Chief executive officers of power companies are rushing to acquire and consolidate the competition. Extra mass, it is thought, will give them more clout in the marketplace and protect them against hostile acquisitions. While there might be some truth in this argument, greater size does not in itself guarantee higher returns for shareholders. The obvious benefits of size for any power company come from economies of scale, which are reaped at the business unit rather than the company level. Moreover, not all businesses in the power industry benefit from scale. Any CEO contemplating a merger or acquisition should be aware of both the extent to which economies of scale differ along the value chain and the disadvantages of size at the corporate level.

Variable benefits

Different parts of the power industry’s value chain benefit from scale to a very different extent—some a good deal, others hardly at all.

Power generation

Apart from the size of individual power stations, economies of scale in power generation derive mainly from the bargaining clout that size gives a company when it negotiates for fuel and other supplies. Yet even this benefit will be limited if the fuel market is liquid and suppliers are fragmented. In any case, generators don’t need to merge entire operations to aggregate purchases. The procurement consortium recently formed by leading European utilities, which expect to make big savings through a shared Internet portal, is a case in point.

Generation offers two other potentially important scale benefits. The first relates to portfolio management. The more plants an operator owns, the easier it should be to maximize their overall performance through greater flexibility; prices, volumes, and margins can all be optimized if decisions about scheduling and bidding are based on the cost and availability of plant capacities in the portfolio as a whole. The second benefit concerns new capacity. Companies that frequently build new plant are likely to enjoy scale advantages in the form of lower prices and better delivery terms from equipment providers. They can also keep abreast of technological developments more easily. Thus companies that specialize in the development of new capacity may find that they need to maintain a minimum efficient scale.

So size is beneficial in generation, but only up to a point. In our experience, once a company holds 10 to 20 percent of its local market, it is unlikely to increase its scale advantages by growing bigger still.

Energy trading and wholesaling

Further along the value chain, the picture is different. If a trader does not have sufficient scale, it will not have access to the kind of market knowledge it needs to create and price new products cost-effectively and to balance its portfolio of risks. In addition, it won’t have credibility with the customers for its purchase and supply contracts. Of course, it will also earn less from trading commissions.

Scale is important for two further reasons in this part of the value chain. First, since most costs and investments in the trading business are fixed, it is critical to generate volume so that costs can be spread over it. Second, scale signals prestige and staying power and can thus help attract the best talent and skill to a trading company. For these reasons, we believe that there will eventually be no more than a handful of large traders operating in global energy markets.

Retailing

Downstream, in the retail businesses that sell energy products to the final customers, size matters less. In industrial and commercial retailing, for example, costs depend mainly on the number of customers a company has. Expenses that can be shared across customers—systems, product development, sourcing, and marketing—tend to be of modest significance in the overall cost structure. In most cases, large size is unlikely to create much of a cost advantage, though it might enhance a company’s reputation.

In mass-market retailing, the picture is slightly different. The expense of many infrastructure items—information technology systems, call centers, billing, marketing, and branding—is partly fixed; these items can be extended to serve a larger customer base without a commensurate increase in cost. Eventually, however, piling on customers ceases to bring cost benefits. Our analysis suggests that this point is reached at the level of 5 million customers, though other estimates put it at anywhere between half a million and 15 million (Exhibit 1).

Two more considerations are important in weighing the value of size in retailing. First, the cost base of any utility depends on the characteristics of its offer, the kinds of customers it serves, the configuration of its business system, and its technology. And it is not only costs that count; marketing skills are an important success factor. Thus, smaller retailers—especially "e-enabled" ones that focus on niches—can still be more profitable than large retailers. Second, because many economies of scale don’t extend across regional or national boundaries, pure size is no great help in competing in international mass markets.

Transmission and distribution

Scale is even less important in the regulated natural-monopoly businesses of transmission and distribution (Exhibit 2). Here, only about 15 percent of the total cost base is fixed; the rest varies with the number of customers and the size of the network. Economies of scale are therefore limited mainly to procurement, but here a quantum change in scale would be needed to achieve significant savings. If all of the regional electricity companies in the United Kingdom were to aggregate their purchasing, for example, they probably would reap big savings. Two together probably would not.

Other benefits

Beyond economies of scale, many people in the power industry would argue that size achieved through consolidation helps support prices by reducing the number of competitors. But it can have that effect only in those parts of the value chain that are competitive and where entry barriers are high—namely, generation and trading. In any case, there is little evidence to show that previously competitive markets have managed to improve prices after waves of consolidation. Factors other than the number of players influence pricing conduct, and any company that used market concentration as a primary driver of its strategy would probably fall afoul of regulators.

Benefits of scale as a result of consolidation should not be confused with other benefits that might arise from it. Consolidation can prompt important structural changes that improve the performance of merged companies. Rigorous new systems might be installed to drive the potential benefits of a merger; best practices may be transferred from one company to another. Such steps often create significant value. Transforming a generating company from an average performer into a best-practice one, for instance, can reduce total operating and capital costs by up to 60 percent. Adopting best practices in distribution can bring savings of up to 50 percent. By contrast, the corresponding economies of scale from corporate mergers are no more than 10 to 20 percent.

In sum, scale at the business unit level does matter, but how much depends on the type of business involved. It can be a prerequisite in energy trading and in building new capacity. Within a single country, it can help mass-market retailers significantly and provides moderate advantages in generation and distribution. But it is unlikely to be of much benefit to industrial and commercial retailers.

