The new electricity industry; what's at stake?

The New Electricity Industry: What’s at Stake? There is enough potential for value creation and growth in the emerging electric indust y to overcome the ve y sign@ant downside facing today’s utilities. In the transition to competition, electricity customers will gain lower prices, and new OY retooled competitors will take market share. To emerge a winner, utilities will have to move quickly on threefionts-strategic, organizational and regulate y. William Heller, Paul Jansen and Les Silverman Editor’s Note: All industy observers

in these new arenas. The fourth arti-

would agree that increasing competi-

cle focuses on the changes that to-

tion is remaking the traditional elec-

day’s utilities need to make to emerge

tric utility industry. There is far less

as winners.

consensus on the outcome of this procWilliam Heller is dfornzer partner in the Los Angeles office of McKinsey

articles, the authors have attempted

& Co., a management

to provide a perspective on this chal-

and consulting

firm specializing in strategy with 67 offices in 35 countries. Paul Jansen is a senior partner in the San Francisco

office of McKinsey

& Co.,

and Les Silverman is a senior partner in their Washington, D.C. office.

lenging area. Thefirst article outlines a vision of thefuture and estimates the economic value at stake. The second and third articles explore in greater detail the nature of the emerging generation and energy services businesses and discuss what will determine success

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.:.

ess. In this and the succeeding three

M

arket forces, now being accommodated by deregula-

tion, are remaking the electric utility industry. As in banking and telecommunications

before it, this

industry is now in the early stages of a complete transformation. There will be mergers and massive consolidation. There will be new competitors who will redefine the

The Electricity Journal

economics and competitive dy-

lated, open access networks.

and will be driven by geography

namics of the business, as MCI

Power services, encompassing

load profile, and willingness to be

did in telecom and Fidelity has

wholesale and retail commodity

interrupted. Regulators may try

done in banking. As in banking

sales and including other energy

to keep price ranges narrow, par-

and telecom, there will be tradi-

and non-energy products, will be

ticularly for residential and small

tional players, like Citibank or

provided by a third set of services

commercial customers, but eco-

ATT, who make and actually

competitors. Scheduling and dis-

nomics will win out in the market-

shape the transition, and others

patch, grid control and price set-

driven world of the future.

who dwindle, vanish or are sub-

tlements will be provided by inde-

sumed. The winners will create

pendent, regulated entities and

utilities in this country could lose

significant value for their share-

are outside the scope of this arti-

nearly $30 billion in revenues an-

holders.

cle.

nually, about 15 percent of today’s

There is tremendous value at

The once vertically integrated

Combined, investor-owned

revenues and over 100 percent of

electric industry will fragment

stake as the industry evolves into

all utilities’ after-tax profit. Fortu-

into three distinct, but linked,

these three businesses. As a result

nately, the offsetting value crea-

businesses-generation,

of this restructuring, we expect

tion from restructuring and

that the delivered cost of electric-

growth into new businesses could

patch function (Figure 1). Each

ity will decline by 10 to 20 per-

exceed the value at risk and in-

will have its own competitors and

cent, depending on the outcome

crease the value of the industry by

particular competitive dynamics.

on stranded cost recovery and im-

some $15 billion. This suggests

wires,

and power services-plus

a dis-

Generation will be a highly com-

plementation of performance-

that, if it is well managed, indus-

petitive, cost-based commodity

based ratemaking. Individual cus-

try restructuring could be a win-

business. Wires businesses, com-

tomer savings will vary widely as

win scenario for participants and

prised of transmission and distri-

future prices will reflect the ac-

customers alike.

bution functions, will be regu-

tual, not average, cost of service

Each of the three businessesgeneration, wires, and power services-offers

significant opportuni-

ties for value creation and each Today

has a different risk profile.

End state

Generation

/

1

l l

Generation

l

r-

l

lntenselv comoetitive Commodity market Cost primary basis of competition Market structure drives profitability

J

Equally important, the factors that will separate the winners from the losers will also vary substantially by business.

