Public Water Suppliers Look to Privatization

New forces are reshaping the responsibilities of water and wastewater
utilities. Although they come in different forms, water utilities conventionally
serve the public and industry supplying, treating, and distributing drinking
water; the collection and disposing of used water or “effluent;” and sometimes
draining storm water and other run-off. Competitive practices evolving
in telecommunications, electric power, and gas utilities are beginning
to emerge in public water. Many municipalities and regional authorities
are inadequately equipped to respond to the challenges of this newly competitive,
market-driven environment.

Water Privatization Becomes a Trend

Municipalities are increasingly considering privatization as a viable
option. Privatization could involve a private company purchasing a public
water system or a private company taking over the operations of a public
water system. Private sector firms supply the investment needed to improve
customer service, the global expertise to employ advanced technologies,
and the incentives required for more efficient practices. Particularly
in a setting where municipalities confront flat or diminishing budgets,
the involvement of private sector firms is appealing because they lower
expenses, improve cash flows, and add new funding sources. The U.S. private
water industry is ready and able to do both asset acquisitions of publicly-owned
properties or contract operations, but U.S. tax law and federal policies
have impeded sale transactions and made contract operations currently
the most used option for U.S. localities.

Until recently, federal grant repayment obligations and IRS policies
impeded the movement to privatize public water systems. In 1992, an executive
order (E.O. 12803) changed the allocation of proceeds from the sale or
lease of municipal facilities built with federal funds. Now, cities will
not be penalized for selling, leasing, or structuring contract operations
for facilities built with federal support. Moreover, in the past, IRS
rules held that municipal water utilities with outstanding tax-exempt
debt could not enter contract operations agreements for terms longer than
five years and still maintain the debt’s tax exempt status. Because private
operators need several years to begin recouping the high costs associated
with beginning contract operations, five-year contracts dramatically limited
the benefits of private sector participation. In 1997, however, the IRS
changed the policy to allow contracts with terms up to 20 years (Rev.
Proc. 97-13).

Now that these obstacles have been removed, incentives exist to create
attractive business opportunities for properly equipped companies, many
of which are poised for success in the emerging industry. The current
circumstances have led to a chance for the private sector to assist municipalities
with reducing operational expenses and improving service delivery quality.
With acquisitions or long-term operations and maintenance contracts, both
the public and private sector can succeed. The public sector can save
on operational costs and attract new funding sources for needed capital
improvements. Meanwhile, the private operator has an incentive to run
the plants more efficiently – profit.

Figure 1
Alternatives to private allocation of services and ownership to the public
sector

Figure 1

Privatization Comes in Different Forms

The French have been far ahead of others in utilizing a practice in which
municipalities continue to own their water utilities, but contract out
services to private operators. They started this in the nineteenth century,
but it is only now being employed in large cities in the United States.
The British, under the Thatcher administration, sold their state-owned
water operations to private investors. Those newly privatized companies
have become multinational players in privatization markets, including
the U.S. In some cases, like in Buenos Aires, governments have sold or
leased out their water facilities, allowing private operators to sell
services directly to the public, with government regulation. Of course,
the U.S. has always had successful privately-owned and publicly-regulated
water and wastewater utilities. Mexico City took yet another approach
to privatization, contracting the rights to operate parts of the city
water system to four operators, with the thought of stimulating competition
among them.

Privatization can be partial; it does not necessarily have to encompass
the entire system. Water utilities are increasingly contracting out specialized
parts of their systems, such as billing, payroll accounting, lab work,
or meter reading. It is now common for public water utilities to engage
an outside firm to operate a treatment plant or another major part of
the system. In cases where the rehabilitating or building of new system
elements is required, a variety of well-known arrangements are possible,
including Build Own Operate (BOO) and Build Own Operate Transfer (BOOT).
Figure 1 illustrates the major alternatives for providing for varying
degrees of private allocation of services and ownership to the public
sector:

What works for one public water supplier, both economically and politically,
may not be the best solution for another. Choosing the most suitable privatization
solution needs to be carefully analyzed for each situation. Following
is a recent example where contract operation of the entire water system
proved to be the solution that best met local objectives and conditions.

Atlanta: A Case Study

The City of Atlanta recently completed the largest water operations outsourcing
in North America, awarding a 20-year full operations and maintenance contract
to United Water Services (UWS) as a result of a competitive procurement
process. While the city will retain ownership, its operations costs will
be cut almost by half. UWS will manage the workforce and all operations
and will coordinate capital improvements to provide clean drinking water
to 1.5 million customers. In doing so over such a long period, UWS can
count on nearly half a billion dollars in service fees to be paid by the
City of Atlanta over the term of the contract.

Background

During a tough mayoral campaign in which both candidates and the major
newspaper favored privatization, incumbent Mayor Bill Campbell promised
to drastically scale back a scheduled water rate increase of 51 percent.
There was no question that a rate increase was imminent. The city faced
EPA fines of $100,000 a day for environmental violations by the wastewater
system and $900 million in necessary repairs and improvements, including
new underground pipe and facility construction and restoration. The question
facing Mayor Campbell was how he could pay for the needed capital facilities
and improve the performance of the city’s water system without a 51 percent
rate increase. This pending financial distress and the fear of an infrastructure
collapse caused Mayor Campbell and other political stakeholders to view
privatization as the right solution.

The First Step: Assess Cost-Effectiveness of Current Operations

As a first step, the city commissioned a detailed study to assess the
cost-effectiveness of its current water and wastewater operations and
identify operational alternatives. This involved analyzing approximately
40 functions and facilities, reviewing documents, interviewing key personnel,
benchmarking against similar systems, and identifying long-term goals
and strategy. The study identified and examined several operational alternatives,
determining their effect on future rates. These options included:

  • Light re-engineering/outsourcing of non-core operations (such as
    grounds keeping)

  • Heavy re-engineering/outsourcing

  • Contract operations of various treatment facilities

  • Contract operations of all system facilities

An outright sale of the assets was not considered because, in this particular
situation, it was not politically feasible. The city wanted the full support
of the council and wanted to act quickly. A sale would have opened public
discussion on a level that could have been too difficult for the council
to support within the timeframe that the city believed was acceptable.

The city then estimated the range of cost savings that could be derived
from each of the options after assembling them into the following savings
alternatives:

  • Light Re-engineering/Outsourcing: Making the straightforward
    changes that can be accomplished within a single system/department.
    Also included in this alternative was the outsourcing of non-core
    functions to the private sector.

  • Heavy Re-engineering/Outsourcing: Adding to the light re-engineering
    package those more difficult internal actions that involve the cooperation
    of two or more departments and/or a basic change in the way that the
    city conducts its business. Also included in this alternative was
    the outsourcing of non-core functions to the private sector.

  • Contract Operations: Selecting through competition a qualified
    private firm or firms to operate one or more of the five treatment
    facilities in the system while implementing the heavy re-engineering
    package on the non-contracted facilities and functions that remain
    under the city’s management.

  • System Management: Selecting through competition a qualified
    private firm to manage the water system, the wastewater/sewer system,
    or both, while implementing the heavy re-engineering scenario on the
    remaining system.

The city constructed a financial model to evaluate the impact of these
alternatives on the customers. The model simulated the flow of revenues
and costs through the systems, including operational costs, indirect costs,
capital spending, debt service on bonds, outside revenue sources, and
other factors, to demonstrate what future rates would look like under
the various alternatives. As Mayor Campbell stated in his campaign, the
city needed to generate cash under any alternative to avoid dramatic rate
increases. This analysis determined that a combination of the alternatives
would realize the greatest overall potential benefit to the city and its
utility customers, at acceptable levels of risk. The chosen combination
was contract management of all water system operations and one wastewater
plant, with re-engineering of the rest of the wastewater and sewer system.

Choosing a Contractor: A Three-Phase Process

The City of Atlanta followed a careful selection process with three phases
that took less than a full year to execute: (1) qualification of bidders;
(2) initial cost and technical proposals; and (3) best and final offers.

In the first stage, the city issued a widely advertised Request for Qualification/Request
for Proposals (RFQ/RFP), which incorporated a draft Operating Agreement.
Five statements of qualification were received. It should be noted that
at least one expected bidder declined to bid because of the form of privatization
that Atlanta selected. Of the five that did bid, three were from consortia
led by French concessionaires, and two were from teams led by U.S. firms.
Using pre-determined criteria, the city evaluated the financial strength
and technical ability of each proponent to fulfill the requirements of
the contract. The purpose of this stage was to narrow the field by eliminating
those contractors who were not substantial enough to meet minimum requirements.
All five contractors, however, met the qualification criteria required
to continue to the next phase.

At the completion of this qualification phase, all five bidders were
invited to submit separate technical and cost proposals. The RFQ/RFP for
these proposals provided such information as historical and current city
water utility operating statistics, staffing, budgetary, and other related
financial data, proposed capital improvement programs, and various policies
and procedures. In addition, the RFQ/RFP included various required levels
of service and performance measures to which the winning contractor would
be held during the contract term. In general, the proponents’ proposals
were to describe the detailed technical project approach, proposed key
personnel and staffing plans for the project team, the proposed annual
cost for the term of the contract, and the mechanism for the escalation
of costs over time. Some of the most important aspects of the entire process
for the city dealt with the requirement that bidders comply with the city’s
Equal Business Opportunity (EBO) policy and its proposed employee relations
and transition plans. (The city had required that no current water system
staff be laid off for the first three years of the contract.)

To ensure that the evaluation process was as democratic and unbiased
as possible, multiple evaluation teams of city staff members were assembled.
Each team was responsible for evaluating various specific aspects of the
proposals, rather than entire proposals, to further decentralize the evaluation
process. As part of the review of the technical and cost proposals, the
city held personal interviews with each of the bidders. Questions raised
by either side that could not be answered during the interview were submitted
and answered as a follow-up to the interview process.

After the interviews and subsequent requests for further information
were completed, the city moved into the “Best and Final Offer” phase.
In this phase, the city refined and standardized the final Operating Agreement
to include any additional information and requirements that resulted from
the entire evaluation process. The bidders then submitted their final
technical and cost proposals based on the revised Operating Agreement.
The city evaluated the final proposals and provided the final ranking
of the bidders and recommendations to the mayor and city council.

A Successful Conclusion

After nearly a year’s effort by the city team, Atlanta contracted with
United Water Services to operate the City of Atlanta’s water system. With
annual revenues of $120 million, United Water Services is a joint venture
of Suez Lyonnaise des Eaux and New Jersey-based United Water Resources,
bringing global expertise to the system. The company offered to operate
Atlanta’s system at a guaranteed annual cost of $21.4 million, almost
half of the city’s current operating budget.

Using Atlanta as an example, it is clear that privatization offers attractive
choices to public and commercial interests. In some cases, the best alternative
will be to sell the entire public water system to a private company. In
others, it may be to outsource only the operation of certain non-core
processes. Or the best solution may fall somewhere in between, as it did
for Atlanta. Each privatization opportunity is different and must be evaluated
on its own merits.

Current trends in water competition are rooted in rising consumer expectations.
As consumers have forced improved services in other utilities, so will
water owners and managers have to meet the demands in this sector. The
water utility of the future will be defined by its ability to deliver
better quality and service for lower rates.

PricewaterhouseCoopers, together with the engineering firm of Brown
and Caldwell, and the law firm of Long, Aldridge & Norman, assisted the
City of Atlanta with the operations assessment, developing the operations
alternatives, and implementing a successful privatization strategy.

The Innovation Imperative

The Value of Innovation

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.
Innovation, and the act of entrepreneurship, not only create wealth but
enhance the overall value of companies as well.

PricewaterhouseCoopers’ research reveals that there is a strong correlation
between revenue from new products and services and overall revenue growth.
For example, we have found that a 10 percent increase in turnover generated
from products and services introduced in the previous five years correlates
to a 2.5 percent increase in revenue growth, year on year. Further, we
find that companies with 80 percent of their revenue from new products
have typically doubled their market capitalization in a five-year period.
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 thus becomes one of creating an environment where new ideas
that add value are the norm – an idea-rich culture where innovation is
embedded as a core capability and principle. Only under such conditions
can companies hope to break from the herd.

According to The Economist, the top 20 percent of firms in an
annual innovation poll have achieved double the shareholder returns of
their less innovative peers. Innovators cited in the poll, such as Dell
and Amazon.com, 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. Similarly, Amazon.com
changed the rules of book-selling by giving customers an online alternative,
offering book buyers a vast product selection, low prices, and convenient
delivery. Reflecting its success, Amazon’s four-year compound annual growth
rate for sales (CAGR) was 370 percent. By comparison, Barnes and Noble
(the largest traditional bookstore) had an estimated four-year compound
annual growth rate for sales of 12.8 percent for the same period.

 

Figure 1
Effects of e-commerce in the book-selling industry

Figure 1

The Energy Imperative

The pressure to innovate and increase competitiveness is significantly
impacting the energy industry, both in the U.S. and abroad. Growing EPS
at 7 percent to 10 percent (a stated goal of many utilities) while prices
are falling and unit sales growth is hovering around 2 percent to 4 percent
is exceedingly difficult. This environment has made the need for innovation
even more critical.

PwC believes that the ongoing changes in the utility industry will result
in five dominant new market paradigms:

  • GREATs – Global Relationship Energy Traders

  • HITs – Horizontally Integrated Transmission Companies

  • WINNs – Wires and Natural Gas Network Operators

  • MAJARs – Major Account Retail Service Providers

  • CHAMPs – Channel Maximizing Retail Players

Within this new framework, energy companies must focus on innovation
by reinventing everything, from their products and services to internal
processes and delivery systems, in order to generate new wealth and new
revenue. Just as important, to excel in the increasingly competitive market,
a spirit of innovation and an entrepreneurial culture must be effectively
nurtured within organizations. The biggest challenge to energy companies
in the near future will be changing the conventional wisdom (ingrained
over almost 100 years of operating in a regulated paradigm) about:

  • Who are customers?

  • What do they value?

  • What are, or should be, the scope of the organization’s product and
    service offerings?

  • How do we think and perform the steps necessary to bring our products
    to market?

