The economics of rural electrification projects

The economics of rural electrification projects Mohan Munasinghe This paper focuses on the economics of rural electrtfication and project selection. The broad criteria for preliminary screening of RE projects are described in relation to national policy objectives. The economic justtfication is the key step in the project processing cycle, and depends on the present discounted value of benefits exceeding costs. A comprehensive analytical model for identtfying benefits is presented and the practical problems of evaluating them are described. Finally, the paper contains the detailed economic evaluation of an RE project in Malaysia. Kqvwords:

Rural electrification; Rural energy; Rural development

Since the 1950s rural electrification has been promoted by enthusiasts, as a driving force for the development of the rural areas of the Third World. The expectations, particularly in the 1960s and 197Os, included rapid economic growth and improvements in the quality of rural life - especially of the poor; increasing use of electricity for productive activities in agriculture, industry and commerce; and modernization and other attitudinal changes [S]. Such hopes were not surprising, given that RE has played a significant role in the developed nations. On the other hand, sceptics were quick to point out numerous potential problems that might interfere with such optimistic scenarios. In fact, many of their concerns have been realized. Some of the difficulties that continue to plague rural electrification efforts in many developing countries, range from scarcity of capital - especially foreign exchange, high costs and poor quality of supply, to disappointing load growth, low benefits and productivity gains, and perverse distributional effects - with benefits favouring the rich rather than the poor. Because of the substantial investments required to accelerate the pace of rural electrification, government involvement of some type becomes necessary, and most developing countries are pursuing RE programmes as a part of their economic development efforts. This in

The

author

is

Chief,

Operations Division, 20433, USA. Final manuscript

received

0140-9883/88/010003-15

Brazil Energy and Infrastructure The World Bank, Washington, DC

8 May 1987.

$03.00 0

1988 Butterworth

turn implies that there are significant advantages to examining RE issues in the context of overall national policy. The broad rationale underlying national planning and policy-making of all kinds is the need to ensure the best use of scarce resources, in order to further socio-economic development efforts and improve the quality of life of citizens. Planning for energy and electric power, including rural electrification in particular, are all components of national economic planning, and therefore share this same general goal. Meanwhile, because of the many interactions and non-market forces that shape and affect the energy sectors of every economy, decision-makers in an increasing number of countries have realized that energy sector investment planning, pricing and management should be carried out on an integrated basis, eg within an integrated national energy planning (INEP) framework which helps analyse the whole range of energy policy options over a long period of time [2]. In summary, RE planning must also be closely integrated with overall economic and energy planning and policy analysis, to meet many interrelated and frequently conflicting national objectives, as effectively as possible. Using a broad brush approach, RE schemes would generally cover regions where agricultural activity (including agro-industries) was dominant, the ratio of labour to capital used in production was high, and incomes were low on average, relative to urban areas. Load densities would also be relatively low, because the number of connections per km of line, the load per connection and the customer load factor tend to be small relative to urban areas. At the same time, costs

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3

The economics qf rural electrification

projects:

M. Munasinghe

per connection and per kWh supplied would be significantly higher, operation and maintenance more problematic, and the quality of supply lower. Often small or medium-sized towns (population up to 50000) in a rural area may be included, or suburban areas of larger cities. In fact, from the socio-economic and demographic viewpoint, the rural-urban gradation may often be continuous, and the terminology ‘regional electrification’ is sometimes used to indicate programmes covering a mix of rural farms, villages and small towns. From the planning and engineering design perspective, the load and customer density are among the chief parameters which would help to distinguish between urban and rural electric distribution systems. Electricity can be introduced into rural area in several ways: (i) isolated generators powered by a variety of means including diesel, mini-hydro, etc, serving a single consumer (for example a business enterprise); (ii) isolated generators serving several consumers who are connected by a local network, for example a small community; and (iii) public supplies from a regional or national grid system. Typically, these are not distinct’ways to introduce electricity into a rural area, rather, they might occur sequentially. This procedure involving several phases ofelectrification can be thought of as an initial building up of demand for rural electricity, by means of autogeneration, to a point where it becomes economically feasible (in most cases) to connect to a central grid

r71In this paper, the term ‘rural electrification’ will refer mainly to connections to a central grid, since most RE projects being studied are those which are sufficiently advanced to make this economically feasible. This is not to say that the most economical method for electrifying every region in every country once the load has built up, is from a central grid. Even in North America and Europe, where the extent of RE is almost lOO%, many areas continue to be served by local autogenerators as this is the least cost way of providing electricity to such areas.

this set of criteria, rural areas that showed the greatest promise in terms of industrial, commercial and agricultural growth would be favoured. Electricity prices would tend towards efficient levels based on the longrun marginal costs of supply, with subsidies (if any) being carefully targetted to poverty groups. Cost recovery would be easier under this regime. A second group of goals are focused on the satisfaction of the basic needs of citizens, providing electricity services to the poor, and improving the distribution of income and welfare. In this case, the more economically depressed regions of a country would receive greater attention. Pricing policy would rely more on subsidies, and be based mainly on the ability-to-pay of low income groups rather than on supply cost or cost recovery. The third major determinant is based on the principle of cost minimization - to reach as many rural consumers as possible, in the shortest possible time, using limited resources. With this approach, it would be prudent to pursue RE schemes in areas closest to the existing grid, thus keeping costs to a minimum. In practice, a single objective is unlikely to be dominant, to the exclusion of all others. However, the relative weights attached to these different objectives are likely to vary significantly from country to country, thus giving rise to quite different strategies for RE in each case. Some specific approaches to RE include [S]:

(9 Integrated (ii)

(iii)

(iv)

Rural electrification criteria Three broad areas of concern that will influence and shape rural electrification policy, may be identified. The first area is centred around the objective of economic efficiency, which implies optimal use of scarce economic resources to maximize output and growth, and therefore, places emphasis on the productive uses of electricity in rural activities. According to

4

(v)

rural development - electricity is treated as only one component of a wider package of infrastructure. Area coverage - comprehensive networking seeks to provide electricity supply quickly to as many customers as possible within the designated project area. More modified approaches may first adopt a backbone system, with increasing numbers of consumers being added on over a phased time period. Grid extension - electrification is based on proximity to existing networks and their relative ease of extension. Each separate branch addition is judged on its own merits. in areas Isolated generation - electrification remote from the national grid, is based on relative cheapness and abundance of local generating sources. Intensification - concentrating on increasing the load factor and connection rates in already electrified areas.

