REFURBISHMENTS AND AUGMENTATIONS

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1 INTRODUCTION TIER WORKING PAPER No. 0 REFURBISHMENTS AND AUGMENTATIONS Workig Paper No. How Water Prices are Set provided a overview of how water prices are set o the basis of lower boud costs. As oted i that paper, lower boud cost pricig requires a water busiess to recover, at the miimum, a umber of differet costs. Oe of the major cost compoets is that relatig to refurbishmet ad replacemet of existig assets. The purpose of Workig Paper No. 0 is to provide a brief isight ito the treatmet of refurbishmet ad augmetatio costs i a water pricig exercise, explai the methodology used to recover these costs through a refurbishmet ad augmetatio auity (the auity), ad to highlight some of the key issues that eed to be cosidered i this regard. POLICY BACKGROUND O 25 February 994, COAG edorsed the implemetatio of a Water Resource Policy Framework. I relatio to pricig ad log-term ifrastructure assets, the framework icluded, iter alia, the followig elemet: The settig aside of fuds for future asset refurbishmet ad/or upgradig of govermet supplied water ifrastructure. The Agriculture ad Resource Maagemet Coucil of Australia ad New Zealad (ARMCANZ) was charged by COAG with the role of support ad coordiatio i relatio to implemetatio of COAG s 994 water reform framework. A task force, which reported to the ARMCANZ stadig committee of seior officials (SCARM), was established to assist ARMCANZ. I October 996, the task force egaged Erst & Youg to examie issues specific to developig water price determiatios i the cotext of COAG s pricig reforms. Oe of the primary issues was to cosider how the issue of asset cosumptio should be icorporated for pricig purposes. 2 O 27 February 998, ARMCANZ edorsed the guidelies developed by the SCARM taskforce. With respect to asset cosumptio, the guidelies recommeded that: ASSET CONSUMPTION be measured: by traditioal depreciatio for o-ifrastructure items, amely those short-lived items, where lives are kow ad ot depedet o the life of the larger system of which they are part, eg motor vehicles, furiture ad equipmet. by reewals auities (coditio based depreciatio based o a asset maagemet pla) for ifrastructure assets, which are those system assets which are essetially reewable rather tha replaceable. This paper highlights the key asset cosumptio issues addressed i the SCARM guidelies, icludig the recommeded formula for the calculatio of the auity. 3. The term refurbishmet is beig used withi SuWater as a replacemet for the term reewals to reflect some key chages i the classificatio of activities ad costs i lie with idustry best practice (i.e. to provide a clearer differetiatio betwee the classificatio of operatig activities, maiteace works ad refurbishmet/reewal works). 3. The project was set up i two stages: Stage I examied ad recommeded methods for valuig assets, asset cosumptio ad opportuity cost of capital i determiig full ecoomic cost for use i the price determiatio process Stage II, based o the recommedatios of Stage I, developed operatioal guidelies ad a practical model to eable water busiesses to examie the implicatios of COAG s full cost recovery objectives for their ow pricig. 4. The WRU adopted the SCARM methodology to calculate the curret reewals auities for SuWater s existig five-year price paths that expire o 30 Jue Page of 7