This can be a great challenge in today’s efficiency-oriented utility
company, where ideas are funded based on near-term profit potential and
ROI. However, with the current uncertainty in the marketplace, companies
must destroy these barriers and create effective means to foster and reward
innovation. New PwC research, including the results of a new PwC survey
of CEOs and Board Directors entitled “Innovation and Growth: A Global
Perspective,” sheds light on how established companies can embrace innovation
– meeting customer and investor expectations. In the U.K., ScottishPower,
the U.K.’s largest utility, and the Royal Bank of Scotland have launched
a business-to-consumer joint venture – Work24 – selling financial services,
home services, energy, telecom, and Internet access to their combined
customer bases, totaling more than 16 million residential and small business
customers. Centrica, the U.K.’s largest gas retailer, operates Goldfish,
one of the most popular consumer Internet sites.

The development of business-to-business (B2B) e-markets by utilities
(similar to the auto industry’s Covisant and Royal Dutch/Shell’s recently
announced Internet marketplace for procurement in the oil, gas, and chemicals
industry) will transform the procurement and supply chain segments. On
June 1, 2000, 21 North American gas and electric companies announced the
formation of Pantellos, which aims to be the leading e-market in the utility
industry in North America. A similar effort in Europe, anchored by ScottishPower,
Endesa, RWE, and others, seeks to expand beyond procurement and logistics
into management of outsourced workforces for WINNS and HITS businesses.

E-business will play a significant role in bringing innovation to the
energy industry over the next several years. PwC’s survey found that e-business
is, in fact, forcing all companies to innovate. Fifty percent of those
senior executives surveyed “saw a need for substantially or radically
more innovation due to e-business.” The impact of e-business will affect
all aspects of a utility’s value chain, including interactions with suppliers,
customers, internal departments, and employees. E-business is a “disruptive”
technology that existing companies must address today since its impact
will be substantial. New Internet-based energy companies have already
emerged, such as Essential.com and Utility.com, utilizing new business
paradigms that now pose real threats to existing energy companies. In
the long term, these companies may even overtake the industry leaders
and dominate the market through efficiencies inherent in an e-business-based
business model.

Deregulation and e-business, as well as other potentially disruptive
technologies (e.g., distributed generation, low-cost wireless access,
and energy storage), require energy companies to find opportunities to
create new wealth and/or watch others loot their markets. Increased competition,
falling prices, and shrinking margins are realities of life in traditional
electricity and natural gas companies. Embracing the disruptive change
of innovation can enhance their ability to compete and thrive.

What is Innovation?

Gary Hamel of Harvard Business School makes the distinction between stewards
of existing wealth and true innovators who are “obsessed with creating
new wealth.” If an organization wants to become a truly innovative company,
in the mode of 3M, GE, and Cisco, a company must “shift the balance of
effort from stewardship to entrepreneurship.”

Accomplishing this is not an easy task. Many of today’s management processes/principles
are geared toward stewardship – the management, maintenance, and improvement
of current revenue streams. Hamel describes stewardship as “spending time
trying to unlock wealth by hammering down costs, outsourcing inefficient
processes, buying back shares, selling off bad businesses, and spinning
out good ones.” While aimed at improving existing processes, reducing
costs, and maximizing return, they do not focus on creating new wealth.
Current corporate management styles encourage these investments, foregoing
more innovative opportunities in favor of short-term profits. Meanwhile,
new technologies and innovations identified and embraced by other firms
(and possibly by new entrants), will overtake established firms and transform
the industry.

Clayton Christensen highlights the danger when new technologies are ignored
by existing successful firms. These firms then find that current technologies
become quickly outmoded, ineffective in satisfying the needs of new and
existing customers. Critically, “sound business judgement” was the basis
upon which investment in new disruptive technologies was not made. And
those business decisions led rather quickly to non-competitiveness and
even, in some cases, obsolescence. In the disk drive industry, new and
initially less profitable disruptive technologies have repeatedly emerged
to overtake profitable established products, leaving the dominant companies
of the day unable to compete. The continual need to innovate and bring
products speedily to market is now upon the energy industry.

The PwC innovation and growth study found that two-thirds of top-performing
organizations fund innovation and new product development through internal
venture capital, most commonly to fund sabbaticals for “intrapreneurial”
staff to work on new ideas. Senior executives believe that this approach
allows for “an active flow of ideas,” critical to fostering innovation.
Talent flow within an organization is an important part of fostering innovation.
By giving talented employees from any department an opportunity to create
and develop their own initiatives, leading firms keep valued employees
motivated and satisfied. Employees feel less “pigeon-holed” in their jobs
knowing that they have opportunities to pursue promising innovative activities.
Seventy-three percent of the most innovative companies in the PwC survey
exhibit an “open style of managing innovation” to foster the generation
of new ideas.

What Can Energy Companies Do?

How can energy companies foster innovation within their walls? Two companies,
Royal Dutch/Shell and AES Corporation, exemplify the encouragement of
innovation in leading energy firms.

Royal Dutch/Shell’s Exploration and Production (E&P) division has been
transformed into an “innovation-friendly zone.” Establishing the GameChanger
process, Shell’s E&P group has created a channel for employees to submit
new ideas that challenge industry conventions, using a four step process:

  • Shell established the GameChanger, which has team authority (apart
    from any of Shell’s divisions) to review and allocate $20 million
    to “game-changing ideas” submitted by any employee.

  • To encourage free thinking, Shell holds internal seminars designed
    to jumpstart the development of innovative ideas through a variety
    of brainstorming exercises. Once viable ideas are submitted, additional
    seminars are held to take these ideas to the planning and development
    phase. Employees are taught how to create viable business plans and
    100-day action plans to test their ideas.

  • The GameChanger team then reviews these plans and awards funding
    to those ventures with the greatest potential. Similar to the venture
    capital process entrepreneurs go through, employees submitting proposals
    pitch their ideas to the panel in successive rounds of review. The
    review process takes approximately one to two weeks and projects gaining
    approval are usually given between $100,000 and $600,000 in seed money.

  • Several months after a project is funded, each project goes through
    a “proof-of-concept” review. The GameChanger panel looks over the
    project’s progress to date and determines whether additional funding
    is appropriate. Those that make it through second round funding are
    integrated, where possible, into existing business units, becoming
    formal corporate initiatives.

In the three years since the process was established, Shell employees
have submitted more than 320 venture ideas. In 1999 alone, four of the
company’s five major initiatives were the direct result of the GameChanger
process and 30 percent of the E&P division’s R&D budget was spent on these
ventures.

The GameChanger process works because it creates markets for ideas, capital
and talent, similar to the dynamics of the Silicon Valley. The GameChanger
process creates markets for ideas by giving employees an opportunity for
“personal wealth creation.” Shell employees can submit ideas to the GameChanger
panel – new ideas are not the exclusive territory of only certain departments
or employees. Employees then shepherd their viable ideas through each
stage of review and development, giving them ownership and an opportunity
to build a business.

GameChanger also provides Shell employees access to a market for capital.
Instead of relying solely on existing departmental investment channels,
employees can obtain funding for their ideas from the GameChanger panel,
which has a significant amount of discretionary monies to invest in promising
new ventures. Providing multiple avenues for ideas is critical to the
development of active entrepreneurial activity within firms.

Advanced Energy Solutions Corporation (AES), a leading global power company
founded in 1981, has set up its organization based on “decentralized organizational
principles and processes.” By minimizing the number of management layers
in the organization and expanding the level of responsibility for each
employee, the company hopes to encourage accountability and innovation.

To further drive free thinking within this structure, AES has adopted
a team approach in which multi-skilled groups are assembled to develop
projects. Rather than establishing departments, such as an engineering
department or human resources department, these teams are responsible
for all functions associated with their assigned projects. This team approach
has been adopted by AES because the company feels it encompasses the four
key values of the firm. In the company’s words, the teams are:

  • Fluid – Many people are members of more than one team at one
    time

  • Autonomous – All decisions about a project are made within
    that team, with final say granted to that team

  • Driven by the front line – Decisions are made not from the
    top-down, but from the bottom-up

  • Accountable – Responsibility is pushed to the lowest level
    possible, encouraging everyone to be part of a decision. As a result,
    each team member views the project in terms of a whole. Colleagues
    and team members must trust each other to follow through to the best
    of their ability.

Creating a less structured, more independent environment has worked very
effectively for AES, giving its employees the freedom to be more entrepreneurial.
In effect, each team functions as an independent business, responsible
for the success or failure of its project. As noted in Business Week,
AES has “generated some very un-utility-like growth.” AES reported a net
income of $377 million in 1999, a 21 percent increase from 1998 and an
astonishing three-year CAGR of 193 percent (1996-1998). As a result of
this phenomenal growth, AES’s stock price has soared by more than 400
percent over the last four years.

Innovative activities such as these – and their resulting impact on shareholder
value – must become a priority for other energy companies, for encouraging
and sustaining innovation within companies will be a critical factor in
the long-term survival of organizations in the 21st century. As found
in the PwC survey, senior management of global companies know that innovation
within an organization and value creation are “inextricably linked.” And
with the increasingly dynamic nature of markets, talent, and ideas, energy
companies must depend more and more on its internal resources to maintain
competitiveness. Relying less on stringent controls and structure, CEOs
and senior management must allow innovation to emerge and thrive within
their organizations to ensure a place in the future energy marketplace.

Appendix

PwC believes that the structural evolution of the industry will eventually
result in the five dominant new market paradigms that include ?GREATs,
?HITs, WINNs, ?MAJARs,

and CHAMPs. These paradigms will form the basis around which companies
and/or business units will be organized. While some energy companies will
position themselves as a single paradigm, others will establish business
units in more than one of the paradigms. A brief description of each is
provided below.

GREATs

Companies configuring themselves as GREATS will be global portfolio generators
and traders pursuing a forward integration, asset-backed trading strategy.
This group may also include upstream fuel supply asset owners and specific
types of pipeline operators. GREATS will achieve global economies of scale
in generation and trading by leveraging their relationship skills with
the infrastructure of host country partners. They will have to satisfy
two market imperatives – the need to maximize plant performance through
effective plant operation and the need to manage price risk through effective
trading. The possession of both generation and trading expertise will
enable GREATS to maximize shareholder value by providing them with a portfolio
of options – at least cost to the company – for satisfying the power needs
of customers.

Examples of companies that are demonstrating these characteristics include
Calpine, AES Corporation, Southern Energy, El Paso Energy, Dynegy, and
Duke Energy.

HITs

HITS are electric and/or gas transmission companies that provide electric,
natural gas, fiber optic, and other “big pipe” transportation services.
They also provide innovations in transportation system pricing, the development
of ancillary services, and the use of derivatives to manage transportation
risk. These network asset managers will leverage their knowledge of operating
a transmission/transportation system to acquire additional transport companies
and identify synergies to reduce cost. Existing utilities and pipelines
with significant transmission assets will form the core of key players.

Examples of companies that demonstrate these characteristics include
National Grid Group, Enron, Williams, Red Electrica, and Powernet.

WINNs

Successful network distribution companies will keenly focus on delivery.
They will aim to capture all possible operational and commercial advantages
available to the network, particularly adopting novel network technologies,
including the use of micro-generation to support the distribution network.
Players will include existing utilities as well as suppliers of network
technologies, metering technology, advanced network mapping, and work
optimization solutions. Network distribution companies will develop a
keen knowledge of both costs (at a process level) and commercial opportunities
for network exploitation; these companies will drive out all non-contributing
processes, then develop out-sourcing partnerships where they can further
reduce the cost of delivery of core processes.

Regulatory alacrity will be essential. These companies will demonstrate
keen skills in regulatory relations, enabling them to skillfully manage
the business regardless of the regulatory regime. Network distribution
companies will create value by driving out the “easy win” efficiencies
and reduce distribution networks to a marginal net cash business. They
will grow revenues by leveraging their existing backbone networks to provide
access to telecommunications, broadband, and Internet service providers.

Examples of companies that are demonstrating these characteristics include
Energy East, GPU, NSTAR, DQE, and 24/7 (outsourced workforce but no ownership
of pipes and wires).

MAJARs

MAJARS will develop national footprints to provide energy management
services to industrial, institutional, and large commercial customers.
These service providers will aggregate the energy needs of companies having
hundreds of geographically dispersed sites. These companies will provide
specialized services including consolidated billing, information management,
energy management, power quality, energy efficiency services, site generation,
and the operation and maintenance of energy-related equipment and supplies.
They will take an active role in expanding the commercial retail use of
distributed generation technologies (including micro-turbines and fuel
cells). They will lure the largest customers away from incumbent utilities
in the earliest stages of customer choice as states restructure, offering
to provide energy solutions that are beyond the geographic reach of the
utility – and at significant cost savings.

Examples of companies that are demonstrating these characteristics include
NewEnergy (AES), DukeSolutions, and Enron Energy Services.

CHAMPs

Companies configuring themselves as national and regional service providers
will aim to maximize the value of customer interactions and leverage existing
customer relationships by offering a broad range of services, including
energy. Initially, these mass market retailers will be based on joint
ventures and alliances since very few, if any, of the existing utility
companies will have the ability and experience to act across all of the
potential services to be offered. The mass market retailers will function
as “brand managers,” utilizing their brand recognition and customer relationships
and mobilizing the skills of different allies and partners to develop
products that meet customer needs. The prime innovators will likely be
new retail entrants seeking to leverage their existing sales and marketing
competencies, existing customer information management technologies, and
strong retail brands. Traditional utilities may not have the full range
of skills necessary to embark alone in this sphere, but will be strongly
sought out as candidates for alliance activity with new market entrants.
The mass market retailer will develop in markets that are fully open to
competition, and where competition is putting strong pressure on energy
commodity sales margins.

Examples of companies that are demonstrating these characteristics include
Centrica (UK), Essential.com, Utility.com, PowerDirect (AES), and The
New Power Company (Enron/IBM/AOL JV).

