Kenya - Private Sector Power Generation Support Project

 PROJECT INFORMATION DOCUMENT (PID) APPRAISAL STAGE Report No.: AB6900 Kenya Private Sector Power Generation Support Project Project Name Region Africa Sector Energy General (75%); Energy Renewable (25%) Project ID P122671 Borrower(s) Government of Kenya Implementing Agency KPLC and the 4 IPPs Environment Category [ X ] A [ ] B [ ] C [ ] FI [ ] TBD (to be determined) Date PID Prepared December 20, 2011 Date of Appraisal December 15, 2011 Authorization Date of Board Approval February 28, 2012 1. Country and Sector Background A. Country and sector Context 1. Kenya has substantial potential for economic growth and can reach middle income country status by 20191. Kenya’s economy is far more diversified than most other countries in Sub-Saharan Africa, which depend principally on agriculture. About 55 percent of GDP comes from services, transport, finance, tourism, information and communications technology (ICT) and trade, sectors that are critically dependent on reliable electricity supply. In 2010, Kenya overcame the quadruple shocks of 2008 and 2009 (post-election violence, drought, and the global food and financial crises) and achieved higher than expected growth of 5.6 percent. The robust recovery was driven by agriculture, a booming financial sector and a fiscal stimulus. If growth accelerates to 6 percent, Kenya can expect to reach middle income status in 2019; however this projection is sensitive to oil and food prices. Growth estimates of the World Bank for 2011 and 2012 are 4.8 percent and 5.0 percent respectively if sound macroeconomic policies (e.g. rebuilding fiscal resilience after the fiscal stimulus in 2010) are preserved. 2. Fiscal adjustment in 2011 following the fiscal stimulus of the past two years will make it more difficult for the government to fully implement its development program. In 2009 and 2010, government expenditure for the development budget supported a number of very large infrastructure projects (e.g. in road construction). This was in addition to a stimulus program of grants amounting to almost US$ 4.25 billion for rural roads, health and education facilities. The development budget grew from 6.7 per cent in 2007/2008 to 10.1 percent in 2010/2011 financed largely from domestic borrowing. As a result the debt to GDP ratio 1 Sources: Kenya Economic Update, Poverty Reduction and Economic Management Unit Africa Region, World Bank, December 2010 and June 2011. 1 increased to about 47.9 per cent in 2010/11. Kenya’s competitiveness has declined so that weakness in exports combined with a strong domestic sector has created a large and growing current account deficit. Monetary and fiscal consolidation in 2011/2012 aims to rein in development spending but may be difficult to maintain in the run up to the general election in 2012. As a result, unless growth accelerates, continued high fuel prices indicate that fiscal deficit, current account and debt targets may be missed. 3. Kenya is at the threshold of a major demographic transition and is urbanizing rapidly. Each year Kenya will grow by more than 1 million people and by 2040 will have an estimated 75 million people and become the 21st largest economy in the world. Increasingly, Kenyans will be longer lived, more urbanized, have fewer children and be better educated. The increase in population will be due more to people living longer than to increasing number of children as in the past. The share of the urban population will be 37 percent by 2020 and over 50 percent by 2033. This demographic transition will in turn facilitate expansion of emerging industrial sectors as increasing agglomeration will generate markets for products and services to serve a growing middle class. 4. Kenya’s vibrant private sector has been the main source of economic growth, driven by expanding services, but the country faces serious infrastructure constraints. The private sector has been particularly active in telecommunications (an outstanding success story) and transport. Kenya benefits from a geographical location that is favorable to trade. The port of Mombasa is the largest in East Africa and is the most important gateway for imports to the countries of the East African community, South Sudan and eastern DRC. Nairobi airport is a regional infrastructure hub that is currently undergoing upgrading and expansion as are a number of airports in other towns such as Eldoret. Nevertheless, internal infrastructure bottlenecks, especially in electricity supply and transport, have prevented Kenya from maximizing its potential for private sector-led growth. Rehabilitation and modernization of physical infrastructure, with the power sector at the forefront, is a key element in Vision 2030 to achieving sustainable economic growth and quality of life improvements. 5. Kenya’s lack of reliable and affordable generation capacity increases the cost of doing business, undermines competitiveness, and diminishes trade prospects. The Bank’s Poverty and Inequality Assessment (2008) concluded that improved infrastructure access is associated with movement out of poverty. Despite this link with promoting economic growth, employment and reducing poverty, there has been insufficient investment in electricity infrastructure to support a major expansion in Kenya’s economy. Kenya suffers from chronic shortfalls in energy supply, and these are amplified by climate variability. The electricity system therefore has come to rely on expensive emergency diesel power, which places a heavy economic burden on households and industry.2 Unreliable electricity supply reduces Kenya’s annual GDP growth by about 1.5 percent.3 The manufacturing sector, which represents 11 2 The emergency diesels, in place since 2006, have recently contributed over 14% of overall generation in the country. This emergency diesel came at a very high wholesale tariff of US 27 cents/kWh last year. As a comparison, end-customers in the Washington DC metropolitan area paid less than half of that as the average retail tariff. Average retail tariffs in Kenya are one and a half time higher than what they are in the Washington DC metropolitan area. 3 This finding of the multi-donor Africa Infrastructure Country Diagnostic in 2008, noted Kenya’s under investment in the power sector. 