Getting the CapEx right in the infrastructure sectors

1. Getting the CapEx right in the infrastructure sectors Phil Caffyn, Utility Consultants Ltd www.utilityconsultants.co.nz Please read disclaimer on second page

2. Disclaimer • This presentation has been prepared for the sole purpose of the NZIGE Spring Technical Seminar 2007 and is not to be relied upon by event participants or any other person as professional advice. • This presentation has been compiled by Utility Consultants Ltd at the invitation of the NZIGE. Neither the NZIGE, its officers or their employers take any responsibility for the factual accuracy of this presentation or for any views, opinions or biases in the content of this presentation. • Utility Consultants Ltd as the author of this presentation shall not be liable in any way whatsoever for any action or failure to act based on the content of this presentation. www.utilityconsultants.co.nz

3. Context for this presentation • This presentation has been prepared for an audience of gas engineers in New Zealand however the general principles discussed in this presentation will be applicable to other network infrastructure. • The context for this preparation includes four converging issues… • A significant shift in the New Zealand government’s thinking on the need to encourage investment in network infrastructure following a blackout at Otahuhu grid exit substation in June 2006. • The review of Part 4A of the Commerce Act (which sets out the regulatory framework for electricity lines price control). • The on-set of the bow-wave of renewals of much of New Zealand’s infrastructure. • A seeming increasing number of asset failures which always seems to spook government agencies. www.utilityconsultants.co.nz

4. Presentation topics • What is CapEx ?? • Different types of CapEx. • How can we get the CapEx wrong ?? • And what’s so wrong about getting the CapEx wrong ?? • How can we get the CapEx right ?? • Getting the right amount of CapEx at the right time. • Regulatory incentives for CapEx. • Valuation & optimisation risks. • Bringing together some practical approaches to getting the CapEx right. • Contact me for more info. www.utilityconsultants.co.nz

5. What is CapEx ?? www.utilityconsultants.co.nz

6. What is CapEx ?? • Short definition of CapEx is funds that are spent on stuff that outlives the current financial year. • In contrast OpEx is funds that are spent on stuff that is fully consumed within the current financial year. • Stuff that CapEx is spent on is called “capital assets”. • CapEx has two key characteristics… • Must be depreciated in the Statement Of Financial Performance (can’t be fully expensed, which reflects its life beyond the current financial year). • Must be added to the Statement Of Financial Position in accordance with specified rules. www.utilityconsultants.co.nz

7. Different types of CapEx www.utilityconsultants.co.nz

8. Different types of CapEx • I’ve found it useful to define three types of CapEx… www.utilityconsultants.co.nz

9. Different types of CapEx • These three different types of CapEx tend to occur in the following circumstances… www.utilityconsultants.co.nz

10. Different types of CapEx • The three different types of CapEx tend to have the following characteristics… www.utilityconsultants.co.nz

11. Different types of CapEx www.utilityconsultants.co.nz

12. Different types of CapEx www.utilityconsultants.co.nz

13. Different types of CapEx www.utilityconsultants.co.nz

14. How can we get theCapEx wrong ?? www.utilityconsultants.co.nz

15. How can we getthe CapEx wrong?? • Quite simple really – in fact the chances of getting it wrong on either or both of two critical dimensions are probably higher than the chances of getting it right !!! • We can get the scope of work wrong… • Too much. • Too little. • We can get the timing wrong… • Too soon. • Too late. • The following 3x3 matrix depicts the possible choices along these two dimensions… www.utilityconsultants.co.nz

16. How can we getthe CapEx wrong?? www.utilityconsultants.co.nz

17. How can we getthe CapEx wrong?? • The coloring of each cell in the matrix probably merits some explanation… • Firstly the fact that only cell #5 is green, and not cells #2, #4, #5, #6 and #8 suggests that both the scope and timing must be right – not simply one or the other. • Secondly the fact that cells #1 and #9 are not green suggests that scope cannot be traded off with timing. • Thirdly the fact that cells #4, #7 and #8 are not green suggests that over-investment is not good. • Fourthly the fact that cells #4, #7 and #8 are a different color to cells #1, #2, #3, #6 and #9 suggests some sort of asymmetry between under and over-investment. www.utilityconsultants.co.nz

18. How can we getthe CapEx wrong?? • So here’s how we can get the CapEx wrong… • By failing to understand that both the scope and timing of the work must be right. • By assuming that scope and timing can always be traded off (and the reality is that some small trade-offs are possible, but these tend to be small). • By failing to understand the different nature and consequences of the risks of under and over-investment. www.utilityconsultants.co.nz

