BUSINESS DIVERSIFICATION STRATEGIES IN U.S. AND JAPANESE ELECTRIC UTILITIES. Hiroyuki Yokoyama. USJP Occasional Paper 07-16

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1 BUSINESS DIVERSIFICATION STRATEGIES IN U.S. AND JAPANESE ELECTRIC UTILITIES Hiroyuki Yokoyama USJP Occasional Paper Program on U.S.-Japan Relations Harvard University 61 Kirkland Street Cambridge, MA

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3 ABOUT THE AUTHOR Mr. Yokoyama earned his B.S. and M.S. in Civil Engineering from Nagoya University. At the Tokyo Electric Power Company (TEPCO), he has been chief of the Minami-Aiki Construction Office, Kanagawa Hydropower Office, and, most recently, Deputy Manager for the Affiliated Companies Department, which is responsible for evaluating new businesses of TEPCO and its subsidiaries. Between 2001 and 2003, he served as a researcher at the Institute for Policy Sciences, a non-profit think tank, where he examined issues related to energy, environment, and regional economic development. While at Harvard, Mr. Yokoyama explored business diversification strategies in the United States and Japan. ON THE OCCASIONAL PAPERS OF THE PROGRAM ON U.S.-JAPAN RELATIONS Established in 1980, the Program on U.S.-Japan Relations of the Weatherhead Center for International Affairs and the Reischauer Institute of Japanese Studies enables outstanding scholars and practitioners to come together for an academic year at Harvard University. During that year, Program Associates take part in a variety of activities and conduct independent research on contemporary U.S.-Japan relations, Japan's relations with the rest of the world, and domestic issues in Japan that bear on its international behavior. The Occasional Paper Series is wide-ranging in scope. It includes papers that are valuable for their contributions to the scholarly literature; it also includes papers that make available in English the policy perspectives of Associates from government, business and banking, the media, and other fields on issues and problems that come within the scope of the Program. Needless to say, all papers represent the views of their authors and not necessarily those of their home organizations, the Program, the Weatherhead Center for International Affairs, the Reischauer Institute, or Harvard University.

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5 TABLE OF CONTENTS Introduction 1 Chapter 1. Why Do Firms Diversify? What Can Be Learned From Past Lessons? 4 Chapter 2. Diversification Strategies of Japanese Electric Power Companies 9 Chapter 3. Diversification Strategies of U.S. Electric Utilities 16 Chapter 4. Learning from Past Experiences 25 Conclusion 28 Figures 31 Bibliography 46

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7 LIST OF FIGURES Figure 1. Growth Vector Components 31 Figure 2. Product-mission Matrix 31 Figure 3. Pattern of Diversification 32 Figure 4. Business Deployment in Electric Utilities 32 Figure 5. Unavoidable Trade-offs Among Modes of Expansion and Diversification Strategies 33 Figure 6. Ten Electric Power Companies by Service Areas 34 Figure 7. Changes in Electricity Sales for 10 Japanese Electric Power Companies 34 Figure 8. Staged Expansion in the Scope of Liberalization 35 Figure 9. Business Deployment in Japanese Electric Power Companies 36 Figure 10. The Progress in Revenue from Sales in Diversified Businesses Between 2002 and Figure 11. The Progress of Operation Profits from Sales in Diversified Businesses Between 2002 and Figure 12. Changes in Operating Revenue for 10 Japanese Electric Power Companies 39 Figure 13. Changes in Net Income for 10 Japanese Electric Power Companies 40 Figure 14. Composition Ratio of Diversified Businesses in Consolidated Business Performance 41 Figure 15. Major Characteristics of U.S. Electric Utilities by Type of Ownership 42 Figure 16. Number of Mergers and Acquisitions in U.S. Shareholder-owned Electric Utilities 43

8 Figure 17. Comparison of Major Electric Utilities in the United States and Japan 44 Figure 18. Comparison of Business Circumstances of Electric Utilities in the United States and Japan 45

9 ABBREVIATIONS CRIEPI EEI EPAct ERO EWG FEPC FERC IOU IPP KEPCO M&A PURPA RTO TEPCO Central Research Institute of Electric Power Industry in Japan Edison Electric Institute Energy Policy Act Electricity reliability organization Exempt wholesale generation Federation of Electric Power Companies of Japan Federal Energy Regulatory Commission Investor-owned utility Independent power producer Kansai Electric Power Company Merger and acquisition Public Utility Regulatory Policies Act Regional transmission organization Tokyo Electric Power Company

