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Policy framework for promoting cogeneration

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CHAPTER 4: P OLICY FRAMEWORK FOR PROMOTING COGENERATION
4.1 Introduction

Small and medium size cogeneration projects extend indisputable benefits to both the cogenerator as well as the utilities/governments. Cogeneration projects are environmentally benign or have greater scope to limit the environmental impact as compared to large-scale fossil-fired or hydropower plants. Moreover, small to medium-scale projects are less risky to implement as they may have a lower life cycle cost as a result of three factors: shorter construction time in comparison with large scale power plants; lower project development expenses due to less complex negotiation process; and perception of lower financial risk by the potential lender. In addition, site selection for setting power generating facility by the utilities is a rather complicated procedure. In comparison, cogeneration is suitable for any site closer to endusers and can lead to savings on costs associated with transmission of electricity. There is thus a great scope for providing electricity in remote areas at a lower cost than from the centralized utility grid. In spite of the above facts, cogeneration development so far has been rather slow because there is a general feeling among the Asian energy policy makers that only large scale thermal power generation projects can be economically and financially viable to tide over the impending electricity capacity shortage. In the process, they have underestimated the risks involved in the implementation of large-scale power generation projects with private sector participation and overlooked the potential contributions from a great number of small-scale cogeneration and renewable energy projects. Secondly, most electric utilities look down upon cogeneration projects as unreliable. It is true that many industries, such as steel, cement, petrochemical and agro-processing, having cogeneration potential consider the output power as a by-product, thermal energy being their main energy source for matching the process energy demand. As the demand for thermal energy may fluctuate with time and production, these industries will find it difficult to optimize firm power purchase agreements with the utility. Instead of looking for innovative risk allocation and pricing schemes, utilities often limit the amount of power that can be sold to them in the power purchase agreement to minimize the risk of depending on the cogenerators. Any additional electricity supplied by the cogenerator is purchased using nonfirm pricing which discourages the cogenerators in investing on such projects. In countries where energy prices have not been rationalized, there is a tendency for the stateowned utilities to charge the industrial and commercial sectors more for the electricity they consume in order to cross-subsidize other sectors. A number of industrial and commercial sector clients have economically viable cogeneration potential. But as they pay a high electricity price to the utilities, any attempt by them to generate their own power is perceived as a loss of revenue and a threat by the utilities. The following section will cover some of the barriers to cogeneration development in general. This will be followed by discussion on the policy, institutional and regulatory measures necessary for overcoming the obstacles and promoting cogeneration.

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4.2

Barriers to Cogeneration Development

Obstacles to cogeneration development can be classified into the following: technical barriers, financial drawbacks, poor institutional framework, short-sighted electric utility policies, and low environmental concern. In most instances, these barriers are country specific because there are a lot of differences in the energy demand patterns, electricity supply structures, fuel pricing, fuel availability, climatic conditions, environmental considerations among the countries in the different continents. For instance in Europe, the share of cogeneration in the overall power generation in a country like France is low because the national policy in the past had been to depend mainly on power generation based on nuclear energy. In Netherlands and Germany where more natural gas and coal are available, the government policy has favoured cogeneration development. In a country like Spain having no need for heating of buildings throughout the year, there is a trend to recover the waste heat for comfort or process cooling applications using vapour absorption chillers in the hotter months. In colder climates, urban cogeneration schemes have been closely associated with district heating schemes to meet the space heating and hot water requirements. The problems associated with industrial or commercial cogeneration are quite different from those encountered in district heating applications which contribute to about 40 per cent of the European Union’s electricity generation through cogeneration.

