Energy cost

analysis

Cost analysis

Price vs costs

Scarcity cost

Marginal cost

Investment analysis

Fixed & running costs

Discounting

External costs

Cost-benefit analysis

Opportunity cost

What is
economic
evaluation?

A SOCIAL SCIENCE
THAT EXAMINES
PEOPLES AIM TO FULFIL
THEIR SELF-INTEREST (?)

Economics: The Science of

Choice

In a world of limited
resources and unlimited
wants, economics
evaluates how countries
(macro-economics) and
individuals (microeconomics) choose
what, how and for whom
goods (and services) are
produced.

The father of modern

economics is Adam
Smith. In his book An
Inquiry into the Nature
and Causes of the
Wealth of Nations he
explained how markets
determine prices.

Scarcity

Limited resources versus unlimited wants and

needs

Resources:

Individual: Time, money, skill

Country: Natural resources, capital, labour force

and technology

Each economy will have different values,

reflecting the particular scarcities they are
faced with. They must decide how to best
allocate their resources

The Economic Spectrum

The systems by which resources are allocated can

be placed on a spectrum.

At one end is the Market Economy. This promotes

the determination of resource allocation by forces in
a competitive market (the invisible hand)

At the other end is the Command Economy. This

relies on government to decide how resources
should be allocated.

Most modern mixed economies lie between the

two.

The price mechanism

Price

Price

The actual cost of acquiring or

producing something
calculated in terms of a
specific measure;

the value of a commodity or

service regarded or estimated
in relation to some quantifiable
unit of comparison;

the exchange value of

something (esp. labour)
expressed in monetary terms.

The price mechanism

The Price mechanism is the

means by which the all the
decisions taken each day
by consumers and
businesses, in a free market
economy, interact to
determine the allocation of
scarce resources between
competing uses in the most
efficient way possible.

Price vs cost

Price value paradox, how come the price of water

is so low when it is so valuable?

Why does a pizza cost 6 USD to buy?

Why does electricity cost 0.1004 USD/kWh?

Definitions

Demand

The quantity of a product or

service that is desired by
buyers at a certain price

The relationship between

price and quantity
demanded is called the
Demand Relationship

Supply

The quantity of a product or

service that producers are
willing to offer at a certain
price

The relationship between

price and quantity supplied
to market is called the
Supply Relationship

Law of demand
As the price of a good
goes up so does the
opportunity cost of
buying the good.
Therefore people will
buy less so they dont
have to go without
something else they
value more

Elasticity of demand

The responsiveness of
demand to a change in
price of a good.

Elasticity=

If elasticity => 1, then elastic

demand

If elasticity < 1, then

inelastic demand

%change in quantity
%change in price

Factors affecting Demand

elasticity

Availability of substitutes

Amount of income available to spend on the good

World oil price compared with the petrol price at local

petrol stations

change in the balance between income and price of

the good will affect the opportunity cost and demand
elasticity

Time

Demand may start as inelastic and then become

elastic as a reaction to difficulty affording the change
in price.

Shift in demand

In addition to price, demand will be affected by other factors, such as:

consumers incomes, advertising, collective fashions, tastes and
preferences, competition from alternative goods, even climate change.

Law of supply
Producers supply more at a higher price because selling a
higher quantity at a higher price increases revenue.

Law of supply

Assumes the incentive for businesses to supply goods to

market is to make profit to sell the good at a higher
price than the cost of production.

If the costs of production (and other factors) remain

constant then producers will increase supply if prices
rise, and decrease if they fall.

At low prices only the most efficient and low cost

producers can afford to produce a good.

If prices increase then new producers will enter the market

and existing producers increase production

At very high prices other businesses may consider

changing their production plans and become suppliers
too.

Elasticity of supply over time

Spot Market

Short Term

Long Term

Supplies are fixed to

existing, identifiable
stocks. For example the
palm oil harvest for
biofuels.