19. And what’s so wrong aboutgetting the CapEx wrong ?? www.utilityconsultants.co.nz

20. And what’s so wrong aboutgetting the CapEx wrong ?? • Actually … there’s heaps wrong with getting the CapEx wrong !!! • If the CapEx is too late, an asset may cross the threshold of minimum acceptable service (and may also fail catastrophically). • If CapEx is too soon, the company incurs a cost of capital sooner than it needs to and may also be discarding unconsumed component life. • If CapEx is too much, there is the risk that it cannot be fully rolled into the Regulatory Asset Value. • If the CapEx is too much the regulator may also conclude that CapEx is “inefficient” or “unjustified” – kind of relates to the above but on a wider scale. www.utilityconsultants.co.nz

21. And what’s so wrong aboutgetting the CapEx wrong ?? • If you’re a UK distributor and your estimated CapEx is more than OFGEM’s estimate you miss out on the reward for being close to OFGEM’s estimates under the Information Quality Incentive (which was included in EDPCR4 and is being included in the current GDPCR). • It should be clear by now that the nature of the risks of getting the CapEx wrong are asymmetrical – the consequences of too little and/or too late are very different from the consequences of too much and/or too soon. • What may not be clear is that the magnitudes of these risks are also hugely different because some form of catastrophic failure often occurs – an explosion, a crash, a derailment etc. www.utilityconsultants.co.nz

22. And what’s so wrong aboutgetting the CapEx wrong ?? • To labor the point a bit more consider the price paid for a kWh of gas (10 … maybe 15 cents), and then consider the losses if that kWh is not supplied... • Patrons walking out of a café because their meals weren’t served. • Guests bailing out of a hotel because there is no hot water. • Molten product such as aluminium, steel or chocolate freezing in a mould. • Delicate processes such as glass blowing, spray painting or annealing being interrupted. • To further labor this asymmetry consider the different consequences of over and under-investing in the rail network !!! www.utilityconsultants.co.nz

23. And what’s so wrong aboutgetting the CapEx wrong ?? • Just to close this section it would be worth noting the recent shift in New Zealand regulatory thinking on this asymmetry. • My view is that some (and certainly not all) regulators have been slow to recognise this asymmetry – will stand corrected on this point if need be !!! • That was until June 12th 2006 when a shackle broke at Otahuhu Substation and Auckland was in the dark for a whole morning. • Within 2 months the Ministers of Commerce and Energy had both released statements recognising the asymmetry of under and over-investing, and of correctly incentivising investment in regulated infrastructure. www.utilityconsultants.co.nz

24. How can we getthe CapEx right www.utilityconsultants.co.nz

25. How can we getthe CapEx right • Correct implementation of CapEx can be broken into six reasonably distinct activities, as follows... • #1 - identifying and understanding why and when CapEx (or any other sort of work) needs to be done to an asset – these are the trigger points for each asset or class of asset. • #2 - continually monitoring each asset for breaches of the trigger levels. • #3 - identifying and understanding the options available to restore asset performance to below the trigger levels. • #4 - identify the option that best meets the business’ priorities. www.utilityconsultants.co.nz

26. How can we getthe CapEx right • #5 - implement the chosen option. • #6 - confirm that the benefits are actually occurring, and capture the learning from each project to feed back into the organisations accumulated experience. • We now need to examine each of these six activities in detail, but most importantly we need to understand that getting the CapEx right actually starts a long way before considering the merits of individual CapEx projects. www.utilityconsultants.co.nz

27. How can we getthe CapEx right • Step #1 is to identify and understand the trigger points associated with each asset or class of assets. • All assets exist to create some sort of outcome – capacity, reliability, security, pressure drop, safety etc. • The assets create outcomes through their physical characteristics eg. a 6” pipe creates a different pressure drop outcome than a 4” pipe for the same flow. • We can then define an acceptable pressure drop trigger for all 6” pipes, and for all 4” pipes and so on. • We can then define similar trigger points for all the other service levels. www.utilityconsultants.co.nz

28. How can we getthe CapEx right • This leads to a table like the following (example drawn from an electricity distribution context). www.utilityconsultants.co.nz

29. How can we getthe CapEx right • Step #2 is to monitor the actual performance of each asset against the established trigger levels. • This monitoring and comparison can range from on-line real-time SCADA to off-line testing and inspection of components. • When trigger levels are exceeded the organisation needs to make a decision – in some cases these may be a simple operational decision, but in some cases an asset characteristic or configuration decision will need to be made. www.utilityconsultants.co.nz

