5 Insights_Capital Allocation

5 Insights for executives

Hidden Value Finding the X-Factor in Capex AllocationIt was enough to make Rick, the veteran head of corporate planning for Ever-Ready Utility Corp. (ERU), wish for the good old days, when rate cases were regularly granted, stable cash flow was a given and¬ funding for maintaining the material condition of the assets was assumed. Sure there could be delays and uneven timing, but nothing like these disallowances and steady assaults on returns on equity (ROEs).

Rick looked over the latest asset plans. The company’s engineers — a risk-averse, technically minded group — had painted a grim picture. The transmission system needed to be built out and upgraded. The utility’s sub-critical coal plants were likely to soon run afoul of air quality regulations — the engineers suggested conversion to natural gas. The aging nuclear plant required a steam generator replacement. The aging natural gas pipeline system was being subjected to increasingly higher levels of regulatory oversight. Last but certainly not least, the team wanted to see further investment in smart grid.

Free cash flow had slowed almost to a trickle, and there was no reason to assume the situation was going to change soon. The balance sheet was already stressed; adding debt made no sense. Issuing more equity meant paying more dividends and diluting existing shares — another non-starter.

The engineers had pulled no punches. Safety, reliability, regulatory compliance: all were at stake if ERU didn’t make the needed investments now. But Sam, the new CFO, had been equally emphatic: the money wasn’t there. ERU would have to do what it could with what it had.

Rick knew that ERU was in many ways conservative to the core. Big projects often focused on “mandatory spend” (safety, reliability, and regulatory mandates) — and nothing else. Project contingency and reserve levels typically grew to formidable heights during the approval process. And a majority of the capital budget was declared off-limits as mandatory spend. The dollars had to come from somewhere, but where?

Perhaps, Rick thought, the answer was everywhere — as in a complete re-think. It was time to question assumptions and to challenge established thinking. It was time to find every available dollar and ensure that each was put to good use.

Of special interest to: Chief financial officers

Power & Utilities business unit leaders

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1 What’s the issue?Energy utilities are facing significant capital demands at a time when capital is hard to come by. Revenue is flat, conservation is taking hold and cash flows are weak, which means borrowing stresses the balance sheet and challenges credit ratings. And issuing equity dilutes shares, creates more dividends and saps the corporation of its earnings power.

To have a hope of meeting their capital needs, utilities need to get as much value as possible from every capital dollar invested. Best-in-class capital allocation processes are a fundamental issue.

2 Why now?The industry has reached an inflection point. In the aftermath of major storms such as Hurricane Sandy, with shale gas pushing down wholesale energy prices, and with many regulated utilities not getting the rate increases they seek, finding the free cash flow to invest has become exceedingly difficult.

At the same time, it’s simply more expensive to deploy capital. Our research suggests as much as an additional 10¢ on the dollar is needed to pay for escalating service and overhead costs. This “crowding out” effect means it takes increasingly more capital to repair and replace assets.

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3 How does it affect you?A focus on maximizing the value of each capital dollar carries short- and long-term benefits. In the short term, it can result in the release of tens of millions of dollars of trapped capital, allowing utilities to fund projects that would otherwise be forced to wait. In the long term, companies can gain certainty that they’re investing capital in the right way and getting the most for every capital dollar.

Take project contingency as an example. Prudent planners allow for extra capital to cover possible overruns. But as the project moves from approval to approval, the contingency funding can grow. Projects end up over-reserved, unnecessarily tying up valuable capital.

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4 What’s the fix?Leading companies are taking a three-pronged approach to the complex balancing act of capital allocation:

1. Align the corporate culture on a consistent definition of a good project.

2. Bring increased transparency to the use of contingency and reserves.

3. Take a deep look at mandatory capital in the system.

1. Align the corporate culture on a consistent definition of a good project. A good project has multiple purposes — in addition to such core objectives as safety and reliability, it needs to reduce the asset’s risk profile and/or offer an acceptable return to shareholders. The key is to shift the way the organization thinks about how it organizes and defines projects — to recognize that good projects will simultaneously meet multiple planning objectives (e.g., safety, reliability, regulatory margin, shareholder value).

2. Bring increased transparency to the use of contingency and reserves. Organizations should make very clear in the project estimates:

• The amount of contingency assigned

• The risk being mitigated

• The person who assigned it

• The percentage of total spend

• The conditions under which the funds can be released

With greater visibility into the process, organizations can more easily determine whether assigned contingency levels make sense.

At the same time, companies should consider the creation of a central reserve. Pooling and holding reserves centrally gives the organization more margin across the business, as well as greater oversight. Reserves that are distributed across the business can be wasteful — time and effort frequently must be spent determining where they are being held, and often the distributed reserves cannot be recalled, resulting in trapped capital or capital invested outside the oversight process.

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3. Take a deep look at mandatory capital in the system. Start with projects in the queue. By definition, excessive spending that is defined as mandated by law or regulation takes all options out of the capital planning process. At some utilities, mandatory spend can consume as much as 80% to 90% of the capital budget. Organizations should strive to bring transparency to the process and to challenge established thinking, with the objective of developing room to maneuver in the capital budget. Is this spend truly mandatory, or is this the utility’s misinterpretation? What went into the decision-making process? How and when are other utilities complying? What options have we explored and how do these compare to the industry? Can we earn on these investments and when?

Throughout the process, consider employing capital investment scenarios. Scenario-based thinking coupled with portfolio planning theories can be powerful tools for illustrating choice points and the trade-offs that are implicit in a budget. They can also be used to develop a more strategic and lasting view and bring more transparency to the choices at hand.

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5 What’s the bottom line?There’s a significant amount of untapped capital in the power and utilities sector. Taking a holistic look at the process, assumptions and decision roles in the allocation of capital can be a healthy exercise. Leading utilities have learned to place a premium on excellence in capital allocation. They recognize it’s just as problematic to be under-spent as over-spent relative to budget.

Faced with weakening and increasingly uncertain cash flows as well as unprecedented levels of investment demands, utilities need to find ways to release nonproductive capital. A higher level of scrutiny around the capital allocation process can help shake free dollars trapped by legacy processes and place those dollars where they can help the organization grow.

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Want to learn more?

For related thought leadership, visit www.ey.com/5

The answers in this issue are supplied by:

Dana HansonPower & Utilities Lead, Americas+1 704 335 [email protected]

Andy PattersonPrincipal+1 404 433 [email protected]

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