FINANCIAL AND ECONOMIC EVALUATION OF

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FINANCIAL AND ECONOMIC EVALUATION OF

CAPITAL INVESTMENT PROJECTS IN SMALL POWER SYSTEMS

IMPLICATIONSFORIMPROVEMENTOFFINANCIALANDECONOMICEVALUATION APPLIEDTOTHENVEBS

by

Robert Pancham Supervised by Dr. David Dingli

This paper was submitted in partial fulfillment of the requirements for the degree of

Master of Business Administration (MBA) at

Maastricht School of Management (MSM) Maastricht, Netherlands

Maastricht School of Management P.O. Box 1203

6201 BE Maastricht The Netherlands

May 2009

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This thesis is displayed at the library of the FHR Lim A Po Institute, Paramaribo, to optimize added value to the reader and to leverage his/her knowledge in the subject covered. For further information about the theses, their contents, value, grade and overall quality, you are advised to contact the Academic Degrees Programs Manager.1

1 Copyright © Robert R N Pancham, 2009. All rights reserved. No part of this thesis may be reproduced, stored in a retrieval system or transmitted in any form or by any means, electronic, mechanical, photocopying, recording or otherwise without prior permission in writing of the author.

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Acknowledgements

I should start by thanking my employer, NV Energiebedrijven Suriname, for providing me with the opportunity to do this MBA study.

I am grateful to my supervisor, David Dingli, who agreed to supervise my thesis and guide me through it. I would also like to express my gratitude to my colleagues Ashwien and Sarwan at work, who carried the load when I was away at Fridays.

Thanks to my friend Viren, with whom I had numerous conversations and discussions and who provided me with the insight in power regulatory issues. He was always ready to advise me, even if he was traveling around the globe. Finally I would like to thank my parents Humphrey and Bea and sister Monique for their love and support.

But certainly not least, most of all my gratitude goes out to my loving wife Anushka and son Rishan, whose everlasting love and support provided continuous inspiration to complete this thesis.

All these people have helped to make this MBA program a valuable and unforgettable learning experience!

Robert Pancham Paramaribo, May 2009

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Abstract

The electricity supply industry is very capital intensive. It is probably more capital intensive than any other sector, particularly in the developing countries. Therefore, planning and proper financial and economic evaluation of projects are important to rationalize investment and achieve economic efficiency.

In the last five years over a hundred million American dollars (U$) have been invested in the power system of Suriname for maintaining, improving and expanding purposes to serve today’s need for electricity. It is expected that the demand for electricity in Suriname will grow with an average of 6% per year and the corresponding investment is estimated to be U$

500 million dollar towards 2023. Decision makers are heavily challenged to aim for efficient use of resources, especially in developing countries due to the scarcity of financial resources.

The main objective of this research is therefore to contribute to better financial and economic efficiency in capital investments in the power sector in Suriname, by evaluating the existing decision making criteria and identifying options for improvement.

From this thesis it can be concluded that there is room for improvement of the decision- making criteria for capital investment projects at the NV Energiebedrijven Suriname, the single, state-owned, electricity distribution utility. The first step towards improvement of the financial and economic evaluation as part of the decision-making process is the shift from a deterministic planning approach to a probabilistic planning approach. It is recommendable that reliability criteria are included in the planning process and that (un)reliability costs are also considered when evaluating investment alternatives.

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List of Figures

Figure 1 Geographic Reference of Power Systems in Suriname 2 Figure 2 High-Level One Line Diagram of EPAR Transmission Network 6 Figure 2.1 Concept related with reliability cost-benefit model 17

Figure 2.2 Incremental cost of reliability 18

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List of Tables

Table 1.1 Capital intensity of energy firms in the Netherlands, measured as

depreciation per employee in 2002 1

Table 2.1 Capital needs by use and country type (in billions of 2000 dollars)

over the period 1995-2010 13

Table 2.1 Limitations of deterministic and probabilistic approaches 16

Table 2.2 Reliability indicators used by regulators 19

Table 4.1 Overview of interviewees 32

Table 4.2 Overview of considered Capital Investment Projects of NV EBS 2004-2009 31 Table 4.3 Overview of reliability criteria used in study projects 39

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Abbreviations

CAIDI Customer Average Interruption Duration Index Capex Capital expenditures

CDF Customer Damage Function CFO Chief Financial Officer CFo Initial Investment CFt Future Cash Inflow CTO Chief Technical Officer

DEV Department for Rural Energy of the Ministry of Natural Resources EBS nv Energiebedrijven Suriname

EENS Expected Energy Not Supplied ENIC Electricity Supply Nickerie ENIC Electricity Supply Nickerie

EPAR Electricity Supply Paramaribo and Surroundings ESI Electricity Supply Industry

ETAP Electrical Transient Analysis Program EUR Euro, currency of the European Union FTE Full Time Employee

GDP Gross Domestic Product GW Gigawatt or 1000 Megawatt

GWh Gigawatthour or 1,000,000 kilowatthours HFO Heavy Fuel Oil

IEEE Institute of Electronic and Electrical Engineers IPP Independent Power Producer

IRR Internal Rate of Return km kilometre or 1,000 meter

kV kiloVolt

LOLE Loss of Load Expected LOLP Loss of Load Probability

LV Low Voltage

MV Medium Voltage

MW Megawatt or 1000 kilowatt

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NV “Naamloze vennootschap” or Corporation

OECD Organization for Economic Co-operation and Development Opex Operational expenses

PPA Power Purchasing Agreement

SAIDI System Average Duration Frequency Index SAIFI System Average Interruption Frequency Index Suralco Suriname Aluminum Company

U$ United States Dollars UIC Unit Interruption Cost

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CHAPTER 1 INTRODUCTION

1.1 General

In the last five years over a hundred million American dollars (U$) have been invested in the power system of Suriname for maintaining, improving and expanding purposes to serve today’s need for electricity. It is expected that the demand for electricity in Suriname will grow with an average of 6% per year and the corresponding investment is estimated to be U$

500 million dollar towards 2023 (KEMA 2008). The energy sector is a very capital intensive sector, and decision makers must aim for efficient use of resources, especially in developing countries due to the scarcity of financial resources.

