2A82 Basic Economic Analysis 2012

Dr. Congxiao ShangRoom No.: 01 30

Email: [email protected]

ENV-2A82: Low Carbon EnergyBasic Economic Analysis

ENV-2A82 (2011/2012): Low Carbon Energy

N.Keith Tovey ( 杜伟贤 ) M.A, PhD, CEng, MICE, CEnv Н.К.Тови М.А., д-р технических наук

Room No.: TP2.09Email: [email protected]

Recipient of James Watt Gold Medal for Energy Conservation

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Objectives of this SessionTo examine methods to assess whether an energy project is economically viable.Energy is a multi-disciplinary subject and other criteria are also needed

PHYSICAL

TECHNICAL

ECONOMIC

ENVIRONMENTAL

SOCIAL

POLITICAL

Fuel Poverty Issues

UEA Heat Pump Scheme 1981

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ENERGY

See Webpage for details

2.1 Introduction• An energy project should consider whether to:

1) promote energy conservation, and/or energy efficiency.

Is there a difference between Energy Efficiency and Energy Conservation?

2) develop low carbon energy resources,

• nuclear, wind, tidal, wave, • solar, hydrogen , and biofuels etc• carbon sequestration3) exploit conventional and cheaper fossil fuels and keep energy bills

low at the present,

But what of the future?

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How and why do charges for fuels vary? e.g. Electricity: - Retail Costs made up of several components1. The cost of actual generation – depends on• fuel used – consequently efficiency e.g. Coal 35 – 38%, Gas 47 – 55% efficient Physically limited by Laws of Thermodynamics – not Technical Limitations • fuel cost – UK is now a significant importer, volatile international markets

affect prices – before 2004 UK was an exporter • Carbon Permit prices – more permits needed for coal2. A charge for High Voltage Distribution – varies significantly

across UK.3. A charge levied by each of 14 Regional Distribution Network

Operators - varies depending on industrial mix in region4. A charge by Electricity Retailer for actual units consumed5. A charge for meter reading.

Gas: tariffs vary with region4

Transmission Demand Charges

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Distributed Network OwnershipScottish & Southern

United UtilitiesCE Electric UK Western Power

Iberdrola

UKPower Networks( Hong Kong Electric)

1

3

2

65

4

11

710

98

1213

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Zone Energy Consumed (p/kWh)

1 0.790954 2 1.547861 3 1.993796 4 2.552189 5 2.520788 6 2.625780 7 2.886193 8 3.184194 9 3.026211 10 3.028765 11 3.377343 12 3.602492 13 3.537180 14 3.553243

Current charges as of 1st April 2011

2.1 Introduction• How is profitability of electricity generation assessed?• Clean Spark Spread (CCS) – a measure of profitability of electricity

generation by gas. CSS = PE - PG /EG - PCO2 * IG Where PE is wholesale price of electricity PG is wholesale price of gas EG is efficiency of gas generation ~ 50% (range 47 – 55%) PCO2 is Price of EU Emission Permits IG is Emission Intensity of gas = 0.20196/ EG (tCO2/MWh)

• Clean Dark Spread (CDS) – equivalent for coal generation CSS = PE - PC /EC - PCO2 * IC

Where PC is wholesale price of gas EC is efficiency of gas generation ~ 38% (range 35 – 38%) IC is Emission Intensity of coal = 0.34056/ EC (tCO2/MWh)

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* Emission Intensity values are typical from IPCC (2006)

See paper by Abadie and Chamorro (2008) for more information

2.1 Introduction• Decisions as to whether an energy project is viable are often/

usually made on the basis of an economic analysis alone.• However, imperfect analysis of energy issues can be flawed,

and give misleading answers on decisions made.• Often different researchers will come up with very different

answers - WHY????

A project costs:

£100

To implement Is this project viable?

£20£20 £20 £20 £20

Annual Saving

1st 2nd 3rd 4th 5th

£20£20 £20 £20£20£20 £20

We will explore many of the issues in this lecture7

2.1 Introduction• Some concepts for simple cost benefit analyses.

• Those who have done/are doing Environmental Economics will know some statements below are somewhat simplified, but some important questions are raised in context of Energy.

Should traditional ideas about cost benefit analysis – e.g. Pay back time prevail?

e.g. Example at NKTs house?

8Solar PV Solar Thermal

How cost effective is Car Insurance???

