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Costs methodology for 2050 Calculator

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Showing just the changes made in the edit by Sophie Hartfield at 2011-08-10 10:58:10 UTC

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Title: Methodology for Costs Calculator

Content: This note sets out the methodology we are using to include costs to the 2050 Calculator.

h1 Summary

The Calculator will include the capital, operating costs and fuel costs associated with supplying and using energy between 2007 and 2050. This includes the cost of heating homes and businesses, producing electricity, traveling, fossil fuels, biomass and reducing emissions in agriculture and industry (see cost description by sector for more detail).

The Calculator will exclude welfare effects such as costs associated with living in cooler buildings or travelling less, administrative costs associated with delivering policy, and wider macroeconomic impacts.  All costs will be presented as a range, where low/high are the lowest/highest that credible experts can foresee them being.  In most cases, the high cost in 2050 is the cost of that technology today.  Costs do not vary according to the deployment of the technology selected by the user (i.e. they are exogenous).  

We are seeking help with the methodological questions, set out at the end of this paper.  These questions are on:

# *Finance costs*
# *Discount rate*
# *Upper end of costs range*
# *Lower end of costs range*
# *Incremental costs*
# *Data on lumpy costs in CCS, international geosequestration, nuclear decommissioning and waste and industry.*

h1 Contents

This paper sets out the methodology used to calculate capital, operating costs and fuel costs and how we are proposing to aggregate these into the 2050 Calculator. Specific questions are set out at the end.  Structure of paper:

* Why add costs to the 2050 Calculator

* Scope: technology and fuel costs only

* Costs expressed as a range

* Costs are exogenous

* Total and incremental costs

* Defining the counterfactual

* Discounting

* Financing

* What this analysis should/not be used for

* Questions

* General comments

h1 Why add costs to the 2050 Calculator?

The 2050 Calculator (see: enables the user to experiment with different ways of reducing emissions 80% by 2050.  For every pathway produced, the Calculator currently shows the impact on emissions, energy consumption patterns across the economy, and landscape impacts (such as the area of land required to grow biocrops).

We are now aiming to update the Calculator to show the costs associated with each pathway. We will also show the Calculator's cost assumptions and data sources through the technical manual wiki.  This will allow users to see how their own cost estimates stack up against those in the Calculator.

h1 Scope: Technology and fuel costs only

The Calculator will capture the technology and fuel costs associated with supplying and using energy and producing emissions between 2007 and 2050.  Specifically:-

* On the energy supply side, this includes power stations, primary energy sources (fossil fuels, uranium and biomass) and transmission networks.
* On the energy demand side, this includes energy users (heating systems, cars and industrial plants) and demand reducing equipment such as insulation.

For these technologies, the cost includes:

* Investment costs
* Fixed operating costs
* Variable operating cost where these costs are material
* Fuel costs
* Infrastructure/system/network costs (such as electricity grid, transport network and charging points for vehicles)
* Cost of decommissioning a nuclear plant, storing nuclear waste, and storing carbon from CCS plants.  These costs are incurred beyond 2050 but we include them in our annualised costs prior to 2050.
* Finance costs (i.e interest payments on loans for expensive capital investments).  

It does not include:

* The cost of Greenhouse gases, either as a damage cost to the environment or the price of carbon in the traded sector.
* Costs of existing infrastructure - we only include the costs of technology installed or purchased from 2010 onwards.
* Welfare loss arising from behaviour change (e.g. inconvenience of living in buildings with less comfortable temperatures, loss of landscape aesthetics from wind farms, potential inconvenience of taking public transport rather than car, less international flights)
* Public safety risks (perceived or actual) associated with incumbent technologies e.g. oil extraction, or new low carbon technologies e.g. nuclear or CCS.
* R&D costs.
* Opportunity cost. The opportunity cost within sectors due to economic activity to produce low carbon technologies rather than alternative activity, such as investment in renewable power research compared to other profitable R&D. There is also the opportunity cost of existing assets. For example, the opportunity cost of agriculture producing bio-crops rather than a more profitable use of land will not be captured.
* Non-market costs such as greater air pollution and noise.
* Macro-economic costs.  We will not quantify what the pathways mean for adjustments in the wider macro economy, or for its resilience to shocks such as oil and gas price spikes, that have in the past caused recessions, business failures and job losses.
* Costs of achieving technology deployment - Administrative costs of adhering to regulations or taxation such as fuel duty or VAT or government subsidies.

