Few companies achieve sustainable high performance. Markets change but companies fail to adapt, and investors are unforgiving. Utilities, and new entrants, learned this lesson during the first competitive market cycle of the late 1990s and early 2000s, when few companies sustained a high-performance leadership. In fact, only two companies, Equitable Resources and Entergy, reached and maintained a total return to shareholders in the top 10 percent over this period. That is entirely consistent with performance across the broader S&P 500, where only 1 in 10 companies outperformed their peer group over a 10-year period. Sustained growth is elusive. From 1955 to 1995, only 1 in 20 of the 172 companies in the Fortune 50 achieved real growth of more than 6 percent.
To meet performance expectations, utilities and other capital-intensive industries have tended to focus on improving operational effectiveness and reducing operating costs, reflected in the "back-to-basics" trend among utilities over the past few years. This approach will improve performance in the short term, and can lay the foundation for redefining the operating model of a company. However, it is only part of the picture, and is unlikely to yield sustainable value creation. In capital-intensive industries, these types of efficiency improvements often are needed simply to maintain the current position on the supply curve, as evidenced by flattening cost curves in industries like petroleum refining and paper production. Any gains quickly vanish as all players make similar cost improvements.
Utilities are no different. Having experienced the wholesale market collapse and the "back-to-the-basics" traditionalism that followed, utilities now are faced with the challenge of generating meaningful, sustained earnings growth. With limited growth options, and generally low-risk tolerances, what will separate the leaders from the others?
Capital management is one of the primary differentiators in the utility industry. Where and how utilities deploy capital will have a major impact on earnings, productivity, and system reliability. But because it is more difficult to assess and measure, capital management is underused in achieving differentiated performance and sustainable competitive advantage.
Effective capital management requires robust strategic management and performance processes. While the importance of capital management may be obvious at one level, it breaks a traditional paradigm that all capital investment is good under rate-based regulatory regimes. However, the environment has changed. Lengthened duration between rate cases, greater downward pressure on allowed rates of return, and increased deregulation and competitive market participation have disrupted this paradigm.
Consequently, leaders increasingly aspire to best-practice capital management processes, often following leaders in other capital-intensive industries.
The importance of capital management is borne out by an examination of performance through the recent competitive market cycle. Capital efficiency was the most consistent defining characteristic of better performing utilities during the recent market cycle, and the only performance trait common across high performers in all competitive segments.
High performers had an average total return to shareholders (TRS) over the period of approximately 15 percent, with an average return on invested capital (ROIC) spread of 2 to 3 percent, versus the industry average TRS of 3.2 percent and average ROIC spread of close to negative 1 percent. Empty growth was common. More than 50 percent of the industry had returns on invested capital that were less than their weighted average cost of capital over the period from 1999 to 2004, though more than 70 percent saw positive revenue growth. And these unsettling ROIC trends continue ().
Higher performers fell into two groups based on the variables that most statistically predicted their TRS performance over the study period. These two groups are what we have called capital-efficient operators and profitable growers.
This performance can be contrasted against the bulk of the industry that we refer to as balanced regulatory managers with an average TRS of 6 percent. The majority of companies showing positive TRS performance fell within the capital efficient operator segment. Its lower TRS performance, relative to profitable growers, reflects some market skepticism of the value story of the diversified energy companies and the often higher current capital investment requirements to implement their strategies.
Why is effective capital management becoming increasingly critical? The industry rapidly is approaching another period of supply-side disruption and volatility while capital demands across all business segments are increasing concurrently under the need for new supply, replacement of aging infrastructure, environmental compliance, etc. This demand for capital is exacerbated by increasing interest rates and balance-sheet limits on capital.
Despite the importance of capital efficiency to high performance and a relatively aggressive "back-to-the-basics" focus on operating performance, capital management has not been addressed comprehensively by the industry. Rather than looking at the broad management and governance issues associated with effective capital management, it typically has been addressed as a budget-cutting, micro-prioritization exercise—often disconnected from its impact on long-term, bottom-line performance.