2.2 Discount Rate

£100 invested in savings giving 5% will generate £105 after 1 year, i.e. 100 * 1.05 = £105

After 2 years the return will be £110.25 i.e. 105 * 1.05 = £110.25This is the compound interest return on £100

It is not £100 * 1.05 + £100 * 1.05 = £110 which would be the simple interest

Similarly after 25 years, compound interest would generate £338.64 compared to £225 from simple interest

If one has to borrow money for a project then these values also indicate the total amount to be repaid – i.e. £110.25 and £338.64 respectively – not £110 and £225

This aims to account or the effects of inflation when assessing the economic viability of a project.

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2.2 Discount Rate

On the other hand what would be the value of £100 saved in 1 years time in present day terms if inflation were 5%?.

£95.84 - not £95 or £100 saved in 25 years time would be worth £29.53 in today’s money

Here we are using the present time as a reference and the present value of money to assess future savings.

This introduces the term Net Present Value (NPV) to evaluate the present value of future savings.

In addition the term Discount Rate is used to deflate future costs/savings to the present day (5% in the example above).

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2.2 Discount RatesSupplementary Information: Mathematically, the discount rate is slightly different from the interest rate.

In the example given above using 5%•£100 in savings would grow to £105 – an increase of £5 in the year.

•However, £100 in a years time at 5% discount rate would be equivalent to £95.84 or a reduction of £4.16.

It is the discount rate that is used to project future cash flows whether these are savings or maintenance costs so that it is in terms of the Net Present Value.

Mathematically the discount rate (D) is related to the interest rate (I) as follows:

D = I / (1 + I) 11

2.2 Discount RatesThe choice of Discount Rate significantly affects the estimated financial viability of a project.•High discount rates favour fossil fuels•Medium discount rates favour nuclear power•Low/zero discount rates favour conservation/renewables as will be seen later.

Even though one might think one is being objective in comparing different energy schemes, the simple selection of one discount rate over another may end up by biasing the result in one direction.

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However we are jumping ahead – how do we work out the overall NPV of a project?

2.2 Discount RatesWe can assess the economic viability of a project using the discount rate to determine the Net Present Value in two different ways: The Individual discount tabular method (the sledge hammer approach)The Cumulative discount approach using cumulative discount factor tables

Example:A conservation project which has a capital cost of £100 but saves £20 p.a. - assume a discount rate, r = 5%:

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Year Capital Outlay

fuel Saving

Discount actor

NPV of fuel

saving0 £100 1 £20 0.952381 £19.052 £20 0.907029 £18.143 £20 0.863838 £17.284 £20 0.822702 £16.455 £20 0.783526 £15.676 £20 0.746215 £14.927 £20 0.710681 £14.21

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2.2 Discount Rates: Individual Discount Rate ApproachThe discount factor of the year n can be computed from the formula: 1

1( ) r nThe NPV of a saving (or cost) = (value of saving in the year n) (the discount factor of the year):

The NPV reflects the value the fuel saving would have if it was accounted at the present time rather than some years into the future.

The cumulative savings over 5 years= £19.05 + £18.14 + £17.28 + £16.45 + £15.67 = £86.59i.e. project would make a loss if equipment only lasted 5 years There would be a profit of £1.51 over 6 years: or £15.73 over 7 years.

Frequently projects will also have annual operating costs/maintenance and these should be treated as future costs in a similar manner to the savings.

Year Capital Outlay

fuel Saving

Cumulative Discount

factor

Cumulative NPV of fuel

saving0 £100 1 £20 0.952381 £19.052 £20 1.85941 £37.193 £20 2.723248 £54.464 £20 3.545951 £70.925 £20 4.329477 £86.596 £20 5.075692 £101.517 £20 5.786373 £115.738 £20 6.463213 £129.269 £20 7.107822 £142.1610 £20 7.721735 £154.43

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2.2 Discount RatesThe approach shown previously is tedious: often

the cumulative discount approach can be usedThe cumulative discount factor is the sum of the discount factors up to and including the year n.

These cumulative factors are available in tables such as the ENV Data Book.

The answer is the same as previously but it is much quicker in use as only the life time number of years is needed.

Note how critical the choice of the life time of the project is in assessing its viability.

Example with 5% discount rate

How can one calculate cumulative discount rate if tables are not available?

2.2 Discount Rates - summary

The Cumulative Discount Factor in year n is the sum of all the discount factors from year 1 to year nAnd this can be shown to be equal to:

The Cumulative NPV to year n is thenAnnual saving x the Cumulative Discount Factor

Remember: If annual saving varies – e.g. because maintenance costs vary, then cumulative approach cannot be used.