From table 1 it appears from a comparison in the Netherlands that the capital intensity in the electricity supply sector is significantly higher than in other industries.

Table 1.1. Capital intensity of energy firms in the Netherlands, measured as depreciation per employee in 2002.

Industry Depreciation per Employee

(EUR/FTE)

Electricity distribution firms 47,633

Other firms 7,840

Source:V.S. Ajodhia, 2006

The dilemma that should be overcome very often in decision making processes is that the best technical solution may not yield the optimal financial and economical benefits and vice-versa.

Demand for electricity is now growing globally with a rate higher than that of economic growth (Khatib 2003). Saturation of electricity use is not yet in sight, even in advanced economies where electricity production claims more than half of the primary energy use.

Electricity has become an important ingredient in human life; it is essential for modern living and business. Electricity will remain a basis for economic growth and therefore continuity of energy is essential, especially for developing countries like Suriname.

The supply of electrical energy in Suriname is under the responsibility of the Ministry of Natural Resources. This is done through the NV Energiebedrijven Suriname (NV EBS), a 100% government owned company, who is solely responsible for transmission and distribution of electrical energy to the customers and partly for generation. Serving a total load of almost 150 Megawatt (MW) in the ‘Electricity Supply Paramaribo and Surroundings’

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(EPAR) system, the power system in Suriname can be qualified as a relative small power system, compared to large interconnected power systems in other countries.

Capital in the form of money invested to pay people, purchase machinery, and materials, is an economic necessity in all engineering and business projects. Those who design projects and make the managerial decisions as to whether they should be undertaken and how they should be operated are always concerned that the available capital be used efficiently.

This thesis deals with a research of decision-making models or criteria that allow financial and economic evaluation of capital investment projects in the electricity supply industry (ESI), the development selection criteria for the existing model in Suriname’s ESI and measuring worth of an investment. An attempt is made to close the gap between practicing engineers and financial specialists by providing a complete description of the selection criteria, their foundations, assumptions, limitations and areas of application. An assessment is done on the effectiveness of the decision-making criteria used within the NV EBS and

recommendations are provided to enhance the effectiveness of the decision-making criteria of the NV EBS.

1.2 The power system in Suriname

The Surinamese power system consists of several electric islands. While some of these electrical islands are interconnected with others, many are operated as independent electrical islands. Figure 1 shows the geographic reference of each electrical island.

IAMGOLD EPAR Boskamp

Figure 1. Geographic Reference of Power Systems in Suriname. Source: KEMA

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NV EBS owns and operates the EPAR system which is the biggest electrical network in Suriname and covers Paramaribo and its surroundings. Reaching as far as the Ocean in the North, Stolkertsijver in the District of Commewijne in the East, Carl Francois in the District of Saramacca in the West and The Zanderij (Airport) area in the South, this system has the highest consumption of electric power in Suriname. The peak load recorded on October 8, 2008 was 152 MW, a system record. Suriname has benefited from the record high hydro levels in the past few years. It is very clear that any disruption in the hydro power supply will cause loss of load in the system.

Suralco is an independent company that owns and operates generation, transmission and distribution in the southern part of Suriname – from Afobaka to Paranam. This system accounts for the largest generation and transmission in the Surinamese power system and serves as the main source of power for the EPAR system.

The ‘Electricity Supply Nickerie’ (ENIC) system for New Nickerie in West Suriname, and the surroundings reaches as far as Groot Henar in the West. The rural district power systems each operating as an isolated power system with one or more diesel generator sets in a local power house are located at: Albina, Moengo, Boskamp, Coronie, Wageningen, Apoera (total

consumption in these areas is around 22 Gigawatthours, GWh, per year). These rural district power systems are managed by the DE operations of the NV EBS. The Rosebel Gold Mines, where gold mine operations of IAMGOLD in the Brokopondo district are located, are supplied with electric power via a dedicated 161 kiloVolt (kV) overhead power line coming from Afobaka Hydro power Plant. This system is built and owned by Rosebel Gold Mines (IAMGOLD). The Brokopondo Distribution system feeds some villages in the Brokopondo district from the 13.8 kV system at the Afobaka Hydro Power Plant.

Other smaller power systems exist in the interior of Suriname. These are owned and operated by the Department for Rural Energy of the Ministry of Natural Resources (DEV).

1.3 The EPAR system

Four power plants are connected to the EPAR transmission & distribution network, of which one plant is owned by NV EBS and the others by private companies. The private companies deliver power to NV EBS and can as such be considered as Independent Power Producers (IPPs) with whom the Government, as the shareholder of NV EBS, has entered into Power

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The Saramaccastraat Thermal Power Plant is owned and operated by NV EBS and is located in Paramaribo. The plant consists of 11 Diesel Generator Sets with a total installed capacity of 82 MW and an actual output of about 68 MW. Four of the machines which were recently (2005- 2008) installed MAN diesel generator sets, are in the capacity range of 8.3 to 9.0 MW. The other diesel generator sets are 14 to 30 years old and their actual output is less than the name plate capacity. One machine was not available in 2007 due to revision. The four MAN diesel generator sets are running on Heavy Fuel Oil (HFO). Of the seven old machines, four have been converted for HFO use. The remaining three (which are also the oldest ones) run on premium diesel fuel.

The Afobaka Hydro Power Plant (HPP) with 6 turbine driven generators and an installed capacity of 189 MW (3x33 MW and 3x30 MW turbines). Hydro electricity is transported from Afobaka to Paranam via a 161 kV transmission line. The Afobaka HPP and the transmission line are owned and operated by Suralco (ALCOA subsidiary). One part of the electricity produced in Afobaka is used by Suralco and another part is transported further to the EPAR system. Since the closing down of the Suralco aluminum smelter at Paranam in 1999, the supply of Afobaka to EPAR has increased considerably.

The Paranam Thermal Power Plant with an installed capacity of 99 MW (owned and operated by Suralco) is located at the Suralco alumina production plant in Paranam. Its main purpose is to produce heat and power for the Suralco operations. This plant does not deliver power to the NV EBS under normal operations.

