new business model initiative

Phase 2: Linking to Value Creation

The New Millennium: The Future is NowAmericas Utilities Meeting 2000February, 2000

New Business Model Initiative

© Andersen Consulting 2000 2

Agenda

• Initiative Overview - Why This Is Important

• Emerging Hypotheses - Linking Shareholder Value to Strategies and Business Models

• Next Steps


Our CEO Agenda Requires Articulating the Relationship of Shareholder Value Creation to Implementation Success

• Our Business Objective: Be the enablers in the execution of strategy

– Help our clients articulate their long-term strategies – Broaden the CEO agenda to include implementation - link our implementation

programs to his value strategies– GPU senior executive: “We want Andersen Consulting to be with us during the

journey…of implementing our eCommerce strategy.”

• Design and implementation cannot be separated from strategy - for example: – Retail access legislation - e.g., price freezes, mandatory reductions - will

establish jurisdictionally-specific cost break-even points– The appropriate CRM solution will need to meet these cost break-even

points


• Understanding shareholder value creation in the energy industry today

• Articulating a long-term vision for the energy industry in the US

• Understanding major drivers of value creation and competitiveness in each major unbundled business segment, e.g., generation, trading, T&D, retail

• Developing differentiated perspectives of how each major business segment will evolve and how value potential will change as the markets mature

• Understanding key regulatory and competitive imperatives in each major region/state (e.g., Northeast, Mid-Atlantic, Texas, California, Southeast)

• Developing a framework(s) to identify key competitive imperatives in each business segment and region – for both incumbents and new entrants – based on our understanding of fundamental value creation

The Objective of the Business Model Initiative Is to Develop a US Market Vision That Links Shareholder Value Creation to Strategic Options


Our Vision for the Industry in the U.S. Should be Specific Enough to Achieve Credibility with Senior Executives

Texas

California

Northeast

Mid-Atlantic

Midwest

Pacific Northwest

Southeast

• • •

Specific Regions/States

Generation Trading eCommerce T&D Retail • • •

End-Game

Transition Paths

Today — Status Quo

Time/Speed

BusinessSegments(Being de-aggregated in increasing numbers)


Our Ultimate Objective Is to Develop a Coherent, Specific and Credible Long-term Vision That All Our Partners Can Present to their Senior Clients

Coherent • Builds upon the existing new utility business model foundation

Specific • Clients want our vision to be applicable to their business i.e., T&D in Texas; they are also very interested in our views on transition paths to the long-term end-game; and in the impact on their company share valuation

Credible • Our vision has to have roots in systematic economic and value creation/destruction analyses

Speed • We all need this vision and related strategy elements today


Agenda



• Next Steps


• Utilities traditionally created value through regulatory-mandated returns on capital investment – creating predictable cashflows and dividends that valued utility equity like bonds

• However, this traditional value model is breaking down.

• Traditional utility stocks are trading at p/e multiples of 13-15 – approximately 40% of the S&P 500 multiple …

• …And the linkage to traditional cash flow/share is eroding

Uncertainty Associated with Electric and Gas Deregulation Has Driven Nine Years of Industry Under Performance

0

500

1000

1500

2000

2500

S&P Tech IndexS&P500DJ Utilities Avg


Most of Our Clients Are Not Capturing Market Value Today

• Most companies are characterized by stalled or empty growth - rather than fundamental value creation

• In particular, traditional sales and EPS growth indicators no longer appear good indicators of market performance

• Uncertainty associated with making the competitive transition is generally depressing valuations…

• … As are strategies that do not reflect the emerging value model

Performance Grid Stock Appreciation v. EPS Growth

-40%

-30%

-20%

-10%

0%

10%

20%

30%

40%

50%

60%

-20% -1 0% 0% 10% 20% 30% 40% 50%

EPS Growth Rate

Stoc

k A

ppre

ciat

ion

Rate

Calpine

AES

Nimo

Con Ed

New Century

Ameren

MidAmerican

Enron

PECONEES

Duke Southern

TXU

Western

NiSource

CinergyAEP

Illinova DQE

Note: Axis’ cross at sample averages. Data represents 1997-99.

Avista

High-GrowthValue Capturers

Low-GrowthValue Capturers

Slow-GrowthStalled Companies Empty Growth

PG&E


However, a Small Number of Top Performers Are Emerging - the Key Appears to be Alignment to Competitive Markets

• Companies embracing the new market structure stand apart from the pack: e.g. Enron, Calpine, AES, PECO

– Calpine: the only pure domestic unregulated generation play

– AES: 100% unregulated generation with significant international exposure

– PECO: aggressively growing nuclear portfolio; telecom

– Enron: integrated natural gas and electricity company with strong risk management and trading expertise

• Interestingly, the relationship to EVA appears to be breaking down - from an EVA/MVA standpoint, only PECO is outstanding (7th rank among utilities*).

