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Spending Capital as if It Mattered

Infrastructure challenges are redefining utility capital-planning methods.

Fortnightly Magazine - May 2007

The electric-utility industry faces a looming capital-commitment challenge. To meet this challenge in a way that satisfies the expectations of boards, capital markets, and regulators, many utilities will need to overhaul their existing capital budgeting and management processes.

The anticipated near-term need for capital resources is at the highest level ever experienced. Rate freezes have built up a bow-wave of deferred investment. Major investments lie ahead in environmental compliance, capacity addition, grid extension, network growth, and infrastructure refurbishment. By an inconvenient stroke of timing, this need for capital renovation and expansion coincides with a rapid rise in the cost of raw materials. Moreover, at many utilities the large-project management skills that took years to develop have atrophied through retirement of critical personnel and through past capital cut-backs.

Yet while the need for capital resources is clearly rising, the capacity of the “regulatory compact” to absorb capital expenditures is constrained. Under pressure to keep overall consumer bills within a range of political tolerance as wholesale prices continue to rise, regulators are likely to tighten review standards for new, significant rate-based investments.

Accordingly, a major strategic challenge for many utilities today is to steer a narrow course between mounting claims for capital and increasingly stringent regulatory expectations—while also maximizing economic returns. Meeting this challenge will stretch and substantially redefine the capital planning methods of most utilities—demanding greater skill in assembling the investment portfolio, greater rigor in evaluating opportunities, and greater discipline in managing project execution. Companies will need to evolve from simple stewardship of their investments to engaged portfolio management.

This evolution will require management to reconsider and revise five dysfunctional premises of capital management that are common today:

• “Capital uses are equivalent.” Management will need to differentiate clearly among the yield potential of capital investment options, as all options are not limited equally to the allowed rate of return.

• “Capital planning is a single event.” Capital planning will need to be viewed as a continuous process of optimization among dynamic investment choices.

• “Capital is owned by the businesses.” Investment dollars need to be seen as the property of the enterprise, deployed to their highest economic purpose, an approach that may drive substantial shifts in capital allocation among business units from year to year.

• “Capital risk is uniform.” Utilities need to recognize that each investment option carries its own risks and requires a commensurate return.

• “Capital spending performance just happens.” Utilities will need to act on a view that spending levels are controllable through project discipline and rigorous attention to the financial factors that determine value: cost, time, return, and risk.

These dysfunctional premises aren’t codified in the company’s capital-planning manuals, but are embedded deeply in behaviors. Thus, it is no surprise that satisfaction over capital planning within the industry is low and that companies are searching for

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