Report No. 13642-PE

PeruA User-Based Approach to WaterManagement and Irrigation Development

Country Department ilINatural Resources Management and RLural PovertvLatin America and the Caribbean Region

Document of the World Bank

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GLOSSARY OF ACRONYMS

AACH Autonomous Hydrographical Basin AuthorityAutoridad Aut6noma de la Cuenca Hidrografica

DGAS General Directorate of Water and LandsDirecci6n General de Aguas y Suelos

EMOS Municipal Water and Sewerage CompanyEmpresa Municipal de Obras Sanitarias

FAO/CP Food and Agriculture Organization/CooperativeProgram

FONCODES National Social Compensation and Development FundFondo Nacional de Compensaci6n y Desarrollo

GDP Gross Domestic Product

IDB Inter-American Development Bank

INADE National Institute for DevelopmzntInstituto Nacional de Desarrollo

INRENA Directorate of the National Institute ofNatural Resources

Instituto Nacional de Recursos Naturales

MAG Ministry of AgricultureMinisterio de Agricultura

MRTA Tupac Amaru Revolutionary MovementMovimiento Revolucionario Tupac Amaru

NGOs Non-Government Organizations

WUAs Water User AssociationsJunta de Usuarios de Agua

WUO Water User OrganizationsOrganizaciones de Usuarios

PERU

A USER-BASED APPROACH TO WATER MANAGEMENT ANDIRRIGATION DEVELOPMENT

Table of Contents

Page No.

Preface

Executive Summary ....... .................. i - viii

Introduction ................................. 1

1. Overview of Irrigation Development in Peru .... ........ 2

A. Agricultural Land and Water Potential and Use .... .... 2B. Synopsis of Agricultural Policies ................. 3C. Irrigation Policies and Institutions ................ 6D. The Current State of the Irrigation Sector .......... 11

2. Tradable Water Rights For Improved Water Management . . 13

A. The Draft Water Law ...................... 13B. Resolving Issues in Establishing Tradable Water Rights . . 24

3. A Strategy for Irrigation Development .... ........... 36

A. Small and Medium Irrigation Investments .... ...... 36B. The Development of Large Hydraulic Projects ... .... 39C. Conclusion ......... .................... 45

TABLES

Table 1. Investments and Project Componentsof Special Projects ....................... 40

Table 2. Peru: Investments and Outcomes ofLarge Hydraulic Coastal Projects .... .......... 42

ANNEXES

A. The Draft Water Law: An Unofficial English Translation

B. Water Reform and Poverty in the Peruvian Highlands

C. Description of the Large Coastal Hydraulic Projects

PREFACE

This report was prepared by Mateen Thobani based on the findings of missions toPeru in May and October 1993 to prepare an Irrigation Sector Project. Loretta Sonn(FAO/CP) and Regina Martinez (Consultant, FAO/CP) participated in the missionsand contributed some of the material for Chapters 1 and 3. Paul Trawick(Consultant), drawing from his four years of field work for his PhD thesis, preparedthe annex on Water Reform and Poverty in the Peruvian Highlands. CarlosEmanuel, Gabriel Montes (IDB) and Hernan Roman (Consultant, IDB) providedconstructive inputs in the analysis of the draft water law and in the formulation of astrategy for the development of large hydraulic projects. Janice Molina translated thedraft water law. The Government sent comments on an earlier draft in February andMarch 1995. The managing division chief is Nicholas Krafft, the Lead Economist isNorman Hicks and the Department Director is Yoshiaki Abe.

Executive Summary

Overview

1 Immediately upon assuming office on July 28, 1990, theFujimori Administration implemented a strong stabilization program thatsucceeded in halting hyperinflation and improving the country's foreignexchange situation. Over the following years, the Peruvian Governmentimplemented a number of structural reforms aimed at reintegrating Peru intothe international community, fostering openness of the economy, broadeningthe scope for private sector development, and enhancing efficiency in resourceallocation. The reforms reversed the decline in GDP that had occurred since1988 and improved prospects for longer-term economic growth and povertyreduction.

2 The structural reforms were implemented in virtually all sectorsof the economy. The agricultural sector underwent a major transformation asa result of far-reaching reforms in land tenure, agricultural pricing andmarketing, agricultural credit, and agricultural research and extension. Whilesome reforms were also implemented in the irrigation area, theAdministration's proposed water reform that will most profoundly affectirrigation activities -- establishing a system of tradable property rights to water-- has been delayed.

3 This report argues that the proposed water reform has thepotential to resolve many of Peru's widespread water problems. However, thedraft law would benefit from some modifications. In addition, the reportprovides some suggestions to ensure that the subsequent regulations to the laware well-designed and implemented. Finally, the report analyzes a proposedstrategy for irrigation development, which complements the water reform andis based on sound economic principles.

Background

4 Although Peru's water resources are abundant, they are poorlydistributed. The bulk (98 percent) of the country's water is located in theAmazon basin, which has limited agricultural potential, while the fertile, low-rainfall coastal region is entirely dependent on variable supplies from riversoriginating in the Andes. Since pre-Columbian times, Peruvians have investedheavily in irrigation systems to store and divert water from Andean basins tothe coastal areas for use by coastal cities and industry, as well as byagriculture. Agriculture accounts for roughly 80 percent of water use in Peru.Presently, almost half of Peiu's cultivated area is under irrigation, and theseareas account for the bulk of agricultural output.

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5 By 1992, following several years of virtually no public spendingfor maintenance or rehabilitation of public irrigation structure, many publicirrigation systems faced a high risk of failure. Water delivery became moreirregular, water quality deteriorated and water conflicts grew. There was alsowidespread reporting of water theft. Even in areas where water was scarce, itcontinued to be used wastefully. Although Peru's existing water law:(i) specified priorities for water use; (ii) mandated that water tariffs cover bothoperations and maintenance (O&M) costs and construction costs; and(iii) established a comprehensive institutional framework, the system ofpriorities for water use has proved unworkable, water tariffs typically do notcover even O&M costs, and the public institutional structure is weak. Despitelow water tariffs, many users were unwilling to pay them and the Governmentrealized that it would be extremely difficult to increase water chargessubstantially or to create strong institutions to plan, assign, monitor andenforce efficient water use. Moreover, it was unwilling to devote substantialpublic resources to subsidizing irrigation activities.

6 Not only has the current system of water allocation resulted ininappropriate water use and poor system O&M, it has discriminated against thepoor. Under a system whereby new water rights were assigned at no charge(except for modest water tariff charges) at the discretion of public officials, thepolitically influential farmers were more easily able to obtain these rights evenwhen there was insufficient water available to justify the granting of newrights. This led to an effective reduction in the rights of existing, lesspolitically influential farmers. In addition, the threat of having one's waterrights being expropriated by the State for higher priority uses has discouragedinvestments in water-intensive activities. At the same time, many of the largepublic investments in hydraulic projects, which were supposed to make Peruself-sufficient in agriculture, have proved to be ineffective, uneconomical anda large fiscal drain.

Proposed Water Law

7 To address these problems, the Ministry of Agriculture hasproposed, as the centerpiece of its water management and irrigationdevelopment strategy, a new water law modelled along the 1981 Chilean watercode, which has successfully improved water delivery and use, stimulatedprivate investment, and reduced water conflicts. Under the proposed Peruvianlaw, existing water users are to be given property rights to water withoutcharge. Rights to new or unallocated surface water are to be distributed via apublic auction. The rights may be traded at freely negotiated prices providedthat the trade would not reduce water availability to others and that there isenough water to maintain a minimum ecological flow and to maintain theaccustomed quality of life in cities and towns. Rights may also be mortgaged

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or leased. The law prohibits altering water quality to the detriment of flora orfauna; however, rather than proposing specific sanctions and fines, it defers tothe Environmental Code and Environmental Authority to set and enforce waterquality standards.

8 Under the draft law, water rights are to be acquired by beingrecorded in a public Water Rights Registry, specifying, inter alia, the flow orvolume (which may be specified in terms of percentage of stream flow or inshifts); the point at which the water will be diverted; whether. it is forconsumptive or non-consumptive use and whether it is for permanent ortemporary use; the point and form in which the water will be returned to theriver system; and the amount paid for the rights. The law also establishes aproperty tax on water rights. In contrast to the current law, the new rights donot have to be used for any specific purpose, there any no priorities amongwater rights for different purposes, and the water right is separate from theland right for both surface and ground water.