2 ASSET CONSUMPTION, DEPRECIATION AND RENEWAL There are two basic approaches to measurig asset cosumptio, the choice depedig o the ature of the assets ivolved:. The first is the covetioal, formula based depreciatio approach used for fiacial reportig purposes. For costig ad pricig purposes, this approach is used oly for oifrastructure assets. 2. The secod measure is coditio-based depreciatio, where the asset cosumptio is derived by calculatig the cost of maitaiig the asset i a operatioal coditio. The latter method is commoly used for depreciatig ifrastructure assets for costig purposes. INFRASTRUCTURE ASSETS A ifrastructure asset is defied as a asset system with two major characteristics:. It is reewable rather tha replaceable. Idividual assets that form the compoets of the system will each be replaced accordig to their ow useful lives, but the operatig capacity of the asset system as a whole is maitaied idefiitely. 2. For the foreseeable future, demad is such as to warrat cotiual extesio of asset system life by reewal. CONDITION-BASED DEPRECIATION A auity is calculated to represet the amout of asset service potetial used up by the cost of replacig it. Ulike covetioal depreciatio, the auity approach is based o projected refurbishmet ad augmetatio costs, ot the value of the asset. It is oly appropriate for ifrastructure assets, defied as those that are beig cotiuously reewed. The method of asset valuatio will ot affect the cost of replacig lost service potetial. Therefore, the auity for a particular asset has o coectio with the asset value. The cost of replacig lost service potetial will always be based o the replacemet cost of the compoets to be refurbished. CALCULATING THE ANNUITY Usig the ecessary data from a strategic asset pla, the followig three-stage process is used to calculate the value of the auity:. The Net Preset Value 4 of refurbishmet ad augmetatio expediture must be calculated for the chose auity period. 2. The value of the Asset Restoratio Reserve (ARR) 5 at the begiig of the auity period is the subtracted from the et preset value of refurbishmet ad augmetatio expeses to determie the Total Amout required to fud the refurbishmet ad augmetatio program. 3. The value of the auity amout is the calculated by applyig a stadard auity formula to covert the Total Amout ito a aual equivalet amout. Appedix A sets out the appropriate formulas used i the calculatio of the auity ad Appedix B sets out a worked example of a 30-year rollig auity calculatio. 4. The et preset value is a commo cocept i ecoomics/fiace used to express the et value of future cashflows i curret dollar value terms. 5. The ARR acts i the same maer as a cash balacig accout carryig the et ogoig balace of the auity receipts offset by drawdows to meet refurbishmet ad augmetatio expeditures, plus ay iterest eared or paid o the balace over the auity period. I priciple, the ARR will have a zero balace at the ed of the chose auity period with all fuds received (from the auity amouts collected ad iterest received) offset by all outgoigs (total refurbishmet ad augmetatio expeditures ad iterest paid). Page 2 of 7

3 REFURBISHMENT AND AUGMENTATION EXPENDITURE The refurbishmet ad augmetatio expediture cashflows are derived from the expeditures required for all works udertake to maitai the existig stadards of services provided by existig ifrastructure assets, icludig the ability to esure ogoig compliace obligatios are satisfied. Therefore, the refurbishmet ad augmetatio expediture cashflows should iclude the costs of refurbishmet ad replacemet of idividual assets required to maitai curret service potetial ad meet all compliace requiremets. Refurbishmet ad augmetatio expeditures iclude amouts for asset substitutios required to cover the replacemet of idividual assets due to techological chage ad process redudacy as well as expediture to improve geeral busiess ad performace efficiecy (e.g. ew SCADA systems ad other operatioal cotrol assets). However, sigificat capital expediture to provide ew assets ad/or to provide sigificatly ehaced levels of services to customers eeds to be idetified separately. SuWater Data Classificatio To esure the data used i the auity calculatio is accurate, SuWater has recetly udertake a review of the refurbishmet ad augmetatio program for each scheme. Based o idustry best practice, expeditures related to stadard operatig activities ad other expeditures more closely aliged to corrective ad prevetative