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3.1 Introduction
All of us are familiar with economics; although we are not, necessarily, able to
define it in scientific terms. It affects our daily lives as we earn money and expend
it afterwards. Economics is, in fact, the study of how a society decides on what,
how and for whom to produce. While the so called microeconomic analysis
focuses on a detailed treatment of individual decisions about some particular
commodities, the so called macroeconomic analysis emphasizes the interactions in
the economy as a whole.
Similar to any other social science, economics has appeared in power system
field, too. Like any other man-made industry, electric power industry is confronted
with revenues and costs; resulting in economic principles to be continuously
observed. The emerged electric power markets have resulted in full involvements
of this industry in economic based theories, applications and principles.
The subject of economics is quite vast. We are not, here, to investigate its prin-
ciples. We do not want to be involved in those aspects of economics which, some-
how, interact with electric markets, too. Instead, we want to, shortly, review the
definitions of some basic terms used in power system planning field and especially in
this book. The terms defined are not, necessarily, related to each other. Later on, they
will be used throughout the book, once needed. The cash-flow concept is reviewed in
Sect. 3.3. The methods for economic analysis are covered in Sect. 3.4.
• Revenue
Revenue is the money that a company earns by providing services in a given
period such as a year.
• Cost
Cost is the expense incurred in providing the services during a period.
• Profit
Profit is the excess of revenue over the cost.
• Investment cost1
Investment cost is the cost incurred in investing on machinery equipment and
buildings used in providing the services.
• Operational cost
Operational cost is the cost incurred on running a system to provide the ser-
vices. Wages, resources (fuel, water, etc.), taxes are such typical costs.
• Depreciation
Depreciation is the loss in value resulting from the use of machinery and
equipment during the period. During a specific period, the cost of using a capital
good is the depreciation or loss of the value of that good, not its purchase price.
Depreciation rate is the rate of such a loss in value.
• Nominal interest rate
Nominal interest rate is the annual percentage increase in the nominal value of a
financial asset. If a lender makes a loan to a borrower, at the outset, the borrower
agrees to pay the initial sum (the principal) with interest (at the rate determined
by interest rate) at some future date.
• Inflation rate
Inflation rate is the percentage increase per a specific period (typically a year) in
the average price of goods and services.
• Real interest rate
Real interest rate is the nominal interest rate minus the inflation rate.
• Present value
Present value of some money at some future date is the sum that if lent out
today, would accumulate to x by that future date. If this present value is rep-
resented by P and the annual interest rate is termed i, after N years we would
have (F)
or
1
P¼ F ð3:2Þ
ð1 þ iÞN
• Discount factor
Discount factor is the factor used in calculating present values. It is equal to 1/
(1 ? i)N (see (3.2)).
1
Sometimes called capital or capital investment cost. In Chap. 5, we differentiate a little bit
more, between these two terms. However, we mainly use investment cost as the most common
term.
3.2 Definitions of Terms 33
• Salvation value2
Salvation value is the real value of an asset/equipment, remaining, at a specific
time and after considering the depreciation rate.
• Gross Domestic Product (GDP)
GDP measures the output produced by factors of production located in a
domestic economy regardless of who owns these factors. GDP measures the
value of output produced within the economy. While most of this output would
be produced by domestic factors of production, there may be some exceptions.
• Gross National Product (GNP) or Gross National Income (GNI)
GNP (or GNI) measures the total income earned by domestic citizens regardless
of the country in which their factor services are supplied. GNP (or GNI) equals
GDP plus net property income from abroad.
• Nominal GNP
Nominal GNP measures GNP at the prices prevailing when income is earned.
• Real GNP
Real GNP or GNP at constant prices adjusts for inflation by measuring GNP in
different years at the prices prevailing at some particular calendar data known as
the base year.
• Per capita income (or per capita real GNP)
Per capita real GNP is real GNP divided by the total population. It is real GNP
per head.
The flow of money, both the inputs and the outputs, resulting from a project is
called cash-flow. In order to understand this concept, we should first define the
time value ofmoney.
Any one easily understands that money makes money. In other words, if we invest
an amount of X, we expect some percent to be added at the end of the year. In other
words R X at present worths more in the future. This concept is used if some one
invests or borrows money.
