Success in Deregulated Markets: The Multi-Utilities Business Model

A paradigm shift in the utilities industry has been underway for some time
now. For decades the industry was characterized by regional and national monopolies,
state ownership, price regulation and long-term price agreements. However, an
even stronger wave of deregulation and privatization is sweeping national utilities
markets. It started in the United Kingdom in the early 1980s, resumed in the
European Union in the mid- to late-1990s, and is now gaining momentum in Central
and Eastern Europe, South America, the United States and beyond.

The traditional business model has been put to test. Is the functionally fully-integrated
utility still the role model for success, or is it a leftover from the past?
This question is reinforced by the capital markets, where most fund managers
believe it is their own prerogative to allocate their capital resources on the
different value chain levels — the capital markets’ bias for “pure plays.”
The allegations against vertically integrated utilities are manyfold. They range
from ignorance of one’s core competencies to internal cross-subsidies between
the different levels of the value chain and a tendency towards ad hoc strategic
decision-making. Electricity companies that have disintegrated are, on average,
enjoying higher market ratings than “vertical integrators.” Radical choice has
therefore become the mode du jour.

While functional specialization has indeed become a widespread phenomena of
the utilities scene, a different approach is needed. It makes sound business
sense for large players to have all of these activities along the value chain.

The Internal Market Place

Over the last 100 years, RWE has developed from an electricity company in the
Ruhr area to one of Europe’s leading power companies. Its sales volume of 212
TWh represents about 10 percent of overall European Union consumption. RWE operates
generation plants with an overall generation capacity of 36 GW. Its transmission
and distribution network with a length of 375,000 km in Germany is the turntable
for the growing volume of electricity traded both nationally and across borders.
During the past decades, the high cash flow from regulated electricity business
was partly invested outside the industry. So RWE, like other major electricity
companies, operates in a vast array of activities, including construction and
mechanical engineering.

Due to deregulation in 1998, the company has undergone a strategic re-alignment
(Figure 1). The challenges of the Europe-wide opening of electricity markets
made it necessary to concentrate financial and managerial resources. At the
center of the current strategy is the differentiation between the core business
and financial holdings, like construction and printing machines. The core business
is energy and environment. In electricity — the largest portfolio segment
— operations on the individual levels of the value chain were transferred
into individual legal and operational companies.

Figure 1 – The New RWE: Clear Function – Competitive Units

While this satisfies the E.U. electricity market directive of 1996 requiring
unbundling, it is also the basis for a far-reaching re-engineering of the complete
production process.

Cost efficiency on every level of the value chain is crucial. Consequently,
the wholesale electricity market provides the benchmark for transfer prices
between the different levels of the value chain as the electricity travels from
the generation plant to the consumer. Applying this principle virtually eliminates
cross-subsidies between different levels. Because management’s incentives include
a leveraged performance-based compensation scheme, they have no inclination
to accept anything other than the going market rate.
The new corporate structure is conducive to the quality of overall strategic
decision-making. In today’s volatile market environment, vertically integrated
utilities lack the capacities to adequately appraise the strategic challenge
on each value chain level. In the new corporate structure, management now specializes
in a narrower field of activities and on its specific market environment. In
generation, for example, the choice of the right generation technology —
gas-fired or coal-fired combined cycle gas turbine — is becoming more important
as input prices of the energies, as well as output prices, are highly volatile.
Another issue is distributed generation (fuel cells, micro turbines) and their
possible impact on conventional centralized generation.

Transmission and distribution companies are increasingly being challenged by
regulators to decrease transmission fees. Keeping good relations with regulators
and lobbying for a framework with adequate incentives for preserving a reliable
network while offering competitive transmission fees are the top priorities
for management. In the supply business, marketing is becoming ever more important
in order to preserve the customer base while attracting new clients.

Power trading is the fastest growing segment in the electricity value chain.
The German wholesale market has a volume of nearly 550 TWh, more than 10 times
that of four years ago. This activity commands management’s full attention.
The extreme price spikes in the United States during 1998, 1999 and 2000 have
demonstrated the risks of this business. RWE Trading is the group’s integrated
energy trader, active in electricity, gas, coal and crude oil, both in physical
and derivatives products. In electricity, RWE Trading commands a position among
the top three European energy traders. The unique advantage of the integrated
approach is the competence synergies between trading in different fuels, which
gives rise to innovative products, such as a contract on the spark spread between
coal and electricity. Trading in weather derivatives and carbon are possible
activities with considerable benefits for mitigating risks.

A stringent process of profit appraisal on the basis of specific costs of capital
gives a guideline for capital allocation between different projects and different
value chain levels.

Separation Yes, but Spin-off No

Separating a traditional vertically integrated utility into different enterprises
with a focus on a specific area of competence can have some very positive effects.
Spinning off entire value chain levels into separately quoted companies is unlikely
to have much benefit for several reasons:
• Risk and return dynamics differ significantly between power generation,
T&D, trading and supply/retail. Therefore it makes good business sense to have
these activities in one corporate group. Earnings are more stable, which is
positive for shareholders.

• The degrees and methods of market liberalization differ between countries
which results in a diverse international landscape of electricity markets. In
Hungary, for example, the state owns and operates the transmission grid, whereas
on the distribution and generation side, there are numerous private companies.
Another example is the United States, where eventually, companies focusing purely
on transmission may emerge from the current process to restructure the nation’s
transmission system. A group that has proven competencies in all segments of
the electricity value chain has more opportunities for profitable international
growth than, for example, a pure generating company or a pure transmission company.

• Operational synergies between value chain levels are easier to identify
and to realize within one group rather than between different companies.

Successful electricity companies will feature operational excellence and cost
efficiency in all of their activities. They will have transparent structures
with well-defined competencies and comprehensive methods of capital allocation
between the different levels of the electricity value chain.

The Multi-Utilities Concept

However, RWE is far more than a pure electricity play. Our core businesses
are energy and the environment based on the four utilities electricity, gas,
water and waste-management (Figure 2). RWE is in a unique position to realize
competence synergies, revenue synergies and the benefits of risk diversification.

 

Figure
2 – Focusing on Energy and the Environment

There is a significant overlap in customer groups between these four utility
products — ranging from large industrial clients to municipalities and
private households. A most recent example of these competence synergies in action
is given by the acquisition of Dutch gas distribution companies Intergas and
Obragas, which were previously owned by Dutch municipalities. RWE, due to its
long business relations with German municipalities in electricity distribution
and a track record as their partner, was able to convince the owners in the
Netherlands of its reliability as a good corporate citizen and of its long-term
perspective as an investor.

Another example is the Rheinpapier project, where we offered an industrial customer
a full utility package that significantly reduced the investment costs for our
partner.1 The company will build one of the most modern and technically advanced
paper factories in the world near Cologne to produce more than 285,000 tons
of paper designed for newspaper. RWE Plus will provide electricity as well as
steam to power the facility. RWE Umwelt, our waste-management division, will
supply Rheinpapier with all waste management and recycling services, a challenging
and demanding task in the environment of a paper production plant. RWE will
be responsible for the facility’s wastewater disposal. Finally RWE Rheinbraun
provided the site for the factory. RWE’s competence as the leading German and
European electricity company to supply large industrial clients with power and
heat is also a competitive advantage in the marketing of other utility services.
In order to better address the specific needs of large industrial key accounts,
RWE Solutions will be responsible within the group for developing integrated
utility products comprising not only power, gas, water, waste management but
also the complete management and maintenance of the utility infrastructure on
large industrial production sites. This ultimately represents a new quality
of outsourcing, because industrial clients eventually entrust RWE with the responsibility
for integral elements within their own production process.

Finally, the acquisition of the United Kingdom’s Thames Water — the world’s
third-largest water supply and wastewater disposal firm — in November 2000
has significantly broadened RWE’s international presence. Thames Water operates
on a worldwide scale, and together with already existing water activities of
RWE in Berlin and in Budapest, supplies about 43 million people (Figure 3).
Thames Water’s undisputed experience in international project development, as
well as its contacts to governments and local authorities, will significantly
contribute to the group’s overall development skills. As far as competence is
concerned, one should not forget that for all utility services, the maintenance
of good relations with regulatory bodies is another key success factor.

Figure 3 – Thames Water International Portfolio Today

Revenue synergies are obviously another potential advantage of the multi-utilities
concept, but heed these words of caution. It is important to clarify what is
meant by the use of the term “multi-utilities.” This concept has been proposed
as a means to escape the “commodity trap” of deregulated utilities markets,
where product diversification (and therefore price differentiation) is virtually
impossible. Its aim is to leverage the existing customer base by cross-selling
different products to the same customers.
This has been demonstrated in other industries, like the financial services,
for example. It’s important that the advantages of convenience are communicated
to private and industrial customers alike. For example, having a single monthly
bill for multiple services is certainly one aspect. What is more important,
however, is that the overall price for a bundle of different utilities must
not be higher than the sum of the individual prices. In contrast, customers
expect a multi-utilities company to pass on any savings that arise out of cross-selling.
As a consequence, cost-cutting remains the top priority. RWE is committed to
reducing costs in the energy and environmental divisions by 2.5 billion Euros
until 2004. For the time being, achieving and increasing stand-alone competitiveness
in each of the four utilities — electricity, gas, water, and waste management
— is a precondition for successful cross-selling.

RWE also feels that a portfolio of assets and activities in electricity, gas,
water and waste management significantly reduces risks. The water division features
a high and stable cash flow, thus contributing to an overall stabilization of
corporate earnings, whereas earnings in electricity and gas are going to fluctuate
more widely due to deregulation. Also, water is a growth business in both highly
developed economies and in high-growth emerging economies. The accessible market
for private companies is expected to increase from $80 billion in 1999 to $375
billion in 2010. RWE feels that together with Thames Water it can significantly
expand its international revenues, which presently has a share in the core businesses
electricity, gas, water and waste management of about 24 percent. Through this,
the dependence on the German home market will be significantly reduced.

In September 2001, RWE implemented this strategy, taking another significant
step to increase its presence in the U.S. utility markets. The group has tendered
an offer to acquire all shares of American Water Works, the leading private
U.S. water company serving about 11 million people. RWE shares the ambitious
growth strategy of American Water Works and supports its goal to become a successful
consolidator in the highly fragmented U.S. water market.

Going International:
An Essential Requisite for Future Growth

Germany is not known for radical reform steps. Yet, international observers
are beginning to appreciate the bold measures Germany has taken to open up electricity
and gas markets for competition. The new German energy law, which came into
effect in 1998, commanded a full-blown market opening for all customers regardless
of their size and electricity and gas consumption. Nearly all other countries
in Europe (and elsewhere, i.e. the United States) have opted for a piecemeal
approach — starting deregulation for the large consumers first and only
gradually giving small customers, such as private households, the choice of
competing suppliers. Also, no arrangements were taken to recover costs of stranded
investments. Due to significant over-capacity in generation of about 10,000
MW, prices in all segments of the market came under severe pressure and customers
saved about 7.5 billion euros on their electricity bills — about 15 percent.

Energy policy is high on the political agenda. However, the emphasis of the
major guidelines of energy policy has shifted to environmental compatibility,
with economic efficiency having secondary importance. Although the opening of
energy markets of 1998 can’t be undone, important parts of the market have been
excluded from competition, imposing a climate protection strategy and favoring
renewable energies.

The cornerstones of this strategy are the promotion of renewable energies and
of CHP, resulting in subsidies of about 2 billion euros per year. These subsidies
have to be borne by electricity companies and their customers. It is very difficult
to offset these burdens through additional domestic growth, because the German
market is expected to expand by one percent annually at best. Also the Federal
Cartel Office, Germany’s anti-trust watchdog, is critical of further acquisitions
by large players, which would have helped them to save costs.

