In less than a decade, three powerful trends will converge on gas distributors. These trends promise to transform local distribution companies (LDCs) beyond recognition, whether municipal or investor-owned.
Few LDC executives and Board members today care to acknowledge these trends. Many find it more comforting to ignore, deny, or misconstrue their impact. But LDCs, having led a sheltered life, now confront a truly defining moment. These trends represent threats to survival. Right or wrong choices can lead to assertive prosperity or befuddled extinction.Threat #1 - Electric Competition
The electric utility industry ($200 billion a year in sales) is restructuring from a lumbering, high-cost business into a competitive provider of electricity and regulated services. This transformation will create powerful unregulated merchants intent on unearthing every conceivable business opportunity among energy consumers. Transmission and distribution firms will maximize deliveries; commodity power generators operating at high capacity will pump electricity under an array of pricing arrangements tailored to capture market share.
Technological and service innovation will explode. Next-generation metering, billing, and customer service systems will accompany efficient electro-technologies-not just for large industrial customers, but also residential and commercial users as well. This potent combination of customer service and product innovation-anchored by steadily falling prices at the meter-will turn electricity into the energy form of choice. Gas distributors will face threats aimed both at industrial users and their core base of institutional, commercial, and residential consumers.
When the gas executives think of electricity, they tend to focus on independent power generation is an unalloyed opportunity. They overlook the transformation of the electricity industry-potentially an even bigger business hazard.Threat #2 - LDC Deregulation
The third wave of natural gas deregulation is now sweeping over LDCs from California to New Jersey. The first wave deregulated gas at the wellhead and in bulk sales. The second wave targeted pipelines: Ending their merchant role, unbundling their services, and creating property rights in transportation and storage capacity. The consolidation is by no means complete.
Natural gas distribution remains highly fragmented. Almost 2,000 distinct entities populate the business; about half are investor-owned and heavily regulated by state utility commissions (PUCs). The largest LDC accounts for less than 5.5 percent of deliveries to final consumers; the ten largest account for less than 20 percent. The vast majority of LDCs (investor-owned and municipal) deliver less gas than most unregulated gas marketers.
This third wave (deregulation of distribution) will wither away any regulated sales to the middle market (e.g., schools, hospitals, hotels, apartment complexes). The first two waves brought competition to over 80 percent of the components of delivered price paid by bulk users, but only 40 to 50 percent of the delivered middle market price (and, on average, less than 40 percent of the residential burnertip price). The third wave will attack the rest of the delivered price by supplying unregulated merchants with unprecedented access to the middle market meter (to be followed by the residential meter). Incipient unregulated retail merchants will campaign hard to unbundle LDC tariffs. The merchant will operate free from traditional administrative functions, exposing high cost structures of LDCs. These high costs will include: gas acquisition costs, demand charges for firm pipeline transportation and storage capacity, expensive on-system storage capacity, high internal overhead, obsolete but undepreciated portions of the physical plant, and excessive administrative, metering,and billing costs.
Consumer advocates and regulators won't stand still. Rate cases will become increasingly contentious, and reductions in internal overhead will lead to write offs. Dividends and stock prices will quite likely suffer as financial markets grow skeptical about the long-term attractiveness of many investor-owned LDCs. Bond ratings may fall for some LDCs.Threat #3 - Information Technology
Information technology marks the great equalizer. It not only diffuses knowledge; it compresses the response time of consumers and competitors. Institutional strengths become weaknesses. For example, LDC billing and collection systems used to stand as a formidable barrier to entry for unregulated merchants seeking to serve the middle market for gas and eventually the residential sector. No more. LDC billing systems now offer bypass opportunities to incipient unregulated retail merchants.
About half a dozen unregulated proto-retailers already exist. More are likely to emerge. These rising new merchants plan to aggregate hundreds of thousands of middle market meters and then millions of residential meters once the middle market falls. To accomplish this goal, they are developing sophisticated next-generation billing, collection, and customer service systems. These systems will boast features no LDC system can duplicate just by tinkering around the edges, such as:highly customized invoicing;
tailored pricing and payment terms;
component billing from wellhead to burnertip; and
automatic disbursement for gas supply, transportation, and storage services.These customized information services transform the gas bill from an accounting document into a business tool for customers or competing merchants. They increase the productivity of financial capital; they convert physical assets into mere commodities.
