BU5053 Introduction to Energy Economics

Professor Euan Phimister (Economics)

Aims
Introduce key concepts economics and finance
•Investment decision making in energy industries
•Economic analysis key issues energy markets and policies.

Assume
No prior economics or finance
Calculations & Diagrams -a little Maths + “Economic Intuition”

Classes – (see MyAberdeen for planned schedule)

Lectures
Monday 2-4pm
Wednesday 10am-12noon
Tutorials –Thursdays 10am – 1pm One hour each – should
know your allocation

Start Thursday 3rd November

Go through exercise sheets handed out in previous week

Assessment
80% Exam - Mock Exam handed out
20% Course Assessment

Two in class Course Assessments

Wednesday 16 November 10am
Wednesday 23 November 10am

Overall Coursework Mark – Best mark either Assessment.

Example Coursework Assessment will be handed out

BU5053 Introduction to Energy Economics 2016-17 Draft Timetable
.
Semester Week 13
Monday 24th October 2pm-4pm Lecture
Wednesday 26th October 10am-12noon Lecture

Semester Week 14
Monday 31 October 2pm-4pm Lecture
Wednesday 2nd November 10am-12noon Lecture
Thursday 3rd November 10am-1pm Tutorials - one hour per student
Semester Week 15
Monday 7th November 2pm-4pm Lecture
Wednesday 9th November 10am-12noon Lecture
Thursday 10th November 10am-1pm Tutorials - one hour per student

Semester Week 16
Monday 14th November 2pm-4pm Lecture
Wednesday 16th November 10-11am In class Coursework Assignment 1
11am-12noon Lecture
Thursday 17th November 10am-1pm Tutorials - one hour per student

Semester Week 17
Monday 21st November 2-4pm Lecture
Wednesday 23rd November 10-11am In class Coursework Assignment 2
11am-12noon Revision Lecture
Thursday 24th November 10am-1pm Tutorials - one hour per student
Expectations

Lecture Notes available before class/Podcast after

Lecture Notes ≠ Lecture ≠ All material required

You should not expect immediate understanding on all issues

Lectures provide guide and focus only

Clarifying questions in lectures welcome

However expect you to work independently to identify areas

and questions which you do not understand arising from
lecture, exercise sheets etc
Topic 1

Investment Decision making in Energy Industry

Supplementary Readings
Newendorp, P., and Schuyler, J. (2000), Decision Analysis for
Petroleum Exploration 2nd edition, Planning Press, ISBN: 0-
9664401-1-0. Chap 1-4

Berk, J and DeMarzo, P (2007) Corporate Finance, Pearson

ISBN: 978-0321416803
Chap 3, 4 (4.5) 6, Chap 14 (14.1-14.3) Chap 22 (22.1,22.2)
There are several copies of both books (including earlier
editions of Newendorp and Schuyler) in the main library
Topics 1
Investment Decision making in Energy Industry

e.g. Kraken Field Enquest

£4bn investment
www.enquest.com/our-business/major-projects/kraken.aspx

e.g. West of Duddon Sands (Irish Sea)

Offshore Wind Farm 108 turbines
3.6MW/389MW

Dong/ScottishPower Renewables
Euro 700 Million investment
www.scottishpowerrenewables.com/pages/west_of_duddon_sands.a
sp
Energy Industry Investments

High Initial Capital Costs

Often Significant Development Time

e.g. Kracken first oil production 2017
West of Duddon Sands
Tendering 2010 First Power Generated 2014

Risks
Oil Field - Exploration, Development, Production, Oil Price,
Political, Decommissioning

Wind Farm - Planning, Development, Production, Electricity

Price?

How should firms make decisions to invest or not?

Introduction to Financial Decision Making

Rest of Lecture Structure

Valuing Decisions

Time Value of Money

Present Value and the NPV Decision Rule

Other Decision Rules

Valuing Decisions Background

Types of Firms
Sole Proprietorship
Partnership
Limited Liability Company
Corporation**
-legal entity separate from its owners

- has many the legal powers individuals have , e.g. ability to enter
contracts, own assets, and borrow money

-solely responsible for its own obligations.

Corporation Ownership
Represented by shares, a.k.a stock/equity

Owner of shares - Shareholder/Stockholder/Equity holder

Sum of all ownership value = equity of corporation/firm.
Owner entitled to dividend payments.

No limit to number of shareholders - anonymous

Typically Management Control separate from Owners

Objectives
Shareholders – want management to maximize share value
Management - assumed to act in shareholders interests
Private Companies Shares traded privately

Public Companies Shares traded on Stock Market/Exchange

Primary Markets
Public Company itself issues new shares and sells to investors.
Secondary Markets
After initial transaction in primary market, shares trade in a
secondary market between investors.

