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Power System Economics

Time value of Money

If a depositor places Rs . 1000 in a bank account that pays 7% interest per year. After 10 years, Rs
1967.15 be the expected amount as a result of interest paid and compounded over 10 year period.
Thus 7%/year is the depositors time value of money
Business Concept
Business owners also have a time value of money. A business may have profits this year and the
owners must decide what to do with these profits like investing in expanding the profits, deposit in
bank account for interests, distributed to other owners of the business for expansion etc.
The merits of these alternatives rest on how the business views its time value (or cost) of money.
Time value money is the opportunity cost of capital for the business or discount or present worth
For electric utilities, the time value of money can be computed by examining the cost of investment
capital or simply cost of money.
The cost of money is the weighted average composite interest cost of bonds, the yield rate of new
investment, and the rate of return on common stock offerings by the utility. These components can
be combined into a term called discount or present worth rate
Time value of money contd..
For example, a utility could finance its new offerings as follows:
50% with bonds at an interest of 7%
10% with preferred stock and a dividend yield of 11%
40% with common equity offerings that are expected to achieve a 15% return
The composite cost of capital for new financing would be 10.6% per year
(0.5 x 0.7 + 0.1 x 0.11 + 0.4 x 0.15 = 0.106)
In economic analysis studies, this composite cost of the new capital
would be the discount rate or time value of money to the utility.
Some utilities use an after tax discount rate such as the following,
Discount rate = (1 t) x b x B + p x P + c x C
t = incremental income tax rate
b = bond or debt interest rate per year (% / year)
B = fraction that is debt financed
p = preferred stock dividend rate (% / year)
P = fraction that is preferred stock financed
c = common stock equity rate
C = fraction that is financed by common stock
Interest Factors
Single payment Interest Factors
Compound Interest Factor (CIF)
Present Value Factor (PCV)
Uniform Series Factors
Uniform Series (Present Worth) Factor
Capital Recovery Factor (CRF)
Compound Amount Factor (CAF)
Sinking Fund Factor (SFF)
Uniform Annual Equivalent of an Inflation Series
Compound Interest Factor
Given P, find F (at n years in the future)
= (1 + )2
As an example of single payment compounding, suppose that an investor has Rs.
1000 in hand, and if he deposits the same in bank for interest rate of 7% p.a.,
then after 10 years,
= (1 + 0.07)2 = 1.96715,
= = . 1967.15
In engineering economic analysis, the inverse of CIF finds extensive application
and is called Single-Payment Present Worth Factor or Present Value Factor. For
this factor, a future amount in year n of value F is known and the objective is to
find the value of amount at time zero, P.
The present value factor, is the inverse of the compound interest factor
Present Value Factor (PVF)
Given F (at n years in the future ) find P,

= . =

As an example of single payment discounting, suppose that an investor wants to have Rs.
1000 in savings account 5 years from now and the bank is paying7% compound interest,
to calculate the single payment,

= 0.71299 1000 = . 712.99

That is Rs. 712.99 has to be deposited for 5 years in order to have Rs. 1000, (the interest
rate is 7% p.a.)
Uniform Series Present Worth Factors
In economic analysis, there often exists uniform series of annual payments (annuity) that extend from today through n
years. To compute, the present worth for the uniform annual series of payments, a convenient formula can be derived as
The formula is computed by calculating the present worth of each one of the annual payments by discounting it back to
time zero, as shown below,

= + + + + -------- (1)
(1+) (1+)2 (1+)3 (1+)

Multiply above equation by 1 +

(1 + ) = + + ++ ------- (2)
(1+)2 (1+)3 (1+)

Subtract (1) from (2), we get,

(1+) 1
= =

As an example, an investor might want to know the equivalent payment, or one-time payment, that is the same as making
equal payments into a savings account on a regular basis. Suppose that Rs. 100 is saved on the last day of the year for 10
years in a savings account, that pays 6% interest. What is the present worth equivalent amount? The amount is,
= 7.36009 100 = . 736.01
Capital Recovery Factor
CRF, finds equivalent value of a future annuity given the present cash equivalent. This is noted in
equation below (1), where CRF is merely inverse of the uniform series present worth factor as
shown (1) and (2).
= = CRF P
(1+) 1
1 (1+)
= =
(1+) 1
As an example of CRF calculation, assume that the interest rate is 10% for 30 years The CRF of
equation (2) can then be calculated. Thus Rs. 1 today is equivalent to 0.10608 rupees per year for
the next 30 years, assuming a discount rate of 10% per year. Given P, find R for n years
= 30, = 10%, = = 0.10608
(1.1)30 1
= . 1,00,000
= 0.10608 1,00,000 = . 10,608 . .
Compound Amount Factor (CAF)
The CAF calculates the future worth of a uniform series. The CAF helps to determine what future
amount an investor would have if equal amounts R were placed in a savings account at the end of
each year for N years. The CAF is the product of
= =
1+ 1 1+ 1
= (1 + ) =
1+ 1
CAF = Compound Amount Factor =

The CAF helps one determine how much money can be saved by regularly putting equal amounts
into a savings account. Suppose that Rs. 100 is saved at the end of each year for 10 years in a
Savings account that pays 6%. On the same day the last payment is made, the saver will have
1 + 0.06 10 1
= (1 + 0.06) 10
0.06 1 + 0.06
= 13.18079 100 = . 1,318.08
Sinking Fund Factor (SFF)
The SFF is uniform series interest factor. In this case, a future payment is given and the objective is to
calculate the value of an annuity in order to accumulate a future cash equivalent.
The formula for the SFF can be calculated using the CAF or the results of CRF formula. A recurring annuity
has a present worth equal to P, the present cash equivalent times the CRF; P is equal to Present Value Factor
PVF times the future value, as shown in the equation (1). Thus sinking fund factor is merely equal to the
present-value factor times the capital recovery factor as shown in equation (2),
= = =
1 1+ 1
= = = = ----- (1)
1+ 1+ 1 1+ 1

