The diversification strategies of the privatised water and sewerage companies in England and Wales: A resource based view

Utilities Policy, Vol. 6, No. 4, pp. 325-339, 1997

Pergamon PII: S0957-1787(97)00010-6

© 1997 Elsevier Science Ltd. All rights reserved Printed in Great Britain 0957-1787/97 $17.00 + 0.00

The diversification strategies of the privatised water and sewerage companies in England and Wales: a resource based view Tony McGuinness and Dennis Thomas

This is a preliminary investigation of the motives behind Water and Sewerage Companies' (WaSCs) diversification, and of the forms it took after their privatisation. We present selective evidence that illustrates the conformity of WaSCs' behaviour with theories of corporate diversification. While company experiences contain many examples of mistakes and subsequent restructuring and refocusing, the evidence suggests that much WaSC diversification displays a pattern and logic which can be related to their resource-base. © 1997 Elsevier Science Ltd. All rights reserved Keywords: utility privatisation; diversification; strategic assets; core competences

Introduction Before their privatisation in November 1989, the water and sewerage companies (WaSCs) in England and Wales were permitted to undertake only a limited set of activities in a limited range of markets. After privatisation, their water and sewerage activities in the UK were regulated, but the firms were allowed to pursue other activities and to operate in other markets (e.g. outside England and Wales), provided such non-regulated developments did not interfere with their core activities and markets in ways judged detrimental by the Director General of Water Services (DGWS). l With a sharp shift in regime, the period since privatisation has offered the ten WaSCs unprecedented scope for diversification, providing an opportunity for testing diversification theories in a clearly delineated context. While the recent cross-utility moves by North West Water and Welsh Water, acquiring Norweb and Swalec respectively, together with Scottish Power's The authors are with the Department of Economics, University of Wales, Aberystwyth, Penglais Campus, Aberystwyth, SY23 3DB, UK

acquisition of Southern Water have attracted much publicity the early diversification experiences of the water companies have been studied only incidentally, insofar as they have implications for their regulated activities. This paper is a more systematic review of the forms and directions that WaSC diversification took after privatisation, and a preliminary investigation of the motives behind it. In addition to documenting the diversification experience of each WaSC, the paper aims to identify aspects of those experiences that conform with theories of firms' diversification. The next section outlines the theories of corporate diversification (taking into consideration the regulatory regime in which the water industry operates) and defines the sense in which they are 'tested' by evidence presented later in the paper. The following section contains a general description of post-privatisation diversification moves by the WaSCs, and relates these to the theory. Our concluding section provides a summary of our findings and some suggestions for further study.

Theories of corporate diversification Montgomery (1994) identifies three broad economic approaches to explaining corporate diversification "2

• the market power view: diversification might add to a firm's market power by enabling it to engage in anticompetitive practices such as cross-subsidisation, mutual forbearance, and reciprocal buying. • the agency view: managers in control of firms that they do not own may diversify 'excessively' (more than shareholders would wish) in order to promote their self-interest through empire-building, job-entrenchment, or reducing their own employment risk. Consistent with this view is Jensen's theory (Jensen (1988)) of free cash flow, which proposes that existing markets (particularly those with low growth prospects)

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Diversification strategies o f privatised WaSC's in England and Wales

may provide the firm with more cash than is needed to finance investments with positive net present values, and that managers, rather than pay out the free cash to shareholders, may use it to finance diversification of dubious value to shareholders. • the r e s o u r c e view: a major aim of this approach is to explain how diversification can contribute to a finn's sustainable competitive advantage (SCA). For this purpose it attaches particular importance to the relationship between diversification and the firm's 'core competencies' (Prahalad and Hamel, 1990) and 'core capabilities' (Stalk et al., 1992). Competencies and capabilities are derived from a synthesis of different skills and technologies within the firm. They are regarded as 'core' when they give the firm a substantial competitive advantage in delivering important benefits to customers, are not easily imitated, and involve costs that can be shared with future new products. 3 Their relationship with diversification is two-way. On the one hand, in static terms, core competencies and capabilities provide direction to corporate diversification: a firm diversifies in ways that give employment to excess capacity in some of the resources it controls. On the other hand, dynamically, diversification is part of a learning process through which firms both develop existing capabilities and acquire new ones (Teece et al., 1990). Montgomery reviews recent (mainly US) empirical research on diversification, and concludes that there is little evidence for the market power view, but much that is consistent with the resource view (e.g. the directions in which firms diversify seem to depend on the kinds of resources in which they have spare capacity). She correctly notes, however, that a convincing explanation of corporate diversification is difficult to provide because empirical tests do not yet discriminate clearly between the agency view and the resource view: for example, both may be consistent with a firm diversifying in a particular direction, but it is difficult to know at what precise point diversification stops being in shareholders' interests and is explained by managerial discretion. Because of this the later sections of this paper provide only a weak test of alternative theoretical explanations of diversification, in the sense that they present empirical evidence chosen selectively to highlight its conformity with one or other theory. Harder tests await further development. Among the alternative explanations of diversification the resource view is of particular interest because it is a key component of a newly-emerging dynamic theory of the firm and it addresses questions that are obscure in other theories (Conner, 1991). For example the resource view is a promising basis for addressing not just the question of why firms diversify, but why they do so

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coherently (Teece et al., 1994). Coherence refers to the extent to which a firm's different business areas share common technological or market characteristics. Teece et al., find that, among US manufacturing firms, those showing greater diversity still maintain local coherence between their neighbouring activities. By analogy with the geographic expansion of a residential neighbourhood: "As the area covered is increased, the distance to nearest neighbours does not change, but the average distance to all other homes does rise. In the industrial landscape, one sees that in a more diverse firm, just as in a larger neighbourhood, the average distance to other activities increases, but the average distance to other neighbours does not." (Teece et al., 1994, p.10) The resource view attributes a firm's SCA to several characteristics that its strategic assets (Dierickx and Cool, 1989), core competencies and core capabilities have in common: namely, that they give the firm a substantial and distinctive advantage in terms of cost or customer-perceived differentiation, and that they are difficult to trade, imitate, or replace by equivalent substitutes. In their resource-based assessment of diversification Markides and Williamson (1994) argue that diversification can contribute to a firm's long run competitive advantage and performance only if it involves 'strategic relatedness', by which they mean relatedness between the firm's strategic assets in different product-markets. Other kinds of relatedness, though these are what are measured in traditional empirical studies of diversification, can not contribute to superior long-term performance because they have no basis in things that rivals find difficult to buy, imitate or replace with equivalent substitutes. The disconnection of traditional measures of related diversification from sources of SCA is blamed by Markides and Williamson for the failure of empirical research to establish the benefits of related diversification. Robins and Wiersema (1995) make a similar point. After defining strategic assets to be more marketspecific than competencies and core capabilities, Markides and Williamson (1994) identify four ways in which strategic-related diversification can contribute to a firm's SCA. Their taxonomy, outlined below, provides a useful framework for discussing the two-way relationship between (strategic) resources and diversification: • a s s e t a m o r t i s a t i o n (static exploitation of economies of

