ECONOMIC ANALYSIS. A. Background and Approach

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1 A. Background and Approach ECONOMIC ANALYSIS Rural Renewable Energy Development Project (RRP BHU 42252) 1. Economic analysis was undertaken to determine the economic viability of the project. The analysis covers the project s four components: (i) on-grid rural electrification, (ii) Off-grid rural electrification through solar home systems, (iii) pilot grid-connected wind power mills, and (iv) pilot biogas plants. The analysis comprises evaluation of (i) national electricity demand forecast and household s demand for electricity, (ii) least-cost plans for each project component, and (iii) cost benefit analysis of each project component. 2. Economic benefits will accrue from incremental energy consumption and from displacement of more expensive sources of energy. The incremental costs and benefits of each project component were estimated by comparing with-project and without-project scenarios. Ongrid rural electrification subprojects have been analyzed on both a per household basis and in aggregate, as were planned investments in solar home systems and biogas plants. The wind power generation component provides for gathering of wind energy data and the possible development of a pilot plant connected to the grid system. B. Demand Analysis and Forecast 3. National demand forecast. The growth in Bhutan s peak demand for electricity averaged 17% per year for and was driven largely by high-voltage consumption that grew at 23% per year. By the end of 2009, the Bhutan Power Corporation (BPC) had 91,119 customers, out of which industry clients in the high-voltage category accounted for 73% of national consumption. The rapid growth of industrial consumption has exceeded Bhutan s existing capacity to supply electricity in the dry season. During the dry winter season, Bhutan s generation capacity declines markedly and electricity supply is now being capped by BPC shedding industrial loads and by the government limiting licenses for new industries. However, this approach has high economic costs, by way of lost industrial production and/or by causing industrialists to invest in captive diesel generation sets. 1 This demand supply gap will grow until more new hydropower plants come on line in the middle of the current decade. Energy sales to residential consumers, however, are not rationed and should continue to grow in line with improvements in the standard of living of the general population. Growth in residential demand, although a minor proportion of total consumption, will thereby account for the bulk of BPC s growth forecast of 2% per year in energy sales. 4. Household demand and affordability. Over 95% of the electricity supplied by the ongrid rural electrification component will be consumed by households; the balance will be used by institutions and other consumers. Houses beyond the economic limit of the grid will be provided with solar home systems that generate up to 2 3 kilowatt-hours (kwh) of electricity per month, sufficient for three 3-watt super-bright light-emitting-diode light bulbs and for charging cell phones. The impacts of electrification on rural household s demand for energy were evaluated and the results show that a grid-connected household purchases an average of 75 kwh per month of electricity and thereby obtains net benefits (consumer surplus) of around Nu1,700 per month by using electricity to replace more expensive forms of energy 2 and by increasing their 1 Electricity produced by diesel generation sets costs Nu17 per kilowatt-hour (kwh) or more under Bhutanese conditions. The Department of Energy is drafting a captive power generation policy. 2 Candles, dry cell batteries, and kerosene used by unelectrified households are highly expensive energy in economic terms. Fuelwood is the main source of household s energy, but the large quantities of fuelwood burned in

