Spending Capital as if It Mattered

Deck: 

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 a different and more insightful model.

The capital pressures squeezing utilities today need to be offset by stronger alignment among the four critical dimensions of capital planning: strategic, regulatory, financial, and managerial.

The Strategic Dimension

Strategy is the design for the company’s future; the capital plan is the blueprint. Together they articulate how the company will deploy today’s resources to achieve tomorrow’s objectives.

Yet in many utilities one of the most striking characteristics of the capital plan is its disconnect from strategy. These two efforts exist without apparent discomfort to anyone in parallel universes, developed on unrelated schedules by separate groups, and often for different executive audiences.

At the root of this paradox is the inherent difference between top-down and bottom-up planning. Strategies emerge from increasingly detailed elaboration of a concise vision laid across a defined set of aspirations. Capital plans, by contrast, typically emerge from increasingly stringent filtering of myriad and disparate project requests. One perspective is visionary, logical, and deductive; the other is tactical, impartial, and inductive. It’s not surprising that the two perspectives yield unaligned results.

Companies should begin by getting the sequence right. Executives should figure out their strategy first. They should then launch development of the capital plan with a clear vision of the strategy, how its elements fit together, and why it has been selected. They should demand projects that fit the strategy rather than simply filtering projects that bubble up through the organization. Conversely, they should treat the strategy as contingent until it has been validated by a workable and fundable capital plan—the strategy’s reality check.

Basic to this reality check is a picture of how the capital investment portfolio fits with the funding sources available and the value growth envisioned. Understanding how portfolio benefits are balanced among revenue generation, margin improvement, cost avoidance, asset productivity, and system reliability allows a company to assess the alignment of capital and strategy.

Unfortunately, a single standard for capital-spending guidelines does not exist in industry practice. Across a large utilities peer group the average annual transmission and distribution expenditures during the past 10 years have ranged from $60 to $330 per customer—almost a six-fold spread. The calculations of long-term profit optimization that help unregulated industries respond appropriately to capital demands are imperfect guides in a rate-of-return environment. What is called for instead is a framework that lets the utility triangulate toward a level of spending that is reasonable in light of industry practice and the particular conditions and dynamics of the utility’s current infrastructure. Industry spending patterns suggest that the strongest drivers of capital spend are those noted in Figure 3.

Finally, if the company hopes to facilitate innovation and advance a vision, its strategic portfolio of investments will allow optionality. The value of these options exists in the assumption that they will be exercised at the most advantageous time in light of evolving conditions. For these reasons, capital planning requires ongoing portfolio review, stage-gated decisions, and frequent feedback.

The Regulatory Dimension

As utilities design their investment strategy, they need to be adroit and inventive at obtaining better regulatory outcomes—faster investment recognition and more certain capital recovery.

Traditional regulatory approaches to investment recovery focus on ex post demonstration of investment need and tariff adjustment through periodic rate cases. Under those circumstances, the large and continuing capital programs that many companies are undertaking can pose serious risks to balance sheets, credit ratings, and cash flow. Both baseline investments and next-stage investments carry the inherent risks that come with promising but unproven technologies, long-term construction cycles, and the unavoidable uncertainties of an evolving market.

A regulatory process that compounds those inherent risks through second-guessing on prudence, and through extended delays in rate-base recognition, confronts the utility with two choices. One choice—in many cases the prudent one—is to continue deferring investment, necessary as it may be in the long term, until the regulatory environment is more accommodating. The other is to swallow the risks and proceed, recognizing that delays in investment recognition will impose higher costs through stress on credit ratings and through accumulation of the carrying costs of capital.

A natural nexus exists between companies and their regulators around minimizing long-term costs to customers and avoiding rate crises. To capitalize on that nexus requires a different set of regulatory mechanisms than the traditional investment-recovery frameworks of prior investment cycles.

Those new mechanisms depend on a changed working relationship with the regulator. In place of the adversarial “barter” mode of regulation, common ground should be sought through information-based collaboration that focuses on a convergent interest—the minimization of costs and risks.

