Lao PDR Development Report 2010 Natural Resource Management for Sustainable Development

Transcription

1 Lao PDR Development Report 2010 Natural Resource Management for Sustainable Development TECHNICAL NOTE Fiscal Regime in the Hydro Power Sector This note was prepared by Richard MacGeorge, James B. Stewart, and Ekaterina Vostroknutova and is based on the data provided by the Ministry of Energy and Mines and prepared by Somneuk Davading. This paper does not necessarily represent the views of the World Bank, its Executive Directors, or the countries they represent. Contents Summary 4 Principles of Natural Resource Taxation 8 History of Hydro Sector Development in Lao PDR 10 Legal and Regulatory Regime Relevant to Hydropower 12 Institutional Framework 13 Description of the Fiscal Regime Relating to Lao PDR Hydropower Projects 16 Royalties 17 Taxation 18 Dividends 19 Discounted Electricity Sales 20 Past Concession Packages for Lao PDR Exports IPP Projects 20 Assessment of historical and projected total revenue share 21 The Risks and Rewards of Government Investment in Hydropower IPP Projects 23 Benefits of Investing in IPPs 23 Risks of Investing in IPPs 24 Lessons Learned 25 Review of Comparable Countries Regarding Fiscal Benefit Packages 26 Recommended Fiscal Benefits Package for Lao PDR Hydropower IPP Projects 27 Core Components of Fiscal Benefits Package 28 Additional Fiscal Benefits 29 Up-front Concession Fee 29 Government Shareholdings in Export-oriented Hydropower Projects 29 Discounted Electricity Sales 30 Main Recommendations 30 References 31 Annex 1: Review of Comparable Countries Regarding Fiscal Benefit Packages 32 Overview 32 Fiscal Benefits 32 Comparable Projects 33 Comparison between Lao PDR and Nepal Fiscal Benefits Regime 36 Overview 37 Fiscal Benefits 37 1

2 Tables Table 1: Types of Natural Resource Taxation Table 2: Power Sector Planning Studies Table 3: Article 18: Incentives Related to Duties and Taxes Table 4: Past Concession Packages for Lao PDR Export IPP Projects Figures Figure 1: Organization of Lao PDR Electricity Sector Figure 2: Ratios of Sources of Revenues Received by the Government (2005 to 2008) Figure 3: Total Government Revenues (historical and projected) from Hydropower Generation ( ) (US$m) Figure 4: Ratios of Sources of Revenues Projected to be Received by the Government ( )

3 Acronyms ADB Asian Development Bank Lao PDR Lao People s Democratic Republic BOOT Build-Own-Operate-Transfer LHSE Lao Holding State Enterprise BOT Build-Operate-Transfer LNCE Lao National Committee on Energy (now EPD) CA Concession Agreement MIH Ministry of Industry and Handicrafts (Now MEM) CDEP Coordinating Committee for the Development of Electric Power MM Million CEM Country Economic Memorandum MEM Ministry of Energy & Mines CIC Committee for Investment and Cooperation MOF Ministry of Finance COD Commercial Operations Date MOU Memorandum of Understanding CPI Committee for Planning and Investment MW Megawatt DDFI Department for Promotion and Management of Domestic and Foreign Investment NEM New Economic Mechanism DOE Department of Electricity NPV Net Present Value DSCR Debt Service Cover Ratio NTPC Nam Theun II Power Company E&S Environmental and Social NT2 Nam Theun II Hydro Power Project EDL Electricite du Laos O&M Operations and Maintenance EGAT Electricity Generating Authority of Thailand PDA Project Development Agreements EIA Environmental Impact Assessment PDP Power Development Plan EIRR Economic Internal Rate of Return PPA Power Purchase Agreement EPD Energy Promotion Department of the Ministry of Energy & Mines PSDP Power Sector Development Plan EVN Electricity of Vietnam PSSS Power Sector Policy Statement FDI Foreign Direct Investment PV Present Value FIRR Financial Internal Rate of Return ROE Return on Equity GDP Gross Domestic Product SA Shareholders Agreement GOL Government of the Lao PDR STEA Science Technology and Environmental Agency GWh Gigawatt Hour THB Thai Baht HHPC Houay Ho Power Company THPC Theun Hinboun Power Company HIPC Heavily Indebted Poor Countries TWh Terawatt Hours IA Implementation Agreement UNDP United Nations Development Program IBRD International Bank for Reconstruction and Development USD IDA International Development Association USc US cents United States Dollars IDC Interest During Construction WACC Weighted Average Cost of Capital IFI International Financial Institutions WREA Water Resources and Environmental Agency (formerly STEA) IMF International Monetary Fund km Kilometre IPP Independent Power Producers kv Kilovolt IRR Internal Rate of Return kwh Kilowatt hour ITD Italian Thai Development Company 3

4 Summary Governments have often found it difficult to set tax levels for resource projects. In particular, it is difficult to find the right balance between under-taxing, thus sacrificing revenues that might be reasonably expected, or overtaxing, which may deter developers from investing. Governments usually need to develop a mechanism that calculates and efficiently transfers economic rents from projects, which would be -- ideally -- based on profits rather than production. One way to do this is to develop a resource tax regime based on the determination of economic rents. This is the value of production after all necessary expenses (such as the minimum return an investor needs to justify investing in a project) have been taken into account. This investment return relates to how efficiently a project can be developed and to the indirect factors that affect the market s expectations about returns on investment. These elements affect the supply price of investment, which is a multi-dimensional price influenced by a range of factors including normal competitive returns to investment, potential monopolistic positions, and degrees of risk associated with a project. Because of a lack of project information, governments, particularly those in emerging countries, have had difficulty in determining the supply price of investment and, consequently, the rents that can reasonably be extracted from a project. Hydropower projects in Lao PDR are no exception. Some systems of natural resource taxation are the ex-ante and the ex-post methods, based on either production or profit respectively. Ex-ante taxes require developers to make an upfront payment based on the expected rents that they will pay for the rights to use a resource. This method includes the auction system although this is not an ideal model as too much risk is transferred to the private sector if bidders do not have sufficient information to be able to make well-informed bids. Ex-post taxes are based on the rents payable by the developer to the government as the resource is used. These include taxes based on cash flow, resource rent taxes, royalties, and production sharing agreements with government equity participation. Other than a fair return on capital to reflect the risks taken by the private sector, a key principle behind resource taxes is that the rents from resource development should accrue to the public rather than to private interests. This principle is even more important for projects that involve private sector participation and that primarily benefit neighboring countries. This is the case in Lao PDR where (a) Independent Power Producers (IPP) are involved in hydro power project development and (b) the country s hydropower resources will be developed primarily to export electricity to neighboring countries. The challenge that faces the Government of Lao PDR is how to provide a commercial environment that promotes the development of export hydro power IPPs while maximizing the social and financial benefits that flow to Lao PDR. In this regard, the interests of the government, the providers of capital to IPP projects (developers and their lenders), and the power purchasers (offtakers) in adjacent countries must all be balanced. In the early 1990s, the government recognized that the development of hydropower resources would require the involvement of the private sector; however there is still no unified framework for doing so. From 1991 to 2005, the government awarded some 33 Memoranda of Understanding (MOUs), Project Development Agreements (PDAs), and Concession Agreements (CAs). To date, only the Theun Hinboun, Houay Ho, and Nam Theun II projects have been financed. As many of these agreements were awarded in a non-competitive manner that did not follow standardized procedures, there were many different arrangements with developers and no standard for determining the fiscal benefits to the government. In the case of export hydro power IPP projects, it is the CA that is intended to specify the fiscal benefits accruing to the government. Furthermore, because of Lao PDR s emergent legal framework, project-specific CAs between the government and developers have attempted to fill gaps and, in some cases, have allowed the developers to contract out of specific legislative requirements. 4

5 Presently, the fiscal regime for hydropower development is based on taxes, royalties (resource usage charges), and dividend payments with a small amount of discounted electricity sales. The fiscal regime for export hydro power projects in Lao PDR has evolved since the promulgation in 1988 of the Law on the Promotion of Foreign Investment (revised in 2004) and other legislative milestones including the Lao PDR Tax Law of 2005 (incorporating the business turnover tax, the excise tax, the profit tax, and the corporate income tax) and the Electricity Law, which enables the government to be a shareholder in hydropower projects to be developed under a concession arrangement. The major challenge has been to quantify the value of the hydro resources. As discussed below, the government has settled on charges based on the volume of energy produced in a particular project as the best proxy for charging for these resources. The Lao Tax Law provides clear instructions on the application of the four types of taxes that relate to hydro power projects. The business turnover tax on the production of electricity turnover is 5 percent on domestic production and on the importation and sale of goods (in other words, electricity exports). In practice, dispensations are usually agreed between the government and developers for this type of tax. Excise tax applies to some 15 categories of goods and services including inflammable fuels for vehicles, but excise taxes are usually waived under the terms of the CA. Profits from the export of natural resources and from import and export trading are subject to the profit tax. A flat rate of 35 percent applies to total annual net profit although the Tax Law provides for exceptions and reductions to this rate on a case-by-case basis if organizations are licensed by the government to invest in projects in priority areas throughout Lao PDR. The Foreign Investment Law also influences the level of taxation for hydropower projects. In particular, the Law specifies certain incentives for foreign investment, particularly in sectors and locations where the government is encouraging investment, including production for export and the construction of infrastructure, and within clearly identified geographic zones. A new investment law was passed by the government in July Although the government has identified the volume of energy produced as the best basis for determining royalties, in practice, royalties are levied as a percentage of gross revenues. No standard percentage is applied to IPP hydropower projects as royalties are constrained by the tariff negotiated between each offtaker and developer. International practice suggests that, if the offtaker is buying power for just less than its system avoided cost, and conversely, the developer s expenses (including the cost of capital) are just covered, the surplus revenue represents economic rent, which should be calculated for each project using an approach specified (by law) for all projects and distributed to the government. However, the government has adopted an alternative approach in which it allocates one-third of this surplus to the offtaker, with the remaining two-thirds are apportioned on a case-by-case basis between the government and the developer. Based on the provisions of the Law on Electricity, the government is likely to become an equity participant in electricity projects that are developed under concession arrangements. However, the Law does not prescribe the extent of the government s shareholdings nor does it designate who the government shareholder will be or the terms and preferred timing of the shareholdings. Decisions regarding the government s shareholding in hydropower projects are usually made during MOU negotiations. Historically, the government has not had the human or financial resources to bear an equal share of the development costs as the other shareholders so the terms of the MOUs have allowed it to defer paying its share of the development costs until the time of the project s financial close.. The government s general approach to IPP projects is to secure a shareholding of between 10 and 25 percent, though there have been some exceptions. The government designated EDL (Electricite du Laos - a state-owned enterprise that owns and operates the country s main generation, transmission, and distribution assets) as a 20 percent shareholder in the Houay Ho project and a 60 percent shareholder in the Theun Hinboun hydropower project. The government has established the Lao Holding State Enterprise (LHSE) as its 25 percent shareholder in the Nam Theun II Power 5