9 Although opposed by some because of its innovative nature,Peru's proposed system of tradable water rights is likely to have manyadvantages over the current system of administered water allocation. Becausea market system increases the value of water, there are greater incentives todefine water rights and to improve their measurement and enforcement. Theconveyance infrastructure required for water transfers is likely to be built morecost-effectively by the private sector. Similarly, water user organizations,which have an important role under either system, will become stronger andbetter-organized when water rights are well-defined and made transferable. Inprinciple, and reflecting the Chilean experience, tradable and secure propertyrights to water should:

(a) Provide an effective way of changing water use towards higherpriority uses without creating conflicts and without having to raisewater tariffs. Thus it would provide farmers financial incentives toswitch to improved irrigation methods or to less water-intensive cropsand to sell their excess water to a neighboring city or other farmers.

(b) Help reduce environmental damage. By inducing waterconservation, the construction of new hydraulic storage or diversioninfrastructure can be avoided, thereby averting possible environmentaldamage. In addition, water conservation by farmers will help controlwaterlogging and soil salinization caused by over-watering.

(c) Assure poor farmers that their effective water availability will notbe reduced. Under the current system, water administrators often givenew water rights to politically influential water users even when there is

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not enough water in the system to meet existing water rights. Thisreduces the water available for others. By defining water rightsappropriately and restricting auctions to those instances where surpluswater rights are clearly available, the proposed law will help reducecurrent abuses of the water rights system.

(d) Be used as a source of collateral. This is especially beneficial forpoor farmers who have few sources of collateral for cheaper loans. Italso provides a large farmer the flexibility of being able to mortgageonly part of his infinitely divisible water rights as opposed to his entireland and water holdings.

(e) Stimulate private investment in activities requiring an assuredsupply of large quantities of water (e.g., farming, mining, some typesof industry, water supply companies) since the uncertainty of access towater will be reduced. The increased investment and improvedproductivity of water use are expected to benefit the poor indirectly as aresult of increased employment opportunities.

(f) Stimulate private investment in hydraulic projects as potentialinvestors will be assured that their water rights will not be expropriatedin future and that the water generated as a result of their investment canbe sold at freely determined prices. This would be particularly useful ifgovernments wished to encourage private investment in hydropower,domestic water supply, and the privatization of large public hydraulicprojects (see below).

(g) Facilitate the transfer of irrigation infrastructure to water usergroups and allow them to be solely responsible for system O&M andfor the setting of water tariffs.

(h) Provide the basis for better protection against overexploitation ofunderground aquifers as compared to the current system, wherebyowners of the land above an aquifer have unlimited rights to its water.

10 To allow for passage of the water law, the 1993 Peruvianconstitution contains a clause (Article 66) which treats land and waterresources equivalently. Thus private property rights to water can exist in thesame way that private property rights to land exist. A draft water law hasbeen prepared. However, its submission to Congress has been delayed. TheGovernment could usefully use this time to make some modifications to thedraft law and ensure that its subsequent regulations are well-designed andimplemented. It is important that the Government proceed expeditiously todraft the regulations to the law and that it devote sufficient resources for the

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effective and fair implementation of the law and its regulations. Suggestionsfor modifying the law and drafting the regulations include:

(a) a public information campaign and debate to make policy makersand water users aware of the problems with traditional approaches andunderstand the operation and potential benefits of water markets. Thiscan help ensure that the final design and implementation of the legalframework is done in a transparent and participatory manner;

(b) the establishment of effective public institutions to draft theregulations and to implement the law efficiently and fairly afterapproval. This may require modifying the law so as to avoidappointing the same people that served as water administrators underthe present water rights regime;

(c) understanding and addressing the implications of various ways ofdealing with the issue of third-party effects arising from "return flows".

(d) the suggestion that in the regulations relating to the proposed waterlaw, the tax: (i) exempt farmers holding very small quantities of waterrights; and (ii) apply to both consumptive and non-consumptive rights,although at different rates. The existing tax on irrigated land shouldsimultaneously be removed;

(e) implementing safeguards to prevent monopolies. While there is nodanger of widespread monopolies, they could occur: (i) followingprivatization of the large hydraulic works and water companies; and (ii)in the area of non-consumptive water rights. To avoid this: (i) anappropriate regulatory framework should be developed prior to anyprivatization; and (ii) a tax on non-consumptive water rights should beintroduced, accompanied with regulations determining power tariffs;

(f) streamlining the law by: (i) transferring some of the institutionaldetail in the law to the regulations to allow them to be changed easily ifthey turn out to be inappropriate; (ii) specifying early in the law(Article 9) that water rights will be given without charge to existingusers; (iii) clarifying that even when water storage and transfer worksare performed by individuals, there needs to be an auction of theassociated temporary water rights; and (iv) addressing the issue of whatwill happen to unregistered water rights if users are unable to registertheir rights 180 days after publication of the law -- one option is toimplement the new law by river basin only if the relevant water userorganizations in the watershed choose to do so, with the remainingwater basins continuing to function under the prevailing law; and

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(g) measures relating to the initial allocation of property rights. Wherethere is sufficient water to honor all existing rights, as in much of theSelva region, the initial allocation could be done simply by re-registering them in the new Public Registry. Where the existingregistry contains many overlapping property rights, as in the Costa, theinitial allocation should be based on past usage. In situations wherethere have existed gross abuses of water rights, as in much of theSierra, water rights should be assigned to communities based onhistoric use, who would then allow individual registration according tothe irrigated land area. In addition, to reduce water losses, the initialrights in the Sierra should specify water distribution patterns that arecontiguous, or concentrated in one area at a time, according to theorder of fields along each canal. In all cases, the Government needs tohelp small farmers to register their water rights, making maximum useof "block titling." Finally, the auction that would allocate new waterrights should be carried out in an open and transparent manner withinformation on prices and volumes made publicly available, and withzero or minimal costs charged to enter the auction.

Strategy for Irrigation Development

11 A strategy for irrigation development that is under discussionproposes treating water and irrigation services no differently from othercommodities or services. According to this strategy, the Government willsubsidize water and irrigation services only to the extent that they exhibitpublic goods characteristics and/or positive externalities (e.g. flood control,drainage, soil erosion and siltation reduction, riparian flows, the formation ofwater user associations and dispute resolution mechanisms, and water supply),or to the extent that a subsidy is an effective poverty alleviation measure.Moreover, the Government will not itself carry out irrigation activities orinvestments if the users or private investors are capable of undertaking them.In addition to providing possible subsidies, the strategy requires establishing alegal and regulatory framework to reduce uncertainties to users and potentialinvestors and to avoid monopolies from developing. This approach isconsistent with sound economic policy and with the Government's approach inother sectors. Tradable property rights to water will greatly facilitate theimplementation of this strategy.

12 Under the proposed strategy, the Government would graduallytransfer without charge all the irrigation infrastructure in its completed projectsto water user associations (WUAs) and would provide them with technicalassistance to operate and maintain it. Giving the infrastructure away withoutcharge recognizes the existing situation whereby the Government has beenunable to impose water charges to recover investment costs -- water charges

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rarely cover full O&M charges. In addition, until the rural banking system issufficiently developed, the Government is considering making long-term fundsavailable for lending toward financially viable off-farm irrigation investments.This would help avoid a possible failure of the irrigation system as a result ofthe past government neglect of O&M activities. While the mechanics of theproposed operation are still being worked out, some of the principles to befollowed are: (i) the loans would have to be guaranteed by collateral; (ii)WUAs or concessionaires, not individuals, would be the final borrowers of thefunds; (iii) the funds would be lent at commercial interest rates; (iv) WUAswould need to demonstrate their ability and willingness to repay the costs ofrehabilitation and to cover the incremental O&M costs; and (v) the WUAswould be responsible for designing the projects and either the WUAs or theconcessionaires for executing the civil works -- the Government would providetechnical assistance for this.

13 For projects in poor communities that may have high social butlow private returns, (e.g., irrigation rehabilitation, contour terracing,reforestation, pasture improvement), the Government would continue toprovide poor communities grant-assistance through its Social Investment Fund,FONCODES. Under this program, communities organize themselves toidentify and implement small-scale infrastructure investments, contributing tothe costs of the investment, usually in the form of unskilled labor, andorganizing themselves to operate and maintain these investments.

14 The strategy for the on-going large public hydraulic projects isalso consistent with the principles above. By the end of 1993, these projectshad already consumed US$3.4 billion (in constant 1993 dollars) in publicfunds. In order to complete them, an additional US$8 billion would berequired, of which US$7 billion would be needed for the coastal projectsalone. Since this is substantially more than Peru's total annual public budgetexpenditure, both capital and current, it is becoming increasing apparent thatwithout substantial private involvement, most of the projects will never becompleted.

