Renewable Energy Development Hydropower in Norway

I N T E R N A T I O N A L B U S I N E S S P R O G R A M S Master Program in International Finance and Economics (MiFE) S E M I N A R P A P E R S I N I N T E R N A T I O N A L F I N A N C E A N D E C O N O M I C S Center for Applied International Finance and Development (CAIFD) Renewable Energy Development Hydropower in Norway Authors: Gonzalez, David; Kilinc, Aygün; Weidmann, Nicole Seminar Paper 1/2011 ISSN 2191 4850

I Renewable Energy Development Hydropower in Norway Table of Contents List of Figures... II List of Abbreviations... III 1. Introduction... 1 2. Renewable energy... 2 2.1 Situation and outlook... 3 2.2 The role of hydropower... 5 2.3 Definition of hydropower... 8 2.4 Technical aspects of hydropower... 10 2.5 Advantages and disadvantages of hydroelectric power... 10 3. Hydropower in Norway... 12 3.1 Norwegian water resources and hydropower... 13 3.2 Norwegian hydropower potential... 14 3.3 Norwegian expertise in the hydropower sector... 15 4. Economic Framework... 16 4.1 Current hydropower market in Norway... 16 4.1.1 Supply and demand in the Norwegian Electric Industry... 17 4.1.1.1 Wholesalers... 18 4.1.1.2 End-users... 18 4.1.2 Price determination... 19 4.2 Norway s power exports... 21 4.3 The Nordic Power Exchange Nord Pool Spot... 24 4.3.1 The physical market... 25 4.3.2 The financial market... 27 4.4 Investing for the future... 27 4.5 Barriers to newcomers in the Norwegian hydropower market... 29 5. Legal Framework... 31 5.1 The Ministry of Petroleum and Energy... 31 5.2 The Norwegian Water Resources and Energy Directorate... 31 5.3 Legislative and political framework... 33 5.3.1 The licensing process... 33 5.3.2 Protection plans and the Master Plan of Water Resources... 35 5.3.3 The Industrial Licensing Act... 36 5.3.4 The Watercourse Regulation Act... 37 5.3.5 The Water Resources Act... 38 5.3.6 The Energy Act... 38 5.3.7 Further Legislation... 40 6. Financial Framework... 42 6.1 Small vs. Large Hydropower plants... 42 6.2 Key players... 44 6.3 Small hydropower project costs... 45 6.4 Profitability analysis of a small hydropower station... 48 6.5 Subsidies and Tradable Green Certificates... 54 6.6 Risks involved in Hydropower Investments... 56 7. Conclusion... 58 7.1 Summary of main points... 58 7.2 Recommendations... 59 References... 61

II Renewable Energy Development Hydropower in Norway List of Figures Figure 2-1: 2008 shares of world Total Primary Energy Supply... 3 Figure 2-2: Annual growth of renewables from 1971 to 2004 relative to TPES... 4 Figure 2-3: 2008 renewables in electricity generation... 6 Figure 2-4: Worldwide hydropower development and capacity... 7 Figure 2-5: Percentage of current electricity generated by hydropower... 7 Figure 2-6: Electricity demand per capita... 8 Figure 3-1: Leading hydropower producing countries in 2007... 12 Figure 3-2: The largest hydropower stations in Norway in 2008... 13 Figure 3-3: Norway s hydropower potential as of January 2008, TWh/year.... 15 Figure 4-1: Electricity spot price in 2008 and 2009, weekly average. NOK/MWh.. 20 Figure 4-2: Electricity spot prices and forward prices in the financial market... 21 Figure 4-3: Norway s Power Imports and Exports, 1970-2007... 22 Figure 4-4: Production split in Nordic countries in 2008... 25 Figure 4-5: Elspot system and area prices as of 13.11.10... 26 Figure 4-6: Power exchange in the Nordic region in 2008, GWh... 27 Figure 4-7: Industry-related objectives, Energi21, sub-group hydropower... 28 Figure 5-1: Organizational Chart NVE... 32 Figure 5-2: Legislation governing licensing in the hydropower sector... 33 Figure 5-3: Licensing process (more than 40 GWh / year)... 35 Figure 6-1: NVE definitions of small hydro plant in kw... 42 Figure 6-2: Investment costs of small hydropower plants in selected European countries... 49 Figure 6-3: Project Cash flows, in NOK... 52 Figure 6-4: Effect of discount rate and lifetime on the NPV... 53 Figure 6-5: Effect of leverage on the IRR... 53 Figure 6-6: NOK/EUR exchange rate development since 2005... 56

III Renewable Energy Development Hydropower in Norway List of Abbreviations CfD: Contract for difference CHA: Canadian Hydropower Association CO 2 : Carbon dioxide CRW: Combustible renewables and waste EEA: European Economic Area EIA: Environmental Impact Assessment EUR: Euro GWh: Gigawatt hour ICOLD: International Commission on Large Dams IEA: International Energy Agency IHA: International Hydropower Association IRR: Internal Rate of Return kwh: Kilowatt hour MFA: Ministry of Foreign Affairs MGCA: Main grid commercial agreement MW: Megawatt NOK: Norwegian kroner Norad: Norwegian Agency for Development Cooperation NPV: Net Present Value NVE: Norwegian Water Resources and Energy Directorate PPA: Purchase Power Agreement R&D: Research and Development SHERPA: Small Hydropower Energy Efficiency Campaign Action TPES: Total Primary Energy Supply TWh: Terawatt hour TSO: Transmission System Operator VAT: Value added tax

1 Renewable Energy Development Hydropower in Norway 1. Introduction Water has always been a vital resource for mankind. In the course of human history, it has not only been used as a source of life, but also as a source of energy. Hydropower, the energy that comes from the natural flow of water, is a renewable, reliable, and most importantly, nonpolluting source of energy. Supplying almost one-fifth of the world s electricity, hydropower exceeds by far the contributions made by other renewable sources, making it especially valuable in reducing energy-related carbon emissions. Thus, hydropower plays and will play an important role in today s paramount endeavor to reduce greenhouse emissions worldwide. The present study aims at providing a thorough insight into the benefits of investing in hydropower. For this purpose, Norway presents itself as an attractive location for such an investment. In Norway, hydropower represents approximately 99% of the total electricity produced, and there is still room for further development. Norwegian expertise in hydropower construction and management of water resources stands out globally, offering an exceptional fundament for a sound investment. Private investment in the hydropower sector can take place either through the upgrading and rehabilitation of existing schemes, or through the construction of new projects. While the first category is clearly important, it nevertheless has no significant impact on emission reduction. This report therefore focuses on attracting private investment to new projects. Large-scale hydropower projects were at peak during Norwegian industrialization. Nowadays, Norway targets the development of small hydropower. Hence, a small hydropower scheme will be the base for analysis. The reader will be introduced to the investment environment and relevant data will be provided which are meant to allow for informed decision-making. The first section of the present report exhibits the current situation of hydropower in the world, and the position of Norway in this field. Subsequently, the economic background as well as the institutional and legal framework in Norway will be examined in detail. The last section considers the financial aspects of the project and is intended to evaluate the profitability of a small hydropower station.

2 Renewable Energy Development Hydropower in Norway 2. Renewable energy Renewable energy sources, among which the most popular are solar, wind, hydro, and biomass, have recently become the heart of sustainable development. Though not new, sustainable development now occupies a primary position in the world s public agendas as a critical concern. Yet, the term is in fact understood by only few, and thus, a clear definition of sustainable development is central to the understanding of the aim of the present paper given the focus on renewable energies. Therefore, an extensive description put forward by the European Commission will serve as the starting point of reference to the reader: Sustainable Development stands for meeting the needs of present generations without jeopardizing the ability of futures generations to meet their own needs in other words, a better quality of life for everyone, now and for generations to come. It offers a vision of progress that integrates immediate and longer-term objectives, local and global action, and regards social, economic and environmental issues as inseparable and interdependent components of human progress. 1 In this respect, renewable energy could contribute to the attainment of sustainable development in the following aspects: Renewable energy promises greater security of energy supply by utilizing abundant, diverse, and domestic (non-imported) sources. This eliminates the resource exhaustion constraint. When substituting fossil fuels with renewable energy, global and local greenhouse gas emissions will be substantially reduced. Innovation and technology development in this field enable enhanced opportunities for implementation, particularly in rural areas and in emerging countries. The exploitation of renewable energy promotes local and regional employment in the energy manufacturing sector, installation and maintenance. 1 European Commission. (2010). Environment. (Internet).

3 Renewable Energy Development Hydropower in Norway Despite this evident potential, renewable energy is being barely exploited in commercial markets. Reasons for this can be attributed to high set-up costs as well as technical and institutional limitations. In the best locations, renewable energy is competitive with ordinary energy sources; however, in most of the cases, it is still at an early stage of development and technically immature. Hence, supportive measures are required to foster the further expansion of renewables in energy markets. 2.1 Situation and outlook With the purpose to understand and illustrate the main features of the current renewable energy situation, this section will provide an overall evaluation of the position of all renewable energy types. When referring to world energy, the standard of measurement is Total Primary Energy Supply (TPES), which represents all energy consumed by end users, except for electricity but comprising the energy needed to produce electricity. To put renewable energy in the context of world energy, Figure 2-1 shows the various shares of energy in 2008. Figure 2-1: 2008 shares of world Total Primary Energy Supply Source: International Energy Agency. (2010). 2010 Key World Energy Statistics. (Internet) In 2008, renewable energy corresponded to 12.9% of TPES. Within this category, combustible renewables and waste represented the largest portion (77.5%), followed by hydropower (17%). Contributions made by solar, wind, and other renewable sources were minimal. Put in other words, Figure 2-1 reveals that renewable energy

4 Renewable Energy Development Hydropower in Norway accounts for a relatively small fraction of TPES, and thus, it has ample room to expand further. Figure 2-2: Annual growth of renewables from 1971 to 2004 relative to TPES Source: International Energy Agency. (2007). Renewables in Global Energy Supply - An IEA Fact Sheet. Retrieved from International Energy Agency Publications and Papers database. With an annual growth rate of 2.3% over three decades, total renewables supply rose only slightly faster than TPES. Nevertheless, certain types of renewable energy experienced an impressive growth rate during the same period of time, most prominently wind (48.1%) and solar (28.1%) energy. This extraordinary growth can be partly explained by the very small base in 1971. At present, markets and political concerns point to a more important future role of renewable energy in the world s total energy supply. Due to increased environmental awareness combined with technological improvement and growing demand in industrialized countries, the use of renewable energy is expected to rise over the next years. 2 The exploitation of renewable energy sources is strongly connected to a country s resource endowment. However, it is also often determined by technology development, policy framework, and private sector investment, to the extent that even countries with limited availability of renewable resources have achieved rapid 2 International Energy Agency. (2002). Renewable Energy. p. 3. Retrieved from International Energy Agency Publications and Papers database.

5 Renewable Energy Development Hydropower in Norway growth through the implementation of measures that encourage the development of renewable energy technologies. Thus, the principal constraint in the progress towards the utilization of renewable energy is its cost-effectiveness. Renewable energy has been, with the exception of large hydropower, combustible biomass, and larger geothermal projects, an expensive source of energy compared with fossil fuels. 3 Hence, substantial technology enhancement to attain cost competitiveness is number one priority. The ongoing implementation of stricter environmental regulations and protocols for greenhouse gas emissions is already a driving force for policy initiatives in many countries that address the cost-effectiveness constraint. Such initiatives concentrate on research and development investments as well as financial incentives. To sum up, markets for renewable energy are growing and look ahead at a promising future. Strategic policy programs are contributing towards making renewable energy exploitation more affordable; i.e. reducing technology costs for users through subsidies and research and development schemes. This not only benefits the users of one country, but also those in other countries, reinforcing overall cost reductions and performance advancement. 2.2 The role of hydropower Hydropower is one of the most mature technologies in the realm of renewable energy supply. For this reason, it is also one of the most competitive renewable energy sources. Due to its technological, economic, and environmental benefits, hydropower is considered to be a significant contributor to the future world s energy supply. According to Figure 2-1, hydropower accounted for 2.2% of TPES in 2008 which is, in fact, a relatively modest share. However, the electricity generation market exhibits a very different pattern. As can be seen from Figure 2-3, hydropower was by far the largest electricity supplier from renewable sources in 2008, representing nearly one-fifth of the world s electricity production. Third in importance after coal and gas, hydropower has been 3 International Energy Agency. (2007). Renewables in Global Energy Supply - An IEA Fact Sheet. p.6. Retrieved from International Energy Agency Publications and Papers database.

