BEEI 

3433
ENERGY EFFICIENCY

CHAPTER 5

Economic Management

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 Learning Outcome

Student should be able to:

 Understand the aim and concept of economic
management system for electrical energy
system
 Evaluate any proposed project using
approaches that have been learnt
 Analyse energy project in economical aspect
numerically

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 Introduction
 Financial Evaluation
– The process of evaluating, projects,
budgets, and other finance-related
transactions to determine their performance
and suitability.
– including capital cost of equipment,
operation and maintenance costs, fuel costs
and interest rate
– to know whether the project could proceed
or not
– Simple Payback Period, Initial Rate-of-
Return, Net Present Value, Internal Rate-of-
Return
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 Introduction
 The conditions of economic justification
fulfillment for efficient-energy project:
– Saving is higher than investment
– The most profitable approach and could reach
the objective
– Must be in the right scale for optimum
economic value
– The availability of capital investment

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 Simple Payback Period
 Simple Payback Period considers the initial
investment costs and the resulting annual
cash saving.
 The payback time (period) is the length of
time needed before an investment makes
enough to recoup the initial investment.
 Shorter paybacks mean more attractive
investments.
 This method is a “first cut” analysis to
evaluate the viability of investment.

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 Simple Payback Period
 Payback period is calculated using the
following equation if the annual savings are
equal
Extra Investment (P )
Simple Payback Period 
Annual Saving (S)

where ∆P is extra investment and S is the annual saving

 For example, an energy-efficient air

conditioner that cost an extra $1000 and
which saves $200/yr in electricity would
have a simple paybacks of 5 years
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 Simple Payback Period
 Advantage
– The easiest to understand of all economic
measures
– Useful where the time scale is relatively short
 Disadvantages
– the least convincing
– Can give an overly simplistic view of the
situation
– doesn’t account for savings after the initial
investment is paid back from the profits
(saving) generated by the investment
– takes no account of what is happening with
interest rates or inflation
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 Initial Rate-of-Return

 An indicator that an investment yields over a

specific period of time.
 Inverse of the Simple Payback Period

Annual Saving (S)

Initial Rate of Return   100 %
Extra Investment (P )

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 Initial Rate-of-Return
 Advantage
– has minimum threshold indicator. If the
value below the threshold, no need to
proceed
 Disadvantage
– doesn't take account of the fact that future
returns may be less valuable

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 Present Value
 Present value is the value on a given date of
a future payment or series of future
payments, discounted to reflect the time
value of money and investment risk.
 Widely used to provide a means to compare
cash flows at different times on a meaningful
"like to like" basis.
 The time value of money
– the fact that RM1, 10 years from now isn’t
as good as having RM1 today
 The analysis in which all future costs are
converted into an equivalent present value
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 Present Value
The formula:
F
P 
1  d n
Where
F = Cash inflow and outflow (investment)
d = interest rate per interest period (discount rate)
n = number of interest periods (years)
P = present sum of money

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 Present Value
 Let say you make an investment, P today,
after 1 year with discount rate (interest rate)
d, it will then be worth
P + d P = P (1+ d)
 Thus, future amount of money, F in an
account that start with P, which earn annual
interest “i” (d) over a period of n year, will be
F = P ( 1 + d )n
 Rearranging gives us,
F
P 
1  d n
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 Present Value
 For example, if an efficiency investment is projected to
save RM1000 in fuel in the 5th year, and the best
alternative investment is one that would have earned
10%/yr interest , the present worth of that RM1000
would be

P = F / ( 1+d )n = RM1000 / ( 1+0.10 )5

= RM620.92
 So, having RM620.92 today, is the same of having
RM1000 in 5 years.
 Notice that, the higher the interest/discount rate, the
less present value becomes.
 For instance, with a 20% discount rate, that RM1000 in
5 years is equivalent to only RM401.87 today

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 Present Value
 If you are given chance to have $1000 after
5yrs or $621 today, which one you
preferred?
 Of course the $621 because you may have
more than $1000 after 5 yrs
 That is if your personal discount rate, d, is
probably much higher than 10%
 Deciding the most appropriate discount rate
for an investment in energy efficiency is
often the most critical and difficult step