Response #1 - Merge
Wall Street will invariably counsel its LDC clients to merge, acquire or be acquired. This advice is understandable, since it generates fees for investment bankers and securities lawyers. Acquisitions cater well to the professional pride of executives, but don't always solve problems. A merger of two flawed strategies or two uncompetitive companies or two obsolete corporate cultures may prove worse than keeping the firms apart.
Nevertheless, some corporate combinations do make sense for LDCs. A merger may allow an LDC to strike a bargain with State regulators to recover the acquisition premium over book value-a common desire in utility merger cases. Recovery might be achieved through credits generated by incentive rate making or trimming the cost of capital through a reconfigured balance sheet. Or, the LDC might join with regulators to cut risk by shedding the merchant function or perhaps even firm transportation and storage capacity on interstate pipelines.Response #2 - Reposition Inside
Precious little value remains in gas commodity sales or bare transportation; the value has migrated to knowledge end-i.e., how to make commodities useful to consumers. The gas molecule itself is not the product; the product arises instead from the portfolio of services that can be stapled to that gas molecule.
Energy consumers do not want energy per se, but the benefits that using energy bring. These benefits (and their perceived value) differ not merely by type or category or consumer, but by individual user. In the years ahead, the greatest asset available to an energy services company will come from a current and comprehensive knowledge about each consumer. But very rarely will an LDC conduct an "exit" poll to fathom why a customer has fled its sales tariffs or high-cost storage rates. LDCs often grow sullen at the loss of a middle market user who sends business to an unregulated merchant. When coupled with the loss of the burnertip, this negative attitude virtually guarantees that the LDC will never grasp the changing needs of middle market buyers.
Each LDC will hold a unique set of core abilities and corporate weakness that will define the pace of change. Further, each LDC must choose from many different options for internal repositioning:(i) Phase out the regulatory bargain. As consumers go elsewhere, phase out all regulated sales by a date certain (including sales to residentials) and file unbundled non-sales tariffs in return for the freedom to offer non-commodity tariff services.
(ii) Write off losers. Abandon or sell portions of the distribution system and physical plant; use the proceeds to finance and include in rate base the cost of the most advanced information technology needed to offer non-commodity tariff-based services.
(iii) Milk the winners. Gain the right to spin off innovative or proprietary services developed within the rate base to non-regulated subsidiaries operating outside the service area, provided rate payers are compensated appropriately.
(iv) Customize tariffs. Offer a portfolio of knowledge- or system-based tariffs, such as physical flow interruption insurance, least-cost route scanning, or system balancing for private retail merchants, large-user shippers, or small-user buying cooperatives.
(v) Straddle the city gate. Offer services such as capacity acquisition for consumers behind the city gate (i.e., a gas travel agency service); storage capacity leasing outside the city gate, physical storage inside the city gate, or contract storage via gas banking programs.
(vi) Offer virtual pricing. Offer hedging for those who can't do it themselves. At regular intervals the LDC would receive from or pay to consumers the difference between (a) a prearranged price and (b) the sum of (1) the cash market city gate price as quoted by wholesalers, (2) a previously agreed upon retailing mark up, and (3) LDC transportation charges relevant to that consumer.
(vii) Upgrade billing. Develop next-generation systems: metering, acquisition of delivery data, billing and collection, and automated customer service and volume reconciliation. Take a look at natural gas credit cards for small business and residential users.
(viii) A lender be. Build rate base with a consumer financing service. Three options arise: (a) short-term collateral lending to smooth out cash flow; (b) seasonal financing of gas in storage or for large shippers; (c) long-term leasing and financing of gas-fueled projects for environmental compliance.At one extreme, the LDC can be satisfied as just a competent and courteous trucker for large users and shippers providing stripped down transportation from city gate to meter. At the other, the LDC can be a non-commodity merchant of a full-service package of transportation, insurance, financing, technology and knowledge. Repositioning can make the LDC the energy company with a thousand faces and a million profit opportunities. The obligation to serve will evolve into the obligation and the desire to be of service. There will then be no captive consumers, only satisfied customers. The rate base will become a very attractive portfolio of physical, financial and intellectual assets. The return on this rate base will combine a utility annuity with enterprise rewards.Response #3 - Diversify Outside
As with all strategies, diversification outside the rate base and the regulated service territory works best if done selectively but leads to woe if performed carelessly. The best opportunities for most LDCs reside in niches lying in and around the energy industry, because LDC executives can either readily learn about these businesses or grasp them intuitively. LDCs have not done well in areas unrelated to energy, such as real estate, or in capital-intensive commodity plays such as coal mining, timber, oil and gas exploration, or hard rock mining. They have written off hundreds of millions in such forays-unable to add executive or entrepreneurial value to upstream energy production or non-energy commodity businesses. This problem will carry over to independent power production during the 1990s, when the numbers will change and dozens of independent power projects could wind up stranded like so many shut-in gas wells.
