Power and Energy Systems Engineering Economics Best Practice Manual

Panos Konstantin
Margarete Konstantin
Power and
Energy Systems
Engineering
Economics
Best Practice Manual
Power and Energy Systems Engineering Economics
Panos Konstantin Margarete Konstantin
•
Power and Energy Systems

Engineering Economics
Best Practice Manual
123
Panos Konstantin Margarete Konstantin
Burgstetten, Baden-Württemberg Burgstetten, Baden-Württemberg
Germany Germany
ISBN 978-3-319-72382-2 ISBN 978-3-319-72383-9 (eBook)

https://doi.org/10.1007/978-3-319-72383-9
Library of Congress Control Number: 2017964241
© Springer International Publishing AG, part of Springer Nature 2018

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Preface
The book’s overall objective is to provide a comprehensive but concise cov-

erage of engineering economics required for techno-economic evaluation of
investments in energy business projects. Throughout the book the emphasis is
on transferring practical know-how rather than pure theoretical knowledge,
avoiding the detail of voluminous reference texts as needed by experts in
specific fields. This is also demonstrated in numerous application examples
and case studies derived from experience of respective projects. These also
are available as softcopies on my website to help practice the contents of the
book. Due to the very close link between engineering and economics and the
concise outline the book is suitable for engineers as well as for economists
and lawyers.
The book is neither a scientific paper nor literature research. In writing this
book I have drawn from my knowledge of over 35 years’ experience as a
consultant in engineering and power economics for energy business projects
worldwide and from numerous training courses I delivered for junior utilities’
staff in several countries.
My aim after my retirement is to make my knowledge and experience
available in practice oriented books. Target audiences of the book are primar-
ily international consultants, staff members of engineering companies, utility
personnel and energy economists and lawyers, as well as employees of gov-
ernment agencies entrusted with regulating the energy and utility sector and
finally, students in related fields of engineering and economics.
I am a non-native English speaker; however, I wrote the book directly in
English because in my opinion, it is the most proper language for the field of
economics among others as most techno-economic terms are available in
English only. I ask native speakers for their understanding for any linguistic
shortcomings.
Comments and recommendations for improvements from readers are high-
ly appreciated and will be thankfully considered in forthcoming editions of
this book.
Burgstetten, Germany, October 2017 Panos Konstantin
V
Acknowledgments
The book mainly reflects the knowledge I have acquired and further devel-
oped from over 35 years’ experience working for Fichtner GmbH & Co.
KG in Stuttgart, Germany as a consultant and trainer for energy business
projects worldwide. I am particularly thankful for their support and the op-
portunity to have access to their technical and human resources during my
employment and beyond.
I am also grateful to many of my Fichtner colleagues as well as friends and
clients for their advice and contribution to the development of this book.
Many thanks are also due to the colleagues of HelpDesk Görlitz GmbH,
Germany for their help in properly formatting the book.
I am grateful to Markus Groissböck, who has developed and maintains my
Website, and to Timo Dimitriades, who designs the covers of my books.
Many thanks to Amy Gooderum, an English teacher in the States, for
proofreading and linguistic revisions of the book’s text, and also for her nu-
merous proposals to make the book’s text better understandable also for read-
ers, who are less familiar with parts of the contents.
Last but not least, I wish to thank Maggie Konstantin, my wife, for her
support in editorial design and a second proofreading of the book’s text and
for her understanding for the long hours and evenings I have been spending
in front of the computer.
All my professional life as a consultant, I wrote hundreds of reports for pro-

jects and attained a certain routine in writing. I have furthermore greatly ben-
efited from the experience in writing my book “Praxisbuch Ener-
giewirtschaft”,1 first published by Springer in 2006 and now available in its
4th edition since January 2017 by SpringerVieweg.
Finally, I like to announce my second book of the series “Best Practice
manual” with the title:
“The Power Supply Industry − Technologies, Economics and Trading”.
1
In English: “Practice Oriented Book on Energy Economy”
VII
Table of Main Chapters
Preface .............................................................................................................V
Acknowledgments ........................................................................................VII
1 Introduction and Scope ............................................................................ 1
2 Financial Mathematics............................................................................. 5
3 Inflation, Interest and Cost of Capital ................................................... 27
4 Investment Appraisal Methods .............................................................. 39
5 Financial and Economic Analysis of Projects ....................................... 65
6 Introduction on Cost Allocation to Cogeneration Products................... 77
7 Project Analysis under Uncertainties .................................................... 83
8 Overview of Energy Markets and Prices ............................................. 109
9 Case Studies ........................................................................................ 133
Bibliography and References ...................................................................... 149
Annexes ....................................................................................................... 153
Glossary ....................................................................................................... 163
Acronyms and Abbreviations ...................................................................... 169
Index ............................................................................................................ 173
IX
Table of Contents
Preface ............................................................................................................. V
Acknowledgments ........................................................................................ VII
1 Introduction and Scope............................................................................ 1
1.1 Brief Outline of the Chapters .......................................................... 1
1.2 Annexes ........................................................................................... 3
1.3 Glossary........................................................................................... 3
2 Financial Mathematics ............................................................................ 5
2.1 Synopsis of the Chapter................................................................... 5
2.2 The Time Value of Money .............................................................. 6
2.2.1 Some Key Definitions of Terms .............................................. 6
2.2.2 The time value of money ......................................................... 6
2.3 Single Payments .............................................................................. 7
2.3.1 Compounding a single payment .............................................. 7
2.3.2 Discounting of a single payment ........................................... 10
2.4 Series of Unequal Payments .......................................................... 11
2.4.1 Compound amount of a series of unequal payments ............. 12
2.4.2 Present value of a series of unequal payments ...................... 12
2.5 Series of Equal Payments .............................................................. 13
2.5.1 The mathematical structure of series of equal payments ....... 13
2.5.2 Compound amount of a series of equal payments ................. 14
2.5.3 Present value of series of equal payments ............................. 17
2.5.4 Annual equivalent amounts of payments (Annuities) ........... 18
2.6 Series of Escalating Payments ....................................................... 21
2.6.1 The present value of a series with escalating payments ........ 21
2.6.2 Levelized values of escalating series of payments ................ 23
3 Inflation, Interest and Cost of Capital ................................................... 27
3.1 Synopsis of the Chapter................................................................. 27
3.2 Inflation & Price Index .................................................................. 27
3.3 Policy Instruments for Controlling Inflation ................................. 28
XI
XII Table of Contents
3.4 Interest Rates and Inflation ............................................................ 29

3.5 Exchange Rate Fluctuations of Currencies.................................... 32
3.6 Interest Rate Formulas................................................................... 34
3.6.1 The nominal interest rate ....................................................... 34
3.6.2 The real interest rate .............................................................. 34
3.6.3 The effective interest rate ...................................................... 35
3.7 Discount rates – Weighted Average Cost of Capital ..................... 36
4 Investment Appraisal Methods .............................................................. 39
4.1 Synopsis of the Chapter ................................................................. 39
4.2 Overview of Investment Appraisal Methods ................................. 40
4.2.1 Overview of appraisal methods ............................................. 40
4.2.2 Definition of the components of the appraisal process.......... 41
4.3 The Net Present Value Method – NPV ......................................... 44
4.3.1 Net present value of an investment........................................ 44
4.3.2 Net Present Costs (NPC) and Levelized Cost (LEC) ............ 45
4.3.3 Calculating LECs of escalating cost series ............................ 49
4.3.4 Dynamic cost based tariff ...................................................... 50
4.4 The Internal Rate of Return Method – IRR ................................... 52
4.4.1 Internal rate of return on investment – IRROI....................... 52
4.4.2 Internal rate of return on equity –– IRROE ........................... 54
4.5 Annual Equivalent Amounts or Annuity Method.......................... 56
4.5.1 The annual equivalent amount of an investment ................... 56
4.5.2 Calculation of levelized cost with the annuity method.......... 59
4.5.3 Application of the method for series with escalation ............ 60
4.6 Payback Time Method................................................................... 62
4.7 Return on Investment (ROI) .......................................................... 63
5 Financial and Economic Analysis of Projects ....................................... 65
5.1 Synopsis of the Chapter ................................................................. 65
5.2 Financial Analysis versus Investment Appraisal ........................... 66
5.3 Financial analysis .......................................................................... 67
Table of Contents XIII
5.3.1 The discounted cashflow model ............................................ 67

5.3.2 Approach for sales revenues and depreciation ...................... 69
5.3.3 Financial performance ratios ................................................. 69
5.4 Economic versus Financial Analysis ............................................. 70
5.4.1 Introduction ........................................................................... 70
5.4.2 Transfer payments ................................................................. 71
5.4.3 Sources of financing and discount rate.................................. 72
5.4.4 Pricing of goods and services ................................................ 72
5.4.5 Externalities ........................................................................... 73
5.4.6 Required skills for conducting economic analysis ................ 73
5.5 Benefit-Cost Analysis of Public Projects ...................................... 74
6 Introduction on Cost Allocation to Cogeneration Products................... 77
6.1 Synopsis of the Chapter................................................................. 77
6.2 The Principle of the Cogeneration Cycle ...................................... 78
6.3 Cost Allocation Methods ............................................................... 79
6.3.1 The residual value method .................................................... 79
6.3.2 The electrical equivalent method........................................... 80
7 Project Analysis under Uncertainties .................................................... 83
7.1 Synopsis ........................................................................................ 83
7.2 of the chapter ................................................................................. 83
7.3 Sensitivity analysis ........................................................................ 84
7.4 Break-even Point Analysis ............................................................ 85
7.4.1 Project Analysis based on Scenarios ..................................... 85
7.4.2 SWOT Analysis..................................................................... 86
7.5 Uncertainty Analysis of Energy Production .................................. 88
7.5.1 The normal distribution ......................................................... 88
7.5.2 Exceedance probability ......................................................... 92
7.6 Risk Analysis and Risk Mitigation................................................ 93
7.6.1 Certainty and uncertainty aspects of electricity business ...... 93
7.6.2 Types of risks and mitigation measures ................................ 95
XIV Table of Contents
7.7 Consideration of Risk Premiums in Discount Rate ....................... 99

7.7.1 Risk Premiums....................................................................... 99
7.7.2 Risk exposure of equity investors and lenders ...................... 99
7.7.3 Estimating risk premiums for different project types .......... 100
7.7.4 Country risks ....................................................................... 102
7.7.5 Hedging country risks with export credit guaranties ........... 102
7.7.6 Officially supported export credits, OECD Arrangement ... 103
7.7.7 Credit ratings ....................................................................... 105
8 Overview of Energy Markets and Prices ............................................. 109
8.1 Synopsis of the Chapter ............................................................... 109
8.2 Definitions of energy terms ......................................................... 110
8.2.1 Forms of energy................................................................... 110
8.2.2 Heating value of fuels .......................................................... 110
8.3 The Wholesale Market of Fuels .................................................. 112
8.3.1 Crude oil .............................................................................. 113
8.3.2 Steam coal ........................................................................... 115
8.3.3 Natural gas ........................................................................... 117
8.3.4 Heating or Calorific price and price relations of fuels ........ 121
8.3.5 End-user fuel prices – domestic fuel transport cost ............. 123
8.3.6 Nuclear fuel ......................................................................... 125
8.4 Conclusions and Recommendations for Fuel Price Forecasts ..... 128
8.4.1 Proposed approach for fuel price escalation ........................ 128
8.4.2 Fuel prices based on opportunity costs ................................ 131
9 Case Studies ........................................................................................ 133
9.1 Synopsis of the Chapter ............................................................... 133
9.2 Basic techno-economic models ................................................... 135
9.2.1 Thermal price of fuels and electricity fuel cost ................... 135
9.2.2 Calculating composite electricity price ............................... 136
9.2.3 Calculating CAPEX including IDC and Reinvestments ..... 136
9.2.4 Levelizing feed-in tariffs ..................................................... 137
Table of Contents XV
9.3 Modelling Energy Balance for Power Generation ...................... 138

9.4 Integrated Models for Electricity Generation Costs .................... 139
9.5 Lifetime Costs Model for Different Load Regimes .................... 143
9.6 Internal Rate of Return and Cashflow Analysis .......................... 145
9.6.1 Internal rate of return model ................................................ 146
9.6.2 Cashflow analysis model ..................................................... 147
Bibliography and References ...................................................................... 149
Annexes ....................................................................................................... 153
Glossary....................................................................................................... 163
Acronyms and Abbreviations ...................................................................... 169
Index ............................................................................................................ 173
List of Tables
Table 2-1: Compound amount of a single payment ........................................ 7
Table 3-1: Consumer Price Indexes of selected countries, OECD [1] .......... 28
Table 3-2: Development of interest rates of central banks and inflation ....... 32
Table 3-3: Comparison of interest rates ........................................................ 35
Table 4-1: Discount rates based on WACC................................................... 47
Table 4-2: Escalation rates in real and in nominal terms .............................. 47
Table 5-1: Main differences between financial and economic analysis ........ 71
Table 7-1: SWOT Matrix example ................................................................ 88
Table 7-2: Overview of possible construction phase risks ............................ 96
Table 7-3: Overview of common operation phase risks ................................ 97
Table 7-4: External risks ............................................................................... 98
Table 7-5: Typical rates and premiums for selected project types .............. 101
Table 7-6: Example premiums for export credits ........................................ 105
Table 7-7: Credit rating classes ................................................................... 106
Table 7-8: Default spreads of government bonds by rating class [23] ........ 107
Table 9-1: WACC for IRR & cash flow models ......................................... 145
Table 9-2: Main inputs for IRR and cashflow models ................................ 145
List of Figures
Figure 2-1: The time value terms .................................................................... 6
Figure 2-2: Future multiple of initial single payment vs. interest and time .... 9
Figure 2-3: Present value of a single payment .............................................. 11
Figure 2-4: PV of a series of equal payments vs. length of the period .......... 18
Figure 3-1: Yields of government bonds and inflation................................. 30
Figure 3-2: Real interest of government bonds ............................................. 31
Figure 3-3: Development of the exchange rate Euro – US$.......................... 33
Figure 3-4: Development of the crude oil prices in real terms 2013 ............. 33
Figure 4-1: Overview of investment appraisal methods ................................ 40
Figure 4-2: Components of an investment appraisal process ........................ 42
Figure 4-3: Components of the NPV appraisal method ................................ 44
Figure 4-4: IRROI – cash inflows and outflows............................................ 52
Figure 4-5: NPV and IRR iteration approach ................................................ 53
Figure 4-6: Payment series and components of the IRROE .......................... 54
Figure 6-1: Cogeneration in a steam Rankine cycle CHP ............................. 78
Figure 6-2: Cogeneration of power and heat in a gas turbine CHP ............... 78
Figure 6-3: Electrical equivalent of extracted steam, approximate values .... 81
Figure 7-1: SWOT statement example for a potential CHP plant project ..... 87
Figure 7-2: Normal distribution of the energy production ............................ 90
Figure 7-3: Standard normal distribution curve ............................................ 90
Figure 7-4: Gauß distribution, Example with µ=50 GWh base yield ........... 91
XVII
XVIII Table of Contents
Figure 7-5: Exceedance probability for different P-values ........................... 93

Figure 7-6: Type of risks referred to the financing resources ....................... 99
Figure 8-1: Crude oil spot prices, OPEC basket annual average price........ 113
Figure 8-2: Cross-border spot prices of imported steam coal, Germany..... 116
Figure 8-3: Average freight rates for coal to ARA terminals ...................... 117
Figure 8-4: Replacement value of natural gas vs. coal as the substitute ..... 118
Figure 8-5: Modelling of replacement values of a market .......................... 119
Figure 8-6: Cross border price of imported natural gas, Germany.............. 121
Figure 8-7: Calorific price of main fuels, cross-border Germany ............... 122
Figure 8-8: Price trends of fuels referring to crude oil price ....................... 122
Figure 8-9: Nuclear fuel production chain for light water reactors ............. 125
Figure 8-10: Prices of nuclear fuel .............................................................. 127
Figure 8-11: Projection of fuel prices with equal escalation rates .............. 129
Figure 8-12: Fuel price projection with constant price difference .............. 130
Figure 8-13: Fuel price projection with constant price ratio to crude oil .... 130
List of Examples
Example 2.1: Future value of a single payment .............................................. 8
Example 2.2: Compounding of a single payment in shorter periods .............. 9
Example 2.3: Present value of a single payment ........................................... 10
Example 2.4: Compounding of a series of unequal payments ...................... 12
Example 2.5: Discounting of a series of unequal payments.......................... 13
Example 2.6: Sum of the numbers of a geometric series .............................. 14
Example 2.7: Future compound amount ....................................................... 15
Example 2.8: Interest during construction .................................................... 16
Example 2.9: Extract of annuity factors (Pv=1) ............................................ 19
Example 2.10: Annuities of a house mortgage loan vs. maturity .................. 20
Example 2.11: Annuities of a mortgage loan vs. interest rate ....................... 20
Example 2.12: Annualized CAPEX of a project ........................................... 20
Example 2.13: Present value of personnel costs incl. escalation................... 22
Example 2.14: Revenues of a solar PV plant, considering degradation ........ 22
Example 2.15: Levelized O&M Costs .......................................................... 24
Example 2.16: Levelized annual costs of personnel ..................................... 24
Example 2.17: Levelized crude oil price ....................................................... 25
Example 3.1: Inflation rate vs. CPI for selected countries ............................ 28
Example 3.2: Effective interest rate .............................................................. 36
Example 3.3: Discount rate on WACC, including corporate tax .................. 37
Example 3.4: Discount rate based on WACC, excluding corporate tax........ 37
Example 4.1: LECs in real terms on year-by-year basis ............................... 48
Example 4.2: LECs in nominal terms on year-by-year basis ........................ 48
Example 4.3: Calculation of the LECs with the Add-In “BWSesc”.............. 49
Table of Contents XIX
Example 4.4: Calculation of the cost based tariff CBT0 ................................ 51

Example 4.5: Calculation of the IRR on investment ..................................... 54
Example 4.6: Calculation of the IRR on equity before tax ........................... 56
Example 4.7: Calculation of the IRR on equity after tax .............................. 56
Example 4.8: Annual returns vs. lifetime ...................................................... 58
Example 4.9: Annuities of options with different lifetimes .......................... 59
Example 4.10: LEC of escalating OPEX with the annuity method............... 61
Example 4.11: Simple and discounted payback time .................................... 63
Example 4.12: ROI ........................................................................................ 64
Example 5.1: Typical structure of DCF model (simplified) .......................... 68
Example 5.2: Financial ratios ........................................................................ 70
Example 5.3: Benefit-cost ratio of a stadium project, simplified .................. 76
Example 6.1: Cost of cogenerated heat, residual value method .................... 80
Example 6.2: Specific cost of heat in a heat-only boiler (fuel cost only)...... 80
Example 6.3: Cost of extracted heat by different pressure levels.................. 82
Example 6.4: Fuel of extracted heat at different pressure levels ................... 82
Example 7.1: Sensitivity cogenerated heat cost ........................................... 84
Example 7.2: Heat cost break-even point - cogen vs. heat only boiler ......... 85
Example 7.3: Scenario analysis of heat generation cost, cogen vs. boiler .... 86
Example 7.4: Probability calculations ........................................................... 92
Example 7.5: Exceedance probability ........................................................... 93
Example 7.6: Country premium for capital market ..................................... 108
Example 7.7: WACC including country risk premium ............................... 108
Example 8.1: Domestic transport cost of coal free power plant .................. 123
Example 8.2: Use of system cost for gas transport...................................... 124
Example 8.3: Heating value and electricity generation of nuclear fuel ....... 126
Example 8.4: Calculation of the nuclear fuel cost ....................................... 126
Example 8.5: Calorific cost of nuclear fuel and fuel cost of electricity ...... 128
Example 8.6: Define escalation rate ............................................................ 131
Example 8.7: Fuel prices based on opportunity cost ................................... 131
1 Introduction and Scope
1.1 Brief Outline of the Chapters
Chapter 1 provides a brief synopsis of the chapters. Throughout the book,

the emphasis is on the transfer of practical know-how rather than pure theo-
retical knowledge. This is also demonstrated in numerous examples and case
studies derived from experience in related projects.
Chapter 2 provides the necessary knowledge in financial mathematics
deemed to be an indispensable prerequisite for the proper application of
methods for appraisal and financial evaluation of investments.
Chapter 3 deals with key financial parameters which are essential for the
evaluation of capital investments in particular: inflation, interest and the cost
of capital. This chapter explains how to properly handle these parameters in
financial evaluations of projects. Financial operations in nominal terms or in
real terms are presented and practiced in examples.
The subject of Chapter 4 is the appraisal of investment projects with re-
gard to their profitability and/or cost effectiveness. Focus is given to the
presentation and application of the methods Net Present Value (NPV), Inter-
nal Rate of Return (IRR) and Annuities.
Chapter 5 deals with project analysis models applied in bankable feasibil-
ity studies namely Financial, Economic and Benefit-Costs analysis. The
methods are often confused with one another; the chapter highlights the dif-
ferent approaches and objectives and addresses different points of view.
Chapter 6 provides an introduction on cost allocation methods for cogen-
eration products heat and electricity.
Chapter 7 discusses methods for project risk assessment and mitigation.
It addresses in particular sensitivity and scenario analysis, SWOT analysis,
probability distribution and exceedance probability. Focus is given to inclu-
sion of project and country risks in the discount rate (WACC).
Chapter 8 focuses on price-setting mechanisms and price development of
the main fuels used for power generation, and also includes different ap-
proaches for the inclusion of price trends and forecasts in project evaluation.
In the final chapter 9 seven case studies, derived from real projects, are
presented, analyzed and discussed.
© Springer International Publishing AG, part of Springer Nature 2018 1

P. Konstantin and M. Konstantin, Power and Energy Systems
Engineering Economics, https://doi.org/10.1007/978-3-319-72383-9_1
2 1 Introduction and Scope
Important notes on the chapters

Examples: All chapters contain numerous practical application exam-
ples. The examples as well as the case studies are intended to practice
the contents of the book only and are not applicable for commercial
use.
Download examples: www.pk-energy-practical-knowhow.com

Almost all examples are developed in MS-Excel® spreadsheets and in-
serted into the text as pictures. We tried to keep them relatively simple;
nevertheless, it is not always easy to retrace the calculation steps be-
cause they often include complex calculation formulas. However, it is
not possible to include these in the examples depicted in the chapters
due to limited space. Readers have the opportunity to download
softcopies of the examples from my website above.
Currencies: The book is written for an international audience in coun-

tries with different currencies. In formulas which are generally appli-
cable, the term “CU” (Currency Unit) is used. In application examples
which are mainly derived from projects, either € (Euro) or US$ are
used, depending on the origin of the projects. The real origin of the
projects, however, is not disclosed.
Unit system: Throughout the book, the Standard International Unit

System is used (based on MKS system: Meter, Kilogram, Second).
This system is based on physics, includes only a few base units, and all
the other units are derived from the base units. The units are easy to
handle in calculations without the need for conversions. In the Europe-
an Union, its use is obligatory for public projects and in most countries
it is the standard unit system.
Heating values: For energy balances, price references etc. the lower
heating values (LHV) are used (also referred to in literature as net calo-
rific values - NCV or inferior heating value - Hi). Worth mentioning is
that natural gas is commonly traded based on its HHV and is to be
converted in LHV for calculations and energy balances.
1 Introduction and Scope 3
1.2 Annexes
Annex 1 provides a brief description of The Standard International Unit

System (metric system) that is used throughout the book. We recommend that
users of the book read this outline for a better understanding of the calcula-
tions in the examples.
Annex 2 includes a conversion table for units and combined unit expres-
sion as US$/MMBTU to US$/GJ, etc.
Annex 3 includes a table with the properties of the main fuels used in
power generation (heating values, CO2 production).
Annex 4 presents a list of the functions and formulas used in the examples
including their syntax and some help for the users.
Annex 5 presents Add-Ins for escalating series of payments developed by
the author.
1.3 Glossary
This glossary contains definitions of techno-economic terms used in this

book and some related terms that are of interest to the readers. The glossary
consists of the following main parts:
• Most frequently used terms, arranged according to their importance
and meaning, not in alphabetical order
• Some costs functions
• Most frequently used operational terms
• Terms in alphabetical order
• Deviations from customary definition of terms
Most of the terms are accompanied by units (e.g. kg/s, kWh/a, $/a, $/kWh) as
it is a standard for engineers.
Please note that the terms are defined as used by the power and energy in-
dustry, and are not generally applicable for other sectors.
Several terms intentionally deviate from the pure economist’s or account-
ant’s terminology whenever we deem this to be appropriate. For example, we
use the term “capital expenditures (CAPEX)” instead of investment costs,
“operation expenses (OPEX)” instead of operation costs, “payment series”
instead of cash flows. Please refer
to glossary item “Deviations from customary definitions” for an explana-
tion of the divergence.
2 Financial Mathematics
2.1 Synopsis of the Chapter
This chapter provides the necessary knowledge in financial mathematics

which is an indispensable prerequisite for the proper application of methods
of appraisal and financial evaluation of investments.
The chapter starts with an introduction regarding the time value of money.
In financial mathematics, values depend not only on their face amount but
also on the time at which they are due. This is because money can earn ac-
cumulated interest during the time it is invested. On the contrary, the basic
operations in classical mathematics do not take into account a time compo-
nent in determining the value of amounts.
The operations associated with the time value of money are compounding
and discounting. Software tools such as MS-Excel® provide some functions
for the calculation of time values; however, users often have only a limited
knowledge of the background of these functions. This may result in their
incorrect application, especially if their use deviates from the standard.
Therefore, the analytic algorithms of these functions are presented in this
chapter and then special focus is given to their proper application.
In the following, the mathematical structure for compounding and dis-
counting of single payments as well as a series of uniform payments, which
are common for financial applications is presented. Beyond this, particular
attention is given to escalating series of payments. For these, specific algo-
rithms and software tools have been developed that allow for the computation
of their present and levelized values. To our knowledge, these are available
neither in literature nor in commercial software tools.
The chapter also includes numerous practical application examples for a
better understanding and strengthening of the presented content.

6 2 Financial Mathematics
2.2 The Time Value of Money
2.2.1 Some Key Definitions of Terms
The primary objective of financial mathematics is to determine the value of

amounts of money occurring during the lifetime of an investment. An invest-
ment is a business activity, like a power plant project. The lifetime of an in-
vestment is the calculative period during which the investment is evaluated;
this is not necessarily identical to the technical lifetime.
The term payment is used for amounts of money which are relevant for the
evaluation of investments. Payments may be cash amounts like revenues or
operating expenses. They may also be non-cash amounts, such as deprecia-
tion or opportunity cost for the use of own land instead of leasing etc. For
more cost definitions see glossary section.
2.2.2 The time value of money
In common mathematics as in arithmetic and algebra, equal amounts also

have the same value. However, in financial mathematics, the value of money
depends on its nominal (or face) value and the due date of the payment. This
is because money can earn accumulated interest during the time it is invested.
An amount of money invested today will be worth more when the initial
payment (principal) and the accumulated interest are due “n” years from
now. On the contrary, a payment of the same amount that is due “n” years
from now is of less worth at the present. Some important terms regarding the
time value of payments are shown in the Figure 2-1:
Figure 2-1: The time value terms

2.3 Single Payments 7
Note: The time value of money is the relationship between its nominal
value and the due date of payment. Payments can be compared, added
or subtracted from each other only if they refer to the same time (e.g.
present values).
The operations in financial mathematics for determining the time value
of money are called compounding and discounting.
2.3 Single Payments
2.3.1 Compounding a single payment
Table 2-1 illustrates the calculation of the future value of a single payment P0
invested at the beginning of the first year with the annual interest rate
i (%/100) including accumulated interest.
Using of the formulas, the algorithm of the future compound amount of a
single payment can be derived. The future compound amount of a single
payment Po invested at the beginning of the first year is mathematically ex-
pressed by the following notation:
n
P0 at the beginning of the year: Pn = P0 ⋅ (1 + i ) = P0 ⋅ q
n
(2.1)
If the payment is made at the end of the year, it does not earn interest in the
first year; therefore the exponent must be “ n-1”.
n −1
P0 at years end: Pn = P0 ⋅ (1 + i ) = P0 ⋅ q n −1 (2.2)
Table 2-1: Compound amount of a single payment

In mathematics, we will say “Pn” is the “nth” term of a geometric sequence

with the first term P0 and the ratio “q”:
Where:
P0 : Initial amount
Pn : Compound amount at the end of the year n
i : Annual interest rate (1/a)
n : Number of years
q = (1+i) : Compound factor
The term q = (1+i)n

is called the compound amount factor of the single payment
Note: Usually the annual interest rate is expressed as percentage per year
(e.g. 10 %/a). In the formula, however, it must be inserted as a digit
(10% = 0.1).
Example 2.1: Future value of a single payment
Find the interest rate at which the future value of a single payment is doubled by the
end of the given period. Note: The calculation is done with formula (2.1) using the
“goal seek” function of MS-Excel (to be found in “data”, “what-if-analysis”, “goal
seek”).
Given:
a) P0 =1000 CU, period 10 a
b) P0 =1000 CU, period 20 a
Results:
a) P10 = 1000 × 1.0718^10 = 2000 CU interest rate 7.18 %/a
b) P20 = 1000 × 1.0353^20 = 2000 CU interest rate 3.53 %/a
Figure 2-2 shows the interest rate as a function of the period during which the
future value of a single payment will rise to 2-fold, 3-fold or 4-fold. This is
helpful for setting adequate escalation rates for cost components (e.g. cost of
personnel or consumables, fuel prices) in investment appraisal of projects.
2.3 Single Payments 9
Figure 2-2: Future multiple of initial single payment vs. interest and time
Compounding for shorter periods
Commonly, the nominal interest rate is given in percent per year (%/a). The
compounding formula for shorter periods is given by the following equations
at the beginning or by the end of the period respectively:
min
 i 
P0 at the period’s beginning Pn = P0 ⋅  1 +  (2.3)
 m
m i ( n −1)
 i 
P0 at the period’s end Pn = P0 ⋅ 1 +  (2.4)
 m
Where:
Pn : Future value of the payment
P0 : Initial value of the payment
m : Number of compounding periods during the year
n : Number of years
Example 2.2: Compounding of a single payment in shorter periods

Given:
a) P0 =1000 CU, years 10 a, compounding periods 1/a, interest rate 7.18 %/a
b) P0 =1000 CU, years 10 a, compounding periods 12/a, interest rate 7.18 %/a
Calculation:
a) P10 / 1 = 1000×(1+.0.718)^10 = 2000 CU
b) P10 / 12 = 1000 × (1+ 0.0718 / 12)^120 = 2046 CU
A shorter compound period gives a higher compound amount of the payment!

2.3.2 Discounting of a single payment
The calculation of the present value of a future payment is called discounting.

The value of a future payment today is called present value (PV). In the for-
mulas (2.1) and (2.2) above, this is the term P0. Again, we have to distinguish
between two cases with regard to the due date of the payment:
The PV of a single payment that is due at the end of the year “n” is given by
the formula:
Pn Pn
Pn at year end: PV = n
= (2.5)
(1 + i ) qn
The PV of a single payment that is due at the beginning of the year “n” is
given by the formula.
Pn Pn
Pn at the beginning of the year: PV = n −1
= (2.6)
(1 + i ) q n −1
Where:
PV : Present value
Pn : Nominal value of a single payment in the year n
i: Discount rate, annual interest rate, (1/a)
n : Number of years
q = (1+i) : Discount factor
Note: The PV of a payment at the beginning of the first year is equal with its
nominal value. The term below is called the present value factor of a single
payment:
1 1
Single payment PV factor n
= (2.7)
q (1 + i )n
Example 2.3: Present value of a single payment

Find the interest rate at which the value of a future payment is halved during the
given period (using goal seek function of MS-Excel, insert any interest rate first and
continue with goal seek).
Given:
c) P10 =1000 CU, due after 10 a
d) P20 =1000 CU, due after 20 a
Result:
PV10 = 1000 / 1.0718^10 = 500 CU interest rate 7.18 %/a
PV20 = 1000 / 1.0353^20 = 500 CU interest rate 3.53 %/a
2.4 Series of Unequal Payments 11
1,000
Present Value of a Single Payment
900
of nominal value 1000 CU
800
Present Value CU
700
600 Discount rate 5%
500
400
300
Discount rate 10%
200
Discount rate 15 %
100
Power Systems Engineering Economics - author's own illustration
0
0 2 4 6 8 10 12 14 16 18 20 22 24 26 28 30
Due year of payment
Figure 2-3: Present value of a single payment

In Figure 2-3, the present value of a future single amount is depicted as a
function of its due year and the discount rate. It becomes evident that the
present value becomes successively lower with the progression of time
and with higher discount rates. This means:
The returns of the first years are of crucial importance for the viability
of an investment while those of later years have a lesser impact.
This is also important for the appraisal of investment options with a different
lifetime. A prolonged lifetime in connection with high discount rates has only
a marginal influence on the net present value of the payment series. Its im-
pact shall be later investigated in a sensitivity analysis.
2.4 Series of Unequal Payments
In investment appraisal, we actually have to deal with series of payments

during the lifetime of an investment. These series are in reality unequal; how-
ever, it is common practice to assume uniform series in most cases. In the
following sections of this chapter, the compounding and discounting of sev-
eral types of series of payments are shown.
2.4.1 Compound amount of a series of unequal payments
The future compound amount of a series with unequal payments is found by

multiplying the time values of each single payment with the corresponding
compound amount factor qt = (1+i)t and subsequently summing up the indi-
vidual future values as shown in Example 2.4.
t =n t =n
FVn = ∑ Pt ⋅ (1 + i )t = ∑ Pt ⋅ q t (2.8)
t =1 t =1
Where:
FVn: Future compound amount of the series of “n” payments
Pt : Single payment due at the time “t”
i: Interest rate (%/a inserted as a digit)
q = (1+i): Compound factor
qt = (1+i)t: Compound amount factor of the year “t”
Example 2.4: Compounding of a series of unequal payments
Item Unit Values

Compounding period - year
Interest rate per period "i" - 10.0%
Compound factor q= 1 + i - 1.10
Timing of payment - beginning of period
Year - 1 2 3 4 5
Compound periods of each payment "t" - 5 4 3 2 1
Nominal values of the payments CU 1,500 2,500 5,000 1,500 2,500
Compound amount factor "q t " - 1.61 1.46 1.33 1.21 1.10
Future values of the payments CU 2,416 3,660 6,655 1,815 2,750
Future value of all payments by the end of 5th year CU 17,296
2.4.2 Present value of a series of unequal payments
The present value of series of “n” unequal payments is found by multiplying

the time values of each individual payment by the corresponding present
value factor 1/qt = 1/(1+i)t and subsequently adding up the present values of
the individual payments, as shown in equation (2.9) and demonstrated in
Example 2.5.
t =n
Pt t =n
Pt
PVn = ∑ t
= ∑ t
(2.9)
t =1 (1 + i ) t =1 q
2.5 Series of Equal Payments 13
The series may contain positive values (income) and negative values (ex-
penses).
MS-Excel function: NPV(Rate%,Value1, Value2,…,ValueN)
The term below is called the present value factor of a single payment at the
time “t”.
1 1
Single payment PV factor: = (2.10)
q (1 + i )t
t
Example 2.5: Discounting of a series of unequal payments
Item Unit Values

Compounding period - year
Interest rate per period "i" - 10.0%
Discount factor q= 1 + i - 1.10
Timing of payment - End of period
Year "t " - 1 2 3 4 5
Nominal values P i CU 1,500 2,500 5,000 -1,500 2,500
Present value factor "1/q t - 0.91 0.83 0.75 0.68 0.62
Present values PV i = P i / q t CU 1,364 2,066 3,757 -1,025 1,552
Nominal value of all payments ΣP i CU 10,000
Present value of all payments ΣPV i CU 7,714
or Excel function: NPV(rate%, value1, value2, ...., valueN) 7,714
2.5 Series of Equal Payments
2.5.1 The mathematical structure of series of equal payments
Payments, e.g. revenues and expenses, during the lifetime of projects, are
usually assumed to be a series of equal amounts of money which occur in
regular time periods.
Regular payments during the lifetime of an investment have the mathemat-
ical form of a geometric series. Each following term of such a series is the
product of the previous one, multiplied by a fixed factor called the common
ratio “r”. The starting value is called the scaling factor “a”. The mathemati-
cal form of a geometric series consisting of “n” terms with the scale factor
“a” and the common ratio “r” as well as the formula of its sum, is shown in
equation (2.11):
n =n
rn −1
0 1 2
S n = a ⋅ r + a ⋅ r + a ⋅ r + ..... + a ⋅ r n −1
= a⋅∑r n −1
= a⋅ (2.11)
n =1 r −1
r is = 1; so the first number of the series becomes a.r0=a (r and a≠ 0).
0
Example 2.6: Sum of the numbers of a geometric series