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 Present Value
 To find the present value P of a stream of annual cash
flows A, for n years into the future , with a discount rate
d, a conversion factor called the present value function
(PVF) is introduced.
P = A x PVF (d ,n)
 For series of n annual $1 amount that start 1 year from
the present, PVF is the summation of the present values:

1 1 1
PVF (d, n)    ... 
1  d 1  d 2
1  d n

 A series analysis yield the following

PVF (d, n) 
1  d  1
n

d 1  d 
n

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 Net Present Value (NPV)
 The present value of all saving (revenue) less the
present value of all cost (investment)
 In energy efficiency, the net present value
calculation is by comparing the present value of
all of those future energy savings, ∆A with the
extra first cost of the more efficient product,∆P.
 NPV = (present value of annual saving) –
(added first cost of better product)
= [∆A x PVF(d,n)] - ∆P
 When a choice is to be made between two
investment the P are compared and called net
present value (NPV) of the lower-cost alternative.

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 Net Present Value (NPV)
 Example 1:
Two 100-hp electric motors are being
considered, call them “good” and “premium”.
The “good” motor draws 79 kW and costs
RM7200; the “premium” motor draws 77.5kW
and costs RM9000. The motor run 1600 hours
per year with electricity costing
RM0.288/kWh. Over a 20-year life, find the
net present value (NPV) of cost saving when
a discount rate of 10% is assumed.

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 Net Present Value (NPV)
 Solution:
The annual electricity cost for the two motors is
A (good) = 79kW x 1600 h/yr x RM0.288/kWh
= RM36,403.20 /yr
A (premium)= 77.5kW x 1600 h/yr x RM0.288/ kWh
= RM35,712.00 / yr
Therefore, ∆A = RM36,403.20 - RM35,712.00
= RM691/yr
PVF(d,n) = [(1 + d )n – 1] / [d ( 1+ d )n]
= [(1+0.10)20-1] / [0.10(1+0.10)20]
= 8.5136 yr

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 Net Present Value (NPV)
Or
 The premium motor is the better investment with a net
present value of (saving)

NPV = ∆A x PVF(d,n) - ∆P
= RM691/yr x 8.5136yr –(RM9,000-RM7,200)
= RM4,084.60

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 Internal Rate of Return (IRR)
 The internal rate of return (IRR) is a rate of return
used in capital budgeting to measure and compare the
profitability of EE investments
 IRR is a discount rate that makes the net present
value of the energy investment equal to zero
 In the simple case of a first cost premium ∆P for the
more efficient product, which results in an annual fuel
savings ∆A, it is the discount rate that makes the net
present value zero:
NPV = ∆A x PVF( IRR,n ) - ∆P = 0
Rearranging gives for finding IRR
PVF(IRR,n) =∆P / ∆A = Simple payback period

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 Internal Rate of Return (IRR)
 Solving PVF(IRR,n) is not straightforward thus, it
helps to have precalculated values for the PVF
such as those presented in Table 1

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 Internal Rate of Return (IRR)
 Table 1 can be used to determine the IRR when the
decision maker wants an energy payback, with interest
and within a certain number of years(life).
 For example, the ‘premium’ motor in Example 1 cost
and extra $1800 and saves $691/yr, giving it a simple
payback period of

∆P / ∆A = $1800 / $691 = 2.6 yrs

 Assuming a 20-year life and using Table 1, IRR is

between 37% and 39%

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 Internal Rate of Return (IRR)
 If the management decides that it wants to
earn all of its extra $1800 investment back
sooner in 5 years.
 With a 5-year life, Table 1 indicates that the
investment would still earn almost 27%
compounded annual interest. It’s a pretty
good investment

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 Internal Rate of Return (IRR)
 Graph below translates payback into the more
persuasive IRR. Notice that for long-lived projects, the
initial rate of return is a good approximation to IRR

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NPV with fuel Escalation/Inflation

 The cost of fuel in the future will be higher

than it is today.
 This means, the annual amount of money
saved by an efficiency measure could
increase with time.
 Thus, the fuel price escalation factor (e)
must be included in the present worth
analysis.

