on industry restructuring Contents 3 Introduction, by Jeremy Stanyard 5 Globalization: causes, pitfalls and enablers, by Michael de Kare-Silver Case study: Universal Music Group 14 Privatization and deregulation: moving from monopolies to markets, by Ed Kee Case study: South Australia electricity industry 24 How to drive industry restructuring: be the hammer, not the nail, by Mark Thomas Case study: Group 4 Falck 34 The art of the deal: pre-deal strategy and doing the deal, by Guy Templeton and Jeremy Godfrey Case studies: Sabre / Northern Ireland Social Security Agency 46 Excellence in post-deal management: transition and transformation, by Jeremy Stanyard Case studies: Société Générale / eircom plc PA Consulting Group Viewpoint on industry restructuring Viewpoint is PA’s international thought leadership publication. It is designed to provide business leaders with insights on a single strategic business issue.
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on industry restructuring
Contents
3 Introduction, by Jeremy Stanyard
5 Globalization: causes, pitfalls and enablers, by Michael de Kare-SilverCase study: Universal Music Group
14 Privatization and deregulation: moving from monopolies to markets, by Ed KeeCase study: South Australia electricity industry
24 How to drive industry restructuring: be the hammer, not the nail, by Mark ThomasCase study: Group 4 Falck
34 The art of the deal: pre-deal strategy and doing the deal,by Guy Templeton and Jeremy GodfreyCase studies: Sabre / Northern Ireland Social Security Agency
46 Excellence in post-deal management: transition and transformation,by Jeremy StanyardCase studies: Société Générale / eircom plc
PAC
onsulting Group
Viewpointon industry restructuring
Viewpoint is PA’s international thought leadership publication. It is designed to provide business leaders with insights on a single strategic business issue.
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Privatization and deregulation have been powerful forces in the transformation of major industries, such as transportation,natural gas, electricity, telecommunications and financial services. Introducing competitive markets into these industries hasbeen a seismic economic change with major ramifications for the affected companies and their consumers.
This article:
� Considers the economic and ideological drivers behindthe move to competitive markets
� Highlights the key performance and behavioralcharacteristics that an organization in a competitivemarket will exhibit
� Traces the progress of a number of key sectors makingthe transition � financial services, and two �natural�monopolies, natural gas and electricity
� Identifies some of the key lessons that governments,regulators and organizations can learn from theseprivatization and deregulation programs.
Economics and ideology � drivingcompetitive markets
In a competitive industry, market prices are at the supply-and-demand equilibrium, allocating resourcesefficiently and maximizing net benefits. In contrast, in a monopoly system, the monopoly will charge higher prices,sell less output, and receive higher profits compared to acompany in a competitive industry (see Figure 1).
Figure 1: Natural monopolyA natural monopoly can produce an unlimited output at a constant long-runmarginal cost (LRMC) after making a fixed cost investment. The firm cannotmake a profit at the efficient output Q1, where price = LRMC. But if themonopoly is allowed to set its own price, it may produce less than Q2, theamount needed to cover costs, resulting in high prices and an output, such asQ3, well below the efficient output.
�Natural� monopolies do occur in industries that exhibiteconomies of scale (decreasing average long-run costs dueto size), such as telecommunications, transportation,natural gas and electricity. They have been controlled viatwo means: regulation and government ownership.Regulation aims to limit prices to a level that might be seenin a competitive industry, or control behavior, such as a requirement to provide universal service. The theory of government ownership is that the government can operate a monopoly in such a manner as to match acompetitive industry, thus achieving the same aim aseconomic regulation.
Over the last two decades, there has been a move against regulation and government ownership, with a wave of deregulation and privatization being driven by a range of factors:
Dissatisfaction
Instead of delivering similar outcomes to a competitiveindustry, government ownership has sometimes resulted in higher prices/rates/costs and lower service levels.Likewise, regulation can simply incentivize companies to focus too much on investment in assets. This over-investment leads to high prices and lessemphasis on customer service and efficiency.
