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

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

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

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

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

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

Competition Moves Forward

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

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

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

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

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

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

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

What are the Leaders Doing?

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

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

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

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

Focus on Growth

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

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

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

Learn to Love Risk

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

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

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

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

Adopt New Business and Finance Models

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

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

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

Foster Innovation

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

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

Maintain a Sharp Focus on Costs

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

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

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

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

Conclusion

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