Power and Energy Series 44

In the highly capital-intensive electricity supply industry, it is

essential that both engineers and managers understand the
methodologies of project evaluation in order to comprehend and
analyse investment proposals and decisions. This fully revised
and updated edition of Economic Evaluation of Projects in the
Electricity Supply Industry (1996) takes a broad introductory
approach, covering market and environmental issues, financial
analysis and evaluation, and clean environmental technologies
and costs. New topics include electricity trading and risk
management, evolving electricity utilities and new and future
generation technologies in a carbon-constrained world.
Written primarily for engineers to assist them in evaluating
economics of power projects and their environmental
implications, the book will also be of value to economists and
financial analysts needing an understanding of the area.

Hisham Khatib has 45 years of experience in energy

and the electricity supply industry as an engineer and
economist. In the 1980s, he was Director General
and later Chairman of the Jordan Electricity Authority.
For many years he was Minister of Energy as well as
Minister of Planning in the Government of Jordan. He is
presently Vice Chairman of Jordan Electricity Regulatory
Commission and is a past Vice Chairman of the World
Energy Council (WEC). He has authored around 100
engineering/economic articles and two books on the
economics of the electricity supply industry. He is well
known for his international activities on global energy,
electrical power and their environmental impact, and is
a Fellow of both the IET and the IEEE.

Economic Evaluation of Projects

in the Electricity Supply Industry

Economic Evaluation of Projects

in the Electricity Supply Industry

Hisham Khatib
Khatib

The Institution of Engineering and Technology

www.theiet.org
0-86341-304-8
978-0-86341-304-9

Economic Evaluation of
Projects in the Electricity
Supply Industry

IET Power and energy series 44

Series Editors: Professor A.T. Johns
Professor D.F. Warne

Economic Evaluation of
Projects in the Electricity
Supply Industry

Other volumes in this series:

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Power circuit breaker theory and design C.H. Flurscheim (Editor)

Industrial microwave heating A.C. Metaxas and R.J. Meredith
Insulators for high voltages J.S.T. Looms
Variable frequency AC motor drive systems D. Finney
SF6 switchgear H.M. Ryan and G.R. Jones
Conduction and induction heating E.J. Davies
Statistical techniques for high voltage engineering W. Hauschild and
W.Mosch
14 Uninterruptable power supplies J. Platts and J.D. St Aubyn (Editors)
15 Digital protection for power systems A.T. Johns and S.K. Salman
16 Electricity economics and planning T.W. Berrie
18 Vacuum switchgear A. Greenwood
19 Electrical safety: a guide to causes and prevention of hazards
J.MaxwellAdams
21 Electricity distribution network design, 2nd edition E. Lakervi and
E.J.Holmes
22 Artificial intelligence techniques in power systems K. Warwick, A.O. Ekwue
and R. Aggarwal (Editors)
24 Power system commissioning and maintenance practice K. Harker
25 Engineers handbook of industrial microwave heating R.J. Meredith
26 Small electric motors H. Moczala et al.
27 AC-DC power system analysis J. Arrill and B.C. Smith
29 High voltage direct current transmission, 2nd edition J. Arrillaga
30 Flexible AC Transmission Systems (FACTS) Y-H. Song (Editor)
31 Embedded generation N. Jenkins et al.
32 High voltage engineering and testing, 2nd edition H.M. Ryan (Editor)
33 Overvoltage protection of low-voltage systems, revised edition P.Hasse
34 The lightning flash V. Cooray
35 Control techniques drives and controls handbook W. Drury (Editor)
36 Voltage quality in electrical power systems J. Schlabbach et al.
37 Electrical steels for rotating machines P. Beckley
38 The electric car: development and future of battery, hybrid and fuel-cell
cars M. Westbrook
39 Power systems electromagnetic transients simulation J. Arrillaga and
N.Watson
40 Advances in high voltage engineering M. Haddad and D. Warne
41 Electrical operation of electrostatic precipitators K. Parker
43 Thermal power plant simulation and control D. Flynn
44 Economic evaluation of projects in the electricity supply industry H. Khatib
45 Propulsion systems for hybrid vehicles J. Miller
46 Distribution switchgear S. Stewart
47 Protection of electricity distribution networks, 2nd edition J. Gers and
E.Holmes
48 Wood pole overhead lines B. Wareing
49 Electric fuses, 3rd edition A. Wright and G. Newbery
50 Wind power integration: connection and system operational aspects B. Fox
et al.
51 Short circuit currents J. Schlabbach
52 Nuclear power J. Wood
53 Condition assessment of high voltage insulation in power system
equipment R.E. James and Q. Su
55 Local energy: distributed generation of heat and power J. Wood
56 Condition monitoring of rotating electrical machines P. Tavner, L. Ran,
J. Penman and H. Sedding
905 Power system protection, 4 volumes
1
4
7
8
10
11
13

