Renewable Energy Project (FFP TON 49450-012)

ECONOMIC ANALYSIS

A. Introduction

1. An economic analysis of the Renewable Energy Project, to be financed through $53.2

million in grants has been conducted in accordance with ADB’s Guidelines for the Economic
Analysis of Projects.1 The project consists of four outputs, of which three comprise the following
subprojects: (i) battery energy storage systems (BESSs) on Tonga’s main island of Tongatapu
to ensure higher renewable energy connectivity, (ii) a solar photovoltaic (PV) array and BESS
integrated into existing power systems on ‘Eua and Vava’u, (iii) new village-level renewable
energy generation and distribution systems in the outer islands of Ha’apai, and a new island-
level renewable energy generation and distribution system in Niuafo’ou.

2. Macroeconomic context. Tonga has achieved high human development, ranking 98th
of 189 countries (second only to Fiji among Pacific economies), with per capita incomes at
about $4,070 in fiscal year (FY) 2018 (ended June 2018). Gross domestic product grew by 2.8%
in FY2017, continuing a period of relatively solid economic growth that averaged 3.0% per
annum during FY2014–FY2016. However, the economy is estimated to have stalled in FY2018
because of damage and losses from the impact of Cyclone Gita. Reconstruction activities are
expected to help support a return to gross domestic product growth of about 1.9% in FY2019.

3. Sector context. Tonga relies heavily on imported fuel oils to meet national energy
needs, including electricity generation and transportation. Fuel imports account for about one-
quarter of all imports, much of which is diesel fuel used for power generation.2 Over 90% of
households in Tonga are electrified. Electricity is generated, distributed, and sold by a fully
government-owned, vertically integrated enterprise, Tonga Power Limited (TPL). Although TPL
operates on a strictly commercial basis to fully recover the costs of supplying electricity, the tariff
is levelized across Tongan geography and various customer groups, resulting in cross-island
and cross-customer subsidization.

B. Cost–Benefit Analysis for Outputs 1 and 2

4. Economic analysis of outputs 1 and 2 of the project was conducted through standard
cost–benefit analysis on the basis of a world price numeraire, as most components of
investment costs are internationally traded. For output 3, a cost-effectiveness analysis was
used, since the small target populations would yield disproportionately low quantifiable benefits
relative to investment costs in the outer islands. Costs in financial prices were adjusted to reflect
the economic resource cost of project inputs. Capital and operation and maintenance (O&M)
expenditures for renewable subprojects in Tonga are exempt from taxes and duties. Investment
costs were estimated to consist of 72% traded goods and services, 8% non-traded goods and
services, and 20% labor. 3 The same cost breakdown was assumed for O&M costs. Traded
goods and services were assumed to reflect the economic prices; hence, no conversion was
applied. Non-traded goods and services were multiplied by the standard conversion factor of 0.9
(implying a shadow exchange rate factor of 1.11) and labor costs were multiplied by the shadow

1 ADB. 2017. Guidelines for the Economic Analysis of Projects. Manila.

2 Government of Tonga, Tonga Statistics Department, 2015.
3 On the assumption that 80% of the total costs are on materials and 20% on labor for both capital and O&M, and
90% of materials are imported, with 10% local.
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wage rate factor of 0.8.4 All costs and benefits are expressed in constant 2018 prices, and the
analysis assumed a 2-year installation period and an asset economic lifespan of 25 years, with
negligible residual value. These renewable investment subprojects were assumed to start in
2019, and the total project assessment period extends until 2044.

5. Demand analysis. The peak demand of the four TPL grids in 2018 was about 11.4
megawatts, and annual consumption totaled about 57.9 gigawatt-hours. Peak demand and
annual electricity consumption in these grids are expected to increase to about 12.8 megawatts
and 66 gigawatt-hours by 2020. The project comprises a suite of renewable energy projects
targeting the energy needs of eight separate islands (Table 1).