= ----- (2)
1+ 1
The SFF tells the saver how much money must have put into a savings account each year (a sinking fund) in
order to have a given amount at the time the last payment is made. For example, a mortgage bonds with a face
value of Rs. 1000, must be redeemed in 20 years. How much money should be put into a savings account at the
end of each year to meet that bond commitment if the savings account pays 7%?
1 0.07 1 + 0.07 20
= 1000 = 0.02439 1000 = . 24.39
1 + 0.07 20 1 + 0.07 20 1
Economic Evaluation
A business enterprise participating in a free-market system attempts to maximize
its profit over a long-term period.
In most cases, this method of conducting business encourages competition and
assures that consumers and society receive the greatest benefits in terms of the
lowest acceptable price for standards of product quality.
An electric utility, however, is granted a monopoly franchise within a service
territory subject to the condition that its rates be regulated in a manner that
allows a fair and reasonable return on its investment
The electric utility must charge the lowest electric rates possible consistent with
providing an acceptable rate of return on its investment and an acceptable
quality of electric service
A business enterprise in a free-market system and an electric utility have
distinctly have different business objectives, and their economic evaluation
methods are markedly different.
Electric utility economic evaluation methods
For a competitive business enterprise, the widely used economic evaluation method is
discounted cash-flow rate-of-return method. In this method, all of the cash flows are examined
for each alternative through the time horizon of the evaluation (several different present worth
For each alternative, the cash flows are discounted at several different present-worth rates. That
discount rate which results in the future cash flows equalling the initial investment is called the
discounted cash-flow rate of return.
The project with the highest discounted cash-flow rate of return is considered the best choice. All
projects that have a discounted cash-flow rate of return that exceeds the cost of money are worth
while projects (ignoring investment risk).
For regulated utilities, the economic evaluation method most widely used is called the
minimum-revenue-requirement method. Because the utility is regulated, the rate of return on
any investment is determined based on the allowed regulated return on investment.
Another evaluation method, the investment-pay-back-method is used by both utility and free
market enterprises for scoping analysis.
The pay-back method is simply calculated as the number of years required for the net benefits to
equal the initial investment.
Economic evaluation contd.
The primary objective of the economic analysis of power projects is to determine the cost of
generation / transmission at their true resources cost to the economy as the financial cost of the
generation / transmission may not reflect the true cost of power to the economy on account of
distortion inherent in the market prices.
While working out the economics, cost of generation / transmission, both the costs and power
generated have to be valued at their true resources cost.
This process involves removal of taxes and duties from their costs as they are not the costs to the
society. Similarly subsidies are also not taken into account as they are only transfer payments.
Coal, fuel oil or other liquid fuel oils have to be valued at their resources cost which may be the
economic cost of production plus transportation cost and international prices in case of gas or
petroleum fuels. Apart from adjustment in the costs, the economic analysis also covers the impact of
the proposed project on the power system.
Efforts should be made to bring out the possible reduction in operating costs for the rest of the system
on account of addition of the proposed project.
Economic Comparison is usually best made on the basis of present worth economics and accounting
for all costs to ascertain total cost of ownership.
The life cost of the system consists of
Capital cost or fixed cost (cost of land, building, machinery installation)
Working capital
operating cost (mostly cost of electrical loss and maintenance)
The truly optimized project is one in which the total lifetime cost is
minimized (for example in case of overhead transmission lines conductor
selection, bundling, tension, effects of terrain, structure configuration and
design all have great potential for cost saving).
For an estimation of the specific energy cost / unit of electricity generated
(expressed in Rs/kWh), the following additional parameters have to be
The rate of discount (in per cent) as determined by the regulatory body
The systems total lifetime (in years)
The annual electricity production (in kWh)
In first step, If these parameters are known, then the initial investment costs can
easily be transformed into annual costs.
In a second step, summed up to the current costs (O & M) to get the total
generation costs for the power plant. The first step is done by means of the
conversion factor (CF)
= , = , =
(1+) 1

In the last step, total generation costs have to be divided by the annual electricity
production (provided this is constant)in order to receive specific energy cost,
which then can easily be compared to the respective cost figure of conventional
energy system (eg. Thermal, diesel generation).
To keep the calculation effort minimum, the cost comparison should always be
conducted in real terms, i.e. all costs should be measured in constant prices
prevailing at the beginning of the investment period, and the discount rate used
to determine the CF should be a real discount rate.
Benefit-Cost Analysis
It is method for determining the economic justification of a power project
Compute Benefit Cost ratio (B-C Ratio) - Benefits are defined to mean all
the advantages, less any disadvantages to the utility, consumers and public.
The time frame must be clearly specified to list out all cost and benefits for
each year over the life cycle
Comparison of various projects for final selection of an economical project
(Generation or Demand side projects)
The B.C. ratio must be more than one for a worthwhile scheme
. . =

