By Peter J. Rae
By understanding the breadth and scope of the work to be completed in developing a new hydroelectric project, developers can manage the process concurrently instead of in series. This management strategy can minimize the amount of time needed for development and maximize return from the project.
The work involved in developing a new hydroelectric facility begins with identifying the initial need for the plant and ends with successful operation. In between, there is typically significant expenditure of capital but no revenue from the project. Thus, the development process should be as short as possible, to minimize the funds expended and the associated interest costs, and to advance the realization of revenues. A short development period can significantly increase the overall return on investment for a hydro project.
However, in reality, development periods for hydro projects can be quite protracted. Delays can arise as a result of regulatory requirements, environmental or social issues, financing difficulties, or construction problems. Examining these problems can reveal that, rather than being random or uncontrollable events, these issues often are evident at the outset of the process. While events can conspire to extend even the best development program, it should be possible to manage a hydro project development in a way that reduces both the time to implementation and the cost of the project.
A professional management approach requires early recognition of the breadth of issues to be considered and the planning needed to achieve the required outcomes in a timely manner. Fundamentally, development should be about mitigating risks that can delay implementation of a project or increase its cost to the point that investor returns are damaged.
A properly staged development program allows identification and management of risks before making a final commitment to invest. As part of the development process, it is important to recognize that not all projects are feasible. At each stage of development, investors must have the information needed to make accurate decisions regarding whether to continue or abandon projects.
The central party in development of a hydro project is the owner, which is often an amalgam of project promoter, a development company, and investors. The promoter identifies the project and proves its initial value. At this point, a developer normally enters the process, with resources available to move toward construction. Investors often have little interest in early stage (and high-risk) development activities but high interest in well-defined projects with a high probability of success.
Other parties in a hydro project development include regulators, the energy purchaser, financiers, a consulting engineer, and constructors. The role of the regulator, which is normally a public entity, is important to establish the framework in which the project must exist. The energy purchaser is fundamental to the commercial benefits of the development. The purchaser must confirm the market and help set the value of the electricity produced. Financiers have a key role in mobilizing the funds needed for development, and their perceptions of risk can decide the viability of a project. Engineering input is provided using conventional consulting arrangements, although the scope of work varies significantly depending on the stage of development. Constructors generally enter the process at the latter stages, when many of the characteristics of the risk profile have been fixed.
Keys to effective management
There are six factors that are key to the effective management of the development process for hydro projects:
- Appreciation of the breadth of activities required to advance a project through the development cycle;
- Understanding of the uncertainties inherent in the development process;
- Ability to recognize critical risks at each stage and to devise a strategy to mitigate the risk;
- Realistic valuation of the project at each stage;
- A ruthless approach to forego development if the project does not appear viable at any stage; and
- A broad skill set including engineering, social, environment, legal, financing, and contracting.
Appreciation of breadth required
Hydropower development involves management of a set of inter-related project elements, each of which could delay or derail the process if not dealt with quickly and properly.
In the past, expansion of generating capabilities by public or publicly regulated utilities was managed largely as an engineering and construction process. Other activities were dealt with as required to meet the on-line date for the project. Today, project development has become a more complex process involving several parallel activities that must be dealt with at each phase of the cycle. The scope of the work at each phase will depend on the project role, its physical characteristics, environmental and social effects, the regulatory environment, and financing requirements.
Essential elements of the development process include:
- Engineering studies and design, which range from initial site identification, project assessment, pre-feasibility and feasibility studies, design for construction tender, and detailed design during construction;
- Contracting for design, construction, and equipment procurement;
- Commercial agreements for power sales, land rights, project concession, and other aspects necessary to establish the regulatory and business framework for the project;
- Environmental issues;
- Social issues, especially when resettlement is required; and
- Financial studies, including tariff analysis and confirmation of the viability of the scheme for the market conditions, funding for project equity, and financing of project debt.
Many developers, especially in the private sector, enter the development process with a set of business skills and an interest in an attractive investment opportunity. What the developer may lack is sufficient experience with the full breadth of the elements required for successful development. As a result, the developer proceeds with activities that are within his or her expertise, while not fully recognizing the importance of the other aspects of the process. Failure to act in any of these elements leads to a delay while work is undertaken to fill in the missing elements. By not recognizing the elements for success and implementing a comprehensive management system, the developer performs tasks in series rather than in parallel. This makes the process unnecessarily protracted.
The full range of activities required for development of a hydro project should not take more than about four years, with many activities running concurrently.
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The full range of activities required for development of a hydro project should not take more than about two to four years. This depends on how well the project is defined, the studies available (e.g., feasibility study and investigations, power planning study, environmental, etc.), and the approach used for financing. Figure 1 illustrates a typical development schedule.
Clear understanding of uncertainties
Uncertainties can arise from a variety of sources, including technical conditions, market conditions for contracting, the social and environmental image of the project, and relations with regulators, power purchaser, and lenders.
