October 2011 investment climate IN P R AC TIC E no. 18 Investing in infrastructure The Power of Renewable Energy Fostering investment and competition to generate electricity Renewable energy is a viable, cost-effective way to provide power to Tania Begazo Gomez rural and remote areas, lower electricity generation costs over time, Martha Martinez Licetti and reduce costly power outages. Renewable energy technologies could benefit the nearly 1.5 billion people who lack electricity access—85 Tania Begazo Gomez (tbegazo@ ifc.org) is a consultant with percent of whom are in rural areas—and reduce losses for firms due to the competition policy team, power outages (which are equivalent to about 8 percent of their sales Investment Climate, World Bank Group. She is experienced in in low-income countries). This note discusses key steps for opening competition policy and economic the power sector to renewable energy projects in developing countries regulation of infrastructure and currently supports work on while encouraging efficient, competitive markets. It recommends policy competition worldwide. approaches, measures to ease entry, and ways of reducing investor risks Martha Martinez Licetti for on- and off-grid renewable energy projects. (mlicetti@worldbank.org) is an economist and the Competition Policy Team Leader, Investment Climate, More than 80 countries have introduced It makes sense for developing countries to World Bank Group. She advises initiatives to promote investments in renewable promote investments in renewable energy given clients on reforming product energy generation. These initiatives are important their potential for lower costs and higher energy market regulations, reducing for their environmental benefits and as a way security. Such investments can also help develop barriers to the development to deliver electricity to rural areas and increase manufacturing clusters related to renewable of competitive markets, and energy security. energy equipment. making competition policies more effective. Renewable energy projects have attracted Using renewable energy available in rural and investments in developing countries, creating remote areas can be the most cost-effective option Investment Climate work jobs and advancing growth. In 2009 developing for electrification, saving resources on expanding aims to create an enabling countries (excluding Brazil and China) had about transmission networks and operating power policy environment and $8 billion in renewable energy investments. plants run on fossil fuels. Moreover, renewable more competitive markets in Renewable power may also reduce costs of energy can cause wholesale spot energy prices to doing business incurred by investors due to fall over the long run by displacing costly fossil the power sector, which can unreliable power systems. In Eastern Europe fuel plants. The benefits of renewable energy are encourage private participation and Central Asia eliminating power outages in even greater when inefficient conventional power to meet the needs of access 2005 could have raised gross domestic product plants account for a large share of electricity and reliability. by 6 percent (Iimi 2008). generation (Pöyry 2010). In addition, renewable energy allows countries To promote investments in renewable energy, to diversify their energy supplies and expand their governments need to foster investment climates that generation capacity using sustainable natural allow for easy entry into the power sector, reduce resources—limiting their dependence on imported investor risks, and facilitate operations. Tax and nontax fuels, separating energy prices from international fiscal incentives can complement policies to encourage fossil fuel prices, and making power systems investment (Table 1; see James and McGregor 2011 more reliable. for a discussion of tax and non-tax incentives). Governments and their development partners can Investments in renewable energy typically incur apply this four-step approach to identify interventions higher costs and risks than traditional investments in renewable energy markets that can deliver socially in generation. These costs and risks require desirable investments and outcomes (Figure 1). government interventions to address market failures and ease barriers to the use of renewable energy. Such projects differ from conventional Step 1: Set targets for power plants in three ways: renewable energy ❏❏Investment requirements are higher. Renewable energy projects connected to ❏❏Operation and maintenance costs are transmission systems (on-grid) and in remote areas lower, and decline over time because of (off-grid) should aim to minimize generation costs technological advances. and maximize access. Setting targets for shares ❏❏Transmission networks have to be extended of renewable energy in power consumption and and reinforced to deliver energy produced in developing national energy master plans that distant locations to national systems. define government visions for renewable energy use are helpful in guiding policies that encourage These features create risks that require adjustments investment. The targets and plans should reflect the to the legal and regulatory framework of the optimal mix of power resources. power sector. For