Upsizing – the other half of the hidden side of CapEx

1. Upsizing – the other half of the hidden side of CapEx Presented at the Electricity Engineers Association (EEA) Conference, Christchurch, June 2008 by Phil Caffyn from Utility Consultants Ltd. www.utilityconsultants.co.nz

2. Disclaimer • This presentation has been prepared primarily for the EEA Conference 2008 and is not to be relied upon by event participants or any other person as professional advice. • This presentation has been compiled at the invitation of the EEA. Neither the EEA nor its officers or its employees take any responsibility for the factual accuracy of this presentation, nor for any opinions, views or biases in 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. Scope of application • This presentation has been prepared primarily for an electricity lines audience, with examples drawn from that sector. • However the principles of upsizing and many of the comments about regulatory price control will be applicable to other network infrastructure sectors such as gas, water, sewage, drainage, roads and rail. www.utilityconsultants.co.nz

4. Presentation topics • What actually is upsizing. • The other half of the hidden side of CapEx. • Investment characteristics of CapEx modes. • Why should assets be upsized. • When should assets be upsized. • The regulatory issues around headroom. • The regulatory issues around spend plans. • Five quick things to take away. • More information. www.utilityconsultants.co.nz

5. What actually is upsizing www.utilityconsultants.co.nz

6. What actually is upsizing • Upsizing is the replacement of a non-consumable component with a non-consumable component of greater functionality (usually capacity, but increasingly often, voltage). • Two key criteria for upsizing... • Must involve replacing a non-consumable component with a non-consumable component. • Must increase functionality. • Table on the next page illustrates the upsizing concept using an overhead electric line. www.utilityconsultants.co.nz

7. What actually is upsizing www.utilityconsultants.co.nz

8. What actually is upsizing • Couple of issues arise from the previous table... • What if the frayed conductor is replaced with a bigger conductor – do we treat that as renewal or upsizing ?? • Suggested approach – might want to consider allocating between both categories, but perhaps more importantly, be consistent over time. • What about areas where technology is advancing rapidly (eg. SCADA) and a like-for-like replacement (renewal) is impossible ?? Does that need to be treated as an upsizing. • Suggested approach – treat as a renewal, but again be consistent over time. www.utilityconsultants.co.nz

9. The other half of thehidden side of CapEx www.utilityconsultants.co.nz

10. The other half of the hidden side • As set out in the previous table, there are five broad types of CapEx… • Renewal. • Upsizing. • Extension. • Overhead to underground conversion (OHUG). • Reliability enhancements. • Each of these different types of CapEx has different characteristics and arises in different circumstances. • Following chart indicates these circumstances and tries to apply some easily understood terms to those circumstances… www.utilityconsultants.co.nz

11. The other half of the hidden side The hidden aspect is the important bit of this argument. www.utilityconsultants.co.nz

12. The other half of the hidden side • As indicated the other half of the hidden side of CapEx is renewal. • Renewal is replacing a non-consumable component with a non-consumable component of equal functionality (usually capacity). • So why have I called upsizing and renewal “the hidden side of CapEx” ?? • Because they can be deferred or avoided, usually with no immediately obvious consequences but often with catastrophic eventual consequences (the big storms in Queensland in early 2004 are a good example). www.utilityconsultants.co.nz

13. The other half of the hidden side • In contrast extensions cannot be avoided because a physical connection between the existing network and the new customer must be provided. • The following Investment Strategy Matrix identifies the predominant CapEx mode under each of four growth scenarios. • In particular, upsizing will be a predominant CapEx mode if growth is occurring within the existing network footprint. • If the growth is occurring outside of the existing footprint, existing assets will still need to be eventually upsized. www.utilityconsultants.co.nz

14. The other half of the hidden side Growth outside the existing network footprint will firstly require extensions, but will also ultimately require upsizing to meet increased demand and security Growth within the existing network footprint will require upsizing to meet increased demand and security www.utilityconsultants.co.nz

15. The other half of the hidden side • With upsizing and renewal the physical connections are already in place and the electricity just keeps on flowing. • So it’s very easy to overlook an undersized asset as long as the electricity keeps flowing - afterall how many of us have said something like “sure we can get another winter (or summer) out of those cables”. • When the total CapEx budget is fixed and new consumers are wanting connection (extensions), guess which modes of CapEx are most likely to take the hit (again, the Queensland storms in 2004) ?? www.utilityconsultants.co.nz