6 Renewable Energy Development Hydropower in Norway propelled to an efficient electricity supply technology which, in contrast to most other renewable sources of electricity, has the capacity to satisfy a considerable portion of the world s electricity needs. Figure 2-3: 2008 renewables in electricity generation Source: International Energy Agency. (2010). 2010 Key World Energy Statistics. (Internet) Hydroelectric power has nevertheless immense remaining potential. In a joint study carried out in 2000 by the IEA Implementing Agreement on Hydropower Technologies and Programmes, the International Hydropower Association (IHA), the International Commission on Large Dams (ICOLD), and the Canadian Hydropower Association (CHA), the world s total technically realizable hydropower potential was estimated at 14,370 Terawatt hours (TWh) per year. About 8,082 TWh/year thereof were considered economically feasible for development, 2,600 TWh/year were already in operation, and around 400 TWh/year were under construction. At the time of publication of the study, reports indicated that hydropower represented more than 50% of national electricity supply in about 65 countries, more than 80% in 32 countries, and almost all of the electricity in 13 countries. 4 In the midst of accelerating economic growth in Europe and North America during the twentieth century, hydropower potential in these regions was extensively developed and progress has continued until today. There, potential has been already utilized by more than 60%. On the contrary, Asia, South America, and Africa still 4 IEA Implementing Agreement on Hydropower Technologies and Programmes, the International Hydropower Association, the International Commission on Large Dams, and the Canadian Hydropower Association. (2000). Hydropower and the world s energy future. p. 4. (Internet).

7 Renewable Energy Development Hydropower in Norway have enormous untouched reserves of hydropower potential. As can be seen from Figure 2-4, for instance, Africa utilizes only 7% of its hydropower capacity. Figure 2-4: Worldwide hydropower development and capacity Source: IEA Implementing Agreement on Hydropower Technologies and Programmes, and the United States Bureau of Reclamation. (1999). Hydropower A Key to Prosperity in the Growing World. (Internet) In contrast, when considering electricity generated through hydroelectric power, it be- comes evident that Asia s generation capacity exceeds to a high degree that of Europe and North America, despite the fact that potential there has Source: IEA Implementing Agreement. (1999). been much less exploited. Hydropower A Key to Prosperity in the Growing World. (Internet) This can be attributed to large-scale hydropower development programs that have hrussave been been undertaken particularly in China and Russia, and thus, total installed capacity is substantially larger. Figure 2-5: Percentage of current electricity generated by hydropower The ever-intensifying need for power as world population increases, emerging economies advance, and developed nations remain on their course for growth allows an early prognosis of augmented demand for electricity in the years to come. Figure 2-6 describes the expected increase in electricity demand per capita from 1990 to 2020. Growth rates in electricity demand are presumed to be highest in South and Central America, and Europe.

8 Renewable Energy Development Hydropower in Norway Figure 2-6: Electricity demand per capita Source: IEA Implementing Agreement. (1999). Hydropower A Key to Prosperity in the Growing World. (Internet) In view of the risk of increased combustion of fossil fuels and its major impact on the environment and climate change, there is a strong focus on renewable energy as an alternative to meet rising electricity demand. In this respect, hydropower, which already makes up a significant share of the total amount of electricity generated, becomes an exceptionally convenient recourse due to not only its large remaining potential but also its remarkable advantages with respect to costs and technology over other sources of renewable energy. The next section will stress the benefits of hydropower as a reliable, clean source of electricity. 2.3 Definition of hydropower Hydropower is an energy that comes from the force of moving water. The water cycle is part of the continuous natural cycle that fall and movement of water. Energy from the sun evaporates water in the earth s oceans and rivers and draws it upward as water vapor. When the water vapor reaches the cooler air in the atmosphere, it condenses and forms clouds. The moisture eventually falls to the earth as rain or snow, replenishing the water in the oceans and rivers. Gravity drives the water, moving it from high ground to low ground. The force of moving water can be extremely powerful. 5 Water on the earth is continuously replenished by precipitation. Hydropower is called a renewable energy source as long as the water cycle continues. 5 The National Energy Education Development Project. (2010). Hydropower. (Internet).

9 Renewable Energy Development Hydropower in Norway Hydropower can be used to generate electric power. Also it can be used to create mechanical motion that runs machines for a variety of needs. 6 Unlike many other sources of energy, water cannot be depleted such as fossil fuels. There are different types of naturally occurring kinds of water that can be used for hydropower. The main occurrence is water that flows along a river, or down waterfalls, which is used for generating power as the force comes from the water flowing from a higher place to a lower place. 7 Dams are mainly used to produce electricity. They are often built alongside other types of power plants. They can be used to regulate the amount of water that flows through them to produce different amounts of power. It is not too much necessary to build a dam for every hydropower plant. Brief History of Hydropower For decades hydropower has been used in the world, Greeks used water wheels to grind wheat into flour. In the early 1800s, American and European factories used the water wheel to power machines. 8 The water wheel is a simple machine which is located below a source of flowing water. It captures the water in buckets attached to the wheel and the weight of the water causes the wheel to turn. Water wheels convert the potential energy of the water into motion. That energy can then be used to grind grain, drive sawmill or pump water. In the late 19th century, the force of falling water was used to generate electricity. The first hydroelectric power plant was built at Niagara Falls in 1879. In the following decades, many more hydroelectric plants were built. 9 Plants were burning coal and oil for many years. It made electricity more cheaply than hydropower plants. 10 After the oil shocks in the 1970s, people showed a renewed interest in hydropower. 6 Ibid 7 Ibid 8 Ibid 9 Ibid 10 Ibid

10 Renewable Energy Development Hydropower in Norway 2.4 Technical aspects of hydropower Damming rivers to store water in reservoirs is the most common method of generating hydroelectric power. The flow turns turbines, which can generate electricity. Water is collected and stored into the dams above the power station for using when it is required. Some dams create a big lake behind the dam wall. Other dams simply block the river and divert the water through pipelines down to the power station. Flowing water gives up some of its energy to run the turbine, which is then discharged through drainage pipes or channels and it is called the tailrace. Small hydropower often simply uses canals or streams to produce enough electricity, for example lighting and running the appliances of individual households. 2.5 Advantages and disadvantages of hydroelectric power Hydropower electricity generation offers several advantages compared with the other energy sources that are renewable. The use of water to generate electricity is considered a renewable energy source and hydropower energy will be available as long as there is water flow. 11 Therefore, hydropower energy generation is not dependent upon the price of uranium, oil, or other types of fuel. This makes electricity costs lower and more stable. This is one of the most significant advantages of hydropower plants. Moreover, working with many employees is not required for hydroelectric stations. This is one of the other advantages which help keep the cost of hydroelectricity low. When in use, electricity produced by dam systems does not produce greenhouse gases. They do not pollute the atmosphere like power plants that burn fossil fuels such as coal, oil or natural gas. Hydropower is a domestic source of energy, produced locally near where it is needed. Furthermore, hydroelectric power stations can be set up in almost any size, depending upon the river or stream used to operate them and these stations can operate for many years after they are built. 11 Vermont Energy Partnership. (2007). A Resource Guide to In-State Hydropower Production. (Internet).

11 Renewable Energy Development Hydropower in Norway Hydropower is also a flexible source of energy. The sluice gates can be shut, stopping electricity generation if electricity is not needed. The water can be saved for being used at another point in time when electricity demand is high. That means that energy can be stored until it is needed. 12 This way, hydropower is generally available as needed and engineers can control the flow of water through the turbines to produce electricity on demand. Nevertheless, it also carries some disadvantages that have to be taken into account when building a new hydropower station. Dams must be built at high standards; therefore building a new dam could be greatly expensive. Therefore, they must be operated for many years to become profitable because of the high cost of construction. 13 Sometimes hydropower stations can cause serious problems between neighboring countries or localities. Dams built blocking the progress of a river in one country usually means that the water supply from the same river in the following country is out of their control. 14 Additionally, in the case of flood, people who live in the villages and towns near the plants must move out. This means that they lose their farms and businesses. 15 As stated before, hydropower is an energy that makes it possible to produce electricity without using fossil fuels. Thus, it does not produce emissions such as those caused by electricity production in coal, oil, or gas fired power plants. However, generating hydropower energy causes some environmental consequences in some cases. Damming areas with rich biodiversity of flora also risks a negative effect on the climate because of large amounts of carbon, thereby leading to a high concentration of methane. 16 Hydropower often entails changes to the natural variations in the water in a watercourse. For instance, dams may cause changes to the level and flow of water, affecting fish population. This means that hydropower has also an effect on biodiversity. 12 Ibid 13 Wordpress. (2008, November 17). Nuclear Energy based power plants Discussions on future dependability for production of cleaner power. (Internet). 14 Ibid 15 Ibid 16 RenewableEnergy.no. (n.d.) Environmental Impact of hydropower. (Internet).

12 Renewable Energy Development Hydropower in Norway 3. Hydropower in Norway As it has been exposed earlier in this paper, electricity generation from hydropower makes a significant contribution to meeting the world s growing demand for electricity. Countries all over the world make use of hydropower, yet capacity and utilization vary considerably among different countries. While some nations demonstrate a share of hydropower equivalent to 99% of total electricity generation, others have no hydroelectric power production at all or it represents only a negligible share. These variations in countries reflect not only geographic and climatic constraints but also policies in operation and, surely, money. Figure 3-1: Leading hydropower producing countries in 2007 Source: Norwegian Water Resources and Energy Directorate. (2009). Energy in Norway. (Internet) Figure 3-1 shows the world s largest hydropower generating countries. In the last decade, China has developed its hydroelectric facilities massively, becoming the leader in hydroelectricity generation with 485 TWh in 2007. Brazil and Canada follow the ranking with 374 TWh and 369 TWh, respectively. It is worth pointing out the position of Norway as the sixth largest hydroelectric power producer. Recalling from section 2.2, Europe s hydropower potential has been already exploited to more than 60%. Nevertheless, hydroelectric power generation by European countries appears to be inferior when compared to other countries where potential has been developed to a lesser extent. This can be indeed attributed to the specific region s water resources and capacity, and thus, the importance of Norway s hydropower strength within Europe becomes evident.

13 Renewable Energy Development Hydropower in Norway 3.1 Norwegian water resources and hydropower Norwegian watercourses have exceptional commercial importance for electricity generation. Norway has been a major producer of hydroelectric power for more than a century. The country possesses natural resources and a geography that enables to build environment-friendly hydroelectric stations. In fact, close to 50% of the European reservoir capacity is located in Norway. 17 Norway counts about 4,000 river systems, each of which comprises a river and all its streams, lakes, snowfields and glaciers. A typical hydropower station in Norway is characterized by a reservoir located in an elevated mountain area which, in turn, benefits from a glacier as second level storage resource. Figure 3-2 exhibits the largest hydropower stations in Norway in 2008; Kvilldal, Sima and Tonstad being the most important ones with an average annual production of 3,517 Gigawatt hours (GWh), 3,441 GWh, and 4,196 GWh, respectively. Figure 3-2: The largest hydropower stations in Norway in 2008 Source: Norwegian Water Resources and Energy Directorate. (2009). Energy in Norway. (Internet) Today, Norway s installed hydropower capacity amounts to 30,000 Megawatt (MW) and annual hydropower production averages 125 TWh. Hydropower currently represents some 96% of the Norwegian electricity production, compared to 11% in the European Union. In this regard, a share of 60% in Norway s total energy 17 Statkraft. (2009). Hydropower in brief. (Internet).