 

Information Technology and the New Energy Industry Model


For the past 50 years, the utility industry landscape has been dominated
by the vertically-integrated business model, with companies owning and
operating most or all elements of the energy value chain within certain
monopoly territories and within certain business segments. During the
past 10 years, this model has begun to “dis-integrate” into separate lines
of business (LOBs), some of which remain regulated and others becoming
unregulated, but typically under a holding company umbrella. However,
this model is transitional and is, at least partially, an attempt to extend
the life of the old vertically-integrated utility model and to resist
the emerging new energy industry paradigm. We believe the transitional
model will dominate for the next five years. The emerging value chain
model will begin gaining acceptance in the 2002-2005 timeframe and become
the dominant model beyond 2005.

Five Major LOBs

This emerging model is characterized by five major LOBs that span the
entire energy value chain (see Figure 1):

  • Extraction of natural resources (e.g., oil, gas, coal)

  • Processing of resources into energy products (e.g., power generation,
    oil refining)

  • Wholesale marketing and trading

  • Delivery of energy via network infrastructure (e.g., transmission
    and distribution)

  • Retail marketing of energy products to end use consumers

 

Figure 1
The New Energy Industry Model
See
larger image

Figure 1

Each LOB can be owned and operated as a separate business or can be combined
or grouped under a single holding company to mitigate risk. Additionally,
each LOB can be associated with other related non-energy businesses, which
provide a benchmark for business performance, a route to business expansion,
and a gateway through which new competitors may enter. For example, the
energy processing LOB (e.g., power generation, oil refining) can be associated
with other process manufacturing businesses such as chemicals or water
treatment. Increasingly, power generation executives are asking which
processes and technology have proven most effective in deregulated process
manufacturing markets. Of the five LOBs, only the delivery business (e.g.,
transmission and distribution) will remain as a regulated utility. All
other LOBs will operate as competitive businesses.

Since technology strategy is profoundly impacted by market structure,
we predict a significant shift in energy industry technology strategy
during the next five years (see Figure 2). Under the old vertically-integrated
utility model, technology strategy focused on transaction efficiency (in
an effort to drive down costs), rates of change were determined by the
regulator, and the regulator/ratepayers shared technology investment risk.
In the new energy industry model, competitive intelligence will dominate
transaction efficiency (but will not eliminate it), cycle times will be
determined by the markets, and technology investment risk will be borne
by shareholders.

 

Figure 2
Impact on technology strategy

Figure 2

How are Market Leaders Responding?

Energy market leaders, both those emerging from the regulated utility
market and those entering from competitive markets, are integrating business
and technology strategy as a primary goal. We believe that success in
integrating business and technology strategy has become an industry best
practice and will become a differentiator in the market. However, we are
also finding that executive commitment is necessary for this integration,
and this is yet another cultural shift for the industry to navigate.

This is forcing companies to re-evaluate their source of IT advantage
– is it transactional efficiency or is it competitive and operating intelligence?
Those focused on competitive and operating intelligence are building IT
knowledge in areas that will be required under the new energy market structure.
Whether competition arrives on time is not the issue. Market leaders are
positioning technology to take advantage of performance-based regulation
and/or competition, whichever comes first.

Pipes and Wires: Transitioning to the New Model

As part of the energy industry evolution to the value chain model, pipes
and wires businesses are transitioning from a traditional utility structure
to a virtual business structure. This transition is forcing pipes and
wires organizations to abandon traditional business models (vertical integration,
local service territory) and move toward a highly-outsourced virtual business
model with global operations (see Figure 3). We believe this transition
will have dramatic IT investment implications during 2000-2004, particularly
in IT organization, outsourcing, architecture, and applications.

Figure 3
Pipes and Wires Business Models

Figure 3

During the transition (a time of uncertainty and change), integrating
business and IT strategy, and minimizing IT cost in the context of business
strategy will be critical success factors. Additionally, the use of internal
shared services by IT organizations will be challenged, accelerating the
growth of separate shared services IT companies. Outsourcing will move
beyond energy network infrastructure-related services (e.g., design, construction,
maintenance) to encompass a wide range of IT, Customer Relationship Management
(CRM), and revenue cycle (e.g., metering, billing, settlement) services.
Development of an enterprise-wide technical architecture (EWTA) to support
the business goals (e.g., reduce costs, increase reliability and quality)
yet provide for adaptability, scalability, and increasing external communications
will also be a differentiator for successful companies. Finally, we expect
the current collection of applications (e.g., GIS, work management, distribution
management, etc.) used by pipes and wires businesses to evolve into an
integrated distribution resource management system.

IT Organization for Pipes and Wires

IT governance will be a critical success factor for pipes and wires companies
navigating this business transition. We believe CIOs will reshape their
existing IT councils into enterprise architecture groups in an effort
to improve the integration of business and technology strategies. Additionally,
the minimization of basic IT service costs will be critical to the pipes
and wires lines of business. Refurbishing the IT council will provide
an important element of governance in reconciling the enterprise demand
of IT operating excellence, while delivering customized IT service to
various LOBs.

For pipes and wires organizations operating as part of a larger energy
holding company and served by a corporate IT shared services group, we
believe these shared services IT structures will run into resistance as
regulators grapple with a mixed market where some LOBs are regulated and
others are unregulated. By 2004, we predict that moving the IT organization
into a separate, unregulated IT services company will be the norm.

Restructuring the Energy Delivery System

New forms of competition on the supply side of the energy industry is
driving discussion regarding restructuring of the delivery function as
well. The development of distributed generation technologies and moves
by aggressive energy retailers will be the greatest influence on these
activities.

As experience is gained in the competitive electric and gas supply markets,
regulators and industry leaders are now turning their attention to the
possible restructuring of the energy delivery system. This shift is driven
partly by the advent of new technologies such as distributed generation
(DG) and partly by the early adopters of supply competition who are now
looking to the distribution arena for innovation and change. The information
requirements necessary to accommodate and enable the types of changes
being envisioned will require significant advances in IT deployment, specifically
in the areas of communications, metering, and control.

Initially, these changes will manifest themselves as enhancements to
existing energy management (EMS), supervisory control and data acquisition
(SCADA), and automated meter reading (AMR) systems. Longer term, we predict
the development of an Internet-based communications network that parallels
the topology of the energy delivery network.

The Competitive “Push” for Distributed Generation

Distributed generation offers opportunities for pipes and wires businesses
to increase the value of their regulated delivery networks in local energy
markets. This notion is premised on the first-mover advantage to those
who create physical and IT infrastructures optimal for DG development.
But this first-mover advantage does not translate to the pipes and wires
businesses being the logical channel to the consumer. Pipes and wires
businesses, or their affiliates, need to ally with distributors of DG
products and services to exploit that market. Currently, however, these
same DG vendors are instead facing impediments that pipes and wires businesses
are erecting to thwart the deployment of DG over their systems.

DG proponents are clamoring for open access to the retail wires, modeled
after federal transmission open access. Competitive retail electric suppliers
are also complaining about the pipes and wires companies’ ability to provide
a preference to their own, or their affiliates, supply. The notion that
is being advanced from both camps is that the pipes and wires should be
truly open and service should be provided on a comparable basis to any
competitors – that is comparable to the terms and conditions that the
company offers to itself or its affiliates. In addition, pipes and wires
companies are being pressured to remove other impediments at the retail
level, such as excessive backup and standby service requirements, and
restrictive interconnection standards.

Energy FAQ

Energy industry business and IT leaders are currently asking themselves
three important questions:

  • What do we need to do to survive?
  • What do we need to do to be competitive?
  • What do we want to be when we grow up?

META Group research indicates that 10 percent of existing energy utilities
are in denial – they believe that the traditional regulated business model
will return and that survival depends on waiting out the “experiment”
with competition. Seventy percent are struggling to define a future state
of the industry, and 20 percent have a vision of the future and coherent
programs in place to migrate the business. However, we believe that most
of the business and IT investments in energy utilities today can be characterized
as related to survival. The real competitive initiatives are coming from
outside the traditional utility space, either from the oil & gas majors
(e.g., Enron, Shell, etc.) or from Internet startups (e.g., Utility.com,
Enermetrix.com, HoustonStreet.com). Regardless, industry leaders must
realize that technology strategy is an important component of the answer
to each of the three questions.

Why is Technology Important?

Technology is important in the energy industry for the same reasons it
is important in other industries – it is the primary source of business
process automation and cost management; it is the desired transaction
medium of high-margin customer segments; and it is the foundation for
emerging customer-focused (i.e., non-asset-based) businesses. However,
this is often a new concept to companies that are transitioning out of
the regulated playing field. With respect to business process automation
and cost management, we believe that substituting technology for labor
is far from exhausted in the energy utility sector. Indeed, utilities
need only look at the petroleum industry to see what can be accomplished.
Technology is important as the preferred transaction medium for certain
customer segments because customers that prefer electronic communication
and business transactions are typically easier to maintain, cheaper to
serve, pay reliably, and use larger amounts of energy. Finally, technology
is the foundation for businesses such as retail and wholesale energy marketing.
Companies operating successfully in these market segments have few capital
assets, experience few barriers to entry or exit, are one of many sellers,
and offer a standardized product – the economic definition of a competitive
market.

Making Technology Decisions

Technologists who have relied on traditional energy industry IT solution
providers (e.g., the “Big 5” consultants, IBM, etc.), and the providers
themselves, are facing difficult choices. Are traditional energy utility
applications, developed in response to the regulatory paradigm, able to
migrate fast enough to match evolution of the energy markets? Furthermore,
can new applications touting competitive capability accommodate draconian
energy market evolution through organic change, or will these products
have to be completely reworked within three to five years?

The answer is traditional applications are inadequate in the face of
new competitive requirements, and recent implementations of new applications
touting competitive capability will have to be reconfigured in the first
decade of the next millennium as the true shape of the competitive energy
markets becomes known. While traditional IT solution providers are quick
to demonstrate success in serving other competitive markets, their experienced
energy utility experts, despite a jocular view of government regulation,
have lived too many years in the regulated paradigm to bring truly competitive
experience to their energy clients.

Technologists relying on the new breed of energy industry IT solution
providers (e.g., ERP and CRM vendors, “new age” integrators) are only
slightly better off, because the form and nature of the future energy
markets and the business processes that will dominate these markets is
uncertain. Thus, bringing pure competitive market experience to the equation
is valuable, but probably not timely. The energy market in transition
is a difficult master to serve from either direction – from the old regulated
paradigm chasing the pace of change, or the new competitive paradigm leading
it.

We caution technologists not to over-invest (1999-2002) in competitive
technologies (e.g., CRM, ERP, e-business) that are either ahead of the
cultural and structural shift in the energy markets, or that stand the
risk of not applying to the energy markets as they will be defined over
the next five years. We believe available products in both spaces will
proliferate (2000-2005), and existing products will become more flexible
and capable of supporting rapid change and off-the-shelf customization
(not an oxymoron, this implies a solution where an enterprise integration
backbone will accommodate various off-the-shelf solutions, enabling users
to customize their CRM “faces” to their customers, etc.). This implies
a strategy of accommodating the existing application suites (including
legacy applications), and awaiting both more information about the shape
of future markets and the inevitable flow of quality off-the-shelf solutions
aimed at that market.

Growth Strategies for Energy Companies

The result of all of this? Energy companies must develop coherent strategies
for sustainable growth. To help guide that process, this white paper describes
seven key principles for growth and shows how two energy companies have
successfully followed those principles to achieve high shareholder returns.

The Importance of Growth

To gain a better understanding of the importance of growth, we examined
the impact of growth on shareholder value by studying the value creation
record of Fortune 500 companies in various industries from 1988 to 1998.
For each company, we compared the average total shareholder return and
revenue growth and found that revenue growth is strongly related to value
growth. While this finding isn’t particularly surprising, it’s important
to note that we also found companies that have grown without creating
value. So it’s clear that revenue growth is a key driver of shareholder
value, but it’s equally clear that revenue growth alone doesn’t guarantee
superior returns. Moreover, we found that even companies that grow and
create value have difficulty maintaining their performance over time.

In analyzing how some companies have implemented successful growth strategies
while others have failed, we’ve found it useful to place companies into
four categories:

Successful Growers – Companies that have achieved both revenue
growth and shareholder value growth above the average for their peer group.
These companies have found the keys to growth and implemented them successfully.

Unsuccessful Growers – Companies that have above-average growth
but below-average value creation. These companies have achieved growth,
but that growth has not generated corresponding profits.

Cost Cutters – Companies that have below-average revenue growth
but above-average value growth. These companies are continuing to successfully
re-engineer to reduce costs, but they need to focus on growth as well
to sustain value growth over the long term.

Shrinkers – Companies that combine below-average revenue growth
with below-average value growth. The long-term prospects for these companies
are questionable, and they will certainly have difficulty competing for
capital.

The Seven Growth Principles

Building on our experience in working with companies in developing and
implementing growth strategies, we recognized that four broad areas distinguish
Successful Growers from other companies:

  • Organization and culture

  • Strategy formulation

  • Strategy enablement

  • Readiness for execution

Using these four areas as a starting point, we identified the most critical
potential factors within each area. We then tested the importance of these
factors by studying companies and establishing which potential factors
have actually contributed to the companies’ successful growth. Our study
resulted in the specification of seven key growth principles, as outlined
in Figure 1.

Figure 1
The Seven Growth Principles: Capturing Value Across the Enterprise

Figure 1

The Growth Principles in Practice at Energy Companies

We next focused our attention specifically on energy companies, first
by categorizing them as Successful Growers, Unsuccessful Growers, Cost
Cutters, and Shrinkers; the results are shown in Figure 2.

Figure 2
10-year TSR and Revenue Growth in Energy/Petroleum Industry

Figure 2

We then studied the companies in each category to better understand why
they succeeded or failed in their quest for growth. Among the energy companies
that have achieved Successful Grower status, Williams and Duke Energy
Corporation serve as good examples of companies that have developed and
implemented coherent and successful growth strategies. Williams and Duke
Energy each operate across several components of the energy industry value
chain:

  • Williams is a diversified pipeline company that operates three primary
    lines of business: natural gas pipelines, midstream energy services,
    and telecommunication networks.

