Renewals – (half) the hidden side of CapEx

1. Renewals – (half) the hidden side of CapEx Presented to the Electricity Network Asset Management Summit, Wellington, November 2007 by Phil Caffyn from Utility Consultants Ltd. www.utilityconsultants.co.nz

2. Disclaimer • This presentation has been prepared primarily for the Conferenz ENAMS 2007 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 Conferenz. Neither Conferenz 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 CapEx 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 renewal. • The other half of the hidden side of CapEx. • Some context for the renewal activity. • Why should assets be renewed. • When should assets be renewed. • Accounting for renewal – keeping the CFO happy. • Justifying renewal – keeping the regulator happy. • Some practical aspects of renewal. • Three things to take away. • More information. www.utilityconsultants.co.nz

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

6. What actually is renewal • Renewal is the replacement of a non-consumable component with a non-consumable component of equivalent functionality (usually capacity). • Two key criteria for renewal... • Must involve a non-consumable component. • Must not increase functionality. • Table on the next page illustrates the renewal concept using an overhead line. www.utilityconsultants.co.nz

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

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

9. The other half of the hidden side • As set out in the previous table, there are five broad types of CapEx… • Renewal. • Up-sizing. • 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

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

11. The other half of the hidden side • As indicated the other half of the hidden side of CapEx is up-sizing. • Up-sizing is replacing a non-consumable component with a non-consumable component of greater functionality (usually capacity, but sometimes voltage). • So why are renewal and up-sizing called “the hidden side of CapEx” ?? • Because they can be deferred or avoided, usually with no immediately obvious consequences but often with catastrophic eventual consequences. www.utilityconsultants.co.nz

12. 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. • With renewals and up-sizing the physical connections are already in place and the electricity just keeps on flowing. • So it’s very easy to overlook the deteriorating asset condition and the diminished security headroom 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”. www.utilityconsultants.co.nz

13. The other half of the hidden side • When the total CapEx budget is fixed and new customers are wanting connection (extensions), guess which modes of CapEx take the hit ?? • This deterioration in asset condition and diminished headroom was identified as a key cause of the widespread outages in Queensland during the storms in January 2004. • Anyway that’s enough on up-sizing - let’s get back to the main theme of renewals. • Pick here to talk some more about up-sizing. www.utilityconsultants.co.nz

14. Some context for therenewal activity www.utilityconsultants.co.nz

15. Some context • Most commentators agree that infrastructural assets are in need of serious renewal spending to maintain service levels, and in some sectors, to avoid catastrophic failure. • Recent infrastructure scorecard results… • United States - D overall. • Australia - C+ overall. • South Africa – D+ overall. • New Zealand – C overall. • Little reason to conclude that other countries would be any better. www.utilityconsultants.co.nz

16. Some context • It is acknowledged that in some (perhaps many) areas the predominant CapEx mode will be up-sizing, however the estimated cost of global renewals over the next 5 years alone runs into trillions of dollars. • So the context for renewals is the urgent need to renew significant percentages of infrastructure across most sectors in many countries. • For more insights on the specific issues of improving CapEx processes, pick here. www.utilityconsultants.co.nz

17. Why should assets be renewed www.utilityconsultants.co.nz

18. Why should assets be renewed • Two reasonably succinct answers to this… • Because eventually assets cease to deliver an acceptable level of service. • Some classes of assets either fail catastrophically or create dangerous situations. • This is obviously distinct from assets that need to be up-sized, however there will still be many low-growth areas where the predominant CapEx mode will need to be renewal ie. assets are wearing out rather than becoming too small – refer to the model on the next page… www.utilityconsultants.co.nz

19. Why should assets be renewed Emphasis of this presentation on renewals restricts the argument to this quadrant. www.utilityconsultants.co.nz

20. When should assets be renewed www.utilityconsultants.co.nz

21. When should assets be renewed • The purest theoretical answer would be “immediately before the asset ceases to deliver an acceptable level of service”. • In practice it depends on the following factors… • How critical is it to avoid service levels declining to an unacceptable level. • How critical is it to avoid catastrophic failure. • How critical is it to avoid discarding unconsumed component life. • Following chart illustrates many of the above principles. www.utilityconsultants.co.nz

