Not so long ago, in the United States and other industrial nations, basic capital-intensive services such as electricity, gas, rail travel, telecommunications, and water were delivered by monolithic monopolies. Almost all of them were heavily regulated or owned by the state. But over the past 10 to 20 years, these industries have disaggregated into businesses that perform one segment of what had formerly been a vertically integrated product-delivery process. The provision of electricity, for example, now involves four distinct businesses focused, respectively, on generation, high-voltage transmission, low-voltage distribution, and retailing. Significantly, each service in the first wave of disaggregation rested on an asset base owned by the company providing it.

The first wave sparked tremendous innovation and improvements in efficiency by introducing competition into those parts of the business system—such as generation in electricity and long-distance service in telephony—that are not natural monopolies. As a result, the logic of disaggregation has become widely accepted, even though the process has some way to go in many countries.

A number of companies are beginning to experiment with disaggregation at a second, deeper level. The major difference between this stage and the first is that now only one of the resulting businesses remains an asset owner; the formerly united functions are disaggregated into asset ownership, asset management, and service delivery (Exhibit 1). So, for example, the distribution entity of a gas utility might split itself into one business that owned the pipelines; one that oversaw operations, maintenance, and upgrading; and one that undertook the day-to-day work.

The initial stage of disaggregation might simply have involved a clearer system of reporting, so that each function’s relative level of performance could be evaluated. The next stage might involve the functions’ internal disaggregation into corresponding subsidiaries or divisions. After assessing their viability as freestanding businesses, the asset owner might choose to spin off the functions of oversight and of day-to-day operations, maintenance, and other work-delivery activities. Each function might continue to perform its accustomed role on behalf of the asset owner, though the relationship would now be contractual.

If the company undertaking a function was especially skilled and efficient at what it did, it might decide to provide its services to other companies as well; in some cases, it may have begun doing so while it still belonged to the asset owner. It could even acquire other companies in the same business. But the company may have been spun off precisely because of its weaknesses. In that case, the asset owner would want to obtain those services from a best-in-class organization with which it had no previous affiliation.

Of course, if the still aggregated business decided that its core competence was, let us say, asset management rather than ownership, it should feel perfectly free to sell its physical assets outright, to divest its asset ownership business, to spin off its service-provision function, or to try some combination of these approaches.

The impact of this second wave of disaggregation will be at least as great as that of the first wave.

Three roads to unbundling

Regulation is still needed, for no one will build, say, a gas pipeline to compete with an existing one

Asset ownership is an activity in its own right. Its responsibilities are financing and compliance with regulatory regimes that are still necessary because no company is going to build, say, a new gas pipeline between two points or a new electricity distribution network in a given area to compete with existing ones. Asset owners own the asset base and provide the capital needed to develop and maintain it. Because they pass on responsibility for construction, management, and maintenance to others, asset-owning businesses—with billions worth of assets on their books—can often be run from offices of no more than 30 people.

Meanwhile, asset managers decide, under contract from the asset owner, what maintenance, replacement, and upgrade work should be done to ensure that the assets are serviced at an acceptable level and at the lowest possible cost over the life of the assets. Asset managers do not themselves perform work on the assets; that is left to service-delivery organizations.

Service deliverers physically carry out the maintenance, replacement, and upgrade work, and sometimes frontline operations, on the asset manager’s behalf and often provide project-management services: procuring and coordinating everything needed to undertake a particular job. It is the responsibility of the service deliverers to improve the quality of the work and the efficiency with which it is done. Such companies typically employ large staffs.

The logic of slicing up activities in this way is the improvement in efficiency to be had from specialization. These three functions require very different skills: for asset ownership, raising and managing capital; for asset management, making clever technical and commercial decisions (knowing what work must be done to achieve a certain standard at a certain cost); for service delivery, getting lots of workers to perform well at maintenance, operations, and so forth.

Would an already focused company split itself into these three businesses? Some have indeed spun off assets to take advantage of temporary investor interest driven by scarcity or to obtain a lower cost of capital by shedding risk. But the short-term financial opportunity that disaggregation sometimes offers¹ is ultimately a zero-sum game. The asset owner assigning its management chores to another company so that it can lower its operational risk, and hence its cost of capital, will have to accept contractual terms steep enough to compensate the asset manager for the risk being transferred. The net effect would be simply to shift the cost of this risk from below to above the line.

A better motive for delegating asset management and service delivery to specialists is the desire to help create—and to reap the rewards of—competitive markets in those functions. Asset ownership, which remains a natural monopoly, will still require regulation. But the separation of the businesses will make the economics of all three more transparent, thereby leading to greater efficiency (and thus lower prices for customers), to improved quality, or both. As a result, given the size of the industries concerned and the difference between the best and worst players performing these functions, huge amounts of value could be released to shareholders and customers.

Managers who have engineering backgrounds often find it hard to give up asset management, the ’crown jewel’ of their duties

Inevitably, many incumbents will resist this second wave. Their managers often have engineering backgrounds and may find it hard to give up asset management, the "crown jewel" of their responsibilities. Regulators, concerned by the apparent complexity of the relationship among the owner, the asset manager, and the service provider—and by the blurring of accountability, especially in the event of system failure—might also prove to be an obstacle.² But good contracting practice can overcome these concerns. It makes increasing sense for companies and investors to embrace disaggregation, particularly in Australia, the United Kingdom, and the United States, where efficiency measures, driven by the regulators’ continuing reluctance to approve rate increases, are producing diminishing returns (not to mention profits and valuations).

