Dr. Congxiao Shang

Room No.: 01 37PEmail: c.shang@uea.ac.uk

Section 2: Basic Energy Economics Analysis

ENV-2D02 (2006):Energy Conservation

2.1 Introduction• Decisions to an energy project should largely be

made on the basis of economic analysis.

• Imperfect analysis of energy issues can be flawed, and give misleading answers on decisions made.

A project costs:

£100

To implement Viable

£20£20 £20 £20 £20

Annual Saving

1st 2nd 3rd 4th 5th

£20£20 £20 £20£20£20 £20

2.1 Introduction

• An energy project should consider:- whether to promote energy conservation, i.e. energy saving,

- or to develop new energy resources, such as wind, tidal energy, solar, hydrogen and biofuels etc

Main objective: To assess whether an energy project is economically feasible.

2.1 Introduction• Decisions to an energy project should largely be

made on the basis of economic analysis.

• Imperfect analysis of energy issues can be flawed, and give misleading answers on decisions made.

A project costs:

£100

To implement Viable

£20£20 £20 £20 £20

Annual Saving

1st 2nd 3rd 4th 5th

£20£20 £20 £20£20£20 £20

2.1 Introduction• Before answering the question – correctly…

Let’s revise some concepts for simple cost benefit analyses.

Those who have done Environmental Economics will know some simplifications in what is described below.

2.2 Discount Rate

On the one hand, money borrowed to implement a project will incur interest charges which are compounded each year.

On the other, the value of money or saving declines with time, due to inflation.

To simplify the analysis, we use the present time as a reference for analysis (hence, interest charge is not an issue), the concept of a Discount Rate to account for inflation, and the Net Present Value (NPV) to evaluate the present value of future savings.

The concept of discount rate is introduced because of the following facts :

2.2 Discount Rates

The term, discount rate , is used to determine the present value of future cash flows arising from a project, i.e. the discounted value of future cashflows, due to inflation.

The actual value of the discount rate is equivalent to the basic interest rate that a high-street bank is charged to borrow funds directly from the Central Bank.

2.2 Discount Rates

We can analyse the economics of a project using the discount rate in two ways:

Individual discount approachCumulative discount approach

For a conservation project which costs £100 to implement, we save £20 p.a. with a discount rate, r = 5%:Year Capital

Outlay Fuel

Saving Discount Factor

NPV of fuel saving.

0 £100 1 - £20 0.952381 £19.05 2 - £20 0.907029 £18.14 3 - £20 0.863838 £17.28 4 - £20 0.822702 £16.45 5 - £20 0.783526 £15.67 6 - £20 0.746215 £14.92 7 - £20 0.710681 £14.21

The discount factor of the year n can be computed from the formula:

2.2 Discount Rates

1

1( ) r n

1

1( ) r n

Year Capital Outlay

Fuel Saving

Discount Factor

NPV of fuel saving.

0 £100 1 - £20 0.952381 £19.05 2 - £20 0.907029 £18.14 3 - £20 0.863838 £17.28 4 - £20 0.822702 £16.45 5 - £20 0.783526 £15.67 6 - £20 0.746215 £14.92 7 - £20 0.710681 £14.21

The NPV( Net Present Value) = (value of saving in the year n) (the discount factor of the year): reflects the value of the fuel saving would have if it were accounted at the present time rather than some years into the future. It accounts for the effect of inflation.

The discount factor of the year n can be computed from the formula:

2.2 Discount Rates

1

1( ) r n

1

1( ) r n

Year Capital Outlay

Fuel Saving

Discount Factor

NPV of fuel saving.

0 £100 1 - £20 0.952381 £19.05 2 - £20 0.907029 £18.14 3 - £20 0.863838 £17.28 4 - £20 0.822702 £16.45 5 - £20 0.783526 £15.67 6 - £20 0.746215 £14.92 7 - £20 0.710681 £14.21

To sum up, the accumulated NPV fuel saving over the first five years is £86.59, which is still £13.41 short of repaying the initial capital of £100, i.e. a loss of £13.41, the project would not be viableHowever, if the project’s life span is 6 years with no further cost, the total NPV becomes £100 +£1.51 For 7 years life span, the NPV = £100 + £15.72, certainly viable!

