Utilities - Power to the people, no delay

Finance directors in the electricity industry face a potentially awkward separation in the year ahead. Following gas industry deregulation, the government has decided that the electricity giants should run their supply and distribution businesses separately, so that customers can shop around.

In addition, they also face being squeezed on a price front, as the new energy industry regulator Callum McCarthy considers altering the way the industry sets electricity prices.

Finance departments are in the front line of change. Billing, cost allocation, and finance department staff levels will all bear the brunt of change as the industry undergoes yet another post-privatisation shake-up.

To complicate matters, though, the DTI and OFFER, the electricity industry watchdog, still have to decide if the supply and distribution arms of the electricity companies should be run as separately owned businesses or separate legal entities but commonly owned (see box).

Not surprisingly, the ‘R’ word – regulation – is a red-hot issue in the electricity sector as companies plan their strategy for the deregulated markets of the next century. Few finance directors are prepared to publicly voice their views on future regulation while the fine print and numbers remain undecided.

But many FDs are not content to wait for the regulator to tell them how to run their business, according to David Hosein, a partner at Arthur Andersen’s energy and utilities division. ‘There’s a lot of uncertainty and it’s still early days yet,’ he says.

‘Finance directors are now deciding their strategic response. It’s now impossible to generalise about what finance directors are doing in the industry. They are pursuing very aggressive challenges in a new, more difficult industry.’

Separating supply and distribution poses a number of financial management headaches. Not only are many assets such as IT systems held in common but, in complex structures, allocating costs to the right business could prove tricky. And if the government reforms the metering system to boost competition, electricity companies will lose control of some meters to rivals.

The unused meters, however, will remain on the balance sheets as fixed assets, forcing the company to write off costs. In the US, this is referred to as the ‘stranded asset’ scenario.

Hosein declines to predict the exact nature of future regulation, but other industry experts believe the government is unlikely to force a complete separation of ownership between supply and distribution.

‘Very few people think the regulator will force electricity companies to split into two separate companies. There’s the threat that you duplicate infrastructure with two separate general ledgers. It’s very inefficient,’ said one Big Five expert.

That said, moves to separate billing and distribution are already gathering momentum. Last October, Midlands Electricity sold off its supply business MEB to National Power, the UK’s second-largest electricity generator.

The deal, due to be completed in March, will see supply and distribution companies run as separate companies, with two accounts.

MEB’s US owner Avon Energy, a holding company formed by two utility companies, will retain ownership of MEB’s distribution business.

The deal, the first of its kind in the UK according to MEB, also puts MEB in line with government thinking on the supply and distribution divide and turns National Power into a major player in the supply side market – or ‘upstream’ market, in the industry jargon.

Andy Donnelly, finance director at Yorkshire Electricity, is well aware of the shifting financial boundaries in the industry. Here – apart from the treasury and tax departments – the supply and distribution businesses are already run semi-independently. At the centre, a 50-strong corporate finance team retains overall control.

‘Over the last eight years, we’ve come a long way down the road of having separate supply and distribution businesses,’ says Donnelly. ‘I think it’s right to have a fair degree of autonomy in the businesses as long as you have decent reporting controls, such as monthly reports to head office.’

Donnelly argues this has brought cost-savings, but it has also meant there is a substantially lower head count at the central corporate finance office as power is diffused to regional offices.

And, in a reflection of the cross-competition between the utility sectors, Yorkshire Electricity is also a ‘dual-fuel’ provider, supplying gas and electricity. ‘We can give customers one point of contact and offer dual fuel cheaper than British Gas,’ boasts Donnelly.

Donnelly, who compares Yorkshire Electricity to a holding company, believes the government should require electricity companies to become two separate legal entities, rather than insist on the independently owned option. One of the major downsides, he says, would be IT-related. Yorkshire Electricity currently runs its two business arms on a common, largely in-house, system and Donnelly fears this may not be possible if it is required to run supply and distribution as independent businesses.

‘We have a customer database with details of two million customers on it which our distributors and suppliers have to access. A separate IT system would mean an increase in overall costs,’ he says.

IT resources are often stretched

Donnelly’s anxiety over IT systems is well placed, according to Jyoti Banerjee, managing director at Tate Bramald Consulting, an IT market analysis and research group.