The development process runs through a series of stages, starting with the initial project identification and ending with commercial operation. From the investor’s perspective, the process should include the operation period from its commercial operations date to the end of the life of the project (or its commercial agreements). Ultimately, management of the development process is about mitigating uncertainty so that the outcome for the developer results in a clear business case for the project and certainty about the return on the investment.
The development cycle for any project includes similar activities. The challenge is to properly assess the scope of activities at the outset of the cycle so that the correct actions can be taken at the appropriate time. Developers often underestimate the required scope of activities, leading to delays in the development cycle. Underestimates often are due to a failure to comprehend the uncertainties in the process.
The obvious activity at the outset of the development cycle must be identification of a project need, i.e. a market opportunity for sale of electricity. The developer must then identify a project that can fulfill the need at a price that is competitive with other options. At one time, utilities conducted this analysis using least cost generation expansion planning. However, in the case of independent power projects, the task falls to a project developer to present a proposal that can provide electricity at a lower cost than competitors. This is an important initial task that requires appraisal of all factors affecting the proposed project and its likely cost. Some projects have spent years in the development cycle without performing this crucial analysis, and the project languishes without significant chances of success.
Next, the developer must establish a business case for the investment. To ensure that investors will be willing to place capital in the development, the project must produce returns equal to or better than competing investment opportunities. Key activities through this stage normally comprise a technical feasibility study (i.e. engineering), environmental impact analysis, social impact analysis, financial modeling, and an appraisal of likely commercial conditions for the project.
Field investigations are a necessary part of the development process for a hydroelectric project, to determine both feasibility of the project and the potential environmental effects.
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Not all projects will be feasible when tested at this stage. Most projects can be technically feasible at a price, but that does not ensure they will be financially, economically, socially, or environmentally feasible. With a significant possibility that the project might fail to meet the required standard, the developer must determine how much to invest in development activities without being assured of success.
If the project passes the tests for feasibility, the developer must prepare for implementation by: finalizing technical studies and investigations, preparing a construction contracting strategy that meets financing constraints, concluding the commercial agreements (power purchase agreement, concession agreement, leases, etc.), and initiating financing.
Financial close for the project is a key milestone. All conditions combine to provide a financially viable project consistent with the market, while achieving the required technical, construction, environmental, and social standards. However, the development cycle does not end until construction is complete and the project achieves its commercial operations date. Some developers underestimate the potential for difficulties during the construction phase and incorrectly assume that development activities end with financial close.
Recognizing and mitigating risk
The overall probability of success at each stage is determined by the combined probability of risks from each of the elements. For example, at an early stage there can be risks due to uncertainty in hydrologic or geological conditions, the fact that people living in the project area are not willing to be resettled, and the chance that the utility will not buy electricity at the required price.
A developer must clearly understand the risks implicit in the project at each phase of the development cycle. It is especially important to understand how these risks originate and who bears the largest cost. For example, with regard to social risks, the group that most directly bears this risk is the project-affected people who experience the cost of changed conditions or resettlement. The risk is often a simple fear of the unknown that can lead to resistance to a new project, in preference of the status quo. The result is manifested to the developer as social risk. By understanding the nature of this risk, the developer has the opportunity to mitigate the risk and improve the overall probability of success.
Realistic valuation of the project
The concept of a development value is a useful way to assess the value of the project through its life cycle and to consider the benefits of management in maximizing value. Figure 2 on page 16 illustrates this concept.
A cash flow can be constructed for an idealized project that includes all activities in the development cycle, through the end of the concession period (for a private sector project) or the end of the useful life of the plant. Cash flow can be thought of as a cost and revenue budget for the project. Costs are incurred during the early years for various studies and investigations. The project has a net consumption of investment capital during this period, with the amounts increasing during the construction period. However, from the commercial operations date to the end of the concession period, the project will provide revenues to the investor in the form of dividends. The dividends will, of course, be the difference between the gross revenue from electricity sales less any expenses for operation and maintenance, debt service, royalties, taxes, and other charges.
One estimate of the value of the project in any year is the net present value (NPV) of all costs and dividend revenues from that year to the end of the concession. For a viable project, NPV will always be positive, even though there is a negative cash flow during the development period. The analysis for a hypothetical project illustrates that NPV increases from the start of the development period, reaching a peak when the last of the project debt is retired. NPV then decreases in the later years of the project life as the remaining revenue accrual period decreases. Note that the analysis treats development costs as sunk costs, which are not included in the future value of the project in any year. In other words, the development costs already expended are excluded from the analysis of future value.
However, the true value of the project should be weighted according to the probability of achieving a successful outcome. In any year, the real value would be NPV multiplied by the probability that the project will be completed and achieve the revenue stream. In many cases, the probability of success is quite low, leaving developers with projects that have very low real value until the correct combination of conditions can be achieved.
