The Color of Capital

Dear Gregarious Green One,

My firm uses Ultrinium™ and Sustained Pressure Rejuvenation to treat cables after they fail. The ability to capitalize single section injection with Novinium technology means we can earn a regulated rate of return on the capital thus expended. I read your four-part blog, “The Color on Money” and was wondering if you could do a similar analysis to help us quantify the benefit of our approach.

Considering Capital in Colorado

Dear CCC-

I am pleased that you appreciated my “Color of Money” posts. Click on I, II, III, and IV to review that work. Many of the concepts in the “Color of Money” apply to the “Color of Capital.” In fact, Parts II and III are prerequisites if you need a primer on depreciation and the time value of money respectively.

The ability to capitalize single sections of injected cable is available only from Novinium. In FERCs (Federal Energy Regulatory Commission) Letter order dated January 18, 2000, John Delaware, the Chief Accountant, wrote to the petitioner, Georgia Power:

“You indicate that CableCURE is used to rehabilitate entire segments of your underground distribution system (e.g. entire residential subdivisions as opposed to individual runs of cable between two terminal points).”

The only way you can capitalize CableCURE is if the entire subdivision is rejuvenated. The letter order is attached to this post for the interested reader. Novinium’s technology has no such limitation. The Letter Order promulgated by FERC’s Chief Accountant on September 4, 2008 and associated submittal information removes that limitation and can be accessed by clicking here. All of the above discussion is also true for RUS-funded circuit owners. Click here is view the RUS order of April 3, 2009.

That takes care of the regulators; now the analysis. We will compare two cases. All of the inputs are shown on the worksheet nearby. Parenthetical references to the worksheet cell designations appear in the following text.

Case 1

The cable fails, is repaired and put back in service. In our model the user can indicate how many faults are tolerated before the cable is replaced, together with an estimate of the time between faults. For this example, we assume the cable will fault twice over a two year period before it is replaced. The capital cost to replace is a modest $33.00/ft (Cell B7) and the O&M cost of a fault is $13.72/ft (Cell D13) in today’s dollars. That’s $4,500 (Cell B11 + Cell B12) divided by as assumed segment length of 328 ft (Cell B13).

Case 2

The cable fails, is repaired and injected in a single integrated operation. In our model the bundled unit capital is $20.06/ft (Cell D23). The model user can change any of the costs inputs and an assumption of the post-treatment reliability. For this example, the post-treatment failure rate is assumed to be 2% (Cell B26), which is about twice Novinium’s actual post-failure experience of about 1%.  To put this 1% failure rate in perspective consider that it is three-times higher than Novinium’s non-post-failure experience of about 0.34%. This higher-than-typical post-treatment failure rate is inherent in post-failure treatment. The post-injection fault is assumed to occur two years (Cell B27) after injection. Again the model user can adjust any of these assumptions.

Other Assumptions

Warranty remittances of $10/ft (Cell B23) are negative capital expenditures, that is, the remittances are subtracted from the subsequent replacement capital. Upon post-injection failure, the book value is written off, terminating the ratemaking-allowed return and providing a lump sum tax benefit of the book value. Cash flows are calculated for two rehabilitation cycles, up to 100 years. This approach allows residual values to be properly ignored as de minimis. Finally, replacement is assumed to have a zero-percent failure rate. At least one major investor owned utility has reported that new installations suffer a 0.6% “infant mortality” failure rate, and hence this assumption results in a slight understatement of the incremental value of Novinium^® post-failure rejuvenation.

Bottom Line

The cumulative net present values (NPVs) for the two cases are plotted nearby. Since the revenue or sale of electricity is the same in all cases, those revenues are ignored and only capital and O&M costs are depicted. This cost-only analysis is why all of the NPV values are negative. Nonetheless, the higher the cumulative NPV value is on the graph, the more advantageous to the circuit owner.

The blue line is for Case 1, and in the short run it is the superior choice. The problem is that once a cable begins to fail, it will re-fail. Sooner or later the ratepayers will be very upset with deteriorating reliability. Capital inefficient replacement is executed after the second fault (Cell B14) and the NPV plummets.

The orange line is for Case 2, and it represents an investment in reliability. The initial cost is about twice as great, but because the investment is capital, the circuit owner begins to earn a regulated rate of return. In the end, the incremental NPV advantage of Novinium post-failure rejuvenation is $18.42/ft. If your replacement cost is higher, say $44/ft, the difference becomes $21.15/ft. If in Case 1, the cable is allowed to fault a total of three times, the difference rises to $24.56/ft. Even if the cable is replaced after a single fault, the best alternative to rejuvenation, rejuvenation still enjoys an $11.45/ft advantage.

If you would like to run this model on your specific circumstances and execute “what if” scenarios, contact us at novinium.com/Contac.aspx.