The benefits and cost present, or equivalent annual amount are computed
using the rate of discount.
Many benefits which embrace valuable benefits also result in inexcapable
Rural electrification in India is done in contrast to the view of private
enterprise which evaluates the investment on the basis of some
measures of profitability.
The forest clearance involving the forest areas of more than 5
hectares in hills or 20 hectares in plains for lines/hydro project is
taken on the basis of B-C analysis (as per forest conservation act
This method is appropriate for appraising of investments in multi
purpose hydro-projects.
The life cycle costs (LCC) can be expressed as follows:
LCC = CI + CP + CO + CG + CD
CI total cost of installation, CP Cost of planned corrective maintenance, CO operation costs, CG outage costs, CF
cost of modernization/refurbishment/extension, CD Cost of decommissioning, disposal
Economic analysis on the basis of project life-cycle cost in real terms suggests that
small or micro hydro generation must be preferred over thermal power generation even
if is a few times costlier than the latter, in interest of overall grid economy. Improvement
in load carrying capacity due to peaking support gives a weightage factor of
approximately 1.3 in favor of hydro.
The hydro projects are proposed on the basis of 90% hydrological dependability. The
actual generation in the long term comes to 10% higher, thereby leading to a weightage
factor 1.1. an escalation of 6% annum in case of thermal over hydro, statistically gives a
weightage of 8.89 in favor of hydro having project life of 60 years or more. Double the
life of hydro projects than thermal leads to weightage of 2. Small projects have
environmentally higher weightage than thermal.
Life-cycle cost in case of new equipment proposed for installation may be called total
owing cost such a transformers, circuit breakers, computer etc. For example, in case of
transformers, there are two kinds of costs purchase price and cost of energy lost in
losses during the active life of the transformer. The total owning cost of a transformer is
the sum of purchase price and net present value of energy losses. The transformer or any
other equipment should be procured on the basis of lowest owning cost.
Cash flow statements
The basic principle of the cash flow is that revenue receipts (inflow)
and revenue expenditure (outflow) are counted for the financial year.
The gross operating surplus / deficit cash flow is calculated as a
difference between these and are compared.
Annual balance sheets are made as per the Electricity (Supply) Annual
Accounts Rules, 1985
Cash flow statements can be attained through
Break-Even Point
Payback method
Rate of Return on investment
Net Present Value Method
Internal Rate of return method
Break Even point
This method is used to determine minimum revenue requirement
The tariffs in public power utilities are generally fixed to break even
costs (fixed and variable ), i.e. at break even point the fixed annual
cost of capital equalizes the revenue earned over the financial year
period as shown in figure.
The method is applied for economic analysis of power system
improvement schemes
Payback method
Payback period definition: The length of time required to recover the
initial investment is computed or It is the time in which the initial
cash outflow of an investment is expected to be recovered from the
cash inflows generated by the investment. It is one of the simplest
investment appraisal techniques.
This does not consider the time value of money and life of investment
after payback period.
But this measure is used as an indication of the amount of the
investments risk in small generation schemes, energy conservation
schemes and system improvement schemes.
The formula to calculate payback period of a project depends on whether
the cash flow per period from the project is even or uneven. In case they
are even, the formula to calculate payback period is:


When cash inflows are uneven, we need to calculate the cumulative net
cash flow for each period and then use the following formula for payback

= +

Where A = last period with a negative cumulative cash flow
B = absolute of cash flow at the end of period A
C = total cash flow during the period after A
Example 1: Even Cash Flows
A electric utility company is planning to undertake a hydro project
after orographic survey requiring initial investment of Rs. 105 million
(inclusive of survey). The project is expected to generate Rs. 25
million per year for 7 years, (if favourable weather conditions exists
and it is persistent, capable of bulk power supply into the grid on the
par capacity) . Calculate the payback period of the project.
Payback Period = Initial Investment Annual Cash Flow
= Rs. 105M Rs. 25M = 4.2 years
Example 1: Un-Even Cash Flows
A electric utility company is planning to undertake another wind energy
harvesting project, requiring initial investment of Rs. 50 million and is expected to
generate Rs. 10 million in Year 1, Rs. 13 million in Year 2, Rs. 16 million in year 3,
Rs. 19 million in Year 4 and Rs. 22 million in Year 5 (varying revenues owing to
varying average wind flow conditions). Calculate the payback value of the project.

Cash flow in Rs. Millions Cumulative Remarks
= +
Year Cash flow Cash flow P Positive Where
N Negative
A = last period with a negative cumulative cash flow
0 -50 -50 N
B = absolute of cash flow at the end of period A
1 +10 -40 N
C = total cash flow during the period after A
2 +13 -27 N

+16 N = +
3=A -11 = B 11
= 3 + 19 = 3.58
4 +8 P
+19 = C
5 +22 +30 P
For example, a cogeneration plant in a sugar factory will give an idea
about pay back analysis. A typical example (1993) is given below:
Cogeneration project cost Rs. 44 Millions
Power feed to grid (in kW) 4750 kW
Power to grid in units considering 19 GWh
4000 hours per annum as the
season for sugar plant
Revenue from power (19 * Rs. Rs. 23.75 Millions
1.25 per unit)
Expenditure per annum (excluding Rs. 9.681 Millions
Net cash revenue Rs. 14.069 Millions
= =
= 3.127 3.15
Advantages and Dis-advantages
Advantages Of Pay Back Period Disadvantages Of Pay Back Period
1. Pay back period is simple and easy to 1. In the calculation of pay back period, time
understand and compute. value of money is not recognized.

2. Pay back period is universally used and easy 2. Pay back period gives high emphasis on
to understand. liquidity and ignores profitability.

3. Pay back period gives more importance on 3. Only cash flow before the pay back period is
liquidity for making decision about the considered. Cash flow occurred after
investment proposals. the PBP is not considered.

4. Pay back period deals with risk. The project

with a shortest PBP has less risk than with the
project with longest PBP.

5. The short term approach of pay back period

is an added advantage of calculation of capital
Rate of Return on Investment (RORI)
The most popular method of measuring profitability/loss as a percentage
of an investment (capital base i.e. net fixed assets of power utility at the
beginning of a year along with additional internal resources that could be
generated during the year) is rate of return on investment.
The RORI of an investment is the average revenue divided by average
capital base.
The revenue and capital base (investment) measures are used in
conventional annual accounting statements.
Power utilities could break even if they could achieve zero percent ROR.
Minimum three percent of RORI on capital is desirable as per the Indian
Electricity (Supply) Act, 1948.
Rate of Return on Investment Formula


Net operating income is the departments revenue minus all expenses for which
the department (utility perspective) manager is responsible.
Average operating assets of the department represent the asset base of the

