detail analysis of economics

1. Decision criteria in Energy projects

2. Total global energy investment based on pre-Covid-19 expectations
Some data…

3. Total global energy investment

4. Why is economic analysis of investments necessary?
Two viewpoints:
National, gouvernemental
The government investment
should contribute to the
development of the national
economy and the investment is
efficiently utilized
Private
Increase of firm revenue
by the project will be the
crucial interest.
companies or households, who are unable to diversify risk as effectively as society as
a whole
But…
• costs of capital
• riskiness of the investment
• finance costs
• behavioral constraints like split incentives (e.g. landlord/tenant)
• short time horizons
• information asymmetries
• other obstacles or barriers

5. Income of university graduates
Net benefits
Obtaining the
university degree
Income of high school graduates
Graduation from
high school
Indirect costs
(lost income)
Direct costs Tuition fees Age
Revenues
and costs
Source: Gundersonet al. (1993)
Economic analysis of projects supports a decision making process

6. The opportunity cost is the value of the next best choice that one gives up when making a decision.
Remember the opportunity cost ?
Example from electricity industry:
- energy-limited power plant may be required to generate at a particular point in time → eliminate future (more
profitable) generation opportunities → a (potentially substantial) opportunity cost on the generator in question
- the opportunity cost incurred by an energy plant relates to the potential value of such energy:
stored water or a limited volume of gas, which the generator could derive from using it in another period (or more
generally for any alternative usage)
- for a thermal power station, the opportunity cost of beginning to generate power might include its start-up costs,
if the power station was not already generating
- intertemporal trade-offs between producing energy today versus at some point in the future→ the foregone
revenue or profit that could be achieved if the fuel is instead stored for use at some future date
Compensation measures based on opportunity costs
over and above direct operating costs
scarcity vs. choice

7. Simple Payback (Static Payback Period)
➢ Payback period, is the number of years it takes for the energy savings to offset the initial investment
➢ The common assumption is the shorter the payback period, the more economical the investment
➢ Simple payback is attractive because it is easy to calculate and understand
Net Energy Savings (€/year) =
Annual Energy Output (kWh/year) x Price (€ /kWh) – O&M (€ /year)
Payback (years) = [Installed cost (€) – Rebates (€)] / Net Energy Savings (€ /year)
➢ Limit: the time value of money is not considered
➢ Time horizon of an investment project in the energy industry is, typically, very long.
PV, wind turbines: 20 years
gas turbines: 35 years
→ Dynamic assessment plays an important role.

8. • Chose between 2 projects:
• Investment of 10.000 € for each project
•Can you compare these 2 projects?
The problem of intertemporal decisions: time is money !

9. The problem of intertemporal decisions: time is money !
Problem:
➢ How to compare costs and benefits that occur at different points in time?
Examples:
• Compare costs for abating CO2 emissions today, with the benefits that accrue in later decades. Which costs
are worth what benefits?
• Do you prefer 1000 € today or 1000 € in 5 years?
Economic solution concept:
Discounting: Describes the valuation in present day terms of future outcomes (damages, costs, benefits, utility values)
Discount factor D: Gives the value of one unit in the future (generally in one year) in present value terms
Discount rate i: Gives the rate at which future value is discounted
𝑫 =
𝟏
𝟏 + 𝒊

10. Discounting
Example 1 (discounting money with bank interest rate):
➢ Q1: Do you prefer 1000 € today or 1000 € in 2 years?
• If 1000€ are received today and invested in a bank account with an interest rate of 5%:
1000 (1+0.05)2
=1102.5 € → Better receive money now and invest
➢ Q2: Do you prefer 1000 € today or 1400 € in 5 years?
1000 (1+0.05)5
=1276 € → Better wait to receive 1400 € in 5 years
➢ Q3: I have a 1000 € bill to pay in one year. What is it worth today?
• If rate of interest in a bank is 5%, I could deposit today 952 €, and would receive next year (including interests)
952 (1+0.05) = 1000 €
• The present value of 1000 € in one year is therefore
1000 / (1+0.05) = 952

11. Example 2 (interest rates, two years):
• i=5%: yearly interest paid on (or for) money in a bank
• I have a 1000 € bill to pay in two years. What is it worth today?
• I could deposit today 907 €, and would receive in one year (including interests)
907 (1+0.05) = 952 €
• ...and in two years (reinvesting interests)
952 (1+0.05) = 907 (1+0.05)2
= 1000
• The present value of 1000 in two years today is therefore
1000 / (1+0.05)2
= 907 €
• Analogous reasoning holds for benefits which accrue in the future.