6 Company (NTPC) and in seven other projects still to be developed. The government has also needed to raise capital to finance its equity commitments and, while it has been successful in doing so in the past, it is not certain whether it will be able to raise up to US$ 400 million per annum (based on the above assumptions about equity participation) to finance its commitments to the proposed IPP development program It is not uncommon to allocate a portion of the capacity from an export hydro power IPP for domestic distribution at a submarket rate. Discounted electricity sales are an indirect benefit because they usually pass through EDL (Electricite du Laos) rather than being monetized and received as revenue by the government. Internationally, the fiscal benefits from thermal and hydro projects accrue through royalties, income tax, gifted equity share (free carry), dividends, and discounted/free electricity. Lao PDR legislation does not clearly prescribe the requirements of a fiscal regime structure for hydropower development, and fiscal packages have so far been determined on a case-by-case basis. While there is merit in allowing flexibility in the negotiation of fiscal packages, there is a risk that the government may not receive the fullest possible economic rents by using this approach. Developing a policy that clearly and publicly defines the standard method for determining fiscal benefits from hydropower projects, specifically export projects, will ensure that developers are fully aware of the government s expectations before project agreements are negotiated. A three-step process should be followed: 1. The first step is to specify that legislated taxes such as profit, excise, and business turnover taxes are primary taxes. No dispensations from these taxes should be permitted, other than the zone-based relief available under the Law on the Promotion of Foreign Investment. 2. The second step is to clearly define how the economic rent (being the value of production after deducting operating and capital costs) is to be charged. This requires that the developer and the government agree in the MOU/PDA/CA that the developer will give the government the information it needs to calculate economic rents. Having determined the economic rent, the government can then decide how the rent should be levied. 3. The third step involves the mechanism for extracting economic rents. The current method is to levy a royalty based on a percentage of gross revenue for each concession operating year. One-third of this royalty is then allocated to the offtaker, and the remaining two-thirds are apportioned on a case-by case-basis between the government and the developer. While the current method is satisfactory, the government could also consider adopting an economic rent taxation system based on actual (not projected) profits, similar to the model used in Australia for oil and gas developments. Rules need to be developed to prevent concessionaires from claiming unnecessary expenses such as management fees. Furthermore, the government could change the policy that governs the distribution of royalties among itself, the offtaker, and the developer to ensure that a more appropriate level of rent is accruing to Lao PDR. In addition to primary and secondary taxes, the government could consider additional types of fiscal arrangements including up-front concession fees, dividend returns from investment, and discounted electricity sales. The rationale for an up-front concession fee is to cover the government s costs of development. The fee should comprise a minimum amount (because all projects affect the government, regardless of their size) and a set percentage based on the estimated cost of the project. The percentage should be set by the government and should not vary on a case-by-case basis. The terms of the concession agreement and its predecessor agreements should allow for the fee to change to reflect changes in the project costs. 6

7 The government could review its IPP investment policy to ensure that it is participating appropriately in export-oriented hydropower projects. To ensure the appropriate allocation of fiscal benefits to the state budget, the LHSE should be clearly identified as the government s shareholder in export IPP developments. Furthermore, acknowledging the requirements of the Electricity Law, the government should consider a shareholding based on a small free carried interest. The government may also give itself an option to take up additional shares when a proposed project demonstrates that it is an attractive commercial proposition with a possible exercise exclusion period shortly before the scheduled financial close and project commissioning to satisfy lenders. Only the value of the free carried interest component and other equity bought at a price lower than that paid by the other shareholders should be treated as economic rent. Importantly, the government should develop a strategy for funding its equity in IPP developments that relies on a certain level of support from international financial institutions and from other sources of finances available to the government and the LHSE. The government could consider discounted electricity sales as another component of a fiscal structure for hydropower developments, although they cannot be expected to contribute much. The value of these sales is usually captured by EDL or at the utility level and is not necessarily remitted to the government. The value of the discount should be treated as a permissible cost to the developer when calculating economic rents, which essentially means a portion of possible economic rent is being allocated to EDL and away from the country s budget. A set percentage discount should apply based on the tariff payable to the major offtaker, for a set percentage of approved installed capacity. Moreover, provision should be made that any beneficiary of this discount, including EDL, should remit the discount to the state budget. Bearing these observations in mind, it is clear that a more clear policy statement from the Ministry of Energy and Mines supported by the Ministry of Finance, and coupled with an amendment to the existing regulations would provide for a minimum fiscal benefits package as described above. The business turnover tax, excise taxes, profit taxes, and the corporate income tax should be the primary forms of taxation for hydropower projects. These taxes may be reduced in accordance with the Law on the Promotion of Foreign Investment, but no project-specific dispensations should be made. Secondary taxes such as the existing royalty arrangements should continue to be used to extract economic rents, but the government should consider moving to a resource rent tax system. The specific ad valorem royalty tax that the government is currently considering should be abandoned. Alongside primary and secondary taxes, other approved sources of fiscal benefit could include: (a) an upfront concession fee; (b) dividends from investments in IPPs as specified by the government s IPP investment policy; and (c) minimal use of discounted electricity sales specified under a discounted electricity policy. These other sources of fiscal benefit, however, do not contribute markedly to economic rents, so the rationale for including them in the fiscal strategy must depend on other criteria. 7

8 Principles of Natural Resource Taxation To provide the context for the regimes applying to export-oriented hydropower projects, particularly Lao PDR, a short review of literature relating to the taxation (including resource rents) of natural resource projects in general is made below. A broad approach was taken in recognition of the limited international experience for setting rents for export-oriented hydropower projects. There is, however, more literature about regimes applying to other natural resource projects, such as in oil and gas, mining and forestry. These are useful comparators because they each involve the exploitation of country s natural bounty to produce a product that is, in the main, exported. A key problem of tax level setting for resource projects is finding the right balance when governments seek rents from the developers of natural resource projects (Garnaut and Clunies Ross (1975) for a framework). If the rents are too low, then the developer benefits from a super profit and if the rents are set too high then some projects will not be developed and the government will consequently forgo revenue. Boadway and Flatters (1993) describe how natural resources are usually subject to normal taxation (primary taxation) and special resources taxes (secondary taxation). Special resource taxes are made in addition to income taxes for two reasons, the first of which is that economic efficiency can be maintained. The second argument is that the public owns resources and the benefits of these should accrue to the public rather than private interests. This leads to determining resource taxes based on economic rents, which is the value of production after all necessary expenses have been taken into account. Necessary expenses include the minimum return an investor needs to justify investing in a project. Garnaut and Clunies Ross describe how this return relates to how efficiently a project can be developed and the indirect factors that affect the market s expectations about return on investment. These affect the supply price of investment. The supply price of investment is a function of normal, competitive returns to investment, of the degree of monopoly in the industry, of the degree of economic and political risk associated with a project, and of investors attitudes to risk. The supply price does not therefore have a single dimension. Determining the supply price of investment for natural resource projects is difficult for governments. This is because they often do not have enough information about the project to form a judgment 1. However, governments must nonetheless put themselves in the position of the investor to assess the supply price of investment and consequently the rents that can be reasonably be extracted from a project. The relative merits of ex-ante versus ex-post methods of taxation are reviewed by Boadway and Flatters. Ex-ante taxes involve an upfront payment based on the expected rents that a developer will pay for the right to use a resource. Ex-post taxes are based on rents payable by the developer to the government as the resource is used. Auction systems as a type of ex-ante tax are considered, but not seen as a model because too much risk is shifted to the private sector. This is because the private sector is depending on the quality of information produced by the government about the project in the auction documents and because of the political risk of government seeking to renegotiate license terms at some later date. 1 This is especially the case in developing countries where governments have insufficient resources to carry out their own feasibility studies. This problem is compounded for hydropower projects because the supply price is largely governed by site characteristics. 8

9 Three ex-post approaches to obtaining rents are also reviewed. These include: (i) cash flow based taxes, which are a percentage of the net value of a resource developer s real transactions for a given period; (ii) Royalties, which are a payment to an owner for the use of property usually levied as a percentage of production or sales, and; (iii) Production sharing agreements and government equity participation. Hogan (2003) extends the range of resource taxation types and categorizes them as being either production or profit based. In particular these are either: (i) Ad valorem royalties, being a constant percentage of the value of production; (ii) Specific royalties, being a constant dollar amount per unit of production; (iii) Excises, being a dollar amount per unit of production that increases as production increases, and; (iv) Resource rent royalty or tax, as described above. Therefore Boadway & Flatters and Hogan s natural taxation types can be combined and expressed as illustrated in the following table. Table 1: Types of Natural Resource Taxation Ex-Ante Ex-Post Production Based Auction Ad valorem royalties Specific royalties Excises Profit Based Auction Cash Flow Based Taxes Resource Rent Royalty Production Sharing Equity Participation Ex-Ante taxation has been discussed and questioned in the literature as an unhelpful means of taxing natural resource projects, so the rest of this section deals with ex-post taxation. Ad valorem royalties, specific royalties and excises are variations of the same theme. Boadway and Flatters argue that these types of royalties are not good proxies for economic rents because per unit royalties do not account for resource value or production costs. An ad valorem royalty does not deal with the costs of production, although such a tax based on net revenues is helpful but still does not fully account for capital costs 2. Turning to cash flow based taxes, resource rent royalties, production sharing and equity participation arrangements, the following observations can be made. Boadway and Flatters assert that cash flow based taxes have a number of detractions, such as: (i) they shift the risk burden to the government; (ii) the cash flow base can be reduced by developers through management fees, staff salary adjustments and transfer pricing, and; (iii) it is difficult to calculate the developer s cost of capital, which is a component of the net cash flow calculation. As of 1993 when Boadway and Flatters wrote their paper, no countries had adopted a cash flow taxation system. However, since then Australia has adopted a derivation of a cash flow tax. Hogan (2003) refers to a cash flow tax as a Brown Tax, being a fixed proportion of a project s annual net cash flows. The Brown Tax provides the conceptual basis for a Resource Rent Tax, which is a profit based tax that becomes payable when a threshold IRR has been achieved. This approach is adopted in the Australian Petroleum Resource Rent Tax Assessment Act Aside from the North-West Shelf project and associated areas, all Australian offshore oil and gas projects are subject to resource rent taxes. 2 As the long run marginal cost of hydropower is mostly tied up in capital costs, an ad valorem royalty that does not measure these costs if of limited value. 9

