Avista to Generate 10% of Capacity from Renewable Sources

Case Type: operations strategy.
Consulting Firm: Siemens Management Consulting (SMC) 2nd round full time job interview.
Industry Coverage: utilities; energy industry.

Case Interview Question #00950: Our client Avista Utilities (NYSE: AVA) is the sole electrical utility provider in the state of Washington. The company was founded in 1889 as Washington Water Power Company, until the board of directors approved a name change to Avista Corporation 1999. It is headquartered in Spokane, Washington.

The client Avista Utilities’ business is regulated by the Washington state government, which allows it to earn a maximum of 10% of assets as income. Our client’s capacity is 1 million megawatt hours (MWH) per year. The government recently mandated that our client generate 10% of its annual capacity from renewable energy sources. The company has two options: (1) buy green credits from a 3rd party and (2) set up a wind farm.

What should our client do?

Possible Answer:

1. Economics of each option

Behind the scenes: Let the interviewee come up with a framework, which should emphasize evaluation of costs/benefits for each option. Competition or market issues should not be relevant since the client is a heavily regulated monopoly. Ideally, the framework should address internal capabilities.

Example starting framework:

The interviewer should suggest focusing on costs for this first part of the case; ask the interviewee what they would like to know about costs.

Interviewer: What would you want to know to analyze the options?

Candidate:

Set up Wind Farm
* Cost of building wind farms ($2,000 per MWH)
* Life of wind farm (30 years)
* Maintenance cost (assume $0 for simplicity)

Buy Green Credits
* Cost of credits ($20 per MWH)
* Change in credit costs over time (price has increased from $5/MWH two years ago)

Interviewer: For each option, could you figure out how much it would cost the client a year to fulfill the government’s mandate? (Note – ideally candidate will pro-actively volunteer to go in this direction)

Candidate:

Renewable energy source requirement is 10% –> either purchase green credits for 100,000 MWH or build a wind farm with that capacity.

(1) Buy green credit: 100,000 MWH * $20/MWH = $2M per year
(2) Build wind farm: 100,000 MWH * $2,000/MWH / 30 years = $6.7M per year (assuming straight-line depreciation)

Interviewer: Assume the cost of implementing either option is absorbed entirely by the consumers through utility rate hikes. If the client buys green credits, utility rate charged to the consumers will be increased from $0.10 to $0.11.

What could we expect the rate to be if the client were to set up a wind farm?

Candidate:

For green credit purchase, $2M in cost translates into a 10% increase in utility rate.

The wind farm costs $6.7M –> the increased utility rate would be ($6.7M / $2M) * 10% * $0.10 + $0.10 = $0.133

Interviewer: Can you comment on profitability implications of each option?

Candidate: Under option #1, which is to purchase the green credits, we know that all costs would be absorbed by the consumers so profitability would be unchanged. This is certainly true for option #2 building a wind farm as well, but what’s interesting is that our asset base has increased due to the capital investment for the wind farm. This would lead to a bigger allowance for income earned (the client earns a maximum of 10% of its assets as income).

2. Qualitative Assessment

Behind the scenes: This section of the case focuses on qualitative benefit/risk profiles of each option. It would be great if the interviewee suggests going down this path, but it’s fine to ask the question directly as well. Ideally, this part of the case interview would include internal capability factors, green factors, and governmental view.

Interviewer: What do you think are the most important pros and cons of each option?

Candidate:

Interviewer: What might the government not like about building a wind farm?

Candidate:

Although it is green, it results in a higher rate hike (government officials who are under political pressure may not like this). On top of that, being able to earn more income now that total assets are bigger, the client may push to sell more electricity, which may conflict with the government’s goal of limiting energy consumption.

3. Wrap-up

Behind the scenes: The ideal answer is a hybrid model. However, it is fine to pick either option as long as the interviewee gives compelling reasons.

Interviewer: So, what would you recommend?

Candidate:

(1) A hybrid model: Look into buying green credits to fulfill the requirement in the short term and investigate the possibility of building a wind farm.
* This is superior because the company has an option of switching to the wind farm if credit price goes up.
* The client company can buy time to develop internal capability to build a wind farm.

(2) Set up a wind farm
* Sustainability is increasingly becoming an important issue so risk of regulation being reversed is very small.
* More environmentally friendly and will generate positive PR.
* Could be used to make existing operation more efficiently (i.e., add capacity during peak hours) to mitigate effect of higher rate hike.