Highly competitive markets, together with a tough political and anti-trust environment
in Germany, are more than enough reason to look for sources of stronger growth
abroad. Europe, including the European Union accession economies of Central
and Eastern Europe, and North America are RWE’s primary markets. Opportunities
for mergers and acquisitions are assessed using a multi-stage filter process
which includes market size and growth potential, regulatory environment, and
overall economic performance indicators. In several Central European economies,
particularly Hungary, RWE has achieved significant positions in electricity,
gas, and water. However, as is commonly the case regardless of location, these
economies are not without risks. Investors should have a blueprint to pull out
of a market in which property rights are not adequately enforceable once performance
indicators have reached critical levels.

However, regulatory deficiencies are by no means the only topic in emerging
economies. Inadequate regulations are also frequently found in industrialized
countries. The U.S. Public Utilities Holding Company Act, for example, is a
case in point. This law came into being in the 1930s to protect consumers from
improper behavior of intransparent interstate utility conglomerates. As a consequence,
domestic and foreign investors in the U.S. utility industry even today have
to submit themselves to severe restrictions of their investment decisions, of
their scope of business and generally have to follow cumbersome SEC reporting
procedures. There is growing consensus that the PUHCA goals today can be served
better with the general legal framework of competition policy and securities
laws. PUHCA has to be regarded as a significant impediment for foreign direct
investment in the U.S. energy markets — an impediment that U.S. utilities
do not have to deal with in foreign markets. Foreign investors in the U.S. gas
and power industries can only evade a registration under PUHCA if they confine
themselves to the non-regulated businesses, such as power generation and wholesale
trading. PUHCA also demands that utility companies must not have a significant
business other than electricity and gas, thus preventing the development of
true multi- utilities companies that at the same time could also offer water
and other utility services.

Conclusion

The deregulation of the world’s utilities markets is far from being fully implemented.
Some regions and countries are only just starting to open up their markets,
which gives them the unique opportunity to learn from other countries’ successes
and failures. While electricity liberalization is relatively progressed, deregulation
in water and wastewater management is just about to begin. The multi-utilities
business model, based on a balanced portfolio of national and international
activities in electricity, gas, water and waste management, is the right recipe
for success in this highly fluid market environment.

Footnote

1 Rheinpapier is a wholly-owned subsidiary of Finnish Papier
company Myllykoski Continental.

Where to Now?

Major states were continuing to open retail electric and gas markets to full competition-in
response, great plans were being laid, and extensive marketing and sales campaigns
were being launched. The competitive future that had been discussed for nearly
a decade was now at hand. Great things were about to occur.

Instead, the unexpected occurred. California and the entire West experienced an
electricity and natural gas blow-out unlike any ever seen. Prices increased nearly
tenfold, markets failed, utilities went bankrupt (or at least insolvent), and
regulators and policymakers stalled, which compounded the problems. Finger-pointing
and vilification became instruments of public policy. California’s Governor, legislators
and regulators blamed the Texas pirates, the Federal regulators, and the bogey
man — anything but the fatally flawed market design of the California PX
and ISO. This was just the latest in a series of disastrous energy policy moves
over the past 30 years.

In California, the state government stepped in to purchase electricity when the
credit of the utilities became junk grade, as regulators refused to permit the
pass-through of $300 per mWh wholesale prices to retail customers. Although initially
confined to California, the contagion spread throughout the West as gas prices
soared and hydro-electric generation fell far short of average year production.
Gas price increases rapidly spread throughout North America, driving up wholesale
electricity prices in the Gulf Coast region. In the newly opened markets of New
England and New York, electric and gas marketers’ spreads evaporated, sending
customers back to the relative safe haven of the default service provided by utilities.
Marketer/traders and independent generators became the darlings of the stock markets,
as price levels rose and hockey stick projections of electric demand drove valuations.
Gas turbines became as sought after as tickets to the Lion King.

Meanwhile, in telecoms and e-business, mayhem reigned supreme as dot-coms became
dot-bombs and broadband heaven quickly became broadband hell. Telecom and Internet
investments that were trading at P/E ratios in the hundreds (if there even were
profits) ran out of money and quietly withered away. Talk about convergence quieted
to a murmur.

Then, almost as quickly as the blow-out arrived, markets fell to traditional trading
levels — and stock prices of generators and traders fell to earth from the
stratosphere, some faster than others. Concerns about shortages of electricity
moved to predictions of regional surpluses, and gas storage levels rose to their
highest point in 10 years.

Those in the industry who have survived the past two years, and not all did, may
yearn for the happy days of a vertically regulated business with reasonably predictable
returns. Yet there is no going back; the eggs have been thoroughly scrambled.
The “good old days” of utilities as a safe investment for widows and orphans are
gone forever. If we can’t go back, we must go forward, but to where?

Competition Moves Forward

While some in the U.S. market are still shell-shocked from the blow-out of
the last year, the same fundamental forces that led prognosticators to advance
theories of rapid movement to competitive markets are still at work, although
somewhat mutedly, at least for the moment. These forces are:

Globalization — Despite the terrible events of 11 September,
2001, the trend of more open and liquid markets is likely to continue, at least
in the OECD countries. Non-U.S. companies are increasingly buying into the U.S.
energy markets, and leading U.S. companies continue to invest in Europe as their
markets open.

Liberalization — Despite the clear failure of California’s
model, many large states will be fully competitive for all electric customers
by year-end 2002 — Ohio, Texas, Illinois, Virginia and Michigan will join
Pennsylvania, New Jersey, New York, New England and others. RTOs will begin
operating in the Midwest, while refinements are made in Northeast markets. Liberalization
in Europe continues, although at a slower pace than most trader/marketers desire.

Consolidation — Liberalization and globalization, combined
with the global reach of the capital markets, drive the continuing consolidation
in the electric and gas businesses; smaller entities find it harder to manage
the risks inherent in liberalized markets and suffer higher costs of capital
than larger and more diverse enterprises. In those markets where economies of
scale and scope exist, larger companies are able to place more distance between
themselves and smaller competitors.

Specialization and Reorganization — While they may initially
seem to be at odds with consolidation, the forces of specialization drive companies
to target all their resources and strategies to drive greater value out of each
part of the energy value chain — generation, trading, retailing, networks.
Many utilities have formed holding company structures that incorporate autonomous
business units to provide the required focus to be successful. As companies
target horizontal “slices” of the business (e.g. generation or distribution),
the traditional style of merger between two vertically integrated utilities
have proved to be destroyers of shareholder value.

Technology — Although the dot-coms and broadband-everywhere
providers are fading from the scene, the dramatic possibilities of Internet
communication across high-speed broadband and wireless networks are just beginning
to be understood and appreciated — and they are likely to be considerable.
Leading companies see significant savings and enhanced customer service from
their early technology investments. As experience grows and more suppliers and
customers are linked to utilities via broadband and wireless, savings are likely
to increase — EDR (economic demand response) and other real-time demand
management, expanded facilities management by energy companies, and remote diagnostics
for networks are but a few of the applications on the horizon. As liberalization
drives innovation in formerly monopolized markets, it is likely that we will
see an explosion of products and services on offer to formerly captive customers
from a variety of suppliers, ranging from enhanced billing and credit options
to power-line technologies for data and IP voice facilities.

In the end, we may find that the blow-out of 2000-01 serves to accelerate the
unleashing of these forces on some key areas of the electric and gas markets
(for example M&A and the wholesale markets) — even while muting their effect
on others (such as competitive markets for residential customers).

What are the Leaders Doing?

Clearly, the electricity and gas industries are fraught with turbulence and
danger. The way forward is not clear, and the wrong moves can mean the end of
the company — or at least the CEO’s employment.

It is said that periods of turmoil freeze many executives in place, but galvanize
the will of a few. This is such a time. Strategies developed and implemented
over the next two years will create the “Energy Majors” that will dominate the
electric and gas markets by the end of this decade. Much like the consolidation
of the financial services business in the 1990s, some of the winners will be
current large players in the electric and gas business (Citibank, Chase, Merrill
Lynch, HSBC are analogous). Other large players will find themselves falling
victim to smaller, more aggressive players who are more adept at operating in
significantly changed market environments (Bank One and Nationsbank are two
examples of conquerors in the banking sector).

The winning strategies of financial services players came to fruition in the
late 1990s, but the seeds for this success were planted in the financial services
crisis of the early 1990s, when Citigroup (now the world’s largest financial
institution) was threatened with bankruptcy due to its devastated loan portfolio.
Similarly, the strategies put into motion in the next two years by electricity
and gas companies will result in the development of the Energy Majors of 2010.

While it remains clear that growing profitability is critical to creating sustained
shareholder value, profitability alone will not result in a company reaching
the top tier of energy companies over this decade. What then are the key elements
of a successful strategy?

Focus on Growth

Energy and utility companies are experiencing turbulent times — more uncertainty
than most executives have been trained to manage. Since the comfortable cloak
of regulation was removed, electricity and natural gas companies have been subject
to a cold wind of market and operational volatility, and they now lack a group
of captive customers to whom this risk can be shifted. High-flying generators
and traders have been brought low — even Enron. The understandable reaction
has been to seek certainty rather than additional risk.

Yet this may be exactly the wrong reaction. Where many see risk and uncertainty,
others see opportunity. Market leaders, while watching their flanks, will seek
opportunities to grow and expand in times of uncertainty and economic downturn.
Key acquisitions or alliances made during time of economic uncertainty can often
position a company for considerable profitability when economic growth returns,
as it always does.

Market leaders understand that companies who consistently grow revenues and
profits will deliver higher P/E multiples than companies that are simply well-managed
and efficient, but slow growing. Growing companies are able to attract and retain
high-performing executives and staff, and can reinvest in the business segments
that fuel the growth engine. Growing companies have an energy and a buzz that
makes them interesting and rewarding places to work — fostering innovation
and new ideas. Shareholders and employees are all significant beneficiaries
of a focus on successful growth.

Learn to Love Risk

The alternate title to the 1960s sardonic comedy Dr. Strangelove was “How I
Learned to Love the Bomb” (as in H-bomb). For many Americans during the Cold
War, getting used to the possibility that nuclear conflict could end life as
they new it was quite difficult, but necessary. So, too, it is for the electricity
or gas company executive these days. As the industry continues to evolve, as
markets become more volatile, and as the nature of regulation changes, executives
must learn to embrace risk — or at least the active management of risk
— if they are to be successful in the new marketplace. The investor view
(which often reflected the reality) was that the utilities business was low
risk, with modest but steady returns that reflected this risk profile. This
reality has clearly been altered, and investors’ views are changing, as well.

Actively managing the host of risks that face energy companies today is a full-time
job for a Chief Risk Officer (CRO). The responsibility of the CRO does not extend
merely to the obvious risk areas, such as wholesale energy trading, but also
to other areas where there may be as much or more risk for the company —
credit risk, operational risk, retail customer risk and regulatory risk.
With less ability to recover the costs of unforeseen events from customers and
the reduced applicability of SFAS 71, many companies now face risks that could
have a significant impact on earnings and balance sheets — and few of the
risks or their implications are well-understood. In just the past year, a number
of companies have taken “surprise” earnings hits resulting from their inability
to fully pass through fuel or purchased power costs to customers, or from significant
operational mishaps where no regulatory cost recovery seems likely. Also, several
large generators have established reserves of several hundreds of million dollars
against unpaid invoices for power delivered to California’s utilities or the
California ISO. At the current time, the outstanding amounts are several billion
dollars. While most should be paid eventually, some discounting seems likely.