In recent years, an increasing number of developing countries have begun to place greater emphasis on the productive uses approach, encouraging electricity consumption for agricultural pumping, agro-industrial

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The economics sf rural electrification

and commercial activity, cottage industries, and SO on. There are several important reasons underlying this trend. First. in a situation of resource scarcity, the greater the mobilization of finances within the sector, the easier it is to use these funds to expand rural electrification to more remote areas. Emphasis on productive use of electricity will lead to faster load growth, better cost recovery, and more resources for further rural electrification expansion. Second, if equity considerations are very important, other basic needs - such as access to a safe water supply, better nutrition, and health and educational facilities ~ might have a better claim on scarce public funds. In fact, it might be difficult to argue that electricity is a basic need in some countries. A better case can be made for other fuels, such as firewood for domestic cooking in rural areas. At the same time, the benefits of rural electrification might be greatly enhanced when this service is provided together with other rural infrastructural services - such as transportation, access to credit facilities, and agricultural extension. Areas of productive electricity use are more likely to have access to these other elements of integrated rural development, thus yielding high economic returns to rural electrification investments. Third, subsidized rural electrification projects are inherently a poor mechanism for achieving long lasting distributional gains, while increasing output and employment through productive electricity use in rural areas is likely to be more effective in this respect - at least in the long run. Specific decisions concerning the pace and timing of RE schemes, selection of areas to be electrified, investment and cost recovery policy, and pricing and connections policy, require more detailed analysis. For example, projected national rural electrification targets over the planning period will depend on the current extent of RE, the resources and implementation capability available, and the socio-political pressures for RE in rural areas. Similarly, quantitative criteria for ranking areas for electrification may be developed and used in conjunction with other more judgemental factors. Thus where data are available, a formula of the following type could be used for ranking: RE merit value = C Wi. Ci where w = weight assigned Ci = ith characteristic consideration

to characteristic

C

of the rural area under

In practice, a wide variety of indicators or chatacteristics and weights may be used, depending on the local conditions and data availability.

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projects: M. Munasinglre

While the qualitative links between RE and other characteristics of rural areas have been examined in several recent studies, no systematic analyses of the quantitative relationships between such variables and the returns to rural electrification projects appear to have been done. It would be useful to carry out a study of past RE programmes and use standard statistical techniques (such as regression analysis, or discriminant analysis) to determine the relative weights or importance of specific rural indicators, in ensuring the success of rural electrification efforts. The results of such an ex post analysis would be helpful in future area selection and targetting of RE investments. However, these relatively simple approaches would only serve as preliminary screening devices, aimed at eliminating the obviously uneconomic RE projects and indicating rough priorities for those that remain, The surviving rural electrification schemes would still have to be subjected to detailed project evaluation and costbenefit analysis, as described below. At this stage, it is useful to examine how individual projects within an overall national or regional RE programme are usually defined. A typical rural electrification scheme will invariably include as its core, the primary and secondary distribution networks. However, the scope of the project may be expanded to incorporate upstream investments such as generation sources, transmission, and sub-transmission facilities, as well as downstream components ranging from house-wiring and small electricity using devices to major electric equipment and complementary infrastructure associated with the integrated rural development approach. From the geographic viewpoint also, rural electrification spans’the spectrum from individual connections, through specific feeders, single villages and village clusters, up to large areas or regions. The foregoing suggests that the definition of an RE project is therefore likely to be quite case specific, and determined on the basis of convenience in identifying the costs and benefits associated with a given package of investments, in a particular location. However, there is a danger that the aggregate analysis of large areas containing many consumers might mask significant variations at a more detailed level. Therefore, it is advisable (provided the necessary data are available), that a two stage approach be used, in which macrolevel evaluation of a large RE project is supplemented by the microlevel analysis of smaller components and subcomponents (especially low load density and thinly populated areas), to help refine the scope of the scheme. The most important thing would be to establish a clear cut procedure, and then adhere to it as firmly as possible. Ad hoc, politically motivated intervention in RE policy, especially area selection, should be avoided, since it frequently has disastrous consequences. One of

5

The economics of rural electrt$cation projects: M. Munasinghe the most important reasons for establishing an RE strategy and master plan is to minimize undesirable changes of this sort. However, the strategy should be reviewed at frequent intervals to maintain flexibility and the ability to address new problems as they arise.

Project evaluation and benefit measurement Projects must be evaluated, because economic resources are not unlimited, especially in the developing country context. The decision to finance an RE scheme implies that the scarce resources used for this purpose will not be available for some other project, such as a school or hospital. Moreover, even within a given rural electrification master plan, it will be necessary to rank individual schemes according to some accepted criteria and select the best ones, because the resources available are generally quite inadequate to undertake all possible projects. These criteria are usually closely related to national policy objectives. One of the chief tools for ranking development projects is cost-benefit analysis, described later. As discussed earlier, some rough choices can be made when regional RE priorities are being established at the national level, but the final investment decision on a particular development project is usually made on the basis of a much more detailed, micro-level analysis. In other words, project analysis from a national viewpoint is the preferred method of rationally allocating scarce productive resources, among the different sectors of the economy, as well as individual projects within a given sector. The successful implementation of any development project usually involves several well defined steps. In order to place RE project decisions and economic cost-benefit analysis in its proper perspective, we summarize the systematic approach used by national governments, aid donors and project financiers in a typical project cycle. The steps include identification, preparation, appraisal, negotiations and financing, implementation and supervision, and evaluation [ 13.

