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**ENV-2A82: Low Carbon Energy Basic Economic Analysis**

Dr. Congxiao Shang Room No.: 01 30 N.Keith Tovey (杜伟贤) M.A, PhD, CEng, MICE, CEnv Н.К.Тови М.А., д-р технических наук Room No.: TP2.09 Recipient of James Watt Gold Medal for Energy Conservation ENV-2A82 (2011/2012): Low Carbon Energy

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**Objectives of this Session**

To examine methods to assess whether an energy project is economically viable. Energy is a multi-disciplinary subject and other criteria are also needed PHYSICAL Fuel Poverty Issues See Webpage for details UEA Heat Pump Scheme 1981 TECHNICAL SOCIAL ENERGY The UEA heat pump scheme was proposed in 1981 and comments on this including analysis by NKT will be posted on the WEB POLITICAL ECONOMIC ENVIRONMENTAL

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**2.1 Introduction An energy project should consider whether to:**

1) promote energy conservation, and/or energy efficiency. Is there a difference between Energy Efficiency and Energy Conservation? 2) develop low carbon energy resources, nuclear, wind, tidal, wave, solar, hydrogen , and biofuels etc carbon sequestration 3) exploit conventional and cheaper fossil fuels and keep energy bills low at the present, But what of the future? Installing renewable energy or any other new technology, as with any development, requires commitment of money, time and effort.

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**How and why do charges for fuels vary?**

e.g. Electricity: - Retail Costs made up of several components 1. The cost of actual generation – depends on fuel used – consequently efficiency e.g. Coal 35 – 38%, Gas 47 – 55% efficient Physically limited by Laws of Thermodynamics – not Technical Limitations fuel cost – UK is now a significant importer, volatile international markets affect prices – before 2004 UK was an exporter Carbon Permit prices – more permits needed for coal 2. A charge for High Voltage Distribution – varies significantly across UK. A charge levied by each of 14 Regional Distribution Network Operators - varies depending on industrial mix in region A charge by Electricity Retailer for actual units consumed A charge for meter reading. Gas: tariffs vary with region NKT’s notes Items 2 and 3 are identical charges for all suppliers. Item 1 will depend on how good the supplier can negotiate with the generator. Item 5 – this is sometimes done in house by the supplier, but increasingly it is done by specialist meter reading companies or all suppliers in an area Item 4 reflect the component directly under the control of the supplier and will incorporate its profit margin

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**Transmission Demand Charges**

Distributed Network Ownership Zone Energy Consumed (p/kWh) 1 2 3 4 5 6 7 8 9 10 11 12 13 14 Scottish & Southern United Utilities CE Electric UK Western Power Iberdrola 1 UKPower Networks ( Hong Kong Electric) 2 4 3 5 6 8 9 7 10 12 13 11 14 Current charges as of 1st April 2011

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2.1 Introduction How is profitability of electricity generation assessed? Clean Spark Spread (CCS) – a measure of profitability of electricity generation by gas. CSS = PE - PG /EG - PCO2 * IG Where PE is wholesale price of electricity PG is wholesale price of gas EG is efficiency of gas generation ~ 50% (range 47 – 55%) PCO2 is Price of EU Emission Permits IG is Emission Intensity of gas = / EG (tCO2/MWh) Clean Dark Spread (CDS) – equivalent for coal generation CSS = PE - PC /EC - PCO2 * IC Where PC is wholesale price of gas EC is efficiency of gas generation ~ 38% (range 35 – 38%) IC is Emission Intensity of coal = / EC (tCO2/MWh) NKT’s notes The terms Clean Spark Spread and Clean Dark Spread have entered the literature in last 3 – 4 years and are used by Energy Traders to estimate profitability of say switching between coal and gas generation If for instance, the price of carbon is high as there are few permits around, this will may the generation costs by coal relatively and may encourage some generators to temporarily shut down coal stations and generate more using gas. Since a large proportion of UK gas now comes from overseas this will tend to push up gas prices, unless there is a mild spell. I prices rise too ar then coal may come back into play, reducing demand for gas which is likely to see international gas prices all. Economists now play an important role in power stations whereas 20 years ago there were few located in actual power stations. * Emission Intensity values are typical from IPCC (2006) See paper by Abadie and Chamorro (2008) for more information

