Business & Money
Merchant Costs: Reckless Abandonment?
Some independent power producers failed to contain capital and O&M costs, adding to financial pressures.
April 2004
By Holt Bradshaw
Merchant generators can substantially increase cash flow by revamping their capital allocation processes. Based on several recent client engagements, a PA Consulting study found that merchant generators often follow a flawed allocation process that misappropriates cash toward wasteful maintenance and capital expenditures, resulting in reduced asset values and erosion of precious cash reserves.
Our study of recently acquired generation assets representing 36 plants and 32,410 MW found a lack of control in the level and growth of non-fuel maintenance expenses and of capital allocated to projects related to operations and maintenance (O&M). Even more troubling is that this lack of investing discipline occurred at a time when merchant producers were under very serious financial pressures.
This situation is the result of a poor capital allocation process that often fails to:
- Tie capital or O&M plans to the company's production strategy;
- Rigorously analyze multiple options and risks for each project;
- Evaluate the impact of single projects on the entire portfolio of investments; or
- Manage the benefits and risks of the projects and portfolio.
O&M Expenditures
Initially, we discovered a disturbing rise in the non-fuel maintenance expenses of divested assets. This is surprising because conventional wisdom suggests that merchant owners of divested plants tend to be very cost-conscious, trying to squeeze as much profit from their recently acquired assets as possible compared with their previous owners-regulated utilities that could pass on operating costs to ratepayers.
In fact, not only were post-divestiture costs higher, but they kept growing. The PA analysis showed that while maintenance costs before divestiture actually shrank slightly on average, post-divestiture maintenance expenses grew at a compound annual average growth rate of 34 percent from 1999 to 2002, defying the conventional wisdom that competition alone would control expenditures. Of course, the traditional argument for post-acquisition maintenance cost increases holds that plants were under-maintained prior to being purchased, but the PA research does not show this to be the case.
Even when maintenance costs are compared with actual net generation, a similar trend is evident. The average maintenance cost ratio did dip in 1999, but this one-time event was driven in large part by a spike in net generation. By 2000 the maintenance ratio returned to within a few pennies of the 1998 level, and by 2001 the ratio was a full 7 percent above the highest level recorded since 1988. What's more, the maintenance ratio continued to rise another 30 percent in 2002 (see Figure 1).
This rise in maintenance expenses is even more surprising because many of these merchants companies were at the same time experiencing dire financial circumstances and were all undergoing significant restructuring. Yet neither their senior nor plant management were able to significantly limit the growth of maintenance expenses.
In fact, we found another surprising trend-an increase in both O&M expenses and O&M capital investments, in spite of these companies' financial problems. Generally, in times of financial distress, companies find slashing capital budgets easier than cutting operating expenses, first eliminating special projects. Although the merchant generators that we studied in our sample did eliminate their special projects and clamped down on certain capital expense categories, they generally increased their O&M capital expenditures.
Capital Expenditures
PA estimated that the average plant in this study was allocated $2 to $3/MWh in capital improvements, which raised the real cost of production by as much as 20 percent, further eroding an already tenuous competitive position for most of these plants. One would have expected a pattern showing an increase in capital investment to reduce rising operating and maintenance expenses (see Figure 2).
To preserve cash, merchant generators slashed their 2002 capital budgets. Significant projects were delayed or canceled, and operating strategies were reconsidered. Keep in mind that plant level capital budgets can be segmented into five generic expense categories:
- Revenue Enhancing: greenfield or brownfield development, or uprates to existing equipment;
- Environmental: generally required by law;
- Major Maintenance: major inspections of existing equipment required to ensure efficiency and availability;
- Reliability: generally significant balance of plant projects intended to ensure plant availability; and
- Other: a variety of plant projects from information technology system enhancements to new plant vehicles.
PA's review of the planned capital expenditures of the merchants showed that peak outlays in 2002, largely driven by the need to meet increasingly stringent environmental limits, were reduced for 2003. We also found that the amount of capital allocated to revenue-enhancing items also dropped due to the over-supplied generation market.
Yet the analysis shows that the capital planned for major maintenance and reliability related projects is expected to grow. Between 2002 and 2005, major maintenance expenditures are planned to increase 30 percent per year, while reliability expenditures are planned to grow some 108 percent (see Figure 3).
Upon further review, PA estimates that 25 to 30 percent of these planned and approved projects were unnecessary. Close examination of each planned project revealed considerable waste. Examples include:
- A $48 million chimney replacement that engineers admitted caused no operational, maintenance, or safety issues. It just needed to be replaced;
- A $17 million low-pressure turbine rebuild that had no negative impact on operations and showed no signs of imminent danger;
- A $7.5 million spare turbine rotor for a rotor not in need of replacement; and
- A $4 million rail-yard upgrade that offered some improved efficiency after several years of construction.
Current Capital Allocation Process
No doubt engineers considered each of these projects necessary and justified, but the examples above and many more were not necessary. Many of these projects fall into the "nice to have" or the "this is the latest technology" categories.
Certainly many retained projects were intended to improve the plant, but the rationale behind the decision was not always explicit. For example, when asked for the reason behind a specific approved project, one engineer explained that the components were old, maintenance was difficult, and that better technology existed. However, there was no explanation whether, or how, he had evaluated the cost and returns of possible replacement options to ensure a maximum return on invested capital.
Yet access to capital is very expensive to most merchants that generally must allocate it across several plants located in different regions in the United States (and even several countries) where each plant's competitive position varies according to its market. PA's experience indicates that the capital allocation process followed by many merchant generators is flawed.
In many cases, proposed capital projects were not linked to the corporate or plant strategy. Examples include painting, parking lot improvements, floor sweeper replacement, purchase of special tools, and large contingent amounts for undefined projects. Additionally, many had weak business cases, and for those with business cases, alternate technical or business options for accomplishing the same goal were not often analyzed. Examples include overly frequent major inspections (4-year cycles that could be delayed), rail upgrades, controls upgrades, and significant capital spare part purchases in maintenance budgets.
Furthermore, there often was a lack of risk assessment (e.g., risks of late delivery; not achieving the performance improvement anticipated, or negative system impacts resulting from an isolated project; and cost overruns). These risks are not negligible. For example, a major unit inspection-an action that was often recommended in the plans that we reviewed-is in reality a collection of many smaller projects (e.g., inspections of boilers, turbines, plant controls, fuel delivery systems), each with its own performance risk and with the potential to delay the unit's return to service. Of course, within each of these smaller projects are still smaller projects, each with its own risks, rewards, and potential to result in cost overruns, or delaying the unit's return to service.
Plant expenditures designated for individual projects should be managed as a portfolio. This ensures not only that risks are fully understood, but also that capital is efficiently invested. While always important, this is especially critical during the current generation oversupply. Many assets may not perform as anticipated, and O&M plans need to take that into account.
Finally, the PA study revealed a disturbing lack of portfolio performance assessment and feedback. Project managers generally track performance during their project, but firms rarely monitor portfolio performance. Even more uncommon is the merchant generator that looks back at performance with a critical eye, searching for opportunities to improve.
In conclusion, each O&M cost re-duction or capital expenditure project should:
- Drive some strategic objective;
- Be selected from many options to accomplish a goal based on rigorous analysis;
- Be evaluated based on its impact on the entire capital portfolio of programs and projects; and
- Be managed to ensure the intended benefits are realized and the risks mitigated.
By following these basic principles, electricity generators can conserve cash, manage risk, and thereby increase value.
Holt Bradshaw is an energy industry specialist with PA Consulting Group. Contact him at holt.bradshaw@paconsulting.com.
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