Costs to produce electricity are traditionally considered to be negative (bad). In the traditional view, planned costs are necessary evils to preserve function, capacity, and/or quality of power production to meet operating targets. Unplanned costs are necessary evils to restore power production after unexpected events.
From the traditional perspective, these costs represent leakage of money from the business…money that otherwise could be used to reduce electricity tariffs, reduce debt repayment periods, increase dividends to shareholders, etc. Given such perspective, it is no wonder that many in the power industry feel justified in keeping strong focus and exerting constant effort to reduce production costs.
This traditional perspective regarding production costs is almost always wrong. It could only be right if the underlying production facility and organization are already perfect in terms of production availability, capacity, efficiency, safety, regulatory compliance, environmental stewardship, and community relations.
Let us consider an alternative perspective provided to us by the financial community. A banker, for example, would not consider a cost to be bad unless the bank is not able to recover that cost and profit therefrom. Indeed, if yielding a profit, costs are good (not bad). This opposite view of cost provides us the following key concepts:
1. Production costs (whether continuing or new) are best viewed as investments in the business.
2. Withholding necessary investments will likely cause future financial loss.
3. New investments yielding incremental profits are generally good.
4. Priorities for new investments may be established using any one of several common techniques and a computer spreadsheet.
5. Expressed as a percentage of revenue, the value of production investments (previously “costs”) should decline over time.
Embracing the above key concepts, we propose dropping the word “cost” from our power production vocabulary, choosing to use the word “investment” instead. We also better-realize that new and continued investments to production are good if: (a) producing greater profits without added risks; or (b) reducing risks while sustaining profits.
Investments in a power production business are usually categorized as planned or unplanned. Planned investments may include:
• Compulsory (plant licenses, permits, insurance, etc.)
• Consumable (oils, chemicals, water, fuel, etc.)
• Organization; the plant operations and maintenance (O&M) team
• Planned maintenance and repair
• Planned business (indirect) expenses
• Planned capital replacements
• Planned capital improvements
Unplanned investments in power production may be required due to:
• Plant emergencies
• Natural disasters
• Unplanned capital replacements
• Unplanned maintenance and repair
• New regulations
• Unexpected business (indirect) expense
Prioritizing Investments for Power Production
Provided below are guidelines for investment priorities within the two main categories: Planned and Unplanned. These are necessarily general and apply to power production facilities beyond their date of commercial operation.
PLANNED INVESTMENT PRIORITIES
1. Compulsory. Includes licenses and registrations, business permits, statutory inspections, compliance reports, insurances for plant property damage and business interruption, etc.
2. Production Consumables. Inputs consumed in the process of power production. Includes fuel, water, chemicals, oils, etc.
3. Plant O&M Organization. Includes cost of labor and associated benefits, payroll taxes, uniforms, personal protective equipment (PPE), health and safety program, etc.
4. Planned Maintenance and Repair. Includes tools, material, spare parts, contractor costs, etc. for minor and major maintenance, including scheduled overhauls of major equipment.
5. Planned Business (Indirect) Expenses. Administrative expenses not directly tied to power production but necessary to conduct successful business. Includes phone-internet expense, office supplies, travel costs, employee training, legal and accounting fees, etc.
6. Planned Capital Replacements. Applies to equipment known to have exceeded physical life, as demonstrated by high maintenance expense (including lost production and inefficiency).
7. Planned Capital Improvements. Capital is made available for planned improvements, provided the underlying investment is known to be profitable within reasonable time horizon or will substantially reduce business risk.
Most planned investments arise year after year, eventually being perceived as routine. As result, it is not unusual for annual budget amounts for planned investments to be escalated by some simple percentage at or near the rate of inflation. This is of course wrong; each planned budget line item should be thoughtfully subjected to the following questions:
• Is this a mandatory investment?
• Are desired results being achieved?
• Are there alternatives to performing this function?
• Could better results be achieved with different level of investment?
• Is the timing of this investment accurate?
It is important to keep in mind that prior-period investments yielded prior-period results (safety, availability, efficiency, outage rates, profitability, etc.). If prior results were not satisfactory then something within the planned investment methodology should change.
UNPLANNED INVESTMENT PRIORITIES
1. Plant Emergencies. May include fire, explosion, electrocution, etc. Likely has some association to/with the plant’s insurance coverage (property damage).
2. Natural Disasters. Includes flooding, hurricane, earthquake, tsunami, etc. Likely to have impact to insurance coverage (business interruption).
3. Unplanned Capital Replacements. Unexpected replacement of plant equipment to re-establish safe and efficient operation of the facility at required capacity.
4. Unplanned Maintenance and Repair. Unexpected restoration of plant equipment to a safe condition and operating at required capacity.
5. New Regulations. Includes unexpected near-term taxes or fees or requirement for a new environmental treatment process.
6. Unexpected Business (Indirect) Expense. May include an unexpected rent increase, or higher than expected legal costs due to contract dispute.
Unplanned events requiring additional investment are expected every year. Indeed, it is common practice to “plan for the unplanned” by forecasting annual forced outage rates-factors and to allocate budget monies thereto.
Linking Potential New Investments to the Income Statement
Appearing earlier in this article is a statement that investment priorities may be established using any one of several common analysis techniques and a computer spreadsheet. Such techniques include, among others:
• Return on Investment
• Net Present Value
• Payback Period
• Internal Rate of Return
Performing the necessary calculations for each technique is relatively straightforward. The first and greater challenge is to objectively quantify the expected financial benefit in a manner understood and transparent to internal parties. The following approach is recommended:
1. Review the high-level key performance indicators (KPI) for the business. These may include power capacity, availability, planned outage rate, forced outage rate, efficiency, non-fuel production expense rate ($/mW-hour), LTI’s, etc.
2. Plot historical trend lines for each KPI over the last three years.
3. Extend the trend line of each KPI into the future for the next three years, absent the intended investment.
4. Using a different colored line, extend the trend line of each KPI into the future for the next three years, assuming the investment was indeed (already) made.
5. Quantify any improvement in KPI’s reflected by the with- and without-investment trend lines.
6. Apply-translate the quantified KPI improvements to associated line items on the company income statement (revenue, fuel cost, depreciation, etc.) for the most recent year. Deduct 25% of the benefit as an investment safety margin.
7. Compare the calculated improvement to the income statement to the cost of the proposed new investment.
8. If the result is beneficial to the company, initiate internal process for formal approval.
A Final Note: Investment Priorities May Differ
As defined by financial method and mission, power production businesses are not all equal. For example, a regional power utility allowed a regulated rate of return (percentage) on top of its total spending may have different investment priorities than an Independent Power Producer (IPP) seeking long-term, high-Dollar dividends. Similarly, IPP’s with long-term investment horizons may have different priorities than IPP’s with short-term horizons. While the different types of businesses and owners have very real impact on spending priorities, it is usually helpful to consider such variables later. First-focus should be on the needs of the production facility and its organization, taking the view that whatever is good for the facility is usually beneficial to its owners, off-takers, and the ratepayers.
About the author: Tom Paul is President & CEO of Productive Outcomes LLC, a global consulting company specializing in alignment of industrial work processes for optimum financial performance. Paul previously was President and CEO of Marubeni Power Asset Management Limited (“MPAM”) in Hong Kong. Overall he has 30 years of experience in the power generation industry encompassing nuclear, conventional thermal, combustion turbine, reciprocating engine, hydroelectric and biomass technologies. His extensive knowledge and expertise include engineering, maintenance, operations, administration, labor relations and adult education with core competencies including applied business analysis, corporate acquisitions analysis, international market analysis, international labor force development, labor conflict resolution, and international business start-ups.