Economic Principles
Dr. Ali Al Awami
King Fahd University of Petroleum & Minerals, Dhahran, Saudi Arabia
[email protected] References
Electric Power System Planning: Issues,
Algorithms, and Solutions by Hossein Seifi and
Mohammad Sadegh Sepasian, Springer-Verlag
Berlin, 2011
Distributed Power Generation: Planning and
Evaluation by H. Lee Willis and Walter G. Scott,
Marcel Dekker, Inc., 2000
2
Costs
• Cost is the expense incurred in providing the services
during a period.
• It includes money, labor, materials, resources, real
estate, lost opportunity, taxes, permits, etc.
• Usually, the costs of all of the resources are measured
against a common basis – that is, money.
• Each resource is given a tag cost.
• Thus, the planning objective is to minimize the lump
sum of all the costs.
3
Costs
• Giving a price tag to everything is not always viable.
• Some planning aspects are intangible, like aesthetic
impact.
• In such a situation, multi-objective optimization is
considered.
4
Types of Cost
• Initial Cost: What must first be spent to obtain the
facility.
• Continuing costs: The costs required to keep the
facility in operation.
– Includes maintenance, fuel, insurance, power posses, taxes,
etc.
– Periodic
5
Types of Cost
• Fixed Costs: Costs not a function of any variable in the
planning analysis.
– Example: For a generation facility, insurance and preventive
maintenance scheduled, say, every six months, are not a
function of how many MWh’s the facility generates. These
are, therefore, fixed costs.
• Variable Costs: Costs that are a function of some
variable(s).
– Example: Fuel cost, some maintenance jobs, for a generation
facility depend on how many MWh’s the facility generates.
6
Types of Cost
Timing of Expense
Initial Continuing
Variability of Expense One-time “first” Periodic, on-going
Fixed
costs that do not costs that do not
depend on usage depend on usage
pattern pattern
Variable
One-time “first” Periodic, on-going
costs that do costs that do
depend on usage depend on usage
pattern pattern
Figure 5.1 Two characterizations, one based on when costs occur and the
other on how they vary with usage, result in four categories of costs.
From [Willis] 7
Revenues and Profits
• Revenue: The money that a company earns by
providing services in a given period.
• Profit = Revenue – Cost
8
Time Value of Money
• https://smartasset.com/investing/inflation-calculator
• Bretton Woods System
• Fixed exchange rate $35 per ounce gold, US will back
every dollar with gold
• https://www.youtube.com/watch?v=RtFz9q26t5A
9
Time Value of Money
• Cash flow: The flow of money, both the inputs and the
outputs, resulting from a project.
• If we invest an amount X, we expect some percent to
be added at the end of the year.
• That is, X at present is worth more in the future.
• Therefore, money is valued based on time.
• Example: If someone invests $100 on a project with a
5% predicted return, he or she would have $105 at the
end of the year. So, $100 at present is worth $105 a
year from now.
10
Time Value of Money
• For a project, cash flows come in two types:
– Inflows (such as income)
– Outflows (such as costs)
• Both may occur at present or in a specific time in the
future.
• Hence, we are going to define the present worth of
money (PW) and the future worth of money (F).
• The number of periods is assumed to be t.
• The interest rate is assumed to be i %.
11
Time Value of Money
• A value of PW at present would be worth:
F1 = PW + PW*i = PW(1+i) at the end of the 1st year
F2 = F1 + F1*i = F1(1+i) = PW(1+i)2 at the end of the 2nd year
.
.
.
F = Ft-1 + Ft-1*i = PW(1+i)t at the end of the tth year
12
Time Value of Money
• That is, if we have $ F in t-year time, it would worth only F/
(1+i)t at present.
• 1/(1+i)t is called the present worth factor. And is denoted by
(PW/F, i%, t)
• Example: If someone invests $100 on a project with a 5%
predicted return, at the end of the 5th year, he or she would
have $100*(1+0.05)5 = $127.6.
13
Time Value of Money
Cash Flow
F
PW
Value
0 1 2 3 4 5
Time (years)
14
Time Value of Money
Cash flow diagram from example on slide 12.
