Financing Watershed Conservation: The FONAG Water Fund in Quito, Ecuador Prepared by Marta Echavarria, Ecodecisión and The Nature Conservancy1 In collaboration with Paulina Arroyo, The Nature Conservancy Do you know where your drinking water comes from? It is very likely that the water that comes out of your tap is brought through miles of pipeline from a protected area. This is particularly true in Latin America, where many national parks and protected forests were originally established to protect water sources. Over time, however, the link between biodiversity conservation and hydrological maintenance has often been lost. National park authorities often lack clear management objectives and resources to insure the regeneration of hydrological resources. Water users, whether they are city dwellers, farmers, or electricity consumers, are frequently not even aware of the source of their water. As a result water resources are being depleted and quality is deteriorating in many countries. In Quito, the capital of Ecuador, threats to water resources are spurring action. In early 2000 the city established a water fund, FONAG, to finance management and conservation of surrounding watersheds. Early experiences are encouraging. This paper describes the attempts to value water services in Quito and surrounding protected areas, the financial mechanism itself - FONAG, outlines its early experience, and highlights emerging risks and opportunities. Quito’s water needs and supply Quito has a population of over 1.5 million people. It is located in an Andean valley at about 2,800 meters above sea level. In total the city consumes around 7 cubic meters of water per second. Drinking water is provided by a municipal public company, the Quito Metropolitan Area Sewage and Potable Water Agency (Empresa Metropolitana de Alcantarillado y Agua Potable de Quito, EMAAP-Q), supplying over 260,000 homes. Consumption is expected to increase by about 50 percent by the year 2025 (Southgate, 2001), increasing pressure on water resources. At the same time, financing for increasing supplies is tight. An estimated 30 percent of consumption is not being charged and those water fees that are collected fail to cover the costs of maintaining the distribution network, let alone broader efforts at watershed protection. Currently, drinking water needs to be subsidized by the city and the central government. About 80 percent of Quito’s drinking water comes from two protected areas, the Cayambe Coca Ecological Reserve and the Antisana Ecological Reserve (Echavarria, 1997). Water is collected through two main systems. The Papallacta Optimization water project diverts water from Cayambe Coca and distributes it to the northern part of the city, while the Mica water project in Antisana provides water for the neighbourhoods in the southern part of the city. Both are operated by EMAAP-Q. The Cayambe Coca and Antisana Ecological Reserves cover over 520,000 hectares and are part of the country’s national park system, managed by the Ministry of the Environment. Their natural ecosystems are characterized by páramos, high-altitude Andean grasslands, and cloud forests recognized for their capacity to retain humidity and regulate water flows (Hofstede, 1995; Stadtmuller, 1983). As the snows from local glaciers in Cayambe, Antisana, and Cotopaxi melt and precipitation occurs, the liquid is retained in the soils and vegetation and is slowly released, depending on the geology of the area, forming different water bodies. Due to the high 1

This summary is based on a chapter prepared by Marta Echavarria for the publication Pagiola, Stefano, Joshua Bishop, and Natasha Landell-Mills. 2002. Selling Forest Environmental Services: Market-based Mechanisms for Conservation. Earth Scan, London.

