Levels of service and their impact on CapEx

1. Levels of service and their impact on CapEx Phil Caffyn, Utility Consultants Ltd www.utilityconsultants.co.nz www.capex.cjb.net Please read disclaimer on second page

2. Disclaimer • This presentation has been prepared primarily for the Infrastructure CapEx Summit 2008 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 Conferenz. Neither Conferenz, its officers or its employees 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 www.capex.cjb.net

3. Presentation topics • Part 1 – What are LOS. • The asset management model • Importance of price • Defining LOS • Classes of LOS • Part 2 – Importance of getting LOS right. • Investing in LOS • Getting the LOS wrong • Part 3 – Linking LOS to CapEx • LOS variations • Lifecycle activity variations • Spend variations www.utilityconsultants.co.nz www.capex.cjb.net

4. Part 1 – What are LOS www.utilityconsultants.co.nz www.capex.cjb.net

5. The asset management model • The asset management activities within an organisation look a bit like this… www.utilityconsultants.co.nz www.capex.cjb.net

6. The asset management model • Four components to this model… • Customer interface. • Transfer of LOS across that interface. • Transfer of cash across that interface in the opposite direction. • Whole range of activities sit against that interface and stretch back into the organisation. • In some instances the person receiving the LOS may be different from the person paying the cash eg. electricity retailer versus connected customer, or subsidy for rail. www.utilityconsultants.co.nz www.capex.cjb.net

7. Importance of price • Price is a key component in the LOS mix – any discussion of LOS without reference to price is meaningless, because we all want more !!! • Books and DVD’s in the library. • More swings and slides at the park. • Trains that run more often. • Streets that don’t flood after heavy rain. • Unfortunately the cost structure of an infrastructure business can make it hard to nail down any direct and obvious linkage between LOS and short-term price. www.utilityconsultants.co.nz www.capex.cjb.net

8. Importance of price • And of course, there is the whole matter of price determining what funds are available for actually doing the work !!! • In many infrastructure sectors, price will also be constrained by “non-market” factors… • Public policy decrees. • Regulatory determinations. • Pricing methodologies that are subject to regulatory approval. • Priorities of elected members. • Subsidies from other users or from tax payers. www.utilityconsultants.co.nz www.capex.cjb.net

9. Defining LOS • LOS are what we (or someone else) pay for every time we use a service, but in this context, LOS are also the destinations of the AM journey. • Without a well-defined destination, it’s hard to make the journey. • As Alice in Wonderland concluded “if you don’t know where you want to go, any road will take you there”. www.utilityconsultants.co.nz www.capex.cjb.net

10. Defining LOS • So the starting point of robust CapEx, and indeed the whole AM process, is a set of well-defined LOS. • We can broadly define infrastructure LOS in terms of three characteristics… • Capacity (“how much”) • Availability (“how often”) – sometimes this can be an operational decision. • Quality (“how good”) • These definitions are a bit arbitrary, and can be broadly juggled to fit with terms like reliability and security of supply. www.utilityconsultants.co.nz www.capex.cjb.net

11. Defining LOS • Just a couple of examples to help set the mode of thinking… www.utilityconsultants.co.nz www.capex.cjb.net

12. Defining LOS • My personal view is that LOS are (or need to be) the next frontier of AM and CapEx. • Many AMP’s have assumed that LOS are going to stay the same, so the LOS thing is quite disconnected from the rest of the AMP. • However after many years of little or no upsizing, capacity headroom across many classes of infrastructure has been eroded to the point where we need to give serious thought to capacity as a LOS. www.utilityconsultants.co.nz www.capex.cjb.net

13. Classes of LOS • LOS fall into two broad classes… • LOS that benefit those who pay for them (eg. capacity, availability, quality). • LOS that benefit others (eg. safety, information disclosure, absence of interference, amenity value). • In the AMP’s that I’ve prepared I’ve found it helpful to consider the LOS in the following classes… • Customer LOS. • Regulatory LOS (because most infrastructure is subject to some form of economic or structural regulation). • Community LOS. www.utilityconsultants.co.nz www.capex.cjb.net

