Fuji! CoPY Report No. 517 Issues in Rural Electrification July 24, 1974 Public Utilities Department Not for Public Use Document of the International Bank for Reconstruction and Development International Development Association This report was pfepared for offcial use only by the Bank Group. It may not be published, quoted or cited without Bank Group authorization. The Bank Group does not actept responsibility for the accuracy or competeness of the report. I TABLE OF CONTENTS Page No. SU1DTARY AND CONCLUSIONS ...........................i - xii I. INTRODUCTION .....................................1 II. RURAL ELECTRIFICATION IN DEVELOPING COUNTRIES ...... 3 Extent and Growth of Rural Electrification ......... 3 Technology and Costs. 4 Uses of Electricity .10 The Aims of Rural Electrification, and the Conflicts Presented by Low Financial Returns ............... 12 The Outlook .13 Supplementary Note on the Effects of Oil Price Increases .14 III. PROJECT JUSTIFICATION PROCEDURES .16 (a) The Nature of the Economic Benefits .17 (b) Practical Aspects of Benefit Measurement 19 (c) Forecasting Demand and Benefits .20 (d) Cost-Analysis .25 (e) Cost-Benefit (IER) Calculations .28 (f) The Criteria for Project Acceptability .30 (g) Pricing Policy .......................... 33 (h) Provisions for Low TIncome and Small Business Consumers .34 IV. PROJECT IDENTIFICATION AND PREPARATION ............. 36 (a) Defining Project Areas .36 (b) Identifying Areas for Investment .............. 38 (c) Working Out an Investment Plan. 39 (d) Rural Electrification and Rural Development Plans ...... 40 (e) Uncertainty and the Need for Experimentation and Evaluation .40 (f) Pricing Policy .41 V. MEANS OF FINANCE .42 Financial Goals ...................... ............. 42 Domestic Finance .43 A Comparison of Domestic Sources of Finance .45 International Finance .46 TABLE OF CONTENTS (Cont'd) Page No. VI. TECHNICAL PROBLEMS . ................................ 47 VII. INSTITUTIONAL PROBLEMS . ............................ 49 Tasks and Responsibilities of the Institutions 49 Which Institutional Arrangement is Best? ......... 52 Analysis of Institutional Problems .... ............. 53 VIII. IMPLICATIONS FOR BANK POLICY AND PROCEDURES ........ 54 The Need for Development Assistance from the Bank .. 54 Prospects for Successful Projects .... .............. 54 The Pattern of Lending Operations .... .............. 55 The Content of Lending Operations .... .............. 56 Which Countries? ................................... 58 The Revised Lending Program FY74-78 .... ............ 59 Operational Procedures ............................. 60 Requirements of Bank Staff ......................... 63 ANNEX 1 - REFERENCES ANNEX 2 - COST COMPARISONS OF AUTOGENERATION AND PUBLIC SUPPLIES FROM THE GRID SUMIARY AND CONCLUSIONS The following summary and conclusions provide a self-contained outline of the report. I. iitroduction i. After an introductory review of rural electrification in developing countries, the report discusses three main topics: (1) The prospects for successful investment in rural electrification; (2) Approaches towards investment, as regards: - economic justification; - identification and preparation; - finance: - technical problems, and - institutional problems. (3) Implications for Bank policy and procedures. The report indicates that there is plenty of scope for successful invest- ments in rural electrification, provided they are properly selected and preparedz and it outlines an approach for undertaking them. Future Bank initiatives for providing funds and technical assistance in this field would require no serious revisions of policy and procedures. The report is an outcome of a research study in El Salvador, field trips to four countries, and correspondence with over twenty countries in Africa, Asia, EMENA and Latin America. II. Rural Electrification in Developing Countries ii. Levels of investraent (paragraphs 2.2 to 2.5). Developing countries are putting increasing resources into rural electrification, and the resources countries allocate to it increase with their per capita incomes. Cumulative investment by countries within the Bank's area of operations was about $10 billion by 1971, or 10% of total investrment in electric power. In the next ten years over $10 to $15 billion will probably be invested, and about one quarter of the village-rural population, or 300 million people, will then be receiving service (as compared to about three quarters in urban areas at the present time). - ii - iii. Aims (paragraphs 2.20 to 2.23). The aims of the investments are both social and economic. On the economic side, most countries state that the results are disappointing unless the programs have a productive context; for social reasons, however, countries often extend service to areas of low income and productivity even if the service is not financially self-sufficient for several years. iv. Response (paragraphs 2.15 to 2.19). There are many rural areas which have very little use for'electricity* the level and growth of con- sumption is low and there are few productive uses. However, some areas shfow a surprisingly good and all-round response to rural electrification projects, reflected in high, sustained growth rates of demand from. households, rural commerce, farms and agro-industries (though initial demands are often low). Typically, the annual rate of growth of demand in rural areas is 10 to 2 0% (c.f. 10% per year in urban areas) over 50%- of consumption may be for productive uses (as in urban areas) and average levels of consumption per consumer 1,000 kWh per year (5,000 kWh/year in urban areas). The main productive uses of electricity ln rural areas are for motive power and refrigeration on farms, agro- industries and village copmmerce. Over 20 kinds of non-domestic consumers may sometimes be found in villages, in addition to the farm and agro-industrial consumers outside them. V. The.phases of rural electrification (paragraphs 2.11 to 2.14). M4ost countries have some degree or rural electrification, but are in different phases of developing it, depending on the level of demand for electricit:y. BSefore public electricity supplies f rom tihe main grid are introduced into an area it is very conmwon to find businesses and communities, in all countries, supplying their own electricity from small diesel or hydro-powered generators (autogenerators). The costs of such sources of electricity are high (typically 9 to 21 cents per kWh as compared with 3 cents in urban areas); nevertheless, such enterprises are often profitable. As the demand develops, and as load factors in.prove, public supplies from the grid (which are more capital, but less fuel intensive, and are very expensive for small demands) become cheaper. It is then economical to replace autegeneration in the main dem.and centers by extending public networks to them. Once the main demand centers are connected, the final phase of electrification can begin: many of the smaller demand centers - which may be the smaller villages or the farmt and agro- industrial consumers outside them - are now close to the networks and can be connected at low marginal cost. Broadly speaking-. African countries are -n the early phnases using autogeneration and bringing some public supplies to the larger demand centers; Asian and E3ENA countries are in the midst of bringing public supplies tc the mair. demand centers; while Latin Am,erican countries are concluding th is phase and beginning the final one of marginal extensions to the smaller centers. vi. Overall costs of -public supplies (paragraphs 2.8 to 2.10p 2.22), As compared to urban areas, the costs of serving rural areas are quite high. Typically, on a good project: - iii - Urban Rural Average costs, cents/kWh 3 6 to 8 initially; 4 after 10 years Load factors (% utilization) 50%O 20% initially; 40% in later years Average price, cents/kWh 3 4 Costs are very sensitive to the level and growth of demand, the level of utilization, the distances between demand centers, and the difficulty of terrain. Subtransmission line costs work out at $3,000 to $5,000 per km, depending on the terrain; over a wide range they do not vary with demand, so that average capital costs dlecline as the level of demand increases. Load factor improvements also mean that increases in kWh demand can be met with proportionately less investment in capacity; this too reduces average costs. The initial investments in public supplies may cost about $50,000 per demand center, rising to $200,000 or more for larger demands in remote areas; but marginal extensions to neighboring demand centers may cost as little as only one-tenth of such levels (again reflecting the very large economies of scale in the early phases of electrification). For villages, initial capital costs work out at about $800 per consumer, but drop to about half of this as the number of consumers and demand levels rise; this works otut at $40 to $80 per inhabitant initially, dropping to $20 to $40 or less as demand rises. On an annual basis, capital costs amount to roughly two- thirds of all costs, the other third being fuel, billing, maintenance and administration. vii. Financial returns (paragraphs 2.20 to 2.27). Experience indicates that revenues are low in the early years, even when response is good. There are high, initial fixed costs in constructing the networks and setting up a billing and administration system; and the demand and load factors have to develop from low levels. Prices are kept lower than average costs in the early years in the interests of (a) promoting efficient use of electricity and (b) social aims. Although prices are normally sufficient both to cover the costs of operation and maintenance, and to contribute usefully to invest- ment costs, it takes several years for average costs to decline to the level of average prices charged, unless the rate of growth of demand is very high. (It should be added that the majority of the projects in most countries are less than 10 years old, and have not yet reached this stage.) viii. The outlook (paragraphs 2.24 to 2.27). Where there is a good response to the investment, reflected in an all-round and quick growth of demand. the indication is that the investment is generating a number of useful social and economic benefits, even if financial performance is poor in the early years. One of the first problems of investment analysis in rural electrification is to investigate the nature of these benefits to determine if the investment is justified (see Part III). - Iv - ix. Oil ri ces_ and rural electrification (paragraph 2.28). The rise in oil prices has had particularly large effects on the costs of:- - electricity from diesel powered autogenerators (increases of roughly 50 to 100% depending on use); - kerosene for lighting-7 - motive power from diesel engines used in irrigation and agro--industries (increases of 30 to 60%, depending on use). Areas already electrified are largely insulated from these increases, as will be areas to be electrified, depending on the mix of hydro, coal and oil plant in the svstem. Generally the effects should be to increase the number of households and businesses using electricity (though, of course, the costs of energy will have risern for those who would otherwise have preferred sub- stitutes). The consurer-response data provided in this report relate to periods before the oil price increases; 1972 cost and price data are also used. III. Project Justification x. Least-cost investments (paragraphs 3.37 to 3.41 and Part VI). As with other projects, the search for a least-cost solution is an important aspect of appraisal. Public supplies from the grid should be shown to cost less than (a) autogeneration and (b) alternative network layouts and expansion plans. xi. Economic benefits (paragraDh 3.3 to 3.13). These are all related to the uses to which electricity is put, and increase commensurately with the level and growth of use (or demand). Broadly speaking: - for productive uses, electricity is often a cheaper or superior form of energy for motive power, refrigeration and, for some purposes, neat. this enables the producer to increase profits by cutting costs and expanding output; - for domestic uses the economic benefits are the households' valuations of a superior cua1ity of lighting and ironing, or of new products like fans, refrigeration and television. The importance of village electrification as a means of encouraging people to live in villages rather than cities is also often cited as an economic benefit, Although there is evidence that village populations increase, and that people often migrate out of rural areas to villages, there is no evidence to show that electrification plays an important role in this. For example, countries with the larges. rural electrification programs generally are the most urbanized. Nevertheless. the growth of village and rural economies continues to provide increasing uses of electricity in these areas. - v - xii. Revenues and benefit measurement (paragraphs 2.14 to 3.16). In many areas of investment the revenues, which are a minimum measure of people's monetary valuation of economic benefits, are sufficient to justify projects. This is not often true of rural electrification, though good pricing policies may raise revenues significantly. In economic justification, it is necessary to look beyond the revenues to determine what additional or "surplus" benefits consumers obtain. This can be done straightforwardly for productive uses by costing out the alternative sources of energy and power available. But for domestic uses. estimation of surplus benefits is too difficult on account of large random differences between consumers and the more complicated nature of household decision making. In practice, therefore, cost-benefit analysis of rural electrification projects has to concentrate on the monetary benefits revealed in the revenues plus the surplus benefits in productive uses. If necessary, some consideration can be given to other benefits when discussing unquantifiables during project justification. xiii. Economic rate--of-return (IER) (paragraphs 3.17 to 3.46). The economic rate of return calculation can begin with a forecast of demand and revenues, an estimate of costs, and then make adjustments for shadow prices and surplus benefits in productive uses. xiv, Criterion for accepting roects (paragraphs 3.47 to 3.59). Calculations of the IER concentrate onlv on economic factors and only on what can be quantified. The resulting estimate of the IER riay be sufficient to justify the project. This is particularly true if a strong demand develops from: - a number of villages, not too widely scattered; - farms, agro-industries and rural cormerce: and if attention is paid to keeping costs down and to pricing policy. This occurs if projects are properly identified and prepared, and relate to the development priorities of the areas they are to serve (as discussed in IV). Also, a rural developrmient program. may stimulate the demand and thus raise the IER by providing, for example, additional uses of electricity on farms and agro-industries. Often, however, the KER may not be sufficient to justify the project. and it is then necessary to examine social aims and unquantifi- ables: this may or may not lead to a recomnendation of accepting a project with an IER lower than the opportunity cost of capital. If the IER is sonewhat lower than but close to the cost of canital, the following factors miglht argue for justification: economic benefits that could not be quantified. special concessions for low-income households and snall businesses: and an allowance for the social conseouences of urban-rural imbalance. But a low IER may also signal that denand is still insufficient for the projectJ poo- pricing policies, wrong priorities or simply that the least-cost profect has not been chosen. A judgement will thus be required in such cases or what is an acceptable IER; it will cepend inter alia on the strength of the social arguments and the inportance of tlhe unquantified econoiic benefits. - vi - In general, however, it can be said that the allowances