How marginal abatement turns limited capital into self-funding projects

About 10 years ago, I was working with a colleague on a project in a small municipality that was struggling with infrastructure. The local joke was that you know someone is driving drunk when they drive in a straight line. The implication was that a sober driver would be driving to avoid the multiple potholes.

During the project, we had the chance to talk to the municipal manager. He wasn’t about to fix the potholes. He was prioritising the spend on water infrastructure. In his words: “You can drive around a pothole; but you can’t drive around a water shortage.”

Instead, his big problem was that when he had asked his engineers the cost of fixing the water system, they quoted a capital cost that was many multiples of his total budget. He needed to prioritise the spend, which he saw as a management problem rather than an engineering problem.

The appropriate tool to use is called marginal abatement. It is a powerful tool that has been designed to achieve the greatest possible impact on a limited budget. This is possible because, as one accountant put it, the cost of water failure is “already on the balance sheet”.

Actually not the balance sheet. More accurately, water is budgeted for as an ongoing cost, which already includes the water wasted due to leaks and neglect. The massive cost of water loss is already part of the income and expenditure budget.

This means that in principle, the investment in infrastructure results in a lower wastage. This in turn reduces the money needed to pay for water. Over time, saving water pays for the upgraded infrastructure. The conundrum is how to do this in the most efficient way. The full infrastructure bill is too large to shell out up front.

The optimum approach is the simple marginal abatement curve. This allows the infrastructure spend to be staggered in a way that maximally starts producing returns.

For each independent infrastructure spend, two numbers are needed – the cost, or budget, on the one hand, and the expected associated saving on the other.

The investments are ranked by the intensity of the saving, that is by the associated saving divided by related cost. These are plotted as rectangles with the Budget Amount on the horizontal axis, and the Saving Intensity on the vertical. The area of the rectangle is a visual depiction of the saving itself. The investments are then cut at the total budget available.

By maximising the returns, the process becomes self-funding. And where contractors are used, it even becomes bankable.

In the corporate world, such changes are often communicated in terms of an improved customer experience. In practice they are driven by a careful calculation of the expected saving, the return on investment and the optimum use of capital.

As a case in point, a healthcare group recently announced the use of wearables for their hospital patients. Clearly this was an improved service to the patients. Equally clearly, one of the primary driving factors was the time saved for the medical staff. The capital cost of wearables, though expensive, was to be paid for through the ongoing improvement in staff utilisation.

Accountability

There are three prerequisites to getting this right.

Firstly, it is necessary to be able to link income and expenditure across an organisation. This is because the investment is made in part by operations while the savings on the bulk water budget sits somewhere else, usually in finance or procurement.

Secondly, accountability needs to be assigned. The projects need to be managed at the organisational level. The projected saving needs to be taken from the budget. The process must prove itself fundable and self-sustaining.

Thirdly, projects need their own timelines and processes. Opportunities with paybacks quicker than a year move past the capital allocation. Similarly, opportunities that are bankable can involve third party risk sharing to accelerate the delivery to the benefit of the fiscus.

Marginal abatement is a simple but powerful tool that corporates use to accelerate the benefit of complex multi-year prioritisations. Interestingly enough, in SA many managers might never have done a marginal abatement calculation.

Here, it is better known by environmentalists. In the environmental space it is a tool that was introduced into policy by the international consulting firm McKinsey. In environmental circles and the green lobby, the tool is widely used and well understood. DM

Michael Gering is a strategy consultant and has consulted in a variety of industries both in South Africa and in Europe. He has a PhD in theoretical physics and an MBA from the Open Business School in Milton Keynes.