Principles of Energy Economics

9.0 Introduction

Energy economics is a specialized field used to make decisions on energy purchases,

selection of competing energy generation technologies, and financing of energy
technologies. A thorough study of this subject is beyond the scope of this course, but every
engineer should have a basic understanding of energy economics in order to bridge the gap
between engineering decision analysis and economic decision analysis.

9.1 Energy Costs

Energy costs can generally be divided into two categories both of which are called by many
different names:

1. Capital: this is the start-up or investment or total initial cost. Examples of capital costs
include cash or borrowed money used for construction of facilities, equipment
purchase, and/or equipment installation. Capital costs are usually one-time expenses
incurred at the beginning of a project. An increase in the capacity factor decreases the
capital cost per energy output.

2. Recurring: this is the ongoing or operational cost which includes operations and
maintenance (O&M), also the income from sales considered to be positive recurring
cost. Examples of recurring costs are numerous; including salaries, taxes, annuity
payments, and maintenance costs, losses due to scheduled shutdowns for
maintenance, loan payments and fuel costs. These costs may be uniform payments in
time (regular) or sporadic (irregular).

The difference in the two categories has to do with time. Capital costs are always in today's
value of money whereas recurring costs occur at some future value of money. This poses
difficulties when comparing competing energy systems. For example, an economic
comparison of a conventional gas fired to a solar home hot water heater requires evaluation
of money at different times. The conventional hot water heater is very low capital costs, but
with recurring future fuel costs. The solar hot water heater has relatively high capital costs,
but minimal recurring costs. Energy economic analysis attempts to convert all monetary
costs to a common basis to enable quantitative comparisons of competing technologies.

9.1.1 Time Value of Money

The premise of time value of money is that a dollar received today is perceived to be worth
more than a dollar received in the future. There are several factors that drive this
perception. The first is time preference.

Time preference of humans is the reason that present consumption (money) is preferred to
future consumption. Time preference is naturally different for each person in a society. It is
difficult to measure for individuals and even more difficult to aggregate for a society. A
second factor affecting the time value of money is the rental rate", or interest rate, on
funds. There is a future cost associated with the present value of the rented funds. Finally, a
third factor is the possibility of currency inflation, which reduces the future purchasing
power of present funds.
Economic comparison of competing energy technologies requires a common time basis for
money. The common basis may be in terms of today's dollar, the value at some time in the
future, or the value at some time in the past.

9.1.2 Discount Rate

The value of money has historically declined with time. The effect of a dollar purchasing less
today than 20 years ago is known as inflation. There are many factors that can cause
inflation, not the least of which is the perception that “a dollar in hand today is more
valuable than one to be received at some time in the future". In order to compare energy
system benefits and costs that occur at different points in time, all monetary factors should
be converted to a common time basis. This conversion is known as discounting.

Discount Rate is the fractional decline in the value of money used for comparing present
and future costs on a common basis. The discount rate may also be thought of as the rental
rate on funds needed for the investment that could be undertaken. This investment may be
for an energy system, or a potential alternative investment used as a comparison.

The value used for a discount rate is industry specific, but some common means for
determining a discount rate are:
• rate higher than the national Treasury Bond
• anticipated rate of inflation
• rate of interest that balances costs and benefits (savings and/or revenues)
• rate of financing available
• rate of return on alternative investment with similar risk

The choice of discount rate depends on the specific scenario being analysed. Low discount
rates tend to be favourable towards projects with long-deferred benefits. High discount
rates tend to be favourable towards projects with quick paybacks. The discount rate should
reflect the `opportunity cost' of the capital to be invested.

9.2 Economic Analysis Methodologies

Any economic-based decision on energy or energy technology will include some type of
analysis involving capital and recurring costs. The scope of the analysis can vary significantly.
The particular choice of analysis will depend on the desired basis for comparison. Typically,
these various analysis methods are subsets of three general methods:
1. determine largest possible savings for a fixed budget,
2. determine the minimum budget required, or
3. determine return-on-investment.

An example of the first is retrofitting an existing facility to be more energy efficient, and the
person/department charged with retrofitting has a fixed budget. An example of the second
scenario could be implementation of a government or corporate regulation to cut electrical
usage by X% with minimum expenditures. The third scenario looks for the optimum energy
technologies that result in the lowest energy usage/cost or largest profit. For all three
methods, the most economically efficient choice may not be the most energy efficient
choice.
The type of analysis chosen has much to do with type of energy project being considered.
For instance, a short-lived project may not be affected by the future value of money, but a
project which is expected to take decades, such as a power plant, will certainly be affected
by future costs. The cost effectiveness of the short-lived project may be accomplished using
a simple payback method. The long-lived project may be better assessed through some form
of a life cycle analysis (LCA).

