38350 No. 7 KNOWLEDGE EXCHANGE Series November 2006 Power Purchase Agreements for Small Power Producers by Steven Ferry and Anil Cabraal Five Asian nations, India, Indonesia, Sri Lanka, Thailand, and Vietnam began designing or instituting Small Power Producer (SPP) programs in the mid- 1990s to support energy development jointly with the private sector. This note draws on important markers and lessons for other countries on how to implement similar programs based on these experiences. While all Asian programs demonstrate certain commonalities due to fundamental legal relationships, each experience has been tailored to local conditions and requirements. Some have introduced innovative bidding, competitive, or incentive structures. The result is a rich palette of experience with small power projects in Asia. Background The power sector in Asia is expanding rapidly. Almost 60 percent of all new power generation capacity financed in developing countries is in the region. Over the past decade, a number of Asian countries began instituting These five Asian nations comprised of different government small power programs to tap into their reservoir of structures and each depended on different available fuel renewable resources for more efficient and cost effective sources (hydro, wind, biomass, gas etc.) In addition, some of energy supply. Institutional policy, regulatory, the national electric systems have an integrated high-voltage contractual, and tariff regimes to support these programs transmission system, whereas others have a non- were particularly successful in India, Thailand and Sri interconnected grid or island system. Despite these Lanka. By 2005, India had over 15,000 MW of small hydro, differences, there are key similarities: wind and biomass power developed by the private All are in need of long-term increases in power sector feeding power to the grids. These constituted more generation capacity. than 12 percent of total generation capacity in India. All have the potential of small-scale renewable Thailand had more than 17 percent (4,600 MW) of its total energy options. power generation being supplied under its small power Each country is being approached by private program. In Sri Lanka, 110 MW small hydro and biomass developers who seek to develop renewable SPP power plants out of a total generation capacity of under projects. 2,500 MW (more than 4 percent), is operating or under Each system employs either deliberately or de facto construction. Experiences in Indonesia and Vietnam a standardized Power Purchase Agreement (PPA), were less successful due to the financial crisis that hit although it is not necessarily a neutral or consensual Indonesia in 1997, and regulatory uncertainties faced by document in all cases. the small power programs in both countries. Although avoided cost concepts for establishing the SPP tariff are recognized in each nation, avoided cost concepts are applied differently in ESMAP is a multi-donor trust fund managed by the World Bank each of these countries' SPP programs. Energy and Water Department (EWD) that promotes the role of energy in poverty reduction and economic growth in an An important lesson derived from their experience in SPPs is environmentally responsible manner. Its work applies to low- that programs must be designed to ensure efficiency, income, emerging and transition economies and contributes to the achievement of internationally agreed development goals. credibility and long-term viability. In three of five countries considered the national or state utility has a monopsony on ESMAP Knowledge Exchange Series No. 7 1 KNOWLEDGE EXCHANGE Series November 2006 the purchase of wholesale power, thus SPP suppliers are operating contingencies. However, these must be set out still dependent on a single state buyer, both to purchase in the PPA and not subject to unpredictable revisions. as well as transmit their power. In the case of India, while sales to third parties were not permitted, wheeling power The PPA must be neutral and objective. The contents of to the developers' own or their `sister' firm facilities is the PPA is critical in attracting private capital and if--as allowed. In the absence of adequate regulation, it is was the case in Thailand--the PPA is seen as being overly imperative that the overwhelming bargaining power of simplistic or not reflecting SPP interests, investment will be the state utility be mitigated and that the utility operate difficult to secure. in its role as purchaser and transmission entity subject to objective PPA and tariff principles. 2. Structured tariff Based on the lessons derived from these five-country The tariff establishes the economic framework for the long- experiences, this note outlines four emerging areas to term power transaction. Over time, tariffs must take into implementing successful SPP programs: account changes in the marginal cost of generation in order to reflect either estimated (at the time of contract 1. Contractually Established Standardized PPA execution), actual long-term (for a contract including energy and capacity payments), or short-term (for a A properly designed and standardized PPA must provide contract with only energy payments) avoided cost. In a fair, neutral, and financeable contractual arrangement some cases the tariff can equalize at the outset, between the power seller and purchaser. Without it, according to estimated future costs, however in most resources are expended unnecessarily, inefficiently