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1 Public Disclosure Authorized Document of The World Bank Public Disclosure Authorized Public Disclosure Authorized FOR OFFICIAL USE ONLY INTERNATIONAL BANK FOR RECONSTRUCTION AND DEVELOPMENT PROGRAM DOCUMENT FOR A PROPOSED FIRST PROGRAMMATIC REFORM LOAN FOR ENVIRONMENTAL SUSTAINABILITY IN THE AMOUNT OF US$ MILLION TO THE FEDERATIVE REPUBLIC OF BRAZIL Report No BR Public Disclosure Authorized July 26,2004 Environmentally and Socially Sustainable Development Unit Brazil Country Management Unit Latin America and the Caribbean Region This document has a restricted distribution and may be used by recipients only in the performance of their official duties. Its contents may not otherwise be disclosed without World Bank authorization.

2 CURRENCY EQUIVALENTS Currency Unit = Real EXCHANGE RATE December 31, R$2.65 = US$ 1 December 31, R$3.52 = US$ 1 December 31, R$2.90 = US$ 1 WEIGHTS AND MEASURES Metric System FISCAL YEAR January 1 - December 31 Vice President: Country Director: Lead Economist: Sector Director: Sector Manager: Task Manager: David de Ferranti Vinod Thomas Joachim von Amsberg John Redwood Abel Mejia Luiz Gabriel T. Azevedo

3 AAE ANA ANEEL APP BNDES BOD BR-163 CAS CDM CITES CNRH CONAFLOR CONAMA CONASQ c02 EC EMB I E.MBRAPA EMS EnvPRL EPE FA0 FDl FNMA GDP GEF GMO GOB IBAMA ICMS INPE IOF PEA MDGs MDG I MDG 4 MDG 7 MMA MIME MP MT NGOF OECD OEMA P2R2 PAS PCF PNF PNRH PPA PRL PROAGUA PROCEL FOR OFFICLAL, USE ONLY ABBREVIATIONS AND ACRONYMS Avaliaylo Ambiental EstratCgica &encia Nacional de Aguas Aghcia Nacional de Energia ElCtrica kea de Proteylo Permanente, Banco Nacional de Desenvolvimento Econamico e Social Demanda Bioquimica de Oxigenio Rodovia Federal que liga Cuiabi a Santadm Estrattgia de Assistsncia para o Pais Mecanismo de Desenvolvimento Limpo ConvenyBo sobre o comtrcio intemacional das esp4cies da fauna e da flora selvagens ameayadas de extinylo Conselho Nacional de Recursos Hidricos Comisslo Coordenadora do Programa Nacional de Florestas Conselho Nacional de Meio Ambiente ComissHo Nacional de Seguranya Quimica Gis CarbGnico Emenda B Constituiylo hdice de Titulos da Divida de Mercados Emergentes Empresa Brasileira de Pesquisa Agropecufia SISNAMA - Sistema Nacional do Meio Ambiente Emprtstimo de Reforma Programitica para o Programa de Sustentabilidade Ambiental Empresa de Pesquisa Energttica OrganizaG2o das Naydes Unidas para Agricultura e AlimentayHo Investimento Estrangeiro Direto Fundaygo Nacional de Meio Ambiente Produto Intemo Bruto Fundo Global para o Meio Ambiente Organismos Geneticamente Modificados Govemo do Brasil lnstituto Brasileiro do Meio Ambiente e dos Recursos Naturais Renoviveis lmposto sobre CirculaCBo de Mercadorias e Services lnstituto Nacional de Pesquisas Espaciais Imposto sobre Operayks Financeiras lnstituto de Pesquisa EconBmica Aplicada Metas de Desenvolvimento do Milenio Meta de Desenvolvimento do MilCnio No 1 - Erradicar a extrema pobreza e a fome Meta de Desenvolvimento do Milenio No 4 - Reduzir a mortalidade infantil Mrta de Desenvolvimento do Milenio No 7 - Garantir a sustentabilidade ambiental Ministtrio do Meio Ambiente Ministtrio de Minas e Energia Minirttrio Publico Ministtrio do Turismo Organizaydes NBo Govemamentais Organizay5o para CooperaGZo EconBmica e Desenvolvimento OrgHos Estaduais de Meio Ambiente Produtos Quimicos Perigosos Plano AmazBnia Sustentivel Fundo de Prot6tipo de Carbono Programa Nacional de Florestas Plano Nacional de Recursos Hidricos Plano Plurianual Einprestimo de Reforma Programbtica ProsguaiSemi-brido Programa de Combate ao Desperdicio de Energia ElCtrica Strategic Environmental Assessment National Water Agency National Electric Energy Agency Permanent Protected Areas National Bank for Economic and Social Development Biochemical Oxygen Demand Federal highway that connects CuiabA to SantarCm Country Assistance Strategy Clean Development Mechanism Convention on Intemational Trade in Endangered Species of Wild Fauna and Flora National Water Resources Council Coordination Committee of the National Forest Program National Environmental Council National Chemical Security Commission Carbonic Gas Amendment to the Federal Constitution Emerging Markets Bond Index Brazilian Agricultural Research Company Environmental Management System Programmatic Reform Loan for Environmental Sustainability Program Energy Research Company Food and Agriculture Organization of the United Kations Foreign Direct Investment National Environmental Fund Gross Domestic Product Global Environmental Facility Program Genetic Modified Organisms Govemment of Brazil Brazilian Institute for Environment and Renewable Natural Resources State Sales Tax National Space Research Institute Tax on Financial Transactions Institute for Applied Economic Research Millennium Development Goals Millennium Development Goal #1 - Eradicate Extreme Poveny and Hunger Millennium Development Goal #4 - Reduce Child Mortality Millennium Development Goal #7 - Ensure Environmental Sustainability Ministry of Environment Ministry of hiining and Energy Public Prosecutor s Office Ministry of Tourism Non-Gowrmnental Organizations Organization for Economic Co-operation and Development State Environmental Agencies Hazardous Chemical Products Sustainable Amazon Plan Prototype Carbon Fund National Forestry Program Water Resources National Plan Multi-Year Plan Programmatic Reform Loan Federal Water Resources Management Project National Program to Combat Electrical Energy Waste This document has a restricted distribution and may be the performance of their official duties. Its contents may not be otherm7ise disclosed without World Bank authorization.