10 Hogan describes three elements of setting resource rent taxes. These are setting the threshold IRR, setting the tax rate and deciding how projects are treated when they make losses. Garnaut and Clunies Ross suggest that IRR 3 and tax rates could be bid by or negotiated with developers, but in the case of hydropower projects this would be difficult in practice, in part because hydropower concession procurement does not work well under competitive conditions. Garnaut and Clunies Ross identify some possible difficulties with resource rent taxes, including: (i) administrative burden; (ii) exchange rate variations; (iii) changes in purchasing power, and; (iv) uncertainty regarding when revenues will be received. At its simplest, production sharing involves an actual share of production or revenues from a project - this is no different to an ad valorem royalty. For production sharing arrangements to approximate economic rents, they would need to vary according to unit prices of production and production costs. They are therefore not an ideal proxy for economic rent (Boadway and Flatters, 1993). Boadway and Flatters argue that government equity participation is only attractive if the government pays less per share for its shareholding than the private shareholders. If the price is the same as the other shareholders then this is included in the capitalized value of the expected rents. Consequently, no additional rents would be collected by government through its equity ownership. Boadway and Flatters instead make a case for discounted and free carried interests in projects for government as one means of increasing economic rents. Government equity participation has some other features, Boadway and Flatters note. Being a shareholder brings voting rights, influence and valuable information that would otherwise not be available to the government. However, as government shareholders are usually state-owned enterprises, dividend receipts do not accrue directly to the state budget. Overall, Boadway and Flatters state that equity participation does not contribute to rent taxation. Thus, governments need to find a balance between under taxing and overtaxing resource projects. After primary taxes such as corporate income tax have been deducted, a mechanism that calculates and efficiently transfers economic rents is needed. An optimal system of taxation would be profit based rather than production based, provided permissible expenses are well defined. To achieve this, an independent regulatory type of arrangement would be needed. In the absence of a robust resource rent tax system, ad valorem royalties are an imperfect proxy for extracting economic rents from projects, but if the percentage royalty can vary for each year (perhaps set at the time the license is granted and amended if economic rents differ from those projected) there is a greater chance of efficient taxation. Regarding equity participation, a free carried interest or discounted shareholding ought to be treated as resource taxation to the extent of the discount only. Fully priced shareholdings should only be contemplated for reasons other than resource taxation. Whatever approach is used, it is important for governments to financially model projects to assess the likely level of economic rent. History of Hydro Sector Development in Lao PDR By way of a brief history, Lao PDR s electricity generation history started in 1971 with the commissioning of the Nam Ngum Dam. The dam had an installed capacity at that time of just 30 Megawatts (MW), increasing to 150 MW by As of the early 1990 s, only twenty per cent of Nam Ngum s generation was consumed domestically (primarily for supply to Vientiane) and the 3 There is an of a hydropower concession being bid based on IRR offers by proponents. This was the Bujagali project in Uganda. 10

11 balance was exported to Thailand. Lao PDR s second dam at Xeset in Southern Lao PDR was commissioned in 1991 with a capacity of 20 MW. The first Lao PDR IPP concession for the development of a hydropower project was issued by the GOL in The Shlapak Group was given the mandate at that time to develop the Nam Ngum II site and to operate it for a set period. The issue of this concession marked a point when the GOL realized that to develop its hydropower resources fully it would require input from the private sector under a new policy. Between 1991 and 2005, the new policy of engaging with the private sector for hydropower development sparked a wave of agreements. In this period some thirty-three Memoranda of Understanding (MOUs), Project Development Agreements (PDAs) and Concession Agreements (CAs) were awarded to various groups. Of these, only the Theun Hinboun, Houay Ho and Nam Theun II projects have been financed. The first two of these projects have entered into commercial operations and the third, Nam Theun II, has been financed and is expected to be commissioned in March Many of the agreements awarding projects to private sector developers followed a non competitive process. Often developers proposed projects to the government and entered into agreements proposed by the developers rather than conforming to model documentation and standards set down by the GOL. The consequence of this meant that the government was faced with a multitude of arrangements with developers and no particular standard regarding how fiscal benefits for the GOL should be determined. In part the weak IPP implementation framework resulted from significant limitations to the GOL s resources. The GOL, to its credit, introduced a series of institutional changes and commissioned a number of studies to deal with deficiencies such that the IPP framework has evolved significantly throughout the course of the last few years. In 1999 the GOL issued a Power Sector Policy Statement (PSSS) to formally acknowledge the need for an IPP implementation framework. This resulted in a number of project evaluation studies and served as the basis for further work, the details of which are tabulated below. In addition to the studies, the development of the Theun Hinboun and Nam Theun II projects have both involved substantial support from International Financial Institutions (IFIs), the most notable of which are the World Bank and the Asian Development Bank (ADB). In addition to the direct assistance provided by the IFI in the development of these projects, there have been a range of intangible benefits including: Improving the public financial management system so that natural resources revenues are managed better; Improving community engagement through information sharing and consultations; Developing tools for and awareness of sustainable environmental and social programs regarding hydropower development; Increasing awareness of global and regional opportunities for the country, strengthening governmental institutions at both international and provincial level; Strengthening the basic framework for which PPPs and IPPs can be developed; and, Increasing interest by private international financiers in large infrastructure in Lao PDR with particular regard to the hydropower sector. 11

12 Table 2: Power Sector Planning Studies Study Year Funding Subject Strategy Studies: Hydropower Development Strategy Study 1999 World Bank Rank domestic & export projects Power System Strategy Study 2002 ADB Domestic and export projects EdL PDP PDP , July 2003 (draft) 2003 EdL Power system expansion. Transmission Planning Studies: Establishment of Lao National Grid Company 1997 ADB Technical legal and commercial. Lao National Grid Study (Lahmeyer) 1997 GOL Development of national 500kV grid Master plan of Transmission Lines and Substation Systems Indicative Master plan on Power Interconnections in GMS Countries 2002 JICA Domestic grid development 2002 ADB GMS grid development Legal and Regulatory Regime Relevant to Hydropower The legal system in Lao PDR is based on traditional customs, French law, and socialist practices. The legal system is not based on precedent and there is no body of case law to provide guidance regarding the attitude of the Lao PDR courts on a particular matter. Legislation has improved markedly since the introduction of the New Economic Mechanism (NEM) adopted in 1986, but some gaps remain. Legislative milestones since the NEM include: a Law on Foreign Investments (1988); the Contract Law (1990); the Commercial Bank and Financial Institutions Law (1992); the Customs Law (1994); the Labor Law (1994); the Business Law (1994); the Secured Transactions Law (1994); the Water and Water Resources Law (1996); the Electricity Law (1997); an Environmental Protection Law (1999); Rules for Consideration and Approval of Foreign Investments Projects in Lao PDR (2002), and the Law on Promotion and Management of Foreign Investment (2004). In terms of relevance to hydropower projects, the Law on Foreign Investments, Electricity Law, Water and Water Resources Law and Environmental Protection Law are especially important for the following reasons: The Foreign Investment Law, for example, provides for property rights to investors, the form that investments can be made, land tenure arrangements, repatriation of earnings to investors, the giving of security and dispute resolution; The Electricity Law provides for hydropower projects being developed as build-own-operatetransfer (BOOT) schemes, for the GOL to have a shareholding in an IPP venture together with the process of awarding concessions; The Water and Water Resources Law provides for provision by developers of feasibility studies and environmental impact standards and studies, watershed management and 12

13 resettlement matters; The Environmental Protection Law takes Environmental Impact Assessment (EIA) arrangements further by specifying the procedures for apply to these studies. Biodiversity management is also covered in the law, together with disaster prevention. Importantly, an environmental protection fund is contemplated for development projects such as hydropower schemes as a source of funds for such protection. Notwithstanding improvements in legislation regarding hydropower projects, the legal framework is not strong enough for developers to rely on legislation without having a comprehensive concession agreement. Consequently, for each hydropower project developed there has been a project specific concession agreement that has been negotiated between the GOL and the development group. Each concession agreement attempts to fill gaps in the legislative framework, and in some cases, allows developers to contract out of specific legislative requirements. This has been particularly so when it comes to agreement on fiscal benefits for example. The determination of fiscal benefits packages is described in more detail in the following sections of this report. A core principle however, is the GOL should not waiver from matters that are prescribed in its legislation. Institutional Framework The current organization of the electricity sector in Lao PDR has IPP responsibilities shared among a number of GOL ministries, departments, agencies, and committees. This arrangement is illustrated in the following diagram. Those organizations that are particularly important to hydropower development include: The Ministry of Energy and Mines (MEM) (formally the Ministry of Energy and Handicrafts, or MIH). MEM has overall responsibility for power sector development, which is administered by the Department of Electricity (DOE) a division within the Ministry. In the context of IPP development, MEM is responsible for a number of planning and regulatory functions including the promotion of a pipeline of projects, review of IPP studies and agreements, participation in tariff negotiations with foreign investors and off-takers, monitoring of environmental and social management plans (in cooperation with other relevant bodies) and establishing and monitoring technical standards for power development in Lao PDR. For IPP project implementation, DOE reviews technical studies prepared by developers and issues a certificate of no objection to the Committee for Planning and Investment (CPI). Electricite du Laos (EDL) is the state-owned corporation operating under MEM. EDL owns and operates the main domestic generation, transmission and distribution assets in Lao PDR. It also manages electricity imports to its grids and electricity exports from some of its generation stations. EDL has a project development role as the implementation agency for GOL s main electricity projects including system expansion planning and potential generation and transmission project analysis. EDL is involved in Lao PDR s IPP program in several capacities: As an off-taker from IPP projects; In the negotiation of tariffs with foreign power purchases for export IPP projects; and, As the historical holder of shares in IPP investments including the Theun Hinboun Power Company (THPC) and Houay Ho Power Company (HHPC). EDL has been designated as the shareholder in six IPP projects, which are intended primarily for domestic supply. These projects are: Nam Lik 1 and 2, Nam Ngum 2 and 5 and Xe Kaman 1 and 3. 13