Cash Flow
F
$127.63
$121.55
$115.76
PW
$105.00 $110.25
$100.00
Value
0 1 2 3 4 5
Time (years)
15
Time Value of Money
• Consider the previous example. What if, instead of
having a single payment at the end of the 5-year period,
a series of yearly payments is performed. How is the
present worth calculated?
From [Seifi] 16
Time Value of Money
• As shown, a present $ PW is paid back in a regular
amount of $ A at the end of each year.
• As a payment of $ A in t-year time is worth A/(1+i)n at
present, we would have
𝑃𝑊=[(1/(1+𝑖)↑1 )𝐴+(1/(1+𝑖)↑2 )𝐴+…+(1/(1+𝑖)↑𝑛 )𝐴]
= [(1/(1+𝑖)↑1 )+(1/(1+𝑖)↑2 )+…+(1/(1+𝑖)↑𝑛 )]𝐴
17
Time Value of Money
𝑥+𝑥↑2 +…+𝑥↑𝑛 =𝑥(1−𝑥↑𝑛 )/1−𝑥
(PW/A, i%, t)
𝑃𝑊=[( 1+𝑖)↑𝑛 −1/𝑖(1+𝑖)↑𝑛 ]𝐴
(A/PW, i%, t)
A=[𝑖(1+𝑖)↑𝑛 /
(1+𝑖)↑𝑛 −1 ]𝑃𝑊 18
Time Value of Money
(F/A, i%, t)
𝐹=[( 1+𝑖)↑𝑛 −1/𝑖 ]𝐴
(A/F, i%, t)
A=[𝑖/(1+𝑖)↑𝑛
−1 ]𝐹
19
Economic Analysis
• Given a number of solutions for a problem, the
planner should select the best, technically and
economically.
• We will quickly cover two methods used for
economical evaluation of a project:
– Present worth method
– Annual cost (or levelized value) method
20
Present Worth Method
• All inflows and outflows are converted to the present
worth value. The plan with the lowest net present
worth (NPW) is selected.
• If the plans have different life spans, an “artificial”
common life span is selected.
21
Present Worth Method
• Example: Consider two plans A and B with the details
shown in the table below. Take a 5% interest rate.
• Also, assume Plan B’s life to be 15 years only while
plan A’s life is 25 years. Which plan is more
economically viable?
15
From [Seifi] 22
Present Worth Method
From [Seifi] 23
Present Worth Method
So, Plan A is cheaper
• NPWA = 1000 + 1000 x (PW/F, 5%, 25) + 1000 x (P/F, 5%, 50)
+ 50 x (P/A, 5%, 75) - 100 x (P/A, 5%, 75)
- 300 x (P/F, 5%, 25) - 300 x (P/F, 5%, 50)
- 300 x (P/F, 5%, 75) = $285.78
• NPWB = 1300 + 1300 x (P/F, 5%, 15) + 1300 x (P/F, 5%, 30)
+ 1300 x (P/F, 5%, 45) + 1300 x (P/F, 5%, 60)
+ 70 x (P/A, 5%, 75) - 150 x (P/A, 5%, 75)
- 500 x (P/F, 5%, 15) - 500 x (P/F, 5%, 300
- 500 x (P/F, 5%, 45) - 500 x (P/F, 5%, 60)
- 500 x (P/F, 5%, 75) = $430.11
24
Annual Cost (Levelized Value) Method
• All inflows and outflows are converted to a series of
uniform annual cash flows. The plan with the lowest
annual cost is selected.
• Example: Repeat the previous example with the
annual cost method.
Again, Plan A is cheaper
• ACA = 1000(A/P, 5%, 25) + 50 - 100 – 300(A/F, 5%,
25) = $14.66/year
• ACB = 1300(A/P, 5%, 25) + 70 - 150 – 500(A/F, 5%,
15) = $22.07/year
25
Annual Cost Method
Advantage
No need for a common life
span for the different plans
26
Present Worth Factor / Discount Rate
• We called 1/(1+i)t the present worth factor. It determines
how much is a future amount worth in today’s money.