The Staatsolie Thermal Power Plant (operated by the State Oil Power Company, which is a subsidiary of the State Oil Company) with two diesel generator sets of 7.5 MW each (an installed capacity of 15 MW) and running on Heavy Fuel Oil. The plant was commissioned in August 2006 and is owned and operated by the State Oil Company of Suriname (Staatsolie).

This plant also produces heat (steam) for the oil refinery and electricity for the EPAR system.

Staatsolie is currently considering installing an additional 15 MW of generation. This proposed addition is driven by the expansion of the refinery and associated need for heat as well as reliability concerns about the supply provided by NV EBS.

Although Staatsolie should deliver 15 MW of base load to NV EBS, as contractually arranged, Suralco is entitled to increase supply to NV EBS. With high deliveries from the

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Afobaka Power Plant, NV EBS can currently operate reliably without additional resources from the Staatsolie Thermal Power Plant.

The four power plants in the EPAR system are running synchronous at 60 Hertz and are interconnected through a transmission system that consists of the following overhead power lines:

One 161 kV double circuit line from the switch yard at Afobaka to the Suralco switch yard at Paranam (owned and operated by Suralco - with a length of 2 x 74 km);

One 161 kV double circuit line from the switch yard at Paranam to the 161 kV switch yard at Menckendam near Paramaribo (owned and operated by NV EBS with a total length 2 x 26.3 km). A 33 kV network from the substation at Menckendam connected to the 33kV/12kV/6kV substations in and around Paramaribo and to the Staatsolie thermal power plant. The

Saramaccastraat Thermal Power Plant is also connected to the 33 kV network. The total length of these 33 kV distribution lines is 275 km. Most of the 33 kV network consists of overhead lines (223 km).

Figure 2 shows the transmission network of the EPAR power system. The 161 kV lines from Afobaka to Paranam and from Paranam to Menckendam play a major role in supporting the load in Paramaribo.

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Figure 2. High-Level One Line Diagram of EPAR Transmission Network

A T L A N T I C O C E A N A T L A N T I C O C E A N A T L A N T I C O C E A N A T L A N T I C O C E A N

X

X X

X

Source: NV EBS

1.4 Problem definition

During the twentieth century, the electric power industry has emerged as one of the most vital and capital intensive sectors in the economy in almost every country. The massive investment needs for power imply that even small improvements in efficiency will lead to significant savings. These are especially important for those developing countries that face shortages of both local and foreign exchange resources.

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Most countries, in particular developing countries, use the traditional deterministic approach in their decision making process for selecting capital projects in their ESI. A commonly held criterion is the (n-1) criterion² (PB associates, 2004). In practice the criterion is easy to understand and apply, but the downside is that it results in the development of a network that can be under-utilized except for short periods of high electricity demand. Deterministic approaches usually consider the worst-case scenario. The selection of the worst-case most often involves a degree of subjective judgement and is therefore difficult to justify as part of an economic decision-making process. Deterministic methods also impose a hard limit on system operations. As a result, systems are often designed, planned or operated to withstand severe problems that have a low probability of occurrence. The economic result may be lower than necessary utilisation and higher investment than is warranted; particularly when capital is scarce, this is an important constraint on funds.

Also in Suriname the challenge for capital investment projects is to select the one alternative that will yield the optimal technical objectives as well as the financial and economic benefits.

The abovementioned leads to the following problem statement:

• The current decision making criteria for capital investments in the ESI in Suriname are not designed to allow effective financial and economic evaluation.

1.5 Research objective

The objective of this thesis is to contribute to better financial and economic efficiency in capital investments in the power sector in Suriname, by evaluating the existing decision making criteria and identifying options for improvement. The model shall be designed in such a way, that it will fit the ESI in Suriname, based on its size and structural characteristics.

1.6 Research questions

The research questions for this thesis are:

1. Which elements should be included in the decision-making model in the ESI of Suriname in order to improve the financial and economic project evaluation?

2(n-1) is a planning practice wherein, no loss of load is experienced when any single component (from a

possible n components) in the power system fails.

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In order to answer research question 1, the following research questions needs to be answered:

2. According to data collection within the ESI in Suriname, which decision-making criteria are generally used with regard to financial and economic evaluation of capital investment projects?

1.7 Theoretical framework

The effectiveness of the decision-making model regarding economic evaluation of capital investments in the electricity supply industry is the dependent variable in this research.

While evaluating a set of alternatives of capital investments, the effectiveness of the decision- making model can be affected by:

• Reliability criteria

• Monopolistic nature

• Unavailability of financial resources or inability to attract financiers

Therefore, these factors are considered to be independent variables in this research.

Political influence will be treated as moderate variable since this variable influences the process as a whole. The underlying theory is mainly focused on the reliability issue, since this is the most important requirement in the electricity supply industry. One of the major authors in this field is Billinton, because of his great contributions to the field of reliability and the many papers and books he authored or co-authored on this issue. Also an attempt is made to look into the other independent and moderate variables, because the effectiveness of the decision-making criteria for investment projects cannot be studied in isolation of these variables, and there is relatively little literature available on these other variables.

1.8 Research methodology

For this thesis a qualitative research approach is applied. This thesis can be divided into two parts namely an analytical part and a recommendation part. The analytical part corresponds to the second research question, as this needs to be answered first, while the recommendation part corresponds to the first research question. In the analytical part, the underlying concepts and approaches for transmission planning and evaluation are explored and evaluated.

Literature review (in chapter two) plays an important role in the analytical part. This review includes both the academic and non-academic literature. The academic literature consists mainly of publications on the economic and reliability aspects of capital investment in the

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ESI. The non-academic literature includes consultancy reports on application of decision making criteria in the ESI. The secondary data collection will mainly consist of data obtained from NV EBS itself. For this secondary data collection, capital investment projects

implemented in the last five years at NV EBS will be analysed with regard to undertaken financial and economic evaluation as part of the decision-making process. This will be done through an analysis of archival documents including consultant reports and project reports from the technical and financial departments about the projects. Also primary data will be collected through interviews with top-management and middle management in order to determine the rationale and factors of influence behind the decisions on the investment projects. From the interviews, the influence of the independent variables on the decision making-process will be considered

The analytical part provides the theoretical framework for the decision-making criteria for integrated economical and technical evaluation of capital investment in the ESI.

