Basic Economic Analysis for energy

INTRODUCTION

Once an energy management opportunity (EMO) has been identified,

the energy manager must determine the cost-effectiveness of the
EMO in order to recommend it to management for implementation, and
to justify any capital expenditure for the project. If a group of EMOs have
been identified, then they should be ranked on some economic basis, with
the most cost-effective ones to be implemented first. There are many measures
of cost-effectiveness, and sometimes businesses and industries use
their own methods or procedures to make the final decisions. The basic
elements of cost-effectiveness analysis are discussed in this chapter and
some of the common techniques or measures of cost-effectiveness are presented.

Categories of Costs for Capital Investments

The costs incurred for a capital investment can almost always be

placed in one of the following categories: acquisition, utilization, and disposal.
Acquisition costs are the initial, or first, costs which are necessary to
prepare the investment for service. These costs include the purchase price,
installation costs, training costs, and charges for engineering work that
must be done, permits that must be obtained, or renovations that must be
made before the project can be started.
Methods for estimating acquisition costs range from using past experience,
to obtaining more precise estimates from vendors, catalogs and
databases. The desired accuracy of the estimate depends on where the
data will be used. If the data is being collected for determining the feasibility
of the project, approximations may be sufficient. If the data is being collected
to obtain financing, the estimates must be as accurate as possible.
Utilization costs are those required on a routine basis for operating
and maintaining the investment. These include energy, maintenance and
repair. Utilization costs can be direct or indirect. Direct costs include labor
and materials for routine repair and maintenance. Indirect costs are the
costs not directly attributable to the project but necessary for conducting
business. Energy costs are usually included in this category. Indirect costs
are also often referred to as “overhead.” Examples of indirect costs include
salaries for staff personnel, janitorial costs, and cleaning supplies. Estimates
for utilization costs can be obtained from databases or professional
experience.

Disposal costs are those incurred (or recovered) when the project has
reached the end of its useful life. These are costs required to retire or remove
the asset. These costs are often referred to as the salvage value if the
project has a positive worth at the end of its lifetime. The actual salvage
value may depend on many factors, including how well the asset was
maintained and the market for used equipment. Estimates for disposal
costs/benefits are often obtained from experienced judgments and current
values of such used equipment.

Cash Flow Diagrams and Tables

It is often helpful to present costs visually. This can be accomplished

with a tool called a cash flow diagram. Alternatively a cash flow
table could be used. A cash flow diagram is a pictorial display of the
costs and revenues associated with a project. An interest rate or discount
rate can also be shown. Costs are represented by arrows pointing down,
while revenues are represented by arrows pointing up. The time periods
for the costs dictate the horizontal scale for the diagram. Although some
costs occur at different points in time, most of the time, an end-of-year
approach is sufficient. This chapter will use end-of-year cash flows for
all analyses.

Figure 4-1 is a cash flow diagram to look at the costs and benefits
of purchasing a heat pump. The costs/benefits associated with the heat
pump are:
• The heat pump costs $10,000 initially
• The heat pump saves $2,500 per year in energy costs for 20 years
• The maintenance costs are $500 per year for 20 years
• The estimated salvage value is $500 at the end of 20 years.
SIMPLE PAYBACK PERIOD COST ANALYSIS

One the most commonly used cost analysis methodologies is the

Simple payback Period (SPP) analysis. Also called the Payback Period
(PBP) analysis, the SPP determines the number of years required to recover
an initial investment through project returns. The formula is:
SPP = (Initial cost)/(Annual savings) (4-1)

Example 4.1
The heat pump discussed above has an initial cost of $10,000, an
energy savings of $2,500 per year, and a maintenance cost of $500 per
year. Thus, the net annual savings is $2,000. Therefore, its SPP would be
($10,000)/($2,000/yr) = 5 years.

The advantage of the SPP is its simplicity, and it is easily understood

by workers and management. It does provide a rough measure of the
worth of a project. The primary disadvantages are: 1) the methodology
does not consider the time value of money; and 2) the methodology does
not consider any of the costs or benefits of the investment following the
payback period. No specific lifetime estimate of the project is required,
but it is assumed that the lifetime is longer than the SPP. These limitations
mean the SPP tends to favor shorter-lived projects, a bias that is often
economically unjustified. However, using the SPP in conjunction with one
of the discounted cash flow methodologies discussed later in this chapter
can provide a better understanding of an investment’s worth.

ECONOMIC ANALYSIS USING THE TIME VALUE

OF MONEY: DISCOUNTED CASH FLOW ANALYSIS

Most people understand that money changes value over time. If

a person is offered $1,000 today, or $1,000 in one year, almost everyone
would choose the $1,000 today. The decision-maker clearly places higher
value on money today. This decision occurs for a variety of reasons, including
how much the person needs the money, but a primary factor is the
recognition that $1,000 today is worth more than $1,000 will be worth in
one year. The change in worth is due to two primary factors: interest (opportunity
cost) and inflation. Interest is the return earned on money when
someone else uses it. If $1,000 were deposited in a bank or invested in a
financial instrument (stock, mutual fund, bond, etc.), then in one year, an
amount greater than $1,000 would be available for withdrawal. Inflation
is a decrease in the purchasing power of money. In other words, $1,000
will buy more at a store today than it will in one year.

The Mathematics of Interest and Discounting

Two factors affect the calculation of interest: the amount and the timing
of the cash flows. The basic formula for calculating interest is:
Fn = P + In (4-2)
where: Fn = a future cash flow of money at the end of the nth year
P = a present cash flow of money
In = the interest accumulated over n years
n = the number of years between P and F

Simple Interest

There are two primary types of interest: simple and compound.

Simple interest is earned (charged) only on the original principal amount,
and paid once, at the end of the time period. The formula is:
I = P × n × i, where
I = the interest accumulated over n years
P = the original principal amount
n = the number of interest periods (often measured in years)
i = the interest rate per period
The general formula for the total amount owed or due at the end of
a loan (investment) period of n years when using simple interest is:
Fn = P + I
=P+P×n×i
= P (1 + n × i) (4-3)
Example 4.2
The ABC Corporation wants to borrow $10,000 for 5 years at a simple
interest rate of 18%/year. How much interest would be owed on the
loan?
I=P×n×i
= ($10,000)(5 years)(.18/year)
= $9,000
The total amount owed at the end of the 5 years would be the principal,
$10,000 plus the interest, $9,000, for a total of $19,000.

Compound interest

Interest which is earned (charged) on the accumulated interest as

well as the original principal amount is said to be compounded. In other
words, the interest which accumulates at the end of the first interest period
is added to the original principal amount to form a new principal amount
due at the end of the next period. The power (or penalty) of compound
interest is illustrated in Table 4-2.