2 percent of total economic activity, and whose competitiveness depends heavily on such infrastructure, is showing signs of stagnation. Without infrastructure constraints, manufacturing would likely provide employment opportunities for nearly one million Kenyans entering the labor market every year. In financial terms, the disruption of public power supply costs Kenyan firms about 7 percent of their annual sales revenues. This constrains their growth and ability to employ more people across industrial and other productive sectors, including SMEs and other employment-generation sectors. It is for these reasons that Vision 2030, Kenya’s long-term development strategy, targets expanded infrastructure access – and power generation – as key elements of achieving higher levels of economic growth. 6. Kenya has a mixed record on governance but positive steps have been taken. In comparison to the country’s peers, Kenya scores below the norm for lower-income countries and for Sub-Saharan Africa on rule of law and control of corruption.4 On the positive side, public financial management, particularly audit capacity, has improved. Kenya also has made progress on public sector reform and results-based management. Nonetheless, poor governance, particularly corruption, remains a risk for any investment in Kenya. The Government has passed legislation to combat corruption including the 2005 Privatization Act and the 2006 Public Procurement and Disposal Act, which established the Public Procurement Oversight Authority. A new Supreme Court has been appointed through an open process thereby strengthening judicial independence and accountability in the public sector. A new public financial management law is being drafted to respond to the needs of the new Constitution that mandates devolution of power to forty seven Country governments. Many of these programs have yet to produce concrete results. Kenya’s independent media and strong civil society are major assets in the drive for improved governance and accountability of public officials. 7. Generation capacity will shift over time from increasingly unpredictable hydropower and fuel price-sensitive thermal options to greener, more sustainable technologies such as geothermal and wind, in addition to inexpensive potential regional imports. Increasingly erratic rainfall patterns and the destruction of key water catchment areas have affected hydroelectricity output. As an interim measure, Kenya will turn to more efficient thermal and geothermal generation to help meet urgent needs for base load generation until cleaner, lower cost options come on line. Within five years, the government wants to diversify its portfolio by adding up to 500 MW each of geothermal and wind energy to the grid, which Kenya’s favorable geology and meteorology make cheaper alternatives over time. Kenya has considerable geothermal resources which are located in the Rift Valley with an estimated potential of between 7,000 MW to 10,000 MW.5 Development of this resource will represent an important low-cost base load. Wind is an intermittent resource and in order for it to be deployed successfully, the grid will require a spinning reserve that can be provided from hydro and 4 See Kenya’s Actionable Governance Indicators (AGIs), which draw on the Bank’s CPIA ratings, the Worldwide Governance Indicators, Doing Business, PEFA indicators and other sources. 5 The current installed geothermal capacity in the country is 198 MW with 150 MW operated by KenGen and 48 MW by OrPower 4, both in the Olkaria Block. 3 thermal sources. All of these investments will be complemented by hydropower imports from Ethiopia and other EAPP countries in the medium- to long-term.6 8. Major reforms have established an efficient and transparent institutional framework that provide the basis for sector sustainability. Kenya’s energy sector reform has advanced quickly, especially relative to other African countries. The Government established its long-term vision and policy framework for the sector in the late 1990s and early 2000s, culminating in the 2004 Energy Policy, the 2006 Energy Act, and the 2010 LCPDP. These milestones established an effective framework for enabling the commercial viability of electricity companies and opened the door for competition in the electricity market. Kenya’s tariff structure also fosters sector sustainability, as fuel costs and exchange rate fluctuations are passed through by bulk suppliers via KPLC to end-consumers on a monthly basis while adjustment for inflation takes place every six months. Electricity suppliers are thus protected from fuel market risk and the impact on consumers of inflation is delayed. Average electricity retail tariffs (revenue per unit sold) are high in Kenya compared with neighboring countries reflecting the fact that in Kenya prices are close to or at cost recovery levels. 9. Government policy has encouraged private participation and competition in the power sector to develop new generation capacity. Kenya’s investment needs for power sector generation investment until 2015 exceeds US$5 billion. In parallel, the Government has also designed an investment program to strengthen and expand the national transmission and distribution grids to improve supply reliability and measures to increase demand side efficiency (such as energy saving light bulbs). This program includes the construction of 5,937 km of transmission lines with an investment cost of another US$3.0 billion until 2015. Raising this magnitude of capital, particularly at a time of global recession and unease in financial markets, poses a significant challenge. In this context, Kenya envisages a multipronged sector financing strategy that includes tapping local capital markets, Kenyan diaspora bond investors as well as global investors from a variety of public, private and concessional sources. GoK recognized that if it were able to attract substantial amounts of private capital investments into the sector through Independent Power Producers (IPPs), it could avoid diverting Government and donor financing from other priority needs. 