Professional Documents
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Margarete Konstantin
Power and
Energy Systems
Engineering
Economics
Best Practice Manual
Power and Energy Systems Engineering Economics
Panos Konstantin Margarete Konstantin
•
123
Panos Konstantin Margarete Konstantin
Burgstetten, Baden-Württemberg Burgstetten, Baden-Württemberg
Germany Germany
This Springer imprint is published by the registered company Springer International Publishing AG part of
Springer Nature
The registered company address is: Gewerbestrasse 11, 6330 Cham, Switzerland
Preface
V
Acknowledgments
The book mainly reflects the knowledge I have acquired and further devel-
oped from over 35 years’ experience working for Fichtner GmbH & Co.
KG in Stuttgart, Germany as a consultant and trainer for energy business
projects worldwide. I am particularly thankful for their support and the op-
portunity to have access to their technical and human resources during my
employment and beyond.
I am also grateful to many of my Fichtner colleagues as well as friends and
clients for their advice and contribution to the development of this book.
Many thanks are also due to the colleagues of HelpDesk Görlitz GmbH,
Germany for their help in properly formatting the book.
I am grateful to Markus Groissböck, who has developed and maintains my
Website, and to Timo Dimitriades, who designs the covers of my books.
Many thanks to Amy Gooderum, an English teacher in the States, for
proofreading and linguistic revisions of the book’s text, and also for her nu-
merous proposals to make the book’s text better understandable also for read-
ers, who are less familiar with parts of the contents.
Last but not least, I wish to thank Maggie Konstantin, my wife, for her
support in editorial design and a second proofreading of the book’s text and
for her understanding for the long hours and evenings I have been spending
in front of the computer.
1
In English: “Practice Oriented Book on Energy Economy”
VII
Table of Main Chapters
Preface .............................................................................................................V
Acknowledgments ........................................................................................VII
1 Introduction and Scope ............................................................................ 1
2 Financial Mathematics............................................................................. 5
3 Inflation, Interest and Cost of Capital ................................................... 27
4 Investment Appraisal Methods .............................................................. 39
5 Financial and Economic Analysis of Projects ....................................... 65
6 Introduction on Cost Allocation to Cogeneration Products................... 77
7 Project Analysis under Uncertainties .................................................... 83
8 Overview of Energy Markets and Prices ............................................. 109
9 Case Studies ........................................................................................ 133
Bibliography and References ...................................................................... 149
Annexes ....................................................................................................... 153
Glossary ....................................................................................................... 163
Acronyms and Abbreviations ...................................................................... 169
Index ............................................................................................................ 173
IX
Table of Contents
Preface ............................................................................................................. V
Acknowledgments ........................................................................................ VII
1 Introduction and Scope............................................................................ 1
1.1 Brief Outline of the Chapters .......................................................... 1
1.2 Annexes ........................................................................................... 3
1.3 Glossary........................................................................................... 3
2 Financial Mathematics ............................................................................ 5
2.1 Synopsis of the Chapter................................................................... 5
2.2 The Time Value of Money .............................................................. 6
2.2.1 Some Key Definitions of Terms .............................................. 6
2.2.2 The time value of money ......................................................... 6
2.3 Single Payments .............................................................................. 7
2.3.1 Compounding a single payment .............................................. 7
2.3.2 Discounting of a single payment ........................................... 10
2.4 Series of Unequal Payments .......................................................... 11
2.4.1 Compound amount of a series of unequal payments ............. 12
2.4.2 Present value of a series of unequal payments ...................... 12
2.5 Series of Equal Payments .............................................................. 13
2.5.1 The mathematical structure of series of equal payments ....... 13
2.5.2 Compound amount of a series of equal payments ................. 14
2.5.3 Present value of series of equal payments ............................. 17
2.5.4 Annual equivalent amounts of payments (Annuities) ........... 18
2.6 Series of Escalating Payments ....................................................... 21
2.6.1 The present value of a series with escalating payments ........ 21
2.6.2 Levelized values of escalating series of payments ................ 23
3 Inflation, Interest and Cost of Capital ................................................... 27
3.1 Synopsis of the Chapter................................................................. 27
3.2 Inflation & Price Index .................................................................. 27
3.3 Policy Instruments for Controlling Inflation ................................. 28
XI
XII Table of Contents
List of Figures
Figure 2-1: The time value terms .................................................................... 6
Figure 2-2: Future multiple of initial single payment vs. interest and time .... 9
Figure 2-3: Present value of a single payment .............................................. 11
Figure 2-4: PV of a series of equal payments vs. length of the period .......... 18
Figure 3-1: Yields of government bonds and inflation................................. 30
Figure 3-2: Real interest of government bonds ............................................. 31
Figure 3-3: Development of the exchange rate Euro – US$.......................... 33
Figure 3-4: Development of the crude oil prices in real terms 2013 ............. 33
Figure 4-1: Overview of investment appraisal methods ................................ 40
Figure 4-2: Components of an investment appraisal process ........................ 42
Figure 4-3: Components of the NPV appraisal method ................................ 44
Figure 4-4: IRROI – cash inflows and outflows............................................ 52
Figure 4-5: NPV and IRR iteration approach ................................................ 53
Figure 4-6: Payment series and components of the IRROE .......................... 54
Figure 6-1: Cogeneration in a steam Rankine cycle CHP ............................. 78
Figure 6-2: Cogeneration of power and heat in a gas turbine CHP ............... 78
Figure 6-3: Electrical equivalent of extracted steam, approximate values .... 81
Figure 7-1: SWOT statement example for a potential CHP plant project ..... 87
Figure 7-2: Normal distribution of the energy production ............................ 90
Figure 7-3: Standard normal distribution curve ............................................ 90
Figure 7-4: Gauß distribution, Example with µ=50 GWh base yield ........... 91
XVII
XVIII Table of Contents
List of Examples
Example 2.1: Future value of a single payment .............................................. 8
Example 2.2: Compounding of a single payment in shorter periods .............. 9
Example 2.3: Present value of a single payment ........................................... 10
Example 2.4: Compounding of a series of unequal payments ...................... 12
Example 2.5: Discounting of a series of unequal payments.......................... 13
Example 2.6: Sum of the numbers of a geometric series .............................. 14
Example 2.7: Future compound amount ....................................................... 15
Example 2.8: Interest during construction .................................................... 16
Example 2.9: Extract of annuity factors (Pv=1) ............................................ 19
Example 2.10: Annuities of a house mortgage loan vs. maturity .................. 20
Example 2.11: Annuities of a mortgage loan vs. interest rate ....................... 20
Example 2.12: Annualized CAPEX of a project ........................................... 20
Example 2.13: Present value of personnel costs incl. escalation................... 22
Example 2.14: Revenues of a solar PV plant, considering degradation ........ 22
Example 2.15: Levelized O&M Costs .......................................................... 24
Example 2.16: Levelized annual costs of personnel ..................................... 24
Example 2.17: Levelized crude oil price ....................................................... 25
Example 3.1: Inflation rate vs. CPI for selected countries ............................ 28
Example 3.2: Effective interest rate .............................................................. 36
Example 3.3: Discount rate on WACC, including corporate tax .................. 37
Example 3.4: Discount rate based on WACC, excluding corporate tax........ 37
Example 4.1: LECs in real terms on year-by-year basis ............................... 48
Example 4.2: LECs in nominal terms on year-by-year basis ........................ 48
Example 4.3: Calculation of the LECs with the Add-In “BWSesc”.............. 49
Table of Contents XIX
Heating values: For energy balances, price references etc. the lower
heating values (LHV) are used (also referred to in literature as net calo-
rific values - NCV or inferior heating value - Hi). Worth mentioning is
that natural gas is commonly traded based on its HHV and is to be
converted in LHV for calculations and energy balances.
1 Introduction and Scope 3
1.2 Annexes
1.3 Glossary
Most of the terms are accompanied by units (e.g. kg/s, kWh/a, $/a, $/kWh) as
it is a standard for engineers.
Please note that the terms are defined as used by the power and energy in-
dustry, and are not generally applicable for other sectors.
Several terms intentionally deviate from the pure economist’s or account-
ant’s terminology whenever we deem this to be appropriate. For example, we
use the term “capital expenditures (CAPEX)” instead of investment costs,
“operation expenses (OPEX)” instead of operation costs, “payment series”
instead of cash flows. Please refer
to glossary item “Deviations from customary definitions” for an explana-
tion of the divergence.
2 Financial Mathematics
Note: The time value of money is the relationship between its nominal
value and the due date of payment. Payments can be compared, added
or subtracted from each other only if they refer to the same time (e.g.
present values).
The operations in financial mathematics for determining the time value
of money are called compounding and discounting.
Table 2-1 illustrates the calculation of the future value of a single payment P0
invested at the beginning of the first year with the annual interest rate
i (%/100) including accumulated interest.
Using of the formulas, the algorithm of the future compound amount of a
single payment can be derived. The future compound amount of a single
payment Po invested at the beginning of the first year is mathematically ex-
pressed by the following notation:
n
P0 at the beginning of the year: Pn = P0 ⋅ (1 + i ) = P0 ⋅ q
n
(2.1)
If the payment is made at the end of the year, it does not earn interest in the
first year; therefore the exponent must be “ n-1”.
n −1
P0 at years end: Pn = P0 ⋅ (1 + i ) = P0 ⋅ q n −1 (2.2)
Where:
P0 : Initial amount
Pn : Compound amount at the end of the year n
i : Annual interest rate (1/a)
n : Number of years
q = (1+i) : Compound factor
Note: Usually the annual interest rate is expressed as percentage per year
(e.g. 10 %/a). In the formula, however, it must be inserted as a digit
(10% = 0.1).
Example 2.1: Future value of a single payment
Find the interest rate at which the future value of a single payment is doubled by the
end of the given period. Note: The calculation is done with formula (2.1) using the
“goal seek” function of MS-Excel (to be found in “data”, “what-if-analysis”, “goal
seek”).
Given:
a) P0 =1000 CU, period 10 a
b) P0 =1000 CU, period 20 a
Results:
a) P10 = 1000 × 1.0718^10 = 2000 CU interest rate 7.18 %/a
b) P20 = 1000 × 1.0353^20 = 2000 CU interest rate 3.53 %/a
Figure 2-2 shows the interest rate as a function of the period during which the
future value of a single payment will rise to 2-fold, 3-fold or 4-fold. This is
helpful for setting adequate escalation rates for cost components (e.g. cost of
personnel or consumables, fuel prices) in investment appraisal of projects.
2.3 Single Payments 9
Figure 2-2: Future multiple of initial single payment vs. interest and time
Compounding for shorter periods
Commonly, the nominal interest rate is given in percent per year (%/a). The
compounding formula for shorter periods is given by the following equations
at the beginning or by the end of the period respectively:
min
i
P0 at the period’s beginning Pn = P0 ⋅ 1 + (2.3)
m
m i ( n −1)
i
P0 at the period’s end Pn = P0 ⋅ 1 + (2.4)
m
Where:
Pn : Future value of the payment
P0 : Initial value of the payment
m : Number of compounding periods during the year
n : Number of years
Note: The PV of a payment at the beginning of the first year is equal with its
nominal value. The term below is called the present value factor of a single
payment:
1 1
Single payment PV factor n
= (2.7)
q (1 + i )n
1,000
Present Value of a Single Payment
900
of nominal value 1000 CU
800
Present Value CU
700
500
400
300
Discount rate 10%
200
Discount rate 15 %
100
Power Systems Engineering Economics - author's own illustration
0
0 2 4 6 8 10 12 14 16 18 20 22 24 26 28 30
Due year of payment
Where:
FVn: Future compound amount of the series of “n” payments
Pt : Single payment due at the time “t”
i: Interest rate (%/a inserted as a digit)
q = (1+i): Compound factor
qt = (1+i)t: Compound amount factor of the year “t”
The series may contain positive values (income) and negative values (ex-
penses).
The term below is called the present value factor of a single payment at the
time “t”.
1 1
Single payment PV factor: = (2.10)
q (1 + i )t
t
Payments, e.g. revenues and expenses, during the lifetime of projects, are
usually assumed to be a series of equal amounts of money which occur in
regular time periods.
Regular payments during the lifetime of an investment have the mathemat-
ical form of a geometric series. Each following term of such a series is the
product of the previous one, multiplied by a fixed factor called the common
ratio “r”. The starting value is called the scaling factor “a”. The mathemati-
cal form of a geometric series consisting of “n” terms with the scale factor
“a” and the common ratio “r” as well as the formula of its sum, is shown in
equation (2.11):
14 2 Financial Mathematics
n =n
rn −1
0 1 2
S n = a ⋅ r + a ⋅ r + a ⋅ r + ..... + a ⋅ r n −1
= a⋅∑r n −1
= a⋅ (2.11)
n =1 r −1
r is = 1; so the first number of the series becomes a.r0=a (r and a≠ 0).
0
Another form of a geometric series where the starting value also includes the
common ratio is shown in equation (2.12).
t =n
r n −1
Sn = a ⋅ r1 + a ⋅ r 2 + .... + a ⋅ r n = a ⋅ ∑ r t = a ⋅ r ⋅ (2.12)
t =1 r −1
Almost all series of payments can be transformed into one of the above math-
ematical forms.
Important Note: For some of the equations given in the following
sections there are functions in MS-Excel and similar software tools.
The names of the formulas for MS Excel are stated hereinafter.
It is to be mentioned however, that Excel assumes payments series to
be cash outflows and assigns to them negative values. If payments se-
ries are cash inflows, they shall have positive values; hence, in front of
the Excel function, we have to put a minus symbol to get positive val-
ues. In costing models, only costs items (cash outflows) are included
and the values are changed to positive values; otherwise all items will
be negative.
1
FVn = P0 ⋅ q + P0 ⋅ q 2 + P0 ⋅ q3 + ...... + P0 ⋅ q n
2.5 Series of Equal Payments 15
t =n
qn − 1
P0 at the year’s beginning FVn = P0 ⋅ ∑ q = P0 ⋅ q ⋅
t
(2.13)
t =1 q −1
The term below is called the compound amount factor of equal payment se-
ries. It returns the future value of a payment with the time value of 1 CU.
Compound amount factor of equal payments
t =n
t qn −1
fCF = ∑ q = q ⋅ (2.14)
t =1 q −1
If the payments are due at the end of each year, the first payment will not
earn interest in the first year. The series will have the form of a geometric
series as in equation (2.11) with the common ratio r = q and the starting
value P0.q0 = P0.
Series of equal payments at the end of the year:
0
S n = P0 ⋅ q + P0 ⋅ q1 + P0 ⋅ q 2 + ...... + P0 ⋅ q n −1
t =n
qn −1
Payment at the end: FVn = P0 ⋅ ∑ q = P0 ⋅
t −1
(2.15)
t =1 q −1
Where:
P0 : The constant payment each year (CU)
q=1+i: The compound factor (-)
i: Annual interest rate (%/a inserted as a digit)
t: Current year of the compounding period
n: Number of years of the compounding period
t =n
1 qn − 1
Equal payments PV factor : f pv = ∑ = (2.19)
t =1 qt q n ⋅ ( q − 1)
The case of discounting payments due at the beginning of the year is not very
common. For the sake of completeness, the formula is given below:
t = n −1
1 qn − 1
PVn = P0 ⋅ ∑ t = P0 ⋅ n −1 (2.20)
t =1 q q ⋅ ( q − 1)
Note: MS-Excel function “PV(rate%, Nper,Pmt, Pv, type)”; Pv=0
In Figure 2-4, the present value of a series of equal payments as a function of
the discounting period is depicted. It becomes evident from the illustration
that the present value of the series does not significantly increase at the end
of longer discounting periods, especially at high discount rates. The PV of the
series with a discount rate of 10%/a remains almost constant for discounting
periods longer than 30 years.
18 2 Financial Mathematics
18,000
16,000
Discount rate
14,000 5% /a
Present value CU
8,000
6,000
4,000
2,000
Power Systems Engineering Economics - author's own illustration
0
5 10 15 20 25 30 35 40 45 50
Years
Figure 2-4: PV of a series of equal payments vs. length of the period
t =n
1 qn − 1
PVn = P0 ⋅ ∑
t =1 q
t
= P0
⋅
q n ⋅ ( q − 1)
The above equation solved for Po gives the following equation for the annual
equivalent amount or annuity:
1 q n ⋅ ( q − 1)
Annuity: PAN = P0 = PVn ⋅ t =n = PVn ⋅ (2.21)
1 qn −1
∑
t =1 q
t
2.5 Series of Equal Payments 19
Where:
PAN: The constant equivalent annual payments (annuities)
PVn: The present value of the equivalent annual payments
t: Current year of the period, n: number of years
q = 1+i: The discount factor (for interest rate i≠ 0)
The term “an” below is called the capital recovery factor or annuity factor
and is the inverse of the present value factor (see equation). The annuity fac-
tor returns the annuities of an amount to the PVn = 1.
Annuity factor a n
1 q n ⋅ ( q − 1) 1 (2.22)
= t =n
1
= n
q −1 a
∑
t =1 q
t
A typical case of annuities are the installments of a house mortgage loan (see
Example 2.10 and Example 2.11). The present value is the principal at the
time of disbursement of the loan. The installments include the repayment of
the principal plus interest payments. Converting payments into annuities is
also common practice in engineering economics. For instance, the CAPEX of
a project is converted into annual equivalent amounts (annualized CAPEX)
during its lifetime (see Example 2.12).
20 2 Financial Mathematics
It becomes evident in this example that the annuities become smaller the longer the
maturity of the loan; on the other hand, the total repayment increases due to interest
payments.
Interest rate
Item Unit
6%/a 7%/a 8%/a
Principal € 300,000 300,000 300,000
Maturity period years 20 20 20
Annuity €/a 26,155 28,318 30,556
Total repayment € 523,107 566,358 611,113
The example above shows that even small differences in interest rates have a signifi-
cant impact on the annuities and the total repayment.
