Economic analysis of an MHPP

The mini-hydro plant

As with any other investment project, the economic feasibility of micro hydro projects must be proven to attract the interest of investors.

It is also of key importance in enabling financial institutions to supply the funds necessary to finance the project in addition to the promoter’s own funds.

This will be possible if the project is “bankable”.

Questions a promoter has to answer prior to the decision to invest is taken include the following:- 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 funds?
- What are the financial sources?

Costs

The cost of an MHPP is site-specific. 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 function 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. The terms for connecting to the grid differ 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 fees to submit the project for approval to the different public bodies involved.

Besides the investment costs, which have to be paid off during the initial life of the project in the form 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 firms. 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 inflation.

The following graph correlates the investment cost in Euro/kW installed capacity for different power ranges and heads.

figure 8 - Investment costs for MHPP

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

Initial costs

Feasibility studies and project development are typical items of MHP projects. They include hydrological and environmental assessment, preliminary designs, permits and approvals (for water, land use and construction), land rights, interconnection studies, power purchase agreements (PPA), project management and financing fees.
One of the aims of the SPLASH Project, through its methodology of the implementation of local plans is to minimizing the development costs of the micro hydro power projects.

As several constraints are analyses simultaneously, over a large area within the plans, several sites could be potentially developed. Therefore, 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 for micro hydro power development.

Construction costs

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

Operation and Maintenance

These 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.

Revenues

Revenues come from specific purchase contracts signed with the electric utilities. Depending on the legislation, electric utilities are usually obliged to buy the electricity generated from renewable energy resources on a priority basis.

In some countries there are specific incentives given to investment in electricity production using RES. According to these special schemes, hydro, wind power and photovoltaic projects can apply for 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 tariff structure different components can be found, according to the country: a market price, an avoided carbon price, a green certificate price or other forms of promotional elements.

Figure 9 illustrates some of the differences between countries. The different support schemes can affect greatly the development of micro-hydro plants. Whereas a fixed feed-in tariff reduces uncertainty and guarantees cash flow for a determined duration, market-based schemes can sometimes reveal themselves too uncertain and therefore unattractive to developers. Even if price alone is not the only factor to take into account for an investment decision, the detailed summary of individual countries’ situation found in Appendix III might prove helpful.

To estimate his revenues, the promoter of an MHPP has to estimate the production and sales during the different periods defined in the tariff legislation. Usually the tariffs 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.

figure 9 - Differences in tariff structure

Project Financing

Project financing is a key element for 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 funding.

The appropriate structure for funding depends much on the promoter and on the specific financing 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 finance scheme, because it provides a guarantee of revenues.

The main sources of equity funding are private capital (from the promoter), shares issued to the public, loans and grants from the government. Debt funding is associated with loans given by banks, lease companies and government agencies. The share of debt on total funding depends on the guarantees offered by investors and on the expected profitability of the project.

Assessing The Profitability Of An MHPP Project

Different summary measures are usually considered for the economic and financial appraisal of investment projects. Among the most frequently used measures we can identify the following: the pay-back method, the rate of return on equity (ROE), the net present value (NPV) or the internal rate of return (IRR).

Definitions

• Payback period: number of years necessary to recover the investment. Usually we encounter payback periods from 5 to 10 years when assessing profitable MHPP projects, which themselves can have a life span of 25 years or more. This varies according to the investment needed, tariffs applied and O&M expenditure.
• ROE: percentage annual average return (net of depreciation) on the initial investment. It is used as a proxy for the average profit rate, which must be compared with the opportunity cost for capital or with the remuneration of an alternative investment.
• NPV: sum of the discounted cash flows over the life time of the project assuming a discount rate.
• IRR: discount rate that equals the inflows (receipts) and the outflows (costs).

It is a proxy for the project’s expected rate of return.

To calculate these indicators a cash-flow table for the life time of the project has to be generated. Figure 10 gives an example of a cash flow table and of the value calculated for the above listed indicators.

The Economic Evaluation

The following table presents a typical cash-flow assessment of a project, adequate to run simple feasibility studies. No assumption is made concerning the way the project is to be financed. If the values estimated for IRR and/or NPV are acceptable for the decision maker, a deeper analysis must be conducted in order to submit the project for final decision and to the banking institutions.

In this example all the figures are in constant prices and according to the estimated IRR, it appears that the project is bankable and will give the investors a profit rate higher than 7,29% if the project can be successfully financed by the banking system at an interest rate lower than 10%. This project is a refurbished old mill and represents a 50 KW installation, run-of-river and is considered to take advantage of a feed-in-tariff.

figure 10 - Project Cash-flow (an example)

We have not taken the value of externalities associated with an MHPP into account. These externalities may either be positive or negative and are sometimes decisive for the approval of the project by public bodies.

Environmental burdens, tourist upgrading of a region, job creation at a local level, income generation by municipalities are some examples of externalities to consider during the assessment.