03 Investment in Energy Sector
Václav Šebek
Literature
• Literature:
– Bhattacharyya, S.C., 2011. Energy Economics:
Concepts, Issues, Markets and Governance.
Springer London, London.
– Presentation = Chapter 7
– Compulsory reading = Chapter 21 (will be in test)
NOT LIKE ANY OTHER
Investment in Energy
Investment
• Remember – Economics is about allocation of
scarce resources
• Investment in energy sector is sometime
difficult to decide
– Often heavily capital-intensive
– Specificity – sources cannot be used elsewhere
– Strategic and security consideration
– Regulation and its predictability (subsidies)
– Long run projects (decades)
Energy Sector Specifics
• Essential change in sector structure today
• Yesterday:
– Big national champions
– Central planning, investments, network, production
(nuclear project, or pipeline taking 15y and more
being no political nor economical problem)
– Stability
– Relatively high fixed costs (huge investments),
relatively small variable costs (nuclear, coal)
– Often no care of ecology
Energy Sector Specifics
• Today:
– Liberalization of electricity (and gas) markets
– Regulator or TSO (net operator) and independent
producers
– Electricity traded on Exchange
– Relative decline of big players
– Decentralization
– Lowering fixed costs increasing variable costs
– New technologies (PV…)
– Energy policies based on ecological assumptions
Energy Sector Specifics
• Today’s situation implications:
– Investment more and more decentralized
– Big projects worse to push trough (see nuclear in
Europe)
– Decision-making more market- and marketregulation
dependent (and less strategic)
– Less stability and predictability makes long term
investment riskier
– Big players adapt – acquire small projects
WEIGHING COST AND BENEFITS
Investment in Energy
Investment Evaluation
• Basic concept fairly simple – Cost Benefit
Analysis (CBA)
– Compare costs and benefits and recognize worthy
investments
– Compare with- and without-project situations
• Not that easy…
Financial v Economic analysis
• Financial
– Monetary flows, incomes and expenditures
– Timing (Cash Flow)
• Economic
– Willingness to pay/accept compensation
– Broader image, more variables
– Financial viability not sufficient condition
– Used onward…
Financial v Economic analysis
Criteria Economic Appraisal Financial Appraisal
Cost elements Costs to the economy including
external costs
Only costs relevant for the project
that involve money outgo are
considered
Benefits Economy-wide benefits relevant Only benefits to the owners are
relevant
Valuation Costs and benefits are valued at the
willingness to pay or willingness to
accept compensation reflecting the
opportunity cost of the resource
Valuation at market price is relevant
Coverage Broad Narrow
Viability Financial viability is necessary for
economic
viability but not a sufficient
condition
Considers financial profitability
Source: Bhattacharyya (2008, 175)
Cost Identification in Economic analysis
• Primarily additional costs
– Sunk costs not included
– Contingencies – increasing resources needed only
– Working Capital – the same…
– Transfer Payments
• Taxes, duties, subsidies – might be important part
– Depreciation not included
– Depletion premium
• Cost of using non-renewable resource
– External costs
Cost Identification in Economic analysis
• Costs accounting heavily method dependable
• CASE – Policy decision
– Many studies with same data might bring
completely different results
– Public debate plagued
– Decision-makers confused
– Decision made by chance
Benefits Identification in Econ Analysis
• Direct financial revenues
– Sold electricity
• Other directly induced products
– New dam brings water supply and recreation
• Consumer’ and producer’ surplus
Valuation of Costs and Benefits
• How to compare such a distant values as
amount of electricity sold and damaged
landscape?
• From whose point of view?
– Producer, consumer, state, people…
• Financial terms usually adjusted somehow
BENCHMARKING
Investment in Energy
Indicators without Time Value
• Simple payback period
– Figuring out, when the investment pays back
– Ex.: Buying energy saving lightbulb is more expensive
but electricity consumption is lower. Payback period is
time needed to repay the cost difference
• Average simple Rate of Return
– Ex.: Initial cost $10m, annual profit $1.2m gives 12%
rate of return = 8 y 4 m
• The simplest methods providing rather first
overview and cash profitability only
Indicators with Time Value
• Time discount is a factor
• People have different appreciation of values
now and in the future (money now is better
than money tomorrow)
• Costs and benefits occurring now and then are
of different value
• Used widely in project (investment) evaluation
Net Present Value
• Suppose I’d like to save money and have $2,000
ten years from now
• How much should I spare?
• What’s todays value of $2,000 ten years ahead?
• Depends on interest rate (r)
• If you put the money in a bank and receive 5%
per annum then its present value is $1,227.8
• 1227.8 =
2000
(1+0,05)10 =
𝑡𝑎𝑟𝑔𝑒𝑡 𝑎𝑚𝑜𝑢𝑛𝑡
(1+𝑟) 𝑡 = 𝑃𝑉
Net Present Value
• Project evaluation
– Initial investment 𝐼0
– Annual costs and benefits (revenues) 𝐶𝑡 and 𝐵𝑡
– Discount rate 𝑖
– Project duration 𝑁
𝑁𝑃𝑉 =
(𝐵𝑡 − 𝐶𝑡)
(1 + 𝑖) 𝑡
𝑁
𝑡=1
− 𝐼0
Sum of discounted
profits
NPV Project Evaluation
Year
Benefits
(revenues)
Costs
Profit
(CF)
Discounted
Profit Benefits Costs
1 1 000 700 300 285,7 952,4 666,7
2 1 000 700 300 272,1 907,0 634,9
3 1 000 700 300 259,2 863,8 604,7
4 1 000 700 300 246,8 822,7 575,9
5 1 000 700 300 235,1 783,5 548,5
6 1 000 700 300 223,9 746,2 522,4
7 1 000 700 300 213,2 710,7 497,5
8 1 000 700 300 203,1 676,8 473,8
9 1 000 700 300 193,4 644,6 451,2
10 1 000 700 300 184,2 613,9 429,7
Sum 3 000 2 317 7 722 5 405
• Discount rate = 5%
• Initial Investment =
$2,000
• NPV = $317
• Simple payback method,
investment repaid in 6
and 2/3 y
• NPV investment repaid
9+ y
NPV Setbacks
• Discount rate i set deliberately
– Usually i equals market interest rate r
– Social discount rate may differ
– Benefits identification problem
Internal Rate of Return (IRR)
• Discount rate when NPV = 0
• Better for project benchmarking (comparison)
• Assume two projects
– A with initial cost $10,000 and $12,000 revenue in
first year (IRR = 20%)
– B with $15,000 and $17,700 (IRR = 18%)
• Their profitability depends on discount rate
chosen
Internal Rate of Return (IRR)
• Decreasing NPV can be seen when DR is rising
• B project favorable when DR below 14%
• At 14% both projects indifferent
-1500
-1000
-500
0
500
1000
1500
2000
2500
3000
0% 2% 4% 6% 8% 10% 12% 14% 16% 18% 20% 22% 24%
A
B