Significance of O&M in Infrastructure

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Installation of new infrastructure assets creates streams of services and improvements to existing services for users. Benefits accrue to these uses as well as a wider set of stakeholders. Maintaining the service potential is a critical element in ensuring that value for money is achieved from the initial capital investment.

However, many governments and asset managers are under significant pressure to trim maintenance budgets and scrimp on operating costs. In some contexts, this emerges as an extreme build-neglect-build scenario. Many Pacific Island nations experience this, as do a number of smaller Australian local government authorities. The full lifecycle cost of infrastructure assets is not factored into the budget planning processes of these organisations. Similarly, many private sector operators of infrastructure have commercial and financial incentives to focus on next quarter financial performance rather than long-term service provision from these assets.

The back end of infrastructure is seen as much less interesting, but it is where all the benefits are generated. So approaches to operating and maintaining these infrastructure assets is as equally critical as the planning and investment decisions to deliver them.

Two broad maintenance strategies are predictive maintenance and condition based maintenance. Predictive maintenance is like regular scheduled servicing based on the design performance of an infrastructure asset. It is less costly to implement but also less likely to match the actual performance of the asset. Condition based maintenance requires the collection of data and information about the actual performance of the asset and provision of a tailored asset maintenance response.

The approaches set up an economic challenge. Should an infrastructure manager simply maintain its assets according to schedule and only collect data and information on condition at the times of regularly scheduled servicing? Or should some initial data costs be incurred to change and adapt design-based, predictive maintenance? Decisions to underfund reasonable maintenance activities need to be made with good information and in an appropriate strategic context.

So it depends. In one sector, for example, the response is clear but not clear-cut. Analysis of wind turbine maintenance to address gearbox, generator and blade failure scenarios shows that for small wind turbines, predictive maintenance is more cost effective than condition based maintenance. Condition based strategies were based on an array of sensor data (optical, oil, vibration and temperature). However, for larger turbines, condition based maintenance where there is a high expected gearbox failure rate is a much better approach. In that instance, the cost of collecting additional data and information enables timelier and more appropriate servicing of the turbines.

For these reasons, infrastructure owners and managers need to ensure there are effective asset management and maintenance policies included in their strategic asset management frameworks. It is not enough to supply the assets, as only the services from them will be able to generate the full suite of expected benefits. This can only be achieved when the design potential of these assets is realised over time.

Performance of Australian Aid

campaign for australian aid logo
Devex recently identified six key takeaways from the 2015-16 review of Australian Aid, which I have been looking at:
1. The hardest target (gender) is the weakest link
2. Programs targeting agriculture, fisheries and water need more support (only 8% of overall budget)
3. Partnerships with disabled peoples’ organisations are wanted
4. Innovation has not been widely adopted in the aid program despite a facility to do this
5. The World Health Organisation continues to underperform according to donors
6. Strong performance and high funding are not necessarily linked (PNG was an example)
A summary of the review is available at:
The review was released in the week before the Federal Budget and the full report is on the DFAT website:

Household Debt and House Prices

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Lytton Advisory was at the Economic Society 2017 Business Lunch in Brisbane yesterday. RBA Governor, Philip Lowe, gave a very lucid presentation on Australian household debt and house prices.

Over 25% of mortgagees have a buffer of three or more years on their home loans.  The top two household quintiles by income are carrying the largest debt burdens.

Recent regulatory changes imposed on banks by the Australian Prudential Regulatory Authority will tighten up lending to property investors.  This may create some short-term breathing room to address fundamental supply-demand imbalances in some of the Australian property markets. It may also take a bit of the speculative heat out of the Sydney and Melbourne property markets.

The RBA Governor touched on a number of other issues as well.  Details can be found at:

http://www.rba.gov.au/speeches/2017/sp-gov-2017-05-04.html

Infrastructure Asset Transactions

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Economic infrastructure provides fundamental services to economies. Typically, this type of infrastructure provides electricity, water and gas to industry, businesses and large institutions, community organisations and households. It also assists in providing transport, freight and logistics services.  In the information age, access to low-cost, high-speed broadband facilitates a range of e-services.

