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Utility CEOs Need to Know How to Deal with Lots of Regulation

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  • Jul 13, 2015
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THE CORE COMPETENCY of a chief executive officer of a public utility must be the ability to manage successfully under regulation. Everything else is secondary.
Historically, boards of directors will frequently select a new CEO based on skills reflecting current issues. During financial turmoil, CFOs are sought. Companies with engineering challenges call for engineers. Utilities facing formidable customer relationship issues pick communicators.
All are reasonable approaches except in each case the ability to deal with regulation and operate in a regulatory environment should be the primary consideration.
The reason is that at the CEO level, one of the key leadership decisions is the establishment of a strategy.
The objective of the strategy, in most cases, is some aspect of growth. Nevertheless, having a strategy is not enough. Once a strategy is selected, the CEO must lead the firm through successful execution. In the case of a regulated public utility, this execution phase finds the utility management directly confronting the realities of modern public utility regulation. This regulation takes the form of external control and oversight of almost all of management's strategic decisions from raising capital to planning the capital budget and to merger, acquisition and divestiture decisions.
The literature of management strategy provides a plethora of approaches for creating and implementing strategy for the business enterprise. This same literature also ignores the special case of the public utility and its unique regulatory environment. Utilities themselves are unique; hence, strategies developed for the general business environment need special care when brought into the regulatory arena.
One of my favorite frameworks for looking at corporate strategies for growth comes from Professor Aneel Karnani, chair of strategy at the University of Michigan.
His research and writings on "Five Ways to Grow the Market and Create Value" have appeared in the Financial Times, Clariden Global Insights and other publications.
Karnani's framework is a matrix of three modes of growth and five directions of growth. His research indicates that most corporate strategic decisions can be placed in this matrix.
Under public utility regulation both the modes of growth and the direction of growth are subject to additional review, modifications and restrictions not found in general business enterprise. This is where knowledge of regulation and skill of leadership under regulation are essential for the successful public utility CEO.
MODES OF GROWTH Looking first at Karnani's modes of action, anyone familiar with public utility regulation would immediately see that all three --- mergers and acquisitions, strategic alliances and organic/internal --- are subject to regulatory review and possible restrictions.
The most frequently applied mode subject to direct regulation is that of mergers and acquisitions.
A utility must apply to the regulator for approval to engage in a merger or acquisition. Successful mergers have occurred when CEOs have been able not only to negotiate the merger, but also the regulatory approvals in such a way that value remains for the shareholder. Recent regulatory history is replete with reports of failed mergers caused by management's misestimates of the regulators' demands for merger approval or misestimates of the time needed for regulatory approval.
Forming a strategic alliance is rare for a public utility, possibly because of the uncertainty over the regulator's authority and subsequent approval requirements. One case of strategic alliance may be the joint development programs undertaken by the U.S. Department of Energy and electric utilities for demonstration projects for clean coal or carbon capture and sequestration. In every instance, these alliances must be carefully vetted by the CEO as to the anticipated regulatory risks.
The organic/internal mode of growth implies future investments with the corporation's own funds. The CEO of any public utility will be familiar with the requirements of certificates of public convenience and the necessity for assets to be added to the rate base, which directly requires regulatory approval. The investment of funds through public utility affiliates, whether subsidiaries of the utility or affiliates through a holding company structure, also may trigger regulatory oversight depending on the nature and location of the investment. For example, the projected growth of distributed energy resource opportunities may draw some attention from utility CEOs, but once again regulatory impediments, barriers or requirements must be understood and skillfully managed.
DIRECTIONS OF GROWTH Globalization: Public utilities, as well as general corporate enterprises, have over the decades, with various degrees of success, chosen strategies implementing Karnani's five directions of growth: unrelated diversification, related diversification, globalization, increased market penetration and vertical integration.
A wise CEO will recognize that each of these has its own regulatory hurdles and pitfalls.
