TIER 1 WORKING PAPER No. 10
REFURBISHMENTS AND AUGMENTATIONS
INTRODUCTION
Working Paper No. 1 ‘How Water Prices are Set’ provided an overview of how water prices are set on the basis of lower bound costs. As noted in that paper, lower bound cost pricing requires a water business to recover, at the minimum, a number of different costs. One of the major cost components is that relating to refurbishment and replacement of existing assets.
The purpose of Working Paper No. 10 is to provide a brief insight into the treatment of refurbishment1 and augmentation costs in a water pricing exercise, explain the methodology used to recover these costs through a refurbishment and augmentation annuity (the annuity), and to highlight some of the key issues that need to be considered in this regard.
POLICY BACKGROUND
On 25 February 1994, COAG endorsed the implementation of a Water Resource Policy Framework. In relation to pricing and long-term infrastructure assets, the framework included, inter alia, the following element:
The setting aside of funds for future asset refurbishment and/or upgrading of government supplied water infrastructure.
The Agriculture and Resource Management Council of Australia and New Zealand (ARMCANZ) was charged by COAG with the role of support and coordination in relation to implementation of COAG’s 1994 water reform framework. A task force, which reported to the ARMCANZ standing committee of senior officials (SCARM), was established to assist ARMCANZ. In October 1996, the task force engaged Ernst & Young to examine issues specific to developing water price determinations in the context of COAG’s pricing reforms. One of the primary issues was to consider how the issue of asset consumption should be incorporated for pricing purposes.2 On 27 February 1998, ARMCANZ endorsed the guidelines developed by the SCARM taskforce. With respect to asset consumption, the guidelines recommended that:
ASSET CONSUMPTION be measured:
• by traditional depreciation for non-infrastructure items, namely those short-lived
items, where lives are known and not dependent on the life of the larger system of which they are part , eg motor vehicles, furniture and equipment.
• by renewals annuities (condition based depreciation based on an asset management
plan) for infrastructure assets, which are those system assets which are essentially renewable rather than replaceable.
This paper highlights the key asset consumption issues addressed in the SCARM guidelines, including the recommended formula for the calculation of the annuity.3
1. The term refurbishment is being used within SunWater as a replacement for the term renewals to reflect some key changes in the classification of activities and costs in line with industry best practice (i.e. to provide a clearer differentiation between the classification of operating activities, maintenance works and refurbishment/renewal works).
3. The project was set up in two stages:
• Stage I examined and recommended methods for valuing assets, asset consumption and opportunity cost of capital in determining full economic cost for use in the price determination process
• Stage II, based on the recommendations of Stage I, developed operational guidelines and a practical model to enable water businesses to examine the implications of COAG’s full cost recovery objectives for their own pricing.
4. The WRU adopted the SCARM methodology to calculate the current renewals annuities for SunWater’s existing five-year price paths that expire on 30 June 2005.
ASSET CONSUMPTION, DEPRECIATION AND RENEWAL
There are two basic approaches to measuring asset consumption, the choice depending on the nature of the assets involved:
1. The first is the conventional, formula based depreciation approach used for financial reporting purposes. For costing and pricing purposes, this approach is used only for non-infrastructure assets.
2. The second measure is condition-based depreciation, where the asset consumption is derived by calculating the cost of maintaining the asset in an operational condition. The latter method is commonly used for depreciating infrastructure assets for costing purposes.
I
NFRASTRUCTUREA
SSETSAn infrastructure asset is defined as an asset system with two major characteristics:
1. It is renewable rather than replaceable. Individual assets that form the components of the system will each be replaced according to their own useful lives, but the operating capacity of the asset system as a whole is maintained indefinitely.
2. For the foreseeable future, demand is such as to warrant continual extension of asset system life by renewal.
CONDITION-BASED DEPRECIATION
An annuity is calculated to represent the amount of asset service potential used up by the cost of replacing it. Unlike conventional depreciation, the annuity approach is based on projected refurbishment and augmentation costs, not the value of the asset. It is only appropriate for infrastructure assets, defined as those that are being continuously renewed.
