Page 1 Risk-Based Modeling Approaches for Determining Current Liability for Future Asset Retirement...

Risk-Based Modeling Approaches for Determining

Current Liability for Future Asset Retirement Obligations

The 2006 Palisade User Conference: Americas

Miami, Florida

Larry Philbin, Principal EngineerSantee Cooper - Quality & Performance Support

November 13, 2006

Agenda

• Santee Cooper background • Financial Obligation Underfunding Background• Santee Cooper Asset Retirement Obligation (ARO)• ARO Modeling Methodology• Example @Risk ARO Models• Concluding Thoughts• Questions

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

Our Electricity Source - Energy Supply (2005)

Coal 73.9%

Purchases & Net Interchanges 6.1%

Hydro 1.9%

Nuclear 9.7%

Oil & Gas 8.4%

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

Agenda


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, 2005

• 2006: Public Pension Funds Survey2:– one-quarter had actuarial funding ratios below 80%– shortfall approaches one trillion for all public systems

•1 http://www.pbgc.gov/media/news-archive/ExecutiveTestimony/tm1166.html, retrieved 10/31/2006.•2 E.J. mcMahon. “Public Pension Price Tag.” The Wall Street Journal, 21 August 2006


• 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


• 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 Retrieved11/01/2006http://www.hooverdigest.org/053/healey.html>

• Currently, 53 utility companies have nuclear plants. It will cost $33 billion to decommission them. <Federal Accounting Standards Board (FASB) March 2000>

• 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.



• 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

<Patterson, Susan (1996). Revised Draft Report on Analysis of Cost Estimates for Closure and Post-Closure Care. U.S. Environmental Protection Agency-Headquarters Office of Solid Waste, 5-6>

<Patterson, Susan (1996). Revised Draft Report on Analysis of Cost Estimates for Closure and Post-Closure Care. U.S. Environmental Protection Agency-Headquarters Office of Solid Waste, 6>

• 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.



• 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

<EPA Introduction to RCRA Financial Assurance (40 CFR Parts 264/265, Subpart H)>

Agenda


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.

<http://www.tfhrc.gov/hnr20/recycle/waste/cfa51.htm>

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.

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 rate4. Credit adjusted risk-free reinvestment interest rate5. Market risk (reflects the uncertainty of future bond initiation and

funding costs-5% is used in this analysis)


Agenda


ARO Modeling Methodology

• An Excel model was created to compute a single funding schedule for Santee Cooper’s total ash pond ARO1. 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.

• 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

• The @Risk 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.


• 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

• The @Risk 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


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

<U.S. Department of Commerce: Bureau of Economic Analysis>

-0.04000

-0.02000

0.00000

0.02000

0.04000

0.06000

0.08000

0.10000

0.12000

19

48

19

51

19

54

19

57

19

60

19

63

19

66

19

69

19

72

19

75

19

78

19

81

19

84

19

87

19

90

19

93

19

96

19

99

20

02

20

05

Yea

r to

Yea

r C

han

ge

Rat

io

Extreme Value DistributionX <= 0.080643

95.0%X <= 0.0021386

5.0%

0

5

10

15

20

25

-0.04 -0.02 0 0.02 0.04 0.06 0.08 0.1 0.12

Year to Year Ratio Changes

Fre

qu

ency

%

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

<U.S. Department of Commerce: Bureau of Economic Analysis>

Construction Cost Estimators <McCabe, Brenda."Monte Carlo Simulation for Schedule Risks"

Proceedings of the 2003 Winter Simulation Conference, (2002): 1561-1565.>

Changes to Most Likely (ML) Duration from Panel of Experts:

Activity Optimistic Pessimistic

Mobilization/Demobilization -15.00% 5.00%

Foundation/Piling -15.00% 20.00%

Demolition -5.00% 40.00%

Labor Intensive -10.00% 30.00%

Equipment Intensive -5.00% 30.00%Roof/External -15.00% 30.00%Mech/Elect/Plumbing -10.00% 30.00%

Commissioning -15.00% 5.00%

SCPSA General Construction: -5.00% 15.00%

Avg.: -10.56% 22.78%

Retirement Cost Estimates

Statistical Fit of Retirement Cost DataResults from applying retirement cost estimate distribution (triangular distribution from -10.56% to 22.78%)

to the single-point estimated retirement cost

Triangular Distribution

X <= 72474475.0%

X <= 902531895.0%

0

1

2

3

4

5

6

7

8

9

6.5 7 7.5 8 8.5 9 9.5 10

$ Cost in Millions

Fre

qu

ency

%


Scenario Name

Retirement Year / Credit Adjusted Risk-Free Rate

20% - 2001 Estimates

From Depreciation Study

80% - 2005 Estimates

from Construction Mgmt.

Cross Generating Station (CGS)

CGG 2054

2054 / 5.5988%

CGG 2059

2059 / 5.6524%

Grainger Generating Station (GGS)

GGS 2015

2015 / 5.1989%

GGS 2016

2016 / 5.2088%

Jefferies Generating Station (JGS)

JGS 2015

2015 / 5.1979%

JGS 2020

2020 / 5.2648%

Winyah Generating Station (WGS)

WGS 2026

2026 / 5.3495%

WGS 2031

2031 / 5.4450%

• 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 the @Risk 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


• 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).


