11.1 Background for Economic Evaluation of Biofuel Use
Essentially, I am a big proponent of the use of alternative fuels, as I believe they are necessary for our environment. However, to convince others of the environmental benefits, we must also have economic benefits. Use of biofuels in power generation must be competitive with coal and natural gas, and using alternative fuels in transportation must be economically competitive with petroleum refining of crude oil. The following section provides methods to evaluate economics of energy facilities.
There is a time value of money. The purchasing power of money is continuously declining, there is inflation, and investors want an increase in their investment beyond inflation. There are ways to track the time value of money, and this is done through the calculation of annual price indexes. The Consumer Price Index (CPI) is a measure of the overall cost of living, while the Producer Price Index (PPI) is a measure of cost of goods and other expenditures needed to stay in business. Table 1 shows the CPI and PPI for the USA and the CPI for the United Kingdom from 1997-2010.
|Year||CPI, USA||PPI, USA||CPI, UK|
Indexed to Year 2000 = 100
Note: 2010 PPI value for US not available at time book went to press
Source for data as cited in Energy Systems Engineering: US Bureau of Labor Statistics (2011) for USA data; UK National Statistics (2011).
Example 11-1 Factor of CPI and PPI (from ESE book)
A particular model of car costs $17,000 in 1998, and $28,000 in 2005, given in current dollars for each year. How much are each of these values worth in constant 2002 dollars? Use the US CPI values from Table 1.
Values from the table are used to correct the constant 2002 dollars, for $17,000 in 1998 dollars, and $28,000 in 2005 dollars, respectively.
If energy projects are going to be funded, the costs and predicted earnings for these projects must be valued for a later date and compared to the option of keeping money in savings or investments. A method to include the actual cost of money in the future is discounting. In discounting, current funds are projected into the future, knowing that the money today is worth less in the future due to inflation. Other terms are also defined:
- Term of project: Planning horizon over which cash flow is assessed – typically the value of years N is divided over the project.
- Initial cost: One time expense at the beginning of first compounding period.
- Annuity: Annual increment of cash flow related to project – can be positive or negative.
- Salvage value: One time positive cash flow at end of planning horizon of project – due to sale of asset at actual condition at end.
Projects can be evaluated without discounting. We are not going to discuss discounting beyond this part because I don’t want to spend too much time on discounting – we can look at energy projects without it. Discounting is also ignored for projects with short lifetimes. These shorter projects are evaluated with what is called a simple payback, and this is the method we’ll focus on. The factors in the simple payback include:
- adding up all cash flows in and out of the project;
- this is known as net present value (NPV);
- if NPV is positive, the project is financially viable;
- breakeven point – the year in which total annuities from the project surpass the initial costs.
There is also terminology for energy projects. One such value is called the Capital Recovery Factor (CRF). This is applied to electricity generation. It is a measure used to evaluate the relationship between cash flow and investment cost. This can be applied to short-term investments (i.e., a project that takes place over 10 years or less).
Annual capital cost (ACC) can be determined from the following equation (1) and the CRF can be determined from ACC and NPV shown in equation (2):
(1) ACC = annuity – NPV/N, where NPV is the net present value and N is the number years.
(2) CRF = ACC/NPV
The Electric Power Research Institute (EPRI) recommends a maximum CRF value of 12%.
So, how can energy projects be evaluated in order to determine their financial viability? There are multiple ways – the most common is the present worth method (PW). This method takes into account discounting of money. For the present worth method, all the elements of the financial analysis are discounted back to the present worth. This takes into account the positive and negative elements of cash flow summed up. If the NPV is positive, it would be a financially attractive project. In this method, a minimum attractive rate of return (MARR) would be chosen (kind of like an interest rate). Example 11-2 first looks at a simple payback NPV. While I do not expect you to know how to discount, I will expect you to know that it can affect the cost of a project, as suggested in the following example.
Example 11-2 Net Worth of a Plant (from ESE book)
A municipality is considering an investment in a small-scale energy system that will cost $6.5 million to install, and then generate a new annuity of $400,000/year for 25 years, with a salvage value at the end of $1 million. Calculate the net worth of the project using a simple payback approach.
