Asset replacement in the electric utility industry.

Author:Brockman, Christopher M.
Position:Report
 
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  1. INTRODUCTION

    In most industries, assets used to generate revenues are replaced based on increasing maintenance costs or on the fact that newer assets have dramatic production improvements, making cost justification relatively easy. Not so in the electric utility industry. There are no dramatic production improvements with newer assets and newer assets require only slightly less maintenance than the older equipment. So when should a utility replace aging assets? Should they follow vendor recommendations; should they wait until the equipment fails; or is there somewhere in between where they should make the decision to replace assets?

    If there are not noticeable efficiency improvements, reason would say to keep using the existing assets for as long as possible, but there are other factors such as safety issues, customer satisfaction issues, and extra expenses that must be considered when running certain equipment to failure. High voltage equipment can experience an explosion upon failure and expose employees and others to a significant amount risk. Failed equipment can also cause a loss of service, and even if this loss of service is momentary, many customers lose thousands of dollars by having to restart manufacturing processes.

    The discussion that follows takes a look into what are the options and what is the low cost and high reliability solution.

  2. ASSET REPLACEMENT COST VERSUS BENEFIT

    When evaluating a new project, it is a fairly straightforward analysis to determine if the project will make money. Three of the most commonly used financial evaluation tools used in capital budgeting decisions are (Brigham and Erhardt, 2008):

    * Payback period--expected number of years to recover the original investment.

    * Net Present Value (NPV)--cash flows for the life of the project are discounted back to present day values and summed. A positive NPV is good and a negative NPV is bad.

    * Internal Rate of Return (IRR)--the rate of return on the project defined as the discount rate that makes the NPV equal to zero.

    In this paper, we will use Net Present Value (NPV) to determine the value of a project. Let us assume an asset can be added at a utility at a cost of $20,000. It will produce revenue of $900 the first year with the revenue increasing by a six-year historical rate of 2.7% each year (InflationData.com). The asset has a life expectancy of 50 years and the company's cost of capital is 6%. Table 1 below shows the NPV of the proposal to be $1,663, and based on these assumptions, this is a good investment.

    Now suppose 50 years have gone by and the asset is said to be at the end of its vendor-recommended life. Assuming that the replacement cost of the asset has increased at half the annual rate (1.35%) of the asset's revenues, the replacement cost after 50 years is $39,100. Again using a 6% cost of capital, the NPV of replacing this asset at the end of its 50-year life is approximately $42,980, as shown in Table 2.

    Now, assume the utility has done studies that indicate the asset actually has many more years of service left and instead of replacing the asset it decides to use the asset another 50 years. Continuing the previous scenario with a 6% cost of capital, Table 3 shows that the NPV of this decision is $82,080.

    The decision to use the asset another 50 years carries considerable risk of failure due to the age of the equipment. A more conservative decision might be to use the asset another 10 years and thus delay the capital expense and then replace it. Table 4 shows an NPV of $57,111 for this decision. This is a substantially higher present value than the first replacement decision, with considerably less risk of failure when compared to the second.

    Now, assume the utility has 10,000 of these assets--the NPV of these decisions are shown in Table 5 below.

    From this simple example, it can be seen that delaying a capital expense pays huge dividends to the company's bottom line. However, there are significant risks associated with keeping assets so long that they fail. There are safety, environmental, customer satisfaction, public perception, and industry regulation factors that all come into play. Making the decision more difficult is the fact that two similar assets can fail at significantly different times.

    In a utility company, revenues are not broken down into individual assets. Assets are evaluated to either be needed or not, as a group. Once they are deemed as needed assets, asset replacement decisions are primarily made based on cost and not value. For this reason, the remainder of this paper focuses on costs and the minimization of those costs.

  3. POSSIBLE COURSES OF ACTION

    Option 1: Replace at end of Life Expectancy

    The easiest course of action would be to replace assets as they reach the end of their life expectancy. Most vendors will give you a recommendation of when to replace their equipment, but this recommendation has to be viewed with skepticism because the vendors have a conflict of interest in their recommendations, as they stand to make a substantial amount of money by selling replacement equipment. As shown above, delaying capital expenditure, assuming other expenses are kept constant, a utility can drastically improve its bottom line.

    Take the example of a relay replacement and it annual maintenance costs. Assume the relay vendor recommends a life expectancy of 20 years, but the utility finds that the relay will actually last 40 years. Also assume the following applies:

  4. Cost to replace a relay is $175,000

  5. Current annual cost of maintenance of a relay is $157

  6. ...

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