An interesting outcome of this approach is that the increase in value as a result of activity in the development cycle can be visualized. A rational developer would only expend funds equal to the potential increase in value as a result of the activity. This actually can explain the reticence of many developers to invest funds where they are unsure of the outcome.
In practice, the amount of value that can be gained by small steps through the development cycle is often quite small. For example, the cost of a comprehensive feasibility study normally far outweighs the increase in value of the project as a result of completing the study. The low value of the feasibility study often results in developers wishing to minimize the money spend on this important step. In fact, failure to prepare a proper feasibility study would subsequently increase uncertainty, so that the project would be delayed or simply impossible to complete. In effect, the developer must be willing to risk money on this important step to ensure success.
The other feature of the analysis illustrated is that a longer development time often increases the sunk costs but does not increase the value of the project from the commercial operations date. The project income only starts from the commercial operations date, so the present value of the income is the same regardless of how long the developer takes to reach commercial operations. Any delay normally results in higher costs due to ongoing overhead cost and the interest cost for funds already expended (actually the lost rate of return on equity invested in the project rather than in another investment).
Foregoing development if appropriate
Not all hydro projects will be feasible for development, especially for private sector developers. However, some developers have persisted with their activities in spite of their inability to reach a successful conclusion. There are many causes leading to a failure to reach a successful outcome. Key factors include:
- A fundamentally infeasible project because of high costs, large environmental effects, or lack of an appropriate commercial and legal framework;
- Insufficient market demand for the electricity;
- Lack of managerial capacity within the developer to deal with the scale or complexity of the project; and
- Lack of financial resources to fund the development activities.
If a developer cannot recognize his or her own limitations or the failings of the proposed project, the result can be lingering expenditures in the forlorn hope that conditions might somehow change.
Performing investigations of a potential project site is part of the work to establish a business case for the project.
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I have examined sites on behalf of developers who were unwilling to accept a negative outcome from a feasibility assessment. In one case, the project would have required construction of a large dam that would quickly be susceptible to reservoir sedimentation. The costs of the spillways and sediment flushing facilities and the loss of revenue due to flushing operations left the project unable to provide an acceptable rate of return. The result was a financially infeasible project. However, the developer was unwilling to accept the negative outcome and continues to hope conditions will change. The project has not advanced.
In another case, the tariff rate available for electricity sales precluded the successful development of an otherwise attractive project. The tariff rate had been set in a political arrangement between two governments and did not reflect the true value of the electricity. The intention was to create an energy subsidy by reducing the returns provided to private sector developers. Projects in this setting have failed to reach a conclusion, although several developers have persisted in the hope that the political framework will change.
If the failure to achieve success is due to the developer’s limitations, the result is that an otherwise attractive site is not available for more capable developers. I am aware of several instances where developers are not capable of reaching a conclusion because the scale or complexity of the projects are beyond their management or financial capacities. These developers continue to expend funds with little hope of success, while preventing other more capable developers from taking over the site. In these examples, the loss is felt by both the developer (lingering development costs) and the nation (loss of economic activity).
In both cases, effective management would imply a ruthless approach to project assessment. Developers should honestly assess their capabilities and limitations to ensure that any given project will achieve a successful outcome. Managerial limitations can be addressed, provided that financial resources are available. Financial capabilities can be improved, but this generally requires that the originating developer give up some control, an outcome not often acceptable. In either case, the developer must make this assessment and take effective actions.
Infeasible projects must be dropped to ensure that the developer does not expend funds unnecessarily. It is far better to redirect development efforts to a more attractive project site than to persist with a flawed project, even if the developer is constrained by a concession or other political constraint.
A broad skill set
Successful developers recognize the multi-faceted nature of hydro development and are able to build teams with the necessary breath of skills. Development teams should include staff experienced in engineering management, commercial agreements, contracts, environmental/social assessment, financing, and project management. The development team should be led by a strong manager with experience necessary to assess issues as they arise and decide on an effective program.
The capability of the developer is directly related to the strength of the team built for the project. Financial returns available from any given project will depend on how well the process is managed. The capabilities of the staff must complement each other to provide an effective team covering all facets of the development. Importantly, the development team should also have good local knowledge, especially with respect to the political and economic framework for the project.
By implementing a professional approach to management, hydro project developers can enjoy significant financial benefits. These result from a reduction in the time needed to advance the project from initial needs assessment to financial close. Many developers do not have the breadth of experience needed to deal with the full gamut of issues involved with hydropower projects. The development process requires a combination of engineering, social, environmental, business, and financing skills. s
Mr. Rae may be reached at Theun Hinboun Power Company Ltd., P.O. Box 3382, Nongbone Road, Vientiane, Laos; (85) 6-205509455; E-mail: [email protected] thpclaos.com.
Peter Rae is president of PJR Consulting Inc. In addition to acting as project manager for the 280-mw Theun Hinboun Expansion project in Laos, which is expected to start construction in 2008, Peter provides ongoing advisory services to the 84-mw New Bong Escape project in Pakistan, which recently achieved financial close.