The present value of a series of payments with a constant escalation rate will
have the form:
1 2 3
p p p p
n t
t =n
p
PVn _ esc = P0 ⋅ + P0 ⋅ + P0 ⋅ + ..... + P0 ⋅ = P0 ⋅ ∑ t
q q q q t =1 q
This is a geometric series with the common ratio p/q (see equation (2.12)). It
is called the geometric gradient series. After some mathematical transfor-
mation, the above equation is:
PVn _ esc
t =n
pt
= P0 ⋅ ∑ t = P0 ⋅
( qn − pn ) ⋅ p
(2.23)
t =1 q ( q − p ) ⋅ qn
This is the form of the equation when there is also escalation in the first year.
If there is no escalation in the first year, the p element in numerator is
omitted and the equation will have the form:
PVn _ esc = P0 ⋅ ∑
t =n
pt
= P ⋅
( qn − p n ) (2.24)
0
t =1 qt ( q − p ) ⋅ qn
Where:
P0 : Constant payment each period before escalation
q=1+i : Discount factor, i : annual interest rate
p = 1+j : Escalation factor, j : escalation rate (may be also <0 !)
n: Number of years of the discounting period
Requirement: q≠p; q≠0; p≠0
If j > 0, the values of the series are increasing; if j < 0, they are decreasing!
Operating expenses, e.g., for personnel, fuels or consumables etc. are usually
subject to escalation during the lifetime of a project. Investment appraisal
methods require the series of payments to be converted in discounted average
annual or per unit equivalent amounts. This is done by calculating the present
value PV of the series and multiplying the PV by the respective annuity fac-
tor. The term levelized is commonly used for the discounted average value of
a series of payments (e.g. levelized electricity cost CU/a or CU/MWh).
The equations of the present value of a geometric gradient series (2.23)
and the equation for the annuity factor (2.22) are shown below:
PVn _ esc
pt
t =n
= P0 ⋅ ∑ t = P0 ⋅
( qn − p n ) ⋅ p
[CU]
t =1 q ( q − p ) ⋅ qn
1 q n ⋅ ( q − 1) 1
an = t =n
1
= n
q −1 a
∑q
t =1
t
By combining the two above equations, we get the equation for the annuities
PAN_esc or levelized cost LC of a geometric gradient series (see also Add-In in
Annex 5):
PAN _ esc = LC = P ⋅
(q n
− pn ) ⋅ p
×
( q − 1) CU
(2.25)
0
( q − p) n
q −1 a
If there is no escalation in the first year, the term “p” in the numerator must
be omitted.
Where:
PAN_esc : Annuity of a series of escalating payments
P0: Constant payment without escalation
q= 1+i : Discount factor, with “i" discount rate (interest rate)
p= 1+j : Escalation factor or geometric gradient, with “j” escalation rate
n: Number of periods (years)
If the annual payments of the series are not constant amounts, their PV is
calculated as the sum of their present values and converted to annual equiva-
lent amounts by multiplying the summarized PV with the annuity factor (see
Example 2.15, Example 2.16 and Example 2.17).
24 2 Financial Mathematics
Item Year 1 2 3 4 5 6 7 8 9 10
Nominal values mln US$/a 0.0 5.5 6.5 25.0 11.5 13.0 14.0 35.0 18.0 20.0
PV factor 8.6 %/a 1.0860 1.09 1.18 1.28 1.39 1.51 1.64 1.78 1.93 2.10 2.28
Present values 86.53 mln US$ 0.00 4.66 5.07 17.97 7.61 7.92 7.86 18.09 8.57 8.76
Money may lose value over the course of time due to inflation. Properly in-
vested money can offset inflation and additionally earn and accumulate inter-
est on top of inflation during the lifetime of the investment. Inflation and
interest are linked to each other and determine the cost of borrowed capital.
In addition, returns for equity investors include venture risks premiums. In
this respect, the Weighted Average Costs of Capital (WACC) approach is
introduced. These are key financial parameters for the evaluation of capital
investments. This chapter explains how to properly handle these parameters
in financial evaluations of projects. Financial operations in nominal terms or
in real terms are presented and practiced.
Inflation is defined as the overall increase in prices of goods and services; the
price increase over a certain period, usually one year, is the inflation rate. It
is noted that inflation does not refer to the price of a single good or service; it
is rather applied to the weighted average price level of a number of goods
which are compiled in a so-called basket of goods.
The price increases of individual goods within a price basket are usually
different. In this book, we define the price increase of a single good as (price)
escalation and the rate, the escalation rate. This may be higher or lower than
inflation. We distinguish between nominal terms, if the inflation is included
in the rate, and real terms or inflation adjusted, if inflation has been deducted
(see also section 3.6.2). There are also the expressions “escalation on top of
inflation” and “escalation below inflation”.
The price changes of goods and services of a defined basket are collected
and published by National or Regional Bureaus and Agencies of Statistics in
price indexes. A price index gives the weighted average price changes in
percentage points for a certain period (e.g. year, month), referring to the price
level of a reference year for which the index 100 is assigned – Table 3-1.
© Springer International Publishing AG, part of Springer Nature 2018 27
P. Konstantin and M. Konstantin, Power and Energy Systems
Engineering Economics, https://doi.org/10.1007/978-3-319-72383-9_3
28 3 Inflation, Interest and Cost of Capital
The most common price indexes are the Consumer Price Index (CPI) and
the Producer Price Index (PPI).
Careful study of Table 3-1 above shows the following: The index of all
countries increases throughout the entire period, with the exception of Japan.
In Japan, the index remains practically constant or declines. This means the
inflation rate is negative. This phenomenon is called deflation and is a bad
sign for the status of a national economy.
Usually statistical bureaus and agencies publish price indexes; the inflation
rate between two different periods is computed from the index as follows:
Example 3.1: Inflation rate vs. CPI for selected countries
• Subtract the index of a former Country 2014 2013 2014 2000
year from the index of this year 110.4 107.7 110.4 74.4
Austria
2.5% 48.4%
• Divide the difference by former 106.7 105.7 106.7 85.7
Germany
year’s index 0.9% 24.5%
108.6 106.8 108.6 79.0
USA
• Format result in percent 1.7% 37.5%
Data taken from Table 3-1
Governments and central banks have two main policy instruments at their
disposal to keep inflation at an acceptable level and thus stimulating the
economy: monetary policy and fiscal policy.
Monetary policy describes the activities undertaken by a government agen-
cy, typically the central bank of a country, to influence the supply of money
and to maintain price stability. Central banks can be considered the banks of
the commercial banks. They lend money to commercial banks with interest
rates that are usually lower than the commercial interest rates. Commercial
banks lend the borrowed money to their clients at higher interest rates to cov-
er their cost and generate some profit. By varying interest rates, central banks
can influence the supply of money to the economy and stimulate economic
activity and price stability. In this context, they must follow a balanced ap-
proach. By lowering interest rates, supply of money increases, helping to
boost the economy during a recession. On the other hand, an increase in infla-
tion, caused by too high liquidity on the market, must be prevented. In case
of overheated economy and/or high inflationary trends, the opposite approach
should be adopted.
Fiscal policy is the process of stimulating the economy through provision
of taxation incentives, e.g., accelerated instead straight line depreciation for
new investments. Fiscal policy may have some immediate effect on invest-
ments as it can accelerate implementation of projects which are in the pipe-
line.
It is noted that most central banks attempt to keep the inflation rate
close to 2% per year; that is worldwide considered as a benchmark.
New Zealand was the first country that introduced the 2%/a inflation target in
their legislation at the end of 1989, followed by Canada and almost all other
developed economies.
Increased government spending for infrastructure projects is also often
used as an instrument to stimulate an economy to overcome recession.
Interest is the price of borrowed capital. The interest rate is the amount of
money payable for interest on borrowed capital; it is usually measured in
percent per year (%/a). The borrowed amount is called the principal. The
time over which a loan is repaid is the maturity.
30 3 Inflation, Interest and Cost of Capital
Interest rates of borrowed capital for project activities are usually linked to
inflation. In general, the lender who grants a loan today expects that the
amount repayable (the returns) at maturity of the loan will be:
Returns = borrowed amount + inflation + net return + risk premium
Energy sector projects are long term investments; usually, they are financed
by a combination of investors’ own capital (equity) and bank loans. Banks
usually expect an equity share of about 30% for large energy sector projects.
The expected return on equity and the bank interest rates are crucial for the
project costs and the economic viability of the investment.
The market model of pricing interest rates for bank loans is very complex.
Below, we will discuss only two aspects considered in fixing the interest rate
for investment appraisal: government bonds and risk premiums.
Government bonds: The minimum interest rate of a risk-free investment
must cover the expected inflation and include an acceptable real interest on
top of the inflation. Government bonds used to be considered a risk-free in-
vestment and their yield a benchmark for a minimum interest rate.
In Figure 3-1, the yield of government bonds and the inflation of the con-
sumer goods during the period from 1991 to 2015 are depicted. It becomes
evident that there has been a distinct link between the yields of the bonds and
the inflation throughout the period from 1991 up the start of the financial
crisis in 2008/2009. Afterwards, massive intervention of central banks to
overcome the financial crisis, have distorted the balance of the system.
7.0
Yield nominal Inflation Real interest
Average 1991 - 2010
6.0 5.7 2.4 3.3
5.1 2.1 3.0
5.6 2.3 3.2
5.0 Average 2001 - 2010
4.1 2.1 2.1
Percent per year
3.0
2.0
1.0
Source of data: Eurostat, Austrian National Bank
0.0
1991
1993
1995
1997
1999
2001
2003
2005
2007
2009
2011
2013
2015
-1.0
Euro area Germany USA
Figure 3-2: Real interest of government bonds
The difference on top of inflation can be interpreted as the expected mini-
mum real interest rate for commercial bank loans. Figure 3-2 shows the de-
velopment of the real interest rates during the same period.
The fluctuations throughout the investigated period are the result of the
state of the global economy and the credit needs of the governments. This
becomes especially apparent in 2009 and 2010. Due to financial crises, the
governments’ credit needs for bail-outs of banks and industries were high and
the rates for government bonds rose for short time. Following the decline of
the economy in 2010, the central banks were forced to supply low-interest
money to the commercial banks in order to boost the economic activity and
thus the rates dropped.
The long term development of the real rates of government bonds, are
essential for setting interest rates for power sector projects. They are
relatively stable for the period before the financial crises as shown in
the embedded box in Figure 3-2. The long term fluctuation margin of
the yields is only about one percentage point.
As already stated, interest rates for borrowed capital for project activities are
linked to inflation. Table 3-2 shows the development of the inflation and
central bank interest rates for selected countries.
32 3 Inflation, Interest and Cost of Capital
United Kingdom
South Africa
Euro Area
Australia
Germany
Russia
Turkey
Brazil
China
India
USA
average
CB Interest rates 2007-2008 3.75 3.75 3.13 4.00 6.50 12.50 6.30 5.50 15.38 10.50 11.00
Inflation rates 2007-2008 2.70 2.10 2.60 2.10 3.35 5.18 3.85 7.61 9.20 12.60 8.75
CB Interest rates 2010- 2011 1.38 1.38 0.50 0.25 4.50 10.88 6.06 6.38 6.13 8.25 5.50
Inflation rates 2010- 2011 2.20 1.90 4.25 2.45 3.10 6.21 4.40 9.41 8.43 7.90 4.80
Source of data: Trading economics; www.tradingeconomics.com 1/9/2012
During the stable period of the economy, before the financial crisis of 2008,
interest rates were generally higher than inflation. In emerging economies,
interest rates as well as inflation have been consistantly high. After the finan-
cial crisis of 2008 and the subsequent recession of the economy, central
banks of countries affected by the crisis drastically reduced interest rates
below inflation to stimulate the economy.
Besides inflation exchange rates, fluctuation between US$ and local curren-
cies have a crucial impact on commodity prices. US$ is still the leading cur-
rency and most commodities are traded in the international marketplace in
US$. Exchange rate fluctuations directly influence commodity prices, such as
prices of metals and crude oil, in all local markets outside the United States.
As an example, Figure 3-3 depicts the exchange rate fluctuations between
US$ and Euro in the time span between 1990 and 2015. Figure 3-4 shows the
development of crude oil prices in real terms (2013) in US$ and in Euro. For
most of this time, the Euro has been stronger than the dollar and has positive-
ly influenced the price of oil and all other fuels.
3.5 Exchange Rate Fluctuations of Currencies 33
120
rate adjusted
80
60
40
20
1992
1994
1996
1998
2000
2002
2004
2006
2008
2010
2012
2014
Figure 3-4: Development of the crude oil prices in real terms 2013
34 3 Inflation, Interest and Cost of Capital
The nominal interest rate is the rate charged by banks for loans. It is ex-
pressed in percent per year (%/a) and includes inflation. Calculation in nomi-
nal terms means that discounting or compounding of payments is conducted
with the nominal interest rate.
The interest rate on top of inflation is called the real interest rate. It is calcu-
lated by adjusting or deflating the nominal interest rate. Often this is simply
calculated arithmetically by subtracting the inflation from the nominal inter-
est rate (3.1). However, this calculation is incorrect in terms of financial
mathematics. The correct calculation of the real interest rate is conducted by
discounting the inflation, as shown in formula (3.3) instead of subtracting it:
1 + in
Real interest factor: qr = 1 + ir = (3.2)
1+ j
1 + in
Real interest rate: ir = −1 (3.3)
1+ j
In the case an investor intends to obtain a certain real interest rate based on
some expected inflation rate the nominal interest rate can be calculated using
the following formula:
Nominal interest rate: in = (1 + ir ) ⋅ (1 + j ) − 1 (3.4)
Where:
in, ir : Nominal, real interest rate (%/100)
j: Inflation rate (%/100)
qn, qr: Nominal, real interest factor
p: Deflator factor 1+j
3.6 Interest Rate Formulas 35
Interest rates are commonly expressed in percent per year. This implies, e.g.
yearly compounding of the principal in a bank deposit.
For cases in which compounding happens in shorter periods, the actual in-
terest rate payable will be higher. This will result in a higher annual interest
rate that is called the effective interest rate. It is calculated with the following
formula:
m
i
ieff = 1 + − 1 [ −] (3.5)
m
Where:
i: Nominal annual interest rate (1/a)
m : Number of periods during a year
36 3 Inflation, Interest and Cost of Capital
Notes:
An equity rate of 30% is common for a first assessment of power sector pro-
jects. Of course, it also depends on the credit-worthiness of the potential in-
vestors. The WACC as stated above is, strictly speaking, valid for the life-
time of the loan only not for the project’s lifetime.
The returns on equity and bank interest rates, as well as the resulting
WACC, are linked to the inflation rate and must correspond with each other.
This means, we cannot arbitrarily increase or decrease the returns or the in-
terest rates without reference to the inflation rate. The stated inflation rate of
2%/a is a benchmark for almost all developed economies since 1990. For
deflation of the nominal WACC, the equation (3.3) is to be used.
Investment appraisal must also consider corporate tax. This is because the
expected returns on equity constitute a profit that is subject to taxation. The
tax rates depend on the country’s tax legislation and are different in various
countries. In most taxation models, only the returns on equity are taxed while
the interest payments on loans are considered as costs and are tax deductible.
Premiums are the extra interest charged in order to take into consideration
any investments risk. There are several types of risks, such as technology
risks, risks of default of the borrower, regional risks, etc. The premiums on
the equity part of the WACC are considerably higher, compared to that on
loans. In WACC we distinguish two different premiums:
• The venture premium is directly related to the type of investment and
shall mainly cover the longevity of the investment, technology risks, per-
formance risks and market risks.
• The country premium shall cover political risks and currency convertibil-
ity risks related to the region or country where the project is located. Es-
timating level or risk premiums for projects and countries are extensively
described in chapter 7, in particular section 7.7.
Generally, commercial banks secure their credit with the investment itself
(some kind of collateral); they may also include a risk premium across their
loans to compensate losses in case of default of any of their borrowers. The
premium may also be the price of a credit default insurance policy (see
7.7.3). Interest rates of loans with a long maturity are usually higher due to
uncertainties in forecasting long term performance of projects.
4 Investment Appraisal Methods
The items which are relevant for investment appraisal processes are shown in
Figure 4-2 and further explained in the text below. The terminology refers to
investments for energy sector projects. Which of these items are to be consid-
ered depends on the method applied for the appraisal.
In general, investment appraisal methods evaluate cash inflows and cash
outflows incurring during the lifetime of a project. Non-cash items such as
depreciation are not the subject of the appraisal. In this respect, it is essential
to distinguish between expenditures, expenses and costs and to understand
which of them are cash in- or outflows. Cash inflows are denoted as positive
values, cash outflows as negative values (see direction of the arrow).
Simply defined, costs are all items which are relevant for taxation or for
the calculation of the per-unit cost of a product. They may be expenses or
other items. Depreciation, for example, is a cost item in the Profit & Loss
Statement, which companies have to submit for tax declaration to the internal
revenue office for each fiscal year. However, depreciation is neither an ex-
pense item nor a cash outflow. The cash outflow occurred initially with the
CAPEX, which is not, however, relevant for taxation. Hence it is not consid-
ered in investment appraisal.
42 4 Investment Appraisal Methods
Capital
Equity Expenditures Loan
CAPEX I0 (CU)
Sales Revenues
Rt (CU/a) Operating Expenses
OPEX Et (CU/a)
Investment Appraisal
Power and Energy Systems -
Cash-inflows (+) positive Profitability ?
Engineering Economics
Cash-outflows (-) negative Cost effectiveness ? Author‘s own illustration
Imputed costs may also be included in the investment appraisal, e.g. oppor-
tunity costs for own land for the production site, working capital, etc. The
profit, which is the return on equity, is also considered as imputed cost.
A strict distinction must be made between fixed and variable costs.
Fixed operating costs are not production related, they occur also in times of
low or no production and they include, among others, capital costs, costs for
operating staff and maintenance costs. The latter are usually calculated with a
rate referring to the equipment costs.
Variable operating costs of energy sector projects include, for example,
costs for fuels, consumables and residues. They are directly dependent on
production and occur in direct proportion to the amount of the product.
Sale revenues are the price of the product (in our case energy) multiplied
by the amount of sold product, e.g. kWh of electricity.
