Economic Evaluation of Projects in the Electricity Supply Industry

1 Global electrical power planning, investments and projects 1
1.1 The value of electricity 1
1.2 Integrated resource planning 2
1.3 The changing electrical power industry scene 4
1.3.1 Reform trends in the electricity supply industry 5
1.3.1.1 Challenges and trends of the power industry in mature economies 5
1.3.1.2 Challenges and trends of the power industry in emerging economies 6
1.3.2 Environmental concerns and the efficiency of generating plant 8
1.3.3 Energy return on energy invested (EROI) 10
1.3.4 Capacity factor in power generation 10
1.3.5 Growing importance of natural gas and shale gas 11
1.3.5.1 Shale gas 13
1.3.6 Rehabilitating, retrofitting and repowering of existing power facilities 14
1.3.7 The importance of demand side management (DSM) 15
1.4 The global electrical power scene 16
1.4.1 Electricity and the world economy 18
1.4.2 Investments in the electricity sector 20
1.5 Cyber security of electrical power system 21
References 22

2 Considerations in project evaluation 25
2.1 Project selection and evaluation 25
2.2 Project development 26
2.2.1 The pre-investment stage 26
2.2.1.1 The feasibility study 26
2.2.1.2 Project appraisal 28
2.2.2 The investment phase 30
2.2.3 The operational phase 31
2.2.4 Post-operation evaluation 31
2.3 Other considerations in project evaluation 31
References 33

3 Time value of money (discounting) 35
3.1 Discounting 35
3.2 Discounted cash flows 37
3.3 Net present value 39
3.4 Accounting for inflation in cash flows 39
3.5 Considerations in present valuing 41
3.5.1 Future and past valuing 42
3.5.2 Annuity factor 42
3.5.3 Capital recovery factor or equivalent annual cost 44
3.5.4 Grouping monthly and hourly flows 45
References 46

4 Choice of the discount rate 47
4.1 Introduction 47
4.2 The discount rate 48
4.3 Calculating the discount rate 49
4.3.1 Government financed projects 50
4.3.2 Business investment projects 50
4.3.2.1 The risk-free rate of interest 51
4.3.2.2 Premium to compensate for risk 51
4.3.2.3 Taxation and its relationship with the discount rates 55
4.3.2.4 Inflation 56
4.4 Controlling the value of the discount rate 57
4.4.1 Capital structuring 57
4.4.2 Transferring risk 58
4.5 Other forms of the discount rate 58
4.5.1 Weighted-average cost of capital 58
4.5.2 Utilisation of multiple discount rates 59
4.6 Summary 60
References 60

5 Financial evaluation of projects 63
5.1 Introduction 63
5.1.1 Evaluation of costs and benefits 63
5.1.1.1 Owner’s evaluation 63
5.1.1.2 Banker’s evaluation 63
5.1.1.3 Economic evaluation 64
5.1.2 Project financial costs 64
5.1.2.1 Investment costs 64
5.1.2.2 Operating costs 64
5.1.2.3 Working capital 64
5.1.3 Financial benefits of the project 65
5.2 Least-cost solution 65
5.2.1 Present value method 66
5.2.2 Annual cost method (equivalent uniform annual cost method) 68
5.2.3 Levelised cost of electricity 70
5.3 Measuring worth of the investment 72
5.3.1 Internal rate of return 73
5.3.2 Net present value 75
5.3.3 Benefit/cost ratio 75
5.3.4 Other non-discount criteria for evaluation 76
5.3.4.1 Payback period 76
5.3.4.2 Profit/investment ratio 76
5.4 Owner’s evaluation of profitability: commercial annual rate of return 76
5.5 Independent power producers 77
References 79

6 Considerations in project evaluation 81
6.1 Base cost estimate and contingencies 81
6.1.1 Physical contingency 81
6.1.2 Price contingency 82
6.2 Interest during construction 83
6.3 Sunk costs 84
6.4 Depreciation and interest charges 85
6.5 Financial projections 85
6.5.1 Financial performance and financial statements 87
6.5.2 Financial ratios 89
6.5.3 Flow of the funds statement: sources and applications of funds 90
6.6 Evaluation of benefits in the electricity supply industry 91
6.7 Timing of projects 92
6.8 Dealing with projects with different lives and construction periods 92
6.9 Expansion projects 93
6.10 System linkages (system effects) 93
References 95