4 PRODES PROINFA RFPP RL SEA SAL SELIC SINGERH SIPAMISIVAM SISNAMA SNUC SRH SWAP TAC TAL TC TFP UNDP WG WWF ZEE Programa de DespoluiqBo de Bacias Hidrogrlficas Programa de Incentivo i s Fontes Altemativas de Energia Elktrica Programa Piloto para a ProtepBo das Florestas Tropicais do Brasil Reserva Legal AvaliapBo Ambiental Estratkgica Emprtstimo de Ajuste Estrutural Sistema Especial de LiquidapBo e de Custddia Sistema Nacional de Gerenciamento de Recursos Hidricos Sistema de ProtepBo da Amazbnia / Sistema de Vigillncia da Amazbnia Sistema Nacional do Meio Ambiente Sistema Nacional de Unidades de ConservapBo da Natureza Secretaria de Recursos Hidricos Instrumento de Abordagem Setorial Termo de Ajustamento de Conduta Emprkstimo de Assistencia Tkcnica Comite Tkcnico Produtividade Total dos Fatores Programa das NapBes Unidas para o Desenvolvimento Grupo de Trabalho Fundo Mundial para a Natureza Zoneamento Ecoldgico Econbmico Water Basins Restoration Program Brazilian Renewable Energy Incentive Program Pilot Program to Conserve the Brazilian Rain Forest Legal Reserves Strategic Environmental Assessment Structural Adjustment Loan Clearance and Trustee System National Water Resource Management System Amazon Protection System / Amazon Surveillance System National Environment System National System of Conservation Units Water Resources Secretariat Sector-Wide Approach Conduct Adjustment Agreement Technical Assistance Loan Technical Committee Total Factor Productivity United Nations Development Program Working Group World Wildlife Fund Environmental-Economic Zoning

5 BRAZIL FIRST PROGRAMMATIC REFORM LOAN FOR ENVIRONMENTAL SUSTAINABILITY Table of Contents LOAN AND PROGRAM SUMMARY... EXECUTIVE SUMMARY Introduction The Economy and Environmental Sustainability... 3 A. Recent Economic Developments Annexes B. Economic Growth. Poverty Reduction and Environmental Sustainability... 7 Environment in Brazil A. Main Environmental Issues B. Environmental Management in Brazil C. Major Recent Advances D. Government Program- Environmental Reform Agenda (PPA ) E. Future Improvements to Environmental Policy The Programmatic Framework and the Proposed Loan Program. 34 A. Objectives. Structure and Justification B. Program Content and Design C. Analytical Underpinnings D. Design of the Proposed First Loan E. Loan Amount. Conditions. and Arrangements Links to the CAS and other Bank Group Operations A. Link to the Country Assistance Strategy B. Complementarity with Other Operations C. Review and Lessons Learned from Other Operations Risks and Risk Mitigation A. Risks B. Risk Assessment and Mitigation i iv Annex I: Annex II: Annex 111: Annex IV: Annex V: Annex VI: Annex VII: Annex VIII: Letter of Development Policy. Portuguese version. Original Letter of Development Policy. English version. Translated Policy Matrix The Matrix of the Government Program Protected Areas Recent Trends in the Deforestation of the Brazilian Amazon Environmental Responsibilities by Level of Government Environmental Licensing in Brazil Federal Public Expenditures in Brazil