22. When should assets be renewed www.utilityconsultants.co.nz

23. When should assets be renewed • Most significant feature of the curve is that the decline in service level is probabilistic … although we might be able to say that a certain percentage of assets will cease to perform (or even fail) in the next year, it is hard to say exactly which individual assets will fail because we are unlikely to know the exact shape of the curve and how far along it we are for each individual asset. • This suggests that a large part of asset renewal is about risk and risk avoidance, and further suggests that avoiding service level lapses or asset failures is a key driver of prioritising renewals. www.utilityconsultants.co.nz

24. When should assets be renewed • A risk approach lends itself to some rules of thumb for renewals (and indeed asset inspections)... • Assets that supply many customers or single large customers should be renewed sooner rather than later to avoid service interruptions, whilst assets that supply only a few customers could be run to breakdown. • Assets that could represent a safety hazard should be renewed sooner rather than later to avoid death, injury or damage, whilst assets that don’t present a safety issue could possibly be run to failure. • Emerging conclusion is that assets that are critical to either customer service or safety should be renewed sooner rather than later. www.utilityconsultants.co.nz

25. When should assets be renewed • Most utilities will have some sort of asset inspection records that will have categorised assets by condition and/or expected remaining life like this. www.utilityconsultants.co.nz

26. When should assets be renewed • The following 2x2 matrix depicts the outcomes of condition assessment decisions... www.utilityconsultants.co.nz

27. When should assets be renewed • In an ideal world we would obviously be in either of the green quadrants. • In the real world, however, there is a distinct possibility of straying into the yellow or red quadrants. • The risks associated with the yellow and red quadrants have different natures and characteristics… • In the yellow quadrant the risk is one of renewing too soon, and the risk tends to be financial and regulatory (renewal deemed inefficient, exclude from RAV). • In the red quadrant the risk is one of renewing too late, and the risk tends to be physical (service failure and safety). www.utilityconsultants.co.nz

28. When should assets be renewed • If we merge the 6 condition categories and the 2x2 matrix we get something like this… Category C assets tend to be in average condition, so there is a distinct chance of a sound asset being incorrectly assessed as unsound. The risk of unnecessary renewal starts to increase further. Category B assets tend to be in a slightly better condition, so there is an increasing chance of a sound asset being incorrectly assessed as unsound. The risk of unnecessary renewal starts to increase. Category E assets tend to be in very good condition, so the chances of a sound asset being incorrectly assessed as unsound decline. The risk of unnecessary renewal also starts to decline. Category F assets tend to be in excellent condition, so the chances of a sound asset being incorrectly assessed as unsound are very low. The risk of unnecessary renewal is also very low. Category D assets tend to be in good condition, so there is still a high chance of a sound asset being incorrectly assessed as unsound. The risk of unnecessary renewal is still high. Category A assets tend to be in very poor condition, hence very low chance of an unsound asset being incorrectly assessed as sound. The risk of unnecessary renewal is therefore low. www.utilityconsultants.co.nz

29. When should assets be renewed • This gives us a reasonably practical tool for prioritising renewals based on the chances of incorrectly assessing an assets condition. • As we’ve seen, the categories of assets that are most likely to be incorrectly assessed are the Category C and D assets, and it is probably better to err on the side of renewing rather than not renewing. • However this simple approach should enable the bulk of obviously unsound assets to be renewed with minimal risk of unnecessary renewal. www.utilityconsultants.co.nz

30. Accounting for renewal –keeping the CFO happy www.utilityconsultants.co.nz

31. Accounting for renewal • Key aspect of accounting in any business is making the distinction between costs that can fully expensed and costs that must be capitalised. • On one hand there are seemingly good arguments for expensing as much renewal work as possible, and on the other hand there are seemingly good arguments for capitalising as much as possible. • Depending on which outcome is most desirable, the definition of “consumable” might be distorted which tends to strike right at the heart of renewals. • The table on the following page sets out some of the likely outcomes … www.utilityconsultants.co.nz

32. Accounting for renewal www.utilityconsultants.co.nz

33. Accounting for renewal www.utilityconsultants.co.nz

34. Accounting for renewal • There is also the dual approach of capitalising work for accounting purposes but also expensing work for tax purposes. • I’m not a tax expert, but I do believe IRD don’t like this approach. www.utilityconsultants.co.nz

35. Justifying renewal –keeping the regulator happy www.utilityconsultants.co.nz

36. Justifying renewal • Regulators generally establish a pipes or wires tariff by using a building block approach. • This approach considers six key building blocks or elements of a business’ costs… • Efficient OpEx. • Efficient CapEx. • Return on capital. • Depreciation. • Tax. • Revaluation gains (claw-back of revenue). • This discussion needs to focus on four of these elements. www.utilityconsultants.co.nz