for social arguments and unquantifiables are likely to be smaller than for alternative investments: (a) electricity is not a basic necessity, and water and health projects, for example, deserve a greater social weight: (b) alternative sources of light and energy, though generally inferior, are available even in the poorest regions, and (c) water, education, health and transport projects, for example. arguably have larger unquantifiable benefits. xv. Pricing policy (paragraphs 3.60 to 3.68; 4.23). This requires compromises between economic, social and financial aims. Economic aims require a forward-looking view with prices related to the marginal costs of expanding investment and output, ignoring the large initial sunk costs; the need to encourage people to use electricity also requires a forward-looking view, with a promotional element in tariffs in the early years; and social aims require provisions for small consumers. On the other hand, to provide the resources for an expanding program, and to limit pressures on the public revenue, financial analysis may suggest higher prices for the larger and better off consumers, and above the prices suggested by economic analysis of marginal costs. In practical terms, these various considerations should result in: - prices that are higher in rural than in urban areas; - prices below average costs in the early years on account of the high initial fixed costs, and also of the need to encourage people to use the service; - low prices only for small consumers; - generally, prices which substantially exceed operation and maintenance costs; and - recovery of investment costs in later years, to an extent depending on the financial goals (see paragraph xx). In practice many of these requirements are not being met. Low prices, for example, are often charged for large consumers who are able to pay more; while cost recovery is often undermined by prices which decline unduly with the volume of consumption. Hence thorough attention to pricing policy is an essential part of project preparation and justification. IV. Project Identification and Preparation xvi. Project definition (paragraphs 4.3 to 4.8). The size of the project needs to be defined in terms of electrifying the main demand nodes of a region as a whole. This is because (a) administration, billing and maintenance responsibilities need to be planned on a regional basis; (b) many network components serve not one, but several demand nodes; (c) the region, rather than, say, thte Aillage, is a more appropriate unit for economic analysis and (d) there are to,-; many villages and other demand nodes to be analyzed comprehensively on an individual basis. - vii - xvii. Identification (paragraphs 4.9 to 4.12). Projects selected need to yield satisfactory economic returns according to the criteria discussed above. This occurs where the level and expected growth of the uses to which electricity is put are reasonably high. This depends in turn on the quality of complementary infrastructure; growing productive uses on farms, agro- industries and village commerce- the presence of some large villages or of several villages not too widely scattered, and on the level and growth of wages and living standards. xviii. Electrification plan (paragraphs 4.9 to 4.12). This begins with a strategy of electrifying the larger demand centers, followed by marginal extensions to smaller centers or consumers close to the networks. Several plans need to be considered which examine various rates of network expansion, alternative policies regarding which demand centers to connect, and alterna- tive network designs (so as to determine a least--cost policy). In new areas, the plan needs to begin with a pilot project. xix. Rural development and rural electrification plans (paragraphs 4.18 and 4.19). The effect of rural development plans, insofar as they succeed in raising productivity and incomes in a region and improving rural infra- structure, generally increase the expected economic returns to rural electri- fication because they increase the uses to which electricity is put. A high IER to the rural electrification element also signals that it forms a very useful and productive part of the rural development plan. V. Means of Finance xx. Financial__oals (paragraphs 5.1 and 5.2). The financial charac- teristics of new or expanding programs are such that the initial investment should be financed by some combination of debt, grants, equity or internal funds of the utility which results in a relatively "soft" blend for the capital structure of the program. The reasons for this are: (a) the long gestation period before demand and revenues build up to reasonable levels, and (b) the various economic, promotional and social constraints acting on pricing policy. Often, these factors are made more difficult, and the financial returns worse than they need to be, by ill-structured prices. But even with suitable reforms to pricing policy, funding on soft terms, and especially with long grace periods, is necessary. In practice, the kind of financial goals that might be achieved would evolve with the level and growth of demand: initially (say, during the first 3 or 4 years) revenues could generally be expected to cover operating and main- tenance costs quite comfortably: in the next phase (say, up to 10 years) revenues could additionally be expected to service debt (assuming the soft blend as suggested above); in subsequent years, revenues may generally be sufficient to make an increasing contribution towards the costs of - vaiii - expansion (sufficient in magnitude, on some projects, to meet a good proportion of the capital required, and to give a good internal financial rate of return to the project). But such achievements, as noted earlier, would depend or. the level and growth of demand; reforms to pricing policy; well-prepared and well-run pr-acJt-s; and also on a systematic follow-up on projects to insure that finacala'@ targets are raised as soon as circumstances warrant. As a matter c.f -r'-,ai ple then, it should not be assumed that costs cannot be recovered over thcL l_1e of the investment; but whether or not they are will be determined by the pricing policies of the agencies involved. The appropriate targets need to be reviewed in each case, bearing in mind: (a) the financial needs of she program (b) the effect of the program on the utility's overall firatldal performance, (c) the fiscal strength of the country, and (d) the economic and social objectives of the program. xxi. Sources of finance (paragraphs 5.3 to 5.16). In most cases, a portion of the capital requirements will have to be provided by the govern- ment or the central electricity utility. The profits of the utility cc.n be a substantial source, and using them has the added advantages of giving the utility some autonomv in expanding and running thie program., and rediucing the strain on the public revenue - which might be better used on projects such as water, education and health where funding problems are more severe. Also. there may be some scope for using general price increases on1 electricity to raise the funds for rural electrification, while tax increases may 1a unacceptable. On the other hand, government funding can be used to 'ielp tshe more backward regions, as a lever on the less innovative utilities (if there are several in the country) , and to prormote standardization and regional cooperation. The choice between using government funds or a pubLic -ti lity's profits (which are equivalent from an economic viewpoint) will doper on these institutional factors, the fiscal strength of the country anc o-t the political acceptability of one arrangement or the other. VI. Technnical Problems xxii. Public supplies from the grid consist of high voltage substatio-n's with transformers and medium voltage outlets; medium voltage subtransrniss-lon to the main demand centers in the rural areas; transformation to Low voltages in the main demand centers; and local distribution at low voltages for service. Although this technology is standard, there is plenty of scope for cutting costs through examination of various design alternatives and expansion plans. The reasons are that, as noted in paragraphs (v) and (vi), costs vary enormously with the density and location of demand, economies of scale are strong and there is a wide range of technical options. Among the most important options to examine are: (a) Autogeneration and public supplies. Relative costs, and thus the choice, are very sensitive to demand, location, terrain and utilization, as remarked in (v) and (vi). Autogeneration costs may range from 9 to 20 cents per kWh or more (1972 oil - ix - prices, depending on load factor. The costs of public supplies for the same load are lower at 4 to 18 cents for villages close togethler, but may be two or three times these levels for widely scattered villages. (See Table 2.5, for example.) (b) Standardization of equipment, construction and contract procedures; (c) Lowered design standards. lowered qusality of supply. (d) Alternative network layouts, expansion plans and equipment designs. Some countries have reported substantial cost reductions by thorough attention to these options. VII. Institutional Problems xxiii. The establishrent of good institutions is of course central to the success of the program. Experience in manv countries underlines both the importance and difficulties of training personnel, of promoting the service, and of building up administrative units capable of taking on many of the responsibilities of running the prograr. in rural areas. Failures in local administration in particular - for examiple in billing or in reporting on and dealing with breakdowns in service - may discredit programs in rural areas, and is a problem experienced by many countries. Local administra- tive units generally need strong support and assistance from the main electric utilities, particularly for training and fot financial and techni- cal assistance. But the extent of the support is partlv a matter of policy. Countries have adopted (or are experimenting with) differing, levels of delegated responsibility, with local administration placing: - heavy reliance on the utility, and being responsible only for local billing and reporting on consumer complaints or requests for service: or - mediuim reliance on the utility, and taking on adeditional responsibilities such as promoting service, identifying new areas to be served, and working out schemres with local people to extend service co them; or - low reliance on the utility (as with the cooperazive arrange- ment), and taking on riany more of the financial, technical and adrministrative responsibi1ities. Wfhich of these arrangements is anpropriate de-ends on the country, the available skills, the size and poDulation of its rural areas, and the ioca3 culture. While, for example. cooperatives are reported to be working weLl in some countries, they are not suited to others. Also, different type5 of organization may work equally well' so in practice it is necessary to be flexible about their form. VIII. Implications for the Bank xxiv. The case for Bank assistance (paragraphs 8.1 to 8.10). This rests on three points: (I) The need expressed by developing countries for financial and technical assistance in this field. (2) The Bank's long experience with institution building and operations in the electric power sector. The pro- grams to electrify rural areas are, in an important number of countries, being undertaken by institutions with which the Bank has had highly successful associations for many years. Rural electrification, which has so far formed a small but increasing fraction of their past investments, is a new dimension with new challenges and is likely to form an increasing portion of future programs. In many countries, there is a strong commitment to rural electri- fication and a desire to make it successful. (3) The good prospects for projects which are related to rural development priorities and can be justi- fied. This last point rests, to repeat, on proper care and attention in project selection and preparation, and matching the project design to local needs. xxv. The pattern of lending Erations (paragraphs 8.9 and 8.10). Projects can be part of (a) rural development projects, or (b) projects for the electric power sector. Both have advantages and are worth pursuing: (a) Rural development projects appeal because they promote coordination between sectors and generate large external economies. On the cost side, for example, imDroved roads reduce the costs of construction, maintenance and adminis- tration of the electrification, program. On the benefit side, there are several inter-relationships: Rural development programs raise the level of output in agriculture and agro- industries, and through this the level of rural incomes. On account of increased incomes and improved infrastructure, commercial activity increases. Together, the growth of incomes and the growth of agriculture, agro-industries and commerce, create increasing demands for power and energy. These demands can be met by public supplies from the grid, local autogeneration or substitute sources of power and energy; which of these alter- natives is best will be revealed by cost--benefit calculations. (b) Electric power sector operations appeal because of the many financial, technicai and admiinistrative responsibilities delegated to the electric power sector, as is apparent from Section VII. Also, the sector still needs loans to finance its investrments in generation and transmission capacity and in urban distribution networks. In some countries, as in India and Iran, for example, rural electrification projects may be large enough to justify an operation specifically for this purpose. But in most countries this would not be the case. (See also the discussion on the lending program in (xxviii) below.) - xi - xxvi. Lendin2 conditions (paragraphs 8.11 to 3.15). Most loans would have to be made through the government (if it is a rural development loan) or the utility (if it is a power loan). The reasons for this are that local rural electrification agencies generally require a lot of financial support from the government or the utility so as to establish, expand and run the electrification programs. Even when local agencies are financially and technically strong, there is still a case for channelling aid through the government or the utility in order to promote regional and sectoral balance in the programs and cooperation between regions. Bank or IDA terms would of course apply according to the country; Bank terms night have to be passed on in part as equity, or blended with cheaper money, since the rural project could probably not generate funds to service a conventional Bank loan (though the utility often can). Local cost financing would be required since much of the materials and equipment would be provided domestically. Most loans would also have to make provisions for technical assistance. xxvii. Which countries? (paragraphs 8.17 to 8.21; also see 2.11 to 2.14). There is scope for sorm,e degree of rural electrification in most countries though of course the type and extent of electrification depends on the level of development. As explained in paragraph (v), countries are in varying phases of the rural electrification process. Also, even when areas are already electrified, there is always a continual need for further investment to extend and reinforce networks within these areas (as in cities) to meet growing demands. Our estimates are that the following proportions of the village/rural populations may be served in 10 years time: Africa and some Arab countries - less than one tenth Asia and sone EiNLENA countries - about one quarter Latin American countries - about one third Which countries would receive assistance would depend on the country's overall rural development effort, the claims for Bank help, and willingness to accept Bank conditions and procedures. xxviii. The revised lending program PY74-78 (paragraphs 8.22 and 8.23). (a) Power loans. Roughly $250 million of the revised lending program for electric power ($3,100 million, in 1974 prices, for 90 loans) is allocated to rural electrification. Nearly half of this, however, is absorbed by three projects, two in India ($40 million each in FY75 and 76) and one in Iran (about $20 million in FY75, but tentative). These are specifically for rural electrification. The remaining proposals, which are relatively small, are components of larger loans to the power sector in 10 other countries (Thailand, Nepal and Pakistan. Panama, Honduras, iexico, Bolivia and Brazil; Liberia, Tunisia). These lending programs were drawn up without anv particular focus on rural electrification needs in the member countries, nor did the Bank have suitably developed operational procedures and guidelines for lending for rural electrification. Following the approach outlined in this paper, identification and preparation might be expanded upon during FYs 75 and 76, leading to an increased rural electrification element in the second half of the program. - xi'i - (b) Rural development loans. Roughly 50% of the loans for Agriculture in FYs 74 and 75 might be classified as rural development loans. The rural electrification element in the projects financed by these loans varies con- siderably between countries. Rough indications are that rural electrification may average about 10% of the project costs in Latin Americarn countries, about 5 to 10% in Asia and EMENA ana very little in Africa. In all, between $150 and $300 million of the projected $6,500 million for Agriculture and Rural Development loans might be associated with rural electri-ficatlon, UFeˇ.de -9'''$sent projections. Again, however, with intensification of initiatives to iden:``y and prepare projects for rural development and rural electrificationu these figures might be revised upwards during the second half of the revised lend- ing program. xxix. Operational rocedures (paragraphs 8.24 to 8.31). Most of these would be unchanged, except in degree, in that more work would be required in identification, preparation and appraisal, and uncertainties would be greater. Apart from this, sector survey work (of the electric power or the rural sectors), identification, preparation and appraisal would require only a widening of scope. The proposal is to begin work in rural electrification with thorough surveys, identification and preparation - the ultimate success of operations rests on this. xxx. Monitoring, evaluation, research (paragraphs 8.32 to 8.34). Because of the uncertainties and the widespread lack of information about rural elec- trification (and, indeed, about rural development) it would be desirable (a) to begin with pilot projects in areas without service, but where there are good grounds for introducing it, and (b) to incorporate monitoring and evatua- tion techniques into both regular and pilot projects. This should provide information for planning further expansion and also a basis for improvements in subsequent operations. Problems requiring separate research in'l.ude: (i) the scope for cutting costs; (ii) the factors affecting consumer response; and (iii) the linkages between economic growth in rural areas and the demands stemming from farms, agro-industries and rural commerce. xxxi, Requirements of Bank staff (paragraphs 8.35 to 8.37). The new institutional and technological dimensions of the work would of course ivqpose further demands on staff. While many of the new skills can be acquiired with experience, consideration should be given to recruitment of people with ex- perience in the field, short training courses, and further cooperation (perhaps sharing resources)between Regional Projects Departments. I. INTRODUCTION 1.1 The possibilities for Bank financing of village electrification projects were first outlined in the Sector Working Paper on Electric Power. Since then, a number of initiatives have been taken to improve our knowledge in this field. Inquiries were made to over 20 countries regarding the extent of their programs and future plans; a major research study has been undertaken in El Salvador. and is nearing completion; there have been brief field trips by staff members to three other Central American countries, and also to India, specifically to look at village electrification programs; pilot village electrification projects were financed in Ecuador on the condition that the socio-economic impact of these projects was monitored over tine, and finally, connections have been established between the Bank and other institutions undertaking research in Turkey, Tunisia, Costa Rica, Colombia and the Philippines. 1.2 A number of countries have also formally approached the Bank for development assistance in this field, including Iran, Oman- India and Thailand. 1.3 The time now seems appropriate to report on our findings to date on rural electrification. A number of diverse questions have been raised since previous reports (listed in Annex 1) were issued. For example: What is the extent of rural electrification in developing countries? and what are the Prospects for successful investment? Is the economic-rate-of-return calculation a suitable basis for project appraisal in low income areas? and if so. how do we estimate economic costs and benefits? How do we identify good projects? Which institutional and financial arrangements work best? What are the technical problems? Finally, what should the Bank do? 1.4 This report is written in response to such questions. It begins with an introductory discussion on:- II. Rural electrification in developing countries - the extent, costs and uses of rural electrifica- tion, the aims, and the outlook for investment, then presents our current thinking on apnroaches towards investment, as regards:- III. Econormic justification procedures; IV. Project identification; V. Means of finance VI. Technical Problems; VII. Institutional problems, and concludes with a discussion of:- VIII. Implications for Bank Policy and Procedures. - 2 - 1.5 We now stand at the end of elementary inquiries to various countries and institutions, and at the end of limited field experience in India, Ecuador and Central America (including the research study in El Salvador, which is now being written up). Our evaluation of this material, which forms the basis of the present report, shows good grounds for the belief that useful and productive investments can be made; and we have proposed methods of under- taking them. So we also stand, if these proposals are accepted, at the begin- ning of project identification and appraisal work backed up by further research and evaluation. - 3 - II. RURAL ELECTRIFICATION IN DLVELOPING COUNTRIES 2.1 Rural electrification in developing countries is intended to serve both economic and social aims. To understand these aim.s and how they might best be achieved, it is first useful to know something about the extent and growth of village electrification in developing countries, the costs and the uses to which electricity is put: these matters are first discussed below. Extent and Growth of Rural Electrification 2.2 Countries are putting increasing resources into rural electrifica- tion. As one might expect, the resources countries allocate to it increase with their per capita incomes, with the result that rural electrification is more extensive in Latin America than in Asia. and more extensive in Asia than in Africa:- Table 2.1 Population in 1971 /1 Village/Rural Population /2 /3 m millions - _ Served 1971 Region Total _illage/9 Rural /2 Millions _ Latin America 282 140 (50%) 32 23% Selected EMENA Countries / 143 87 (61%) 45 15% Asia 934 700 (75%) 105 15% Africa 182 165 (90%) 7 4% 1789 1300 73% 187 14% Source: Electrification data are compiled from miscellaneous documents and correspondenc- with the countries and are not official statistics. Population data are from UN documents. /1 Population figures refer to the whole region, except EIfENA (see 4). /2 The definitions of "village" and "rural"! varv between countries. Generally, villages are conglomerations of 5,000 to 10,0nno people or less; rural refers to low density populations outside the villag,es, often living in clusters close to large farms. /3 Electrification dat,a no. available for each country and the percentages should be taken as typ.ial fevels £or countries in the region, about wnic there may be considerablo variance, /4 Cvprus, Egypt, Iran, Saudi Arabia. Tunisia, Algeria, Mlorocco, Turkey. -4- 2.3 Total cumulative investment in rural electrification by developing countries within the Bank's area of operations was about $10 billion by 1971, or about 10% of total investment in the electric power sector. This figure includes generation, transmission and distribution which in the early stages of a project breakdown roughly as follows: Investment in Generation and Transmission Capacity 30% Investment in SuWb-Transmission and Distribution Networks 70% (Costs are discussed in more detail in paragraphs 2.6 et. seq.). 2.4 Future investment is likely to be much larger than in the past. We have formally questioned over 20 countries about their planned programs and have received information on several others. According to this informa- tion the rate of investment is generally likely to be higher than in the past and to form an increasing proportion of total investment. Some countries, including Iran, Egypt, Turkey and Thailand have announced major new initiatives, while others, in particular India and most of Latin America, are to continue and often expand on theirs. 2.5 The information is not good enough for a precise forecast of the level of investment, nor of the population likely to be affected. But it does seen that total new investment is likely to exceed $10-$15 billion in the next ten years (which is over 10% of total nei investment), bringing supplies within the reach of 300 million more people, up to about half of these people, comprising 15% of the village/rural population, may be able to afford service. Thus a total of. say, one quarter of the village/rural population would be served in ten years time (as compared to about three quarters at the present time in urbarn areas). Technolos.y and Costs 2.6 Electricity is introduced into rural areas in three ways, through: (1) Autogenerators serving single consumers, (2) Autogenerators serving several consumers on a local network (3) Public supplies from the main grid system. The term autogeneration refers to isolated generators powered by diesel engines, small steam turbines, or micro-hnydro turbines. They range in size from about 5 kW, sufficient to meet minor needs of, for example, refrigeration and lighting on a farm, to over 1503 kW, sufficient to meet the motive power needs of a large sugar processing plant. Public supplies from the main grid conslst of medium volta-e (about 40 KV!) subtransmission links to transmit electricity from the grid to the larger demand centers of an area, plus low volta,oe distribution within the demand centers. 2.7 Investment in rural electrification is mostly in public supplies from the main grid: at a guess, over 80% of rural electrification is supplied in this way. For small loads in remote localities, however, utilities often find that it is cheaper to meet electricity needs by installing small auto- generators. In the absence of public supplies, shops, farms and agro- industries will often install their own autogenerators to meet their own particular needs in lighting, refrigeration, heating and motive power; often, they also supply a few local consumers and provide public lighting if such demands occur when their equipment would otherwise be unused. Autogeneration, serving single or several consumers, is very common in rural areas. 2.8 Evidently, the utility must often make a decision whether to provide electricity from the grid or from local autogenerators. This decision depends on a number of factors, including the expected level and growth of demand, the expected utilization of the investment, the distance from the main net- work and the difficulty of terrain (which can affect costs enormously). The following table displays some typical cost data at two levels of demand: - 6- Table 2.2 Typical Costs of Public Supplies and Autogeneration (1972 data) Autogeneration Supply from Grid /1 Capacity of Project kW 50 25 50 25 Consumers Served 140 70 140 70 Capital Costs $ 34,000 25,000 56,000 38,000 Fuel, Operation and Maintenance i/kVWh 6 6 0.5 0.5 Billing' Admin. etc. $/year 2,000 1,000 2,000 1,000 Source: See Annex 2. /1 Average length of subtransmission line per village = 4 km in this case. Note the economies of scale in capital costs. The 50 kW and 25 kW projects could serve fully developed loads in villages of about 2,000 and 1,000 people respectively. Demands from farms and agro-industries outside the village may add anything from 20 kW to 1000 kW or more to total capacity demands. Capital costs, it can be seen, range from $400 to $550 per consumer in the above case of supplies from the grid (or $40 to $55 per capita in the village served). However, for large villages of five to ten thousand people, these costs may drop to $200 per consumer ($20 per capita) or less. 2.9 The capital costs of supplies from the grid are much higher than those of autogeneration, but the fuel, oDeration and maintenance costs are much less. When the utilization of the project is high, this strongly favors the more-capital, less-fuel intensive investment in supplies from the grid. Taking the 50 kW projects, the relative annual costs of the two projects at various levels of utilization are: - 7 - Table 2.3 /1 Autogeneration Supplies from Grid Load Factor 10% 25% 50% 10% 25% 50% Annual Capital Costs $4,500 4,500 4,500 5,600 5,600 5,000 Fuel, 0 & M. $2,600 6,600 13,200 200 500 1,000 Billing & Admin. $2,0 00 2,000 O 21OO 2,000 2,000 Total $9,100 13,100 19,700 7,800 8,100 8,600 Average, 4/KWh 21 12 9 18 7 4 /1 See Annex 2 for calculations. 2.10 The fuel bill heavily penalizes autogeneration. In general, it compares well with public supplies from the grid only at low levels of utilization - except when the demands are remote. This last point is import- ant. since to extend a subtransmission link by 25 km to an isolated demand may cost around $100,000 ($10,000 per year at 10% annuity), with the follow- ing kinds of effect on the capital costs of public supplies: Table 2.4 Capacity of Scheme 50 kW 50 kw Distance from Grid, 4 km* 29 km Generation and Transmission Costs. $ 24,000 24,000 Subtransmission Costs, $ 18,000 118,000 Local Distribution, $ 141900 14,000 Total, $ 56,000 156,000 Annual Capital Costs, $ 5,600 15,600 Source: See Annex 2. *The 4 km case corresponds to the data in T ables 2.2 and 2.3. Such cost increases are sufficient to make autogeneration the better alter- native for all but high load factor demands. To see this it is useful to - 8 - consider the effect of distance on the cost comparisons previously presented in Table 2.3. Table 2.5 Average Costs of Different Schemes (cents/KWh) Supplies From Grid Load Factor 4 km 29 km Autogeneration 10% 18 40 21 25% 7 17 12 50% 4 8 9 (Note that average costs in urban areas are about 3 cents per KWh). Obviously, it is extravagant to extend networks to meet small demands in areas remote from the grid. However, the same subtransmission networks can be used to meet much larger demands, so tnat if a good demand develops from farms, agro- industries and several villages, average costs decline very quickly to about 4 to 8 cents per kWh. 2.11 It is now possible to explain how electrification schemes evolve in rural areas. It is a fascinating process which has three or four phases. In the initial phase, only a few scattered, isolated businesses may need and can afford electricity. They obtain it by installing their own generators and it is common to find them used for such purposes as refrigerating milk on farms, providing light and heat to egg and chicken farms, for refrigera- tion and light in shops, for refrigeration on a large scale in slaughter- houses, or for the motive power needs of large agro-industries such as sugar processing. During this phase, the motive power needs of small farms and businesses are generally met directly by animals or by small diesel engines. In the second phase, a small collective demand for electricity may develop from several households and businesses to meet needs like public lighting, private lighting, and further demands from large and small businesses and farms. During this phase, small local networks ("micro-grids") are often extended from local autogenerators installed through public or private initia- tive. If the collective demand becomes large enough, and offers good utiliza- tion of equipment, the second phase may be by-passed or lead to the third phase - fully-fledged electrification from the grid system. The "micro-grids" are taken over and extended, subtransmiassion links replace the old auto- generators, which are scrapped or used elsewhere. and small and large businesses begin to turn to electricity as a source of motive power in preference to animals or diesel engines (often creating a useful second-hand market in the latter), and may even introduce some new processes as a result. 