During the 1990s, America's electric utilities made investments overseas in regulated electric utilities in Europe, South America and Asia. Because most of these investments were made at the holding company level and there was minimal affiliated transaction with the state-regulated utility, the direct state regulatory issues were minor, other than any public relations issues. However, in many of these cases the CEOs misestimated the uniqueness of regulation and politics of the host country. Knowledge of regulation in one's home state did not necessarily translate into competence or useful experience when dealing with regulation in a foreign land. By 2005, most of these investments were divested.
Vertical integration: The United States now has two structures for the electric power industry. The individual states have decided the industry structure, and at this time it does not look as though changes are imminent at the state level.
However, new opportunities for vertical integration exist in areas downstream such as distributed generation, energy efficiency and energy storage, and upstream in natural gas supply acquisition. All of the downstream investment will require upfront regulatory policies and rules clearly acceptable to the CEO before any utility investments can go ahead.
One typical downstream investment has been the move into energy services on the customer side of the meter. Most typically, this has come in the form of acquiring energy services companies (escos) such as HVAC companies, electrical contractors and related energy services companies. Here the knowledgeable CEO will recognize the future regulatory risk of royalties to be paid and affiliate cost allocations, especially when the esco operates in the affiliated utility's service territory.
The opportunity for upstream investment also arose at various times. During the periods of natural gas shortages in the 1970s and 1980s, the FERC-created shortage of natural gas in interstate markets caused some utilities to look to acquire gas fields to ensure access to gas supply. Today, natural gas utilities and electric power producers are again looking at the acquisition of long-term gas supply, driven by their desire to avoid price volatility.
Then and now, CEOs needed to obtain regulatory approvals to fairly share the benefits of such practices between rate-paying customers and shareholders.
Synergy-related Diversification: The most common synergy-related diversification has been the acquisition of a natural gas distribution company by the electric utility in the same franchise territory. In 1990, there were 54 gas companies. Only 15 gas distribution companies remain listed on our exchanges. All of the acquisitions required regulatory approvals, and in all cases, the benefits found by the regulators came primarily from synergies in the joint operations of both utilities on common geography. In all cases, the CEOs successfully negotiated both sequential steps of approval for the acquisition from the gas utility's board of directors, followed by approval from the state regulator.
Conglomerate/Unrelated Diversification: One assumes that the driver to unrelated diversification is management's ability to spot investment opportunities with growth opportunities exceeding the cost of capital. During the 1990s, a few public utilities diversified into unrelated businesses. Among the more unusual was the acquisition of a minor league baseball team and the other was an acquisition of an automobile auction company. Enron, which started as a FERC-regulated pipeline company, diversified into related and unrelated markets. One type of diversification that saw success in some cases is the diversification into urban development or renewal in the utility's service territory.
The regulatory issues are apparent and direct; thus, a CEO contemplating an unrelated merger would be sure to check with regulators about whether the nature of the acquired company and its services, products or geography would raise any concerns.
Market Penetration Karnani uses the term market penetration to identify growth opportunities marked by increasing the share of the existing market either through the creation of new products and services or by consolidation of smaller players.
As the utility industry contemplates issues such as distributed energy resources, distributed storage, electric vehicle charging services, microgrid management, demand response and the Internet of Things, opportunities for new revenue streams will become apparent to the utility CEO as well as the entrepreneur.
Rooftop solar is one new market where these questions are an issue. Solar panels owned by the customer or third party reduce kilowatt-hour sales by the electric utility. Should utilities be allowed to offer a tariffed solar panel service to compete?
Conclusion
It is not my attempt here to answer questions about what regulators should decide when it comes to the new issues before them concerning renewable energy, distributed generation and the smart grid, among others.
It is my objective to remind the CEOs of regulated utilities that they cannot address these issues without understanding regulation, and they cannot move forward without obtaining regulatory rulings favorable to their strategy. All of the strategic options previously mentioned required regulatory actions of some sort before the CEO could implement a strategy.
That alone should suffice to support my contention that management under regulation should be the CEO's core competency.
Branko Terzic is a managing director at The Berkeley Research Group, a former utility CEO, and a commissioner on the Federal Energy Regulatory Commission and the Wisconsin Public Service Commission.

