In the fall of 1996, when deregulation was picking up steam in the United States, three McKinsey consultants—William Heller, Paul Jansen, and I—wrote an article predicting how and where value would be created in the newly refashioned electric power industry.¹ Two and a half years and hundreds of mergers, asset sales, business restructurings, and CEO changes later, it is time to review our forecasts and see what, if anything, we would say differently today.

In general, the changes we expected have indeed come to pass. We made no serious gaffes. Our observations about the likely winners were correct, as far as they went. Our rough quantification of the amount of value at stake appears to have been on target: we said that although investor-owned utilities could collectively lose almost $30 billion a year, growth in new businesses could create as much as $45 billion a year—more than offsetting the loss.

Some of our thinking did not go sufficiently far, however. Three predictions in particular cry out for refinement and augmentation.

1. "This vertically integrated industry is about to fragment into three separate but linked businesses—generation, wires, and power services—plus a dispatch function..."

We predicted that electric utilities would be unbundled once competition permitted customers to choose their electricity suppliers—much as, for a decade, they have chosen their long-distance telecommunications providers. New entrants would then compete in those parts of the business amenable to competition. In fact, rather than the one-off split-up implied by our prediction, the reality has been a dynamic and sometimes messy process, with businesses splitting, reaggregating, and fading. We probably also underemphasized the benefits of links across several businesses.

The experience of the power generation segment shows how dynamic this industry has become. As we expected, generation is developing into a separate business. With increasing competition, many companies have chosen to leave it, while others are expanding their stakes. In the past two years, almost 45,000 megawatts of capacity (about 6 percent of the US total) have been sold or put on the block. Among the biggest owners of generating capacity in the Northeast are the new entrant Sithe Energies (in which the French water company Vivendi holds a majority of the shares) and leading utilities from outside the region, such as PG&E and Southern Company.

It is even clearer now than in 1996 that distinct businesses will emerge within power generation. Entergy and PECO Energy have each acquired nuclear plants as a step toward becoming national nuclear companies. Reliant Energy (formerly Houston Industries) and Duke purchased generating plants in California to participate in the lucrative market for ancillary services (standby and ready-reserve power supplies, as well as voltage support), among other things. Many companies provide nothing but plant operations and maintenance services.

The services business, which the 1996 article described as supplying electricity and other energy and nonenergy products, is also proving to be dynamic. Wholesale services—commonly known as trading—quickly matured as a business, one that is now dominated by a few large companies. Margins have fallen and the predicted volatility has surfaced, much to the chagrin of those caught on the wrong side of price spikes in the Midwest last summer.

By contrast, the retail-services segment is developing more slowly. In fact, several different retail businesses are emerging. During the past two years, for example, the subsegment dealing with middle-market customers has taken shape: companies like Enron, New Energy Ventures, and PG&E Energy Services have signed up national chain accounts including Burger King, Safeway, Saks Fifth Avenue, and the California State University campuses. The mass-market subsegment is taking longer to emerge because of transitional arrangements that for the next few years will blunt any incentive residential and other small customers might have to switch suppliers. Yet many utility affiliates and other would-be suppliers are positioning themselves for this large potential market, so product innovation and changes in market share can’t be very far away.

In 1996, we saw the three emerging businesses (generation, wires, and services) as to some degree linked but underestimated the benefits of competing in more than one business in the same region. The information gained by owning generating assets, for example, offers and will continue to offer an advantage to a trading business, at least until the generation market becomes more liquid and transparent. Meanwhile, generators, which have inherent "long" positions in the emerging commodity markets, see owning a distribution business as a natural hedge because it provides a market for power. As a result, owners of generation assets are emulating Enron and Dynegy and moving to trade futures and derivatives on energy markets. AEP, a leading asset owner in the Midwest, now boasts a staff of experienced traders. In the same way, traders such as Enron and Dynegy are acquiring generating assets.

