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 utility’s 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 utility’s risk profile. Although obvious, but much less practiced, the utility’s
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 utility’s 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 (company’s
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 company’s creditworthiness.
This, combined with limited rate case opportunities, has constrained the utility’s
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 utility’s only choice is to reduce costs – an effort
they’ve 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 that’s 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 company’s 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 utility’s 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 portfolio’s 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 utility’s 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.