Overview

As public utilities face deregulation and increasing competition, senior management can benefit by adopting Shareholder Value Added (SVA), a strategy that has guided major corporations to achieving impressive gains in shareholder wealth.

The true power of SVA-based management is that it provides a single focal point for strategic decisions, resource allocation, and performance management. It unites all levels of employees within an organization to sharpen their customer focus and increase shareholder value.

Deregulation Alters the Competitive Landscape

As the business environment evolves from one ruled by regulation to one increasingly driven by competition, the public utilities industry is undergoing radical change. Mergers and acquisitions have risen dramatically, and markets are restructuring.

New strategies will be adopted to survive in the market-driven years ahead. Public utility management will evaluate the potential impact of the growing number of strategic options and will rethink key strategies with respect to products, markets, customers, employees, and assets. The industry leaders will determine how to deploy resources more effectively and adopt accurate performance measures to achieve their new objectives.

Utilities are also looking inward to launch restructuring and management initiatives — process reengineering, activity-based management, compensation management, benchmarking, focusing on core competencies, and outsourcing non-core activities. Many internal approaches, however, may fall short due to poor or obsolete metrics. Senior managers frequently lack the ability to cut through the plethora of data supplied by various management tools. As a result, they do not know if they are applying the correct strategies or optimizing resource allocation, or if implementation is on target.

Utilities need new tools to manage the change movement, to surmount the bumps and rifts ahead, and to guide the organization in the right direction. The right tools, properly aligned with a shareholder-value focus, enable managers to meet the needs of the new constituencies, or stakeholders, emerging in a restructured industry.

Need for a New Paradigm

To succeed on this emerging path, fundamental assumptions are being reexamined. As in other competitive industries, the emphasis is shifting from merely managing costs to adding shareholder value. Managers and employees are becoming valued for more than loyalty; they are being empowered and being given authority over factors that sharpen customer focus and improve profitability.

Public utilities have succeeded largely by avoiding major mistakes and avoiding risk. Success has been couched in terms of meeting budgets, achieving dividend growth and “allowed” return on equity, and keeping customers satisfied. By and large the industry has been an accommodator rather than an optimizer. Utilities must now prove that they can create real value for customers by providing products and services at competitive prices.

PARADIGM SHIFT

Focusing on shareholder value has helped businesses in previously regulated industries adjust to competitive markets and discern what truly matters.

What Is SVA?

The SVA concept compels management to focus on value‑creating strategies.  At the highest level, we define SVA as net operating profit after tax (NOPAT) less capital charges. NOPAT is essentially cash flow from operations, less depreciation.  From NOPAT, we subtract a charge for the value of assets used.  SVA can be enhanced by focusing on its four components: revenue and expenses (NOPAT), capital (value of assets) and cost of capital (adjusted for risk).

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SVA = NOPAT — Capital Charges

SVA = Shareholder Value Added

NOPAT = Net Operating Profit After Tax

Capital Charges = Value of Assets X the cost of capital

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A key notion is that the full cost of capital must be earned before shareholder value can be created. Merely earning the cost of capital pays the investor only that which could be earned in the market with securities of like risk. To enhance shareholder value, returns must be greater than the risk-adjusted returns required by investors.

Current financial performance measures, which have tended to be at the corporate level, can be misleading or subject to distortion. Earnings-per-share growth can be achieved but with real returns on capital declining each year. Any measure that uses reported earnings (including earnings per share and return on equity) is subject to distortions caused by noncash entries and one-time gains or losses. 

For many years utilities have set financial targets of growing dividends per share.  SVA properly sees the dividend decision as the directors’ determination on allocating corporate cash, quite separate from an indication of financial performance. (It may, in fact, be a better indicator of the availability or lack of attractive investment alternatives.)

It is generally accepted that a corporation’s intrinsic value equals the present value (PV) of all net future cash flows.  While a compelling tool for valuing long‑term strategies and major capital decisions, PV of cash flow creates problems in managing near‑term performance.  It treats capital dollars exactly as it does all revenues and ongoing expenses, yet capital is invested for a longer‑term value.  As a result, lower‑level managers may wait a long time to see the payoff of an investment, thereby undermining effective performance measurement.  With the weakness inherent in pure cash flow as an annual measure, SVA emerges as a better measure, working consistently for capital evaluations as well as near‑term performance.