2 3 4
S5 = 5 + 5 × 3 + 5 × 3 + 5 × 3 + 5 × 3 = 5 + 15 + 45 + 135 + 405
n =5 35 −1
= 5 × ∑ 3n −1 = 5 × = 605
n =1 3−1
Another form of a geometric series where the starting value also includes the
common ratio is shown in equation (2.12).
t =n
r n −1
Sn = a ⋅ r1 + a ⋅ r 2 + .... + a ⋅ r n = a ⋅ ∑ r t = a ⋅ r ⋅ (2.12)
t =1 r −1
Almost all series of payments can be transformed into one of the above math-
ematical forms.
Important Note: For some of the equations given in the following
sections there are functions in MS-Excel and similar software tools.
The names of the formulas for MS Excel are stated hereinafter.
It is to be mentioned however, that Excel assumes payments series to
be cash outflows and assigns to them negative values. If payments se-
ries are cash inflows, they shall have positive values; hence, in front of
the Excel function, we have to put a minus symbol to get positive val-
ues. In costing models, only costs items (cash outflows) are included
and the values are changed to positive values; otherwise all items will
be negative.
2.5.2 Compound amount of a series of equal payments
Compounding a series of equal annual payments due at the beginning of each

year will have the form of a geometric series, as in equation (2.12) with the
common ratio r = q. The exponent of the first term of the series is “1”, as the
first payment will earn interest by the end of the first year.
1
FVn = P0 ⋅ q + P0 ⋅ q 2 + P0 ⋅ q3 + ...... + P0 ⋅ q n
t =n
qn − 1
P0 at the year’s beginning FVn = P0 ⋅ ∑ q = P0 ⋅ q ⋅
t
(2.13)
t =1 q −1
The term below is called the compound amount factor of equal payment se-
ries. It returns the future value of a payment with the time value of 1 CU.
Compound amount factor of equal payments
t =n
t qn −1
fCF = ∑ q = q ⋅ (2.14)
t =1 q −1
If the payments are due at the end of each year, the first payment will not
earn interest in the first year. The series will have the form of a geometric
series as in equation (2.11) with the common ratio r = q and the starting
value P0.q0 = P0.
Series of equal payments at the end of the year:
0
S n = P0 ⋅ q + P0 ⋅ q1 + P0 ⋅ q 2 + ...... + P0 ⋅ q n −1
t =n
qn −1
Payment at the end: FVn = P0 ⋅ ∑ q = P0 ⋅
t −1
(2.15)
t =1 q −1
Where:
P0 : The constant payment each year (CU)
q=1+i: The compound factor (-)
i: Annual interest rate (%/a inserted as a digit)
t: Current year of the compounding period
n: Number of years of the compounding period
MS-Excel function: FV(Rate%,Nper, Pmt, Pv,Type),terms see example below

Example 2.7: Future compound amount
Due date
Item
Begin End
Interest rate 5% /a 5% /a
Number of periods, Nper 20 a 20 a
Constant payments each period, Pmt 1000 1000
Present value of a payment at the periods end, P V 0 0
Due date, Type 1 0
Future compound amount FV 34,719 33,066
MS-Excel function: FV(rate%,Nper, Pmt , Pv, type)
Shorter compounding periods:

If the compounding period is shorter than a year, e.g. quarter or month, the
formulas are as follows:
t =n ⋅ m
qn⋅ m − 1
P0 at the beginning FVn ,m = P0 ⋅ ∑ q t = P0 ⋅ q ⋅ (2.16)
t =1 q −1
t = n⋅m
q n⋅ m − 1
P0 at the end FVn.m = P0 ⋅ ∑ q t −1 = P0 ⋅ (2.17)
t =1 q −1
Where:
P0 : The constant payment each period (CU)
q=1+i/m : The compound amount factor (-)
i: Annual interest rate (%/a inserted as a digit)
m: Number of compounding periods per year
n: Number of years of the compounding period
The function for future values in MS-Excel is “FV”
Example 2.8: Interest during construction

During the construction time of a project, it is assumed that equal payments are made
quarterly. Find the cumulated interest during the 5-year construction time.
Item Unit Values

Given
CAPEX mln US$ 1000
Loan mln US$ 700
Construction time a 5
Equal quarterly payments mln US$/quarter 35
Payment periods - 20
Annual interest rate - 6 %/a
Interest rate per period - 1.5 %/quarter
Results
Compound amount of loan *) mln US$ 821
Interest during construction mln US$ 121
In percent of CAPEX - 12.15%
*) by the end of the construction period calculated with MS-Excel formula FV
2.5.3 Present value of series of equal payments
In engineering economics, it is assumed in most cases that payments during

the lifetime of projects are due at the end of each year. Discounting of series
of equal payments P0, which are due at the end of each year, will have the
form of a geometric series as in equation (2.12) with the common ratio r =
1/q (with q = 1+i). The present value of a series of equal payments at the end
of each year is as follows.
P0 P0 P0 P0
PVn = 1
+ 2
+ 3
+ ...... + n
q q q q
t =n
1 qn − 1
PVn = P0 ⋅ ∑ = P0 ⋅ n (2.18)
qt
t =1 q ⋅ ( q − 1)
The term below is called the present value factor of equal payment series.
This returns the present value of a series of equal payments with the time
value = 1.
t =n
1 qn − 1
Equal payments PV factor : f pv = ∑ = (2.19)
t =1 qt q n ⋅ ( q − 1)
The case of discounting payments due at the beginning of the year is not very
common. For the sake of completeness, the formula is given below:
t = n −1
1 qn − 1
PVn = P0 ⋅ ∑ t = P0 ⋅ n −1 (2.20)
t =1 q q ⋅ ( q − 1)
Note: MS-Excel function “PV(rate%, Nper,Pmt, Pv, type)”; Pv=0
In Figure 2-4, the present value of a series of equal payments as a function of
the discounting period is depicted. It becomes evident from the illustration
that the present value of the series does not significantly increase at the end
of longer discounting periods, especially at high discount rates. The PV of the
series with a discount rate of 10%/a remains almost constant for discounting
periods longer than 30 years.
Present Value of a Series of Equal Payments of 1000 CU/a

20,000
18,000
16,000
Discount rate
14,000 5% /a
Present value CU
12,000 Discount rate

10 % /a
10,000
8,000
6,000
4,000
2,000
0
5 10 15 20 25 30 35 40 45 50
Years
Figure 2-4: PV of a series of equal payments vs. length of the period
2.5.4 Annual equivalent amounts of payments (Annuities)
An amount of money can be converted to equivalent annual constant pay-

ments over a certain period in such a manner that their present value is equal
to the initial amount of money. These equivalent annualized payments are
called annuities.
This means the amount “P0” in the equation for present value (2.18) of a
series of equal payments shall be found, as shown below.
t =n
1 qn − 1
PVn = P0 ⋅ ∑
t =1 q
t
= P0
⋅
q n ⋅ ( q − 1)
The above equation solved for Po gives the following equation for the annual
equivalent amount or annuity:
1 q n ⋅ ( q − 1)
Annuity: PAN = P0 = PVn ⋅ t =n = PVn ⋅ (2.21)
1 qn −1
∑
t =1 q
t
Where:
PAN: The constant equivalent annual payments (annuities)
PVn: The present value of the equivalent annual payments
t: Current year of the period, n: number of years
q = 1+i: The discount factor (for interest rate i≠ 0)
The term “an” below is called the capital recovery factor or annuity factor
and is the inverse of the present value factor (see equation). The annuity fac-
tor returns the annuities of an amount to the PVn = 1.
Annuity factor a n
1 q n ⋅ ( q − 1) 1 (2.22)
= t =n
1
= n
q −1  a 
∑
t =1 q
t
Note: The MS-Excel function for the calculation of annuities’ is:

PMT(rate%, Nper, Pv, type); Pv=amount today, type 0 end 1 beginning of period
Example 2.9: Extract of annuity factors (Pv=1)
Interest Years "n"

rate 1 5 10 15 20 30 40 50
0 %/a 1.0000 0.2000 0.1000 0.0667 0.0500 0.0333 0.0250 0.0200
5 %/a 1.0500 0.2310 0.1295 0.0963 0.0802 0.0651 0.0583 0.0548
10 %/a 1.1000 0.2638 0.1627 0.1315 0.1175 0.1061 0.1023 0.1009
15 %/a 1.1500 0.2983 0.1993 0.1710 0.1598 0.1523 0.1506 0.1501
A typical case of annuities are the installments of a house mortgage loan (see
Example 2.10 and Example 2.11). The present value is the principal at the
time of disbursement of the loan. The installments include the repayment of
the principal plus interest payments. Converting payments into annuities is
also common practice in engineering economics. For instance, the CAPEX of
a project is converted into annual equivalent amounts (annualized CAPEX)
during its lifetime (see Example 2.12).
Example 2.10: Annuities of a house mortgage loan vs. maturity

Maturity years
Item Unit
10 a 20 a 30 a
Principal € 300,000 300,000 300,000
Interest rate %/a 6% 6% 6%
Annuity €/a 40,760 26,155 21,795
Total repayment € 407,604 523,107 653,840
It becomes evident in this example that the annuities become smaller the longer the
maturity of the loan; on the other hand, the total repayment increases due to interest
payments.
Example 2.11: Annuities of a mortgage loan vs. interest rate
Interest rate
Item Unit
6%/a 7%/a 8%/a
Principal € 300,000 300,000 300,000
Maturity period years 20 20 20
Annuity €/a 26,155 28,318 30,556
Total repayment € 523,107 566,358 611,113
The example above shows that even small differences in interest rates have a signifi-
cant impact on the annuities and the total repayment.
Example 2.12: Annualized CAPEX of a project
Discount Project Annuity Annualized

CAPEX
rate life time factor CAPEX
€
- years - €/a
10 0.1531 153,087
1,000,000 8.6 %/a 20 0.1064 106,442
50 0.0874 87,413
The annuities in the examples have been calculated with the Excel function PMT”.
2.6 Series of Escalating Payments 21
2.6 Series of Escalating Payments
2.6.1 The present value of a series with escalating payments
The present value of a series of payments with a constant escalation rate will
have the form:
1 2 3
 p  p  p  p
n t
t =n
p
PVn _ esc = P0 ⋅   + P0 ⋅   + P0 ⋅   + ..... + P0 ⋅   = P0 ⋅ ∑ t
q q q q t =1 q
This is a geometric series with the common ratio p/q (see equation (2.12)). It
is called the geometric gradient series. After some mathematical transfor-
mation, the above equation is:
PVn _ esc
t =n
pt
= P0 ⋅ ∑ t = P0 ⋅
( qn − pn ) ⋅ p
(2.23)
t =1 q ( q − p ) ⋅ qn
This is the form of the equation when there is also escalation in the first year.
If there is no escalation in the first year, the p element in numerator is
omitted and the equation will have the form:
PVn _ esc = P0 ⋅ ∑
t =n
pt
= P ⋅
( qn − p n ) (2.24)
0
t =1 qt ( q − p ) ⋅ qn
Where:
P0 : Constant payment each period before escalation
q=1+i : Discount factor, i : annual interest rate
p = 1+j : Escalation factor, j : escalation rate (may be also <0 !)
n: Number of years of the discounting period
Requirement: q≠p; q≠0; p≠0
If j > 0, the values of the series are increasing; if j < 0, they are decreasing!
The equations presented above allow for the conducting of calculations of

PVs arranged in a simple column, without the need to calculate year-by-year.
Note: Functions for gradient series are not currently known to be
available in MS-Excel. The author developed his own Add-Ins based
on the above formulas, which are used in most of the examples (see al-
so Annex 5). They are available for download as a macro in the exam-
ple section of the author’s website.
Example 2.13: Present value of personnel costs incl. escalation

Calculate the present value of personnel costs “without” as well “with” escalation.
Item Unit Values

Given
Cost of personnel P0 US$ / a 2,500,000
Inflation rate (for info only) - 2.0 %/a
Escalation rate of personnel costs j - 4.0 %/a
Discount rate i - 8.6 %/a
Lifetime of the project n a 20
Results
Personnel costs:
Lifetime cost in current US$, undiscounted US$ 50,000,000
Present value without escalation *) j = 0.0% US$ 23,487,058
Present value with escalation *) j = 4.0% US$ 32,737,690
*) calculated with the Add-In BWSec
Example 2.14: Revenues of a solar PV plant, considering degradation

The revenues of a photovoltaic solar plant are estimated to be 100,000 US$/a, if there
is no degradation during the lifetime.
Calculate the present values of the revenues including and excluding degradation.
Item Unit Value

Given
Revenues, 1st year P0 US$ /a 100,000
Degradation rate / factor -j= 1.00% /a - 1.010
Discount rate / factor i= 8.60% /a - 1.086
Lifetime a 25
Results
PV of revenues excluding degradation j= 0.00% /a US$ 1,014,963
PV of revenues considering degradation -j= 1.00% /a US$ 929,274
*) calculated with the Add-In BWSesc
Note: The difference in revenues if considering and not considering degradation is

relatively small, as revenues of later years have a small impact on the present value
(Figure 2-3).
2.6.2 Levelized values of escalating series of payments
Operating expenses, e.g., for personnel, fuels or consumables etc. are usually
subject to escalation during the lifetime of a project. Investment appraisal
methods require the series of payments to be converted in discounted average
annual or per unit equivalent amounts. This is done by calculating the present
value PV of the series and multiplying the PV by the respective annuity fac-
tor. The term levelized is commonly used for the discounted average value of
a series of payments (e.g. levelized electricity cost CU/a or CU/MWh).
The equations of the present value of a geometric gradient series (2.23)
and the equation for the annuity factor (2.22) are shown below:
PVn _ esc
pt
t =n
= P0 ⋅ ∑ t = P0 ⋅
( qn − p n ) ⋅ p
[CU]
t =1 q ( q − p ) ⋅ qn
1 q n ⋅ ( q − 1) 1 
an = t =n
1
= n
q −1  a 
∑q
t =1
t
By combining the two above equations, we get the equation for the annuities
PAN_esc or levelized cost LC of a geometric gradient series (see also Add-In in
Annex 5):
PAN _ esc = LC = P ⋅
(q n
− pn ) ⋅ p
×
( q − 1)  CU 
(2.25)
0
( q − p) n
q −1  a 
If there is no escalation in the first year, the term “p” in the numerator must
be omitted.
Where:
PAN_esc : Annuity of a series of escalating payments
P0: Constant payment without escalation
q= 1+i : Discount factor, with “i" discount rate (interest rate)
p= 1+j : Escalation factor or geometric gradient, with “j” escalation rate
n: Number of periods (years)
If the annual payments of the series are not constant amounts, their PV is
calculated as the sum of their present values and converted to annual equiva-
lent amounts by multiplying the summarized PV with the annuity factor (see
Example 2.15, Example 2.16 and Example 2.17).
Example 2.15: Levelized O&M Costs

In real operation, the operation and maintenance (O&M) costs of power plants are
different each year. For investment appraisal, however, they are commonly consid-
ered as constant annual expenses calculated with a constant rate referred to the
CAPEX. The example below demonstrates how this rate is derived (Coal fired PP,
600 MW). The rate is based on the discounted average of the O&M costs.
Item Year 1 2 3 4 5 6 7 8 9 10
Nominal values mln US$/a 0.0 5.5 6.5 25.0 11.5 13.0 14.0 35.0 18.0 20.0
PV factor 8.6 %/a 1.0860 1.09 1.18 1.28 1.39 1.51 1.64 1.78 1.93 2.10 2.28
Present values 86.53 mln US$ 0.00 4.66 5.07 17.97 7.61 7.92 7.86 18.09 8.57 8.76
Levelized O&M 13.25 mln US$ /a Discounted average
in percent 1.5% CAPEX CAPEX 900 mln
Example 2.16: Levelized annual costs of personnel

Item Unit Value
Given
Cost of personnel 1st year P0 US$ / (Pers. a) 50,000
Lifetime of the project "n" n a 20
Escalation rate / factor j = 4.000% - 1.040
Discount rate /factor i = 8.60% - 1.086
Results
Costs by the end of lifetime (1+j)^n x P 0 US$ / (Pers. a) 109,556
Levelized cost excl. escalation US$ / a 50,000
Levelized cost incl. escalation "P AN_esc " US$ / a 69,693
*) Calculated with the Add-In function P AN_esc
Example 2.17: Levelized crude oil price
Item Unit Values

Given
Barrel price of crude oil in current US$ US$ / Bb 80
Discount rate i 8.60 %/a
Escalation rate j of crude oil - 4.00 %/a
Period years 20
Inflator "p=1+j" - 1.0400
Discount factor "q=1+q" - 1.086
Results
Price at the end of the period "(1+j)^n×P0 US$ / Bb 175
Levelized price during the lifetime *) US$ / a 112
*) calculated with the Add-In "Anesc" developed from the above formula
Note: See also Chapter 9 Case Studies

3 Inflation, Interest and Cost of Capital
Money may lose value over the course of time due to inflation. Properly in-
vested money can offset inflation and additionally earn and accumulate inter-
est on top of inflation during the lifetime of the investment. Inflation and
interest are linked to each other and determine the cost of borrowed capital.
In addition, returns for equity investors include venture risks premiums. In
this respect, the Weighted Average Costs of Capital (WACC) approach is
introduced. These are key financial parameters for the evaluation of capital
investments. This chapter explains how to properly handle these parameters
in financial evaluations of projects. Financial operations in nominal terms or
in real terms are presented and practiced.
3.2 Inflation & Price Index
Inflation is defined as the overall increase in prices of goods and services; the
price increase over a certain period, usually one year, is the inflation rate. It
is noted that inflation does not refer to the price of a single good or service; it
is rather applied to the weighted average price level of a number of goods
which are compiled in a so-called basket of goods.
The price increases of individual goods within a price basket are usually
different. In this book, we define the price increase of a single good as (price)
escalation and the rate, the escalation rate. This may be higher or lower than
inflation. We distinguish between nominal terms, if the inflation is included
in the rate, and real terms or inflation adjusted, if inflation has been deducted
(see also section 3.6.2). There are also the expressions “escalation on top of
inflation” and “escalation below inflation”.
The price changes of goods and services of a defined basket are collected
and published by National or Regional Bureaus and Agencies of Statistics in
price indexes. A price index gives the weighted average price changes in
percentage points for a certain period (e.g. year, month), referring to the price
level of a reference year for which the index 100 is assigned – Table 3-1.
28 3 Inflation, Interest and Cost of Capital
Table 3-1: Consumer Price Indexes of selected countries, OECD [1]

Time 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014
Australia 74.4 77.7 80 82.2 84.1 86.3 89.4 91.5 95.5 97.2 100 103.3 105.1 107.7 110.4
Germany 85.7 87.4 88.6 89.6 91 92.5 93.9 96.1 98.6 98.9 100 102.1 104.1 105.7 106.7
Japan 102.7 101.9 101 100.7 100.7 100.4 100.7 100.7 102.1 100.7 100 99.7 99.7 100 ..
United Kingdom 81.3 82.3 83.3 84.5 85.6 87.3 89.4 91.5 94.8 96.8 100 104.5 107.4 110.2 111.8
United States 79 81.2 82.5 84.4 86.6 89.6 92.4 95.1 98.7 98.4 100 103.2 105.3 106.8 108.6
G7 83 84.7 85.8 87.3 89.1 91.3 93.5 95.6 98.7 98.6 100 102.6 104.6 106 ..
OECD - Europe 74.4 78.4 82 84.4 86.4 88.4 90.7 93 96.6 97.7 100 103.2 106.2 108.1 ..
OECD - Total 78.2 81 83.2 85.3 87.3 89.5 91.9 94.2 97.7 98.2 100 102.9 105.2 106.9 ..
Non-OECD 52.5 56.1 60.9 69.8 74.4 79.5 82.9 85.9 90.8 95.2 100 106.6 112.4 119.4 126.9
Member
Data extracted on 01 Feb 2015 17:42 UTC (GMT) from OECD.Stat
The most common price indexes are the Consumer Price Index (CPI) and
the Producer Price Index (PPI).
Careful study of Table 3-1 above shows the following: The index of all
countries increases throughout the entire period, with the exception of Japan.
In Japan, the index remains practically constant or declines. This means the
inflation rate is negative. This phenomenon is called deflation and is a bad
sign for the status of a national economy.
Usually statistical bureaus and agencies publish price indexes; the inflation
rate between two different periods is computed from the index as follows:
Example 3.1: Inflation rate vs. CPI for selected countries
• Subtract the index of a former Country 2014 2013 2014 2000
year from the index of this year 110.4 107.7 110.4 74.4
Austria
2.5% 48.4%
• Divide the difference by former 106.7 105.7 106.7 85.7
Germany
year’s index 0.9% 24.5%
108.6 106.8 108.6 79.0
USA
• Format result in percent 1.7% 37.5%
Data taken from Table 3-1
3.3 Policy Instruments for Controlling Inflation
Inflation is a key indicator and a determining factor to stimulate the national

economy. An optimal situation for a national economy is when demand and
supply are in equilibrium. Inflation occurs when the demand of goods and
services exceeds the supply on the marketplace. High inflation is caused by
an oversupply of money in the economy. In general, the inflation rate tends to
grow when the economy is booming, and drops during a recession. The op-
posite of inflation is deflation, which is an overall decline of prices and nega-
tive inflation rates. Persisting deflation creates a spiral of negative impacts on
a national economy and is more difficult to control than inflation.
3.4 Interest Rates and Inflation 29
Governments and central banks have two main policy instruments at their
disposal to keep inflation at an acceptable level and thus stimulating the
economy: monetary policy and fiscal policy.
Monetary policy describes the activities undertaken by a government agen-
cy, typically the central bank of a country, to influence the supply of money
and to maintain price stability. Central banks can be considered the banks of
the commercial banks. They lend money to commercial banks with interest
rates that are usually lower than the commercial interest rates. Commercial
banks lend the borrowed money to their clients at higher interest rates to cov-
er their cost and generate some profit. By varying interest rates, central banks
can influence the supply of money to the economy and stimulate economic
activity and price stability. In this context, they must follow a balanced ap-
proach. By lowering interest rates, supply of money increases, helping to
boost the economy during a recession. On the other hand, an increase in infla-
tion, caused by too high liquidity on the market, must be prevented. In case
of overheated economy and/or high inflationary trends, the opposite approach
should be adopted.
Fiscal policy is the process of stimulating the economy through provision
of taxation incentives, e.g., accelerated instead straight line depreciation for
new investments. Fiscal policy may have some immediate effect on invest-
ments as it can accelerate implementation of projects which are in the pipe-
line.
It is noted that most central banks attempt to keep the inflation rate
close to 2% per year; that is worldwide considered as a benchmark.
New Zealand was the first country that introduced the 2%/a inflation target in
their legislation at the end of 1989, followed by Canada and almost all other
developed economies.
Increased government spending for infrastructure projects is also often
used as an instrument to stimulate an economy to overcome recession.
3.4 Interest Rates and Inflation
Interest is the price of borrowed capital. The interest rate is the amount of
money payable for interest on borrowed capital; it is usually measured in
percent per year (%/a). The borrowed amount is called the principal. The
time over which a loan is repaid is the maturity.
Interest rates of borrowed capital for project activities are usually linked to
inflation. In general, the lender who grants a loan today expects that the
amount repayable (the returns) at maturity of the loan will be:
Returns = borrowed amount + inflation + net return + risk premium
Energy sector projects are long term investments; usually, they are financed
by a combination of investors’ own capital (equity) and bank loans. Banks
usually expect an equity share of about 30% for large energy sector projects.
The expected return on equity and the bank interest rates are crucial for the
project costs and the economic viability of the investment.
The market model of pricing interest rates for bank loans is very complex.
Below, we will discuss only two aspects considered in fixing the interest rate
for investment appraisal: government bonds and risk premiums.
Government bonds: The minimum interest rate of a risk-free investment
must cover the expected inflation and include an acceptable real interest on
top of the inflation. Government bonds used to be considered a risk-free in-
vestment and their yield a benchmark for a minimum interest rate.
In Figure 3-1, the yield of government bonds and the inflation of the con-
sumer goods during the period from 1991 to 2015 are depicted. It becomes
evident that there has been a distinct link between the yields of the bonds and
the inflation throughout the period from 1991 up the start of the financial
crisis in 2008/2009. Afterwards, massive intervention of central banks to
overcome the financial crisis, have distorted the balance of the system.
Figure 3-1: Yields of government bonds and inflation

3.4 Interest Rates and Inflation 31
7.0
Yield nominal Inflation Real interest
Average 1991 - 2010
6.0 5.7 2.4 3.3
5.1 2.1 3.0
5.6 2.3 3.2
5.0 Average 2001 - 2010
4.1 2.1 2.1
Percent per year
3.9 1.8 2.2

4.0 4.7 1.8 2.9
3.0
2.0
1.0
Source of data: Eurostat, Austrian National Bank
0.0
1991
1993
1995
1997
1999
2001
2003
2005
2007
2009
2011
2013
2015
-1.0
Euro area Germany USA
Figure 3-2: Real interest of government bonds
The difference on top of inflation can be interpreted as the expected mini-
mum real interest rate for commercial bank loans. Figure 3-2 shows the de-
velopment of the real interest rates during the same period.
The fluctuations throughout the investigated period are the result of the
state of the global economy and the credit needs of the governments. This
becomes especially apparent in 2009 and 2010. Due to financial crises, the
governments’ credit needs for bail-outs of banks and industries were high and
the rates for government bonds rose for short time. Following the decline of
the economy in 2010, the central banks were forced to supply low-interest
money to the commercial banks in order to boost the economic activity and
thus the rates dropped.
The long term development of the real rates of government bonds, are
essential for setting interest rates for power sector projects. They are
relatively stable for the period before the financial crises as shown in
the embedded box in Figure 3-2. The long term fluctuation margin of
the yields is only about one percentage point.
As already stated, interest rates for borrowed capital for project activities are
linked to inflation. Table 3-2 shows the development of the inflation and
central bank interest rates for selected countries.
Table 3-2: Development of interest rates of central banks and inflation
United Kingdom
South Africa
Euro Area
Australia
Germany
Russia
Turkey
Brazil
China
India
USA
average
CB Interest rates 2007-2008 3.75 3.75 3.13 4.00 6.50 12.50 6.30 5.50 15.38 10.50 11.00
Inflation rates 2007-2008 2.70 2.10 2.60 2.10 3.35 5.18 3.85 7.61 9.20 12.60 8.75
CB Interest rates 2010- 2011 1.38 1.38 0.50 0.25 4.50 10.88 6.06 6.38 6.13 8.25 5.50
Inflation rates 2010- 2011 2.20 1.90 4.25 2.45 3.10 6.21 4.40 9.41 8.43 7.90 4.80
Source of data: Trading economics; www.tradingeconomics.com 1/9/2012
During the stable period of the economy, before the financial crisis of 2008,
interest rates were generally higher than inflation. In emerging economies,
interest rates as well as inflation have been consistantly high. After the finan-
cial crisis of 2008 and the subsequent recession of the economy, central
banks of countries affected by the crisis drastically reduced interest rates
below inflation to stimulate the economy.
3.5 Exchange Rate Fluctuations of Currencies
Besides inflation exchange rates, fluctuation between US$ and local curren-
cies have a crucial impact on commodity prices. US$ is still the leading cur-
rency and most commodities are traded in the international marketplace in
US$. Exchange rate fluctuations directly influence commodity prices, such as
prices of metals and crude oil, in all local markets outside the United States.
As an example, Figure 3-3 depicts the exchange rate fluctuations between
US$ and Euro in the time span between 1990 and 2015. Figure 3-4 shows the
development of crude oil prices in real terms (2013) in US$ and in Euro. For
most of this time, the Euro has been stronger than the dollar and has positive-
ly influenced the price of oil and all other fuels.
3.5 Exchange Rate Fluctuations of Currencies 33
Figure 3-3: Development of the exchange rate Euro – US$
120
Real 2013 Real 2013

100 € /barrel US$ /barrel
exchange
Real price, inflation adjusted
rate adjusted
80
60
40
20

0
1990
1992
1994
1996
1998
2000
2002
2004
2006
2008
2010
2012
2014
Figure 3-4: Development of the crude oil prices in real terms 2013
3.6 Interest Rate Formulas
3.6.1 The nominal interest rate
The nominal interest rate is the rate charged by banks for loans. It is ex-
pressed in percent per year (%/a) and includes inflation. Calculation in nomi-
nal terms means that discounting or compounding of payments is conducted
with the nominal interest rate.
3.6.2 The real interest rate
The interest rate on top of inflation is called the real interest rate. It is calcu-
lated by adjusting or deflating the nominal interest rate. Often this is simply
calculated arithmetically by subtracting the inflation from the nominal inter-
est rate (3.1). However, this calculation is incorrect in terms of financial
mathematics. The correct calculation of the real interest rate is conducted by
discounting the inflation, as shown in formula (3.3) instead of subtracting it:
Arithmetic approximation: ir = in − j (3.1)
1 + in
Real interest factor: qr = 1 + ir = (3.2)
1+ j
1 + in
Real interest rate: ir = −1 (3.3)
1+ j
In the case an investor intends to obtain a certain real interest rate based on
some expected inflation rate the nominal interest rate can be calculated using
the following formula:
Nominal interest rate: in = (1 + ir ) ⋅ (1 + j ) − 1 (3.4)
Where:
in, ir : Nominal, real interest rate (%/100)
j: Inflation rate (%/100)
qn, qr: Nominal, real interest factor
p: Deflator factor 1+j
3.6 Interest Rate Formulas 35
Important Note: Discounting can be done in nominal terms or in real

terms.
Discounting or compounding in nominal terms implies that all the
payment series are subject to inflation, as they include inflation, and
the discounting or compounding must be done with the nominal inter-
est rate.
Discounting or compounding in real terms implies that the payment
series are inflation adjusted (deflated) and the discounting must be
done with the real interest rate.
The PV or the compound amount will be have equal values in both cas-
es, provided that the real interest rate is defined correctly according
equation (3.3)!
As shown in Table 3-3 the arithmetical approximation of the real interest rate
can deviate significantly from the correctly determined real interest rate.
Table 3-3: Comparison of interest rates
Position Value
Inflation rate j 0% 5% 10% 15% 20%
Nominal interest rate n i 5% 10% 15% 20% 25%
Real interest rate i r , discounted 5.00% 4.76% 4.55% 4.35% 4.17%
Real interest rate i r , approximation 5.00% 5.00% 5.00% 5.00% 5.00%
3.6.3 The effective interest rate
Interest rates are commonly expressed in percent per year. This implies, e.g.
yearly compounding of the principal in a bank deposit.
For cases in which compounding happens in shorter periods, the actual in-
terest rate payable will be higher. This will result in a higher annual interest
rate that is called the effective interest rate. It is calculated with the following
formula:
m
 i 
ieff =  1 +  − 1 [ −] (3.5)
 m
Where:
i: Nominal annual interest rate (1/a)
m : Number of periods during a year
Example 3.2: Effective interest rate

Given:
Annual interest rate 8 %/a
Sought:
a) Annual compounding
b) Quarterly compounding
c) Monthly compounding
d) Daily compounding
Results:
a) ieff = (1+ 0.08/1)1- 1= 0.08 ≙ 8 %/ a
b) ieff = (1+ 0.08/4)4 -1= 0.0824 ≙ 8.24%/a
c) ieff = (1+ 0.08/12)12 -1= 0.083 ≙ 8.3 %/a
d) ieff = (1+ 0.08/360)360 -1= 0.08328 ≙ 8.328 %/a
As already mentioned, even small differences in interest rates have a signifi-

cant impact on the repayment of a loan, e.g. on a house mortgage (Example
2.10 and Example 2.11).
3.7 Discount rates – Weighted Average Cost of Capital
Evaluation of investments with regard to their profitability is done based on

their lifetime performance. This requires discounting the income and costs
series during the lifetime of the investments with an appropriate discount
rate. The definition of the discount rate is a very critical issue for the evalua-
tion of financial and economic viability of investments. The discount rate
affects only future returns and cost streams during the lifetime of the projects.
However, a large part of the costs, especially capital expenditures (CAPEX),
incur before the start of the commercial operation and remain unaffected
from the discount rate. Thus a high discount rate will mainly reduce the net
income (returns minus expenses) and will have a negative impact on the pro-
ject’s outcome.
Energy sector investments such as power station projects require high
capital outlays, in the magnitude of millions or even billions of dollars. Fi-
nancing such investments is done with a mixture of investors’ own capital
(equity) and bank loans with different expectations for returns, respectively
interest rates. The composition of the financing is determined by the
Weighted Average Cost of Capital (WACC).
Hence, appropriate discount rates for the evaluation of investments must
be based on the WACC and take into account the shares of the invested capi-
tal and the different expectations for returns.
3.7 Discount rates – Weighted Average Cost of Capital 37
The WACC determines the minimum acceptable discount rate of an in-

vestment project and is also called the hurdle discount rate.
The algorithm for the calculation of the WACC is presented in the following
two examples. They may include (Example 3.3) or exclude corporate tax
(Example 3.4) depending on the applied appraisal method. Furthermore, we
distinguish between WACC on nominal terms and on real terms (after infla-
tion adjustment).
Example 3.3: Discount rate on WACC, including corporate tax
Item Equity Loan
Asset shares 30% 70%

Risk free rate of return / interest 5.0 %/a 5.0 %/a
venture risk premium 6.0 %/a 1.0 %/a
Country risk premium *) 0.0 %/a 0.0 %/a
Expected return after tax 11.0 %/a 6.0 %/a
Corporate tax **) 25% 3.7 %/a 0.0 %/a
Returns before tax, in nominal terms 14.7 %/a 6.0 %/a
WACC n in nominal terms, incl. tax 8.60 %/a
./. expected inflation rate 2.00 %/a
WACC r inflation adjusted, incl. tax 6.47 %/a
*) Country risk premiums depend among other things on the credit rating of the
country. Zero country risk premium referrs to countries with AAA rating
**) Depends on the country's tax legislation and refers to the return on equity
before tax rate).
**) The calculation is conducted:
Tax = return on equity before tax x tax rate /(1 - tax rate)
Example 3.4: Discount rate based on WACC, excluding corporate tax
Item Equity Loan

Venture risk premium 6.0 %/a 1.0 %/a
Country risk premium *) 0.0 %/a 0.0 %/a
Expected returns, net 11.0 %/a 6.0 %/a
WACC n in nominal terms, excl. tax 7.50 %/a
WACC r inflation adjusted 5.39 %/a
*) Country risk premiums depend among other things on the credit rating of the
country. Zero country risk refers to countries with AAA rating
Notes:
An equity rate of 30% is common for a first assessment of power sector pro-
jects. Of course, it also depends on the credit-worthiness of the potential in-
vestors. The WACC as stated above is, strictly speaking, valid for the life-
time of the loan only not for the project’s lifetime.
The returns on equity and bank interest rates, as well as the resulting
WACC, are linked to the inflation rate and must correspond with each other.
This means, we cannot arbitrarily increase or decrease the returns or the in-
terest rates without reference to the inflation rate. The stated inflation rate of
2%/a is a benchmark for almost all developed economies since 1990. For
deflation of the nominal WACC, the equation (3.3) is to be used.
As a rule of thumb, the following can be estimated for studies on pow-

er sector projects:
- A bank interest rate 3 to 4 percentage points on top of inflation
- Return on the equity after tax to be about 2 x the bank interest rate.
Investment appraisal must also consider corporate tax. This is because the
expected returns on equity constitute a profit that is subject to taxation. The
tax rates depend on the country’s tax legislation and are different in various
countries. In most taxation models, only the returns on equity are taxed while
the interest payments on loans are considered as costs and are tax deductible.
Premiums are the extra interest charged in order to take into consideration
any investments risk. There are several types of risks, such as technology
risks, risks of default of the borrower, regional risks, etc. The premiums on
the equity part of the WACC are considerably higher, compared to that on
loans. In WACC we distinguish two different premiums:
• The venture premium is directly related to the type of investment and
shall mainly cover the longevity of the investment, technology risks, per-
formance risks and market risks.
• The country premium shall cover political risks and currency convertibil-
ity risks related to the region or country where the project is located. Es-
timating level or risk premiums for projects and countries are extensively
described in chapter 7, in particular section 7.7.
Generally, commercial banks secure their credit with the investment itself
(some kind of collateral); they may also include a risk premium across their
loans to compensate losses in case of default of any of their borrowers. The
premium may also be the price of a credit default insurance policy (see
7.7.3). Interest rates of loans with a long maturity are usually higher due to
uncertainties in forecasting long term performance of projects.
4 Investment Appraisal Methods
Investment appraisal is the evaluation of investments with regard to their

profitability and/or cost effectiveness. The overall objective is to identify the
attractiveness of the investment from the view point of the investor. The
methods used are the Net Present Value (NPV), Internal Rate of Return (IRR)
and Annuity method. For small scale investments, the payback method and
the return on investment method (ROI) are also applied.
Investment appraisal includes cash items only (cash inflows and cash out-
flows). Non-cash items, such as depreciation, are excluded. This is an im-
portant distinction of investment appraisal versus financial analysis (see 5.3).
The description and understanding of the methods is relatively simple; expe-
rience has shown, however, that problems arise during application, especially
when deciding which method is the right one and how it shall be applied.
A most distinctive aspect of engineering economics versus classical eco-
nomics is the least cost approach. This is because electricity is an indispen-
sable commodity for each national economy. Power sector projects such as
power plants or electrical networks are commonly must-investments. When
the power demand of the economy grows, investments in power infrastruc-
ture must be done. There is only the choice of what type of power plant is the
most appropriate. Hence, instead of maximizing profit, minimizing the cost
of the power supply is the aim. Therefore, the least cost approach is a key
issue in engineering economics.
Following the least cost approach, the focus is given to the cost effective-
ness of a project; consequently, only the cost side of the project is relevant in
investment appraisal. The criterion is, in most cases, the levelized cost over
the lifetime of a project and is commonly calculated in real terms.
All these issues are thoroughly explained in this chapter and supported by
numerous application examples.