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**? Is this project viable? 2.1 Introduction**

Decisions as to whether an energy project is viable are often/ usually made on the basis of an economic analysis alone. However, imperfect analysis of energy issues can be flawed, and give misleading answers on decisions made. Often different researchers will come up with very different answers - WHY???? £20 Annual Saving 1st 2nd 3rd 4th 5th ? A project costs: £100 To implement Congxiao’s notes Economic supply is usually taken to mean “low price to the consumer within a competitive market”. There are various methods used to analyse and quantify such decisions. However, it is vital to realise that there are no absolute or “perfect” methods, in the sense used in science and engineering. This section will consider some cost beneficial analysis, such as capital pay back time, net present value and sample rate of return Is this project viable? We will explore many of the issues in this lecture

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**2.1 Introduction Some concepts for simple cost benefit analyses.**

Those who have done/are doing Environmental Economics will know some statements below are somewhat simplified, but some important questions are raised in context of Energy. Should traditional ideas about cost benefit analysis – e.g. Pay back time prevail? e.g. Example at NKTs house? Congxiao’s notes Evaluating what is “economic” is attempted by various forms of analysis, usually based on “discounting”, but the actual price per unit tends to dominate once a supply id available. Renewables, by definatio, utilise energy from the environment, which usually arrives without payment as with sunshine, wind and rain. The major coat of renewables is therefore the initial capital cost of the equipment, and so the method of integrating capital and operational costs is vital for economic comparisons with fossil and nuclear fuel systems. The relatively large capital costs and initial loans for renewables, together with low fossil fuel price competition, require relatively long payback periods. Settled economies with small present and predicted inflation rates favour such investment (small interest rates). Unsettled economies with large interest rate discourage capital investment. Solar Thermal Solar PV How cost effective is Car Insurance???

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2.2 Discount Rate This aims to account or the effects of inflation when assessing the economic viability of a project. £100 invested in savings giving 5% will generate £105 after 1 year, i.e. 100 * 1.05 = £105 After 2 years the return will be £110.25 i.e * = £110.25 This is the compound interest return on £100 It is not £100 * £100 * 1.05 = £110 which would be the simple interest Similarly after 25 years, compound interest would generate £ compared to £225 from simple interest If one has to borrow money for a project then these values also indicate the total amount to be repaid – i.e. £ and £ respectively – not £110 and £225 Congxiao’s Notes The word “discount” in accountancy was originally use in the 17th Century to mean So when we borrow a lump sum for a project that leads to an annual saving and has a certain life span, we pay interest for the money borrowed and the effective values of the money and the projected saving reduce each year due to inflation. This makes cost analysis rather complicated… Renewable energy systems generally have small operational costs and large initial, capital cost, fossil fuel plants has the reverse, especially if there is no emissions prevention. Economists have developed tools for combining future and continuing known costs with initial costs.

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2.2 Discount Rate On the other hand what would be the value of £100 saved in 1 years time in present day terms if inflation were 5%?. £ not £95 or £100 saved in 25 years time would be worth £29.53 in today’s money Here we are using the present time as a reference and the present value of money to assess future savings. This introduces the term Net Present Value (NPV) to evaluate the present value of future savings. In addition the term Discount Rate is used to deflate future costs/savings to the present day (5% in the example above).

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**2.2 Discount Rates Supplementary Information:**

Mathematically, the discount rate is slightly different from the interest rate. In the example given above using 5% £100 in savings would grow to £105 – an increase of £5 in the year. However, £100 in a years time at 5% discount rate would be equivalent to £95.84 or a reduction of £4.16. It is the discount rate that is used to project future cash flows whether these are savings or maintenance costs so that it is in terms of the Net Present Value. Mathematically the discount rate (D) is related to the interest rate (I) as follows: D = I / (1 + I)

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2.2 Discount Rates The choice of Discount Rate significantly affects the estimated financial viability of a project. High discount rates favour fossil fuels Medium discount rates favour nuclear power Low/zero discount rates favour conservation/renewables as will be seen later. Even though one might think one is being objective in comparing different energy schemes, the simple selection of one discount rate over another may end up by biasing the result in one direction. However we are jumping ahead – how do we work out the overall NPV of a project?