15 These projects (or stages of projects) may be divided into fourcategories. The first category include those that are largely complete and haveestablished WUAs (initial stages of Chira-Piura, Tinajones, Jequetepeque,Majes, and Chavimochic). Under the proposed strategy, most of the hydraulicinfrastructure would be transferred to the Associations without charge just asfor the completed schemes above (and for the same reasons). The WUAswould then be responsible for completing any outstanding works and foroperating and maintaining the system. However, any unallocated land andwater rights and any infrastructure needed for further development would beauctioned (through competitive bidding). The Government would provide

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association members with technical assistance and would make availablecollateralized loan financing and/or matching grants to the extent that thereexist activities with positive externalities or of a public goods nature.

16 The second category includes projects where, because of pastlarge public expenditures, the incremental financial rates of return ofinvestments are acceptable (Chinecas, Pasto Grande, Tacna, and the newstages of the first category). Here, the proposed strategy calls for the sale ofthe hydraulic infrastructure and unallocated land and water rights to privateinvestors through a transparent process that involves competitive bidding. Inaddition, a regulatory framework for the privatized enterprise would beprepared that will allow for the "unbundling" of water services so that theinvesting consortium will be able to sell, for example, the non-consumptiverights to a hydropower generation company and the consumptive rights to aurban water supply company and a land developer. The regulations wouldalso define any monopolistic pricing rules, define whether and for how longany monopoly rights will be awarded, and define how fees for system O&Mwill be determined. If there are to be any public subsidies to address marketimperfections, these would be clarified and the financing mechanism spelledout. The privatization would free-up scarce public resources and increase thelikelihood that the project will be completed faster and cheaper.

17 The third category includes projects that are at an early stage ofimplementation (Olmos, Alto Piura, Sur Medio). Their incremental costs perhectare are estimated to be much higher than their expected benefits asreflected in the projected increase in land prices. There is little chance thatprivate investors would be willing to take over the schemes without enormous,and totally unjustifiable, government subsidies and guarantees. Under thisapproach, the projects would be shut down for once and for all, thereby savingPeru tremendous fiscal resources as well as stopping the wasteful lobbyingefforts from contractors, financing agencies and potential beneficiaries.

18 The fourth category includes those projects with a strategic orsocial rationale (Tumbes, Rio Cachi, and all the Selva projects). Here, thestrategy suggests that the Goverrnent first evaluate whether the non-economicobjectives for each project are still valid. If so, the Government wouldcommit sufficient budgetary funds to implement them as rapidly as possible,using local participation in the design and implementation and cost sharingwith beneficiaries to the extent possible. If the Government no longer regardsthese projects as priority, it would see whether it can transfer such projects tobeneficiaries to complete the works and operate and maintain the project. Insuch cases, the Government may provide credit guarantees or matching grants.If there is no interest from beneficiaries despite such efforts, the Governmentwould shut down the projects.

Introduction

1 Peru's water resources are not being used well and its publicirrigation infrastructure, which has been costly to build, is not being operatedor maintained well. A lack of incentives to conserve water, combined withpoor institutional capacity to plan, assign, monitor and enforce waterdistribution and use, has led to a wasteful use of water. Furthermore, the lackof secure water rights has resulted in conflicts over water and discouragedprivate investment in irrigation and in water-intensive activities. At the sametime, many of the large public investments in hydraulic projects, which weresupposed to make Peru self-sufficient in agriculture, have proved to be veryuneconomical and a large fiscal drain. Despite various policies aimed atensuring adequate operations and maintenance (O&M) of irrigationinfrastructure, the operation of most irrigation systems is poor and themaintenance so inadequate that many systems face a high risk of failure.

2 The objective of this paper is to identify an irrigation sectorstrategy to address the above-mentioned problems. Resolution of theseproblems is expected to increase output and incomes, thereby helping to reducepoverty. Although the focus of the paper is on irrigation, some of the reformsdiscussed here will have a profound effect on other uses of water (water fordomestic use, industry and mining, and hydropower) as well as on publicfinances. The primary audience for this report is Peruvian policy-makers,both in the executive and legislative parts of the Government. In addition, thisreport is expected to be valuable to the local and international communityinvolved in Peru's development efforts. Finally, since there are some novelaspects to the strategy, the report is expected to be useful to policy advisors,researchers and policy-makers working on other water-scarce countries aswell.

3 The structure of this report is as follows: Chapter 1 provides anoverview of irrigation development in Peru. It describes Peru's land andwater resources, discusses past agricultural policies, provides a brief history ofirrigation development, and analyzes how Peru's irrigation policies andinstitutions have affected water use and irrigation development. Chapter 2describes the proposed water law which would establish a system of well-defined property rights to water that can be traded relatively freely. It showshow effective implementation of such a law could increase the productivity ofwater use, help improve the O&M of existing irrigation systems, resolve waterconflicts, stimulate private investment, and benefit the poor. It then suggestssome reforms to the law and discusses how best to implement the legislation.Chapter 3 discusses a strategy for the rational development of irrigation inPeru. It suggests measures to improve the effectiveness of existing irrigationschemes and to ensure the rational development of on-going and futureirrigation schemes. Finally, Annex A provides an English translation of theMay 1994 version of the draft water law, Annex B focusses on water reformand poverty alleviation in the highlands of Peru, and Annex C summarizes keycharacteristics of the large coastal hydraulic projects.

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1. Overview of Irrigation Development in Peru

A. Agricultural Land and Water Potential and Use

1.1 Peru's twenty-three million people inhabit an area of 129 millionhectares, greater than the combined areas of France, Italy and Germany.About 10 percent of Peru's area is located in a narrow coastal strip betweenthe Pacific ocean and the foothills of the Andes (Costa); 30 percent ismountainous (Sierra), made up of the valleys and western plateaus of theAndes; and 60 percent is in the Amazon watershed (Selva), comprised of thevalleys and eastern plateaus of the Andes (Ceja de Selva) and the low Amazonrainforest (Selva Baja).

1.2 The Costa is largely arid with an annual average rainfall of only38 mm. However, it enjoys moderate temperatures and fertile soils andreceives water from 53 rivers that flow from the Andean mountains. It alsohas limited underground water in some areas. The Sierra receives an averageof 600 mm. of rainfall but has a harsh topography and climate. The Selvasuffers from torrential rainfall (annual average 3500 mm), fragile ecosystems,acid soils, pest problems, and is isolated from the Pacific and Atlantic Oceansby the Andean mountains and Amazon rainforest. As a result, the potentiallycultivable area in Peru is estimated at only 6 percent of its total area.

1.3 The availability of surface water in Peru is estimated at over2 trillion cubic meters, equivalent to a runoff of 64,800 cubic meters persecond. This represents 5 percent of the world's runoff. Although waterresources are abundant in national terms, they are geographically poorlydistributed in terms of agricultural needs, which constitute about 80 percent oftotal water demand in Peru. The bulk (98 percent) of the country's watersupply is located in the Amazon basin where the potential for agriculturalexpansion is limited while the area of greatest potential expansion, the Costa,is entirely dependent on uncertain and highly variable seasonal supplies fromrivers originating in the Sierra -- over three-quarters of the water flow isbetween January and April.

1.4 Peru's development of water resources and agriculture reflectsits regional characteristics. The scarcity of surface water in the fertile coastalregion and Peru's concern with food self-sufficiency has led successivePeruvian Administrations to invest heavily in irrigation systems to regulate anddivert surplus water from Andean basins and convey and distribute it to coastalusers. Some of these systems are hundreds of years old. Currently some717,000 hectares are irrigated in 53 valleys in the coast. Of these only about320,000 hectares have permanent surface water resources for irrigationpurposes. Nevertheless, given its better access to domestic and internationalmarkets, as well as its milder weather and fertile soils, the Costa accounts for60 percent of Peru's agricultural GDP. The region's most important

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agricultural outputs are cotton, rice, sugarcane, yellow corn, beans, andpoultry. Although the region has significant potential to develop non-traditional exports such as fruits and vegetables, it has only recently begun todiversify into some high-value export crops such as asparagus.

1.5 The majority of usable land in the Sierra is suitable only forgrazing. However, the region does have about 310,000 hectares of irrigatedland, mostly in very small irrigation schemes of 100 to 3,000 hectares that aremanaged directly by community organizations (See Annex B). TheGovernment is also executing three large projects in the Sierra, orientedmainly at irrigation. In spite of such irrigation efforts, crops on almost80 percent of the 1.9 million cultivable hectares are rainfed. This is due topredominantly mountainous terrain which lends itself mostly to cultivation ofsmall plots on the mountainsides of the Sierra. The region accounts for about25 percent of agricultural GDP, with important crops being potatoes, whitecorn, wheat, barley, and several native crops.