Economic Evaluation of
Projects in the Electricity
Supply Industry
Hisham Khatib

The Institution of Engineering and Technology

Published by The Institution of Engineering and Technology, London, United Kingdom

1996, 2003 The Institution of Electrical Engineers
New cover 2008 The Institution of Engineering and Technology
First published 1996 (0 85296 908 2)
Revised edition 2003 (0 86341 304 8)
This publication is copyright under the Berne Convention and the Universal Copyright
Convention. All rights reserved. Apart from any fair dealing for the purposes of research
or private study, or criticism or review, as permitted under the Copyright, Designs and
Patents Act, 1988, this publication may be reproduced, stored or transmitted, in any
form or by any means, only with the prior permission in writing of the publishers, or in
the case of reprographic reproduction in accordance with the terms of licences issued
by the Copyright Licensing Agency. Enquiries concerning reproduction outside those
terms should be sent to the publishers at the undermentioned address:
The Institution of Engineering and Technology
Michael Faraday House
Six Hills Way, Stevenage
Herts, SG1 2AY, United Kingdom
www.theiet.org
While the author and the publishers believe that the information and guidance given
in this work are correct, all parties must rely upon their own skill and judgement when
making use of them. Neither the author nor the publishers assume any liability to
anyone for any loss or damage caused by any error or omission in the work, whether
such error or omission is the result of negligence or any other cause. Any and all such
liability is disclaimed.
The moral right of the author to be identified as author of this work has been asserted
by him in accordance with the Copyright, Designs and Patents Act 1988.

British Library Cataloguing in Publication Data

Khatib, Hisham, 1936
Economic evaluation of projects in the electricity supply industry.
New ed. (IET Power and energy series no. 44)
1. Electric utilities Finance Evaluation
2. Electric utilities Economic aspects Evaluation
I. Title II. Institution of Electrical Engineers
333.79323
ISBN (10 digit) 0 86341 304 8
ISBN (13 digit) 978-0-86341-304-9

Typeset in India by Newgen Imaging Systems (P) Ltd, Chennai

First printed in the UK by MPG Books Ltd, Bodmin, Cornwall
Reprinted in the UK by Lightning Source UK Ltd, Milton Keynes

Contents

Preface

xi

Acknowledgements

xv

Global electrical power planning, investments and projects

1.1
The value of electricity
1.2
Integrated resource planning
1.3
The changing electrical power industry scene
1.3.1 Reform trends in the electricity supply industry
1.3.2 Environmental concerns and the efficiency of
generating plant
1.3.3 Environmental concerns and the growing
importance of natural gas
1.3.4 Rehabilitating, retrofitting and repowering of
existing power facilities
1.3.5 The growing importance of demand side
management (DSM)
1.4
The global electrical power scene
1.4.1 Electricity and the global energy scene
1.4.2 Electricity and the world economy
1.5
Considerations that will influence future investments in
electricity generation
1.5.1 Future electricity generation technologies
1.5.2 Future electricity generation fuels
1.6
Projects and capital investments
1.6.1 Generation investment and projects
1.6.2 Transmission and distribution projects
1.6.3 Sources of investment funds
1.7
Epilogue
1.8
References

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4
5
6
7
9
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12
13
14
14
15
16
17
18

vi

Contents

Considerations in project evaluation

2.1
Project selection and evaluation
2.2
Project development
2.2.1 The pre-investment stage
2.2.2 The investment phase
2.2.3 The operational phase
2.2.4 Post-operation evaluation
2.3
Other considerations in project evaluation
2.4
References

21
21
22
22
26
27
27
28
30

Time value of money (discounting)