Simple Payback Method determines the time period to recover capital costs. Typical
considerations are accumulation of savings, no future value of money, no interest on debt,
and no comparison to fuel costs. The Simple Payback Method penalizes projects with long
life potentials in part because any savings beyond payback period are ignored. There is no
accounting for inflation or for escalation of future savings in fuel costs that historically have
increased at a faster rate than inflation.

Life Cycle Analysis, also known as Engineering Economic Analysis, considers the total cost
over anticipated useful life, where useful life is the lesser of lifetime or obsolescence.
Analysis may include:
• capital costs
• operating costs
• maintenance costs and contracts
• interest on investment
• fuel cost
• salaries
• insurance
• salvage value
• taxes

Life Cycle Analysis (LCA) may account for all costs including indirect costs paid by society but
not reflected as cash ow. An example would be health and environmental costs associated
with pollution due to electric power generation from coal; a cost not directly paid by the
power generating utility. The difficulty with life cycle analysis is that many of the costs are in
the future and can only be estimated with some unknown uncertainty. New technologies
may also result in unanticipated obsolescence that, in hindsight, will turn a `cost effective'
decision into an investment loss. For the purposes here, Life Cycle Analysis is a method that
encompasses several variations.

All of the economic evaluation analysis methods are attempting to do two things. The first is
to manipulate costs and savings in time to some common basis. The second is to assess
these costs against some comparative objective; i.e., (i) which energy system has the lowest
total expense, (ii) which system maximized return on investment, or (iii) which system will
maximize savings in energy costs. Some common evaluation methods2 are:

• Life-Cycle Cost Method (LCC): all future costs are brought to present values for a
comparison to a base case. The base case may be a conventional energy system, design
variations in alternative energy systems, or the alternative of not making the investment.
LCC is commonly used to determine the `cost- minimizing' option that will achieve a
common objective.

• Levelized Cost of Energy (LCOE): seeks to convert all costs (capital and recurring) to a value
per energy unit that must be collected (or saved) to ensure expenses are met and
reasonable profits collected. Future revenues are discounted at a rate that equals the rate
of return that might be gained on an investment of similar risk; often called the `opportunity
cost of capital'. LCOE is often used to compare competing energy producing technologies.

• Net Present Value (NPV): (also known as Net Benefits, Net Present Worth, Net Savings
Methods) determines the difference between benefits and expenses with everything
discounted to present value. NPV is used for determining long-term profitability.

• Benefit-to-Cost Ratio (BCR): (also known as Savings-to-Investment Ratio) is similar to NPV,

but utilizes a ratio instead of a difference. Benefits usually imply savings in energy cost.
What to include in the numerator (benefits) and denominator (costs) varies and care should
be taken when assessing a reported benefit-to-cost ratio. This method is often used when
setting priorities amongst competing projects with a limited budget. Projects with the
largest ratio get the highest priority.

• Overall Rate-of-Return (ORR): determines the discount rate for which savings in energy
costs are equal to total expenditures. This is equivalent to determining the discount rate
that results in a zero NPV. This method enables cash ow to be expressed in terms of the
future value at the end of the analysis period. Previous methods require specification of a
discount rate; this method solves for the discount rate.

• Discounted Payback Method (DPM): determines the time period required to offset the
initial investment (capital cost) by energy savings or benefits. Unlike the simple payback
method, the time value of money is considered. DPM is often used when the useful life of
the project or technology is not known. The number of analysis methods and the associated
jargon (CRF, ACC, LCOE, MARR, DCFROI, PPM, IRR, TER, FVF, PWF, NPV, BCR, SIR . . .) can be
overwhelming. As stated previously, all of the economic evaluation analysis methods are
attempting two objectives:

1. manipulate costs and savings to a common time basis, and

2. assess these costs against some comparative objective.

The focus of the remaining discussion is on the first objective. The second objective will
always depend upon the particular scenario being evaluated. The various forms of analysis
and vocabulary are generally built using two simple arithmetic concepts: (i) compounding
and (ii) uniform series. Using these two arithmetic concepts, three methods for determining
equivalent values of money will be examined; future value, present value, and levelized
value. All of the various economic factors commonly used (P/F, i%, n), (P/S, i%, n), etc.) can
be obtained through simple algebra and an understanding of exponentials and logarithms;
easy arithmetic for any engineer.