  • Duke Energy is an integrated energy and energy services provider
    engaged in the electric generation, transmission, and distribution
    businesses, as well as the natural gas pipeline business.

The following describes the seven growth principles in more detail, with
references to how Duke Energy and Williams have successfully implemented
and executed growth strategies by following these principles.

Principle 1 – Create a Hunger for Growth

Successful Growers create a hunger for growth by fully committing to
growth throughout the organization at all times. This commitment is demonstrated
in four primary ways:

  • Executive-level communication that frequently and consistently reinforces
    the importance of growth

  • Employee incentive structures that reward growth-related behavior

  • Communications with the investor community that convey a compelling,
    credible, and achievable growth story

  • Promotion of customer-centricity across all levels and functions
    of the company, and use of this focus to drive and unite the growth
    culture

For example, Williams clearly exhibits its hunger for growth by including
growth as a central strategic objective, with explicitly stated growth
goals for all three business units. And Williams isn’t shy about aggressive
growth targets; for its pipeline business, Williams’ goal is to grow profits
at two to three times the rate of U.S. natural gas demand growth. In its
rapidly growing telecommunications business, Williams plans to complete
its 32,000-mile fiber optic network during 2000, and it has conveyed a
compelling picture of its telecommunications growth strategy to investors.

Duke has also shown a hunger for growth, with the stated goal of growing
earnings per share by 8 to 10 percent per year. Duke creates the hunger
for growth throughout the company by aligning training, pay, and benefits
to reward successful execution of the company strategy.

Principle 2 – Develop an Insightful Vision of the Future

Successful growers bring two critical elements together to develop an
insightful vision of the future and the ways it can be shaped to create
value:

  • They bring a customer-centric view to their efforts to identify how
    customer needs and markets are evolving

  • They tap their innovation capabilities to find creative ways to increase
    customer and company value

For example, Duke was one of the companies that recognized early on the
significance of energy trading and marketing and the convergence of electricity
and gas in a deregulated environment. These insights have helped to guide
Duke in the establishment of partnerships and pursuit of acquisitions
over the last five years.

Williams has shown a consistent ability to anticipate and capitalize
on new opportunities. The best example is Williams’ pioneering use of
decommissioned pipelines and pipeline rights of way to build a fiber optic
network. In fact, Williams built one fiber network, sold it for considerable
profit, and plans to finish building another during 2000.

Principle 3 – Find the Fit that Sustains Advantage

Not all growth opportunities in the marketplace are right for each and
every company. Successful Growers recognize this and find the fit that
sustains advantage by pursuing only those opportunities that:

  • Support or advance strategic intent, as expressed in the company’s
    mission, vision, and values, and as reflected by its culture

  • Fit with the company’s unique capabilities (both those that exist
    today and those that can be developed) and activity systems

  • Establish, maintain, or enhance a unique competitive position and/or
    barriers to the entry of competitors

For example, Duke’s activities fit well with its integrated, regional
energy center business model. Duke tries to focus its investments in areas
with the greatest growth, allowing it to exploit opportunities that involve
generation and natural gas supply. Duke’s purchase of a pipeline in Queensland,
Australia, and generation assets in Latin America, and its opening of
a Duke Energy Trading and Marketing office in Argentina are good examples.
But Duke also knows to avoid opportunities that don’t fit – its decision
to stay out of the retail electricity market because it doesn’t build
on Duke’s competitive advantage is a good example.

Principle 4 – Create an Innovation Pipeline

Successful Growers renew their business through their ability to create
and manage an innovation pipeline, and by constantly tuning and adjusting
the pipeline through experimentation and application of lessons from the
past. In managing the innovation pipeline to refresh their strategies,
Successful Growers:

  • Demonstrate a clear understanding of the stages of the pipeline

  • Appropriately balance the allocation of resources and management
    among both mature and developing ideas

  • Understand how to apply metrics and gates to meet growth objectives

  • Ensure that the pace of innovation outperforms that of competing
    firms

Williams has created an innovation pipeline to renew each of its three
businesses. For example, Williams developed an innovative way to capitalize
on the opportunities presented by the deregulation of long distance telephone
services. By leveraging its skills in negotiating rights-of-way for pipelines
and managing capacity for wholesale gas transmission, Williams reinvented
its growth strategy by diversifying from delivering gas to delivering
voice, video, and data communications.

Principle 5 – Draft and Enable the Growth Blueprint

Successful Growers draft and enable the growth blueprint by detailing
their growth initiatives and developing or acquiring the capabilities
needed for execution. They use alliances and partnerships to build or
enhance their capabilities where organic development or direct acquisition
of a capability is impractical, uneconomical, or would limit flexibility.

Duke has systematically acquired the capabilities it needs to enable
and pursue its growth strategies. For example, Duke recognized that participation
in the marketing and trading portion of the new energy value chain was
a key to its growth. Recognizing the difficulty in developing such capabilities,
Duke acquired Pan Energy to build its expertise in gas marketing.

A good example of drafting and enabling the growth blueprint at Williams
is its development of Wiltel. In 1985, Williams launched Wiltel and constructed
a $50 million, 750-mile fiber optic link. During the period from 1986
through 1993, Williams systematically grew this business through both
the construction of fiber optic lines and the strategic acquisition of
other communication networks that complemented its existing infrastructure.
In 1994, Williams sold 95 percent of its Wiltel network for a substantial
profit.

Principle 6 – Recognize that It’s Not Only Growth; It’s also Capturing
Value

Successful Growers recognize that it’s not only about growth, it’s also
about capturing value across the enterprise-wide value chain. While growth
is a key strategic priority for these companies, they also recognize the
importance of cost management and asset efficiency, and they successfully
link these to create customer and shareholder value.

As the electric business deregulates, Williams is capturing value across
the elements of the changing value chain. For example, Williams is extracting
value out of portions of the electric value chain through the creative
use of tolling arrangements with electric power producers. Under these
arrangements, Williams supplies fuel to electric producers and also sells
the output from these generators, allowing Williams to derive value on
both sides of the generation portion of the value chain.

Principle 7 – Wire for Execution

Successful Growers prepare for effective and seamless implementation
of their growth strategies by “wiring” the company for execution using
three critical components:

  • Strategy Deployment Process: Successful Growers continually
    identify, test, and measure the fitness of various projects against
    the company’s strategy. The strategy deployment process includes a
    balanced portfolio of market-facing and capability-enhancing initiatives,
    provides visibility of resources, and allows for efficient tradeoffs
    among competing projects.

  • Governance Model: The governance model of a Successful Grower
    defines roles and accountabilities appropriately, actively tracks
    performance against logical and measurable key performance indicators,
    and rewards employees based on an incentive system tied to those indicators.

  • Operational Plan: Successful Growers have an operational plan
    that focuses on the management of operating costs to achieve industry
    best practices and the continual optimization of asset use.

Duke’s growth strategy is fully “wired” into its day-to-day operations,
with a governance model that clearly defines roles and accountabilities.
Each business segment’s performance is tracked by earnings, and the Director’s
and Executive Officer’s compensation programs are linked to Duke’s performance,
with a focus on enhancing shareholder value. Short-term incentive plans
are also linked to performance indicators, with employee bonuses tied
to earnings.

The Growth Journey

Williams and Duke have clearly demonstrated successful application of
the growth principles. But knowing what separates Successful Growers from
other companies is only part of the battle. How do you actually make these
principles come alive for your company? We believe that each company,
in its quest for sustainable growth and value creation, must undertake
what we call “The Growth Journey,” with the seven Growth Principles as
its foundation.

Before any growth strategy is considered, the company must strongly embrace
the growth mindset, with a growth strategy that is intimately linked to
the company’s overall corporate strategy. Once the growth mindset has
been established, the company can begin the strategy formulation stage.
In our view, companies begin with a choice of six potential growth paths
that provide broad direction for the strategy:

  • Product and service innovation

  • Channel innovation

  • Customer intimacy

  • Globalization

  • Convergence/Consolidation

  • Diversification

But knowing the path and being able to walk down it are not the same
thing. The unique route that each firm must follow on its journey to growth
and value creation requires exceptional capabilities, some of which are
new to the company. We believe that this is the point at which many firms
stumble, since it can be difficult to fully understand and articulate
the required capabilities. As a result, they are often discussed at high
levels of abstraction, left largely undefined, and not clearly mapped
to the market initiatives they are intended to enable. Our examination
of Successful Growers has identified five key growth-enabling capabilities:

  • Customer Relationship Management

  • Innovation Management

  • M&A and Alliance Management

  • Information Technology Management

  • Agility and Change Management

Once the growth-enabling capabilities have been identified and put in
place, the strategy deployment process converts the strategic direction
into specific projects, and assesses the fit of growth initiatives projects
emerging from the organization. A well-functioning deployment process
not only prioritizes the necessary projects and allocates appropriate
resources, it also identifies gaps when the current project mix is not
sufficient to execute the strategy. An effective governance model controls
the entire process by defining roles and accountabilities appropriately,
clarifying lines of authority, and tracking performance against measurable
key performance indicators. Finally, an operational plan manages operating
costs and assets throughout the growth journey.

e-business in a Competitive Utility Industry: Managing to Become an e-business


Introduction

The restructuring of the utilities industry is now a global phenomenon.
Many utility companies are recasting business strategies to meet the uncertainty
of the new, evolving regulatory environment. IBM’s own market research
indicates that utility companies are focusing on the elements within the
utilities value chain (generation/gathering/processing, transmission,
distribution, trading, and retail) and considering a range of strategic
options, as described in Figure 1.

Acquire Others

When utility companies merge, IT savings are often identified as a major
element of cost savings, yet post acquisition, few companies move aggressively
to consolidate those savings beyond amalgamation of data centers and IT
departments. An e-business strategy, implemented at the start of the merger
of the enterprises, goes beyond simple “overhead savings” and identifies
how operational savings will be made and the target systems to be used.

Figure 1
No matter what strategies a utility embarks upon, e-business is vital
to the implementation and success of that strategy.

New Unregulated Ventures

Pursuing a retail strategy often requires the invention of a new business
to compete against new Internet-based retailers working on razor-thin
margins, while at the same time leveraging existing investments in energy
trading skills and generation capacity. e-commerce and an integrated Web-enabled
fulfillment process are critical to maintain the broad reach and low overheads
required for profitability.

Global Expansion

National and international expansion requires the ability to quickly
and efficiently transfer knowledge and skills, as well as to extend operational
platforms while limiting the costs to support a larger business structure.

Cut Costs

Cutting costs is a constant for all enterprises. For both the new unregulated
ventures and re-regulated operations, cutting costs and sustaining service
levels is fundamental for survival and superior returns to shareholders.
Initiatives such as e-procurement, Web-based customer service, e-commerce,
pervasive and wireless computing, and online learning can greatly reduce
operational costs and improve customer service.

The State of e-business in the Utilities Industry

Market research conducted by IBM has found that companies across many
industries follow a similar pattern of e-business adoption. Figure 2 depicts
these common adoption stages and where the “early majority” from each
industry are positioned.

 

Figure 2
The common adoption stages of e-business.

Overall, mainstream utilities have passed the initial “brochureware”
stage where marketing information simply is published on a website; they
have now started to link customers with existing business processes. For
example, enabling utility billing systems with e-business capabilities
to provide customers the ability to make service requests, view account
information via the Web, and make simple business requests. Transactions
like these address the growing demands of today’s savvy consumers while
helping the utility company to reduce service costs.

Companies making this transition have overcome a major challenge known
as the “security chasm.” As an organization opens up its internal systems
to the outside world, it is concerned not only about potential security
issues but also about exposing inefficient processes. As a company progresses
in its adoption of e-business, another set of challenges, the “business
value chasm,” needs to be addressed in order to justify significant process
transformation and integration.

Further work by the Meta Group1 indicated that while many utilities companies
have made small investments in e-business, most invest-ments have been
limited to customer-facing processes and that most back-office and operational
systems have yet to be considered within e-business strategies.

To date, utilities investments in e-business can be characterized by
ad hoc investments in discreet business processes. Enterprises have gained
experience in deploying technologies but in many cases have yet to make
significant investments that will transform business processes, reduce
costs, and improve competitiveness.

Implementing the Next Stage of e-business

There is no doubt that e-commerce is a driving force for the adoption
of e-business projects within utilities. Forrester Research predicts that
by 2004, utility business-to-business commerce alone will surpass $240
billion.2

e-business however, is more than e-commerce. e-business provides the
greatest value when applied to the transformation of business processes
that drive out inefficiencies by integrating across operational units.
Through linking processes from customer to supplier and reinventing processes,
organizational performance is enhanced through lower cost structures and
quicker, more informed decisions. e-commerce is often one of the tools
used to meet a greater strategic goal.

The recent move toward the creation of B2B e-markets, the adoption of
e-procurement, and Internet-based customer enrollment processes to support
retail competition, are examples of external initiatives that can cause
utilities to undertake large e-business projects with significant organizational
change impacts.

Consider the opportunities for implementing e-procurement. One approach
is simple automation of existing processes. This enables the procurement
organization to purchase items quicker, and at a lower transaction cost.
An alternate e-business approach is to restructure the internal processes
between procurement and operational business unit. The e-procurement project
would rationalize and leverage the spending power of the enterprise, optimize
the supply chain, capture usage data to support continual improvement,
and ultimately use e-commerce to conduct the final transactions. The benefit
to the enterprise from this e-business strategy is considerably more than
the limited savings from cost reductions in the procurement process and
potential discounted prices from online purchases. In addition, the enterprise
has gained value through:

  • Reduced costs through leveraging enterprise spend.
  • Reduced inventory costs.
  • Increased productivity through enabling users to order and track equipment
    items, and to coordinate their work schedule appropriately. This capability
    is extended to the field through a range of wireless and computing devices
    such as WAP-enabled phones, two-way pagers, Palm or Windows CE devices.
  • Increased productivity through closer integration between the operating
    units and strategic suppliers.
  • Providing real usage information to allow disposal of excess items,
    and purchasing of “virtual inventory” using e-markets.