1.6 Agriculture in the Selva is primarily in the valleys of the Ceja deSelva, at altitudes of 500 to 1500 meters. Of the one million hectares ofcultivated land in the Selva, only ten percent is irrigated and three hundredthousand hectares are utilized as pasture land. The bulk of the area remainsunder rainforest (72 million hectares). The region produces 15 percent oflegal agricultural output, with the main crops being coffee, cocoa, rice, yellowcorn, and cassava. During the last 15 years, this region has witnessedtremendous growth in the cultivation of coca, mostly for illegal export in theform of paste, base or cocaine. Finally, the Selva has significant un-exploitedpotential to diversify into non-traditional exports such as palm oil and Brazilnuts. However, erratic government policies, a deterioration in publicinfrastructure, and violence spawned by the illegal drug trade has severelyhampered the development of this region.

B. Synopsis of Agriculture Policies

1.7 While Peru cannot be characterized as an agricultural economy,its agricultural potential is far greater than has been exploited. Peru'sagricultural share of GDP fell from 22 percent in 1950 to 13 percent by 1970.By 1990, it stood at only 6 percent of GDP at current prices, although almosta third of Peru's labor force was involved in agriculture. While part of thedecline can be explained by unfavorable terms of trade, erratic andinappropriate government policies have played a major role. There were fivebasic policy regimes during the last half of this century. The first period,during the 1950s and through most of the 1960s, was characterized by littlegovernment intervention in the sector. Agricultural GDP grew by 3 percentannually over this period. However, there was widespread social unrest,mainly because of growing income disparities between rich and poor. In1968, following a military coup, General Velasco came into power and began

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implementing a far-reaching land reform program, known as the AgrarianReform, aimed at redistributing wealth and reducing income inequality. Thesecond period from 1969 to 1978 saw polices aimed at redistribution and statecontrol.

1.8 Under the Agrarian Reform, about 9.5 million hectares ofagricultural land, previously held by 10 thousand owners, were expropriatedand transferred to over 400 thousand families. The holdings represented about85 percent of all privately held land. There were few large individually-heldfarms left following the land reform, especially in the richer coastal area. The1984 rural household survey showed that only 1 percent of individually-heldcoastal farms were greater than 20 hectares and that only 3 percent of the landarea was in farms of greater than 50 hectares. In order to try to maintaintechnical efficiency and economies of scale, the large land holdings were notbroken up into small units but were organized into cooperatives. The AgrarianReform prohibited the use of land as collateral (except to public developmentbanks) and disallowed corporations from owning rural land, thus limitingvertical integration of agro-industry. With the exception of some privatelyheld land, agricultural land transfer and rental were effectively prohibited inPeru. These restrictions severely affected the efficiency with which land couldbe used and inhibited innovation and private investment.

1.9 In addition to the land reform policy, Velasco's agriculturalpolicies included: (a) state control of production, marketing, and pricing ofmajor food crops and agricultural inputs; (b) industrial import substitution,which led to a general erosion in agricultural terms of trade with the rest ofthe economy; (c) reorganization and disruption of extension and researchactivities; and (d) the initiation of massive public investments in hydraulicinfrastructure, some of which have yet to be completed. Although the policieswere aimed at food self-sufficiency, agricultural output grew by only0.5 percent annually during the 1970s. Similarly, although the land reformwas meant to reduce poverty, rural poverty actually worsened. While landreform succeeded in reducing incomes of the richest and in temporarilyincreasing incomes of those that received land, the landless poor became worseoff.

1.10 When General Morales Bermudez ousted Velasco in a coup in1975, he initially continued with the thrust of Velasco's policies. However, in1978, following large fiscal and external imbalances, the Morales Governmentimplemented a stabilization and liberalization program. These market-orientedreforms were deepened by the civilian president Belaunde, who was elected toa five-year term in 1980. The key reforms affecting agriculture includedelimination of nearly all quantitative import restrictions and significant importtariff reductions; improvements in agricultural research and extension; and theintroduction of legislation allowing cooperatives to be broken up intoindependently owned and managed smallholder units. However, State controlof agricultural marketing and credit continued. Agricultural growth during this

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period was sporadic. While there were some reversals in trade liberalization,the third period (1978-1985) can be characterized as one of marketliberalization efforts. During this period, terrorist activities of the ShiningPath and MRTA began to take hold, especially in the Sierra, and the illegalcultivation of coca for export increased rapidly.

1.11 Upon being elected President in 1985, Alan Garcia began aheterodox stabilization program. This fourth period (1985-1990) consisted ofrenewed state controls and widespread subsidies. An important component ofthe Garcia Administration's program was price controls that discriminatedagainst agriculture, accompanied with other input, output and credit subsidiesto help farmers. Some large hydraulic projects were also initiated during thisperiod. Although the heterodox program was initially successful in reducinginflation and stimulating growth, it was unsustainable and the subsidies had tobe abandoned as the fiscal situation deteriorated and inflation reached 1700 in1988, 2800 percent in 1989, and accelerating further during the first sevenmonths of 1990. The early gains in growth were also rapidly eroded as GDPfell by 7.4 in 1988 and an additional 12.4 percent in 1989. Moreover, it wasthe richer farmers that had benefitted from the subsidies, while the pricecontrols and multiple exchange rate system had discriminated against the poor.This period also witnessed a sharp increase in coca cultivation and terrorism.

1.12 Since his election in 1990, President Fujimori has implemented aseries of broad-based reforms to restore macroeconomic stability and long-termeconomic growth. The budget was rapidly brought under balance; inflationfell steadily so that by 1994, it had been brought to an annual rate of15 percent; gross official international reserves rose dramatically to US$ 7.1billion; and GDP grew by 6.5 percent in 1993 and by 12.9 percent in 1994.The main reforms affecting agriculture included:

macroeconomic and trade policy reform to improve the fiscalbalance and eliminate import duty exemptions and quantitativerestrictions;

* pricing and marketing reforms which dismantled consumer pricecontrols and the costly guaranteed producer price mechanism andreplaced them with a variable import surcharge scheme;

* new land tenure legislation which removed restrictions on thesale or lease of agricultural land, allowed landowners tomortgage lands in excess of 5 hectares, raised maximumlandholding limits, and greatly simplified land registrationprocedures;

* rural financial reforms that eliminated preferential agriculturalinterest rates, allowed banks to freely set interest rates, andliquidated the Agrarian Development Bank, which hadcontributed to inflation and benefitted the wealthier farmersdisproportionately;

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* research and extension reforms which drastically reduced staff,converted research and extension stations to private foundations(composed of associations of agricultural producers, exporters,extension agents and NGOs) so as to make these activities moreresponsive to farmer needs, and provided public funding forfoundation research and extension staff;

coca eradication efforts which involved farmers in the design andexecution of coca substitution programs and included land titlingprograms, and improved interdiction efforts; and

irrigation policies described below.

C. Irigation Policies and Institutions

Water Rights Legislation

1.13 The use of water in Peru today is determined by the 1969General Water Law (Legislative Decree 17752) along with the 1991Agricultural Investment and Promotion Law (Legislative Decree 653) and theirrespective regulations. The 1969 law abrogated a 1902 law under which waterrights were privately owned''. Under the law currently in force, which stemsfrom the 1969 law, all water resources in the country belong to the State.They are not susceptible to either private ownership or transferable rights.The use of water is subject to specific social and development needs. The lawprescribes preferential uses of water, in the following order:

(i) for human consumption and basic necessities;

(ii) for livestock development;

(iii) for agriculture;

(iv) for the energy, industry and mining sectors; and

(v) for other uses.

1.14 Water resource allocation amongst the different uses is made bygranting: (i) licenses, for permanent uses; (ii) permits, for temporary use ofexcess water and, in agriculture, for annual crops (cultivos transitorios); and(iii) special authorization, for the implementation of specific studies and/orworks. Private investment by an individual in groundwater development (e.g.,construction of wells on private property) provides the investor with an assureduse of this water, without interference from the State. Licenses and permitsare revoked or declared null and void when: (a) the use of water istransferred to other parties or differs from that originally prescribed

1/ However, under the 1902 law, the water rights were given in conjunction with landrights and hence could not be traded separately from land.

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(revocaci6n); and/or (b) the water tariff has not been paid for two consecutiveyears or when water is not used according to the cropping and irrigation plans(caducidad).

