Energy Economics

By:
Shivshankar Tale
SIT Lonavala
 Introduction
• Economics

Social science that analyzes the production,

distribution, and consumption of goods and services
• Energy Economics
1. Deals with demand and supply of energy and hence the exact cost
of energy used for manufacturing a product

2. Efforts for energy saving needs investment so financial decisions

needs to be taken

3. These must be based on scientific financial analysis techniques to

assure success
 Financial Analysis
• Financial analysis refers to an assessment of the viability, stability, and
profitability of a business, sub-business or any project

• Performed by professionals who prepare report using ratios that

make use of information taken from financial statement and other
reports

• These reports are usually presented to top management as one of

their bases in making business decisions
Continue or discontinue its main operation or part of its business
Make or purchase certain materials in the manufacture of its
product
Acquire or rent/lease certain machineries and equipment in the
production of its goods
Issue stocks or negotiate for a bank loan to increase its working
capital
Make decisions regarding or lending capital
Allow management to make an informed selection on various
alternatives in the conduct of its business
• The basic criteria for financial investment appraisal include:
Simple Payback
a measure of how long it will be before the investment makes
money, and how long the financing term needs to be

Return on Investment (ROI) and Internal Rate of Return (IRR)

measure that allow comparison with other investment options
Net Present Value (NPV) and Cash Flow
measures that allow financial planning of the project and provide the
company with all the information needed to incorporate energy
efficiency projects into the corporate financial system
Protecting Energy Investment
• Essential to keep a careful watch on your organization's
maintenance policy and practicto protect any investment
already made in reducing your organization's energy
consumption

• There is a clear dependence relationship between energy

efficiency and maintenance
• This operates at two levels:
1. Initially, improving energy efficiency is most cost-effectively done in
existing facilities through normal maintenance procedures

2. Subsequently, unless maintenance is regularly undertaken,

savings from installed technical measure, whether in new-build or
existing facilities, may not be realized
 Financial Analysis Techniques
• Simple Pay Back period
Payback period in capital budgeting refers to the period of time
required for the return on an investment to “repay” the sum of the
original investment

Simple Payback Period (SPP) represents, as a first approximation; the

time (number of years) required to recover the initial investment (First
Cost), considering only the Net Annual Saving
 𝐅𝐢𝐫𝐬𝐭 𝐜𝐨𝐬𝐭
• 𝐒𝐢𝐦𝐩𝐥𝐞 𝐏𝐚𝐲𝐛𝐚𝐜𝐤 𝐩𝐞𝐫𝐢𝐨𝐝 =
𝐘𝐞𝐚𝐫𝐥𝐲 𝐛𝐞𝐧𝐞𝐟𝐢𝐭𝐬−𝐘𝐞𝐚𝐫𝐥𝐲 𝐜𝐨𝐬𝐭
• Calculate Simple payback period for a continuous Deodorizer
that costs Rs.60 lakhs to purchase and install, Rs.1.5 lakhs per
year on an average to operate and maintain and is expected to
save Rs. 20 lakhs by reducing steam consumption (as
compared to batch deodorizers)?

60
𝑠𝑖𝑚𝑝𝑙𝑒 𝑝𝑎𝑦𝑏𝑎𝑐𝑘 𝑝𝑒𝑟𝑖𝑜𝑑 = =3.24=3 years 3 month(approx.)
20−1.5
Advantages
• A widely used investment criterion
• It is simple, both in concept and application. Obviously a shorter
payback generally indicates a more attractive investment
• It does not use tedious calculations
• It favours projects, which generate substantial cash inflows in
earlier years, and discriminates against projects, which bring
substantial cash inflows in later years but not in earlier years
Limitations
• It fails to consider the time value of money
• Cash inflows, in the payback calculation, are simply added
without suitable discounting. This violates the most basic
principle of financial analysis, which stipulates that cash flows
occurring at different points of time can be added or subtracted
only after suitable compounding/discounting
• It ignores cash flows beyond the payback period. This leads to
discrimination against projects that generate substantial cash
inflows in later years.
The payback criterion prefers A, which has a payback period of 3
years, in comparison to B, which has a payback period of 4 years,
even though B has very substantial cash inflows in years 5 and 6
• It is a measure of a project's capital recovery, not profitability

