A paradigm shift in the utilities industry has been underway for some time
now. For decades the industry was characterized by regional and national monopolies,
state ownership, price regulation and long-term price agreements. However, an
even stronger wave of deregulation and privatization is sweeping national utilities
markets. It started in the United Kingdom in the early 1980s, resumed in the
European Union in the mid- to late-1990s, and is now gaining momentum in Central
and Eastern Europe, South America, the United States and beyond.
The traditional business model has been put to test. Is the functionally fully-integrated
utility still the role model for success, or is it a leftover from the past?
This question is reinforced by the capital markets, where most fund managers
believe it is their own prerogative to allocate their capital resources on the
different value chain levels the capital markets’ bias for “pure plays.”
The allegations against vertically integrated utilities are manyfold. They range
from ignorance of one’s core competencies to internal cross-subsidies between
the different levels of the value chain and a tendency towards ad hoc strategic
decision-making. Electricity companies that have disintegrated are, on average,
enjoying higher market ratings than “vertical integrators.” Radical choice has
therefore become the mode du jour.
While functional specialization has indeed become a widespread phenomena of
the utilities scene, a different approach is needed. It makes sound business
sense for large players to have all of these activities along the value chain.
The Internal Market Place
Over the last 100 years, RWE has developed from an electricity company in the
Ruhr area to one of Europe’s leading power companies. Its sales volume of 212
TWh represents about 10 percent of overall European Union consumption. RWE operates
generation plants with an overall generation capacity of 36 GW. Its transmission
and distribution network with a length of 375,000 km in Germany is the turntable
for the growing volume of electricity traded both nationally and across borders.
During the past decades, the high cash flow from regulated electricity business
was partly invested outside the industry. So RWE, like other major electricity
companies, operates in a vast array of activities, including construction and
Due to deregulation in 1998, the company has undergone a strategic re-alignment
(Figure 1). The challenges of the Europe-wide opening of electricity markets
made it necessary to concentrate financial and managerial resources. At the
center of the current strategy is the differentiation between the core business
and financial holdings, like construction and printing machines. The core business
is energy and environment. In electricity the largest portfolio segment
operations on the individual levels of the value chain were transferred
into individual legal and operational companies.
Figure 1 – The New RWE: Clear Function – Competitive Units
While this satisfies the E.U. electricity market directive of 1996 requiring
unbundling, it is also the basis for a far-reaching re-engineering of the complete
Cost efficiency on every level of the value chain is crucial. Consequently,
the wholesale electricity market provides the benchmark for transfer prices
between the different levels of the value chain as the electricity travels from
the generation plant to the consumer. Applying this principle virtually eliminates
cross-subsidies between different levels. Because management’s incentives include
a leveraged performance-based compensation scheme, they have no inclination
to accept anything other than the going market rate.
The new corporate structure is conducive to the quality of overall strategic
decision-making. In today’s volatile market environment, vertically integrated
utilities lack the capacities to adequately appraise the strategic challenge
on each value chain level. In the new corporate structure, management now specializes
in a narrower field of activities and on its specific market environment. In
generation, for example, the choice of the right generation technology
gas-fired or coal-fired combined cycle gas turbine is becoming more important
as input prices of the energies, as well as output prices, are highly volatile.
Another issue is distributed generation (fuel cells, micro turbines) and their
possible impact on conventional centralized generation.
Transmission and distribution companies are increasingly being challenged by
regulators to decrease transmission fees. Keeping good relations with regulators
and lobbying for a framework with adequate incentives for preserving a reliable
network while offering competitive transmission fees are the top priorities
for management. In the supply business, marketing is becoming ever more important
in order to preserve the customer base while attracting new clients.
Power trading is the fastest growing segment in the electricity value chain.
The German wholesale market has a volume of nearly 550 TWh, more than 10 times
that of four years ago. This activity commands management’s full attention.
The extreme price spikes in the United States during 1998, 1999 and 2000 have
demonstrated the risks of this business. RWE Trading is the group’s integrated
energy trader, active in electricity, gas, coal and crude oil, both in physical
and derivatives products. In electricity, RWE Trading commands a position among
the top three European energy traders. The unique advantage of the integrated
approach is the competence synergies between trading in different fuels, which
gives rise to innovative products, such as a contract on the spark spread between
coal and electricity. Trading in weather derivatives and carbon are possible
activities with considerable benefits for mitigating risks.
A stringent process of profit appraisal on the basis of specific costs of capital
gives a guideline for capital allocation between different projects and different
value chain levels.
Separation Yes, but Spin-off No
Separating a traditional vertically integrated utility into different enterprises
with a focus on a specific area of competence can have some very positive effects.