altitude, temperatures are low, and therefore little evaporation. The high soil organic matter insures long-term water retention. In addition, the water vapour that is carried by the wind currents, and the trans-evaporation generated by the vegetation in the lower elevation cloud forests, is an important source of moisture. The Cayambe Coca glaciers alone store 1.4 cubic kilometres of water, and the reserve is the source of 11 important rivers, and houses numerous lagoons and wetlands. In addition to EMAAP-Q, important water users in and around Quito include farmers that depend on water for irrigation, rural households that rely on water for drinking and sanitary purposes, flower plantations in the Central Valley, and hydropower stations. The electricity supplier for Quito (Empresa Eléctrica de Quito, EEQ) generates around 22 percent of its hydropower in the watersheds surrounding Quito. HCJB, a Christian radio station, generates its own hydropower and is currently building another plant within Cayambe Coca. There are plans to build a hydroelectric plant in the Quijos River, one of the leading watersheds in the area. Several important irrigation projects also draw water from Cayambe Coca. Threats to Quito’s water resources Although the Cayambe Coca and Antisana Ecological Reserves are formally protected for conservation, they face a number of threats. Communities with more than 7,000 people are found within Cayambe Coca. They require water for their crops and have ancestral rights to use the grasslands for extensive cattle raising. Over 20,000 people live in communities and agricultural cooperatives in the areas surrounding the Reserves. Their principal activity is dairy production and the sale of timber. Unsustainable agricultural practices, such as overgrazing and burning of the grasslands, affect the viability of the páramos. In addition to EMAAP-Q’s water diversion projects described above, there are other development initiatives, such as an oil pipeline and irrigation and hydroelectricity plants that put further pressure on the area affecting land cover and natural vegetation. Although very few hydrological studies have been undertaken, it is widely believed that these productive activities risk undermining the local watershed functions, in particular the maintenance of water flow and quality. Not only do water diversion projects reduce supplies downstream, but the associated network of paved roads is also thought to reduce groundwater replenishment. Likewise, the drainage of wetlands has negative impacts for water retention and the combination of grazing and burning of the páramo reduces soil moisture content. The loss of vegetative cover can lead to erosion processes and the subsequent sediment load could affect water quality, particularly for drinking purposes. Potential solutions to address these threats To control these threats, the Ministry of Environment hired a local environmental NGO, Fundación Antisana, to design management plans for the two Reserves. Fundación Antisana’s analysis singled out a number of actions for improving information and protecting the local hydrology. Five stand out: 1. Watershed valuation: There are critical information gaps on the hydrological system, how it works, what benefits it offers local populations, and how these are affected by human intervention. In order to effectively value the watershed services provided by these natural ecosystems, further research has to be undertaken. There is also a need to improve monitoring, both to assess trends in water supply and to evaluate the impact of any interventions. 2. Land purchase or compensation measures: Although the land within the reserves is technically patrimony of the government, the original landowners were never compensated for their loss of land title. Continuing land conflicts have meant that land may need to be

2

bought or compensation paid (for example, conservation easements or payments for environmental services designed to encourage more appropriate land uses) to insure the protection of water sources. 3. Enforcing protection: To prevent damage to the upper watersheds, it is important to have an effective system for controlling illegal logging, hunting, fishing, burning, overgrazing and trash disposal. 4. Targeted land management: To improve or protect hydrological functions, special measures may be needed to protect waterholes, prevent erosion, and stabilize stream banks and slopes. 5. Sustainable production systems: To reduce the human pressures in critical watershed areas, it is necessary to promote sustainable resource use by local communities. Sustainable agricultural practices, for instance, can prevent further damage and generate income for local inhabitants. To implement these measures, funding is necessary. However, as in most developing countries, the Ecuadorian park service, Sistema Nacional de Areas Protegidas, lacks sufficient resources to fulfil its mandate. To overcome this problem Fundación Antisana, with support from the United States Agency for International Development (USAID) and The Nature Conservancy, developed the idea of a new independent water fund – FONAG – dedicated to financing watershed protection around Quito to complement other conservation efforts underway. The emergence of FONAG The central idea behind FONAG is simple: watersheds surrounding Quito provide critical water services to local inhabitants and beneficiaries should pay for the continued provision of these services. Different institutional mechanisms that implement this idea exist in Latin America and can provide interesting lessons. For example, in Paraná State in Brazil, 5 percent of the sales tax collected is distributed to the municipalities based on their commitment to conserve areas surrounding watersheds that provide drinking water to urban centers. In Costa Rica, reforestation projects receive an economic incentive that recognizes the water service provided by the trees that are planted. Finally, in the Cauca Valley of Colombia, agricultural water users pay an additional voluntary user fee to invest in hydrological protection measures and other initiatives in the upper part of the watersheds (Echavarria, 1999). After reviewing various options, Fundación Antisana proposed the creation of a mutual fund with the voluntary participation of water users, most notably EMAAP-Q, in 1997. EMAAP-Q had no permanent watershed protection effort throughout its jurisdiction, nor the capacity to implement such a program. Considering that their business was the sale of water, it was accepted that efforts needed to be undertaken to protect water sources. Similar arguments were used to persuade other organizations that depend on water for their production process, such as electrical utility EEQ, to contribute to watershed protection efforts. A proposal for FONAG was presented by Fundación Antisana and The Nature Conservancy to different decision-makers, including the Mayor of Quito, the leading municipal authority. The proposal highlighted the emerging hydrological problems facing Quito and potential mechanism for financing watershed protection. The decision-makers involved at the time, particularly the Mayor of Quito (during the period concerned there was a change of administration when the Mayor of Quito decided to run for President), were willing to consider the proposal seriously, realizing the critical role played by water resources in urban development. Another important driver for the acceptance of the FONAG proposal was the change in the law governing public financing in 1999. Previously, government organizations were not allowed to invest funds in private financial mechanisms. The change in regulation