40 4 Investment Appraisal Methods
4.2 Overview of Investment Appraisal Methods
For the evaluation of the economic viability of investments, we distinguish in

this book between investment appraisal and financial analysis. The former is
mainly applied in the evaluation of the economic viability and comparison of
options for a certain project by using methods such as net present value, in-
ternal rate of return and annuities. The latter is applied to a more detailed
analysis of the preferred option by using financial models as the discounted
cash flow. Economic analysis may also be applied to the evaluation of pro-
jects from the viewpoint of the national economy and is also briefly ad-
dressed at the end of this chapter.
4.2.1 Overview of appraisal methods
In general, an investment is a business activity during which capital is de-

ployed to generate future returns. Investment appraisal is the process of as-
sessing the viability of investment options. Methods which are applicable for
energy sector investments are shown in Figure 4-1.
A distinction is usually made between discounting methods (dynamic) and
non-discounting methods (static). Investments in the energy supply sector are
long-living; therefore, discounting methods are mainly applied in order to
take into account the time value of payments. Non-discounting methods, in
particular the payback period and ROI, are applied for small scale invest-
ments like energy saving measures in the course of energy audits.
Figure 4-1: Overview of investment appraisal methods

4.2 Overview of Investment Appraisal Methods 41
In a market economy the investor may have several opportunities to invest

his money and will usually prefer the investment that generates the highest
returns with acceptable risks, regardless in which sector of the economy this
is made. Such an investment is subordinated to the principle of profit maxi-
mization.
Investment projects in the energy sector aim to provide essential services
for the population and economy of a country. They are in most cases must
investments. If, for example, electricity demand rises, new power stations are
needed. Their objective is to provide the necessary service with the least cost.
Therefore the principle of the maximization of profit is replaced by the least
cost approach.
Investment appraisal methods in their original form evaluate all payment
series of revenues and expenses during the investment period. The appraisal
of investment options for energy sector projects, however, focuses mainly on
the cost side only (least costs approach); hence, in most cases, only the cost
side of the payments series is considered for appraisal and the models used
are mainly costing models. In the following, both approaches are described.
4.2.2 Definition of the components of the appraisal process
The items which are relevant for investment appraisal processes are shown in
Figure 4-2 and further explained in the text below. The terminology refers to
investments for energy sector projects. Which of these items are to be consid-
ered depends on the method applied for the appraisal.
In general, investment appraisal methods evaluate cash inflows and cash
outflows incurring during the lifetime of a project. Non-cash items such as
depreciation are not the subject of the appraisal. In this respect, it is essential
to distinguish between expenditures, expenses and costs and to understand
which of them are cash in- or outflows. Cash inflows are denoted as positive
values, cash outflows as negative values (see direction of the arrow).
Simply defined, costs are all items which are relevant for taxation or for
the calculation of the per-unit cost of a product. They may be expenses or
other items. Depreciation, for example, is a cost item in the Profit & Loss
Statement, which companies have to submit for tax declaration to the internal
revenue office for each fiscal year. However, depreciation is neither an ex-
pense item nor a cash outflow. The cash outflow occurred initially with the
CAPEX, which is not, however, relevant for taxation. Hence it is not consid-
ered in investment appraisal.
Capital
Equity Expenditures Loan
CAPEX I0 (CU)
Sales Revenues
Rt (CU/a) Operating Expenses
OPEX Et (CU/a)
PROJECT Imputed costs (CU/a)

Other Revenues Lifetime Return on equity
(CU/a) Discount Rate WACC Opportunity costs
PV Reference Time
Investment Appraisal
Power and Energy Systems -
Cash-inflows (+) positive Profitability ?
Engineering Economics
Cash-outflows (-) negative Cost effectiveness ? Author‘s own illustration
Figure 4-2: Components of an investment appraisal process

The present values of all payments series are usually calculated for the start
of the commercial operation of a project (PV reference time) or for the pre-
sent time.
Capital expenditures (CAPEX) are the initial cash outlays for an invest-
ment project. The term investment cost that is often used is actually not cor-
rect. For energy supply sector projects, the CAPEX usually comprises an
equity portion (own capital) and loans (see WACC section 3.7). For large
projects, the CAPEX is due in several installments during the preparation and
the construction phase of the project. Payments due before the start of the
commercial operation must be compounded; the difference between time
values of these payments and their compound amount is called interest dur-
ing construction (see Example 2.8). For projects with longer lifetimes, re-
placement of main components may be necessary. Capital expenditures for
such reinvestments are discounted to the reference discounting year. Often,
the term overnight costs is also used, this is the CAPEX excluding interest
during construction.
Again depreciation is a non-cash item and is ignored in investment ap-
praisal. The cash outflow is considered in the CAPEX. By adding deprecia-
tion, this would be double-counting.
Operating expenses (OPEX) are regular payments – cash outflows – that
incur during the operation of a project. Operating expenses are costs, e.g.
personnel costs, fuel costs, costs for consumables and residues, etc. For in-
vestment appraisal, it is assumed that they occur at the end of each year of
operation.
4.2 Overview of Investment Appraisal Methods 43
Imputed costs may also be included in the investment appraisal, e.g. oppor-
tunity costs for own land for the production site, working capital, etc. The
profit, which is the return on equity, is also considered as imputed cost.
A strict distinction must be made between fixed and variable costs.
Fixed operating costs are not production related, they occur also in times of
low or no production and they include, among others, capital costs, costs for
operating staff and maintenance costs. The latter are usually calculated with a
rate referring to the equipment costs.
Variable operating costs of energy sector projects include, for example,
costs for fuels, consumables and residues. They are directly dependent on
production and occur in direct proportion to the amount of the product.
Sale revenues are the price of the product (in our case energy) multiplied
by the amount of sold product, e.g. kWh of electricity.
Lifetime (economic) of the investment project is the defined period during
which the invested capital, including the appropriate compounded interest
must be recovered. This is the economic lifetime and is usually shorter than
the technical lifetime of the plant.
The investment period is the time during which payments must be consid-
ered during the appraisal process and can be defined as the construction time
plus the (economic) lifetime.
Preferably, we use a discount rate based on the method of the Weighted
Average Costs of Capital (WACC), as presented in section 3.7. The WACC
is the minimum acceptable rate of return, also called the hurdle rate.
The profitability criteria are specific to each of the different appraisal
methods. We distinguish between absolute and relative profitability. The
former is to assess the profitability of a project in general while the latter is
used to find out which of the options is the most favorable. For comparison
of options, the specific levelized electricity cost LEC (in CU/kWh) is often
used as the profitability criterion.
It is to be noted that the profit is considered an inputted cost item in in-
vestment appraisal. This is the return on equity, implicitly considered in the
WACC that is used as the discount rate.
For clarification: If we calculate, for example, the net present value (NPV)
by discounting first with the WACC and afterwards with a discount rate that
includes only the interest rate for the loans, the NPV would be higher in the
second calculation. The positive difference corresponds to the profit.
In the following section of this chapter, the methodology of the different ap-
praisal methods is explained and supported with simple examples for better
understanding.
4.3 The Net Present Value Method – NPV
4.3.1 Net present value of an investment
The Net Present Value is the basic form of all investment appraisal methods
which consider the time value of money by applying discounting and com-
pounding of all payment series during the investment period.
Figure 4-3 shows the items which are to be considered for investment ap-
praisal with the NPV method. Cash inflows are denoted as positive, and cash
outflows as negative values (see direction of the arrows).
Capital Expenditures
CAPEX I0 (CU)
Operating Expenses
Imputed Costs OPEX Et (CU/a)
Et (CU/a)
PROJECT
Sales Revenues Lifetime Other Revenues
Rt (CU/a) Discount Rate (WACC) Rt (CU/a)
PV Reference Time
Net Present Value (CU) Power and Energy Systems -

Cash-inflows (+) positive
NPV > 0 ? Engineering Economics
Cash-outflows (-) negative
Author‘s own illustration
Figure 4-3: Components of the NPV appraisal method
The NPV of an investment is calculated by discounting the time values

of all payments during the lifetime of an investment project and adding
their cumulative present value of the invested capital. This is mathe-
matically expressed with the following equation:
NPV = − I 0 + ∑
t =n
( Rt − Et )
[CU ] (4.1)
t =1 qt
I0 : Capital expenditures present value (CAPEX)
Rt : Time value of sale revenues of the year t
Et : Time value of expenses at the year t (OPEX)
q: Discount factor q = 1 + i
i: Discount rate % / a
n: Lifetime of the investment project in years
t0 : Reference year for discounting (start of commercial operation)
4.3 The Net Present Value Method – NPV 45
The meaning of the NPV is that the invested capital (I0) must be recovered
during the lifetime of the investment, including acceptable compound interest
by appropriate returns (Rt - Et).
Discounting is done with the minimum acceptable rate of return (hurdle
rate). We commonly use the WACC as a discount rate that must be deter-
mined for each individual project separately.
A salvage value at the end of the project’s lifetime is assumed to be zero.
Any future decommissioning costs (e.g. for nuclear PP) are considered a cost
item for accumulating reserves.
The following two profitability criteria must be met for economic via-
bility of an investment:
Absolute profitability: The Net Present Value of an investment option
must be positive or at least zero (NPV≥ 0). Discounting is done with
the minimum acceptable rate of return (WACC = hurdle rate)
Relative profitability: The option with the highest positive NPV is the
most profitable and usually the preferred option, provided that the in-
vestment risk is the same.
Note: The Net Present Values (NPVs) of different options can only be
compared if their lifetime is the same.
A NPV equal to zero means that the returns (sale revenues minus expenses)
recover the invested capital (CAPEX) with the minimum acceptable rate of
return. A NPV higher than zero means that the rate of return is even higher
than the minimum acceptable rate of return.
4.3.2 Net Present Costs (NPC) and Levelized Cost (LEC)
Investment appraisal for energy sector projects is, in most cases, done by
applying a least cost approach. That means, the option with the lowest dis-
counted project’s lifetime cost is sought. For this purpose, only the cost side
of the NPV equation, the net present costs (NPC), is relevant.
t =n
Et
NPC = I o + ∑ [CU ] (4.2)
t =1 qt
With I0=CAPEX as the initial cash outflow and the annual operating expenses
Et=OPEXt , the NPC can be expressed by the following notation.
t =n
OPEX t [CU/a ]
NPC = CAPEX [CU ] + ∑ [CU] (4.3)
t =1 qt [1/a ]
In comparing options for a project, the one with the lowest NPC is the eco-
nomically most favorable. It is noted again that the investor’s profit is con-
sidered in the WACC.
For energy projects, the levelized electricity generation cost per unit of
product (LEC in CU/KWh) is often preferred as the criterion for economic
viability. The levelized electricity cost is the discounted average of the elec-
tricity generation cost over the lifetime.
After introducing the LEC, the NPC can also be expressed as a product of
the LEC and the energy produced We_t during the lifetime of the project.
 kWh 
t =n We _ t  a 
 CU 
NPC = ∑ LEC  kWh  × [CU ] (4.4)
1 
t =1 qt  a 
After equating both NPC expressions and placing the term LEC in front of
the Σ symbol, as it is a constant value, we get the following equation:
We _ t  kWh 
 a  OPEX t  CU 
 a 
t =n t =n
 CU 
LEC  kWh  ⋅∑ × = CAPEX [CU ] + ∑
1 t 1
t =1+ qt  a  t =1 q  
a 
After resolving the equation for LEC, we get the following formula:
t =n
OPEX t
CAPEX + ∑
qt  CU 
LEC = t =1
 kWh  (4.5)
t =n We _ t
∑
t =1 qt
This Levelized Electricity Cost (LEC) is the net present costs NPC
(numerator of the equation) divided by present value of the electricity
generation We over the lifetime (denominator).
The denominator is the present value of the electricity production during the
lifetime. This may lack of understanding as discounting is understood in
terms of money. This is, however, the result of the conversion of the original
equation (4.4) and placing the constant value LEC before the Σ symbol.
In the following two examples, Example 4.1 and Example 4.2 the NPCs and
the LECs for the same power plant project are calculated in real terms and in
nominal terms on a year-by-year basis. The purpose is to demonstrate that the
PVs are the same. The discount rates and escalation rates used are shown in
the tables below:
Table 4-1: Discount rates based on WACC
Item Equity Loan
Expected returns after tax

Venture risks premium 6.0 %/a 1.0 %/a
Country risk premium (depends on country) 0.0 %/a 0.0 %/a
Cost of capital in nominal terms, after tax 11.0 %/a 6.0 %/a
Corporate tax 25% 3.7 %/a 0.0 %/a
Cost of capital in nominal terms, before tax 14.7 %/a 6.0 %/a
WACC n in nominal terms, before tax 8.60 %/a
./. Expected Inflation rate 2.00 %/a
WACC r inflation adjusted 6.47 %/a
Table 4-2: Escalation rates in real and in nominal terms
Item Symbol Real terms (r ) Nominal terms (n)
Inflation rate r 0.00%/a 2.00%/a

OPEX fixed j 1.00%/a 3.02%/a
OPEX variable j 1.50%/a 3.53%/a
Conversion Formula j n =(1+j r )×(1+r)-1
Note: The PVs in Example 4.1 and in Example 4.2 are equal. The LEC in
nominal terms however in Example 4.2 is higher. This is because the PV of
the electricity production (denominator) is discounted with the higher
nominal discount rate and so it becomes smaller. In other words, the LEC in
nominal terms includes the assumed inflation rate.
Hence, it is highly recommended to always calculate LECs in real
terms and current currency units (CU) in order to have comparable
LECs!
Example 4.1: LECs in real terms on year-by-year basis

Calculation in real terms *) Year
Item Unit Rates 0 1 2 ............ 9 10

CAPEX (Steam PP 700 MW, gross ) mln € - 1,240 0 0 ................ 0 0
Electricity generation, net GWh /a - 4,860 4,860 4,860 ................ 4,860 4,860
OPEX
OPEX, fixed, real terms *) mln € / a 1.00% esc /a 27.3 27.6 27.8 ................ 29.9 30.2
OPEX, variable, real terms *) mln € / a 1.50% esc /a 153.2 155.5 157.8 ................ 175.2 177.8
OPEX, fixed discounted **) mln € / a 6.47%/a 25.9 24.6 ................ 17.0 16.1
OPEX, variable, discounted **) mln € / a 6.47%/a 146.0 139.2 ................ 99.6 95.0
Present values
Electricity generation, discounted GWh 6.47%/a 34,986
t =n
OPEX t
CAPEX mln € - 1,240 CAPEX + ∑
OPEX, fixed, discounted mln € - t =1 qt
207 LEC = t =n
Wel _ t
OPEX, variable, discounted mln € - 1,189 ∑
t =1 qt
Total PV mln € - 2,636
LEC, in real terms € / MWh
-
75.33
Note: the spreadsheet is linked to the spreadsheets: WACC_incl._tax and Ex. 4.1_LEC_NPV_short
*) inflation adjusted 0.0 %/a ** ) Discount rate in real terms, from file WACC_incl_tax
Example 4.2: LECs in nominal terms on year-by-year basis

Calculation in nominal terms *) Year
Item Unit Rates 0 1 2 ............ 9 10

CAPEX (Steam PP 700 MW, gross) mln € - 1,240 0 0 ................ 0 0
Electricity generation GWh /a - 4,860 4,860 4,860 ................ 4,860 4,860
OPEX
OPEX, fixed, nominal **) mln € / a 3.02% esc /a 27.3 28.1 29.0 ................ 35.7 36.8
OPEX, variable, nominal **) mln € / a 3.53% esc /a 153.2 158.6 164.2 ................ 209.3 216.7
OPEX, fixed, discounted mln € / a 8.60%/a 25.9 24.6 ................ 17.0 16.1
OPEX, variable, discounted mln € / a 8.60%/a 146.0 139.2 ................ 99.6 95.0
Present values
t =n
Electricity generation, discounted GWh 8.60%/a 31,747 OPEX t
CAPEX + ∑
CAPEX mln € - 1,240
t =1 qt
OPEX, fixed, discounted mln € 8.60%/a
LEC = t =n
207 Wel _ t
OPEX, variable, discounted mln € - 1,189 ∑t =1 qt
Total PV mln € - 2,636
LEC, nominal € / MWh - 83.02
Note: the spreadsheet is linked to the spreadsheets: WACC_incl._tax and Ex. 4.1_LEC_NPV_short
*) including Inflation 2.0 %/a
** ) Discount rate in real terms, from file WACC_incl_tax
t**) The escalation rates on nominal terms are calculated from the real escalation rates and the inflation rate
Note: The complete calculation is available for download in the authors

Website. See also case studies Exercise 9.4-1 and Exercise 9.4-2.
4.3.3 Calculating LECs of escalating cost series
In Example 4.1 and Example 4.2, the present values and the LECs are calcu-
lated on a year-by-year basis.
In the case of constant annual values of the series (O&M cost and electrici-
ty production), a calculation year-by-year is not necessary. The PVs can be
calculated in single columns with the NPV function of MS-Excel.
In the above examples, however, the payment series for OPEX are not
constant amounts because they are subject to escalation. In section 2.6.1, we
developed the Add-In “BWSesc” that calculates the PV of escalating series.
By using these functions we can calculate the PVs in columns. A year-by-
year calculation is not necessary; this approach requires much less numerical
computation efforts and appears far more transparent. This is demonstrated in
the following example.
Example 4.3: Calculation of the LECs with the Add-In “BWSesc”
In this example the NPCs are calculated with the developed Add-Ins based on the
formulas for series with escalation, presented in section 2.6.1.
In real In nominal
Item Unit
terms terms
Electricity generation, net We GWh /a 4,860 4,860
CAPEX (steam PP 700 MW gross) mln € 1,240 1,240
Rates
Inflation rate j inf % /a 0.00% 2.00%
Discount rate (WACC) ir; in % /a 6.47% 8.60%
OPEX
OPEX, first year, fixed mln € / a 27.3 27.3
Escalation rate **) jr; jn % /a 1.00% 3.02%
OPEX, first year, variable mln € / a 153.2 153.2
Escalation rate *) jr; jn % /a 1.50% 3.53%
Present values
Electricity generation *) PV (W e ) GWh 34,986 31,747
CAPEX (steam PP 700 MW gross) mln € 1,240 1,240
OPEX, fixed, discounted ***) 10 a mln € 207 207
OPEX, variable, discounted ***) 10 a mln € 1,189 1,189
Net present cost NPC, total mln € 2,636 2,636
LEC (= NPC / PV (W e )) € / MWh 75.33 83.02
Note: the spreadsheet is linked to the spreadsheet WACC_incl._tax
*) Calculated with Excel function PV **) j n =(1+j r ) x (1+j inf ) -1 in percent format
***) Calculated with Add-In: BWSesc
Note: The results are exactly the same as in the year-by-year calculation in Example
4.1 and Example 4.2. The year-by-year calculation provides the same result; it is
not more accurate!
4.3.4 Dynamic cost based tariff
The LEC is a constant value for given cost series of a project. In contrast, a
Cost Based Tariff (CBT0) is calculated in current dollars for the first year of
operation and is subject to escalation during the project’s lifetime.
The CBT0 can be easily calculated with a slight transformation of the LEC
formula. We just replace the term “LEC” with term “CBT0 × pt “ in the for-
mula:
t=n Wel _ t  kWh 

 a  OPEX t  CU 
t =n
 CU 
× = CAPEX [ CU ] + ∑  a 
LEC  kWh  ⋅ ∑ 1 t 1
t =1+ qt  a  t =1 q  
a 
t=n Wel _ t  kWh 

 a  OPEX t  CU 
t =n
CBT0 × p  CU 
× = CAPEX [CU ] + ∑  a 
t
 kWh  ⋅ ∑ 1 t 1
t =1+ qt  a  t =1 q  
a 
So we get the formula for the cost based tariff for the starting year in current
currency values:
t =n
OPEX t
CAPEX + ∑
qt  CU 
CBT0 = t =1
t  kWh  (4.6)
t =n
 p
∑ Wel _ t ×  
t =1 q
Where:
p = 1+j: Escalation factor – j : escalation rate %/100 per year
q = 1+i : Discount factor– i : discount rate %/100 per year
Important Note: In contrast to the LEC, the cost based tariff CBT0 for
the starting year has the same value for calculation in nominal terms as
in real terms. The discount rate and escalation rates must be, of course,
in nominal or in real terms respectively.
In the following example, the cost based tariff for the same power plant as in
Example 4.1, Example 4.2 and Example 4.3 is calculated. We distinguish
between a capacity and a volume tariff.
Example 4.4: Calculation of the cost based tariff CBT0
In real In nominal
Item Unit
terms terms
Power plant
Electrical output, gross P gross MW 700 700
Electrical output, net P net MW 648 648
Full load hours t h/a 7,500 7,500
Electricity generation, net We GWh /a 4,860 4,860
Lifetime a 10 10
CAPEX mln € 1,240 1,240
Rates
Inflation rate j inf % /a 0.00% 2.00%
Discount rate (WACC) ir; in % /a 6.47% 8.60%
OPEX
OPEX, first year, fixed mln € / a 27.3 27.3
Escalation rate **) jr; jn % /a 1.00% 3.02%
OPEX, first year, variable mln € / a 153.2 153.2
Escalation rate *) jr; jn % /a 1.50% 3.53%
Present values
Power ***) PV (P net ) MW 4,904 4,904
Electricity production ***) PV (W e ) GWh 34,986 34,986
CAPEX mln € 1,240 1,240
OPEX, fixed, discounted ***) mln € 207 207
OPEX, variable, discounted ***) mln € 1,189 1,189
st
Tariff, for the 1 year of the period
Capacity tariff € /kWa 295.0 295.0
Volume tariff € / MWh 33.98 33.98
Composite tariff € / MWh 73.31 73.31
Note: the spreadsheet is linked to the spreadsheet WACC_incl._tax
*) Calculated with Excel function PV **) j n =(1+j r ) x (1+j inf ) -1 in percent format
***) calculated with Add-In: BWSesc
4.4 The Internal Rate of Return Method – IRR
The Internal Rate of Return (IRR) method is a special form of the NPV meth-
od. The IRR is the discount rate at which the NPV becomes zero. The IRR is
the appraisal method that banks and equity investors usually prefer. There are
two different forms of the method:
• IRR on investment (IRROI)
• IRR on equity (IRROE)
The former refers to the entire invested CAPEX, the latter, to the equity share
of the CAPEX.
4.4.1 Internal rate of return on investment – IRROI
The relevant payments series and components associated with the IRR on
investment are shown in the figure below.
CAPEX I0 (CU)
Sales Revenues Operating Expenses
Rt (CU/a) OPEX Et (CU/a)
PROJECT
Lifetime
WACC
PV Reference Time
Power and Energy Systems -

Cash-inflows (+) positive IRROI = Engineering Economics
Cash-outflows (-) negative Discount Rate for NPV = 0 Author‘s own illustration
IRROI ≥ WACC
Figure 4-4: IRROI – cash inflows and outflows

The IRROI focuses on the entire invested capital for a project. The calcula-
tion does not distinguish between equity and debt. The following equation
gives the IRR on the investment, the sought-after term is IRROI:
NPV = − I 0 + ∑
t=n
( Rt − Et ) = − I t =n
( Rt − Et )
t 0 +∑ t
=0 (4.7)
t =1 q t =1 (1 + IRROI )
4.4 The Internal Rate of Return Method – IRR 53
Where:
I 0 : Capital expenditures, present value
Rt : Sales revenues of the year t
Et : Expenses of the year t (OPEX)
q : Discount factor q = 1 + IRROI
The equation (4.7) can be resolved with the Newton iteration algorithm as
illustrated below. This is done by inserting an assumed IRR in the equation
until the NPV becomes zero. Each calculation attempt brings the result closer
to NPV=0. This was the common approach before the computer and PC era.
Figure 4-5: NPV and IRR iteration approach

Nowadays, the iteration can be easily done with the goal seek function of
MS-Excel by calculating first with any interest rate and seeking the rate at
which the NPV becomes zero.
Furthermore, MS-Excel provides two functions for a direct calculation of
the internal rate of return (see also description in the help on the function in
MS-Excel), syntax:
• IRR(values, [guess])
• MIRR(values, finance-rate, reinvest-rate)
The former returns the IRR for a series of cash in- and outflows that occur in
regular periods- [Guess] a number to be inserted close to actual IRR.
The latter returns the IRR considering both the cost of the investment and the
interest received on reinvestment of the cash. If the finance and reinvest rates
are assumed to be equal, the IRR is the same with both functions. The func-
tion is useful if the reinvestment rate is higher or lower compared to the fi-
nance rate.
Before starting with the calculations, the hurdle discount rate shall be de-
termined based on the WACC, as shown in Example 3.4 and Table 4-1.
The profitability criteria are as follows:

Absolute profitability: IRROI ≥ hurdle rate (WAAC).
Relative profitability: The option with the highest positive IRR is the
preferred option provided that the investment risk is the same
Example 4.5: Calculation of the IRR on investment

Item year 0 1 2 3 4 5
CAPEX -1,000,000
Payment series
Revenues esc 2.5 %/a 294,886 302,258 309,815 317,560 325,499
Expenses esc 3.5 %/a -50,000 -51,750 -53,561 -55,436 -57,376
Total in- & outflows *) IRROI=8.7 %/a -1,000,000 244,886 250,508 256,253 262,124 268,123
*) Excel function: IRR (mark series of values, guess 10%)
The WACC is 8.6%/a (Table 4-1), hence the investment is profitable.
4.4.2 Internal rate of return on equity –– IRROE
The IRR on equity considers that the invested capital is financed by different
shares of equity and loans. The relevant cash series and components associat-
ed with the IRR on equity are shown in the figure below.
CAPEX I0 (CU)
Loan L (CU/a) Operating Expenses
OPEX Et (CU/a)
Sales Revenues Loan Repayment
Rt (CU/a) RLt (CU/a)
Interest on Loans
PROJECT Ilt (CU/a)
Lifetime
WACC Corporate Tax *)
PV Reference Time CTt (CU/a)
*) Included as a cash series
for IRROE after tax
IRROE =
Discount Rate for NPV = 0
Cash-inflows (+) positive Power and Energy Systems -
Cash-outflows (-) negative Engineering Economics
IRROE ≥ Return on Equity
Author‘s own illustration
as in WACC
Figure 4-6: Payment series and components of the IRROE

4.4 The Internal Rate of Return Method – IRR 55
IRROE is essentially the actual profitability criterion for the investor. There
are two versions of the method: IRR before tax implies that the corporate tax
is not included as a payment series – equation (4.8); in contrast, after tax
implies that corporate (CT) tax is included as a payment series − equation
(4.9).
Before tax NPV = − I 0 + L + ∑

t =n
( Rt − Et − RLt − ILt ) = 0 (4.8)
t
t =1 (1 + IRROE )
t =n
( Rt − Et − RLt − ILt − CTt ) = 0
After tax: NPV = − I 0 + L + ∑
t =1 (1 + IRROE )
t
(4.9)
Where:
I 0 : CAPEX
L : Loan
R : Revenues
E : Operating expenses
RL: Loan repayments
IL: Interest payments on loans
CT : Corporate tax payments (if calculated after tax)
n : Lifetime
t : Year during lifetime
IRROE: Internal rate of return on equity
The profitability criteria are as follows:

Absolute profitability: IRROI ≥ returns on equity in WAAC. This is
the return on equity including any project and country risks premiums.
Relative profitability: The option with the highest positive IRROI is
the preferred option, provided that the investment risk is the same.
The calculation of both IRROE, before and after tax, is demonstrated in Ex-
ample 4.6 and Example 4.7 below using the Excel function IRR.
Note: See also Chapter 9, Case Studies, Exercise 9.6-1 and Exercise 9.6-2.
Example 4.6: Calculation of the IRR on equity before tax

Item Year 0 1 2 3 4 5
CAPEX -1,000,000
Loan 70% 700,000
Outstanding principal (for calculation of interest) 560,000 420,000 280,000 140,000 0
Payment series
Revenues esc 2.5 %/a 294,886 302,258 309,815 317,560 325,499
Expenses esc 3.5 %/a -50,000 -51,750 -53,561 -55,436 -57,376
Interest on loan 6.0 %/a -42,000 -33,600 -25,200 -16,800 -8,400
Loan repayment 5a -140,000 -140,000 -140,000 -140,000 -140,000
Total in- & outflows *) IRROE=14.0 %/a -300,000 62,886 76,908 91,053 105,324 119,723
The expected return on equity before tax in Table 4-1 Example 3.4 is 14.7%, hence
the investment does not fully meet the investor’s profitability requirement.
Example 4.7: Calculation of the IRR on equity after tax

Item Year 0 1 2 3 4 5
CAPEX -1,000,000
Depreciation (for calculation of corporate tax only) -200,000 -200,000 -200,000 -200,000 -200,000
Loan 70% 700,000
Outstanding principal (for calculation of interest only) 560,000 420,000 280,000 140,000 0
Payment series
Revenues esc 2.5 %/a 294,886 302,258 309,815 317,560 325,499
Expenses esc 3.5 %/a -50,000 -51,750 -53,561 -55,436 -57,376
Interest on loan 6.0 %/a -42,000 -33,600 -25,200 -16,800 -8,400
Corporate tax 25.0 % -722 -4,227 -7,763 -11,331 -14,931
Loan repayment 5a -140,000 -140,000 -140,000 -140,000 -140,000
Total in- & outflows *) IRROE=11.0 %/a -300,000 62,165 72,681 83,290 93,993 104,792
The expected return on equity before tax in Table 4-1 is also 11%/a, hence the in-
vestment just meets the investor’s profitability requirement.
4.5 Annual Equivalent Amounts or Annuity Method
4.5.1 The annual equivalent amount of an investment
The annual equivalent amount method requires that the discounted annual
returns (Rt-Et) during the lifetime of a project are added to the capital expend-
itures (-I0) and their sum is multiplied by the annuity factor. The result is the
annual equivalent amount ANU (or annuity) of the investment.
4.5 Annual Equivalent Amounts or Annuity Method 57
 t =n
(R − E )  CU 
An = an ⋅  − I 0 + ∑ t t t  = an ⋅ NPV  a  (4.10)
 t =1 q 
The term within the brackets is the net present value (NPV) of the investment.
The factor “an” is the capital recovery factor or annuity factor. It returns the
annuity of an initial payment of the value 1.
1 q n ⋅ ( q − 1) 1
Annuity factor: an = t = n = n  a  (4.11)
1 q −1
∑q
t =1
t
Where:
An: Equivalent annual amount or Annuity (CU/a)
an: Annuity factor (1/a)
I0: Capital expenditures
Rt - Re: Revenues minus Expenses of the year t
n: Lifetime (a)
q=1+i: Discount factor, i interest rate %/100
Annuities can also be calculated with MS-Excel function PTM.

Syntax: PMT (Rate%, Nper, Pv, Fv, Type)
Where:
PMT: The constant annual equivalent amounts or annuities
Rate: Interest rate in % per period
Nper: Number of periods, usually years
Pv: Present value of CAPEX (for value 1 PMT returns the annuity factor “an”)
Fv: Future value also called salvage value, in our examples it is zero
Type: For payments at the end of the period zero (0), at the beginning on (1)
Profitability criteria for economic viability of an investment:

Absolute profitability: The annuity of an investment must be positive
or at least zero (ANU ≥ 0). The discount rate in the equations of the an-
nuity must be equal to the WACC.
Relative profitability: The option with the highest positive annuity is
the most profitable as the annuity of the returns (Rt - Re) exceeds the
annualized capital expenditures.
Important Note: A distinct advantage of the annual equivalent amount
method is that investments with different lifetimes can be compared based on
their annuities. In contrast, the NPV method requires that the lifetimes must
be equal (or salvage value must be considered for the investment with the
longer lifetime). An estimate of salvage value for energy sector projects after
a lifetime of 20 to 50 years does not seem to be realistic. The annuity method
does not ignore the different lifetimes of the options; it simply removes the
difference from the comparison. This is explained below:
In practical application of investment appraisal, the annual returns (Et-At)
are taken to be constant amounts during the lifetime of the investment and
can be taken out of the parenthesis. Equation (4.10) becomes:
t =n
1  CU 
An = an (− I 0 ) + ( Rt − Et ) ⋅ an ⋅ ∑  a  (4.12)
t =1 qt
1
The annuity factor an = t =n
inserted in the equation above, we get:
1
∑
t =1 q
t
t =n
1 1
An = an ⋅ (− I 0 ) + ( Rt − Et ) ⋅ t =n ⋅∑
1 qt
∑q
t =1
t
t =1
Finally we get the equation:

An = an ⋅ ( − I 0 ) + ( Rt − Et ) (4.13)
The lifetime is applied for annualizing the investment expenditures only that
is a constant value, while it is not required for the annual returns.
Example 4.8: Annual returns vs. lifetime
Item Present Annuity
Unit
Formula value an x NPV
Interest rate - 6.50% 6.50%
Annual returns (R-E) € /a 1,000 1,000
Lifetime:
10 a - 7189 € 1,000 €/a
20 a - 11019 € 1,000 €/a
30 a - 13059 € 1,000 €/a
Commonly, the annual revenues and expenses are assumed to be constant

over the lifetime of a project. If the annual payment series are not constant
amounts, their cumulative present value must first be calculated and multi-
plied by the annuity factor to get levelized cash flows. It is also evident that
the annuity of the project is equal to the annualized NPV of the project, see
equation (4.10).
The reason becomes evident in following example.
Example 4.9: Annuities of options with different lifetimes

In the example, three options are being evaluated. The lifetime of “option 1” is
4 years and that of “option 2” is 12 years including reinvestments in the 5th and 9th
years in order to obtain equal lifetimes for both options.
The annuities of the first two options are the same in both calculations; hence the
calculation with reinvestments to achieve an equal lifetime to the second option was
not necessary.
In “option 3” the capital expenditures are the sum of the initial capital expendi-
tures and of the reinvestments, while the lifetime is 12 years.
The annuities are equal in all of the three options. It is proven therewith that in-
vestments with different lifetimes can be compared based on their annuities.
st
Options 1: Single Investment in 1 year only, life time 4 years discount rate i = 6.0%
Item Unit 0 1 2 3 4 5 6 7 8 9 10 11 12
ΣP i CU 100.00 100.00 0 0 0
ΣPV0 CU 100.00
Annuity CU / a 27.23 Excel Function PMT(Interest rate; life time ;PV CAPEX; 0;1)
st th th
Option 2 as above: Investments 1 , 5 and 9 year, total life time 12 years discount rate i = 6.0%
ΣP i CU 300.00 100.00 0 0 0 100 0 0 0 100 0 0 0
ΣPV0 CU 241.95 100.00 79.21 62.74
Option 3: Single Investment, life time 12 years discount rate i = 6.0%

ΣP i CU 241.95 241.95
ΣPV0 CU 241.95 241.95 0 0 0 0 0 0 0 0 0 0 0
Note: All investments at the beginning of the respective year
ΣP i : V alues at current cost level (CU year 0), (1st, 5th, 9th year)
ΣPV 0 : Present values of investments P i referred to the time "0" PVo =PVi /(1+i)^(t-1)
4.5.2 Calculation of levelized cost with the annuity method
The comparison of options for energy sector projects is commonly conducted

based on the levelized energy generation cost – LEC. The annuity is the pre-
ferred method for this application; it is the most transparent, requires far less
effort in calculation compared to the NPV method and allows for conducting
sensitivity analysis for different technical economic parameters.
In general, the equation for the calculation of the LEC requires that the annui-
ties of the costs are divided by the annuity of the energy production over the
lifetime.
t =n
 CU  OPEX t  CU 
an ⋅ CAPEX   + an ⋅ ∑  
a qt a  CU 
LEC = t =1
 MWh  (4.14)
t =n We _ t  MWh 
an ⋅ ∑  
qt  a 
t =1
Where:
an; Annuity factor (1/a)
CAPEX: Capital expenditures (CU)
OPEX: Operating expenses in the year t (CU/a)
We t: Electricity production in the year t (MWh)
If the electricity production is assumed to be constant over the lifetime of the

project, as it is commonly the case, the term in the denominator is simply We
as the annuity factor is inverse of the PV factor of the series as shown below:
t =n We _(t ) 1 t =n
1  MWh 
an ⋅ ∑ t
= t =n
⋅ We ⋅ ∑ = We  a 
q 1 qt
t =1
∑q
t =1
t
t =1
The equation for the LEC for a constant energy production over the lifetime
is:
t =n
OPEX t  CU 
an ⋅ CAPEX  CU  + an ⋅ ∑  
a qt a  CU  (4.15)
LEC =  MWh 
t =1
 MWh 
We  
 a 
4.5.3 Application of the method for series with escalation
In practice, the payment series of a project are simply assumed to remain

constant over the lifetime of an investment. This is especially the case when
calculating the LEC with the annuity method; several items of the OPEX of
the starting year of operation are used for the entire lifetime. With this ap-
proach, escalation of payments is not considered. This is one of the reasons
that the PV method, which requires significantly higher computing effort, is
preferred by economists instead of the annuity method.
In order to avoid this alleged disadvantage, the annuity method has been
further developed in this book by introducing in section 2.6.2 a formula for
levelizing escalating payment series. Furthermore, we have developed the
Add In “ANesc” that calculates annuities of escalating series of payment. In
the following example, the calculation of the LEC of a project with an esca-
lating OPEX series is shown. This is done in real terms (inflation adjusted
and escalation rates on top of inflation) as well as in nominal terms (includ-
ing inflation):
Example 4.10: LEC of escalating OPEX with the annuity method
In Example 4.1, Example 4.2 and Example 4.3, the LEC have been calculated
with the NPV method. In the following examples, the LEC of the same project are
calculated with the annuity method. The OPEX is broken down in its fixed part (cost
of personnel, maintenance, etc.) as well as in a variable part mainly consisting of fuel
costs. Their escalation rates are different.
in in
Item Unit real nominal
terms terms
Techno / economic constraints
Rated power output, net (700 MW gross) MW 648 648
Electricity generation, net 7500 h/a GWh / a 4,860 4,860
Lifetime a 10 10
Discount rate %/a 6.47% 8.60%
Inflation %/a 0.00% 2.00%
Escalation rate OPEX, fixed %/a 1.00% 3.02%
Escalation rate OPEX, variable %/a 1.50% 3.53%
CAPEX mln € 1,240 1,240
OPEX at operation start (beginning of 1st year)
OPEX, fixed (personnel, maintenance, etc) mln € / a 27.3 27.3
OPEX, variable (fuel, consumables) mln € / a 153.2 153.2
Annual costs
Annualized CAPEX mln € / a 172.3 189.8
OPEX, fixed *) (Add-In ANesc) mln € / a 28.7 31.6
OPEX, variable (incl. fuel) *) (Add-In ANesc) mln € / a 165.2 182.0
Total mln € / a 366.1 403.5
Specific costs
Capacity cost (fixed costs) € / (kW a) 310.11 341.75
Energy cost € / MWh 33.98 37.45
Composite cost LEC € / MWh 75.33 83.02
*) levelized including escalation
The LECs are equal to those calculated with the NPV method in the examples men-
tioned above. It becomes evident that we get the same results with far less effort in
calculation and better transparency.
If the annual energy production varies over the lifetime, its present value
must be calculated first and levelized afterwards with the annuity factor ac-
cording to equation (4.14).
Note: See also Case Studies Chapter 9, Exercise 9.4-1and Exercise 9.4-2.
Important Note: It is to be emphasized again that LEC should always

be calculated in real terms in order to be comparable.
The value of the LEC calculated in nominal terms depends on the as-
sumed inflation rate. Different inflation rates deliver different values
for the LEC that are not comparable.
4.6 Payback Time Method
The payback time is the time during which the cumulative cash flows become
equal with the invested capital.
The method is mainly used in energy audits to evaluate the economic via-
bility of cost-saving measures. The annual cash flows are thereby the cost
savings versus a base case. The method can be applied in two different ways.
Simple payback does not use discounting; the payback time is found by di-
viding the estimated additional capital expenditures ∆I0 by the estimated
average cost savings per year ∆E, compared with the base case option:
∆I 0 CU 
Payback time: t pb =  CU 
[a ] (4.16)
∆E  
a 
Discounted payback: The payback time is found when the cumulative PV of

the discounted cost savings equals the invested additional capital compared to
the base case option.
t =t pb
∆Et
−∆I 0 + ∑ t
=0 (4.17)
t =1 q pb
The equation can be solved with the goal seek function of MS-Excel. The
discounted payback time is longer than the simple payback time.
Commonly, the simple payback is applied. Depending on the sector, com-
pany managements expect quite short payback times for costs saving
measures typically in the range of 3 to 5 years.
As energy saving measures are commonly financed by own capital, the
expected returns on equity are correspondingly high and the discounted pay-
back becomes longer. Presenting discounted payback to decision makers can
even be counterproductive, as the expected payback times in their heads are
commonly based on simple payback.
4.7 Return on Investment (ROI) 63
Example 4.11: Simple and discounted payback time

Comparison of the payback times of a high efficiency motor vs. a standard motor.
High
Standard
Item Unit efficiency
motor
motor
Technical parameters
Rated capacity kW 1,500 1,500
Full load operating hours h/a 7,000 7,000
Efficiency - 92.1% 95.3%
Electricity consumption MWh /a 11,404 11,018
CAPEX US$ 750,000 835,000
Electricity price US$ / MWh 55.00 55.00
Discount rate - 15.0%
Annual costs US$ / a 627,229 605,981
Incremental CAPEX: - ∆I o US$ 85,000
Cost saving: ∆E t US$ / a 21,248
Simple Payback a 4.0
Discounted payback t pb *) a 6.6
t = t pb
∆Et
−∆I 0 + ∑q
t =1
t pb
=0
*) Discounted payback calculated with the goal seek function of MS Excel
4.7 Return on Investment (ROI)
Return on investment (ROI) is just the inverse of the payback time. Manage-
ment of companies may prefer the Return on Investment method instead of
payback.
The ROI is found by dividing the average annual cost savings by the in-
cremental capital expenditures compared to a base case.
∆Et CU /a  %

ROI = × 100   (4.18)
∆I 0 CU a
The preferred application is, again, the simple ROI method for small scale
investments for energy and cost-saving measures.
Example 4.12: ROI

The ROI is calculated for the previous Example 4.11.
High
Standard
Item Unit efficiency
motor
motor
Technical parameters
Rated capacity kW 1,500 1,500
Full load operating hours h/a 7,000 7,000
Efficiency - 92.1% 95.3%
Electricity consumption MWh /a 11,404 11,018
CAPEX US$ 750,000 835,000
Electricity price US$ / MWh 55.00 55.00
Annual costs US$ / a 627,229 605,981
Incremental CAPEX: - ∆I o US$ 85,000
Cost saving: ∆E t US$ / a 21,248
ROI - 25%
5 Financial and Economic Analysis of Projects
The primary objective of the investment appraisal methods presented in chap-

ter 4 is to assess the profitability and cost-effectiveness of potential invest-
ment projects. After a favorable project has been identified, a financial analy-
sis applying a cashflow model has to follow. The primary objective of finan-
cial analysis is to demonstrate that the cashflow is positive and sufficient to
repay the loans and deliver the expected returns (dividends) for the investors.
Cashflow is defined as the net income (revenues minus expenses) plus depre-
ciation.
Financial analysis is mainly conducted with cashflow models on a year-by-
year basis. Cashflow models are actually projections of Profit and Loss
Statements. They also include non-cash items such as depreciation and must
be conducted in nominal terms including expected inflation. It is emphasized
that cashflow models are not more accurate compared to appraisal methods;
they focus, however, on a broader range of objectives. An important objec-
tive of financial analysis is to determine the financial performance ratios re-
quired for bankable feasibility studies of projects.
There is often some confusion between financial analysis and economic
analysis of projects. The financial analysis studies the performance of a pro-
ject from the point of view of the investors and lenders. Economic analysis
aims at identifying economic, social and environmental benefits from the
perspective of the national economy.
Public projects such as schools, sport complexes, swimming pools etc. are
evaluated with cost-benefit models. The approach is similar to the economic
analysis with the difference that it is not referred to the entire economy of a
country. Its objective is instead to assess monetary intangible aspects for the
society of a community or a region.