4.2.1 Technical hurdles
First technical barrier is the lower level of awareness about the soundness of cogeneration technologies due to the lack of technical information at the level of local utilities, industries, potential cogenerators and governments. In fact, awareness building about cogeneration is the very first step to promote cogeneration systems. Lack of capability to locally manufacture some energy supply equipment can lead to higher investments linked with higher cost of imported equipment. Inferior quality of equipment produced by local manufacturers with poor technologies also hampers the propagation of cogeneration systems. In many developing countries, the technical expertise to design, construct and operate energy efficient cogeneration systems is quite limited. For grid-dependent systems with the option of electricity export to the grid, advanced electrical control systems are necessary for both cogeneration plants and local electric utilities. The local electric utilities must have competent personnel who are capable of operating a more complicated system consisting of utilityowned power plants and cogenerators. The cogeneration systems need skilled technicians for regular maintenance and trouble-free operation. Lack of infrastructure is also one of the obstacles in promoting cogeneration systems. For instance, there are natural gas networks in many developed countries. The lack of infrastructure such as gas handling, storage and distribution auxiliaries in some developing countries leads to technically more complicated systems for gas powered cogeneration.

4.2.2 Economic and financial constraints
Cogeneration systems are somewhat capital intensive. Investments required are sometimes out of reach of energy consuming facilities such as industries, commercial buildings, hospitals, etc., in many developing countries.

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Any lack of guarantee for long term availability of fuels can lead to higher risks in investing in cogeneration systems. For example, unlike the developed economies, the availability of fuels in most developing countries depends on the government’s policy changes due to the monopoly of the energy sector. There will be uncertainties about the actual energy cost savings unless long-term fuel supply is ensured. A cogeneration scheme may be found to be a good financial investment and provide reasonable payback period. The hindering factors however are those which limit the income derived from the products (heat and electricity) or increase the cost of inputs (equipment and fuel). Among these, electricity pricing appears to be the deciding factor that is beyond the control of the cogenerator. Some sort of involvement of energy companies and development of third-party financing schemes can help to reduce the financial uncertainties. In countries where prices of other fuels and electricity are subsidized, cogeneration systems cannot be financially attractive for private or public enterprises if the energy consuming facility has easy access to the grid or can buy other subsidized fuels. The low rate of return on investment would not justify the high capital requirement of a cogeneration system. Investors may often look for some form of incentives such as reduced fuel prices, investment subsidy, tax benefits and attractive tariffs. In countries having no or inadequate incentives, cogeneration development has been found to be low or marginal. In industrialized countries, cogeneration has been promoted through financial incentives such as soft loans, subsidies, tax credit, etc. Experiences show that these financial incentives are effective tools to enhance the development of cogeneration in industries and utilities.

4.2.3 Poor institutional structure and inadequate regulatory framework
Like other energy efficient technologies, cogeneration can be effectively and rapidly promoted by the government and appropriate institutions working together in harmony. Institutional issues are mainly related to the seriousness of the national authorities in promoting cogeneration in order to achieve conservation of fossil fuels and protection of the environment. In some instances, existence of a promotional organization for cogeneration has helped to establish policy measures and develop cogeneration market. Some developing countries lack institutions or have inadequate institutions to deal with energy and environment matters. In such instances, there are no energy conservation campaigns and distribution of information on energy efficient technology such as cogeneration. Inadequate regulatory framework can set negative example in the form of poorly planned and designed projects. For bigger cogeneration projects involving district heating/cooling network in city centres or industrial estates, the need for investment may be high. When foreign investment is involved, the question of allocating sovereign risks and guaranteeing utility payment obligations must be resolved. Lack of experience in planning and lack of transparent power purchase agreement can lead to prolonged process of negotiation between the project developers and the concerned authorities, resulting in unnecessary delays in project implementation and financial losses to the developers. Some of the regulatory issues concern fulfilling of technical requirements, licensing arrangements, ability to “wheel” (i.e. allowing cogenerators to sell electricity and heat directly to energy consumers, not through utilities), etc. While the principle of authorization sounds reasonable, procedures can be bureaucratic, complex and time consuming, thus perceived as a disincentive for potential cogenerators with little experience in the power sector. It is also important that the government and institutions themselves must be aware of the benefits of cogeneration in achieving higher overall energy efficiency and lower emission of

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pollutants. However, the lack of expertise in government body and relevant institutions leads to lower level of awareness on cogeneration and weak policy on the development of cogeneration. Some developing countries have realized the importance of energy conservation in the economic growth. They have formed a number of institutions to handle the energy matters including promotion of cogeneration. However, the duty and responsibility of each institution is not clearly defined or there is an overlapping of responsibility among the institutions. Such an inefficient institutional structure leads to ineffective cooperation between the government and industries or other energy intensive facilities. Contradictory policies and complicated procedures often frustrate the potential cogenerators.