Failure of central planning
Even if government ownership and economic regulationwere successful in controlling monopoly behavior, bothapproaches contain a potential flaw. Without market pricesignals to drive new investment, some form of centralplanning must instead decide how, where, and in whatassets the monopolies under control will invest and thecosts they will incur. Even the most skilled plannerssometimes make mistakes. Investment decisions madeunder government ownership or by regulated entities aremade without price signals, without the discipline of risk,and with the potential influence of special interest groups.Central planning has been blamed for some spectacularfailures that again resulted in higher rates for consumers.
Market ideology
The school of thought that says the so-called �natural�monopolies might in fact be more efficient if certainelements of the industry were subject to market forces andcompetition has grown more influential and accepted. This belief that markets can better allocate resources andmanage industries has powered significant privatization andderegulation initiatives, as exemplified by the Thatchergovernment in the UK and the Reagan government in theUS. Also, the demonstrated failure of socialism as a viablealternative to free-market capitalism has led some countriesto abandon or greatly scale back the role of government inthe economy, such as New Zealand.
Need for investment
The need for private investment led other less-developedcountries to privatize natural monopolies and implementmarkets in order to encourage foreign private capitalinvestments in infrastructure projects that the localgovernment could not afford. At times, these efforts werealso encouraged by international donor agencies, whichmade privatization and the introduction of markets a pre-condition of assistance and development loans.
Early success
The early experience in privatization and deregulationshowed that consumers benefited. As these early effortswere seen to succeed, interest in further privatization andderegulation was stimulated. The benefits of deregulationin some major US industries that have undergonederegulation � natural gas, telecommunications andtransportation � were shown to have generated beneficialresults. After deregulation in these industries, prices fell,sometimes dramatically, and service quality improved,providing incentives for further privatization and deregulation.Figure 2 (over page) shows the effects on price in the US natural gas market.
A new incarnation � the characteristics ofthe competitive organization
The organization operating in a competitive market will be:
De-integrated. Most privatization and deregulation effortsinvolved both vertical and horizontal de-integration, in orderto encourage competition and to separate the parts of theindustry that would remain regulated from those that wouldoperate in the market. For example, in the UStelecommunications industry, this involved both vertical de-integration (separating the long-distance provider fromthe local telephone companies) and horizontal de-integration (breaking the local regulated telephoneservice providers into regional companies).
Transparent. Privatization and deregulation exposes long-standing implicit subsidies to classes of consumers,certain suppliers, or other groups. Once these subsidiesare no longer hidden in the rates/tariffs of controlledmonopolies, they must either be provided explicitly bygovernments or discontinued. Identifying and re-thinkingthe implementation mechanisms of subsidies can lead tomore focused, effective and cost-efficient subsidies.
Market-driven. The customer relationships and offerings ofmonopolies are usually explicitly defined by governments orregulators, covering areas such as service offerings orrate/tariff structures that subsidize some customers at theexpense of others. In a competitive world, where themarket is king, products and services may be discontinuedor priced more highly, new products and services willemerge, and some customer classes will not receivepreferential treatment at the expense of others.
Risk-focused. Monopolies face little risk compared to acompany operating in a competitive industry, and the resultof bad decisions is usually higher rates, prices or tariffs.Competitive companies focus on risk, working as they do inan environment where the return may be zero or evennegative, with shareholders suffering from bad decisions.
Transaction, not asset focused. Monopolies are oftendefined by the assets that they have built, operated andmaintained. Competitive companies focus on maximizingprofitable transactions with customers, with asset ownershipplaying a supporting role.
Global, not local. Monopolies are often restricted in theirability to own or operate in non-regulated businesses due toconcerns about cross-subsidies. Competitive companiesdevelop strategies that result in national or globalcompanies to gain economies of scale and scope and toprofitably serve multiple markets.
Inexorable progress � privatization andderegulation in key industries
These changes are being felt across a range of industries � including transportation, natural gas, electricity,telecommunications and financial services � and thissection of our paper looks at the financial services sector, as well as two �natural� monopolies, natural gas and electricity.