14 Figure 1: Organization of Lao PDR Electricity Sector Source: 14

15 The Water Resources and Environmental Agency (WREA) was established as the Science Technology and Environmental Agency (STEA) in 1999 as the main coordinating agency for environmental planning and management across all government sectors. The agency s responsibilities are set out in the Environmental Protection Law and include forming environmental policy, receiving and evaluating environmental impact assessments and other reports and implementing environmental action plans. WREA has an important role in IPP project procurement through its review of IPP feasibility studies and EIA. In co-operation with the DOE, WREA evaluates the proposed environmental programs for the compliance with current policy and, if approved, issues environmental certificates. Thereafter, WREA monitors the environmental management plans of IPP projects and revokes environmental licenses of IPP sponsors as required. The Committee for Planning and Investments (CPI) is a high level committee established within the Prime Minister s Office. The CPI is chaired by the Deputy Prime Minister and includes the Minister of Energy and Mines and Minister of Finance as permanent members together with other ministers as appropriate. CPI is the agency charged with the responsibility for entering into commitments with IPP developers and it therefore signs MOUs, PDAs and CAs on behalf of the GOL. Reporting to the CPI is the Committee for Investment and Cooperation (CIC) and under the CIC is the Department for Promotion and Management of Domestic and Foreign Investment (DDFI) with the responsibility for the administration and regulation of foreign and domestic investment in Lao PDR. The Energy Promotion Department (EPD) was formerly known as the Lao National Committee for Energy (LNCE). It was established under a presidential decree in 1999 to improve coordination between MEM and CPI in the evaluation, negotiation and approval of IPP projects. EPD is chaired by the Deputy Prime Minister and the Minister of MEM serves as vice chairman and permanent member. EPD represents the sovereign interests of Lao PDR in IPP projects and operates in the capacity of a contracting authority representative for CPI. It negotiates matters relating to investment in power projects, regional grid and connection, export sales of electricity and contracts with project sponsors. It is responsible for the promotion of investment in the power sector (having the website and meeting market demand for power in neighboring countries. Importantly, the EPD is responsible for acting as the GOL s representative in negotiating concession agreements (including the fiscal benefits package) and also serving on the committee that reaches tripartite agreement on electricity tariffs. The Ministry of Finance (MOF) is responsible for implementing GOL s fiscal and monetary policies either by direct control or through the Central Bank of Lao PDR. In the context of IPP development, the MOF approves loans and issues sovereign guarantees on behalf of the GOL and in compliance with the GOL s international covenants including those entered into with the IMF. MOF holds accounts at the Central Bank that receive soft loans which are periodically on-lent to power sector projects, including finance provided through IFI loans for GOL equity and IPP projects which are onlent to the agency designated as the GOL shareholder. Those agencies include EDL (largely for domestic hydropower projects) and Lao Holding State Enterprise (LHSE), primarily for export related IPP projects. The Lao Holding and State Enterprise (LHSE) was established under the Business Law as a state enterprise wholly owned by the MOF following a prime ministerial decision of January LHSE is designated as the GOL shareholder in Nam Theun Power Company (NTPC), the company developing the Nam Theun II project. LHSEs role is to represent the GOL s commercial interest, to receive dividends from Nam Theun 2 Hydro Power Project (NT2) and remit these into the GOL s NT2 revenue management system. While LHSE was principally incorporated as a single purpose company, it is also designated as the GOL shareholder in six prospective IPP projects. These include: Xe Kong 4 and 5; Nam Kong 1; Hongsa Lignite; Nam Theun 1; and Xe Pian-Xe Nam Noy. 15

16 Description of the Fiscal Regime Relating to Lao PDR Hydropower Projects This report focuses mostly on export hydro power IPP projects rather than domestic projects because it is particularly important to charge appropriate rents for projects that primarily benefit neighboring countries. Export projects tend to have a Power Purchase Agreement (PPA) with an international power purchaser and a Concession Agreement with the host government. Electricity projects that sell to domestic customers usually have the PPA as a cornerstone agreement and a simple Implementation Agreement (IA) is used instead of a Concession Agreement. The Implementation Agreement does not usually provide for fiscal benefits accruing to the host government because these are socialized through the tariff, which in turn is minimized if a competitive procurement process can be implemented. As a result domestic IPPs are not helpful for accessing fiscal benefits that should accrue to a host country for export generation projects. This limits the number of potential projects against which export power projects can be compared, which is discussed in Section 7 and Attachment. The challenge that faces the GOL is how to provide an environment that promotes the commercial development of export hydro power IPPs while maximizing the social and financial benefits that flow to Lao PDR. In this regard, the interest of the GOL, providers of capital to IPP projects and power purchasers located in countries adjacent to Lao PDR must all be balanced. To achieve this means understanding the perspective of each party which can be characterized as follows: The GOL stands to benefit from the projects through macro economic or social benefits (such as increased economic activity and living standards resulting from increased electrification) and fiscal revenues such as royalties, taxes, dividends and cost effective electricity sales; The providers of capital to the projects are subcategorized as equity providers (usually from the developers of the project) and debt providers because each has quite different needs. Equity providers want to maximize their Return on Equity (ROE), for those returns to be paid out as early as possible and also to minimize their direct and contingent exposures to the projects. Debt providers are the lowest common denominator in any financing arrangement because they want to minimize risk to justify making loans available; The offtaker has quite different interests to the GOL and the providers of capital to the IPP projects. Where the GOL and project financiers share a common interest in maximizing project revenues, the offtaker quite naturally wishes to minimize the tariff that it agrees with each developer. Solving the tension that exists between the GOL, the developer and offtakers is a role that falls upon the Coordinating Committee for the Development of Electric Power (CDEP). The CDEP is a committee which involves representatives from EPD, LHSE, EDL the Ministry of Foreign Affairs and WREA. It has the sole purpose of negotiating export tariffs with Electricity Generating Authority of Thailand (EGAT), Electricity of Vietnam (EVN) and other international power purchasers. While the committee does not have permanent offices or staff it is supported by EPD, which acts as its secretariat. The CDEP has evolved from the process of determining an appropriate balance of benefits between the three principal stakeholders of the GOL, developer and offtaker. From 1988 when the Foreign Investment Law was promulgated there was no experience in determining these benefits nor was there much international experience on which to draw. 16

17 The GOL was therefore required to identify an appropriate fiscal regime for export hydro power projects. It saw that the most significant fiscal benefits to the GOL would come through taxes and a resource usage charge (royalties). This is consistent with the theoretical best practice discussed in Section 2 regarding primary and secondary taxes. The resource usage charge is a rent for the use of natural resources, but the major challenge was to quantify what value should be placed on those natural resources. EPD financially models each project to estimate the economic rents that can be derived. This approach is consistent with the literature on natural resource taxation. Various methodologies for establishing a resources tax were applied, such as basing charges on the volume of water that would pass through a particular project or by basing charges on the inundation area associated with a project. However these two bases were not helpful because not all water is equal the value of a cubic meter of water depends on the head associated with that water, and secondly, area is not helpful because it cannot be used as a basis for charging for run of river projects. Consequently the GOL settled on the volume of energy produced for a particular project as the best proxy for determining a basis for charging for the use of natural resources. It was decided not to use MW capacity as a basis because hydropower projects are generally optimized for Gigawatt (GW) hour sales rather than full capacity. The literature shows that this takes account of production but not revenues or the cost of production. Therefore, basing a system of taxation on production alone is an imperfect means of extracting economic rents. Royalties Despite having decided that the volume of energy produced for a generating project would be the best basis for determining resource usage charges, these are in practice levied as a percentage of gross revenues. The rationale behind this is that there is a disconnection between the methodologies considered by the GOL versus the manner in which royalties are charged. There is no standard resource usage charge percentage that is applied to hydro power IPPs as this, according to EPD, is constrained by the actual tariff negotiated between each offtaker and developer. EPD believes that developers need to retain a return on equity of between 11 and 12 percent and lenders need to achieve a debt service cover ratio at least 1.3 times. From an offtaker s perspective however, system avoided cost or long run marginal cost is the benchmark by which the offtakers will make a determination as to whether an export IPP project is attractive or not. If the generation project can deliver energy at a price below the offtaker s system avoided cost or long run marginal cost, the power purchaser is better off by buying power from this generator. The approach that the CDEP takes is, assuming an offtaker has an avoided cost of seven cents per kilowatt hour (kwh) and the developer has a five cent per kwh cost of production, then two cents per kwh is available for sharing between the offtaker and Lao PDR. The CDEP and the offtakers have agreed that one-third of that difference will be shared by the offtaker while two-thirds will be to the benefit of Lao PDR. Of the two-thirds, the developer and Lao PDR agree on an apportionment between them on a case by case basis. This approach is contrary to the literature, which would suggest that if the offtaker is buying power for less than its avoided cost and the developer s expenses (including cost of capital) are also covered, the surplus represents economic rent, which should all be for the government s account. In any event, having worked through this process and having determined royalties for an IPP project, it may be found that the project is unable to bear all taxes that are prescribed by the Lao PDR Tax Law of 19 May 2005 and in that case it is necessary to negotiate some dispensations. Again the literature suggests that primary taxes should not be varied for individual taxpayers. 17