4.2.4 Role of electric utilities
Equally important is the role and attitude of electric utilities towards cogeneration. In spite of the fact that these utilities are being restructured in many parts of the world including Asia, many among them remain monopolistic in nature. Significant investments have been made in the past to develop their generation capacities. As some of these investments have been written off, relatively inexpensive electricity is produced which is not conducive to the development of alternative options of power generation even when they are found economic. If electricity prices are low, there is little incentive for the users to consider supplying their own power or sell it to the grid with unattractive payback periods. Unhelpful utility attitudes and actions are manifested in the following recurring themes: • • • • tariffs fixed for purchasing surplus electricity from cogenerator are too low; tariffs for stand-by or back-up supplies to the cogenerator are excessive; sale of electricity to third parties is rarely permitted or is too expensive; technical authorization to new schemes are not always fully transparent; procedure followed can be time consuming and costly.

Where utilities do not consider the cost of additional power generation (system avoided costs) while fixing the power purchase agreement with the cogenerators, they cannot raise enough funds to expand their generating capacities, while they hinder the growth of private investment in power generation or cogeneration. In the process, there is a shortfall between the supply and the demand and there is a slowdown of the national economy. Sometimes, although there are several energy and environment related institutions in some countries, they are not capable of formulating suitable energy policies. For instance, they cannot draft well-structured electricity tariffs. These institutions often imitate the energy policies directly from other countries that are not always suitable for their respective countries. Therefore, the lack of ability to formulate and implement sound energy policies leads to improper dissemination of energy efficient and environmentally sound technologies including cogeneration.

4.2.5 Environmental issues
Some developing countries feel that environment is a matter of concern of industrialized countries. They are reluctant to impose environmental restrictions on industries, being afraid that local industries would lose the competitiveness in world market. Such a situation favours the use of cheaper and pollution intensive fuels in inefficient manner. Without energy efficiency standards and environmental regulations, cogeneration systems would not get an advantage over other systems. Therefore, higher environmental concern is necessary to promote cogeneration.

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Where emission regulations are used to limit air pollution related to various economic activities, they can be discriminatory against cogeneration installations, as the emission thresholds set do not always recognize the efficiency of energy conversion of the cogeneration process. Though a cogeneration plant may increase the local emissions, it normally displaces even more emissions at the fossil fuel power plant. Any relaxation in the limit of air pollution can help to reduce the investment on cogeneration facilities. Natural gas is widely recognized as a clean fossil fuel for cogeneration applications. Where it is available and the gas network exists, natural gas can be a promising fuel if it is not too expensive. The Netherlands has been most successful in gas powered cogeneration whereas the price of gas is cited as a major obstacle for its propagation in Germany. Other barriers include the lack of skilled manpower and management. In most cases, both the electric utilities as well as the industrial plants lack skilled manpower and managers to handle the specific task of heat and power production.

4.3

Policy and Regulatory Framework for Promoting Cogeneration

4.3.1 Establishing right policy framework
The development of cogeneration is basically a policy issue. The first prerequisite therefore is an ideal policy framework, as has been demonstrated by some countries which have made considerable progress in this domain, such as Japan, Republic of Korea and Thailand in Asia, and the Netherlands and Denmark in western Europe. The motives for action may vary depending on the priorities set, and the methodology pursued may also be different. Whatever may be the rationale behind such a move and whatever the tools used, the policies must be supported by a clear political will for achieving any tangible result. Planning and decision making regarding capacity expansion should involve the national authorities, electricity producers and distributors as well as potential developers of alternative energy sources including cogeneration. Fair and transparent criteria such as costeffectiveness and environmental benefits will help to create a more competitive and convivial atmosphere for greater investment. Certain principles need to be upheld by the policy makers to assure greater private sector participation in energy generation and cogeneration, so that the capital requirements for power system expansion can be met. These include: • • • preparation of a well structured regulatory framework, including separation of responsibilities and authorities for efficient and timely project implementation; launching of balanced programme in terms of the type of project (project size, technology, choice of fuel) and the type of market served (sale to utility, third parties); systematic implementation of programmes and projects following a well defined work plan, including completion of important planning activities and establishment of bidding and contract awarding procedures; setting of fair and transparent procedures for soliciting, evaluating and awarding bids, which will help to maximize competition thanks to a greater participation of lenders and investors; conducting negotiations in an open and transparent manner, without resorting to negative tactics;

