but outsourcers could be cutting in.Wholesale competition and the prospect of competitive retailing are leading many electric utilities to turn their distribution activities into discrete business units. But the emergence of the "DisCo" as a distinct entity may only mark the first step in a more radical disaggregation.
Why the distribution business may see radical change isn't immediately apparent. Electric utilities staking out positions in the emerging electricity commodity markets will be tempted to view their DisCos as a source of dependable cash flow and, perhaps, as durable brand franchises that will continue to retain significant local market shares in the event of retail competition. In contrast to generation and retailing, distribution looks safe and staid. It remains a natural monopoly (it will rarely make sense to duplicate pipe or wire), and will likely continue subject to local regulation. Functions (such as marketing) that are critical to survival under retail competition are migrating to other parts of the utility.
Nevertheless, electricity distribution, along with gas distribution, remains a mammoth industry. With the wholesale commodity value of kilowatt-hours and therms removed, the distribution industry in the United States still generates revenues of about $50 billion in electricity, and $25 billion in natural gas. Most of these revenues, arguably, represent the value added from energy distribution (em and compensation for a wide-ranging and complex set of activities. In the electric utility industry, distribution represents only one-third of the assets, but half of the employees and an even larger share of the collection of
technologies and skills involved in creating and delivering kilowatt-hours.
Yet energy distribution remains both highly fragmented and vertically integrated in ways that leave open possibilities for changes as dramatic as those taking place on the commodity side. There are over 200 electric and gas utilities in the United States with over 100,000 customers each; none has a market share in fuel sales of more than 4 percent. Still, these companies maintain internally virtually all of the functions and capabilities required to procure, transport, meter, bill, collect payment, and initiate and terminate energy service.
A number of forces will lead the vertically integrated DisCo industry to restructure, most likely along more horizontal and functionally disaggregated lines:
s Unbundling. As in the State of New Hampshire's pilot to test retail competition, markets that embrace customer choice of supply are likely to develop pricing structures that involve unbundled distribution charges, either on a fixed or per-kilowatt-hour basis. These markets will allow the emerging wires businesses to claim identifiable revenue and profit streams that are independent of the generation or retailing operations (em the first step toward developing distinctive business strategies.
s Performance-based Ratemaking (PBR). Price caps or other forms of PBR will allow distribution utility shareholders to benefit from improvements in operations & maintenance (O&M) efficiency, by allowing them to achieve higher rates of return than those allowed traditionally, and by coaxing them to seek more optimal mixes of O&M expenses and fixed-asset investments.
s Technological Change. The decoupling of distribution asset investments from guaranteed returns will 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). While they must demonstrate that capital investments will improve power quality and reliability, the magnitude and nature of such investments is left for the distribution companies to determine; there are no such things as "regulatory assets." Indeed, the rapidity and the extent to which specialized distribution businesses emerge in the United States will depend partly on the degree to which states adopt new means of inspiring local distribution franchise operators to become efficient.
The Shape of Business to Come
As there will be a variety of specialized distribution businesses, some leading competitors will likely come from outside the ranks of existing utility operators, and include current contractors, equipment suppliers, and service bureaus to other industries.
The new businesses may take shape earliest in those distribution functions that are experiencing rapid technological change or that must become more complex to accommodate retail competition. For example, utilities will need new customer information and billing systems, and new metering technology, so that retail electricity suppliers can offer a variety of pricing and service options, including real pricing and consumption measurement. But utilities remain uncertain as to how soon these new capabilities will be needed, whether local distribution companies will deploy them, and if so, how DisCos will charge for them. As a result, few utilities have committed to building such systems.
Utilities that do wish to leverage their own operations by competing in the emerging distribution businesses may face some disadvantages if they go it alone. First there is the problem of selling services to other utilities that may view them as competitors. Then there is absence of experience in, and a culture that is comfortable with, competition. A specific operation's excellent performance, capabilities, and cost-effectiveness do not automatically translate into competitive success or profits in obtaining or performing service contracts with outside customers. A first-mover whose capabilities may lie in the middle of the pack, but who uses the experience of bidding and performing early contracts to build a competitive service organization may enjoy a greater likelihood of success than the leaders in today's benchmarking comparisons.
Of course, not all of the new businesses that emerge will prove attractive. Utilities will likely want to be selective about which businesses they enter, and avoid those (em such as manual meter reading (em that involve little opportunity to leverage scale, technology, or geographic diversity.
To stake out a position in the looming, specialized distribution businesses, utilities can pursue several alternative strategies other than going it alone.
s Spin out functions as profit centers or business units. These businesses could start by serving the distribution franchise's internal needs, using outside contractor bids or prices to establish market prices for the service contract. Once the managers at these divisions had proven their ability to earn acceptable returns as stand-alone profit centers, they would be encouraged to compete in the market at large. Granting existing employees a share of equity in the new ventures would provide them and their unions with an incentive to support the restructuring and would ease the pain associated with downsizing.
s Pool specific functions with other utilities. This approach presents an alternative to wholesale mergers and may be especially appropriate for functions that will require new investment in assets such as software or communications networks that are highly leverageable across volume scale. There is danger, however, that the pooled entity will simply serve a larger protected market, yielding the benefits associated with greater scale, but not those that can only come from competition.
s Take equity in return for contracts. Utilities can take advantage of the fact that many companies, including existing vendors to the industry, will want to enter the new service businesses. By being an early outsourcer, a utility could extract equity ownership in the new business, in return for helping its partner establish a market presence. An advantage of this approach is that the utility can choose to align itself with companies likely to be the strongest competitors. One disadvantage: The partnering company will likely only give up a small equity share.
Participating in the "virtualization" of the industry is not incompatible with outright mergers with other distribution utilities. A company with functional businesses that serve other distribution franchises would be well positioned to gain from a potential acquisition (em it would have the experience to know what operational efficiencies and contractual profits it could bring. Conversely, generators seeking to acquire local distribution franchises as outlets for their power need no longer be as concerned about how best to achieve operational efficiencies in distribution operations; their third-party services suppliers will be pleased to provide competitive solutions.
The virtual path may not appeal to everyone, but there will be pressures to take it. Current vendors of hardware or technology will need to assess the likely pace of market evolution for specific services, their own willingness to take on some of the responsibility for assuring local electric or gas service reliability, and how to approach long-time customers (em who may themselves become competitors. If they choose not to participate in the new service businesses, they may face increased buyer concentration from their customers who do, with resulting pressures on prices and profit margins.
Regulators who have balked at performance-based regulation in the past may also be uneasy about the diffusion of responsibility for network reliability or consumer satisfaction that might accompany the virtual utility. The U.K.'s Regulator has overcome this objection by instituting uniform national service standards for all electric distribution franchises. It is unclear whether state commissions in the United States will be willing to set similar standards.
Utilities considering whether to take their own capabilities to market will need to weigh the potential for new revenue and profit against the risks and costs of dramatic organizational and structural change and of outright failure. Alternatively, they could also become virtual utilities without competing in the emerging distribution businesses; the other players would be happy to have them as customers. t
Corey Stone is vice president and managing director in the Stamford, CT, office of Easton Consultants, a management consulting firm.
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