30. How can we getthe CapEx right • Step #3 is to firstly understand and then secondly identify what options are available to bring the assets performance back under the trigger levels. • Those options include a range of non-CapEx solutions such as (again drawn from an electrical context)… • Do-nothing eg. let the voltage on a long rural feeder drop below 0.94pu for a few days per year (would only only do this is if the risk profile was contained). • Operational activities eg. switching load to a lightly loaded supply point. • Demand side measures eg. encouraging off-peak usage. www.utilityconsultants.co.nz

31. How can we getthe CapEx right • Lift an assets’ trigger point eg. forced cooling on a transformer. • Re-think an assets’ trigger point eg. using fancy software to re-rate transmission lines closer to the trigger point (making the most of the generous design margins of a by-gone era). • Adopt a CapEx solution – up-size, renew or extend the asset. • Important to understand that each of these options will affect the business’ performance in different ways – service delivery, cashflow, profitability, depreciation, tax, asset valuation etc. www.utilityconsultants.co.nz

32. How can we getthe CapEx right • Important to also recognise that unless demand growth is very low many of these options will only defer CapEx, they will not avoid it. • In that context it probably merits noting that high global prices for key inputs such as plastic, steel, cement, copper and man-power mean that it will probably be cheaper to do CapEx sooner rather than later. • Traditional reasoning of avoiding capital charge of about 10% per year breaks down when input costs are escalating in some cases at 30% per year !! www.utilityconsultants.co.nz

33. How can we getthe CapEx right • Step #4 is to identify which option (CapEx or otherwise) will best fulfil the business’ objectives. • Projects (CapEx or otherwise) must compete in two senses… • Firstly they must compete in an absolute sense against pre-defined criteria such as Discount Rate or Payback Period to see whether it will add or destroy value. • Secondly they must compete in a relative sense against other projects on the basis of how much they contribute to the business’ overall priorities. • First step tends to be simple – classical NPV analysis using a defined Discount Rate. www.utilityconsultants.co.nz

34. How can we getthe CapEx right • Accept or reject the project based on the NPV of its discounted cashflows – might also reject the project if its payback period is too long. • Second step arises from CapEx rationing, and may involve rejecting projects that could create value for the business. • This requires the business to not only know what its objectives are but to also have a clear sense of priority amongst competing and potentially conflicting goals. • Important that both costs and benefits are realistic and don’t include people’s bias either for or against the project. www.utilityconsultants.co.nz

35. How can we getthe CapEx right • Step #5 is to implement the chosen option. • This option must obviously firstly create value for the business and secondly contribute more to the business’ priorities than other projects. www.utilityconsultants.co.nz

36. How can we getthe CapEx right • Step #6 is to capture the learning experience from the project and modify the business’ processes, thinking and behavior. • Important to confirm that projected benefits are actually occurring, especially if they are based on subjective parameters such as the probability of a supply interruption occurring, the value of energy not served, or the likely extent of a catastrophic failure. • Key issue is knowing whether an event didn’t happen because the project was done, or whether it wouldn’t have happened anyway. www.utilityconsultants.co.nz

37. How can we getthe CapEx right • Also important to capture the little quirky, qualitative things that can make or break a project… • Who the best people to deal with in various agencies are (and who are the ones to avoid). • Which suppliers provide good service. • Which model or type of product has the cheapest installed costs. • Which products require extensive IT upgrade or support to make them work. www.utilityconsultants.co.nz

38. Getting the right amount ofCapEx at the right time www.utilityconsultants.co.nz

39. Getting the right amount ofCapEx at the right time • The colored 3x3 matrix indicated that there are two dimensions to getting the CapEx right – scope and timing. • Until we perfect the art of telling the future with absolute certainty getting both of these dimensions right will be very difficult. • I would go as far as to say that erring on a slight over-investment slightly ahead of time would be the best approach – aiming for cells #4 or #8, or even cell #7 if the consequences of getting it wrong are severe. • So this section presents a couple of rules of thumb for getting the CapEx right… www.utilityconsultants.co.nz

40. Getting the right amount ofCapEx at the right time • Amount of CapEx (scope)… • First rule of thumb – is the total annual depreciation for the whole asset base being off-set by renewal CapEx ?? • Second rule of thumb – if it is not, does including the up-sizing CapEx off-set the total annual depreciation ?? • Third rule of thumb – is the total annual depreciation for each class of asset being off-set by renewal CapEx ?? • Fourth rule of thumb – if it does not, does including the up-sizing CapEx off-set the total annual depreciation for each asset class ?? www.utilityconsultants.co.nz

41. Getting the right amount ofCapEx at the right time • Timing of CapEx… • First rule of thumb – what are the risks if renewal (or up-sizing) occurs too late – is it catastrophic (eg. a ruptured steam pipe in down-town Manhattan) or is it inconsequential (eg. a 5kVA transformer in a remote rural area cooks itself) ?? • Second rule of thumb – what are the risks if renewal or up-sizing occurs too soon – could that CapEx be disallowed from inclusion in the RAV ?? www.utilityconsultants.co.nz