66 5 Financial and Economic Analysis of Projects
5.2 Financial Analysis versus Investment Appraisal
For the evaluation of the economic viability of investments, we distinguish in

this book between investment appraisal and financial analysis. The invest-
ment appraisal methods have been presented in chapter 4. For projects with a
longer lifetime the NPV, the IRR and the annuity method are commonly used.
The primary objective of investment appraisal is to assess the absolute and
relative profitability of potential investment projects.
After verification of the profitability of a potential project based on in-
vestment appraisal a financial analysis is needed to identify its corresponding
financial returns and performance ratios required for bankable projects. This
includes among others, cashflow projections, sensitivity analysis and risk
assessment. The primary objective of financial analysis is to demonstrate if
the cashflow (revenues minus costs – see definition in section 5.3.1) is posi-
tive and sufficient for repayment of loans and pay off expected returns for the
equity investors (dividends). This is mainly conducted with cashflow models
on a year-by-year basis.
There are distinctive differences between investment appraisal and finan-
cial analysis, the most important of which are outlined below:
• Investment appraisal requires cash items only; these are inflows and
outflows of money, such as capital expenditures (CAPEX), operating
expenses (OPEX) etc. Depreciation is a non-cash item. It would be
double counting if both CAPEX and depreciation were considered
• Cashflow models also explicitly include non-cash items as deprecia-
tion (instead of CAPEX)
• Investment appraisal is preferably conducted in real terms and not
necessarily on a year-by-year basis. It can also be conducted with
costing models without consideration for revenue streams
• Cashflow models must be done in nominal terms including inflation
and on a year-by-year basis in order to reflect the actual revenue and
costs streams. For instance, revenues and expenses are increasing due
to the inflation; depreciation or repayments on loans are constant se-
ries of payments.
It is to be emphasized that cashflow models are not more accurate compared

to appraisal methods; they focus, however, on a broader range of objectives.
5.3 Financial analysis 67
5.3 Financial analysis
5.3.1 The discounted cashflow model
Discounted Cashflow (DCF) models are originally used for the assessment of
the value of a company or a project. This is based on the philosophy that this
value is equal to the expected future net incomes discounted back to a present
value with an appropriate discount rate.
The DCF analysis is actually a projection of profit and loss (P&L) state-
ments over the lifetime of the investment. The P&L statement gives all pay-
ment series on how the project incurs its revenues and expenses through its
operating activities and shows the profit or loss and the cashflow incurred
over a specific accounting period, typically over a fiscal year.
Project developers use cashflow models in order to ensure creditors and
investors that the project will generate sufficient cashflows to repay loans and
to obtain adequate returns on the equity investors’ capital. In this respect a
discounting is not imperative.
The cashflow is calculated by adding depreciation, a cost item but not a
cash outflow, to the net income after interest payments and taxes, as follows.
Sales revenues
Minus operating expenses
Minus depreciation
Minus interest on loans
= Net income before taxes
Minus corporate tax
=Net income after tax
Plus depreciation
= Cashflow
Minus principal repayment (loan)
= Free cashflow
We use the term cashflow as defined above throughout this book.
The cashflow shall be sufficient for the repayment of the loans, provision of
dividends for the investors and for financial reserves to cover future capital
expenditures, e.g. for general overhauls, for decommissioning etc. Further-
more the IRR and financial performance parameters required by banks, such
as the debt service coverage ratio, are calculated with cashflow models.
Investment appraisal with methods as presented in chapter 4 is commonly
conducted in real terms excluding inflation. In contrast, cashflow analysis
must be done in nominal terms including inflation. This is because a main
purpose of cashflow analysis is to demonstrate if the repayment of the loan is
secured and if the investors can earn sufficient returns. While revenues and
costs are subject to inflation, the series for principal repayment are constant
installments in nominal terms (not inflated). Hence, inflation gradually in-
creases the cashflow over time and has a positive impact on the repayment of
the loans and will deliver higher returns.
Cashflow analysis is conducted with payment series and discount rate
in nominal terms including inflation.
Example 5.1: Typical structure of DCF model (simplified)
The typical structure of a DCF model is presented in the example below. The short
project lifetime of 5 years is for demonstration purposes only (see also detailed cash-
flow model in chapter 9, Case Studies, Error! Reference source not found.).
Item Rates Projection over life time €

Shares of capital 1,000,000 €
Equity 30% 300,000 €
Loan (outstanding debt, by year's end) 700,000 € 560,000 420,000 280,000 140,000 0
Project life time 5a
Year
Profit and Loss Statement 0 1 2 3 4 5
Revenues (Gross income) 5 %/a 226,552 237,879 262,262 303,601 369,029 470,985
- Operating expenses (OPEX) -52,500 -55,125 -57,881 -60,775 -63,814
= Operating income (EBITDA) 185,379 207,137 245,720 308,253 407,170
- Depreciation 20% -200,000 -200,000 -200,000 -200,000 -200,000
- Interest on loans 6% -42,000 -33,600 -25,200 -16,800 -8,400
= Net operating income before taxes (EBT) -56,621 -26,463 20,520 91,453 198,770
- Corporate tax 25% 0 0 -5,130 -22,863 -49,693
= Net operating income after tax -56,621 -26,463 15,390 68,590 149,078
+ Depreciation 200,000 200,000 200,000 200,000 200,000
= Cashflow (CF) 143,379 173,537 215,390 268,590 349,078
- Principal repayment of loan 20 %/a -140,000 -140,000 -140,000 -140,000 -140,000
= Free cashflow 3,379 33,537 75,390 128,590 209,078
Discounted cashflow (DCF) *) 1.0750 334,773 3,143 29,020 60,686 96,288 145,635
*) 'Note: Discount rate WACC excluding corporate tax
The results of Example 5.1 can be summarized as follows: The net income in the
first two years is negative; therefore, there is no corporate tax. In spite of a negative
net income after tax, the cashflow is positive and sufficient for the repayment of the
loan over the entire lifetime.
Important note: The discount rate must be in nominal terms based on

the WACC excluding corporate tax; corporate tax is included in the
calculation as a payment series!
5.3 Financial analysis 69
5.3.2 Approach for sales revenues and depreciation
Revenues: The annual revenues are calculated with the selling price (tariff)
per kWh, multiplied by the annual net energy production. The selling price is,
however, subject to supply and demand on the market and is actually fore-
cast. Commonly, the expected selling revenues are based on the cost base
tariff (CBT) presented in section 4.3.4. The CBT corresponds to the tariff of
the first year of operation in current dollars and is subject to inflation in the
following years.
Straight-line depreciation over the project’s lifetime is the most common
practice in cashflow analysis for projects of the energy supply sector. The
annual amount of depreciation is computed by dividing the initial capital
expenditures by the number of years of its estimated lifetime. Other deprecia-
tion methods such as the declining balance method and the sum-of-the-years'-
digits method are applied in exceptional cases only.
5.3.3 Financial performance ratios
Financial performance ratios refer to the ability of the company or the project
to pay its debt with available cash from its operating activity. In the cashflow
projections, the following financial performance ratios are also calculated.
The definitions of the most common ratios are stated below [2] [3]
Debt service coverage ratio (DSCR): The DSCR is defined as the cashflow
available for debt service for any given debt service year, divided by the re-
spective amount of debt service of the respective year. This is calculated in
cashflow projections with following formula.
operating revenues - operating expenses

DSCR =
principal repayment + interest
The DSCR must be higher than one; if not, it means the cashflow is not
sufficient to repay the debt of the respective year. Typical is a value
>1.2.
The loan life coverage ratio (LLCR) is defined as the net present value of
cashflow available for debt service divided by the outstanding debt in the
period. This is calculated in cashflow projections with following formula
NPV (operating revenues - operating expenses) over loan life

LLCR =
outstanding debt
An LLCR of two (2) means that the discounted cashflow available is double
the amount of the outstanding debt balance. A specific value for LLCR may
be preset in a loan agreement contract by the lender in order to assess if the
borrower will be capable of making the required interest and principle re-
payment over the lifetime of the loan.
The project life coverage ratio (PLCR) is defined as the net present value of
the project’s cash available for debt service over the remaining full lifetime
of the project to the outstanding debt balance in the period. This ratio is simi-
lar to LLCR, however, the cashflow for the PLCR is calculated over the “pro-
ject life” instead of the “loan life”. This is calculated in cashflow projections
with the following formula.
NPV (operating revenues - operating expenses) over the project´s life

PLCR =
outstanding debt
Example 5.2: Financial ratios

The financial performance ratios of the cashflow presented in Example 5.1 are calcu-
lated and shown below. The LLCR and PLCR have the same values because loan life
and project life are equal in the example (see also cashflow model in case studies,
Error! Reference source not found.)
Year Unit 0 1 2 3 4 5
outstanding debt by year's end € 700,000 560,000 420,000 280,000 140,000 0
Operating income €/a - 185,379 207,137 245,720 308,253 407,170
Interest on loans €/a - -42,000 -33,600 -25,200 -16,800 -8,400
Principal repayment €/a - -140,000 -140,000 -140,000 -140,000 -140,000
Debt service coverage ratio, DSCR - 1.02 1.19 1.49 1.97 2.74
Loan life coverage ratio, LLCR 7.5% - 1.52 1.71 1.96 2.28 2.71
Project life coverage ratio, PLCR 7.5% - 1.52 1.71 1.96 2.28 2.71
5.4 Economic versus Financial Analysis
5.4.1 Introduction
There is often some confusion between economic and financial analysis. A

common misunderstanding is that they are the same and usually financial
analysis is wrongly specified as economic analysis. Although economic anal-
ysis is not a main subject of this book, the differences between the two forms
of project evaluation must also be clear to practitioners of engineering eco-
nomics.
5.4 Economic versus Financial Analysis 71
Financial analysis studies the performance of a project from the point of view
of the investors or the enterprise with the overall objective of determining its
profitability for a company. Economic analysis aims at identifying economic,
social and environmental benefits of the project from the perspective of na-
tional economy and assesses the effects that the project will have on the wel-
fare of a country as a whole. There are several other significant differences in
conducting the analysis that are briefly outlined below. For a more detailed
but still concise description, refer to [4] and [5].
The following issues are to be highlighted with regard to financial and
economic costs: transfer payments, pricing mechanisms, border and shadow
pricing externalities and system linkages.
Table 5-1: Main differences between financial and economic analysis
Item Financial Analysis Economic Analysis

Perspective Investors, beneficiaries Country, state, community
Includes inflation, PV in Excludes inflation *), PV in
Inflation
nominal terms real terms
Financial discount rate Economic discount rate
Discount rate
**) ***)
Interest during
Included Not included
construction
Financial costs Included Not included
Transfer payments
Considered Omitted
(see 0)
Source of financing
Equity, loans, considered Not considered
(see 5.4.3)
Pricing of tradable
Local market prices Border prices
goods (see 5.4.4)
Pricing of non-
Local market prices as
tradable goods (see Shadow prices
far as quantifiable
5.4.4)
External costs (see Considered as far as quan-
Not considered
5.4.5) tifiable
*) Escalation on top of inflation may be included
**) Including returns on equity and interest on loans but excluding
corporate tax, see Example 3.4
***) Sources of financing and related returns are not considered
5.4.2 Transfer payments
Transfer payment is a disbursement of money without receiving any good or

service in return. Transfer payments in economic evaluation of projects such
as customs, taxes, grants or subsidies are omitted in economic analysis of

projects because they do not contribute to an increase or decrease of the real
value of a domestic product.
Transfer payments may have a negative or positive impact on the econo-
my. For instance, transfer payments for insuring security of supply or pro-
moting innovative technology at its development phase can have a positive
impact for the national economy. In contrary, subsidizing coal mining will
have a negative impact in the long term.
5.4.3 Sources of financing and discount rate
Sources of investment funds from entities within the country as grants, equity
and loans, as well as the corresponding interest payments and principal re-
payments, are ignored in economic analysis. They are treated as transfer
payments because they only shift claims on the project resources and returns
between equity investors and lenders and do not increase the national income.
Foreign loans only have to be considered in economic analysis if they have
an impact on the balance of payments of a country.
The discount rate does not take equity and loan into consideration as a part
of financing and related return expectations. Instead, the yield of long term
government bonds is proposed as an appropriate discount rate; this is roughly
the rate for loans minus two (2) percentage points (see Example 3.4).
5.4.4 Pricing of goods and services
Inputs of resources in the form of goods or services incurred during the con-
struction phase and operation time of energy sector projects are classified in
tradable and non-tradable items.
Tradable items are traded in the international markets and include, for ex-
ample steel, metals, cement, equipment, fuels and engineering services.
Non-tradable items are those that are not traded internationally. They in-
clude services where the demander and bidder must be in the same country,
and commodities which have low value relative to either their weight or their
volume and therefore cannot be profitably exported. Typical non-tradable
items are land and real estate, cooling water, materials for civil works, poor
quality indigenous fuels, local transportation services, hotel accommodation
and local labor.
In financial analysis, tradable items are considered with their market pric-
es. Market prices of goods and services are determined, in principle, in mar-
5.4 Economic versus Financial Analysis 73
ketplace by the rule of supply and demand. In reality, however, prices are
always distorted by customs, duties, taxes, subsidies and other restrictions.
In economic analysis, tradable items are priced according to their border
prices. Border prices for exports are FOB (free on board) prices and CIF
(cost, insurance, freight) for imports. The border price for tradable domestic
coal is equal to mining cost plus transport charges to the nearest port, plus
handling and ship loading cost (FOB).
Non-tradable items are priced with shadow prices. These are assigned
monetary values and shall represent their true costs for the national economy.
Shadow pricing is usually subject to various assumptions within certain
guidelines and is fairly subjective [3]; they are determined by applying con-
version factors.
5.4.5 Externalities
Projects of the power industry usually have negative and positive effects out-
side of their boundaries, particularly pollution and other environmental im-
pacts, and the creation of jobs directly or indirectly. These effects are called
externalities.
The flue gases of a power station may cause, for instance, damages to
buildings and health problems for the population. A wind farm will have a
negative scenic impact on the landscape.
In financial analysis, such externalities are not considered in the project
costs. Economic analysis, however, tries to quantify externalities in monetary
terms and to incorporate them as the project’s economic costs.
As an example, lignite is a low grade non-tradable fuel. It is extracted in
open-cut mining and power stations firing lignite are built close to the mine
to avoid transportation costs. A lignite power plant may be profitable from
the point of view of the utility, due to the low cost of the fuel, but when its
environmental impacts such as land use, non-acceptance by the population,
displacement of the population, and recultivation of the area are included as
economic costs, the project may be rejected on economic rather than financial
grounds.
5.4.6 Required skills for conducting economic analysis
The energy supply industry provides indispensable services to all sectors of

the national economy and is highly capital intensive. Power supply projects
cost hundreds of millions of dollars; evaluation of projects of this size should
not be restricted to its profitability from the point of view of the investors
alone but should also include analysis of environmental and social impact,
job creation opportunities and other externalities related to the national econ-
omy with the goal to optimize the use of limited economic resources and to
ensure economic efficiency along with financial viability.
Financial analysis is always the first step of project evaluation. If a project
proves to be profitable from the investors’ viewpoint, an economic analysis
should follow to investigate its implications on the national economy.
While financial analysis of energy supply projects may be done either by
engineers with skills and training in economics or by economists with tech-
nical background, handling detailed economic analysis requires skills and
extensive experience in national economy issues and is solely the job of na-
tional economists.
5.5 Benefit-Cost Analysis of Public Projects
The primary objective of private investments is to generate profit. They are

selected and analyzed based on their expected returns and risks. On the con-
trary, public projects such as schools, stadiums, public swimming pools, etc.,
are designated to provide benefits for the public and society of a community
or region. Alternatives to these kinds of projects are evaluated based on the
benefits they would provide to meet public objectives and their lifetime costs.
The benefit-cost analysis is a special variant of economic analysis. Its ac-
tual subject is, however, not the entire national economy but a community or
a region.
Benefit-cost analysis is the procedure where the different benefits and
costs of proposed projects are identified and measured (as far as possible in
monetary terms) and then compared with each other to determine if the as-
sessed monetary value of the benefits of the project exceeds its costs. It can
be displayed either as: [6]
• The net benefits (NB), the difference between benefits minus disben-
efits and annual costs
• The benefit-cost ratio (BCR), the quotient of the benefits divided by
the costs over the lifetime of the project.
These can be displayed either as present values (PV) or annual equivalent

amounts (annuities):
 CU  (5.1)
NB = benefits − disbenefits − annualized CAPEX − expenses  a 
5.5 Benefit-Cost Analysis of Public Projects 75
PV of (benefits - disbenefits) [CU]

BCR = [ −] (5.2)
CAPEX + PV of operation exp enses [CU]
annual benefits - disbenefits  CU 

 a  (5.3)
BCR =
 CU 
[ −]
annualized CAPEX + operation expenses  a 
Public projects of public entities such as communities are usually financed
with longterm bank loans. Hence, bank interest rates are usually an appropri-
ate discount rate.
Benefit-cost analysis is the primary method used to determine if a public
project is economically viable. A project is economically viable when: [5].
• Estimated total lifetime net benefits exceed total costs
• Cost-benefit- ratio is higher than 1, BCR > 1
• The size of the project provides maximum net benefits. This means
there are no smaller or larger alternatives of the same project which
provide greater benefits
• There are no other technical-economic means to accomplish the same
project more economically
The initial approach of the benefit-cost analysis is the determination and vali-
dation of benefits, disbenefits and cost items. Benefits are values of goods
and services attributed to the projects, such as revenues or savings. Disbene-
fits are disadvantages for the users resulting from the realization of the pro-
ject.
There is a distinction between tangible and intangible benefits and disben-
efits. The former can be easily expressed in monetary terms such as revenues
from admission tickets (+) or rent for the land area (-). The latter are not easi-
ly quantifiable in monetary terms such as increased traffic or noise disturb-
ance caused by the project; they are subject to individual judgement and
therefore some evaluation standards are needed from regulatory authorities.
The contribution of engineers in benefit-cost-analysis of projects is mainly
required for the cost side and tangible costs items. For intangible aspects
special skills by economists and regional administration staff are required.
Furthermore the involvement of the public from the beginning of the project
is indispensable.
In general a cost-benefit-analysis of public projects is a very complex and
time consuming undertaking.
For BCR computation, usually only monetarily quantifiable items are in-
cluded. Non-quantifiable items can be considered in an additional SWOT
analysis Example 5.3.
Example 5.3: Benefit-cost ratio of a stadium project, simplified

Item Unit Value
Capital expenditures, CAPEX mln € 158.0
Buildings and access roads, parking mln € 125.0
Interior facilities mln € 25.0
Compensation fees to land owners mln € 8.0
Benefits "B" mln € /a 18.0
Admission tickets for sport events mln € /a 12.0
Revenues from concerts mln € /a 3.5
Other revenues mln € /a 2.5
Disbenefits "DB" mln € /a 3.0
Rent for the site mln € /a 2.5
Others mln € /a 0.5
Operation expenses "OPEX" mln € /a 4.0
Administration and Personnel mln € /a 1.0
O&M cost mln € /a 3.0
Annualized CAPEX "AnuC" 40 a 5.0%a mln € /a 9.21
BCR =(B-DB)/(AnuC+OPEX) - 1.14
6 Introduction on Cost Allocation to Cogeneration
Products
Cogeneration of electricity and heat is a highly fuel-efficient process and is

broadly applied for process steam supply in industries and heat supply in
district heating systems. The cogeneration of the two different products in the
same process requires appropriate models for allocation of costs and other
expenses, such as fuel consumption, emissions, etc., to the cogenerated prod-
ucts. Methods applied are:
• The residual value method
• The electrical equivalent method
• The exergy method
• The calorific method
Which method is most appropriate is a case-by-case decision. The application

requires however, besides knowledge in engineering economics, a strong
background in the thermodynamics of the different cogeneration cycles.
The dissemination of the respective knowledge goes beyond the scope of this
book. Nonetheless, this chapter provides a brief introduction of the first two
allocation methods without a claim of completeness. A comprehensive elabo-
ration of cogeneration technologies and of the related allocation methods is
provided in the book “Power and Energy Systems – Technologies and Eco-
nomics”2), and for German speakers, in the book “Praxisbuch Ener-
giewirtschaft” both by the same author.3)
2)
“Power and Energy Systems Technologies and Economics”, forthcoming, publica-
tion in summer 2015
3)
“Praxisbuch Energiewirtschaft”, Panos Konstantin, 3rd Edition 2013, published by
Springer Vieweg, 4th Edition planed 2016
78 6 Introduction on Cost Allocation to Cogeneration Products
6.2 The Principle of the Cogeneration Cycle
Cogeneration is the process of simultaneous production of electricity and heat

in a combined heat and power (CHP) plant.
In a steam Rankine cycle CHP,

HP-steam 160 bar
Cogen steam is extracted from the tur-
electricity
η = 35 %
bine at a higher pressure and
Fuel HP
HP
Turbine
Cond-
G
temperature compared to con-
100 % Boiler densing pressure, causing some
LP-steam loss of electricity generation and
(e.g.) 3 bar
lower electrical efficiency. How-
Cogen Heat
η = 50% ever, about 85% of the fuel ener-
gy can be utilized as usable ener-
Author's own illustration
gy in the form of cogenerated
heat and electricity.
Figure 6-1: Cogeneration in a steam Rankine cycle CHP
Industries usually install CHP

Fuel
plants with gas turbines and
upstream heat recovery steam
Cogen
electricity generators (GT-HRSG). Typical
Compressor G
sizes are 1 MW to 16 MWe,
Turbine
Gas turbine
often with two or more units for
generator set 500°C
redundancy purposes. For this
HRSG LP steam
air type of CHP, there is no loss of
electricity as the heat is recov-
Flue gas
Heat ered from the hot exhaust gases
consumer of the gas turbines. The steam
Author's own illustration pressure has no impact on the
power output.
Figure 6-2: Cogeneration of power and heat in a gas turbine CHP

In continental Europe, there is an extensive application of cogeneration. Al-
most all cities have district heating networks which are supplied with base
load heat from cogeneration plants in winter, ranging from 1 MWe engine
CHPs in small towns to up to 600 MWe steam CHPs in large cities. From a
600 MW steam power plant, up to about 300 MWt heat (110°C) can be ex-
tracted. About 75,000 apartments can be supplied with base load cogen heat.
Power output at full heat production is reduced thereby to about 564 MW.
6.3 Cost Allocation Methods 79
The infrastructure for district heating is very costly (piping, substations etc.).
Therefore the entire energetic and cost advantage of cogeneration is allocated
to the heat to compensate the cost of the costly infrastructure while the cost
of electricity is kept the same as in a condensing power generation process.
6.3 Cost Allocation Methods
There are the following methods for fuel and cost allocation for the cogenera-
tion products:
• The residual value method
• The electrical equivalent method
• The exergy method
• The calorific method
In this chapter, only the first two methods are briefly presented because the
proper application requires a strong background in thermodynamics that is
beyond the scope of this book.
6.3.1 The residual value method
The residual value method is very common for municipal utilities and for
factories that operate small scale captive engine or gas turbine CHP plants.
The approach is briefly described below:
Total production costs for cogeneration of power & heat

minus a credit for avoided costs for one of the two products
The residual costs are allocated to the second product
The cogeneration benefit is fully allocated to the second product

the costs of the first product are kept unchanged
The method finds application mainly for small or medium scale engine or gas
turbine with Heat Recovery Boilers CHP plants. The credit may be either an
electricity credit for avoided costs for electricity purchase from the grid or a
heat credit for avoided heat production cost in a captive heat-only boiler
plant. The former is mainly practiced by municipal utilities while the latter
mainly by industrial factories.
Example 6.1: Cost of cogenerated heat, residual value method
Item Unit Value

Power balance,engine CHP
Electrical output, net kWe 1,500
Thermal output, σ =70% kWt 2,143
Fuel input η =85% kWt 4,286
Energy balance, cogeneration
Electricity generation 7,000 h/a MWhe / a 10,500
Heat generation 7,000 h/a MWht / a 15,000
Fuel consumption 7,000 h/a MWht / a 30,000
Financial constraints
Gas price for LHV € / MWht 25.00
Electricity purchase price *) € / MWhe 60.00
Annual costs
Fixed costs **) th.€ / a 176.0
Fuel costs th.€ / a 750.0
Subtotal th.€ / a 926.0
minus electricity credit ***) th.€ / a 630.0
Residual costs of heat th.€ / a 296.0
Specific cost of heat € / MWht 19.73
*) For purchase from grid + including use of system charges
**) Calculated in separate file (annuity CAPEX + fixed O&M costs)
***) Avoided costs for purchase electricity from the grid
Example 6.2: Specific cost of heat in a heat-only boiler (fuel cost only)
The same amount of heat is produced in standby boiler instead of cogeneration.
Heat generation MWht / a 15,000

Fuel consumption η =88% MWht / a 17,045
Gas price in LHV € / MWht 25.00
Specific cost of heat € / MWht 28.41
6.3.2 The electrical equivalent method
The electrical equivalent method is based on the fact that steam (≙heat) ex-
tracted from a steam turbine induces some loss of electricity production. This
is referred to as the electrical equivalent β (kWhe/kWht) of the extracted heat
and mainly depends on the extraction pressure. Hence, the steam is charged
with the costs of the equivalent (lost) electricity production – see Example
6.3. We can express this mathematically with the following equation:
6.3 Cost Allocation Methods 81
 CU 
Heat generation costs: ch =β × c e   (6.1)
 kWh t 
Where:
ce: Electricity generation cost in condensing mode of operation (CU/ kWhe)
ch: Generation cost of the extracted heat (CU/kWht)
The method can also be applied for fuel allocation to the extracted steam –
see equations below and Example 6.4.
3.6  MJ 
Heat rate of cond. electricity qɺe =
  (6.2)
ηe  kWhe 
3.6 × β  
Heat rate of the product heat: qɺh = = β × qɺ e  MJ  (6.3)
ηe  kWh t 
1  
Or Heat rate of the product heat: qɺh = β  kWhf  (6.4)
ηe  kWh t 
Where:
β : Electrical equivalent of heat (MJ / kWht)
ηe : Electrical efficiency in condensation mode
qɺe : Heat rate of electricity in condensing mode of operation (MJ/ kWhe)
qɺh : Heat rate of the extracted heat (steam) MJ/kWht or kWhf /kWht
The determination of the electrical equivalent requires calculation with ther-

modynamic cycle simulation programs such as Fichtner’s KPRO . Approx-
imate values for rough calculations of prefeasibility in studies can be taken
from Figure 6-3.
0.35
Equivalent cond. efficiency 42%

Electrical equivalent kWhe / kWht
0.30
Condensing pressure 0.045 bar
0.25
0.20
Equivalent cond. efficiency 36%
Condensing pressure 0.045 bar
0.15
0.10
0.05
Author's own calculation and illustration

0.00
0 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16
Extraction pressure bar
Figure 6-3: Electrical equivalent of extracted steam, approximate values

Example 6.3: Cost of extracted heat by different pressure levels
Heat Extraction from 600 MW Power Station

Electricity generation cost c e = 63.00 €/MWh
Steam Steam Electrical Heat
pressure Temperature equivalent cost
p ts β β x ce
bar °C kWhe / kWht € / MWht
12.0 218 0.251 15.81
6.0 189 0.220 13.86
1.7 145 0.164 10.33
Note: Performance parameters from Cycle calculation
Electricity generation costs calculation in separate file
Example 6.4: Fuel of extracted heat at different pressure levels
Heat extraction from 600 MW power plant

Heat rate of electricity q e = 8.60 MJ/kWhe
Steam Steam Electrical Steam
pressure Temperature equivalent heat rate
p t s + 30°c β β x qe
bar °C kWhe / kWht MJ / kWht
12.0 218 0.300 2.58
6.0 189 0.270 2.32
1.7 145 0.190 1.63
Note: Electrical equivalent taken from figure 6-3, upper curve
For comparison: The heat rate of a heat-only boiler with thermal efficiency of 88%
will be:
1  MJ   GJ 
qɺ h _ boiler = × 3.6 = 4.1   or  
0.88  kWh t   MWh t 
The fuel cost for heat generation in a heat-only boiler at a natural gas price of
25 €/MWht (6.94 €/GJ) and a thermal efficiency of 88% will be 28.45 €/MWht.
7 Project Analysis under Uncertainties
7.1 Synopsis
7.2 of the chapter
In general, projects in the power industry are low-risk investments compared

to other business fields: the marketplace is relatively secure due to continuous
growth of electricity demand, utilities and investors are experienced and fi-
nancially strong players, most state-of-the-art technologies are mature and
proven and there is extensive and long term experience of almost one century
in operation and management of power systems.
Despite these advantages, there are still particular risks: a common risk for
all power system projects is the high capital intensiveness in conjunction with
their longevity. Lifetimes of power plants for conventional fuels are 25 to 35
years; hydropower, nuclear power plants and power networks 50 years and
longer. Over such a long time span, changes in technology, stricter environ-
mental and safety legislation and availability of fuel are likely and may en-
danger the projects’ success. The penetration of renewable energy technolo-
gies is also a challenging task for the entire power supply system, involving
technological and commercial risks.
In chapters 4 and 5, a base case was assessed with realistic technical and
economic inputs and assumptions from the current point of view. This kind
of evaluation is, however, subject to a number of uncertainties and risks asso-
ciated with the long operation phase of the projects.
This chapter is devoted to providing an overview of project analysis under
consideration of uncertainties and probable project risks; this includes de-
scriptions of methods like sensitivity analysis, risk analysis and risk mitiga-
tion measures. The chapter also presents methods for estimation and consid-
eration of project and country risks in financial analysis. Furthermore, it is
shown how to include risk premiums in the WACC that is used as discount
rate. Energy production of renewable energies depends on fluctuating natural
resources. The production that can be expected with some degree of certainty
over the project lifetime requires a probability analysis; the basic approach of
which is presented in this chapter.