12. K - capital
i - interest rate ( discount rate)
T - time horizon (economic lifetime)
K0 - present value
KT - value at T
Compounding: Discounting:
Present value
Future value
0 1 2 3 T
K0
KT
Present value
Future value
0 1 2 3 T
K0
KT
Discounting and Time value

13. Discounting and Time value: annuity
Annuity is a regular payment during a fixed number of periods.
Remark: Regular cashflows are uncommon in the energy sector but nevertheless used for simplification.

14. Numbers to thrill the imagination…
➢ Discounted at 8%, the French GNP from 2019 2715 billion $ if we looked at 300 years ago,
would be worth less than a good smart phone!
➢ This also means that a disaster which would occur in 300 years and would result in a loss equivalent
to the this GNP, is seen as the loss of a good smart phone today.
➢ Any resource committed today to avoid this disaster and exceeding this value is reflected as a
negative NPV in a standard project analysis.
➢ For the analysis of long-term projects, the choice of rate is crucial. He wins practically on any other
consideration.

15. Question:
If an investment (planting a tree) brings (once and for all) 100 € in T = 30 years, or
in 60 years, what is that amount worth today? How much would we be ready to
spend today to plant that tree?
Answer: At most this value
r 2% 6% 10%
V(30) 54.88 16.53 4.97
V(60) 30.12 2.73 0.25
𝑉 𝑇 = 100 × 𝑒−𝑟×𝑇
in continuous time
𝑉 𝑇 =
100
(1+𝑟)𝑇 in discrete time

16. The example of Climate Change → High discount rate implies:
• A dollar today is much more valuable than a dollar tomorrow
• Hard to justify climate policy where costs occur today but benefits (abated damages) accrue later
Choice of the discount rate
Option 1: Simple take the market rate
➢ real interest paid on certain investment =
productivity of capital in the market equilibrium
Difficulties:
For the climate change evaluation and long time
horizons, the market rate might not reflect preferences
of society correctly:
• Market failures and market imperfections
• Responsibility of government concerning current
and future generations
• Dual‐role of individuals
Option 2: Social discounting
➢ determinants of the discount rate are based
on economic (or ethical) considerations
Reasons to discount (on preference/utility side):
• Pure rate of time preference,
Pure impatience: rather consume /get utility now
than later
• Economic growth
If someone is richer in 10 years, 1 dollar today might b
e worth more than a dollar in 10 years
(the utility function is concave)
• Uncertainty ‐> Later

17. • How to take risk into account when calculating the NPV?
• What should be (and not be) considered in a discount rate?
• What discount rate should be used?
How to integrate the risk into the economic calculation?

18. Governmental Planning Agency (Commissariat au Plan)
• Considers, in January 2005, to lower the discount rate for public investment projects from 8% to 4%
• The reason given:
The risk should not be taken into account in the discount rate because the projects are different, while the
discount rate is unique.
"8% unfairly penalizes the less risky projects, or those whose uncertainties are far away in time. "
Context
Consequences:
According to some experts : some projects will become profitable (NPV> 0), while they were not before
=> funding problem
Net Present Value

19. • Not necessarily, if the risk is integrated into the cash flows (ie the numerator of the NPV)
- With this approach, the discount rate becomes again an exchange rate between future consumption
and some immediate consumption
- Average yield of French shares in XXs: 4%, while the risk free rate was close to zero
- Risk Premium: 4%
- If we add it to the discount rate of 4%, we find the former
• The good discount rate (shown in the article): 4% for short term and 2% for long term (> 30 years)
Gollier’ s Answer (1)

20. Rate of time
preference
Growth rate of consumption
(per capita)
Volatility in the growth rate
of consumption in t
degree of risk aversion
→ The discount rate, 𝑟𝑡 is independent of the considered project, but may vary depending on the maturity of
the project (t)
Gollier’ s Answer (2)
Rate of time preference
(Impatience)
Growth rate of consumption
per capita (wealth effect)
Volatility in the growth rate
of consumption in t
(precautionary effect)

21. 1) The component : rate of time preference
- If the preference for present is strong, higher discount rate
2) A wealth effect: 
- If >0, agents expect an increase in their consumption: an euro has less effect on the utility of the
agent in the future than today (the marginal utility decreases)
- Positive effect on the discount rate: incentives to reduce our efforts to improve the future
3) Precautionary effect: -
1
2
2
σ2
- An increase in the uncertainty about future consumption increases the value of a supplementary
euro in t when the agent is prudent (power utility function)
- Here, the uncertainty reduces the discount rate
What discount rate?

