UNIT-3

Economics of Energy Conservation

• In the process of energy management, at some stage,
investment would be required for reducing the energy
consumption of a process or utility.

•Investment would be required for modifications/retrofitting

and for incorporating new technology.

•It is essential to identify the benefits of the proposed

measure with reference to not only energy savings but also
other associated benefits such as increased productivity,
improved product quality etc.
 The cost involved in the proposed measure
should be
• Direct project cost
• Additional operations and maintenance cost
• Training of personnel on new technology etc.
 Investment Need, Appraisal and Criteria

• The size of the energy problem it currently

faces
• The technical and good housekeeping
measure available to reduce waste
• The predicted return on any investment
• The real returns achieved on particular
measures over time.
The need for investments in energy conservation

• For new equipment, process improvements

etc.
• To provide staff training
• To implement or upgrade the energy
information system
 Investment Appraisal

• Reducing operating /production costs

• Increasing employee comfort and well-being
• Improving cost-effectiveness and/or profits
• Protecting under-funded core activities
• Enhancing the quality of service or customer
care delivered
• Protecting the environment
 Financial Analysis

• 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.
 Simple Pay Back Period:

• 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
• The simple payback period is usually
calculated as follows:
 Examples
• 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), may be calculated as follows:
Advantages

• 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 favors' 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.
• To illustrate, consider the cash flows of two projects, A
and B:
• Investment Rs. (100,000) Rs.(100,000)
Savings in Year Cash Flow of A Cash flow of B
• 1 50,000 20,000
• 2 30,000 20,000
• 3 20,000 20,000
• 4 10,000 40,000
• 5 10,000 50,000
• 6 - 60,000
• 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

• A project usually entails an investment for the initial cost of

installation, called the capital cost, and a series of annual
costs and/or 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. The
relationship between present and future value is determined
as follows:
Future Value (FV) = NPV (1 + i)n or
NPV = FV / (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)
• ROI expresses the "annual return" from the project
as a percentage of capital cost.

• 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.
• The annual return expected from initial capital
investment, expressed as a percentage:

• 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.

Where NPV = Net Present Value

CFt = Cash flow occurring at the end of year ‘t’
(t=0,1,….n)
n = life of the project
κ = Discount rate
Example

• To illustrate the calculation of net present value,

consider a project, which has the following cash flow
stream:
Investment Rs. (1,000,000)
Saving in Year Cash flow
• 1 200,000
• 2 200,000
• 3 300,000
• 4 300,000
• 5 350,000
• The cost of capital, κ, for the firm is 10 per cent. The
net present value of the proposal is:
• 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
• 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
• It is the discount rate in the equation

• where CFt = cash flow at the end of year “t”

κ = discount rate
n = life of the project
• CFt value will be negative if it is expenditure and
positive if it is savings.
• To illustrate the calculation of internal rate of return, consider
the cash flows of a project:

• The internal rate of return is the value of “ k ” which satisfies

the following equation

• The calculation of “κ” involves a process of trial and error. We

try different values of “κ” till we find that the right-hand side of
the above equation is equal to 100,000. Let us, to begin with,
try κ = 15 per cent. This makes the right-hand side equal to
• This value is slightly higher than our target value, 100,000. So
we increase the value of κ from 15 per cent to 16 per cent. (In
general, a higher κ lowers and a smaller r increases the right-
hand side value). The right-hand side becomes

• Since this value is now less than 100,000, we conclude that the
value of k lies between 15 per cent and 16 per cent. For most of
the purposes this indication suffices.
• Advantages (B)
• A popular discounted cash flow method, the internal rate
of return criterion has several.
• It takes into account the time value of money.
• It considers the cash flow stream in its entirety.
• It makes sense to businessmen who prefer to think in
terms of rate of return and find
• an absolute quantity, like net present value, somewhat
difficult to work with.
• Limitations
• High internal rate of return need not necessarily be a
desirable feature
 Cash Flows

• There are two kinds of cash flow; the initial investment as one
or more installments, and the savings arising from the
investment. This over simplifies the reality of energy
management 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, although, as in the example, installments paid
over a period of time will have time costs associated with
them.
• Annual cash flows, such as annual savings accruing 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.
 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.
• Sensitivity analysis is an assessment of risk.
• 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 favorable as
predicted? How much would it have to vary before the project
becomes unviable? What is the probability of this happening?
• 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 equity
• Changing of the forms of finance e.g. leasing
• Changing the project duration
• Macro factors
• Changes in interest rates
• Changes in the tax rates
• Changes in the accounting standards e.g. methods of calculating
depreciation
• Changes in depreciation rates
• Energy Price change
• Technology changes
 Financing Options

There are various options for financing in-house

energy management
1. From a central budget
2. From a specific departmental or section budget
such as engineering
3. By obtaining a bank loan
4. By raising money from stock market
5. By retaining a proportion of the savings achieved.