3

permitted public organizations like EMAAP-Q and EEQ to assign resources to a private and autonomous financial mechanism such as FONAG. Following an intense process of promotion, negotiation and fine-tuning, FONAG was

Figure 1: Flows of funds and benefits - FONAG Project management

FONAG Financial Manager

$$

Water users Domestic households, companies, farmers, hydropower stations

$$ Watershed protection activities Land purchase Controlled access Targeted land management Sustainable production Environmental valuation

Watershed service

launched in 2000. Its main features are depicted in Figure 1 and briefly described below. FONAG is a non-declining endowment fund that can receive money from government, private, and non-government organizations. The rationale behind working only with the financial returns is to insure the constant availability of resources in the long-term. It is governed by a contract that establishes the terms for the fund, its institutional structure, and what resources can be used for. The aim of the fund is to collect payments from water users and channel these funds towards watershed protection activities. To achieve its aim, FONAG is managed by a Board of Directors, and supervised by a Technical Secretariat that reviews its financial performance and ensures project implementation. The fund is managed by an independent financial manager. Following open competition, Enlace Fondos, which is part of a socially-responsible private bank, was selected as FONAG’s financial manager. The Technical Secretariat reviews how the financial manager is distributing the investments and periodically informs the Board of Directors. Currently, project management regulations are being developed in order to set procedures and project areas to be funded. Critically, FONAG has an open governance structure that seeks to encourage broadbased stakeholder participation. This is particularly important since payments by water users are voluntary and success depends on generating willingness to pay. To encourage participation, all those that put money in the fund can become members of the Board, either individually or by electing a representative, as in the case a small irrigation water user group. In

4

order to insure commitment, donors must sign the Fund's contract. Voting power is dependent on the amount of resources provided to the Fund. Although this is a voluntary mechanism, there has been an effort to establish common criteria for determining the amount users should contribute. Ideally, the amount paid to the Fund should be a reflection of the value of water for its particular use. However, because information on water values is lacking, it has been suggested that a more practical option is to encourage water users who are heavily dependent on the water resource for their business to pay a percentage of their monthly sales. FONAG today FONAG received seed funding from EMAAP-Q and The Nature Conservancy. In terms of establishing a sustained income stream, FONAG has received commitments from two major water users: EMAAP-Q and EEQ. In January 2000, EMAAP-Q committed to paying 1 percent of sales of drinking water on a monthly basis, amounting to an average of around US$14,000 per month. The decision to pay contributions out of existing revenues was made because it was felt that the creation of a user fee would not be viable. However, considering the inadequacy of existing revenues the future expectation is that an additional fee be instituted. EEQ’s board has also agreed to a flat fee of US$45,000 per year, starting in September 2001. By the end of August 2001, FONAG had received US$301,700. The following table illustrates the contributions to date: Contributor s EMAAP-Q TNC EEQ

Contribution to Fund* Seed capital: $15,000 1% drinking water sales Seed capital: $1,000 Technical assistance and support $45,000 per year

