  Principles of Subsidies Mechanism
Types of Subsidy Mechanisms Output Based Aid Subsidies for Service Providers
Principles of Subsidies Mechanism Public money is often required to support the operation of rural (as well as urban) infrastructures, and subsidies to promote mini-grid electrification in rural communities, especially where it provides the least cost service option, can be justified on the basis of social equity, poverty reduction or other political considerations. The critical question regarding subsidies is not whether they are necessary, but how can they be spent most effectively to complement payments by the users. Subsidies can range from initial investment grants to tariff based cross-subsidies, and there are many good policies, but it is important that they do not have a negative influence on rational use of energy and local energy sources. Government should establish a subsidy mechanism to take into account regional and other considerations, with due consideration to efficiency and sustainability under a regime of cost-based regionally-differentiated tariffs and multiple service providers. In particular, the Government should design subsidy schemes and allocation procedures that:
· Follow pre-established clear, explicit rules that Þ Are transparent, i.e., avoid implicit (and operating) subsidies that frequently lead to waste and non-accountability. Þ Are targeted to the segments of the rural population that most need the support, Þ Are easy to administer, Þ Are linked to results, i.e., maintain the focus on expanding access by subsidizing the initial cost of investment rather than the cost of operation. Þ Provide strong cost-minimization incentives, i.e., retain the commercial orientation to reduce costs even though subsidies are being provided.
· Ensure good governance, i.e., the institutional responsibility for policy and rule setting for the subsidy mechanism are clearly separated from its administration, and an independent entity is responsible for requisite checks and balances, monitoring performance, and ensuring compliance. Subsidy policies can be measured according to their efficiency (the economic cost-benefit of the subsidy program), equity (whether the subsidy actually reaches the poor people that need electric services) and effectiveness (the ability of the subsidy program to achieve the results of increased electric services to rural populations). In principal, subsidies for rural electrification and mini-grid energy systems are more sustainable when applied to the capital investment rather than to the on-going operating and maintenance costs. Capital subsidies generally support expanded access and are definable and periodic. Subsidies that support operating costs often result in an unsustainable commitment. 
Types of Subsidy Mechanisms In a number of countries, subsidies for rural electrification are managed and implemented through rural electrification funds. They provide partial capital subsidies for new electricity connections and require the distribution company to cover the operating costs of service through revenue collection. The funding sources for such funds usually come from government budget, donors, and levies on electricity bills. In Guatemala, the funding for the rural electrification fund came from the sales of utility privatization. Such funds are usually administered by an independent Rural Electrification Agency, who is also responsible for rural electrification planning, technical assistance, promotion, supervision, etc. When properly administered, such subsidies can make rural electrification a profitable business. In most successful programs, a substantial portion of the capital is obtained at concessional rates or in the form of grants. Such rural electrification funds should provide subsidies for both grid extension and off-grid options including mini-grids, but adopt different subsidy schemes for grid extensions and off-grids. Bulk power subsidies are not a good idea from a strictly economic point of view, but they have been used successfully in several cases. In Thailand, the bulk power supplier was not affected financially by the bulk power subsidies it provided for financing rural electrification because it is able to recover the subsidies with higher prices to its urban customers. In the United States, the cheap power from the public darns was given to the rural cooperatives because of their role in providing affordable electricity to people in rural areas. Operational subsidies are very problematic in that they make the rural electricity supply companies critically vulnerable as revenues do not cover operating costs without continuation of the subsidy. When the subsidy is reduced (as inevitable happens) the virtue of increasing sales turns into a vice of greater losses, creating a significant disincentive to extend electricity to new customers. Within electricity companies that have both urban and rural consumers, lifeline rates and cross-subsidies have been an effective policy for encouraging rural consumers to use electricity. However, the lifeline should not be set so high that it compromises the financial viability of the rural energy companies, usually it should be set up within 30-50 kWh/month. Where the lifelines are properly tied to the poverty profiles of consumers, the suppliers have been able to absorb the subsidies for the poorest consumers without causing financial difficulties. The bottom-line is that the form of subsidy generally is not as important as the way in which such the subsidies are administered. The trick is to attain a balance between too little and too much subsidy. The programs with too little subsidy generally can not ensure commercial viability of service providers, and can not benefit the poor. The programs with too much subsidy would limit the number of connections or installations of mini-grid systems, since public funds are limited.