Cumulative discount approach2.2 Discount Rates

Year Capital Outlay

Fuel Saving

Cumulative Discount Factor

Cumulative NPV of fuel saving.

0 £100 - 1 - £20 0.952381 £19.05 2 - £20 1.859410 £37.19 3 - £20 2.723248 £54.46 4 - £20 3.545951 £70.92 5 - £20 4.329477 £86.59 6 - £20 5.075692 £101.51 7 - £20 5.786373 £115.73 8 - £20 6.463213 £129.26 9 - £20 7.107822 £142.16 10 - £20 7.721735 £154.43

It gives the cumulative factor of discount up to and including the year n. it is usually quicker to use such values rather then some the individual discount values as shown in the previous table

How to calculate Cumulative discount factors?

2.2 Discount Rates

The Cumulative Discount Factor in year n is the sum of all the discount factors from year 1 to year n

The Cumulative NPV to year n is the sum of all the NPVs of individual savings from year 1 to year n;

or

= Annual saving x the Cumulative Discount Factor

Project Life depends on a number of factors:

A single initial cost

Compensation factors, e.g. fuel price rises

Offsetting factors, e.g. maintenance charges

Competing schemes, e.g. a new process that gives more profit than the saving from the project, for the same initial investment

2.3 Project life and Choice of Discount Rate

2.3 Project life and Choice of Discount Rate

Life span:

Small Schemes

Exceptional Schemes with pay back period

no more than 9-18 monthsCost effective 2 years

will be considered; Over 5 years rarely considered

2.3 Project Life and Choice of Discount Rate

• Discount rates vary from time to time depending on the economic climate;

• Different organizations will set different target discount rates

1) A higher discount rate 10%+ favours coal and fossil fired

power generation.2) Moderate discount rates ~5% tend to favour gas and

nuclear options.

3) Low discount rates, even≤ zero, favour conservation and renewable energy.

2.4 Fuel Price Rises

2.5 Negative Discount Rates

At one discount rate, the NPV over the life of the project is 0, this corresponds to the Internal Rate of Return.

The figure shows the results of analyzing the example in 2.2 with differing discount rates for a project life of 7 years.

The NPV becomes zero for a discount rate of 9.2% - the Internal Rate of return.

The graphical approach is much quicker to determine the IRR than a numeric method.

2.6 Internal Rate of Return (IRR)

2.6 Internal Rate of Return (IRR)

•The IRR is the discount rate that makes net present value of all cash flow equal zero or the project will break even.

• If you apply a discount rate to future cashflows that is higher than the IRR, the project will make a loss in real terms. If you apply a discount that is lower than the IRR, the project will be profitable

Profitable Non-profitable

2.7 The Changing Price Structure for Electricity & Gas

Electricity Charges will be in three parts: 1.Charge to the Regional Electricity Company

(REC) for transmission which will be the same for all suppliers

2.Charges for the actual units used 3.A charge for meter reading

GasDuel fuel

2.8 Trends in Energy TariffsIn the case of electricity, the corresponding tariffs are: (from WEB Site, 19th December 2005)

EDF Tariff

PowerGen Tariff

Standing Charge per annum £59.24 unit charge 6.56p

First 800 units (p) 10.7415p Remaining units (p) 8.1165p

First 900 units (p) 12.31p Remaining units (p) 7.33p

Scottish Power Tariff

2.8 Trends in Energy Tariffs

0

50

100

150

200

250

300

350

0 500 1000 1500 2000 2500 3000 3500 4000

Scottish Power

EDF

PowerGen

Comparison of three electricity tariffs

2.8 Trends in Energy TariffsIn the case of gas, the corresponding tariff for PowerGen: (19th December 2005)

Unlike the electricity, the gas tariffs were more uniform across the country. However, there are variations recently due to competition introduced to the distribution of gas as well

Standing Charge 0 unit charge for first 4572 kWh 3.63 unit charge for gas consumed above the threshold