The risks in the electricity and gas business are not necessarily all negative.
Understanding and managing specific risks can also present opportunities for
companies that have specialized expertise or particular competencies. For example,
some large marketers have assumed significant risk from gas distribution companies
and industrial customers by taking over the gas supply and transportation management
responsibilities — providing price and delivery guarantees that often generate
significant value. Similarly, some transmission and distribution companies have
developed network service companies that outsource the planning, construction
and O&M responsibilities from energy transmission and distribution owner/operators.

Even transferring risk (through insurance, management of gas supply portfolios
by others, hedging currency risk, etc.) requires a good understanding of what
the risks are — what might trigger negative consequences, how large the
effects might be, etc. Management must evaluate the risks, determine which provide
the greatest threats or opportunities to the company, and understand the financial
implications of those risks. In conjunction with the Board, they also need to
determine the company’s tolerance for risk. Only then can they develop a risk
management strategy that properly balances risk mitigation measures and their
financial costs.

Adopt New Business and Finance Models

One hallmark of successful companies in other industries that have undergone
a deregulation or liberalization process is the creation of new business and
financial models, or at least adopting successful models from other industries.
Those models that are likely to provide significant benefit will combine models
already tested in other industries with the skillful adoption of more collaborative
methods of interaction with suppliers and customers, and leverage the capabilities
of IP technology delivered via broadband or wireless. Two of these new or adapted
models are described below:

Asset Manager Model — Much like the commercial real estate industry,
the network businesses (transmission and distribution) lend themselves to the
opportunities and advantages provided by the asset manager model, and then disaggregate
them into separate businesses. These components are:
• Asset owner — The core competencies are financing and regulatory
management, and asset development. A real estate corollary is the REIT or pension
fund owner.
• Asset manager — Working on a contract basis with the asset owner,
the asset manager decides how the assets will be maintained and upgraded to
ensure that the required levels of service, safety and reliability are met at
acceptable costs. The asset manager will also be responsible for the day-to-day
operations of the local distribution grid and may play a key role in the interface
with the assets’ customers on commercial and operational issues. A real estate
corollary is the property management and leasing firm.
• Service delivery organizations (SDO) — The asset manager is likely
to contract with several service delivery organizations to carry out the various
tasks that must be performed to ensure safe, efficient and reliable operations.
SDO service provisions may range from billing and collection to field operations.
The real estate corollary would be firms that specialize in building operations
and maintenance.

Collaborative Value Chain Model — By integrating process improvement
initiatives (i.e.. supply chain management, customer relationship management,
and collaborative product commerce) with enabling technologies, suppliers, customers,
and trading partners can collaborate with one another throughout the entire
value chain. This collaboration enables real-time synchronization of business
operations and reduces value chain inefficiencies, shortens cycle times, enhances
customer service, and ultimately increases profitability and market share.

Foster Innovation

Even with the stock market turmoil of the past two years, it is apparent that
investors want — and are willing to pay — significant premiums for
innovation. The market handsomely rewards those companies that successfully
redefine markets or create new market spaces. As cost and asset efficiencies
become harder to achieve, success will depend on a corporation’s demonstrated
ability to innovate, which drives both revenue growth and shareholder value.
Innovation continues to distinguish the winners from the losers.
As described by Peter Drucker, innovation refers to the function of entrepreneurship,
the means by which new wealth-producing resources are created or existing resources
are endowed with the enhanced potential for creating wealth. PricewaterhouseCoopers’
research reveals that there is a strong correlation between overall revenue
growth and revenue from new products and services. Innovation has been confirmed
as a lever of growth and value creation, and product and service innovation
has been demonstrated to be a key performance indicator. We also find that companies
who are excellent in product and service innovation likewise excel at innovation
in other parts of their business.

The challenge is one of creating an environment where new ideas are the norm
— an idea-rich culture, where innovation is a fundamental operating principle
Only under such conditions can companies hope to break from the pack. According
to an annual innovation poll in The Economist, the top 20 percent of firms have
achieved double the shareholder returns of their less innovative peers. Innovators
cited in the poll, such as Dell, have transformed their industries through new
products and processes that have fundamentally changed the marketplace. Dell’s
made-to-order direct-to-consumer business, established in 1984, and its early
adoption of e-business have revolutionized the PC market and led the company
to top-rank status in the PC business. The real test of Dell’s innovations have
come as the PC market tanked over the past year. Dell’s low-cost structure,
zero inventory, and online ordering system (allowing the customer to custom
configure their PC) have permitted Dell to grow market share profitably at the
expense of its less innovative competitors.

Maintain a Sharp Focus on Costs

Like all companies, utilities have been through several rounds of cost reduction,
as the demands of financial markets have forced them to remain competitive by
improving earnings. However, few companies have made intensive cost management
a core focus. Traditional cost management techniques tend to focus on increasing
profitability — especially in the next four to six quarters, but real cost
management entails far more than simply cutting costs.

Some would argue that a consistent focus on cost management runs counter to
the first maxim, which is to focus on growth. In reality, leading companies
with consistent records of growth in revenue and profitability, such as General
Electric, BP and Citigroup, maintain an almost maniacal focus on cost management.
These companies see value-added cost management as a key component of corporate
growth, rather than as an arduous and punishing chore.

Cost management and managerial accounting has traditionally focused on historic
reporting, particularly variances, budgets and contributions. However, today’s
electricity and gas companies face the complex challenges of global competition,
product and service diversity, shorter product and technology lifecycles, and
greater customer expectations for quality and service. Value-added cost management
requires tools and techniques that make significant improvements in cost management,
a thorough understanding of the cost drivers in the segments and markets in
which the company operates, and a consistent approach that links with the company’s
strategic objectives.

Electricity and gas companies sometimes fail to focus on cost management due
to concerns that “the regulator will simply take it away, sooner or later.”
But, this is a fact of life in business. No advantage — whether cost, product
or innovation — can be maintained without a consistent focus on improvement.
Companies in non-regulated businesses face the same issue — if they develop
a cost advantage through skillful cost management, competitors will seek to
meet or exceed cost advantage. The skill is in maintaining the advantage for
as long as possible. For electricity and gas companies’ regulated business,
this means careful linking of cost management efforts with regulatory strategy
in order to maintain the benefits of value-added costs management for as long
as possible.

Conclusion

Out of the chaos that has overwhelmed the electric and gas industry in the
last year or two, a select number of companies will emerge and succeed in harnessing
the strategic imperatives necessary to become one of the ultimate winners. Within
the next 10 years, these Energy Majors will ascend to domination of the electric
and gas markets by adopting rigorous portfolio optimization, embracing an enterprise
view of risk, implementing new business and financial models, making information
a strategic weapon, and focusing relentlessly on cost management. The competitive
future is upon us, and great things are about to occur.

The Changing Role of the Utility CFO

Industry Transformation: The New Competitive Landscape

The global energy industry is experiencing extraordinary transformation. The
forces of deregulation, increased competition, simultaneous unbundling and convergence
of traditional business models, globalization, and the rise of e-business are
driving radical changes in global energy markets. As a result, a new competitive
landscape is emerging, exerting tremendous pressure on the utility industry
and rendering the traditional utility model obsolete. Winners in this new environment
will transform their organizations based on a new business agenda.

Foremost on this new agenda is the growing awareness of shareholder expectations
and the need to increase and drive shareholder value through the business. Looking
ahead, a heavy emphasis will be placed on cost reduction and asset management
as companies attempt to enhance the efficiency of their existing business models
while simultaneously positioning themselves for growth. Growth will come in
three forms. First, increased awareness of the customer and the need to leverage
branding to enhance market positioning will drive the development of customer-focused
businesses, products, and services. Second, acquisitions, divestitures, and
corporate restructuring will provide a basis for realizing growth opportunities
through geographic expansion, new customer solutions, and enhanced focus and
scale around core competencies. Finally, e-business and emerging technology
solutions will provide both the “backbone” and “platform for change” that enable
utilities to transform and realign their business models with changes in the
industry. In response to this new agenda and the changing competitive landscape,
energy companies are realigning themselves around new go-to-market structures
and strategies focused on growth and specialization in different areas of the
value chain.

To be successful, each strategy will need to focus on core competencies demonstrating
“best-of-breed” performance. Similarly, key support functions, such as finance,
information technology, and human resources need to be aligned with the overall
strategy. The remainder of this article focuses on defining the emerging role
of the utility CFO in support of the new agenda, identifying key challenges
for finance, and outlining a blueprint for transforming the finance function
to meet the challenges of the business.

The Emerging Role of the Utility CFO

The role of finance is expanding as CEOs and business unit managers demand
that finance executives serve as partners in setting strategy, achieving business
goals, dealing with emerging issues, and as finance becomes embedded in the
heart of the business. Utility chief financial officers need to be “leading
architects of their corporation,” trusted business partners and play a key role
in setting strategies and implementing business change. Consequently, the utility
financial executives of the future will play vital roles in areas once considered
outside the province of finance — restructuring the business, leveraging
e-commerce, enhancing corporate reputation and brand equity, optimizing customer
relationships, and driving corporate transformation. Never have the qualities
of leadership, innovation, and creativity, along with the ability to deliver
tangible results in the business, been more in demand from utility finance professionals.

Figure 1 – The New Energy Enterprise Industry Role Map
See Larger Image

 

Key Challenges: The CFO Agenda

Given this hefty role and its associated responsibilities, where should utility
CFOs focus their attention? While the importance of the finance function has
grown, uncertainty has increased about how to best realize its potential. While
areas of focus will vary based upon specific business models and strategic agendas,
CFOs of leading energy companies are focused on a number of key business challenges.
These challenges and associated implications for finance include:

Generating Shareholder Value — Creating and managing shareholder
value is a strategic imperative of the new competitive landscape. However, shareholder
value as a single goal is insufficient. The broader challenge is to create value
concurrently while balancing and capitalizing on other key stakeholder relationships,
including customers, employees, regulators, and strategic partners. What are
the sources of value creation? How can value creation be institutionalized in
the planning, performance management, and governance processes? How can value
management be integrated into business operations?

Realizing the Benefits from Mergers and Acquisitions (M&A)
In the past few years, there has been an explosion in the number and size of
M&A transactions in the utility industry. Mergers, acquisitions, and joint ventures
have become standard methods of seeking growth as the industry consolidates.
How does finance ensure that the value promised in the merger is ultimately
delivered? How can the integration process be managed effectively?

Planning for Value — Global strategies must be executed regionally
and across business units. Processes to promote desired behavior must work their
way through an increasingly complex organization if value is to be delivered.
How does finance ensure that strategy is implemented throughout the organization?
How does finance bridge strategy, process, and the implementation through planning
and budgeting? How can we thread a value philosophy throughout the planning
and performance management processes?

Re-examining the Role of the Corporate Center and Administrative and
General (A&G) Functions
— Corporate centers have tended to evolve over
time, rather than being designed purposely. Today, penetrating questions are
being raised about the corporate center and its role in creating or destroying
value. The end of the 1990s saw most of the fat trimmed out of frontline operational
units; now it is the turn of the corporate center. How should finance be organized
in the future? What is its role in assuring that the corporate center creates
value? How are A&G functions best aligned across corporate, business unit, and
shared service organizations?

Leveraging E-Business Opportunities — Almost overnight, the
Internet and other forms of e-commerce have created not only a vast new marketplace
for information, services, and goods, but also innovative ways to conduct business.
How does finance help to forge and implement an Internet strategy? How does
finance develop and communicate the longer-term business case for e-business?
How will the Internet impact transaction processing?

