Energy & Commodities

Maximize Utility Shareholder Returns with Dynamic Capital Planning

United States-based regulated, investor-owned utilities (IOUs) have been expanding their capital investment budgets. This growth has been driven largely by the sector’s support of energy transition mandates, resulting in both new investment and accelerated capital replacement.

However, with these new investment opportunities come plenty of challenges, as IOUs must juggle an increasing number of complex, long-term projects while ensuring disciplined cost management that provides shareholders appropriate return on equity.

These growth patterns are even more pronounced at the asset level, where distribution investment has more than tripled since 2003 and transmission investment has grown five times over that same period (Figure 1). Looking into the near-term forecasts shared by IOUs, capital investment is expected to grow around eight percent annually, implying total investment will double again by 2033. Industry analysts predict that in total, between 2024 and 2050, North American electric utility investments will cumulatively exceed $3.4 trillion.

How can IOUs maximize rates of return on equity (ROE) while increasing investment? With improved discipline and digitalization of capital investment tools and governance, Publicis Sapient forecasts that a 100 basis-point (BPS) uplift in ROE would yield $5 billion to $10 billion of increased earnings to shareholders annually over that same period.
 

What is driving this challenge for utilities?

Regulated utilities invest capital at enormous scale to accommodate changes to the grid and ensure service reliability for their customers. These investments are generally split between assets that serve ratepayer needs (i.e., plant additions) and capital expenditures (i.e., capex) not included as part of their regulated rate base. In order to realize a predictable ROE for shareholders, utility planning teams need to hit their targets on both of these numbers, otherwise they risk deploying more capital than they can charge customers for in monthly utility bills.

As a result, overseeing an accurate, predictable investment planning process is essential to deliver earnings to shareholders as close to what regulators have permitted as possible (i.e., authorized or allowed ROE). This planning process will also help utilities organizations develop and leverage agile capabilities that will enable them to effectively strategize and generate value for ratepayers too.

Publicis Sapient’s analysis of North American IOUs indicates that a lack of discipline in capital planning and reporting is responsible for approximately 150 BPS of the difference between authorized and achieved ROEs, all of which would otherwise flow to shareholders. Why does this happen?

In many instances, this ROE shortfall occurs because of a lack of predictability across assumptions built into utility revenue requirements, including capex, plant additions, construction work in progress (CWIP) and allowance for funds used during construction (AFUDC).

As an example, if a utility spends more than forecast on plant additions, revenue collection from customers will not be enough to cover the amount of assets placed in service, leading to erosion and underperformance of ROE.

In simplified terms, if a utility agrees with regulators to place $10 of assets in service at 10 percent ROE, that utility would then be allowed to collect $11 through customer bills for that asset: $10 to cover the build cost and $1 in earnings (10 percent). However, if that same company spends more than contemplated in its annual plan and places $11 of assets in service, it still only collects that $1 in earnings but erodes ROE to approximately 9 percent, a loss of more than 90 BPS for shareholders.

This admittedly narrow example is far more complex and multidimensional in practice, where a utility is actively managing all the moving parts of revenue requirement on a dynamic basis. However, when looking at these investment processes more broadly it becomes clear that having accurate, timely and well-consolidated spend data is a common and unresolved challenge facing planning teams.

Outside of concrete investment variables like plant additions, another opportunity for planning teams is to improve the predictability and traceability of project financing mechanisms such as CWIP and AFUDC. In their own ways, these tools help utilities mitigate “rate shock” for customers, but weak controls or line of sight into how these factors are changing over the year can impact both above- and below-the-line utility income. Among other drivers of this effect, two common scenarios are when (a) CWIP balances have non-interest-bearing project spend or (b) projects are expected in-service within a time frame that rules them ineligible for AFUDC, but actual project duration extends well beyond original forecast and thus leaves ‘on the table’ customer funding that could have benefited shareholders.

So, what can utility organizations do to more tightly safeguard shareholder ROE in such an unpredictable environment? Dynamic capital planning offers a path forward.
 

What is dynamic capital planning?  

First and foremost, utilities do not need to invest in expensive, multi-year system replacements (e.g. ERP modernization) to restore this lost value. Instead, planning teams should focus on connecting existing systems with an integrated platform that enables end-to-end dynamic capital planning (DCP).

At the most basic level, DCP platforms can streamline annual planning cycles, monthly reforecasting and financial governance processes. More comprehensive DCP platforms tackle planning challenges broadly, pulling in project management data elements (e.g., changes to scope/cost, in-service dates), regulatory commitments (e.g., rate case work-units, budgets, technical requirements), approval management and tracking (e.g., changes, offsets), and risk-based portfolio prioritization (e.g., “next best” project alternatives).
 

Where should companies start?

Choosing the right course of action to digitalize and implement DCP principles requires careful consideration of options, from investing in full-system overhauls (e.g., ERP) to deploying agile, low-code platforms. A series of steps will help planning stakeholders navigate a rigorous decision process that better frames the desired business outcomes and alternative paths to mature their dynamic planning capabilities:

1. Identify goals: Clearly define the organization’s current positioning vis-à-vis capital predictability and establish reasonable improvement targets through benchmarking and peer practice-sharing.
2. Create a shared sense of urgency: Understand the current state of planning processes, governance and supporting technology. Frame the opportunity in terms each planning stakeholder will appreciate personally. Establish shared responsibility for the changes in behavior that will help the organization hit financial targets.
3. Anticipate growth: When evaluating digital solutions, consider portfolio scalability and organization flexibility that would be required to accommodate step-change growth (e.g., acquisitions/divestitures), changing regulatory requirements and more advanced DCP features. Choose a digital solution that can scale with the business, adapt to evolving portfolio requirements and minimize system replacements or structural overhauls.

Finally, when evaluating alternatives, keep in mind that not every organization is in a financial position to fund major system replacements or platform overhauls. Asynchronous regulatory processes often limit the ability of an IOU to get multi-jurisdiction approval for large shared investments, or the time required to secure those approvals is untenable. For businesses working within complex organizational structures, low-code platforms can often benefit finance and planning teams through reduced total investment (versus system replacements) and time to active deployment (six to 12 months). In most cases, building low-code platforms through an agile development process can quickly benefit these businesses, providing more timely visibility into unfavorable capital variances while also enabling greater traceability of changes for regulators and shareholders (Figure 3).
 

As operating companies and business predictability scale, there should be a larger emphasis on agile, low-code solutions and analytics.

To fully realize the value available through dynamic capital planning, utility organizations must take an agile approach that addresses business strategy and data requirements holistically—from quantifying opportunity ranges to assessing functional requirements and technical alternatives to mapping out changes required in the planning model, teaming and collaboration processes.

As a modern digital transformation partner, Publicis Sapient helps leading utility organizations become digitally enabled so that they can thrive in the future.