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Chapter 6: Economics of Energy Supply and Use

6.1 Economic Analysis

The purpose of the economic analysis of projects is to bring about a betterallocation of resources, leading to enhanced incomes for investment orconsumption. For a directly productive project, where the output is sold in arelatively competitive environment, choices are made within the economy toensure that projects selected for investment meet a minimum standard forresource generation and to weed out those projects that do not. For an indirectlyproductive project, where the output is not sold in a competitive environment,choices are made within the project between different means of achieving thesame objectives. Economic analysis is used to choose the means using the least

resources for a given output. All resource inputs and outputs have an opportunitycost through which the extent and value of project items are estimated. Projectsshould be chosen where the resources would be used most effectively.

Economic viability depends upon the sustainability of project effects. Projects aresustainable if their net benefits or positive effects endure as expected throughoutthe life of the project. Sustainability is enhanced if environmental effects areinternalized, and if financial returns provide an adequate incentive for project-related producers and consumers. Sustainable development is concerned alsowith distributional issues. When looking at the distribution of project effects and

judging project social acceptability, it is important to determine who benefits andwho pays the costs. An assessment of the capacity of the project to cope with anuncertain future is another measure.

In some cases, project preparation does not end with the decision to accept aproject. In process projects, design and appraisal are continual and go along withproject implementation. This allows for greater participation by projectbeneficiaries in the design and testing of different options. Economic analysis canbe applied at the outset of such projects to test the underlying rationale.

The procedure for undertaking economic analysis follows a sequence of

interrelated steps:i. Defining project objectives and economic rationale.ii. Forecasting effective demand for project outputs.iii. Choosing the least-cost design for meeting demand or the most cost-

effective way of attaining the project objectives.iv. Determining whether economic benefits exceed economic costs.v. Assessing whether the project's net benefits will be sustainable

throughout the life of the project.vi. Testing for risks associated with the project.vii. Identifying the distributional effects of the project, particularly on the

poor.

viii. Enumerating the non-quantifiable effects of the project that mayinfluence project design and the investment decision.


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6.2 Financial and Economic Analysis

The economic analysis of projects is similar in form to financial analysis: both

appraise the profit of an investment. But, a traditional financial analysis examinesa project from the narrow perspective of the entity undertaking the project. Itdoes not take account of effects on other enterprises or individuals. Projects mayinvolve asset construction, purchase, lease or sale and may be financed in awide variety of ways - grants, borrowings, revenues, supplier finance or acombination of these. The concept of financial profit is not the same as economicprofit. The financial analysis of a project estimates the profit accruing to theproject-operating entity or to the project participants, whereas economic analysismeasures the effect of the project on the national economy. For a project to beeconomically viable, it must be financially sustainable, as well as economicallyefficient. If a project is not financially sustainable, economic benefits will not be

realized. Financial analysis and economic analysis are therefore two sides of thesame coin and complementary.

Both types of analysis are conducted in monetary terms, the major differencelying in the definition of costs and benefits. In financial analysis all expendituresincurred under the project and revenues resulting from it are taken into account.

This form of analysis is necessary to assess the degree to which a project willgenerate revenues sufficient to meet its financial obligations, assess theincentives for producers, and ensure demand or output forecasts on which theeconomic analysis is based are consistent with financial charges or availablebudget resources.

Economic analysis attempts to assess the overall impact of a project onimproving the economic welfare of the citizens of the country concerned. Itassesses a project in the context of the national economy, rather than for theproject participants or the project entity that implements the project. Economicanalysis differs from financial analysis in terms of both (i) the breadth of theidentification and evaluation of inputs and outputs, and (ii) the measure ofbenefits and costs. Economic analysis includes all members of society, andmeasures the project's positive and negative impacts in terms of willingness topay for units of increased consumption, and to accept compensation for foregone

units of consumption. Willingness to pay and willingness to accept compensationare used rather than prices actually paid or received because many of the projectimpacts that are to be included in the economic analysis either will be non-marketed, for example, biodiversity preservation, or incompletely marketed, suchas, water supply and sanitation benefits. Thus, some form of non-market valuemust be estimated. Many project impacts that are marketed will be bought andsold in markets where prices are distorted by various government interventions,by macroeconomic policies, or by imperfect competition.

Shadow prices may be used in estimating the willingness to pay and willingnessto accept compensation values in the face of these market absences and market

imperfections. The benefits from a project constitute the extent to which the


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project contributes to increasing the value of the consumption available tosociety. Consumption can be defined broadly. Societal consumption may applyequally well to a society's willingness to pay for preservation of plant or animalspecies, as to society's willingness to pay for the consumption of agriculturalproduce or clean drinking water. Shadow prices are used to take into account the

major impacts of a project where economic values differ from financial values.

Costs reflect the degree to which consumption elsewhere in society is sacrificedby diverting the resources required by the project from other uses. The total netchanges in consumption available to the society represent the net impact of theproject. When the units of consumption are valued in terms of marginalwillingness to pay for the units of increased consumption and marginalwillingness to accept compensation for foregone units of consumption, theresulting economic net benefits from the project will reflect the summation of thechanges in the net income of the society as a whole, resulting from the situationwith the project compared with that without the project.

6.3 Identification and Quantification of Costs and Benefits

There are four basic steps to analyzing the economic viability of a project:identify the economic costs and benefits; quantify the costs and benefits, asmuch as possible; value the costs and benefits; and compare the benefits withthe costs. The first two steps can generally be undertaken together. However,there will be some types of benefits, and sometimes costs, that cannot bequantified and valued for inclusion in the cost-benefit comparison. They willsimply be stated alongside the results of the economic analysis.

To identify project costs and benefits, the situation without the project should becompared with the situation with the project. The without-project situation is notthe same as the before-project situation. The without project situation cansometimes be represented by the present levels of productivity of the relevantresources. However, present levels of productivity would frequently changewithout the project, and this should be taken into account in defining the without-project situation.

For directly productive projects, the main benefits will be in the form of productionthat is sold. It is important to determine whether a projects output is incremental

to existing supplies. If the project is small relative to the size of the market, it islikely that the project output will be fully incremental. This is the case for mostoutputs that are traded internationally.

Project benefits also include the extent of any consumer surplus. A project maylower the price of the output for all consumers. The savings to existingconsumers, because of the difference between what they are willing to pay andwhat they will now have to pay, is not reflected in the financial effects. Consumersurplus can also arise when the output price is fixed by government below thedemand price. The difference between the actual price and what consumers arewilling to pay can be estimated through a price elasticity of demand, if available.

If no direct estimate of the elasticity is available or can be estimated, then thelikely magnitude of this form of benefit should be discussed.


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While several types of cost need to be included in the economic analysis of aproject, some types of financial cost must be excluded. The underlying principleis that project costs comprise the difference in costs between the without andwith project situation, that is, the extra use of resources necessary to achieve the

corresponding benefits.