9.3 Discounting Tool - Future Value

A basic measure of the time value of money is the future value obtainable through
compounding. Compounding is a fractional growth rate based on finite time intervals;
similar to exponential growth which is fractional growth at infinitesimal time intervals.

9.3.1 Compounding Formula

Compounding can be described mathematically in terms of a growth rate, a time period

over which compounding occurs, and the number of compounding periods being
considered.
 • P: quantity which increases by a fractional rate at fixed time intervals
• : time interval; hr, day, month, year, quarter, . . .
• j: growth rate, fractional increase in value per time interval [% of t]
• n: number of time intervals

The compounding formula can be derived by examining the increase in P after each time
interval. At the end of the first-time interval, the initial value, P0, has increased by the
fractional amount (j )P0. Similarly, at the end of the second time interval, the starting value,
P1 has increased by a fractional amount.

Compound Interest Formula:

Typically, the compound interest formula is expressed as an annual growth and the time
interval is implicit; Pn = P0(1 + j)m, where j is the percent growth per year and m is the
number of years.

Relationship between Compounding and Exponential Growth As alluded to previously;

compounding is essentially the same as exponential growth but with finite time intervals for
fractional growth.

Multiple Compound Rates

When dealing with energy, the escalation rate due to inflation is often insufficient to
describe future increase in costs. Historically, fuel prices have increased at a rate higher
than inflation so if recurring costs include fuel then two rates should be considered. In the
simplest terms, the two factors are multiplied. If i is the rate of inflation and j is the
escalation rate, then from the compound interest formula,

The growth factor (right side of equation) may be substituted with by a Total Escalation Rate
growth factor, Pn = P0(1 + TER)n, where

9.4 Effective Interest Rate (Short-Term Interest Rate)

Many financial institutions calculate interest payments on an annual basis even though the
time interval for compounding is less than a year. The annual percentage rate (APR) is not
necessarily the annual growth rate because of the multiple compounding periods which
occur per annum. For example, an APR of 18% compounded monthly is in actuality 1.5%
interest on a balance applied monthly with an effective annual interest rate of 19.56%. The
effective annual interest rate can be determined by equating compounding formulas for
which the beginning and ending balances should be the same; i.e., Pn must be the same
regardless of how growth rate and compounding period are calculated.

The effective annual interest rate can be derived by equating the monthly and yearly
growths and rearranging to solve for j.

Example 9-1: APR, Compounded Quarterly: Determine the effective annual interest rate on
a loan with 6% APR compounded quarterly.
Example 9-2: APR, Compounded Daily Determine the effective annual interest rate on a
loan with 17.23% APR com- pounded daily.

9.5 Uniform Series Formula (Equal Payment Annuity Formula)

The uniform series formula expresses the growth of a quantity due to a fractional increase
plus a regular annuity or payment. This may be used to determine the amount of money
that should be collected per time interval in order to recoup capital costs.

The symbols used are the same as for the compound interest formula with the addition of
the fixed payment, S, per time interval.

P: quantity which increases by a fractional rate at fixed time intervals

S: payment or annuity per time interval ; S will be added after each
: time interval; hr, day, month, year, quarter, . . .
j: growth rate, fractional increase in value per time interval [%]
n: number of time intervals

The uniform series formula can be derived in a similar manner as the compound interest
formula; by examining the increase in P after each time interval. At the end of the first-time
interval, an initial value of zero will increase by S. At the end of the second time interval, the
value, P1, will increased by a fractional amount plus another S.
Uniform Series Formula:

Starting Point for First Payment

The derivation of the Uniform Series Formula was based on the first payment beginning at
the end of the first-time interval. For payments that start at the beginning of the first-time
interval, there is an extra compounding period,

Gains and Losses

Examples using Future Value

Example 9-3: Effective Heating Costs – Alternative Investment

A solar-powered home heating system can be built for $8000 and will supply all of the
heating requirements for 20 years. Assume that the salvage value of the solar heating
system just compensates for the maintenance and operational costs over the 20-year
period. If the interest on money is 8%, compounded annually, what is the effective cost of
heating the house? Another way to ask this question is “How much would you have to
save per year to equal the future value of $8,000 invested for 20 years at 8%?"5

The discount rate is based on the lost future value of the $8000 at 8% compounded
annually. Therefore, the total capital cost is based on the build cost plus the lost future
value of an alternative investment.

The capital cost is considered to be $37,287.66 and not just the immediate cost of $8,000.

The current annual heating costs which just offset the capital cost are found using the
uniform series formula where S is the yearly heating cost saved with the new solar heating
system.
The annual savings in heating costs required to offset the capital cost, including lost
potential earnings, is $815 per year. This analysis does not account for inflation or any
escalation in fuel prices.