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revising regulatory frameworks, legal and institutional arrangements, bidding as well as negotiation procedure periodically on the basis of experience gained, and in consultation with all the other partners concerned.

4.3.2 Adequate regulatory measures
There should be certain regulations that clearly define the cogeneration system by specifying the fuel to be used, energy efficiency, minimum or maximum ratio of heat to power, etc. Regulations should allow the purchase and sale of power between cogenerators and electric utilities. The obligations and rights of cogenerators and electricity utilities must be clearly defined as well as the interaction between them. A sound investment climate should be created in order to attract foreign investment into the field of cogeneration. Development of a positive regulatory framework regarding the role of the electricity industry will send the right signal to the potential cogenerator. This should include purchase and sale of electricity, back-up facilities and wheeling of electricity to third parties. There should be arrangement for the grid to buy back electricity from a cogenerator. The price of electricity purchased should be based on avoided cost of electricity generation by the utility. Experiences in many countries show that capacity allowances fixed are inadequate and the principle of avoided costs is not fully applied while setting up the pricing structure for purchasing cogenerated electricity. Small cogenerators are prone to equipment failure or unscheduled breakdown. Penalties for importing electricity during these periods can have severe impact on the economics of the cogeneration project, as has been found in a number of countries. The utility should be lenient in such cases and provide emergency power at a reasonable rate. The arrangements for “wheeling” or selling electricity to third parties are not widely adopted or accepted by energy policy makers in many countries. Wheeling should not only be allowed but also encouraged at sites where there is a shortage of local supply of electricity or when power is delivered at a lower level than that of the electricity network.

4.3.3 Examples of regulations in selected Asian countries
Some aspects of regulations for cogeneration facilities in Thailand are presented here. The benefits that can be enjoyed by cogenerators in some other selected countries are also mentioned in order to give an idea of how cogeneration can be effectively promoted by means of good regulations. In Thailand, regulations for the purchase of power from small power producers were approved in 1992. The sections that are relevant to the cogeneration systems are mentioned below.1 The operating standard of a cogeneration facility is that the process must involve continuous use of energy by employing a topping cycle or a bottoming cycle thermal process. The thermal energy to be used in thermal processes other than electricity generation, must be no less than an average of 10 per cent of the total energy production during each year.

The efficiency standard of cogenerators is set such that if oil and/or natural gas is used either as a primary or supplementary fuel, the sum of the electricity produced and one half of the

1

Electricity Generating Authority of Thailand, Regulations for the Purchase of Power from Small Power Producers, Thailand, 1992.

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thermal energy used in the thermal process on an annual average must be at least 45 per cent of the total energy from oil and/or natural gas (based on Lower Heating Value). In case of the electricity being exported from a cogeneration facility to the power utilities, the cogenerator will be qualified as a small power producer if the following criteria are met: I. II. Electricity export capacity to utilities should not exceed 60 MW (this can be raised to 90 MW on a case by case basis) The cogenerator must generate and supply electricity to the public utility during the utility’s system peak months of March, April, May, June, September and October, and the total hours of electricity production supplied to the utility must be no less than 7,008 hours per year.