During the recommendation phase, recommendations are presented to upgrade the decision- making criteria for the ESI in Suriname.

1.9 Research limitations

This thesis is subjected to the following limitations:

1. Because of the nature of the topic, most of the information about decision-making criteria will be derived from papers, books and existing studies. The most

sophisticated decision-making models are however largely used by developed countries, having competitive markets and interconnected grids. An attempt shall be made however, with this data to develop a model, which will fit the ESI in Suriname.

2. Because of the time and financial constraints, it will not be possible to investigate into detail the decision-making models of other countries having a similar ESI as

Suriname. It will be shown in the literature review, that every country in some way has its own way (and restrictions) of selecting capital investments in their ESI.

3. It should be stated that there are more variables that can significantly influence the decision making on investment projects, such as environmental regulations. Due to time restrictions, the focus will be on the abovementioned variables.

4. For the focus of this research, this thesis is restricted to the summary of the reliability evaluation methods and indicators only and no further analysis of the indicators is provided.

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1.10 Thesis structure

This first chapter presents the reader with an overview of the contents of this thesis and a brief description of the problem definition, research objective and the research methodology. It also sheds some light on the reason why the researcher chose this topic: Financial and economic evaluation of capital projects in small power systems.

Chapter two forms the theoretical framework of this thesis. In this chapter the theory about planning and project selection criteria in the electricity supply industry is dealt with.

In chapter three the research methodology is presented, while chapter four analyses the collected information. Finally, in chapter five theory and data analysis are combined into some important conclusions and recommendations decision-making criteria regarding capital projects in the ESI in Suriname.

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CHAPTER 2 LITERATURE REVIEW

2.1 An overview of the Electricity Supply Industry

2.1.1 The Electricity Supply Industry

The physical electricity system can generally be divided into three main segments:

Generation, Transmission and Distribution. Electricity is produced in generating plants and these typically feed into the transmission networks. The transmission network effectively connects all generating plants and acts as an interface to the distribution network. At the terminals of the transmission network, voltage is transformed into lower levels and this is where the distribution network starts. The distribution network’s function is to take the electricity from these terminal points to the final consumers. The distribution network can be divided into the medium and the low voltage network (MV and LV). The MV distribution network distributes the electricity from the terminals of the transmission system to the smaller MV/LV transformer stations. From here on, the LV network distributes the electricity further to the final consumers. In appendix A the principles are explained of an electricity supply system.

2.1.2 Considerations in the decision-making process in the ESI

Billinton and Adams (1996) define the primary emphasis of a power system as to provide a reliable and economic supply of electrical energy to their customers. Spare or redundant capacities in generation and network facilities have been inbuilt over decades in order to ensure adequate and acceptable continuity of supply in the event of failures and forced

outages of plant, and the shutdown of system components for regular scheduled maintenance.

They further implied that the probability of consumers being disconnected for any reason can be reduced by increased investment during planning phase, operating phase or both.

Overinvestment however can lead to excessive operating costs which must be reflected in the tariff structure. Consequently, the economic constraint can be violated, although the system may be very reliable. On the other hand, underinvestment leads to the opposite situation.

Hence, it is obvious that the economic and reliability constraints can be conflicting, and this can lead to difficult managerial decisions at both the planning and operating phases.

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As Billinton and Allan (1996) brought forward, these problems have been widely recognized and understood, and design and operating criteria and techniques have been developed over many decades in an attempt to resolve and satisfy the dilemma between the economic and the reliability constraints. The criteria and methods first used in practical applications were all deterministically based. Typical criteria are:

(A) Planning generating capacity – installed capacity equals the expected peak demand plus a fixed percentage of the expected peak demand

(B) Operating capacity – spinning capacity exceeds the load demand with a reserve equal to one or more largest units

(C) Planning network capacity – construct a minimum number of circuits to a load group (generally known as (n-1) or (n-2)³ criterion depending on the amount of redundancy).

Although these and other similar criteria have been developed in order to account for

randomly occurring failures, they are inherently deterministic. Their essential weakness is that they do not and cannot account for the probabilistic or stochastic nature of system behaviour, of customer demand or of component failures.

In order to reduce the frequency and duration of these failures and to reduce their impact, it is necessary to invest in the design phase, the operating phase or both. Billinton and Allan raise the following questions:

• How much money to be spent?

• Is it worth spending any money?

• Should the reliability be increased, maintained at existing levels, or allowed to degrade?

• Who should decide-the utility, a regulator, the customer

• On what basis should the decision be made?

They also conclude that, since costs and economics play a major role in the application of reliability concepts, the question posed in this context is: “Where or on what should the next pound, dollar, or franc be invested in the system to achieve the maximum reliability benefit?”

(Billinton & Adam 1996: 12). This can be extremely difficult to answer, but it is vital and hereto a consistent set of reliability indices should be developed and evaluated for each of the alternatives.

3 (n-2) is a planning criteria, similar as (n-1), where no loss of load occurs when two components (out of n components) in the power system fail.

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2.1.3 Capital investments in the ESI in global perspective

The electricity supply industry is highly capital intensive. It is probably more capital intensive than any other sector, particularly in developing countries. Therefore, planning and proper financial and economic evaluation of projects are important to rationalise investments and achieve economic efficiency. A review of recent studies (Khatib 2003) indicated that there is a need to invest $2,700 billion (in 2000 dollars) in the electricity supply industry worldwide over the period 1995-2010, that is, $175 billion on the average per annum. Generation

projects will account for 63 percent of these capital investments, transmission for 8.8 percent, and distribution for 21.2. percent. The remaining 7 percent will be general expenditure, mainly concerned with control, telecommunications and similar activities. Developing countries will account for over 58 percent of these investments, developed countries (OECD) for 32 percent and the Transitional Economies (East Europe and former Soviet Union) for the remaining 10 percent, as detailed in Table 2.1

Table 2.1: Capital needs by use and country type (in billions of 2000 dollars), over the period 1995-2010

Type Generation T&D and general Total %

Developed 560 300 860 32

Developing 970 615 1585 58

Transitional 170 85 255 10

Total 1700 1000 2700 100

Source: Khatib 2003

Generation investment and projects

According to Khatib (2003), most of ESI projects will be in generation, and will take place in developing countries. To the existing capacity global generation capacity of 3,580 GW in the year 2000, it is expected that 1,200 GW of extra capacity will be added, that is, an increase of at least one third over 15 years. It is expected that China alone will account for almost 20 percent of the new generation capacity, by investing in 230 GW of new capacity over the period. This is more than the whole extension of capacity of Western Europe that is supposed to increase by 200 GW. Costs per MW of capacity vary from one country to another,

depending on the type of generation, fuels utilised, and more importantly investments in environmental protection facilities.