Always conserving capital,

T. B. Frog

70-20120322_FERC_Letter_of_Approval.pdf (78.87 kb)

The Color of Money – Part IV

In my post of February 27^th, The Color of Money – Part I, I gave the big picture answer to Cap’s query. In February 28^th’s follow-up post we delved into the details of depreciation. On my Leap Day post we deliberated discounting. Today, in the fourth and last post of the series, we will tie up loose ends and cover the rest of the assumptions.

Rejuvenation Technology Inputs

In cells B12, B13 and B14, the name for “Product X”, the fully absorbed cost for product X, and the warranty length are entered respectively. Cells B16, B17 and B18, hold the same values for “Product Y.” Cell B20 is the ratio of the warranty length of Product Y divided by the warranty length of Product X.  The accounting lives are assumed to be the respective warranty lives.  The actual life multiplier in cell B21 is the ratio of the actual life of Product Y divided by the actual life of Product X. The warranty life is an approximate indicator of the actual life, as the technology suppliers use some combination of experience, accelerated life experiments, and accelerated life simulations to arrive at reliable life expectations.

For individual large and stable firms, such as most utilities, the spread or difference between the discount factor in cell B3 and the inflation rate in cell B6 is quite constant. If inflation increases, discount factors increase too. The 5.9% spread in the example is typical for the power distribution industry in North America.

Accounting Treatment of Warranty Remittance 

GAAP would suggest that warranty remittances are handled as negative capital expenditures. That is, the cost of replacement is reduced by the amount of the warranty remittance. Any remaining undepreciated value associated with rejuvenation is written off in the year of the failure on both the tax books and the rate-making books. Individual circuit owners may treat these warranty refunds differently. Write to me to tell me how your firm accounts for these warranty payments.  I’ll enhance the model to accommodate your method.

Residual Value

For any net present value analysis there has to be an assumption regarding the handling of residual values at the end of the analysis period. Where two rejuvenation technologies with different actual lives are compared, the technology with the longer life will have a greater residual value than the product with lesser life. For the purposes of this analysis a single replacement cycle is executed after the rejuvenation cycle has completed and future value is calculated to a one century horizon. Cash flows after 100 years are ignored. This assumption favors the technology with the shorter life, since the product with the longer life would have the greater residual value.

Bottom Line

This rigorous analysis confirms and quantifies what should be self evident. The longer the life – the greater the value.

Greener is better,

Thermonuclear Frog 

The Color of Money – Part III

In my post of February 27^th, The Color of Money – Part I, I provided the big picture answer to Cap’s query. In yesterday’s follow-up post we delved into the details of depreciation. Today we will deliberate discounting – muse over money’s time-value. Please dust off your Frogonomics 201 textbook, The Time Value of Money, and Turn to Chapter 3. Consider the common amphibious aphorism used to explain why future cash flows must be discounted, to wit: “A frog in the hand is worth two in the pond.”

A dollar earned or saved today has a greater value than a dollar earned or saved in a future time period for two reasons. First, inflation – we all experience its pernicious penalty. In cell B6 illustrated nearby, the annual replacement inflation is assumed to be 2.4%. The inflation of replacement is due primarily to the increasing cost of labor, secondly to the increasing cost of the commodities that make up a new cable, but thirdly both increases are mitigated by increases in the productivity of the people and tools performing replacement. Inflation then, is the composite of these three effects. Notwithstanding claims by the Federal Reserve Chairman, nobody can predict what future inflation will be, but that shortcoming is not as onerous as one might expect.

For individual large and stable firms, such as most utilities, the spread or difference between the discount factor in cell B3 and the inflation rate in cell B6 is quite stable. If inflation increases, discount factors increase too. The 5.9% spread in the example is typical for the power distribution industry in North America.

The second component of the discount factor involves a dispassionate assessment of the future financial risk – taking into account the financial expectations of the firm’s capital sources. The capital sources might include public debt and equity markets, they might include the ratepayers of a cooperative, or they might be taxpayers of a government-owned distribution firm. With the exception of some improperly functioning government entities, no capital source makes an investment without an expectation of a return. Further, the greater the perceived risk of the investment, the greater the expected return.

In yesterday’s post on depreciation, we also touched upon the rate of return on capital, and here again there is a generally stable historical spread between the rate of return and the discount factor.  Thus modelers must generally move these three values together for any sensitivity analysis. Inflation is less than the discount factor, which in turn is less than the rate of return.  The spreads are fairly stable for individual firms and are typically about 6% and 1% respectively. Check with your finance folks to determine the discount factor, inflation, and rate of return. Let this frog know of any values that differ substantially from the norms.

In my next post in this series we will examine the remaining assumptions required to compare two rejuvenation options.

For me, every day is a Leap Day,

Thermonuclear Frog

The Color of Money – Part II

In yesterday’s post, The Color of Money – Part I, I gave the big picture answer to Cap’s query. Today we will dive into the first of three sets of details that impact the answer, namely depreciation. In subsequent posts we will examine discounting and other assumptions. I had to pull out my green eyeshades to properly address depreciation. In the foreground of each of the graphs in yesterday’s post, a table of assumptions was provided.  In the illustration below I zoom in on the second table to shed light upon the details.