The method of asset valuation will not affect the cost of replacing lost service potential. Therefore, the annuity for a particular asset has no connection with the asset value. The cost of replacing lost service potential will always be based on the replacement cost of the components to be refurbished.
CALCULATING THE ANNUITY
Using the necessary data from a strategic asset plan, the following three-stage process is used to calculate the value of the annuity:
1. The Net Present Value4 of refurbishment and augmentation expenditure must be calculated for the chosen annuity period.
2. The value of the Asset Restoration Reserve (ARR)5 at the beginning of the annuity period is then subtracted from the net present value of refurbishment and augmentation expenses to determine the Total Amount required to fund the refurbishment and augmentation program.
3. The value of the annuity amount is then calculated by applying a standard annuity formula to convert the Total Amount into an annual equivalent amount.
Appendix A sets out the appropriate formulas used in the calculation of the annuity and Appendix B sets out a worked example of a 30-year rolling annuity calculation.
4. The net present value is a common concept in economics/finance used to express the net value of future cashflows in current dollar value terms.
5. The ARR acts in the same manner as a cash balancing account carrying the net ongoing balance of the annuity receipts offset by drawdowns to meet refurbishment and augmentation expenditures, plus any interest earned or paid on the balance over the annuity period. In principle, the ARR will have a zero balance at the end of the chosen annuity period with all funds received (from the annuity amounts collected and interest received) offset by all outgoings (total refurbishment and augmentation expenditures and interest paid).
R
EFURBISHMENT ANDA
UGMENTATIONE
XPENDITUREThe refurbishment and augmentation expenditure cashflows are derived from the expenditures required for all works undertaken to maintain the existing standards of services provided by existing infrastructure assets, including the ability to ensure ongoing compliance obligations are satisfied. Therefore, the refurbishment and augmentation expenditure cashflows should include the costs of refurbishment and replacement of individual assets required to maintain current service potential and meet all compliance requirements.
Refurbishment and augmentation expenditures include amounts for asset substitutions required to cover the replacement of individual assets due to technological change and process redundancy as well as expenditure to improve general business and performance efficiency (e.g. new SCADA systems and other operational control assets). However, significant capital expenditure to provide new assets and/or to provide significantly enhanced levels of services to customers needs to be identified separately.
SunWater Data Classification
To ensure the data used in the annuity calculation is accurate, SunWater has recently undertaken a review of the refurbishment and augmentation program for each scheme. Based on industry best practice, expenditures related to standard operating activities and other expenditures more closely aligned to corrective and preventative maintenance activities have been reclassified out of the refurbishment database and into the general operating and maintenance budgets.
E
XPENDITURE ONN
EWA
SSETS ANDS
IGNIFICANTE
NHANCEMENTSAs already noted, expenditure separately identified from the annuity calculation includes:
(a) capital expenditure on new water infrastructure assets covering both new schemes and major extensions to existing schemes (e.g. assets for new customers and expenditure to meet new demand from existing customers)
(b) capital expenditure on significant asset enhancements to considerably improve the level of service to existing customers above the original standards of service.
Current examples of such expenditure would include the expenditure associated to provide ‘new water’ from the new Burnett River Dam and Kirar Weir.
Consistent with COAG’s framework, capital expenditure of this nature is not supposed to occur unless the assets are expected to earn an appropriate rate of return.
TERM OF THE ANNUITY
The choice of term for the calculation of the annuity is based on the need to secure a reasonably stable level of expenditure on refurbishment and augmentation works over time. With short cash flow periods (e.g. 5 to 10 years) normal fluctuations in refurbishment and augmentation activities result in variable annuity provisions not conducive to pricing stability. Beyond 30 years, the declining accuracy of assessment and the small difference that successive calculations make to the total NPV calculation, even for large expenditure amounts, suggests 25 to 30 years may be the most appropriate period for calculating an annuity.
