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Page 1 Risk-Based Modeling Approaches for Determining Current Liability for Future Asset Retirement Obligations The 2006 Palisade User Conference: Americas.

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Presentation on theme: "Page 1 Risk-Based Modeling Approaches for Determining Current Liability for Future Asset Retirement Obligations The 2006 Palisade User Conference: Americas."— Presentation transcript:

1 Page 1 Risk-Based Modeling Approaches for Determining Current Liability for Future Asset Retirement Obligations The 2006 Palisade User Conference: Americas Miami, Florida Larry Philbin, Principal Engineer Santee Cooper - Quality & Performance Support November 13, 2006

2 Page 2 Agenda Santee Cooper background Financial Obligation Underfunding Background Santee Cooper Asset Retirement Obligation (ARO) ARO Modeling Methodology ARO Models Concluding Thoughts Questions

3 Page 3 Santee Cooper Established in 1939 Non-profit, owned by State of South Carolina Senate-confirmed board of directors $1.4 billion revenue 149,024 direct customers $5.0 billion total assets 1,740 employees 4,277 megawatts generation capacity

4 Page 4 Our Electricity Source - Energy Supply (2005 ) Coal 73.9% Purchases & Net Interchanges 6.1% Hydro 1.9% Nuclear 9.7% Oil & Gas 8.4%

5 Page 5 Quality and Performance Support Services Business Planning/Benchmarking Process Mapping/Improvement Management/Decision Analysis Tools Performance Measures Survey Questionnaires Statistical Analysis Forecasting & Scheduling Models Economic Analysis Maintenance Management Systems Project Management Simulation Modeling & Analysis Risk Management Modeling

6 Page 6 Agenda Santee Cooper background Financial Obligation Underfunding Background Santee Cooper Asset Retirement Obligation (ARO) ARO Modeling Methodology ARO Models Concluding Thoughts Questions

7 Page 7 Financial Obligation Underfunding Background 2005: U.S. Pension Benefit Guarantee Corporation (PBGC) 1 : –estimates that total underfunding in the single-employer defined benefit plans it insures exceeded $450 billion as of September 30, : Public Pension Funds Survey 2 : –one-quarter had actuarial funding ratios below 80% –shortfall approaches one trillion for all public systems 1 retrieved 10/31/ E.J. mcMahon. “Public Pension Price Tag.” The Wall Street Journal, 21 August 2006

8 Page 8 Financial Obligation Underfunding Background President Bush Signs H.R. 4, the Pension Protection Act of 2006 –requires companies who underfund their pension plans to pay additional premiums –insists that companies measure obligations of their pension plans more accurately

9 Page 9 Financial Obligation Underfunding Background The present underfunding of Medicare ($29.7 trillion) is more than seven times that of Social Security ($4 trillion). To bring Social Security into balance over the next 75 years would require a 15 percent increase in payroll taxes today. Bringing Medicare into balance would require an immediate 107 percent increase in revenue. < Thomas J. Healey and Robert Steel MEDICARE: Rx for Medicare Hoover Digest 2005 No. 3 Retrieved11/01/2006

10 Page 10 Currently, 53 utility companies have nuclear plants. It will cost $33 billion to decommission them. Typical (57%) decommissioning accounting method is to record expected costs as a depreciation expense, thus removing the liability from the balance sheet. Next most common (26%) method is to record expected costs as a liability accrued over the life of the asset rather than the present value thus significantly understating the real costs. Neither method establishes current funding. Financial Obligation Underfunding Background

11 Page 11 Financial Obligation Underfunding Background 1996 U.S. Environmental Protection Agency (EPA): –determined that the cost estimates prepared by owners and operators for 89 of the 100 hazardous waste facilities reviewed were lower than the corresponding cost estimates prepared under EPA recommended methodology –cost estimates for 54 of the facilities were more than 50 percent below the estimates prepared under their methodology –cost estimates for 35 facilities were 50 percent or less than 50 percent lower than the estimates prepared under their methodology

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13 Page 13 The main variables are in the discount rate used to calculate the present value of costs, assumed inflation rates, expected age used to estimate when expenditures will commence and the amount of costs that will become payable. Tendency to use a lower inflation rate, a higher discount rate that reflects expected investment returns or perhaps an average of past investment returns (versus a risk free rate of return-usually based on Treasury securities), and later expected ages that do not assume increased rates (amounts) of costs. Financial Obligation Underfunding Background

14 Page 14 Financial Obligation Underfunding Background 2001 EPA Continued: –developed requirements & methodology for determining accuracy of cost estimates for closure and post-closure care of hazardous waste treatment, storage, and disposal facilities (TSDF) under the Resource Conservation and Recovery Act (RCRA) –includes closure activities, factors affecting cost estimate accuracy, and cost estimating worksheets

