Economics of Renewable Energy Systems

1. Economics of Renewable Energy Systems Professor Ian G Bryden University of Edinburgh

2. Important of Cost and Price • Once engineers have established that a renewable energy system works, it is necessary for them to assess how much energy it can produce and what will be the cost of this production. • It has been common in the early evolution of renewable energy as a serious business to neglect serious analysis of costs and to consider that financial analysis is simply a tool put into place by the opponents of renewable energy. • Biased analysis may have been used to present renewable energy as a “pie in the sky” concept but, increasingly, serious analysis can and should be used to determine the future evolution of our energy infrastructure.

3. “Soft” and “Firm” Supply • A renewable source is defined as “hard” if it could, in principle, be used to displace a fossil supply totally. In other words, there was no necessity to maintain a backup supply for when there was no environmental flux. • The source is “soft” if the backup system is considered essential. • Wind power is a soft source because it is necessary to maintain a reliable supply such as diesel generators for use when the wind is not blowing. Similarly wave power, solar power and tidal current power systems are essentially soft in nature.

4. Input Ambient Energy Flux Renewable Energy Conversion System Output electrical energy “Soft” Sources • Even after many decades of electricity generation from renewable sources, experts still disagree on even the most basic aspects of the procedure! • We must establish whether we are dealing with firm or soft sources. • The conversion of energy from an environmental flux can be considered diagrammatically as shown. With a “soft” source it will not be possible to guarantee the electrical output flux from the conversions system, as it is dependent upon the input ambient energy flux, which is outside the control of the operator.

5. Ensuring “Firm” Supply from Soft Sources • If a consumer demands reliable supply on demand, it will be necessary to introduce an element of storage or an alternative supply for use when in the ambient flux is insufficient for a guaranteed supply. This represents an integrated system. We must considered the cost, not just of electricity output from the renewable hardware, but output from the total system. Input Ambient Energy Flux Renewable Energy Firm “Backup“ Conversion System supply Output electrical energy

6. Cost • If I, as an individual, or as a corporate entity, decide to generate electricity for sale, I will have inevitable costs. • These are what I would pay to generate the electricity, which I would then sell. • This can, under some circumstances, be described in terms of p/kWh but, as we proceed, it is possible to identify many pitfalls in this simplistic approach. • Costs generally consist of: • Fuel • Staffing • Maintenance • Capital repayment • Grid connection etc.

7. Price • This is really an entity closely linked to market forces. • Realistically I will sell the electricity for as much as I can get for it, so as to maximise the profits. If I sell at the cost price, I will make no profit. • In addition, it is possible to consider the generation of, say, 1000kWhrs of electricity using wind power and by diesel power. • As a result of the predictability of diesel, consumers might be prepared to pay more for diesel electricity than wind because they know it is reliable. • On the other hand, environmentally sensitive consumers might be willing to pay more for electricity generated from sustainable sources than from fossil sources!

8. Calculating Costs • In principle, this could be done by establishing the capital cost of the necessary hardware(C), estimating the working lifetime (L), the operating costs in one year and electrical energy produced during one year (E). The cost for one unit of energy would be given by: This is a very simplistic approach and is not used in commercial analysis.

9. Other Factors: • We have a time preference for money. • Given a choice, most of us would prefer money now rather than the promise of money tomorrow. • We would need to be offered a pound plus some additional sum of x% next year to forgo the use of a pound today. • If we had the money today we could lend it out and charge interest on it! • Inflation progressively erodes the ability of money to buy goods.

10. Compounded Value Based Upon 10% Interest 300 200 Pound Sterling 100 0 0 5 10 15 Years from Initial Investment Temporal Value of Money • If I invest £100 at 10% interest in a bank, I will be able to settle a bill of £110 in one year! • Similarly, I could pay a bill of £260 in ten years. • We can say that the “present value” of £260 in ten years at an interest rate of 10% is only £100. We must establish a method of discounting for future payments by saying that sums of money in the future can be expressed in terms of smaller amounts today.

11. This concept leads to a method of appraisal known as Discounted Cash Flow (DCF) analysis. This allows us to express a series of bills at various times in the future as a single lump sum in the present. • E.g. consider three bills, £100 today, £110 in one years time and £260 in ten years. As we saw from the graph, the separate Net Present Value (NPV) of each of these bills is £100 and together, the total NPV is £300 (Based upon 10% interest rate!). • The relationship between discount rate and interest rate is very close and it is not uncommon for them to used interchangeably. Strictly speaking discount rate should include an assessment of the risk as well as reflecting bank interest rates.

