate, as this would negatively affect its credibility. Thus, possibilities include voluntary renegotiation or buyouts, and parallel IPP trading (in the latter case, until market prices are more attractive than those stated in the PPA contracts). Since Indonesia s supply will be limited at least in the short and medium term, integration presents less of an issue, and plans can be designed that will smoothly integrate the IPPs into the sector (at present, PLN has established an IPP Trade unit at its headquarter). Stranded costs. In principle, these are the costs which exceeds the market price and which cannot be recovered in the sales of the assets. This issue has received considerable attention, particularly in the US, but in Indonesia it is less a problem given the high growth forecast and need for additional generation capacity. However, some stranded costs are inevitable in any industry when the regulatory environment changes; in such cases, partial or full compensation is normal practice when monopolies are thrust into a competitive market. These costs can be passed along to consumers as a transition charge or competition transition charge (CTC), or recovered by a utility through direct Government funding or deferred taxes. To the extent that the future market value of electricity will exceed the prices stipulated in the existing PPA, the sunk costs are reduced. Although the issue of stranded cost is prima facie less a problem, nonetheless, it must be carefully analyzed and dealt with. It should be noted that the stranded costs are easier to absorb under the SBM model, where costs can be passed on to consumers transparently. Therefore, on the question of which model is more appropriate for Indonesia, it is difficult to see how the number of requirements stated above for an MBMS model can be met in the immediate future. Further, during the initial years, extensive and complicated regulations will be needed. While these obstacles shift the argument and the choice in favor of an SBM, there are several disadvantages to the SBM which must be noted: (a) it does not provide opportunities for competition in transmission and distribution; (b) most PPA agreements give limited incentives to plant owners to improve efficiency, and the costs of uneconomic plants tend to be passed on to consumers; and (c) under a SBM, and given the fragility of PLN s financial situations, private investments in generation are unlikely to be forthcoming without explicit or implicit payments guarantees by the I 139

154 Electric Power Government; and (d) prices under SBM are mostly from the supply side. Still, the model has three key advantages which, given current conditions, provides a practical approach that will more likely promote a competitive market: (a) under the SBM, generation plants are procured through competition and generation investment costs (which are significant) can be reduced substantially; (b) stranded and social costs are less problematic and more transparent, as they are passed on to consumers; and (c) it is much simpler to administer. In selecting an approach to the next phase of the power market structure, considerations must be given to the (a) law, (b) new regulations and the shape/role of the regulatory agency, (c) existence of substantial IPP capacity with long-term contracts, (d) PLN s precarious finances (e) tariff limits (f) inevitability of cross subsidies, (g) urgently needed infrastructure and (h) bottlenecks in existing facilities. When all these issues are considered, they collectively set a path which begins defacto with a quasi-sbm model (due to the needs of existing operations), and ends with an MBMS market, with an interim option of a wholesale competition market. 90 A critical issue is the time needed to move from the structure of the existing sector to a fully functioning SBM, through a possible WSC model, and ultimately to an MBMS. It should be noted that although a quasi-sbm model has already emerged, still regulations must be issued and the regulatory agency must be functioning in order to establish an effective SBM since SBM will have to be regulated with respect to bulk supply tariffs and least-cost solutions for transmission/generation. Once a fully functional SBM is established and operating for several years, the sector could experiment with a small-scale MBMS model (say, in Batam), and then gradually develop a more complex one. In the meantime, PLN will need to aggressively improve its efficiency, and fully unbundle/corporatize its functions. Clearly, a trade-off exists with respect to the timeframe involved to arrive at a MBMS market. If the Government moves too rapidly, it runs the risk of by-passing pivotal issues that must be resolved in order to achieve a smoothly-functioning competitive market. However, the sooner the Government has a fully competitive market in place, the sooner it will eliminate the burden of covering the costs for a sector that operates in the red (particularly given the huge investment needs over the next years and PLN s precarious finances), bring increased competitive pressure to bear on operators to improve efficiency, and reduce or eliminate it ongoing contingent liabilities. The pace of reform can indeed be accelerated. As stated earlier, the most crucial step is establishing the regulatory agency and promulgating the rules. Equally important, the southern 500kV transmission line which is backbone for transporting power from east to west must be completed. While the Government should continue rationalizing tariffs and subsidies, liberalizing primary fuel prices and integrating the IPPs into the market, these measures can be introduced at the same time as it moves towards an MBMS market. Further, while the law provides that within a minimum period of 5 years there shall be a region applying competition limited to the generation aspects, the elucidation also provides that if no such region exists, the EMSA must take the required steps, including preparing market rules, grid codes, distribution codes and tariff codes. Further, the law states that until EMSA is established, the Government must assume the tasks of regulating and supervising the sector, as well as pave the way for competition. Thus, the law provides a tool for the Government to begin implementing actions now, and to establish an MBMS market and competitive conditions by Still, it could take much longer, depending on the pace at which the Government moves. While all steps towards an MBMS need to be deliberated, the Government will surely benefit if it keeps the timeframe relatively short, to reap the benefits of increased competition and lessen the fiscal burden and contingent liabilities, as mentioned earlier. Increase Access While a detailed discussion of options to accelerate electrification is outside this report, it should be noted that expanding power to rural areas outside Java Bali (and to some within Java-Bali), need and should not rely entirely on PLN s grid connections. Instead, a clear power sector structure for outside Java Bali and regulations for grid and tariff codes, along with the recent decentralization laws, will provide a rich menu of options to accelerate electrification, including schemes for local participation and village/province cooperatives. To assess these options, a rural electrification strategy is needed that will establish optimal schemes and targets, particularly for areas that cannot be supplied through grids for many years. Also, it should include options for involving captive power and cogeneration plants, along with small producers willing to sell power to PLN through its regional grid, as well as developing renewable energy resources (within the framework of a least-cost rural electrification strategy), particularly mini-hydro and small biomass plants. One should not overlook the fact that direct competition is eminently feasible and very beneficial between small scale, sometimes informal, providers in almost all infrastructure sectors. The Government should take steps, when needed, to ensure that such competitive pressures are maximized. For example, an appropriate framework should be established to enable self generating and small electricity producers to distribute electricity directly to the third parties, and to sell electricity to PLN or to gain non-discriminatory access to PLN s grid to deliver power to other customers, as the producers choose. To achieve these aims, the Government must (a) decide on the nature of the power sector structure outside Java Bali, (b) clarify the regulatory framework and regulations under which the sector will operate, particularly the basis for transmission/sub-transmission charges and (c) develop a more detailed implementation plan for the two existing subsidies (to low-voltage users and those across regions). 140 Averting an Infrastructure Crisis: A Framework for Policy and Action

155 Table I.5. The Way Forward Steps for the Short Term (0-2 years) Steps for the Medium Term(up to 5 years) Reliability Issue the implementing regulations for Law 20/2002 Issue implementing regulations related to the 2001 Oil and Gas Law Improve power tariff structure Adopt rational pricing policy for natural gas Develop investment plan Complete negotiations of IPPs, settle litigation with Kahara Bodas, and assess lessons Consult with private sector to close gap with private investors Unbundle risks associated with future PPAs and devise policy on contingent liability accounting Integrate the CPPs into the national power system Efficiency Issue the implementing Establish effective SBM and regulations for Law 20/2002 regulations to support it on Update efficiency drive Java Bali program, quantify achievements and plan to address the remaining issues Address obstacles to competition (establish EMSA, rationalize the tariff structure, finalize PLN corporate restructuring, and develop plan to integrate IPPs into market) Complete southern 500 kv transmission line Access Decide on the final structure of the sector outside Java Bali Prepare rural electrification strategy Take steps to liberalize market for self-generators and other small electricity producers Background Sector Report I 141

156 Annex I.1 Cost Benefit Analysis Electric Power This annex provides an estimate of the benefits of investing in the electricity sector of Indonesia. Such benefits arise mainly in two forms: (i) as avoided costs of electricity interruptions for customers already connected to the power grid (industrial, commercial, residential), and (ii) as welfare benefits for new customers that could with further system expansion become connected to the grid and enjoy electricity services. Aggregate estimates of such benefits are subject to the uncertainties of statistical averaging of a broad range of costs, perceptions of costs, and limited information on customers willingness and ability to pay. Nevertheless, conservative estimates for electricity shortages only are at a level of about 0.15% of GDP, while a figure of 0.8% of GDP is not unreasonable. Moreover, such electricity interruption costs are sensitive to system reliability, which in turn is directly related to overall investments in the sector. Should investments in the sector not keep up with the rate of growth of projected electricity demand, system reliability is bound to deteriorate resulting in considerable costs that will likely impact adversely the country s investment climate and macroeconomic condition. Introduction Electricity use correlates strongly with economic activity. Benefits from electricity use in the various sectors of the economy (industrial, commercial, agricultural) are a result of improved productivity through the use of advanced technology and machinery that require electricity. Indeed, higher value economic activities need ample and reliable electricity supply. In the residential sector, welfare benefits from electricity stem from reduced costs of supplying lighting, heating and cooling services, time-savings for household chores, and enhanced opportunities for education, communication and leisure time activities. In the same manner, the lack of electricity increases unit production costs across the economy (thereby negatively affecting overall investment opportunities) and reduces overall social welfare. This annex will provide a range of estimates for the benefits of electricity use in Indonesia, by investigating its effect to connected and yet un-connected users. Electricity demand in Indonesia has been growing at 10-12% in most of the past years, and is expected to continue to expand, at average annual levels of 5-8 % or more. However, if available supplies fail to meet the demand, costs to the economy are incurred across sectors. To evaluate these costs the industrial, commercial and residential sectors already connected to the electricity network will be firstly examined. Then the costs of not providing electricity to consumers who are not yet connected to the grid, but nevertheless incur costs for services that could be provided more efficiently with electricity, will be estimated. To estimate electricity benefits, both a macroeconomic (top-down) approach and a microeconomic (bottom-up) approach will be employed. A brief review of the methodologies will be presented and available data from a previous detailed study of the industrial sector in Indonesia will be contrasted with a number of results from different studies across countries. A range of estimates will be thus calculated to summarize the expected benefits of electricity provision in the country. It should be emphasized that in part II of the following analysis the amount of investments necessary to achieve benefits of avoided electricity outages is not explicitly addressed. This is because an accurate evaluation of such investments requires detailed least-cost electricity planning 142 Averting an Infrastructure Crisis: A Framework for Policy and Action

157 studies to optimize the system in terms of generation, transmission and distribution. Such a detailed analysis is beyond the scope of this note; however, it should be noted that estimates of investment costs needed in the electricity sector to avoid power shortages are well within the range of the benefits presented here. Moreover, delays or constraints of such investments are bound to further increase the costs of electricity shortages. For these reasons, the benefits of least-cost investing to supply the expected electricity demand are very likely to outweigh the costs of power sector spending. In addition, the expected costs of outage indicate that there is great potential in adjusting tariffs during times of peak demand to improve the economic efficiency of the system. The analysis outlined in part III concerns yet unconnected customers and calculates consumer surplus; it thus represents net benefits accrued to new consumers receiving electricity through system expansion. Benefits as Avoided Costs of Electricity Shortage Users connected to the electricity network invest in devices that increase their productivity, improve their living conditions, and enhance their overall welfare. Use of such devices over time provide cumulative productivity benefits and can induce further capital investments. When electricity is interrupted these benefits are lost. The cost of an electricity outage depends upon: (i) the consumer s activities impacted; (ii) the nature of, and degree to which, the impacted activities are dependent upon electricity; (iii) the availability of backup power sources; and (iv) the ability to resume the impacted activity normally after power is restored. In the industrial and commercial sector, for instance, short-run direct economic costs stem from impacts such as idle resources labor, capital, and entrepreneurship raw materials and in-process inventory losses, equipment damage, process re-start costs, customer sales lost, and costs related to human health and safety. In the residential sector consumers experience inconvenience, loss of leisure and run risks of experiencing health and safety costs as well (Sanghvi 1982). From the consumer s perspective costs of electricity outage depend on: when it occurs, for how long it lasts, whether it was expected or unexpected, how frequently it happens, and how large a region it affects. Even a short duration outage of small magnitude can cause chaos if it materializes during a rush hour in the evening. Long outages in the early morning hours may not be as costly since few consumers will be impacted however, round-the-clock industrial processes may suffer. To estimate the costs of lack of electricity to a user, the following formula can be used: Ct = VOLLt * Qt (1) Where, Ct : Cost of lack of electricity VOLLt : Value of Lost Load (for instance, in $/kwh) Qt : Quantity of lost electricity (in kwh) Background Sector Report The actual VOLL is a non-linear and non-uniform function. It is a measure of customers value of the opportunity cost of outages, or benefits foregone through interruptions of electricity supply. As mentioned earlier, it is dependent on the actual user (how he/she uses electricity and what the importance of electricity is to perform economic activities), and the particular characteristics of the outage. Estimating the VOLL for each consumer is clearly a complicated exercise and since in any case electricity systems are organized in networks serving simultaneously numerous customers it is more valuable to look at aggregate approaches to estimate the costs of unavailable electricity. Macroeconomic approach A simple way to calculate the average value of a unit of lost electricity in a country s economy has been proposed, in an attempt to assess the economic efficiency of electricity systems, in the mid-seventies (Telson 1975). According to this approach it is: VOLL = GDP (2) Q Where, GDP : Gross domestic product Q : Quantity of electricity consumed (annually) The method has shortcomings due to the diversity of consumers, uses of electricity, and time-specific factors, and is therefore unlikely to be correct for a specific user, at a specific time. However, this formula represents in a simple manner the importance of electricity in the economy. The VOLL calculated in this mode is a key figure used in the privatized UK electricity market to calculate the price of electricity in the electricity pool: PPP=SMP + LOLP [VOLL-SMP] (3) Where, PPP : Pool purchase price (paid by electricity distribution companies to purchase electricity that they then sell to end users) SMP : System Marginal Price (determined by the price of the most expensive generator unit that is called to supply in the system) LOLP : Loss of Load Probability VOLL : Value of Lost Load In the early stages of privatization in the UK, in 1989, VOLL was originally set at 2 pounds/kwh (about 3.2 $/kwh) and has been indexed annually to the retail price index; today it is about 4.2 $/kwh (Willis and Garrod 1997). Application of the same formula (2) in the USA for instance yields 2.7 $/kwh for 2002, whereas in Indonesia in 2002 it is about Rp/ kwh (2 $/kwh) 91. I 143

158 Electric Power investments in generating capacity and network upgrades that will maintain a low probability of outages are needed, otherwise the economy will likely start incurring costs proportional to the inability of the electricity system to supply energy. Microeconomic approach To finalize the calculation of the costs of electricity shortages over a year to the economy an average figure of the quantity of electricity lost is needed. This is given by: Qt= LOLP * Q (4) Where, LOLP : Loss of Load Probability (in %), defined as number of hours expected to be lost as a percentage of total hours over a period Q : Annual consumption of electricity (in kwh) The concept of LOLP originates in engineering practices reliability standards in the USA in the sixties and seventies would require, and achieve, for instance a LOLP of one day every ten years 1/3650, about 0.03% (Sanghvi 1983). The chances of an outage occurring (LOLP) are calculated using technical data of the network (its capacity at different nodes and overall design), and a probabilistic simulation at various points of the system of the available generating capacity, and expected demand. Higher reserve capacity and more dependable equipment results in fewer occurrences of system failures and electricity interruptions (lower LOLP). As the demand for electricity increases investments in generating capacity, and the transmission and distribution network, are needed to maintain the ability of the system to provide electricity to users without interruptions. Equation (1) then becomes: C= VOLL * LOLP * Q (5) Assuming an average figure of 100 hours of electricity lost on a yearly basis in Indonesia for 2002, the total outage costs are about 16.7 trillion Rp (about $ 2 billion), or 1.15 % of the GDP. The above relationship (5) indicates the importance of maintaining a low LOLP in the electricity system; rewriting costs as a percentage of GDP it is: GPD * LOLP * Q C GPD = Q (6) GDP Simplifying (6) it becomes apparent that electricity outage costs as a percentage of GDP equal LOLP. To illustrate this, consider an expected average of 87 hours over a year (about one hour and forty minutes each week) when supply cannot meet demand. This corresponds to a LOLP of 1% and, as indicated by (6), costs to the economy would be equal to 1% of the GDP. In effect, as demand for electricity grows (note that GDP growth correlates strongly, and positively, with electricity demand growth in Indonesia) The cost of a unit of unsupplied electricity to a consumer can also be estimated at the consumer level by trying to assess individual effects of shortages of supply. If all such individual costs can be assessed and summed together, a full and accurate value can be measured of the electricity benefits foregone when supply is short. In practice, statistical sampling of consumers and individual surveys of costs are performed to estimate the total costs. Several approaches have been pointed out in the literature to calculate such shortage costs, depending on which type of costs are accounted in such surveys. The main costs to be accounted are: i. observed, or estimated, willingness to pay for planned production of electricity (Brown and Johnson 1969; Crew and Kleindorfer 1978) ii. losses in production value for the various goods and services affected (Munasinghe and Gellerson 1979; Munasinghe 1981) iii. iv. opportunity costs of back-up power (Bental and Ravid 1982; Sanghvi 1982) estimated willingness to accept compensation for disruptions (Willis and Garrod 1997) The willingness to pay approach, (i) above, involves surveying users asking them to estimate the costs to themselves of supply interruptions of varying characteristics. Early surveys of this type in the seventies in Finland showed for industrial users a cost per kwh of about 6$/kWh for a one-hour shortage, falling to 2$/kWh for a 24-hour outage. Higher values were recorded for commercial users, but much lower values for domestic users. Other studies conducted in the UK in the mid-eighties indicate values of about 16 $/kwh for commercial and industrial users, and 1 $/kwh for domestic users (Andersson and Taylor 1986; Willis and Garrod 1997). These approaches to calculating VOLL are based on assessments of the financial costs to consumers, and do not always incorporate the utility lost by consumers which may be greater than financial costs imposed (especially if consumers are risk-averse). Load shedding in general does not necessarily take place according to the ranking of willingness to pay and therefore method (i) may be an underestimate of true costs. On the other hand, studies that estimate the value of production losses may be more accurate if conducted when actual interruptions occur as suggested by method (ii). These surveys typically address costs of equipment damage, loss of in-production materials and products, and lost employee productivity among other factors. Estimates in the USA using this approach show costs in the industrial sector at a range of 7-40 $/kwh and for the commercial sector 6-20 $/kwh (IEEE 1997; Newton-Evans 1998; Primen 2001). The third (iii, above) approach is based on the argument that firms experiencing power shortages have the option of resorting to buying generators and operating them when interruptions occur (back-up power). This represents broadly the maximum limit that a consumer 144 Averting an Infrastructure Crisis: A Framework for Policy and Action

159 is willing to pay to avoid electricity interruptions and is based on revealed preferences rather on questionnaires and surveys. The issue with this method is that because the marginal opportunity cost of self-generating electricity is also a function of how often the generator is used and its underlying fuel costs, costs can fluctuate over time periods. A detailed study in Sweden has identified costs to industry ranging from 2 to 12 $/ kwh, for residential users $/kwh, and commercial users 5-40 $/ kwh (Andersson and Taylor 1986). The fourth method (iv, above) is based on the argument that the welfare economic effect of a singly supply outage, the lost utility, or value of lost load to customers is equivalent to the maximum sum that they would be willing to pay to avoid and outage, or the minimum that they would be willing to accept as just compensation for inconveniences caused by the break of supply. A contingent ranking survey of customers in the UK estimated that benefits customers derive from supply reliability are considerably higher than the VOLL estimated through the macroeconomic approach. Moreover, for the majority of the firms surveyed, increased duration of outages results in increasing per unit costs (Willis and Garrod 1997). All of the above methodologies show that in the industrial and commercial sector costs estimated using a bottom-up approach tend to be much higher than average costs calculated through the macroeconomic approach (depending, among others, on overall characteristics of the electricity systems, nature of industry, alternative fuels available, duration and frequency of disruptions). The World Bank concluded in 1996 a study on the Economic Consequences of Power Supply Inadequacy in Indonesia (Sanghvi and Bandaranaike 1996), focusing primarily on the industrial sector and applying mainly methodologies (ii) and (iii). The study distinguished between three major components of the private costs of power supply inadequacy in Indonesia: costs of poor supply reliability, the costs of poor power quality, and the costs of power shortages. A stratified random sample representing the structure of industry in Indonesia was surveyed to estimate costs in the short-run and long-run. The key findings indicated that in 1996 costs of power supply inadequacy in Java-Bali alone where above 1 billion $ annually. Costs of self-generation of electricity were at the range from 0.1 $/kwh to 1 $/kwh (in 1996 dollars). It should be noted however, that prices of fuels very critical as variable costs of generation where subsidized heavily during the time of the survey, indicating that the cost of self-generation would likely have been much lower than the current figure. Depending on the duration of the outage, economic costs of unplanned interruptions ranged from $ 0.95 to 1.92 $/kwh. The average value was calculated at 0.83 $/kwh. Estimating the current (2003) value of shortages in Indonesia would require a replication of the study, since the industrial sector of the country has undergone major changes after the financial crisis. However, since the objective of this analysis is to provide a broad based estimate of costs, the available 1996 figures are adjusted for inflation and exchange rates. Most likely these estimates are quite conservative given that self-generation and fuel costs have been increasing in real terms. Based on the above literature review and corroborated with a number of other studies in developing countries (Pasha, Ghaus et al. 1989; Wijayatunga and Jayalath 2003), the following assumptions are reasonable, and probably on the conservative side, assuming long-term adjustments by firms that would require investments in self generation : outage costs in the industrial and commercial Background Sector Report sector range between 0.3 $/kwh to 0.8 $/kwh, whereas residential sector costs range between 0.1 $/kwh to 0.3 $/kwh. Total costs on an annual basis can be calculated applying formula (5) for each sector in Indonesia. Figures per sector for 2001 are presented at the table below: Table Annex I Cost to sector due to power shortage Loss of Load Value of Consumption Probability Lost Load Total Sector (GWh) (hours/year) ($/kwh) ($ billion) Industrial Commercial Public Service Residential Total N/A It should be emphasized that these figures are likely to be a quite conservative estimate of actual costs; they can be translated to a range of % of the GDP. In addition, for the upcoming years all consumption figures are expected to present strong growth of 5-8%, which, if investments in the sector are constrained, might lead to higher LOLP figures and subsequently to increased final costs. Furthermore, dispersed inefficient generation at small scale is likely to add to atmospheric pollution and therefore have additional external costs 92. Such externalities are in addition to economic costs presented above and, depending on the valuation of health and environmental effects, could become significant if significant numbers of small generators are used in already polluted urban areas (The World Bank 2003). Benefits of Electricity System Expansion Indonesia has enjoyed rapidly growing rates of expansion of the electricity network adding almost a million of new connections annually in recent years. Nevertheless household electrification was at 53% in 2000 presenting a considerable challenge in increasing coverage around the country. Benefits of rural electrification stem from mainly from (i) benefits for domestic and residential consumers that save from higher spending in alternative lighting (kerosene lamps) and (ii) opportunity cost of alternative diesel driven equipment for industrial and irrigation consumers. In addition to these benefits there is further consumer surplus related to improved quality of life (opportunities for education, longer working hours for enterprises, communications) as has been shown in a number of studies (Bank 2002; Barnes, Domdom et al. 2002; The World Bank 2002). I 145

160 Electric Power For this section, results of economic benefits assessed during the Implementation Completion Report of a previous Rural Electrification project in Indonesia (The World Bank 2000) will be used to provide approximate figures for the potential economic benefits of further investments in expanding electricity services. According to the report, average consumption per new customer per year was estimated at kwh/year for residential users and kwh/year for nonresidential customers (low figures are for locations outside Java, higher figures in Java). The EIRR of the project was 26.2% exceeding comfortably the benchmark rate of 12%. An average consumer surplus of 690 Rp/kWh was estimated, that could be as high as 1150 Rp/kWh 93. Using the assumptions above, maintaining a rate of one million new connections annually, and without accounting for the very likely increases in demand over time for newly connected users, additional benefits at a range of US$ million are quite possible for the next decade. References Andersson, R. and L. Taylor (1986). The social cost of unsupplied electricity : A critical review. Energy Economics 8(3): Barnes, D. F., A. Domdom, et al. (2002). Rural Electrification and Development in the Philippines: Measuring the Social and Economic Benefits. Washington, DC, ESMAP / The World Bank. Bental, B. and S. Ravid (1982). A simple method for evaluating the marginal cost of unsupplied electricity. The Bell Journal of Economics 13: Brown, G. J. and B. Johnson (1969). Public Utility Pricing and Output Under Risk. The American Economic Review 59(1): Crew, M. A. and P. R. Kleindorfer (1978). Reliability and Public Utility Pricing. The American Economic Review 68(1): IEEE (1997). Recommended Practices for the Design of Reliable Industrial and Commercial Power Systems, Institute of Electrical and Electronic Engineers. Munasinghe, M. (1981). Optimal electricity supply : Reliability, pricing and system planning. Energy Economics 3(3): Munasinghe, M. and M. Gellerson (1979). Economic criterion for optimizing power system reliability levels. The Bell Journal of Economics 10(1): Newton-Evans (1998). Market Trend Digest. Balitmore, Newton-Evans Research Company. Pasha, H. A., A. Ghaus, et al. (1989). The economic cost of power outages in the industrial sector of Pakistan. Energy Economics 11(4): Primen (2001). The Cost of Power Disturbances to Industrial and Digital Economy Companies. Palo Alto, CA, EPRI (Electric Power Research Institution). Sanghvi, A. P. (1982). Economic costs of electricity supply interruptions : US and foreign experience. Energy Economics 4(3): Sanghvi, A. P. (1983). Optimal electricity supply reliability using customer shortage costs. Energy Economics 5(2): Sanghvi, A. P. and D. R. Bandaranaike (1996). Indonesia Economic Consequences of Power Supply Inadequacy. Washington, DC, The World Bank, Industry and Energy Division. Telson, M. (1975). The Economics of Alternative Levels of Reliability. Bell Journal of Economics 6(2): The World Bank (2000). Indonesia - Second Rural Electrification Project: Implementation Completion Report. Washington, DC, The World Bank, Energy and Mining Sector Unit. The World Bank (2002). Sri Lanka Renewable Energy Development, Project Appraisal Document. Washington, DC, The World Bank, South Asia Energy Unit. The World Bank (2003). Indonesia Environment Monitor Jakarta, The World Bank. Wijayatunga, P. D. C. and M. S. Jayalath (2003). Assessment of economic impact of electricity supply interruptions in the Sri Lanka industrial sector. Energy Conversion and Management In Press, Corrected Proof. Willis, K. G. and G. D. Garrod (1997). Electricity supply reliability: Estimating the value of lost load. Energy Policy 25(1): Averting an Infrastructure Crisis: A Framework for Policy and Action

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162 sector II Telecommunications 148 Averting an Infrastructure Crisis: A Framework for Policy and Action

163 Indonesia s telecommunications sector has weathered the economic crisis and the bursting of the global telecommunications bubble moderately well. Dramatic growth in the number mobile subscribers since 1997 has been accompanied by solid increases in numbers of fixed lines in service, public payphones, teleshops (wartels) and internet shops (warnets). Despite reverses, private sector interest has also remained strong, as evidenced by the government s sale in December 2002 of an additional 41.9% interest in international and mobile operator PT Indosat for around US$627 million. Throughout the 1990 s the Indonesian telecommunications sectors was dominated by two companies: Telkom which was designated as the organizing body for basic domestic (local and long distance) telecommunications, and Indosat which was designated as the organizing body for basic international services sector. The onset of the economic crisis underscored the need for liberalization, leading the Government to prepare a Sector Blueprint outlining its strategy for transition to full competition by The Blueprint provided the framework for a new Telecommunications Law, enacted in 1999, that eliminated the organizing body roles previously enjoyed by Telkom and Indosat, and also enabled an early termination of exclusivities on basic telephony services. As an intermediate step towards full competition, the Government opted to transform Telkom and Indosat into competing full network and service providers and to require them to unwind anti-competitive cross-holdings in mobile operators and other service providers. Indonesia s first limited steps on the path to privatization were taken in the early 1990s, with both SOEs PT Telkom and PT Indosat being listed on the New York Stock Exchange by Both companies have since continued to feature prominently in the Government s privatization program, with Indosat becoming the first SOE to be transferred to majority private ownership. 149

164 Telecommunications Despite significant progress, much remains to be done and three main priorities have emerged. The first is to intensify and entrench pro-competitive policies for the sector to promote efficiency, investment, and utilization of new technologies by customers. The second is to support these procompetitive policies by establishing a credible and effective non-ministerial institution and processes that can de-politicize tariff-setting, and address and remove impediments, sometimes caused by outdated regulations, market power, or vested interests, to investment and deployment of new communications technology. The third priority is to adopt and implement a set of policies and programs that will systematically address the inadequate access to telecommunications and information services for the thousands of underserved villages in Indonesia. Policy and Institutional Framework Main Laws and Regulations The main goals for developing the telecommunications sector are defined in the 1999 Sector Blueprint. They are as follows: Improve performance to position the economy to face the challenges of globalization; Liberalize in line with global trends to eliminate monopolies and establish the foundations for competition; Increase transparency and clarity of regulatory processes to enhance investor confidence; Create opportunities for national operators to form alliances on a global scale, for medium and small enterprises and cooperatives to participate in the sector, and for expanded employment. The program for amending the legal framework, reshaping the market, and restructuring and further privatizing Telkom and Indosat is based on three main themes: Elimination of all forms of monopoly by enabling competition in all market segments and preventing abuse of market power; Elimination of all forms of discrimination impeding private businesses wishing to provide telecommunications networks and services. Distinguishing government s roles of policy-making, regulation, supervision and control, and keeping these fully separate from operations. As indicated in Table II.1, the key changes introduced by the 1999 Telecommunications Law (Law 36 / 1999) are broadly in line with these themes. Table II.1. Key Reforms Introduced by Law 36/1999 Law 3/1989 Law 36/1999 Operator Government through SOEs Public and privately-owned as Organizing Bodies. companies and cooperatives Service Basic and non-basic Telecommunications networks, Categories services and special telecommunications services, telecommunications and special communications Business Cooperation with an SOE No obligation to cooperate modalities through joint venture, with an SOE. operating concession or management contract. Exclusivity Monopoly (local, domestic Monopoly practices forbidden. long distance) and duopoly Provision for accelerated (international) exclusivity for termination of exclusivities for basic telephony services basic services subject to fair compensation Tariffs Determined by Government Determined by operators based on formula established by Government Interconnection Interconnection and other Establishes right and Agreement payments due by other obligation of network operators to Telkom are operators to obtain and determined by Government. provide interconnection, and outlines principles on which agreements are to be negotiated. Regulator Government Government, with the possibility of delegation to a regulatory agency Source: Adapted from PT Telkom 2001 Annual Report Law 36 / 1999 sets out the basic principles governing the regulation and operation of the sector and provides for these to be further elaborated by Government Regulations. Two Government Regulations on Management of Telecommunications and Use of the Radio Frequency Spectrum and Satellite Orbits were issued in 2000, and these in turn have been partially implemented by Ministerial Decrees. However many key Decrees including on the determination of tariffs for fixed and mobile telephony services, universal service obligations, and interconnection are still pending. Ministerial Decree No. 31/2003 slightly extends the principles set forth by Law 36/1999 by establishing a regulatory body, BRTI. The definition in the Ministeral Decree states that, BRTI is the Directorate General of Posts and Telecommunications and the Committee on Telecommunications Regulation. The Committee, which is to comprise five members, including the Chairman, is chaired by the Director General while the other members (who are chosen by the Minister) must be telecoms/it professionals. The decree requires that the Committee make its decisions on a collegial basis, with votes to be cast only where agreement is not reached. Allocation of Responsibilities for Policy-Making and Regulation The key government functions relating to the telecommunications sector are formally assigned to the Minister of Post and Telecommunications, who is assisted by the Director General of Post and Telecommunications. Other important actors are the State Ministry for Communications and Information, which was established in 2001 and whose responsibilities include shaping policy on telematics and broadcasting, and the State Ministry 150 Averting an Infrastructure Crisis: A Framework for Policy and Action

165 Table II.2. Allocation of Policy and Regulatory Responsibilities Agency Function Ministry of Post and Telecommunications Director General of Post and Telecommunications (in conjunction with BRTI) State Ministry for Communications and Information Indonesian Telematic Coordinating Team Coordinating Ministry for Economic Affairs Telecommunications Sector Restructuring Team Committee on Policy for the Acceleration of Infrastructure Development State Ministry of State Enterprises of State Enterprises, which represents Government in its role as shareholder in Telkom and Indosat. Various inter-agency teams and committees also play important roles. Notable among these are the Telecommunications Sector Restructuring Team and the Committee on Policy for the Acceleration of Infrastructure Development, both are chaired by the Coordinating Minister for Economic Affairs. The former is charged with guiding and overseeing the termination of exclusivities on basic telephony services, resolving compensation issues, and unwinding Telkom and Indosat s crossholdings. The latter is assigned a broader role in dealing with regulatory and other impediments to infrastructure development. Regional government is assigned no role in the management of telecommunications services. Sector Structure and Ownership Steps Toward Liberalization Exercises policy functions regarding telecommunications. Exercises main regulatory functions regarding telecommunications. Exercises policy functions regarding telematics and broadcasting. Assigned the task of formulating government policy in telematics Chairs the Telecommunications Sector Restructuring Team and the Committee on Policy for the Acceleration of Infrastructure Development see below. Oversees the termination of exclusivities on basic telephony services and the unwinding of Telkom and Indosat s cross-holdings. In charge of addressing regulatory and other impediments to infrastructure development. Represents the Government in its role as shareholder in Telkom and Indosat. Under Law 3 / 1989 responsibility for provision of public telecommunications services was assigned to Government, which was empowered to delegate to organizing bodies. Telkom was designated as the organizing body for basic domestic (local and long distance) telecommunications, while Indosat was designated as the organizing body for basic international services. Under this arrangement, any private entity seeking to provide basic telecommunications services could do so only in conjunction with Telkom or Indosat through either joint venture, joint operation (KSO), or management contract. Background Sector Report II In order to encourage investment in basic telephony services, the Government elected to award exclusivities on basic services from Telkom was granted exclusivity on local fixed wire services to 2010 and on domestic long distance services to For international services, Indosat and a part private company, PT Satelindo, were granted a duopoly until end The local fixed wireless market was designated as being open to limited competition and in 1994 one company (PT Ratelindo) was awarded a license. 94 Mobile services were designated as open to competition, and by 1996 three companies (Satelindo, Telkomsel, Excelcomindo) had been awarded national GSM 900 licenses while several others were awarded licenses for analog services. Each of the new license holders was required to have either Telkom or Indosat as a shareholder. Both Telkom and Indosat had stakes in Telkomsel and Satelindo. The GSM business proved attractive to international operators, with KPN, Deutsche Telekom, and Bell Atlantic (Verizon) taking substantial stakes in Telkomsel, Satelindo and Excelcomindo respectively. In August 2001, the Government announced the schedule for the early termination basic telephony exclusivity rights and a policy aimed at ensuring that there would be a minimum of two full service providers with Telkom and Indosat both becoming full network and service providers as a transition step toward full competition in Telkom s monopoly on provision of local services was ended from August 1, Telkom s monopoly on long distance services and the Indosat and Satelindo duopoly on international services was scheduled to end on August 1, However, due to unspecified reasons, the license issuance has been delayed indefinitely. Indosat has been awarded an operating license for fixed local telecommunications effective from August , and is now developing fixed wireless networks in Jakarta and Surabaya. Meanwhile Telkom and other operators have anticipated the ending of the international duopoly by offering VOIP international services at substantially discounted rates. Table II.3. Telkom and Indosat Transition to two Full-Service Providers Market Segment BeforeAug Aug. 2003* Operator Telkom Indosat Telkom Indosat Telkom Indosat Local fixed Domestic Long Distance International Long Distance * Originally scheduled for August 2003 but has been delayed indefinitely 151

166 Telecommunications The effectiveness of competition has also been increased by the significant reduction of cross-ownership in the sector. In February 2001 Telkom and Indosat signed a Memorandum of Understanding providing for Telkom to acquire Indosat s 35% interest in Telkomsel and for Indosat to acquire Telkom s 22.5% interest in Satelindo. As a result, both Telkom and Indosat respectively have control of a major cellular operator without crossownership from the other. These moves prompted further key changes in the ownership structure of the two leading cellular operators. In October 2001, Singtel Mobile committed to purchasing KPN and Sedco s interests in Telkomsel (17.3% and 5% respectively) for a total of US$602 million, with Singtel Mobile subsequently increasing its stake to 35% through an agreement with Telkom. In parallel, Indosat moved to secure full ownership of Satelindo by acquiring PT Bimagraha, which had a 45% stake, and by purchasing Deutsche Telekom s 25% interest. Concessioning of Local Services In 1995 following an international competitive bidding process, largescale build-operate-transfer schemes (known as KSOs) between Telkom and private investors were started in order to accelerate investment in and expansion of local telephone networks. Fifteen-year KSO concessions and licenses were awarded to private consortia to operate fixed line local services in five of Telkom s seven regions. Each of the winning consortia included at least one international operator (see Table II.4 below). The agreements provided for specific line installation obligations, totaling around 2 million lines, and for revenue-sharing with Telkom according to a defined formula. The KSOs were granted control over existing Telkom as well as newly built assets, and were required to assume all commercial risks. Table II.4 Investment in KSO Regions West Central East Sumatra Java Java Kalimantan Indonesia Region I Region III Region IV Region VI Region VII KSO Investor Pramindo Aria Daya Bukaka MGTI Consortium Ikat West Mitra Malindo Foreign France MediaOne Telstra Cable & Singapore Telecom Cable (subsequen- Global Wireless Telecom & Radio tly AT&T and NTT Participant Wireless) The onset of the economic crisis in 1997 and the Rupiah s subsequent sharp depreciation rapidly impacted the sector and particularly the KSOs. As a short term measure, the government brokered a Memorandum of Understanding between Telkom and the KSOs designed to ensure the latters continued financial viability. This provided for lower new line build-out obligations, reduced revenue sharing and other payments during 1998 and 1999, and the formation of a committee to develop a tariff action plan. However, little concrete progress was made on tariffs and, by May 2001, one of the KSOs had filed for international arbitration while three of the other four were discussing buy-outs with Telkom. The status of the KSOs is currently as follows: KSO Region I (Pramindo) In August 2002, Telkom concluded the purchase of Pramindo Ikat from France Telecom and its Indonesian partners. KSO Region III (AriaWest) Although Telkom had concluded a conditional sale and purchase agreement in May 2002 for AriaWest., the agreement did not transpire because of a dispute over debt restructuring. The buy-out eventually took place through an arbitration settlement in July KSO Region IV (MGTI) The February 2001 Memorandum of Understanding with Indosat provided for the latter to acquire Telkom s KSO IV assets and for Telkom to assign to Indosat the KSO IV agreement with operator Mitratel. However, the conditions precedent for closing this transaction were not met and negotiations concerning the further restructuring of this KSO agreement are ongoing. 95 Subsequently, in October 2003, Telstra announced that it had accepted an offer from PT Alberta Telecommunication for its 20.4 per cent stake in MGTI. KSO Region VI (Daya Mitra) In May 2001, Telkom acquired 90% of Daya Mitra from Cable & Wireless and its Indonesian partners and entered into an agreement to acquire the remaining shares. KSO Region VII (Bukaka SingTel) KSO VII plans to continue under an amended agreement. Privatization of Telkom and Indosat Prior to the crisis, Government had also moved to expand private participation in the sector through the partial privatization of Telkom and Indosat. In 1994, Government sold a 35 % stake in Indosat, which became the first Indonesian company to be listed on the New York Stock Exchange. This was followed in 1995 by the sale of a 34% stake in Telkom, which was listed on both the New York and London exchanges. The onset of the crisis persuaded Government of the need to press ahead with the further privatization of Telkom and Indosat, although strong resistance from employees led to a decision to maintain majority State ownership of Telkom and to position Indosat as the flagship of the privatization program. Public ownership of Telkom has been reduced from 66.2% to 51.2% through direct placements of an 11.9% interest in December 2001 and a 3.1% interest in July 2002, with most shares being acquired by foreign buyers. Meanwhile Indosat s full acquisition of Satelindo paved the way for Government to sell a 41.9% stake in the former to a strategic investor through an open competitive process. Although international interest was dampened by the Bali bombing, the process was completed on December 18, 2002 when Singapore Technologies Telemedia (STT) was announced as winner. Its bid of US$627 million valued Indosat s shares at 50% above their then market price. As part of the purchase agreement, STT has committed to Indosat s building a minimum of 759,000 fixed access lines by STT s acquisition of a 41.9% stake in Indosat demonstrates that, while many foreign investors have exited the Indonesian market, interest on the part of regional players remains very strong. Current State of Competition Four years on from the height of the crisis, the sector s structure and ownership is much changed, although Telkom remains the principal actor 152 Averting an Infrastructure Crisis: A Framework for Policy and Action