= 100

RORI is a very popular metric because of its versatility and simplicity. Essentially
RORI can be used as a rudimentary gauge of an investments profitability.
RORI can be very easy to calculate and to interpret and can apply to a wide
variety of kinds of investments.
Positive value of RORI indicates Gain or Profit, when RORI is negative, it reflects a
loss. This information is very useful in determining whether or not the choice of
investment made was a Appropriate.
Example RORI
An electric utility invests Rs. 100 Million on constructing a Thermal Power station.
It also invests, Rs. 10 Million on importing coal from Australia and purchase of Rs.
5 Million on in-house coal from Jharkhand (Jharia, Bokaro, Godda) per year. The
maintenance cost of the power station is 5 % of Investment cost (includes of raw
material procurement). The revenue for the power station over a period of 6
years after supplying 150 MW bulk power to grid/year is Rs. 250 Million. Estimate
the RORI after six years.
Investment = Rs 100 M + (Rs. 10 M + Rs 5 M) *6 + 0.05 * (Rs 100 M + (Rs. 10 M + Rs
5 M) *6) = Rs. 199.5 M
RORI = ((Rs. 250 M Rs. 199.5) / Rs. 199. 5 ) * 100 = 25.31 %
Gain in investment.
Net Present Value (NPV)
Net Present Value of a utility project is the potential change in an investors
wealth caused by that project while time value of money is being
accounted for. It equals the present value of net cash inflows generated by
a project less the initial investment on the project.
It is one of the most reliable measures used in capital budgeting because it
accounts for time value of money by using discounted cash flows in the
NPV calculations takes the following two inputs:
Projected net cash flows in successive periods from the project
A target rate of return i.e. the hurdle rate
Where, net cash flow equals total cash inflow during a period, including
salvage value if any, less cash outflows from the project during the period
Hurdle rate is the rate used to discount the net cash inflows. Weighted
average cost of capital (WACC) is the most commonly used hurdle rate.
Step 1: The first step in the computation of the net present value of
an investment is to choose a rate of discount (this may be required
return) (step involved in the calculation of NPV is the estimation of
net cash flows from the project over its life)
Step 2: The second step is to compute the present value equivalents
of all cash flows (considering inflow as positive and outflows as
negative) associated with investment (on an after tax basis) and add
these present value equivalents to obtain the net present value of the
investment over period of time (step is to discount those cash flows
at the hurdle rate).
The net cash flows may be even (i.e. equal cash flows in different periods) or uneven (i.e.
different cash flows in different periods). When they are even, present value can be
easily calculated by using the formula for present value of annuity. However, if they are
uneven, we need to calculate the present value of each individual net cash inflow
Once we have the total present value of all project cash flows, we subtract the initial
investment on the project from the total present value of inflows to arrive at net present
Thus we have the following two formulas for the calculation of NPV:
When cash inflows are even:

R is the net cash inflow expected to be received in each period;
i is the required rate of return per period;
n are the number of periods during which the project is expected to operate and generate
cash inflows.
Formulas contd
When cash inflows are uneven:
1 2
= + +
(1+)1 (1+)2 (1+)
i is the target rate of return per period;
R1 is the net cash inflow during the first period;
R2 is the net cash inflow during the second period;
R3 is the net cash inflow during the third period, and so on ...
Decision Rule
In case of standalone projects, accept a project only if its NPV is positive,
reject it if its NPV is negative and stay indifferent between accepting or
rejecting if NPV is zero.
In case of mutually exclusive projects (i.e. competing projects), accept the
project with higher NPV.
Even Cash Inflows: Calculate the net present value of a wind hydro based project
which requires an initial investment of Rs. 243,000 and it is expected to generate a cash
inflow of Rs. 50,000 each month for 12 months. Assume that the salvage value of the
project is zero. The target rate of return is 12% per annum.
We have,
Initial Investment = Rs. 243,000
Net Cash Inflow per Period = Rs. 50,000
Number of Periods = 12
Discount Rate per Period = 12% 12 = 1%
Net Present Value
= Rs. 50,000 (1 (1 + 1%)-12) 1% Rs. 243,000
= Rs. 50,000 (1 1.01-12) 0.01 Rs. 243,000
Rs. 50,000 (1 0.887449) 0.01 Rs. 243,000
Rs. 50,000 0.112551 0.01 Rs. 243,000
Rs. 50,000 11.2551 Rs. 243,000
Rs. 562,754 Rs. 243,000
Rs. 319,754
Uneven Cash Inflows: An initial investment of Rs. 8,320 thousand on plant
and machinery is expected to generate cash inflows of Rs. 3,411 thousand,
Rs. 4,070 thousand, Rs. 5,824 thousand and Rs. 2,065 thousand at the end
of first, second, third and fourth year respectively. At the end of the fourth
year, the machinery will be sold for Rs. 900 thousand. Calculate the net
present value of the investment if the discount rate is 18%. Round your
answer to nearest thousand.
PV Factors:
Year 1 = 1 (1 + 18%)^1 0.8475
Year 2 = 1 (1 + 18%)^2 0.7182
Year 3 = 1 (1 + 18%)^3 0.6086
Year 4 = 1 (1 + 18%)^4 0.5158
Example contd
Year 1 2 3 4
Net cash inflow Rs. 3,411 Rs. 4,070 Rs. 5,824 Rs. 2,065
Salvage value 0 0 0 Rs. 900
Total cash inflow Rs. 3,411 Rs. 4,070 Rs. 5,824 Rs. 2,965
x Present Value 0.8475 0.7182 0.6086 0.5158
Present Value of cash Rs. 2,890.68 Rs. 2,923.01 Rs. 3,544.67 Rs. 1,529.31
Total PV of cash Rs. 10,888
# # #
- Initial Investment Rs. 8,320 # # #
Net Present Value Rs. 2,568 # # #
Strengths and Weaknesses of NPV
Strengths Weakness
NPV is after all an estimation. It is
Net present value accounts for time sensitive to changes in estimates for
value of money which makes it a future cash flows, salvage value and the
sounder approach than other cost of capital.
investment appraisal techniques Net present value does not take into
which do not discount future cash account the size of the project. For
example, say utility Project A (wind based)
flows such payback period and requires initial investment of Rs. 4 million
accounting rate of return. to generate NPV of Rs. 1 million while a
competing utility Project B (Solar based)
Net present value is even better requires Rs. 2 million investment to
than some other discounted cash generate an NPV of Rs. 0.8 million. If we
base our decision on NPV alone, we will
flows techniques such as IRR. In prefer Project A because it has higher
situations where IRR and NPV give NPV, but Project B has generated more
conflicting decisions, NPV decision shareholders wealth per dollar of initial
investment (Rs. 0.8 million/Rs. 2 million vs
should be preferred. Rs. 1 million/Rs. 4 million).
Internal Rate of Return (IRR)
The internal rate of return is defined as the unique rate of discount that causes the sum of the
present value of the cash flows, i.e. sum of cash inflow (+) and cash outflow (-) to be equal to zero
over the investments economic life of project life.
This definition can then be used to compute an investments internal rate of return.
The internal rate of return is found by a trial and error procedure (when the net present value is
found equal to zero, the rate of discount being used is the rate of return) if analysis is done with
the help of present value tables.
It can be defined as rate of discount at which sum of the present value of future net benefits
generated by the project during the life spans equal its initial investment. This means NPV of the
project is zero.
When a project has a more complex cash flow pattern, computer aided calculations are used, for
which standard spreadsheet softwares are available in market.
The internal rate of return is much superior for ranking investment compared to simple methods
(payback, balance sheet statements).
MINIMUM IRR of 3% to 4% above the borrowing interest rate is considered generally viable
IRR of 11% to 12% with 16% return on equity on the thermal, hydro private sector power projects
respectively will come. This method is used for analysis of rural electrification projects in many
developing countries.
Internal rate of return or IRR is the minimum discount rate that electric power utility
management uses to identify what capital investments or future projects will yield an
acceptable return and be worth pursuing.
The IRR for a specific project is the rate that equates the net present value of future cash
flows from the project to zero. In other words, if we computed the present value of future
cash flows from a potential project using the internal rate as the discount rate and subtracted
out the original investment, our net present value of the project would be zero.
This sounds a little confusing at first, but its pretty simple. Think of it in terms of capital
investing like the companys management would. They want to calculate what
percentage return is required to break even on an investment adjusted for the time value of
It can be thought of as the internal rate of return as the interest percentage that utility
company has to achieve in order to break even on its investment in new capital. Since
management wants to do better than break even, they consider this the minimum
acceptable return on an investment.
The IRR formula is calculated by equating the sum of the present value of future
cash flow less the initial investment to zero. Since we are dealing with an
unknown variable, this is a bit of an algebraic equation. Heres what it looks like:
1 2 3
+ + + = 0
(1+)1 (1+)2 (1+)3

