Generation
With this data as background, let's analyze the strategies for success in the three key business segments, starting with generation. It is a key segment for several reasons. First, it has, as we've just seen, by far the largest impact on the customer's bill and, therefore, on the customer's bottom line. If you want to cut costs, this is the place to start. And cutting costs is necessary since the product of the generation sector is largely homogeneous-perceived by customers as just a commodity. Other than so-called "green" power, the kilowatts are all the same color and consumers can't differentiate one from the other- they simply want the cheapest. Also, the product of the generation sector typically can't be stored-it needs to be sold now or the opportunity is lost forever. Today, it's easier for new producers to enter the power generation market because new technologies have lowered the barriers to entry, eliminated economies of scale, and cut installation and operation costs. A business with an undifferentiated, temporal product, low barriers to entry, and great potential for cost reduction is definitely going to be highly competitive. So, the general industry mantra of the need to compete and cut costs is surely true for the generation sector.
The new technologies that have transformed this sector have, as we know, left many utilities with fossil and nuclear plants that are no longer worth their book value-a major component of the industry's stranded investment. If stranded costs could somehow magically disappear, customers' bills could come down significantly. But, guaranteeing rate cuts to consumers while awarding 100% stranded cost recovery is the economic equivalent of perpetual motion. In fact, an Energy Information Administration study showed that if policymakers permitted full recovery of stranded costs, competitive prices would not differ from the previously regulated rates for a number of years. This is a particularly important issue for residential customers, also known as voters, because not only do they have very little individual bargaining power, they also have typically been subsidized by commercial and industrial customers, a subsidy utilities cannot afford to continue. But, if residential customers don't get the savings the politicians have promised, a customer revolt will likely follow. In fact, such a revolt is already brewing in California where one consumer group has calculated that instead of a promised $6 per month reduction, rates will actually increase $1.60 a month when the charges to repay the "rate-reduction" bonds are taken into account. So, politically, full stranded cost recovery may not be completely practical and utility shareholders may be required to absorb some stranded costs. Utilities should, however, continue to fight for full stranded-cost recovery. It's certainly justified since all those costs were incurred and approved under the long-standing regulatory structure.
To optimize shareholder value and to compete in the long term, electric utilities will need to mitigate stranded costs. This could involve writing these assets down as quickly as possible. It could also involve the sale of some generating plants, especially early in the game while others are anxious to buy their way into the power generation segment. In fact, most utilities that have chosen to sell their plants early have found that the market value of the plants was actually higher than book value.
Since cost will be such a key driver of success in the power generation segment, it is fortunate there are tremendous opportunities to reduce costs. Dr. Robert Hawley, former CEO of the now-privatized nuclear power production firm British Energy, recently affirmed that unit costs are the key measure of competitiveness for a baseload generator and that by focusing on cutting costs and increasing productivity, British Energy was able to increase output per employee by an astounding 88%.
Summing up these power generation segment strategies, the bottom line is that the oft-repeated desire to be competitive and cut costs to help achieve competitive success is definitely on the mark in this segment.
Transmission
The same is not true, however, for the transmission business. Because it's not practical to run parallel competing lines, this segment will remain a monopoly. As Terry Winter, COO of the California Independent System Operator said, the prime responsibility of the transmission organization is reliability with the second responsibility to ensure that markets are as efficient and open as possible. Re-regulation, not competition, will likely be used to ensure reliability and equal access for all. Also, since, as we saw earlier, transmission has such a minuscule impact on the customer's bill, cost cutting has minimal leverage to save money for customers. Accordingly, the omnipresent themes of competition and cost cutting do not apply to this segment. The key strategies for success in this business segment are clearly very different from those in power generation. For example, this monopoly should be extremely low profile so that everyone takes the transmission system for granted. This means maintaining high reliability, fair and equitable access, and sufficient capacity. The transmission organization that meets these requirements should be able to negotiate with the regulators for a decent rate of return for this business. In fact, the transmission business can be relatively profitable, as was demonstrated by Australia's PowerNet which has regularly achieved a return on sales in excess of 25%. Clearly, the transmission business has strategies for success that are quite different from those in power generation.