6.3.1 System Costs

If a project is part of a larger system, then the expected benefits may not accrueunless some matching investments are made. For example, power generationbenefits rely on investments in transmission and distribution. A highway sectionmay need investment in preceding sections or interchanges for the expectedtraffic flow and cost savings to occur. The project boundary must include the totalsystem investment required to achieve the benefits and, correspondingly, thetotal system benefits. If the total system of investments is viable, then the project

can also be considered viable.

6.3.2 Sunk Costs

A project may require the use of facilities already in existence. The costs of suchfacilities are sunk costs and should not be included in the project cost, providedtheir use in the project involves no opportunity cost. Put another way, sunk costsare those costs that would exist both without and with the project, and thus arenot additional costs for achieving project benefits.

Many projects will be implemented through existing enterprises or agencies. Theproject analysis must separate the additional agency costs from the whole coststructure of the enterprise. At the same time, the project may succeed only if theenterprise itself is stable. The analysis of the whole enterprise, including sunkcosts together with the project, is necessary to determine financial sustainability.

6.3.3 Contingencies

Contingency allowances, which are determined by engineering and financialconsiderations, also have implications for economic appraisal. When estimatingproject costs for financial planning purposes, both physical and price

contingencies are included. Since economic returns are measured in constantprices, general price contingencies should be excluded from the economic cost ofthe project. Physical contingencies represent the monetary value of additionalreal resources that may be required beyond the base cost to complete theproject, and should be treated as part of the economic cost of a project.

6.3.4 Working Capital

Working capital is commonly defined in financial analysis as net current assets,consisting of inventories, including goods in process; net receivables; marketablesecurities; bank balances; and cash in hand. A certain amount of working capital

is normally required to run project facilities created by investment in fixed assets.


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For purposes of economic analysis, only inventories that constitute real claims onthe nation's resources should be included in the project economic costs. Otheritems of working capital reflect loan receipts and repayment flows, and are notincluded in the economic cost.

6.3.5 Transfer Payments

Some of the items included in the financial costs of a project are not economiccosts, as they do not increase or decrease the availability of real resources to therest of the economy. These items will, however, affect the distribution of financialcosts and benefits between the project entity and other entities, and amongproject beneficiaries. They are thus referred to as transfer payments, as theytransfer command over resources from one party to another without reducing orincreasing the amount of resources available as a whole. Taxes, duties, andsubsidies are examples of items that, in some circumstances, may be consideredto be transfer payments. They can affect the income of the government, and that

of the payer and the recipient simultaneously and in opposite and identicalamounts, thus canceling out in an economic analysis summation. However, thereare circumstances when tax and subsidy elements should be included in theprice of an input or output. The economic cost of an input should include the tax(subsidy) element, if the demand is non-incremental. If the government iscorrecting for an externality by applying a tax or a subsidy to reduce or toincrease production, for example, where a tax is levied on project output that isequivalent to the costs of waste processing undertaken by a government agency,the economic cost of the input should also include the tax element. Finally, theeconomic value of incremental outputs will include any tax element imposed onthe output, which is included in the market price at which it sells.

6.3.6 Depreciation

The financial accounts of agencies implementing a project will include provisionfor depreciation and amortization on the basis of prevailing accounting practice.However, for project economic analysis, the stream of real investment required torealize and maintain project benefits is included in the resource flow, togetherwith a residual value for these assets at the time they are released from projectuse at the end of the projects life. The stream of investment assets includesinitial investment and replacements during the projects life. This stream of

expenditures generally will not coincide exactly with the time profile ofdepreciation and amortization in the financial accounts.

6.3.7 Depletion Premium

Many projects involve the exploitation of a nonrenewable natural resource, suchas oil, natural gas, or mineral deposits. The economic cost of using these naturalresources must be included in the economic analysis. Because they cannot bereplenished, and when depleted must be replaced by imports or domesticsubstitutes, the opportunity cost of the resource includes the cost of thesubstitutes when the resource is exhausted. The depletion premium or allowance

depends on this economic price and the proportion of the total reserves exploitedduring each year. It is added to the economic cost of exploitation to arrive at the


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full economic cost of using the nonrenewable resource. If the resource will not beexploited to exhaustion, the salvage value of the land at the end of the projectmust include the economic value of any remaining un-depleted reserves.

6.3.8 External Costs

In many projects, effects will go beyond the financial analysis from the point ofview of the implementing agency. These external effects may include significantcosts that must be accounted for in an economic analysis from the nationalperspective. For example, increased air and water pollution from an industrialplant may be measured and its effects on surrounding entities estimated. In somecases, it may be helpful to internalize these external costs by including allrelevant effects and investments in the project statement, including, in this case,pollution control equipment costs and effects.

6.4 The Economic Valuation Techniques

The basic feature of economic valuation is a systematic examination of all theadvantages and disadvantages of each practicable alternative way of achievingan objective such as solving a problem or overcoming a deficiency. This iseconomic appraisal's main strength.

While the techniques have been developed mainly in the context of investmentdecisions, the principles apply to any specific proposal for the use of resources orfor spending or saving money. Economic appraisal sets the framework forthinking rationally about the use of resources through a systematic approach tocapital expenditure and asset management decisions. The techniques ofeconomic appraisal are also applicable to decisions with regard to the disposal ofassets, the design or provision of standards or the assessment of plans (e.g.security of supply of services, environmental standards or Land and WaterManagement Plans).

A range of recognised economic appraisal techniques exist. The majordistinction between these techniques is the extent to which benefits arequantified.

6.4.1 Cost Benefit Analysis

Cost Benefit Analysis (CBA) is the most comprehensive of the economicappraisal techniques. It quantifies in money terms all the major costs andbenefits. CBA can be applied to most, if not all, public agencies that cover costswith revenue and to agencies, which do not fully cover costs by revenue butwhich produce traded outputs. The technique is also applicable in varyingdegrees to social infrastructure such as schools, hospitals and public housing.

The key strength of CBA is that it considers on a consistent basis the benefitsand costs of alternatives. Thus the outcomes for a range of options aretranslated into comparable terms which facilitate evaluation and decision making.

Against this CBA does not by itself provide direct consideration of the distribution


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of benefits and costs and can require considerable data for satisfactoryimplementation. Further, the concentration on valuation of impacts cansometimes lead to the overlooking of impacts, which cannot be valuedquantitatively, although CBA does allow for the incorporation of such impacts.Overall, CBA is most easily applied to public sector agencies producing outputs

that generate revenue (for example water supply and electricity) or else wherethe major benefits can be quantified fairly readily (for example roads).

6.4.2 Cost Effectiveness Analysis

Where the output of a project is not readily measurable in monetary terms (usingeither actual or proxy values) such as in certain areas of health, education orsocial welfare, it may not be possible to apply CBA.