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11 INTRODUCTION Since the deregulation of electric utilities in 2000, Japanese electric power companies have been trying to expand their business activities to other fields. In other words, they are making efforts to diversify. I think Japanese electric power companies have a wealth of management resources including customer bases, technology, corporate brands, and financial power. Some of their non-electric businesses, however, do not seem to have prospered. On the other hand, in general, large Japanese firms drastically diversified during the years of Japan s economic bubble at the start of the 1980 s. Since the collapse, most of them have been restructuring and applying thorough selection and concentration in their core field. Nonetheless, it is said that even when business selection and concentration were important management challenges, diversification was an essential strategy for corporations whose main businesses had slowed down. 1 As many U.S corporations diversified in the 1960 s and 1970 s, considerable research on corporate strategy and business diversification was conducted on such firms to examine their performance. At present, it seems that conclusions from such research vary widely depending on who is doing the analysis and on the issues being addressed. Much of the research to date has been conducted in pursuit of an unequivocal conclusion that business diversification is either universally profitable or universally unprofitable. 2 1 Hideaki Miyajima et al., Ministry of Finance, Report of the Research Committee on the Diversification of Japanese Companies and Corporate Governance, 2003, 20 November 2006, < 2 David J. Collis and Cynthia A. Montgomery, Corporate Strategy: A Resource-Based Approach (New York: McGraw-Hill Irwin, 2005) 98. 1

12 In this paper, I will examine the business diversification of electric utilities in the United States and Japan considering the relevant business circumstances. As a first step, I will attempt to organize and arrange the theoretical framework of diversification. I will begin by defining diversification and asking why firms embark on this path. After that, I will examine the differences in business diversification between U.S. and Japanese electric utilities. Finally, I will try to identify some implications from my findings. My hypotheses are follows: Under deregulation, major Japanese electric power companies, such as Tokyo Electric Power Company (TEPCO), with their management resources, would have the potential to expand their business fields outside of electricity. There will be a certain amount of trial and error before achieving a favorable outcome. There should be something to learn from past lessons as well as experiences with diversification both in the United States and Japan. I would like to clarify the possibilities, describe the strengths and weaknesses in the industry, and explore them by examining various resources. In Chapter 1, the reasons why firms diversify and the framework of diversification will be outlined in order to prepare for an examination of diversification. Diversification will also be defined in this chapter. In Chapter 2, the business diversification of Japanese electric power companies will be covered. In this chapter, after presenting an outline of electric power companies and deregulation in Japan, the progress of business diversification will be explored and discussed using financial data. 2

13 In Chapter 3, transitions of diversification strategies of U.S electric utilities will be described. In this chapter, after giving an overview of electric power utilities and deregulation in the United States, the progress of business diversification will be examined. In Chapter 4, the differences in business circumstances between the electric utilities in the United States and Japan will be compared to discuss business diversification strategies. The lessons to be learned from U.S electric utilities, which are in an advanced stage of diversification, are also described in this chapter. Finally, in the conclusion, issues to keep in mind in addressing business diversification are proposed and the implications of empirical knowledge derived from past business practice and research will be noted. 3

14 CHAPTER 1 WHY DO FIRMS DIVERSIFY? WHAT CAN BE LEARNED FROM PAST LESSONS? Before examining the business diversification strategies in electric utilities, the growth of the firms and diversified expansion should be discussed. This chapter begins by defining diversification and trying to clarify the reason why firms diversify. What Is Business Diversification? The concept of corporate strategy was explained clearly in the 1960 s and 1970 s by academics. Igor Ansoff, a business policy scholar, defined expansion and diversification as a fundamental perspective of decision-making about business structures and made several important statements on these topics. Growth vectors indicate the direction in which firms move with respect to their current product-market posture. As shown in Figure 1, market penetration denotes a growth direction through an increase of market share for present product-markets. In market development, new missions are sought for the firm s products. Product development creates new products to replace current ones. Finally, diversification is distinctive in that both products and missions are new to the firms. As shown in Figure 2, the growth of the firm is divided into expansion and diversification. By definition, diversification is a more drastic and risky strategy because of the involvement of a simultaneous departure from familiar products and familiar markets. 3 3 H. Igor Ansoff, Corporate Strategy: An Analytic Approach to Business Policy for Growth and Expansion (New York: McGraw-Hill, 1965)

15 There is also a pattern of diversification, as shown in Figure 3. 4 Expansion starts within the core industry and is undertaken to enhance or protect a firm s position in that market. The firm may then move outside its initial industry, often tentatively at first, until over the years it becomes increasingly more diversified. 5 On the other hand, Hideki Yoshihara, a specialist in business administration, defined diversification as increased diversity on a whole line of products to sell through business activities of firms. 6 In this definition, the line of products and criteria on diversity should be clarified in order to facilitate the discussion. Diversification is defined as growth and expansion of firms entering related fields and new businesses. Of particular note is a recent study aimed at the electric power industries, in which Masayuki Yajima, of the Central Research Institute of Electric Power Industry in Japan (CRIEPI), has taken some important steps and created the conceptual figure of business deployment in electric utilities 7 that is shown in Figure 4. Diversification is often used synonymously with start-up business development. In this paper, the term can be defined in a broad sense as expanding business fields either to new markets, new products, or both, while retaining strong core businesses. 4 Collis and Montgomery Collis and Montgomery Hideki Yoshihara et al., Nihon Kigyo no Takakuka Senryaku Keiei Shigen Apurohchi (Tokyo: Nihon Keizai Shinbunsha, 1979) 9. 7 Masayuki Yajima et al., Denryoku Jiyuuka ni Kachinuku Keiei Senryaku: Denki Jigyo no Kinmirai, (Tokyo: Energy Forum, 2005) 22. 5