example, capital costs for wind power plants can be more than five times those A key decision is whether renewable energy efforts for combined cycle plants fired by natural gas, and should focus on providing electricity in rural and total costs may be more than 50 percent higher— remote areas—where it has proven to be cost- increasing investment recovery times. In addition, effective relative to grid connections—or if resources renewable energy projects are subject to the should also promote on-grid projects that could cost availability and accessibility of resources—such as more in the short and medium term. This decision rain, wind, and solar radiation—that cannot always depends on the availability of public resources and be predicted or managed. consumers’ willingness to pay for electricity. Table 1: Components of an Enabling Investment Climate for Renewable Energy Reducing revenue risks and Providing fiscal incentives to Facilitating entry facilitating operations encourage investment ❏❏ Provisions to allow for independent ❏❏ Price guarantees (feed-in tariffs) ❏❏ Tax incentives private providers ❏❏ Power purchase agreements ❏❏ Nontax incentives ❏❏ Coordinated, streamlined licensing ❏❏ Quantity guarantees ❏❏ Disincentives for fossil fuels and permitting ❏❏ Other regulatory measures ❏❏ Grid access regulations (on-grid projects) Governments should address bottlenecks in these areas to promote investments in renewable energy. Investment Climate In Practice 2 Figure 1: Four Steps to Promote Investments in Renewable Energy STEP 1 Electricity demand Production costs and access Availability of Fiscal resources (fossil fuels, Power policy: resources renewables) on-grid and off-grid targets STEP 2 Remove Constraints Market structure and on Economy-wide policies institutional setting investment toward investors of the power sector STEP 3 Business-enabling interventions: regulations and incentives Procompetition Efficient STEP 4 Nondistortionary e main steps: set policies, identify constraints, and implement efficient, pro-competition, nondistortionary mechanisms. In rural and remote areas renewable energy is Step 2: Facilitate entry and preferable if natural resources are available, large remove constraints on and dispersed populations lack electricity access, investment potential electricity consumption is not large enough, and renewable energy plants are cost-effective in Once the factors limiting investments in renewable the medium term relative to grid connections and energy have been identified, interventions to fossil fuel plants. Several developing countries have improve the business environment should consider included solar, mini-hydro, and biogas projects in the market structure and institutions affecting their rural electrification policies. the power sector, as well as other economy-wide Investment Climate In Practice 3 policies. The market structure and functioning of 27 developing ones—had feed-in tariffs the power sector define the range of interventions. for at least one source of renewable energy (REN21 2010). These tariffs guarantee a Where there is wholesale competition—that is, certain amount of revenue per unit of energy competition to serve large customers—market- delivered to the system, mitigating price oriented approaches are possible and preferable. risks for investors. Such tariffs are essential In markets with a single state-owned buyer, if renewable energy investments would supporting measures are part of the conditions not occur under current electricity prices. that the buyer sets in power purchase agreements. Governments should decide how to set these Similarly, institutions governing the power sector tariffs and premiums (for example, based on determine whether it is prudent to rely more on actual or avoided costs, or in competitive regulatory interventions (if there is a solid regulatory tenders), whether feed-in tariffs should differ framework and regulatory independence) or fiscal by energy source, technology, size, location, and financial incentives (which are easier for the and time of dispatch, how long the tariffs central government to administer). should be applied, and how they should be funded (by higher consumer prices or To level the playing field for investors in renewable government financing). energy projects relative to conventional plants, ❏❏Conditions for power purchase agreements. governments try to ensure stable, reasonable To make renewable energy projects more revenue streams. Governments can ensure prices financially viable in developing countries, high enough to attract investors using tools such long-term power purchase agreements are as feed-in tariffs or ensure minimum production a useful complement to feed-in tariffs, quantity by imposing, for example, mandatory guaranteeing production volumes for quotas for the use of renewable sources in power a certain period (usually 10–20 years). generation. But burdens on consumers and Conditions of these contracts are especially government budgets must be balanced against the important in single-buyer markets because benefits of the supporting mechanisms. they are the only way to enter the generation market. Moreover, when there are concerns Regulatory interventions for on-grid and off-grid about a utility’s