STOP PROCRASTINATING! NPV IS DEAD: USE RISK AS A KEY DECISION PARAMETER.
Aug 19th, 2009
We have taken a case study from our day to day practice. We presented it to show:
a) how to Use Risk as a Key Decision Parameter and
b) how the commonly used Net Present Value (NPV), can create distortions and biases when analyzing reclamation (or other) alternatives.
The case study looks at Long Term Pumping v.s. Encapsulation of a very large, leaching, underground storage of a toxic water soluble compound. There is potential to leach into the water table. To prevent leaching a pumping system is installed in the Status Quo. The permanent pumping system keeps the underground water level below the storage’s bottom. Water percolates from the surface, leading to the need to treat the leachate. Others assessed presently negligible risk to the ecosystem and human health. Tab;e 1 summarizes the “financial parameters” and risks linked to maintaining the Status Quo (in Million $, noted M).
Cause/Hazard for Status Quo alternative Probability Cost M$
Capital investment necessary at start on the treatment plant 90% 5
Energy cost (diesel for power plant) has a yearly chance of 30% to double
Climate changes has a yearly chance of 15% to triple
Table 1. “Financial parameters” of the Status Quo alternative.
The alternative to the Status Quo would be a Rehabilitation of the site. That is Encapsulation of the underground storage following a procedure not within the scope of this paper. The encapsulation would require a large capital investment (120M$), but afterwards would considerably reduce the permanent pumping and treatment.
Cause/Hazard for Encapsulation alternative Probability Cost M$
Capital investment chance to double (additional 120M) 10% 120
Energy cost (diesel for power plant) has a yearly chance 30% to double
Climate changes can force to pump like today despite the
encapsulation work, with a chance of 5% 3.6
Table 2. “Financial parameters” of the Ecapsulation alternative.
As this encapsulation constitutes a “first in the world,” a Risk Assessment has been performed which has shown that there is a significant likelihood (10%) that the encapsulation may cost twice as foreseen. Table 2 summarizes the “financial parameters” and risks linked to building and maintaining the Rehabilitation (in Million $, noted M).
Finally, because of uncertainties (construction, long term climate change, etc.) there is also a probability that after developing the encapsulation as above (i.e. with the 10% likelihood it may cost twice the initially foreseen amount), it may be necessary to maintain pumping as in the Status Quo. This means that despite investing in the encapsulation the project would still not work properly. That is a failed rehabilitation case or worst case scenario.
Traditional NPV Analysis
Let’s use a Rate of Return of 9% for this analysis and consider a life duration of forty years. The NPV show negative signs because the project generates only expenses and no profits.
Rehabilitation: 120M$ construction, then 0.3M$/yr, 40 years life span NPV: -123.23M$
Status Quo: 3.6M$/yr, 40 years life span NPV: -42.33M$
This case study is particularly strong in building an argument against using NPV. That is because most of the Rehabilitation expenditure is upfront, and the yearly costs (as traditionally done, without the risks) are small. Meanwhile the duration is very long. In this case the NPV almost “nullifies” any expense coming after approximately 20 years.
We can infer by this simple analysis that the Status Quo has by far a better NPV value than the Rehabilitation.
We will show later that this a wrong conclusion because of the long life of the project. Additionally risks need to be included. Indeed, there are two ways we could alter such an analysis to include risks. One would be to include yearly risks as additional costs. The other would be to increase the rate of discount to “include uncertainties”. However, both these attempts would fail to yield pertinent results. The NPV would strongly indicate the Status Quo as the most viable among the two alternatives.
Suppressing NPV and Use Risk as a Key Decision Parameter
We can use innovative approaches which eliminate the pitfalls of NPV at preliminary design level (Oboni and Oboni 2007, 2008; Oboni 1999-2000, 2005). Indeed, CDA/ESM compares alternatives by evaluating: a) life’s cycle balance encompassing internal and external risks over a selected duration and b) project implementation and demobilization costs and risks.
Figure 1 displays CDA/ESM (average and spread) cumulative cost results at the 40 year time horizon for Status Quo (-295M), Rehabilitation (-140M), and the Failed Rehabilitation (-405M) case. In fact, the Status Quo alternative will cost cumulatively twice as much as the Rehabilitation. That is because of the risks afflicting each alternative, such as the possible increase in energy costs, which were included in this analysis (see Tables 1 & 2).
If, for the sake of comparison, risks are now introduced in the NPV evaluations as described in the prior section it appears that the Rehabilitation CDA (average) result is roughly equal to the NPV with risks and not far from the traditional “riskless” NPV.
Figure 1. For each analysis: min, max, average of the cumulative cost at forty years
This happens because the initial amount spent is very large compared to the yearly spending which seems, indeed, negligible. However, the NPVs of the Status Quo with (-90.2M) and without risks (-42.3M) are lower than the Rehabilitation’s one (-139M). This blatant contradiction between CDA/ESM and NPVs confirms that NPV evaluations are plain inadequate when integrating alternatives’ specific risks in the comparison process (see link in references) because their “discounted nature” annihilates the effects of long term expenditures, and makes it essentially impossible to consider risks in a proper way.
A Cases Study taken from our day to day practice has been presented to show that risks should be used as a discriminant parameter from the beginning of any project for successful long term planning and to manage rational decisions.
At the preliminary design level we showed that the use of innovative approaches eliminates the pitfalls of NPV, an obsolete financial concept still used by many. The evaluation of a project should of course include the annual risks potentially afflicting the project, construction risks, and risks of malfunctioning, and possibly also the demolition/reclamation costs. We have showed that the NPV can lead to erroneous conclusions in terms of the overall cost of a project, in particular for very long term projects. Because of this the NPV is particularly dangerous when dealing with long term environmental rehabilitations/reclamations.
We call the tool necessary to avoid the NPV pitfalls CDA/ESM. As a matter of fact, it compares alternatives in financial terms, including: a) life’s cycle balance encompassing internal and external risks over a selected duration and b) project implementation and demobilization costs and risks.
To date we have applied CDA/ESM to rope v.s. road transportation, surface v.s. underground solutions, water treatments alternatives, transportation networks, go/no-go decisions.
F. Oboni. 1999-2000. Risk/Crisis Management Systems Design, University of British Columbia
F. Oboni. 2005. Do Risk Assessments Really Add Value To Projects?. CIM, Ottawa
F. Oboni and C. Oboni. 2007. “Improving Sustainability through Reasonable Risk and Crisis Management”. ISBN 978-0-9784462-0-8
F. Oboni and C. Oboni. 2008. Oboni, Risk and Decision Making. www.edumine.com
Answers Corporation. 2009. Net Presetn Value Common Pitfalls
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Category: Consequences, Hazard, Mitigations, Probabilities, Risk analysis, Risk management, Tolerance/Acceptability