Page 1 of 55 By Prof. Amrit Nakarmi I/II MSREE 09 July 2008 Introduction to Economics of Energy Projects (EG854ES) What Is Economics? Scarcity All economic questions arise from a single and inescapable fact: you can't always get what you want. We live in a world of scarcity. Scarcity means that wants always exceed resources available to satisfy them. People get involved in Economic Activity to cope with Scarcity. Economics is the study of how people use their limited resources to try to satisfy unlimited wants. Faced with scarcity, we have to make choices because we can't have all what we want. Balancing the wants and the resources available is called economizing or optimizing. What Is Energy Economics? What is competition? Competition is the contest for command over scarce resources. For human life and the production processes, a sufficiently available of energy is the highest priority. Human beings can live without other things, but not without energy resources. Energy resources are also scarce and hence, needs its optimization and it is dealt by energy economics. What Is Economics of Energy Projects? Economics of Energy Projects deals with how economically an energy project can be established and operated. Cost structure, financing, capital budgeting (project evaluation), and financial performance analysis of the energy projects or firms are looked into. Types of Firms Three basic types of firm Sole proprietorship Partnership Corporation or limited company Sole proprietorship It is the oldest form of business organization. A single person owns the business, holds title to all its assets, and is responsible for all of its liabilities. Advantages Simplicity Quicker decision‐making Easy to establish
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Page 1 of 55
By Prof. Amrit Nakarmi I/II MSREE 09 July 2008
Introduction to Economics of Energy Projects (EG854ES)
What Is Economics?
Scarcity
All economic questions arise from a single and inescapable fact: you can't always get what you want. We live
in a world of scarcity.
Scarcity means that wants always exceed resources available to satisfy them.
People get involved in Economic Activity to cope with Scarcity.
Economics is the study of how people use their limited resources to try to satisfy unlimited wants.
Faced with scarcity, we have to make choices because we can't have all what we want. Balancing the
wants and the resources available is called economizing or optimizing.
What Is Energy Economics?
What is competition?
Competition is the contest for command over scarce resources.
For human life and the production processes, a sufficiently available of energy is the highest priority.
Human beings can live without other things, but not without energy resources. Energy resources are also
scarce and hence, needs its optimization and it is dealt by energy economics.
What Is Economics of Energy Projects?
Economics of Energy Projects deals with how economically an energy project can be established and
operated. Cost structure, financing, capital budgeting (project evaluation), and financial performance analysis
of the energy projects or firms are looked into.
Types of Firms
Three basic types of firm
Sole proprietorship
Partnership
Corporation or limited company
Sole proprietorship
It is the oldest form of business organization. A single person owns the business, holds title to all its
assets, and is responsible for all of its liabilities.
Advantages
Simplicity
Quicker decision‐making
Easy to establish
Page 2 of 55
Disadvantages
Good for small firms and not good for big firms such as energy Cos.
Responsible for all liabilities
Difficult to raise capital
Cost of capital is high
Partnership
A partnership is similar to a proprietorship in all aspects except that there is more than one owner.
Advantages
Decision made through consensus/agreement , hence low risk
Can raise higher capital
Easy to establish but more complex than single proprietorship
Disadvantages
Responsible for all liabilities
Slower decision‐making process than single proprietorship
Difficult to raise capital
Corporation or Limited Company
A company is an impersonal entity created by law, which can own assets and liabilities. The main
feature of this form is that the Co. is separate from its owners. A owner’s liability is limited to his/her
shareholding only.
Advantages
Limited liability
Can raise higher capital (a kind for energy Cos.)
Lower cost of capital
Decision‐making through consensus
Disadvantages
Slow decision‐making
Difficult to set up
RAISING
Equity CEquity cap
Rights of
R
th
re
R
ev
G FINANCES
Capital pital represen
Authorized
memorand
Issued cap
Subscribed
Paid‐up ca
Par value –
Book valu
outstandin
Market Va
market.