2.12 During this third phase, a number of major demand centers can be identified in a region, stemming from the larger villages and the farms - 9 - and agro-industries which lie outside them. A network design plan has to be worked out, to route the network so as to economize on the heavy costs of subtransmission and distribution lines. Once the networks have been established, a fourth and final phase follows quite obviously. Centers of low demand are now close to the networks and can be cornected up at very low marginal cost. Whereas the initial thrust into a region may cost $50,000 to $200,000 per demand center, secondary thrusts into areas of low denand may now cost only $5,000 to $20,000. (Many areas of low demand remain remote from the main networks, and for this reason it is never worth electrifying them from the main grid; even in N. America and Europe, where rural electrification programs were substantially completed 20 years ago, many areas continue to be served by local autogenerators.) 2.13 Practically every country has some degree of rural electrification, but different countries are in different phases. Broadly speaking, African countries are largely in the first phase of private generation, but are gradually beginning the second and third phases of meeting the larger col- lective demands from the grid or local autogenerators. Asian and ENENA countries are mostly in the midst of the third phase, of connecting the main demand centers to the grid. Most Latin American countries are in the fourth and final phase, of connecting low demand centers to networks already established in rural areas. 2.14 As remarked earlier, the term rural electrification is normally associated with electrification from the grid system, that is, with the third and fourth phases of electrification. The relative magnitudes of these phases may be gauged from Table 2.1 and also from the following statistics for Mexico, which show that over 50% of the rural population live in areas of low demand: Table 2.6 Population Distribution of Villa ges in Mexico Population of No. of Population Village Villages No. _____ Remarks Less than 100 55,376 1,823,900 7%) ) Low Demand Areas, 25% 100 - 499 28,494 6,944,500 26%) Electrified ) 500 - 999 7,346 5,091,900 19%) 1000 - 4999 5,207 9,681,800 37%) Medium-to-High Demand ) Areas, 80% Electrified 5000 - 9999 416 2,g94,300 11%) 96,839 26,436,400 100% Source: Supplied by Comision Federal de Electricidad. - 10 - Similar distributions in the size of village, and in the areas of high and low demand, can be observed in most countries. (In the Cameroons, much emphasis is placed on forming larger-sized villages before providing elec- tricity and other infrastructure.) Uses of Electri city 2.15 There is a surprisingly wide range of uses of electricity in rural areas, for both household and productive needs. Generally speaking, the total demand stemming from productive needs is higher than that stemming from households, as can be seen from the following table: Table 2.7 Percentage Distribution of Electricity Demand in Urban and Rural Areas for Various Countries (1971 data) Rural Areas Urban Productive Demands Domestic Productive Domestic Agro- Commercial- Farms Industry Community Total Total Total Total Ethiopia - - - 55% 45% 44% 56% Tanzania - - - 75% 25% 80% 20% Chile 9 26 32 67% 33% n.a. n.a. Costa Rica - - - 70% 30% 43% 57% Nicaragua 15 ..... 45 60% 40% 30% 70% El Salvador - - - 45% 55% 60% 40% India 59 ..... 21 ....... 80% 20% 89% 11% Pakistan 23 ..... 17 ....... 40% 60% 90% 10% Taiwan 10 .....16 ....... 26% 74% 80% 20% Sources: Rural data: Correspondence and miscellaneous documents provided by the countries. Urban data: From similar sources and Bank Appraisal Reports. These data, which refer to typical situations, understate the productive uses since many small business demands creep in under domestic and general tariffs. - 11 - 2.16 The relative demands from households and producers change markedly from one area to another. Often, the demand in an area may be dominated by one large consumer, as with irrigation or cotton processing; and though some areas may use electricity for a wide range of productive purposes, others may use it for little more than domestic and public lighting. 2.17 In addition to the various agro-industrial demands which develop from the local agriculture, it is not unconmon to find demands developing from 20 or more commercial activities in a single village, such as for light and refrigeration in shops and services, and for light, heat and motive power in workshops (carpentry, welding and repairshops, for example). Community demands may include public lighting and demands from the local church, a water pump, a police station, school and health centers. Growth in local agriculture and wages, and improvements in complementary infrastructure, can thus generate all kinds of uses for electricity. 2.18 Consumption levels in rural areas are of course much less than in urban areas. But again it is surprising that there is often a strong response to rural electrification from consumers, reflected in high, sustained rates of growth of demand once an area is electrified: Table 2.8 Level and Growth of Consumer Demand in Urban and Rural Areas. Estimates for Various Countries (1jj7) /1 Demand per Consumer, kWh/y ear/2 Yearly Rate of Growth of Demand Rural Urban Rural Urban India 1000 n.a. 15% 10% Thailand 200 4000 12 - 20% 22% Ethiopia 800 2000 40% 15% Costa Rica 1900 6000 20% 10% El Salvador 1000 4000 20% 10% Sources: Rural data are estimates based on various documents and project reports provided by the countries. Urban data inferred from Sector Working Paper on Electric Power and Bank Appraisal Reports. /1 Data purely illustrative, not average, for the country. /2 Rural data for selected areas; Urban data for capital cities, except for Thailand, which is an average. - 12 - Demand per consumer varies between areas largely on account of variations in the type of productive uses, and also with the age of the project on account of the growth of demand per consumer. Irrigation pumpsets, for example, consume about 3000 kWh per year in India, while a large agro-industry may consume 100,000 kWh per year or more. 2.19 To sum up, there is often a surprisingly strong response to rural electrification projects. This is reflected in high rates of growth of demand, though they start from very low initial levels. This response stems from a wide range of uses of electricity. The Aims of Rural Electrification, and the Conflicts Presented by Low Financial Returns 2.20 Having discussed the demand side and the supply side, it is now useful to put the two together and discuss the net returns - social, economic and financial - that are expected from the investments. 2.21 Most countries stress the social importance of their rural electri- fication programs, in particular the need to raise the standard of living in rural areas and to provide a counterweight to excessive urbanization. But many of the returns, as illustrated above, are of economic importance since they stem from the voluntary demands of communities, houses and businesses for a cheaper or superior form of energy. Indeed, many countries state that unless the programs are set in an economic context, the results are disappoint- ing. For this reason, they stress the importance of both economic and social aims. 2.22 Where the economic content of rural electrification programs is large, it may seem reasonable to expect satisfactory financial returns - electricity increases energy use in the area, often reduces energy costs, and is far superior in quality to the alternatives. But there are three reasons why this is not the case, at least for a period of years: a) the high initial investment costs associated with low density populations, often remote from the main networks; b) low initial demand levels in relation to the capacity of the networks (which have large indivisibilities); it may take over 10 years for demand to develop fully in relation to capacity, c) the arguments for keeping tariffs low in relation to costs to meet the social aims of cheap energy to low income house- holds and small businesses. - 13 - The following figures illustrate tnese points: Table 2.9 Comparative Data for Urban and Rural Areas Urban Rural Consumption: kWh/consumer/year 4,000 600* Load Factor 50% 20%* Investment in subtransnission and distribution per consu1mer (approx.) $100 $300 Average costs, cents/kWh (approx.) 2.5 6 to 8* Average price, cents/kWh (approx.) 2.8 4 Mean per capita incomes $800 $125 Source: El Salvador Study. * Figures refer to typical initial conditions. The initial average costs are over two or three tines those of urban areas, and though average prices are nearly 50% higher, this is not of course suf- ficient to make up the deficit. As both load factors and the level of demand rise, average costs decline very quickly but the possible financial gains from this are often undermined by the system of declining block tariffs widely adopted in many countries throughout the world. 2.23 Financial assistance is generally considered to be necessary, there- fore, at least in the early years. The assistance takes several forms, including low interest capital from internal or international sources, special deprecia- tion provisions, preferential tariffs and contributions in kind from the rural areas, such as unpaid labor. (It is also interesting to note that when it was desired to promote rural electrification in the USA in the 1930's, it was considered necessary to finance it on concessionary terms in accordance with the Rural Electrification Act of 1936.) The Outlook 2.24 So long as the investment programs are expanding, the fact is that continued financial assistance is required. Accepting this, however, three other facts are becoming clear: - 14 - a) In many electrified areas in all parts of the world the financial returns are improving markedly over time, though from very low initial levels. One reason is that there are substantial economies of scale as demand and consumer density increase. b) Although existing projects are in the 'best' areas, extensions to 'worse' areas in the same region need not undermine overall financial or economic performance; the 'best' areas have absorbed the brunt of the high initial costs and, as explained earlier, subsequent extensions cost much less. c) Financial performance can often be improved significantly by appropriate attention to pricing policy. Low prices often exist in places where they are unnecessary on account of ill-structured tariffs - the consumption of large farms and agro-industries is often subsidized, for example, even though they are able and willing to pay more for the service. 2.25 Taking a long perspective, therefore, and a constructive attitude towards tariff policy, it seems there are prospects both for continued expan- sion and improved financial performance. 2.26 Nevertheless, the prospects or low financial returns in the initial years, and the argumLents for subsidizing small businesses and low income households, remove a simple criterion for project selection based on financial profitability. A broader basis for project selection is called for and is being sought by many countries and institutions. 2.27 Hence there are serious difficulties with project justification and identification, as there are, of course, serious difficulties with finance, institutional development and zechnical choice. None of these seem insur- mountable however, as will be apparent from the following analysis of them. pj,em try Note on the Effects of Oil Price Increases 2.28 The recent rise in oil prices has had particularly large effects on the costs of:- - electricity from diesel powered autogenerators (increases of roughly 50 to 100% depending on use); - kerosene lighting; - motive power from diesel engines used in irrigation and agro- industries (increases oL 30 to 60%, depending on use). - 15 - Areas already electrified are largely insulated fron these increases, as will be areas to be electrified, depending on the mix of hydro, coal and oil plant in the systen. Generally the effects should be to increase the number of households and businesses using electricity (though, of course, the costs of energy will have risen for those who would otherwise have preferred substitutes). The consumer-response data provided in this report relate to periods before the oil price increases; 1972 cost and price data are also used. - 15 - III. PROJECT JUSTIFICATION PROCEDURES 3.1 In the social and economic justification of rural electrification projects, it is useful to begin with a study of economic returns and then work social factors into the analysis. Confusion between social and economic aims is then avoided and trade--offs (to the extent that they occur) can be examined. This approach is followed below. The starting point is a discus- sion to clarify: a) The nature of the (econonic) benefits. This is followed by a discussion of: b) Practical aspects of benefit measurement; c) forecasting demand and benefits; d) cost analysis; and e) cost-benefit (economic rate-of-return) calculations. This covers the economic side. It will be seen that it is a traditional analysis of forecasting benefits and comparing them with the costs of the (least-cost) project in an economic rate-of-return calculation. The social side is then brought into the picture in the discussion of: f) Criteria for project acceptability. Finally, if the social and economic aims are to be m.et in practice, it is necessary to attend to the following, which are also discussed: g) Pricing policy, h) provisions for low income families and small businesses. 3.2 There are two main purposes, it should be noted, of the economic analysis of costs and benefits. One is the usual one of providing a consistent guideline for an efficient allocation of investments between the various sectors in urban and rura'l areas, and some indication, therefore, of economic priorities. The other is to provide some measure of the economic costs of investments when social aims are strong, economic returns low and conflicts arise. (Conflicts do not always arise, however, and some investments are socially and economically desirable.) Economic rate-of-return calculations can be very helpful for these purposes, and are adopted here. They only break down when social arguments are overwhelmingly strong -- as with water supply projects in drought areas. But this, in our experience, is not the case for rural electrification. - 17 - (a) The Nature of the Economic Benefits 3.3 There is a very close relationship between the level of use of electricity and the level of benefits derived from it, in the sense that when use is low, only a few people may be benefiting marginally from the service, and conversely when use is high. The benefits most frequently quoted, and which are all related to use, are that electricity: (i) increases productivity and output in rural areas through reducing the costs of energy and thus increasing the profitability and output of farms, agro-industries and commerce, (ii) adds to the standard of living in village homes and com- munities; and, on account of (i) and (ii): (iii) helps stem migration from rural areas to cities -- the problem of urban--rural balance. (The third is related to use because to the extent that people and businesses are attracted to rural areas by electricity, they will use it.) 3.A There is, in fact, little hard evidence as to the effect of elec- tricity on migration. Our investigations have revealed, as one might expect, that older people migrate mainly in search of jobs, while the younger ones migrate in search of jobs and education or to begin families. Also, the countries with the largest rural electrification programs generally are the most urbanized (see Table 2.1 for example). Nevertheless, despite migration to cities, and whatever its causes, tha Pennomic output of farms, agro-industries and rural commerce is increasing, large numbers of villages are increasing in population and are in a process of modernization. The result is that the demands for electricity, and the range of uses to which it is put, are also increasing. Hence there are positive benefits to look for, even if electricity by itself has little or no effect on stemming migration to cities. 