2
This term is not a very common economic term. However, as it is used in WASP package (see
Chap. 5) for GEP problem, it is introduced here.
34 3 Some Economic Principles
For a project, the cash flows are of the following two types
• Inflows (such as an income)
• Outflows (such as a cost)
Both types may occur at present or in a specific time in the future. We should,
then, define the present value of money (P) and the future value of money (F). The
number of periods is assumed to be n while the interest rate is assumed to be i (%).
A value of P at present in n-year time worths as follows
F1 ¼ P þ P i ¼ Pð1 þ iÞ at the end of the first year
F2 ¼ F1 þ F1 i ¼ F1 ð1 þ iÞ ¼ Pð1 þ iÞ2 at the end of the second year
.. ..
. .
F ¼ Fn1 þ Fn1 i ¼ Pð1 þ iÞn at the end of the nth year
R F in n-year time, it would worth F/(1 ? i)n at present.
In other words if we have
n
(1 ? i) is named as compound amountfactor and is denoted by (F/P, i%, n).
1/(1 ? i)n is named as present worth factor and is denoted by (P/F, i%, n).
Example 3.3 If we repeat example 3.1 for a 5-year period, the investor gains
R (1 ? 0.05)5 9 100 =
R 127.6 at the end of the fifth year.
Example 3.4 What happens if we repeat example 3.2 for a 10-year period. In other
words, the borrower has to pay back the money in 10-year time. We can readily
R (1 ? 0.1)10 9 100 =
check that the borrower should return a total amount of
R 259.4 at the end of the 10-year time.
Regarding example 3.3, the investor may get equal annual payments and not the
total amount at the end of the fifth year. In example 3.4, the borrower may have to
pay the money back in equal annual amounts. As cash flows occur in different
times, how should we calculate them?
3.3 Cash-flow Concept 35
1 2 3 4 5 6 7 n-2 n-1 n
A A A A A A A A A A A
or
ið1 þ iÞn
A¼ P ð3:6Þ
ð1 þ iÞn 1
½ðð1 þ iÞn 1Þ=ðið1 þ iÞn Þ is named as uniform series present worthfactor and is
denoted by (P/A, i%, n). ½ðið1 þ iÞn Þ=ðð1 þ iÞn 1Þ is named as capital recovery
factor and is denoted by (A/P, i%, n). It is easy to verify that
i
A¼ F ð3:7Þ
ð1 þ iÞn 1
ð1 þ iÞn 1
F¼ A ð3:8Þ
i
where the brackets in (3.7) and (3.8) are named as sinking fund factor and series
compound amount factor, respectively; denoted by (A/F, i%, n) and (F/A, i%, n),
respectively.
36 3 Some Economic Principles
From various solutions available for a problem, a planner should select the best, in
terms of both technical and economic considerations. Here we are going to discuss
the economic aspect of a problem.
Three methods may be used for economic appraisal of a project, namely as
• Present worth method
• Annual cost method
• Rate of return method
In evaluating a project, we should note that various plans may be different in
terms of effective economic life. Sometimes, it is assumed that the economic life
of a plan is infinite (n ? ?).
In this method, all input and output cash flows of a project are converted to the
present values. The one with a net negative flow (Net Present Worth, NPW) is
considered to be viable. From those viable, the one with the lowest net flow is the
best plan.
In this method, if the economic lives of the plans are different, the study period
may be chosen to cover both plans in a fair basis. For instance, if the economic
lives of two plans are 3 and 4 years, respectively, the study period may be chosen
to be 12 years.
Example 3.5 Consider two plans A and B with the details shown in Table 3.1.
With an interest rate of 5%, NPWA and NPWB are calculated as
Plan A
Period 1 Period 2 Period 3
…… …… ……
…… …… ……
Plan B
…… …… …… …… ……
…… …… …… …… ……
As both NPWs are positive, we can conclude that for both plans, the costs are more
than the profits and none is a good choice. However, plan B is more attractive if we
have to choose a plan.
Example 3.6 Repeal example 3.5, if the economic life of plan B is 15 years.