Movement toward this different approach can be found in the various construction cost “riders” and investment carve-outs that a number of regulators have provided. By providing some mix of investment pre-approval, immunity from later prudence reviews, and annual recovery of expenditures, these riders improve cash flow, mitigate risk, and lower total cost. To date these mechanisms have been targeted toward expenditures that have been mandated by governmental agencies, determined as critical to the existing system infrastructure, or recognized by regulatory bodies as requiring special consideration in light of circumstances. Companies like Xcel Energy, Duke Energy, and TXU have had great success in attaining responsive regulatory recognition for expenditures for environmental improvement, transmission infrastructure, and/or mandates for conservation and network improvement.

Utilities can strengthen their credibility and channel regulatory oversight in constructive directions by engaging the regulator in both after-the-fact examination of lessons learned and root-cause analysis, as well as contemporaneous review. Collaborative review, particularly with respect to externalities that affect factor costs, such as labor availability, raw-materials escalation, and delays from regulatory review, can provide vital mutual insight.

Armed with this understanding, regulators may be amenable to tailored incentives for project construction performance. In contrast to performance-based ratemaking based on broad financial performance indicators, these incentives would target specific outcomes (cost, schedule, etc.) that both management and the regulator recognize as critical to project success and create the potential for some form of shared benefits.

This approach would provide significant benefits:

Cash-Flow Preservation. More of the cash flow needed to support ongoing annual investment increments would become available from internal operations, rather than from borrowings;

Lower Customer Costs. Total revenue requirements would be reduced by avoiding the compounding of capital carrying costs;

Higher Earnings Quality. Recovery of capital costs in current rates would reduce non-cash earnings (AFUDC), which are viewed with suspicion by the financial community; and

Reduced Regulatory Risk. Clear cost-recognition policies and recovery mechanisms would provide assurance that prudently incurred investments will be recompensed.

This approach involves no contraction of regulatory authority; rather, it shifts the exercise of that authority from exclusive reliance on ex post punitive remedies toward opportunities for collaboratively shaping the utility’s investment program. It fully preserves regulators’ ability to monitor project or expenditure progress and to assess the prudence of dollars spent against agreed-upon targets. At the same time, risk to the company is reduced without transferring that risk to customers, and the quality of the regulatory relationship is enhanced as regulators and utilities focus collaboratively on a shared goal—minimizing the cost to the customer and eliminating counterproductive and asymmetrical risk absorption.

The Financial Dimension

As utilities work to align their long-term strategic and regulatory agendas, the financial dimension of capital planning turns from adjudication of business-unit squabbles over “fair share” to prioritization of capital availability to its “highest and best” use. Setting and targeting spending levels so that each marginal dollar of investment produces the optimum long-term cash yield requires a rigorous focus on portfolio economics.

Quantitative project evaluation criteria should be sharpened to reflect different businesses, different portfolio categories, and different types of project benefit. Distribution refurbishment investments, for example, typically are viewed as either capturing an authorized rate of return, once they can be placed in rate base, or permitting future reductions in maintenance expense. Many such projects, however, offer additional benefits: future capital avoidance, improved system performance, reduced operating expense, or mitigation of failure risk.

By unbundling investment requests into discrete projects and identifying specific economic contributions and outcomes, utilities are able to analyze the specific “cash-yield” benefits associated with each, and to assign differentiated hurdle rates appropriate to the specific risk factors of each. The specificity of this perspective allows management to be discriminating in its application of capital without being discriminatory in its overall allocation.

As companies deepen their appreciation of cash yield, they should become more willing to revisit predetermined funding limitations. Properly applied, capital investment is a creator of resources. Rather than regarding capital as a scarce, fixed resource to be allocated until it runs out, the company should recognize that capital is abundant and readily available, but only at a price. Once business units regard capital as attainable, but only for compelling reasons, they can be challenged to generate innovative ideas that create value, without feeling that persistent capital constraints render such ideas futile. Conversely, a predetermined pool of available capital should not in itself constitute a license to spend that amount. Only projects that have passed rigorous screens for value creation and strategic relevance should be funded, regardless of the “budget headroom” that may remain.

