Upsizing – the other half of the hidden side of CapEx Presented at the Electricity Engineers...

Upsizing – the other half of the hidden side of CapEx

Presented at the Electricity Engineers Association (EEA) Conference, Christchurch, June 2008by Phil Caffyn from Utility Consultants Ltd.

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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.


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.


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.


What actually is upsizing


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.


What actually is upsizing

Activity Description Why it is or isn’t upsizing

Replacing a blown fuse. Maintenance Not upsizing because a consumable component has been replaced.

Replacing a frayed conductor with a similar size conductor.

Renewal Not upsizing because although a non-consumable component has been replaced with a non-consumable component no increase in functionality has occurred.

Replacing a small conductor with a bigger conductor.

Upsizing Upsizing because the functionality of a non-consumable component has been increased.

Adding a new length of line to reach a new customer.

Extension Not upsizing because the functionality of a non-consumable component has not been altered (more components have been added).

Replacing an existing line with cable.

OHUG Not upsizing because the functionality of a non-consumable asset has not been altered.

Inserting a recloser halfway along a line.

Reliability enhancement

Not upsizing because the functionality of a non-consumable component has not been altered.


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.


The other half of thehidden side of CapEx


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…


The other half of the hidden side

Existing asset

Condition

Service capability hasdeclined to below an

acceptable level(“too sick”)

Insufficient capacityto meet demand

(“too thin”)

Cannot physicallyreach new customer

(“too short”)

Pressure to replacelines with cables

(“too ugly”)

Reliability doesn’t meet requirements(“too unreliable”)

Required modeOf CapEx

Renewal

Up-sizing

Extension

OHUG

Reliabilityenhancement

Hidden

Obvious

The hidden aspect is the important bit of this argument.


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).


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.


The other half of the hidden side

Prevailing load growth

Location of demand growth

Lo Hi

Within existing network footprint

Outside of existing network

footprint

Quadrant 4

· CapEx will be an even mix of both extensions to reach new customers and then up-sizing to supply that demand through existing upstream assets .

Quadrant 3

· CapEx will be dominated by extensions because load growth is occurring beyond the reach of existing assets, and then maybe some up-sizing to supply this additional demand through existing upstream assets.

Quadrant 1

· CapEx will be dominated by renewals because assets will wear out before they get “too small”.

Quadrant 2

· CapEx will be dominated by up-sizing because assets become “too small” before they wear out.

Growth within the existing network footprint will require upsizing to meet increased demand and security

Growth outside the existing network footprint will firstly require extensions, but will also ultimately require upsizing to meet increased demand and security


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) ??


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.



Characteristic Renewal Upsizing Extension

Location Within the existing network foot-print by definition.

Within the existing network foot-print by definition.

Outside of existing network foot-print by definition.

Nature of load increase

Isn’t any – driven by asset condition, not capacity.

Supplying either new load or increasing load at an existing connection within existing foot-print.

New supply to a new customer outside of network footprint.

Upstream reinforcement

Isn’t any – by definition renewal replaces assets with assets of similar capacity of functionality.

Forms the focus of upsizing.

Will only be needed if demand from new customers cannot be supplied by existing upstream assets.




Visibility Generally invisible (might look new and shiny).

Generally invisible (might look new, but hard to tell that the wires are bigger)

Generally very visible – new asset where previously there wasn’t any.

Quadrant in the investment strategy matrix

Tends to be restricted to Quadrant 1 because assets wear out before they become too small.

Usually restricted to Quadrants 2 and 4 because it requires assets to get too small rather than wear out.

Restricted to Quadrants 3 or 4 by definition. Precise quadrant will depend on rate of load growth and will define degree of associated upsizing.

Necessity Possible to avoid by deferring renewal – carries increased risk of condition related failure.

Possible to avoid by over loading – carries increased risk of capacity related failure.

Can’t avoid – a new physical connection is required between the network at large and the new load.




Impact on revenue

Generally doesn’t result in any increased revenue.

Hard to attribute revenue from increased demand or connections to up-sized assets.

Generally results in increased revenue directly attributable to new connections.

Impact on costs Can range from modest to large, no revenue impact to be phased to.

Can range from modest to large, generally better matched to revenue growth than extensions.

Likely to be large and over a short period, generally always occurs ahead of revenue, precise phasing depends on nature of new load.

Impact on asset valuation

Can range from modest to large.


Generally large depending on length of extension and degree of upsizing required.




Impact on profit



Can be large, but often mitigated through customer contributions.

Means of cost recovery

Generally spread over all customers as part of on-going line charges.

Generally spread over all customers as part of on-going line charges.

Generally through capital contribution, possibly up to 100% depending on policy.

Nature of work carried out

Replacement of worn out assets with new assets of similar capacity or functionality.

Replacement of assets that are “too small” by new assets of greater capacity or functionality.

Construction of new assets to connect new customers to existing assets, may also require upsizing depending on surplus of up-stream capacity.


Why should assets be upsized


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.


When should assets be upsized


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…



Time

Demand or security

headroom

Investment


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).



TimeOne-off cost of works

Risk of failure due to under investment

Over investment

Possible constraint of maximum recovery of investment



• If we muck about with the time interval between upsizing

we can derive the following two curves...

Time Time



• These two curves have different whole of life costs as

follows...

Time

•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.



• 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.

Time


Time interval between upsizing

Whole of life upsizing cost


• Plotting the value of each cost against the time interval

between upsizing gives something like this…

Cost of over investment

Cost of under investment (depending on when upsizing occurs – likely to accelerate away rather than be linear

One-off costs

Total costs

Optimum time interval between upsizing


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).


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.


Time interval between upsizing

Whole of life upsizing cost


Investment beyond the headroom limits set out in the ODV Handbook could incur a higher WACC because of regulatory uncertainty


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.



• 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).


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.



• 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.



• 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.



• However the Commission is the final authority on this

matter and their published requirements will need to

be complied with as a minimum requirement.


Five quick things to take away


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.


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.


More information


More information

• Phone +64-7-8546541

• Mobile +64-21-606670

• Email [email protected]

• Skype philcaffyn

• Web www.utilityconsultants.co.nz

• Web www.capex.cjb.net

mailto:[email protected]

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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

mailto:[email protected]?subject=Request%20PAS%2055%20slide%20show

mailto:[email protected]?subject=Request%20%22Getting%20the%20CapEx%20right%22%20slide%20show

mailto:[email protected]?subject=Request%20%22Setting%20service%20levels%20for%20utility%20networks%22%20slide%20show

mailto:[email protected]?subject=Request%20%22Tariff%20control%20of%20pipes%20&%20wires%20utilities%22%20slide%20show


More information• Visit Utility Consultants library to request other slide

shows, monographs and research reports.

• Visit Utility Consultants specialist CapEx website for more insights.

http://www.utilityconsultants.co.nz/library1.htm

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Upsizing – the other half of the hidden side of CapEx Presented at the Electricity Engineers...

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