This post is co-authored by Stephen Comello, Associate Director of the Sustainable Energy Initiative at Stanford Graduate School of Business and a Research Fellow at the Steyer-Taylor Center for Energy Policy and Finance.

With about 80 million households across rural India lacking access to electricity, the country’s policymakers have been searching for solutions to close this development gap. At the same time, the public-sector electricity distribution companies (DISCOMs) are unable to systematically extend the central grid to where it is needed.

Off-grid alternatives include kerosene lanterns and small, individual home solar systems. However, another alternative, called mini-grids, offers what these lanterns and small solar systems cannot ­­– the promise of at-scale, off-grid electrification with productive capacity; that is, the ability to simultaneously power multiple loads such as lighting, tools, appliances and machinery.

A mini-grid is a group of interconnected loads and distributed energy resources that acts as a single entity. On a per unit basis, mini-grids offer electricity at least 50% lower life-cycle cost than diesel generators, kerosene lanterns and individual home systems. Moreover, mini-grid development could spur entrepreneurship and local business opportunities in the energy sector.

Enabling mini-grid development by the private sector is mainly the purview of the State Energy Boards (SEBs) across India. While the central government has developed national mini-grid guidance, clear policy that creates the mini-grid market must originate with the state governments. Formation of such a policy is a delicate balance, as there are multiple significant barriers to mini-grid development, such as financing, revenue collection and system maintenance. Most of these hurdles can be overcome with well-formed business models, supported by effective policies.

Uttar Pradesh (UP), which has some of the lowest electricity access rates in the country, has recently announced a promising first-of-its-kind new policy promoting mini-grids, which could set the benchmark for other states to follow.

The policy offers developers flexibility with respect to the general business model to be pursued through the choice of two models. Model 1 offers a 30% capital subsidy, in exchange for the DISCOM regulating project location, mini-grid technical specification, the service level, and, customer-wise tariff rates. Model 2 is arguably the diametric opposite; no subsidy offered, with the developer free to choose location, technology service level and rate charged. Given the flexibility, there has been great interest in Model 2, with 85% of applications made under this scheme.

The policy also provides guidance with respect to the key risk for mini-grids – the threat of central grid extension. There have been multiple instances where the central grid eventually extended to a mini-grid and forced the operator out because entrepreneurs couldn’t compete with DISCOMs’ highly subsidized rates. This situation is known as a hold-up problem, where a developer is deterred from making any investment, given the lack of safeguards to provide the confidence of earning an appropriate return.

The UP policy specifies that if or when the central grid extends to the mini-grid, mini-grid electricity would be purchased by the DISCOM at “the tariff decided by UP Electricity Regulatory Commission or a tariff decided on mutual consent”, and “based on the cost-benefit analysis of the installed project, the project will be transferred to the DISCOM at the cost determined on mutual consent between DISCOM and developer by the estimation of cost (or profit loss) of the project installed by the developer.”

Unfortunately, the UP policy does not fully address the hold-up problem, primarily because of the ambiguity faced by the developer in terms of securing his investment at the time of central grid extension. Specifically, the prospect of the stated “cost-benefit analysis of the installed project”, provides no guidance or methodology necessary for a developer to understand the expected value of the mini-grid in the event of grid extension before the initial investment is made. This raises concerns about the effectiveness of the policy in deploying mini-grid capacity.

Thankfully, based on a recent study at Stanford Graduate School of Business, this policy gap can be closed with two amendments which ensure that the entrepreneur would be indifferent between the event of grid extension and continuing as an independent operator.

First, the entrepreneur should have the unilateral right to transfer ownership of all distribution and generation assets of the mini-grid to the DISCOM.

Second, the transaction price must be given by the current book value of these assets. The book value must be calculated so as to reflect economic fundamentals, based on the concept of replacement cost accounting. What this means is that if revenues are set so as to cover all operating costs, depreciation and a fair return, the developer will be indifferent between receiving a one-time buyout of the mini-grid equal to current book value, or continuing to operate the mini-grid.

Taken together, these amendments would significantly improve UP’s mini-grid policy, leading to UP maximizing mini-grid investment and, therefore, deployment. The success of UP’s mini-grid policy would send a positive signal to other states, and enable them to help India move towards its off-grid deployment targets of 3 GW.