Project identification involves preliminary selection of potential RE projects that appear to be feasible and conform to national and sectoral development goals. In the preparation phase which may last a year or engineering-technical, institutional, more, the economic and financial aspects of a proposed RE project are systematically studied. At this stage, a potential external financier may provide staff guidance and financial assistance or help the national RE authorities obtain other assistance to carry out the studies. In the next stage, project appraisal consists of a

detailed review of all aspects of the project. An appraisal report is prepared that comprehensively evaluates the project, in the context of the national and sectoral strategies, as well as the engineering-technical, institutional, economic and financial issues. In particular, the economic evaluation involves several welldefined stages, including the demand forecast, leastcost alternative, benefit measurement and cost-benefit analysis. If foreign financial assistance is involved, the appraisal report may be used as the basis for negotiations at which the country and financier discuss the measures required to ensure the success of the project, and the conditions for funding which are usually included in loan agreements. Supervision of the implementation process should be carried out through periodic field inspections and progress reports. Reviews of ongoing RE projects help to update and improve implementation procedures. Evaluation is the final stage of the project cycle, following disbursement of funds. Project performance audits should be carried out by an independent group involving review of previous project documents and field visits where appropriate. This analysis yields valuable experience that helps improve the work at all stages of the project cycle for future projects. Economic just$cation In view of its importance, the procedure for the economic justification of an RE project is described in greater detail. As mentioned earlier, the first stage involves the preparation of a demand (or market) forecast. The least cost alternative, benefit measurement and cost-benefit analysis are interrelated and depend on the economic criteria described. Two related criteria are useful in the economic evaluation of investment projects: maximization of net benefits or minimization of costs. Maximization of net benefits is the more general approach, used in the costbenefit analysis stage, to justify the use of scarce resources in an RE project, rather than elsewhere in the economy. To make optimal inter-sectoral allocation decisions in such situations requires the explicit determination of all benefits and costs over the lifetime of the investment. By contrast, a cost minimization approach, used in the least-cost solution stage, eliminates the need to measure the value of the benefits provided. This approach assumes that a given level of demand must be provided in similar quantities and qualities, whatever the supply source. The question then becomes simply one of selecting the lowest-cost method of supplying rural electric consumers. Both these criteria are helpful and used in a complementary way to evaluate RE projects.

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The economics of rural electrification

Following usual cost-benefit practices, the basic objective function to be maximized here is developed in terms of net benefits or income. This leads to maximum economic efficiency in resource allocation. Under certain restricting assumptions mentioned earlier, net benefit maximization is equivalent to minimization of economic costs. Making efficiency, at least initially, the sole criterion for the choice among alternatives has obvious technical advantages. We find that the choice of efficiency as the goal provides us with an unambiguous ranking order among alternative rural electrification schemes. If we ignore the problems that are common to all objective functions, including the evaluation of uncertainty and risk, of unpredictable changes in technology.and relative price levels, of the valuation of intangibles and non-marketed outputs, of positive or negative externalities or spillovers, and the troublesome issue of individual and collective time preferences, any project that yields more net income will be preferable to one that yields less. However, from the rural consumers viewpoint, it is not really income that we ought to maximize but welfare, or total utility. The result is that an analysis which tells us how to maximize income does not necessarily tell us whether or not we are also maximizing welfare. Nevertheless, the choice of income maximization could be defended if the government would be willing to approach more equitable distribution patterns by redistributing income from the original beneficiaries to those considered to be more deserving.

EJicient

horder

(shadow)

prices

In the ideaIized worId of perfect competition, the interaction of atomistic profit-maximizing producers and utility-maximizing consumers give rise to a situation that is called pareto-optimal. In this state, prices reflect the true marginal social costs, scarce resources are efficiently allocated and, for a given income distribution, no one person can be made better off without making someone else worse off. However, conditions are likely to be far from ideal in the real world. Distortions due to monopoly practices, external economies and diseconomies (which are not internalized in the private market), interventions in the market process through taxes, import duties, and subsidies all result in market (or financial) prices for goods and services, which may diverge substantially from their shadow prices or true economic values. Elliciency shadow prices help to establish the actual economic values of project inputs and outputs [6]. To derive a consistent set of economic shadow prices for goods and services a common yardstick or numeraire to measure value is necessary. A most appropriate numeraire in many instances is a unit of uncommitted

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public income at border (shadow) prices. Essentially, this unit is the same as freely disposable foreign exchange available to the government, but expressed in terms of units of local currency converted at the official exchange rate [3]. The estimation and use of shadow prices is facilitated by dividing economic resources into tradeable and non-tradeable items. Tradeables and nontradeables are treated differently. The values of directly imported or exported goods and services are already known in border prices, that is, their foreign exchange costs converted at the official exchange rate. Locally purchased items whose values are known only in terms of domestic market prices, however, must be converted to border prices, by multiplying the former prices by appropriate conversion factors (CF). Border (shadow) price = conversion factor x domestic (market) price or BP=CFxDP

Given the prevalence of non-efficiency considerations like low incomes and a large non-monetized sector in rural areas, does it still make sense to begin by analysing the efficiency solution? The answer is: yes, it does. First of all, it is useful to know by itself which of the various alternatives will result in the largest increase in total net income to the national economy. Second, only if we do know how much income is obtainable can we make an assessment of the ‘costs’ that various distributional or non-quantifiable objectives may have. The efficiency measure provides us with something of a yardstick that can be used to measure the consequences of the latter even if it cannot tell us what their real value is. In some cases we might find that these costs are unacceptably high. In others it might turn out that the proposed beneficiaries of a specific distributional objective may voluntarily opt for compensatory payments instead, if they find that such payments could make them better off. Knowing the economic losses associated with the realization of nonefficiency goals would greatly facilitate evaluations of potential trade-offs between the multidimensional objectives that usually form part and parcel of any comprehensive national development programme, and associated RE master plan. What we can conclude is that despite its shortcomings, an income maximization function serves a useful purpose for the evaluation of alternative development policies and rural electric investment decisions. What must be remembered, however, is that finding the most efficient solution by itself does not answer the question: which of the various policies are preferable in terms of overall community welfare? It only provides us with a

7

The economics oJ‘ rural electr+cation projects: M. Munasinghe

tool that can be used to calculate the necessary sacrifices in terms of total income that are needed in order to include other and possibly broader social objectives. The objective function has been formulated in terms of total net benefits, whereby net benefits represents the present value excess of all social benefits over all social costs. The most basic rule for accepting a project is that the net present value (NPV) of benefits is positive [4]: NPV=

f: (Bt-Ct)/(l r=0

productive activities and lifestyles with and without the project.