Not every investment provides a payback that can be persuasively calculated in advance, and few projects of any description come with ironclad performance guarantees. Promising innovations can be justified in many cases only on their option value—a legitimate basis for funding—so long as the downsides are understood, the exit strategies are identified, and the options are managed in a timely way. A portfolio of capital initiatives ideally will comprise ideas in various stages of viability. Gating criteria will set standards for moving projects from one stage to the next, jettisoning expired or negative options while nurturing those whose option value grows. Smart companies revisit the capital budget throughout the operating year to reassess current needs and priorities compared with those established under circumstances prevailing months earlier.

The Performance Dimension

The value created by the capital plan is a function of both the choice of projects to fund and the manner in which those projects are managed. Yet once the capital allocation process has assigned a given budget to a given project, the responsible executive committee normally assumes that its work is done and that the budget will be spent fully. To the extent that managers subsequently are held accountable, it is to the budget, not to the value created. Going forward, the implementation of the capital plan needs to be much more closely aligned with the strategic and financial expectations that have shaped the plan.

Once it is understood that the capital plan is not simply a set of discrete budgets and timetables, but a portfolio of value-creating initiatives, it follows that the capital-management process should encourage project managers to focus on value creation. All else being equal, every acceleration of cash inflow, and every delay of cash outflow, adds value. Project managers should be rewarded for creativity and success in finding alternative methods for accomplishing tasks—in searching for unit-cost reduction opportunities, exploring least-cost methods, designing “fit for purpose” standards rather than gold-plating, and sharing resources with other projects.

In most companies, the primary constraint on capital planning is not availability of funds; it is the organizational capacity to manage capital projects. While managerial “bandwidth” can be expanded over time, it is relatively fixed in the short term. Credible forecasts and informed feedback are difficult to achieve when the managerial pipeline is choked with an over-ambitious schedule of projects. The company needs to ask itself: How much spending activity can we effectively manage and track? Who will be providing financial control, forecasting cash outlays, and monitoring progress against initial value assumptions? What is our track record for meeting project deadlines, and how should that shape our expectations and commitments? Do we need to take special steps to revive and enhance our project management capabilities or possibly utilize third parties?

Feedback loops need to be constructed between project management and portfolio decision makers—not just for annual “lessons learned,” but for ongoing portfolio monitoring and adjustment. Option value is purely academic unless options are supported by a willingness to exercise them when circumstances indicate an economic advantage in doing so. That willingness implies openness to mid-cycle course corrections, the kind of flexibility that allows a management team to back away from authorized projects that appear unable to deliver their promised value and to replace them with expenditures more aligned with current situational demands. The difference between planning authorization and spending approval is an important distinction for companies to impart to their business units.

These feedback loops need to be supported with streamlined project reporting protocols. Frequent, high-level, consistently formatted project information provides an evolving overview of portfolio performance, revealing target areas that require further examination and improvement.

Finally, “forcing functions” need to be introduced to the capital plan. Industrial techniques like supply consolidation, leverage of common processes, rigorous project management protocols, and tight linkage with asset-management methods have the potential to affect factor, unit, and total costs, and thus capital efficiency. Some portion of these potential efficiencies should be built into the capital-allocation assumptions. Future operating budgets should incorporate the expected operating savings that a given capital investment is designed to provide.

Spending Smart

Bringing alignment to these four dimensions of the capital plan requires process clarity. Management needs to understand the various roles it must fill in the broad task of designing and managing an investment portfolio. It needs to synchronize those roles, ensure that they reinforce each other, and keep information channels operative. Managing capital effectively in today’s demanding utility environment is no longer a routine and tangential process. It now has become table stakes for financial performance, and is a mandatory component of any company’s capabilities.