Looking Beyond ERP — Large investments in enterprise resource
planning (ERP) systems are coming under the microscope. Some have fallen short
of their promise; others just do not go far enough. Many utility CEOs are asking
CFOs and CIOs, How can I maximize the return on my investment in ERP? How does
finance assemble the most effective portfolio of information and knowledge management
systems? What new decision support processes are possible? What form will future
knowledge and intellectual management systems take?

Managing the “Virtual Finance” Organization — Investments
in technology, process improvements, and outsourcing are sharply reducing the
size of the finance function, but expectations for performance are increasing.
What is the role of finance in a “virtual” organization, and how does finance
itself become more “virtual?” How does finance respond to change while maintaining
financial risk management standards with fewer people? How does finance attract,
reward, develop, and retain the best people?

Addressing these interdependent challenges effectively requires a new level
of competence, enhanced tools, and many new skill sets. The primary role of
finance must shift from keeping score to providing the knowledge and capabilities
necessary to enhance decision support and drive value.

Meeting the Challenge

Recognizing the broader role in supporting these business challenges, leading
finance organizations are developing new financial management models focused
on transforming finance into an integrated business partner (Figure 2). Transformation
strategies have typically followed two different, although not mutually exclusive,
paths:
• Redeploying resources to reduce overall costs and enhance decision support
(Finance Effectiveness Model).
• Re-aligning finance functions based on key roles and responsibilities,
creating a virtual finance community across the business (Business Alignment
Model).

Figure 2 – The Transformed Finance Vision
See Larger Image

 

The Finance Effectiveness Model

The Finance Effectiveness Model focuses primarily on key financial processes
and technology solutions to increase the efficiency of transactional and reporting
processes while enhancing the value of information and decision support capabilities.
Financial processes can be grouped into Transactional Processing (accounts payable,
billing, time and expense, fixed asset accounting), Reporting and Control (general
ledger, closing, compliance reporting), and Decision Support (planning and budgeting,
financial forecasting, management reporting, cost accounting). The approach
to redesigning these processes and leveraging technology varies across each
category.

Redesigning transactional processes focuses heavily on achieving low costs and
efficiency through increased automation and the consolidation of activities
across the business. They are typically the greatest candidates for shared service
models or outsourcing. Heavy automation, data capture, and integration with
operational processes through enhanced ERP capabilities provide the basis for
improvement.

On the other hand, reporting and control processes require a high degree of
integrity in order to translate data into business information and maintain
effective compliance with external reporting requirements. While low costs and
efficiency are still important, the emphasis of these processes is to ensure
that there is a central point of control for information and to maintain “one
version of the truth.” Redesign efforts typically focus on standardizing a chart
of accounts, integrating or consolidating multiple general ledgers, and improving
information delivery and reporting.

Decision support processes focus on using information to enhance value and making
effective business decisions. Redesign efforts are less focused on efficiency
gains and more focused on utilizing information and decision support tools to
maximize business value. Improvement solutions are focused on management information
capabilities, use of predictive analytics, and data warehouse/data mining.

The Business Alignment Model

The Business Alignment Model focuses on achieving greater alignment
across corporate and business unit finance functions and ensuring clear lines
of responsibility and accountability across core finance roles. This approach
is more prevalent in instances of corporate separation, restructuring, or M&A
activity as finance functions are realigned along with the business structure.
Key finance activities are organized across three key roles.

Corporate or “central finance” is focused on two objectives — providing
overall corporate governance and driving value through the portfolio of businesses.
It consists of a small core group or “center of excellence” that sets corporate
direction, evaluates and funds business strategies, manages the overall risk
profile, and evaluates performance relative to overall value creation. Key activities
include setting strategy, developing policy, setting enterprise goals, and coordinating
across businesses to achieve strategic objectives.

Business unit finance is focused on enhancing decision support through
forward-looking analysis and interpretation of results rather than transactional
processing or historical reporting. Relying on a “single book of record” as
the basis for management information, business unit finance consists of distributed
teams that provide dedicated planning and analytical support to business units.
Key activities include analyzing business results, planning and forecasting,
project and investment evaluation, and profitability analysis.

Shared service models can be constructed in a number of ways, varying
from distributed processing networks to fully consolidated organizations residing
at a corporate or services company level. To be effective, they are enabled
by consistent practices and heavy levels of automation. Business services groups
are managed typically as stand-alone business units with market-based pricing
and service level agreements established to operate the unit as a competitive
entity. Implementing this model requires the creation of a virtual finance community
that enables sharing of best practices, consistent career development and training,
effective processes and integration across each role, and a robust technology
environment.

Achieving the Vision

Starting with an understanding of key business strategies and the requirements
for finance to support the business, the transformation process must address
several key enablers to achieve the role of an integrated business partner (Figure
3).
Core financial processes must be integrated with the overall business model
with an end-to-end design that maximizes efficiency and effectiveness. Organization
design decisions must consider the relationship between corporate and business
unit finance requirements and the role of each. Similarly, skill sets and individual
capabilities must be addressed as increased complexity requires both business
and financial acumen. Integrating core and emerging technologies still remains
a critical strategy particularly with the evolution of e-business and Web capabilities.
Finally, ensuring a continuous improvement mentality through ongoing education
and a communication program regarding the transformation process is critical
to shaping the organizational culture.

Figure 3 – The Transformation Path
See Larger Image

Conclusion

The very nature of finance in the energy industry is undergoing change. New
tools, techniques, and concepts are transforming the whole discipline, requiring
a new level of competence, capabilities and skills, new working processes, and
increasing use of emerging technologies across the finance community.

Leading finance organizations are responding to this change with various technology
and process initiatives. Regardless of the paths chosen, several key principles,
described in this article, are clear as finance organizations develop their
agendas for the future.

Evolution of the Energy Value Chain

The energy industry continues its metamorphosis, driven in various parts by
business imperatives to enhance shareholder value, meet industry-restructuring
mandates, and realize the benefits of economic and technological advances. The
energy value chain, previously defined as a five segment model spanning extraction,
processing, wholesale, delivery and retail, continues to evolve, with new segments
emerging via the combination of previously separate segments and the splitting
of previously single segments into multiple segments (Figure 1).

Figure 1 – Evolution of the Energy Value Chain

For example, combining the processing and wholesale segments of electricity
into a generation and trading entity has emerged as a successful market configuration.
On the other hand, the delivery segment is splitting into separate transmission
and distribution businesses. This has been the case for gas, and is now impacting
electricity as well. Similarly, we are observing the retail segment split into
two to three markets, one focused on large customers, another focused on the
mass market (both typically involving choice of retail energy supplier) and
possibly a third market focused on the remaining regulated retail (including
utility provider of last resort) market.

During 2001-05, despite the recent slow down in deregulation and restructuring
efforts in the U.S. market, we predict a continued move toward separation in
each segment of the energy value chain as a distinct business. Although companies
may choose to operate in some or all of these segments, we believe the era of
vertically integrated monopolies has come to an end.

Energy companies will choose different business strategies to play across this
value chain. One strategy will be re-verticalization, where large players will
seek to participate in most or all segments of the value chain. Examples would
be oil and gas majors with subsidiary operations in extraction (exploration
and production), processing/wholesale (generation and trading), transmission
(big pipes and wires), distribution (little pipes and wires), large customer
retail (energy services) and mass-market retail (joint venture with non-energy
marketer).

Another strategy will be horizontal specialization, where companies will choose
to focus on one or two segments of the value chain and possibly extend their
capabilities to other similar industries (e.g., power generation extending to
other process manufacturing, energy trading extending to other commodities,
energy transmission extending to other network infrastructures, etc.) or expanding
geographically via mergers and acquisitions. Examples would be former utility
companies building large regional transmission or distribution operations, or
independent power producers building up a large fleet of generating plants complemented
by a wholesale trading operation.

Figure 2 – Primary values serve as the basis for strategy.

Other strategies, which could be combined with either re-verticalization or horizontal
specialization, include convergence (a focus on multiple commodities such as electricity,
gas, water, telecom, etc.) and geographic reach (global, national or regional).
Each segment will focus on a primary value discipline as the basis for strategy.

Since technology strategy is profoundly impacted by both market structure and
business strategy, and since changes imposed by industry restructuring will
be a constant feature of the market, we predict that an adaptable and scalable
architecture will be a competitive advantage for market leaders. Agility will
be a key differentiator for companies adopting customer intimacy and product
leadership as their strategic value discipline. Those adopting operational excellence
must also embrace agile approaches to transform and position the company for
a competitive future, albeit to a lesser extent.

Extraction

This segment of the energy value chain is focused on the extraction of hydrocarbons
(e.g., oil, gas, coal) from the ground. Typical business activities therefore
include oil and gas exploration and production and coal mining. Examples of
businesses in this segment include Conoco, Royal Dutch Shell, BP Amoco, TotalFinaElf,
Coastal, ExxonMobil, Chevron/Texaco, BHP, Arch Coal, Peabody Group and service
companies like Schlumberger
and Halliburton. These types of businesses may choose to operate on a regional,
national or global level to match the geographic scope of production fields.

We believe successful business strategies for extraction companies must focus
on operational excellence (for example, given the high cost of R&D, technical
collaboration between industry participants will be pursued and costly exploration
will be maximized through increased efficiency in drilling time and higher production
volumes). Other operational imperatives include accelerating time to market,
exploiting global markets and resources, and achieving cost/quality leadership.
Critical success factors for extraction companies include low cost producer,
reduction in unplanned shutdown losses, improvements in maintenance and increase
in overall equipment efficiency (OEE), improvement in volume, and net reserve
additions through:

• Continental integration
• Deep water development
• Optimizing exploration, gathering, separation and storage
• Waste management and reclamation
• Workflow and knowledge management

An appropriate application portfolio for extraction companies must, at a minimum,
include:
• Seismic data acquisition, processing and interpretation
• Geographic information systems including gridding, contouring and mapping
• Reservoir characterization and simulation
• Drilling applications such as well planning and well log analysis
• Economic applications for budgeting, decision analysis and risk management
• Knowledge management and collaboration

In addition, many of these applications can be horizontally leveraged for other

META Trends

During 2001-05, new energy industry value chain segments
will emerge (generation/ trading combination, transmission vs. distribution
split, large-customer vs. mass-market retail split). Players will choose
strategies based on convergence (electric, oil/gas, communications, water),
re- verticalization (exploration/production to retail), or horizontal
specialization (in each segment of the value chain). An adaptable and
scalable architecture will be a competitive advantage for market leaders.

Energy company performance management will change (2001-03),
but organizations’ ability to link performance metrics to critical success
factors and map information technology and solutions will sustain success.
Value will be derived more by agility than by operational efficiencies
and performance excellence (2003-05).

Industry consolidation will intensify via mergers and acquisitions (2001-05)
to help energy companies gain scale, diversify risk, and enter new markets.
Benefits will increasingly depend on successful exploitation of information
and technology.

mining and mineral and chemical extraction processes in other horizontal industries.
This segment is unique in that there is less information technology vertical
leverage potential than in other segments.

 

Processing and Wholesale

This segment is focused on processing the extracted hydrocarbons into refined
energy products and includes oil refining, gas processing, power generation
(including non-fossil generation, such as hydro, other renewables, and nuclear),
liquefied natural gas and coal gasification. Additionally, the segment includes
the buying and selling of energy at the wholesale level. Examples of businesses
in this segment include Enron, Williams Energy, Koch, Dynegy,
PG&E, Reliant, TXU, Duke, Mirant, AES, Calpine, AEP, Exelon, and Constellation.

These types of businesses may choose to operate on a regional, national or global
level to match the geographic scope of their processing facilities.

