ENERGY PROJECTS BE EVALUATED CONSIDERING EXTERNALITIES IMPACT OF ERR
SYED ALAMDAR ALI, Hailey College of Banking & Finance Lahore
June 09 - 15, 2008
Energy Return on Investment (EROI) is a snapshot in time of a technology combined with an energy source and an infrastructure. Oil is pervasive in impacting the EROIs of alternatives. The main point is that we can impact EROI not only by technology, but by demand choices. The energy input into an energy harvesting process is subtracted from the gross energy to get the net energy available. But societies a) choices and b) infrastructure also impact EROI.
It has often been cited how economics does not incorporate or look at physics and biology when it comes to sustainability issues. However it can also be said that physicists and biologists have failed to recognize economics when it comes to studying energy alternatives. One of the more interesting dimensions in the discussions of net energy analysis is the Energy Utilization Chain (EUC). Instead of looking only at the net energy from say the oil well to the car wheel (well to wheel) it is important to also look at the energy service itself. For instance, one can have a wheel on a car, but one can also take a train or develop other forms of transportation that can use high net energy sources. In economics, this is called substitution and the degree of that substitution is called the elasticity of substitution. However, the problem from the economics side is that economists are quick to say that substitution is possible, which gives the appearance that the economists have won the day. But they then fail to consider physics and the entropy law. For example if the net energy for an alcohol fueled car is low, then just use a coal fired steam locomotive train instead or use nuclear power to run electric trains. But if that is your substitute you need to ask, how many railroad tracks and electric corridors are you going to need to build, to replace all the automobiles you have? Such infrastructure would take a long time to build, but more than that it would also require a lot of energy. Thus the net energy of the EUC from in-situ energy source all the way to the energy service is important.
Energy development is the ongoing effort to provide abundant and accessible energy, through knowledge, skills and constructions. When harnessing energy from primary energy sources and converting them into ever more convenient secondary energy forms, such as electrical energy and cleaner fuels, both quantity (harnessing more primary energy) and quality (more efficient conversion to secondary energy) are important. The combined production of mechanical or electrical and thermal energy using a simple energy source affords remarkable energy savings and in many cases makes it possible to operate with greater efficiency when compared to a system producing heat and power separately. The economic optimization in the design and operation of a combined heat and power (CHP) unit is usually performed through an examination of the investment criteria. In spite of the numerous criteria available, virtually the only ones used to determine whether to reject or to accept a project has been the net present value (NPV), internal rate of return (IRR) and payback period (PP). However, another very critical method that has evolved during the phases of investment appraisal based upon the method of yield calculation is called External Rate of Return. ERR is a modified internal rate of return (IRR) that allows for the incorporation of specific reinvestment- borrowing and sinking fund assumptions. The internal rate of return ROR method includes the possibility of multiple rates satisfying the criterion of the rate that makes the present value = 0. The ERR is an alternative method which is based on the rate which makes the future value of Costs (- cash flows) equal the future value of the revenues (+ cash flows) invested at the reinvestment rate for surplus funds (usually the MARR, Minimum Attractive Rate of Return).
The external rate of return is not a true ROR like the internal rate but it may be easier to calculate, especially if there are swings of negative to positive to negative cash flows during the life of an investment. Such swings depend upon various issues e.g., political instability, price instability, economic fluctuations, human resources unavailability and many other alike issues. The ERR appears to be a dual rate situation but there is only one unknown rate and it is exactly the same as the internal ROR when the PV of the positive flows equals the PV of the negative flows at the same discount rate.
This is the crux of the issue. In theory you are correct. However in reality, using dollars to generate decisions gives you a constant moving target, based on the markets sloth at recognizing scarcity. The decisions would change monthly in an energy crisis. Net energy analysis attempts to jump ahead of this by acknowledging that energy is important (implicitly, energy is more central to our needs, whereas the market is good at pricing our wants), and pricing things in energy terms so that accurate planning can be made in advance. I suspect that as we begin to run faster on our natural gas treadmill, the value of pricing ethanol in energy terms instead of $ will become apparent.
In a perfectly functioning market that has no subsidies, that values externalities, and that doesn't exhibit very steep discount rates (valuing the present more than it should), pricing in dollars would equal pricing in energy, but we are a long way from that, and the cost of that distance is turning out in the form of transformed IRR into ERR!