Using cost-benefit analysis to appraise investments

FINANCE

Introduction
Every morning millions of people in the UK have a bath or shower, make a cup of tea and wash the dishes before they start the day. Thousands of businesses use water in hundreds of different ways from hairdressers and hospitals to factories and farms. Yet most people do not consider where water comes from or where it goes once they have finished using it. It is the job of United Utilities to bring three million households and 200,000 businesses in North West England an incredible 2,000 million litres of clean water each day and take it all away again. It then treats it to make it safe to go back into the environment through rivers and the sea. United Utilities has a licence to provide water and sewerage services to around seven million people in North West England. Ofwat, the economic regulator, is responsible for overseeing companies like United Utilities to ensure they meet their obligations to customers. These obligations include meeting standards of service and charging fair prices. United Utilities also has to meet strict environmental standards set by the Environment Agency which manages discharges to the environment. These relate to the water quality of rivers, shellfish and bathing waters along the North West coastline. To deliver these services, United Utilities employs over 5,000 skilled employees, from apprentices to graduates, with diverse skills. These range from engineers, scientists and project managers to operational colleagues running the treatment works. Equally important are the frontline customer-facing employees and those staff in support functions such as finance, HR and IT. United Utilities has to consider how its decisions affect its various stakeholder groups including customers, shareholders, local councils, MPs, the media and the wider community. United Utilities recognises its responsibility to the community in many ways,

including working with young people in schools from Year 9 upwards. United Utilities encourages the take up of Science, Technology, Engineering and Maths subjects in schools. It also emphasises the importance of learning about the environment. In the period from 2010 to 2015 United Utilities will invest more than 3 billion to improve the water and wastewater infrastructure and the environment across the North West. As a commerciallyoperated business which provides a public service, United Utilities seeks to carry out all its projects in the most cost-effective way. It embraces cost-saving innovations without compromising the service to customers. A breakdown of where this money is spent is illustrated below.

Water treatment & mains

Water treatment & mains

Improving the quality of our assets

Maintaining our assets

Water treatment & sewers Water

United Utilities spend between 2010 and 2015 > 3bn

Water treatment & sewers

S&D* Waste water

*S&D = Supply and demand expenditure to meet population growth

This case study examines one major wastewater quality improvement investment made by United Utilities. This was for a bathing waters and shellfish waters project in Millom, a coastal area in Cumbria in North West England. It shows how important non-financial considerations, such as the impact on the environment, were in arriving at the best decision.

Curriculum topics covered: Cost-benefit analysis Average rate of return Payback Stakeholders

Drivers for investment

Businesses invest for many reasons, such as: to grow an existing business. United Utilities expanded by building new assets such as storage tanks and water treatment works to replace and improve existing facilities. In United Utilities case, this has involved upgrading or replacing sewers and water mains to meet legal or environmental requirements. There were two main drivers for United Utilities to invest in the Millom project: 1. European legislation. The European Union sets out regulations known as directives. The Bathing Waters Directive sets the standards for water quality where people may want to swim or paddle. Similarly, the Shellfish Directive covers the quality of water where shellfish may be grown and harvested. Only shellfish that are cultivated in clean water can be sent to market. 2. Environmental factors relating to the quality of discharged water. The Millom project was designed to improve the quality of wastewater discharged back into the environment. United Utilities identified a need to improve its management of water and waste water in the area around Millom and the Duddon Estuary. It aimed to combine engineering design with a consideration of environmental factors to generate the best solutions. This required working with a range of stakeholders to determine the best possible investment decision. Stakeholders are groups with an interest in a business decision. The investment decision was ultimately based on a cost-benefit analysis. Cost-benefit analysis involves taking into account both financial factors and wider social issues (including environmental impact).

Payback calculates the length of time needed to recover the money originally invested from the cash generated by the project. For example, if an investment of 200,000 is expected to lead to cash flows of 25,000 per year, then the payback period is eight years.

200,000/25,000 = 8 years

However, United Utilities, when appraising any investments, needs not only to consider the financial return on the investment but also to assess the benefits to communities and the environment. These are called external benefits. For United Utilities, the private benefits consist of the revenues from domestic and business customers. The wider external benefits include the benefits to local communities, to nature lovers, to the environment (including bird and animal life), as well as cleaner water. Capital investment projects incur costs that need to be quantified. Internal costs are easy to determine, a major one being the cost of borrowing money (for example, the interest on a loan). Added to this are the direct project costs these include materials, labour etc. However, projects can have negative effects on the locality. To arrive at the best decision for all relevant stakeholders, any project that United Utilities engages in requires a careful assessment of both the commercial costs and revenues and the external costs and benefits. The bases for decision-making using cost-benefit analysis are summarised in the following formulae:

Social benefits less social costs = cost-benefit analysis Social benefit = internal (company) revenues + external benefits Social costs = internal costs + external costs

External factors affecting investment appraisal

Any investment requires initial capital expenditure (capex). Appraising an investment project involves weighing up the likely future return on that investment (ROI) against the expenditure. Methods often used include calculating the Accounting Rate of Return and the Payback period: Accounting Rate of Return (ARR) is calculated as the average annual profit that is expected over the life of the investment project compared with the amount of capital invested. For example, if the investment in a project is 200,000 and the expected profit is 15,000 a year, then the ARR is 7.5%.

United Utilities is keenly aware of the social costs and benefits of its investments and always seeks to maximise the social benefits whilst minimising the social costs. Since 1990 United Utilities has invested more than 4,000 for every household in the North West. The benefits of these investments include: halving leaks from water networks improved compliance with bathing water standards from 30% to 90% across the North West improving water quality to the best that it has ever been.