2.05

2.9 Some Examples on loft insulationExample 1: Area of average house = 49m2

Assume house with no loft insulation Situation after insulation measures

Pre War Post War

Heat Loss through roof (WoC-1) 146 85

Annual Energy Loss (GJ) 30.7 17.8

Full rate Electricity 100 625.09 484.49*

362.43 282.06*

Off Peak Electricity 90 336.85 272.47*

195.31 158.63*

Gas 75 233.09 164.96*

135.15 96.04*

Gas condensing Boiler 90 194.24 137.47*

112.62 80.03*

After Saving Post War House Annual Energy Loss (GJ) 3.34 14.5 Full rate Electricity 100 68.01

52.85* 295.24 229.21*

Off Peak Electricity 90 36.6529.72*

159.10 128.91*

Gas 75 25.3618.00*

110.09 78.04*

Gas condensing Boiler 90 21.1315.00*

91.74 65.03*

* Energy costs based on tariffs from Dec. 2003. The differences indicate the rise in prices over last two years.

2.9 Some Examples on loft insulation

Gas heated (condensing boiler) case again

Initial consumption will be 6.48 GJ (c.f. 30.6 GJ) for pre-war house.

Initial annual consumption for post war house = 5.63 GJ (c.f. 17.8GJ)

NOTE: you will be shown howto calculate the values of 6.48and 5.63 later in the course.

Example 2: Area of average house = 49m2; some house with 50mm insulation already

Calculation:

2.11 Criteria for Investing in a Project

The project must have a net positive present value over its life span

The project has the most favourable 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 rate of return must be significantly above the direct investment rate as capital is tied up and cannot be used for other things.

2.2 Discount RatesExample of a compounded interest rate: A project is cost £100, borrowed at 5% interest rate

The total amount repaid: £100×1.05=£105

After one year

After two years

The total amount repaid: £105×1.05=£110.25

By the end of fifth year

The total amount repaid: £100 ×1.055 = £127.63

not £100 +5 × £100 × 5% = £125 in the simple interest case

2.2 Discount RatesOptional Information: In fact a discount rate is slightly different from the

interest rate, mathematically…The discount rate is based on the future cash flow in lieu of the present value of

the cash flow.E.g. we have $80, and we buy a government bond that pays us $100 in a year's

time. The discount rate represents the discount on the future cash flow:(100-80)/100= 20%

The interest rate on the cash flow is calculated using 80 as its base:(100-80)/80= 25%

Hence, for every interest rate, there is a corresponding discount rate, given by:d= i/(1+i)

Again when referring to a cash flow being discounted, it will likely refer to the interest rate and not the proper mathematical discount rate.

However, the two are separate concepts in financial mathematics.

2.10 Some Comments on these examples.

• The examples show exactly how cost effective loft insulation can be particularly if there is no insulation to start with.

• It pays to install thicker insulation at outset as it will be cost effective (even if there is no grant).

• It becomes progressively uneconomic to upgrade insulation standards, and that if 100m already exists, it is not cost effective to upgrade, even though it is cost effective to put in 150mm from scratch

• The present grant system is a disincentive to those who have spent money in the passed.

• Grants of up to 90% are available for pensioners• It is argued that the poor cannot afford the capital outlay. The poor will not

have condensing boilers, and are more than likely to have electric heating, and pay back is within a few weeks. With an extended 90% grant, the capital cost is no more than £10, so this can hardly be construed as a deterrent

Or see the lecture notes

Scottish Hydro

Scottish Power

Northern

Yorkshire

Eastern

London

East Midlands

SEEBOARDSWEB Southern

NORWEB

MANWEB

Midlands

SWALEC

Scotland

Шотландия

England & Wales

Англия

и Уэльс

Structure of Electricity Supply in early 1990s Структура

системы энергоснабжения в начале 1990 г.г.

Scotland Шотландия

Vertical Integration Вертикальная интеграция

• two companies две компании

England and Wales Англия и Уэльс

12 Regional Supply Companies 12 региональных компаний

also Distributed Network Operators а также распределяющие сетевые операторы

Regional Supply

Ownership Владение

региональных поставщиков

Distributed Network Ownership in 2004

Scottish & SouthernScottish Power

nPowerPowerGen

Electricité de France

Scottish & SouthernScottish Power

United Utilities

Mid American

Electricité de France

Western Power

Distributed Network

Ownership Владение

распределительной сети

PowerGen

Aquila

Central Networks

Distributed Network Ownership in 2005 Владение распределительной сетью в 2005