18 While the process described above determines the resource usage charge pool of revenues available to the GOL it does not determine the profile for payment. Therefore a resource usage charge profile represented as a percentage of gross revenues is negotiated with each developer so that the developer is able to meet its debt service obligations. Typically this means that the resource usage charge is low during the early years of a projects operations and it increases substantially once debt has been fully retired. EPD now wants to depart from the approach that is has taken to date and instead agree a specific royalty of US 0.65c/kWh payable from the developer to the GOL. EPD is discussing this approach with EVN regarding Xe Kaman I. There is resistance to the approach however because EVN does not believe that the GOL shares sufficiently in the risks of the project. From time to time differences of opinion have arisen between EPD and the Ministry of Finance as to whether resource usage charges should be subordinate to taxation or vice versa. EPD and the Ministry of Finance hold different views in this respect and there is a risk that royalty (or resource usage charges) are determined independent from other fiscal benefits when it is better that a holistic approach is taken. Again, the theoretical best approach is to not waiver from the Tax Law so that projects can enjoy some sort of tax dispensation. Those taxes should be treated as primary taxes. Secondary resource taxes that cater for the specific needs of investors and offtakers should then be implemented in a manner that causes economic rents to be extracted from the project efficiently Taxation Regarding taxation of hydro power projects, the Tax Law provides for four types of taxes. These include the Business Turnover Tax, an Excise Tax, a Profit Tax and Corporate Income Tax. The Business Turnover Tax is dealt with in Part 3 of the Tax Law. The Business Turnover Tax for the production of electricity turnover is 5 percent for domestic production and the importation and sale of goods, so the turnover tax applicable to the electricity generation is 5 percent. In practice, some dispensation is usually agreed between the GOL and developers. Excise taxes are dealt with under Part 4 of the Tax Law. Excise taxes are indirect taxes collected from certain types of luxury goods and services. There are fifteen categories of goods and services that are subject to excise tax, including inflammable fuels such as lubricants, grease and brake oil (which attract an excise tax of 5 percent) and vans, buses, trucks and other types of vehicles (which attract excise taxes between 10 percent and 70 percent depending on the nature of the vehicle). In general, excise taxes for export hydro power IPP projects are waived under the term of the Concession Agreements negotiated with developers. Profit tax is dealt with in Part 5 of the Tax Law. Profits that are subject to tax includes exportation of natural resources and import and export trading, with export hydro power IPP projects being involved in both of these activities. However under Article 34 of the Act certain exceptions or reductions of profit tax are provided to people who have been licensed by the government to invest in projects in other priority areas in Lao PDR. These dispensations are agreed on a case by case basis. Profit Taxes are based on the total annual net profit according to a flat rate of 35 percent unless the rate has been reduced in accordance with the law on promotion of foreign investment. Taxes prescribed under the Tax Law are reduced further under the Law on the Promotion of Foreign Investment of In particular Chapter 4 of the Law provides for certain incentive for foreign incentive investment where The State shall consider granting incentives for foreign investments in accordance with the sectors and zones of investment promotion as provided in Article 16 and 17 of this Law. Article 16 provides for several types of promoted activities including production for export and construction of infrastructure. Export hydro power projects would fall into both of these categories. Article 17 of the foreign investment law provides for three geographic zones that attract 18

19 different treatments. The first zone involves mountainous plains and plateau zones with no economic infrastructure to facilitate investments, zone two is class as moderate where as zone three is referred to as good, presumably in terms of the degree to which economic infrastructure has been developed. Article 18 provides for the specific incentives relating to duties and taxes for each of these zones which are tabulated below. Zone Table 3: Article 18: Incentives related to Duties and Taxes Profit tax exemption period (years) Reduced profit tax period Reduced profit tax rate Profit tax imposed thereafter 1 7 n/a n/a 10% % 15% % 20% A new investment law was passed by the GOL in July 2009, but it has not yet been ratified and is not publically available. It is therefore not possible to test what the implications of the new law will be. Dividends Article 12 of the Law on Electricity provides for the GOL to be a shareholder in hydro power projects that are the subject of a concession. The law provides that the government of the Lao Peoples Democratic Republic will participate in the shareholding when there is a concession for an electricity enterprise. The literal translation of the Lao word will is not absolute but suggests that there is a high likelihood of the GOL being an equity participant in these projects. The law does not specify which arm of the GOL shall be designated as the government s shareholder representative, what level of shareholding will be taken in each concession IPP project, when that shareholding must be taken up or what terms the shareholding must have in order to be acceptable to the GOL. These commercial decisions should involve the entity that ultimately takes the risk on investing in these projects, whether that is LHSE or EDL. However, neither of these entities have particular involvement in the decision making process and instead are allocated shareholdings on what appears to be an arbitrary basis. New arrangements are necessary in order for the GOL to be able to make better decisions regarding which projects it invests in and on what terms. While the Electricity Law is not prescriptive regarding the extent to which shareholdings are taken in IPP projects, the general policy is that the GOL will not have less than 10 percent equity in a hydro power project and not more than 25 percent. The experience to date has seen the GOL become a 20 percent shareholder in the Houay Ho project, a 60 percent share holder in the Theun Hinboun and a 25 percent shareholder in NTPC. Decisions regarding shareholding are made generally at the Memorandum of Understanding stage, which commits the GOL to being an equal shareholder with private developers and bearing development costs equally unless alternative arrangements are made. The GOL historically has not had the capacity in terms of human resources and financing to be able to bear the development equally with the private sponsors. Memoranda of Understanding have usually provided for the GOL to be exempted from development costs, with these costs being funded by the private sector participants and then being reimbursed around the time of financial close. The GOL also needs to raise capital to finance its equity commitments and based on projections made by the World Bank these have amounted to approximately USD 250 million for the THPC, HHPC and NTPC projects to date. In future it is expected that the GOL will need to raise up to USD 400 million per annum to finance its equity commitments to IPP projects that are in the planning stages. There is 19

20 considerable uncertainty about the GOLs ability to raise that level of capital. These issues are discussed in more detail in the following section. EDL is the shareholder in the Houay Ho and Theun Hinboun projects and it has had markedly different experiences with these projects. In the case of Houay Ho the dividends from the project have been limited whereas in the case of Theun Hinboun, dividends have reached around USD 30 million per year. These have become part of EDLs general revenue and have led to an effective reduction in the operating cost of the utility meaning that the retail tariff is lower than it ought to be. During the development of NT2, it was anticipated that EDL would be the GOL shareholder in that project as well. However, because of the difficulties in ring-fencing NT2 dividends from EDL s other business it was decided by the GOL to establish a separate entity, namely LHSE. Based on projections made by the World Bank, the dividends from the Theun Hinboun project between the period 2010 and 2040 are expected to exceed USD 1 billion. By comparison, the dividends from the Houay Ho project for the same period are not expected to exceed USD 350 million. The dividend from the Nam Theun 2 project for the same period is projected to be some USD 1.5 billion and these make up around one third of the total fiscal benefits to the GOL from that project. In total these projects are expected to generate close to USD 3 billion in dividends between them over the course of the next thirty years. A further USD 1.7 billion in dividends are projected to be generated from the Xe Kaman III, Nam Ngum II, Nam Ngum III, Nam Ngiep I and Nam Theun I projects. Each of these projects is currently under construction. If a further six planned IPP hydro power projects are developed, it is projected that a further USD 3 billion of dividends will be generated from the Hong Sa lignite project, Xe Kong IV, Xe Kong V, Xe Pian-Xe Namnoy, Me Kong-Xayaboury and Me Kong-LPB projects. Discounted Electricity Sales It is not uncommon for a portion of an export hydro power IPPs capacity in generation to be earmarked for domestic distribution at a submarket rate. The benefits that flow directly to the GOL from this arrangement are two-fold: Firstly the avoided costs of producing this power from other sources is saved directly; and, Any subsidy on the market price that can be negotiated between the IPP developer and EDL provides additional benefits to the GOL. However the value of the discounted electricity must be monetised so that it can be compared like with like against other forms of financial benefit to the GOL. Discounted electricity sales are an indirect benefit because they pass through EDL as a state-owned enterprise rather than going directly to the state budget. Discounted electricity can create distortions because it lowers the cost of sales to the utility, which could become an indirect and unintentional tariff subsidy. Past Concession Packages for Lao PDR Exports IPP Projects The section above deals with the law relating to taxation but, as mentioned earlier, developers usually negotiate further dispensations with the GOL under terms of the concession agreement. The table that follows tabulates the packages that have been agreed for the Theun Hinboun, Nam Theun II and Houay Ho projects. From this data it can be seen that the tax dispensations agreed between the GOL and the developers are materially different to the provisions of the Tax Law and Law on Foreign Investment, in the developers favor. 20

21 Table 4: Past Concession Packages for Lao PDR Export IPP Projects Theun Hinboun Nam Thuen II Houay Ho VAT Assumed to be zero Assumed to be zero Assumed to be zero Royalties 5% throughout Years 1-15 = 5.2% Years =15% Years 21+ =30% Income Tax Five year holiday 15% thereafter Years 1-5 = 0% Years 6-11 =5% Years =15% Years 18+ =30% Not disclosed Not disclosed Equity Share 60% purchased 25% purchased 20% purchased Dividends As per equity share As per equity share from mid 2010 As per equity share Discounted/ Free Electricity reduction in tariff for EDL purchases Not disclosed Other Benefits to the GOL USD 2.6m environmental mitigation costs USD 30m project opportunity cost (land and biodiversity) Not disclosed Concession Term Plant transfer at concession end 30 years + 10 year option Plant transfer at concession end 25 years 30 years Assessment of Historical and Projected Total Revenue Share The World Bank projections of GOL revenue from the power sector was analyzed to determine the historical and projected ratios between royalties, taxes and dividends projected to be received by the GOL from hydropower generation projects. During the period , total revenue of USD million was received by the GOL from hydropower projects. As is illustrated in Figure 2 below, with the exception of an abnormally large dividend payment in 2006 (from a THPC refinancing) the revenue streams from these three sources are relatively constant. 100% 90% 80% 70% 60% 50% 40% 30% 20% 10% 0% Figure 2: Ratios of Sources of Revenues Received by the Government of Lao PDR (2005 to 2008) Royalty (IPP) Profit tax (IPP) Dividend (IPP) As illustrated, the percentage revenue from royalties is relatively constant over the period, averaging approximately 11 percent of total receipts. The percentage of revenues arising from dividends shows gradual increase (with a slight reduction in 2008) as projects mature and profitability increases. 21

22 Financing costs are typically lower in the later years of a project s life, increasing the level of funds able to be distributed to shareholders. Dividends average approximately 29 percent of total receipts over this period. Taxes comprise the largest proportion of GOL revenues from hydro generation during this period. Almost 60 percent of total revenues are from project taxes. Figure 3 illustrates the projected increase in total revenues to be receipted by the GOL arising from hydro generation to Figure 3: Total Government Revenues (historical and projected) from Hydropower Generation, , USD million Dividend (IPP) Profit tax (IPP) Royalty (IPP) EDL (all taxes incl. VAT 10%) Over the long term the ratios between royalties, taxes and dividends projected to be received by the GOL are relatively constant as illustrated in Figure 4. Fluctuations do occur as projects come on-line or retire debt facilities. Figure 4: Ratios of Sources of Revenues Projected to be Received by the Government of Lao PDR ( ) 100% 80% 60% 40% 20% 0% Royalty (IPP) Profit tax (IPP) Dividend (IPP) These fluctuations are more prominent in early years as the level of revenue from hydropower projects is lower and variations by any one plant are more visible. A large spike in the ratio of revenue from royalties is evident in 2010 when NT2 is commissioned. 22

