Energy System Investment and Risk Management Unit 2A: Energy Economics and Markets Paul Rowley 1, Simon Watson 1 and Andy Williams 2 1 CREST & 2 Wolfson School, Loughborough University

Overview In this unit, we will explore the techno-economic aspects of energy generation and supply, along with the nature of electricity markets. In particular we will: Examine how energy generation is economically evaluated Carry out some simple financial modelling Characterise electricity markets, with a focus on the UK Evaluate the relevance of carbon markets Use case studies to illustrate key aspects of the Unit Slide 2

Energy Economics – Costs and Revenues Capital costs include: Equipment (Generating, balance of system, fuel storage, electrical connection, metering, civil works… Professional fees (planning, design, health and safety, CDM, EIA, commissioning…) Ongoing costs include: Fuel, maintenance, insurance, rates, debt interest, payroll, carbon certificates… End of life costs/vlue include: Disposal, decontamination, decommissioning, redundancy payments, salvage value…. Revenues include: Sale of energy, subsidies (CfDs, FITS etc), by-products (eg fly-ash), carbon credits, avoided energy costs…. Uncertainty mean risk – often (but not always) related to timescales. Risk can be partially mitigated via appropriate modelling and contracting (Unit 3). Slide 3

Slide 4 Energy Economics – New Technologies LIFE CYCLE

Slide 5 Energy Economics – Mature Technologies LIFE CYCLE

Simple Cashflow Analysis – Example #1 Slide 6 Consider an energy efficiency project that costs £78,000 and will save 160 MWh/year of electricity. The end-of-life salvage value of the project is predicted to be £19,000. The electricity is expected to be sold at 10p/kWh and the maintenance and running costs are £2,000 per year. Wiki Question: Carry put a simple cash flow analysis. Is the project viable over a 5 year period?

Cashflow Analysis – Simple Examples Slide 7 A graphical example of the previous example

The Time Value of Money The previous examples did not account for the fact that the objective value of money changes with time. What £100 bought in the past will not buy the same today, or What £100 buys today will not buy the same in the future (inflation/deflation) A specific investment ties up capital that could have been invested elsewhere (‘opportunity cost’) A specific investment requires capital that itself may carry a cost (interest) Future uncertainties can effect the likelihood of specific cash-flows being realised (risk) Slide 8

Cash-flow Discounting - The Time Value of Money ‘Real terms’ cost comparisons should account for factors such as inflation and cost of capital via a time-adjusted £/$/€ Slide 9 Consumer Price Index – based on cost of living Producer Price Index – based on cost of goods

Investment Appraisal – Cashflow Analysis In cash-flow analysis, Net Present Value (NPV) is a metric which reflects a project’s net costs and revenues over its lifetime In simple terms: If NPV > 0 then the investment is projected to be profitable If NPV < 0 then the investment is projected to make a loss If NPV = 0 then the investment is projected to break even In mathematical terms: where A t is the project’s cash flow (revenues minus costs) in time t, from year 0 to year n and d is the discount rate (an interest rate used to calculate the present value of future cash flows). More on this later… Slide 10

Discounted Cash-flow Analysis – Example #2a Slide 11 Consider the previous example in which an energy efficiency project that costs £78,000 will save 160 MWh/year of electricity. The end-of-life salvage value of the project is predicted to be £19,000. The electricity is expected to be sold at 10p/kWh and the maintenance and running costs are £2,000 per year. The system will only last for 5 years. Wiki Question: Is this project viable considering a discount rate of 5%?

Simple (non-discounted) Cashflow Analysis – Example #2 Consider an energy generation project that costs £500,000 and produces 1800 MWh per year of electricity and has a resale value of £30,000 at the end of its life of 15 years. The electricity is sold at 10p/kWh and the maintenance and running costs are £50,000 per year. Slide 12 Wiki Question: Find the discount rate at which the break even is indicated (i.e. value of n for NPV =0).

Discounted Cash-flow Analysis – Key Variables Slide 13 Discounted Cash Flow Analysis takes into account the time value of money i.e. Present Value = Future Value x (1 + r ) -t When selecting a discount rate note that r reflects: Opportunity cost (the potential value of an alternative investment) Perceived risk (what is the minimum return required given the apparent risk of an investment) Inflation Interest on borrowings Interest rate is usually included in the project discount rate (opportunity cost and risk are reflected in it). Inflation must be included in the cashflow and the discount rate or neither. It does not matter which. Discount rate

Discounted Cash-flow Analysis – Example #2a Slide 14 Consider the previous example in which an energy efficiency project that costs £78,000 will save 160 MWh/year of electricity. The end-of-life salvage value of the project is predicted to be £19,000. The electricity is expected to be sold at 10p/kWh and the maintenance and running costs are £2,000 per year. The system will only last for 5 years. Wiki Question: Is this project viable considering a discount rate of 3.7%? What about 10%?

Discounted Cash-flow Analysis – Solution Slide 15 Wiki Question: Is this project viable considering a discount rate of 3.7%? Refer to: Simple NPV Calculation.xlsx in Unit 2 Resources Folder

Discounted Cash-flow Analysis – Solution Slide 16 Wiki Question: Is this project viable considering a discount rate of 3.7%? Simple NPV Calculation.xlsx YearDiscount RateCostsCost PVRevenueRevenue PVNet PVYear Notes £78, £0.00-£78, Construction cost at begnning of year £2,000.00£1,928.64£16,000.00£15,429.12£13, £2,000.00£1,859.83£16,000.00£14,878.61£13, £2,000.00£1,793.47£16,000.00£14,347.75£12, £2,000.00£1,729.48£16,000.00£13,835.82£12, £2,000.00£1,667.77£16,000.00£13,342.16£11, £0.00 £19,000.00£15, Residual value at end of year 5 £698.10TOTAL

Some Words of Warning… Slide 17 Not all costs (or revenues) will be well defined at the investment appraisal stage. Therefore confidence intervals (or uncertainty distributions) may be useful when comparing alternatives Methods such as Discounted Cash Flow Analysis (DCFA) do not on their own offer a robust way to evaluate uncertain future market or policy conditions Nor does DCFA predict organisational flexibility to respond as uncertainties are resolved. Relatively new ‘green’ energy technology investments are particularly exposed to such issues, and so robust risk appraisal and project/contract structuring are advisable.