14 Renewable Energy Development Hydropower in Norway consumption stems from renewable energy, which is by far larger than the European Union s target of 20% by 2020. 18 3.2 Norwegian hydropower potential Primary energy demand is expected to increase in the following years, not only in developing countries but also in industrialized nations. This increase in energy demand poses a challenge for modern society in view of climate change and global warming. New renewable power is therefore important to reduce the world s greenhouse gas emissions. At present, Norwegian power generation produces virtually no carbon dioxide (CO 2 ) emissions, and thus, it can contribute to the reduction of greenhouse gases and create added value for Norway. Still, an active approach is required or otherwise, growing domestic demand will lead to an increase in CO 2 emissions. Within this context, the need for increased water-storage capacity in Norway is now more imperative than ever. In a speech held by State Secretary Sigrid Hjørnegård at the 6 th International Conference on Hydropower in February 2010, he declared: Some think that developing hydropower here in Norway, is history. That is wrong! We will both develop new median size projects and upgrade existing plants to secure more renewable and clean electricity supply. There is also a huge interest in developing small hydro projects below 10 MW. Estimations by Norwegian authorities indicate that the available potential in the country is about 205 TWh, out of which around 45.5 TWh are located in protected areas. 121.8 TWh have already been developed, leading to a remaining potential for development of 37.7 TWh. 19 As can be seen from Figure 3-3, new projects with a capacity of 1.3 TWh are currently under construction. In the same manner, licenses were granted for construction as well as refurbishment and upgrade projects which correspond to increased generating capacity of about 1.8 TWh. 18 Hjørnegård, Sigrid. (2010, February). Norwegian Policy on Renewable Energy. Opening address at the 6 th International Conference on Hydropower. (Internet). 19 Ministry of Petroleum and Energy, (2008). Fact 2008 Energy and Water Resources in Norway. p.24. (Internet).

15 Renewable Energy Development Hydropower in Norway Figure 3-3: Norway s hydropower potential as of January 2008, TWh/year. Source: Ministry of Petroleum and Energy. (2008). Fact 2008 Energy and Water Resources in Norway. (Internet) 3.3 Norwegian expertise in the hydropower sector As a result of Norway s long hydropower history, the country has gained expertise covering all stages of hydropower development, from planning and design to the delivery and installation of technical equipment. More importantly, there has always been a strong focus on achieving efficient, environment-friendly practices. Norwegian authorities and power companies have developed expertise in monitoring and managing hydropower resources, leading the national power market to become an exemplary embodiment of operating efficiency. 20 Demand for Norwegian expertise in hydropower operation and market development is augmenting. Hydropower will play a crucial role in the output of energy in the future, in which climate issues will require a substantially cleaner power production and in which Norway will interact with the European power market ever more. Norway s hydropower expertise will be of great value internationally to educational and research institutions, consultants, suppliers, and energy companies. Knowledge transfer will most probably take place in fields such as operational and environmental regulation of power generation, market-related and technical coordination of production as well as the optimal usage of water resources to enhance operational efficiency. 20 Ibid., p. 29.

16 Renewable Energy Development Hydropower in Norway 4. Economic Framework 4.1 Current hydropower market in Norway Norway has the world's largest per capita hydropower production, and is the sixth largest hydropower producer in the world and the largest hydropower producer in Europe. 21 In 2009, hydropower generation in Norway amounted to around 132.8 TWh and electricity production declined about 6.9% compared to the previous year. Norwegian electricity generation varies with the inflow conditions. Dry weather conditions in 1996 and 2002 resulted in low production, and wet conditions in 2000 and 2005 resulted in high production. Low snow volumes in winter 2006 and the dry summer in the same year caused low generation. A lot of rain and high inflow in 2008 led to high production. The hydropower generation was down again during the first half of 2009 in Norway. 22 Norwegian electricity consumption amounted to 123.8 TWh in 2009. This was a reduction of 3.9% on the previous year. The reduction in the year 2009 was primarily due to lower consumption in the power intensive industries in the same year. 23 From April 2006, consumption was reduced for 12 months. From May 2007, consumption rose until summer 2008. Since then, consumption has trended downwards. The main reason for this is the financial crisis and the slowdown of the economic growth. Around 50% of Norway s electricity generation capacity is owned by local authorities and county councils. Central government owns about 30%, and private companies roughly 13%. Norway s 10 largest generating companies have nearly 70% of the country s total mean production, and about the same proportion of installed capacity. 24 Statkraft, Statnett, Hafslund, BKK, Lyse, Agder, Skagerak, Eidsiva, and Trønderenergi are the major players on the market. There are also a number of smaller companies geographically spread around the country. Whereas large companies naturally represent a major share of the market, the smaller parties tend to 21 Ministry of Petroleum and Energy. (2007, March 23). Norway s Energy Profile. (Internet). 22 The Norwegian Energy Regulator. (2009). Annual Report 2009. (Internet). 23 Ibid, p.37 24 Ministry of Petroleum and Energy. (2007). Owners and organization in the power sector. (Internet).

17 Renewable Energy Development Hydropower in Norway group into regional cooperation units in order to derive synergies in smaller procurement projects. 25 These companies are Kjøpekraft Vest in Western Norway, Trønderkraft, Buskerud, and Elinor in the north. Similarly, there are a lot of grid companies in Norway. A grid company may own a local, regional or central grid. 178 companies are engaged in grid management and operations. Of these, 42 are solely grid operators and 136 companies are vertically integrated in the sense that they are engaged in production and/or trading. Municipalities and counties own most of the regional and distribution grids in Norway. The authority to make decisions pursuant to the Energy Act has largely been delegated to the Norwegian Water Resources and Energy Directorate (NVE), which is subordinate to the Ministry of Petroleum and Energy. Because the grid is a natural monopoly, consumers are obliged to buy grid services from the owner of the local grid. 26 The NVE is responsible for monitoring and regulating grid management and operations. 4.1.1 Supply and demand in the Norwegian Electric Industry There are a lot of players and consumers that actively participate in the Norwegian electricity market. Therefore electricity supply is a highly competitive business in Norway. The prevalence of expensive deliveries makes the industry be preoccupied by general reliability, quality, compatibility and complementarily of the sought solutions. A wrong choice of either supplier or product can result in a range of problems, such as reduced lifespan or a sudden electricity black-out in a given geographical area. As such, the consequential cost can be much higher than initial investment costs. Under the administrative regulation in the supply sector, pursuance of laws about public procurement was introduced in 1994 and was then was revised in 2010. In the same manner, the power supply is subject to governmental legislation, which includes licensing, supervision, control and other regulations. 25 Dalane, Natalia. (2010). Supplier Cartels in the Norwegian electric utility business, How Buyers Behavior Affects Competition. Norges Handelshøyskole, Bergen. 26 IPA Energy Consulting. (2006). Review of EU Electricity Markets. (Internet).

18 Renewable Energy Development Hydropower in Norway High shifting costs related to existing solutions, unavailability of substitutes in the market, the importance of system reliability for the customer combined with well established selling networks with sometimes exclusive access to sub-suppliers, all this creates an imbalance in favor of the supplier. Moreover, should they try to cooperate on pricing this would have a negative impact on the utilities industry and lead to increased costs for the end consumers. In order to counterbalance this imbalance, the government regulates the settings in which competition takes place. On the one hand, suppliers are regulated through the Competition Law supervised by the Norwegian competition authorities. On the other hand, buyers have to follow clearly defined tendering procedures established under EU-regulations on public procurement. Both sets of laws are relatively new and came into force within the last two decades. The Competition Law was established in 1993 with last revisions in 2009. The power market is often divided into two parts, the first one being wholesale market and the second one being end-user market. 4.1.1.1 Wholesalers The wholesale market consists of generators, suppliers, big industrial enterprises and other large undertakings. Electricity is traded bilaterally between different market players and in the markets organized by the Nordic power exchange, Nord Pool. 27 Currently, a number of company trade standard bilateral contracts, but growing proportions of contracts are traded in Nord Pool s markets. For a power producer, the amount of electricity sold directly to clients at any time need not correspond to the amount generated. Generators dispose the water in the reservoirs on the basis of the spot price at any given time and future price expectations to maximize the income. To ensure that output corresponds to sales commitments, generators can buy and sell power in the market. 28 4.1.1.2 End-users The end user market is characterized by a division between its participants, namely the suppliers, distributors and end-users. Anyone who buys electricity for his or her 27 Ministry of Petroleum and Energy. (2007). The power market. (Internet). 28 Ibid

19 Renewable Energy Development Hydropower in Norway own consumption is an end-user. Normally, small end-users buy electricity from an electricity supply company. In contrast, larger end-users often buy from the wholesale market directly. 29 The distribution companies operating as natural monopolies are subject to regulation. On the other hand, supplier companies operate as the generators under free competitive conditions. Therefore, the distribution companies have important responsibilities. 30 The total electricity invoice has several components such as electricity price, transmission tariff, consumption tax, and value added tax (VAT). All end-users must pay a transmission tariff to the connected local grid company and the consumption tax is imposed on electricity that is consumed in Norway. 31 4.1.2 Price determination All generating companies supply electricity to the transmission or distribution network. Supply and demand in the Nordic power market determines the electricity price. The Nordic countries power systems are connected, and the countries systems are mutually dependant. The power price is determined based on generation, transmission and consumption conditions in the Nordic electricity market. And the price will vary over time. The power price also reflects possible congestions in transmission capacity between the areas. But if there are no such congestions, the price is equal in all areas of the Nordic region. Inflow to hydropower plants is of great importance for the determination of the power price, since hydropower represents such a large share of the Nordic power supply. In Norway, consumption is slightly higher than the power production in years with normal precipitation and temperature conditions. In years with low inflow, the need for power imports is even higher. 32 Also temperature and weather conditions influence demand in the Nordic region on short term, which also affects the power prices. Especially periods with cold temperatures and high demand can result in 29 Ministry of Petroleum and Energy. (2007). The power market. (Internet). 30 The Norwegian Energy Regulator. (2009). Annual report 2009. (Internet). 31 Ministry of Petroleum and Energy. (2007). The power market. (Internet). 32 The Norwegian Energy Regulator. (2009). Annual report 2009. (Internet).

20 Renewable Energy Development Hydropower in Norway higher power prices. All end-users are free to choose electricity supplier and contract type. The most common contracts for households have prices that vary according to market conditions. 33 Figure 4-1: Electricity spot price in 2008 and 2009, weekly average. NOK/MWh. Source: Nord Pool Spot. (2010). Nord Pool Spot. (Internet) Between the start of 2009 and the end of September, the spot price decreased from 400 NOK/MWh to 200 NOK/MWh. Figure 4-1 shows variations in the spot price for the years between 2008 and 2009. Nord Pool's financial derivatives market covers the market for futures, forward and option contracts. Futures and forward markets are financial markets for price hedging and risk management. The system price in the spot market is the reference price for future and forward contracts traded on the Nordic power exchange. Power derivatives enable to hedge purchases and sales of power with a time horizon of several years to market participants. Such products can be traded on the Nordic power exchange. 34 33 Ministry of Petroleum and Energy. (2007). The power market. (Internet). 34 The Norwegian Energy Regulator. (2009). Annual report 2009. (Internet).

21 Renewable Energy Development Hydropower in Norway Figure 4-2: Electricity spot prices and forward prices in the financial market Source: Nord Pool Spot. (2010). Nord Pool Spot. (Internet) Nord Pool forward contract prices increased during the fourth quarter of 2009 and also in the first and second quarter of 2010. At the beginning of the quarter, the contract for the first quarter 2010 could be traded at 283 NOK/MWh, while the contract for the second quarter was traded at 257 NOK/MWh. 35 4.2 Norway s power exports In 2008, Norway s electricity exports were estimated to 17.29 billion kilowatt hour (kwh). 36 Historically, Norway has been a net exporter of power. However, this has changed since the late 1990s as power consumption in Norway increased faster than the production of hydroelectric power. As it was already described above, precipitation influences the electricity output generated by hydropower. Consequently a higher precipitation and a higher inflow to reservoirs lead to a net export position of Norway, while imports exceed exports in dry years. Figure 4-3 shows the high fluctuations in Norway s import and export position. Therefore, it is important for Norway to reduce its dependency on precipitation and inflow as well as the reserve capacity as insurance in dry years for its power generation. A stable 35 Ibid 36 Central Intelligence Agency. (n.d.). The World Factbook. (Internet).

22 Renewable Energy Development Hydropower in Norway energy supply is guaranteed for Norway by trading as most of the countries trading electricity with Norway base their power production on thermal energy sources such as coal, oil, gas and nuclear energy. At the same time, the high price fluctuations in the Norwegian energy supply system are softened by trade. Figure 4-3: Norway s Power Imports and Exports, 1970-2007 Source: Norwegian Ministry of Petroleum and Energy. (2008). The electricity market. (Internet) The power exchange between countries is determined by the following factors: Ways of generation and consumption patterns Maximum capacity of interconnectors Conditions of accessing and using power from interconnectors Benefits from differences in national generating systems for all countries involved Norway is trading electricity with the following countries: Russia, the Netherlands, Sweden, Denmark and Finland. The trading connection to Russia is limited to electricity imports to Norway and is currently very small. To increase electricity trade between Norway and the Netherlands, Statnett in Norway and the Dutch transmission system operator (TSO) TenneT invested in a subsea cable with a capacity of 700 MW. Sweden, Denmark, Finland and Norway are forming together the Nordic Power Pool which will be explained in detail in chapter 4.3. The transmission capacity between Norway and Finland is again regarded as relatively small. The highest trading capacity of Norway is towards Sweden, where Norway is exporting approximately 3,450 MW while the imports from Sweden to Norway are smaller. The transmission between Norway and Denmark amounts to 1,000 MW.

