ELEC5206 Sustainable Energy Systems

Module 3 | Economics of Sustainable Energy Systems

Dr Archie Chapman | Research Fellow in Smart Grids

School of Electrical and Information Engineering

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 Who am I?

– Dr Archie Chapman
– Research Fellow in Smart Grids.
– Economist - not an engineer!
– Work on power systems research with Dr Verbic.

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 Purpose of this module

– To introduce analytical tools for estimation of costs and economic

viability associated with the development and implementation of
sustainable energy projects
AGL
• Nyngan solar PV plant
• 250 hectares, 102 MW
• $290 million

Union Fenosa
• Paling Yard wind farm
• 55 turbines, 178 MW
• $287 million investment

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 Economics 101 – Supply and demand

Demand curve - D
– “Willingness to pay” for one more unit of the good.
– First derivative of utility.

Supply curve - S
– Marginal cost of producing one more unit.
– First derivative of short-run cost.
– Eg. Quadratic SRC gives linear supply.

Market clearing price and quantity (p,q)

– Found at the intersection of S and D.
– Called a competitive equilibrium.
– Marginal cost = marginal utility.

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 Economics 101 – Surplus and welfare analysis

Assumptions of perfect
competition:
– No market power.
– No external costs.
– No asymmetric information.
– No transaction costs.

Equilibrium is Pareto efficient

– No one can do better without
another doing worse.

Total social welfare

= consumer + producer
surplus.
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 Economics 102 – The investment cycle

Increases in wealth (income) raise

demand, and increases in productivity
and technical efficiency reduce costs.
– Opportunity to invest in new
capital.
– Capital typically represents a
large, upfront cost.
– Requires finance to build.
The link between markets and
investments is cashflow analysis:
– What producer surplus can be
earned in the market?
– Is the potential surplus great
enough to make a new investment
economically viable?
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 The Australian National Electricity Market (NEM)
– AEMO operates the NEM’s energy-only
gross pool electricity market.
– Dispatch is determined using a bid
order obtained in a reverse auction:
1. AEMO announces day-ahead demand
forecasts for 30 minute intervals.
2. Generators bid by offering a firm supply
curve for each interval.
3. AEMO’s dispatch engine computes the market
supply curve, also called a “bid stack.”
4. At dispatch time, a more accurate demand
forecast is used to find the spot price that
balances supply with load, which effectively
chooses the dispatch levels for each generator.
– Is the new investment economically
viable?
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 Calculation of economic viability

– The economic evaluation of a sustainable energy project

requires a meaningful quantification of cost elements (e.g.
fixed costs, variable costs) over a lifetime of the project
– We use engineering economics notions for this purpose since
they provide the means to compare on a consistent basis
– two different projects; or,
– the costs with and without a given project
– Often, a sustainable energy project (i.e. a capital investment)
requires funds, either borrowed from a bank, or obtained from
investors
– Conceptually, we may view the investment as a loan with
interest rate i that converts the investment costs into a series of
equal annual payments to pay back the loan with the interest

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 Calculation of economic viability

– The main challenge is the comparison of inherently different

alternatives
– In a residential building, for example, there are different ways to
reduce energy expenditure:
– Install rooftop PV
– Improve wall insulation
– Buy more energy efficient appliances
– Switch to gas heating, etc.
– There are many ways to calculate the economic viability of
sustainable energy projects:
– Simple Payback Period
– Initial (Simple) Rate-of-Return
– Net Present Value
– Internal Rate of Return (IRR)
– Modified Internal Rate of Return (MIRR)

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 Simple payback period

– Simple payback period is just the ratio of the extra first cost
∆P to the annual savings S
Extra first cost ∆P ($)
Simple payback =
Anual savings S ($/year)
– Easy to understand, but the least convincing ways to present the
economic advantages of a project
– Misleading, as it doesn’t include anything about the longevity
of the system
– Example: Two air conditioners may both have 5-year payback
periods, but even though one lasts for 20 years and the other
one falls apart after 5, the payback period makes absolutely
no distinction between the two
In economic terms, salvage value of the equipment at
the end of the project is neglected
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 Initial (simple) rate-of-return

– The initial (or simple) rate of return is just the inverse of the
simple payback period
– That is, it is the ratio of the annual savings to the extra initial
investment:
Anual savings S ($/year)
Initial (simple) rate of return =
Extra first cost ∆P ($)
– Just as the simple payback period makes an investment look
worse than it is, the initial rate of return does the opposite and
makes it look too good
– Example: if an efficiency investment with a 20% initial rate of
return, which sounds very good, lasts only 5 years, then just as
the device finally pays for itself, it dies and the investor has
earned nothing
– Useful as a convenient “minimum threshold” indicator

