Market forces unleashed by deregulation are starting to reshape the US electric utility industry. As with banking and telecommunications before it, the sector is set to be transformed. Mergers and massive consolidation will take place. New competitors will emerge to redefine the economics and competitive dynamics of the business, just as MCI did in telecom, and Fidelity in banking. Some traditional players, like AT&T and Citibank, will make and mold the transition; others will dwindle, vanish, or be subsumed. The winners will create substantial value for their shareholders.

This vertically integrated industry is about to fragment into three separate but linked businesses—generation, wires, and power services—plus a dispatch function (Exhibit 1). Each will have its own players and distinctive competitive dynamics. Generation will be a cost-based commodity business. Wires, combining transmission and distribution functions, will consist of regulated open-access networks. Power services, encompassing wholesale and retail commodity sales and including other energy and nonenergy products, will be provided by a third set of competitors. The dispatch function, responsible for scheduling, grid control, and price settlements, will be fulfilled by an independent regulated entity.

Tremendous value is at stake as the industry evolves into these three businesses. The delivered cost of electricity can be expected to fall by 10 to 20 percent, depending on the outcome of regulatory decisions on the recovery of uneconomic supply costs (so-called "stranded costs") and performance-based rate-making. Individual customer savings will vary widely, since future prices will reflect the real (rather than average) cost of service according to geography, load profile, and willingness to suffer interruptions in supply. Regulators may try to protect residential and small commercial customers, but economics will win out in the market-driven world of the future.

All told, investor-owned utilities (IOUs) could collectively lose nearly $30 billion annually—about 15 percent of today’s industry revenues, and over 100 percent of the after-tax profits of all utilities combined. Fortunately, the value created through restructuring and growth into new businesses could exceed this value at risk by as much as $15 billion. This suggests that if it is managed well, industry restructuring could benefit both participants and their customers. Each of the three businesses—generation, wires, and power services—offers different opportunities for value creation, and each has a unique risk profile. Equally important, the factors that will separate the winners from the losers will also vary from one business to another.

Generation

Despite fears of 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 new competitive regions will be defined by transmission limitations and are likely to be very large—far bigger than current reliability councils.

Bilateral and spot markets will exist in parallel. In each region, supply and demand dynamics will follow long cycles, causing prices to waiver between replacement and marginal costs. This typical commodity pricing pattern will produce unattractive average returns for many participants, with a great deal of variability between players.

Just under half of all utility supply portfolios are uncompetitive, owing to high costs and low capacity value

Our analysis of plant assets indicates that just under half of all utility supply portfolios are uncompetitive, owing to a combination of high costs and low capacity value. Industrywide, the potential for stranded investment in generation looks to be approximately $20 billion a year; to bring all utility portfolios in line with competitive markets would require a write-off of about $150 billion. Actual stranded costs will, of course, depend on eventual market prices as well as on the regulatory handling of uncompetitive assets and contracts.

To bring all utility portfolios in line with competitive markets would require a write-off of about $150 billion

Despite the relatively unattractive starting point, there are still opportunities for value creation beyond obtaining favorable transition terms for uncompetitive plants. In a business where being able to produce and sell power below the market price will determine profitability, nothing will be more important than keeping costs low. Key factors for achieving profitable operations include:

• Innovative fuel contracts that share risk between generators and fuel suppliers and create flexibility.
• Redesigned operational and maintenance practices that defy current industry wisdom about the level of staffing and attention to cost that are required for safe, reliable operations.
• A much more disciplined approach to capital investment based on the assumption that capital must pay back in a few years, not decades.
• Operating flexibility and reliability that will permit individual facilities to capture the peak prices that will be the source of most of a generator’s gross margin.

Industry structure will be another key driver of value—and one of the most sensitive to resolve. While the Federal Energy Regulatory Commission (FERC) and the Justice Department will be concerned that concentration does not become excessive, generators face the critical task of preventing its opposite: destructive "atomistic" competition where every plant is under separate ownership, virtually ensuring that capacity values will always tend toward zero. It will be important to build a portfolio of assets, whether through ownership or via effective control. Bidding strategies that maximize profits from a generation portfolio rather than from individual plants will be the priority of leading generators.

With many utilities expected to exit generation, there will be over 80 GW of opportunities to buy existing facilities

Additional sources of value in the generation business will include tightening reserve margins in some regions. Cycle management—the judicious timing of major capital investments, plant retirements, and asset sale decisions—will be essential, as has been demonstrated in commodity industries, including chemicals, pulp and paper, and oil refining. With many utilities expected to exit generation, there will be over 80 GW of opportunities to buy existing facilities and assemble a winning portfolio.