1.15 While the 1969 law focusses exclusively on water and considerswater in all its uses, the 1991 law has only a small water-related componentaimed at making the irrigation sector more modern and efficient. A key aspectof this component is that it fully transferred responsibility for the managementand financing of all completed irrigation systems to water user associations2'.However, the law does not clearly define user's rights with regard to theirrigation infrastructure. This law also specified how water tariffs were to beimplemented and established a new administrative structure at the water basinlevel (see below).

1.16 The current system of priorities for water use has someconceptual and practical shortcomings. It is not sensible that a high-value usefor water such as for hydropower generation or industry should be deniedwater rights in favor of a lower priority activity such as livestock developmentor agriculture. Similarly, since new water rights can, in principle, be obtainedwithout charge (except for the annual water tariff) by confiscating them fromother lower priority uses, there is less incentive for water companies to reducewater losses. In practice, there is no mechanism to transfer water rights fromone user or sector to another to meet priorities and changing demands. Forexample, although legally permissible under the law, it is in practice verydifficult to expropriate irrigation water from farmers to give to a neighboringcity. Thus cities such as Lima suffer from water shortages whereas farmers inthe nearby rural areas continue to grow water-intensive agricultural crops.Furthermore, since water tariffs are very low and unrelated to the volume ofwater used (irrigation charges are based on area under irrigation), the systemprovides little incentive to conserve water.

1.17 There are other practical reasons for why the current system hasfailed to rationalize water use. Licenses for water use are often obtained frompublic authorities (see below) even when it is clear that the available water in astream or canal is already fully allocated. It is not unusual to find that theamount of water rights along a water course is twice the amount of wateravailable in a normal year. This intensifies water conflicts and leads touncertainty over water availability. Finally, the current law, by giving landowners to unlimited rights to underground water, ignores the linkage betweenground water and surface water even when the well is close to a river. It alsoprovides inadequate protection against aquifer depletion.

2/ O&M for the large hydraulic projects ("proyectos especiales") that have not yet beenfully completed continue to be the responsibility of project authorities under thedirection of INADE (Instituto Nacional de Desarrollo)

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Institutional Legal Framework

1.18 The 1969 and 1991 laws mentioned above entrust themanagement of water resources to public institutions at different levels:national, regional and local.

1.19 National level: Since 1902, water resources management hasbeen the responsibility of the General Directorate of Water and Lands(DGAS), initially under the Ministry of Public Works and, since 1968, underthe Ministry of Agriculture (MAG). The role of DGAS, however, has beenlimited to the agricultural sector, leaving other Ministries (such as Fisheries,Health, Energy and Mines) to regulate the use of water in their own sectors.Although a multi-sectoral Water Council (Consejo Superior de Aguas) wasestablished by the 1969 General Water Law, this council has apparently nevermet. Since the promulgation of the a law reorganizing MAG in December1992, DGAS has been a Directorate of the National Institute of NaturalResources (INRENA), which is in charge of the rational and integralmanagement of renewable natural resources within MAG.

1.20 Regional/River basin level. The 1991 Agricultural Investmentand Promotion Law established regional inter-sectoral water entities.Officially under MAG, these Autonomous Hydrological Basin Authorities(AACHs) are to be responsible for formulating master plans for the rationalmanagement of natural resources and for implementing irrigation andconservation activities in their specific areas. An AACH consists of a Boardchaired by the irrigation district's Technical Administrator. Its members arethe representatives of regional governments, the Ministries of Energy andMines, Housing and Construction, the National Development Institute, andfive representatives of producer groups or associations. As of October 1993,only three AACHs had been established (in Jequetepeque, Chira-Piura andChancay-Lambayeque).

1.21 Local level: At the local level, responsibility for irrigation restswith an Technical Administrator (Administrador Tecnico), who is appointedby and reports to the Ministry of Agriculture. The Technical Administrator isto:

* ensure the rational and efficient use of water resources;

* approve cropping and irrigation plans and supervise theirimplementation;

* authorize and approve the studies and infrastructure constructionassociated with requests for licenses and permits for water;

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* issue water licenses and permits;

* approve and keep water use registers up to date;

* establish, modify or cancel water rights;

* impose restrictions on water use for conservation purposes;

* resolve conflicts amongst water users;

* support and approve the creation of water user associations;

* propose and set water tariff levels; and

* approve plans for the O&M of the irrigation systems.

1.22 The Technical Administrator oversees an "irrigation district",and its Water User Association (Junta de Usuarios). There are 97 irrigationdistricts in the country, each including one or more river basins and/or sub-basins. Water User Associations (WUAs) are responsible for thedevelopment, conservation, preservation and rational use of water and landresources, in coordination with the Technical Administrator. The WUAs areprivate organizations and are legally entitled to collect tariffs, operate andmaintain the irrigation works, and to take out loans to undertake works andstudies, either directly or through contractual agreements. They also have theauthority to cut off water to users under certain conditions (see below).Membership, statutes and by-laws of these associations are regulated by law.WUAs are to be comprised of representatives of all users, agricultural andnon-agricultural, within a district, and theoretically, only one WUA can existwithin each irrigation district. In practice, there is sometimes more than oneWUA in a district and non-agricultural users do not participate in the WUAs,which generally comprise only Irrigator Commissions (Comisiones deRegantes). Currently at least one WUA exists in each of the 97 irrigationdistricts.

1.23 Conceptually, the formal establishment of the AACHs could helpto ensure that water resource management decisions within the samehydrological basin are made in a concerted manner among water users andbetween the public and private sectors. Currently, however, the structure ofthe AACH may limit its effectiveness. There is too much public sector controlin the AACH, which is likely to inhibit dynamic and voluntary privateparticipation. The Technical Administrator designated by MAG is thePresident of the AACH. This is inappropriate because the TechnicalAdministrator deals only with irrigation while the AACHs have a wider, inter-

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sectoral function. In addition, the Technical Administrator is low within thepublic hierarchy. Moreover, the Technical Administrator, as President of theAACH, is placed in the powerful position of considering appeals on cases onwhich he as ruled in his capacity as Technical Administrator. It would bemore appropriate for the President of the AACH to be elected by its members,with the Government either abstaining from voting or having only a minorityvote. Finally, the funding for the AACH's operations is uncertain. AACHs'financial resources are to come from: (i) the water levy or "canon," which isonly a small fraction of the low irrigation water tariff; (ii) loans, grants andany revenues that the AACH can generate for themselves; and (iii)contributions from the various groups that form the AACHs.

1.24 At the irrigation district level, the Technical Administratorreceives little technical support and few human and physical resources to carryout his functions. This technician generally operates alone, with an extremelylimited resources. As a result, water resources are poorly managed at theirrigation district level. Situations of conflict often arise, as out-of-date wateruser registers do not correspond to the actual use of water in the district whilenew licenses and permits are issued without due regard for the available waterresources, often resulting in over-exploitation and severe shortages duringperiods of drought.

Water Tariffs

1.25 The existing legislation prescribes two classes of water tariffs,one for agricultural use and the other for non-agricultural use. Neither reflectsthe true cost of water. In agriculture, the water tariff includes threecomponents:

* A so-called water user association component ("ingresos junta deusuarios"), to meet O&M expenses and to finance the operatingbudget of the Administrador Tecnico.

* A water levy or "canon de agua" component, representing10 percent of the first component.

* An "amortization" component, to recover the cost of publicinvestment in storage structures ("obras de regulaci6n") ofirrigation systems. This component is to represent also only10 percent of the water user association component, except whenotherwise determined by "special" project authorities.

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1.26 Irrigation water tariffs (tarifas) are proposed by the TechnicalManager to the water user association and in case of disagreement, are decidedby an ad-hoc, informal committee. In addition, special water levies (cuotas)are collected by the WUA or Irrigator Commission as mandatory contributionsfrom the water users for specific works or activities in the irrigation system orsub-system. According to the existing law, these cuotas are to meet onlyextraordinary expenses. In reality, as the tarifas are too low to cover O&Mexpenses, the cuotas often constitute the only means for a WUA or IrrigatorCommission to operate and maintain its irrigation system or canal. Since thetransfer of irrigation infrastructure O&M by the Government to water users,the cuotas have helped to improve O&M of canals and irrigation systems.

1.27 As the portion of the water tariff allocated to amortization isrestricted to only 10 percent of the amount required for O&M, the amount isunlikely to recover construction costs. In fact, water tariffs actually paid byfarmers account for only 1 to 3 percent of the total construction costs.Although the water tariffs are low, an estimated 30 percent of farmers do notpay their dues. This is probably due to: (i) poor organization of water userassociations; (ii) perception of the State as provider; (iii) little or noinvolvement of beneficiaries at the time the schemes were built; (iv) frequentconflicts and uncertainty over the use of a resource that is often unavailable;and (iv) minimal penalties in case of default.