Table 1: Renewable Energy Project Components

Renewable Energy Capacity BESS Capacity Economic Cost
Component
($ million)
Output 1: Battery Energy Storage System on Tongatapu 44.7a
Grid stability BESS 5.1 MW/2.5 MWh
Load-shifting BESS 5.0 MW/17.4
MWh
Output 2: Grid-connected Renewable Energy Generation on ‘Eua and Vava’u islands
Solar PV farm with BESS in 'Eua 0.35 MW 0.4 MW/0.9 MWh 2.42
Solar PV farm with BESS in Vava’u 0.9 MW/0.45
0.3 MW 2.21
MWh
Output 3: Renewable-Based Hybrid Systems and Mini-Grids on Outer Islands
O’ua 59 kW 471 kWh 1.26
Tungua 71 kW 580 kWh 1.28
Kotu 71 kW 580 kWh 1.27
Mo’unga’one 50 kW 390 kWh 1.05
Niuafo’ou 0.25 MW 2.275 MW 5.51
kW = kilowatt, kWh = kilowatt-hour, MW = megawatt, MWh = megawatt-hour.
Note: The economic cost of output 4 (capacity building and project management support) is included in the analysis,
distributed across various subprojects based on their share in total investment costs.
a Includes economic capital costs associated with additional solar and wind energy investments (expected to be

undertaken by private sector independent power producers or public–private partnerships) that will be facilitated by
the availability of battery storage in the Tongatapu grid.
Sources: Government of Tonga; and Tonga Power Limited.

6. Valuation of project benefits. For grid-connected renewable energy generation

systems in ‘Eua and Vava’u, and also the BESS installation component in the Tongatapu grid,
project benefits are considered to be mostly non-incremental, involving the following:
(i) Fuel cost savings. Diesel consumption will be reduced with the partial switch to
renewable energy. For the Tongatapu component, availability of a BESS is seen to
facilitate the development of solar PV and wind generation by private sector independent
power producers (IPPs), through which existing diesel generation could be replaced.5
Costs and benefits associated with renewable energy generation by IPPs are included in
the economic analysis of Output 1. Generation cost savings were derived by multiplying
the amount of avoided diesel consumption by the unit economic cost of diesel at
constant prices. The volume of net diesel savings was estimated by multiplying the
electricity produced by diesel generators that will be replaced by solar in kilowatt-hours
4 Consistent with conversion factors used in ADB. 2016. Report and Recommendation of the President to the Board
of Directors: Proposed Loan and Grant for Additional Financing to the Kingdom of Tonga for the Outer Island
Renewable Energy Project. Manila.
5 The recipient, through TPL, shall ensure that these renewable energy and carbon-free electricity generation
systems operated by IPPs start commercial operation in Tongatapu within 6 months from the commission dates of
the BESS component as set forth in the grant agreement.
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(kWh) by the unit volume of diesel required to produce 1 kWh of electricity. Transport
costs to ship diesel from Tongatapu to outer islands were also considered.
(ii) Environmental benefits. Carbon savings were calculated from the estimated diesel
volume savings at a rate of 2.68 kilograms of carbon equivalent per liter. The economic
cost of carbon is much higher than existing carbon market prices, as the price of carbon
should ideally equal the social cost. The social cost of carbon emissions is assumed to
have a unit value of $36.3 per ton of carbon emissions or its equivalent as of 2016 (i.e.,
$38.9 per ton in 2018), as specified in ADB’s Guidelines for the Economic Analysis of
Projects (footnote 1). This increases by 2% annually in real terms, reflecting the rising
marginal damage of global warming over time.
(iii) Unquantified Benefits. Other benefits, which are unquantified, include better lighting
quality, more useful hours for productive activities, education, better access to
information, and possible positive impacts on tourism with a cleaner environment. These
positive externalities have not been measured and included in the analysis for a
conservative approach in valuing economic benefits.

7. Results of cost–benefit analysis. The economic modeling was set up to estimate the
net economic value of outputs 1 and 2 by calculating the economic internal rate of return (EIRR)
and the economic net present value. For output 1, an EIRR of 28.8% was estimated, above
ADB’s prescribed economic opportunity cost of capital for investment projects of 9.0%.
Sensitivity analyses confirmed that the economic viability of the project’s Tongatapu component
is highly robust against adverse changes to costs and benefits (Table 2).

