Future Imperfect: Managing Strategic Risk In an Age of Uncertainty

Deck: 

Part 1 of a 2-part article explores new technologies most likely to influence competitive success.

Fortnightly Magazine - January 2007

When fighter pilots list the advantages of one combat aircraft over another, they do not speak primarily of speed. Rather, they refer to the ability of one aircraft to “turn inside” another, to negate other aspects of performance with a superior turning radius. (Figure 1 shows the contrails of the newer F-16 turning inside the vintage F-4.)

For the utility industry, fundamental changes in technology, markets, or regulatory requirements can “turn inside” the ability of companies to respond, as long-lived investments and choice of fuels lock them into their strategic choices for decades. In the meantime, such changes can expose shareholders and customers alike to unnecessary strategic risk if they are left unattended. This article proposes ways for utility leaders to understand strategic risk better and manage it more effectively.1

Part 1 of this article sets out the problem—the essence of strategic risk, its consequences for the unprepared, and the implications for utility companies. Part 2 will show how utility companies can manage, but never eliminate, strategic risk by using real options analysis and scenario planning, and by building a culture of open inquiry.

Thinking Differently

Though we tend to think of risk as the monster under the bed, it often appears in the most pleasant of disguises—success. One story—told from the perspective of the victim, Western Union— illustrates how a powerful and successful market incumbent can succumb to risks that spring from a flawed strategic logic. On Jan. 27, 2006, Western Union sent its last telegram, and the company whose name had become synonymous with telegraphy left the business—though in truth, there remained very little business for it to leave. This exit marked the end of a protracted decline that began with a strategic decision to focus on the core telegraph undistracted by any capabilities in telephony.

It was 1879 when Western Union sold its formidable telephone business to a small, start-up company built around the inventions of Alexander Graham Bell, gaining in exchange royalties and a non-compete agreement from Bell. Historian George David Smith notes how this choice focused Western Union’s strategy on its highly profitable core, telegraphy, and on the market for long-distance, business-related communications.2 To serve this market, Western Union’s leadership fixed upon the notion that wire communication was not about interactive conversations, especially social conversations among individuals, but rather about bursts of terse data—analogous to e-mail. Further, they had become convinced that telephone technology could never improve to offer voice-grade conversations over long distances. Thus, the company concentrated on delivering its standard product to its best customers—and chose exactly the wrong thing to do. No amount of focus in execution could redeem this flawed logic.

The Western Union experience speaks to the enduring power of technology to inflict strategic surprise. We see this power today in the contemporary telephone. Today the incumbent telecoms, heirs to the Bell legacy, find their market attacked by technologies that send voice signals over an Internet connection (termed voice-over-Internet-protocol, or VOIP). Do similar strategic surprises stalk the electric utility business today?

The Technology Dimension of Strategic Surprise

A qualitative assessment of emerging technologies can help identify those that might prove decisive in some future competitive environment. Consider the framework for analysis in Figure 2, a matrix that relates the growth potential of a technology to its effect on the business model of a regulated electric utility company. This framework provides the strategic leadership of a company with a systematic way to debate and understand the inherent capabilities of the new technologies most likely to influence competitive success.

The horizontal azis divides the universe of relevant technologies into those that reinforce the prevailing business model and those that could overthrow it. The vertical axis divides the relevant technologies into those with high potential for performance growth and those with limited growth potential. Into each quadrant, I have sorted examples of technologies to illustrate how this framework can raise important strategic questions. The sorting process requires many judgments, and reasonable persons might well disagree with the assessments in Figure 2. But the value of this (or any similar framework) resides less in the precision with which technologies can be sorted and more in the quality of strategy debate that attends the sorting. Below, let’s consider the implications of each of the four quadrants.

The Quiet Life. Technologies judged to fall within the southwest quadrant of Figure 2 generally sustain the current market relationships and hence the business model of the regulated electric utility. Consider, for example, a modern, state-of-the-art power plant fueled by pulverized coal. Though such power plants are technologically sophisticated, the potential for efficiency improvement is bounded by the ability of materials to withstand high temperatures and pressures and by the Second Law of Thermodynamics. Further, the recent experience with independently produced power suggests that the business risk attending such plants will be lower when owned and operated by an incumbent electric utility—hence the reinforcing nature of the technology. Nuclear power plants (but only the light-water reactors) have similar characteristics.

Paradise Lost. Diagonally across the matrix, a set of technology possibilities currently dwell outside the scope of most utility industry experience—those with the potential for high-performance growth and that attack the dominant business model of the regulated electric utility. Consider the fuel cell as a source of distributed generating capacity. Large units in the 200-kW range have been on the market for many years, but at $4,500/kW, they cost too much for all but special applications. However, laboratories around the world are racing to improve the fuel cell in response to markets that promise extraordinary opportunities:

• Low-maintenance energy for remote sites;
• Very small-scale replacements for battery systems for mobile electronic equipment; and
• Vehicular power systems.

Entrepreneurs and innovators in fields far removed from the electric utilities will pursue both of these opportunities. In doing so, they will advance the basic technologies required for all fuel cells, and vehicular electric systems will offer special challenges to the utility business model through their ready adaptability for distributed generation.

