by Thomas J. Flaherty III, Booz & Co.
The level of capital expenditures planned within the utility industry is targeted at a mix of infrastructure and capacity investment for modernization and growth that will sustain itself annually for the foreseeable future.
Large-scale capital investment is being directed toward: the fulfillment of regulatory mandates; the replacement of aging assets; the expansion of grid capabilities and the readiness of next-generation supply sources, all without a clear view of policy contours or market structures. Nonetheless, each category of expenditures is viewed as accomplishing two outcomes: increased earnings capability and an upgraded supply and delivery system.
Yet, managements view the prospect of significant and sustained capital investment in the form of megaprojects, particularly with respect to baseload capacity, with trepidation. This apprehension reflects unpredictable construction outcomes and uncertainty regarding the recovery of incurred costs if future circumstances differ from those expected today. Both factors recently have resulted in promising large-scale projects’ being pushed back or abandoned. Managements face missing out on the cheapest borrowing costs in modern times or committing to scale investments that carry the potential for uncompensated risks.
Large Capital Commitments
Megaprojects—those greater than $1 billion—are no longer extraordinary within the portfolio of capital projects for development and construction. Given baseload technology choices, transmission additions scale, environmental retrofit requirements and network replacement ubiquity, the number of billion-dollar projects is increasing because of the magnitude and breadth of planning conditions the industry addresses.
Making the megaproject commitment requires that managements become comfortable with uncertainties related to long-term decisions while incomplete information and imperfect choices exist. These conditions arise from an inability to understand factors that affect project outcomes. Each of the following factors affects how managements deploy capital for large-scale projects:
- Economic Recovery. The quicker than expected return of industrial load in much of the country surprised observers. Whether the resulting load level is sustainable is an open question and complicates decision-making for the next stage of baseload investment. With continuing surplus capacity available, the impetus for major spend is a question mark for managements that seek to avoid investing on false signals.
- Materials Prices. During the run-up in global commodity prices for steel, copper and other basic items that peaked in 2008, the ability to accurately gauge future costs of critical materials was a challenge. Moreover, it made estimating for even short-cycle, noncomplex construction difficult and drove project costs upward.
- Regulatory Uncertainty. Continuing pressure on prices from cost escalation creates concerns about the impact of higher rates on consumers’ abilities to pay. This creates conditions where regulatory responses can become unpredictable and utility financial results subject to unexpected outcomes, which creates uncertainties about cash flows.
- Forecast Accuracy. Increasingly, capital project investment focuses on technological advances that have not been deployed or are less predictable in cost than simpler options. Whether for generation choices such as integrated gasification combined cycle (IGCC) or Generation III+ nuclear, or for new high-voltage transmission, the ability to determine future completed costs has grown more complex.
- Project Exposure. Even when managements feel planning-stage confidence about project cost predictability, the scale of megaprojects creates risks related to ultimate business impact on the enterprise. With the recent compression in utility market capitalizations, megaprojects can have an increasingly more significant impact to utility financial outcomes and cause managements to evaluate risk and reward trade-offs.
Further, new nuclear baseload generation can cost $7 billion to $8 billion for a single unit. Compared with current capitalization levels, this expenditure can amount to more than 25 percent of the market value of equity. When all other capital investment requirements are considered, companies might be spending more than 40 percent of their current capitalization. These types of outcomes stress balance sheets and expose cash flows. Consequently, several proposed new-build plants have slipped their planned commercial operations dates from 2016-2017 to sometime after 2020.
In many cases, regulatory policy supports new investment and provides for risk minimization through the application of targeted cost-recovery riders, e.g., for transmission or environmental expenditures, or adopts supportive expenditure review policies that minimize the potential for second-guessing management decisions. These types of policies mitigate risk and establish more certainty over cost recovery, thus reducing management concerns that constrain capital investment.
Utility managements are deferring major decisions until the landscape is more stable. This emphasizes in the near term only those projects that appear most predictable and manageable. While this reduces exposure to project and financial risks, it results in higher construction costs because of delay and might limit the advantages that can be obtained from investment.