Example 9-4: Effective Heating Costs – Minimum Payments

A proposed solar-heating system for a home costs $6,000 and has a rated operational life of
20 years. Purchase and installation of the system is to be financed by a 60-month loan with
an annual percentage rate of 7.2%. The salvage value of the solar-heating system will
essentially be zero. Determine the maximum effective yearly heating costs for the system to
pay for itself if the annual savings could be invested at 6% interest compounded annually.6

In order to determine the required annual savings in heating costs, the capital cost must be
determined. The initial loan is $6000 with a 7.2% APR for 60 months. The monthly interest
rate on the loan is:

Therefore, the capital cost associated with the borrowed money is:

This value, however, is not the complete capital cost because the funds could have been
invested at 6% per annum. Thus, the total capital cost includes the lost future value of the
initial loan plus interest.

Note the change in time interval to reflect the 20-year lifetime and 20 years of lost future
revenue. The total capital cost of the solar-heating system is estimated to be $27,551.63.
The annual savings in heating costs required to break even with the total capital cost is:

If the opportunity cost of the capital is not considered, then the annual heating costs would
have to be less than

Now the annual heat cost must be S ≥ $233.56, which is likely too low to justify purchase of
the solar-heating system. Both scenarios assume 0% inflation and no escalation of fuel costs.

Example 9-5: Effective Heating Costs – With & Without Inflation

What should be the annual savings in heating costs in order to \break even" after twenty
years on an $8000 solar-powered residential heating system? Consider two cases, one
without inflation and one with inflation.

Case 1 (future value without inflation)

• long-term investment at 8% per year, compounded annually
• no operational or maintenance costs,
• no inflation
• no fuel cost escalation
• no salvage value or tax incentives
• savings reinvested at 6% APR, compounded monthly

First, the capital cost, which is based on the as-built cost plus lost future value on the
money, must be determined.
P20 = $8000 (1 + 0.08)20 = $37, 287.66

The savings in heating costs required to “break even" after 20 years is based on investing
the savings at 6% APR, compounded monthly.

Monthly basis:

Yearly basis:

The annual savings in heating costs should be at least $995. This does not account for
inflation. Notice that the required monthly savings multiplied by 12 does not equal the
required annual savings.

Case 2 (future value with inflation)

• long-term investment at 8% per year, compounded annually
• no operational or maintenance costs
• inflation rate of 4% per year
• no salvage value
• no fuel cost escalation
• no tax incentives
• savings reinvested at 6% APR, compounded monthly
From Case 1, the capital costs are estimated at $37,287.66 and the effective annual interest
rate available for reinvestment of savings is 6.17%, compounded annually. The savings in
heating costs required to “break even" after 20 years is:

The calculated required annual savings of $722.15 is only valid for the first year. After that
inflation will increase the cost of home heating by 4% per year. The required savings in
heating costs for future years is:
Sn = S0(1 + d )n

but what is S0? We can rewrite this in terms of S1 by recognizing that S0 = S1(1 + d )−1.

Subsequently, Sn = S1(1 + d )n−1

The required savings in heating costs for future years are:

10th year: S10 = S1(1.04)9 = $1, 027.84
20th year: S20 = S1(1.04)19 = $1, 521.46

9.6 Relation to Discounting Factors

Many energy economic analysis books or articles will begin with six basic discounting factors
that can be tabulated for various discount rates and time periods. The discounting factors
are typically tabulated on an annual basis. Instead of annualized discount factors, we are
working with two basic growth rate expressions.

The six discounting factors are simply algebraic manipulation of these two equations. While
there is no common language or nomenclature, a commonly used nomenclature is F for
future value (Pn), P for present value (P0), and A for uniform series payment (S); the annual
growth rate is i% over m years.
9.7 Discounting Tool - Present Value

The present value methods are used to bring all future costs, which may occur in different
years, back to today's value of money. In this way, the cost effectiveness of different energy
technologies can be compared on an equal basis.

Compounding – Present Value

Compounding in terms of present value is the inverse of future value.

In other words, use equation (1) and solve for P0.

Uniform Series – Present Value

In terms of future value, a uniform series annuity was derived as [eq. (2)]:

The present value can be determined by substituting equation (1) into the uniform series
formula:

Another way to look at this is that there are two equations (1 & 2) and two unknowns (P0
and Pn).

Examples using Present Value

Example 9-6: Home Mortgage Payments & Present Value

A good example of the need to calculate present value is with a home mortgage. A lump
sum is borrowed at a fixed annual interest rate and uniform series payments are made on
the mortgage while interest is accruing. Consider a 30-year fixed-rate mortgage for
$250,000 at 6% per year.