23 Renewable Energy Development Hydropower in Norway The difference in the transmission capacities into and out of the country lies within different forms of generation and demanded amount for consumption. 37 The total Nordic region has interconnectors for trade with Germany, Estonia, Russia and Poland. The way Norway profits from trading through stable prices and stable supply, so do its trading partners from Norway in the same aspects. As it is not easy to adjust the production in thermal power to the current demand and an enlargement of existing power plants is very expensive, Norwegian power supply can overwhelm these short cuts. 38 By participating in international agreements such as the European Economic Area Agreement, EEA, for a common energy policy as well as the development of the energy market and renewable energies, Norway prepares the way for further trading and integration on an international basis. 39 Companies licensed to export power Currently, two Norwegian companies hold a license which allows them to trade power with other countries. These two companies are Statnett SF and Nord Pool Spot AS. 40 The TSOs of the Nordic region, which are Statnett SF in Norway, Affärsverket Svenska Kraftnät in Sweden and Fingrid in Finland, own the Nord Pool Spot AS. The Norwegian and Swedish companies own 30% each, while Finland and the Danish company Energinet.dk possess 20% of Nord Pool Spot AS each. 41 This company is the marketplace for physical power contracts in the Nordic Pool Group which will be explained in detail in chapter 4.3. In the year 2007, approximately 70% of the total electricity consumption in the Nordic countries was traded through Nord Pool Spot AS, which is in fact a monopoly company. This monopoly arises as the delivery of power is limited to the ability and capacity of transmission of the cables and grids. 42 The company was established in 2002 with the aim to create a market place for spot trade in electrical energy as well as offering services with regard to this 37 Norwegian Ministry of Petroleum and Energy. (2008). Appendix. Facts 2008: Energy and Water Resources in Norway. p. 12. (Internet). 38 Norwegian Ministry of Petroleum and Energy. (2008). The electricity market. (Internet). 39 Norwegian Ministry of Petroleum and Energy. (2008). International Cooperation. (Internet). 40 Norwegian Ministry of Petroleum and Energy. (2008). The Legal Framework. p. 10. (Internet). 41 Nord Pool Spot AS. (Internet). 42 Norwegian Ministry of Petroleum and Energy. (2008). The electricity market. (Internet).

24 Renewable Energy Development Hydropower in Norway topic. The goal is to create a transparent market with an optimized use of grid capacities, reduced price differences and a product mix for customers. Nord Pool Spot AS s vision is to become the leading physical energy exchange in Europe. 43 Statnett SF became an independent state owned company in 1992 when the administration company Statkraftverkene was split into Statnett SF, responsible for the grids, and Statkraft SF, responsible for the power plants. 44 Statnett SF has three main functions: it is the main grid owner, the main grid operator and the main grid regulator in Norway. As the main grid owner, Statnett is not generating electricity itself but is responsible for the high voltage electricity transmission and distribution in Norway. By leasing transmission facilities to the main grid commercial agreement, MGCA, most of the revenues are earned. It is Statnett s task as Norway s TSO to ensure the balance between supply and demand, the electric power exchange with other nations and the operation of Norway s electric power system. 45 Three levels of electricity grids can be distinguished: the main grid, the regional grid and the distribution grid. Statnett owns and manages the main grid and is as main grid operator responsible for the development of the infrastructure. Therefore it developed an annually updated grid development plan with a 10-year time perspective. Within this plan, the grids are adapted according to the demand based on an analysis of the changing environment, for example industrial developments or the building of new international cable connections. 46 Finally, Statnett s task as main grid regulator is to guarantee a constant balance between supply and demand in real time. It ensures an optimal use of the grid with a reliable supply as well as routine disconnections for maintenance purpose and temporary restrictions. 47 4.3 The Nordic Power Exchange Nord Pool Spot As a result of power market deregulation, a common Nordic market for electrical energy has emerged. Norway, through its Energy Act of 1990, was the first Nordic country to liberalize its power market. Sweden, Finland and Denmark eventually 43 Nord Pool Spot AS. (Internet). 44 Statnett SF. (Internet). 45 Ibid 46 Ibid 47 Ibid

25 Renewable Energy Development Hydropower in Norway followed suit, laying the groundwork for an integrated market for electricity trading. Nowadays, Nord Pool Spot represents the largest market for electricity worldwide: 317 companies from 20 countries trade on the exchange. In 2008, electricity production in the Nordic countries amounted to 397.5 TWh. Power production differs considerably among countries. Figure 4-4 displays the various energy sources in the Nordic region in 2008. While Sweden and Finland use a combination of different sources, it is clear that Norway relies heavily on hydropower and Denmark mainly utilizes conventional thermal power. Figure 4-4: Production split in Nordic countries in 2008 Source: Own creation based on Nordel annual statistics 2008. Nord Pool Spot serves as a marketplace to producers, energy companies, and large consumers, on which electricity can be bought or sold. This marketplace accomplishes the key function of balancing supply and demand, which is particularly critical in the power market due to the inability to store electricity and the high costs associated with any supply failure. 48 On Nord Pool Spot, the electricity spot price is set hourly. The spot price provides a reference price for the Nordic bilateral wholesale markets as well as end consumer prices. 4.3.1 The physical market Physical power contracts are traded at Elspot for physical delivery the next day. As in every other market, the price is determined by establishing the equilibrium between bids and offers made by market participants. The spot market price provides 48 Hjalmarson, Lennart. (n.d.). Price Formation at Nord Pool Spot. (Internet).

26 Renewable Energy Development Hydropower in Norway the basis for the TSOs, which are responsible for both the security of supply and the high-voltage grid. Elspot differentiates between system and area prices (see Figure 4-5). The system price reflects sales and purchases in the entire region without taking into account transmission capacity between geographical areas. On the other hand, area prices may arise because of possible bottlenecks in the transmission network, meaning that areas with a deficit of power have a higher price than the system price. In the absence of bottlenecks, area prices equal the system price. The difference between area and system prices is called the capacity fee. This fee represents an income for the TSOs, namely the congestion income, and thus, it contributes to tariff-reduction for network users. Figure 4-5: Elspot system and area prices as of 13.11.10 Source: Nord Pool Spot. (2010). Nord Pool Spot. (Internet) Once the day-ahead market (Elspot) is closed, trading can take place up to one hour prior to delivery on Elbas, the intra-day market. In addition to the Nordic countries, Elbas covers Germany and Estonia. Elbas offers the possibility to adjust imbalances that an energy company may face after Elspot trading has finished.

27 Renewable Energy Development Hydropower in Norway Figure 4-6: Power exchange in the Nordic region in 2008, GWh. Source: Nordel annual statistics 2008. Power exchange between countries depends on local production and consumption patterns, in addition to the interconnectors capacity and the conditions for their use. Through power trading, countries can obtain reciprocal benefit from variations in national generating systems. Figure 4-6 illustrates the flow of power between Nordic countries in 2008. Norway s power exchanges were primarily with Sweden. 4.3.2 The financial market Trading in derivative contracts is also possible at Nord Pool Spot. The financial market uses various financial instruments that are intended for risk management and price hedging; a physical delivery of power does not take place. The most common instruments include futures contracts, forward contracts, options contracts, and contracts for differences (CfDs). 4.4 Investing for the future According to the Energy Information Administration, Norway had resources of oil on January 1, 2009 of 6.68 billion barrels and 81.68 trillion cubic feet of natural gas. 49 Even though Norway has the greatest reserves within Europe, these resources are limited while energy consumption is growing steadily. Therefore, effort has to be put in further development and investment of renewable unlimited energies such as hydropower. To ensure a steady and innovative development of future energy generation and consumption, Norway developed a plan called Energi21. This strategy aims at 49 Energy Information Administration. (2009). (Internet).

28 Renewable Energy Development Hydropower in Norway increasing value creation by investing in research and development (R&D) and new technology 50. The stationary production of energy as well as its distribution and use is covered within this strategy. Additionally to a focus on basic and applied R&D, training of specialists and development and demonstration of new technologies, the following priority areas have been determined: Development of good framework conditions for research and innovation in the field of energy and business as well as industry policy. Creation of a flexible energy system including the infrastructure and transmission grids. Encouraging CO 2 -neutral heating from bioresources and heat pumps. Further development of climate-friendly power from wind, water and the sun. Promoting efficient energy use in buildings, households and the industry. 51 The ministry of Petroleum and Energy demanded a review of the original strategy to form a more concrete target. This revised version is expected to be published in 2011, leading to the vision Norway: Europe s leading energy and environmentconscious nation from a national energy balance to green energy exports 52. Within this review of the original strategy, the hydropower industry has developed four industry-related objectives as follows: Figure 4-7: Industry-related objectives, Energi21, sub-group hydropower Industry-related objective 1: Industry-related objective 2: Industry-related objective 3: Develop short and long-term balance power production for Europe and a competitive industry to serve this market. Industry-related objective 4: Construct new hydropower capacity to boost energy production in Norway and internationally. Maintenance, conversion, modernisation and expansion of existing hydropower systems. Develop and further refine expertise within all areas of the hydropower segment. Source: Energi21. (2010). (Internet) The target of the EU countries and Norway is to increase the production of renewable energy by 2020. One objective to reach this goal was stated by the 50 Norwegian Ministry of Petroleum and Energy. (2008). Appendix. Facts 2008: Energy and Water Resources in Norway. p. 4. (Internet). 51 Ibid. 52 Energi21. (2010). (Internet).

29 Renewable Energy Development Hydropower in Norway hydropower industry in Norway by demanding an enlargement of hydropower capacity. 4.5 Barriers to newcomers in the Norwegian hydropower market Markets with many players usually have low barriers for entry. As soon as the existing companies set prices to a certain level via coordinated price setting practices, 53 newcomers are attracted. Therefore the existence of barriers to entry is an important condition for the investors. Entry into power production is severely restricted in Norway. New generation facilities signify large investments that require high prices to be profitable. Such investments are strictly regulated through concession laws. Therefore, current Norwegian hydropower projects are generally small and some of them disputed. But only actors with already established power plants can expand these plants. 54 The incentives for established actors to invest in new production capacity will be reduced if they possess market power. The current concession law discourages to entry into hydro generation through acquisition of existing capacity. The provisions oblige private undertakings to return acquired waterfalls to the State after a period of 60 years. These provisions do not apply to state or municipal companies. 55 Limited amount of producers accounts for the high level of concentration in the selling industry. The production is characterized by high fixed costs which translate into high barriers to entry. The industry-specific products have no substitutes for buyers. Coupled with the fact that all existing solutions have been delivered by the same suppliers, it makes the demand both predictable and very inelastic, despite of either positive or negative decisions regarding investments into new procurement projects, service, maintenance and replacement on the existing plants have to be carried out no matter what. 56 53 Danish Competition and Consumer Authority. (2003). The Nordic Electricity Sector. (Internet). 54 Ibid 55 Ibid 56 IEA ETSAP Technology Brief. (2010, May). Hydropower. (Internet).

