Lecture in Energy Economics: Life Cycle Cost Analysis for Bankable Projects in Sustainable Energy INOGATE Programme Slides prepared by: New ITS Project, Ad Hoc Expert Facility (AHEF) Ali Korakan, CEA Task AM-54-55-56 Lecture Learning Objectives • Learn basics of Life Cycle Cost (LCC) feasibility analysis • Learn structured methodology for performing LCC analysis to develop bankable energy efficiency and renewable energy projects • Learn Data collection and reality checks necessary for inputing to LCC analysis • Learn report writing techniques to convince investors of feasible projects • Case studies of economic analysis for energy efficiency/renewable energy projects. Energy Efficiency Projects • Energy conservation Any behavior that results in the use of less energy. • Energy efficiency The use of technology that requires less energy to perform the same function. Requires investment, hence financing. Energy Systems Energy is used in residential, comercial and industrial buildings, in industry and in transport • Power generation • Hot water systems • Special purpose production • Electrical systems & process equipment or systems • Lighting • HVAC system – for production • Compressed air systems processes or personal comfort • Motors • Boiler and steam systems • Transportation Sources of Energy • Non-renewable energy sources - energy sourced that we use up and cannot recreate in a short period of time e.g., fosil fuels: coal, oil and gas • Renewable energy sources - energy sourced that we can use over and over again, and can be replaced naturally in a short period of time e.g., solar, wind, geothermal, biomass, hydro, wave The Need for Economic Analysis • Economics play a dominant role in the decision whether the management/owner and the financing institutions will invest in an energy efficiency/renewable energy project or not. • The communication of engineers/energy managers with the decision makers is very important in investment decisions. The engineer/energy manager must learn to speak management’s language. • The engineer/energy manager must present projects in economic terms in order to help the top management/financiers to make their decisions. Project Profitability Analysis • Profitability analysis is a method used for assessing finacial feasibility of a project. • Life Cycle Cost Analysis (LCCA) is used for project profitability analysis because it takes into account the entire life of a project and time value of money. Life Cycle Cost Feasibility Analysis • LCCA is an engineering economic analysis tool used to calculate the financial feasibility of a project. • Considers all costs, revenues and savings incurred during the service life of the project from cradle to grave. • It compares the relative merits of competing project implementation alternatives. • Helps the decision maker to accept or reject a project and prioritise accepted projects. LCC Indicators NPV, SIR and IRR are LCC indicators which demonstrate the economic feasibility of a project. • Absolute project worth: NPV (Net Present Value) shows how much value will be generated during the life cycle of the project. It takes into account time value of money and shows the present (today’s) value of the project. Value generation can be from the savings in the case of energy efficiency projects or it can be from the revenues as in the case of the renewable energy projects. LCC indicators LCC indicators demonstrate the economic feasibility of a project. • Relative project worth: SIR (Savings-to-Investment Ratio) shows the value of the project relative to the investment. SIR considers time value of money both for the investment and net cash flow generated by the project. • Specific to project: IRR (Internal Rate of Return) shows the average annual return earned through the life cycle of the project. The term internal refers to the fact that it is independent of economic environmental factors. Discount rate has no effect on IRR. Time Value of Money Basic rule: Money you have today is worth more than in the future. • Future Value (FV) shows the value of money/project at a specific time in the future that is equivalent in value to a specified sum today. We use compounding to calculate FV. • Present Value (PV) shows how much future money/project is worth today. We use discounting to calculate PV. Future cash flows are discounted at the discount rate, and the higher the discount rate, the lower the present value of the future cash flows . LCCA Parameteres • Discount rate (i) - a rate at which the future benefit (loss) can be compared to the present value. Determining the appropriate discount rate is the key to properly valuing future cash flows. Discount rate is calculated by using the following parameters. – Risk free interest rate – Inflation – Risk premium • Analysis Period - the period of time over which LCCA is performed. • Residual Value – the value of the investment at the end of the analysis period. Time Value of Money Compounding: Suppose you put €100 in a saving account at 5% interest rate for 5 years. How much money you will have at the end of the period? 