As it can be seen, the only variable in this equation that management wont know
is the IRR. They will know how much capital is required to start the project and
they will have a reasonable estimate of the future income of the investment. This
means we will have to solve for the discount rate that will make the NPV equal to
A private investor, is considering to purchase a year Revenue IRR Innvestment NPV

new wind turbine system for commissioning 1 20000 8% 18518.52 100000 5393.167
2 30000 8% 25720.16
and bulk power supply, but he is unsure if its 3 40000 8% 31753.29
the best use of his funds at this point in time. 4 40000 8% 29401.19
With the new Rs. 100,000 wind turbine unit, Total Revenue 105393.2
the investor will be able to inject power into
the grid based on the forecasted wind power year Revenue IRR Innvestment NPV

level, such that he will get a revenue of Rs. 1 20000 9% 18348.62 100000 2823.371
2 30000 9% 25250.4
20,000, Rs. 30,000, Rs. 40,000, and Rs. 40,000
3 40000 9% 30887.34
in subsequent assessment periods. Lets 4 40000 9% 28337.01
calculate investors minimum rate. Since its Total Revenue 102823.4
difficult to isolate the discount rate unless you
use an excel IRR calulator. You can start with an year Revenue IRR Innvestment NPV
approximate rate and adjust from there. Lets 1 20000 10% 18181.82 100000 348.3369