Effective capital management cannot be achieved in isolation. Capital management is part of a broad and inter-related set of management and governance processes. This set of processes typically is referred to as portfolio performance management. Portfolio management processes are the common thread between strategy and execution—and hence, are a key enabler of market success. The ability effectively to allocate and reallocate limited capital across businesses and functions is a key differentiating characteristic of high performers in capital-intensive industries.
Our experience with multiple types of capital-intensive industries suggests that most utilities lack best-practice capital management practices. The challenge is not one of simply adjusting the particulars of capital planning, i.e., hurdle rates, plan/request formats, and timing. The challenge encompasses all aspects of corporate governance and management. It involves the complete set of performance-management and corporate-governance processes, including strategic planning, capital allocation, asset management/optimization, and performance measurement/incentives. Four integrated areas should be addressed to achieve top-tier capital management:
Few utilities do this well, i.e., planning and managing performance by looking primarily at operational performance and O&M costs, with little emphasis on getting the most out of their capital dollars. The traditional planning and budgeting process fails to drive a comprehensive look at capital needs, links them ineffectively with outcomes, and does not facilitate appropriate tradeoffs at each level of the organization. There typically is a heavy emphasis on budgets, disconnects from strategic plans to resource allocation, poor business unit-level planning, and insufficient emphasis on shareholder value-based measures.
A recent Accenture survey of corporate executives revealed that close to two-thirds are unhappy with one or more aspects of their corporate-planning processes. The highest level of dissatisfaction was with the disconnect between strategy and capital allocation.
Building these capabilities is not a challenge of infrastructure, or even technology, but rather a challenge to change how we do business and measure performance. It challenges executive accountability and requires analytic rigor. The largest hurdle often is mustering the political will to address processes that hit so close to home for many executives.
When these problems are addressed as part of a broader improvement program, the results can be impressive. Of course, one must remember that while operational improvement programs yield results, these improvements often are relatively short lived. The solutions to sustain the improved results generally are lacking. Ultimately, increasing costs and performance reductions creep back. When corporate performance management strategies are addressed concurrently the result is more long-lasting, yielding more sustainable results and reduced performance volatility.
A key example of this is illustrated by one of the consistent high performers in our analysis, Equitable Resources. While we can debate all the drivers of Equitable Resources' performance results, one thing does stand out. In the mid-1990s, Equitable, suffering under poor performance, moved to incorporate Shareholder Value Analysis (SVA) and increased attention to SVA drivers such as ROIC into its management processes. The result has been an ability to anticipate markets and effectively allocate and reallocate capital in anticipation of market cycles where it has produced optimal returns.
For most utilities, the weaknesses in the portfolio management processes reflect their overall governance model. Most utilities historically have had an operational focus, whether on generation or T&D. This operational management style works well in smaller enterprises and under paternalistic regulatory regimes. However, as utilities increasingly are exposed to competitive pressures, lengthened regulatory cycles, and increasing capital demands, decision-making becomes more complex and the focus on shareholder value increases.
We continuously observe this operational management mindset in utilities. The utility focus on budgeting rather than planning is a key characteristic mentioned here. This operational focus also manifests itself in misaligned plans across organizational units and the use of metrics and incentives that do not accurately reflect relative organizational contributions and joint accountabilities. Effectively instituting and managing a best-practices portfolio-management process, and hence capital-management process, requires a fundamental shift in the management/governance style of the company.
Competitive companies most often employ corporate models that reflect one of three options based on the level of corporate-center control. For utilities, where business-unit integration and management often is key, a governance model more closely reflecting that of the strategic manager is appropriate. As a company acquires multiple utilities, for example, it might evolve toward the strategic architect or financial holding model. For example, Mid-American (Berkshire Hathaway) reflects more of the financial holding mindset toward utility ownership and management.
