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EC HARRIS | GETTING READY FOR AMP6: THE OPEX CHALLENGE

GETTING READY FOR AMP6: THE OPEX CHALLENGE Capex Opex efficiency challenge Operational efficiency Reductions Outcomes Outperforming Ofwat Ofgem Value levers Output based OPA SIM CIS AMA Customer focused Asset management planning Utility operating model Effective planning Plant and network operations Inspection and maintenance Productivity Operational risk and control DLO performance Energy and carbon efficiency Data quality and knowledge Organisational efficiency and logistics Price review PR09 PR14 Totex RIIO Service quality Operating model ÂŁ in ground Target unit cost Benchmarking Baseline Frontier performance Key drivers Cost control Root causes ÂŁ5m saving over 25 years Bottom line Upper and lower quartile performance Lessons from Oil & Gas Planned and reactive maintenance Improved visibility Supply chains Regulatory measures Capital investment No silver bullet Confidence organisations Capex Opex efficiency challenge Operational efficiency Re ctions Key drivers Outcomes Outperforming Ofwat Ofgem Value levers Output based OPA SIM CIS AMA Customer focused Asset management planning Utility operating model Effective planning Plant and network operations Inspection and maintenance Productivity Operational risk and control DLO performance Energy and carbon efficiency Data quality and knowledge Organisational efficiency and logistics Price review PR09 PR14


EC HARRIS | GETTING READY FOR AMP6: THE OPEX CHALLENGE

Shift in focus towards opex to deliver financial return and improved customer service Since privatisation, the UK water industry has invested more than £90 billion to help replace and upgrade a largely antiquated asset base that in some cases, dated back to the Victorian period. As a result of this capital investment programme, the quality and quantity of the asset base has significantly improved, delivering considerable benefits to the customer. Having successfully tackled this challenge, the industry is now shifting its focus towards operating, maintaining and managing these assets, and ensuring that inefficiencies are minimised during such activities.

A study of operational costs for waste water treatment works in the UK shows that top performing sites can be nearly 50% more efficient than their counterparts.

This shift towards operational asset management has seen opex spend increase through successive AMP periods, and indeed in the current AMP5 period, outlay is estimated to be around £19 billion compared to a capex spend of £24 billion. With early projections suggesting this figure will increase during the AMP6 cycle, it comes as little surprise that water companies are increasingly exploring how they can minimise costs and remove any wasteful processes. Such improvements will be critical to sustaining customer service performance, protecting customer bills and fully realising the benefits of the previous capital investment. Traditionally however, opex has been a weak point for the industry particularly when it comes to efficiency initiatives. There are two primary reasons for this - firstly, the benefit opportunity for capex initiatives has been greater because the level of capex spend has been much higher, and secondly, the level of benchmarked cost and performance data for opex is far below the quality that has typically been available in the capex arena. For utilities, the challenge now lies in identifying how they can go about making these improvements without adversely impacting the level of service they provide to their customer base. With new regulatory rules already shifting performance measurement from an output based mechanism in OPA to a more customer-focused mechanism in SIM, water companies will have to clearly demonstrate that any changes they make to their business model deliver additional benefits to the end customer.

What do we mean by opex and what are the key issues to consider? The term ‘opex’ covers a broad landscape within a utility including the physical operational control of the network, pumping stations and treatment plants. In turn, this creates an inspection and maintenance regime, which in some cases creates a requirement for capital maintenance or a larger scale intervention to deliver the asset serviceability required. Reactive maintenance and response to incidents or faults is also a key work area. Each of these attracts ‘direct’ costs of labour, plant and materials, all of which can be assigned for each activity. Energy, chemical dosing and consumable materials costs can also be measured. However, there are also significant costs associated with the enabling systems and functions. Examples include the telemetry and remote control systems to operate the plant, the customer call

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handling systems and processes to deal with faults or customer requests, and the scheduling and dispatch tools used to manage field crews and operatives. In turn, the resources and business processes required to support these activities can also be significant.¹ Figure 1 below outlines the EC Harris reference utility operating model which illustrates how high-level functions fit together across a regulated utility. There are many key interfaces at both a functional and process level, all of which ultimately have an impact on cost, performance and risk. In our experience, the root causes of operational cost, performance and risk are similar to the key drivers for capital programmes. As such, the principles and disciplines applied to capex schemes are equally applicable to opex programmes. Effective planning is very often the key enabler as it should

provide visibility of work volumes, cost profiles and target outcomes. For opex related activities (e.g. inspection and maintenance), this is typically low unit cost but high volume and should be driving the plan. As in capex, the ability to execute this plan efficiently is dependent on accurate data, logistics support, effective processes, an aligned supply chain and a focus on efficiency as well as outcomes.