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**Example: 2.2 Discount Rates**

We can assess the economic viability of a project using the discount rate to determine the Net Present Value in two different ways: The Individual discount tabular method (the sledge hammer approach) The Cumulative discount approach using cumulative discount factor tables Example: A conservation project which has a capital cost of £100 but saves £20 p.a. - assume a discount rate, r = 5%: NKT’s notes The individual discount tabular method will always work even if savings and maintenance costs vary from year to year The cumulative approach is much quicker, but only works if savings and operating costs are the same each year. However, this cummulative approach can still be be used if either the savings and/or operating costs change by a ixed amount each year – e.g. 2% per annum

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**2.2 Discount Rates: Individual Discount Rate Approach**

The discount factor of the year n can be computed from the formula: The NPV of a saving (or cost) = (value of saving in the year n) (the discount factor of the year): The NPV reflects the value the fuel saving would have if it was accounted at the present time rather than some years into the future. The cumulative savings over 5 years = £ £ £ £ £ = £86.59 i.e. project would make a loss if equipment only lasted 5 years Year Capital Outlay fuel Saving Discount actor NPV of fuel saving £100 1 £20 £19.05 2 £18.14 3 £17.28 4 £16.45 5 £15.67 6 £14.92 7 £14.21 There would be a profit of £1.51 over 6 years: or £15.73 over 7 years. Frequently projects will also have annual operating costs/maintenance and these should be treated as future costs in a similar manner to the savings.

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**2.2 Discount Rates Example with 5% discount rate**

The approach shown previously is tedious: often the cumulative discount approach can be used The cumulative discount factor is the sum of the discount factors up to and including the year n. These cumulative factors are available in tables such as the ENV Data Book. The answer is the same as previously but it is much quicker in use as only the life time number of years is needed. Note how critical the choice of the life time of the project is in assessing its viability. Year Capital Outlay fuel Saving Cumulative Discount factor Cumulative NPV of fuel saving £100 1 £20 £19.05 2 £37.19 3 £54.46 4 £70.92 5 £86.59 6 £101.51 7 £115.73 8 £129.26 9 £142.16 10 £154.43 NKTs notes Remember this cumulative method can only be used if future costs/savings are constant or change at a regular rate. I savings or operating costs vary from one year to next then the individual dicount method must be used.

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**2.2 Discount Rates - summary**

How can one calculate cumulative discount rate if tables are not available? The Cumulative Discount Factor in year n is the sum of all the discount factors from year 1 to year n And this can be shown to be equal to: The Cumulative NPV to year n is then Annual saving x the Cumulative Discount Factor Remember: If annual saving varies – e.g. because maintenance costs vary, then cumulative approach cannot be used.

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**2.3 Internal Rate of Return (IRR)**

For a Project to be viable it must have a positive NPV taking into account capital costs, running costs, savings etc. However, two projects may seem similar, but because of different times of expenditure, one may be preferable to another. Two cases both have capital cost of £100, Case A has savings of £60, £60, £40, £20, £20 in years 1 – 5 Case B has savings of £20, £20, £40, £60, £60 – i.e. Same total saving Which is more attractive? Timing 5% discount factor CASE A CASE B Net Cash Flow Present Value Capital Expenditure -£100.00 Year 1 £60.00 £57.14 £20.00 £19.05 Year 2 £54.42 £18.14 Year 3 £40.00 £34.55 Year 4 £16.45 £49.36 Year 5 £15.67 £47.01 TOTAL £100.00 £78.24 £68.12

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**2.3 Internal Rate of Return (IRR)**

The internal Rate of Return IRR is the discount rate at which the NPV becomes zero over the project lifetime. If discount rate < IRR then scheme is profitable – otherwise a loss will ensue. In case A, IRR is ~ 38% In case B it is ~ 22% Thus option A is a better investment and considerably better than normal savings, against which IRR should be compared. This is an example of Congxiao – see link for a ull discussion o example See also

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**2.4 Discount Rates: A cautionary note when assessing different energy projects**

Fossil fuels have relatively low capital costs, but significant fuel costs. NPV significantly affected by discount rate. Nuclear has medium capital costs but low fuel costs. NPV less affected. Renewables/ Conservation usually have high capital costs but low running costs. Little effect on NPV Discount Rate Net Present Value nuclear coal Renewables/conservation nuclear Capital Costs coal +ve -ve