16 Why Do Firms Diversify? As noted above, firms diversify to grow and survive in a sustainable fashion. Naturally, even though there might be risk, the decision as to whether or not to diversify depends on corporate strategy and is critical in the growth of firms. A number of papers that give different reasons for diversification can be summarized as follows 8 : Firms might diversify when their objectives can no longer be met within the product-market scope defined by expansion. Firms might diversify because the retained cash exceeds total expansion needs. Firms might diversify when diversification opportunities promise greater profitability than expansion opportunities. Firms might continue to explore diversification when the available information is not reliable enough to permit a conclusive comparison between expansion and diversification. The British economist Edith Penrose said that companies seek to diversify as external and internal inducements for growth. 9 External inducements mean conditions or opportunities in a firm s external environment, such as a downward shift in demand in a firm s primary market. Internal inducements, on the other hand, indicate conditions within a firm that prompt it to diversify. A very typical internal inducement would be a firm s desire to utilize its resource base. 10 At this point, I can apply existing research findings as reasons for diversification in the electric utilities industry. These can be summarized as follows. 8 Ansoff Edith T. Penrose, The Theory of the Growth of the Firm (London: Basil Blackwell, 1959) Collis and Montgomery 88. 6

17 As external inducements, slow growth in the demand for electricity, regional monopolies (in the case of Japan as will be described in detail below), and deregulation and tough competition in the electricity market. As internal inducements, effective utilization of unused management resources, such as human, goods, capital, and information resources. In Japanese electric power companies, in particular, decrease of the investment in the electric power business brings some cash flow under deregulation. What Can Be Learned from Past Lessons? To date, many researchers have examined the performance of diversification, but their findings were different, depending on the scholar or the issues examined. 11 Even though I hoped that these differences could be clearly accounted for, in the end, they seemed to be far too complex for simple answers. Michael Porter of the Harvard Business School studied the diversification records of 33 large, prestigious U.S. companies between 1950 and During this period, each of them entered an average of 80 new industries and 27 new fields. About 70 percent of the new entries were acquisitions. According to his study, on average, corporations divested more than 50 percent of their acquisitions in new industries and more than 60 percent in entirely new fields. Moreover, the track record in unrelated acquisitions revealed that the average divestment rate was 74 percent. These results showed that the success ratio of the unrelated diversified activities was extremely low Collis and Montgomery Michael E. Porter, From Competitive Advantage to Corporate Strategy, Harvard Business Review (May-June 1987). 7

18 In a recent study on the diversification of Japanese companies and corporate governance, the following diversification and performance trends were noted 13 : The business structure of Japanese companies was drastically diversified during the years of the bubble economy in the 1980 s. While some companies have shifted to more focused business strategies since the second half of the 1990 s, others have been increasingly diversifying. It has become clear that unrelated diversification, where no synergy can be expected, results in low performance. Factors behind the establishment of subsidiaries have diversified. In the past, the main reason for establishing subsidiaries was to slash personnel expenses; at present, however, strategic use of subsidiaries has increased. As modes of expansion and diversification strategies, firms can implement their diversification strategy through internal development, acquisitions, mergers, joint ventures, or alliances. It is said that choosing among the various modes involves unavoidable trade-offs, as shown in Figure In the case of a spin-off business from the parent company and/or the intrapreneur business, there is a tendency to choose internal development. On the other hand, mergers and acquisitions (M&A s) or alliances with outside partners can often be used to enter unrelated businesses because of the company s own poor business know-how. In these cases, there could be a problem between the controlling share and acquiring management know-how in corporate governance. 13 Miyajima and Inagaki. 14 Collis and Montgomery

19 CHAPTER 2 DIVERSIFICATION STRATEGIES OF JAPANESE ELECTRIC POWER COMPANIES This chapter covers diversification strategies of Japanese electric power companies, including major gas firms. First of all, an outline of Japan s electric power industry and electric retail deregulation will be given as a background of diversification. Second, the progress of diversification in electric power companies will be discussed. The Structure of Electric Power Companies in Japan Most Japanese electric power companies (Hokkaido, Tohoku, Tokyo, Chubu, Hokuriku, Kansai, Chugoku, Shikoku, and Kyushu) were established in Okinawa Electric Power Company was founded in 1972 as the 10 th in Japan. At present, as shown in Figure 6, the 10 privately owned regional electric power companies are responsible for providing local operations from power generation to distribution and supplying electricity to their respective service areas. 15 In the case of emergency situations, such as peak demand in the summer or if an accident occurs, they cooperate with each other to ensure a stable supply. For over half a century, regional electric power companies have made a contribution to social development and quality of life through a stable supply of high-quality electricity. As shown in Figure 7, demand for electricity continues to grow at an average rate of 1 percent per year with the progress of information technology and the aging society. 15 The Federation of Electric Power Companies of Japan (FEPC), Electricity Review Japan , 6 November 2006 < 9