Initial Pub
Subsequen
Rights Issu
existing sh
f equity shar
ight to incom
he debt obliga
etained earni
ight to contr
very resolutio
S
nts ownershi
d capital –
dum of assoc
pital – the am
d capital – Th
apital – The a
– It is the valu
e – It is the s
ng shares.
alue – It is th
blic Offering (
nt offering is
ue –It is the
hareholders.
reholders
me – The equi
ation and pre
ngs or paid o
ol – Equity sh
on placed bef
p capital as e
The amoun
iation.
mount offered
he part of the
ctual amount
ue stated in t
um of the pa
he value of t
(IPO) – The in
called Second
e selling of th
ity sharehold
eferred share
ut as dividen
hareholders a
fore the Co.
quity (comm
t of capital
by the Co. to
issued capita
t paid up by t
he memoran
aid‐up capital
the share at
nitial public is
dary public of
he security i
ers have resi
dividends. Th
d.
are the actual
on) sharehold
that a Co.
o the shareho
al which has b
the investors.
dum and the
and retained
which it is tr
ssue of the sh
ffering (SPO).
n the primar
dual claim to
he residual in
l owners of th
ders collectiv
can potent
olders.
been subscrib
share certific
d earnings div
raded in the
hares to the m
ry market by
o the income
ncome can be
he Co. and ha
Pa
ely own the c
ially issue, a
bed to the inv
cate.
vided by the
stock exchan
members of t
y issuing sha
of the firm af
e withheld by
ave the right
age 3 of 55
company.
as per its
vestors.
number of
nge or the
the public.
res to the
fter paying
the Co. as
to vote on
Page 4 of 55
Pre‐emptive rights – It enables the existing shareholders to maintain their proportional ownership of
the shares if the Co. issued additional shares in the market.
Sources of Finance
Preferential Capital (Preferred shares)
Preferred shares are hybrid forms of capital. They have the characteristics of both the equity (common
shares) and the debt such as debentures.
Main features are :
1. preferred share dividend is payable after net income,
2. it is cumulative (dividend if not paid in year, will be accumulated next year), and
3. it is taxable and has no voting rights.
Internal accumulation (retained earnings)
The internal accruals consist of depreciation and retained earnings. Retained earnings are
much more expensive than bank loans, because they are retained without paying out the dividend and cost
of capital (interest rate) of equity is higher than that of the loan.
Term Loans/debentures
Terms are given by financial institutions such as banks and have term of less than 10 years.
Debentures (bonds) are loans raised from the public and the interest (called here as coupon) is paid every six
months. It can be secured and unsecured. Debentures can be convertible into common shares.
Working capital advances (loans)
Under a cash credit or overdraft arrangement, a company can borrow required amount if it is within its limit
in the agreement with the financial institution or the bank.
Weighted Average Cost of Capital (WACC)
Cost of Debt
A firm with a 40% tax rate issues $1,000 bonds at a face value with coupon rate of 16%. Ignoring
b/d: barrels per daya O&M include the cost of fuel used by the refineryb based on 330 days per yearcbased on the yield of various products (gasoline,jet fuel,gasoil,fuel oil and butane) from the refinery and the market prices of theses products
Financial Analysis of a Petroleum Refining Project
Example 7 (IRR)
Benefit-Cost RatioThis method compares the discounted total benefits of the project to its discounted costs:
0
0
(1 )/
(1 )
nt
ttn
t
tt
Br
B CC
r
Only projects of B/C > 1.0 are adopted. The criteria is useful in capital constraint situation e.g., utility has a lot of feasible projects but limited investment budget. In this case, projects are ranked in accordance with their B/C ratio and are adopted accordingly until their combined costs equal the capital investment budget.
Example 8:
B/C of example-1 = 1.15
Page 47 of 55
Payback period
It is the time required for a project's total benefits to exceed its total cost. At that time project can be said to
have “paid back” its initial cost.
The most common applications is in the analysis of energy conservation programs.
Example 9:
Energy efficiency retrofit of large building reduces the annual electricity demand for heating and cooling
from 2.3 GWh to 0.8 GWh and the peak demand for power by 150 kW. Electricity costs $ 0.06/kWh and
demand charges are $7/kW‐month.If the project costs $ 500,00,what would be the payback period of the
investment ?
Energy Savings (A)
= (2.3‐0.8) x 106 kWh/yr x $ 0.06/kWh = $ 90,000/yr
Demand Savings (B)
= 150 kW x $ 7/kW‐month x 12 months/yr = $ 12,600/yr
Total Annual Savings: (A ) + (B) = $ 102,600/yr
Simple payback period = Initial Investment / Annual Savings
= $500,000/$102,600/yr
= 4.87 yr.
An Overview of Renewable Energy Project Financing through CDM
Brief Background
Formulation of the United Nations Framework Convention on Climate Change (UNFCCC) in 1992.