• Despite its limitations, the simple payback period has

advantages in that it may be useful for evaluating an investment
• Time Value of Money
• capital cost- Cost for a project usually entails an investment for
the initial cost of installation

• other cost like

1. a series of annual costs
2. cost savings (i.e. operating, energy, maintenance, etc.)
throughout the life of the project
• To assess project feasibility, all these present and future cash
flows must be equated to a common basis

• The problem with equating cash flows which occur at different

times is that the value of money changes with time

• The method by which these various cash flows are related is

called discounting, or the present value concept
• For example, if money can be deposited in the bank at 10%
interest, then a Rs.100 deposit will be worth Rs.110 in one
year's time. Thus the Rs.110 in one year is a future value
equivalent to the Rs.100 present value

• In the same manner, Rs.100 received one year from now is only
worth Rs.90.91 in today's money (i.e. Rs.90.91 plus 10%
interest equals Rs.100). Thus Rs.90.91 represents the present
value of Rs.100 cash flow occurring one year in the future. If the
interest rate were something different than 10%, then the
equivalent present value would also change
• 𝑓𝑢𝑡𝑢𝑟𝑒 𝑣𝑎𝑙𝑢𝑒 𝐹𝑉 = 𝑁𝑃𝑉 (1 + 𝑖)𝑛

Where,
• FV = Future value of the cash flow
• NPV= Net Present Value of the cash flow
• i = Interest or discount rate
• n = Number of years in the future
• Return on Investment (ROI)
1. ROI expresses the "annual return" from the project as a
percentage of capital cost

2. The annual return takes into account the cash flows over the
project life and the discount rate by converting the total
present value of ongoing cash flows to an equivalent annual
amount over the life of the project, which can then be
compared to the capital cost
3. ROI does not require similar project life or capital cost for
comparison

𝑎𝑛𝑛𝑢𝑎𝑙 𝑛𝑒𝑡 𝑐𝑎𝑠ℎ 𝑓𝑙𝑜𝑤

𝑅𝑂𝐼 = × 100
𝑐𝑎𝑝𝑖𝑡𝑎𝑙 𝑐𝑜𝑠𝑡

4. ROI must always be higher than cost of money (interest rate);

the greater the return on investment better is the investment
Limitations

• It does not take into account the time value of money

• It does not account for the variable nature of annual net cash
inflows.
Net Present Value
• The net present value (NPV) of a project is equal to the sum of
the present values of all the cash flows associated with it

𝐶𝐹0 𝐶𝐹1 𝐶𝐹𝑛 𝑛 𝐶𝐹𝑡

𝑁𝑃𝑉 = 0 + 1 +-----+ 𝑛 = 𝑡=0
(1+𝐾) (1+𝐾) (1+𝐾) (1+𝐾)𝑡

Where NPV = Net Present Value

CFt = Cash flow occurring at the end of year 't' (t=0,1,….n)
n = life of the project
k = Discount rate
• The net present value represents the net benefit over and
above the compensation for time and risk

• Hence the decision rule associated with the net present value
criterion is: "Accept the project if the net present value is
positive and reject the project if the net present value is
negative
Advantages
The net present value criterion has considerable merits
• It takes into account the time value of money

• It considers the cash flow stream in its project life

Internal Rate of Return
• This method calculates the rate of return that the investment is
expected to yield

• The internal rate of return (IRR) method expresses each

investment alternative in terms of a rate of return (a compound
interest rate).
• The expected rate of return is the interest rate for which total
discounted benefits become just equal to total discounted costs
(net present benefits or net annual benefits are equal to zero, or
for which the benefit / cost ratio equals one)

• The criterion for selection among alternatives is to choose the

investment with the highest rate of return.