An alternative approach is available, that of Cost Effectiveness Analysis (CEA).This type of appraisal compares the costs of different initial project options with

the same or similar outputs. CEA is applicable to a wide range of public sectoragencies with strong community or social welfare objectives. For example, in thehealth sector, CEA could be used to assess the relative merits of alternativetreatments for severe kidney problems in terms of relative cost for givenincreases in life expectancy. Of course the quality of this additional lifeexpectancy would need to be considered in qualitative terms.

It should be noted that CEA cannot be used directly to compare projects withdifferent objectives. Nevertheless, the fact that the costs and benefits are allidentified will allow more informed subjective decisions to be made. It should alsobe noted that while some benefits may be difficult to assess in monetary terms,the technique still requires the valuation of as many benefits of the project aspossible.

Careful identification and analysis of all the benefits and costs remains a keyelement of CEA. The temptation to list the benefit of a project as "improvedservice provision" (or something similar) should be resisted. In all cases somebetter indicator of the benefits will be available.

6.5 Steps in Preparing a Full Economic Evaluation

The following discussion outlines the steps, which must be followed whenpreparing a standard economic evaluation. These steps are useful for projectplanners, evaluators, developers in performing economic assessments. In otherwords, to perform economic cost-benefit analysis of energy production andenergy efficiency projects these steps would be useful.

6.5.1 Define Objectives

Every proposal to spend money must have an underlying objective. Theimportance of specifying objectives when considering investment proposalscannot be over-stated. The worth of an investment can only be evaluated in

terms of its objective(s). This objective should be related to the performance of a


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particular function, be clearly and unambiguously stated and be compatible withthe broader Department, group or corporate objectives.

In certain circumstances, the achievement of an objective is essential (forexample, meeting the statutory requirement to provide education services). This

does not necessarily imply that expenditures to achieve essential objectives willbe without choice, as various alternative methods of meeting the objectives areusually available. It may also be possible to vary the level or quality of serviceprovided.

6.5.2 Identify Options

It is necessary to identify the widest possible range of realistic options at theearliest possible stage of the planning process. In developing alternativesolutions, the first option to be considered is the base case of "do nothing", i.e.,retain the status quo. This is not to say the base case will not involve costs; in

many cases doing nothing (for example, continuing with a low maintenanceprogram) will result in cost penalties. One of the benefits of "doing something"may be the avoidance of these costs.

Options might include refurbishing existing facilities, variations in staging aninvestment (demand and population growth forecasts should be reviewed),demand management or maintenance by the private sector. Appraisals shouldreport on all feasible options and clearly explain cases where potential optionsmay not have been evaluated.

6.5.3 Identify Benefits

There are five separate types of benefits, which may be relevant:

i. Avoided costs - incremental costs which are unavoidable if nothing is doneto solve a particular problem, but may be avoided if action is taken.

ii. Savings - verifiable reductions in existing levels of expenditure if aprogram proceeds. Where manpower savings are claimed, the clearidentification of the areas of such savings and costs saved is necessary sothat any post audit review can judge whether they have actually been

achieved.

iii. Revenues - incremental revenues which result directly or indirectly from aparticular program. Revenue changes which would have occurredregardless of the program must not be included.

iv. Benefits to consumers not reflected in revenue flows. For a variety ofreasons, such as the nature of the service provided or equityconsiderations in pricing policies, the user of a service may not be chargeda price which reflects the benefits received (for example, recreational useof national parks). While it may prove difficult, attempts should be made to

quantify such benefits wherever possible. If quantification proves


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impossible, as much detail of the benefits as possible should be includedin the report.

v. Benefits to the broader community. Benefits of services such as policeservices flow to the community as a whole rather than to individual

consumers. Alternatively, an activity may have secondary or subsidiaryeffects on groups or industries other than the direct recipient (for example,urban public transport can reduce pollution levels). Commonly the pricewill not reflect the benefits received and hence alternative means ofvaluing the benefits must be developed.

6.5.4 Identify Costs

All economic evaluations should be based on incremental costs and benefitsassociated with a particular program. All relevant cost items which can beidentified, quantified or estimated must be included. The stream of costs should

cover the full project period which will be based on the economic life of thebuilding or equipment. Assumptions underlying all estimates should be madeexplicit in the evaluation.

6.5.5 Identify Qualitative Factors

Documentation of the economic evaluation should also include other relevantinformation which can affect the recommendation/decision. The costs andbenefits which can be quantified are only part of an economic evaluation. Otheraspects, such as environmental considerations, industrial relations, social orregional impact, safety, public relations, resource availability, etc, will also haveto be taken into account in choosing between competing options. In every casethese qualitative factors should be identified and where possible given asubjective weighting.

6.5.6 Assess Net Benefits

Once all costs and benefits over the life of the program have been identified andquantified, they are expressed in present value terms in CBA. For CEA a presentvalue is only provided for costs. In doing these: costs and benefits should bevalued in real terms: that is they should be expressed in constant rupees and

increases in prices due to the general rate of inflation should not be included inthe values placed on future benefits and costs. The stream of costs and benefits(expressed in real terms) should be discounted by a real discount rate.

Using the discounted stream of costs and benefits, the following decisionmeasures should be calculated: net present value (NPV); net present value perrupee of capital outlay (NPVI); benefit-cost ratio (BCR); internal rate of return(IRR).


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6.6 Specific Issues

6.6.1 Avoidance of Double Counting or Overstating of Benefits

In enumerating the costs and benefits of a proposal, care should be taken toavoid double counting. The danger of double counting is particularly great wherean effect of the project, be it beneficial or otherwise, is incorporated insubsequent valuations of assets or prices.

For example, the construction of a dam may increase the value of the land, whichis to be irrigated as a result of the increased ability of the land to grow crops.

The increased value of the land merely reflects the market's capitalisation of theincreased output stream. Inclusion of both the net value of the increased outputand the increased land value would count the same benefit twice.

Another danger is the overstatement of benefits by attributing the total output of aprocess to a single input. Where infrastructure is provided which enables theexpansion of an industry the gross output of that industry should not be attributedto the provision of the infrastructure. Account has to be taken of the otherresources used in production in the "downstream" industry.

In the example above, the total value of the crops made available by the waterirrigation project should not be attributed to the project. Rather the net value ofthe additional production should be derived by deducting all additional input costsfrom the value of the additional output; i.e., the costs of labour, capital and otherinputs such as fertiliser and fuel should be deducted from the value of the output.Measured in this way the value of net output, subject to provision for a "normal"profit, provides a measure of the "willingness-to-pay" for water. Hence, theinclusion of this benefit would also require adjustment for actual payments madefor the water provided.