84 7 Project Analysis under Uncertainties
7.3 Sensitivity analysis
Financial evaluation of projects is usually first conducted for a base case

under the most likely inputs for operational and financial parameters. A fol-
low-up sensitivity analysis involves calculating the consequences of limited
variations of the inputs on the outcome. Sensitivity analysis is carried out
during every financial evaluation of a project [4]. Usually only one of the
variables is altered. For projects in the energy sector, this involves changes in
CAPEX estimates, influence of lifetime, fluctuation in energy productions
especially in the first years after commissioning, fuel price fluctuations, ener-
gy selling price, etc. This kind of sensitivity analysis is mainly done in the
context of a risk assessment and the evaluation provides substantial conclu-
sions for risk mitigation. A helpful tool for sensitivity analysis is the “table
function” of MS-Excel (available under: “data”, “what if analysis”, data ta-
ble). A typical application of sensitivity analysis is demonstrated in the fol-
lowing example.
Example 7.1: Sensitivity cogenerated heat cost
In Example 6.1, the heat cost of cogenerated heat was calculated with the residual
value method. The base case was calculated with the following basic inputs:
full load hours (7000 h/a), gas prices (25 €/MWht) and credit for avoided electricity
purchase (60 €/MWhe). The resulting heat cost is shown in the white cells in the
tables below. All three parameters involve uncertainties; their impact on the specific
heat cost is shown in the sensitivity analysis shown in the tables below. This is con-
ducted with the “table function” of Excel, applied on the heat cost calculation of
Example 6.1.
Full load hours Gas price Electricity credit

h /a € / MWht € / MWht € / MWht € / MWhe € / MWht
base case 19.73 base case 19.73 base case 19.73
4000 28.53 20 9.73 50 26.73
5000 24.43 25 19.73 55 23.23
6000 21.69 30 29.73 60 19.73
7000 19.73 35 39.73 63 17.63
8000 18.27 40 49.73 70 12.73
Note: Heat cost in heat only boiler without cogeneration 28.41
Discussion of results: Each one of the three uncertainties has a significant impact on
the heat cost. The most critical is the gas price. The conclusion drawn is:
a) Full load hours: the plant size shall be rather small to cover the base load heat
demand only, in order to obtain high full load hours (capacity factor)
b) Gas price seems to be the most critical parameter, see breakeven point Example
7.2
c) Electricity credit is less critical in the range shown.
7.4 Break-even Point Analysis 85
7.4 Break-even Point Analysis
A very practical sensitivity application is the break-even point analysis. It is

directly demonstrated in a typical case, based on Example 6.1 and Example
7.2.
Example 7.2: Heat cost break-even point - cogen vs. heat only boiler
Cost of cogenerated heat is highly dependent on the gas price, as shown in Example
7.1; it is likely that at high gas prices, heat generation in heat-only boilers (HOB)
may be more economic than in cogeneration. The figure below shows the break-even
point of the gas price at which shifting from cogeneration to heat-only generation is
more economic. Industrial CHP plants usually have standby boilers installed and can
easily shift heat production from cogeneration to heat-only boilers
50
45
Full capacity hours 7000 h/a
40 Electricity credit 60 €/MWh
Specific Heat Cost €/MWht
35 Cogen heat Boiler heat

Gas price Cogen heat Boiler heat
30 €/MWhf €/MWht €/MWht
30.00 29.73 34.09
25 31.00 31.73 35.23
32.00 33.73 36.36
20 33.00 35.73 37.50
34.00 37.73 38.64
15 35.00 39.73 39.77
36.00 41.73 40.91
10 37.00 43.73 42.05
38.00 45.73 43.18
39.00 47.73 44.32
5
40.00 49.73 45.45
Author's own computation and illustration Computation with Excel "Table function"
0
20 22 24 26 28 30 32 34 36 38 40
Gas Price € / MWh
It is evident from the figure above that for gas prices higher than 34 €/MWh, heat
generation in heat-only standby boilers is more economic than in cogeneration.
7.4.1 Project Analysis based on Scenarios
In a sensitivity analysis, the impact of change of only one variable on the

project outcome is analyzed. A different approach is the building of scenari-
os. Scenarios involve the changes of a set of variables at once.
Usually three scenarios are set up: A “worst case”, “most likely” and “best
case” scenario. The “most likely” scenario is the base case where the input
parameters are considered as the most realistic from the current point of view.
For the “worst case”, less favorable input parameters are assumed and the
opposite is done in the “best case” scenario.
The approach is demonstrated again on the basis of Example 6.1 by adding
a “worst case” and a “best case” scenario and alternative heat generation in a
heat-only boiler for comparison. The outcome is shown in shortened form in
Example 7.3.
Example 7.3: Scenario analysis of heat generation cost, cogen vs. boiler
Item Unit Worst Case Most Likely Best Case

Energy balance, cogeneration
Full load hours h/a 6,000 7,000 8,000
Electricity generation MWhe / a 9,000 10,500 12,000
Heat generation MWht / a 12,857 15,000 17,143
Fuel consumption MWht / a 25,714 30,000 34,286
Financial constraints
Gas price in LHV € / MWht 30.00 25.00 20.00
Electricity purchase price *) € / MWhe 57.00 60.00 63.00
Annual costs
Fixed costs **) th.€ / a 176.0 176.0 176.0
Fuel costs th.€ / a 771.4 750.0 685.7
Subtotal th.€ / a 947.4 926.0 861.7
minus electricity credit ***) th.€ / a 513.0 630.0 756.0
Residual costs of heat th.€ / a 434.4 296.0 105.7
Specific cost of heat € / MWht 33.79 19.73 6.17
Heat-Only Boiler
Heat generation MWht / a 12,857 15,000 17,143
Fuel consumption η =88% MWht / a 14,610 17,045 19,481
Gas price in LHV € / MWht 30.00 25.00 20.00
Specific cost of heat € / MWht 34.09 28.41 22.73
The outcome can be interpreted as follows: the cost of cogenerated heat is, even in
the worst case scenario, at an acceptable level, while in the other two scenarios it is
considerably lower.
7.4.2 SWOT Analysis
SWOT analysis is used to evaluate the Strengths, Weaknesses, Opportunities

and Threats involved in a project. It is usually done in order to also include
monetary intangible aspects in the evaluation that may be favorable and un-
favorable to achieve the project’s objective. SWOT analysis may be helpful
for comparison of project options, especially if the results of the financial
7.4 Break-even Point Analysis 87
evaluation are close to each other. SWOT analysis can be applied in two dif-
ferent ways:
• SWOT statement: The strengths, opportunities, threats and weaknesses of
the project are just highlighted and verbally commented while the overall
judgement of the merits remains on the side of the investor. In general,
this will be subjective.
• SWOT evaluation matrix: Different evaluation criteria are defined and
put together in groups in the form of a matrix. Each criterion receives
evaluation marks, for example, from 1 to 5. The marks of each group are
summed up and a weighted average number is calculated.
Figure 7-1: SWOT statement example for a potential CHP plant project
Table 7-1: SWOT Matrix example

Central Central
All Distributed
CCGT-PP Steam PP
Criterion from PPs Explanatory Notes
1 PP 1 PP
Utility in 2 Sites
Seasite Seasite
Technical/Operational Criteria
Construction constraints / permits 3 1 1 5 Possibility to obtain construction permit
Power transmission requirements 2 2 2 5 Dependency on the public grid
Cooling water requirements 5 2 1 5 Access to cooling water required
Fuel price sensitivity 5 5 5 2 Power gen. cost vs. fuel price increase
Security of supply 4 3 3 5 Risk supply interruptions, black out
Energy efficiency 5 5 3 4 Self explanatory
Maintenance requirements 5 4 2 3 For GTs high, CCGT only for GTs high
Economic Criteria
Operating staff requirements 4 2 1 2 Qualification and number of staff
CAPEX 5 2 1 4 Self explanatory
OPEX 1 5 3 4 Self explanatory
Externalities
HAZOP Risk 2 2 2 4 Hazard and operational Rrsks
Environmentally harmful emissions 5 4 1 4 Emissions of particulates, SO2, NOx
Green house gas emissions 5 5 1 3 CO2 emissions, carbon fines
Total, technical criteria 29 22 17 29
Total, economic criteria 10 9 5 10
Total, externalities 12 11 4 11
Weighted Average 17 12 11 14
Note: Grades from 5 (BEST) to 1 (WORST) HAZOP: Hazard and operability
7.5 Uncertainty Analysis of Energy Production
7.5.1 The normal distribution
Renewable energy projects are highly capital-intensive; the annual produc-

tion costs mainly consist of capital costs (depreciation, interest on loans, loan
repayment, etc.) which remain high during the entire lifetime, while energy
production and the related revenue streams are subject to variations, depend-
ing on the availability of natural resources such as solar irradiation or wind.
The annual energy production is usually assessed for a base case scenario
based on the available data for a variety of factors that are considered in the
calculation. For a wind farm, for example, following factors among others are
assessed: Wind resources for a typical year, technical data and performance
characteristics of the wind turbines, wind farm topology and layout, technical
losses etc.
These factors are subject to a number of inherent uncertainties that may
have a significant impact on the annual energy production and the revenue
streams during the lifetime of the project. Therefore, an uncertainty analysis
must be conducted to assess the financial risks associated with the variation
7.5 Uncertainty Analysis of Energy Production 89
of the annual energy production in the different years of the project’s life-
time. The uncertainty analysis is usually conducted under the assumption that
the energy production in the different years falls into a normal distribution
around the calculated production for the base case.
Normal distribution is a bell shaped curve depicting the density of values
on the x-axis and the frequency of occurrence on the y-axis. Such a distribu-
tion is a very helpful tool for analyzing uncertainties, as it is characterized
only by two parameters, the statistical mean µ and the standard deviation σ.
The formula of the normal distribution is:
( x − µ )2
1 −
2⋅σ 2
g ( x; µ , σ ) = ⋅e (7.1)
σ ⋅ 2 ⋅π
Where:
x The values for which the distribution is sought; x-axis
g(x;µ,σ) Distribution function with variables x; µ,;(g stands for Gauß)
µ The statistical mean of the values
σ The standard deviation
Figure 7-2 illustrates the normal distribution of the energy production of a

wind farm. The mean, “µ”, in our case, is the calculated energy production
for the base case and the standard deviation “σ” is the statistical sum (square)
of the deviation of a number of key uncertainties.
The characteristics of the standard distribution are summarized below [7].
a) The curve has a maximum where x = µ.
b) The standard deviation or overall uncertainty is the sum of the devia-
tions of the key parameters that are considered in the base case calcula-
tion. It is calculated from the square root of the sum of the squares of
the deviations of the key parameters
c) The curve is symmetrical with values clustered on both sides of the
mean
d) The curve has two inflection points at “x+σ” and “x-σ”
e) The curve theoretically extends out indefinitely in both directions, the
x-axis asymptotically approaching (limes y for x→ ±∞ =0)
f) The area under the curve is equal to 1 or 100%. It encompasses all the
values that can occur.
The two features d) and f) above imply that curves with a big σ tend to be
broad and their maximum is low; in contrary, curves with a smaller σ are
narrow and have a higher maximum (see Figure 7-2).
Figure 7-2: Normal distribution of the energy production
A central distribution with µ = 0 and σ = 1 is called standard normal distri-
bution.
Figure 7-3: Standard normal distribution curve
7.5 Uncertainty Analysis of Energy Production 91
Figure 7-4: Gauß distribution, Example with µ=50 GWh base yield
The curves in Figure 7-2 and Figure 7-3 play an outstanding role for proba-
bility analysis in the statistics. We have to distinguish between the probabil-
ity of occurrence and the cumulative probability. - Figure 7-4.
The probability of occurrence is the value of the g-axis (“g” stands for
Gauß instead of y) for a given x-value. The area (mathematically, the inte-
gral) under the curve from negative infinity (- ∞) to x-value 45 GWh, is the
cumulative probability. This includes all of the cluster of x-values below the
given x. The area to the right represents the cluster of x-values exceeding the
given x.
MS-Excel provides a function to calculate both types of probability. The
syntax of the formula is:
Value on g-axis: NORM.DIST(x,µ ,σ ,FALSE) (7.2)

Cumulative value: NORM.DIST(x,µ ,σ , TRUE) (7.3)
Where:
x: the x-value for which the probability is sought
µ : the arithmetic mean of the x-values
σ : the standard deviation
FALSE, TRUE: logical values
If the logical value in the function is “FALSE”, NORM.DIST returns the

value on the g-axis, if “TRUE”, NORM.DIST returns the cumulative distri-
bution that is the area under the curve from - ∞ to the given x value.
2
z
1 −
g ( z) = ⋅e 2 (7.4)
2 ⋅π
Example 7.4: Probability calculations
The base case yield of a wind farm for reference conditions is µ = 50 GWh/a, and the
standard deviation is σ = 5. Find the g-value, the cluster of values below
x=45 GWh/a (cumulative probability CUP).
g ( x) = NORM .DIST (45,50,5, FALSE ) = 0.048
CUP = NORM .DIST (45,50, 5, TRUE ) = 0.16
A cumulative probability CUP=0.16 (16%) means that the probability that a yield of
45 GWh may not be reached is 16%; the probability that it may be reached or ex-
ceeded is 84%. In other, words the exceedance probability is P84 (see also Figure
7-4).
7.5.2 Exceedance probability
The objective of section 7.5.1 was to understand the philosophy of normal

distribution. More important to our purpose is the exceedance probability;
this is the cluster of x-values on the normal distribution that may be reached
or exceeded. The energy production (yield) of renewable energy projects is
calculated for a base case for the climatic conditions of a reference year.
There is a probability of 50% that the base case yield may be exceeded and
50% that it may be lower. In the normal distribution, this is the mean value µ
and the exceedance probability is denoted with P50 (P stands for probability).
Investors usually base their decision for investment on P50 exceedance prob-
ability, while banks prefer P90 or even P95. The exceedance probability for
different P-values is shown in following figure.
The exceedance probability depends on the standard deviation “σ”, which
is the function of the uncertainties related to the assumption for the combus-
tion of the base case. It is calculated as the square root of the squares of the
individual uncertainties. For a wind farm, for instance, the formula is:
2 2 2 2
σ = U wind data + U wind mod el + U farm mod el + U wind turbine (7.5)
7.6 Risk Analysis and Risk Mitigation 93
The exceedance probability XEP can be calculated with the EXCEL function
NORM.INV as follows:
X P = 2 ⋅ µ − NORM .INV ( P / 100, µ , σ ) (7.6)
P100
σ =5 ≙ 10% Exceedance Probability
P90 Mean value = 50 GWh/a
10% 20%
P80 PXX
GWh / a GWh / a
Exceedance Probability
P95 41.8 33.6

P70 P90 43.6 37.2
P75 46.6 43.3
P60 P50 50.0 50.0
P25 53.4 56.7
P50 P5 58.2 66.4
P40
P30 σ = 10 ≙ 20%
P20
P10
P0
30
35
40
45
50
55
60
65
70
Wind farm energy production GWh / a
Figure 7-5: Exceedance probability for different P-values

Example 7.5: Exceedance probability
The base case yield of a wind farm for reference conditions is µ = 50 GWh/a, and the
standard deviation is σ = 5. Find the yield with an exceedance probability of P90.
X P = 2 ⋅ 50 − NORM .INV (90 / 100,50,5) = 43.6 [ GWh/a ]
7.6 Risk Analysis and Risk Mitigation
7.6.1 Certainty and uncertainty aspects of electricity business
In pure economics’ teaching, the risk of investment is usually defined in

terms of the degree of security of expected returns. In general, if risks occur
during the lifetime of a project, they may affect the cashflow by increasing
operating cost.
From a practical point of view, there is no investment without risk. This
became evident recently: Government bonds have been considered for dec-
ades the most secure investment because the returns were guaranteed by the
government. After the financial crisis of 2008 and the subsequent economic
crisis, we have learnt that even government bonds are insecure.
Nevertheless, projects in the energy supply sector are commonly classified as
low risk investments. This is because energy supply is not an ordinary busi-
ness activity. Energy is an indispensable commodity for every national econ-
omy. Furthermore, the demand for electricity is, in most economies, rising or
remains stable, power generation and distribution infrastructure need re-
placement and renewal.
In spite of all these advantages, there are still risks. However, there is
again a crucial difference compared to other businesses. Risks of energy sup-
ply projects are not in “any case” risks for the investor. This is because costs
can often be rolled over to the consumers. Hence, we must distinguish be-
tween risks for the investor and risks for the consumer. In this context, some
explanations are below:
Before the liberalization of the energy markets, energy supply used to be
an almost risk-free business. Electricity and gas supply were monopolies
dominated by a few vertically integrated companies. The tariffs were subject
to approval by some regulatory authority; however, the approval was merely
based on costs control.
The overall objective of the liberalization has been the creation of frame-
work conditions that enable competition and free trade of grid-based energy
such as electricity and natural gas. Liberalization starts with the unbundling
of the utilities into independent business units for production, transmission,
distribution and trade. Unbundling enables a competitive market environment
for power generation (production), while transmission and distribution still
remain natural monopolies and are regulated.
Even after liberalization, the energy supply business is still a relatively se-
cure business; however, there are differences in the risk exposure depending
on the business field and the applied technology.
Transmission and distribution of power can be considered the most secure
business field. In most countries, electricity demand is growing or remains
almost constant. This business sector will remain a natural monopoly in a
regulated market environment. The use of system tariffs needs approval by
the regulator, usually on a year by year basis.
Hydro power: Although it is capital intensive and the lifetime of plants is
much longer than 50 years, it can be considered a secure investment. The
technology is robust and mature. Sale of produced electricity can be consid-
ered secure due to the very low marginal costs (almost zero). The actual risk
is that the annual electricity production varies, depending on the water avail-
ability for run-of-river plants. This is not the case for pump storage plants
that are deployed to cover peak load.
Nuclear power plants: They are capital intensive and their lifetime is long-
er than 50 years. Retrofitting with higher safety standards during their life-
time is very likely. High financial reserves for decommissioning are required.
Earlier shut down due to phase-out governmental policy after accidents is
likely (Germany, Japan); in general, a risky investment.
Conventional power plants fired with fossil fuels are still a “relatively se-
cure” investment. There are risks due to technology development, stricter
environmental standards and climate requirements such as carbon trade and
costs for carbon certificates.
Solar power generation: Depending on the technology, there are different
kinds of technology and operational risks. The most mature for utility-sized
plants are parabolic trough and photovoltaic technology. Large scale projects
with solar tower and Fresnel technology are currently at the start but not
proven yet in long term operation.
7.6.2 Types of risks and mitigation measures
An integral part of financial analysis for new projects is a risk assessment and
mitigation process. This includes risk identification, analysis of the conse-
quences in the case of occurrence and risk management and mitigation.
The types of risks for energy supply sector projects can be classified as in-
ternal and external risks. The former are those that can be controlled by the
investor or plant operator and include mainly construction phase risks and
operation-phase risks. External risks are beyond of the control of the investor
or plant operator.
Table 7-2, Table 7-3 and Table 7-4 provide some overview of common
construction phase, operation phase and external risks along with their conse-
quences and mitigation measures described in key words. A detailed risk
analysis must follow for each particular project. It is noted, however, that
there are different project-specific risks especially, in connection with inno-
vative and renewable technologies that need special attention and mitigation
in order to ensure that the project will be a success.
Risks and risk mitigation measures usually have cost implications that
must be considered in the project costs. In this context, we have to distin-
guish between those that can be considered implicitly in the costs series and
those that are considered with risk premiums in the discount rate.
Table 7-2: Overview of possible construction phase risks

Type of risk Consequences Mitigation
Completion delays due to:
Delayed delivery of main Delayed start of oper- Obtain completion
components ation guarantees
Poor time management, Prolonged construc- Fixed time turn-key
construction site supervision tion time contracts
Shortages in skilled con- Delays, construction Payments based on
struction staff site accidents construction progress
Withdrawal/postponement Contractual penalties Engage reputable
of construction permits or in fuel purchase and consultant for site
operation licenses power supply con- supervision
Delays due to unforeseen tracts Loan with reasonable
incidents such as strikes, Accumulation of debt grace period
destruction of main compo- and interest payments
nents by natural events due to postponed debt
service
Price increases of goods and Budget overruns Fixed price EPC
labor contract
Unforeseen complications Additional, unfore- Include sufficient
requiring additional services seen services charged contingencies in the
not included in the construc- at considerably higher budget estimates
tion contract costs
Force majeure risks such as Damage of machin- Covered by EPC
floods, earth quakes etc. ery, interruption of contractor insurance
construction work
Table 7-3: Overview of common operation phase risks

Excess supply on the
Obtain purchase
Overestimated demand marketplace leads to
agreement for the
growth and market volume strong fall of prices of
bulk of production
the product
Backup fuel, diversi-
Insecurity of fuel supply or Reduced production
fication of fuel
interruption of supply, e.g. and lower sale reve-
sources, sufficient
of natural gas nues
storage capacities
Overestimated natural re- Resource assessment
sources for renewables such Less production output, based on historical
as water, solar irradiation, reduced sale revenues data for at least the
or wind resources previous decade
Preventive mainte-
nance. Considered
Gradually declining plant
Lower plant output and with degradation
performance over the life-
efficiency factors based on the
time of the project
experience from
similar projects
Operation & mainte-
Poor plant performance Production interrup-
nance agreements
caused by frequent forced tions, failure to meet
with reputable con-
outages supply obligations
tractors
Costs cannot be re- Obtain purchase
Unpredictable and frequent
flected in the price of agreements including
fluctuations in fuel prices
the product price indexation
Technological innovations Plant design acc. to
Competitive disad-
and development of more the best available
vantage
efficient technologies technology (BAT)
Long-term loan
Increased cost of loans Reduced debt service
agreements with
caused by higher inflation ability
fixed interest rate
Flexible plant design
Stricter environmental Danger of earlier plant
to allow for future
legislation standards shutdown
retrofits/conversions
Table 7-4: External risks

Pilot, demo project
Introduction of a new and
Phased development phase before scaling
innovative technology
up to commercial size
Project-specific
Longevity of the project Project-specific risks measures, higher
rates of return
Require higher re-
Country risks Country-specific risks
turns
Try to involve popu-
Non-acceptance by the Delays of construction
lation in the decision
population work
process
Use of financial in-
Currency risks Cost overruns
struments for hedging
Future regulations and Cost overruns, danger Obtain government
legislation of earlier shut-down guarantees
Consider cyclical
Demand and price economic downturns
Economic downturn
decline in fixing rate of re-
turn
Insurrections, strikes,
Country-specific
Political risks expropriation, national-
mitigation
ization
Conduct due dili-
Force majeure, natural Minor floods, fire, gence during devel-
disaster earthquakes opment phase of the
project
Costs for most of the internal risks are usually reflected in the payment series
as additional capital expenditures or operation expenses. In this context, the
following examples are mentioned:
• Completion or performance guarantees are reflected in increased pro-
ject costs (CAPEX) by the EPC contractors
• A grace period will have impact on the loan costs, e.g. a higher interest
rate
• Costs for maintenance agreements are considered in the operational
expenses (OPEX)
• Preventive maintenance to reduce degradation during operation (e.g.
frequent mirror cleaning for solar plants) will require increased
maintenance costs.
7.7 Consideration of Risk Premiums in Discount Rate 99
7.7 Consideration of Risk Premiums in Discount Rate
7.7.1 Risk Premiums
Risk premiums are allowances in interest rates of loans or in the expected

rates of return on equity compared to some benchmark. This benchmark may
be the yield for a risk-free investment, e.g. governments’ bonds in countries
with a high financial credibility.
In investment appraisal models, the discount rate becomes the instrument
for including risk perception in project valuation. If, for example, the net
present value is the criterion for economic viability of investments, high-risk
projects will be discounted at a higher discount rate and less risky projects at
a lower discount rate. The NPV must be the same for both cases (revenues
minus costs); this means the riskier investment must generate higher returns
to balance risk allowances considered in the costs streams.
In the context of energy supply projects, the risks related to the sources of
financing and the corresponding risk premiums are shown below.
While the types of risk premium are almost the same for investors (equity)
and for creditors (loan), their values are different, depending on the risk ex-
posure.
Source of Financing
Equitiy Debt
Risk-free rate of return Risk-free interest rate

Business risk premium Credit default premium
Country risk premium Country risk premium
Figure 7-6: Type of risks referred to the financing resources
7.7.2 Risk exposure of equity investors and lenders
In general, investors bear the bulk of the project risks. The invested equity
capital is bound during the entire lifetime of the project. Investors can expect
returns (dividends) only if the free cashflow at the end of each year of opera-
tion is positive and provides some margin for dividend payments. This means
after all the operating costs are covered, including taxes, interest payments
and annual amortization of the loan. Furthermore, the returns on equity are
subject to taxation; hence, only the after-tax return is relevant for the inves-
tor. Consequently, the risk premium for equity will be considerably higher in
order to attract investors to bear the risks of the usually long-living projects
of the energy supply business.
The risk exposure of the lenders may be considered to be lower. Due to the
size of the investment, e.g. for power plant projects, the borrowers are institu-
tional investors such as large utilities or trustworthy independent power pro-
ducers (IPP) with a long-standing reputation for power plant projects world-
wide. Interest payments are tax deductible and the loan is gradually repaid
during the maturity time, hence, the lenders’ capital is not entirely bound
during the lifetime of the project. Furthermore, lenders disperse risks by
forming consortiums consisting of several banks.
7.7.3 Estimating risk premiums for different project types
There are different models on how to measure and validate risks [8] [9] [10].
In general, they are dealing with all types of investment from government
bonds, stocks, etc. In the following, we focus on investments for the power
supply industry only, first in countries with zero country risk (country risks
are discussed in the next section).
Energy supply is an indispensable service for any national economy. Pro-
ject investments in the energy supply sector have a history of about one cen-
tury worldwide. The most practical approach therefore is to estimate risk
premiums based on historical data and experience from similar projects in
comparable national economies.
A risk-free rate is the rate of return on equity or bank loan that is consid-
ered as guaranteed return. With regard to a power supply business, this means
that the project must be state-of-the-art, with long-term operational experi-
ence and proven performance in commercial scale. In this case, we can as-
sume that the risk-free rates are the same for both sources of financing.
The venture risk premium is the vehicle to attract investors to invest equity
capital in a project. For long-term projects in the energy sector, they reach the
order of magnitude of the risk-free rates or even higher. The credit default
premium is smaller for the reasons mentioned in the previous section, regard-
ing investors for energy supply sector projects with proven performance.
Risks related to the type of the project are in most cases technology risks.
Some typical examples are mentioned below:
Solar power with parabolic trough technology is state-of-the-art and mature;

a large number of plants are in operation with proven performance. Solar
tower technology is considered to be technically superior and more efficient;
however, it is not proven in commercial scale yet and the occurrence of per-
formance risks during operation is likely. Consequently, an appropriate risk
premium for the latter is to be included in the WACC.
Steam power plants with ultra-super critical parameters have a considera-
bly higher energy efficiency compared to those with subcritical steam param-
eters but they are more expensive and their long term performance in com-
mercial scale is not yet proven.
Investment in power transmission and distribution networks can be con-
sidered as secure and almost riskless. The sector is a regulated natural mo-
nopoly. The tariffs are cost based but need approval from the regulator.
In Table 7-5, typical discount rates (WACC) for different types of power
sector projects are stated. They reflect the author’s opinion based on experi-
ence from former projects. They can be applied for projects and countries
with best creditworthiness and negligible country risk.
Table 7-5: Typical rates and premiums for selected project types
Equity 30% Loan 15 years70% WACC WACC
after tax in %/a after tax in %/a in %/a in %/a
Project type Life in in

Technology
interest rate
default risk
Technology
Risk free
Risk free
Venture
Utility size plants time nominal real *)

Credit
return
risk
risk
risk
terms terms
before before
tax tax
Steam power plant subcritical, coal 30 5.0 6.0 0.0 6.0 0.0 0.0 8.60 6.47
Steam power plant supercritical, coal 30 5.0 6.0 0.5 6.0 0.0 1.0 9.50 7.35
CCGT, natural gas 25 5.0 6.0 0.0 6.0 0.0 0.5 8.95 6.81
Nuclear power plant 50 5.0 6.0 3.0 6.0 0.0 1.0 10.50 8.33
Hydro power plant 50 5.0 6.0 0.0 6.0 0.0 1.0 9.30 7.16
Waste-to-energy plant 20 5.0 6.0 3.0 6.0 0.0 1.0 10.50 8.33
Wind power plant, on-shore 25 5.0 6.0 1.0 6.0 1.0 0.5 10.05 7.89
Wind power plant, off-shore 25 5.0 6.0 2.0 6.0 1.0 0.5 10.45 8.28
Solar PV power plant 25 5.0 6.0 0.0 6.0 1.0 0.5 9.65 7.50
Solar power plant, parabolic trough 25 5.0 6.0 0.0 6.0 0.0 0.5 8.95 6.81
Solar power plant, tower technology 20 5.0 6.0 3.0 6.0 1.0 1.0 11.20 9.02
Seawater desalination, thermal 20 5.0 6.0 0.0 6.0 0.0 0.0 8.60 6.47
Seawater desalination, reverse osmosis 20 5.0 6.0 1.5 6.0 1.0 0.5 10.25 8.09
High voltage grid 40 5.0 6.0 0.0 6.0 0.0 0.0 8.60 6.47
Low voltage grid 40 5.0 6.0 1.0 6.0 0.0 0.0 9.00 6.86
WACC: Weighted Average Cost of Capital Corporate Tax 25.0% * ) Inflation 2.0 %/a
Note: Company and country rating AAA
7.7.4 Country risks
Country risks include political risks, economic risks, sovereign risks, expro-
priation risks, transfer risks and currency risks. Country risks differ from one
country to the other.
Political risks include, e.g. subversion of the existing political system, civil
disturbance, insurgency, acts of terrorism, etc.
Economic risks and sovereign credit default risks can occur in developing
as well as in developed countries over the course of global financial and eco-
nomic turmoil.
Currency transfer & convertibility risks (T&C) are the most significant
risk if investing in foreign countries. Currency convertibility risk refers to the
inability of the investor to legally convert local currency into foreign curren-
cy. Transfer risks refer to restrictions to transfer capital from business activi-
ties (revenues, royalties, interest etc.) outside the country. Such a situation
may result from government action in several countries.
Expropriation risks may arise from government actions which reduce or
eliminate ownership on the investment. This may imply creeping expropria-
tion as confiscation or blocking funds up to outright nationalization.
A credit worthiness of a country or entity is evaluated by different institu-
tions and agencies. It is an evaluation of the debtor's ability to pay back the
debt and the likelihood of default. In this context, the following are men-
tioned.
• Export credit guaranties provided by Export Credit Agencies
• The OECD Arrangement on Officially Supported Export Credits
• The credit ratings by rating agencies
7.7.5 Hedging country risks with export credit guaranties
Institutions dealing with export credits are called Export Credit Agencies
(ECAs). Export credit agencies provide financing services such as guaran-
tees, loans and insurance to domestic companies in order to promote their
exports activities (Investopedia definition [11]). The primary objective of
ECAs is to remove the risk and uncertainty of payments to exporters when
exporting outside their country. ECAs take the risk away from the exporter
and shift it to themselves, for a premium. ECAs also underwrite the commer-
cial and political risks of investments in overseas markets that are typically
deemed to be high risk.
Export credits can be backed by official support meaning that government
support is involved. Official support can take the form of direct cred-
its/financing, refinancing, interest-rate support (where the government sup-
ports a fixed interest-rate for the lifespan of the credit), aid financing (credits
and grants), export credit insurance and guarantees.
In case of official support, an ECA can be a government department or a
commercial institution administering an account for or on behalf of govern-
ment, separate from the commercial business of the institution (see list of
ECAs in [12]).
7.7.6 Officially supported export credits, OECD Arrangement
Export credits generally enjoy government backed support which raises po-
tential concerns about free and fair competition; therefore, they have been
subject to agreements and understandings within the framework of the OECD
that led to a formal agreement, “The Arrangement on Officially Supported
Export Credits” known as “the Arrangement” [13] .
The overall objective of the OECD Arrangement is to provide a framework
for the orderly use of officially supported export credits and to ensure a level
playing field for official support. In particular, the Arrangement seeks to en-
courage a fair competition among exporters based on quality and price of
goods and services exported rather than on most favorable officially support-
ed terms and conditions and to eliminate trade distortions related to officially
supported export credits.
Participants are the formal negotiating forum for rules that are considered
binding. Participants administer and further develop the Arrangement. Partic-
ipants are currently the following OECD members: Australia, Canada, the
European Union, Japan, Korea, New Zealand, Norway, Switzerland and the
United States. Other OECD Members (list of members see [14]) and non-
members may be invited by the Participants to become Participants.
A fundamental building block of the Agreement is the country risk classi-
fications (Chapter II, section 25. [15]). The country risk classifications are
meant to reflect the country risk. Under the Agreement, country risk is com-
posed of transfer and convertibility risk, cases of political risks and of force
majeure (e.g. war, expropriation, revolution, civil disturbance, floods and
earthquakes). The Participants’ country risk classification system uses a scale
of eight risk categories (0 -7). High income4 OECD countries and high in-
come Euro Area countries are classified in category 0. Their country risk is
considered to be negligible or zero. The country risk classifications are not
sovereign risk classifications and should not, therefore, be compared with the
sovereign risk classifications of private credit rating agencies (CRAs).
4
Defined by the World Bank on annual basis according to per capita gross national
income (GNI)
The Arrangement on Officially Supported Export Credits provides a frame-

work for defining
a) Commercial Interest Reference Rates (CIRRs)
b) Minimum Premium Rates for credit risks (MPR),
The Arrangement stipulates that minimum interest rates shall apply to official
financing support for export credits. The minimum interest rates are the rele-
vant Commercial Interest Reference Rates (CIRRs) that are established by the
participants of the Arrangement for any of the eligible currencies5. They are
calculated by adding a fixed margin of 120 basis points to the yields of gov-
ernment bonds for repayment terms longer than 10 years. A basis point (Bps)
is equal to 1/100th of 1%. CIRRs are set on the 15th of each month and pub-
lished on the internet [16]6.
In addition to interest rates, the participants shall charge Minimum Premi-
um Rates (MPRs) to cover the risk of non-payment of export credits. The
(MPRs) are established for the country categories 1 to 7. They are produced
solely for the purpose of setting minimum premium rates for transactions
supported according to the Arrangement and they are made public so that any
country that is not an OECD Member or a Participant to the Arrangement
may observe the rules of the Arrangement. They cover non-payment of the
credit only; however, they do not cover long-term operating costs and losses.
The MPRs for transactions involving obligors (credit receiver, buyer) of
the categories 1 to7 are calculated on a case-by-case basis with a formula
given in Annex VIII of the Arrangement. The premium rate depends primari-
ly on the country risk category into which the country of the obligor is cate-
gorized. Category 0 indicates a very low risk and thus the lowest premium
rate, while Category 7 signifies the highest risk and the highest premium. The
premium is further influenced by the credit amount, the repayment terms, and
the buyer's status (public or private), with or without a bank guarantee and
also by the level of the uninsured percentage (percentage of cover). In case of
a private buyer/guarantor, (e.g. bank), its credit standing also influences the
premium amount (buyer/bank category).
The amount of the minimum premium rates (MPR) is determined as a
percentage of the credit value to be covered and is payable in advance.
The German Export Credit Agency Euler Hermes (see Brochure “Practical
Information, Hermes cover” [17]) provides an Excel-based tool for the calcu-
lation of MPRs [18].
5
Eligible currencies are: Canadian Dollar, Czech Koruna, Danish Krone, Japanese
Yen, Norwegian Krone, Swedish Krona, Swiss Franc, UK Pound, US Dollar, Euro
6
http://www.oecd.org/tad/xcred/cirrs.pdf
Table 7-6: Example premiums for export credits

Premium for Premium for
Country Buyer's credit € 1 million credit € 1 million
Classification Risk Horizon 5 years Horizon 15 years
*) category
Euro % Euro %
1 7,200 0.72% 15,300 1.53%
2 12,100 1.21% 30,000 3.00%
3 18,600 1.86% 49,600 4.96%
4 Sov+ **) 27,400 2.74% 76,100 7.61%
5 39,400 3.94% 104,800 10.48%
6 50,300 5.03% 129,700 12.97%
7 64,400 6.44% 161,400 16.14%
*) Valid as of 29 June 2012 acc. OECD Arrangement
**) Private-sector buyers'/banks with an external rating better than SOV
for the buyer's country
Source: Calculated with the Excel Tool of Euler Hermes, WWW.AGAPORTAL.DE
Author's compilation
The percentage of the premium is almost independent from the credit

amount. The buyer’s risk category has a significant influence; Sov+ is the
best out of eight. See table overview of buyer risk categories in [17] and An-
nex VI of the OECD Arrangement.
7.7.7 Credit ratings
Credit ratings are financial indicators that measure the creditworthiness and
the ability of issuers of debt securities to meet their financial obligations in
full and in time. Credit ratings are also indicators about the credit quality of a
security and the relative likelihood that it may default. They are assigned by
credit rating agencies (CRA) specialized in analyzing and evaluate the cre-
ditworthiness of entities such as governments, municipalities and enterprises
that issue debt securities (bonds) that can be traded in the capital market.
CRAs compile the results of their evaluation in ratings consisting of a combi-
nation of letters ranging from AAA or Aaa (best) to D (credit default). The
best known CRAs are Standard & Poor’s (S&P), Moody’s and Fitch.
Credit ratings may play a useful role in enabling corporations and govern-
ments to raise money in the capital market for funding their projects. Instead
of taking a loan from a bank, these entities (issuers) sometimes borrow mon-
ey directly from investors by issuing bonds. Investors purchase these debt
securities, such as municipal bonds, expecting to receive interest plus the

return of their principal, either when the bond matures or as periodic pay-
ments.
Credit ratings are determined in rating classes as shown in Table 7-7. Rat-
ings considered being investment grade, means that the security or the entity
being rated carries a level of quality that investors require when considering
overseas investments. Ratings that fall under "BBB" are considered to be
speculative or junk.
Table 7-7: Credit rating classes
Agency
Notation Grade
Moody's S&P Fitch
Aaa AAA AAA Prime

Aa, Aa1, Aa2, Aa3 AA+, AA, AA- AA+, AA, AA- High grade Investment
A1, A2, A3 A+, A, A- A+, A, A- Upper medium grade grade
Baa1, Baa2, Baa3 BBB+, BBB, BBB- BBB+, BBB, BBB- Lower medium grade
Ba1, Ba2, Ba3 BB+, BB, BB- BB+, BB, BB- Speculative Non-
B1, B2, B3 B+, B, B- B+, B, B- Highly speculative investment
grade
Caa1, Caa2, Caa3 CCC+, CCC, CCC- Extremely speculative
CCC
Ca CC, C Default imminent speculative
C D DDD, DD, D In Default In Default
In general, interest rates depend on the risk of the issue or issuer of a debt
obligation. A low-rated security has a high interest rate in order to attract
buyers. In contrast, a highly-rated security (assigned with AAA rating) has a
lower interest rate because it is a low-risk investment.
Credit rating agencies designate their ratings as opinions about relative
credit risk [19]. Relative means, for example, that the risk of default of a
bond bearing a BBB rating is less risky than that of a bond with a BB rating.
Credit agencies observe market developments that may affect the credit risk
and update ratings at least once a year. They may also issue an updated rating
outlook regarding a possible change to be “positive”, “negative” or “stable.
“Developing outlook” means that it is uncertain whether the rating may be
up- or downgraded in the near future [20]. Investment grade ratings are usual-
ly more stable than speculative ratings.
Updated ratings are listed on the websites of the rating agencies and also in
newspapers such as, Guardian [21], among others.
Ratings can be used to estimate risk premiums for corporate or government
bonds. One way of establishing risk premiums is to compare the interest rate
that the market establishes for a security to a comparable security of a

benchmark country. To be comparable, securities must have the same maturi-
ty and involve payments in the same currency [22].
Table 7-8 below summarizes estimates of default spreads of government
bonds corresponding to rating classes in basis points (Bps) referred to Aaa
rating bonds with zero spread. A basis point is equal to 1/100th of 1%. Basis
point 120, for example, means that 1.2 percentage points must be added to
the standard rate. A default spread is the difference of the yield of bonds of
different classes compared to the yield of a benchmark bond; in our case, this
is a bond with Aaa rating.
Table 7-8: Default spreads of government bonds by rating class [23]
Baa1
Baa2
Baa3
Rating class
Aaa
Aa1
Aa2
Aa3
A1
A2
A3
investment grade
Country default spread, Bps 0 25 50 70 85 100 115 150 175 200
Caa1
Caa2
Caa2
Caa2
Rating class
Ba1
Ba2
Ba3
B1
B2
B3
speculative
Country default spread, Bps 240 275 325 400 500 600 700 850 850 -
Author's own compilation based on data from:
Source: http://pages.stern.nyu.edu/~adamodar/New_Home_Page/datafile/ctryprem.html
Reference interest rate for Aaa rating 6%/a, Currency US$
Spread is the difference in Bps referred to the Aaa rating bonds with zero spread
A rough estimate of the risk premium for government bonds in percentage

points above the reference interest rate is CRP = Bps/100 % and for capital
market bonds CRP = 1.5 x Bps/100 % [23].
The spreads in Table 7-8 are in nominal terms. Interest rate capital market
bonds: in = 6% + Bps/100 %. The computation to express capital market
bonds in real terms is as follows:
 in 
 1 + 100  (7.7)
CRPr =  − 1 × 100 [%]
6
1+ 
 100 
Example 7.6: Country premium for capital market

Given:
Currency US$
Interest rate for Aaa rating 6%
Country’s rating class: Baa1, Bps 150
Premium:
Premium in nominal terms: CRPn = 1.5x150/100 = 2.25 %
Interest rate, nominal: in = 6%+2.25% = 8.25%
Premium in real terms: CRPr = ((1+0.0825) / (1+0.06)-1) x 100 = 2.12 %
Example 7.7: WACC including country risk premium
Item Equity Loan

Expected returns after tax rates
Risk free rates 5.0 %/a 5.0 %/a
Venture/credit default premium 6.0 %/a 1.0 %/a
Project type risk premium 0.0 %/a 0.0 %/a
Country risk premium Rating Baa1 1.5 %/a 1.5 %/a
Cost of capital in nominal term, after tax 12.5 %/a 7.5 %/a
Corporate tax *) 25% 4.2 %/a 0.0 %/a
Cost of capital in nominal terms, before tax 16.7 %/a 7.5 %/a
WACCn in nominal terms, before tax 10.25 %/a
./. Expected Inflation rate 2.00 %/a
WACCr inflation adjusted 8.09 %/a
*) depends on country legislation
Note: Country with country risk zero: WACCn=8.6%, WACCr=6.47
8 Overview of Energy Markets and Prices
The overall objective of this chapter is to analyze the price setting mechanism
and price development of various types of primary energy (crude oil, coal,
nuclear, natural gas) used for power generation. The analysis covers the peri-
od from 1970 until the year of publishing this book as far as data from pub-
licly accessible statistics were available. The purpose is to draw conclusions
for future fuel price approaches in project evaluation.
The findings in this chapter can be summarized as follows: The market
prices of primary energies are subject to strong periodic fluctuations with
crude oil being the price leader; they are particularly sensitive to geopolitical
events such as crises and unrest in the producing countries. News and rumors
in the commodity markets, which cause fears regarding shortages or oversup-
ply among consumers, may also trigger price volatility even intraday.
It becomes clearly evident that crude oil still exerts a price leadership func-
tion on the energy market. The prices of all other primary energies follow the
price development of the price leader crude oil with a short delay.
The pricing of energies, which are in competition with each other, is based
on the replacement value concept. This implies, for example, that the power
generation costs of competitive fuels are kept at the same level and define the
prices. This price setting principle is commonly applied in long term con-
tracts for imported natural gas.
Import coal prices are heavily influenced by fluctuating overseas freight
rates which in turn depend on available overseas transport capacities and may
reach up to half of the CIF coal price.
Based on the findings from the past, we can conclude that medium- and
long-term price forecasts for primary energies are practically impossible. The
influence of fuel price development on the evaluation of investment projects
should rather investigate their influence in sensitivity or scenario analysis
taking into account their interdependence.