Provides liquidity to shareholders.

Liquidity – sell asset for close to the price you can currently buy
it for
Assume

Public Companies – equity/shares liquid

Equity – held by large no “anonymous” owners

Ownership separate from Management

Managers seek to maximize shareholder value

How should Managers make decisions?

Valuation Principle

Example
Manager at Firm has Following Opportunity Due to pre-existing
contract Could acquire 200 Barrels Oil & 3000 pounds Copper
for $12000

Does not need oil or copper

- Current market prices Oil $50 per barrel, Copper $2 per pound

If Manager acquires Oil + Copper and then sells

Net Benefit = 50*(200) + (2)*(3000) – 12000 = 4000>0

Valuation Principle: Manager make decisions to maximize value

Interest Rates & Time Value of Money
Difference in value between money today and money in future
due to time value of money.

Current interest rate - Rate at which exchange money today

for money in the future. Suppose current interest rate - r is 7%.

Assume this is Risk–Free - money borrowed or lent without risk

By investing or borrowing at this rate, can exchange £1.07 in

one year for each £1 today.

Rate of Exchange £1.07/£1 = 1.07 = 1 + r

r often also referred to - “Cost of Capital” “Discount Rate”,

“Hurdle Rate”
Example Consider investment opportunity following certain
cash flows.

Investment Cost: £100,000 today: Benefit: £105,000 one year

Interest rate r = 7%

Equivalent Cost of Investment in One Year

= (£100,000) (1 + r)= (£100,000) (1.07) = £107,000

Value of Investment in One Year (Future value)

Costs and benefits now in terms of “pounds in one year,”

Net value: £105k − £107k = −£2k in one year

i.e. earn £2000 more in one year by putting £100,000 in bank.

Therefore reject investment.

Value of Investment Today
Consider benefit of £105,000 in one year.

What is equivalent amount in terms of £ today?

If 7% interest rate – if repay £105,000 in one year

Bank would lend £98,130.84 today.

£98,130.84 × (1 + r) = £98,130.84 × (1.07) = (£105,000)

Equivalent Benefit Today =

(£105,000) × 1/(1 + r) = (£105,000) × 1/1.07 = £98,130.84

Net Value of Investment Today (Present Value)

Costs and benefits now in terms of “pounds in today”

£98,130.84 − £100,000 = −£1869.16 today (Reject)

Present Versus Future Value
Decision is same whether value of investment expressed in £
one year or £ today.

Net benefit £ today to £ in one year equivalent

(−£1869.16)(1 + rf) = (−£1869.16)(1.07) = −£2000.

Values expressed in terms of

£ today - the present value (PV) of the investment.
£ in the future - future value (FV) of the investment.
Exchange Rate = value in one year equivalent to £1 today
 1  r  1.07

Discount Factors - value today of £1 in one year

1 1
   0.93458
1  r 1.07

What is the value today of £1 in 2, 3, 4 etc …. years?

Exchange Rate = value in one year equivalent to £1 today
 1  r  1.07

What is the value in 2, 3, 4 years equivalent to £1 today?

Today £1 equivalent to £ 1  r  one year

One year £1 equivalent to £ 1  r  two years

One year £ 1  r  equivalent to £ 1  r 1  r   £ 1  r 

2

in two years

£ 1  r 
2
Hence today £1 equivalent to in two years
Future Value Argument generalizes

£1 today equivalent to £ 1  r 1  r   £ 1  r 

2
in 2 years

£1 today equivalent to £ 1  r 1  r 1  r   £ 1  r  in 3 yrs

3

£1 today equivalent to £ 1  r 
N
in N yrs

Present Values/Discount Factors -

1 1
Value today of £1 in one year    0.93458
1  r 1.07
1 1
Value today of £1 in two years = £ £  0.8734
1  r  1.07 
2 2

1 1
Value today of £1 in N years = £ £
1  r  1.07 
N N
Net present value (NPV)

NPV of a project or investment is the difference between the

present value of its benefits and the present value of its costs.

Net Present Value NPV  PV (Benefits)  PV (Costs)

NPV Decision Rule - Most Important Investment Criterion

Only accept projects with positive NPV - equivalent to receiving
their NPV in cash today.
Reject projects with negative NPV – would reduce the wealth of
investors.

Choosing one project among alternatives?