scope): the cost of an existing strategic asset is spread across several product-markets, as when a distribution system serves several different product-markets simultaneously. 4 • a s s e t i m p r o v e m e n t : existing strategic assets in different product-markets draw on a common core competence for their improvement. For example, by developing a

Diversification strategies of privatised WaSC's in England and Wales distribution system in one product-market, a firm might learn something that can be used to improve its separate distribution system in another. • asset creation: a core competence developed in one product-market leads to economies in creating new strategic assets in another. For example, building a distribution system in one product-market may make it easier to build a separate distribution system in a new market. • asset fission: by building assets in a new productmarket the firm may develop new core competencies. Markides and Williamson suggest that 'asset amortisation' can enhance SCA only in the short-term: "We will argue that the long-run value of a related diversification lies not so much in the exploitation of economies of scope (asset amortization) - where the benefit is primarily short-term - - but in allowing corporations to more cost efficiently expand their stocks of strategic assets. Relatedness, which opens the way for asset improvement, asset creation and asset fission, holds the key to the long-run competitive advantages of diversification. This means that in most cases, similarities in the processes by which strategic assets are expanded and new assets are created are more important than static similarities between the strategic assets that are the outcome of these processes." (Markides and Williamson, 1994, p. 150, original emphasis). The Markides and Williamson framework provides a concept, 'strategic relatedness', that is a useful basis on which to assess the coherence of a diversified firm and to evaluate the merits of any new diversified growth. The likelihood that it is a significant force in practice, either (ex ante) in a firm's decision-making process or (ex post) in determining the competitive success of past decisions, depends on how urgent is the need for competitive advantage. One might suspect that this need is not so great for English and Welsh water firms because they are local natural monopolies in the supply of water and sewerage services. 5 However the firms' interest in strategic-relatedness is maintained by the competition they face in other product-markets into which they diversify. A firm's strategic assets in the water industry may be the basis of a leveraged competitive advantage in its other product-markets. For example, knowledge gained from the design, construction and operation of water and sewerage projects in their local monopoly area might influence the firm's ability to compete for similar contracts in overseas markets or involving products other than water and sewerage services. In addition, however, the way in which the water firms are regulated gives the local monopolies an indirect incentive to compete with each other for persistent rewards in the industry itself. The privatised water firms are subject to price-cap regulation, known as RPI+K, in

which yardstick competition influences the level of K that is set for each firm at each periodic review. With the revisions to K dependent on some average of industry performance, acquired advantages are not entirely wiped away by the DGWS at times of regulatory review, so superior returns to strategic assets persist in the water industry itself. Under this kind of regulation the separate local monopolies have an incentive to compete with each other indirectly, via competition for how tightly, relative to costs, the regulator caps their prices. The potential role of yardstick competition was recognised in the 1991 Water Industry Act, 6 though limited use of it was made when the K-values were originally set (Cowan, 1992). The DGWS, Ian Byatt, has however been insistent on the value of yardstick competition for comparative purposes and, as the following quote shows, seems to have made some use of it in the first (July 1994) review of the privatised water firms: "We discovered that costs (of implementing the urban waste water treatment directive) varied enormously and so we then developed some notions of yardsticks. What we said was that not everybody had to be at the yardstick level, instead we took a position halfway between where they said they were and the yardstick. We used this as a method of deciding what costs it was appropriate to allow for when setting the price limits. I was very keen that setting price limits should not be a cost plus system." (Byatt, 1995, p. 19, emphasis added). The study by Sawkins (1995), based on interviews with managers in the privatised water companies, concludes that yardstick competition was successful in giving firms an incentive to reduce costs. His empirical evidence supports the above theoretical reasoning, therefore, in suggesting that the water firms do have an incentive to diversify in ways that are strategicallyrelated.

Empirical evidence on diversification by privatised water firms Empirical background: the situation before, and immediately after, privatisation Before their privatisation in 1989, the water and sewerage authorities in England and Wales had developed experience in supplying water and sewerage services, and in other activities relating to resource planning, pollution control, fisheries, land drainage, water recreation and conservation. 7 Water supply involves the abstraction of water from reservoirs, rivers or aquifers, its treatment in various ways, and its distribution under pressure to customers through networks of mains. Water quality is regulated, more stringently for domestic purposes, by minimum standards relating to microbiological, chemical, physical and

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Diversification strategies of privatised WaSC's in England and Wales aesthetic properties. Sewerage services involve the collection of domestic sewage, consented trade effluent and surface water, and the provision and maintenance of an adequate sewerage system to convey it. The sewage may be treated in various ways before final discharge. 8 Technologically, even before privatisation the water authorities had begun to invest in telemetry (computerised remote monitoring and control of operations), digital mapping, computerised systems, and closedcircuit television surveying of mains and sewers. After the 1983 Water Act, the authorities were allowed to supply advice, training and assistance to overseas clients, but only with the Secretary of State's permission. They were otherwise constrained to trading activities related to their statutory functions. At privatisation the ten water and sewerage authorities in England and Wales became public limited companiesfl Each was organised as a group holding company with a number of subsidiaries. The core business of providing water and sewerage services was transferred to the main operating subsidiary (known as the Appointee) acting under an Instrument of Appointment granted by the Secretaries of State of the Environment and for Wales under the Water Industry Act (1991). In addition to the introduction of commercial decision making to the regulated core business, privatisation provided the opportunity for diversification into other activities. ~° There is persuasive evidence that the initial regulatory settlement, determined in 1989 by a Government for which privatisation was a politically-sensitive issue, was generous to the newly-privatised firms. The initial settlement left them cash-rich, but in a core business that was mature, regulated, and whose future returns to shareholders seemed under threat from an anticipated tighter regulatory review (Sawkins, 1995). The firms recognised both the limited potential for direct competition in their regulated water and sewerage activities (arising from logistical constraints in the supply network) H and the desirability of entering unregulated markets that offered greater freedom to manoeuvre and to increase shareholder dividends. With the regulated water business characterised by low volume growth, and requiring a heavy investment programme to meet enhanced environmental regulations and to improve levels of service, many managements justified diversification in terms of a need to secure alternative sources of income and profit. For example, in 1995 the (then) North West Water Group reported their belief that '... total shareholder returns in the medium and longer term would be significantly enhanced if the Group grew its non-regulated earnings over the coming years to a level which was material within the overall context of the Group's earnings, in order to offset the impact of any future decline in regulated earnings in the United Kingdom'. 12

