On 21 January 2020, Ross Waugh and Heather Himmelberger held another Ask-the-Experts webinar titled, “Infrastructure Asset Management – How to Start.” Inframanage.com presents the webinar topics through a series of blog posts.
This post deals with two questions from the webinar participants.
- Can you give a little background on funding depreciation?
- Does funding replacement cost a more fundamental approach when dealing with asset management issues?
Heather requested Ross to answer first, considering that New Zealand has rules and requirements with depreciation.
I was just thinking really that we do, but we’re unique internationally in that regard. So I think it’s possibly better if you could give the US experience answer.
I mean the simple answer in New Zealand is we have to account for depreciation and then we have to fund it as an operational cost.
And this asset depreciation accounts that build up over time, and in theory, when you go to major replacement of assets, the money is there.
Same theory because often it’s borrowed for other purposes, but in theory, the money is there—the major asset replacements.
And the system is working reasonably well in New Zealand and that we go back before we started asset management.
A significant asset, big pipe replacement, let say it’s a foot pipe in a small town, that would be a major drama.
It will be all over the front page of the local paper and how we are going to afford this. Now there are just no issues around that; the money is there.
Everybody knows the money is there. It’s just about sequencing the replacements in the right order and not going too soon or not leaving it too late.
But that’s in New Zealand.
And I think everybody has. I would suspect every state in the US has slightly different sets of rules around that.
Explaining depreciation cost and replacement cost
Heather discussed further what Ross shared, explaining depreciation cost and replacement cost.
Yes, I mean a lot of times, it’s not an economy mandated. It depends on if you’re a regulated utility or not.
And so very few states regulate municipal or publicly owned utilities. It’s more rate regulation on privately-owned services. But it does vary quite a bit from state to state.
And often, the regulated utilities, the ones with rate regulation, have to do some type of depreciation funding, and non-regulated ones are not required. They can, but they are not necessary.
And I think the question was sort of about, do you fund depreciation? Do you fund replacement cost?
It’s kind of two slightly different questions. And the concept to funding depreciation I think as Ross is talking about, is the idea that you’re incrementally funding.
So, you’re not waiting until, okay I have a utility, I put in the pipe in 1906, and I’m going to replace it in 2006. But I’m not going to put one penny aside until I hit 2006 and then all of a sudden I have to pay the replacement cost of a hundred miles of pipes, which is now a hundred million dollars.
So, if I had done nothing for the hundred years, then where am I going to come up with the hundred million dollars for the new pipe? But if I depreciate and fund that, what I can do is put a little bit of money aside every year.
And maybe it doesn’t come up to a hundred million dollars. And there’s even some thinking about, whether you even should fund the whole hundred million dollars; whether that’s even possible to put that much money in the bank and have nobody rob it or use it for other purposes.
So we won’t go there. But just the idea that you’re incrementally putting money aside. So even if it isn’t the entire full replacement cost. You still have something in the bank that helps you fund that replacement later on.
But when you come to the time to fund the project, you are going to be using the actual replacement cost. Because you’re not going to fund it out of what is your depreciation. You are going to or not.
I mean, the amount of money you need is not going to come from what you set aside for depreciation. The amount is going to come from what it has cost me to replace whatever asset it is that I need to replace.
And then hopefully if you set some depreciation funding aside, which typically is in a reserved account somewhere. You usually got a reserved account sitting somewhere for that specific purpose that hopefully others can’t take the money out of for other purposes.
And you pull that money out, and you apply it to the replacement. It may not and probably will not be the whole amount you need, but it can help you match other funds. It can help cut down the amount that you have to loan or borrow or bond.
So, they both are important concepts, but I think the main point of depreciation is to get you to be thinking about renewing those assets.
And that is not out of sight, out of mind for 20 years, 30 years, 40 years, 50 years, whatever the timeframe. And then all of a sudden, boom! I have to replace it, and I have not put any money aside to do it.
So I think the concept of funding depreciation is to help you think about incremental funding instead of slamming your customers with this massive influx of needed capital when you have a replacement project.
Thinking around your replacement cost versus expected depreciation cost.
Further on the topic, Ross shared an example and more of his thoughts.
We are required to do the math in New Zealand. It’s not hard math to do, but it’s very, very instructive.
If you sit down and you say, well, what’s the life of a pipe? Will we just use a hundred years for a nice easy figure?
And you say, right, well if my depreciation is 1% a year, and you can work out what that would be in monetary terms across the whole network.
If we were funding depreciation, it’s X amount of dollar a year. If you then come the other way, which is a pure engineering way, so hey, let’s, depreciation is an accounting thing. Let’s do it by replacement cost, flag those within the years where they need to be.
If you’re getting a significant discrepancy, one or the other pieces of the math is wrong. And then that’s a great test to say, have I got my replacement cost right?
Or have I’ve got my depreciation analysis wrong? And it’s a good test. And our auditors check authorities and networks on precisely that test.
Particularly for long-life assets like pipes, over 20- or 30-year period, there might be a shortfall from depreciation to the replacement or the other way around. You might have a lot more money accumulating depreciation or replacements. But over the long term, those two should even up.
Now the differences of credit or a shortfall, particularly a shortfall as Heather said, that’s when you go, hey for a ten-year time I’ve got to spend a hundred million and I’ve only got 20 million in the bank. I’ve got an 80 million shortfall there.
As the pipe breaks to the point where we cannot supply service, it doesn’t matter. If you have no water, you either have to fix the pipe, or you’re going to be tankering it in. You don’t get too many other choices. And tankering is expensive. So you’re going to fix the pipe.
What it allows the decision-makers, the governance, and the funders is you go, okay, we’ve got this 80 million dollars shortfall in ten years, how are we going to make that? Are we going to bond? Are we going to loan, or are we getting a grant from the state government or whatever it is?
We know further on we may have some new pipe and we don’t have much an issue with 30 or 40 years, but it allows you to have that conversation early. And it also allows you to check your thinking around your replacement cost versus expected depreciation cost.
If it’s a big difference, then you’re back to asking that “why” question. Why have I got that difference? Am I just doing the math wrong?
Have I got the wrong assumptions in the math? Have I got not enough analysis around the depreciation, or am I overcooking my replacement cost? Those sorts of questions.
So it helps you refine your assumptions and your math around those questions, and also, then you can give more assurance to your decision-makers and your funders around, hey, we’ve got pretty much the right numbers at the right time.