6 Annex E: Programs of the Ministry of Environment for Annex X: List of Bank s Analytical Work Annex XI: IFC S Environmental Activities in Brazil Annex XII: IMF Note Annex XIII: Statement of Loans and Credits Annex XIV: Brazil Statement of IFC Held and Disbursed Portfolio Annex XV: Country at a Glance This Program Document was jointly prepared by Luiz Gabriel Azevedo, Sergio Margulis, Gar0 Batmanian, Dorte Verner, Josef Leitmann, Mark Thomas, Maria ValBria Pena, ZezB Weiss, JosB Augusto Carvalho, Fldvio Chaves and Juliana Garrido under the supervision of Abel Mejia and Joachim von Amsberg. Consultants were Luiz Noronha, Alexandre Fortes and Christoph Diewald. Comments and inputs were provided by Todd Crawford, Jan. P. Bojo, Guillermo Perry, Mauricio Carrizosa, Harold Bedoya, Adriana Moreira, Lilian Pena, Gregor Wolf, Robert Schneider, Daniel Gross, Dan Biller, John Redwood, Kenneth Chomitz, Lisa da Silva, Angela Furtado and Mauro Azeredo, Ernest0 Sanchez-Triana, Martin Gambrill, Kulsum Ahmed, Mary C. Sheehan, Regis Cunningham. Peer reviewers were Paulo Guilherme Correa and Aziz Bouzaher. The team is grateful to Tatiana Teles, Greicy Amjadi, Cristina Roriz, and Lilian Santos for logistics and support.

7 BRAZIL FIRST PROGRAMMATIC REFORM LOAN FOR ENVIRONMENTAL SUSTAINABILITY LOAN AND PROGRAM SUMMARY Borrower: Implementing Agency: Poverty Category: Amount: Terms: Commitment Fee: Front-End Fee Objective: Description: Federative Republic of Brazil Ministry of Finance and Ministry of Environment Not Applicable US$ million (single tranche) Fixed-spread loan in US dollars, with a repayment period of 17 years including five years of grace percent per annum during the first four years and 0.75 percent per annum thereafter on undisbursed loan amounts, beginning to accrue sixty days after the loan agreement i s signed. 1 percent of the loan amount, to be financed under the loan. The principal objective of the proposed program is to support Brazil s goal of balancing economic growth with social development and the maintenance and improvement of environmental quality. In line with the CAS, the program would contribute to the objective of a more sustainable Brazil to reduce poverty and achieve a higher quality of life for all Brazilians in both rural and urban areas. A sustainable Brazil will also be a source of competitiveness and provide wealth for the future. The proposed loan forms a significant part of the Bank s overall assistance strategy to an innovative, committed, and high-performing client. The proposed loan will support environmental sustainability through policy reforms focusing on two major areas: (i) increasing the effectiveness and the efficiency of the environmental management system; and (ii) mainstreaming environmental sustainability in selected sector policies and programs. This loan would be the first operation in a series of up to three loans over a four-year period, possibly totaling US$ 1.2 billion. The proposed operation does not involve additional spending and focuses on policy and institutional changes that should lead to more effective and efficient environmental management. A companion Technical Assistance Loan of up to US$ 10 million is planned to follow this operation. The program is expected to result in the improvement of

8 Benefits Risks environmental conditions in the medium and long term. The set of policy and institutional reforms supported by the proposed loan include: (a) increasing the transparency and social control of the environmental management system (EMS); (b) improving the effectiveness of the EMS through better coordination and clearer definition of responsibilities among the three levels of government; (c) increasing the use of economic instruments as compared to commandand-control mechanisms; (4 promoting sustainable development in the Amazon and the protection of other key ecosystems; (e) improving water resources management through increased decentralization, improved local management and increased financial autonomy; and promoting the upstream inclusion of environmental sustainability concerns in sector policies and programs, as well as in the planning and implementation of major development projects. The short-term benefits of the project include a more effective and responsive environmental management system, which will improve the business environment in the country. It will also signal to society as a whole GOB S serious commitment to the long-term environmental sustainability of its development path. The loan will contribute to the establishment of a framework for dialogue and improved collaboration on environmental sustainability among key sectors in the Government, as well as the private sector and civil society. The loan also reduces external vulnerability by covering part of Brazil s external financing requirements and bolstering net international reserves. The loan is proposed on the basis of a continuous and sound management of the macro economy which is assessed as part of the ongoing dialogue and review. The project s longer-term benefits entail welfare gains associated with improved environmental conditions in the country, which should in principle accrue proportionally more to poorer populations. If successfully implemented, the policies supported by the loan will contribute to: improving Brazil s environmental management system; while increasing the sustainable management of water resources, forests and biodiversity; strengthening the capacity to respond to environmental emergencies; and incorporating of environmental concerns in the planning and implementation of major development projects (mainstreaming), among others. This will result in improved environmental quality, which will in turn foster sustainable growth and economic development. The companion technical assistance loan (TAL) will contribute to building the knowledge base required for the advancement of the reform agenda and to improving the Government s capacity to both monitor environmental indicators and manage the implementation of priority programs for results. The proposed loan is the Bank s first programmatic reform loan package in Brazil to support environmental sustainability strictly through policy.. 11