D. The Current State of the Irrigation Sector

1.28 While the institutional and policy framework described aboveappears rational, in practice it has proved unworkable. This has been partlydue to the inability to set and collect adequate water tariffs, which has resultedin: (i) a lack of financial resources to operate and maintain the irrigationsystems adequately, so that most of these systems are now in an advancedstage of deterioration; (ii) excessive water consumption at farm level, whichmay be due both to the lack of an incentive to use water efficiently and to highconveyance losses; (iii) preference for crops (such as sugarcane and rice) withlarge water requirements; and (iv) few incentives to move towards moreefficient irrigation techniques such as sprinkler or drip irrigation.

1.29 It is estimated that at least one half of the irrigated area in theCosta is badly in need of rehabilitation and modernization. Furthermore,excessive use of water in the upper reaches of irrigation systems has alsocontributed to soil salinization problems in the lower parts of the valleys. Anestimated two to three hundred thousand hectares in the Costa are

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detrimentally affected by waterlogging and salinization. This is almost equalto the planned new area to be brought under irrigation from the completion ofthe all of the expensive large irrigation schemes in the Coastal Region(Chapter 3, Table 1).

1.30 Scarcity coupled with misallocation of the water resource withinthe same river basin or sub-basin has created conflicts amongst the differentwater users (for water supply or electricity versus irrigation, e.g. in theArequipa region and in particular the Zamacola-Chili Regulado irrigationarea). In certain cases this has led to the illegal multiplication of WUAs, andin some irrigation systems such as La Joya, more than one user group hasbeen established. Similarly, while some of the WUAs are strong anddynamic, the majority of them are weak, organizationally and technically aswell as financially, and are unable to maintain the irrigation infrastructureadequately. As a result, the infrastructure continues to deteriorate, with someinfrastructure facing a high risk of failure.

1.31 In the Sierra, some 310,000 ha are currently irrigated, mostlyunder traditional communal administration. Traditional irrigation practices anddifficult climatic, topographical and geotechnical conditions have constrainedthe optimal use of the soil and water resources available in the region (seeAnnex B). This situation is aggravated by the way the current water law isimplemented, by the fragmentation of the rural properties and by the lack ofappropriate agricultural extension services in the region.

1.32 The policy of having the Government design, evaluate andexecute the large hydraulic systems has proved to be very costly and has failedto bring about even a small fraction of the estimated benefits. A primaryexample is the Majes project, which was started in the 1970s. Although aboutUS$ 1 billion (in historical dollars) has been spent on this scheme, it hasachieved only one-sixth of its targeted new irrigation area and none of itsplanned hydropower potential. Perhaps the biggest reason for its failure wasthat this project, like most others, was selected on political rather thaneconomic considerations. Furthermore, project implementation suffered fromdelays in the budget release process due to macroeconomic imbalances and achanging of priorities for the project with each new Administration.Moreover, there were few incentives for project managers to control costs orexpedite construction as well as reports of corruption in the awarding ofcontracts. These problems are typical of Peru's large hydraulic projects.

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2. Tradable Water Rights for Improved Water Mnagement

A. The Draft Water Law

Introduction

2.1 By 1992, following several years of virtually no public spendingfor maintenance or rehabilitation of public irrigation structures, many publicirrigation systems faced a high risk of failure. Water delivery became moreirregular, water quality deteriorated and water conflicts grew, both withinagriculture and between the various water users. There were also reports ofwidespread water theft. Although water was scarce, it was often usedwastefully or in low productivity activities. Despite low water tariffs, manyusers were unwilling to pay them and the Government realized that it would beextremely difficult to increase water charges substantially in order to generatefunds for system operations and maintenance (O&M). Even if water tariffscould be increased substantially, they would fail to provide incentives forwater conservation since the tariffs were based on irrigated area rather thanvolumetric measurement. At the same time, the Government realized that itwould be very difficult to create strong institutions to plan, assign, monitorand enforce efficient water use. Moreover, the Government was unwilling todevote substantial public resources to subsidizing irrigation construction,rehabilitation or maintenance as it had done in the past.

2.2 Not only had the system of publicly allocated water rights failedto provide incentives to conserve water, to use water for high-valued purposes,or to carry out adequate O&M activities, it discriminated against the poor andcaused insecurity to users, thereby discouraging investment in water-intensiveactivities and water-related infrastructure. Since valuable water rights havebeen given without charge, with only modest tariffs to be paid subsequently,there has been tremendous demand for additional water rights. With waterrights being allocated at the discretion of public officials, it is not surprising tofind that the richer, more influential farmers were more likely to obtain thenew water rights, even when the water along a watercourse was already fullyallocated. This resulted in a proportional reduction in the availability of waterto other farmers, typically the poorer ones, and led to water conflicts. In theSierra, where the bulk of the small poor farmers reside, richer farmers wereable to use their influence over the Technical Managers to receive water out ofturn (Annex B).

2.3 In addition, the threat posed by the ability of the State to divertwater for higher priority uses under the existing law has probably discouragednew investments in water-intensive activities. An export-oriented farm or anindustrial company that requires large amounts of water is not likely to invest

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if there is a threat that their water rights could be taken away withoutcompensation in future for some "higher priority" purpose. Indeed, some beercompanies in Lima have been obliged to pay the Lima Water Companysubstantial sums in order to prevent the water company from exercising itspriority right to water.

2.4 In order to address the problems above, several Governmentofficials, under the leadership of the Minister of Agriculture, realized that asubstantial reforn of the water sector, including the 1969 water law, wasrequired. The Peruvian Government sought assistance from the World Bankand Inter-American Development Bank (IDB) to understand world-wideexperience with water markets. Responding to this request, the World Bankinvited selected congressmen, senior officials and private sector executives to aworkshop in Washington to learn from international experts about theexperience of other countries in the sale of water rights and the developmentof irrigation systems. The objective of the workshop was to improve the wayin which water was used in Peru, to improve the O&M of existing irrigationsystems and to ensure the rational and cost-effective development of largehydraulic projects. International experts discussed the advantages anddisadvantages of water markets and the experiences of Chile, Mexico, UnitedStates, France and Spain in irrigation and water markets. The PeruvianGovernment was particularly interested in the 1981 Chilean water law, whichappeared to be working well and which had a private sector orientation.Under the Chilean law, private entities are allowed to buy and sell propertyrights to water with few restrictions.

2.5 Although there were differing points of view expressed at theworkshop, the Government of Peru came away with the impression that somemodified version of the Chile water law would be suitable for Peru. Ittherefore used technical assistance funds under an IDB loan to hire consultantsto prepare a draft water law based on the Chilean model. To allow effectiveimplementation of such a law, the Government also introduced into the 1993Peruvian constitution a clause (Article 66) that treats water and land rightsequivalently, thereby opening the way for property rights to water. Thesubmission of the draft water law to Congress has been delayed because ofopposition to the law. This opposition stemmed partly because there wasinsufficient participation of some important stakeholders at the design stage. Alack of full dissemination of the law during the early phase also led muchmisinformation about the law, emanating particularly from those who areopposed to Fujimori's market oriented reforms. By clarifying the law and itsrationale in this chapter, and by pointing out the difficulties with alternateways of addressing water problems, it is hoped that the legislature will be ableto make a more informed decision on the design of a new water law.

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Key Characteristics

2.6 This section highlights some of the important characteristics ofthe law and provides a rationale for the law. For greater clarification anddiscussion of issues not mentioned here, the reader should refer to theunofficial English translation of the law provided in Annex A (May 1994version) or the original draft law in Spanish.

Assignment of Terrestrial Waters

2.7 The law deals with the use, preservation and conservation ofterrestrial waters found in liquid state, either surface or ground water, eitherflowing or standing. While water is a national asset, the right to use it is aproperty right which consists of the authority to hold or use it in an exclusivemanner and designate it for any purpose, as stipulated by law. Thus the rightsdo not have to be used for any specific purpose; nor are there any prioritiesamong water rights for different purposes. A user may only use water in anexclusive manner to the extent that it is the holder of the corresponding waterrights. However, provided that surface waters are found at their naturalsource, anyone can drink from, bathe, navigate or water animals in them, inobservance of municipal or other legal regulations.

