making proactive investment decisions: a practical guide of... · 2013. 4. 23. · q1. what is a...

Making Proactive Investment

Decisions:

A Practical Guide

By David Marlow, David Beale & Duncan Rose

TABLE OF CONTENTS

1 PRACTITIONER QUESTIONS ___________________________________________ 1

2 BACKGROUND ________________________________________________________ 5

2.1 What is a Proactive Investment _____________________________________________ 5

2.2 A Practical Focus _________________________________________________________ 7

2.3 The Time Value of Money __________________________________________________ 8

2.4 Net Present Value _______________________________________________________ 10

3 BASIC ELEMENTS OF THE ANALYSIS __________________________________ 11

3.1 Introduction ____________________________________________________________ 11

3.2 Fundamental Concepts ___________________________________________________ 11 3.2.1 Analysis of proactive investments _______________________________________________ 11 3.2.2 Analysis of other investment decisions ___________________________________________ 12 3.2.3 More detail on LCC analysis ___________________________________________________ 12 3.2.4 Establishment cost ___________________________________________________________ 14 3.2.5 Operating costs ______________________________________________________________ 14 3.2.6 Maintenance costs ___________________________________________________________ 15 3.2.7 Risk-costs __________________________________________________________________ 15

3.3 Estimating Costs ________________________________________________________ 17

3.4 Future Performance _____________________________________________________ 17 3.4.1 Reliability and failure rate _____________________________________________________ 18 3.4.2 Failure modes _______________________________________________________________ 19 3.4.3 Failure rates for the base case __________________________________________________ 19 3.4.4 Failure rates for alternative interventions _________________________________________ 23

3.5 Assessing Relative Worth _________________________________________________ 23 3.5.1 Simple payback period ________________________________________________________ 23 3.5.2 Benefit:Cost ratio ____________________________________________________________ 24 3.5.3 NPV approach ______________________________________________________________ 25 3.5.4 LCC and cumulative cost calculations ____________________________________________ 25 3.5.5 Annualized equivalent costs ____________________________________________________ 26 3.5.6 Marginal cost approach _______________________________________________________ 29

3.6 Other Considerations ____________________________________________________ 29 3.6.1 Discount rate _______________________________________________________________ 30 3.6.2 Analysis period _____________________________________________________________ 31 3.6.3 Uncertainty _________________________________________________________________ 32 3.6.4 Revenues __________________________________________________________________ 33 3.6.5 Available budgets ____________________________________________________________ 33 3.6.6 Inflation ___________________________________________________________________ 33

4 UNDERTAKING THE ANALYSIS ________________________________________ 34

4.1 Introduction ____________________________________________________________ 34

4.2 Designing the Analysis ___________________________________________________ 35 4.2.1 Specify which costs to use _____________________________________________________ 35 4.2.2 Specify criteria for assessing the worth of an investment _____________________________ 35 4.2.3 Specify how uncertainty will be considered _______________________________________ 36 4.2.4 Specify economic parameters to be used __________________________________________ 37

4.3 Screening ______________________________________________________________ 37 4.3.1 Identify candidates for proactive replacement. _____________________________________ 37 4.3.2 Define the base case and alternative investment options ______________________________ 38 4.3.3 Collate initial data ___________________________________________________________ 38 4.3.4 Undertake screening analysis ___________________________________________________ 39

4.4 Detailed Analysis (where required): ________________________________________ 40 4.4.1 Collate or generate detailed data ________________________________________________ 40 4.4.2 Formally record all assumptions ________________________________________________ 40 4.4.3 Specify cost and benefit streams ________________________________________________ 41 4.4.4 Undertake analysis ___________________________________________________________ 42

4.5 Develop Portfolio ________________________________________________________ 42

4.6 Develop a Business Case Justifying Investment _______________________________ 42

5 ILLUSTRATIVE CASE STUDIES ________________________________________ 43

5.1 Introduction ____________________________________________________________ 43

5.2 Case Study of a Deteriorating Sewer ________________________________________ 44 5.2.1 Scenario 1: Running the asset until catastrophic failure ______________________________ 44 5.2.2 Scenario 2: Inspection and proactive lining ________________________________________ 45 5.2.3 Scenario 3: Inspection and routine root cutting. ____________________________________ 46 5.2.4 Insights ____________________________________________________________________ 47

5.3 Case Study of a Sewer Subject to Blockages __________________________________ 48

5.4 Case Study for Mechanical & Civil Assets ___________________________________ 50 5.4.1 Reverse valuation ____________________________________________________________ 52 5.4.2 Life cycle cost comparison ____________________________________________________ 53

GHD: End of Asset Life Reinvestment Decision Making Process Tools; CSIRO Contribution 1

1 PRACTITIONER QUESTIONS

The following list of questions provides a summary of the information detailed in this report. Illustrative case studies relating to the analysis of proactive investments are also given in Chapter 5.

Q1. What is a proactive investment?

A capital investment made explicitly because it will improve performance and thus reduce on-going costs. Proactive investments are thus made when an asset ceases to be the lowest cost alternative to satisfy a specified level of performance (the asset is at the end of its economic life).

Q2. How does this differ from other investments

Capital investments can also be made because an asset is no longer fulfilling its function. Such investments are reactive, being made when an asset is at the end of its service or physical life. End of service life is defined as when an asset can no longer do what we/our customers/stakeholders require it to do, such that it compromises service provision. End of physical life is defined as when an asset’s state is below some ‘acceptability threshold’ defined in terms of an unacceptable risk of failure or in terms of condition and performance grades.

Q3. What kind of questions leads to a consideration of proactive investments?

There are essentially two fundamental questions that can be asked

− For non-deteriorated assets: are there technical innovations that imply a proactive investment is worth it?

− For deteriorating assets: can I save money by replacing a deteriorating asset early?

Q4. Why should I consider making proactive investments?

Proactive investments have the potential for reducing costs over the long term, and may also help to smooth the demand for operational and maintenance resources from one year to the next (e.g. to manage peaks in sewer blockages).

Q5. How do I determine which assets are potential candidates for proactive investments?

This can be done by mobilizing operational experience or knowledge of technological innovations. The marginal cost approach can also be used to determine when the marginal cost of asset ownership is increasing.


Q6. What is the general process for undertaking analysis of proactive investments?

Specify which Categories of Cost to

Use

Specify Criteria for Assessing Worth

Des

igni

ng E

cono

mic

Ana

lysi

s

1

Specify How Uncertainty Will Be

Considered

Specify Economic Parameters

Identity Candidates for Proactive Investment

Define Base Case (Existing Asset)

Scre

enin

g An

alys

is

2

Define Alternative Intervention

Options

Collate Initial Data

Undertake Screening Analysis

Collate or Generate Detailed Data

Formally Record All Assumptions

Det

aile

d An

alys

is (I

f Req

uire

d)

3

Specify Costs & Benefits Streams

Undertake Detailed Analysis

Portfolio Analysis

Develop Business Case Justifying

Investment

4

5

If Appropriate, By-Pass Detailed Analysis & Undertake Portfolio Analysis

This process is described fully in Chapter 4.

Q7. How do I assess the relative worth of different options?

This can be done by estimating the relative costs and cost savings of each option, taking into account the time value of money. A range of techniques are available for summarizing the analysis of cost streams including calculating a simple payback period, a benefit cost ratio, taking an NPV approach, calculating life cycle and cumulative costs, and annualized equivalent costs.

Q8. What is the difference between financial and economic analysis?

In undertaking an economic analysis, we are seeking to maximize the benefits delivered to customers through the allocation of resources. Financial analysis is, in contrast, concerned with how to fund programs of work. The difference can be highlighted by considering that the economic value of an investment is not dependent on whether that investment can be afforded. However, the ability to finance the work is obviously a key consideration to the business and this is the focus of financial analysis.

Q9. What does the time value of money relate to and how is it considered?

The time value of money represents an economic concept known as an opportunity cost. An opportunity cost occurs because the use of money and resources precludes the possibility of employing them elsewhere, which implies some other goods or services must be sacrificed. At the very least, money can be invested in a bank to earn interest. We take the time value of money into account by applying a discount rate.


Q10. What discount rate should be applied?

Utilities may have a standard discount rate to use in comparison of different investment options, and these should then be used. As a minimum, the discount rate should be set to reflect the interest that can be earned from relatively certain investments (e.g. in AAA bonds). A higher discount rate may be used for assessing the relative worth of options that are risky; e.g. the use of new technology.

Q11. How do I calculate the net present value of a future stream of costs?

The process of calculating the present value of future cash flows is called discounting and uses expressions of the form:

PV = FV / (1 + r)t

where PV = present value of the future costs FV = future costs r = discount rate t = the number of years over which we are discounting

Q12. What is the difference between Life Cycle Cost analysis and Benefit-Cost analysis?

In Life cycle cost (LCC) analysis: the utility has determined a project needs to be undertaken and is seeking the most cost effective alternative. Technically, LCC is strictly applicable only when the levels of service/performance are the same for all options.

In Benefit-cost (BC) analysis: the utility is seeking to determine if something is worth doing. Technically, BC analysis is applied when the options provide different levels of service/performance, which implies that different benefits are generated. The objective is to identify the investment that delivers the greatest life cycle benefits net of cost

Q13. When undertaking LCC, what analysis period should be used?

This depends on the expected life of the asset. For short to medium life assets, the analysis period should be set to the life of the asset or, at least, to cover one major renovation/overhaul. For longer life assets, an analysis period of 40 years can be selected because after this time, future cost streams have a limited impact on the LCC, although this does depend on the depreciation rate used.

Q14. What costs are considered in the calculation of LCC?

All costs associated with an asset, including establishment costs, operating and maintenance costs and risk-costs. Risk costs reflect the expected cost consequences of failure, expressed in $/year.


Q15. Should I consider inflation in my analysis of proactive investments?

Inflation is not taken into account in the assessment of proactive investment decisions, because it does not reflect real economic gains, which is the focus of the analysis. Inflation should, however, be taken into account when analyzing historical costs and in financial analysis.

Q16. What do I take as my base case?

For proactive investments, the base case is always retaining the existing asset into the future. This becomes the basis for considering the relative value of other options.

Q17. Why is undertaking sensitivity analysis important?

The analysis of proactive investments is made using uncertain cost estimates. Sensitivity analysis should thus be undertaken to determine how robust the decision is; if the investment is justified under a range of assumptions, then it is considered robust.

Q18. What is reverse valuation?

Reverse valuation is used to scope out whether more detailed analysis should be undertaken. In this approach, we assume that some benefits of an investment can be easily estimated, such as energy savings, but others can not be. If the estimate of known savings does not justify the investment, then it is possible to calculate the magnitude of additional savings that would need to be generated by the investment to make it feasible, and then consider if this is likely to be realized.

Q19. Should economic analysis be undertaken for other types of investment?

An opportunity cost is defined in terms of the next best available use of the funds. If there is no alternative, as in the case when a needed asset is derelict and must be replaced, it might be supposed that there is no opportunity cost. However, in practice there may be different intervention options, each of which creates different cost streams. Any differences in costs imply there is an opportunity cost (i.e., spending money on one option precludes it being used elsewhere). Hence, the techniques presented herein should also be used to compare alternative intervention options even when the investment is related to end of service or physical life. In such analysis, the capital costs occur in year 0, and are thus not in any case discounted, but future costs streams do need to be compared and should be discounted due to the opportunity cost these represent.


2 BACKGROUND

Wastewater assets are created to generate value for communities. In this context, value implies a measure of benefits net of any dis-benefits and incurred costs. Benefits imply some kind of advantage delivered by an investment, dis-benefits imply some disadvantage (such as removal of trees, reduction in commercial activity or loss of farm land), and costs imply the money required to fund the investment. More specifically, creation of a system of wastewater assets and its operation and maintenance incurs costs. In return for this investment, benefits are provided in the form of improved sanitation, which has a positive effect on human health and wellbeing and on the environment.

Given assets deteriorate over time, eventually a state is reached where further capital investment must be made because the asset is failing when judged against one or more acceptability criteria. Investments of this type can be considered reactive in that they are made in response to a known shortfall.

Before such reactive investments are necessary, a proactive investment might be justifiable if it improves performance and thus reduces on-going costs. For example, sewers can be lined to inhibit root intrusions (thereby reducing or eliminating the need to undertake reactive maintenance to clear blockages), and electro-mechanical assets such as pumps, motors and blowers can be replaced with more efficient models to save energy and provide more effective treatment. In light of other budgetary demands, the question of relevance to a decision maker is whether the potential savings of proactive investments justify the outlay required. In the face of increasing public scrutiny, utilities are expected to be able to provide rational justification for all investments.

