Utilities: Inventory-Driven Customer Affordability
May 31, 2021
When we talk to our U.S. utilities clients, the conversation often turns to customer affordability. Utility leaders know the economic pressures facing so many customers, particularly over the last year. Meanwhile, regulators remain equally focused on fair and transparent ratemaking.
The spotlight is firmly on utility leaders to ask themselves: are they doing everything they can to improve customer affordability? To be able to say yes, they must balance the books to stabilize pricing, while managing investments and costs.
Let’s start with the basics. At the simplest level, utilities earn money by investing in capital, with key metrics Return on Equity (ROE) and Capital Ratio. For example, let’s consider a utility with a ROE of 10% and a debt-to-capital ratio of 50/50. If the utility chooses to invest in a $1bn plant, the utility must put $500m of equity toward the investment. The utility will then earn 10% ROE on the $500m million it invested, in this case $50m.
So why not continually invest in new assets? Here’s why: the utility has to raise rates to cover the cost of the initial equity (in our example $500m) with every new investment. And if rates get raised continuously, customers and regulators will both be unhappy. So what else can utilities do to balance the books?
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Look to optimize Operations & Maintenance (O&M) expenses
O&M costs are related to the maintenance of the assets the utility has invested in, and other costs incurred that are considered a service.
So why is O&M relevant here? The answer is: utilities can “find” more money by cutting O&M dollars, repurposing these funds into new investments.
In fact, O&M cuts are a major value driver for utilities. Our analysis finds the rule of thumb is generally $1 to $8—for every O&M dollar cut, utilities can spend $8 of capital. By reducing O&M dollars, utilities can create headroom for capital investment while keeping customer rates steady and simultaneously driving earnings (remember the $50m).
Additionally, by reducing working capital (i.e., reducing stocked items, effectively managing inventory), utilities prove to regulators that they are deploying capital as a company efficiently.
But how do you do that in practice? Step one should be to establish a good, clean, item master. This enables downstream benefits such as: real-time visibility into on-hand inventory, the ability to implement advanced inventory and order fulfillment, cleaner source-to-settle (S2S) processes, and limited stock outs.
S2S value levers
Within the source-to-settle process, a number of different levers can be used to drive down utilities’ costs.
For instance, many utilities leverage automation to generate purchase orders or requisitions without the need for human interaction. Within finance, the automatic payment of invoices which meet matching criteria is another area for potential improvement.
However, an area that is often overlooked is the maintenance of utilities’ inventory.
Why? Inventory management is typically thought of as a supply chain function. It is the flow of goods from the manufacturers or vendors to the warehouse where the goods are classified, stored, and allocated out to projects. Utilities are not manufacturing goods for sale from what they have in inventory; utilities are using their stored items to build or maintain their assets.
Consequently, lowering the cost of inventory will not lead to a lower cost of goods sold or “typical” measurable benefits.
Sidebar: Utilities’ unique inventory scenario
It’s worth remembering, utilities have higher inventory levels than some other industries because of the pressure to keep the lights on—literally. If a power plant goes down due to a missing part with a long lead time, there could be a major issue with keeping the plant running. Because of this, the same lean warehousing strategies that other industries use don't necessarily apply to utilities.
The distinction between types of items in stock differs by utility, but is generally something like this:
- Critical Spares, Stocked Items – Working Capital
- Capital Spares – Capitalized
- Consumables (gloves, screws, miscellaneous small tools) – O&M
The points of interest around storeroom management and spares treatment are usually regulatory and cash flow related. This can differ on a state-by-state basis, but capital spares are added to rate base in some states. So, the utility is earning a return on these items that are in stock. Then why would they be interested in cutting stocking levels?
Two reasons spring to mind.
#1 There is usually a specific dollar amount or ratio that the Public Utility Commission (PUC) allows towards capital spares, which is periodically audited. If the PUC audit shows that the utility propped up their capital spare dollars too much, then those monies that were previously allowed can be completely disallowed by the commission, creating a loss for the utility. Therefore, careful management is needed to stay in the allowable band of dollars.
#2 Investing too much money in inventory creates a cash flow problem. Utilities run toward book earnings, and don’t necessarily have the same cash flow concerns that other companies have. Capitalizing assets makes their earnings look better. However, if they are spending too much on spares or inventory that is just sitting in the warehouse, this can degrade cash flow.
The bottom line for customers
If utilities take the finance bull by the horns, they can genuinely use these levers to drive up customer affordability, while shoring up investments for long-term infrastructure and growth.
And they can genuinely say they’re putting fair pricing at the top of the agenda, now more than ever. Contact us to find out more about how.