167 in the embryonic full network - full service provider duopoly: Fixed Local and Long Distance Services Telkom still dominates the domestic local and long distance markets. Indosat is however well positioned to compete with Telkom in providing fixed local services in the most attractive regions. In addition, real competition for fixed local services now comes from cellular: with about 8.6 million cellular subscribers at the end of 2002 compared with 8.2 million fixed lines in service, there are now more cellular than fixed lines in Indonesia. International Services Indosat is currently the sole provider of international services but it is facing imminent and formidable competition from Telkom which is very well positioned to enter the international market aggressively once a license is issued. Cellular Services Currently, vigorous competition occurs between three national cellular operators with estimated 2002 market shares as follows: Telkomsel (51%); Satelindo (30%); Excelcomindo (17%). Telkom owns the majority stake in Telkomsel while Indosat is now the sole owner of the second largest GSM operator, Satelindo. Satelindo s growth has accelerated over the last year following the resolution of ownership and debt issues, with its mobile customer base having increased by over 80% during ISP and Broadband Services The market for ISP services is competitive. Telkom is a major player in the provision of internet services through TelkomNet and other operators (Telkom s market share is around 55%) but Indosat also has its own ISP and other operators are active in that market. Both Telkom and Indosat are venturing into cable and multimedia. In addition, many other operators are now offering VOIP, internet and other value added services and their prospects have been improved by the unraveling of the web of anti-competitive cross-holdings between Indosat and Telkom. Investment and Financing Background Sector Report II While the challenge has been eased by the continuing sharp decline in capital costs per line, Indonesia will nonetheless require massive investments in fixed nework to raise its teledensity to the levels of its neighbors. Raising teledensity by one point will require bringing an 2.2 million lines into service, which at current costs would involve an investment of the order of U$330 million. 96 Thus for Indonesia to reach China s 2001 main line teledensity of around 14 within five years would require annual investments of around US$660 million. To place this in perspective, Telkom s 2001 total operating revenues from fixed line services, KSO revenue sharing, and interconnection was around US$970 million. Adequate tariff levels are crucial if operators are to be able to finance these investments. In 1995 Indonesia adopted a price cap mechanism for determining the maximum overall percentage increase in tariffs for domestic fixed network services. This provided for tariffs to be reviewed and adjusted annually, with the ceiling weighted average increase (for monthly subscription and for local and long distance pulse rates) being calculated as the increase in the Indonesian Consumer Price Index (CPI) in the preceding year less an efficiency factor (X). Adjustments were to be implemented on the basis of a formula determined by Government. However this formula has yet to be established and ceiling average tariff increases have in practice been decided through consultations between Government and the DPR. Figure II.1. Indonesian Telecommunications Sector Structure International Long Distance Domestic Long Distance Local Cellular ISPs Aug Scheduled, but has been delayed indefinitely Telkom Telkomsel Telkom.net KSO joint ventures Indosat Aug Scheduled, but has been delayed indefinitely Indosatnet Excelcomindo CBN Ratelindo WLL in West Java Regional Cellular Operator Others Table II.5. ICT Expenditures as a Share of GDP in Selected Countries Country ICT Expenditures (% of GDP) Indonesia 0.6 India 1.0 Malaysia 2.4 Philippines 1.5 Singapore 3.7 Thailand 1.2 Source: BAPPENAS Infrastructure White Paper (Draft January 27, 2003), p. 126 In 1999, the 24% tariff increase announced by the Minister of Communications was reduced to 15%, and tariffs were then frozen for 2000 and On February 1, 2002, Government reached agreement with the DPR on the need to raise tariffs to the level needed to justify new investment and announced a circa 45% increase to be implemented over a period of three years. An initial increase of 15% was implemented immediately and a further 15% was announced from January 1, However, the 2003 increase was later postponed as a result of demonstrations against this increase and simultaneously announced increases in fuel prices and power tariffs. 153

168 Telecommunications Following the postponement of the 2003 increase, both Telkom and Indosat have indicated they will be reviewing previously announced plans for expansion of their fixed line / fixed access networks. This prompted Government to announce in February 2003 that it would finance directly the installation of phone line in 43,000 villages outside Java over a three year period. While telecommunications remains attractive for private investment, raising financing on the scale indicated above for fixed network development will be challenging. Telkom, which is rated AAA by Indonesia s rating agency Pefindo, was able to raise Rp. 1 trillion (circa US$ 112 million) in July 2002 through the issue of a 5-year bond with a coupon of 17%. However, plans to follow this with the issue of a US$ bond were cancelled. Indosat, with a Pefindo AA+ rating, accessed the market in October 2002 raising Rp. 1 trillion through a 5-year bond with 15% coupon that was substantially oversubscribed. In April 2002, Telkomsel demonstrated the greater attractiveness of the mobile market, with its US$100 million 5-year 9.75% coupon bond issue being increased to US$150 after it was 3.6 times subscribed. Sector Performance Access to Services Over the decade from 1991 to 2001, the number of main lines in service in Indonesia has grown from 1.27 million to 7.22 million, an average annual growth rate of 19% pa, with teledensity increasing from 0.68 lines to 3.25 lines per 100 residents. At the peak, year-on-year growth rates exceeded 30% pa in 1994 and However, with the onset of the crisis, the pace of new investment has slowed with the average increase from 1996 to 2001 being 11.5% pa. The number of public telephones provided by Telkom has increased rapidly from around 163,000 in 1997 to 383,000 by end In addition, there has also been steady growth in numbers of private teleshops (Wartels). The teledensities in Telkom s seven regions in 2001 ranged from 2.11 in Division VII (Eastern Indonesia) to in Division II (Greater Jakarta), with the second highest being Region III (East Java) with a teledensity of While the teledensity spread between regions is relatively narrow, the spread between urban and rural areas is large. As of December 2001, six large metropolitan cities Jakarta, Surabaya, Semarang, Bandung, Medan and Denpasar with a combined population of 17.3 million accounted for 48.5% of all fixed lines in service. Denpasar topped the table with a density of 34.1, followed by Surabaya with 28.1, and Jakarta with Averting an Infrastructure Crisis: A Framework for Policy and Action

169 As elsewhere in the region, the mobile market has enjoyed explosive growth. The number of subscribers increased from 211,000 in 1995 to 6.52 million by end-2001, an average annual increase of 77.2%. This rapid growth continued through 2002 and by the end of the year the number of mobile subscribers for the first time exceeded the number of fixed lines in service. Background Sector Report II Table II.6. Teledensities in Selected Countries Country Fixed Mobile Total Fixed Mobile Total China India Indonesia Malaysia Philippines Singapore Thailand Vietnam Source: ITU Indonesia s 2001 fixed line teledensity of 3.6 placed it in the company of India (4.0), Philippines (4.2), and Vietnam (6.9), but left it trailing far behind regional neighbors and competitors China (16.7), Malaysia (19.8), Singapore (46.4) and Thailand (9.9). If mobile subscribers are included, Indonesia moves ahead of India and in line with Vietnam, but the gap with the other listed comparators widens. Political liberalization and the removal of media controls following the fall of the Soeharto regime fueled rapid growth in internet use, a proliferation of internet service providers, and an explosive increase in the number of Indonesian web sites. There are currently around 190 licensed internet service providers (ISPs), although only around 35 of these are active. By end-2002, there were an estimated 580,000 internet service subscribers, of which around 93% were personal / residential accounts, and an estimated 4,500,000 internet users. While the growth in numbers of subscribers and users has slowed over the last couple of years, traffic volume has continued to grow very rapidly with expanding corporate use and improving backbone infrastructure. Table II.7. Internet Use in Selected Countries 2001 Hosts Hosts/10 5 Users Users/10 5 Country Inhabitants 10 3 Inhabitants China 89, , India 82, , Indonesia 45, , Malaysia 74, ,500 2,731 Philippines 30, , Singapore 197, ,500 3,631 Thailand 71, , Vietnam , Source: ITU Quality of Service Indonesia s local and trunk exchanges are fully digital, while transmission networks are over 98% digital. Call completion rates for local and domestic services have improved steadily in recent years, reaching 74% and 66% respectively in However the fault rate, measured as faults per 100 lines per month, has deteriorated from 1.14 in 1997 to 1.67 in Table II.8. Telephone Faults per 100 Lines per month Country /2001 India Indonesia Malaysia Philippines 0.43 Singapore Thailand Source: ITU, data for China & Vietnam not available Efficiency On the basis of the most commonly used indicator of efficiency (the number of telephone main lines per employee), Indonesia appears to be somewhat lagging: in 2001, it was more efficient than China, India and Vietnam, but less so than other countries in the region such as Malaysia, Philippines, Singapore and Thailand. Table II.9. Telephone Main Lines per Employee Country /2001 China India Indonesia Malaysia Philippines Singapore Thailand Vietnam Source: World Bank Tariff Levels Telkom s fee for connection of a new residential line is relatively moderate (both for fixed and for analog cellular services), and fixed monthly charges are among the lowest in the region (once again for both fixed and analog cellular services)

170 Telecommunications Table II.10. Fixed and Analog Cellular Fees 2000/2001 Residential Analog Residential Telephone Analog Cellular Telephone Monthly Cellular Monthly Connection Subscription Connection Subscription Charge Charge Charge Charge Country (US $) (US $) (US $) (US $) China India Indonesia Malaysia Philippines Singapore Thailand Vietnam Source: ITU and World Bank Affordability From the standpoint of affordability, the key issue for fixed network services is the line connection charge. While Telkom s maximum fee for connection of a new residential line is relatively limited, in rural areas installation is handled through contractors who typically charge an all up fee of Rp.2 million (US$220) which corresponds to approximately 63% of average per capita income in rural areas. Table II.11. Fixed and Analog Cellular Fees as Percentage of Per Capita GNI 2000/2001 Residential Analog Residential Telephone Analog Cellular Telephone Annual Cellular Annual Connection Subscription Connection Subscription Country Charge Charge Charge Charge China 31.8% 4.3% 0.0% 8.6% India 4.0% 14.8% 6.3% 0.0% Indonesia 3.5% 3.4% 2.8% 11.0% Malaysia 0.4% 1.7% 0.4% 5.7% Philippines 1.2% 16.2% 3.1% 13.7% Singapore 0.1% 0.3% 0.0% 1.2% Thailand 3.9% 1.4% 1.2% 7.0% Vietnam 27.1% 5.4% 18.1% 36.2% Source: ITU and World Bank Main Issues The priority public policy issues for development of the telecommunications sector in Indonesia are competition, regulation, and dramatically improved rural access to telecommunications and information services. Each of these priorities are related to each other: Thus, competition is a powerful incentive for excellent performance. Credible and effective regulatory institutions and processes support competition and investment. And improved rural access depends on investment, competition, tariffs, network interconnection, and the most effective use of scarce subsidy funds. These priorities, including both regulatory institutions and selected regulatory policies, are discussed further below. Competition The 1999 Sector Blueprint envisages a transition to full competition over the period 2010, and the Government has since moved to establish Telkom and Indosat as competing full network and service providers by eliminating exclusivities and unwinding cross-holdings in other operators. While competition is already flourishing in the profitable mobile market, the powerful position of Telkom, coupled with the relatively weak regulatory institution, increases risks for competitors, which in turn discourages investment and increases the cost of capital in the sector. Furthermore, major question marks remain as to whether Indosat will want and be able to develop a significant presence in the fixed line businesses currently dominated by Telkom. Although mobile telephony is a competitive fixed line substitute for many customers, this is not the case at this time for broadband access. In many areas, there have been complaints that Telkom uses its control of the last mile to buttress its own value-added services. Thus, many ISPs complain of problems securing adequate numbers of high speed phone lines. Likewise, while fully private cable infrastructure provider Kabelvision offers customers a choice of 6 ISPs, those signing up with Telkomvision are required to use a service provided by Telkom Multimedia. DGPT has also received reports that Telkom is abusing its position, for example by routing international calls intended for Indosat through its own VOIP network. Regulatory Institutions Indonesia implicitly endorsed the principle of regulatory independence from operators with its ratification in 1994 of the establishment of the WTO and its subsequent commitment in 1997 to the Reference Paper on Regulatory Principles for Basic Telecommunications Services. The 1999 Sector Blueprint for its part recognized that political decisions would not deliver effective liberalization, and that the transition from monopoly to competition would require continuing supervision coupled with the capacity to resolve emerging problems and issues. The Sector Blueprint accordingly records the Government s intent to establish when appropriate a strong regulatory agency with a highly competent staff and broad authority to regulate, control and supervise the sector and maintain the momentum of liberalization. Law 36/1999 however makes no specific provision for independent regulation other than through a reference in its Elucidation to the Minister being empowered to delegate his authority to regulate control and supervise the industry to a regulatory body. During the last couple of years there has been intensifying pressure on Government to improve regulatory arrangements, including from the DPR and the industry association (Mastel). This pressure has led to the establishment of a new regulatory body, BRTI. BRTI is chaired by DGPT and comprised of four others chosen from the public. It is evidence of 156 Averting an Infrastructure Crisis: A Framework for Policy and Action

171 steps taken to improve the regulatory environment, but it does not meet the criteria of a strong, independent regulatory body. Given BRTI s status and structure, it represents only a limited step towards an effective credible non-ministerial regulatory agency that would compare with international best practice. Background Sector Report II Tariffs The current practice of seeking Parliamentary endorsement of proposed telecom price changes inevitably involves the politicization of pricing. This approach introduces enormous risks for investors and thereby discourages investment. The government decision in January 2003 to postpone the 15% tariff increase announced only a few days previously has exacerbated concerns about this critical element which affects investment decisions. Interconnection A transparently managed and non-discriminatory interconnection regime under which major providers are obliged to provide cost-reflective rates and are prohibited from engaging in anti-competitive cross-subsidies is a key prerequisite for effective competition in the sector. Telkom currently occupies an overwhelmingly dominant position in the fixed market and complex interconnection issues are arising as Indosat seeks to become a competitor and Telkom divests its stakes in other operators. The planned Ministerial decree on Interconnection has not yet been finalized and DGPT has acknowledged that it is poorly equipped to deal with the emerging problems in this area. Licensing Procedures for the award of licenses for telecommunications network and service operators remain ill-defined and non-transparent. During the Suharto era, licenses were issued to connected parties without competitive tendering. The Government not only missed opportunities to generate significant non-tax revenues, it also failed to set specific investment and other performance obligations for licensees. 98 While there has subsequently been much discussion of the need to improve licensing procedures and license documents, there has been little concrete progress to date and the handling of VOIP licensees in 2002 has prompted renewed concerns about lack of transparency and high-level corruption. 99 Particular attention needs to be given to managing the use of the radio spectrum. Implementation of improved management and licensing arrangements has the potential to optimize the economic benefit of this scarce resource while also generating substantial revenues. Access The number of telephone lines per 100 people shows a large variation between Jakarta and rural areas of Indonesia where the problem of thousands of unserved or underserved villages needs to be addressed. As mentioned 157

172 Telecommunications above, the Government announced in February 2003 that it would finance directly the installation of phone line in 43,000 villages outside Java over a three year period. Under such a scenario, there is no guarantee, however, that public resources will be used in the most efficient way. More fundamentally - although it is presented in part as a move to support the more rapid counting of votes for the 2004 General Election - the Government s decision to invest directly in the sector marks a significant shift in policy and raises important questions about the Government s future role in the sector. The Way Forward The overarching challenge now facing Government is to establish an effective policy and regulatory environment conducive to the mobilization of the large scale private investments needed to rapidly increase Indonesia s teledensity, particularly in rural areas, and to improve the quality and capacity of other telecommunications services. Three main priorities emerge. The first is to intensify and entrench pro-competitive policies for the sector to promote efficiency, investment, and timely utilization of new technologies by customers. The second is to support these pro-competitive policies by establishing a highly credible and effective non-ministerial institution and processes that can serve to de-politicize tariff-setting, and address and remove impediments (sometimes caused by outdated regulations, market power, or vested interests) to investment and deployment of new communications technology. The third priority, for areas that are not wellserved by the market, is to adopt and implement a set of policies and programs that will systematically address the inadequate access to telecommunications services, and more broadly to information services, in thousands of villages in Indonesia. While there is a broad consensus within Indonesia on many of these items, actions have been delayed in part because of reluctance to move regulatory authority out of the sector ministry, and because of anticipated delays in drafting and passing new legislation. The more detailed Roadmap to address the challenge is discussed below. Promote Competition The development of competition in the ICT sector has provided enormously powerful incentives for investments and innovation. In order to maximize the benefits of competition, a first priority is to ensure that competition in the sector is not eroded through anti-competitive ownership structures or conduct. Before an independent regulatory body is fully functional (see below), there might be merit in requesting the Government s Business Competition Supervisory Agency (KPPU) to conduct an early review to assess whether the key actors in the sector are abusing their market power and pursuing anti-competitive behaviors. In addition, the Government should take step to increase competition in basic telephony services. International experience demonstrates that duopoly structures have usually failed to yield substantial competition benefits and new competitors will be needed to create effective competition in basic telephony services. Establish an Independent Regulatory Body The Government should act quickly to establish an interim independent (non-ministerial) regulatory agency under the umbrella provided by Law 36. This could be accomplished by: (a) creating the new agency through an implementing Government Regulation under Law 36; (b) having the Minister assign his authority for sector regulation, supervision and control to the new agency through an irrevocable Ministerial Decree; and (c) amending and supplementing as appropriate the two existing Government Regulations issued for Law 36 so as to better define the regulatory powers that would be delegated and the policies and criteria to govern their use. Such a move would be in line with recent developments in the energy sector, where the 2001 Law on Oil and Natural Gas provides for the establishment of a Downstream Regulatory Agency and the 2002 Law on Electricity provides the establishment of an Electricity Market Supervisory Agency. The financing for the new Agency should enable it to recruit highly qualified professionals and to engage world class professional advisors as needed. Adjust and Rebalance Tariffs for Fixed Services The Government s decision in January 2003 to postpone the 15% tariff increase announced only a few days previously has exacerbated operator concerns regarding this critical element of sector policy and has caused both Telkom and Indosat to cut back their plans for fixed access network expansion. As a short term measure, the Government needs to commit to a firm plan for completing the implementation of the circa 45% tariff increase over three years already agreed with the DPR. In addition, MOC needs to finalize the long delayed decree on tariff setting so as to provide clear guidelines for tariff rebalancing. Finally, once an independent regulatory body is in place, that body should become responsible for price regulation. Establish a Credible and Equitable Interconnection Regime Enforcement of a credible and equitable network interconnection regime is critical to facilitate new entry as well as to provide incentives for existing operators to make investments. Draft Ministerial Decrees are still pending in this area since the enactment of Law 36/1999 and adoption of sound regulations in this domain is a matter of urgent priority. Improve Licensing and Radio Spectrum Management The Government should as a matter of urgency initiate a comprehensive review of its current policies and practices for awarding licenses and managing the radio spectrum. The objective should be to ensure economically optimal use of scarce resources. Properly implemented, improved policies and practices should also generate substantial non-tax and tax revenues for the State budget. It is recommended that such a review be completed before any new licenses are issued for radio-based services. Promote Extension of Rural Telecommunications Services The Government s recent announcement of plans to finance the extension of fixed access networks to villages in remote areas raises fundamental questions about its future role in the sector. While improving rural access to telecommunications services is a valid objective, it is important that the 158 Averting an Infrastructure Crisis: A Framework for Policy and Action

173 adopted strategy should not distort or undermine the framework for private investment. The Government should accordingly consider possible outputbased approaches whereby subsidy funds are used in the most effective way through transparent and carefully designed bidding schemes that leverage in private investment to achieve specified minimum levels of improved access. Background Sector Report II Update the Telecommunications Sector Blueprint The1999 Sector Blueprint requires updating so as to provide the Government with a comprehensive and soundly based road map for addressing the challenges ahead. This will need to take appropriate account of the achievements to date and should focus in particular on developing a sound policy and strategy framework for managing the transition from the present embryonic duopoly to early and effective competition in basic telephony services and for the issuing of new telecommunications licenses. It should also reflect and incorporate the adopted policies on tariffs, interconnection, universal service obligations, and radio spectrum management. Draft New Telecommunications Law Law 36 has provided for fundamental reforms in the telecommunications sector but is nonetheless deficient in several critically important respects. In particular, it fails to make explicit provision for an independent regulatory body and relegates the setting of policies in several key areas, including tariff-setting, to subordinate regulations. Once significant progress has been made with updating the Sector Blueprint, Government should initiate the drafting of a new telecommunications law designed to provide a more conducive overall environment for new telecommunications investment. Establish adequate institutional framework to ensure implementation of proposed reforms Most of the policy and regulatory issues that face Indonesia s telecommunications sector today are not new. In fact as a result of discussions over several years, there are very broad areas of consensus on the kind of policy and regulatory decisions that need to be taken. For a variety of reasons, actions in several areas have been delayed. Thus the question arises of how best to move towards preparation of a blueprint, perhaps along the lines of that developed for the power sector, for implementation of the roadmap discussed above. One approach would be to use an existing or new ministerial-level interdepartmental committee, chaired by the Coordinating Ministry for Economic Affairs, to begin implementation planning. The committee would need to be given instructions, resources and target dates to review telecommunications development policies and issues, undertake consultations, and begin development of specific plans to implement the key reforms identified above and in particular to establish: (i) the main policy principles to be encompassed in an updated telecommunications sector blueprint; (ii) a non-ministerial regulatory agency; (iii) approaches to rapidly improve rural access to telecommunications services; and (iv) approaches to modernize radio frequency management. Table II.12. The Way Forward Steps for the Short Term Steps for the Medium Term (0-2 years) (up to 5 years) Promote competition Business Competition Supervisory Agency (KPPU) to conduct an early Opening the provision of fixed telephony services review to identify possible anti-competitive practices in the sector. to new operators (other than Telkom and Indosat) Establish independent Adopting the regulation required to create an independent regulatory regulatory body body and to delegate ministerial regulatory powers to that body. Adjust and rebalance tariffs Commitment by the Government to complete the implementation of the for fixed services circa 45% tariff increase over three years already agreed with the DPR and finalization of the long delayed decree on tariff setting. Establish a credible and Adopting the required ministerial decrees on interconnection equitable interconnection regime Improve licensing and radio Adopting the required ministerial decrees to ensure economically -spectrum management optimal use of scarce resources. Promote extension of rural Reconsidering direct Government investment in telecommunications Implementation of some OBA schemes to promote telecommunication services and identifying instead feasible OBA schemes extension of rural telecommunications services Review legal framework Reviewing sector blueprint emphasizing the importance of competition Drafting new telecommunications law in line with for telecommunications and reflecting the adopted policies on tariffs, interconnection, revised sector blueprint universal service obligations, and radio spectrum management. Establish adequate Establish an existing or new ministerial-level interdepartmental institutional framework to committee, chaired by the Coordinating Ministry for Economic Affairs, ensure implementation of to begin implementation planning of the key reforms identified above. proposed reforms 159

174 Annex II.1 Cost Benefit Analysis Telecommunications This annex estimates the benefits of tariff reforms in the Indonesian telecom sector. The model used in the annex examines three reform scenarios (i) no tariff reform (beyond those which the Government already committed to undertake), (ii) partial tariff reform in which prices move halfway to current international levels over five years, (iii) full tariff reform in which prices meet international levels over five years. These three scenarios are analyzed as they apply to the local call market, mobile market, national long distance market, and international long distance market. For each segment and scenario, the model estimates the cumulative effect of a price change and steady state growth on the quantity of minutes demanded and change in consumer surplus over a five year period. In the model, changes in consumer surplus are cumulative. For instance, as long distance tariffs decrease every year, the change in consumer surplus reaches higher levels every year. It is important to mention that the model considers changes in tariffs are entirely due to reform. For this reason, it is likely that the model underestimates negative change in consumer surplus in the local market and overestimates the positive change in consumer surplus in the two long distance markets, thereby inflating overall results. However, it is also important to note that the model does not account for the positive fiscal impact of reforms, resulting in an underestimate of the (positive) impact of reforms. Despite these shortcomings, the model provides useful, broad figures of the impact of tariff reform. A summary of the results is found below. Table Annex II NPV of the Change in Consumer Surplus by Segment (in Millions) No (Additional) Reform Partial Reform Full Reform Segment US$, M % GDP US$, M % GDP US$, M % GDP Local Call $0 0.0% ($262) -0.2% ($4,096) -2.8% Domestic Long Distance $0 0.0% $62 0.0% $ % International Long Distance $0 0.0% $1, % $14, % 160 Averting an Infrastructure Crisis: A Framework for Policy and Action

175 Figure Annex II Local Market Change in Consumer Surplus over Time 0 Change in CS (Local) Background Sector Report II Change in CS -500,000,000-1,000,000,000-1,500,000,000-2,000,000, Year No (Additional) Reform Partial Reform Full Reform Table Annex II Cumulative Change in Consumer Surplus for All Telecom Segments (in Millions) No (Additional) Reform Partial Reform Full Reform Year US$, M % GDP US$, M % GDP US$, M % GDP 0 $0 0.0% $0 0.0% $0 0.0% 1 $0 0.0% $30 0.0% ($9) 0.0% 2 $0 0.0% $ % $ % 3 $0 0.0% $ % $ % 4 $0 0.0% $ % $2, % 5 $0 0.0% $1, % $7, % NPV $0 0.0% $1, % $10, % Figure Annex II National Long Distance Market Change in Consumer Surplus over Time Figure Annex II Cumulative Change in Consumer Surplus for All Telecom Segments over Time 250,000,000 Change in CS (National) 8,000,000,000 Change in CS (Aggregate) 7,000,000,000 Change in CS 200,000, ,000, ,000,000 Change in CS 6,000,000,000 5,000,000,000 4,000,000,000 3,000,000,000 2,000,000,000 50,000, Year 1,000,000, ,000,000, Year No (Additional) Reform Partial Reform Full Reform No (Additional) Reform Partial Reform Full Reform Change in CS Figure Annex II International Long Distance Market Change in Consumer Surplus over Time 10,000,000,000 8,000,000,000 6,000,000,000 4,000,000,000 2,000,000,000 0 Change in CS (International) Year No (Additional) Reform Partial Reform Full Reform Overview This annex estimates the impact of tariff reform on the level of consumer surplus in the Indonesian telecom sector. This is done primarily through examining the benefits of potential tariff reforms in four segments - local, domestic long distance, international long distance, and mobile. For each segment, the model investigates the following three reform scenarios. Full reform prices reach international level in five years Partial reform prices move half-way from existing levels to international levels in five years No (additional) reform prices remain at existing levels except for local charges increased by a certain percentage that will be later discussed. Using regression and simulation analysis, the model estimates the effect each of these price reform scenarios has on consumer demand and change in consumer surplus over a five year period. 161

176 Telecommunications Model Framework The model calculates the effect a change in price has on consumer demand and change in consumer surplus for each of the four segments over five years. The method in which the model operates can be summarized in three main steps. The first step involves determining elasticities using historical data. Once the coefficients are determined, the model calculates an aggregate steady state growth rate in order to isolate the price effect. The final step involves a Monte Carlo simulation to generate the output. Each step is explained further below. Determining Elasticities Any calculation of price elasticity must consider trendline growth. There are two major factors that drive telecom trendline growth. The first is population, growing approximately at a rate of 1.5% per year, and the second is increasing GDP per capita, rising at a nominal rate of 4.6% per year. A portion of the demand for telecom services can be attributed to changes in these macroeconomic factors. As a result, in order to obtain an accurate demand elasticity, one must examine the relationship between the dependent variable (quantity that measures the amount of usage) and the independent variables (price, population, and GDP per capita). One method of doing so is linear regression analysis. This analysis involves regressing the percentage change in quantity against the percentage change in price, population, and GDP per capita 100 The coefficients in the equation represent the amount the dependent variable changes when the independent variable changes one unit. Since the regression models the percentage change in demand, the coefficients represent the elasticities of the corresponding variables to the quantity. Note that there is an independent steady growth rate in the equation, meaning that the quantity will still grow at a constant rate even if all variables are held constant. Determining the Aggregate Steady State Growth Rate Running the above regression model for the four different segments of the telecommunications market in Indonesia yields the desired coefficients and volatility. Then, a predefined equation is used to model the dynamic behavior of demand 101 Without loss of generality, rates of change in population and GDP per capita are fixed at 1.5% and 4.6% respectively. These figures are the average growth rates based on the data from 1992 to Hence, by combining these two terms with the independent steady growth rate, an aggregate steady growth rate is derived. The dynamic behavior of demand will then only depend on the price change and the random term. The percentage change in price is defined by the reform scenario and adjusted such that the price levels move towards international levels, which is assumed to be the average price level in the US and UK five years into the future. Simulation Now that the model depends only on the change in price and the random term, the next step is to perform a Monte Carlo simulation. This involves generating 250 normally distributed random numbers with mean zero and variance ó 2 for each time step. In the model, five years are simulated at yearly steps for a total of five time steps. The model substitutes a random number for the random term, together with the predefined coefficients and price changes into the modeling equation in order to project the quantity for the next time step. This is repeated for every random number, for a total of 250 quantities for each time step. Repeatedly applying the same concept to model the quantity for 5 years yields 250 different paths for quantity demanded over five years. Taking the average of them for each time step gives the final path for the quantity, which is used to compute the change in consumer surplus given by a linearized curve function. The change in consumer surplus equations are based on the assumption that the demand curve is shifting to the right as time progresses. Due to the steady state growth of quantity, consumer surplus increases even if price stays constant. Thus, the change in consumer surplus takes into account not only the price reform effect, but also the time effect. In this annex, which studies the effect of undertaking a reform, the change in consumer surplus is determined by comparing the consumer surplus in the two reform scenarios with the consumer surplus in the no reform scenario. The calculation can be explained graphically by the following diagrams. Figure Annex II Model simulation - Price elasticity Case I Price goes up (the highlighted area is the negative change in consumer surplus) P1 P0 P0 P1 Price Price CS CS Q0 Q0 Q1 Q1 Demand Case II Price goes down (the highlighted area is the positive change in consumer surplus) Demand 162 Averting an Infrastructure Crisis: A Framework for Policy and Action

177 Local Market Segment Inputs and Assumptions The following list presents the information gathered from the International Telecommunication Union (ITU) database and the assumptions for the model: 800 minutes per month is assumed to be used Monthly costs in Indonesia is Rp. 21,300 or US$2.29 Cost of three minute call in Indonesia is Rp or $US Number of subscribers in Indonesia, as of 2002, is 19,332,556 Total number of call minutes is not given, so the model assumes that it is directly proportional to the number of subscribers Using the assumptions and the facts above, it is possible to calculate the average price (basket) per minute which includes the cost of calling time and monthly subscription charge. The calculation is shown as follows: Average_price(basket)/minute = [ (annual subscription charge) + (cost of 800 mins of local call)*12 )] / [800*12] The average price per minute is found to be Rp or US$0.012 based on the average local call per subscriber of 800 minutes per month. In a similar manner, the equation above is used to calculate figures for the US and UK in order to obtain an international benchmark. The figure for the US is $0.011/minute, while the UK figure is $0.041/minute. Taking the average of the two yields the current international standard level of $0.026/minute. However, because of technological change, the price level will decrease over time. Assuming that the international standard will decrease at the same rate as it did from 1992 to 2001 (4.8 percent per year) 102, the international standard in five years will be $0.020/min. Reform Scenarios In view of the massive investment required to raise teledensity ($330 M per percentage increase), the Indonesian government reached agreement with the DPR to raise tariffs in February It announced a 33.3% increase in local tariff and 31.1% increase in the monthly subscription charge, which yields an overall increase by 32.8% to the price basket. In line with the agreement, the model assumes the increase to be enacted immediately. This information, along with the calculated international standard levels, is needed to define the reform scenarios. In the case of no (additional) reform, tariff for local lines will still increase by 32.8%. Thus, in this case, we will assume 32.8% increase in tariff for the first year and no change for the following four years. For partial reform, the tariff will move half way from the existing level to the international level. Thus, the tariff will go up by 33.47% for the first year and 0.54% p.a. for the remaining four years. For full reform, the tariff will increase by 39.93% for the first year and 5.40% p.a. for the remaining four years to fully reach the international level. This information is summarized in the following table and graph. Price Table Annex II % Change in Price for Local Segment Year No (Additional) Reform Partial Reform Background Sector Report Full Reform % 33.47% 39.93% % 0.54% 5.40% % 0.54% 5.40% % 0.54% 5.40% % 0.54% 5.40% Figure Annex II Local Market Price vs. Time Model Results Prices over Time Year No (Additional) Reform Partial Reform Full Reform II Calculating elasticities is the first step in the model. However, total number of call minutes is not given, so the model assumes that it is directly proportional to the number of subscribers. Thus, the model regresses the percentage change in total number of subscribers on the percentage change in price, population and GDP per capita. The results are displayed below. Table Annex II Model Result - Local Market Segment Coefficients Standard Error Intercept (steady growth rate) % change of total price in basket Population Growth rate GDP per Capita Growth rate

178 Telecommunications Figure Annex II Local Market Quantity Demanded over Time 450,000,000,000 Quantity over Time 400,000,000, ,000,000,000 From the table above, the demand elasticities for price, population and GDP Per Capita are , and respectively. The standard deviation, s, is The intercept, shown to be , corresponds to the steady growth rate, which means that the number of subscriber will grow at a rate of 11.66% p.a. without the effect of price, population and GDP Per Capita. Assuming the population and nominal GDP per Capita grow at 1.4% and 4.3% respectively, the steady growth rate becomes %. The calculation is displayed below. Aggregate Steady State Growth Rate = 11.66%+3.46*(1.4%)+0.72*(4.3%) = 19.62% The price changes at each step are given in table Annex II The following tables summarize the average quantity demanded from the 250 paths at each time step and the resulting change in consumer surplus. Given that technological change in Indonesia will gradually decrease tariffs over time, reforms to increase the tariff to international levels requires higher tariff increases each year as tariffs gradually decline. The model does not consider technological change in Indonesia. For this reason, it is likely that the following change in consumer surplus figures are underestimated (not sufficiently negative). Table Annex II Local Market Average Total Call Minutes Year No (Additional) Reform Partial Reform Full Reform 0 185,592,537, ,592,537, ,592,537, ,741,893, ,085,535, ,135,918, ,345,368, ,047,760, ,444,982, ,448,902, ,286,986, ,191,951, ,721,741, ,405,703, ,459,938, ,578,302, ,750,621, ,093,948,460 Table Annex II Local Market Change in Consumer Surplus (in Millions) No (Additional) Reform Partial Reform Full Reform Year US$, M % GDP US$, M % GDP US$, M % GDP 0 $0 0.0% $0 0.0% $0 0.0% 1 $0 0.0% ($16) 0.0% ($157) -0.1% 2 $0 0.0% ($39) 0.0% ($384) -0.3% 3 $0 0.0% ($71) 0.0% ($699) -0.5% 4 $0 0.0% ($116) -0.1% ($1,134) -0.8% 5 $0 0.0% ($176) -0.1% ($1,721) -1.2% NPV $0 0.0% ($262) -0.2% ($4,096) -2.8% Quantity Change in CS 300,000,000, ,000,000, ,000,000, ,000,000, ,000,000,000 50,000,000, Time Mobile Market Segment Inputs and Assumptions No (Additional) Reform Partial Reform Full Reform Figure Annex II Local Market Change in Consumer Surplus over Time 0-500,000,000-1,000,000,000-1,500,000,000-2,000,000,000 Change in CS (Local) Year No (Additional) Reform Partial Reform Full Reform The following mobile market segment data is gathered from the ITU database. One-time connection charge is assumed to spread across 3 years. Connection costs is $US Monthly subscription cost is US$6.98 Cost of a three minute call is $US 0.10 Number of mobile subscribers, as of 2002, is 11,700,000 The information above and equation below are used to calculate the average price (basket) per minute, based on 200 minutes per month. Average_price(basket)/minute = [( 1/3*(connection charge) + (residential annual subscription charge) + (cost of 200 mins of local call)*12)] / [200 minutes * 12] 164 Averting an Infrastructure Crisis: A Framework for Policy and Action

179 In this segment, the tariff levels in Indonesia are currently lower than the international level. The average cost per minute charged in Indonesia is US$0.07, while the average cost per minute charged at international levels is US$ This observation implies that the mobile market in Indonesia is already competitive. Intense competition already exists between the three national cellular operators: Telkomsel, Satelindo and Excelcomindo. Because of the existing level of competition, no reforms are examined for this segment of the market. Domestic Long Distance Market Segment Inputs and Assumptions Information on the total number of domestic long distance minutes for Indonesia is not available. However, since Philippines is comparable to Indonesia in terms of population growth and GDP per capita, its data can be used by making pro rata adjustments to derive an estimate for Indonesia. According to the ITU database, the total number of domestic long distance minutes for Philippines in 2001 is 2,756,300,032. Assuming a 15% of annual growth rate, the total number of minutes is projected to be 3,169,745,037 in The conversion factor (convert from Philippine data to Indonesia data) is estimated at Hence, the projected total number of domestic long distance minutes for Indonesia in 2002 is 93,127, (or 3,169,745,037 * ). For this segment, monthly subscription charges are not included in the calculation of the price basket. This is because these fees are charged for maintaining the local service. Hence, there is little relationship between the number of domestic long distance minutes and the connection and monthly subscription charges. As a result, cost per minute is the only factor in the price basket. The average domestic long distance cost per minute is found to be Rp or US$0.14. The cost for US is $0.09/ minute, UK is $0.06/minute and the international level is computed to be $0.076/minute. If the international level follows US national long distance historical price trends from 1992 to 2001, it will decrease at a rate of 6.7 percent a year 104. After five years, the international standard will be $0.054 per minute. Unfortunately, time series domestic long distance cost per minute is not available. Without a time series for the cost, the model regresses the percentage change in total number of minutes called on only the percentage change in population and GDP per capita. Given that the domestic long distance market is likely to be more price elastic than the local market (calculated to be 0.5), price elasticity for the domestic long distance market is assumed to be 1.5 (i.e., about three times more elastic than demand for local services). Reform Scenarios In order for Indonesia to meet current international level of domestic long distance prices, the price will have to decrease from US$0.14 to US$0.054/ minute. In the case of no reform, the tariff for the domestic long distance will remain unchanged for 5 years. Under the partial reform scenario, the tariff will move half way from the existing level to the international level. Thus, the tariff will go down by 7.04% p.a. for 5 years. Under full reform, the tariff will decrease by 17.23% p.a. for five years to fully reach the international level. Price Background Sector Report Table Annex II % Change in Price for National Long Distance Segment Year No Reform Partial Reform Full Reform % % % % % % % % % % % % % % % Figure Annex II National Long Distance Market Price over Time Model Results Price over Time Time No (Additional) Reform Partial Reform Full Reform II As previously discussed, the model regresses the percentage change in total minutes on the percentage change population and GDP per capita. Price elasticity is assumed to be 1.5. The results of the regression are displayed below. Table Annex II Model Result DLD Market Segment Coefficients Standard Error Intercept (steady growth rate) % change of total price in basket -1.5 NA Population Growth rate GDP per Capita Growth rate From the above table, the demand elasticities for price, population and GDP Per Capita are 1.5, 5.32 and respectively. The standard deviation, s, is The intercept, which is shown to be 0.065, corresponds to the steady growth rate and signifies that the number of subscriber will grow at a rate of 6.5% p.a. without the effect of price, population and GDP Per Capita. 165