Identifying the size of the challenge Capital efficiency data, in terms of ‘£ in the ground’², has shown a 30% differential between upper quartile and lower quartile performance. However in the opex arena, this variance is significantly greater. A study of operational costs for waste water treatment works in the UK supports this as it shows that top performing sites can be nearly 50% more efficient than their counterparts.

Figure 1 - EC Harris reference utility operating model - which components influence opex efficiency? Work Delivery

Asset Management Planning

Operations

Connections delivery Business plan and regulatory strategy

Asset Management strategy and planning

Investment planning and allocation

Work design and delivery planning

Capital delivery Inspection and maintenance delivery

Plant and Network Operations

Emergency response / Fault repair

Support Services Customer contact

Metering

IT

SHEQ

Customer billing

Finance

Procurement

HR

As an example, the outputs from some recent individual studies revealed startling inefficiencies in maintenance: Up to 90% of maintenance activity was reactive, not planned ■

On occasions, as little as 10% of planned work was carried out ■

75% of all maintenance activities at one treatment works were solely on one process stream; one third of which was on a singular component ■

Unplanned maintenance activities equated to 33% of down time losses ■

Unplanned maintenance is 50% more expensive than planned maintenance ■

Whilst there are clearly performance issues to tackle, there is also a significant challenge to overcome around data quality and knowledge. There are two fundamental issues - firstly, ¹ Our analysis does not include pension or business rate costs, as defined by Ofwat’s PR09 final determination ² ‘£ in the ground’ is a benchmark used to assess on-costs and capital efficiency

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EC HARRIS | GETTING READY FOR AMP6: THE OPEX CHALLENGE

Utility functions

Capex focus 1. Asset Management

Opex focus 1. Customer service

Delivery

2. Procurement

2. Inspection and maintenance

3. Delivery efficiency

3. Productivity

4. Cost efficiency

Planning

Operations

4. Operational risk and control

5. Supplier performance

5. DLO performance

6. Risk

6. Energy and carbon efficiency

7. Organisational efficiency

7. Operational efficiency and logistics

8. Data improvement

8. Data improvement Emergency / Repair Figure 2 - What are the key focus areas for capex and opex delivery?

there is simply not enough data available especially when compared with capex where greater emphasis has always been placed on data collection to help inform final determinations. Secondly, when it comes to the data sets that do exist, close analysis raises serious question marks over its quality and the structure in which it’s presented. Indeed in some cases there is up to a 300% variance on unit cost for operations between upper and lower quartile performance. Consequently, a change in attitude and focus is urgently needed around the collection, management and utilisation of data, with a greater understanding ultimately required around what costs are, where they are incurred and why they are incurred. Until robust data is available in a structured format, it will be difficult to facilitate accurate benchmarking and identify where improvements can be made. On a separate but related issue we have found that in other sectors, cost savings and efficiencies can be further enabled by adopting more effective whole life asset management decision making. For these benefits to be realised, the organisation needs effective end-to-end processes, with appropriate capabilities and incentives at each stage of the journey. Leading infrastructure organisations in other sectors combine capability and process benchmarks with cost benchmarks, to enable root causes of inefficiency to be identified and more easily rectified.

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Satisfying customers and the direct impact on future price reviews When it comes to addressing the opex challenge, water companies need to be smart around cost reduction to ensure that service quality is not compromised. The new Service Incentive Mechanism (SIM) is more customer focused rather than simply output focused, and puts a different emphasis on the whole aspect of value, risk and cost benefit analysis in terms of capex and opex decisions. It is also likely that PR14 will include lessons learned from Ofgem’s approach to Totex, and the RIIO (Revenue = Innovation + Incentives + Outputs) framework for gas and electric utilities. RIIO calls for even greater understanding of how inputs will link to asset performance and customer satisfaction over a long-term horizon. The roll out of smart metering and smart grids will bring the customer ever closer to all utilities, with customer expectation on service and value for money likely to rise. If we look back at where companies have traditionally reduced operational costs, the main focus tends to be around headcount reduction and consumption (prices paid for chemicals and power). Whilst important, these alone will not be sufficient to enable water companies to leap frog up the efficiency table as every other company is looking at the same thing. Instead,