2 2 overall energy consumption. The survey results and analyses of observed behavior 3 confirm that the demand for access to electricity is substantial and affordable. Relatively poor rural households purchase rice cookers and other appliances even before they are connected to the grid. While solar home systems do not have the capacity to provide the same magnitude of benefits as a grid connection, they do provide the highly valued benefits of electric lighting and cell phone communications to households beyond the reach of the grid. 5. Tariffs and subsidies. Significant cross-subsidies within the electricity sector are funded by the hydropower generators and embedded in BPC s retail tariff. The government intention is to maintain the current lifeline tariff approach for residential consumers and for a number of small and medium-sized enterprises, but eliminate subsidies for high-voltage consumers. The economic costs of low-voltage supply to residential consumers when all network and export opportunity costs are accounted for were close to Nu6 per kwh in 2009; however, the tariff for consumption of up to 100 kwh per month is only Nu0.85 per kwh. 4 The use of the electricity supply system to distribute economic benefits to rural consumers is considered well justified by the positive impacts of incremental electricity consumption on poverty alleviation, conservation of forests, and reduced use of fossil fuels. The high-voltage industry customers currently receive approximately 40% of the total consumer subsidies that are delivered by the BPC. However the high-voltage tariff has steadily increased over time and the high-voltage subsidies will be eliminated after Figure 1 shows how electricity subsidies account for a significant proportion of the average residential consumer s energy bills. 5 The subsidy given to off-grid solar home system users is only 55% of that provided to on-grid electrified customers; adequate subsidies sourced from the energy royalty would be justifiable to off-grid solar home system users in a fair manner. Figure 1: Household s Economic Energy Cost and Payment Nu per month 1,400 1,200 1, Unelectrified Household Solar Home System Grid Access House Holder Cost Nu = ngultrum. Subsidy C. Least-Cost Analysis, Economic Benefits, and Risk Assessment 7. Least-cost rural electrification. Bhutan s program for rural electrification is based on providing electricity for all within the present five-year plan, using least-cost solutions for highly inefficient stoves offsets its relatively low unit energy cost. ADB Technical Assistance to the Kingdom of Bhutan for Preparing the Rural Renewable Energy Development Project. Manila. The socioeconomic survey was conducted. From tariff schedule approved by the Bhutan Electricity Authority in August 2010 for next 3 years. From costs of kerosene, dry cell batteries, fuelwood, solar home systems, and grid extension.

3 3 economically justified investment. The Rural Electrification Master Plan prepared in 2005 assessed economic limits for grid extension the point at which the costs of any further grid extension would exceed the economic benefits. The economics of grid extension have subsequently been reviewed and detailed least-cost investment plans were updated during project preparation. Given that the proposed rural electrification program addresses the last mile of rural electrification, the BPC has opted to use lighter telescopic poles and single-phase transformers to facilitate delivery and installation in remote areas. For households beyond the reach of the grid, the provision of solar home systems is considered to be the only economic option and therefore the least-cost solution. Other feasible options are expensive. The most likely without-project options would be small battery-integrated diesel generators or micro hydro systems. Both of these without-project options are problematic given the high costs imposed by isolation, difficulty of access, and low density of households. For mini hydros, these difficulties would be exacerbated by the costs of developing suitable sites, the absence of technical support and assistance for operation and maintenance (O&M), the large variations in water flows between the dry and wet seasons, and the very low demand by households for power. 8. The objective of the wind power component is to lay the groundwork for possible diversification of Bhutan s generation, particularly during the dry season when hydropower generation capacity is substantially reduced by low river flows. The pilot plant will involve purchase of the smallest grid-connected units and is therefore the least-cost way to provide Bhutan with practical experience in wind farm development and operation, including studies of impacts on the power supply system. 9. Project costs. All costs and benefits are in constant mid 2010 prices with an allowance for physical contingencies. As foreign equipment is purchased on the international market, the estimated prices have been taken as indicative of their economic value. Capital cost estimates include physical contingencies, but exclude taxes, price contingencies, and finance charges. The operating costs for the grid extension subprojects have been based on BPC experience. Projections of crude oil prices were used to establish the value of petroleum fuels (such as kerosene and diesel) that will be saved or consumed if electricity is unavailable. 10. Net benefits of electrification. Economic benefits of on-grid rural electrification are (i) the incremental benefits to households of increased energy consumption; (ii) Bhutan s cost savings from reduced consumption of kerosene, batteries, and fuelwood; and (iii) the avoided costs of the without-project option. In the increasingly remote areas that will be electrified by grid extension, the most likely without-project option that would fulfill Bhutan s plans of providing electricity for all is solar home systems; they are considered avoided costs. Fuelwood is the largest single source of energy used by households and the savings in costs of firewood collection have been monetized using a shadow wage rate of Nu100 per day. Incremental benefits are the result of households induced consumption of energy when they gain access to a lower-priced energy source, valued at their willingness to pay for incremental energy. The costs of providing grid access are (i) the grid system investment and house wiring costs, (ii) the incremental O&M costs of system investment, and (iii) the foregone returns from exports of electricity valued at the border price. The economic benefits of solar home systems are the cost savings from the avoided without-project investment and Bhutan s savings in the cost of kerosene and dry cell batteries. 11. Benefits of grid-connected wind power. Bhutan s inability to meet demand during the dry season has focused attention on possible options to hydropower. The planned pilot project will assist in reducing impacts of load shedding during the dry season and contribute to exports to India in the remainder of the year. The economic cost of planned load shedding depends