maiteace activities have bee reclassified out of the refurbishmet database ad ito the geeral operatig ad maiteace budgets. EXPENDITURE ON NEW ASSETS AND SIGNIFICANT ENHANCEMENTS As already oted, expediture separately idetified from the auity calculatio icludes: (a) capital expediture o ew water ifrastructure assets coverig both ew schemes ad major extesios to existig schemes (e.g. assets for ew customers ad expediture to meet ew demad from existig customers) (b) capital expediture o sigificat asset ehacemets to cosiderably improve the level of service to existig customers above the origial stadards of service. Curret examples of such expediture would iclude the expediture associated to provide ew water from the ew Burett River Dam ad Kirar Weir. Cosistet with COAG s framework, capital expediture of this ature is ot supposed to occur uless the assets are expected to ear a appropriate rate of retur. TERM OF THE ANNUITY The choice of term for the calculatio of the auity is based o the eed to secure a reasoably stable level of expediture o refurbishmet ad augmetatio works over time. With short cash flow periods (e.g. 5 to 0 years) ormal fluctuatios i refurbishmet ad augmetatio activities result i variable auity provisios ot coducive to pricig stability. Beyod 30 years, the decliig accuracy of assessmet ad the small differece that successive calculatios make to the total NPV calculatio, eve for large expediture amouts, suggests 25 to 30 years may be the most appropriate period for calculatig a auity. Nevertheless, if the itetio is to esure future costs are always brought to accout, the auity ca be calculated o a rollig basis. This ca be every oe, three or five years as is deemed appropriate. The WRU adopted a 30-year rollig auity approach to calculate the curret fiveyear price paths Note that calculatio of a 30-year rollig auity for a five-year price path requires at least 34 years of forecast data for refurbishmet ad augmetatio expeditures Page 3 of 7

4 DISCOUNT RATE SCARM recommeded that the discout rate (r) to be used for calculatig both the et preset value of refurbishmet ad augmetatio expediture ad i the auity formula should be based o the real rate of retur that ca be achieved from ivestmet earigs whe the Asset Restoratio Reserve (ARR) is positive, or the borrowig rate whe fuds are borrowed. The weighted average cost of capital (WACC) should be used if reewals are fuded from fuds geerated iterally. ASSET RESTORATION RESERVE The ARR carries the accumulated balace of the uspet portio of the auity, or overspet amout, ad the iterest thereo. The balace o the ARR (which ca be positive or egative) is calculated each period as follows: i = ARRi i= ARR + Auity Amout Refurb& AugmetCapexp + Iterest i The ARR is deducted from the NPV of the refurbishmet ad augmetatio expeditures i determiig the auity amout. This provides the busiess with the opportuity to: make adjustmets to the refurbishmet ad augmetatio programs for future chages i project scope (eg. chages i materials ad techology) adjust for chages i timig of refurbishmets ad augmetatios, ad hece restrict overchargig overcome the problems with the refurbishmet/augmetatio approach which would ot otherwise accommodate uderspet or overspet amouts o future works. Existig Auity Balaces Whe the WRU origially cosidered calculatig auities for each of SuWater's schemes, it was ackowledged that some schemes had a cosiderable backlog of maiteace to brig them up to a reasoable service stadard. Accordigly, a program of backlog works was established with the required expediture excluded from the irrigatio price paths. Therefore, the WRU was able to calculate the scheme auities for the curret irrigatio price paths usig a opeig ARR balace of zero. Curret balaces for the ARR of each scheme will become the opeig balaces for the ew price paths. However, i the evet that segmet pricig is adopted for the ew price paths, the ARR