The attraction of corporate clout

In assessing the importance of scale to a corporation as a whole, the picture is mixed. Size is often seen as protection against takeovers in today’s acquisitive and consolidating utility industry. But shareholders should be wary of such reasoning, for they are best served when their company is owned and run by those best qualified to extract the highest value from it. If the current management is struggling, a takeover might be the shareholders’ best option.

That said, corporate scale does deliver some advantages. One is that companies above a certain size are listed on key stock market indexes such as the S&P 500 and the FTSE-100. Being listed can automatically boost the price of a company’s shares by raising demand for them among index funds. Moreover, the recommendations of analysts are statistically biased toward "buy" and "hold" rather than "sell." Any stock finding its way to the main indexes can expect analysts’ coverage of and demand for the stock to rise as a result of enhanced expectations. This attention could be particularly appealing for utilities, given the otherwise lukewarm coverage the sector has received of late.

Big companies with deep pockets and extensive financing capacity also have a tangible advantage in dealing with the market transition that utilities face. As liberalization stirs up the business, and competition intensifies, periods of low returns are likely. The survivors will need strong balance sheets. In addition, some assets may be available at attractive prices to those with the necessary capital, and better-capitalized companies can afford to keep more business options open and to develop them when the time is right.

Corporate mass can also mean that companies rely less on any one business for profits and might thus permit utilities to balance expectations and performance in a way likely to appeal to investors. Although conventional wisdom holds that diversification destroys value, it is also true that managers who must constantly worry about next quarter’s results pay less attention to long-term performance and growth. A diversified portfolio is likely to produce less volatile cash flows, which in turn may increase a utility’s ability to raise financing and thus give the company greater strategic flexibility.

Finally, larger utilities often believe that the market intelligence and the ideas on M&Amp;A and financing that they receive as preferred customers of investment bankers give them an advantage. Much restructuring is expected in the utilities industry during the next decade, so companies in the deal flow will be able to play a role in shaping these developments.

The downside

Despite the benefits of size for corporate strategy and finance, there is a catch. Indeed, we believe that, at the corporate level, the disadvantages of large scale usually outweigh the potential advantages. This view is borne out by our recent research into 80 US and European utilities in the gas and electric-power sectors. The study showed that the bigger a company, the lower its return on capital relative to its cost of capital. Moreover, larger companies—particularly those in the United States—appeared to find it tougher to keep up with the growth expectations that drive share prices and thus had inferior returns to shareholders (Exhibit 3).

Why should this be so? The answer lies in the phenomenon of conglomerate discounts. Once a utility reaches a size requiring increased diversification, capital markets question the value of keeping all the company’s businesses under one umbrella. This reaction is easily explained: the larger the company, the broader the range of skills the corporate center must master to add value to business units. How can the top team of a diversified international utility understand the strategic issues and opportunities in all industry segments from generation to mass-market retailing, especially across several geographies? It is more likely that the company will end up being mediocre in a number of businesses when it should actually strive for global distinctiveness in a few.

Another problem is that utilities, in common with large companies in many industries, are at a disadvantage in today’s war for talent. Although they may be willing to pay what they regard as large salaries and bonuses, they struggle to provide the sense of entrepreneurialism or to match the potential financial upside that new-economy companies can offer. This problem, coupled with the fact that the career path for managers in utilities is predictable and slow moving, explains why many large companies in gas and electricity find themselves without a pipeline of high-caliber people for the future.

As a result, large utilities are highly exposed to competition, and their prevailing culture can render them helpless to improve matters. Companies that attract the best people set high performance expectations, tie them to clear incentives, and then give managers the freedom to deliver. In marked contrast, many utilities still tolerate a culture of command and control—the most effective way to drive away good people.

Better growth strategies

To sum up, scale delivers benefits only in certain businesses, and large, increasingly diversified companies tend not to be the best creators of value. In this environment, which growth strategy should utilities pursue?

Ideally, large companies should change their focus from owning and building assets to creating distinctive competencies and leadership. Top-flight companies base their expansion on a bedrock of distinctive corporate capabilities, such as asset management, M&A valuation and execution, and customer relationship marketing. Such capabilities form the common thread that brings value and synergies to a large number of diverse businesses; companies that ignore these core competencies and instead focus on core businesses cut off avenues for future growth.

Thus Enron, which has developed the core skills of identifying market inefficiencies and exploiting them through its trading operations, has extended its success to other geographies and to a growing number of product markets, including weather and telecommunications derivatives. AES, another top performer, has honed its project negotiation, management, and operational skills to become the world’s leading independent developer of power projects.

At the same time, Enron and AES guard against the inherent dangers of size by focusing on leadership. Both companies have performance-oriented cultures. Both set high aspirations for the organization and tough targets for employees, and both reward or penalize individuals and teams for their performance. They encourage entrepreneurial behavior and allow managerial independence. Their corporate structures are disaggregated and fluid, fostering internal competition and innovation, and they develop leaders who understand the value of this approach and work hard to implement it. Developing distinctive competencies and leadership isn’t easy for companies that have lived for so long in a protected environment. But neither is the current pursuit of size the way to transform indifferent performance. If companies are to grow and create value, they will have to restructure their portfolios with a view to concentrating their skills and capabilities and must build the leadership capacity needed to manage and maintain profitable growth. A few companies in the utilities industry are doing this. Others are concentrating on size alone as a delaying tactic—putting off the day when they address the much tougher tasks they know lie ahead.