The cogenerator is responsible for the cost of system interconnection which includes the costs of the transmission and distribution systems, metering, protective devices and other expenses arising from undertaking to purchase electricity from the cogenerator. The cogenerator is also responsible for the cost of equipment inspection which refers to the utility system and the expenses to be incurred from corrective actions that may arise in addition to the normal practices of the utility. If the electric export contract period is more than 5 years, the qualifying cogenerator can obtain the capacity payment and energy payment based on long term avoided costs of electric utility. Otherwise, the cogenerator can obtain only energy payment calculated on the basis of short run avoided energy cost of utility. Cogenerators are allowed to use electricity from the public utility as back-up power. In this case, they must pay demand and energy charges to the utilities. Cogenerators must be billed energy charges (Baht/kWh) at the same price as other electricity consumers pay, but they pay only half of the demand charges (Baht/kW/month) which are applicable to other small power producers. In Malaysia, the energy policy is geared towards cutting down on the use of oil and promoting the use of non-oil indigenous resources such as gas, hydro and coal. Major gas infrastructure developments are being carried out and greater use of gas for power generation is planned. The Electricity Supply Act (ESA) of 1990 provides a legislative framework for regulating any activity in the electricity supply industry in Malaysia. Together with any regulations that can be made by the Minister (of Energy, Telecommunications and Posts) under section 53 of this Act, it forms the regulatory framework for those who opt for cogeneration.2 Benefits of cogenerators under ESA are: • • • Electric utilities must sell power to cogenerators’ facilities; Electric utilities must provide inter-ties with cogeneration systems, if requested by the cogenerator; Electric utilities must operate in parallel with a cogenerator facility if the cogenerator wishes to do so;

2

F. X. Jacob, “Development of cogeneration and its regulation in Malaysia”, National Seminar on Energy for Future Generation, Malaysia, 1995.

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• • •

Electric utility rates for the sale of electricity to a cogenerator must be non discriminatory when compared with other customers; The electric utility must provide special services to cogenerators, even though similar services are not extended to other customers; these include top-up and stand-by power; Rates for stand-by power shall not be based on the assumption that outages of all cogenerator’s facilities on a given electric utility system will occur simultaneously or during peak periods. The rates for power purchased during maintenance shall take into account the extent to which the scheduled outages of the cogenerator's facility can be usefully co-ordinated with those of the utility’s facilities; Cogenerators who qualify to sell electricity to the utility will be paid for at the utility avoided cost.

In the Philippines, Energy Regulations No. 1-95 allows private sector participation in power generation activities and also covers cogeneration systems.3 Under this regulation, the benefits gained by cogenerators are: Electric utilities shall sell power to a cogenerator if requested; Cogenerators can sell power to the electric utilities and the utilities can purchase at a rate based on utilities’ avoided cost; Except for back-up power, rates for sales of electric utilities to cogenerators can be based on the net interchange of energy between them. The applicable rates in this case shall be the rates stipulated in a contract between cogenerators and utilities; Electric utilities shall provide the back-up power and maintenance power at a rate approved by Energy Regulatory Board; For small scale cogenerators (having capacities below 10 MW), the electric utilities shall shoulder all costs needed for establishing the physical connection between the cogeneration facilities and utilities’ transmission network; For the cogeneration facility of any size, maintenance costs for the interconnection facilities shall be borne by electric utilities.

4.3.4 Financing issues
Cogeneration systems are somewhat capital intensive. Many countries in the region face a major obstacle to the development of innovative energy technologies such as cogeneration due to lack of investment financing, particularly when there is a rapid economic growth taking place and the energy prices are low. It becomes imperative to look for financing techniques that will have less impact on a firm’s financial balance sheet. In some cases, grants can help to reduce investment costs and to promote the financing of remaining investment. The aim of the grant should not be merely subsidized to improve the company’s profit, but to minimize financial risks associated with innovative technologies. Incentives provided by the public authorities may include tax relief and accelerated depreciation for investments in cogeneration systems. Interest rate subsidies and loan/equity guarantees may also be considered for reducing the risks associated with private sector investment in small and medium enterprises. As an energy efficient device, some equipment
3

Department of Energy, Implementing Rules and Regulations, Executive Order No. 215, the Philippines, 1995.

