The Lessons of Deregulation

As leaders in the utility industry, part of your job is to conjure up a full understanding
of both the perils and opportunities confronting your organizations. Given the
pace of change these days, that’s a risky endeavor. I think you’d agree that most
of us find it hard enough to understand what’s happening today, let alone what
might occur tomorrow.

Much of this effort rests on the importance of good information and on not
assuming that what you see going on today has much to do with what’s going to
happen tomorrow. This is especially good advice, it seems to me, for any business
operating in an industry in the midst of, or on the verge of, deregulation.

While I am certainly no expert when it comes to utilities, the ongoing debate
over the wisdom and methods of deregulating the generation and distribution
of electric power is reminiscent of the debates that swirled around the airline
business 25 years ago.

It’s hard to argue with the notion that in any business, competition tends
to drive prices lower, while promoting both efficiency and innovation. In a
macro sense, that’s certainly been true in the case of the airlines, which have
responded to deregulation by providing consumers with ever-more service at ever-lower
fares. Today, despite the enormous losses airlines are suffering, fares are
lower than they have been for 15 years.

Despite that success, airline deregulation has distributed the benefits of
change less equally, and in less predictable ways, than the theoreticians of
deregulation imagined it would. That reality underscores an important point
— when regulation is removed or modified, what actually happens often bears
little resemblance to what was anticipated.

To illustrate my point, let’s turn back the clock and review some of what has
changed since deregulation swept over the airline industry back in 1978. Given
the behavior of today’s airlines, it’s hard to believe that from 1938 to 1978,
airlines couldn’t fly anywhere, couldn’t change their fares, couldn’t even vary
their menus without the explicit permission of something called the C.A.B. —
the Civil Aeronautics Board.

Quick, Brutal Change

All that changed in April 1978. Suddenly — literally overnight —
every airline could fly wherever it wanted and charge whatever it deemed appropriate.
Suddenly, what had been a carefully regulated semi-utility became a ferociously
competitive, capital- and labor-intensive business, selling a non-differentiated
product in a nearly perfect retail market at very low margins.

The tumultuous years that followed brought about the demise of more than 180
airlines, including such venerable names as Pan Am, Eastern, and Braniff. For
my company, American Airlines, deregulation represented both a dire threat and
a great opportunity. Although the company’s history dates to the mid-1920s,
by the early ’70s it had become a distinct also-ran, falling behind its competitors
on many fronts. The analysts of the time, noting its weaknesses, marked it as
a probable loser in the deregulation game.

We weren’t sure what the deregulated industry was going to look like, but we
were very sure it wasn’t going to look anything like it had before. We also
knew that the analysts were right in believing we were clearly at risk. That
meant we had to very carefully evaluate the strengths and weaknesses of our
past strategies and come up with some dramatically different approaches.

That’s exactly the analytical challenge your business now faces — and
is part one of what I think of as the two-part job description of every business
leader. Part one requires creative, imaginative thinking about what your business
now is and might be in the future, with the objective of producing a business
plan consistent with your opportunities and responsive to your perils. Part
two of the job is execution — making sure your organization does its job
better than your competitors do theirs, day in and day out.

Normally, both halves of the management equation are important. However, during
times of rapid change, the part of your job that is focused on figuring out
what is going on and determining what might happen in the future becomes uniquely
important. As many failed business leaders have discovered, an inaccurate vision
will send you off in the wrong direction. If that happens, good execution will
do little to make things better.

Unforeseen Circumstances

Unfortunately, accurate crystal balls are hard to come by. As airline deregulation
was occurring, there was lots of speculation about how the airlines would respond.
Almost all the speculation was wrong — and in fact, the changes that occurred
are far more radical than anything then foreseen. Let me touch on just a few
of the highlights:

• Since deregulation, each of the major U.S. airlines has restructured
its route system around several major hubs and has discontinued various nonstop
routes mandated by the C.A.B. during the industry’s regulated years. The hubs
have several purposes but are primarily a means of offering many more products
using the same amount of productive capacity. For example, five airplanes, each
flying from point “A” to point “B”, produce just five products. On the other
hand, five airplanes flying from various points east of a hub and then to various
points west of the hub offer service in 35 separate origin-destination city
pairs, or markets. (See Figure 1.)