Table 2: Sensitivity Analyses Results for Output 1

Switching
Change ENPV EIRR Value
Variable (%) ($ million) (%) (%)
Base case 52.8 28.75
Capital cost overrun 10 49.5 25.67 159.0
O&M costs increase 10 52.6 28.67 2,720.7
Benefits decline (e.g., lower diesel
savings, reduced solar
generation) (10) 44.0 25.29 (60.0)
( ) = negative, EIRR = economic internal rate of return, ENPV = economic net present value, O&M = operation and
maintenance.
Source(s): ADB’s estimates

8. Under output 2, subprojects target smaller, rural, and more vulnerable populations on
‘Eua and Vava’u. ADB’s Guidelines for the Economic Analysis of Projects allows for the use of a
lower minimum EIRR threshold of 6% for social sector projects, selected poverty-targeting
projects (e.g., rural electrification), and projects that primarily generate environmental benefits.
Output 2 clearly fits into at least two of these criteria by targeting improved reliability of electricity
supply for rural households through renewable energy investments that have long-term
environmental benefits. The lower EIRR threshold was also previously applied to a project to
rehabilitate electricity grid networks in both ‘Eua and Vava’u.6 Output 2 yields a base case EIRR
of 8.7%, and sensitivity analyses further shows that Output 2’s EIRR remains above 6% under
all adverse scenarios considered, confirming these subcomponents’ robust economic viability.

9. Distribution Analysis. Table 4 summarizes the distribution of estimated financial versus

economic net present values of project flows on consumers, labor, and the overall economy.

6 ADB. 2016. Report and Recommendation of the President to the Board of Directors: Proposed Loan and Grant for
Additional Financing to the Kingdom of Tonga for the Outer Island Renewable Energy Project. Manila.
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The results confirm that the bulk of economic benefits accrue to the overall economy given large
savings in foregone annual diesel consumption. Latest available estimates place the proportion
of Tonga’s population living below the basic needs poverty line at 22.1% as of 2015. No poverty
estimates by island group are available, but under a reasonable assumption that poverty in the
outer islands is about 5 percentage points higher than the national average, Output 2’s poverty
impact ratio is estimated at 0.28. These results confirm that output 2 investments could
indirectly contribute to poverty alleviation efforts by government and development partners.

Table 3: Sensitivity Analyses Results for Output 2

Switching
Variables Change ENPV EIRR Value
(%) ($ million) (%) (%)
Base case 1.0 8.73
Capital cost overrun 10 0.6 7.50 24.6
O&M costs increase 10 0.9 8.59 189.3
Benefits decline (e.g., lower diesel
savings, reduced solar generation) (10) 0.4 7.23 (17.9)
( ) = negative, EIRR = economic internal rate of return, ENPV = economic net present value, O&M =
operation and maintenance.
Source(s): ADB’s estimates.

Table 4: Distribution of Project Impacts

Project Financial and Distribution of Project Effects
Economic Benefits among Stakeholders
($`000) ($`000)
ENPV– Gov’t /
Project Costs and Benefits FNPV ENPV FNPV Consumer Labor Econ. Total
Output benefits - 378 378 378 378

Capital costs (3,370) (3,236) 134 134 134

O&M costs 1,021 3,732 2,711 2,711 2,711
Labor costs (587) 124 711 711 711
Tax (281) - 281 281 281
Project effects (3,218) 997 4,215 378 711 3,126 4,215
Net financial benefits (3,218) (3,218) (3,218)
Net economic benefits 997 378 711 (92) 997
Proportion of poor in stakeholder group (%) 27.1 27.1 22.1
Benefits to poor stakeholders 102 193 (20)275
Poverty impact ratio 0.28
( ) = negative, ENPV = economic net present value, FNPV = financial net present value, O&M = operation and
maintenance, TPL = Tonga Power Limited.
Source(s): ADB and Government of Tonga