42. Getting the right amount ofCapEx at the right time • The previous page suggests that the disciplines of CapEx scope and timing are both strongly risk driven. • Timing the CapEx right involves the following… • Knowing the shape of an assets “decline in service capability” curve. • Knowing what mix of parameters drive that curve. • Knowing exactly how far along that curve we are. • Practical reality is that while we can statistically predict the likely failure rate for a large population of assets, we can’t predict the failure of any single asset. • Pick here to discuss this issue further with me. www.utilityconsultants.co.nz

43. Regulatory incentives for CapEx www.utilityconsultants.co.nz

44. Regulatory incentives for CapEx • Most infrastructural assets are subject to tariff regulation to safeguard “customer interests” in the face of supposed monopoly suppliers. • Over the period 1990 to about 2003 most regulators seemed to have interpreted the phrase “customer interests” as driving down tariffs. • So when regulators have used a building block approach to compiling or assessing allowable tariffs it’s not surprising that CapEx gets a lot of scrutiny (usually second after WACC and efficiency carry overs). • Its also not surprising that infrastructure owners have tried to boost profits by withholding approved CapEx. www.utilityconsultants.co.nz

45. Regulatory incentives for CapEx • However, as discussed previously, regulatory thinking seems to have shifted over the last 2 or 3 years to recognise the asymmetry of under and over investing. • Hence we might expect that regulators would be less inclined to disallow proposed CapEx. • While that seems to be happening, there are also several other factors in play … • Steep increases in renewal CapEx compared to previous control periods as the bow wave of renewals kicks in. • Steep increases in up-sizing CapEx as demand grows and the need to both meet demand and restore security head-room is recognised. www.utilityconsultants.co.nz

46. Regulatory incentives for CapEx • Steep increases in renewal CapEx to catch up where funds were diverted toward extensions. • Steep increase in renewal CapEx to catch up where funds may have been diverted to profit. • These other factors make it difficult to clearly say that regulators are less inclined to disallow CapEx, but it seems to be pointing in that direction. • What is clear is that regulators are augmenting tariff control regimes with additional features to better incentivise infrastructure owners to get the CapEx right. www.utilityconsultants.co.nz

47. Regulatory incentives for CapEx • These incentives generally allow an increased revenue take so the infrastructure owner can boost their profit through increased revenue rather than by cutting costs (which was generally renewal and up-sizing CapEx). • Some of the features used to incentivise CapEx are... • S-Factor (used in the Victorian electricity sector). • Information Quality Incentive (used in the UK electricity and gas sectors). • Ex-post CapEx review. • Guaranteed Service Levels (used in the Victorian electricity sector). • Promoting certification of processes and systems. www.utilityconsultants.co.nz

48. Regulatory incentives for CapEx • S-Factor essentially augments the CPI-X tariff control by adding a Service Factor to reflect under-performance or out-performance of target reliability levels. • If an infrastructure owner out-performs the reliability target for any given year set by the regulator at the start of the control period, they are rewarded by an increased tariff in the subsequent year. • Conversely if they under-perform the reliability target, they are penalised with a decreased tariff in the subsequent year. • Reliability performance is, of course, something that an infrastructure operator can influence through their CapEx spend. www.utilityconsultants.co.nz

49. Regulatory incentives for CapEx • Information Quality Incentive is based on the premise that an infrastructure owner may seek to artificially inflate its CapEx requirements to obtain a higher tariff and then take the excess funds as profit. • The core of this argument is that it is difficult for a regulator to discern between genuinely required CapEx and artificially inflated CapEx. • Under an IQI approach, infrastructure owners are incentivised to make their requested CapEx as close as possible to that estimated by the regulator (OFGEM in this case), with the key parameter being the ratio of the owner’s forecast to OFGEM’s forecast. www.utilityconsultants.co.nz

50. Regulatory incentives for CapEx • These IQI’s take the following forms... • Retaining a higher percentage of any under-spent CapEx relative to the owner’s forecast (up to a maximum of 40% if the owner’s forecast matches OFGEM, and down to 20% for a ratio of 140%). • Capturing (or foregoing) a specified percentage of the forecast CapEx as additional revenue (ranging from 2.5% if the owner’s forecast matches OFGEM, down to -3.5% for a ratio of 140%). • Being allowed to spend a specified percentage of OFGEM’s forecast CapEx (up to a maximum of 110% for a ratio of 140%). www.utilityconsultants.co.nz