Spinning off entire value chain levels into separately quoted companies is unlikely
to have much benefit for several reasons:
Risk and return dynamics differ significantly between power generation,
T&D, trading and supply/retail. Therefore it makes good business sense to have
these activities in one corporate group. Earnings are more stable, which is
positive for shareholders.
The degrees and methods of market liberalization differ between countries
which results in a diverse international landscape of electricity markets. In
Hungary, for example, the state owns and operates the transmission grid, whereas
on the distribution and generation side, there are numerous private companies.
Another example is the United States, where eventually, companies focusing purely
on transmission may emerge from the current process to restructure the nation’s
transmission system. A group that has proven competencies in all segments of
the electricity value chain has more opportunities for profitable international
growth than, for example, a pure generating company or a pure transmission company.
Operational synergies between value chain levels are easier to identify
and to realize within one group rather than between different companies.
Successful electricity companies will feature operational excellence and cost
efficiency in all of their activities. They will have transparent structures
with well-defined competencies and comprehensive methods of capital allocation
between the different levels of the electricity value chain.
The Multi-Utilities Concept
However, RWE is far more than a pure electricity play. Our core businesses
are energy and the environment based on the four utilities electricity, gas,
water and waste-management (Figure 2). RWE is in a unique position to realize
competence synergies, revenue synergies and the benefits of risk diversification.
2 – Focusing on Energy and the Environment
There is a significant overlap in customer groups between these four utility
products ranging from large industrial clients to municipalities and
private households. A most recent example of these competence synergies in action
is given by the acquisition of Dutch gas distribution companies Intergas and
Obragas, which were previously owned by Dutch municipalities. RWE, due to its
long business relations with German municipalities in electricity distribution
and a track record as their partner, was able to convince the owners in the
Netherlands of its reliability as a good corporate citizen and of its long-term
perspective as an investor.
Another example is the Rheinpapier project, where we offered an industrial customer
a full utility package that significantly reduced the investment costs for our
partner.1 The company will build one of the most modern and technically advanced
paper factories in the world near Cologne to produce more than 285,000 tons
of paper designed for newspaper. RWE Plus will provide electricity as well as
steam to power the facility. RWE Umwelt, our waste-management division, will
supply Rheinpapier with all waste management and recycling services, a challenging
and demanding task in the environment of a paper production plant. RWE will
be responsible for the facility’s wastewater disposal. Finally RWE Rheinbraun
provided the site for the factory. RWE’s competence as the leading German and
European electricity company to supply large industrial clients with power and
heat is also a competitive advantage in the marketing of other utility services.
In order to better address the specific needs of large industrial key accounts,
RWE Solutions will be responsible within the group for developing integrated
utility products comprising not only power, gas, water, waste management but
also the complete management and maintenance of the utility infrastructure on
large industrial production sites. This ultimately represents a new quality
of outsourcing, because industrial clients eventually entrust RWE with the responsibility
for integral elements within their own production process.
Finally, the acquisition of the United Kingdom’s Thames Water the world’s
third-largest water supply and wastewater disposal firm in November 2000
has significantly broadened RWE’s international presence. Thames Water operates
on a worldwide scale, and together with already existing water activities of
RWE in Berlin and in Budapest, supplies about 43 million people (Figure 3).
Thames Water’s undisputed experience in international project development, as
well as its contacts to governments and local authorities, will significantly
contribute to the group’s overall development skills. As far as competence is
concerned, one should not forget that for all utility services, the maintenance
of good relations with regulatory bodies is another key success factor.
Figure 3 – Thames Water International Portfolio Today
Revenue synergies are obviously another potential advantage of the multi-utilities
concept, but heed these words of caution. It is important to clarify what is
meant by the use of the term “multi-utilities.” This concept has been proposed
as a means to escape the “commodity trap” of deregulated utilities markets,
where product diversification (and therefore price differentiation) is virtually
impossible. Its aim is to leverage the existing customer base by cross-selling
different products to the same customers.
This has been demonstrated in other industries, like the financial services,
for example. It’s important that the advantages of convenience are communicated
to private and industrial customers alike. For example, having a single monthly
bill for multiple services is certainly one aspect. What is more important,
however, is that the overall price for a bundle of different utilities must
not be higher than the sum of the individual prices. In contrast, customers
expect a multi-utilities company to pass on any savings that arise out of cross-selling.
As a consequence, cost-cutting remains the top priority. RWE is committed to
reducing costs in the energy and environmental divisions by 2.5 billion Euros
until 2004. For the time being, achieving and increasing stand-alone competitiveness
in each of the four utilities electricity, gas, water, and waste management
is a precondition for successful cross-selling.
