Engineering Economics for Public Water Utilities Max Maurer Eawag: Swiss Federal Institute of Aquatic Science and Technology Imprint Author Prof. Dr. Max Maurer, Institute of Environmental Engineering, ETH-Zürich, Switzerland [email protected] Aim This script constitutes part of my lecture ‘Infrastructure Systems in Urban Water Management’ given at ETH Zürich, Switzerland Version 4.7, Jan 2019 License Creative Commons Attribution 4.0 International (https://creativecommons.org/licenses/by/4.0/) Title photo Wastewater Treatment Plant (Mönchaltorf, ZH) Maurer: Engineering Economics Contents 1. Aim of this script ......................................................................................................................... - 5 - Inflation, Interest & Discount Rate ...................................................................................................... - 7 - 2. The strange concept of money .................................................................................................. - 8 - 3. Inflation........................................................................................................................................ - 8 - 4. Interest rates ............................................................................................................................. - 10 - 5. Discount rate ............................................................................................................................. - 10 - 6. Replacement value ................................................................................................................... - 13 - Engineering Economic Analysis ....................................................................................................... - 17 - 7. Engineering economic analysis ................................................................................................ - 18 - 8. Assumptions and simplifications .............................................................................................. - 20 - 9. Present value analysis ............................................................................................................... - 20 - 10. Annual cash flow analysis (annuity method) ........................................................................ - 23 - 11. Sensitivity analysis ................................................................................................................. - 24 - Depreciation & Hidden Assets ......................................................................................................... - 27 - 12. Depreciation ......................................................................................................................... - 28 - 13. Hidden assets ........................................................................................................................ - 30 - Cost Calculations Debt-to-Asset Ratio ............................................................................................. - 33 - 14. Cost calculations ................................................................................................................... - 34 - - 3 - Maurer: Engineering Economics 15. Debt-to-asset ratio ................................................................................................................ - 37 - The Value of Flexibility ...................................................................................................................... - 41 - 16. The future is uncertain .......................................................................................................... - 42 - 17. Plant utilisation and idle capacity ......................................................................................... - 44 - 18. Specific net present value (SNPV) ........................................................................................ - 46 - 19. Considering uncertainty ....................................................................................................... - 47 - 20. Estimating the value of modularisation ................................................................................ - 50 - Formulas, Tables & References ........................................................................................................ - 52 - 21. Formulas & Tables ................................................................................................................ - 53 - 22. References und further reading ........................................................................................... - 58 - Examples & Exercises ....................................................................................................................... - 61 - 23. Exercises ................................................................................................................................ - 62 - - 4 - Maurer: Engineering Economics 1. Aim of this script This script was written to support my lecture ‘Infrastructure Systems in Urban Water Management’ at ETH Zürich. The target audience are engineers aiming to gain a basic understanding of the tools and methods used to manage water infrastructures. Asset management is meaningless without an idea of the strange concept of money and engineering economics. This script provides the key formulas and concepts to deal with monetary values so that engineers can make fair cost compari- sons of various project variants and develop basic cost projections within the scope of asset man- agement plans. The focus is clearly on public utilities providing water supply and sewerage services. This is not only due to it being my principal domain of experience, but also because it enables some substantial simplifications to be made, so that I can ignore weighty issues such as taxes and profits. Moreover, public utilities are a very common organisational form in the water sector. This is not a script of the entire course, nor is it a script on asset management in general. It focuses only on the monetary part and is taught in the first 4 weeks of the course. Considerable attention is also devoted to Swiss-specific issues, as many of my students will find work in Switzerland. I try to bring this aspect out clearly, so that the reader can identify the generic concepts involved. I hope you find this script useful. Please let me know if you have any suggestions for improvement or find any errors. I am still in the phase of improving and changing the course content, and this script will be adapted accordingly. If not very quickly, then at least continuously. - 5 - Maurer: Engineering Economics - 6 - Maurer: Engineering Economics Inflation, Interest & Discount Rate - 7 - Maurer: Engineering Economics 2. The strange concept of money For engineers, monetary values are very strange. They change over time in unpredictable ways. Today CHF 100 is not the same as CHF 100 next year or CHF 100 fifty years ago, even if we still talk about CHF 100. We can describe these changes with three basic concepts: 1. Inflation: For some dubious reason, the general price level of goods and services in an economy changes over time. Each unit of money buys a different amount of goods and ser- vices over time. If it is less then we speak about inflation, if it is more, then it is called defla- tion. We also say that the purchasing power of a unit of money changes over time. 2. Interest is a fee payable for the right to use somebody else’s money. 3. The discount rate roughly describes the fact that we value having money today more than having it tomorrow. This fact is independent of inflation. If given the option of paying their tuition fees at the beginning of the semester or the same amount after the end of the se- mester, most people choose the second option. This preference can be quantified and is expressed in the discount rate. We cannot go into too much economic detail about these three concepts here. In the following chapters, we will present the most basic formulas that enable us engineers to navigate these tricky monetary waters. 3. Inflation To keep it short and easy: don’t do any mathematical operations with two monetary values unless they are in- Convert all monetary dexed to the same year. We will call this the reference year. As pointed out earlier, a unit of money changes its values to a reference purchasing power over time. A pump valued at CHF year before you do any 1000 today will have had a different monetary value last calculations. year than it will have next year. We therefore need to be aware which year the CHF 1000 is associated with. There are two ways to adjust a monetary value to the reference year: firstly, by using an average inflation rate, and secondly by using cost indices that try to capture the change of purchasing pow- er over time. 3.1. Using average inflation rates Calculating the present value P from a past value V with an average inflation rate f and a time differ- ence of n years: - 8 - Maurer: Engineering Economics n PV=⋅+(1 f) (1) P = Present value [CHF] V = Past value [CHF] f = Average inflation rate [a-1] n = Number of periods between P and V [a] where the present value P is set as the reference year. If the value we would like to convert to the reference year is in the future, then we naturally invert equation (1). 3.2. Using cost indices This method only works for values in the past. You need access to a relevant cost index list. Many different lists are available. They measure the cost development of a specific number of items or services over time and for