180 Telecommunications Figure Annex II National Long Distance Market Quantity Demanded over Time 700,000,000 Quantity over Time 600,000,000 Assuming the population and nominal GDP per Capita grow at 1.4% and 4.3% respectively, the steady growth rate becomes % as described previously. The price changes at each step are given in table 4. The following tables summarize the average quantity demanded from the 250 paths at each time step and the resulting change in consumer surplus. It is likely that Indonesia will experience technological improvement as well, which will result in a decrease of national long distance prices over the five years. This being the case, the decrease in price will be a brought about by a combination of technological change and tariff reform. However, the figures below consider the change in consumer surplus to be result of tariff reform only. It is difficult to measure how much of the change in consumer surplus is solely due to the tariff reform, but it is important to mention that the figures below are an overestimate of the benefits of tariff reform because they do not consider the portion of change in consumer surplus due to technological change. Quantity 500,000, ,000, ,000, ,000, ,000, Time No (Additional) Reform Partial Reform Full Reform Figure Annex II National Long Distance Market Change in Consumer Surplus over Time 250,000,000 Change in CS (National) Table Annex II National Long Distance Market Average Total Call Minutes Year No (Additional) Reform Partial Reform Full Reform 0 93,127,109 93,127,109 93,127, ,998, ,832, ,072, ,694, ,233, ,446, ,484, ,057, ,537, ,183, ,543, ,671, ,246, ,137, ,533,126 Change in CS 200,000, ,000, ,000,000 50,000, Year No (Additional) Reform Partial Reform Full Reform Table Annex II National Long Distance Market Change in Consumer Surplus (in Millions) No (Additional) Reform Partial Reform Full Reform Year US$, M % GDP US$, M % GDP US$, M % GDP 0 $0 0.0% $0 0.0% $0 0.0% 1 $0 0.0% $1 0.0% $3 0.0% 2 $0 0.0% $4 0.0% $11 0.0% 3 $0 0.0% $11 0.0% $31 0.0% 4 $0 0.0% $26 0.0% $79 0.1% 5 $0 0.0% $61 0.0% $ % NPV $0 0.0% $62 0.0% $ % International Long Distance Market Segment Inputs and Assumptions According to the ITU database, the total number of international long distance minutes for Indonesia in 2001 is 365,844,000. Assuming a 15% of annual growth rate, the total number of minutes is projected to be 420,720,600 in Like domestic long distance service, international long distance service is assumed to be provided using the existing local phone lines. Hence, as monthly subscription fees have already been included in the local market segment, it is reasonable to use cost per minute as the only metric to calculate the price basket. The average international long distance cost per minute (calling from Indonesia to US and to UK) is found to be Rp. 8, or US$ The average cost for US (calling to Indonesia) is $0.36/minute, UK (calling to Indonesia) is $0.27/minute and the international level is computed to be $0.314/minute. Taking into account 166 Averting an Infrastructure Crisis: A Framework for Policy and Action

181 technological change, the international standard will decrease at 11 percent per year assuming that it follows US trends from 1997 to Therefore, the international standard in five years will be $0.176 per minute. Background Sector Report II Unfortunately, time series for the average international long distance cost per minute is not available. Thus, without a time series for the cost, the model regresses the percentage change in total number of minutes called on only the percentage change in population and GDP per capita. Price elasticity is assumed to be 1.5, a reasonable assumption given that the international long distance market is likely to be more price elastic than the local market (calculated to be 0.5). Reform Scenarios In order for Indonesia to meet current international level local long distance prices, the price will have to decrease from US$.952 to US$0.176 per minute. In the case of no reform, tariffs for international long distance will remain unchanged for 5 years. For the partial reform scenario, the tariff will move half way from the existing level to the international level, decreasing by 9.95% p.a. for 5 years. For full reform, the tariff will decrease by 28.68% p.a. for five years to fully reach the international level. Table Annex II % Change in Price for International Long Distance Segment Year No Reform Partial Reform Full Reform 1 0% -9.95% % 2 0% -9.95% % 3 0% -9.95% % 4 0% -9.95% % 5 0% -9.95% % Table Annex II Model Result - ILD Market Segment Coefficients Standard Error Intercept (steady growth rate) % change of total price in basket -1.5 NA Population Growth rate GDP per Capita Growth rate From the above table, the demand elasticities for price, population and GDP Per Capita are 1.5, 5.26 and 0.16 respectively. The standard deviation, s, is Assuming the population and nominal GDP per Capita grow at 1.4% and 4.3% respectively, the steady growth rate then becomes 4.88% as described previously. The following tables summarize the average quantity demanded from the 250 paths at each time step and the resulting change in consumer surplus. Similar to the national long distance segment, the figures of change in consumer surplus overestimate the benefits of reform because it disregards the fact that tariffs will decrease as a result of technological change. Thus, a portion of the change in consumer surplus is due to this technological change. The model, however, considers reform as the only means to decrease tariffs. Cost / minute Figure Annex II International Long Distance Market Price over Time Model Results International Reform Time No (Additional) Reform Partial Reform Full Reform As previously discussed, the model regresses the percentage change in total minutes on the percentage change population and GDP per capita. Price elasticity is assumed to be 1.5. The results of the regression are displayed below. Table Annex II International Long Distance Market Average Total Call Minutes Year No (Additional) Reform Partial Reform Full Reform 0 420,720, ,720, ,720, ,556, ,334, ,602, ,174, ,209, ,685, ,862, ,785,482 1,373,177, ,172, ,291,835 2,033,275, ,474,054 1,043,183,415 2,991,766,249 Table Annex II International Long Distance Market Change in Consumer Surplus (in Millions) No (Additional) Reform Partial Reform Full Reform Year US$, M % GDP US$, M % GDP US$, M % GDP 0 $0 0.0% $0 0.0% $0 0.0% 1 $0 0.0% $45 0.0% $ % 2 $0 0.0% $ % $ % 3 $0 0.0% $ % $1, % 4 $0 0.0% $ % $3, % 5 $0 0.0% $1, % $8, % NPV $0 0.0% $1, % $14, % 167

182 Telecommunications Figure Annex II International Long Distance Market Quantity Demanded over Time 3,500,000,000 Quantity over Time Quantity 3,000,000,000 2,500,000,000 2,000,000,000 1,500,000,000 1,000,000, ,000, Time No (Additional) Reform Partial Reform Full Reform Table Annex II Aggregate Change in Consumer Surplus (in Millions) No (Additional) Reform Partial Reform Full Reform Year US$, M % GDP US$, M % GDP US$, M % GDP 0 $0 0.0% $0 0.0% $0 0.0% 1 $0 0.0% $30 0.0% ($9) 0.0% 2 $0 0.0% $ % $ % 3 $0 0.0% $ % $ % 4 $0 0.0% $ % $2, % 5 $0 0.0% $1, % $7, % NPV $0 0.0% $1, % $10, % Figure Annex II International Long Distance Market Change in Consumer Surplus over Time Figure Annex II Aggregate Change in Consumer Surplus over Time 10,000,000,000 Change in CS (International) 8,000,000,000 Change in CS (Aggregate) 7,000,000,000 Change in CS 8,000,000,000 6,000,000,000 4,000,000,000 Change in CS 6,000,000,000 5,000,000,000 4,000,000,000 3,000,000,000 2,000,000,000 2,000,000, Year 1,000,000, ,000,000, Year No (Additional) Reform Partial Reform Full Reform No (Additional) Reform Partial Reform Full Reform 168 Averting an Infrastructure Crisis: A Framework for Policy and Action

183

184 sector III Road and Road Transport 170 Averting an Infrastructure Crisis: A Framework for Policy and Action

185 Roads and road transport affect the daily lives of most Indonesians. The sector accounts for by far the major share of domestic intra-island freight and inter-urban passenger movements and plays a crucial role in linking communities and markets throughout the country. Its efficient functioning is vital for maintaining and enhancing international competitiveness as well as for improving the availability and reducing the prices of goods and services within the economy. For many remote and isolated areas, availability of basic road transport services is a prerequisite for reducing poverty and providing access to health and education services, information and markets. Successive national plans have recognized the sector s importance, as reflected in the large share of development spending provided for upgrading, expanding and extending the public road network over the last two decades. Government s concern to see these funds used well is confirmed by substantial investments to develop and apply improved planning and programming tools and to build institutional capacities at the central and regional levels. While the achievements in terms of improving overall network condition have been impressive, many issues still remain. Substantially higher expenditures on road preservation and capacity expansion works would be justified by resultant user savings in fuel and maintenance costs. Well justified investments to expand the capacity of heavily congested links in the Java arterial network have had to be deferred because of tight budget constraints during the economic crisis, while planned private investments in new toll roads have been halted. Additionally, the condition of the kabupaten road network has deteriorated significantly. Inadequate routine maintenance is resulting in accelerated deterioration of road conditions across regions and networks. The net result is greatly increased road provision and user costs. Moreover, there remains considerable scope for further increasing efficiency in infrastructure provision by securing an adequate and predictable level of funding for road works, allocating that funding in an optimal manner, and ensuring that funded road works are effectively and efficiently implemented. It is clear that a combination of under-funding, sub-optimal allocation of available funds, and poor quality of construction contributed to the current condition of the road network. 171

186 Road and Road Transport There is also considerable scope for further improving the efficiency of road infrastructure use by reducing damage through more effective enforcement of vehicle loading limits and by enabling more effective utilization of existing road capacity through improved traffic management and public transport licensing policies and better control of roadside activities. Ensuring traffic safety is also a significant concern and must be dealt with. Work is also needed to strengthen institutional and regulatory issues, particularly regarding toll roads and decentralization, in order to attract private investment. Government should separate Jasa Marga s regulatory and operating roles, and establish a national Indonesian Toll Road Authority responsible for designing, procuring, and entering into concession agreements. Challenges now have to be addressed in the context of decentralization which, from 2001, has accorded greatly expanded responsibilities and financial autonomy to kabupaten (District) and kota (Municipal) governments. Sector legislation needs to be aligned with the laws on regional autonomy and to provide an improved framework for private participation. The capacities of regional governments to handle expanded road sector responsibilities need to be strengthened quickly. Government has recognized that the prescriptions of the past will not suffice. It now has to realign incentives for the private sector and civil society to participate in the change. The agenda for the coming years is daunting. In order to improve infrastructure provision, incentives need to be put in place to promote better and more participatory planning, ensure improved quality of road works implementation, and foster more effective regulatory enforcement. Also, the burden of financing the costs of infrastructure preservation needs to be shifted to road users, who should be given an effective say in ensuring that their payments are used efficiently. Steps are already being taken to address some of these challenges. Considerable preparatory work has already been undertaken to establish a system of road funds that would give users well defined responsibilities for financing and managing road rehabilitation and preservation programs. Work is also underway to develop improved institutional and regulatory arrangements for the provision of toll roads. These and other initiatives designed to enhance the management and use of road infrastructure and the provision of road transport services need to be actively pursued and carefully coordinated as part of a coherent overall strategy for improving the sector s performance and integration with other elements of the transport system. Policy and Institutional Framework Main Laws and Regulation The basic legal framework for the roads sector comprises the 1980 Law on Roads (Law 13/1980) and the 1992 Law on Road Traffic and Transport (Law 14/1992), together with their many implementing regulations. Key provisions of both laws have been significantly amended by the passage in 1999 of two laws on regional autonomy. The Law on Regional Government (Law 22 / 1999) provides for the extensive decentralization of powers to kabupaten, kota and to a lesser extent provincial governments, while the Law on Fiscal Balance between Central Government and the Regions (Law 25 / 1999) provides regional governments with additional sources of revenue whose use is not subject to central direction or control. Both laws became effective on January 1, Table III.1. Classification of Roads and Allocation of Responsibilities for Development and Maintenance Network / Link Administrative Classification Classification Primary Network Arterial National Collector National or Provincial Local Provincial or Kabupaten Secondary Network Arterial Kota or Kabupaten Collector Kota or Kabupaten Local Kota or Kabupaten Toll Roads National (PT Jasa Marga) Special Roads Private Table III.2. Main Legal and Regulatory Provisions Key Provisions Law 13/1980 on Roads Classifies roads according to their function, thereby determining the level of public authority responsible for their maintenance and development Establishes legal basis for special roads (i.e. privately developed roads serving private needs) and for toll roads Presidential Decree 15/1987 Establishes PT Jasa Marga, the State-owned toll road corporation Law 14/1992 on Road Traffic Regulates prices of basic public transport and Transport services Law 22 / 1999 on Regional Provides for allocation of increased Government responsibility at the kabupaten level. Law 25 / 1999 on Fiscal Provides for increased local authority to Balance between Central raise revenue. Government and the Regions Law 13/1980 establishes the basis for classifying public roads according to their function and for assigning responsibilities for their development and maintenance. The primary network comprises roads that connect cities, towns and villages, while the secondary network comprises roads that connect areas within a city, town or village. Individual links are classified according to their role within the primary or secondary network, with the hierarchy comprising arterial, collector and local roads. Administrative responsibilities for the financing, planning and implementation of works on the public network are determined from this broadly as shown below. 107 Law 13 / 1980 also establishes the legal basis for special roads and toll roads. Special roads may be developed and maintained by private companies to serve their own private needs (e.g. plantation businesses). Toll roads are required to be high standard limited access expressways and must provide 172 Averting an Infrastructure Crisis: A Framework for Policy and Action

187 an alternative to an untolled public road. The right to organize the provision of toll roads is assigned to a State-owned toll road corporation (PT Jasa Marga), which by virtue of Presidential Decree 15 of 1987 and Government Regulation 8 of 1990 is required to cooperate with the private sector to develop new toll roads. Law 14/1992 regulates the prices of public transport. The focus of economic regulation is on basic or economy class passenger services and tariffs for higher standard services are for practical purposes set by operators. The road freight industry is not subject to any form of tariff regulation, although State enterprises which are a major user are influential in setting market rates Allocation of Responsibilities for Policy-Making and Regulation Central Government has given a strong lead in expanding and developing the network. There are two key central government actors in the road transport sector: Ministry of Settlements and Regional Infrastructure (Kimpraswil or MSRI), through its Directorate General of Regional Infrastructure (DGRI) has primary responsibility for setting national policies, standards and guidelines; for managing the development and maintenance of the road network and for the development and management of toll roads. It is also responsible for managing the development and maintenance of the national network and for guiding and overseeing the implementation of works on lower level roads that are funded from the State budget. Ministry of Communications (Perhubungan or MOC), through its Directorate General of Land Transport (DGLT) has primary responsibility for setting national policies, standards and guidelines relating to the use of the public road infrastructure and to the provision of road-based public transport services. The Ministry of Home Affairs (MHA) is involved in the sector through its linkage to regional governments and its role in supporting the implementation of regional autonomy. Likewise the Ministry of State Enterprises is involved through its role as shareholder in Jasa Marga and in the two State-owned bus corporations (Perum PPD and Perum Damri). The Traffic Directorate of the National Police plays a role through setting policy for enforcement of traffic regulations and through accident reporting. Regional governments - district (kabupaten), municipal (kota) and provincial - each have agencies (Dinas) whose responsibilities broadly align with those of the central Ministries: Dinas Kimpraswil (or PU) agencies are responsible, among others, for the road infrastructure functions and programs of their respective regions. Dinas Perhubungan agencies are responsible for road traffic and transport functions and programs, including route licensing and tariff regulation for public passenger transport services. Passenger services on routes that are entirely within a kabupaten or kota are regulated by the kabupaten / kota Dinas; those that cross kabupaten or kota boundaries are regulated by the provincial Dinas, while those that cross provincial boundaries are regulated by DGLT. Background Sector ReportIII Table III.3. Allocation of Policy and Regulatory Responsibilities Agency Name Function Ministry of Settlements and Plan and implement the maintenance and Regional Infrastructure development of the national road network (Kimpraswil or MSRI), Establish standards for road and bridge through its Directorate construction (including expressways); General of Regional Infrastructure (DGRI) plan strategically for the expressway network Establish criteria for determining the function and status of individual road links; designate specific links as national roads Ministry of Communications Set standards for road signs and marking; (Perhubungan or MOC) set guidelines on placement of road through its Directorate furniture and equipment General of Land Transport Establish criteria for vehicle road- (DGLT) worthiness; set standards and procedures for vehicle registration, vehicle testing, and vehicle load control Set standards and conditions for the issuance of driving licenses Determine basic tariffs for economy class passenger transport services that cross provincial boundaries Establish conditions and requirements for transport of dangerous cargos Dinas Kimpraswil at Plan and implement maintenance and provincial level development of the provincial network Provide support and assistance for cooperation among kabupaten / kota in the development of road and bridge infrastructure (including expressways) Grant licenses for the development of expressways that cross kabupaten / kota (but not provincial) boundaries Dinas Perhubungan Provide and maintain road signs and traffic control and safety equipment on provincial roads and manage vehicle weighbridges Set tariffs for economy class passenger transport services that cross kabupaten / kota boundaries within the province Dinas Kimpraswil at Take responsibility for road infrastructure kabupaten/kota level functions that are not specifically assigned to central or provincial governments Dinas Perhubungan at Take responsibility for road traffic and kabupaten/kota level transport functions that are not specifically assigned to central or provincial governments 173

188 Road and Road Transport Sector Structure and Ownership The Public Road Network In 2000, the total length of the classified non-toll road network was reported at 310,026 km, with national roads accounting for 8.5%, provincial roads for 12.6%, kabupaten roads for 72.0% and secondary kota / urban roads for 6.9. In addition there was some 244,000 km of non-engineered village or desa roads. Table III.4. Length of the Public Non-Tolled Road Network (Km) Region Classified Network by Ownership Responsibility Desa / /Island Total Village Group National Provincial Kabupaten Kota Classified Roads Sumatera 7,622 14,654 75,470 7, ,852 52,169 Java 4,373 8,498 60,445 9,714 83,030 68,207 Kalimantan 4,804 3,557 20,560 1,307 30,228 45,786 Bali & Nusatenggara 2,069 4,724 20,507 1,020 28,320 54,304 Sulawesi 5,235 4,631 32,028 2,019 43,913 17,969 Maluku & Papua 2,167 2,848 14, ,683 5,391 Total 26,270 38, ,318 21, , ,826 Source: DG Praswil, 2000 Densely populated Java, with only 6.8% of Indonesia s land area but 61.9% of its population, accounts for 26.8% of the classified road network. At the other end of the spectrum, Maluku and Papua with 23.5% of the land area but only 1.8% of population account for 6.8% of the network. Some remote areas are still not connected to the road network. A national survey of services at the desa level showed that roughly 11 million people (5% of the national population) were not reached by the road network. An additional 6 million people reported (3% of the national population) lack any reliable connection to the motorised transport network. These people are mostly amongst the poorest in the country and they live in some of the most disadvantaged areas. Table III.5. Regional Shares of Classified Road Network, Land Area and Population, 2000 (%) Region Share (%) of Network Land Area Population Sumatera Java Kalimantan Bali & Nusatenggara Sulawesi Maluku & Papua Total Source: DGRI, BPS The Toll Road Network Indonesia s first toll road 108 was opened in 1978 and placed under the management of newly established Jasa Marga. Jasa Marga now has overall responsibility for some 515 km of toll roads, of which around 460 km is on the island of Java. 109 Since 1987, all proposed toll road projects have been required to be offered to private investors and some 30% of the network in operation has been developed by private consortia. Some projects have been developed under Build, Operate, Transfer (BOT) agreements and others under Build, Transfer, Operate (BTO) agreements. A total of 161 km of operating toll road has been developed by nine consortia, with Jasa Marga being a minor equity partner in each. Agreements for several other urban and interurban toll road sections had been authorized when the economic crisis struck in mid-1997, while many more were being negotiated or discussed. Presidential Decree (Keppres) 39 of 1997 postponed thirty-seven proposed toll road projects and required a further eighteen to be reviewed. 110 Nine projects, including one widening project, were allowed to proceed but none has been completed. Several more, including sections of the partially completed Jakarta Outer Ring Road (JORR), have been taken over by the the Indonesian Bank Restructuring Agency (IBRA). In total, Jasa Marga has entered into more than 90 joint operation schemes involving BOT, BTO, or modified turn-key projects. The Road Transport Industry Indonesia s road transport services are provided predominantly by private enterprises and cooperatives. Two State-owned bus companies play a significant but not dominant role in the provision of urban passenger services using large buses: PPD operates only in Greater Jakarta; Damri operates in Surabaya, Bandung, Semarang, Medan and several other major cites. Damri also operates some inter-urban services (though its overall share of this market is insignificant) along with some airport and charter services In the larger cities there are also private companies operating services with large buses there are around half a dozen in Jakarta while cooperatives operate services with smaller buses and pick-ups. Road freight transport is generally competitive and lightly regulated. Road freight is moved by a combination of own-account and for hire operators, with the latter being exclusively private sector. 111 Competition is intense in most regions and mostmarket segments, with users generally being very price sensitive. There are few if any regions or market segments where a single haulier has established a dominant position. In many regions competition among for-hire firms has been intensified by own-account operators playing for hire (e.g. by seeking to back-load their vehicles). The industry is generally inefficient, according to a recent study 112, because of excessive legislation and a general lack of expertise. ORGANDA, the Indonesian Road Transport Operators Association, was found to lack focus, in some respects being regarded more as a Government enforcement agency than as a representative of the operators. Tariffs are tightly controlled - so most operators focus in areas of concentrated demand. Road Transport Terminals Responsibility for the provision and operation of public bus terminals is vested in regional governments, with the Dinas Perhubungan agencies being responsible for their management. A small number of bus terminals 174 Averting an Infrastructure Crisis: A Framework for Policy and Action

189 have been developed by private investors under BOT or similar schemes, most notably the Blok M terminal in Jakarta. There are only a handful of public road freight terminals, and truckers have shown limited interest in using those that have been developed because there is little transhipment of freight between small and large trucks. However, this picture is beginning to change with the the arrival of integrated logistics companies operating modern warehouse and distribution centers, principally in and around Jakarta. Investment and Financing Overall expenditure on road infrastructure The budget share for road infrastructure has varied considerably. In the mid-1980s road infrastructure accounted for less than 10% of total government development spending, as is shown in table III.6. The share of public spending on roads rose steeply during Repelita 5 (the National plan for 1989/1994) to a peak of 22% in 1993/94. The proportion of expenditure on roads declined sharply in 1994/95 but then did not vary greatly during the economic crisis and it leveled out at about 11% by the late 1990s. Maintenance took an increasing proportion of the road budget up to 1992/93 but it then declined steadily. The composition of spending across the four main road works programs maintenance, betterment, new construction, and bridge replacement has varied considerably since the mid-1980s (as can be seen from Figure III.1). Spending on maintenance increased during the late 1980s and early 1990s, but has since declined considerably. Within the roads budget the increase in expenditure for roads was attributable to new construction and betterment works and was matched by more than doubling of the expenditure on road maintenance. This healthy balance was not maintained when road expenditure dropped sharply, since most of the decrease was due to a reduction in road maintenance expenditure. In constant price terms spending on roads maintenance in particular has declined even more significantly as a result of the rapid inflation in 1997/98 related to the financial crisis. The overall real reduction in road maintenance expenditure was most significant. By 1999/00 public spending on roads had returned to a level which was similar (in constant prices) to Background Sector ReportIII that of the mid-1980s. Also road spending had returned to nearly the same proportion of the national budget at around ten percent (see above). The constant price analysis underlines that, by 1999/00, real spending on road maintenance had dropped to less than 40% of the level in 1984/85. Over this period the proportion of the road budget which was allocated to maintenance had reduced from just under 30% to below 10%. Financing expenditures on the non-tolled network In the late 1970s Government signaled its intention to require road users to contribute to funding the costs of road infrastructure provision and there has since been much discussion on the structuring of a sound road user charges regime and the sharing of its proceeds. The main taxes and fees that could be viewed as road user charges 113 currently comprise: taxes on vehicle acquisition, notably luxury goods sales tax (which is collected by central Government), and the motor vehicle ownership transfer fee or BBNKB (which is collected by provinces); taxes on vehicle ownership, notably the annual motor vehicle tax or PKB (which is collected by provinces); and taxes on vehicle operation, notably the motor vehicle fuel tax or PBBKB (which is collected by provinces), along with import duties and luxury goods sales tax on vehicle spare parts (which are collected by central Government). The DGRI Road Funds Study estimated that the PKB motor vehicle tax contributed Rp. 2.1 trillion per year at then current rates. Revenues from the present 5% PBBKB motor vehicle fuels tax contribute a further Rp. 2 3 trillion depending on the price of crude. The proceeds from other taxes on road users such as the BBNKB ownership transfer tax may contribute about 2 trillion per year. Figure III.1. Public Expenditure on National, Provincial and District Roads (current prices) Figure III.2. Public Expenditure on National, Provincial and District Roads (constant 2002 prices) Annual Expenditure (Rp billion - current prices) 6,000 5,000 4,000 3,000 2,000 1, /85 TA, Equipment etc. Bridge Replacement Toll Roads New Construction (total) Betterment (total) Maintenance (total) Source: DGRI Road Fund Study 1985/ / / / / / / / / / / / / / /00 Annual Expenditure ( ) Rp billion - constant 2002 prices 20,000 18,000 16,000 14,000 12,000 10,000 8,000 6,000 4,000 2, /85 TA, Equipment etc. Bridge Replacement Toll Roads New Construction (total) Betterment (total) Maintenance (total) Source: DGRI Road Fund Study 1985/ / / / / / / / / / / / / / /00 175

190 Road and Road Transport Table III.6. Governmental Expenditures on Roads, 1984/ /2000 Road Class and Activity 1984/ / / / / / / / / / / / / / / /00 Source of Funds <7> A. National and Provincial Roads Maintenance Betterment , , , , , , , ,628.9 New Construction Bridge Replacement TA/Supplies/Equipt./Materials Subtotal , , , , , , , , , , ,393.4 Central Govt. Funds (APBN) <1> , , , , , , , ,748.1 APBD I <2> IPJP <3> Foreign , ,137.4 Subtotal , , , , , , , , , , ,393.4 B. District Roads IPJK <4> , , ,147.0 Inpres Dati II <5> Other Local Funds Foreign Subtotal , , , , , , , , ,112.6 Total (A+B) , , , , , , , , , , , , ,506.0 Domestic , , , , , , , , , , ,615.6 Foreign , , , ,890.4 C. Toll Roads <6> Central Government Funds Jasa Marga Foreign Subtotal Total (A+B+C) , , , , , , , , , , , , , ,683.9 Domestic , , , , , , , , , , , ,793.5 Foreign , , , ,890.4 Total Govt. Devt. Expenditure 9, , , , , , , , , , , , , , , ,448.3 Road Sector Share (%) <1> APBN = National budget <2> APBD I = Provincial budget <3> IPJP = Central government grants to provinces for road works <4> IPJK = Central government grants to kabupatens for road construction <5> Inpres Dati II = Central government grants to kabupatens for road maintenance <6> Excluding private-sector expenditures <7> Actual expenditures in 1999/2000 are thought to be only about percent of those shown. Source: DGRID, July 2000, quoted in ADB RRP Road Rehabilitation (Sector) Project, September Averting an Infrastructure Crisis: A Framework for Policy and Action

191 Revenues from the PKB, BBNKB and PBBKB are collected by the provinces and shared with their constituent kabupaten and kota in accordance with minima specified in Law 34 of Together these taxes account for a major part of the own source revenues of regional governments, although the proportion varies considerably from region to region. The proceeds are treated as general tax revenues and are not earmarked for financing the road programs. While total receipts from these sources are significant, they have been more than offset by the subsidies road users have enjoyed as a result of low administered prices for petroleum fuels, and particularly automotive diesel oil (ADO). Government announced its intent to raise fuel prices to international levels as far back as 1993, and in 1997 was close to eliminating the subsidy when the Rupiah s sharp depreciation and the coincident sharp rise in crude oil prices caused the amount of subsidy to blow out. 115 A significant proportion of the subsidies has gone to road users and in particular to operators of diesel-engine vehicles. Prices have since been increased progressively and the subsidy on both gasoline and ADO was scheduled to be eliminated from January A surge in crude prices coupled with adverse public reaction to simultaneous increases in power and telephone tariffs caused the Government to defer this important step but it is expected to be implemented once crude oil prices have stabilized at or below the levels that prevailed prior to the build up to the Iraq war. Prior to decentralization, expenditures on the national and provincial road programs were funded almost entirely from the State budget through special purpose (Inpres) road grants for provincial roads, with a large and increasing proportion of the total being sourced from foreign loans. The picture was broadly similar for kabupaten roads, with most works being Background Sector ReportIII financed from the State budget through special purpose road construction and maintenance grants and allocations from foreign loans. The picture has changed significantly as a result of decentralization, with provinces and in particular kabupatens and kotas now enjoying greatly increased revenues from the General Allocation Fund (DAU) and royalties on natural resources. Special purpose Inpres grants have ceased, but central government continues to channel foreign loans to provinces, kabupatens and kotas for road works and does not require repayment under existing loans. 116 From 2003, central government will also provide funding from the State Budget through the Special Fund Allocation mechanism (Dana Alokasi Khusus or DAK) for works on rural roads. 117 Overall a significantly greater proportion of road works expenditures is now being financed by the respective owner governments using revenues sources over which they have full control. Financing expenditures on toll roads Government initiated the toll road program in the late 1970s when it recognized the need for users to participate in financing the construction of high standard limited access expressways. During the mid-1980s it 177

192 Road and Road Transport concluded the public sector would be unable to finance construction of the envisaged toll road program and invited private participation. In the early 1990s continuing constraints on the State budget led to toll road developers being required to finance land acquisition costs. 118 Developers are expected to recover their costs and generate a return entirely from the collection of tolls, the level of which is set by Presidential Decree. The guiding principle for the setting of tolls is that they should not exceed 70 percent of the user cost saving relative to the alternative route. There is no legal provision for toll road developers to obtain payments through mechanisms such as shadow tolls. Indonesia s first toll road was financed by the Government and transferred to Jasa Marga as equity. The development of subsequent Jasa Marga toll roads was financed primarily by a combination of foreign loans on-lent by the Government and Rupiah bonds issued by Jasa Marga. Equity investment in private toll roads has been sourced exclusively from domestic investors, while debt has been financed by a mix of domestic bank lending and commercial paper, some of which was purchased by foreign buyers. The Government is now seeking to reactivate some of the toll road projects that stalled or were put on hold as a result of the crisis. In October 2002 the Ministry of Settlements and Regional Infrastructure proposed proceeding quickly with toll road projects totalling 322 km. However private interest has so far been limited and no fully conforming bids were received in response to two attempts to tender missing sections of the Jakarta Outer Ring Road (JORR). As a result Jasa Marga has been tasked with completing the JORR and with constructing of part of the Cikampek Padalarang road. 119 Sector Performance Access The overall network length is on the low side in relation to the size of the country and it has not kept pace with population growth during recent years. National indicators for some broadly comparable Asian countries are shown in Table III.7. These suggest that Indonesia has a road network which is slightly below average density, both in relation to population and to arable land area. Table III.7. Total Road Network Per 1000 People Per Arable Land Area Country China India Indonesia Malaysia Philippines Vietnam Source: World Development Indicators, World Bank, various years Quality of Service The proportion of the network which has been paved is a common indicator for an aspect of the quality of the road infrastructure since the cost of running vehicles on a paved surface (provided that it is well maintained) is much lower than for running on an unpaved surface. The indicator is shown for several countries in the Region in Table III.8 and this suggests that Indonesia is in the middle range in this respect. Table III.8. Paved Roads as % of Total Road Length (including District roads) Country China India Indonesia Malaysia Philippines Vietnam Source: World Development Indicators, World Bank, various years There is generally a relationship between the design type of the road pavement and the quality of the surface for the vehicles which use it. This is illustrated in Table III.9 which shows the condition (in terms of roughness) of different forms of pavement construction. Table III.9. Condition of the Kabupaten Road Network by Construction Type, 2002 Condition - % Construction Good Fair Fair/Poor Poor Bad Total Asphalt Stone Gravel Earth All roads Source: DGRI The incidence of road accidents is one significant indicator of quality of the road transport system, reflecting as it does inadequacies in the infrastructure, the vehicles that use it, and the interactions with the people who operate the vehicles or walk on the infrastructure. Table III.10 shows the rates of occurrence of fatalities as a result of road accidents. Table III.10. Road Accident Fatalities, 2001 Fatalities Fatalities Country per 100,000 People per 10,000 Vehicles Cambodia China Indonesia Korea Malaysia Philippines Source: International Road Federation 178 Averting an Infrastructure Crisis: A Framework for Policy and Action

193 Efficiency Maintenance of road condition. A key aspect of the efficiency with which the road infrastructure is managed relates to how effectively the network is maintained. Assessment of road pavement condition is a way to summarise this for a road network. Clearly the standard to which it is optimal to maintain any part of the road network does depend on the trade off between construction/ maintenance costs and the differential costs of operating vehicles on roads in different conditions. Effective maintenance tends to exert high gearing by lowering operating costs so there is justification for keeping all roads which carry reasonable traffic in good condition. The average condition of national and provincial roads in different regions of Indonesia are shown in Table III.11. Table III.11. Condition of the National and Provincial Road Network by Region, 2001 (%) Region Good Fair Poor Bad Sumatera Jawa-Bali Kalimantan Sulawesi E.Region Total Source: DGRI National roads are mostly in sound condition - Provincial roads are less well maintained and over half of the extensive network of District roads is in poor condition. Overall the network is in poorer condition in the eastern region. With the substantial expenditures to date, the majority of the primary network is in sound condition, but there are significant exceptions in the eastern region and the kabupaten network which have inferior standards and condition. In 2002, 75% of the national and provincial network was in good or fair condition, up from 67% over the previous five years. 120 A significant proportion of the national and provincial network % - remains unsealed and accounts for one-half of the poor-bad condition: all of it outside Java and Bali and 67% in Kalimantan and Eastern Indonesia, where 27% of the national and provincial network is unsealed. Both traffic demand and population density are low in the outer island provinces and particularly in the easternmost regions, but the lower standards inhibit all-season access and improvement is an issue of development investment. The condition of the larger kabupaten network is much poorer. In 2002 only 44% was sealed, only 50% was rated as being in a sound, maintainable condition, and only 19% was rated as being in good condition. As with the national and provincial network, conditions vary significantly from region to region, with certain areas of the eastern Indonesia provinces having the highest proportion of weak kabupaten roads. Traffic congestion is a very pronounced indication of inefficiency. Congestion has become a widespread problem, especially in Java. The 1997 Road Sector Study 121 estimated that capacity expansion needed to proceed nationally at a rate of about 180 km annually, but little has been invested since due to the financial crisis. The recent Java Arterial Road Network Study (JARNS) 122, which assessed long-term investment needs for a 7,372 km strategic primary network comprising 2,539 km arterial, Background Sector ReportIII 1,336 km collector and 3,496 km of other strategically significant links, concluded that in 2000, 43 % of the primary arterial network was moderately congested while a further 4% was significantly or highly congested. 123 By 2010, 55% of the primary arterial network would be moderately congested, 21% significantly congested and 16% highly congested, while 42% of the non-arterial network would be moderately congested and 12% significantly or highly congested. Such prevalence of congestion is indicative of serious inefficiency in the form of long delays and very high vehicle operating costs. Ideally it is best dealt with through a planned combination of demand management and increasing physical capacity. Tariff levels Overall levels of tariff should be determined from annual gross receipts for a particular service factored by the amount of that service which has been delivered. The broad categories of service are for passenger and freight transport. The required data has not been identified. Passenger fares are regulated at a flat rate of Rp 1,200 (about US$ 0.15) for travel on economy class buses in Jakarta. Observation suggests that operators find it very difficult to sustain services on this return vehicle bodies are in very poor condition and drivers manoeuvre for passengers. The flat fare for the next level of service (which is air conditioned and quite comfortable) is Rp 3,000. Affordability Little can be said about affordability in the absence of data on tariffs. Visual evidence is that passenger services are stratified and readily available at locations of high demand (markets, road junctions etc). There are several subsidies to road transport: direct subsidy (or cross-subsidy) per passenger to ensure a low tariff (as for Jakarta above); subsidy of motor vehicle fuels as a major input to all motorized road transport services (being phased out); public finance of the road network constitutes a subsidy to road transport to the extent that revenue is not recovered from road users. Analysis of these has not been seen. Amount of Public Investments The proportion of the national budget which is spent in the road sector is an indicator of national priority. In Indonesia this has varied from less than ten percent in 1985/86 to more than 22%in 1993/94 and back to just over ten percent by 1998/99. Figures are not readily available for comparable countries. The annual public expenditure on roads as a proportion of gross national income is shown for several Asia countries in Table III

194 Road and Road Transport Table III.12. Government Expenditure on Roads, Millions 1999 USD Country 1997exp 2000 exp Gross Nat. Inc. exp/gni (%) Cambodia , Indonesia 2, , Mongolia Philippines , Source: DGRI, International Roads Federation; Italics refer to closest prior year Main Issues The issues in the road and road transport sector fall into three broad categories. First, provision of the road network has been inadequate. Provincial and kabupaten roads are in poor condition, congestion is a significant problem, and access to rural communities is low. Many factors contribute to poor provision of the road network. Funding is inadequate and unpredictable, which is exacerbated by the fact that expenses are misallocated, and the works that are allocated funds are generally expensive and of low quality. Second, use of the road network is inefficient, characterized by overloading, suboptimal use, and a lack of traffic safety. Lastly, institutions and the legal framework, especially with toll roads, are weak. Inadequate Provision of the Road Network Poor Condition of the Network While central funding has been adequate for keeping the national / arterial network in satisfactory and sustainable condition, there is a backlog of preservation and upgrading needs on the provincial network and a very large backlog on the kabupaten network. In the absence of budget and implementation constraints, the 2000 SEPM analysis indicates that expenditures on road preservation should increase sharply from their 1999 level of circa Rp. 4.5 trillion to finance a massive program of betterment, followed by a sharp decline in expenditures once the major part of the network is in a stable maintainable condition. The unconstrained 2001 budget (in 2000 prices) was estimated at circa Rp. 21 trillion, with expenditures in subsequent years falling to circa Rp. 13 trillion in 2002 and to less than Rp. 4 trillion in Over a ten-year period, the analysis indicates an average budget of circa Rp trillion, efficiently allocated, would be needed to bring the network to an optimal condition. The computed relationship between average road agency expenditures and road user costs for alternative budget constraints (10-year averages) is shown in Table III.13. A further analysis of table III.13 is found in Road Annex 1. Table III.13. Projected Road Agency and Road User Costs by Budget Level Av. Annual Costs (10-year) Annual Road (Rp. Trillion) Budget Constraint Agency User Total Unconstrained Rp. 2 Trillion Rp. 4 Trillion Rp. 6 Trillion Rp. 8 Trillion Rp. 10 Trillion Source: Consultant s estimate using SEPM Capacity Expansion Needs in Highly Congested Areas Managing the increase in traffic demand that results from economic growth requires a systematic investment in expansion of network capacity and improvements in traffic management. Deferral of a substantial program of upgrading at the time of the financial crisis and the subsequent resumption of traffic growth have resulted in very pressing needs to expand the capacity of sections of the arterial road network. High congestion costs are being imposed on users of some heavily trafficked corridors. This applies particularly to Java, where it is estimated that at least 240 km of capacity expansion per year is economically justified through 2010, which is 30% higher than similar estimates in All the major urban areas are subject to severe traffic congestion and this is a growing problem for the smaller satellite towns. Urban traffic flows have continued to increase rapidly, despite the financial crisis. Private motor vehicle use has grown particularly fast, following liberalization of motor vehicle import regulations 124. Atmospheric pollution is a serious problem in the large cities (in the 1990s Jakarta was ranked the third most polluted mega-city in the world) and is an rapidly emerging concern for the next level of cities. Vehicle emissions are considered to contribute much to local levels of air pollution and the use of leaded gasoline has been a major concern. Low Access for Remote Communities The Government has made considerable progress over recent decades in extending the coverage of the modern transport network throughout the country. The nature of the country naturally gives inter-island shipping an important role. Moreover the topography of some areas means that coastal shipping and inland waterways may continue to be an important transport mode for those locales. However, the increased coverage of transport services is achieved primarily by extending the road network. Some 5 % of the population remains without direct access to the all-season road network. There has been a strong commitment to extend road transport and other basic services to the more remote parts of the country. However, the marginal costs of providing the infrastructure become much higher for remote locations. Operating costs also tend to be well above average in these areas so, when demand is in any case rather weak, improved services may be costly and difficult to sustain. 180 Averting an Infrastructure Crisis: A Framework for Policy and Action