Payments starting date January, 2000

Amount contributed to June 2003 $480,000

January, 2000 Since December 1997 September, 2001 January, 2003

$1,000 $145,000 $90,000

$6,000 per year $6,000 Cervecería Nacional * As determined by the contract. All monetary figures U.S. dollars. FONAG’s financial performance to date has been marred by rapid deterioration in the global economic outlook. Since 1998, Ecuador has undergone one of its worst economic and financial crises. Consequently, returns on FONAG’s investments, which are all domestic, have averaged 7.6 percent, significantly below expectations (Technical Secretariat Report, August 2001). Notwithstanding lower than expected financial performance, FONAG is expected to generate interesting amounts within 5 years. Implementation of watershed protection activities has been deferred until 2002, when it is expected that sufficient resources will have been accumulated. According to the FONAG’s rules, resources can be implemented in project areas identified in Fundación Antisana’s original study (see discussion above). FONAG expects to channel resources through independent implementation organizations (private and public) that comply with a clear set of criteria, such as a positive track record in the area where the project is proposed (3 to 5 years); good community relations; institutional credibility; proposal linked to the Management Plans of the Reserves.

5

Potential pitfalls FONAG’s voluntary nature leaves it open to unexpected funding shortfalls and freeriding, despite the legal commitment entered into by those that sign the Fund's contract. FONAG is particularly vulnerable to unexpected reductions in payments, since its revenue depends on only two water users. If either EMAAP-Q or EEQ decide to halt or cut back payments, this will have severe implications for FONAG. With respect to free-riding, this is already evident as smaller users look to larger users to foot the bill for watershed protection. While long-term contracts that are legally binding go some way to minimizing the risks of sudden reductions in payments, overcoming incentives to piggy-back on others’ payments is perhaps the most significant challenge facing FONAG. Given the importance of domestic water consumption in total consumption, it is reasonable for EMAAP-Q to be dominant. Yet, the fact that two water users control FONAG’s revenue stream is not only worrying because it raises FONAG’s exposure to shifts in willingness to pay by these organizations, but because it gives these institutes a dominant role in FONAG’s governance. EMAAP-Q, as the leading water user, has significant power to impose its will and its interests may differ from other water users. For example, EMAAP-Q needs large amounts of water and of excellent quality, which could prevent access or certain activities for other users. It is critical that a broader set of beneficiaries participate to insure FONAG operates to the advantage of a wider cross-section of watershed inhabitants. Conclusions and Recommendations Political leadership A critical prerequisite for implementing such a financing mechanism is local political support. The support of leading decision-makers is vital for the implementation of new and innovative mechanisms for conservation, such as this Fund. Without the comittment of the Mayor of Quito and a group of enthusiasts of the proposal, the FONAG would not be a reality. As the environment gains space in the public agenda, and city dwellers increasingly demand solutions to their environmental problems, such support will be more and more likely. We recommend that local organizations continue to support FONAG and serve as watch-dogs in watershed conservation, to ensure that results are met in field. There also needs to be the appropriate legal framework to guarantee the mechanism’s continuity, such as a municipal ordinance. Water users’ support Ensuring the support of the two leading water users, EMAAP-Q and EEQ was paramount. The open governance structure of FONAG means that it offers a space for discussion and consensus building around the protection of watersheds, as well as a financing mechanism. Users can leverage their resources by pooling them around the FONAG. The Board can be an interesting forum to coordinate activities and exchange opinions, furthering understanding of the hydrological system that is being impacted. However, we recommend that team building and institutional strengthening strategies need to accompany these processes since many of these groups are not adept at team work or inter-institutional collaboration. Avoid excessive concentration of power The fact that two water users control FONAG’s revenue stream is worrisome because it gives these institutes a dominant role in FONAG’s governance, which could affect investment decisions. It is critical that a broader set of beneficiaries participate to insure FONAG operates to the advantage of a wider cross-section of watershed inhabitants. With the recent inclusion of the Cervecería Nacional, these power structures will be distributed. However, the Fund needs to establish decision making regulations and procedures to avoid power plays.

