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Regulated Utilities: Reinventing the Classic Business Strategy

Opportunities and limitations of five top strategies.

Fortnightly Magazine - December 2005

of another sequence of negotiations. This time the two CEOs, after obtaining approval from their shareholders, must next negotiate with their respective state regulatory commissions and with FERC.

In the first round of negotiations, the benefits of the merger result in the agreement to pay the shareholders of the company to be acquired. In the second round, the regulators determine how much of the remaining benefits of the proposed acquisition or merger need to be allocated to the customers of the utility to meet a “public interest” or harsher “public benefit” standard. (Regulators signaled long ago that the easiest way an acquirer can show a public benefit from a proposed merger is to have the approval result in an immediate rate decrease. There are other ways to meet the public interest standard—increased service quality, introduction of new technologies, and pre-empted future rate increases—but rate decreases are usually sure-fire.)

Thus, the synergy strategies via mergers, while available to the regulated utility, also include an additional set of critical negotiations and risks that must be considered to ensure enough benefits to go around.

Globalization: The British Are Coming

In the retail, manufacturing, financial, and professional services industries, the main growth strategy has been the pursuit of “global” markets. Corporate strategists teach that global expansion allows a company to exploit economic scale, technological edge, and marketing and brand-name advantages and expertise.

During the 1990s and continuing into this century, a number of regulated electric and water utilities also have made acquisitions of regulated public utilities in foreign countries. Utilities based in the United States have invested in Europe, Latin America, Asia, Australia, and China. European utilities, based in the UK and Germany, have made acquisitions in the United States. The UK’s Scottish Power acquisition of PacifiCorp, the National Grid acquisition of the New England Electric System, and Germany’s RWE acquisition of The American Water Works System are the most prominent inward investment examples. A number of U.S. utilities, such as American Electric Power and TXU, acquired regional electric utilities in the UK.

At the time of their international acquisitions, the U.S.-based utilities had 100 years of experience as private corporations operating under independent regulatory agencies at the state and federal level. Retail rate regulation in the United States predominately has been under a “cost-of-service” (also called “rate of return”) ratemaking model. The western European utilities, when they acquired utilities in the United States, had a decade or so of experience operating in restructured environments (with separated electric generation, transmission, and distribution) and had more experience with a competitive wholesale power market. UK utilities also had experience under the more modern “price cap” (CPI-X) or “incentive” rate-making model.

At this point in time, the United States utilities have divested their UK utility investments, and Scottish Power has agreed to sell PacificCorp. The Scottish Power decision follows the failure of Western states to embrace restructuring and “incentive rates” and problems in the western U.S. wholesale power market triggered by the failed California market experiment. The U.S. utilities’ decision to leave the UK followed problems in the UK’s