The present value is P0 = $250, 000. If no payments were made, the future value would be
P30 = P0(1.06)30 = $1, 435, 873. With uniform annual payments of S, we could calculate the
future value. However, what we would like to determine is the value of S which pays o_ the
mortgage while interest is accruing at 6% per year.

The problem is that we have one equation and two unknowns P30 and S:

The monthly uniform series payment required to pay o_ in 30 years a present value of
$250,000 which grows at 6% per year is approximately $1,500.

Example 9-7: Least Current Cash Option

You are in charge of purchasing several new fleet vehicles. You are offered two payment
options. Option A requires a $30,000 payment at the end of the year for four years. Option
B requires a $39,000 payment at the end of the year for the next three years. Which is the
least costly option if the long-term interest is 8%, compounded annually? In other words,
what is the minimum amount of cash that should be set aside now to make the annual
payments?

The two options require uniform payments, but over different periods of time. In order to
compare the two options, calculate how much money today (present value) would be
required to make the payments if the lump sum was invested at 8%, com- pounded
annually.

Option A: The cash outlay in present value is 4 × $30, 000 = $120, 000. This calculation,
however, does not account for the future value of this money, which is:
Example 9-8: Alternative Energy Payback - Present Value

A small municipality is considering installing a 1MW e wind turbine that will cost $6.5
million to install, and then generate a net annuity of $400,000 per year for twenty-five
years, with an estimated salvage value of $1 million.9 The inflation rate is estimated to be
5% per year.
(a) Use a simple payback method to assess the economic viability.
(b) Calculate the present value to assess the economic viability.

Part (a) Using a simple payback method, the net value of the project is the income plus
salvage value less the capital cost.

The income from annuities and salvage exceed the initial cost by 69%. However, that the
value of money is the same twenty-five years from now. Part (b) if the value of money
changes in time, then the income gathered over time needs to be discounted. In this case,
the easiest method would be to convert the income into present value since the project cost
is already at present value.
Based on the present value analysis, the project is not economically viable at 5% inflation.
Economic viability will require a lower inflation rate, higher income, or tax incentives or
subsidies.

9.8 Discounting Tool - Levelized Value

Levelized value is a technique used to convert a series of non-uniform payments into a

uniform series payment per time per energy unit. In this way, the cost of a project relative
to the energy produced can be examined through an equal payment or dividend per some
time period; usually a year. This method is useful when comparing two different energy
technologies; especially when comparing a fossil fuel technology with a renewable energy
technology. Fossil fuel renewable energy relatively low capital high capital cost Significant
recurring costs in fuel; may escalate at different rate than inflation low recurring costs

Levelization of Values

The levelization process is straightforward:

1. convert each value (future, present, series) into a present value
2. sum all of the present values
3. convert total equivalent present value into an equivalent uniform series of values over
the anticipated life of the project; usually this is on an annual basis, but the time
interval can be anything
4. divide (equivalent cost/time interval) by the energy produced/consumed in that time
interval

These steps will use only the two basic equations derived, compounding and uniform series,
but will require some manipulation of the equations.

Examples using Levelized Values

Example 9-9: Levelizing a Non-Uniform Series

A series of payments will be made annually for ten years. The initial payment is $20,000 and
each year the payment increases by $5,000. The interest rate is 10%, compounded annually.
Determine the equivalent uniform series value from the non- uniform series value.10

First, convert each payment into a present value based on a 10% escalation.

Example 9-10: Levelizing Cost of Electricity

An electric power plant that produces 2 billion kWh e per year has a capital cost of $500
million and anticipated lifetime of 20 years. The salvage value is estimated to cover the cost
of dismantling the plant. The capital cost of the plant is repaid at 7% interest, compounded
annually. The total annual operational cost of the plant is $25 million, and the annual return
to investors is estimated at 10% of the operating cost plus the capital repayment cost.
Determine the levelized cost of electricity for this plant, in $/kWhe.

The levelization will be done on an annual time increment. First, annualize the capital cost
by taking the initial loan plus the interest and converting it into a uniform series of annual
costs. Then add the other annualized cost; operational costs and annual dividends to
investors. The levelized cost is the total annualized (uniform series) cost divided by the
annual energy output.
In 2007, the average electrical energy price for all customers (residential, commercial,
industrial and transportation) was $0.089/kWhe. This price includes taxes and transmission
costs. Based on the levelized cost of $0.0397/kWhe , this plant appears to be competitive in
many U.S. markets.