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 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