The Management Cycle

Few companies can demonstrate that their major management processes are as tightly linked as those depicted in the diagram above. Strategy formulation focuses on creating long-term plans to build shareholder wealth at the corporate and business-unit levels. Resource allocation, a method of funding programs to achieve strategic objectives, channels capital and other resources to programs that optimize overall investment objectives. Finally, performance management establishes measures and provides compelling incentives to reward the creation of shareholder value.

Below is a closer look at the use of SVA throughout the management cycle: strategy formulation, resource allocation, and performance measurement.

STRATEGY FORMULATION

Shareholder value serves as a focal point or the “north star,” providing a single direction for many management actions in the corporate arsenal. SVA keeps score on all of these strategic decisions, both internal (e.g., reengineering, corporate restructuring) and external (e.g., acquiring or divesting businesses).

To enhance value, management can look internally at corporate restructuring needs. Business units may need to be created, with managers held accountable for bottom-line results in their units. Another tool is refinancing, such as greater use of debt leverage, or having a subsidiary financed differently from the company as a whole. Product lines, marketing, and sales issues can be reexamined to improve revenues and margins. These kinds of objective, shareholder value-driven decisions must be made by top-level management to succeed in the coming years.

Management can also look outside the company. If a strategic acquisition might help unlock value by creating synergy, a better product package, or a better distribution channel, management should move forward to seek such an opportunity. If assets or businesses are not creating value, however, management must be dispassionate about correcting or shutting down non-value-added businesses. While such judgments are not popular, it is the responsibility of senior management to make difficult decisions to ensure long-term survival of the organization and continuing profitability.

Utilities are creating business units to identify clearly where value is being created. Managers, in effect,”own” their business and are held accountable for enhancing value.

A business unit structure can identify where value is being created and who is accountable for enhancing that value. When business units are formed, SVA can provide a compelling framework for managing the performance of those units.

The next step in creating shareholder value is to execute relatively straight forward improvements in company operations, such as reducing costs.  Corporate raiders are notorious cost-cutters, and business history suggests that many acquired companies are able to succeed with diminished cost structures. Why isn’t corporate management itself making the kinds of decisions that raiders do?

The answer, of course, is multifaceted, having to do with differences in corporate culture and having to make difficult decisions (e.g., not wanting to be responsible for painful layoffs, embarking upon a significant restructuring or leading a major change management initiative). SVA encourages executives, however, to think in value-based terms and make bold decisions that result in growing shareholder wealth.

Formulating strategy is the first essential component of SVA. Once your mission, strategic objectives, and broad strategies are aligned, decisions on resource allocation become clearer.

RESOURCE ALLOCATION

Given the competitive direction of the industry, public utilities need to seize the opportunity to manage both the level and productivity of their spending. The goal of strategic resource allocation is to maximize the use of corporate resources by:

• Understanding where value is created in the corporation

• Analyzing future decisions on the basis of that value creation

• Allocating resources in a manner consistent with long-term optimization of shareholder value

Resource allocation decisions are typically made by separating capital from operations and maintenance cost objectives. Many utilities allocate resources primarily through the budgeting process. Decision makers, managers, and planners often view capital spending as creating value (presumably a relic of rate-base regulation), yet the SVA formula (NOPAT minus capital charges) suggests that capital spending destroys value unless it causes NOPAT to increase by more than the additional capital charges associated with new investment.

Understandably, major problems still exist with respect to capital spending. Except at the CEO level, rarely does anyone have accountability for capital once it is spent. Despite an industry environment of slower growth, capital spending for transmission and distribution assets has remained constant or even increased.

Another problem seen in almost all companies is a failure to reflect risk adequately in the investment analysis.  Current analytical tools tend to treat every project as being of equal risk, yet investors abhor uncertainty. The cost of capital is a function of general market capital costs and the risk of particular investments. Risk needs to be quantified and reflected in the cost of capital.

Resource allocation involves making capital decisions, yet it covers all corporate resources, such as human resources, customer relationships, and information. Managing resource allocation under SVA requires that capital expenditures meet SVA tests and those managers who request capital be accountable for its productive use.  Obligations regarding safety, service, and government-mandated spending must be met, but alternatives for meeting them must be analyzed rigorously by SVA criteria.