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])1(*[11

nrrr

2.3 Internal Rate of Return (IRR)• For a Project to be viable it must have a positive NPV taking into account

capital costs, running costs, savings etc. However, two projects may seem similar, but because of different times of expenditure, one may be preferable to another.

• Two cases both have capital cost of £100,– Case A has savings of £60, £60, £40, £20, £20 in years 1 – 5– Case B has savings of £20, £20, £40, £60, £60 – i.e. Same total saving

• Which is more attractive?

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Timing5%

discount factor

CASE A CASE B

Net Cash Flow

Present Value

Net Cash Flow

Present Value

Capital Expenditure -£100.00 -£100.00 -£100.00 -£100.00

Year 1 0.952381 £60.00 £57.14 £20.00 £19.05Year 2 0.907029 £60.00 £54.42 £20.00 £18.14Year 3 0.863838 £40.00 £34.55 £40.00 £34.55Year 4 0.822702 £20.00 £16.45 £60.00 £49.36Year 5 0.783526 £20.00 £15.67 £60.00 £47.01

TOTAL £100.00 £78.24 £100.00 £68.12

2.3 Internal Rate of Return (IRR)• The internal Rate of Return IRR is the discount rate at which the NPV

becomes zero over the project lifetime.

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If discount rate < IRR then scheme is profitable – otherwise a loss will ensue.

In case A, IRR is ~ 38%In case B it is ~ 22%

Thus option A is a better investment and considerably better than normal savings, against which IRR should be compared.

See also http://www.solutionmatrix.com/internal-rate-of-return.html

http://www.solutionmatrix.com/internal-rate-of-return.html

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2.4 Discount Rates: A cautionary note when assessing different energy projects

Discount Rate

Net Present Value

+ve-ve C

apita

l Cos

ts

coal

nuclear

Renewables/conservation

coal

nuclear

Fossil fuels have relatively low capital costs, but significant fuel costs. NPV significantly affected by discount rate.

Nuclear has medium capital costs but low fuel costs. NPV less affected.

Renewables/ Conservation usually have high capital costs but low running costs. Little effect on NPV

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2.4 Discount Rates: A cautionary note when assessing different energy projects

+ve-ve

coal

nuclear

Fossil fuels have lowest NPC at high discount rates therefore more financially attractive

Nuclear lowest NPC at medium discount rates.

Renewables/ Conservation have lowest NPC at low discount rates.

What about negative discount rates?

Renewables/conservation

Discount Rate

Net Present Cost

2.5 Example 1: An Economic Assessment of loft insulationRoof Area of average house = 49m2, post-war house with no insulation U-value – a measure of heat loss is ~ 1.6 WoC-1m-2

The lower the U-value the less heat is lost You will cover U-values later in the course

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Insulation thickness (mm)

U-Value (WoC-1m-2 )

Heat Loss through 49m2 roof(WoC-1 )

Annual Heat Loss

(GJ)

Saving (GJ)

0 1.6 78.4 14.90 0%100 0.33 16.2 3.07 79%200 0.18 8.8 1.68 89%300 0.12 5.9 1.12 93%

The annual heat loss is the Heat loss multiplied by number of second in a day (86400) multiplied by Degree days (typical average 2200). Then divide by 109 to get to GJ

Price of Energy [British Gas Standard Tariffs on 12/01/2012] Gas: (break point 2680 kWh per year) Tier 1 8.755p/kWh Tier 2 4.036p/kWh [£11.21/GJ] Full Rate Electricity (break point 720 kWh per year) Tier 1 24.806p/kWh Tier 2 11.4536p/kWh [£31.82/GJ] Off Peak Electricity 6.919p/kWh [£19.22/GJ] Oil BoilerJuice.Com [12/01/2012] 59.3p per litre equivalent to 5.735834 p per kWh* [£15.93/GJ] [* conversion factors1244 litre/tonne and 46.3 GJ/tonne ]

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Capital Cost B & Q 12/01/2012 -£3.00 per roll of 5.5sqm @ 200mm thick = £1.84 per sqm. However, cost of 100mm thick was ~ £3.60 per sqm!!!