23 Overall, from 2009 to 2040, royalties are projected to account for approximately 19 percent of total GOL revenues, a significant increase on the period. Taxes are projected to contribute approximately 46 percent of all hydro fiscal benefits in the future, a decrease from the 60 percent historically. The remaining 35 percent of revenues are projected to arise from dividend payments, an increase in the 29 percent average proportion of dividends to total hydro fiscal benefits between 2005 and These projections paint an attractive future for the GOL, although it must be noted that not all planned projects will necessarily proceed. Equally some projects that do proceed will be delayed or will not perform as expected. These factors when considered together with questions about whether the GOL can finance the level of equity it currently contemplates having in future projects underpins the projections being a best case outlook. The Risks and Rewards of Government Investment in Hydropower IPP Projects The GOL does not have a clear policy of investing in IPPs, other than as provided for in the Electricity Law. However, having a policy is important from a financial benefits perspective and this should be formalized, possibly by an amendment to the Electricity Law. Internationally, governments are tending to see their role as planner, procurer and regulator of infrastructure assets, leaving the private sector to deliver the inputs required for projects to be developed, financed, built and operated. Against this backdrop, it would be reasonable to ask why the GOL wishes to be an investor or part financier of IPP projects. Further questions might also be raised about the GOL s ability to finance the equity required for these capital intensive businesses, particularly when funding might not come from IFIs and bilateral agencies. The following discussion provides some input regarding the likely net benefits that accrue to the GOL by investing in IPPs. Benefits of Investing in IPPs Dividends - Royalties and taxes are more secure revenue streams and less susceptible to developer manipulation than dividends. However dividends are an effective means of obtaining higher GOL returns from export IPP projects provided that (i) the economics of a project are thoroughly investigated and are sound; (ii) GOL s equity is financed on attractive terms and (iii) the GOL can choose the timing of its investment after development and, possibly, once construction risks have abated. IPP lender comfort - Equity investment by the GOL, in addition to leveraging greater returns from export IPPs, is considered to be desirable by potential lenders. Commercial lenders draw comfort from the clear commitment to a project implied by GOL s shareholding. Lenders see this as a positive, if not essential, requirement to their IPP lending in Lao PDR. In short, the GOL s presence as a shareholder helps project financeability. Influence, information and technology transfer - If the GOL invests alongside developers it has access to information, can influence shareholders and build its own capacity. However, it must take care to avoid conflicts of interests with EPD as the authority that grants IPP concessions. The chances of this being achieved are better when the investor and concession grantor are independent, as is the current situation in Lao PDR. Even if the investor gains information and wants to use it to influence its fellow shareholders, voting right arrangements may prevent it from doing so. The other shareholders might also arrange things so 23

24 that some tasks are assigned to individual investors or classes of shareholder and this can weaken the GOL investor s position. Some basic principles for shareholder agreements are needed to protect against these risks. A policy statement, legislative change or model provisions for concession agreements that sets down some of these principles would be useful. Helps develop local equity capital market - At present, IPPs in Lao PDR will need to be financed from friendly developer terms or other international sources because the local capital market is not yet well enough developed. However, the Projects can help develop the local capital markets if some funding requirements for local materials can be identified. Local preference rules have a part to play in this context. The dividends from IPP projects should also be directed in part towards further power sector developments. This raises a question about which entity is most appropriate to act as the vehicle through which a disciplined and skilled approach is made to channeling these IPP dividends to selected power projects. If a special purpose power sector investment vehicle like LHSE is used, it can raise capital from both domestic and international lenders and investors, helping develop the local equity and debt capital markets further. Risks of Investing in IPPs Conflicts with Sovereign Objectives - The way in which each IPP project is managed by the GOL will give some insight into the potential conflicts that arise if the GOL acts as concession grantor, project investor and offtaker. The role of the investor is to minimize its risk and maximize returns (dividends). The role of a concession grantor is to ensure that national resources are applied in such a way as to maximize macroeconomic returns (royalties and taxes, other financial benefits, social and environmental protection). The role of the offtaker is to obtain cost-effective electricity through minimizing the tariff. The roles of sovereign, investor and offtaker are therefore quite different. The GOL s interface with each project developer is primarily through EPD/CPI as concession grantor and EDL or LHSE as GOL investor. A further separation could be achieved by not designating EDL as a shareholder in IPPs that will be financed in part with private funding. Financial Risks - Export IPPs are necessarily capital intensive and the returns from these investments are uncertain. Some projects are more risky than others and project selection is therefore a vital ingredient to success. Poor projects will deliver poor results and can be an inefficient use of the GOL s limited resources. The GOL needs to use discretion in its investment decisions according to: The profitability of the project; The financing of GOL equity; and, The risk attaching to investment. As an investor GOL (or its nominee) participates not only in the profits but also the losses made by the project. If a project runs into serious problems - which can happen, usually at the development stage - then the shareholders will need to put in more equity. Lenders will require standby equity to be raised and committed to deal with this risk after financial close, so the GOL is required not only to raise base equity but usually another twenty percent or so to cover potential cost overruns during construction. Therefore, unless there are special arrangements, which might be possible, the public shareholder shares both the upside and the downside in proportion to its holding. It is prudent for GOL to delay making an investment decision until more is known about a project s development. One way of dealing with this issue is to require that developers provide the GOL with a small free carried interest (say 5 percent) plus an option to take up further shares during an option period. That period would run at least until the projects financial close so that the GOL can reserve its position until it has sufficient certainty that the project will go ahead. At this stage the GOL has the 24

25 option of either purchasing the additional shareholding as per the option, on selling part or all of the option to a third party (which could help fund that part of the paid for shareholding the GOL does take up) or not taking up the option at all. Development Expenses - Even with an equity option and free carried interest, the GOL is still required to fund its share of the developer s expenses and its own costs. The project development phase, being the period up to a project s financial close, is the period that holds most risk and is usually financed entirely with equity As part of future concession arrangements, the GOL might require that a concession fee is payable to help finance its development costs (as sovereign and investor). Additionally, there should be no special limits placed on the GOL as to how much it can claim for development expenses. The GOL s financial benefits will be reduced if development costs are not well managed. Non Parity with Private Shareholders - There is the real potential for the GOL to receive terms that are less attractive than its private co-developers unless care is taken to avoid this outcome. Private developers often have better access to finance than the GOL and have ancillary roles in the project, such as construction or operation and maintenance. The private developers bear the bulk of development costs as well and, while this is welcomed, it creates opportunities for them to add profit components to their development expenses. The GOL should also ensure that it receives comparable equity returns to developers. Investment Decisions Being Made For Non Investment Reasons - The GOL investor must have the sole authority for making decisions about whether or not it ultimately invests in each Project. It should have internal investment guidelines upon which its governing body makes an investment decision. It should be free to decide whether to invest in IPPs or not purely on the commercial merits of each investment and its ability to finance those investments. The GOL investor should not be required to consider any other criteria (such as social considerations) in making investment decisions. The concept of a free carried interest with an option to purchase additional shares mentioned above in IPPs fits well with the objective of independence. The GOL investor should not have to commit itself to exercising the option of additional ownership unless the project concerned can demonstrate that certain investment criteria have been met. Under these arrangements, a decision about whether or not to invest can be delayed until the investor has good quality information about each Project. Ideally this would occur later in the development period but before financial close 4 Lessons Learned The private sector carries the bulk of IPP development responsibilities and has better resources and access to capital than the GOL. GOL equity in IPPs is likely to require funding by IFIs, but IFIs have limits and there are many competing interests for that capital. The GOL s investment in IPPs is helpful but not necessarily crucial to IPP financing, meaning that this capital could be reallocated to other GOL initiatives without unduly affecting the rollout of IPP projects. However, as articulated above, there are arguments for the GOL to be an investor in export IPPs. For hydropower IPPs there is an even stronger case in favor of the state being an investor for the following additional reasons: State investment facilitates IFIs supporting the project on concessionary terms to bridge the gap between economic and financial viability. Many hydro projects are economically attractive but financially weak because they bring public good benefits such as the four value drivers of climate change, energy, regional coordination and water and food security listed by the World Bank in its 2009 Directions in Hydropower paper. 4 The use of a free carried interest for government shareholders is quite common in project financing. The use of options to take up shares is also quite common and is a feature of the Nam Theun II Shareholders Agreement. 25

26 State shareholdings are often financed through soft loans to government, which then on-lends the money at commercial rates to its investment arm, usually the utility company. The government therefore generates revenue through margin inherent in the on-lending process; Hydro projects have an indefinite working life (unlike thermal projects) and it is therefore in the state s interest to have partial ownership of an asset that it will eventually inherit at the end of the concession. Equally important is the state imposing upon the concessionaire, minimum working lives for the civil and electro-mechanical works associated with the project; It is very difficult to determine the correct level of financial benefits to be taken by the state from a large hydro project because of the uncertainties at the time of negotiation. By being a shareholder, the state covers itself against underselling its position, and will benefit from any asset revaluations and windfall gains that might arise from refinancing after completion (which is common); and, Bearing in mind that hydro sites are unique national assets, it is usually politically more acceptable for the state to be seen as a part owner so such projects which use national resources and have a bearing on others who are dependent on the river. In summary, in general case for state participation as an investor in a hydro project is much clearer than for most types of thermal projects. However, (as we see from the discussion in Section 2), government equity in projects should not form part of the economic rent calculation unless that equity costs less than the other shareholders pay. For Lao PDR specifically, hydropower development is fundamental to the country s future economic development. The GOL needs to control this development and being a shareholder is one of several tools that GOL can use to exert that control. The question for the GOL is not whether it should be an investor but how much it should invest and when should that investment be made. In that regard, the GOL should have a free carried interest of say 5 percent each IPP and an option to take up further shares of say 20 percent provided: (a) the option can be exercised as late as possible in the development period but leaving enough time for the other shareholders to make alternative arrangements if not taken up; (b) the option can also be taken up after commissioning (an exercise of an option during construction would not be bankable); and (c) the option may be on sold to a third party in whole or in part, the sale of which could finance that part of the option retained by the GOL for its own account. To adopt this approach would require a policy statement followed by either an amendment to the Electricity Law or issuance of detailed implementing regulation. Review of Comparable Countries Regarding Fiscal Benefit Packages Internationally, fiscal benefits from thermal and hydroelectric projects are delivered through five main mechanisms: royalties, income tax, gifted equity share, dividends and discounted/free electricity. As discussed in Section 5, each of these revenue sources is exposed to a varying degree of risk. On this basis, a dollar of fiscal benefits from one revenue source is not necessarily equal to one dollar from an alternative source. When comparing financial arrangements from other concession projects, these projects should have similar characteristics to the projects in Lao PDR, noting however that there can be significant differences between one concession and another as agreements are often purpose built for each 26

