The production of electricity and gas, the primary sources of revenue for most
utilities, requires a wide variety of assets. Most of these assets are mechanical
or electrical equipment – pumps, generators, transformers, regulator valves,
etc. – that have an expected service time before degraded function or failure
occurs. The potential financial losses due to a generator or transformer failure
(on the electric side) or a regulator failure or transmission line breach (on
the gas side) are obvious. Equipment at risk is identified, and sophisticated
techniques are used to monitor their condition. Companies develop programs to
determine when “end of service” is likely to occur, and budgeting and planning
activities are initiated well in advance of potential failures.

However, one critical and very near-term end-of-service issue is not receiving
the same level of scrutiny. The utility workforce retains a vast array of experience-based
knowledge that is specific to critical assets of the utility’s operations. But
this army of highly skilled, well-trained and hardworking men and women is coming
perilously close to its end-of-service date over the next five to seven years
(see sidebar). The aging workforce is as critical a part of utilities’ asset
profile as an aging piece of equipment, and the current scarcity of replacement
talent makes it arguably the asset in most dire need of immediate attention.

Cost cutting over the past decade left a substantial gap in the pool of experienced
internal talent to replace retiring workers. Layoffs and buyout programs were
used to cut workforces, vacated positions went unfilled and new hiring slowed
to a crawl. The willingness of younger, more mobile employees to move on in
the face of instability worsened this imbalance.

Unlike a transmission line or a cooling water pump, off-the-shelf replacements
for people cannot simply be procured. These new workforce assets must be recruited
and trained on the key operational and safety functions of the physical assets.
They also must be given incentives to remain with the company for the long haul
– otherwise, the utility runs the risk of acquiring assets with very short service
lives, a dangerous and costly proposition for any asset, physical or human.

Human Capital as Key

Current financial accounting measures treat investments in people as costs,
no different than raw materials. The financial accounting profession has long
argued that since people do not meet the tests of an intangible asset set out
by the U.S. Financial Accounting Standards Board (FASB), they cannot be regarded
as an asset. In recent years, cost reduction has been considered the mark of
good executive stewardship and rewarded in the short term by Wall Street. Executives,
pressured to cut costs across the board, had little alternative but to treat
the workforce as a cost available for reduction.

Thinking of people as assets with corresponding investments, value and returns
is a concept that executives may intuitively understand; in fact, executives
routinely declare that “people are our most important asset.” But this is where
intuition comes at odds with finance and accounting standards. For example,
human capital could not be considered an asset unless it met the following criteria:

• It has productive capabilities;
• It is controlled by the company; and
• It was acquired through a defined transaction that gave the company control.

To resolve this conflict between human intuition and financial guidelines,
it is necessary to clarify the definition of the “human capital” asset. People
are, without question, the owners of their own human capital – their time, effort,
energy and enthusiasm. However, when people invest their human capital in their
work, it becomes an asset of the company. The company acquires this asset through
the package of rewards (compensation, benefits and work environment factors)
that it offers people in exchange for their human capital. Human capital, as
an asset defined in this way, now satisfies executive intuition, business practicality
and (at least in concept) meets the FASB standards for an intangible asset.[1]

However, rewards are not the only investment companies make in human capital.
Other expenses associated with managing human capital typically include administration
of human resources, recruiting, training, etc. These expenses are investments
in the asset management of human capital and are not dissimilar from the concept
of maintenance and repairs in the management of physical assets.

Asset Value

Assets require investment to generate value. Consider the value of a specific
physical asset – a turbine generator owned by an electric utility company. Its
“value” could be based on one of three characteristics:

• Its purchase cost;
• Its sale price on the open market today; and
• Its production, i.e., the value of the energy that can be produced by it.

For a going concern (i.e., an operating utility), the third characteristic
provides the truest measure of value. However, for accounting purposes, asset
value is recognized as the first characteristic, adjusted over time on the balance
sheet as the remainder of the purchase cost after depreciation is subtracted.
The value of the second characteristic is applied to an asset in liquidation,
not one in a going concern.

Shareholders are interested in going-concern value, not liquidated value. (When
firms liquidate, shareholders are “last in line.”) Calculating this value requires
evaluation of both the throughput – the ongoing output that has economic value
– and the inputs that the organization’s assets convert to throughput. For a
turbine generator, the value of the economic output is easy to compute; it is
the kilowatt-hours produced times the price per kilowatthour the electricity
market (regulated or unregulated) will pay for the power. The cost of the inputs
includes the total expended on fuel, subcontracted services, etc., in the process
of producing throughput using the asset.

Yet, it takes more than a turbine generator to make a kilowatt. There are two
other critical assets required for the production function – technology capital
and human capital. If one of the required sets of assets is missing, no energy
is created and no revenue is generated, and the throughput (output that has
value) of the system is zero. This is a critical concept: Assets have value
because throughput has value.

Since physical, technology and human capital (the organizational assets) must
perform in combination in a production function to transform inputs to throughputs,
an overall equation for return from a going concern would use them in the following
way:

The throughput minus the input is the value of the assets in a going concern
provided the investment in assets and generation of value are “periodicity-matched”
– i.e., the value is measured over the useful life of the assets. Depreciating
and amortizing expenses is one technique for reducing assets to a one-year investment
equivalent that tends to match the time frame for standard annual reporting.
But human capital is not treated as an asset today. If it were, there would
need to be an estimate of its useful life.