15 Page 15 Agenda Santee Cooper background Financial Obligation Underfunding Background Santee Cooper Asset Retirement Obligation (ARO) ARO Modeling Methodology ARO Models Concluding Thoughts Questions

16 Page 16 Santee Cooper Asset Retirement Obligation (ARO) Santee Cooper maintains ash ponds at each of its four coal-fired generating stations: 1.Cross (CGS) 2.Grainger (GGS) 3.Jefferies (JGS) 4.Winyah (WGS) FASB 143 / FIN 47 requires that if there is a legal requirement that involves cost of retiring assets, Santee Cooper must book the liability for those retirements in the current year. South Carolina / DHEC regulations require that Santee Cooper account for its ash pond (asset) retirement obligations. Several areas of uncertainty exist regarding ash pond retirement costs. Based on FASB 143, the primary uncertainties must be addressed in determining Santee Cooper’s accounting treatment by creating and quantifying multiple retirement scenarios.

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20 Page 20 Coal-fired Combustion By-Products Fly ash-a fine-grained powdery particulate material suspended in flue gases. Bottom ash-agglomerated ash particles coarse, with grain sizes spanning from fine sand to fine gravel.

21 Page 21 Santee Cooper maintains ash ponds at each of its four coal-fired generating stations: 1.Cross (CGS) 2.Grainger (GGS) 3.Jefferies (JGS) 4.Winyah (WGS) FASB 143 / FIN 47 requires that if there is a legal requirement that involves cost of retiring assets, Santee Cooper must book the liability for those retirements in the current year. South Carolina / DHEC regulations require that Santee Cooper account for its ash pond (asset) retirement obligations. Several areas of uncertainty exist regarding ash pond retirement costs. Based on FASB 143, the primary uncertainties must be addressed in determining Santee Cooper’s accounting treatment by creating and quantifying multiple retirement scenarios. Santee Cooper Asset Retirement Obligation (ARO)

22 Page 22 Santee Cooper Asset Retirement Obligation (ARO) Santee Cooper maintains ash ponds at each of its four coal-fired generating stations: 1.Cross (CGS) 2.Grainger (GGS) 3.Jefferies (JGS) 4.Winyah (WGS) FASB 143 / FIN 47 requires that if there is a legal requirement that involves cost of retiring assets, Santee Cooper must book the liability for those retirements in the current year. South Carolina / DHEC regulations require that Santee Cooper account for its ash pond (asset) retirement obligations. Several areas of uncertainty exist regarding ash pond retirement costs. Based on FASB 143, the primary uncertainties must be addressed in determining Santee Cooper’s accounting treatment by creating and quantifying multiple retirement scenarios.

23 Page 23 Santee Cooper maintains ash ponds at each of its four coal-fired generating stations: 1.Cross (CGS) 2.Grainger (GGS) 3.Jefferies (JGS) 4.Winyah (WGS) FASB 143 / FIN 47 requires that if there is a legal requirement that involves cost of retiring assets, Santee Cooper must book the liability for those retirements in the current year. South Carolina / DHEC regulations require that Santee Cooper account for its ash pond (asset) retirement obligations. Several areas of uncertainty exist regarding ash pond retirement costs. Based on FASB 143, the primary uncertainties must be addressed in determining Santee Cooper’s accounting treatment by creating and quantifying multiple retirement scenarios. Santee Cooper Asset Retirement Obligation (ARO)

24 Page 24 The primary uncertainties, or variables, in this analysis were identified as: 1.Retirement year (the year of remediation, for each generating station) 2.Retirement cost (permitting, engineering, quality control & construction) 3.Inflation rate 4.Credit adjusted risk-free reinvestment interest rate 5.Market risk (reflects the uncertainty of future bond initiation and funding costs-5% is used in this analysis) Santee Cooper Asset Retirement Obligation (ARO)

25 Page 25 Agenda Santee Cooper background Financial Obligation Underfunding Background Santee Cooper Asset Retirement Obligation (ARO) ARO Modeling Methodology ARO Models Concluding Thoughts Questions

26 Page 26 ARO Modeling Methodology An Excel model was created to compute a single funding schedule for Santee Cooper’s total ash pond ARO 1.Two scenarios were modeled for each station, for a total of eight independent scenarios (2 scenarios x 4 stations). 2.The scenarios were based on using two different retirement years. 3.In addition to quantifying scenarios based on retirement year, Santee Cooper incorporated the range of uncertainty regarding retirement costs, inflation rate, reinvestment interest rates, and market risk premiums. This uncertainty was addressed by assigning probability distributions (representing the likelihood of occurrence) to these variables. 4.A different credit adjusted risk-free reinvestment interest rate was used for each scenario, as it is based on the retirement year used and principal amount.

