From Second To Third: How PH Dropped To 3rd Place in Geothermal Power Production

The Philippines was once the second largest producer of geothermal power in the world. Sadly, this is no longer true.

Last year, the Mineral Resources Industry of Indonesia announced that its country’s geothermal power production has reached 1,800 megawatts (MW), making the country the second largest geothermal power producer. The Philippines, on the other hand, production has decreased from 1850 MW to 1600. We now just rank third.

There are many reasons for our country’s lower geothermal power production. And we need to look at the history of geothermal power development in the country to understand how we got to our current state.

In the early 1970s, the government had a partnership with Union Oil Company of California, or Unocal, now known as Chevron. Under this partnership, the Unocal will provide technical expertise while the Philippine government, through the National Power Corporation on NPC will build and operate the geothermal plants. In 1976, the government decided to do away with the private sector and build and do the exploration with Philippine National Oil Corporation-Exploration Development Corporation (PNOC-EDC) as the head agency.

At the height of the power crisis in the 1990s, the National Power Corporation signed an agreement with PNOC-EDC, then a government corporation, to develop and provide 700 MW of geothermal power in Leyte. This move catapulted the Philippines to the second largest producer of geothermal power in the world. We were second only to the US.

The Electric Power Industry Reform Act or EPIRA was a game changer for the energy sector. With the passage of this law, geothermal power exploration and development was left to the hands of the private sector. This means that the private sector has to spend for the exploration of possible geothermal sources and build the power plants, which are expensive. Exploration expenses cost more than half of the total project cost for geothermal power plant projects. And test drilling just a single hole can cost some $5 million as it is the most costly phase of the exploration. It is the private firm that assumes the cost and risk of the exploration activities.

The high capital needed for greenfield exploration is one of the reasons why most private entities stay away from geothermal power development. There was a time when the government shouldered the cost of the preliminary survey of the areas, but this is now being assumed by the private sector developer.

Unfortunately, our regulations do not help in making geothermal exploration and development enticing to investors. On the contrary, our regulators have little appreciation for the risks being taken by geothermal developers in our tariff setting.

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I have talked about this greatly in a separate post. But to put it simply, we use the BETA in the computation of the cost of equity under the Capital Asset Pricing Model or CAPM for our tariff setting. The Beta in the tariff equation determines the return on equity for any project. And sadly, the Energy Regulatory Commission uses the same Beta of ~1.03 for all power plant project regardless of technology. This means that the ERC does not consider the risk profile of the power plant project. This is an incorrect application of the CAPM and sadly puts geothermal power developers at a disadvantage since they assume the high-risks of the exploration but will not be properly compensated for it.

Why the ERC insists on using the same Beta for all power projects is mind- boggling especially since it has long been established that geothermal development is a high-risk undertaking. A study conducted by the International Finance Corporation years ago concluded that only 60 percent of the explored holes during geothermal exploration worldwide turned out to be successful.

The ERC’s attitude towards geothermal energy is just one of the regulatory issues that renewable energy advocates and developers have to contend with. Overall, previous administrations have paid little attention to renewable energy development anyway. Unfortunately, the lack of opportunities in this field has also lead geothermal energy experts to find work in other countries such as Indonesia.

It is no wonder why many local investors are not too keen to get into geothermal development in the Philippines. It also does not help that our constitution prevents us from getting more foreign investors to help us develop our natural resources.

It’s sad that a country like ours is missing the missing out on the benefits of geothermal power. The Philippines also has a great advantage in geothermal since we are located in the ring of fire and has many volcanic areas where geothermal resources are abundant. In fact, some studies show that the Philippines 2,047 MW of proven reserves and 4,790 MW of potential reserves.

We have to keep in mind that geothermal energy can act as a base load plant, which makes it a great substitute for traditional sources of power. And if we can just use geothermal power to replace coal, then we can surely enjoy cheaper power rates. Geothermal energy, as well as any other renewable power technologies, have a fixed price as I have discussed previously. This means Filipinos will no longer have to pay for the fluctuating cost of international coal prices and foreign exchange rates.

The Philippines’ drop to third place in geothermal energy production worldwide only shows that the lack of government support for renewable energy development has dire consequences. It may be a pity that we now rank lower than our neighbor. But what’s worse is that our country is failing to harness its rich natural resources properly for the benefit of the Filipino consumers.

References:

https://www.pwc.com/id/en/media-centre/infrastructure-news/infrastructure-news—archive/december-2017/indonesia-second-biggest-geothermal.html

CAPM and Geothermal Energy Projects in the Philippines

Aside from the relatively high cost of developing geothermal energy sources, there is another challenge that the private sector deals with in developing the said renewable energy in the country: regulatory challenges, particularly the tariff setting mechanism.