Since the mid-1980s there has been an ongoing program ofderegulation in the financial services market around theworld. This has included:
� Opening up domestic markets to foreign players
� Removing restrictions on product offerings by differenttypes of institutions, thereby breaking down thedistinction between the banking, insurance andsecurities sectors
� Allowing a financial institution to distribute products of other providers.
Coupled with the removal of regulatory barriers to entry,rapidly evolving technologies have lowered the cost of entryas well. This has led to a variety of new players emergingonto the financial services landscape and many have builttheir financial services capabilities quickly through the useof outsourcing, alliances and joint ventures.
A financial services organization today can be anythingfrom the traditional bank with a large branch network, or aninsurance company with a sales force, to a virtualorganization that leverages its brand, deals direct withcustomers and outsources all the rest of its functions. The vertically integrated financial services organization isno longer the default model. Increasingly financial servicescompanies are specializing in different parts of the valuechain � distribution, manufacturing or servicing.
The intensely competitive marketplace that has developedas a result of deregulation is leading to considerableconsolidation as all participants seek cost efficiency throughgreater scale. This is not only occurring amongst thetraditional vertically integrated players but also amongstthose that specialize in specific parts of the value chain,particularly at the distribution level. This is particularlyevident in the independent financial adviser (IFA) sector inthe UK where largely small independents are formingpowerful national chains or being bought by traditionalfinancial services companies to strengthen their distribution capability.
Natural gas
The US natural gas industry was restructured in stages,beginning with the separation of transport (moving the gasthrough inter-state pipelines) and merchant (buying andselling gas) functions in the mid-1980s. In 1992, aftersignificant progress in introducing competition, additionalsteps were taken to preclude inter-state pipelines fromoperating as merchants of gas, preventing sales of�bundled� gas (priced to include both gas price andtransportation price) by the pipelines.
The result has been the transformation of natural gas into acommodity business, with prices determined by supply anddemand. Prices are now determined by competition at the�burner tip� rather than by regulated well-head prices. There has been significant consolidation of participants inthe US pipeline industry.
Winners in the industry changes included those companies that were focused on marketing and high-valueassets and services (eg, forward market area gas storage).North American natural gas infrastructure is highlydeveloped and supported deregulation. There are multipleproduction fields, multiple major underground storagefacilities, many large cities that represent significantmarkets for gas, and multiple options to move gas fromproduction fields to markets.
Australia, in comparison, has a much simpler system that may not be as easily reformed. This system ischaracterized by single pipelines from production fields intomajor markets, accompanied by long-term contracts. Until more pipelines are built, there is little opportunity forbasin-on-basin production competition or of competition intransportation. Duke Energy�s new pipeline from Victoria toNew South Wales will introduce competition between theBass Straits producers in Victoria and the Cooper Basinproducers supplying the Sydney market.
The last decade of relatively low US gas prices, coupledwith an explosion in the amount of gas-fired electricitygeneration (a result of new high-efficiency gas turbinetechnology combined with the de-integration of the electricutility industry), has stressed this system and created highprices in the last two years. In response to these highprices, there is a flurry of drilling to bring in new sources ofgas and a number of pipelines are under development.
Electricity
Today, electricity is the most visible industry undergoingprivatization and deregulation. After the introduction ofreforms and privatization in the UK market in the early1990s, Australia, New Zealand and some South Americancountries followed quickly. The US is also adoptingelectricity industry reform, but more slowly.
The primary reason that the UK, Australia, and New Zealand were able to move quickly to reformed and privatized electricity industries was governmentownership, which was the pre-existing industry structure.These governments disaggregated the industry, putwholesale markets into operation, and then sold off the bitsof the industry to private owners. If there were excesscapacity, the lower prices for generation assets (due to lowspot prices) would be absorbed by Treasury.
In the US, privately owned regulated companies are theprimary industry structure. In this system, a shift toelectricity markets would result in significant valuedislocations for the owners of assets. For example, theowner of a large nuclear plant might be earning a regulatedreturn on the asset, but might earn much less as a sellerinto a spot market. The potential for �stranded assets�, asthese value dislocations were termed, drove much of thedebate in the 1990s. Most large utilities only agreed toderegulation and markets if they could be allowed torecover a significant portion of these stranded assets.