With the emergence of asset management concepts, life cycle concepts are increasingly important, which require judicious use of maintenance expenditure to prolong the life of assets, coupled with timely capital investments. Overall, the objective is to deliver service at least life cycle cost, which implies balancing capital and operational expenditure in light of asset-related risks. Hence, there is an increasing need to focus as much on the financial aspects of utilities as the engineering aspects of service delivery. This implies new approaches to decision making are embraced within the asset management community. The analysis of proactive investments undertaken to achieve this is the focus of this guidance document.

2.1 What is a Proactive Investment

In general terms, we can define the end of an asset’s life as being the time when we make a capital investment to renovate or replace it. In other words, when we make an investment such that the asset is substantially changed, the original asset is considered to have been at the end of its life. For the purposes of this work, the end of an asset’s life can be defined in three ways:


1 End of service/capacity life – when an asset can no longer do what we/our customers/stakeholders require it to do. To implement this, business rules are specified that define end of life for particular asset classes. The aggregate impact of these business rules allows the utility to meet its strategic service level mandates and maintain local performance targets.

2 End of physical life – when the asset’s state is assessed as being below some ‘acceptability threshold’. The threshold may be defined in terms of an unacceptable risk of failure or in terms of condition and performance grades, with some specified grade indicating investment is needed.

3 End of economic life – when an asset ceases to be the lowest cost alternative to satisfy a specified level of performance or service level. Importantly, an asset may become uneconomic long before it reaches the end of its physical life. If an investment is made based on this criterion, it can be termed a ‘proactive investment’.

The sequence in which these different aspects of asset life are conceptualized is shown in Figure 1, and different analysis is required for each aspect. From the perspective of service life, analysis is required to determine if an asset contravenes key performance targets, or at least contributes significantly to such shortfalls at the system or sub-system level. Any financial and economic considerations are then over-ridden to some extent by the need to maintain service (it may be cheaper to continue to run the asset, but service levels, including compliance with legislative requirements like environmental protection and health and safety laws, necessitate investment to be made). The inability of an asset to contribute to service provision is related to either a change in operational context leading to a change in load, a change in requirements (e.g. an increase in mandated quality standards) or the deterioration of an asset’s capacity. These issues need to be considered in terms of average and peak demands/loads.

Figure 1: Summary of End of Asset Life Assessments

From the perspective of physical life, analysis is required to determine when an asset has reached (or will reach) a state where the risk of retaining the asset is deemed unacceptable to the business. End of physical life is related to various deterioration processes, which can be progressive or


punctuated, depending on an asset’s operating environment. Often, failure itself results from an unpredictable operational event such as a pressure surge, operator error or other unusual loading condition. Nevertheless, it is worth trying to identify an asset or group of assets that have deteriorated to a condition where they are substantially more likely to fail in such events.

As noted previously, we are here concerned with the justification for proactive investment. Such justification will be possible when an existing asset is at the end of its economic life. Determining whether this is the case requires the relative merits of feasible replacement or other intervention options to be considered. Since the asset is neither at the end of its service life or physical life, the analysis focuses broadly on the capital investment needed and the cost of operating and maintaining the existing asset compared to alternatives. Importantly, all past investments and expenses connected with the existing asset are ‘sunk costs’ and do not effect the decision to make a proactive investment; only current and future costs and investments are relevant to the decision.

2.2 A Practical Focus

At a practical level, at any time in an asset’s life cycle, an asset manager might consider the scope for a proactive investment by asking the following question:

• Are there significant costs savings (e.g. lower energy consumption) to be made by investing in new technologies?

For asset managers who are examining assets that are starting to show signs of deterioration (wear and tear, corrosion, etc), the consideration of whether to make a proactive investment often starts with the following questions:

• Should I renew this asset now or should I try to get more life out of it with an enhanced operations and maintenance approach?

• Should I wait until it fails, then reinvest, or take a proactive approach and reinvest before it fails?

• If it is cost effective to renew now, which renewal alternative should I choose?

• If renewal is not cost effective now, when will it likely be? How to determine?

• How do I factor in changing (usually increasing) risk over time into the reinvestment timing decision?

• Is investing in extensive condition assessment for this asset cost effective?


• There are some really great new technologies available now; does it make good business sense to replace my existing asset with an upgraded one now?

However the questions are posed, the decision to make a proactive investment implies some kind of significant saving is anticipated relative to the base case of retaining an asset. Since we are generally considering assets that have relatively long lives, answering these questions requires us to consider the time value of money, as discussed in the next section. Affordability also needs to be considered, since there may be potential investments that provide economic benefits, but that can not be afforded due to budget constraints.

2.3 The Time Value of Money

Before considering the details of how proactive investments may be analyzed, it is important to introduce a key concept; the time value of money. In essence, decision making with respect to cost and benefit streams over time must reflect the fact that money loses value over time. Consider, for example, if someone were to offer you $500 now or $500 in five years time. Most people would intuitively take the money now. Part of this rationale is that our experience tells us that things generally get more expensive over time (dollar for dollar purchasing power goes down with inflation). As a result, $500 in five years is worth less than $500 today. As will be discussed later, inflation reflects changes in the price of goods and services and is a relevant consideration in financial analysis. However, inflation does not reflect real economic gains. Inflation is thus not the reason we consider the time value of money in the analysis of proactive investments.

A more relevant way of viewing the time value of money is in terms of investments that can be made to earn interest. If money is invested, accrues interest each year, and the interest is reinvested, then the principle (the amount we have invested) grows according to compound interest, the effect of which can be calculated as:

FV = PV (1 + r)t

This where

FV = future value of the investment in year t PV = present value of principle r = interest rate t = the number of years over which we are earning compound interest

In our example, if we take the $500 now and invest it in a financial instrument accruing 5% interest per year, in five years time our investment would be worth $638. Hence, while $500 in 5 years time has the same nominal value as $500 today, the actually value is less. By taking the $500 now and spending it on goods or services, we are forgoing the opportunity to earn this interest. However, if we invest the money, we forgo the ability to purchase goods and services. The time value of money can thus either


be considered from the perspective of the interest an investment can accrue or compensation to forgo spending money on goods and services to satisfy our immediate needs.

The view that money has a time value because of its alternative uses is related to the economic concept of scarcity. Scarcity implies that resources are finite in comparison to there potential uses. This leads to what economists refer to as opportunity cost. An opportunity cost occurs because the use of money and resources precludes the possibility of employing them elsewhere, which implies some other goods or services must be sacrificed. More technically, the opportunity cost is the sacrifice related to the second best choice available among several mutually exclusive choices. This is particularly important when considering proactive investments because, by definition, the utility has the choice of whether or not to fund the capital works. From the perspective of end of physical or service life, there may be no ‘second best choice’, because the municipality is required to make an investment to replace a failing or derelict asset so as to preserve a given service or function. However, we are then still interested in the future cost streams associated with different replacement or renovation options, and any difference will generate opportunity costs. As such, the time value of money is relevant to all investment decisions where there are two or more options with different cost streams into the future.

Opportunity cost may be expressed in terms of money or some other measure. A classic example is that if a person chooses to undertake further education, they incur an opportunity cost in that they must forgo earning wages during the period of their studies. From an economic perspective, the decision to undertake further education is thus an assessment of future benefits compared to the cost of undertaking the studies, including the opportunity cost of lost wages.

In analysis of proactive investments, we are generally concerned with the opposite of compound interest; i.e., that the value of future cash flows is worth less than equivalent cash flows today. This is captured by discounting future cash flows (costs or revenues). Discounting is the process of calculating the present value of future cash flows using the following expression:

PV = FV / (1 + r)t

where PV = present value of the future cash flows FV = future cash flow (positive for revenues, negative for costs) r = discount rate t = the number of years over which we are discounting

A key factor in this equation is the discount rate ‘r’. In effect, a higher discount rate implies that money loses value at a faster rate. To illustrate this, if we consider a discount rate of 1% compared to 5%, then $500 in five years time would be worth:

PV (r=1%) = $500 / (1 + 0.01)5 = $475.7


PV(r=5%) =$ 500 / (1 + 0.05)5 = $391.8

As a minimum, the discount rate reflects the opportunity cost incurred by not investing money and accruing interest (it reflects the ‘opportunity cost of money’ in that it measures the opportunity lost from not placing the money in a relatively risk free financial instrument). Discount rates used in the analysis can also be set to reflect the risk of a specific investment (see Section 3.6.1).

In practice, we must consider the present value of a sequence of different cash flows in each year. A key simplifying assumption made is that initial investment occurs at the start of year 1, designated as year 0, and all future operational and maintenance costs occur at the end of each subsequent year. With this assumption, for a period t=0...T, the present value of future cash flows is given as:

∑ =+=

TtPV

..0t

t r) (1 / FV

Where FVt is now the flow of benefit net of costs in year ‘t’.

2.4 Net Present Value

The present value of a sequence of future cost and benefits associated with an investment is often referred to as the Net Present Value (NPV) of that investment. In this context, value again implies a measure of benefits (e.g. revenue) net of costs. The term is also sometimes used to refer to the present value of costs alone, though from a technical perspective NPV must include a consideration of benefits. As described in Chapter 3, cost savings (avoided costs) can be taken to be a benefit of an intervention, in which case we can refer to the assessment as an NPV analysis.

In pure investment decisions, an NPV of less than zero implies that costs will exceed benefits, so the investment should not be made. An NPV exceeding zero implies that benefits exceed costs, so the investment might be considered feasible. Whether or not the investment is actually made would depend on the competing demands for available budgets. For example, another investment with a higher NPV would be more attractive.

Budget constraints also need to be considered, so there is a need to prioritize investments to produce a portfolio of work that delivers greatest benefits within the available budget envelope.


3 BASIC ELEMENTS OF THE ANALYSIS

3.1 Introduction

When determining if a proactive investment is worth making, the decision is always made in the face of uncertainty as to future costs and benefits. In fact, economic justification of proactive investments is only concerned with the future. Any cost in the past is ‘sunk’ and should not influence decision making, excepting that such costs may provide insight into future cost streams.

The analysis of investments involves of a range of elements, as detailed below. Before considering these elements, however, it is worth noting the difference between economic and financial analysis of investments. In undertaking an economic analysis, we are seeking to maximize the benefits delivered through the allocation of resources. Financial analysis is, in contrast, concerned with how to fund programs of work.

Economic analysis can provide a rational basis for justification and prioritization of investments. What should (or could) be funded is, however, different to what can be funded. The former is concerned with the relative merits of investment options, while the later is dependent on what can be afforded. The difference can be highlighted by considering that the economic value of an investment is not dependent on whether that investment can be funded or not. However, the ability to finance the work is obviously a key consideration to the business.

3.2 Fundamental Concepts

In general, economic analysis can be undertaken using one of two overarching approaches; analysis of life cycle cost (cost being a negative measure of an investment) and analysis of benefit-cost (benefit being the positive measure of an investment). In summary:

− Life cycle cost (LCC) analysis: the utility has determined a project needs to be undertaken and is seeking the most cost effective alternative. Technically, LCC is strictly applicable only when the levels of service/performance are the same for all options.

− Benefit-cost (BC) analysis: the utility is seeking to determine if something is worth doing. Technically, BC analysis is applied when the options provide different levels of service/performance, which implies that different benefits are generated. The objective is to identify the investment that delivers the greatest life cycle benefits net of cost.

In this work, we are generally considering LCC for the reasons highlighted in the next sub-section.

3.2.1 Analysis of proactive investments

When undertaking an assessment of proactive investments, we are seeking to determine whether feasible alternatives create sufficient benefits to justify the investment. However, by definition, this


is done within the constraint of satisfying a specified level of performance. Generally, the benefits an investment provides can thus be expressed in terms of cost savings (avoided costs compared to the base case). Hence, whilst we are seeking the solution that generates the greatest benefit net of cost, this still reduces to a consideration of costs. As such, the required analysis falls within the realms of LCC.

Even though we are assuming that there is a specified service/performance level, any excess performance above that level is still desirable, but the over-riding consideration is cost. As such, we should not pay a premium for any additional performance. Nevertheless, given two interventions with similar LCCs but different levels of performance, both of which meet the minimum required standard, we would still select the intervention that provides better performance.

3.2.2 Analysis of other investment decisions

When assessing interventions at the end of an asset’s service and physical life, we are often concerned with like-for-like replacement. LCC analysis is then the most appropriate approach because an intervention must be undertaken and the focus of the analysis is to determine which is the most cost effective replacement or renovation option. The most cost effective solution is the one with the lowest life cycle costs, though investment decisions also need to be considered in the context of risk, available budgets and political and environmental considerations.