Nevertheless, if the intention is to ensure future costs are always brought to account, the annuity can be calculated on a rolling basis. This can be every one, three or five years as is deemed appropriate. The WRU adopted a 30-year rolling annuity approach to calculate the current five-year price paths.6
6. Note that calculation of a 30-year rolling annuity for a five-year price path requires at least 34 years of forecast data for refurbishment and augmentation expenditures
DISCOUNT RATE
SCARM recommended that the discount rate (r) to be used for calculating both the net present value of refurbishment and augmentation expenditure and in the annuity formula should be based on the real rate of return that can be achieved from investment earnings when the Asset Restoration Reserve (ARR) is positive, or the borrowing rate when funds are borrowed. The weighted average cost of capital (WACC) should be used if renewals are funded from funds generated internally.
ASSET RESTORATION RESERVE
The ARR carries the accumulated balance of the unspent portion of the annuity, or overspent amount, and the interest thereon. The balance on the ARR (which can be positive or negative) is calculated each period as follows:
i i i i n i i ARR
ARR = − +AnnuityAmount −Refurb&AugmentCapexp+Interest
=1 1
The ARR is deducted from the NPV of the refurbishment and augmentation expenditures in determining the annuity amount. This provides the business with the opportunity to:
• make adjustments to the refurbishment and augmentation programs for future changes in project scope (eg. changes in materials and technology)
• adjust for changes in timing of refurbishments and augmentations, and hence restrict overcharging
• overcome the problems with the refurbishment/augmentation approach which would not otherwise accommodate underspent or overspent amounts on future works.
Existing Annuity Balances
When the WRU originally considered calculating annuities for each of SunWater's schemes, it was acknowledged that some schemes had a considerable backlog of maintenance to bring them up to a reasonable service standard. Accordingly, a program of backlog works was established with the required expenditure excluded from the irrigation price paths. Therefore, the WRU was able to calculate the scheme annuities for the current irrigation price paths using an opening ARR balance of zero.
Current balances for the ARR of each scheme will become the opening balances for the new price paths. However, in the event that segment pricing is adopted for the new price paths, the ARR opening balance for any particular scheme will need to be segregated into opening ARR balances for each segment within that scheme.
Unfortunately, as early historical data has only been maintained on a total scheme basis, there is insufficient data to accurately allocate past annuity receipts and refurbishment and augmentation expenditures to each scheme segment on a backward-looking, project by project basis. Therefore, a methodology is required to derive the segment opening ARR balance for each scheme. The proposed methodology is to allocate the scheme ARR opening balances based on each segments share of the relevant scheme total asset value.7
WATER INDUSTRY PRACTICE
Southern Rural Water (SRW) reviewed the annuity periods for its irrigation systems and showed that periods greater than 30 years generally result in a relatively stable annuity, whereas periods of 20 years or less result in a volatile annuity. SRW uses a 40-year period to provide a balance between price stability and inter-generation equity.
7. Note that the purpose of the allocation methodology is only to allocate an existing scheme ARR balance amongst the segments within that scheme, so the total sum of the segment ARR opening balances in each scheme will not be changed.
SRW uses a 90-year period for headworks as the expenditure profiles for these assets are even more variable and therefore require a longer period to buffer the pricing impacts from large refurbishment activities. The SRW model also excludes any asset that has a renewal life longer than the modelling period, from the renewal calculations.
In regards to the discount rate, the SRW renewal annuity model includes a module to allow annual step calculations of the annuity so that it can progressively apply different interest rates when the annuity reserve is in surplus (interest rate on investments) to when it is in deficit (interest rate for borrowings). In the past, SRW has used four per cent.
CONCLUSION
Tier 1 accepted Indec and GHD’s assessments that SunWater’s enhancement and enhancement program was appropriate. Tier 1 also accepted a 30 year rolling annuity plan.
