Using an Index to Help Project Capital Costs Into the Future

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Shadi Eskaf is a Senior Project Director at the Environmental Finance Center at UNC.

Sitting at your desk very late in the afternoon, your coffee going cold, staring at a spreadsheet, crunching numbers for a Capital Improvement Plan. You’re ready to call it a day, but decide to do “just one more quick calculation” (you tell yourself). You glance over to the next cell, and you see it. It’s a simple question, but hundreds of thousands of dollars, maybe millions, hinge on it. “At what annual rate are your capital costs inflated into the future?” Do you have a good answer off the top of your head?

Not everyone uses the same method to calculate the construction costs of capital projects that are planned for the future. But in almost all cases, the costs that will be incurred during the year of construction need to be determined, even ten years from now, in order to plan for adequate rate increases and other sources of funding for the projects. Usually you can estimate what the construction costs would be if the utility began construction today – but five or ten years from now? Some may seek out price guarantees. Others have complex models that make an art form of predicting future construction costs. Most will probably estimate the costs in today’s dollars, and then do a simple projection into the future using one or more estimated/expected/predicted/calculated/guessed inflation factor (including our own free do-it-yourself Capital Improvement Planning tool). But what is that factor? How high should that rate be?

The short answer is there isn’t really one correct answer, and there are many ways to try to estimate the cost inflation factor. One of those ways is to look at established cost or price indices to get a good starting point for your estimate. There are many such indices available for your use – I describe two of the most commonly used in this scenario. The most well-known is the Consumer Price Index, which creates the “inflation” rate that we hear and read about in the news. Another option is the Construction Cost Index. But what are those indices, and what have those rates been in recent years?

The commonly-known “inflation” is really the annual rate of change of the Consumer Price Index-All Urban Consumers (CPI-U). The Consumer Price Index is compiled by the Bureau of Labor Statistics and it tracks the change in consumer prices for “a representative basket of goods and services” for urban consumers. The basket of goods and services includes a combination of food, beverages, housing, apparel, transportation, medical care, recreation, education and communication, and other goods and services (including water and sewer prices). Essentially, it tracks how much life in general is getting more (or less) expensive for an urban consumer. It has little to do with the cost of building water or sewer infrastructure.

Perhaps a better index that more specifically applies to capital infrastructure projects is the Construction Cost Index (CCI). CCI is calculated by ENR (Engineering News-Record) and tracks the change in price for a specific combination of construction labor, steel, concrete, cement and lumber using data from 20 cities across the United States. The price for this combination of construction labor and materials is probably much closer to the actual costs that your water or sewer utility may pay for its infrastructure projects, at least compared to the prices of the CPI-U’s basket of consumer goods. CCI isn’t perfect for utilities, but in tracking changes to the costs of building infrastructure, CCI is better suited than CPI-U.

The choice of CPI-U vs. CCI used to make a significant difference in future-value cost calculations, until recently. This graph reveals the annual change in both indices since 1984. Since 2002, construction costs have generally risen faster than the rate of inflation of consumer goods prices. In fact, between 2012-2016, CCI averaged 2.6%/year increase while CPI-U inflation averaged 1.3%/year. You may hear people warn that “the cost of construction and capital projects rise faster than the rate of inflation.” This is true even after the recession. CCI is still generally higher than CPI-U, and to be more conservative in your capital planning it is wise to use the higher inflation rate in order to better prepare for possible increases to construction costs.

I would caution, though, that both CPI-U and CCI can be volatile from one year to the next, even though recently CCI has stabilized close to 2.6%/year. CPI-U has risen each year by more than one percentage point a year, while CCI hit 3.0% in 2016. Predicting what will happen to these indices is difficult (ENR forecasts CCI for 12 months once a year), but by using this graph, you can come up with a reasonable and justifiable estimate of the range of inflation factors you might choose to use in your own C.I.P. You can also download the CPI-U and CCI data at USDA’s Natural Resources Conservation Service webpage to calculate your own trends. That resource is regularly being updated.

In a future blog post, we will discuss the use of inflation factors (CPI-U, CCI, and even the Municipal Cost Index) in determining annual water and sewer rate adjustments. In the meantime, please feel free to leave a comment below letting us know what capital cost inflation factor you are using, and if it is based on an index or another method to estimate that factor.

Update: This blog post and the graph were updated on March 14, 2017 to reflect more recent price index estimates and trends.