Soaring energy costs herald more whole life costing in construction

When assessing a project’s viability, it seems obvious that account should be taken not only of capital costs but also the long-term impact of the design including operating, maintenance, replacement, energy and disposal. In effect, this means basing a decision to build on the best value over time.

However, while the Treasury requires all public-sector construction projects to be evaluated on a whole life cost (WLC) basis and a number of high-profile companies and organisations strongly support the technique, it is rarely used as a key decision-making tool. Even when WLC studies are commissioned, the exercise often seems cosmetic and geared to justifying decisions already made for reasons other than long-term economics. What can be done to increase the use of WLC?

The technique, also called life-cycle costing, is relatively easy to do with modern software and spreadsheet applications. But it relies substantially on sound professional judgement and must be conducted in a manner that establishes credible results. Key issues are:

• the life of the asset or assets
• the discount rate to be used
• the data source underpinning the calculations for operational and maintenance costs.

Asset life

The various systems and component parts of a project have different physical lives. For example, most engineering services plant and equipment is expected to last 15-20 years, while elements such as the building structure are designed to last considerably longer, with periods of 60 years not uncommon.

As a result, many WLC studies have used the physical life of the structure as the basis for the period or time horizon of the study. But other forms of obsolescence (economic, technical, functional and social) may have an even greater influence on asset life. Data/communication systems typically become technically obsolescent after three to five years. A retailer may alter its store layouts every five years to reflect changing fashions.

So when assessing the life of an asset or project and thus the length of a WLC study, recognition needs to be given to the type of asset, the rapid pace of change in society, technological advancement and, most importantly, the client’s economic time horizon.

It is often now advocated that, notwithstanding the physical life of the asset, the time horizon for capital projects should not exceed 25 years. The uncertainty inherent in forecasting costs beyond this seriously undermines the credibility of results. In addition, many WLC studies, such as those associated with engineering services and communications, could and should use much shorter time horizons.

Discount rates

The basic premise is that a sum of money received today is worth more than the same sum in one year’s time. To assess the present value of future sums, whether costs or benefits, a discount rate has to be applied to reduce them to today’s value.

In the public sector, the rate often used is known as a no-risk discount. This is generally based on the rates available from secure fixed-interest investments such as long-term Treasury bonds, which are adjusted by the rate of inflation to arrive at what is a real discount rate, ie a rate net of inflation. For example, if bonds are paying 6% and the rate of inflation is 2.5%, the real discount rate will be [(1+0.06)/(1+0.025)]-1, which equals 3.4%.

Rates are generally best expressed in real terms because they eliminate an unknown variable in inflation and as such all future costs and benefits are priced at today’s prices before discounting. If a particular element of cost is expected to increase or decrease in price significantly when measured against inflation, then such a differential can be acknowledged and explicitly illustrated in the cashflows.

Discount rates tend to be considerably higher in the private sector because of market demands for high returns and the factoring in of substantial risk premiums. This can mean discount rates of 15-20% or a demand for short payback periods of three to five years.

An important point to remember is that the higher the discount rate, the more future benefits and costs are reduced in today’s terms. For example, at a discount rate of 5%, a benefit of £1000 due in year 20 of a study is worth £377 today, whereas at a rate of 20% it is worth only £27. This means solutions which are initially more expensive but have lower operating costs are effectively penalised by high discount rates.

Data source and compilation

It is widely believed that applying WLC techniques requires the collection, analysis and management of extensive databases of information. Notwithstanding the accepted weaknesses in the use of historical data – it may reflect past mistakes and is generally not collated under consistent headings – this view has been challenged by a number of people.

When setting operational budgets, managers or FM providers can produce an assessment of the future costs using their own professional judgement. If the person or company is responsible for delivering within the budgets set, a great deal of purpose will be lent to the exercise. This is arguably the case with Private Finance Initiative projects where, in theory at least, those estimating future operational costs are held accountable.

