ENERGY CONVERSION

ES 832a

Eric Savory
www.eng.uwo.ca/people/esavory/es832.htm

Lecture 2 – The definition of energy,

the costs of energy and
economic considerations

Department of Mechanical and Material Engineering

University of Western Ontario
 Engineering definition of energy
conversion
• Thermodynamic relationships between
systems and the surroundings.
• Our interest - the change in the energy
content of a given system and its
interaction with the surroundings during
the course of change.
• Energy analysis
– The total amount of energy a system can give
or take from its surroundings.
– What fraction of the exchanged energy can
be converted to useful purposes (motion,
electricity, etc.)
 Thermodynamic considerations (1)
• A closed thermodynamic system is completely
surrounded by movable boundaries permeable
to heat but not to matter (e.g. a piston.)
• By adding weight to the piston, we can
compress the gas and store energy; work
performed by the surroundings.
• The resulting downward movement of the piston
is work obtained by the system from its
surroundings.
• The amount of work taken up by the system is
always less than the work done on the system
by its surroundings by an amount of energy
equal to the heat gained by the system.
Thermodynamic considerations (2)
• Heat – the mode of energy transfer to or from
the system by virtue of contact with another
system at different temperature.
• Work – the mode of energy transfer, other
than heat, that changes the energy of the
system (e.g. chemical reaction, electrical
generator.)
• Power – the rate of energy exchange
between two systems.

E  Q  W
 Changes in system properties that produce or
consume work

Category of work Physical process Energy-related example

Pressure-volume Volume change caused Movement of piston in IC

by force per unit area engine
Surface deformation Surface area change Small stationary droplet of
caused by surface liquid fuel suspended in a
tension quiescent fluid assumes
spherical shape
Transport of ionized Movement of charged Electrostatic precipitation of
(electrically charged) matter caused by an particulate pollutants in
material electrical field stack gas
Frictional Movement of solids in Generation of waste heat by
surface contact unlubricated moving parts in
machinery
Stress-strain Deformation (strain) of a Pumping of a viscous
material caused by a (highly frictional) liquid
force per unit area through a pipe
(stress)
 Economics of Globalization (1)
Increased per capita energy demand directly proportional
to increase in standard of living (e.g. 0.5 kW / person in
developing world vs. 10 kW / person in USA)
 Economics of Globalization (2)
Why use low-cost, non-renewable resources
(pollution, depletion of resources)?
- Rich countries (high production costs) must compete
with products from poorer countries (low production
cost) in the same market. A loss of market  a decrease
of living standards.

Public awareness and consumer habits:

Why do we always choose the cheapest product?
- Poor understanding of long-term cost associated with
the effect of different energy and manufacturing methods
on the environment and population health.
 Technical limitations, efficiency of scales
and cost effectiveness
• The most suitable energy source depends greatly on the final use
since efficiency and environmental friendliness change with scale
and application.

• Energy use: Transportation ~15%; Industry (manufacturing and

extraction) ~ 50%; Commercial (mainly buildings) ~ 15%; Domestic
(home heating etc) ~ 20%.
– Wind turbines: can only be used in small areas to be efficient.
– Hydro power: only justifiable at very large scale.
– Efficiency of Natural gas: 95% for direct use (heating); 30% to
generate electricity.

• CONCLUSION: Selection criteria for energy conversion designs

require that we understand the end use and the economic (and
sometimes social) factors which will ensure its feasibility. Thus, a
system must be:
– Selected based on the scale of use.
– Be cost effective (globally) compared to other solutions (i.e.
efficient thermodynamically and socially.)
Economic considerations:

The Cost of Operation

 Cost of operation (1)
• MOTIVATION: Survival of any energy
conservation / production scheme depends on
the ability to generate a rate-of-return (i.e.
profit) within a reasonable period (payback
time). This elementary calculation is an
important first step in selecting a design.

• OBJECTIVES:
1) Assessing the Cost of Operations
2) Assessing Rate of return: Value of
Investment
3) External considerations
 Cost of operation (2)
Cost of Operation: Costs consist of Fixed and
Variable costs:
- Fixed Costs: do not change with production
● Capital Investment: Initial
Investment to permit production
● Interest: Cost of borrowing
capital
● Depreciation: Remaining value on
equipment after given period (also
known as salvage value)
● Site / plant Costs: e.g. rent,
insurance
- Variable Costs: depend on production
Example:

A company requires 1,000 kW of electrical power. You are

to determine whether it is more economical to buy
electricity from Hydro One (the cost of power is 8c / kWh)
or to buy a new Diesel Generator delivering 1,000 kW at a
fuel cost of 5c / kWh. The generator’s initial cost is
$250,000, for which money was borrowed at a rate of 7.5%
over five years and its depreciation rate is given as 20%.

The criterion for selection is that the payback period must

be less than one year. The generator operates 12 hrs / day,
6 days / week.

Can this be done? If yes, how long will it take (in days)?
Conclusion:

Cost of operation is a cost per unit time.

The cost is a combined quantity of fixed and

variable costs.

In our example, the diesel had a fixed purchase

cost, with financing and depreciation, and the
fuel was a variable, whereas the Hydro One
option was a variable rate of electricity.
Economic considerations:

The Value of Investment

 Value of Investment (1)
• LESSON FROM LAST EXAMPLE: Allowing
the project to run longer provided a different
selection choice.