We believe successful business strategies for generators/wholesalers are driven
by operational excellence (for example, high volume, high speed, low cost per
transaction, highly secure systems). Critical success factors for processing
and wholesale include mass production to lean production, asset life extension,
asset optimization, low-cost production, and world-class trading through:
• Engineering and construction
• Production, fuels management ramping/automated dispatch control, process
efficiency
• Environmental monitoring
• Plant-predictive maintenance, risk-based maintenance, outage planning
and management
• Decommissioning and waste management
• Enterprise-wide asset optimization
• Controlling/mitigating financial exposure
• Integrating physical and financial portfolios
• Financial, analytical, and risk management

An appropriate application portfolio for generator/wholesaler must, at a minimum,
include:
• Plant process control systems
• Operational data warehouses and analytical tools
• Limited operational CRM and contract management
• Price, credit and volumetric risk management
• Security and audit
• Enterprise asset management

In addition, many of these applications can be leveraged as service offerings
to mass- market retailers, regulated retail and large energy end-use customers
in the form of energy management, insurance and risk management, bill management
(consolidation, aggregation), and electronic bill presentment and payment services.

Transmission

The transmission segment is focused on moving large amounts of energy commodities
(liquids, gas, power) over relatively long distances. Primary business assets
include oil and gas pipelines and electric transmission networks. In the previous
energy value chain model, electric transmission and distribution and natural
gas transportation and distribution were subsumed in delivery. However, electric
transmission and distribution are increasingly treated as distinct business
units in the ongoing unbundling of the energy industry (this has been the case
in liquids and natural gas for some time with market leading companies like
Duke Energy, El Paso Energy, NiSource, Williams, Equilon, Colonial, and Buckeye).
Examples of electric businesses in this segment include National Grid, Entergy
Transco, and the State of California. These types of businesses may choose to
operate on a regional, national or global level to match the geographic scope
of their authorized service territory.

We believe successful business strategies for transmission companies are driven
by operational excellence (for example, technologies, such as distributed generation
or superconducting magnetic energy storage, are deployed as low-cost solutions
rather than new product rollout, and promote open access and network development).
Critical success factors for transmission companies include strong asset management,
business process optimization, operating efficiency and reliability through:
• Engineering and construction
• Operations management, maintenance and work management
• Control, measurement communications systems and capital asset investment
integration
• Outage recovery

An appropriate application portfolio for a transmission company must, at a
minimum, include:
• Operational CRM and contract management (focused on partner relationship
management)
• Geographical information systems (GIS)
• Energy management systems (EMS)/ supervisory control and data acquisition
systems (SCADA), including advanced applications such as transmission scheduling
• Enterprise asset management
• Wholesale settlement
• Electronic bulletin boards

In addition, many of these applications can be leveraged as service offerings
to distribution providers in the form of network architecture and open access
tools.

Distribution

The distribution segment of the value chain is focused on the local network
of pipes and wires that deliver electricity and natural gas from the transmission
systems to the end-use customers, and includes electric and gas distribution
companies, but may also include truck-based delivery of fuel oil and propane.
Examples of businesses in this segment include TXU and Reliant T&D, Atlanta
Gas Light, Rochester Gas and Electric, BG&E, KeySpan, and Nicor. These types
of businesses may choose to operate on a local or regional level to match the
geographic scope of their territory authorized by state regulators, for monopoly
franchises, or by geographic scope defined by operational limits (delivery radius
miles), for non-economic regulated industries.

We believe successful business strategies for distribution companies are driven
by operational excellence. We believe that by 2003-05, an open access model
will emerge where the revenue will be driven by multi-flow pricing versus the
current model of leveraging vertical market power to support sales of other
vertical services and products. The distribution system will evolve from a hierarchical
model to a geodesic network model.

Critical success factors for distribution companies include setting the regulatory
agenda, increasing market share, increasing customer satisfaction, exceeding
performance-based rate indices, managing assets, decreasing costs per customer
while increasing revenue per customer through:
• Engineering and construction
• Operations management, maintenance, and work management
• Control, measurement and communications systems and capital asset investment
integration
• Outage recovery

An appropriate application portfolio for a distribution company must, at a
minimum, include:
• Operational CRM and contract management (focused on partner relationship
management)
• GIS
• SCADA
• Work management systems
• Distribution/outage management systems
• Automated meter reading and interval data recorder for large customers
on the system
• Mobile data systems

In addition, many of these applications can be leveraged as enablers of an open
access model, where the hierarchical system evolves into a network system that
will enhance the potential for energy management, alternative energy options,
and comprehensive customer solutions, with distribution being a commodity that
is incorporated into those solutions.

Large Customer Retail

This segment of the value chain is focused on the marketing and selling of
energy commodities and related services to large commercial, industrial and
institutional end-users where energy is a significant percentage of the cost
of goods sold. These are typically soph isticated energy users that not only
need commodity energy but also have requirements for high power quality or other
premium energy services. Examples of businesses in this segment include Enron
Energy Services, DukeSolutions, Avista Advantage, Equitable Resources, and Allegheny
Energy Solutions. These types of businesses may operate on a regional, national
or global level to match the geographic scope of their customers.

We believe successful business strategies for these retailers must focus on
customer intimacy and must provide multiple commodity supply and services (e.g.,
performance contracting, energy management, consolidated billing, commodity
management). Critical success factors for large customer retailers include being
a strong asset optimizer, maximizing sales margins, growing existing and new
markets, delivering performance, comfort, and convenience through:
• One-on-one CRM
• Commodity pricing and risk management
• Geographic reach
• Knowledge of customers’ markets
• Integration with customers’ business processes and applications
• Meeting customer power quality needs

An appropriate application portfolio for a large customer energy retailer must,
at a minimum, include:
• Operational CRM (contact/contract management, complex billing, sales
automation)
• Analytical CRM (cost-to-serve calculations)
• Meter data management
• Load profiling/demand forecasting
• Energy trading
• Risk management
• Settlement

In addition, many of these applications can be leveraged as service offerings
to customers in the form of energy management, customer self service, bill management
(consolidation, aggregation), and electronic bill presentment and payment services,
risk management and insurance.

Mass-Market Retail

The mass-market retail segment of the value chain is focused on marketing and
selling energy commodities and related services to small commercial and residential
customers. Examples of businesses in this segment include The Home Depot, 7-Eleven,
Wal-Mart, L.L. Bean. These types of businesses may choose to operate on a regional,
national or global level to match the geographic scope of their customers.
We believe successful business strategies for these retailers must focus on
customer intimacy (for example maximize value of customer interactions, leveraging
customer relationships and offering a broad range of products and services)
and product leadership (for example, green power or residential distributed
generation in the future). Critical success factors for large customer retailers
include:
• Partnering with other retailers or commodity providers
• Sales expansion with existing customer base
• Commodity pricing and risk management
• Strong brand-supporting business strategy
• Marketing

An appropriate application portfolio for a large customer energy retailer must,
at a minimum, include:
• Operational CRM: sales, marketing, service and field service
• Collaborative CRM: channel management, customer interaction center
• Analytical CRM: segmentation, behavior patterns
• Load profiling
• Energy trading
• Risk management
• Shadow settlement

In addition, many of these applications can be leveraged as service offerings
to customers in the form of energy management, bill management (consolidation,
aggregation), and electronic bill presentment and payment) services, and partner-customer
self-service applications.

Regulated Retail Market

The regulated retail market segment of the value chain is focused on providing
energy supply through a regulated entity (in the case of jurisdictions that
are open to competition, this includes utilities with provider-of-last-resort
responsibility) to customers for whom choice of supplier is not available or
where the customer chooses not to chose. Examples of businesses in this segment
include Southern Company, Cobb EMC, Colorado Springs Utilities, and Idaho Power.
These types of businesses will operate on a local or regional level to match
the geographic scope of their franchised service territory.

We believe successful business strategies for these regulated retailers must
focus on operational excellence (for example meeting regulator expectations,
while building for the competitive market future, strengthening the incumbency
and maintaining system reliability). Critical success factors for large customer
retailers include:
• Used and useful investments in CRM
• Setting the regulatory agenda
• Supply portfolio management
• Understanding cost structures

An appropriate application portfolio for a large customer energy retailer must,
at a minimum, include:
• Operational CRM (typically a vertically specialized billing system)
• Integrating CRM with operational systems
• Work management
• Outage management
• Metering
• Mobile data
• GIS

In addition, many of these applications can be leveraged as enablers of an open
access model where the hierarchical system evolves to a network system that
will enhance the potential for energy management, alternative energy options
and comprehensive customer solutions.

Linking Business Strategy With IT for Performance

We believe it is critical to link information strategies and investments with
business strategy. Our research indicates that companies have deployed a variety
of successful approaches.

While IT organizations “operating like a business” are still in the minority,
some ITOs have employed balanced scorecards to measure IT performance. Experience
with balanced scorecards has shown considerable diversity in practice with varying
degrees of success. Some ITOs use balanced scorecards to put their IT strategy
into a measurable framework; others use them to link their operational measures,
showing performance against industry levels. Still others use them to communicate
how IT products and services are contributing to business outcomes.

To manage IT performance against business objectives, balance must be struck
between cost and benefit, shareholder and customer, efficiency and effectiveness,
and long and short term. In addition, the ITO will often establish service-level
agreements to effectively manage the IT/business interface. We believe service-level
agreements should evolve from technology-based metrics, which are not linked
to business metrics to a business/IT measures correlation model to promote service
“value” agreements. This becomes even more critical as sourcing strategies to
meet line-of-business objectives are externalized. Second-generation SLAs (or
SVAs) are needed that clearly identify the service-level objectives that are
required by the lines of business to achieve key business goals.

We believe that energy companies have been struggling to bridge the gap between
business goals and implementation tactics. Energy companies must demonstrate
agility to improve efficiency, provide reliable service and grow revenues. IT
solutions and architecture must be equally, if not more, flexible. As companies
define their role in the energy value chain, it is even more important for the
lines of business to have a shared vision of the business and ensure that performance
to that end is enhanced, and not lost, through sourcing strategies. This business/IT
partnership must drive from a common value proposition that is unique to their
segment of the energy value chain, and understand the business strategies and
critical success factors (embodying the information requirements necessary for
success) Then it must deploy IT architecture, applications and solutions to
enable the strategies.

Business Impact: Lines of business must ensure that their value proposition,
business strategies, critical success factors and information requirements are
well defined relative to the energy value chain segment in which they operate,
and articulated so that IT organizations can begin to “operate as the business.”

Bottom Line: The information technology organization must collaborate
with the line of business to develop agile IT solutions that enable business
strategies and meet value propositions, ensuring that each are supported by
sourcing strategies.

The Changing Role of the Utility CFO

Industry Transformation: The New Competitive Landscape

The global energy industry is experiencing extraordinary transformation. The
forces of deregulation, increased competition, simultaneous unbundling and convergence
of traditional business models, globalization, and the rise of e-business are
driving radical changes in global energy markets. As a result, a new competitive
landscape is emerging, exerting tremendous pressure on the utility industry
and rendering the traditional utility model obsolete. Winners in this new environment
will transform their organizations based on a new business agenda.

Foremost on this new agenda is the growing awareness of shareholder expectations
and the need to increase and drive shareholder value through the business. Looking
ahead, a heavy emphasis will be placed on cost reduction and asset management
as companies attempt to enhance the efficiency of their existing business models
while simultaneously positioning themselves for growth. Growth will come in
three forms. First, increased awareness of the customer and the need to leverage
branding to enhance market positioning will drive the development of customer-focused
businesses, products, and services. Second, acquisitions, divestitures, and
corporate restructuring will provide a basis for realizing growth opportunities
through geographic expansion, new customer solutions, and enhanced focus and
scale around core competencies. Finally, e-business and emerging technology
solutions will provide both the “backbone” and “platform for change” that enable
utilities to transform and realign their business models with changes in the
industry. In response to this new agenda and the changing competitive landscape,
energy companies are realigning themselves around new go-to-market structures
and strategies focused on growth and specialization in different areas of the
value chain.