10. While Kenya presents overall governance risks, the electricity sector’s reform trajectory and institutional set up helps mitigate this. The governance risk in the electricity sector was assessed as moderate for the Electricity Expansion Project approved by the Bank Board in May 2009. The assessment carried out by the Bank project team at that time with the assistance of the Preventative Services Unit of the Integrity Vice Presidency (INT) was based on the following factors: • The regulatory framework is robust and resistant to interference. The Energy Regulatory Commission (ERC), created in 2007, regulates wholesale and retail tariffs and issues licenses. The Commission has a successful track record on contested issues including approval of PPAs and tariff reform. A separate Energy Tribunal hears appeals to the decisions of the ERC. 6 Proposed hydro imports through the East African Power Pool require significant investment in construction of transmission interconnection with neighboring countries. 4  • The negotiations for tariff-setting and power purchase agreements are transparent and ensure the pass-through of non-controllable costs, such as fuel costs, inflation and foreign exchange change, to ensure financial sustainability of the power entities such as KPLC. • Bid invitations conducted under ongoing IDA investment lending projects have resulted in a good number of bidders and competitive prices. • Procurement oversight mechanisms have been invoked on several major contract awards, leading to greater confidence in the procurement processes. 2. Objectives 11. In line with the Bank’s Country Partnership Strategy (CPS) for 2010 - 2013 and the Government’s strategic priorities, the proposed Project will contribute to unleashing Kenya’s growth potential by expanding electricity infrastructure based on the participation of the private sector as a key partner in development. It will contribute to the achievement of the following CPS outcomes: (a) improving core infrastructure, especially in roads, electricity and water supply (Outcome 1.2); and (b) expanding access to health care, education and basic infrastructure services (Outcome 2.1). 12. Furthermore, the proposed Project is in line with the need for infrastructure improvements necessary to support Kenya’s Vision 2030 for economic and social development. To compete in the world economy, Vision 2030 recognizes the need to reduce the cost of doing business in Kenya. This is especially important in the sectors expected to be the key drivers of economic growth, which include offshore services for global corporations and light industrial developments for the regional (East African) market, particularly in agro-processing and tourism. By improving the quality of electricity supply, the Project will reduce the cost of doing business in these key sectors, increase competitiveness and lead to employment creation. 13. In addition, the PRGs in the proposed Series will help to catalyze private investment in Kenya and have a nearly 4:1 leveraging effect with US$166 million in IDA resources mobilizing over US$600 million in private sector resources. It is expected that the proposed framework of PRGs and MIGA termination cover will spur investor interest in subsequent IPPs that will include one or more wind projects and new geothermal investments. The success of this IPP program in the energy sector could be replicated in other sectors, enabling the GoK to free up its own resources for other investments while deepening private sector engagement in Kenya’s economy. 3. Rationale for Bank Involvement B. Sectoral and Institutional Context 14. Power sector expansion is a key element of Vision 2030, the Government’s national development strategy. Vision 2030 aspires to transform Kenya from a low income, agrarian 5 economy into a industrialized middle-income country providing a high quality life to all its citizens by the year 2030 anchored on three pillars: political stability, social development and economic growth. Rehabilitation and modernization of physical infrastructure, with the power sector at the forefront, is a key element in Vision 2030 to achieving sustainable economic growth and quality of life improvements. Kenya’s total installed power generation capacity as of June 2010 was 1,473 MW. Under 25 percent of the total population is covered by this capacity, and penetration in rural areas rests at only 5 percent. In order to achieve Vision 2030, the Government has established ambitious targets for scale-up and supply expansion with a goal of achieving 40 percent electrification by 2030. Intermediate targets include electrifying a million new customers in the next five years and extending electricity service to priority loads. 15. The Least Cost Power Development Plan prioritizes the development of a diversified portfolio of complementary generation assets. Kenya’s current power sector fuel mix is comprised of hydropower (52 percent), diesel (22 percent), geothermal (10 percent), thermal (5 percent), and the balance (11 percent) of wind, gas, emergency plants and co-generation assets. The Government recognizes that the dependence on hydropower makes the system especially vulnerable to serious shortages during periods of drought, as has been experienced in recent years. For this reason, the LCPDP calls for the development of a diversified portfolio of generation assets. This portfolio balances sources of power and types of technology that will help meet demand projections over time in a least-cost and environmentally friendly manner. 