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 NPV with fuel Escalation
 For an annual amount that is worth RM1 at
time t = 0, but becomes RM(1+ e) at t=1
year, and escalates to RM(1+ e)n in the n
year.

1  e 1  e  1  e
2 n

PVF (d, e, n)    ... 

1  d 1  d 2
1  d n

 Where d is the buyer’s discount rate and e is

the escalation rate of the annual savings.

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 NPV with fuel Escalation
 This gives an equivalent discount rate d’
when there is fuel savings escalation e
1 e 1

1 d 1  d'
' d e
 d 
1 e

 This equivalent discount rate can be used in

all of previous present value relationship.

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 NPV with fuel Escalation
 Example : Net Present Value of Premium Motor with
Fuel Escalation
The premium motor in previous example costs an extra
RM1800 and saves RM691/yr at today’s price of
electricity. If electricity rises at an annual rate of 5%,
find the net present value of the premium motor if the
best alternative investment earns 10%.

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 NPV with fuel Escalation
Solution:
The equivalent discount rate with fuel escalation:
d = 10% = 0.1
e = 5% = 0.05

' d  e 0.1  0.05

d    0.04762
1e 1  0.05

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 NPV with fuel Escalation
 The present value function for 20 years of escalating
savings is:

' n
' (1  d ) 1
PVF (d , n) 
d ' (1  d ' )n


1  0.0476220  1
0.047621  0.04762 
20

 12.717yr

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 NPV with fuel Escalation
The net present value is
NPV = ∆A x PVF(d’,n) - ∆P
= RM691/yr x 12.717yr – RM1800
= RM6987

Without fuel escalation, the net present value of saving from

the premium motor is only $4084)

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 IRR with fuel Escalation
 Since d is the buyer’s discount rate that
results in NPV of zero. It is the same as the
IRR with fuel escalation, which we will call
IRRe :
IRRe = IRR0 ( 1 + e) + e

IRRe = 0.385(1+0.05) + 0.05 = 45.4%

From Previous slide ( example )
SPP = ∆P / ∆A = $1800 / $691 = 2.6 yrs

Assuming a 20-year life and using Table 1, IRR is between

37% and 39% ( 38% or 0.385 as IRRo )

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 IRR with fuel Escalation
 Example:
IRR for an HVAC Retrofit Project with Fuel Escalation

Suppose the energy-efficiency retrofit of a large

building reduces the annual electricity demand for
heating and cooling from 2.3 x 106 kWh to 0.8 x 106
kWh and the peak demand for power by 150 kW.
Electricity costs RM0.288/kWh and demand charges
are RM29.6/kW-mo, both of which are projected to
rise at an annual rate of 5%. If the project costs
RM1.5 million, what is the internal rate of return
over a project lifetime of 15 years?

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 IRR with fuel Escalation
Solution
The initial annual savings will be
Energy savings = (2.3 – 0.8) x 106 kWh/yr x RM0.288/kWh
= RM432,000 /yr
Demand savings = 150 kW x RM29.6/kW-mo x 12 mo/yr
= RM53,280 /yr
Total annual savings , ∆A = RM432,000 + RM53,280
= RM 485,280/yr

 Simple payback period = ∆P / ∆A

(use 3.09yr to find IRRo ) = (RM1,500,000)/(RM485,280/yr)
from table 1 = 3.09 yr

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 Internal Rate of Return (IRR)
 Solving PVF(IRR,n) is not straightforward thus, it
helps to have precalculated values for the PVF
such as those presented in Table 1

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 IRR with fuel Escalation
Solution

From Table 1, the IRR without fuel escalation, IRR0 is close

to 32%.

 IRR with fuel escalation is

IRRe = IRR0 ( 1 + e) + e = 0.32(1 + 0.05) + 0.05
= 0.386
≈ 39% /yr

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 BETI 3433 Energy Efficiency 37
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