20 Deregulation of Electric Utilities in Japan The deregulation of electric utilities in Japan has been discussed and carried out with the aim of achieving an internationally competitive level of cost. The liberalization of retail electricity sales began for extra-high voltage customers (2000kW or above), such as large factories, department stores, and office buildings, in 2000, and was gradually expanded in scope and extended to include small-scale users (50 2,000 kw) by 2005 (Figure 8). As the number of companies entering the electric power business increases, competition is steadily intensifying. 16 A detailed study on full liberalization, to include residential customers, will begin some time around According to an up-to-date report released by the Advisory Committee for Natural Resources and Energy: Since the introduction of institutional system reform of the electricity industry in 1995, the cost of electricity has been decreasing steadily in Japan. Despite the recent surge in fuel costs, the price of electricity decreased by 18 percent during the period between fiscal 1995 and Since the liberalization of the retail market in fiscal 2000, the price of electricity in the liberalized sector has been steadily declining. In particular, the price of electricity for commercial demand, which is relatively higher than that for industrial demand, decreased substantially i.e., by about 30 percent during the period between the first half of fiscal 2000 and the first half of fiscal 2005, reflecting the entry of many new businesses other than general power utilities. The price for industrial electricity, on the other hand, declined by about 13 percent during the same period. The price of electricity for household customers, where liberalization has not been introduced, also dropped by 10 percent from fiscal 2000 to 2005 as a result of improvements in 17 efficiency. 16 Tokyo Electric Power Company (TEPCO), TEPCO Corporate Brochure Agency for Natural Resources and Energy, Report by the Subcommittee to Evaluate System Reforms, 22 May 2006, 23 November 2006 < 10

21 According to the Nikkan Kogyo Shimbun, TEPCO lost market share corresponding to 2200 million watts and Kansai Electric Power Company (KEPCO) lost 580 million watts since the liberalization of retail electricity sales in Both firms have a strong sense of crisis about this situation. Business Diversification of Electric Utilities in Japan Japanese electric utilities are facing a turning point originating from slow growth in demand for electricity and intensifying competition with phased expansion in the scope of deregulation of electric utilities. On the other hand, deregulation also means the chance for electric utilities to expand their business activities into non-electric fields using their management resources. According to business plans released by the electric utilities, the annual growth rate in demand for electricity over the next 10 years is expected to be about 1 percent, 19 which would be the lowest level ever. Under these business circumstances, electric utilities are trying to achieve sustainable development. As one of the methods to achieve this goal, electric utilities have diversified into non-electric business fields. Numerical targets for growth in non-electric businesses have also been set in the business plans of TEPCO, KEPCO, Chubu Electric Power Company, and Kyushu Electric Power Company, to enhance enterprise value and attain growth under deregulation. 18 Toden wa Kawarerunoka Nikkan Kogyo Shinbun 16 February Ministry of Economy, Trade and Industry, Heisei 18 Nendo Denryoku Kyokyuu Keikaku No Gaiyo, March 2006, 18 January 2007 < >. 11

22 In its management plan, TEPCO set a goal of pursuing development in four strategic business areas (information and telecommunications, energy and environment, living environment and lifestyle, and overseas) by applying selection and concentration and undertaking strategic development focused on fields associated with energy. 20 Commonly observed features are that most of the companies are conducting energy-related, IT and communications, and living environment-related businesses. Some companies are also embarking on nursing, home security, personnel services, housing evaluations and guarantees, and real estate, as can be seen in Figure 9. The Progress of Diversified Businesses in Terms of Financial Data (2002 versus 2005) Figures 10 and 11 show the progress of the revenues and operation profits from sales in diversified businesses in terms of financial data between 2002 and As a general trend, both sales from diversification and the number of consolidated subsidiaries increased sharply during that period. According to company financial reports, TEPCO, for example, had 140 consolidated subsidiaries in 2005 versus 58 in Operation profits from sales of diversified businesses, however, have not improved drastically compared to fiscal 2002, except for a few companies. It may be possible to construe the following reasons for this: The sales of most start-up businesses that have been established since 2000 are relatively small in scale. Some diversified firms prosper in business, though, because of their limited sales, they make only a small contribution to overall business performance. 20 Tokyo Electric Power Company (TEPCO), Annual Report