30 Renewable Energy Development Hydropower in Norway Presence of large customers who might tolerate higher input prices in the industry is at place. That means that buyers themselves strengthen entry barriers by creating market limitations. In other words, it could be difficult for new players to come in and provide more competition. This way, the current suppliers would be given an opportunity to have a technology-based artificial monopoly on their products with related services, a monopoly that differs from the conditions in which the buyers themselves as a legal monopoly have to operate. 57 The main distinction of monopolies in private markets is not regulated by the government. And that means competitors can demand whatever prices they want. 57 Ibid

31 Renewable Energy Development Hydropower in Norway 5. Legal Framework 5.1 The Ministry of Petroleum and Energy The principal responsibility of the Ministry of Petroleum and Energy is to achieve a coordinated and integrated energy policy. 58 The Ministry of Petroleum and Energy is responsible for the energy policy and legislation in Norway, supported by its associated organizations Enova SF, the Norwegian Petroleum Directorate and the Norwegian Water Resources and Energy Directorate. While the Norwegian Petroleum Directorate and the Norwegian Water Resources and Energy Directorate are departments of the Ministry, Enova SF is a public enterprise owned by the Ministry. Its contribution to the Ministry s tasks is to stimulate market actors and mechanisms to achieve national energy policy goals 59 by financial instruments and incentives. The Norwegian Petroleum Directorate aims at a responsible management of the resources oil and gas and creating with that the greatest value for the society. As our focus lies on hydropower, the Norwegian Water Resources and Energy Directorate is the responsible department. Therefore its aims and tasks will be explained separately in the next chapter. To sum up, the topics the Ministry of Petroleum and Energy is covering are carbon capture and storage, power and consumers, energy and petroleum research, state participation in the petroleum sector, energy in Norway, oil and gas as well as water resources. 60 5.2 The Norwegian Water Resources and Energy Directorate The Norwegian Water Resources and Energy Directorate was founded in 1921 as a department of the Ministry of Petroleum and Energy. The NVE aims at ensuring an integrated and environmentally sound management of the country s water resources 61. This includes not only the national flood contingency planning and the maintenance of national power supplies, but also the promotion of efficient energy 58 Norwegian Ministry of Petroleum and Energy. (n.d.). (Internet). 59 Norwegian Ministry of Petroleum and Energy. (n.d.). Enova SF. (Internet). 60 Norwegian Ministry of Petroleum and Energy. (n.d.). Subjects. (Internet). 61 Norwegian Water Resources and Energy Directorate. (n.d.). (Internet).

32 Renewable Energy Development Hydropower in Norway markets, cost-effective energy systems and efficient energy use. As national center of expertise for hydrology in Norway 62, the NVE is also doing research on the respective topics. The head office of the NVE is located in Oslo with departments in five regions to cover the West, the East, the North, the South and the central regions of Norway. Figure 5-1: Organizational Chart NVE Source: Norwegian Water Resources and Energy Directorate. (2010). NVE Organisation. (Internet) Additional to its tasks in its home country, the NVE transfers its knowledge and expertise to support other countries. This refers mainly to developing countries as water and energy are seen as fundamental factors in the struggle to combat poverty, improve health conditions, and increase prosperity 63. This international engagement is no single work but a cooperation of the Norwegian Agency for Development Cooperation (Norad), the Ministry of Foreign Affairs (MFA) and the NVE 64. While the other two involved parties determine the country of engagement and suggest possible projects to the NVE, the tasks of the NVE vary 62 Ibid. 63 Ibid. 64 Norwegian Water Resources and Energy Directorate. (2009). Annual Report 2009. (Internet).

33 Renewable Energy Development Hydropower in Norway from identifying specific water and energy projects, analyzing and evaluating reports as well as managing and monitoring new projects. Anyone who wants to undertake a project related to the energy sector needs to apply for a license at the NVE. The NVE weighs up the impacts on the environment and surrounding society against the use and necessity of the construction. The detailed process will be described in the next chapter. All in all, the NVE possesses the legislative power to issue regulations 65 and to grant licenses following these regulations. 5.3 Legislative and political framework As the aim of the NVE and the Ministry of Petroleum and Energy is to ensure an efficient and adequate use of Norway s water resources, they created a legal framework. The following figure gives an overview of the respective acts and regulations which are applied when exploiting water as an energy source. Figure 5-2: Legislation governing licensing in the hydropower sector Source: Norwegian Ministry of Petroleum and Energy. (2008). The Legal Framework. (Internet) 5.3.1 The licensing process Before someone is allowed to build a new power plant, he or she has to apply for a licence at the licensing authorities. These licensing authorities are the NVE, the Ministry of Petroleum and Energy, the Government and the Storting, the Norwegian Parliament. It is their task to examine possible conflicts between the environment and 65 Norwegian Ministry of Petroleum and Energy. (2007). Rules. (Internet).

34 Renewable Energy Development Hydropower in Norway the different interests groups involved. Underlying this examination process is a framework of laws and regulations, containing the protection plans for water resources, the Master Plan for Water Resources, the Industrial Licensing Act, the Watercourse Regulation Act and the Water Resources Act 66. After the applicant has gotten an approval according to the Master Plan for Water Resources, this notification is sent to the NVE to open the public examination of the application. Within this public examination, the authorities involved decide together with the NVE, if an environmental impact assessment (EIA) is demanded. The Regulations on Environmental Impact Assessment determine that an EIA is needed for all power stations larger than 40 GWh 67. In case the authorities are highly concerned about the impacts on the environment, the nature and local community, the EIA can also be required from 30 GWh on. Independently from the GWh, the applicant has to describe in detail the consequences of the project following the Planning and Building Act. In the next step, the project is discussed by government authorities, landowners and other organisations affected. Basis for the discussion is the EIA together with the licence application. At the end of this discussion, the NVE sends an overall evaluation to the Ministry of Petroleum and Energy. Based on all available information about the project, the Ministry gives a separate recommendation which then goes to the Government for preparing the final decision in form of a royal decree. In case of a major or controversial project, the Storting is involved in the process, too, so that it has an opportunity to debate the matter before a licence is formally granted by the King in Council 68. The following figure provides an overview of the whole licensing process. 66 Norwegian Ministry of Petroleum and Energy. (2008). The Legal Framework. p. 3. (Internet). 67 Ibid., p. 3 68 Ibid., p. 4

35 Renewable Energy Development Hydropower in Norway Figure 5-3: Licensing process (more than 40 GWh / year) Source: Norwegian Ministry of Petroleum and Energy. (2008). The Legal Framework. (Internet) The process for smaller plants with a yearly capacity of less than 10 MW is simpler. Additionally, the NVE having the authority of licensing according to the Water Resource Act has fastened the process, too. 5.3.2 Protection plans and the Master Plan of Water Resources The Protection Plan for Watercourses protects many watercourses legally against an extensive exploitation. These plans prevent authorities from licensing regulation or development of certain watercourses for the purpose of hydropower generation 69. All in all, a potential of 45.5 TWh per year of hydropower have been protected. As the Protection Plans are binding for all mentioned watercourses without exceptions, the Government developed the Master Plan of Water Resources. It is a bunch of recommendations to the Storting to evaluate certain projects individually. Therefore, the projects are split into two categories, the one determining the project as it can be considered for licensing immediately 70 and the other for possible licensing in the future. All projects of the second category as well as projects not included in the Master Plan will not be licensed at the moment. 69 Ibid., p. 5 70 Ibid., p. 5

36 Renewable Energy Development Hydropower in Norway While the protection plans base on for example preserving river systems or possible outdoor recreation areas, the Master Plan is founded on economic aspects as well as the degree of conflict with other interests. Generally, the recommendation is to implement projects with the lowest impacts and the cheapest power gain first. The notification of the Master Plan is only the first step to take for the final license. Today, the Master Plan faces two major problems. First of all, all projects with a capacity of less than 10 MW per year are excluded from the Master Plan and therefore are not proven. As most of the major developments have already been carried out 71 future projects might easily avoid a categorization by the Master Plan. The second problem is that there have been several changes and developments in technology which affects the impact on the environment as well as financial aspects. Judging these projects according to the Master Plan established in 1993 does not seem appropriate. Consequently, an adjustment by the Government is already in progress. 5.3.3 The Industrial Licensing Act In case the applicant wants the ownership of a waterfall to implement a hydropower plant there, he will be licensed according to the Industrial Licensing Act. Exceptions are the State as well as small waterfalls with less than 2,944 kw. The major regulations of the Industrial Licensing Act are the pre-emption rights, the right of reversion to the State and the licences of limited duration. The pre-emption right says that the State is allowed to take over an agreement instead of a purchaser without changes in the rights and obligations. With the right of reversion, the State can get possession of a waterfall and any hydropower installation free of charge when a licence expires 72. The Industrial Licensing Act has been adjusted to avoid a further violation of the EEA Agreement. The EEA Agreement makes sure, that hydropower resources belong to the general public and therefore need to be managed in the public s interest. Consequently, the ownership structure must be based on that of public ownership on the central, county and municipal level. 71 Ibid., p. 5 72 Ibid., p. 6

37 Renewable Energy Development Hydropower in Norway The changes undertaken to fit the EEA Agreement were the following: New licences for the ownership of waterfalls are only granted to public-sector owner. The right of reversion is only possible for public-sector operators. Private entities have no right to renew their licences in a sale-back or lease after the reversion right has been exercised. Private entities cannot buy more than one-third of publicly owned waterfalls or power plants. Untouched by the changes, private owners are still allowed to own up to one-third of public-sector companies. When current licences expire, they are still reverted to the state. Private owners may then sell their power plants to a public-sector owner or merge with it. In case of a merger, the private stake may not exceed one-third. All the changes entered into force on September 25, 2008. Obligatory according to the Industrial Licensing Act is the payment of a licence fee as well as a sale of 10% of the power generated to the municipalities within the area of the waterfall. Further conditions may be considered depending on the impact on the environment and the local communities. 5.3.4 The Watercourse Regulation Act It is economically necessary to be able to regulate the output of a power plant according to the current need. Therefore, it should be possible to store the water in a regulation reservoir. The authority to use water from a regulation reservoir is not included in the ownership of a waterfall but is determined separately by the Watercourse Regulation Act. The measures of the Watercourse Regulation Act are meant to balance fluctuations in the water flow during the year. For that, it works with similar conditions as the Industrial Licensing Act. Additionally, the act allows the authorities to demand a compensation for a damage caused by the regulation, for example a fish fund for damages in the fish stocks.

38 Renewable Energy Development Hydropower in Norway The rules fix not only the highest and lowest water levels in the reservoir, but also the minimum rate of flow of the watercourse as well as the permitted volume that may be released in the different times over the year. The NVE decides whether the regulations for the specific plant are revised after 30 or 50 years to adjust to changes or unforeseen damages in the environment. Included in the Watercourse Regulation Act is again an obligatory sale of the generated power as well as an annual licence fee to the central government and the municipal authorities. Basis for the calculation is the additional electricity won by the regulation. Furthermore, the plant contributes to a business development fund. The aim of this fund is that the municipality profits of the economic benefits of the hydropower station and has the means to reduce damages and other adverse effects. 5.3.5 The Water Resources Act The Water Resources Act gives regulations to compensate for and mitigate the adverse impacts of developments in river systems 73. Even though it is considered better to have a licence following the Water Resources Act, small power stations are not obliged to undertake the process. The Water Resources Act is valid for any kind of works in a watercourse and all measures that are needed to exploit the hydropower potential. Again the aim of the act is to make sure that the benefits gained through the plant outweigh the caused damage or inconvenience to the surrounding. The river systems as well as the groundwater shall be used and managed in the interests of the whole society. 5.3.6 The Energy Act Norway was the first country to allow its customers to choose their power supplier freely. This was able through the Energy Act, the organizational framework of Norway s power supply system. The Energy Act includes regulations of: Construction and operation of electrical installations District heating systems 73 Ibid., p. 7

39 Renewable Energy Development Hydropower in Norway Electricity trading Control of monopoly operations Foreign trade in power Metering Settlements and invoicing Physical market for trade in power System coordination Rationing Electricity supply quality Energy planning and contingency planning for power supplies It lies within the authority of the Ministry of Petroleum and Energy to issue electricity export and import permits. All other licences are granted by the NVE directly, in contrast to the licensing process according to the Water Resource act, for example. Within the local area licence, distribution companies are obliged to supply electricity to the communities in the area covered by the licence. The licence is demanded for the construction of installations of electricity distribution and lines carrying less or equal 22 kv. All installations, lines and plants with a higher voltage are licensed following the construction and operating licence. This licence guarantees standards in the construction and operation of electrical installations. Due to a higher impact on the environment and the landscape of high-tension transmission lines and transformers, a contribution to rational energy supplies, regulations to avoid or limit damage to the environment and utilisation of capacity at each plant is determined, for example. To ensure that most of the possible impacts are known in advance, the applicants have to present long-term plans of their projects to the responsible authorities. All companies except from the State need a trading licence when they are trading electricity. This is obligatory for pure trading companies as well as companies transmitting power through their own grids to end-users and companies with distribution or transmission grids. With the regulation of prices for electricity transmission which may not exceed what is required over time to cover grid