As already noted, we need to evaluate the plans for a 75-year period; to cover
both plans in a rational basis. The case is depicted in Fig. 3.2. NPWA and NPWB
are calculated as
NPW A ¼ 1000 þ 1000 ðP=F; 5%; 25Þ þ 1000 ðP=F; 5%; 50Þ
þ 50 ðP=A; 5%; 75Þ 100 ðP=A; 5%; 75Þ
300 ðP=F; 5%; 25Þ 300 ðP=F; 5%; 50Þ
300 ðP=F; 5%; 75Þ ¼
R 285:78
NPW B ¼ 1300 þ 1300 ðP=F; 5%; 15Þ þ 1300 ðP=F; 5%; 30Þ
þ 1300 ðP=F; 5%; 45Þ þ 1300 ðP=F; 5%; 60Þ
þ 70 ðP=A; 5%; 75Þ 150 ðP=A; 5%; 75Þ
500 ðP=F; 5%; 15Þ 500 ðP=F; 5%; 30Þ
500 ðP=F; 5%; 45Þ 500 ðP=F; 5%; 60Þ
500 ðP=F; 5%; 75Þ ¼
R 430:11
38 3 Some Economic Principles
We find out the fact that if we have to choose a plan anyway, plan A is more
attractive in this case. We should emphasize that considering a 75 year period does
not mean that the actual economic lives of the plans are longer in this case and is
used only for comparison purposes.
In this method, all input and output cash flows of a project are converted to a series
of uniform annual input and output cash flows. A project with a uniform annual
output less than its respective input is considered to be attractive. From those
attractive, the one with the least Net Equivalent Uniform Annual Cost (NEUAC) is
considered to be the most favorable.
This method is especially attractive if the plans economic lives are different.
Example 3.7 Repeat example 3.5 with the annual cost method.
There are some input and output cash flows during the economic life of a project.
If we consider an interest rate at which these cash flows are equal (i.e., the net is
zero), the resulting rate is named as Rate Of Return (ROR). ROR should be
compared with the Minimum Attractive Rate Of Return (MAROR). Provided ROR
is greater than MAROR, the plan is attractive. From those attractive, the one with
the highest ROR is the most favorable.
3.4 Economic Analysis 39
ROR can be calculated using one of the methods outlined in Sects. 3.4.1 or
3.4.2. A trial and error approach may be used to find out the solution.
Example 3.9 Calculate ROR of example 3.5 using the method outlined in Sect.
3.4.1.
PWCA ¼ PWBA
1000 þ 50 ðP=A; ROR%; 25Þ ¼ 100 ðP=A; ROR%; 25Þ
þ 300 ðP=F; ROR%; 25Þ ) ROR ¼ 3:1%
PWCB ¼ PWBB
1300 þ 70 ðP=A; ROR%; 25Þ ¼ 150 ðP=A; ROR%; 25Þ
þ 500 ðP=F; ROR%; 25Þ ) ROR ¼ 4:8%
where PWC is Present Worth Cost and PWB is Present Worth Benefit.
If MAROR is considered to be 5%, none is attractive. If we have to choose a
plan anyway, plan B is more attractive due to its higher ROR.
For supplying the loads in a utility, new generation facilities, namely, 400 and
600 MW, in 5-year and 10-year times, respectively, are required. Three scenarios
are investigated as follows
• Scenario 1
The utility may install a 400 MW natural gas fueled unit in the first period and a
600 MW hydro unit in the second period. However, transmission lines with
1500 MVA km equivalent capacity should be constructed (500 MVA km in the
first period and 1000 MVA km in the second period), while no new natural gas
piping is required in either of the periods.
• Scenario 2
Installing two natural gas fueled units at the heavy load area (400 MW for the
first period and 600 MW for the second period) is another choice by which no
new transmission line is required. However, new natural gas piping is required,
as the heavy load area is confronted by natural gas deficiency. The piping should
provide full capacity requirement for each unit. Assume that 2 9 106 m3 km is
required for the 400 MW generation, while 3 9 106 m3 km is needed for the
600 MW one.
• Scenario 3
The utility has a third option in which the generation requirements may be
fulfilled through neighboring systems. However, an equivalent of 500 MVA km
transmission line should be constructed within the second period.
