The energy utility supply base historically has been a built-in shock absorber on rate increases, a place where continuous improvement could occur and price concessions extracted. Today, however, as we move into the top of the cycle for the utility infrastructure buildout, the supply market has turned on utilities with a vengeance. The twin shocks of rising commodity prices and emerging labor scarcities have all but eliminated the “low-cost bid” era. Utility project managers everywhere are asking, “How do we explain these budget increases?”
Economic forecasts are mixed as to what 2007-2008 will bring, although there is an increasing consensus that recessionary forces are at work. Earnings softness coupled with rising interest rates and overvalued global-equity markets likely will lead to downward pressures on U.S. GDP growth. Thus, 2007 likely will see base materials and finished good prices increasing overall, but at much slower rates and with greater volatility than in 2006.
Recent declines in petroleum prices and related reductions in energy costs may work to stave off a slowdown. The problem lies in an uncertain Middle East, where virtually all of the infrastructure is supporting global demand and excess production is concentrated in Saudi Arabia. Any supply disruptions such as a hurricane create exaggerated price volatility, amplified by global demand that continues to outpace the introduction of new supplies.
Global demand also will continue to keep metals pricing high. Copper, aluminum, steel, tungsten, zinc, and other industrial metals will continue the historically high pricing curves seen in 2006. Although prices have come off somewhat, the fundamentals mirror the petroleum sector, with demand outpacing new supply.
U.S. labor costs are the hardest of all to predict. The federal government reported a 2006 unemployment rate of 4.6 percent, down from 5.1 percent in 2005, and it expects the rate to hold relatively steady in 2007. A raise in the federal minimum hourly wage from $5.15 to $7.25 and the looming scarcity posed by an aging workforce are major uncertainties. Will labor scarcity tied to retiring baby boomers become a real issue or another “Y2K scare”? In practical terms, an aging workforce will be less productive and tightening labor markets have the potential to drive wage costs higher.
To assess the future talent outlook for critical energy utility jobs, it’s important to start with facts on several fronts:
• Quantifying the entry and exits of workers in key industry jobs over the next 10 years;
• Identifying the approaches and strategies of major peer companies and analogous industries for filling critical talent gaps and managing the loss of knowledge; and
• Preparing one’s utility for the challenges of workforce planning and talent strategy development.
An aging workforce is an issue facing most energy companies worldwide. Our research, data, and experience with clients indicate that managers should consider the implications for both company employees and their key supply-chain partners.
For utility procurement teams facing a sellers’ market, a portfolio of change initiatives can prevent purchased goods and services from becoming the highest-growth cost center. The following five strategies should prove effective in coping with turbulent supply markets.
1. Build Out and Integrate Your Supply Market Intelligence Function
Have a plan to stay informed of volatile price movements, as a more interconnected global economy will amplify price-volatility curves. Procurement teams need to stay informed of changes affecting spending categories, and especially multi-year projects, on a weekly and monthly basis. Historically, such intelligence has been undervalued and often lacks the necessary expertise.
Develop cost models for specific spending categories and major projects that weights pricing trends of specific categories. Integrate this total-cost view with periodic cost reporting. Only with a total-cost model can one accurately predict the impact of a commodity price movement to spending categories. Only when asset managers pay attention to the impact of commodity price swings will this intelligence find a home. This last thought suggests the need to build stronger relationships and trust with asset managers.
2. Diversify the Supply Base to Foster Competition and Improve Security of Supply
Break down old biases surrounding the preferred supplier network. Most utilities have the opportunity to qualify new suppliers and help operations teams understand the value of new sources. This requires a more open-minded approach, as well as reducing the complexity of many supplier-qualification processes.
Take off-shoring seriously as well. Leading companies in many industries have developed and tailored global sourcing strategies. Airlines and manufacturing companies, for example, have made significant progress in identifying appropriate products to be sourced globally. They have developed the supporting supplier management infrastructure to manage off-shore projects successfully and are reaping the benefits.