6.6.2 Treatment of Inflation

Due to inflation, costs and benefits, which occur later will be higher in cash termsthan similar costs or benefits which occur earlier. There are two different ways totackle this issue. Either nominal values can be used for each time period and

then discounted with a nominal discount rate, or real cash flows can be useddiscounted by a real discount rate. There is no inherent reason to choose onerather than the other as both will provide the same answer, but the importantfactor is that real and nominal cash flows and discount rates must never bemixed in the one evaluation. Where cash flows are in real or un-escalated terms,only the real discount rate should be used and where nominal or escalated cashflows are used the nominal discount rate must be used.

In practice, however, there are strong merits in adopting a uniform basis ofanalysis and it is considered that the use of real cash flows and discount ratesmay simplify the forecasting and calculation processes. Hence, analysis should

use costs and benefits valued in real terms and discounted by a real discount


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rate. The base date for the calculations should be the same as that used for anyaccompanying financial analysis.

6.6.3 Timing of Cash Flows

The conventional approach to preparing cash flows is to set the initial cashoutflow at year zero and centre all future inflows and outflows at 12-monthlyintervals from that date. This regular 12-monthly "gap" simplifies the discountingof future cash flows to their present values. The reality is that cash flows will notbe evenly spaced with a 12-monthly gap nor can they necessarily be centred at12-month intervals without some distortion to their true pattern. However, theabove approach to the cash flow timing problem will not introduce unacceptabledistortions for programs, which are long term (five years or longer).

Where within year variations in timing will make a significant difference in theevaluation, it is suggested that a two stage discounting procedure be followed.

Initially within year cash flows are discounted to the same month in each year(the month in year zero that the project is deemed to commence). The annualcash flows can then be discounted back to the base year in the normal way.

6.6.4 Use of Shadow Prices

As noted above, the general principle is that where market prices are available,they should provide the basis for the measurement of the opportunity cost ofinputs or the willingness to pay for outputs. However, in some cases such pricesmay contain distortions which require the use of shadow prices. (The term isalso sometimes used in relation to outputs for which no prices are charged butthe discussion in this section excludes this usage).

It is generally considered that the problems of measurement of shadow pricesmay often be substantial and the size of the impact on the analysis comparativelysmall. Hence, this level of sophistication in the analysis will not generally bewarranted as it will introduce unnecessary controversy.

Where a successful case has been made for the use of shadow prices in aparticular area, it is intended that the accepted prices be distributed to otherpublic sector agencies so as to standardise the use of prices wherever possible.

6.7 Discounting of Future Costs and Benefits

6.7.1 The Concept of Discounting

The costs and benefits flowing from an investment decision are spread over time.Initial investment costs are borne up front while benefits or operating costs mayextend far into the future. Even in the absence of inflation, a rupee received nowis worth more than a rupee received at some time in the future. Conversely, arupee's cost incurred now is more onerous than a rupee's cost accruing at somefuture time. This reflects the concept of time preference which can be seen in

the fact that people normally prefer to receive cash sooner rather than later and


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pay bills later rather than sooner. The existence of real interest rates reflects thistime preference.

In order to compare the costs and benefits flowing from a project it is necessaryto bring them back to a common time dimension. This is done by discounting the

value of future costs and benefits in order to determine their present value. Theprocess of discounting is simply compound interest worked backwards.

6.7.2 The Recommended Discount Rate

Private sector entities sometimes require that the rate of return on a particularproject exceeds the return expected on an alternative project which mightotherwise be undertaken. Or they might stipulate a return somewhat in excess ofthe cost of borrowed funds. Public sector decision-makers will be encouraged toinvest in projects, which generate returns greater than the government's testdiscount rates. Three alternative bases for the setting of the discount rate have

been proposed: social time preference; opportunity cost of capital; and cost offunds.

The first two concepts of the discount rate relate to the opportunity cost of theresources used in the public sector investment projects. Resources could beused elsewhere and the discount rate attempts to measure such opportunitiesforegone. In principle the social time preference rate and the opportunity cost ofcapital should be the same. However, for various reasons such as private sectorprofit and capital constraints in the public sector, the two will differ. Typically theopportunity cost of capital will be greater than the social time preference rate.

Resources devoted to public investment will be at the expense of currentconsumption or private sector investment. In a growing economy with risingliving standards, a rupee's consumption today will be more valued than a rupee'sconsumption at some future time for, in the latter case, the rupee will besubtracted from a higher income level. This so-called marginal social rate of timepreference is, of course, not easy to measure.

If alternatively, public investment takes place at the expense of privateinvestment then, from an economic efficiency viewpoint, public investments of aneconomic nature should not be sanctioned if they are expected to earn

significantly lower rates of return than those same resources might earn (beforetax) in the private sector (the so-called marginal social opportunity cost).

This concept is also difficult to measure accurately. The concern is not with theaverage rate of return in the private sector, but with the marginal rate - that iswith the rate which would be earned by the private sector if additional capitalallowed further private investment to occur. In theory a perfectly competitivecapital market will see equality of the consumer's marginal rate of timepreference, the investor's rate of return on the marginal project and the marketrate of interest. In practice interest rates provide limited guidance to theestimation of discount rates on these bases.


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In the face of the difficulty of measuring discount rates on these bases, it hassometimes been argued that the appropriate rate of return or discount rateshould be derived from the interest rate at which government borrows funds inthe market. But given the dominant position of government in the capital market,the variability of interest rates and the wide range of factors which impact on

interest rates this is quite an inadequate way of deriving the appropriate discountrate.

6.7.3 Impact of Discount Rates on Project Ranking

It should be noted that the choice of the discount rate is an important issue as itcan have a significant impact on the ranking of options/projects and hence theirchoice. In general, as the discount rate rises projects with larger initial outlaysand lower ongoing outlays become relatively less attractive compared withprojects with lower initial outlays and higher ongoing outlays. Thus, a higherdiscount rate would favour maintenance options as against asset replacement.

Similarly in the case when net benefits are spread far into the future, the higherthe discount rate, the more net benefits far in the future are downgraded inpresent value terms relative to net benefits closer to hand. Thus, short livedoptions are favoured by higher discount rates relative to long-lived options.

It is also sometimes argued that the discount rate should be made dependent onthe degree of risk associated with the project: high risk projects would beallocated high discount rates and low risk projects low discount rates. Thisargument presupposes that risk increases over time. This is clearly notnecessarily the case - the risk may be introduced by an event due to occur in thenear future or may be the same throughout the life of the project. Adjustments tothe discount rate should therefore not be made because of the risk associatedwith the project.

6.8 Investment Decision Making

It is possible to calculate key statistics and develop decision criteria based onthem. Such statistics will only take account of benefits and costs on which avalue has been placed and can only therefore provide part of the picture to thedecision maker. The un-quantified effects will also need to be considered. While

this chapter discusses various decision criteria, the importance of the un-quantified benefits and costs must not be forgotten.

