From the early 1970s to the mid-2000s, demand for electric power and natural gas in North America outpaced the growth in invested capital. Regulated gas and electric utilities were therefore stable and profitable. They earned reliable returns and were also able to keep customer rates down, satisfying both customers and regulators. These positive conditions, however, also meant that utilities didn’t need to be as efficient with their capital as other capital-intensive industries, such as metals, mining or oil and gas.
Now things are different. Since 2008, there has been no electric load growth in North America. Thirty-three states and several Canadian provinces have actually registered declines, thanks largely to greater efficiency and lower industrial demand. For gas utilities, higher efficiency in home heating and insulation has contributed to stagnating demand. Nevertheless, utilities still need capital, to upgrade aging infrastructure and to make investments in flexibility, resiliency, and functionality. According to Global Market Intelligence, capital expenditures for major North American electric and gas utilities have risen 7 percent a year over the past five years, with transmission and distribution (T&D) accounting for about 60 percent of the total.
At the same time, regulators are pushing back against rate increases. In 2018, they approved only 38 percent of such requests, compared with 52 percent over the previous nine years. Regulators in North Carolina, Virginia, Kentucky, and Massachusetts, for example, rejected requests for rate increases to fund utility grid modernization. There is a growing gap, then, between the amount of money needed to maintain and upgrade North American grids, and what regulators are allowing utilities to charge to raise that investment.
Given these constraints, utilities need to use their capital more productively. They do have options. Among them: aligning capital plans to strategic priorities; focusing on the minimum technical solution; applying lean-construction techniques; and using advanced analytics to make asset-management decisions.
In this article, we discuss each of these options, and suggest questions leaders can ask themselves to determine whether they are using their capital as productively as possible.
Aligning capital plans to strategic priorities: Utilities need a rigorous capital planning and risk-assessment process. This starts with developing a common understanding and quantification of the most important risks. In practice, different asset classes and planning groups often have different views of what matters most; as a result, utilities’ capital plans often miss the mark. Done right—that is, by focusing on the biggest risks and rethinking where dollars are spent—we estimate that utilities can deploy their capital as much as 20 percent more efficiently.
One gas utility achieved this level of impact after doing a thorough evaluation of the roughly $3 billion in capital projects planned for the next three years. The utility created a consistent record of the rationale and scope for each project; this understanding enabled it to figure out which projects mattered most and to spend accordingly.
The types of investments utilities need to make are changing. For example, as more investments are made in supervisory control and data acquisition, automation, analytics, and grid modernization, information technology (IT) needs to support these efforts. Under typical capital-planning approaches, however, IT investments are often left to the end, and then get squeezed for funding. Implementing a planning process that shows regulators the trade-offs between core power systems and supporting infrastructure is an important first step to establish which projects utilities should pursue, in what order.
Questions to ask:
- How do you incorporate new and supporting investments into your capital-planning process?
- Are you assessing the projects in your capital plan in a consistent and rigorous way?
- How has spending evolved over the last five years in different asset classes, such as poles, transformers, IT, and analytics?
- Do your decisions on capital spending fit your overall business strategy?
Focusing on the minimum technical solution: It is relatively easy to re-think the business case, design, and scope of a project in the early stages. One way is the “scrub.” This is a process in which a cross-functional group of experts ask structured questions and scrutinize the project’s scope and design to identify ways to develop it more cost effectively.
Project scrubs are common in unregulated, capital-intensive businesses that are seeking the “minimum technical solution”—meaning the lowest-cost design that meets current and likely future objectives. The context is somewhat different for utilities, because they have a wider set of stakeholders, including regional transmission organizations, regulators, customers, and municipalities, with varying priorities. Finding the minimum technical solution provides a way to assess whether project add-ons, such as upgrading substation breaker designs or replacing equipment not yet at end of life, are worthwhile. At one utility, a series of project scrubs before design and construction identified 15 percent savings on $400 million of annual spending on large, complex projects in the transmission organization. The effort also identified more than $50 million in large projects that were no longer needed.
Applying lean-construction techniques to capital projects can deliver planned work for less, and additional work within the same budget. Lean-construction techniques have a proven track record in other industries, as well as in utility operations and maintenance (O&M), but they have not been widely deployed in utility capital projects. One reason is that once regulators approve a project budget, the utility has little incentive to cut costs. Another is that utilities make greater use of outside contractors, rather than in-house crews. Lean techniques for field execution, such as daily huddles (Exhibit 1), and tracking and monitoring unit productivity, should be standard practices, but are not.
Lean techniques should also be applied earlier in the project planning process. “Pull planning” is one example (Exhibit 2). In this process, a cross-functional team starts with the commissioning date of a project and identifies the critical dependencies, such as permitting, rights of way, and design. Then it establishes milestones against each critical component, with clear accountability. In one transmission organization, the pull-planning team found in its first week of work that 40 percent of projects were either not on track or the utility didn’t know if they were. By week four, that was down to less than 10 percent.
Ideally, lean-construction techniques should be incorporated in parallel with the capital-planning process. By using a combination of lean techniques, we estimate that utilities can cut costs 10 percent to 15 percent.
Questions to ask:
- Do you have a formal process to assess project plans against the minimum technical solution?
- Once a project business case has been set, how are scope additions justified and approved?
- How is project accountability assigned?
- Do your crews or contractors know how productive they were on any given day?
Of projects to be put in service in the next 10 weeks, do you know how many are on target?
Using advanced analytics to make asset-management decisions: Making sound maintenance, renewal, and replacement decisions conserves capital and lowers the total cost of ownership. Better decisions start with the collection and analysis of data, and this is easier than ever, through the use of monitoring software, automated sensors, drones, satellites, and the improved analytical capabilities available in the market.
One utility improved the use of its data to inform asset-management decisions, leading to almost 10 percent savings in O&M and capital spending. For example, the utility analyzed the maintenance records of the breakers that were scheduled to be replaced in the following year. It found that 40 percent had never needed any attention; for these, preventive maintenance was the right choice. On the other hand, three percent of the breakers had incurred significant maintenance costs; for these, quick replacement was the better option. Though the decisions were different, in both cases, the utility optimized its spending. In general, we estimate better asset management decisions can save about 10 percent—and more if digital tools and data analytics are fully incorporated.
Questions to ask:
- What data do you use for maintenance capital expenditure decisions?
- How do you decide whether to maintain, repair, or replace an asset?
- How has asset management decision-making evolved over the last two years, taking into account developments in technology and data?
Improving capital productivity can seem daunting, particularly since many utilities have not had to make this a priority. However, many of these options can be implemented independently and even small changes can yield significant improvements. With affordability pressures increasing and the need for investment growing, utilities have to accept that using their capital better is a matter of urgency.
Adam Barth is a partner in McKinsey’s Houston office. Sarah Brody is a consultant in Washington, DC. Zak Cutler is a partner in Toronto. Corey Hopper is an engagement manager in New York City.