Utilities have a significant opportunity to move domestically produced products to low-cost countries. Product specifications are precise and well written and can be produced easily. A few good candidates are any type of steel or metal items, components or sub-assemblies, poles, pole line hardware, and commodity plastics such as PVC pipe. (To be sure, managers also need to pay attention to “buy local” pressures in their regions.)
Although opportunities exist in other geographies, China is the primary source for international procurement. In addition to the short-term cost benefits, many companies are attracted to China because of the longer-term potential for a permanent structural reduction in supplier costs.
China offers tremendous advantages to an off-shoring program. But utilities should be careful in how they pursue off-shoring. They should develop core competencies in this area and slowly expand their footprint around a core set of purchase categories and developing markets that offer long-term upside.
3. Identify and Realize Specification Changes to Offset Escalation
Understand where changes to design specifications will bring supply-base leverage. The “design basis” for most energy utilities is steeped in tradition and generates tremendous passion among the engineering and design ranks. Yet in most cases, traditional design standards for everyday applications like substations, transmission lines, and distribution feeders are relatively static. This is particularly true for the underlying bill of materials.
There is a major opportunity to offset commodity-price escalation with material specifications that are tied more closely to an OEM’s scale economies. Rather than shop your tailored material specifications, adopt material standards that comport with the industry. You can use a similar approach in supplemental labor markets, where utilities should pay closer attention to work methods prescribed by large contractors.
4. Establish Strategic Supplier Alliances
Today’s competitive dynamics call for a strategic-supplier relationship that goes beyond a “lowest price” relationship. Supply challenges of the past two years have been a rude awakening for companies maintaining a price-focused procurement strategy.
Both customers and suppliers are interested in such alliances. But these require capitalizing on product redesign and innovation. Sourcing organizations should focus more on value engineering and benchmarking activities in the sourcing process to identify product specification, design, and substitution opportunities.
Strategic supplier alliances can be applied equally to services spending, an area that has had less attention than materials/ products sourcing but that holds tremendous opportunities for value engineering. Tactics for unlocking this potential include creating a formal process for supplier development; involving suppliers as equal team members; engaging in “margin deconstruction” to fully understand service providers’ costs; and working with internal users to simplify their requirements. Many of these value engineering opportunities require changes on the utility side, so managers should be open to change where warranted.
5. Consider the Power of Outsourcing
Begin to develop the competencies needed to outsource. The U.S. market for business process outsourcing (BPO) is growing at 20 percent annually, and most providers in this area focus on providing transaction-intensive, back-office services in the areas of human resources, finance and accounting, supply chain/procurement, and administration.
The market is evolving toward integrated business process and technology service providers. Utilities generally lag behind other industries in evolving their business models to accommodate the benefits of outsourcing.
BPO has two main levers for improving costs and efficiencies—cost savings and efficiency gains. On the cost-savings side, labor arbitrage (the spread between the utility’s and outsource provider’s wage structure) contributes substantial, near-term savings. On the efficiency side, BPO providers tend to employ the latest automation technology, which they view as a way to grow revenues. As a result, cost containment here could be substantial without sacrificing service quality.
Several trends will plague utility procurement teams for the foreseeable future. Global economic growth, particularly in China, India, and other developing nations, will continue over the long term. A combination of scarcity and environmental concerns will amplify price disruptions to fossil fuels, industrial metals, and power prices. Last, building out the infrastructure with an aging supply base that lacks depth will invoke further price escalation.
Each element of the energy utility infrastructure build-up will be affected by cost increases. Perhaps the biggest effect will be felt by the next generation of nuclear power-plant developers. The supply base needed in the nuclear sector suffers the additional burden of not having built a new plant in three decades. Capacity for these sophisticated units and the underlying supply base technologies could be tapped out after as few as two or three new units. This capacity will be further eroded by potential nuclear-plant construction in China.
The rules of the game have changed. It is time to adapt and change procurement strategies and tactics in response.