start with 8 percent. 2 30000 10% 24793.39

3 40000 10% 30052.59
4 40000 10% 27320.54
Total Revenue 100348.3
Remember, IRR is the rate at which the net present value of the costs of an investment
equals the net present value of the expected future revenues of the investment. Utility
Management can use this return rate to compare other investments and decide what
capital projects should be funded and what ones should be scrapped.
Going back to our renewable wind based project example, assume investor could
purchase a wind turbine unit and install it in a wind favourable regime. He can purchase
two other wind turbine units from different manufacturers. Each unit has different
characteristics, and the unit which has highest Cp would definitely harvest more power
from existing favourable wind flow conditions. Hence, different magnitude of power
would be injected into grid and thereby different cash flow. The investor can calculate
the internal rate of return on each machine and compare them all. The one with the
highest IRR would be the best investment.
Since this is an investment calculation, the concept can also be applied to any other
investment. For instance, private owner can compare the return rates of investing the
companys money in the stock market or new unit. Now obviously the expected future
cash flows arent always equal to the actual cash received in the future, but this
represents a starting point for private utility management to base their purchase and
investment decisions on.
Life cycle costing
Life cycle costing is the accumulation of costs over a product's entire
life. The practice of obtaining over their life time, the best use of
physical asset at the lowest cost of entity.
Life cycle costing is different to traditional cost accounting system
which report cost object profitability on a calendar basis i.e. monthly,
quarterly and annually. In contrast life cycle costing involves tracing
cost and revenues on a product by product basis over several
calendar periods.
Contents of LCC
I. Meaning of Life Cycle Costing
II. Characteristics of Life Cycle Costing
III. Stages of Product Life Cycle Costing
IV. Benefits of Product Life Cycle Costing
V. Life Cycle Costing Process
I. Meaning of LCC
Life cycle costing is a system that tracks and accumulates the actual costs and revenues attributable to
cost object from its invention to its abandonment. Life cycle costing involves tracing cost and revenues
on a product by product base over several calendar periods.
The LCC of an asset is defined as:
The total cost throughout its life including planning, design, acquisition and support costs and any other
costs directly attributable to owning or using the asset.
Life Cycle Cost (LCC) of an item represents the total cost of its ownership, and includes all the cots that
will be incurred during the life of the item to acquire it, operate it, support it and finally dispose it. Life
Cycle Costing adds all the costs over their life period and enables an evaluation on a common basis for
the specified period (usually discounted costs are used).
This enables decisions on acquisition, maintenance, refurbishment or disposal to be made in the light
of full cost implications. In essence, Life Cycle Costing is a means of estimating all the costs involved in
procuring, operating, maintaining and ultimately disposing a product throughout its life.
Life cycle costing is different from traditional cost accounting system which reports cost object
profitability on a calendar basis (i.e. monthly, quarterly and annually) whereas life cycle costing
involves tracing costs and revenues of a cost object (i.e. product, project etc.) over several calendar
periods (i.e. projected life of the cost object).
Thus, product life cycle costing is an approach used to provide a long-term picture of product line
profitability, feedback on the effectiveness of the life cycle planning and cost data to clarify the
economic impact on alternative chosen in the design, engineering phase etc.
It is also considered as a way to enhance the control of manufacturing costs. It is important to track and
measure costs during each stage of a products life cycle.
II. Characteristics of LCC
Product life cycle costing involves tracing of costs and revenues of a
product over several calendar periods throughout its life cycle.
Product life cycle costing traces research and design and development
costs and total magnitude of these costs for each individual product
and compared with product revenue.
Each phase of the product life-cycle poses different threats and
opportunities that may require different strategic actions.
Product life cycle may be extended by finding new uses or users or by
increasing the consumption of the present users.
III. Stages of product LCC
Following are the main stages of Product Life Cycle:
(i) Market Research:
It will establish what product the customer wants, how much he is
prepared to pay for it and how much he will buy.
(ii) Specification:
It will give details such as required life, maximum permissible maintenance
costs, manufacturing costs, required delivery date, expected performance
of the product.
(iii) Design:
Proper drawings and process schedules are to be defined.
(iv) Prototype Manufacture:
From the drawings a small quantity of the product will be manufactured.
These prototypes will be used to develop the product.
(v) Development:
Testing and changing to meet requirements after the initial run. This period of testing
and changing is development. When a product is made for the first time, it rarely meets
the requirements of the specification and changes have to be made until it meets the
(vi) Tooling:
Tooling up for production can mean building a production line; building jigs, buying the
necessary tools and equipments requiring a very large initial investment.
(vii) Manufacture:
The manufacture of a product involves the purchase of raw materials and components,
the use of labour and manufacturing expenses to make the product.
(viii) Selling
(ix) Distribution
(x) Product support
(xi) Decommissioning:
When a manufacturing product comes to an end, the plant used to build the product
must be sold or scrapped.
IV. Benefits of product LCC
Following are the main benefits of product life cycle costing:
It results in earlier action to generate revenue or lower costs than
otherwise might be considered. There are a number of factors that
need to be managed in order to maximise return in a product.
Better decision should follow from a more accurate and realistic
assessment of revenues and costs within a particular life cycle stage.
It can promote long term rewarding in contrast to short term
It provides an overall framework for considering total incremental
costs over the entire span of a product.
5. Life Cycle Costing Process
Life cycle costing is a three-staged process. The first stage is life cost planning stage which
includes planning LCC Analysis, Selecting and Developing LCC Model, applying LCC Model and
finally recording and reviewing the LCC Results. The Second Stage is Life Cost Analysis Preparation
Stage followed by third stage Implementation and Monitoring Life Cost Analysis
The three stages are:

LCC Analysis is a multi-disciplinary activity. An analyst, involved in life cycle costing, should be fully
familiar with unique cost elements involved in the life cycle of asset, sources of cost data to be
collected and financial principles to be applied.
He should also have clear understanding of methods of assessing the uncertainties associated
with cost estimation. Number of iteration may be required to perform to finally achieve the
result. All these iterations should be documented in detail to facilitate the interpretations of final
Stage 1: LCC Analysis planning
The Life Cycle Costing process begins with development of a plan, which
addresses the purpose, and scope of the analysis.
The plan should:
Define the analysis objectives in terms of outputs required to assist a
management decision.
Typical objectives are:
Determination of the LCC for an asset in order to assist planning,
contracting, budgeting or similar needs.
Evaluation of the impact of alternative courses of action on the LCC of an iv. Identify alternative courses of action to be evaluated.
asset (such as design approaches, asset acquisition, support policies or The list of proposed alternatives may be refined as new
alternative technologies). options are identified or as existing options are found to
violate the problem constraints.
Identification of cost elements which act as cost drives for the LCC of an
asset in order to focus design, development, acquisition or asset support v. Provide an estimate of resources required and a
efforts. reporting schedule for the analysis to ensure that the
LCC results will be available to support the decision-
Make the detailed schedule with regard to planning of time period for each making process for which they are required.
phase, the operating, technical and maintenance support required for the
asset. Next step in LCC Analysis planning is the selection or
development of an LCC model that will satisfy the
Identify any underlying conditions, assumptions, limitations and constraints objectives of the analysis. LCC Model is basically an
(such as minimum asset performance, availability requirements or accounting structure which enables the estimation of an
maximum capital cost limitations) that might restrict the range of acceptable asset components cost.
options to be evaluated. Identify alternative courses of action to be
Stage 2: Life Cost Analysis preparation
The Life Cost Analysis is essentially a tool, which can be used to control and
manage the ongoing costs of an asset or part thereof. It is based on the LCC
Model developed and applied during the Life Cost Planning phase with one
important difference: it uses data on real costs.
The preparation of the Life Cost Analysis involves review and development
of the LCC Model as a real-time or actual cost control mechanism.
Estimates of capital costs will be replaced by the actual prices paid.
Changes may also be required to the cost breakdown structure and cost
elements to reflect the asset components to be monitored and the level of
detail required.
Targets are set for the operating costs and their frequency of occurrence
based initially on the estimates used in the Life Cost Planning phase.
However, these targets may change with time as more accurate data is
obtained, from the actual asset operating costs or from the operating cost
of similar other asset.
Stage 3: Implementation and Monitoring
Implementation of the Life Cost Analysis involves the continuous
monitoring of the actual performance of an asset during its operation
and maintenance to identify areas in which cost savings may be made
and to provide feedback for future life cost planning activities.
For example, it may be better to replace an expensive building
component with a more efficient solution prior to the end of its
useful life than to continue with a poor initial decision.
Phases in a Life Cycle of a product
Every product goes through a life cycle. A product life cycle can be divided into five phases.
(a) Development. The product has a research and development stage where costs are incurred but no revenue is generated.

