Geothermal energy holds significant promise for the low-carbon energy systems of developing countries. As a renewable electricity source with the ability to meet baseload power demand and backstop fluctuating supply from other renewable sources, it can be a vital component of low carbon electricity systems – where resources allow.
Kenya is one of the leading countries globally for geothermal development, with significant geothermal resources and a government already undertaking significant investment, including supporting scientific research, drilling and the generation of electricity.
The Government of Kenya recognizes the importance of geothermal as cost-effective option for reducing the country’s reliance on expensive fossil fuel and weather-dependent hydro power generation as well as improving energy access. As a consequence, it has set the ambitious target of increasing its geothermal power capacity from 600 MW to 5,000 MW by 2030, taking the share of geothermal in the power mix from 15% to 27%.
The Kenyan government is seeking to accelerate geothermal development to meet ambitious deployment targets through a series of reforms.
Annual deployment rates have increased significantly following the introduction of financial and fiscal incentives by the Kenyan Government, including the coverage of upfront resource risks, with the aim to incentivize private investment in particular. However, the sector isn’t attracting the level of investment necessary to achieve national deployment targets, mainly because of the long timeframe required to confirm a geothermal resource, high upfront risks related to exploration and the significant capital investment required (ESMAP, 2012; GDC, 2015b).
Private sector engagement in geothermal development in the Olkaria III geothermal plant
This case study analyzes the Olkaria III geothermal power plant in Kenya, as part of a research program carried out by Climate Policy Initiative on behalf of the Climate Investment Funds to help policymakers and donors, as well as private stakeholders, understand how to most effectively support geothermal development along the project lifecycle, and specifically which financing structures and instruments are most suited to attract private capital.
The Olkaria III project is the first privately funded and developed geothermal project in Africa. It was enabled by a phased development strategy, and a combination of public and private financing and risk mitigation instruments that ensured the viability of the project.
Olkaria III is a 110 MW binary geothermal power plant, whose resources were explored by the government before development was undertaken by private actor Ormat Technologies. Ormat used a modular, phase by phase expansion of its generation capacity, from an initial 8 MW to 110 MW, which allowed the progressive exploitation of the steam power generated by the geothermal reservoir and reduced investment exposure in the initial, more risky, years.
The project had a cost of USD 445 million. Initially financed by equity in the late 1990s, the project was able to attract debt needed for its expansion only in 2009 after renegotiation of the power purchase agreement (PPA) and the attachment of a government security package to back the payments to the off-taker, the utility Kenya Power and Lighting Company.
The private developer Ormat provided equity financing with an initial USD 40 million commitment in the years 1998-1999, which reached USD 150 million in 2006. Ormat had to extend its equity commitment for longer than originally expected, securing debt financing only 11 years from the inception of the project. The current project finance structure relies heavily on debt from Development Finance Institutions, which now accounts for 85% of overall investment costs. Germany’s Deutsche Investitions- und Entwicklungsgesellschaft mbH (DEG), together with KFW Development Bank,
headed a financing consortium that refinanced Ormat’s equity in Phase I with a USD 105 million loan. The U.S.’s Overseas Private Investment Corporation (OPIC) provided a 19-year tenor senior loan of USD 310 million disbursed in three tranches used to finance Phase II and Phase III development and refinance part of the equity and debt provided earlier.
Lessons for policymakers and public international actors
Olkaria III demonstrates that the combination of national government support, in the form of an early-stage exploration and grant, a security package guaranteeing power purchase, a power purchase agreement addressing main operational risks, and international public finance, in the form of loans and Political Risk Insurance, can attract private investors in the geothermal sector in countries with significant perceived political risk.
Lessons for policymakers
Olkaria III delivered power at a lower cost than comparable projects in Kenya and East Africa with purely public development and finance models, suggesting that private investment and development in geothermal energy could be a cost-effective and promising way for the Kenyan government to meet its ambitious deployment targets. Olkaria III achieved a 13% lower LCOE than the average for similar geothermal projects in Kenya. Its private developer model with public sector support was important in keeping the costs low. Local and international public financial support lowered the cost per unit of geothermal power by 31%, keeping the tariff of the project competitive, ultimately lowering overall system generation costs.