Lifetime (economic) of the investment project is the defined period during
which the invested capital, including the appropriate compounded interest
must be recovered. This is the economic lifetime and is usually shorter than
the technical lifetime of the plant.
The investment period is the time during which payments must be consid-
ered during the appraisal process and can be defined as the construction time
plus the (economic) lifetime.
Preferably, we use a discount rate based on the method of the Weighted
Average Costs of Capital (WACC), as presented in section 3.7. The WACC
is the minimum acceptable rate of return, also called the hurdle rate.
The profitability criteria are specific to each of the different appraisal
methods. We distinguish between absolute and relative profitability. The
former is to assess the profitability of a project in general while the latter is
used to find out which of the options is the most favorable. For comparison
of options, the specific levelized electricity cost LEC (in CU/kWh) is often
used as the profitability criterion.
It is to be noted that the profit is considered an inputted cost item in in-
vestment appraisal. This is the return on equity, implicitly considered in the
WACC that is used as the discount rate.
For clarification: If we calculate, for example, the net present value (NPV)
by discounting first with the WACC and afterwards with a discount rate that
includes only the interest rate for the loans, the NPV would be higher in the
second calculation. The positive difference corresponds to the profit.
In the following section of this chapter, the methodology of the different ap-
praisal methods is explained and supported with simple examples for better
understanding.
44 4 Investment Appraisal Methods
The Net Present Value is the basic form of all investment appraisal methods
which consider the time value of money by applying discounting and com-
pounding of all payment series during the investment period.
Figure 4-3 shows the items which are to be considered for investment ap-
praisal with the NPV method. Cash inflows are denoted as positive, and cash
outflows as negative values (see direction of the arrows).
Capital Expenditures
CAPEX I0 (CU)
Operating Expenses
Imputed Costs OPEX Et (CU/a)
Et (CU/a)
PROJECT
Sales Revenues Lifetime Other Revenues
Rt (CU/a) Discount Rate (WACC) Rt (CU/a)
PV Reference Time
NPV = − I 0 + ∑
t =n
( Rt − Et )
[CU ] (4.1)
t =1 qt
I0 : Capital expenditures present value (CAPEX)
Rt : Time value of sale revenues of the year t
Et : Time value of expenses at the year t (OPEX)
q: Discount factor q = 1 + i
i: Discount rate % / a
n: Lifetime of the investment project in years
t0 : Reference year for discounting (start of commercial operation)
4.3 The Net Present Value Method – NPV 45
The meaning of the NPV is that the invested capital (I0) must be recovered
during the lifetime of the investment, including acceptable compound interest
by appropriate returns (Rt - Et).
Discounting is done with the minimum acceptable rate of return (hurdle
rate). We commonly use the WACC as a discount rate that must be deter-
mined for each individual project separately.
A salvage value at the end of the project’s lifetime is assumed to be zero.
Any future decommissioning costs (e.g. for nuclear PP) are considered a cost
item for accumulating reserves.
The following two profitability criteria must be met for economic via-
bility of an investment:
Absolute profitability: The Net Present Value of an investment option
must be positive or at least zero (NPV≥ 0). Discounting is done with
the minimum acceptable rate of return (WACC = hurdle rate)
Relative profitability: The option with the highest positive NPV is the
most profitable and usually the preferred option, provided that the in-
vestment risk is the same.
Note: The Net Present Values (NPVs) of different options can only be
compared if their lifetime is the same.
A NPV equal to zero means that the returns (sale revenues minus expenses)
recover the invested capital (CAPEX) with the minimum acceptable rate of
return. A NPV higher than zero means that the rate of return is even higher
than the minimum acceptable rate of return.
Investment appraisal for energy sector projects is, in most cases, done by
applying a least cost approach. That means, the option with the lowest dis-
counted project’s lifetime cost is sought. For this purpose, only the cost side
of the NPV equation, the net present costs (NPC), is relevant.
t =n
Et
NPC = I o + ∑ [CU ] (4.2)
t =1 qt
With I0=CAPEX as the initial cash outflow and the annual operating expenses
Et=OPEXt , the NPC can be expressed by the following notation.
46 4 Investment Appraisal Methods
t =n
OPEX t [CU/a ]
NPC = CAPEX [CU ] + ∑ [CU] (4.3)
t =1 qt [1/a ]
In comparing options for a project, the one with the lowest NPC is the eco-
nomically most favorable. It is noted again that the investor’s profit is con-
sidered in the WACC.
For energy projects, the levelized electricity generation cost per unit of
product (LEC in CU/KWh) is often preferred as the criterion for economic
viability. The levelized electricity cost is the discounted average of the elec-
tricity generation cost over the lifetime.
After introducing the LEC, the NPC can also be expressed as a product of
the LEC and the energy produced We_t during the lifetime of the project.
kWh
t =n We _ t a
CU
NPC = ∑ LEC kWh × [CU ] (4.4)
1
t =1 qt a
After equating both NPC expressions and placing the term LEC in front of
the Σ symbol, as it is a constant value, we get the following equation:
We _ t kWh
a OPEX t CU
a
t =n t =n
CU
LEC kWh ⋅∑ × = CAPEX [CU ] + ∑
1 t 1
t =1+ qt a t =1 q
a
After resolving the equation for LEC, we get the following formula:
t =n
OPEX t
CAPEX + ∑
qt CU
LEC = t =1
kWh (4.5)
t =n We _ t
∑
t =1 qt
This Levelized Electricity Cost (LEC) is the net present costs NPC
(numerator of the equation) divided by present value of the electricity
generation We over the lifetime (denominator).
The denominator is the present value of the electricity production during the
lifetime. This may lack of understanding as discounting is understood in
terms of money. This is, however, the result of the conversion of the original
equation (4.4) and placing the constant value LEC before the Σ symbol.
4.3 The Net Present Value Method – NPV 47
In the following two examples, Example 4.1 and Example 4.2 the NPCs and
the LECs for the same power plant project are calculated in real terms and in
nominal terms on a year-by-year basis. The purpose is to demonstrate that the
PVs are the same. The discount rates and escalation rates used are shown in
the tables below:
Table 4-1: Discount rates based on WACC
Note: The PVs in Example 4.1 and in Example 4.2 are equal. The LEC in
nominal terms however in Example 4.2 is higher. This is because the PV of
the electricity production (denominator) is discounted with the higher
nominal discount rate and so it becomes smaller. In other words, the LEC in
nominal terms includes the assumed inflation rate.
Hence, it is highly recommended to always calculate LECs in real
terms and current currency units (CU) in order to have comparable
LECs!
48 4 Investment Appraisal Methods
Electricity generation, net GWh /a - 4,860 4,860 4,860 ................ 4,860 4,860
OPEX
OPEX, fixed, real terms *) mln € / a 1.00% esc /a 27.3 27.6 27.8 ................ 29.9 30.2
OPEX, variable, real terms *) mln € / a 1.50% esc /a 153.2 155.5 157.8 ................ 175.2 177.8
OPEX, fixed discounted **) mln € / a 6.47%/a 25.9 24.6 ................ 17.0 16.1
OPEX, variable, discounted **) mln € / a 6.47%/a 146.0 139.2 ................ 99.6 95.0
Present values
Electricity generation, discounted GWh 6.47%/a 34,986
t =n
OPEX t
CAPEX mln € - 1,240 CAPEX + ∑
OPEX, fixed, discounted mln € - t =1 qt
207 LEC = t =n
Wel _ t
OPEX, variable, discounted mln € - 1,189 ∑
t =1 qt
Total PV mln € - 2,636
LEC, in real terms € / MWh
-
75.33
Note: the spreadsheet is linked to the spreadsheets: WACC_incl._tax and Ex. 4.1_LEC_NPV_short
*) inflation adjusted 0.0 %/a ** ) Discount rate in real terms, from file WACC_incl_tax
In Example 4.1 and Example 4.2, the present values and the LECs are calcu-
lated on a year-by-year basis.
In the case of constant annual values of the series (O&M cost and electrici-
ty production), a calculation year-by-year is not necessary. The PVs can be
calculated in single columns with the NPV function of MS-Excel.
In the above examples, however, the payment series for OPEX are not
constant amounts because they are subject to escalation. In section 2.6.1, we
developed the Add-In “BWSesc” that calculates the PV of escalating series.
By using these functions we can calculate the PVs in columns. A year-by-
year calculation is not necessary; this approach requires much less numerical
computation efforts and appears far more transparent. This is demonstrated in
the following example.
Example 4.3: Calculation of the LECs with the Add-In “BWSesc”
In this example the NPCs are calculated with the developed Add-Ins based on the
formulas for series with escalation, presented in section 2.6.1.
In real In nominal
Item Unit
terms terms
Electricity generation, net We GWh /a 4,860 4,860
CAPEX (steam PP 700 MW gross) mln € 1,240 1,240
Rates
Inflation rate j inf % /a 0.00% 2.00%
Discount rate (WACC) ir; in % /a 6.47% 8.60%
OPEX
OPEX, first year, fixed mln € / a 27.3 27.3
Escalation rate **) jr; jn % /a 1.00% 3.02%
OPEX, first year, variable mln € / a 153.2 153.2
Escalation rate *) jr; jn % /a 1.50% 3.53%
Present values
Electricity generation *) PV (W e ) GWh 34,986 31,747
CAPEX (steam PP 700 MW gross) mln € 1,240 1,240
OPEX, fixed, discounted ***) 10 a mln € 207 207
OPEX, variable, discounted ***) 10 a mln € 1,189 1,189
Net present cost NPC, total mln € 2,636 2,636
LEC (= NPC / PV (W e )) € / MWh 75.33 83.02
Note: the spreadsheet is linked to the spreadsheet WACC_incl._tax
*) Calculated with Excel function PV **) j n =(1+j r ) x (1+j inf ) -1 in percent format
***) Calculated with Add-In: BWSesc
Note: The results are exactly the same as in the year-by-year calculation in Example
4.1 and Example 4.2. The year-by-year calculation provides the same result; it is
not more accurate!
50 4 Investment Appraisal Methods
The LEC is a constant value for given cost series of a project. In contrast, a
Cost Based Tariff (CBT0) is calculated in current dollars for the first year of
operation and is subject to escalation during the project’s lifetime.
The CBT0 can be easily calculated with a slight transformation of the LEC
formula. We just replace the term “LEC” with term “CBT0 × pt “ in the for-
mula:
So we get the formula for the cost based tariff for the starting year in current
currency values:
t =n
OPEX t
CAPEX + ∑
qt CU
CBT0 = t =1
t kWh (4.6)
t =n
p
∑ Wel _ t ×
t =1 q
Where:
p = 1+j: Escalation factor – j : escalation rate %/100 per year
q = 1+i : Discount factor– i : discount rate %/100 per year
Important Note: In contrast to the LEC, the cost based tariff CBT0 for
the starting year has the same value for calculation in nominal terms as
in real terms. The discount rate and escalation rates must be, of course,
in nominal or in real terms respectively.
In the following example, the cost based tariff for the same power plant as in
Example 4.1, Example 4.2 and Example 4.3 is calculated. We distinguish
between a capacity and a volume tariff.
4.3 The Net Present Value Method – NPV 51
In real In nominal
Item Unit
terms terms
Power plant
Electrical output, gross P gross MW 700 700
Electrical output, net P net MW 648 648
Full load hours t h/a 7,500 7,500
Electricity generation, net We GWh /a 4,860 4,860
Lifetime a 10 10
CAPEX mln € 1,240 1,240
Rates
Inflation rate j inf % /a 0.00% 2.00%
Discount rate (WACC) ir; in % /a 6.47% 8.60%
OPEX
OPEX, first year, fixed mln € / a 27.3 27.3
Escalation rate **) jr; jn % /a 1.00% 3.02%
OPEX, first year, variable mln € / a 153.2 153.2
Escalation rate *) jr; jn % /a 1.50% 3.53%
Present values
Power ***) PV (P net ) MW 4,904 4,904
Electricity production ***) PV (W e ) GWh 34,986 34,986
CAPEX mln € 1,240 1,240
OPEX, fixed, discounted ***) mln € 207 207
OPEX, variable, discounted ***) mln € 1,189 1,189
st
Tariff, for the 1 year of the period
Capacity tariff € /kWa 295.0 295.0
Volume tariff € / MWh 33.98 33.98
Composite tariff € / MWh 73.31 73.31
Note: the spreadsheet is linked to the spreadsheet WACC_incl._tax
*) Calculated with Excel function PV **) j n =(1+j r ) x (1+j inf ) -1 in percent format
***) calculated with Add-In: BWSesc
52 4 Investment Appraisal Methods
The Internal Rate of Return (IRR) method is a special form of the NPV meth-
od. The IRR is the discount rate at which the NPV becomes zero. The IRR is
the appraisal method that banks and equity investors usually prefer. There are
two different forms of the method:
• IRR on investment (IRROI)
• IRR on equity (IRROE)
The former refers to the entire invested CAPEX, the latter, to the equity share
of the CAPEX.
The relevant payments series and components associated with the IRR on
investment are shown in the figure below.
Capital Expenditures
CAPEX I0 (CU)
Sales Revenues Operating Expenses
Rt (CU/a) OPEX Et (CU/a)
PROJECT
Lifetime
WACC
PV Reference Time
NPV = − I 0 + ∑
t=n
( Rt − Et ) = − I t =n
( Rt − Et )
t 0 +∑ t
=0 (4.7)
t =1 q t =1 (1 + IRROI )
4.4 The Internal Rate of Return Method – IRR 53
Where:
I 0 : Capital expenditures, present value
Rt : Sales revenues of the year t
Et : Expenses of the year t (OPEX)
q : Discount factor q = 1 + IRROI
The equation (4.7) can be resolved with the Newton iteration algorithm as
illustrated below. This is done by inserting an assumed IRR in the equation
until the NPV becomes zero. Each calculation attempt brings the result closer
to NPV=0. This was the common approach before the computer and PC era.
The former returns the IRR for a series of cash in- and outflows that occur in
regular periods- [Guess] a number to be inserted close to actual IRR.
The latter returns the IRR considering both the cost of the investment and the
interest received on reinvestment of the cash. If the finance and reinvest rates
are assumed to be equal, the IRR is the same with both functions. The func-
tion is useful if the reinvestment rate is higher or lower compared to the fi-
nance rate.
Before starting with the calculations, the hurdle discount rate shall be de-
termined based on the WACC, as shown in Example 3.4 and Table 4-1.
54 4 Investment Appraisal Methods
The IRR on equity considers that the invested capital is financed by different
shares of equity and loans. The relevant cash series and components associat-
ed with the IRR on equity are shown in the figure below.
Capital Expenditures
CAPEX I0 (CU)
Loan L (CU/a) Operating Expenses
OPEX Et (CU/a)
Sales Revenues Loan Repayment
Rt (CU/a) RLt (CU/a)
Interest on Loans
PROJECT Ilt (CU/a)
Lifetime
WACC Corporate Tax *)
PV Reference Time CTt (CU/a)
*) Included as a cash series
for IRROE after tax
IRROE =
Discount Rate for NPV = 0
Cash-inflows (+) positive Power and Energy Systems -
Cash-outflows (-) negative Engineering Economics
IRROE ≥ Return on Equity
Author‘s own illustration
as in WACC
IRROE is essentially the actual profitability criterion for the investor. There
are two versions of the method: IRR before tax implies that the corporate tax
is not included as a payment series – equation (4.8); in contrast, after tax
implies that corporate (CT) tax is included as a payment series − equation
(4.9).
Where:
I 0 : CAPEX
L : Loan
R : Revenues
E : Operating expenses
RL: Loan repayments
IL: Interest payments on loans
CT : Corporate tax payments (if calculated after tax)
n : Lifetime
t : Year during lifetime
IRROE: Internal rate of return on equity
The expected return on equity before tax in Table 4-1 Example 3.4 is 14.7%, hence
the investment does not fully meet the investor’s profitability requirement.
Payment series
Revenues esc 2.5 %/a 294,886 302,258 309,815 317,560 325,499
Expenses esc 3.5 %/a -50,000 -51,750 -53,561 -55,436 -57,376
Interest on loan 6.0 %/a -42,000 -33,600 -25,200 -16,800 -8,400
Corporate tax 25.0 % -722 -4,227 -7,763 -11,331 -14,931
Loan repayment 5a -140,000 -140,000 -140,000 -140,000 -140,000
Total in- & outflows *) IRROE=11.0 %/a -300,000 62,165 72,681 83,290 93,993 104,792
*) Excel function: IRR (mark series of values, guess 10%)
The expected return on equity before tax in Table 4-1 is also 11%/a, hence the in-
vestment just meets the investor’s profitability requirement.
The annual equivalent amount method requires that the discounted annual
returns (Rt-Et) during the lifetime of a project are added to the capital expend-
itures (-I0) and their sum is multiplied by the annuity factor. The result is the
annual equivalent amount ANU (or annuity) of the investment.
4.5 Annual Equivalent Amounts or Annuity Method 57
t =n
(R − E ) CU
An = an ⋅ − I 0 + ∑ t t t = an ⋅ NPV a (4.10)
t =1 q
The term within the brackets is the net present value (NPV) of the investment.
The factor “an” is the capital recovery factor or annuity factor. It returns the
annuity of an initial payment of the value 1.