22. • We should choose a lower discount rate to discount cash flows that are further away in time?
YES two arguments for a decreasing discount rate:
1) We can assume that the trend of growth rate  does not last forever and it is expected to lower the
rate in a distant future
- In this case, the discount rate of short-term is higher than the discount rate of long term
2) Relationship rather "explosive" (convex) between the variance of 𝑐𝑡 and t
- the risk is relatively more important for the LT than ST: the precautionary effect will dominate in LT, this explains
a smaller rate for the LT than for the ST
➢ Illustration of policy question: Climate change
• Price of permits on the ETS market in September 2016: 4.63 €/tCO2

23. 𝐷 =
1
1 + 𝑟
• Present value depends on time of payment (the sooner, the higher PV) and on the discount rate (the
lower the discount rate, the higher the PV)
• No attention is given to long-term benefits : lifetime of nuclear power plants and their production, long-
term benefits of different energy efficiency measures
• Also the suppression of long term costs such as nuclear waste disposal, decommissioning costs,
climate change damages
Long term effect of discount factor

24. • In general we want to evaluate a project or a cash flows that gives rise to benefits in some periods and costs
in other periods.
• Economic solution concept:
Cost Benefit analysis:
• Assess costs and benefits (in different periods) in monetary units
Assess costs and benefits (in different periods) in monetary units
• Express all benefits and costs in present value terms
• Support a project (only) if benefits exceed costs!
• Net present value NPV:
Cost Benefit Analysis
Invest in the project if
𝑁𝑃𝑉 = ෍
𝑡=0
𝑇
𝐵𝑡 − 𝐶𝑡
1 + 𝑟 𝑡
= ෍
𝑡=0
𝑇
𝐶𝐹𝑡
(1 + 𝑟)𝑡
= −𝐼0 + ෍
𝑡=1
𝑇
𝐶𝐹𝑡
(1 + 𝑟)𝑡

25. Example Cost Benefit analysis (1)
Consider two projects with the following benefits in € and a discount rate of 5%
Only project A worth investing!
NPV𝐴 = −30€ + Τ
20€ 1.05 + Τ
20€ 1.052+ Τ
20€ 1.053=24.46 €
NPV𝐵 = −30€ + Τ
10€ 1.05 + Τ
10€ 1.052+ Τ
10€ 1.053= - 2.77 €

26. Year t 0 1 2 3 … T = 20
Investment It 80.000 0 0 0 0
Operating costs Ct 0 2.000 2.000 2.000 2.000
Revenue Rt= pQt 0 10.000 10.000 10.000 10.000
Cash-Flow CFt -80.000 8.000 8.000 8.000 8.000
D-factor 5% 1
(1 + r)0
1
(1 + r)1
1
(1 + r)2
1
(1 + r)3
1
(1 + r)20
𝑁𝑃𝑉 = −80.000 + ෍
𝑡=1
𝑇
10.000 − 2.000
1 + 𝑟 𝑡
= −80.000 + 8.000 ∙
1 + 𝑟 𝑇
− 1
𝑟 ∙ 1 + 𝑟 𝑇
= −80.000 + 8.000 ∙ 12,5 = 19.698
Capacity 100 kW
Investment cost 800 €/kW
O&M cost 20 €/kW/y
Subsidy (FiT) 0.1 €/kWh
Load hours 1000 h/y
FiT period 20 years
Example Cost Benefit analysis (2)
Remark!!!! for r = 8% NPV = −80.000 + 8.000 ∙ 9,8 = −1.454