The typical electricity company, he says, will has a common IT system for its supply and distribution but pours most of the IT resources into either supply or distribution – whichever is strongest. The result, according to Banerjee, is an uneven IT system which will only suit the finance director of one business. ‘You might be better off starting afresh if you inherit an inappropriate system,’ he advises.

Besides these organisational hurdles, however, a more profound sea change is taking place. For the first time since the state-run monopoly, electricity suppliers and distributors have to worry about customer retention and special offers. ‘How do you differentiate between Yorkshire Electricity and PowerGen other than cost?’ asks Ian Mcleod, a partner at KPMG Consulting, and a utility specialist, who compares the electricity industry with the UK’s booming mobile phone market. ‘You have to look at customer relationship management,’ he says.

‘Take the mobile phone market, which has become very good at differentiating its products. They identify customers who are large users and target them with a low tariff per second and a high monthly charge. They’ll also offer several of them 500 free minutes a month.’

With more sophisticated marketing, pinpointing the large electricity users becomes crucial – particularly if a utility company wants to compete with rivals outside its traditional region.

One increasingly popular way to target customers is Customer Relationship Management. KPMG Consulting, for instance, has a partner focusing on CRM business consulting, while enterprise resource planing giants such as Baan and JD Edwards offer CRM modules.

CRM software, which is client/server based, links into existing enterprise-wide software to automate business processes such as customer and sales management. The successful companies, it seems, can no longer content themselves with speeding up the time it takes to bill a customer. What matters are customer profiles.

The other key issue for finance directors is pricing. Wholesale prices are currently set by electricity generators – such as National Power, PowerGen, and Eastern Electricity – which bid into a national electricity trading pool a day ahead, to supply power for half-hour periods. But the system has been attacked by consumers, who accuse the power suppliers of abusing their market dominance to artificially inflate prices. Last month, Callum McCarthy, the energy industry regulator, said that electricity prices for December could have been #90m lower if there had been cost-effective bidding by the generators.

There is also a European context to UK deregulation. Following a EU directive last month, large-scale European users will be able to shop around for their electricity.

This will mean utilities placing their power lines under separate management and offering fair terms to outsiders for transporting electricity. In the UK, Scandinavian and Dutch markets’ power is now just another commodity to be traded.

At the moment, however, the prospect of an offensive on European markets is beyond the short-term horizon of many UK electricity companies such as Yorkshire Electricity. Intense regional competition and shifting consumer demands are challenging enough before considering other factors like diverging European accounting rules.

Andersen’s Hosein remains upbeat about the future of the electricity industry. He sees international competition and deregulation as the dawn of a more mature and less privileged industry.

‘The supply business is all about retail and brand management like Tesco,’ he says. ‘Distribution is working with engineers and more like the manufacturing industry.

‘The electricity industry is less special now; it’s like a normal business.’

DEREGULATION – A BEGINNER’S GUIDE

Under the 1989 Electricity Act, electricity supply and distribution businesses are run under one licence.

The businesses are required to have separate regulatory accounts but are bought together for statutory accounts. One of the main reasons for this is to stop anti-competitive cross-border subsidies.

But in the gas industry, distribution and supply have been licensed separately since 1995, creating two separate companies that are owned by the same parent.

After a two-year long consultation period, the government has still not decided exactly how electricity supply and distribution businesses should be separated – options range from the relatively straightforward separate licensing of supply and distribution to separately owned businesses.

The government’s preferred option is for supply and distribution businesses to separate legal entities, while still commonly owned.

OFFER, the independent electricity regulator headed by Callum McCarthy, has outlined the steps companies need to take to separate supply and distribution businesses. It will require companies to publish a detailed plan of how they intend to separate supply and distribution, and appoint a compliance director who will report to OFFER.

OFFER is also drafting recommendations on reforming the way electricity generators set wholesale electricity prices in the national pool where electricity is traded. Generators, such as National Power and PowerGen, bid a day ahead to supply electricity in half-hour periods. But consumer groups have accused the generators of price fixing.

The government is committed to putting an Energy Bill before parliament at the next available slot, which will be next autumn in the Queen’s speech.