C. Cost-Effectiveness Analysis for Output 3

10. Given small populations in the target outer islands of Ha’apai and Niuafo’ou, standard
demand analysis for calculating the benefits of the project would yield disproportionately low
quantifiable benefits relative to investment costs. In such cases, a basic needs or basic public
goods and services provision perspective is more applicable. A cost-effectiveness analysis was
therefore used to evaluate components under output 3 (renewable-based hybrid systems and
mini-grids) from an economic perspective. Since the project is cofinanced by the Green Climate
Fund, nonrenewable generation options such as diesel or petrol generators cannot be
considered. Feasibility assessments also rule out biodiesel generation, given limited local
biomass resource availability in these small outer islands. The only technically feasible options
for the renewable-based hybrid systems and mini-grids on the outer islands are therefore solar
PV and onshore wind power. These were evaluated through a cost-effectiveness analysis.
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11. Based on estimated costs for alternative generation options in Tongatapu, solar PV
generation generally has higher associated initial investment costs relative to the onshore wind
option, but with far fewer annual O&M expenditure requirements. Further, wind-based systems
also require larger battery storage capacities to bridge the mismatch between peak generation
during nighttime and peak energy demand during the daytime. Table 4 shows the cost
associated with the two options (aggregated across the five outer islands subprojects) to
generate the same amount of energy. At a discount rate of 6%, the solar PV option is the least-
cost option, with a lower average incremental economic cost of $3.08 per kWh, compared with
$3.42 per kWh for the onshore wind power option. Solar PV also comes out as the least-cost
renewable energy generation option in each of the five outer islands, with cost savings ranging
from $0.08 per kWh in Niuafo’ou to $0.66 per kWh in Mo’unga’one. The use of solar PV as the
renewable energy component for hybrid mini-grid systems is therefore selected as the most
cost-effective option for providing consistent and reliable electricity supply in the outer islands.

Table 5: Renewable-Based Hybrid Systems and Mini-Grids on the Outer Islands:

Solar Photovoltaic versus Onshore Wind
Option 1: Solar PV ($`000) Option 1: Onshore Wind ($`000)
Year Capital O&M Total Costs Energy Output Capital O&M Total Energy
Costs Output
2019 1,087.5 1,087.5
2020 9,787.1 104.3 9,891.4 311.7 1,006.0 1,006.0 311.7
2021 103.4 103.4 311.7 9,054.0 208.7 9,262.7 311.7
2022 104.3 104.3 311.7 206.8 206.8 311.7
2023 104.3 104.3 311.7 208.7 208.7 311.7
2024 104.3 104.3 311.7 208.7 208.7 311.7
2025 104.3 104.3 311.7 208.7 208.7 311.7
2026 104.3 104.3 311.7 208.7 208.7 311.7
2027 104.3 104.3 311.7 208.7 208.7 311.7
2028 104.3 104.3 311.7 208.7 208.7 311.7
2029 104.3 104.3 311.7 208.7 208.7 311.7
2030 104.3 104.3 311.7 208.7 208.7 311.7
2031 104.3 104.3 311.7 208.7 208.7 311.7
2032 1,601.6 1,601.6 311.7 208.7 208.7 311.7
2033 104.3 104.3 311.7 3,203.1 3,203.1 311.7
2034 104.3 104.3 311.7 208.7 208.7 311.7
2035 104.3 104.3 311.7 208.7 208.7 311.7
2036 104.3 104.3 311.7 208.7 208.7 311.7
2037 104.3 104.3 311.7 208.7 208.7 311.7
2038 104.3 104.3 311.7 208.7 208.7 311.7
2039 104.3 104.3 311.7 208.7 208.7 311.7
2040 104.3 104.3 311.7 208.7 208.7 311.7
2041 104.3 104.3 311.7 208.7 208.7 311.7
2042 104.3 104.3 311.7 208.7 208.7 311.7
2043 104.3 104.3 311.7 208.7 208.7 311.7
2044 104.3 104.3 311.7 208.7 208.7 311.7
Present value at 6% 11,563.2 3,759.6 12,846.6 3,759.6
Average incremental
economic costs at 6% 3.08 3.42
O&M = operation and maintenance, PV = photovoltaic.
Source(s): ADB’s estimates.