capacity to pay for electricity, renewable energy projects address a range of issues additional guarantees are essential. to promote market entry and support business ❏❏Transparent rules to access the national operations (Figure 2). grid. Access rules and grid codes are essential to allow renewable energy projects to Prioritize regulatory interventions dispatch energy to national power systems. for on-grid projects Regulations should prevent discrimination ❏❏Legal provisions for independent power in access against independent producers, producers. Independent power producers are uncertainty about connection costs and private companies that generate electricity in access charges, delays in connection their own facilities and sell it to the national timeframes, and limitations to access due to grid or isolated electricity networks. Without transmission congestion. legal provisions allowing private participation ❏❏Licensing procedures. This type of in the sector, private renewable energy projects intervention addresses licenses and cannot emerge. Lacking private participation, concessions to exploit natural resources such investments will be entirely dependent for power generation, siting and building on public resources and the ability of state regulations, and environmental impact enterprises to undertake them. Entry by assessments. Simple, transparent procedures private producers is controlled in single-buyer are needed to ease entry and surmount a markets, which account for most electricity range of potential problems. These include markets in developing countries. conflicts of interest that arise when license ❏❏Price guarantees (feed-in tariffs). Feed-in grantors own plants that compete with new tariffs encompass fixed tariffs and premiums renewable energy plants, entry deterrence due above market prices for traditional energy. to lack of licensable sites, requirements that As of August 2010, 54 countries—including favor large or national firms, complex and Investment Climate In Practice 4 Figure 2: Government Interventions to Promote Investment in On-grid and Off-grid Projects On-grid projects Off-grid projects Provisions for independent power Off-grid projects as part of the producers electrification policy Entry Access to the grid Provisions for independent power Licensing providers Licensing Price guarantees (feed-in tariffs) Funding for renewable energy Business Power purchase agreements projects in rural or remote areas operation Quantity guarantees Pricing mechanism (mitigation Removal of energy price distortions of risks) Removal of undesirable subsidies Other regulatory measures Quality standards Note: denotes key issues covered in this note. Improving the regulatory framework for renewable energy requires allowing for private investment, easing entry procedures, and reducing investor risks through predictable prices and demand. overly lengthy procedures for environmental power for their own consumption could impact assessments, and delays caused by sell excess electricity to nearby populations. unclear procedures, unexpected public To ease entry, coordination mechanisms consultations, and a lack of participatory between distribution companies (usually state spatial plans that specify territorial and enterprises), providers, the electrification maritime zones for renewable energy authority, and other government agencies projects. In addition, there is enormous should be enshrined in sector regulations. variation in the duration of administrative ❏❏Allocation of funds for projects in processes: in Europe the lead time on wind rural or remote areas. National rural projects ranges from 18 to 60 months. (The electrification policies should develop European Commission is conducting public transparent mechanisms to allocate funds consultations to expedite the deployment of for communities and private companies to energy infrastructure.) develop renewable energy projects if deemed necessary. Competitive tenders for allocating Prioritize regulatory interventions subsidies are recommended for this purpose. for off-grid projects ❏❏Pricing mechanism. Prices should allow ❏❏Off-grid projects as part of electrification providers to recover their investments within policy. Governments should avoid crowding a reasonable period and to cover operation out private investments in off-grid projects and maintenance costs. Prices in urban and relying on grid expansion as the primary areas should not be used as a reference for means for electrification even when such rural areas because costs differ. For projects expansion is not cost-effective. that do not receive public funds, prices can ❏❏Private participation in off-grid projects. be unregulated but supervised. For other Laws should allow private providers to projects, prices should guarantee their manage mini-grids and to generate in small financial equilibrium, taking into account facilities close to consumption centers and rural consumers’ capacity to pay and any interconnected to distribution networks. available government subsidies or other Firms in rural areas that already generate potential financing. Investment Climate In Practice 5 ❏❏Light-handed licensing. Licensing conditions most efficient providers. For example, if Peru and procedures for