27. Levelized cost of production
• Enables comparison between investment options
– Eg. power plants have different life span
• NPV does not define directly their affordability
– Differences need to be analyzed separately
• Cost / energy produced
• € / kWh, € / MWh…
• Takes into consideration:
– All costs during lifetime
– Amount of energy produced during lifetime
– Discount rate
Levelized cost of energy = NPV of costs / NPV of energy produced

28. Levelized cost of production - example
• Power plant:
– Investment cost 20 000 €
– Annual costs 1000 €
– Lifetime 6 years
– Production / year 100 MWh
– Discount rate 5 %
• Levelized cost of production
– Total costs / energy produced

29. Components of levelized cost of energy
Source: Lazard's Levelized Cost of Energy Analysis

30. Source: Lazard's Levelized Cost of Energy Analysis
Levelized cost of energy comparison

31. Example: Investment in a small wind turbine (1)
➢ We use values consistent with a typical household wind turbine (rated at 2.4 kW) on a site with 12 mph
average wind speeds.
➢ Given the basic information, calculate the net annual energy savings for the wind turbine:
Installed cost 12 000 €
Rebates/incentives 4 000 €
Annual energy output 5280 kWh/year
Annual operation and
maintenance costs
120€
/year
Useful life 20 years
Retail electricity price 0.11 €
/kWh
Discount rate 2%
Net Energy Savings (€/year) = Annual Energy Output (kWh/year) x Price (€/kWh) – O&M (€/year)
= 5280x0.11-120=460.80 €

32. Example: Investment in a small wind turbine (2)
A) Determine the simple payback
Payback (years) = [Installed cost (€) – Rebates (€)] / Net Energy Savings (€ /year)
= [12000-4000] / 460.80= 17.4 years
B) Determine the NPV
NPV (€) = - [Installed cost (€) – Rebates (€)] +Discounted Net Annual Savings
=- [12000-4000] + 460.80 x
1+0.02 20−1
0.02 1,02 20= -8000+7534.74 €=-465.26€
C) Determine the LCOE
LCOE (€ /kWh) =
[Installed cost (€) – Rebates (€)] +Discounted Annual O&M(€/year)
Discounted Annual Energy Output(kWh/year)
LCOE (€ /kWh) =
[12000−4000]+120 x16.35
5280x16.35
= 0.115 € /kWh
Conclusion
- Important to use multiple methods!
- Simple payback: the wind turbine will pay for itself before it stops working
- NPV negative → not economical to invest
- LCOE : the cost of electricity generation is higher than the market price → for an increase in the electricity
the wind turbine may be cost competitive

33. Other decision criteria
Internal Rate of Return (IRR)
• Determines the interest rate that is associated with a zero NPV and is consequently associated with an
equilibration of present value of benefits and present value of costs.
• The value of the interest rate that satisfies the above equations can be found using trial and error, or a
computer spreadsheet.
• If several alternative investments are being evaluated, the best investment is one that has the
highest IRR.
IRR is r for which NPV=0

34. Minimum rate of return - r
• This is the minimum acceptable rate of return required by the investor to assess the profitability of a project.
• Cost of capital: Weighted average cost of the different sources of long-term financing used by the company
(equity, debts) ; the rate of return a business would receive if it invested its money in another project with
similar risk
• Risk premium The additional risk associated with the project (geopolitical risk, maturity of the technology
implemented ...)
𝒓 = 𝑪𝒐𝒔𝒕 𝒐𝒇 𝒄𝒂𝒑𝒊𝒕𝒂𝒍 + 𝑹𝒊𝒔𝒌 𝒑𝒓𝒆𝒎𝒊𝒖𝒎
• If IRR > Minimum acceptable rate of return, the project is accepted
• If IRR = Minimum acceptable rate of return, it does not matter (indifferent)
• If IRR <Minimum acceptable rate of return, the project is rejected

35. Benefit Cost Ratio (BCR)
• A ratio of the net present value of all benefits to that of all costs incurred over the analysis period
• A project is economically feasible if BCR > 1
• The alternative with the highest BCR value is considered the best alternative
𝑹𝑩𝑪 =
𝑵𝑷𝑩
𝑵𝑷𝑪
> 1
• The number of years from which the net present value is zero NPV = 0
• The future cash flows considered are discounted to the initial period of the project
• A measure of the time needed to repay the initial investment taking into account the time value of money
Dynamic Payback