Annuity= +$400,000 per year
N = 25 years
Salvage value = $1,000,000
Installation cost = $6,500,000
NPV = total value of annuities + salvage value – installation cost
This looks like the project is a good deal.However, if discounting were to be included in this, there would be a factor to reduce the value of the annuities for the 25 years, so the salvage value would be reduced by a significant factor. These factors would be based on a parameter called the minimal attractive rate of return (MARR) – if the MARR is 5%, this project would not be viable.
Another parameter that can be used is the called the benefit-cost ratio (B/C) method. This is a method that is a ratio of all the benefits of the project to all of the costs. If the B/C ratio is greater than 1, the project is acceptable. When the B/C ratio is less than 1, the project is unacceptable. If the B/C value is close to 1, it may be necessary to reevaluate the project to see if minor changes would make it acceptable. The conventional B/C ratio equation is shown in equation (3).
(3) B/C = Total benefits / (Initial cost + Operating costs)
Example 11-3 Benefit to Cost Ratio
Let’s take the example in 11-2. In Part a, we’ll calculate the B/C for the investment using the simple payback method. In Part b, we’ll add in $50,000/year in operating costs for 25 years.
- Total benefits include:
Income (annuity over 25 years) $400,000 x 25 = $10,000,000
Total costs = $6,500,000
- Now we’ll add in the operating costs for 25 years
25 x $50,000 = $1,250,000
So operating costs can influence the costs.
Discounting will also influence the costs, maybe to the point that the project would not be viable.
The last factor we will look at is the Levelized Cost of Energy. This is a method that incorporates the role of both the initial capital costs and ongoing costs. The levelized cost is determined per unit of energy output. Therefore, all the cost factors are combined into a cost-per-unit measure. We need a predicted average output of electricity in kWh and a sum of all the costs on an annual basis, divided by the annual output (see equation 4):
(4) Levelized cost = (Total annual cost)/(annual output)
Total annual cost = annualized capital cost + operating cost + return on investment (ROI)
Annual output is in kWh
Example 11-4 Levelized Cost of Energy
So, now we’ll continue with Example 11-3 and input the information into a formula to examine the Levelized Cost of Energy. This plant would produce 2.6 million kWh per year.
Income per year $400,000
Total costs = $6,500,000
$50,000/year operating costs for 25 years
So, the first thing to do is to determine the overall costs on an annual basis – recall that we are not discounting at all, we are doing a simple payback method.
Costs on an annual basis
= Income/year – Operating Costs/Year + (Salvage – Initial costs) /25 years
= $400,000 – $50,000 + ($1,000,000 - $6,500,000)/25
= $130,000 per year
Levelized costs = $130,000/2.6 million kWh
= $0.050/kWhThe average electric energy price in the US in 2004 for all types of customers was $0.0762 – this has not changed drastically in the current year. Therefore, with a plant of this size, this would be competitive in the US.
Another aspect that needs to be considered is the direct costs versus external costs and benefits. Direct costs include capital repayment costs and operating costs. Operating costs include energy supply, labor, and maintenance costs. However, there are also external costs that are sometimes called overhead. These costs include health care and lost productivity due to pollution. Direct benefits include revenues from selling the product and services. External benefits include benefits to the local environment or the use of unusual energy technology, which could encourage visitors to the company.
Costs are important, but by using biofuels, we also expect a benefit to the environment. So, there have been interventions in energy investments for social aims. We expect the alternative form of energy to be “clean” energy. This means that there may be intervention in the marketplace because of the potential social benefit, which is typically done by government. Intervention by government can be on the local, state, and federal levels. Why do this? It is because we can’t put a “value” on the social benefit, and it gives fledgling technologies a chance to grow in sales volume to allow for competition in the marketplace. For example, government subsidies were given to the production of ethanol from corn for many years, and now ethanol from corn in the US is the most viable method of ethanol production (data will be presented on this in the following section).
There is more than one method of intervention. One support mechanism is to support research and development (R&D). The support usually comes from the government, but industry may also participate so that they are not supporting the funding all on their own. Government can also support commercial installation and operating systems. This can be in the form of direct costs, tax credits, and interest rate buydown.