9 reforms. For this reason, the more concrete impacts of the project and program in terms of improved environmental conditions, which are naturally its ultimate objective, require a longer period to materialize. Its impacts should therefore not be assessed based on short-term changes in environmental conditions, but in terms of policy reforms and institutional conditions leading to them. The risk of failure is higher for a novel operation simply because there is less past experience to draw from, and thus a higher degree of uncertainty. The following risks have been identified: (a) the environmental reform agenda is not carried out adequately, i.e. not in the agreed scope or within the expected timeframe; and/or (b) reforms are carried out as agreed, but do not have the desired impacts in terms of the behavioral changes of economic agents, environmental quality and natural resource conservation. The latter is more technical in nature and depends on the complex links between environmental policies and outcomes. This is an important risk in light of the complexity of environmental effects, but it is an issue faced by all countries and requires continued attention. The possibility of the reform agenda not being carried out as planned is considered a high risk. This is primarily because of macroeconomic, coordination and institutional risks. First, the economy remains vulnerable to external shocks and social and political pressures that could dilute the Government s focus on the sustainability agenda; second, lack of coordination among the key stakeholders could affect program implementation; third, discussions on future reforms and the approval process by the Congress could take longer than estimated;fourth, a change in leadership in individual ministries could lead to a delay in the implementation of the reforms; and fifth, vested interests could oppose and delay the implementation of key elements of the reform agenda. These risks have been explicitly recognized and have been partly mitigated by: (i) complementary operations; (ii) the proposed technical assistance loan; (iii) transparent and participatory preparation; (iv) upstream consultation with civil society; (v) strong Government ownership; (vi) due diligence; (vii) realistic expectations; and (viii) a programmatic framework that is flexible. All things considered, the program s overall risk is high. On the other hand, if it is successful, the potential returns would be far higher, and hence the strong justification for the proposed operation. Financing Plan Net Present Value Single tranche disbursed after effectiveness Not Applicable Project ID Number PE-P LEN-BB

10 EXECUTIVE SUMMARY 1. This document proposes a First Programmatic Reform Loan for Environmental Sustainability of US$ million to the Federative Republic of Brazil. This loan would be the first in a series of up to three loans over a four-year period, possibly totaling US$ 1.2 billion, and support key measures within a broader government program for the reform of environmental management. The loan would be accompanied by a separate Technical Assistance Loan (TAL) of up to US$ 10 million. The strategic objective of the program is the consolidation of the process to revitalize environmental policy in Brazil. The expected outcome of the program over the course of four years would include significant improvements in the environmental management system and a reversal in a few selected but critical environmental trends. The program and proposed loan provide direct support for sustainability, which together with equity and competitiveness, is one of the three pillars of the CAS and of the Government's own strategy. Objective and justification 2. The principal objective of the proposed program is to support Brazil's goal of balancing economic growth with socio development and the maintenance and improvement of environmental quality. In line with the CAS, the program would contribute to the objective of a more sustainable Brazil, to reduce poverty and achieve a higher quality of life for all Brazilians in both rural and urban areas. A healthy natural and physical environment provides basic services in both urban and rural areas in a sustainable and efficient way (MDG 7). It will build on the country's comparative advantage in natural resources while also conserving them. A sustainable Brazil will also be a source of competitiveness and provide wealth for the future. 3. The proposed programmatic policy-based loans would complement existing programmatic approaches involving both investment and capacity building in such key priority areas as: public sector environmental management at the national and subnational levels (NEP II), soil conservation and micro-basin management in the south and southeast, water resource management in the northeast, biodiversity conservation and forest management in the Amazon (PPG7, ARPA, PROARCO, etc.), and urban sanitation improvements, etc., with which the Bank and GOB'S other partners (IDB, KfW, USAID, IFC, WWF, etc.) have been closely involved over the past two decades. Together, this unique combination of adjustment, investment, and institutional strengthening lending represents one of the most -- if not the most -- complete and comprehensive "packages" of Bank support to environmental improvement and sustainable development anywhere in the world. 4. The loan would build on recent analytical work. The program rests on a solid foundation, stemming from a body of analytical work carried out by the GOB, the Bank, bilateral institutions (KfW, USAID, DFID, etc.), the IDB, Brazilian and international researchers, and NGOs (e.g. IMAZON, PAM, ISA, SOS Mata Atliintica, WWF, CI, iv

11 TNC, etc.) over the past two decades. The results of much of this work have been used and summarized in the Policy Notes prepared by the Bank for the current administration. Economic and sector work has focused primarily on the following topics: (i) the sustainable development of the Amazon, including forest management; (ii) causes and dynamics of deforestation; (iii) water resources management; (iv) urban water supply and sewerage issues and their health impacts on the poor; and (v) urban air and water pollution issues and their impact on the poor. 5. The Government has requested an adjustment operation from the Bank to support its environmental sustainability program and to mainstream environmental objectives more firmly in its broader development agenda. This choice for a programmatic policy-based operation follows the recently completed CAS, which indicates that policy-based (or adjustment) lending aims to galvanize and support policy reforms. Experience shows that programmatic adjustment lending, which shifts the emphasis to lending in response to reforms already enacted rather than conditioning loan disbursements on predefined government actions, increases countries commitment to reforms. Brazil s external vulnerability makes the flexibility of programmatic lending especially advantageous. Given the Bank s small financial role, such programs require a strong lead from the Government. 6. Brazil has used the programmatic framework successfully in the recent past, with two loans each made under the Fiscal Reform Programmatic Structural Adjustment Loan series and the Financial Sector Programmatic Structural Adjustment series. More recently (June 2003), a programmatic loan series in the area of human development policies, and a loan series focusing on sustainable and equitable growth (January 2004) were launched. The currently proposed operation focusing on environmental sustainability would lead to one broad program of policy-based lending in each of the CAS thematic areas. 7. The proposed loan forms a significant part of the Bank s overall assistance strategy to an innovative, committed, and high-performing client. In recent years Brazil has cemented a development strategy that combines reinforcing the disciplined approach to macroeconomic management, establishing best-practice social programs targeted at the poor, consolidating progress in health and education, tackling microeconomic reforms to ignite growth, and building the institutional bases for environmental sustainability. The proposed loan should therefore be seen in the wider context of support to a coherent development strategy in Latin America s largest economy. The Government s approach 8. There are indications that the Government will grasp the opportunity to focus on the sustainability agenda, but also concerns that the opportunity may pass, and that environmental indicators may deteriorate. Lagging behind on the Brazil Equitable - Competitive - Sustainable - Contributions for Debate, prepared in 2002 and published in Of special relevance for the EnvPRL are chapters 8,9, 10 and 11. V