The most successful diversification opportunities will fall within the range of $5 to $25 million of equity per transaction. This range affords incremental investment, permits the creation of a portfolio of related opportunities and avoids the historical error of exposing capital to one or two large business bets. The investment vehicles will vary widely: internal startups and spin offs, second-stage investments in young niche companies, taking over a small- to medium-sized private company whose growth is limited by inadequate capital or management, or acquiring a friendly controlling interest in a "small-cap" public company (capitalization less the $50 million) that operates in an appropriate business segment.Response #4 - Build a Fortress
Many LDCs will find it tempting to rely on rate design to thwart competition and frustrate customer choice. While conceding the public policy issues of open access and comparability of service, LDCs understand the devil in the details. Property structured, tariffs can deny real choice to consumers in the residential and middle market segments and genuine access to non-regulated competitors.
As a strategic option, fortress rate design was tried unsuccessfully by certain interstate natural gas pipelines during the late 1980s and early 1990s, but that failure might not deter some LDC executives. Rate design tinkering can fight off competition when the state PUC is understaffed or distracted by other issues (e.g., telecommunications and electricity restructuring). Or when residential, institutional, and small commercial customers account for over 50 percent of system deliveries. When the LDC serves few large industrials (and those it does have already negotiated special treatment on transportation and storage). When middle market consumers lack an organized voice (almost always true). When unregulated wholesalers and retailers haven't yet arrived. Or when the home state is small, with only one or two politically powerful LDCs dominating the distribution business.
Some common fortress rate design techniques include high monthly fixed meter charges for transportation customers, prohibitive imbalance penalties, onerous credit requirements for shippers, denying load pooling to middle market consumers (blocking system balancing for the emerging non-regulated retail merchants), overallocating interstate charges to LDC transportation rates, making it difficult to obtain necessary metering and dispatching data and back-up service; setting exorbitant winter storage service rates, and giving preferential treatment to transportation customers who acquire brokered interstate transportation capacity from the LDC.
Fortress rate design can and will succeed as an expedient but temporary solution. Some LDCs may lean on this strategy to prolong the transition to retail deregulation and competition. But it won't prepare LDCs for the day when unregulated merchants and outraged captive consumers smash the rate base and storm the Bastille.A Time To Change
The rate base today is something to build on, not live on. The LDC rate base, as we have known it, is melting away. It cannot be frozen in place. Those LDCs who recognize this fundamental truth will become something new: A hybrid energy services company with a regulated logistical franchise and an unregulated brand name. Those LDCs that fail to evolve will disappear-their managers scattered and their very name forgotten. For some, a mere two to three years remain before it is too late. None enjoys so much as a decade's grace.
Vinod K. Dar is Chairman of both Jefferson Gas Systems, Inc., a private investment company, and its electric subsidiary, Jefferson Electric Inc. He also serves as Senior Advisor to RCG/Hagler, Bailly, Inc., an international energy and environmental consulting firm. As industry executive and private consultant, Vinod Dar he has written over 100 articles and given over 70 speeches on the strategic and management issues facing North American energy companies.
The vast majority of LDCs deliver less gas than most unregulated marketers.LDCs have not done well in capital-intensive commodity plays such as coal mining, timber, oil and gas exploration, or hard rock mining.(Sidebar:)
LDC Core Assets
Access to consumers
System operating knowledge
Monopoly over physical gas movement (to all but largest customers)
Rights of way
Large cash balance (sometimes)
LDC Core Weaknesses
Stale corporate culture
Decisionmaking by committee
Ignorance of customer needs
Mistaking rate design for pricing
Obsolete billing software
Fragmented physical systems (sometimes)(Sidebar:)
Winners for the 90s
Unregulated gas and electricity marketing
Measuring and metering technologies
Billing and collection systems
Gas gathering, treatment and processing
Second-generation market area supply hubs
Needle peaking market area storage projects
Gas-fired peaking generation (markets with transmission bottlenecks)
Fuel procurement (as an outsource vendor)
Gas vehicle fueling stations
Vehicle fleet conversion
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