4 4 upon the structure and contribution of the affected sectors. The economic costs to industries of load shedding have been taken as being equivalent to the costs to industry of diesel-powered generation (around Nu17 per kwh). The electricity produced during the remainder of the year will have an economic value equivalent to the marginal export price. Besides supplying electricity to the national grid, the pilot project will provide Bhutan with insight into and experience in the use of wind power, for possible future developments. 12. Benefits of biogas plants. The biogas units to be installed on dairy farms produce a clean burning gas (75% methane) that is a substitute for fuels used in cooking. The saved fuel costs can include electricity, liquefied petroleum gas, fuelwood, and kerosene, depending on the households energy supply mix and consumption patterns. Additional benefits of biogas production include a reduction in emission of methane (a potent greenhouse gas), improvements in peoples health from reduced indoor smoke from wood fires, production of fertilizer as a by-product, and savings in labor incurred in collecting fuelwood. D. Calculation of Economic Internal Rate of Return and Sensitivity Analysis 13. Estimated economic internal rates of return. A period of 25 years was used for economic evaluation, with due allowance for residual values of assets with a long economic life. The results of the economic internal rates of return (EIRRs) for all components are summarized in Table 1, showing that the project and its key components are all projected to make a positive economic contribution. Table 1: Economic Internal Rate of Return Results Component EIRR (%) On-grid rural electrification 12.7 Grid-connected wind power mills (combined with on-grid rural electrification) 12.7 Off-grid rural electrification (through solar home systems) 28.7 Biogas plants 14.3 Aggregate of all components The overall aggregate EIRR for the project of 13.9% is dominated by the contribution of the on-grid rural electrification program, which accounts for the major portion of the overall project investment. The impact of the wind power pilot on the grid component EIRR is by contrast negligible. The off-grid rural electrification component has the highest overall EIRR, reflecting the benefits of lighting and cell phone communications that can be obtained by providing access to electricity using solar home systems. While they are highly cost-effective when compared with alternatives such as diesel-powered generators, the absolute benefits for off-grid consumers are much smaller than ones for on-grid consumers due to limited capacity for electricity use Sensitivity and risk analyses. The major risks faced by the project have been tested by sensitivity analysis. The adverse impact of EIRR on the project s costs and schedules, and on the realization of economic benefits is summarized in Table 2. 6 While the solar home systems can be used for three bulbs for lighting, and small electric appliances including cell phone chargers and radios, they are not available for power-consuming appliances such as rice or curry cookers, televisions, and water heating boilers.

5 5 Table 2: Sensitivity Analysis Item Variable EIRR (%) Base case 13.9 Project cost +10% 11.8 Benefits 10% 11.6 Time period + 1 year Sensitivity analysis shows that returns are acceptable under adverse circumstances with aggregate returns close to the economic hurdle rate of 12%. The returns are most sensitive to time delays on project completion, especially for the on-grid extension component. The likelihood of delay, however, is low, given that the BPC is continuously working on rural electrification and can readily deploy experienced people and quickly mobilize other available resources as demonstrated under the past and ongoing ADB-funded rural electrification projects. 17. Economics of grid extension. The detailed costs and benefits of the on-grid extension and the economic cost benefit calculation are presented in Table 3. 7 Table 3: Economic Internal Rate of Return Calculation for Grid Extension ($ million) Benefits Costs Year Incremental Consumption Cost Savings Capital Operation and Maintenance Supply Net Benefits (1.73) (6.69) (5.73) EIRR 12.7% 18. The detailed breakdown shows the significant contribution of incremental consumption to economic welfare, which is a direct benefit that is captured by rural households when they are connected to the grid and can make good use of the lifeline tariff to meet their basic needs. 7 See also Assumptions for Economic Analysis supplementary document (RRP, Appendix 2).