23 Some information and telecommunications businesses are now gradually improving their corporate earnings. On the other hand, the operating revenues and net incomes in the electric power business of the 10 privately owned regional electric power companies between fiscal 1995 and 2005 exhibited wavelike fluctuations, as shown in Figures 12 and 13. This reflected not only the stagnant economy and moderate temperatures, but also the influence of the reduction in electricity rates. For reference, the operating revenue and net income of TEPCO are also shown. Gas companies, such as Tokyo Gas and Osaka Gas, on the other hand, feature higher profit/earning ratios in diversified businesses than other electric power companies. In addition, the component ratios of diversification businesses in consolidated sales account for more than 30 percent in gas companies. Comparatively, they tend to focus on core-related businesses, such as sales of electric appliances for gas instruments, etc. As noted, gas companies have diversified into related business fields. Consequently, they attain almost the same profit/earning ratios as their core businesses, as shown in Figure 14. With the progress of deregulation in the electricity market, most electric utilities have diversified into non-electric and unregulated businesses. The ratio of operating profits to sales in diversified businesses in each electric power company, however, is relatively low. It seems that Japanese electric utilities are seeking for ways to expand their businesses into non-electric fields using their resources under deregulation and stagnation in demand for electricity. 13

24 According to Yajima 21 : Even though Japanese electric utilities have a tendency to emphasize diversification into information and telecommunications, home security, and senior nursing care, to the contrary, European electric power utilities in advanced stages of deregulation are trying to concentrate on their core businesses. He also notes that: Growth of the free cash flow resulting from a decrease of investment in electric facilities has been speeding the reduction of interest-bearing debt and electricity price and investments in new businesses Diversification Strategy in Japanese Electric Utilities According to the business plans 22 of electric utilities, generally, their diversified activities are classified broadly into energy- and living environment-related businesses, information and communications, the environment, and overseas activities. Even though the segmentations and names assigned to them are not the same among electric power utilities, the descriptions of the businesses are similar. The performance of each of these, however, cannot be precisely evaluated because their segmental financial data are kept private. To a greater or lesser extent, most Japanese electric utilities are trying expand their businesses focusing on energy-related activities. They also recognize that the gas business has good synergy with them. While they are striving to work with local communities for mutual harmony and benefit, some of them are trying to expand overseas projects. This does not seem to indicate that they are attempting to become global firms. It seems rather that they are aiming at providing multi-utilities in regional societies. 21 Yajima Business plans, annual reports, corporate brochures and other literature from Japanese electric power companies are cited in this section. 14

25 Among the 10 Japanese electric utilities, TEPCO, KEPCO, Chubu Electric Power Company, and Kyushu Electric Power Company have set concrete sales volume goals for diversified businesses. TEPCO and KEPCO also set profit goals and are especially active in diversification activities. As noted previously in this chapter, the portions of diversified activities in consolidated sales are relatively small. Based on segmental financial data, there has already been great improvement in the degree of dependence on the parent firms, i.e., a lessening of the dependence of the diversified activities on inter-company transactions. Sales volume goals in diversified businesses are almost below 10 percent of the consolidated sales because of the huge size of the core businesses. Diversified activities in Japanese electric power companies are in the process of trial and error before they achieve a favorable outcome. To some degree or another, they have been expanding their business fields for several years and have seemed to learn a number of things. As the result of their explorations over the next few years, I think they will be able to a find better ways to diversify their businesses depending on their corporate strategies. 15

26 CHAPTER 3 DIVERSIFICATION STRATEGIES OF U.S. ELECTRIC UTILITIES This chapter covers diversified business activities among U.S. investor-owned electric utilities. First of all, an outline of investor-owned utilities (IOU s) and electric retail deregulation in the United States is briefly given as a background of diversification. Secondly, the progress of diversification in various electric power companies is discussed. Electric Utilities in the United States The electric power industry is divided into two categories: traditional electric utilities and non-traditional entities, such as power marketers and non-utility power producers. The traditional electric utilities are composed of investor-owned, publicly owned, cooperative, and federal utilities. Power marketers are entities that buy and sell electricity, but usually do not own or operate generation, transmission, or distribution facilities. Non-utility power producers are also called independent power producers (IPP s). They are usually authorized to sell at market-base rates. Unlike traditional electric utilities, IPP s do not possess transmission facilities or have retail electric sales. On the other hand, traditional electric utilities have generally been vertically integrated companies that provide for generation, transmission, and distribution and energy services for customers in a designated area. Under deregulation, however, they are changing from vertically integrated monopolies to functionally unbundled entities with a competitive market for power generation DOE/EIA, Electric Power Annual 2000 Volume II, 2002, 29 November 2006, < 16

