Capital vs. O&M Investments: What’s the Cost to Customers?
When working with utilities, we often find that capital and O&M dollars have different rules and value associated with them. At many utilities, an O&M dollar is perceived as being much more valuable than a capital dollar. For example, an investment that costs $100,000 in capital is typically much easier to get approved than an investment that costs $100,000 in O&M dollars.
Why? Because almost every utility, regardless of whether it is a government-owned or regulated, investor-owned utility, is very sensitive to rate impacts. Any significant rate increase is newsworthy even if the rate increase is necessary and justified. And because the immediate rate impact of the O&M spend is much greater than that of the capital spend, O&M spending becomes an important focus at every utility to minimize rate increases.
Should a utility spend $100,000 of capital or O&M?
Let’s say we have two ways to solve a problem: we can solve it by spending $100,000 of capital this year or we could spend $100,000 of O&M this year. If we are looking at immediate rate impact, the capital alternative is the better option. But is it really better for the customer? What is the cost to the customer?
The impact on the customer varies from utility to utility depending on exactly how capital and O&M expenditures are recovered by rates. A relatively straightforward assumption typical of a government-owned utility is this:
- For O&M spend: the customer will bear the cost of the entire investment in the current year.
- For capital spend: the utility will borrow money to pay for the capital investment and will repay that money over the lifetime of the asset.
Again, this is a simplification of the exact accounting treatment and the detailed calculation differs from utility to utility. However, in general, from a customer perspective, for the capital investment, the utility is effectively borrowing on behalf of the customer, and the customer will be obligated to pay that back over time.
Which option is better for customers?
It turns out it depends on the customer! For example:
- If the customer is a residential customer or a small business owner struggling to pay off debt and borrowing money on credit cards, their cost of capital is much higher than the utility and such a customer is better served by the utility choosing the capital alternative.
- If the customer is a commercial or industrial customer and is not in the position of needing to borrow money, their cost of capital might be lower than the utility and they are better served by the utility choosing the O&M alternative.
As you can imagine, this makes it very difficult to calculate the average cost of capital across the entire customer base. To simplify the problem, it is assumed that the customer’s cost of capital is the same as the utility’s cost of capital. By making this assumption, and understanding the rate recovery rules for a utility, it becomes possible to compute the cost of capital and O&M dollars to customers. When one does such a calculation, typically the customer costs are quite similar.
If the costs to the customer are similar, then how do we account for the very real difference in rate impacts?
Capital investments can have an impact on O&M spend. For example:
- Replacement of aging assets with newer assets can reduce routine O&M costs, or avoid increased O&M costs in the future
- Installation of new assets can result in increased O&M costs to maintain those new assets
In Copperleaf’s solution, avoided increased O&M costs, avoided future O&M costs, and new O&M costs can all be calculated as part of a capital investment. This makes it possible to understand the total O&M impact of a portfolio for any scenario.
For example, we can run an optimization to determine the best value to customers with the capital budget constrained to $100M/year for the next 5 years. As an output of this optimization, we can see the impact this will have on the O&M budget. Let’s say it shows us that it will result in a $5M increase in O&M costs. If that increase in O&M costs is not acceptable, we can rerun the optimization and constrain the O&M costs to not increase. By adding this additional constraint, the Copperleaf solution will find the portfolio that provides the most value to customers, meets the capital constraints, and does not increase O&M costs.
We can even take this further. We can define ‘rate impact’ as a value measure and calculate the rate impact of the capital investments and the rate impact of the O&M investments. This allows us to see the total rate impact of the portfolio of investments. Then, instead of putting specific constraints on capital and O&M spend, we can put the constraint on rate impact. We can then run an optimization to find the portfolio that provides the most value to customers while staying within a specified rate impact.
Want to find out more?
A Master’s thesis research project conducted at the University of Southampton concluded that optimization yields 7% to 20% higher portfolio value for the same monetary constraints compared to prioritization.
Download a free copy of the research report to learn more about how optimization can help your business.