ScottishPower’s Donald Miller and Calum Storrie, and Dr Lisa Gahan from ICS Consulting explain how a new risk-based portfolio approach to investments is allowing ScottishPower to better manage its risk.
Large asset-intensive companies are accustomed to considering the benefits of individual investments, in terms of financial return and impact on asset risk. However, at ScottishPower Energy Wholesale, we have taken the next step and moved to a risk-based portfolio approach, which integrates the financial benefits and service risk-improvements into our asset investment decisions. We have also introduced a powerful optimisation approach that will allow us to undertake rapid scenario analysis on our investment portfolios.
To do this, we have worked with the investment consultancy ICS Consulting, which has a history of providing methodologies and tools to help companies answer difficult investment planning questions – particularly in the regulated utility sector where regulators require every pound of investment to be justified. Our specific challenge was to bring the same logic to risk-based investment selection without the underpinning mechanisms of regulation.
We already had an existing investment assessment framework. This considered the impact of individual investments on financial drivers, such as net present value (NPV), and on the non-financial investment drivers – that is, health and safety risk and environmental risk.
We have traditionally estimated the relative weights for the non-financial investment drivers so that all investments could be articulated and ranked against their contribution to any or all of the remaining drivers.
We then looked to manually select the mix of investments that allowed us to make sure safety and environmental risks were managed to as low a level as reasonably possible. Having spent many years developing our approach and planning tools, we were keen to build on this rather than sweep it aside. So, working with ICS Consulting, we have joined the two toolsets to give us the best fit for our business.
We wanted to move to a complete risk-based approach that allowed us to fully consider, on a consistent basis, all the benefits from individual investments and combine these into the optimal portfolio that met all of our risk, performance and financial targets. This approach gives us
the ability to articulate and quantify the key risks pre- and post-investment under differing investment scenarios – an increasingly important challenge.
Defining investment drivers
The first step in enhancing our approach was to refine our list of investment drivers. The set of drivers that had been used by the organisation for a number of years, but had known gaps in it. Following a process of business engagement, two more were included: employee welfare and stakeholder perceptions – the latter being the perceptions of the media and the local communities in which we operate (see Figure 1). These drivers are important and often have an indirect financial impact.
Each investment driver was defined in terms of quantifiable performance measures. For example, a key financial service measure is NPV. A key stakeholder perception service measure is the number of community complaints we receive. Each of the performance measures, within each driver, was defined using risk quantification to allow a consistent and defensible assessment of risk to be made for each asset and investment.
Valuing investment impacts
The second step was to ensure that we could continue to compare the investment drivers, and associated performance measures, by assessing them on the same basis – in other words, to quantify the relative weight of the investment drivers. To derive the relative weights, we used choice experiments, which are based on the principle that decisions involve choices, and are a mechanism for statistically and robustly representing the choices of decision makers. A number of scenarios are presented to individuals, via choice cards, who then pick the choice they prefer.
Our choice cards gave three options to choose between: the current budget and risk profile – the status quo; and two alternative budget and risk profiles, which could involve the same budget with risk rebalanced. For example, improved health and safety risk achieved at the expense of a worsening of environmental risk; or an increase (decrease) in the budget and commensurate improvement (deterioration) in the overall risk profile.
Choice experiments are increasingly being used by organisations to find out the priorities of customers and other stakeholders. Our business operates in a wholesale environment and is remote from its customers in the traditional sense, so instead, we asked business decision makers from Operations, Asset Management, Health, Safety & Environment and Finance, as well as our Directors.
ICS Consulting helped design the choice cards, worked with our team to ensure they understood and completed the choice cards, and then used statistical modelling to turn the survey choices into a quantitative view of the importance of the investment drivers and associated service measures – both relative to each other and in monetary terms (see Figure 2).
We were particularly keen to be able to quantify the value of changes in risk in monetary terms. This would give us a consistent view of our Willingness to Pay for service-risk improvements. Having incorporated published data from the Health and Safety Executive’s Cost Benefit Analysis checklist to calibrate Willingness to Pay for Health and Safety (H&S) risks, the relative valuations of the other drivers were found to be consistent.
The findings were in line with what we expected: H&S is the key driver of decisions in our organisation by a significant margin, representing 79 per cent of the value across the four main groupings of service measures – H&S, employee, environment and stakeholder. This outcome is the result of H&S being of particularly high value to us, rather than the other three measures being of lower value.
Optimising our investment plans
A key aspect of developing any investment plan is to ask the “what if” questions – that is, scenario analysis:
n What if we had less (or more!) to spend?
n What if the cost of our factor inputs (energy, raw materials, etc) increased?
n What if we wanted to achieve a lower level of risk?
These questions were often difficult to answer, especially within the challenging timescales of budget iteration, which left the organisation questioning the selected portfolio of investments and internal challenge post budget. This cycle in the process wasa key factor in the drive to enhance our investment selection capability.
The first stages of the project involved revisiting and improving current working methods. In contrast, introducing the capability to assess portfolios of investment was new, giving the organisation the ability to optimise the investment plan and develop powerful scenario analysis.
Our Capital Investment Planning (CIP) database is a repository to capture risks as well as the potential investments to mitigate those risks. We updated our CIP to record the new drivers and risk performance measures and then integrated it with an optimisation solution provided by ICS Consulting.
This allows us to understand:
n the portfolio of investments that allows us to meet business and external constraints (financial or risk-based) at least cost
n the portfolio of investments that provides the greatest benefit to the company, while allowing us to meet business and external constraints (see Figure 3).
As all of the impacts of investment are expressed in risk and financial terms, ScottishPower can undertake cost benefit analysis for all our investments. The solution allows us to change optimisation parameters – we can change performance constraints, acceptable risk profiles, cost of factor inputs or investment costs, or the risk mitigation of investments – and see the impact on the optimal plans. In addition, it provides a platform to develop scenario comparison analysis tools.
Benefits of the approach
The changes we have made to our approach are allowing us to better manage our risk. This, in turn, means we have more confidence that we are making the right investment decisions and targeting our investment more effectively. And that is good for ScottishPower employees,
investors and the community in which we operate.
*Additional information on the technical approach to undertaking choice card experiments and producing quantitative values for performance measures and investment drivers is given on the IAM website.
Donald Miller is formerly of Energy Wholesale Asset Management and is currently working for H&S within ScottishPower’s corporate team.
Calum Storrie is an Analyst in the Asset Management Section of ScottishPower.
Dr Lisa Gahan is a partner with ICS Consulting.