generation and distribution had not used an open, competitive tendering should not impose unduly high costs on mechanism, consumers would have paid nearly a providers. For example, small generation third more for renewable energy. In small projects, projects may have a fast-track procedure or complex tendering processes may discourage be exempted, as in Nepal and Tanzania. And entry. Thus governments may require competitive public and private projects should be treated processes only for projects above a certain size. the same in terms of approval requirements. The design of tenders is central to preventing distortions in competition. Conducting cost studies Step 3: Ensure that to determine a reasonable range for tariffs is also useful policies foster competitive, as an internal reference. In addition, governments efficient markets should take actions to prevent speculative behavior in tenders—such as requesting financial and The goal of incentives for renewable energy operational guarantees—so that investors seek investments is to put renewable and conventional credible energy prices that ensure bankable projects energy projects on a level playing field. Incentives that comply with required operational schedules. provided at the kickoff stage should shrink as renewable energy becomes more competitive Efficient feed-in tariffs. Depending on their design, with other sources of energy. For that to happen, fixed feed-in tariffs that are independent of market renewable energy projects should progressively be prices can discourage efficiency and require higher exposed to competition and market risks using payments from consumers, taxpayers, or both. In market mechanisms (such as competitive tenders liberalized wholesale markets, sliding premiums when awarding power purchase agreements or (premiums that fall when electricity prices rise) falling premiums instead of fixed feed-in tariffs). In or systems with minimum and maximum tariffs addition, support for renewable energy should not are more compatible with the functioning of the seek to attract investment at any cost for consumers electricity market and may reduce the burden on and governments—whether through high electricity users. Tariff “degression” (fixed tariffs that fall over tariffs for consumers or higher costs and risks for time), as used in Germany, is another way to induce governments because of excessive guarantees—but technological improvements and limit the costs of also guarantee that the mechanisms selected are the support mechanisms. most efficient. That approach imposes the least cost on the economy. Efficient transmission systems. Transmission charges that vary based on location and grid Regulations can help ensure competitive conditions connection costs borne by renewable energy plants for business operations while promoting efficiency. result in higher costs for renewable energy, but they Such regulations include using tenders to allocate the foster efficient location of plants. Thus, taking into benefits of feed-in tariffs, power purchase agreements account the locations of renewable energy resources and electrification funds for energy generators that and transmission systems, governments need to ask for the lowest prices or subsidies, overseeing select the most efficient mechanism for access charges power procurement practices of single buyers and (uniform or based on location) and for sharing the distribution companies to avoid distortions in costs of the additional transmission requirements. competition (such as collusion among investors or discrimination against certain investors), and Smart technical rules. Rules should ensure a setting clear rules to avoid manipulation of energy reliable electricity supply and not unduly burden spot prices or dispatch volumes. To design specific renewable energy projects. Because renewable interventions, a thorough assessment of each of energy depends on the availability of natural these issues is required given the unique conditions resources, energy production is unstable and cannot of each country. be accurately predicted, particularly for wind power. Some countries, such as Spain, provide incentives Design pro-competitive regulations to renewable energy plants that can manage the Tenders. Tendering can lower the costs of energy delivery of intermittent energy and mitigate the and be used to grant feed-in tariff benefits to the inaccuracy of energy delivery predictions. Investment Climate In Practice 6 Step 4: Prevent policy Conclusion Investment Climate distortions In Practice Renewables are an attractive option for expanding The final step for government interventions in the electricity supplies in developing countries. They renewable energy market involves ensuring that the benefit rural populations that lack access and This note series is published interventions are designed so that they minimize businesses that face recurrent power outages. by the Investment Climate economic distortions. Specific interventions to promote renewable energy Advisory Services of the World in the power sector depend on the context and Bank Group. It discusses practical Avoid or limit unintended negative effects require periodic adjustments to ensure that policy considerations and approaches Well-designed