and cases the tariff will need to gradually change in response unpredictably. to movements in the marginal cost. It is important that the methodology on which these changes arise be The PPA must be contractually established and binding predetermined and credibly secure, such that long-term in order to maintain investor confidence and long-term investment decisions can be made with confidence. program viability. In Indonesia, for example, a series of unilateral changes in the PPA, including revisions to the Avoided cost is generally deemed the equitable tariff structure, led to problems of price stream uncertainty foundation on which to base the tariff structure of a and undermined project financeability in many cases. standardized PPA. Avoided cost reflects the cost to a Even though only a few PPA clauses were altered, they utility of acquiring power either by purchase (from external were crucial in determining the allocation of the risk of sources or at market rates), or by constructing additional the venture. generating capacity itself. Thus, with an avoided cost tariff, the utility system gets power at its opportunity cost As a binding legal relationship, it is essential that the of alternative power supply. There is, however, significant contract anticipates a variety of construction and diversity in the tariff design. However, financiers need Table 1: Overview of SPP Programs some degree of predictability in prices, especially to can be reduce the downside risk of a avoided cost decline in the accomplished by future. A floor price is used in some programs to mitigate an express subsidy this risk. as in the Thai system. Import Most programs periodically adjust their tariffs. This is duty exemptions necessary to reflect the changes in the marginal costs of and income tax fuel, a significant element of avoided energy cost, as well holidays, can as changing costs of operation such as tax changes, or e n c o u r a g e law and regulation changes. In Sri Lanka the tariff is revised renewable SPP annually but based on a three-year moving average fuel developers to price in order to smooth out volatilities. o v e r c o m e perceive risks in Some programs, such as the Indonesian program, have the start up of their indexed their tariffs to foreign exchange. This ensures that programs. With the project cash flow is held constant in the converted significant oil price currency in which international investments in capital increases in equipment are foreign sourced. The necessity of this has recent years, the been demonstrated in India, where IPP contract prices need for have not always been respected when currency incentives has de devaluations alter the expected cost of power in the c l i n e d . However, there are still some utilities that resist equivalent local currency. adjusting the tariff to reflect full avoided cost. While the principle that avoided cost is an efficient economic pricing Many of the smaller renewable power projects are not formulation still holds, the utilities argue that the developers dependent on foreign exchange and--on the basis that are reaping windfall profits and that there needs to be borrowing will be local--do not currently index their tariffs. `sharing' of benefits. It is also important to ensure that any This will need to change if projects are to attract foreign incentive payments that support a national interest are not direct investment (FDI). For example, during the financial solely borne by the power purchaser as it results in a crisis of 1997, some Thai projects that had borrowed in reluctance of the purchaser to participate in such a foreign currency were receiving PPA payments in Baht. program. Tariffs can also be designed to provide financial incentives Competitive bidding has been particularly successful in for SPP delivery of power at peak times. The Indonesian minimizing the requirements for incentive payments. This program, for example, provided for strong incentives for system has been used in Thailand where prospective SPPs on-peak hourly delivery of SPP power, and correspondingly bid for the amount of subsidy per kWh that is required to decreasing off-peak hourly prices so that the weighted enter into a PPA. SPPs are then awarded subsidy in the average is equal to the avoided cost.1 The economic order of the lowest bid, until the gross subsidy allocation is incentive can be maximized where the incentive is exhausted. This guarantees the most cost-effective embedded in the energy payment rather than split into a projects are subsidized. fixed capacity plus an energy payment; when power is not supplied, the SPP loses 100% of the potential revenue In Sri Lanka, the developer who receives a Letter of Intent stream, thus creating the strongest incentive for reliability (LoI) has 6 months to obtain permits for development for of power delivery. site before the LoI can be revoked. This prevents award recipients from attempting to prospect for hydroelectric The alternative to financial incentives built into the tariff, is sites for which they have no resources to develop, and to include legal sanctions in the PPA for non-delivery. This once controlling these rights, try to sell them to other however, has proven more controversial as it necessitates developers. complicated decisions on the reason for failure to deliver, and ultimately recourse to a reliable arbitration or litigation 4. Legal Infrastructure process. Dispute adjudication ­ there must be a system of law and 