There is now acute uncertainty surrounding future sludge investment planning, leading to high levels of business risk. Real options analysis can reduce this risk, and this project will demonstrate how.
Water companies now face a very high level of uncertainty when planning investment in sludge operations. This is due to the proposed introduction of competition to sludge treatment and disposal, along with uncertainty around energy prices, climate change, regional population and economic growth patterns, as well as innovation in sludge technologies. Overlaying this is Ofwat's evolving regulatory framework and how energy policy and environmental regulations may develop. A number of these have been compounded by the UK's intention to withdraw from the EU. This poses practical challenges in future business planning - how to decide whether to propose investment in specific sludge projects in this context of an extremely uncertain future?
In situations of uncertainty, Real Options Analysis (ROA) can reduce the planning risk associated with standard investment appraisal techniques; such as indicating when to propose investment in sludge solutions which allow for more flexible responses to possible future developments.
When this costs more money, the approach provides a sound justification to demonstrate to Ofwat that this flexibility is worthwhile. It can also help to avoid making costly mistakes, such as undertaking investments which later turn out not to be needed.
This project will explore key sources of uncertainty related to the current sludge planning situation and provide practical support in understanding when and how to use ROA in order to improve investment planning.
An implementation of ROA will not only deliver improvements in water company efficiency but also justify PR19 business planning decisions, thereby helping with fast-tracking.
Working in conjunction with Europe Economics, experts experienced in ROA, WRc will scope the role of ROA for use in sludge business plans and deliver practical recommendations. We shall gauge the key sources of uncertainty related to sludge planning and identify when ROA would best be used. Options covered will include
- Deferral (e.g. proposing opex solutions which allow capex to be deferred);
- Flexibility (e.g. by adopting a more flexible technology in plans);
- Phasing (e.g. phased investment allowing abandonment if expectations are not met).
This will involve the application of real options valuation to sludge investments (with the sludge investment options drawn from participants). The project will also provide support for development of WaSCs' in-house ROA expertise. The initial project provides entry to the optional second stage of the project: ROA tools development. The findings from the initial stage will help determine whether additional bespoke models/tools would facilitate the use of ROA for sludge planning, which would then be developed in 2017.
WaSCs will have to demonstrate the effectiveness of their approach to procuring sludge services (including self-provision) in their 2019 business plan. There is a strong regulatory precedent for using ROA (as seen in the energy sector) and it makes clear sense to adopt ROA for sludge investment planning given the high level of uncertainty. WRc has a strong legacy across the range of water processes, with a number of experts in both sludge and asset management. This knowledge will be combined with our delivery partner's expertise in ROA to support cost-effective sludge planning.