Investment decision-making is primarily concerned with three types of processes:

1. The screening process, whereby the decision-maker, faced with a range ofindependent projects and adequate resources, must accept or reject theindividual projects.

2. The choice process between mutually exclusive projects, whereby thedecision-maker must choose from a range of mutually exclusive projects

(commonly directed at similar objectives).


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3. The ranking process, whereby the decision-maker is faced with resourceconstraints which prevent all acceptable projects from being proceededwith - hence the projects must be ranked in an objective manner.

Various investment criteria are available to assist in reaching decisions in each of

these circumstances. Commonly used criteria are the Net Present Value (NPV);Internal Rate of Return (IRR), Benefit-Cost Ratio (BCR) and Net Present Valueper constrained unit of input (NPV/I).

6.9 Energy Economics

The primary goal of energy management is to maximise cost- effectiveness for afirm/utility or for a consumer. This depends mainly on the type and timing ofcapital investment. Energy economics focuses attention on the evaluation ofcapital investment alternatives by analysing the amount and timing of eachproject's cash flows and expenditure. Central to this analysis is the concept of

"Time value of money" and the techniques based upon it, viz., payback period,net present value, internal rate of return, life-cycle cost, profitability ratio, etc.

Time value of money

For deciding whether to accept or reject a proposal or invest in energy efficientdevice or not, one thing that everyone should keep in mind is the time value ofmoney. Because, the amount of money one invests now will be worth more after"n" years when we accumulate the principal and interest. To compare aninvestment in the present to the benefits in the future, an index called "discount

rate" is being used.

Discount rate

To compare an investment in the present to benefits in the future, an index isneeded to characterise the time value of money. The most common index is thediscount rate "d" which can be interpreted as

Rs 1 now =(1+d) Rs after 1 year

The discount rate takes the form of an interest rate expressed as a fraction and

not as a percentage. The nominal discount rate depends on the inflation rateand the real discount rate accounts for inflation.

(1+d') =(1+i') (1+d)

where

i' = rate of inflation (fraction)d' = real discount rate.

If i


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ex: bank interest rate = 18%, rate of inflation = 9%, the discount rate is

(1.18/1.09)-1 = 0.102

Nominal and real discount rates

The nominal discount rate depends on inflation and the real discount rate is theone which is adjusted for inflation.

(1+i1) = (1+d) (1+i)

where

d = inflation ratei1

Nominal and effective interest rate

= real discount rate

If the bank interest rate is 12% and the inflation rate is 7%, then the discount rateis

(1.12/1.07) -1 =0.047 or 4.7%

Because, the formula for compounding is usually based on an interest period ofone year, this annual interest rate of compounding is called the nominal rate of

interest. If it is less than an year, then the effective interest rate will be greaterthan the nominal one due to more frequent compounding.

ie = (1+i/m)m

Implicit discount rate:

- 1 where m = no. of interest payments.

A discount rate can be calculated from the decisions of the individuals andinstitutions among alternatives that have costs and benefits vary and spread overtime. This is called "implicit discount rate".

A discount rate can be calculated from how people or countries or institutionscould make investments among alternatives that have costs and benefits spreadover time. This is called "implicit rate". For example, there are two appliances,one with high initial cost and low operating cost and the other vise versa. Theconsumer may favour latter because it has a low initial cost because theoperating costs are not generally recognised.

An "economically rational discount rate" can be calculated depending on thealternative investment or the availability of loans. Implicit discount rates aredifferent and usually higher than the corresponding rational values. The reasonsare: (i) the consumer may be ignorant about the operating costs of the device (ii)the initial cost is low and the consumer generally prefers it. In the case of energyconservation investments, the implicit discount rates are very high because the


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operating costs of are not well recognised, for ex: refrigerators or the consumersare uncertain about the savings.

Generally for policy making, rational discount rates are being used.

Present Value analysis:

F =P (1+i)n

where

F = future value of the investment,P = present valuei = annual interest raten = no.of interest periods

If the future value of an investment is known, (if we want to know how muchmoney to invest now at 10% interest rate in order to receive certain amount infuture) then we can derive its present value by the following equation.

P =F/(1+i) n.

where

P = present value of moneyn = no. of years

d = interest rateF = future value of money after n years

If there is an annual flow during "A" during n years, then the PV of this flow wouldbe to add all the PVs of the amounts for each future year and the total PV couldbe given by

P = A/(1+i) n

This is a geometric series and the sum is

P =A [(1+i) n -1]------------------

[i(1+i) n]

The factor in the bracket is called "uniform present worth factor" and its reciprocalis called "capital recovery factor (CRF)".

CRF = [i(1+i) n]------------[(1+i) n - 1]


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A =P * CRF

CRF represents the annualised value during n years equivalent to a quantity P atpresent for a given discount rate.

To evaluate two alternatives, which of them is more economical, the choice maybe made on the basis of the lowest cost. For example, there are two devices.

Device1 Device 2Initial cost (Rs.) 9,000 10,000Operating cost (Rs./year) 1,500 1,000Useful life (years) 5 5Interest rate (%) 10 10

Using the present worth factor, the operating costs of each device are discountedto their PV and added to the initial cost.

PV of cost of device 1 is 14,686 and that of device 2 is 13,791.

Net present value (NPV)

The NPV method requires that all cash flows be discounted to the PV using thefirms required rate of return.

The advantage of NPV is that it takes into account the time value of money andregardless of the pattern of cash flows a single NPV is calculated.

When the cost of project is spread over number of years, the NPV of investmentis:

NPV = (At/(1+d)t) - IC

where

At = Cash flow for period t

IC = initial cost of the project

When the cost of project is spread over a number of years, the NPV ofinvestment is:

NPV = (At/(1+d)t) - - IC/(1+d)t

Pay-back period

)

Many times the HH/industry is concerned with the number of years to recover aninvestment if an efficient device/appliance is purchased. The payback periodconcept is used to evaluate the feasibility of such an investment. The PP is the

time taken to recover the investment in terms of energy savings. Generally,there are two types of payback periods.


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Simple payback period

Suppose there are two devices: one efficient and expensive and the other not somuch efficient but less costly. To compare the benefits and costs for these twoalternatives we consider many indices:

SPP is the ratio between the additional investment and the energy cost savings.It is simply the time taken to recover the investment in terms of energy savings.

(Ie - Ic)SPP = ---------

pe

Discounted payback period:

(E)

Suppose there are two refrigerators one costing Rs 12,000 but consumes 600kWh/year. A second one costs Rs 10,000 and consumes 500 kWh/year. If thelife time of both the devices are 25 years, and the price of electricity is Rs

2.00/kWh, then, what is the SPP.

12,000 - 10,000SPP = --------------------- = 1.6 years

2.00 (600-500)

In the SPP, the time value of money is not considered. In the DPP, we considerthe time also.