The e-business initiative described above may employ a number of technologies
typically labeled as e-commerce, workflow, e-procurement, pervasive computing,
and business intelligence. The modularity and openness of e-business allows
such an initiative to be imple-mented in stages to match corporate capability,
however the strategic intent and broader value requires a more coordinated
management approach.

While ad hoc management of early e-business projects may have sufficed,
the organizational impact of the next phase of e-business requires a broader
organizational commitment. Experience shows that companies that transition
to the next stage of e-business, but maintain ad hoc management practices,
are unlikely to capture the full benefits of strategic initiatives. They
dissipate organizational energy and resources through failure to integrate
and reuse organizational, process, and technology skills and infrastructure.
Ultimately this management approach will result in escalating technology
support budgets and increased operational risks to new “always open for
business” applications.

Put simply, e-business is not something a utility does – it is what a
utility becomes.

Managing the e-business

No single e-business expert with all the answers exists today. Instead,
there is a wealth of collective experience. IBM has established an impressive
track record in becoming an e-business. By capturing our own experiences
and leveraging the knowledge, experience, and insights drawn from working
with a broad range of clients, IBM has found that a key element to achieving
e-business success involves creating an “e-business management system.”
The system is based on pragmatic answers to real e-business issues.

IBM’s e-business program has enabled the company to achieve considerable
business performance. In 1999, IBM:

  • Completed Web-based sales worth $14.8 billion.
  • Provided 42 million Web-based service transactions.
  • Enabled online support and services to over 14,000 business partners.
  • Procured $13 billion in goods and services over the Web.
  • Reduced the costs of employee training by over 25 percent through
    Internet-based training and education.

These initiatives alone allowed IBM to avoid $250 million of expense
every quarter.

When IBM began its e-business transformation, we discovered that simply
immersing ourselves into e-business was not enough to make it operationally
or financially successful. We needed to build a model to control and manage
our e-business strategy and investments. We knew that simply controlling
e-business was not the answer. We also needed a way to leverage and incubate
e-business for it to prosper. We found that an e-business management system
construct helped us coordinate better and move faster in implementing
successful e-business initiatives.

The concerns and issues related to e-business are remarkably common.
You can probably relate to the following company issues which are composites
of comments from a variety of clients:

“Our senior management team does not understand this new technology,
but if they don’t get involved in these decisions, we won’t have the leadershipor
the clout that we need to be successful.”

“We have an idea about how we want to approach e-business, but we
don’t know the best way to begin implementing it at our company. We want
to make sure that our efforts are profitable and effective, but we also
know that we could stifle e-business if we control it too closely. What
is the right balance?”

“I wonder how implementing e-business will impact our organization’s
current processes. Also, are there new processes we need to implement
that are specific to e-business?”

“Who should own this initiative? Who should be making the decisions?
Who should be taking what action? What types of people should I look for,
and how will I know if they have the right credentials?”

“I struggle with knowing how well we are really doing with our e-business
initiatives. I know that some of our current metrics won’t apply to this
new way of doing business, but what is the right way to gauge our effectiveness
and justify our investments?”

The e-business Management System: A Tool for Better Decision-Making

The e-business management system, shown in Figure 4, supports both a
company’s e-business strategy and the initiatives required to deploy that
strategy. Essentially, the e-business management system seeks to achieve
a workable balance between simultaneously controlling and nurturing the
e-business effort. The e-business management system also acts as the single
point of convergence between various e-business efforts and the operations
of the broader enterprise. This includes the efforts and involvement of
key internal and external stakeholders in the enterprise.

Figure 3
e-business management systems.

 

Critical Considerations for Establishing an e-business Management System

Generally, companies must address two fundamental questions to establish
and run an effective e-business:

  • How are we going to organize around the need to manage our e-business
    efforts?
  • What measures do we need to take to ensure that we are moving forward
    swiftly and effectively in creating an e-business environment?

While each company’s approach is unique, several critical considerations
dictate how the e-business management system should be established. IBM
– along with our clients – has uncovered seven components necessary to
create an effective e-business management system:

  • Mission: Purpose and approach to nurturing and managing e-business
    within the enterprise (including its extended-enterprise components).
  • Organization: Structure, reporting relationships, and connections
    between the e-business resources and their counterparts in other areas
    of the enterprise.
  • Roles and responsibilities: Definition of work requirements
    mapped tothe groups and individuals who will perform them.
  • Processes: Predefined activity flow for the necessary e-business
    actions and creation of e-business outcomes.
  • Measures: Accountability mechanisms for e-business at the
    enterprise, operating, process, group, team, and individual levels.
  • Policies: Predefined e-business decisions with associated boundaries,
    standards, and latitude.
  • Content model: Definition of consistency in content and its
    portrayal on websites so that decentralized execution of content management
    can be performed in a coordinated, well-planned manner, as shown in
    Figure 5.
Figure 4
Component alignment throughout the e-business management system is critical
to the success of the enterprise’s e-business efforts.

To address both the organizational and operational needs of an enterprise,
these components must be structured to work together as a system. IBM
has evolved, over time, an understanding of these components and how to
best configure them, both from our own experience as an e-business and
from working with our e-business clients.

Internally, our e-business management system of today is very different
compared with when we started e-business management in 1997 with IBM Enterprise
Web Management (EWM). We also know that different clients have different
needs and that there is no single answer to every problem. There are fundamental
differences that must be addressed. Simply replicating another company’s
experience is not likely to be successful. Tailoring systems to each unique
situation is vital to achieving e-business success and requires evaluating
every client’s management objectives against the seven system components,
as shown in Figure 6.

 

Figure 5
Managing the business of e-business.

Lessons Learned: How to Avoid Common Problems Faced by Companies New
to e-business

In addition to its own transformation, IBM has completed a range of e-business
strategy and implementation for utility companies and companies from other
industries. Regardless of the industry or e-business goals of our customers,
key e-business lessons that these companies emerged are:

  • Launch and learn: Swift, innovative implementation, with the
    understanding that the solution must constantly evolve, will ultimately
    provide a better outcome than working to develop precise answers to
    issues. We call this “launch and learn,” and we know it is often difficult
    to implement. It is important to set the expectation that these decisions
    will change, both incrementally and significantly, and that changes
    will occur more frequently than in the past.
  • Define roles and responsibilities: The organizational structure
    for an e-business management system is often complex, so it is vital
    that roles and responsibilities are clearly defined to avoid problems
    of role overlap or role gap. This is especially true with activities
    where multiple groups or individuals participate.
  • Commit to invest: Although it is important to steer e-business
    efforts toward a clear path of return on the company’s investment, a
    premature focus on the financial aspects may thwart the development
    of innovative initiatives. Often, the best initial focus is speed or
    learning through the quick and broad dissemination of information company-wide.
  • Explore policies: Make sure policy issues are explored and
    that policy-related decisions are communicated company-wide. Website
    audits have uncovered embarrassing and illegal materials. Unfortunately,
    this is not uncommon and most companies are unaware of the full extent
    of their exposures. Access to technology and content is pervasive, and
    this has led to difficult situations for many companies.
  • Design for Web use: Strategically reducing website content
    often increases site use and revenue. Rather than read content word
    for word, users scan site information. Making the most relevant content
    quickly and easily accessible is the secret to a valuable and profitable
    website. The content model helps focus a company on these important
    aspects.
  • Re-examine funding: Funding may be found by re-examining a
    company’s entire list of initiatives and projects. The most successful
    companies have been willing to decommission some initiatives that were
    underway in order to free up needed funding, resources, executive leadership
    capacity, and organizational capacity for change.
  • Focus on business goals: Remember the “business” in e-business.
    Transformation to e-business is not a technology issue. If you treat
    it like a technology effort by failing to establish effective reporting
    relationships and business-executive involvement, it is less likely
    that your organization will make the fundamental shifts necessary for
    e-business success.
  • Make resource commitments: Consultants are limited in the amount
    of aid they can provide their clients regarding important managerial
    issues. The organization must provide adequate resources for its effort
    from the very beginning. Without the proper resources, both in terms
    of organization and numbers, only slow progress will be made in the
    e-business space.

Conclusion

The global utilities industry is changing to meet the new competitive
environment. By becoming an e-business, utility companies can implement
new business strategies, be they delivering the synergies from mergers
and acquisitions, capturing cost savings from regulated business, or improved
competitiveness in deregulated business.

The value of e-business is captured through organizational commitment
and management. e-business is not what an enterprise does, it’s what an
enterprise becomes.

The principles of the e-business management system are paying great rewards
for IBM and for our clients. Undoubtedly, e-business is radically changing
the way business is done. New e-business models are enabled by emerging
technologies that allow companies to more effectively unite with customers,
partners, and suppliers. Utilities that can successfully leverage these
new technologies and ways of doing business will position themselves for
unprecedented growth.

Footnotes

1 Meta Group, Energy Information Strategies, e-business survey results,
January 2000

2 Forrester Research, E-Marketplaces Boost B2B Trade, February 2000.

 

 

Preface from PricewaterhouseCoopers

We are delighted that you are about to read these pages, which we are
confident will give you unique and timely insights into the rapidly transforming
energy industry and provide you with the tools necessary to achieve extraordinary
value. The future landscape of the utilities industry is changing at an
unprecedented pace that presents participants with huge opportunities
as well as substantial risks.

PricewaterhouseCoopers’ Energy Practice has experienced tremendous growth
over the past several years. Our strategy, performance improvement, and
technology solutions practitioners have worked with many of the world’s
leading energy companies to help them achieve success as the future utilities
landscape unfolds.

The invitation from Montgomery Research to bring together current energy
industry thought leadership from leading practitioners, academics, system
and software providers, and corporations who are helping shape the new
energy industry landscape was timely and enticing. We are pleased to provide
you with this thought leadership initiative, a venue for e-enabled discussion
and debate on this topic.

Each of the seven sections within this project explores the key issues
facing utility and energy company executives as the industry transforms
and becomes increasingly competitive. Taken together, they construct a
roadmap for success, providing a path for skillfully navigating the increasingly
complex and challenging utility landscape. From understanding the global
power company of the future, to harnessing the power of e-business and
creating a customer-centric organization, you will gain fresh insights
and practical guidance in developing and implementing strategies necessary
to compete and win in the future energy landscape. All of the contributors
to this publication help to identify, describe, and explain how to achieve
breakthrough success and deliver the greatest value.

PricewaterhouseCoopers believes that this collection of thought leadership
pieces will provide you with the insights and tools necessary for succeeding
in increasingly competitive energy markets. The future is filled with
opportunities and challenges. Companies must respond with bold, innovative
steps to gain and maintain competitive advantage. Timing truly is everything.
Act, respond, and succeed now — or be overwhelmed as your competitors
step up and pass you by.

On behalf of the partners in the PricewaterhouseCoopers Energy Practice,
I wish you lasting victories as you navigate the unfolding energy industry
landscape.

Michael Hamilton
Gerald Keenan

PricewaterhouseCoopers

 

 

The Global Utility: The Experience from an Acquisition Made in the United States by a Foreign Utility


Our story starts in 1991.

After 40 years of government ownership, the U.K. electricity industry
began to privatize in 1990. England and Wales were first, with the formation
of 12 regional electricity distribution companies, a transmission company,
and two new generating companies. The following year, it was Scotland’s
turn. That’s when the customers and employees of a government-run electricity
board became the customers and employees of a new, vertically-integrated
company called ScottishPower.

As recently privatized companies, we were all novices facing a new, complex
competitive environment. Many utility brethren entered with gusto – and
their tales of woe are well documented in U.K. utility folklore. ScottishPower’s
approach was more measured.

Figure 1
ScottishPower Regional Territory – 1991

Figure 1

Inventing the Wheel

It was apparent to ScottishPower management that the company must first
get its core business in order. Certain issues required urgent executive
attention:

  • No clear strategic direction existed.

  • Commercial market savvy was lacking at all management levels.

  • The company culture was focused internally rather than on the needs
    of customers.

Reshaping the core business required clear leadership, focused on improving
cost and customer service efficiency. That process began with improvement
programs driven primarily by benchmarking and business process re-engineering
(BPR). ScottishPower learned from its employees, from other utilities,
and from companies in other industries that enjoyed high levels of customer
interaction.

ScottishPower learned from its customers that their attitudes and expectations
were changing and that we needed to recognize this to be competitive.

Also, underpinning the internal transformation was a complete overhaul
of the human resource strategy. Executives became directly involved in
developing management capabilities. Managers were groomed through the
use of personal development plans, MBA, and senior executive courses.
Formal succession planning was initiated. Task-specific training centers
were developed as were more broadly focused open learning facilities.

Best in Class

The payoff became apparent as competitive benchmarking was conducted
against other U.K. utilities for 1994-1995. ScottishPower was rapidly
becoming best in class.

Expanding Horizons

External commentators, such as regulators and industry analysts, confirmed
ScottishPower’s leading position. It was time to take a larger view of
the world. From ScottishPower’s beginnings as a newly privatized utility,
the strategic approach needed to create shareholder value was clear: maximize
performance in the core business by transforming it from a bureaucratic
entity to a competitive leader – and then grow by replicating that model.

Adopting a measured approach, it was decided that the first opportunities
to expand and diversify should be close to home in the U.K. As the company’s
abilities matured, international targets would follow.

ScottishPower made its first move in 1995. That’s when it became the
first U.K. electricity utility to buy another with a successful takeover
of Manweb. This was followed in 1996 by the acquisition of Southern Water
– marking the first purchase of a U.K. water utility by a U.K. electricity
company.

Since being acquired, both Manweb’s and Southern Water’s operations have
improved dramatically. Each has significantly reduced costs while raising
performance and customer service levels. Both are now positioned among
the leaders in their sectors.

ScottishPower also benefited through the valuable experience it gained
as a result of the acquisitions of Manweb and Southern Water. Among the
lessons learned were:

  • The need for full executive commitment

  • The need to gain detailed knowledge of value drivers within a business

  • The importance of a clear focus on customer service

  • The necessity of thorough due diligence and careful valuation

  • How to set aggressive targets during transition

  • How to develop a comprehensive approach to implementation and its
    tracking

  • The need to focus on management and people development

In addition to these two acquisitions, ScottishPower also grew organically.
The company built on its existing telecommunications infrastructure by
adding fiber optic access lines and strategically placed switches, combined
with a strategy to build traffic on the network. Small acquisitions brought
in additional business. By November 1999, ScottishPower’s telecommunications
business offered 49 percent of its stock in an initial public offering
worth $1.6 billion – a good return on a $0.5 billion total investment.