1 q n ⋅ ( q − 1) 1
Annuity factor: an = t = n = n a (4.11)
1 q −1
∑q
t =1
t
Where:
An: Equivalent annual amount or Annuity (CU/a)
an: Annuity factor (1/a)
I0: Capital expenditures
Rt - Re: Revenues minus Expenses of the year t
n: Lifetime (a)
q=1+i: Discount factor, i interest rate %/100
Where:
PMT: The constant annual equivalent amounts or annuities
Rate: Interest rate in % per period
Nper: Number of periods, usually years
Pv: Present value of CAPEX (for value 1 PMT returns the annuity factor “an”)
Fv: Future value also called salvage value, in our examples it is zero
Type: For payments at the end of the period zero (0), at the beginning on (1)
longer lifetime). An estimate of salvage value for energy sector projects after
a lifetime of 20 to 50 years does not seem to be realistic. The annuity method
does not ignore the different lifetimes of the options; it simply removes the
difference from the comparison. This is explained below:
In practical application of investment appraisal, the annual returns (Et-At)
are taken to be constant amounts during the lifetime of the investment and
can be taken out of the parenthesis. Equation (4.10) becomes:
t =n
1 CU
An = an (− I 0 ) + ( Rt − Et ) ⋅ an ⋅ ∑ a (4.12)
t =1 qt
1
The annuity factor an = t =n
inserted in the equation above, we get:
1
∑
t =1 q
t
t =n
1 1
An = an ⋅ (− I 0 ) + ( Rt − Et ) ⋅ t =n ⋅∑
1 qt
∑q
t =1
t
t =1
st
Options 1: Single Investment in 1 year only, life time 4 years discount rate i = 6.0%
Item Unit 0 1 2 3 4 5 6 7 8 9 10 11 12
ΣP i CU 100.00 100.00 0 0 0
ΣPV0 CU 100.00
Annuity CU / a 27.23 Excel Function PMT(Interest rate; life time ;PV CAPEX; 0;1)
st th th
Option 2 as above: Investments 1 , 5 and 9 year, total life time 12 years discount rate i = 6.0%
ΣP i CU 300.00 100.00 0 0 0 100 0 0 0 100 0 0 0
ΣPV0 CU 241.95 100.00 79.21 62.74
Annuity CU / a 27.23 Excel Function PMT(Interest rate; life time ;PV CAPEX; 0;1)
t =n
CU OPEX t CU
an ⋅ CAPEX + an ⋅ ∑
a qt a CU
LEC = t =1
MWh (4.14)
t =n We _ t MWh
an ⋅ ∑
qt a
t =1
Where:
an; Annuity factor (1/a)
CAPEX: Capital expenditures (CU)
OPEX: Operating expenses in the year t (CU/a)
We t: Electricity production in the year t (MWh)
t =n We _(t ) 1 t =n
1 MWh
an ⋅ ∑ t
= t =n
⋅ We ⋅ ∑ = We a
q 1 qt
t =1
∑q
t =1
t
t =1
The equation for the LEC for a constant energy production over the lifetime
is:
t =n
OPEX t CU
an ⋅ CAPEX CU + an ⋅ ∑
a qt a CU (4.15)
LEC = MWh
t =1
MWh
We
a
the following example, the calculation of the LEC of a project with an esca-
lating OPEX series is shown. This is done in real terms (inflation adjusted
and escalation rates on top of inflation) as well as in nominal terms (includ-
ing inflation):
Example 4.10: LEC of escalating OPEX with the annuity method
In Example 4.1, Example 4.2 and Example 4.3, the LEC have been calculated
with the NPV method. In the following examples, the LEC of the same project are
calculated with the annuity method. The OPEX is broken down in its fixed part (cost
of personnel, maintenance, etc.) as well as in a variable part mainly consisting of fuel
costs. Their escalation rates are different.
in in
Item Unit real nominal
terms terms
Techno / economic constraints
Rated power output, net (700 MW gross) MW 648 648
Electricity generation, net 7500 h/a GWh / a 4,860 4,860
Lifetime a 10 10
Discount rate %/a 6.47% 8.60%
Inflation %/a 0.00% 2.00%
Escalation rate OPEX, fixed %/a 1.00% 3.02%
Escalation rate OPEX, variable %/a 1.50% 3.53%
CAPEX mln € 1,240 1,240
OPEX at operation start (beginning of 1st year)
OPEX, fixed (personnel, maintenance, etc) mln € / a 27.3 27.3
OPEX, variable (fuel, consumables) mln € / a 153.2 153.2
Annual costs
Annualized CAPEX mln € / a 172.3 189.8
OPEX, fixed *) (Add-In ANesc) mln € / a 28.7 31.6
OPEX, variable (incl. fuel) *) (Add-In ANesc) mln € / a 165.2 182.0
Total mln € / a 366.1 403.5
Specific costs
Capacity cost (fixed costs) € / (kW a) 310.11 341.75
Energy cost € / MWh 33.98 37.45
Composite cost LEC € / MWh 75.33 83.02
*) levelized including escalation
The LECs are equal to those calculated with the NPV method in the examples men-
tioned above. It becomes evident that we get the same results with far less effort in
calculation and better transparency.
If the annual energy production varies over the lifetime, its present value
must be calculated first and levelized afterwards with the annuity factor ac-
cording to equation (4.14).
Note: See also Case Studies Chapter 9, Exercise 9.4-1and Exercise 9.4-2.
62 4 Investment Appraisal Methods
The payback time is the time during which the cumulative cash flows become
equal with the invested capital.
The method is mainly used in energy audits to evaluate the economic via-
bility of cost-saving measures. The annual cash flows are thereby the cost
savings versus a base case. The method can be applied in two different ways.
Simple payback does not use discounting; the payback time is found by di-
viding the estimated additional capital expenditures ∆I0 by the estimated
average cost savings per year ∆E, compared with the base case option:
∆I 0 CU
Payback time: t pb = CU
[a ] (4.16)
∆E
a
t =t pb
∆Et
−∆I 0 + ∑ t
=0 (4.17)
t =1 q pb
The equation can be solved with the goal seek function of MS-Excel. The
discounted payback time is longer than the simple payback time.
Commonly, the simple payback is applied. Depending on the sector, com-
pany managements expect quite short payback times for costs saving
measures typically in the range of 3 to 5 years.
As energy saving measures are commonly financed by own capital, the
expected returns on equity are correspondingly high and the discounted pay-
back becomes longer. Presenting discounted payback to decision makers can
even be counterproductive, as the expected payback times in their heads are
commonly based on simple payback.
4.7 Return on Investment (ROI) 63
High
Standard
Item Unit efficiency
motor
motor
Technical parameters
Rated capacity kW 1,500 1,500
Full load operating hours h/a 7,000 7,000
Efficiency - 92.1% 95.3%
Electricity consumption MWh /a 11,404 11,018
CAPEX US$ 750,000 835,000
Electricity price US$ / MWh 55.00 55.00
Discount rate - 15.0%
Annual costs US$ / a 627,229 605,981
Incremental CAPEX: - ∆I o US$ 85,000
Cost saving: ∆E t US$ / a 21,248
Simple Payback a 4.0
Discounted payback t pb *) a 6.6
t = t pb
∆Et
−∆I 0 + ∑q
t =1
t pb
=0
*) Discounted payback calculated with the goal seek function of MS Excel
Return on investment (ROI) is just the inverse of the payback time. Manage-
ment of companies may prefer the Return on Investment method instead of
payback.
The ROI is found by dividing the average annual cost savings by the in-
cremental capital expenditures compared to a base case.
High
Standard
Item Unit efficiency
motor
motor
Technical parameters
Rated capacity kW 1,500 1,500
Full load operating hours h/a 7,000 7,000
Efficiency - 92.1% 95.3%
Electricity consumption MWh /a 11,404 11,018
CAPEX US$ 750,000 835,000
Electricity price US$ / MWh 55.00 55.00
Annual costs US$ / a 627,229 605,981
Incremental CAPEX: - ∆I o US$ 85,000
Cost saving: ∆E t US$ / a 21,248
ROI - 25%
5 Financial and Economic Analysis of Projects
Discounted Cashflow (DCF) models are originally used for the assessment of
the value of a company or a project. This is based on the philosophy that this
value is equal to the expected future net incomes discounted back to a present
value with an appropriate discount rate.
The DCF analysis is actually a projection of profit and loss (P&L) state-
ments over the lifetime of the investment. The P&L statement gives all pay-
ment series on how the project incurs its revenues and expenses through its
operating activities and shows the profit or loss and the cashflow incurred
over a specific accounting period, typically over a fiscal year.
Project developers use cashflow models in order to ensure creditors and
investors that the project will generate sufficient cashflows to repay loans and
to obtain adequate returns on the equity investors’ capital. In this respect a
discounting is not imperative.
The cashflow is calculated by adding depreciation, a cost item but not a
cash outflow, to the net income after interest payments and taxes, as follows.
Sales revenues
Minus operating expenses
Minus depreciation
Minus interest on loans
= Net income before taxes
Minus corporate tax
=Net income after tax
Plus depreciation
= Cashflow
Minus principal repayment (loan)
= Free cashflow
We use the term cashflow as defined above throughout this book.
The cashflow shall be sufficient for the repayment of the loans, provision of
dividends for the investors and for financial reserves to cover future capital
expenditures, e.g. for general overhauls, for decommissioning etc. Further-
more the IRR and financial performance parameters required by banks, such
as the debt service coverage ratio, are calculated with cashflow models.
Investment appraisal with methods as presented in chapter 4 is commonly
conducted in real terms excluding inflation. In contrast, cashflow analysis
must be done in nominal terms including inflation. This is because a main
purpose of cashflow analysis is to demonstrate if the repayment of the loan is
68 5 Financial and Economic Analysis of Projects
secured and if the investors can earn sufficient returns. While revenues and
costs are subject to inflation, the series for principal repayment are constant
installments in nominal terms (not inflated). Hence, inflation gradually in-
creases the cashflow over time and has a positive impact on the repayment of
the loans and will deliver higher returns.
Cashflow analysis is conducted with payment series and discount rate
in nominal terms including inflation.
Example 5.1: Typical structure of DCF model (simplified)
The typical structure of a DCF model is presented in the example below. The short
project lifetime of 5 years is for demonstration purposes only (see also detailed cash-
flow model in chapter 9, Case Studies, Error! Reference source not found.).
The results of Example 5.1 can be summarized as follows: The net income in the
first two years is negative; therefore, there is no corporate tax. In spite of a negative
net income after tax, the cashflow is positive and sufficient for the repayment of the
loan over the entire lifetime.
Revenues: The annual revenues are calculated with the selling price (tariff)
per kWh, multiplied by the annual net energy production. The selling price is,
however, subject to supply and demand on the market and is actually fore-
cast. Commonly, the expected selling revenues are based on the cost base
tariff (CBT) presented in section 4.3.4. The CBT corresponds to the tariff of
the first year of operation in current dollars and is subject to inflation in the
following years.
Straight-line depreciation over the project’s lifetime is the most common
practice in cashflow analysis for projects of the energy supply sector. The
annual amount of depreciation is computed by dividing the initial capital
expenditures by the number of years of its estimated lifetime. Other deprecia-
tion methods such as the declining balance method and the sum-of-the-years'-
digits method are applied in exceptional cases only.
Financial performance ratios refer to the ability of the company or the project
to pay its debt with available cash from its operating activity. In the cashflow
projections, the following financial performance ratios are also calculated.
The definitions of the most common ratios are stated below [2] [3]
Debt service coverage ratio (DSCR): The DSCR is defined as the cashflow
available for debt service for any given debt service year, divided by the re-
spective amount of debt service of the respective year. This is calculated in
cashflow projections with following formula.
The DSCR must be higher than one; if not, it means the cashflow is not
sufficient to repay the debt of the respective year. Typical is a value
>1.2.
The loan life coverage ratio (LLCR) is defined as the net present value of
cashflow available for debt service divided by the outstanding debt in the
period. This is calculated in cashflow projections with following formula
An LLCR of two (2) means that the discounted cashflow available is double
the amount of the outstanding debt balance. A specific value for LLCR may
be preset in a loan agreement contract by the lender in order to assess if the
borrower will be capable of making the required interest and principle re-
payment over the lifetime of the loan.
The project life coverage ratio (PLCR) is defined as the net present value of
the project’s cash available for debt service over the remaining full lifetime
of the project to the outstanding debt balance in the period. This ratio is simi-
lar to LLCR, however, the cashflow for the PLCR is calculated over the “pro-
ject life” instead of the “loan life”. This is calculated in cashflow projections
with the following formula.
5.4.1 Introduction
Financial analysis studies the performance of a project from the point of view
of the investors or the enterprise with the overall objective of determining its
profitability for a company. Economic analysis aims at identifying economic,
social and environmental benefits of the project from the perspective of na-
tional economy and assesses the effects that the project will have on the wel-
fare of a country as a whole. There are several other significant differences in
conducting the analysis that are briefly outlined below. For a more detailed
but still concise description, refer to [4] and [5].
The following issues are to be highlighted with regard to financial and
economic costs: transfer payments, pricing mechanisms, border and shadow
pricing externalities and system linkages.
Table 5-1: Main differences between financial and economic analysis
Sources of investment funds from entities within the country as grants, equity
and loans, as well as the corresponding interest payments and principal re-
payments, are ignored in economic analysis. They are treated as transfer
payments because they only shift claims on the project resources and returns
between equity investors and lenders and do not increase the national income.
Foreign loans only have to be considered in economic analysis if they have
an impact on the balance of payments of a country.
The discount rate does not take equity and loan into consideration as a part
of financing and related return expectations. Instead, the yield of long term
government bonds is proposed as an appropriate discount rate; this is roughly
the rate for loans minus two (2) percentage points (see Example 3.4).
Inputs of resources in the form of goods or services incurred during the con-
struction phase and operation time of energy sector projects are classified in
tradable and non-tradable items.
Tradable items are traded in the international markets and include, for ex-
ample steel, metals, cement, equipment, fuels and engineering services.
Non-tradable items are those that are not traded internationally. They in-
clude services where the demander and bidder must be in the same country,
and commodities which have low value relative to either their weight or their
volume and therefore cannot be profitably exported. Typical non-tradable
items are land and real estate, cooling water, materials for civil works, poor
quality indigenous fuels, local transportation services, hotel accommodation
and local labor.
In financial analysis, tradable items are considered with their market pric-
es. Market prices of goods and services are determined, in principle, in mar-
5.4 Economic versus Financial Analysis 73
ketplace by the rule of supply and demand. In reality, however, prices are
always distorted by customs, duties, taxes, subsidies and other restrictions.
In economic analysis, tradable items are priced according to their border
prices. Border prices for exports are FOB (free on board) prices and CIF
(cost, insurance, freight) for imports. The border price for tradable domestic
coal is equal to mining cost plus transport charges to the nearest port, plus
handling and ship loading cost (FOB).
Non-tradable items are priced with shadow prices. These are assigned
monetary values and shall represent their true costs for the national economy.
Shadow pricing is usually subject to various assumptions within certain
guidelines and is fairly subjective [3]; they are determined by applying con-
version factors.
5.4.5 Externalities
Projects of the power industry usually have negative and positive effects out-
side of their boundaries, particularly pollution and other environmental im-
pacts, and the creation of jobs directly or indirectly. These effects are called
externalities.
The flue gases of a power station may cause, for instance, damages to
buildings and health problems for the population. A wind farm will have a
negative scenic impact on the landscape.
In financial analysis, such externalities are not considered in the project
costs. Economic analysis, however, tries to quantify externalities in monetary
terms and to incorporate them as the project’s economic costs.
As an example, lignite is a low grade non-tradable fuel. It is extracted in
open-cut mining and power stations firing lignite are built close to the mine
to avoid transportation costs. A lignite power plant may be profitable from
the point of view of the utility, due to the low cost of the fuel, but when its
environmental impacts such as land use, non-acceptance by the population,
displacement of the population, and recultivation of the area are included as
economic costs, the project may be rejected on economic rather than financial
grounds.
alone but should also include analysis of environmental and social impact,
job creation opportunities and other externalities related to the national econ-
omy with the goal to optimize the use of limited economic resources and to
ensure economic efficiency along with financial viability.
Financial analysis is always the first step of project evaluation. If a project
proves to be profitable from the investors’ viewpoint, an economic analysis
should follow to investigate its implications on the national economy.
While financial analysis of energy supply projects may be done either by
engineers with skills and training in economics or by economists with tech-
nical background, handling detailed economic analysis requires skills and
extensive experience in national economy issues and is solely the job of na-
tional economists.
2)
“Power and Energy Systems Technologies and Economics”, forthcoming, publica-
tion in summer 2015
3)
“Praxisbuch Energiewirtschaft”, Panos Konstantin, 3rd Edition 2013, published by
Springer Vieweg, 4th Edition planed 2016
© Springer International Publishing AG, part of Springer Nature 2018 77
P. Konstantin and M. Konstantin, Power and Energy Systems
Engineering Economics, https://doi.org/10.1007/978-3-319-72383-9_6
78 6 Introduction on Cost Allocation to Cogeneration Products
The infrastructure for district heating is very costly (piping, substations etc.).
Therefore the entire energetic and cost advantage of cogeneration is allocated
to the heat to compensate the cost of the costly infrastructure while the cost
of electricity is kept the same as in a condensing power generation process.
There are the following methods for fuel and cost allocation for the cogenera-
tion products:
• The residual value method
• The electrical equivalent method
• The exergy method
• The calorific method
In this chapter, only the first two methods are briefly presented because the
proper application requires a strong background in thermodynamics that is
beyond the scope of this book.
The residual value method is very common for municipal utilities and for
factories that operate small scale captive engine or gas turbine CHP plants.
The approach is briefly described below:
The method finds application mainly for small or medium scale engine or gas
turbine with Heat Recovery Boilers CHP plants. The credit may be either an
electricity credit for avoided costs for electricity purchase from the grid or a
heat credit for avoided heat production cost in a captive heat-only boiler
plant. The former is mainly practiced by municipal utilities while the latter
mainly by industrial factories.
80 6 Introduction on Cost Allocation to Cogeneration Products
Example 6.2: Specific cost of heat in a heat-only boiler (fuel cost only)
The same amount of heat is produced in standby boiler instead of cogeneration.
The electrical equivalent method is based on the fact that steam (≙heat) ex-
tracted from a steam turbine induces some loss of electricity production. This
is referred to as the electrical equivalent β (kWhe/kWht) of the extracted heat
and mainly depends on the extraction pressure. Hence, the steam is charged
with the costs of the equivalent (lost) electricity production – see Example
6.3. We can express this mathematically with the following equation:
6.3 Cost Allocation Methods 81
CU
Heat generation costs: ch =β × c e (6.1)
kWh t
Where:
ce: Electricity generation cost in condensing mode of operation (CU/ kWhe)
ch: Generation cost of the extracted heat (CU/kWht)
The method can also be applied for fuel allocation to the extracted steam –
see equations below and Example 6.4.
