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long term infrastructure risk management: problems in the use of the net present value criterion

Long term infrastructure risk management: problems in the use of the net present value criterion
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Wi jnia, Y.C.; P.M. Herder; M. Korn; E. Veldman and M. Poorts: Long term infrastructure risk management: problems in the use of the net present value criterion, pp. 1747-1759. In: Proceedings of the 3rd World Congress on Engineering Asset Management and Intelligent Maintenance Systems (WCEAM-IMS 2008), 28-30 Oct. (2008). At: Beijing, China. London: Springer-Verlag, 2008. Eds.: Gao Jinji; Jay Lee; Jun Ni; Lin Ma and Joseph Mathew. ISBN: 978-1-84882-216-0. International Proceedings (refereed)

Paulien Herder
Ype Wijnia

One of the problems in the management of infrastructures is the replacement of the constituting components because of old age. Replacement is very costly, however, not replacing them but running them until failure can be very risky. In determining the optimal replacement moment two major problems exist. The first is how to compare the costs of replacement with the non financial risk. The simplest way around this is treating the non-financials as a financial risk by monetizing the effects. The second problem is the method to use to calculate the optimum. For financial optimization a net present value approach is best used. However, using the NPV criterion for alternatives with differences in duration is not straightforward, the present values should be translated into equivalent annual costs. For replacement decisions the duration of the alternatives is not known exactly, which presents some extra challenges. A potential resolution is using a very long period, in which multiple replacements take place. But how do you know what the asset will be replaced with in a couple of 100s of years? Therefore, a much simpler method for optimization is the marginal approach. This means comparing the risk of failure with the cost of advancing the replacement one year. If a parameterized failure model is used, this moment can even be determined analytically. In theory, this should yield exactly the same outcome as the NPV approach. Surprisingly, if this moment is applied on a population of infrastructure assets, one typically finds that this does not result in the lowest NPV for the population. Analysis of this anomaly showed that this appears in case the life expectancy of the assets is long relative to the interest rate, because the present value of the risk then only builds after what is generally accepted as a reasonable cut-off point for the NPV calculation. Therefore, for long term risk management decisions one should be careful not to rely on the NPV criterion but to use the marginal approach instead.

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