RWE also feels that a portfolio of assets and activities in electricity, gas,
water and waste management significantly reduces risks. The water division features
a high and stable cash flow, thus contributing to an overall stabilization of
corporate earnings, whereas earnings in electricity and gas are going to fluctuate
more widely due to deregulation. Also, water is a growth business in both highly
developed economies and in high-growth emerging economies. The accessible market
for private companies is expected to increase from $80 billion in 1999 to $375
billion in 2010. RWE feels that together with Thames Water it can significantly
expand its international revenues, which presently has a share in the core businesses
electricity, gas, water and waste management of about 24 percent. Through this,
the dependence on the German home market will be significantly reduced.
In September 2001, RWE implemented this strategy, taking another significant
step to increase its presence in the U.S. utility markets. The group has tendered
an offer to acquire all shares of American Water Works, the leading private
U.S. water company serving about 11 million people. RWE shares the ambitious
growth strategy of American Water Works and supports its goal to become a successful
consolidator in the highly fragmented U.S. water market.
An Essential Requisite for Future Growth
Germany is not known for radical reform steps. Yet, international observers
are beginning to appreciate the bold measures Germany has taken to open up electricity
and gas markets for competition. The new German energy law, which came into
effect in 1998, commanded a full-blown market opening for all customers regardless
of their size and electricity and gas consumption. Nearly all other countries
in Europe (and elsewhere, i.e. the United States) have opted for a piecemeal
approach starting deregulation for the large consumers first and only
gradually giving small customers, such as private households, the choice of
competing suppliers. Also, no arrangements were taken to recover costs of stranded
investments. Due to significant over-capacity in generation of about 10,000
MW, prices in all segments of the market came under severe pressure and customers
saved about 7.5 billion euros on their electricity bills about 15 percent.
Energy policy is high on the political agenda. However, the emphasis of the
major guidelines of energy policy has shifted to environmental compatibility,
with economic efficiency having secondary importance. Although the opening of
energy markets of 1998 can’t be undone, important parts of the market have been
excluded from competition, imposing a climate protection strategy and favoring
The cornerstones of this strategy are the promotion of renewable energies and
of CHP, resulting in subsidies of about 2 billion euros per year. These subsidies
have to be borne by electricity companies and their customers. It is very difficult
to offset these burdens through additional domestic growth, because the German
market is expected to expand by one percent annually at best. Also the Federal
Cartel Office, Germany’s anti-trust watchdog, is critical of further acquisitions
by large players, which would have helped them to save costs.
Highly competitive markets, together with a tough political and anti-trust environment
in Germany, are more than enough reason to look for sources of stronger growth
abroad. Europe, including the European Union accession economies of Central
and Eastern Europe, and North America are RWE’s primary markets. Opportunities
for mergers and acquisitions are assessed using a multi-stage filter process
which includes market size and growth potential, regulatory environment, and
overall economic performance indicators. In several Central European economies,
particularly Hungary, RWE has achieved significant positions in electricity,
gas, and water. However, as is commonly the case regardless of location, these
economies are not without risks. Investors should have a blueprint to pull out
of a market in which property rights are not adequately enforceable once performance
indicators have reached critical levels.
However, regulatory deficiencies are by no means the only topic in emerging
economies. Inadequate regulations are also frequently found in industrialized
countries. The U.S. Public Utilities Holding Company Act, for example, is a
case in point. This law came into being in the 1930s to protect consumers from
improper behavior of intransparent interstate utility conglomerates. As a consequence,
domestic and foreign investors in the U.S. utility industry even today have
to submit themselves to severe restrictions of their investment decisions, of
their scope of business and generally have to follow cumbersome SEC reporting
procedures. There is growing consensus that the PUHCA goals today can be served
better with the general legal framework of competition policy and securities
laws. PUHCA has to be regarded as a significant impediment for foreign direct
investment in the U.S. energy markets an impediment that U.S. utilities
do not have to deal with in foreign markets. Foreign investors in the U.S. gas
and power industries can only evade a registration under PUHCA if they confine
themselves to the non-regulated businesses, such as power generation and wholesale
trading. PUHCA also demands that utility companies must not have a significant
business other than electricity and gas, thus preventing the development of
true multi- utilities companies that at the same time could also offer water
and other utility services.
The deregulation of the world’s utilities markets is far from being fully implemented.
Some regions and countries are only just starting to open up their markets,
which gives them the unique opportunity to learn from other countries’ successes
and failures. While electricity liberalization is relatively progressed, deregulation
in water and wastewater management is just about to begin. The multi-utilities
business model, based on a balanced portfolio of national and international
activities in electricity, gas, water and waste management, is the right recipe
for success in this highly fluid market environment.
1 Rheinpapier is a wholly-owned subsidiary of Finnish Papier
company Myllykoski Continental.