Figure 1 illustrates the likely effects of introducing electricity to a rural area that had no such services available previously. To simplify the exposition, the analysis is presented in comparative static terms. The effects of introducing electricity are likely to be felt over a number of years, as potential users make the necessary investments in electricity using appliances over a period of time to take full advantage of the new energy source. The three graphs in the figure represent three distinct types of energy use. First, Figure I(a) indicates the demand for an output such as mechanical energy for pumping, where the new electricity supply can substitute for another form of energy that was previously used, with no significant change in the qualitity of the useful output. The horizontal axis is in units of useful output, eg gallons of water pumped, while the vertical axis shows the effective total cost to the customer (including fuel as well as the annuitized and prorated appliance capital costs), per unit of useful output. Since the overall costs of mechanical energy from network-based electricity supply are usually much lower than the costs of operating diesel or gasoline consuming motors, nonelectricity consumers will shift to electricity use, while their demand will also increase from AB to AC, due to the reduction in effective costs. Other examples in this category include kerosene refrigerators, diesel autogenerators of electricity, and so on. The second category ofdemand shown in Figure l(b) arises from new uses of electricity that were previously not thought of, or considered infeasible because of technical problems or prohibitively high costs. Typical examples include small power tools, television, air conditioning, and so on. The consumption, GH, therefore, represents an entirely new or induced market for electricity.

costs in year t, r is horizon. is also used as a by:

,io (Bt - Ct)/( 1 + IRR)’ = 0 Thus, the IRR is the discount rate which reduces the NPV to zero, and the project is generally acceptable if IRR > R (some critical discount rate). Both benefits and costs are defined as the difference between what would occur with and without the project being implemented. As described earlier, for the economic testing, B, C and r are defined in economic terms and appropriately shadow priced using efficiency border prices. In particular, the shadow price of r is the accounting rate of interest (ARI) which is equivalent to the opportunity cost of capital (OCC) in efficiency prices. However, for the financial analysis of RE projects B, C and r may be defined in financial terms.

Benefit measurement If benefits are to be measured accurately, it is important to identify the types of electricity end-use and patterns of demand over the duration of the RE project. Therefore, before describing methods of estimating the benefits of rural electrification schemes, it is helpful to begin by analysing the likely evolution of

a

AB

G

C

Useful output

b

Figure 1. Rural electrification

region,

Patterns of energy use

+r)’

where Bt and Ct are the benefits and the discount rate, and T is the time The internal rate of return (IRR) project criterion. It may be defined

in a rural

JL

H Useful output

C

F’

F

Useful output

and energy use.

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The economics of rural electrification projects: M. Munasinghe

The third graph, Figure l(c), shows the demand for a service such as illumination or lighting, where electricity will displace another energy source (say kerosene), but with a significant improvement in the final output. The higher quality of output results in the demand curve shifting out from D, to D,. If there was no such shift, demand would have increased from JL to JF because of the lower price of electricity, but with the demand shift, the overall need for lighting would be JF. Basic economics

of benefit measurement

Consider Figure 2, which is a static picture of the likely energy use by a typical consumer in the RE project area, both with and without the project being implemented. This case is similar to the one shown in Figure l(c) except for the fact that the X-axis here is measured in kilowatt hours (kWh) or their equivalent. The symbols indicated in the figure are: Without project

condition

With project condition D, = demand curve

for electricity, shifted outwards due to higher quality of output (eg electric lighting); QE = quantity of electricity consumed, in kWh per month; MC, = marginal cost of supplying electricity pE = price of electricity (subsidized below MC)

In conventional microeconomic consumer theory, the benefit derived from consuming a good or service may be measured by the area under the demand curve. Therefore, in the without project situation, [GAGa is the user benefit of consuming an amount of energy QA, where the symbol [. . . . .] is used to indicate an area. The corresponding cost of supplying this energy is MC,. QA. In the same way, the benefit and cost in the with project condition are [OEIJ] and MC,. QE, respectively. The incremental benefit, defined as the change in benefits brought about by the project, is:

D, =

demand curve for an alternative form of energy QA = quantity of alternative energy consumed, in kWh per month of electricity required to produce the equivalent output MC, = marginal cost of supplying alternative energy pA = price of alternative energy (subsidized below MC)

IB = COEIJI - [OAGKJ + PE.(QE-

= [AEFG]

Q,A

Similarly, the incremental cost is: lC= MC,.Q,-

MC,.Q,

‘_

0

.K

_J

QA

QE

t

Energy used per month

Figure 2. tion.

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January 1988

net economic

benefits

of rural electrifica-

+ [FHI]

The economics of rural electriJication projects: M. Munasinghe

Finally,

the net benefit

due to the RE project

is:

NB=IB-IC

=

{PE(QE - Q/t) + MC,. QA + CFHII + [AEFG]}

-

Q,}

(MC,.

In the above expression, the last term indicates project costs, and we may write:

the

C = [MC,. QEI The remaining part of the expression is usually called the project benefit:

represents

what

B = IPE.(QE - Q,d + MC,. QA + CFHII + [AEFG]} If we consider the expression for C, the marginal cost element MC, is the long-run marginal cost (LRMC) of supply [4]. The expression for B is somewhat more complicated to interpret. The first term in B is the sales revenue corresponding to the additional energy used, while the second is the cost saving due to alternative energy not used. The final two terms are areas representing consumer surplus. In general, these demand curves will shift and consumption levels will change over time. The present value of the stream of (shadow priced) net benefits must be evaluated, year by year, over the lifetime of the project, to yield the NPV described earlier. The other cost-benefit criteria may also be calculated, once the annual stream of net benefits are estimated.

