The Challenge of Low-Carbon Development - World Bank Internet ...

Box 2.1The Economics of Grid-Connected Renewable EnergyA stylized model provides useful insight into what financial and policy levers can boost the economic attractivenessof a renewable energy project. The economics depend on four factors: unit cost, capacity utilization, tariff, andcarbon credit rate.A developer needs to finance a power plant with a unit cost of $1,000–$4,000 per kW. The plant will produce a flowof electricity. But most renewable energy plants do not operate at full capacity. Wind plants, for instance, may onlyproduce 25–40 percent of their theoretical full output. This ratio is the capacity utilization. The electricity is soldat a net tariff of, say, 5–15 cents per kWh after transmission costs. This renewably generated electricity may alsodisplace fossil-generated electricity, generating a carbon credit rate of, say, 0.2–1.2 cents per kWh, depending onthe price of carbon and the kind of fuel displaced. Then (with some simplifying assumptions, such as negligiblecosts of operations and maintenance, no peak-period tariffs, and no payments for capacity or penalties forintermittency) the pretax financial rate of return to the project isFinancialrateofreturn=(Tariff +Carbon Credit Rate)8,760 *Capaci ty Utilization.Unit Cost(To get the ERR, use economic rather than market values for electricity and carbon, and account for local environmentalbenefits.)This shows that if electricity sells for $.06 per kWh, then the following actions would have equivalent impacts onthe rate of return:• Adding carbon credits at $10 per ton CO (assuming displacement of .6 kilograms per kWh)2• Adding a renewable energy premium of $0.006 to the tariff• Boosting capacity utilization from 30 to 33 percent through better siting, better design, or improved maintenance• Reducing construction costs from $1,100 to $1,000 per KW.The developer cares about the return on equity, not the overall return, and therefore leverages its equity byborrowing, ideally, 60–80 percent of the capital cost. This works as long as the returns are greater than the interestrate on the loan. The prospective returns have to be high enough to outweigh the risks. These include the risk thatthe buyer will renege on the promised tariff, which must be sustained over many years to pay back the large initialcapital investment.Meanwhile, the lender wants to make sure that the investment is sufficiently lucrative that the developer canreadily afford the loan repayments. So lenders insist that the project’s revenue be sufficient to easily cover theloan repayments—that is, that the debt service coverage ratio be significantly greater than one. This ratio can beenhanced through longer loan lengths and lower interest rates.Source: IEG.Note: 8,760 is the approximate number of hours in a year.lines. The WBG has funded a number of mapping exercises(appendix B). Most of these modestly funded exercises arestill under way, and impact evaluation is not possible.The WBG has financed development of anumber of renewable energy resource mapsthat might assist in siting decisions andthus improve capacity utilization.The WBG could also help, through technical assistance, toensure that projects’ design plans for capacity utilizationare realistic. Hydropower, wind, and landfill gas plants haveundershot their planned production levels; in many casesthis is because of inadequate assessment of resources at thesite. Box 2.2 explains why this has happened for landfill gasprojects and what is being done in response.Operations and maintenance can affect capacity utilization.Unavailability of spare parts can put turbines out of commission,for instance. Technical assistance for maintenance andmanufacturing could reduce downtime. As a crude measureof WBG support in this area, IEG’s review of the 2003–08portfolio found that about one-third of minihydro and onequarterof wind investment components included trainingand capacity building for installation or maintenance.Renewable Energy | 19