Energy Economics are Important analysis since its necessary to estimate the whether our investment give us the required output or profit without concerning it is private or public project
- Economic comparison of energy supply systems
- Economics of energy efficiency
- Energy Pricing
- Economic cost-benefit and Financial analysis of energy sector projects
Why conduct economic/financial evaluation?
It is conduct to weigh the costs and benefits of an investment and compare with norms and compare projects for their profitability, especially when investment funds are limited.
Analyses are required for both private projects (e.g.: manufacturing industry) and public projects (e.g.: power generation, transport)
Economic and Financial Evaluation of Energy Projects – Energy Economics
- Due to purpose of analysis and definitions
- Due to simple payback analysis
- Discounted cashflow analysis
Economic vs Financial evaluation for public projects
- All costs and benefits are measured in economic terms
- They reflect the point of view of the country due to Economic
- Prices exclude all taxes and customs duty, which are local transactions.
- considers all costs and benefits of the project, measured in current units of currency due to Financial.
Economic vs financial evaluation for public projects
- Typically applied to infrastructure projects due to they are simply public
- Roads, electricity, irrigation, water supply
- They are expected to be economically viable ventures due to they are simply public
- Profit is not the only objective due to they are simply public
- Typically applied to business ventures, mostly with a clear profit motive due to they are simply private
Economic costs and financial costs
Economic costs or border prices
If cost of imported goods or services. Local costs and services are converted to border prices by applying a conversion factor.
Actual costs at market prices.
Constant terms and Current terms
Costs in constant terms
Also costs measured in the currency of a (past) reference year. Hence, they exclude inflation.
Costs in current terms
Also costs measured in the currency of the day. Includes inflation, escalation and all other effects.
The increase in current costs of a predefined mix of goods and/or services In addition Inflation includes escalation.
The change in the costs of pre-defined goods and/or services, in constant currency terms. Escalation excludes inflation.
The percentage increase in the value of money over a period of one year. In addition to the time value of money, interest rate includes the effects of inflation and escalation.
The time value of money, as perceived by an investor. Usually expressed in percentage per year. Depending on the context, a market discount rate or a real discount rate may be defined. Also For public infrastructure projects, it is common to use the real discount rate and to work in constant currency terms. In addition Escalation may be applied if desired.
Simple pay-back period (SPP) – Energy Economics
- Most convenient method to screen energy management projects.
- Adequate to decide on most projects.
- No further analysis required if SPP < 2 years
SPP = Investment (USD)/Monthly Savings (USD/month) SPP is a “static” index. Also It does not consider the time-value of money
Discounted cashflow analysis
All public and private energy projects with longer (say over 2 years) SPP are usually evaluated using the discounted cashflow analysis technique. In addition The technique attaches a time-value to the expenditure and income that occurs in the future.
Discounted cash flow analysis example
USD 10 million is to be invested in a new boiler for a factory. The fuel savings will be USD 1.3 million per year. Also At the end of 10-years, it is considered to have fully depreciated.
Is the investment viable?
Assume Discount rate = r
Let r be 10%
So All costs are in constant terms of year zero. Also Assume a real discount rate of 10%. Neglect escalation.
Net present value = 7.99-10 = -2.99
Hence the project is not viable.
Present value factor
Useful index when cash flows are equal over several years
Benefit-cost analysis – Energy Economics
Present value of costs
Present value of benefits
Net present value
NPV = B – C
Project accepted if NPV > 0
Benefit-cost ratio – Energy Economics
- Project accepted if CBR > 1
- Highest CBR preferred when there are optional projects.
- The company may have a lower limit, below which projects are not Consider e.g. CBR >1.8
Internal rate of return – Energy Economics
Internal rate of return (IRR), is the value of the discount rate r, at which
B = C
- Project accepted if IRR is above the investor’s norm
- Highest IRR preferred when there are optional projects.
- IRR must be above the discount rate/bank rates, for projects to be accepts.
Also Other indices used to compare projects against each other
Life cycle cost – Energy Economics
The total PV of costs of a project to meet a given requirement are giving below due to life cycle cost
(if the product/service must be provided at any cost e.g. due to Electricity demand, due to health care, due to transport). Also Specific cost the long-term average cost of a unit of the product or the service to be provided. In addition as examples Long-term average cost of generation from a steam power plant will be 5.8 USD/kwh. Also Above things are more important in Energy economics and read next article for more energy economics details