195 The challenges above are exacerbated by the following: Inadequate and Unpredictable Funding Funding for the road programs from sub-national government budgets will fall well short of the economically justified road expenditure needs over the coming decade, especially as there is currently no mechanism for overall monitoring nor allocation of funds for the sector under the regional block grant allocations. In addition, the funding of road preservation is still seen as a general public expenditure responsibility, and there is no explicit recovery of costs from road users for the specific costs they impose on the assets or economy. The proceeds from road-related taxes are treated as general tax revenue and are not all allocated for funding the road programs. As a result, under-funding and uneven funding is compounded by unpredictability of funding, with the road programs and sub-networks having to compete with other sectors to secure budget resources. This poses particular problems for road preservation programs which need a reliable and predictable funding stream. Sub-optimal Allocation of Expenditure Indonesia has devoted considerable resources to improving the planning and programming of road works. The Indonesia Road Management System (IIRMS) has been developed over many years and applied effectively to the National and Provincial road networks. Consequently, funding allocated to the National network is reasonably close to the need, (see Figure III.3). However, the Provincial network has been relatively under-funded, due in part to the continual addition of low standard roads through reclassification. Annual Funding (IDR billion) Figure III.3. Adequacy and Allocation of Resources for Road Preservation Source: DGRI, National Needs 00 Provincial Road Network FY 98 FY 99 FY 99 Kabupaten Funds allocated to maintain roads at the District level and below are even more deficient. Tools have also been developed for managing the kabupaten and kota roads, but those networks have remained under-funded by at least 30% (Figure III.3). Substantial inputs have been invested to build the institutional capacities needed to manage these roads but routine maintenance in particular continues to be under-funded. Several factors make it difficult to address the problem: Background Sector ReportIII Decentralization has shifted substantial planning responsibilities to regional agencies that lack the capacity or incentives to use available planning tools effectively. Inter-agency coordination is inadequate. At the national level interaction between DGRI and the MOC Directorates General has long been relatively limited. It will also take time to establish effective centerregional relationships to replace the pre-decentralization line-of-control. Plans and programs are often developed without adequate public consultation. Some provinces have established transport planning groups and an unshackled press is pressing government agencies to be more open and accountable. Reliable data on road condition, traffic volumes and speeds, axle loads, origins and destinations essential inputs for planning and evaluating road works programs are not always available. Indications are that some data has been systematically adjusted to improve funding prospects. Road Works are Expensive and of Low Quality Uncompetitive procurement results in high costs and poor performance of construction and maintenance works. A survey of preservation works on national and provincial roads carried out during the late 1990s recently revealed that 25% were performing significantly less well than designed and reaching a critical condition at least 30% earlier than projected. 125 Corruption, collusion and nepotism remain pervasive in the construction industry and contribute substantially to the problem. Collusion between bidders and officials undermines competition, leading to higher initial prices and losses estimated at 10-30%. When this weakens supervision control over the quality of work, the consequent under-performance can increase losses to in the order of 40%. The impact is even more negative when poor supervision performance on the part of public authorities, particularly at the kabupaten level, also significantly diminishes the effectiveness of maintenance - resulting in premature road deterioration, excessive vehicle operating costs and a greater need for costly rehabilitation. Reform in these areas can give rise to substantial direct savings together with even greater indirect benefits through reduced vehicle operating costs as a result of the improved condition of the network. Inefficient Use of the Road Network Vehicle Overloading The enforcement of vehicle loading and dimension regulations in Indonesia is very weak, with between 30 and 100% of heavy vehicles overloaded such vehicle overloading has been estimated to increase road preservation costs by between 20-60%. 126 As long ago as 1981 Government closed all roadside weighbridges due to their being ineffective and functioning primarily as collection points for illegal levies. Most have since been reopened, some have been upgraded, and some new stations have been built, but little else has changed. Visual observation confirms that the 181

196 Road and Road Transport Official statistics are believed to understate actual number of fatalities, in part because deaths occurring more than 24 hours after an accident are often not included. Inadequate Institutional and Regulatory Framework for Toll Roads problem remains very serious and is possibly worsening. In Sumatera trucks transport logs that overhang far beyond the permitted the limit. In Java hungry boards are used to enable trucks to carry excessive volumes of sand and aggregates. Similarly in Jakarta, ready-mix concrete trucks are fitted with drums that are much larger than the volume stated on the vehicle documents. Many overloaded trucks enjoy military or police protection and indeed many are operated by military or police cooperatives. Sub-optimal Utilization of Existing Road Network Capacity With budget constraints limiting the scope for road capacity expansion investments, it will be essential in the medium term to maximize utilization of existing capacity. At present, serious congestion, which greatly increases road user costs, is commonly caused by poor traffic engineering and traffic management, especially at intersections, by roadside activities such as markets that impede traffic flow, by slow-moving vehicles that are overloaded, under-powered or unsafe, and by poor driver behavior. In some areas, problems are compounded by poor public transport route licensing practices that allow the operation of excessive numbers of small pick-ups and that require these to pass through badly located and managed terminals for the primary purpose of revenue generation. Some basic traffic management measures such as traffic lights and one way streets are applied in most urban areas. To date there have been rather limited attempts to introduce more sophisticated traffic management measures such as segregated traffic, tidal flow lanes and variable geometry at roundabouts. The very substantial needs for improved regulation and management of urban transport as well as for capital investment must be assessed in the complex context of urban management and planning. Poor Road Traffic Safety Road traffic accidents cause around 25 deaths per day in Indonesia and give rise to substantial material costs. Road accidents impose an estimated cost of 1.5% of GDP. The number of reported fatalities has declined in recent years, falling from circa 11,800 in 1998 to 8,762 in The number of fatalities per 100,000 population is relatively low at 4.6, but the number per 10,000 registered vehicles is relatively high at 4.5. Poor public and driver education coupled with lax driver testing procedures for drivers of public transport and heavy goods vehicles, are important factors. They are compounded by weak enforcement of safety-related traffic regulations, ineffectual inspection of motor vehicle condition, which is currently required only for commercial vehicles, and poor road and intersection geometry and signing. In some instances, notably driver and vehicle testing, corruption is recognized to be a significant underlying factor. Information on the causes and consequences of traffic accidents is poor, in part because it has taken more than a decade to secure inter-agency agreement on the adoption of an improved traffic accident reporting and data processing system whose implementation is only now commencing on a pilot basis. Private interest in developing toll roads has not recovered from the significant setbacks brought about by the financial and economic crisis in As a result of the crisis, GOI eventually canceled 37 projects and subjected 18 to further review. In October 2002, MSRI proposed reactivating stalled projects and proceeding quickly with toll road projects totaling 322 km, but there has been limited private interest. Clearly, many years after the crisis, there is still no sign of renewed private interest in the toll roads. The limited interest now being shown in the toll road sector by serious private investors is attributable to several factors aside from the overall investment climate. Prominent among them are: Concerns regarding the concessions award process and the multiple roles assigned to Jasa Marga, which acts as a toll road developer, an agent of development required by the Government to construct roads that are not commercially viable, and as a counter-party for concession agreements with private developers or as a joint venture partner for such developers; Absence of an agreed automatic tariff adjustment mechanism to reflect changes in costs not controllable by developers; Difficultly of acquiring land in a timely manner, as there is no enforceable legal framework to expropriate land for public purposes; Requiring developers to be responsible for the costs of land acquisition in the absence of functioning eminent domain powers; Unclear allocation of government responsibility, particularly on tariff policy and regulation; Slow progress in the resolution of existing concessions; and Absence of a well designed and updated toll road master-plan on which to prepare meaningful feasibility studies. The Way Forward Government has recognized and has been seeking to tackle the core problems impeding the efficient functioning of the road sector for more than two decades. While some initiatives have borne fruit, the overall pace of progress has been disappointingly slow. The resultant costs for the budget and for road users amount to several trillions of Rupiah per year. These are real costs that impact the performance of the economy and impede efforts to alleviate poverty. A fundamental rethinking on the way in which the sector is managed and regulated is clearly needed. Improve Road Network Provision Expand and Extend Network Managing the increase in traffic demand that results from economic growth requires a systematic investment in expansion of network capacity and improvements in traffic and demand management. Programs of priority investment on the core sections of the network should be identified, particularly those that may be suitable for private investment. 182 Averting an Infrastructure Crisis: A Framework for Policy and Action

197 A recent study for Java s arterial road network identified the growing congestion and concluded that: Background Sector ReportIII by around 2007, all primary arterial and collector links of less than 7 meters width should be widened to 7 meters; by 2030, the entire arterial road network should be developed to a 4- lane standard. 127 A preliminary screening process identified a program of economically warranted upgrading projects amounting to Rp. 106 trillion at 2000 prices over the period Of this total, Rp. 4.5 trillion is for widening to a 7-meter 2-lane unseparated standard (U7), 128 Rp trillion is for widening to 4-lane dual carriageway standard on existing alignments (4D), and Rp trillion is for construction of new 4-lane dual carriageway limited access roads (LAN). The criteria for including investments in the program was a first year economic rate of return of 20% or greater, which is estimated to equate to an EIRR of over 40% with the projected traffic growth rates. As shown in Figure III.4, the preliminary screening indicated that further investments in new 4-lane dual carriageway inter-urban limited access roads would not be justified prior to However, the study s subsequent more detailed analyses identified some promising candidates for toll road development prior to Billion Rp in Period Figure III.4. Economically Warrented Road Capacity Expansion rogram for Java Strategic Network ,000 35,000 30,000 25,000 20,000 15,000 10,000 5,000 Improve Access to Remote Communities There is a need to extend the all-season road network in order to provide reliable access for the 9% of the rural population which is not directly connected. However, the marginal costs of reaching the more isolated communities and of sustaining effective links to them are increasingly high. It will be important to make careful choices to keep design standards consistent with expected levels and types of traffic. The aim will be to draw on local and regional experience to keep the construction and maintenance of new roads cost effective and consistent with local capacity. There may be opportunities to directly generate local employment in poor areas by adopting labour-based technologies. Given the high costs, these development investments require a strong political commitment. Such new roads cannot compete with other investments in the road network in terms of economic returns. Resources must be allocated on the basis of other local or national criteria: regional coherence, social inclusion, poverty reduction etc. Additionally, the following steps should be taken. Clarify a process for identifying Provincial priorities for extending the road network to desa which are still not connected. Establish criteria for Central Government support for extending the network in the context of the Poverty Reduction Strategy. Ensure that decisions to extend the network take adequate account of the expected recurrent cost implications for maintaining the new road links. Remove Government influence from ORGANDA, the Indonesian Road Transport Operator s association, and encourage the Association to represent its members interests more effectively Period 2-lane - widening 4-lane existing -widening 4-lane - new Source: Java Arterial Road Study The identified capacity expansion investment needs for Java massively exceed past levels of funding for all new construction works (see Table 6). The study s recommended expenditure program for the period was prepared on the basis that funding available for Java capacity expansion works would increase progressively from Rp. 0.5 trillion in 2002 to Rp. 1.0 trillion in 2007 and remain at that level through 2010, with the total budget over the period being Rp 6.4 trillion. This necessarily involves deferring many projects with high rates of return. Equivalent studies have yet to be conducted for other island groups. While their collective capacity expansion needs will not be as large as those for Java, they will nonetheless be significant and justify substantial investments. In order to effectively implement the recommendations above, the following are required. Stabilize the Funding for Road Assets Managing road assets is an expensive business, and while roads are seen as a public good, they are competing for public expenditures with other sectors on the basis of outputs which are difficult to compare. Under the public expenditure model, the road networks have been unevenly funded or under-funded the economic needs-based estimate for preservation of satisfactory service on the primary networks is an average of IDR 6.5 trillion annually (1999 values) with a gap in 2000 of about IDR 2.2 trillion, a 15-20% shortfall on Provincial roads and 30% shortfall on District roads. 129 Instead, if the provision and preservation of road assets is considered as a commercial service rather than a public good, the costs of preservation can be recovered through a fee charged to road users for the services they receive. Road users are paying about IDR 220 trillion annually in operating costs, and the added costs they incur through the under-funding on roads is estimated to be about IDR 6 trillion, or three times the funding gap. If the 183

198 Road and Road Transport financing of road preservation was put on a fee-for-service basis, users may pay an additional IDR 2.2 trillion but they would have net savings of double that amount. Under a commercial service model, the full economic costs of road preservation would be recovered from users and invested in the road assets, in a similar way to the operation of utilities such as telephones or electric power. Adoption of this cost recovery model could place the management of road assets on a fully sustainable basis which does not impose on general public expenditures, because the revenue would keep pace with the expenditure needs, provided that the funds were invested back in the assets efficiently. In essence the funds would pass through from road user revenues to the budget for road expenditures and eventually, with the appropriate controls, could be managed off-budget. Off-budget road funds financed by predictable revenue streams from user charges have proven effective in many countries, particularly where they are part of a broader strategy for managing roads on a business-like fee-forservice basis. Road fund revenues should be sourced from specific road user charges, not from general tax revenue, and its claim to these revenues should be established in law. The level of revenues should be sufficient to finance the works and services needed to improve and maintain the network to a satisfactory standard, while the structure of user charges should provide incentives for economically sound vehicle purchase and operating decisions. Road preservation works would thus be funded entirely off-budget by users and without financing from foreign loans. When the subsidy on gasoline and ADO is eliminated, road users will start to make a substantial contribution towards the costs of road preservation (rehabilitation, routine and periodic maintenance and limited betterment). Revenues from the PKB motor vehicle tax, the PBBKB motor vehicle fuels tax, and other taxes on road users would be broadly in line with the desirable level of preservation expenditures. 130 The present structure of the existing road user charges is far from that ideal, however. The PKB was conceived as a wealth tax and, although its potential role as a road user charge was recognized in the early 1990s, the main determinant of the PKB rate is vehicle book value (with a cap of 5%). Rates accordingly decline with vehicle age, with the rate for an old truck capable of causing considerable road damage being very low. This structure is also undesirable inasmuch as it encourages retention of vehicles beyond their economic working lives. BBNKB is payable on each ownership transfer, with the amount payable being a percentage of book value. It is probably best viewed as a general tax. 131 The PBBKB is critically important as a road usage related charge, as the amount a user pays depends on the size of the vehicle and the distance it travels. However, it is an ad valorem tax and the revenue per liter accordingly fluctuates with the price of fuel. The sources of revenues for the road fund system should therefore be the annual motor vehicle tax (PKB) and the motor vehicle fuel tax (PBBKB). Both will require some restructuring for this purpose. For the PKB, the rates for commercial vehicles should be reflect their road damaging 184 Averting an Infrastructure Crisis: A Framework for Policy and Action

199 potential (gross vehicle weight and axle configuration) and should not decline with vehicle age as is the case at present. There could be a case for splitting the PKB into two components, a wealth tax and road damage charge, with only the latter being designated as a road user charge. The PBBKB, which is currently an ad valorem tax, should be replaced by a levy or levies expressed as a fixed Rupiah amount per liter, with the amount being subject to periodic review and adjustment. These changes will require amendments to the provisions of Law 18/1997 that relate to the structure of the PKB and PBBKB. The Road Funds study estimated that the levy would need to be set initially at around Rp 140 per liter for gasoline and diesel on the basis of an annual road preservation funding requirement of Rp. 6.5 trillion and a contribution of circa Rp. 2.1 trillion from the PKB. It will also be necessary to amend the provisions of Law 34/2000 that relate to the collection and sharing of these taxes. In particular, it will be necessary to provide for the proceeds of the PKB to be channeled to the provincial road funds and for part of the proceeds from the PBBKB levy to be allocated to the national road fund. Alternatively, there could be a case for establishing a new national motor vehicle fuel levy whose proceeds would accrue entirely to the national road fund. There will also be a need for changes to the 1980 Law on Roads in order to provide the legal basis for, or otherwise to accommodate, the establishment of national and provincial road funds and related institutional changes. MSRI has indicated its strong support for the road fund concept and proposes amending the Law on Roads to provide a suitable enabling framework. Socialization has already commenced in several provinces, and there are plans to commence preparation of a pilot scheme shortly. But there is still a long way to go. In particular, there is opposition in some quarters to the principle of the PKB and PBBKB being treated as road user charges and allocated to finance a system of road funds. Moreover regions that have high revenues from PKB and PBBKB are likely to be averse to any pooling. The next steps will therefore need to involve further development of the concept, preparation of a comprehensive and detailed implementation plan, coupled with intensive efforts to build understanding of the benefits. The DGRI Road Funds study identified and evaluated alternative models for a system of road funds in Indonesia, with the most promising option involving a combination of national and provincial road funds. Provincial road funds in each province would fund the rehabilitation and maintenance of national roads, acting as deconcentrated agents of central government, and of provincial roads. Within this framework, the primary function of the national road fund would be to adjust the balance between the revenues and expenditure needs of individual provincial funds. While the MSRI will need to keep playing a key role in further defining the road fund concept, it is not well positioned, as a sector technical ministry, to identify, guide and coordinate all of the many actions required. There would seem to be a strong case for assigning this role to Government s minister-level KKPPI committee, with its road sector sub-committee committee acting as the focal point in close consultation with other stakeholders. Improve the Allocation of Road Expenditures Responsibility for road maintenance should, as mentioned above, be allocated to a combination of national and provincial road funds. The provincial funds should provide transfers to participating kabupaten administrations to finance rehabilitation and maintenance of their networks, subject to them adopting and applying sound road management practices. Establishing a sound governance framework for the road funds is critical in order to improve the allocation of expenditures for maintenance work. Background Sector ReportIII The task of managing funds for road preservation should be handled by boards with legally defined powers and obligations that operates at arm s length from government. The majority of board members should represent stakeholders other than government (e.g. industrial, agricultural and commercial associations, aspects of civil society, passenger and freight transport organizations; and key government departments), and decisionmaking should be insulated from political interference. Having road users more directly involved in the funding and management of the road system creates a sense of ownership and a concern for value for money that in turn pressures road agencies to become more efficient, accountable and transparent. The Provincial Roads Boards should be responsible for the strategic oversight of all the roads in the Province (National, Provincial and kabupaten) down to, but not including, the desa level, while the National Roads Board should maintain an oversight for national policy issues and will provide for coordination between the Provincial Roads Boards. The road agencies should use the IIRMS planning and management procedures to assess needs and determine priorities for allocation of funds. They should have updated maintenance programs, which take into account prevailing constraints of finance and capacity. Design, civil works, and works supervision should be tendered by the road agencies, as should also the collection of data (road condition, traffic, vehicle loading). Agencies should be required to report to the Boards on the management of the network and arrange for independent auditing. As far as network expansion is concerned, a soundly prioritized pipeline of economically justified projects needs to be prepared based on an agreed strategic network development plan. The JARNS study has provided an evaluation of priorities for Java but the approaches and procedures developed now need to be institutionalized, with the data bases being maintained and refined and coverage being extended to other regions. For this purpose DGRI should establish a permanent strategic road network planning unit whose duties should include: maintaining and further developing the network / link planning and evaluation systems developed under JARNS and extending their application to relatively heavily trafficked regions outside Java; developing and maintaining a primary arterial road network plan, including a plan for toll road network development, so as to provide the basis for the programming and budgeting of capacity expansion works and for assessing the viability of investments in toll roads; carrying out detailed technical, economic and financial feasibility studies of specific capacity expansion and major network extension proposals, including for limited access expressways proposed for development as toll roads. Ensure that Road Works Yield Better Value for Money Once road funds are in place, the function of funds management needs to be clearly distinguished from that of works and services implementation. 185

200 Road and Road Transport The road funds should act as a purchaser of works and services and should promote the effective competition needed to push down prices and improve quality of works and services. Reporting arrangements must provide the information needed for independent assessments of performance, and independent technical and financial audits should become mandatory. In addition, actions and incentives to improve the efficiency of works and services should be encouraged and put in place. A more balanced share of risk between contractor and client, or transfer of risk to the contractor, would reduce the indirect costs being incurred through inadequate quality. Further consideration needs to be given to the implementation of outputbased contracting (in which payments are made only when the work passes technical audit and extended warranty periods may be included). The possibility of introducing multi-year performance-specified contracting (in which a contractor fully maintains a road or sub-network over several years to specified performance standards) is also worth a trial. MSRI and a number of provinces have shown strong interest in proceeding with pilot schemes but these have not yet progressed due to problems in securing agreement to making multi-year budget commitments. The success of such approaches depends on internal discipline and project management by the contractor, and rigorous and impartial evaluation and monitoring by the client of the contractor s achievements, exerting control through the payment schedule. For the initial trials, a good governance environment should be selected and, for the performance-specified contracts, a medium period of 3 to 5 years will allow opportunity for review and refinement of the approach before broader dissemination. Increase Efficiency of Road Network Use Address the Issue of Vehicle Overloading Reduction of vehicle overloading remains a top priority, and a pilot project involving several roadside weighbridges now being developed by MOC merits careful monitoring. The project will upgrade the weighbridges, including by the addition of secure in-ground weigh-in-motion equipment that will enable reliable monitoring of axle loads. Weighbridge operation will be contracted out, and an incentive structure will be established with the WIM system providing the basis on which to measure performance. Government s efforts must be actively supported by a freight transport industry that wishes to eliminate the damaging practice of over loading amongst its members, so awareness must be raised concerning the massive costs which are inflicted by overloaded vehicles in terms of excessive road damage. Improve Road Infrastructure Use In a decentralized environment under which central government s powers are quite limited, increased attention will need to be given to building awareness of the public and private costs of inefficient use of the road network, to working with progressive regional governments to pilot improvements, and to publicizing successes so as to encourage their wider adoption. Continued efforts should be made to improve traffic management and public transport licensing and to reduce roadside friction caused by markets and other commercial activities. These will reduce congestion at low cost, but will require effective consultation with stakeholders. Publicizing a few success stories would put pressure on other governments to follow suit. For new roads such as urban bypasses, restrictions should be placed on frontage development so as to enable them to serve their intended function. Improve Road Safety The Government embarked on a comprehensive program to address road safety problems in The more important achievements include enforcing use of helmets by motor cyclists, implementing sound remedial works at major accident black spots, and eliminating the movement of ISO containers on rigid trucks. However, overall progress in most areas has been very limited and the successes few. In the near term, the most cost effective initiatives for traffic safety improvement will likely continue to be remedial measures at accident black-spots. The recently adopted accident reporting (3L) system needs to be implemented rapidly so as to improve information on the location, causes and consequences of accidents. Attention should also be given to improving road safety education, including through finalizing and publishing the draft highway code developed by MOC in the mid-1990s. Improving driver testing, vehicle inspection, and traffic regulation enforcement remain important priorities, but the pressures for this will need to come increasingly from the public rather than from central Government. Operators who appreciate the commercial benefits (as well as the social) of employing good practice to ensure safe and cost effective transport will have a strong incentive to support education and enforcement activities which are designed to encourage all operators to adopt safe practice. Central Government can potentially play an important role in benchmarking the performance of the regions, although this will require careful planning and preparation and sound data. Consideration should again be given to the possibility of establishing a national road safety council so as to help promote public awareness and coordinate the activities of the many agencies and boards with traffic safety-related responsibilities. Strengthen Institutional and Legal Framework Strengthening the Institutional and Regulatory Framework for Toll Roads It is vital to strengthen the institutional and regulatory environment in order to revitalize private participation. GOI has recognized the need to amend the framework for toll roads and proposals for an improved structure are now being developed. The overarching goal is to attract substantial private investment on reasonable terms and with an appropriate sharing of risks in a manner that contributes to the achievement of overall sector and regional development goals. Efforts for reform should be focused on the following specific measures: Enable Jasa Marga to operate as a commercially viable company by separating its regulatory and operating roles; Establish a national Indonesian Toll Road Authority, empowered to produce, procure and enter into concession agreements with third parties with the full backing of government; Enable the automatic adjustment of toll rates based on an appropriately structured formula; 186 Averting an Infrastructure Crisis: A Framework for Policy and Action

201 Enable timely land acquisition by introducing an enforceable legal framework to expropriate land for public use and agree on a pricing policy; Establish a clear and appropriate allocation of responsibilities for handling toll road development and supervision among the different levels of government; Establish sound, transparent and competitive procedures for soliciting bids for proposed toll road projects; Design a sound framework for public support for developing economically justified toll roads that will not be financially viable for private investment if dependent solely on toll revenues. Provision for many of these changes will need to be appropriately reflected in the draft amendments to the 1980 Road Law now being prepared by MSRI, and in a new Government Regulation on Toll Roads that will replace GR 8/1990. Institutional and regulatory reforms will not by themselves be sufficient to attract sufficient new private investment into the sector. There may be justifiable reasons for providing public support for private toll road investments, for which a framework was prescribed earlier in this section. For example, developing toll roads can both reduce the need for public investment in the widening of existing roads and also provide important spillover regional development benefits, which may be difficult to recoup from user tolls alone. However, careful analysis is needed to develop a clear and sound set of policies that will enable the government to Background Sector ReportIII appropriately partner with private investors without undertaking unnecessary risks. Given the potential implications on government finances, MOF should have a central role in determining government support. It should consider creating a dedicated department with adequate technical capacity to analyze issues related to government support as well as developing an adequate framework for accounting for government support in the debt and budgeting process. GOI will also need to address the complex issue of land acquisition, either by implementing effective eminent domain powers or possibly by establishing a revolving fund to finance land acquisition for toll roads. In addition, GOI should consider the development of one or two pilot toll road projects which work through and demonstrate some of the measures listed above. Pilot projects attempting to improve transparency, allocation of responsibility, regulation, risk sharing, financing, land acquisition, and tariff structures would be very useful in developing best practice and determining what forms of government support may be needed to remobilize private investment. 187

202 Road and Road Transport Adopting the Necessary Legal and Institutional Reforms The passage of the laws on regional autonomy makes it necessary to amend or replace Law 13/1980 on Roads and Law 14/192 on Road Traffic and Transport to reflect the greatly altered allocation of responsibilities between the different levels of government. Both laws also need to be amended to provide a more conducive framework for private participation. For the Road Law particular attention needs to be given to establishing an improved framework for the development and operation of toll roads, and to creating the legal basis for the introduction of road funds. MSRI is already far advanced with the drafting of an amendment to the Road Law while MOC has already embarked on the drafting of a new Road Traffic and Transport Law. Before this is finalized and submitted to the DPR it is recommended that a roads and road traffic and transport sector blueprint be prepared. This would provide a comprehensive road map for the sector s development over the medium term and should show how the proposed legal changes would fit with and support proposed policy and institutional reforms. The KKPPI Roads Steering Committee should take the lead in coordinating the preparation of this blueprint and in ensuring that the proposed legal changes are in line with this. Over the last two decades corporatization of state enterprises, private participation in infrastructure provision, and decentralization have dramatically changed the landscape of the transport sector, and hence the role and tasks of central government. While there have been consequent changes in the structure and staffing of some ministries, including for example the transformation of the Ministry of Public Works into the Ministry of Settlements and Regional Infrastructure, others including MOC have changed relatively little so far. Table III.14. The Way Forward Issue Steps for the Short Term (0-2 years) Steps for the Medium Term (up to 5 years) Expansion and extension Adopt and initiate preparation of a program of priority Increase road development budget allocation from IDR 0.5 tr of the road network feasible road capacity expansion and construction projects to IDR 1.0 tr by 2007 and sustain that through for Java. Implement capacity expansion and construction program. Study and forecast capacity needs for other regions and Audit (technically and financially) expansion program. networks Determine and plan financing for medium-term program within national development budget, and foreign finance Increase access to remote areas Clarify process for identifying provincial priorities for extending road network Establish criteria for central government support for extending road network Stable sustainable financing Establishment of a fuel levy (amend Law 18/1997) Progressive increase of fuel levy to about IDR 140 / L. for road asset preservation Dedication of fuel levy and road licence fee to road Allocation of fuel levy to a national road fund. expenditures and separation from wealth tax element Pilot allocation of vehicle registration tax (PKB) to a provincial (amend Law 34/2000) fund in a pilot Province. Legislation enabling establishment of national and provincial Establishment and operation of national road fund and road funds (amend 1980 Law on Roads) board. Socialization of RUC concept nationally and provincially, Establishment, operation and assessment of pilot provincial and selection of pilot Province. road fund and boards. Detailed design of pilot road fund and oversight arrangements. Improve allocation Improve use of IIRMS programming tool at national and Base allocation of road program budgets on results of of road expenditures provincial level planning and programming tools Establish a permanent strategic road network planning unit. If allocations at sub-national levels have become more Develop operational toolkit on planning and programming efficient, accelerate reduction of backlog on Provincial and methods, for pilot road fund board District roads Conduct training on road programming tools with provincial Review experience with sub-national block grants and pilot and local government road officials road fund, recommend sub-national road management model and adopt it. Improve value-for-money Intensify training in project and contract management, and Expand use of computerized tools to improve efficiency and of road works focus accountability on project manager. link promotion to performance for project managers. Conduct independent technical audits on contracts, act on Include performance history in contractors pre-qualification findings and publish results evaluation, and introduce computerized prequalification Increase transparency and efficiency in procurement, procedure expanding use of ICT to publish projects, bid results, awards Publish statistics on average costs of works against target and performance trends and compare with external benchmark values. Require and enforce quality management plans from Implement program of area-based and performance contractors under the Quality Assurance system -specified multi-year contracts. Initiate pilot trials of multi-year performance-specified contracts. 188 Averting an Infrastructure Crisis: A Framework for Policy and Action

203 Background Sector ReportIII The ongoing preparation of new laws on roads, road traffic and transport, railways, maritime and inland waterway transport and civil aviation necessarily involves redefining the role of central government. As this work progresses, it will be important to start considering how organization structures and skill mixes should be changed in order to better meet their changed responsibilities and the evolving needs and challenges. Table III.14. The Way Forward (continued) Issue Steps for the Short Term (0-2 years) Steps for the Medium Term (up to 5 years) Reducing excessive vehicle Monitor pilot project with new roadside weighbridges under Link road budget / road fund allocation to provincial overloading. outsourced operation performance in reducing overloading Engage primary firms and industries in control at the gate National road fund board to implement independent sample approach monitoring of overloading Improving road safety Implement remedial measures at priority accident blackspots Improve driver testing, vehicle inspection and traffic Publish highway traffic code regulation enforcement Raise enforcement of safety device usage: cyclist helmets, Strengthen voice on safety issues at provincial level and on seat belts road fund boards Improve operation Build awareness at provincial and District levels of causes Continue to improve traffic management, public transport of road infrastructure and costs of traffic congestion, develop action plans for licensing, and actions to reduce commercial misuse of improving traffic and road use management, publicize results. roadside and road space. For new road facilities and major widening projects, implement and enforce controls over frontage and strip development. Strengthening institutional and Amend the institutional and regulatory framework for toll Develop toll road pilot projects Proceed with priority regulatory framework roads, in 1980 Road Law and new regulation replacing program of toll road investments for toll roads. GR 8/1990. Unbundle regulatory and operating roles of Jasa Marga Establish a national Indonesian Toll Road Authority Introduce tariff adjustment mechanism Develop sound policies to enable suitable incentives for private investment without undue risk to Government. Address land acquisition issue, through establishment of revolving fund or implementing effective eminent domain Adoption of legal Amend or replace Law 13/1980 on Roads and Law 14/1992 on Amend legislation to provide for forms of autonomous road and institutional reforms Road Traffic and Transport, to reflect, e.g.: regional autonomy, management organization. framework for private participation, framework for development Initiate and implement pilot for reform of road management and operation of toll roads, and establishment and organization in a selected province. administration of road funds. Review and study needs for alternative organization of road management at sub-national level, e.g. statutory authority operating on a commercial basis 189

204 Annex III.1 Cost Benefit Analysis Road and Road Transport This annex provides a brief cost benefit analysis of road preservation expenditures. It also evaluates the effects of a decrease in expenditure allocation efficiency. Specifically, the annex further develops table 13 in the Roads and Road Transport chapter and concludes that efforts should be made to increase initial, up front preservation expenditures in order to minimize total cost. At the same time, it is critical that these initial payments must be allocated efficiently to avoid significant amounts of wasted expenditure, which can instead be invested in numerous expansion projects with high economic rates of return. Analysis Table Annex III NPV of the Change in Consumer Surplus by Segment (in Millions) Average Annual Costs Annual Budget (10 years, Trillion Rp.) Cumulative % of Maximum Constraint Agency User Total Annual Savings Savings Rp. 2 Trillion Rp. 4 Trillion % Rp. 6 Trillion % Rp. 8 Trillion % Rp. 10 Trillion % Unconstrained % The table above is derived from the Strategic Expenditure Planning Model (SEPM). This model determines the optimal allocation of a total roads budget between road class, status, region, and works program. As stated in the Roads and Road transport chapter, SEPM concludes that road preservation expenditure should increase dramatically from its 1999 level of circa Rp. 4.5 trillion (US$ 483 million, 0.3% of GDP) to finance a massive betterment program. Given an unconstrained budget, circa Rp. 21 trillion (US$ 2255 million, 1.6% GDP) should be spent in the first year, Rp. 13 trillion (US$ 1396 million, 1.0% GDP) in the next year, and subsequent expenditures falling over the remaining years of a ten year period. On average, Rp trillion, efficiently allocated, is needed to bring the network to optimal condition. At Rp. 6.5 trillion, total cost is minimized at Rp trillion per year (US$ million, 16.2% of GDP) as seen in the table above and graphically below. A more realistic scenario incorporates an annual budget constraint. With a budget constraint of Rp. 2 trillion (US$ 215 million, 0.1% GDP) per year, total annual costs would be Rp trillion (US$ 1579 million, 1.0% GDP) higher than under the unconstrained scenario. With constrained budgets higher than Rp. 2 trillion per year, costs progressively go down. The cumulative annual savings are displayed in the fifth column of table 1. Notably, increasing the annual budget constraint from Rp. 2 trillion to Rp. 4 trillion saves Rp. 7.5 trillion (US$ 805 million, 0.6% GDP) of total annual cost and captures over half of the maximum cost savings. Furthermore, increasing the budget constraint to Rp. 6 trillion 190 Averting an Infrastructure Crisis: A Framework for Policy and Action

205 captures 73 percent of the maximum savings. Further increases in the budget constraint continue to decrease total cost, though not at the same rate. Thus, in order to maximize cost savings, it is critical to permit a high budget constraint and allow large initial payments. The consequence of not doing so is a disproportionately large increase in average total costs. Background Sector ReportIII Average Annual Total Cost (Rp. Trillion, 10 years) Figure Annex III Average Annual Agency Costs (Rp. Trillion, 10 years) Retained cost savings can be invested in numerous expansion and extension projects with high economic rates of return. As stated in the report, the Java Arterial Road Network Study (JARNs) identified a program of economically warranted upgrading projects (road widening and new construction) amounting to Rp. 106 trillion (US$ million, 7.9% GDP) at 2000 prices over the period 2000 to 2030, with Rp trillion (US$ 2717 million, 1.9% GDP) occurring in the first 10 years. Each of these projects has a minimum first year economic rate of return of 20 percent, which is estimated to be close to 40 percent given the projected increase in traffic congestion over the long term. So clearly, there are numerous projects worthy of investment, with Indonesia potentially benefiting from Rp. 4.2 trillion (US$ 451 million, 0.3% GDP) of economic gains per year for the first ten years (assuming a 25 percent economic rate of return each year). Efficient deployment of funds will maximize these significant gains. It is also important that all preservation expenditures be deployed efficiently. Table 1 assumes 100 percent efficiency, although this is unlikely to be the case. Table 2 calculates the costs associated with 80 percent efficiency. The table assumes that inefficiently deployed funds are wasted. Thus, spending Rp. 2.0 trillion at 80 percent efficiency is equivalent to spending Rp. 1.6 trillion. As expected, inefficiency results in losses up to Rp. 5.5 trillion (US$ 591 million, 0.4% GDP) annually as actual average agency cost increases. Although it is critical that budget constraints be maximized in order to capture savings, it is also extremely important that funds be spent efficiently so that the resulting savings be retained rather than wasted due to inefficiency. Table Annex III Projected Road Agency and Road User Costs Assuming 80% Efficiency Average Annual Costs (10 years, Trillion Rp.) Equivalent Agency Agency Cost Estimated Total Cost Loss Cost at 80% User Efficiency Cost

206 sector IV Water Supply and Sanitation 192 Averting an Infrastructure Crisis: A Framework for Policy and Action

207 Background Sector Report IV The water and sanitation sectors are in a state of crisis, undeniably amongst the weakest sectors in Indonesia. The inadequacy of service delivery in the sector in recent years has had significant impacts on human development outcomes. The most compelling indicator of the problems in the sector is the high incidence of typhoid, invariably amongst the poorer sections of society. No other country in the region with a GNI per capita of US$710 (2002) finds itself in this situation. Urban activity is at the heart of economic growth in Indonesia and water and sanitation services are particularly critical to the development of productive cities throughout the country. Over the last decade, the urbanization process has become a key determinant of the future structure of water and sanitation policy and investment. Although the current urban population is estimated at 40% of the total, at the current rate of growth 133 it is expected to reach about 60% by 2025, and the delivery of safe and adequate water and sanitation services to this growing population, many of whom are poor, will need to be prioritized by government. While the picture of water and sanitation is disturbing, there has been significant progress in generating awareness and capacity for water and sanitation policy-making over recent years and the potential of change lies in the hands of all stakeholders. The new opportunities created by the implementation of the 2001 decentralization agenda, mean that the water and sanitation sector is at a turning point. 193