7 Economic evaluation of projects 97
7.1 Introduction 97
7.2 From financial evaluation to economic evaluation 99
7.3 Transfer payments 99
7.4 Externalities 100
7.5 Border and shadow pricing 101
7.5.1 Pricing traded inputs and outputs 102
7.5.2 Pricing non-traded inputs and services 103
References 105

8 Environmental considerations, cost estimation and long term discounting in project evaluation 107
8.1 Introduction 107
8.2 Environmental impacts of electricity fuels 109
8.2.1 Environmental impact of different generation fuels 111
8.3 Environmental evaluation 112
8.4 Health and environmental effects of electricity 112
8.4.1 Direct health effects 112
8.4.1.1 Fossil-fired generation plants 112
8.4.1.2 Renewable 113
8.4.1.3 Transmission and distribution 113
8.4.2 Environmental impact 113
8.4.2.1 Local impacts 114
8.4.2.2 Regional impacts 114
8.5 Investment costs in reducing dangers to health and environmental impacts 115
8.6 Evaluation of the environmental cost of electricity generation 116
8.6.1 Assessing health impacts and costs 116
8.6.2 Assessing damage to buildings, properties and forests by air pollution 117
8.7 Climate change costing 118
8.7.1 Environmental impacts and the environmental discount rate 120
8.8 Discounting concepts in climate change 121
8.8.1 The welfare discount rate 121
8.8.2 The welfare discount rate rsw, abatement policies and carbon pricing 122
References 123

9 Electricity generation in a carbon-constrained world
Part I – The strategies, national requirements and global agreements 125
9.1 Introduction: the carbon dilemma 125
9.2 UK Electricity White Paper 2011 127
9.3 US Climate Action Plan 2013 128
9.4 Climate conventions: Kyoto and beyond 129
9.5 Electricity generation and climatic change agreements 132
9.5.1 Carbon taxation 132
9.5.2 Emissions trading 133
9.5.3 Flexible project mechanisms 133
9.6 The negative effect of power sector subsidies 134
9.7 Prospects for non-fossil-fuel power generation 136
9.7.1 Prospects for nuclear energy 136
9.7.2 Prospects for wind power 137
9.7.3 Future prospects for solar cells 138
9.7.4 The virtual power plant 139
References 139

10 Electricity generation in a carbon-constrained world
Part II – The technologies 141
10.1 Introduction to clean electrical power 141
10.2 Improving efficiency of the generation sector 142
10.2.1 Improving efficiency of electricity generation 143
10.2.2 Future trends in efficiency of electricity generation 144
10.2.3 Carbon emissions from electricity generation 146
10.2.4 Factors affecting the efficiency of generating plant 147
10.2.5 Improving efficiency of the generating cycle 147
10.3 Clean fossil fuel technologies 148
10.3.1 Clean fossil-fuel-based power technology 148
10.4 Carbon capture, usage and storage (CCS) 151
10.4.1 Introduction 151
10.4.2 The technologies and storage 151
10.4.2.1 Oxy-fuel combustion 152
10.4.2.2 Pre-combustion CO2 capture 152
10.4.2.3 Storage 152
10.4.3 Carbon usage 152
10.4.4 The economics 152
10.5 Smart grids 153
10.5.1 Metering 155
10.5.2 Storage issues 155
10.5.3 Evolution of the smart grid 157
10.5.4 Summary 158
References 159

11 Economics of reliability of the power supply 161
11.1 Introduction 161
11.2 The value of reliability 162
11.3 Reliability in system planning 164
11.3.1 Empirical planning rules 164
11.3.2 Supply design standards 165
11.3.3 Cost–benefit analysis 165
11.4 Detailed financial and economic evaluation 166
11.4.1 System adequacy and economics 166
11.4.2 Assessment and economics of generation adequacy 167
11.4.2.1 Loss-of-load expectation (LOLE) method 167
11.4.2.2 Frequency and duration method with a load model 169
11.4.2.3 Percentage energy loss (PEL) index 169
11.5 Financial and economic evaluation of quality of electrical power 170
11.6 Evaluation of investment in generation 171
11.6.1 Valuing cost of interruptions 172
11.6.2 Incorporating reliability worth in generation planning 173
11.7 Renewables and reliability of supply 175
References 177