UNFCC sets an “ultimate objective” of stabilizing atmospheric concentrations of greenhouse gases at
safe levels.
Categorization of countries into two groups: Annex I Parties i.e. the industrialized countries who have
historically contributed the most to climate change, and non‐Annex I Parties, i.e. developing
countries.
Conference of Parties (COP)
United Nations Framework Convention on Climate Change‐ As the Precursor of Clean Development
Mechanism
Kyoto Protocol
The Protocol was adopted in December 1997.
It creates legally binding obligations on Annex I countries to reduce their emissions of GHGs.
A
in
Th
Kyoto pro
below to t
C
C
de
What ar
En
fl
A
de
In
H
de
What do
Dual Obje
• lo
• w
s of 27 Febru
nstruments of
he protocol e
otocol requir
the level of 1
DM is one of
DM allows
eveloping cou
re the aspe
nables Annex
exible and co
ssist develop
evelopment o
nvestors bene
ost Countries
evelopment.
oes CDM ai
ectives:
ower the over
while also sup
uary 2006, 16
f ratifications
entered into f
es developed
990 by 2012
the Kyoto me
emission re
untries to gen
cts of CDM
x‐1 countries
ost‐effective m
ping countrie
objectives.
efit by obtaini
s benefit in t
im to achie
rall cost of red
porting susta
62 states and
s, accessions,
force on 16 Fe
d countries t
(the first com
echanisms to
duction proj
nerate “certif
M ?
(developed c
manner.
es (non‐Ann
ing Certificat
he form of in
ve?
ducing GHG e
inable develo
d regional eco
approvals or
ebruary 2005
o reduce the
mmitment per
o achieve the
jects that a
fied emission
countries) to
ex I or the
es of Emissio
nvestment, ac
emissions
opment initia
onomic integr
acceptances
5.
eir GHG emis
riod :2008‐20
objective of
ssist in crea
reductions (C
meet their em
host count
ons Reduction
ccess to bette
tives within d
ration organi
.
ssions ( CO2 e
012).
reducing GHG
ating sustain
CER)” for use
mission reduc
ries) in mee
ns (CER).
er technology
developing co
Pag
zations have
equivalent) a
G emissions.
nable develo
by the invest
ction commit
eting their s
y, and local s
ountries.
ge 48 of 55
deposited
t least 5%
opment in
tor.
ments in a
sustainable
sustainable
Page 49 of 55
Benefits of CDM for developing countries
• Attract foreign investment to countries engaged in the trading of CERs
• Increase the profitability of cleaner and more efficient technology in energy, industry, and transport
sectors.
• Help in waste management operations.
• Contribute to sustainable development of the host country.
Project Sustainability Screening
Establishment of Sustainable Development criteria
Should reflect economic, social, and environmental sustainability dimensions.
The assessment of SD aspect of a project will involve a set of indicators.
A transfer of finances and contribution to sustainable development in the Host Country
Host Country
Flow of Finances
Flow of Credits
Annex I Country
Page 50 of 55
The indicators should be :
Complete: adequate to indicate the degree to which the overall objective of sustainability has been
met.
Operational: can be used in a meaningful way in the analysis.
Decomposable: the decisions can be broken down into parts involving a smaller no. of indicators.
Non‐redundant: The indicators should be defined to avoid double counting of consequences.
Minimal: It is desirable to keep the set of indicators as small as possible. For instance it may be
possible to combine indicators to reduce the dimensionality of the decision problem.