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**What about negative discount rates?**

2.4 Discount Rates: A cautionary note when assessing different energy projects Fossil fuels have lowest NPC at high discount rates therefore more financially attractive Nuclear lowest NPC at medium discount rates. Renewables/ Conservation have lowest NPC at low discount rates. What about negative discount rates? Discount Rate Net Present Cost nuclear coal Renewables/conservation +ve -ve

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**2.5 Example 1: An Economic Assessment of loft insulation**

Roof Area of average house = 49m2, post-war house with no insulation U-value – a measure of heat loss is ~ 1.6 WoC-1m-2 The lower the U-value the less heat is lost You will cover U-values later in the course Insulation thickness (mm) U-Value (WoC-1m-2 ) Heat Loss through 49m2 roof (WoC-1 ) Annual Heat Loss (GJ) Saving (GJ) 1.6 78.4 14.90 0% 100 0.33 16.2 3.07 79% 200 0.18 8.8 1.68 89% 300 0.12 5.9 1.12 93% NKTs notes The U-value is the heat lost through a fabric element (such as walls, roof, windows, floor) per square metre per 1 degC temperature difference between inside and out. It is related to the R-value as this latter is the reciprocal of the U-Value. However, in most cases, the fabric elements are made up of more than one material and the U value = 1/R i.e. the summation of the R values. Do note that in addition to the fabric elements, there are also internal and external surface resistances arising from boundary layers of air on either side of the fabric element and these must be included in the overall summed R value. The total heat lost from a component e.g. the roof will be the U-value multiplied by the area of the element – 49sqm in this case and this will give the total heat loss for each 1 deg temperature difference The annual heat loss is the Heat loss multiplied by number of second in a day (86400) multiplied by Degree days (typical average 2200). Then divide by 109 to get to GJ

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**2.5 Example 1: An Economic Assessment of loft insulation**

Price of Energy [British Gas Standard Tariffs on 12/01/2012] Gas: (break point 2680 kWh per year) Tier p/kWh Tier p/kWh [£11.21/GJ] Full Rate Electricity (break point 720 kWh per year) Tier p/kWh Tier p/kWh [£31.82/GJ] Off Peak Electricity 6.919p/kWh [£19.22/GJ] Oil BoilerJuice.Com [12/01/2012] p per litre equivalent to p per kWh* [£15.93/GJ] [* conversion factors1244 litre/tonne and 46.3 GJ/tonne ] NKT’s notes – conversion factors – see ENV Data Book and DUKES (2011) For oil, conversions are needed: Gross Calorific Value of burning oil =46.3 GJ/tonne – density of burning oil 1244 litres per tonne For all fuels, the figure in kWh needs conversion from kWh to GJ 1 kWh = 3.6 MJ so 1GJ = /3.6 ~ 277 kWh Capital Cost B & Q 12/01/2012 -£3.00 per roll of 200mm thick = £1.84 per sqm. However, cost of 100mm thick was ~ £3.60 per sqm!!!

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**2.5 Example 1: An Economic Assessment of loft insulation**

Capital Costs Case 1 No insulation Case 2 Provide 200 mm insulation – capital cost = 49 * £ = £90 Case 3 Provide 300 mm insulation - capital cost = 49 * £ = £266 Case 4 Existing 100mm insulation Case 5 Top up to 200mm insulation – capital cost = 49 * £ = £176 Case 6 Top up to 300mm insulation – capital cost = 49 * £ = £90 From slide 21 Energy Requirements Efficiency No Insulation 100mm 200mm 300mm Heat Lost 14.90 3.07 1.68 1.12 Energy Required (GJ/annum) Electricity 100% Gas Condensing 90% 16.56 3.41 1.87 1.24 Oil Non Condensing 70% 21.29 4.39 2.40 1.60 NKts notes Gross Calorific Value of burning oil =46.3 GJ/tonne – density of burning oil 1244 litres per tonne – Data from DUKES (2011) Energy Required = Heat Lost / Efficiency

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**2.5 Example 1: An Economic Assessment of loft insulation**