14. Classes of LOS • Customer LOS can be further broken into sub-classes based on what customers say is most important… • Primary • Secondary • Tertiary • Customer surveys in the electricity lines industry reveal that customers primary LOS is keeping the lights on, and getting them back on if they go off. www.utilityconsultants.co.nz www.capex.cjb.net

15. Classes of LOS • LOS like quick processing of new connection applications, or providing technical advice are rated as relatively unimportant when compared to real-time delivery of LOS across the customer interface. • Unfortunately for infrastructure operators, the most important LOS are those requiring fixed assets rather than processes. www.utilityconsultants.co.nz www.capex.cjb.net

16. Part 2 – Importance ofgetting LOS right www.utilityconsultants.co.nz www.capex.cjb.net

17. Investing in LOS • The CapEx process turns cash into physical assets which deliver outcomes (the LOS). • Referring back to the asset management model, we note that CapEx is very remote from the customer interface. • We all appreciate that the moment-by-moment decisions (operations) made at the customer interface can significantly impact on LOS. www.utilityconsultants.co.nz www.capex.cjb.net

18. Investing in LOS • We also all appreciate that the CapEx decisions made in the boardroom and the backroom will significantly impact on LOS. • It’s also very clear that the linkages between CapEx decisions (especially capacity) and LOS are not simple. • Hence the CapEx activity has an implicit risk of mis-matching the capacity and the LOS (and that’s just when the LOS sits still !!) www.utilityconsultants.co.nz www.capex.cjb.net

19. Getting the LOS wrong • This mis-match of capacity to LOS can occur in two ways… • Under investment in capacity. • Over investment in capacity. • Each of these modes of investment has significantly different types of risk which (in my view) are only just beginning to be understood. • Under investment usually results in a service failure in which LOS are not met – the loss of economic value easily exceeds the cost of service, and can mean injury or death. www.utilityconsultants.co.nz www.capex.cjb.net

20. Getting the LOS wrong • Over investment usually results in capacity being built ahead of time (and if demand growth is low, it may never be used). • The risks of over investment therefore tend to be more commercial (and often regulatory) in contrast to the risks of under investment which tend to be operational, safety or reputation. • My view is that it is better to err on the side of over investment than under investment as getting it totally right will prove very hard. www.utilityconsultants.co.nz www.capex.cjb.net

21. Part 3 – Linking LOS to CapEx www.utilityconsultants.co.nz www.capex.cjb.net

22. Introductory remarks • Having concluded that the linkage between CapEx and LOS is complicated, and that precisely matching CapEx to future LOS is not easy, this section sets out some thoughts which will hopefully make it a bit easier. • A key component of linking LOS to CapEx is understanding the risks along the way, because afterall CapEx is a risk-based discipline. www.utilityconsultants.co.nz www.capex.cjb.net

23. LOS variations • Understanding that the three classes of LOS (customer, regulatory and community) are likely to vary over time is very obvious. • Understanding how those classes of LOS might vary is a bit more challenging… • How will residential electricity customers demand for supply quality change as they all buy heat pumps and plasma TV’s ?? • How will the properties of an airport runway need to be altered when more airlines start flying A380’s ?? • Will the roads in rural areas withstand increased numbers of logging trucks as forests are harvested ?? www.utilityconsultants.co.nz www.capex.cjb.net

24. Lifecycle activity variations • Understanding what variations in lifecycle activities might be required to accommodate variations in LOS is where it starts to get tricky. • Varying operational decisions to meet LOS variations is pretty straightforward… • Coupling a few extra carriages on to a train or tram when a big footy game or concert is on. • Working a fleet of mining trucks two shifts instead of one to increase production tonnage. • Winding up a tap changer when the voltage drops. • Starting a pump when a sump fills up. www.utilityconsultants.co.nz www.capex.cjb.net