As well as being a leader in the deregulated electricity market, ScottishPower
expanded into the natural gas retail market. With 700,000 gas customers
by March 2000, the company was placed among the top three U.K. gas retailers.

Heading West

In 1998, ScottishPower initiated the next part of its strategic plan
– the move to international markets.

A small corporate team initially undertook a global search of countries
to identify environments that would support value-creating deals and offer
more than one possible acquisition target. With its apparent strategic
synergies with the U.K., the U.S. emerged as the favorite. Common language,
similar culture, fragmented industry, and markets on the verge of deregulation
combined to make it the top choice. Once this was decided, selection criteria
were established such as company size, presence of nuclear generation,
and the strength of the share price stock. Scrutiny of the top-10 ranked
companies followed, and PacifiCorp emerged as a leading candidate.

A multi-billion-dollar electric utility, PacifiCorp offered a wide service
area that stretched across six U.S. states, as well as a large, low-cost
asset base, and international experience of its own with its Australian
subsidiary, Powercor. ScottishPower’s acquisition of the Portland, Oregon-based
company would create benefits for all stakeholders. It would also mark
the first acquisition of a major U.S. electric utility by an overseas
company.

The proposed acquisition was announced on December 7, 1998.

Figure 2
Competitive positioning among UK utilities in 1994-95.
See
larger image

Figure 2

The Art of the Deal

Executing an international acquisition is a complex process in any industry.
But ScottishPower’s acquisition of PacifiCorp was made even more so by
regulatory hurdles in six states and three countries. However, good corporate
finance, regulatory, legal, and communications advice, which had been
put in place at least nine months before the merger announcement, all
contributed to making the merger a success.

As soon as the deal was announced, the approval clock started ticking.
New to doing business in the U.S., state and federal approval processes
were completely alien. Due to the deal’s uniqueness, scale, and complexity,
the aggressive timelines would not have been possible without the full
support of PacifiCorp management. But even with PacifiCorp’s valuable
assistance during this process, it was useful to have independent advice
as well.

The original, ambitious timeline was to complete the deal within one
year – half the time most industry pundits deemed necessary. We made it.

The eventual milestones achieved were the following:

  • December 7, 1998 – Merger announced

  • Winter/Spring 1998-99 – State and federal filings and testimony

  • May 6, 2000 – U.K. and U.S. shareholder documentation published

  • June 1999 – U.K. and U.S. shareholder votes

  • Summer 1999 – State regulatory hearings

  • November 30, 1999 – Merger approved

Figure 3
ScottishPower’s strategy to expand and diversify

 

Figure 3

How We Got There

A ScottishPower/PacifiCorp Joint Executive Committee met monthly to oversee
business operations and the regulatory approval process. It was balanced
in numbers between ScottishPower and PacifiCorp. A series of teams were
created to handle the day-to-day work of completing the merger.

A Transaction Team dedicated to corporate finance, investor relations,
and advisory services was established in the U.K. The team’s primary responsibility
was ensuring the deal could be concluded satisfactorily from a financial
and legal perspective.

A Portland-based Regulation Team of 20 people was created to drive the
robust project management needed to execute the regulatory approval process
on such aggressive timelines.

Fulfilling the requirements of state-level procedure proved a significant
task in itself. Though previous research made team members aware of the
process, only experience could really teach us just how much work was
really involved.

The process is handled much like a court case, except that all testimony
is presented in writing. After testimony is filed, intervenors such as
major customers, community groups, or state utility commission staff cross-examine
by submitting written questions in a process known as “discovery.”

In the merger case, more than 2,000 discovery questions were submitted
– each of which needed to be answered within 10 days of when it was filed.
The sheer workload required a dedicated team to manage the process. Questions
ranged from simple information inquiries to requests requiring very detailed
analysis.

A network of experts had to be established in the U.K. and U.S. to ensure
consistency and quality of responses. This team, in turn, was backed by
a team of customer service, community and environmental experts charged
with communicating ScottishPower’s policies and achievements to key influencers,
community, and pressure groups.

 

Figure 4

The evolution of ScottishPower Group – 1997

Figure 4

Communications

For any acquisition to succeed, a robust communication plan is needed.
This requirement only escalates when dollar amounts increase and oceans
separate the parties involved.

Face-to-face contact is everything in terms of winning stakeholder approval.
Within the first four months, I personally met with several thousand PacifiCorp
staff, local and national press, more than half a dozen U.S. congressmen,
five governors, more than 100 state legislators, 48 mayors, 50 elected
officials, and 12 state regulatory commissioners. Other ScottishPower
and PacifiCorp team members conducted similar meetings as well.

Local customers, especially in certain rural areas, required face to
face comforting. Public meetings in the U.K. involving utilities are rare
and sparsely attended. Yet in some U.S. communities, such meetings brought
standing-room-only crowds. ScottishPower executives won respect and quelled
fears at these meetings by sharing the customer service successes of our
previous acquisitions.

Since any issue, however small, has the potential to derail a deal in
such an environment, we made a concerted effort to use people on the ground
in local communities to quickly and proactively deal with issues as they
arose. Knowing that several thousand PacifiCorp employees lived in these
communities, regular efforts were made to keep them informed of the latest
merger developments. In addition, a number of key ScottishPower and PacifiCorp
employees were assigned to work in local communities to resolve their
issues and answer questions about ScottishPower and the merger.

In the end, we delivered. We made our one-year approval target with a
week to spare. The deal was approved November 30, 1999 – on St. Andrew’s
Day.

 

Figure 5

PacifiCorp’s reach in 1998

Figure 5

Looking Ahead

Despite the thousands upon thousands of hours that went into making the
deal happen, the real work has only just begun. PacifiCorp has a workforce
of 8,000 – of which only 20 are strategically placed Scots. We need to
make sure all 8,000 employees are proud of PacifiCorp and ScottishPower
and anxious to help us all succeed. Their response thus far has been truly
encouraging.

Going forward, we face the significant task of seeing that PacifiCorp
delivers on our merger commitments to provide improved customer service,
increased shareholder value, increased community involvement, and an increased
commitment to the environment. These factors, together with our commitments
to efficiency and safety, will soon make PacifiCorp a top-10 U.S. investor-owned
utility.

For just as ScottishPower once reinvented itself to thrive in a newly-competitive
utility market, PacifiCorp will soon need to do the same. Retail electric
deregulation is occurring to some degree in most states, albeit at a different
pace in each jurisdiction. Federal laws about who owns and has access
to utility transmission systems will soon change the rules of the game
even more. PacifiCorp will learn to adapt because it must – and it will
have the benefit of ScottishPower’s experience to draw upon.

The Global Power Company of the Future

The initial stages of the liberalization process currently underway across
parts of the globe see individual countries separating out the traditional
monopoly areas of generation, transmission, distribution, and supply and
then opening up supply and generation to competition. This process provides
an opportunity for companies facing limited growth prospects in their
home markets to expand through international asset acquisition in newly
liberalized markets.

As international boundaries are swept aside and the race to become a
key global power player gathers momentum, companies have some major strategic
decisions to make in order to survive and deliver shareholder value. As
in almost every other industry exposed to strong competitive forces, there
is an increased drive to become best of breed in areas of perceived core
competence. Therein lies the key to efficiency and competitiveness, profit,
and ultimate success. Therefore, companies that are to succeed in the
power sector will have to excel in each sector of the industry in which
they have elected to remain – or be forced out by their competitors.

With some likely notable exceptions, the winners will be those companies
that adopt a strong horizontal focus, pursuing growth as global players
specializing in different parts of the supply chain. There may be a few
companies that have the size, management competence, and resources to
gain from a more integrated, vertical position, but even those who seek
to retain an integrated ownership structure will probably seek the strategic
advantages of creating managerial and operational separation to enable
them to compete in intensively competitive markets.

Retail – Seller or Service Provider?

As supply markets open up to new competitors and customer communication
channels become ever more effective, incumbent supply companies must decide
whether they are capable of building sufficient critical mass and developing
the right skills to remain in the supply business. Those that choose to
stay must decide whether to strive to become either a world-class retailer,
creating new market propositions and exploiting new channels to market,
or a world-class service provider to utility retailers.

Increasing sophistication of customer demand is emerging in both industrial
and domestic arenas, forcing power companies to reconsider their business
strategy. Industrial customers are increasingly utilizing their newly
acquired negotiating power to demand cheaper electricity, sometimes extracting
double-digit discounts from their suppliers. Domestic customers are increasingly
experiencing freedom of choice in other utility markets, such as telecoms,
prior to the opening up of the electricity sector. This means that they
are not only looking to replicate this experience across other services,
but in addition are looking for the added convenience of a “bundle” of
service products while at the same time demanding better standards of
customer care and value-added services from their supplier.

The customer in a liberalized market is spoiled for choice and will focus
on price, convenience, and reliability of supply from their home services
provider. New market entrants, unencumbered by past “baggage” and a traditional
utility services background, will offer a broad product portfolio, possibly
selling energy as a low margin “loss leader” in a portfolio product offering.
Powerful global retail brands such as Wal-Mart and Virgin will make tough
competitors in this now specialized retail battleground. Retailers will
therefore need to focus on developing a range of services around customer
needs in order to raise their sales value per customer. They will need
to create premier brand recognition and excellent customer service and
use technology both as a tool to aid customer service and to facilitate
better management of their customer asset base.

Utility companies born out of government or state-run bodies already
have large customer bases and therefore have a natural initial advantage.
While in the short term the ability to withstand margin pressure will
be key, in the longer term only marginal differences in price will remain
between retailers and branding will become increasingly important. The
power and credibility of a retailer’s global brand identity, together
with a reputation for excellence resulting from sustained high-quality
service, will be critical for winning or retaining customers after the
initial price war in a newly competitive market has died down.

Does all this mean that it is necessary to retain customers to stay in
the market? Those companies that have built up expertise in customer management
and customer-related systems and services may choose to reduce risk by
exiting the “selling” market completely. Instead they will focus on providing
a customer management service to other retailers who have concentrated
on building a strong brand name but have not developed the same level
of service capability.

Generators – Big is Best?

Generators in particular see advantages from internationalizing their
businesses, and a “super league” of global generating companies is emerging.
These companies have sufficient mass and low enough cost of capital to
participate fully in the growing international trend to liberalize power
markets, acquiring local and national companies when privatization or
relaxation of ownership regulations allows this to happen.

Capturing economies of scale through the development of best practices
in construction, trading, procurement, and technological advancement,
among other areas, will enable generators to take advantage of an increasingly
global market. The need to focus on cost reduction is especially important,
as competition in the retail sector and the related demands of the fast
developing energy trading markets will pressurize generators toward ever-cheaper
power production. In addition, regulatory and environmental requirements
to reduce emissions and develop sustainable energy sources (reinforced
by a change in consumer requirements for “clean” energy and a shift in
emphasis by shareholders to more corporate environmental responsibility)
will require major R&D investment by generators and the engineering support
companies.

For many generating companies, particularly those in developed countries,
there are limited growth prospects in their home market, and international
growth is the only option for expansion. As investment opportunities in
other developed countries dry up, however, global expansion will require
investment in countries with heavily underdeveloped power infrastructure,
which often have unstable markets. The ability to spread risk is a key
driver for globalization as having a power project portfolio of sufficient
scale is fundamental in order to mitigate some of the political and economic
risks of investing in such countries.

The recent emergence of fast-growing IPP developers creates additional
competitive pressure on the existing players. IPP projects require specific
expertise, particularly in key areas, such as funding, development of
contractual arrangements to ensure that the project realizes a proper
return, and managing local political and physical conditions. All of these
areas are of fundamental importance, and companies that focus on such
developments are creating a market niche. The projects often introduce
the latest technologies and production efficiencies and may become benchmark
low-cost producers in growing markets. Larger traditional generators that
have set up their own IPP companies, and the investment in independent
power projects by some oil companies that have large cash and raw material
resources, provide some signposts for the future in terms of the competitiveness
in this area.

The traditional roles of a generator, from ownership of the generating
station to maintenance of assets, operation of the station, and the trading
of the power output, will start to disaggregate as power companies assess
where their expertise lies. One result could be an international tolling
station operator that is engaged by the owners of power stations (e.g.,
banks) to operate those assets while outsourcing the maintenance of specific
equipment to the original manufacturers and the trading of the station
power-sourcing and output to various trading organizations.

Trading – Outside the Capabilities of the Traditional Power Companies?

New trading markets will open up as liberalization of power markets moves
electricity and gas trading toward a more liquid market. The number of
pure energy traders will increase as gas and electricity become traded
in the same way as other commodities such as metals and foreign exchange.

Trading is a specialist skill, and experiences from other commodity and
financial markets show the potentially devastating effects of “getting
it wrong.” Already, some utilities that have little of their own production
capacity have encountered major difficulties with forecasting demand during
extreme weather conditions, thus having to procure power at high prices
while their customers have fixed price deals. This has led to a cautious
approach to trading and the emergence of three clear types of operation.

First, there are the portfolio managers whose job is essentially to operate
robust risk management strategies, hedging business unit needs. The second
are asset-based traders with access to plant data and with a superior
forward price model. They will leverage a physical position, and the trades
may become larger and more sophisticated as systems and trading skills
become more advanced. The advent of liquid markets will open up a role
for a third type of trader, the pure trader, who will compete on the basis
of trading skills and knowledge developed in other markets and will be
likely to build business through innovation in deal-making.

Some traditional power companies have developed highly-skilled trading
departments, conducting high-volume trading operations that have expanded
beyond a pure risk management role. In an increasingly complex and geographically
diverse energy trading market, these companies may choose to concentrate
on exploiting their experience and consolidating a position as global
power traders in one or more geographical markets, with the potentially
high margins that accompany success in this area. Their market knowledge,
together with their asset backing, good credit ratings for the large incumbents,
and the likelihood of imperfect markets for the short term at least, will
make it harder for the pure trader to flourish in competition with these
operators.

