European Energy Industry Business Strategies

By Atle Midttun

Since the European Union's de-regulation policy for electricity and energy suppliers was implemented, new strategic configurations have emerged. Traditional restraints of geographical limitations on energy companies have been partly removed: the diversity at national regulatory and company level means that the European scene is one of a multiplicity of strategic configurations and developments, whilst also being complex and segmented.

This book highlights the strategic and regulatory challenges of European deregulation, with its main focus being on the business strategies within the emerging de-regulated electricity markets; various regulatory implications which are being raised in this new climate are discussed. Some of the central strategic issues facing the electricity industry in its new competitive context are explored and reviewed, with classical themes debated as a prelude to the following empirical investigation of actual business strategies pursued by the electricity and energy industries.

The main section of this work consists of 7 national case studies of business strategies which also include one North and one South American case. These were considered important inclusions as the North American companies are large investors in the European market, whilst the European companies invest in the South American market. The final chapter is a comparison and summary of the national patterns of market structures, business strategies and regulatory styles with a brief look at some challenges to be faced in future.

• Language: English
• Publisher: Elsevier Science
• Release date: Apr 20, 2001
• ISBN: 9780080531281

Atle Midttun

Atle Midttun is Professor at the Norwegian School of Management and Co-director of its Centre for Energy and the Environment. He holds a PhD from Uppsala University (Sweden) and a Magister Artium from the University of Oslo (Norway). His research focuses on energy and Environmental Policy issues, especially their regulatory and industrial organisation aspects. He has been the editor of a number of books, including Approaches and Dilemmas of Economic Regulation (forthcoming), European Electricity Systems in Transition (published by Elsevier Science) and The Politics of Energy Forecasting. He is also the author of an extensive collection of journal articles on these topics.

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economics.

Introduction

The European Union’s electricity deregulation policy, which started to be implemented in February 1999, has created a basis for new strategic configuration of European energy companies. Traditional restraints on energy companies in terms of sectoral and geographical limitation and organisational form are extensively softened or have partly been taken away. In most European countries the regulatory regimes are now opening up for integration of electricity companies with oil and gas companies into broader energy companies; joint ventures between telecommunication companies and electricity companies as well as integration of electricity into broad infrastructure companies, including also water and transport. By breaking down national barriers to trade, the deregulation process also encourages European energy companies to make new engagements in markets outside their traditional supply areas, and for the most advanced liberal markets also increasingly across national boundaries.

Nevertheless, competition in the European deregulated electricity markets is very much competition under institutional diversity. Firstly, this is due to the partiality of the EU deregulation and the subsidiarity in applying this partial market opening to various national contexts. This implies that market rules and market institutions are extensively shaped to national taste. Secondly, institutional diversity can also be found at the firm level, as national and even sub-national idiosyncrasy also characterises the players in the electricity markets. The market players are companies with varying mixes of public and private ownership, with varying financial constraints, and with different combinations of political and commercial mandates.

As a consequence of the high diversity, both at the regulatory regime and firm level, the European scene is therefore one of multiplicity of strategic configuration and strategic developments. This diversity at the national regulatory and at the company level points at a co-evolution of regimes and company configuration along several different paths, which again makes the strategic context for European electricity industry complex and segmented.

The diversity of regulatory style is also matched by diversity at the structural level. The scale of European electricity industry does to a large extent reflect the scale of national markets, although modified by different traditions for national and regional organisation. Small states thereby tend to have industrial players at a scale that is highly incongruent with the industrial scale of companies in larger states. The structural asymmetry of national industrial configuration therefore implies challenges to small states in large markets where they are vulnerable to takeovers and where governments thereby lose control over traditional partners in energy policy and energy-industrial development.

In the longer run, the deregulation policy does not only pose challenges to competitively exposed companies, but also to society and regulatory authorities. At least three major challenges can be foreseen: the challenge of competition, the challenge of cross-sectoral operation and the challenge of environmental policy.

As far as competition is concerned, the increasing integration of electricity companies, following the strategic challenges of European deregulation, may in the medium and long term face the European community with problems of market concentration even at the European level. This development may then in the next round undermine the competitive pressure on the firms, which was the main factor motivating the deregulation reform. A pessimistic view is that European competition is at best a transitory phase from national monopolies on the path to European oligopolistic alliances, and with the accelerating pace of European mergers and acquisitions it will take strong anti-trust intervention from the EU authorities to counteract such a scenario.

As far as cross-sectoral operation is concerned, the deregulation and competitive exposure basically induces companies to experiment with combinations of industrial activities in order to gain competitive advantage. Indeed, as already mentioned, leading European electricity companies are now orienting themselves more broadly and redefining themselves into energy—and even ‘infrastructure’—firms. However, the multi-sectoral complexity of advanced strategic business configuration challenges regulatory authorities to assess the strategic interaction effects of cross-sectoral engagements, especially as far as the pricing of natural monopoly services in grid access is concerned. Furthermore, the basic idea behind the deregulation reform is that regulation must remain ‘light’, as it might otherwise become a cost-burden as well as an unnecessary limitation on commercial experimentation. How well the EU and state regulatory apparatus will be able to devise advanced regulatory strategies to cope with the complexity of industrial structuration is still an open question.

