Tuesday, October 21, 2008

Hydropower Development - Irrelevant Debate of Small vs. Big

Ever since Schumacher wrote his influential book “Small is Beautiful,” there is a raging debate as to whether Nepal should pursue small hydro development primarily for domestic and local use, or it should go for big dams with electricity for export. On the one side, there are people who firmly believe that “small is beautiful” while people on the other extreme of the spectrum chant the Mantra that “big is bountiful.” They consider their respective mantras very sacred and refuse outright others view. As it is, what is small and what is big is very arbitrary. In India, a project of up to 25 MW installed capacity is deemed to be small while in Pakistan this threshold is fixed at 50 MW. But in Nepal, a project of up to 10 MW is categorized as small.

Economic Linkages
Instead of arguing whether a small or big hydropower project is good for Nepal, the assessment of whether a project is “good” for Nepal must be judged from its impact on and contribution to the economy of the nation. Such an assessment can be made by examining/analyzing various linkages to the economy like backward, forward, investment and fiscal linkages of specific projects. In this endeavor, this paper is attempting to examine/analyze the linkages to the economy of Nepal using West Seti hydropower project, 750 MW, undertaken by Snowy Mountain Engineering Corporation (SMEC), to illustrate the point.

Backward Linkage
Hydropower projects are of capital intensive nature, entailing high initial investment. Depending on the nature of backward linkages of a specific project, the contribution of each project to the country’s economy can be assessed by evaluating how much of the initial investment is retained by the economy, resulting in employment generation, higher level of industrialization, increased contribution to foreign exchange reserve, capacity enhancement and capital formation.

Absorption capacity of the economy also dictates the value/volume of the backward linkage. Obviously, if closer to a hundred percent of the initial investment percolates into the economy, the contribution of such a project to the economy due to backward linkage will be very high. Conversely, if the economy is able to retain very little of the initial investment then the benefit accruing to the economy from such a project will be proportionately low. From this perspective, a project which makes substantial contribution to the economy due to backward linkage is good for the country and vice versa. It is now time to see how backward linkage takes place or fails to take place.

As mentioned above, this write-up attempts to estimate the contribution to the Nepali economy by the West Seti project due to backward linkage, to drive the point home. For this purpose, one needs to take a look at the structure of the initial investment[1] which is as follows (the amounts are inclusive of contingency at the rate of 15% for civil works and at 10% for equipment, project management and resettlement, as provided for in the Detailed Engineering Report of the project):

Of the total cost of civil works of $ 469 million, most of it will be incurred for the procurement of cement, steel bars and other construction materials. Although there are two cement factories (other factories mainly grind clinker imported from India and fill in sacks) the production capacity of these are not adequate even to meet the present domestic demand. And there also are a number of factories producing steel bars in Nepal but these too are unable to meet domestic demand (and, moreover, as these use imported raw materials, the percolation from the use of such steel bars into the Nepali economy is very little). Therefore, the requirement of this project will have to be met by imports. The project will, however, be able to source for gravel and sand within Nepal and it is estimated to cost about $ 1 million.

As Nepal is yet to set up industries manufacturing/fabricating electro-mechanical equipment even for projects below 10 MW, the entire budget of $ 180 million is likely to be spent on imports of electro-mechanical equipment for the project. Same will be the case of investment of $ 22 million in the transmission line. However, it can be fairly assumed that it will cost about $ 1 million in Nepali workers in the installation/erection of electro-mechanical equipment and transmission network.

The resettlement entails purchasing land and building houses for the displaced populace and the land and construction materials is expected to cost 50% of the budget. Project management, to be the responsibility of SMEC, is expected to be predominantly expatriate affair and about 10% is expected to be spent on the technocrats from Nepal.

SMEC has been making it public that 5,000 unskilled workers are expected to get employment during the construction period (as have been seen during the construction of most of the hydropower projects, most of the skilled workers will be sourced from foreign countries). Over the construction period, lasting 5.5 years, the workforce at the construction site will be relatively small in the initial years which will peak during the 4th year and will taper off as the time of commissioning of the plant nears. Therefore, it is estimated that the construction of the project will entail 165,000 worker/months. Total payment to the workers over the construction period is estimated amount $ 15 million at the rate of Rs 6,000 per worker/month.

Multilateral Investment Guarantee Agency (MIGA), being a member of the World Bank group, the premium of $ 34 million will be spent overseas. Similarly, as debt financing for the project will be coming from foreign financial intermediaries, the interest during construction and other financing costs will not percolate into Nepali economy. It is expected that about $ 0.2 million will be spent on lawyers from Nepal and the balance of $ 17.8 million will be paid out to foreign lawyers. SMEC is entitled to a development cost of $ 27 million for preparing the project and it can be fairly assumed that about 10% of this amount will be spent in Nepal.

In this manner, of the total initial investment of $ 1,097 million, about $ 39 million will be spent in Nepal – amounting to 3.56% percolation into the domestic economy. Therefore, the employment generation, level of industrialization, capacity enhancement and capital formation will be limited by this percentage. In the similar vein, although this project entails foreign direct investment of $ 1,097 million but the contribution to foreign exchange reserve of Nepal (another form of backward linkage) will be limited to $ 39 million that will be spent in Nepal. Rest will come to Nepal as the foreign direct investment and will desert the country immediately due to outlays in foreign countries.