Output Based Aid Subsidies for Service Providers Increasingly, the World Bank has been following the Output Based Aid principles to design subsidy schemes and disbursement schedules for rural electrification (including mini-grids and stand-alone renewable energy systems) projects. Output-Based Aid (OBA) is a strategy for using explicit performance-based subsidies to support the delivery of basic services where policy concerns would justify public funding to complement or replace user-fees. The core of the OBA approach is the contracting out of service delivery to a third party, usually a private firm, but in some cases not-for-profit operators such as NGOs, where payment of public funds is tied to the actual delivery of these services. Affordability concerns for particular groups of users, positive externalities, or the infeasibility of imposing direct user-fees represent examples of the types of policy concerns that have motivated governments to use public funds to support the delivery of basic services. In January 2003, the United Kingdom's Department for International Development (DFID) and the World Bank established the Global Partnership on Output-Based Aid (GPOBA), a multi-donor trust fund administered by the World Bank. The goal of GPOBA is to provide increased access to reliable basic infrastructure and social services to the poor in developing countries through the wider use of OBA approaches. GPOBA will demonstrate and document OBA methods of supporting the sustainable delivery of basic services (water, sanitation, electricity, telecommunications, transportation, health and education) to those least able to afford them and to those currently without access. The primary outputs of GPOBA are pilot demonstration projects and related activities to identify and disseminate lessons of experience on the design and implementation of OBA schemes, including the targeting of eligible beneficiaries, definition of performance requirements, the determination of payment structures, and the design of monitoring arrangements. More at http://www.gpoba.org There are two specific types of OBA subsidy schemes for mini-grid service providers: Connection subsidies reimburse the service provider for part of the costs of establishing new connections once these connections have been verified. Thus, they allow the service provider to lower the up-front connection fee, and they provide incentives to the provider to establish and maintain as many customers as possible.
Transition subsidies bridge the gap between the revenues collected through monthly tariffs and the costs incurred in providing service. They are most applicable in areas where the general customers’ ability to pay electricity tariffs is well below costs. These subsidies support on-going operation and maintenance costs, but only for a transition period and would be phased out over time. The expectation is that during the transition these costs would decline as the service provider improves its efficiency and customer resistance to tariff increases would lessen as service improves.
In Bolivia, a WBG project used OBA principles to provide four different types of subsidies: i) direct up-front customer subsidies on the initial investment cost, paid to the supplier on the basis of actual installations; ii) service quality subsidies, paid to the supplier against installation and service performance targets; iii) market development service subsidies, paid to the supplier against training of local technicians, yearly visits, users training, etc.; and iv) indirect market development subsidies (aggressive overall promotion activities, support to the formulation of business development strategies, training and technical assistance).
For another WBG project in Nicaragua OBA principles were an integral part of pre-project design. Based on the specific demand in rural Nicaragua, the project focused on microcredit (to address liquidity gaps of rural users) and targeted business development services (to increase the potential for productive uses, which in turn makes the energy provider’s business more sustainable). Approximately two thirds of the IDA credit will be used for OBA payments to the private sector providers of (i) off-grid electricity services and (ii) accompanying microcredit and business development services.
Subsidies to customers Subsidies to customers in mini-grid service areas are best used where there is diverse customer set with a wide variation in their ability to pay. In these situations, grant payments may come from poverty alleviation funds or other such mechanisms that may be available in the country or region. Grants to consumer may be used to defer the cost of up-front connection fees, or they can take to form of productive use incentives, whereby support is provided to qualifying households or micro-enterprises to encourage or enable productive uses of the electricity provided through the mini-grid system.
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