Emerging Winners

0% 10% 20% 30% 40% 50% 60%

Average IOU's

Enron

PECO Energy

Calpine

AES

Profit Margin (1998) Sales Growth Rate (1996-99)Stock Appreciation Rate (1996-99) EPS Growth Rate (1996-99)

*Public Utilities Fortnightly, 12/99


Deregulation is Increasing the Gap Between “Winners” and “Losers”

Simple Average Running 1yr Return by Strategy - DJ AdjustedGrouping by Corporate Strategy

-30.00%

-25.00%

-20.00%

-15.00%

-10.00%

-5.00%

0.00%

5.00%

10.00%

15.00%

20.00%

Stoc

k Ap

prec

iatio

n

Supply Companies Distribution Companies Vertically Integrated Companies Diversified Companies


The Challenge : Deregulation is Essentially Redistributing Risk and the Ability to Create Value in Any Specific Market Segment

• The Market Is Dis-aggregating Into Three Fundamental Segments

• As deregulation disaggregates the market into discrete segments, it essentially shifts/redistributes risk, and the ability to create value in any market

• Examining stock performance versus competitive intent can provide some insights into what business models are associated with superior value

Mass CommercialIndustrial

ValueCreationPotential

High Value Creation OpportunityMedium Value Creation OpportunityLow Value Creation Opportunity

— Value Chain —

Volatility

GenerationMarketing

&Trading

Transmission Distribution

Retail Services

Upstream: Supply Downstream: Retail

Moderate High Low Low Moderate Moderate Moderate

C: C: C:VAS: VAS: VAS:

Calpine, AES

Enron, Duke, Williams

DQE, Con Edison

PGE, Green Mountain, Utility.com

Vertically Integrated

Supply

Retail

Delivery


• There are several key questions to understand in each market segment– Value creation model in each market segment– How each market will evolve and the impact on value creation over time– Linkages between each major segment; e.g. supply to trading, supply to

retail– Continuum of potential competitive positions and their value potential

over short and long-term– Business capability requirements associated with each segment; i.e.

profile of “winner”

Capturing Shareholder Value Long-term Requires Understanding How Value Will Be Created Along the Energy Value Chain Segments


Some Clear Messages Are Emerging

• Strong generation, particularly those of focused merchants, and pure distribution plays are outperforming all other strategies

• Market certainty is being valued• The market is discounting complexity,

uncertainty and strategic “dabbing”, e.g. vertically integrated companies in states with impending retail access

• Strategies focused on aggressive sales growth and attention to EPS measures are not being rewarded

– Growth-based mergers without strong strategic synergies, e.g., CPL/FPC, PSCo/NSP, WR/KCPL

– Diversification plays are also being viewed with skepticism, e.g. Connectiv, SCANA, and Avista

– Though some, such as PECO’s and Montana Power telecom investments, have been successful to-date

Note: Bubble size represents standard deviation on stock appreciation. Datafor 1997-99.

Performance GridStock Appreciation v. EPS Growth

-30%-20%-10%

0%10%20%30%40%50%

-5% 0% 5% 10% 15% 20% 25%

EPS Growth Rate

Stoc

k Ap

prec

iatio

n Ra

te

RegulatedSupply PA/NJ

Diversified VerticallyIntegrated

Distribution

UnregulatedSupply

M&ACA


0.28

12.72

7.67

17.99

1.81

13.74

10.21

0.77

18.91

10.28

71.2549

0 20 40 60 80

Beta

ROE

ProfitMargin

P/E Ratio

Utility Avg AES Calpine

For Example, Established Pure-Play Supply Companies Are Trading at 2x Multiples of the Industry

1.33%

2.80%

0%

1%

1%

2%

2%

3%

3%

RegulatedGeneration

UnregulatedGeneration

Market Comparison of Unregulated vs. Regulated Suppliers . . .

. . . From a Financial Standpoint, Maintaining Ownership of Assets

Under Regulation Appears Unattractive


• The unregulated U.S. supply market is rapidly developing - and commoditizing– Merchant activity is accelerating - shifting the asset

profile in markets toward more flexible, efficient capacity– Large traders - increasingly squeezing the middle - are

emerging, predominately asset-backed– Since 1995, the volume of wholesale physical power

marketed has grown at a continuously compounded annual rate of 91% to approximately 2,500 Twh in 1999

– However, electronic trading is increasing and may reshuffle the competitive structure

The Emerging Supply Value Model :A Commodities Market Model


Value Creation in the Unregulated Supply Market Will be Driven by the Competitiveness of Asset Portfolios and the Ability to Manage Volatility

• Fundamental value is driven by increasing the spread between the market price of power and the asset portfolio marginal costs - or the “spark spread”

• Generation is equivalent to owning a call option on the “Spark Spread’.