2.5 Example 1: An Economic Assessment of loft insulation

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Capital CostsCase 1 No insulation Case 2 Provide 200 mm insulation – capital cost = 49 * £1.84 = £90Case 3 Provide 300 mm insulation - capital cost = 49 * £5.44 = £266Case 4 Existing 100mm insulationCase 5 Top up to 200mm insulation – capital cost = 49 * £3.60 = £176Case 6 Top up to 300mm insulation – capital cost = 49 * £1.84 = £90

Efficiency No Insulation 100mm 200mm 300mmHeat Lost 14.90 3.07 1.68 1.12

Energy Required (GJ/annum)Electricity 100% 14.90 3.07 1.68 1.12Gas Condensing 90% 16.56 3.41 1.87 1.24Oil Non Condensing 70% 21.29 4.39 2.40 1.60

Energy Requirements From slide 21

Energy Required = Heat Lost / Efficiency


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No Insulation 100mm 200mm 300mmElectricity Full rate £474.05 £97.67 £53.45 £35.63Electricity Off Peak £286.37 £59.00 £32.29 £21.53Gas Condensing £185.66 £38.23 £20.96 £13.90Oil Non Condensing £339.21 £69.95 £38.24 £25.49

Annual Energy Running costs using Tier 2 values from slide 22

Annual Savings

Initial Status

Upgrade to

Full Rate Electricity

Off Peak Electricity Gas Oil

No insulation

200mm £421 £254 £165 £301300 mm £439 £265 £172 £314

100 mm 200 mm £44 £27 £17 £32 300 mm £62 £37 £24 £44


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Initial Status

Upgrade to

Capital Cost



No insulation

200mm £90 2.6 months 4.3 months 6.6 months 3.6 months300 mm £266 7.3 months 12.1 months 1.5 years 10.2 months

100 mm 200 mm £176 4.0 years 6.6 years 10.2 years 5.6 years 300 mm £90 1.5 years 2.0 years 3.7 years 2.0 years

Simple Payback time – no discounting

Note: cost effectiveness is very much less if there is 100mm loft insulation, but grants favour those with no insulationPayback using 5% discount

Initial Status

Upgrade to

Capital Cost



No insulation

200mm £90 2.7 months 4.5 months 6.9 months 3.8 months300 mm £266 7.6 months 1.1 years 1.7 years 0.9 months

100 mm 200 mm £176 4.6 years 8.2 years 14.6 years 6.7 years 300 mm £90 1.5 years 2.6 years 4.2 years 2.2 years


• Always add the most insulation possible – incremental upgrades are much less cost effective.

• Grants are available 50%+, but only if insulation is fitted professionally. Analysis on previous slides is DIY, for which there are usually no grants.

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2.6 Example 2: Solar PhotovoltaicWhat is cost of generating electricity– e.g. solar Photovoltaic???

nn rEuI )1(

n

x

xrEuCI1

)1(

In is income in year nE is annual energy generatedr is discount rateu is unit charge for electricity

In absence of maintenance charges, income over life time of n years must >= capital cost C

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2.6 Example 2: Solar Photovoltaic

nrr

ECu

)1(1Rearranging gives:

Solar PV Solar Thermal

PV array has a gross output of 1.25 kW and after inverter losses ~ 1.15kW

At Load factor of ~ 10% this will generate ~1000 kWh per annum.

The capital cost was £6500What is unit cost which would make scheme profitable over 25 years.For simplicity – ignore maintenance costs.Load factor = Net output over year as % of theoretical generation

– see notes on this slide

Life time Discount Rateyears 2% 4% 6% 8% 10%

15 50.2 58.0 66.4 75.4 84.820 39.5 47.5 56.2 65.7 75.825 33.0 41.3 50.5 60.4 71.1

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2.6 Example 2: Solar Photovoltaic

Unit Cost of generating electricity by Solar PV to ensure investment is recouped over life span of project

Notice how dependent actual cost o generation is on:•Discount rate chosen•Life Span of project (note – some of cells on ZICER are having to be replaced after 8 years

2.6 Project life and Choice of Discount Rate

Small Schemes:

Exceptional Schemes: with pay back period over 5 years are rarely considered unless the existing equipment is nearing the end of its life and has to be replaced anyway

Usually must have pay back in no more than 9-18 months

Definitely Cost effective in 2 years

Project life for an installation in industry:

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2.7 Summary Conclusions The project must have a net positive present value over its life

span The project should have the most favorable rate of return when

compared to other projects, or to direct investment (i.e. use IRR as an indicator here).

If money has to be borrowed to undertake the project, then the rate of return must be greater than the borrowing rate.

The choice of specific discount rate can often bias an answer towards a particular option

The choice of discount rate and life span of a project affects estimates of future costs of generating electricity

Other considerations are also relevant – What price SECURITY of SUPPLY??

An Economic assessment should be only one of several considerations when assessing a project

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2A82 Basic Economic Analysis 2012