h1 Costs expressed as a range

Future fuel and technology costs are highly uncertain.  The following are just a few high-level factors, which could cause future technology costs to be lower or higher:

* The climate change policy of other countries: lots of long term, predictable climate initiatives internationally could have a big effect on R&D expenditure globally which could bring down technology costs
* Technology roll out in other countries.  This could push prices up (e.g. if it results in a shortage of, say, CCS engineers), or push prices down (if learning by doing reduces unit costs).  The UK is not a very large market and so could be a price taker for many technologies.
* Technology roll out in the UK.  For example, the marginal cost of land used for wind turbines will increase as the roll out of wind increases.  Alternatively, marginal cost of installing charging points for electric vehicles may decline as the number of electric vehicles in circulation increases through learning by doing / economies of scale.

Our cost range is a simple way of capturing all the above factors.

h2 The high and low ranges

High and low costs are defined as follows:

* *The lower cost estimate for 2050 is an optimistic assessment of future technology costs, assuming technological progress drives costs down over time.  It is the lowest that credible experts can foresee the cost falling to, for example assuming technology breakthroughs and availability of the skilled staff and materials required to build and operate it.  This could arise through well designed climate policy in the UK and other countries.*

* *The upper cost estimate for 2050 is a pessimistic view, assuming minimal technological progress  over the next 40 years.  The upper estimate is the highest that credible experts can foresee the costs being and usually assumes that technology costs remain frozen at today’s prices.  This could happen if the UK and rest of the world implemented badly designed climate policy or none at all.*

In reality, we know that costs are likely to look like chart 1: falling over time with a fan of uncertainty.  In some cases, the "high" cost estimate could even stay the same or rise (e.g. gas power stations and off shore wind costs have increased in recent years driven by various factors including regulatory costs and materials prices).  Where we have high/low data for various years similar to chart 1, we have used it.

Insert chart 1

But for many sectors, data availability is very limited.  In these cases, we will represent the range as in chart 3.  The 2050 "high" estimate is the technology price today.  The 2050 "low" estimate is the lowest available estimate (which in all cases is an estimate of technology costs from economic models, sectoral studies, etc for 2050).

Question for stakeholders: we have assumed that the low cost estimate declines linearly between 2007 and 2050.  Do you have any views on whether there is a better simple methodology we could use to sketch out the trajectory between 2007 and 2050?

Insert chart 3

h1 Costs are exogenous

The high/low costs we use for each technology will be the same regardless of which pathway the user selects.  In other words, costs are treated as exogenous to the model, not endogenous.

We will do this for two reasons:

# To keep the simplicity of the Calculator. If we made the Calculator capable of modelling learning rates then it would be a less transparent, simple and accessible tool.  
# The UK is likely to be a price taker in many technologies. It would arguably be spurious accuracy because levels of technology R&D and roll out in other countries will arguably have more of an impact on the UK than our own choices (i.e. the UK is a price taker). 

Although costs are exogenous, we do make a provision for minimal technological improvement over time.  For most technologies, we will assume incremental improvements in energy efficiency over time.  So although the high, low cost estimates appear constant over time, on a like for like comparison prices are actually falling slightly.

h1 Total and incremental costs

We will capture the total cost of each technology in the Calculator.  For example, the transport cost will include the total cost of new cars purchased (rather than the incremental cost of an energy efficient car).

However for a small number of technologies we have only included the incremental costs. e.g. For new buildings, we have only included the incremental cost of "greener" buildings over and above the cost of conventional buildings.  This is because estimating house prices out over the next forty years would be too difficult.

For a given pathway, the Calculator will be able to add together these individual technology costs to work out the total cost.  This total cost will capture the cost of heating homes and businesses, producing electricity, travelling, fossil fuels, biomass and reducing emissions in agriculture and industry over the period 2007 to 2050.

By comparing the total costs of two pathways, we will be able to work out incremental cost.  The method we propose to use to calculate incremental cost is set out in the incremental cost page.

h1 Defining the counterfactual

Given that the costs in the Calculator will be total costs, rather than incremental costs, we need a counterfactual to compare the costs of any pathway against. Even if we will give users the option to pick a preferred counterfactual, we need to decide what option we will give them by default.