40 Renewable Energy Development Hydropower in Norway investment and operating costs plus a reasonable return on investment 74, fair prices in the customers interests are ensured. With the market place licence, authorities gain the possibility to fix certain conditions and factors such as price-setting, transparency, neutral behaviour and nondiscrimination. This licence is required for the organisation and operation of marketplaces for physical trading in electrical energy 75. As the authority of electricity export and import permits is with the Ministry of Petroleum and Energy, a licence has to be demanded there when trading power with foreign countries. Within this licence a most secure and efficient power exchange shall be guaranteed. Today, Statnett SF and Nord Pool Spot AS have this licence in Norway. The municipal authority is allowed to require plants in their area to connect to the district heating system. Furthermore, all district heating plants with a higher output than 10 MW have to be licensed. All companies in the energy sector have the responsibility to ensure the sufficient and high quality supply of electricity. Consequently, they have to make sure that the generation and the consumption are in balance. The Energy Act demands an energy report of all distribution companies which describes for example the current system, the energy mix and the expected future demand. This yearly energy report shall contribute to an efficient energy planning and therefore to the development of a rational energy supply system. To ensure a sufficient power supply in case of a state of emergency or in the event of war, contingency measures are implemented by the authorities. 5.3.7 Further Legislation The environmental assessment EIA, described in the licensing process, is part of the Planning and Building Act and obligatory for projects in the energy and water sector. As an extension to the Energy Act, the new Competition Act of 2004 also regulates competition in the power market. Dominant market positions often appear in the 74 Ibid., p. 8 75 Ibid., p. 9

41 Renewable Energy Development Hydropower in Norway energy sector due to natural monopolies. A misuse of this is punished under the act. Furthermore, an examination of mergers and acquisitions is compulsory. The rights of the consumers are protected in the Consumer Purchase Act, which is also valid for the energy sector. For example it is the right of the customer to demand a price reduction or compensation in case the supplier does not deliver the good as promised. According to the Pollution Control Act, no one is allowed to pollute the environment without a licence from the pollution control authorities. Hydropower stations have to apply for a licence at the Ministry of Environment, too.

42 Renewable Energy Development Hydropower in Norway 6. Financial Framework 6.1 Small vs. Large Hydropower plants Hydropower plants can be categorized into small and large schemes. Large hydropower schemes capacity is over 10,000 kw and small hydropower schemes is up to 10,000 kw according to EU definition. The definition of small hydropower schemes also covers micro schemes with installed capacity of up to 100 kw. Figure 6-1 shows NVE definitions of small and large hydro plants in kw. Figure 6-1: NVE definitions of small hydro plant in kw Source: Energy policies of IEA Countries Norway (2005). International Energy Agency. Norwegian energy production focused on large hydro plants after World War II. And most of micro, mini and small hydropower plants closed down in these years. Operating costs and inflexible electricity production from small plants were the main reasons for this development. 76 However, during the last decade there has been an increased interest in hydropower projects with capacity less than 10,000 kw. Norway is positive about developing small hydropower plants because they usually have a smaller environmental impact and are used as a local energy resource. In the recent years, the development of small scale hydropower production portfolios has proven popular with the major domestic power producers in Norway. 77 Small hydropower generation plants have two to five years gestation period. Conversely, large hydropower plants usually have a longer gestation period (about seven years) than small hydropower plants. Additionally, small hydropower plants give a higher return on investment due to the low capital investment and operational costs. 76 International Energy Agency. (2005). Energy policies of IEA Countries Norway. (Internet). 77 Sandwick, Jarle Erick and Jon Rabben. (2009). New Opportunities in the Norwegian Renewable Sector. Wikborg Rein, p.3. (Internet).

43 Renewable Energy Development Hydropower in Norway Construction and commission due to simpler designs of small hydropower plants are easier than those of large schemes. This helps to keep costs down. Small hydro facilitates community participation and capitalizes on local skills for plant construction. Small hydropower plants do not require things that are necessary for constructing a large hydro plant such as rigorous surveys, investigations and designs. In addition to the above, construction of small hydropower plants are more environmentally friendly than larger plants as they do not disturb the local habitat. Small hydropower installation does not involve the building of large dams and reservoirs. Therefore deforestation, submergence and rehabilitation problems do not occur. 78 Furthermore, it does not require a large land area. Small hydro plants can be constructed in areas with small streams of water and small to medium rivers. Educating developers is an important aspect of the effort to improve small hydro development in Norway. 79 The land and rivers ideal for small hydro development usually are owned by small farmers. Also, larger energy firms have found small hydro interesting for investment, and they are growing in number. Development Capacity Although the hydropower potential in Norway is large and the focus on renewable energy is growing, only modest activities are expected. This will change as a result of higher prices for renewable energy in the electricity market. 80 Norway is giving special attention to small hydro and focuses on this technology through research and development and also by giving priority to the licensing procedure. The political parties continue to favor small hydropower development. The government has decided that each county can develop its own master plan for small hydro development. 81 This plan will include identifying areas for the development outside protected rivers and mapping out areas where conflict may exist with regard 78 AltEnergy emagazine. (2010). Global Small Hydropower Market Analysis to 2020 Installed Capacity, Generation, Investment Trends. (Internet). 79 Ray, Russell and Andrew Lee. (2010). A World of Opportunity. (Internet). 80 Norwegian Water Resources and Energy Directorate (NVE) and Ministry of Petroleum and Energy. (2003). Norway Report. (Internet). 81 Ibid

44 Renewable Energy Development Hydropower in Norway to development of small hydropower plants such as landscape, natural environment, cultural monuments and outdoor life. This work began in 2007. Small hydropower has a huge, as yet untapped potential, which could allow it to make a significant contribution to future energy needs. There is a considerable scope for improvement and optimization. Maintenance and refurbishment of existing plants could contribute to the development of small hydro. 82 6.2 Key players Several parties are involved in building up a new hydropower plant. Among the key players are the developer of the project, the contractor, the sponsor, the lenders and the investors. The developer is one of the most important participants in the development of a hydropower project. He ensures that all necessary permissions are acquired, that the contracts with consultants, equipment suppliers and contractors are signed as well as that all financial resources necessary for the project are available. In such a project, there are many separate contracts to be signed for different elements. To avoid losing the overview of the contracts and resulting obligations, a turnkey contract is signed with a contractor who takes over the responsibility for all contracts and their fulfilment. The role of the sponsor is more important for large hydropower projects and loses its importance for small hydropower projects. The sponsor is a government agency or utility that is promoting the project. The majority of the financial resources needed to install such a project are provided by lenders such as banks or other investment institutions. Their contribution amounts to 60 to 80% of the money needed. The missing financial resources of 20 to 30% is provided as equity capital by investors who get in return for the higher risk of providing equity capital an anticipation on the profits, a strong influence on the project or other special benefits. 82 Ibid

45 Renewable Energy Development Hydropower in Norway Investors are mainly: Local industry or local government agencies that want to promote electrification in their area. Power utilities that long to influence or control the electricity supply in their area. Industrial companies that seek for access to power production utilities. Financial institutions that look for a long-term investment. 83 Investors play a key role in the realisation process of a hydropower project. 6.3 Small hydropower project costs The first step in the economic valuation of a small hydropower project is to estimate its costs. When assessing an investment in hydropower plants, two major characteristics must be taken into consideration: (a) Large costs of technical infrastructure, and (b) Long lifetimes of hydropower projects. It is difficult to determine a general cost level for investments in small hydropower schemes given that projects are neither uniform nor comparable, and depend on several aspects that include (1) the type of hydropower system (run of river, reservoir); (2) installed power and number of hydro-generators; (3) useable head; (4) capacity of water reservoir; (5) financing sources; and (4) local environmental circumstances such as terrain configuration, hydrological conditions, costs of land use, etc. 84 Generally, small hydropower plants have high initial costs but relatively low annual costs compared with conventional fossil production. In fact, maintenance costs are the lowest of all energy-producing technologies. Given that each hydro site is unique, about 75% of the development cost will be determined by the location and site 83 Jenssen, Lars, Tor Gjermundsen and Grøner Trondheim AS. (2000). Financing of Small-Scale Hydropower Projects. IEA Technical Report, Trondheim. 84 Bobrowicz, Wladyslaw. (2006). Small Hydro Power Investor Guide. p. 35. Koncern Energetyczny SA. (Internet).

46 Renewable Energy Development Hydropower in Norway conditions. Only about 25% of the cost can be categorized as fixed, i.e. the cost of the electro-mechanical equipment. 85 Cost estimates incorporate construction costs, development costs, and the different operating expenses that would be expected in the process of power generation. Construction costs comprise those for the major equipment components, supplementary mechanical and electrical gear, and the civil works. Total costs of development, in turn, encompass construction costs together with costs incurred for licensing, feasibility studies, and project design. Operation and maintenance expenses include salaries, insurance and taxes in addition to cash outlays in major component replacement or repair. 86 a. Construction costs A more detailed breakdown of the construction costs includes the costs for civil works, turbines, generators, transformers and transmission lines as well as other required mechanical and electrical equipment. Likewise, engineering and construction management make part of the total construction costs. As mentioned before, these costs are determined by various aspects such as the plant capacity, turbine type, the design head, transmission line length and voltage, etc. b. Total development costs Total development costs consist of the construction cost in addition to a variety of costs that are applicable to the development of a small hydropower plant. These entail costs of feasibility studies, licensing costs, and transmission right costs, amongst others. Furthermore, site-specific costs which include fish passage requirements, water quality monitoring, and mitigation for wildlife and recreation may apply. Mitigation costs arise when the project development is expected to impact upon the environment, and thus, planning permissions are required. 85 Natural Resources Canada. (2010). Micro-Hydropower System: A Buyer s Guide. (Internet). 86 U.S. Department of the Interior. (2010). Draft Hydropower Resource Assessment at Existing Reclamation Facilities. (Internet).

47 Renewable Energy Development Hydropower in Norway c. Operation and maintenance costs Although minimal for a hydropower system, the most important annual costs are for operation and maintenance. These costs reflect an array of expenses that are incurred for electricity generation and the proper functioning of the plant. Typically, they include labour and materials for clearing the intake, equipment servicing, spare parts, and general maintenance. Others costs may comprise land leases, insurance, property taxes, water rental and general administration. The estimates for these expenses are usually based on either the installed capacity or the total construction cost, and are generally indicated as a fixed lump sum. The project s prospects are examined carefully in the feasibility study, i.e. the hydrological and environmental situation is assessed, the preliminary design is created, and permit applications for water, land use and construction are filed. In the same manner, interconnection studies need to be carried out in order to determine whether the electricity generated can be transmitted to the central power grid. Another fundamental factor is the drafting and negotiation of power purchase agreements (PPA), which by definition are legal contracts between an independent power generator and a power purchaser. It is important to point out that generation costs per MWh will be determined by the annual electricity output. In other words, the more electricity is produced the lower the generation costs per MWh. Furthermore, many hydropower stations are principally operated for peak load demands during cold seasons and as back-up for frequency fluctuations, which raises the marginal costs, and ultimately the value of the electricity generated. Since generation costs are almost entirely linked to the depreciation of fixed assets, the generation cost will decrease if the project s lifetime is extended. Many hydropower plants built 50 to 100 years ago are fully amortized and still operate efficiently today. 87 The most recent data available report total electricity generation costs from small hydropower in Norway that fall into a range between 120-450 NOK/MWh (15.43-57.86 EUR/MWh). 88 87 International Energy Agency. (2010). Renewable Energy Essentials: Hydropower. (Internet). 88 Juliussen, Erik. (2007). Small hydro Possibilities and experiences for remote communities. p.7. Norwegian Water Resources and Energy Directorate. (Internet).