2.8 The water rights may be for consumptive or non-consumptiveuse, temporary or permanent use. Holders of consumptive rights do not needto have the water returned to the river system. Holders of non-consumptiverights must return the same quantity of water to the river system (allowing fornormal losses). In order for the right to allow water of inferior quality to bereturned or to alter the normal runoff conditions or the timeliness with whichwater flows down the river, any injured parties must receive compensation.Temporary water rights may be exercised only when the natural source is ableto supply permanent rights fully. If there is not sufficient water for all holdersof temporary rights, preference will be given to upstream users in the case ofexisting temporary rights. In this, the draft law simply acknowledges thesystem in the prevailing law. However, for new temporary rights, preferencewill be based on the seniority of rights.

2.9 Water rights are established by the Watershed Director eitherupon its own initiative or at the request of interested parties, provided that thewater is available and no rights to it currently exist, that third parties are notaffected, that there is enough water to maintain a minimum ecological flowand maintain the accustomed quality of life in cities and towns. Water rightsmay also be obtained by adverse possession under the civil code(prescripci6n). For lakes, the water rights are established with respect towaters above minimum levels. For groundwater, the Deputy Watershed

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Director may declare certain areas restricted from new groundwater rights ifdata suggests that increased exploitation of the aquifer would jeopardize thirdparty water rights. Once these conditions are met, the Deputy WatershedDirector publicly auctions water rights to new or currently unallocated water.However, water that has already been allocated to users (via licenses or viacustom) are to be given without charge to those already receiving water (seeFinal Provisions below).

2.10 Water rights are acquired by being recorded in a special publicregistry (Water Rights Registry), specifying, inter alia, the name of the titleholder; the name of the riverbed or natural source; the flow or volume (whichmay be specified in terms of percentage of stream flow or in shifts); the pointat which the water will be diverted; whether it is for consumptive or non-consumptive use and whether it is for permanent or temporary use; the pointand form in which the water will be returned to the river system; and theamount paid for the rights. The supply source or intake point may be changedat the request of the holder of water rights, provided that third parties are notinjured.

2.11 The water right is separate from the land right for both surfaceand ground water. However, to obtain ground water rights, one must eitherown the land on which the well is to be built or have the owner's explicitauthorization. Water rights are transferred by registering the respective titlewith the Water Rights Registry. The establishment and transfer of mortgagesor other rights on water also require registration. The sale or mortgage ofland does not include water rights, unless explicitly stated otherwise, and themortgager is owner of such rights.

Institutional Matters

2. 12 Under the draft water law, water distribution according toestablished water rights is to be done by the various types of Water UsersOrganizations (WUOs). WUOs include the Watershed Users Committees,(currently known as the WUAs), with jurisdiction over each watershed, andthe Canal Commissions (now known as the Irrigator Commissions), withjurisdiction over canals or other hydraulic works. In addition, there may beWUOs for underground aquifers and for drainage works. There may be nomore than one WUO for each watershed, canal, underground aquifer anddrainage work. The Watershed Users Committee are to also performhydrological measurements and studies and protect riverbanks and riverbeds.

2.13 These organizations must be legally recognized entities,registered in a Registry of Water Users Organizations, and they are governedby bylaws approved by a Board of Directors. At meetings, votes are issued in

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terms of volume of flow, with non-consumptive rights having one-third theweight of consumptive rights per unit of volume. Members of WUOs haverights and obligations, including organization dues. After two reminders, theBoard of Directors has the authority to deny water allocations to thosemembers who are late in paying. Compliance with resolutions taken by theBoards of Directors is mandatory for these organizations.

2.14 The National Water Council, the Watershed Directors, DeputyWatershed Directors and the Public Registry of Water Rights hasadministrative jurisdiction over water. The law specifies the minimumqualifications of the Director of the Water Council, the Watershed Director,and the Deputy Watershed Director. The National Water Councilresponsibilities include, inter alia, establishing criteria for the initial allocationof water rights, issuing environmental and other regulations needed for theproper understanding and enforcement of this Law, and appointing WatershedDirectors. The Council possesses technical, economic, budgetary andadministrative autonomy and is comprised of the representatives of theMinistries of Agriculture; the Presidency; Energy and Mines; Industry,Tourism, Integration and Trade; Health; and Economy and Finance.

2.15 There is to be one Watershed Director for each one of the fiveWatershed Bureaus to be established under the law. The Watershed Directoris responsible for: (i) establishing the original water rights in accordance withthe regulations to the law; (ii) authorizing the transfer or water from onewatershed to another; (iii) authorizing the construction or modification ofintakes, retaining walls, dams or any other works in riverbeds; and(iv) verifying river depletion. The resolution authorizing or denying thetransfer of water from one watershed to another is to consider and mention notonly the availability or water and damage to third parties, but also how thetransfer will affect the recharging of the ground water table and the naturalenrichment of the lower parts of the original watershed. However, thestatements in this law do not affect enforcement of the Environmental Codeand other related laws. Other important functions of the Watershed Directorinclude: (i) coordination with public or other authorities with water-relatedexpertise in the watersheds under their jurisdiction; (ii) dispute resolution; and(iii) proposing to the National Water Council a list of candidates for theposition of Deputy Watershed Director.

2.16 The Deputy Watershed Director reports to the WatershedDirector and is responsible for authorizing changes in the supply source andintake point for specific water use rights, for decreeing restricted areas withrespect to ground water, determining mandatory rights of way, levying finesand sanctions, and delimiting the banks of riverbeds. He is also responsiblefor resolving first administrative appeals on disputes, for overseeing the

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application of water quality regulations and for hiring persons to performhydrological studies in the area under his jurisdiction.

Fines and Sanctions

2.17 Persons violating this law will receive administrative sanctions,separate from any civil or criminal proceedings. The Deputy WatershedDirector shall, by means of administrative resolution, levy fines on those whoviolate the provisions of this law. The amount of fine shall vary according tothe severity of the infraction, the damage caused, and whether the violator is arepeat offender or in default, and shall be repeated as long as the lawcontinues to be violated. The money collected from fines shall be used forwatershed protection.

Final Provisions

2.18 The law is to become effective 180 days after publication andwill revoke all previous laws and regulations dealing with similar issues. Theregulations of this law will be prepared by the National Water Council andapproved by Supreme Decree, with the Council of Ministers' vote of approval.Supplementary Provisions under the law include the establishment of aproperty tax on water rights and the clarification that when water regulationand transfer works are built that allow surplus water to be stored, this waterbecomes the property of the executor of these works. The draft law'sTemporary Provisions explain that in consideration of the availability of waterresources based on hydrological studies, the Water Authority will allocate thecorresponding water volumes to Water Users Organizations. They, in turn,will allocate them to their members according to criteria adopted by theNational Water Council. Once the water allocations of each user aredetermined, the Watershed Director shall validate them and acknowledgecorresponding water rights. Holders of acknowledged water rights do not payfor such rights. For Peasant Communities (Comunidades Campesinas) in theSierra and Selva regions, water rights will be acknowledged based on theaverage water volumes used historically. Water rights corresponding to realestate that is mortgaged at the time that the law is published will remainlegally mortgaged together with the real estate.

Operation and Rationale

2.19 Once property rights to water are assigned to existing waterusers (such as farmers, water supply companies, large industrial users andhydropower companies), those individuals or other legal entities will be free tobuy and sell them in the open market at a price determined freely by supply

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and demand. They can also lease them in the secure knowledge that suchleasing will not jeopardize their rights in future.

2.20 In addition to the price of the rights, purchasers will have to paythe cost of any changes to infrastructure to effect the transfer as well ascompensation to any injured parties. The sale price has little relation to thewater tariff that must be paid to ensure adequate O&M of the system. To usean analogy from the condominium market, one can think of the price of waterrights to be the purchase price for the apartment and the water tariff to be theannual condominium fees. Just as a condominium association decides on itsfees for its operations and maintenance activities in line with prudent financialmanagement, the WUO will decide on the level of water tariffs. The tariffrevenues will be retained by the WUOs rather than be handed over to aGovernment agency. This will increase the user's willingness to pay the tariff.Another important difference with the prevailing system is that the tariff willbe proportional to the amount of water rights held. Under the prevailingsystem, water tariffs are typically based solely on irrigated area, whichprovides less incentives for water conservation.