Transmissior Wires (T&D)

l l l l

Distribution

Power services

Customer service

l l l

Open access Natural monopoly, for now Performance-based rate making Synergies across geographies and products increasingly important

Retail and wholesale segments Convergence of electric, gas, ? Scale, scope and skills are basis of competition

Generation Despite the potential for billions of dollars of stranded investments, changes in the generation industry could offset the shareholder value at risk. Generation is well on its way to becoming a highly competitive, regionally based commodity business. The competitive regions will be defined by transmission limitations

Figure 1: Electricity Sector Vision

Augmst&ptember

1996

and are likely to be very large-

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far broader than current reliability

l

Redesigned operations and

profits from a generation portfo-

councils. Bilateral and spot mar-

maintenance practices that shatter

lio, as opposed to individual

kets will exist in parallel. In each

the current utility mindset about

plants, will be the focus of leading generators.

region, supply and demand dy-

what level of staffing and atten-

namics will follow long cycles,

tion to cost is required for safe, re-

causing prices to vary between re-

liable operations;

placement and marginal costs.

l

Additional sources of value in the generation business will in-

A much more disciplined ap-

clude tightening reserve margins

This typical commodity pricing

proach to capital investment

in some regions. Cycle manage-

pattern will result in unattractive

based on the assumption that

ment-the

average returns for many partici-

capital must pay back in a few

investments, plant retirements,

pants, with a great deal of variabil-

years, not decades;

and asset sale decisions-will

ity across generators.

l

Operating flexibility and reli-

timing of major capital be a

driver of value for astute owners.

Our analysis of utility plant as-

ability that allows individual fa-

With many utilities expected to

sets indicates that just under half

cilities to capture the peak prices

exit generation, there could be 80

of all utility supply portfolios are

to 180 GW of opportunities to buy

uncompetitive due to a combina-

existing facilities and thereby as-

tion of high costs and low capac-

semble a winning portfolio. Of the three businesses, genera-

ity value. Industrywide, we estimate the potential for “stranded

tion will be the first to go fully

investment” in generation to be

global and is already well on its

approximately $20 billion a year,

way Winners will capture scale

requiring about a $150 billion

economies and apply superior

write-off to bring all utility genera-

skills in plant development, opera-

tion portfolios in line with com-

tion, maintenance, and fuel man-

petitive markets. Actual stranded

agement on a global basis. A supe-

costs will, of course, depend on eventual market prices as well as

rior “product” and a disciplined

regulatory treatment of uncompe-

hallmark of truly global competi-

development process will be the

titive assets and contracts. Despite the relatively unattractive starting point, there are still

that will be the source of most of a

tors, while passive investors will

baseload generator’s gross mar-

find it increasingly difficult to

gin.

achieve returns above their cost of capital.

significant opportunities for value

Industry structure will be an-

creation beyond obtaining favor-

other key driver of value and one

able transition terms for uncompe-

of the most sensitive to resolve.

tion business will be huge, with a

titive plants. Nothing will be

While FERC and the Justice De-

significant downside risk (Figure

more important than being low-

partment will be concerned that

2). At best, however, the $20 bil-

cost in a business where the abil-

excessive concentration does not

lion in stranded costs could be off-

ity to produce and sell power under the market price will

occur, it will be difficult but criti-

set with favorable outcomes on

cal for generators to prevent the

transition cost recovery, industry

determine profitability Key fac-

opposite-destructive

tors for achieving profitable op-

competition-where

“atomistic”

erations include:

is under separate ownership.

every plant

Building a portfolio of assets

0 Innovative fuel contracts

The value at stake in the genera-

structuring, cost control, and cycle management. Wires There is far more value at stake

which share risk and create flexi-

through either ownership or effec-

bility;

tive control will be important. Bid-

in the wires business than many

ding strategies that maximize

realize. As a natural monopoly,

12

The Electricity Journal

the wires business will continue

such as Metropolitan Fibre Sys-

graphic expansion, nationally and

to be regulated at the FERC and

tems, long distance companies,

internationally As in generation,

state levels. Owners of wires-

and cable companies are targeting

there will be significant interna-

transmission and distribution-

high density, high-volume cus-

tional growth opportunities in

will be required to provide access

tomers that frequently subsidize

wires. Estimates run as high as

on a nondiscriminatory

other users under regulated pric-

$100 billion in assets that may

ing. The potential for bypass will

come on the market through pri-

basis.

There will be obligations in terms of connecting customers, main-

increase as technology for distrib-

vatization over the next five to 10

taining reliability and possibly

uted generation (e.g., photovol-

years. In many developing econo-

acting as a supplier of last resort.

taics and small scale turbines) im-

mies, transmission and distribu-

In most instances, regulation will

proves. Large transition charges

tion investments have actually

be performance- rather than cost-

placed on the wires will encour-

been lagging generation capacity

based.

age new levels of creativity by

additions. Wires and pipes compa-

ortunately, performance-

large customers and munis, accel-

nies with world-class skills in sys-

based regulation (PBR) cre-

erating the threat.