Take automotive, for example: Each fuel cell must deliver between 75 kW and 100 kW to compete with the internal combustion engine on performance; and, it must cost under $100/kW for the vehicles to compete on price. But once these goals are achieved, possibly within 15 or so years, significant numbers of fuel-cell vehicles will enter the world marketplace.3 In the United States, about 235 million vehicles are registered for use. Even the lower figure of 75 kW per vehicle would eventually yield about 18 TW4 of vehicular generating capacity—capacity that spends about 88 percent of the time sitting around parking lots and garages waiting to go somewhere. Generating electricity at the marginal cost of the fuel, the parked fleet could provide formidable competition for backup power systems—also termed uninterruptible power systems (UPS)—where the standard is now set by the noisy, polluting, and somewhat dangerous gasoline generator.

Whether these UPS installations eventually could compete with the conventional fleet of large-scale, utility-owned power plants will depend on a key enabling technology. An “enabling technology” provides a service essential to the disrupting technology, but one that remains quite independent of it. Think, for example, about the overthrow of the manufactured ice industry, enabled by the electric utilities. The disruptive technology that penetrated the home refrigeration market in the 1930s and 1940s included compact refrigeration cycles and small, efficient electric motors—all packaged as the home refrigerator. But mechanical refrigerators would have penetrated nothing without the widespread availability of electric energy, so electricity became the enabling technology that allowed home refrigerators to displace the ice industry in its chief market.

For massively distributed generation (perhaps through parked vehicular fuel cells) to compete with central generation, the electric grid must become capable of absorbing and distributing the energy. Thus, a grid that can operate as a network of a very large number of nodes, any of which might alternatively serve as a source of electric energy or as a sink for electric energy would serve as an enabling technology for these distributed generators. This will require digital grid control—switching devices, computers, and software—that is not available right now. But if it were to develop, the effects on the business model of the incumbent electric utility could be profound. Thus, we must include digital grid control among the high-potential technologies that could attack the current business model. Indeed, this set of technologies could treat the business model of the integrated electric utility as roughly as VOIP treats the business model of the incumbent telecom.

Paradise Gained. If paradise can be lost, so too can it be gained. Some of the high potential technologies that could reinforce the electric utility business model appear in the southeast quadrant of Figure 2. Note that several technologies can either reinforce or attack the business model, depending upon how they enter the market. Fuel cells, for example, might be deployed by a utility company to improve grid reliability and lower peak generation costs.

Digital grid control also appears in this reinforcing quadrant because, in its earliest phases, the digital grid actually makes the dispatch of existing power plants much more efficient. And if automotive fuel cells never become practical, then digital grid technologies actually might reinforce the electric utility business model.

Integrated gasification combined-cycle (IGCC) technology also appears in both “Paradise Gained” and “Paradise Lost,” but for a different kind of reason. This technology essentially “cooks” the coal under high pressure to set in motion a series of chemical reactions that produce a synthetic gas, “syngas.” The syngas chiefly contains hydrogen, carbon monoxide, methane, and other gaseous constituents whose content varies depending upon the conditions in the gasifier and the type of feedstock. The gas can be burned in a combined-cycle power plant or processed to create a broad slate of other fuels and chemicals. Thus, in principle, the output can be tailored to the relative prices of electricity, synthetic fuels, or synthetic chemicals. Currently, the IGCC technology achieves efficiencies in the range of 45 percent, and future systems might reach the 60 percent range.

Great potential plainly exists for growth in IGCC technology. The real issue concerns the ability of the electric utility companies to include IGCC as a reinforcer of their business model—as distinct from allowing others to use the technology to attack it. The good news is that electric utilities count the building of large-scale industrial facilities among their core skills. But on the bad news side, the essential operating characteristics of an ICGG unit appear closer to an oil refinery or chemical processing plant than to a coal-burning power plant. Further, the slate of products offered by IGCC will require utilities to understand fuels and chemical markets if they are to gain full value from the technology.

Thus, utility companies need to adopt new skill sets to succeed with this technology. New skills, of course, are not without precedent. For example, utility companies had to reach well beyond their customary licensing, construction, and operating practices when nuclear power plants were introduced in the 1970s. Utilities that mastered the new skills did well; those that did not reaped costly mistakes, illustrating the strong link between an effective corporate culture and strategic risk—a link that we shall revisit in Part 2 of this article.

What ... Me, Worry? Finally, we reach the strategically unimportant quadrant where niche technologies attack the business model. Rooftop photovoltaics and merchant-power producers illustrate this well. As long as strategic management can remain confident that these niches will remain so, then little more needs to be done here.

Managing Strategic Risk

All this demands the most important question: How should strategic leaders of utility companies identify and manage the risk that a capricious future will “turn inside” strategic decisions made today? Deferral of choice offers no solution, as new uncertainties always lie beyond the unfolding horizon of foreseeable events—and failure to make decisions becomes itself a decision.

In Part 2 of this article, I shall propose two management tools—real options analysis and scenario planning—which can combine to provide warning of occurrences that currently reside over the horizon of the foreseeable. And I will suggest that building a culture of open inquiry and communication will make a material difference in responding to those developments that still emerge unbidden and unanticipated from an imperfect future.

 

Endnotes:

1. This article is adapted with permission from Managing Enterprise Risk: What the Electric Industry Experience Implies for Contemporary Business, Karyl Leggio, David L. Bodde, and Marilyn Taylor, eds. (Elsevier, 2006).

2. The Western Union case draws upon: Smith, George D. “The Bell-Western Union Patent Agreement of 1879: A Study in Corporate Imagination,” Readings in the Management of Innovation, Michael L. Tushman and William L. Moore eds. (Ballinger, 1988).

3. National Research Council and National Academy of Engineering, The Hydrogen Economy, National Academies Press, 2004.

4. In contrast, the stationary generating fleet in the United States has a generating capacity of around 1 TW, according to the U.S. Energy Information Administration.