• CFt value will be negative if it is expenditure and positive if

it is savings.
The rate of return is usually calculated by a process of trial
and error, whereby the net cash flow is computed for
various discount rates until its value is reduced to zero.

The internal rate of return (IRR) of a project is the discount

rate, which makes its net present value (NPV) equal to zero
In the net present value calculation we assume that the
discount rate (cost of capital) is known and determine
the net present value of the project

In the internal rate of return calculation, we set the net

present value equal to zero and determine the discount rate
(internal rate of return), which satisfies this condition.
 Advantages
• It takes into account the time value of
money
• It considers the cash flow stream in its
A popular discounted cash entirety
flow method, the internal
rate of return criterion has • It makes sense to businessmen who
several advantages: prefer to think in terms of rate of
return and find an absolute quantity,
like net present value, somewhat
difficult to work with
 Limitations

The internal rate of return figure cannot

distinguish between lending and borrowing and
hence a high internal rate of return need not
necessarily be a desirable feature
 Cash flow
Generally there are two kinds of cash flow:

1. the initial investment as one or more installments

2. the savings arising from the investment

Capital costs are the costs associated with the
design, planning, installation and commissioning of
the project

these are usually one-time costs unaffected by

inflation or discount rate factors
Annual cash flows, such as annual savings occuring from a
project, occur each year over the life of the project

these include taxes, insurance, equipment leases, energy

costs, servicing, maintenance, operating labour, and so on

Increases in any of these costs represent negative cash flows,

whereas decreases in the cost represent positive cash flows
 • Taxes, using the marginal tax rate
applied to positive (i.e. increasing
taxes) or negative (i.e. decreasing
Factors that need taxes) cash flows
to be considered in
calculating annual • Intermittent cash flows occur
cash flows are:- sporadically rather than annually
during the life of the project,
relining a boiler once every five
years would be an example
 Sensitivity and Risk Analysis

Many of the cash flows in the project are based on assumptions that
have an element of uncertainty

The present day cash flows, such as capital cost, energy cost savings,
maintenance costs, etc. Can usually be estimated fairly accurately

Even though these costs can be predicted with some certainty, it

should always be remembered that they are only estimates
Cash flows in future years normally contain
inflation components which are often "guess-
timates" at best

The project life itself is an estimate that can vary

significantly
• Sensitivity analysis is an assessment of risk
• Because of the uncertainty in assigning values to the analysis, it is
recommended that a sensitivity analysis be carried out - particularly
on projects where the feasibility is marginal
• How sensitive is the project's feasibility to changes in the input
parameters?
• What if one or more of the factors in the analysis is not as favourable
as predicted?
• How much would it have to vary before the project becomes
unviable?
• What is the probability of this happening?
• Suppose, for example, that a feasible project is based on an
energy cost saving that escalates at 10% per year, but a
sensitivity analysis shows the break-even is at 9% (i.e. the
project becomes unviable if the inflation of energy cost falls
below 9%)

• There is a high degree of risk associated with this project -

much greater than if the break-even value was at 2%.
Sensitivity analysis is undertaken to identify those parameters
that are both uncertain and for which the project decision, taken
through the NPV or IRR, is sensitive

Switching values showing the change in a variable required for

the project decision to change from acceptance to rejection are
presented for key variables and can be compared with post
evaluation results for similar projects
Sensitivity and risk analysis should lead to improved
project design, with actions mitigating against
major sources of uncertainty being outlined

Many of the computer spreadsheet programs have

built-in "what if" functions that make sensitivity
analysis easy

If carried out manually, the sensitivity analysis can

become laborious -reworking the analysis many
times with various changes in the parameters
The various micro and macro factors that are considered for the
sensitivity analysis are listed below
• Micro factors
Operating expenses (various expenses items)
Capital structure
Costs of debt, equity
Changing of the forms of finance e.g. leasing
Changing the project duration
Macro factors