• For a given time span t, we assumed that the present
worth factor to be a function of only the interest rate (i).
• In addition to the interest rate (i), utilities use other
factors to identify their present worth factor.
• These factors are all lumped in what is called the
discount rate (d).
• So, the present worth factor is actually 1/(1+d)t
27
How is the Discount Rate
Determined?
• Interest rate
• Inflation
• Earning targets
• Risk
• Planning errors
Note
Different entities set their
discount rates differently! 28
How is the Discount Rate
Determined?
Table 5.1 Discount Rate “Computation” for Two Utilities
Factor IOU Muni
Prevailing interest rate 5.7% 5.1%
Inflation factor - -
Earnings target 5.5% -
Risk 1.5% 3.0%
Planning error 1.0% 1.5%
“We just don’t have funds” - 5.0%
Total discount 13.7% 14.6%
Equivalent PWF 87.9% 87.3%
From [Willis] 29
Decision Bases
• Lowest cost among alternatives
This is what we have had done so far
30
Decision Bases
• Payback period
– The time required for a long-term savings to re-pay the
initial investment.
– It answers the question of “when will I get my money
back?”
– The shorter the payback period, the more desirable the
option is.
– It is often used informally.
31
Decision Bases
• Benefit/Cost Ratio Analysis
– Can be used if the options have both costs and benefits and
there are constraints that impact the selection of the plan.
– Example: A utility considers implementing DSM. Despite the
fact that DSM will cost money, it will bring benefits. If a
certain option has a benefit-cost ratio that is greater than one,
that option is beneficial. If the ratio is less than one, that
option makes a loss.
– Example: A DSM project has a PW cost of $160,000. It will
cause PW savings of $258,600. The benefit-cost ratio of this
project is 258,600/160,000 = 1.62>1 à This project has more
benefits than cost; 62% more.
32
Decision Bases
• Benefit/Cost Ratio Analysis
– Good for comparing alternatives within one project
– Can result in sub-optimal decisions if used to compare options
across project boundaries!
33
Decision Bases
– Example: A utility has two projects to work on. They have 10
options for each project, the first being “do nothing”.
– Options are arranged from least to
most costly.
– Based on least PW cost, option 5 of
project A (or A5) and option 7 of
project B (B7) should be picked.
– Total cost would be $500k+$700k=
$1.2M.
– Now, assume the budget is limited
to $800k!
34
From [Willis]
Decision Bases
– Example: A utility has two projects to work on. They have 10
options for each project, the first being “do nothing”.
– Now, assume the budget is limited
to $800k!
– The utility can say, “we are going to
approve only projects with B/C
ratio of 3.4 or above.
– That would make it good for A5
and B3, cost being $800k.
– B/C = (BA5+BB3)/(CA5+CB3)
= (1715+1005)/(500+300)=3.4
35
From [Willis]
Decision Bases
– Example: A utility has two projects to work on. They have 10
options for each project, the first being “do nothing”.
– Now consider options A4 and B4.
Total cost would still be $800k.
– H o w e v e r, B / C = ( BA4+ BB4) /
( CA4+ CB4) = ( 1 6 0 0 + 1 2 8 0 ) /
(400+400)=3.6
– That is a higher B/C ratio for the
same cost!
– Solution – Use marginal benefit to
cost ratio. See next!
36
From [Willis]
Decision Bases
• Marginal Benefit/Cost Ratio Analysis
– Marginal benefit of option x = (Bx-Bx-1)
– Marginal B/C ratio of option x = (Bx-Bx-1)/(Cx-Cx-1)
– See Table 5.6 on next slide…
37
Decision Bases
• Marginal Cost/Benefit Ratio
Analysis
Rule:
The choices that maximize
the benefits are those obtained
when the marginal B/C ratios
are equal.
• In this case, options A3 and B5.
From [Willis] 38
Decision Bases
• Marginal Cost/Benefit Ratio
Analysis
Rule:
The choices that maximize
the benefits are those obtained
when the marginal B/C ratios
are equal.
• In this case, options A3 and B5.
From [Willis] 39