To be successful, each strategy will need to focus on core competencies demonstrating
“best-of-breed” performance. Similarly, key support functions, such as finance,
information technology, and human resources need to be aligned with the overall
strategy. The remainder of this article focuses on defining the emerging role
of the utility CFO in support of the new agenda, identifying key challenges
for finance, and outlining a blueprint for transforming the finance function
to meet the challenges of the business.

The Emerging Role of the Utility CFO

The role of finance is expanding as CEOs and business unit managers demand
that finance executives serve as partners in setting strategy, achieving business
goals, dealing with emerging issues, and as finance becomes embedded in the
heart of the business. Utility chief financial officers need to be “leading
architects of their corporation,” trusted business partners and play a key role
in setting strategies and implementing business change. Consequently, the utility
financial executives of the future will play vital roles in areas once considered
outside the province of finance — restructuring the business, leveraging
e-commerce, enhancing corporate reputation and brand equity, optimizing customer
relationships, and driving corporate transformation. Never have the qualities
of leadership, innovation, and creativity, along with the ability to deliver
tangible results in the business, been more in demand from utility finance professionals.

Figure 1 – The New Energy Enterprise Industry Role Map
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Key Challenges: The CFO Agenda

Given this hefty role and its associated responsibilities, where should utility
CFOs focus their attention? While the importance of the finance function has
grown, uncertainty has increased about how to best realize its potential. While
areas of focus will vary based upon specific business models and strategic agendas,
CFOs of leading energy companies are focused on a number of key business challenges.
These challenges and associated implications for finance include:

Generating Shareholder Value — Creating and managing shareholder
value is a strategic imperative of the new competitive landscape. However, shareholder
value as a single goal is insufficient. The broader challenge is to create value
concurrently while balancing and capitalizing on other key stakeholder relationships,
including customers, employees, regulators, and strategic partners. What are
the sources of value creation? How can value creation be institutionalized in
the planning, performance management, and governance processes? How can value
management be integrated into business operations?

Realizing the Benefits from Mergers and Acquisitions (M&A)
In the past few years, there has been an explosion in the number and size of
M&A transactions in the utility industry. Mergers, acquisitions, and joint ventures
have become standard methods of seeking growth as the industry consolidates.
How does finance ensure that the value promised in the merger is ultimately
delivered? How can the integration process be managed effectively?

Planning for Value — Global strategies must be executed regionally
and across business units. Processes to promote desired behavior must work their
way through an increasingly complex organization if value is to be delivered.
How does finance ensure that strategy is implemented throughout the organization?
How does finance bridge strategy, process, and the implementation through planning
and budgeting? How can we thread a value philosophy throughout the planning
and performance management processes?

Re-examining the Role of the Corporate Center and Administrative and
General (A&G) Functions
— Corporate centers have tended to evolve over
time, rather than being designed purposely. Today, penetrating questions are
being raised about the corporate center and its role in creating or destroying
value. The end of the 1990s saw most of the fat trimmed out of frontline operational
units; now it is the turn of the corporate center. How should finance be organized
in the future? What is its role in assuring that the corporate center creates
value? How are A&G functions best aligned across corporate, business unit, and
shared service organizations?

Leveraging E-Business Opportunities — Almost overnight, the
Internet and other forms of e-commerce have created not only a vast new marketplace
for information, services, and goods, but also innovative ways to conduct business.
How does finance help to forge and implement an Internet strategy? How does
finance develop and communicate the longer-term business case for e-business?
How will the Internet impact transaction processing?

Looking Beyond ERP — Large investments in enterprise resource
planning (ERP) systems are coming under the microscope. Some have fallen short
of their promise; others just do not go far enough. Many utility CEOs are asking
CFOs and CIOs, How can I maximize the return on my investment in ERP? How does
finance assemble the most effective portfolio of information and knowledge management
systems? What new decision support processes are possible? What form will future
knowledge and intellectual management systems take?

Managing the “Virtual Finance” Organization — Investments
in technology, process improvements, and outsourcing are sharply reducing the
size of the finance function, but expectations for performance are increasing.
What is the role of finance in a “virtual” organization, and how does finance
itself become more “virtual?” How does finance respond to change while maintaining
financial risk management standards with fewer people? How does finance attract,
reward, develop, and retain the best people?

Addressing these interdependent challenges effectively requires a new level
of competence, enhanced tools, and many new skill sets. The primary role of
finance must shift from keeping score to providing the knowledge and capabilities
necessary to enhance decision support and drive value.

Meeting the Challenge

Recognizing the broader role in supporting these business challenges, leading
finance organizations are developing new financial management models focused
on transforming finance into an integrated business partner (Figure 2). Transformation
strategies have typically followed two different, although not mutually exclusive,
paths:
• Redeploying resources to reduce overall costs and enhance decision support
(Finance Effectiveness Model).
• Re-aligning finance functions based on key roles and responsibilities,
creating a virtual finance community across the business (Business Alignment
Model).

Figure 2 – The Transformed Finance Vision
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The Finance Effectiveness Model

The Finance Effectiveness Model focuses primarily on key financial processes
and technology solutions to increase the efficiency of transactional and reporting
processes while enhancing the value of information and decision support capabilities.
Financial processes can be grouped into Transactional Processing (accounts payable,
billing, time and expense, fixed asset accounting), Reporting and Control (general
ledger, closing, compliance reporting), and Decision Support (planning and budgeting,
financial forecasting, management reporting, cost accounting). The approach
to redesigning these processes and leveraging technology varies across each
category.

Redesigning transactional processes focuses heavily on achieving low costs and
efficiency through increased automation and the consolidation of activities
across the business. They are typically the greatest candidates for shared service
models or outsourcing. Heavy automation, data capture, and integration with
operational processes through enhanced ERP capabilities provide the basis for
improvement.

On the other hand, reporting and control processes require a high degree of
integrity in order to translate data into business information and maintain
effective compliance with external reporting requirements. While low costs and
efficiency are still important, the emphasis of these processes is to ensure
that there is a central point of control for information and to maintain “one
version of the truth.” Redesign efforts typically focus on standardizing a chart
of accounts, integrating or consolidating multiple general ledgers, and improving
information delivery and reporting.

Decision support processes focus on using information to enhance value and making
effective business decisions. Redesign efforts are less focused on efficiency
gains and more focused on utilizing information and decision support tools to
maximize business value. Improvement solutions are focused on management information
capabilities, use of predictive analytics, and data warehouse/data mining.

The Business Alignment Model

The Business Alignment Model focuses on achieving greater alignment
across corporate and business unit finance functions and ensuring clear lines
of responsibility and accountability across core finance roles. This approach
is more prevalent in instances of corporate separation, restructuring, or M&A
activity as finance functions are realigned along with the business structure.
Key finance activities are organized across three key roles.

Corporate or “central finance” is focused on two objectives — providing
overall corporate governance and driving value through the portfolio of businesses.
It consists of a small core group or “center of excellence” that sets corporate
direction, evaluates and funds business strategies, manages the overall risk
profile, and evaluates performance relative to overall value creation. Key activities
include setting strategy, developing policy, setting enterprise goals, and coordinating
across businesses to achieve strategic objectives.

Business unit finance is focused on enhancing decision support through
forward-looking analysis and interpretation of results rather than transactional
processing or historical reporting. Relying on a “single book of record” as
the basis for management information, business unit finance consists of distributed
teams that provide dedicated planning and analytical support to business units.
Key activities include analyzing business results, planning and forecasting,
project and investment evaluation, and profitability analysis.

Shared service models can be constructed in a number of ways, varying
from distributed processing networks to fully consolidated organizations residing
at a corporate or services company level. To be effective, they are enabled
by consistent practices and heavy levels of automation. Business services groups
are managed typically as stand-alone business units with market-based pricing
and service level agreements established to operate the unit as a competitive
entity. Implementing this model requires the creation of a virtual finance community
that enables sharing of best practices, consistent career development and training,
effective processes and integration across each role, and a robust technology
environment.

Achieving the Vision

Starting with an understanding of key business strategies and the requirements
for finance to support the business, the transformation process must address
several key enablers to achieve the role of an integrated business partner (Figure
3).
Core financial processes must be integrated with the overall business model
with an end-to-end design that maximizes efficiency and effectiveness. Organization
design decisions must consider the relationship between corporate and business
unit finance requirements and the role of each. Similarly, skill sets and individual
capabilities must be addressed as increased complexity requires both business
and financial acumen. Integrating core and emerging technologies still remains
a critical strategy particularly with the evolution of e-business and Web capabilities.
Finally, ensuring a continuous improvement mentality through ongoing education
and a communication program regarding the transformation process is critical
to shaping the organizational culture.

Figure 3 – The Transformation Path
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Conclusion

The very nature of finance in the energy industry is undergoing change. New
tools, techniques, and concepts are transforming the whole discipline, requiring
a new level of competence, capabilities and skills, new working processes, and
increasing use of emerging technologies across the finance community.

Leading finance organizations are responding to this change with various technology
and process initiatives. Regardless of the paths chosen, several key principles,
described in this article, are clear as finance organizations develop their
agendas for the future.

Setting a Target for Cost Reduction Programs

Many believe cost performance is back, but we don’t think it’s ever been gone.
One outcome of the California energy crisis has been a slowdown in the pace
of deregulation, and many utilities are refocusing attention on their core regulated
operations. We believe that the U.S. utilities industry will continue its inexorable
path towards a deregulated state (despite the aftermath of the California crisis
of the past year), growth in unregulated businesses will continue to be an important
managerial goal, and continuous cost improvement in regulated business will
remain vitally important. Not only can cost improvements be a source of value
creation when coupled with a performance-based rate-making regime, but they
can also generate cash needed to fund growth opportunities and better prepare
companies to compete when markets do deregulate.

This article takes a closer look at cost performance target-setting across the
utility value chain. In our experience, we have found that companies struggle
with three critical issues in establishing cost performance targets:

Deciding on the right measures when selecting performance indicators.
For example, in the distribution business, should distribution costs be measured
per customer, per MWh of generation, or per mile of distribution line?

Establishing relevant peer groups against which performance can be
benchmarked.
Once measures have been selected, to which companies should
performance be compared? Are comparisons against other companies even necessary?
We will suggest an approach that makes comparison beneficial, but not necessary.

Determining performance targets. Having selected the right measures
and peer groups, what should actual cost targets be? We will recommend a method
to set optimal performance standards.

Selecting Cost Measures: Denominators Matter

Many executives have heard “what gets measured gets done.” But that does not
answer the vital question of whether the appropriate measures are being used.
In measuring operating and maintenance (O&M) costs, it is useful to unbundle
costs into generation, transmission, distribution, customer service, and administrative
and general costs. Doing so provides much more information about the specific
actions that can most effectively decrease operation and maintenance costs.1

Careful consideration of the units of measure for each of these categories is
important. Selecting numerators is generally straightforward. Selecting denominators
is slightly more complicated, in that the true drivers of costs should be determined
and applied.

Generation

The appropriate measure, as one would expect, is non-fuel generation O&M expense
per MWh. It is important to remove fuel costs from the measure and look at those
costs separately. Factors that drive fuel costs are different from those that
drive non-fuel O&M costs. We worked with one overseas client interested in entering
the U.S. market via acquisition. Looking at generation costs, our client believed
the target to be one of the lowest cost producers in the country. Our client
believed that this target could serve as a future growth platform — by
transferring its generation skills to follow-on acquisitions, the target could
create value for the client. However, in reality, the target had extremely low
fuel costs because it located its plants literally on top of their fuel sources
— a geographical advantage that cannot be transferred to other companies.
A look at the target’s non-fuel generation O&M costs revealed that it was actually
a relatively inefficient generator, and would not be a reliable platform for
skill transfer. Knowing the difference saved the client from committing to a
poor deal.

