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The Color of Capital

March 22, 2012

The Color of Capital

Q:

My firm uses Cablecure 732/733 [Ultrinium™] and Sustained Pressure Rejuvenation to treat cables after they fail. The ability to capitalize single section injection with Novinium technology means we can earn a regulated rate of return on the capital thus expended. I read your four-part blog, “The Color on Money” and was wondering if you could do a similar analysis to help us quantify the benefit of our approach.

A:

I am pleased that you appreciated my “Color of Money” posts. Click on I, II, III, and IV to review that work. Many of the concepts in the “Color of Money” apply to the “Color of Capital.” In fact, Parts II and III are prerequisites if you need a primer on depreciation and the time value of money respectively.

The ability to capitalize single sections of injected cable is available only from Novinium. In FERCs (Federal Energy Regulatory Commission) Letter order dated January 18, 2000, John Delaware, the Chief Accountant, wrote to the petitioner, Georgia Power:

“You indicate that CableCURE is used to rehabilitate entire segments of your underground distribution system (e.g. entire residential subdivisions as opposed to individual runs of cable between two terminal points).”

The only way you can capitalize CableCURE is if the entire subdivision is rejuvenated. The letter order is attached to this post for the interested reader. Novinium’s technology has no such limitation. The Letter Order promulgated by FERC’s Chief Accountant on September 4, 2008 and associated submittal information removes that limitation and can be accessed by clicking here. All of the above discussion is also true for RUS-funded circuit owners. Click here to view the RUS order of April 3, 2009.

That takes care of the regulators; now the analysis. We will compare two cases. All of the inputs are shown on the worksheet nearby. Parenthetical references to the worksheet cell designations appear in the following text.[dt_fancy_image type=”image” image=”http://www.novinium.com/wp-content/uploads/2015/09/color_of_capital_worksheet.png” style=”2″ width=”600″ padding=”10″ margin_top=”0″ margin_bottom=”0″ margin_left=”0″ margin_right=”0″ align=”center” animation=”none”]

It’s easy to change the assumptions!

Case 1

The cable fails, is repaired and put back in service. In our model the user can indicate how many faults are tolerated before the cable is replaced, together with an estimate of the time between faults. For this example, we assume the cable will fault twice over a two year period before it is replaced. The capital cost to replace is a modest $33.00/ft (Cell B7) and the O&M cost of a fault is $13.72/ft (Cell D13) in today’s dollars. That’s $4,500 (Cell B11 %20 Cell B12) divided by as assumed segment length of 328 ft (Cell B13).

Case 2

The cable fails, is repaired and injected in a single integrated operation. In our model the bundled unit capital is $20.06/ft (Cell D23). The model user can change any of the costs inputs and an assumption of the post-treatment reliability. For this example, the post-treatment failure rate is assumed to be 2% (Cell B26), which is about twice Novinium’s actual post-failure experience of about 1%.  To put this 1% failure rate in perspective consider that it is three-times higher than Novinium’s non-post-failure experience of about 0.34%. This higher-than-typical post-treatment failure rate is inherent in post-failure treatment. The post-injection fault is assumed to occur two years (Cell B27) after injection. Again the model user can adjust any of these assumptions.

Other Assumptions

Warranty remittances of $10/ft (Cell B23) are negative capital expenditures, that is, the remittances are subtracted from the subsequent replacement capital. Upon post-injection failure, the book value is written off, terminating the ratemaking-allowed return and providing a lump sum tax benefit of the book value. Cash flows are calculated for two rehabilitation cycles, up to 100 years. This approach allows residual values to be properly ignored as de minimis. Finally, replacement is assumed to have a zero-percent failure rate. At least one major investor owned utility has reported that new installations suffer a 0.6% “infant mortality” failure rate, and hence this assumption results in a slight understatement of the incremental value of Novinium® post-failure rejuvenation.

Bottom Line

The cumulative net present values (NPVs) for the two cases are plotted nearby. Since the revenue or sale of electricity is the same in all cases, those revenues are ignored and only capital and O&M costs are depicted. This cost-only analysis is why all of the NPV values are negative. Nonetheless, the higher the cumulative NPV value is on the graph, the more advantageous to the circuit owner.

The blue line is for Case 1, and in the short run it is the superior choice. The problem is that once a cable begins to fail, it will re-fail. Sooner or later the ratepayers will be very upset with deteriorating reliability. Capital inefficient replacement is executed after the second fault (Cell B14) and the NPV plummets.

The orange line is for Case 2, and it represents an investment in reliability. The initial cost is about twice as great, but because the investment is capital, the circuit owner begins to earn a regulated rate of return. In the end, the incremental NPV advantage of Novinium post-failure rejuvenation is $18.42/ft. If your replacement cost is higher, say $44/ft, the difference becomes $21.15/ft. If in Case 1, the cable is allowed to fault a total of three times, the difference rises to $24.56/ft. Even if the cable is replaced after a single fault, the best alternative to rejuvenation, rejuvenation still enjoys an $11.45/ft advantage.[dt_fancy_image type=”image” image=”http://www.novinium.com/wp-content/uploads/2015/09/color_of_capital-graph.png” style=”1″ width=”600″ padding=”10″ margin_top=”0″ margin_bottom=”0″ margin_left=”0″ margin_right=”0″ align=”center” animation=”none”]

The difference between these two lines in our example is about $18.42.