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Transmission and distribution projects

As shown by table 2.1, transmission, distribution, and general investments are expected to amount to $1,000 billion over the period 1995-2010 period. Most transmission projects will take place in developing countries, particularly Latin America, where large transmission lines will be needed to convey electricity from remote hydro-stations. A few transmission facilities will be needed in Europe where the network is already well developed.

Most developed and developing countries need to invest sufficiently to extend and improve their distribution networks. Losses in the distribution system include most system losses in the developing countries.

Together, developing countries need to invest $1,585 billion in their electric power system during the period 1995-2010. Because of subsidies and low electricity tariffs, internal fund generation in these countries is limited. Government capabilities to finance such

infrastructural projects are becoming more limited, owing to the other more pressing social sectors (education, health, nutrition, etc).

Therefore, the electricity supply industry in developing countries must attract a sizeable portion of the investment from international private capital. For this to be achieved, much reform and regulatory arrangements must take place in developing countries. Three conditions are mandatory:

• Governments must be committed and guarantee a financially independent electricity supply industry.

• Electric utilities have to perform in a financially and economically viable way.

• Investors (foreign as well local) must be convinced that they will obtain a good return on their investment, and will be able to repatriate these returns.

Hence Khatib (2003) concludes that the financial and economical evaluation of projects in the electricity supply industry, and the techniques for the calculation of return requirements, are becoming increasingly important.

2.2 Transmission Planning Methodologies

In a report, the Parson Brinckerhoff Associates (PB Associates, 2004) outlined that transmission grid planning methodologies can mainly be divided into two approaches:

• The deterministic approach

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• The probabilistic approach

The (n-1) is a common deterministic approach. The (n-1) criterion states that a transmission grid should be able to withstand any event of a loss of any single transmission load-carrying segment in the grid, without affecting the supply to costumers. Under the (n-1) design criteria, the number and the capacity of the segments are designed at peak demand, expected to be served at the bulk-supply grid exit points.

According to PB associates (2004), there are three main categories of probabilistic methods:

1. Enumeration methods use Markov models and Markov chains to evaluate reliability of generation and transmission elements and systems respectively

2. A frequency and duration method develops reliability indices for load points and for overall system adequacy for generation only or for a composite system evaluation 3. Monte Carlo methods are used to run probabilistic simulations for generation only

(production costing) and for composite system evaluation.

PB Associates (2004) outlined the limitations of deterministic and probabilistic techniques.

Deterministic approach usually considers the worst-case scenario. Since the selection of the worst case scenario usually contains some subjective judgement, it is difficult to include an economic decision-making process. As a result, the system will then be designed to withstand the most severe events with a very low probability of occurrence.

The economic benefits of the projects may be lower because of the imbalance of the overinvestment compared to the level of reliability.

On the other hand, transmission grid investment decision-making processes, on the basis of a probabilistic approach, include the consideration of the probability-weighted influence on supply reliability of probabilistic, high cost events. Typically, those events include single and multiple outages of transmission elements, generation plant and unexpectedly high levels of demand.

Probabilistic techniques considers factors that influence the performance of the system and therefore uses a quantified risk assessment using performance indices such as probability and frequency of occurrence of failures, duration and severity of those failures etc. These are called performance indices and are sensitive to factors that affect the reliability of the system.

PB associates produced a table with the comparison of the limitations of deterministic and probabilistic approach in planning:

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Table 2.1: Limitations of deterministic and probabilistic approaches

Deterministic Probabilistic

Contingency Selection

Typically a few probable and extreme contingencies

More exhaustive of contingencies Contingency

Probabilities

Implicit, based on judgement Explicit, but generally based

Load Levels Typically seasonal peaks and selected off peaks

Multiple levels

Analysis Steady state/dynamics Steady state as present

Reliability None Various indices calculated

Criteria for Decisions

Well established Need a cautious approach to select criteria due to limitations in data contingencies probability and the models

(Source: PB associates 2004)

Further PB associates describes some international practices about the decision making criteria in several countries like or within the US, Canada, Australia, Europe, Asia and New Zealand. They indicate that it is a common practice that every industry employs their own mix of deterministic and probabilistic approaches.

Li and Choudhary (2007) outlined that the fundamental objective of transmission planning is to develop the system as economically as possible and maintain an acceptable level of

reliability. They also distinguish two methods namely the deterministic planning criterion and the probabilistic planning criterion, whereby the latter one has become increasingly necessary and important in recent years. The probabilistic method is not intended to replace the

deterministic criterion but rather adds one more dimension to improve the transmission planning process.

2.3 Economic evaluation of transmission capital investments

In their publication regarding reliability cost-benefit evaluation of transmission capital projects, Chowdhury and Koval (2006) stated that determination of acceptable levels of supply reliability is presently achieved by comparing interruption frequency and duration indices with arbitrary targets. In their paper they provided a value-based methodology to

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enhance the understanding of transmission capital projects justification. There is an

increasing recognition in the ESI that investments related to the improvement of the electric service reliability should be more explicitly evaluated including their cost and benefit implications. A value based reliability planning methodology attempts to ascertain the minimum cost solution, where costs are identified as the sum of investment cost plus operating and maintenance cost plus customer outage cost.

The value-based planning concept is based on surveys of costumer perception regarding the level of reliability for which they are willing to pay. Figure 2.1 shows how utility costs increase as costumers are provided with a higher level of reliability, while customer costs related to electricity supply outages decrease as the reliability level increases. The total costs to the customer are the sum of these costs. This total customer costs show a minimum at which costumers receive the least cost service (dotted line). Van Kruining et al (2001) indicate that if both costs levels as function of reliability are known, power system optimization can be done at lowest costs. This approach is however very abstract and practically very difficult to use.