Macro economic variables are the variable that

affects the operation of the industry of which the
firm operates. They cannot be changed by the firm's
management
• Changes in interest rates
• Changes in the tax rates
• Changes in the accounting standards e.g. methods of calculating
depreciation
• Changes in depreciation rates
• Extension of various government subsidized projects e.g. rural
electrification
• General employment trends e.g. if the government changes the
salary scales
• Imposition of regulations on environmental and safety issues in the
industry
• Energy Price change
• Technology changes
Determination of cost of steam
Effective cost of steam
• Depends upon the path it follows to the point of use
• Considered the entire boiler area, including the effect of
blowdown,parasitic steam consumption,deaeration
• Also steam loads at different pressures, multiple boiler and waste
heat recovery system
• To determine the effective cost of steam, use a combined heat and
power simulation model that includes all the significant effects
Multi-Fuel Capability

• For multi-fuel capability boilers, take advantage of volatility in fuel

prices by periodically analyzing the steam generation cost and use the
fuel that provides the lowest steam generation cost
Higher versus lower heating values
• Fuel is sold based on its gross or HHV

• If, at the end of the combustion process, water remains in the form of
vapour ,the HHV must be reduced by the latent heat of vaporization
of water

• This reduced value is known as LLV

Benchmark for fuel cost of steam generation
• Benchmarking the fuel cost of steam generation (Rs./1000 lbs of
steam) is an effective way to assess the efficiency of your steam
system

• This cost is dependent upon fuel type,unit fuel cost,boiler

efficiency,feed water temperature and steam pressure
Determination of cost of compressed air

• Most industrial facilities need some form of compressed air, whether

for running a simple air tool or for more complicated tasks such as
operation of pneumatic controls
Compressed air generation may account for 30% or more of the
electricity consumed

Compressed air is an on-site generated utility

Very often the cost of generation is not known; however, some

companies use a value of 15-30 % per 1000 cubic feet of air
Compressed The overall
air is one of efficiency of a
the most typical
expensive compressed
sources of air system can
energy in a be low as 10-
plant 15%
𝑪𝒐𝒔𝒕 𝑖𝑛 𝑅𝑠.
(𝑏ℎ𝑝) × (0.746) × (𝑛𝑜. 𝑜𝑓 𝑜𝑝𝑒𝑟𝑎𝑡𝑖𝑛𝑔 ℎ𝑟. ) × (𝑅𝑠. 𝑘𝑊ℎ) × (% 𝑓𝑢𝑙𝑙 𝑙𝑜𝑎𝑑 𝑏ℎ𝑝)
=
𝑀𝑜𝑡𝑜𝑟 𝑒𝑓𝑓𝑖𝑐𝑖𝑒𝑛𝑐𝑦
Determination of cost of Electricity

Tariffs in India are structured in a relatively simple manner

High tension (HT) consumers are charged based on demand

(kVA) and energy (kWh)

Low tension (LT) consumer pays only for the energy consumed
(kWh) as per tariff system in most electricity boards in India
• Some of the electricity boards have additional recovery in form of fuel
surcharges, electricity duties and taxes

• In India industrial units largely purchase electricity from state

electricity boards , so cost calculation depends upon the standard
tariffs declared from the respective SEB’s
• LT-Industry: (in Maharashtra)
Applicable for industrial use at low/medium voltage in premises for
purpose of manufacturing

Including that used within these premises for general lighting,

heating-cooling etc. and IT industry and IT enabled services

Excluding agricultural pumping loads

• HT-Industry:-(in Maharashtra)

Includes consumers taking 3-phase electricity supply at high voltage for

industrial purpose.
Also applicable for IT industry and IT enabled Industry
Power factor incentive
• Whenever the average power factor is more than 0.95, an incentive
shall be given on monthly bill including
1. Energy charges