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The firms thus were, immediately after privatisation, in a situation described by Jensen (1988) as one of free cash flow, with the additional feature that any distribution of funds to shareholders in the short term ran the risk of incurring the DGWS's wrath and an even tighter review. It is not surprising to observe, therefore, that the firms quickly used the funds to take up the new opportunity to diversify.

Empirical evidence: the overall pattern of WaSC diversification For each WaSC the Appendix contains a table that classifies, by activity and administrative form, the home and overseas ventures undertaken between privatisation and the end of September 1995. The tables are derived from information in Aveline et al. (1995) and, despite several qualifications, give the fullest picture so far available of the directions in which the WaSCs spread in the first six years after privatisation. The main qualifications of the tables are: • that the tables classify only the number of ventures, ignoring their size; • that the assignment of ventures to activities is based on the arbitrary judgements of Aveline et al. and so 'cannot be definitive descriptions of what has happened' (1995, p. 5); • that the tables record ventures even if they were later divested (within or beyond the reported period); • that there are a few ventures that Aveline et al. identify but to which they do not assign an activity or a form - in which case the ventures have been omitted from the tables reported in the Appendix. Nevertheless, these tables provide a useful picture of the WaSCs diversification moves. Some of the above qualifications are partly redressed later in this paper. Table 1 classifies the ventures of each firm by activities only, regardless of whether they took the form of an acquisition, joint venture, stake, or organic subsidiary. Not surprisingly most companies (with the exception of South West Water and Wessex) have undertaken ventures involving water and sewerage activities. In the UK these involve bidding for buildown-operate (BOO), and build-own-operate-transfer (BOOT) contracts in Scotland and Ireland, one example being Birse, Anglian Water's joint venture with John Laing construction company. Despite the considerable amount of horizontal consolidation among water-only companies in England and Wales (of the 29 that existed in 1989, only 18 remained in existence by the end of 1996) there are only a few examples of them being absorbed by WaSCs, possibly because of the regulatory attention that such moves would prompt. Most new ventures in water and sewerage have been overseas, reflecting the enormous global potential in this sector.

Diversification strategies of privatised WaSC's in England and Wales Table 1. W a S C ventures, from privatisation to 30 September 1995, classified by activity Activity

Angl

Nmbn

NWW

SvnTr

Sthn

Water & Sewerage; Water-only Bottled Water Waste Management; Clinical Waste Disposal Water Treatment Chemicals

4 (+5)

1 (+3)

3 (+9)

2 (+5)

1 (+2)

4

1 5 (+ 1)

4 (+2)

1 4

Welsh

1 (+7)

1 (+ 1)

1

1

1 (+ 1) 1 3 (+2)

3 6

3

3 4

Wssx

Yorks (2)

22

3

1 (+ 1)

3 (+2)

4

5 1 (+ l)

4 (+2)

(1)

1

1 (+1)

1

1

(1)

1

2

3

6

1 3 (+ l) 2 (+1) ( 1) 2 1 (+ 1)

1

(small scale) P r o p e r t y Development;

Hotels Fisheries Broadcasting; Cable Telephone & Television Miscellaneous Services; Landscaping Software

8

Thms

1

U K n o n - W a t e r Utility;

Overseas Utility Utility Services Engineering; Environmental Eng.; Equipment/Technology Consultancy Finance Contracting Infrastructure Electricity generation

SWW

1

3

1

4

1

2

1

1 1

1

1 ( + 1) 2 (+ 1)

1

4

1

2

1 1

1 (+2)

Notes: a) For full titles of each WaSC see Appendix. b) Unbracketed numbers refer to ventures within the UK, bracketed numbers refer to overseas ventures. c) Where a venture involves joint activities (Engineering/Consultancy; Fisheries/Hotels; or Finance/Infrastructure) it is assigned to them both, separately, in the table. d) 'Miscellaneous Services' comprises laboratory and security services, and surveying.

The World Bank has estimated that, in developing countries between 1995 and 2005, some $(US)600 billion must be invested to avoid severe water shortages; in developed countries huge amounts need to be invested to comply with tougher environmental standards. ~3Many of these moves overseas have been in the form of joint ventures, a point that is further discussed below. Other new ventures are numerically concentrated in three other groups of activities that also seem obviously related to the kinds of resources and competences needed in the WaSCs' traditional product-markets: namely in engineering, waste management, and contracting. A substantial number of ventures in engineering have been overseas; in contrast, the ventures in the latter two groups of activities have been predominantly UK-based. In waste management, the most striking observation is the number of (mainly small) acquisitions made by Wessex Water, which has the most distinctive pattern of diversification of any WaSC: Wessex has made no overseas moves and, outside its statutory water and sewerage activities, has focused entirely on waste management. The recorded ventures in finance and infrastructure include UK Highways, which is the name of Welsh Water's joint venture with John Laing, Tarmac (both firms with experience in motorway construction) and Transroute (the largest French toll road operator), established to bid for long term (15-30 years) contracts for road design-build-finance-operate projects. As such,

they are similar in key ways to the type of joint venture mentioned earlier, whose purpose is to bid for BOO and BOOT contracts in the water and sewerage sector. Also similar (though recorded, on the basis of Aveline et a l ' s (1995) judgements, as an overseas utility venture) is North West Water's partnership with the US engineering and construction firm Bechtel. These moves are discussed further below. Table 1 indicates that diversification into other activities is spread more sporadically across the WaSCs, taking in activities as different as: property development, hotels and fisheries (based on the WaSCs' initial 'land banks'); South West Water's stake in regional television broadcasting; landscaping; and security services. The table records (as a UK non-water utility venture) only the first cross-utility move (that between North West Water and Norweb) but this, together with the later acquisitions of Swalec by Welsh Water and of Southern Water by Scottish Power, merit further comments below. Also omitted from the table is Northumbrian Water's acquisition by the French water conglomerate Lyonnaise des Eaux, the first example, after expiry of the Government's 'golden share', of a WaSC being the target of a successful takeover bid. The above empirical evidence indicates that all ten WaSCs have actively pursued diversification since privatisation and that, collectively, they exhibit a wide range of experiences. The next sub-section identifies