Where an asset is being considered for replacement due to a change in performance or capacity requirements, this can again be considered in terms of LCC if the additional requirements are mandated. For example, if a combined sewer has insufficient capacity due to urban development (and is therefore associated with flooding risk), then it needs to be upsized. While upsizing the pipe provides additional benefits (relating to flood mitigation) compared to the existing pipe, these benefits are already captured by the mandate to enhance capacity. The issue is then again one of selecting the least cost approach to upsizing the sewer, so LCC analysis applies.

3.2.3 More detail on LCC analysis

LCC can be conceptualized as the amount of money needed to pay for the asset throughout its life, considering the time value of money. In LCC analysis, the total direct costs borne by the water utility are estimated over some defined period. An extension is sometimes referred to as whole life costing (WLC), which considers the whole asset life, and includes cost elements for which the water utility is directly responsible and also costs borne by others. For the purposes of this work, we will use LCC in that we are considering costs over a defined period, but we will extend this approach by considering cost elements born by others when appropriate. We refer to the period over which life cycle costs are analyzed as the analysis period.


When the analysis period does not cover the whole asset life for one or more investment options, the remainder of the expected life is taken into account by calculating the residual value of the asset. We will consider this residual value in terms of straight line depreciation, as per the example in sub-section 5.4.2. As such, the asset’s value is assumed to be ‘consumed’ linearly over its expected service life. Hence, the residual value at the end of the analysis period is calculated as the initial capital value of the asset multiplied by the portion of the expected service life remaining. This means the residual value is a notional amount reflecting the expected remaining life of the asset at the end of the analysis period, rather than representing a market or scrap value.

The expected life should be selected as the ‘book life’ of the asset; i.e., the life over which the asset value is fully depreciated. Under broad equivalence assumptions, this should reflect the expected/average life of an asset. In any case, the analysis period should be set long enough to ensure that the residual value is not a major contributor to the overall LCC, and should cover at least one major renovation.

In some instances, an asset manager may be faced with a decision either to carry on maintaining an existing asset or to undertake a capital intervention to renovate or replace it. If the asset is required into the future, the maintenance option will in reality also involve a capital intervention at some point. In LCC analysis, ignoring the future capital intervention (i.e. comparing maintenance costs to an alternative capital intervention) is only meaningful if it is possible to defer the capital intervention over a long enough period for the future investment to have little impact on the LCC calculation. This will depend on the discount rate selected. For example, for a discount rate of 7%, the discount factor implies that a dollar in 40 years time is worth only $0.07 and in 50 year is worth $0.03, so the impact of capital investments at this time on the LCC will be negligible in many cases.

Since we are considering future cost streams, assessment of life cycle costs is associated with significant levels of uncertainty, so any measure of life cycle cost is a random variable and its expected value generally serves as a criterion for decision making. The variation around this expected value is considered as a measure of investment risk. In this work, we take a simplified view of this issue and assess the robustness of a given investment using sensitivity analysis.

LCC analysis is effectively reliant on modeling the time-dependent nature of the costs resulting from use of an asset over its lifetime. Three categories of costs need to be included in any assessment of proactive replacement; establishment costs; operating costs and maintenance costs. For some asset classes, an additional category of costs must be considered in proactive investment decisions, which are referred to herein as ‘risk costs’.


3.2.4 Establishment cost

Establishment costs constitute the capital investment being considered. It is assumed that establishment costs occur at the start of the year in which they occur. In practice, for an investment at the start of the analysis period, the establishment costs occur at the start of year 1, which is designated as ‘year 0’ in the calculation of LCC. The sub-categories of this cost categories include:

− Removal – cost of removal and disposal of the existing asset; the disposal cost may be significant especially for assets associated with environmental or health impacts.

− Capital – costs associated with the development of a replacement asset, including site acquisition, planning, design, construction, fees and charges, interim financing and management (covers supply and delivery, including materials; disposal cost).

− Installation and commissioning – costs of installing/commissioning assets, including specialized activities such as pipe laying or rehabilitation.

− Land – fixed capital cost to reflect value of land area occupied.

− Other – any establishment costs not covered by the above categories.

3.2.5 Operating costs

Operating costs are the cost of operating an asset or its alternatives. For the purpose of calculating LCC, it is assumed that the costs for a given year all occur at the end of that year. The sub-categories of this cost categories include:

− Consumables – costs of materials (other than energy) regularly consumed during the operation of an item of infrastructure (e.g. chemicals, cleaning materials).

− Electrical energy – costs of electrical energy regularly consumed during the operation of an item.

− Other energy – costs of other energy regularly consumed during the operation of an item.

− Staffing – costs of personnel involved in operating the item.

− Other – any operating costs not covered by the above categories.


3.2.6 Maintenance costs

Maintenance costs are the cost of maintaining an asset or its alternatives. For the purposes of the analysis, it is again assumed that these costs occur at the end of each year. The sub-categories of this cost categories include

− Planned maintenance – the cost of planed maintenance tasks required to maintain an asset in a state such that it can deliver adequate levels of performance and/or attain a reasonable service life.

− Reactive maintenance – includes any action required to restore or make good a system or asset after failure or damage.

Reactive maintenance is, by definition, required in response to asset functional failures (the asset fails to fulfill a specified function in some way). As noted above, such failures impose a range of direct costs on the utility, examples of which are shown in Table 1. For the purposes of this work, we will consider these direct costs as reactive maintenance costs (we assume that they are, or could be, allocated to maintenance budgets).

Table 1: Categories of Direct Costs

Category Description Costs associated with asset failure

Costs of restarting, testing and monitoring failed equipment Direct costs of responding to the failure, including staff time, excavation works, asset repair, material and equipment, traffic management, clean up costs (public property) and any other reactive maintenance costs Disposal of any non-compliant waste Costs associated with health and safety incidents Compensated damage to property and other infrastructure Operational impacts resulting in increased costs

Costs associated with a loss of service

Direct cost of customer service responses (e.g. clean-up costs for private property, additional costs associated with effected customers etc.) Business interruption costs (inability of other businesses to operate) Regulatory costs, including fines Any compensation to customers (domestic and commercial)

3.2.7 Risk-costs

Given the spatially distributed nature of sewerage infrastructure and the fact that it is installed in publicly and privately owned property, failures of some asset classes (sewers, pumping stations, overflow structures, etc) impact customers, the community and the environment. These impacts may be directly related to service interruptions (customer impacts), or the damage or disruption


incurred due to the asset failure. Such impacts are often defined as failure consequences in risk assessments. Examples of these are shown in Table 2.

Risk costs are defined as the monetized costs of failure consequences weighted by the probability of that failure. For example, if the probability of failure is 0.01 (no units by definition) and the cost consequence of failure are estimated to be $100,000, then the risk cost is 0.01 x $100,000 or $1,000. If the probability of failure is given in terms of a specified time period, e.g. probability of failure over a year, then the risk cost provides an estimate of the expected cost over this time.

To extend this discussion, it is perhaps easier to consider probability of failure from the perspective of failure frequency. The failure frequency (also referred to as the failure rate) is defined as the total number of failures occurring in a population divided by the exposure time. For example, for a population of 1000 similar assets (similar implying similar loads and structural design), if there are 100 failures observed over a ten year period, then the failure frequency is 10/year for the population of assets or 0.01/year for each asset.

Table 2: Categories of Failure Consequences

Category Descriptions Service failures Service interruptions like restrictions on toilet flushing or internal and external

flooding Customer impacts Impacts of service failures including associated customer dissatisfaction, Environmental impacts Unacceptable environmental impacts considering natural and constructed

environments Externalities Traffic disruptions, third party discomfort, aesthetic impacts, health impacts Health and Safety impacts

Possible death or injury to water utility staff and members of the public, including health impacts

Public relations impacts Public (community) relation issues arising from asset failures; for example, discharges resulting in pollution of recreational waters and other social disruption

For small values (noting by definition failure probability can not exceed 1, whereas failure frequency/rate can), it is often assumed that the failure frequency is approximately the same as the failure probability and can thus be used in risk calculations. Using this assumption, if on average a given asset will fail at a rate of 0.01 failures/year and the average cost of failure is again $100,000, then the risk cost would be $1,000/year (0.01/year x $100,000). Of course, in reality there is no such thing as 0.01 failures per year; it is a statistical convenience based on the fact that 100 failures are observed across an asset population over the observation period of ten years. In reality, on average the utility carries the cost of 10 failures each year.

Risk costs can be used in the same way as any other annualized costs to determine the relative worth of alternative interventions. For example, if replacing an asset reduces the expected failure


frequency to 0.001 and the risk cost associated with the new asset is thus $100/year, the question is then whether the savings in risk and other costs justifies the proactive investment.

As noted above, we will consider direct costs associated with reactive maintenance separately to risk costs associated with other failure consequences, though in practice the frequency with which both are incurred relate to the failure of the asset, and both will depend on the failure mode as well as the location and context of the failure. Following the convention adopted for other annualized costs, risk costs are assumed to occur at the end of each year.

3.3 Estimating Costs

Cost items for the base case and possible alternative investments may be estimated from historical data when available. As noted below (sub section 2.7.6), inflation must be taken into account when analyzing historical cost data so that these are adjusted to a common basis. This can be achieved by identifying an appropriate price index. The equivalent dollars in the base year are then calculated as:

yeardata

yearbaseyeardatayearbase IndexPrice

IndexPricexDollarsDollars =

Where there is no reliable historical data, it may be necessary to estimate future maintenance costs. Cost estimation of this type will typically involve operations and maintenance crews, along with asset managers. The costs of failure and repair need to be estimated, as well as the costs associated with any planned maintenance.

3.4 Future Performance

A key aspect of any analysis of economic life is to consider an asset’s future performance and its contribution to service. Different technologies deliver different levels of performance. Furthermore, deterioration in performance can affect costs by increasing energy consumption (e.g. reduction in pumping efficiency), increasing operational costs (e.g., more operator time to keep a process within desired parameters) and increasing planned maintenance.

Another key issue is that the number of failures tends to increase as an asset deteriorates, eventually leading to the point where investments must be made due to the end of service or physical life. Since we are focusing on economic life, we are not so much concerned with estimating when the end of service or physical life will be reached rather we are considering whether increases in reactive maintenance costs justify proactive replacement. In turn, this requires us to understand asset reliability into the future.


3.4.1 Reliability and failure rate

The reliability of an asset is defined in terms of the probability that it will perform its intended function under stated conditions without failure over a given period of time. Reliability can thus be considered to be the probability of survival of an asset. Reliability is, however, often expressed in terms of failure rate, which is a measure of ‘unreliability’. A conceptual model commonly used to describe the change in failure rate (and thus reliability) over the life of assets subject to mechanical wear and/or similar deterioration processes is the ‘bathtub’ curve. The classic bathtub curve is shown in Figure 2, which needs to be interpreted from the perspective of a population of similar assets. From the Figure, it can be seen that there are three characteristic phases, namely:

1. An early life (burn in or infant mortality) failure period: a period of decreasing failure rate within the population of assets in which quality-related failures predominate;

2. A useful life failure period: a period of constant failure rate in which asset failures are primarily due to externally imposed stresses or other factors that occur at a constant (average) rate. Being event driven, these failures are essentially random in nature;

3. A wear-out failure period: a period of increasing failure rate in which deterioration-related failures predominate.

Figure 2: Failure rate over an asset’s life (the ‘bathtub’ curve)

The bathtub curve does not apply to all components; for example, some electronic components do not exhibit a wear out period. However, the distribution of failure rates shown in Figure 2 does apply to the majority of wastewater assets. Hence, some failures might be expected in the early part of an asset’s life due to defects in materials, installation and commissioning. As an asset reaches the end of its useful life, failures due to fatigue, corrosion, and wear-out start to predominate. In between, there is a period of ‘normal’ operation where failures occur at a lower,

Early life failure period

Useful life failure period

Wear-out failure period

Time (t)

Failu

re R

ate

λ

t1 t2


approximately constant, rate. The time taken to move through each of these life cycle phases will vary according to the characteristics of the asset in question, its operating context (loads, usage, planned maintenance, etc.) and environmental factors.

Failure rate is defined as the total number of failures within a population during a particular measurement interval under stated conditions. Hence, for a population of 1000 similar assets (similar implying similar loads and structural design), if there are 100 failures observed over a ten year period, then the average failure rate during this time is 0.01/year for each asset. As noted previously, for small values, it is often assumed that the failure rate (or frequency) is approximately the same as the probability that a failure occurs in a specified interval.