3.6 In monetary terms, and ignoring complications about shadow prices and income distribution for the moment, the benefits of electricity to families and businesses are to be measured by the amount of the family or business income they are prepared to allocate to it. This is the monetary value placed by individuals on the service. Small businesses and low income families, in particular, make this allocation decision very carefully. The decision is made in the light of the many complex and varied circumstances of the family or business and of the alternative uses of this portion of family or business income. - 18 - 3.7 The estimation of benefits, in monetary terms, can begin by adding up these monetary valuations over all family and business consumers. For practical purposes it is useful to divide the monetary benefits into two parts: - actual revenues (the "direct consumer benefits") - the surplus monetary benefits ("consumers' surplus benefits") where the latter simply reflect the point that people generally do value service by more than the amount they may be asked to pay for it. 3.8 Revenue estimation presents no new problems apart from the dif- ficulties of forecasting; but what is the nature of the surplus benefits? and how can they be estimated? 3.9 For farms, agro-industries and commerce, there is normally a sub- stitute for publicly supplied electricity in the form of: - Autogenerators for large agro-industries; - diesel engines for many purposes, including irrigation, corn grinding, and motive power in small agro-industries; - often, animal power; - small autogenerators for refrigeration on farms; - kerosene refrigerators, etc. The surplus benefits are the net advantages of electricity over these alter- natives. In many activities tile same output can be produced by the substitute, so the net advantages are cost-savings. This is commonly the case, for example, with uses of electricity for motive power, as in irrigation pumping and corn grinding, where diesel engines can do the same job, though often at a higher cost. It is also the case for many large farms and agro- industries which can also produce the same output using diesel powered auto- generators, though again, often at a higher cost. 3.10 In other activities, however, electricity is far cheaper or of higher quality, and extra output also results; the net increase in the profits of the activity are the benefits. This is often the case, for example, for small businesses using electricity for motive power or refrigeration. The alternatives (including the associated capital and maintenance costs) are often too expensive or unreliable, and the business cannot make a profit with them. So new business activities can and do spring up if costs are cut sufficiently for them to become profitable. Refrigeration in shops and corn grinding are common examples in Central America. - 19 - 3.11 By taking a representative sample of such activities, covering different types and sizes, it is possible to estimate a typical ratio of surplus benefits to actual amounts paid for electricity. From these ratios, and knowing the number of different types and sizes of business consumer, it is then possible to calculate total surplus benefits directly. 1/ Clearly the level of these benefits rises commensurately with the number and total demand of these consumers. 3.12 On the household side, the surplus benefits of some uses, such as for lighting and ironing, are also the net advantages over substitutes; while the benefits of others, such as refrigeration and television, are generally the household's valuation of a new product, practical substitutes not being readily available. As remarked earlier, the total monetary benefits would be the amount of income the households are prepared to allocate to such goods. 3.13 It is, however, exceptionally difficult to estimate the monetary value of surplus benefits to households, even with well-conceived sample surveys and elaborate econometric analysis. The problems of randomness, of specifying a correct algebraic model of household behavior, and of identify- ing the separate influences on household behavior, have so far precluded reliable estimation. What we do know, however, is that when service is benefiting many households, there will be a strong demand for it, reflected in quite good revenues (the direct benefits). So it is still revealing to look at the direct benefits even if the surplus benefits cannot be estimated -- though the point that such monetary benefits are omitted from the economic rate of return calculations means that tolerance is needed for projects with returns somewhat below the opportunity cost of capital (see paragraphs 3.47 et.seq.). (b) Practical Aspects of Benefit Measurement 3.14 In practice, therefore, it will be necessary to confine cost- benefit analysis to what can be measured, and to supplement this as necessary by descriptive analysis. The benefits which can be measured will generally be: - the direct benefits to households, reflected in the revenues; - the direct benefits to farms, agro-industries and connerce, again reflected in the revenues; 1/ The forthcoming research study in El Salvador will provide illustrations of such calculations. - 20 - - the surplus benefits to farms, agro-industries, and commerce, reflected in the net effects on profits and output of electricity to these activities. Descriptive analysis of households, and of household demand, can be couched in terms of indications of living standards, the number and percentage of the people demanding service and what they are likely to use it for. Analysis of the growth of the area, its history, whether people are likely to move into it and/or remain there are also important. 3.15 Where there is a strong demand for "productive uses" the above basis of benefit estimation will be more than sufficient to justify a good project. The revenues from farms and agro-industries should boost the proj- ect, unless tariffs are low. Counting in the surplus benefits to productive uses will boost justification further. If, for example, 80%OZ of demand is from productive uses, and surplus benefits are (typically) 50%, then benefits are 120% of revenues not counting household demand, and 140% in total. This can make a large difference in rate-of-return calculations. 3.16 Where, on the other hand, there is a small demand for productive uses, coupled with low tariffs and a low level of demand from households, justification will be difficult -- as perhaps it should be in these situations. (c) Forecasting Demand and Benefits 3.17 Demand forecasting in areas hitherto without service involves more uncertainty than in areas with service, on account of information shortages; it requires, therefore,-a good-deal of judgment and guesswork. This points to the importance of flexibility in project design and investment planning, as discussed in VI; and to the need to collate information from several sources and to experiment, as discussed below. (i) Evidence from Other Prolects 3.18 The most concrete basis for a forecast is provided by projects already functioning in other areas of the country. Most countries in Latin America, EMENA, and Asia, and several in Africa have had pilot projects and sometimes extensive programs for several years. The obvious thing to do is to examine how both domestic and non--domestic consuners have responded to these projects; things to look at are: - The growth in the number consumers; - the growth in consumption per consumer; - the types of consumer, including a breakdown by large and small, irrigation, various agro-industries, various levels of household consumption, etc.; - the changes in load factor. and, if possible, - 21 - - the kinds of uses to which electricity is put. This information should not be difficult to obtain in a well-run program; if it is, serious questions should be raised about whether projects are being monitored properly and about the systematic keeping of records. 3.19 An elementary understanding of the areas in which these projects are located is also necessary in order to understand the factors which affect the projects returns. Often, a look at the living conditions in an area, its infrastructure and the growth of local agriculture, agro-industries, commerce and wages may be sufficient for this purpose. 3.20 In building up forecasts from experience with other projects, it is of course desirable to take areas that are comparable with the area under consideration -- comparable population and income levels, and comparable with respect to local infrastructure, housing quality, and levels of activity in agriculture, agro-industries and commerce; or more generally, areas which are comparable in levels of development and size. 3.21 Such coincidences in levels of development and size do not always occur even within broad limits. However, to obtain an impression of how levels of development and size interact with the project, it is a good idea to look at how projects have functioned in larger and smaller areas, and in both more and less developed areas. This will provide a range to the forecasts. (ii) Evidence from Neighborinj Countries 3.22 If such evidence is scarce or is not available within the country, either because there are no pilot projects or because they are new and it is too early to fonn a judgment, the experience of neighboring countries is often highly relevant (indeed one can often go further afield than this). Again, the aim is to see how people and businesses have responded to projects in different situations. (iii) The Use of Pilot Projects 3.23 Where there is absolutely no local precedent for the forecast, it is of course difficult to justify a full scale program. The case for pilot projects and the use of these as a base for forecasting, as well as experience in project design and management, is a strong one. It should be noted, too, that pilot projects can often be provided out of a very small fraction of a utility's budget. Typically about 5 villages can be electrified for $250,000 depending on their size and location. (iv) Evidence from Low-Income Areas of Cities 3.24 As regards household demand, it is often the case that many house- holds in villages are no poorer than many electrified households in low income areas of cities. Analysis of the latter may give some indication of - 22 - likely response from households in villages (even though the costs of serving villages are higher). (v) Economic and Social Analysis of the Area 3.25 Any evidence carried over from the experience in other localities and countries must, of course, be supplemented by local inquiries. On the non--domestic side, items to look at are: - the type and growth of local agriculture; - the development of local agro-industries; - the extent of local commerce (strong correlations here with population of area); - quality of local infrastructure such as roads, schools, water and health centers; - any government plans on projects for the area. Apart from its importance for forecasting, this information is important for determining priorities. For this reason, it is perhaps best provided by regional surveys of the rural sector. 3.26 On the domestic side, items to look at are: - family income data (if available or ascertainable); - quality of housing; - history of the area; - migration in the area. There are some empirical points to be made about each of these items. 3.27 The main factor which determines household demand is household income. Electrical appliances and the costs of running then can be expensive for a low income family, even if large subsidies are offered on electricity costs. The following table illustrates these points. - 23 - Table 3.1 Relation Between Household Income and Expenditure on Electricity /1 Per Annual COSTS: US$ Capita Cost + Connec- Appli- Elec- Annual Family Family Family Appliance tion /2 ances tricity Total /3 Income /4 Income /4 Income Lights (L) 13 2 6 9 430 72/6 2% L+Iron (I) 18 15 8 15 550 90 3% L+I+Refrig. (R) 18 270 22 81 850 140 10% /5 L+I+TV 18 240 10 62 1,000 170 6% L+I+R+TV 18 600 40 160 2,300 380 7% /5 /1 Source: El Salvador Study. /2 Includes housewqiring. /3 Using 20% annuity on connections and appliances. /4 Group means. Family size of 6 taken in computing per capita family incomes. /5 Refrigerator sales often used to augment family income by unascertainable amounts; family income is probably underestimated. /6 The actual threshold income, at which families began to consume, was about $50 per capita. 3.28 Family income and costs are not the sole determinants of course. A large proportion of fanilies in rural areas often can afford electricity but nevertheless do not request it. One reason for this is that there is a high propensity for fanilies to move between regions in search of jobs, the onportunities for which may vary seasonally in the case of agriculture and agro-industries. Illiteracy, fragmentation of the family unit, a lack of incentive to develop the home, are also important. Generally, though there are exceptions, it is those families which seek better housing who are also likely to seek electricity; some kind of solidity or permanence in house structure is an important indicator of the likelihood of demand. 3.29 Turning to the history of the area, this too can provide indica- tions of the likelihood of demand. Mlany villages, for example, have long (if scantily recorded) histories, with long traditions in commerce and socialization; for this reason they can and do form points for growth. 3.30 Related to this is the possibility of people migrating into an area. Even in the presence of migration from rural areas to cities, rural - 24 - populations often do not decline. Furthermore, there is evidence from several countries to show that villages are often able to attract people out of rural areas on a par with cities. (Nearly all the villages we have studied in El Salvador also showed a general increase in the number of homes.) Evidence of this kind is exceptionally important in indicating people's regard for the future of the village; and it also indicates whether demand can be ex- pected to grow. 3.31 This list of items for economic analysis is not, of course, ex- haustive. Nor is such information often available. But analysis of what is known about the development of the area will add substance to the fore- casts decided upon. (vi) Evidence on Energy Use 3.32 Further evidence on the potential demand for electricity can be obtained by a sample study of energy use by households and businesses in the area. Items to concentrate on are: - types, costs, and extent of motive power (generally animal and diesel) for various purposes: - sources and costs of refrigeration; - sources and costs of light in businesses and horaes; - sources and costs of heating for various purposes. This information is not only useful for forecasting, but also for benefit calculations. Although it is not often available, it is not too difficult or costly for the utility to obtain, and it is all part of good record- keeping and an institutional interest in the prorgram. When it is not available, no harm is done by suggesting that someone should look into it, even if it is on a sample basis. (vii) Building up a Forecast 3.33 Attempts are being made to interpret such data econometrically or through other statistical models. This is of course to be encouraged. 