Distribution
The distribution wires segment of the business is probably the most complex from a strategic standpoint, which means we've got to look very carefully to find the pitfalls that may not otherwise be obvious. Since it's not really practical to run duplicate lines down the street, the distribution wires segment will not be competitive but, instead, will remain regulated. And, the distribution system will continue to play the biggest role in determining whether or not the output of the generation and transmission segments actually gets to customers reliably. To quote the Canadian Electricity Association's ERIS report, "Approximately 80% of customer interruptions in Canada are associated with distribution systems. Customer service and satisfaction are directly linked to this segment of the system." How important is distribution system reliability? A few years ago, a utility with rates well above the US average suffered some significant and extended distribution system outages during a hot summer.
Figure 7. Without a reliable distribution system the generated power can't get to customers.
Cartoons like this [Figure 7] ran in the papers and the utility was actually in danger of losing its franchise, not because of those high rates but because of the reliability problems on its distribution system. The issue was resolved only when the utility agreed to invest $1 billion to improve the reliability of the aging distribution system. Another utility was recently taken to task by its regulatory commission because the company had undertaken a downsizing program in the name of competitiveness. In the years the program was in effect, the average length of power interruptions increased by 50%, complaints to the commission increased 57%, and complaints to the utility more than doubled. In its report, the commission said, "In a future competitive arena in which retail [competition] provides a choice of electric service . . . the quality of service issues will be of critical importance to . . . customers." This same thing could happen to other utilities if the current preoccupation with cost cutting continues. As Steve Frank, President of Southern California Edison, said, "The distribution company will not exist if it doesn't provide reliable service. Utilities need to be very aggressive advocates of reliability." The distribution wires business has a clear "obligation to deliver."
And, there's another important issue. Reliability of the distribution system is clearly the key to success, but when were these systems built? Large portions of many utility systems date back to the post-World War II boom. At 40 to 50 years of age, they are now reaching end of life. Many utilities have not yet recognized that, for the first time in their history, they will need to invest in replacing large portions of the system due simply to their having reached end of life. And, if this is not recognized and acted upon quickly, the utility may fall hopelessly behind and end up in an unenviable situation where reliability declines, customer complaints increase, and commissions penalize the utility, making less money available for the crucial investments needed. Clearly, investment now is required to maintain the reliability of these aging systems.
Another important reason why single-minded cost cutting on the distribution system is a flawed strategy is that it has minimal impact on the customer's bill. As the analysis of the FERC Form 1 data showed, the average cost of owning and operating the distribution system-including the O&M, depreciation, and interest expenses-is less than 10% of the customer's bill, so cost cutting has very little ability to lower the customer's costs. For example, a 10 to 15% reduction in the cost of owning and operating the system- a major cut, especially given the difficulty of impacting depreciation and interest expenses in the short run-would only save the customer 1 or 2% of their bill. Such a cut could, however, have a huge negative impact on the reliability of service. It's hard to believe many customers would be willing to accept such a potentially catastrophic decline in reliability in exchange for a mere l or 2% rate cut.
This is not to say that the cost of the distribution system is unimportant- prudent cost control is important in every business. The key point is that, in the distribution wires business, reliability is crucial to customers and cost has little leverage so investment for the future should produce better results than cost cutting for the short term. These investments should, of course, be carefully analyzed to ensure they represent the best long-term value and provide an appropriate payback. And, a focus on investment to enhance the productivity of people and capital instead of on short-term cost cutting should actually result in lower costs in the long term, as has happened in the U.S. automotive industry. With utilities these days focusing so much on the near term, few utilities are investing as much as they used to for the future. But, the companies that do look to the future and focus on upgrading technology as a key strategy will likely be the winners. Utilities can't serve 21st century power users with 19th and 20th century technology. As management guru Peter Drucker said, "Long-range planning does not deal with future decisions, but with the future of present decisions."
The strategy of forgoing short-sighted cost cutting and instead investing for the future is precisely what the US local telephone companies did when massive changes swept their regulatory environment. They invested in upgrading the infrastructure, including the installation of fiber-optic cables and the development of new service features that both increased the value of telephone service to the customer and produced extra revenue for the telephone utility.