40 3 Some Economic Principles
The studies have shown that for the above scenarios, the system losses would be
increased by 40, 4 and 12 MW, respectively, in the first period and by 60, 6 and
18 MW, respectively, in the second period.3
Assuming the interest rate to be 15%, the cost of the losses to be R 800/kW,4
the cost of meeting the loads through neighboring systems to be R 0.1/kWh and
R 0.07/kWh for the first and the second periods, respectively, and the load factor to
be 0.8 for both periods, find out the best scenario using the cost terms as outlined
in Tables 3.2 and 3.3. In the evaluation process, assume the costs would be
increased based on annual inflation rate. Moreover, assume the investment costs to
be incurred at year 3 and year 7, in the first and the second periods, respectively.
Consider the study period to be 15 years.
Defining the following variables
CIG: The generation unit investment cost,
CIL: The transmission line investment cost,
CIP: The piping (natural gas) investment cost,
COG: The generation unit operational cost,
COL: The transmission line operational cost,
COP: The piping operational cost,
CL: The cost of the losses,
CF: The fuel cost.
and assuming
• The costs are incurred as shown in Fig. 3.3 (All costs assumed to be incurred at
the end of each year).
• The concept of NPV to be used. As the elements life times are not identical and
are larger than the study period, the investment costs are initially converted to an
3
Resulting in new facilities to be installed for compensating such losses.
4
For each year.
3.4 Economic Analysis 41
Period of study
1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19
annual basis and added to all other annual terms. The costs after the study period
(up to the life times) are converted to the base year and considered as negative
costs (i.e., income or, in fact, asset).
The details for the scenarios are as follows5
• Scenario 1
1
CIG R 400 250 103
¼
2
CIG R 600 1000 103
¼
1
CIL R 500 5 103
¼
2
CIL R 1000 5 103
¼
1
COG R 400 20 103 =year
¼
2
COG R 600 5 103 =year þ
¼ R 400 20 103 =year
1
COL R 500 0:025 103 =year
¼
2
COL R 1000 0:025 103 =year þ
¼ R 500 0:025 103 =year
CF1 ¼
R 0:8 400 8760 30=year
CF2 ¼
R ð0:8 1000 8760 600 8760Þ 30 /year
CL1 ¼
R 40 800 103 =year
CL2 ¼
R 60 800 103 =year
In terms of CF1 and CF2 , it is assumed that the energy requirement of the first
period is produced by the gas fueled unit; while in the second period, some part is
generated by the hydro unit (at its full capacity due to low operation cost) and the
rest is generated by the gas fueled unit.
5
Superscripts 1 and 2 denote periods 1 and 2, respectively.
42 3 Some Economic Principles
Now based on the points already described, the values should be properly
modified as follows
1 2
CIG ¼ CIG ðP=F; 15%; 3Þ þ CIG ðP=F; 15%; 7Þ
1
CIG ðA=P; 15%; 25ÞðP=A; 15%; 15ÞðP=F; 15%; 15Þ