37. Justifying renewal • First element is efficient CapEx. • Unnecessary renewal of sound assets obviously increases the forward CapEx spend which requires an increased tariff to recover. • Hence there will be regulatory pressure to eliminate unnecessary renewals – this is a long story which is discussed at length in “Getting the CapEx right in the infrastructure sectors” (available on request). • This obviously becomes problematic when there is pressure to begin excluding renewal of obviously unsound assets from the efficient CapEx spend. www.utilityconsultants.co.nz

38. Justifying renewal • Second element is return on capital. • Putting aside the on-going WACC debate (which took a turn for the better in the recent draft paper on Vector and Powerco’s gas businesses), we need to ensure that the RAV correctly reflects the capital tied up. • There is always the risk that weakly justified renewals (or any other weakly justified CapEx) will be excluded from the RAV. • The effect is that a return will be made on less than the full amount of funds tied up. www.utilityconsultants.co.nz

39. Justifying renewal • Third element is depreciation. • If depreciation is understated, insufficient revenue will be gathered to fund future renewals (the recent Rates Inquiry suggests that some Councils might be doing the opposite). • Building on the previous issue, if funds spent cannot be rolled into the RAV the calculated depreciation will be less than it should be. • Result is that the depreciation expense won’t be fully recovered. www.utilityconsultants.co.nz

40. Justifying renewal • Fourth element is revaluation gains. • If renewals are not correctly rolled into the RAV, there is the possibility that future asset valuations will be deemed to include a significant revaluation gain. • This revaluation gain may be treated as revenue and clawed back from the building block model. www.utilityconsultants.co.nz

41. Justifying renewal • So it seems that a key part of keeping the regulator happy is to have robustly justified renewals. • Given the obvious tension between an infrastructure owners need to maximise profit and a regulators need to limit tariffs there will always be some argument over exactly which renewals are genuinely required and which are not. • It is therefore necessary to adopt approaches to compiling renewals that the regulator can take confidence in and that minimises the scope for dispute. • Two possible approaches include… www.utilityconsultants.co.nz

42. Justifying renewal • An outcome-based approach such as the IQI method used by OFGEM for the gas and electricity price determinations in the UK. • This approach rewards the owner for submitting a CapEx estimate that is close to the regulator’s estimate by allowing an increased revenue take. • Concept is simple, but the details are rather complex – details are in recent OFGEM gas and electricity papers. www.utilityconsultants.co.nz

43. Justifying renewal • An input-based approach such as PAS 55-1:2004 which has become an expected way of doing business in the UK electricity and gas sectors. • PAS 55-1:2004 is the publicly available specification for asset management in sectors whose performance depends heavily on fixed assets. • Regulators are taking increasing confidence from independent accreditation to PAS 55-1. • Pick here for more info on PAS 55-1. www.utilityconsultants.co.nz

44. Some practical aspects of renewal www.utilityconsultants.co.nz

45. Some practical aspects of renewal • So far we’ve covered a lot of fine sounding theory, but what are some practical aspects of renewal that can be applied on a daily basis ?? • Make a clear and reasonable distinction between consumable and non-consumable components so that we adequately distinguish renewals from maintenance. This distinction may need to be defensible in accounting, regulatory and tax contexts as well as engineering terms. • Understand that renewals is a discipline than involves concepts such as probability, uncertainty and risk, but most importantly that the risk profile is generally highly asymmetric. www.utilityconsultants.co.nz

46. Some practical aspects of renewal • Understand what generic approach to renewals is best suited to various categories of asset condition in terms of balancing the risks of service lapse, asset failure and minimising life-cycle costs. • Correctly account for renewals by ensuring they are rolled into the RAV. • Understand that renewals will be an element of CapEx that will always be under close regulatory scrutiny, and must therefore be rigorously justified in a way that gives the regulator confidence and minimises the chances of being second-guessed. www.utilityconsultants.co.nz

47. Three things to take away www.utilityconsultants.co.nz

48. Three things to take away • Clearly distinguish between maintenance and renewals. • For assets in poor condition that could result in either significant service lapses or safety issues, consider erring on the side of renewal. • Ensure renewals are justified as rigorously as possible. www.utilityconsultants.co.nz

49. More information www.utilityconsultants.co.nz

50. 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