Hidden value of capital allocation
Rick, the veteran head of corporate planning for Ever-Ready Utility Corp. (ERU), wished 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.
Rick looked over the latest asset plans. The company’s engineers — a risk-averse, technically minded group — had painted a grim picture.
The engineers had pulled no punches. Safety, reliability and regulatory compliance were all 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 rethink.
It was time to question assumptions and to challenge the status quo. It was time to find every available dollar and put each to good use.
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.
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 cents 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.
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 be confident that they’re investing capital in the right way and getting the most for every capital dollar.
Leading companies are taking a three-pronged approach to the complex balancing act of capital allocation:
- 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.
- Bring increased transparency to the use of contingency and reserves.
In project estimates, organizations should clarify:
- 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
- Take a deep look at mandatory capital in the system.
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?
Throughout the process, consider employing capital investment scenarios.
Scenario-based thinking and 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.
There’s a significant amount of untapped capital in the power and utilities sector. Taking a holistic look at the process, assumptions and 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 underspend as it is to overspend.
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.