2.21 With the establishment of tradable water property rights, waterwill have an implicit value or "opportunity cost", creating built-in incentives toconserve water and put it for the most productive uses. If farmers are able tosell their water rights at freely negotiated prices, some farmers will choose togenerate extra income by selling any surplus rights to a neighboring city or tomore efficient farms, where the water has a higher value. They cansometimes generate a surplus by using more efficient irrigation techniques orby switching to less water-intensive crops. This is indeed what happened inparts of Chile and in the State of Colorado in the United States. For example,the city of La Serena in Chile, which needed large amounts of water rights tomeet its rapidly growing demand for water, purchased 30 percent of its waterrights from farmers, rather than contribute towards the construction of a newdam (the Puclara) to obtain additional water rights. At the same time, farmerswere able to switch to use more efficient irrigation techniques and to increasetheir incomes. In this way, Chile was also able to avoid the conflicts thatoften come about when governments attempt to take water away from farmersto divert for human consumption. Tradable property rights thus helped shiftwater to higher-value uses in a cheaper and fairer way than such alternativesas building expensive new hydraulic infrastructure, confiscating water fromfarmers, or substantially raising water charges to force farmers to conservewater.

2.22 A market for water rights also helps reduce environmentaldamage. By obtaining additional water rights from farmers instead of via theconstruction of the Puclara dam, the city of La Serena succeeded in postponing

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its construction indefinitely, thereby averting possible environmentalconsequences. Although the conveyance infrastructure to carry out thetransfers must exist or be built, its cost and environmental implications areoften less than that of generating new water rights by constructing dams, newreservoirs, or tunnels to bring water from another watershed.

2.23 Another environmental benefit is that the incentive to conservewater, such as by farmers switching to drip and sprinkler irrigation, helpscontrol waterlogging and soil salinization, which is caused mainly by over-watering and excess use of fertilizer. As seen earlier, soil salinization is aparticularly serious problem in the coastal region of Peru. In addition tohelping reduce fertilizer costs and avoid salt build-up in downstream lands,such improved irrigation systems also benefit farmers by allowing a greatersurface area in which to plant, reduced topsoil erosion, greater control overthe water, and the ability to switch to higher value-added crops.

2.24 Purchasers of water will also have a strong incentive to conservewater. If a water supply company is able to obtain water rights withoutpayment based on its higher priority use, it has little incentive to conservewater. When it has to pay to obtain new water rights, it will try to find waysto conserve water. Thus, EMOS, the largest water supply company inSantiago, Chile found it cheaper to invest in mechanisms to reduce waterlosses than to pay the higher prices to induce farmers to sell them part of theirrights or to build new hydraulic infrastructure. In the past, it had been able toobtain new water rights without charge. Similarly, farmers in Chile thatpurchased water rights for their export-oriented fruit businesses, typically useefficient irrigation technology.

2.25 Whereas raising water charges substantially so as to cover bothO&M and investment costs (its long-run marginal cost) would provide similarincentives to conserve water, it would have vastly different income distributionand social consequences and be politically difficult to introduce. Raising waterprices substantially would transfer incomes from heavy water users such asfarmners to the Government. Moreover, such a policy requires infrastructurethat allows for water measurement and institutions that are able to (i) decideon appropriate water tariffs by area, (ii) adjust them over time as required and(iii) enforce the tariffs -- something that is particularly difficult if waterdelivery is not reliable.

2.26 Establishing a regime of tradable property rights to water islikely to help the poor, especially when compared to the alternative of raisingwater charges substantially. Once poor farmers are given property titles towater, they are much more assured that their access to water will not bereduced in future. Under the current system, poor farmers have been

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particularly vulnerable to a reduction in their water allocations over timecaused by water administrators granting additional rights without charge topolitically influential farmers, even when water rights along a certain river,stream or canal were already fully allocated.

2.27 Another advantage of tradable property rights to water is that itcan be used as a source of collateral. This is particularly beneficial for poorerfarmers who have few assets that can be used as collateral for obtaining accessto lower interest loans. In addition, the system provides a larger farmer theflexibility of being able to mortgage only part of his infinitely divisible waterrights as opposed to his entire land and water holdings.

2.28 The ability to purchase water is expected to stimulate privateinvestment in activities requiring an assured supply of large quantities of water(e.g. farming, mining, some types of industry, water supply companies) sincethe uncertainty of access to water will be reduced. This has shown to be thecase in Chile where farmers' increased security in their supply of water hasled to investment in fruit crops and in efficient irrigation technology. Bystimulating private investment and by providing incentives to improve theproductivity of water use, both urban and rural poor will also gain indirectlyfrom having increased employment opportunities as a result of increasedeconomic activities. In addition, the ability to buy options on water leases, asoccurs in Chile, also has a positive impact on private investment. An optionscontract will allow a fruit farmer to protect against a drought by paying anannual fee to a neighboring corn farmer for the option of purchasing the cornfarmer's water at a pre-determined price. The advantage to the corn farmer isthat he will receive an income supplement during the non-drought years and becompensated for the loss of corn production by the sale of water during thedrought year.

2.29 Private investment in hydraulic projects will also be stimulatedas potential investors become assured that once the water rights are obtained,they will not be expropriated and that the water generated as a result of theinvestment (e.g. storage reservoirs) can be sold at a freely determined price.Moreover, establishing tradable property rights to water could attract privateinvestment in some of the partially-completed large public hydraulic projects.Once property rights are established, the Government could choose to privatizethe large hydraulic projects by auctioning, through a sealed-bid process, theexisting hydraulic infrastructure and unallocated water and land rightsassociated with these projects. The privatization would free-up scarce publicresources and increase the likelihood that the project will be completed fasterand cheaper. Because of changing Government priorities, budgetary shortagesand limited incentive to control costs, these publicly executed and financedprojects have run into enormous delays and cost overruns.

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2.30 Presently, there are few incentives and resources for theseprojects to be operated cost-effectively and maintained adequately aftercompletion. For this reason, even in completed public projects, it is desirableto transfer the infrastructure and water rights to water user organizations, whocould then become solely responsible for system O&M and for the setting ofwater tariffs. Having property rights in water would facilitate this processsince it is a logical outcome of a system where the users own tradable waterrights and irrigation infrastructure. Virtually all the irrigation infrastructure inChile is owned by the users themselves and they have found that they are ableto carry out O&M activities at a much cheaper cost than the Government.Given Peru's experience with public investment in hydraulic infrastructure, theability to transfer existing infrastructure to users, privatize on-going projectsschemes, and provide incentives for the private sector to execute futureprojects is valuable (see Chapter 3).

2.31 Through the establishment of the Groundwater Users'Commissions, the law also provides the basis for better protection againstoverexploitation of underground aquifers. Under the current law, owners ofthe land above an aquifer have full rights to its water, even if their use were toresult in depletion of the aquifer and even if its extraction infringes uponsurface water rights. Regulations issued pursuant to the draft water law areexpected to limit the ground water rights to the recharge of the aquifer andprohibit the drilling of new wells once the safe yield of the aquifer has beenreached. While there are limited opportunities for large-scale exploitation ofground water in Peru, in the few areas where there is substantial use of groundwater (e.g., Ica), aquifers are being exploited at unsustainable rates.

2.32 The law has been criticized for discriminating against the poorand indigenous populations, who have limited funds with which to buy newwater rights. However, the current system, whereby water rights are givenwithout charge (except for some nominal water tariffs) at the discretion of theTechnical Administrator, has led to rights being given to the politicallyinfluential, often at the expense of the poor. Experience has shown that whenvaluable public resources are given for free, it is the relatively wealthy thattend to get them. If the Government would like to provide additional waterrights to certain groups, it is far better to do this via direct income transfers,which are transparent and less distortionary, and with which the farmers canpurchase water rights. In fact, proceeds from auctions of water rights couldbe used for such purposes.

2.33 The law has also been criticized for not including provisionsthat allow for the confiscation of rights if the water is used wastefully or inan environmentally damaging way. Although it is conceptually easier toconfiscate rights for misuse under an administered system, the current system

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Questions and Answers on the Draft Water Law

Q. Since Article 66 of the Constitution water is rationed even in Lima, while in thespecifies that natural resources are a national asset outskirts of Lima, farmers grow water intensive(patrimonio de la Naci6n), does not this imply crops such as rice. This is because there isthat water, a natural resource, cannot be sold or currently no mechanism to effect the transferassigned to individuals as a property right? required under the current law. Instead there is

talk of building very expensive infrastructure toA. While lawyers disagree on the legal transfer water to Lima from another water basin.interpretation of this Article, for practical The proposed system, by providing incentives topurposes, the authority to use natural resources conserve water, is likely to result in increasedsubject to certain norms is in fact a property right water availability for city dwellers. Given that(derecho real). If land -- another natural resource water is valued much higher in urban rather than-- can be privately owned under the Constitution, agricultural use, water companies will be able towhy not water? buy water rights more cheaply from farmers as

compared to the alternative of building newQ. If water rights are to be auctioned, will hydraulic infrastructure.not the ri