Even if power companies choose to focus in another area of the power
industry and do not adopt speculative positions, they will still have
to have access to skilled traders who can assist them in managing their
natural generation or retail risk position. Excellence in risk management
processes and the quality and experience of their traders are essential
ingredients for market participants if they are to create success in an
exchange based market. With the potential for development of trading markets
across borders, companies cannot afford only to focus on traditional territorial
markets and keep abreast of what will be a challenging and fast developing
area.

Asset Managers/Network Operators – One and the Same?

Since a local distribution network constitutes a natural monopoly, a
liberalized power market is likely to retain some level of revenue regulation
for distributors. The extent and structure of regulatory control will
determine the attractiveness for investment in distribution assets. While
some governments may act as a “Customer’s Champion” and adopt a fairly
hands-on regulatory role, others will choose to appoint an independent
“Refereeing” body to ensure a level playing field. Maintaining the status
quo will lead distribution companies down the path of declining shareholder
returns, as strategies need to be developed to maintain and grow profits
in the face of regulatory pressure, which by definition is there to ensure
that customers are protected.

In the face of high fixed maintenance costs and regulated revenues, network
managers will have to explore new avenues of operation in order to succeed.
The fundamental question for such businesses is whether owning and operating
a network have to be combined or whether to separate such functions. The
answer will require a decision as to whether the core competencies of
the company lie in dealing with an electricity or gas network, or within
infrastructure management itself.

Many traditional network managers will grow their revenues by acquiring
or running other infrastructure maintenance businesses such as telecom
network maintenance or by creating new value-adding services such as joint
metering services for multi-utility clients. They will need to find ways
of working their assets harder and more creatively, utilizing different
organizational structures, and managing and developing new management
outlooks and skills. Management of networks is increasingly likely to
be exercized on a “virtual” basis (i.e., managing and controlling assets
without actually owning them).

Harnessing E-Business

Harnessing e-business will become an essential success criterion for
utilities, driving the speed of the industry’s transformation. As with
all new paradigms, there are both gains to be embraced and risks to be
managed. What is clear is that this new enabling technology cannot be
ignored and all businesses need to develop their thinking as to how to
take advantage of new ideas and, moreover, to understand the risks that
these pose to a traditional business.

Customers will become rapidly accustomed to choosing deals through the
Internet and will be quick to grasp online utility offers. New entrants
are already using this as an avenue to develop customer access and are
taking advantage of the low entry cost of an online operation to combine
product offerings as part of their “proposition” to the market. Increased
access to information through these non-traditional sources will help
change the supplier/customer relationship as comparing offers is simple
and the methodology and speed of switching suppliers is simplified. Business-to-business
transactions are of even more import to the supply companies as commercial
enterprises will be even faster at grasping the opportunities offered
by e-business, adopting its use in the management of their supply chain.

E-business is delivering a more effective platform for energy trading
which, for the first time, is seeing gas and electricity traded like goods
in other commodity markets. As for the customer arena, the low set-up
cost is encouraging new entrants to the trading scene, though for a time
they will be hampered by their own size and by related credit issues.

The advantages of using new technologies to enhance basic processes at
low cost are significant. From online customer billing to remote meter-reading
input by customers, through adopting e-procurement methodologies directly
or through new portals, utilities will be able to benefit from improved
business processes. At the more strategic level, the use of technology
to facilitate the development of “virtual” businesses across geographies
will favor those companies that embrace them first.

The impact of e-business cannot be ignored by the utilities. Companies
have no choice but to develop their responses and in doing so will need
to be imaginative and flexible as the one sure thing is that the ultimate
development of e-business in the power markets will not fit any of today’s
definitions.

Where Now?

Choosing their final destination on the new global power stage will require
a rigorous evaluation by power companies of where value will lie, the
scale at which they will need to operate, their current core competencies,
and how far these factors take them toward the key capabilities that they
will require. One thing is certain – the industry transformation is gaining
momentum. One only has to look at the emerging (and dramatically changed)
pattern of ownership in countries where liberalization has been challenging
old structures to see that complacency is not an option. Changes which
have taken place slowly over the past decade in liberalized countries
such as Norway and the U.K. are gathering pace as reform spreads throughout
the rest of the European Union, Argentina, South America, the United States,
and beyond. The need for size to compete, new skills to stay ahead, and
a focus on value creating elements of the business, will change the industry
out of all recognition.

It is unlikely that many global power companies will be able to develop
and sustain long-term excellence in all of the segments of the industry
value chain. Increasingly, the global power markets will see the development
of functional disaggregation and consolidation within functions, as companies
focus on building their chosen specialties. Radical choices have to be
made. Companies failing to deploy radical strategies now will be swept
away, either by the forces of competition or by those that implement rapid
and innovative changes.

Report from New England: Lessons Learned on the Road to Competition

This white paper reviews the restructuring experiences in three New England
states – Massachusetts, New Hampshire, and Maine – and their trials and
successes. Additionally, the paper considers the role of the New England
Independent System Operator in establishing free and open power markets
and the disconnect between the development of the retail and wholesale
electric markets in the region. The New England experience demonstrates
the difficulty in creating competitive markets for an essential commodity
that has historically been subject to command and control regulation and
used as a vehicle to support numerous social programs. The tension between
the popular desire to create a free market and the political will to shield
consumers from the risks inherent in such markets has created distorted
price signals and dampened the growth of a once promising retail electric
market in the region.

Three Different Approaches

By 1997 a number of New England states were fully engaged in the race
to restructure their electric utilities and provide consumers with retail
access to third-party suppliers of electricity. The discrepancy between
low wholesale electric prices and high retail electric rates spurred state
utility regulatory commissions and legislators to find a way to bridge
the gap. States competed to be the first to create new markets that would
hopefully reduce the traditionally high New England energy rates and make
their state more attractive to economic development. The California experiment
with retail access, the Federal Energy Regulatory Commission’s action
to provide open access transmission and competitive wholesale markets,
and the desire to attract new competitors and capture a “first-in” premium,
quickly produced an almost unanimous political groundswell for electric
industry restructuring.

Before any markets were opened and the rules established, eager marketers
from all parts of the country converged upon New England in hopes of capturing
market share and getting a jump on the learning curve that could be used
in other regions opening up their retail electric markets. Three years
later, after the scheduled “customer choice” dates have come and gone
in all three states, many retail energy sellers have abandoned New England.
In several states, retail customers granted “customer choice” in open
access states have no options to choose a third-party supplier because
the marketers have fled, unable to compete with the mandated standard
offers or transition service made available through electric distribution
utilities. All three of the New England states discussed here adopted
distinctively different approaches to introducing competition, and each
achieved varying success in attracting new market entrants.

Massachusetts

Massachusetts was one of the first states in the nation to embark on
electric industry restructuring when the Massachusetts Department of Public
Utilities opened an investigation into the matter in February, 1995. In
a number of decisions over the next two years the Department announced
its general principles for restructuring and concluded that there is a
strong public policy basis for providing electric utilities a reasonable
opportunity for recovery of non-mitigatable stranded cost. While the Department
did not accept the utilities’ legal arguments that they were absolutely
entitled to such recovery, based upon exclusive franchises, it recognized
that lengthy litigation over the matter could derail efforts to introduce
competition.

While developing rules and requiring utilities to file restructuring
plans, the Department encouraged stakeholders to negotiate settlements
as the most efficient means of moving forward. In October, 1996, Massachusetts
Electric Company (MECo) filed a settlement with the Attorney General and
numerous other parties, under which MECo agreed to provide retail access
to its customers, divest its generating assets, and implement an immediate
10 percent discount in its rates. The parties also agreed that MECo should
be allowed to recover all of its non-mitagatable stranded costs through
a Contract Termination Charge over a 12-year period.

The MECo settlement provided a framework for the Department’s Electric
Industry Restructuring Plan issued in December 1996. The Department concluded
that it required legislative authorization to implement its plan, which
would provide immediate consumer benefits through mandatory rate reductions,
allow utilities an opportunity for full-stranded cost recovery, and prevent
vertical market power by encouraging voluntary divestiture of utility-owned
generation. The Plan also provided that distribution service would remain
a monopoly service and postponed consideration of whether to allow competition
in metering, billing, and information services (MBIS).

After the filing of several other utility restructuring settlements,
and approval by the Department of the MECo proposal, the Massachusetts
Legislature enacted restructuring legislation in November 1997. The legislation
embodied most of the principles in the Settlements and the Department’s
Plan, and mandated rate decreases of 10 percent in 1998 and 15 percent
in 1999. The Legislation also included adders to distribution rates for
energy efficiency programs and to support renewable sources of generation.

The compromise reached by the legislature on stranded cost recovery and
rate reductions produced an immediate barrier to market entry entitled
Standard Offer Service. All customers would be eligible to continue to
take service through the standard offer which would include three parts:
the stranded cost recovery charge, the distribution charge, and the Standard
Offer for generation. In order to ensure the mandated discounts, utilities
were to price their “standard offer” at a rate below wholesale prices
and could defer for collection in later years, the difference between
the wholesale price and the artificially deflated Standard Offer.

All of the Massachusetts electric distribution companies filed restructuring
plans or settlements and opened up to competition on March 1, 1998. Unfortunately,
the below-market standard offer made it extremely difficult for new market
entrants to offer a “competitive” price without taking the risk of a large
loss leader in the early years and gambling that the new markets would
eventually reduce wholesale prices to the levels of the standard offer.
Two years after open access, only 0.2 percent of Massachusetts residential
customers are buying competitive supplies, and only 19 percent of industrial
customers have switched. By comparison, in Pennsylvania, almost 10 percent
of residential customers and 56 percent of the industrials are buying
competitive supplies. 1

New Hampshire

New Hampshire, which was paying the highest electric rates in the country
to one electric utility serving over two-thirds of the state, took a decidedly
different tack than the Massachusetts negotiation and settlement strategy.
After attracting significant market interests in 1996 with an electric
competition Pilot Program, the legislature provided the Public Utilities
Commission with a broad outline for electric industry restructuring and
directed them to implement that plan in short order. Encouraged by the
flood of marketers participating in the Pilot Program, the legislature
and Commission focused on creating a truly “competitive” market, and included
no hard and fast requirements for immediate rate reductions or discounted
standard offer service.

The Commission’s Final Plan sought to impose a new regulatory regime
by which any stranded costs recovery would be tied to a comparison of
a utility’s rates with a regional average. Utilities with rates at or
below the regional average would have an opportunity for 100 percent recovery
of their standard costs, while those above the regional average (i.e.,
Public Service Company of New Hampshire) would not be allowed to recover
that percentage of their stranded cost equal to the percentage by which
their rates exceeded the regional average. This recovery mechanism was
based, in part, upon the Commission’s determination that as a matter of
state and federal law, utilities had no legal right to stranded cost recovery,
even if they purchased the power under federally approved wholesale rates
that have traditionally been found to preempt any state attempts to disallow
those costs in retail rates.

The Commission’s Final Plan led to immediate litigation in the federal
courts and a stay of the state’s restructuring plan. While the MECo affiliate,
Granite State Electric, was able to develop a settlement along the same
lines as the Massachusetts plans, the other utilities in the state have
been involved in the federal lawsuit for over three years, including five
interlocutory reviews by the 1st Circuit Court of Appeals.

In August 1999, PSNH filed a comprehensive settlement that provided for
implementation of electric retail choice in 2000, an 18 percent electric
rate reduction for standard offer (transition) service customers, divestiture
of PSNH’s generating assets, a write-off by PSNH of $367 million in stranded
costs, and securitization of up to $725 million of PSNH’s stranded costs.
In conditionally approving the settlement, the Commission required PSNH
to absorb additional stranded costs and increase the transition service
rates in order to bring them closer to wholesale prices and avoid creating
large deferrals for later recovery.

In June 2000, the New Hampshire Legislature passed, and the governor
signed, new legislation authorizing securitization of PSNH’s stranded
costs, establishing transition service rates and requiring a system benefits
charge. The law required certain revisions to PSNH restructuring settlement,
which are currently under consideration by the Commission. Assuming those
modifications are approved, most of New Hampshire is now open to competition
– over three years after the originally mandated customer choice date.
It may be too early to predict whether marketers will return to New Hampshire,
but at this time there is only one registered competitive supplier in
the state.

Maine

The Maine legislature also passed electric restructuring legislation
in 1997, but provided for a three-year implementation period culminating
with retail choice in March, 2000. The extended period for accomplishing
restructuring provided the Commission with an opportunity to conduct numerous
rulemakings and consider stranded cost recovery and restructuring plans
for each of the electric utilities in the state. The Maine restructuring
statute includes a requirement for standard offer service through at least
2004, divestiture of generation assets by March 1, 2000, and stranded
cost recovery determined by the Commission, with true up at least every
three years.

During 1998 and 1999, prior to the start of retail access, all of the
Maine electric utilities sold their fossil fuel generation assets through
auctions, which proceeds allowed them to mitigate their stranded costs
and reduce rates or deferrals. The Commission also completed proceedings
on establishment of stranded cost recovery for each of the electric utilities.
These proceedings culminated in settlements or stipulations establishing
not only stranded cost recovery, but also the unbundled transmission and
distribution rates and new rate designs.

The one area in which Maine has encountered difficulties is in the solicitation
of Standard Offer suppliers. The Maine Commission, like several other
states, has conducted auctions for standard offer service from third-party
suppliers. The intent of bidding out the right to serve customers is to
counteract any advantage of the incumbent utility. Commission mandated
auctions in 1999 for standard offer supply yielded bids which the Commission
ultimately determined were too high for two of the three participating
utilities. The Commission has sought to balance the need to keep rates
down with desire to make the Standard Offer as close as possible to actual
market prices so as to encourage new market entrants.