Figure 2.1: Concept related with reliability cost-benefit model.

Source: Chowdhary and Koval, 2006

Billinton and Allan (1996) also emphasize that reliability and economics play a major

integrated role in the decision-making process. From figure 2.2 it can be seen that the general trend is that the incremental cost DC to achieve a given increase in reliability DR increases as the reliability level increases. High reliability is expensive to achieve. The incremental cost of reliability D^C/DR is one way of deciding if an investment in the system is worth it. The

Total Cost

Customer Cost Utility Cost

Reliability Cost

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disadvantage is that it does not consider the benefits seen by the utility, the customer, or society. The two aspects of reliability and economics can be appraised more consistently by figure 2.1, by comparing reliability costs (the investment costs needed to achieve a certain level of reliability) with reliability worth (the benefit derived by the customer and society).

Figure 2.2: Incremental cost of reliability

Source: Billinton and Allan, 1996

According to Van Kruining et al. (2001) the cost to be considered in network planning consists of investment costs (capex), operational and maintenance costs (opex), network losses and costs of energy not delivered. In network planning (distribution) practices in the Netherlands, the situation is such, that the cost of energy not delivered is only a small fraction of the compared capex and network losses. This is also the case for other West-European countries where estimations have been made. The danger is that in network planning, decisions can be taken mainly on the basis of capex and losses; network reliability will be rather a consequence than a weighing factor. In this book, van Kruining et al. (2001) illustrate this by a real example in the distribution system of the Netherlands.

The conclusion is that minimum reliability criteria should be considered in the power system planning rather than only cost of energy not delivered.

2.3.1 Reliability indicators

There is a wide range of indices which can be calculated at each major load point and for the overall system. There is, however, no consensus in the industry as to which adequacy indices

1.0

Investment cost C

Reliability R DC

DR

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are the best. It may therefore be appropriate to summarize a variety of indices which convey meaningful information regarding the performance of the system and are also well suited to making system modification decisions:

• Loss of Load Expectation, LOLE

• Loss Of Load Probability, LOLP, these first two are mainly used for generation only or composite (generation and transmission) systems.

• Expected Energy Not Served, EENS

• System Average Interruption Frequency Index, SAIFI

• System Average Interruption Duration Index, SAIDI

• Customer Average Interruption Duration Index, CAIDI

The calculation formulae of these reliability indicators are given in Appendix C. For the focus of this research, this thesis is restricted to the summary of the indicators only and no further analysis of the indicators is provided. The calculation of these indices is normally done with simulation programs.

In table 2.2 an overview is presented of some countries and their selected indicators used by regulators.

Table 2.2: Reliability indicators used by regulators

Country Quality indicator

Australia (Victoria) SAIFI, SAIDI, CAIDI

Belize SAIDI, SAIFI

France SAIFI

Italy SAIDI

The Netherlands SAIFI, CAIDI

Norway EENS

Portugal SAIFI, SAIDI

Sweden SAIFI, CAIDI

Source: Ajodhia, 2006

2.3.2 Economic impact of reliability – Outage costs

System unreliability can be expressed using unreliability cost so that system reliability and economic analysis can be assessed on a monetary basis. Two main methods that exist according to Li and Choudhury (2007) are the total cost method and the benefit/cost ratio method.

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The total cost method indicate that the best alternative in system planning should achieve the least total cost, whereby total cost is defined as:

Total cost = investment cost + operation cost + unreliability cost.

The unreliability cost is obtained by using the expected energy not supplied (EENS) index (in MWh/year) times the unit interruption cost (UIC) (in US$/kWh). The EENS can be calculated through a probabilistic evaluation method, whereas the UIC can be estimated out of four techniques:

• Using customer damage functions (CDF’s) that can be obtained from customer surveys. A CDF curve provides data about the average UIC due to power outages

• The gross domestic product (GDP) divided by the total energy consumption

• The relationship between the capital investment projects and the system EENS indices

• The lost revenue to the utility due to power outages. This last technique would typically represent the lowest level of UIC.

The utilities usually make their own choice of which method to be used, based on the best fit with their business objectives or in this case planning criteria.

The Benefit/Cost ratio method simply recognizes the reduction in operation and unreliability cost as a benefit and the capital investment as a cost. Alternatives can be ranked using this benefit/cost ratio. The present value method is usually used to calculate this ratio.

In a World Bank research publication, Munasinghe (1979) defines outage costs as the economic costs suffered by society when the supply of electricity is not perfectly reliable or when it is not expected to be perfectly reliable. Reliability problems are manifested in different ways, ranging from power surges, frequency variations and voltage level drops to load shedding and complete interruptions of supply (blackout).

Munasinghe (1979) concludes that outage costs should be estimated on the assumption that all electricity is used for productive purposes. Electricity is combined with other inputs and raw material to produce various outputs. In a case study conducted by Munasinghe (1979) in Cascavel, Brasil, the residential and industrial outage costs were estimated through a survey with questionnaires.

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2.3.3 Financial evaluation of projects

During the life of the project, there will be two financial streams: one is the cost stream and the other is the benefit (income) stream (Khatib 2003). In financial evaluation of projects, the two streams will contain only the estimated actual cash costs and the benefits of the projects during its life cycle. The economical evaluation will influence the two streams, to include all the economic (social and environmental) costs and benefits of the projects that can be evaluated. The difference between these two streams is the cash flow, the net benefit stream.

From an owner’s point of view, the evaluation interest is in net benefits and the net present value in comparison with the value of the investment (equity).

Project financial costs

Khatib (2003) distinguishes three main categories of costs:

Investment costs:

These include initial costs, replacement costs and residual values. Initial costs reflect the costs involved in construction and commissioning, including land, civil works, equipment and installations.

Operating costs:

These costs are a combination of fixed and variable costs. Fixed costs, independent from the level of production, will include salaries, cost of management, part of maintenance cost and the like. Variable costs will depend on the level of production like fuel, lubricants, water and part of the maintenance costs. The total operating costs are the sum of the fixed and variable costs.