27 Page 27 ARO Modeling Methodology An Excel model was created to compute a single funding schedule for Santee Cooper’s total ash pond ARO 1.Two scenarios were modeled for each station, for a total of eight independent scenarios (2 scenarios x 4 stations). 2.The scenarios were based on using two different retirement years. 3.In addition to quantifying scenarios based on retirement year, Santee Cooper incorporated the range of uncertainty regarding retirement costs, inflation rate, reinvestment interest rates, and market risk premiums. This uncertainty was addressed by assigning probability distributions (representing the likelihood of occurrence) to these variables. 4.A different credit adjusted risk-free reinvestment interest rate was used for each scenario, as it is based on the retirement year used and principal amount.

28 Page 28 ARO Modeling Methodology An Excel model was created to compute a single funding schedule for Santee Cooper’s total ash pond ARO 1.Two scenarios were modeled for each station, for a total of eight independent scenarios (2 scenarios x 4 stations). 2.The scenarios were based on using two different retirement years. 3.In addition to quantifying scenarios based on retirement year, Santee Cooper incorporated the range of uncertainty regarding retirement costs, inflation rate, reinvestment interest rates, and market risk premiums. This uncertainty was addressed by assigning probability distributions (representing the likelihood of occurrence) to these variables. 4.A different credit adjusted risk-free reinvestment interest rate was used for each scenario, as it is based on the retirement year used and principal amount.

29 Page 29 ARO Modeling Methodology An Excel model was created to compute a single funding schedule for Santee Cooper’s total ash pond ARO 1.Two scenarios were modeled for each station, for a total of eight independent scenarios (2 scenarios x 4 stations). 2.The scenarios were based on using two different retirement years. 3.In addition to quantifying scenarios based on retirement year, Santee Cooper incorporated the range of uncertainty regarding retirement costs, inflation rate, reinvestment interest rates, and market risk premiums. This uncertainty was addressed by assigning probability distributions (representing the likelihood of occurrence) to these variables. 4.A different credit adjusted risk-free reinvestment interest rate was used for each scenario, as it is based on the retirement year used and principal amount.

30 Page 30 The basis of the scenarios, the year of retirement, is the following: –Scenario Group 1: External depreciation study performed in Fall 2001 (for year-end 2000) –Scenario Group 2: Internal Santee Cooper Construction Management estimates provided in December 2005 Excel add-in software by Palisade, Inc. was used to compute the results. It was also used to: –Determine the appropriate probability distribution to model the uncertainty within the retirement cost and inflation rate estimates –Apply Monte Carlo methodology in modeling the large number of potential combinations of the variables. Five thousand runs (5,000 simulations) were performed for each of the eight scenarios in order to generate reliable confidence intervals for the calculated outputs. ARO Modeling Methodology

31 Page 31 The basis of the scenarios, the year of retirement, is the following: –Scenario Group 1: Depreciation study performed in Fall 2001 (for year- end 2000) –Scenario Group 2: Santee Cooper Construction Management estimates provided in December 2005 and BestFit Excel add-in software by Palisade, Inc. was used to compute the results. It was also used to: –Determine the appropriate probability distributions to model the uncertainty within the retirement cost and inflation rate estimates –Apply Monte Carlo methodology in modeling the large number of potential combinations of the variables. Five thousand runs (5,000 simulations) were performed for each of the eight scenarios in order to generate reliable confidence intervals for the calculated outputs ARO Modeling Methodology

32 Page 32 Inflation Rate “Raw Data” GDP Implicit Price Deflators Used for Inflation Factor

33 Page 33 Statistical Fit of Inflation Rate Data GDP Implicit Price Deflators Used for Inflation Factor

34 Page 34 Retirement Cost Estimates

35 Page 35 Statistical Fit of Retirement Cost Data Results from applying retirement cost estimate distribution (triangular distribution from % to 22.78%) to the single-point estimated retirement cost

36 Page 36 ARO Modeling Methodology Scenario Name Retirement Year / Credit Adjusted Risk-Free Rate 20% Estimates From Depreciation Study 80% Estimates from Construction Mgmt. Cross Generating Station (CGS) CGG / % CGG / % Grainger Generating Station (GGS) GGS / % GGS / % Jefferies Generating Station (JGS) JGS / % JGS / % Winyah Generating Station (WGS) WGS / % WGS / %