• As a consequence of that comprehensive route restructuring, competition
in the airline business is now principally between airline networks, rather
than between airlines serving the same point-to-point route.

• Twenty-five years ago, no one had ever heard of airline loyalty programs,
better known as frequent flier plans.

• Twenty-five years ago, airline computerized reservations systems (CRS)
were in the very early stages of development. Today, access to these powerful
systems is ubiquitous and is fundamentally altering the industry’s distribution
channels.

• And finally, in the airline industry of 25 years ago, pricing was straightforward.
If you wanted to change your price, you applied to the C.A.B., which most often
declined the request. Today, when one airline decides to cut a price, it can
be sure that within 15 minutes — and more likely within 15 seconds —
competitors will follow suit.

None of these changes was predicted by the academic theoreticians behind deregulation,
and only a few were properly anticipated by airline practitioners. Those who
got it wrong — Braniff and Pan Am are excellent examples — failed
rather quickly, as did many lesser contenders. Their experience underscores
the fact that everyone in a business that is in the process of being deregulated
has to think long and hard — not just about what changes are likely in
the first, second, or third year, but about what changes are conceivable across
a longer time frame.

(See Larger Image)
Figure 1: Under the deregulated system, five non-stop flights simply allow
for five city pairings. The deregulated route system makes use of a central
hub, enabling 35 possible pairings with the same productive capacity.

Wild Ride Ahead

While you all know much more about it than I do, I think it’s safe to say that
already, in California and elsewhere, the effects of deregulation in your business
have diverged wildly from expectations.

California taxpayers are on the hook for tens of billions of dollars the state
has committed to assure a steady supply of electricity. In the early days, wholesale
prices spiked — driven, some contend, by various highly technical and entirely
unanticipated market-manipulation mechanisms. That outcome has slowed the deregulation
bandwagon considerably, as politicians, academics, and industry theoreticians
debate alternative approaches to the goal of stimulating non-destructive competition.

While California’s disastrous early experience has proven how badly things
can go, there is as yet no broad-based consensus on the best alternative approach
— or even about the wisdom of deregulation as a strategy.

As you know, the Federal Energy Regulatory Commission has issued a proposal
for a major overhaul of the nation’s power distribution rules, calling for a
“standard market design” that would reduce state and local control over individual
power markets and attempt to create a more efficient national grid open to all
generators.

While debate on the specifics of the FERC proposal rages, the more interesting
question is whether, once let out, the deregulation genie can be put back in
its bottle. In my view, it probably cannot, which suggests that the probability
of more dramatic change in your business is high. That means, of course, that
the importance of part one of the leadership challenge — understanding
the most likely outcomes — is higher than ever.

Short-Lived Advantages

But let us not forget part two of the challenge — execution. One of the
realities of life is that your competitors are thinking hard about the same
issues you’re considering. If you do an outstanding job of figuring out what
lies ahead, you’ll have some advantage. But it won’t be long-lived. In fairly
short order, it’s likely that most of your competitors will be following a game
plan quite similar to yours.

In the airline industry of the 1980s, American was a step ahead in lots of
important areas. We were first with a full-featured reservation system. We were
first with the frequent flier idea. We led the way in the black art of yield
management. And we were more aggressive than most in focusing our airplanes
on hub-and-spoke operations. But our competitors moved quickly to catch up,
and each advantage was short-lived.

In most businesses, as in aviation, a given company’s strategy is quite transparent.
So where do you find your competitive advantage? Faced with competitors with
ample access to capital, the same technology, and similar strategies, your best
chance to win is to simply execute better than the other guy. And unless you’re
a very small business, outstanding execution depends entirely on the performance
of your people.

I’m sure you’ve heard it said that people are a company’s greatest resource.
I would amend that slightly to say the right people are a company’s greatest
resource. Talented people — in the right environment and properly motivated
— have better ideas and execute those ideas better. Larry Bossidy, former
CEO of Allied Signal, put it well when he said, “At the end of the day, we bet
on people, not strategies.”