CAPM Formula. Photo from www.money-market-trading.com

CAPM Formula.
Photo from http://www.money-market-trading.com

In my previous post, I have discussed the Capital Asset Pricing Model (CAPM). The CAPM assumes that investors will choose the assets that will yield higher returns over risk-free assets that provide a premium. The CAPM developers used Beta to measure the premium for the risk of an asset, assuming that using the entire market can reflect accurately the correct return of the risk of a particular asset

The Energy Regulatory Commission or ERC uses the CAPM in the tariff setting scheme.

Under the CAPM, the cost of equity is calculated based on the following formula and parameters:

re =rf + betae x MRP

where:

re = nominal cost of equity

rf = risk free rate for the Philippines

betae= the equity beta for benchmark generation company

MRP= Market Risk Premium (MRP)

Both the risk- free rate and market risk premium are based on the historical ERC approvals.

However, the ERC reportedly uses the same beta of (~1.03) for the tariff setting of power plant projects regardless of the technology without consideration to the risk profile of the power plant project. This means that the value of Beta is the same for coal power plants and geothermal power plants. And here lies the problem.

Using the same beta for coal-fired power plants for cost recovery is unfair to geothermal developers and does not reflect the proper conceptual use of the CAPM.

Let’s look at the case of two power plant projects—a geothermal and a coal-fired power plant.

The ERC approved a coal-fired power plant project of 110 megawatts in Mindanao. Its total project cost is roughly P14.6 billion.

The ERC also approved a 40-megawatt geothermal power plant with a total project cost of more than $207 million dollars or roughly P9.1 billion pesos. (at $1=P44 Exchange Rate).

Both projects are financed by 70 percent from loans and 30 percent through equity.

In our above examples, it is obvious that geothermal power plant project costs more. The coal-fired power plant has a capacity of 110 megawatts and costs P14.6 billion, whereas the geothermal project has 40 megawatts capacity but costs around P9.1 billion.

Of course, the costs of geothermal exploration and power plant construction are higher than putting up a coal-fired power plant. But, again, it is wise to invest in geothermal energy since it is not subject to price fluctuations, unlike fossil fuel-based plants.

As mentioned in my previous post, the private sector undertakes high risks because of the exploration required to develop the geothermal sources. Geothermal power projects entail exploration including the drilling of wells to determine if steam is available. Test drilling alone can cost $5 million per hole, and there is no guarantee that steam is available from the hole being explored.

In fact, according to a study conducted by the International Finance Corporation, roughly only 60 percent of the explored holes worldwide turned out to be successful.  This means that geothermal exploration is a high-risk and expensive undertaking. Exploration alone costs more than half of the total project cost for geothermal power plant projects.

On the other hand, coal-fired power plants only require the importation of the fuel and the power plants structures that are almost uniform.

The ERC uses the beta for coal (~1.03) to determine the return on equity for any project regardless of the risk profile.

Arguably, ERC’s choice of using the same Beta for coal and all other power projects is an incorrect application of the CAPM. Plus, of course, it is most unfair for renewable energy developers especially for geothermal energy developers in the country because they bear risks that are higher compared to the risks undertaken by coal-fired power plant owners.

The Beta in the CAPM, again, measures the risk. It follows that an asset, which has a higher risk profile, should have a higher Beta value. Under the CAPM, the riskier the asset is, the farther the asset is from having a Beta that equals to 1. Simply put, the value of the Beta used for the computation of the tariff should reflect the specific risks assumed by that particular asset in relation to the entire market.

The value of the Beta should reflect the risk of the market since CAPM assumes that the entire market can reflect the correct return of the risk of a certain asset. It is then sensible to use a Beta that reflects the premium for the specific risk of investing in a geothermal energy power project in relation to the entire market rather than a Beta for a different type of asset or technology, in this case, the coal-fired power plant.

It is therefore, logical that a geothermal energy power project will have a different value for the Beta, a higher value at that since geothermal development is riskier than a coal-fired power plant project.

The geothermal power plant projects should be given a higher yield than coal-fired power plant given the higher capital and risk exposure of the private developers. This is especially true these days where the government no longer shells out money for the exploration, but rather leaves the private sector to do its own exploration of geothermal sources, which comes at a high price.

Unfortunately, the ERC does not see it this way as it uses the same Beta for all power plant projects.

So, what incentives do geothermal power plant producers have to invest their money on such a risky undertaking when they are unable to obtain the required return given the incorrect valuation of the risks involved in these projects?