208 Water Supply and Sanitation Water Supply Approximately 85 million people live in the service areas of water utilities (PDAMs), of which only about 35% are served through 5.25 million connections. This makes up approximately 17% of the total population. Almost 5 years after the economic crisis, there is evidence that publiclyfunded water supply systems have deteriorated and service quality has fallen. New investments have been postponed and the lack of adequate maintenance is causing systems throughout the country to fall into disrepair. Some 221 PDAMs (out of 307) hold more than 400 outstanding loans with MOF, with about 63% of these in arrears or in default. MOF has accrued $500 million in debt as a result. 134 Tariffs are well below cost recovery levels ($0.08 per cubic meter) and the sector is estimated to be making losses of about Rp. 100 billion per year excluding depreciation and rural investment. Unaccounted for water is over 40% across the sector. In the absence of effective delivery by government agencies, two significant areas of activity have developed and are key to a practical understanding of how people get water services in Indonesia today. The first of these is self provisioning be it by communities in a collective delivery system, or by individuals developing access to water services at the household level. The second area of activity occurs in the informal sector through alternative provision. Small-scale private water providers interface with both PDAMs and self-suppliers by distributing PDAM water (illegally) and by providing technical support to households and communities to access water themselves. Together these are the more common forms of supply, reaching as much as 50% in smaller cities. In rural areas, utility provision is as low as 11% while community and self-provision total around 88%. This implies that over 100 million rural people are providing water for themselves. In this context, the main objective in the water sector is to increase access and sustainability of service delivery. In order to do so, a number of concerns need to be addressed. First, PDAMs are hindered by financial, political, and institutional blockages and it is necessary to establish how existing PDAMs will be transformed into efficient and viable utilities. It is also vital that coverage is extended to meet significant, growing urban demand, and there is a key question as to how formal utilities can be developed to meet these requirements. Second, it is necessary to develop better understanding of the role played by small-scale private water providers, and to establish mechanisms that optimize the contribution they can make. Third, it is now necessary to bring about the institutionalization and replication of community-managed models and to solve some of the legislative and policy blockages hindering their sustainability; and in view of significant levels of household provision, it is necessary to work out how to address the serious risks associated with water quality and sustainability even in the short term. Lastly, the lack of an enabling framework for this multi-provider market means that action needs to be taken to optimize the opportunities that are there, to regulate providers, and ensure that delivery is pro-poor. Sanitation The lack of institutions and investment in the sanitation sector create a situation that is one of the greatest challenges for service delivery in the country. There is virtually no formal institutional structure for sanitation in Indonesia: there is no ministry at the national level responsible for sanitation policy or designated to lead a national sanitation campaign; and local governments requires greater clarity of their roles. Levels of investment in sanitation have been negligible for some time. Indonesia has one of the lowest rates of urban sewerage coverage in Asia. Less than 10 cities have some form of network sewerage and these reach as few as 1.3% of the urban population. Cost recovery of sanitation is consequently an undeveloped matter. Due to the lack of any formal (public or private) networks and infrastructure, households and small-scale operators provide the majority of services, including installation and removal. Currently 73% of urban households are estimated to have on-site sanitation, mostly in the form of septic tanks, many of which are not functioning effectively. However, self-provisioning by households has not been accompanied by complementary public good investments in drainage, septage collection and disposal and the lack of adequate, functioning public facilities, or even oversight and regulation by local government, means that proper disposal is rare. Most sewerage finds its way into open access resources such as rivers or canals. Widespread contamination of surface and ground waters across the country has resulted in repeated local epidemics and a high incidence of fecal-borne disease as well as severe environmental impacts. Economic losses attributed to inadequate sanitation services are estimated at US$6.8 billion per year and 2.4% of 2001 GDP, roughly equivalent to US$12 per household per month. 135 Urgent action is required to avoid the continued impact on health, environmental and economic impacts for decades to come. The key issues facing the sanitation sector are threefold. First, a lack of political will and commitment in government at all levels to improved sanitation contributes to the lack of access and worsening environmental pollution characterizing the sanitation sector. Second, the lack of a policy framework and institutional responsibility for policy and implementation is central to the sanitation crisis. There is an urgent need for a formal urban sanitation policy that identifies and sets priorities, sets out the legal and regulatory framework, and defines a strategy that links the household, community, and city-wide issues into a comprehensive framework. Lastly, it is necessary to consider the constraints and opportunities for financing the sanitation sector effectively and thereby address the severe deficiency of infrastructure and facilities in cities. The lack of government activity must be addressed together with the blockages and problems associated with the services provided by small-scale private enterprise, communities and by households themselves. The Way Forward The strategic framework for action suggests that the focus of efforts in the water sector over the next five years should be to address the specific issues of each form of provision, while also providing an overall enabling framework to revitalize the sector. This enabling framework should formulate a comprehensive policy and legislative framework, revise allocation of responsibilities, and move towards predictable, cost recovery tariffs. With regards to the forms of provision, a program should be launched to establish efficient and viable utilities (critically important to meet growing 194 Averting an Infrastructure Crisis: A Framework for Policy and Action

209 urban demand), to capitalize on the role of alternative providers, to encourage community-managed provision, and address the sustainability and quality of household self-provision. The sanitation sector presents such an extensive and untackled problem to government in Indonesia that there is not always consensus as to what should be done. The solutions to the sanitation crisis will inevitably involve all forms of provision, and will also need to place government, independent providers, communities, and householders in a regulated multi-provider framework. Incentives for performance and for investment need to be implemented along with sanctions that hold local government accountable through existing legislation. Urgent efforts are needed to develop a nationwide sanitation campaign and prescribe a new active role for local government in sanitation service delivery. With this in hand, it is necessary to look at the mechanisms to: inject finance, improve regulation of on-site sanitation especially in urban areas, enhance community sanitation initiatives and capitalize on, and regulate, activities by private small-scale providers. One of the fundamental problems of describing these sectors in Indonesia is the inconsistency of the data available through a vast range of reports and assessments. Although specific initiatives have started filling data gaps in specific areas, there is an urgent need to compile a comprehensive set of data and to keep it relevant and updated. This is vital to inform the development of policy and legislation that is relevant to market forces and user demands. The data provided in this document is estimated and is often qualified to present the actual situation on the ground. World Bank Assistance Since 1975, the World Bank has supported up to US$ 2.45 billion in loans for 24 urban development and water supply projects. They have introduced piped water services to many medium and small size towns, and financed expansion of water networks in major cities. Since 1991, the World Bank financed water and sanitation investments have formed part of the Integrated Urban Infrastructure Development Project (IUIDP) approach. Whilst these projects have contributed towards greater local government participation in the management of urban development and its infrastructure, there has been a lack of focus on other important sector issues, such as operational efficiency and financial viability of PDAMs, institutional reform and capacity building. Starting with the Water Supply and Sanitation for Low-income Communities project (WSSLIC 1), in 1994, community-based approaches established service delivery decisions based on consumer demand indicated by community willingness to contribute a fixed portion of construction costs, and responsibility for operations and maintenance costs. Consulting poor communities, offering them the freedom to choose service types and levels and transferring funds to them for managing construction were features introduced in infrastructure development projects such as VIP and KDP in the mid-1990s. Technical assistance to help communities make more informed choices from among alternatives were further added in VIP and WSSLIC 2. To respond to institutional issues, after 1999 a number of new sector initiatives were introduced. The Water Sector Adjustment Loan (WATSAL) was launched to provide budgetary assistance to the GoI to improve the national policy, legal, institutional and decision-support framework for water resources development and management. With the assistance of the World Bank and ASEM Trust Fund, the Financial Recovery Action Plan (FRAP) was developed in 17 PDAMs under a PDAM Rescue Program over the period PPIAF has also supported the development of a Background Sector Report IV Benchmarking System implemented by PERPAMSI, the Professional Association of Indonesia Water Utilities, to gauge the performance of PDAMs. Consistent with the recent Country Assistance Strategy for Indonesia, which prioritized good corporate governance and efficiency in water supply and improved access to basic water and sanitation services, especially to the poor, for the next four years ( ), the World Bank will continue its dialogue with the GoI on water and sanitation sector reform, and will support new lending and non-lending operations. One of the first sector operations will be the Urban Water and Sanitation Improvement and Expansion Project, which aims to improve water and sanitation services by strengthening local water utilities to become operationally-efficient and financially-sustainable. This loan will also be supported by the World Bank Institute/PERPAMSI twinning program aimed at strengthening communication and information services of PERPAMSI and PDAMs, promoting PDAM benchmarking and performance monitoring/improvement, and upgrading the PERPAMSI Education and Training Foundation. PART A: WATER SUPPLY Policy and Institutional Framework (Water) Legislative and Regulatory Framework In April 1999, the Government of Indonesia formulated the Letter of Sector Policy and Policy Reform Matrix, which formed the basis of the Indonesian Water Sector Adjustment Loan (WATSAL) from the World Bank. This was intended to start a process of major institutional reform, including policy, legal, organizational and financing aspects. The comprehensive policy framework currently before parliament locates policies for water supply and sanitation under the umbrella of water resources. The WASPOLA working group, comprised of members from BAPPENAS, KIMPRASWIL and others 136 has agreed a national policy document to govern community-provision and is in the preliminary stages of producing a framework for utility-provision. In this policy framework there is an emphasis on water as an economic and public good. Despite these planning efforts, the realization of sector reform is urgent. For any substantive improvements to be made in the sector it is necessary to finalize the policy framework, to better understand and enforce the roles and responsibilities of key agencies and to address the limitations of the legislative and regulatory framework. 195

210 Water Supply and Sanitation Main Laws and Regulations The legislative framework (described in Annex 1) sets out the legal basis for the establishment of water enterprises. 137 Law No. 5 of 1962 on Regional Enterprises provides for Water Enterprises or PDAMs to be established, through Kabupaten or Kotamadya legislation, as regional enterprises or regional companies (BUMDs) at the Kabupaten or Regency level, wholly owned by the Kabupaten/Kotamadya they serve. Under this legislation, local governments are given responsibility for tariff setting, and under specified conditions, a part of the profit of PDAMs can be used for specified regional purposes. In May 1999, the Ministry of Home Affairs took steps to ensure that Regional Enterprises would be converted into limited liability companies (PTs). As a result the law providing for water enterprises will be replaced by a new law, which divides regional companies (BUMDs) into two types, namely, a regional enterprise BUMD and a limited liability company MUMD. Among other things, the new law would allow MUMDs to obtain loans from domestic and off-shore lenders for business, investment and development. When enacted, the water resources law, will integrate water resources management, addressing water supply and quality, to irrigation, river basin management, and water allocation. However, domestic water supply, which accounts for less than 4% of the total water resource allocation, is only marginally represented in the draft legislation under discussion. The overall legislative framework was developed with the vision of a public utility water supply system and therefore fails to address a number of sector components that have arisen to fill gaps in supply. In the context of a multi-provider framework and the importance of rural water supply, it is notable that there is no legislation relating to community systems (that would provide clarity over legal ownership), and no provision for allocating any role to independent providers. Allocation of Responsibilities for Policy-Making and Regulation The principal agencies involved in policy formulation and implementation are listed in Annex 2 together with their respective functions. The primary role of the central government is to develop an overall water sector policy and provide technical assistance for sector development. To this end, the central government s role includes: setting overall quality standards and coverage targets; developing policies and mechanisms; establishing mechanisms to target low-income consumers and vulnerable groups; developing investment policies and funding mechanisms particularly related to international assistance and use of central government funds; and defining institutional roles and responsibilities of the various stakeholders involved in the sector. Water supply and sanitation services are considered to be devolved to the local level; and LGUs have the primary responsibility for implementing policy, and carrying out regulatory and planning functions in their jurisdictions. This includes: ensuring services are provided at the community level (though not necessarily taking the role of provision themselves); determining tariff structures; establishing levels of service, operational performance, and customer relations, i.e., setting the standards and/or targets specific to service providers; providing investment and funding support, as required; and providing targeted assistance for low-income consumers. Sector Structure and Ownership (Water) The structure for the supply and distribution of water in Indonesia can be described in terms of three fundamentally different types of provision. These are represented in Figure IV.1 and detailed below. Estimated distribution is disaggregated in Tables IV.1 and IV Utility Provision formal utilities (PDAMs and private utilities) with a mandate to produce and sell water Self Provision households and communities that obtain their water for themselves Alternative Provision independent and intermediate providers selling a water service to households and communities (e.g. water tankers and vendors). Figure IV.1. Sector Structure and Ownership PDAMs 17% PDAM provision (piped supply) Existing PDAM Coverage Existing Urban Population 40% Alternative small-scale water provision (13%) Urban Population in 2025 estimate 60% Gray area of provision - 83% Self provision (household and community) (70%) 196 Averting an Infrastructure Crisis: A Framework for Policy and Action

211 Table IV.1. Estimated distribution in urban areas Urban Supply % Urban Distribution % PDAM Supply 50 PDAM Distribution (HH connections 35 / PDAM tanker supply) Non-PDAM distribution (PDAM water) 15 (includes commercial on-selling, reselling, tanker supply, donor-funded community networks) ALTERNATIVE 8 ALTERNATIVE Distribution (includes 8 Supply developer initiatives, Aqua providers, and (non-pdam water) distribution of extracted water) SELF SUPPLY COMMUNITY supply 1-2 (non-pdam water) HOUSEHOLD supply 40 Note: Data available in the water sector is inconsistent. The data shown above was developed and agreed in meetings with key stakeholders in order to ensure all existing forms of provision were represented. PERPAMSI data (December 2001) also shows that 16.5% of the total population is served by PDAMs. Table IV.2. Estimated distribution in rural areas Rural Supply % Rural Distribution % PDAM supply 8 PDAM distribution (household connection, 5 standpipe) Non-PDAM distribution to house (on-selling 3 or transported) ALTERNATIVE 2-4 ALTERNATIVE distribution to house 2-4 (non-pdam water) (network or transported) SELF-SUPPLY 88 COMMUNITY supply 33 (non-pdam water) (community or HOUSEHOLD supply(wells etc.) 55 household) Note: The data shown above was developed and agreed in meetings with key stakeholders. According to KIMPRASWUL Indonesia Country Report, only 8% of those living in rural areas have access to piped water Utility Provision PDAMs In urban areas, water supply is undertaken by water enterprises (called PDAMs) under the ownership and jurisdiction of local government. The official objective for urban water supply is for PDAMs to serve customers through house connections. As preciously mentioned, however, the level of access through PDAMs is very low. Furthermore, high rates of urbanization coupled with deteriorating service means that this rate of coverage is declining. 139 It is estimated that as many as 15% of the urban population receive PDAM water, but not through legal or direct PDAM distribution networks. PDAM distribution in rural areas is estimated at only 5-8%. Almost all Kabupatens and all municipalities have their own PDAMs. 140 Currently there are 307 PDAMs throughout the country, but this number is expanding rapidly as new Kabupatens, created through the decentralization process, are opting to create their own. These PDAMs are often small and unviable (85% of PDAMs have less than 10,000 customers see Table 3), as they are unable to achieve economies of scale and many have service areas that lack any correspondence with watershed boundaries. Background Sector Report Table IV.3. Coverage Statistics for PERPAMSI Member PDAMs PDAM Service Level (% of Population ) Number of PDAMs Less than Over 80 5 Source: PERPMASI Benchmarking Exercise (2003) IV Despite the legislative intent to create autonomous organizations, in practice, local governments interfere in PDAM management, notably by insisting on receiving dividends even when the utility is incurring losses. 141 In the context of decentralization, local government is increasingly ignoring national decrees and their role remains one of the key problems of the sector. In order to limit involvement, efforts are currently under way to encourage PDAMs to conform to the Ministry of Home Affairs Regulation 7/1998 (which does not permit the head of the local government to be part of the PDAMs supervisory board and limits the number of bureaucrats on the board). 142 This will be strengthened by simultaneous efforts to create limited liability companies (MUMD) or regional companies (BUMD). The financial condition of most PDAMs are dire. As previously mentioned, they have accumulated substantial debt that they are unable to service in many cases. As a result, the debt burden has extended to the Ministry of Finance. 143 Given estimated revenue and interest charges, the sector is estimated to make losses of about Rp. 100 billion per year. When depreciation charges and rural investment are factored in, these figures substantially increase. 144 Private Operators There have been a few examples of PSP in Indonesia. The largest and bestknown example is the PPP in Jakarta. Two foreign private partners, PT. PAM Lyonnaise Jaya (Palyja) and PT. Thames PAM Jaya (TPJ) assumed responsibility for investment, management and operation functions of Jakarta s water utility under 25-year concession contracts for the west and east zones respectively. While investment has been limited, the concessions have resulted in more transparent management, expansion of coverage and reductions in the number of employees. To date however there has been little improvement in service quality or efficiency (unaccounted for water lies between 47 and 49%). 145 The concessionaires attribute their performance to the fact that agreed water charges have not been fully paid by DKI Jakarta, even after the recent rebasing. Extremely poor quality raw water (supplied by government) has also resulted in high treatment costs. By March 2003, shortfalls had accumulated to approximately US$50 million for each concessionaire (See Annex 3). To date, there has been little interest in extending private sector involvement to operation and management in secondary cities or towns. The preferred 197

212 Water Supply and Sanitation PSP option has been BOT contracts for source works, in which the demand risk is borne by the public sector. The other visible involvement of the private sector is in fact not so much the operation and management of water services, but the construction of infrastructure by developers in residential and industrial estates. Although important, this is a markedly different role. Self-Provision As the groundwater table is fairly high in many provinces of Indonesia, self-provisioning has developed as a solution achievable in both rural and urban areas. In total, an estimated 150 million people (over 60%) rely on ground water as their main source, but this abstraction is neither controlled nor licensed. Community Managed Water Supply Predominantly features of rural areas, community-managed systems are estimated to be meeting the needs of at least 33% of the rural population. 146 They have been established in rudimentary forms by the communities themselves, or constructed with support from government and NGOs using national and donor funds. Funders generally dictate the rules and arrangements that characterize these operations. However, as a result of the overwhelming evidence 147 that supply-driven projects were failing, in the last decade most projects have introduced demand-led mechanisms, especially for decision-making on service types, levels and cost recovery. The success of these participatory initiatives has challenged many views held by government institutions that communities were unwilling to invest, and that water services in poor rural communities were unaffordable. Where communities have had a role in decision-making, they have been able to control quality and cost and have developed financially sustainable systems. Community-managed services (both community-created solutions and systems built with some external assistance) are expected to continue to be the mainstay for rural water supply in Indonesia for many years to come and have proven appropriate in low-income urban kampungs. While the policy framework is agreed however, there is a need for greater understanding and planning on the implementation of this policy. A key question is how community-based solutions can be utilized to complement PDAM functions and other providers of services to serve the poor in cities, small towns and rural areas. Household-Managed Water Supply As the groundwater table is fairly high in many provinces of Indonesia one of the primary characteristics defining water supply in Indonesia is the extremely high level of self-provision by households. A vast and increasing number of households, poor and non-poor, rural and urban, have developed 198 Averting an Infrastructure Crisis: A Framework for Policy and Action

213 their own water source. 148 The quality of water as well as the sustainability of this supply mechanism is questionable. Closely associated with household self-provisioning is the emerging group of small enterprises paid to extract, store and purify water at the household level (described below). The impacts of household-provision on the structure of the water sector are far reaching for policy, regulation and enforcement. Whereas collective forms of self-provision, such as the community-managed systems described above, can be regulated, the sheer numbers of household systems present a regulatory challenge. Two key issues need to be addressed in regulatory frameworks to address self-provisioned water supply: the impact on the water table and the regulation of the quality of water consumed after extraction and storage. Notwithstanding the important role of household self-provisioning in filling gaps in formal institutional supply over past decades, the sheer magnitude of the self-provisioning market has significant consequences for PDAMs creating a viable customer base as households have, for decades, relied on alternatives to piped water. Alternative Provision For those households without access to utility supply or the opportunities for self-provision, the remaining alternative is to rely on the market of alternative providers. The informal water sector includes a multitude of unregulated, competitive service providers reliant on the water business for their livelihoods. With an estimated 50 per cent of consumers in urban areas and 88 per cent in rural areas not receiving direct or indirect services from PDAMs, the role of these informal providers is likely to be important they either provide a direct water supply service or they assist communities and households to become self-providers. It is important to differentiate the water providers from the supporting enterprises in order to understand their function and the role of government in supporting their activities. Independent or intermediate water distributors The small-scale private water providers (SSPWPs) may be small or medium scale entrepreneurs that have made water distribution their main source of income and, although their business is generally not legal, many have invested small amounts of their own capital. The role of SSPWPs vary but include operators that distribute PDAM water at neighborhood, lane and household levels. Typically, they will be transporting or reselling water, as there is little evidence of private networks. Each of these modes of delivery differentiates their role and performance and this results in different behavior (business-like, competitive, exploitative etc). The majority of these SSPWPs are informal, some are exploitative, while others provide a useful service without formal recognition but often with the tacit agreement of the PDAM or PDAM staff. Many households, especially the poor, are actually served through a system of reselling (sometimes called on-selling) by small-scale providers distributing PDAM water. In April government announced that all households with a metered connection would be permitted to sell water to their neighbors and to vendors. Despite this, in practice this activity is still strongly discouraged. Data on the impacts of this reform are old and further analysis is needed to provide better understanding for appropriate policy development. Global research is constantly providing more sophisticated sectoral knowledge about SSPWPs. Notable in the context of Indonesia is the absence of a number of alternative forms of water delivery. Unlike many other countries, utilities have not facilitated arrangements with alternative providers that allow the distribution of PDAM water (from regulated Background Sector Report IV supply points) by non-pdam water sellers. Second, there is only a limited market of alternative providers developing their own source and providing non-pdam water. 150 The lack of activity along these supply chains has significant policy implications. Private enterprises supporting self provision A second category of SSPWPs provides support to households and communities to access their own water. The emergence of the pattern of household self-provisioning is entirely dependent on this group of suppliers of the technologies, materials and equipment and the workforce to construct household level facilities. The drilling of wells, installation of pumps and overhead tanks is a substantial activity that employs thousands of workers. Investment and Financing (Water) Although there has been a stabilization of the economy, the financial crisis of 1997 left a mark on the water sector. The sharp and sudden devaluation of the Indonesian Rupiah from 2,317 to $US 1 at pre-crisis to 16,950 in June 1998 resulted in massive deterioration in investment and financing levels and many infrastructure projects were no longer affordable. PDAMs mostly became bankrupt as their cost/revenue balance, already faltering, was affected by the escalation in FX components of investment as well as the costs of imported inputs and electricity. According to the Indonesia Country Report prepared for Kyoto in , it would require a total investment of Rp trillion (US$ 7.5 billion) or Rp.5.1 trillion (US $573 million) annually to reach the MDG targets. Typical annual government spending for all public infrastructure (including roads, bridges, irrigation, water, housing, etc.) is about Rp.11 trillion annually. The shortfall in current and future public expenditure means that it is necessary, not only to stimulate greater commitment of government (and donors) to the sector, but also to mobilize the private sector, communities and households to improve access to safe water supply and sanitation. Public Investment and Financing For the last decade or so, investment in the water sector has been made through public financing. Before the IUIDP program all financing was grant-based, but more recently have taken the form of loans from central government, made through subsidiary loan agreements (SLAs) with the PDAMs/Local Governments funded by donors or domestic borrowing through regional development accounts (RDAs). The Ministry of Finance, through the Directorate General of Financial Institutions (DGFI), retained the contingent liabilities, and as a result the arrangement did not provide any incentive for PDAMs to amortize the loans, or hold local government or other central agencies accountable. At the same time it is argued that some PDAMs and Local Governments were not consulted in the process, or were advised of their liabilities after the event. In addition to the impact of this financing mechanism, a number of other factors have contributed 199

214 Water Supply and Sanitation to the weak financial position of PDAMs: (i) the arbitrary acts of local government, especially in relation to the payment of dividends; (ii) the lack of viability of some PDAMs due to their size; (iii) the lack of concern for demand-led planning and investment, consumer affordability or willingness to pay; and (iv) the reluctance of many local governments to set tariffs at cost recovery levels. In 2002, fixed assets totaled Rp7.5 trillion while loans outstanding were estimated at Rp.3.2 trillion. Most of the loans to PDAMs have been extended at subsidized interest rates (between 9% and 11.5%) at maturities of 20 years with 5 years grace on principal repayment and it has been impossible for the Ministry to cover foreign exchange exposure during the steep devaluations in As such, losses from the lending program to the PDAMs are substantially higher than those purely reported by the PDAMs on their own accounts. As meniotned previously, PDAMs today have a number of outstanding loans, many of them in arrears, which straddle MOF with a substantial amount of debt. 152 It is estimated that the sector is making losses of about Rp. 100 billion per year. When depreciation charges and rural investment are factored in, these figures increase substantially. 153 The financial recovery action plan (FRAP) (detailed in Annex 4) sets out the steps that are envisaged to restore financial conditions to a more manageable level, to overcome the added effects of the economic crisis and create the potential for a viable functioning institutional provision in the future. The program is also intended to develop the financial capacity of PDAMs to undertake new investments. The actions envisaged require stakeholder commitment to reform and need to be negotiated by all interested parties to ensure a sustainable financial solution. The policy framework proposed envisages that PDAMs would utilize: (a) their own resources, generated out of cashflow arising from efficient operations; and complemented by; (b) equity contributions from local government; (c) domestic commercial loans; and (d) grants and loans from central government. Proposed policy to convert PDAMs into limited liability or regional companies would enable them to obtain loans from domestic and off-shore sources. The key corporate restructuring and training requirements are described in Annex 5. However, it should be noted that debt restructuring is not confined to the WSS sector, the debt overhang in the sector is closely linked to public finance management and institutional reform, particularly the allocation of roles to central and local government in debt restructuring. Private Investment To date, formal private financing for water has not been forthcoming. In the Jakarta concessions, Palyja has invested $132 million, and TPJ $85 million respectively in the past five years. This is equivalent to an average of about $40 million a year in a metropolis of over 10 million people, which is not significant enough to generate major efficiency gains. (Further information on the concessions in Jakarta is provided in Annex 3). Elsewhere investment has been relatively insignificant. In the water sector, information on the scale of small-scale provider investment however is very limited. Their informal status makes access to institutional finance very difficult but they do invest in the equipment they need to provide their service. Better understanding of how much and under what circumstances is essential in developing an enabling framework that enhances incentives for entrepreneurs and users. In the past ten years, the World Bank-funded WSSLIC projects have demonstrated the viability of community financing in conjunction with operation and management roles. In WSSLIC I, communities paid 20% of construction costs. Poor rural communities actually contributed more than 200 percent of expected projections, despite the fact that they had had little choice in project inputs and key decisions. The KDP implementation experiences in different parts of Indonesia have shown that communities contribute as much as is necessary to bridge gaps between project grants and the costs of their preferred service. Household investment is significant. Given that around 50 per cent of the total population is obtaining water for themselves at the household level, it would be reasonable to assume that investments run into hundreds of millions of dollars every year. The sheer quantity of investment required in the next decade to improve service delivery suggests that, for the foreseeable future, households will continue to shoulder a major part of the investment for water supply. Sector Performance (Water) Access Official SUSENAS data categorizes access to drinking water according to ownership whether private or public and whether ownership is individual or shared. For Indonesia as a whole (rural and urban) the data indicates that of those that have access to drinking water supply at household level, 52% have individual privately-owned sources (e.g. pump, well etc.), 25% have a jointly-owned source (e.g. communal taps) and that nearly 15% rely on public (communal) utilities. (e.g. PDAMs). In 2000, WHO figures 154 suggest that 78% of the population of Indonesia as a whole had access to what was termed an improved 155 water source. However, in rural areas, where access was estimated at 69%, surveys show that households have access to communal facilities if such facilities exist in the community not that they obtained improved water. The limitations of this data are revealed through participatory evaluations 156 that showed great variations in actual proportions of village populations that gained access to improved water supply in practice. 157 In urban areas, access to improved water was estimated to be 90%. Yet data from PERPAMSI (shown in Table 3), indicate that only five PDAMs in the country are achieving over 80% coverage, and further examination (see tables 1 and 2) shows that a proportion of this water is distributed by onselling, or by household reselling. 158 Irrespective of the quality and lack of consensus on data, the fundamental issue is that access is dependent on the contribution of self and alternative forms of provision. Furthermore the use of the improved water supply indicators at the national level does not provide adequate information on the level of consumption by the poorest households. The bench marking study provides a draft analysis of East Jakarta in 2002 and shows that lowincome connections are providing an average of 100 liters per capita per day or 11 liters per connection per day 159 ; middle-income households are utilizing 150 liters per capita per day and high-income households an average of 250 liters per capita per day. 200 Averting an Infrastructure Crisis: A Framework for Policy and Action

215 Quality After more than five years since the economic crisis, there is evidence that water supply infrastructure has deteriorated and service quality has fallen. In relation to utility water, there is evidence that PDAMs have postponed maintenance in an effort to reduce costs, and few PDAMs use the required chemical dosages for water treatment. The incidence of water-borne diseases has increased as a result. 160 Inefficiencies in management and operations have severely impaired the opportunity of improving services to existing and new customers and the quality of water is a serious issue in many of the large cities such as Jakarta, Surabaya and Bandung. In self-provisioning by households and communities, water quality, quantity and reliability of service has tended to vary with the type of water supply technology used. While the more convenient piped systems are reportedly satisfactory, dug wells, hand pumps and rainwater harvesting systems present concerns over water quality as they are often affected by lack of acceptable standards of water storage. Quantity and reliability presents less of a problem in most areas where water is plentiful. The quality of service provided by alternative providers is also variable. The utilization of PDAM water by most SSPWPs means that water quality will be similar or will have deteriorated in the transportation and storage process. Further information is needed to improve understanding of this is relation to different types of providers functioning in different locations. Efficiency Only the efficiency of the services delivered by PDAMs can be measured in both operational and financial terms. Overall, the figures for both nonrevenue water (NRW) and unaccounted for water (UFW) are very high, suggesting that PDAMs are not optimizing the use of their existing assets. PDAMs are often too small to take advantage of economies of scale and they tend to have low managerial and technical capacity. 161 As with coverage there are wide variations in the efficiency of different PDAMs but overall, inefficiencies constrain service quality to existing users, and any scope for expanding and improving services to existing and new customers. The poor are disproportionately disadvantaged by this failure and Indonesia has fallen well behind in achieving its MDG targets for the sector. In summary: Unaccounted for water (UFW): BAPPENAS data suggest that for Indonesia as a whole UFW is about 40%. 162 For Jakarta, the figure is 53%, which, although very high, is comparable to other Asian cities. Non-revenue Water (NRW): Based on a sample of 68 PDAMs, PERPAMSI has estimated that average NRW is 44%, with a standard deviation of 17%, again suggesting a wide variation in operational performance. Problems are not limited to physical assets, a great deal of leakage and informal payment occurs in the large market of unrecognized on-selling and a lack of control over non-connection water supply. Staffing Ratios: A case study of 16 PDAMs across Indonesia 163 indicates that kabupaten PDAMs usually have staffing ratios of 11 staff per 1000 connections whereas kotamadyas PDAMs, in more densely populated service areas, have ratios of around 7 per 1000 connections. Staff ratios for the major cities of Jakarta and Medan, not included in the above study, are 5.9 per 1000 and 4.9 per 1000 connections respectively. 164 Cash / Operating Expenses: A vast majority of PDAMs are not in a position to recover operating expenses from the cashflow, or repay loans signed through SLAs. Available figures for accounts receivable show Jakarta at 1.0 month, Medan at 0.1 month and Bandung at 1.0 month. 165 Background Sector Report IV Debt service Ratio: In the benchmarking study of PDAMs, debt-service ratio exceeded 1 for only 8 of the 28 PDAMs in the sample. Tariffs PDAM tariffs are well below cost recovery levels they are regulated by local governments seeking to address social and political considerations, often in conflict with technical and financial requirements. Reports from PERPAMSI indicate that most PDAMs have negative profitability and nearly half charge tariffs below the cost of operations and maintenance. Overall, average tariffs are Rp. 980 or US$0.08 per cubic meter sold 166 and the average monthly bill per connection was Rp.26,150 or $2.20. PDAM tariff structures are usually based on the rising block tariff systems in which high consumption customers cross-subsidize low consumption, normally poorer, customers. With increasing costs of production the tendency has been to overprice the big consumers and under-price the small. As a consequence, and in an environment where self-provision is a norm, this has promoted a situation in which many high consumptions customers opt out of the system and construct their own boreholes. Also, the low tariffs to low level consumers dictated by public policy have exacerbated financial problems and are thereby contributing to the limited coverage of PDAMs (with particular consequences for poor households). In community-managed systems, water tariffs are virtually non-existent for point sources (dugwells, handpumps, rainwater harvesters). For piped systems there is usually a tariff fixed by the community or by project functionaries. Water tariffs for community-managed systems are typically very low, and only sufficient to cover daily operating expenses. Funds for maintenance and repairs are typically collected on a case-by-case basis as needs arise, making it difficult to meet any contingency expenditure. These are rarely based on proper cost estimates, and may be unpaid or collected. Conflicts often arise on the issues of community cost-sharing for repair and maintenance for both point sources and piped distribution systems, since projects have often neglected to facilitate formal agreements about ownership and O&M responsibilities that all users consider fair. However evaluations of community-managed systems also identified cases where communities were not only sustaining their services fully, but had financed expansions and replacements of the system, and built up financial reserves that were used for micro-credit activities. 167 Pricing by alternative providers varies substantially, from the competitive to the exploitative, (although the incidence of exploitation is unknown). The group that provides support to the self-provisioning of households has generally been viewed as performing a vital economic function at competitive prices, while the group that sells water from kiosks, conveys water to homes in push carts or through plastic hoses have been viewed in a more negative light because of the price differentials compared with the utility charges. While there is some evidence that mafia-like organizations control pricing of resold water and hijackers control water points in some areas, there are also studies that show that pricing of water piped through hoses for instance, can be quite competitive and that price differentials reflect incremental costs of conveying the water to homes. For example, 201

216 Water Supply and Sanitation for water vendors, the volume of water and distance between the standpost and a home appears to dictate pricing differentials, rather than monopoly pricing. 168 Nevertheless, some PDAMs and SSPWPs often engage in anticompetitive practices vis-ŕ-vis other operators. Such practices hinder the operations of new small-scale water vendors. More information is needed on the determinants of pricing structures, competition and exploitation, and on the reasons why the poor access the types of provision that they do. With this information in hand, non-pdam supply in Indonesia including SSPWPs and self provision presents significant opportunity that must be optimized in the short to medium term. Affordability Given the disparity in water supply service provision and the considerable variation in the cost of water, there is inevitably a corresponding variation in affordability. PDAM customers in Jakarta and Bandung pay between 1-2% of average annual incomes on water, and in Medan, less than 1%. 169 By comparison, non-pdam customers may pay considerably higher proportions of their incomes for water. In Tangerang, Indramayu and Semarang, three areas dependent on water vendors, a USAID survey found that the poorest of the sampled households spent from 16% to 33% of their household income on water. 170 According to this survey, non-pdam customers paid from 33 to 122 times the price per-volume faced by PDAM customers and said they were willing to pay prices for PDAM-supplied water far in excess of that currently charged by their local PDAM. Nevertheless, the interest of urban poor households not currently served by their local PDAM to connect to the PDAM system varied across the three areas surveyed and appeared to be influenced by perceptions of the quality, convenience and cost of PDAM service as well as other factors affecting their livelihoods. Public Financial Transfers Most local governments routinely require dividend payments from their PDAMs. This is recorded in the PDAM s accounts as advance payment of dividends and occurs even when the cashflow is negative. On the expenditure side, and rarely, local governments may provide some very small budgets for projects, based on proposals submitted by the PDAMs. Financially distressed PDAMs that requested help were assisted in preparing Financial Recovery Action Plans (FRAPs) (see Annex 4). Financial projections were developed, and utilized to engage the PDAM management and its local government counterpart in agreeing to a package of debt relief through loan rescheduling, along with commitments by local governments to rebase tariffs to generate enough revenues, so that by the end of the rescheduling period PDAMs are in a position to once again amortize their loans. The FRAP contained, among others, commitments by PDAMs and local government, including: (i) increased tariffs as required; (ii) reduction in unaccounted-for water to acceptable levels; (iii) connection of as many new connections as the system could accommodate; (iv) reductions in collection period to acceptable levels; (v) a freeze in the hiring of new employees until a desirable staffing ratio is achieved; and (vi) suspension of dividends payments to local governments. Main Sector Issues (Water) In the current situation, the fundamental objective of the water sector in Indonesia is to improve access to safe, reliable and affordable water and especially to improve access for the poor. The projected increase in population by 100 million in the next 20 years means that multi-faceted action is needed urgently. To this end, the main issues to be addressed in future activity within the water sector can be defined in terms of the primary forms of provision, and the umbrella framework that determines the way the sector structure functions. How will PDAMs be made into efficient and viable utilities? While PDAMs are currently limited in coverage, rapid rates of urbanization and economic growth, clearly point to utility provision as the main way forward in urban areas. The current form of PDAM is hindered by financial, Figure IV.2. Key Issues for future action in the water sector 6 What enabling framework is required? 1 How will existing PDAMs be made into efficient and viable utilities? 2 How will utility provision be developed to meet growing urban demand? 3 How can government capitalize on existing alternative provision? 4 How can community provision be enhanced in rural areas? 5 How can the quality and impacts of household self provision be addressed? PDAM provision Alternative provision Self provision 202 Averting an Infrastructure Crisis: A Framework for Policy and Action

217 political and institutional blockages. PDAMs have inherited or accumulated heavy debts and continue to be loss-making. Even with higher tariffs and more efficient operations, many PDAMs would still remain in a financially unviable situation, many are too small. The institutional relationship between PDAMs and local government hinders improved utility performance. Currently, PDAMs are owned by and subject to interference from local government and their ability to work as autonomous corporate entities is compromised. PDAMs and established water vendors often engage in anti-competitive practices. Furthermore, public authorities lack capacity and have not created enabling environments to promote effective service delivery or to encourage effectively PDAM delivery incentives and private sector investment, there is a perception of risk of working in the current conditions. Sector governance is not conducive to effective provision of services by public and/or private sector and there is a lack of political will for change at the local government level. While the PDAM reform envisaged (which includes the formation of other institutional models) is still to be rolled out, the inefficiency and financial viability of PDAMs are key issues to be constantly emphasized in the short to medium term and requires understanding that financial viability is also dependent on demand for piped services. How will utility provision be extended to meet growing urban demand? Notwithstanding the urgent need for PDAM reform, it is also necessary for government to invest in and develop water sector assets. Investment in large cities is urgently needed. This lack of investment occurs at all levels of infrastructure: tertiary (household and street infrastructure), secondary (mains and pumping) and primary (bulk supply, pumping, treatment and primary mains). There are currently no strategies and action plans describing how coverage will be extended and how existing infrastructure will be improved to match the 4.4% projected growth rate. Greater understanding is also needed of the factors that affected the efficiencies of past investments. The utilities that emerge from the reform process, whether public or private, will need to be backed with significant investment to meet the growing needs of the urban population. How can government capitalize on existing alternative provision? Alternative forms of provision by informal and small-scale operators are an untapped market whose role can be enhanced in improving access, especially for the poor, in the short and medium term. Existing urban data clearly indicates that non-pdam actors have stepped in to fill the gap in distribution, and their contribution needs to be formalized and regulated. While a large number of independent and intermediate providers are able to assist in the expansion of current levels of access, they currently provide services illegally. The lack of any effort to date to include independent providers in the overall delivery system through, for instance, bulk sale arrangements is a missed opportunity. The lack of recognition of their role means there is a lack of regulation of existing practices. As a result, quality is variable and some price structures and local markets are distorted and exploitative, with disproportionate impact on the poor. How can community provision be enhanced in rural areas? In rural areas, community-based management systems now provide an established model and are likely to constitute a main way forward in the medium to long term. While a policy framework for this is agreed at the Background Sector Report IV national level, serious problems in relation to financing and local government commitment stand in the way of effective implementation and replication. Community-based options are not legally recognized and the approach not institutionalized, despite their success in a number of districts. Long-term management solutions for these systems are still to be tested. Voluntary management is rarely a viable long-term solution and, in Indonesia, these systems will need to undergo a transition to more formal forms of management (community-appointed managers or local private operators). Future expansion and higher levels of service are emerging as important issues for the future as the composition and wealth of communities change. How can the quality and impacts of household self-provision be addressed? The high levels of household self-provision in both rural and urban Indonesia are a unique characteristic of the Indonesian water sector. Whereas in rural areas household provisioning remains viable, in urban areas, household provision has grown to the extent that sustainability is or will soon be at question. and this form of self-supply has implications for the viability of PDAMs when demand for networked services is kept low. Impacts on ground water are not adequately monitored and the lack of regulation (and opportunities for enforcement) over extraction present significant risk in relation to quality (especially given the prevalence of onsite sanitation). What enabling framework is required? The inconsistency and usability of existing data on all providers, their performance, actual costs and investment, is a key issue in the sector. Adequate and updated data is required to provide a sound basis for planning an enabling framework (and then monitoring) sector performance. The lack of an effective enabling framework means that it is not possible at this stage to capitalize on the potential of all forms of provision, to regulate delivery or to ensure that delivery is pro-poor. The legislative and regulatory framework is weak and without appropriate regulation (and enforcement) over pricing, quality and performance standards. There is also no provision or incentive for local government to establish effective pricing regimes or deal with issues of efficiency or sustainability. Water tariffs are well below cost recovery levels or are unpredictable and unstable. Very low tariff levels exacerbate the financial position of the sector and the ability of all providers to expand and improve services is hindered. Very high levels of unaccounted for water and non-revenue water need to be addressed and other sustainability issues such as high ground water abstraction considered as a part of a long term strategy. Financing mechanisms create a lack of accountability by local government for proper and sustainable investment, operations and maintenance. The SAP funding mechanism is yet to be replaced. There are also a number of policy gaps and institutional blockages, and the allocation of responsibilities fails to provide incentives for service delivery agencies public or private. Policy in relation to alternative forms of provision is non-existent despite 203