110 8 Overview of Energy Markets and Prices
8.2 Definitions of energy terms
8.2.1 Forms of energy
Energy is defined in physics as the ability to produce work. Based on this

definition, several forms of energy are distinguished:
• Mechanical energy may occur as kinetic energy (movement energy)
or potential energy (energy of a body with respect to its elevation)
• Thermal energy is contained in energy carriers as steam, hot water,
thermal oil etc.
• Chemical energy is contained, e.g. in fossil fuels
• Nuclear energy is contained in the nucleus of atoms
• Radiation energy such as solar irradiation
A different classification is done according to the state of the energy conver-

sion and usage chain. There are following forms:
• Primary energy
• Secondary energy, including the sub forms
o Final energy
o Useful energy
Primary energy is extracted from stocks of natural resources through mining

or exploration; examples include coal, uranium, crude oil and natural gas or
are captured from natural energy flows as solar radiation or wind. Primary
energy has not undergone any conversion other than separation and cleaning.
Final energy is produced from primary energy through a conversion pro-
cess. The conversion process may take place in a refinery, power generation
plant or a different type of energy converter. Examples include oil products
as light and heavy fuel oil or gasoline, natural gas, electricity. Other forms of
final energy are, e.g. blast furnace gas, converter gas, district heat or chilled
water.
Final energy is converted into useful energy in end-use appliances. These
include, e.g. electrical light, space heating or cooling, movement or rotation
of tools.
8.2.2 Heating value of fuels
Fuels are available in the form of primary energy (e.g. coal, natural gas) or
final energy (e.g. fuel oil, Liquified Petroleum Gas (LPG), blast furnace gas).
Fuels are traded on the marketplace with different mass or volume units as
8.2 Definitions of energy terms 111
barrel crude oil, tons of coal, normal cubic meters (nm3) of gas, liter of diesel
oil, etc. However, the actual value of a fuel is not solely its mass or the vol-
ume but its energy content. There are, for example, different qualities of coal
or oil with different energy contents per mass unit.
Notations like tons of coal equivalent (tce) or tons of oil equivalent (toe)
provide better information regarding the value of a fuel as they are referred to
the energy content. One tce contains 7 billion calories7 (7 Gcal/tce); one toe
contains 10 billion calories (10 Gcal/toe). So coal or oil types with different
energy contents can be made comparable if their quantity is given with their
equivalent units, but these notations are still trade units and not applicable for
all types of fuels.
Hence, in order to compare the value of different types of fuels, their quan-
tities must be converted from trade units into thermal units. This is neces-
sary, for example, to establish energy balances or even to conduct financial
calculations with different types of fuels. The conversion in thermal units is
done by multiplying the trade units with the heating value.
The heating value is the measurement for determination of the energy con-
tent of the fuels. There are two heating values for each type of fuel. The terms
used are in American English: “lower heating value (LHV)” and “higher
heating value (HHV)”; in British English, instead, the terms used are “net
calorific value (NCV)” and “gross calorific value (GCV)”. In German litera-
ture, the terms Hu and Ho8 are common. In scientific papers, the terms “inferi-
or heating value (Hi)” and “superior heating value (Hs)” have been introduced
but they are rarely used in practice.
The higher heating value is defined as the amount of heat released by
complete combustion of one unit of fuel, all combustion products
cooled down to the temperature before the combustion and the water
vapor formed during the combustion is condensed into water and its
condensation heat is included in the HHV.
In contrast, the lower heating value does not include the condensation
heat of the water vapor formed during the combustion.
Heating values for selected fuels are shown in Annex 3. They are given in kJ,
MJ, kWht, MWht per unit of fuel (kg, metric ton, normal cubic meter (nm3)).
The notation in kWht or MWht is more practical for energy balances and is
preferably applied in this book.
7
) Calorie is an old thermal unit. In practice, the multiple kilocalorie (kcal) is used.
1 kcal =4.187 kilo Joule (kJ) = 1,163 kWht. 1 Gcal =1,000,000 kcal
8
) Hu:Unterer Heizwert, Ho Oberer Heizwert (corresponding to: LHV, HHV)
It is worth mentioning that in British and US literature the higher heating

values are common, while in continental Europe the lower heating values are
preferably used.
In power engineering and in this book, the lower heating values are ex-
clusively used for energy balances and for financial calculations.
Some orientation ratios for conversion of HHV to LHV for selected fuels are
given below:
Fuel LHV/ HHV
Natural gas 0.903
Heating oil 0.940
Hard coal 0.958
Coal and HFO are traded in metric tons; for the conversion in thermal units
based on MWht or GJ, the commercial price is divided with the lower heating
value of the fuel.
cc  US$/t   US$  cc  US$/t   US$ 
ct =   or ct =   (8.1)
LHV  MWh t /t   MWh t  LHV GJ/t   GJ 
The wholesale price of natural gas in international energy purchase contracts

is usually referred to 1000 normal cubic meters (nm3):
cc  US$/1000 nm3   US$  cc  US$/1000 nm3   US$  (8.2)

ct =   or ct =  
LHV MWh t /1000 nm3   MWh t  LHV GJ/1000 nm3   GJ 
In general, gas utilities sell gas based on the HHV; for energy balances, it
must be converted in LHV.
Note: See also Chapter 9 Case Studies, Exercise 9.2-1, Exercise 9.2-2 and Exercise
9.3-1 and Exercise 9.3-2.
8.3 The Wholesale Market of Fuels
This section describes and analyses the development of prices of the main
fuels which are used for power generation and provides a brief overview of
the pricing mechanisms. The analysis covers the period 1970 up to the pub-
lishing year of this book. Based on the outcome of this analysis, conclusions
are drawn regarding the development of fuel prices in the economic evalua-
tion of long term energy sector projects.
8.3 The Wholesale Market of Fuels 113
8.3.1 Crude oil
Crude oil is traded in international commodity exchanges and has developed

all the instruments linked to commodity trading, such as spot and futures
markets with all the derivatives to hedge and/or to speculate on future prices
[24]. The different qualities and locations of crude oil are quoted in the com-
modity exchanges in reference to crude oil types such as Brent (North Sea
Brent) in the London Petroleum Exchange IPE, WTI (West-Texas-
Intermediate) at Nymex9, New York and Dubai. OPEC10 countries in Middle
East usually sell their oil at a price linked to the price of the OPEC basket11.
Crude oil with a consumption level of about 85 to 90 MBD (million barrels
per day) is the main primary energy and price leader worldwide and exerts a
global price regulation function on all other energy forms.
Crude oil is usually traded in US$ per barrel (US$/bbl) (CIF) with refer-
ence to the main import terminals as ARA (Amsterdam-Rotterdam-Antwerp)
for continental Europe.
The following Figure 8-1 depicts the development of crude oil prices since
1970 in nominal terms, as well as in real terms, related to the 2013 US$ or
Euro values (Sources: [25], [26], [27]).
120
Nominal Real 2013 Real 2013

US$ / barrel € /barrel US$ /barrel
100 exchange
rate adjusted
80
Price /barrel
Real 2013 Prices

60
40
20
0
1970
1972
1974
1976
1978
1980
1982
1984
1986
1988
1990
1992
1994
1996
1998
2000
2002
2004
2006
2008
2010
2012
2014
2016
Data Sources: OPEC annual statistic Bulletin, CPI: German Federal Bank, The Federal Reserve Bank USA
author's own compilation as a graph
Figure 8-1: Crude oil spot prices, OPEC basket annual average price
9
) New York Mercantile Exchange
10
) Organization of the Petroleum Exporting Countries
11
) The “OPEC basket” is a mix of eleven oil types
The price is subject to strong, even hourly fluctuations and is extremely vola-
tile. The prevailing price drivers are geopolitical events and uncertainties as
well as speculation. Oversupply during weak periods or shortages in supply
during booming periods in the economy, cause price erosion or rising prices.
Exchange rate fluctuation between local currencies and the dollar play an
important role. For example, a strong Euro makes crude oil imports in the
countries of the Euro Area cheaper, and vise-versa.
The development of the crude oil price in real terms during the considered
time frame is characterized by a high price phase followed by a longer, calm-
er price period and a renewed high price phase. The sharp rise of the oil price
in the decade 1974 to 1984 was caused by the two so-called oil-price shocks12
in 1973/74 and 1979/80. The oil price reached a peak of 85 US$/barrel in
1981 in real terms (2013 US Dollar). The high oil price triggered strong in-
centives for oil-producing companies to intensify research for oil resources
and to invest in new oil production fields. Oversupply and economy recession
caused the reverse oil-shock in 1985/86 and a collapse in oil prices for almost
20 years (1985 to 2005). The peak of 85 US$ in 1981 was reached in 2007/8,
again, with prices becoming higher than 100 US$/barrel.
Rising prices along with technology development have made
non-conventional oil production economically viable, such as deep and ul-
tra-deep development oil exploration, and the Canadian oil tar sands and
recently fracking. A sharp drop in oil price that occurred again in 2009/10
caused by the financial crisis and following economic downturn.
Reasons for the extreme drop of crude oil prices in 2014 and 2015 are
oversupply during global economic downturn, in connection with presumed
attempts of oil producing countries to keep oil prices low and make fracking
of oil and gas uneconomic for the foreseeable future, especially in the USA.
Crude oil itself is not a direct end-use13 energy; it is refined in refineries in-
to different petroleum products such as aviation fuel, gasoline, diesel oil,
heavy and light fuel oil (HFO, LFO). The market values of these products
depend on their properties, quality and end-use application. The total value of
products processed from crude oil is called the Gross Product Worth (GPW)
[24]. The GPW is equal to the crude oil price plus production costs. Refiner-
ies have own methods for apportioning production costs among the products.
12
) These were the oil embargos imposed by the oil producing countries in 1974 and
the Iran revolution in 1979.
13
) Notable exceptions are Saudi Arabia, India and China where some crude oil is
used directly for power generation
The lesson learnt from this historical analysis is that long term oil price
forecasts are practically impossible because the causes are out of con-
trol and not predictable.
8.3.2 Steam coal
Coal is the main fuel used for power generation worldwide. According to the
IEA [28] [29] classification, there are two types of coal; namely, brown coal
and hard coal, distinguished by carbon and moisture content. Hard coal con-
sists of coking coal and steam coal; Steam coal is mainly used for power
generation while coking coal is used for steel production in blast furnaces.
Hard coal is traded globally; brown coal is commonly used in power plants
near the open cut mining site, as, due to its low heating value, transportation
costs are too high.
Steam coal with a share of more than 40% is the main primary energy used
for power generation worldwide. This section deals with steam coal only.
Coal is mainly traded based on long-term bilateral contracts between min-
ing companies and utilities of large coal-fired power plants. This is because
of the large capital investments involved in the projects on both sides. Long
term contracts provide securities for financing such projects.
Since the beginning of this century, short-term contracts and spot transac-
tions are also increasingly gaining importance. The reason is that after liber-
alization of the markets, prices of electricity are fluctuating and utilities try to
reduce risk by splitting the supply of coal into long-term contracts and short-
term transactions for more flexibility. Spot market transactions are often lim-
ited to only one cargo or to a series of cargo shipments.
The introduction of standard coal benchmarks regarding origin, quality and
delivery place has enabled coal trade in international commodity exchanges
in spot markets as well as in futures and options transactions. Coal bench-
marks [30] are among several others [31], such as
• API#2, NAR14 CIF ARA15 terminals, South Africa coal ex Richard
Bay, 6000 kcal/kg
• API#4, NAR FOB Richard Bay Coal Terminal (RBCT), South Afri-
ca coal, 6000 kcal/kg
• API#6, NAR FOB New Castle, Australia, 6000 kcal/kg
14
) NAR stands for Net as Received
15
) ARA: Amsterdam, Rotterdam, Antwerp
Handling of business transactions are managed by brokers via the electronic

trading platform Global Coal.
Coal is usually priced internationally in US$/tce. The spot prices of steam
coal (CIF ARA terminals) can be considered as typical for most of the central
European countries importing coal. They are officially published by the Ger-
man Federal Office of Economics and Export Control (BAFA) [32]. Their
development – Figure 8-2 – shows a similar shape as that of crude oil. There
is a drastic peak in the eighties after two oil price shocks; however, the in-
crease in the high price period starting after 2007 is less pronounced com-
pared to crude oil. (Data Sources: [33], [34], [26]).
Figure 8-2: Cross-border spot prices of imported steam coal, Germany

It is noted, however, that the sea freight rates are an additional significant
price driver for coal imports – Figure 8-3 – and can reach almost half of the
CIF ARA price.
Sea freight rates are published by the SSY Ship broking Group [35] and by
Baltic dry index (BDI) and others.
The international coal market is divided in two regional markets – the At-
lantic and the Asian-Pacific market. The seaborne transport of coal is done by
dry bulk carriers of the Panamax class (80,000 DWT16) and the Cape size
class (120,000 DWT). If the available ship transport capacities during eco-
nomic booms are insufficient, the rise of freight rates may be significant; on
16
DWT: Deadweight tonnage, a measurement for ship transport capacity
the other hand the freight rates decline with excess transport capacities during
recession periods of the economy. For instance, sea freight rates rose signifi-
cantly in 2007/8 due to high demand of dry bulk carriers to transport other
commodities such as iron ore and bottlenecks in available transport capaci-
ties. In the aftermath of the economic downturn following the financial crisis
of 2008 they collapsed for a short time and remained at a low level until
2014.
Figure 8-3: Average freight rates for coal to ARA terminals
8.3.3 Natural gas
Natural gas is, in contrast to oil and coal, a grid-bound energy; therefore sup-
ply, trading and pricing of gas follows other principles. In this regard, we
have to distinguish between four geographically distinct market segments
which are subject to different supply and pricing characteristics, as well as
regulatory regimes [24]. These are: USA, United Kingdom (UK), continental
Europe and the Far East.
Until now, the gas markets in the USA and UK have been based almost
exclusively on domestic gas resources. In contrast, natural gas in continental
Europe is almost entirely imported. It is transported via long distance pipe-
lines from the Netherlands, Russia, Norway and recently also from the UK.
The markets in the Far East are mainly relying on imports of Liquified Natu-
ral Gas (LNG).
This section mainly covers the market of continental Europe and describes
only briefly those of the other regions17.
The development of the import-based gas supply industry in continental
Europe started with the discovery of the giant Groningen gas field in the
Netherlands in 1961. Gas started to penetrate the household and industrial
heating market and to substitute energies already used. The pricing of the gas
for domestic use in the Netherlands as well as for export has been based on
the replacement value concept versus competitive energies that could be sub-
stituted by natural gas (e.g. heating oil for space heating, heavy fuel oil for
industry or coal for electricity generation). The philosophy thereby is that the
replacement value of gas is defined by the production cost of the useful ener-
gy of the competitive fuel. This is illustrated in the example of electricity as
useful energy in Figure 8-4 below.
The total electricity production costs, Figure 8-4, are defined by the coal
option as the leading fuel in the power sector; coal is already on the market
and its costs are known. The difference between the total production cost and
the fixed cost of the gas option determines the replacement value of the gas
versus coal as a competitive price. The difference between the fixed costs of
the coal and the gas option is called the gas premium.
Figure 8-4: Replacement value of natural gas vs. coal as the substitute
The concept of the replacement value in Figure 8-4 is limited to one competi-
tive plant & fuel option only. The calculation of the replacement value of a
whole market includes all plant-fuel configurations, including all sectors and
17
) More information is provided in the report of the Energy Charter Secretariat “In-
ternational Pricing Mechanisms for Oil and Gas [24]
subsectors of the economy (industry, households, heat & power, etc.) and is
calculated with complex models, as shown in Figure 8-5.
Evaluation of statistical data Author‘s own illustration

by sector (Industry, Households, Heat &Power)
Selection of competing plants & fuels by sector

plant types and sizes, fuels, utilization time
Market shares of competing plants & fuels

by sector
Calculation of the replacement values

of the competing plants by sector
Calculation of the average replacement value for each sector
Projection of the sectoral replacement values on the whole market
Figure 8-5: Modelling of replacement values of a market

The gas price based on the replacement value is defined at the end of the
supply chain. Pricing for export gas for the market of a specific whole coun-
try is based on the concept of the net back value. On this basis, the replace-
ment value is calculated versus all competitive energy forms in the buyer’s
country, which can be substituted by gas and is called the replacement value
at the delivery point (or cross border value). The net back value is the value
of the gas at the wellhead of the gas field and is calculated from the border
replacement value by deducting the transportation costs.
Net back value = Replacement value at delivery point minus Trans-
portation costs from the gas wellhead to the delivery point (border).
Note: The gas transport is a significant cost factor. The Yamal-Europe pipe-
line [36] from Russia to Germany, for example, has a length of about 4,200
km, a diameter of 1,400 mm and a transport capacity of 33 billion cubic me-
ters per year (bcm/a). Along the pipeline, there are 31 compressor stations
installed with a capacity of about 4,200 MW18, maintaining a maximum gas
pressure of 80 bars.
18
) The capacity of a coal-fired power plant with USC parameters is 800 MW
In order to recover and guarantee the payback of the huge capital expendi-
tures, import gas supply is based on long-term contracts19, the main elements
of which are:
• Availability commitment of the seller, including delivery obligation for
certain amounts of gas (nm3/a) and delivery capacity (nm3/day)
• Off-take obligation of the buyer based on a take-or-pay (TOP) clause
for a certain gas quantity
• A long-term minimum pay obligation of the buyer for the TOP quantity
• Net back pricing formula based on the replacement value at the point of
delivery (border)
• Price adjustment period (month, quarter, year), usually quarter
• Clause for a regular review (usually every three years) of the price for-
mula with the possibility to adapt the formula to reflect changes in the
structure and replacement value
• Arbitration in the case of disagreement
The price formula under the net back value concept in its simplest form is:
 US$ 
Pt = Po + a ⋅ ( LFOa − LFOo ) + b ⋅ ( HFOa − HFOo )   (8.3)
3
1000 nm 
Where:
Pt: Actual gas price at the time “t”
Po: Starting gas price reflecting the net back value to the point of delivery
(border) at the signing of the contract
a and b: A product of dimensionless factors reflecting the shares and the re-
placement values of competing energies, thermal equivalence factors,
factors to share changes in the market value
LFOa, LFO0: Actual (a), starting price (0) of light fuel oil (LFO)
HFOa, HFOo: Actual (a), starting price(0) of heavy fuel oil (HFO)
1000 nm3 Russian gas is sold in US$/1000 nm3
During the review of contracts, the replacement value is recalculated and the
factors included in “a” and “b” are accordingly readjusted. Figure 8-4 shows
that if the environmental legislation becomes more stringent, the costs for
flue gas cleaning of the coal plant or the carbon fees will increase. This will
have some positive impact on the replacement value as the gas premium will
also increase.
The cross-border prices to Germany are typical for the continental Europe-
an market. They are published monthly by the German Office of Export Con-
trol (BAFA) [37]. The development of the cross-border price in nominal and
19
) The contract duration may be 25 to 30 years with an option for extension
real terms is depicted in Figure 8-6 below. The shape of the gas price devel-
opment is similar to that of crude oil.
Figure 8-6: Cross border price of imported natural gas, Germany
8.3.4 Heating or Calorific price and price relations of fuels
The calorific price refers to the heat content of each fuel and is expressed in
currency units per thermal unit, e.g. in CU/MWht or CU/GJ (1 CU/MWht =
3.6 CU/GJ).
Figure 8-7 depicts the development of calorific prices for the main fuels
used for power generation for the period 1991 to 2016. The prices are Ger-
man cross-border prices and can be considered as typical for most of the
countries of continental Europe. They are derived from prices in trade units
after conversion to calorific prices. It becomes evident that there is a distinct
correlation between prices of the different fuels during the entire period under
consideration. The long term ratios referring to crude oil for the period 1991
to 2016 are stated in the box embedded in the figure. The calorific price of
crude oil is taken thereby as the reference price with ratio =1.
Note: See also Case Studies, Exercise 9.2-1

Figure 8-7: Calorific price of main fuels, cross-border Germany
The ratios of the fuel prices to the crude oil price are depicted in Figure
8-8. The trend is evident; the prices are correlated. For example, price
peaks and bottoms are coincident. The ratios (Figure 8-7) can be con-
sidered an appropriate basis for price forecasts for the evaluation of
long-term investments in the energy sector.
1.6
Price trends refered to crude oil
1.4
1.2
1.0
0.8
0.6
0.4
0.2
0.0
1991
1993
1995
1997
1999
2001
2003
2005
2007
2009
2011
2013
2015
crude Steam natural HFO LFO

oil coal gas 3.5% S 0.2% S
Data Sources: BAFA, German Coal Association (GVSt), OPEC (Platt's oilgram, Reuters)
author's own calculations and compilation as a graph
Figure 8-8: Price trends of fuels referring to crude oil price

Although the difference between fuel prices and crude oil price does not re-
main constant the relative price level is maintained. The natural gas price
shows the largest deviations. This is because gas prices are contract prices
while all the others are spot prices. The coal price shows some upward trend;
the reason might be that competitiveness to cleaner fuels suffers due to im-
posed carbon fees.
8.3.5 End-user fuel prices – domestic fuel transport cost
The fuel prices discussed until now were cross-border prices. The end-user
prices include, among others, cost for domestic transportation and may also
be subject to taxation. Within the European Union, fuels for power generation
are tax exempt; however, those used for heating or industrial use are subject
to taxation. In the following, we will confine ourselves to fuels for power
generation only; a detailed description of fuel pricing for all users would go
beyond the scope of this book.
Oil products such as HFO and LFO are delivered free refinery and trans-
ported to the end user via road tanker. Due to the high heat content of oil, the
transportation costs are not a significant cost component.
Imported coal is delivered CIF at the overseas ports (e.g. ARA terminals).
The transportation from the overseas port to the final destination site is done
by inland water vessel or by rail. The associated costs may be significant, as
shown for three destinations in the example below:
Example 8.1: Domestic transport cost of coal free power plant
Dortmund Karlsruhe Linz

Item Unit Germany Germany Austria
303 km 668 km 1350 km
Coal price CIF ARA port 79.00

Inland transport
Transshipment to inland water vessel 4.50 4.50 4.50
€/t
Freight by inland water vessel *) 2.85 4.30 12.50
Unloading to the site 4.00 4.00 4.00
Transportation costs 11.35 12.80 21.00
*) Average for 10 destinations 0.95 €/(t km) Exchange rate USD/€=0.7515
Imported natural gas is transported from the border delivery points through
the national gas grids to the end users. These grids consist of several sub-
grids with different pressure levels. The pressure of the trans-regional grid is
PN 60 bar to PN 80 bar. Gas-fired utility size power plants are mainly con-
nected to this grid. Gas supply systems of cities consist of several sub-grids
with different pressure levels such as high pressure (HP) with PN 4 bars to
1 bar, medium pressure (MP) with PN 1 bar and low pressure (LP) with PN
25 mbar to 100 mbar. The subgrids are interconnected by pressure reduction
stations.
In general, the use of system charges for gas transport depend on the pres-
sure level of the grid from which the gas is delivered and the amount of gas
[38]20. The tariffs consist of a capacity charge and a volume charge and some
smaller fees for services such as metering and billing. In Example 8.2, the use
of system cost for three different consumers are shown. They have been cal-
culated with the tariff calculation tools from different utilities available in the
Internet (e.g. EnBW [39] and others) and can be considered weighted averag-
es for Germany.
Example 8.2: Use of system cost for gas transport
Type of plant
Item Unit Small scale Medium scale Utility size

engine district heating CCGT
cogeneration cogeneration power plant
Technical Parameters
Power output MWe 3.5 150 400
Full load hours h /a 5,000 5,000 5,000
NG demand (capacity), HHV MWt 10 300 750
NG consumption, HHV MWht / a 50,000 1,500,000 3,750,000
Border price 2013 € / MWht 27.56
Use of system charges
Capacity charge € / (MWt a) 9,950 5,760 5,590
Volume charge € / MWht 1.50 0.98 0.97
Annual transport costs
Capacity costs 1000 € / a 100 1,728 4,193
Volume costs 1000 € / a 75 1,470 3,638
Total costs 1000 € / a 175 3,198 7,830
Specific cost € / MWht 3.49 2.13 2.09
Exchange rate USD/€=0.7515
20
For German speaking readers, a comprehensive elaboration of the topic is available
in: [38] Praxisbuch Energiewirtschaft, Panos Konstantin, SpringerVieweg
4. Auflage, 2017
8.3.6 Nuclear fuel
Uranium deposits consist of the two uranium isotopes, namely about 99.3%
U-238 of and 0.7% U-235. Only the isotope U-235 is fissile and can generate
huge amounts of thermal energy in a fission chain. At the mines, the natural
uranium is separated from waste residues and comes to the marketplace in
form of Uranium Oxide U3O8, also called yellow cake. This undergoes sever-
al process steps [40] to become Uranium dioxide UO2, that is, the actual nu-
clear fuel – Figure 8-9. The nuclear fuel used for power generation is en-
riched Uranium, in which the content of the isotope U-235 is increased from
0.7% to about 3% to 4%. This is compiled in nuclear fuel assemblies that
come into the reactor core of the power plants.
Figure 8-9: Nuclear fuel production chain for light water reactors
In Example 8.3, the heating value, and in Example 8.4, the calculation of the
cost of nuclear fuel is shown.
Example 8.3: Heating value and electricity generation of nuclear fuel

Convoy Advanced
Item Unit type type Comments
reactor reactor
Nuclear fuel UO2 spent kg 1 1 Reference
Content of U-235 *) kg U / kgUO2 0.89 0.89 3.6% enriched fuel
Burnup per kg nuclear fuel *) MWtd / kgUO2 43.5 60.0 Heat release in 24 hours
Hours per day h/d 24 24
Heat release in the reactor **) kWht / kgUO2 929,160 1,281,600 PP-coal 8.14 kWht/kgcoal
Electrical efficiency - 34.5% 37.2% 40.0%
Electricity generation kWhe / kg UO2 285,299 424,312 PP-coal 3,3 kWhe/kgcoal
*) typical values **) Corresponds to LHV
The cost of nuclear fuel is expressed in US Dollar per kg uranium dioxide –

US$/kgUO2. The prices of nuclear fuel are composed of the following cost
components. The calculation scheme is shown in Example 8.4.
• Cost for Uranium oxide U3O8
• Conversion cost of Uranium oxide to Uranium hexafluoride UF6
• Cost for enrichment of Uranium hexafluoride UF6
• Cost of nuclear fuel fabrication to UO2 assemblies
Example 8.4: Calculation of the nuclear fuel cost
Item Unit Values

Composition of nuclear fuel UO2
Uranium dioxide UO2, reference amount kgUO2 1.0
Yellow cake (Uranium oxide U3O8) kgU3O8 / kgUO2 8.5
Uranium content U in UF6 by conversion kg U / kgUO2 7.2
Enrichment SWU-input SWU / kgUO2 4.0
Nuclear fuel (3.6 % U-235) kg U / kgUO2 0.89
Prices *)
Market price Uranium oxide U3O8 US$ / lbU3O8 38.6
Market price Uranium oxide U3O8 0.454 US$ / kgU3O8 85.0
Conversion price per kg U US$ / kg U 10.1
Enrichment cost per SWU US$ / SWU 108.0
Fabrication cost per kg nuclear fuel US$ / kgUO2 275.0
Costs pro kg nuclear fuel (UO2)
Uranium oxide U3O8 85.0 x 8.5 US$ / kgUO2 723
Conversion UF6 10.1 x 7.2 US$ / kgUO2 73
Enrichment 108.0 x 4.0 US$ / kgUO2 432
Fuel fabrication 275.0 x 1.0 US$ / kgUO2 275
Total US$ / kgUO2 1,502
*) Source: The Ux Consulting Company, (average 2013 based on monthly price
notations), author's own computation
The cost structure of the nuclear fuel and the price development in the recent
20 years is depicted in Figure 8-10 [41]. It becomes evident that the main cost
drivers are the cost of yellow cake, while the other cost components remain
stable. The shape of the price development shows no similarities to those of
crude oil and the other fossil fuels. The reason for this is that the price build-
ing mechanisms follow different paths. The low prices in the period 1994 to
2004 were caused by oversupply of nuclear fuel converted from uranium
weapons following the agreement between the big powers. Due to the low
prices, no investment in new mines had been made in this time, resulting in a
shortage of supply on the market and a sharp rise of prices after 2004.
Figure 8-10: Prices of nuclear fuel

In Example 8.5, the specific heat cost and the fuel cost of electricity are cal-
culated for nuclear power generation and for a coal fired power plant for
comparison. The fuel costs of electricity of the coal fired power plant are
about 7 to 10 times higher compared to those of the nuclear power genera-
tion. On the other hand, the capital costs of nuclear power are about 3 to 4
times higher compared to coal fired power plants.
Example 8.5: Calorific cost of nuclear fuel and fuel cost of electricity
Convoy Advanced Coal *)
Item Unit type type steam
reactor reactor Power Plant
Fuel unit - 1 kgUO2 1 kgUO2 1 kg ce
Heating value per unit MWht 929 1,282 0.00814
Power plant electrical efficiency - 34.5% 37.2% 42.0%
Electricity generation per unit MWhe 321 477 0.00342
Price per unit 2013 US$ 1,502 1,502 0.110
Calorific price US$ / MWht 1.62 1.17 13.51
Fuel cost of electricity, only US$ / MWhe 4.69 3.15 32.18
*) Steam coal: 8.14 MWht/tce; 110 US$/tce
8.4 Conclusions and Recommendations for Fuel Price

Forecasts
8.4.1 Proposed approach for fuel price escalation
The lessons learnt from the analysis of the fuel price development during a
long time span from 1970 until today can be summarized as follows:
a. Long term fuel price forecasts are unrealistic and highly speculative
because the causes are out of control and unpredictable – Figure 8-1.
b. The prices of the main fuels are correlated to each other and follow
the price trend of crude oil – Figure 8-7
c. Prices of competitive fuels are set based on the replacement value
approach – Figure 8-4
d. For price forecast over longer periods an average ratio between the
fuel prices and crude oil is a realistic assumption taking into account
all the other uncertainties – Figure 8-8.
For investment appraisal of projects, the same escalation rates (%/a) are usu-
ally assumed for different fuels. With this approach, however, the price gap
between low- and high-priced competitive fuels increases over the lifetime of
the investment, as shown in Figure 8-11.
8.4 Conclusions and Recommendations for Fuel Price Forecasts 129
Figure 8-11: Projection of fuel prices with equal escalation rates

This contradicts lessons learnt from the historical analysis of the fuel price
development (item b and d above) as well as the replacement value principle
(c). Investment appraisal of options with a price trend as shown in Figure
8-11 would provide an unfair advantage for the option with the cheaper fuel.
Based on the outcome of the analysis of the fuel price development in the
past, there is every reason to maintain a constant price difference between
competitive fuels during the investment period. In this respect, the following
two alternative approaches are proposed:
• Escalating of the initial price of only one of the fuels and keeping the
price difference of all the other fuels constant to the first (Figure 8-12).
This would correspond to the replacement value approach (Figure 8-4).
• Escalation of only the crude oil price as the reference price and keeping
the price ratios of the other fuels to crude oil constant (Figure 8-13).
This would correspond to the outcome of the historical statistics
(Figure 8-7 and Figure 8-8).
60
Approach: Escalate the price of one of the two fuels only

and keep the initial price difference constant over the lifetime
50
Calorific price €/ MWht
40
30
20
10
Coal 5.0%/a NG price difference constant

-
1 3 5 7 9 11 13 15 17 19 21 23 25
Author's own illustration year
Figure 8-12: Fuel price projection with constant price difference
180
Approach: Escalate only the price of oil and keep
the price ratio of fuel to crude oil constant over the lifeitme
160
Average Period 1991 - 2013
140 Fuel *) € /MWht Ratio
Crude oil 22.03 1.00
Calorific price €/MWht
Steam coal 7.12 0.39

120
Natural gas 16.02 0.80
HFO 17.85 0.77
100 LFO 27.30 1.25
*) calorific prices in nominal terms
80
60
40
20
Crude 5.0%/a NG constant price ratio coal constant price ratio
-
1 3 5 7 9 11 13 15 17 19 21 23 25
Author's own illustration year
Figure 8-13: Fuel price projection with constant price ratio to crude oil
The annual escalation rate in the figures above has been arbitrarily chosen; in
practice, the selection of escalation rate remains the judgment of the expert
who makes the financial evaluation. A possible approach is to fix a price at
the end of the period in real terms and to calculate back the annual escalation
rate as it is demonstrated in Example 8.6.
8.4 Conclusions and Recommendations for Fuel Price Forecasts 131
Example 8.6: Define escalation rate

Item Symbol Unit Value Formula
Basic assumptions
Lifetime of the investment n a 20
Starting crude oil price po US$ / bbl 100
Calculation in real terms
n
Expected price at the end of lifetime p 25_r US$ / bbl 150 p 25_r = p 0 x (1+i r )
Seek escalation rate in real terms ir - 2.05%/a goal seek function
Calculation in nominal terms
Expected inflation rate j - 2.50%/a
Escalation rate in nominal terms in - 4.60%/a i n = (1+i r )x (1+j)-1
Crude oil price in nominal terms p 25_n US$ / bbl 246 p 25_n = p 0 x (1+i n ) n
8.4.2 Fuel prices based on opportunity costs
In several countries, fuel prices for power generation are set by the govern-
ment under political considerations and artificially very low. This is often the
case in countries with large oil resources. Financial evaluation of projects
with such low prices will result in the selection low cost and low energy effi-
cient solutions which will have a longterm negative impact on the national
economy of the countries. It is recommended to conduct economic evaluation
of projects based on opportunity costs derived from the international market
price of crude oil. The premise is thereby, “each barrel of oil saved can be
exported and generate revenues for the national economy”. For such an ap-
proach, the ratios of fuel prices to the crude oil price can be helpful.
Example 8.7: Fuel prices based on opportunity cost
HHV 5.80 MMBTU/bbl 6.20 GJ/bbl 1.70 MWht / bbl Ratio in percent
crude oil
LHV 5.51 MMBTU/bbl 5.89 GJ/bbl 1.62 MWht / bbl of crude price
Insert crude oil price 100 US$ / bbl
Based on HHV US$ / MMBTU US$ / GJ US$ / MWht %
crude oil 17.24 16.13 58.82 100.0%
steam coal 6.72 6.29 22.94 39.0%
HFO 308 13.28 12.42 45.29 77.0%
LFO 21.55 20.16 73.53 125.0%
Sales Gas 13.79 12.90 47.06 80.0%
Based on LHV US$ / MMBTU US$ / GJ US$ / MWht %
crude oil 18.15 16.98 61.92 100.0%
steam coal 7.08 6.62 24.15 39.0%
Heavy Fuel Oil 13.97 13.07 47.68 77.0%
LFO 22.69 21.22 77.40 125.0%
Sales Gas 14.52 13.58 49.54 80.0%
9 Case Studies
The examples in chapter 2 to 8 are setup as simple and short as possible with
the purpose of enabling a better understanding and deepening of the contents
of the chapters. The case studies go one step further towards real project ap-
plication with regard to details and complexity. The following case studies
and models are presented:
• Case Study 9.2, basic techno-economic models
• Case Study 9.3, modelling energy balance for electricity generation
• Case Study 9.4, integrated models for calculation of electricity gen-
eration costs
• Case Study 9.5, lifetime cost model including different load re-
gimes
• Case Study 9.6, models on internal rate of return and cashflow
analysis.
Case studies 9.2 and 9.3 start with the presentation of basic techno-economic
models which are essential and an integral part of more sophisticated models.
Experience has shown that such simple calculations are rarely practiced and
take long working time whenever they must be done.
In case study 9.4 an integrated model for electricity generation cost calcu-
lations is presented. In this model, the generation costs of three different
power plants are calculated. For the calculations, the annuity method and the
present value method are applied in order to show that both methods are ap-
plicable and provide the same results. Furthermore, the results are also shown
in the form of graphs (cost breakdown and cost break-even).
In case study 9.5, the lifetime cost for changing load regimes during the
project lifetime of a power plant are calculated.
In case study 9.6, three variations of the internal rate of return method are
practiced, notably IRR on investment, pretax IRR on equity and IRR after
tax, and a cashflow model is developed.
All case studies are introduced with explanatory notes, outcomes are ana-
lyzed and important statements are highlighted.
134 9 Case Studies
Case Studies - List of Exercises