Of the three businesses, generation will be the first to go fully global; indeed, it is already well on its way. Winners will capture scale economies and apply superior skills in plant development, operations, maintenance, and fuel management on a global basis. A superior "product" and disciplined development process will be the hallmark of truly global competitors, while passive investors will find it increasingly difficult to achieve returns above their cost of capital.

The value at stake in generation will be huge (Exhibit 2). However, the $20 billion in stranded costs could be offset if transition cost recovery, industry restructuring, cost control, and cycle management proceed favorably.

Wires

Far more value is at stake in the wires business than many realize. As a natural monopoly, wires will continue to be regulated at the FERC and state levels. Owners of wires will be required to provide access to transmission and distribution on a nondiscriminatory basis. They will face obligations to connect customers, maintain reliability, and possibly act as a supplier of last resort. In most cases, regulation will be based on performance rather than cost.

Fortunately, performance-based regulation (PBR) creates an opportunity for wires to be an attractive business. Companies that can negotiate and execute well against PBR mechanisms will enjoy returns that exceed their cost of capital. The United Kingdom’s regional electric companies (RECs), having operated under regulatory price caps since their privatization, were jointly valued at £15.9 billion in late 1994—more than three times their market value at flotation in 1990. The scope for additional value creation in these companies is reflected in the premiums several have attracted in recent bidding wars. Winning US wires companies will be good at negotiating favorable PBR schemes, controlling costs, promoting load growth, and dealing effectively with bypass threats.

Bypass will be the chief danger for wires players. As local telecommunications companies have discovered to their chagrin, there is no such thing as a safe monopoly. Alternative access providers such as Metropolitan Fiber Systems, long-distance operators, and, in the near future, cable companies are targeting high-density, high-volume customers that frequently subsidize other users under regulated pricing. The potential for bypass will increase as the technology for distributed generation (for example, photovoltaics, fuel cells, or small-scale turbines) improves. Large transition charges placed on the wires will push large customers and municipal utilities to new heights of creativity, intensifying the threat.

Some wires competitors will seek economies of scale in their region by consolidating their activities and assets with those of other local utilities, such as gas LDCs, water utilities, and municipal or co-op electric companies. Others will look for growth through geographic expansion, nationally and internationally. As in generation, there will be international opportunities for growth. An estimated $100 billion in assets may come on the market through privatization over the next five to ten years.

In many developing economies, transmission and distribution investments have been lagging generation capacity additions. Wires companies with world-class skills in system expansion, operation, and maintenance will find attractive opportunities around the globe.

Initial PBR negotiations are likely to result in shareholders putting value on the table, either by lowering initial rates or by accepting lower price escalation rates. With a 5 percent give-back, the annual ante could be over $6 billion. Given estimates of potential improvements in operating efficiency and volume increases, however, the net upside for the business could be as much as $6 billion annually (Exhibit 3). Prudent acquisitions, both domestic and international, could push these gains still higher.

Power services

Marketers will seek to bundle electricity, gas, and possibly other products to meet the needs of different customer segments

The emerging power services business will evolve into wholesale and retail segments. Value-added services such as energy management and infrastructure maintenance will be an important ingredient in the marketer’s portfolio, especially in retail. Commodity marketers will seek to bundle electricity, gas, and possibly other products to meet the needs of increasingly differentiated customer segments. These marketers will offer financial dimensions to their products—for example, allowing buyers to lock in prices or index them to customers’ costs.

The power services business will be highly competitive and involve many players, including today’s utilities, gas marketers, and possibly oil companies. Over 100 companies have already applied for power marketer status, and we believe this number will rise rapidly before the inevitable consolidation takes place.

Such companies as Enron, Duke/Louis Dreyfus, and LG&E Energy are already offering one-stop shopping for gas and electricity, while others are looking beyond the meter with energy service companies and other ideas. Several have announced their intention to "go national" by creating brand-name energy products and services. No-one has yet discovered the electric equivalent of call waiting or cellular phones, but if we look back ten years from now, we will doubtless see many new sources of revenue that emerged during the decade. Participants will adopt one of three basic approaches in serving the power services market:

• The generation-based approach will concentrate on placing plant output into the market with the highest value: spot, power pools, wholesale intermediate, or direct to end users.
• The retail approach will involve working closely with end users to identify their needs, and then going into the market to buy energy and bundle it with other products and services to meet these needs.
• The intermediary approach, exemplified by Enron’s strategy in the natural gas business, straddles the power services market, aggregating power from all available sources (including proprietary assets), breaking down electricity purchases into individual risk components (such as location, timing, transmission, and production), and then restructuring or repackaging all these components into physical and financial products to meet customers’ needs. These products will be either marketed directly to end users or provided to retailers to sell as part of their packages.