12 sustainability pillar could have a significant impact on Brazil s overall development agenda. The proposed operation is intended to consolidate the emerging trend toward a stronger focus on sustainability and support the Government s efforts to avoid backsliding. The current administration team has already made some clear commitments to implement a model of sustainable development, maintaining and furthering existing initiatives and pursuing necessary advances in the country s environmental management system (EMS). Continued progress has been observed in the management of water resources, in creating a more concerted effort to address the problem of deforestation in the Amazon, in promoting a dialogue with sector ministries and other levels of government, and involving civil society in reviewing instruments, norms, and regulations in various fields. 9. The proposed programmatic operation recognizes the Federal Administration s renewed commitment to address the major environmental problems and challenges facing Brazil, mainstreaming the environment by synchronizing environmental objectives with the government s broader development objectives. Also, the proposed operation endorses the recent evolution of the EMS and the Federal Administration s vision for its longer-term reform. 10. The proposed operation does not involve additional spending and focuses on policy and institutional changes that should ultimately lead to a more efficient and effective environmental management. If successfully implemented, the loan will contribute to: improving Brazil s environmental management system; increasing the sustainable management of water resources, forests and biodiversity; increasing capacity to respond to environmental emergencies; and increasing the incorporation of environmental concerns in the planning and implementation of major development projects (mainstreaming), among others. This will result in improved environmental quality to foster sustainable growth and economic development. The supported reforms are entirely in line with what the Bank also considers key improvements in the country s environmental management system. This should come as no surprise, given the excellent long-lasting relationship between the Bank and the Government in the environmental area, allegedly one of the strongest among all sectors. 11. The proposed programmatic policy-based approach, divided into three stages with clear triggers will provide the right incentives to sustain progress in mainstreaming environmental considerations in sector policies, which is one of the major pillars of the improvements needed in the national environmental management system. It will also help align the interests of the Finance Ministry, which can influence many of the sectoral ministries where mainstreaming is necessary, with environmental management concerns, thus being of interest to the Environment Ministry as well. The loan helps to build coordination across ministries, an important dimension reflected in the Development Policy Letter as well. 12. This program is justified by the sound overall economic management of the Government. As detailed in the CAS and other recent Bank documents, Brazil s govemment is effectively addressing the double challenge of macroeconomic

13 vulnerability and fiscal constraints as well as social deficits. Financing provided under this loan will help meet Brazil s external financing requirements as well as its public sector borrowing requirements. The structure and content of the program 13. The strategy for this first proposed operation is to focus on the GOB S shortterm policies and programs that can lay the foundation for supporting the achievement of its long-term objectives for environmentally sustainable economic development and poverty reduction. It is divided into two main components: (a) the first focuses on issues under the more direct influence and control of the Ministry of Environment - institutional strengthening, better coordination of the National System of Environment Management (SISNAMA), and flexible instruments and social control; and (b) the second focuses on issues the resolution of which depends on a high degree of involvement and collaboration across specific economic sectors, i.e., on mainstreaming. 14. Specifically, the first loan would support the following reforms and actions that are critical and strategic for attaining the program s overall desired outcomes and underpinning the Government s commitment to a change in the direction of its environmental policy: Improving the effectiveness of the environmental licensing process and integration among the three levels of government, providing for clearer definition of functions and responsibilities, and eliminating gaps and overlaps in the licensing process; Approval of the transparency law to allow public tracking of the licensing process, so as to contribute to clearer rules of the game and improved efficiency by increasing social controls; Establishment of a public career category of environmental specialists and hiring of new staff for MMA and IBAMA with the objective of improving institutional effectiveness; Approval of a law establishing the conditions and means for water basin management to allow basin agencies to serve as the executing arm of basin committees and to collect bulk water tariffs; Creation of an inter-ministerial working group to work on plans for the prevention and control of deforestation followed by the launch of the first action plan for controlling deforestation in the Amazon and introducing sustainability in its growth strategies; Establishment of an inter-ministerial working group for the sustainable development of the BR-163 region in the Amazon, allowing for the implementation of a zoning exercise (ZEE) prior to the future paving of the road in the Amazon region; Approval of the Atlantic Rainforest Law by the House of Representatives, which represents a first important step towards the consolidation of a legal framework vii