Take alternative with highest NPV equivalent to receiving its
NPV in cash today.
Example Project – initial investment cost £400m, generates
NCF £150m for 3 subsequent years. r=5%
0 1 2 3

Investment (I) 400

Revenues (R) 250 250 250
Operating Costs (O) 100 100 100
Net Cash Flow -400 +150 +150 +150

Net Cash Flow  R  O Flow of Actual Money +/- associated with Project

Should investment be made? Calculate “Discounted Cash

Flows” (DCF)
R1  O1 R2  O2 R3  O3
NPV   I 0   
1  r  1  r  1  r 3
2

150 150 150

r=5% NPV  400   
1.05 1.05 1.053
2

 400  142.86+136.05+129.58 =8.49

Example Project – initial investment cost £400m, generates
NCF £150m for 3 subsequent years.

Should investment be made if r=10%

R1  O1 R2  O2 R3  O3
NPV   I 0   
1  r  1  r  1  r 3
2

150 150 150

NPV  400    
r=10% 1.1 1.1 1.1
2 3

 400  136.36+123.97+112.69  26.97

In Risk Free Environment

Project NPV – value added/subtracted from firms value

Conceptually measure which managers should maximize

For project which lasts N periods

R1  O1 R2  O2 R3  O3 Rn  On
NPV   I 0     .. 
1  r  1  r  1  r 
2 3
 
1  r
n

N
Rt  Ot
Using summation notation NPV   I 0  
1  r 
t
t 1
Determining the risk free interest rate?

Government Bonds – sells to individuals/institutions

One Method through which Government borrows.

e.g. Buy One year UK Govt bond now. Promise to Pay £1000
one year time. Assuming No Default Risk – Inflation known –
Risk free

Say current Market Price = £928.8

Current Price of Bond – determines risk free interest rate
1000
929.80 
1  rf  Hence risk free interest rate is
1000 7.55%
1  rf   1.0755
929.80
Inflation - general rise in prices and costs

Nominal cash flows (Money of the Day (MOD)) – Includes

impact of inflation

Real Cash Flow – accounts for effect of inflation

Nominal Cash Flow Year t
Real Cash Flow Today 
1  inflation rate 
t

Note: Nominal Interest rate include Inflation impact

1  rnominal   1  rreal 1  inflation rate 

rnominal  rreal  inflation rate
Base Calculations – Inflation No Impact on NPV decision rule if
Correctly Accounted for.
Other Investment Decision Metrics

Internal Rate of Return (IRR) - rate of interest which

equates the Project NPV to zero.

Example Project 0 1 2 3
Investment (I) 400
Revenues (R) 250 250 250
Operating Costs (O) 100 100 100
Net Cash Flow -400 +150 +150 +150

150 150 150

NPV  400   
1  r  1  r  1  r 3
2

To find the IRR find rIRR

150 150 150
400    0
1  r  1  r  1  r 
IRR IRR 2 IRR 3
 NPV versus r
NPV 50

40

30

20

10

0
0.01 0.02 0.03 0.04 0.05 0.06 0.07 0.08 0.09 0.1 0.11 0.12 0.13 r
-10

-20

-30

-40
IRR
-50

-60

IRR r where NPV=0 , Here IRR =6.13%

Interpretation IRR - average return of capital investment

IRR Investment Rule
Accept investment where the IRR exceeds the interest rate
(cost of capital).
Reject investment if IRR is less than the interest rate (cost of
capital).
The IRR Investment Rule will give the same answer as the NPV
rule in many, but not all, situations.
Situations where the IRR rule and NPV rule may be in conflict:
•Project NPV increasing with r
•Multiple IRRs - When cash flows of a project change
sign more than once, there will be multiple IRRs
•Different Patterns of Cash Flows
Example Project NPV increasing with r

Year 0 1 2 3
Project NCF 1000 -3600 4320 -1728

IRR = 20% at r=10% NPV= -0.72

NPV versus r IRR Decision Rule

Accept if r< 20%

But NPV for these

values negative!
 Example Multiple IRRs

Project Year 0 1 2 3 4 5 6
Net Cash Flow -1000 800 150 150 150 150 -150
1500
NPV versus r
1000

500

-500

-1000

IRR=-50% and 15.2%

Example Different Cash Flows Patterns Mutually Exclusive
Projects
Year 0 1 2 3 4 5 6
Project G -9000 6000 6000 0 0 0 0
Project H -9000 1500 1500 2000 2500 5000 4000

IRR Project G = 22% Project H = 16%

G should be preferred to H?
NPV versus r Unless actual
r “high”
H Using IRR
G
Rule will
select wrong
project
Other Investment Decision Metrics
Simple Payback Method - Time required to recover
investment costs.