218 Water Supply and Sanitation the high dependence on non-pdam supply. Apart from the specific policies relating to community provision developed under the WASPOLA project, there is currently no overall framework that protects the interests of the poor, and this has led to a lack of direction and mandate for service delivery institutions. PART B: SANITATION Policy and Institutional Framework (Sanitation) Main Laws and Regulations The legislative framework for sanitation aims to define the areas of authority for municipalities and regencies (see Annex 1). Urban wastewater services are not specifically mentioned in the Autonomy Law but it is generally understood that they lie within the purview of local governments. The provisions for the health aspects of urban sanitation are covered by the Health Law No.23 of 1992 and are developed through a regulatory framework prescribing the requirements of water quality. 171 A draft regulation on environmental health and safety has been prepared in accordance with the Autonomy Law and includes further provisions on water quality and on the discharge of wastewater. The primary act from an environmental viewpoint is Law No. 23 of 1997, Regarding Environmental Management which increases the legislative power of government, recognizes the right of individuals to a clean and healthy environment and puts the onus on business and industry to provide accurate information on environmental management within their area of responsibility. As it currently stands, however, the legislative framework for sanitation is weak and lacks the provisions necessary to respond to existing and future opportunities for improving service delivery. In particular, it lacks any provisions necessary for effective governance over those enterprises, community organizations and households that are, in practice, the primary providers of sanitation services in Indonesia today. Allocation of Responsibilities for Policy making and Regulation It is the central government s role to determine policy, and it does so by establishing norms, standards, criteria, procedures, and guidelines for each sector. Although a formal urban sanitation policy does not exist in Indonesia, there is a de facto framework that includes matters of jurisdiction and delegation as well as the delineation of roles and activities of all stakeholders. Legislative functions including the formulation of policies and the enactment of laws, regulations, and decrees that are necessary for the sustainable delivery of urban sanitation services are exercised both by the central government and by the local governments. Regulatory functions to pursue the policy goals of urban sanitation (including tariffs, quality and coverage) are performed at the national level, although such responsibilities are dispersed among several ministries: MOHA, the Ministry of Home Affairs, is responsible for regional companies; KIMPRASWIL, the Directorate General of Ministry of Settlements and Regional Development is responsible for urban sanitation projects funded by the central government; BAPPENAS, the National Development Planning Board, is responsible for urban sanitation planning; including coordination and monitoring functions at national level; MOH, the Ministry of Health, is responsible for monitoring and ensuring adequate environmental health standards, including the health aspects of sanitation; MOF, the Ministry of Finance, is responsible for the allocation of finances to central and local government agencies for developmental infrastructure projects and for regulating off-shore financing; and MOE, the Ministry of Environment, is responsible for formulating and enforcing the legislative framework on environmental management. In conjunction with the relevant central government agencies, local government (either district/regency or municipality) is responsible for enforcing laws and regulations on regional autonomy, fiscal balance, water quality and the management of PDAMs(in the context of decentralization important issues arise about their role and lack of capacity). Under the autonomy law, the responsibility for sanitation service provision rests with local governments requiring them to ensure that such services are provided within their respective jurisdictions, but does not imply that technical departments in local government should themselves undertake the actual operation and delivery of these services or that they currently have the capacity to do so. Sector Structure and Ownership (Sanitation) Sanitation service is mainly provided by three groups: by utilities, by self provisioning by users, and by alternative service providers. Whereas in the water sector, some 15-20% of services are provided by formal institutions (PDAMs, PPPs, LG), in sanitation, the public sector has played an even smaller role. GOI policy treats basic sanitation 172 as primarily a private responsibility. Households and developers have been expected to invest in on-site sanitation improvements to conform to public health regulations, although these are poorly enforced. The conveyance of this waste away from the living environment for treatment and disposal is considered to be a public responsibility, but investment in sewerage and sewage treatment facilities has been negligible. The construction of septic tanks is normally carried out by private enterprises, as is the desludging of tanks and removal of septage. Most of those without access to some sanitation services are poor. According to overall SUSENAS data, 13% of sewage goes into rivers and lakes, and 6% in to rice fields etc. Utility Provision Local Government The sanitation sector does not have the equivalent of PDAMs or any other well-developed public sector delivery system. In nearly all cities, the 204 Averting an Infrastructure Crisis: A Framework for Policy and Action

219 responsibility for community or neighborhood sanitation systems, desludging septic tanks and operating septage treatment plants rests with the local government. However, within local governments, departmental responsibilities are often unclear, and in practice their delivery role, whether enabling or through direct provision is very limited. The responsibilities of local government are also not being taken up with any urgency. Existing sewerage systems only serve approximately 1.3% of the urban population (about 200,000 households are connected to a network). There are seven sewerage systems operating in Indonesian cities: five are operated by special sections of PDAMs (Bandung, Cirebon, Medan, Surakata, and part of Tangerang). Local government is responsible for the public good aspects of sanitation infrastructure, although this is limited at the neighborhood-level to some communal toilets and bathing facilities (MCKs), and at the city-level to limited local networks, feeder sewerage infrastructure and often poorly operated treatment facilities. Table IV.4. Sewerage Coverage # of Population Population Area City Connections Served Served Served ( 000) ( 000) (%) (%) Bandung Cirebon Jakarta negligible Medan Surakarta Tangerang negligible Yogyakarta Self-provision Community Managed Sanitation Community-managed services include MCKs, neighborhood sewerage networks and treatment facilities. In general, the type of operators found for neighborhood or community level sanitation service depends upon the initiators of the projects or the ownership of the infrastructure. Examples of sustained informal and formal community management of neighborhood sewerage systems can be found at Tlogomas and at Mergosono, respectively, both in Malang. SANIMAS (Sanitasi oleh Masyrakat Sanitation by Communities) is a small initiative managed by the Water and Sanitation Program 173 aimed at demonstrating viable options for solving sanitation problems at the community or neighborhood level in a handful of cities in East Java and Bali. When complete, it will provide a model of approaches which enable low-income communities to manage their own neighborhood sanitation. Critical lessons include support from local governments and a conducive policy and regulatory framework. Lessons from this and similar communitymanaged sanitation projects also point toward the need for significant support from NGOs in relation to community engagement and preparation, and as a critical stakeholder in mobilizing the commitment of local government. Household Managed Sanitation Despite these successes, individual household provision remains unquestionably the primary means of obtaining sanitation services. The lack of access to sewerage systems has meant that most households construct Background Sector Report IV their own facilities: there is extensive use of septic tanks, estimated at 59% and pit latrines, 21%. In Jakarta alone there are about one million septic tanks, providing local sanitation solutions, but resulting in significant problems with the disposal of septage. The whole system of this provision is supported by the group of small-scale providers (described below) that construct these facilities. Alternative Provision As a consequence of the high level of on-site sanitation, the sector is supported by informal small-scale entrepreneurs that assist in household provisioning of sanitation services in the country. Experience suggests that they are demand-responsive both to the needs of poor and non-poor households and tend to be competitive. Their ability to develop and expand is limited, however, as they have minimal access to finance or support capacity development initiatives. As with the water sector, the alternative (or independent) sanitation provider group can be disaggregated into two distinct categories: (i) those that actually provide a sanitation service (such as vacuum tankers, pit-emptying services) and (ii) those that help construct on-site facilities (such as septic tanks and pit latrines) to assist households provide for themselves. There is no evidence of independent operators of disposal services (such as sludge tipping sites). At the same time however, safe disposal of effluents is rare: disposal from septic tanks has not been properly regulated or controlled. Dumping in open water bodies and urban drains has contaminated both surface and ground water resources which has economic as well as health and environmental impacts. There has been only limited involvement of NGOs in provision of neighborhood sanitation services in urban and rural areas. At settlement and neighborhood levels, there is evidence of direct service provision, and they have been effective as social and technical intermediaries, technical advisors to private entrepreneurs, as builders of facilities, and as operators of facilities they have constructed. 174 Investment and Financing (Sanitation) The lack of institutional commitment to sanitation is reflected in the extremely limited investment in the sector. The responsibility for financing urban sanitation systems has been transferred to regional governments and regional enterprises, including PDAMs. Sources of such investments potentially include regional shares of national revenues; 175 loans and grants from private domestic, off-shore and central government sources; 176 and private sector participation. 177 In practice however investment is negligible. Prior to the decentralization process, local governments relied heavily on special investment grants (INPRES) to finance sanitation infrastructure. Since decentralization, INPRES grants have been replaced by block grants (DAU) and a new special subsidy (DAK). At present, however, the DAK has been kept at a very low level and local governments rely on the DAU to finance infrastructure and the allocation of the DAU to different sectors 205

220 Water Supply and Sanitation is left to the discretion of the local governments, which prefer allocating these resources to investments that have the greatest political visibility. The greatest casualty in this process is sanitation that brings little political kudos. Despite their statutory obligation, most local governments regard sanitation as the business of NGOs, the private sector or the national government. In one local government, only about 6% of the DAU was allocated to human settlements, and of this 80% was allocated to water supply, 15% to housing, and only 5% to sanitation. Evidence also suggest that local governments commonly allocate some budget, however small, for sanitation activities, but often do not know how best to spend it. Of several cities in East Java and Bali included in the SANIMAS project described above, local governments had budgets for sanitation that were underused. Given the option to facilitate community-level sanitation development, most of the cities were eager to contribute these budgets for meaningful investments into the sector. For large scale improvements, the potential financing arrangements include the Subsidiary Loan Agreement, designed for on-lending multilateral loans for local infrastructure projects. The subsidiary loan agreement entails a two-stage loan process with agreements between the GoI and an international lender followed by a second agreement between the government and the local government that serves as the final borrower. Domestic private sources to local governments are another untapped source of finance. Finally, the DAK Mechanism is a special new mechanism through which grant funds can be provided for projects with high social externalities such as urban sanitation. Although currently kept at a low level, the DAK could become an important source of grant funding for urban sanitation provided there are clear rules for allocation, and that transparency and administrative simplicity can be ensured. Alternative providers mainly rely on their own equity and very expensive short-term loans from informal creditors to finance their investments. The primary source of investment however is individual households and communities, although accurate data indicating its magnitude is lacking. In the city of Jakarta alone, self-provisioned investments in septic tanks by households are estimated to be around $150 million. The multiplier effects that are generated among tukangs who construct the septic tanks, and other service providers who collect and empty the wastes, can be significant. Access to Service Access to sanitation is significantly lower than water and presents a different policy challenge. Whereas there is some recognition of the main issues of the water sector, the need for reform in relation to the sanitation sector is largely unrecognized, only tentatively accepted or perhaps too large to contemplate. Indonesia has the lowest percentage of urban households with adequate sanitation in Asia. 178 Of the urban population, SUSENAS data indicate that 68% have access to private basic sanitation. Service coverage at the neighborhood, community and citywide levels is very low. There has been no significant investment in city-wide sanitation infrastructure during the last 20 years. 206 Averting an Infrastructure Crisis: A Framework for Policy and Action

221 Approximately 73% of the existing access is through on-site sanitation. While this is a reflection of government policy, which assigns responsibility for sanitation to households, the disposal of waste is largely unregulated, and therefore, proper disposal of human waste is rare. 179 The lack of all levels of sanitation service results in severe health and environmental consequences and economic losses of an estimated 2.4% GDP equivalent to US$6.8 billion per year in According to the Joint Monitoring Program on access to water supply and sanitation, 76% of the urban population in Indonesia has access to basic sanitation. Based on SUSENAS data, of the urban population that has access to basic sanitation at household level, 68% has access to private basic sanitation; 14% use shared facilities, 8% use public facilities; and 10% use other non-specified facilities. Rural sanitation coverage at household level was estimated in 1997 to be about 44% percent. 181 Of these, 45% use private facilities, 11% use shared facilities; another 11% use public facilities and 33% use unspecified facilities. Participatory evaluations have shown that these coverage statistics may be masking the fact that the poor are not gaining access to improved sanitation. 182,183 In rural areas, pit latrines are the most popular technological choice (37%) followed by use of rivers and lakes (23%), septic tanks (18%), beaches and open spaces (7%), ponds and rice fields (7%), and other sources (8%). With increasing urbanization and greater use of piped water in urban areas, pollution levels have been increasing both in watercourses and in wastewater, especially in the larger cities. 184 Services prevent pollution through either the control of effluent discharges into public water bodies or through the use of public infrastructure in the form of a sewer network and appropriate treatment facilities for municipal waste. The lack of sanitation services is further reflected in the delivery of software sanitation services such as hygiene promotion, especially for the poor. This reliance on household level responsibility and on-site sanitation implies that the government has not facilitated efforts to stimulate household demand and use proper methods of sanitation. By extension there has been little coordination with awareness building efforts on the importance of sanitation, few social marketing initiatives associated with improved sanitation facilities, or efforts to stimulate demand for sanitation services. Quality of Service In the context of widespread household provision, quality of service is largely dependent on the proper functioning of on-site sanitation systems. While the extent of failure is difficult to quantify, it is known that the performance of septic tanks presents a significant problem in urban areas. With virtually no regulation or enforcement of performance standards, most septic tanks are not appropriately designed and not adequately maintained. 185 As a consequence, semi-treated wastewater is simply discharged into open drains and water bodies and contributes significantly to the increasing pollution of the urban environment. The problem is undoubtedly exacerbated further by the effects of urban stormwater, which causes major flushes of highly polluting material from the urban drains into rivers. Septage collection and disposal is also not controlled. The city of Jakarta has only one septage treatment plant located at one end of the sprawling city. Consequently, unregulated and poorly supervised septage haulage contractors from the other end of the city often simply dump waste into nearby streams and public drains under the cover of darkness. Poor design and poor performance of sludge treatment plants have affected proper operation and maintenance in some cases; in others, public pressure has Background Sector Report IV led to the abandonment septage plants without alternatives to replace them. This has contributed significantly to urban pollution. It has been estimated that 70-75% of organic pollutant load in Indonesia s water bodies comes from household waste, while the remaining % comes from industries. The worst affected region appears to be West Java, followed by Central Java and Jakarta. In community level systems in rural and low-income urban areas, a lack of maintenance has also been a major cause of poor performance of sanitation systems. In some cases, inadequate supervision, coupled with a lack of (contractor and operator) accountability to communities, has resulted in poor construction. This, in turn, has increased the cost of communitybased operation and maintenance. In rural areas, satisfaction with household sanitation facilities is closely linked to the type of water supply facility available. Satisfaction with household latrines is markedly higher in communities with piped water supply (which can be connected to homes), than in villages with point sources (where water for flushing has to be carried home). This has had direct effects on use and sustainability of household latrines in rural areas. Efficiency Most of the performance parameters are inapplicable to the sanitation sector at its present stage of development. However, with regard to technical performance, in the few sewerage systems, efficiency of removal of pollutants (measured in terms of reductions in BOD or Biochemical Oxygen Demand) range from 75% to 95%. Tariffs Few households pay tariffs for sewerage, and those that exist have not been based on cost recovery principles, but have taken the form of a modest surcharge over the cost of water. For instance, the surcharge rate is 15% in Cirebon and 30% in Bandung, those cities with the greatest coverage. In the cases of Jakarta and Medan, the tariff is not related to water consumption but is based on floor area, building type and use. The lack of cost recovery of sewerage services accounts at least in part for the lower levels of coverage. For Community Sanitation Centers, a user charge is levied for each use of the facility. Where NGOs are the providers, the levy has often been determined in consultation with the users. Given the predominance of household provision, it is the cost of constructing and maintaining on-site sanitation and intermittent servicing that constitutes the service cost. This is significant and likely to far exceed a cost-recovery tariff for potential sewerage service (if that infrastructure were costed and available). Affordability In urban areas, as sewerage tariffs are not universally charged or are in the form of a relatively small charge in relation to income, access is by far the key issue, not affordability. However, as noted above, households are 207

222 Water Supply and Sanitation faced with the costs of routine desludging of septic tanks and disposal of the septage. In SANIMAS, efforts to established community based sanitation systems also sought to achieve adequate cost recovery. SANIMAS demonstrated that the use of subsidies was far more likely to fail than the focus of mobilizing communities and offering choice. In rural areas, sanitation programs have consistently promoted a single technology, communities have not been offered lower-cost or upgradeable choices. Often, an externally pre-determined package of sanitation construction materials is provided to each project community as a stimulant. The project functionaries or community heads decide to allocate them to families wishing to build latrines by paying for the remaining costs. Invariably the better-off households capture these subsidies, as they have the financial means and household water connections/facilities to make regular use of pour-flush latrines possible. Main Sector Issues (Sanitation) How can interest in sanitation be stimulated? Sanitation coverage is critically low and worsening, resulting in health and environmental degradation and economic loss. Few poor households, rural or urban, have access to adequate sanitation. Middle and highincome groups access on-site services, but the lack of adequate collection and disposal means that these contribute to the public health and environmental crisis. The lack of access and worsening environmental pollution characterizing the sanitation sector is partly caused by a lack of political commitment. There is a lack of political will and commitment at the highest level and at local government levels to improved sanitation; a lack of awareness of the high costs of these problems (including public health and environmental damage, rising costs of water treatment resulting from deterioration of raw water quality, economic growth and development, higher costs for water-dependent industries, and adverse impact on tourism); and a lack of agreement and coordination for the implementation of policies developed. How can the institutional and policy framework be developed? The institutional framework is inadequate. There is an urgent need for a formal sanitation policy (and a national level owner/advocate for that policy) that identifies and sets priorities, goals and objectives for the development and delivery of urban sanitation services; identifies the opportunities of the sector, sets out the legal and regulatory framework within which such services should be managed; and defines a strategy that links the household, community and city-wide issues into a comprehensive framework. Unlike the water sector that has an institutional structure in need of restructuring and strengthening, there is no formal structure for the sanitation sector to be strengthened. Decentralization has produced an orphan in sanitation. The lack of clearly allocated responsibility for delivery at the local level is at the heart of the sanitation crisis. The level of financial, technical and managerial capacity is also inadequate to meet the challenge of meeting sanitation needs at household, community and citywide levels. A major cause of the inadequacies in the sanitation sector is the absence of consensus and action on a strategic and policy framework to form a basis for developing sanitation action program at various levels and to guide external support agencies to provide effective and coordinated support to the sector. There is no regulatory framework in the sector essential for economic and technical regulation, financial allocation, and the formulation of appropriate performance standards. Figure IV.3. Key Issues for future action in the sanitation sector 1 How can interest in sanitation be stimulated? 2 How can an institutional and policy framework be developed? 3 How can coverage be increased rapidly? Govt. provision How government will mobilize investment in city-wide infrastructure and facilities? Alternative provision How can government capitalize on, and regulate, alternative provision? How can the quality and impacts of household self provision be addressed? How can community provision be enhanced? Self provision Existing coverage Expanding network coverage to meet urban demand 208 Averting an Infrastructure Crisis: A Framework for Policy and Action

223 How can coverage be rapidly increased? Current levels of investment are inadequate. Financing is a problem not only for new and rehabilitation works, but also for operation and maintenance. This is caused by inadequate cost recovery mechanisms and lack of a proper institutional structure for the sector. The problems associated with financing of new investments and solutions are the same as those associated with the water supply sector. Absence of appropriate incentives is a major factor that prevents local governments from borrowing or committing funds to the sanitation sector at all levels within their jurisdiction. To increase coverage rapidly and affordably, the solutions to the sanitation crisis will inevitably involve all forms of provision, and will need to place government, independent providers, communities and householders in a multi-provider framework. Consequently, it is necessary to understand: How government will mobilize investment in city-wide infrastructure and facilities? How government can capitalize on, and regulate, alternative provision? How the quality and impacts of household self provision can be addressed? How community provision can be enhanced? The Way Forward ( Water and Sanitation) In nearly all contexts, water and sanitation in Indonesia have functioned as two separate sectors. In terms of institutional, financial and technical aspects of delivery there is little similarity or convergence, and little reflection of a holistic system of water supply and wastewater disposal. This cannot be over-emphasized. The unbundling of sectors that are inextricably linked may be useful at this stage, however for detailed analysis and for tackling the idiosyncrasies of reform and sector development, the way forward is to create greater integration and understanding of the dual nature of the water and sanitation sector. The lack of connection in the eyes of policymakers is a critical gap to be addressed in the development of capacity in the future. Water Supply The financial health of the water sector has now been taken up as a priority item of Government. The Coordination Ministry for Economic Affairs has been mandated to look into the burden of debt plaguing the sector and to establish an agenda for comprehensive policy reform and a Committee established to accelerate infrastructure development is considering debt restructuring guidelines. 186 The above actions make it possible to undertake a national roll-out of the Financial Rescue Program since it provides additional incentives to PDAMs and local governments to come to the table and agree on more substantial performance action items. These government actions need to be extended by strategic planning in the sector that reflects the importance of alternative supply mechanisms and provides the necessary institutional supporting arrangements. With the aim of addressing the potential health, environmental and economic impacts of the sector, a strategic framework would identify key initiatives in relation to the necessary expansion of water supply and sewerage services, address self provision, facilitate alternative approaches to delivery and underpin these in the regulatory, legislative and institutional framework. Background Sector Report Key actions for government fall into five key areas: Develop an enabling framework to revitalize the water sector IV Although efforts are underway to improve the policy environment for water services, it is necessary to ensure the reform package is comprehensive and results in an enabling framework to revitalize the water sector. It should address policy-making, regulation, and institutions, and should be followed with an action plan for implementation and the resources to make it happen. Formulate a comprehensive policy and legislative framework with strategies and action plans for implementation. The policy framework should explicitly target the poor, eliminate barriers to entry for non-pdam providers, encourage further development of community-managed systems, and address issues of price and performance standards. Specific interventions and targeting mechanisms are required both in rural and urban areas to mitigate problems faced by the poor and improve their access to water and sanitation services. Elements of the necessary legal framework exist, but require revision to reflect the opportunities of decentralization and private sector participation and to remove impediments to implementation. 187 A legislative and regulatory framework for the sector will require the ownership and agreement of all parties at central and local government levels and consistent local government regulations are an essential aspect of the overall framework. In the short to medium term, given the shortfall in PDAM distribution, there is a need to recognize existing opportunities and create new opportunities for all providers (independent, community, household) within the scope of a predefined regulatory environment. Appropriate performance standards regulating quality and operations will need to be established, 188 which enable the adoption of technologies that end-users can afford. At the same time, appropriate arrangements for enforcement, including appropriate sanctions and rewards, need to be put in place. It is vital to strengthen sector data at an early stage. Current information is neither accurate nor consistent, and the sector lacks rigorous monitoring and evaluation. Once relevant data is updated, it is vital that it be kept updated on a bi-annual basis. Benchmarking arrangements on all aspects of performance, including the impact on the poor, and the publication of this data would provide incentives to improve performance. Revise the allocation of responsibilities In view of the changes associated with decentralization, it is necessary to clarify roles, responsibilities and relationships for the various functions that need to be performed in the sector, including policy making, financing, service provision and regulation. In addition, the allocation of risks has to be reviewed so that they can be assigned to those parties 209

224 Water Supply and Sanitation best able to bear and to manage them. Some of the key functions include GOI s policy-making role in the water and sanitation sector should be emphasized and focused on adopting measures, not only to revitalize PDAMs to plan for future expansion of their coverage, but also to encourage efficient service provision by other existing providers (such as community organizations, alternative providers and the large-scale private sector), and to facilitate innovation in the sector in relation to delivery to the poor. MOF needs to continue to bear foreign exchange risks, while developing mechanisms for encouraging domestic investment and an accurate approach to pricing loans and covering foreign currency risks. A common guarantee framework needs to be established at the national level for sub-sovereign guarantees that could be extended by local governments to certain projects. KIMPRASWIL, as the sector ministry, has the important roles of benchmarking sector performance trends, providing technical assistance to PDAMs on a demand basis, and overseeing GOIfunded targeted programs. Local government needs to assume regulatory and planning responsibilities. Move towards cost-recovery and a predictable tariff regime Efforts should focus on developing and implementing policy that ensures water and sanitation services become self-financing. A process of ongoing restructuring of the tariff regime is critical to achieving sustainability, generating a reliable cash flow to cover operating expenses, paying debt obligations, funding new investments to increase service coverage, and improving reliability. It is also necessary to ensure that tariff structures do not create barriers or marginalize and discriminate against poor consumers. Price also needs to be correlated with appropriate performance standards. The strategy would also need to ensure that pricing becomes predictable and stable. This will require local government commitment to a reformed regulatory framework. In order to promote the adoption of sustainable, cost-covering prices, a national body could be set up with the task of advising local governments on price setting issues (requiring that these opinions be published might give them more weight). Local governments could also be given the option to delegate to that body their price setting responsibilities. Launch a program to establish efficient and viable water utilities Establish commitment to reforms in Local Governments Commitment to reform is not a given but can be developed through supportive technical assistance to reform-minded local governments. Building capacity and awareness amongst implementing agencies and leaders is a vital ingredient of change that can be strengthened by providing political incentives to formulate (and enforce) local regulations. Carry out a widespread program of PDAM reform Within the context of broader sectoral reform, a well-managed program for restructuring inefficient and financially burdened PDAMs would have a significant impact on the sector and its ability to expand coverage and serve poor communities. The PDAM rescue program takes each case on a demand basis and, in exchange for debt restructuring, develops financial recovery plans with agreed actions to be taken by PDAM management and local governments. The rollout of this program would include significant monitoring to ensure the financial revitalization course is maintained. Support will be required to assist local government to identify the most appropriate management and organizational solution(s) and to implement a plan of action. A number of options to create efficient functional PDAMs are under discussion and are suggested below. Before any other steps can be taken, however, the first of these, debt restructuring and rescheduling is urgently required. The financial ring fencing of sectoral activities is a key milestone in the push to create efficient organizations and sectoral governance. Pilot activities have provided a number of lessons on how a broader PDAM reform program will work. These include the need to involve local government and establish strong political will for change amongst key stakeholders, that changes in management alone will not solve the PDAM problems; to consider ways of recapitalizing on assets, charging cost-recovery tariffs and ensuring autonomy; to manage debt rescheduling; to take account of different conditions and specific rather than general solutions; and to ensure monitoring of financial recovery plans and the capacity to undertake the required follow-up. Through a process of corporatization, improved management and partnerships with all stakeholders, the current PDAM should aim to become a functional utility able to draw in the resources of all stakeholders and maximize on the potential roles of other existing and new stakeholders household, community or small-scale providers. The first step is a new level of viability enabled by debt restructuring, and also accountability developed through restructured organizations under new management rules and a revised regulatory regime, providing demand-led services. A key part of this process is creating citizen demand for improved services through increased community awareness and the adequate price structure of piped water versus other sources of water. Through the reform of PDAMs greater transparency and accountability should be achieved. It would be useful to also prepare general guidelines at the national level (and ensure enforcement at the local level) to eliminate: (i) anti-competitive agreements between PDAMs and established water vendors; (ii) anti-competitive practices by PDAMs that exploit their exclusivity rights in the franchised area. It is necessary to promote broader partnerships that enhance transparency of PDAM activities and in particular strengthen the capacity of public sector agencies to work with private developers as well as communities and small-scale providers. Creating more dialogue and awareness of consumer roles in enhancing and monitoring performance is a key step in improving accountability. Debt Restructuring: It is necessary to develop guidelines for debt restructuring and re-scheduling. The restructuring process will require decisive support to PDAMs from MOF and local governments through equity contributions and rescheduling of existing debt. 210 Averting an Infrastructure Crisis: A Framework for Policy and Action

225 Corporatization: Creating autonomous limited companies, protected from local government interference is a key starting point of reform. Converting PDAMs into corporate entities with an independent Board of Directors would enable these utilities to adopt standard operational business practices, be independently audited and be exempted from unduly restrictive civil service rules. Assistance would establish specific guidelines for the corporatization process where utilities are viable entities and this is an appropriate solution. Mergers: A majority of PDAMs are currently not viable operations. As the advantages of economies of scale become more apparent, it is anticipated that more local governments will merge, following the lead of reform-minded PDAMs. 189 Incentives should be provided to local governments to accelerate such reforms. An additional advantage of creating larger, more autonomous PDAMs is to eventually facilitate their access to the commercial banking and capital markets. Private Sector Participation: Corporatization and economies of scale are likely to both precede and generate private sector interest. Ultimately, the level and form of private participation, be it in relation to investment or delegated management, depends upon the objectives being pursued. In the Indonesian context, redefining the financing framework, reforming regulatory arrangements, and converting the local governments to subnational guarantors, are key steps in this process. Rethinking monopoly status: Rethinking exclusivity and fostering a more open market ultimately results in better utility coverage and improved outcomes. Alternative providers are distributing PDAM water without regulation or control and exacerbate rent-seeking behavior. Best practice elsewhere has shown unequivocally that, given the right incentives, utilities can work effectively in transparent partnerships with local smallscale providers and communities. The unbundling of production and distribution functions should be accompanied by regularization of reselling (watchful of disincentives), enabling greater control over quality, less NRW and can provide greater protection to the poor. Eliminate barriers to entry: It is therefore necessary to eliminate barriers to entry into the market for water vending and small-scale water including: (i) anti-competitive agreements between PDAMs and certain water vendors aimed at preventing other water vendors from entering the market; (ii) exclusive rights granted to PDAMs to serve certain areas, which make small-scale supply and vending illegal and discourage entry; (iii) anti-competitive practices by PDAMs vis-ŕ-vis small-scale suppliers of piped water. Expand network coverage to meet growing urban demands In view of the 4.4% urban growth and the critical role of cities in economic growth, it is necessary to work with reform-minded PDAMs and /or local government to improve and extend network coverage and meet growing demand. For selected PDAMs and LGs, a strategic framework and action planning process should be undertaken to instigate investment programs in urban areas. Significant investment is required to increase bulk supply, treatment and distribution of water. Before any new investments are considered it is first necessary to develop a clearer understanding of the efficiency and effectiveness of current investments, to address any blockages identified, and to ensure that a monitoring and evaluation regime (including efficiency and targeting) forms a critical part of the reform and investment process. Background Sector Report IV National government will need to develop a new financing framework together with a plan for its operationalization. KMK35, which regulates multi-lateral and bi-lateral funding to PDAMs needs to be operationalized to encourage reform-minded PDAMs and to endorse the actions of those local governments that have corporatized the PDAM function (as well as output-based aid schemes targeted at the poor). A key component of this expansion is the inclusion of poor households and communities in underserved areas (to an agreed target by 2015), if necessary through the design of appropriate low-cost interventions. Capitalize on the potential of the alternative water provider market Given the limited coverage of PDAM provision at present, it is vital that the alternative sector of intermediate and independent operators and service providers is drawn in, and not excluded. More information is needed to understand how it works, what services are provided, whom it supplies, the levels of investment, mechanisms for pricing and market entry, and the blockages to this form of provision. As a part of broader strategic planning process it is vital to consider the potential mechanisms for encouraging effective contribution of SSPWPs in the sector. The enabling framework described above would include provision for the encouragement of small-scale private initiative and remove any legal blockages constraining small and medium-scale providers from improving the scope and quality of their inputs in the sector. While the framework should control exploitative behavior, anti-competitive associations with PDAMs and other dubious practices, care must be taken to ensure the regulatory regime does not create disincentives for investment. In addition, the local private sector operators would benefit from capacity building initiatives to support and extend their businesses (e.g. technical and financial management support) and from development of mechanisms for SSPWPs to interface effectively with utilities 190 and enforcement agencies. Consideration should be given at the local level as to whether the promotion of small-scale private sector involvement should be targeted at expanding existing businesses or expanding the market with new businesses, or both. Efforts supporting self-regulation in the form of provider associations may be workable in some circumstances. Establish a strategy and action plan to encourage community managed provision Informed choice is the basis for demand-responsive approaches and community decision-making and management of water supply systems is at the forefront of the strategy of improving rural access. The involvement of communities (and especially women) is a key factor in securing ownership and sustainability, and corollaries include stakeholder endorsement of cost recovery, enforcing accountability of all service providers, and better operation and maintenance. A number of government actions would remove constraints to, and promote further action by, communities. In particular it is necessary to: 211

226 Water Supply and Sanitation Operationalize the community-managed services policy framework. Implement action plan in agreed areas and monitor progress and arising blockages. The policy framework developed through WASPOLA (to be promulgated through a ministerial decree) requires financial support and dissemination. It is vital that efforts are taken to build on the WSLIC community model to facilitate the scaling up of community-management in rural areas not served by formal utility arrangements. Develop a financing strategy for community level activity. Large-scale investment is then needed in coordination with other large-scale donors to increase the poor s access to services in rural areas. Guidelines and testing of approaches in relation to cost recovery should be a key aspect of the financial strategy adopted. Support implementation at the local level through capacity building. Blockages to the operationalization of policy in local government need to be addressed through building capacity and developing incentive mechanisms. It is not only necessary to generate better understanding of the benefits of the approach but also to clear the way for establishing clarity of ownership of community schemes and enabling community contracting processes to be implemented. Currently, presidential decrees exist to allow these practices but they are either considered unclear, or are ignored or evaded at the local government level. Establish a strategy and action plan for regulating household self provision The level and location of household provisioning needs oversight to minimize the potential impact on the environment and to ensure that water quality standards are maintained. In particular it is necessary to: Develop a regime for regulating household provision and ensure enforcement. This would include efforts to understand local impacts and the restrictions needed to protect ground water resources. It is also necessary to ensure technical standards for construction and to consider how and where enforcement can best be achieved. Facilitate changeover to network service as adequacy improves. In the medium term, and especially in large urban areas, it is necessary to develop a strategy enabling a transition to the network system as these develop. This is necessary both to promote efficient utility provision through the development of networks with economies of scale and to place restrictions on unregulated ground water extraction. Sanitation Urgent action is also recommended for developing a national sanitation policy. Although the way forward is the subject of some debate, the main constraints revolve around a lack of political will, a lack of policy, and a lack of institutional responsibility at both national and local levels. In the immediate future, action needs to be taken to recognize, regulate and enhance the activities of those actors that have stepped in to fill the gaps in service provision, but a more comprehensive approach is essential for the longer term and would include the following steps recommended for government. Develop a nation-wide campaign to focus attention on the impacts of inadequate sanitation Develop a strategy for securing political will for sanitation An advocacy campaign is required to secure awareness and commitment to sanitation at the highest political level at central, regional and local government levels in the country. Develop a nation-wide capacity and awareness building strategy Advocacy work amongst politicians should be accompanied by a broader awareness-raising campaign targeted at civil society, especially amongst school children and women, that identifies and generates local interest in the household and community benefits of improved sanitation. Political will can only arise from more aware citizens demanding change and a more receptive political climate. Develop a National Sanitation Policy and Strategy To provide the basis for the development of a legal and regulatory framework for investment in sanitation, a national sanitation policy is vital. It should outline rights, responsibilities of households, local government and national government, create incentives, propose financing options as well as mechanisms to ensure demand responsiveness, and provide for the involvement of the private sector. In addition, it should address the issues brought about by decentralization and the implications for bundling and unbundling sanitation in urban areas particularly. Develop a relevant institutional and policy framework Identify departmental responsibility for, and initiate, sanitation policymaking At the national level, government should urgently identify departmental responsibility for sanitation policy development and clarify responsibility at local level. It will then be possible to: develop a national policy framework that recognizes the need for a multi-provider solution, as well as define appropriate standards; develop an enabling framework to operationalize the policy agenda; allocate central funds to address the inadequacy of sanitation infrastructure; develop sustainable public and private sector (and user) financing instruments; assist local governments develop strategies and action plans for implementation, and support these with technical assistance and guidelines to assist them to prepare strategic sanitation plans (which they need for qualifying for DAK incentive mechanisms); support a process of capacity building for sanitation service delivery to undertake priority interventions to pave the way for sustainable investments and expansion of service in the sanitation sector; create incentives and sanctions to ensure local governments improve sanitation services. At the local level, government should: stimulate demand for improving the local environment and health through better sanitation. develop and roll-out a multi-provider strategy for community, household and small scale provider activity; 212 Averting an Infrastructure Crisis: A Framework for Policy and Action

227 develop a local regulatory framework to operationalize policy agenda, strengthen compliance in relation to sanitation, and address cost recovery. generate political will and develop capacity for implementing the new policy agenda and build awareness of the policy framework amongst the stakeholders responsible for implementation. ensure that the sanitation agenda is emphasized until coverage targets are reached. Prescribe a pro-active financing and strategic planning role for government in sanitation service delivery Underpin financing of the sanitation sector Fundamental to any reform of the sanitation sector is a financing strategy which addresses the chronic under-investment of the past. New institutions, no matter how effective, will be unable to address the public good aspect of sanitation, without adequate finance. Although much of the problem of sanitation can be traced back to the lack of demand and lack of institutional clarity, the fundamental absence of funding to the sector is both a cause and effect. Incentive-based management for effective cost recovery approaches will be crucial to effective use of funding. It will be necessary to establish sector-specific central funds to finance local governments plans, (structured through incentives for innovative solutions in sanitation investment), and to introduce a demand responsiveness in the distribution of targeted resources. Providing local governments sufficient support to realize their investments is critical to establishing a pattern of change and success in the sector. Meeting increased demand for sanitation with improved supply is a critical aspect of stimulating the sector. The investment strategy should improve access to treatment and disposal facilities that are appropriate under local conditions. There is a need for the government to take responsibility for facilitating disposal and secondary services needed to supplement on-site sanitation. Formulate a strategy to regulate on-site sanitation In order to understand the existing dimensions of sanitation service delivery, there is a need for a review of the status and conditions at the community and household levels. A thorough mapping and impact analysis would help strengthen the efforts needed to support existing delivery processes at the local level. With stronger political will and strengthened capacity, it is necessary for local governments to develop and implement a regulatory regime for household sanitation, with specific time bound targets. This should include technical standards for construction of on-site sanitation and disposal. In large cities, a foreseeable goal will be to shift from on-site sanitation to network sewerage, and it will be vital to put in place a strategy for such a transition, once institutions are reformed and investment is facilitated. Background Sector Report IV Formulate a strategy to enhance, scale-up and replicate community initiatives Community involvement is essential to stimulate demand, identify priority investments and mobilize the resources needed to construct sanitation infrastructure at the household level. Better understanding and specific action is needed to enhance the role played by communitymanaged sanitation systems in rural and low-income urban areas. Steps would include the development of a strategy towards scaling-up community sanitation models to link into city-wide institutions and infrastructure, and working in conjunction with identified government and local communities to pilot, monitor and evaluate the scaling up process and then launch a nation-wide replication campaign. Capitalize on, and regulate activities by private small-scale providers and householders Small-scale private providers currently play a critical role in supporting existing provision and will continue to do so in the foreseeable future. It is necessary to better understand the various services they provide, to what extent, where and how they perform them (where they dump waste, what the standard is etc.) and to then respond to this at the local level to enhance their performance and contribution to the sector. In order to draw small-scale independent providers into a functioning and structured sector, it will be necessary to: identify optimal relationships between SSIPs and local government, and review relationships with households, address factors constraining investment such as insecurity of tenure, develop a strategy for the short and medium term (in the absence of infrastructure and facilities) to enhance SSPWP service and to provide incentives and demand-led support packages to improve service to consumers and facilitate disposal caused by widespread contamination of indiscriminate dumping; develop an approach to regulation, through licensing and local regulations appropriate to the context (recognizing the disincentives such formalization may create). The suggested program for Government action is given below. The matrix covers steps to be taken in the immediate term (0-2 years) and medium term (up to 5 years) and these actions are separated into water and sanitation sectors. 213