2
CIG ðA=P; 15%; 50ÞðP=A; 15%; 45ÞðP=F; 15%; 15Þ ¼
R 206529190:1
1 2
CIL ¼ CIL ðP=F; 15%; 3Þ þ CIL ðP=F; 15%; 7Þ
1
CIL ðA=P; 15%; 50ÞðP=A; 15%; 40ÞðP=F; 15%; 15Þ
2
CIL ðA=P; 15%; 50ÞðP=A; 15%; 45ÞðP=F; 15%; 15Þ ¼
R 2603205:4
1
COG ¼ COG ðF=A; 15%; 5ÞðP=F; 15%; 10Þ
2
þ COG ðF=A; 15%; 5ÞðP=F; 15%; 15Þ ¼
R 22447524:4
1
COL ¼ COL ðF=A; 15%; 5ÞðP=F; 15%; 10Þ
2
þ COL ðF=A; 15%; 5ÞðP=F; 15%; 15Þ ¼
R 51905:2
CF ¼ CF1 ðF=A; 15%; 5ÞðP=F; 15%; 10Þ
þ CF2 ðF=A; 15%; 5ÞðP=F; 15%; 15Þ ¼
R 183706824:6
CL ¼ CL1 ðF=A; 15%; 5ÞðP=F; 15%; 10Þ
þ CL2 ðF=A; 15%; 5ÞðP=F; 15%; 15Þ ¼
R 93104503:6
• Scenario 2
Similar to the above, for scenario 2
CTOTAL ¼ CIG þ CIP þ COG þ COP þ CF þ CL ¼
R 475313882:3 ð3:10Þ
where
1 2
CIG ¼ CIG ðP=F; 15%; 3Þ þ CIG ðP=F; 15%; 7Þ
1
CIG ðA=P; 15%; 25ÞðP=A; 15%; 15ÞðP=F; 15%; 15Þ
2
CIG ðA=P; 15%; 25ÞðP=A; 15%; 20ÞðP=F; 15%; 15Þ ¼
R 93175249:6
1 2
CIP ¼ CIP ðP=F; 15%; 3Þ þ CIP ðP=F; 15%; 7Þ
1
CIP ðA=P; 15%; 50ÞðP=A; 15%; 40ÞðP=F; 15%; 15Þ
2
CIP ðA=P; 15%; 50ÞðP=A; 15%; 45ÞðP=F; 15%; 15Þ ¼
R 27441104:6
1
COG ¼ COG ðF=A; 15%; 5ÞðP=F; 15%; 10Þ
2
þ COG ðF=A; 15%; 5ÞðP=F; 15%; 15Þ ¼
R 29904937:7
3.4 Economic Analysis 43
1
COP ¼ COP ðF=A; 15%; 5ÞðP=F; 15%; 10Þ
2
þ COP ðF=A; 15%; 5ÞðP=F; 15%; 15Þ ¼
R 224287:0
CF ¼ CF1 ðF=A; 15%; 5ÞðP=F; 15%; 10Þ
þ CF2 ðF=A; 15%; 5ÞðP=F; 15%; 15Þ ¼
R 314360704:9
CL ¼ CL1 ðF=A; 15%; 5ÞðP=F; 15%; 10Þ
þ CL2 ðF=A; 15%; 5ÞðP=F; 15%; 15Þ ¼
R 9310450:4
in which
1
CIG R 400 250 103
¼
2
CIG R 600 250 103
¼
1
CIP R 2 106 15
¼
2
CIP R 3 106 15
¼
1
COG R 400 20 103 =year
¼
2
COG R 600 20 103 =year þ
¼ R 400 20 103 =year
1
COP R 2 0:15 106 =year
¼
2
COP R 3 0:15 106 =year þ
¼ R 2 0:15 106 =year
CF1 ¼
R 0:8 400 8760 30=year
CF2 ¼
R ð0:8 1000 8760Þ 30=year
CL1 ¼
R 4 800 103 =year
• Scenario 3
In this scenario, we would have
1
CIL ¼
R0
2
CIL R 500 5 103
¼
1
COL ¼
R 0=year
2
COL R 500 0:025 103 =year
¼
CL1 ¼
R 12 800 103 =year
CL2 ¼
R 18 800 103 =year
If CS1 and CS2 denote the costs of providing the electricity through the neighboring
systems in the first and the second periods, respectively, we would have
CS1 ¼
R 0:8 400 8760 103 0:1=year
CS2 ¼
R 0:8 1000 8760 103 0:07=year
44 3 Some Economic Principles
Therefore
2
CIL ¼ CIL ðP=F; 15%; 7Þ
2
CIL ðA=P; 15%; 50ÞðP=A; 15%; 45ÞðP=F; 15%; 15Þ ¼
R 632893:4
2
COL ¼ COL ðF=A; 15%; 5ÞðP=F; 15%; 15Þ ¼
R 10357:5
CS ¼ CS1 ðF=A; 15%; 5ÞðP=F; 15%; 10Þ
þ CS2 ðF=A; 15%; 5ÞðP=F; 15%; 15Þ ¼
R 873663842:6
CL ¼ CL1 ðF=A; 15%; 5ÞðP=F; 15%; 10Þ
þ CL2 ðF=A; 15%; 5ÞðP=F; 15%; 15Þ ¼
R 27931351:1
and
CTOTAL ¼ CIL þ COL þ CL þ CS ¼
R 902238444:6 ð3:11Þ
The results for scenarios are reported in Table 3.4. As seen, scenario 2 is the
best choice in terms of economical considerations.
References
The books published on principles of economics are quite high. Three typical ones are introduced
in [1–3]. Reference [4] is the typical book extensively used for power system economics.