Transmission and Distribution (T&D)

Some companies measure T&D costs per MWh and others look at costs per customer,
in order to establish more customer-centric measures. We believe that both measures
can be misleading, and neither tells the whole story. Given the highly fixed-cost
nature of T&D businesses, a per MWh measure will be highly skewed by the level
of throughput in the wires. Increases in throughput will result in decreases
in unit costs, even though total costs remain the same, or even increase. Assessing
T&D costs per customer skews findings because not all customers are equal. Companies
adopting this measure could separate costs per customer into separate categories
for residential, commercial, and industrial categories, but not all companies
currently have the financial management systems required to perform such activity-based
costing for their T&D businesses. The measures we believe are most useful for
the wires businesses are transmission O&M expense per transmission line mile
and distribution O&M expense per distribution line mile. We like these measures
because (for the most part) a mile of wire is a mile — and perhaps more
importantly, the biggest driver of T&D O&M costs is the amount of T&D assets
in place that need to be operated and maintained.2 Later,
we will discuss some situations where the statement “a mile is a mile” is not
strictly true.

Customer Service

Since the fundamental and most obvious driver of customer service costs is
the number of customers, the preferred way to analyze these costs is on a per
customer basis, segregated by customer class.

Administrative and General (A&G)

This is the area where executives are most likely to get misled. We have seen
A&G costs measured per customer, per employee, and per dollar of revenue. Yet
the fundamental driver of A&G costs is not customers, employees, or revenues!
The other non-A&G O&M activities are the real driver of A&G O&M expenses. The
reason that companies have A&G expense is because of the generating plants,
the wires, and the customer-service centers that they have to operate and maintain.
While there are strong correlations between A&G expense and customers, employees,
and revenue, these correlations are derivatives of the non-A&G operations. Consider,
for example, measuring A&G expense as a percentage of revenues. Due to the way
regulated rates are set, a high-cost producer will have a lower A&G expense
as a percentage of revenues than a low-cost producer, which will make a high-cost
producer appear to be more cost-effective when measuring A&G in this way. Further,
a simple rate increase will give executives using this measure a false sense
of improvement (with a rate increase, revenues increase while expenses remain
the same). For these reasons, we suggest looking at A&G O&M as a factor of the
total of all other non-fuel O&M costs.

Establishing Peer Groups: Apples to Apples

In establishing groups against which relative performance is compared or benchmarking
is performed, it is important to establish peer groups. Otherwise, executives
can make less meaningful comparisons and, as a result, set performance bars
too low (overlooking opportunities for performance improvement) or too high
(potentially generating cynicism and weakening morale). In a PricewaterhouseCoopers
study on cost drivers using FERC Form 1 data, we came to the following conclusions
regarding peer group establishment for each of the O&M cost categories:

Generation

Non-fuel generation O&M expense per MWh should be benchmarked at the plant
level. Analyzing performance at the aggregated operating company level creates
an “averaging effect” through which well-performing plants mask the poor performance
of others. We have found that the optimal peer group will be composed of plants
that are of the same fuel source and technology, have similar capacity and capacity
factor, and have equivalent staffing levels. These entail factors that management
generally cannot control, yet drive a substantial share of costs.3
While the need to isolate similar fuel sources is relatively obvious, comparisons
along capacity-based factors eliminate the performance biases that would otherwise
allow the larger plants to spread their fixed costs over a larger asset base.
Similarly, accounting for capacity utilization factors allows managers to eliminate
distortions that arise from local market con-ditions such as transmission constraints.
Finally, accounting for staffing levels removes distortions that special situations
(union contracts, technological complexity, etc.) might bring to the analysis.

Distribution

Earlier we stated that sometimes “a mile is not a mile.” For example, statistical
evidence supports the common assumption that underground distribution wires
are far more expensive to maintain than overhead ones. This is explicitly accounted
for in our model. By also including the number of customers in the service territory,
we are able to account for cost differences due to service territory densities
(since density in this case is defined as customers per line mile).

Transmission

Because of the large size and higher level of preventive maintenance required
of bulk transmission wires, the relationship between transmission O&M and the
factors upon which it depends is more straightforward than it is for distribution.
We have demonstrated in our regressions that the strongest drivers of O&M costs
are line miles, which determine the “quantity” of maintenance needed at a gross
level; and total electricity sales, which are a proxy for “intensity of use”
— the more intensely used wires will suffer more faults over the long run
and require more maintenance. Just using these two independent variables produces
a remarkably high r-squared of 86 percent.

Customer Service

Unlike generation, transmission, and distribution, customer service has many
analogues outside the industry. Here we suggest that executives look beyond
the boundaries of the utilities industry for customer service benchmark groups.
In doing so, executives need to consider the levels of service provided by the
benchmarked companies, the regulatory constraints under which they operate,
and the service levels to which the utility aspires.

Administrative and General

A&G O&M expense target planning should not be isolated from other O&M cost
planning. As A&G costs are fundamentally driven by non-A&G O&M operations, improvements
in O&M cost performance should lead to some level of A&G cost performance. Our
studies suggest with high statistical significance that for every $100 in O&M
performance improvement, $12 of A&G improvement will eventually result. As for
customer service O&M expenses, many areas of A&G can be compared to best-in-class
across industry functions, which is what we recommend.

Setting Targets

Peer groups are important for identifying best-in-class companies from which
meaningful lessons can be learned. But in setting actual targets, companies
often make arbitrary choices. For example, one company with below-average performance
might set its target performance to equal the median of its selected peer group,
while a similarly performing company might aim for top-quartile performance.
While it might be hard to determine which company is setting better targets
(perhaps the first company is setting its sights too low, while the second is
setting its sights too high),4 we suggest
an alternative method that can serve as a minimum baseline.

We suggest an approach that uses regression analysis to determine the relationship
between cost performance and various operational factors that are often beyond
management control but which strongly influence cost performance. Figure 1 shows
how minimum targets for distribution O&M cost performance might be established
at two peer companies. At first glance, both companies A and B have similar
nominal distribution O&M cost performance of about $3,000 per line mile; however,
given Company B’s higher service territory density, it is actually a more efficient
cost performer. In contrast, Company A has the potential to improve its cost
performance to at least $2,000 per line mile given its lower service territory
density. While this example illustrates use of regression-based benchmarks for
distribution O&M costs, the same approach can be used for other functional aspects
of the value chain as well.

Figure 1 – Despite the same nominal $3,000 per line mile distribution O&M
cost performance, Company B is an efficient performer given its territory density;
similarly-situated utility operating companies incur distribution O&M costs
of $4,000 per line mile. In contrast, Company A could be reasonably expected
to have the potential to improve its performance to at least $2,000 per line
mile.

Of course, like other data-driven analytical approaches, this technique for
setting cost performance improvements provides only a guide, and should not
be applied blindly. In setting targets, executives should identify unique circumstances
that can affect any particular company’s performance, and be aware of any non-recurring
anomalies (e.g., an unusual storm the previous year) and reporting biases that
can skew performance setting targets. These reporting biases are especially
important if using FERC Form 1 data to compare utilities; reporting guidelines
are vague enough that the assignment of costs into various categories can differ
widely from one utility to the next. Caution and good judgment must be used
to ensure that a utility’s perceived good or bad relative performance is not
driven entirely by the categorization of costs for Form 1 reporting purposes.

Going Forward with Execution

Selecting the right measures and targets enables utility executives to address
cost issues proactively and integrate cost reduction programs into their business
strategy.5
In executing cost reduction programs, executives should keep in mind that sustainable
cost reduction:
• Eliminates work — not merely reduces staff — by eliminating
non-value activities and simplifying processes
• Fully leverages information technology investments (e.g., enterprise
resource planning or e-business)
• Is part of a continuous improvement effort driven from the top of the
company. A cost reduction mindset must become embedded in the culture (e.g.,
through Six Sigma programs)
• Is monitored and tracked — if cost performance is not measured,
improvements are not likely to be achieved
Furthermore, to position a company for future growth, the cost reduction program
must:
• Enhance, not reduce, the capability of the revenue generating functions
(e.g., sales, customer service)
• Increase competitiveness by improving the company’s cost structure
• Release trapped capital and reallocate it from low-performing to high-performing
business areas

Conclusion

In conclusion, a thoughtful, proactive approach to cost reduction can be a
source of value that can generate the cash needed to fund growth opportunities
and better prepare the company to compete as markets continue to deregulate.
The type of quantitative analysis demonstrated in this article can be used as
a means to successfully leverage such an approach and obtain value-producing
results.

Footnotes

1 We also recommend that a company further break down these
elements into subcategories; however, this could be done at a later stage as
the company determines specifically where to improve cost performance within
a category.

2 While it is tempting to measure T&D O&M expense per some other asset-based
measure, such as per (gross or net) book value of T&D assets, such asset-based
measures are subject to accounting distortions.

3 While one could argue semantically that management can control capacity factor
and staffing levels, we maintain that at a gross level these measures are truly
driven by the size, location, complexity, and comparative economics of the plant
technologies, so that these are not completely under management control. We
also recognize that there are other factors that in reality drive costs to some
extent (e.g., heat rates, plant vintage, etc.); however, statistical analysis
shows that the effects of these factors pale in comparison to fuel source and
technology, capacity and capacity factor, and staffing levels.

4 Successful cost reduction initiatives require considerable time and effort.
Cost performance is important, but overly ambitious projects can cause a utility
to overemphasize cost reduction programs at the expense of other company initiatives.

5 For example, Company B in Figure 1 might de- emphasize focus on cost reductions
in its distribution operations in order to better focus on another area of business
(e.g., customer service). Indeed, it might take a fresh look at the implications
of being efficient at the wires business and consider whether it should acquire
another company’s under-performing wires business to improve its profitability
by transferring best practices.

 

Impact of Re-Regulation on Utility Nuclear Generation

Business Drivers

Some state regulators have already required their incumbent utilities to decide
which line of business to pursue as they are forced to separate their generation,
transmission/distribution and retail business units into regulated and non-regulated
companies. Whether these utilities divest their nuclear generation units or
continue to operate them as part of a separate company, they need to maximize
the value of these assets to remain competitive in this new and open market.
The long-term return on investment of these assets is imperative to their success.

Key performance indicators for nuclear generation include the number of staff
per unit, operating capacity of the unit vs. rating, cost per megawatt (fixed,
fuel, operations, other), outage durations (compared to other comparable units),
and radiation exposure.

Internal Drivers

The major cost component of nuclear energy is the capital depreciation cost
per megawatt-hour. As a fixed cost, it rises per production unit if the productivity
of the unit falls below forecasted levels. Any improvement in the ROI of a nuclear
generating unit is, therefore, inexorably tied to maximizing the operating hours
at the rated output (i.e., percent of maximum capacity the unit is authorized
to operate) of that unit. This can be achieved by: minimizing the frequency
and duration of forced outages (e.g., critical equipment failure), minimizing
the duration of scheduled outages (e.g., re-fueling), protecting a unit’s permit
to operate at full capacity, and optimizing the number of staff required to
operate and maintain the unit.

That is not to say that this should be done at any cost — the profitability
of the unit is still linked to its operating budget as a whole. Achieving these
performance measures must also be constrained by the level of resources budgeted
for the effort. That budget must also result in a competitive price for the
production units, while maintaining an acceptable profit level. Any increase
in unit performance over the forecasted level will have significant impact on
the unit’s profit, which will likely raise the expectation for future performance
and hence the projected ROI of the unit and ultimately its market value.