The standard offer rates in Maine are move “competitive” than those adopted
in Massachusetts, and the impact of these prices can be seen in the greater
migration of customers to competitive electric providers. In the first
four months of open access in Maine, a large portion of industrial customers
have switched to competitive suppliers, though there has been little movement
of residential customers.

The Power Markets: Price Administration or Reregulation

In attempting to design a market structure for competitive retail markets,
all of the states recognized the importance of creating a workable wholesale
market as a key ingredient to restructuring the electric industry. The
New England wholesale market operates over a coordinated transmission
grid or power pool known as NEPOOL. In 1997, NEPOOL which was formerly
controlled by the integrated utilities which were the major transmission
owners, restructured to create an Independent System Operator (ISO-NE).
The ISO-NE is a not-for-profit, private corporation charged initially
with management of the regions electric bulk power generation and transmission
systems and ensuring open access. As of May 1999, the ISO-NE also administered
the restructured wholesale electricity marketplace for the region. Market
participants buy and sell seven electricity products through an Internet-based
market system.

In New England, and more recently in California, the price spikes in
the volatile new wholesale electric markets have collided head on with
the desires of end users, regulators, and legislators to shield consumers
from such risks. After all, the intent of restructuring the electric industry
is to harness the forces of competition to reduce overall prices to consumers,
not enrich marketers and generators. Electricity’s unique characteristics,
however, make price volatility inevitable in a free market.

Electricity can not be economically stored, creating a need to constantly
balance supply and demand.2 Moreover, demand for electricity is extremely
inelastic during the short run, and there is a constant need to ensure
reliability of the grid.3 Thus, when demand rises above production, the
inelastic demand results in higher prices, which prices do not necessarily
produce increased supply or decreased demand, but rather can result in
extreme price spikes.4

In May 2000, an unseasonably hot day in New England coincided with a
number of planned and unplanned outages of generating units. The resulting
demand and price escalation was from $10 per megawatt to $6,000 per megawatt.
The reaction of the ISO-NE to a comparable price spike in the previous
year was to seek a retroactive price cap. While the ISO-NE is now investigating
the cause of this year’s spike, many parties are seeking imposition of
price caps to protect against such price volatility.

The issue has not attracted the same attention as in California, however,
in part because consumers in states like Massachusetts are protected from
any short-term impacts. Under the retail regulatory regime, utilities’
standard offer and default service rates are capped to ensure the mandated
15 percent discount. To the extent the utility is purchasing supplies
that reflect the volatile market rates, any increases in the actual cost
of standard offer or default service above the overall rate ceiling are
deferred for future recovery. Thus, consumers are shielded from the actual
market prices today, but they face prospects of paying for those increases
somewhere down the road when the utilities’ combined rates fall beneath
the overall price cap. The danger is that these artificial upfront discounts
will create growing deferrals that will continue for years to prevent
imposition of accurate price signals.

Conclusion

Replacing regulated electric prices, subject to command and control regulation
for over 100 years, with competitive retail and wholesale markets can
not be achieved overnight. Decision-makers may have to choose between
guaranteed price reductions, which will inhibit market entrants and postpone
the development of a viable market, and exposing consumers to the risk
that the market may not produce savings in the short run and will inevitably
be volatile. A structured timetable, rather than a rush to the finish
line, allows opportunities for consensus-building, negotiation, and settlement.
Postponing the scheduling of retail choice may provide sufficient time
for divestiture of utility assets and market development, so that customers
actually have competitive options on the date retail access occurs.

Imposition of artificial rate reductions through retail price caps may
be the price to be paid for gaining a political consensus to accomplish
restructuring. While such compromises may be preferable to attempting
to achieve immediate rate reductions through litigation, they create a
potential for ever-increasing deferrals of costs that will eventually
be passed onto consumers. These artificial discounts also prevent accurate
price signals that are essential to a fully operational market.

The issue of price volatility in wholesale electric markets will likely
be addressed in multiple forums in the coming months and years. Shielding
customers from these impacts and deferring the recovery of market increases
for years will not allow for an informed debate. A viable and competitive
market is one in which customers are to be provided an opportunity to
choose, even if they do not exercise that option.

Footnotes

1 Admittedly, Pennsylvania has taken the opposite approach and instituted
“shopping credits” at prices above the utilities’ cost of supplying power,
thus providing an incentive for migration.

2 Severin Borenstein and James Bushnell, Electricity Restructuring: Deregulation
or Reregulation, Regulation, Vol. 23, No. 2, 2000, pp. 48-49.

3 Ibid

4 Ibid

How Did We Get Here?

For eight decades, the electricity supply industry and its customers
enjoyed the benefits of increasing economies of scale. Electric utilities,
people reasoned, were natural monopolies because they enjoyed economies
of scale. In other words, the larger the generating station, the lower
the cost per unit of output. In order to assure that the utility could
install the largest possible unit and operate it at maximum output, the
state would prevent others from selling in that market. (Many small generators
would produce electricity at a higher cost than one large generator.)
Then, in order to assure that consumers would capture the benefits of
the lower costs, rather than the monopolist, the state regulated the price
charged by the monopolist, limiting the price to costs incurred, plus
a fair profit for the capital employed.

As the industry installed larger generating stations, the cost per unit
of output declined. Thanks to the regulatory system in place, the utility
had to pass on to customers those cost reductions in the form of lower
prices. Customers took more electricity because of lower prices and a
plethora of new uses. Higher sales volume enabled the utilities to install
even larger generators. That reduced costs and prices even more, and the
cycle continued, until the 1960s, when conventional steam generating stations
ran up against the efficiency limits inherent in the Rankine Cycle. From
that point forward, electricity suppliers could eke only minimal additional
efficiencies from the system, not enough to overcome the inflation in
other costs.

Solving the Problem

Electric utility executives did not rest on their laurels. They embraced
a technology that they knew would bring about an unprecedented new age
of abundant and cheap electricity – nuclear power. Unfortunately, nuclear
power raised rather than lowered costs, and the financial stress of financing
the long-drawn-out construction processes pushed many utilities to the
brink of, or into, bankruptcy.

Ironically, during the 1960s, equipment manufacturers introduced the
stationary gas turbine, a derivative of the aircraft jet engine, as a
power generator. Utilities must have viewed these little devices with
as much disdain as did the American automobile manufacturers when they
saw those first, tinny, little Japanese imports. “Gas turbines? They’re
okay for peaking,” they said. Over the coming decades, though, manufacturers
perfected the gas turbine, raising it to unprecedented levels of efficiency
and reliability, while the conventional, huge power station favored by
the utilities showed minimal improvement. The electric utility industry
had bet on the wrong horse. Or better still, at a key point in the industry’s
evolution, the industry bet on the dinosaur instead of the rat.

Figure 1
The evolution of electricity pricing and the power plant (Source: Leonard
S. Hyman, Andrew S. Hyman, and Robert C. Hyman, “America’s Electric Utilities:
Past, Present and Future” (7th Edition) Vienna, VA: Public Utilities Reports,
scheduled for 2000 publication).

Figure 1

 

Technological change will not take hold if the only possible users of
it resolutely decide to ignore it. The utilities, after all, did have
a monopoly on electric generation, unless you planned to do it yourself
off the grid. Congress changed that stranglehold on generation when, in
1978, it passed the Public Utility Regulatory Policies Act (PURPA), whose
Title II established a special type of generator that could sell its output
to utilities. Those qualifying facilities (QFs), in the main, employed
gas turbines to produce electricity. The independent power producers,
over the next decade, demonstrated that they could efficiently and reliably
build and operate the new power stations.

The electric industry pushed up prices to reflect higher costs due to
nuclear cost overruns, environmental controls, and higher fuel costs.
Industrial customers began to notice that the independent power producers,
without the baggage that the utilities carried, could produce electricity
for less. Some industrial customers realized that they could put in their
own generation and produce power for less than the local utility charged.
Small, modern gas turbines produced electricity at costs competitive with
those of large electric utility generators. Electric utility generators
no longer had a natural monopoly. Regulation now protected the utility
against competition rather than the consumer against exploitation by the
monopolistic utility.

Industrial customers first noticed the increasing gap between price and
marginal cost. They began to demand lower prices, threatening to move,
close up, divert production to other places, or self generate unless the
electric utility reduced prices to them. The utilities or the state regulators
usually caved in to the pressure. Industrial customers gained the benefits
of competitive pricing despite the lack of competitors.

In 1992, Congress passed the Energy Policy Act, which removed restrictions
on independent power producers and enjoined the transmission-owning utilities
to open their lines to all comers, including competitors that needed the
utilities’ lines to transport power to the utilities’ own customers. The
industry paid little attention to the change. The Federal government moved
slowly and had jurisdiction over only a small part of the industry’s sales.
Then regulators in California decided to ask why Californians paid such
high prices for electricity, and other high-cost states quickly began
their own inquiries. By the end of 1996, 14 states had either enacted
new regulations or had investigations underway with action likely to open
up the electricity market to competition at the retail level. The old
state-protected monopoly seemed on the way out.

The Reaction

Utilities reacted to the changes in law and the threat of competition.
They decided to invest in utility properties abroad, because of greater
opportunities for growth. They put money into unregulated generation in
the United States, figuring that they understood that business. Many utilities
decided to get out of the regulated generating business, and some decided
to get out of the generating business altogether. Success in the commodity
generating market required expertise and scale that the exiting utilities
believed they did not possess.

For that matter, the utilities believed that they had to achieve greater
scale in their overall operations in order to efficiently serve consumers.
They had to offer consumers a greater choice of energy services in order
to remain competitive. They required a wider range of skills, too, in
order to succeed in rapidly changing businesses. Rather than attempt to
develop scale, scope, and expertise internally, the utilities launched
into a wave of mergers probably unprecedented since the 1920s. They bought
or merged with neighboring electric and gas utilities, natural gas pipelines,
energy traders, telecommunications firms, and even water utilities. Meanwhile,
foreign utilities eyed the U.S. market, plunged into generation and power
trading here, and then purchased two large utilities.

Utility managements know best how to manage regulation. They proved that
during the restructuring process. In almost every jurisdiction, they convinced
regulators of the need to allow the utilities to recover the costs that
were supposedly “stranded” by the introduction of competition – that is,
the costs above the competitive level that they could not charge customers
in a competitive environment.

The states, however, wanted something in return. They introduced competitive
choice for retail customers, demanded immediate price reductions from
the utilities, and in order to create competitive markets, many states
insisted that the local utilities sell off their generating plants, so
they could no longer exercise local monopoly power over both generation
and distribution of electricity. Meanwhile, Federal regulators worried
that the utilities, as owners of generation and transmission assets, would
operate their transmission lines in a manner that would disadvantage competitive
generators seeking to reach the market. Therefore, late in 1999, the Federal
Energy Regulatory Commission told the utilities to put their transmission
lines under the supervision of independent regional transmission organizations.
That order could encourage some utilities to get out of the transmission
business altogether.

Neither the shareholders nor the managers of the investor-owned utilities
seemed to know how to react. Despite regulatory settlements, sale of power
plants at high prices, and the recovery of stranded costs through securitization,
utility stocks performed poorly. Perhaps the old utility investor, who
sought high dividends and steady income, no longer approved the new mix
of foreign investments, domestic competition, and uncertain dividends.
The utility companies, despite the dramatic changes in the business, not
only maintained the old financial policies, appropriate for the regulated
monopoly, but they actually put on more debt than before, acting as if
the business had gotten safer than when they had the monopoly. No wonder
investors were confused.

As illustrated in Figure 2, the business turned upside down within a
few years, but some folks did not seem to notice.

Figure 2
Trends in the utilities industry (Source: See Figure 1.)

Figure 2

What Next?

The electricity supply sector barely has moved into the competitive era.
The same managements run the same corporations with the same financial
structure and shareholder base as before. Consumers have limited choices
determined by regulators, who (in conjunction with state legislatures)
continue to set prices for much of the business. Transition periods stretch
on for years, with different terms for each state, thereby balkanizing
the market in a way that discourages the formation of nationwide competitors.

But, if a revolution in generating technology, aided by a worldwide retreat
from government regulation of the economy, could upset a well entrenched
industry over a 30-year period, how long will it take for the next technological
revolutions – encompassing distributed generation, time-of-day metering,
a more efficient transmission network, and the Internet – to shake up
a market that has not even completed the restructuring prompted by the
last revolution?

Major industrial corporations have launched programs to develop and market
small generators. Both microturbines and fuel cells could go on sale in
volume within two or three years. Those small generators could enable
consumers to either bypass the electric grid altogether or to limit their
use of grid electricity when price rises too much. Obviously, that distributed
technology could threaten the monopolistic position of the distribution
network and the profitability of power stations that make their profits
during peak periods.

Customers, of course, need real-time metering that allows them to make
decisions. Right now, the market does not take into account consumer reaction
to price, because most consumers do not see price until months later,
when the electric bill arrives, or maybe not at all. Competition will
not work until customers see prices. When they do, their reactions could
upset many a plan devised by aggressive electricity suppliers whose profitability
depends on shortages that might melt away when price rises in a visible,
real-time manner. Thus, real-time metering could have a profound influence
on the industry.

Generators today seem to assume that the transmission network remains
in its strangled state, with no improvements possible due to lack of financial
incentives. Even regulators will wake up to the possibilities, after a
few scary summers of shortages. Yet means do exist to improve the operation
of the network, without stringing new lines, and the introduction of more
economical DC technology and, later, superconducting cable, could transform
the network over the coming decade. Imagine the possibility of a deadly
price war that pits local central station generators against distributed
generation on one side and distant central stations that can now reach
the market, thanks to improved transmission, on the other. Then, consider
that Internet suppliers can cut out middlemen and achieve direct access
to the utility’s customers. They can run virtual utilities, relegating
the old utility to the position of supplier to the virtual utility, which
has the all-important contact with the consumer. Internet markets can
replace vast trading floors and reduce the value of expensively acquired
trading operations.

Is that all? The next revolutions, the third wave, could encompass decarbonization,
the hydrogen economy, and interactive markets between consumers and producers
that do away with the intermediary organizations that the regulators,
utilities, and marketers have worked so hard to erect. This will no longer
be the “old utility business.”