Asset Management Do You Know Your Risk? by Chris Trayhorn, Publisher of mThink Blue Book, May 15, 2006 Asset management is the focus for most utilities, primarily because of cost pressures resulting from the limited availability of capital and O&M funds, and from customer/regulatory pressure to improve physical network reliability and operating efficiency. A recent META Group study, Promising Initiatives in Distribution Asset Management, found that utilities are divesting themselves of noncore utility businesses, resulting in a back to basics strategy where the only choice is to reduce costs. Utilities struggle with how to practically accomplish this, often resulting in the implementation of autonomous business processes and technology improvements. As asset management encompasses many of the utilitys key business processes and extends across the organization, it becomes obvious that technology solutions are a necessary enabling tool and that associated changes to the business processes must be fully embraced by the workforce and the benefits expected to be realized must be consistent with the utilitys risk profile. Although obvious, but much less practiced, the utilitys propensity to assume/accept risk is directly related to the benefits they can expect to achieve. The difficulty in doing this has been the lack of a practical risk measurement that accounts for the major elements of the utilitys risk that must be managed. The business drivers for focusing on asset management provide excellent indicators of the types of projects that must be undertaken for which the risk potential impact/degree of influence on expected return must be evaluated. For example, a utility may make a large capital investment in network assets (assess capital risk) to improve reliability in response to customer satisfaction concerns (companys perception/ reputation risk). A Primen-Electric utility study showed that by investing an average of $1.64 per customer in service delivery a utility company can achieve an 8 percent increase in customer satisfaction, while investing $180 per customer in improving distribution infrastructure only improves customer satisfaction by 5 percent. Clearly, there is a need for a comprehensive risk/return model that can be used to evaluate the various utility investments (not just capital, and not just physical network improvements) that returns/maintains an acceptable level of balanced, aggregated risk. The following sections provide a high-level overview of asset management business drivers to profile projects/risks, and the use of an efficient frontier analysis to measure and manage portfolio return/risk. Use of Asset Management Business Drivers to Profile Risk Utilities, particularly the distribution business, are faced with a number of critical business drivers, from regulatory compliance (e.g., financial/governance Sarbanes- Oxley), security and operational (e.g., system reliability, pipeline safety) to operational efficiency requirements. Combined with an aging workforce and aging assets, utilities have realized the need to refocus. As a result, utilities are moving to a back to basics or core business strategy that requires a shift in the areas and amount of emphasis placed on each risk element. Figure 1 summarizes the key asset management business drivers. Utilities have long recognized that they make money based on a return against the asset base, but the noncore investments made over the last 10 years have done little to contribute to generating returns against this asset base or improve revenue/profit, and in many cases, have resulted in compromising the companys creditworthiness. This, combined with limited rate case opportunities, has constrained the utilitys access to capital. With the back to basics strategy and constraints to the access to capital, the utility must reduce costs. While internally, the utility employees focus is on reducing cost, externally this must be transitioned to and presented as improving shareholder value. Thus, all projects to be considered within the portfolio should address how shareholder and customer value is improved. META Group, Inc. (now a part of the Gartner Group) has presented this very succinctly in an article, Promising Initiatives in Distribution Asset Management. As can be seen from Figure 2, shareholder value, the difference between allowed returns and operating costs, has continued to erode. Allowed returns in the European and Australian markets have been largely limited as a result of price cap regulation, while U.S. markets have to face limited organic growth (resulting in more M&A activity). The utilitys only choice is to reduce costs an effort theyve taken on a number of occasions (represented by a series of reductions in cost over time) that has only resulted in sweating the assets in terms of addressing the low-hanging fruit. Any further cost-out efforts will not be easy. While operational efficiency and regulatory compliance currently dominate the scene, other factors such as an aging workforce, aging assets, etc., must be appropriately considered to maintain an appropriate level of risk while making further cost reductions. As can be seen from Figure 3, a larger capital investment in assets is likely necessary to achieve an acceptable risk profile as it relates to the overall age of the asset base. Similarly, as the average age of the workforce is now approximately 47 years, with retirement typically at age 55 years, capturing the knowledge base through technology-enabled business processes, again requires some level of capital investment commensurate with the acceptable level of risk. The question becomes one of finding a manageable and practical way of considering all of these investments and achieving the expected return without creating an undue imbalance in the risk profile thats acceptable to the utility. A method commonly used by companies as well as individuals in making financial instrument and project investment decisions is efficient frontier analysis. This same analysis can be applied here. Application of Efficient Frontier Analysis As a utility operates as a business, it must provide both shareholder and customer value (see again Figure 2). The utility must