THE CORE COMPETENCY of a chief executive officer of a public utility must be the ability to manage successfully under regulation. Everything else is secondary.
Historically, boards of directors will frequently select a new CEO based on skills reflecting current issues. During financial turmoil, CFOs are sought. Companies with engineering challenges call for engineers. Utilities facing formidable customer relationship issues pick communicators.

All are reasonable approaches except in each case the ability to deal with regulation and operate in a regulatory environment should be the primary consideration.

The reason is that at the CEO level, one of the key leadership decisions is the establishment of a strategy. The objective of the strategy, in most cases, is some aspect of growth. Nevertheless, having a strategy is not enough. Once a strategy is selected, the CEO must lead the firm through successful execution. In the case of a regulated public utility, this execution phase finds the utility management directly confronting the realities of modern public utility regulation. This regulation takes the form of external control and oversight of almost all of management's strategic decisions from raising capital to planning the capital budget and to merger, acquisition and divestiture decisions.

The literature of management strategy provides a plethora of approaches for creating and implementing strategy for the business enterprise. This same literature also ignores the special case of the public utility and its unique regulatory environment. Utilities themselves are unique; hence, strategies developed for the general business environment need special care when brought into the regulatory arena.

One of my favorite frameworks for looking at corporate strategies for growth comes from Professor Aneel Karnani, chair of strategy at the University of Michigan. His research and writings on "Five Ways to Grow the Market and Create Value" have appeared in the Financial Times, Clariden Global Insights and other publications.
Karnani's framework is a matrix of three modes of growth and five directions of growth. His research indicates that most corporate strategic decisions can be placed in this matrix.

Under public utility regulation both the modes of growth and the direction of growth are subject to additional review, modifications and restrictions not found in general business enterprise. This is where knowledge of regulation and skill of leadership under regulation are essential for the successful public utility CEO.

MODES OF GROWTH

Looking first at Karnani's modes of action, anyone familiar with public utility regulation would immediately see that all three --- mergers and acquisitions, strategic alliances and organic/internal --- are subject to regulatory review and possible restrictions.

The most frequently applied mode subject to direct regulation is that of mergers and acquisitions. A utility must apply to the regulator for approval to engage in a merger or acquisition. Successful mergers have occurred when CEOs have been able not only to negotiate the merger, but also the regulatory approvals in such a way that value remains for the shareholder. Recent regulatory history is replete with reports of failed mergers caused by management's misestimates of the regulators' demands for merger approval or misestimates of the time needed for regulatory approval.

Forming a strategic alliance is rare for a public utility, possibly because of the uncertainty over the regulator's authority and subsequent approval requirements. One case of strategic alliance may be the joint development programs undertaken by the U.S. Department of Energy and electric utilities for demonstration projects for clean coal or carbon capture and sequestration. In every instance, these alliances must be carefully vetted by the CEO as to the anticipated regulatory risks.

The organic/internal mode of growth implies future investments with the corporation's own funds. The CEO of any public utility will be familiar with the requirements of certificates of public convenience and the necessity for assets to be added to the rate base, which directly requires regulatory approval. The investment of funds through public utility affiliates, whether subsidiaries of the utility or affiliates through a holding company structure, also may trigger regulatory oversight depending on the nature and location of the investment. For example, the projected growth of distributed energy resource opportunities may draw some attention from utility CEOs, but once again regulatory impediments, barriers or requirements must be understood and skillfully managed.

DIRECTIONS OF GROWTH

Globalization: Public utilities, as well as general corporate enterprises, have over the decades, with various degrees of success, chosen strategies implementing Karnani's five directions of growth: unrelated diversification, related diversification, globalization, increased market penetration and vertical integration. A wise CEO will recognize that each of these has its own regulatory hurdles and pitfalls.