3.1
Discounting
3.2
Discounted cash flows
3.3
Net present value (NPV)
3.4
Accounting for inflation in cash flows
3.5
Considerations in present valuing
3.5.1 Future and past valuing
3.5.2 Annuity factor
3.5.3 Capital recovery factor (CRF) or equivalent
annual cost
3.5.4 Grouping monthly and hourly flows
3.6
References

31
31
33
34
35
37
37
38
39
41
41

Choice of the discount rate

4.1
Introduction
4.2
The discount rate
4.3
Calculating the discount rate
4.3.1 Government financed projects
4.3.2 Business investment projects
4.4
Controlling the value of the discount rate
4.4.1 Capital structuring
4.4.2 Transferring risk
4.5
Other forms of the discount rate
4.5.1 Weighted-average cost of capital
4.5.2 Utilisation of multiple discount rates
4.6
Summary
4.7
References

43
43
44
45
46
46
52
52
53
53
53
54
54
55

Financial evaluation of projects

5.1
Introduction
5.1.1 Evaluation of costs and benefits
5.1.2 Project financial costs
5.1.3 Financial benefits of the project

57
57
57
58
59

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Contents
5.2

5.3

5.4
5.5
6

Least-cost solution
5.2.1 Present value method
5.2.2 Annual cost method (equivalent uniform
annual cost method)
Measuring worth of the investment
5.3.1 Internal rate of return
5.3.2 Net present value (NPV)
5.3.3 Benefit/cost ratio
5.3.4 Other non-discount criteria for evaluation
5.3.5 Payback period
5.3.6 Profit/investment ratio
Owners evaluation of profitability commercial
annual rate of return
References

Considerations in project evaluation

6.1
Base cost estimate and contingencies
6.1.1 Physical contingency
6.1.2 Price contingency
6.2
Interest during construction
6.3
Sunk costs
6.4
Depreciation and interest charges
6.5
Financial projections
6.5.1 Financial performance and financial statements
6.5.2 Financial ratios
6.5.3 Flow of the funds statement sources and
applications of funds
6.6
Evaluation of benefits in the electricity supply industry
6.7
Timing of projects
6.8
Dealing with projects with different lives and
construction periods
6.9
Expansion projects
6.10 System linkages
6.11 References
Economic evaluation of projects
7.1
Introduction
7.2
From financial evaluation to economic evaluation
7.3
Transfer payments
7.4
Externalities
7.5
Border and shadow pricing
7.5.1 Pricing traded inputs and outputs
7.5.2 Pricing non-traded inputs and services
7.6
References

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vii
59
60
62
65
65
67
67
68
68
68
69
69
71
71
71
72
73
74
74
75
76
78
80
81
82
82
83
83
85
87
87
89
89
90
91
92
93
95

viii

Contents

Environmental considerations and cost estimation in

project evaluation
8.1
Introduction
8.2
Environmental impacts of electricity fuels
8.2.1 Environmental impact of different generation fuels
8.3
Environmental evaluation
8.4
Environmental impacts and the discount rate
8.5
Health and environmental effects of electricity
8.5.1 Direct health effects
8.5.2 Environmental impact
8.6
Investment costs in reducing dangers to health and
environmental impacts
8.7
Evaluation of the environmental cost of electricity generation
8.7.1 Assessing health impacts and costs
8.7.2 Assessing damage to buildings, properties and
forests by air pollution
8.7.3 Climate change costing
8.8
References

10

Electricity generation in a carbon-constrained world

9.1
Introduction
9.2
Climate conventions and Kyoto
9.2.1 Case Study: the Kyoto Protocol and the Marrakech
declaration and accords
9.3
Electricity generation and climatic change agreements
9.3.1 Flexible project mechanisms
9.3.2 Emissions trading
9.3.3 Encouraging emissions reductions
9.4
Introduction to low emissions and emissions-free
power generation
9.4.1 Generation cost of power sources
9.5
Clean fossil-fuel-based power technology
9.6
Prospects for non-fossil-fuel power generation
9.6.1 Prospects for nuclear energy
9.6.2 Prospects for wind power
9.6.3 Prospects for solar cells
9.6.4 The virtual power plant
9.7
References
Economics of reliability of the power supply
10.1 Introduction
10.2 The value of reliability
10.3 Reliability in system planning
10.3.1 Empirical planning rules