The Mean Time Before Failure (MTBF, 1/λ) can be used instead of the failure rate, but is only valid during the flat region of the bathtub curve (see comments on Weibull analysis below). For completeness, MTBF can be estimated from commercial publications when there is no historical data available specific to the context under consideration.

3.4.2 Failure modes

In general, we consider failures to be defined in terms of functional failures, and specify a failure mode as a particular way in which the asset fails to provide service. For example, relevant failure modes for sewers include hydraulic failure (spills and surcharging), structural failures and blockages. Causes of these failure modes include inadequate capacity compared to flow, root intrusion, corrosion and excessive loading. Given the potential for generating different failure consequences and reactive maintenance requirements and costs, we should ideally specify failure rates separately for each of an asset’s predominant failure modes.

3.4.3 Failure rates for the base case

Data on failure rates for the base case can be obtained in several ways. A common source of data is historical data stored on maintenance or asset management systems relating to a population of assets similar to that under consideration for proactive investment. The data can be used to estimate failure rates for those assets. From the perspective of analyzing proactive investments, we start from the assumption that there will be two kinds of assets for which such analysis may be undertaken:

1. Non-deteriorated assets; these assets are considered for replacement based on available technical innovations or changes to business drivers (such as the need to address greenhouse gas emissions or increasing energy costs). The additional efficiency of alternative technologies may provide a rational business case for replacement.

2. Deteriorated assets; these assets are being considered for replacement based on the potential savings in maintenance costs, though other savings may also be considered. While


operational and maintenance costs of such assets are increasing, by definition, their performance does not justify investment for physical or service life if proactive investments are being considered.

For non-deteriorating assets, failure rates can be considered in terms of the MTBF. For deteriorating assets, the failure rate can be expected to be increasing with time, rather than being constant. Hence, the MTBF can not be used.

For deteriorating assets, a number of levels of sophistication can be applied to estimate failure rates. At the highest level, we can use advanced statistical analysis (e.g. generalized linear modeling) to develop relationships between explanatory variable and failure rates (see WERF, 2009 for a review). Another approach is to use Weibull analysis, as described briefly below. At the simplest level, we can use estimates of average failure rate.

The average failure rate (for a specified failure mode) can be calculated from historical data over a specified period and used as a measure of expected average failure rate over an equivalent period into the future. This simplified approach can be justified if the period under consideration is relatively short (relative to the expected service life of the asset) and the rate of deterioration is expected to remain relatively constant. As an example, assume we are considering replacement of an asset in the next investment cycle; a five year period (t=5 years). Whilst we acknowledge that the failure rate may increase, we calculate the average failure rate from historical data for similar assets over the preceding five years and assume this approximates the performance of such assets over the next five years.

To allow for some deterioration, we can calculate or assume a rate of rise in the average failure rate. This can again be specified using expert opinion and expressed as a percentage (e.g., failure rate will increase on average 5% per year). Where historical data is available, it might be possible to assess the rate of rise by plotting failure history (failure rate versus time) and fitting a straight line to the data by linear regression. A plot of the data will generally indicate if a linear approximation is reasonable. If this is the case, the corresponding regression equation can then be used in the analysis as a rough approximation of future deterioration. This will generally not be possible where failure modes are highly dependent on external factors, since failure rates can then be very peaky. For example, Figure 3 shows the observed failure rates for a class of pipeline assets in the years during which failures have been recorded (2001-2009).

As shown in the Figure, the failure rates vary from around 12 failures per 100km per year in some years and up to approximately 105 failures per 100km per year. Such variations may be due to the interaction between the asset and some effect of weather (increased or reduced flow, increased soil heave due to frost or drought, increases in root penetration due to drought, etc.). The average failure rate for all years is approximately 42 failures per 100km per year. Since in this case there is


no obvious linear relationship, the use of the average rate would be an appropriate representation of performance. By definition, this captures on average the peaky nature of the failures, and a rate of rise should not be applied. We can investigate the sensitivity of our decision to assumed failure rates using sensitivity analysis.

0

20

40

60

80

100

120

2001 2002 2003 2004 2005 2006 2007 2008 2009

Failu

re R

ate

(per

100

km

per

yea

r)

Figure 3: Failure rates for a cohort of pipe assets

From the perspective of proactive investments, it should be noted that annual peaks in failures such as those observed in 2002 (Figure 3) may impose excessive demand on maintenance resources in that year and imply that planned maintenance can not be undertaken. Implicitly, this means that there could be additional failures generated, which in turn can create a higher demand for maintenance resources and increased costs. An additional benefit of undertaking a proactive investment is that it improves maintenance planning and smoothes the demand for resources.

Weibull analysis

A common approach for considering the failure of assets is to apply Weibull analysis. Strictly speaking, Weibull analysis is only applicable to non-repairable systems and should not be applied to complex repairable assets, especially where the repair improves reliability. Weibull analysis can, however, be applied to the analysis of the time to first failure for such assets.

In application, a Weibull distribution is fitted to the failure data that includes a measure of the time at which each asset fails (e.g. age, number of operational cycles, etc.). The form of the Weibull distribution is:


The constant α is called the scale parameter because it scales the t variable. The constant β is called the shape parameter, because it determines the shape of the rate function. The shape parameter, β, indicates whether the failure rate is increasing, constant or decreasing. A β <1.0 indicates that the asset has a decreasing failure rate. This is typical of the "infant mortality" portion of the bathtub curve and indicates that the asset is failing during its "burn-in" period. A β =1.0 indicates a constant failure rate, in which case the Weibull distribution equals the exponential distribution and the failure rate reflects the MTBF, as noted above. A β >1.0 indicates an increasing failure rate, which is associated with the wear out period. The parameters of the distribution can be determined using a spreadsheet application following these steps:

1. Collate failure data (failure mode and ‘age’ of asset when failure occurred; i.e., the time to failure).

2. For each failure mode, sort the values in ascending order by time to failure.

3. Assign a rank to each value from 1 to N, where N is the total number of failures.

4. Calculate the median rank using Benard’s approximation:

Where MR is the median rank, j is the rank of the relevant failure in question.

5. Calculate 1/(1-MR) for each failure.

6. Calculate the double natural logarithm (the log log) of the values calculated in Step 5.

7. Calculate the natural logarithm of the time to failure.

8. Plot the values calculated in Steps 6 and 7. The values from Step 7 are those plotted against the x-axis.

9. For a Weibull distribution, the plotted values should be linear. Where this requirement is met (or approximately met), fit the plotted points with a linear trend line and determine the regression equation.

10. The Weibull Shape parameter (β) is the gradient of the trend line.

11. The Weibull Scale parameter (α) is given as a function of the trend line intercept; i.e.,:


Once the parameters for the Weibull distribution have been estimated, the instantaneous failure rate for one asset expressed as a function of service life can be calculated from:

Essentially, this is the condition probability that failure occurs at time t given that the asset has survived to that time.

3.4.4 Failure rates for alternative interventions

Where alternative interventions involve installation of a new asset, consideration of failures can be undertaken in terms of the MTBF estimated for the proposed assets. As noted above, MTBF can be estimated from commercial publications or from maintenance records, if available.

As illustrated above, early life failures do occur in new assets, but such issues should be controlled through appropriate quality assurance practices and contractual arrangements (where work is being done by external contractors), and can thus be ignored in decision making with respect proactive decisions. The exception is where there is an inherent rate of defects involved in a particular decision. For example, industry experience shows that there is an inherent defect rate associated with installing polyethylene pipe using electro-fusion fittings. Where the cost of such failures is born by the utility, an allowance should be made for them in the economic analysis.

3.5 Assessing Relative Worth

Various approaches can be used to assess the relative worth of different investment options, including an assessment of payback period, the benefit to cost ratio (over the whole analysis period and in terms of the time in which the ratio first exceeds 1), the relative LCC of different options and the NPV of the investment. Another approach that can be used is the calculation of annualized equivalent costs, including the equivalent uniform annualized cost (EUAC). Finally, an approach that could be used to assess relative value of investments is the marginal cost approach. However, we use this approach as part of the work to understand if proactive investments should be considered. For completeness, this approach is presented at the end of this section.

3.5.1 Simple payback period

The simplest measure of investment worth is the ‘payback period’, which is a measure of the time required for the return on an investment to "repay" the sum of the original investment; i.e., how long the investment takes to pay for itself. The time value of money is ignored, so payback period is calculated as:


Payback Period = Investment/cost savings per year

For example, consider an investment of $1,000 that generates savings of $250/year. The payback period would thus be calculated as $1,000/$250/year = 4 years; i.e., ignoring the time value of money, the investment would essentially pay for it self after 4 years.

In asset management, an important consideration when assessing if a payback period is reasonable is the expected life of the asset class in question, or the expected life of the rehabilitation or other intervention. At the very least, a proactive investment must deliver a payback within the life of the asset. Hence, payback periods must be shorter for shorter life assets.

3.5.2 Benefit:Cost ratio

As noted above, the payback period does not take into consideration the time value of money. More generally, we are interested in the present value of the investment in comparison to the benefits accrued. If it is assumed that the cost savings are a benefit, we can express the value of an investment in terms of the benefit to cost ratio. Over any period, this is defined as:

costs of luePresent vasavingscost of luePresent vaC:B =

Given the focus of this work, we can define the benefit to cost ratio in terms of the total costs or the relative costs of the options. For example, if an investment delivers a net saving on maintenance cost, but requires a capital investment to achieve this, then we can calculate the B:C in terms of the cost savings achieved and the capital cost of the improvement. Hence, if we assume an asset will deliver $250/year net savings over an expected life of ten years, then the present value of savings at a 5% discount rate are $1,930. The B-C ratio is calculated as $1,930/$1,000 = 1.93. Note this ratio expresses the net savings of the investment when compared to the base case. In practice, there may be additional benefits associated with the investment that are not taking into consideration during the analysis, though these may influence our choice if one option provides additional benefits at no significant additional cost.

For an investment to be justified, the ratio calculated for the analysis period should exceed a specified threshold; the higher the ratio, the more attractive is the investment. Within the logic of assessing proactive investments, the B:C ratio should always exceed 1, since this implies savings exceed costs. Given uncertainty associated with future savings, we are also interested in the time it takes before the ratio goes above 1. The time when this occurs can be termed the ‘discounted payback period’ (it provides an equivalent measure to the payback period, but considering the time value of money). This metric can be determined by calculating the ratio of the cumulative net cost savings in each year compared to the establishment costs; i.e.,:


costsent Establishmsavingscost PV

C:B 1.ti it''year ∑ ==

The numerator expresses the cumulative net savings (compared to the base case) to year ‘t’. When defined in this way (net savings), the present value of costs will simply be the establishment cost of the asset, as shown. As noted above, a proactive investment must deliver a payback within the life of the asset. Hence, it is desirable to have the B:C ratio exceed 1 as quickly as possible and well within the expected (design) service life of the intervention.

3.5.3 NPV approach

The present value of a sequence of future cost and benefits associated with an investment is referred to as the Net Present Value of that investment. In this work, we are not considering broader benefits, but are considering net cost savings associated with an investment. We can therefore calculate the NPV over the analysis period (t = T) as:

∑∑ ==−=

TtTt ..0..1(year t) costs of PV(year t) savingscost of PVNPV

NPV defined in this way is a different means of expressing the B:C ratio discussed above.

An NPV of less than zero implies that costs will exceed savings, so the investment should not be made. An NPV exceeding zero implies that savings exceed costs, so the investment might be considered attractive, though other investments may provide a higher NPV.

3.5.4 LCC and cumulative cost calculations

As noted previously, the justification of a proactive investment is made in light of specified performance requirements. Hence, broader benefits do not need to be considered. While we can express the net cost savings delivered by an investment as benefits, in general, we are still considering cost streams associated with different options (net savings being defined as the difference between the cost streams of an option compared to those of the base case). As such, we can assess the relative value of investments purely in terms of the cost streams associated with each option and calculate the LCC of each. The option with the lowest present value of LCC is the most cost-effective means of providing the specified level of service.

This approach can be extended by plotting the present value of cumulative costs over the analysis period for all options, which then provides insights into when an investment delivers net savings. The present value of cumulative costs in each year is calculated as:

∑ ==

ti ..0i)(year costs of luePresent va(year t)cost Cumulative


As an illustrative example, Figure 4 compares the present value of cumulative costs over the analysis period of 15 years for a base case when compared to an alternative investment option.