Depreciation is the allocation of capital cost over an accounting life of an asset. The accounting life and the actual life are not the same thing. Accounting life generally considers the actual life together with regulatory requirements and generally accepted accounting principles (GAAP). The accounting life for new cable is usually 40 years, so 40-years is the model assumption for “Replacement asset life” in cell B8.

There are a variety of ways in which the original capital cost of, say, a new cable might be spread over its accounting life of 40 years. The simplest method is called straight-line depreciation and it allocates an equal amount of depreciation expense for each of the 40 years of anticipated life. In our example, the replacement cost of $33.00 per foot in cell B7 would be spread over 40 years, and hence the annual straight-line depreciation would be 82.5¢ (i.e. $33 ÷ 40 yrs). There are other depreciation methods that accelerate expenses into the earlier years of the asset life. In my example, the double declining balance (DDB) method is used for tax purposes in cell B9. Wikipedia does a nice job of defining the concepts of depreciation, so the interested reader should visit …

http://en.wikipedia.org/wiki/Depreciation. 

Now for a not-so-secret secret – investor owned utilities keep at least two sets of books! One set of books is kept for the taxing authorities and the second set of books is kept for regulatory authorities. Often a third set of books is kept for internal purposes, but that has no impact on our analysis, because all we care about is actual cash flow.

In my next post in this series we will dive into discounting, but for now let’s agree that accelerated savings are good – a dollar saved today is worth more than a dollar saved tomorrow. That’s why for the tax books, the accountants use the most aggressive depreciation allowed by the tax authorities. For our example, I used DDB that switches to straight-line when straight-line becomes more favorable. The “2” in cell B9 represents the “Double” in “Double Declining Balance.”  The switch to straight line is controlled by a “True/False” switch in cell J9, which is not shown for brevity. If one has a depreciation expense of $100 and an “Incremental Income Tax Rate” of 32%, one would enjoy a $32 tax benefit. This is so because the $100 expense offsets $100 of revenue on which no taxes need be paid.

Now to the second set of books.  As long as the “Rate of Return on Capital” in cell B5 is greater than the “Discount Factor” in cell B3, it is to the circuit owner’s advantage to use the slowest depreciation method allowed by the regulators. In the long run the rate of return must be greater than the discount factor or investments by the circuit owner would make no sense. The FERC (Federal Energy Regulatory Commission) promulgates a Uniform System of Accounts (USoA) to regulate how capital assets are depreciated. For the example provided in this model, regulatory depreciation is straight line, indicated by a “1” in cell B10.

What if your firm is not an investor owned utility? What if your firm does not pay any income taxes? At first glance it appears that publically owned utilities should set both their incremental income tax rate and rate of return on capital to zero. That would ignore the stakeholders of public utilities have the same expectation of economic return as their investor owned neighbors. If the publically owned entity did not provide a return in the form of lower electrical rates or direct payments to a governmental unit, there would be a strong case to privatize the utility. This frog would argue that the same values used by neighboring investor-owned utilities should be utilized for this analysis, but check with the green-eyeshade guys upstairs.

Using GAAP (generally accepted amphibian practices),

T. B. Frog

Middle East Query – Rejuvenation Saves Capital

Dweller of the Desert asked 22 questions in his post …

Middle East Query – 22 Questions.

In this installment I address question 12.

12.   What is the expected cost of curing compared to cable replacement?

Typical costs for injection are one-half to one-third of the cost of cable replacement.  For submarine cables and armored cables, cable injection can be only one-sixth the cost of replacement.  With soaring costs for copper, aluminum, and petroleum-based polymers the economics of injection only get more compelling.  In addition to raw material costs, skilled craftsman to replace cables are becoming increasingly scarce and more costly.  Rejuvenation requires one-half to one-third of the labor-effort to replace a length of cable, so the cost to rejuvenate will always be proportionally less than replacement.  With the state-of-the-art sustained pressure rejuvenation process, even cables in ducts, conduits, or trays enjoy the cost advantage of rejuvenation. Because splices are either non-existent or easily accessible in these systems, the rejuvenation productivity remains two to three times higher than replacement. Hence the cost to deliver rejuvenation remains below the cost of replacement.  Finally, the funds expended for cable rejuvenation are capital cost – just as cable replacement is a capital cost.  In fact, Novinium technology is the only cable rejuvenation that the FERC (U.S. Federal Energy Regulatory Commission) and the RUS (Rural Utility Services) have approved to be capitalized for post-failure treatment.  Check out the FERC Letter Order and the RUS Letter Order for more details.  Saving capital is what we do.  Technology invented by Novinium founders has saved circuit owners around the world over one billion U.S. dollars!

For now, Ma’a salama (مع السلامة/Good bye)

T. B. Frog