opeig balace for ay particular scheme will eed to be segregated ito opeig ARR balaces for each segmet withi that scheme. Ufortuately, as early historical data has oly bee maitaied o a total scheme basis, there is isufficiet data to accurately allocate past auity receipts ad refurbishmet ad augmetatio expeditures to each scheme segmet o a backward-lookig, project by project basis. Therefore, a methodology is required to derive the segmet opeig ARR balace for each scheme. The proposed methodology is to allocate the scheme ARR opeig balaces based o each segmets share of the relevat scheme total asset value. 7 WATER INDUSTRY PRACTICE Souther Rural Water (SRW) reviewed the auity periods for its irrigatio systems ad showed that periods greater tha 30 years geerally result i a relatively stable auity, whereas periods of 20 years or less result i a volatile auity. SRW uses a 40-year period to provide a balace betwee price stability ad iter-geeratio equity. i i 7. Note that the purpose of the allocatio methodology is oly to allocate a existig scheme ARR balace amogst the segmets withi that scheme, so the total sum of the segmet ARR opeig balaces i each scheme will ot be chaged. Page 4 of 7

5 SRW uses a 90-year period for headworks as the expediture profiles for these assets are eve more variable ad therefore require a loger period to buffer the pricig impacts from large refurbishmet activities. The SRW model also excludes ay asset that has a reewal life loger tha the modellig period, from the reewal calculatios. I regards to the discout rate, the SRW reewal auity model icludes a module to allow aual step calculatios of the auity so that it ca progressively apply differet iterest rates whe the auity reserve is i surplus (iterest rate o ivestmets) to whe it is i deficit (iterest rate for borrowigs). I the past, SRW has used four per cet. CONCLUSION Tier accepted Idec ad GHD s assessmets that SuWater s ehacemet ad ehacemet program was appropriate. Tier also accepted a 30 year rollig auity pla. Page 5 of 7

6 APPENDIX A CALCULATING THE ANNUITY Usig the ecessary data from a asset maagemet pla, the followig three-stage process is used to calculate the auity:. The Net Preset Value of refurbishmet ad ehacemet capital expediture must be calculated for the relevat auity period: NPV + i= ( Refurb & Augmet CapExp Yr ) = { NPV ( RE ) + ( ) + ( )} i Yr NPV REYr K NPV RE 2 Yr 2 = { RE *( + r) } + RE * ( + r) + [ { } + { ( + ) }] Yr Yr K REYr * r 2 Where: NPV Net Preset Value REYr i Refurbishmet ad Augmetatio expese i year i (i = to ) Term of the auity (i.e. years i the refurbishmet ad augmetatio program) r Real Discout Rate 2. The value of the Asset Restoratio Reserve at the begiig of the auity period is the subtracted from the et preset value of refurbishmet ad ehacemet expeses to determie the Total Amout required to fud the ew refurbishmet ad ehacemet program. Where: Total Amout = = i NPV ( Refurb & Augmet CapExp Yr ) ARR i Yr0 ARRYr Closig Balace of 0 Asset Restoratio Reserve i Year 0 Note: If the Asset Restoratio Reserve is egative at the begiig of the auity period, the Total Amout required to fud the refurbishmet ad ehacemet program over the auity period will icrease ad if the Asset Restoratio Reserve is positive at the begiig of the auity period, the Total Amout required to fud the refurbishmet ad ehacemet program will decrease. 3. The auity amout is the calculated usig the followig formula: Where: Auity Amout = TotalAmout - r ( ) + r Term of the auity (i.e. years i the refurbishmet ad r Real Discout Rate augmetatio program) Page 6 of 7