To move from an operational to a strategic focus requires a clear understanding of the key decisions made, who needs to participate in the decisions, and who has final authority. At the same time, it simplifies decision-making and ensures integration by making sure the "right" people and inputs are involved in the process. This also provides a key cultural benefit by de-emphasizing the often slow and disjointed consensus decision-making process, and begins to instill performance-based culture tenets on the executive team.
Asset optimization is critical to implementing operational strategies at the tactical level. A utility can have the best capital management processes at the corporate level, but if it is not proficient making day-to-day spending decisions and tradeoffs, performance will lag.
The ability to balance disparate performance and operational objectives requires new approaches to asset management/investment decision-making within the utility. This is particularly acute in transmission and distribution (T&D). In T&D, the demand for capital to replace aging infrastructure is especially high, as many T&D systems in North America were built up in the 1950s, but T&D capital replacement programs were cut in the 1990s to help fund competitive market investments.
Three fundamental asset optimization capabilities should be addressed:
Investment management effectively manages the trade-offs among performance, risk, and total lifecycle cost. Keys to achieving effective investment management are robust processes, organizational and governance structure within the organization supported by information and toolsets that enable effective decision-making. The investment management capability is fundamental to the effective development, tracking, and reporting of capital and operating spend, balanced against factors such as system performance and risk.
Information management is a key enabler to investment management. It defines and manages the information needed to fuel fact-based, data-driven decision-making to optimize asset spend. Typically, there are a large number of information sources and models that support decisions, and these must be properly integrated, aligned, and often expanded.
Technical management is the capability to develop, implement, monitor, and review commercially and operationally astute technical policies, procedures, and specifications—the drivers for the majority of spend within T&D. Typically, between 60 to 80 percent of T&D spending directly or indirectly is affected by these policies, and historically, policies have been treated predominantly as only a technical, rather than a commercial, consideration. Technical management can be a differentiating capability by treating policy development and execution with a "commercial lens," complete with business cases, to translate corporate philosophies on risk and performance into tactical execution.
Most capital-intensive industries embrace asset optimization decision making at the tactical level. For example, when Chevron discovered that it was spending more than its competitors to execute major projects, it developed a rigorous process to manage all capital investments. The Chevron Project Development & Execution Process (CPDEP, nicknamed "Chip-dip") contains five very well-defined phases. The first three are designed to ensure that an organization fully evaluates a project's worthiness. In a 1998 interview, Vice Chairman Jim Sullivan observed that without sufficient "front-end loading" focused on evaluation "you might select the wrong project, and even if you build it well, it will still be the wrong project." Today CPDEP provides a common language across Chevron, and engineers at all levels of the organization are trained on the methodology that can be applied, with different levels of rigor, to all projects, from a $500,000 "in-kind" equipment replacement to a $1 billion deepwater platform.
Several North American T&D utilities are starting to embrace asset optimization, and it has become institutionalized at many UK and Australian utilities. These companies have seen sustainable reductions of total expenditures (cap-ex and op-ex) in the range of 10 to 15 percent (which are frequently re-invested back into the business) from:
Performance measurement is the final, and most important, piece of the puzzle. An effective measurement scheme serves as the glue holding the processes together and helps drive maximum value creation. Performance accountability often is insufficient across an organization. Metrics typically do not:
Performance measurement involves a rigorous process to roll down metrics in an integrated, progressive manner from strategy throughout the organization, ultimately to individual incentives. In the process, metrics must clarify organizational boundaries and responsibilities down to the individual level. Metrics should be linked to all dimensions of SVA and ROIC, with the typical focus on EPS reduced. And the metrics should be designed top-down.
While utilities are dedicating significant attention to restructuring their balance sheets and pursuing operational improvements, little attention is being paid to the overall capital management and decision-making models. The pieces of an effective process invariably exist within a utility, but few companies excel at all dimensions. And even fewer effectively integrate the processes.
Increasing exposure to competitive markets and uncertainties puts an increasing premium on the effective use of capital. The experiences of the past six years bear this out. Without attention to the capital management and the comprehensive portfolio management processes that support it, sustained high performance will be elusive.