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Diversification strategies of privatised WaSC's in England and Wales some key elements in the overall pattern, and relates these to the theories of corporate diversification discussed earlier.

Key elements in the pattern of WaSC diversification • WaSC diversification to exploit and develop existing core competences. Of the four ways in which Markides and Williamson (1994) suggest that corporate long-term performance can be enhanced by strategically-related diversification, there are alternative ways of exploiting or developing the firm's existing core competences: namely asset amortisation (which involves the firm's different businesses sharing the same strategic asset), asset improvement and asset creation (both of which involve different businesses drawing on the same core competence). Because strategic assets and core competences are by nature usually 'invisible' it is not easy to test empirically whether diversification conforms in practice with this view. ~4 Nevertheless, by focusing on the constituent features of core competences (that they potentially make a substantial contribution to cost advantage or a distinctive contribution to customer-perceived differentiation, and that they are difficult to trade, imitate, or replace by equivalent substitutes) and by reviewing company literature, we are able to suggest several existing core competences that the WaSCs possess and have exploited in their diversification. An obvious example of a strategic asset is a WaSC's ability to manage sales activities to its customer network. The costs of metering, billing, and answering customer enquiries are a substantial part of each WaSC's cost base, and depend on the efficient operation of its customer service networks. Once achieved, superior management of a customer network is difficult to imitate because other firms would need to re-organise and re-train workers employed in customer services, and to upgrade their information technology. Management of the WaSC customer network therefore has the essential features of a strategic asset, with the implication that any cost advantage derived from it will not be quickly matched by rivals. Cross-utility mergers appear to have a simple and seductive logic based on synergies and cost savings arising from the joint management of sales activities to their overlapping customer networks (the savings are potentially greater the closer the geographic fit of the merging firms). By spreading, over a larger number of transactions, the costs of metering, billing, and answering inquiries, and by rationalising offices, vehicle depots and maintenance etc., such multi-utilities would seem to provide a straightforward example of 'asset amortisation' involving static gains from diversification. The

330

experiences of United Utilities (formed in November 1995 by North West Water's takeover of Norweb) and Hyder (formed in January 1996 by Welsh Water's acquisition of Swalec) seem to indicate that substantial savings are available from this source] 5 After the acquisitions, each firm re-structured its facilities management so that a single subsidiary - Vertex in the case of United Utilities; Hyder Services in the case of Hyder provides common customer services, accounting services and IT support to its regulated businesses. Vertex also handles United Utilities' procurement and training needs (OXERA, 1997, p. 14). The cross-utility mergers also provide an example of potential 'asset improvement'. Sales activities to water customers can be improved by learning how similar services are provided to electricity customers. Compared with a multi-utility, the pace of learning might be slower in a non-diversified WaSC, though this implication depends on whether a non-diversified firm can find some other organisational arrangement that, to the same extent as a merger, facilitates cross-utility learning. One possibility is the kind of collaboration adopted by Thames Water and London Electricity. In November 1995 Thames Water reported that it had ruled out a bid for London Electricity (being unable to justify the payment of a hefty bid premium) and announced negotiations regarding the possibility of collaboration and joint ventures. Thames Water claimed that significant cost savings could be achieved by collaborating in areas such as customer services and IT] 6 These plans were later fleshed out with a series of bilateral contracts covering procurement logistics, streetworks management, maintenance work, selected aspects of IT, and customer services including joint billing. Another source of cross-utility learning is some arrangement for benchmarking a water firm's activities against firms providing similar services in other sectors. In any attempt to evaluate the merits of cross-utility mergers, the crucial question is not whether these alternative arrangements can support any cross-sector learning, but whether they lead to faster learning than does a merger. As a final example, a WaSC may be able to derive competitive advantage by leveraging, into other productmarkets, its existing access to water customers. Part of Scottish Power's case for acquiring Southern Water was that it would make it easier, once consumers are free to choose their gas and electricity suppliers, to sell Scottish Power's electricity and gas in Southem Water's catchment area. ~7 This, and the possibility of diversifying more broadly, into the direct marketing of non-utility products, provide further examples of asset amortisation, and perhaps of asset creation] s Such resource-based reasoning allows one to speculate that, on the basis of their existing telemetry skills as well as access to customer premises, WaSCs might in future be able to

Diversification strategies of privatised WaSC's in England and Wales diversify successfully into new markets such as the supply of remote security services. • WaSC diversification to learn: accessing and building new competences. The above cases involve related diversification that makes use only of existing strategic assets or core competences. Our research has also identified several examples where WaSCs have diversified into markets that required, in addition to their existing competences, others that they did not possess. One example already mentioned is Welsh Water's participation in UK Highways plc, the road design-build-finance-operate consortium to which Hyder contributes its core skills in managing the costs and maintenance of a very long-lived asset, and the other partners contribute their construction and operating skills. A second example, also mentioned earlier, relates to the WaSCs' diversification, mostly in the form of joint ventures, into overseas water and sewerage markets. In many countries, contracts for such projects are often financed by the World Bank which favours bidders who can provide comprehensive solutions that encompass design, construction and operation of the new water systems. ~9 Such 'turnkey' solutions often go beyond the existing core competences of WaSCs which, in order to win such contracts, then need to form a strategic alliance. A specific example is provided by North West Water's partnership with Bechtel (USA), for the purpose of developing, financing, building, owning and operating water and sewerage facilities outside North America and Britain. Dan Chao, Bechtel's executive vice president, explained the partnership by saying 'There exists a need for a full-service company that is qualified to solve and manage difficult and complex water infrastructure problems on a worldwide basis'.2° The case of Welsh Water (now Hyder) may be taken as illustrative, if not entirely typical, of the alliances formed by WaSCs in their overseas activities. The company advises on, develops, designs and manages infrastructure programmes around the world, as well as providing operating expertise and management for overseas water utilities. The activities listed in Hyder's 1996 brochure, Life, include: a substantial stake in, and long term partnership with, the newly-privatised water company, ScVK, in the Czech Republic; a joint venture led by its Acer engineering and environmental subsidiary, to design, manage and supervise the construction, outside Athens, of Europe's biggest sewage treatment works; involvement in the Cairo Wastewater project, and a new water system in Madras, together with various transport projects in Australia (including the Melbourne City Link), China, Hong Kong, Malaysia, Thailand, and Turkey; and the delivery of a programme of technical

