The key to successful IPPs10 November 1998
Conflicting objectives must be met to develop a successful independent hydro power project. James Arthur* reports
Developing a successful private hydro project depends on simultaneously meeting a number of often conflicting objectives. The short term goals of developers, financiers and contractors and the long term aims of owners and customers must be reconciled with political and environmental perspectives.
The principal aim of any power project is, of course, an affordable and reliable source of electricity for consumers. If this is to be provided by a privately funded hydroelectric scheme then those interested in the promotion of the scheme must take account of the legitimate short and long term objectives of those concerned.
An unfilled demand for energy, either now or in the near future, provides the basis to promote an independent hydro project.
For consumers to take advantage of any new resource, it is fundamental that they are willing and able to pay for their energy. This may appear to be obvious, but in some countries power is sold to consumers at less than the price paid to private generators. The governments of these countries may consider that this is acceptable and be prepared to subsidise the utility. However, it is unsustainable long term and for any hydro IPP to be successful, the ultimate consumer must be able to pay. There will be considerable doubt in the mind of a potential developer if the cost to a consumer is less than the cost the intervening utility pays through the Power Purchase Agreement (PPA), even if the PPA is guaranteed.
In every country, the framework for developing generating capacity is driven by politicians whose objective is to seek re-election or re-appointment. A developer must therefore take account of national, party and individual political objectives, particularly when energy is sold across an international boundary.
The ability of private industry to develop hydro resources is at bottom governed by politicians who must create the environment to attract investment and remove restrictions. The temptation to encourage grandiose projects for their own sake must be resisted.
If politicians are serious about attracting investment in hydro power then they must assist developers by creating:
•Single contact points within government organisations.
•Simplified procedures for concessions and licences.
•Free repatriation of the profits on investments.
•Long term PPAs.
•Institutional arrangements to encourage project investment.
•Assistance with infrastructure and land acquisition.
Politically, hydroelectric power has its advantages: long term, low cost generation; lack of reliance on imported fuel; and the high proportion of construction costs spent locally due to the larger amount of civil works.
The responsibility for planning power generation usually lies with public sector engineers in governments or a national utility. Many of these individuals are competent, enthusiastic and motivated but for many the objective is to retain employment or gain promotion. They must address deficiencies in power development programmes, despite political or cultural obstacles or inappropriate regulations and procedures.
In private hydro power projects these public sector engineers play a key role in preparing development plans. Instead of traditional cost-benefit analyses and the inclusion of non-power benefits (eg roads and clinics), the plans should consider the investor’s view and include:
•Preliminary risk assessment.
•Technical options to give the greatest rate of return.
•Environmental impacts and mitigation measures, including costs.
•Limitations to power production.
•Ability to pay.
•Financial and economic analyses.
The execution of these studies by the private sector, as private speculative ventures, is very risky commercially, with likely returns not dissimilar to a lottery. The preparation of studies by the public sector is therefore preferable.
Public funds are frequently inadequate if studies are restricted to single projects and funding is by loans. Is enough thought given to the content of existing studies or to alternatives? Maybe an existing plant can be refurbished or uprated? Can a power plant be added to an existing water project, at little cost and virtually no environmental impact? Are there plants in operation which could be sold to the private sector to provide a basis for further development?
If there is a firm political commitment to develop at least one of some potential projects within a catchment, it may be possible to fund a study for a group of projects using a loan paid back later by the developer of the successful project. There would be little additional capital cost and the studies for the other projects are available for future developers.
A successful hydro power project produces a return on investment commensurate with the risk taken. Hydro power generation is a high risk activity, so returns must be higher than alternative ventures. More than a simple financial return may be sought and successful hydro developers are usually a joint venture between at least two of:
•International contractors or equipment suppliers expanding their business.
•Utility companies from developed countries increasing their portfolio.
•Local companies with varied commercial interests.