1. Effective operating model - processes and functional interfaces within the business need to be aligned with ‘single point accountability’ allocated for asset decisions. Clarity is required around Asset Management and Operations interfaces and the expectations for specific roles and responsibilities. For example, who is accountable for operational risk particularly if the asset requires replacement? Equally, who is accountable for asset data quality? A similar approach should also be considered for the DLO, contractors and service providers.

companies need to look at the bigger picture and develop a clearer understanding of inputs, outputs and drivers for performance, as shown in Figure 3 below. Outputs are lagging measures, and show the result of the overall business operation in terms of SIM results, CIS assessment and ‘£ in the ground’ efficiency. The effectiveness of the operating model enables operators to see results but this is dependent on the quality of the inputs which drive the business operations. These inputs should be measured by leading indicators including clarity of customer needs, asset needs and an appreciation of where there are Asset Management strengths and weaknesses (AMA score).

2. Effective planning - total visibility is needed on the maintenance plan and efficient mechanisms need to be in place to control reactive work. This should encompass an effective logistics function for scheduling jobs, dispatch and control of inventory and spares.

Achieving frontier performance Having turned their focus towards the opex challenge, the critical question many water companies are now considering is what actually drives best-in-class operational performance? In our experience, achieving frontier performance requires a focus on five key components:

3. Productivity - in this case the focus should be on maximising the amount of productive work completed per shift. This should also consider how work is allocated to field crews and the role of the site supervisor or depot manager in helping to drive improved performance by working closely with the work scheduling team to maximise the volume of jobs that can be completed in a single shift.

EC Harris Reference Utility Operating Model INPUT measures ■

OUTPUT measures

Customer needs Work Delivery

Asset Management Planning

Asset management needs

AMA scores

Effective organisation and sourcing model

Data quality

Target unit costs

Target benchmarks

Connections delivery Business plan and regulatory strategy

Asset Management strategy and planning

Investment planning and allocation

Work design and delivery planning

Capital delivery Inspection and maintenance delivery

SIM

CIS

Relative efficiency

% planned / unplanned work

Unit costs

£ in the ground

Process duration efficiency

Operations

Plant and Network Operations

Emergency response / Fault repair

Support Services Customer contact Customer billing

Metering

Finance

IT

Procurement

SHEQ

HR

1. End-to-end alignment and clarity of operating model

Key drivers for ‘frontier’ opex performance

2. Effective planning and scheduling for planned and reactive work 3. Productivity - ensuring effective utilisation of DLO and contractor terms 4. Cost control - understanding and controlling direct and indirect operational costs 5. Benchmarking - frontier targets for capability, process and cost

Figure 3 - Enablers to achieving “frontier” performance are similar for capex and opex

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EC HARRIS | GETTING READY FOR AMP6: THE OPEX CHALLENGE

4. Cost control - all direct and indirect opex costs, at unit cost and cost base level need to be effectively managed. This should include the creation of accurate estimates for labour and materials for routine inspection and maintenance activities and a regular assessment of estimate versus actual cost per work type. 5. Benchmarking - it is crucial that ‘should cost’ and ‘should take’ benchmarks are set for key tasks and activities. The ‘should cost’ estimate needs to include both unit costs and a provision for indirect cost categories considered collectively in terms of what a work function ‘should cost’ to deliver. The ‘should take’ benchmarks consider process and work activity durations, which in turn should drive the overall cost and efficiency expectation for a work function such as planned maintenance activities. An operating model review also needs to examine more fundamental questions such as, for a District Meter Area (DMA), who decides on whether the service reservoir stock should be maintained or if a better solution would be to build a new and larger reservoir? Equally, clarity needs to be established around which responsibilities lie with the Asset Management team and the Work Design team e.g. who makes the decision on mains flushing rather than re-lining or replacement, or who identifies and implements the decision to fit extra screens on wastewater treatment works to prevent UV bulbs breaking? In our experience, a review of the business operating model combined with benchmarking of current performance, capability and unit costs is critical to enable a baseline to be established. Once this is in place companies have a clearer picture on what ‘good’ looks like and can begin to define and implement specific improvement initiatives to drive further value in the key areas that impact on overall operational performance.