• MOTIVATION: Hence, in order to assess the

economic viability of a project it is important
to clearly identify the influence of time.

• OBJECTIVE: To introduce different criteria

for evaluating viability. Each method has
advantages and disadvantages: the proper
criteria for selecting a method still depends
on the end goal !!
 Value of Investment (2)

ARR method: Accounting Rate of Return

ARR = [average net annual saving (after

depreciation)] / capital cost

Payback method: Length of time required for

running total of net savings (before depreciation)
to equal the cost of the project.
 Value of Investment (3)
DCF method: Discounted Cash Flow Method

Both ARR and Payback methods fail to allow for

the timing of the saving (they are OK for short-
term solutions or small projects).

However, when the time scale is longer, the value

of the money changes over time. This is
important, since often the value of a company is
assessed on the value of its returns (e.g. stocks
or bonds). The idea is to compare the growth of
capital to the desired rate of return.
 Value of Investment (4)

For example: compare the fixed rate of return in a

bank at 10% interest

Today (Year 0) = 100

Year 5 = 100*(1+0.10)5 = 161

Thus, the company must generate a net saving or

return of 61% over 5 years to match this 10% rate.
 Value of Investment (5)
Two methods are commonly used
• NPV method: Net Present Value Method
The strategy involves bringing all net savings
(after depreciation) to “Year 0” (today’s) value. It
is calculated over the entire life of the project.
– The project is acceptable if NPV > 0 (savings > costs)
– The discount rate is essentially the target rate (based
on internal cost of money or target rate of return)
To rank several projects, which may have
different capital costs, the profitability index is
used:
– p. i. = sum of discounted savings / capital cost
= (capital cost + NPV) / capital cost
 Value of Investment (6)

IRR method: Internal Rate of Return Method

This is the discount rate needed to make NPV=0

It is essentially the maximum rate of return on

the invested capital. It is based on the entire life
of the project.

It is clear that the Accounting Rate of Return

(ARR) and Payback methods are straightforward,
whilst Net Present Value (NPV) and Internal Rate
of Return (IRR) methods are a little trickier.
 Value of Investment (7)
The Net Present Value (NPV) is usually determined
as an equivalent to money placed at a constant
rate of return.

This approach is good if the financing is done

through fixed return sources (e.g. bonds or
dividend yielding stock.)

The Internal Rate of Return (IRR) is used to

determine the target ratio of return.

This approach is riskier and is more suited to

financing through common shares.
Example:

A company is considering investing $12,000 to $16,000 in

energy saving strategies.

The energy manager has three different schemes (Projects)

to choose from and their accounting details are given
below.

The savings are calculated as the monetary value less

interest charges and operating costs. The manager also
knows that the competitor’s stocks have been increasing at
a rate of 8.5% a year.

All the Projects have a depreciation of $500 / year.

Evaluate the three projects using the ARR, Payback, NPV

and IRR methods.
 Project 1 Project 2 Project 3
Capital $12,000 $12,000 $16,000
invested:
Annual
saving (after
depreciation):
Year 1 $3,000 $3,600 $3,500

Year 2 $3,000 $3,400 $3,750

Year 3 $3,000 $3,200 $4,000

Year 4 $3,000 $2,800 $4,250

Year 5 $3,000 $2,600 $4,500

Year 6 $3,000 $2,400 $4,750

Assessment using Accounting Rate of Return (ARR)
ARR = [average net annual saving (after depreciation)]
/ capital cost

Project 1 Project 2 Project 3

 Assessment using Payback method
Payback = time required for net savings (less depreciation
[$500]) to equal capital cost

Project 1 Project 2 Project 3

Saving / Total Saving / Total Saving / Total

Year 1

Year 2

Year 3

Year 4
Interpolate to
capital cost
 Project 1 Project 2 Project 3
Year Saving Disco- Saving Disco- Saving Disco-
unted unted unted
0 -12000 -12000 -16000
1 3000 3600 3500
2 3000 3400 3750
3 3000 3200 4000
4 3000 2800 4250
5 3000 2600 4500
6 3000 2400 4750
NPV
p.i.
Summary of results from the different methods

Method Best project

ARR 3

Payback 2

NPV 2

IRR 2
 Summary of Value of Investment Methods
Advantages Disadvantages
ARR – Accounting Quick Ignores timing issues
(cost of money)
Rate of Return
Payback Quick. Good for Poor indicator for long
short term term
projects Does not account for net
saving
NPV – Net Present Gives “true” Requires correct rate
saving estimation
Value
Provides for cost Discount rate assumed
of money constant (usually)
IRR – Internal Rate Allows to account Success depends on r
for targets, such selection
of Return as minimum rate Discount rate assumed
of return constant
Inflation is ignored
 Other factors affecting project appraisal

(1) Outside bodies (e.g. government, through

regional development grants) who may
contribute to costs of energy saving projects.

(2) Tax on net savings, but also possible tax

incentives on energy saving projects.

(3) Large-scale fluctuations in energy prices.

(4) Inflation rates have a direct bearing on the

discount factor required for NPV and IRR
calculations.