27 project. Consequently, a range of export based and IPP projects were assessed as potential reference cases. This assessment also led to many being excluded, such as: Power projects in Paraguay, where the country exports over 64 billion Terawatt Hours (TWh) per annum and is the second largest exporter of electricity in the world. Paraguay's projects are not applicable to this study as they almost entirely flow from the 12,600 MW Itaipu Project in which the Paraguayan government is a 50 percent shareholder and for which no concession agreement exists; IPP projects which export generation in Eastern Europe such projects are common, particularly in the Czech Republic where electricity exports are substantial (25,000 MW). However, in this particular market all IPPs sell to the state-owned transmission network CEZ which then on-sells to neighboring countries through their own bilateral PPAs; Projects in Africa despite there being significant cross-border electricity exports within Africa, no projects currently export under concessions. The Bujugali hydropower project in Uganda initially appeared to be an attractive project because it was originally intended to export a large portion of its generation. However, due to project delays and increased domestic demand, there are limited opportunities for export sales and those that are made are through Uganda s utility; Hydropower projects located in Bhutan, because of the non-commercial nature of export arrangements between the generators and the Indian off-takers. Power trading between Bhutan and India has historically formed part of bilateral trade agreements with sub-market tariffs being offered. The 114MW Dagacchu plant is the only Bhutanese export project with private sector involvement (Tata power taking a 26 percent shareholding in mid-2008) but in this instance the private shareholder is also the off-taker. This aspect also results in a noncommercial export scenario, making comparisons with Lao PDR projects impractical. The result of the analysis is that Nepal is the only country which exports hydropower under concession arrangements and is comparable to Lao PDR. Mozambique is also developing a number of major thermal and hydropower projects which are intended to export the majority of their generation to South Africa under concessions. The experience of these two countries regarding hydropower exports are discussed in detail in Attachment. The Nepalese experience, in particular, provides further insights which are useful to Lao PDR. However, Lao PDR has come a very long way in developing a fiscal benefits framework for hydropower projects and is to some extent is a world leader in this regard. However, that is not to say that Lao PDR has perfected its approach and, accordingly, suggestions to improve the fiscal benefits framework are set out in Section below. Recommended Fiscal Benefits Package for Lao PDR Hydropower IPP Projects As discussed earlier in this report, the Electricity Law and other Lao PDR legislation do not clearly specify the policy of the government regarding fiscal benefits, nor do they spell out the methodology for their determination. Even though the law exists, it has been applied on a case-bycase basis rather than systematically. While the current approach is flexible enough to accommodate the varying needs of financiers and international offtakers, it often results in the government s interests coming last in the triangular process of sharing benefits between developer, offtaker, and the government. Furthermore, the approach is not transparent, thus leaving it open to criticism, irrespective of how well it may be administered. The process would become more transparent if the 27

28 government were to publically document its minimum expectations regarding the fiscal benefits of hydro projects and the process for calculating the benefits over and above that minimum. Core Components of Fiscal Benefits Package By outlining a clear policy, the government would specify how its fiscal benefits from hydropower projects (especially export-oriented hydropower projects) should be calculated and taxed. The policy should be published so that developers are informed of the government s expectations before any agreements are negotiated between project sponsors and power purchasers. If the government sets the target level of benefits that it expects to receive before PPA prices are set, then the project sponsor will have an incentive to push for a tariff from the offtaker that would include these benefits. If the government does not set out its fiscal expectations before the PPA negotiations, the sponsor and the offtaker might agree on a power purchase price that covers return on equity but leaves little benefit for the government, even though the process is managed by the CDEP. Primary Taxation - The first step should be for the government to define the primary taxes that apply to hydropower projects (the business turnover tax, excise taxes, profit taxes, and the corporate income tax). This would mean that no developer would be allowed to obtain a project-specific dispensation, being entitled only to the zone-based relief specified under the Law on the Promotion of Foreign Investment of Secondary Taxation - The second step should be for the government to determine for each hydropower project the economic rent to be charged. This is the value of production after all necessary expenses such as operating and capital costs have been taken into account. The obligation to determine the economic rent for each project should continue to fall on the government and, in particular, the EPD and the Ministry of Finance. The government should develop a standardized spreadsheet model into which project-specific data can be entered. The government s standard form of MOU should require developers to be forthcoming with information needed for the model that cannot be obtained from other sources. The government will need to have a way to check and validate that information. Having determined the economic rent it wishes to obtain from a project, the government needs to decide how that rent should be levied. Up until now, the government specified a percentage of gross revenue for each concession operating year on a project-by-project basis. While the current royalty arrangement is an imperfect way of extracting economic rent, it is a better system than imposing a specific royalty, which is the system that the government is currently thinking of introducing. This system would levy a constant US 0.65 cents per kwh on projects that will necessarily have different economic rents. In short, any resource charge that cannot be tailored to the individual cash flows of each specific project is inefficient. For the time being, the current system of royalty determination should be maintained and improved. Further work may be necessary before the government can make a transition towards resource rent taxation, in other words, a profit-based system of taxation similar to the Australian oil and gas model described earlier. Between now and the adoption of any new system of economic rent taxation, the government could improve the royalty system by standardizing and continually improving its modeling of hydropower projects. In addition, as the royalty profile is set before the project begins operating, there is a risk that the royalty profile will not, in practice, extract economic rents efficiently. One way to address this risk is to introduce a re-assessment arrangement that allows a retrospective adjustment of the royalty if it is proven to have been too high or low for the previous year. 28

29 Additional Fiscal Benefits While primary and secondary taxes should form the core of the fiscal benefits package for each hydropower project, the government can obtain additional benefits in the form of up-front concession fees, dividend returns from investment, and discounted electricity sales. Each of these benefits needs to be approached cautiously, as explained below. Up-front Concession Fee An up-front concession fee to cover the government s costs of development should be allocated among the relevant government agencies to reflect the extent to which they have been involved in a project s development. This amount should be treated as a permissible expense of the developer when determining economic rent. The concession fee should be based on a minimum amount payable (because all projects impose a load on the government irrespective of their size) and a set percentage of the project s estimated cost. The percentage should be set by the Ministries of Finance and Energy and Minerals from time to time but not on a project-specific basis. As project costs have a tendency to increase over time, the standard MOU should specify the payment of additional concession fees (using the set percentage discussed above) as those increases become known. Government Shareholdings in Export-oriented hydropower Projects As discussed above, the case for the government investing in hydro IPPs is strong but this case is less strong for thermal projects. The LHSE should be designated as the government s shareholder in all export-oriented hydropower projects. The government s shareholding could be based on a small free carried interest (say 5 percent) to satisfy the requirements of the Electricity Law and to realize the benefits of IPP investment set out in Section 6.1. As part of its publicly announced policy, the government should also require an option to take up additional shares when a proposed project demonstrates that it is an attractive commercial proposition. The option might be to have an exclusion period shortly before scheduled financial close and project commissioning to satisfy the needs of lenders. The LHSE ought to be the sole decision-maker about whether to exercise share options because it must bear the risks of investment. Only the value of the free carried interest component of the government s shareholding and the value of any other equity bought at a price that is lower than that paid by the other shareholders should be treated as economic rent. Equity for which the government has paid the same price as the other developers should not be justified on the basis that it delivers economic rents. Instead, justification should be made on the basis of commercial criteria. The government also needs to develop a strategy for how it will fund its equity in IPPs. Currently, it tends to look to developers to help it to buy its shares, but the drawback of this is that it does not put the government in control of the financing process. The government needs to decide how much it wishes to seek support from international financial institutions and other sources of finance (preferably on non-concessional terms to reflect the commercial rationale of investing in IPPs). Care needs to be taken to ensure that some of the financial benefits derived from hydropower projects are re-invested in the electricity sector. In short, the government s IPP investment policy should provide for: (a) a set percentage of free carried interest in an IPP; (b) an option to take up a further set percentage of the concessionaire s equity at any time up to a reasonable period before the project s financial close based on a preset valuation formula; (c) the specification of the LHSE as the government s shareholder in export IPPs; and (d) certain important principles that are the basis of the government s investments in the sector, such as the Equity Internal Rate of Return (IRR) being equal for all shareholders. 29

30 Discounted Electricity Sales These discounts are not likely to yield major fiscal benefits to the government. This is because these discounts are captured at the utility level and are not necessarily remitted to the state budget. Moreover, the value of the discount should be treated as a permissible cost to the developer when calculating economic rents, which means that part of the economic rent will be allocated to EDL instead of to the state budget. The government s discounted electricity policy could provide for a set percentage discount of the tariff payable to the major off-taker for a set percentage of approved installed capacity. The government could have the option of not taking up the discount in return for other approved types of financial benefit. The policy might also provide for EDL or some other beneficiary of discounted sales to remit the discount to the state budget. Main recommendations Bearing these observations in mind, it is clear that regulations chould be amended to detail a revised government policy regarding concession financial benefits. A clear policy statement from the Ministry of Energy and Mines coupled with an amendment to the Electricity Law or implementing regulations could provide for a minimum fiscal benefits package as described above. 1. The business turnover tax, excise taxes, profit taxes, and the corporate income tax should be the primary taxes for hydropower projects. The government may reduce these taxes in accordance with the Law on the Promotion of Foreign Investment, but it should make no project-specific dispensations. 2. Secondary taxes such as the existing royalty arrangements should continue to be used to extract economic rents, but the government should consider moving to a resource rent tax system. The specific ad valorem royalty tax that the government is currently considering should be abandoned. 3. Alongside primary and secondary taxes, other approved sources of fiscal benefit could include: (a) an upfront concession fee; (b) dividends from investments in IPPs as specified by a government IPP investment policy; and (c) minimal use of discounted electricity sales specified under a discounted electricity policy. These other sources of fiscal benefits, however, do not contribute markedly to economic rents, so the rationale for including them in the fiscal strategy must depend on other criteria. 30

