Section 2: Basic Energy Economics Analysis

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Section 2 Basic Energy Economics Analysis
Dr. Congxiao Shang Room No. 01 37P Email
c.shang_at_uea.ac.uk
ENV-2D02 (2006)Energy Conservation
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2.1 Introduction

• Decisions to an energy project should largely be
  made on the basis of economic analysis.
• Imperfect analysis of energy issues can be
  flawed, and give misleading answers on decisions
  made.

?
A project costs 100 To implement
Viable
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2.1 Introduction

• An energy project should consider
• - whether to promote energy conservation, i.e.
  energy saving,
• - or to develop new energy resources, such as
  wind, tidal energy, solar, hydrogen and biofuels
  etc

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

• Decisions to an energy project should largely be
  made on the basis of economic analysis.
• Imperfect analysis of energy issues can be
  flawed, and give misleading answers on decisions
  made.

?
A project costs 100 To implement
Viable
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2.1 Introduction

• Before answering the question correctly

Lets revise some concepts for simple cost
benefit analyses. Those who have done
Environmental Economics will know some
simplifications in what is described below.
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2.2 Discount Rate
The concept of discount rate is introduced
because of the following facts

• On the one hand, money borrowed to implement a
  project will incur interest charges which are
  compounded each year.
• On the other, the value of money or saving
  declines with time, due to inflation.
• To simplify the analysis, we use the present
  time as a reference for analysis (hence, interest
  charge is not an issue), the concept of a
  Discount Rate to account for inflation, and the
  Net Present Value (NPV) to evaluate the present
  value of future savings.

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2.2 Discount Rates

• The term, discount rate , is used to determine
  the present value of future cash flows arising
  from a project, i.e. the discounted value of
  future cashflows, due to inflation.
• The actual value of the discount rate is
  equivalent to the basic interest rate that a
  high-street bank is charged to borrow funds
  directly from the Central Bank.

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2.2 Discount Rates

• We can analyse the economics of a project using
  the discount rate
• in two ways
• Individual discount approach
• Cumulative discount approach

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2.2 Discount Rates

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

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

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

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

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2.2 Discount Rates

• Cumulative discount approach

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

• How to calculate Cumulative discount factors?

The Cumulative Discount Factor in year n is the
sum of all the discount factors from year 1 to
year n
The Cumulative NPV to year n is the sum of all
the NPVs of individual savings from year 1 to
year n or Annual saving x the Cumulative
Discount Factor
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2.3 Project life and Choice of Discount Rate

• Project Life depends on a number of factors
• A single initial cost
• Compensation factors, e.g. fuel price rises
• Offsetting factors, e.g. maintenance charges
• Competing schemes, e.g. a new process that gives
  more profit than the saving from the project, for
  the same initial investment

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2.3 Project life and Choice of Discount Rate

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2.3 Project Life and Choice of Discount Rate

• Discount rates vary from time to time depending
  on the economic climate
• Different organizations will set different target
  discount rates
• 1) A higher discount rate 10 favours coal and
  fossil fired power generation.
• 2) Moderate discount rates 5 tend to favour
  gas and nuclear options.
• 3) Low discount rates, even zero, favour
  conservation and renewable energy.

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2.4 Fuel Price Rises

• 2.5 Negative Discount Rates

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

• The figure shows the results of analyzing the
  example in 2.2 with differing discount rates for
  a project life of 7 years.
• The NPV becomes zero for a discount rate of 9.2
  - the Internal Rate of return.
• The graphical approach is much quicker to
  determine the IRR than a numeric method.