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97
97
99
101
102
102
103
103
104
106
107
107
107
109
111
113
113
114
115
116
117
118
120
120
121
121
124
124
124
125
126
126
129
129
131
132
132

Contents

10.4

10.5
10.6

10.7
11

12

10.3.2 Supply design standards

10.3.3 Costbenefit analysis
Detailed financial and economic evaluation
10.4.1 System adequacy and economics
10.4.2 Assessment and economics of generation adequacy
Financial and economic evaluation of quality of
electrical power
Evaluation of investment in generation
10.6.1 Valuing cost of interruptions
10.6.2 Incorporating reliability worth in
generation planning
References

ix
133
133
134
134
135
138
139
140
141
144

Electricity trading
11.1 Introduction
11.2 Electricity trading worldwide
11.2.1 Electricity trading in the US
11.2.2 UK electricity market trading
11.2.3 The Nordic market
11.2.4 The California market
11.2.5 Electricity markets across Europe and elsewhere
11.3 Electricity traders
11.3.1 Case study: sample of services offered by
power marketers (traders)
11.4 Future strategies and growth
11.5 References

145
145
146
147
148
150
150
152
153

Evolvement of the electricity sector utility for the future

12.1 Introduction
12.1.1 Phase I: early 20th century private sector investment
and monopolistic market behaviour
12.1.2 Phase II: mid-20th century public sector intervention
and inefficiency
12.1.3 Phase III: late-20th century unbundling, competition,
regulation and privatisation
12.1.4 Phase IV: recent developments industry convergence
and globalisation
12.2 Reorganising the ESI
12.2.1 The opportunities presented by liberalisation
12.3 Barriers in liberalised markets
12.4 Electricity and the new digital economy
12.5 The utility of the future
12.6 The virtual utility of the future
12.7 DSM programmes in deregulated markets

159
159

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155
156
157

159
159
160
160
160
162
164
164
166
167
167

Contents
12.8
12.9

The need for a regulator

References

169
170

13

Project analysis: evaluation of risk and uncertainty

13.1 Introduction
13.2 Project risks
13.3 Sensitivity analysis
13.4 Break-even point analysis
13.5 Decision analysis
13.6 Risk analysis (the Monte Carlo simulation)
13.7 Consideration in risk analysis
13.7.1 Building up probability distributions
13.7.2 Disaggregation
13.7.3 Correlation
13.7.4 Effect on the discount rate
13.8 The value of risk management in liberalised markets
13.9 References

171
171
171
174
176
177
178
182
182
183
183
184
184
185

14

Risk management in electricity markets

14.1 Introduction
14.2 Qualifying and managing risk
14.2.1 Forward contracts
14.2.2 Futures contract
14.2.3 Options
14.2.4 Swaps
14.2.5 Political risk
14.3 Decision making
14.3.1 The decision-making process
14.4 References

187
187
187
189
189
190
191
192
192
193
194

Appendix 1 Financial evaluation for choice of transformer

195

Appendix 2 Glossary

201

Index

209

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Preface

The first edition of this book appeared in 1997, it is now more than five years since then.
During that time significant developments (technological as well as managerial) have
taken place in the electricity supply industry (ESI) in Europe as well as in many countries in the world. Significant strides in technology and efficiency of power generation
have materialised during the past few years as well as advancement in information
and telecommunications, which has helped to promote electricity markets and trade.
There is a global trend towards liberalisation and privatisation of the electricity
supply industry. This is coupled with growing environmental awareness and increasing prospects for ratification of the Kyoto Protocol. All have dramatically affected the
ESI worldwide. Developments that have taken place during the past decade outweight
all that has taken place since the middle of the 20th century.
This necessitated a review and a new edition of this work to take into account
these developments that affect the way projects are conceived and evaluated by
the industry. With the gradual demise of government-owned utilities, financial and
economical evaluation of projects is gaining more importance in competitive and
liberalised markets, as is risk management.
Financial and economic evaluation of projects is usually carried out by a team
of engineers, economists and financial analysts. In the case of economic evaluation
of large projects, there is an involvement of economic and environment disciplines,
and the undertaking of an analysis that is beyond the proficiency of most engineers,
accountants and financial analysts. Projects in the electricity supply industry are
slightly more sophisticated than other investment projects in the industrial sector
and more capital intensive. It is not easy to introduce people from other disciplines
(economists, accountants, financial analysts) into the intricacies of electrical engineering; however, their role remains very important in the evaluation of projects in
the power industry. It may be easier to acquaint engineers with the fundamentals of
financial and economic evaluation of projects. This will allow for an easier dialogue
between different disciplines in any project evaluation team, and correspondingly
lead to better results.
This book is written primarily for engineers to assist them in project evaluation; therefore the treatment assumes some understanding of engineering, particularly
the electrical power technology and utilisation of computers for simulation. All the