• 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.



• 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.

Weighted Present Value Costs by Scenario

Scenario Expected PV Cost Probability Weighted PV Cost

CGS 2054 $5,241,678 20% $1,048,336

CGS 2059 $4,858,761 80% $3,887,009

JGS 2015 $13,563,482 20% $2,712,696

JGS 2020 $12,866,614 80% $10,293,291

GGS 2015 $8,251,040 20% $1,650,208

GGS 2016 $8,175,884 80% $6,540,707

WGS 2026 $24,410,482 20% $4,882,096

WGS 2031 $22,831,412 80% $18,265,130

Total 1.00 $49,279,473

All Ash Pond Weighted Funding Requirements Summary

Year Beg. Balance Annual Pmts. Escalation Ending Balance Year Beg. Balance Annual Pmts. Escalation Ending Balance2005 $49,279,473 2039 $30,185,745 $0 $1,702,827 $31,888,5732006 $49,279,473 $0 $2,643,517 $51,922,990 2040 $31,888,573 $0 $1,798,888 $33,687,4612007 $51,922,990 $0 $2,785,412 $54,708,402 2041 $33,687,461 $0 $1,900,368 $35,587,8292008 $54,708,402 $0 $2,934,929 $57,643,331 2042 $35,587,829 $0 $2,007,573 $37,595,4012009 $57,643,331 $0 $3,092,476 $60,735,807 2043 $37,595,401 $0 $2,120,825 $39,716,2262010 $60,735,807 $0 $3,258,486 $63,994,292 2044 $39,716,226 $0 $2,240,466 $41,956,6932011 $63,994,292 $0 $3,433,413 $67,427,705 2045 $41,956,693 $0 $2,366,857 $44,323,5502012 $67,427,705 $0 $3,617,737 $71,045,442 2046 $44,323,550 $0 $2,500,378 $46,823,9282013 $71,045,442 $0 $3,811,962 $74,857,404 2047 $46,823,928 $0 $2,641,431 $49,465,3602014 $74,857,404 $0 $4,016,621 $78,874,025 2048 $49,465,360 $0 $2,790,442 $52,255,8022015 $78,874,025 $0 $4,232,276 $83,106,301 2049 $52,255,802 $0 $2,947,859 $55,203,6612016 $75,864,243 $10,867,893 $3,516,967 $68,513,316 2050 $55,203,661 $0 $3,114,156 $58,317,8172017 $68,513,316 $0 $3,707,359 $72,220,676 2051 $58,317,817 $0 $3,289,835 $61,607,6522018 $72,220,676 $0 $3,908,064 $76,128,740 2052 $61,607,652 $0 $3,475,425 $65,083,0772019 $76,128,740 $0 $4,119,640 $80,248,380 2053 $65,083,077 $0 $3,671,484 $68,754,5612020 $80,248,380 $21,111,478 $3,231,198 $62,368,100 2054 $68,754,561 $0 $3,878,604 $72,633,1652021 $62,368,100 $0 $3,407,797 $65,775,896 2055 $57,504,854 $0 $3,250,404 $60,755,2582022 $65,775,896 $0 $3,594,050 $69,369,946 2056 $60,755,258 $0 $3,434,130 $64,189,3882023 $69,369,946 $0 $3,790,486 $73,160,432 2057 $64,189,388 $0 $3,628,241 $67,817,6292024 $73,160,432 $0 $3,997,661 $77,158,094 2058 $67,817,629 $0 $3,833,324 $71,650,9532025 $77,158,094 $0 $4,216,164 $81,374,257 2059 $71,650,953 $71,650,953 $0 $02026 $81,374,257 $0 $4,446,612 $85,820,8692027 $71,236,475 $0 $3,909,467 $75,145,9422028 $75,145,942 $0 $4,124,067 $79,270,0092029 $79,270,009 $0 $4,350,449 $83,620,4582030 $83,620,458 $0 $4,589,261 $88,209,7192031 $88,209,719 $68,749,974 $1,097,749 $20,557,4942032 $20,557,494 $0 $1,159,675 $21,717,1702033 $21,717,170 $0 $1,225,095 $22,942,2652034 $22,942,265 $0 $1,294,206 $24,236,4712035 $24,236,471 $0 $1,367,215 $25,603,6852036 $25,603,685 $0 $1,444,342 $27,048,0282037 $27,048,028 $0 $1,525,821 $28,573,8492038 $28,573,849 $0 $1,611,896 $30,185,745

Agenda


Regression Sensitivity for PV Capital/B13

Std b Coefficients

Market Risk Premium/B11 .009

Closure Capital $:/A5 .111

Reinvestment Rate:/A11-.638

Inflation Factor: / Most L.../B8 .681

-1 -0.75 -0.5 -0.25 0 0.25 0.5 0.75 1

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

Regression Sensitivity for PV Capital/B13

Std b Coefficients

Closure Capital $:/A5 .095

Inflation Factor: / Most L.../B8 .497

Reinvestment Rate:/A11-.739

-1 -0.75 -0.5 -0.25 0 0.25 0.5 0.75 1

Agenda


• 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

Larry Philbin

843-761-8000 ext. 4634

[email protected]

Questions?

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