3.6 MJ
Heat rate of cond. electricity qɺe =
(6.2)
ηe kWhe
3.6 × β
Heat rate of the product heat: qɺh = = β × qɺ e MJ (6.3)
ηe kWh t
1
Or Heat rate of the product heat: qɺh = β kWhf (6.4)
ηe kWh t
Where:
β : Electrical equivalent of heat (MJ / kWht)
ηe : Electrical efficiency in condensation mode
qɺe : Heat rate of electricity in condensing mode of operation (MJ/ kWhe)
qɺh : Heat rate of the extracted heat (steam) MJ/kWht or kWhf /kWht
0.30
Condensing pressure 0.045 bar
0.25
0.20
Equivalent cond. efficiency 36%
Condensing pressure 0.045 bar
0.15
0.10
0.05
For comparison: The heat rate of a heat-only boiler with thermal efficiency of 88%
will be:
1 MJ GJ
qɺ h _ boiler = × 3.6 = 4.1 or
0.88 kWh t MWh t
The fuel cost for heat generation in a heat-only boiler at a natural gas price of
25 €/MWht (6.94 €/GJ) and a thermal efficiency of 88% will be 28.45 €/MWht.
7 Project Analysis under Uncertainties
7.1 Synopsis
50
45
Full capacity hours 7000 h/a
40 Electricity credit 60 €/MWh
Specific Heat Cost €/MWht
For the “worst case”, less favorable input parameters are assumed and the
opposite is done in the “best case” scenario.
The approach is demonstrated again on the basis of Example 6.1 by adding
a “worst case” and a “best case” scenario and alternative heat generation in a
heat-only boiler for comparison. The outcome is shown in shortened form in
Example 7.3.
Example 7.3: Scenario analysis of heat generation cost, cogen vs. boiler
Heat-Only Boiler
Heat generation MWht / a 12,857 15,000 17,143
Fuel consumption η =88% MWht / a 14,610 17,045 19,481
Gas price in LHV € / MWht 30.00 25.00 20.00
Specific cost of heat € / MWht 34.09 28.41 22.73
The outcome can be interpreted as follows: the cost of cogenerated heat is, even in
the worst case scenario, at an acceptable level, while in the other two scenarios it is
considerably lower.
evaluation are close to each other. SWOT analysis can be applied in two dif-
ferent ways:
• SWOT statement: The strengths, opportunities, threats and weaknesses of
the project are just highlighted and verbally commented while the overall
judgement of the merits remains on the side of the investor. In general,
this will be subjective.
• SWOT evaluation matrix: Different evaluation criteria are defined and
put together in groups in the form of a matrix. Each criterion receives
evaluation marks, for example, from 1 to 5. The marks of each group are
summed up and a weighted average number is calculated.
Figure 7-1: SWOT statement example for a potential CHP plant project
88 7 Project Analysis under Uncertainties
of the annual energy production in the different years of the project’s life-
time. The uncertainty analysis is usually conducted under the assumption that
the energy production in the different years falls into a normal distribution
around the calculated production for the base case.
Normal distribution is a bell shaped curve depicting the density of values
on the x-axis and the frequency of occurrence on the y-axis. Such a distribu-
tion is a very helpful tool for analyzing uncertainties, as it is characterized
only by two parameters, the statistical mean µ and the standard deviation σ.
The formula of the normal distribution is:
( x − µ )2
1 −
2⋅σ 2
g ( x; µ , σ ) = ⋅e (7.1)
σ ⋅ 2 ⋅π
Where:
x The values for which the distribution is sought; x-axis
g(x;µ,σ) Distribution function with variables x; µ,;(g stands for Gauß)
µ The statistical mean of the values
σ The standard deviation
The two features d) and f) above imply that curves with a big σ tend to be
broad and their maximum is low; in contrary, curves with a smaller σ are
narrow and have a higher maximum (see Figure 7-2).
90 7 Project Analysis under Uncertainties
bution.
Figure 7-3: Standard normal distribution curve
7.5 Uncertainty Analysis of Energy Production 91
Figure 7-4: Gauß distribution, Example with µ=50 GWh base yield
The curves in Figure 7-2 and Figure 7-3 play an outstanding role for proba-
bility analysis in the statistics. We have to distinguish between the probabil-
ity of occurrence and the cumulative probability. - Figure 7-4.
The probability of occurrence is the value of the g-axis (“g” stands for
Gauß instead of y) for a given x-value. The area (mathematically, the inte-
gral) under the curve from negative infinity (- ∞) to x-value 45 GWh, is the
cumulative probability. This includes all of the cluster of x-values below the
given x. The area to the right represents the cluster of x-values exceeding the
given x.
MS-Excel provides a function to calculate both types of probability. The
syntax of the formula is:
Where:
x: the x-value for which the probability is sought
µ : the arithmetic mean of the x-values
σ : the standard deviation
FALSE, TRUE: logical values
92 7 Project Analysis under Uncertainties
2
z
1 −
g ( z) = ⋅e 2 (7.4)
2 ⋅π
Example 7.4: Probability calculations
The base case yield of a wind farm for reference conditions is µ = 50 GWh/a, and the
standard deviation is σ = 5. Find the g-value, the cluster of values below
x=45 GWh/a (cumulative probability CUP).
g ( x) = NORM .DIST (45,50,5, FALSE ) = 0.048
CUP = NORM .DIST (45,50, 5, TRUE ) = 0.16
A cumulative probability CUP=0.16 (16%) means that the probability that a yield of
45 GWh may not be reached is 16%; the probability that it may be reached or ex-
ceeded is 84%. In other, words the exceedance probability is P84 (see also Figure
7-4).
2 2 2 2
σ = U wind data + U wind mod el + U farm mod el + U wind turbine (7.5)
7.6 Risk Analysis and Risk Mitigation 93
The exceedance probability XEP can be calculated with the EXCEL function
NORM.INV as follows:
X P = 2 ⋅ µ − NORM .INV ( P / 100, µ , σ ) (7.6)
P100
σ =5 ≙ 10% Exceedance Probability
P90 Mean value = 50 GWh/a
10% 20%
P80 PXX
GWh / a GWh / a
Exceedance Probability
P40
P30 σ = 10 ≙ 20%
P20
P10
P0
30
35
40
45
50
55
60
65
70
Wind farm energy production GWh / a
ades the most secure investment because the returns were guaranteed by the
government. After the financial crisis of 2008 and the subsequent economic
crisis, we have learnt that even government bonds are insecure.
Nevertheless, projects in the energy supply sector are commonly classified as
low risk investments. This is because energy supply is not an ordinary busi-
ness activity. Energy is an indispensable commodity for every national econ-
omy. Furthermore, the demand for electricity is, in most economies, rising or
remains stable, power generation and distribution infrastructure need re-
placement and renewal.
In spite of all these advantages, there are still risks. However, there is
again a crucial difference compared to other businesses. Risks of energy sup-
ply projects are not in “any case” risks for the investor. This is because costs
can often be rolled over to the consumers. Hence, we must distinguish be-
tween risks for the investor and risks for the consumer. In this context, some
explanations are below:
Before the liberalization of the energy markets, energy supply used to be
an almost risk-free business. Electricity and gas supply were monopolies
dominated by a few vertically integrated companies. The tariffs were subject
to approval by some regulatory authority; however, the approval was merely
based on costs control.
The overall objective of the liberalization has been the creation of frame-
work conditions that enable competition and free trade of grid-based energy
such as electricity and natural gas. Liberalization starts with the unbundling
of the utilities into independent business units for production, transmission,
distribution and trade. Unbundling enables a competitive market environment
for power generation (production), while transmission and distribution still
remain natural monopolies and are regulated.
Even after liberalization, the energy supply business is still a relatively se-
cure business; however, there are differences in the risk exposure depending
on the business field and the applied technology.
Transmission and distribution of power can be considered the most secure
business field. In most countries, electricity demand is growing or remains
almost constant. This business sector will remain a natural monopoly in a
regulated market environment. The use of system tariffs needs approval by
the regulator, usually on a year by year basis.
Hydro power: Although it is capital intensive and the lifetime of plants is
much longer than 50 years, it can be considered a secure investment. The
technology is robust and mature. Sale of produced electricity can be consid-
ered secure due to the very low marginal costs (almost zero). The actual risk
is that the annual electricity production varies, depending on the water avail-
7.6 Risk Analysis and Risk Mitigation 95
ability for run-of-river plants. This is not the case for pump storage plants
that are deployed to cover peak load.
Nuclear power plants: They are capital intensive and their lifetime is long-
er than 50 years. Retrofitting with higher safety standards during their life-
time is very likely. High financial reserves for decommissioning are required.
Earlier shut down due to phase-out governmental policy after accidents is
likely (Germany, Japan); in general, a risky investment.
Conventional power plants fired with fossil fuels are still a “relatively se-
cure” investment. There are risks due to technology development, stricter
environmental standards and climate requirements such as carbon trade and
costs for carbon certificates.
Solar power generation: Depending on the technology, there are different
kinds of technology and operational risks. The most mature for utility-sized
plants are parabolic trough and photovoltaic technology. Large scale projects
with solar tower and Fresnel technology are currently at the start but not
proven yet in long term operation.
An integral part of financial analysis for new projects is a risk assessment and
mitigation process. This includes risk identification, analysis of the conse-
quences in the case of occurrence and risk management and mitigation.
The types of risks for energy supply sector projects can be classified as in-
ternal and external risks. The former are those that can be controlled by the
investor or plant operator and include mainly construction phase risks and
operation-phase risks. External risks are beyond of the control of the investor
or plant operator.
Table 7-2, Table 7-3 and Table 7-4 provide some overview of common
construction phase, operation phase and external risks along with their conse-
quences and mitigation measures described in key words. A detailed risk
analysis must follow for each particular project. It is noted, however, that
there are different project-specific risks especially, in connection with inno-
vative and renewable technologies that need special attention and mitigation
in order to ensure that the project will be a success.
Risks and risk mitigation measures usually have cost implications that
must be considered in the project costs. In this context, we have to distin-
guish between those that can be considered implicitly in the costs series and
those that are considered with risk premiums in the discount rate.
96 7 Project Analysis under Uncertainties
Costs for most of the internal risks are usually reflected in the payment series
as additional capital expenditures or operation expenses. In this context, the
following examples are mentioned:
• Completion or performance guarantees are reflected in increased pro-
ject costs (CAPEX) by the EPC contractors
• A grace period will have impact on the loan costs, e.g. a higher interest
rate
• Costs for maintenance agreements are considered in the operational
expenses (OPEX)
• Preventive maintenance to reduce degradation during operation (e.g.
frequent mirror cleaning for solar plants) will require increased
maintenance costs.
7.7 Consideration of Risk Premiums in Discount Rate 99
Source of Financing
Equitiy Debt
In general, investors bear the bulk of the project risks. The invested equity
capital is bound during the entire lifetime of the project. Investors can expect
returns (dividends) only if the free cashflow at the end of each year of opera-
100 7 Project Analysis under Uncertainties
tion is positive and provides some margin for dividend payments. This means
after all the operating costs are covered, including taxes, interest payments
and annual amortization of the loan. Furthermore, the returns on equity are
subject to taxation; hence, only the after-tax return is relevant for the inves-
tor. Consequently, the risk premium for equity will be considerably higher in
order to attract investors to bear the risks of the usually long-living projects
of the energy supply business.
The risk exposure of the lenders may be considered to be lower. Due to the
size of the investment, e.g. for power plant projects, the borrowers are institu-
tional investors such as large utilities or trustworthy independent power pro-
ducers (IPP) with a long-standing reputation for power plant projects world-
wide. Interest payments are tax deductible and the loan is gradually repaid
during the maturity time, hence, the lenders’ capital is not entirely bound
during the lifetime of the project. Furthermore, lenders disperse risks by
forming consortiums consisting of several banks.
There are different models on how to measure and validate risks [8] [9] [10].
In general, they are dealing with all types of investment from government
bonds, stocks, etc. In the following, we focus on investments for the power
supply industry only, first in countries with zero country risk (country risks
are discussed in the next section).
Energy supply is an indispensable service for any national economy. Pro-
ject investments in the energy supply sector have a history of about one cen-
tury worldwide. The most practical approach therefore is to estimate risk
premiums based on historical data and experience from similar projects in
comparable national economies.
A risk-free rate is the rate of return on equity or bank loan that is consid-
ered as guaranteed return. With regard to a power supply business, this means
that the project must be state-of-the-art, with long-term operational experi-
ence and proven performance in commercial scale. In this case, we can as-
sume that the risk-free rates are the same for both sources of financing.
The venture risk premium is the vehicle to attract investors to invest equity
capital in a project. For long-term projects in the energy sector, they reach the
order of magnitude of the risk-free rates or even higher. The credit default
premium is smaller for the reasons mentioned in the previous section, regard-
ing investors for energy supply sector projects with proven performance.
Risks related to the type of the project are in most cases technology risks.
Some typical examples are mentioned below:
7.7 Consideration of Risk Premiums in Discount Rate 101
interest rate
default risk
Technology
Risk free
Risk free
Venture
risk
risk
risk
terms terms
before before
tax tax
Steam power plant subcritical, coal 30 5.0 6.0 0.0 6.0 0.0 0.0 8.60 6.47
Steam power plant supercritical, coal 30 5.0 6.0 0.5 6.0 0.0 1.0 9.50 7.35
CCGT, natural gas 25 5.0 6.0 0.0 6.0 0.0 0.5 8.95 6.81
Nuclear power plant 50 5.0 6.0 3.0 6.0 0.0 1.0 10.50 8.33
Hydro power plant 50 5.0 6.0 0.0 6.0 0.0 1.0 9.30 7.16
Waste-to-energy plant 20 5.0 6.0 3.0 6.0 0.0 1.0 10.50 8.33
Wind power plant, on-shore 25 5.0 6.0 1.0 6.0 1.0 0.5 10.05 7.89
Wind power plant, off-shore 25 5.0 6.0 2.0 6.0 1.0 0.5 10.45 8.28
Solar PV power plant 25 5.0 6.0 0.0 6.0 1.0 0.5 9.65 7.50
Solar power plant, parabolic trough 25 5.0 6.0 0.0 6.0 0.0 0.5 8.95 6.81
Solar power plant, tower technology 20 5.0 6.0 3.0 6.0 1.0 1.0 11.20 9.02
Seawater desalination, thermal 20 5.0 6.0 0.0 6.0 0.0 0.0 8.60 6.47
Seawater desalination, reverse osmosis 20 5.0 6.0 1.5 6.0 1.0 0.5 10.25 8.09
High voltage grid 40 5.0 6.0 0.0 6.0 0.0 0.0 8.60 6.47
Low voltage grid 40 5.0 6.0 1.0 6.0 0.0 0.0 9.00 6.86
WACC: Weighted Average Cost of Capital Corporate Tax 25.0% * ) Inflation 2.0 %/a
Note: Company and country rating AAA
102 7 Project Analysis under Uncertainties
Country risks include political risks, economic risks, sovereign risks, expro-
priation risks, transfer risks and currency risks. Country risks differ from one
country to the other.
Political risks include, e.g. subversion of the existing political system, civil
disturbance, insurgency, acts of terrorism, etc.
Economic risks and sovereign credit default risks can occur in developing
as well as in developed countries over the course of global financial and eco-
nomic turmoil.
Currency transfer & convertibility risks (T&C) are the most significant
risk if investing in foreign countries. Currency convertibility risk refers to the
inability of the investor to legally convert local currency into foreign curren-
cy. Transfer risks refer to restrictions to transfer capital from business activi-
ties (revenues, royalties, interest etc.) outside the country. Such a situation
may result from government action in several countries.
Expropriation risks may arise from government actions which reduce or
eliminate ownership on the investment. This may imply creeping expropria-
tion as confiscation or blocking funds up to outright nationalization.
A credit worthiness of a country or entity is evaluated by different institu-
tions and agencies. It is an evaluation of the debtor's ability to pay back the
debt and the likelihood of default. In this context, the following are men-
tioned.
• Export credit guaranties provided by Export Credit Agencies
• The OECD Arrangement on Officially Supported Export Credits
• The credit ratings by rating agencies
Institutions dealing with export credits are called Export Credit Agencies
(ECAs). Export credit agencies provide financing services such as guaran-
tees, loans and insurance to domestic companies in order to promote their
exports activities (Investopedia definition [11]). The primary objective of
ECAs is to remove the risk and uncertainty of payments to exporters when
exporting outside their country. ECAs take the risk away from the exporter
and shift it to themselves, for a premium. ECAs also underwrite the commer-
cial and political risks of investments in overseas markets that are typically
deemed to be high risk.
Export credits can be backed by official support meaning that government
support is involved. Official support can take the form of direct cred-
its/financing, refinancing, interest-rate support (where the government sup-
7.7 Consideration of Risk Premiums in Discount Rate 103
ports a fixed interest-rate for the lifespan of the credit), aid financing (credits
and grants), export credit insurance and guarantees.
In case of official support, an ECA can be a government department or a
commercial institution administering an account for or on behalf of govern-
ment, separate from the commercial business of the institution (see list of
ECAs in [12]).
Export credits generally enjoy government backed support which raises po-
tential concerns about free and fair competition; therefore, they have been
subject to agreements and understandings within the framework of the OECD
that led to a formal agreement, “The Arrangement on Officially Supported
Export Credits” known as “the Arrangement” [13] .
The overall objective of the OECD Arrangement is to provide a framework
for the orderly use of officially supported export credits and to ensure a level
playing field for official support. In particular, the Arrangement seeks to en-
courage a fair competition among exporters based on quality and price of
goods and services exported rather than on most favorable officially support-
ed terms and conditions and to eliminate trade distortions related to officially
supported export credits.
Participants are the formal negotiating forum for rules that are considered
binding. Participants administer and further develop the Arrangement. Partic-
ipants are currently the following OECD members: Australia, Canada, the
European Union, Japan, Korea, New Zealand, Norway, Switzerland and the
United States. Other OECD Members (list of members see [14]) and non-
members may be invited by the Participants to become Participants.