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xii

Preface

financial and economic analyses and examples are brief and simplified to allow for the
quick grasp of ideas and understanding of the subject by the non-specialist. However,
the book is also useful to economists and financial analysts in understanding issues
encountered in engineering projects and the electricity supply industry and the means
of evaluating their economic implications. Chapters 1, 812 and 14 are, in particular,
power engineering biased.
Simplified techniques for the financial and economic evaluation of projects are not
difficult to understand by power engineers with their engineering and mathematical
knowledge. There are plenty of simple evaluation rules that have to be grasped by
engineers and which will give them a good insight to simple financial analysis and
economic evaluation that will sharpen their understanding of the economic implications of investments and allow them to understand concepts such as the time value of
money, discounting and the discount rate, rate of return and risk evaluation. Such concepts are essential knowledge for power system planners and others who are involved
in project selection and strategies.
The book is mainly concerned with the financial and economic evaluation of
projects. Therefore it does not dwell on the other related aspects of demand prediction,
technology, management and the framework of the power sector planning. These are,
of course, very important for financial and economic evaluation; however, they are
treated in detail in the available literature, and will be referred to when they are of
direct bearing on evaluation. Also this book does not dwell on financial projections
of a commercial nature. Therefore the book is mainly concerned with the evaluation
of projects, particularly capital-intensive projects like those of the electricity supply
industry. Most of the investments carried out by utilities and investors are in the form
of individual projects. The evaluation is required to find out the least-cost solution as
well as the rate of return on the investment. The whole performance of the investor, as
a complex commercial entity, can be assessed through financial ratios and pro forma
financial statements. These are briefly described in Chapter 6.
Many books have been written in the United States about engineering economics
and evaluation of projects, than have been written in the UK. Evaluation is not a
universal science; approaches and criteria for assessment differ in the UK and Europe
from North American practices in some aspects. The differences are, however, limited
and some of them will be pointed out in the book.
International development agencies, particularly the World Bank, the Organisation for Economic Corporation and Development (OECD), different United Nations
agencies and other national and regional development funds significantly contributed
towards understanding project evaluation, especially the economics of externalities,
shadow pricing and environmental damage costing aspects. This book draws on their
work wherever relevant.
This second edition is significantly enlarged compared with the first edition. There
are three major significant additions. The first concerns environmental considerations
and prospects for emissions trading in a carbon constrained world (Chapters 8 and 9),
the other is electricity trading and financial management of risk in growing liberalised
markets (Chapters 11 and 14) as well as the evolution of the electricity sector and utility

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Preface

xiii

of the future (Chapter 12). The second edition contains four additional chapters to cater
for these recent and possible future developments in the electricity supply industry.
This book will also be useful for post-graduate electrical power engineering
students preparing for a higher degree. It introduces them to the concepts of financial and economic evaluation and the criteria that govern investment in the electricity
supply industry.
This book covers a wide ground and could not be written without benefiting from
the published effort of others as well as on a lot of literature; therefore every chapter
has a list of relevant references, upon which I have drawn, and that will enable the
interested reader to sharpen his knowledge about the subject.

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fm 2003/6/19 page xiv #10

Acknowledgements

The analysis in this book has greatly benefited from my extensive experience in
project evaluation which I gained while associated with the electricity supply industry
world wide as well as in Jordan, through my association with the World Electricity Council and the Arab Fund for Economic and Social Development, a leading
regional development institution located in Kuwait. However, any omissions are my
responsibility.
I am particularly thankful to the management of the Arab Fund for supporting
this work.

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