Annual Energy Running costs using Tier 2 values from slide 22 No Insulation 100mm 200mm 300mm Electricity Full rate £474.05 £97.67 £53.45 £35.63 Electricity Off Peak £286.37 £59.00 £32.29 £21.53 Gas Condensing £185.66 £38.23 £20.96 £13.90 Oil Non Condensing £339.21 £69.95 £38.24 £25.49 Annual Savings Initial Status Upgrade to Full Rate Electricity Off Peak Electricity Gas Oil No insulation 200mm £421 £254 £165 £301 300 mm £439 £265 £172 £314 100 mm 200 mm £44 £27 £17 £32 £62 £37 £24

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**2.5 Example 1: An Economic Assessment of loft insulation**

Simple Payback time – no discounting Initial Status Upgrade to Capital Cost Full Rate Electricity Off Peak Electricity Gas Oil No insulation 200mm £90 2.6 months 4.3 months 6.6 months 3.6 months 300 mm £266 7.3 months 12.1 months 1.5 years 10.2 months 100 mm 200 mm £176 4.0 years 6.6 years 10.2 years 5.6 years 2.0 years 3.7 years Note: cost effectiveness is very much less if there is 100mm loft insulation, but grants favour those with no insulation Payback using 5% discount Initial Status Upgrade to Capital Cost Full Rate Electricity Off Peak Electricity Gas Oil No insulation 200mm £90 2.7 months 4.5 months 6.9 months 3.8 months 300 mm £266 7.6 months 1.1 years 1.7 years 0.9 months 100 mm 200 mm £176 4.6 years 8.2 years 14.6 years 6.7 years 1.5 years 2.6 years 4.2 years 2.2 years

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**2.5 Example 1: An Economic Assessment of loft insulation**

Always add the most insulation possible – incremental upgrades are much less cost effective. Grants are available 50%+, but only if insulation is fitted professionally. Analysis on previous slides is DIY, for which there are usually no grants. 2.6 Example 2: Solar Photovoltaic What is cost of generating electricity– e.g. solar Photovoltaic??? In is income in year n E is annual energy generated r is discount rate u is unit charge for electricity In absence of maintenance charges, income over life time of n years must >= capital cost C

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**2.6 Example 2: Solar Photovoltaic**

Rearranging gives: PV array has a gross output of 1.25 kW and after inverter losses ~ 1.15kW At Load factor of ~ 10% this will generate ~1000 kWh per annum. The capital cost was £6500 What is unit cost which would make scheme profitable over 25 years. For simplicity – ignore maintenance costs. Solar PV Solar Thermal NKTs notes Load factor (sometimes also called capacity factor) is a measure of how much a device is used over a given period such as a month, year etc. Coal fired generation typically have load factors in the range 50 – 70%, gas 50 – 80%, nuclear %. The reduction from 100% arises rom maintenance periods or when stations are o because o low demand. Or wind load actor onshore is around 26% - and this can be interpreted in one o three ways: 1) machine running at 100% output for 26% of time, or 2) 26% o output or 100% of time, or 3) any variable combination. Or solar, a typical load actor is 10% as used in the example above. A car doing miles a year averaging say 30 mph will have a load actor o just 4.5%. Load factor = Net output over year as % of theoretical generation – see notes on this slide

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**2.6 Example 2: Solar Photovoltaic**

Unit Cost of generating electricity by Solar PV to ensure investment is recouped over life span of project Life time Discount Rate years 2% 4% 6% 8% 10% 15 50.2 58.0 66.4 75.4 84.8 20 39.5 47.5 56.2 65.7 75.8 25 33.0 41.3 50.5 60.4 71.1 Notice how dependent actual cost o generation is on: Discount rate chosen Life Span of project (note – some of cells on ZICER are having to be replaced after 8 years

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**2.6 Project life and Choice of Discount Rate**

Project life for an installation in industry: Small Schemes: Exceptional Schemes: with pay back period over 5 years are rarely considered unless the existing equipment is nearing the end of its life and has to be replaced anyway Usually must have pay back in no more than 9-18 months Definitely Cost effective in 2 years

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**– What price SECURITY of SUPPLY??**

2.7 Summary Conclusions The project must have a net positive present value over its life span The project should have the most favorable 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 choice of specific discount rate can often bias an answer towards a particular option The choice of discount rate and life span of a project affects estimates of future costs of generating electricity Other considerations are also relevant – What price SECURITY of SUPPLY?? An Economic assessment should be only one of several considerations when assessing a project

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