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Economic analysis of an MHPP

by Edvard

As with any

The mini-hyd ro p lant at the up land s itio o f Camp ue s to han, Brg y. Cab atang an, Talis ay City

other investment project, the economic f easibility of micro hydro projects must be proven to attract the interest of investors. It is also of key importance in enabling f inancial institutions to supply the f unds necessary to f inance the project in addition to the promoters own f unds. T his will be possible if the project is bankable. Questions a promoter has to answer prior to the decision to invest is taken include the f ollowing: What are the costs incurred by the project of MHPP? What will be the revenues? Does the project generate a reasonable rate of return to their own investment f unds? What are the f inancial sources?


T he cost of an MHPP is site-specif ic. It depends on the necessary civil works, the generating equipment and the electrical transmission/distribution lines. While the cost of the generating equipment is almost a linear f unction of power size (in kW), the cost of civil works depends on the physical characteristics of the site. Similarly, the cost of the electrical lines depends on the type of grid and on the distance to the connection point. T he terms f or connecting to the grid dif f er widely in the EU with some countries deliberately leaving only part of the cost to developers, while in other Member States (eg Spain, Germany) all the costs are born by the investor. Other development costs have to be taken into account: engineering studies, environmental impact studies and the legal f ees to submit the project f or approval to the dif f erent public bodies involved. Besides the investment costs, which have to be paid of f during the initial lif e of the project in the f orm of depreciation, operation and maintenance costs (O&M) have also to be estimated and depend mainly on the permanent personnel involved, on the insurance costs and on repair and maintenance contracts concluded with specialized f irms. Certain expenses which will not be encountered every year, like major repair/maintenance of machinery and replacement of brushes, will also have to be taken into account. Payment of the debt and interest on bank loans will also need to be estimated. Usually the whole calculation is made in current costs in order to avoid making estimates of inf lation. T he f ollowing graph correlates the investment cost in Euro/kW installed capacity f or dif f erent power ranges and heads. Cost

fig ure 8 - Inve s tme nt c o s ts fo r MHPP (s o urc e : Euro p e an Co mmis s io n, Dire c to rate -G e ne ral fo r Ene rg y and trans p o rt, Brus s e ls , 2001.)

evaluation must be conducted caref ully because such projects are capital intensive and costs depend very much on the characteristics of the site. In brief , the f ollowing typology of costs applies to micro hydro projects:

Init ial cost s

Feasibility studies and project development are typical items of MHP projects. T hey include hydrological and environmental assessment, preliminary designs, permits and approvals (f or water, land use and construction), land rights, interconnection studies, power purchase agreements (PPA), project management and f inancing f ees. One of the aims of the SPLASH Project, through its methodology of the implementation of local plans is to minimising the development costs of the micro hydropower projects. As several constraints are analysed simultaneously, over a large area within the plans, several sites could be potentially developed. T heref ore, cost analysis and the economical risks could then be assessed in an easier manner and comparisons done. In this order, the support to decision makers and stakeholders could become a handy tool f or micro hydropower development.

Const ruct ion cost s

T his type of costs is incurred af ter the decision to go ahead with the project is taken. Such costs include engineering, insurance premiums, civil works and equipment.

Operat ion and Maint enance

T hese are regular costs that occur on a yearly basis and include transmission line maintenance , general administration, repairs and contingencies. Operation and maintenance cost most importantly include maintenance of the civil works and the equipment of the microhydropower plant. Advertisement