27 There are more than 3,000 electric utilities (excluding power marketers) in the United States. In terms of number, there are more than 200 investor-owned electric utilities, 2,000 publicly owned electric utilities, some 900 consumer-owned rural electric cooperatives, and 10 federal electric utilities. 24 Even though IOU s represent less than 10 percent of the total U.S. number, they generate almost 60 percent of the electricity produced by U.S. electric utilities. The characteristics of U.S. electric utilities are shown in Figure 15. The Changing Structure of the U.S. Electric Industry 25 As described above, the electric power industry in the United States is changing from a regulated to a competitive sector. In the past, vertically integrated IOU s, which owned most of the generation capacity, transmission, and distribution facilities in the nation, dominated power generation. At present, the electric power industry has many new companies that produce and market wholesale and retail electric power. They are in direct competition with traditional electric utilities DOE/EIA, Electric Power Industry Overview, 22 January 2007, < 25 Most of material in this section is derived from the DOE/EIA website. 26 DOE/EIA, The Changing Structure of the Electric Power Industry 2000: An Update, 22 January 2007 < >. 17

28 The Public Utility Regulatory Policies Act (PURPA) of 1978, which was designed primarily to encourage the use of renewable energy for electricity production, demonstrated that generation of electricity is not a natural monopoly through the growth in non-utility power producers and IPP s. PURPA established the groundwork for deregulation and competition by opening wholesale power markets to non-utility power producers. This was due to the rise in prices for electricity primarily caused by increases in fuel costs. 27 Liberalization in the electricity market began with the enactment of the Energy Policy Act (EPAct) of 1992 as a turning point. EPAct meant that the electric power industry would evolve from a regulated monopolistic sector to a less regulated, more competitive one. The Federal Energy Regulatory Commission (FERC) issued Orders 888 and 889, requiring utilities to file open access transmission tariff. In 1999, FERC also issued Order 2000 calling for the creation of regional transmission organizations (RTO s), independent entities that control and operate transmission grids free of any discriminatory practices. These orders substantially forced utilities to restructure the electric industry. In addition, the Energy Policy Act of 2005 (EPAct 2005) assigned the responsibility for overseeing operations, energy efficiency, and conservation, as well as for enforcing mandatory rules in the electric power industry to an electricity reliability 28, 29 organization (ERO) under FERC. 27 DOE/EIA, Wholesale Competition in the U.S. Electric Power Industry Fact Sheet 22 January 2007 < 28 DOE/EIA, Electric Power Annual 2005, November 2006, 23 January 2007 < 29 DOE/EIA, Changing Structure. 18

29 As of now, 18 states have undertaken restructuring. States that historically had higher-than-average prices, such as California, Pennsylvania, New York, and most of New England, were the first to open their retail electricity markets to competition, allowing customers to choose their electricity supplier. Now other states are beginning with a limited number of consumers. One of the major goals in restructuring is to lower the price of electricity. 30 In , however, major failures, such as the California electricity crisis and the Enron debacle, caused a slowdown in the pace of change, an increase in market regulation, and a reduction in competition. 31 Since then, electricity deregulation in the United States has decelerated. Business Diversification Processes in Investor-owned Electric Utilities in the United States Electric utilities in the United States began to diversify significantly into non-electric and unregulated businesses in the early 1980 s. At that time, because of the economic slowdown resulting from the oil crisis in the 1970 s, the electric industry faced an annual increase in demand of only about 2 percent after decades of rapid growth. Many leading utilities experienced a reduction in construction expenses and looked for new opportunities to invest their extra cash flow. Some of them prepared to invest in new businesses, while the cash was returned to investors as common dividends. Some electric utilities changed their firms names to demonstrate that they were no longer no-growth firms. The following examples will suffice to show diversified businesses in electric utilities. Potomac Electric Power leased Boeing 747 s to KLM and Singapore Airlines. 30 DOE/EIA, Electric Power Industry Restructuring Fact Sheet, 29 November 2006 < 31 Wikipedia, Electricity Market, 23 January 2007 < 19

30 FLP Group Pacific Lighting acquired an insurance company. Pacific Lighting Corp. brought a chain of drug stores. Pinnacle West invested in Merabank, Arizona s largest saving and loan association. Some of these diversification activities stirred up controversy. 32 From the historical viewpoint, IOU s primarily invested in related areas such as fuel supply, transport, district heating, and appliances. According to studies conducted by the Edison Electric Institute (EEI) in the early 1980 s, these non-utility activities generally had positive effects on the utility s overall performance. By contrast, some diversification activities outside core businesses in the 1980 s produced widely publicized losses. Consequently, some stakeholders take a dim view of diversification in general. On the other hand, it is also said that diversified investments have generally had a minor impact on utility performance and that the failed business efforts served as valuable lessons for utilities managers Tomas Jandik and Anil K. Makhija, "Can Diversification Create Value? Evidence from the Electric Utility Industry" 17 December Charles A. Dice Center Working Paper No , 23 January 2007 < 33 Edison Electric Institute, Diversified Business Activities of Investor-Owned Electric Utilities (Washington D.C: EEI, 1996) 1. 20