3.34 But generally, forecasts have to be made in a rough and ready way. In practice, the most straightforward thing to do is to begin with concrete evidence from other electrified areas within the country and, if possible, from other countries. Next, an economic analysis of the area should indicate whether the demand data obtained from these areas should be revised up or down. such revisions will be further strengthened by the studies of energy use. If there are concrete plans for the area's development, the revisions can be made fairly precisely, otherwise they can only be based on judment, the bounds of which can be determined by studying areas of higher and lower levels of development from the one considered. - 25 - (viii) Demand for Community Purposes 3.35 These include street lighting and service to schools and health centers. They can be estimated directly from technical coefficients. (ix) Forecasting Benefits 3.36 From the demand forecasts, the forecasts of revenues follow rather obviously to give the direct benefits. To get the consumers' surplus benefits it is first necessary to distinguish between the various types of consumer: - various sizes and types of farms, agro-industries and commerce; - demand for community purposes; - various levels of household demand. An idea of what they use electricity for and of the costs of the substitutes will then give a basis for estimating surplus benefits per unit of demand. As remarked earlier, it will only be practicable, in general, to estimate surplus benefits for consumption for "productive uses". But information about what households are expected to use electricity for will give some qualitative idea of the benefits; also, as will be apparent later, this information is particularly important (i) for shadow price adjustments and (ii) for analyzing income distribution issues in pricing policy. (d) Cost--Analysis 3.37 Once the forecasts of demand and benefits have been obtained, the next steps are to determine: - the least-cost means of meeting demand, and - if costs can be further reduced by lowering design standards and accepting an increase of supply inter- ruptions. The second problem is discussed later (Part VI), except to note here that some countries report large economies by careful attention to design and by keeping standards to a bare minimum. 3.38 The main alternatives to be considered in the least-cost exercises are: (i) public supplies from the main grid; (ii) the same, but with different network layouts, equipment capacities and expansion plans; and (iii) local autogenerators serving local micro-grids. - 26 - The third needs to be considered before the initial decisions are taken to bring electricity into an area; and also, of course, for obviously small demands in remote areas. In areas close to the grid, or close to existing subtransmission networks, the main alternatives to be considered are (i) and (ii), that is, alternative plans for public supply. 3.39 Both the least-cost studies and the comparisons of costs (of the least--cost proposal) with benefits require a dynamic analysis over a long time horizon. As illustrated in Section II, costs change enormously over time with the growth of demand and utilization of equipment (load factors); and since the electrical equipment in the networks lasts about 30 years, this is the sort of time horizon needed for the study of costs and benefits. 3.40 Although there are periodic needs to reinforce and extend networks as demand increases, the costs of service per consumer and per unit of power and energy demand decline (in real terns). This is the case for both auto- generation and public supplies, for the following reasons: (1) There is a large initial fixed cost in setting up the local networks and installing local-autogeneration or, in the case of public supplies, of setting up the subtransmission links to the main grid. Also, equipment costs per unit capacity decline very quickly with size. The following data taken from a project in Ethiopia illustrate these points: Table 3.2 /1 1st Year 7th Year 14th Year Peak Demand kW 100 425 1,120 Capacity /2 kW 150 1,150 1,500 Total Investment $ 104,000 254,000 288,000 Investment per kW Demand $/kW 1,040 598 257 Investment per kW Capacity $/kW 690 220 192 Average Costs per Consumer $ 870 320 72 /1 Source: Supplied by Ethiopian Electric Power and Light Company (1971 data). Data relates to Ghimbi district, 450 km from Addis Ababa. Population about 10,000 but apparently increasing rapidly. Forecasts were based oni experience with similar project in Shashemene district which was of "similar economic status". /2 Local autogeneration of following capacities 1 x 150 kW in 1st year; 1 x 150 kW + 2 x 500 kW by 7th year; 3 x 500 kW by 14th year. - 27 - (2) Related to (1) is that costs decline as consumer density increases. For a rural center with 500 persons per square mile, the Kenya Light and Power Company reports initial investment costs of $1,700 per kW, as compared with $250 per kW for a center of three times this population density (1971 prices). (3) There are also fixed costs of administration, billing and maintenance which also decline in relation to demand. Again, this is illustrated by data supplied by the Ethiopian Electric Power Company. Table 3.3 /1 1st Year 7th Year 14th Year Peak Demand, kW 100 425 1,120 Energy Demand, kWh per year 120,000 629,000 3,307,000 Capacity Costs. $ per year /2 15,600 38,000 43,200 Fuel Costs, $ per year 5,400 28,200 148,400 Acdmin. Costs - Fixed, $ year /3 13,600 13,600 15,100 - Variable, $ year /4 5,000 11,000 28,000 Total Costs per year, $ 39,600 90,800 234,700 Average costs, cents per kWh 33.0 14.4 7.1 Admin. Costs, cents per kWh 15.6 3.9 1.3 /1 Same project as for Table 3.2, all cost data refers to 1971 (including fuel) and are presented here for purposes of comparison. /2 15% annuity applied to capital costs of Table 3.2. /3 Mainly comprise the salaries of the branch manager, clerk, cashier, production foreman and 4 mechanics, 1 distribution foreman and 4 electricians, plus guards. A4 Meter readers and miscellaneous. The costs, it can be seen, are dominated in the initial stages by the fixed costs of capital and administration. Later it is the fuel costs which predominate. The factors underlying costs structure thus shift markedly over time. (4) As the demand per consumer increases, load factors improve. This means that peak demiands and thus the investments in - 28 - more capacity do not rise as quickly as energy demand. Typicallv, load factors may rise from 10-20% initially to 30-40% after 10 years, thus doubling the returns only at the cost of extra fuel. 3.41 The changes in demand, load factor and cost structure over time clearly have an important bearing on both the least-cost and the cost-benefit analysis. In most cases it will be necessary to estimate a time-stream of costs for the following items: - Running costs, related to kWh sales. Fuel and vari- able costs of maintenance and administration, mainly. - Capacity costs, related to kW peak demand. Generators, local distribution networks and, in the case of public supplies from the grid, transmission and subtransmission capacity. - Fixed overheads. Administration, mainly. (e) Cost-Benefit (IER) Calculations 3.42 As in other projects, the time-streams of costs and benefits need to be calculated on a present worth basis. Calculations of internal econo- mic rates of return (IER) and cost-benefit ratios also follow customary practices. 3.43 Shadow price adjustments are, as usual, required to allow for dis- tortions in the pricing system. We have found that the most important adjust- ments to make are for: (i) Net tax revenues: - These are part of the Government's profit stemming from sales of electrical appliances and equipment, and also of electrical energy if the utility pays taxes on inputs or sales. These should be counted in on the benefit side (or deducted from the cost side); often they can be quite large if appliances are heavily taxed. These revenues are offset to some extent by reduced tax revenues due to a reduced use of substitutes. Mainly, this is only significant for farms and agro-industrial demands which would otherwise use autogenerators, diesel engines and alternative sources of refrigeration. (ii) Foreign exchange: - The usual shadow price adjustments need calculating when the balance of payments is in dis- equilibrium and/or if there is heavy protection. The penalty applies to electrical appliances and equipment as well as to the production of electricity. - 29 - The penalty is partly offset because substitute sources of energy and equipment are often imported. Again, the most significant cases are generally to be found in the demands of farms and agro-industries -- autogeneration, diesel engines, substitute sources of refrigeration. (iii) Capital: - A specific adjustment may often be needed to allow for scarcity of credit. This affects, mainly, the sales of appliances and equipment and the costs of connec- tion. Local inquiries may sometimes show effective rates of interest above the opportunity cost of capital. The profits made out of this do not, of course, accrue to the consumers but to the sellers; nevertheless, they are part of the monetary benefits. (iv) Labor: - The main element here is to be found in con- struction of the networks, where unskilled labor costs may form about 25% of initial investment costs, depending on the difficulty of terrain. The excess of wages over the shadow wage of labor can be deducted from cost-streams. Since it is linked to investment rather than operations, the adjustment will be lumpy. 3.44 Evidently the calculation of shadow price adjustments requires good records and data about consumers. Items (i) and (ii), for example, require some knowledge of what consumers use electricity for, and item (iv) a study of credit. It is desirable to encourage utilities to record and take an interest in such data. It is useful not only for cost-benefit calculations and investment decisions, but also for efficiently running and promoting electrification programs. 3.45 The assumption of the analysis becomes clearer if each of the time-streams of benefits, costs and shadow price adjustments are listed separately, so that the cost-benefit tableau contains, for example: Benefit Streams: - - direct benefits to households (revenues); - direct benefits to agro-industries, farms and commerce (revenues) - surplus benefits to agro-industries, farms and commerce. Cost Streams: - - generation, capital costs- - transmission and subtransmission, capital costs; - 30 - local distribution networks, capital costs; generation, energy costs; administration and maintenance costs. Shadow Price Adjustment Streams: - - net tax revenues (deducted from costs, or added to benefits); - net foreign exchange penalties; - profits from credit rationing; - shadow wage adjustments to labor costs. The cost streams, of course, refer to the least-cost project. 3.46 Some demand statistics, on total demand, its division between pro- ductive and domestic uses, load factors and numbers of consumers might also be added to the tableau for explantory purposes. (f) The Criteria for Prject Acceptabiljtv 3.47 Most of the economic factors so far discussed act to increase the calculated returns to electrification. The economic picture is thus some- what more optimistic than the financial one. Taking a long run view, for example. shows benefits rising faster than costs (this is not so apparent in the financial analysis which is heavily preoccupied with financing the initial investments, low short-run returns and high risks). Counting in the surplus benefits to farms, agro-industries and commerce will, if the demands for these "productive uses" are high, add quite significantly to the calculated returns. The shadow price adjustments will generally be favorable towards the project because tax revenues, and the shadow price adjustments for capital and labor are likely to be greater than the penal- ties on foreign exchange costs. (In the El Salvador study we have found that the net adjustment for shadow prices works out at about +30% of sales; the mark--up for surplus benefits to agro-industries, farms and commerce varies, but may average around 50% or more of sales to these consumers.) 3.48 After all such adjustments have been made, what should be the cri- terion for project acceptability? 3.49 Strictly speaking, it should be somewhat lower than the opportunity cost of capital because some social and economic benefits generally cannot be quantified but are nevertheless considered to be important. Among these are: - 31 - The surplus benefits to households; the value judgment that rural poverty is unacceptable and some degree of subsidy is desirable; institutional benefits in that it is a stimulus to public and private institutions, as well as to the area itself, to take a stronger interest in the areats devel- opment; this should feed back positively on the returns to the project but to an immeasurable extent (an example of Professor Hirschman's dictum that the benefits of unintended side effects on institutions are often more far-reaching than those of the intended effects of policy); 1/ the expected returns may be lower than the optimistic returns: but an otimnistic view of the project should be taken: the social consequences of neglect in rural areas far outweigh the risks of limited success. (Related to the last point is tne observation by many countries that demand is often higher than expected; and as regards institutional benefits, it is commonly reported that the initiative of one institution leads to initia- tives by others.) Such matters are clearly of sufficient importance for tolerance to be exercised when the quantified economic returns are somewhat lower than the opportunity cost of capital. The degree of tolerance will depend on the country and in particular on its fiscal strength. 3.50 How much lower than the opportunity cost of capital the IER can be permitted to go is a matter of judgnent, only experience and discussion can decide. But there are several related arguments for not permitting it to go too low. 3.51 Firstly, if rural electrification is to contribute towards the economic output and wages in rural areas, it must be couched in a productive context. Where it is, the demands from agriculture, agro-industries and commierce will be large, and the revenues and surplus benefits from these should provide a good economic return to the investment. In this respect, electricity is simply a factor input to agriculture and rural commerce, so the economic returns should be comparable to other investments in these sectors. Indeed, on a good project with strong demands from these consumers, the IER may often exceed the opportunity cost of capital and there will be no need to invoke the above arguments. 1/ "A Bias for Hope" - A. 0. Hirschman, 1970. - 32 - 3.52 On the other hand, where the IER is low it is a sign that demands for productive uses may be low and that its contribution towards raising productivity and incones in the areas is linited. 3.53 Secondly, and closely related to this, is that it may signal that there is insufficient attention to the development of local infrastructure and agriculture: poor or no credit for example, or bad roads. Electricity is only one of many factor inputs needed for development. if the comple- mentary inputs are neglected, the contribution of electricity to development is diminished. 