Working capital:

Working capital refers to the physical stock needed to allow continuous production. The stock is normally built up at the commissioning phase and for network projects there is usually one component of working capital, which is the initial stock necessary for the operation.

Calculation of benefits in the electrical supply industry is not an easy task. Not all projects in the ESI imply production like generation projects. Some projects are carried out for

improvement of the supply reliability, rural electrification, and environmental preservation.

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2.3.4 Least-cost solution

It is important to ensure that the project is the least-cost alternative for attaining the required output. The ESI is one of the best industries to employ least-cost solution techniques, since there are more ways in how a given project objective can be achieved. The least-cost solution selects the one alternative on a financial and economic base, which achieves the project objectives at the least cost.

Kathib (2003) categorizes two main methods for financial evaluation and comparing alternatives:

• The present value method.

• The annual cost method.

The present value method

The present value (PV) method aims at present valuing (discounting) all costs and benefits of the proper cash flows (net benefits) to a specified date, the ‘base year’. In this way, all cash flows prior or after the base year are discounted to the base year through multiplying by the discount factor [1 / (1+r)ⁿ], where ‘n’ is negative for the years prior to the base year. All cash flows are assumed to occur at year end. Khatib (2003) concludes that the PV method is suitable for choosing the least-cost solution. The method discounts the capital and future operational costs of each considered alternative to its present value, using a discount rate that is equal to the opportunity cost of capital. The alternative with the least present value cost is the chosen least-cost solution. The method is also useful for comparing alternatives with different outputs (kWh). The evaluated costs (capital and operational) and benefits (in kWh) are discounted to the base year. The least-cost alternative will be the one least discounted cost divided by the discounted energy output.

The annual cost method

This method is useful and quick for choosing the least cost solution. The equivalent annual cost is defined as the amount of money to be paid at the end of each year ‘annuity’ to recover

‘amortise’ the investment, at a rate of discount ‘r’ over ‘n’ years. If the capital is obtained through loans, this method is easier for business decisions and is easier to compute for regular annual series of disbursements. In the ESI however, annual costs are irregular, utilisation varies from year to year and here the PV method is better since it allows variations in input, operating costs over time and other factors.

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Measuring worth of an investment

Many of the projects in the ESI are imposed on the planner and are beyond his control like building new power plants to meet lead demand, building new facilities to improve security of supply, rural electrification, etc. Therefore, many decisions in the ESI are restricted to the choice of least-cost solution. However, with recent developments in market structures and the introduction of competition, a more detailed analysis of the profitability of investment is also becoming increasingly important. The traditional cost-benefit analysis of projects is still useful to assess the acceptability of projects to utilities, governments, investment bankers and development funds.

The most useful ways of assessing if a project is worth undertaking are:

1. computing the internal rate of return

2. evaluating the net present value of the project 3. calculating the benefit/cost ratio

4. other criteria (pay back period, profit/investment ratio, commercial return on equity capital)

2.3.5 Establishment of the discount rate

The choice of the discount rate is probably the most important factor in evaluating the project in the decision-making phase. The calculation of the net returns of the project is greatly influenced by the choice of the discount rate. A high discount rate will tend to weigh the decision towards the alternative with low capital costs and high operational costs as a low discount rate will do for the opposite situation. The discount rate is the opportunity costs of capital. The opportunity cost of capital is the return on investments forgone elsewhere by allocating capital to the selected project.

Khatib (2003) distinguishes two different kinds of discount rates namely:

• discount rates in government financed projects

• discount rates in business investment projects

Normally, projects financed by the government use a different discount rate than if it were private investors. Government investments are less risky, because they are mostly in regulated industries. For government financed projects, the discount rate is sometimes decided by the responsible institutions, which greatly eases the work of the evaluators.

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In business invested projects, the investors require a minimum acceptable return on investment to balance:

• the risk-free rate of interest,

• the risk of investing in the project,

• taxation

• inflation.

The establishment of the discount rate are well explained in the finance theory. In financial evaluation it is also important to assess the amount of risk to which the project is exposed. If the project is exposed to high risks, the costs of capital will increase and consequently, a higher return on investment will be required in order to remain feasible. This relation between risks and return is well known in finance theory (Gitman 2006).

2.4 Monopoly, reliability and efficiency

In his dissertation, Ajodhia (2005) conducted a research about ‘integrated price-quality regulation for electricity distribution networks’. Two of the issues he addressed were the level of quality⁴ and the regulatory issues in a monopolistic market situation. It is well known that competition stimulates economic efficiency and that this generally leads to increased welfare at the benefit of society. Sometimes however, competition is not feasible. This is especially the case if natural monopoly exists. Natural monopolies exists if duplication of an

infrastructure or service is economically not feasible, i.e. the character of the technology and demand dictate that the service is cheaper if the market is served by a single firm rather than by competing firms. Networks i.e. transmission and distribution networks, are a clear example of a natural monopoly and this is also the case in Suriname for the NV EBS. Economic theory indicates that the existence of a monopolistic market leads to inefficiency in the allocative and productive sense as well as to suboptimal supply quality.

Secondary sources Ajodhia (2005) outline Spence’s (1975) conclusion that a monopoly firm will generally not supply an output according to the Pareto efficient level, that is the ideal level where maximum allocative efficiency is reached when costs and willingness to pay are equal at margin. Therefore, the monopoly and social optimum will generally not match and will give way to allocative inefficiency. This problem indicates the necessity of a regulating

4 Quality in this regard can primarily be considered as reliability, since reliability is the most important quality feature in the ESI besides power quality and commercial quality

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body (usually the government) to intervene in order to reach efficient outcomes i.e. outcomes that would be reached if the market would have been competitive. The problem of monopoly also includes the quality of the supply. Ajodhia (2005) determines, also through White (1977), that monopoly leads to suboptimal levels of quality of supply and the solution to the natural monopoly problem must be sought in regulation. Regulation in this regard must counteract the adverse monopoly effects by creating mechanisms that stimulates or drives the monopoly to maximize total social welfare. This objective can be divided into two components: Achieving maximum economic efficiency and attaining an optimal quality level. On the other hand, the regulator also needs to consider the interests of the (monopolistic) firm. Investors require a sufficiently high return on their investment. Too low price levels reduce profitability and may make it unattractive for investors to invest in the industry. The regulator therefore needs to set prices at sufficiently high levels in order for the investor to earn a reasonable rate-of-return.