Example
Project A 0 T1 T2 T3 T4 T5

Net Cash Flow -100 +50 +50 +1 0 0

Project B 0 T1 T2 T3 T4 T5

Net Cash Flow -100 +20 +20 +20 +200 +200

Project A has a shorter payback period

Payback does not measure the profitability of the project.

At 5% NPV(A) = -6.16 NPV(B) = 275.7

Payback only considers cash flows up to the achievement of

project payback.

Does does not properly consider the time value of money.

Ad hoc Measure – Exposure to Risk

Capital Rationing - If Capital available restricted
Either self- imposed (e.g. internal financial discipline) or
Externally imposed (e.g. Restrictions on access to finance).

Objective - obtain greatest return from limited budget.

NPV
Profitability Index Useful criterion to rank projects. PI  I
0
Example
I0 NPV NPV/I0
Project A 100 210 2.1
Project B 50 160 3.2
Project C 50 120 2.4

Capital budget $100M. Investor can invest in 1 Type A or 1 Type B +1 Type C

projects. Best 1 Type B +1 Type C

NPV/I identifies greatest return per $ from the limited budget.

NPV Application – Levelized Cost of Energy (LCOE)

Method of Calculating “Average Cost” for Energy Production

production – Most typically electricity but more generally

Alternative sources of electricity :

1. Conventional sources of generation – coal, nuclear, gas
2. Renewable Resources – wind, solar, biomass

Different economic lifetimes, Some 50+ years; other 20 years.

Costs structures - initial capital cost versus annual operating
Environmental Costs
UK Department of Energy Climate Change

Electricity Generation Costs (December 2013)

www.gov.uk/government/publications/electricity-generation-
costs-december-2013

Used by policy makers

Calculation of subsidy level for new Renewables Technologies
Discussion of targets for cost reduction

Technologies for example include

CCGT (Gas), Coal Plant with 300MW of CCS, Nuclear
Onshore Wind, Offshore Wind, Biomass, Co-firing standard
CHP, Hydropower, Wave, Tidal Stream etc.
 .Source DECC 2013
.See also UK Electricity Generation Costs: Mott MacDonald update (2010)
Available via ww.gov.uk/government/collections/energy-generation-cost-projections
Oil – Extraction Costs vary location & technology

Reuters 2014 - Breakeven oil prices for U.S. shale: analyst

estimates
http://uk.reuters.com/article/2014/10/23/idUKL3N0SH5N220141023

Credit Suisse Estimates – Various Fields

Eagle Ford Liquids Rich - $53
Wolfcamp North Midland - $57
Bakken Core - $61
Niobrara Extension - $64
Eagle Ford Oil - $65
Niobrara Core - $68
Wolfcamp South Midland - $75
Bakken Non Core - $75
Texas Panhandle - $81
Mississippi Lime - - $84
Barnett Combo - $93
“Method”
N
Ct
TLCC  
1) Find Total Lifecycle Costs (NPV) 1  r 
t
t 0

2) Estimate Likely Energy Output Each period yt

3) Calculate LCOE - “Average Cost per unit output”

So that PV of (LCOE x Output) equals Total Lifecycle Costs

N
 LCOE. yt
  TLCC
1  r 
t
t 0

Or TLCC NPV Total Costs

LCOE  
 N yt  NPV Output
 
 t 0 1  r t 
 
Example r=10%
Technology A
Year 0 1 2 3 4 5 NPV
Costs £ 1500 100 100 100 100 100 1879.08
Output MWh 0 8 8 8 8 8 30.33
LCOE £/MWh 61.96
100 100 100 100 100
TLCC  1500       1879.08
1.10 1.10 1.10 1.10 1.10 
1 2 3 4 5

1879.08
LCOE   61.96
 5
8 
 
 t 1 1.10 t 
 
N
 LCOE. yt
  TLCC
1  r 
t
t 0

LCOE *8 LCOE *8 LCOE *8 LCOE *8 LCOE *8

     1879.08
1.10 1.10 1.10 1.10 1.10 
1 2 3 4 5
 Example r=10%
Technology A
Year 0 1 2 3 4 5 NPV
Costs £ 1500 100 100 100 100 100 1879.08
Output MWh 0 8 8 8 8 8 30.33
LCOE £/MWh 61.96

Technology B
Year 0 1 2 3 NPV
Costs £m 500 10 10 10 524.87
Output MWh 0 4 4 4 9.95
LCOE £/MWh 52.76

Allows Comparison of Cost of Electricity Generation across

Technologies

Here “Average Cost” per MWh Cheaper for Technology B

Summary

Time Value of Money

Present Value and the NPV Decision Rule

Other Decision Rules

Levelized Cost of Energy

Next Lecture –cost of capital and risk

.