# Presentation: 500755

## Overview of Financial and Economic Concepts

- Shilpa Shah
- U.S. Energy Information Administration
- June 2004

- Philippines Department of Energy (PDOE)
- Energy Pricing Model Project

## Financial Basics

- Discount Rate
- Net Present Value
- Internal Rate of Return

## Discount Rate (Rate of Return)

- Used to compare monetary values across time
- One dollar today  One dollar in one year
- Given one dollar today (present value, PV), the value of that dollar in one year (future value, FV) is given by
- 		FV = PV * (1+R)  where R is the rate of return
- Equivalently, the present value of an amount of money received in one year is given by
- 		PV = _     FV__	_
- 			(1+R)
- In both cases, we see the discount rate enables the comparison of present and future values at a particular point in time

## Discount Rate

- Components of discount rate, R
- R = r + i + m
-    where,  r = real rate of return
- 			i = inflation
- 			m = country/project specific risks
- Discount rates for project evaluation
- National discount rates typically 10% – 12%
- Company discount rate normally higher

## Net Present Value (NPV)

- For project evaluation,
- 		NPV = PV(earnings) – PV(investment)
- NPV Criteria
- Accept project when NPV > 0, reject when NPV < 0
- In other words, the future benefits of a project must more than offset the present and future costs of that project for it to be accepted

## Internal Rate of Return (IRR)

- IRR is the discount rate at which a project breaks even
- In other words, the NPV of a project that is discounted at the IRR leads to NPV = 0.
- NPV = PV(earnings) – PV(investment) = 0
- IRR indicates the maximum rate of return that a project can support
- IRR Criteria
- Accept project if IRR is greater than the project’s discount rate, R
- 			IRR > R   accept project
- 			IRR < R   reject project
- In practice, NPV tends to perform better as project evaluation measure, because IRR can lead to misleading results

## PDOE Resource Costing Model

- Uses economic methodology to establish a pricing policy for an energy resource including
- Economic prices
- Based on supply-demand analysis
- Financial prices
- Distortions from economic price due to government or market failures
- Shadow prices
- Provides an economic opportunity value closer to the real value of an economic resource

## Economic Price of Energy Resource

- Encourage patterns of production and use that result in energy sector yielding the highest possible value to society
- Supply side
- Cover total costs for producing the energy resource, including the benefit to society of depleting the last unit of energy
- Demand side
- Consumers choose the least-cost energy resource for a given application and use that resource only as long as the value of the last energy unit consumed equals or exceeds the cost to the consumer

## Economic Price of Energy Resource

- Then, in a freely competitive market, the appropriate economic price of the energy resource will occur where the marginal cost of production equals the marginal benefit of consumption

- P = MC (Supply) = MB (Demand)

## Economic Price of Energy Resource

- Marginal cost often difficult to estimate because it requires perfect information about present and future technology and costs (exploration and production, including unexplored fields)
- To account for these information/measurement constraints, economists use Average Incremental Cost (AIC) as a proxy
- Marginal benefit is generally difficult to measure as it is based on information on quantities purchased at different price levels (often requires inferences about consumer preferences)
- As a proxy, economists use Netback Value

## Economic Price of Energy Resource

- Supply
- Average Incremental Cost
- Economic Rents
- Depletion Allowance
- Scarcity Rents
- Externality Costs
- Demand
- Netback Value

## Average Incremental Cost (AIC)

- Practical measure for approximating marginal cost (P = MC ~ AIC)
- Measures the additional investment and operating costs required to increase the output of an energy resource and to maintain it at a designated level of production for a designated period of time
- Sets the minimum economic value of gas needed to recover all economic costs at the national discount rate
- AIC = _NPV(incremental investment and operating costs)_
- 		                NPV(incremental production)

## Depletion Value (DV) 

- Measures the additional costs associated with supplying an exhaustible resource
- Reflects the fact that a unit of a resource used today will not be available at some time in the future and another fuel will have to be used in its place, normally at higher cost
- AIC does not account for depletability of finite resources
- Calculated for a specified time, n, in relation to a backstop fuel, BF, and a future year, T, in which the fuel under analysis becomes depleted
- DVn = _NPV (backstop fuel price in year T)_
-                                     (1+r)T-n
- This rent accumulates to producers and the government

## Scarcity Rent (SR)

- Reflects the premium value of a resource to consumers when demand exceeds supply
- Raises economic price as rent accrues to producers
- Measured as the difference between the present value of the price of the next best fuel in a particular year, n, and the AIC
- SRn = PV(backstop fuel in year n) – AICn

## Externality Costs (SC)

- External costs of resource extraction, processing and transport that are borne by society at large rather than by producers
- Include air and water pollution and other forms of environmental degradation
- Methodologies for quantifying and incorporating externalities are not well-developed, although the U.S. electricity sector is notably advanced in this area
- Cost of pollution allowances, pollution tax

## Netback Value (NB)

- Indicates the highest price that consumer is willing to pay for an energy resource
- Assume consumer wishes to buy resource at lowest cost possible and will evaluate relative costs of different resources on a comparative basis
- As calculated, netback value shows the maximum a consumer is willing to pay given the cost of the next best available fuel for a given application
-  NBNatGas = _[I_Oil_ – I_NatGas_+ F_Oil_]_
- 			       ConsNatGas
- 	where,  INatGas = investment and operating costs required to use natural gas
- 		   IOil = investment and operating costs required to use oil
- 		   FOil = price of oil
- 		   ConsNatGas = consumption of natural gas

## Economic Price of Resource

- In a perfect market environment, for a given energy resource, X, a consumer will demand X when,
- 		NBX > AICX + DVX + SRX + SCX
- The difference between the left and right sides of these equations represent persisting rents that have not been captured by producers, government or consumers
- Ideally, in equilibrium they should be equal although market imperfections and barriers often prevent such an outcome
- Noting the above, the cost of supply (AICX + DVX + + SRX SCX) and value of demand (NBX) represent the respective minimum and maximum of the appropriate economic price range for an energy resource

## Economic Price and Project Evaluation

- Economic Price Path (EPP)
- EPP = AICX + DVX + SRX + SCX
- Determination of an appropriate EPP enables the evaluation of an energy resource project using that EPP as an input for the projection of revenues

## Financial Price of Energy Resource

- Adjusts the economic price to incorporate market barrier and government policy distortions that prevent market equilibrium
- Represents the price that a producer must receive from exploration, development, operation, and delivery of the energy resource to allow for reasonable profit based on its required rate of return and compensate it for :
- Risks
- Income taxes
- Depreciation
- Royalties or shares of production paid to government

## Shadow Prices

- For economic pricing purposes, the price used in economic analysis to represent a cost or benefit from a good when the market price is a poor indicator of the value of the good or no market exists at all
- In the context of optimization, the rate at which an optimal value changes in response to a unit change in one of its constraints (e.g., supply or demand requirements)

## Questions?