31 References Boadway, Robin & Flatters, Frank (1993) The taxation of natural resources: principles and policy issues, Policy Research Working Paper Series 1210, The World Bank.* Bosquet, Benoit (2002) The role of natural resources in fundamental tax reform in the Russian Federation, No 2807, Policy Research Working Paper Series, The World Bank, Brennan Michael J. and Schwartz Eduardo S (1985) Evaluating Natural Resource Investments, The Journal of Business, Vol. 58, No. 2 (Apr., 1985), pp , Published by: The University of Chicago Press. Campbell H. F., Lindner R. K (1985) A Model of Mineral Exploration and Resource Taxation, The Economic Journal, Vol. 95, No. 377 (Mar., 1985), pp , Published by: Blackwell Publishing for the Royal Economic Society.* Conrad, R, Gillis, M & Jenkins G (1980) Taxation And The Development Of The Mining Sector In Developing Countries, Development Discussion Papers , JDI Executive Programs. Fraser Rob (1998) An analysis of the relationship between uncertainty-reducing exploration and resource taxation, Resources Policy, Volume 24, Issue 4, December 1998, Pages Fraser, Rob and Kingwell, Ross (1997) Can expected tax revenue be increased by an investmentpreserving switch from ad valorem royalties to a resource rent tax?, Resources Policy, Volume 23, Issue 3, September 1997, Pages * Garnaut, Ross and Clunies Ross, Anthony (1975) Uncertainty, Risk Aversion and the Taxing of Natural Resource Projects, The Economic Journal, Vol 85, No. 338 (June 1975) pp * Hogan, L. (2003) Australia s Petroleum Resource Rent Tax: An Economic Assessment of Fiscal Settings, ABARE ereport 03.1, Prepared for the Department of Industry, Tourism and Resources, Canberra. Leland Hayne E (1978) Optimal Risk Sharing and the Leasing of Natural Resources, with Application to Oil and Gas Leasing on the Ocs, The Quarterly Journal of Economics, Vol. 92, No. 3 (Aug., 1978), pp Published by: The MIT Press Plourde, André (2005) Natural Resource Revenues and Equalization: A Partial Overview of Selected Issues. University of Alberta. Submission to the Expert Panel on Equalization and Territorial Formula Financing. August Shah, Anwar (1997) The Reform of Intergovernmental Fiscal Relations in Developing and Emerging Market Economies. World Bank Policy and Research Series.* 31

32 Annex - Review of Comparable Countries Regarding Fiscal Benefit Packages Nepal Overview Nepal and Lao PDR share geography which is favorable to hydro generation and a neighbor with large demand for energy imports. As illustrated in Figure 1, Nepalese exports grew from 72 GWh per annum in 2000 to over 100 GWh in Hydro generation in Nepal is typically comprised of a larger number of smaller-medium size plants (40-50MW). 5 Larger plants have however, been commissioned in later years with the 750MW West Seti project in the early stages of development to benefit from India s increasing demand. Figure 1 - Nepalese Electricity Exports Fiscal Benefits Under the Nepalese Electricity Act (1992) licenses for generation, transmission and distribution are available for a maximum of 50 years (Chapter 5.2). At the end of the concession term all property plant and equipment is transferred to The Government at no cost (Chapter 10.2). Royalties are payable to The Government at the rate of Rs. 100 per kw installed and 2 percent of sales revenue for the first 15 years of a projects operational life (Chapter 11.1). For the remainder of the concession term the royalty increases to Rs per kw installed and 10 percent of sales revenues (Chapter 11.2). Generation projects up to 1MW are exempt from income tax (Chapter 12.1). Generation, transmission or distribution projects are eligible to have income tax lessened by 10 percent (Electricity Act - Chapter 12.2 and Income Tax Law Chapter 7.16). In addition to the 10 percent reduction above, Section 12.3 of the Electricity Act states that projects addressing generation, transmission and

33 distribution for commercial purpose are exempt from income tax for 15 years and transmission or distribution projects are exempt for 10 years (Chapter 12.4). If a licensee obtains a management contract for a generation, transmission or distribution asset owned by The Government an income tax exemption is available for the first five years of the licence (Chapter 12.5). Reinvestment by a licensee in generation, transmission or distribution assets that increases installed capacity by at least 25 percent enables the licensee to deduct 50 percent of the expenditure from net income either in a lump sum or spread over a period of up to three years. Customs duties are reduced to 1 percent on all construction equipment, machines, tools and equipment used in repairs and maintenance not produced in Nepal. Additionally, such imports are exempt from sales taxes and import licenses are granted without charge (Chapter 12.7). Agreement must be obtained from The Government prior to exporting electricity (Chapter 22.2). Export duties of 0.5 percent are due on all exports, however export duties are frequently waived under bilateral trade agreements with India. It is understood such agreements are negotiated on a case by case basis between the respective governments (Chapter 22.3). Comparable Projects Three projects have been selected for comparison with those developed in Lao PDR. They have been chosen due to their size (40MW or greater), their export focus, and their involvement with the private sector. The three projects are Upper Bhoti Koshi, West Seti, and Arun III. Seven areas have been given specific attention in order to provide the best comparison of fiscal benefit packages. These are royalties, income tax, equity stake agreed with the host government, dividends, discounted/free electricity, concession term and export duties. A summary of these fiscal benefits across the three projects are outlined in the table below. Table 1 Comparison of Fiscal Benefits Package for selected Nepal hydropower Projects Upper Bhote Koshi West Seti Arun III Royalties Assumed to be zero Years 1-15 = 2% Years = 10% 7.5% Income Tax Assumed to be zero 25% of profits Assumed to be zero Equity Share 27% gifted 15% gifted Assumed to be zero Dividends As per equity share As per equity share Assumed to be zero Discounted/ Electricity Free 12% of all generation provided free of charge 10% of all generation provided free of charge Other Benefits Nil Export duties of 0.5% Undisclosed payments for land lease and land taxes Concession Term Assumed to be years 30 years years 21.9% of all generation provided free of charge First right for additional purchases Export duty of 0.5% 33

34 Upper Bhote Koshi (45 MW Hydropower) In February 2008 a Memorandum of Understanding (MOU) was signed between GMR Energy Ltd and the Italian-Thai Development Co. (ITD) regarding a 45MW power station in the Upper Bhote Koshi region of Nepal. The concession was issued on a BOOT basis with the primary intention being to export power from Nepal into India. As part of the concession agreement the consortium agreed to provide 12 percent of all electricity output to the Nepal Electricity Authority (NEA) free of charge. Output for the project is approximately 225 GWh per annum equating to 27 GWh being granted to the NEA. The NEA was also granted a 27 percent equity stake in the project company at no cost as part of the concession agreement. Dividends will be payable to the NEA over the life of the project as a result of this stake-holding. It is understood that these benefits are in addition to royalties payable to the Government of Nepal under the Electricity Law. West Seti (750 MW Hydropower) The 750MW storage-hydro project located in the west of Nepal is in the early stages of development. The project was established under a 30 year concession between SMEC Developments of Australia, the Asian Development Bank (ADB) and the Government of Nepal (15 percent equity stake-holding) for the purposes of exporting electricity to neighboring India. As part of the concession agreement the government of Nepal is entitled to 10 percent of all energy produced free of charge. The government will also be paid royalties on the electricity sales to India. For the first 15 years of the project royalties are set at 2 percent of all revenues with this figure increasing to 10 percent for years 15-30, which is in line with the provision of Nepal s Electricity Law. In addition to the electricity granted and royalties, the Government of Nepal will also collect export duties of 0.5 percent together with (undisclosed) payments for leasehold and land taxes of the associated forest area. The government will also collect revenue from corporate tax on profits (25 percent). Direct financial benefits from the West Seti project are estimated to total USD 2 billion over the project life, roughly equal to those of Nam Theun II in Laos in aggregate but equal to USD 2.67 million per MW The project is also estimated to add another USD 1.1 billion into the local economy through employment and resources purchases. Arun III (402 MW Hydropower) Whilst the Arun III project was abandoned in 1996 due to social and environmental concerns, project planning proceeded as far as negotiating a 30 year concession agreement whereby the benefits to the government of Nepal were established. The proposed 402MW hydro station was to be constructed at a cost of USD 860 million by India s state-owned Sutlej Jal Vidyut Nigam (SJVN). The Memorandum of Understanding (MOU) provided that Nepal was entitled to the 21.9 percent of all power produced free of charge. Nepal would also have the first right to purchase any additional subsequent power for its own use. The SJVN were required to pay royalties amounting to 7.5 percent of total income to the Nepalese government. In addition to this revenue, the government also received an export tax of 0.5 percent of all electricity sold into the Indian network. 34

35 Quantitative Analysis Information regarding Nepal's concession agreements is more suited towards a quantitative analysis of the projected fiscal benefits arising to the Government of Nepal. However, what is not known is the tariffs paid to the generators, financing arrangements of the plants (debt to equity ratios, loan tenor and interest rate), Operations and Maintenance (O&M) costs, or the IRRs required by each project company. Assumptions have been made on each of these variables and a simple project model has been created for each of Upper Bohte Koshi, West Seti and Arun III. It is important to note that whilst this analysis will provide an indication on respective ratios of each plant, the assumptions made have significant impacts upon the accuracy of the results. As such, the interpretation and use of the data outputs should reflect this. Inputs The following inputs were used in the assessment of Nepalese hydropower projects. Grey cells are based on documented information and yellow cells have had assumptions made regarding their values. Table 2 Nepalese Projects Financial Inputs Financial Inputs Interest Rate (% per annum) 14.00% Loan Tenor (years) Inflation (% per annum) 4.00% Debt to Equity 66.00% NPR:USD Table 3 Nepalese Project Specific Inputs Based on the financial and project specific inputs above the following results were calculated. 35

36 Table 4 Nepalese Projects Results Summary As is evident in Table 4 above, the Government of Nepal places a high priority on the provision of free electricity from hydropower projects. Free electricity is essentially a non-cash royalty as it is not exposed to cashflow risk as taxes are nor operational cost over-runs as dividends are. As such, free electricity is included in the royalties category for the international comparison below. Figure 2 below illustrates the ratios the combined revenue sources from Upper Bhote Koshi, West Seti and Arun III over a 30 year operational period. It has been assumed that all three projects are commissioned at the same time (year 1) after a four year construction period. Figure 2 Ratios of revenue source projected to be receipted by the Government of Nepal (USD million) Comparison between Lao PDR and Nepal Fiscal Benefits Regime As can be seen in Figure 2, the ratios between Nepalese projects and those projected for revenues arising from Lao PDR projects are markedly different. Royalties comprise a far greater proportion of 36