DPP = n * CRF (d,n) * SPP

The DPP for the above example is (assuming a real discount rate of 0.10 peryear):

DPP = 25 * CRF (0.10,25) * 12,000 - 10,000------------------------2.00 (600 - 500)

The CRF (from the tables is 0.110)

DPP = 25 * 0.110 * 1.60 = 4.4 years

Internal Rate of Return (IRR)

IRR is a very useful tool in evaluating either a capital project or an investment.Its major advantage is that it expresses profitability of an investment inpercentage terms. The IRR for an investment is the rate of return (i.e., theinterest rate) that makes the present value of the cash flows equal to the cost ofthe investment. In other words, it is that value of the discount rate for which twoinvestment alternatives have same PV.


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Let

Cc = Capital cost of the conventional device

Ce = Capital cost of the efficient device

Ec = energy consumption through the conventional device

Ee = energy consumption through the efficient device

Cc + p * Ec (1/1+i)k = Ce + p * Ee (1/1+i)

k

or

Cc + Ce = p * (Ec - Ee) * (1/1+i)k

i.e., the difference in investment = PV of the savings in energy

From the earlier equation, we know that

CRF (i.n) is the reciprocal of (1+i)k

Ce - Cc * CRF (i.n) = p (Ec - Ee)

or

p (Ec - Ee)CRF (i, n) = --------------

Ce - Cc

Where i is the IRR for the extra investment in energy efficiency. This is anon-linear equation and can be solved by iteration. Other wise, we can use thetable of discount rates with different i and n.

For the refrigerator example,

2.00 (600 - 500)CRF (i,25) = ------------------------ =0.10

12,000 - 10,000

For larger values of n, the CRF is i. If we look at the definition of CRF, then

i (1+i)nCRF = ---------

(1+i)n - 1

If n is very large, then, (1+i)n

- 1 (1+i)n


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CRF = i

Cost of saved energy (CSE)

The cost of saved energy is a measure of developed especially for the energy

conservation investments. The cost effectiveness of the investment is expressedas the ratio of the cost of the equipment to a unit of energy saved.

CSE = CRF (i,n) * (Ce - Cc)/(Ec - Ee

Life Cycle cost

)

In the refrigerator example, we have

CSE =CRF (0.10, 25) = (12,000 - 10,000)/(600 - 500) = 0.20/kWh

Here, the conservation measure is cost effective because the price of electricityis Rs 2.00/kWh and the cost of saved energy is Rs 0.20/kWh. As in the case ofIRR, the cost of saved energy gives a direct indication of whether a conservationis cost- effective or not.

LCC is the PV of all costs (capital, interest on loan, O & M costs) associated withan investment over its life-time.

LCC =IC + (En * Pn)/(1+d)n

where

IC = initial cost of the projectEn = Energy use (kWh/year)Pn

6.10 Life Cycle Costing Approach

= Price (Rs/kWh)N = Expected life time of the investment (years)

Annualised LCC is the equal payment (in discounted PV) that would be requiredeach year to fully pay the LCC associated with an investment over its life time. Itis also referred to as levelised cost and is calcuated as the product of LCC andCRF.

ALCC =LCC * CRF (d,n)

LCC and ALCC are useful in making comparisions between different newinvestments options. If ALCC for an investment is less than the operating cost, itwould make economic sense to replace the existing std.one with efficient one.

The determination of costs is an integral part of the project evaluation processand is a common element in economic evaluation, financial evaluation, value


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management, risk management and demand management. In the past,comparisons of project alternatives, whether at the concept or detailed designlevel, have been based mainly on initial capital costs. Growing pressure toachieve better outcomes from projects means that ongoing operating andmaintenance costs must be considered as they consume more resources over

the projects service life. Both the capital and the ongoing operating andmaintenance costs must be considered wherever project management decisionsinvolving costs are made. This is the Life Cycle Cost approach. Life CycleCosting is a process to determine the sum of all the costs associated with anasset or part thereof, including acquisition, installation, operation, maintenance,refurbishment and disposal costs. In other words, it is an economic method ofproject evaluation in which all costs arising from owning, operating, maintainingand ultimately disposing of a project are considered to be potentially important tothat decision.

The Life Cycle Cost (LCC) of an asset is defined as: "the total cost throughout

its life including planning, design, acquisition and support costs and any othercosts directly attributable to owning or using the asset". Life Cycle Costing addsall the costs of alternatives over their life period and enables an evaluation on acommon basis for the period of interest (usually using discounted costs). Thisenables decisions on acquisition, maintenance, refurbishment or disposal to bemade in the light of full cost implications.

6.10.1 Life Cycle Cost Planning

Life Cycle Cost Planning concerns the assessment and comparison ofoptions/alternatives during the design/acquisition phase. It utilises similartechniques as those for Economic Evaluation in that future, nominal costs arediscounted to today's rupees discounted cost. The application of discounted costanalyses to Life Cycle Cost Planning differs from that in Economic Evaluation inthat Life Cycle Cost Planning generally:

Considers all cost components within asset options over the assets life

Does not directly consider benefits or revenue streams that are generallyassumed to be equal amongst the options being compared (benefits andrevenues are considered in the evaluation of options).

6.10.2 Discounting Future Amounts to Present Value

Project related costs occurring at different points in time must be discounted totheir present value (PV) as of the base date before they can be combined into anLCC estimate for that project. The discount rate used to discount future cashflows to PV is based on the investors time-value of money. In the private sector,the investors discount rate is generally determined by his minimum acceptablerate of return for investments of equivalent risk and duration. Since differentinvestors have different investment opportunities, the appropriate discount ratecan vary significantly from investor to investor.


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6.10.3 Interest, Discounting and Present Value

When we choose among potential project investments, we are sensitive to thetiming of the cash flows generated by those investments. We generally prefer arupee to be received (or saved) earlier than later. For example, we would prefer

the annual yield schedule of {Rs.200, Rs.200, Rs.200, Rs.200} to the annualyields schedule of {0, 0, 0, Rs.800}, even though they both have the same totalcash amount. An investor prefers cash receipts earlier rather than later for twoprimary reasons: rupees generally loose purchasing power over time due toinflation, and cash amounts received earlier can be reinvested earlier, therebyearning additional returns.

Some of the discounting preliminaries are as follows:

Future value (FV) of an investment made in base year (0th year) at a discountrate d after t years is given by

FV = P t = P0 (1+d)t

Conversely, the present value of a future amount received at the end of t yearsis given by

PV = P0 = P t/(1+d)t

6.10.4 Discount Formulas and Discount Factors

The discount rate is a special type of interest rate, which makes the investorindifferent between cash amounts received at different points in time. That is, the

investor would just as soon have one amount received earlier as the otheramount received later (adjusted by discount rate). The mathematics ofdiscounting is identical to the mathematics of compound interest.