Second-wave disaggregation will also make it easier for companies that excel at particular activities to expand into new markets. Because specialists are, almost by definition, good at what they do, consumers will benefit from the trend. And investors interested in a given industry will, for the first time, be able to buy shares in either asset-owning businesses that have relatively low risk and high capital intensity or asset-light businesses that offer higher returns, albeit with greater risk.

The second wave in action

Companies are exploring the second wave of disaggregation in a number of ways (Exhibit 2). AGL, Australia’s oldest and largest natural-gas distributor, plans to transform itself from an asset-intensive player in regulated businesses into an asset-light supplier in the country’s soon-to-be deregulated electricity and gas markets.³ One step the company took was to form a business unit, under the name Agility, that provides asset-management and work-delivery services. The unit now has long-term contracts with its old pipeline business (renamed Australian Pipeline Trust when AGL floated most of its equity) and with other customers, such as the Australian Capital Territory’s Electricity and Water Authority (ACTEW). Through the ACTEW deal, Agility manages assets, worth US $405.8 million, that are owned by a joint venture between AGL and ACTEW.

In Europe, the electricity distributors TXU Europe and London Electricity have created a joint venture—24seven—that describes itself as a "network-management services business"; it has taken on most of the workforce of its parent asset owners and entered into long-term contracts to manage their assets and to deliver services. With the help of 24seven, TXU and London Electricity expect to improve the efficiency of their own networks significantly and to do the same for other asset owners (such as the municipal owners of water supplies) that choose to renounce the functions of asset management and service delivery.

Variations on this approach are being implemented in the United States. In June 2000, Puget Sound Energy (PSE), a US distributor, created InfrastruX, a wholly owned service provision subsidiary. InfrastruX has since acquired a number of electricity and gas utility service providers and is aggressively pursuing growth opportunities in service delivery.

Creating value through disaggregation

Each of the three disaggregated activities—asset ownership, asset management, and service delivery—offers a significant, though differing, degree of value, both to those performing the activity and to those with whom they enter into contracts.

Asset owners

Although not a highly profitable business, asset ownership is an attractive one. Owners, whether their assets are plants or networks, can earn low-risk returns of around 5 to 10 percent by shifting some higher-risk activities to third parties and developing debt-heavy capital structures. Having moved out of day-to-day management, and thus away from the rigors of competition, asset owners can focus intensively on managing their financial (interest rate) and regulatory risks.

Asset managers

McKinsey research shows that for many businesses, sound asset management can reduce total costs (including those associated with lower quality and with interruptions of service, such as train delays) by more than 20 percent. The UK distributor and supplier East Midlands Electricity, for example, was able to realize savings of more than 25 percent of the expected life cycle costs of its 33-kilovolt oil circuit breakers by changing its maintenance and replacement strategy for these assets.

The skills and track records of the very best managers are difficult to replicate, and switching costs for asset owners are relatively high

Such benefits can be taken in cash or reinvested in higher levels of quality or safety. Good asset managers should be able to retain a significant fraction of these benefits, since the skills and track records of the very best managers are difficult to replicate, and switching costs for asset owners are relatively high.

While the logic of disaggregation should create markets in which companies can prosper, a lot of asset owners still need convincing. Many integrated incumbents think that asset management should be their core competence and would therefore rather develop than outsource it. Yet our research suggests that an objective appraisal of their capabilities would dictate the latter course (see sidebar, "Who should manage the incumbents’ assets?").

Asset service deliverers

Exposing service delivery to competition could also improve efficiency substantially—perhaps, judging from the experience of some early movers, by 20 to 40 percent of total asset costs: that is, the cost of delivering maintenance, replacement, and upgrade services to the assets. Higher productivity, partly attributable to better front-line management of the workforce involved and partly to better design and planning of the work, deserves most of the credit.

Early movers in service provision have been rewarded and are achieving high growth in a rapidly expanding outsourcing market

The one-off benefits of whipping these operations into shape are likely to be captured primarily by the asset manager, which sets productivity standards, though most contracts award a bonus to the service provider for beating them. In the longer term, service providers can wind up with a relatively low-margin business (operating margins of 5 to 10 percent) facing high competition and, in many cases, limited economies of scale. Early movers, however, have been rewarded and are achieving high growth in a rapidly expanding outsourcing market.

One such company is US-based Quanta Services, founded in 1997 as a nationwide provider of network-infrastructure design, installation, and maintenance services to a diverse group of cable, electricity, and telecom providers. Quanta is targeting the $20 billion US network-infrastructure services market, which is growing rapidly because of what until very recently was sharply increasing demand for communications networks and for bandwidth, as well as an outsourcing trend among electric utilities, which are facing calls to upgrade aging networks and to reduce costs at the same time. Quanta has met demand for its services by "rolling up" more than 30 established contracting firms. The resulting company has achieved earnings-per-share growth of more than 80 percent over the past three years.

You could certainly argue that there is really nothing revolutionary about the early moves that companies are taking to disaggregate further their already disaggregated businesses: utilities, for example, even now routinely contract out their construction work. And surely there will be a temptation to outsource to companies that are still partly owned by the incumbents rather than lose control over activities completely. We would argue, however, that the second wave of disaggregation will eventually go well beyond simple outsourcing to create a new set of business models and relationships that build on the existing strengths and minimize the irremediable weaknesses of asset ownership, asset management, and service delivery.