But what is the useful life of human capital? Remember, human capital is not
people, but rather what people invest in their work. Therefore, the useful service
life of any investment in human capital will always be bound by two parameters
– the nature of the investment and the length of service of the employee.

ROI on Human Capital

When employees go through certain types of training, or when executives are
relocated, companies make large investments expected to pay off over time. The
payoff comes from having the human capital performing well in the business operation
in combination with the other assets. Because the assets’ value is based on
their performance in combination, the value of human capital is derived from
the value of all the assets.

The theory of production functions states that for optimized assets, it is
not possible to trade a dollar of investment in one asset for a dollar of investment
in another to get a better return. Technically, when this condition exists,
value can be assigned in proportion to the investment. This decomposition of
value can be helpful to making investment decisions for human capital when the
production function is fixed, i.e., the work intended to be performed by human
capital (versus that performed by plant and equipment) is clear. The value of
this work in an optimized production function is:

To finish with a calculation of return on investment in human capital (ROI-HC),
the investment in human capital alone needs to be isolated from the numerator.
Dividing the value of human capital calculated above by this investment in human
capital produces the ROI-HC.

Today’s power plants generally perform, in historical context, at high efficiencies
and low cost. The performance of transmission and distribution systems lies
in a similar historical context – the huge investments in recent years in analysis
and IT have brought the industry to a higher standard of performance than ever.
So while the optimized asset assumption may not be strictly accurate (or else
the discipline of asset management would have been retired by now!), the concepts
underlying these equations are reasonable assumptions for use in modeling human
capital’s part in utility asset valuation today.

Once ROI-HC is calculated, the natural next question from boards or investors
will be, “Is this good?” The answer lies in benchmarking where the company stands
with respect to its peers. The value of a company and the strength of its management
team are determined by what decisions they make in the context of the industries
in which they operate. Investors want to own shares in companies that have management
teams that understand the trends, make keen investments and position themselves
for the future.

While companies in the lowest quartile in ROI-HC have much work to do, even
those in the top quartiles may find their performance falling precipitously
should they fail to manage the transition of their current aging workforce.
Putting investments in the context of their value is critical to knowing how
much return a company is generating. Putting their ROI-HC in the context of
industry performance is critical to knowing if the return is good.

The Strategic Imperative for Workforce Renewal

Failure to plan for this transition will likely result in a workforce that
will be under-equipped to perform their jobs, less productive and more error-prone.
Human errors or inefficient activities that lead to generation, transmission
and distribution losses have clear financial implications. When the increased
likelihood of such problems is considered, a case can be made that the revenue
at risk from the potential loss of talent will dwarf the investments in successfully
managing the transition of a retiring workforce.

Each organization faces a critical strategic choice: continue to rely on the
strategies and tools of the past, or recognize the competitive advantage that
can be gained by developing strategies to manage the new reality. Historically,
utility investors have placed a high value on stability and predictability.
More recently, however, utility investors have also been conditioned to expect
ever-decreasing cost structures – and there is little question that effective
workforce renewal programs will cost money in the short term. How effectively
the long-term vision is communicated to investors will be crucial to assuring
that the strategic and financial benefits of good long-term programs are not
hijacked by the desires of short-term investors.

With new, more relevant measures, executives can lay out a clear and compelling
case for investments in human capital. Furthermore, managing expectations conveys
a command of the sources of long-term value for the company. After all, investors
looking for long-term sustainable value vis-à-vis other investment alternatives
are attractive shareholders for a utility. Demonstrating that proactive steps
are being taken to mitigate risk may not only show the value of management’s
foresight and judgment, but may spark investors to ask questions of other companies.
Savvy executives must ask themselves, “What will we say when this dialogue starts?”

Conclusion

There is no question that an aging workforce presents challenges no less critical
(and arguably more critical) than an aging turbine generator. It has strategic
and financial impact, and utilities cannot wait to see how things play out.
This workforce transition will happen in the next five to seven years, hitting
some segments (e.g., nuclear generation, transmission and distribution line
maintenance) especially quickly.

The workforce renewal crisis presents utility executives with a serious dilemma,
but it also presents them with a golden opportunity. Visionary executives who
choose to manage human capital as an asset rather than a pure cost may discover
that applying disciplined techniques to human capital can yield the same dramatic
productivity improvements they have seen with physical asset management. Since
productivity is rooted in returns on investment, the performance of any asset
that is managed with an outdated strategy can be improved with a new focus on
its strategic function and impact on financial value. Achieving that understanding
and applying it to the impending workforce transition is the opportunity within
the crisis that successful executives of the next decade will exploit.

Endnotes

1. DiFrancesco, Jeanne, “Managing Human Capital as a Real Business Asset.”
   IHRIM Journal. March 2002. “Human Productivity: The New American Frontier.”
   National Productivity Review. Summer 2000.
2. Toossi, Mitra, “Labor force projections to 2012: The Graying of the U.S.
   Workforce,” Monthly Labor Review, U.S. Bureau of Labor Statistics, February
   2004.
3. From summary of “The Aging Workforce and U.S. Utilities Industries,” UTC
   Research, United Telecom Council, March 2004.
4. “2003 Workforce Survey – Findings and Recommendations,” Nuclear Energy Institute,
   January 2004.
5. Valocchi, Michael and Juliano, John, “The Aging Workforce: What Can You
   Do About It?” Electric Light and Power, January 2004.