The discounting operations can be divided into two types:

i. A method for discounting one-time amounts to present value. Thedefinition of one-time amounts includes costs occurring at irregular or non-annual intervals. Examples of one-time costs are a capital replacement at

the end of year 8, overhauling requirements at five-year intervals, and aresidual value at the end of the study period.

ii. A method for discounting a series of annually recurring amounts to apresent value. Examples of annually recurring costs are routinemaintenance costs occurring each year over the project life in the sameamount (uniform amounts) and annual energy costs based on the samelevel of energy consumption from year to year but increasing from year toyear at some known or estimated escalation rate (non-uniform amounts).


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Following paragraphs deals with some of the common discounting formulas usedin project evaluation. Each of the discount formulas shown below includes afuture amount or an annually recurring amount, and a sub-formula, which can beused to compute a corresponding discount factor

Single Present Value (SPV) factor

. The computed discount factoris a scalar number by which an amount is multiplied to get its present value. The

following two discount factors are the most often used in project evaluation usingLCC analyses

Uniform Present Value (UPV) factor

6.10.5 PV formula for one-time amounts

The Single Present Value (SPV) factor is used to calculate the preset value, PV,

of a future cash amount occurring at the end of year t, F t, given a discount rate,d.

PV = Ft * 1/(1+d)t

In spreadsheet software, this formula is depicted as PV (FV=F t, d, t)

PV formula for annually recurring uniform amounts

The Uniform Present Value (UPV) factor is used to calculate the PV of a series ofequal cash amounts, A0, that recur annually over a period of n years, given d.

n

PV = A0 * 1(1+d)t = A0 * (1+d)n 1t=1 d(1+d)n

In spreadsheet software, this is depicted as PV (An

6.10.6 Life Cycle Costing

Ann, d, n)

The Present Value (PV) of the costs incurred throughout the project life areestimated with respect to a reference year (say year of Commissioning) withfollowing steps

PV of Investment

Annual investments (Kg) made during the construction or gestation period (g) arefuture valued to the commissioning year using discount rate of d.

G


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PV(I) = PV(FV=Kg, d, g) = Kg* (1+d)

PV of Other Capital Costs (after commissioning)

g

g=1

Capital costs (Ku) incurred after the commencement of the project are discountedto the commissioning year.

L

PV(Ku) = Kun / (1+d)

PV of Replacement Cost

n

n=1

Some of the equipments associated with the project will be of shorter lifecompared to the project life. They need to be replaced periodically. The presentvalue of the cost of replacements (KR) is estimated as follows.

NR

PV(KRAnn, deff, NR) = KR* 1/(1+ deff)NR

NR=1

Where, deff= (1+d)Le 1 = Effective discount rate

NR = (L/Le) 1L = Life of the ProjectLe

PV of Operation & Maintenance Cost

= Life of the Replacement Device

Present value of annual operations and maintenance costs are given by

L

PV(O&MAnn, d, n) = O&MAnnn/(1+ d)

PV of Fuel Cost

n

n=1

If the O&M costs are constant, then

PV(O&MAnn, d, n) = PV(1Ann, d, L) *O&Mann

Present value of annual fuel cost for a given level of capacity utilization areestimated as follows


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L

PV(FAnn, d, n) = FAnnn/(1+ d)

Life Cycle Cost (LCC)

n

n=1

If the Fuel costs are constant, then

PV(FAnn, d, n) = PV(1Ann, d, L) *Fann

All the above present value of different cost components is summed up to obtainthe life cycle cost of installing and operating the project. The cost of disposal alsocan be included depending on the type of projects and the needs of decisionmaking.

LCC = PV (I) + PV(Ku) + PV(KR

Annualized Life Cycle Cost (ALCC)

) + PV(O&M) + PV(F)

The annual cost of installing and operating a project is given by

ALCC = LCC / PV(1Ann, d, L)

6.10.7 Unit Cost of Output (UCOO) Rs./unit

UCOO = ALCC / Annual Production

For example, if the project is related to energy, then Unit Cost of Energy (UCOE)in Rs./kWh can be estimated as

UCOO = ALCC / Annual Energy Generation.

The UCOEs of different energy projects (e.g., coal thermal, hydro, nuclear, wind,biomass, etc.) can be used to select the best alternatives.

6.10.8 Estimating Environmental Costs using LCC

The environmental impacts of a given project can be estimated (in monetaryterms) by using incremental cost concept. For example, if we take carbonemissions as the possible environmental impact of power generation projects,then the objective could be how to reduce carbon emissions by choosingappropriate technology/alternative. The method is to pair-wise compare thecarbon abatement cost of competing technologies.

The carbon abatement cost of a particular technology/alternative to save a tonneof carbon is determined as follows -

Cost Rs./tC = Incremental ALCC of a technology in (Rs./kWh or GJ ) * 1000


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Incremental carbon abatement in kg/kWh or GJ

Incremental ALCC of a technology = [ALCC of a technology (Rs./kWh or GJ )] [ALCC of (Rs./kWh or GJ ) a competingtechnology (Rs./kWh or GJ )]

Incremental carbon Abatement = [Emission from a competing technology inkg/kWh or (kg/kWh or GJ ) GJ ] [Emission froma technology in kg/kWh or GJ ]

These unit carbon abatement costs can be compared to select the besttechnologies in terms of reducing carbon emission impacts. Similarly otherenvironmental implications can be evaluated using incremental cost concepts.

6.10.9 Life-cycle costing: Examples

The life cycle cost of an investment is the PV of all expenses related to a givenalternative during the entire life of investment. Its LCC is:

Ec * PeLCC = I + --------------

CRF (i,n)

where

I = Initial cost of the device

Ec = Energy consumption through I

P = price of energy

For the refrigerator example

Ieff= Rs 12,000

Istd = Rs 10,000

Eeff= 400 kWh/year

Estd = 600 kWh/year

Pe = Rs 2.00/kWh

CRF (i,n) = CRF (0.10,25) = 0.110/year

Therefore,

LCC = 10,000 + (600 * 2.00)/(0.110)


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= 10,000 + 10,900 = Rs 20,900

For standard refrigerator, the LCC is more than the initial cost, that too, if weassume that there will not be any increase in the electricity price in the future.

Now, for the efficient refrigerator, the LCC is

LCC = 12,000 +(400 * 2.00)/(0.110) =7,273

LCC = 12,000 + 7,273 = Rs 19,723

Thus, the LCC of efficient refrigerator is substantially lower than the standardone.

One disadvantage with LCC is that we can not compare alternatives with differentlife times. However, this problem can be solved with annualised LCC.

Annualised LCC

It is the sum of the annualised value of the initial investment and the annualenergy cost.