During the 1990s, America's electric utilities made investments overseas in regulated electric utilities in Europe, South America and Asia. Because most of these investments were made at the holding company level and there was minimal affiliated transaction with the state-regulated utility, the direct state regulatory issues were minor, other than any public relations issues. However, in many of these cases the CEOs misestimated the uniqueness of regulation and politics of the host country. Knowledge of regulation in one's home state did not necessarily translate into competence or useful experience when dealing with regulation in a foreign land. By 2005, most of these investments were divested.

Vertical integration: The United States now has two structures for the electric power industry. The individual states have decided the industry structure, and at this time it does not look as though changes are imminent at the state level.

However, new opportunities for vertical integration exist in areas downstream such as distributed generation, energy efficiency and energy storage, and upstream in natural gas supply acquisition. All of the downstream investment will require upfront regulatory policies and rules clearly acceptable to the CEO before any utility investments can go ahead.

One typical downstream investment has been the move into energy services on the customer side of the meter. Most typically, this has come in the form of acquiring energy services companies (escos) such as HVAC companies, electrical contractors and related energy services companies. Here the knowledgeable CEO will recognize the future regulatory risk of royalties to be paid and affiliate cost allocations, especially when the esco operates in the affiliated utility's service territory.

The opportunity for upstream investment also arose at various times. During the periods of natural gas shortages in the 1970s and 1980s, the FERC-created shortage of natural gas in interstate markets caused some utilities to look to acquire gas fields to ensure access to gas supply. Today, natural gas utilities and electric power producers are again looking at the acquisition of long-term gas supply, driven by their desire to avoid price volatility.

Then and now, CEOs needed to obtain regulatory approvals to fairly share the benefits of such practices between rate-paying customers and shareholders.

Synergy-related Diversification: The most common synergy-related diversification has been the acquisition of a natural gas distribution company by the electric utility in the same franchise territory. In 1990, there were 54 gas companies. Only 15 gas distribution companies remain listed on our exchanges. All of the acquisitions required regulatory approvals, and in all cases, the benefits found by the regulators came primarily from synergies in the joint operations of both utilities on common geography. In all cases, the CEOs successfully negotiated both sequential steps of approval for the acquisition from the gas utility's board of directors, followed by approval from the state regulator.

Conglomerate/Unrelated Diversification: One assumes that the driver to unrelated diversification is management's ability to spot investment opportunities with growth opportunities exceeding the cost of capital. During the 1990s, a few public utilities diversified into unrelated businesses. Among the more unusual was the acquisition of a minor league baseball team and the other was an acquisition of an automobile auction company. Enron, which started as a FERC-regulated pipeline company, diversified into related and unrelated markets. One type of diversification that saw success in some cases is the diversification into urban development or renewal in the utility's service territory.

The regulatory issues are apparent and direct; thus, a CEO contemplating an unrelated merger would be sure to check with regulators about whether the nature of the acquired company and its services, products or geography would raise any concerns.

Market Penetration

Karnani uses the term market penetration to identify growth opportunities marked by increasing the share of the existing market either through the creation of new products and services or by consolidation of smaller players.

As the utility industry contemplates issues such as distributed energy resources, distributed storage, electric vehicle charging services, microgrid management, demand response and the Internet of Things, opportunities for new revenue streams will become apparent to the utility CEO as well as the entrepreneur.

Rooftop solar is one new market where these questions are an issue. Solar panels owned by the customer or third party reduce kilowatt-hour sales by the electric utility. Should utilities be allowed to offer a tariffed solar panel service to compete?

Conclusion

It is not my attempt here to answer questions about what regulators should decide when it comes to the new issues before them concerning renewable energy, distributed generation and the smart grid, among others.

It is my objective to remind the CEOs of regulated utilities that they cannot address these issues without understanding regulation, and they cannot move forward without obtaining regulatory rulings favorable to their strategy. All of the strategic options previously mentioned required regulatory actions of some sort before the CEO could implement a strategy.

That alone should suffice to support my contention that management under regulation should be the CEO's core competency.

Branko Terzic is a managing director at The Berkeley Research Group, a former utility CEO, and a commissioner on the Federal Energy Regulatory Commission and the Wisconsin Public Service Commission.

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