Had the absorption capacity of Nepali economy been better, the percolation or backward linkage benefit of this project would have been higher. Conversely, backward linkage benefit of other projects which are not too dependent on foreign sources will be higher. An ideal hydropower project from this perspective will result in 50% or more absorption of the initial investment. Therefore, the debate should be over choosing projects that results in higher backward linkage benefit based on the absorption capacity of the economy. It should also be remembered that the absorption capacity of an economy is not static. It grows with the industrialization of the country. Today backward linkage benefit from this type of project is less than 5% but within a couple of decades it will be closer to 50%. Therefore, from the perspective of absorption capacity of the economy West Seti project is not an ideal size in the near future but it will become an ideal size in a couple of decades.

Forward Linkage
Another important way a hydropower project can benefit an economy is due to the forward linkage benefit which entails using the electricity domestically. Use of electricity by an economy results in multiplier effect on the economy resulting in employment generation, higher level of industrialization, increased contribution to foreign exchange reserve, capacity enhancement and capital formation. The electricity, upon it becoming available, can be used in all sectors. It can be used, for example, in agro-processing, like tea which is currently processed using furnace oil or firewood. With this one change economy will benefit from decrease in import of fossil fuel that drains hard currency, decrease in deforestation and decrease in environmental pollution. Similarly, by using electricity for irrigation, farmers, consequently the economy can benefit due to cultivation of multiple crop, cash crop, etc.

Currently industrialization in Nepal is stifled due to non-availability of abundant electric energy. Even existing industries have to rely on fossil fuels which are not cost effective – resulting in higher cost of production that impacts both the industry and its consumers. But it also drains foreign exchange reserve and also results in environmental pollution due to emission of greenhouse gasses. The fate of transport sector is also not different from the industry which is heavily dependent on imported fossil fuel requiring convertible foreign exchange and resulting in environmental pollution in massive scale. Similar parallels can be drawn in connection with tourism, health, education and domestic sectors.

From the above it is clear that use of electricity generated by a project results in import substitution to an extent and, therefore, positively impacts foreign exchange reserve. However, there are “economists” who believe that exporting electricity from such a project to India helps mitigate the problem of balance of payment deficit of Indian currency – to the extent of total revenue generated by this project by exporting electricity. This, unfortunately, is untrue which can be substantiated by looking at future cash flow of the project subsequent to its commissioning. For the duration of debt service period of about 15 years, of the total revenue generated by this project a large portion will be used up in the payment of interest on the debt and repayment of a part of the principal. Anything left after meeting the debt service requirement as such and operation and maintenance cost will be distributed as dividend of which only 15% will reach Nepal. However, as Government of Nepal is borrowing money to invest in the equity of this project company, most of the money from dividend in the hands of GoN will be spent in meeting this part of the debt service obligation. Therefore, the only “foreign exchange” that will enter and stay in Nepal in the first 15 years of project operation are the energy and capacity royalties, which adds up to about 2.66% of the total export revenue in the case of this project (this is further elaborated under fiscal linkage below).

If the electricity generated from a project like West Seti is to be used domestically, the forward linkage benefit to Nepali economy would have been tremendous. In order to simplify the matter, as only 10% of electricity generated from this project will be available to the Nepali economy[2], we can award it 10% mark for forward linkage.

From the perspective of forward linkage, therefore, the debate should focus on use of the electricity domestically, instead of size, in order to ensure that Nepal benefits from the project. In other words, if a project is built for domestic consumption, irrespective of size it would be a better project than an export-oriented project.

Investment Linkage
Under investment linkage the economy will benefit due to construction and operation of the project from the perspective of return on investment. The return, in the hands of the recipient, will either be used as increased purchasing power which will result in employment generation or will be saved and invested again resulting in capital formation. If a project is fully financed domestically then the financial intermediaries would have earned interest on their investment and the equity holders would have received dividend both of which would have stayed in Nepali economy.

In the case of West Seti, as all debt is being sourced from foreign financial intermediaries and all equity investors are foreigners, except for 15% of GoN, almost all of the return on investment will not percolate into Nepali economy. If the GoN was to take up 15% equity in this project from domestic sources, at least 3.75% of the return from the project would have accrued to Nepal. But, as GoN is borrowing money to invest in this project whatever dividend GoN will receive from this project will flow right back to the lender in debt service. Therefore, this project gets less than 0.1% mark on this count.

It is now clear that the country’s economy gains due to construction and operation of a project as such if it is fully financed from domestic resources due to investment linkage. At this juncture, Nepal is not in a position to invest from its domestic resources in this sized project. However, in a couple of decades this will not be the case. Therefore, from the perspective of investment linkage, this sized project is not an ideal size now but with the gradual increase in the capacity to mobilize fund domestically even this sized project will become appropriate for Nepal.