In addition, to enable private investment in the project, the Kenyan government had to take on some risks:
- Kenya Power and Lighting Company (KPLC) signed a renegotiable 20-year PPA with Ormat Technologies to guarantee purchase of the energy produced by Olkaria III and provide the project’s source of return. We estimate a 16% internal rate of return (IRR) on the project’s equity after tax, meeting investment expectations in the country, which generally range from 15% to 23% for geothermal projects (Ngugi, 2012b).
- The PPA also includes clauses that mitigate the impact of external risk factors on the profitability of the project, for example foreign exchange risks. Risk mitigation clauses include partial adjustments to the Consumer Price Index to compensate for potential escalation of operation and maintenance costs, a relief formula ensuring capacity payments to address the risk of resource degradation due to force majeure, and, more importantly, a tariff pegged to the US dollar, which shields Ormat from currency exchange risk and a potential fall in equity returns.
- To ensure project viability the government had a key role in mitigating exploration and credit risk.
• Exploration risk was significantly mitigated by the government of Kenya thanks to previous exploration in the field performed by the public utility KenGen. KenGen provided data on the resource and donated 8MW of wells to Ormat Technologies. The provision of the wells was equivalent to a 13.5% equity share from the government in the first phase and reduced time between initial private investment commitment and returns. Without these actions expected returns for the whole project would have dropped to 13% from 16%, insufficient for the private developer to make the necessary equity investment without a 15% increase in the PPA tariff.
• The support of the Government of Kenya was also critical in attracting long-term debt finance needed to develop the plant by backing off-taker payments with a security package including a letter of credit and a letter of comfort, which supported the creditworthiness of the off-taker.
Lessons for development finance institutions
DFIs covered political risk during the first phase of the project. MIGA’s PRI offered coverage for the equity exposure, fundamental in the early years of project implementation (Phase I). MIGA’s PRI is able to strongly mitigate political risk. Over the years, indeed, MIGA has successfully resolved more than 90 disputes that had the potential to develop into payable claims.
Low-cost, long-term financing from DFIs was also important to guarantee access to finance during the subsequent expansions and increase the
attractiveness of the investment.
DFIs refinanced Ormat Technologies’ initial equity investment, freeing additional equity resources for the subsequent development phases of the project, and raising the internal rate of return on equity from 12% to 16%. The favorable conditions of the public debt ensured the financial viability of the project during Phase I, helping the project to generate returns in line with expectations for geothermal projects in Kenya. Returns improved particularly in Phase II and in Phase III once the resource was proven and the project reached maturity.
Until recently, public finance dominated geothermal development in Kenya, but going forward, private finance will be increasingly important to achieving the country’s deployment goals.
Olkaria III is the only geothermal project in operation in the country with private participation from field development through to operation and maintenance so far. It represents the first step in a transition from publicly based geothermal development to a development model with increased private participation.
The establishment of the Geothermal Development Company (GDC) serves a valuable purpose as a proactive government mechanism to stimulate private sector investment. GDC carries out early stage exploration and then sells the proven steam resources to private power producers, shifting exploration risks away from investors.
Alternative project development models where the private sector takes a greater role in earlier stages of geothermal projects are also emerging in Kenya, but public support plays a significant role in covering the high risk of the exploration drilling phase and ensuring the creditworthiness of the off-taker.
The potential of geothermal energy in East African countries on the Great Rift Valley is estimated at 14,000 MW. Olkaria III’s experience shows that government financing in the resource exploration and appraisal phase plays an important role in attracting private investors. Moreover, it shows that a country’s attractiveness to private investors does not only depend on proven resource availability. It also requires a combination of in-country skills, data availability, regulatory frameworks (including FiT) and a creditworthy off-taker.
It is also worth noting that attracting private investment in project development before exploration drilling could require governments to offer a higher tariff because of the risks that the project developer would be taking on, which could then be passed on to consumers’ electricity bills. A desire to keep electricity bills low may then influence governments’ choice of geothermal development models going forward.