3.54 Thirdly, low economic returns can also lead to disillusionment among both investors and, perhaps more important, consumers. One reason for this is that even subsidized electricity and the appliances to use it often cost far more than consumers anticipate; this can be an exceptionally unwelcome setback for low income households and a high rate of disconnection results. Another reason is that where development is expected but not realized there is cynicism (our study in El Salvador and an AID sponsored study in Costa Rica and Colombia have found solid evidence of this). 3.55 Fourthly, where there is a strong demand from households and busi- nesses, a low IER probably indicates that tariffs are too low and wrongly structured. Many of the larger household consumers in villages are often above average per capita incomes, while many of the larger farm and business consumers make quite good profits. It is invariably the case, however, that subsidies continue, even though such consumers are able and willing to pay more, Tariffs can be restructured so as to help the lower income groups more while enabling the utility to earn a better financial return and extend service more widely. 3.56 Fifthly, the basic reason for a low IER is low levels of use on a high-cost project. It is possible in such cases that a least--cost solution has not been found. Low demand stemming from simple uses like lighting, ironing and one or two refrigerators in village shops, can be met by small diesel or micro-hydro powered autogenerators at relatively low costs. When such alternatives are adopted, the economic rate of return is not only good but the schemes are often financially profitable. 3,57 Finally, there is the obvious point that a low IER signifies an inefficient investment and, perhaps, wrong priorities. For the $250,000 or more which it may cost to electrify about five villages, good water supplies may be provided; alternatively, respectable improvements to the access roads can be contemplated (this has the added advantage of cutting the costs of electrification significantly); or schools and health centers can be built -- villagers generally list these to be higher in their preferences. 3.58 In sum, the economnic return calculation provides some useful messages. A high IERx signifies a good investment. An IER somewhat below - 3 3- but approaching the opportunity cost of capital deserves tolerance since there are several benefits of importance which cannot be quantified. Low and very low IERs on the other hand may signal an ineffective project, wrong priorities and the possibility of disillusionment. 3.59 It should be added that postponement or rejection of electrification projects until priorities are sorted out need not lead to disaster -- as with rural water projects in drought areas for example. Farms, agro-industries and conmerce can and do turn to useful substitutes in the form of diesel motors and autogenerators, and households are well adapted to using substitutes and doing without electricity. (g) Pricing Polic 3.60 Pricing policy, like investment policy, has to take into account the social and economic aims of the program. In addition, financial obligations have to be designed and met for various reasons -- fairness to investors and other (non-rural) consumers; to reduce the burden, such as it exists, on the public revenue; and to enable the utility finance, and perhaps widen the scope of its investments. To reconcile these various requirements of pricing policy, the most appropriate approach is to proceed in four steps (as outlined in the references in Annex 1): (i) Estimate the structure of marginal costs; (ii) decide on the form of a metering and tariff policy which may practically reflect this structure in one or two respects; this will meet efficiency aims; (iii) incorporate any fairness aims into the pricing structure; and finally; (iv) place any further financial burden on those elements of tariff structure so as to minimize any adverse impact on fairness and efficiency. A few remarks can be made on each of these steps. 3.61 The marginal costs of reinforcements and extensions to capacity, in order to meet increased demand, are well below (less than 50% of) average costs for the first 10-20 years of a project on account of the high initial fixed costs. Economies of scale and increasing consumer density also act to reduce the long-run marginal costs once an area is electrified (note again the cost estimates provided earlier in 3.37 et. seq.). For many years there is also excess capacity in the sub--transmission and distribution networks. In principle, efficient use of the services should not be held back by high sunk costs. hence. there is an economic rationale for not demanding too high a financial return on assets, at least in the early years. (This is also desirable in the interests of promoting the project.) - 34 - 3.62 As far as possible, there should be some steadiness in pricing policy. For this reason, it is best to take estimates of the long-run marginal costs (or average incremental costs) of future reinforcements and extensions and expansion -- of generation, transmission, sub-transmission and distribution -- as an initial basis for pricing policy calculations. 3.63 Metering and tariff policies have to be simple for most consumers. Complicated tariffs bewilder most people, and advanced metering is often too expensive. For most domestic consumers in rural areas, and for a good number of small business consumers, a flat rate tariff, accompanied as necessary by a fixed charge (which could serve revenue raising purposes or as an incentive to economize at times of peak demand) will do. Where metering and billing costs are very high, a device to reduce them is to eliminate meters and in- troduce a fixed charge, related to the setting on a simple load limiter, for very small consumers- however, this arrangement is only suitable if fuel costs are not high, for it encourages wasteage of energy. Seasonal varia- tions in tariffs -- "wet"' and "dry" seasons -- may be contemplated if there tends to be energy shortages in the dry season. For the larger farms and agro-industrial consumers more complicated metering (such as time-of-day for irrigation and other uses) may be considered. 3.64 The widely adopted system of declining-block tariffs to all consumers has several defects, and its application in rural areas should be questioned. Small household consumers don't understand it, it doesn't exploit willingness or ability to pay and so keeps financial returns down, and it has no obvious economic merit. 3.65 Fairness aims can be incorporated by providing concessions on one or more of the elements of the tariffs at low levels of consumption. Devices which can be used are a low first block followed by a higher flat rate in excess, say, of 50 kWh/month, a low connection cost to small consumers, and concessions on fixed charges. 3.66 If it is desired to raise financial returns further, while minimiz- ing the impact of tariff increases on efficiency and fairness, increasing the fixed charges to lar-e consumers and/or raising the flat rate at high levels of consumption are obvious devices. 3.67 Pricing policy clearly has an important bearing on the social and economic aims of the investments. It is nevertheless true that most pricing policies are a direct contradiction of these aims. Generally, the larger consumers get subsidized the most in tariff systems unrelated to economic aims and which also undermine financial performance. Pricing policy will, therefore, require thorouga attention during appraisal, not only from the viewpoint of finance, but also from the viewpoints of fairness and efficiency. (h) Provisions for Low Income and Small Business Consumers 3.68 Concessions to these consumers are of course helpful but the income distribution impact is small in relation to household or business income. The - 35 - cost of electricity rarely exceeds 2 to 5% of the household or the business budget, even in rural areas (see Table 3.1 for example). There are two fur- ther points to bear in mind: (i) the larger businesses are often making good profits and there is no need for concessions; they are often willing and able to pay more and by being expected to do so will help financial performance; (ii) similarly, as remarked earlier, many household consurmers in rural areas are also able and willing to pay more. - 36 - IV. PROJECT IDENTIFICATION ANID PREPARATION 4.1 Perhaps the single most important factor which determines a pro- gram's success is care and thoroughness in identifying and preparing projects -- identifying the areas to be served, working out the investment plan, choosing equipment and designing networks so as to keep costs down and the continuity of service to satisfactory level, and attending to all the financial and institutional matters which will enable the program to be expanded and run efficiently. Project appraisal and justification, in a broad sense, is nothing more than establishing if the groundwork on these matters has been properly done. 4.2 This section discusses the economic side of identification and pre- paration, while later sections deal with finance, technology and institutions. The discussion begins with the problem of: a. Defining Project Areas; and then turns to: b. Identifying Areas for Investment7 c. Working Out an Investment Plan; d. The Relation Between Rural Electrification and Rural Development Plans; e. Uncertaintv and the Need for Experimentation and Evaluation; and f. Pricing Policy. (a) Defining Project Areas 4.3 One particular problem of identifying and appraising projects is posed by the very large number and interconnectedness of projects to be con- sidered. It is particularly troublesome if the village is defined to be the unit for project evaluation. Even small countries have several thousand villages. Roughly speaking there are two to four thousand villages for each million of rural population, so that a country with a rural population of 30 million may have about 100,000 villages (as in Mexico for example). It is too much to expect (or to ask) that appraisal can be rigorous and com- prehensive in each of these cases: it is also unnecessary. 4.4 Generally it is better to think in terms of the best way of in- troducing electricity into a region or zone, and then to calculate the over- all costs and benefits of electrifying the region. One reason is that most of the non domestic consumption stems from outside the villages--irrigation is an obvious example, but it is also widely the case, for example, for the - 37 - processing of rice, sugar, coffee and cotton. Villages are major demand nodes, of course, but so are demands outside the villages. Another reason is that the appropriate unit for economic analysis is the region rather than the village. It is an analysis of a region - of its demography, agriculture, wage levels, agro-industries, commerce and general infrastructure - which will give the main indications of the desirability of introducinig rural electrifica- tion. 4.5 There are also technical and administrative reasons for thinking in terms of a region. Plans have to be made regarding the locations and capacity of substations and transformation points, the various voltage levels of subtransmission and distribution, the type of automatic protection equipment, and the routing and interconnection of the circuits between the various demand nodes. (Most lines and substations in any case serve not one, but several demand nodes.) Administration, maintenance and billing procedures also need to be worked out on a regional basis. Costs can be reduced consider- ably by coordinated planning rather than ad hoc piecemeal extensions in a region. 4.6 So generally it makes sense to enlarge the definition of the project and to relate it to the problem of electrifying a region or zone. In doing so, there are two sources of error to guard against. The first is that this pro- cedure does not of course imply electrifying the whole region. There will be many demands not worth bothering with because they are to small and remote from the main demand nodes. Other demands can wait until the networks have been constructed to meet the more important demands; after this, extensions to neighboring demand nodes can be accomplished at low marginal cost. 4.7 The second source of error to guard against is that the sizes of the regions chosen for analysis should not be too large, otherwise control can be lost. The aggregate return can be held down heavily by a number of, for example, ill-chosen extension projects. One thing that is apparent is that some places are emphatically worth electrifying and others are emphatically not: but the latter are often electrified and this detracts not only from the merits of the former, but often from the whole program. 4.8 As in many other aspects of this work, the actual size of the region defined for study, and thus the 'size' of the project, is a matter of judge- ment. It is influenced by the availability of data, by the structure of economic and political institutions for regional administration as well as by project technicalities. Each of the following has to be considered: - A similar problem occurs in arranginrg for local administra- tion of the project. Within the region, local administra- tion may be responsible for promoting the project and making arrangements to bring new consumers into the system, for billing, reporting faults, keeping records and perhaps undertaking some local engineering and maintenance work. They will, therefore, provide the information base for future extensions and supervision. - 38 - - Many countries are divided into a number of economic and political administrative districts, and it will often be useful to follow this division. Indeed the institutional framework (for local administration) is often best designed round such districts because it gives the districts a more direct involvement with the project and its success. Finally, the census and economic data are often classified according to such districts. - Once the major denand centers have been identified, the network design will follow and it is often quite obvious on site how large the region slhould be from the viewpoints of expansion planning, administration, and thus of project identification and evaluation. Very often, these considera- tions may lead the utility to group several districts together. (b) Identifying Areas for Investment 4.9 Having decided that it is best to evaluate projects on a regional or zonal basis, how is it decided which regions or zones to electrify and at what rate? 4.10 In answering this question, the obvious point to keep in mind is that the projects identified must eventually pass the appraisal test. From an economic viewpoint, then, the short answer is to choose regions which are likely to offer satisfactory economic rates of return to the investment, where the calculation and criteria are as discussed in Section III. 4.11 From this it follows that the projects should be in regions where reasonably strong and growing demands might be expected for the service, and wlhere the resulting benefits can justify the costs. In general this will be the case for regions where:- - the quality of infrastructure, particularly of roads, is reasonably good; - there is evidence of growth of output from agriculture, and where, therefore: - there is evidence of a growing number of productive uses in farms and agro-industries: - there are a number of large villages, not too widely scattered; - wages and living standards are improving, - there are plans for developing the region; - 39 - - the region is reasonably close to the main grid (though if demand is particularly strong, remote regions may be considered too). 4.12 Such information about the region merely indicates the likelihood of useful investment. The first test will come where some rough estimates of deniand and costs are made. From the demand estimates, the revenues and the consumers surplus benefits to non-domestic consumers can be esti-mated -- again, rather approximately. If the economic returns look reasonable, subject to all the allowances discussed earlier (in III) for social aims and for the economic benefits which cannot be quantified, a more thorough plan can be worked out and appraised rigorously. (c) Working Out an Investment Plan 4.13 Generally, several alternative plans have to be considered in the interests of ensuring that (i) reasonable demands have not been excluded from the plan: (ii) unreasonably low demands have not been included when the costs of inclusion are high; (iii) the proposed expansion plan is not too fast or too slow, and (iv) that a least-cost plan has been deternined. 