A fundamental building block of the Agreement is the country risk classi-
fications (Chapter II, section 25. [15]). The country risk classifications are
meant to reflect the country risk. Under the Agreement, country risk is com-
posed of transfer and convertibility risk, cases of political risks and of force
majeure (e.g. war, expropriation, revolution, civil disturbance, floods and
earthquakes). The Participants’ country risk classification system uses a scale
of eight risk categories (0 -7). High income4 OECD countries and high in-
come Euro Area countries are classified in category 0. Their country risk is
considered to be negligible or zero. The country risk classifications are not
sovereign risk classifications and should not, therefore, be compared with the
sovereign risk classifications of private credit rating agencies (CRAs).
4
Defined by the World Bank on annual basis according to per capita gross national
income (GNI)
104 7 Project Analysis under Uncertainties
5
Eligible currencies are: Canadian Dollar, Czech Koruna, Danish Krone, Japanese
Yen, Norwegian Krone, Swedish Krona, Swiss Franc, UK Pound, US Dollar, Euro
6
http://www.oecd.org/tad/xcred/cirrs.pdf
7.7 Consideration of Risk Premiums in Discount Rate 105
Credit ratings are financial indicators that measure the creditworthiness and
the ability of issuers of debt securities to meet their financial obligations in
full and in time. Credit ratings are also indicators about the credit quality of a
security and the relative likelihood that it may default. They are assigned by
credit rating agencies (CRA) specialized in analyzing and evaluate the cre-
ditworthiness of entities such as governments, municipalities and enterprises
that issue debt securities (bonds) that can be traded in the capital market.
CRAs compile the results of their evaluation in ratings consisting of a combi-
nation of letters ranging from AAA or Aaa (best) to D (credit default). The
best known CRAs are Standard & Poor’s (S&P), Moody’s and Fitch.
Credit ratings may play a useful role in enabling corporations and govern-
ments to raise money in the capital market for funding their projects. Instead
of taking a loan from a bank, these entities (issuers) sometimes borrow mon-
ey directly from investors by issuing bonds. Investors purchase these debt
106 7 Project Analysis under Uncertainties
Baa1, Baa2, Baa3 BBB+, BBB, BBB- BBB+, BBB, BBB- Lower medium grade
Ba1, Ba2, Ba3 BB+, BB, BB- BB+, BB, BB- Speculative Non-
B1, B2, B3 B+, B, B- B+, B, B- Highly speculative investment
grade
Caa1, Caa2, Caa3 CCC+, CCC, CCC- Extremely speculative
CCC
Ca CC, C Default imminent speculative
In general, interest rates depend on the risk of the issue or issuer of a debt
obligation. A low-rated security has a high interest rate in order to attract
buyers. In contrast, a highly-rated security (assigned with AAA rating) has a
lower interest rate because it is a low-risk investment.
Credit rating agencies designate their ratings as opinions about relative
credit risk [19]. Relative means, for example, that the risk of default of a
bond bearing a BBB rating is less risky than that of a bond with a BB rating.
Credit agencies observe market developments that may affect the credit risk
and update ratings at least once a year. They may also issue an updated rating
outlook regarding a possible change to be “positive”, “negative” or “stable.
“Developing outlook” means that it is uncertain whether the rating may be
up- or downgraded in the near future [20]. Investment grade ratings are usual-
ly more stable than speculative ratings.
Updated ratings are listed on the websites of the rating agencies and also in
newspapers such as, Guardian [21], among others.
Ratings can be used to estimate risk premiums for corporate or government
bonds. One way of establishing risk premiums is to compare the interest rate
7.7 Consideration of Risk Premiums in Discount Rate 107
Baa1
Baa2
Baa3
Rating class
Aaa
Aa1
Aa2
Aa3
A1
A2
A3
investment grade
Country default spread, Bps 0 25 50 70 85 100 115 150 175 200
Caa1
Caa2
Caa2
Caa2
Rating class
Ba1
Ba2
Ba3
B1
B2
B3
speculative
Country default spread, Bps 240 275 325 400 500 600 700 850 850 -
Author's own compilation based on data from:
Source: http://pages.stern.nyu.edu/~adamodar/New_Home_Page/datafile/ctryprem.html
Reference interest rate for Aaa rating 6%/a, Currency US$
Spread is the difference in Bps referred to the Aaa rating bonds with zero spread
in
1 + 100 (7.7)
CRPr = − 1 × 100 [%]
6
1+
100
108 7 Project Analysis under Uncertainties
The overall objective of this chapter is to analyze the price setting mechanism
and price development of various types of primary energy (crude oil, coal,
nuclear, natural gas) used for power generation. The analysis covers the peri-
od from 1970 until the year of publishing this book as far as data from pub-
licly accessible statistics were available. The purpose is to draw conclusions
for future fuel price approaches in project evaluation.
The findings in this chapter can be summarized as follows: The market
prices of primary energies are subject to strong periodic fluctuations with
crude oil being the price leader; they are particularly sensitive to geopolitical
events such as crises and unrest in the producing countries. News and rumors
in the commodity markets, which cause fears regarding shortages or oversup-
ply among consumers, may also trigger price volatility even intraday.
It becomes clearly evident that crude oil still exerts a price leadership func-
tion on the energy market. The prices of all other primary energies follow the
price development of the price leader crude oil with a short delay.
The pricing of energies, which are in competition with each other, is based
on the replacement value concept. This implies, for example, that the power
generation costs of competitive fuels are kept at the same level and define the
prices. This price setting principle is commonly applied in long term con-
tracts for imported natural gas.
Import coal prices are heavily influenced by fluctuating overseas freight
rates which in turn depend on available overseas transport capacities and may
reach up to half of the CIF coal price.
Based on the findings from the past, we can conclude that medium- and
long-term price forecasts for primary energies are practically impossible. The
influence of fuel price development on the evaluation of investment projects
should rather investigate their influence in sensitivity or scenario analysis
taking into account their interdependence.
Fuels are available in the form of primary energy (e.g. coal, natural gas) or
final energy (e.g. fuel oil, Liquified Petroleum Gas (LPG), blast furnace gas).
Fuels are traded on the marketplace with different mass or volume units as
8.2 Definitions of energy terms 111
barrel crude oil, tons of coal, normal cubic meters (nm3) of gas, liter of diesel
oil, etc. However, the actual value of a fuel is not solely its mass or the vol-
ume but its energy content. There are, for example, different qualities of coal
or oil with different energy contents per mass unit.
Notations like tons of coal equivalent (tce) or tons of oil equivalent (toe)
provide better information regarding the value of a fuel as they are referred to
the energy content. One tce contains 7 billion calories7 (7 Gcal/tce); one toe
contains 10 billion calories (10 Gcal/toe). So coal or oil types with different
energy contents can be made comparable if their quantity is given with their
equivalent units, but these notations are still trade units and not applicable for
all types of fuels.
Hence, in order to compare the value of different types of fuels, their quan-
tities must be converted from trade units into thermal units. This is neces-
sary, for example, to establish energy balances or even to conduct financial
calculations with different types of fuels. The conversion in thermal units is
done by multiplying the trade units with the heating value.
The heating value is the measurement for determination of the energy con-
tent of the fuels. There are two heating values for each type of fuel. The terms
used are in American English: “lower heating value (LHV)” and “higher
heating value (HHV)”; in British English, instead, the terms used are “net
calorific value (NCV)” and “gross calorific value (GCV)”. In German litera-
ture, the terms Hu and Ho8 are common. In scientific papers, the terms “inferi-
or heating value (Hi)” and “superior heating value (Hs)” have been introduced
but they are rarely used in practice.
The higher heating value is defined as the amount of heat released by
complete combustion of one unit of fuel, all combustion products
cooled down to the temperature before the combustion and the water
vapor formed during the combustion is condensed into water and its
condensation heat is included in the HHV.
In contrast, the lower heating value does not include the condensation
heat of the water vapor formed during the combustion.
Heating values for selected fuels are shown in Annex 3. They are given in kJ,
MJ, kWht, MWht per unit of fuel (kg, metric ton, normal cubic meter (nm3)).
The notation in kWht or MWht is more practical for energy balances and is
preferably applied in this book.
7
) Calorie is an old thermal unit. In practice, the multiple kilocalorie (kcal) is used.
1 kcal =4.187 kilo Joule (kJ) = 1,163 kWht. 1 Gcal =1,000,000 kcal
8
) Hu:Unterer Heizwert, Ho Oberer Heizwert (corresponding to: LHV, HHV)
112 8 Overview of Energy Markets and Prices
Coal and HFO are traded in metric tons; for the conversion in thermal units
based on MWht or GJ, the commercial price is divided with the lower heating
value of the fuel.
cc US$/t US$ cc US$/t US$
ct = or ct = (8.1)
LHV MWh t /t MWh t LHV GJ/t GJ
In general, gas utilities sell gas based on the HHV; for energy balances, it
must be converted in LHV.
Note: See also Chapter 9 Case Studies, Exercise 9.2-1, Exercise 9.2-2 and Exercise
9.3-1 and Exercise 9.3-2.
This section describes and analyses the development of prices of the main
fuels which are used for power generation and provides a brief overview of
the pricing mechanisms. The analysis covers the period 1970 up to the pub-
lishing year of this book. Based on the outcome of this analysis, conclusions
are drawn regarding the development of fuel prices in the economic evalua-
tion of long term energy sector projects.
8.3 The Wholesale Market of Fuels 113
80
Price /barrel
40
20
0
1970
1972
1974
1976
1978
1980
1982
1984
1986
1988
1990
1992
1994
1996
1998
2000
2002
2004
2006
2008
2010
2012
2014
2016
Data Sources: OPEC annual statistic Bulletin, CPI: German Federal Bank, The Federal Reserve Bank USA
author's own compilation as a graph
Figure 8-1: Crude oil spot prices, OPEC basket annual average price
9
) New York Mercantile Exchange
10
) Organization of the Petroleum Exporting Countries
11
) The “OPEC basket” is a mix of eleven oil types
114 8 Overview of Energy Markets and Prices
The price is subject to strong, even hourly fluctuations and is extremely vola-
tile. The prevailing price drivers are geopolitical events and uncertainties as
well as speculation. Oversupply during weak periods or shortages in supply
during booming periods in the economy, cause price erosion or rising prices.
Exchange rate fluctuation between local currencies and the dollar play an
important role. For example, a strong Euro makes crude oil imports in the
countries of the Euro Area cheaper, and vise-versa.
The development of the crude oil price in real terms during the considered
time frame is characterized by a high price phase followed by a longer, calm-
er price period and a renewed high price phase. The sharp rise of the oil price
in the decade 1974 to 1984 was caused by the two so-called oil-price shocks12
in 1973/74 and 1979/80. The oil price reached a peak of 85 US$/barrel in
1981 in real terms (2013 US Dollar). The high oil price triggered strong in-
centives for oil-producing companies to intensify research for oil resources
and to invest in new oil production fields. Oversupply and economy recession
caused the reverse oil-shock in 1985/86 and a collapse in oil prices for almost
20 years (1985 to 2005). The peak of 85 US$ in 1981 was reached in 2007/8,
again, with prices becoming higher than 100 US$/barrel.
Rising prices along with technology development have made
non-conventional oil production economically viable, such as deep and ul-
tra-deep development oil exploration, and the Canadian oil tar sands and
recently fracking. A sharp drop in oil price that occurred again in 2009/10
caused by the financial crisis and following economic downturn.
Reasons for the extreme drop of crude oil prices in 2014 and 2015 are
oversupply during global economic downturn, in connection with presumed
attempts of oil producing countries to keep oil prices low and make fracking
of oil and gas uneconomic for the foreseeable future, especially in the USA.
Crude oil itself is not a direct end-use13 energy; it is refined in refineries in-
to different petroleum products such as aviation fuel, gasoline, diesel oil,
heavy and light fuel oil (HFO, LFO). The market values of these products
depend on their properties, quality and end-use application. The total value of
products processed from crude oil is called the Gross Product Worth (GPW)
[24]. The GPW is equal to the crude oil price plus production costs. Refiner-
ies have own methods for apportioning production costs among the products.
12
) These were the oil embargos imposed by the oil producing countries in 1974 and
the Iran revolution in 1979.
13
) Notable exceptions are Saudi Arabia, India and China where some crude oil is
used directly for power generation
8.3 The Wholesale Market of Fuels 115
The lesson learnt from this historical analysis is that long term oil price
forecasts are practically impossible because the causes are out of con-
trol and not predictable.
Coal is the main fuel used for power generation worldwide. According to the
IEA [28] [29] classification, there are two types of coal; namely, brown coal
and hard coal, distinguished by carbon and moisture content. Hard coal con-
sists of coking coal and steam coal; Steam coal is mainly used for power
generation while coking coal is used for steel production in blast furnaces.
Hard coal is traded globally; brown coal is commonly used in power plants
near the open cut mining site, as, due to its low heating value, transportation
costs are too high.
Steam coal with a share of more than 40% is the main primary energy used
for power generation worldwide. This section deals with steam coal only.
Coal is mainly traded based on long-term bilateral contracts between min-
ing companies and utilities of large coal-fired power plants. This is because
of the large capital investments involved in the projects on both sides. Long
term contracts provide securities for financing such projects.
Since the beginning of this century, short-term contracts and spot transac-
tions are also increasingly gaining importance. The reason is that after liber-
alization of the markets, prices of electricity are fluctuating and utilities try to
reduce risk by splitting the supply of coal into long-term contracts and short-
term transactions for more flexibility. Spot market transactions are often lim-
ited to only one cargo or to a series of cargo shipments.
The introduction of standard coal benchmarks regarding origin, quality and
delivery place has enabled coal trade in international commodity exchanges
in spot markets as well as in futures and options transactions. Coal bench-
marks [30] are among several others [31], such as
• API#2, NAR14 CIF ARA15 terminals, South Africa coal ex Richard
Bay, 6000 kcal/kg
• API#4, NAR FOB Richard Bay Coal Terminal (RBCT), South Afri-
ca coal, 6000 kcal/kg
• API#6, NAR FOB New Castle, Australia, 6000 kcal/kg
14
) NAR stands for Net as Received
15
) ARA: Amsterdam, Rotterdam, Antwerp
116 8 Overview of Energy Markets and Prices
the other hand the freight rates decline with excess transport capacities during
recession periods of the economy. For instance, sea freight rates rose signifi-
cantly in 2007/8 due to high demand of dry bulk carriers to transport other
commodities such as iron ore and bottlenecks in available transport capaci-
ties. In the aftermath of the economic downturn following the financial crisis
of 2008 they collapsed for a short time and remained at a low level until
2014.
Natural gas is, in contrast to oil and coal, a grid-bound energy; therefore sup-
ply, trading and pricing of gas follows other principles. In this regard, we
have to distinguish between four geographically distinct market segments
which are subject to different supply and pricing characteristics, as well as
regulatory regimes [24]. These are: USA, United Kingdom (UK), continental
Europe and the Far East.
Until now, the gas markets in the USA and UK have been based almost
exclusively on domestic gas resources. In contrast, natural gas in continental
Europe is almost entirely imported. It is transported via long distance pipe-
lines from the Netherlands, Russia, Norway and recently also from the UK.
The markets in the Far East are mainly relying on imports of Liquified Natu-
ral Gas (LNG).
118 8 Overview of Energy Markets and Prices
This section mainly covers the market of continental Europe and describes
only briefly those of the other regions17.
The development of the import-based gas supply industry in continental
Europe started with the discovery of the giant Groningen gas field in the
Netherlands in 1961. Gas started to penetrate the household and industrial
heating market and to substitute energies already used. The pricing of the gas
for domestic use in the Netherlands as well as for export has been based on
the replacement value concept versus competitive energies that could be sub-
stituted by natural gas (e.g. heating oil for space heating, heavy fuel oil for
industry or coal for electricity generation). The philosophy thereby is that the
replacement value of gas is defined by the production cost of the useful ener-
gy of the competitive fuel. This is illustrated in the example of electricity as
useful energy in Figure 8-4 below.
The total electricity production costs, Figure 8-4, are defined by the coal
option as the leading fuel in the power sector; coal is already on the market
and its costs are known. The difference between the total production cost and
the fixed cost of the gas option determines the replacement value of the gas
versus coal as a competitive price. The difference between the fixed costs of
the coal and the gas option is called the gas premium.
Figure 8-4: Replacement value of natural gas vs. coal as the substitute
The concept of the replacement value in Figure 8-4 is limited to one competi-
tive plant & fuel option only. The calculation of the replacement value of a
whole market includes all plant-fuel configurations, including all sectors and
17
) More information is provided in the report of the Energy Charter Secretariat “In-
ternational Pricing Mechanisms for Oil and Gas [24]
8.3 The Wholesale Market of Fuels 119
subsectors of the economy (industry, households, heat & power, etc.) and is
calculated with complex models, as shown in Figure 8-5.
18
) The capacity of a coal-fired power plant with USC parameters is 800 MW
120 8 Overview of Energy Markets and Prices
In order to recover and guarantee the payback of the huge capital expendi-
tures, import gas supply is based on long-term contracts19, the main elements
of which are:
• Availability commitment of the seller, including delivery obligation for
certain amounts of gas (nm3/a) and delivery capacity (nm3/day)
• Off-take obligation of the buyer based on a take-or-pay (TOP) clause
for a certain gas quantity
• A long-term minimum pay obligation of the buyer for the TOP quantity
• Net back pricing formula based on the replacement value at the point of
delivery (border)
• Price adjustment period (month, quarter, year), usually quarter
• Clause for a regular review (usually every three years) of the price for-
mula with the possibility to adapt the formula to reflect changes in the
structure and replacement value
• Arbitration in the case of disagreement
The price formula under the net back value concept in its simplest form is:
US$
Pt = Po + a ⋅ ( LFOa − LFOo ) + b ⋅ ( HFOa − HFOo ) (8.3)
3
1000 nm
Where:
Pt: Actual gas price at the time “t”
Po: Starting gas price reflecting the net back value to the point of delivery
(border) at the signing of the contract
a and b: A product of dimensionless factors reflecting the shares and the re-
placement values of competing energies, thermal equivalence factors,
factors to share changes in the market value
LFOa, LFO0: Actual (a), starting price (0) of light fuel oil (LFO)
HFOa, HFOo: Actual (a), starting price(0) of heavy fuel oil (HFO)
1000 nm3 Russian gas is sold in US$/1000 nm3
During the review of contracts, the replacement value is recalculated and the
factors included in “a” and “b” are accordingly readjusted. Figure 8-4 shows
that if the environmental legislation becomes more stringent, the costs for
flue gas cleaning of the coal plant or the carbon fees will increase. This will
have some positive impact on the replacement value as the gas premium will
also increase.