APPENDIX A
CALCULATING THE ANNUITY
Using the necessary data from an asset management plan, the following three-stage
process is used to calculate the annuity:
1. The
Net Present Value
of refurbishment and enhancement capital expenditure
must be calculated for the relevant annuity period:
(
)
∑
{
(
)
(
)
(
)
}
∑
= + + + = i n Yr Yr Yr n i Yr NPV RE NPV RE NPV RE CapExp Augment & Refurb NPV K 2 1 1(
)
{
}
{
(
)
}
{
(
)
}
[
]
∑
+
−+
+
−+
+
+
−=
n Yr Yr Yrr
RE
r
RE
r
RE
n*
1
1
*
1
*
1 2 2 1K
Where:
Value
Present
Net
NPV
⇒
n) to 1 (i i year in expense on Augmentati and ent Refurbishm REYri ⇒ = program) on augmentati and ent refurbishm the in years (i.e. annuity the of Term n⇒Rate
Discount
Real
r
⇒
2.
The value of the
Asset Restoration Reserve
at the beginning of the annuity
period is then subtracted from the net present value of refurbishment and
enhancement expenses to determine the
Total Amount
required to fund the new
refurbishment and enhancement program.
(
)
0 1 Yr n i Yr ARR CapExp Augment & Refurb NPV i − =∑
= Amount TotalWhere:
0 Year in Reserve n Restoratio Asset of Balance Closing 0 ⇒ ARRYrNote:
If the Asset Restoration Reserve is negative at the beginning of the annuity
period, the Total Amount required to fund the refurbishment and enhancement
program over the annuity period will increase and if the Asset Restoration Reserve
is positive at the beginning of the annuity period, the Total Amount required to fund
the refurbishment and enhancement program will decrease.
3.
The annuity amount is then calculated using the following formula:
(
)
⎟⎟ ⎠ ⎞ ⎜ ⎜ ⎝ ⎛ + × = − n r 1 -1 r Amount Total Amount AnnuityWhere:
program) on augmentati and ent refurbishm the in years (i.e. annuity the of Term n⇒Rate
Discount
Real
r
⇒
Working Paper No. 10 Page 7 of 7
APPENDIX B – EXAMPLE ANNUITY CALCULATION (30-Year Rolling)
DATA ASSUMPTIONS
7.50% Discount Rate (r) Note: This example uses randomly generated data that is not real data for any SunWater scheme.
30 Annuity Period-years (n)
$0.00 ARR Balance (ARRi-1) Year 1 Year 2 Year 3 Year 4 Year 5
Calculated Annuity Amounts $5,059,313.81 $5,049,068.94 $5,058,265.62 $5,052,866.50 $5,113,284.00 FORECAST REFURBISMENT AND
ENHANCEMENT SPEND ANNUITY RECEIPTS NET ANNUAL BALANCE ASSET RESTORATION RESERVE (ARR)
PERIOD (i)
Years Capital Expenditure (REi)
NPVRE
Annuity Collected (RevA)
NPVRevA
Net Period Expense