For electric utilities, new technologies such as distribution automation, data acquisition, and AM/FM/GIS systems have tremendous potential to improve both reliability and productivity. These investments will become particularly important when regulators introduce performance-based rates. Such rates provide monetary rewards or penalties based on reliability, productivity, customer satisfaction, and safety. Since investments in new technologies can improve productivity and reliability and, therefore, customer satisfaction, they can earn extra revenue under these rates, thereby producing very handsome returns on the investment. And, the money should be there to make the investments because, as has been shown in the U.K. and elsewhere, the distribution wires business should be relatively profitable. Therefore, utilities should have the capital to invest in these technologies that, in turn, can provide a good rate of return for the distribution wires business.
When investing in new technologies, the distribution wires business should not be constrained by what it appears the regulators will allow. The division of responsibilities at the customer's end of the wire will include many gray areas. Consider, for instance, the new solid-state switching technologies that can provide customized, premium-quality power for customers whose processes can't stand power-system disturbances. This type of equipment could be provided by either the wires business or the non-regulated energy services businesses. Utilities, fed up with decades of dealing with regulators, seem inclined to move as much of their business as possible out from under regulation. But, the non-regulated energy services businesses will operate on very slim margins with plenty of competition from outside the electric power industry. The disdain for regulation notwithstanding, it might be wise for the distribution wires business to argue for the right to offer certain functions, like custom power, at the customer's end of the wire and to use those functions to generate extra revenue under the regulated business.
The bottom line for the distribution wires business is that the strategies that will result in success for this segment do not come from the theme of becoming competitive and cutting costs. Instead, investment to increase the reliability of service and improve productivity emerges as a more prudent and productive approach.
Dis-integrate
To make the strategies for these three business segments work to optimize shareholder value and to maximize customer focus, the next logical step is to separate the segments both organizationally and financially. This trend has started with the move toward separate business units within vertically integrated utilities. But, without a financial separation, cross-subsidies between the businesses will still exist and will mask weaknesses. For instance, in a vertically integrated company today, a dollar saved in the distribution wires business could help subsidize an inefficient generation sector. While this may have the appearance of supporting shareholder value in the short term, it covers weaknesses in the generation business and mortgages the future of the distribution wires business. In the long term, both the shareholder and the customer will be better off if these segments are spun off into separate businesses where each can focus on its core competencies, strategies, and customers and each can face up to its own internal weaknesses.
Another benefit of achieving full separation of the business segments is an improved ability to negotiate with customers over power quality issues. Today, many vertically integrated utilities are reluctant to openly discuss power quality issues with major customers because those customers can use their significant power bill as a rather large club in arguing for the utility to provide expensive solutions to mitigate problems coming from the utility's system. With the utility disintegrated, the customers won't have much of a club in dealing with the distribution wires business, the source of most of these power quality problems, as the bill from that segment will be a small fraction of the total. Accordingly, power-quality-improvement projects will need to be justifiable in terms of the cost of the solution relative to the savings achieved by the customer, which is certainly how these investments should be analyzed. Many utility executives are concerned about taking this step to dis-integrate their vertically integrated company because there may be negative short-term consequences. But, as David Lloyd George said, "Don't be afraid to take a big step if one is indicated. You can't cross a chasm in two small jumps."
And why not take the bull by the horns and do it now, because most utility executives believe this restructuring will eventually be required. In a recent survey by the Washington International Energy Group, only a small minority of utility executives felt their companies would be intact in 10 years. If these changes are inevitable, wouldn't it be advantageous to
take the initiative and achieve separation on more desirable, voluntary terms instead of waiting and being subjected to the dictates of politicians and regulators?
In summary, then, electric utilities can achieve business success and enhance customer satisfaction by developing unique strategies for each individual segment of the electric utility business, keyed to the success drivers and customers of that segment. The generation business will, indeed, benefit from the oft-stated strategy of competition and cost reduction. The transmission and distribution wires businesses will not because they will likely remain
regulated and because they represent only a small portion of the customer's bill. These businesses will benefit from investment for the future, not shortsighted cost reduction. And, the distribution wires business will particularly benefit from investment in new technologies that can enhance reliability and productivity and can provide new sources of revenue.
This is a critical time in our industry's history. It is imperative that we think carefully about these strategic implications in order to avoid falling victim to the old Italian proverb, "After the ship has sunk, everyone knows how she might have been saved." The future, after all, is not something we enter. The future is something we create