In a fast-changing world, in which no one knows for sure what lurks around
the next corner, good people who are able to help think and help execute are
every leader’s best hope. This, of course, makes the role of the leader even
more important, for it is he or she who will shape employee experiences and
perceptions.

Unfortunately, as we’ve all learned, even if your strategy is first-class and
you hire and motivate an excellent team that executes on all cylinders, disruptive
change remains a constant threat. Aspects of your company’s fate — particularly
in a deregulated environment — will always be, at least partially, beyond
your immediate control. So, without losing sight of who you are or where you
want to go, you must build as much flexibility as possible into your contingency
plans and always be prepared to shift gears in response to changing circumstances.

New Frustrations

Consider my former colleagues in the airline industry. Today, the major carriers
— each a survivor of the deregulation trauma — are confronted with
a new series of challenges, even more threatening than those of 1978.

The first is what the industry calls the hassle factor, which is the impact
on customer service of the various security steps that have been taken since
the dreadful events of 9/11. While no one disagrees with the need for a high
level of aviation security, the unhappy truth is that much of what has been
done to date has little to do with enhancing security, and lots to do with increasing
both costs and customer annoyance.

While there has been some encouraging talk of late about modifying some of
the more bothersome practices, the reality is that today’s aviation security
system is inappropriately intrusive and inordinately expensive. And it’s likely
to get both more intrusive and more expensive in the months to come. Among other
new challenges are:

• The proliferation of sophisticated online travel agencies that make
it easier for consumers to find the cheapest alternative.

• The rapid emergence of low-fare carriers, whose costs are dramatically
lower than those of the established carriers.

• The decline of business travel, coupled with a new tendency of business
travelers to “buy down.”

The impact of these challenges can be far-reaching. For example, the pattern
of frequent and affordable service across connecting hubs was put in place to
cater to business fliers. After deregulation, the airlines sold the system’s
excess capacity to leisure travelers — using mechanisms such as Saturday
night stays and advance purchase requirements to prevent high-fare travelers
from buying down. For reasons I’ve already noted, this plan isn’t working anymore,
and unless the airlines find a way to cut their costs dramatically, the inevitable
result will be many fewer flights and a much less convenient system.

Industry Response

The major airlines have responded vigorously by grounding hundreds of aircraft,
laying off tens of thousands of workers, and taking on billions of dollars of
debt to cover their losses. The carriers are attacking their costs on every
level. In the months ahead, I think you can expect to see their efforts reflected
in fewer flights, less personal service, higher seat density, less food, and
various other changes.

On the other hand, some things will almost certainly remain much the same.
The hub and spoke system will be modified, but won’t disappear, because most
point-to-point markets in this country are simply too small to warrant nonstop
service. As long as the industry remains deregulated, nobody is going to offer
nonstop service between Syracuse and Des Moines. That means anyone who wants
to make that journey will continue to connect over a hub.

In an effort to cut costs, the airlines are restructuring their hubs to maximize
airplane and employee productivity rather than customer convenience. The airlines
are also substituting regional jets for big airplanes in more markets, and are
working hard to increase employee productivity — which will mean lots more
self-service automation at the airports.

My friends in the airline business certainly have their hands full as they
contend with what you might call the second big wave of post-deregulation change.
While some airlines will fail, I think most of the industry will eventually
manage its way through this trauma and return to at least minimal profitability.
We should all hope they do, because the alternative, which would leave the United
States without any viable inter-city transportation system, is simply not acceptable.

Visionaries Needed

Whether any of the big carriers can make it through without going through the
bankruptcy process is an open question. To a large extent, the outcome for each
airline will be determined by the skills and attitudes of its leaders —
with the gold ring going to those best able to formulate, articulate, and merchandise
an accurate vision of the future.

You may take comfort in the fact that you don’t work in the airline industry.
Yet, as deregulation impacts your business more and more, your success will
similarly depend on your ability to anticipate and respond quickly to dramatic
upheaval.

In your business and mine — indeed, in any business — today’s tremendous
pace of change means, among other things, that what got you here won’t keep
you here. In a period of disruptive change — whether it’s driven by deregulation
of some other force — it’s up to every organization’s leadership to determine
which aspects of its plan fit with tomorrow’s reality, and which don’t.