F

ates the opportunity for wires to

tem expansion, operation and maintenance will find attractive

Some wires competitors will

be a generally attractive business.

seek economies of scale in their re-

opportunities around the globe.

Returns for companies that can

gion by consolidating their activi-

Initial PBR negotiations are

negotiate and execute well

ties and assets with other local

likely to result in regulators re-

against PBR mechanisms will ex-

utilities, perhaps including gas

quiring that shareholders put

ceed their cost of capital. The

companies, water utilities, and

value on the table, either through

U.K. regional electric companies

municipal or co-op electric compa-

lowering initial rates or accepting

(RECs), which have operated un-

nies. The recent Texas Utilities ac-

lower price escalation rates. The

der price cap regulation since

quisition of Ensearch is likely a

annual ante could be over $3 bil-

their privatization, were jointly

move in this direction. Others will

lion if a five percent give-back is

valued at 15.9 billion pounds in

look for growth through geo-

assumed. However, based on esti-

late 1994, more than three times their market value when their shares were originally floated in 1990. The potential for additional value creation in these companies is reflected in the substantial premiums several are attracting in recent bidding wars. Winning U.S.

20

wires companies will similarly be successful in negotiating favorable PBR schemes, controlling costs, promoting load growth, and dealing effectively with bypass threats. Bypass will be the chief threat to wires companies. As local telecommunications

companies have

discovered to their chagrin, there

Stranded cost (depending on industry structure)

l l l

Transition cost recovery Cost performance Bidding strategy

is no such thing as a safe monopoly Alternative access providers

Aupstkptember

1996

Figure 2: Value at Stake in Generation (Annual $ Billions)

13

mates of potential improvements

keters will offer financial dimen-

management, financing and other

in operating efficiency and vol-

sions to their products; for exam-

ideas. Several have announced

ume increases, the net upside for

ple, allowing buyers to lock in

their intention to “go national” by

the business could be $6 billion

prices or index them to the cus-

creating brand-name energy prod-

annually Prudent expansion into

tomer ‘s costs.

ucts and services. UtiliCorp

other geographies and other network businesses, both domestic

The power services business

United is an early leader in sign-

will be highly competitive with

ing national deals with hotel, gro-

and international, could increase

many players, including today’s

cery and retail chains. No one has

the gains further for those concen-

utilities, gas marketers, and possi-

yet found the electric equivalent

trating on the wires business (Fig-

bly oil companies. Over 200 com-

of call waiting or cellular phones,

ure 3).

Power Services The emerging power services

panies have already applied for

but if we look back 10 years from

power marketer status, and we be-

now, we will doubtless see that

lieve that number will continue to

many new sources of revenue will

grow before the inevitable consoli-

have emerged during the decade.

hree basic approaches

will

business will evolve into whole-

dation takes place. The focus to-

sale and retail segments. Value-

day is on the wholesale market,

added services such as energy

which has been opened by federal

services market. They can be char-

management and infrastructure

legislation, but the increasingly ac-

acterized as generation, retail, and

maintenance will be an important

cessible retail market will be the

intermediary strategies.

piece of the marketer’s portfolio,

future target.

emerge to serve the power

The generation-based approach

Companies such as Enron,

especially in the retail segment.

T

will concentrate on placing plant

Commodity marketers will seek

Duke-Louis Dreyfus, and LG&E

output into the highest value mar-

to bundle electricity, gas, and po-

Energy are already offering one-

ket: spot, power pools, wholesale

tentially other products to best

stop shopping for gas and electric-

intermediate, or direct to end us-

meet the needs of increasingly dif-

ity, while others are looking be-

ers. The retail approach will focus

ferentiated segments. These mar-

yond the meter with energy

on working closely with end users to identify needs and then going into the market to buy energy and bundle it with other products and services to meet customer requirements. The intermediavy strategy (e.g., Em-on’s approach in the

rL

natural gas business) straddles 12

Range -6 to 6

gating power from all available sources (including from proprietary assets), breaking down the

-6

PBR starting point

the power services market, aggre-

electricity purchases into individual risk components (e.g., location, timing, transmission, production), and then restructuring or l l l

Cost performance Higher volume Consolidation

repackaging all the components into physical and financial products to meet customer needs. These products will be marketed

Figure 3: Value at Stake in the Wires Business (Annual $ Billions)