(b) Introduction. The product is introduced to the market. Potential customers will be unaware of the product or service, and the
organization may have to spend further on advertising to bring the product or service to the attention of the market.

(c) Growth. The product gains a bigger market as demand builds up. Sales revenues increase and the product begins to make a profit.

(d) Maturity. Eventually, the growth in demand for the product will slow down and it will enter a period of relative maturity. It will
continue to be profitable. The product may be modified or improved, as a means of sustaining its demand.

(e) Decline. At some stage, the market will have bought enough of the product and it will therefore
reach 'saturation point'. Demand will start to fall. Eventually it will become a loss-maker and this is
the time when the organization should decide to stop selling the product or service.
Power Supply Reliability
System Reliability Consumer Centric
Modern society excepts that the supply of electricity should be continuously available on
demand. This exactly may not be possible due to random system failures which are
generally beyond the control of power system engineers.
The probability of consumers being disconnected, however, can be reduced by increased
investment on power systems by providing high quality equipment or redundancy and
better maintenance.
The economic and reliability constraints are conflicting in nature and make the planning
decisions difficult.
The reliability of supply to consumers is judged from the frequency of interruptions, the
of each interruption and the value a consumer places on the supply of electricity at the
time that service is not provided.
The value to consumers is determined by the benefits which they can derive from using
it e.g. the production of goods, lighting, TV viewing, air conditioning and heating at home
and in shops and offices, improvement in their standard of living and for entertainment
purposes in theatres, cinemas etc.
These factors depend upon the individual reliability of equipment, circuit length and
loading, network arrangement etc.
System planners advise the decision makers by evaluating the major alternatives for facing the
future. The economic crisis experienced during the recent years, the technological developments
and the changes in the sociological environment reinforced the importance of the factors which
were poorly taken into account in the past-the uncertainty of the future and the call for security
from the system.
A first answer to the problem of uncertainty consists in devising a system sufficiently robust to
withstand the impacts. This approach was usually followed in the past. However, at the present
time the amplitude and the number of the possible impacts is such that the cost of a robust
system becomes prohibitive, if one wants to face most of the uncertainty factors.
A second answer adapted to the present time is to introduce flexibility within the system
development. From the planners point of view a flexible system which will be able to be adapted
quickly to any external change. This is achieved either because the planner made provisions to
change over to diverse fuels or diverse power generations or because it was decided to install
equipment which makes better use of existing system.
In most utilities, a temporary degradation of the reliability in case of deviation of the
development parameters will be accepted, but some countries do not accept such degradation
and consider that this is not acceptable for facing external impacts.
Uncertainty contd
In recent years the need for flexibility has become particularly
apparent because both planners and operators had to cope with
more and more significant trends:
Industry structure trends:
Financial trends:
Technical trends:
Environment and health issues





Modern society expects supply of Electricity should be continuously
available on demand
Probability of failures fail to supply reliable power to consumers
Providing high Quality equipment or redundancy and better
maintenance with increased investment on power system improves
reliability of supply

Judged from
Freq. of interruptions,
Duration of each interruption,
And value a consumer when supply fails.
Value to consumers is determined by
Benefits from using appliances (production of goods, lighting, TV, air
conditioner, etc).
Reliability factors depends on
Individual reliability of equipment
Circuit length and loading
Network arrangement etc.
System planners advise decision makers to consider major
alternatives for future like
economic crisis
Technological development
Changes in sociological environment
Which are not taken in past
Two ways to solve uncertainty of supply
Devising robust system to withstand uncertain impacts
Introduce flexibility by the planner within system
development to meet external changes
Need for flexibility among plannners and operators to cope with
more significant trends are:
1. Industry structured trends
Vertical disaggregation
Wheeling for non-utility generation, transmission access for
consumers for power purchases from other utilities
2. Financial trends
Capital availability and cost uncertainity
Rate base incentives and constraints
Stockholder risks and uncertain rates of return
Construction expenditure recovery risks
SYSTEM RELIABILITY- Uncertainty (Contd)

3. Technical trends
Load management and conservation
Generation technology and licensing issues
Transmission technology
4. Environment and health issues
Emission limits
Power frequency and electromagnetic field constraints
Radio active waste storage/ disposal

Adequacy :
Capability of system to meet system demand within major component ratings and in
the presence of scheduled and un-scheduled outages of generation, transmission and
distribution facilities.
Relates to static system conditions
Security :
Capability of system to withstand disturbances arising from faults and un-scheduled
removal of equipment without further loss of facilities or cascading.
Relates to dynamic system conditions
Basic aim power utility is to meet
Various demands of energy and power at lowest possible cost to consumers
while maintaining acceptable levels of quality (V, f, wave shape, flicker, etc.)
Continuity of supply.
Task of power system planning is
To configure an electric power system
With compromise between requirements perceived by consumers for
adequacy and security
To achieve continuity and quality of supply
Economics of power system in terms of operating and capital cost.
Basic function of power system is to meet electricity requirements with adequate
quality and reliability in an economical manner.
Reliability levels are interdependent with economics since more investments are
necessary to increase reliability / even maintain it at current and acceptable
Reliability preferences can shift over time due to
Changes In technology
Consumer needs and lifestyles
Economic factors
Above requires periodical revision

Fig (a): Reliability improves with investment cost

Fig (b): Reliability occurs at minimum system cost, interruption
cost and total cost