16. Investment characteristicsof CapEx modes www.utilityconsultants.co.nz

17. Investment characteristicsof CapEx modes • Already commented that the three predominant modes of CapEx (renewals, extensions and upsizing) have different investment characteristics. • Useful to take a slight diversion from the main theme of upsizing to quickly compare and contrast the investment characteristics of these three modes. www.utilityconsultants.co.nz

18. Investment characteristicsof CapEx modes www.utilityconsultants.co.nz

19. Investment characteristicsof CapEx modes www.utilityconsultants.co.nz

20. Investment characteristicsof CapEx modes www.utilityconsultants.co.nz

21. Investment characteristicsof CapEx modes www.utilityconsultants.co.nz

22. Why should assets be upsized www.utilityconsultants.co.nz

23. Why should assets be upsized • This is the simplest of the two headline questions - the short answers are… • The need to provide sufficient capacity for present and future demand. • The need to provide sufficient security of supply for both the present and future. • I’ll use the broad term “headroom” to embrace both of these concepts. • Both of these answers embody a wide range of engineering, economic and regulatory issues which the following sections will try to address. www.utilityconsultants.co.nz

24. When should assets be upsized www.utilityconsultants.co.nz

25. When should assets be upsized • The ideal answers for an ideal world are… • Just before its needed (and when that might be is likely to depend strongly on the assets criticality). • Just a little bit at a time. • This would be a curve exactly following the demand or required security headroom increase – perhaps like a giant hand slowly winding up a knob. • For those of us in the real world, investment is likely to be stepped or lumpy like this… www.utilityconsultants.co.nz

26. When should assets be upsized www.utilityconsultants.co.nz

27. When should assets be upsized • Like any other business decision, the “when to upsize” decision is just a matter of maximising benefits and minimising costs subject to any constraints. • Lets re-visit the previous chart and examine exactly what these benefits, costs and constraints are. • It goes without saying that in these sorts of situations the predominant benefit will be avoiding the risk of asset failure (and hence supply interruption). www.utilityconsultants.co.nz

28. When should assets be upsized Over investment Possible constraint of maximum recovery of investment Risk of failure due to under investment One-off cost of works www.utilityconsultants.co.nz

29. When should assets be upsized • If we muck about with the time interval between upsizing we can derive the following two curves... www.utilityconsultants.co.nz

30. When should assets be upsized • These two curves have different whole of life costs as follows... • Reduces one-off works costs. • Increases level of over investment. • May increase risk of failure due to under investment (depends on when next upsizing is timed). • May reach the limit of how much investment can be recovered, and may therefore include regulatory risk. www.utilityconsultants.co.nz

31. When should assets be upsized • These two curves have different whole of life costs as follows... • Increases one-off works costs. • Reduces level of over investment. • May reduce risk of failure due to under investment (depends on when next upsizing is timed). • Unlikely to reach the limit of how much investment can be recovered, so unlikely to include regulatory risk. www.utilityconsultants.co.nz

32. When should assets be upsized • Plotting the value of each cost against the time interval between upsizing gives something like this… Total costs Cost of under investment (depending on when upsizing occurs – likely to accelerate away rather than be linear Optimum time interval between upsizing Cost of over investment One-off costs www.utilityconsultants.co.nz

33. When should assets be upsized • Key features of the previous chart include... • As one-off costs increase (resource and building consents, design, fuel, travel time, reinstatement etc) the optimum time interval between upsizing increases. • As the costs of under investing increases (increased risk of asset failure due to insufficient capacity or security headroom) the optimum time interval between upsizing decreases (the precise shape of this curve will reflect both the asymmetry between under and over-investing and the likely acceleration of failure probability as demand exceeds capacity). www.utilityconsultants.co.nz

34. When should assets be upsized • What is difficult to show on this chart is that as the interval between upsizing increases, the constraints in the ODV Handbook may be reached. • This may introduce regulatory risk into this cost which in turn may merit a WACC higher than that applied to invested capital for which recovery is certain. www.utilityconsultants.co.nz