31 Until about 1980, utility diversification mainly focused on the need for guarantees on the supply of fuel for companies power plants. These activities relied mainly on vertical integration and the sales of excess natural resources to other utilities. In the 1980 s, as mentioned above, utilities focused on acquisitions outside their core businesses. This means that they invested in financial services, real estate development, insurance companies, telecommunications, and cable TV. Then, in the early 1990 s, there seems to have been a tendency to go back to basics. After the passage of EPAct in 1992, competitive pressure increased, and diversification was more core-related. A remarkable increase in the number of subsidiaries with core- and energy-related businesses was observed at this stage. EEI studies showed new subsidiaries/divisions engaged in diversified activities among 96 investor-owned electric utilities between 1992 and About 80 percent of the 175 new subsidiaries/divisions were in core-related products and services. Since EPAct went into effect, they have also been busy acquiring international businesses. Other activities have been directed towards core-related areas including the sales and servicing of heating and cooling equipment, domestic exempt wholesale generation (EWG) and cogeneration facilities, environmental and engineering consulting, and electricity/gas brokering and marketing activities. Utility firms have taken advantage of their expertise in their core businesses and will likewise keep seeking ways to do so in non-regulated markets. As of 1996, they had accelerated global expansion and such deals had been getting larger. There were no signs of abatement at that point. As the background of global expansion, the slow growth rate and increasing competition in the domestic electricity market made the electric utilities pursue foreign opportunities so that they could utilize their experience and expertise in managing privately owned utilities EEI, Diversified. 21

32 Recent Trends of Business Diversification Strategies in Investor-owned Electric Utilities 35 According to EEI reports, the electric utility industry will face three major issues over the next five years: ongoing changes in regional transmission structure, enactment of stricter environmental regulations, and federal legislation affecting the structure of the sector. In addition, the move toward transmission reliability and stricter environmental regulations might involve additional costs and capital investments in the future. As mentioned previously, the trend of the electric industry since the 1990 s has been back to basics, focusing on the energy business. Recent trends in corporate strategy in the electric utilities, in particular, could be best explained by three terms: M&A s, in other words, enlargement of scale; global expansion; and business diversification. First, during the period from 1995 to 2005, M&A activities in investor-owned electric utilities kept up a steady pace, as shown Figure 16. It seems that most M&A s were motivated by the desire to increase the scale and scope of business, strengthen power in competitive markets, and create efficiencies and synergies. After peaking in 2000, utility M&A activities have stabilized ). 35 EEI, Business Profiles and Activities of Shareholder-Owned Electric Utilities, (Washington DC: EEI, 36 EEI, 2005 Financial Review Plus 2006 Developments, 30 January 2007 < cialreview.pdf>. 22

33 Second, in the 1990 s, most U.S. IOU s had positively accelerated global expansion in South America, Europe, Australia, and Asia. With the slow growth rate of demand for electricity and increasing competition, they invested in power plants and distribution companies to utilize their experience and know-how in managing privately owned utilities. Since 2003, however, they have begun to divest their overseas businesses or narrow down the target countries for investment to improve their balance sheets and focus on their domestic core businesses. Third, concerning business diversification, electric utilities are continuing to exit from non-core businesses with great rapidity. As a result of examinations of business diversification trends among shareholder-owned electric utilities, which generate about 60 percent of the electricity produced by U.S. electric utilities, most of them had non-core businesses such as telecommunications or real estate. Over the past several years, most such companies have continued to divest their non-core assets and refocus on their core businesses. Business diversification strategies in U.S. electric utilities can be summarized as follows: Most of the electric utilities strongly recognize energy and energy-related businesses as their core businesses and are trying to establish business platforms for growth and to improve their balance sheets by selling non-core assets and reducing expenses. Though most electric utilities expanded their overseas operations actively to pursue opportunities for attractive growth in the face of the slow increase in demand for electricity and greater competition in the 1990 s, over the past several years they have been continuing to exit or narrow down their overseas activities to focus on their domestic core businesses. 23

34 In order to cut expenses, some electric utilities tried to reduce the cost of benefits and the number of employees. At the same time, the firms wanted to pursue market power and increase the scale and scope of business, so the number of M&A s peaked around 2000 and has stabilized since then. 24

35 CHAPTER 4 LESSONS FROM PAST EXPERIENCES This chapter summarizes diversification activities in U.S. IOU s and Japanese electric utilities. To put it simply, there might be two main choices: diversification into non-core businesses or back to basics. As discussed in the previous chapter, generally speaking, U.S. IOU s have been opting for the latter alternative over the past decade or so. This trend can be explained as follows. There was diversification into non-electric businesses in the 1980 s, while, in the 1990 s, the targets began to shift to energy-related businesses with the increase of competitive pressure as a result of EPAct in In the 1990 s, in particular, the utilities diversified into energy-related and overseas businesses to utilize existing resources in view of the slow growth in domestic demand for electricity. Around 2000, M&A s were active, and the number of utilities in the EEI index group of electric utilities declined more than 30 percent, from 98 in 1995 to 65 in Most M&A s were undertaken to increase the scale and the scope of business. Since 2002, across the board, most utilities have accelerated their exits from non-core businesses and begun to eliminate energy-related overseas businesses and/or narrow down target countries to improve their financial strength in the competitive market. Among U.S. investors, electric utilities are considered to be conservative shares, so it is hard to allow risky diversification into unrelated businesses, while it is relatively easy to permit divesture because a significant concern is profit performance. 25