3. Solicitation and Funding regulation that facilitates orderly SPP development. For example the difficulties involved in accessing neutral court The value renewable energy SPP projects that contribute to fuel source diversity or reduction in fuel imports can be 1NB: Indonesia program was designed, and solicitations obtained, but captured by giving a premium above avoided cost. This contracts never issued due, inter alia, to the Asian financial crisis. ESMAP Knowledge Exchange Series No. 7 3 even though the energy-only (non-firm) PPA obligates neither party to sell or buy power, the design shifts the risk to the utility by requiring it to pay for `deemed energy' even when it does not accept SPP energy.3 Conclusion Some of the recent SPP programs in developing countries were initiated in response to funding opportunities from the World Bank or other multilateral funding authorities. These targeted efforts have provided technical assistance to the countries for the development of a structure for the SPP program. From past experience it has emerged that a standardized PPA, standardized tariff structure and increased access to long- adjudications in Indonesia is thought to have contributed term financing can be crucial to the success of SPP programs. significantly to the truncation of commercial international If not developed in an impartial, credible, and secure manner, capital flow by undercutting confidence in a fair adjudication PPAs can become extremely contentious between various as became evident during and after the financial crisis stakeholders, leading to the risk of project failure. It is in the interest of any nation that needs additional generation In order to introduce competition into the distribution of capacity to most efficiently mobilize SPP and renewable electricity, thereby reducing the monopsony power of state energy resources. When the objective is to mobilize private distributors, many countries are considering allowing SPPs to capital, a standardized SPP agreement is the most efficient provide power directly to third party consumers. However, if and cost-effective--as well as transparent--mechanism. the retail structure is not based on reasonable cost-based principles, any form of competition, whether that is net References metering, energy banking, or retail sales, the risk of cream- Ferrey, Steven. (2004). Small Power Purchase Agreement Application skimming emerges.2 This occurs when only the most attractive for Renewable Energy Development: Lessons from Five Asian customers, those paying a tariff above the cost of marginal Countries*, World Bank, Washington DC supply, are served directly by the private SPP causing those loads cross-subsidizing the system to be the first to utilize and Ferrey, Steven with Anil Cabraal. (2006). Renewable Power in benefit from these innovations and exit as captive customers. Developing Countries: Winning the War on Global Warming. Pennwell This can further erode system revenues for the utility. This has Publishers. been a major concern in India, where regulatory commissions Hamrin, Jan, Dan Lieberman and Meredith Wingate. (2006). are being urged to increase wheeling tariffs to prevent private Regulator's Handbook on Renewable Energy Programs & Tariffs*. developers taking over the utility's prime customers. Center for Resource Solutions, San Francisco. Great diversity exists in how systems allocate risk of 2 Under net metering, the owner of a self-generation system receives retail nonperformance between seller and buyer, in most cases risk credit for at least a portion of the electricity they generate in excess of their own requirements. In effect the electricity meter counts supply to the grid is disproportionately placed with the seller. The Thai program against demand drawn down from it, effectively banking excess electricity reduces the SPP capacity payment where the producer does production for future credit. Retail sales are where regulations are introduced not deliver, but has no equivalent sanction against the utility to allow power producers to sell electricity directly to consumers. 3 Note that the 2001 Vietnam system design cited in this study is not yet in for failure to take power. In the Vietnam program, by contrast, place, and may well be rewritten before being made operational. Copyright 2006 Photo Credits: © Anil Cabraal Production Team: Marjorie K. Araya, Douglas F. Barnes, and Samantha M. Constant Contact Information: esmap@worldbank.org Steven Ferrey is Professor of Energy and Contract Law at Suffolk University Law School in Boston, MA. Anil Cabraal is Lead Energy Specialist at the Energy and Water Department, Sustainable Development Vice Presidency at the World Bank in Washington DC. This note is based on an investigation conducted in 2003-2004 under the auspices of the World Bank Asia Sustainable and Alternative Energy Program. Further acknowledgements to Enrique Crousillat, Lead Energy Specialist, and Daniel Farchy, a Junior Professional Associate, in the Latin America and Caribbean Region at the World Bank. For more information, please visit us at our website: http://www.esmap.org. *References 1 and 3 can be downloaded from http://www.worldbank.org/retoolkit. The Knowledge Exchange Series is issued by ESMAP to disseminate the results of significant work in the energy sector for the benefit of the development community in the most effective and most accessible way possible. This brochure is printed on recycled paper. http://www.esmap.org