What's acceptable Project IRR for Mini Hydro in Java, Indonesia? Does it matter? or Any other things to be considered?

This question has challenged many mini hydro players in Indonesia.  With the existing feed-in-tariff (FIT) of Rp 656 per kwh (assigned by the Ministry of Energy and Mineral Resources Decree back in December 2009) for Java Island as a benchmark tariff, today is valued at only USD 5.5 cents per kwh which represents a fall by 18% since August of 2013.  At the same time, we can effectively see that all construction costs has risen by 20% in Rupiah terms.  Not to mention, the country's inflation which was 8% in 2013.

Allow us to set an example on mini hydro investment in Java Island, Indonesia.  According to our real case experience, the investment for mini hydro in Java in general is estimated to be USD 1.5 - USD 1.8 million per MW.  Of which, civil works (including transmission, project management, engineering cost, and IDC) account for USD 0.9 to USD 1.0 million per MW, and the rest is allocated for land and M&E for USD 0.6 - 0.8 million per MW.  Assuming the project is 70% financed by bank loan with capacity plant factor of 65%, the project will generate an IRR of 12 - 15% in today's interest rate of 12.0% p.a and 10 years payback period (including 2 years construction period).

In summary, we can argue that the project IRR of 12 - 15% is too low or just right. Many would say that it is just not very attractive since the rate is equal to the bank's yield. Whatever the IRR level might be, we can't escape from the 10 years payback period with 15 years power purchase agreement.  The key is to find the banks or financial institutions who are willing to support us for the next 10 years.  It is a long term partnership.  It is a perpetual game and a fixed income play.

The writer hopes that with the right structure and economical yield, the domestic infrastructure financing institutions like Sarana Multi Infrastruktur, Indonesia Infrastructure Fund, Pusat Investasi Pemerintah, syariah banks, and other large commercial banks in Indonesia can contribute more in boosting the investment of mini hydro power plant.  They have done so, but the interest rate is just too high momentarily. Increase in new FIT and breakthrough design of FIT that the writer proposes in his other previous writings may reenergize this lucrative investment.

Why Increase in Feed-in Tariff for Mini Hydro Power Plant in Indonesia Is Not the Only Factor Urgently Needed...New Feed-In Tariff Payment Mechanism Needs to be Changed ! -

By The Flying Garuda

Indonesia's good economic climate during 2009 until the 1st half of 2013, in addition to the Decree of Minister of Energy and Mineral Resources (MEMR) in late 2009 on the revitalization of renewable energy, had surely supported the growing interests in the investment of renewable energy sector, particularly in mini hydro power projects. More investors started to test the water in the sector.

Investing in this sector takes more than money & passion. It takes so much patient & energy. The work starts from processing the permit from the regency, detailed river & land survey, hydrology study, & soil test. These steps may take easily two months, & when the results are considered worthwhile, one can further continue making pre-feasibility study & land acquisition program. Not forgetting additional permits like the regency location permit, environmental approval, water usage, & project construction license. These steps are still not enough. Prospective investors have to start talking to the state-owned electricity company PLN whom by law will and must purchase the power from the project. Acceptable detailed engineering design & the complete feasibility study must be submitted & reviewed by PLN. In parallel, investors also have to apply for the permit to produce power from the MEMR. The whole process easily takes one year to complete until investors obtain the Purchasing Power Agreement with PLN.

The other challenge is to source secured financing from banks. Not many banks in Indonesia understand the business of mini hydro power plants. Some simply don't understand the business, but many have the views that the project is quite risky. Number of reasons why banks view this project is risky. For example, considered as a greenfield project, 60% of the mini hydro power total project cost is allocated for civil work, & the rest consists of mechanical, electrical, & balance of plants. Bear in mind many of potential mini hydro projects are located in remote areas. This factor weakens the collateral value of the bank loan in the case when the bank needs to reposses the collateral in the area which has minimal land value with unfinished assets. The project's nature of fixed local currency tariff with long-term tenor of more than 10 years has both forex risk and risk of inflation of operating costs, of which the value of Rupiah tariff will no longer keep up with the increasing costs.

The obstacle doesn't stop here. The M&E on turbines and generators are priced in US Dollar & the recent Rupiah depreciation in the 2nd half of 2013 had a significant impact to mini hydro power plant projects. Bear in mind that the Purchasing Power Agreement with PLN is in Rupiah locked up with no adjustment for 15 to 20 years. Unfortunately, the depreciation of Rupiah has also pushed the rise in cost of basic raw materials for civil works like cement, steel pipes, iron bars, & equipment rentals.

High pre-operating costs, long process of approvals, increased construction civil works costs and weakening Rupiah currency surely caused the fall of the project's attractive yield to the level that may no longer be suitable or acceptable for investors. This dilemma should trigger the creativity and innovation by the PLN and the Country's Ministry of Mines and Mineral Resources to do the followings:

1. New Design on Tariffs: The Ministry should divide the tariffs into two composition i.e. the Rupiah and USD portion. The total feed-in tariff should be priced proportianately in a composition of 60% in Rupiah tariff and 40% in US Dollar tariff. For example, if the government decides to improve the basic feed in tariff from Rp 656/kwh to Rp 800/kwh in Java, then the new designed feed-in tariff in Java should be 60% of the energy produced by the mini hydro power plant is priced in Rupiah i.e. Rp 800 per kwh, and 40% of the energy produced is priced in USD at USD 0.067 per kwh (Rp 800 divided by the prevailing Rp exchange rate to USD of Rp 12,000 per kwh). Thus, the energy produced from the power plant is 60% paid in Rupiah and 40% paid in USD which is converted to Rupiah when paid by PLN. By doing so, the government has created the natural hedge on foreign exchange for the project.
2. Inflationary Adjustment Factor to Tariff: It would also be fair if the basic feed in tariif can be adjusted yearly on the Rupiah portion based on the official inflation rate announced by the government. Using our example, the 60% Rupiah portion of Rp 800 per kwh is automatically adjusted by the rate of inflation yearly. This would minimize the inflation risk on a long term commitment to PLN for the next 15 years. As a result, steady fair profit generated from the power plant can be used for maintenance assuring the delivery of energy to the PLN.

Conclusion: It is just not a matter of tariff increase. The government must look beyond this tariff issue. More practical check list of approval system by the related government offices to speed up the process and investor friendly and simple tariff automatic adjustment with fair and healthy proportianately design payment mechanism can be introduced. Afterall, the electricity tariff charged to the end customers are adjusted yearly. It is then fair to adjust the feed-in tariff of power producer on yearly basis. It is the government initiative and the country's mission to prosper the renewable energy business. Let's make the flow of energy from water to power easier and more productive and beneficial to the stakeholders.