0 i = 5% 1 2 3 4 5 100 105,00 110,25 115,76 121,55 127,63 0 FV0=100*(1+5%) 1 FV1=100*(1+5%) 2 FV2=100*(1+5%) 3 FV3=100*(1+5%) 4 FV4=100*(1+5%) 5 FV5=100*(1+5%) Time Value of Money Compounding • Year 1: 5% of $100.00 = $5.00 + $100.00 = $105.00 • Year 2: 5% of $105.00 = $5.25 + $105.00 = $110.25 • Year 3: 5% of $110.25 = $5.51 + $110.25 = $115.76 • Year 4: 5% of $115.76 = $5.79 + $115.76 = $121.55 • Year 5: 5% of $121.55 = $6.08 + $121.55 = $127.63 Compounding 130 125 FV (Net Value) PV (Discounted Value) 140 120 120 FV = PV x (1+ i)n 100 $ 115 80 $ 110 60 40 105 20 100 0 0 1 2 3 4 5 0 1 2 3 4 5 years Years Time Value of Money Discounting: How much is a € 100 bill worth today compared to its value 1 year? The interest rate is 5%. 0 i = 5% 1 2 3 4 5 100 95.24 90.70 86.38 82.37 78.35 0 PV0=100/(1+5%) 1 PV1=100/(1+5%) 2 PV2=100/(1+5%) 3 PV3=100/(1+5%) 4 PV4=100/(1+5%) 5 PV5=100/(1+5%) Time Value of Money Discounting • Year 0: 5% of $100,00 = $100 / (1+0,05)0 = $100 • Year 1: 5% of $100,00 = $100 / (1+0,05)1 = $95,24 • Year 2: 5% of $100,00 = $100 / (1+0,05)2 = $90,70 • Year 3: 5% of $100,00 = $100 / (1+0,05)3 = $86,38 • Year 4: 5% of $100,00 = $100 / (1+0,05)4 = $82,27 • Year 5: 5% of $100,00 = $100 / (1+0,05)5 = $78,35 100 Discounting 95 FV = ─────PV FV (Net Value) PV (Discounted Value) (1+ i)n 100 90 $ 80 85 $ 60 80 40 20 75 0 1 2 3 4 5 0 0 1 2 3 4 5 years Years Net Present Value (NPV) NPV (Net Present Value) is calculated by discounted cash flow method. It is the difference of all discounted cash in (B –benefits) and all discounted cash out (C – Costs) • NPV – net present value • B – benefits • C – Costs • i – interest rate • t - period Internal Rate of Return (IRR) Theoretically IRR (Internal Rate of Return) is the value of discount rate that makes NPV zero. • NPV – net present value • B – benefits • C – Costs • i – interest rate • t - period • IRR – internal rate of return Simple Payback Period (SPB) • Simple Payback Period (SPB) – the length of time required to recover the cost of the investment. SPB = ─────────────Cost of Project Annual Cash Inflows • There are two drawbacks with the payback period – It ignores net benefits that occur after the payback period and therefore does not measure profitability – It ignores the time value of money Ten Steps for LCCA The discounted cash flow life cycle cost analysis methodology in 10 steps is used to calculate the financial feasibility of an energy efficiency or renewable energy project. The 10 step methodology utilizes a spreadsheet running on a computer to calculate the discounted cash flow in order to analyze the feasibility of a project. Ten Steps Ten Steps to determine Finacial Feasibility of an Energy Project. 1. Determine old costs (existing baseline conditions). 2. Determine new costs (implementation and beyond). 3. Calculate differences. 4. Choose discount rate. 5. Choose analysis period. 6. Estimate residual value of equipment at end of service life. 7. Calculate present value of annual savings. (PV) 8. Calculate present value of investments (PV). 9. Calculate net present value (NPV). 10. Calculate savings-to-investment ratio & internal rate of return (IRR). Step 1 Determine Old Costs (Baseline Conditions) a) Life cycle re-investments b) Annual energy costs c) Annual operations & maintenance (O&M) costs d) Other annual costs Good analysis begins with good definition of the existing situation. Definition considers the schedule of predicted costs of major non-annual replacements of the old technology, as well as annual energy costs, O&M costs and other current costs. Step 1a Life Cycle Re-investments Life cycle investments consist of capital required in year zero plus future irregular expenses, i.e., re-investment costs separate from annual O&M. They comprise only non-annual costs. The best source of information for re-investments is maintenance records. • Does existing equipment need an overhaul now (in year zero?) to continue in service? • If not, when? And how often? • How much money would have to be re-invested each time? Examples of re-investments • Overhauling a compressor every 5 years • Replacing lamps every 10,000 hours Step 1a Year Old 0 Old Re-investment Table 1 2 € 50,000 • Old equipment probably needs 3 periodic re-investment to keep going.