48 Renewable Energy Development Hydropower in Norway 6.4 Profitability analysis of a small hydropower station The profitability analysis is an evaluation of costs and benefits that will enable the investor to make an informed choice whether to proceed with the project or abandon it. In the present report, the method that will be applied for the assessment of the profitability of a prospective small hydropower project is the net present value method (NPV). This approach integrates two important variables that must be considered in any economic analysis, namely money and time. According to the concept of time value of money, a certain amount of money paid or received at a sooner point in time is more valuable than if it is paid or received at a later point in time. This follows from the theory of opportunity cost of capital. In general, the value of a project can be described as the value of its output less production costs, and this is also true for small hydropower plants. Hence, the value of the plant will equal the expected cash flows from the sale of electricity during the lifetime of the plant minus the cost of generation, discounted over the lifetime by the appropriate discount rate. The concept of present value allows the evaluation of how much the annual sales revenue is worth to the investor today. At the heart of the NPV method is the discount rate, i.e. the rate at which the future cash flow stream will be converted into today s monetary terms. With regard to a small hydropower plant, there are some possible risk factors that may influence the discount rate. These comprise technical and political risk. The technical risk is associated to a probable malfunction and the necessity of replacement of components, but also the danger that the plant is not built properly. Similarly, there is a bankruptcy risk that arises when precipitation is unusually low during several consecutive years. The political risk entails the risk that the taxes for small hydropower plants are modified or that the government starts providing subsidies to this type of electricity generation. Based on this reasoning, a risk premium should be incorporated into the profitability analysis of the small hydropower plant through the discount rate. In other words, to allow for the riskiness of future cash flows, a risk premium rate needs to be added to the risk-free rate. Such a composite discount rate is intended to reflect the investor s attitude towards risk. The long-term interest rate for 10-year Norwegian government

49 Renewable Energy Development Hydropower in Norway bonds (risk-free rate) equals 3.30% as of November 19, 2010. 89 Considering the high level of technology and expertise in the Norwegian hydropower sector and the current stable legal framework, technical and political risks are believed to be relatively low. The current market risk premium of 4.70% for Norway 90 therefore be used as the risk premium. From this, the discount factor for the NPV calculations will be 8.00%. The effective life of a small hydropower station can vary from project to project, with some larger plants reporting effective lives of more than 50 years. Normally, a lifetime of at least 25 years is assumed. 91 An effective lifetime of 35 years will be taken into consideration for the calculations in this report. With regard to the investment costs, estimates for Norway were extracted from a study that was carried out by the Small Hydropower Energy Efficiency Campaign Action (SHERPA). As can be seen from Figure 6-2, Switzerland and Germany report the highest investment costs which fall into a range of 4,000-10,000 and 4,000-6,000 EUR per installed kw, respectively. Scandinavian countries, more specifically Sweden and Norway, exhibit relatively low investment costs with an average of 1,500-2,500 and 1,000-1,500 EUR/kW, respectively. Figure 6-2: Investment costs of small hydropower plants in selected European countries Country Investment costs Euro/kW Switzerland 4,000-10,000 Germany 4,000-6,000 Austria 2,900-4,300 UK 2,000-4,800 Norway 1,000-1,500 Sweden 1,500-2,500 Source: Small Hydropower Energy Efficiency Campaign Action. (2008). Strategic study for the development of small hydropower in the European Union. will For the purpose of valuating a small hydropower project in Norway, a hydropower scheme with installed capacity of 4.5 MW will serve as the basis for calculations. Based 89 Financial Times. (2010, 19 November ). Bonds & Rates Overview. (Internet). 90 Damodaran, Aswath. (2010). Country Default Spreads and Risk Premiums. (Internet). 91 Bøckman, Thor et al. (2006). Investment Timing and Optimal Capacity Choice for Small Hydropower Project., p. 10. Norwegian University of Science and Technology, Trondheim.

50 Renewable Energy Development Hydropower in Norway on the study previously mentioned, investment costs will amount to 1,500 EUR/kW which corresponds to around 12,028 NOK/kW. This leads to total investment costs of 54,126,500 NOK (6,750,000 EUR). One portion of the investment costs will be externally financed. Therefore, a bank loan amounting to 35,944,000 NOK (4,480,000 EUR) will be made. This equals to 66% of total investment costs. A finance period of 12 years with 2 years grace period will be assumed for calculations. The bank interest rate on loans in Norway currently amounts to about 5%. The leverage ratio is an important aspect of the profitability analysis as it exerts a strong impact on the investor s return. This will be explained in more detail later in this chapter. The input data that have been exhibited so far can be summarized as follows: a. Total investment costs 54,126,500 NOK 6,750,000 EUR b. Bank loan 35,944,000 NOK 4,480,000 EUR c. Interest rate on loan 5% d. Discount rate 8% e. Effective life of the plant 35 years As a general rule, a small hydropower plant is a price-taker. Once the generation capacity has been fixed, optimal production is always at full capacity provided that the price exceeds production cost. 92 The average production per year depends to a large extent on capacity choice, but also on the water inflow to the plant. For this reason, electricity generation may vary from year to year. This contingency together with electricity distribution losses during power transmission may well influence actual output. For the sake of simplicity, a constant annual output of 15,800 MWh has been assumed in the present study. Revenues from hydropower plants come from the sale of electricity, which is normally done through a power company that participates in the Nordic power exchange, Nord Pool. Consequently, revenues are strongly dependent on price developments in the Nordic market. After a fall in electricity consumption in the Nordic region due to the decline in industrial consumption during the recent financial crisis, Nordic power demand is expected to recover in 2010 with a lasting upward 92 Ibid, p. 7.

51 Renewable Energy Development Hydropower in Norway trend. 93 Moreover, integration with the continental European market is advancing, where production costs are higher because of the dominance of thermal power plants. These two aspects are likely to exert an upward pressure on future electricity prices. Next to the generation costs, the costs for grid use have to be included. In Norway, transmission tariffs are set by Statnett, a state-owned company responsible for the national power grid. The tariff is composed of a variable component (also called energy component) and a fixed component. When electricity is transmitted, heat is generated in cables and transformers, leading to a loss of energy. The energy component is intended to reflect the electricity loss for every MWh that is transmitted to the grid (marginal loss), and thus, it depends on the current input of energy and is determined for each input point. The fixed component shall cover the remaining costs that cannot be directly attributed to the individual producer. Finally, the cost for selling the electricity to an electricity company has to be considered. This cost depends on what the company offers and therefore varies from company to company. From the above, supplementary information needed for the NPV calculation has been collected: f. Current electricity spot price 405 NOK/MWh 50.51 EUR/MWh g. Fixed tariff component 8 NOK/MWh 0.99 EUR/MWh h. Energy component 2.5 NOK/MWh 0.31 EUR/MWh i. Cost for selling electricity 3.5 NOK/MWh 0.44 EUR/MWh j. Contribution margin 391 NOK/MWh 48.76 EUR/MWh k. Annual growth rate of electricty prices 1% It is assumed that the project will be developed in four years. The feasibility study, project design, and licensing process will be done in the first year. This will result in nearly one-sixth of the investment costs being spent by the end of the first year. Similarly, costs incurred in the second year will amount to a further one-sixth of total costs. In the third year, about one-third of total costs are assumed to be due. At the end of the fourth year the whole development is finished and paid. In the first two 93 Fortum, Keilaniemi. (2009). Annual report 2009. (Internet).

52 Renewable Energy Development Hydropower in Norway years, only interest payments are made to the bank; principal repayments on the bank loan start in year three. As reported by already existing plants, operation and maintenance costs per year are estimated at 3% of the total investment. This amounts to 1,623,795 NOK (202,490 EUR). These costs will grow annually at the current inflation rate of 1.9%. The annual cash flows of the investment are shown in Figure 6-3: Figure 6-3: Project Cash flows, in NOK Investment Contribution Interest on Energy price Bank loan O&M Annual output Inflation Discount rate cost margin loan annual growth 54,126,500 NOK 35,944,000 NOK 1,623,795 NOK 15,800 kwh 391 NOK 5.00% 1.90% 8.00% 1% Year Investment Bank loan Principal Principal Interest on Operation and Cumulated cash Revenues Cash flow PV of cash flow repayment residual loan maintenance flow -4-8,947,500.00-8,947,500.00-8,947,500.00-8,947,500.00-3 -9,235,000.00-9,235,000.00-18,182,500.00-9,235,000.00-2 -16,727,500.00 16,727,500.00 0.00-16,727,500.00 0.00-18,182,500.00 0.00-1 -19,216,500.00 19,216,500.00 0.00-35,944,000.00-836,375.00-836,375.00-19,018,875.00-836,375.00 0 0.00-35,944,000.00-1,797,200.00 6,177,800.00-1,623,795.00 2,756,805.00-16,262,070.00 2,756,805.00 1-2,995,333.00-32,948,667.00-1,797,200.00 6,239,578.00-1,654,647.11-207,602.11-16,469,672.11-192,224.17 2-2,995,333.00-29,953,334.00-1,647,433.35 6,301,973.78-1,686,085.40-26,877.97-16,496,550.07-23,043.53 3-2,995,333.00-26,958,001.00-1,497,666.70 6,364,993.52-1,718,121.02 153,872.80-16,342,677.28 122,149.19 4-2,995,333.00-23,962,668.00-1,347,900.05 6,428,643.45-1,750,765.32 334,645.08-16,008,032.20 245,974.12 5-2,995,333.00-20,967,335.00-1,198,133.40 6,492,929.89-1,784,029.86 515,433.62-15,492,598.57 350,795.46 6-2,995,333.00-17,972,002.00-1,048,366.75 6,557,859.19-1,817,926.43 696,233.01-14,796,365.57 438,744.89 7-2,995,333.00-14,976,669.00-898,600.10 6,623,437.78-1,852,467.03 877,037.65-13,919,327.92 511,743.04 8-2,995,333.00-11,981,336.00-748,833.45 6,689,672.16-1,887,663.91 1,057,841.80-12,861,486.12 571,519.01 9-2,995,333.00-8,986,003.00-599,066.80 6,756,568.88-1,923,529.52 1,238,639.56-11,622,846.57 619,628.16 10-2,995,333.00-5,990,670.00-449,300.15 6,824,134.57-1,960,076.58 1,419,424.83-10,203,421.73 657,468.34 11-2,995,333.00-2,995,337.00-299,533.50 6,892,375.91-1,997,318.04 1,600,191.38-8,603,230.36 686,294.65 12-2,995,333.00 0.00-149,766.85 6,961,299.67-2,035,267.08 1,780,932.74-6,822,297.61 707,232.90 13 7,030,912.67-2,073,937.15 4,956,975.51-1,865,322.10 1,822,669.61 14 7,101,221.79-2,113,341.96 4,987,879.83 3,122,557.74 1,698,178.76 15 7,172,234.01-2,153,495.46 5,018,738.56 8,141,296.29 1,582,115.70 16 7,243,956.35-2,194,411.87 5,049,544.48 13,190,840.77 1,473,913.90 17 7,316,395.92-2,236,105.70 5,080,290.22 18,271,130.99 1,373,044.71 18 7,389,559.88-2,278,591.70 5,110,968.17 23,382,099.16 1,279,014.82 19 7,463,455.47-2,321,884.95 5,141,570.53 28,523,669.69 1,191,363.92 20 7,538,090.03-2,366,000.76 5,172,089.27 33,695,758.96 1,109,662.48 21 7,613,470.93-2,410,954.78 5,202,516.15 38,898,275.11 1,033,509.74 22 7,689,605.64-2,456,762.92 5,232,842.72 44,131,117.84 962,531.74 23 7,766,501.69-2,503,441.41 5,263,060.28 49,394,178.12 896,379.61 24 7,844,166.71-2,551,006.80 5,293,159.91 54,687,338.03 834,727.81 25 7,922,608.38-2,599,475.93 5,323,132.45 60,010,470.48 777,272.65 26 8,001,834.46-2,648,865.97 5,352,968.49 65,363,438.98 723,730.78 27 8,081,852.81-2,699,194.42 5,382,658.38 70,746,097.36 673,837.88 28 8,162,671.34-2,750,479.12 5,412,192.22 76,158,289.58 627,347.34 29 8,244,298.05-2,802,738.22 5,441,559.83 81,599,849.41 584,029.12 30 8,326,741.03-2,855,990.25 5,470,750.78 87,070,600.19 543,668.62 31 8,410,008.44-2,910,254.06 5,499,754.38 92,570,354.57 506,065.67 32 8,494,108.52-2,965,548.89 5,528,559.64 98,098,914.20 471,033.53 33 8,579,049.61-3,021,894.32 5,557,155.29 103,656,069.49 438,398.04 34 8,664,840.11-3,079,310.31 5,585,529.80 109,241,599.29 407,996.73 35 8,751,488.51-3,137,817.21 5,613,671.30 114,855,270.59 379,678.09 NPV 9,824,383.31

53 Renewable Energy Development Hydropower in Norway The NPV of the project is positive and amounts to 9,824,383 NOK (1,225,138 EUR) at a discount rate of 8.00%. This is a signal to the investor that the project is indeed profitable. The NPV method is usually employed when comparing different projects, among which those with the greatest NPV value will be chosen. Nevertheless, it needs to be mentioned that NPV results are extremely sensitive to the discount rate and the lifetime of the project. In other words, the higher the discount rate and the shorter the lifetime, the lower the NPV value will be (see Figure 6-4). Figure 6-4: Effect of discount rate and lifetime on the NPV 8.00% 10.00% 12.00% 25 years 4,468,597.52-725,506.67-4,457,552.04 30 years 7,621,211.25 1,166,066.35-3,311,367.53 35 years 9,824,383.31 2,372,104.66-2,643,530.17 Source: Own calculation A further consideration which is of great importance to the investor is the internal rate of return (IRR). The IRR is the discount rate which reduces the NPV of the project to zero. Generally speaking, the higher the IRR the more attractive is the project. The IRR can be thus expressed as the return that investors will receive on their equity. The small hydropower plant being analyzed yields an IRR of 10.85%. The IRR can be improved by increasing the leverage ratio, i.e. by reducing the equity portion. As Figure 6-5 shows, as the leverage ratio increases, the IRR becomes higher. This is due to the advantage of substituting equity capital by debt as the latter is less expensive. Figure 6-5: Effect of leverage on the IRR Leverage ratio 0% 66.00% 75.00% 80.00% IRR 9.39% 10.85% 11.04% 11.16% Source: Own calculation Based on the effect of leverage on the IRR, investors will strive for a high leverage ratio in order to get the highest possible return. However, the leverage ratio is limited since lenders will always demand a minimum portion of equity so as to assure that risk is borne by all involved parties. Debt financing has a significant effect on the return to the investor, yet the extent to which the project can be financed by debt will depend on the financial prospects of the project as assessed by the lender.

