About four months ago, at a conference at Stanford University’s Center for International Development, the economist and utility industry expert Frank Wolak turned heads with a not-so-new but very...
The Efficient Utility: Labor, Capital, and Profit
Are utilities working at top productive capacity? A novel look at 19 investor-owned electrics in the Sun Belt.
Major restructuring is expected to hit investor-owned utilities (IOUs) over the next decade. Competitive market forces, in place of rate-of-return regulation, will require many companies to evaluate their resource allocations. No longer will singular adjustments in resource use suffice when both capital and labor resources must be realigned. Realignments may well prove as significant to the electric industry as the triumph of AC over DC current in the late 19th century. Electric utilities must begin now to realign their firms to the market.
Several fundamental questions arise. How do we stand, relative to our peers? Is our production side aligned with the market? How do we move from where we are to where we need to be? What will we gain in profits from such moves? IOUs must gain insight into the answers to these questions before making major decisions.
In this study, we considered data for 19 IOUs located and operating in the southern air-conditioning belt of the United States (see Table 1 on page 26). We have analyzed how each utility, relative to its peers, transformed its labor and capital into gross profit. The results indicate significant opportunities to improve efficiency across this set of firms. Nearly all of the 19 IOUs studied could make more efficient use of their capital and labor. Most of them appear poorly positioned to compete in the forthcoming competitive arena. Several large and prominent utilities must change appreciably to become well-positioned. Otherwise, they may well represent attractive targets for independent power producers (IPPs), since significant profit potential exists.
Frame of Reference
For all 19 IOUs, we focused on the two production inputs of labor (total employees) and capital (total assets) and then on the single output of profit (gross profit), as a surrogate for total productive output. "Total employees" encompasses all of the personnel employed by a utility; "total assets" represents all of the capital employed by a utility. "Gross profit" is a comprehensive measure of a firm's total product.
Within this frame of reference, if one utility's labor, applied to its capital, generates more product than any other utility's, the former receives the highest efficiency rating. This utility lies on the efficient production frontier and is labeled technically efficient. Conversely, if this utility is labeled technically inefficient, then some other utility is obtaining the same level of product with less labor, relative to its capital. Technical efficiency assumes that the there are no wastes (slacks) in resource use either by the firms on the efficient frontier or by the inefficient firms when projected to the efficient frontier.
Beyond technical considerations, we analyzed the alignment between each efficient utility's production and market sides. The Best Practice match was found between the utilities on the efficient frontier and plausible price bounds formed from data approximating a wide range of market conditions. Such a "matched utility" is said to be economically efficient; it has achieved the Best Practice in production and is economically aligned with the market.