The Economics of Energy-Saving Schemes

Facts

• Very few energy-saving schemes are implemented for the sake of extending the life of the
world’s fuel resources: they are adopted because they save money.

• Any organization which is thinking about investing money in an energy-saving project

will ask the question: how much money will be saved and how long will it take to get
a return on the initial investment?

• It is not usually a simple matter to answer such a question because of the engineering
complexity of a project and the difficulties in accurately evaluating savings particularly
when fuel prices are changing over a short period of time.

• However, the question must be answered, and for this reason, a number of techniques
have been developed to help the investor in his/her planning.
 Costs

• The types of costs associated with energy usage and the

calculation of the value of energy savings are:

 Initial investment (ie the capital costs of the project)

 Fuel costs (e.g. gas, oil, coal, electricity)

 Other operating costs (i.e maintenance, materials, labour, service utilities, storage, handling etc)
 Capital Investment
• Capital investment can be pictured as expenditure for which benefits can be expected in
the long term. Most energy savings schemes require an initial investment for new
equipment to achieve energy savings. The monetary value of the savings, which will
invariably show as reduced fuel costs, must recover the initial costs in as short a time as
possible.

• If the initial capital is borrowed money then interest will be charged: interest charges are
one of two types – simple or compound.

• Simple Interest
 Charges are a fixed percentage of the borrowed capital. The charges are calculated for an agreed period of
time (say one year) and a total interest charges found by multiplying the charge per year by the number of
years given to repay the loan
 Capital Investment Con
• Compound Interest
 In this system, interest is charged at the end of each time period based on the total
(capital plus interest charges up to that point)

• Surely the amount paid under compound interest would be greater than that accrued by
simple interest. With compound interest the company will has an incentives to repay the
loan at regular intervals. The interval may be every year to every month by agreement.
 Example
• A company is investing in a computerized energy management system which will cost
P90 000 to purchase and install. The money is loaned by a bank which charge simple
interest at the annual rate of 17% for a period of 3 years . Calculate the total repayment
required by the banks. Rework out the total repayment based on compound interest.
Make comment.
 Depreciation
• From time to time, a company may choose to sell a piece of equipment after using it for a
number of years. The value of the equipment at this time is said to be its depreciation or
salvage value, the amount being related to the initial capital cost.

• Most commonly the depreciation is expressed either as a rate at which the value
decreases or as a fixed amount per year.
 The depreciation may be set at P20 000 per year (depending on the product)
 The depreciation may be set at the rate of 15% drop in value per year.

• The salvage value could be found more quickly by applying the following relations:

• The salvage value is a factor which will be used later in the financial assessment of a
project proposal
 Investing in New Energy saving Project

• The primary question here is what is the most effective method of investing capital in
energy-saving project?

• There are a large number of methods which claims to give consistent and meaningful
results.

• These methods include the followings:

 Accounting Rate of Return (ARR)
 The payback time
 Discounted Cash Flow (DCF)
 The Net Present Value (NPV)
 The Internal Rate of Return (IRR)
 Accounting Rate of Return (ARR)
• This technique is often called the Rate of Return (RR) method. ARR is defined as below:

• The basic idea of this method is that it should indicate to the Energy Manager what level
of return will be obtained by the investment of capital into energy-saving schemes.

Example
A company ZK is considering investing P12000 in energy-saving measures. The Energy
manager has prepared details of three schemes which require P12000 of capital and
which generate the patterns of net savings (after depreciation) shown in the next slide. (in
this discussion, the net saving will be taken as the monetary value of saving less
depreciation and interest charges). Calculate the value of ARR for each scheme.
 Accounting Rate of Return (ARR)

Clearly the higher the rate of return, the more attractive the investment . The example details the basic
method and hence illustrates the advantages and disadvantages of the method.

The method is simple to apply and gives a quick indication of the scale of profit. From the figures it can be
seen that the ARR is the same value for all three projects, in spite of the fact that the timing of savings is quite
different. Project 2 for example, generates higher savings than the others in the early years of the project;
this would be an advantage if further investment was needed for other energy-saving measures.

The fact that the ARR ignores the timing of the net savings is a definite flaw in the method and suggests that
ARR should be used as a rough indicator only, preparatory to using a more detailed technique.
 Discounted Cash Flow (DCF) Method
• DCF methods are based on interest rates; for a rate of 8% for example, a deposit of P100
in the bank will accrue P8 of interest in the first year and your account will therefore be
worth P108 at the end of year 1.
• Another way of looking at the figure would be to say at an interest rate of 8%, a figure of
P108 in one year’s time would be worth P100 now, at the present time.
• Expressing this idea in a general way; the value of an initial deposit D in N years’ time
will be as below;

Here I = interest rate

• It therefore follows that the Present Value (PV) of an amount of money (S) saved in year
N will be.
 Discounted Cash Flow (DCF) Method
Example
A project generates cash flows of P1500 in both year2 and 5 of its operation. Calculate
the present value of these savings for an interest rate of 15%
 Discounted Cash Flow (DCF) Method Con
• If we extend this idea demonstrated by the previous slide to a complete project which
generates saving over a sequence of years then for each year there will be a factor given
as below

• This factor relates the savings at year “N” to a present value. This factor is called a
discount factor and its effect is to reduce the value of savings achieved in the later years
of a project life. The next slide gives discount factors for various interest rates (discount
rate) for a 10 year span.
Table of Discount Factors
 Discount Factors Con
• Based on table of discount factors year 0 is the present time and therefore will always
have a discount factor of 1.

• The basic idea of discounting cash flows of future years to a present value leads directly
to a technique of project appraisal known as the Net Present Value methods.
 NET PRESENT VALUE METHOD
• This method involves calculating the present value of all yearly capital costs and net
savings throughout the life of a project. By summing all these present values (costs
being represented as negative amounts and net savings as positive) a total will be
obtained; this total is called the NPV of the project.

• If the NPV is negative then the project will be rejected. If the NPV is positive then the
project would be automatically be accepted.

• The example presented in the next slide illustrate the NPV method and how the
application of discounting reveals one project to be more attractive than the others.
 Illustration by Example
The table below shows the capital costs and net savings of three projects. For a discount rate
of 12%, calculate the NPV of each project.
 NPV (Discount Rate 12%)

The discount factors for a rate of 12% are taken from slide number 14. The columns of present
values in table above are obtained by multiplying the net savings by the appropriate discount
factor. The NPV is obtained by subtracting the capital cost from the sum of the discounted net
saving.
 Profitability index

This is useful in comparing projects having different capital cost.

The higher the index the more attractive the project

Calculate the profitability index for the example given earlier. Also use different discount
rate and rework out the NPV as well as the profitability index. Make comments