25. Lifecycle activity variations • These are very straightforward decisions that don’t put the organisation to any capital cost, and can be easily undone if the decision proves wrong. • Most importantly, the linkage between the LOS variation and the variation to the lifecycle activity is obvious. • When variations to LOS require variations to capacity, availability and quality that are beyond simple operational activities, things start to get a bit tricky. www.utilityconsultants.co.nz www.capex.cjb.net

26. Lifecycle activity variations • Consider the previous example of working a fleet of mining trucks two shifts instead of one to increase production tonnage. • That option will probably work fine for a short period – sure there will be maintenance and personnel issues to be addressed. • If, however, the increased production is likely to be a long-term thing, there will be other options such as buying a fleet of bigger trucks, or replacing trucks with conveyors. www.utilityconsultants.co.nz www.capex.cjb.net

27. Lifecycle activity variations • Each of those options (two shifting, bigger trucks, conveyors) stretches back into the asset management model away from the customer interface, into that area that is less obviously connected to the LOS. • The choices involve long-term capital decisions that the organisation will be stuck with for a long time. • The right choice will depend on the organisations policies, strategies and markets (and in many cases the regulatory regime). www.utilityconsultants.co.nz www.capex.cjb.net

28. Spend variations • Once we think we know the variations to lifecycle activities that are required to meet varying LOS, the final step is to identify the spend variations. • This used to be as simple as estimating present day costs and multiplying by an agreed inflation index. • Alas – no more !!! • Costs of key inputs – steel, cement, copper, glass, diesel and labor - all seem to be rushing ahead of the official inflation rate. www.utilityconsultants.co.nz www.capex.cjb.net

29. Getting the linkages right Very straightforward – no excuse for getting this wrong • Conclude this section with a brief model... Can be hard, but some well thought out scenarios should provide accurate estimates None of these are dead easy, but neither are they very hard. Some clear thought around each of these issues will minimise the risks of each step, which in turns minimises the cumulative risk Can be hard, but again some well thought out scenarios should provide some reasonable forecasts Getting people on side can be hard, but still no excuse for getting this wrong www.utilityconsultants.co.nz www.capex.cjb.net

30. Practical things to take away www.utilityconsultants.co.nz www.capex.cjb.net

31. Practical things to take away • Understand what LOS your organisation provides, and how they might fit within a generic framework of capacity, availability and quality. • Understand exactly what the customer interface is, both physically and commercially. • Understand that some LOS do not directly benefit your paying customers . www.utilityconsultants.co.nz www.capex.cjb.net

32. Practical things to take away • Understand the role of price, how it funds the business model, and what factors might constrain prices or distort price signals. • Understand the nature and risks of over- and under-investing in capacity. • Clearly understand the risks involved in linking CapEx to LOS, and how clear thinking and appropriate use of analytical tools can minimise those risks. www.utilityconsultants.co.nz www.capex.cjb.net

33. Contact me for more info. www.utilityconsultants.co.nz www.capex.cjb.net

34. Contact me for more info. • Phone (07) 854-6541 • Mobile (021) 606-670 • Email phil@utilityconsultants.co.nz • Skype philcaffyn • Web www.utilityconsultants.co.nz • Web www.capex.cjb.net • Subscribe to “Pipes & Wires” (email me). www.utilityconsultants.co.nz www.capex.cjb.net

35. Contact me for more info. • Request the following slide shows on similar topics… • Implementing the UK asset management specification PAS 55-1:2004 in the infrastructure sector. Request • Setting service levels for utility networks. Request • Tariff control of pipes & wires utilities – where is it heading. Request • Renewals – (half) the hidden side of CapEx. Request • Upsizing –the other half of the hidden side of CapEx. Request • Getting the CapEx right in the infrastructure sectors. Request www.utilityconsultants.co.nz www.capex.cjb.net

36. Contact me for more info. • Visit Utility Consultants library to request other slide shows, monographs and research reports. • Visit Utility Consultants specialist CapEx website for specific insights. www.utilityconsultants.co.nz www.capex.cjb.net