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 Cash flows

– The calculation of economic viability requires the analysis of

the cash flows over a project’s lifetime
– Each cash flow has (1) amount, (2) time, and (3) sign
$ 2000

End of year 1 Convention for

1 2 3 4 5 cash flows:
+ inflow
0 years
Present – outflow
A A A A A
Incoming Outgoing
cash flows cash flows
Example Example
Take out a loan Loan repayments made
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 Cash flow projections

– For a project to be economically viable we need to a least recover

the initial investment, but often we would also like to make some
money
– Thus, we need to project the cash flows in the future
Simple cash flow 4
Cumulative cash flow
x 10
1.5

0
1

Cumulative cash flow [CAD]

0.5
Cash flow [CAD]

-5000

-0.5
-10000

-1

-15000 -1.5
0 5 10 15 20 25 30 0 5 10 15 20 25 30
Time [years] Time [years]

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 Discounted cash flows

Need to take into account the time value of money!

Nominal and discounted cash flows assuming a 10% discount rate
4
x 10
1.5
Discounted
Nominal
1
Cumulative cash flow [CAD]

0.5

-0.5

-1

-1.5
0 5 10 15 20 25 30
Time [years]
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 Present worth analysis

A dollar today is not the same as a dollar in a year

– Relationship between a future amount of money and what it
should be worth to us today
P – investment
F F – future amount of money
P=
(1 + d ) d – discount rate
n
n – number of years of investment

– The present value P of a stream of annual cash flows A

P= A ⋅ PVF (d, n )

– Present value function (PVF)

(1 + d ) − 1
n
1 1 1 1
PVF= + ++ + =
1+d
(1 + d ) (1 + d ) (1 + d ) d (1 + d )
2 n −1 n n

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 Net Present Value (NPV)

– The present value of all costs, present and future, for a project is
called the life-cycle cost of the system under consideration
– All future costs are converted into an equivalent present value or
present worth
– The difference between two investments based on the life-cycle cost
computation is called the net present value (NPV) of the lower-cost
alternative
– It allows one to choose the alternative that is cheaper in the long
term
– Two cash-flow sets

{ A at : t = }
0,1,2,..., {
n and Abt : t 0,1,2,..., n }
– under a given discount rate d are said to be equivalent cash-flow sets
if their worths, discounted to any point in time, are identical

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 Example: Present and future value

– Consider the set of cash flows illustrated below

$ 400
$ 300
$ 200 $ 200

0 1 2 4 5 6 7 8

d = 6%
$ 300

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 Example: Present and future value

– We compute F8 at t = 8 for d = 6%
( ) ( )
7 5
F8 = 300 1 + .06 − 300 1 + .06 +
Future
200 (1 + .06 ) + 400 (1 + .06 )
4 2
Value + 200
= $ 951.56
– We next compute P
( ) ( )
−1 −3
P = 300 1 + .06 − 300 1 + .06
Present
( ) ( ) ( )
−4 −6 −8
Value + 200 1 + .06 + 400 1 + .06 + 200 1 + .06
= $ 597.04

– We check that for d = 6%

( )
8
F=
8
597.04 1 + .06= $ 951.56
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 NPV of an energy-efficient motor

Example 1
– Two 100-hp electric motors are being considered, call them
“superior” and “good”
– The good motor draws 79 kW and costs $2,500; the superior
motor draws 76 kW and costs $3,000
– The motors run 1600 hours per year with electricity costing
$0.2/kWh
– Over a 20-year life, find the net present value of the cheaper
alternative when a discount rate of 10% is assumed

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 NPV of an energy-efficient motor

– The annual electricity cost for the two motors is

– Note that the annual energy cost of a motor is far more than the initial cost
– The present value factor for these 20-year cash flows with a 10% discount
rate is

– The present value of the two motors, including the first cost and annual costs,
is therefore In Excel: PV(0.1,20,1)

– The superior motor is the better investment with a net present value of

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 NPV of an energy-efficient motor

– The net present value calculation can be simplified by

comparing the present value of all of those future fuel savings
∆A with the extra first cost of the more efficient product ∆P

– Therefore, in this example

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 Internal Rate of Return (IRR)

