Attractiveness of Kenya’s Geothermal Electricity Generation Investments; A Risk Perspective

Ngugi Paul
Geothermal Development Company


The study sought from a risk perspective to answer the question as to how financially attractive Kenya’s geothermal electricity generation investments would be given the private sector risk appetite, prevailing electricity tariff, representative geothermal resource characteristic, typical industrial costs and financing opportunities within the financial market. Alternatively stated is whether Kenya will raise private sector capital for its geothermal sector that lies underutilized despite a sizeable potential. Monte Carlos simulation was used in the study. Expected (mean) internal rate of return based on free cash flow to equity was computed for different combination of inputs. Inputs included a range of values of development costs such as infrastructure costs, drilling costs and drilling success rate, steam gathering system, consultancy fees and cost of power plant, typical field characteristics including average well yield and field production decline, project design factors such as plant size and project development period, commercial issues such as power purchase agreement period, bulk power tariff and prevailing tax rate, operation and maintenance issues including load factor, parasitic load, and financing variables including interest on debt, and financial leverage. The probability of success of exploration was also incorporated in the simulation. For each of the variables an appropriate probabilistic function was assigned to each of the variables. Two measurements were used to measure risk. Type I measurement measured the coefficient of variance of computed internal rate of return and Type II measurement measured risk by probability that the computed internal rate will exceed a hurdle rate required by investors. Literature showed that the investors set the hurdle rate at internal rate of return not less than about 10% but could span as high as 30%. In recognizing the role of debt in the success of the investment, debt service coverage ratio (DSCR) and payback period were computed as measures indicating lenders willingness to finance the projects. Literature further showed that lenders would require a DSCR whose minimum would range between 1.4 and 1.7. The foregoing analysis was undertaken assuming private sector entry at exploration, appraisal, and production drilling phases or at power plant construction phase. The study outcomes for the mean internal rate of return were -36%, 7.7%, 10% and 8.7%, ranging from -55.6% to 10.5%, and from 0.05% to 15.2% and from 6% to 14.6% and from -3.6% to 18.7% assuming private sector entry at exploration, appraisal, production drilling and power plant construction phases respectively. In addition dispersion of the internal rate of return about the mean as measured by coefficient of variance was 0.64, 0.26, 0.13 and 0.33, for the probability that the various outcomes would at least be or exceed 10% were 0.08%, 11.92%, 47.87 and 31.6% and average DSCR 1.23, 1.51, 1.69 and 1.47 assuming private sector entry at exploration, appraisal, production drilling and power plant construction phases respectively. From the result, Type I risk measurement indicate that the investment have very high risk at exploration and generally but significantly reduce as the project progress. This would imply investors would be attracted to the projects after exploration. On the other hand, the results showed that the probability that the simulated outcomes for all entry cases fell below a threshold of about 80% probability of success that would interest investors. This imply that investors would not take up every project but would be very cautious and selective on the project they take. Further, lenders would most likely avoid funding exploration phase of development but may consider financing subsequent phases. From the study, the exploration phase should be a preserve for a public entity as the risk is too high and the super profit to entice the private sector to this phase are non-existence. On the other hand, appraisal phase has a high chance of trailing thresholds set by private investors. Investors at production drilling phase will require to select projects and cut costs especially drilling cost to make the projects pass the investment hurdle. Power plant phase will attract investors who are not excessively risk averse. The general conclusion is that risk reduction using Type I measurement does not in every case result to investment grade projects and the country might be forced to address offered tariff otherwise the public sector will continue to dominate the geothermal sector.
Keywords: Risk, coefficient of variance, internal rate of return, debt service coverage ratio, hurdle rate

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