Clearly, a strategy for managing capital and other corporate resources is critical for success. The most effective means to manage spending is to link strategic planning and resource allocation using SVA-based decision-support tools. These tools support optimization of shareholder value. The next step — to ensure that you are actually adding value — is performance measurement.

PERFORMANCE MANAGEMENT

SVA-based performance measurement provides assurance that managers throughout the organization focus on key corporate values or the drivers of those values. By understanding where value is created and where the leverage points are, performance is measured by the results of processes and activities that impact shareholder value.

Performance management that is based on the production of shareholder value provides a powerful linkage from the executive suite through the organization to operations management. Each level is held accountable for a meaningful contribution — from the chief executive officer, who is accountable for total SVA; to business unit executives responsible for the performance of their own units; to operations management, which may be accountable for some aspects of expense control, inventory management, and various aspects of time and quality; and so on throughout the organization.

Performance management focuses on production of SVA for interim periods, typically a year at a time. Following are the three key components:

• Planning—Setting goals and committing resources

• Performance reporting—providing feedback on performance against the business plan

• Compensation—paying for performance based on measurable goals that tie directly to corporate strategic objectives

To implement a comprehensive performance measurement system, SVA concepts must be implemented within the organization based on factors that enable value to be created (“value drivers”). Value-driver analysis focuses first on SVA components (revenues and expenses, capital, and cost of capital) and then on leverage points (where you get the most “bang for the buck”). Linking these operational factors to SVA, and organizing them in both a business unit and business process management scheme, strengthens the impact of performance measurement.

By creating a chain of performance measures, from strategic objectives at the CEO level to operationally oriented measures at the level of field superintendent, a utility ensures that actions and decisions directly support the strategic objectives of the corporation or holding company.

Each layer of the pyramid above has distinct objectives. The top level is concerned with mission and overall strategic objectives. Group objectives might include adding a specific amount to shareholder value.  A process objective might consist of setting a target amount for the contribution margin of a given energy product or reducing supervisory costs to a given amount per employee. An activity objective might consist of reading a given number of meters per day without exceeding a certain error rate. The performance scorecard must include all levels of the organization because everyone can contribute in some way to the production of shareholder value.

Performance management completes the management cycle by providing feedback on progress toward strategic goals. Performance measures, when tied to SVA and linked with appealing incentives, create organizational change and long-term shareholder value.

SVA and SBUs: The Search for Value Creation

As competition intensifies, utilities are restructuring into separate business units.  Many companies are responding by forming strategic business units (“SBUs”) around the core functions of their business, which include transmission, generation, distribution, and supply.

There are complex issues, however, in implementing business unit management. Most utilities do not have the requisite management reporting infrastructure, especially in a framework able to capture costs at the business unit level or below. In addition, transfer pricing must be done with a solid methodology to ensure fairness and to reflect value creation accurately within each business unit. Finally, restructuring will not succeed without adopting a process view of the organization as it relates to customers, products, and shared services.

SVA and Implementing Change

Once SVA is embraced as the new strategic direction, the real challenge begins. Change management is a central issue because SVA involves significant cultural change — a paradigm shift in the way everyone in the organization thinks.  Anticipating customer needs versus responding to regulators, for example, represents a radical cultural shift.

It is absolutely critical to acknowledge that, without creating value for customers, no shareholder value will ever be created. All corporate value is ultimately derived from revenues that customers pay in exchange for goods or services. It is important to drive the shareholder-value message throughout the organization, particularly to lower-level employees, where eliminating unnecessary tasks or improving customer focus must occur. Whatever the words used, however, the message must be delivered frequently and consistently, with training courses offered to help personnel make a successful adjustment.

In implementing SVA, leadership must come from the top. Utilities planning to adopt SVA must commit to implement the strategy, resource allocation, and performance measurement throughout the organization. Attempts are likely to fail when companies do not make SVA a way of life — when it is viewed as merely the latest management fad. Executed properly, however, SVA results in a productive cultural shift. Like a shining star, it gives everyone in the organization a clear sense of direction and purpose: meeting customer needs and building shareholder value.