As shown, the alternative option requires an initial investment of $40,000 but costs then accumulate at a slower rate than for the base case, which implies the cost of operating and maintenance the asset are lower for the alternative. We can consider the difference in costs as being a saving, as in the approaches described above, but in this case, we simply assess the costs associated with each option. In this case, the cumulative cost of the base case exceeds that of the alternative after about 5 years. Hence, the investment provides payback after about 5 years.

$0

$20,000

$40,000

$60,000

$80,000

$100,000

$120,000

$140,000

0 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15

Years

Cum

ulat

ive

cost

s

Cum LCC base case

Cum LCC investment

Figure 4: Plot of Cumulative Costs

3.5.5 Annualized equivalent costs

In using NPV or LCC concepts, we must be careful to include the residual value of assets at the end of the analysis period. An alternative option is to express cost streams in terms of an equivalent annualized cost. The simplest way of calculating such a measure is to calculate the total cost of asset ownership and divide by the life of the asset. This provides the annual amount that must be paid to fund the whole life cost ignoring the time value of money. Another simple approach is to calculate the NPV of the investment and divide by the life of the asset.

More technically, the equivalent uniform annualized cost or ‘EUAC’ can be calculated for each investment option. The EUAC represents the amount that must be paid annually to fully fund the


whole life cost of asset ownership at a given discount rate. The EUAC is calculated by dividing the NPV of a project by the present value of an annuity factor, as shown below:

rtALCCEUAC

,

= with r

rAt

rt)1/(11

,+−

=

The annuity factor counters the tendency for the discount rate to reduce the influence of future costs, which is important if we are considering repeat interventions into the future.

The EUAC is preferred to just taking an average NPV of costs over the analysis period because if we are comparing two interventions of different length, the longer life one will tend to have an artificially low average NPV due to the extended period of life and the effect of discounting future costs. The average NPV is thus not a consistent comparison of annual costs.

The derivation of the EUAC formula can be found in standard engineering economic books. In practical terms, the EUAC represents a uniform cost spread across the life of the asset, such that the present value of those uniform costs has the same present value of the actual cost stream of the asset/investment. To illustrate what this means, consider Table 3 below, which shows the EUAC calculated for a specified cost stream is $2,250. As defined above, the stream of EUACs has the same present value as the present value of the actual cost streams. In practice, this means that $2,250 must be provided each year to meet the full life costs of ownership.

Table 3: Clarification of the EUAC Definition

Costs NPV EUAC PV EUAC

Year

0 $5,200 $5,200 1 $758 $722 $2,250 $2,143 2 $775 $703 $2,250 $2,041 3 $793 $685 $2,250 $1,943 4 $811 $667 $2,250 $1,851

Total $7,977 $7,977 Like LCC analysis, the use of EUAC presupposes that the discounted benefits of all potential options over the planning horizon are identical and therefore only the discounted costs of various projects need be considered. To illustrate the concept in practice, let us consider an example where a manager must decide on which of two assets to purchase, assuming the discount rate is 5%. The required investment, expected life and annual maintenance costs are:


Asset A Asset B

Investment $50,000 $150,000

Expected Life 3 years 8 years

Annual maintenance $13,000 $7,500

To determine the EAUC, The manager calculates the NPV of the machines as in Table 4. Note, since asset A only has a life of 3 years, it is assumed it will be replaced after this time with the same asset.

Table 4: Illustration of the EUAC concept

A B PV A PV B 0 $50,000 $150,000 $50,000 $150,000 1 $13,000 $7,500 $12,381 $7,143 2 $13,000 $7,500 $11,791 $6,803 3 $13,000 $7,500 $11,230 $6,479 4 $7,500 $6,170 5 $7,500 $5,876 6 $7,500 $5,597 7 $7,500 $5,330 8 $7,500 $5,076

Total $89,000 $172,500 $85,402 $198,474

The annuity factors are for t years (3 and 8 years) and a discount rate of r= 0.05 (5%) are given by:

A3,5 is given by 05.0

)05.1/(11 3−= 2.723 and A8,5 by

05.0)05.1/(11 8−

= 6.463

The EUAC can then be determined by:

Asset A EUAC =$85,402/A3,5=$31,360

Asset B EUAC =$198,474/A8,5=$30,708

As noted above, the practical interpretation of the EUAC is that it is the amount of money needed each year to run a given asset. It is meaningful because all other things being equal, the option with the lowest EUAC incurs less cost each year. In this case, the base conclusion is to invest in machine B since it has a lower EUAC, though the difference is not particularly great and other factors would need to be considered. In particular, option A only requires a capital outlay of $50k, which may be more affordable depending on the other demands placed on capital budget.

In summary, the EUAC method provides a means of comparing interventions with different service lives, by expressing costs as an annualized estimate of cash flow instead of a lump-sum estimate of present value. However, as shown above, the use of the EUAC method also implies that an asset will


be replaced by an identical one. Hence, it would not be correct to apply the EUAC to a one-off renovation option (i.e., the asset can be renovated now, but must then be replaced) when compared to alternatives. Within the constraints of its applicability, the EUAC of different options can be compared, the lowest one indicating the preferred choice.

3.5.6 Marginal cost approach

The marginal cost approach is premised on the assertion that over the life of an asset, the average total cumulative cost of owning the asset provides a measure of when the marginal cost of asset ownership is increasing, which in turn indicates the time at which an investment might be considered.

In more detail, it should be recognized that the capital cost of an asset is sunk at the time the asset is installed and commissioned. The average annual cumulative capital cost thus falls over time, as illustrated in Table 5. The operational and maintenance (O&M) costs tend to increase over time, such that the average O&M costs also increase, again as shown in Table 5. The average annual cumulative total cost of owning the asset is the sum of these two averages. Initially, the high capital cost and low O&M cost mean that the average annual cumulative total cost falls. At some point, however, this measure of marginal cost starts to rise. From the perspective of an existing asset, this implies that the marginal cost of owning the asset (the cost of running the asset for one more year) is greater than the marginal cost of replacing that asset with a similar asset. Installing a different type of asset may provide additional benefits as well and imply that earlier replacement is justified.

From the perspective of a like-for-like replacement (where we can assume identical cost structures), consider the example in Table 5. The minimum cumulative total cost (of asset ownership) is reached in year 8. Hence, the marginal cost (cost per year) of owning the asset starts to increase from that time and a like-for-like replacement could therefore be justified since replacing the asset at this point would imply that over the life of both assets (the existing asset and replacement), the total cost of asset ownership was minimized, assuming the cost streams were repeated.

The marginal cost approach thus provides an insight into the timing of an intervention and can be useful when analyzing historical data to determine if an asset is a candidate for proactive investment. Other metrics of investment value should be calculated to assess the relative value of the investment in comparison to other options.

3.6 Other Considerations

While the approach taken to the analysis, the estimation of future performance and costs, and the assessment of investment worth are all critical elements of the analysis, there are other issues that must be considered, as described below.


Table 5: Marginal Cost Approach

Year Average

annual cum capital cost

Annual O&M

Average annual cum cost O&M

Average annual cum

total cost

1 2000 200 200 2200 2 1000 230 215 1215 3 667 265 232 898 4 500 304 250 750 5 400 350 270 670 6 333 402 292 625 7 286 463 316 602 8 250 532 343 593 9 222 612 373 595

10 200 704 406 606 3.6.1 Discount rate

Since the discount rate reflects the present value of future cost streams, determining the rate to use in the analysis of proactive investments is critical.

Discount rates can be defined in two ways. When the discount rate includes inflation, it is referred to as the ‘nominal discount rate’, when it does not it is referred to as the ‘real discount rate’. The real discount rate reflects opportunity cost and is net of inflation. A real discount rate is used in the analysis of proactive investments because we are interested in real gains, rather than price effects.

It can be difficult to set an appropriate discount rate. Fortunately, many utilities have standard rates and where these exist, they should be used. If this is not the case, as a minimum, the discount rate should be set to reflect the opportunity cost of money. In effect, investments are judged against the ‘baseline’ alternative use of the money, which is to invest it in financial instruments that provide a ‘no risk’ (relatively certain) return (e.g. safe AAA bonds).

More generally, an approach applied in the evaluation of investments in private businesses is to use a discount rate that reflects the minimum acceptable rate of return (MARR) the business demands from an investment. The MARR can be set to reflect

1) The opportunity cost of money,

2) The average rate of return on investment achieved, or

3) To reflect investment risk.

In the case of 1 &2, the MARR is referred to as an ‘attainable rate’ as there are investment options that will actually achieve that rate, whereas option 3 is referred to as a ‘target rate’ because there


is no guaranteed means of realizing it. Target rates are set to reflect risk associated with innovation or commercial issues. For example, consider two potential investments, the first of is relatively certain in terms of its benefit-costs, whereas the second has significant levels of technical or commercial risk. In the first investment, the MARR could be set to reflect the opportunity cost of money, whereas the MARR may be set at a higher level for the second investment to compensate for the additional risk.

If the MARR is used as the discount rate, an investment with a negative net present value is unacceptable because it does not provide sufficient savings in comparison to costs, taking into account the risk and the opportunity cost of forgoing other investments.

Utilities can use a combination of sources to fund an investment, including debt (borrowing money from creditors) and the use of equity. The weighted average cost of capital (WACC) is the rate a utility pays on average to finance its investments. The WACC can be regarded as the minimum acceptable rate of return used in discounting, since any project with a negative net present value does not generate sufficient savings to cover the company's cost of capital.

As noted above, if one option is more risky, then a higher discount rate can be used to reflect the fact that it would need to deliver higher net savings to justify taking the additional risk.

As noted earlier, opportunity cost is defined in terms of the next best available use of the funds. If there is no alternative, as in the case when a needed asset is derelict and must be replaced, it might be supposed that is no opportunity cost. However, in practice there may be different intervention options, each of which creates different cost streams. Any differences in costs imply there is an opportunity cost (i.e. spending money on one option precludes it being used elsewhere). Hence, the techniques presented herein should also be used to compare alternative intervention options even when the investment is related to end of service or physical life. In such analysis, the capital costs occur in year 0, and are thus not in any case discounted, but future costs streams do need to be compared and should be discounted due to the opportunity cost these represent.

3.6.2 Analysis period

As we are concerned with life cycle costs, the analysis of investments depends on the timeframe over which costs and savings are considered. The analysis period should be set in light of the expected life of available options, particularly the base case of retaining the existing asset. The expected service life of asset classes can be used as a guide to specifying the appropriate analysis period. For example, assets can be categorized in terms of their expected lives:

− Short (up to 10yrs): Instrumentation, control and automation (ICA) assets

− Medium (up to 25 yrs): Mechanical and electrical assets


− Long (up to 50 yrs): Civil and building (C&B) assets

− Very long (> 50yrs): Pipeline assets

These estimated service lives will provide an initial guide for setting the analysis period for proactive investments involving the different asset categories. In LCC analysis, it is usual to consider a timeframe that spans at least one major rehabilitation or overhaul, and also necessary to consider residual value at the end of the analysis period.

Depending on the discount rate used, costs incurred over a period longer than 40 years can have little effect on the LCC calculation. Hence, the analysis period should be set to the estimated life of the asset for short to medium life assets, but capped at (say) 40 years for long and very long life assets, again depending on the discount rate used.

3.6.3 Uncertainty

In general, we can take either a deterministic or a probabilistic approach to economic assessments. In a deterministic approach, we specify point values for each variable of interest (costs, failure rates etc.) and analyze the decision using those values. In a probabilistic approach, we treat the variables as random numbers and specify distributions that describe the probability that the variable will take a given value. In this work, we will consider only a deterministic approach. However, we must still consider the uncertainty in the analysis. Sources of uncertainty include:

− Future performance of the base case and alternative investment options

− The capital cost of interventions

− The operational, maintenance and risk costs of options.

Uncertainty in the variables can be assessed by undertaking sensitivity analysis. Sensitivity analysis is a technique whereby variables in a model are systematically changed to determine the effects on the model’s output(s). In our case, the inputs to the ‘model’ are the costs and other assumptions being used to assess the proactive investment. If the investment is economic under a range of values for costs and other inputs, it is reasonable to assert it is a robust decision; i.e., it will likely provide economic payback. If the sensitivity analysis shows that the investment is only economic under specified ranges of input variables, then either the decision should not be supported or further work would need to be undertaken to investigate if the assumed costs are reasonable or to constrain the likely range of costs further. The later would only be undertaken if the likely benefits (cost savings) were sufficiently high, or there were other drivers such as political or community considerations.