– The IRR allows the energy investment to be directly compared

with the return that might be obtained for any other competing
investment
– IRR is the discount rate that makes the net present value of the
energy investment equal to zero

NPV = ∆A ⋅ PVF ( IRR, n ) − ∆P = 0

– In the simple case of a first-cost premium P for the more

efficient product, which results in an annual fuel savings A, it is
the discount rate that makes the net present value be zero
∆P
PVF ( IRR,=
n) = Simple payback period
∆A
where
∆A – annual payments
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∆P – added first cost of the better project Page 23
 Internal Rate of Return (IRR)

Example 2
– Referring to Example 1 and assuming 20-year life, what is the
internal rate of return of the superior motor?
Solution
– According to the given equation

– By putting n = 20 and several iterations, the internal rate of

return is given by

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 Internal Rate of Return (IRR)

Assuming salvage value of

the equipment at the end of
the project is zero

Internal rate of return as a function of the simple payback period, with project life
as a parameter
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 NPV and IRR with fuel escalation

– Equivalent discount rate with fuel escalation

1+e 1 d −e d – buyer’s discount rate
= ⇒ deq=
1 + d 1 + deq 1+e e – escalation rate of the annual savings

– So the equivalent Present Worth Factor is

( 1+d ) −1
n

PVF (d , n ) =
eq

d (1 + d )
eq n
eq eq
– To find the IRRe when there is fuel escalation, the present
value of the escalating series of annual savings must equal the
extra initial principal
NPV = ∆A ⋅ PVF (deq , n ) − ∆P = 0 d ↓ ⇒ PVF ↑
The reasoning here goes something like: The present value of future fuel savings is
more if the fuel price will go up in the future, hence the lower equivalent discount rate.
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 NPV and IRR with fuel escalation

– From which it follows

∆P
PVF deq ,=
n ( ) = Simple payback period
∆A
Annual payments
– IRR without and with fuel escalation
With fuel
 escalation Without
 fuel escalation

∆P ∆P d −e
PVF deq , n = = ( )
∆A
PVF ( IRR0 , n ) = → IRR0 =
∆A
deq =
1+e
=
d IRRe ⇒ IRR=
e
IRR0 ⋅ (1 + e ) + e

d can be thought of as the buyer's discount rate (taking into

account the fuel escalation) that results in NPV of zero, i.e. IRRe
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 NPV of superior motor with fuel escalation

Example 3
– The superior motor in Example 1 costs extra $500 and saves
$960/yr at today’s price of electricity. If electricity rises at an
annual rate of 5%, find the net present value of the superior
motor and compare it to the original NPV.

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 NPV of superior motor with fuel escalation

Solution
– Using the equivalent discount rate equation

– The present value function for 20 years of escalating savings is

– The net value is

(Was $7,674 without fuel escalation)

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 Modified Internal Rate of Return (MIRR)

– The IRR is not suitable in cases of negative cash flows during the
project’s life time as it leads to multiple solution
– Negative cash flows may result from the need to replace some
components 10 x 10 7

Cumulative disc. cash flow

Net cash flow
8

6
Cash Flow [CAD]

-2

-4
0 2 4 6 8 10 12 14 16 18 20
Time [Years]
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 Modified Internal Rate of Return (MIRR)

– In the calculation of the MIRR, the assessment of negative cash

flow impacts after the initial investment year is done by
discounting the negative cash flows with respect to the project’s
first year based on the finance rate
– The positive cash flows, on the other hand, are discounted with
respect to the last year of the project based on the reinvestment
rate
– The finance rate is usually assumed to be equal to weighted
costs of capital (WACC)
– The reinvestment rate is usually assumed to be the same as
typical discount rates used in the industry (i.e. the investor’s
“personal” discount rate)

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 Annualizing the investment

– In many circumstances the extra capital required for an energy

investment will be borrowed
– The economic analysis can be thought of as a loan that converts
the extra capital cost into a series of equal annual payments
that eventually pay off the loan with interest
– The same approach can be used to annualize the cost of the
energy investment, which has many useful applications
– The key equation is
A= P ⋅ CFR (i, n )
P – principal borrowed ($)
i – annual interest rate
n – load terms (years)
– Capital recovery factor
i (1 + i )
n

CFR (i, n ) =
Capital Recovery Factor (year )−1

(1 + i )
n
−1
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 Annual costs and annual savings

Example 4
– An efficient air conditioner that costs an extra $1000 and
saves $200 per year is to be paid for with a 7% interest, 10-
year loan. Find the annual monetary savings.
Solution
– From the capital recovery factor