deliver an appropriate level of return while maintaining an acceptable level of risk. Everyone knows (or should know) that there is a direct relationship between return and risk the larger the return, the higher the risk. Few companies, however, truly understand whether their assets reflect appropriate returns for the risks they face. Constrained by finite budgets, staff and other resources, companies are continually faced with the issue of deciding where to invest to deliver the most value to the business. With millions of dollars and hundreds, if not thousands of project investments at companies each year, it makes sense to treat these investment decisions in a manner similar to how a fund manager determines a portfolio of stocks. The concept of projects, here, must be expanded beyond the traditional capital investments in physical assets, to encompass projects focused on improving the companys perception, retaining the knowledge base of an aging workforce, etc. From the Primen-Electric utility study referenced earlier, it showed that by investing an average of $1.64 per customer in service delivery, a utility company can achieve an 8 percent increase in customer satisfaction, while investing $180 per customer in improving distribution infrastructure only improves customer satisfaction by 5 percent. This indicates that customers are willing to accept lower reliability, if they have a better means of communicating or better experiences with the utility. The capital investment swing in this example exceeds tenfold. Figure 4 is an example of the efficient frontier approach. It is a portfolio analysis concept that: Evaluates risk versus return for portfolios that can be comprised of a given group of investments; Identifies the single highest level of expected return for a given portfolio risk profile; and Requires information about individual investment opportunities, including the expected return (return) and the standard deviation of return (risk). The efficient frontier (curved line) represents the maximum return one can expect to achieve given all combinations of investments that are constrained by the utilitys finite budgets, staff and other resources. The portfolio projects represented here are those that have been identified through the evaluation of the asset management business drivers, and could include projects such as capital asset construction, security upgrades, technology solutions to address the aging workforce, increased customer satisfaction through improved communication means (e.g., customer self-service), selling-off noncore businesses, improving cash flow, etc., that need to be considered in efficiently managing assets while generating the highest return with acceptable risk. To determine the efficient frontier: The expected value (return) of each project under consideration is estimated; The variance in the potential values (returns) of each project is estimated as a measurement of risk; The correlation between each project and every other project is estimated; and Constraints (e.g., budget, staff, other resources) that limit which portfolios (combination of projects) are acceptable are expressed. At every level of risk, the portfolio that generates the highest return determines the efficient frontier curve. A number of commercially available software solutions will support the required data development and analysis. Portfolios along the curve are said to be efficient because the utility is getting maximum value from the available budget, staff and other resources. Points under the curve are inefficient because they either represent less-than-an-optimal return or higher-than-acceptable risk. Many factors can result in a portfolio being under the curve, including taking on too many low-value projects or a mismatch between the supply and demand of technical skills/competencies, leaving a portfolio that yields less than it could have from the total available resources. Thus, any position that moves the portfolios position away from the efficient frontier should be challenged. Another important outcome in using the efficient frontier modeling is opportunity cost. The efficient frontier shows the opportunity cost of investing a unit of additional resources versus the additional value (return) received. As the utility discovers their most valuable projects, those with the highest value-to-cost ratios, the efficient frontier is very steep. As fewer valuable projects remain, the curve flattens out. This is essentially the 80/20 rule, where 80 percent of the value is achieved from 20 percent of the investment/effort. For utilities, or any company that normally experiences additional budget cuts or other resource constraints during the year, the efficient frontier provides a means to identify those projects that should be placed on hold or cancelled. Conclusion Asset management business drivers should be used to drive the portfolio of projects to be considered for implementation by the utility. Efficient-frontier analysis provides the means to determine a portfolio of projects that can achieve the maximum return within the utilitys propensity to assume the associated risk. Any decisions made by the utility that result in a portfolio that falls below the efficient frontier must be challenged, as the portfolio is yielding less than it should based on the level of investment made. The efficient frontier method will provide the utility with better return and risk information upon which investment decisions can be based and periodically evaluated as conditions change. Furthermore, it encourages more personnel within the utility to make economically based decisions, including the consideration of shareholder and customer value. Filed under: White Papers Tagged under: Utilities About the Author Chris Trayhorn, Publisher of mThink Blue Book Chris Trayhorn is the Chairman of the Performance Marketing Industry Blue Ribbon Panel and the CEO of mThink.com, a leading online and content marketing agency. He has founded four successful marketing companies in London and San Francisco in the last 15 years, and is currently the founder and publisher of Revenue+Performance magazine, the magazine of the performance marketing industry since 2002.