instruments should not: goals are achieved efficiently, limiting burdens on consumers and taxpayers. for implementing reforms that ❏❏Disrupt the dynamics of incentives to aim to improve the business technological improvements by setting tariffs Government interventions to promote renewable environment. The findings, or premiums for long periods instead of energy markets should be transitional until interpretations, and conclusions having them fall over time. renewable energy technology develops enough in this note are those of ❏❏Crowd out private provision of goods and efficiency and scale to compete freely in the the authors and do not necessarily services by limiting investments in efficient electricity market on a level playing field. conventional power plants. reflect the views of the Executive ❏❏Support inefficient firms by not using To facilitate the entry of on-grid renewable Directors of the World Bank or the mechanisms based on competition to select energy projects, developing countries need to governments they represent. renewable energy projects with the lowest foster conducive business environments that generation costs. allow independent power providers to participate ❏❏Cause major distortions to competition by in such projects, establish price mechanisms that About the Investment limiting price competition through rigid guarantee revenue while promoting long-term Climate Advisory feed-in tariffs, deterring future entry through efficiency, implement power purchase agreements long-term contracting, or creating conditions that facilitate entry, give renewable energy projects Services that facilitate collusion among competitors. nondiscriminatory access to power grids, and ❏❏Distort trade in regional markets through establish coordinated, transparent, streamlined The Investment Climate Advisory differentiated retribution practices for licensing procedures to ease entry. Services of the World Bank Group domestic and imported electricity. helps governments implement Promotion of off-grid investments requires that these Consider links between incentives and review projects be part of national electrification policies, reforms to improve their business them regularly involve private power providers and transparent environments and encourage and Most countries apply a range of instruments to funding mechanisms for renewable energy retain investment, thus fostering support renewable energy. India and the Philippines electrification projects, set pricing mechanisms competitive markets, growth, and use feed-in tariffs, quotas, and financial and tax that allow investments to recover their costs in a job creation. Funding is provided support mechanisms. India also uses tradable reasonable period, and expedite licensing procedures. by the World Bank Group (IFC, certificates for renewable energy. Governments should assess whether all these components are To guarantee competitive and efficient entry, MIGA, and the World Bank) and needed and ensure that they do not have unintended governments should implement competitive over 15 donor partners working effects when combined. tenders to allocate feed-in tariffs, power purchases, through the multidonor FIAS and electrification funds to providers that offer the platform. Support mechanisms should be assessed regularly lowest energy generation prices or subsidies. It is for their necessity and relevance in light of also essential to oversee competitive conditions in technological improvements and the evolution of the power procurement practices of single buyers green markets. The review process must take into and distribution companies. account the imbalance among stakeholders— well-informed investors in renewable energy Finally, policymakers need to be aware of the relative to dispersed consumers who bear unintended effects of implementing an array of diffuse costs due to renewable energy support instruments and periodically review the suitability mechanisms—to avoid capture and make socially of support mechanisms to minimize distortions on beneficial decisions. competition, efficiency, and private investment. Investment Climate In Practice 7 References James, Sebastian, and Nathalie McGregor. Forthcoming. “Green Incentives for Renewable Ceña, A., D. Iuga, E. Simonot, N. Fichaux, S. Wokke, Energy in the Power Sector.” Investment Climate and S. Strøm. 2010. “Administrative and Grid Access In Practice note. Investment Climate Advisory Barriers to Wind Power.” European Wind Energy Services, World Bank Group, Washington, D.C. Association, Brussels. Pöyry, A.S. 2010. “Wind Energy and Electricity Iimi, Atsushi. 2008. “Effects of Improving Prices: Exploring the ‘Merit Order Effect.’” European Infrastructure Quality on Business Costs: Evidence Wind Energy Association, Brussels. http://www. from Firm-Level Data.” Policy Research Working ewea.org/fileadmin/ewea_documents/documents/ Paper 4581. World Bank, Washington, D.C. publications/reports/MeritOrder.pdf International Energy Agency. 2008. “Deploying Renewable Energy Policy Network for the 21st Renewables: Principles for Effective Policies.” Century (REN21). 2010. “Renewables 2010 Global Paris. Status Report.” REN21 Secretariat, Paris. International Finance Corporation World Bank Group www.wbginvestmentclimate.org