54 Renewable Energy Development Hydropower in Norway In conclusion, the small hydropower plant exhibited here is believed to be an attractive investment. Notwithstanding, the investor has to take into account the exceptionally long investment horizon and the large initial investment costs that are associated with such an investment. For this reason, small hydropower plants are believed to be of interest to a selected investor segment, namely owners of water resources as well as electricity companies that want to hedge against supply shortages. 6.5 Subsidies and Tradable Green Certificates The development of new projects of renewable energy in Norway is relatively low, as the market especially the hydro electric industry is already very well established and supports from the state are low. As Norway is participating in the EU targets to increase the share of renewable energy, it aims at increasing the number of new projects. For that reason, a common market for electricity certificates with Sweden has been established, although throughout Europe feed-in tariff systems are more practiced 94 In 2006, the first attempt of a common certificate market was stopped by Norway with the reasoning of high costs. Norway wanted to promote renewable energy projects through the state energy fund. 95 In Sweden, however, the electricity certificate system was introduced successfully in 2003. This system aims at the development of renewable electricity production and is created technology neutral, which means it does not differentiate between wind power, hydropower, biofuel etc. At the beginning, targets are defined by how much the electricity produced by renewable energies has to rise till a certain date. As the production in Sweden increased by more than 6.5 TWh/year since 2002, the aims for the future development have been adjusted to a higher level. Through the trading of electricity certificates, the government supports on a marketbased system the construction and development of renewable energy projects. The State awards for every unit of renewable electricity generated one certificate, which corresponds to 1 MWh of electricity, to the electricity producer. To create a demand 94 Economic Instruments Tradable Permits. (2008). Green Electricity Certificates (Sweden). (Internet). 95 EurActiv. (2009). Nordic green power certificate becomes reality. (Internet).

55 Renewable Energy Development Hydropower in Norway for these certificates, a quota obligation is introduced. This is an obligation for electricity suppliers and certain electricity users such as electricity intensive companies to purchase and hold a certain quota of certificates related to their delivery and consumption of electricity. The supply of certificates on the certificate market is provided by the producers of renewable electricity. Through the selling of certificates, they gain additional money to the selling of electricity. As electricity gets more expensive for the suppliers, there will be a small increase in market prices for the end users. 96 The introduction of green certificates has three major effects: The production costs for electric energy will decline. Unless the supply of traditional energy is completely price inelastic, its production will decline. The production of renewable energy will increase. 97 By introducing the green certificate market, Norway aims at increasing its share of renewable energy from today s 60% to 70 74% which means a plus of 25 TWh/year between 2002 and 2020. As Norway is regarded to small for a national solution, an agreement has been signed between Sweden and Norway for a common market. As it is the case in Sweden, the certificates will be technology neutral. If plants want to participate in the system, they need to refund any previously received subsidies. All plants constructed after September 7, 2009 or plants constructed after January 1, 2004 with 1 MW or less may participate. Till the establishment planned on January 1, 2012, the final targets of the participating countries, the duration of the certificates and the eligible production still have to be determined. 98 To ensure new projects till the date of establishment, Enova will provide investment support. 99 Enova s task is, among others, the administration of the Norwegian Energy fund. This renewable energy fund amounted to 2.5 billion EUR in the year 2006, which corresponded to 20 billion NOK, and was based on a 96 Wikborg Rein. (2009). A common Swedish-Norwegian Market for Electricity Certificates. p.12-13. (Internet). 97 Bye, Torstein and Hoel, Michael. (2009, December 7). Green certificates and the effect on the climate. (Internet). 98 Wikborg Rein. (2009). A common Swedish-Norwegian Market for Electricity Certificates. p.12-13. (Internet). 99 AMT. (n.d.). A market for electricity certificates. (Internet).

56 Renewable Energy Development Hydropower in Norway tax on transmission tariffs. 100 In 2010, the EFTA Surveillance Authority agreed to an increase of the budget of 365 million NOK. 101 6.6 Risks involved in Hydropower Investments Financing a hydropower project is very heavily dependent on the prudent management of various types of risks. This involves identification of various risks associated with a project and assessment thereof. However, the most important step lies in arranging measures to mitigate such risks including an effective insurance program. For a foreign investor, the first risk that becomes apparent is exchange rate risk. Because revenues are denominated in foreign currency, fluctuations in the foreign exchange market may alter, either in a positive or negative manner, the relative performance of the project when results are translated into the investor s own currency. Assuming that mainly European investors seeking to secure local energy supply will be interested in Norwegian hydro, the exchange rate risk is reasonably low since large fluctuations against the Euro have been rather unusual. Figure 6-6 shows the development of the exchange rate over the last five years. It can be seen that only in the aftermaths of the recent financial crisis a significant depreciation of the NOK took place. On average, however, a fairly stable performance around 8.00 NOK per EUR can be observed. Figure 6-6: NOK/EUR exchange rate development since 2005 Source: Reuters. (2010). Currencies. (Internet) 100 Finfacts Ireland. (2006). Norway launches 2.5 billion renewable energy and energy efficiency fund. (Internet). 101 EFTA Surveillance Authority. (2010). PR (10)09: The EFTA Surveillance Authority approves NOK 365 million budget increase of the Norwegian Energy Fund. (Internet).

57 Renewable Energy Development Hydropower in Norway A foreign investor is also exposed to risk such as those associated with the government s credit worthiness, the possibility of confiscation, expropriation and nationalization changes in the local political environment and enforceability of contracts. 102 These types of risks are called sovereign and country risk. Usually lenders offer two kinds of interest rates to the borrowers. These are floating rate and fixed rate. During the term of the loan, the floating rate requires to be changed according to the changes of the interest rate. Generally, banks prefer floating rate as they need to be able to adapt to changes in financial market as well as cover their own exposure to the changing interest rates that includes bank rates. Fixed rate is the best way to mitigate this risk for the developer. Inflation risk is also a big risk factor for investors. The real value of a unit of nominal currency tends to depreciate over time with inflation. Even hard currency is subject to this risk. 103 Changes in the country s laws are another risk such as increasing rates and taxes or other expenses and liabilities which reduce project revenues and the value of the assets. Such changes impact the viability of a project. Payment risk exists when there is a lack of creditworthiness on the part of the utility, the buyer of the energy. Developers are known to ask the government to issue a counter guarantee to cover the payment risk. This basically entails a government standing surety to the fact that the utility pays its dues to the developer in time. 104 And in the case of a utility s failure to meet its obligations the government is required to make the payment to mitigate the delinquency of the utility. Time and cost overrun risks are one group of construction risks. Time overrun risk results in a loss of revenue due to inflation and an increase in the total amount of interest during construction on the debt financing. If there is no water to generate energy due to the change in the level of precipitation, climatic reason or changes in the hydrology of the catchments area create an hydrological risk as well. 102 Shrestha, Ratna Sansar. (2007). Investment in Hydropower Sector: Opportunities and Risks. (Internet). 103 Ibid 104 Ibid

58 Renewable Energy Development Hydropower in Norway 7. Conclusion 7.1 Summary of main points This paper has shown that sustainable development is a core issue in today s world to reduce greenhouse effects and CO 2 emissions. The development of renewable energies is part of such sustainable development. Renewable energies guarantee a stable energy supply compared to fossil fuels, as they are available without limits. Furthermore, countries use their own available sources and offer a high potential of development. Hydropower provides one of the most mature technologies among renewable energies and therefore, it is highly competitive within this group. The potential to exploit hydropower worldwide is estimated to be 14,370 TWh/year. Norway has a huge expertise in the field of hydropower due to its long history in this sector. Norway participates in the European Economic Area s goals of increasing the portion of renewable energy on the long-term and it offers a great potential for hydropower investments. Furthermore, investments in Norwegian hydropower projects support the Energi21 strategy of Norway which aims at an increase of hydropower capacities for a higher supply in Norway and Europe. Hydropower offers some advantages compared to other energy sources. It is not only free of greenhouse gases in the production but is also available locally and continuously, which keeps electricity prices rather stable. The supply can easily be adapted to the demand by shutting down the dams. However, the building of the plant can affect the environment and surrounding area. To ensure that the hydropower project is really implemented in an environmentally friendly manner, the licensing process proves the fulfilment of the respective legal regulations. The responsible authority is the Norwegian Water Resources and Energy directorate which examines, together with all parties involved in a public examination, the impacts of the project on the environment and the society and outweighs these factors against the benefits of the hydropower plant. Among a list of other laws, the Protection Plan for Watercourses which treats environmental aspects and the Master Plan of Water Resources, treating economic aspects, are proven for fulfilment.

59 Renewable Energy Development Hydropower in Norway Due to less environmental impacts and the focus on guaranteeing regional supply, there is a high interest to install small hydropower plants in Norway. One positive aspect of small hydropower lies in that operational and maintenance costs are lower than for other renewable sources of energy. The financial attractiveness of small hydropower projects has been shown in the profitability analysis resulting in a positive NPV of 9,824,383 NOK and an IRR of 10.85% by using a leverage ratio of 66%. Long effective lives of hydropower plants enable a full amortization and still efficient operation. The Norwegian government is starting to support the generation of electricity from new projects in renewable energy by establishing a green certificate market. Although new hydropower plants are very attractive investments, investors have to be aware that these investments are long-term and require high initial costs. 7.2 Recommendations Finally, there are some recommendations to make for the investment in a hydropower project in Norway about the profitability of projects and the risks involved. In the profitability analysis it is shown that a higher leverage ratio leads to a higher internal rate of return. Therefore, investors should consider the leverage ratio while they are comparing their possible small hydro investments. If they seek for a higher rate of return for their investment, they should decide for the project with the highest leverage ratio. However, investors have to be aware that this will be more risky because the project will have to pay back a higher amount of debt. This may lead to bankruptcy in the long-run in the case of instable incomes. The profitability analysis shows as well that the life time of the project affects its NPV, meaning that a higher investment horizon will lead to a higher NPV. When choosing a longer lifetime, investors should consider the increased risks associated with the longer time period of their investment. Further, investing in the Norwegian electricity market contains other risks such as exchange rate risks, interest rate risks and foreign market risks. The investor who runs up into these risks should be able to manage them. If an investor is able to do so,

60 Renewable Energy Development Hydropower in Norway the opportunity to invest in the hydropower sector in Norway is highly recommendable. Reducing foreign exchange risks can be possible through hedging in the long-term horizon, but in some cases this can be expensive for investors. The best way to manage interest rate risks is to negotiate fixed interest rates with lenders. However, banks will probably add a margin to this fixed rate to reduce their own risks. A simple way to mitigate the market risk is to acquire a long-term PPA with the local utility. PPAs are long-term agreements to buy power from an electricity producer and serves as an alternative to secure revenues.

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