Supplies are price

inelastic. Increase
gained by working
existing resources harder

Supplies are price

elastic. More factors of
production are
employed

Shift in supply

As with demand, supply will be affected by other factors, such

as: a change in production costs due to technological
breakthrough or breakdown, an increase in wages, distribution
hold-ups; and government regulations, taxes and incentives.

Supply and demand

equilibrium

At this point the allocation of resources is its

most efficient.

Ecuador?

19

Case study: Wind power

integration

Case study: Wind power

integration
How wind power influences the power spot Price at different times of day:

Higher winds ~ Lower power prices

Case study: Wind power

integration

An increase in wind will influence the electricity Price most

furing pweriods of high demand

Case study: Wind power

integration
Based on actual data, the difference between the influence of
wind during periods of high demand (day time) and low demand
(night time) can be clearly seen.

24

Investment analysis

How much does it cost to produce 1 kWh of

electricity from a coal fired power plant?

Basic methods for

comparison and selection

Sustainable energy relative to

conventional energy
Pros
Usually lower operating cost
Environmentally cleaner
Often more cost effective on
life-cycle cost basis

Cons
Typically higher initial costs
Lack of infrastructure

Energy Project Development

Pre-feasibility Analysis
Feasibility Analysis
Development and Engineering

Construction and
Commissioning

Projects
often stall
here

Annual fuel costs

Life cycle cost

Total costs Initial costs

O&M costs
Major overhaul costs
Decommissioning cost
Financing costs
Unforeseen costs

Methods for comparison and

selection

Simple payback

Discounted payback

Net Present Value

Internal Rate of Return

Modified internal rate of

return

Profitability Index

Benefit to cost ratio

Total life cycle costs

Levelised cost of energy

Savings to investment
ratio

Sensitivity analysis

Probability analysis

Be aware of the use and limitations of each one

Payback period

When net savings =

capital cost

Any cost savings beyond

the payback period can
be considered as profit.

The shorter the period

the more attractive a
proposal

The acceptable length

depends on the investor.

[years]

CC = capital cost of
the Project [$]

AS = anual net cost

savings after O&M
costs have been
accounted for [$]

Limitations of the simple

payback period method

The payback method would select project A or B, but would

be unable to decide between the two.

Interest

Investors will often use loans to help pay for capital

investments.
Investments funded this way will cost more than those
funded by 100% equity, because interest will be
charged on the loan
Interest can be calculated as simple interest or
compound interest

Interest

Simple Interest

Interest is charged as a fixed

percentage of the capital
borrowed.

Repayments are calculated using:

= +

100

TRV = total repaiment value ($)

LV = initial loan value (S)

IR = interest rate (%)

P = repayment period (years)

Compound Interest

The interest is charged as a

percentage of the outstanding
loan at the end of each given
time period (typically a year).

The outstanding loan is the sum

of the unpaid capital and the
interest charges up to that point

It is calculated by:

= 1 +

100

The discounting method

A cash flow of $1000 in the tenth year of a project

will be worth less than a cash flow of $1000 in the
second year of a project.

The discounting method accounts for this by

equating each future cash flow value to its present
value (usually year 0 of a project)

The present value (PV) is determined by using an

assumed interest rate, referred to as a discount
factor.

Future Value (FV)

For the previous example of a

company investing in CHP,
imagine instead they
invested the money ($37,000)
in the bank, at an interest
rate of 8%.

The value of the investment

would grow as the
compound interest is added.

After n years the value of the

sum would be:

100

The value of the sum at the

end of year 1

= 37,000 + (0.08 x 37,000) =

$39,960.00

FV = future value of the

investment ($)

The value of the sum at the

end of year 2

D = value of the initial deposit

(investment) ($)

= 39,960 + (0.08 x 39,960) =

$43,156.80

IR = Interest rate (%)

= 1 +

Present Value and

Discount factor

Present value (PV)

The present value (PV) of an

amount of money at any
specified point in the future
can be determined by:

1+100

PV = present value of S ($)

S = value of cash flow ($)

n = number of years in the

future (years)

Discount factor (DF)

Based on an assumed
discount rate, DR (interest
rate)

Determined using:

1+100

Net present value (NPV)

The summed up present value of all the yearly

cash flows (capital costs and net savings)
incurred or accrued throughout the life of a
project

Costs have a negative NPV.