Pructicai

estimation

ofbenefits

The project costs C, evaluated in border shadow prices, may be estimated more easily by using the following breakdown: C = (LRMC

grid).

of supplying

RE grid + LRMC

of RE

QE

= (total cost of supplying

RE grid)

+ (cost of RE grid) The cost of supplying electricity to the RE grid, to meet consumption QE as well as losses, either from the bulk supply network or from isolated generation, is straightforward to estimate. The least-cost solution has already been identified, and therefore the cost of the (cheapest) RE grid is also available. Based on the demand forecasts already made, and the corresponding price of rural electricity, the benefit term involving revenues from incremental consump-

10

tion may be evaluated quite simply. Since the demand projections are usually made with the explicit (or sometimes implicit) assumption that the current price will prevail into the future, in real terms, this is the appropriate price to use when estimating benefits. It is theoretically possible to assume that the future value of pE will increase or decrease in real terms, but in this case the demand forecast should also be based on the same projected evolution of price. Given the quality of data available, it is rather unlikely that such forecasts of price and consumption can be made with any degree of accuracy. Therefore, the ‘neutral’ assumption of constant real price of electricity is the safest to use. If this RE price is well below the level of LRMC, then the consumer surplus portion of benefits [FHI] will be relatively large and its estimation becomes more important, as discussed below. On the other hand, in the (rather unlikely) event that price is not very different from LRMC, then the incremental revenues will approximate the full benefits more closely. These revenues are evaluated in domestic market prices, and if the latter are distorted, appropriate shadow prices must be used. One well known approach is to transform market priced values into border priced ones, by multiplying by the appropriate conversion factor, usually the standard conversion factor (SCF), or consumption conversion factor (CCF) c31.

The second term in the expression for B represents cost savings. Usually, it is reasonably safe to assume that all existing non-electricity using equipment such as kerosene lamps and diesel motors will be replaced, and therefore, equivalent border priced cost savings may be estimated. The rate at which this substitution takes place has to be predicted, and also reflected consistently in the demand forecast. However, there is also the issue of new energy using equipment that might have come into use, in the without project situation. Forexample, the presenceofdiesel pump sets suggests that it is profitable for farmers to invest in them, and therefore, more such pumps may be purchased in the future if the RE scheme is not implemented. Alternatively, private electricity generation which would be more costly than the RE scheme might have emerged. In theory, cost saving benefits may be claimed for all these possibilities, but in practice, such predictions are risky to make. Therefore, the usual approach is to evaluate savings on existing energy using equipment, as a base. Additional cost saving benefits due to substitution of hypothetical new equipment that might have been bought, in the absence of the RE project, must be carefully justified on a case-by-case basis. the consumer surplus on incremental consumption of electricity. Additional output due to increased produc-

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The economics of rural electrification projects: M. Munosinghe

tivity in new activities may be used to approximate some of this willingness-to-pay for rural electricity. For example, the electrification of rural households might result in incremental earnings due to new cottage industries or sewing and tailoring activity. Alternatively, new electric pumps might increase farm yields significantly. The border priced economic value of additional output, net of all input costs including expenditures on electricity, is the appropriate measure of consumer surplus to be used. Similarly, higher net output derived by replacing an existing energy source with electricity, may be used to estimate the consumer surplus area [AEFG]. This benefit is over and above the cost saving benefit arising from the replacement of alternative energy described earlier. Several typical examples of potentially quantifiable benefits of rural electrification, that may be used to estimate both cost savings and net increases in output, are summarized in Table 1. The actual evaluation of such RE benefits is described in greater detail in the case studies that follow. Some results of quantitative benefit measurement and cost-benefit analysis from recent RE schemes are also summarized in Table 2.

Table 1. Typical examples of rural ekecectrificationbenefits.

Quantifiable

benefits: cost savings and increased productivity

Industrial and commercial uses of electricity (i) Motive power - replacing liquid fuel (ii) Lighting - replacing liquid fuel or gas (iii) Space heating, cooling and refrigeration - replacing liquid fuel, coal, gas, biomass or animal waste (iv) Processing food - replacing liquid fuel, coal, gas, biomass or animal waste (v) Transport - replacing liquid fuel Household uses of electricity (i) Lighting - replacing liquid fuel, gas, biomass, or animal waste (ii) Preparing meals - replacing biomass, animal waste, liquid fuel, coal or gas (iii) Space heating, cooling and refrigeration - replacing biomass, animal waste, liquid fuel, coal or gas (iv) Home appliances (fan, iron, radio, television etc) - replacing batteries. biomass or coal (v) Drinking water - replacing liquid fuel (for pumping) Agricultural uses of electricity (i) Water pumping - replacing liquid fuel, coal, gas or muscle power (ii) Parboiling, heating and drying - replacing biomass. coal or liquid fuel (iii) Milling, chaff cutting, threshing, etc - replacing liquid fuel, hydro and muscle power, coal or biomass Benefits that are difficult or impossible to quantify

(i) Modernization, dynamism, and attitude changes - catalytic effects (ii) Quality of life, community services, and participation (iii) Income redistribution and social equity (iv) Employment creation (v) Other sociopolitical effects

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January 1988

Table 2. Benefit measurement in selected rural electrification

Country

Bangladesh Colombia Egypt India Ivory Coast Malaysia Morocco Philippines Syria Thailand Tunisia Yemen (Arab Republic) Yemen (People’s Democratic Republic)

and internal economic rate of return projects (1975-84).

Incremental revenues (% of total benefits) <5 55-100 65-85
Sources: World Bank, Asian Development Bank, USAID.