Distribution of Registered CDM Projects by Host Countries
Distribution of Registered CDM Projects According to the Sectoral Scopes
Others, 16.31%Sri
Lanka, 2.13%Guatemala, 2.13%
Ecuador, 2.13%
Argentina, 2.13%
Republic of Moldova, 2.13%Panama, 2.1
3%
China, 4.26%
Chile, 4.96%
Honduras, 6.38%
Mexico, 9.22%
India, 19.86%
Brazil, 26.24%
Energy Demand, (2.96%)Fugitive emissions from fuels (solid, oil and gas), (1.18%)
Fugitive emissions from production and consumption of halocarbons and sulphur hexafluoride, (2.96%)Waste handling and disposal, (23.67%)
Chemical industries, (1.18%)
Manufacturing industries, (1.78%)
Agriculture, (10.65%)
Energy industries (renewable - / non-renewable sources), (55.62%)
Page 51 of 55
According to the Sectoral Scopes
CDM Project Requirements
Baseline study for emissions
Emissions additionality & financial additionality
Host country government approval
Meets the sustainable development criteria
Demand for CERs ‐ price of CERs
Additionality and Baseline
Additionality
GHG reduced below what would have occurred without the project activity
Baseline scenario
Representing anthropogenic emissions by sources of GHGs that would occur without the proposed
project activity Additionality and Baseline
Energy in dustries24%
Energy d d9%
Energy distribution2%
Manufacturing industries12%
Chemical industries5%
Fugitive emissions from fuels 6%
Fugit ive emiss ions from halocarbons and sulphur
hexafluorid2%
Waste handling and 25%
Afforestat ion and reforestatio
3% Agriculture
8%
Transport2%
Mining2%
Identify B
Base line/
t0
E0
EC
C
= ton of e
Examples
Impact o
Baseline Em
/CER concept
0 = starting ye
0t =Total emis
CDMt =Total em
ER = E0t – ECDM
equivalent CO
s:
f CERs price o
mission Meth
ts
ear of CDM
ssion without
mission with C
Mt
O2 reduction
on the projec
hodology
CDM project
CDM
(traded in th
cts’ IRR
t
e internationnal market: e.g., 5 $ to 25$
Pag
$/tC )
ge 52 of 55
Page 53 of 55
The substantial improvement in IRR observed in Biomass and Solid Waste management projects.
Case Study Presentation Financial Analysis of a Small Hydro Project with and without CDM Benefits
Characteristics of the proposed CDM Project
Type : Run‐of‐the river hydro project
Installed Capacity: 3.5 MW
Category : Renewable Energy project (<15 MW)
Load type : National grid
Developer : Private
Country’s Power Development Scenario
• The project is situated in a country where diesel and fuel oil based generation system supply 70% of
electricity and the remaining is supplied by hydro sources.
• In the last 5 years, all the new capacity added is based on diesel and fuel oil.
• LCGEP shows that future additions to power generation capacity will be based on fuel oil or diesel
though some exploitable hydro capacity is available.
• The baseline emission factor is the emission factor of the diesel based generation system of
appropriate capacity and load factor. (Method I)
Estimation of Base‐line CER‐Method I
Estimation of Base‐line CER‐Method II
The emission factor is the weighted average emissions (in kg CO2e/kWh) of all the generation units in the
system. The emission coefficient is calculated as sum of total emission from each of the generation units
divided by the sum of their generation in that year.
Emissions 0 t CO2/a Emissions (3)=(1)*(2) 36,506 tC/a
Efficiency 0.37Output 67 GWh/a
CER price (4) 10 US$/tC
CERs (3)*(4) 365,059 US$/a
CDM Paramters
Page 54 of 55
Identification of Additionality of the Proposed CDM Project
• GHG emissions from this project activities is lower than that in the baseline
• Proposed CDM project activities is not a baseline scenario project.
• The project activity is not expected to get implemented in the absence of the CDM due to the
investment barrier and financial analysis is used to demonstrate this:
24
Detail Cash-flow analysiswithout CDM Credit
Detail Cash-flow analysis with CDM Credit
Compute FIRR and FNPV
Compute FIRR and FNPV
Is financiallyattractive ?
Not a CDM ProjectYES
NO
Is financiallyattractive ?
Consideration for CDM Project
YESNOInfeasible project
Financial Analysis
F u e l
N e t G e n e r a t io n
( G W h )
F u e l C o n s u m e d
( 1 0 3 to n n e s ) ( A )
N e t C a lo r i f ic V a lu e ( T J /1 0 3 to n n e s ) - ( B )
C a r b o n E m is s io n *
F a c to r ( I P C C ;
tC /T J ) - ( C )
E m is s io n tC O 2 ( D ) =
( A ) x ( B ) x ( C ) x 4 4 /1 2
C o a l 7 2 5 6 3 5 0 7 7 6 1 6 .2 2 2 5 .8 7 7 9 1 1 3 0 1 L ig n i t e 1 6 3 6 8 1 1 4 5 4 1 6 .2 2 2 7 .6 1 8 8 0 1 3 2 8 G a s 1 8 8 2 6 3 7 4 3 4 3 .3 3 1 5 .3 9 1 1 6 3 7 3 H y d r o 1 6 5 8 7 0 0 N u c le a r 4 1 2 2 0 0 T o ta l 1 2 8 4 6 6 1 0 5 8 2 9 0 0 2