A key element of uncertainty is that performance into the future and performance requirements both change. As such, the longer the period we have to wait before the savings payback the investment, the more uncertain we are that the investment is worth undertaking. A key measure of investment potential is thus the period before an investment provides economic payback.

3.6.4 Revenues

Revenues in terms of customer bills are not considered in the analysis of benefits, since they reflect a payment for benefits to customers of improved sanitation and/or environmental health.

3.6.5 Available budgets

Ultimately, the level of funding a utility receives can have a significant impact on when assets are considered at the end of their economic life. All other things being equal, a utility may wish to replace an asset to realize savings, but if there are insufficient budgets, it may be forced to carry the cost of operating it. In many instances, this type of consideration is intimately linked with the ability to convince regulators, customers and other stakeholders of the need to renew assets, which is the purpose of undertaking the analysis considered herein.

More generally, and as noted previously, the analysis of whether an investment is desirable is separate from consideration of if it can be afforded. The former is concerned with the relative merits of an investment, the later relates to available budgets. The prioritization of investments that are viable also needs to be undertaken in light of available budgets. Prioritization should consider measures of economic value, and also consider if there are broader business initiatives, such as to reduce energy consumption, greenhouse gas emissions, maintenance etc.

3.6.6 Inflation

As noted above, the tendency of costs to rise over time is termed inflation. Inflation must be considered when setting budgets to ensure that capital and operational expenditure can be financed. However, the economic value of a project relates to real benefits and should not be considered in light of price fluctuations. Hence, inflation can be ignored in the analysis of proactive investments. Inflation must, however, be considered when assessing historical costs so that these are adjusted to a common basis.


4 UNDERTAKING THE ANALYSIS

4.1 Introduction

As outlined in the sections to this point, the key question to be answered in the analysis is: ‘can proactive investment be justified’. In other words, the aim is to determine if proactive investments represent a rational and prudent business decision. In simple terms, the net savings or other benefits must provide sufficient ‘payback’ over a short enough period to justify the capital outlay. This includes consideration of:

− What the feasible interventions are;

− What the cost and benefits of these options are relative to the base case;

− How we assess the potential for future failures and the cost consequences;

− Whether we take a narrow view of costs (direct costs borne directly by the utility) or a broader view (considering risk costs borne by others);

− The implications of our options on broader business considerations such as meeting energy efficiency targets, reducing greenhouse gas emissions, etc.

Figure 5 summarizes the recommended process for undertaking the analysis of proactive investments. The individual steps are discussed in the sub-sections that follow.

Specify which Categories of Cost to

Use

Specify Criteria for Assessing Worth

Des

igni

ng E

cono

mic

Ana

lysi

s

1

Specify How Uncertainty Will Be

Considered

Specify Economic Parameters

Identity Candidates for Proactive Investment

Define Base Case (Existing Asset)

Scre

enin

g An

alys

is

2

Define Alternative Intervention

Options

Collate Initial Data

Undertake Screening Analysis

Collate or Generate Detailed Data

Formally Record All Assumptions

Det

aile

d An

alys

is (I

f Req

uire

d)

3

Specify Costs & Benefits Streams

Undertake Detailed Analysis

Portfolio Analysis

Develop Business Case Justifying

Investment

4

5

If Appropriate, By-Pass Detailed Analysis & Undertake Portfolio Analysis

Figure 5: Process for Analyzing Proactive Investments


4.2 Designing the Analysis

These initial steps ensure the consistency of application of analysis for proactive investments.

4.2.1 Specify which costs to use

The utility should specify the circumstance under which to use only direct costs and when to include risk costs that reflect the cost of failure consequences incurred by customers and other parities.

4.2.2 Specify criteria for assessing the worth of an investment

The criteria for assessing if a particular investment is potentially worth undertaking should be specified in the utilities procedural documents. In this work, we will use the marginal cost approach to determine if an asset should be considered for proactive investment and the following measures to assess the value of any investment option

− Simple pay-back period (for short to medium life assets only)

− Benefit-cost ratio (assuming the discount rate is set as the utility’s MARR)

− Lowest LCC or cumulative LCC

− NPV (assuming the discount rate is set as the utility’s MARR)

− EUAC (only useful if option can be repeated into the future)

Different acceptance criteria levels may be specified for initial screening studies and detail analysis. At the screening stage, thresholds should be set that dictate that a) the investment should be rejected, b) where refined analysis is needed or c) where an investment can be accepted without further analysis. Potential thresholds are provided in Table 6.

Where the investment is neither accepted nor rejected, it should be considered in more detail. As a first step, reverse valuation can be undertaken to determine if it seems likely that the option will deliver sufficient savings to justify the investment.

Detailed analysis may not need to be undertaken where there is insufficient budget to undertake all those investments that are considered acceptable at the screening stage (these can be considered ‘low hanging fruit’ and should be done before considering more risky proactive investments).

The criteria used to determine if an option should be retained as a potential investment after detailed analysis should also be specified. The retained options will be subsequently prioritized in terms of relative worth. Hence, criteria for considering a portfolio of investments can be set at the minimum threshold that the proactive investment must deliver net savings over the analysis period when compared to the base case, see Table 7.


Table 6: Acceptability Thresholds for Screening Analysis

Approach Thresholds

Pay-back period >80% service life: reject

< 20% service life: accept

Benefit-cost ratio <1: reject

>3: accept

EUAC EUAC (investment) > EUAC (base case): reject

EUAC (investment) < 50% EUAC (base case): accept

Lowest life cycle costs LCC (investment) > LCC (base case): reject

LCC (investment) < 50% LCC (base case): accept

NPV Use benefit-cost ratio at the scoping stage

It should also be recognized that the magnitude of maintenance savings is an important consideration, given the pressure on this budget element. Reducing the overall amount of maintenance required delivers additional benefits in that it helps smooth resource requirements and can help backlog in planned maintenance from developing.

Table 7: Acceptability Thresholds for Detail Analysis

Approach Thresholds

Pay-back period <50% of service life

Benefit-cost ratio B:C > 1

EUAC EUAC (investment) < EUAC (base case)

Lowest life cycle costs LCC (investment < LCC (base case)

NPV (using MARR) NPV (investment) > 0

4.2.3 Specify how uncertainty will be considered

Expected values (point estimates) of different cost elements and other variables are used in the analysis. For screening studies, these estimates are used without considering uncertainty. In detailed analysis, sensitivity analysis should be undertaken. For the purposes of assessing proactive investments, where we are interested in net savings, sensitivity analysis can be undertaken on the present value of aggregated costs, as shown in Table 8.

Both the discount rate and analysis time should be specified according to the business rules applied for the kind of investment under consideration and are thus not considered in the sensitivity analysis.


4.2.4 Specify economic parameters to be used

Economic parameters to be used, including discount rates and analysis period should be specified. In general, the discount rate should be set as the MARR or utility default for the type of investment being considered. Where new innovations are being considered, the discount rates should be adjusted in light of risk/uncertainty (in general, higher discount rates can be used to reflect higher levels of risk/uncertainty)

The analysis period should generally be specified in terms of the expected service life of the base case, with consideration given to key maintenance interventions (overhauls).

Table 8: Suggested Range for Uncertainty Analysis

Suggested range

Variable Impact on investment Base case Investment

Establishment cost Increased investment costs, favor the base case Na +20%

Operational costs Differential savings favor the cheaper option +/- 10% +20%

Maintenance costs Differential savings favor the cheaper option +/- 10% +20%

Risk costs Differential cost-consequences favor the associated option +/- 10% +20%

Failure rate Differential favors the more reliable option +/- 20% - 20%

Discount rate Not considered in sensitivity analysis na

Analysis time Not considered in sensitivity analysis na

4.3 Screening

Practitioners need to identify potential candidates for proactive investment. Again, proactive investment implies that the asset does not yet meet criteria for service life investment nor is the asset at the end of its physical life (i.e., the asset is not ‘failing’ in terms of either service, performance or condition). The primary failure mode of interest is thus related to efficiency gap in relation to some viable and realistic solution. The following sub-tasks should be undertaken.

4.3.1 Identify candidates for proactive replacement.

Potential candidates for proactive replacement should be identified through the mobilization of operational and other practitioner knowledge. Various processes can be used, including a call for potential investments, polling knowledgeable individuals for ideas, or undertaking technical


workshops involving individuals with detailed knowledge of the system and potential interventions. Which ever approach is taken, relevant considerations include:

− Cost streams associated with an asset (or cohort of similar assets) to identify high cost elements that could be the target for proactive investment, considering:

High or increasing maintenance costs (reliability issues in terms of costs, consumables like chemicals, cleaning materials etc., staff time)

High or increasing operational costs (staffing costs, including additional effort to avoid operational/performance issues, increase consumables, etc.)

Maintainability issues (obsolescence, availability of spares, time to undertake maintenance due to design, etc.)

High or increasing energy costs

− Technical innovations that imply a potential for economic justification of asset replacement (innovative solutions provide the same or better performance/function at lower life cycle costs). For example:

Knowledge of new technologies or types of equipment that promise operational or other savings (energy, chemicals, etc)

Alternatives interventions, including available rehabilitation techniques

As noted previously, the historical capital and O&M costs can be used to calculate the marginal cost of asset ownership, which provides an indication of when proactive investments may be justified.

4.3.2 Define the base case and alternative investment options

The base case is defined as the existing asset running for its design (or expected) life, with consideration given to key maintenance interventions (overhauls).

The alternative intervention options (capital or operational) should be defined over the analysis period.

4.3.3 Collate initial data

Initially, we are seeking easily collated data that can be obtained from historical maintenance records, expert opinion, manufacturer’s data, other utilities, etc.


It should be noted that cross-utility pooling of knowledge with respect to the performance and costs of potential innovations is a useful input at this stage.

4.3.4 Undertake screening analysis

The screening analysis is a rough cut assessment undertaken to determine which options are worth more detailed consideration.

Detailed analysis may not be needed if the benefits of investment are highly uncertain or certain. In particular, if investments are large and returns low, it is unlikely that these will be taken forward, so additional analysis should not be undertaken. In contrast, there may be some decisions that require little analysis to justify (what are colloquially referred to as ‘no brainers’); e.g. converting from ageing energy intensive treatment assets to more efficient ones where the payback period is short. With respect such opportunities, there is still a need to consider affordability and relative priorities for investment.

The general approach to screening is to undertake analysis of LCC or equivalent using easily available data, with assessments made in terms of specified acceptability criteria. For each option, including the base case, an estimate should be made of the most significant differences in:

The capital investment required

The future operational costs (or net savings)

The future planned maintenance costs (or net savings)

The future reactive maintenance costs (or net savings)

The potential for any significant risk-costs (in this context we consider that reactive maintenance costs borne by the company are separate to other consequences). If there is potential, assess the risk.

Expected life and whether this influences the economics of the decision.

Other performance or benefits associated with feasible options

Note, justification of proactive investments is based on the relative cost savings of an option compared to the base case. Hence, we only need to consider cost elements that are different for the range of options under consideration. For example, if monitoring costs are the same for the base case and other options then these costs do not need to be considered.


As noted previously, thresholds should be set that dictate that the investment should be rejected, where refined analysis is needed or where an investment can be accepted without further analysis.

The EUAC can be used to assess the potential value of different intervention options, assuming they can be repeated into the future. Where available options have significantly different EUAC, the cheaper of the options should be considered as the most suitable. The decision to remove other options from the analysis should be made in light of other considerations, including the affordability of the initial investment, risk and other potential performance advantages.

At this stage, consideration should be given to whether a specific intervention has the potential for creating maintenance issues into the future. For example, one utility in Australia used a lining technique for sewers to prevent root intrusion. The lining was approximately 50% cheaper if the junction between the sewer and lateral connections were not lined (using a ‘top hat’ or ‘tee’ insert). However, subsequent experience showed that roots still entered sewers at this junction, but the lining prevented root cutting from being undertaken. Hence, while the capital cost of lining was relatively low, the intervention created on-going problems with maintenance and thus added additional life cycle costs.

Before undertaking detailed analysis, the screening study should be extended to include a reverse valuation. As noted previously, in this approach we assume that some benefits of an investment can be estimated easily, such as energy savings, but others are potentially more difficult to constrain. In the screening analysis, we undertake a simple calculation to determine if the estimate of known savings justifies the investment. If this is not the case, we then calculate how much additional savings would need to be delivered by the investment for it to be considered attractive, and assess if this seems feasible.