Development

Internal rate of return (% )

II 8-13 3-10 17-70 I5 I7 6 1622 8 12-15 S-12 1618 13-15

Bank,

Inter-American

Incremental revenues appear to provide the bulk of the benefits, except in Bangladesh and India, which are both low income countries where the ability-to-pay is a serious problem. The internal economic rates of return (IERR) compare favourably with the opportunity costs of capital (8-12 %) in most countries, except for the case of Egypt where rural electricity prices are heavily subsidized. Other benefits

Promoters of rural electrification often claim that there are significant non-quantifiable gains. These benefits may be conveniently examined in five categories as discussed below, and summarized in Table I. First, it is argued that rural electrification results in widespread modernization and dynamic growth in rural areas. Most of the productivity gains by households, agriculture and industry, may be quantified as explained earlier. However, if RE acts as a catalyst, there may be further unrecognized benefits due to revitalization and change in attitudes of the entire community. Second, social benefits could accrue due to overall improvements in the quality of life. For example, electric lights will invariably enhance the ability to study, leading to greater literacy, or the presence of a village centre equipped with a television set, radio and other amenities, might help to improve cooperation and the community spirit. Similar gains could occur in other areas affecting social welfare, such as health and sanitation (eg safe drinking water), communications, and personal security (eg due to better lighting). Third, rural electrification may be viewed as an

11

The economics of rural eiectr$cation projects: M. Munasinghe

effective instrument for improving social equity and income distribution. As described earlier shadow prices may be used to weight benefits and cost to the poor, in order to quantify some of the welfare gains due to income redistribution. However, this is rather difficult in most cases for several reasons. Data on rural incomes are usually very weak, and therefore it is difficult to identify poverty groups and determine the correct social weights. At the same time, the benefits of RE may in fact accrue mainly to the better off sections of the rural community, such as local officials, wealthy landowners, and entrepreneurs. Therefore, targetting the benefits of rural electrification, especially through connections policy and price subsidies, is frequently a much more important practical goal than attempting to quantify distributional benefits, fruitlessly. Fourth, there may be significant employment impacts following the electrification of rural areas. The direct employment effects due to greater productive uses of electricity will be captured by analysing incremental output, as described earlier. However, intangible benefits include increased personal satisfaction and family welfare, as well as reduced congestion, crime and social discontent. Another important benefit may arise from reduced rural to urban migration. This may be caused by the perception of greater employment and other opportunities for advancement in hitherto stagnant villages, or because of general improvement in the quality of life. Finally, it is sometimes argued that rural electrification may provide a number of other general benefits, viewed from the national viewpoint, such as improving political stability and reducing discontent, improving national cohesion, and reducing urban-rural and inter-regional tensions and inequalities. The economic basis for claiming additional essentially unrecognized social benefits is analysed in Figure 2. Consider the ‘social’ demand curve for electricity D,, which includes surplus benefits represented by the area [ERSI], due to the factors indicated above. While some of the unquantifiable benefits are included conceptually within the users demand curve D,, the social surplus benefits are usually not internalized directly within the consumers demand curves, because they are not perceived as benefits by individual users. However, such benefits may be included under the curve D, which indicates the willingness-to-pay of society as a whole, if they yield identifiable gains to the rural community. Since it is very difficult or almost impossible to quantify these benefits, great care and discipline must be exercised to avoid the temptation of using such claims to justify an RE project that otherwise would not have been viable.

RE project evaluation in Malaysia Background

Malaysia is a middle income developing country, with a 1983 income per capita of USS 1860 and a population of 14.9 million. During the decade 197&80 real gross domestic product (GDP) grew at an average rate of almost 8%, while the total energy consumption increased at 8.6%. In 1980, total energy use was 57 million barrels of oil equivalent, of which over 90% was derived from petroleum products. The sectoral breakdown of oil use was 43 % for transport, 29 % for power generation, 21 % for industry, and 7 % for other uses including households. Malaysia is relatively well endowed with energy resources. Current recoverable oil reserves are estimated to be about 3.5 billion barrels, but if recent domestic consumption growth rates of 8-9% per annum continue unchecked, the country might become a net oil importer within the next decade. Recoverable non-associated natural gas reserves (mainly off-shore) are greater, and have been estimated at 38 trillion standard cubic feet (scf) or about 6 million barrels of oil equivalent. Planned uses of the gas include: electric power generation, chemical feedstocks, and liquified natural gas (LNG) for export. The usable hydroelectric potential of the country is about 120000 GWh per year, but less than 15% of this lies in peninsular Malaysia, where over 90 % of the load is located. Over 70% of the hydro potential is in Sarawak, and harnessing it would require transmission via undersea cable to the load centres on the peninsula. Recoverable coal resources of 400-500 million tons are quite modest and located mainly in Sarawak. Furthermore, they are relatively low quality lignite with a high moisture content. Electricity is supplied in peninsular Malaysia by the Lembaga Listrik Negara or National Electricity Board (NEB), an autonomous government power utility. The Sarawak Electricity Supply Corporation (SESCO) and the Sabah Electricity Board (SEB) perform the same functions in the states of Sarawak and Sabah respectively, located on Borneo island. All three organizations fall under the Ministry of Energy, Telecommunications and Posts (METP), which also created an Energy Unit (in 1980) to coordinate overall energy policy and provide infrastructural support to the Cabinet level Energy Committee. Since the rural electrification project described below lies in the peninsula, information concerning Sabah and Sarawak will not be used in the subsequent analysis. References to Malaysia will generally refer to the peninsula, unless otherwise stated.

ENERGY

ECONOMICS

January

1988

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The economics

gf rural electrification projects: M. Munasinghe

Table 5. Population, electrification,

Total population ( x 103) Population,

of states

Pahang

Kedah

Kelantan

Total

770.6

1 102.2

877.6

73 292.7

538 492.3 100855 88 559 39042 (44.1)

794 780.3 260 679 235 978 38 733 (16.4)

386 545.0 128 836 109 561 22 648 (20.7)

3691 2 130.8 554458 492 176 124 386 (25.2)

58.8 26.7 14.5

82.5 12.7 4.8

84.9 11.0 4.1

77.7 15.6 6.7

in kampungs

313.2 64128 58 578 23 963 (40.9)

income distribution in kampungs

Less than $250 (%) $250-400 (X) Above $400 (X) Occupation

82.4 13.6 4.0

profile in kampungs

Shops Rice mills Oil mills

1512 124 6

2433 83

Fish, ice and coffee processing Saw mills Iron works Dressmaking, weaving, batik, handicrafts