The quality, cost, and access to these services affect the productivity of an economy, the efficiency with which goods and services are both produced and consumed, and the equity between different sections of society.

The physical aspects that underpin these services have a range of characteristics that separate these services from everyday goods and services delivered through competitive markets. Service provision can be characterized by a large, up-front capital investment. Installation of an asset can create a local demand response and establish a natural monopoly. Economic arguments for duplication of the asset to stimulate competition are usually weak.

Also, there is usually a long-term stream of benefits that are generally small relative to the capital investment. In some cases, user benefits alone are insufficient to justify the construction and operation of economic infrastructure. Wider benefits can accrue to society, and some societal costs can be avoided.

These assets contain a high level of optionality. Unlike purchasing a retail good, it is possible to develop the asset in phases or stages, with options to scale up or down or abandon operations. In other cases, once the decision to build has been made and construction started, it is tough to change the project scale or scope.

These factors contribute to determining how these assets can be funded as well as who should potentially own and control them.

The classic argument for government provision of infrastructure assets, and consequently related services, concerns market failure. That is, the operation of the private market leads to under or over provision of services from these assets. As a result, mismatch of supply and demand reduces economic value in the economy. In the case of under provision, supply is constrained and the level of inputs is less than required to meet the demand. As infrastructure services are critical inputs into other sectors of the economy, economic efficiency is impeded. The productive potential of the economy is not fully realized and potential economic growth is stymied.

Where there are significant externalities, these are not captured in the price mechanism, where price signals between buyers and sellers determine the optimal level of production and consumption.

This affects the funding and revenue models for infrastructure assets. Consequently, asset transactions can become very complicated.

Where benefits largely accrue to users, and use of infrastructure services can be individually identified, it is possible to develop cost reflective charging regimes. The funding model, without recourse to other sources than user charges, is only limited by extant economic regulation where this is imposed on assets with strong monopolistic characteristics. This river of user revenue forms the basis of the transaction value, and also the initial assessment of feasibility.

It is not without significant risk because of the long period evaluation, accompanied by the risk around maintaining fixed parameter assumptions over that timeframe. Construction cost blow outs, poor demand forecasts, changes in consumer preferences, shifts in relative related prices for products and services that are substitutes or complements can all combine to turn a positive investment into a financial fiasco.

This is before considering the situations where direct asset-related revenue streams cannot support the creation and operation of economic infrastructure.

An infrastructure asset that cannot be funded from its future stream of user revenues requires additional funding contributions. The private sector will not fund infrastructure without a financial return. It is important to distinguish from an economic return.

Economic infrastructure may produce a return to an economy but will not be provided by the private sector if the private sector cannot get a return on its investment. In other words, the return to the economy is contrasted with the return to the balance sheet of a private investor.

Given the extraordinary imbalance in costs and benefits in any particular period over the life of an infrastructure asset, some form of financial intermediation is necessary. It is important to see this as a financial service rather than a private sector investment. This ensures that the cash flows needed to build, operate and maintain the economic infrastructure asset are provided as and when they are required.

Similarly, change of economic control of an infrastructure asset occurs at a specific point in time – a transaction date. The control is exchanged for a specific valuation of the asset.

As an example, early stage infrastructure development is heavily exposed to construction risk and unproven demand. In contrasts, mid-life infrastructure assets have mature demand profiles and risks associated with construction are better known. Late life assets face potential increases in maintenance and rehabilitation costs, as well as changes in user demand and the impact of technology.

Having a very clear perspective on the inherent economic and financial values of an economic infrastructure asset is very important. These valuations are combinations of knowledge at a point in time. It is where a very strong risk assessment is needed as well as an understanding of the relevance of that point in time.

Infrastructure Complexity

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Why does delivering infrastructure have to be so complex on so many different levels? It seems hard to correctly identify infrastructure, assess the need for services from those assets, discern which infrastructure to maintain, rehabilitate, replace or build new. Further, there are strong disagreements at the political level, between infrastructure agencies and, within infrastructure agencies, between different asset managers.

Complexity arises from the involvement of a broad array of participants in the provision of infrastructure assets, as well as the managers of the services provided from those assets.