4.4 Detailed Analysis (where required):

If it is determined that detailed analysis is required for a potential proactive investment, then improved data will be required on historical costs of the existing asset, the predicted costs of that asset into the future and the assumed costs of the viable alternatives.

4.4.1 Collate or generate detailed data

Where historical data is available, this should be collated and analyzed. Where it is not, expert opinion should be used to refine the data applied in the screening study.

4.4.2 Formally record all assumptions

All assumptions with respect to the data and analysis should be formally recorded, including failure rates, deterioration rates, expected service lives, etc.


4.4.3 Specify cost and benefit streams

Cost and benefit streams should be specified into the future for each alternative. The costs associated with an asset can be determined using either an estimate or through analysis of historical and other data, building on the data used in the screening analysis. The screening analysis focused on the key elements of cost that are driving the consideration of the proactive investment. In the detailed analysis stage, we need to consider all significant elements of cost that vary between the options under consideration. From this perspective, costs are significant when they are large enough to make a credible difference to the life cost of alternatives.

In more detail, for each option still under consideration, including the base case, the following items should be assessed:

− Estimate the expected performance of the baseline asset, considering the condition of the asset and anticipated deterioration rates (this can be a complex step involving interpreting inspection data in terms of a physical deterioration and using this to estimate failure rates into the future).

− Estimate the expected costs, considering:

The capital investment required

The future operational costs (or net savings)

The future planned maintenance costs (or net savings)

The future reactive maintenance costs (or net savings)

The potential for any significant risk-costs (in this context we consider that reactive maintenance costs borne by the company are separate to other failure consequences). If there is potential, assess the risk.

Other costs that will change by making an intervention.

− Determine rates at which costs will be accrued.

− Consider expected life and whether this influences the economics of the decision.

− Consider if there are performance or other benefits associated with options

As noted above, this type of analysis can be supported through trending of data, assuming the future trends will reflect the past, complimented by deterioration modeling in combination with cost estimates.


4.4.4 Undertake analysis

Analysis should be undertaken using the cost streams given above. The analysis must consider both ‘what to do’ (which alternative management intervention is the lowest cost) and ‘when to do it’. In particular, we are interested in investments to make in this planning period and those that should be considered in future planning periods.

Specified cost streams are used to calculate various measures of investment worth. Sensitivity analysis should be undertaken to determine if the decision is likely to be robust. Any additional benefits associated with the investments should be recorded, but the justification of the investment should be made initially without reference to these. Potential investments that do not meet specified criteria should be rejected. The retained options should be prioritized.

4.5 Develop Portfolio

When undertaking the analysis for a portfolio of investment options, it is necessary to rank the potential investments in terms of the metrics of relative worth derived.

All potential investments that exceed the acceptability criteria should be ranked and a portfolio of affordable investments selected that deliver the greatest benefit net of cost across the feasible options. The assessment should be undertaken in light of broad business needs, as well as the metrics of investment value.

4.6 Develop a Business Case Justifying Investment

The purpose of the analysis is to provide the basis for a business case to be presented to stakeholders for budget approval. Detailed costing of options may be included at this stage.


5 ILLUSTRATIVE CASE STUDIES

5.1 Introduction

To highlight some of the practical implications of concepts discussed in this report, it is informative to look at a range of scenarios where we know cost streams into the future. For illustrative purposes, we will calculate the present value of the known cost streams retrospectively for a time we will specify as ‘year zero’, and use these calculations as a means of demonstrating the elements of the analysis that must be undertaken to determine if proactive investment would have been justified. In practice, of course, the performance of existing assets, available alternatives and thus future cost streams are all uncertain and must be estimated in some way. The point of the scenarios is that they demonstrate:

1. How the present value of future cost streams are calculated.

2. That the cost streams incurred depend on the reactive and planned maintenance costs of running an asset and these must be balanced against the cost of alternative investments.

3. That we must consider costs from a life cycle perspective, so the timing of investments is important, as is the time value of money.

4. That asset failures impose both direct costs on the utility and other consequences that are born by the community. Our investments can be justified based on the avoidance of either direct or total costs (total costs being direct costs borne by the utility plus other costs associated with the failure and borne by others).

5. Generally, there are a range of investments that can be made (including undertaking capital works and committing to a change in planned maintenance). In assessing the relative value of investments, we compare each option with the base case (running the asset into the future) and other feasible options. These comparisons are informed by knowledge of deterioration processes, condition assessment, life cycle costs, etc.

6. That proactive investment can also be justified based on other performance improvements and related cost savings (energy, reduction in greenhouse gas emission)

7. That the period over which an asset must provide net benefits compared to the base case is important, especially with respect to the expected service life of the asset.

In all scenarios, a discount rate of 5% has been applied to represent the time value of money.


5.2 Case Study of a Deteriorating Sewer

To illustrate the concepts involved in the analysis of proactive investments, let us first consider a 100m long (manhole to manhole) small diameter concrete sewer that is 70 years old and runs down a relatively busy street on which there are some domestic dwellings, a school and a commercial office building. The soil surrounding the sewer is sandy. Flow and weather conditions during the summer imply that there will be some hydrogen sulfide production within the sewer, so corrosion of the concrete is likely. Due to its age and operating conditions, the sewer is thought to be in a deteriorated condition, but maintenance crews can not remember any structural or hydraulic failures. Given this history and being small diameter, the sewer has not been subject to routine inspections. In essence then, the utility has incurred no routine maintenance costs up to year zero.

For the sake of the discussions, we will assume that lining the sewer would cost $300/metre, whereas replacing it using a trenched approach costs $600/metre. Lining of the asset is only possible before the sewer collapses. Where the sewer is relined or replaced, we will assume that there are no on-going maintenance costs for decades. As noted above, a discount rate of 5% will be applied to represent the time value of money and we will calculate the present value of the known cost streams for year zero, the final year when the sewer provides trouble free operation.

5.2.1 Scenario 1: Running the asset until catastrophic failure

First, let us consider a scenario where the performance of the sewer deteriorates over a 10 year period. Table 9 shows the failures and reactive maintenance that occurs during this time. As can be seen, a number of blockages occur and there is then a significant collapse of the sewer in year 10 that necessitates a trenched replacement (being collapsed, the sewer can not be relined).

Table 9 also highlights that there are both direct costs associated with sewer failures (reactive maintenance, clean up costs, etc.) and also other consequences imposed on the community, noting the domestic dwellings, a school and a commercial office building can all be impacted by loss of service and any flooding. Similarly, disruptions to pedestrians and traffic can occur when the sewer fails or during reactive maintenance. These failure consequences can be considered to be a cost even though the utility does not have to pay for them. Hence, the utility carries directs costs associated with reactive maintenance, but the cost-consequences are born by others. Since communities ultimately fund the utilities activities, the cost of the failure from the perspective of the community is the total cost of the failure (direct plus other costs).

From the perspective of year zero, we can calculate the present value of direct and total cost streams, taking the sum to give the net present cost of this scenario. Table 10 shows the present value and discounted costs in each year. At year zero, the present values of all direct and total costs over the ten year period are $52,860 and $78,094 respectively.


Table 9: Ten Year Performance and Maintenance for Scenario 1

Year Event Consequences Response Direct costs

Total Costs

1 Blockage Service interruption Roding of sewer $500 $1,000 2 3 Blockage Service interruption

External flooding Roding of sewer Clean up

$1,000 $2,000

4 5 Blockage Service interruption

External flooding Internal flooding at school

Roding of sewer Clean up Root cut/jetting

$10,000 $20,000

6 7 Blockage Service interruption

External flooding Roding of sewer Clean up

$1,000 $2,000

8 9

10 Collapse of sewer section under intersection

Damage to road Service interruption External flooding

Repair of road Clean up Replacement

$70,000 $95,000

NB: Direct costs are born by the utility; total costs are the costs from the perspective of the community

Table 10: Calculation of Present Value for Scenario 1 Costs

NB: DC: direct costs; TC: total costs; PV DC: present value (year zero) of direct costs and PV TC: present value of total costs.

5.2.2 Scenario 2: Inspection and proactive lining

In the next scenario, let us suppose that instead of the reactive management strategy undertaken in scenario 1, the asset manager requires the sewer to be inspected (cost of $500) after the second blockage (i.e., the first ‘repeat’ blockage). The CCTV inspection reveals the asset is in poor condition. Given the sewer is in sand, it is considered likely that it will continue to deteriorate as

Year DC TC PV DC PV TC

1 $500 $1000 $476 $952

2

3 $1,000 $2,000 $864 $1,728

4

5 $10,000 $20,000 $7,835 $15,671

6

7 $1,000 $2,000 $711 $1,421

8

9

10 $70,000 $95,000 $42,974 $58,322

$52,860 $78,094


infiltration of ground water washes the surrounding soil into the sewer (this process means soil support around the pipe is lost, which can lead to further deterioration). The decision is thus made to reline the sewer in year 4. The cost elements and details of this scenario are summarized in Table 11, noting that we have an additional $500 in year 3.

Table 11: Performance and Maintenance for Scenario 2


Total costs

1 Blockage Service interruption Roding of sewer $500 $1000 2 3 Blockage Service interruption

External flooding

Roding of sewer Clean up CCTV inspection

$1500 $2500

4 Lining of sewer $35,000 $40,000

To stress, we are assuming there is a lower unit cost for the lining compared to a trenched replacement, but lining is only possible as an early intervention (before the sewer collapses). Furthermore, by undertaking the lining other reactive costs associated with the failures incurred in scenario 1 are not borne by the utility, though there is still some community disruption and/or interruption to service created by the lining work, which generates other costs ($5,000).

As above, we can calculate the present value of costs in each year, taking the sum to give the net present cost of the strategy (from the perspective of year zero), as shown in Table 12. Hence, assuming the lining is successful and prevents future failures, the net present value of direct and total costs for this scenario over the ten year period are $30,567 and $36,020 respectively.


Year Direct Total PV DC PV TC

1 $500 $1000 $476 $952

2

3 $1,500 $2,500 $1,296 $2,160

4 $35,000 $40,000 $28,795 $32,908

$30,567 $36,020

5.2.3 Scenario 3: Inspection and routine root cutting.

For the third scenario, we will assume that the sewer is again inspected after the second blockage (the first ‘repeat’ blockage), but the structural condition is considered acceptable. As such, root cutting is undertaken into the future and the sewer collapse does not occur (for consistency this implies that root cutting prevents the deterioration that eventually leads to the collapse in scenario 1). The cost elements and details of this scenario are summarized in Table 13. It is assumed that


there are no other costs associated with root cutting (service is not interrupted and there is no significant disruption caused).

As above, we can calculate the present value of costs in each year, taking the sum to give the net present cost of the strategy (in year zero). In this case, we have on going maintenance costs after year 10. If we only consider root cutting out to year 10, the direct costs are $5,521 and total costs are $6,861. However, in the absence of lining, root cutting is a long term commitment. So if we extend the root cutting out to year 20, we find that the present values of direct costs for Scenario 3 are $9,076 and total costs are $10,416. If we assume that sewer must be lined in year 21, then the direct costs are $21,639 and total costs are $24,774. Note, the present value of costs thus depend on what analysis period we pick, as well as the assumed life of the asset.



Total costs

1 Blockage Service interruption Roding of sewer $500 $1000 2 3 Blockage Service interruption

External flooding Roding of sewer Clean up CCTV inspection

$1500 $2500

4+ Root cut/jetting $750 5.2.4 Insights

Assuming we are committing to long term maintenance in scenario 3 (20 years rather than 10), then the present value of direct costs is $52,860 for scenario 1; $30,567 for scenario 2 and $9,076 for scenario 3. The total costs, including costs carried by the community, are $78,094, $36,020 and $10,416 respectively. If we consider that the sewer must be lined in year 21 of scenario 3, then the present value of direct costs for that scenario becomes $21,639 and total costs are $24,774.

Compared to the reactive approach of scenario 1, the proactive relining of the sewer in year 4 is thus economic given knowledge of the future maintenance and replacement costs. Of course, in year 4 it is not known what the future cost streams will be and these must be estimated in some way if we were to make the decision in year 4. In essence, this is the challenge of making economic decisions for this type of asset.

It is also interesting to note that the planned maintenance of the sewer remains the cheaper of the options even if the sewer is relined in year 21. Committing to this long term maintenance, however, assumes that the utility has sufficient resources to undertake root cutting each year. The other issue is, of course, that whilst we must take into account the time value of money when comparing decisions, in each year the real cost of the maintenance will be borne (baseline cost used in the analysis adjusted for inflation).


