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ENERGY CONVERSION ES 832a Eric Savory Lecture 2 – The definition of energy, the costs of energy and economic considerations Department of Mechanical and Material Engineering University of Western Ontario

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Engineering definition of energy conversion Thermodynamic relationships between systems and the surroundings. Our interest - the change in the energy content of a given system and its interaction with the surroundings during the course of change. Energy analysis –The total amount of energy a system can give or take from its surroundings. –What fraction of the exchanged energy can be converted to useful purposes (motion, electricity, etc.)

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Thermodynamic considerations (1) A closed thermodynamic system is completely surrounded by movable boundaries permeable to heat but not to matter (e.g. a piston.) By adding weight to the piston, we can compress the gas and store energy; work performed by the surroundings. The resulting downward movement of the piston is work obtained by the system from its surroundings. The amount of work taken up by the system is always less than the work done on the system by its surroundings by an amount of energy equal to the heat gained by the system.

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Heat – the mode of energy transfer to or from the system by virtue of contact with another system at different temperature. Work – the mode of energy transfer, other than heat, that changes the energy of the system (e.g. chemical reaction, electrical generator.) Power – the rate of energy exchange between two systems. Thermodynamic considerations (2)

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Changes in system properties that produce or consume work Category of workPhysical processEnergy-related example Pressure-volumeVolume change caused by force per unit area Movement of piston in IC engine Surface deformationSurface area change caused by surface tension Small stationary droplet of liquid fuel suspended in a quiescent fluid assumes spherical shape Transport of ionized (electrically charged) material Movement of charged matter caused by an electrical field Electrostatic precipitation of particulate pollutants in stack gas FrictionalMovement of solids in surface contact Generation of waste heat by unlubricated moving parts in machinery Stress-strainDeformation (strain) of a material caused by a force per unit area (stress) Pumping of a viscous (highly frictional) liquid through a pipe

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Economics of Globalization (1) Increased per capita energy demand directly proportional to increase in standard of living (e.g. 0.5 kW / person in developing world vs. 10 kW / person in USA)

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Why use low-cost, non-renewable resources (pollution, depletion of resources)? - Rich countries (high production costs) must compete with products from poorer countries (low production cost) in the same market. A loss of market a decrease of living standards. Public awareness and consumer habits: Why do we always choose the cheapest product? - Poor understanding of long-term cost associated with the effect of different energy and manufacturing methods on the environment and population health. Economics of Globalization (2)

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Technical limitations, efficiency of scales and cost effectiveness The most suitable energy source depends greatly on the final use since efficiency and environmental friendliness change with scale and application. Energy use: Transportation ~15%; Industry (manufacturing and extraction) ~ 50%; Commercial (mainly buildings) ~ 15%; Domestic (home heating etc) ~ 20%. –Wind turbines: can only be used in small areas to be efficient. –Hydro power: only justifiable at very large scale. –Efficiency of Natural gas: 95% for direct use (heating); 30% to generate electricity. CONCLUSION: Selection criteria for energy conversion designs require that we understand the end use and the economic (and sometimes social) factors which will ensure its feasibility. Thus, a system must be: –Selected based on the scale of use. –Be cost effective (globally) compared to other solutions (i.e. efficient thermodynamically and socially.)

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Economic considerations: The Cost of Operation

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Cost of operation (1) MOTIVATION: Survival of any energy conservation / production scheme depends on the ability to generate a rate-of-return (i.e. profit) within a reasonable period (payback time). This elementary calculation is an important first step in selecting a design. OBJECTIVES: 1) Assessing the Cost of Operations 2) Assessing Rate of return: Value of Investment 3) External considerations

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Cost of operation (2) Cost of Operation: Costs consist of Fixed and Variable costs: - Fixed Costs: do not change with production ● Capital Investment: Initial Investment to permit production ● Interest: Cost of borrowing capital ● Depreciation: Remaining value on equipment after given period (also known as salvage value) ● Site / plant Costs: e.g. rent, insurance - Variable Costs: depend on production ● Fuel, Maintenance, Labour, Delivery, Storage

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Example: A company requires 1,000 kW of electrical power. You are to determine whether it is more economical to buy electricity from Hydro One (the cost of power is 8c / kWh) or to buy a new Diesel Generator delivering 1,000 kW at a fuel cost of 5c / kWh. The generator’s initial cost is $250,000, for which money was borrowed at a rate of 7.5% over five years and its depreciation rate is given as 20%. The criterion for selection is that the payback period must be less than one year. The generator operates 12 hrs / day, 6 days / week. Can this be done? If yes, how long will it take (in days)?

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Conclusion: Cost of operation is a cost per unit time. The cost is a combined quantity of fixed and variable costs. In our example, the diesel had a fixed purchase cost, with financing and depreciation, and the fuel was a variable, whereas the Hydro One option was a variable rate of electricity.

