Tuesday, January 13, 2009

Nepal earning Rs 250 billion - III

January 1, 2009

Dear Shankarjee

I am glad that you have realized that you should do some more thinking about it. I am also glad that you too have agreed that water resource has more to it than just hydropower; like "water management, flood control, irrigation, exports and its economics." People in Nepal rather tiring equate water resource with hydropower, that too for export in the hope of Nepal earning the mythical amount (captioned) as royalty and make Nepal fabulously rich.

1. In the context of Nepal earning Rs 250 billion issues like "debt: equity ratio, cost of constructions, risk and its internalization, construction period, interest rate, expected return on equity, payment period, runoff the river type or reservoir type" and so on are not relevant under extant law (under the new law - yet to be promulgated - royalty rates for run of the river (RoR) and storage type is different and, hence, will become relevant). The parameters like "energy output, energy selling price, escalation" that you have mentioned in the first part of the particular sentence are relevant for energy royalty. For the capacity royalty these too aren't relevant; only installed capacity is relevant.

I still stand by my statement that there is no way for Nepal to receive Rs 250 billion from 10,000 MW, at 50% plant factor, even at the bulk rate of Rs 5.70 (here I have changed the rate from US cents to Rs to make it simple for people to figure out) merely because Rs 250 billion is the total amount from the proceed of sale and paying this very amount to GoN in royalties will leave nothing for the investors/developer (no dividend), for banks providing debt finance and even for O&M.

Designing a hydropower plant at Q40/Q45 will indeed generate more electricity from the same site. By reducing the exceedence (from Q65), installed capacity will increase and wet season generation will also increase commensurately. However, with the same dry season flow the dry season generation will increase only marginally. Therefore, for a specific site there is way to increase the plant factor simultaneously with the reduction in exceedence. It means there will be more secondary energy which fetches lower bulk tariff compared to firm energy. You will need to remember that PTC India agreed to pay less than US 5 ¢ (less than Rs 4) for peak-in energy from west seti project. Thus, with the increase in wet season energy (and only marginal increase in dry season energy) due to increase in the installed capacity, the weighted average tariff commanded by a specific project will go down and, therefore, Nepal's royalty earning also will go down ratably. As regards the plant factor of 68%, it will be possible in the case of RoR projects only, which too don't fetch good tariff. Storage projects, rarely, achieve plant factor higher than 50% - there may be some rare exceptions, though.

2. When you say that Nepal has not revised electricity tariff for about 10 years you must be referring to retail tariff. While the recent revision in "PPA prices" is with regard to bulk tariff. This is an excellent formula to run down NEA in the fashion and manner of NOC.

3. I agree.

4. I agree with you regarding governance issues.

(a) One way for GoN to earn Rs 250 billion in royalties is to be able to sell the electricity at Rs 19.026/kWh and charge about 30% as royalties. No detailed analysis is required to arrive at this number and in current market condition it will not be possible to achieve this bulk rate. It is true that GoN intake of 30% level has been achieved in the case of Arun III. There is a poignant lesson here. West Seti project is a reservoir project which not only generates peak-in energy but even augmented flow in the dry season but Nepal's intake from this project is limited to about 13% including free electricity. This confirms that Nepal has been short changed, rather massively (the phrase short changed is defective, due to the work "short"). Lesotho receives $ 25 million per annum for 18 m3/s from South Africa while Nepal gets nothing for 90 m3/s which is worth about Rs 6 billion if same rate is used.

(b) Karnali Chisapani, 10,884 MW
You have assumed the plant factor to be 68% and then you go on to say that "It may be higher in this reservoir project." This is absolutely incorrect. Reservoir projects operate at a lower plant factor. Therefore, your statement that "The energy that can be sold will be 59568 GWh" is also wrong. From the information I have it will generate only 21,496 GWh (vide "Hydropower Pricing in Nepal" published by Jalsrot Vikas Sanstha, in 2004).
Wish you happy new year and with best regards,


Ratna Sansar Shrestha, FCA
Senior Water Resource Analyst


-----Original Message-----
From: Shankar Sharma [mailto:shankarpsharma@gmail.com]
Sent: Tuesday, December 30, 2008 9:08
To: Ratna Sansar Shrestha
Cc: NNSD@yahoogroups.com
Subject: Re: Rs 250 billion as royalty from 10,000 MW

Dear Ratna Sansarji,

Further to my yesterday's email, I found a small error in Case 2. The total investment is not 21, 000 billion, but 2,100 billion and the last line in this paragraph should be "This will give less than 10% return." Sorry about the error. There could be others, but other numbers look ok to me at least now.

With best regards,


On Mon, Dec 29, 2008 at 10:07 PM, Shankar Sharma shankarpsharma@gmail.com> wrote:

Dear Ratna Sansarji,

It has been an interesting debate and I felt that I should do some more thinking on it. It is not because that I am an expert on it, but because I also would like to know more about it.