In addition to the stranded asset problem, electricityregulation in the US is the responsibility of a separateregulator in each state, with some states even having city-level regulators (eg, the city of New Orleans).
The primary electricity industry structure change was aseparation of the industry into the parts that would remainregulated (eg, distribution and transmission) and thoseparts that would operate in a competitive industry (eg, retailand generation). In addition, the opening of marketscreated opportunities for newly formed trading companies.As in the natural gas industry, these new trading companieshave grown and prospered in the new industry.
In addition to the de-integration of the existing functionalparts of the electricity industry, industry reforms havecreated some new entities. In most of the reforms, thereare market and system operators (sometimes one entitydoes both) that are independent from the participants in themarkets. These entities may be formed from the systemcontrol functions of predecessor utilities or may be anentirely new entity.
An example is the National Electricity Market ManagementCompany (NEMMCO) in Australia, a large entity withsignificant investments in communications and computerequipment to operate the Australian market andtransmission system. NEMMCO did not exist beforeelectricity industry reforms. Similarly the move to RegionalTransmission Operators in the US is creating new entities.
Hard-won lessons from success and failure
Significant changes have come from privatization andderegulation, with huge ramifications in particular for thenatural monopolies. There is also great momentum still tobe unleashed, as privatization and deregulation programscomplete, more countries make the shift (like Singapore,which is now undertaking electricity sector reform), andother sectors become targets for similar programs.Deregulation and privatization have not always gonesmoothly. For every success story, there are tales ofdiscord and failure (see Profile of California electricity crisis).
Many countries have looked at the news coming out ofCalifornia and have asked: �Can the California crisishappen to me?�. Our view is that the California electricitycrisis is not evidence that electricity industry reforms willfail. This crisis is not even proof that electricityderegulation can only work if there is an excess ofcapacity and low spot prices. Instead, this crisisdemonstrates that a deregulation plan based on a belief inlow spot prices, without hedging, is very risky.
Belief in low spot prices led to the requirement thatCalifornia utilities buy spot market power, largely withouthedge contracts, for resale at frozen retail rates. This approach created enormous financial risk and madeCalifornia�s deregulation plan into a bet-the-state electricitytrade that could succeed only if spot prices were low.
Now, high spot prices and losses of over $15 billion makethe California electricity crisis larger than some earlier well-known hedging disasters � Metallgesellschaft (1991),Barings Bank (1995), and Long Term Capital Management(1997) � combined. While these earlier hedging disastersinvolved sophisticated traders and complex hedgingstrategies that went wrong, the California crisis appears tobe as simple as the failure to hedge.
Hedge contracts signed before spot prices were highcould have locked-in utility power costs, largely preventingthe current financial crisis. Even better, hedge contractsassigned to generators prior to divestiture, referred to asvesting contracts, could have easily supported the originalrate freeze. Vesting contracts have been used inelectricity market introductions outside the US, with SouthAustralia providing a good example.
The spot market opened in South Australia at the end of 1998 with a shortage of generating capacity andreliance on imported power resulting in high spot prices(often reaching the cap of AUS$5,000 per MWh). Vesting contracts permitted controlled consumer rateswhile creating a viable retail entity that was successfullyprivatized, controlled the potential market power ofprivatized generators and allowed the spot market to
work. As a result, South Australia has seen a rapidincrease in new generation and market-based demandreduction arrangements.
With little hedging of spot market purchases, Californiahas focused on spot price caps to control losses �removing important market price signals. New generationplants in California already face significant environmentaland siting hurdles and price caps will further reduce theattractiveness of power plant investments. Also, retailersand customers are unlikely to hedge spot marketexposure when frozen retail rates and spot market pricecaps are in place.
California is now negotiating hedge contracts that willreduce or end the exposure to spot prices. However, it is unlikely that negotiated contracts will contain all thefeatures of vesting contracts or that negotiated prices willbe consistent with low retail rates. High contract pricesare the cost of waiting until spot market prices are high toarrange hedging for retail rates.