Revenues come f rom specif ic purchase contracts signed with the electric utilities. Depending on the legislation, electric utilities are usually obliged to buy the electricity generated f rom renewable energy resources on a priority basis. In some countries there are specif ic incentives given to investment in electricity production using RES. According to these special schemes, hydro, wind power and photovoltaic projects can apply f or special loans with low or even zero interest rates, or receive other types of investment subsidies. Prices paid to MHP producers vary considerably among European countries. In the tarif f structure dif f erent components can be f ound, according to the country: a market price, an avoided carbon price, a green certif icate price or other f orms of promotional elements. Figure 9 illustrates some of the dif f erences between countries. T he dif f erent support schemes can af f ect greatly the development of micro-hydro plants. Whereas a f ixed f eed-in tarif f reduces uncertainty and guarantees cash f low f or a determined duration, market-based schemes can sometimes reveal themselves too uncertain and theref ore unattractive to developers. Even if price alone is not the only f actor to take into account f or an investment decision, the detailed summary of individual countries situation f ound in Appendix III might prove helpf ul. To estimate his revenues, the promoter of an MHPP has to estimate the production and sales during the dif f erent periods def ined in the tarif f legislation. Usually the tarif f s have an hourly and seasonal structure to take into account the shape of the load demand curve and the marginal costs of electricity production during every period.

fig ure 9 - Diffe re nc e s in tariff s truc ture amo ng Euro p e an Unio n c o untrie s (s o urc e : http ://www.ap p a.e s /d c h/min_e n.htm)

Project Financing
Project f inancing is a key element f or decision making in capital intensive projects and it is a common rule that developers rely on capital markets and other types of lending to obtain the required f unding. T he appropriate structure f or f unding depends much on the promoter and on the specif ic f inancing sources available (e.g. loans through government incentive programs, government grants). Also, if a PPA is signed, it can be of great help in a project f inance scheme, because it provides a guarantee of revenues. T he main sources of equity f unding are private capital (f rom the promoter), shares issued to the public, loans and grants f rom the government. Debt f unding is associated with loans given by banks, lease companies and government agencies. T he share of debt on total f unding depends on the guarantees of f ered by investors and on the expected prof itability of the project. Top

Assesing The Prof itability Of An MHPP Project

Dif f erent summary measures are usually considered f or the economic and f inancial appraisal of investment projects. Among the most f requently used measures we can identif y the f ollowing: the pay-back method, the rate of return on equity (ROE), the net present value (NPV) or the internal rate of return (IRR).

Def initions
Payback period : number of years necessary to recover the investment. Usually we encounter payback periods f rom 5 to 10 years when assessing prof itable MHPP projects, which themselves can have a lif e span of 25 years or more. T his varies according to the investment needed, tarif f s applied

and O&M expenditure. ROE: percentage annual average return (net of depreciation) on the initial investment. It is used as a proxy f or the average prof it rate, which must be compared with the opportunity cost f or capital or with the remuneration of an alternative investment. NPV: sum of the discounted cash f lows over the lif e time of the project assuming a discount rate. IRR: discount rate that equals the inf lows (receipts) and the outf lows (costs). It is a proxy f or the projects expected rate of return. To calculate these indicators a cash-f low table f or the lif e time of the project has to be generated. Figure 10 gives an example of a cash f low table and of the value calculated f or the above listed indicators.

The Economic Evaluation

T he f ollowing table presents a typical cash-f low assessment of a project, adequate to run simple f easibility studies. No assumption is made concerning the way the project is to be f inanced. If the values estimated f or IRR and/or NPV are acceptable f or the decision maker, a deeper analysis must be conducted in order to submit the project f or f inal decision and to the banking institutions. In this example all the f igures are in constant prices and according to the estimated IRR, it appears that the project is bankable and will give the investors a prof it rate higher than 7,29% if the project can be successf ully f inanced by the banking system at an interest rate lower than 10%. T his project is a ref urbished old mill and represents a 50 KW installation, run-of -river and is considered to take advantage of a f eed-in-tarif f . We have not taken the value of externalities associated with an MHPP into account. T hese externalities may either be positive or negative and are sometimes decisive f or the approval of the project by public bodies. Environmental burdens, tourist upgrading of a region, job creation at a local level, income fig ure 10 - Pro je c t Cas h-flo w (an e xamp le ) generation by municipalities are some examples of externalities to consider during the assessment.