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Marketing & Competing

Fortnightly Magazine - December 1996

make these investments riskier, particularly where adoption of new technologies brings added uncertainty (will they perform as expected?) and requires importing new skills and ways of organizing. This is especially true in the case of information technology (IT), where distribution utilities need to invest in advanced customer information, metering, and billing systems to support retail competition.

These forces will conspire to make distribution companies take a more strategic view of investments in their businesses going forward. In many cases, they will be more inclined to rent assets and capabilities rather than buy them (witness the rapid increase in IT outsourcing in the 1990s). In other cases, they will want to increase (em through restructuring (em the likelihood and magnitude of returns by leveraging their investments and capabilities over a broader scale and scope of operations than their current service areas allow them.

Two Paths to Restructuring

The conglomeration of distribution businesses (em such as has taken place in the largest U.S. utility mergers that have occurred over the past two years (em represents the most obvious means by which restructuring will occur and will be motivated in part by integrated utilities that seek captive retail markets (in the near term) for their generation capacity. Under this scenario, there will be fewer, but larger, distribution companies that bring economies and concentrations of expertise to the various distribution functions by virtue of scale.

Little change in the amount of vertical integration prevailing in the industry is likely to occur if the merger and acquisition (M&A) path to restructuring predominates, since it is largely compatible with rate-of-return regulation: Regulators will jawbone companies to hold distribution charges flat, or to reduce them, in return for merger approval. In turn, acquirers will justify acquisition premiums to shareholders largely based on the economies and consolidation-based savings that they can bring to the merged entity.

But an equally likely scenario could bring both greater efficiencies and more dynamism: the emergence of large, national, but specialized businesses that perform specific distribution functions on behalf of local distribution franchise owners. Candidates include many of the activities performed by today's integrated DisCos (see sidebar).

At the extreme, a company that operates a local distribution franchise could procure all of these functions from outside contractors, while continuing to own critical distribution assets and without jeopardizing its local brand equity. Competitive bidding would assure the functions were performed both effectively and cost-efficiently, while pricing signals would indicate clear tradeoffs between cost and service levels. Competition among specialized wholesale service providers would evolve to the point where each service would be performed at an appropriate scale, using an economic mix of labor and capital, and deploying the latest technologies.

A "virtual DisCo" may never come to exist, but the prospect of much greater outsourcing and the emergence of large businesses that will perform specific distribution functions already looms on the horizon.

Britain's price-driven approach to regulation has provided distribution companies with strong incentives to become cost-efficient and, in particular, to outsource functions and investments that can most economically be provided by someone outside (see sidebar).