The cross-border prices to Germany are typical for the continental Europe-
an market. They are published monthly by the German Office of Export Con-
trol (BAFA) [37]. The development of the cross-border price in nominal and
19
) The contract duration may be 25 to 30 years with an option for extension
8.3 The Wholesale Market of Fuels 121
real terms is depicted in Figure 8-6 below. The shape of the gas price devel-
opment is similar to that of crude oil.
The calorific price refers to the heat content of each fuel and is expressed in
currency units per thermal unit, e.g. in CU/MWht or CU/GJ (1 CU/MWht =
3.6 CU/GJ).
Figure 8-7 depicts the development of calorific prices for the main fuels
used for power generation for the period 1991 to 2016. The prices are Ger-
man cross-border prices and can be considered as typical for most of the
countries of continental Europe. They are derived from prices in trade units
after conversion to calorific prices. It becomes evident that there is a distinct
correlation between prices of the different fuels during the entire period under
consideration. The long term ratios referring to crude oil for the period 1991
to 2016 are stated in the box embedded in the figure. The calorific price of
crude oil is taken thereby as the reference price with ratio =1.
The ratios of the fuel prices to the crude oil price are depicted in Figure
8-8. The trend is evident; the prices are correlated. For example, price
peaks and bottoms are coincident. The ratios (Figure 8-7) can be con-
sidered an appropriate basis for price forecasts for the evaluation of
long-term investments in the energy sector.
1.6
Price trends refered to crude oil
1.4
1.2
1.0
0.8
0.6
0.4
0.2
0.0
1991
1993
1995
1997
1999
2001
2003
2005
2007
2009
2011
2013
2015
Data Sources: BAFA, German Coal Association (GVSt), OPEC (Platt's oilgram, Reuters)
author's own calculations and compilation as a graph
Although the difference between fuel prices and crude oil price does not re-
main constant the relative price level is maintained. The natural gas price
shows the largest deviations. This is because gas prices are contract prices
while all the others are spot prices. The coal price shows some upward trend;
the reason might be that competitiveness to cleaner fuels suffers due to im-
posed carbon fees.
The fuel prices discussed until now were cross-border prices. The end-user
prices include, among others, cost for domestic transportation and may also
be subject to taxation. Within the European Union, fuels for power generation
are tax exempt; however, those used for heating or industrial use are subject
to taxation. In the following, we will confine ourselves to fuels for power
generation only; a detailed description of fuel pricing for all users would go
beyond the scope of this book.
Oil products such as HFO and LFO are delivered free refinery and trans-
ported to the end user via road tanker. Due to the high heat content of oil, the
transportation costs are not a significant cost component.
Imported coal is delivered CIF at the overseas ports (e.g. ARA terminals).
The transportation from the overseas port to the final destination site is done
by inland water vessel or by rail. The associated costs may be significant, as
shown for three destinations in the example below:
Example 8.1: Domestic transport cost of coal free power plant
Imported natural gas is transported from the border delivery points through
the national gas grids to the end users. These grids consist of several sub-
grids with different pressure levels. The pressure of the trans-regional grid is
124 8 Overview of Energy Markets and Prices
PN 60 bar to PN 80 bar. Gas-fired utility size power plants are mainly con-
nected to this grid. Gas supply systems of cities consist of several sub-grids
with different pressure levels such as high pressure (HP) with PN 4 bars to
1 bar, medium pressure (MP) with PN 1 bar and low pressure (LP) with PN
25 mbar to 100 mbar. The subgrids are interconnected by pressure reduction
stations.
In general, the use of system charges for gas transport depend on the pres-
sure level of the grid from which the gas is delivered and the amount of gas
[38]20. The tariffs consist of a capacity charge and a volume charge and some
smaller fees for services such as metering and billing. In Example 8.2, the use
of system cost for three different consumers are shown. They have been cal-
culated with the tariff calculation tools from different utilities available in the
Internet (e.g. EnBW [39] and others) and can be considered weighted averag-
es for Germany.
Example 8.2: Use of system cost for gas transport
Type of plant
Technical Parameters
Power output MWe 3.5 150 400
Full load hours h /a 5,000 5,000 5,000
NG demand (capacity), HHV MWt 10 300 750
NG consumption, HHV MWht / a 50,000 1,500,000 3,750,000
Border price 2013 € / MWht 27.56
Use of system charges
Capacity charge € / (MWt a) 9,950 5,760 5,590
Volume charge € / MWht 1.50 0.98 0.97
Annual transport costs
Capacity costs 1000 € / a 100 1,728 4,193
Volume costs 1000 € / a 75 1,470 3,638
Total costs 1000 € / a 175 3,198 7,830
Specific cost € / MWht 3.49 2.13 2.09
Exchange rate USD/€=0.7515
20
For German speaking readers, a comprehensive elaboration of the topic is available
in: [38] Praxisbuch Energiewirtschaft, Panos Konstantin, SpringerVieweg
4. Auflage, 2017
8.3 The Wholesale Market of Fuels 125
Uranium deposits consist of the two uranium isotopes, namely about 99.3%
U-238 of and 0.7% U-235. Only the isotope U-235 is fissile and can generate
huge amounts of thermal energy in a fission chain. At the mines, the natural
uranium is separated from waste residues and comes to the marketplace in
form of Uranium Oxide U3O8, also called yellow cake. This undergoes sever-
al process steps [40] to become Uranium dioxide UO2, that is, the actual nu-
clear fuel – Figure 8-9. The nuclear fuel used for power generation is en-
riched Uranium, in which the content of the isotope U-235 is increased from
0.7% to about 3% to 4%. This is compiled in nuclear fuel assemblies that
come into the reactor core of the power plants.
Figure 8-9: Nuclear fuel production chain for light water reactors
In Example 8.3, the heating value, and in Example 8.4, the calculation of the
cost of nuclear fuel is shown.
126 8 Overview of Energy Markets and Prices
The cost structure of the nuclear fuel and the price development in the recent
20 years is depicted in Figure 8-10 [41]. It becomes evident that the main cost
drivers are the cost of yellow cake, while the other cost components remain
stable. The shape of the price development shows no similarities to those of
crude oil and the other fossil fuels. The reason for this is that the price build-
ing mechanisms follow different paths. The low prices in the period 1994 to
2004 were caused by oversupply of nuclear fuel converted from uranium
weapons following the agreement between the big powers. Due to the low
prices, no investment in new mines had been made in this time, resulting in a
shortage of supply on the market and a sharp rise of prices after 2004.
Example 8.5: Calorific cost of nuclear fuel and fuel cost of electricity
Convoy Advanced Coal *)
Item Unit type type steam
reactor reactor Power Plant
Fuel unit - 1 kgUO2 1 kgUO2 1 kg ce
Heating value per unit MWht 929 1,282 0.00814
Power plant electrical efficiency - 34.5% 37.2% 42.0%
Electricity generation per unit MWhe 321 477 0.00342
Price per unit 2013 US$ 1,502 1,502 0.110
Calorific price US$ / MWht 1.62 1.17 13.51
Fuel cost of electricity, only US$ / MWhe 4.69 3.15 32.18
*) Steam coal: 8.14 MWht/tce; 110 US$/tce
The lessons learnt from the analysis of the fuel price development during a
long time span from 1970 until today can be summarized as follows:
a. Long term fuel price forecasts are unrealistic and highly speculative
because the causes are out of control and unpredictable – Figure 8-1.
b. The prices of the main fuels are correlated to each other and follow
the price trend of crude oil – Figure 8-7
c. Prices of competitive fuels are set based on the replacement value
approach – Figure 8-4
d. For price forecast over longer periods an average ratio between the
fuel prices and crude oil is a realistic assumption taking into account
all the other uncertainties – Figure 8-8.
For investment appraisal of projects, the same escalation rates (%/a) are usu-
ally assumed for different fuels. With this approach, however, the price gap
between low- and high-priced competitive fuels increases over the lifetime of
the investment, as shown in Figure 8-11.
8.4 Conclusions and Recommendations for Fuel Price Forecasts 129
60
40
30
20
10
180
Approach: Escalate only the price of oil and keep
the price ratio of fuel to crude oil constant over the lifeitme
160
Average Period 1991 - 2013
140 Fuel *) € /MWht Ratio
Crude oil 22.03 1.00
Calorific price €/MWht
60
40
20
Crude 5.0%/a NG constant price ratio coal constant price ratio
-
1 3 5 7 9 11 13 15 17 19 21 23 25
Author's own illustration year
Figure 8-13: Fuel price projection with constant price ratio to crude oil
The annual escalation rate in the figures above has been arbitrarily chosen; in
practice, the selection of escalation rate remains the judgment of the expert
who makes the financial evaluation. A possible approach is to fix a price at
the end of the period in real terms and to calculate back the annual escalation
rate as it is demonstrated in Example 8.6.
8.4 Conclusions and Recommendations for Fuel Price Forecasts 131
Basic assumptions
Lifetime of the investment n a 20
Starting crude oil price po US$ / bbl 100
Calculation in real terms
n
Expected price at the end of lifetime p 25_r US$ / bbl 150 p 25_r = p 0 x (1+i r )
Seek escalation rate in real terms ir - 2.05%/a goal seek function
Calculation in nominal terms
Expected inflation rate j - 2.50%/a
Escalation rate in nominal terms in - 4.60%/a i n = (1+i r )x (1+j)-1
Crude oil price in nominal terms p 25_n US$ / bbl 246 p 25_n = p 0 x (1+i n ) n
In several countries, fuel prices for power generation are set by the govern-
ment under political considerations and artificially very low. This is often the
case in countries with large oil resources. Financial evaluation of projects
with such low prices will result in the selection low cost and low energy effi-
cient solutions which will have a longterm negative impact on the national
economy of the countries. It is recommended to conduct economic evaluation
of projects based on opportunity costs derived from the international market
price of crude oil. The premise is thereby, “each barrel of oil saved can be
exported and generate revenues for the national economy”. For such an ap-
proach, the ratios of fuel prices to the crude oil price can be helpful.
Example 8.7: Fuel prices based on opportunity cost
HHV 5.80 MMBTU/bbl 6.20 GJ/bbl 1.70 MWht / bbl Ratio in percent
crude oil
LHV 5.51 MMBTU/bbl 5.89 GJ/bbl 1.62 MWht / bbl of crude price
Insert crude oil price 100 US$ / bbl
Based on HHV US$ / MMBTU US$ / GJ US$ / MWht %
crude oil 17.24 16.13 58.82 100.0%
steam coal 6.72 6.29 22.94 39.0%
HFO 308 13.28 12.42 45.29 77.0%
LFO 21.55 20.16 73.53 125.0%
Sales Gas 13.79 12.90 47.06 80.0%
Based on LHV US$ / MMBTU US$ / GJ US$ / MWht %
crude oil 18.15 16.98 61.92 100.0%
steam coal 7.08 6.62 24.15 39.0%
Heavy Fuel Oil 13.97 13.07 47.68 77.0%
LFO 22.69 21.22 77.40 125.0%
Sales Gas 14.52 13.58 49.54 80.0%
9 Case Studies
The examples in chapter 2 to 8 are setup as simple and short as possible with
the purpose of enabling a better understanding and deepening of the contents
of the chapters. The case studies go one step further towards real project ap-
plication with regard to details and complexity. The following case studies
and models are presented:
• Case Study 9.2, basic techno-economic models
• Case Study 9.3, modelling energy balance for electricity generation
• Case Study 9.4, integrated models for calculation of electricity gen-
eration costs
• Case Study 9.5, lifetime cost model including different load re-
gimes
• Case Study 9.6, models on internal rate of return and cashflow
analysis.
Case studies 9.2 and 9.3 start with the presentation of basic techno-economic
models which are essential and an integral part of more sophisticated models.
Experience has shown that such simple calculations are rarely practiced and
take long working time whenever they must be done.
In case study 9.4 an integrated model for electricity generation cost calcu-
lations is presented. In this model, the generation costs of three different
power plants are calculated. For the calculations, the annuity method and the
present value method are applied in order to show that both methods are ap-
plicable and provide the same results. Furthermore, the results are also shown
in the form of graphs (cost breakdown and cost break-even).
In case study 9.5, the lifetime cost for changing load regimes during the
project lifetime of a power plant are calculated.
In case study 9.6, three variations of the internal rate of return method are
practiced, notably IRR on investment, pretax IRR on equity and IRR after
tax, and a cashflow model is developed.
All case studies are introduced with explanatory notes, outcomes are ana-
lyzed and important statements are highlighted.
© Springer International Publishing AG, part of Springer Nature 2018 133
P. Konstantin and M. Konstantin, Power and Energy Systems
Engineering Economics, https://doi.org/10.1007/978-3-319-72383-9_9
134 9 Case Studies
Fuels are offered on the marketplace in trade units such as metric tons, nor-
mal cubic meter, etc. The real value of the fuels is, however, the thermal
price (also called calorific price). This is calculated from the trade price per
unit divided by the heating value. Throughout this book, the lower heating
value (LHV) is used. The standard unit for thermal energy according to the
SI-unit system is “J” and its multiples kJ, MJ and GJ. A more practical unit
is, however, the unit kWht and its multiples, because energy balances can be
directly conducted without the need for conversion. One kWht is 3600 kJ or,
more practically, 1 MWht is 3.6 GJ. In the following three tables of Exercise
9.2-1 the calculation of thermal price (also known as calorific price) of se-
lected fuels and the fuel cost of electricity are shown. The heating values are
taken from Annex 3.
Exercise 9.2-1: Thermal price of fuels and electricity fuel cost
Thermal fuel prices in US$/GJ
Item Unit Fuel type
Given
Fuel type - Crude oil Heavy fuel oil Steam coal Natural gas
3
Trade Unit - Bbl t t 1000 nm
LHV GJ / unit 5.4 40.2 26.0 37.3
Trade price US$ / unit 100.0 200.0 100.0 365.0
Thermal price *) US$ / GJ 18.52 4.98 3.85 9.79
*) Trade price divided by LHV
Thermal fuel prices in US$/ MWht
Electricity generation cost (and also price) is defined by two cost compo-
nents: the “capacity cost Cc in CU/(kWa)” which is fixed and independent
from the level of production, and “energy cost Ce in CU/MWh” which is di-
rectly dependent on the level of production. Both components together give
the composite cost. The composite cost refers to a certain utilization time of
the rated capacity only; this can be computed based on either the equivalent
full capacity hours tfch or capacity factor CF with the following formulas. The
computation is shown in the Exercise 9.2-2 below:
1000 × Cc CU
kW a CU
C= + Ce CU MWh
h MWh
t fch a
CU
1000 × Cc
kW a CU
C= + Ce CU MWh
MWh
CF [ − ] × 8760 h
a
The entire period for the evaluation of power system projects encompasses
several years of construction time followed by a long period of commercial
operation. During the construction time, disbursement of capital is made in
several installments based on the construction progress. The capital outlays
are financed by equity capital and loans. For the disbursed loans, interest
payments during construction (IDC) are due. Capital expenditures for rein-
vestments during the long operation time may also be required, e.g. for mod-
ernization or retrofits. For financial evaluations of such investments, the en-
tire capital outlays must be considered. The IDC installments are usually
9.2 Basic techno-economic models 137
The specific costs breakdown for the main cost components is shown in Ex-
ercise 9.4-3 based on the outcome of the calculation with the annuity method.
They are also depicted in form of in Graph 9.4-1 and Graph 9.4-3.
Exercise 9.4-3: Specific cost breakdown
Steam CCGT GT
Item Unit
coal NG NG
Energy balance
Electricity generation, net GWhe / a 4,856 1,755 149
Fuel consumption GWht / a 11,413 3,214 441
Levelized annual generation cost, in real terms
Fixed costs US$ /MWh 28.3 19.8 46.2
Annualized CAPEX US$ /MWh 21.1 15.9 32.1
Fixed O&M costs US$ /MWh 7.2 3.9 14.1
Variable costs US$ /MWh 33.3 67.7 117.9
Fuel costs US$ /MWh 30.6 64.1 112.9
Non-fuel variable costs US$ /MWh 2.7 3.6 5.1
100%
90%
80%
70%
Cost share
60%
50%
40%
30%
20%
10%
0%
Steam CCGT GT
coal NG NG
Annualized CAPEX PP h /a CF
Fixed O&M costs Steam coal 7,500 0.86
Fuel costs CCGT NG 4,500 0.51
Non-fuel variable costs GT NG 1,000 0.11
1,000,000
600,000
500,000
400,000
300,000
200,000
Steam CCGT GT
100,000 coal NG NG
0
1000
1500
2000
2500
3000
3500
4000
4500
5000
5500
6000
6500
7000
7500
8000
500
Graph 9.4-2: Intersections of annual generation costs vs. full capacity hours
500
450
400
Specific cost US$ / MWh
Steam CCGT GT
350 coal NG NG
300
250
200
150
100
50
0
500
1000
1500
2000
2500
3000
3500
4000
4500
5000
5500
6000
6500
7000
7500
8000
Full capacity h / a
The model is developed for the CCGT option of case study 9.4. New power
plants are usually utilized in base load mode at the beginning of their life-
time; later, they may be shifted to intermediate load and even to peak load at
the end of their lifetime. In the case, however, because excessive new genera-
tion capacities are coming into commercial operation at the same time, it may
happen that in the first years, new plants will be underutilized. This will have
a negative impact on the lifetime cost, as demonstrated in Exercise 9.5-1and
Exercise 9.5-2.
