5 Insights - Capital Allocation

5
Insights for executives
Hidden Value
Finding the X-Factor in Capex Allocation
Of special interest to:
Chief financial officers
Power & Utilities
business unit leaders
It 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 companys engineers a risk-averse, technically minded
group had painted a grim picture. The transmission system needed to be built out and upgraded. The
utilitys 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
didnt make the needed investments now. But Sam, the new CFO, had been equally emphatic: the money
wasnt 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.
1
2
2
Whats 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.
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, its 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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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 theyre 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.
Whats the fix?

Leading companies are taking a three-pronged approach to the complex balancing act
of capital allocation:
1.
1.
2.
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.
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 assets 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).
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
utilitys 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. Scenariobased 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.
Whats the bottom line?

Theres 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 its 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?

The answers in
this issue are
supplied by:
Dana Hanson
Power & Utilities Lead,
Americas
+1 704 335 4210
[email protected]
Andy Patterson
Principal
+1 404 433 4040
[email protected]
For related thought leadership, visit

www.ey.com/5
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are subjects you would like
5: insights for executives to cover.
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5

Insights for executives

Whats the issue?

How does it affect you?

Whats the fix?

Take a deep look

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

Whats the bottom line?

Want to learn more?

For related thought leadership, visit

We want to hear from you!

EY | Assurance | Tax | Transactions | Advisory

2013 Ernst & Young LLP.

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