Strategy returning to the fore in electric power industry

HOUSTON, Feb. 12, 2004 — The electric power industry’s dramatic earnings and valuation swings in recent years, plus increasing experience with the limitations of a “back-to-basics” approach, is creating recognition in a broad range of companies that strategies must be reset to meet new challenges and objectives, Cambridge Energy Research Associates (CERA) Senior Director of Global Gas and Power Lawrence J. Makovich told a briefing at CERAWeek 2004 recently.

“In the wake of a crisis of confidence, trading scandals and valuation collapses, companies in many segments of the power industry turned to a ‘back-to-basics’ model, but they are now finding that this approach falls short in providing earnings growth,” Makovich said. He noted that the combined net income of the companies in the Dow Jones Utilities Index fell from $12 billion in 2001 to a loss of more than $5 billion in 2002, and the 15 companies’ combined market capitalization was cut in half from almost $250 billion to less than $123 billion from 2001 to 2002. Net income recovered to about $8 billion during the first nine months of 2003, but market cap has remained less than two-thirds of what it was at the start of 2001.

“As back-to-basics is recognized as a holding action, companies must develop new strategies that can sustain improved returns over longer periods of time. This requires understanding that the industry landscape has changed dramatically, and then fitting strategy to the opportunities that are available. However, when the landscape shifts, people are often slow to recognize it because of blind spots that result from missing or misinterpreting information. That’s what creates the real opportunities in the power business — finding places where other people have blind spots,” he noted.
Blind Spots & Failure of Foresight

Dramatic shifts in the power industry have been caused in part by blind spots and failures of foresight, according to Makovich. Understanding and analyzing these failures, which are not unique to the power business, provides important insight into strategy development. This is particularly applicable to strategic planning in the power business, or any industry where high complexity and multi-dimensional change makes foresight difficult, and where organizational cultures define the assumptions employees make as they carry out their work.

Blind spots arise when poorly informed assessments persist over a long period of time, and knowledge gaps occur when hazards and warning signs are either ignored or misinterpreted, producing unreasonable expectations and even myths about performance. Experience across industries also indicates that beliefs held in common throughout an organization can resist alteration, and put an organization in a position in which its members are unable to critically analyze and intervene.

“The lessons for the power business are clear,” Makovich said. “The combination of complexity and change can easily produce persistent blind spots that result in a failure of foresight, foiled plans and missed opportunities.”

Industry Landscape

To develop winning strategies, companies must decipher trends in the electric power industry value chain and determine which segments or combinations of segments create the most value in the future. Five primary dynamics are shaping the landscape in which power companies must now make accurate, timely competitive and economic assessments in order to correctly derive their new strategies, according to Makovich:

* The New Hybrid – Uncertainty in the uncoordinated half-regulated, half- market industry structure, with the opposing camps further polarized by the August 14th blackout.

* Fuels Transitions – Sustained tension between increased reliance on natural gas for power generation and natural gas resource depletion, creating large new opportunities for LNG and a looming collision between increased use of coal and tightening environmental restrictions.

* Generation Surplus – The oversupply of regional electric generation capacity which, combined with the emergence of new supply sources, will require a multi-year work-off as well as pushing the bottom of this generation market cycle further into the future.

* Trading Rationalization – Right-sizing of trading as a tool for asset optimization and risk management, rather than speculation, with a new set of rules and institutional framework.
* Performance Pressure – Cost performance pressure in the form of extended price caps and rate freezes, and increased application of performance-based ratemaking.

“Our work with companies across the power business indicates many have not yet made the adjustment to a new, shifting landscape, and that the industry as a whole is approaching a period of widespread unsettlement and repositioning as companies develop, implement and refine their new strategic directions,” Makovich concluded.

Cambridge Energy Research Associates (CERA) is an advisor to major North American and international companies, financial institutions and organizations, delivering strategic knowledge and independent analysis on energy markets, geopolitics, industry trends and strategy. CERA is headquartered in Cambridge, Mass., and has offices in Beijing, Calgary, Mexico City, Moscow, Oakland, Paris, Sao Paolo, and Washington, D.C.