7 DATA ASSUMPTIONS APPENDIX B EXAMPLE ANNUITY CALCULATION (30-Year Rollig) 7.50% Discout Rate (r) Note: This example uses radomly geerated data that is ot real data for ay SuWater scheme. 30 Auity Period-years () $0.00 ARR Balace (ARR i- ) Year Year 2 Year 3 Year 4 Year 5 Calculated Auity Amouts $5,059,33.8 $5,049, $5,058, $5,052, $5,3, PERIOD (i) Years FORECAST REFURBISMENT AND ENHANCEMENT SPEND Capital Expediture (RE i ) NPV RE ANNUITY RECEIPTS NET ANNUAL BALANCE ASSET RESTORATION RESERVE (ARR) Auity Collected (Rev A ) NPV RevA Net Period Expese (NPV) Balace (NPV) ARR Opeig Balace Net Period Expese Iterest Eared o ARR Balace Closig ARR Balace Yr -$2,000, $,860,465.2 $5,059,33.8 $4,706, $2,845,873.3 $2,845,873.3 $0.00 $3,059,33.8 $0.00 $3,059,33.8 Yr 2 -$500, $432,666.3 $5,049, $4,369,24.0 $3,936,457.7 $6,782,33.02 $3,059,33.8 $4,549, $229, $7,837,83.29 Yr 3 -$4,000, $3,29, $5,058, $4,07, $85, $7,634,93.2 $7,837,83.29 $,058, $587, $9,483, Yr 4 -$,000, $748, $5,052, $3,783,589. $3,034, $0,668,98.70 $9,483, $4,052, $7, $4,248, Yr 5 -$3,000, $2,089, $5,3, $3,56,702. $,472,026.2 $2,4,007.9 $4,248, $2,3, $,068,607.9 $7,429,987.0 Yr 6 -$7,000, $4,535, $5,3, $3,33,2.27 -$,222,59.36 $0,98, $7,429, $,886,76.00 $,307, $6,850, Yr 7 -$6,500, $3,97, $5,3, $3,082, $835, $0,082, $6,850, $,386,76.00 $,263, $6,727, Yr 8 -$0,000, $5,607, $5,3, $2,867, $2,739, $7,342,646. $6,727, $4,886,76.00 $,254, $3,095, Yr 9 -$4,000, $2,086, $5,3, $2,667, $580, $7,923,36.65 $3,095, $,3, $982,58.49 $5,90,889.0 Yr 0 -$7,000, $3,396, $5,3, $2,480, $95,423.5 $7,007, $5,90, $,886,76.00 $,39,36.68 $4,443, Yr -$,000, $45,343.9 $5,3, $2,307,845.9 $,856, $8,864, $4,443, $4,3, $,083,26.73 $9,640,035.4 Yr 2 -$2,000, $839, $5,3, $2,46, $,307,25.4 $0,7,52.36 $9,640,035.4 $3,3, $,473, $24,226, Yr 3 -$7,000, $2,733, $5,3, $,997, $736, $9,434,64.82 $24,226, $,886,76.00 $,86,974.6 $24,56, Yr 4 -$9,000, $3,269,82.24 $5,3, $,857, $,42, $8,022, $24,56, $3,886,76.00 $,8, $22,08, Yr 5 -$5,000, $5,069, $5,3, $,728,6.24 -$3,34, $4,68,7.50 $22,08, $9,886,76.00 $,656,20.58 $3,85,02.32 Yr 6 -$6,000, $,886,32.97 $5,3, $,607, $278,77.98 $4,402, $3,85, $886,76.00 $,038, $4,003,22.25 Yr 7 -$5,000, $,462, $5,3, $,495, $33,30.25 $4,435, $4,003,22.25 $3, $,050,234.7 $5,66, Yr 8 -$8,000, $2,76, $5,3, $,39, $785,329.2 $3,650, $5,66, $2,886,76.00 $,37, $3,47, Yr 9 -$,000, $253,069.3 $5,3, $,294,04.35 $,040, $4,69,45.86 $3,47, $4,3, $,006, $8,537,03.3 Yr 20 -$4,000, $94, $5,3, $,203, $262,08.69 $4,953, $8,537,03.3 $,3, $,390, $2,040,573.2 Yr 2 -$7,250, $,587, $5,3, $,9, $467,97.25 $4,485,30.3 $2,040, $2,36,76.00 $,578, $20,48,900.0 Yr 22 -$2,25, $2,469,99.93 $5,3, $,04, $,428,36.39 $3,056,948.9 $20,48, $7,0,76.00 $,536,42.5 $5,006,326.6 Yr 23 -$9,000, $,705, $5,3, $968, $736, $2,320, $5,006, $3,886,76.00 $,25, $2,245,085. Yr 24 -$0,000, $,762, $5,3, $90, $86,48.03 $,459, $2,245,085. -$4,886,76.00 $98,38.38 $8,276, Yr 25 -$5,000, $89, $5,3, $838,47.5 $8, $,477,58.0 $8,276, $3, $620, $9,00, Yr 26 -$4,000, $60,54.64 $5,3, $779, $69,88.85 $,647, $9,00, $,3, $675,809.3 $0,799, Yr 27 -$0,000, $,48, $5,3, $725, $693, $953,992.3 $0,799, $4,886,76.00 $809,99.3 $6,723,59.39 Yr 28 -$9,000, $,87,970.0 $5,3, $674, $53, $440,958.7 $6,723, $3,886,76.00 $504, $3,340, Yr 29 -$8,000, $982, $5,3, $627, $354, $86, $3,340, $2,886,76.00 $250,55.03 $704,55.37 Yr 30 -$2,000, $228, $5,3, $584, $355,602.5 $442,08.26 $704,55.37 $3,3, $52, $3,870, Yr 3 -$4,000, $425, $5,3, $543, $8, $560, $3,870, $,3, $290, $5,274,29.88 Yr 32 -$6,000, $593, $5,3, $505, $87, $472, $5,274, $886,76.00 $395, $4,783, Yr 33 -$4,500, $43,745.4 $5,3, $470,32.85 $56, $529,42.20 $4,783, $63, $358, $5,755, Yr 34 -$,300, $966, $5,3, $437, $529,42.20 $0.00 $5,755, $6,86,76.00 $43,63.35 $0.00 Year -$79,375, $59,752, $53,64, $60,94, $442,08.26 $0.00 -$26,20,0. $30,080,739.4 $3,870, Year 2 -$8,375, $58,36, $53,28, $56,03, $2,285, $0.00 -$28,56,30.93 $30,37, $2,24, Year 3 -$86,875, $58,477, $53,283,084.4 $52,67, $6,309, $0.00 -$33,59,95.86 $30,537, $3,054, Year 4 -$87,375, $55,67, $53,338,02.52 $48,566, $7,05, $0.00 -$34,036, $30,308, $3,728, Year 5 -$97,675, $55,888,940.2 $53,398, $45,29, $0,668,98.70 $0.00 -$44,276, $30,028, $4,248, Workig Paper No. 0 Page 7 of 7

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