Fiscal Linkage
The fiscal linkage of a project to the economy of the country manifests in its contribution to the treasury – in the form of payment of various rates, taxes and duties. A hydropower project’s fiscal linkage takes place in two stages – during construction period and post commissioning.

For the construction/erection of a hydropower plant, as described above, a lot of materials and equipment are required to be imported. The hydropower projects are entitled to exemption from custom duty on its import of plant, machinery and equipment, except for 1%. Exemption of value added tax (VAT) on the import of plant, machinery and equipment is applicable for projects up to 3 MW only and projects bigger than this size are required to pay VAT on import of such items. However, as this project is entitled to exemption from sales tax (applicable prior to imposition of VAT), the chances are high that GoN will interpret the legal provision to grant it exemption of VAT. In this manner, this project will be paying about $ 2 million as custom duty on the imports of electro-mechanical and transmission equipment at the rate of 1% during the construction period. This works out to 0.18% of the total initial investment. Apart from this, this project will not be making any contribution to government treasury during the construction period. Compared to this other projects (above 3 MW) would be contributing 2.31% of the total initial investment to the treasury – as 1% custom duty and 13% VAT on the electro-mechanical and transmission equipment. This works out to 7.79% of what other projects would have paid.

During the operational period a hydropower project is required to pay capacity royalty of Rs 100 per kW and energy royalty of 2% of the revenue during first 15 years of the project operation. Due to variation in plant capacity factor of each plant (which in turn is governed by the factors like hydrology, exceedence, etc.), the total contribution to the treasury in the form of royalty ranges from 2.4% to 2.85% of the total revenue of a power plant. Under the prevailing Electricity Act, 1992, the applicable rates for both capacity and energy royalty are common to all projects and this project will be paying 2.84% as royalties. Under current Nepal law, a hydropower project is required to pay income (corporate) tax at the rate of 20% of the net income post commissioning. However, West Seti project is exempt from paying income (corporate) tax. Therefore, this project will not be paying any taxes to GoN during the first 15 years’ operation, except for a very meager export tax of 0.05% of the revenue, which other projects do not pay. Whereas, other projects will be paying income tax at the rate of 20% of the net income, which works out to over 7% of the revenue in the first year and exceeds 14% after completion of debt service. Moreover, under the Project Agreement for this project GoN has exempted even the tax on interest paid out to the lenders and dividend distributed to equity holders/owners. Other projects do contribute to the national treasury through these taxes as well. Compared to this project, paying only 2.89% as royalties (and no income tax) other projects will be paying income tax additionally – this project less than 25% of what other projects will be paying.

Furthermore, as this is a reservoir type project, it augments the downstream flow during the dry season by 90 m3/s; equivalent to 7,770 million liters per day (MPLD). No arrangement has been made to receive recompense for this. No efforts seems to have been made even to emulate the precedent set by Columbia Treaty between Canada and USA or the agreement between Lesotho and South Africa.

From this it is clear that the fiscal linkage of West Seti project, both during the construction period and during the operation period, with the government treasury is tenuous at best. In other words, the contribution to the treasury of this project to the GoN is quite low compared to other projects (7.79% of what others pay during the construction period and one fourth of what others pay subsequent of completion of the project).

Conclusion: Mark-sheet
This project contributes 3.56% as backward linkage, 10% as forward linkage and 0.1% as investment linkage (the lower fiscal linkage contribution of this project is not considered here as it is not due to the size). From this it is clear that out of the aggregate of 300 marks this project’s tally is a meager 13.66. Therefore, the debate should not be as to the small or big project. A project’s advisability from national perspective must be decided on the basis of its score on above basis. If a project deserves at least 150 marks out of 300 then that project enriches the economy a lot than a project like West Seti.

Backward linkage of small and medium sized project now is higher than this sized project and this will increase with the increase in the absorption capacity of the economy. Similarly, if the electricity generated from a project is exported, there will be no the percolation into economy in terms of forward linkage. Moreover, foreign investment means percolation of benefit accruing from investment linkage in the foreign countries. Thus, foreign investment in export oriented project is a deadly combination which deprives Nepal of both forward and investment linkage. Conversely, even if the backward linkage is low, the project will contribute to the Nepali economy substantially if it is constructed for domestic consumption with domestic investment. In this way it is not the size that matters but how the project is structured.

(Published as a chapter of book compiled by Institute of Foreign Affairs titled "Water Resource Management of Nepal: A Strong Means for Sustainable National Development" in January 2008)

[1] Source: Detailed Engineering Report of West Seti Hydroelectric Project, prepared by SMEC International PTY. LTD., December 1997.
[2] Pursuant to the decision of Natural Resource and Means Committee of the Parliament, GoN is required to take 10% of the electric energy in kind, although the Project Agreement with the proponents of this project (as amended by 8th amendment) envisages receiving money in lieu of energy. In this paper, it is assumed that GoN will succeed in amending the project agreement to receive energy itself, instead of money in lieu, in order to conform to the Committee’s decision.

1 comment:

Unknown said...

Well structured and analysed scenerial and hope someone, somewhere and somehow will in future projects worldwide will take an approach of this kind before implementing any project regardless of the magnitude of that project