Total cost = system cost + consumer outage cost

Lowest point in the total cost curve defines optimal balancing of system cost
and consumer cost and determines optimum reliability level, reserve margin,
LOLP, EUE (Expected Un-served Energy).
From implementation standpoint, following analysis is required
For each of the pre-selected reserve margins, optimum resource mix is first
For each such resource mix, production costing, revenue requirements and
reliability calculations are performed to estimate total cost as:
Revenue requirement + (EUE) x (Outage cost in Rupees/kWh)
EUE-Expected Unserved Energy

The Central Electricity Authority(CEA) uses the following

reliability criteria on deterministic and probabilistic basis
System contingency for lines 66-800kV = N-1
Loading under normal operating condictions with 20% margin for
400kV S/C line : 360-800MW
220kV S/C line : 160-200MW
132kV S/C line : 50-70MW
Transmission system configurations depends on
generation scenarios worked out by CEA.
Peaking capacities and energy generation capabilities are
determined based on following norms:
1. Thermal and nuclear plants :
Norms for availability of peaking capability :
Rated capacity (Maintenance @ 5% + Partial outage
rate @ 15% + Forced outage rate @ 17% + Auxilliary
consumption @ 10% + Spinning reserve @ 5% )
2. Annual energy generation
500 MW units 6000kWh/kW
200/210MW units- 5500kWh/kW
Units with ratings less than 200MW 5000kWh/kW
3. Availability from new units
Peaking capacity and annual generation capability of newly
commissioned thermal and nuclear units would be taken as:

Peaking capability Energy generation

During Next After 1 First Second Third Fourth
first 3 nine year year year year year
months months
Nil 50% 100% 2500kW 4000kW 5000kW 6000kWh/
h/kW h/kW h/kW kW
4. Hydro plants
Norms for deciding overall peaking capacities of hydro units:
Rated capacity- (maintanance @3% + Forces outage rate @ 9.5%
+Auxilliary consumption @ 0.5 %)
5. Generation expansion
LOLP = 1%, 2%, 5%
The power system reliability studies are conducted for two
1. Long term reliability evaluations may be performed to assist
long range system planning

2. Short term reliability predictions may be undertaken to assist

in day-to-day operation decisions including system security

The main steps in reliability studies are

1. Define the system--list the components and collect the
necessary component failure data from field surveys available.
2. Define the criteria for system failure
3. List the assumptions to be used.
4. Developing the system model.
5. Perform failure effects analysis and compute the system
reliability indices
6. Analyze and evaluate the results.
Reliability Calculations
The scope of reliability engineering in power systems depends upon:
The collection and evaluation of component failure data and load
curve model of the system.
The definition of reliability measures and the determination of
reliability requirements or standards for the various applications.
The development of mathematical models for system reliability and
the solution of these models.
The verification of the results.
The evaluation of results and the preparation of recommmendations.
Reliability Programs
Computer programs (eg) WASP, ISPLAN, EGEAS which are equipped with
several solution techniques have been developed by CEA for evaluating
HL-II adequacy.
In Tamilnadu Electricity Board, VINCOM is used for load curve, load

The programs are based on a contingency enumeration algorithm which

includes systematic selection and evaluation of disturbance, the classification
of each disturbance according to failure criteria and the accumulation of
reliability indices.

The program provides an appropriate set of adequacy indices at each load

bus and the overall HL-II indices.
Sensitivity Analysis
Several sensitivity studies carried out to examine effect of variations in
various power planning parameters
1. Variation in the electricity demand projection by 10% and 20%
2. Low level of Hydro development
3. Improvement in performance of thermal power plants
4. Improvement in system load factor by employing available load
management techniques etc.
System Reliability Analysis
The essence of total system analysis is simulation of system
operation with respect to both reliability and economy of electric
power supply

The simulation is carried out over a period of time which is

estimated to include most of the economic impacts of the
alternatives being studied.
Flow chart for reliability cost Analysis
System Reliability Analysis
Alternate cases to be studied are defined by types and sizes
of proposed generating units, listed in sequences in which
they are to be added
Reliability calculation then determines timing of additions as
required to maintain a stipulated reliability, considering
magnitude of load for each year of the system expansion.
With pattern of unit additions established, production cost
calculation determines how total system should be operated
for adequate reliability and maximum economy.
Fixed charges are calculated for each year as product of
each units line capital cost and fixed charge rate.
Sum of production, losses costs and fixed charges is the
total cost .
Functional zones
Three basic functional zones are generation, transmission and distribution
Functional zones are combined into hierarchical level(HL).
Three hierarchical levels are
1. HL-I consists of generation facilities alone.
2. HL-II includes both generation and transmission facilities in order to
assess system adequacy to meet the demand at major area load
3. HL-III adequacy assessment involves starting at generating points and
terminating at the individual consumer loads.
Functional zones (Contd)
The reliability performance of a network can be expressed by appropriate
The primary adequacy indices at HL-I are
Loss of load probability (LOLP)
Loss of load expectation (LOLE)
Loss of Energy Expectation (LOEE)
Expected Energy not supplied (EENS)
The frequency of loss of load and its duration.

In HL-II studies bulk transmission is included and there are two sets of
adequacy indices namely individual load bus indices and system indices.
Functional zones (Contd)
The basic HL-III system indices are
The system average interruption frequency index(SAIFI)
The system average interruption duration index(SAIDI)
Consumer average interruption frequency index(CAIFI)
Consumer average interruption duration index(CAIDI) etc
The most commonly used indices are SAIDI,SAIFI,CAIDI
Reliability indices
1. The system average interruption duration
index(SAIDI): Average total duration of interruptions
of supply per annum that a consumer experiences.
2. The system average interruption frequency
index(SAIFI): Average number of interruptions of
supply in the year for consumers who experience
interruption of supply.
3. Consumer average Interruption Duration
index(CAIDI): Average duration of an interruption of
supply in the year for consumers who experience
interruption of supply.