Savings have a positive NPV.

The higher the NPV the more attractive the

proposed project

Project 1 Project 2

Example
Use the NPV method
to evaluate the
financial merits of the
two proposed projects
shown below. Assume
an annual discount
rate of 8% for each
project.

Capital cost

$ 30000

$ 30000

Year

Net annual savings

$ 6000

$6600

$ 6000

$6600

$ 6000

$6300

$ 6000

$6300

$ 6000

$ 6000

$ 6000

$ 6000

$ 6000

$5700

$ 6000

$5700

$ 6000

$5400

10

$ 6000

$5400

Total net saving at end

of year 10

$ 60000

$ 60000

Solution
Project 1
Year DF for 8%

Project 2

Net savings

Present value

Net savings

Present value

1,000

$ -30.000,00

$ -30.000,00

$ -30.000,00

$ -30.000,00

0,926

6.000,00

5.555,56

6.600,00

6.111,11

0,857

6.000,00

5.144,03

6.600,00

5.658,44

0,794

6.000,00

4.762,99

6.300,00

5.001,14

0,735

6.000,00

4.410,18

6.300,00

4.630,69

0,681

6.000,00

4.083,50

6.000,00

4.083,50

0,630

6.000,00

3.781,02

6.000,00

3.781,02

0,583

6.000,00

3.500,94

5.700,00

3.325,90

0,540

6.000,00

3.241,61

5.700,00

3.079,53

0,500

6.000,00

3.001,49

5.400,00

2.701,34

10

0,463

6.000,00

2.779,16

5.400,00

2.501,24

NPV = $ 10.260,49

NPV = $ 10.873,91

Project 2 is the preferred choice as it has greater present value

Limitations of NPV

Depends on the realistic prediction of future

interest rates, which can be unpredictable.

Usual to set the discount rate above the

interest rate at which the capital for the
project was borrowed. This gives a pessimistic
prediction, but helps account for the inherent
uncertainties.

The Internal Rate of Return

(IRR)

The discount rate which

gives a NPV equal to zero.

The higher the IRR, the

more attractive a project.

In the example used for

NPV, it can be seen that
the discount rate required
to bring the NPV for
Project 2 to zero would be
greater than for Project 1
as Project 2 had the
higher NPV.

Limitations of the IRR method

The result is given as a percentage, which has

to be compared against a minimum required
rate for a decision to be made.

The IRR envisages that cash surpluses will be

reinvested at the IRR discounting rate, whereas
the NPV method makes the more realistic
assumption that they will be reinvested at the
minimum acceptable rate of return.

Total Life Cycle Costs (TLCC)

Used to evaluate the differences

in costs and the timing of costs
between alternative projects,
when the benefits and returns are
judged to be the same.

Only costs relevant to the

decision should be included

There is no frame of reference for

what is acceptable and what is
not, so should not be used for
deciding to accept or reject an
investment

Can be used for ranking or

selecting among mutually
exclusive alternatives for which
all else is equal.

=0 (1+)

TLCC = Present value of total life

cycle costs

Cn = cost in period n (finance

charges, salvage value, nonfuel
O&M & repair costs,
replacement costs, energy
costs)

N = analysis period

DR = annual discount rate

TLCC
example

A standard 75 W incandescent light bulb operates 6 hours a night

throughout the year, requiring 164.25 kWh annually. If electricity
costs 6 cents/kWh then it costs $9.86 per annum. If electricity costs
remain constant and a bulb needs replacing once a year at $1 per
bulb the TLCC (using a DR of 12%) is $39.56 for 5 years.
An alternative would be to buy a 40 W fluorescent bulb that will last
for 5 years. With the same usage pattern the bulb will require 87.6
kWh to operate. Assuming a $15 initial investment and the same
electricity unit cost, the TLCC is $33.95 for 5 years.
The net saving, based on TLCC is $5.61

Annualised Costs

The annualising process is used if the alternatives being

considered cannot use the same study period.