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2.6 Internal Rate of Return (IRR)

• The IRR is the discount rate that makes net
  present value of all cash flow equal zero or the
  project will break even.
• If you apply a discount rate to future cashflows
  that is higher than the IRR, the project will
  make a loss in real terms. If you apply a
  discount that is lower than the IRR, the project
  will be profitable

Profitable
Non-profitable
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2.7 The Changing Price Structure for Electricity
Gas

• Electricity
• Charges will be in three parts
• 1.Charge to the Regional Electricity Company
  (REC) for transmission which will be the same for
  all suppliers
• 2.Charges for the actual units used
• 3.A charge for meter reading
• Gas
• Duel fuel

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2.8 Trends in Energy Tariffs

• In the case of electricity, the corresponding
  tariffs are (from WEB Site, 19th December 2005)

EDF Tariff
PowerGen Tariff
Scottish Power Tariff
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2.8 Trends in Energy Tariffs
Comparison of three electricity tariffs
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2.8 Trends in Energy Tariffs
In the case of gas, the corresponding tariff for
PowerGen (19th December 2005)
Unlike the electricity, the gas tariffs were more
uniform across the country. However, there are
variations recently due to competition introduced
to the distribution of gas as well
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2.9 Some Examples on loft insulation

• Example 1 Area of average house 49m2

Assume house with no loft insulation
Situation after insulation measures
Energy costs based on tariffs from Dec. 2003.
The differences indicate the rise in prices over
last two years.
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2.9 Some Examples on loft insulation
Example 2 Area of average house 49m2 some
house with 50mm insulation already

• Gas heated (condensing boiler) case again
• Initial consumption will be 6.48 GJ (c.f. 30.6
  GJ) for pre-war house.
• Initial annual consumption for post war house
  5.63 GJ (c.f. 17.8GJ)
• NOTE you will be shown how
• to calculate the values of 6.48
• and 5.63 later in the course.

Calculation
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2.11 Criteria for Investing in a Project

• The project must have a net positive present
  value over its life span
• The project has the most favourable rate of
  return when compared to other projects, or to
  direct investment (i.e. use IRR as an indicator
  here).
• If money has to be borrowed to undertake the
  project, then the rate of return must be greater
  than the borrowing rate.
• The rate of return must be significantly above
  the direct investment rate as capital is tied up
  and cannot be used for other things.

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2.2 Discount Rates

• Example of a compounded interest rate
• A project is cost 100, borrowed at 5 interest
  rate

After one year
The total amount repaid 1001.05105
After two years
The total amount repaid 1051.05110.25
By the end of fifth year
The total amount repaid 100 1.055
127.63 not 100 5 100 5 125 in the
simple interest case
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2.2 Discount Rates
Optional Information In fact a discount rate is
slightly different from the interest rate,
mathematically The discount rate is based on the
future cash flow in lieu of the present value of
the cash flow. E.g. we have 80, and we buy a
government bond that pays us 100 in a year's
time. The discount rate represents the discount
on the future cash flow (100-80)/100 20 The
interest rate on the cash flow is calculated
using 80 as its base (100-80)/80 25 Hence, for
every interest rate, there is a corresponding
discount rate, given by d i/(1i) Again when
referring to a cash flow being discounted, it
will likely refer to the interest rate and not
the proper mathematical discount rate. However,
the two are separate concepts in financial
mathematics.
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2.10 Some Comments on these examples.

• The examples show exactly how cost effective loft
  insulation can be particularly if there is no
  insulation to start with.
• It pays to install thicker insulation at outset
  as it will be cost effective (even if there is no
  grant).
• It becomes progressively uneconomic to upgrade
  insulation standards, and that if 100m already
  exists, it is not cost effective to upgrade, even
  though it is cost effective to put in 150mm from
  scratch
• The present grant system is a disincentive to
  those who have spent money in the passed.
• Grants of up to 90 are available for pensioners
• It is argued that the poor cannot afford the
  capital outlay. The poor will not have
  condensing boilers, and are more than likely to
  have electric heating, and pay back is within a
  few weeks. With an extended 90 grant, the
  capital cost is no more than 10, so this can
  hardly be construed as a deterrent

Or see the lecture notes
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Structure of Electricity Supply in early 1990s
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Scotland ?????????

• Scotland ?????????
• Vertical Integration ???????????? ??????????
• two companies ???
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England and Wales ?????? ? ????? 12
Regional Supply Companies 12 ????????????
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Distributed Network Ownership in 2004
Distributed Network Ownership in 2005
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2005
Regional Supply Ownership ???????? ????????????
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PowerGen
Central Networks
Distributed Network Ownership ????????
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