– The annual payments will be

– The annual saving will be $200 - $142.38 = $57.62/yr

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 Levelized bus-bar costs

– Various alternatives must be compared on a consistent basis taking

into account
– inflation impacts Key advantage of sustainable energy – not
subject to increasing fuel costs
– fixed investment costs
– variable costs
– The customary approach for cost valuation consists of the following
steps:
– present worthing of all the cash-flow
– determining the equal amount of an equivalent annual uniform cash-flow set
– determination of the yearly total generation
– The ratio of the equivalent annual cost to annual electricity
generated is the levelized bus-bar cost or Levelized Cost of Electricity
(LCOE)
– The “bus-bar” refers to the wires as they leave the plant boundaries

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 Levelized bus-bar costs

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 Levelized bus-bar costs

– Present value of escalating annual costs

PVannual costs= A0 ⋅ PVF (deq , n )
– Now find an equivalent annual cost
= C A,L PVannual costs ⋅ CRF (d, n )

C A,L = PVF (deq , n ) ⋅ CRF (d, n ) ⋅ A0

 
LF
– This is called the levelized annual cost, and the Levelizing
Factor (LF) is
=LF PVF (deq , n ) ⋅ CRF (d, n )
– LF = 1 means no inflation

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 Cost of electricity of a microturbine

Example 5
– A microturbine has the following characteristics:
– Plant cost = $850/kW Initial investment cost
– Heat rate = 13,200kJ/kWh Energy efficiency of the unit
– Capacity factor = 0.70
– Initial fuel cost = $4.00/GJ
– Variable O&M cost = $0.002/kWh Depends on how much the unit is being used
– Fixed charge rate = 0.12/yr Fixed cost (e.g. cost of labour for larger units)
– Owner discount rate* = 0.10/yr
– Annual cost escalation rate = 0.06/yr
– Find its levelized ($/kWh) cost of electricity over a 20-year lifetime.
*The fixed charge rate covers costs that are incurred even if the plant doesn’t operate,
including depreciation, return on investment, insurance, and taxes. Fixed charge rates
vary depending on plant ownership and current costs of capital, but tend to be in the
range of 10–18% per year.
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 Cost of electricity of a microturbine

Solution
– The levelized fixed cost is
$850/kW × 0.12/yr
=
Levelized fixed cost = $0.0166/kWh
8760h/yr × 0.70
– The initial annual cost for fuel and O&M is
A0 =13,200kJ/kW × $4/GJ + $0.002/kWh =
$0.052/kWh

– This needs to be levelized to account for inflation. The inflation

adjusted discount rate d’ is
d − e 0.10 − 0.06
d′
= = = 0.037736
1+e 1 + 0.06

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 Cost of electricity of a microturbine

Solution
– The levelizing factor for annual costs is

 1.03773620 − 1   0.10 × 1.1020 

=
Levelizing factor (LF)  ⋅ =  1.628
20 20
 0.037736 × 1.037736   1.10 − 1 
– The levelized annual cost is therefore

Levelized annual cost =A0 × LF =$0.052/kWh × 1.628 =$0.0847/kWh

– The levelized fixed plus annual variable cost is

Levelized =
bus-bar cost $0.0166/kWh + $0.0847/kWh=$0.1013/kWh

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 Cost of electricity of a PV system

Example 6
– A 3-kW photovoltaic system, which operates with a capacity
factor (CF) of 0.25, costs $10,000 to install
– There are no annual costs associated with the system other than
the payments on a 6%, 20-year loan
– Find the cost of electricity generated by the system ($/kWh)

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 Cost of electricity of a PV system

Solution
– From the capital recovery factor

– The annual payments will be

– The annual electricity generated will be

– The cost of electricity from the PV system is therefore

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 Cost of electricity of a wind turbine

Example 7
– Suppose that a 900W wind turbine with a 2.13m blade costs
$1600
– By the time the system is installed and operational, it costs a
total of $2500, which is to be paid for with a 15-yr, 7% loan
– Assuming O&M costs of $100/yr, estimate the cost per kWh
over the 15-year period if average wind speed at hub height
is 6.7m/s
– Assume Raleigh wind speed distribution, which renders the
following relation between the average wind speed and the
capacity factor
Pt (kW)
CF =
0.087 ⋅ vavg (m/s) −
[D(m)]2

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 Cost of electricity of a wind turbine

Solution
– The capital recovery factor would be

– The annual payments on the loan would be

– The annual cost, including $100/yr of O&M, is therefore

$274.49 + $100 = $374.49

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 Cost of electricity of a wind turbine

Solution
– Given the capacity factor equation

– The average cost per kWh is therefore

– Worth investing?