I would like to convey some of my thoughts on Rs 250 billion, again. The purpose of the following argument is on Rs 250 billion and not on other aspects of the hydropower development. It has other aspects like water management, flood control, irrigation, exports and its economics. I am sure they all can be debated in due course of time.

Similarly, there are also issues related to maximization of government revenues without repelling the investors, optimization of hydro projects by providing reasonable rates of return and implementation of policies and project. They should also be taken into consideration. In addition, there are other problems like Nepal's governance, conflict, local problems, political interests and commissions, Indian interest etc. to optimize the solution.

Government did a study before introducing VAT in Nepal, with the help of the 'best' VAT experts in the world including that from the Harvard University. The report said that the revenue from Sales tax would double once VAT is introduced in the country. But it didn't happen, although the progress was commendable. Similarly, most of the people could not visualize the expected problems in Middle Marsyagdi and we know the problems. One has to take into considerations these constrains for hydropower development and the issue is extremely complex.

I also believe that the environment in Nepal at present is not conducive for accelerated hydropower development. Nevertheless, we should try to be positive, support the country in the development of hydropower and make it as one of the major inputs for making Nepal more prosperous. I believe that it is possible.

Rather than going into all the details of hydro, my argument today will be just on financial return and some of the analysis related to it. I want to tell you that I am not an expert on electricity development and its analysis. But I want to examine the possibility of maximizing revenue from Hydro in Nepal in relation with what we have been discussing on 10, 000 MW and Rs. 250 billion annual revenue for Nepal.

First of all to understand the details of financial analysis, you know we need to talk about a number of things including energy output, energy selling price, escalation, debt: equity ratio, cost of constructions, risk and its internalization, construction period, interest rate, expected return on equity, payment period, runoff the river type or reservoir type and so on. Therefore, it is not that easy to say anything firmly. We have to have probably 100s of assumptions related to different parameters and the results will be based on those parameters and assumptions. Therefore, we can have different results based on different assumptions.

Given all these conditions I would like to provide the followings in favor of Rs 250 royalty/income. Please give some thoughts on it.

1. The argument you mentioned in the email ".. 10,000 MW, at 50% plant
factor, at the bulk rate of US 8.65¢ amounts to about Rs 250 billion, there is no way Nepal can receive the same amount in royalties. No expert worth the salt will ever be able to prove this." I think the assumptions are very conservative. Most of the projects that have been applied in NEA these days have designed at Q40/Q45 and the plant factor of 68%. The revenue that you mentioned will not make any project feasible and we want to talk only feasible projects to get the optimal solution. The construction period and loan repayment period will be easily 15-20 years. The capital of the investor will increase to Rs 1197 in 15 years time from RS 100 today, after capitalizing IDC and debt repayment. If the return to him is guaranteed to 16-18% (let's say 18%) he has to get at least Rs. 215.5 annual return for the invest Rs. 100 made earlier. Third, price should not stay constant, it has to be adjusted according to some parameters—government adjusted feasible escalation rates and or inflation. When we consider all these parameters, the assumption that you mentioned will make little sense.

2. Nepal, has not revised electricity tariff for more than 10 years and the inflation has increased by more than 55% (simple average) during the same period. The revised PPA prices announced this week, will help very little in expediting hydropower development. (Also see Kantipur, 29 December 2009 for detalis).

3. Policy of the government says the PPA rate will be determined on the basis of avoidance cost, inflation and existing tariff rate or return on equity. If it has to be translated into action, a lot more has to be done. Otherwise, hydropower development will be slower in Nepal. This has not happened.

4. I also don't think that given Nepal's governance and political situation it will be easy to expedite hydropower development in Nepal. Nevertheless, the positive scenario is that, Nepal can benefit a lot from hydropower development and I am also inclined to say that it is not impossible to get Rs. 250 billion revenue (don't see this as a point but largely as a significant resources coming from hydro) to the government and reasonable rate of return to investors (say 18% annual return). If it is not possible, there is no point investing in hydropower development and the country will not benefit out of it. But again, you have to realize that the return to investor as well as to the government can not be fully realized until the project starts > generating revenues and debt are fully paid. I would like to illustrate from the following examples.

