The year 2013 will be busy with project evaluation.  In California, the Bay Delta Conservation Program (“BDCP”) will roll out an economic cost/benefit study.  In Texas, the Legislature will engage in its biennial exercise of trying to fund the Texas Water Plan.  Any state funding plan must evaluate projects.  Local agencies and the private sector throughout the west are developing and accessing their next water investments.

In my more than three decades of experience, I have seen many project evaluations.  Many miss the mark.  Starting with this post and continuing every Friday through February 8^th, I share my views on issues that are sometimes handled properly, but often not or incompletely.

• Capital Investment
• Interest Rates
• Risk Premium/Risk Assessment
• Time Horizon
• Comparing project alternatives

The last post in this series assembles the proposed lists of Best Practices into a package for addressing the issues challenging project evaluation.  The hope is that this information will be useful to anyone interested in water projects.

What follows is a compilation of my own reflections.  What are yours?   I’m sure the WSC can collectively generate a better list than my own.

Common Practice for Estimating Capital Investment

A key part of project evaluation is determination of capital investment. The current practice is list the components of the project and then estimate the cost of each component.  This information forms an “Opinion of Probable Cost” (“OPC”).

A OPC is an excellent starting point.  Normally, that is the end of the inquiry.  This cost estimate will understate required project capital investment for two reasons: project timing and project capital structure.

Project Timing

A OPC answers the question: what would be the cost of building the project today.  As a practical matter, construction will not start today.  Project evaluation often occurs in early stages of project development.  Environmental review, engineering design, permitting, financing and construction lay ahead.  Especially for large projects, there are many years between the preparation of a OPC and when construction contracts executed and construction started.

Project timing would not be important if we lived in a world where the price of goods and services do not change over time.  This is not the case.  If capital investment costs simply reflected inflation (change in the general price level), the solution is simple: state the cost estimate in terms of dollars of the year of OPC preparation.  This, in fact, is standard practice.

Life is rarely simple.  Compare the annual increase in the Bureau of Reclamation Cost Indices (google “Bureau of Reclamation Construction Cost Indices”) and the Consumer Price Index since 2000.  The annual increase in BOR Cost Indices ranged from 3.6% to 3.9% for Concrete Dams, Diversion Dams, Pumping Plants, Steel Pipelines, Concrete Dams and Tunnels—the average was 3.7%.  In contrast, the Consumer Price Index increased by 2.6% (see figure below).  In other words, the BOR’s Construction Cost Indices have increased faster than inflation.

The figure below shows how Project Capital Investment based on a $1 billion OPC varies with the years between OPC preparation and construction.  The cost “OPC+inflation” is $1 billion increased by the historical rate of inflation (2.6%).  The cost “Project Cost” is $1 billion increased by the historical annual rate of increase of BOR Construction Cost Indices (3.7%).  If the project initiated construction four years after OPC preparation, the Project Cost would be about $150 million above the OPC and $50 million above the OPC adjusted by inflation.  If the project initiated construction a decade after the OPC preparation, the Project Cost would be $450 million above the OPC and $150 million above the OPC adjusted by inflation.

Proposed Best Practices.   Here are some ideas about what to do in practice:

• Have OPCs anticipate changes in project costs between the OPC’s preparation date and the start of construction.
• Examine recent trends in the cost of project components and assess whether these trends will continue or change and, if so, how.
• Present the OPC of future costs as a range to show uncertainty about the future and discuss the factors determining where future costs will fall within the range.
• Incorporate the range of the OPC of future costs into project risk assessment (see post, Project Evaluation III on January 18^th).
• Update the OPC and include in the due diligence package accompanying the project’s “go/no go” decision.

Project Capital Structure

A project’s capital requirements involve more than construction, design, permitting and so on.  For example, I assisted the Imperial Irrigation District acquire 42,000 acres of land in the Imperial Valley from the U.S. Filter Corporation in 2004.  The acquisition cost was $76.8 million.  To finance the acquisition, IID issued $87.7 million in Taxable Revenue Certificates of Participation.  The difference ($10.9 million) represented issuance costs and deposits into reserve funds required for the financing.  That is, capital requirements exceed narrowly defined project costs (in this case the cost of land acquisition) by 15%.

Depending on the structure of contracts, projects may need more capital.  A significant issue involves working capital—the cash reserves needed to bridge mismatches in timing between revenues and costs.  Capitalized interest funded by project financing bridges timing mismatches post-financing and during the construction period.  Post-project completion timing mismatches are addressed by other capital sources.  Public agencies have operating reserves.  Private firms have cash reserves and equity.

Proposed Best Practices.  Here are some ideas about what to do in practice:

• Initiate financial planning in tandem with project development.
• Cross-link the financial plan with project definition and contract structure with project users.
• Initiate early consultation with investment bankers.
• Include the cost of the capital structure and working capital requirements in the estimate of project capital investment.

I expect that the larger the scope of the project, the more significant the benefits from moving these financial considerations earlier in project development.

Next post in this series (January 11th) will address project interest rates.