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to be used in cogeneration systems should avail duty-free or low duty benefits. Several countries in Asia have already adopted a number of these measures in their efforts to encourage efficient energy generation and utilization. For example, the government of India has listed a number of energy generating devices which are eligible to apply for reduced import taxes and duties, accelerated depreciation, income tax holiday, capital and interest subsidy, etc. (for more details, please see Part II, Chapter 1). In Europe, apart from the national incentives given to private companies, there are several European Union energy programmes that provide grants to encourage investment in energy efficiency (e.g. JOULE, THERMIE). The concept of third party financing is strongly supported by the European Commission in order to help companies finance investment without affecting their balance sheets. Projects suitable for third party financing can get assistance from the SAVE programme and the Technology Performance Financing (TPF) system developed under the SPRING programme of the European Commission.

4.3.5 Role of electric utilities
A factor of prime importance appears to be an adequate definition of the structure and activity of the electric utility. There is a trend across the globe for liberalization, restructuring and gradual disintegration of the traditional vertical energy supply monopolies. Some Asian developing countries are already envisaging to separate the production and distribution operation of the vertically integrated utilities. The emphasis should be clearly to bring forth progressive changes in the utilities so that they gradually become suppliers of energy services. The public and monopolistic natures of electric utilities in many developing countries lead to subsidized price of electricity and improper tariff structures that hinder the promotion of cogeneration systems. The electric tariff should be acceptable to all parties concerned and not protect the interest of any specific entity. For projects with long term commitments, the tariff structures should reflect the long-run marginal cost of electricity generated. There should be rules and regulations for the sale and buy-back rates for electric utilities and cogenerators; the latter should get benefits for their installed capacities and exported electricity based on the avoided costs of electric utilities. The active and supportive role of electric utilities in different forms, such as promotional activities on behalf of cogenerator, investment in schemes, establishment of joint ventures and setting up conducive tariff structures, can be crucial to the development of cogeneration. For example, utility owned cogeneration is quite common in Denmark and Germany that have a long record of adopting district-heating networks. In countries like the Netherlands, Spain and the United Kingdom of Great Britain and Northern Ireland (United Kingdom), joint ventures have been established between utility and cogenerator. Similar initiatives have also been taken in Japan, Republic of Korea and Thailand. A contentious issue related to private participation in power generation is the decision on fixing the new capacity that should be added. Capacity planning should not only have representation from government and electricity producers and distributors, the interests of those willing to contribute to decentralized power generation and cogeneration, should also be protected. The procedure applied should be fair and transparent, taking into account factors such as cost-effectiveness, location of the plant, environmental benefits, etc. If a cogeneration facility shows the same economic promise as a conventional power plant, it is obvious that the former should be given a priority. The idea of the power utilities implementing a competitive bid process seems the right approach to determine the realizable potential for cogeneration. This helps to avoid situations of the supply of power greatly exceeding the demand.

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4.3.6 Internalization of environmental costs
Fossil fuel and electricity prices are forecasted to remain low for the short and medium terms. As a result, there is likely to be a lack of market forces to support energy efficiency projects, including cogeneration using fossil fuels. In the absence of other specific incentives for cogeneration development, there is a need to develop a mechanism to internalize external environmental costs. Though Denmark and Sweden have succeeded in introducing such measures for energy conservation, the European Union proposal for an energy/carbon tax has met with significant resistance. The tax revenues on fossil fuel and electricity, similar to the one introduced in Thailand (a small tax imposed on oil products to sustain the Energy Conservation Promotion Fund), could be used to promote all activities leading to energy conservation, including cogeneration.

4.3.7 Setting targets for cogeneration development
It is important to set ambitious but realistic targets for cogeneration development as it demonstrates a clear political commitment. If insufficient action is being taken, pressure may be applied by the organizations that are in-charge of promoting cogeneration. In the European Union, specific targets have been set by a number of countries including the Netherlands, France, Spain and the United Kingdom. This obliges the concerned authorities to monitor the evolution of cogeneration on a regular basis, and intervene, if necessary, in a proactive manner by taking timely policy and implementation decisions in consultation with all the beneficiaries.