Exercise 9.5-1: Lifetime costs, base load operation in the first 10 years
Power Electricity Production Fixed Costs Variable Costs
7,500 h/a
1,000 h/a
Exercise 9.5-2: Lifetime costs, part load operation in the first 10 years
Power Electricity Production Fixed Costs Variable Costs
2,500 h/a
1,000 h/a
It becomes evident from the calculations that the lifetime costs will be con-
siderably higher in the case of underutilized capacities at the beginning of the
lifetime.
9.6 Internal Rate of Return and Cashflow Analysis 145
Main Inputs:
This case study presents a model for the calculation of the internal rate of
return (IRR) and a model for cashflow analysis. The main inputs are shown
in the following two tables. The models are developed for CCGT option of
case study 9.4.
Table 9-1: WACC for IRR & cash flow models
Item Equity Loan
Asset shares 30% 70%
Risk free rate of return / interest 5.0 %/a 5.0 %/a
Venture risk premium 6.0 %/a 1.0 %/a
Expected return after tax 11.0 %/a 6.0 %/a
Corporate tax 25% 3.7 %/a 0.0 %/a
Returns before tax, in nominal terms 14.7 %/a 6.0 %/a
WACCn in nominal terms, incl. tax 8.60 %/a
./. expected inflation rate 2.00 %/a
WACCr inflation adjusted, incl. tax 6.47 %/a
Three versions of the internal rate of return are presented: IRR on the project,
pretax IRR on equity and IRR on equity after tax. The model is depicted in
Exercise 9.6-1. Due to the limited space of the text mirror, only the columns
with inputs and the first three and the last three years of operation time are
shown in the table. The model for the entire lifetime can be downloaded from
the author’s website.
Exercise 9.6-1: Internal rate of return
Item Year 0 1 2 3 ...... 23 24 25
Sales of electricity 1755 GWh 100% GWh 1,755 1,755 1,755 ........ 1,755 1,755 1,755
Electricity price *) 86.66 $/MWh 2.00% /a €/MWh 88.4 90.2 92.0 ........ 136.6 139.4 142.2
Revenues mln US$/a 155 158 161 ........ 240 245 250
Operating expenses mln US$/a 121 124 127 ........ 196 200 205
IRR on investment
Revenues 0.00 155 158 161 ........ 240 245 250
CAPEX -340 mln $ -340.00 0.0 0.0 0.0 ........ 3.0 4.0 5.0
Operating expenses 0.00 -121 -124 -127 ........ -196 -200 -205
Cash flows IRR= 9.9% -340.00 33.7 34.1 34.6 ........ 46.8 48.3 49.8
Loans 238 mln $ 238.00 0.0 0.0 0.0 ........ 0.0 0.0 0.0
Operating expenses 0.00 -121 -124 -127 ........ -196 -200 -205
Repayment of loans 15 a Grace 0 a 0.00 -15.9 -15.9 -15.9 ........ 0.0 0.0 0.0
Interest on loans 15 a 6.00% /a 0.00 -14.3 -13.3 -12.4 ........ 0.0 0.0 0.0
Pre tax cash flow IRR= 13.1% -102.00 3.5 4.9 6.3 ........ 43.8 44.3 44.8
corporate tax 25.00% -0.6 -0.9 -1.3 ........ -11.0 -11.1 -11.2
Cashflows after tax *) IRR= 11.0% -102.00 2.9 4.0 5.0 ........ 32.9 33.2 33.6
*) goal seek IRROE after tax 11% by changing electricity price
**) for calculation of corporate tax only (Revenues-expenses-depreciation-interest on loans)
The defining criterion for financial viability from the point of view of the
investor is, in our opinion, the IRR after tax. Hence the starting electricity
price at the beginning of the lifetime is determined with the goal seek func-
9.6 Internal Rate of Return and Cashflow Analysis 147
tion of MS-Excel to return an IRR of equity after tax of 11%; this is equal to
that defined in the WACC.
The main risk as well as the opportunity is the electricity production. The
plant is scheduled to be operated for intermediate load with 4500 hours utili-
zation on its full capacity. However, the electricity production may be higher,
if, for example, the plant is also partly dispatched for base load (7500 h/a),
for instance, while actual base load power plants are in annual revision. The
capacity utilization may also be lower if excess capacities are available for
the grid or if large amounts of electricity from renewable sources are fed into
the grid. A sensitive analysis has shown that between 105% and 95% capaci-
ty utilization the IRR is changing in the range of 12% to 10% only.
The cashflow model is depicted in Exercise 9.6-2. Due to the limited space of
the text mirror, only the columns with inputs and the first three and the last
three years of operation time are shown in the table. The model for the entire
lifetime can be downloaded from the author’s website.
The main results based on the underlining assumptions can be summarized
as follows: operating income and net income after taxes are positive through-
out the project life. The cashflow is sufficient for repayment of the loan from
the very beginning and the remaining free cashflow allows dividend pay-
ments and accumulation of some reserves.
Financial performance parameters are in a positive range as well; most
important are the ratios of the first years of operation. Benchmarks are:
• Debt coverage ratio (DCR) higher than 1.1, obtained in the first year
already.
• The target for the Loan life coverage ratio (LLCR) of >2 is obtained in
7th year
• The project life coverage ratio (PLCR) of >2 is obtained in the 4th year.
The ratios are increasing in the course of the lifetime. This is because the
revenues are increasing due to assumed escalation in line with inflation while
the repayments of loans remain constant and the interest payments for loans
are declining, resulting in an increase of the net income.
148 9 Case Studies
Sales of electricity from IRR 1755 GWh 100% GWh 1,755 1,755 1,755 ........... 1,755 1,755 1,755
Electricity price (from IRR ) 86.66 $/MWh 2.00% /a €/MWh 88.4 90.2 92.0 ........... 136.6 139.4 142.2
Revenues mln US$/a 155 158 161 ........... 240 245 250
Operating expenses CAPEX= 340 mln US$ mln US$/a 121 124 127 ........... 196 200 205
Fixed 2.00% /a 6.8 mln US$ 2.50% /a mln US$/a 7.0 7.1 7.3 ........... 12.0 12.3 12.6
Variable 67.70 $/MWh 118.8 mln US$ 2.20% /a mln US$/a 121 124 127 ........... 196 200 205
Operating Income mln US$/a 33.7 34.1 34.6 ........... 43.8 44.3 44.8
- Depreciation 340 mln US$ 20 a straight mln US$/a 17.0 17.0 17.0 ........... - - -
.- Interest on loans 238 mln US$ 15 a 6.0% /a mln US$/a 14.3 13.3 12.4 ........... - - -
Income before taxes mln US$/a 2.4 3.8 5.2 ........... 43.8 44.3 44.8
- Corporate tax 25.00% mln US$/a 0.6 0.9 1.3 ........... 11.0 11.1 11.2
Net Income mln US$/a 1.8 2.8 3.9 ........... 32.9 33.2 33.6
Cashflow mln US$/a 18.8 19.8 20.9 ........... 32.9 33.2 33.6
- Repayment of loans 238 mln US$ 15 a Grace 0 a mln US$/a 15.9 15.9 15.9 ........... - - -
Free cashflow mln US$/a 2.9 4.0 5.0 ........... 32.9 33.2 33.6
Loan Life Coverage Ratio (LLCR) 15 a 8.6% /a - 1.3 1.3 1.4 ........... - - -
Project Life Coverage Ratio (PLCR) 15 a 8.6% /a - 1.7 1.8 1.9 ........... - - -
Bibliography and References
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Annexes
The SI System specifies that all variables and symbols in a formula have to
be written in italics. Constant values and units are written with standard char-
acters. See example:
ρ L N
Pressure drop : ∆p = λ ⋅ ⋅ υ 2 2
2 D m
According to the rules of ISO it is not allowed to alter SI Units e.g. by adding
indices or put them within brackets, for example:
kWe or kWt
This rule, however, is not practicable for our purposes. Hence, indices are
used wherever it seems necessary for clarification.
The most important derived units for our purposes course are listed and ex-
plained in Table 2.
multiply multiply
Imperial Metric Imperial
by by
Power, Energy flow
BTU / h x 0.293 J/s = W x 3.412 Btu / h
MMBTU/ h x 0.293 MJ/s = MW x 3.412 MMBtu / h
TR (tons refrigeration) x 3.517 kW x 0.284 TR
hp x 0.746 kW x 1.341 hp
ton of refrigeration x 3.517 kW x 0.284 ton of refrigeration
Calorific Value
BTU / lb x 2.326 kJ / kg x 0.430 BTU / lb
BTU / lb x 0.000646 kWh / kg x 1547.8 BTU / lb
MMBTU / t x ce x
MMBTU / t x ce x
3 3 3
BTU / ft x 37.260 kJ / m x 0.027 BTU / ft
3 3 3
BTU / ft x 10.349 kWh / m x 0.097 BTU / ft
3
BTU /scf (gas) x 39.382 kJ / nm x 0.025 BTU / scf
3
BTU /scf (gas) x 0.01094 kWh / nm x 91.412 BTU /scf (gas)
Energy Prices
US$ / MMBTU x 0.948 US$ / GJ x 1.055 US$ / MMBTU
US$ / MMBTU x 3.412154 US$ / MWh x 0.293 US$ / MMBTU
US$ / MMBTU x 5.442 US$ / Bb x 0.184 US$ / MMBTU
US$ / Bb x 0.174 US$ / GJ x 5.743 US$ / Bb
US$ / Bb x 0.627 US$ / MWh x 1.595 US$ / Bb
Annexes 159
Liquid Fuels
Oil equivalent oe=10000 kcal/kg kg - - 41.87 11.63 - -
Crude oil bbl 6,100 1,694 5,400 1,500 - -
Crude oil kg 47.35 13.15 41.92 11.64 80 288
Heating oil light LFO l 39.04 10.85 36.72 10.20 74 266
Heating oil heavy HFO kg 42.30 11.75 40.20 11.17 78 281
Rape oil l 35.10 9.75 0 0
Gaseous Fuels
3
Methane mn 39.85 11.07 35.79 9.94
3
natural gas Low mn 35.20 9.78 31.80 8.83 56 202
3
Natural gas High mn 41.30 11.47 37.30 10.36 56 202
Propane, liquid kg 50.34 13.98 46.35 12.88 64 230
3
Propane, gaseous mn 101.70 28.25 93.18 25.88 64 230
Butane, liquid kg 49.50 13.75 45.72 12.70 64 230
3
Butane, gaseous mn 133.78 37.16 123.57 34.33 64 230
3
Blast furnace gas mn - - 3.30 0.92 268 965
3
Converter gas mn - - 8.20 2.28 183 659
3
Coke oven gas mn - - 19.00 5.28 40 144
3
Sewer gas mn - - 21.00 5.83 0 0
3
Landfill gas mn - - 21.00 5.83 0 0
160 Annexes
Net present value function NPV (NBW): Calculates the net present value
of future payments using a constant discount rate. In contrast to the PV func-
tion the payments can be equal or unequal, positive (cash inflows) or negative
(cash outflows).
Syntax: NPV(Rate, value 1, value 2, ….value n)
If the values 1 to n are arranged in series, just mark the range of series (e.g.
A2:A20) instead of inserting the values one by one.
Where:
Rate: Interest rate in % per period
Nper: Number of periods
Fv: Future value (in the examples in this book it is usually zero)
Type: For payments at the year’s end zero, at the year’s beginning 1 (in the exam-
ples in this book it is usually zero)
Pmt: The constant future payments
Pv: The present value of CAPEX or principal
“Goal Seek” and “Table” are frequently used in examples. They can be
found under “Data”, “what if analysis”. Goal seek will find the right input to
obtain a certain result (e.g. find rate to get NPV=0, this is the IRR). Data
Tables allow calculations of many different possible inputs at the same time.
This is a very useful tool for sensitivity analysis.
21
) For the theoretical background pls. refer to item7.5.1
162 Annexes
PAN _ esc = LC = P0 ⋅
( )
q n − p n ⋅ p ( q − 1)
× n
CU
( q − p) q −1 a
Where:
PAN_esc: Annuity of a series of escalating payments
P0: Constant payment without escalation
q= 1+i: Discount factor, with “i" discount rate (interest rate)
p= 1+j: Escalation factor or geometric gradient, with “j” escalation rate
n: Number of periods (years)
See Example 2.16, levelized annual personnel costs.
Most of the terms are accompanied by units being a standard for engineers.
The units used are:
The definitions are mainly referring to the power and energy industry and are
not generally applicable. Several terms intentionally deviate from the pure
economist’s or accountant’s terminology whenever we deem this to be ap-
propriate. Please refer to “Deviations from customary definitions”.
Capital expenditures (CU): Acronym CAPEX, the initial capital outlay for
an investment project to generate future returns.
Annualized CAPEX (CU/a): The initial capital outlay of a project con-
verted in constant annual equivalent amounts (annuities) for a period equal to
the lifetime of a project. Alternative term capital costs.
Operating expenses (CU/a): Acronym OPEX, Cash outflows during the
operation phase of a project e.g. for fuels, personnel, maintenance. Note:
operating expenses are costs.
Costs CU/a: In general, regularly recurrent outlays such as operating ex-
penses, corporate tax and depreciation which is a non-cash item. They are
usually assumed to be due at the year’s end. In general they are composed of
fixed costs and variable costs (see definitions).
Specific cost (e.g. CU/unit): Annual costs divided by the production units
(e.g. kWh) in a certain period (a). Alternative term used per unit cost (e.g.
CU/kWh).
Fixed costs (CU/a): Costs that do not depend on the output level e.g. cost
of personnel, cost of maintenance, capital cost.
Variable costs (CU/a): Costs directly dependent on the output level such as
fuel costs, costs for consumables and residues.
Capacity cost (CU/kWa): Fixed costs (CU/a) divided by the net power
output (kW) in a certain period (a).
Energy cost alternative term volume cost (CU/kWh) or (CU/MWh) such
as fuel costs plus non-fuel variable costs divided by the net electricity pro-
duction (kWh) in the period (a).
Composite cost, specific (CU/kWh): Capacity cost (CU/kWa) plus energy
cost (CU/kWh) converted to per production unit cost (CU/ kWh) – see item
conversion functions below.
Revenues (CU/a): Price of product multiplied by the production amount.
Income, gross (CU/a): Revenues minus expenses.
Income, net (CU/a): Revenues minus expenses, loans, interest on loans,
corporate tax.
Cashflow CU/a: The difference between revenues and costs; amount avail-
able for repayment of loans and dividends for equity investors (see also free
cashflow).
Free cashflow (CU/a) : Cashflow minus amortization of loans; amount
available for dividend payments to equity investors and building of reserves
to cover future costs.
Glossary 165
Equity: The share of the investors’ own capital on the total capital ex-
penditures for an investment project.
Expenditures (CU): Capital outlays at the beginning of an investment pro-
ject with the purpose to generate future returns. The term usually used is
capital expenditures (acronym CAPEX).
Expenses (CU/a): Cash outflows during the operating phase of a project,
see operating expenses. Expenses are costs.
FOB (Free on Board): The cost of an exported good loaded on a ship at the
seller’s oversea terminal.
Fuel conversion costs: These are practically fixed costs and non-fuel vari-
able costs for power generation. The term is used in Saudi Arabia and other
oil producing countries for IPP projects. The fuel is provided to IPPs for con-
version in electricity free of charge, IPPs business is just the conversion of
the fuel to electricity.
Hurdle (discount) rate (%/a): The minimum acceptable rate of return of a
project for investors.
Grant: Non-repayable financial resources (money) provided by govern-
ment agencies for projects, usually to promote development of new technolo-
gies or renewable energy projects.
Grace period: A period during which repayment installments (and eventu-
ally interest payments) are deferred. In power sector projects, especially re-
newable power generation, it may last 2 to 3 years.
Interest during construction (IDC): The interest paid for loans during the
construction of a project until the start of commercial operation. It is usually
compounded and added to the capital expenditures.
Investment is a business activity, e.g. investing capital in projects to gen-
erate future returns.
Profit & Loss (P&L) Statement: A document summarizing the revenues
and costs (expenses, corporate tax, and interest on loans) of a company in-
curred during a fiscal year or quarter. The difference between revenues and
costs is the net income. After adding depreciation to the net income the bot-
tom line is the cashflow that is available for amortization of the loans and
dividends to the equity investors.
Repayment of loans: see amortization
Shadow pricing: Estimated economic prices for goods and services where
market prices are not available. The term is a common in economic evalua-
tion of projects.
Working capital: The term is defined in economics as “current assets and
current liabilities”. In power system projects it is the capital needed to cover
liabilities (costs, amortization etc.) after the start of commercial operation of
a project until sufficient earnings from electricity sales are obtained.
168 Glossary
Payment series instead of cashflows is used for “cash inflows” such as reve-
nues, and “cash outflows” such as operating expenses or for non-cash items
like the depreciations. The term cashflow is defined as difference between
revenues and costs at the bottom of Profit and Loss (P&L) statement projec-
tions.
Acronyms and Abbreviations
€ Euro
a Annus (Latin), year
acc. According
an Annuity factor
ANU Annuity
API Standard Coal Index
ARA Amsterdam, Rotterdam Antwerp
BAFA Bundesanstalt für Wirtschaft und Ausfuhrkontrolle
BAFA German Federal Agency for Export Control
bbl Barrel oil
bcm Billion cubic meter
BDI Baltic Dry Index
Bps Basis point 1%=100 Bps, 0.01% = 1 Bsp
CAPEX Capital expenditures
CBTo Cost based tariff
CCGT Combined cycle gas turbine power plant
CHP Combined heat and power plant
CIF Cost insurance freight
CF Capacity factor
CIRR Commercial Interest Reference Rate
COP Conference of parties
CPI Consumer price index
CRA Credit Rating Agency
Ct Cent
CU Currency unit use in formulas as neutral term
DCF Discounted cashflow
DSCR Debt service coverage ratio
DWT Deadweight tonnage (ship transport capacity)
Greek Characters
∆ Difference
∆E Difference of Expenses
∆I Difference of capital expenditures
µ mi, Symbol for mean value (Gauß distribution)
σ Sigma, Symbol for standard deviation
ϕ Phase
Σ Symbol for Sum
Index