Sources:

1980 National

Census

1

4 607 487 2

3 054 489 2

11606 1 I83 11

102 43 12

17 101 40

17 63 41

123 50 34

259 257 127

649

116

121

399

1285

and NEB.

live in kampungs or traditional villages, with a mean size of about 577 persons or 133 households. The rate of electrification of homes varied from a low of 16.4 % in Kedah to a high of 44% in Pahang. The main economic activities in rural areas are agriculture (including rice, rubber and palm oil), forestry, fishing and cottage industries. Only about 22 % of all families had a monthly income exceeding M$250 (US$108.7). On average, there were about 5.5 commercial establishments (mainly small shops), and less than one small industrial enterprise per 1000 population. This background information, and expected future development of the rural areas, may be used to analyse and forecast future demand for electricity. The results are summarized in Table 6. Next, appropriate least cost rural distribution networks are designed to meet the expected load growth. The physical details of the project and the corresponding costs are given in Table 7. All costs are in 1982 prices, and the foreign component is net of taxes and duties. A conversion factor for local costs (LCF = 0.85) is used to transform the domestic priced local costs into border prices. In addition to the electrification component, a number of broader issues were identified, to be addressed during the course of the project. These issues

14

Pahang. Kedah and Kelantan.

542.3

1973

(%)

villages) in Trengganu,

Trengganu

households and electrification

Number of kampungs Population (x 103) Families Households Electrified households

Monthly

income, and occupation data of kampungs (traditional

included: (i) encouraging more productive uses of electricity; (ii) improving the engineering standards and design criteria for greater cost effectiveness, while maintaining an acceptable quality of supply; (iii) strengthening RE planning; and (iv) implementing an information gathering and feedback system to improve future projects.

Estimation

of benefits

The three principal groups of rural electricity consumers for whom benefits need to be measured are households, commercial and industrial users. At this stage, it is convenient to rewrite the equation that defines RE project benefits, as follows: B =

PE.

QE + (MC,

-

PE). QA + CFHII + CAEFGI

Household consumers. Starting with the domestic consumers and focusing attention on the first term in the above equation, it is relatively straightforward to estimate the incremental revenues, from forecast electricity sales in Table 6 and the present average household price of M$0.20/kWh. Next, the cost saving

ENERGY

ECONOMICS

January

1988

The economics

qf rural electrification

projects:

M. Munasinghe

Table 6. Load forecast. Sales to consumers (GWh)

Year

Households” connected

1983 1984 1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996-2010

31195 75 946 114 537 128 614 135 761 138476 141245 144070 146951 149 890 152 888 155946 159065 159065

Domestic

Commercial sod industrial

Total

Bulk supplyb Requirement (GWh)

18.0 43.0 65.6 74.7 81.1 85.9 91.1 96.6 102.4 108.5 115.0 121.9 129.2 129.2

84.5 183.5 268.0 281.3 295.5 310.2 325.8 342.0 359.1 377.1 395.9 415.4 436.5 436.5

102.5 226.5 333.6 356.0 377.3 396.1 416.9 438.6 461.5 485.6 510.9 537.6 565.7 565.1

108.7 239.6 353.6 377.4 399.9 419.9 441.9 464.9 489.2 514.7 541.6 569.9 599.6 599.6

a Growth of connections assumed to be 2 % from 1987 to 1996. ‘Bulk supply (at 33 kV) = total sales x 1.06 (based on approximately

6 % losses in RE networks).

Table 7. Project components and costs (MS x 10% Foreign costs,

Local costs,

Local costs,

Total costs,

Border prices

Domestic prices

Borderb prices

Border prices

33 kV OH lines 33 kV UG cables 33/l 1 kV substation 11 kV lines 33 and 11 kV/400 V substations

27.17 4.15 11.13 53.00 25.66

3.94 2.78 8.24 37.07 21.27

3.35 2.36 7.00 31.51 18.08

30.52 6.51 18.13 84.51 43.74

LV lines Service connections and meters Land and way leave Consulting services

29.02 22.61

87.76 51.56 15.85 3.19

74.60 43.83 13.41 3.22

103.62 86.43 13.47 3.22

172.74

232.26

197.42

390.16

Item

Total costs a 1982 prices. b Border price = domestic

price x local costs conversion factor (LCF = 0.85).

benefits represented by the second term in the above equation is evaluated, by calculating the foregone expenditures on alternative kerosene lighting. Details of this computation are summarized in Table 8. Further household related benefits may be identified, but are difficult to quantify accurately. For example, considerable surplus benefits appear to be derived from appliances like fans, rice cookers, electric irons and television, based on the willingness-to-pay for these items. Such benefits may stem from greater convenience and efficiency (eg electric versus charcoal

ENERGY ECONOMICS

January 1988

iron), as well as better quality and greater hours of use (eg electric versus kerosene lighting). Survey data also indicated more general benefits perceived by potential electricity consumers, including improved opportunities for children to study, greater village and household security, and better socioeconomic conditions and opportunities for modernization. Household activities are also made more productive, due to improved working conditions brought about by better lighting and cooling (with fans) in tropical conditions, as well as better electrical equipment and

15

The economics

of rural electrification prqjects: M. Munasinghe

Table 8. Annual savings due to electric lighting (border prices). Electricity item

Cost (MS)

Kerosene item

Wiring costs (MS200 annuitized over 10 years at 10%)

35.4

One Petromax lamp (MS45.0 annuitized over 10 years at 10%)

1.4

MS1.0 per bulb and a life of 1000 hours Cost of 96 kWh at 17.6 cents per k Wh”

16.9

Total cost

53.7

Annual a Border

(M$)

Cost 8.0

Fuel cost for 96 kWh equivalent of kerosene at M$ 1.45 per kWh

139.2

Total cost

147.2

cost saving = MS 93.5 per household price = domestic

price x SCF = 20 x 0.88 Mcents/kWh.