The whole life cycle cost cannot be simply divided by the

study period, as the discount factor needs to be taken into
account.

Important not to confuse the equivalent annual cost with an

actual budget forecast it is used for comparison not
prediction.

Calculated by use of an annual cost factor (also known as a

uniform capital recovery factor).

(1 + )
=
(1 + ) 1

Equivalent annual cost = ACF * NPV

Annualised Costs Example

Levelised Cost of Energy

(LCOE)

Allows alternative technologies to be compared

when they have different scales of operation,
investment and operating time periods, or both.

Therefore useful for comparing renewable energy

with standard fossil fuels.

LCOE is recommended for ranking alternatives,

given a limited budget the alternatives can then
be selected in order, until the budget is exhausted.

Not recommended for mutually exclusive projects

as different investment sizes are not taken into
account

Calculating the LCOE

The LCOE is the cost that if assigned to every unit of

energy produced or saved by a project over the
analysis period will equal the TLCC when discounted
back to the base year.

=1(1+)

LCOE = levelised cost of energy

TLCC = total life cycle cost

Qn = energy output or saved in year n

DR = discount rate

N = analysis period

If Q remains constant over

time the equation can be
reduced to:

Q = annual energy output

or saved
UCRF = uniform capital
recovery factor
(equivalent annual cost
factor)

Example of LCOE
Base case

Alternative

Bulb type

75 watt incandescent

40 Watt fluorescent

Hours of operation

6 hours per night

6 hours per night

Total energy requirement 164.25 kWh per year

87.6 kWh per year

Unit price of electricity

6 cents/kWh

6 cents/kWh

Cost of bulb

$1 once a year

$15 once at the

beginning

Nonfuel cost of option

$4.03 (discounted cost of

$15 (initial investment)

new bulbs for 12% DR)

For a study period of 5 years and a discount rate of 12% the UCRF is 0.2774
Calculate the LCOE saved
The LCOE (saved) = ([15 - 4.03]/[164.25-87.6])x0.2774 = 0.04 USD/kWh
The cost per unit required to save energy is cheaper than the cost to purchase the energy
(0.04 USD/kWh < 0.06 USD/kWh), so the alternative should be chosen.
Conversely, if the cost of electricity drops below 4 cents/kWh then it should not be
chosen.

How much does it cost to

produce 1 kWh of electricity from
a coal fired power plant?

Fuel cost

Coal price: 1 USD/GJ

Conversion Efficiency 36%

1 USD/GJ/0.36 = 2.77 USD/GJe

1 GJ = 277 kWh

0.01 USD/kWh electricity

Is that all???

50

How much does it cost to

produce 1 kWh of electricity from
a coal fired power plant?

51

Capital cost

r, Discount rate is the interest rate used

to discount future cash flows, say
5%/year

I, Cost of capital (investment), 1200 USD

T, Life time of plant (30 years)

ep, Amount of electricity

produced/year

1 kW -> 8760 kWh * load factor

Levelised cost approach: We need to

get our money back, i.e., sum of all
discounted future revenues should
equal the initial investment cost

How much does it cost to

produce 1 kWh of electricity from
a coal fired power plant?

Fuel cost:

1 USc/kWh

Investment cost 1.3 USc/kWh

Total

2.3 USc/kWh

Is that all?

Operation and maintenance (can be important!)

Other fixed and variable costs

External costs

52

53

External costs

Effects that are not included in the production cost,

e.g., effects on the environment, health, crops,
monuments, etc

We will talk about these effects later in the course

Should they be included?

Can they be included?

TAXES

Levelized electricity cost

projections

54

International average cost versus

preferred energy prices (feed-in-tariffs)
for renewable energy in Ecuador

55

56

Energy prices

Electricity prices (2014)

Renewable energy vs Energy

conservation

Popular microgeneration technologies

are unlikely to give a positive NPV
unless they are heavily subsidised.

Energy conservation measures often

cost little and save much.

Different levels of the same

measure