12. A Note on Inflation • It is important to realise that discounting is not the same as inflation. • It relates rather to the issue of expectation and risk. • Discount rates are quoted exclusive of inflation and refer to a hypothetical zero inflation currency. • Inflation is such that we really should refer to the date at which the currency value is evaluated. • It is not uncommon for large projects to have their costs quoted as, for example, £(1982) or any other particularly relevant year.

13. Methodology • Given a discount rate of r%, then a sum of Vp today, will have a value of: This can be inverted to yield: This is the net present value, today, of a sum of money Vn, n years into the future.

14. Annuitisation • It is likely that we will pay the capital costs over the anticipated lifetime of the system or project. • If we know the capital cost of a renewable energy system then it will be possible to determine an annuity, which is an annual payment over a know number of years to repay the initial capital. • In effect we would establish n equal payments of value A. • The NPV of each of these payments would be given by:

15. The total payment in terms of NPV would be given by: Assuming that there will be N payments, with the first payment at the commencement of the project. This is obviously the sum of a geometric series and is given by: The annual payment is given, therefore by:

16. Annual Cost of Energy • The annuitised capital cost can, therefore, be used to determine the annual cost of energy by combining it with the annual operating cost, O to give an annual generation cost of: The cost per unit of electrical energy produces is given, therefore by:

17. Costs of Generation in a Combined Renewable and Fossil Based System • It is interesting and useful to consider the costs of maintaining a firm backup to a renewable supply. The cost of electricity from a fossil system can be determined in exactly the same way as for a renewable system but with the addition of fuel related costs so that: AF is the annuitised cost for the fossil system, OF is the annual operating cost of the fossil system, FF is the annual fuel cost and EF is the annual energy produced by the fossil system.

18. Renewable Fossil Generation Generation Hardware Hardware Electrical Distribution Grid Consumers • Similarly and using the same notation, the cost per unit for the renewable system can be expressed as: • Consider these combined in an isolated grid: It should be possible to determine the total generating costs

19. If we assume that the total energy demand for the grid in one year is given by ETtot=ER+EF, then the cost of generation of this electricity will be: • (FC is the fuel cost in a combined fossil/renewable system) • If we assume that the operating costs of a fossil fuel plant are independent of the amount of electricity generated then, the difference between the cost of electricity produced in a combined scenario and a fossil only scheme is given by: • (F =FF-FC= Cost of fuel saved by including a renewable generating capacity)

20. It can be seen in this equation that it only becomes economic to include renewable generators into a grid if the cost of the renewable electricity per unit is less than the cost of the fuel saved in the fossil plant. • This depends upon the assumption that operating costs are the same for the fossil plant in both scenarios. • This assumption is generally correct when the proportion of the total energy which renewable systems deliver is a relatively small proportion of the overall energy. • Once the proportion of renewable energy exceeds approximately 10% of the total, this assumption starts to break down as the operating costs of the fossil plant start to vary and, indeed, the operating efficiency of the fossil plant is likely to fall, thus increasing costs.

21. External Costs • The concept of external costs relates to costs, which might not immediately and directly be borne by the producer. • eg costs resulting from: • air pollution (measured in terms of damage to human health, crops and buildings, etc.), • noise pollution (measured in terms of the reduction of property prices in noisy areas), or costs resulting from the risk of major accidents in mines or power stations.

22. External costs may be negative: for example, the security of supply resulting from an energy source being indigenous can be treated as a benefit, with an associated negative cost. • Conversely, it has been suggested that the costs of the 1991 Gulf War constituted an external cost to oil of $23.50 per barrel imported into the USA (House of Commons Select Committee on Energy, 1992). • Some external costs are already to some extent internalised (i.e. incorporated into market prices) by means of taxes or the cost of complying with government regulations. • In the future, other external costs, such as those of' global warming', may be reflected in new taxes, like the proposedEuropean carbon tax, or new regulatory measures.

23. Results of one study of the external costs of the production of electricity from various different technologies in the UK. Units are p/kWhr

24. Comments on External Costing • How can we possibly put a value of the environment? Just what is the value of an individual puffin killed in an oil spill? • Who has the right to say who is right and wrong? • What should or should not be included in the 'real' cost? • Even if everyone could agree on a costing for wind energy, for example, it may be argued that it is not valid to apply the same criteria to tidal energy, and even for a given technology the cost can vary depending on how it is operated within a system • Whenever quoting comparative costs, therefore, all the above factors should be borne in mind, and wherever possible the assumptions behind the costing should be stated in full.