2. Reliability charges

3. Fixed/demand charges but excluding taxes and duties

Power factor penalty
Whenever the average PF is less than 0.9 ,penal charges shall be levied
on the amount of monthly bill including
1. Energy charges

2. Reliability charges

3. Fixed/demand charges but excluding taxes and duties

load factor incentive
• Consumers having load factor over 0.75-0.85 will be entitled to a
rebate of 0.75% on the energy charges for every percentage point
increase in load factor from 0.75-0.85

• Consumers having load factor over 0.85 will be entitled to a rebate of

1% on the energy charges for every percentage point increase in load
factor from 0.85
• MSEDCL has to take a commercial decision on the issue of how to
determine the time frame for which the payments should have been
made as scheduled, in order to be eligible for the load factor incentive
Cost of generating electricity by DG sets
• Typical operating cost
1. Fuel consumption is the major portion of diesel plant owning and
operating cost for power applications, whereas capital cost is the
primary concern for backup generators

2. SEC varies , but a modern diesel plant will consume between 0.28
and 0.4 litres of fuel per kWh at the generators terminals
• Diesel engine can operate on a variety of different fuels, depending
on configuration, though the diesel fuel derived from crude oil most
common

• Conversion to 100% diesel fuel operation can be achieved

instantaneously
• Calculations
𝑛 𝐼𝑡 +𝑀𝑡 +𝐹𝑡
𝑡=1 (1+𝑟)𝑡
𝐿𝑒𝑣𝑒𝑙𝑖𝑠𝑒𝑑 𝑒𝑛𝑒𝑟𝑔𝑦 𝑐𝑜𝑠𝑡 𝐿𝐸𝐶 = 𝑛 𝐸𝑡
𝑡=1(1+𝑟)𝑡

𝐼𝑡 = 𝑖𝑛𝑣𝑒𝑠𝑡𝑚𝑒𝑛𝑡 𝑒𝑥𝑝𝑒𝑛𝑑𝑖𝑡𝑢𝑟𝑒𝑠 𝑖𝑛 𝑦𝑒𝑎𝑟 𝑡

𝑀𝑡 = 𝑜𝑝𝑒𝑟𝑎𝑡𝑖𝑜𝑛𝑠 𝑎𝑛𝑑 𝑚𝑎𝑖𝑛𝑡𝑒𝑛𝑎𝑛𝑐𝑒 𝑒𝑥𝑝𝑒𝑛𝑑𝑖𝑡𝑢𝑟𝑒𝑠 𝑖𝑛 𝑦𝑒𝑎𝑟 𝑡
𝐹𝑡 = 𝑓𝑢𝑒𝑙 𝑒𝑥𝑝𝑒𝑛𝑑𝑖𝑡𝑢𝑟𝑒𝑠
𝐸𝑡 = 𝑒𝑙𝑒𝑐𝑡𝑟𝑖𝑐𝑖𝑡𝑦 𝑒𝑥𝑝𝑒𝑛𝑑𝑖𝑡𝑢𝑟𝑒𝑠
r=discount rate
n=life of system(typically 20-40 years)
• Cost of electricity generated from thermal plant includes
1. Fuel cost
2. Plant capital cost
3. Manpower cost
4. Maintenance cost
5. Waste disposal cost
• Indirect ,social and environmental cost such as-
1. Economic value of environmental impacts

2. Environmental and health effects of the complete cycle and plant

decommissioning are not attributed to generation cost for thermal
stations in utility practice, but may form part of an environmental
impact assessment
Cost of natural gas
• The government has been the sole authority for fixing the price of
natural gas in the country

• It has also been taking decisions on the allocation of gas to various

competing consumers

• Prior to 1987, gas price were fixed by ONGC/OIL

The gas is allocated as follows:

• Fertiliser producers
• City gas distribution (CGD)
• LPG and petrochemicals
• Refineries
• Power plants
• others