14 . for the protection of a very sensitive and endangered ecosystem. This law is also being considered in an urgent basis by the Senate; Identification by Minister of Environment of priority areas for conservation, sustainable use and benefits from biodiversity for the entire country, which leads to the creation of conservation units and sustainable use of those relevant areas; Mainstreaming environmental sustainability in key economic sectors where the dialogue with MMA is more mature, which involves a number of actions taken by the GOB such as: (a) the signature by the President and five Governors of the Sustainable Development Program for the Amazon region; (b) creation of an inter-ministerial working group on environment and sanitation; (c) creation of a technical group between MMA and Minister of Finance to determine ways to introduce sustainability criteria in tax laws and regulations; (4 approval of a law requiring upstream environmental analysis and issuance of preliminary licenses prior to bidding of hydropower concessions; (e) launching of a new national plan for agrarian reform that includes environmental criteria; and (f, the signature of a Technical Cooperation Agreement between MMA and Ministry of Tourism for the inclusion of environmental criteria in the management of the tourism sector, among others. This set of actions taken together represents a solid policy reform package that serves as a strong foundation to support the government s objective of advancing the sustainability agenda. 15. These are considered critical actions and are generally the ones that any structural adjustment would have to support. They can be implemented in the shortterm both to help protect the country s most threatened and important biomes and open opportunities for the economy to develop in a more sustainable manner. As with the rest of the issues to be considered under this program, they are all under the responsibility of the federal government (as opposed to states or municipalities). 16. The possibility of follow-up lending operations would provide an incentive to stay on the path of fundamental change in the status and role of environmental policy. Some of the key measures that would have strategic importance in cementing this shift include: (i) definition of licensing procedures and harmonization of legislation for the three levels of government; (ii) strengthening and reorganizing of MMA and IBAMA; (iii) creation of management committees and bulk water charges implemented in key water basins; (iv) ecological zoning adopted as a planning tool in the regional development plans; (v) launching of an action plan for the BR-163 region derived from the ZEE; (vi) a law to include environmental sustainability criteria (e.g. polluters pay principle) in fiscal mechanisms submitted to Congress; (vii) establishment of the institutional framework to manage the national forest program; and (viii) strategic environmental analysis applied to the new proposed major hydropower plants and the oil and gas sector.... VI11

15 Benefits and Risks 17. The program will result in short and long-term benefits. The short-term benefits of the project are a more effective and responsive environmental management system, which will improve the business environment in the country and signal to society as a whole GOB S serious commitment to the long- term environmental sustainability of its development path. The loan will also contribute to the establishment of a framework for dialogue and improved collaboration on environmental sustainability among key sectors in the Government as well as with the private sector and civil society. The longer term benefits of the project are the welfare gains associated with improved environmental conditions in the country, which should in principle accrue in greater proportion to poorer populations. 18. The proposed loan is the Bank s first programmatic reform loan package in Brazil to support environmental sustainability mainly through policy reforms. For this reason, the more concrete impacts of the program in terms of improved environmental conditions, which are naturally its ultimate objective, require a longer time to materialize. Its impacts should therefore not be assessed based on short-term changes on environmental conditions, but on the path of policy and institutional conditions leading to them. 19. Risk of failure is higher for a novel operation simply because there is less past experience to draw from and thus a higher degree of uncertainty. The following possible negative outcomes have been identified: (a) the environmental reform agenda is not carried out adequately, Le. not in the agreed scope or within the expected timeframe; andor (b) reforms are carried out as agreed, but do not have the desired impacts in terms of the behavioral changes of economic agents, of environmental quality and natural resource conservation. The latter is more technical in nature and depends on the complex links between environmental policies and outcomes. This is an important risk in light of the complexity of environmental effects, but it is an issue faced by all countries and requires continued attention. 20. The possibility of the reform agenda not being carried out as planned is considered a high risk. This is primarily because of macroeconomic, coordination and institutional risks. First, the economy remains vulnerable to external shocks and social and political pressure; second, lack of coordination among the key stakeholders could affect program implementation; third, discussions on future reforms and the approval process by the Congress could take longer than estimated; fourth, a change in the leadership of individual ministries could lead to a delay in the implementation of the reforms; and fifth, vested interests could oppose and delay the implementation of key elements of the reform agenda. 21. The EnvPRL package was designed so as to enhance the probability of its actual implementation and to mitigate risks, The existence of a broad, medium-term reform agenda agreed among several different ministries and agencies coupled with the sequencing of the loans and their release only upon compliance with key policy actions (triggers) are expected to help maintain the momentum of reforms and reduce the risk of incomplete or delayed implementation. Additionally, the focused investment in ix