ALC =C * CRF (d,n) +pe

ALC with different useful life

* E

The LCC and ALC are thus related to each other

ALC =LCC * CRF (d, n)

Using the refrigerator example, the ACC of standard one is

ACC (1) =10,000 * 0.11 +600 * 2.00=1,100 +1200 = Rs 2,300

ALCC (2) =12,000 * 0.11 +400 * 2.00

=1,320 +800 = Rs 2,120

As stated earlier, ALC has several advantages. It can be used to comparealternatives with different useful life or components which have different useful life.Fuel switching or multiple fuels also can be considered.

If n1 and n2 are the useful lives of devices 1 and 2, then,

ALC1 = I1 CRF (i,n1) + E1 * Pe

ALC2 = I2 CRF (i,n2) + E2 * Pe


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In each case, the capital recovery factor is determined according to the useful lifeof the device to annualise the initial cost and this is added to the correspondingenergy cost. Like this any number of alternatives can be compared.

Components with different useful lives

If the costs and life times of various components for a given alternatives are (I1,n1), (I2, n2), etc., the ALC is calculated as:

ALC =I1 CRF (i,n1) +I2 CRF (i,n2) + ..... +E * E e

Here I1, I2,.... are the initial costs and n1, n2

Maintenance costs

, etc. are the useful lives of thecomponents of the same technology.

The annual maintenance costs (M) should be added to the energy costs fordifferent alternatives. Thus,

ALC =I CRF (i,n) + E * P +M

Example of IB vs CFL

Comparing more than two alternatives

In earlier examples we consider only two alternatives, i.e., standard and efficient

devices. Let us now consider two examples of different categories

1. A farmer is interested in retrofitting his agriculture pumpset. The costs and energysavings for various types of retrofittings are given below

Level of Electricity Savings Investmentretrofitting consumption (kWh/year) (Rs)

(kWh/year)

A 7000 1500 500B 8000 2500 1000

C 20,000 10,000 6000

2. Let us assume you want to purchase some electrical equipment and there arepossibilities of saving energy. The alternatives are

i. conventional and efficient refrigerator

ii. conventional and efficient stove

iii. conventional and efficient water-heater


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The costs and savings are given here

Device Capital Energy consumption Lifecost (Rs) (kWh/year) (yr.)

Refrigerator

Conventional 10,000 600 25Efficient 12,000 400 25

StoveConventional 2000 500 15Efficient 3000 350 15

GeyserConventional 6000 400 20Efficient 8000 200 20

Before solving the problem, let us compare the two examples. In each case,there are three alternatives to compare against doing nothing (conventionaldevice). In the first case, the options are mutually exclusive - one may carry anyone of the options or none at all. In the latter case, the options are independent -the decision to buy an equipment is independent of the other. Of course, we canassume that the funds are available for any combination of options.

Here, we will use the costs and savings data to compare the effectivenessindices to discuss methodologies for comparing more than two mutually exclusiveenergy conservation options, i.e., we use SPP, DPP, IRR, CSE.

We compare the option of retrofitting pumps to each levels of A, B and C relativeto the option of doing nothing D.

Example 1

Assume that the real discount rate =0.10Life of the retrofit = 10 yearsElectricity price = Rs 0.50/kWh

Consider first SPP for all the options

Energy savings/year (Rs)

(i) 0.5 * 1500 =Rs 750(ii) 0.5 * 2500 =Rs 1250

(iii) 0.5 * 10,000 =Rs 5000

SPP =Investment/energy cost per year

(i) 500/750 =0.67 years

(ii) 1000/1250 =0.80 years


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(iii) 6000/5000 = 1.2 years

DPP =life * CRF (i, n) * (investment)/(energy cost)

(i) 10 * 0.165 * 500/750 =1.1 years

(ii) 10* 0.165 * 1000/1250 =1.3 years

(iii) 10 * 0.165 * 6000/5000 = 2 years

IRR

CRF (i, n) =energy cost/initial investment

(i) 750/500 =1.5 or 150%

(ii) 1250/1000 =1.25 or 125%

(iii) 5000/6000 = 0.83 or 83%

CSE =CRF (i,n) * investment/energy cost

(i) 0.165 * 500/750 =0.11 Rs/kWh

(ii) 0.165 * 1000/1250 =0.13 Rs/kWh

(iii) 0.165 * 6000/5000 =20 Rs/kWh

The results are given in the following table

Retrofitting Savings Investment SPP DPP IRR CSElevel (kWh/year) (Rs) (years) % Rs/kWh

A 1500 500 0.67 1.1 150 0.11B 2500 1000 0.80 1.3 125 0.13C 10,000 6000 1.2 2.0 83 0.20

The SPP for all the retrofittings is around one year while the DPPs are longer.The IRR decreases as the retrofitting level increases and the cost of savedenergy increases.

Based on the above table, we can conclude that level A seems to be the mostcost-effective because it has the lowest payback period, highest rate of returnand the lowest CSE.


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Instead of comparing each against D which is not doing any thing, we cancompare pairs of alternatives.

Otherwise, instead of comparing by pairs, the ALC can be calculated for eachalternative. The alternative with the lowest ALC is the most economical.

In this case, the electricity consumption of three groups before retrofitting wasdifferent and a comparison of cost- effectiveness can not be made. However, weuse D as the base, i.e., if we do nothing, then ALC is zero. Then alternatives A,B and C involve investments which increases ALC and realise an energy savingrelative to doing nothing which decrease ALC.

ALC =C * CRF (d,n) +pe

IRR

* E

Rectification Savings Investment ALC relative to Dlevel (kWh/year) (Rs) (Rs)

A 1500 500 - 832.5B 2500 1000 - 1415C 10,000 6000 - 4650

As shown, C is the most cost effective option.

Now we turn to another example with different and independent options wherewe considered refrigerator, stove and water-heater. How do we determine if aninvestment in an energy-efficient stove is better than water-heater? The ALCsare not comparable because they are for different and independent uses.Different alternatives can be compared using DPP, IRR or CSE.

CRF (i,n) =energy cost/initial investment

(i) (600-400) * 2.00 / 12,000 - 10,000 =0.20

(ii) (500 - 350) * 2.00 / 3000 - 2000 =0.3

(iii) (400 - 200) * 2.00/ 8000 - 6000 =0.13

CSE =CRF (i,n) * investment/energy cost

(i) 0.11 * (12,000-10,000)/ (600 - 400) * 2.00 = 1.1 Rs/kWh

(ii) 0.11 * (3000 - 2000) / (500 - 350) =0.87 Rs/kWh

(iii) 0.11 * (8000 - 6000) / (400 - 200) = 1.4 Rs/kWh


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Device IRR CSEper year Rs/kWh

Refrigerator 0.20 1.1Stove 0.30 0.87Geyser 0.13 1.4

Here, the highest IRR and the lowest CSE are the most cost effective options.Here, in the order of cost effectiveness, we can invest in Stove, refrigerator andgeyser.

Notes LEC3

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