An international company needs a strong local partner. A local company needs technical expertise and project management capability. A developer looks for value for money, reduction in risk due to technical failures, delays and cost overruns and environmental approval. He needs resources and enthusiasm.
Banks make their profits by lending money but are essentially risk-averse.
Hydro IPPs are perceived as risky, expensive and long term, with marginal benefits and huge downside potential. However, compared with petrochemical developments, the risks are much smaller: hydro power uses well proven technology; it is safe; and it carries no fuel cost risk.
Banks perceive that hydro power projects are always late and over budget. Analysis by the World Bank of 66 projects shows an average overrun of 27% on cost and 28% on programme (6% and 30% respectively for thermal projects). But most of these projects were built under foreign aid provisions without private sector discipline, and even publicly funded hydro projects can be built on time and within budget (eg the 180MW Mrica project in Indonesia and the 72MW 'Muela project in Lesotho).
Banks are keen to see each risk properly identified, mitigated and then allocated to, and funded by, the party best able to control the risk. Hydro power developers must address risks such as:
•Sovereign and country risks (government creditworthiness, expropriation and nationalisation risks, local political environment, enforceability of contracts, foreign exchange, force majeure).
•Market risks (demand projection, selling price, market regulation, competition).
•Project risks (time to first generation, cash flow, capital costs, hydrology, geology, technical failure).
Funding agencies (public sector)
Funding agencies may guarantee funds to support development which is related to political objectives. Power projects are perceived as being financially self-supporting and there is a growing reluctance to support hydro power directly, particularly in view of the environmental lobby.
It is clear that the support of the funding agencies is a prerequisite to many successful projects as they can provide loans and, in some instances, an insurance against some risks.
Contractor and supplier
A lump sum engineering–procurement-construction contract is usually demanded and the construction contractor must absorb all construction risk, including unforeseen ground conditions. An effective pre-contract site investigation will lower the risk to the contractor and reduce his price for covering this risk. For contractors or suppliers, a successful project is one with few design changes, expensive confrontations or claims.
The technical advisor (consulting engineer, lawyer, insurer) may be employed by the project sponsor, developer, banker or contractor. His role is crucial, as private power requires simple, cost-effective solutions to technical and contractual problems and successful risk management rather than technical excellence per se. Least cost per MW is more important than most MW from the available water. Advisors should encourage enough investigation to allow risks to be quantified. Other parties should recognise that most advisors do not have large capital resources and, to make the most of their expertise, need to be paid for their services.
In any hydro project mitigation and monitoring of ecological and socio-economic effects are obligatory. It is essential for developers to reduce the real environmental impact by:
•Designing to reduce unnecessary impact.
•Compensating where disruption and/or loss is unavoidable.
•Consulting with affected groups.
Massive inundation and extensive involuntary resettlement are not prerequisites for a hydro development.
An examination of hydro power projects worldwide reveals common ground between the successes. Omission of only one element can cause failure before a project even starts and can waste considerable time, effort and money.
Successful private hydro power projects include not only simple low capacity run-of-river projects but also medium size schemes with significant engineering works. They have common features:
•Active encouragement by government .
•Institutional arrangements which encourage foreign investment.
•A strong market for the power.
•Tariffs arranged to allow repayment of debt during the first years of the project.
• Profits repatriation permitted.
• Exchange rate fluctuation covered.
•Hydrological risk properly covered.
•Development by local and international interests supported by technical expertise.
From this brief review the primary elements of success appear to be:
•Alignment of political and commercial objectives.
•Political commitment and creation of a positive political environment.
•Adequate feasibility studies.
•Addressing real environmental issues.
•A developer combining international construction and/or utility expertise and finance with active local participation.
•Contractors and suppliers prepared to undertake lump sum EPC contracts.
•Technical advisors prepared to address commercial as well as technical issues.
However, the two most significant elements are how well a country presents its power development programme to the international market and, subsequently, how successfully the risks are managed.
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