assistance to Lithuania, Latvia and Estonia. Finally, the distinctive case of Wessex Water is relevant here. Dale (1995) views the Wessex case as a model of diversification that has been successful for the firms' owners. The Wessex model involves diversification into product-markets in which the firm has limited existing competence, but recognises and overcomes this by forming a strategic alliance with an existing expert in the field. In Wessex Water's own case this involved a joint venture in solid waste management services with Waste Management International, recognised as the global industry leader. These examples beg the question of how the WaSCs can best organise their access to new core competences. Dosi and Malerba (1996b) view the firm as a learning organisation, where learning is cumulative and local: in other words, a firm finds it easiest to learn something closely related to its existing organisational skills. The idea of the firm as a learning organisation has been explicitly recognised by Welsh Water, whose approach was described by its Chief Executive as 'building on what we know in incremental steps' ]1 This view of the firm implies that, at least in the short term, many new core competences are better accessed through strategic alliances, though in the long run they may be absorbed in-house. Wessex Water is reported to have calculated that strategic alliances could deliver two-thirds of the cost savings to be expected from a multi-utility m e r g e r . 22

• WaSC diversification 'mistakes': experimental reorganisation and learning. Our empirical approach has so far been based on monitoring all the WaSCs since the time they were privatised. This approach has the advantage of avoiding 'survivor bias': we observe their mistakes as well as successes. Even cursory observation suggests that their early diversification experiences were frequently unsuccessful, and were accompanied by repeated internal reorganisation. Diversification moves that were later reversed include moves into hotels management (Welsh Water), and underground pipe laying and maintenance (Northumbrian Water), while Yorkshire Water disposed of its investment in the Yorkshire Cable Group (although retaining some commercial and other arrangements). In 1994, Welsh Water's Chief Executive stated that any future diversification would have to be treated cautiously following the Group's unhappy experiences, 23 and in March 1996 Thames Water announced the reversal of its 'disastrous diversification into overseas contracting '24 and presented a restructuring programme that involved selling 60 per cent of the businesses acquired in its earlier diversification. 331

Diversification strategies of privatised WaSC's in England and Wales

Even when moves were not completely reversed several firms, in the light of their early experiences, soon undertook a radical review of how they organised their diversified activities. In 1994-95, following disappointing profits in its non-regulated businesses, Anglian Water merged its process engineering and international consultancy segments into a single, integrated management structure with the aim of better exploiting synergy between them. Also during 1994-95 North West Water (as it still was then known) merged several of its process businesses that had been performing disappointingly; and, in 1996, following the formation of United Utilities. the company announced its decision to pull out of four peripheral businesses. Prior to the formation of Hyder. Welsh Water had substantially restructured and refocused the activities of Acer, its international consultancy business, with the aim of providing fully-integrated consulting, project management, engineering and environmental services. The picture one perceives is of the WaSCs, cash-rich after the initial regulatory settlement, using their funds to diversify quickly, but struggling to find successful ways of doing so. With hindsight, this aspect of the diversification story is not surprising, and indeed may be typical of the teething process of diversification in other sectors. In the resource view, diversification is expected to enhance a firm's performance only if it is strategically-related. However, managers of the newly-privatised WaSCs had no experience of identifying and merging with related businesses that (statically or dynamically) enhanced water-sector performance. 25 Nor had the struggle to diversify successfully been unexpected: Dale (1995) notes the stock market's sense of the water firms' 'diversification risk', based on a lack of confidence in management's ability to diversify in ways that would contribute to the firm's performance. The WaSCs' behaviour in the years soon after privatisation conforms with the kind of evolutionary process described in dynamic versions of the resource view of the firm. 26 In this process firms pursue their goals not by making choices from a pre-specified menu of alternatives, but by learning through trial and errorcorrection. Nelson (1991) describes this as part of a theory of the co-evolution of organisational forms, technology and institutions, in which a firm's internal structure (how a firm is organised, and how decisions actually are made and carried out) is difficult to change effectively, though such change is sometimes needed to augment the firm's capabilities. For Nelson organisational differences in the ability to innovate are the key source of durable, difficult-to-imitate differences among firms, but 'devising and learning to use effectively a significantly new organisational form involves much the same kind of uncertainty, experimental groping, and learning by mistakes and correcting them, that marks

332

technological invention and innovation'. (Nelson 1991 p.71). 'Experimental groping' seems to typify the diversification experiences of the water firms in the first few years after privatisation, and may have been a necessary price to pay for learning. After Thames Water's radical re-structuring in 1996 its new executive chairman openly accepted that the firm's previous diversification had been badly handled, but went on to say: "It's been a bitter learning curve but we could not have got where we are today without having done it"Y Whether there are cheaper ways to learn remains open to debate.