The simplest, easiest to understand counterfactual is to assume minimal effort across all sectors.  This si generated by selecting effort level 1 (minimum) for all sectors in the Calculator.  However we should bear in mind the followign about this "All Level 1s" pathway:

* It does not reflect the effect of existing or planned policy.
* It does not meet the 80% 2050 target.
* It makes unrealistic assumptions about energy imports. The pathway would have a strong dependence on natural gas, comprising nearly 2/3rds of primary energy demand in 2050 with the majority imported (90% including oil).
* It is not least cost - for example, there is no use of behavioural change to reduce energy demand and emissions. 

All level 1s will form our best guess counter-factual, however for the webtool we intend that users will have to choose a counterfactual to compare costs with.

h1 Discounting

The Calculator will have functionality to show costs in undiscounted or discounted form.  If we wish to discount costs (for example, to present a Net Present Value), we could use the HMG Green Book suggestion of 3.5%.  However the 3.5% rate takes account of catastrophe risk and pure time preference and there are arguments against accounting for this in climate change appraisal (as set out in Stern Review).

So alternatively we could use a lower discount rate which did not account for these elements.

Question for stakeholders: do you think we should use 3.5% or a lower discount rate?

h1 Financing

Expensive capital infrastructure such as power stations have to be paid for, by someone, at the time of construction but last for many years.  The Calculator will have functionality to present costs in the following ways:-

h2 Cash Flow

Investment costs occur at the year of deployment. The cash flow profile will show the lumpy nature of capital investments. 

h2 Financing Costs (amortised capital)

This would involve spreading the cost of capital over a typical loan period with an associated interest rate. Both will be defined by assumptions on where the investment will be funded from and the risk premium we could expect from the technology. For example, the interest rate is likely to be progressively higher using the following sources of finance: government (general taxation), government (bonds), green investment bank, private finance.

For simplicity, we would like to use the same interest rate for all technologies - we are thinking of using a real interest rate of 6.5%.

Question for stakeholders: what loan period are appropriate for different technologies?  What interest rate would be appropriate to use for all technologies? 

h1 What this analysis should/not be used for

The Calculator indicates:

* How costs and cost uncertainty varies by sector, technology and pathway
* How costs are split by capital, operating and fuel costs by technology and sector

Beyond the scope of the model:

* Testing out different policy or global scenarios.  For example:
** Effect of high roll out of nuclear globally on nuclear costs in the UK
** Effect of high levels of R&D globally
** Effect of different levels of technology roll out in the UK on costs.  e.g. Effect of "big bang" roll out of electric vehicles compared to a gradual scale up.
* Analysis of the drivers of technology costs and the effects on price
* Household bill impacts or any analysis of who pays
* Appraisal of policy options.

h1 Questions for stakeholders

# *Finance costs*: what loan periods are appropriate for different technologies?  What interest rate would be appropriate to use for all technologies?
# *Discount rate*: we could use a discount rate of 3.5% for the first 30 years and 3% for the remainder of the appraisal period (in line with HMG Green Book guidance).  However, part of the 3.5% reflects catastrophe risk and pure time preference.  There is a debate to be had on whether we should discount for these elements; excluding them would reduce the discount rate.
# *Upper end of costs range*: our upper estimate of technology costs in 2050 is technology prices today.  We judge that this is the highest that credible experts can foresee the costs being in 2050.  Do you have any views on whether this is a sensible definition of the upper estimate for all technologies? 
# *Lower end of costs range*: for simplicity, for each technology we have assumed the low cost estimate is constant between 2007 and 2050 (see graph 2).  But it would be more realistic to make this cost decline over time (see graph 3).  Views on how to do this would be helpful.
# *Incremental costs*: there are three possible ways of working out the total cost of one pathway over and above another pathway, as set out in the incremental costs page.  We propose to use a method that compares the best case for a scenario against the worst case of the counterfactual.  Your views on whether this is sensible would be helpful.
# *Data on lumpy costs in CCS, international geosequestration, nuclear decommissioning and waste and industry.*  Wherever possible, we seek to record capital costs as lumpy investments.  But for the above named technologies we have not been able to do this because the costs data has been expressed as a function of energy output.  Any data to correct this would be appreciated.

h1 General comments

Please add any general comments or responses to above questions in here.

User: Sophie Hartfield

Picture updated at: 

Signed off by: Sophie Hartfield

Signed off at: 2011-08-10 10:58:10 UTC