Despite our discussion of the convergence of electricity and natural gas, cross-commodity linkages have proved to be a stronger driving force than we expected in 1996. Because of the importance of arbitraging across commodities, for instance, all major traders have capabilities in both sources of energy. Cross-commodity synergies have led to "wires and pipes" mergers in California, New York, Texas, and Washington. Telecom and cable are being bundled in "multiutility" packages.

Another example of a beneficial linkage is the way incumbent distribution companies have found that they have an advantage in the retail business. Recent McKinsey market research suggests that an incumbent can expect to keep about 70 percent of its customers when they first get to choose their electricity supplier. This advantage, which helps explain merger activity that focuses on expanding the retail footprint of local distribution companies, is seen as well in the movement of some electric utilities into related utility services, including telecommunications. As we noted in 1996, however, many incumbents will lose this advantage by failing to meet their customers’ expectations.

2. "... economics will win out in the market-driven world of the future."

Where regulation or public ownership generated market distortions or cross-subsidies, we figured in 1996 that competition would stamp them out. We still think economics will rule, but we probably underestimated the importance of getting the timing right.

As expected, market forces are proving to be strong. When offered the possibility of a better deal, customers—especially bigger ones with large electric needs—leap at the opportunity. After the New England power market was deregulated, for example, neighboring states fell like dominoes as customers there sought similar deals: once the Massachusetts market was restructured, New York soon followed, thus prompting changes in Pennsylvania and New Jersey, which is stimulating action in Maryland and Ohio.

Yet strong as market forces might be, they take time to play out, and getting too far ahead of the market can be costly. Regulatory efforts to balance the competing interests of consumers, utility companies, and investors have slowed the start of effective competition in the mass market, leaving several early entrants in the retail electric business, such as Enron in California, with huge expenses and limited market share. Sometimes, pioneers attract arrows.

By contrast, the early purchasers of privatized electric assets seem to be faring well. When experience in Argentina, Chile, and the United Kingdom showed that efficiency and local finances could benefit from privatization, pressure for it was unleashed elsewhere. The result has been widespread movement toward private ownership around the world. Early movers in the United States with knowledge of local systems bought the best assets at attractive prices, as shown by the recent resale, at considerable profit, of two UK distribution companies acquired earlier by US buyers.

In general, first and early movers receive a disproportionate share of the value created by deregulation: as the industry makes the transition, they can build up their management benches, help shape the rules, and establish business franchises and brands. Those with the insight to get in—and out—at the right time will make the big money.

3. "... it is unlikely that any company will be able to succeed in every aspect of a new, fragmented industry."

When we wrote those words, we believed that different businesses require different skills. Most companies will not achieve across-the-board success, but we now think that a handful of businesses with strong talent and organization, as well as the right assets and relationships, will have an opportunity to dominate a number of businesses, even in a disaggregated world.

For in 1996, we underestimated the strategic value of the assets and relationships of the big incumbent utilities. We also put too little emphasis on what have become the industry’s key issues: lack of management talent and weak organization. All companies want to create a cadre of smart, entrepreneurial, and experienced managers, but most utilities continue to fill key positions internally. The industry must reach outside for talent, and the companies that do so will have a chance to dominate. Enron, for instance, has been investing in people for years, hiring scores of fast-trackers from leading business schools and courting the senior echelons of consulting firms and investment banks. The company has always been willing to make personnel changes: only 9 of the top 77 managers on board when Enron was founded in 1985 still worked for the company in 1991. Graduates of "Enron U" now populate the senior-management ranks of other industry participants.

But talented people can make a difference only if their organizations let them function effectively, and many of today’s electrics are not yet there. To be successful in all parts of the electric business, they need to emulate companies, such as GE and Emerson Electric, that use planning and performance systems to create ideas, foster initiative, speed up decision making, and get results.

Here is a prediction that cannot be wrong: taken together, these three refinements to our 1996 view of the electric industry paint a picture of a business with great promise for those who understand its underpinnings and act accordingly. In another three years, we will know the winners.