tools. At the prevailing wage rate, one extra manhour per day would be worth about M$20 per month to a family. Incomes in the target rural areas are significantly higher than in most Asian and African developing countries. The willingness-to-pay for rural electricity services offered by private operators is quite considerable (Mcents 40/kWh). Another indicator of the extent of electricity consumption benefits is the use of home

autogenerators in the 1-3 k W range, producing city at a cost of about M$l/kWh.

electri-

Commercial and industrial consumers. As described earlier, most of the business enterprises in the project areas consist of small shops, and a few industries such as rice, oil and saw mills, iron works, and processing plants. A survey of these types of consumers indicated that the benefits derived from increased output made

Table 9. Economic cost-benefit calculation (1981 border prices). Costs (MS x 1W)

Benefits (MS x I@‘)

Year

Investmenta

Operation and maintenanceh

Bulk supply’

Total

Domestic revenued

Kerosene savings’

Commercial and industrial’

Total

I983 1984 1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996-2010

136.22 115.92 87.47 6.80 6.80 6.80 6.80 6.80 6.80 6.80 6.80 6.80 6.80 0.0

2.12 5.04 6.79 6.93 6.93 6.93 6.93 6.93 6.93 6.93 6.93 6.93 6.93 6.93

20.86 46.10 67.89 72.45 76.79 80.6 1 84.85 89.26 93.92 98.83 103.98 109.41 115.13 115.13

159.80 167.06 162.15 86.18 90.52 94.34 98.58 102.99 107.65 112.56 117.71 123.14 128.86 128.86

3.17 7.57 11.55 13.15 14.27 15.12 16.03 17.00 18.02 19.10 20.24 21.45 22.74 22.14

2.9 I 7.09 10.69 12.01 12.67 12.93 13.19 13.45 13.72 13.99 14.27 14.56 14.85 14.85

33.12 71.93 105.06 110.27 115.84 121.60 127.71 134.06 140.77 147.82 155.19 162.84 171.11 171.11

39.20 86.59 127.29 135.43 142.78 149.65 156.94 164.52 172.51 180.9 1 189.70 198.85 208.70 208.70

Internal

economic

rate of return

(IERR) = 20.3%

’ 1981 border price = 1982 border price (Table 6)/1.09 (inflation). Investments from 1986-95 are 2% of the 1983-85 total, to meet load growth. h 2 % of cumulative investment. ’ Bulk supply cost = energy supplied (Table 6) x 0.192 (LRMC of bulk supply in 198 1 border prices). d Domestic revenue (border price) = sales (Table 6) x average price x SCF average price = M$ O.Z/kWh; and SCF = 0.88. ‘Total kerosene savings = annual savings per household (Table 8) x households connected (Table 6). ’ Commercial and industrial surplus benefits = sales (Table 6) x benefits per kWh (border price). Border priced benefits per kWh = 0.392.

ENERGY

ECONOMICS

January

1988

The economics of rural electr$cation projects: M. Munasinghe

possible by rural electricity supply (eg refrigeration), or through the replacement of existing alternative energy sources (eg isolated generators), range from MS0445 to over M$0.6 per kWh used. Economic

cost-hen&

analysis

The economic cost-benefit calculation, based on the above estimates of costs and benefits, is summarized in Table 9. The values in this table are derived as follows. The 1982 border priced investments (from Table 6) are divided by an inflation factor of 1.09, to derive the 198 1 border priced investments, and then allocated over the period 1983-85. Investments from 198695 are 2% of the 1983-85 cumulative investment, to meet continued load growth. Annual operation and maintenance costs are estimated as 2% of the 1983-85 cumulative investment. The bulk supply costs are equal to the bulk energy supplied (from Table 6) multiplied by the LRMC of bulk supply in 1981 border prices. The latter is M$O.l92/kWh, based on the LMRC of bulk supply in 1984 domestic prices (M$0.262/kWh) multiplied by the standard conversion factor (SCF = 0.88), and divided by an inflation factor of 1.2. Household incremental revenues in border prices are the produce of the sales (from Table 6), multiplied by the 1981 average price (MSO.ZO/kWh), and the SCF. Total kerosene savings may be computed as the savings per household (from Table 8) multiplied by the number of households connected (from Table 6). The other domestic consumption benefits discussed earlier are not included in the numerical computation, because they cannot be quantified with sufficient accuracy. The chief commercial and industrial electricity consumption benefits are based on the incremental

ENERGY

ECONOMICS

January

1988

consumption (from Table 6), multiplied by the minimum value from survey data (M$0.445/kWh), and the SCF. The internal economic rate of return (IERR) for these streams of costs and benefits is about 20%, which compares very favourably with the opportunity cost of capital in Malaysia, of 12%. A sensitivity analysis shows that either raising all costs by 10 % or reducing all benefits by 10 %, reduces the IERR to about 15 %. If all costs are increased by lo%, while all benefits are also decreased by lo%, then the IERR falls to 11%. Therefore, the project is acceptable from the viewpoint of economic efficiency, especially since all the benefits were quantified rather conservatively.

References W. Baum, ‘The project cycle’, Finance and Development, Vol 15, December 1978, pp 12-15. M. Munasinghe, ‘Integrated national energy planning (INEP) in developing countries’, Natural Resources Forum, Vol4, 1980, pp 359-373; also available as reprint No 165, The World Bank, Washington, DC. M. Munasinghe, Energy Pricing and Demand Management, Westview Press, Boulder, CO, 1985. M. Munasinghe and J. J. Warford, Electricity Pricing, Johns Hopkins University Press, Baltimore, MD, 1982. M. Munasinghe and C. J. Warren, ‘Rural electrification, energy economics and national policy in developing countries’, Future Energy Concepts, Institution of Electrical Engineers, London, UK, 1979. M. Munasinghe, Rural Electrification for Development. Policy Analysis and Applications, Westview Press, Boulder, CO, 1987. Rural Hectrification, The World Bank, Washington, DC, 1975. D. V. Smith, D. B. Mehta and P. Hayes, Regional Rural Etectr#ication Survey, draft report, Asian Development Bank, Manila, Philippines, October 1983.

17