37 Page 37 Running a scenario, or executing the model, performs the following steps: –A retirement cost is sampled from the range of possible values –The 5% bond risk premium is applied to the retirement cost sampled –An inflation rate is sampled from the range of possible values –The retirement cost is carried-forward (escalated) to a future value, based on the sampled inflation rate –The retirement cost is then discounted back to a present value based on the fixed credit adjusted risk-free rate –The result of the run is stored in software –The above steps are performed 4,999 additional times –All 5,000 results are combined to produce a range of possible outcomes, along with confidence levels, for the given scenario ARO Modeling Methodology

38 Page 38 Running a scenario, or executing the model, performs the following steps: –A retirement cost is sampled from the range of possible values –The 5% bond risk premium is applied to the retirement cost sampled –An inflation rate is sampled from the range of possible values –The retirement cost is carried-forward (escalated) to a future value, based on the sampled inflation rate –The retirement cost is then discounted back to a present value based on the fixed credit adjusted risk-free rate –The result of the run is stored in software –The above steps are performed 4,999 additional times –All 5,000 results are combined to produce a range of possible outcomes, along with confidence levels, for the given scenario ARO Modeling Methodology

39 Page 39 Running a scenario, or executing the model, performs the following steps: –A retirement cost is sampled from the range of possible values –The 5% bond risk premium is applied to the retirement cost sampled –An inflation rate is sampled from the range of possible values –The retirement cost is carried-forward (escalated) to a future value, based on the sampled inflation rate –The retirement cost is then discounted back to a present value based on the fixed credit adjusted risk-free rate –The result of the run is stored in software –The above steps are performed 4,999 additional times –All 5,000 results are combined to produce a range of possible outcomes, along with confidence levels, for the given scenario ARO Modeling Methodology

40 Page 40 Running a scenario, or executing the model, performs the following steps: –A retirement cost is sampled from the range of possible values –The 5% bond risk premium is applied to the retirement cost sampled –An inflation rate is sampled from the range of possible values –The retirement cost is carried-forward (escalated) to a future value, based on the sampled inflation rate –The retirement cost is then discounted back to a present value based on the fixed credit adjusted risk-free rate –The result of the run is stored in software –The above steps are performed 4,999 additional times –All 5,000 results are combined to produce a range of possible outcomes, along with confidence levels, for the given scenario ARO Modeling Methodology

41 Page 41 Running a scenario, or executing the model, performs the following steps: –A retirement cost is sampled from the range of possible values –The 5% bond risk premium is applied to the retirement cost sampled –An inflation rate is sampled from the range of possible values –The retirement cost is carried-forward (escalated) to a future value, based on the sampled inflation rate –The retirement cost is then discounted back to a present value based on the fixed credit adjusted risk-free rate –The result of the run is stored in software –The above steps are performed 4,999 additional times –All 5,000 results are combined to produce a range of possible outcomes, along with confidence levels, for the given scenario ARO Modeling Methodology

42 Page 42 Running a scenario, or executing the model, performs the following steps: –A retirement cost is sampled from the range of possible values –The 5% bond risk premium is applied to the retirement cost sampled –An inflation rate is sampled from the range of possible values –The retirement cost is carried-forward (escalated) to a future value, based on the sampled inflation rate –The retirement cost is then discounted back to a present value based on the fixed credit adjusted risk-free rate –The result of the run is stored in software –The above steps are performed 4,999 additional times –All 5,000 results are combined to produce a range of possible outcomes, along with confidence levels, for the given scenario ARO Modeling Methodology

43 Page 43 Running a scenario, or executing the model, performs the following steps: –A retirement cost is sampled from the range of possible values –The 5% bond risk premium is applied to the retirement cost sampled –An inflation rate is sampled from the range of possible values –The retirement cost is carried-forward (escalated) to a future value, based on the sampled inflation rate –The retirement cost is then discounted back to a present value based on the fixed credit adjusted risk-free rate –The result of the run is stored in software –The above steps are performed 4,999 additional times –All 5,000 results are combined to produce a range of possible outcomes, along with confidence levels, for the given scenario ARO Modeling Methodology

44 Page 44 Running a scenario, or executing the model, performs the following steps: –A retirement cost is sampled from the range of possible values –The 5% bond risk premium is applied to the retirement cost sampled –An inflation rate is sampled from the range of possible values –The retirement cost is carried-forward (escalated) to a future value, based on the sampled inflation rate –The retirement cost is then discounted back to a present value based on the fixed credit adjusted risk-free rate –The result of the run is stored in software –The above steps are performed 4,999 additional times –All 5,000 results are combined to produce a range of possible outcomes, along with confidence levels, for the given scenario ARO Modeling Methodology