Vesting contracts are a powerful tool to facilitate electricitymarket transition. These contracts can protect customers(or the retailers serving the customers) from spot marketprices even in capacity-tight markets, kick-start the hedgecontract market, maintain a viable spot market, provideincentives for new entry, and facilitate other aspects of a transition to electricity markets.
Wholesale spot market price caps, as seen in California, are not a necessary part of electricity reform.Deregulation plans that recognize the potential for highspot market prices and incorporate appropriate hedgingstrategies will be viable regardless of spot prices.
The California crisis does not mean that electricitymarkets are unworkable. Instead it: reminds us that spotmarket prices can be unpredictable and sometimes veryhigh; demonstrates that deregulation plans withoutappropriate hedging strategies are risky; and shows thatbeing wrong on a bet-the-state electricity trade can bevery expensive.
By looking at what went wrong and what went right, we can build a solid foundation for ongoing and future initiatives. We would point to these lessons in particular:
Powerful forces unleashed
Governments, politicians and regulators should be awarethat privatization and deregulation unleash very powerfulforces, especially when enormous and pervasive industriessuch as electricity are involved. Mistakes, flawedassumptions or wrong decisions can very quickly createmammoth problems. These problems may confoundreformers, as controls to rescue the situation may be nolonger present, or the political will to take difficult decisionsmay be absent. Indeed, political intervention mayexacerbate problems and delay functional markets, with theproblems in California being an excellent example of this.We urge reformers to take note and actively learn fromsituations like California, and to avoid novel solutionspressed on them by any special interest groups.
Passive acceptance is not enough
Companies that are destined for, or aspire to, a state ofprivatization and deregulation should not simply wait forevents and decisions. Neither should these companieslook only to their own narrow self-interest. It is doubtful thatthe generators selling power in California would havewanted the current outcomes (litigation, price caps, andrefunds), even though they have been selling at high prices.Most would have been much better off under a moresuccessful deregulation scheme. Companies in an industryshould strive to maximize profits within the rules of thenewly established markets. But they should be wary ofinfluencing the deregulation or privatization scheme in a way that produces one-sided gains.
As private companies are most likely to be in the position ofinvesting capital in newly deregulated or privatizedindustries, there is a risk that any excessive gains may betaken away. However, losses due to overpayment forprivatized assets or poorly performing investments areunlikely to be made up. In the California context, thismeans that price caps may become a political necessitywhen prices are very high, but that price floors are unlikelyif prices become low. Active involvement in thederegulation planning process is important, but if anyparticular part of the market succeeds wildly at the expense of another part of the market, political action may result.
Careful planning translates into successful action
Governments, regulators and the affected organizationsthemselves should embark on an exhaustive analysis of alloptions and potential outcomes. Effective transition andmitigation measures can ensure negative outcomes arenipped in the bud, as long as they are in place before theprocess begins, rather than developed in reaction toevents. This analysis will need to draw on extensiveinvestment analysis and proven risk managementtechniques, and will be formulated against a background ofgreat complexity, with multiple stakeholders and potentialscenarios. The case study that follows of privatization ofthe Australian electricity industry illustrates how complex anundertaking this is, but how rigorous work made a successof the program.
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Ed Kee is a member of PA�s Management Group and a specialist in the electricity and natural gas industries, includingindustry restructuring and market reform, competition policy, and transmission pricing and regulation. Views and commentson this article are welcomed at: [email protected]
The Eastern states of Australia (Victoria, New SouthWales, Queensland and South Australia) had agreed onfundamental reforms of the electricity sector. The electricity sector in Australia was largely government-owned, with significant over-capacity andassociated high rates in Victoria and New South Wales.Aside from unhappiness with the existing industry, thesereforms were driven by the success of electricity industryreform in England and Wales and were consistent withAustralia�s broad shift toward markets.