External drivers

Federal and state regulators (such as NRC, OSHA, EPA, PUC) and independent
“watch-dog” groups are primarily concerned with the safety of the general public
and the employees who support the operation of the units. The unit’s “safe operation”
must, therefore, be of paramount importance if these business objectives are
to be achieved and the unit’s rating to be protected. Other critical success
factors include:

• Identifying critical components before failure
• Maximizing the productivity of maintenance/operational staff during any
outage
• Creating and executing an effective preventive maintenance program, including
mandated surveillances and inspections

Once the management focus, culture, and discipline required to implement these
supporting programs is in place, the next requirement is for business processes
and systems infrastructure to align and optimize results, effectively managing
utility systems for the foreseeable future.

MySAP Utilities Work Management Solution

SAP’s Product Life Cycle Management Solution provides all of the critical capabilities
required to support the forementioned business objectives. SAP’s commitment
to the utility industry ensures that the product will continue to offer new
functionality, as the industry changes and evolves. The integrated nature of
the SAP’s solution means that each SAP business function is “aware” and capable
(out of the box) of referencing and impacting other related SAP business functions
in real-time without the use of interfacing software.
The following features of mySAP PLM directly address these work management requirements:

• Deficiency reporting and tracking by technical component or structure
(the analysis of breakdown, down time and cost to repair)
• Powerful and flexible preventive maintenance capability
• Work layout automation using variant configuration
• Integrated work planning and scheduling
• Integrated OSHA compliance
• Lock-out/Tag-out for worker protection
• Safe handling of hazardous material
• Extensive work monitoring and management reporting
• Flexible cost tracking and allocation schemes
• Historical reporting of work, equipment movement, material usage, documents
and business KPIs

MySAP Utilities Work Management solution is used in power plants by over 500
utilities worldwide, including more than 100 plants in North America. SAP’s
nuclear generating customers using mySAP Utilities Work Management solution
include PSE&G & NPPD in North America; VSE, Vattenfall-Ringhals, Iberdrola &
Electrabel in Europe; TUAS Power & CS Energy in Asia-Pacific.

Plant Shutdown Work Management

One of the critical activities supported by SAP’s solution is the scheduling
of work related to a plant shutdown. However, most utilities still use a stand-alone
project planning tool for this task. These “best-of-breed” applications do not
have real-time access to staff, tool or material availability. As a result,
either scheduled work cannot be performed during the shutdown or the duration
of the shutdown is extended to permit the rescheduling of this critical work.
Less-than-optimal scheduling means that non-critical remedial maintenance, preventive
maintenance and inspection work is never scheduled or assigned to a crew unable
to execute it on time.
The lack of accurate, real-time feedback information about the work also disguises
the true problem. Is it poor planning, poor scheduling or poor execution that
jeopardizes the success of the shutdown?

Figure 1 – Work Clearance Management: Work protection documents are linked
to the actual maintenance work order.

The integrated nature of the mySAP Utilities Work Management solution supports
all of the necessary business functions while maintaining a current, complete
and correct view of all resources, work in progress and work safety, under one
umbrella.

Business Process Model for Plant Shutdown

Before looking at the components of mySAP Utilities Work Management Solution,
which fully supports plant shutdown/turnarounds, let us first review the business
processes that such a solution must sustain. Using the eight-step approach defined
by the SAP Plant Maintenance User Group in a Plant Maintenance Shutdown/Turnaround
White-paper issued in July 1999, the key business processes were defined as:

• Work Identification and Selection
• Planning and Budgeting
• Scheduling and Capacity Planning
• Planning Approval and Release of Plan
• Work Execution and Feedback
• Management of Emerging work
• Completion of work
• Analysis of work results

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Figure 2 – Hierarchical graphical representation of the building blocks of
an SAP project, including WBS elements, work orders and spares.

The objectives (deliverables) and pre-conditions or characteristics of SAP’s
world-class solution are examined below:

Work Identification and Selection

The objective of this step in the process is to provide a series of work requests
that identify all candidates for work, whether part of the formal shutdown plan
template, preventive maintenance work (either due or requiring a shutdown),
surveillances, inspections, remedial maintenance or any other work that is either
time- or operationally-qualified for consideration.

MySAP Utilities Work Management solution can create work requests from automatically
triggered preventive maintenance plans (based on elapsed time, equipment counter/condition
or both), from surveillance/inspection lists, from externally triggered events
(such as SCADA systems), as well as manually generated requests.

SAP provides sophisticated selection and review tools that provide a means for
planners to assign the appropriate work requests to a weekly maintenance window
within the shutdown. This selection and assignment process will repeat itself
throughout the shutdown planning and execution steps as additional critical
work arises.

Planning and Budgeting

Once the preliminary candidates for work within the shutdown windows have
been identified, detailed planning of work and the necessary labor, materials,
services, and tools must be performed. The result of this step will be the detailed
definition of the resources and work-step dependencies required to execute each
work request as well as the expected cost associated with that work. Various
tools are provided in mySAP Utilities Work Management to facilitate quick and
easy work layout, especially repetitive tasks with many variations.

MySAP Utilities Work Management solution ensures that material availability
is considered very early in the planning cycle. Some work may be shifted or
even dropped from the plan if the necessary material cannot be provided in time.
SAP’s world-class Supply Chain Management solution is a key under-pinning to
the Work Management system. The integration, vendor-control and ability to reserve
and yet see stock levels in all company storage areas maximizes the effective
use of spares and tools. The earlier this step is executed the better the opportunity
to expedite material delivery. Critical material can also be reserved into “project-stock”
to avoid its inadvertent use for other less critical work. SAP’s Quality Management
functionality ensures that regulatory sourcing requirements are met, and Q-level
plant conditions are maintained. The resulting work plan represents a series
of weekly work schedules merged into an overall shutdown plan. The master outage
plan will most likely be created from one or more templates that have been adjusted
to fit the unique objectives and requirements of this particular shutdown. In
addition, mySAP Utilities Work Clearance Management functionality (including
links to the external radiation tracking system) ensures that the details of
the work protection required as a condition of safe work execution are defined.
These OSHA-compliant lock-out/tag-out procedures are integrated with the actual
planned maintenance work orders.

Scheduling and Capacity Planning

Shutdown/turnaround work may be planned as an operating project utilizing critical
path analysis, reconciling float across windows of time in a hierarchical structure
enabled by the seamless integration of the project systems module and the plant
maintenance module. A planned turnaround uses all of these integrated tools
to plan, report, execute, close and analyze the operating maintenance project
against the maintenance budget. An emergency shutdown uses those tools best
suited to plan and execute work in a timely manner, with follow-up rescheduling
of backlog work (online or turnaround), where resources were re-allocated to
the emergency shutdown.

The reality of finite, qualified and available staff (either internal or external
to the company) to execute the planned work must be considered. The scheduling
of this “interim master plan” will produce for each crew or groups of crews,
a resource loading demand that must be compared to its capacity and capability.
Any shortfall or surplus in capacity or capability (i.e., available hours of
work and skills or qualifications to do that work) must be considered in developing
the “master plan,” which will be submitted for approval and eventual execution.

SAP provides rough-cut capacity planning tools for evaluating and rescheduling
resource overload, as well as a fully automated, finite leveling capability
for rescheduling mass orders to available capacity.

MySAP Utilities Work Management Solution provides integration with SAP’s world-class
Human Capital Management functionality to ensure that only qualified crews or
individuals are assigned to work that requires special skills. The work schedules
of these individuals are available to the Work Management solution, ensuring
that the most current and accurate availability and qualifications information
is used in preparing the detailed work assignments. The work required by operations
staff to execute the work protection activities can also be assigned at his
time. Additionally, better control of work assignments and their sequencing
may result in the reduction of radiation exposure to employees.

Approval and Release of Plan

The ‘master plan’ that has been prepared and submitted for approval includes
the work plan, the resource plan and the budget plan. Based on the business
unit’s operations budget constraints, this plan may be modified before it is
approved. Approval would typically result in the release of all or a portion
of the budget required in order to move forward with the plan. The approved
plan is then saved to form the baseline against which the actual results will
be measured. The established baseline incorporates costs, resource quantities,
dates and times on a step-by-step basis, with rollup capability. The Release
of Schedule could result in the isolation of material into project stock, the
communication of the plans to the maintenance and operations units involved
and the beginning of preparatory work required to execute the plan once the
actual shutdown takes place.

The integration of mySAP Utilities Work Management solution with SAP’s world-class
Financial Capital Management functionality ensures that the appropriate allocation
of the planned and actual costs to capital assets or to operations accounts
is supported. In cases where FERC reporting is required, mySAP Utilities also
provides IS-U/FERC to meet regulatory reporting requirements.

Work Execution and Feedback

As shutdown work proceeds, it is critical to the successful management of this
effort that current, complete and correct reporting of work activity be available
to the planners and schedulers. To achieve this result, all work including maintenance
and safety, material usage, tool usage and contractor services must be reported
in a timely fashion (typically at the end of each shift/day). SAP’s solution
offers timely reporting with superior functionality supporting the entry of
confirmations via the Internet.

To ensure outage schedule compliance, the “working plan” will be updated to
reflect remaining work and then rescheduled based on the latest available capacity
for qualified resources. Changes to the plan will be communicated to affected
staff and management. Prior to updating the working plan for the remaining work
a new baseline is obtained. SAP supports multiple baseline versions for different
work stages, if needed. Each baseline can be automatically compared to others
as well as the current version of the project, with a step-by-step calculation
of variances, and rollup capability.

Management of New Work

In reality, new unapproved work will be identified after the initial approval,
release and execution of the working plan. Based on management controls in place
for this project, these “new work” requests must be presented to appropriate
management for approval and incorporation into the working plan.

The use of workflow is supported within mySAP Utilities Work Management solution
to facilitate the automatic flow of work requests from the identification phase
through planning and finally to approval/rejection. MySAP Utilities Work Management
also supports the analysis of these processes for elimination of bottlenecks.
These approved additions to the working plan are included in the next re-scheduling
exercise in the same manner that actual results drive adjustments to the current
plan. Appropriate costs and durations are automatically recalculated.

Work Completion

All activity associated with the shutdown must be completed and records updated
to reflect the work done, as well as the final facility status. The work includes
final confirmations, applying the correct status to each job, removing all safety
tags, post-maintenance testing, updating documentation, releasing of dedicated
staff, processing all outstanding invoices, returning unused material and tools,
cost settlement and root-cause analysis where required.

Work Results Analysis

In order to ensure that the organization learns from each shutdown, it is imperative
that defined metrics are calculated for both planned/approved values and for
actual results. MySAP Utilities Work Management provides extensive analytical
and reporting tools to support KPI measures and the investigation of deviations
so that the template plan can be approved accordingly.
This analysis will help to drive improvements in the shutdown template plan
as well as identify opportunities for improving the planning, scheduling and
execution phases of future shutdowns.

MySAP Utilities Work Management solution results in shorter outages, fewer maintenance
staff and a higher level of reliability and safety than can be achieved with
a loosely linked set of stand-alone applications. Improved performance translates
to higher return on investment for the unit, and therefore the asset.

Summary

Any utility considering improvement in their nuclear generation business unit
should consider the opportunities offered by mySAP Utilities. SAP’s 29-year
history of success, impressive list of satisfied customers, innovative technology
and long-term commitment to the utility industry clearly illustrates that SAP
is a world-class solution for utilities today and is committed and capable of
answering utilities’ specific pain points and requirements well into the future.