45 Page 45 The results of each scenario are presented in the form of a cumulative probability graph showing Present Value Costs and associated levels of confidence. In accordance with a fiscally conservative approach, Santee Cooper has decided to use the Present Value Cost calculated at the 90% level of confidence. This means Santee Cooper is 90% certain that sufficient funds will exist to cover the estimated remediation cost. An funding schedule is then created for each scenario (using the Present Value Cost corresponding to 90% level of confidence). ARO Modeling Methodology

46 Page 46 The results of each scenario are presented in the form of a cumulative probability graph showing Present Value Costs and associated levels of confidence. In accordance with a fiscally conservative approach, Santee Cooper has decided to use the Present Value Cost calculated at the 90% level of confidence. This means Santee Cooper is 90% certain that sufficient funds will exist to cover the estimated remediation cost. An funding schedule is then created for each scenario (using the Present Value Cost corresponding to 90% level of confidence). ARO Modeling Methodology

47 Page 47 The results of each scenario are presented in the form of a cumulative probability graph showing Present Value Costs and associated levels of confidence. In accordance with a fiscally conservative approach, Santee Cooper has decided to use the Present Value Cost calculated at the 90% level of confidence. This means Santee Cooper is 90% certain that sufficient funds will exist to cover the estimated remediation cost. An annualized funding requirement schedule is then created for each scenario (using the Present Value Cost corresponding to 90% level of confidence) and the credit adjusted risk-free rate. ARO Modeling Methodology

48 Page 48 ARO Modeling Methodology Weights, or the probabilities of occurrence, were assigned to the two scenarios run for each station: –Scenario 1: 80% (Santee Cooper Construction Management estimates provided in December 2005) –Scenario 2: 20% (Depreciation study performed in Fall 2001) The funding schedules generated by running each of the eight scenarios are weighted at the above values (80% and 20%), and are then added to produce one funding schedule per station (for a total of four schedules). These four schedules are then added to produce a single funding schedule. This single funding schedule is the schedule for all stations.

49 Page 49 ARO Modeling Methodology Weights, or the probabilities of occurrence, were assigned to the two scenarios run for each station: –Scenario 1: 80% (Santee Cooper Construction Management estimates provided in December 2005) –Scenario 2: 20% (Depreciation study performed in Fall 2001) The funding schedules generated by running each of the eight scenarios are weighted at the above values (80% and 20%), and are then added to produce one funding schedule per station (for a total of four schedules). These four schedules are then added to produce a single funding schedule. This single funding schedule is the schedule for all stations.

50 Page 50 ARO Modeling Methodology Weights, or the probabilities of occurrence, were assigned to the two scenarios run for each station: –Scenario 1: 80% (Santee Cooper Construction Management estimates provided in December 2005) –Scenario 2: 20% (Depreciation study performed in Fall 2001) The funding schedules generated by running each of the eight scenarios are weighted at the above values (80% and 20%), and are then added to produce one funding schedule per station (for a total of four schedules). These four schedules are then added to produce a single funding schedule. This single funding schedule is the schedule for all stations.

51 Weighted Present Value Costs by Scenario ScenarioExpected PV CostProbabilityWeighted PV Cost CGS 2054$5,241,67820%$1,048,336 CGS 2059$4,858,76180%$3,887,009 JGS 2015$13,563,48220%$2,712,696 JGS 2020$12,866,61480%$10,293,291 GGS 2015$8,251,04020%$1,650,208 GGS 2016$8,175,88480%$6,540,707 WGS 2026$24,410,48220%$4,882,096 WGS 2031$22,831,41280%$18,265,130 Total1.00$49,279,473

52 Page 52 All Ash Pond Weighted Funding Requirements Summary

53 Page 53 Agenda Santee Cooper background Financial Obligation Underfunding Background Santee Cooper Asset Retirement Obligation (ARO) ARO Modeling Methodology ARO Models Concluding Thoughts Questions

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57 Page 57 Private Equity Reinvestment Rate Assumption is 85%-90% Less Than Risk Free Bond Reinvestment Rate!

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59 Page 59 Agenda Santee Cooper background Financial Obligation Underfunding Background Santee Cooper Asset Retirement Obligation (ARO) ARO Modeling Methodology ARO Models Concluding Thoughts Questions

60 Page 60 Determining present values for future financial obligations is complex and comprised of numerous uncertain variables. Organizations can and do manipulate key variables for current economic gain. Risk based simulation tools are robust methods for dealing with the above issues. Concluding Thoughts

61 Page 61 Larry Philbin ext Questions?


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