228 Water Supply and Sanitation Table IV.5. The Way Forward - WATER Issue Intermediate Term (0-2 years) Medium Term (up to 5 years) Develop an enabling framework Develop system for ensuring reliability of data. Continuing collection and monitoring of data. for revitalizing the water sector Continue revising policy and legislation to optimize the Promulgation of legislative amendments. opportunities of a multi-provider water sector. Monitor impacts of policy change on poor Revise allocation of responsibilities Complete tariff restructuring to achieve sustainable levels of GOI focus on policy making role for all service providers, cost recovery. regulation MOF bear foreign exchange risks and develop mechanisms encouraging domestic investment KIMPRASWIL M and E, technical assistance, overseeing PDAM reform (MOHA) Local Government set standards, ensure services delivered Establish a predictable tariff regime focused on achieving cost recovery. Launch program to establish Establish commitment to PDAM reform packages with reform- Evaluate reform process on ongoing basis efficient and viable utilities minded Local Governments. Develop investment strategy to give incentive to improved Carry out a widespread program of PDAM reform including: performance Restructure or reschedule debt corporatize PDAMs to protect from government interference identify opportunities for PSP Identify unviable PDAMs for mergers Expand network coverage to Agree 2015 targets, develop strategy and action plans for Develop and begin to implement investment program in meet growing urban demands expanding and improving structured, organized supply in urban areas to expand service delivery and improve water towns over quality. Develop financing framework (including private sector Monitor performance including UFW and NRW. involvement), identifying funding channels and strategy for Monitor targeting of the poor. operationalizing in rural and urban areas. Establish strategy to capitalize Investigate SSPWPs to understand influence and potential in Monitor levels of investment and activity, improvements of on the role of alternative sector especially in serving the poor. quality in relation to incentive mechanisms. providers Develop policy to enable effective SSPWP contribution. Support efforts promoting self-regulation Develop incentives / support for small and medium scale providers to improve sector performance and promote entrepreneur and user investment (capacity building, lowinterest finance) Establish replicable models of PDAM-SSPWP interface (bulk water pricing, bulk supply points) Establish strategy for encouraging Disseminate agreed policy framework developed through Monitor progress and blockages arising. community-managed provision WASPOLA, remove final blockages to replication (e.g. legality Implement action plan in agreed areas and develop especially in rural areas of community ownership) subsequent stage. Build capacity and provide LG with incentives to operationalize policy. Develop financing strategy for community level activity especially in rural areas. Develop plan for roll-out. Address the sustainability and Develop policy on regulating HH provision to ensure quality Develop regulatory framework and enforcement systems quality of household provision and minimize environmental impact. Develop strategy for transition to networks in urban areas 214 Averting an Infrastructure Crisis: A Framework for Policy and Action

229 Background Sector Report IV Table IV.6. The Way Forward SANITATION Issue Intermediate Term (0-2 years) Medium Term (up to 5 years) Develop a strategy for stimulating Develop and begin to implement a nation-wide capacity Ongoing nation-wide capacity building strategy and demand building and public awareness campaign. sanitation campaign. Develop a strategy for expanding political will for sanitation. Develop the institutional and Develop a sanitation institutional framework, policy and strategy. policy framework Identify departmental responsibility for sanitation policy making Develop a national policy framework that recognizes the Build awareness of policy framework amongst the need for a multi-provider solution, and redefines standards stakeholders responsible for implementation. and create an enabling framework to operationalize the Implement regulatory framework to operationalize policy policy agenda. agenda. Develop strategy and funding for LG support program Roll out strategy development with LG. (below) Ensure profile of sanitation agenda until coverage targets Develop a Financing Strategy that includes all stakeholders. are reached. Explore financing options and identify bottlenecks Monitor and evaluate progress in relation to predefined time Allocate central funds to address fundamental inadequacy bound targets of sanitation infrastructure. Tie down sustainable public and private sector (and user) financing instruments. Prescribe a pro-active role for Assist LGs develop incentive-based strategies and action plans Establish sector-specific central funds to finance local local government in sanitation for improving service delivery. governments plans. service delivery Develop political will and capacity for implementation of new Roll out enforcement of regulatory regime including on-site policy agenda sanitation Develop local regulatory framework Begin to replicate city-wide strategic approach to sanitation; Develop strategies and action plans for scaling up monitor and evaluate scaling up process; develop strategy community-based solutions and promoting household and for interim role of SSPPs in cities in the absence of small-scale provider activity, including pilots in interested infrastructure. cities. Implement strategy to improve access to treatment and Address on-site sanitation in cities. disposal facilities Carry out thorough mapping and impact analysis Develop regulatory regime to be implemented by municipalities to include technical standards for construction and disposal Develop strategy to improve access to treatment and disposal facilities 215

230 Annex IV.1 Legislation relevant to water supply and sanitation service provision Table Annex IV Legislation Significance Constitution 45 Article 33 Para 3. States that water should be treated as a social commodity: Earth, water, and the wealth contained therein is under the state possession and shall be used to the utmost benefit of all the people. Law 5/1974 Regulates the principles of governance. Ministry of Home Affairs decrees Nos and delineate essential elements of water tariff policy. Law 5/1962 Law 8/1999 Law 12/1998 Law 11/1974 Law 23/1997 Law 22/1999 Law 25/1999 Law 30/1999 Law No. 25 of 2000 that has a section (Chapter IX, Article C, Paragraph 2.6) Keppres 7/1998 Keppres 18/2000 Regulation 7/1998 (MoHA) MoH Decree No. 907/2002 Permendagri /1994 Kepmendagri 2/1998 and Regulation 8/1998, MoHA Law 23 /1992 Law 1/ 1967 Provides the legal basis for the establishment of PDAMs as semi-autonomous enterprises, with local governments responsible for tariff-setting. Some of these enterprises are responsible not only for water supply provision but also sewerage services in urban areas. Under current law, PDAMs are wholly owned by the Kabupatens / Kotamadyas they serve. Provides for consumer protection and disputes settlement (water and wastewater). Relates to the establishment of a limited company (In Indonesian: PT: Perseroan Terbatas). This is used as basis when a PDAM is considering to change its status to become a PT. The draft law states that users of water resources are to be charged a fee based on the cost of mobilizing and conserving water and also on the economic capabilities of users groups. Provides for environmental quality and wastewater discharge. Provides for decentralization of all public functions except defense, foreign affairs, monetary and trade policy, and legal systems to local governments. Calls for fiscal balance between central government and the regions 40% of national revenues to be shared with lower tiers of government. Deals with disputes settlement (water and wastewater) Focuses on improvement in the quality of service and management of housing infrastructure such as drainage, wastewater disposal, and flood control. Includes regulation pertaining to private sector participation in water supply. Gives preference to unsolicited bids. Allows community contracting to carry out simple infrastructure projects offered through development programs for amounts less than 1 billion Rupiah. Prevents the head of the local government to be part of the PDAM s supervisory board and limits the number of bureaucrats on the board. Sets drinking water standards. Provides guidelines for evaluating and monitoring financial performance of PDAMs Proposes local government-owned water enterprises should limit tariffs in low income areas. These social tariffs should be set so as to allow enterprises to recover only their costs of operations and maintenance, but not depreciation or interest due on loan repayment. Concerns health, and a water resources law under preparation. Deals with foreign investments 216 Averting an Infrastructure Crisis: A Framework for Policy and Action

231 Annex IV.2 Principal agencies involved in policy formulation and implementation Table Annex IV Water Supply Agency Name Provincial and municipal governments BAPPENAS - Central level Planning Agency Department of Public Works (Kimpraswil): DG Urban and Rural Department of Public Works: DG Water Resources Ministry of Home Affairs (MoHA) Ministry of Health State Ministry of Environment Ministry of Finance Ministry of Industry Ministry of Agriculture Central Statistic Bureau Table Annex IV Sewerage Agency Name Ministry of Home Affairs, MOHA Directorate General of Ministry of Settlements and Regional Development, KIMPRASWIL National Development Planning Board, BAPPENAS Ministry of Health Ministry of Finance Ministry of Environment Local Government Function Law No. 22/1999 states that Province, district, and city have a right to manage and take care of local community business based on initiative and community aspiration. Responsible for all infrastructure, urban, and rural planning. Coordinates national level policy reform processes for water resources and community based WSS. Responsible for public works administration including support for PDAMs in terms of technical standards and design. Responsible for national water resources policy and development strategy, support for technical design of water supply and wastewater infrastructure, promotion of PSP in the sector. Guidance for allocation of raw surface water among users. Comprises three directorates with differing responsibilities: BANGDA for monitoring and evaluation, and coordination with local governments; BPM for community development aspects; and OTDA for decentralization aspects. MoHA sets guidelines for tariffs, customer service standards, and information requirements. Responsible for national health service, public health, and drinking water quality. Role in monitoring and evaluation of water quality, sanitation coverage, and hygiene promotion programs. Sets minimum standards for drinking water quality; provides guidance for monitoring and enforcement. Sets minimum wastewater discharge standards into environment. Provides guidance for monitoring and enforcement. Provides credit backing to PDAMs and investment into WSS sector. Responsible for water pollution control. Responsible for water pollution control. Census, data collection including figures for access and coverage. Function Responsible for regional companies, and PDAMs and for regional loans Responsible for urban sanitation projects funded by central government and for various water laws and regulations Responsible for planning for all sectors, including urban sanitation; provides coordination and monitoring functions at national level; involved in regulations of offshore finances and with cooperation of private sector infrastructure projects Ultimately responsible for monitoring and assuring adequate environmental health standards, and for regulation of water quality and for the health aspects of water supply and sanitation Allocation of finances to regional governments for various developmental purposes including infrastructure projects; responsible for regulation of off-shore financing Responsible for various laws and regulations on environmental protection. Responsible for the delivery of sanitation services such as disposal and treatment. 217

232 Annex IV.3 The Jakarta Concessions The problems faced by the formal private sector are illustrated by the experience in Jakarta of the two concessionaires, PT. PAM Lyonnaise Jaya (Palyja) and PT. Thames PAM Jaya (TPJ). In April 2001, when the contract was renegotiated, the reimbursable water charge and the tariffs paid by consumers were equalized. However, the consumer tariffs were not linked to inflation, and adjustments were left to a largely discretionary process. Over time, the tariffs, unlike the water charge, have not kept pace with inflation, and as a result Pam Jaya has accumulated arrears with the two private operators. Even at the conclusion of the rebasing exercise - how quickly the accumulated arrears will be cleared, and on working out new water charges/tariffs to support future capital expenditures - the issues above have not been addressed. The concessionaires do not believe that DKI has the resources to pay the shortfall, and are of the view that the tariff increases required to meet the full capex program requirements may not be politically and socially feasible in the current environment. By March 2002, TPJ had a shortfall of Rp. 400 per cubic meter, and Palyja of Rp 200 per cubic meter, between the tariffs and the contracted water charge. By March 2003 this shortfall had accumulated to approximately $50 million for each concessionaire. The quality of raw water supplied by the government through the West Tarum Canal has also been of such poor quality that expensive treatment has been required. Box Annex IV Targets vs. achievements in the two concession areas Concession Targets for 2002 West Area (Palyja) East Area (TPJ) Five year coverage target (1997) 62% 70% Actual coverage % 62% Five year connections target (1997) 380, ,000 Actual connections , ,000 Five-year target for cumulative water sold (1997) 98 million cu m. 85 million cu. m. Actual cumulative water sold million cu m. 66 million cu. m Five year target UFW (1997) 38% 39% Unaccounted for water % 49% Source: Regulatory Framework for Private and Public Water Supply and Wastewater Enterprises ADB TA: 3761-INO (Draft) 218 Averting an Infrastructure Crisis: A Framework for Policy and Action

233 Annex IV.4 Financial Recovery Action Plan (FRAP) Features of the FRAP The financial recovery action plan (FRAP) is prepared by a water utility (PDAM) which has a desire to improve its performance to enable it to improve and expand its services to consumers. It consists of an analysis of the existing problems of the PDAM, whether they are technical, financial, commercial or managerial. These problems are analyzed by the PDAM as to their causes so that appropriate actions can be implemented. The required actions are contained in the FRAP details, and supported by financial projections to show the results of these combined actions on the PDAM operations. The FRAP may just be management, commercial and /or technical improvements requiring only minor investments. It may also involve major investments, depending on the technical problem that needs to be addressed. If the PDAM has delinquent loans with the Ministry of Finance, a proposed loan rescheduling scheme is included. The FRAP is developed by the PDAM, and is then discussed and agreed with its Mayor/Bupati and DPRD. The FRAP becomes a commitment between these three parties to implement the FRAP on the part of the PDAM, and to see to it that it is implemented, on the part of the Mayor/ Bupati and DPRD. The PDAM s accountability is thereby improved, as the latter s regulatory and oversight responsibility is strengthened. The PDAM Rescue Program also showed that just by streamlining operations and with some boost from loan rescheduling with MOF, a PDAM can be brought back to operate profitably. The FRAP has been piloted in 17 PDAMs under the PDAM Rescue Program during It was funded by a grant from the ASEM Trust Fund to finance technical assistance to PDAMs willing to be reformed. During that time, PDAMs were almost on the verge of bankruptcy as the financial crisis that hit Indonesia starting from the middle of 1997 exacerbated weak management, poor financial discipline, and deteriorating network systems. Inflation reached 78% at the end of 1998, and the rupiah was devalued from a pre-crisis level Rp 2000 to a US dollar to as high as Rp15000 at one point. They could not borrow to properly maintain their network system much more expand it, because they could not promptly repay their outstanding obligations. The Program was intended to help PDAMs survive the crisis, not only in the short-run, but also in a more sustainable manner that will enable them to be self-sufficient in the long run. The Program was expected to be achieved by improving the operational and financial efficiency of the PDAM consistent with the overall direction of water sector reform. Since there was no financial assistance involved, additional cash had either (1) to be earned by the PDAM out of improved management and tariff increases; (2) to be provided by its local government in the form of additional equity, (3) to be obtained by the deferment of loan repayment as part of loan rescheduling; or (4) a combination of all of these. Parties to the FRAP The FRAP is a commitment from these parties: 1. The PDAM who commits to: Raise tariff to required levels; Add new connections, depending on available capacity; Shorten collection period to improve its cash position; Reduce unaccounted-for water and turn these into revenues; Improve staffing ratio by suspending hiring of new employees and not filling up vacated positions; Reschedule delinquent loan accounts based on its financial capability after considering the positive effects from the above; and Implement the required investment based on agreed program which are intended to deal with the technical problems existing in the PDAM. 2. The PEMDA and DPRD who independently commit to: Suspend the collection of dividends from the PDAM until the required service coverage has been attained by the PDAM; Support the implementation of the required increases tariff; Allow the PDAM to reschedule its delinquent loans; and Monitor the PDAM performance based on FRAP and take action, if required. 3. The MOF who commits to: Reschedule the PDAM s delinquent loan accounts based on the PDAM s financial capability after considering the results of the FRAP actions before loan rescheduling. 219

234 Water Supply and Sanitation FRAP Targets and Desired Results In the FRAP, targets are made for reduction of unaccounted-for water, additional connections that can be generated, shorter collection period, lower staffing ratio, tariff increases, and debt service that is affordable in relation to the rescheduling of delinquent loans. It also includes the investments that need to be made to improve the system, and the PDAM s equity in the project. Based on these targets, the expected results are increased population served, sufficient water supply where once there may have been a shortage, a net profit after tax, an operating ratio of at most 70% that affords the PDAM to earn a decent profit, a debt service coverage ratio higher than 1.3 times to ensure repayment of debts as they fall due, and average tariff that enables the PDAM to fully recover its O&M costs and depreciation. 220 Averting an Infrastructure Crisis: A Framework for Policy and Action

235 Annex IV.5 Corporatization of PDAMs Successful water utilities worldwide share the common characteristics. Accepting these principles and creating the conditions for making them work, may lead to the development of an efficient water sector that can provide adequate services at a reasonable cost: Autonomy in all aspects of management and operation of systems by the enterprise, including planning, financing, and implementing investments; A clearly defined regulatory framework by government that holds water companies to high standards of efficiency, but allows professional management that is insulated from undue political interference; Financial self-sufficiency gained through the collection of tariffs that are sufficient to meet all financial needs (operational, maintenance, investment, and debt service); Transparent, targeted and efficient governmental subsidies to support the poorest segments of the population that are not able to pay the water and sanitation fees; A strong sense of public service and consumer orientation; Access to a convenient source of credit for financing investments; and Reliance on a strong, competitive private sector from which to obtain quality support services. Following the above mentioned principles the Government of Indonesia (GOI) initiated the major decentralization and corporatization steps. In May 1999, the Ministry of Home Affairs issued a circular to all local governments and PDAMs to convert Regional Enterprises into limited liability companies (PTs). As a result the law providing for water enterprises will be replaced by a new law, which divides regional companies (BUMDs) into two types, namely, a regional enterprise BUMD and a limited liability company MUMD. Proposed PDAM Reform Strategy The profile that emerges from the Indonesian water sector comprises a number of different agencies and ministries, often with overlapping or unclear lines of authority. Each ministry has independently progressed into sectoral implementation tasks, thus impeding the efficient development of multisector planning, programming and budgeting initiatives. The result has been a piecemeal response to sectoral needs that has tended to focus on the installation of large-scale physical infrastructure facilities. Because many of these facilities were not operationally integrated into a program of asset maintenance and improvement at the planning and implementation stage, operating and maintenance requirements have traditionally assumed a low priority in the national budgeting process. Today, many of the infrastructure systems, have regressed into a state of systemic degradation, exhibiting the accumulated effect of decades of inadequate maintenance. Nevertheless, over the last three decades, the GOI has made substantial investments in water infrastructure. However, the focus of this investment policy has been on the quantity of investments. Improving the quality of investments is also vital. Further, while the PDAMs are the public utilities and should be perceived as commercially oriented undertakings, it should be recognized that until recently they have always operated at a loss, never generating sufficient funds to meet day-to-day expenses nor to cover their working capital needs, or the contributions required to finance new works; the PDAMs 221

236 Water Supply and Sanitation became accustomed to operating as a highly subsidized institutions, and their management philosophy has been deeply ingrained along these lines. This, coupled with the sectoral fragmentation at the national level and low operating efficiencies at the sectoral level, have all played a part in reducing the impact of the earlier investments and point to the need for a major reform initiative. Creating the institutional and organizational conditions that oblige the water utilities to be more efficient and more responsive to the needs of users is clearly the major challenge of the sector. This challenge will be addressed through a five-point intervention program: (i) creating a macro environment conducive to change; (ii) establishing corporatization partnerships; (iii) creating an appropriate institutional framework; (iv) establishing the internal capacity to manage reform; and (v) corporatizing PDAMs. Creating a Macro Environment Conducive to Reform. It is envisaged that the GOI will have a continuing but changed role in the PDAMs - from that of a direct financier to that of a regulator. In this connection, it is important that a policy and regulatory framework be established at the national level that coordinates cross-sectoral interactions, including private involvement in the provision of infrastructure, safeguards the interests of the low income groups, and improves environmental safeguards. Establishing Corporatization Partnerships. Twinning arrangements with modern water utilities and related training will provide the framework for the commercial operation of PDAMs. Specific programs will be designed to assist PDAMs in this process and the implementation of further steps including preparation of the consumer education program, the introduction of new technology into PDAMs, and the implementation of an Institutional Restructuring Plan aimed at reorganizing and strengthening the management systems, especially accounting, billing and collection, financial management, information management, and operations management. Similarly, both formal and informal on-the-job training to all staff will be provided; Creating the Appropriate Institutional Framework. As the first step in the reform process, the participating PDAMs should be established as a legal entity subject to company law, including formal separation of ownership and management responsibilities through a board of directors. Each PDAM should have its charter, board of directors (including professional managers and user representatives), its own contracting and salary regime. Corporatizing the PDAMs. Responsibility for the corporatization of the PDAM will rest with its management with the support of the Corporatization Partner which will prepare an overall corporate restructuring plan. The plan will include explicit performance objectives and well-defined budgets. As an important tool in this process, a management information system linked with both operational budget planning and strategic planning will be installed and will include, inter alia, a general ledger module with provision for departmental accounting; an automated, fixed-asset module to provide all pertinent information on depreciation and an easily retrievable means of handling revaluations; a general accounts receivable module for fully automating the billing and collection process; a payroll module for processing salaries and wages with provision for receiving data from timekeeping and job cost-modules; and a cost accounting module to separately account for wages, materials, etc. in the central and district workshops, as well as in the treatment facilities and major pumping stations. The corporate restructuring plan will place special emphasis on improving the maintenance capability of PDAMs. The existing entities currently operate a passive leakage control policy, in that leaks are repaired only when they are visible above the ground. This was appropriate in view of the shortage of materials for repairs and the high losses caused by burst mains and customer plumbing systems. However, as the system is renewed and pressures increase, the incidence of pipe failure will likely increase, thus escalating the need for efficient and responsive operational control. Training will undoubtedly need to take place and be sustained to ensure the quality of the repairs made. It is important, therefore, that a leakage inspection repair team be set up and properly equipped to travel the routes of trunk mains so that leaks may be promptly repaired. This effort will be targeted at those trunk and transmission mains which are shown by measurement to have high losses. At present, public perception of the service provided by PDAMs is negative. The future success of PDAMs is largely contingent on successfully soliciting consumer cooperation. To ensure proper implementation of this part of the restructuring plan, it will be necessary for each PDAM to recruit a public information officer with a small department to develop and deliver a proactive public relations strategy aimed at reversing the image of the agency and explaining its current and future plans and the important role it plays in respect to the quality of life in the city. The present personnel function deals principally with personnel records and recruitment. Little or no emphasis has been placed on staff demands, personal development, industrial relations and structured training programs. In fact, over the past several years staff training initiatives have experienced a steady decline. To ensure the success of this part of the restructuring plan, therefore, it will be necessary for the PDAMs to recruit the qualified human resource and training coordinators to rationalize personnel services and develop and deliver training programs aimed at both operational and administrative personnel. Moreover, there will be a need to consolidate human resource functions within the new corporate structure along with the training function. 222 Averting an Infrastructure Crisis: A Framework for Policy and Action

237 Annex IV.6 Cost Benefit Analysis Water Supply This annex estimates the benefits of tariff and efficiency reforms in Indonesian PDAMs. The model used in the annex examines three scenarios: (i) status quo, (ii) partial reform, which involves a 50% tariff increase, and (iii) full reform, which involves increases in tariffs by 50%, efficiency by 20%, and bill collection rates by 20%. In conjunction with the three scenarios, the model investigates two hypotheses regarding the number of direct PDAM end-users: (i) maintaining current service levels and (ii) expanding the number of direct connections by reinvesting additional revenue from tariff increases in network expansion. For each outcome, the model generates an estimate of profit from continuing operations and change in consumer surplus for direct PDAM end users over five years. In the model, the change in consumer surplus is cumulative (i.e. it is computed by comparing consumer surplus during any given year with consumer surplus prior to the reforms). The model assumes that additional profits are reinvested to expand the network. As new connections bring additional profit, and as new users benefit from these new connections, the change in consumer surplus reaches higher levels every year. Furthermore, the model determines the required increases in tariffs needed to cover cost under each reform scenario. The results show significant potential gains, which increase as the number of direct end users and implemented reforms increase. A summary of the results is found in the tables below. The following analysis ignores some significant elements and requires numerous assumptions. First, the annex mainly deals with existing and new PDAM direct end users, disregarding the those not served by PDAMs and the sanitation sector. Second, it also does not take into account the differences in water quality or service as an individual moves from self provisioning to PDAM direct connection or vice versa. Lastly, the model relies on country wide aggregation of PDAMs and averages, which may limit the significance of the results. There is significant variation in PDAM performance and the situation will therefore vary from municipality to municipality. However, the figures used in the analysis are best estimates of "representative" figures. Despite these shortcomings, the analysis provides a useful, rough estimate of potential benefits of reform in PDAM water supply management. 223

238 Water Supply and Sanitation Table Annex IV.6.01 Summary of Model Results (US$ Millions) Status Quo Partial Reform Full Reform US $, M % of GDP US $, M % of GDP US $, M % of GDP Maintain current NPV of Profit & Change in CS ($216) -0.1% ($128) -0.1% $32 0.0% service levels NPV of Profit ($216) -0.1% ($32) 0.0% $ % Reinvest additional NPV of Profit & Change in CS $ % $1, % revenue from tariff increases NPV of Profit ($45) 0.0% $ % Table Annex IV.6.02 % Change in Tariffs Needed to Cover Costs Partial Reform Full Reform Maintaining current service levels 59% 18% Reinvest additional revenue from tariff 62% 20% increases Model Assumptions Numerous assumptions are required to perform the scenario analysis. A summary of inputs can be found in Table Annex IV The following data has been collected during the preparation of the WSS Sector Background Review million people (direct end users) are served by PDAMs through 5.25 million connections Approximately 35% of the population (74 million) in Indonesia is served directly or indirectly by PDAMs; hence approximately 45.2 million people are served by PDAMs through vendors (74 million 28.8 million) 2.55 billion m 3 are produced by PDAMs 1.53 billion m 3 were sold to customers, indicating that the unaccounted for water was over 40% Fixed assets total Rp. 7.5 trillion; assuming fixed assets are depreciating at 5% per annum over 20 years, depreciation per year would be Rp. 375 billion Loans outstanding are estimated at Rp. 3.2 trillion; assuming loans extended to PDAMs are charged at a subsidized interest rate of 10% at maturities of 20 years with 5 years grace on principal repayment, debt repayment per year would be Rp. 320 billion The PDAMs collective gross profit, before depreciation and interest charges, is Rp. 200 billion ($16.7 million at the current exchange rate) Tariffs charged to house connections (PDAM end-users) are Rp. 470 per m 3 Tariffs charged to vendors are Rp. 750 per m 3 Tariffs charged by vendors to end users are Rp. 20,000 per m 3 The cost for PDAMs building one additional house connection varies from Rp. 350,000 to Rp. 750,000. Averaging these two figures yields an average investment cost of Rp. 515,455 In addition, the model assumes the following: Constant elasticity of demand for PDAM direct end users of % of water is sold to PDAMs end-users (0.99 billion m 3 ) 35% of water is sold to vendors (0.54 billion m 3 ) Discount rate is 10% End-users per connection is 5.5 users/connection (28.8 M users / 5.25M connections) Required investment by PDAMs to install new connections to accommodate one additional user is Rp. 93, per user (Rp. 515,455 per connection / (28.8 M users / 5.25 M connections)); Volume consumed per person per month for PDAMs end-users is 2.88 m 3 (1.53B m 3 * 0.65/28.8M/12) for vendors end users is 0.99 m 3 (1.53 B m 3 *0.35 / 45.2M / 12) Marginal cost to mobilize water is half of the new connection cost per cubic meter. The calculation is as follows: 224 Averting an Infrastructure Crisis: A Framework for Policy and Action

239 Investment_Cost Rp. 515, M_Connections 28.8M_TotalCustomers = * * m 3 Connection 28.8M_EndUsers 1.53B_m 3 *0.65 = Rp. 2, m 3 Mobilization_Cost = 1 Rp. 2, * m 3 2 m 3 = Rp. 1, m 3 Mobilization cost of water increases by 10% if demand exceeds 1.6 billion m 3 of water per year to account for increasing water production costs Assumptions need to be made to disaggregate the Rp. 200 B profit, as shown in the article, to estimate the costs of delivering water to vendors and end-users. Applying the simple calculation for profit gives the following formula: Gross_Profit = (P pdam VC pdam )*Q pdam + (P vendors VC vendors )*Q vendors where P pdam = Rp. 470 (tariff charged to PDAM end-users) P vendors = Rp. 750 (tariff charged to PDAM vendors) Q pdam = 0.99 B m 3 (volume sold to PDAM end-users) Q vendors = 0.54 B m 3 (volume sold to vendors) VC pdam = variable cost due to PDAM end-users VC vendors = variable costs due to vendors Given that Gross Profit is Rp. 200 billion and assuming that VC vendor is fixed at Rp. 150, it can be found that VC pdam is Rp so as to satisfy the above equality. The figures seem reasonable, as it is expected that the cost to PDAMs end-users is significantly higher than that to vendors. Hence, the profit on vendors per cubic meter of water sold is assumed to be Rp. 600 (Rp Rp. 150) and the loss on PDAMs direct end-users per cubic meter of water sold is Rp (Rp. 470 Rp ). Table Annex IV.6.03 summarizes the model s inputs and assumptions. Model Framework The model examines three scenarios and two cases, for a total of six possible outcomes. The scenarios and cases are further described below and summarized in Table Annex IV Table Annex IV Inputs and Assumptions Background Sector Report PDAM Direct End Users 28.8 M PDAM Connections 5.25 M Water Produced by PDAMs 2.55 B m 3 Water Sold to Customers 1.53 B m 3 UFW (%) 40% PDAM Fixed Assets Rp. 7,500 B PDAM Depreciation/year Rp. 375 B PDAM Loans Outstanding Rp. 3,200 B PDAM Interest Payments/year Rp. 320 B PDAM Collective Gross Profit Rp. 200 B Tariffs for PDAM End Users (Rp./m 3 ) Rp. 470 Tariffs for PDAM Vendors (Rp./m 3 ) Rp. 750 Tariffs for Vendor End Users (Rp./m 3 ) Rp. 20,000 Average Investments Cost per Connection Rp. 515,455 Water Elasticity of Demand 0.3 Water Sold to PDAM End Users 0.99 B m 3 (65% of Total Water Sold) Water Sold to PDAM Vendors 0.54 B m 3 (35% of Total Water Sold) Discount Rate 10% End Users per Connection 5.5 PDAM New Connection Investment per Additional User Rp. 93, Total Number of direct and indirect PDAM Customers 74 M Volume Consumed per person per month (direct end users) 2.88 m 3 Volume Consumed per person per month (vendor customers) 0.99 m 3 Water Mobilization Cost per m 3 Rp. 1, Variable Cost for PDAM End Users Rp Variable Cost for PDAM Vendors Rp Profit on Vendors (per m 3 ) Rp Profit on End Users (per m 3 ) Rp IV Model Scenarios Examined 1. Status Quo This scenario involves no adjustment in PDAM tariffs, efficiency, or bill collection. 2. Partial Reform This scenario includes an increase in PDAM tariffs by 50%. Thus, the tariff for PDAM end users increases to Rp 705 per m 3 (from Rp. 470), and the tariff for PDAM vendors increases to Rp 1,125 per cubic meter (from Rp. 750). 3. Full Reform This scenario includes an increase in PDAM tariffs by 50% (as in scenario 2) as well as increases in PDAM efficiency by 20% and bill collection by 20%. Gains in efficiency result in decreased cost. Thus, a 20% decrease in the PDAMs variable costs for end users and vendors represents the 20% efficiency gain. Furthermore, a 20% increase in bill collection results in a 20% increase in total revenue. Model Cases Examined 1. Maintaining current service levels There is no increase in the number of direct PDAM end users. The only factor influencing the number of customers is the change in tariffs, which is determined by demand elasticity. 2. Increase in the number of PDAM direct end users This case involves increasing the number of PDAM direct end users by reinvesting the additional profit resulting from tariff increases in network expansion. 225

240 Water Supply and Sanitation New PDAM direct end users are assumed to have previously bought water from vendors at 20,000 Rp. (US$ 2.30) per m 3 before the new direct connection. Table Annex IV Model Outcomes Status Quo Partial Reform Full Reform Maintain Current No change in 50% increase in 50% increase in Service Levels PDAM tariffs or PDAM tariffs PDAM tariffs, 20% costs decrease in cost, 20% increase in revenue No network No network No network expansion (no expansion (no expansion (no change in change in PDAM change in PDAM PDAM direct direct end users direct end users end users) except for those except for those lost due to lost due to increased tariffs) increased tariffs) Reinvest Additional This outcome is 50% increase in 50% increase in Revenue from Tariff the same as PDAM tariffs PDAM tariffs, 20% Increases the status quo decrease in cost, outcome above 20% increase in as there is no revenue additional reve- Reinvest additional Reinvest additional nue to reinvest. revenue each year revenue each year (as compared to (as compared to status quo) to status quo) to expand network expand network For each scenario and case, the model determines four outputs. The first output is the PDAMs profit from continuing operations (earnings after interest payments and depreciation) for each year over a five year period, given by the gross profit formula less interest and depreciation. The model also estimates the change in consumer surplus for existing users for outcomes involving tariff reforms. Change in consumer surplus (CS) is given by the following formula: where n = elasticity P = price β = constant > 0 The last two outputs are estimates of NPV, one involving the profit from continuing operations over the five year period, and the other including both profit from continuing operations and change in consumer surplus over the five year period. Model Results Scenario 1 Status Quo Maintain Current Service Levels In this outcome, there are no reforms undertaken or additional revenues reinvested. Since there is no change in price, change in consumer surplus is 0. The model yields the following baseline results (Table Annex IV.6.05). Scenario 2 Partial Reform Maintain Current Service Levels This outcome takes into account 50% increase in tariffs and no changes in coverage. Assuming the elasticity of demand be 0.3, demand of PDAM direct end users will go down by 15%. Regarding vendors, because the price of water sold by vendors is dramatically higher than the price of water sold by PDAMs to their end-users, one can assume that vendors will be able to pass on the Rp. 375 price increase to their own end-users. Thus, the effect on vendor end-users demand will be negligible, and the volume of water demanded by vendors remains the same. For this outcome, the model yields the following results (Table Annex IV.6.06). Reinvest Additional Revenue to Expand Access This outcome involves PDAMs using the additional revenue generated from the increase in tariffs to build additional direct connections. Compared to status quo, increasing tariffs by 50% results in an additional US$ 49 million over the first year. This additional profit is invested over the year in approximately 818,007 new connections, increasing demand by 0.08 billion m 3. Since this increase in demand is less than the demand lost due to the price increase, no mobilization investment is required in the first year. The additional profits from added connections, along with the differences in profit from the status quo in subsequent years, are invested to increase the number of direct PDAM connections. In years four and five, mobilization cost increases by 10% because demand is greater than 1.6 billion m 3 per year. Following this methodology, the model generates the following results (Table Annex IV.6.07). Scenario 3 Full Reform Maintain Current Service Levels This outcome determines the effects of tariff, efficiency, and bill collection reform. An efficiency increase of 20% is assumed to decrease cost by 20%. Furthermore, a 20% increase in bill collection increases revenues by 20%. These reforms result in the following figures (Table Annex IV.6.08). Reinvest Additional Revenue to Expand Access This outcome involves PDAMs using the additional revenue generated from the three reforms to build additional direct connections. Compared to status quo, increasing tariffs by 50%, efficiency by 20%, and bill collection by 20% result in an additional US$ 91 million over the first year. This additional profit is invested over the first year in new connections, which generate an additional 0.14 billion m 3 over the first year. The additional profits from added connections, along with the differences in profit from the status quo in subsequent years, are invested to increase the number of direct PDAM connections. The model generates the following results (Table Annex IV.6.09). 226 Averting an Infrastructure Crisis: A Framework for Policy and Action

241 Background Sector Report IV Table Annex IV Scenario 1 - Status Quo: Maintain current service level Year 1 Year 2 Year 3 Year 4 Year 5 Profit (US$) (57,016,771.26) (57,016,771.26) (57,016,771.26) (57,016,771.26) (57,016,771.26) Change in Consumer Surplus (US$) 0.00 NPV of Profit (US$) (216,138,422.12) NPV of Profit & Change in CS (US$) (216,138,422.12) Table Annex IV Scenario 2 - Partial Reform: Maintain current service level Year 1 Year 2 Year 3 Year 4 Year 5 Profit (US$) (8,449,346) (8,449,346) (8,449,346) (8,449,346) (8,449,346) Change in Consumer Surplus (US$) (25,243,074) (25,243,074) (25,243,074) (25,243,074) (25,243,074) NPV of Profit (US$) (32,029,668) NPV of Profit & Change in CS (US$) (127,720,779) Table Annex IV Scenario 2 - Partial Reform: Reinvest additional revenue to expand access Year 1 Year 2 Year 3 Year 4 Year 5 Profit (US$) (8,654,835) (10,220,465) (12,056,063) (13,988,520) (15,837,918) Change in Consumer Surplus (US$) 59,234, ,241, ,323, ,006, ,436,867 NPV of Profit (US$) (44,761,044) NPV of Profit & Change in CS (US$) 722,296,479 Table Annex IV Scenario 3 - Full Reform: Maintain current service level Year 1 Year 2 Year 3 Year 4 Year 5 Profit (US$) 33,590,368 33,590,368 33,590,368 33,590,368 33,590,368 Change in Consumer Surplus (US$) (25,243,074) (25,243,074) (25,243,074) (25,243,074) (25,243,074) NPV of Profit (US$) 127,333,922 NPV of Profit & Change in CS (US$) 31,642,811 Table Annex IV Scenario 3 - Full Reform: Reinvest additional revenue to expand access Year 1 Year 2 Year 3 Year 4 Year 5 Profit (US$) (25,243,074) (25,243,074) (25,243,074) (25,243,074) (25,243,074) Change in Consumer Surplus (US$) 132,357, ,444, ,281, ,871, ,218,688 NPV of Profit (US$) 146,402,379 NPV of Profit & Change in CS (US$) 1,751,531,

242 Water Supply and Sanitation Additional Analysis Sensitivity Analysis Water mobilization cost is an important parameter, particularly because increasing deterioration of water resources will most likely result in increased mobilization cost. The sensitivity analysis below examines the effects of an increase in mobilization cost from the current rate of Rp. 1, to Rp. 2, per m 3. It also includes the effect of increasing connection cost from Rp. 515,455 to Rp. 1,900,000 per connection. Increased mobilization and connection costs result in fewer new connections built, lower profits, and lower changes in consumer surplus. These changes can be seen in the Table Annex IV.3.10 below which compares the effects of increased mobilization and connection cost with the baseline figures (baseline scenario reinvests additional revenue in new connections). Effects of a Price Decrease on Self Provisioned Water Given that 85% of the population is without a direct PDAM connection, it is important to analyze the effect a decrease in tariffs has on self provisioned water. As stated in the assumptions, an individual served by vendors consumes 0.99 m 3 per month, for a total of 2.13 billion m 3 a year. Given a 10 percent reduction in water vendor tariffs, from US$ 2.30 to US$ 2.07, quantity demanded increases to 2.20 billion m 3 a year, generating a gain in consumer surplus of US$ 499 million over the year. Summary of Results Table Annex IV.3.11 summarize the NPV estimates in all outcomes. It is also interesting to determine the percentage increase in tariffs needed to cover costs. The cost coverage point is defined as the point at which the NPV of profit from continuing operations over the five year period equals zero. The same two reform scenarios are examined, and the required tariff increases are displayed in the following table Table Annex IV Table Annex IV.3.10 Sensitivity Analysis Comparison Partial Reform Full Reform US $, M % of GDP US $, M % of GDP Baseline NPV of Profit & Change in CS $ % $1, % NPV of Profit ($45) 0.0% $ % Increased Mobilization NPV of Profit & Change in CS $86 0.1% $ % and Connection Costs NPV of Profit ($49) 0.0% $ % Table Annex IV.3.11 Summary of Model Results (US$ Millions) Status Quo Partial Reform Full Reform US $, M % of GDP US $, M % of GDP US $, M % of GDP Maintain current NPV of Profit & Change in CS ($216) -0.1% ($128) -0.1% $32 0.0% service levels NPV of Profit ($216) -0.1% ($32) 0.0% $ % Reinvest additional NPV of Profit & Change in CS $ % $1, % revenue from tariff increases NPV of Profit ($45) 0.0% $ % Table Annex IV.3.12 % Change in Tariffs Needed to Cover Costs Partial Reform Full Reform Maintaining current service levels 59% 18% Reinvest additional revenue from tariff 62% 20% increases 228 Averting an Infrastructure Crisis: A Framework for Policy and Action

243 List of Abbreviations A AAA AIM APEKSI B BAKN BANGDA BAPEDAL BAPPEDA BAPPENAS BEN BKM BKN BKP4N BKTRN BOO BOT BPPN BPS BTN BUMD BUMN C CBHD CBH Analytical and Advisory Activities Association of Indonesian Municipalities Association of Indonesian Municipalities Board for the Analysis of National Finances Directorate-General for Local Development Local Environmental Protection Agency Local Development Planning Agency National Development Planning Agency National Land Administration Agency Community Development Committees National Civil Service Agency National Board for Policy and Supervision of Housing and Settlements Development National Spatial Coordination Board Build Operate Own Build Operate Transfer Indonesia Bank Restructuring Agency Central Bureau of Statistics National Savings Bank Public enterprise owned by an autonomous regional government State owned enterprises Project Community-Based Housing Development Project Community-Based Housing CBO CBUIM CoBILD D DAK DAU DGURD Dinas Perumahan DPOD DPR DPRD Community-Based Organization Capacity Building for Urban Infrastructure Management Project Community-Based Initiatives for Housing and Local Development Special Local Government Grant Consolidated Block Grant Directorate General of Urban and Rural Development Housing section of a local government Regional Autonomy Advisory Council Parliament Local Council E - F - G - H EKUIN FRAP GDP GOI Gotong Royong GRDP I - J IBRA IUIDP JABOTABEK JABODETABEK Coordinating Minister for Economy, Industry and Finance Financial Recovery Action Plan Gross Domestic Product Government of Indonesia Mutual help Gross Regional Domestic Product Indonesia Bank Restructuring Agency Integrated Urban Infrastructure Development Program Jakarta-Bogor-Tangerang-Bekasi-Region Jakarta-Bogor-Depok-Tangerang-Bekasi-Region 229