Victoria and New South Wales had been the first movers inthis electricity sector reform, implementing spot markets inthe early 1990s that exhibited low spot market prices dueto the excess of capacity. Queensland also initiated a spotmarket in early 1998 before the national market began,even though it was not physically connected to the otherstates� transmission lines until their completion in 2000.Victoria had completed the privatization of its electricityindustry, largely eliminating the state�s government debt.
South Australia�s challenge
South Australia was faced with a commitment to undertakethe reforms, but without the level of excess capacitypresent in Victoria and New South Wales. The state wasnearing the time when it would need to invest in newgenerating capacity to maintain reliability.
South Australia had not participated in the state-operatedspot markets and other reforms that were present inVictoria, New South Wales and Queensland. For theselatter states, the start of the National Electricity Market(NEM) in late 1998 was to be a fairly simple switch fromtheir existing markets, while South Australia had significantwork to catch up.
Scheduled to join the Australian NEM in 1998, the SouthAustralian government embarked on fundamental reform ofits electricity sector in early 1998. This reform involved ashift from two government-owned electricity companies (SA Generation Corporation, covering principal generation,and ETSA Corporation, covering distribution, transmissionand retail) to a market-based, disaggregated and privatizedelectricity sector.
Cas
e st
udy
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South Australia electricity industryReform and privatization of the electricity sectorOur thought-piece examined how privatization and deregulation are driving corporaterestructuring across industries. Our case study looks at PA�s work with the Government ofSouth Australia � helping it transform an integrated, government-owned electricity sector intoa de-integrated industry with an electricity spot market.
This was accomplished over a much shorter period than inneighboring Victoria, with South Australia building on theexperience in the other states to deliver an ambitiousschedule. An experienced team of consultants, bankers,lawyers, accountants and engineers with experience inelectricity industry reforms were retained to drive theprocess. Many of these key advisors had been involved inthe efforts in the other states.
The first step in this process was the disaggregation of theexisting incumbent utility companies into corporate entitiesin mid-1998. These newly formed companies wereprovided with the resources to operate as independentcompanies under government ownership before and duringthe establishment of the electricity market.
After the NEM was implemented at the end of 1998, thecorporatized companies were privatized in a series of tradesale auctions under long-term (eg, 100-year) leases. All the companies had been transferred to new operatorsby late 2000.
South Australia after electricity sector reform
The State of South Australia put in place legislation,established regulations and regulatory bodies to regulatethe privatized electricity distribution and transmissionbusinesses. The Government used vesting contractsbetween privatized companies, sale conditions andundertakings, as well as a long-term electricity pricingorder, to ensure a smooth transition to electricity marketsfor both participants and consumers.
The privatization process resulted in fundamental changesin the ownership and structure of the electricity industryand the entry of a number of large multi-nationalcompanies into the electricity business in South Australia:
� UK-based International Power controls the peakingpower plants around the state and has constructed a new combined-cycle power station
� US-based TXU controls the large gas-fired power plantsat Torrens Island
� US-based NRG Energy controls the coal-fired powerplants at Port Augusta and the associated coal mine
� AGL (Australian Gas Light Company), owner of gastransmission and gas and electricity distributioncompanies elsewhere in Australia, controls the non-regulated retail electricity supplier
� Hong-Kong-based Cheung Kong Infrastructure (affiliateof Hong Kong Electric and Hutchison Whampoa)controls the regulated electricity distribution company
� A consortium composed of ABB, Queensland Electricityand Transmission Company (Powerlink), YTL PowerInvestments and Macquarie Bank have a long-termlease for the electrical transmission network
� The South Australian Government�s gas tradingcompany (holding a portfolio of gas purchase and gashaulage contracts) was sold to Tarong Energy.
Electricity customers in South Australia are now able to buypower from about ten retailers and traders, including theincumbent retailer. International Power and Origin Energybuilt new generation plants shortly after market start.Other private investments in power plants and majortransmission lines to other states (where excess capacityremains) are under development.
Note: Putnam, Hayes and Bartlett (PHBAP), assisted South Australia in this reform and privatization process from early 1998 through the end of 2000. PHBAP became part of the PA Consulting Group in October 2000 following PA�s acquisition of Hagler Bailly, Inc. and its constituent companies.