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Economic considerations: The Value of Investment

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Value of Investment (1) LESSON FROM LAST EXAMPLE: Allowing the project to run longer provided a different selection choice. MOTIVATION: Hence, in order to assess the economic viability of a project it is important to clearly identify the influence of time. OBJECTIVE: To introduce different criteria for evaluating viability. Each method has advantages and disadvantages: the proper criteria for selecting a method still depends on the end goal !!

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ARR method: Accounting Rate of Return ARR = [average net annual saving (after depreciation)] / capital cost Payback method: Length of time required for running total of net savings (before depreciation) to equal the cost of the project. Value of Investment (2)

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DCF method: Discounted Cash Flow Method Both ARR and Payback methods fail to allow for the timing of the saving (they are OK for short- term solutions or small projects). However, when the time scale is longer, the value of the money changes over time. This is important, since often the value of a company is assessed on the value of its returns (e.g. stocks or bonds). The idea is to compare the growth of capital to the desired rate of return. Value of Investment (3)

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For example: compare the fixed rate of return in a bank at 10% interest Today (Year 0) = 100 Year 5 = 100*(1+0.10) 5 = 161 Thus, the company must generate a net saving or return of 61% over 5 years to match this 10% rate. Value of Investment (4)

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Two methods are commonly used NPV method: Net Present Value Method The strategy involves bringing all net savings (after depreciation) to “Year 0” (today’s) value. It is calculated over the entire life of the project. –The project is acceptable if NPV > 0 (savings > costs) –The discount rate is essentially the target rate (based on internal cost of money or target rate of return) To rank several projects, which may have different capital costs, the profitability index is used: –p. i. = sum of discounted savings / capital cost = (capital cost + NPV) / capital cost Value of Investment (5)

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IRR method: Internal Rate of Return Method This is the discount rate needed to make NPV=0 It is essentially the maximum rate of return on the invested capital. It is based on the entire life of the project. Value of Investment (6) It is clear that the Accounting Rate of Return (ARR) and Payback methods are straightforward, whilst Net Present Value (NPV) and Internal Rate of Return (IRR) methods are a little trickier.

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Value of Investment (7) The Net Present Value (NPV) is usually determined as an equivalent to money placed at a constant rate of return. This approach is good if the financing is done through fixed return sources (e.g. bonds or dividend yielding stock.) The Internal Rate of Return (IRR) is used to determine the target ratio of return. This approach is riskier and is more suited to financing through common shares.

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Example: A company is considering investing $12,000 to $16,000 in energy saving strategies. The energy manager has three different schemes (Projects) to choose from and their accounting details are given below. The savings are calculated as the monetary value less interest charges and operating costs. The manager also knows that the competitor’s stocks have been increasing at a rate of 8.5% a year. All the Projects have a depreciation of $500 / year. Evaluate the three projects using the ARR, Payback, NPV and IRR methods.

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Project 1Project 2Project 3 Capital invested: $12,000 $16,000 Annual saving (after depreciation): Year 1$3,000$3,600$3,500 Year 2$3,000$3,400$3,750 Year 3$3,000$3,200$4,000 Year 4$3,000$2,800$4,250 Year 5$3,000$2,600$4,500 Year 6$3,000$2,400$4,750

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Assessment using Accounting Rate of Return (ARR) ARR = [average net annual saving (after depreciation)] / capital cost Project 1Project 2Project 3

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Assessment using Payback method Payback = time required for net savings (less depreciation [$500]) to equal capital cost Project 1Project 2Project 3 Saving / Total Year 1 Year 2 Year 3 Year 4 Interpolate to capital cost

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Project 1Project 2Project 3 YearSavingDisco- unted SavingDisco- unted SavingDisco- unted NPV p.i.

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Summary of results from the different methods MethodBest project ARR3 Payback2 NPV2 IRR2

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Summary of Value of Investment Methods AdvantagesDisadvantages ARR – Accounting Rate of Return QuickIgnores timing issues (cost of money) Payback Quick. Good for short term projects Poor indicator for long term Does not account for net saving NPV – Net Present Value Gives “true” saving Provides for cost of money Requires correct rate estimation Discount rate assumed constant (usually) IRR – Internal Rate of Return Allows to account for targets, such as minimum rate of return Success depends on r selection Discount rate assumed constant Inflation is ignored

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Other factors affecting project appraisal (1) Outside bodies (e.g. government, through regional development grants) who may contribute to costs of energy saving projects. (2) Tax on net savings, but also possible tax incentives on energy saving projects. (3) Large-scale fluctuations in energy prices. (4) Inflation rates have a direct bearing on the discount factor required for NPV and IRR calculations.

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