12 Economics of new renewables: is there viable energy at the end of the renewables tunnel? 179
Part I: Debating the value of the new renewable technologies 179
12.1 Introduction 179
12.2 Economics of renewables and the role of the state 181
12.2.1 UK renewable energy strike prices 183
12.3 Debating new renewables 183
12.3.1 The utilisation factor (capacity factor) 184
12.3.2 Dispatching and transmission cost 185
12.4 Considerations in costing of renewables generation 186
12.4.1 Economic value of green energy 188
12.4.2 New renewables as a disruptive technology 188
12.4.3 Net energy metering 188
12.4.4 Smart grids value to new renewables 189
12.5 Part I conclusions 189
Part II: The financial and economic evaluation 189
12.6 Assessing the returns on investment in renewables 189
12.7 The value factor 191
12.8 Effects of new renewables on the merit-order (merit-order effect) 192
12.9 Calculating benefits in investing in renewables 192
12.10 The challenge of net energy metering (NEM) 193
References 194

13 Electricity trading 197
13.1 Introduction 197
13.2 Electricity trading worldwide 198
13.2.1 Electricity trading in the US 200
13.2.2 UK electricity market trading 201
13.2.3 The Nordic market 203
13.2.4 Electricity markets across Europe and elsewhere 203
13.3 Trade in electricity – the spot market 205
13.4 Cross-border trade in electricity 206
13.5 Electricity traders 207
13.6 Value of cross-boundary electricity trade to renewables 208
13.6.1 Pricing cross-border RE trade 209
13.7 Future strategies and growth 210
References 211

14 Evolvement of the electricity sector – utility for the future 213
14.1 Introduction 213
14.1.1 Phase I: Early 20th century – private sector investment and monopolistic market behaviour 213
14.1.2 Phase II: Mid-20th century – public sector intervention and inefficiency 213
14.1.3 Phase III: Late 20th century – unbundling, competition, regulation and privatisation 214
14.1.4 Phase IV: Recent developments – industry convergence and globalisation 214
14.1.5 Phase V: Empowering the consumers, through the encouragement of small power (mainly in renewables) both among investors and households 214
14.2 Reorganising the ESI 215
14.2.1 The opportunities presented by liberalisation 217
14.3 Barriers in liberalised markets 218
14.4 The changing utility of the future 219
14.5 Electricity and the new digital economy 221
14.6 The utility of the future 222
14.7 The ‘virtual utility’ of the future 223
14.8 DSM programmes in deregulated markets 224
14.9 The need for a regulator 226
References 226
  
15 Investment projects analysis: evaluation of risk and uncertainty 229
15.1 Introduction 229
15.2 Generation investment 230
15.2.1 Deterministic generation investment decisions 230
15.3 Project risks 231
15.4 Sensitivity analysis 233
15.5 Break-even point analysis 235
15.6 Decision analysis 237
15.7 Risk analysis (the Monte Carlo simulation) 238
15.8 Consideration in risk analysis 241
15.8.1 Building up probability distributions 241
15.8.2 Disaggregation 242
15.8.3 Correlation 243
15.8.4 Effect on the discount rate 243
15.9 The value of risk management in liberalised markets 244
References 245

16 Risk management – in electricity markets 247
16.1 Introduction 247
16.2 Qualifying and managing financial risks 248
16.3 Quantifying and managing risk 248
16.3.1 Forward contracts 249
16.3.2 Futures contract 250
16.3.3 Options 251
16.3.4 Swaps 252
16.3.5 Political risk 253
16.4 Decision making 253
16.4.1 The decision-making process 254
References 255

Appendix A Levelised cost of electricity generation 257
Appendix B Social discount rate for climate change evaluation 261
Appendix C Calculating the economic benefit of renewables 263
Appendix D Glossary 269