Investment project appraisal.

In this example, we will consider a common scenario where a company needs to decide what type of new boiler to purchase. It needs to consider the initial outlay that's the CapEx, as well as the ongoing operating costs, including carbon costs. In this scenario, the company has two options. It could buy a cheaper boiler based on traditional, heavy fuel oil technology, or a more expensive biomass boiler that will cost more to acquire. But the operating costs would be lower for the biomass boiler. Carbon costs need to be considered alongside the other operating costs, and they are lower in the case of the biomass boiler.

Analysis of the net present value of the project will reveal which technology should be used. It may be that without the inclusion of the carbon price the heavy fuel oil boiler would work out better. But, after including the carbon costs, the decision swings in favor of the more modern biomass boiler. In the following numerical example, we consider a scenario in which a company needs to purchase 25 vans to support its operations. It is considering two options. The first one is a purchase of vans with petrol engines. The second option is to buy hybrid vans. The left hand side shows the assumptions, the cost of the 25 hybrid vans would be higher while their petrol consumption would be lower in the case of the hybrids leading to lower annual fuel costs. In the table on the right we calculate the net present value of the project on a per van basis. In this case, it is the net present value of the difference between a petrol van and a hybrid van. The calculation shows the difference in the initial outlay offset by the difference between the annual running costs. The hybrid vans would cost 5,000 pounds each more while the annual running costs would be 1,105 pounds lower for each hybrid van.

We assume that the cost of capital that's the discount rate is 7% and we ignore taxes to keep the illustration simple and we'll assume that the residual values after five years are the same for both types of vehicle. The calculation shows that the net present value from buying the hybrids rather than the petrol vans is actually negative, meaning that this is not worth spending more initially and investing in the hybrids. We now revisit the same scenario, but consider the carbon emissions generated by the vans by reflecting such costs in the cash flows. Again, we focus on the differences between the two options. The assumptions shown on the top part of the left panel are the same as earlier. At the bottom of the left panel we include our carbon assumptions as is commonly assumed the expectation is that burning one liter of petrol generates about 2.3 kilograms of carbon emissions. The carbon price is assumed to be 80 pounds and the carbon cost is calculated by multiplying the annual CO2 emissions in tons by the carbon price per ton. For petrol vans, that is 4,600 kilograms which is 4.6 tons multiplied by 80 pounds giving 368 pounds per annum of carbon cost.

For hybrid vans, we multiply 2.645 tons by 80 pounds giving 211 pounds, 60 per annum of carbon cost. The data on the right shows the calculation of the net present value of buying a hybrid van rather than a petrol vehicle. This time, we incorporate the carbon saving of 156 pounds 40 per van per year, which is the difference between 368 pounds for the petrol van and 211 pounds 60 for the hybrid van into the calculation. We can see that the resulting savings from buying the more fuel efficient hybrid vehicle leads to a different conclusion than before. It is because in this scenario with carbon prices the net present value is positive and leads to the conclusion that the hybrid van should be bought instead of the petrol vans.