Most of our discussion so far has been on electricity systems. But how do we evaluate the production of biofuels and economic viability? There are two metrics that are used: 1) net energy balance ratio and 2) life cycle assessment. The net energy balance ratio is a metric to compare bioenergy systems. It is a ratio to compare energy available for consumption to the energy used to produce the fuel. So, for example, how might we look at ethanol? The energy carrier itself is ethanol. However, energy was consumed in order to grow, harvest, and process the corn in order to produce the ethanol. This is known as energy to produce. The ratio would look like this:
(5) NEB = Energy from fuel/ Energy to produce
If the NEB ratio is greater than 1, there is more energy available for consumption than is used to produce the biofuel. If the NEB ratio is less than 1, then more energy is required to produce the fuel than is available in the fuel for consumption – which makes for an unattractive project. This is a good metric for debate, but it is not a parameter than can stand alone.
The other metric is life cycle assessment (LCA). It is a method of product assessment that considers all aspects of the product’s life cycle. One way to express this is a cradle-to-grave analysis. For biofuels in transportation, it could be plant/harvest-to-wheels. In the petroleum industry, it’s known as well-to-wheels.
Example 11-5 Shows How the NEB and LCA are Determined
There are two farms that grow corn to produce ethanol. Farm A is 40.2 km from the ethanol plant. Farm A sells corn for $289.36 per metric ton. Farm B is 160.0 km from the ethanol plant, and corn sells for $284.02 per metric ton. Other information:
Truckload can carry 10.9 metric tons (500 bushels)
Truck emits 212.3 g CO2eq/metric ton-km (310 g CO2eq/ton-mile)
Plant needs 130.6 metric tons per year (6000 bushels/year)
Truck weighs 9.1 metric tons empty
Plants needs: 130.6 metric tons/year @ 10.9 metric tons
= 12 truckloads per year
For the two farms, examine the two farms – both for economics and GHG emissions.
- Economic return
- Empty truck:
- Full truck:
- Total 2.98 Mg CO2eq
- Economic return
- Empty truck:
- Full truck:
- Total 11.90 Mg CO2eq
We also want to determine the fuel productivity per unit of cropland per year. This should be done before choosing a regional crop. Keep in mind that, depending on location, sunlight provides 100-250 W/m2 – however, less than 1% is available in starches and oils as a raw material for conversion to fuel. Research has focused on conversion of lignocellulosic biomass (whole biomass) and utilization of the entire plant in order to produce fuel and/or value-added products – the economics improve under these conditions. Data on changes to the land must also be incorporated, especially if the land is being changed to sustain a large-scale biofuels program. For example, if a rainforest or peatland is removed to make space, the material from the land is typically burned, adding CO2 to the atmosphere before even getting the system started.
So, what is the NEB ratio of ethanol? Early on in conversion of corn to ethanol, the ratio was positive, but not a very high ratio – 1.25. However, recent assessments show improved NEB of 1.9-2.3. And if the fuel used to run the plant that produces the ethanol is 50% biomass, the NEB is 2.8, almost 3. And you will see in the economics, production of ethanol is economical. The problem comes up when petroleum prices go down, such as in recent months; ethanol production is less economical.
So, what about the NEB ratio of biodiesel? When compared to the NEB of ethanol, in early stages of biofuel production, the NEB ratio of biodiesel was 1.9 when co-products are included. It is higher because biodiesel production requires reduced energy requirements during processing, mainly because less distillation is required. The one drawback to biodiesel production is the GHG contains N2O, so use of biodiesel has ~60% of petrodiesel emissions instead of being neutral. Another issue for biodiesel is soybeans suffer as a crop due to lower yields per land area compared to corn. Example 11-6 shows the NEB ratio calculation of soybeans to biodiesel.
Example 11-6 Calculate the Ratio of Energy Available in the Resulting Biodiesel to the Total Energy Input
Does biodiesel provide more energy than it consumes?
- Each gallon of biodiesel requires 7.7 lbs. of soy as feedstock
- Acre yields ~452 lbs. soy
- Assume pure biodiesel
- Assume a gallon of biodiesel contains 117,000 Btu net
|Input||Energy (1000 Btu)|
|Input||Energy (1000 Btu)|
|Process heat & electricity||1784|
- Energy in to produce biodiesel
- Energy out from biodiesel produced
- = 2.02
So, are ethanol and biodiesel being consumed in our current fuel supply? Yes, they are, but partially because of an Environmental Protection Agency (EPA) mandate to use oxygenated fuel in a blend with gasoline and diesel fuel. Approximately 10% of the gasoline supply is ethanol, while in diesel, it’s estimated that diesel sold contains ~5-6% biodiesel.