7 16. Electricity demand is expected to double every five years from 2010 to 2020. With Vision 2030 as a background, the Ministry of Energy in 2010 developed the country’s Least Cost Power Development Plan (LCPDP) for the next 20 years. The LCPDP forecasts an increase in power demand (expressed as Peak Load Factor) from 1,227 MW in 2010 to 4,220 MW in 2020 and 11,510 MW in 2030 in a Low Case Scenario, and 4,755 MW in 2020 and 15,026 MW in 2030 in a Base Case Scenario, representing average energy growth rates of 14.5 percent for the period from 2010 to 2020, and 13.4 percent for the entire period. It emphasizes the need to expand Kenya’s current installed power generation capacity in order to secure the sustainability of the current growth rate, to support future economic growth, and to improve the quality of life of the population. 17. Generation capacity will shift over time from increasingly unpredictable hydropower and fuel price-sensitive thermal options to greener, more sustainable technologies such as geothermal and wind, in addition to inexpensive potential regional imports. Increasingly erratic rainfall patterns and the destruction of key water catchment areas have affected hydroelectricity output. As an interim measure, Kenya is relying on imported thermal fuels to help meet urgent needs for base load generation. Thermal assets will be prioritized as base load generation until cleaner, lower cost options come on line. Within five years, the government wants to diversify its portfolio by adding up to 500 MW each of geothermal and wind energy to the grid, which Kenya’s favorable geology and meteorology make cheaper alternatives over time. Kenya has considerable geothermal resources which are located in the Rift Valley with an estimated potential of between 7,000 MW to 10,000 MW.8 7 The Prime Minister has established a task force on accelerating development of green energy and Kenya currently has 175 MW of geothermal capacity, and 440 MW of wind capacity under development or construction. 8 The current installed geothermal capacity in the country is 198 MW with 150 MW operated by KenGen and 48 MW by OrPower 4, both in the Olkaria Block. 6 Development of this resource will represent an important low-cost base load. Wind is an intermittent resource and in order for it to be deployed successfully, the grid will require a spinning reserve that can be provided from thermal sources. All of these investments will be complemented by hydropower imports from Ethiopia and other EAPP countries9 in the medium- to long-term.10 18. Major reforms have established an efficient and transparent institutional framework that provide the basis for sector sustainability. Kenya’s energy sector reform has advanced quickly, especially relative to other African countries. The Government established its long-term vision and policy framework for the sector in the late 1990s and early 2000s, culminating in the 2004 Energy Policy, the 2006 Energy Act, and the 2010 LCPDP. These milestones established an effective framework for enabling the commercial viability of electricity companies and opened the door for competition in the electricity market. Kenya’s tariff structure also fosters sector sustainability, as fuel costs and exchange rate fluctuations are passed through by bulk suppliers via KPLC to end-consumers on a monthly basis while adjustment for inflation takes place every six months. Electricity suppliers are thus protected from fuel market risk and the impact on consumers of inflation is delayed. Average electricity tariffs (revenue per unit sold) are high in Kenya compared with neighboring countries reflecting the fact that in Kenya prices are close to or at cost recovery levels. 19. As a result of Kenya’s comprehensive power sector reforms over the past decade, Kenya has strong sector institutions. The 2006 Energy Act established the Energy Regulatory Commission (ERC) as an autonomous body.11 Kenya’s major energy sector institutions include the Kenya Electricity Generating Company Ltd. (KenGen) for power generation and the Kenya Power and Lighting Company (KPLC or Kenya Power) for electricity distribution. Both companies are majority owned by the government with private minority shareholders and operate on a sound commercial basis. Their strong reputation in the marketplace and their creditworthiness is enabled by their professional management as well as their ability to benefit from cost-reflective tariffs established by the ERC.12 In 2008, the government created the Kenya Electricity Transmission Company (Ketraco) with a mandate to develop, build and operate new transmission assets. Ketraco is still in the process of fully developing its capacity as a transmission owner and operator and, in this regard, has a service agreement with KPLC to support it, particularly to manage dispatch. 9 Screening curve analysis in the LCPDP establishes that of the candidate projects for base-load generation, geothermal followed by wind are the least cost indigenous technologies after imports from Ethiopia. For intermediate and peak load capacity, medium speed diesel plants using heavy fuel oil is the least cost technology. 10 Through the East African Power Pool that requires significant investment in construction of transmission interconnection with neighboring countries. 11 Over a seven-year period (FY2004 to FY2010), KPLC has been able to expand its customer base, increase its profitability, improve its operational performance, and maintain a healthy financial position. 12 The ERC is empowered to autonomously set, review and adjust tariffs and tariff structures at levels that enable licensees to recover their costs. The Energy Act of 2006 mandates the Energy Regulatory Commission (ERC) to “set, review and adjust electric power tariffs and tariff structures, and investigate tariff charges.