Placing a sewer on an annual root cutting program is a common management strategy adopted in Australia (sewers with a repeat blockage problem are put on a planned cleaning program and subject to root cutting and/or foaming). In fact, the rule of thumb applied by some utilities is that if a sewer blocks at a rate of 3 blockages in 5 years, it is considered more cost effective to undertake planned root cutting. This is illustrated in the second case study.

5.3 Case Study of a Sewer Subject to Blockages

For this case study, let us consider a different sewer that starts to exhibit performance issues from time zero and blockages then occur over a ten year period, as shown in Table 14 (scenario 4). This is again a reactive strategy in that blockages occur and maintenance is then undertaken. An alternative strategy is to undertake planned root cutting from year 6 and on because there has then been 3 blockages in 5 years (scenario 5). This represents the trigger to switch from reactive to planned maintenance.

Table 14 shows the failures and maintenance interventions that occur over the ten year period for scenario 4. The present value (again in year zero) of costs incurred over the ten year period can be calculated, as shown in Table 15. Table 16 provides the details for scenario 5, whereby there is a switch to planned maintenance from year 5.


Year Event Consequences Reactive response Direct cost Total costs 1 Blockage Service interruption Roding of sewer $500 $1,000 2 3 Blockage Service interruption Roding of sewer $1,000 $2,000

External flooding Clean up 4 5 Blockage Service interruption Roding of sewer $1,000 $2,000

External flooding Clean up 6 Blockage Service interruption Roding of sewer $500 $1,000 7 8 Blockage Service interruption Roding of sewer $1,000 $2,000

External flooding Clean up 9 Blockage Service interruption Roding of sewer $500 $1,000

10




1 $500 $1,000 $476 $952

2

3 $1,000 $2,000 $864 $1,728

4

5 $1,000 $2000 $784 $1,567

6 $500 $1000 $373 $746

7

8 $1,000 $2,000 $677 $1,354

9 $500 $1,000 $322 $645

10

$3,496 $6,992



1 $500 $1000 $476 $952

2

3 $1,000 $2,000 $864 $1,728

4

5 $1,000 $2,000 $784 $1,567

6+ $750 $560

$4,668 $6,791

In this case, the present value of running a reactive maintenance strategy (dealing with sewer blockages as they arise) over a ten year period is cheaper than the planned response. However, when total costs are taken into consideration, there is some justification for the planned maintenance, especially when considering these reflect additional costs imposed on customers. Furthermore, since the number of blockages is often reported to stakeholders, the planned maintenance will also help to improve the headline service indicator (rate of blockages across the network).

Of course, there is no reason to suppose that the blockages will stop in year 10. If the same pattern of blockages could be expected into the future, then for a 20 year period, the present value of direct costs would be $5,642 and total costs $11,284 for the reactive strategy, whereas for planned maintenance the present value of direct and total costs would be $8,223 and $10,347 respectively. The reactive strategy is thus still cheaper in terms of direct costs, but 12 additional blockages are incurred, other costs are imposed on customers and the community, and there is always the chance that any given blockage will result in a serious incident imposing much more cost. The decision to commence planned


maintenance will thus need to be made in light of overall service mandates and the risk posed by repeat blockages. As noted above, some Australian utilities have undertaken this analysis and determined that, on balance, a cost effective strategy is to switch to planned maintenance at the specified blockage rate.

5.4 Case Study for Mechanical & Civil Assets

Investment scenarios can also be constructed for other asset classes including mechanical and electrical (M&E) assets in pumping stations and treatment works. However, in the case of M&E assets, there will be on-going maintenance and operational costs across the life of the asset (not just when the asset is deteriorating, as in the scenarios involving the sewer), as well as reactive maintenance costs. Table 17 indicates the type of costs associated with a pumping station. The degree of impacts associated with a given pumping station failure will depend on whether effluent is spilled and, if so, the quantity of effluent discharged to the environment, the sensitivity of the receiving waters and the potential for community disruption and outrage. Again, investments can be justified based on the avoidance of future failures, as in the previous examples.

Table 17: Cost Elements for a Pumping Station

Cost Category Cost Element Direct cost Planned maintenance costs

Reactive maintenance costs Cost of clean up for spills and floods Fines

Other costs Environmental damage Social and recreational disruption Aesthetic impacts Public relations impacts

Technological advancements, or at least replacing old assets with newer technologies, can also generate cost savings for M&E assets. For example, consider processes such as aeration within a wastewater treatment plant where there is a significant opportunity for saving energy by undertaking capital investment in blowers, diffusers, controls and/or motors. The improvements might also reduce the risk of contravening discharge consents and/or reduce maintenance costs. As an example, consider two potential investments to reduce energy consumption:

− Two high efficiency blowers and premium efficiency motors @ $454,000 total. The new blowers and motors reduce energy use by 752,000 kWh (approximately $26,000 in energy cost savings) per year; and

− Two 200 hp Premium Efficiency Motors @ $22,882 each. The new motors reduce energy use by 157,000 kWh (approximately $5,300 in energy cost savings) per year.


In addition to direct reductions in operational costs, energy savings create a reduction in greenhouse gas emissions. If we consider an average conversion rate of 0.433 kg CO2 emission per kWh of electrical energy, and assume a cost for CO2 of $30/Tonne, then we have an additional cost savings for each of these investments as presented in Table 18. The net present value of these savings after 1, 5, 10 and 15 years is presented in Tables 19 to 22. Tables 19 and 21 show the savings from energy only (this is a cost born by the utility) and Tables 20 and 22 show the total savings considering the cost of greenhouse gas emissions.

Table 18: Investment and Savings

Investment 1 Investment 2 Units Capital investment 454,000 45,764 $ Energy saving 752,000 157,000 kWh Cost Saving 26,000 5,300 $/yr CO2 reduction 325,616 67,981 kg Cost CO2 9,768 2,039 $/yr

Table 19: Present Value of Savings for Investment 1 (Energy Only)

Year Direct Discounted Cum Ratio 1 $26,000 $24,762 $24,762 0.1 5 $26,000 $20,372 $112,566 0.2

10 $26,000 $15,962 $183,167 0.4 15 $26,000 $12,506 $252,273 0.6

Table 20: Present Value of Savings for Investment 1 (Total)

Year CO2 Discounted Total Cum Ratio 1 $9,768 $9,303 $34,065 $34,065 0.1 5 $9,768 $7,654 $28,026 $154,859 0.3

10 $9,768 $5,997 $21,959 $251,985 0.6 15 $9,768 $4,699 $17,205 $347,055 0.8

Table 21: Present Value of Savings for Investment 2 (Energy Only)

Year Direct Discounted Cum Ratio 1 $5,300 $5,048 $5,048 0.1 5 $5,300 $4,153 $22,946 0.5

10 $5,300 $3,254 $37,338 0.8 15 $5,300 $2,549 $51,425 1.1


Table 22: Present Value of Savings for Investment 2 (Total)

Year CO2 Discounted Total Cum Ratio 1 $2,039 $1,942 $6,990 $6,990 0.2 5 $2,039 $1,598 $5,751 $31,776 0.7

10 $2,039 $1,252 $4,506 $51,706 1.1 15 $2,039 $981 $3,530 $71,213 1.6

The ratio in the tables is the ratio of savings to investment; in effect a measure of the benefit-cost ratio in each year, with the investment as the cost and the cumulative present value of savings to that year as the benefit. When the ratio reaches 1, the savings have paid back the investment made taking in to account the time value of money. Table 23 summarizes the time when the ratio first exceeds 1, which is equivalent to saying when the present value of savings outweigh the investment costs.

Table 23: Time when Savings Payback Investment

Direct Total

investment 1 49 yrs 23 yrs

Investment 2 13 yrs 9 yrs M&E assets are assumed to be medium life assets, having service lives up to 25 years depending on operating context and maintenance practices. With reference to Table 23, it is clear that investment 1 would not really pay for itself even assuming a relatively long life was attained and performance was maintained over the whole asset life. In contrast, investment 2 would be likely to pay for itself. The arguments for investment are strengthened in both cases when the total savings are considered; i.e., the direct energy savings and the savings associated with reduced greenhouse gas production.

5.4.1 Reverse valuation

Another concept to consider from the perspective of this case study is one of reverse valuation, which is analogous to a ‘breakeven analysis’ (breakeven analysis can be undertaken to determine the minimum benefit a project must deliver and still cover the cost of the investment). Reverse valuation is used to scope whether more detailed analysis should be undertaken. In this approach, we assume that some benefits of an investment can be easily estimated, such as energy savings, but others can not be. If the estimate of known savings does not justify the investment, then it is possible to calculate the magnitude of additional benefit that would need to be generated by the investment to make it feasible and/or attractive, and then consider if this is likely.

Hence, in the example of investment 1, additional benefits may be expected in terms of reduced maintenance costs, increased worker satisfaction and lower risk of discharge failures. Assuming we


wish to see benefits over the period of the minimum assets life (say 15 years), then for investment 1 we can calculate the additional benefits that would need to be delivered for the present value of savings to outweigh the investment costs at 15 years. This can be done by trail and error, changing the savings achieved in each year in a simple spreadsheet model. In this case, the savings outweigh the investment costs at 15 years if there is an additional saving of $8,000 per annum generated (assuming the savings associated with greenhouse gas reduction are considered). We then need to decide if it is likely that the investment will deliver this level of annual saving. If this is the case, additional effort can be expended to understand the potential benefits and justify the investment. It is also worth noting that since we are estimating based on minimum life, any additional life achieved makes the investment relatively better.

5.4.2 Life cycle cost comparison

To this point, we have only considered the direct savings associated with a new technology. We have not considered any savings in maintenance costs, nor the timing of future investment required to replace the existing asset due to service and physical life investments. To extend this case study, let us assume that the annual routine maintenance costs are the same for the new and old asset. As they are the same, we do not need to consider these in the analysis. However, let us also assume that there will be a requirement for overhauls for both the existing assets and the new ones. The two motors being considered for replacement in investment 2 (see Table 18) are ten years old and it is expected that they will need a major overhaul in 5 years, costing $5,000, which will then allow a service life of 25 years to be achieved (an additional 15 years from when we are considering the proactive investment).

Similarly, we expect the new motors to achieve a 25 year life, but require major overhauls in year 10, 15 and 20, each costing $5,000. It is recognized that a poorly rewound motor can result in a loss of efficiency of up to 3 per cent, but it is assumed that quality control procedures are sufficient to prevent this from occurring. So, taking the analysis period to be to the end of service life for the existing motors, we have major planned maintenance, as indicated in Table 24.

Table 24: Major Overhaul Schedule

Yr Existing Alternative 5 $5000 10 $5000 15 End of life $5000 20 $5000 25 End of life


Since we are assuming an analysis period of 15 years, the replacement motors still have a residual life of ten years and this must be taken into account in some way. Assuming linear depreciation, the loss of value in each year can be calculated as:

Linear depreciation = (Investment - estimated salvage value)/estimated life

Assuming no salvage value, and an estimated life of 25 years, then the residual value of the motors at the end of year 15 is $18,306, which has a present value of $8,805.

The present value of the cost of overhauling the existing motors at year 10 is $3,918. The present value of the additional energy costs in running these older and less efficient motors for 15 years is $51,425, or $71,213 if the additional cost associated with the greenhouse gas emissions is considered. So the life cycle cost of running the existing motors until the end of their expected service life is $55,343, or $75,131 if greenhouse gas emissions are considered. In comparison, the capital cost and overhauling of the replacement motors up to year 15 is $51,239. However, the residual value of the motors also needs to be considered. We do this by subtracting $8,805 from the present value of costs incurred over the analysis period, thereby effectively reducing the LCC by the residual value of the investment at the end of the analysis period. This means that the LCC evaluated at year 15 for investment 2 is $42,433. There is thus a strong case for replacement.

The key points are that the LCC is sensitive to the analysis period selected and to the residual life of options at the end of that period, which in turn depend on estimates of service life. This is a significant issue because while the book life of an asset, under broad equivalence assumptions, should be ‘on average’ the life of an asset, the actual life of a given asset can vary and we want to make decisions based on asset-specific estimates, not on ‘average’. Furthermore, it is noteworthy that we could have included the actual cost of energy and routine maintenance in the calculation to assess the full life cycle costs, but since these are the same for both the base case and the investment option, they would cancel out. Hence, the decision to make a proactive investment or not depends on cost elements that differ. Nevertheless, the assessment of investments can be made in absolute terms (total costs can be used in the analysis) or cost differentials.

making proactive investment decisions: a practical guide of... · 2013. 4. 23. · q1. what is a...

Documents