15,000/200,000 x 100% = 7.5%

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All possible solutions when costed out were over the original budget. Therefore the partners in the plan engaged in a costbenefit analysis to identify which of the three options put forward gave the best return against all factors. The whole-life cost assessment of the solutions involved examining capital costs of construction (e.g. concrete structures, pumps and pipe work) as well as operating costs e.g. power and chemicals for treatment. Although option 1 had a significantly lower initial capital outlay, originally United Utilities had discounted options 1 and 3 as the application of the technology was new to the company and the regulator, so more data was needed to accept the solution. This only left option 2, despite it being the most costly and potentially having a negative impact on the environment. However, United Utilities found positive evidence from colleagues at Welsh Water to demonstrate how the ultraviolet treatment processes could be used effectively. It then worked closely with the Environment Agency to ensure the project minimised the negative external costs and maximised the external benefits. This resulted in United Utilities adopting option 1 as the most innovative, cost-effective and environmentally beneficial option that in some way satisfied all stakeholders. The key reasons were: It had the lowest capex and whole-life cost - the infrastructure for option 1 can be contained within the existing waterworks/treatment works site. Its carbon footprint and environmental impact was lowest - it minimises the use of concrete and construction waste. When storms and heavy rain occur the excess water is treated with ultraviolet disinfection and is discharged into the estuary. This eliminates strong odours that would have affected the local community and delivers benefits to the shellfish and bathing waters.

As a project always has the potential for both positive and negative external effects, United Utilities seeks to quantify these to help select the best overall decision from its range of options. The following sections show the basis for such decisions relating to the Millom project. These include the costing criteria and how the options specifically met stakeholder needs.

Investment for the Millom project

The original budget for the Millom project was set at 14.5m. However, this was before a full evaluation of the social costs was carried out. Having consulted with the Environment Agency, United Utilities aimed to identify the best possible solution for its shareholders, the environment, local communities and other stakeholders. The key considerations were: 1. the initial capital outlay of the project (capex) 2. the ongoing operating expenditure from running the project (opex) 3. the wider costs and benefits to the environment and other stakeholders.

Option 1. Small scale upgrade to the site and using ultraviolet rays in tubes to kill bacteria in wastewater to improve quality

Key elements Lowest capex, but higher opex

Whole-life cost 18.5m

Benefits Uses least land and lowest initial capex

Risks and issues High power and other operating costs. Uses a technique in a new way for United Utilities and the Environment Agency in the North West

2. Create new large storage and pipe work requirements

Highest capex but relatively low opex

22.8m

Confident that the solution would work and deliver the benefits

Over budget. Results in very large concrete structures that generate waste for disposal Over budget. Uses a technique in a new way for UU and EA

3. Major site upgrade and using ultraviolet in tubes to kill off bacteria

Middle for capex and opex

21.3m

Uses a little less land than option 2

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www.unitedutilities.com

Working with stakeholders

In a public service industry like water, gas or electricity, it is essential to make investment decisions that respect the requirements of many different stakeholders. United Utilities sought to find a solution that met with commercial criteria, met budget and also minimised negative impacts on the community. By working closely with the Environment Agency, United Utilities was able to come up with a socially and environmentally acceptable solution.
Stakeholders in the Millom project
United Utilities shareholders Employees

Conclusion
United Utilities is a major partner in the economic life of the North West. It manages huge reservoirs such as Thirlmere and Haweswater in Cumbria and treats the wastewater from homes and businesses across the North West before disposing of it safely back to the environment. It is committed, through investments, to providing sustainable solutions to business and environmental challenges. The company recognises that quality management begins at the start of the water production process and continues right down to safe discharge of wastewater. United Utilities keeps its catchment land as clean and sustainable as possible. In the Millom project, United Utilities was faced with a number of drivers requiring better water management to meet consumer needs, legislation and environmental demands. It responded by identifying three alternative options and then working with the Environment Agency to identify the solution which offered the best value for money and long term sustainability. The use of cost-benefit analysis meant that the chosen solution minimised financial costs and limited the impact on the local landscape whilst giving acceptable benefits to shareholders, the local community and the environment.

Fishermen in the Duddon estuary area

Nature lovers

Stakeholders in improving water and waste water

OFWAT (economic regulator)

The Environment Agency (environment regulator)

Local communities

In terms of satisfying stakeholders, United Utilities considered (and by selecting option 1) fulfilled the following key requirements: 1. Convinced its own shareholders that the decision was good in terms of financial criteria and maintaining the excellent reputation of the company. 2. Convinced the Environment Agency that wastewater would be treated to the required standards so that the EU directives could be met in this area of the North West. 3. Demonstrated to landowners that their land rights would be respected and that huge areas of land would not be taken away from them. 4. Provided fishermen and consumers of shellfish with good quality stocks and supplies. 5. Provided swimmers with bathing waters that are of a high standard. The table below summarises the financial and environmental impacts considered as part of the investment appraisal in order to assess the overall impact of the three options. This clearly shows how option 1 provided the most effective balance of commercial and environmental factors.
Option Capex (m)

1. Describe how stakeholders affect a business and its investments. (2 marks) 2. Explain the benefits of effective investment appraisal for the company and its stakeholders. (4 marks) 3. Compare the advantages and disadvantages of using a cost-benefit analysis of an investment rather than using ARR or Payback alone. (6 marks) 4. Evaluate how you might carry out an investment project of your choice (e.g. a new school building or the development of a local sports centre) to take into account a range of stakeholder interests. (8 marks)
Exam-style questions

Whole-life cost (m)

Carbon (tonnes) from construction

Carbon (tonnes per year) from operating the site 273 827

1. Minor changes to site + UV treatment 2. Storing wastewater in concrete structures 3. Major changes to site + UV treatment

15.8 24.0

18.5 22.8

5127 8719

22.0

21.3

6553

349

United Utilities | Using cost-benefit analysis to appraise investments