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

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).