244 List of Abbreviations K Kabupaten Kanwil KASIBA Kelurahan Kimpraswil KIP Kota Krismon KPR L LAP LIDAP LISIBA LO M - N - O MDF MSIP MSRI NGO O&M OTDA P - Q PAD PBB PDAM PDK PDPP PERDA District Government Deconcentrated Regional Office Ready-to-build area Administrative Sub-district (lower level government administrative unit in a Kota) Ministry for Settlements and Regional Infrastructure Kampung Improvement Program City District Monetary crisis (used to indicate the 1997/98 crisis) Kredit Pemilikan Rumah/Home Ownership Loan Land Administration Project Local Institutional Development Action Program Stand-alone ready to build environment Land Office Municipal Development Fund Multi-Sectoral Investment Program Ministry of Settlements and Regional Infrastructure Non-Government Organization Operation and Maintenance Directorate General for Local Autonomy Local Own Revenues Property Tax (Pajak Bumi dan Bangunan) Local Water Supply Enterprise Local Solid Waste Management Enterprise Basic Urban Development Program Regional Regulation PERPAMSI Perum Perumnas PIPP PJM PLN PP PPP PROPEDA PROPENAS PSPI PUMDA PUOD R Rakorbang RDA RIAP ROW RS RSS S SASKENAS SK SLA SMERU SPAPB SUSENAS National Association of Water Supply Enterprises National Urban Housing Development Corporation Urban Services Investment Program Medium-Term Investment Program State-Owned Electricity Company Government Regulation Public-Private Partnership Regional Development Plan National Development Plan Pusat Studi Properti Indonesia Directorate-General for Local Governance Directorate-General for Governance and Regional Autonomy Local development coordination meeting Regional Development Account Revenue Improvement Action Program Right of Way Low-cost housing units Very low-cost housing units National Labor Force Surveys Surat Keputusan (Decree) Subsidiary Loan Agreement Social Monitoring and Early Response Unit Grants from central to local governments National Household Expenditure Survey T - U - V - W - X - Y - Z TELKOM TKPP UDF UNCHS UNDP UPP URDI USDRP WSS State-owned telecommunication company Coordination Team for Urban Development Urban Development Fund United Nations Center of Human Settlements United Nations Development Program Urban Poverty Project Urban and Regional Development Institute Urban Sector Development and Reform Project Water and Sanitation Sector 230 Averting an Infrastructure Crisis: A Framework for Policy and Action

245 End Notes Chapter 1 - Achievements, Challenges, and Opportunities 1. By way of examples, some provinces are seeking to impose a revenue tax on operators of mobile telephone services. Chapter 2 - Improving Public Management of Infrastructure 2. The Perjan is the most weakly corporatized of Indonesia s three forms of State-owned enterprise, and was used for enterprises whose mission was deemed to be primarily social (e.g. hospitals). Perjans legally formed part of the related department and their principal targets were set in production rather than financial terms. The two main forms of State enterprise today are the Perum and the Persero. A Perum is required to cover its costs but not to earn a profit. Its capital is not divided into shares and it cannot be privatized. A Persero is required to be profit-seeking and is founded on the same legal code as fully private limited liability shareholder companies, with Government being permitted to sell part or all of its shares. 3. Law 22 of 1999 on Regional Governance and Law 25 of 1999 on Fiscal Balance between Central and Regional Governments. 4. The main exceptions are the non-toll road network, railway infrastructure (but not services), and very small ports and airports. 5. Most State-owned transport operators, including Garuda, Merpati (airlines) and Pelni (shipping), are also Perseros. There are few Perums, with PPD and Damri (bus services) being the main exceptions. 6. The websites of these Persero companies provide a reasonable good proxy indicator of their relative managerial performance. 7. Telkom and Indosat are listed on the New York Stock Exchange and obliged to meet its more exacting requirements. 8. The railway sector presents a special challenge because the SOE operates railway services and, on behalf of Government, maintains and operates the state-owned infrastructure. When Perumka was transformed into PT KA, a decision was taken to place the shareholder function with MOC and not with MOSE. This policy has now been reversed, but the delayed move perhaps partly explains the slower progress on PT KA s corporate restructuring. 9. Indonesia Integrated Road Management System (IIRMS) for the national and provincial networks, the Ministerial Instruction 77 (SK77) procedures for kabupaten roads, the Urban Road Management System (URMS), and the Bridge Management System (BMS). 10. See Decentralizing Indonesia (World Bank, June 2003, report IND) for a comprehensive initial assessment of the impacts of decentralization. 11. These include the intergovernmental fiscal equalization system, the state administrative system, State economic institutions, human resource development and empowerment, utilization of natural resources and strategic advanced technology, conservation, and national standardization. 12. In practice, the increased financial autonomy accorded to kabupatens and kotas should reduce 13. These powers are handled by agencies( Dinas) whose responsibilities broadly align with those of the Ministry of Settlements and Regional Infrastructure (Kimpraswil or MSRI) and the Ministry of Communications (Perhubungan or MOC). Dinas Kimpraswil (or PU) agencies are responsible, among others, for the road infrastructure functions and programs of their respective regions. Dinas Perhubungan agencies are responsible for road traffic and transport functions and programs, including route licensing and tariff regulation for public passenger transport services. 14. The 2002 Electricity Law stipulates that a bupati/walikota in a noncompetition region may issue business and operating licenses for 231

246 End Notes enterprises whose activities are located entirely within the kabupaten/kota and not connected to the national grid. Likewise a governor may issue licenses for enterprises whose activities span kabupaten or kota boundaries but are located entirely with a province and not connected to the national grid. Authority to issue licenses for enterprises whose activities span provincial boundaries and/or are connected to the national grid continues to reside with the sector Minister. 15. In two years, more than 100 new local governments have been created, raising the total to over 400. While their average sizes are not small by international standards, many new local governments currently lack the capacities and resources to deliver services satisfactorily. 16. The authority of regions to impose taxes and levies is defined by Law 18 of 1997 as amended by Law 34 of Regional budget (APBD) receipts per capita for rich regions are of the order of fifty times those for the poorest regions. 18. The DAK program comprises two components, namely DAK DR and DAK non-dr. The DAK DR is a special reforestation program and all references in this chapter are to the DAK non-dr. Total DAK non-dr funding in 2003 is around Rp.2.3 trillion (or around 2% of the funding being channeled to regions through revenue sharing and the DAU). 19. Law 18 includes provisions that would restrict some desirable changes in the fees and taxes paid by road users. In particular, it caps the amount of motor vehicle tax (PKB) at 5% of book value (a truck s road damaging potential does not diminish with age whereas as its book value does) and defines the motor vehicle fuel tax to be an ad valorem tax (an adjustable Rupiah levy per liter would be preferable). 20. Reflecting its changed role post-decentralization, its name was changed from Ministry of Energy and Mining to Ministry of Energy and Natural Resources. 21. At present responsibilities for energy policy formulation in Indonesia are dispersed among a number of agencies. In principle, overall policy is determined by a Minister-level National Energy Coordinating Board (Bakoren), with inputs being provided by units of MEMR and by other agencies such as BPPT and BATAN. However, Bakoren is no longer a functioning forum and there would be merit in consolidating policy analysis expertise into fewer units. The Center for Energy Information was initially conceived as an embryonic policy analysis unit and has indeed performed such a role. 22. Including, for example, Telkom and Indosat, Garuda, Pelni, PTKA, the four Pelindos and the two Angkasa Puras. 23. The present BRTI would appear to leave DGPT s powers essentially intact. 24. The scope of the Department s activities have changed significantly inasmuch as responsibility for posts and telecommunications was transferred to a new Ministry of Posts Telecommunications and Tourism in the early 1980s and then restored in the late 1980s. 25. GOI s Economic Policy Package issued in September 2003 provides for drafts of new laws for these sectors to be prepared during Chapter 3 - Restoring Private Participation 26. Sarinah functions more as a building management company, and earns much of its revenues from letting space to fast-food chains and restaurants and other vendors. 27. The lack of consensus is well captured by an article dated September in the Jakarta Post. Entitled Laksamana lambasts ludicrous lawmakers, the article goes on to note State Minister for State Enterprises Laksamana Sukardi erupted in anger on Tuesday during a hearing with House of Representatives legislators, blaming them as the main culprits behind the government s failure to meet the privatization target and schedule. How can we work if you (the legislators) keep on wasting our time by asking insignificant questions, and... quarreling with each other. With all due respect, I don t see any point to this hearing, said Laksamana. 28. There were originally five such KSO agreements but three have been bought out by Telkom subsequent to the onset of the economic crisis. 29. There are many variants of the BOT model, with Indonesia having favored the BOO (Build Own Operate) scheme for many of its IPP projects. 30. Government provides compensation to PLN to cover the difference between the efficient costs of supplying power to small customers (<450VA for up to 60kWh per month) and the revenues received from these customers at the Government mandated tariffs. This should be seen as a subsidy to targeted end-users and not to PLN. The budgeted cost of this compensation for 2003 is around Rp.4.5 trillion. 31. Telkom is competing ahead of schedule by offering a high quality and easy to use VOIP service. 32. Williamson, Oliver Franchise Bidding for Natural Monopoly in General and with Respect to CATV, Bell Journal of Economics, 7 (Spring): Yardstick regulation has been extensively employed in the UK, including for setting rates for water, sewerage and power distribution companies, and is also now being used in Latin America and elsewhere. 34. See Judith Rees. Regulation and Private Participation in the Water and Sanitation Sector and authors 35. Telkomsel has slightly over 50% of the market, Indosat/Satelindo around one third, while Excelcomindo has most of the remainder. 36. Government envisages transitioning to full competition through a duopoly stage under which Telkom and Indosat-Satelindo would compete head-to-head as full service providers. As part of the first phase it is planned that Indosat-Satelindo would develop fixed access networks in Jakarta and Surabaya 37. Despite reducing capital costs, further progress on tariff rebalancing will be needed to create incentives for expanded investment in fixed access local services, especially in rural areas. 232 Averting an Infrastructure Crisis: A Framework for Policy and Action

247 38. It should be noted that the PDAMs account for only around 16% of the total water supply market. Efforts also need to be made to maintain and foster competition among informal service providers, including those who supply water to homes by pushcart or hose, and those who remove septage. 39. Reference to Acil Tasman Final Report and PPIAF. 40. One notable example is UK s British Gas, which repeatedly resisted efforts to introduce effective competition in gas supply. Ultimately the Monopolies and Mergers Commission (MMC) in 1993 imposed a restructuring which separated the company s gas supply and transportation arms and laid the foundations for a truly competitive gas market in the UK. 41. Blueprint for the Development of the National Electricity Industry, , Ministry of Energy and Mineral Resources, April In the interim, it is proposed that the small Batam grid serve as the laboratory for implementing competition. 43. Reference Hunt and Shuttleworth book on Competition in Electricity Supply 44. Insert reference to Tim Irwin / Phil Gray paper. 45. section draws on Penelope J. Brook and Suzanne M. Smith, Contracting for Public Services: Output-based Aid and its Applications, The World Bank and International Finance Corporation. 46. Expected costs should be assessed based on the probability of payment being realized to assess cost of guarantee and potential future burden of budget. Chapter 4 - Getting a Grip on Corruption 47. Developed with Gallup International s Voice of the People Survey. 48. For a comprehensive overview of corruption in Indonesia and a strategy for tackling it, see Combating Corruption in Indonesia, World Bank, October Much of the material in this chapter is drawn from this document. 49. According to a study financed by the ADB, basic salaries of government Project Managers are mostly below Rp 1,400,000 (US$165) per month while tender committee members generally earn less than Rp 980,000 per month. Salaries of similar positions in the private sector are more than four times higher. 50. A colluding favored contractor could skew its unit rates so as to come in with a low initial bid in the knowledge that additional earthworks under a pre-arranged contract amendment would make the contract very profitable. A variant of this practice, used when budgets cannot be increased, involves subsequent amendment of the contract, following a design review, to narrow its scope so as to favor the more profitable components. 51. See Combating Corruption in Indonesia. Op Cit. 52. The PPA for Tanjung Jati A was signed but the project was put on hold by Keppres 39/1997. The project was subsequently closed out during the renegotiation. 53. While PLN uses financial models to evaluate IPP tariff proposals, there will always be differences of opinion regarding appropriate values for key inputs such as achievable capital costs, financing charges, and returns on equity capital. End Notes 54. As indicated previously, high prices do not automatically imply that deals were secured corruptly. On the other hand, the low prices that can be achieved through intense competition allow little room for significant corruption. It should be noted in this context that PLN has recently been a pioneer in using life cycle costing in its procurements, including notably for a recent major power plant procurement where account was taken of financing costs and fuel efficiency as well as capital costs. 55. Few of these had been the subject of sound feasibility studies and many had very questionable prospects for being commercially viable even under very optimistic assumptions. 56. Country Department III, East Asia Pacific Region, World Bank. Report No IND, June Op Cit Chapter 5 - Mobilizing Finance for Infrastructure Development 58. See Klein and Roger (1994) Back to the Future: The Potential In Infrastructure Privatization 59. For eg: the ongoing and widely publicized difficulties of lenders to Asia Pulp & Paper creates significant doubts in the minds of international lenders whether their rights can be adequately protected in Indonesia. 60. There is significant liquidity in the Indonesia banking system at present. However, much of this is because of short-term deposits which are a poor funding source for long-term investments. 61. The Asian Development Bank estimates that TASPEN was in a cashflow deficit (excess of payouts over contributions) of Rp trillion in 2000 while ASABRI was in a cash flow deficit of Rp. 30 billion in the same year. These deficits are funded out of the Government s general budgetary resources and are expected to grow dramatically over the coming years, thereby becoming a part of the fiscal problem for the government as opposed to being a part of the solution.. Background Sector Report I Electric Power 62. Blueprint for the Development of the National Electricity Industry Ministry of Energy and Mineral Resources. April 21, Private participation in the power sector should also comply with cross-sectoral policies on private participation in infrastructure provision contained in Keppres 7/1998 (now being revised) and policies on foreign investment contained in Government Regulation 20/

248 End Notes 64. The law provides for a power system manager to be responsible for plant dispatch and for controlling and coordinating between generation, transmission and distribution, and for a power market manager to be responsible for the matching power demands with bids to supply. 65. The national power grid has been defined by Minister of Energy and Mineral Resources Decree 55K/30/MEM/2003. It is anticipated that this decree will later be reissued as a Presidential Decree. 66. The Elucidation to the Law states that these levies are to be collected in regions that apply competition and are not to burden consumers connected at low voltage. 67. One further contract, for Tanjung Jati C, was signed in December 1997 when PLN was already in serious financial distress. This was linked to Tanjung Jati B and was terminated as part of the latters restructuring. ESCs are three-way contracts for geothermal power plants between Pertamina (as steam owner), PLN (as buyer) and an IPP developer. While there were a few proposed private transmission projects, no agreements had been concluded by the time the crisis struck. 68. One geothermal project developer was able to secure a Government guarantee for PLN s payment obligations. 69. Some of the affected projects were subsequently cleared to proceed by Keppres 47/1997, but this decree was revoked a couple of months later by Keppres 5/ The other plants on which agreement has already been reached are Sibolga, Amurang, Palembang Timur, Asahan, Sibayak and Cibuni. Construction on these has either not started or was halted at an early stage. 71. Karaha Bodas. An international arbitration panel found in favor of the developer and awarded a settlement of $261 million that was subsequently overruled by the Jakarta District Court. An out of court solution is now being sought by Government. 72. See the report on World Bank-PLN Joint Seminar on Captive Power in Indonesia-July A significant part of Pertamina s output is produced by contractors under Technical Assistance Agreements. 74. PLN recently announced plans to source some fuel through overseas trading entities. 75. Although a reliable supply for the entire country is the ultimate objective, the Java-Bali power system, which represents over 75 % of the country s power market, is the immediate goal: The impact of frequent and prolonged blackouts in Java-Bali on industry, commerce and tourism would be substantial. The effect of blackouts outside Java-Bali is significantly less, although this is not to say that outside Java-Bali should be ignored. 76. The period was considered critical with respect to potential power shortage, because by beginning 2007, Tanjun Jati B plant, with a capacity of 1,320 MW, would come on stream, thus adding substantially to the installed capacity and help in mitigating the risk of power shortage. 77. While traditional indicators of the level of generation reserves (i.e., generation reserves margin, which is the difference between installed capacity and peak load, divided by peak load) in case of Indonesia seems to be ample thus implying that there is excess of generation capacity in reality the maximum available capacity is substantially less (even if no units were on forced outage, on maintenance, or experiencing some temporary derating of the capacity). This is because of the constraints resulting from (i) derated capacity (4%- 5% per year), (ii) long term outage capacity (350 MW), and (iii) constrained capacities (1500 MW). To present a more realistic picture of the level of generation reserves which can actually be dispatched, an available capacity margin was arrived at by allowing for these constraints, and then compared with required target capacity margin. Security of the system was measured to meet the level of installed capacity needed to satisfy both the target capacity margin and the essential spinning reserve (615 MW) requirements. 78. Several sources have estimated the total investment to be as high as $28 billion. IEA estimates that based on 5%-5.5% average growth between , the sector s investment needs for generation only for is US$15 billion, for is US$25 billion, and the total for is US$77 billion. 79. The Law also provides for tariff to be set at economic value before electricity competition is introduced, and the elucidation defines the economic value as that which recovers costs and ensures fair return. But there is no definition on what constitutes fair return. 80. This differed from the situation in Malaysia, which weathered the crisis more easily because most of its IPPs were domestically funded. 81. These figures exclude use of power from captive generation. Indonesia has an unusually high proportion of captive generation capacity and allowing for this would likely improve Indonesia s relative position. Note also that PLN s power sales per capita had increased to around 400 kwh per year by Government provided no operating subsidies but did finance a significant proportion of PLN s investment programs, including in particular for rural electrification, through equity injections. 83. PLN s average revenue for the last quarter of 2002 was Rp. 480 or approximately US 5.3 cents per kwh. Implementation of the agreed quarterly increases for 2003 should raise this to around Rp. 615 or approximately US 6.8 cents per kwh (at Rp. 9,000 to the US$) by year-end. 84. Minister of Finance Decree 431/KMK/.06/ This is defined in Law 20/2002 as a level that covers costs plus a fair return. 86. The retail tariff comprises capacity and usage charges, with the unit rates for both varying with customer category, connection capacity, and usage level. 87. It is estimated that the most CPP-generated electricity that PLN could replace through its grid supply would be about 10,000 GWh (out of 37,000 GWh), if all the CPPs had access to PLN s grid and if the tariff charged would be based on supply costs. 88. See also Indonesia s IPP Rationalization Program: A proposed Approach-June See Indonesia Oil and Gas Sector Study Report June Averting an Infrastructure Crisis: A Framework for Policy and Action

249 Q t 90. Under a Wholesale competition market, the developers assume the investment risks. The stranded costs associated with the wholesale model (WSC) are much lower than for MBMS, since no retail contracts are needed. Although disadvantages arise with wholesale competition (for example, consumers may not get full benefit from electricity competition), the model is an important first step to developing a fully competitive retail market. Background Sector Annex I.1: Cost Benefit Analysis Electric Power 91. Figures for GDP and total electricity consumption for 2002 are based on the Country Analysis Briefs of the Energy Information Administration of the Department of Energy, available at: Unit costs of electricity production by small individual generators are higher than the Long Run Marginal Cost (LRMC) of the system because, among other reasons, of the lack of economies of scale. In addition smaller generators consume more fuel per unit produced adding further inefficiency in the system. 93. The consumer surplus estimate on the above report is based on a linear consumer demand function for electricity, and could therefore be overestimated. Further analysis on the costs and benefits of rural electrification needs to be undertaken to assess the economics of rural electrification in Indonesia adequately. Background Sector Report II Telecommunications 94. The processes by which licenses were awarded to Satelindo and Ratelindo in 1994 were opaque, with the domestic private shareholders being politically well-connected. 95. Indosat s planned acquisition of KSO IV was designed in part to give it a fixed line subscriber base from which to start competing with Telkom on local services. However, the transaction was strongly resisted by Telkom employees. 96. This assumes a capital cost per line of circa US$150 and a population of 220 million. Telkom s reported capital cost per line in 2001 was significantly higher at around US$530 but it now projects the cost per line for fixed access radio to be around $150. By way of comparison, Telkom s cost per line was around US$3000 in the late 1980s. 97. Figures for 2003 have slightly increased: the connection fee for a new residential line is Rp. 295,000 (circa US$33) while the monthly charge is around Rp. 34,000 (circa $3.80). 98. The one notable exception was the selection the five KSOs, which was handled openly and competitively. 99. Initially some 12 companies were granted VOIP licenses but Government subsequently elected to allow only five players. Three licenses were issued to the major operators (Telkom, Indosat and Satelindo) and two were awarded to new start-up companies that had not previously been in this business. Background Sector Annex II.1: Cost Benefit Analysis Telecommunications 100. It can be displayed in the following equation: where Qt = total number of minutes call in year t Pt = price measured as a segment price basket Lt = population in year t GDPt = GDP per Capita in year t ut = noise term which is normally distributed with mean zero and variance?? = operator that represents the difference between a variable in time t+1 and that in time t The following equation is used to model the dynamic behavior of demand, Qt: where End Notes Given that Qt+1 = Qt +, the model projects Qt for t > 0 from the initial quantity Q0, which is known from historical data Based on the ITU Database 103. While most of the recent time series on the total number of domestic long distance minutes are missing, time series for both Philippines and Indonesia are available from 1990 to 1994 inclusively. The data reveals that despite a smaller population in Philippines, the total number of domestic long distance minutes in the Philippines is higher than that of Indonesia, and the ratio (Philippines minutes to Indonesia minutes) is increasing over time. A linear regression in which the ratio of Philippines minutes to Indonesian minutes is regressed on time produces the following linear equation: y = 3.202x , where x denotes the number of years from 1990 and y represents the ratio of minutes. Using the regression equation, the ratio in 2002 is computed to be (or 3.202* ), and the resulting conversion factor (Indonesia to Philippines) is (or 1 / ) FCC Press Release July 15, 2003 hraunfoss.fcc.gov/edocs_public/ attachmatch/doc a1.pdf 105. The tariff rates are found in the Indosat website. It is shown that the calling costs from Indonesia to US and to UK are Rp. 8,300 and Rp. 9,400 per minute respectively, resulting in an average cost of Rp. 8, FCC Presentation October 2001, consumer_education_website.pdf 235

250 End Notes Background Sector Report III Road and Road Transport 107. This is a simplified representation of complex mapping rules. It should be noted that central Government deconcentrates certain responsibilities (e.g. implementation of betterment and maintenance works on national roads) to provincial agencies, and that kabupaten and kota governments may request provincial governments to perform certain of their functions on their behalf The Jakarta-Cibinong section of the Jagorawi toll road, which links Jakarta to Bogor and Ciawi There are two toll roads outside Java, namely in North Sumatera (34.4 km near Medan) and in South Sulawesi (20.3 km near Makassar) Keppres 39/1997, issued in September 1999, affected publicly and privately financed infrastructure, energy and petrochemical projects. The toll road sector was most affected in terms of numbers of projects put on hold while the power sector was most affected in terms of value of projects. The Decree was revoked in February 2002 by Keppres 15/ Vehicles owned by for-hire and own-account operators can be distinguished by the background color of their number plates. Forhire vehicles (trucks, buses, taxis, etc.) have yellow backgrounds while own-account vehicles have black backgrounds Road Transport Industry Development Component; Mott MacDonald Ltd. March, VAT (PPN) is a general tax and accordingly is not considered to be a road user charge At least 30% of the net proceeds from PKB and BBNKB and 70% of the net proceeds from the PBBKB is required to be transferred by provinces to their constituent kabupaten and kota The total cost of subsidies enjoyed by the households, industry, power and transport sectors for all fuel types (gasoline, ADO, kerosene, industrial diesel, and fuel oil) from the State budget was Rp trillion in 2000, Rp trillion in 2001 and Rp trillion in In 2000, subsidies accounted for around 40% of total State budget expenditures, with fuel accounting for 85% of the total subsidy payments Minister of Finance Decree 35 of 2003 establishes new interim procedures and criteria to govern the on-lending and on-granting of foreign loans. Preliminary indications are that works on non-tolled roads would be treated as non-cost recovery projects and accordingly be eligible for on-granting rather than on-lending The scope of the DAK has been expanded from 2003 to include items other than reforestation. Rural roads receive a total budget Rp trillion which is allocated among provinces and kabupatens This runs contrary to provisions of Government Regulation 8 of 1990 on Toll Roads that stipulate Government shall be responsible for the costs of land acquisition 119. This is the missing link in the toll road connection between Jakarta and Bandung. Jasa Marga is developing only the comparatively low cost end-sections The condition assessment is made using International Roughness Index (IRI) and Surface Distress Index (SDI) of the road pavement as follows: Good = IRI<=4 and SDI<50; Fair = 4<IRI<=8 and SDI<100; Poor = 8<IRI<=12 and SDI<250; Bad = IRI>12 or SDI>250. It does not account for traffic capacity Country Department III, East Asia Pacific Region, World Bank. Report No IND, June Carl Bro International a/s in association with MVA Asia Ltd., ND LEA Consultants, PT Amythas, PT Dressa Cipta Rekayasa, PT Jasa Citra Manunggal, and PT Multi Phi Beta. October Based on volume:capacity ratios as follows: Moderate = ; Significant = ; High = > Cities in Transition: Urban Sector Review in an Era of Decentralisation in Indonesia. World Bank. June, Second Highway Sector Investment Project, Implementation Completion Report. World Bank, December Country Department III, East Asia Pacific Region, World Bank. Report No IND, June The study determined that the economically optimal path for providing additional corridor capacity was through incremental widening up to a maximum 4-lane dual carriageway road, beyond which construction a new road on a new alignment would be justified Widening to U7 standard will also have been included under the limited betterment program identified by the Road Fund Study and should not be double-counted. Since the SEPM runs conducted for the Road Fund Study did not provide for expansion to LAN standard, user costs will include a substantial congestion component in the outer years These analyses were undertaken as part of the DGRI Road Funds study (PT Hasfarm Dian Konsultan, March The SEPM enables the impact of alternative, optimally allocated, budget levels for road works to be assessed in terms of their impact on road user costs. It considers national, provincial, kabupaten and kota roads, but not bridges It should be noted that road transport usually gives rise to significant external costs in the form of polluting emissions, road crashes, construction intrusion etc 131. The BBNKB tends to discourage reporting of ownership transfers. Road user charges studies conducted by MOC have proposed it be discontinued, with the loss of revenue being offset by increases in PKB rates. Background Sector Annex III.1: Cost Benefit Analysis Road and Road Transport 132. Estimated User Cost is based on the polynomial regression equation: Estimated User Cost = 0.178*(Agency Cost) *(Agency Cost) (R 2 =0.98) 236 Averting an Infrastructure Crisis: A Framework for Policy and Action

251 Background Sector Report IV Water and Sanitation 133. During the 1990s, while average annual population growth was about 1.7%, urban population grew at a rate of 4.4% BAPPENAS, 2003, Infrastructure White Paper (draft of January 7, 2003), p ADB, 1998, quoted in Wright, A, 2003, Draft Report Indonesia Urban Sanitation Policy Framework p1, adjusted for Including DEPKES and MOHA 137. Establishment of Water Enterprises Perusahaan daerah air minum (PDAMs) Note that this data does not include the population that does not have access to safe water at all Assuming coverage at 6 persons per connection and an urban population of 90 million - roughly 40% of the total population of Indonesia. Data obtained from PERPAMSI raw data reports December This coverage is comparable with the Philippines and lower than Thailand BAPPENAS, Op. Cit. p Ibid. p Elvas, L. and A. Baietti, 2001, Delivery of Water Supply Services in the Context of Decentralization and Regional Autonomy, at Annex 1, pp BAPPENAS Op. Cit. p Elvas and Baietti, Op. Cit. p ADB 2001, Regulatory Framework for Private and Public Water Supply and Wastewater Enterprises, TA: 3761-INO (Unpublished Draft) 146. SUSENAS, Evaluations conducted by the Water and Sanitation Program East Asia and the Pacific. See WSP-EAP, 1998, Study of Communitybased Approaches in UNICEF s WES Program in Indonesia; WSP- EAP, 1999 Evaluation of the Community-Managed Activities component of AusAID-supported NTB ESWS Project. ; WSP- EAP, 2001, Achieving Sustained Sanitation for the Poor: Lessons from Participatory Policy Assessments in Cambodia, Indonesia, Vietnam, Do Project Rules Promote Sustainability and Equity? An assessment in 40 communities served by 5 past projects in Indonesia, in Mukherjee, N. and van Wijk, C. (eds.) Sustainability Planning and Monitoring; WSP-EAP, Flores Revisited. Evaluation of RWSS project interventions funded by AusAID (FLOWS), World Bank (WSSLIC) and NGOs (CARE, Dian Desa, Delsos, Tana Noa) in Flores, NTT. Draft report dated December It is not uncommon to find that affluent households have invested significantly in wells, pumps and storage tanks. Many households use several sources of water even when connected to the public distribution system. In lower income areas, people tend to limit piped water consumption for drinking and cooking purposes, and still rely on wells and surface water for bathing and laundry. In the wealthiest urban areas, households tend to use water from their deep wells for most purposes, with the exception of drinking where the norm is still bottled water PAM JAYA Director General Announcement 030/INSTR/PAM/IV/ 1990 End Notes 150. This has generally been restricted to businesses selling (aqua) drinking water Ministry of Settlements and Regional Infrastructure, 2003, Water Resources Management: Towards Enhancement of Effective Water Governance: Country Report. World Water Council, prepared for 3rd World Water Forum in Kyoto March, See BAPPENAS Op. Cit p Assuming 10% interest rates on the Rp. 3 trillion of outstanding loan (i.e. Rp. 300 billion per year and revenue of Rp. 200 billion) 154. WHO, This may include one or more of the following: standpost/pipe, borehole, protected spring or well, collected rain water. Improvement does not ensure that water is safe WSP-EAP, 1999 op cit In a random sample conducted % households gained access to an improved water supply in South Sulawesi, while only 4-9 % of village households gained access to improved water in West Java and a significant range (14-100%) was found in West Nusa Tenggara. Ibid Location is also a key determinant of access to PDAM water, as revealed in the massive imbalance in rural and urban water access in table 2. It is difficult for small consumers, often the poor, to opt in to the system because PDAMs do not generate enough revenue to expand services beyond the core service areas With 9 people drawing on one water connection Anecdotal evidence suggests that many PDAMs do not use chemicals, although they appear on the accounts Elvas and Baietti, Op. cit. p BAPPENAS Op. cit. p Data obtained from the PDAM Rescue Program 164. These are in the low to mid range compared with other Asian cities of similar size. ADB, 1997, Second Water Utilities Data Book A benchmarking exercise conducted for 28 PDAMs showed the operating cost recovery percentage exceeded 100% for 25 PDAMs. However, these were among the better performing PDAMs. ADB, 1997, ibid As a point of reference, the average tariff for the water supply utility in Phnom Penh was $.29/m3 and the average monthly bill was $ ADB, ibid, WSP-EAP, Op Cit. 1998; 1999; Shugart, C. 1991, An Exploratory Study of the Water Standpipe- Vendor System in Jakarta, Harvard Institute for International Development 169. These data are consistent with those for other Asian cities provided in ADB regional surveys. ADB, Second Water Utilities Data Book,

252 End Notes 170. For those with income below Rp200,000 per month. USAID survey, ADB, 1997, ibid Regulation No. 416/MENKES/PER/IX/1990 for the Ministry of Health Regulation on Water Quality Basic sanitation includes toilets and septic tanks, on-site collection of excreta and wastewater Sub-project of WASPOLA with grant funding from AusAID 174. An example of the NGO role as operators can be found in Tengarang and Surabaya where they have been involved in the construction of some 30 community sanitation centers Distributed in accordance with rules governed by the Law on Fiscal Balance between Central and Regional governments Law No. 25/ Governed by Law No. 25/1999, government Regulation on Regional Loans (No. 107/2000), by Ministerial Decree No. 347a/KMK.017/ 2000; and 177. Presidential Decree on Cooperation with the Private Sector (No. 7/ 1998) Sukarma, R. and R. Pollard., 2001, Indonesia: Overview of Sanitation and Sewerage Experience and Policy Options, Urban Development Sector Unit ibid. p ADB, 1998, TA No INO, Strengthening of Urban Waste Management Policies and Strategies, October SUSENAS, Op. Cit WSP-EAP, 2001, Is it selling toilets? No, a lifestyle WSP Fieldnote Gross, B., 2003, Do project rules promote sustainability and equity? WSP-IRC 184. SUSENAS, Op. Cit Moreover in densely populated urban areas this would not even be practical The intention is to submit the guidelines and a six point action plan to revitalize the sector to the National Parliament for approval and implementation A start has been made under the WASPOLA initiative but this work needs to be accelerated, especially in relation to utility and informal service provision Drinking water quality standards have recently been revised by the GOI for all public utilities 189. Voluntary mergers between PDAMs have taken place, for instance, with Medan and Semarang In order to create a unified system of delivery, local government and PDAMs need to consider their relationship with these independent providers. Do they want SSPWPs to go on siphoning water illegally, or do they want to establish up-front bulk sales of water by providing purpose made standposts (hydrants) allowing control over water quality and procurement of water at cost recovery levels? 238 Averting an Infrastructure Crisis: A Framework for Policy and Action

253 Bibliography Anjali, Kumar et. al Mobilizing Domestic Capital Markets for Infrastructure Financing. World Bank Discussion Paper No Amis, Philip and Sashi Kumar Urban Economic Growth, Infrastructure, and Poverty in India: Lessons from Visakhapatnam. Environment & Urbanization. Vol. 12, no. 1, pp Brenneman, Adam Infrastructure and Poverty Linkages: A Literature Review. World Bank. Bappenas Infrastruktur Indonesia: Sebelum, Selama, dan Pasca Krisis. Bappenas: Jakarta, Indonesia. Bappenas, BPS Statistics Indonesia, and UNDP Indonesia Human Development Report 2001: Towards a New Consensus, Democracy and Human Development in Indonesia. Bappenas, BPS Statistics Indonesia, and UNDP: Jakarta, Indonesia. Clarke, George and Scott Wallsen Universal(ly Bad) Service: Providing Infrastructure Services to Rural and Poor Urban Consumers. Development Research Group. The World Bank: Washington, DC. Canning, David, and Esra Bennathan The Social Rate of Return on Infrastructure Investments. Policy Research Working Paper The World Bank: Washington, DC. Coordinating Ministry for Economic Affairs Rural Infrastructure for Development: Linking Rural Infrastructure Development with Poverty Alleviation and Employment Creation. Secretariat, Coordination Team on Rural Infrastructure Development: Jakarta, Indonesia. Department for International Development Draft- Making Connections: Infrastructure for Poverty Reduction. Dollar, David, and Aart Kraay Growth is Good for the Poor. Policy Research Working Paper The World Bank: Washington, DC. Dubash, Navroz Power and Politics: Equity and Environment in Electricity Reform. World Resources Institute: Washington, DC. Dwiyanto, Agus Reformasi Tata Pemerintahan Dan Otonomi Daerah. Universitas Gadjah Mada: Yogyakarta, Indonesia. Eastwood, Robert, and Michael Limpton Pro-poor Growth and Pro-growth Poverty Reduction: Meaning, Evidence, and Policy Implications. Asian Development Review, vol 18, no. 2, pp Elvas, Leila, and Aldo Baietti Delivery of Water Supply Services in the Context of Decentralization and regional Autonomy. World Bank: Jakarta, Indonesia. Fan, Shenggen, Linxiu Zhang, and Xiaobo Zhang Growth, Inequality, and Poverty in Rural China. Research Report 125. International Food Policy Research Institute: Washington, DC. Fan, Shenggen, Peter Hazell, and Sukhadeo Thorat Linkages Between Government Spending, Growth, and Poverty in Rural Indonesia. Research Report 110. International Food Policy Research Institute: Washington, DC. Harris, Clive, John Hodges, Michael Schur, and Padmesh Shukla Infrastructure Projects. The World Bank Group Private Sector and Infrastructure Network. Note 252. KKPPI Pre-CGI Meeting: Infrastructure Session Proceedings. Komite Kebijakan Percepatan Pembangunan Infrastruktur: Jakarta, Indonesia. Klausen, Anne-Lise Big Ticket Corruption in Infrastructure Development. World Bank: Jakarta, Indonesia. Ministry of Energy and Mineral Resources Blueprint for the Development of the National Electricity Industry Indonesia. Ministry of Settlements and Regional Infrastructure, Directorate General of Water Resources, Republic of Indonesia Water Resource Management: Towards Enhancement of Effective Water Governance, Country report. World Water Council. Mukherjee, Nilanjana and Ratna Josodipoero Is it selling toilets? NO, a lifestyle. WSP-EAP, The World Bank. 239

254 Bibliography Sawada, Yasuyuki, and Naoko Shinkai Do Infrastructure Investments Help Reduce Poverty? Evaluation of an Irrigation Project in Sri Lanka. University of Tokyo.: Tokyo, Japan. Sukarma, Risyana and Richard Pollard Indonesia: Overview of Sanitation and Sewerage Experience and Policy Options. Urban Development Sector, World Bank: Jakarta, Indonesia. Williamson, Oliver Franchise Bidding for natural Monopoly in General and With Respect to CATV. Bell Journal of Economics 7 (Spring): World Bank Bureaucrats in Business: the Economics and Politics of Government Ownership. New York: Oxford University Press. World Bank Cities in Transition: Urban Sector Review in an Era of Decentralization in Indonesia. World Bank: Washington, DC. World Bank, East Asia Poverty Reduction and Economic Management Unit Combating Corruption in Indonesia: Enhancing Accountability for Development. World Bank: Jakarta, Indonesia. World Bank, East Asia Poverty Reduction and Economic Management Unit Decentralizing Indonesia: A Regional Public Expenditure Review Overview Report. World Bank: Jakarta, Indonesia. World Bank Indonesia: Accelerating Recovery in Uncertain Times. World Bank: Jakarta, Indonesia. World Bank Indonesia: Beyond Macro-Economic Stability. World Bank Brief for the Consultative Group on Indonesia: Jakarta, Indonesia. World Bank Indonesia in Crisis: A Macroeconomic Update. World Bank: Washington, DC. World Bank Indonesia: Maintaining Stability, Deepening Reforms. World Bank Brief for the Consultative Group on Indonesia: Jakarta, Indonesia. World Bank Second Highway Investment Project, Implementation Completion Report. World Bank: Jakarta, Indonesia. World Bank World Development Indicators Word Bank: Washington, DC. World Bank World Development Report 1994: Infrastructure for Development. New York: Oxford University Press. World Bank Vietnam: Country Framework Report on Private Participation in Infrastructure. World Bank: Washington, DC. World Bank, East Asia Poverty Reduction and Economic Management Unit Philippines Improving Government Performance: Discipline, Efficiency and Equity in Managing Public Resources. World Bank: Philippines Country Office. World Bank, Public Private Infrastructure Advisory Facility (PPIAF) Private Solutions for Infrastructure in Mexico: Country Framework Report for Private Participation in Infrastructure. World Bank: Washington, DC. Wright, Albert Draft: Indonesia Urban Sanitation Policy Framework. World Bank: Jakarta, Indonesia. van de Walle, Dominique, and Dorothyjean Cratty Impact Evaluation of a Rural Road Rehabilitation Project. World Bank: Washington, DC. van de Walle, Dominique Are Returns to Investment Lower for the Poor? Human and Physical Capital Interactions in Rural Vietnam. World Bank: Washington, DC. van de Walle, Dominique Infrastructure and Poverty in Viet Nam. The Living Standards Measurement Study. World Bank: Washington, DC. 240 Averting an Infrastructure Crisis: A Framework for Policy and Action

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