6

Water pricing to reflect real costs Ecuador has been implementing policies to make water pricing more transparent and to phase out subsidies, particularly for irrigation and drinking water. In 1998, EMAAP-Q’s earnings only covered 54 percent of its costs (Southgate, 2001). While the company is gradually increasing its tariffs to reflect its operation and maintenance costs, to date no account has been taken of watershed management costs. This should change, however, as EMAAP-Q increases its payments for watershed protection and these costs are passed on to its customers. A recent survey of water users in Quito suggests that there is a willingness to pay higher fees (OIKOS, 2000).2 We recommend that the FONAG be more agile in decision making about project investments to produce in field results. These results are needed to sell the idea to other potential investors. Improvement in scientific understanding FONAG’s success in delivering watershed benefits is dependent on its understanding of local hydrological relationships. Yet, information is scarce, making it difficult to set investments priorities. TNC’s Freshwater Initiative should eventually help, but results will take time to feed through. It is essential that FONAG strengthens its scientific understanding of local hydrology and monitors the impacts of its efforts to improve water flows. Potential for replication While FONAG’s progress in realizing a sustainable financial mechanism for watershed protection is unusual, its goals are not. Rather they fit well with efforts in many cities around the world to raise the profile of watershed protection in the provision of regular and high quality water services. Kingston in Jamaica, Tegucigalpa in Honduras, and Caracas in Venezuela are just a few examples of capital cities that depend on water resources that flow from surrounding protected areas. The Nature Conservancy is working with a number of local NGOs in Latin America to apply similar mechanisms in Bogóta, Colombia, and Tarija, Bolivia. FONAG may thus provide a valuable model for others. Despite the model’s potential, any attempt at replication must take account of local conditions, and political, physical, and legal constraints. Critically for this model to work, a number of prerequisites need to exist. It is important to have a scientific understanding of the hydrological relationships and broad-based participation to develop the mechanism. Participation, in turn, depends on a willingness to pay among beneficiaries – particularly the largest water users. The feasibility of an endowment fund also depends on available funding to establish a large enough endowment which can generate adequate annual returns to finance watershed protection activities. Supporting legislation is also key. For instance, in Ecuador, legislation allowing public entities to participate in private funds and rules governing the new financial mechanism were essential. In Cuenca, another Ecuadorian city, for instance, a different approach is emerging. In this case a system of contributions by water users has also been introduced, but a specific fund has not been set up. Rather, the city's water company, ETAPA, assigns the resources for watershed protection, buys land to protect and implements hydrological protection projects. Finally, there are clear potential risks associated with scaling up the FONAG model. Efforts to implement a water fund at the national level are likely to be bureaucratic, involve 2

This may not seem credible considering the adverse reactions to increased prices. However, in Quito, water prices are still low ($1.04 per cubic meter) and 5 percent of the city‘s population still do not have a reliable service. This causes them to rely on water deliveries by truck, which are expensive (around $4 per cubic meter) and of poor or uncontrolled quality.

7

higher transaction costs and be far removed from local realities. A critical prerequisite for FONAG has been the generation of willingness to pay amongst specific beneficiaries. However, where payments are not destined for the protection of a particular watershed, but go to a regional or national fund, water users are less likely to be willing to contribute. Acknowledgements FONAG is the result of many individual and institutional efforts, which a short publication may not reflect. The author would like to highlight that this mechanism is a group effort of many years and recognize that it has taken actions, efforts and united support from public and private institutions, such as Fundación Antisana, TNC, present and past Mayors of Quito, EMAAP-Q, EEQ, Ministry of Environment, and as well as others. References Corporación OIKOS. June 1990 Programa de Comunicación y Educación sobre la Problemática del Agua de Quito. Working Document USAID. Echavarria, M. 1997. Agua: !Juntos Podremos Cuidarla! Estudio de Caso Para un Fondo Para la Conservación de las Cuencas Hidrográficas Para Quito, Ecuador. The Nature Conservancy/USAID, Quito. Echavarria, M. 1999. Agua: Valoración del Servicio Ambiental que Prestan las Áreas Protegidas. Manual de Capacitación América Verde No.1, Vol.1. The Nature Conservancy, Quito. FONAG. 2001. Technical Secretariat Report. FONAG, Quito. Hofstede, Robert. 1995. Effects of Burning and Grazing on a Colombian Páramo Ecosystem. University of Amsterdam, The Netherlands. Southgate, D. July 2001. Los Valores Ambientales y su Internalización. Paper presented at the Tenth Anniversary Celebration of Fundación Antisana, Quito. Stadtmuller, Thomas. 1983. Los Bosques Nublados en el Trópico Húmedo. Universidad de las Naciones Unidas, San José.

8