Power services will be a moderately attractive business on average, with wide variations in competitors’ financial performance. The winners will be those that can develop and deliver innovative products first, or those that can execute simple commodity transactions at low cost thanks to their scale or synergy with other businesses. At one point, natural gas marketing was pursued by virtually every pipeline, plus hundreds of independent marketers; it is now dominated by half a dozen players. We believe electricity will follow a similar pattern. A period of rapid entry by power marketers will give way to a wave of consolidation and exit as winners exert scale and skill advantages to gain share. Growth will come from geographic expansion and product line addition.

The power services business has considerable potential (Exhibit 4). However, most companies will have to build people, systems, product development, and marketing capabilities while the markets are emerging, which suggests an initial period of investment ahead of demand. Once the market moves into its growth phase, the incremental revenue available for capture from commodity marketing margins and new products and services is estimated to be in the range of $5 to $14 billion annually—not bad for a business provided at cost by utilities today.

Getting ready

Utility executives are beginning to face challenges similar to those that commercial bankers or telephone companies have been confronting over the past decade. Winning utilities will move aggressively on three fronts during the transition period that is now under way:

• Strategy. Taking decisive action to create value in (or exit) each business. Most traditional players will have to close or sell large portions of their current business, since it is unlikely that any company will be able to succeed in every aspect of a new, fragmented industry. They must recognize that attackers will fare better than defenders, and look for first-mover advantages. New businesses will need aggressive funding if they are to secure a place among the survivors.
• Organization. Building the capabilities to succeed in new businesses. Executional excellence, even more than sharp strategic insight, will be the path to success. Few utilities have the culture or capabilities to deliver consistently against emerging business requirements. Many talk the game of competition, but few are demonstrating that they are prepared to make the tough organizational decisions necessary to compete.

  Many talk competition, but few are demonstrating that they are prepared to make the tough organizational decisions necessary to compete

• Regulation. Developing and negotiating a comprehensive plan. Winning utilities will craft a transition with regulators and other key constituents that provides the time, incentives, and industry structure to enable competitive success. As well as dealing with the stranded cost recovery issue that preoccupies many today, utilities will need to pursue a regulatory agenda that establishes a workable industry structure, introduces performance-based rate-making, and permits marketing flexibility.

Ultimately, a broad spectrum of companies will emerge from the transition. One thing is certain, however: it will not produce anything like the current hundred-plus investor-owned utilities. Consolidation is inevitable. Last year was a busy one for utility mergers—a trend that can only continue.

Many of today’s utilities will end up as wires companies or as part of larger wires companies, although they will not accept this fate willingly. Several have already conceded the generation business, and, once the stranded cost issue is resolved, will exit by selling or spinning off assets. Many will regard power services as attractive because of existing strong customer relationships, but only those able to develop new skills will compete successfully.

Regulatory resistance to combinations of wires and power services may be significant. Wires companies are likely to evolve into combined wires and pipes (gas, water, and telecom) companies to capture regional economies of scale in meter reading, billing, collections, and phone centers. The potential savings could help overcome the inevitable regulatory hurdles and justify acquisition premiums.

In both the power services and wires businesses, utilities will also need to compete with today’s power marketers, new entrants such as oil companies, and players controlling distribution networks, such as credit-card companies that aspire to become national or regional service companies. Independent power producers and some utilities will likely evolve to be major national or international generators. Many others will lose money trying.

Despite the prevailing atmosphere of uncertainty and gloom, we are confident that the opportunities for growth in the new global electric utility industry outweigh the threats. Thanks to a combination of regulatory restraints, defensive company strategies, and, in many cases, a lack of business acumen, untapped value-creation opportunities abound.

Not everyone will be a winner in the new competitive world of electric power. As in other industries undergoing the transition to competition, customers will gain lower prices and more choice, and new competitors will take market share from the former monopolies. Losers will likely outnumber winners when all is said and done.