It also arises from complex streams of benefits. In addition to benefits accruing to consumers of infrastructure services, there are often significant streams of benefits that are positive externalities. Wider benefits to society from improved health services, better access to education, cleaner water supplies, stable supply of electricity, and improvements to travel time and quality of the trip. A healthier workforce improves productivity. A more educated populace can generate higher disposable incomes. Purer water supplies enhance public health. Stable electricity supplies reduce business interruptions. Improved transport systems make labour markets function better and increase intra and inter city productivity. The benefits are multifaceted and often hard to quantify on cost-benefit analyses.

On the supply side, it is often too easy to overlook the range of solutions that are on offer. After a need has been identified, solutions could well include non-built options. This may involve active demand management, improving utilization and output of existing assets, repairing and rehabilitating existing infrastructure, changing the infrastructure asset operating environment to foster demand for alternatives.

The options analysis needs to be undertaken at the output/outcome level, rather than at the input/resource level. That is where actual economic value can be identified. To do otherwise creates the risk of estimating the cost of sub-optimal options.

Complexity also arises in terms of finding the financial resources to commission and operate infrastructure assets. Also, implementation through procurement and construction may have complexity.

Large, nationally significant infrastructure contains a lot of first pass risks. Getting the right scale and scope of infrastructure to match the most likely demand profile requires a lot of analysis.

Many infrastructure assets contain hiding optionality benefits. The ability to set the ultimate scale and scope, as well as the possible staging to achieve that is a significant real asset option. At the outset, a lot of choices can be made that close off options later on. Least cost solutions are not necessarily the best solutions where service quality between options can vary.

So what gets bought and how it gets built becomes critical.

Ultimately financial resources are committed. This is because small annual benefits are often realized over long periods. This is in contrast to large initial construction costs. Construction costs and some measure of operating expenses have to be funded. User charges do not always cover these costs. Finance addresses the imbalance of cash flows inherent in infrastructure. Ultimately, infrastructure must be paid for either by users or taxpayers. There is a significant range of public and private financing mechanisms. Financing choices are complex and can carry different risk profiles. This can affect asset valuation, as well as commercial risks around viability.

These are all significant touch points highlighting infrastructure complexity. They warrant detailed consideration and investigation in each infrastructure project.

Entrepreneurs

At the heart of economic progress are entrepreneurs. An entrepreneur is someone who starts up a business by creating a new product of service that someone else wants to buy.

Entrepreneurship involves high levels of creativity and innovation, and is not without considerable risk. Converting a great idea into a physical prototype or beta version of a service requires managerial skills, lots of time and lots of energy. It can also require a solid approach to patenting a product. Entrepreneurs have to interact with governments, potential investors and lenders, patent attorneys, as well as identifying, recruiting and driving high performing staff.

Joseph Schumpeter was amongst the first to conceptualise entrepreneurship. He drew a clear distinction between inventions and innovations, noting entrepreneurs not only invented but also included new means of production, new products and services as well as new forms of organisation.

Today we can see this in the business models of firms as different as Amazon, Google and Facebook. In the past, innovation in production led to mass production assembly lines, lean manufacturing, and, more recently, mass customisation of industrial and consumer products. Innovation in customer service is now increasingly blurring the boundaries between producer and consumer, as some information sevrices are crown sourced, and businesses operate platforms that simply facilitate social interaction on defined topics. The consumers develop and drive the content. Innovation in the service and knowledge economies is becoming increasingly important.

However, new ideas, methods and products/services are also accompanied by high levels of risk. So the rewards need to be significant. Not all innovators capture the rewards. Entrepreneurs have to address risk, ambiguity and uncertainty in order to be successful. They employ a wide range of strategies including: continuous improvement methods, application of technology; use of business analytics/intelligence; frugal/lean approaches; optimised talent management and development of leading edge/future oriented products and services.

Is the role of entrepreneurship critical to economic growth or does public policy in many countries overemphasis it at the extpense of improving the productivity and efficiency of existing industries? What do you think?

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This Micro Brief is part of an ongoing series provided as a general public information service.  These concepts underpin modern economic analysis.  Find out more about smarter capital investment decisions using economics at http://www.lyttonadvisory.com.au.