(NPV) Balance (NPV) ARR Opening Balance Net Period Expense Interest Earned on ARR Balance Closing ARR Balance Yr 1 -$2,000,000.00 -$1,860,465.12 $5,059,313.81 $4,706,338.43 $2,845,873.31 $2,845,873.31 $0.00 $3,059,313.81 $0.00 $3,059,313.81 Yr 2 -$500,000.00 -$432,666.31 $5,049,068.94 $4,369,124.01 $3,936,457.71 $6,782,331.02 $3,059,313.81 $4,549,068.94 $229,448.54 $7,837,831.29 Yr 3 -$4,000,000.00 -$3,219,842.28 $5,058,265.62 $4,071,704.37 $851,862.09 $7,634,193.12 $7,837,831.29 $1,058,265.62 $587,837.35 $9,483,934.25 Yr 4 -$1,000,000.00 -$748,800.53 $5,052,866.50 $3,783,589.11 $3,034,788.58 $10,668,981.70 $9,483,934.25 $4,052,866.50 $711,295.07 $14,248,095.82 Yr 5 -$3,000,000.00 -$2,089,675.90 $5,113,284.00 $3,561,702.11 $1,472,026.21 $12,141,007.91 $14,248,095.82 $2,113,284.00 $1,068,607.19 $17,429,987.01 Yr 6 -$7,000,000.00 -$4,535,730.63 $5,113,284.00 $3,313,211.27 -$1,222,519.36 $10,918,488.55 $17,429,987.01 -$1,886,716.00 $1,307,249.03 $16,850,520.04 Yr 7 -$6,500,000.00 -$3,917,906.86 $5,113,284.00 $3,082,056.99 -$835,849.86 $10,082,638.68 $16,850,520.04 -$1,386,716.00 $1,263,789.00 $16,727,593.04 Yr 8 -$10,000,000.00 -$5,607,022.33 $5,113,284.00 $2,867,029.76 -$2,739,992.57 $7,342,646.11 $16,727,593.04 -$4,886,716.00 $1,254,569.48 $13,095,446.52 Yr 9 -$4,000,000.00 -$2,086,333.89 $5,113,284.00 $2,667,004.43 $580,670.54 $7,923,316.65 $13,095,446.52 $1,113,284.00 $982,158.49 $15,190,889.01 Yr 10 -$7,000,000.00 -$3,396,357.50 $5,113,284.00 $2,480,934.35 -$915,423.15 $7,007,893.50 $15,190,889.01 -$1,886,716.00 $1,139,316.68 $14,443,489.68 Yr 11 -$1,000,000.00 -$451,343.19 $5,113,284.00 $2,307,845.91 $1,856,502.72 $8,864,396.22 $14,443,489.68 $4,113,284.00 $1,083,261.73 $19,640,035.41 Yr 12 -$2,000,000.00 -$839,708.26 $5,113,284.00 $2,146,833.40 $1,307,125.14 $10,171,521.36 $19,640,035.41 $3,113,284.00 $1,473,002.66 $24,226,322.07 Yr 13 -$7,000,000.00 -$2,733,933.87 $5,113,284.00 $1,997,054.33 -$736,879.54 $9,434,641.82 $24,226,322.07 -$1,886,716.00 $1,816,974.16 $24,156,580.22 Yr 14 -$9,000,000.00 -$3,269,821.24 $5,113,284.00 $1,857,724.96 -$1,412,096.28 $8,022,545.54 $24,156,580.22 -$3,886,716.00 $1,811,743.52 $22,081,607.74 Yr 15 -$15,000,000.00 -$5,069,490.29 $5,113,284.00 $1,728,116.24 -$3,341,374.05 $4,681,171.50 $22,081,607.74 -$9,886,716.00 $1,656,120.58 $13,851,012.32 Yr 16 -$6,000,000.00 -$1,886,321.97 $5,113,284.00 $1,607,549.99 -$278,771.98 $4,402,399.52 $13,851,012.32 -$886,716.00 $1,038,825.92 $14,003,122.25 Yr 17 -$5,000,000.00 -$1,462,265.09 $5,113,284.00 $1,495,395.34 $33,130.25 $4,435,529.76 $14,003,122.25 $113,284.00 $1,050,234.17 $15,166,640.42 Yr 18 -$8,000,000.00 -$2,176,394.55 $5,113,284.00 $1,391,065.43 -$785,329.12 $3,650,200.64 $15,166,640.42 -$2,886,716.00 $1,137,498.03 $13,417,422.45 Yr 19 -$1,000,000.00 -$253,069.13 $5,113,284.00 $1,294,014.35 $1,040,945.22 $4,691,145.86 $13,417,422.45 $4,113,284.00 $1,006,306.68 $18,537,013.13 Yr 20 -$4,000,000.00 -$941,652.59 $5,113,284.00 $1,203,734.28 $262,081.69 $4,953,227.55 $18,537,013.13 $1,113,284.00 $1,390,275.98 $21,040,573.12 Yr 21 -$7,250,000.00 -$1,587,670.07 $5,113,284.00 $1,119,752.82 -$467,917.25 $4,485,310.31 $21,040,573.12 -$2,136,716.00 $1,578,042.98 $20,481,900.10 Yr 22 -$12,125,000.00 -$2,469,991.93 $5,113,284.00 $1,041,630.53 -$1,428,361.39 $3,056,948.91 $20,481,900.10 -$7,011,716.00 $1,536,142.51 $15,006,326.61 Yr 23 -$9,000,000.00 -$1,705,484.72 $5,113,284.00 $968,958.63 -$736,526.08 $2,320,422.83 $15,006,326.61 -$3,886,716.00 $1,125,474.50 $12,245,085.11 Yr 24 -$10,000,000.00 -$1,762,774.90 $5,113,284.00 $901,356.87 -$861,418.03 $1,459,004.80 $12,245,085.11 -$4,886,716.00 $918,381.38 $8,276,750.49 Yr 25 -$5,000,000.00 -$819,895.30 $5,113,284.00 $838,471.51 $18,576.20 $1,477,581.01 $8,276,750.49 $113,284.00 $620,756.29 $9,010,790.78 Yr 26 -$4,000,000.00 -$610,154.64 $5,113,284.00 $779,973.49 $169,818.85 $1,647,399.86 $9,010,790.78 $1,113,284.00 $675,809.31 $10,799,884.09 Yr 27 -$10,000,000.00 -$1,418,964.29 $5,113,284.00 $725,556.74 -$693,407.55 $953,992.31 $10,799,884.09 -$4,886,716.00 $809,991.31 $6,723,159.39 Yr 28 -$9,000,000.00 -$1,187,970.10 $5,113,284.00 $674,936.50 -$513,033.60 $440,958.71 $6,723,159.39 -$3,886,716.00 $504,236.95 $3,340,680.35 Yr 29 -$8,000,000.00 -$982,300.86 $5,113,284.00 $627,847.91 -$354,452.95 $86,505.76 $3,340,680.35 -$2,886,716.00 $250,551.03 $704,515.37 Yr 30 -$2,000,000.00 -$228,442.06 $5,113,284.00 $584,044.57 $355,602.51 $442,108.26 $704,515.37 $3,113,284.00 $52,838.65 $3,870,638.03 Yr 31 -$4,000,000.00 -$425,008.48 $5,113,284.00 $543,297.27 $118,288.79 $560,397.05 $3,870,638.03 $1,113,284.00 $290,297.85 $5,274,219.88 Yr 32 -$6,000,000.00 -$593,035.09 $5,113,284.00 $505,392.81 -$87,642.28 $472,754.76 $5,274,219.88 -$886,716.00 $395,566.49 $4,783,070.37 Yr 33 -$4,500,000.00 -$413,745.41 $5,113,284.00 $470,132.85 $56,387.43 $529,142.20 $4,783,070.37 $613,284.00 $358,730.28 $5,755,084.65 Yr 34 -$11,300,000.00 -$966,475.08 $5,113,284.00 $437,332.88 -$529,142.20 $0.00 $5,755,084.65 -$6,186,716.00 $431,631.35 $0.00 Year 1 -$179,375,000.00 -$59,752,450.37 $153,164,898.89 $60,194,558.64 $442,108.26 $0.00 -$26,210,101.11 $30,080,739.14 $3,870,638.03 Year 2 -$181,375,000.00 -$58,316,993.74 $153,218,869.07 $56,031,517.48 -$2,285,476.27 $0.00 -$28,156,130.93 $30,371,036.99 $2,214,906.07 Year 3 -$186,875,000.00 -$58,477,362.53 $153,283,084.14 $52,167,786.27 -$6,309,576.26 $0.00 -$33,591,915.86 $30,537,154.95 -$3,054,760.92 Year 4 -$187,375,000.00 -$55,671,265.67 $153,338,102.52 $48,566,214.74 -$7,105,050.92 $0.00 -$34,036,897.48 $30,308,047.88 -$3,728,849.60 Year 5 -$197,675,000.00 -$55,888,940.21 $153,398,520.02 $45,219,958.51 -$10,668,981.70 $0.00 -$44,276,479.98 $30,028,384.16 -$14,248,095.82