16 monitoring, evaluation, coordination and strategic communication, along with institutional strengthening and the sustained involvement of powerful federal agencies should help diminish the risks and enhance the returns of EnvPRL. Moreover, the accompanying Technical Assistance Loan (TAL) will provide direct support to a participatory monitoring and evaluation process which should involve civil society, including the private sector and it will contribute to the implementation of the reform actions planned of all involved ministries. 22. The environmental sustainability program would be supported by an accompanying technical assistance loan (TAL). The TAL is currently being prepared and, subject to approval of the proposed adjustment operation, would be presented to the World Bank Board of Directors within a few months. The technical assistance support to strengthen the capacities of the ministries involved with the implementation of the proposed first loan would be important in supporting the reform process for the subsequent loans in the program. It will allow the GOB and the Bank to closely monitor and assess results and bring to bear international good practice as this process moves forward. X

17 BRAZIL PROGRAM DOCUMENT FIRST PROGRAMMATIC REFORM LOAN FOR ENVIRONMENTAL SUSTAINABILITY 1. Introduction 1.1 In few countries is the national environment as crucial to development and people s welfare, and at the same time vital to a sustainable global ecology, as in Brazil. Among other things, Brazil has one third of all the tropical rain forest of the world, the largest reservoir of fresh water (20 percent), the second longest coastal line with over 8,500 km, and the savanna with the highest biodiversity in the world. These natural assets are especially important for the poor for whom they constitute a significant share of their wealth. The Amazon s regional and global influence is legendary. Clouds formed in the Amazon are responsible for the precipitation on the central part of the continent, all the way to SZio Paulo. Moreover, just the annual burning in the region currently contributes with about two percent of the world annual C02 emissions. It is for these local, national, regional and global considerations that an environmentally sustainable Brazil is of great concern. And yet attention to the issue remains inadequate. This is why the success of this program is of vital importance. 1.2 Brazil has historically based its economy on exploiting the immense wealth of its natural resources. A significant part of its economy still relies on the use of natural resources, whether they are used as production inputs or as sinks for production waste. The forest sector alone is responsible for four percent of the GDP. Despite the importance of its natural resource base, Brazil faces major challenges to reverse a trend of unsustainable use of its natural resources. 1.3 It is difficult to estimate the social costs of environmental degradation in Brazil. Rough estimates of such costs, focused only on a limited range of the consequences of environmental problems, indicate that they may be in the range of 1-4 percent of the country s GDP per year. This emphasizes the fact that environmental management and protection involve major welfare issues which go beyond simple amenity issues and small externalities. There are clearly direct welfare gains to be obtained from improved environmental conditions, particularly for the poor. 1.4 The mainstreaming of environmental concerns in and with other sectors is another major challenge for the country. The approach of leaving environmental management almost exclusively to the Environment Ministry led to an over-emphasis on command-and-control mechanisms, which tended to create attritions with sector ministries. The poor integration of environmental with sectoral and macroeconomic policies causes environmental aspects to be neglected or considered too late in project 1

18 ~ two planning and sector policy design, leading to high transaction costs. Environmental decisions usually come after economic decisions have been made. In many parts of government resistance remains to incorporating such matters in the planning of core economic and sector decisions. 1.5 There remain many win-win-win opportunities (policies that are good for the poor, the environment, and growth), and not all have yet been taken advantage of. It has proven difficult to negotiate solutions in those situations where trade-offs do exist between environment and growth, or environment and poverty alleviation. Such compromises depend, on the one hand, on the defenders of environmental interests to identify and address trade-offs and to be more flexible and capable of reconciling environmental conservation objectives with social and economic ones. On the other hand, it also depends on the capacity of ministries in other economic sectors (including Finance and Planning), to incorporate environmental considerations in their sector and macro policies. 1.6 Brazil is thus at a crossroads in its search for equitable and sustainable growth. It has to find the right balance between its need to grow, reduce poverty, and maintain its natural resources base. This year is President Lula s opportunity to focus on the sustainability agenda. There are hopeful signs that the Government will seize this opportunity, but also concerns that the opportunity may pass, and that environmental indicators may deteriorate. Lagging behind on the sustainability pillar could have significant consequences to Brazil s overall development agenda. The proposed operation is intended to consolidate the emerging trend toward a stronger focus on sustainability and avoid backsliding. 1.7 The proposed operation supports fundamental first steps by the Government to modernize the environmental management system (EMS) and bring it more in line with the broader growth agenda, desired improvements in the business environment, and better quality of life for Brazilians. If followed up systematically by the actions outlined in the Government program, these first steps will pave the way toward important environmental improvements in the medium to long run. In addition to addressing important policy issues, the preparation of the proposed loan has facilitated the initiation of a process of bridging the gap between the views of different sectors in government, the private sector, and civil society in a way that will make the modernization of the EMS more broadly accepted by stakeholders and thus more effective. Its implementation will enable the increased collaboration and better understanding of opportunities and challenges. Additionally, the loan sets up the foundation for the implementation of more ambitious reforms that could be supported by two possible future loans in this programmatic series. 1.8 The moment is right for the proposed program. Brazil has done a lot over the past decades to improve environmental management at both the national and sub-national levels. The progress achieved during this period has stalled or even reversed the trend of rapid environmental degradation in some key areas. The current administration is anxious to do more; it is making a clear attempt to better integrate environmental objectives with social and economic ones. If successful, the new direction will be a valuable lesson not only for Brazil but also to other larger countries struggling with the 2