36 As noted in Chapter 1, it is obvious that the success ratio of unrelated diversified activities has been extremely low. On the other hand, diversification is also an important strategy for firms characterized by slow growth and intense competition in their efforts to pursue sustainable growth. It seems to me that diversification activity trends in most Japanese electric power companies follow the business activities of U.S. investor-owned electric utilities. It is not necessarily appropriate, however, to assure that similar trends will be observed among U.S and Japanese electric utilities in the future. This is because there are definitely differences in business circumstances, corporate structures, and regulations between the two countries. U.S IOU s have adopted the holding company system, and there are some electric utilities including gas utilities and others under the control of holding companies. Japanese electric power companies, on the other hand, have not adopted this system, and the business scale of each company is larger than that of U.S electric utilities, as shown in Figures 17 and 18. Certain successful diversification strategies in U.S. utilities, which include important implications and messages, can be summarized as follows. 37 U.S. investor-owned electric utilities were fast-moving, early entrants into growth markets. Many of them exited their less successful businesses, cutting losses early. Joint ventures were common; projects were undertaken with experienced operators. Few made large acquisitions in unrelated businesses. They made careful appraisals of their new subsidiaries true strengths, weaknesses, and capabilities. 37 EEI, Diversified

37 They meticulously matched those skills and capabilities with joint venture partners and suppliers, venders, or other parties needed to excel in the new market. They also undertook in-depth assessments of the purpose and role of diversification vis-à-vis core businesses, considering the financial aspects, any human resource issues, and synergies or future value imparted to core businesses for having entered into the venture. In addition, diversified investments have generally had a minimal impact on corporate or utility financial performance and have provided a new impetus for corporate growth. On the other hand, failed businesses offered valuable lessons for utility managers. For this reason, diversification is an attractive option to electric utilities. Porter made several important statements about corporate strategy. 38 They are: Competition occurs at the business unit level. Diversification inevitably adds costs and constraints to business units. Shareholders can readily diversify themselves. We should examine whether incorporating new diversified units would mean that the corporation is better off. The new unit should bring some advantages to the corporation or the corporation should offer significant advantages to the new unit. The corporation should examine this issue properly before embarking on the new venture. It appears that some companies fail to do this adequately, and this is one of the reasons that corporate strategies fail. 38 Porter. 27

38 CONCLUSION Business diversification is an essential corporate strategy for firms that have few prospects for growth. In particular, it seems natural to me that Japanese electric power companies would try to explore diversification into non-electric businesses given the slow growth in demand and the progress of deregulation. It should be remembered, however, that U.S. investor-owned electric utilities in an advanced stage of diversification have a tendency to focus on their energy-related businesses, and most of them have attempted to exit from non-core businesses to strengthen their core business platforms and improve their balance sheets. Also, over the past several years, they have accelerated their exit from overseas businesses or narrowed down the target countries. It is said that Japanese electric power companies have recently been absorbed in diversification into non-electric businesses. These operations, however, are small in scale as compared with their electric utility businesses, and about half of their operations are intra-group transactions. More recently, I think these companies have been exploring better ways to expand business fields into information technology and telecommunications, living environment, overseas businesses, and energy-related fields, with a central focus on the electric utility business. At present, they classify their business fields into three to five segments, and this division is relatively similar among most Japanese electric power companies. It does not seem to me that there are definite prioritizations among segmentations. While some electric power companies advocate the importance of finding common interests with local communities, they are seeking business opportunities overseas to utilize their experience in management of utilities. This seems to be paradoxical, but I think these movements mean transition in firms. 28

39 From the foregoing, it can be concluded that: For the past several years under deregulation, most Japanese electric power companies have been exploring better ways to diversify into non-electric businesses with their management resources. At present, they are in transition and need to identify synergizing businesses that they can hold for more than five years to give them a chance to grow. I think it should be remembered that careful appraisal of new businesses and subsidiaries should be implemented before embarking on new ventures. Based on the business diversification strategy, the gap in business performance might widen and distinctive features might be observed among electric power companies. I hope that, for the next several years, these companies could identify some business fields as synergizing businesses and reexamine the effect of the incorporation of the new diversified units into the parent firm. The diversified firms should bring some advantages to the parent firm or the parent firm should offer some advantages to the new firms. Some implications from past lessons show that business diversification should create values for the firms. Business diversification would surely offer valuable lessons for utility managers, and experiences in new units/entities would provide a fresh impetus for a firm s growth. 29