Regularly updating the calculations and building up an intimate knowledge of operating and maintenance costs by asset type will allow the FM provider to refine the estimates and more accurately predict future costs without resorting to the use of large databases.

Another view is that it is always better to estimate future costs from first principles using current knowledge and experience (much as is done with capital cost estimating), resorting to historic data only as a means of establishing a reference point.

For example, detailed discussions with the building owners and occupiers will reveal how a facility is to be operated and maintained and the likely intensity of use. This will provide a much better indication of future trends than reliance on a database of historic information.

Barriers to use of WLC

Critics of the technique often complain that it is “crystal ball” form of forecasting and it is not real expenditure being calculated. In addition, actual durability and running costs have rarely, if ever, been measured and updated against the original forecasts. Equally, many people have been deterred by the belief that costly assembly and analysis of large amounts of data is necessary to underline the accuracy of the forecasts.

The cost of energy has been generally accepted as a major factor in WLC appraisals. Yet, despite the impact of the Climate Change Levy and recent price increases, it is viewed by many organisations as insignificant in terms of its effect on the bottom line.

There has been a growing trend for big organisations, and to some extent consultants and advisers, to promote a whole life approach in procurement of capital projects. There has been much talk of a significant shift in emphasis, with clients, both public and private, increasingly demanding this approach. It could be argued, however, that much of this is window dressing by organisations eager to be seen following a sustainable agenda, and that practice is somewhat different.

This view is reinforced by clients’ unwillingness to pay for proper studies into competing options. All too often design consultants are appointed in fierce competition on the basis of a lump-sum fee, which is unlikely to encourage them to explore all the options open to a client.

Another hurdle for WLC is “the market” and its pressure for high returns over the short term, which discourages decisions which reward only over the long term. Even now, in a time of relatively low interest rates and inflation, it is not unusual to have firms demanding rates of return in excess of 20%. Such expectations are likely to be unrealistic, particularly when averaged out over time, and generally give little guidance on the risks inherent in the particular asset investment.

In the public sector the pressures can be quite different. The availability of capital is often strictly limited and in effect this puts a stranglehold on long-term capital investment. The UK’s transport infrastructure is a prime example of lack of foresight in public expenditure. It costs a fortune just to keep it going, increasing all the time the capital investment required to bring the system into the 21st century and making it less affordable to do so. Many councils face a backlog in maintenance and repair work.

Glimmer of hope

Subject to final sign-off, a new international standard, ISO15686 Part 5 – Whole Life Costing, will be available this year. This will provide a much-needed common basis and standard terminology for the use of life-cycle cost studies in construction. The standard provides a general framework without attempting to replace country-specific decision models and approaches.

Also, the public sector appears to be adopting a more rigorous approach by ensuring that WLC studies are carried out and solutions chosen on the basis of best value, albeit the hurdle of limited capital funds remains.

It is, however, the drive towards more sustainable development and the increasing cost of energy that is helping to increase the use of WLC. Organisations are becoming more aware of the scarcity of resources and understanding the long-term consequences of decisions.

Having an international standard should help to make WLC a more understandable and transparent measure of best value over time. What hampers the technique strongly, though, is the use of unnecessarily high discount rates, often coupled with a failure to recognise that the skills needed to implement a study effectively have to be paid for.

One way forward could be the widespread acceptance of an approach that at all times uses a no-risk discount rate and identifies risk premiums separately, underpinned by a robust risk management strategy. These risk premiums would be much more transparent and measurable against the risks inherent in the investment and the alternative returns available elsewhere. It could even be the case that solutions which have low capital but high recurrent costs are forced to carry greater risk premiums because of their long-term impact on the environment.

A change in attitude is required and persuading clients and investors to take a long-term view is the real challenge. While rising energy and commodity costs help to increase awareness, it is clear that practitioners will have to become better at presenting information in a transparent and understandable manner, demonstrating hard evidence of the true value of the technique.

Original print headline - Playing the long game