35. When should assets be upsized Investment beyond the headroom limits set out in the ODV Handbook could incur a higher WACC because of regulatory uncertainty www.utilityconsultants.co.nz

36. The regulatory issuesaround headroom www.utilityconsultants.co.nz

37. The regulatory issuesaround headroom • In broad terms the ODV Handbook allows the following load growth horizons to be rolled into the ODV… • 15 years for trans lines, sub-trans lines, zone subs (excl. transformers), primary distribution lines and grid connection points. • 10 years for zone sub transformers. • 5 years for HV and LV distribution. • Nil for distribution transformers. • My view is that this limits the amount of capacity and security headroom investment that can be rolled into the ODV and therefore recovered from consumers. www.utilityconsultants.co.nz

38. The regulatory issuesaround headroom • Asset owners could therefore adopt one of two approaches… • Upsize to the level suggested by the optimum time interval and accept that at least some of this investment may be unrecoverable (or at least until any revaluation occurs). • Upsize to the limit allowed by the ODV Handbook and accept that the time interval to the next upsizing may be sub-optimal (ie. will incur greater than necessary one-off costs). www.utilityconsultants.co.nz

39. The regulatory issuesaround spend plans www.utilityconsultants.co.nz

40. The regulatory issuesaround spend plans • Since the requirement to disclose AMP’s emerged late last century, my view is that the emphasis has been on the format and the words rather than on the spend plans, which is obviously concerning. • Over the last two years I have suggested to several lines businesses that they disaggregate their spend projections by both asset class and by spend category, and that in particular they clearly separate their CapEx into renewals, extensions and upsizing to help them understand in their own minds the different investment characteristics of each mode. www.utilityconsultants.co.nz

41. The regulatory issuesaround spend plans • The latest requirements for presenting spend plans are set out in paragraphs 446 to 466 of the Commerce Commission’s Companion Paper to the Exposure Draft of 20 December 2007. • These requirements are similar to my suggested CapEx disaggregation as follows… • Customer connections • System growth • Replacement & renewal • Reliability, safety & environmental • Non-system. www.utilityconsultants.co.nz

42. The regulatory issuesaround spend plans • However my personal view is that the Commission’s disaggregation doesn’t go far enough… • System growth should be further split into upsizing and extensions because these two modes of CapEx have different investment characteristics. • Reliability should be separated from safety & environmental because of the somewhat discretionary nature of reliability versus the largely unavoidable nature of safety and environmental, and also because they benefit different stakeholder groups. www.utilityconsultants.co.nz

43. The regulatory issuesaround spend plans • However the Commission is the final authority on this matter and their published requirements will need to be complied with as a minimum requirement. www.utilityconsultants.co.nz

44. Five quick things to take away www.utilityconsultants.co.nz

45. Five quick things to take away • Upsizing requires a non-consumable component to be replaced with a non-consumable component of greater functionality. • Upsizing (and renewal) can be very much hidden, so care must be taken not to overlook their requirements. • Recovering the cost of upsizing (and renewals) is likely to be indirect, as opposed to extensions which usually bring direct revenue and customer contributions. www.utilityconsultants.co.nz

46. Five quick things to take away • The principal benefit of upsizing is avoiding supply interruption, hence the optimum time to upsize must consider an assets criticality – if necessary err on the side of sooner rather than later. • Spend plans will need to be disaggregated to at least the level specified in the December 2007 Companion Paper. www.utilityconsultants.co.nz

47. More information www.utilityconsultants.co.nz

48. More information • Phone +64-7-8546541 • Mobile +64-21-606670 • Email phil.caffyn@utilityconsultants.co.nz • Skype philcaffyn • Web www.utilityconsultants.co.nz • Web www.capex.cjb.net www.utilityconsultants.co.nz

49. More information • Slide shows on similar issues… • Implementing the UK asset management specification PAS 55-1:2004 in the infrastructure sector. Request • Getting the CapEx right in the infrastructure sectors. Request • Setting service levels for utility networks. Request • Tariff control of pipes & wires utilities – where is it heading. Request www.utilityconsultants.co.nz

50. More information • Visit Utility Consultants library to request other slide shows, monographs and research reports. • Visit Utility Consultants specialist CapEx website for more insights. www.utilityconsultants.co.nz