Exercise 9.2-1: Thermal price of fuels and electricity fuel cost .................. 135
Exercise 9.2-2: Calculating composite electricity price .............................. 136
Exercise 9.2-3: Calculating CAPEX including IDC and reinvestments ..... 137
Exercise 9.2-4: Levelizing feed-in tariff ..................................................... 137
Exercise 9.3-1: Energy balance, elec. efficiency vs. full capacity hours .... 138
Exercise 9.3-2: Energy balance, heat rate vs. capacity factor ..................... 138
Exercise 9.4-1: Electricity generation cost applying annuity method ......... 139
Exercise 9.4-2: Electricity generation cost applying NPV Method............. 140
Exercise 9.4-3: Specific cost breakdown .................................................... 141
Exercise 9.5-1: Lifetime costs, base load operation in the first 10 years .... 143
Exercise 9.5-2: Lifetime costs, part load operation in the first 10 years ..... 144
Exercise 9.6-1: Internal rate of return ......................................................... 146
Exercise 9.6-2: Cashflow model ................................................................. 148
9.2 Basic techno-economic models 135
9.2 Basic techno-economic models
9.2.1 Thermal price of fuels and electricity fuel cost
Fuels are offered on the marketplace in trade units such as metric tons, nor-
mal cubic meter, etc. The real value of the fuels is, however, the thermal
price (also called calorific price). This is calculated from the trade price per
unit divided by the heating value. Throughout this book, the lower heating
value (LHV) is used. The standard unit for thermal energy according to the
SI-unit system is “J” and its multiples kJ, MJ and GJ. A more practical unit
is, however, the unit kWht and its multiples, because energy balances can be
directly conducted without the need for conversion. One kWht is 3600 kJ or,
more practically, 1 MWht is 3.6 GJ. In the following three tables of Exercise
9.2-1 the calculation of thermal price (also known as calorific price) of se-
lected fuels and the fuel cost of electricity are shown. The heating values are
taken from Annex 3.
Exercise 9.2-1: Thermal price of fuels and electricity fuel cost
Thermal fuel prices in US$/GJ
Item Unit Fuel type
Given
Fuel type - Crude oil Heavy fuel oil Steam coal Natural gas
3
Trade Unit - Bbl t t 1000 nm
LHV GJ / unit 5.4 40.2 26.0 37.3
Trade price US$ / unit 100.0 200.0 100.0 365.0
Thermal price *) US$ / GJ 18.52 4.98 3.85 9.79
*) Trade price divided by LHV
Thermal fuel prices in US$/ MWht
Item Unit Fuel type

Given
Fuel type - Crude oil Heavy fuel oil Steam coal Natural gas
3
Trade Unit - Bbl t t 1000 nm
LHV MWht / unit 1.50 11.17 7.22 10.36
Trade price US$ / unit 100.0 250.0 100.0 365.0
Thermal price US$ / MWht 66.67 22.39 13.85 35.23
*) Trade price divided by LHV
Electricity generation fuel cost only

Type of PP - Steam Steam Steam CCGT
Elec. Efficiency, net - 42.55% 42.55% 42.55% 54.60%
Type of fuel - Crude oil Heavy fuel oil Steam coal Natural gas
Fuel thermal price US$ / MWht 66.67 22.39 13.85 35.23
Elec. fuel cost *) US$ / MWhe 156.7 52.6 32.5 64.5
*) Fuel thermal price divided by electrical efficiency
136 9 Case Studies
9.2.2 Calculating composite electricity price
Electricity generation cost (and also price) is defined by two cost compo-
nents: the “capacity cost Cc in CU/(kWa)” which is fixed and independent
from the level of production, and “energy cost Ce in CU/MWh” which is di-
rectly dependent on the level of production. Both components together give
the composite cost. The composite cost refers to a certain utilization time of
the rated capacity only; this can be computed based on either the equivalent
full capacity hours tfch or capacity factor CF with the following formulas. The
computation is shown in the Exercise 9.2-2 below:
 
1000 × Cc  CU 
 kW a   CU 
C= + Ce  CU   MWh 
h  MWh 
t fch  a 
 CU 
1000 × Cc  
 kW a   CU 
C= + Ce  CU   MWh 
 MWh 
CF [ − ] × 8760  h 
a 
Exercise 9.2-2: Calculating composite electricity price

Given
Capacity cost Cc US$/kWa 212 89 46
Energy cost Ce US$/MWh 33.30 67.70 117.90
Full load hours t fc h /a 7,500 4,500 1,000
Capacity Factor CH - 0.86 0.51 0.11
Composite cost calculated from:
Full capacity hours Cc US$/MWh 61.57 87.48 163.90
Capacity Factor Cc US$/MWh 61.57 87.48 163.90
9.2.3 Calculating CAPEX including IDC and Reinvestments
The entire period for the evaluation of power system projects encompasses
several years of construction time followed by a long period of commercial
operation. During the construction time, disbursement of capital is made in
several installments based on the construction progress. The capital outlays
are financed by equity capital and loans. For the disbursed loans, interest
payments during construction (IDC) are due. Capital expenditures for rein-
vestments during the long operation time may also be required, e.g. for mod-
ernization or retrofits. For financial evaluations of such investments, the en-
tire capital outlays must be considered. The IDC installments are usually
9.2 Basic techno-economic models 137
compounded and the reinvestments discounted to the starting year of com-

mercial operation (year 0). The calculations are demonstrated in the follow-
ing Exercise 9.2-3.
Note: For compounding IDC, the nominal bank interest rate is used; for dis-
counting reinvestments, a rate based on the weighted average cost of capital
(WACC) is used. This shall be in nominal or in real terms corresponding to
the method by which the investment appraisal is done.
Exercise 9.2-3: Calculating CAPEX including IDC and reinvestments
Item Year *) -5 -4 -3 -2 -1 0 1 2 3 4 5 6 7 8 9 10
Loan mln CU Li 7.0 14.0 21.0 21.0 7.0 70.0
IDC CU **) 6.0% /a 2.4 3.7 4.0 2.6 0.4 13.1
Equity CU 3.0 6.0 9.0 9.0 3.0 30.0
ReinvestmentsCU ***) - - - - - 5.0 - - - - 10.0
PV Reinvestments *)8.6% /a 7.7 - - - - 3.3 - - - - 4.4
Total CAPEX in year 0 120.8
Annualized CAPEX CU/a 8.6% /a 25 a 11.9
*) Year 0 denotes the start of commercial operation
**) IDC: Interest during construction, installments compounded with bank interest rate = 6.0% /a IDC=(1+i)^-t*L i - L i
***) Reinvestments discounted with discount rate = 8.6% /a (WACC: 30% equity, 70% loan)
9.2.4 Levelizing feed-in tariffs
The Exercise 9.2-4 demonstrates the levelizing procedure of a series of pay-

ments over the lifetime of 10 years. Feed-in tariffs for electricity, for exam-
ple, are passed on for a certain time period in different ways, notably as con-
stant amounts, irregularly declining or gradually declining amounts.
Exercise 9.2-4: Levelizing feed-in tariff
Feed-in tariff for Cogen electricity, constant
Item Year 1 2 3 4 5 6 7 8 9 10
Feed-in tariff cent / kWh 2.50 2.50 2.50 2.50 2.50 2.50 2.50 2.50 2.50 2.50
Discount factors i=8.6% 1.09 1.18 1.28 1.39 1.51 1.64 1.78 1.93 2.10 2.28
Present values PV Sum PV=16.33 2.30 2.12 1.95 1.80 1.65 1.52 1.40 1.29 1.19 1.10
Levelized tariff PMT(i,10a, ΣPV,0,0) 2.50 cent/kWh
Feed-in tariff for Cogen electricity, declining

Item Year 1 2 3 4 5 6 7 8 9 10
Feed-in tariff for Cogen electricity, uniformly declining

Item Year 1 2 3 4 5 6 7 8 9 10
138 9 Case Studies
9.3 Modelling Energy Balance for Power Generation
Integrated models for electricity generation cost calculations are made up of

different modules. The starting module is a power and energy balance over
the lifetime of the projects’ evaluation. Key parameters thereby are the fuel
efficiency and capacity utilization. Fuel efficiency is expressed either as elec-
trical efficiency “η in %” or “heat rate q in KJ/kWhe”. Capacity utilization is
expressed either as equivalent full capacity hours “tfch” or as capacity factor
“CF”. The former are mainly practiced in continental Europe, the latter in the
English business environment. The establishment of a power and energy bal-
ance is demonstrated for both modes in the following Exercises.
Exercise 9.3-1: Energy balance, elec. efficiency vs. full capacity hours
Symbols Steam CCGT GT
Item Unit
Calculation coal NG NG
Technical parameters at RSC
Rated power output, gross P gross MWe 700 400 150
Own electriciy consumption ∆P %/a 7.5% 2.5% 1.0%
Power output, net P net =(1- ∆P)*P gross MWe 648 390 149
Electrical Efficiency, gross η - 46% 56% 34%
Thermal fuel capacity P t = P gross / η MWt 1,522 714 441
Energy balance
Full capacity hours, typical t FC h/a 7,500 4,500 1,250
Electricity generation, gross W e_gross =P gross × t FC GWhe / a 5,250.0 1,800.0 187.5
Electricity generation, net W e_net =(1- ∆P) ×W e_gross GWhe / a 4,856.3 1,755.0 185.6
Fuel consumption Q =P t × tFC GWht / a 11,413.0 3,214.3 551.5
Exercise 9.3-2: Energy balance, heat rate vs. capacity factor

Item Unit
calculation coal NG NG
Own electricity consumption ∆P %/a 7.5% 2.5% 1.0%
Power output, net P net =(1- ∆P)*P gross MWe 648 390 149
Heat rate, gross *) q MJ / kWhe 7.83 6.43 10.59
P t = q × P gross / 3.6 MJ / s 1,522 714 441
Fuel capacity
P t = q × P gross / 3.6 MWt 1,522 714 441
Energy balance
Capacity factor, typical **) CF - 0.856 0.514 0.143
Electricity generation, gross W e_gross =CF ×8760*P gross GWhe / a 5,250.0 1,800.0 187.5
Electricity generation, net W e_net =(1- ∆P) ×W e_gross GWhe / a 4,856.3 1,755.0 185.6
TJ / a 41,087.0 11,571.4 1,985.3
Fuel consumption Q = CF ×8760*P gross
GWht / a 11,413.0 3,214.3 551.5
*) This is an input, but calculated from spreadsheet "El_balance_eta_tFC" q =3.6/ η
**) This is an input, but calculated from spreadsheet "El_balance_eta_tFC" CF= t FC / 8760
9.4 Integrated Models for Electricity Generation Costs 139
9.4 Integrated Models for Electricity Generation Costs
Integrated models for electricity cost calculations include several modules;

the modules power and energy balance, as well as operational and financial
parameters provide basic parameters for the actual calculation of the electrici-
ty generation costs. The final outputs are the levelized costs on an annual
basis or as present values broken down in fixed and variable costs and the
specific costs. These are given as capacity cost in CU/(kWa) and energy cost
in CU/MWh and as composite cost CU/MWh. The calculations can be done
either with the annuity method or with the net present cost method.
First, the calculation of electricity generation costs is depicted in Exercise
9.4-1 and Exercise 9.4-2 for three different power plants, applying the annui-
ty method.
Exercise 9.4-1: Electricity generation cost applying annuity method
Symbols & Steam CCGT GT
Item Unit
Formulas *) coal NG NG
Power output, net P net MWe 648 390 149
Electrical Efficiency, gross − - 46% 56% 34%
Fuel capacity Pt MWt 1,522 714 441
Energy balance
Electricity generation, gross W e_gross GWhe / a 5,250 1,800 150
Electricity generation, net W e_net GWhe / a 4,856 1,755 149
Fuel consumption Q GWht / a 11,413 3,214 441
Operational financial parameters
CAPEX, 2013 US$, ± 25% I0 mln US$ 1,400 340 53
Discount rate, in real terms i - 6.50% 6.50% 6.50%
Lifetime t Lt a 35 25 20
Fixed operation costs c fix % / CAPEX 2.5% 2.0% 4.0%
Spec. Fuel cost c fuel US$ / MWht 13.0 35.0 38.0
Non-fuel variable costs cv US$ / MWhe 2.5 3.5 5.0
Levelized annual Generation cost, in real terms
Fixed Costs C FIX mln US$ / a 137.3 34.7 6.9
Annualized CAPEX PMT(i,t Lt ;I 0 ;0;0) mln US$ / a 102.3 27.9 4.8
Fixed O&M costs c fix × I 0 mln US$ / a 35.0 6.8 2.1
Variable costs CV mln US$ / a 161.5 118.8 17.5
Fuel costs f Fuel × Q mln US$ / a 148.4 112.5 16.8
Non-fuel variable costs c v ×W e_gross mln US$ / a 13.1 6.3 0.8
Levelized el. Generation cost, in real terms
Capacity cost C FIX / P net US$ / kWa 212.0 88.9 46.2
Energy cost C V / W e_net US$ / MWh 33.3 67.7 117.9
Composite cost (C FIX +C V )/W e_net US$ / MWh 61.53 87.45 164.17
*) Multiplications or Divisions with 1000 not shown in the formulas
140 9 Case Studies
In the following Exercise 9.4-2, the electricity cost calculation is repeated,

applying the net present value method. The calculated specific costs are the
same as those calculated with the annuity method.
Exercise 9.4-2: Electricity generation cost applying NPV Method
Item Unit
calculation *) coal NG NG
Own electricity consumption %/a 7.5% 2.5% 1.0%
Power output, net P net MWe 648 390 149
Electrical Efficiency, gross - 46% 56% 34%
Fuel capacity Pt MWt 1,522 714 441
Energy balance
Electricity generation, gross W e_gross GWhe / a 5,250.0 1,800.0 150.0
Electricity generation, net W e_net GWhe / a 4,856 1,755 149
Fuel consumption Q GWht / a 11,413 3,214 441
Operational financial parameters
CAPEX, 2013 US$, ± 25% I0 mln US$ 1,400 340 53
Discount rate, in real terms i - 6.50% 6.50% 6.50%
Lifetime t Lt a 35 25 20
Fixed operation costs c fix % / CAPEX 2.5% 2.0% 4.0%
Spec. Fuel cost c fuel US$ / MWh t 13.0 35.0 38.0
Non-fuel variable costs cv US$ / MWhe 2.5 3.5 5.0
Present Values C FIX
Net output PV P (i,t Lt, P net ,0,0) MW 8,862 4,757 1,636
Net output PV W (i,t Lt, W e_net ,0,0) GWh 66,467.3 21,407.3 1,636.2
Fixed Costs C Fix 1,879.0 422.9 75.6
CAPEX, 2013 US$, ± 25% I0 mln US$ 1,400.0 340.0 52.5
Fixed O&M costs PV(i,t Lt ,c fix × I 0 ,0,0) mln US$ 479.0 82.9 23.1
Variable costs CV mln US$ 2,210.4 1,449.1 193.0
Fuel costs PV(i,t LT ,f Fuel × Q,0,0) mln US$ 2,030.7 1,372.3 184.7
Non-fuel variable costs PV(i,t Lt ,c v ×W e_gross ,0,0) mln US$ 179.6 76.8 8.3
Levelized el. Generation cost, in real terms
Capacity cost C FIX / PV P US$ / kWa 212.0 88.9 46.2
Energy cost C V × PV W US$ / MWh 33.3 67.7 117.9
Composite cost (C FIX +C V )/PV W US$ / MWh 61.53 87.45 164.17
*) Multiplications or Divisions with 1000 not shown in the formulas
Note: In this context, the following is to be highlighted: the three power

plants have different lifetimes; their annual as well as their specific genera-
tion costs can be compared by applying the annuity method (see also Exam-
ple 4.9).
In contrast, the NPV method is not applicable for investments with differ-
ent lifetimes. This is true as far as their present values (mln US$) are con-
cerned. The specific costs, however, can be compared. The reason for this is
that the present values of the costs are divided by the present value of the
power generation, so the lifetime is neutralized as it is included in both.
9.4 Integrated Models for Electricity Generation Costs 141
The specific costs breakdown for the main cost components is shown in Ex-
ercise 9.4-3 based on the outcome of the calculation with the annuity method.
They are also depicted in form of in Graph 9.4-1 and Graph 9.4-3.
Exercise 9.4-3: Specific cost breakdown
Steam CCGT GT
Item Unit
coal NG NG
Energy balance
Electricity generation, net GWhe / a 4,856 1,755 149
Fuel consumption GWht / a 11,413 3,214 441
Levelized annual generation cost, in real terms
Fixed costs US$ /MWh 28.3 19.8 46.2
Annualized CAPEX US$ /MWh 21.1 15.9 32.1
Fixed O&M costs US$ /MWh 7.2 3.9 14.1
Variable costs US$ /MWh 33.3 67.7 117.9
Fuel costs US$ /MWh 30.6 64.1 112.9
Non-fuel variable costs US$ /MWh 2.7 3.6 5.1
100%
90%
80%
70%
Cost share
60%
50%
40%
30%
20%
10%
0%
Steam CCGT GT
coal NG NG
Annualized CAPEX PP h /a CF
Fixed O&M costs Steam coal 7,500 0.86
Fuel costs CCGT NG 4,500 0.51
Non-fuel variable costs GT NG 1,000 0.11
Graph 9.4-1: Cost breakdown in absolute values

In Graph 9.4-2 intersection of the annual generation costs curves and in
Graph 9.4-3, the break-even of the specific cost versus equivalent full capaci-
ty operation hours of the three power plants are depicted. The cost break-even
points are essential for selecting the proper power plants for a power plant
fleet according merit order of their total cost. These costs are called “the long
run marginal cost – LRMC in CU/MWa”. They include fixed and variable
costs.
142 9 Case Studies
1,000,000
900,000 Steam CCGT GT

Item Unit
coal NG NG
800,000 Capacity net MWe 647.5 390.0 148.5
Capacity cost CC US$ / kWa 212.0 88.9 46.2
Generation Costs US$ / MWa
700,000 Energy cost EC US$ / MWh 33.3 67.7 117.9
600,000
500,000
400,000
300,000
200,000
Steam CCGT GT
100,000 coal NG NG
0
1000
1500
2000
2500
3000
3500
4000
4500
5000
5500
6000
6500
7000
7500
8000
500
Full Capacity hours /a
Graph 9.4-2: Intersections of annual generation costs vs. full capacity hours
500
450
400
Specific cost US$ / MWh
Steam CCGT GT
350 coal NG NG
300
250
200
150
100
50
0
500
1000
1500
2000
2500
3000
3500
4000
4500
5000
5500
6000
6500
7000
7500
8000
Full capacity h / a
Graph 9.4-3: Generation costs break-even points

It is noted that in an existing system dispatching of power plants is done ac-
cording to the merit order of their “short run marginal cost – SRMC in
CU/MWhe”, which are identical with the variable cost (specific fuel and non-
fuel variable cost, Exercise 9.4-1).
Merit order means that power plants with the lower marginal cost are dis-
patched first until the power demand of the system is completely covered.
9.5 Lifetime Costs Model for Different Load Regimes 143
9.5 Lifetime Costs Model for Different Load Regimes
The model is developed for the CCGT option of case study 9.4. New power
plants are usually utilized in base load mode at the beginning of their life-
time; later, they may be shifted to intermediate load and even to peak load at
the end of their lifetime. In the case, however, because excessive new genera-
tion capacities are coming into commercial operation at the same time, it may
happen that in the first years, new plants will be underutilized. This will have
a negative impact on the lifetime cost, as demonstrated in Exercise 9.5-1and
Exercise 9.5-2.
Exercise 9.5-1: Lifetime costs, base load operation in the first 10 years
Power Electricity Production Fixed Costs Variable Costs
Net Present Electricity Present CAPEX Fixed PV Fixed Variable Present

Operation
year Values production Value Costs O&M costs Value
Mode Actual Costs
6.00%/a 390 MW 6.00%/a 6.00%/a 67.69 US$/MWh 6.00%/a
MW GWh/a mln US$ mln US$/a

0 340.0
1 390 368 2,925 2,759 - 6.8 6.4 198.0 186.8
2 390 347 2,925 2,603 - 6.8 6.1 198.0 176.2
3 390 327 2,925 2,456 - 6.8 5.7 198.0 166.2
4 390 309 2,925 2,317 - 6.8 5.4 198.0 156.8
Base load
7,500 h/a
5 390 291 2,925 2,186 - 6.8 5.1 198.0 148.0

6 390 275 2,925 2,062 - 6.8 4.8 198.0 139.6
7 390 259 2,925 1,945 - 6.8 4.5 198.0 131.7
8 390 245 2,925 1,835 - 6.8 4.3 198.0 124.2
9 390 231 2,925 1,731 - 6.8 4.0 198.0 117.2
10 390 218 2,925 1,633 30.0 6.8 3.8 198.0 110.6
11 390 205 1,755 925 - 6.8 3.6 118.8 62.6
12 390 194 1,755 872 - 6.8 3.4 118.8 59.0
Intermediate load
13 390 183 1,755 823 - 6.8 3.2 118.8 55.7

14 390 172 1,755 776 - 6.8 3.0 118.8 52.5
4,500 h/a
15 390 163 1,755 732 - 6.8 2.8 118.8 49.6

16 390 154 1,755 691 - 6.8 2.7 118.8 46.8
17 390 145 1,755 652 - 6.8 2.5 118.8 44.1
18 390 137 1,755 615 - 6.8 2.4 118.8 41.6
19 390 129 1,755 580 - 6.8 2.2 118.8 39.3
20 390 122 1,755 547 - 6.8 2.1 118.8 37.0
21 390 115 390 115 - 6.8 2.0 26.4 7.8
Peak load
1,000 h/a
22 390 108 390 108 - 6.8 1.9 26.4 7.3

23 390 102 390 102 - 6.8 1.8 26.4 6.9
24 390 96 390 96 - 6.8 1.7 26.4 6.5
25 390 91 390 91 - 6.8 1.6 26.4 6.2
Total 9,750 4,986 48,750 29,253 370 170 87 3,300 1,980
Present values Symbols - Formulas Unit Values

PV net power output PV ΣP MW 4,986
PV of electricity production PV ΣWe GWh 29,253
PV fixed costs PV CostsFixed mln US$ 457
PV of total costs PV ΣCostVar mln US$ 1,980
Levelized electricity cost
Capacity cost PV CostsFixed / PV ΣP US$ / kW a 91.65
Energy cost PV ΣCostVar / Σ We US$ / MWh 67.69
Composite electricity cost PV( Σcost+ΣCostsVar) / PV We US$/ MWh 83.31

144 9 Case Studies
Exercise 9.5-2: Lifetime costs, part load operation in the first 10 years
Power Electricity Production Fixed Costs Variable Costs
Operation Net Present Electricity Present CAPEX Actual Present Present

year Actual
Mode Actual Values production Value values Values
6.00%/a 390 MW 6.00%/a 6.00%/a 67.69 US$/MWh 6.00%/a
MW GWh/a mln US$ mln US$/a

0 340.0
1 390 368 975 920 - 6.8 6.4 66.0 62.3
2 390 347 975 868 - 6.8 6.1 66.0 58.7
3 390 327 975 819 - 6.8 5.7 66.0 55.4
4 390 309 975 772 - 6.8 5.4 66.0 52.3
Base load
2,500 h/a
5 390 291 975 729 - 6.8 5.1 66.0 49.3

6 390 275 975 687 - 6.8 4.8 66.0 46.5
7 390 259 975 648 - 6.8 4.5 66.0 43.9
8 390 245 975 612 - 6.8 4.3 66.0 41.4
9 390 231 975 577 - 6.8 4.0 66.0 39.1
10 390 218 975 544 30.0 6.8 3.8 66.0 36.9
11 390 205 2,925 1,541 - 6.8 3.6 198.0 104.3
12 390 194 2,925 1,454 - 6.8 3.4 198.0 98.4
Intermediate load
13 390 183 2,925 1,371 - 6.8 3.2 198.0 92.8

14 390 172 2,925 1,294 - 6.8 3.0 198.0 87.6
7,500 h/a
15 390 163 2,925 1,221 - 6.8 2.8 198.0 82.6

16 390 154 2,925 1,151 - 6.8 2.7 198.0 77.9
17 390 145 2,925 1,086 - 6.8 2.5 198.0 73.5
18 390 137 2,925 1,025 - 6.8 2.4 198.0 69.4
19 390 129 2,925 967 - 6.8 2.2 198.0 65.4
20 390 122 2,925 912 - 6.8 2.1 198.0 61.7
21 390 115 390 115 - 6.8 2.0 26.4 7.8
Peak load
1,000 h/a
22 390 108 390 108 - 6.8 1.9 26.4 7.3

23 390 102 390 102 - 6.8 1.8 26.4 6.9
24 390 96 390 96 - 6.8 1.7 26.4 6.5
25 390 91 390 91 - 6.8 1.6 26.4 6.2
Total 9,750 4,986 40,950 19,710 370 170 87 2,772 1,334
Present values Symbols - Formulas Unit Values

PV net power output PV ΣP MW 4,986
PV of electricity production PV ΣWe GWh 19,710
PV fixed costs PV CostsFixed mln US$ 457
PV of total costs PV ΣCostVar mln US$ 1,334
Levelized electricity cost
Capacity cost PV CostsFixed / PV ΣP US$ / kW a 91.65
Energy cost PV ΣCostVar / Σ W e US$ / MWh 67.69
Composite electricity cost PV( Σcost+ΣCostsVar) / PV We US$/ MWh 90.88
It becomes evident from the calculations that the lifetime costs will be con-
siderably higher in the case of underutilized capacities at the beginning of the
lifetime.
9.6 Internal Rate of Return and Cashflow Analysis 145
9.6 Internal Rate of Return and Cashflow Analysis
Main Inputs:
This case study presents a model for the calculation of the internal rate of
return (IRR) and a model for cashflow analysis. The main inputs are shown
in the following two tables. The models are developed for CCGT option of
case study 9.4.
Table 9-1: WACC for IRR & cash flow models
Item Equity Loan
Venture risk premium 6.0 %/a 1.0 %/a
Expected return after tax 11.0 %/a 6.0 %/a
Corporate tax 25% 3.7 %/a 0.0 %/a
Returns before tax, in nominal terms 14.7 %/a 6.0 %/a
WACCn in nominal terms, incl. tax 8.60 %/a
WACCr inflation adjusted, incl. tax 6.47 %/a
Table 9-2: Main inputs for IRR and cashflow models

Item Unit Values Notes
Electricity production GWh 1,755 constant
CAPEX mln US$ 340 30%
Loan mln US$ 238 70%
Starting electricity price, year 0 *) US$ / MWh 86.65 for IRROE after tax 11%
Inflation - 2% /a
Escalation of electricity price - 2% /a
Escalation of variable O&M expenses - 2.50%
Escalation of fixed O&M expenses - 2.20%
Discount rate (WACC), in nominal terms - 8.60% for LLCR and PLCR
Lifetime a 25
Depreciation period a 20 straight
Loan maturity a 15
Grace period a 0
Interest on loan - 6% /a
Corporate tax - 25%
*) The starting electricity price is determined with the goal seek function of Excel to return an IRR on
equity after tax of 11%
146 9 Case Studies
9.6.1 Internal rate of return model
Three versions of the internal rate of return are presented: IRR on the project,
pretax IRR on equity and IRR on equity after tax. The model is depicted in
Exercise 9.6-1. Due to the limited space of the text mirror, only the columns
with inputs and the first three and the last three years of operation time are
shown in the table. The model for the entire lifetime can be downloaded from
the author’s website.
Exercise 9.6-1: Internal rate of return
Item Year 0 1 2 3 ...... 23 24 25
Sales of electricity 1755 GWh 100% GWh 1,755 1,755 1,755 ........ 1,755 1,755 1,755
Electricity price *) 86.66 $/MWh 2.00% /a €/MWh 88.4 90.2 92.0 ........ 136.6 139.4 142.2
Revenues mln US$/a 155 158 161 ........ 240 245 250
Operating expenses mln US$/a 121 124 127 ........ 196 200 205
IRR on investment
Revenues 0.00 155 158 161 ........ 240 245 250
CAPEX -340 mln $ -340.00 0.0 0.0 0.0 ........ 3.0 4.0 5.0
Operating expenses 0.00 -121 -124 -127 ........ -196 -200 -205
Cash flows IRR= 9.9% -340.00 33.7 34.1 34.6 ........ 46.8 48.3 49.8
IRR on equity, pre tax

Revenues 0.00 155 158 161 ........ 240 245 250
Loans 238 mln $ 238.00 0.0 0.0 0.0 ........ 0.0 0.0 0.0
CAPEX -340.00 0.0 0.0 0.0 ........ 0.0 0.0 0.0
Operating expenses 0.00 -121 -124 -127 ........ -196 -200 -205
Repayment of loans 15 a Grace 0 a 0.00 -15.9 -15.9 -15.9 ........ 0.0 0.0 0.0
Interest on loans 15 a 6.00% /a 0.00 -14.3 -13.3 -12.4 ........ 0.0 0.0 0.0
Pre tax cash flow IRR= 13.1% -102.00 3.5 4.9 6.3 ........ 43.8 44.3 44.8
IRR on equity after tax

Pretax income **) Depreciation 20 a 2.4 3.8 5.2 ........ 0.0 0.0 0.0
Pretax cashflow 3.5 4.9 6.3 ........ 43.8 44.3 44.8
corporate tax 25.00% -0.6 -0.9 -1.3 ........ -11.0 -11.1 -11.2
Cashflows after tax *) IRR= 11.0% -102.00 2.9 4.0 5.0 ........ 32.9 33.2 33.6
*) goal seek IRROE after tax 11% by changing electricity price
**) for calculation of corporate tax only (Revenues-expenses-depreciation-interest on loans)
The defining criterion for financial viability from the point of view of the
investor is, in our opinion, the IRR after tax. Hence the starting electricity
price at the beginning of the lifetime is determined with the goal seek func-
9.6 Internal Rate of Return and Cashflow Analysis 147
tion of MS-Excel to return an IRR of equity after tax of 11%; this is equal to
that defined in the WACC.
The main risk as well as the opportunity is the electricity production. The
plant is scheduled to be operated for intermediate load with 4500 hours utili-
zation on its full capacity. However, the electricity production may be higher,
if, for example, the plant is also partly dispatched for base load (7500 h/a),
for instance, while actual base load power plants are in annual revision. The
capacity utilization may also be lower if excess capacities are available for
the grid or if large amounts of electricity from renewable sources are fed into
the grid. A sensitive analysis has shown that between 105% and 95% capaci-
ty utilization the IRR is changing in the range of 12% to 10% only.
9.6.2 Cashflow analysis model
The cashflow model is depicted in Exercise 9.6-2. Due to the limited space of
the text mirror, only the columns with inputs and the first three and the last
three years of operation time are shown in the table. The model for the entire
lifetime can be downloaded from the author’s website.
The main results based on the underlining assumptions can be summarized
as follows: operating income and net income after taxes are positive through-
out the project life. The cashflow is sufficient for repayment of the loan from
the very beginning and the remaining free cashflow allows dividend pay-
ments and accumulation of some reserves.
Financial performance parameters are in a positive range as well; most
important are the ratios of the first years of operation. Benchmarks are:
• Debt coverage ratio (DCR) higher than 1.1, obtained in the first year
already.
• The target for the Loan life coverage ratio (LLCR) of >2 is obtained in
7th year
• The project life coverage ratio (PLCR) of >2 is obtained in the 4th year.
The ratios are increasing in the course of the lifetime. This is because the
revenues are increasing due to assumed escalation in line with inflation while
the repayments of loans remain constant and the interest payments for loans
are declining, resulting in an increase of the net income.
148 9 Case Studies
Exercise 9.6-2: Cashflow model

Year
Item Inputs Unit
1 2 3 ...... 23 24 25
Sales of electricity from IRR 1755 GWh 100% GWh 1,755 1,755 1,755 ........... 1,755 1,755 1,755
Electricity price (from IRR ) 86.66 $/MWh 2.00% /a €/MWh 88.4 90.2 92.0 ........... 136.6 139.4 142.2
Revenues mln US$/a 155 158 161 ........... 240 245 250
Operating expenses CAPEX= 340 mln US$ mln US$/a 121 124 127 ........... 196 200 205
Fixed 2.00% /a 6.8 mln US$ 2.50% /a mln US$/a 7.0 7.1 7.3 ........... 12.0 12.3 12.6
Variable 67.70 $/MWh 118.8 mln US$ 2.20% /a mln US$/a 121 124 127 ........... 196 200 205
Operating Income mln US$/a 33.7 34.1 34.6 ........... 43.8 44.3 44.8
- Depreciation 340 mln US$ 20 a straight mln US$/a 17.0 17.0 17.0 ........... - - -
.- Interest on loans 238 mln US$ 15 a 6.0% /a mln US$/a 14.3 13.3 12.4 ........... - - -
Income before taxes mln US$/a 2.4 3.8 5.2 ........... 43.8 44.3 44.8
- Corporate tax 25.00% mln US$/a 0.6 0.9 1.3 ........... 11.0 11.1 11.2
- Other taxes mln US$/a - - - ........... - - -
Net Income mln US$/a 1.8 2.8 3.9 ........... 32.9 33.2 33.6
+ Depreciation mln US$/a 17.0 17.0 17.0 ........... - - -
Cashflow mln US$/a 18.8 19.8 20.9 ........... 32.9 33.2 33.6
- Repayment of loans 238 mln US$ 15 a Grace 0 a mln US$/a 15.9 15.9 15.9 ........... - - -
Free cashflow mln US$/a 2.9 4.0 5.0 ........... 32.9 33.2 33.6
Debt Coverage Ratio (DCR) - 1.1 1.2 1.2 ........... - - -
Loan Life Coverage Ratio (LLCR) 15 a 8.6% /a - 1.3 1.3 1.4 ........... - - -
Project Life Coverage Ratio (PLCR) 15 a 8.6% /a - 1.7 1.8 1.9 ........... - - -
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Annexes
Annex 1: The Standard International Unit System...................................... 154
Annex 2: Conversion table metric – imperial units ..................................... 157
Annex 3: Fuel properties ............................................................................. 159
Annex 4: Frequently used Excel functions .................................................. 160
Annex 5: Add-Ins developed by the author ................................................. 162

154 Annexes
Annex 1: The Standard International Unit System

1. Some basic rules:
Within the European Union, the use of the SI-System is mandatory for all
public contracts (R_80/181/EWG; Einheiten Gesetz, DIN 1301). However, it
is allowed to state other units in brackets after the SI Unit.
Example: 2,000 kJ/kg [477.7 kcal/kg]
The SI System specifies that all variables and symbols in a formula have to
be written in italics. Constant values and units are written with standard char-
acters. See example:
ρ L N
Pressure drop : ∆p = λ ⋅ ⋅ υ 2  2 
2 D m 
According to the rules of ISO it is not allowed to alter SI Units e.g. by adding
indices or put them within brackets, for example:
kWe or kWt
This rule, however, is not practicable for our purposes. Hence, indices are
used wherever it seems necessary for clarification.
2. The Standard Units

The Standard International Unit System (SI unit system) is based on 7 base
units as shown in the following table. The major advantage of the SI-unit
system is that all the other units are derived from these base units by applying
the laws and principles of physics.
Table 1: Base units

SI - Quantity SI-Base unit
Name Symbol Name Unit
Length l Meter m
Mass m Kilogram kg
Time t Second s
Thermodynamic temperature T Kelvin K
Amount of substance n Mol mol
Electric current I Ampere A
Luminous intensity L Candela Cd
Annexes 155
The most important derived units for our purposes course are listed and ex-
plained in Table 2.
Table 2: Selected derived Units

Physical Symbol
Definition
Quantity Unit
υ, w , c Displacement of a body in m per time
Speed,
unit in seconds.
Velocity
m/s υ =s / t
Accelera-
a The change of velocity of m/s per s
tion
m/s2 a=υ/t
F 1 N is the force which, when applied to a
Force body having a mass of 1 kg, gives it an
N - Newton acceleration s of 1 m/s2
( 1N = 1 kg⋅m/s2) F=m·a
W, E
Work, Work is force multiplied by the displace-
J - Joule
Energy ment in the direction of the force.
J=N⋅m=Ws
W=F·l
(1 J = 1 kgm2/s2)
P
Power is the rate of energy transfer divid-
Power W - Watt
ed by time.
W = J/s
P=W/t
(1 W= 1 kgm2/s3)
p
Force divided by the area of its applica-
Pa - Pascal
Pressure tion
Pa = N/m2
P = F/A
(1 Pa = kg/ (m s2) )
156 Annexes
Table 3: Prefixes, decimals and multiples