2.5 Synthesis

In this chapter the conflicting nature of reliability and economics in the ESI and the growing importance of efficient resource allocation are emphasized. A review is presented about the two main methodologies that can be distinguished in capital investment evaluation, namely the deterministic and the probabilistic approach. Also a brief overview of reliability

indicators and methodologies of how to quantify costs related to (un)reliability, as the heart of an effective financial and economical evaluation of capital investments, is presented. These issues can not be considered in isolation of the utility form and market structure, as these also impact the effectiveness of the evaluation criteria in de decision-making criteria. In the remainder of this report the research methodology is explained and the data collected from interviews and archival documents are analysed, to finally reach to the final chapter of conclusions and recommendations.

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CHAPTER 3 RESEARCH METHODOLOGY

3.1 Introduction

This chapter explains in detail how this theory building research was conducted and analyzed.

The theoretical framework described in chapter 2 will be used to identify and analyze the decision-making models or criteria which are generally used in developed countries. This data will be used to derive guidelines for effective decision-making criteria in the ESI in Suriname for deciding on investment projects. Section 3.3 describes and defines the problem, which results in the research objective for this study, as described in section 3.4. The research questions and proposition are detailed in section 3.5. The perspective, from which the

research object is analyzed, is described in section 3.6 (theoretical framework) and finally, in section 3.7, the research approach is defined.

3.2 Multidisciplinary nature

Planning in the electricity supply industry contains both an economical and engineering aspect. This thesis combines these disciplines i.e. those of economics and engineering. In fact, this thesis is a blend of economic and reliability aspects in transmission planning. This mix of social science and engineering disciplines reflects the multi-dimensional nature of the

electricity supply industry. On the one side, it can be considered a complex physical industry, while on the other hand it can be considered a social network, serving the public demand (and need) for electricity.

3.3 Problem definition

The electric power industry has emerged as one of the most vital and capital intensive sectors in the economy in almost every country. The massive investment needs in the ESI indicate that even small improvements in allocative efficiency will lead to significant savings. These efficiency improvements are especially important for those developing countries that face shortages of financial resources.

Reliability planning theory predicts that the use of the traditional deterministic approach in the decision making process for selecting and deciding on capital projects in their ESI does not necessarily lead to optimal financial and economic benefits as this approach usually assumes the worst-case scenario, with a very low probability of occurrence. In Suriname,

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most investment decisions are made on a deterministic basis. This is usually the case for developing countries with an ESI, sharing the same characteristics as the ESI in Suriname, primarily being regulated and monopolistic. Application of deterministic approaches often involves subjective approaches based on possible worst-case scenarios and this makes it difficult to economically justify a capital investment.

The challenge for capital investment projects is to select the one alternative that will yield the optimal technical objectives as well as the financial and economic benefits.

The abovementioned leads to the following problem statement:

• The current decision making criteria for capital investments in the ESI in Suriname are not designed to allow effective financial and economic evaluation.

3.4 Research objective

The objective of this thesis is to contribute to better financial and economic efficiency in capital investments in the power sector in Suriname, by evaluating the existing decision making criteria and identify options for improvement. The model shall be designed in such a way, that it will fit the ESI in Suriname, based on its size and structural characteristics.

3.5 Research questions

The research questions for this thesis are:

1. Which elements should be included in the decision-making model in the ESI of Suriname in order to improve the financial and economic project evaluation?

In order to answer research question 1, the following research questions needs to be answered:

2. According to data collection within the ESI in Suriname, which decision-making criteria are generally used with regard to financial and economic evaluation of capital investment projects?

3.6 Theoretical framework

3.5.1 Dependent variable

The dependant variable in this research is the effectiveness of the decision-making model regarding financial and economic evaluation of capital investments in the electricity

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supply industry. Most countries that have a sophisticated and comprehensive decision making model for evaluating capital investment in their ESI are either developed countries or developing countries having a large ESI with deregulated markets. The models differ from one country to another based on their experience, market structure, government imposed regulations, etc. Small developing countries use either a deterministic approach, or a more comprehensive approach derived from the approaches used by other countries worldwide.

3.5.2 Independent variables

The effectiveness of a decision-making model for capital investments in the ESI regarding financial and economic evaluation is dependant on the following variables:

• Reliability targets

• Monopolistic nature

• (Un)availability of financial resources or (in)ability to attract financiers These variables are considered to be independent variables. Political influence will be treated as moderate variable since this variable influences the process as a whole.

3.7 Research methodology

For this thesis a qualitative research approach is applied. This thesis can be divided into two parts namely an analytical part and a recommendation part. The analytical part corresponds to the second research question, as this needs to be answered first, while the recommendation part correspondents to the first research question. In the analytical part, the underlying

concepts and approaches for transmission planning and evaluation are explored and evaluated.

Literature review (in chapter two) plays in important role in the analytical part. This review includes both the academic and non-academic literature. The academic literature consists mainly of publications on the economic and reliability aspects of capital investment in the ESI. The non-academic literature includes consultancy reports on application of decision making criteria in the ESI. The secondary data collection will mainly consist of data obtained from NV EBS itself. For the secondary data collection, capital investment projects

implemented in the last 5 years at NV EBS will be analysed with regard to undertaken financial and economic evaluation as part of the decision-making process. This will be done through an analysis of archival documents including consultant reports and project reports from the technical and financial departments about the projects. Also primary data will be collected through interviews with top-management and middle management in order to

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determine the rationale and factors of influence behind the decisions on the investment projects. From the interviews, the influence of the independent variables on the decision making-process will be considered.

The analytical part provides the theoretical framework for the decision-making criteria for integrated economical and technical evaluation of capital investment in the ESI.

During the recommendation phase, recommendations are presented to upgrade the decision- making criteria for the ESI in Suriname.

FINANCIAL AND ECONOMIC EVALUATION OF