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 Index of real levelised cost of electricity generation
technologies excluding carbon emission costs
2017 update:
The projected price for new supercritical coal power is
around $75/MWh, which is higher than the recent prices for
newly installed wind power at around $60-70/MWh in
current prices over the 20-year contract period (which is
similar to a levelised cost). Solar PV has a similar price tag.

ABARE: Australian energy projections to 2029-30 (March 2010)

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 Market failure

– Markets are used because (under ideal conditions) they lead to

Pareto efficient allocations at fair prices.
– These if these conditions are not satisfied, then markets can
fail:
1. No external costs (i.e. costs not born by the producer),
2. No excessive market power,
3. Information symmetry (esp. regarding production costs and quality),
4. Transaction and search costs,
In power systems, assumptions 1, 2 and 3 are of most concern.
– Externalities: Network costs, pollution costs.
– Market power: Very large generators, or single a company
owning many.
– Information asymmetry: Dealt with by using a reverse auction.

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 Externalities – Transmission access

– Networks are required to move energy, but they have capacity

constraints.
– New generators connecting to the transmission grid can affect
dispatch decisions, due to transmission line constraints.
– Example – Transmission network externality:
– Firm 1 has a 100MW OCGT generator at the end of a 120MW capacity
transmission line (e.g. in a gas field), which is used as a peaking plant.
– Firm 2 wants to build a new solar 40MW concentrated solar thermal +
storage plant and connect it along the line.
– CST generation peaks on hot sunny days in summer, and grid demand is at
its peak at the same time.
– NEM rules mean that network access is bundled with dispatch, so the CST
plant, with close to zero marginal cost, will dispatched before the OCGT
plant, and line constraints limit the maximum power generated by the
OCGT plant to 80MW.
– Thus, building the CST plant imposes a negative externality on the OCGT
plant.

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 Externalities – Distribution cost allocation

– Regulated tariff structures have contributed to power market design

failure.
– Example – Cross-subsidised distribution network costs to households with
high power devices and/or rooftop PV:
– The effect of a small number of high power user on network costs are not
reflected in tariff structures. These structures recover costs at a “per unit of
energy” rate; however, networks are built for capacity or peak power.
– Similarly, high PV penetration on residential feeders require network upgrades/
augmentation, but the costs of this work is spread across all energy users.
– “Death spiral” for utilities, as increasing costs drive more users away to install
rooftop PV, leaving a greater proportion of network costs to be born by those
who don’t have PV.
– The problems addressed by network augmentations are peak congestion
and reverse power flow, but there are no price signals for these factors
under standard tariff designs (a case for electricity market reform).
– Can be addressed by new tariff structures, or new business models.
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 Externalities – Pollution costs

– Carbon pollution (could be NOx, particulate or heavy metal pollution).

– Production costs for coal and gas fired generation plants includes only
the cost of fuel, and does not include “externalised” costs, such as
environmental degradation or potential catastrophic climate change.
– Externalities are addressed by the Coase theorem, which depends on
clearly defining property rights and institutions that facilitate exchange:
– Allocate property rights or obligations over the externality, and allow
negotiations or market exchange to reallocate the rights to an efficient use, or
– Use corrective taxation to impute an efficient allocation (i.e. Government holds
the property rights and licences them to users).
– Examples – Two approaches to pricing carbon pollution:
– A cap-and-trade carbon market defines the rights to pollute (cap) and a
mechanism for finding an efficient allocation of pollution rights (trade),
– An optimal carbon pollution tax charges polluters a price that implements an
“efficient” level of pollution.

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 Market power – Monopoly and oligopoly

– Excessive market power refers to a participants ability to alter

prices.
– In the extreme case, a monopolist can set the price to
maximise its own profit (at the expense of buyers).
– Calculates its marginal revenue curve, the
change in revenue for a change in quantity.
– Profit is maximised at the q where MR
crosses supply, with the price is determined
by the demand curve.
– Producer surplus is maximised (rectangle
below pm).
– Consumer surplus is reduced.
– Social welfare is reduced, by an amount
called the deadweight loss (triangle ABC),
compared to the competitive equilibrium.
– Duopoly and oligopoly significantly complicate this model.

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