19 sustainable agenda, be it Indonesia, India, China or Russia. Several key areas of intervention are currently high priorities, including: (i) increasing the transparency and accountability of the environmental management system (EMS); (ii) improving the effectiveness of the EMS through better coordination and clearer definition of responsibilities among the three levels of government; (iii) increasing the use of economic instruments compared to command-and-control mechanisms; (iv) promoting sustainable development in the Amazon and the protection of other key ecosystems; (v) improving water resources management through increased decentralization, improved local management and increased financial autonomy; and (vi) promoting the upstream inclusion of environmental sustainability concerns in the planning and implementation of major development projects. 1.9 It is envisioned that, if successfully implemented, the proposed program would contribute to a more sustainable Brazil where economic growth would be balanced with social development and the improvement of environmental quality. A country in which priority ecosystems of national and global significance such as the Amazon, the Cerrado and the Atlantic Forest would have better chances of being conserved for the benefit of future generations; where the natural resources would be sustainable managed; where the EMS would be more effective and efficient leading to coherent and well thought decisions regarding environmental licensing and other important aspects of environmental management; where environmental concerns would be truly mainstreamed into the plans and programs of key sectoral ministries; a country with a more sustainable, decentralized and participatory management of water resources; and a place where the poor would have access to a healthier and more pleasant environment. 2. The Economy and Environmental Sustainability A. RECENT ECONOMIC DEVELOPMENTS 2.1 Brazil s economic management continues to be strong. The country continues to operate the trio of fiscal balance, inflation targeting, and very limited exchange rate intervention that it has been utilizing since January 1999, when the Real was allowed to float. There is no sign of reduced commitment to this strategy. 2.2 The country s public finances continue to be well managed, with the primary budget surplus of 4.25 percent of GDP agreed with the IMF likely to be surpassed again this year. The combined surplus for January to April has already met the IMF target for the first half of Public debt fell to 56.6 percent of GDP in April 2004 from 57.4 percent in March. 2.3 Perhaps equally important, the Treasury has taken advantage of favorable global economic conditions to improve the composition of debt issuance and therefore of outstanding public debt quite aggressively, reducing the rollover of dollar or other foreign-exchange linked debt to zero in recent months: the proportion of these bonds in public debt outstanding has fallen by more than half since the 2002 election, and now stands at about 16 percent. Conversely, fixed rate and inflation-linked debt, which reduce

20 economic vulnerabilities, have more than doubled their share since January 2003 to over 26 percent of debt outstanding. 2.4 Inflation targeting is also being pursued with discipline by the Central Bank: 2003 consumer price (IPCA) inflation at 9.3 percent fell within the revised target band - it was higher than the original target mainly owing to pass-through from currency depreciation early in the year. The Central Bank has held monetary policy steady in the face of recent oil price rises and market nervousness about higher future US interest rates. Market expectations suggest Brazil s year-end 2004 inflation will be close to the target rate of 5.5 percent. The target for 2005 remains at 4.5 percent. 2.5 The external accounts have been the source of the most encouraging news in 2004, with exports remaining robust and the current account slightly in surplus. The 2004 trade surplus is expected to be about US$24 billion, reducing external financing needs to about US$ 36 billion in 2004, much less than in recent years, of which a substantial part has already been pre-financed. The country has also built international reserves to above US$ 50 billion, further reducing external vulnerability. Based on this performance, Brazil s stated intention not to renew its Stand-By Agreement with the IMF may be judged as realistic. The present SBA ends in March Structural reforms have been slower than might have been hoped about a year ago, with only a small part of the initially proposed tax reform actually passed and some dilution of the social security reform. The social security reform nonetheless represented an important advance (this and other reforms may be supported by the Bank s Programmatic Fiscal Reform Loan series). 2.7 As was to be expected, the social security problem has not been resolved overall. New legislative reform will soon have to address shortfalls in the private sector INSS pillar (including the recent recognition of a net liability of R$ 12.3 billion) and in the regulatory framework for closed funds. Moreover, the social security reform passed by Congress in December 2003 still has to survive constitutional scrutiny by the Supreme Court. At the time of writing, the outcome of one challenge to the 11 percent tax on pensions remained hard to predict. Were the Court to strike down this reform, this would certainly imply a tougher challenge ahead. Nonetheless, performance to date suggests that the Government would find an appropriate response to preserve fiscal performance. 2.8 In addition to the measures taken to date, legislative directions are positive overall and, subject to the speed of legislation, significant improvements in the economic environment are in the pipeline: new insolvency law, new innovation law, improved regulatory agencies, a new model for the power sector, and law strengthening the framework for public-private participation in infrastructure investments. Many of these structural reforms are supported by the Bank s series of Programmatic Reforms for Sustainable and Equitable Growth, the first of which was discussed by the Bank s Board in December Against this backdrop, the growth response to recent interest rate cuts has been slow to come but is now becoming apparent. In the first quarter of 2004 the Brazilian 4