Concluding remarks Following a sharp shift in regime, from scope restraining to scope permissive, the privatised water companies were motivated, and enabled, to diversify. As such, the experiences of the companies during the first half of the 1990's provides an opportunity for a clearly delineated and contextualised examination of diversification theories of corporate behaviour. Certain extemal elements of diversified growth may originally have reflected 'novelty' and 'cash rich' behaviour, heavily influenced by what was readily available and sometimes involving over-priced purchases. As such, there are many examples of diversification mistakes; but these together with subsequent corporate restructuring and refocusing on core activities, and an emphasis on strategic alliances, may be viewed as part of a leaming process involving, on the one hand, the discovery and appreciation of core competences and, on the other, an awareness of corporate and strategic hmltatlons.- Interpreted in this way the evidence examined in our preliminary investigation would seem to suggest that much of the pattern of water company diversification is consistent with Montgomery's conclusion after reviewing studies of US corporate diversification: "There appears to he a pattern and logic to the diversification choices of most firms that is related to their base of resources ...... The evidence above provides substantial evidence that existing organizational capabilities, particularly in R&D and marketing, often guide diversified expansion." (Montgomery, 1994 p. 174). Further research is required on the success of diversification strategies and on the financial performance of water companies since privatisation, together with regulatory implications. "-9 From the specific viewpoint of strategic management, further development requires an in-depth investigation of decision making by, and corporate restructuring within, individual water firms. •

•

"

~8

The authors wish to thank anonymous referees of this journal

Diversification strategies of privatised WaSC's in England and Wales for helpful comments on earlier drafts, and the participants of the Aberystwyth Economics Staff Seminar for useful comments and encouragement. Financial support from the University of Wales Aberystwyth College Research Fund is gratefully acknowledged.

tAt the time the water and sewerage authorities were privatised there were also 29 water-only companies in England and Wales. These operated mainly in urban areas and were already privately owned. They are excluded from the coverage in this paper. 2Montgomery's review of recent (mainly US) empirical work finds little evidence for the market power view, but much that is consistent with the resource view (e.g. the direction in which firms diversify seems to depend on the kinds of their resources that have spare capacity). Convincingly clear explanation of corporate diversification is difficult, however, because empirical tests do not yet discriminate clearly between the agency view and the resource view: for example, both may be consistent with a firm diversifying in a particular direction, but it is difficult to know at what precise point diversification stops being in shareholders' interests and is explained by managerial discretion. 31n this section 'core' is used in a theoretical sense. Although its theoretical use has prescriptive implications for the appropriate scope of a firm, the implied activities do not necessarily coincide with 'core' as commonly used to describe some of the activities of water firms. 4Collis and Montgomery (1995) note that, if managerial responsibility for a strategic asset is shared across several organisational units in the firm, there is a danger that free-riding will cause under-investment. The same argument applies to core competences, with the implication that responsibility for them should lie at the corporate, rather than any lower, level. 5Scope for competition is limited to the shared boundaries of firms' geographical areas. 6The current regulatory framework was laid down by the 1989 Water Act, and by licences issued to each firm under the Act. The 1989 Act was succeeded by the 1991 Water Industry Act (which dealt with economic regulation) and the 1991 Water Resources Act (which dealt with the National Rivers Authority). 7This sub-section is drawn mainly from Schroder, Wagg and Co. (1989). 8After privatisation, some of the water firms' previous activities (those relating to pollution control, water resource management, fisheries, flood protection and land drainage) were transferred to a new public organisation, the National Rivers Authority. ~For details regarding industry structure and regulation see (Armstrong et al. (1994), Chapter 10), Cowan (1992), Mayer (1994), OFWAT ( 1996a, 1996b), Price-Waterhouse (1996) and Thomasson (1993). ~°Although the extent and direction of diversification entered into is a matter for the parent group and is outside the remit of the regulator, the DGWS needs to ensure that diversified activities are not detrimental to the core business, with the regulated business having sufficient resources to carry out its function, and that its customers are protected from any potential losses from diversification. In addition to strengthened ring fencing protection the DGWS also emphasises the need for accounting transparency regarding the fulfilment and financing of the core business. Transfer price guidelines have been set down in an attempt to deal with the potential problem of cross-subsidisation (see OFWAT, 1996a). Armstrong et al. (1994) examine three practical reasons why diversification should worry a regulator. "In recognition of limited opportunities for direct competition in the water industry Parliament placed a duty on the DGWS to facilitate competition, rather than promote competition as in the gas and electricity industries. This is reflected in the licences or appointments which are issued for a specified geographical area. There is, however, some (albeit limited) scope for competition to supply water and/or sewerage services within a licence area via inset competition (see OFWAT, 1995). ~2North West Water Group, Annual Report and Accounts 1995, p. 7. ~3The Economist, 24 February 1996, p. 89. ~4This point is discussed in Godfrey and Hill (1995) and McGuinness

(1997). '5Hyder argued that its ability to generate substantial cost savings could have been constrained by OFWAT's proposal that shares in Dwr Cymru (Hyder's wholly-owned subsidiary, which carries out regulated water activities) be listed separately on the Stock Exchange. In the event, OFWAT accepted the listing of preference shares in Hyder. It may be noted that City opinions have been reportedly split on the questions of savings to be realised from cross-utility mergers, with some analysts questioning whether the savings (often involving large job cuts) really come from merger or would have happened anyway from direct cost cutting of the sort already undertaken in some utilities (e.g. Swalec). It may also be argued (Oxera (1997), p. 14) that the formation of 'super utilities' has more to do with marketing strategy than synergy per se, with the emphasis on market protection and the winning of new customers ahead of full deregulation of the electricity and gas markets in 1998. ~6Financial Times, 1 November 1995. 17Financial Times, 19 June 1996. ~SHowever, there are currently-unresolved arguments about the legality of the uses to which WaSCs can put their customer databases (Financial Times, 11 February 1997). tgSee Garrette and Dussauge (1993) for a description of the July 1990 merger of Lyonnaise des Eaux with Dumez as creating a group of world-wide scale in the 'green' sector (environment and habitat) with the mission of offering comprehensive solutions to the problems of urban planning and environment. Instead of piecemeal provision of traditional services, the new group was viewed as offering comprehensive turnkey solutions by designing, constructing, financing and managing necessary equipment and infrastructure. In 1995 Lyonnaise des Eaux (one of France's two biggest water companies which has grown into a worldwide environmental services and urban development group) acquired Northumbrian Water, the smallest of the ten privatised water companies in England and Wales. The company already owned the water-only companies of North East Water and Essex and Suffolk. 2°Financial Times, 2 October 1996. 2~Welsh Water, Chief Executive's Review, Annual Report and Accounts 1995, p. 5. ~:Utility Week, 14 February 1997. 23Financial Times, 26 November 1994. :4Financial Times, 22 March 1996. 25Notice that this comment also applies to newly-appointed managers who may have had experience of diversification in other sectors, but not of identifying strategic-relatedness involving water and sewerage resources. 26The dynamic resource view of the firm is developed in Teece et al. (1990), Nelson (1991) and Dosi and Malerba (1996a, 1996b). 27Financial Times, 22 March 1996. 28The retrenchment, refocusing and restructuring of many water companies coincided with the aftermath of the relatively benign Periodic Review of 1994 which, according to some market observers, reduced the need to chase unregulated markets to sustain overall profitability. Whether the DGWS's recent decision to bring the next periodic review forward from 2004 to 1999 will have any implications for future diversification remains to be seen. 29Dale's (1995) view is that water firms' diversification has been unsuccessful in financial terms. Similarly Shaoul (1994) states that the diversifications may be viewed as being less than successful and carried by the core businesses. Shaoul (1997) further observes that, in aggregate, the appointed water businesses account for a disproportionately high share of sales (85% in 1994) and profits (101%) relative to the net assets of parent companies.