• Integrated risk management expertise and strategic siting of facilities are vital

Profit fromgeneration

Return onCall Option

Fixed Cost• capital expenditure• cost of capital • depreciation• non-fuel O&M

Fuel Sales andPurchases

Supply/DemandBalance

Profit fromtrading

Volatility ofSpark Spread

Option Premium

Power Salesand Purchases

Plant Heat Rate

Option Strike

Volatility ofgas price

Volatility ofpower price

Supply/DemandBalance

Fluctuationsin Supply

Fluctuationsin Demand

Fluctuationsin Supply

Fluctuationsin Demand

Storage

Transportation• inter and intra-regional

System Reliability

Transmission Availability• frequency of line outages

Imports

Exports

Intra-regionalflows

Generation Availability• frequency of unit outages

Weather

Trading Activities

Regional Characteristics


Effective Management of Financial Exposure to Price Volatility Is Critical to Market Success

• The degree of volatility and how it is managed will evolve as the markets mature

– Shifts in capacity mix, availability, and transmission bottlenecks

– Improved understanding of optionally inherent to owning assets

– Development of ISO/RTO’s and related market controls

• The ability to manage assets in a manner that is responsive to market signals will drive financial performance of power market participants

Annualized One Day Volatility of Returns

0%

5000%

10000%

15000%

20000%

25000%

CinergyComEd

PJM

Entergy

FL/GA Border

ERCOT

Mid-Columbia


The Supply Market Is Evolving to an Asset Optimization Model Built Around Commercial Re-integration

The Financial Markets Tend to Support a Re-integrated Commercial Business

Model . . .

. . . However, a Continuum of Trading Models Exist

Generation and Contractual Supply Portfolio

Trading Retail

Wholesale and LargeIndustrial Markets

Mass Residential

and Middle Market

External MarketPrice-Takers Hedgers Market

Markers

• IPP’s/Developers• Owns assets• No trading skills

• Owns assets• Trade around

their physical positions

• Speculation• May or may

not own assets• Trade without

or beyond their asset base


The Financial Markets Appear to Recognize Specific Trading Business Models

• A fully hedged position appears the winning trading strategy among suppliers - highest profit margin with the most certainty

• Speculative plays can yield superior returns but with higher volatility

• Speculative trading have led to some significant debacles - Illinova, LGE, Cinergy, Federal, PCA

Performance by Trading Strategy

0%

1%

2%

3%

4%

5%

6%

7%

8%

9%

10%

0% 1% 2% 3% 4% 5% 6% 7% 8% 9% 10%

Sales Growth Rate

Profi

t Mar

gin

Speculators

Riders

Hedgers

Note: Bubble sizes represent the standard deviation of profit margin as a percentage of total profit margin. Data for 1997-99.


The Ability to Create Value in the Supply Market Will Be Influenced By Market Structures and Distinct Characteristics of Regional Models

Lack of Customer Phase In

Sales &Trading Trans Dist RetailKey Issue Gen

Shopping Credit or Standard Offer

Power Exchange Rule - Must Run

Power Exchange Rule - Must Bid

Brand Name

Market Power / Divestiture

Stranded Cost

POLR - Default

Mandatory Rate Reductions

Performance Based Rates

Facilities Operated

Accounting and Billing - Data Ownership

N F G

Positive ImpactUnclear ImpactNegative Impact

CaliforniaPJMMidwestNEPOOL


Preliminary Hypotheses for the Deregulated Supply Market...

• Utilities should strip away generation assets from beneath the regulatory umbrella to the extent possible

• Market price will rise in the short-term but will likely decline significantly with new capacity - this is a game of chicken, and it is possible that parties will not back down until markets have become over-supplied.

• Sell marginal assets now - they will become less, not more, competitive and excess cash in the industry is lending to overvaluation of existing assets.

• However, the difference between winners and losers will be driven by the ability to understand risk and basic asset optimization

• Market development will drive players to an integrated market maker position - development only and non-asset trading positions will be tenuous

– Players that effectively manage risk and volatility - and have efficient assets - will succeed– Traders without assets are being largely shaken out– Speculators that own assets will struggle initially but will become more successful as market

liquidity and transparency improve


• THE PLAY:

– Ride the volatility in the markets over the next few years, acquiring generation aggressively and trading around the assets.

– At first signs of waning interest in generation assets, SELL. – Ride the market on a reduced portfolio of assets for a few years until over-supply

begins to take effect on capacity retirements. – As retirement rates increase, scour the market for strategically located efficient

assets and BUY as companies who bought at the top release assets to cut losses

These Hypotheses Point to Strategies That Impacting the Extent and Timing of Capability Investments - For Example...


Agenda



• Next Steps


Status/Next Steps

• Work effort approximately 50% complete– Focus to date on fundamental shareholder value analysis

– Supply market analysis

• 3-4 weeks behind schedule due to staffing difficulties

• Next steps– Complete assessment of wholesale markets/market structure

– Begin deeper assessment of retail and asset business segments

– Schedule workshop(s) on emerging findings