4.14 In the case of regions which are to receive electricity from the grid for the first time, the first phase of an electrification plan consists of pilot projects -- unless there is good information about the use of auto- generators in the area indicating that demand is likely to be strong. This provides the necessary information and experience for future expansion, and for flexibility in decision making. 4.15 Both the pilot projects and the early phases of electrification con- centrate on the main demand centers: subsequent phases extend the network to the smaller villages, and to new farm and agro-industrial consumers. Evidently, the early appraisals for electrifying the region need to make some allowance for the net benefits of subsequent extensions. 4.16 Following the pilot projects and the decisions to construct the main networks, decisions about subsequent reinforcements and extensions can be made on an incremental basis, as the demand develops, through a comparison of in- cremental returns with incremuental costs (an exercise which can be left in the responsibility of the distribution engineers, say, rather than central manage- ment). This permits flexibility in decision making and enables the engineers to match investments and capacity more closely to the demand. The ground rules for decisions to extend the networks can often be stated quite simply: for example "the expected revenues, once the demand has developed, should be greater than (a) the annuitised capital costs of extension, plus (b) local running costs) plus (c) costs of bulk supply." Cost-coefficients for (b) and (c), per kWh of demand, and the appropriate annuity rate need to be snecified. - 40 - 4.17 Summing up, thne investment plan generally begins with a pilot project followed by a more comprehensive network plan which is: - the best of alternative proposals regarding which demand centers to connect up (in the early phase); and - the least costly of alternative layouts and designs to connect up these centers. Subsequent reinforcements and extensions can be decided on an incremental basis. (d) Rural Electrification and Rural Developent Plans 4.18 The returns to rural electrification increase with the level of developmernt in rural areas. On the cost side, improved roads reduce the costs of construction, maintenance and administration of the electrification programs. On the benefit side, there are several inter-relationships, as follows. Rural development programs raise the level of output in agricul- ture and agro-industries, and through this the level of rural incomes. On account of increased incomes and improved infrastructure, commercial activity increases. Together, the growth of incomes and the growth of agriculture, agro-industries and commerce create increasing demands for power and energy. These demands can be met by public supplies from the grid, local autogenera- tion or substitute sources of power and energy. Mhich of these alternatives is best will be revealed directly by the calculations of the costs and benefits of public supply. the reason is that these calculations involve a comparison of public supplies with the alternatives. 4.19 hence the economic rate-of-return calculation also provides a measure of the need for the project when there are plans for developing the area at public, private or local initiative. that is, it indicates if the electrifica- tion project fits into the rural development plans for the area. The main effects of such plans are, as just indicated, to raise the expected economic returns. (e) Uncertainty and the Need for Experimentation and Evaluation 4.20 Uncertainty, and the related problems of information shortage and inexperience, can only be reduced through concrete experience and evaluation. This rather obvious point is the main reason for beginning with pilot projects. As a general rule: - in countries without a rural electrification program, and where there are good grounds for embarking on one, experimenta- tion is a necessary first step, this will generate information and experience for the subsequent program; - in countries with programs, evaluation may be encouraged as a basis for improvements. - 41 - 4.21 Part of the task of project preparation is to identify the need for and define the scope of such experiments and studies. One particular require- ment is to keep their size within reasonable bounds and concentrate on what is relevant. A common occurrence, for example, is for the studies to become very large, costly and tine consuming; often much can be accomplished by elementary investigations which concentrate on a few items such as: - demand analysis; - cost analysis; - effectiveness of various management and promotional procedures; - descriptive studies, for projects in selected areas, of the development of local agriculture, agro-industries and commerce;? of the living standards of households and the community; and of how these relate to project performance. If the utilities keep good records, all the project-related information should be available. If it is not, a start should be made to keep good records. (In many countries with rural electrification programs, records are not good, even on obvious things like demand and costs.) (f) Pricing Policy 4.23 During project justification, it is necessary to show that pricing policy is satisfactory, as discussed earlier. During the preparatory stages, the main work will be in estimating the long-run marginal costs, selecting a simplified metering and tariff system, and then working promotional, social, and financial aims into the cost structure. In practical terms this results in: - prices that are higher in rural than in urban areas; - prices well below average costs in the early years, on account of the high initial fixed costs (and also to help promote the project); - some degree of cost recovery in later years; and - low tariffs only at low levels of consumption. Decisions on the price levels and structure are generally less flexible than investrment decisions, on account of the exceptional unpopularity and difficulty of effecting price changes. For this reason it is necessary to get the pricing policy into a satisfactory si.a-e during the early stages of the program. - 42 - V. 1MEANS OF FINANCE Financial Goals 5.1 The financial characteristics of new or expanding programs are such that the initial investment should be financed by some corabination of debt, grants, equity or internal funds of the utility which results in a relatively "soft" blend for the capital structure of the pro-ramn long grace periods are also required. The reasons for this are: (a) the long gestation period before demand and revenues build up to reasonable levels, and (b) the various economic, promotional and social constraints also acting on pricing policy. Often, these factors are made more difficult, and the financial returns worse than they need to be, by ill-structured prices. But even with suitable reforms to pricing policy, funding on soft terms is necessary. In practice, the kind of financial goals that might be achieved would evolve with the level and growth of demand: - initially (say, during the first 3 or 4 years) revenues could generally be expected to service debt (assuming the soft blend as suggested above); - in subsequent years, revenues may generally be sufficient to make an increasing contribution towards the costs of expansion (sufficient in magnitude perhaps, on some projects, to meet a good proportion of the capital required, and to give a good internal financial rate of return to the project). But such achievements would depend on the level and growth of demand; reforms to pricing policy; well--prepared and well-run projects; and also a systematic follow-up on projects to insure that financial targets are raised as soon as circumstances warrant. 5.2 As a matter of principle, then, it should not be assumed that costs cannot be recovered over the life of the investment; but whether or not they are will be determined by the pricing policies of the agencies involved. During project preparation and appraisal it is thus necessary to review the financial targets bearing in mind: - the financial needs of the program; - the effect of the program on the utility's overall financial performance, - the fiscal strength of the country; and - the economic and social objectives of the program. - 43 - Domestic Finance 5.3 In the early years of rural electrification projects, average costs are exceptionally high --- perhaps three or more times the average costs of urban electrification projects. Though average prices are generally higher than in urban areas, they have to be kept down as far as possible in the early years in the dual interests of promoting efficient use of the project and meeting social aims. The transition to the point where average costs fall below prices, and for cost-recovery to begin, may take 5 to 15 years on quite good projects -- larger, of course, if the social aims are strong or prices are poorly structured. Furthermore, as the programs expand, the low financial returns on assets of new projects offset financial gains which may be appear- ing from the older projects. 5.4 The result is that continual financial assistance is required on new or expanding programs. On the domestic side, the main sources of fi- nancial assistance are: (i) Funds from the government, either as cash grants or as loans at low interest rates; (ii) Funds generated internally in the utility through general tariff increases to urban areas or to the country at large; or through cost reductions as the utility expands; (iii) Raising and restructuring tariffs in rural areas; (iv) Offering bulk supplies to the distributors at lowered prices; (v) Local contributions in kind (e.g. "self-help" in the form of unpaid local labor). Private sector finance is of course ruled out for some time on account of high risks. The last two items are only of indirect help, and mainly on expand- ing programs, since they reduce the financial burden rather than raise funds. Combinations of (i) to (v) are often used. What are their merits? (i) Government Funding 5.5 Grants and low interest loans from the government have particular advantages in large countries where the supply and distribution of electricity may be undertaken by several independent regional utilities. It can be used to help the more backward regions, as a lever on the less innovative utilities, and to promote cooperation between regions. This system is used in India, under the administration of the Rural Electrification Corporation (REC). Apart from its success in deflecting capital to the more backward regions, it has also promoted some degree of coordination in policy, including equipment standardi- zation, and a considerable interchange of ideas and experience. - 44 - 5.6 The case for this source of financing is stronger the greater the fiscal strength of the country. When the public revenue is heavily burdened, however, it is practically necessary to turn to other sources. One of the more copious of these is internal cash generation. (ii) Internal Cash Generation 5.7 Tariff increases to urban consumers, or to the country at large, can raise funds on an enormous scale. In many countries, tariff increases have been highly successful in providing capital to finance the very large investment programs of electric utilities; for many years the encouragement of this has been a cornerstone of Bank policy. There is no reason why a similar policy cannot successfully serve a similar purpose in financing rural electrifica- tion. Only a small increase in the average level of urban tariffs can provide funds for quite ambitious programs of rural electrification. Roughly speaking, when rural electrification takes 10% of total investment, a 5% increase in general tariffs will meet 50% of annuitised investment costs. 5.8 The same effect can be obtained as the system expands by keeping prices constant, apart from adjustments for inflation. The reason is that average costs in utilities generally decline (in real terms) with system ex- pansion. The extra profits this leads to can be used to finance rural elec- trification. 5.9 The device of using internal cash generation is evidently worth pursuing if other sources are difficult to tap. An economic argument can be advanced in its favor in that it is consistent with the general aims of promoting urban-rural balance. Also, it can be adapted to a variety of institutional arrangements. Where electricity distribution is administered through several independent utilities, it can take the form of a trust fund to be redistributed through some central agency. Where electricity supply is the responsibility of one national organization, the transfer is internal. And where, for exanple, distribution is through cooperatives, soft loans or straight cash grants can be offered to them. (iii) Increased and Restructured Rural Tariffs 5.10 Generating funds, or reducing the need for them, by increasing or restructuring tariffs may seem a contradiction - if this can be done, why the problem of finance in the first place? iNainly it is a question of degree: while the problem of finance is genuine, it appears that it is made far more difficult than it should be by badly structured tariffs that even conflict with the social airs of the programs. This is so even though tariffs in rural areas generally are higher than those of urban areas. The two most common defects of tariffs are: - 45 - - excessive use of declining block tariffs (whlich do not correspond to narginal cost structure); - low tariffs are often offered to large consumers who are able and willing to pay more. Flat rate or two-part tariffs, redesigned to pass on more oL the financial burden to larger customers, can result in very useful improvements in fin- ancial returns. (It is necessary not to go too far in this regard, of course, since large consumers can and sometimes do opt for the alternative energy sources if the flat rates are set too high above the costs of supply.) (iv) Low-Priced Bulk Supplies to Rural Areas 5.11 The device of selling electricity at low prices to the electricity distribution agencies in rural areas is also useful, and it can help them func- tion on a normal profit and loss basis. (It is pointless to apply it, of course, if generation and distribution is undertaken by the same entity.) But the device has its limitations. Tlle capital and running costs of generating and transmitting electricity - that is of providing supplies to distributors - are less than 40% of the total cost of providing supplies to rural areas. So if electrical energy were sold in bulk at half price to the distribution agencies, it would only cut their costs by 20%. This is helpful, but generally it is not sufficient. 5.12 One other limitation of this device is that it is not very helpful in raising the capital initially required for electrification: its efLec- tiveness is after the investment, not before, so that its resource mobiliza- tion function is weak. Nevertheless it can help financial viability and reduces the funding requirements for the expansion programs of distributors. (v) Local Contributions 5.13 Local contribution in the form of unpaid labor, materials and capital are also helpful, if limited in scope: they also engender more local interest in and appreciation for the area's development. As regards unpaid labor. however, the question should be raised if, through sensible financial policies, there is the means to pay for it; it is provided by the lowest income groups and the idea of not paying then should not be accepted lightly. A Co_mparison of Domestic Sources of Finance 5.14 The main sources to consiner will be the public revenue, general tariff increases and raising or res :ruccuring tariLfs in rural areas. The latter is worth considez4int in its own_ ri