(i) Case 1: The following is an example based on a more "realistic" PPA proposal (still conservative especially for plant factor and escalation –years as well as rates)

Installed capacity 43 MW;
Plant factor 63%;
Debt equity ratio: 70:30
Escalation 3% annually for 10 years
ROE = 19%
Design discharge Q40
Total energy: 239 GWh (after deducting outage)
Corporate tax: 20%;
Income tax: 1.5%
Energy sale price Rs 6.40 (0.8 cents @ Rs. 80); however, it was not the proposed rate; it is different. It is my assumption based on (i), (ii) and (iii) above

a. Under these assumptions, in 15 years (after 4-5 years construction period and 6-7 years of loan repayment plus two to three years) one can have the following output:

i. Revenue 2.06 billion

ii. Government's share:
1. Capacity royalty @1500/Kw (new proposed by the government) =0.065 billion
2. Revenue (energy) royalty @10% of revenue =0.206 billion
3. Tax (21.5% on profit)= 0.25 billion (approx.)
4. Total = 0.521 billion
b. Or Government's share could be Rs 0.521 billion per annum for 43 MW
c. If the above assumption hold true for 10,000 MW, the government's portion of income could be Rs. 121.2 billion per annum
d. If the plant factor is increased to 68% from 63%, the income from 10,000 MW to the government could go up to 130 billion
e. If the entire project is for exports and 25% free energy is provided to the government then Rs. 2000x43000 (capacity royalty) + Rs. Billion 2.06 x.15 (energy royalty) + Rs billion 2.06 x.25 = Rs billion for 0.807 for 43 MW; This translates to Rs 188 billion for 10,000 MW
f. If plant factor is increased to 69% and 30% energy is provided free to the government than the income to the government could be around Rs. 250 billion. It will still provide good rate of return to the investors.
g. The calculations provided in (e) and (f) above may be slightly in the higher side as one has to deduct energy capacity revenue for the free energy provided to the government. These are only approximation. On the other hand, if the projects are of reservoir type, NEA (unofficial version) can consider buying electricity at a higher rate. Similarly, Indian act has become so liberal these day that they have been able to sale electricity for about IC Rs 10/Kwh in a captive market and I heard that Indians also get some refund from carbon trading. I got it confirmed from one of the participants (Dr. Kohli) from the Planning Commission, India in a recent SAARC conference held in Pakistan last week as well as the Indian investors in Nepal. This will be more beneficial to Nepal and the expected gain could be higher. Therefore, we could have better prospect to increase the financial benefits.
h. Validation of the above analysis : If ROE is given at the rate of 18% (the norm in NEA is 16-18%), then his capital after IDC as well as repayment (7 years average as all the expenditures will not be done in year 1 or 2 or 3) will be greater than Rs 319 and the return he should be getting is 57%. The equity investment will fetch 57% return beginning from the 8th year of the start of the construction period.
i. These parameters and calculations satisfy the optimization of the project, provide reasonable return to investors and in the meantime maximize the revenue to the government.

(ii) This example is only one of the proposals closer to "reality" and therefore I just wanted to project/extrapolate on the basis of it. However, the purpose of developing 10, 000 MW should not be mistaken by developing 233 different projects of the average size of 43 MW. Therefore, let's take another case for illustration.

5. Case 2: 10,000 MW (Karnali Chisapani):
• The construction period for this project will be at least 10 years (normal estimate is 12 years+).
• This is a reservoir project and will have a higher value.
• The energy selling price is Rs. 6.40 (8 cents with an escalation of > 3% per annum for 15 years). As this is a reservoir project, the selling price will be higher. However, I am using conservative estimate on it.
• The plant factor is assumed 68%. It may be higher in this reservoir project.
• The energy that can be sold will be 59568 GWh

Under these assumptions and using the royalty rate of exports for capacity and energy and 25% free energy the share to the government will be Rs 258 billion. This can be realized when the plant comes into operation and loan is repaid, and I don't think this can happen before 15 years (and normally in 20 years time) of the start of the construction of the project.

Validation: As discussed in the 4 (h) if the total investment is about 21,000 billion and debt ratio is 30:70, the equity capital will be about Rs. 3279 billion and the annual return should be more than Rs.590 billion after 15th year. This will give only 14% return.

The assumption in this case is highly conservative, in terms of cost of project, rate of return to investor and number of other parameters. However, if the cost in high—about 70-75% higher than the present estimate and which is more likely for high dam projects, then the selling price should be higher. It is however, possible as we are talking in the time frame of 15-20 years and if we see the past trend, the inflation for the next 20 years will be more than 120%. The export price if it starts about Rs. 8 and if escalation is adjusted to a > certain extent, then the project will be optimal and viable. In that case, the revenue to the government will also be higher.

This case is simplistic, but a feasible scenario.

I did all these assumptions and calculations based on some of the PPA proposals submitted to NEA and a two hour discussions with a senior > engineer and a senior financial analyst. These are all indicative and may not exactly match the real project. It may have number of unrealistic assumptions and calculation could have gone wrong, as I have done a very complex exercise in a few hours. And in the meantime I am not an expert, like some of you. This is probably the first analysis that I have done on electricity of Nepal. However, the only idea is to find out a situation in which Government can maximize the benefit (not the total or economic, but I am talking at this point on IRR) and the investors get reasonable rate of return. I hope it can provide some "food for thought" to you.

With best regards and a Happy New Year 2009!


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