References A r m s t r o n g , M., C o w a n S. and Vickers, J. (1994) Regulatory Reform: Economic Analysis and British Experience. T h e M I T Press C a m b r i d g e , M a s s a c h u s s e t t s / L o n d o n . Aveline, M., Overd, A. a n d Stout, H. (1995) Acquisitions and Diversification: the Record of the Privatised Utilities. T h e O X E R A Press Oxford.

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Diversification strategies of privatised WaSC's in England and Wales Byatt, I. (1995) The importance of process in economic regulation, in Hicks (ed.), 1995. Collis, D. and Montgomery, C. (1995) Competing on resources:strategy in the 1990s. Harvard Business Review July-August, 118-128. Conner, K. (1991) A historical comparison of resource-based theory and five schools of thought within industrial organization economics: do we have a new theory of the firm?. Journal of Management 17, 121-154. Cowan, S. (1992) Regulation of the water industry in England and Wales, Privatization and Regulation - The UK Experience, Bishop M., Kay J. A., Mayer C. P. & Thompson D. J.(Eds), Oxford University Press Oxford Dale, B. (1995) The investors' judgement, in Hicks (ed.), 1995. Dierickx, I. and Cool, K. (1989) Asset stock accumulation and sustainability of competitive advantage. Management Science 35, 1504-1511. Dosi, G. and Malerba, E (1996a) Organization and Strategy in the Evolution of the Enterprise. MacMillan London Dosi, G. and Malerba, E (1996b) Organizational learning and institutional embeddedness, in Dosi, G. and E Malerba (eds.), 1996a. Garrette, B. and Dussauge, P. (1993) The Lyonnaise des EauxDumez Merger. Groupe HEC, School of Management Case Study. European Case Clearing House, 393-112-1 .. Godfrey, P. and Hill, C. (1995) The problem of unobservables in strategic management research. Strategic Management Journal 16, 519-533. Hicks, C. (Ed) (1995) The Water Industry: Looking Forward from the Periodic Review. CIPFA, Centre for the Study of Regulated Industries, London Jensen, M. (1988) Takeovers: their causes and consequences. Journal of Economic Perspectives 2, 21-48. McGuinness, A. J. (1997) The Resource Based View of the Firm and Competitive Strategy. Aberystwyth Economic Research Paper University of Wales Aberystwyth Markides, C. and Williamson, P. (1994) Related diversification, core competences and corporate performance. Strategic Management Journal 15, 149-165. Mayer, C. (1994) The regulation of the water industry:An interim assessment. Regulating Activities:The Way Forward, Beesley M. E.(Eds), The London Business School: The Institute of Economic Affairs London Montgomery, C. A. (1994) Corporate diversification. Journal of

Economic Perspectives 8, 163-178. Nelson, R. (1991) Why do firms differ, and how does it matter?. Strategic Management Journal 12, 61-74. OFWAT (1995) Competition in the Water Industry: Inset Appointments and their Regulation. Office of Water Services, Birmingham. OFWAT (1996a) Diversification by Water Companies, Information Note No. 9 (revised). Office of Water Services, Birmingham. OFWAT (1996b) The Changing Structure of the Water and Sewerage Industry in England and Wales, Information Note No. 29. Office of Water Services, Birmingham. OXERA. Utility takeovers. Briefing Paper 2/97 (1997) The OXERA Press Oxford. Prahalad, C. and Hamel, G. (1990) The core competence of the corporation. Harvard Business Review May-June, 79-91. Price-Waterhouse Regulated Industries: The UK Framework, Regulatory Brief 2, (second edition)(1996) Centre for the Study of Regulated Industries: CIPFA London. Robins, J. and Wiersema, M. (1995) A resource-based approach to the multibusiness firm: empirical analysis of portfolio interrelationships and corporate financial performance. Strategic Management Journal 16, 277-299. Sawkins, J. (1995) Yardstick competition in the English and Welsh water industry. Utilities Policy 5, 27-36. Schroder, J. H. et al. (1989) Pathfinder Prospectus, 3rd November. Shaoul, J. (1994) Accounting for Muddy Waters, (working paper). Department of Accounting and Finance, University of Manchester. Shaoul, J. (1997) A critical financial analysis of the performance of privatised industry: The case of the UK water industry. Critical Perspectives on Accounting 1997 (forthcoming). Stalk, G., Evans, P. and Shulman, L. E. (1992) Competing on capabilities: the new rules of corporate strategy. Harvard Business Review, March-April, 57-69. Teece, D., Pisano, G. and Shuen, A. (1990) Firm Capabilities, Resources and the Concept of Strategy. Working Paper EAP38. University of California at Berkeley California. Teece, D., Rumelt, R., Dosi, G. and Winter, S. (1994) Understanding corporate coherence: theory and evidence. Journal of Economic Behavior and Organization 23, 1-30. Thomasson, K. (1993) Water Utilities: Keynote Report: A Market Sector Overview. Keynote Publications, London.

Appendix Home (and overseas) ventures undertaken by WaSCs between privatisation and 30 September 1995.

and the end of September 1995. The tables are derived from information in Aveline et al. (1995).