14

directly to end users or provided

The Electricity Journal

to retailers to sell as part of their

Figure 5: Winners Will Move Agressively on Three Fronts

packages. Power services will be, on aver-

Strategy

age, a moderately attractive busi-

Move decisively to create value in (or exit) each

ness, but there will be a wide range of financial performance among competitors. Winners will be those who can develop and deliver innovative products first or

Winning company

can execute the transactions at lowrcost because of large scale or synergy with other businesses. At one point natural gas marketing was pursued by virtually every pipeline plus hundreds of independent markets; it is now domi-

0 r g anizat ionz

Regulation

Build capability to succeed in new businesses

Develop and negotiate comprehensive plan

nated by less than a half-dozen players. We believe electricity will follow this pattern-a

period of

rapid entry of power marketers will give way to a wave of consoli-

The power services business

markets emerge, which suggests

dation and exit as winners exert

has a significant upside. (Figure

an initial period of investment

scale and skill advantages to gain

4). However, most companies will

ahead of demand. Once the mar-

share. Growth will come from

have to build capabilities in terms

ket moves into the growth phase,

geographic expansion and prod-

of people, systems, product devel-

the incremental revenue potential

uct line addition.

opment, and marketing while the

in terms of commodity marketing margins and new products and services is estimated to be in the $5-14 billion range annually-not bad for a business that generally doesn’t exist today Getting Ready

Range -3 to +14

Utility executives are beginning to face challenges similar to those that commercial bankers have confronted over the last decade. Winning utilities will move aggressively on three fronts during the transition period now under-

Marketing costs

. Margins on wholesale commodity . Risk Management . Margins on retail sales . Beyond-the-meter products and services

way (Figure 5). Most traditional players will have to close, spin off or sell large portions of their current business, because it is unlikely that any

Figure 4: Value at Stake in the Power Services Business (Annual $ Billions)

Aupst/Septembev

1996

company will be able to succeed

15

in every aspect of a new, frag-

troduces performance-based

mented world. They must recog-

making and provides marketing

gional economies of scale in meter

nize that attackers will fare better

flexibility

reading, billing, collections, and

than defenders and will look for

rate

Ultimately, very different types

nies to capture significant re-

phone centers. Those potential

the advantage of moving first.

of companies will emerge from

savings could help overcome the

New businesses will need to be

the transition, but one thing is cer-

inevitable regulatory hurdles and

funded aggressively to ensure a

tain: there won’t be anywhere

could justify acquisition premi-

place among the survivors. Execu-

near the current 180-plus investor-

ums.

tional excellence, even more than

owned electric utilities. The past

In both the power services and

great strategic insight, will be a

year has been a busy one, includ-

wires businesses, utilities will also

path to success.

ing another hostile takeover at-

need to compete with today’s

tempt, and that trend will only

power marketers, new entrants

continue.

such as oil companies, or entities

Few utilities have the cultures or capabilities today to consistently deliver against these emerg-

Many of today’s utilities will

with distribution networks such

ing business requirements. Many

end up as wires companies, or

as credit card companies that

talk the game of competition, but

part of larger wires companies, al-

have aspirations to become na-

few are demonstrating that they

though they will not accept this

tional or regional service compa-

are prepared to make the tough

fate easily. Several utilities have

nies. IPPs and some utilities will

organizational decisions required

conceded the generation business

likely evolve to be major national

to compete.

and, once the stranded cost issue

or international generators. Many

is resolved, will exit by selling or

will lose money trying.

Winning utilities will craft a

eare confident

that there

transition with the regulators and

spinning off assets. Many will,

other key constituents that will

however, regard power services

provide the time, incentives and

as attractive because of today’s

value creation and growth in the

industry structure needed to en-

strong customer relationships, but

new electric industry. There are

able competitive success. In addi-

only those utilities that are able to

many untapped value-creation

tion to the stranded cost recovery

develop new skills will compete

opportunities due to the combina-

issue, on which many are focused

successfully.

W

is significant potential for

tion of regulatory restrictions,

today, utilities will need to pursue

Wires companies are likely to

largely defensive company strate-

a regulatory agenda that provides

evolve into combined wires-and-

gies, and, in many cases, a lack of

a workable industry structure, in-

pipes (gas, water, telecom) compa-

business acumen and capability. Not everyone will be a winner in the new competitive electric power industry. As with other industries going through the transition to competition, electricity customers will gain lower prices and more choices, and competitors will take market share from the former monopolies. Among today’s utilities, losers will likely outnumber winners when all is said and done. Would-be winners have their strategic organizational and regulatory work cut out for them.

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