Case study - a waste water programme We have recently implemented an operational efficiency improvement programme for a large WASC for its wastewater treatment works. In this example, we firstly established a baseline of cost and operational performance for both works and then identified focus areas for improvement across maintenance, logistics, energy and materials and indirect costs, using the reference operating model outlined in Figure 1 (p.3). The root causes of inefficiency were addressed through a number of initiatives. At a strategic level, these included maintenance specifications and standards, and associated operational procedures and behaviours. Additional improvements were also made at a tactical and more pragmatic level such as ensuring skips were only emptied when full, that polymer usage was measured, and that mess rooms and welfare facilities were fit for purpose to minimise downtime. The results yielded substantial benefits for the two treatment works as shown in Figure 4 below: Efficiency initiatives

AMP5 net saving (£k)

Dissolved oxygen Dry solids into digester

£174 £54

Increase drum thickeners throughput Maintenance optimisation Polymer optimisation Replace gas tank Replace karcher Screens to UV banks Single tool compressor Skip lift optimisation

£137 £269 £43 £180 £6 £86 £3 £40

Total

£992

Graph shows potential payback of operational efficiency roll out at two Waste Water Treatment Works using 5% NPV

£5.03 £4.46 £3.73

£2.79

£1.57 £0.99

AMP5 Remainder

5 Year

10 Year

15 Year

20 Year

25 Year

Figure 4 - Savings delivered on opex efficiency initiative for a large WASC in £ m

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Lessons from other sectors?

The time is now…

As the sector begins to examine how it can deliver a more consistent level of performance it should consider lessons from other sectors especially those where a commercially competitive product is the output. In these cases, any reductions in the cost base and improvements in operational efficiency deliver a very tangible benefit that will inevitably resonate with the C-suite.

As the industry approaches the half-way point in the current AMP5 period, how many water companies could confidently say they have made significant inroads towards addressing the operational performance challenge set out in 2009? As the industry shifts its focus from capex to opex efficiency, we are seeing utilities making an aggressive move to improve performance, and get ready for AMP6.

One example is from the oil and gas sector which is particularly strong in driving man-hour efficiency, data capture and adopting a more strategic approach to planning operational expenditure. In this sector, for each £1 that’s spent on maintenance activities, 80p is on planned work and 20p on reactive work. In the water sector the situation is reversed with reactive spend typically accounting for at least 80% of the overall outlay and planned maintenance just 20% in the best case scenarios. This is an important difference because having better visibility over where investment is required enables supply chains to be more organised and operating models to run more effectively as volume, nature of work and timing is more clearly defined ahead of schedule.

With analysts predicting that inflation rates will increase over the next 12 months, higher opex costs will inevitably follow. As the cost of doing business increases, water companies will need to find this additional savings from somewhere. Furthermore, with PR14 rising closer on the horizon and OFWAT moving to a straight final determination on investment plans, the window of opportunity to address any existing operational inefficiencies continues to shrink even further. In reality it’s not a total surprise that some companies have been slower to react to this issue as addressing the opex challenge represents unchartered territory for the industry. Fortunately, there are some disciplines and approaches that can be transitioned from the capex space, none more important than the need to establish an initial baseline position for capability and cost performance. Conducting an initial review will enable firms to use best-in-class benchmarking data to create an opex efficiency roadmap that outlines how they can reach upper quartile performance. Whilst there is no silver bullet that will help them achieve a 15-20% step change, by examining several key areas including their operating model, their approach to planning, and issues including productivity, cost control and benchmarking, water companies can begin to identify how and where these improvements can be made over time. If the industry can get this right, the prize on offer is all too evident as operational asset management costs will become a major driver for utility profitability and customer bills. Furthermore, by removing operational inefficiencies, water companies will enter the new price review period as leaner organisations that deliver significant benefits to their customer base, all of which will help to build confidence with the regulator, resulting in a more positive PR14 experience for all.

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EC HARRIS | GETTING READY FOR AMP6: THE OPEX CHALLENGE

About the authors Terry Povall Partner, Head of Water e terry.povall@echarris.com Terry has over 35 years of experience in the utility sector, encompassing all commercial and contractual aspects of the planning and delivery of major capex and opex investment programmes. He combines his expertise in capital investment strategies with first hand knowledge of the regulatory process, developed through several regulatory reviews, to provide business improvement solutions to clients in meeting their performance challenge.

Greg Bradley Partner, Utilities Sector e greg.bradley@echarris.com Greg is one of the UK’s leading industry experts in utilities asset management. He leads Asset Management Strategy and Transformation for the firm’s utilities and transport clients globally, where he is responsible for developing solutions that enable clients to improve business performance and outperform regulatory and corporate targets.

To download your own copy of this publication visit: www.echarris.com/water


Responding to AMP5