The following tables classify, by activity and form, the ventures undertaken by WaSCs between privatisation

334

Explanatory notes (a) In each cell a number without brackets refers to ventures within the UK, a bracketed number refers

Diversification strategies of privatised WaSC's in England and Wales

to overseas ventures. (b) Key to the form of ventures: The ventures are classified by the forms identified in Aveline et al. (1995). Where Aveline et al. did not identify the form of a venture, it has been ignored when deriving the tables. A: Acquisition. 51% or more of an existing firm purchased. JV: Joint Venture. A new firm formed with one or more other companies (includes the formation of partnerships). S: Stake. 50% or less of an existing firm purchased. SUB: Subsidiary. Organic creation of a new division within the WaSC.

(c) Key to activities: The ventures are classified by the activities identified in Aveline et al. (1995). The tables reported below conform with the judgements made there about assigning ventures to activities, though some of the activities have been combined, as indicated in the first column of each table. Where Aveline et al. did not identify the activity of a venture, it has been ignored when deriving the tables. Where they identified a company venture involving joint activities (Engineering/Consultancy; Fisheries/ Hotels; or Finance/Infrastructure) it is assigned to them both, separately, in the company table below. In every company table Miscellaneous Services comprises laboratory and security services, and surveying.

Anglian Water

Water and Sewerage; Water-only Bottled Water Waste Management; Clinical Waste Disposal Water Treatment Chemicals UK non-Water Utility; Overseas Utility Utility Services Engineering; Environmental Eng.; Equipment/Technology Consultancy Finance Contracting Infrastructure Electricity generation (small scale) Property Development; Hotels Fisheries Broadcasting; Cable Telephone and Television Miscellaneous Services; Landscaping Software

A

JV

S

SUB

Total

(1)

3 (+3)

(1)

1

4 (+5)

1

2

1

1 (+2)

1

1 1

1 3 (+2)

1

1

1

3

4

335

Diversification strategies of privatised WaSC's in England and Wales

Northumbrian Water Group:

Water and Sewerage; Water-only Bottled Water Waste Management; Clinical Waste Disposal Water Treatment Chemicals UK non-Water Utility; Overseas Utility Utility Services Engineering; Environmental Eng.; Equipment/Technology Consultancy Finance Contracting Infrastructure Electricity generation (small scale) Property Development; Hotels Fisheries Broadcasting; Cable Telephone and Television Miscellaneous Services; Landscaping Software

A

JV

(1) 1 2

1 (+2) 3 (+ 1)

5

1

S

SUB

Total

1 (+3) 1 5 (+ 1)

3

3 6

3 4

3 4

1

1

North West Water:

Water and Sewerage; Water-only Bottled Water Waste Management; Clinical Waste Disposal Water Treatment Chemicals UK non-Water Utility; Overseas Utility Utility Services Engineering; Environmental Eng.; Equipment/Technology Consultancy Finance Contracting Infrastructure Electricity generation (small scale) Property Development; Hotels Fisheries Broadcasting; Cable Telephone and Television Miscellaneous Services; Landscaping Software

336

A

JV

S

1 (+2)

1 (+6)

(1)

1

( 1)

2 ( + 2)

1

SUB

Total

2 (+9)

1 (+ 1)

1

1 1

3 (+ 2) 1

1 1

Diversification strategies of privatised WaSC's in England and Wales

Severn Trent:

Water and Sewerage; Water-only Bottled Water Waste Management; Clinical Waste Disposal Water Treatment Chemicals UK non-Water Utility; Overseas Utility Utility Services Engineering; Environmental Eng.; Equipment/Technology Consultancy Finance Contracting Infrastructure Electricity generation (small scale) Property Development; Hotels Fisheries Broadcasting; Cable Telephone and Television Miscellaneous Services; Landscaping Software

A

JV

2 (+4)

(1)

2 (+ 1)

2

1

1

S

SUB

Total

2 (+5)

(1)

4 (+2)

1 (+ 1)

4 1 (+1)

1

1

1

1 4

3

1 1

Thames Water:

Water and Sewerage; Water-only Bottled Water Waste Management; Clinical Waste Disposal Water Treatment Chemicals UK non-Water Utility; Overseas Utility Utility Services Engineering; Environmental Eng.; Equipment/Technology Consultancy Finance Contracting Infrastructure Electricity generation (small scale) Property Development; Hotels Fisheries Broadcasting; Cable Telephone and Television Miscellaneous Services; Landscaping Software

A

JV

1 (+2)

(5)

S

SUB

Total

1 (+7)

1

1

(1)

(i) (1)

(1) 5

1

1

6

1

337

Diversification strategies of privatised WaSC's in England and Wales

Welsh Water: A

Water and Sewerage; Water-only Bottled Water Waste Management; Clinical Waste Disposal Water Treatment Chemicals UK non-Water Utility; Overseas Utility Utility Services Engineering; Environmental Eng.; Equipment/Technology Consultancy Finance Contracting Infrastructure Electricity generation (small scale) Property Development; Hotels Fisheries Broadcasting; Cable Telephone and Television Miscellaneous Services; Landscaping Software

JV

S

SUB

Total

1 (+1)

1 (+1)

1

1 1 (+ 1)

1

1 (+ 1) 1

2(+1) 2(+1)

3(+1) 2(+1)

(1)

(1) 1

1

2 1 (+1)

1

1

1 (+ 1)

Wessex Water:

Water and Sewerage; Water-only Bottled Water Waste Management; Clinical Waste Disposal Water Treatment Chemicals UK non-Water Utility; Overseas Utility Utility Services Engineering; Environmental Eng.; Equipment/Technology Consultancy Finance Contracting Infrastructure Electricity generation (small scale) Property Development; Hotels Fisheries Broadcasting; Cable Telephone and Television Miscellaneous Services; Landscaping Software

338

A

JV

19

3

S

SUB

Total

22

Diversification strategies of privatised WaSC's in England and Wales

Yorkshire Water: A

Water and Sewerage; Water-only Bottled Water Waste Management; Clinical Waste Disposal Water Treatment Chemicals UK non-Water Utility; Overseas Utility Utility Services Engineering; Environmental Eng.; Equipment/Technology Consultancy Finance Contracting Infrastructure Electricity generation (small scale) Property Development; Hotels Fisheries Broadcasting; Cable Telephone and Television Miscellaneous Services; Landscaping Software

JV

S

SUB

(2) 1 1

1

2

(1)

(2)

3

1

3 1

1 (+1)

1 (+1) 2 (+ 1) 3

1 2

1 2 1

1 (+2)

Total

1 1 (+2)

339