In determining whether to undertake a large capital project in the current market and regulatory and financial environment, managements must be aware of current and prospective risks. Megaprojects generally are susceptible to cost overruns and schedule extensions. While this is not uniform, two industry surveys show that large-scale projects often experience execution difficulties. The first survey captured data from more than 30 projects around the globe, with an average cost of $1.5 billion. Nearly half underperformed, with an average growth in costs of more than 30 percent and average schedule slippage of 12 percent. Regardless of geography and industry type, a correlation existed between project scale and the potential for adverse outcomes.
The second survey, conducted by Booz & Co. and focused exclusively on the energy sector, indicated less severe results. For the more than 100 global pipeline and refining projects addressed, the rate of significant schedule slippage was more than three times that of smaller projects, with more than one in five experiencing significant extension. The track record of large-project performance, regardless of the industry or global setting, is similar. In both surveys, poor project planning and management, lack of design completion adequacy, work execution failures and higher than expected escalation combined to introduce variability into project performance.
Another recent megaproject survey Booz & Co. conducted indicated that the three most recognized risks to project success were material price escalation, shortage of skilled craft labor and engineers, and owner project management capabilities. Owners were circumspect about their ability to achieve desired outcomes because of the number and magnitude of planning and execution uncertainties.
Headlines from international and U.S.-based projects further indicate that megaprojects can be prone to cost growth and schedule delay. The nuclear experience in Finland and France has been more challenging than expected. The Canadian oil sands show how poor estimating, labor shortages, project management shortfalls and high escalation can impact a project adversely. In the U.S., new nuclear, conventional coal and IGCC projects have experienced continuing increases in cost estimates because of being a first-of-a-kind technology project or being in the planning queue during high commodity prices for raw materials. The more conventional projects, e.g., transmission, combined-cycle plants, also experienced cost increases, although these generally were driven by materials’ costs.
These results and the experience of project owners create skepticism in utility managements regarding large-capital project risks and outcomes. History can help owners avoid repeating problems of the past.
Overcoming the Execution Gap
Committing capital to a megaproject in this economic and regulatory environment is difficult to justify. Many discrete challenges exist. Most cannot be avoided by being more deliberate in decision-making. For future large projects to become realities, managements must attain comfort and confidence levels that validate moving forward—comfort that the relevant execution risks have been identified and confidence that they can be addressed adequately.
Managements can learn from predecessor megaprojects’ errors and are not destined to repeat them because of a potential project’s dollar scale. These issues will recur, however, if managements ignore past experience. Consequently, companies must identify what attributes matter to project success and build or refine their internal capabilities to execute.
To mitigate the trepidations related to large capital projects and position a project for a more predictable outcome, several elements must be addressed:
- Project Management. Strong, not just adequate, capabilities in project oversight and controls form the foundation for ensuring that utilities position themselves to plan, manage and execute megaprojects. These capabilities are distinguished by integrated management structures, line-of-sight project management and rigorous, task-based management processes.
- Risk Apportionment. Establishing the roles and responsibilities between the owner and the EPC, as well as the manner in which risks are to be shared, are table stakes. While EPC firms are reluctant to assume any risk for planning and execution, owners must be able to obtain an equitable split of responsibility based on the underpinning of which party controls the risk.
- Readiness Plan. Project experience indicates that underestimating megaproject complexity causes adverse project outcomes. This element can be mitigated best through advanced planning that culminates in a comprehensive, detailed, project plan prior to work initiation.
- Financial Strength. Deciding to proceed with a large capital program or project requires that managements assure themselves that a robust balance sheet and level of liquidity is available. Sustaining the program or project then necessitates the continuity of predictable cash flows to maintain credit ratings and access to capital.
- Regulatory Positioning. Given the propensity for megaprojects to experience cost overruns and schedule slippage, utilities must be certain local regulatory environments are as supportive of and predictable on cost recovery as possible. This requires as much transparency as possible on contemporaneous project events and progress, rather than parsed, ex ante reporting.
Thomas J. Flaherty III is a Dallas-based senior partner with Booz & Co. He has been involved with more than 30 large capital projects in excess of $5 billion spanning the power, pipeline and oil sands sectors. He has provided expert testimony on project management before more than 20 state regulatory commissions and is a frequent author on the topics of capital allocation, risk management and project management, particularly with respect to nuclear plants. Reach him at firstname.lastname@example.org.