Example
Prefix Symbol Factor
Name Unit
Micro µ 10-6 Micrometer µm
-3
Mil m 10 Millimeter mm
Centi c 10-2 Centimeter cm
Deci d 10-1 Decimeter dm
Hecto h 102 Hectoliter hl
3
Kilo k 10 Kilogram kg
Mega M 106 Megawatt MW
Giga G 109 Gigawatt GW
12
Tera T 10 Tera joule TJ
Peta P 1015 Peta joule PJ
Annexes 157
Annex 2: Conversion table metric – imperial units

multiply multiply
Imperial Metric Imperial
by by
Length
inches (in) x 25.40 mm x 0.039 inches
feet (ft) x 30.48 cm x 0.033 feet
feet (ft) x 0.305 m x 3.281 feet
yard (yd) x 0.914 m x 1.094 yard (yd)
miles (mi) x 1.609 km x 0.621 miles
Area
2
square inch (si) x 0.6452 cm x 1.550 square inch (si)
2
square feet (sf) x 0.0929 m x 10.764 square feet (sf)
2
square yard (sy) x 0.8361 m x 1.196 square yard (sy)
Volume
gallon (IG) x 4.546 ltr x 0.220 gallon (IG)
US gallon x 3.785 ltr x 0.264 US gallon
cubic feet (cf) x 28.320 ltr x 0.035 cubic feet (cf)
3
cubic feet (cf) x 0.0283 m x 35.311 cubic feet (cf)
3
scf x 0.0268 nm x 37.327 scf
Note: Standard cubic feet (scf): volume at 60°F/15.6°C and 14.7 psi/1.013bar;
3
Normal cubic meter (nm ) : Gasvolume at 1.013 bar, 0°C
Mass
pound (lb) x 0.4536 kg x 2.205 lb
ton x 1.016 t x 0.984 ton
Notes: 1 ton = 2,240 lb; 1 t = 1000 kg
Force/weight
pound-force (lbf) x 4.448 N x 0.225 pound-force (lbf)
Pressure
psi x 0.069 bar x 14.503 psi
psi x 6.895 kPa x 0.145 psi
2 5
Note: 1 Pa=N/m ; 1 bar = 10 Pa; 1 kPa=0.01bar
Energy
BTU (or Btu) x 1.055 kJ x 0.948 BTU
BTU x 0.293 Wh x 3.412 BTU
MMBTU x 1.055 GJ x 0.948 MMBTU
MMBTU x 0.293 MWh x 3.412 MMBTU
toe (ton oil equivalent) x 41.850 GJ x 0.024 toe
boe (barrel oil equivalent) x 1.697 MWh x 0.589 boe
boe (bbl=159 l) x 6.110 GJ x 0.164 boe
Therms x 0.106 GJ x 9.479 Therms
Therms x 29.310 kWh x 0.034 Therms
Continuation the next page

158 Annexes
multiply multiply
Imperial Metric Imperial
by by
Power, Energy flow
BTU / h x 0.293 J/s = W x 3.412 Btu / h
MMBTU/ h x 0.293 MJ/s = MW x 3.412 MMBtu / h
TR (tons refrigeration) x 3.517 kW x 0.284 TR
hp x 0.746 kW x 1.341 hp
ton of refrigeration x 3.517 kW x 0.284 ton of refrigeration
Calorific Value
BTU / lb x 2.326 kJ / kg x 0.430 BTU / lb
BTU / lb x 0.000646 kWh / kg x 1547.8 BTU / lb
MMBTU / t x ce x
MMBTU / t x ce x
3 3 3
BTU / ft x 37.260 kJ / m x 0.027 BTU / ft
3 3 3
BTU / ft x 10.349 kWh / m x 0.097 BTU / ft
3
BTU /scf (gas) x 39.382 kJ / nm x 0.025 BTU / scf
3
BTU /scf (gas) x 0.01094 kWh / nm x 91.412 BTU /scf (gas)
Volume flow, output rates

cfm x 0.472 l/s x 2.119 cfm
3
MIGD x 4.546 1000 m /d x 0.220 MIGD
3
SCFD (gas) x 0.027 1000 nm /d x 37.327 SCFD
MIGD: Million Imperial gallon per day (Water unit)
SCFD: Standard cubic feet per day
Viscosity
-4 2
1 St x 10° m /s x
-6 2
1 cSt x 10 m /s x
Energy Prices
US$ / MMBTU x 0.948 US$ / GJ x 1.055 US$ / MMBTU
US$ / MMBTU x 3.412154 US$ / MWh x 0.293 US$ / MMBTU
US$ / MMBTU x 5.442 US$ / Bb x 0.184 US$ / MMBTU
US$ / Bb x 0.174 US$ / GJ x 5.743 US$ / Bb
US$ / Bb x 0.627 US$ / MWh x 1.595 US$ / Bb
Annexes 159
Annex 3: Fuel properties

Trade HHV LHV CO2-Emissions
Type of fuel unit per unit per unit ref. To LHV *)
3.6 MJ kWht MJ kWht kg / GJ kg / MWh
Solid Fuels
Carbon, pure kg 33.83 9.40 33.83 9.40 108 390
Coal equivalent ce=7000 kcal / kg kg - - 29.30 8.14 94 337
Anthracite kg 34.00 9.44 33.30 9.25 95 342
Steam coal kg 27.00 7.50 26.00 7.22 95 342
Lignite kg 21.40 5.94 19.90 5.53 114 410
Wood, air dried (1 m3 = 0.7 t) kg - - 14.70 4.08 0 0
Tree bark kg - - 17.00 4.72 0 0
Straw kg 15.00 4.17 0 0
Household garbage kg - - 9.50 2.64 45 162
Liquid Fuels
Oil equivalent oe=10000 kcal/kg kg - - 41.87 11.63 - -
Crude oil bbl 6,100 1,694 5,400 1,500 - -
Crude oil kg 47.35 13.15 41.92 11.64 80 288
Heating oil light LFO l 39.04 10.85 36.72 10.20 74 266
Heating oil heavy HFO kg 42.30 11.75 40.20 11.17 78 281
Rape oil l 35.10 9.75 0 0
Gaseous Fuels
3
Methane mn 39.85 11.07 35.79 9.94
3
natural gas Low mn 35.20 9.78 31.80 8.83 56 202
3
Natural gas High mn 41.30 11.47 37.30 10.36 56 202
Propane, liquid kg 50.34 13.98 46.35 12.88 64 230
3
Propane, gaseous mn 101.70 28.25 93.18 25.88 64 230
Butane, liquid kg 49.50 13.75 45.72 12.70 64 230
3
Butane, gaseous mn 133.78 37.16 123.57 34.33 64 230
3
Blast furnace gas mn - - 3.30 0.92 268 965
3
Converter gas mn - - 8.20 2.28 183 659
3
Coke oven gas mn - - 19.00 5.28 40 144
3
Sewer gas mn - - 21.00 5.83 0 0
3
Landfill gas mn - - 21.00 5.83 0 0
160 Annexes
Annex 4: Frequently used Excel functions

In the following some frequently used Excel functions are listed and ex-
plained. The name of the function in the German Excel version is shown
within parentheses.
Future value function FV (ZW): Returns the future value of an investment

based on periodic constant payments and a constant interest rate.
Syntax: FV(Rate, Nper, Pv, Fv, Type)
Present value function PV (BW): Returns the present value of a series of

periodic future equal payments and a constant interest rate.
Syntax: PV(Rate; Nper; Pmt; Fv, Type)
Net present value function NPV (NBW): Calculates the net present value
of future payments using a constant discount rate. In contrast to the PV func-
tion the payments can be equal or unequal, positive (cash inflows) or negative
(cash outflows).
Syntax: NPV(Rate, value 1, value 2, ….value n)
If the values 1 to n are arranged in series, just mark the range of series (e.g.
A2:A20) instead of inserting the values one by one.
Annual equivalent amounts (annuities) function PMT (RMZ): Calculates

the annualized constant amounts of the present value of an initial payment
(principal) at a constant interest rate.
Syntax: PMT(Rate; Nper; Pv; Fv; Type)
Where:
Rate: Interest rate in % per period
Nper: Number of periods
Fv: Future value (in the examples in this book it is usually zero)
Type: For payments at the year’s end zero, at the year’s beginning 1 (in the exam-
ples in this book it is usually zero)
Pmt: The constant future payments
Pv: The present value of CAPEX or principal
Note: Excel assumes payments to be cash-outflows and returns them as nega-

tive amounts. In the cost models in this book all series are costs, hence it does
not make sense to designate them as negative values.
All payment series have positive values therefore a minus sign must be
inserted in front of the function to get positive values.
Annexes 161
Other Excel functions

Internal Rate of Return Function IRR (IKV): Returns the internal rate of
return of a periodic series of payments consisting of cash in-flows (positive
values) and cash- outflows (negative values). The payments must occur in
regular intervals (e.g. yearly) but they do not have to be equal.
Syntax: IRR(range of values; guess)
Where:
Range of values: just mark the range of payment series (e.g. A2:A20)
Guess: give an estimated IRR otherwise Excel will assume 10%.
Modified Internal Rate of Return function MIRR (QIKV): As IRR, how-

ever, the returns are reinvested. MIRR considers both the IRR of the initial
investment and the interest rate of the reinvestment.
Syntax: MIRR(Range of values; finance rate; reinvest rate)
Where:
Range of values: Just mark the range of payment series (e.g. A2:A20)
Finance rate: The interest rate used in the initial investment
Reinvest rate: The interest rate expected for reinvestments
Exceedance Probability calculation PXX21: Exceedance probability is cal-

culated using the NORM.INV function as follows.
Syntax: XP=2µ - Norm.Inv(Probability; mean; standard deviation)
Where:
Probability: PXX, a number between 0 and 1 (or PXX/100);
this is the probability corresponding to normal distribution.
Mean: The arithmetic mean µ of the distribution
Standard deviation σ: A positive number, or percentage
Example:
Exceedance Probability
Mean value = 50 GWh/a Note: The cells PXX are customized:
10% 20% e.g. cell with 90; Format cells, custom,
PXX
GWh / a GWh / a “P90”; insert Probability in the function
P95 41.8 33.6 P90/100 instead of 0.9.
P90 43.6 37.2
P75 46.6 43.3
“Goal Seek” and “Table” are frequently used in examples. They can be
found under “Data”, “what if analysis”. Goal seek will find the right input to
obtain a certain result (e.g. find rate to get NPV=0, this is the IRR). Data
Tables allow calculations of many different possible inputs at the same time.
This is a very useful tool for sensitivity analysis.
21
) For the theoretical background pls. refer to item7.5.1
162 Annexes
Annex 5: Add-Ins developed by the author

BWSesc: Calculates the present value (PV) of a series of payments escalating
with a constant escalation rate. The Add-In is based on the equation shown
below.
Syntax: BWSesc(escalation rate%; Discount rate%; Number of periods,
starting value without escalation).
t =n
pt
PVn _ esc = P0 ⋅ ∑ t = P0 ⋅
(
qn − pn )
t =1 q ( q − p ) ⋅ qn
Where:
P0 : Constant payment each period before escalation
q=1+i : Discount factor, i : annual interest rate
p = 1+j : Escalation factor, j : escalation rate (may be also <0 !)
n: Number of years of the discounting period
Constraints: q≠p; q≠0; p≠0
If j > 0 the PV of the series is increasing, if j < 0 it is decreasing!
See Example 2.13, Present value of Personnel costs over lifetime.
ANesc: Converts a series of payments escalating with a constant escalation

rate in constant annual equivalent amounts (annuities). The function calcu-
lates first the NPV of the series and uses the PMT function to convert the
NPV in annuities. The Add-In is based on the equation shown below. The
function is used for levelizing escalating payment series.
Syntax: ANesc(escalation rate%; Discount rate%; Number of periods, start-
ing value without escalation).
PAN _ esc = LC = P0 ⋅
( )
q n − p n ⋅ p ( q − 1)
× n
 CU 
( q − p) q −1  a 
Where:
PAN_esc: Annuity of a series of escalating payments
P0: Constant payment without escalation
q= 1+i: Discount factor, with “i" discount rate (interest rate)
p= 1+j: Escalation factor or geometric gradient, with “j” escalation rate
n: Number of periods (years)
See Example 2.16, levelized annual personnel costs.
IntCon: Calculates the interest during construction assuming disbursement

of loan in constant installments over the construction time. The Ann-In is
developed based on the FV function of Excel.
Syntax: IntCon(Capex; loan % of CAPEX; years of construction, interest for
loans, periods per year).
See Example 2.8, interest during construction.
Glossary
Contents of the Glossary

This glossary contains definitions of techno-economic terms used in this
book and some related terms that are of interest to the readers. The glossary
consists of the following case studys:
1. The most frequently used terms arranged according to their im-
portance and meaning and not in alphabetic order
2. Some costs functions
3. Frequently used operational terms
4. Terms used in alphabetical order
5. Deviations from customary definition of terms
Most of the terms are accompanied by units being a standard for engineers.
The units used are:
“CU” Currency units that may be any currency

“a” Acronym for year, latin “annus”
“kWh” and its multiples are the most common production unit in the pow-
er and energy industry.
The definitions are mainly referring to the power and energy industry and are
not generally applicable. Several terms intentionally deviate from the pure
economist’s or accountant’s terminology whenever we deem this to be ap-
propriate. Please refer to “Deviations from customary definitions”.

164 Glossary
Most frequently used financial terms

The terms below are arranged based on their importance, meaning and their
content relationship and not in alphabetic order.
Capital expenditures (CU): Acronym CAPEX, the initial capital outlay for
an investment project to generate future returns.
Annualized CAPEX (CU/a): The initial capital outlay of a project con-
verted in constant annual equivalent amounts (annuities) for a period equal to
the lifetime of a project. Alternative term capital costs.
Operating expenses (CU/a): Acronym OPEX, Cash outflows during the
operation phase of a project e.g. for fuels, personnel, maintenance. Note:
operating expenses are costs.
Costs CU/a: In general, regularly recurrent outlays such as operating ex-
penses, corporate tax and depreciation which is a non-cash item. They are
usually assumed to be due at the year’s end. In general they are composed of
fixed costs and variable costs (see definitions).
Specific cost (e.g. CU/unit): Annual costs divided by the production units
(e.g. kWh) in a certain period (a). Alternative term used per unit cost (e.g.
CU/kWh).
Fixed costs (CU/a): Costs that do not depend on the output level e.g. cost
of personnel, cost of maintenance, capital cost.
Variable costs (CU/a): Costs directly dependent on the output level such as
fuel costs, costs for consumables and residues.
Capacity cost (CU/kWa): Fixed costs (CU/a) divided by the net power
output (kW) in a certain period (a).
Energy cost alternative term volume cost (CU/kWh) or (CU/MWh) such
as fuel costs plus non-fuel variable costs divided by the net electricity pro-
duction (kWh) in the period (a).
Composite cost, specific (CU/kWh): Capacity cost (CU/kWa) plus energy
cost (CU/kWh) converted to per production unit cost (CU/ kWh) – see item
conversion functions below.
Revenues (CU/a): Price of product multiplied by the production amount.
Income, gross (CU/a): Revenues minus expenses.
Income, net (CU/a): Revenues minus expenses, loans, interest on loans,
corporate tax.
Cashflow CU/a: The difference between revenues and costs; amount avail-
able for repayment of loans and dividends for equity investors (see also free
cashflow).
Free cashflow (CU/a) : Cashflow minus amortization of loans; amount
available for dividend payments to equity investors and building of reserves
to cover future costs.
Glossary 165
Some cost functions

Total cost(s) (CU/a): The sum (CT) of fixed (CF) and variable costs (CV) for
the production of given amount of the product (x); mathematically expressed
it is:
 CU 
CT = CF  CU  + CV  CU  ⋅ x  kWh  
 a   kWh   a   a 
Incremental cost(s) (CU/kWh): The difference in total costs (∆CT) caused by
an increase or decrease of output (increment ∆x) divided by associated num-
ber of units of output (∆x). The fixed costs remain thereby the same in abso-
lute terms and influence the incremental costs (see equation below). Incre-
mental costs are typically expressed on a per unit basis (see also total costs
and marginal costs). Mathematically expressed it is:
 CU   CU  ⋅ ∆x  kWh 
+ CV
∆CT CF  a   kWh   a   CU 
=  kWh 
∆x  kWh 
∆x  
 a 
Marginal cost(s) (CU/kWh): The change in (variable) costs for an increase
of output (production) by one additional unit; the specific fixed costs do not
influence the marginal cost. In mathematical terms marginal cost is the first
derivative of the total cost:
dCT  CU 
= CV  kWh 
dx
There is a distinction between short run marginal costs (SRMC) and long run
marginal costs (LRMC). The definition above refers to the former. LRMC
also include cost for expansion of the production capacities to meet growing
demand e.g. in the course of expansion planning for a power system.
Composite electricity cost (CU/MWh): Capacity cost is usually given in

CU/kWa and Energy cost in CU/MWh. The conversion formula is:
1000 × Capacity cos t  CU 
 kWa 
C= + Energy cos t  CU 
h  MWh 
Full capacity equivalent hours  a 
166 Glossary
Frequently used operational terms

Operating time (h/a): The time of the year when a power plant unit is per-
forming generation function.
Full capacity equivalent hours (h/a): Energy production of a power plant
unit in a certain period of time e.g. a year (kWh/a) divided by the rated capac-
ity of the unit (kW). See also operating time and equivalent operating hours.
Full load equivalent hours (h/a): As above, however referring to the peak
load of the grid; often the term “full load hours” is erroneously used for both.
See also operating time and equivalent operating hours.
Equivalent operation hours EOH (h/a): The term is used in maintenance
contracts. In addition to the operating hours it takes into account surcharges
for start-ups, change of fuel and other parameters.
Capacity factor CF (-): Energy production of a power plant unit in a cer-
tain period of time e.g. a year (kWh/a) divided by the hours (h/a) in this peri-
od. This corresponds to the average output (kW) during the period. Often the
term “load factor” is erroneously used for both.
Load factor LF: As CF however referred to the peak load of the grid
Relation: tFC = CF⋅(h/period).
e.g. period one year 8760 h/a CF=0.6 tFC= 0.6×8760= 5.256 h/a
Terms in alphabetical order

Amortization: Gradual repayment of a loan
Capital service (CU/a): In annuity appraisal method the Annualized
CAPEX.
CIF (Cost Insurance Freight): The costs of an imported good on the buy-
er’s oversea terminal including the costs for oversea freight and insurance.
Cross border price: The price of a traded good at the country’s border.
For exports this is the FOB-price for imports the CIF-price. For natural gas
this is the price at the border delivery station before adding costs of domestic
transmission and distribution.
Depreciation CU/a: The gradual annual reduction of the initial capital out-
lay (CAPEX) for a project or a project component for a fixed period (eco-
nomic lifetime). Depreciation is neither a cash outflow nor an expense but it
is a cost item and reduces the taxable income. There are three methods used:
straight line (constant annual amounts), declining and accelerated. The most
common is straight line depreciation. It is noted that depreciation is not in-
cluded in investment appraisal (NPV, IRR, and Annuity). It is included in
discounted cashflow project analysis.
Glossary 167
Equity: The share of the investors’ own capital on the total capital ex-
penditures for an investment project.
Expenditures (CU): Capital outlays at the beginning of an investment pro-
ject with the purpose to generate future returns. The term usually used is
capital expenditures (acronym CAPEX).
Expenses (CU/a): Cash outflows during the operating phase of a project,
see operating expenses. Expenses are costs.
FOB (Free on Board): The cost of an exported good loaded on a ship at the
seller’s oversea terminal.
Fuel conversion costs: These are practically fixed costs and non-fuel vari-
able costs for power generation. The term is used in Saudi Arabia and other
oil producing countries for IPP projects. The fuel is provided to IPPs for con-
version in electricity free of charge, IPPs business is just the conversion of
the fuel to electricity.
Hurdle (discount) rate (%/a): The minimum acceptable rate of return of a
project for investors.
Grant: Non-repayable financial resources (money) provided by govern-
ment agencies for projects, usually to promote development of new technolo-
gies or renewable energy projects.
Grace period: A period during which repayment installments (and eventu-
ally interest payments) are deferred. In power sector projects, especially re-
newable power generation, it may last 2 to 3 years.
Interest during construction (IDC): The interest paid for loans during the
construction of a project until the start of commercial operation. It is usually
compounded and added to the capital expenditures.
Investment is a business activity, e.g. investing capital in projects to gen-
erate future returns.
Profit & Loss (P&L) Statement: A document summarizing the revenues
and costs (expenses, corporate tax, and interest on loans) of a company in-
curred during a fiscal year or quarter. The difference between revenues and
costs is the net income. After adding depreciation to the net income the bot-
tom line is the cashflow that is available for amortization of the loans and
dividends to the equity investors.
Repayment of loans: see amortization
Shadow pricing: Estimated economic prices for goods and services where
market prices are not available. The term is a common in economic evalua-
tion of projects.
Working capital: The term is defined in economics as “current assets and
current liabilities”. In power system projects it is the capital needed to cover
liabilities (costs, amortization etc.) after the start of commercial operation of
a project until sufficient earnings from electricity sales are obtained.
168 Glossary
Deviations from customary definition of terms

Cost(s): The term cost(s) is used in this book for regularly recurrent outlays
(e.g. CU/a) such as operating expenses (OPEX), corporate tax, interest pay-
ments on loans, as well as for non-cash items, such as depreciation, which is
a non-cash item. The term “cost” may also refer to a production unit as “per
unit cost” or “specific cost”, e.g. CU/kWh.
The term “capital expenditures” instead of “investment cost(s)” is used in this

book for the initial capital outlays – non-recurrent – for an investment project
to generate future returns, acronym CAPEX. It is also used for reinvestments
during the operation time of a project. The term investment cost(s) often re-
ferring in literature for CAPEX is not correct according to the above defini-
tion for cost(s) and thus is not used in the book.
Payment series instead of cashflows is used for “cash inflows” such as reve-
nues, and “cash outflows” such as operating expenses or for non-cash items
like the depreciations. The term cashflow is defined as difference between
revenues and costs at the bottom of Profit and Loss (P&L) statement projec-
tions.
Acronyms and Abbreviations
€ Euro
a Annus (Latin), year
acc. According
an Annuity factor
ANU Annuity
API Standard Coal Index
ARA Amsterdam, Rotterdam Antwerp
BAFA Bundesanstalt für Wirtschaft und Ausfuhrkontrolle
BAFA German Federal Agency for Export Control
bbl Barrel oil
bcm Billion cubic meter
BDI Baltic Dry Index
Bps Basis point 1%=100 Bps, 0.01% = 1 Bsp
CAPEX Capital expenditures
CBTo Cost based tariff
CCGT Combined cycle gas turbine power plant
CHP Combined heat and power plant
CIF Cost insurance freight
CF Capacity factor
CIRR Commercial Interest Reference Rate
COP Conference of parties
CPI Consumer price index
CRA Credit Rating Agency
Ct Cent
CU Currency unit use in formulas as neutral term
DCF Discounted cashflow
DSCR Debt service coverage ratio
DWT Deadweight tonnage (ship transport capacity)

170 Acronyms and Abbreviations
EBIDA Earnings before interest depreciation and amortization

EBIT Earnings before interest and taxes
EBITDA Earnings before interest taxes depreciation amortization
EEX European Energy Exchange
EnBW Energie Baden Württenberg (German Utility)
Et Expenses at time t
etc. Et cetera
FOB Free on board
FV Future value
Gcal Giga calorie
GCV Gross calorific value
GPV Gross product value (refinery term)
GWh Gigawatt hours
HFO Heavy fuel oil
Hi Inferior heating value
hl Hectoliter (100 liter oil)
Ho Oberer Heizwert (higher heating value)
HP High pressure
Hs Superior heating value
Hu Unterer Heizwert (lower heating value)
i Interest rate
IEA International Energy Agency
ieff Effective interest rate %/a
in Nominal interest rate
Io Capital expenditures for investment
IPE International Petroleum Exchange (in London)
IPP Independent power producer
IPWP Independent power and water producer
ir Real interest rate
IRR Internal rate of return
IRROE Internal rate of return on equity
IRROI Internal rate of return on investment
j Escalation rate %/a
kcal Kilo calorie, old thermal unit
kW Kilowatt
kWh Kilowatt hour
Acronyms and Abbreviations 171
lb Pound, English weight unit

LEC Levelized electricity cost
LF Load factor
LFO Light fuel oil
LLCR Loan life coverage ratio
LNG Liquified natural gas
LP Low pressure
LPG Liquified petroleum gas
LRMC Long run marginal cost
MBD Million barrels per day
mln Million
MP Medium pressure
MPR Minimum Premium Rate for Credits
MW Megawatt
MWh Megawatt hours
n Number of years lifetime
NAR Net as received (coal term)
NCV Net calorific value
NG Natural gas
NPC Net Present cost
NPV Net present value
NYMEX New York Merchantile Exchange
O&M Operation and maintenance
OECD Organization of Economic Cooperation and Development
OPEC Organization of oil Exporting Countries
OPEX Operation expenses
OTC Over the counter
p Escalation factor (1+escalation rate j %)
P Payment, amount of money
P Power kW, MW, GW
P&L Profit & Loss statement
PLCR Project life coverage ratio
PN Pressure normed
PP Power plant
PPI Producer price index
PV Present value
172 Acronyms and Abbreviations
q Discount factor (1+ discount rate i %)

ROI Return on investment
Rt Revenues at time t
SRMC Short run marginal cost
SWOT Strengths, Weaknesses, Opportunities, Threats
t Time
T&C Transfer and Convertibility (Risk)
tce Tons of coal equivalent
tec Tons of oil equivalent
to Reference time for discounting
TOP Take or Pay, term commonly used for imported natural gas
tpb Payback period
U3O8 Uranium Oxide, trade name yellow cake
UF6 Uranium Hexafluorid
UK United Kingdom
UO2 Uranium Oxide
US$ US Dollar
USA United States of America
WACC Weighted average cost of capital
We Electricity production (kWh/a)
WTI West Texas Intermediate (crude oil quality)
yr Year
Greek Characters
∆ Difference
∆E Difference of Expenses
∆I Difference of capital expenditures
µ mi, Symbol for mean value (Gauß distribution)
σ Sigma, Symbol for standard deviation
ϕ Phase
Σ Symbol for Sum
Index
Absolute profitability, 45, 54, 55, 57 Coal benchmarks, 115

Add-Ins developed by the author, 162 Cogeneration Cycle, 78
annual equivalent amount method, 56 combined heat and power (CHP)
annual interest, 8 plant, 78
annualized CAPEX, 19 Commercial Interest Reference Rates
annualized capital expenditures, 56 (CIRRs), 104
annuities, 18 Compound amount factor
annuities of escalating series of of equal payment series, 15
payment, 60 single payment, 8
annuity factor, 19 Compounding
ARA terminals, 116, 123 compound amount, 7
basket of goods, 27 shorter periods, 9
Benefit-Cost Analysis, 74 single payment, 7
benefit-cost ratio, 74 unequal payments, 12
border price, 73 construction phase risks, 95
Break-even Point Analysis, 85 Consumer Price Index (CPI), 28
bulk carriers, 116 Conventional power plants, 95
Calorie, 111 conversion of HHV to LHV, 112
calorific price, 121 Conversion table metric – imperial
Capesize class, 116 units, 157
CAPEX, 42 corporate tax, 37
Capital expenditures, 42 correlation between prices, 121
capital recovery factor, 19 Cost allocation
Case Studies, 133 electrical equivalent method, 80
Cash flow analysis, 68 residual value method, 79
cash inflows, 41 Cost Based Tariff (CBT0), 50
cash outflows, 41 Cost(s)
cashflow models, 66 Fixed operating costs, 43
Cashflow models, 66 Variable operating costs, 43
cashflow projections, 66 costing models, 41
Central Banks, 29 country premium, 38
CIF (cost, insurance, freight), 73 country risk classifications, 103
Coal Country risks
brown coal, 115 Economic risks, 102
coking coal, 115 Expropriation risks, 102
hard coal, 115 Political risks, 102
steam coal, 115 credit default insurance policy, 38

174 Index
Credit rating equity share, 30

investment grade, 106 equivalent annualized payments, 18
junk, 106 escalation rate, 27
rating outlook, 106 Exceedance probability, 92
speculative, 106 Excel functions
credit rating agencies (CRA), 105 Other Excel functions, 161
Credit rating classes, 106 exchange rates fluctuation, 32
Credit ratings, 105 Export Credit Agencies, 102
cross border value, 119 Export credits, 103
Crude oil, 113 externalities, 73
crude oil prices, 113 Financial Analysis, 66
Crude oil types financial mathematics, 5
Brent (North Sea Brent), 113 Financial performance ratios, 69
OPEC basket, 113 Debt Service Coverage Ratio
WTI (West-Texas-Intermediate), (DSCR), 69
113 Loan Life Coverage Ratio (LLCR),
cumulative probability, 91 69
deflation, 28 Project Life Coverage Ratio
degradation, 22 (PLCR), 70
degradation during operation, 98 Fiscal policy, 29
Depreciation, 42 FOB (free on board), 73
declining balance method, 69 Forms of energy, 110
Straight-line, 69 fracking, 114
sum-of-the-years'-digits method, Free Cashflow, 67
69 freight rates, 116
discount rate, 36 Fuel prices based on opportunity
Discount rate, 10, 37, 71, 162 costs, 131
discount rates (WACC), 101 Fuel properties, 159
discounted average value, 23 gas premium, 118
Discounted Cashflow (DCF), 67 geometric gradient series, 21
Discounting geometric sequence, 8
a single payment, 10 geometric series, 13
escalating payments, 21 common ratio, 13
series of equal payments, 17 scaling factor, 13
unequal payments, 12 Global Coal, 116
due date, 6 Glossary, 163
Economic analysis, 71 Deviations from customary
electrical equivalent, 80 definition of terms, 168
electricity credit, 79 financial terms, 164
End-user fuel prices, 123 operational terms, 166
Energy forms Some cost functions, 165
Final energy, 110 Terms used in alphabetical order,
Primary energy, 110 166
useful energy, 110 Government bonds, 30
enriched Uranium, 125 governments’ bonds, 99
Index 175
grace period, 98 liberalization, 94

grid-bound energy, 117 lifetime, 6
Groningen gas field, 118 Liquified Natural Gas (LNG), 117
Gross Product Worth (GPW), 114 long run marginal cost – LRMC, 141
Heating or Calorific price, 121 long-term contracts, 120
Heating values maturity, 29
gross calorific value, 111 Minimum Premium Rates for credit
higher heating value, 111 risks (MPR), 104
inferior heating value, 111 monetary non-tangible, 86
lower heating value, 111 Monetary policy, 29
net calorific value, 111 monopolies, 94
superior heating value, 111 must investment, 41
Hedging country risks, 102 Natural gas, 117
house mortgage, 19 natural monopolies, 94
hurdle discount rate, 37 Net back pricing formula, 120
Hydro power, 94 net back value, 119
Imputed costs, 43 net benefits (NB, 74
independent power producers (IPP), Net Present Costs, 45
100 Net Present Value, 44
Inflation, 27 nominal terms, 27, 35
below inflation, 27 nominal value, 6
on top of inflation, 27 Non-tradable items, 72, 73
inflation adjusted, 27 normal distribution, 88
inflation rate, 27 Nuclear fuel, 125
interest during construction, 42 nuclear fuel cost, 125, 126, 127, 128
interest rate, 29 nuclear power generation, 127
Interest rate Nuclear power plants, 95
effective interest rate, 35 OECD Arrangement, 103
nominal interest rate, 34 Off-take obligation, 120
real interest rate, 34 oil price shocks, 116
Internal Rate of Return (IRR) method, oil tar sand, 114
52 oil-price shocks, 114
investment, 6 Operating expenses, 42
Investment appraisal, 40 OPEX, 42
investment period, 43 opportunity costs, 43
IRR on equity, 54 Panamax class, 116
IRR on equity (IRROE), 52 Participants, 103
IRR on investment, 52 payback time, 62
IRR on investment (IRROI), 52 Payback time
least cost approach, 39, 41, 45 Discounted payback, 62
LECs of escalating cost series, 49 Simple payback, 62
Levelized Electricity Cost (LEC), 46 Payments, 6
levelized electricity cost LEC, 43 performance guarantees, 98
Levelized values of escalating series, policy instruments, 29
23 premiums for export credits, 105
176 Index
Present value salvage value, 45

of a series with constant escalation Scenario analysis
rate, 21 best case, 85
of a single payment, 10 most likely, 85
of equal payments, 17 worst case, 85
series of equal amounts, 13 Sensitivity analysis, 84
price basket, 27 Series of Unequal Payments, 11
price escalation, 27 Shadow pricing, 73
price formula, 120 short run marginal cost – SRMC, 142
price gap, 128 SI Unit system
price indexes, 27 base units, 154
principal, 6, 29 Prefixes, decimals and multiples,
probability of occurrence, 91 156
Producer Price Index (PPI), 28 Selected derived Units, 155
Profit & Loss Statement, 41 Some basic rules, 154
profit maximization, 41 Solar power generation, 95
Profitability spot prices, 113, 116, 123
absolute, 43 spreads of government bonds, 107
relative, 43 standard deviation σ, 89
Rankine cycle CHP, 78 standard deviation “σ”, 92
ratios of the fuel prices, 122 standard normal distribution, 90
real interest rate, 31 statistical mean µ, 89
real terms, 27, 35 Steam coal, 115
Relative profitability, 45 subgrids, 124
replacement value, 118 SWOT Analysis, 86
return on equity, 30, 43, 54, 55, 56, SWOT evaluation matrix, 87
99, 100, 170 SWOT statement, 87
Return on investment (ROI), 63 take-or-pay (TOP), 120
Risk Analysis, 93 tangible and intangible benefits, 75
risk assessment, 95 technical life time, 6
risk categories, 103 The Standard International Unit
risk exposure, 99 System, 154
risk free investment, 30 thermal units, 111
risk free rate, 100 tons of coal equivalent (tce), 111
Risk Mitigation, 93 tons of oil equivalent (toe), 111
Risk premium tradable items, 72, 73
credit default premium, 100 Tradable items, 72
venture risk premium, 100 trade units, 111
Risk premiums, 30, 99 Transfer payment, 71
Risks Transmission and distribution, 94
internal and external risks, 95 trans-regional grid, 123
operation phase risks, 95 Unbundling, 94
risk mitigation, 95 Uranium dioxide UO2, 125
technology risks, 100 uranium isotopes, 125
Sale revenues, 43 Uranium Oxide U3O8, 125
Index 177
use of system charges, 124 Weighted Average Cost of Capital, 36

venture premium, 38 weighted average price, 27
vertically integrated, 94 yellow cake, 125
WACC on nominal terms and on real yield of government bonds, 30
terms, 37

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Power and Energy Systems Engineering Economics Best Practice Manual

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Panos Konstantin

Power and Energy Systems

ISBN 978-3-319-72382-2 ISBN 978-3-319-72383-9 (eBook)

© Springer International Publishing AG, part of Springer Nature 2018

Printed on acid-free paper

The book’s overall objective is to provide a comprehensive but concise cov-

Burgstetten, Germany, October 2017 Panos Konstantin

All my professional life as a consultant, I wrote hundreds of reports for pro-

3.4 Interest Rates and Inflation ............................................................ 29

5.3.1 The discounted cashflow model ............................................ 67

7.7 Consideration of Risk Premiums in Discount Rate ....................... 99

9.3 Modelling Energy Balance for Power Generation ...................... 138

Figure 7-5: Exceedance probability for different P-values ........................... 93

Example 4.4: Calculation of the cost based tariff CBT0 ................................ 51

1.1 Brief Outline of the Chapters

Chapter 1 provides a brief synopsis of the chapters. Throughout the book,

© Springer International Publishing AG, part of Springer Nature 2018 1

Important notes on the chapters

Download examples: www.pk-energy-practical-knowhow.com

Currencies: The book is written for an international audience in coun-

Unit system: Throughout the book, the Standard International Unit

Annex 1 provides a brief description of The Standard International Unit

This glossary contains definitions of techno-economic terms used in this

2.1 Synopsis of the Chapter

This chapter provides the necessary knowledge in financial mathematics

© Springer International Publishing AG, part of Springer Nature 2018 5

2.2 The Time Value of Money

2.2.1 Some Key Definitions of Terms

The primary objective of financial mathematics is to determine the value of

2.2.2 The time value of money

In common mathematics as in arithmetic and algebra, equal amounts also

Figure 2-1: The time value terms

2.3 Single Payments

2.3.1 Compounding a single payment

Table 2-1: Compound amount of a single payment

In mathematics, we will say “Pn” is the “nth” term of a geometric sequence

The term q = (1+i)n

Example 2.2: Compounding of a single payment in shorter periods

A shorter compound period gives a higher compound amount of the payment!

2.3.2 Discounting of a single payment

The calculation of the present value of a future payment is called discounting.

Example 2.3: Present value of a single payment

600 Discount rate 5%

Figure 2-3: Present value of a single payment

2.4 Series of Unequal Payments

In investment appraisal, we actually have to deal with series of payments

2.4.1 Compound amount of a series of unequal payments

The future compound amount of a series with unequal payments is found by

Example 2.4: Compounding of a series of unequal payments

Item Unit Values

2.4.2 Present value of a series of unequal payments

The present value of series of “n” unequal payments is found by multiplying

MS-Excel function: NPV(Rate%,Value1, Value2,…,ValueN)

Example 2.5: Discounting of a series of unequal payments

Item Unit Values

2.5 Series of Equal Payments

2.5.1 The mathematical structure of series of equal payments

Example 2.6: Sum of the numbers of a geometric series

2.5.2 Compound amount of a series of equal payments

Compounding a series of equal annual payments due at the beginning of each

MS-Excel function: FV(Rate%,Nper, Pmt, Pv,Type),terms see example below

Shorter compounding periods:

Example 2.8: Interest during construction

Item Unit Values