Hydropower - Grants & Subsidies

If the price of the energy supplied by micro hydro is too expensive for poor people who need it, then the issue of subsidies and/or grants cannot be avoided. The political acceptability of subsidies has undergone wild fluctuations in recent years. All governments provide subsidies, but it is clear that some have done more harm than good. The essential question that has emerged from the ideological posturing of recent years is less about the rights and wrongs of subsidies in principle, but rather whether a particular form of subsidy actually achieves its intended purpose. The arguments for using money that is supplied at less than full commercial rates of interest are overwhelming if large numbers of people are to be given access to improved energy services. This ‘soft money’ will be required to enable people with insufficient purchasing power to gain access to electricity, and to other more convenient forms of energy. In the most general terms, the reasons why agencies of the state, whether national or multinational, should provide soft money are well known:

• to capture the existence of many positive ‘externalities’ not reflected in market prices, such as the benefits of health, education, welfare, and environment;
• to redistribute income from richer to poorer parts of the community for reasons of equity and or human rights;
• to kick start an ‘infant’ industry by enabling the volume of production to be increased and skills developed to the extent that unit costs of production fall to levels where the target consumers can afford to buy them on a sustainable basis in the future;
• to remove or reduce the barriers associated with inefficient operation of the market. Usually including the unequal distribution of information between buyers and sellers, monopoly elements among both buyers and sellers, and hostile features of the ‘enabling’ environment, such as the unintended consequences of taxes, subsidies to competing options, lack of appropriate regulation, inadequate financial and physical infrastructure, etc.; and
• to assist users in overcoming the high initial costs of purchases that are ‘least cost’ when considered over the their operational lifetime.

While subsidies to ‘pump prime’ markets are quite different from those intended to lower the cost of ‘social infrastructure’, perhaps the most persuasive argument for subsidising micro hydro is made in terms of ‘levelling the playing field’ with other competing options and concern about ‘fairness’. This arguments suggests that:

• micro hydro should receive subsidies that are equivalent to those received by competing options such as the grid or PV;
• micro hydro needs to be compensated as it is unfairly discriminated against in-so-far as it does not get the same tax breaks and other concessions as other technologies;
• micro hydro needs to be compensated because the full cost of other options is not included in the price. For example, the environmental costs of using fossil fuels such as petrol, or biomass fuels such as woodfuel.

There is also weight in the argument that people in remote locations ‘deserve’ electricity as much as poor people in other parts of the country. Furthermore, subsidies to micro hydro may well be justified because they are the least cost way of achieving other development objectives, such as motive power to secure livelihoods, lighting for health and education, refrigeration for the storage of food or medicines.

Before considering subsidies in more detail, it is important to stress two points that have emerged in the current debate. Firstly, the ability of governments, aid agencies or charities to provide subsidies is severely limited in relation to the numbers of people who do not have access to modern forms of energy. Secondly, there is probably more energy-related purchasing power in poor communities than was previously thought. There is now substantial evidence that people currently excluded from most ‘modern forms of energy’ do already spend considerable amounts of money to meet their energy requirements, on charcoal, dry cell and lead acid batteries, candles and kerosene, and in some locations, on fuel wood.

This variability in the ability of even poor people to pay for energy services suggests that from a policy perspective it will be important to distinguish at least three types of financial sustainability. In this way subsidies are used to maximise access and are not wasted on people who already have the ability to pay. This approach forms the basis of recent changes in the Peruvian government’s policies for rural electrification. In this case the National Electrification Plan established three types of electricity expansion projects, depending on the economic characteristics of the target market:

• Class I Projects: Profitable Projects. These projects are intended to make a profit, and under the provisions established in the Electricity Concessions Law, any entrepreneur who identifies a profitable energy project is given the opportunity and the necessary guarantees to implement it.
• Class II Projects: Non-profitable but sustainable projects. If these projects are adequately managed they are capable of covering their operating and maintenance costs, even if they do not make a profit. In this case, the State tries to implement joint financing programmes in order to obtain the so-called ‘investment commitments’ from the private sector. Such projects include those built with State funds but which are subsequently transferred to private or other companies for their operational phase.
• Class III Projects: Non-profitable and non-sustainable projects. These are projects
  aimed at expanding the electrical frontier, for which all that is required is to select technological alternatives that produce the least operating and maintenance costs.

Smarter Subsidies

If the case can be made for subsidies, experience suggests that the use of soft money can both help the expansion of the micro hydro sector and harm it. As always the ‘devil is in the detail’ and in the specifics of each context. Hence the phrase ‘smart subsidies’ has been coined to put some distance between current forms of subsidy and the earlier forms that were shown to stultify innovation, destroy markets, and support the already rich. Examples of this were the subsidies for grid-based electricity, kerosene and diesel.

The key lesson from past experience appears to be to avoid applying un-ending subsidies to the recurrent costs of micro hydro operation, or more specifically do not directly subsidise the price charged to the energy end-user.

‘Smart subsidies’ should be designed in such a way as to re-enforce the commercial orientation of micro hydro schemes to reduce costs and improve service. In most cases this will mean focussing on reducing the cost of the initial investment, thereby increasing the numbers of people who have access to electricity, rather than continuously subsidising the recurrent cost of operation.

More generally subsidies that are based on rules and are transparent to all parties and well known before investments have taken place are less likely to result in waste and corruption. It is also important to consider a wide range of ways in which the costs of the whole micro hydro development can be reduced, and not just be a subsidy to the providers of finance. Providing subsidised assistance for the training of turbine manufacturers, or independent onsite feasibility studies appears to be particularly effective in reducing costs to the user, and in reducing the risks to the investor.

A particular problem with current subsidies provided by bilateral donors is that they have a tendency to ‘pollute the well’ – that is, they use their subsidies to spoil the market for others. This can occur if aid subsidies are available to a particular technology thereby making it very difficult for other technologies to compete. This again happens where subsidies are tied to a particular supplier, usually nationals of the donor country, thereby giving them an unfair advantage. Donor subsidies are currently even being awarded to huge multinational corporations in a number of areas of renewable energy and in particular countries, which makes it particularly difficult for smaller local suppliers to compete.

Best Practice for Smarter Subsidies

Subsidies should be designed to achieve clearly stated objectives and should develop rather than destroy markets.

A particular problem with current subsidies provided by bilateral donors is that they have a tendency to ‘pollute the well’ – that is, they use their subsidies to spoil the market for others.

Smart subsidies should:

• follow pre-established rules that are clear, and transparent to all parties;
• focus on increasing access by lowering the initial costs (technical advice, capital investment) rather than lowering the operating costs;
• Provide strong cost minimisation incentives such as retaining the commercial orientation to reduce costs;
• remain technologically neutral;
• cover all aspects of the project including end-use investments, particularly to encourage pro-poor end-uses; and
• use ‘cross subsidies’ within the project to pay for life line tariffs and other ‘pro-poor’ recurrent cost subsidies (e.g. enable transfer from richer sections of the community, and commercial users to marginal connections).

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Source: Best Practices for Sustainable Development of Micro Hydro Power in Developing Countries; URL: http://www.microhydropower.net/download/bestpractsynthe.pdf

Link to: GTZ study "Energy Subsidies: Why, When and How?"