The challenge of environmental policy under deregulation basically has to do with the fact that the dissimilarities of ecological vulnerability and abatement costs imply that collective strategies through unanimous multilateral agreements are hard to achieve, as the commercial interests of European nations and ‘national champions’ are too diverse to find a common ground. It may, in fact, be argued that with weak central governance at the relevant market level, the ability to take effective measures in environmental regulation is weakened by the liberal, deregulated regime. The fact that companies with different resource-bases—which would be highly unequally hit by common measures—compete in the same market exposes the more polluting company to very high ‘green costs’ and thereby easily undermines their competitiveness.

The book highlights the strategic and regulatory challenges of European deregulation in nine chapters. While the book’s main focus is on the business strategies within the emerging deregulated electricity markets, regulatory implications are discussed, particularly in the final chapter.

Chapter I spells out some of the central strategic issues facing the electricity industry in its new competitive context. Classical themes such as national styles versus globalisation; scale and scope versus flexible specialisation; horizontal versus vertical integration; static versus dynamic efficiency, and business and public interest are briefly discussed, as a prelude to the following empirical investigation of actual business strategies pursued by electricity and energy industry.

The main part of the book consists of seven national case studies of business strategies. The selection of European cases ranges from the early liberalisers like the UK and the Nordic countries to France, which only very reluctantly moves towards competitive exposure of its industry. Within these two extremes, countries such as Germany, the Netherlands and Denmark take up middle positions.

Although mainly focused on European experiences, the book includes both US and Latin American/Brazilian chapters. The motivation for including these studies in a European-oriented book is twofold:

Firstly, US companies are the major foreign investors in the European electricity industry, which makes them directly relevant on the European scene. Similarly, Latin America is one of the major arenas for European electricity industry’s foreign engagements. Including this market is therefore also highly relevant for understanding the strategic positioning of European electricity/energy industry.

Secondly, the two non-European cases serve to create contrasts to the European scene. Among other things, the US case illustrates a highly dynamic arena for mergers and acquisitions which is yet unparalleled in Europe except perhaps in the UK. The Brazilian/Latin American case illustrates the strategic and regulatory challenges of large-scale privatisation dominated by foreign multinationals.

A final chapter sums up the national patterns in a comparative analysis of market structures, business strategies and regulatory styles. This chapter also raises, and briefly discusses, some of the regulatory challenges that face the future governance of European energy markets.

Chapter I

Perspectives on Commercial Positioning in the Deregulated European Electricity Markets

ATLE MIDTTUN

The commercial re-positioning of the European energy industry following deregulation raises fundamental strategic issues. This chapter will elaborate on some of the underlying theoretical issues of economic organisation as a prelude to the following national case studies and the final comparative analysis.

I. Globalisation/Europeanisation or National Styles: Competition under Institutional Diversity

The tension between globalisation and/or Europeanisation, on the one hand, and path dependency/national styles of industrial organisation, on the other, is fundamentally built into the European electricity market deregulation. On the one hand the deregulation project has a vision of an integrated European market with competition on equal terms for all. On the other hand, national interests have limited the competitive scope and tailored their deregulation to national taste according to the so-called subsidiarity principle.

More theoretically formulated, the so-called convergence perspective argues that, on facing a common competitive market, companies will tend to scale up and converge in function and organisational structure. Against the convergence perspective the national business systems literature argues that industrial development is highly shaped by national styles and national institutions.

One of the most clearly articulated proponents of the convergence perspective is Kenichi Ohmae (1985, 1995) whose basic argument is that as the 21st century progresses, industry, investment, individuals and information flow will be relatively unimpeded across national borders. In this situation, he argues, the strategies of modern, multinational companies are no longer shaped and conditioned by reasons of state, but rather, by the desire—and the need—to serve attractive markets wherever they exist and to tap attractive pools of resources wherever they sit. He claims that the capital markets in most developed countries are flush with excess cash for investment and that the investors will look for multinational companies with their competencies to play key roles in local developments, rather than support local industry. The global orientation of financial sources will, therefore, also serve to support large globally converging firms. Modern commercial dynamics, such as that which is being unleashed by the present European electricity market deregulation, pushes companies to spread across borders in a new way, tapping into global or at least European markets for technology, investment and consumers. In this context, Ohmae argues that national diversity will diminish rapidly and that the nation states no longer have a market-making role to play.

Yet another type of argument in favour of strategic convergence—the so-called institutional isomorphism argument—is put forward by the new institutionalist school in organisation theory. The basic argument here is that national differences are challenged by international learning, co-operation and/or dominance. This constitutes forces towards cross-national harmonisation of strategies and organisational models, or what Di Maggio and Powell (1991) have termed institutional isomorphism. They point out three mechanisms through which institutional isomorphic change occurs.

1. Changes towards organisational convergence may occur as mimetic processes, where changes in relevant reference nations act as a signal to own change, perhaps in response to uncertainty;

2. organisational convergence may also occur through what Di Maggio and Powell call coercive isomorphism, where the need for political legitimacy acts as a driving force for institutional isomorphism; and

3. isomorphism may be closely associated with normative pressure arising from professionalisation.

Against the globalisation and institutional isomorphism arguments a national business systems literature launches a competing perspective with a core argument that differences in major national, regional and sectoral institutions generate significant variations in how firms and markets are structured and operate. On this basis, the national styles literature argues that analytical perspectives that reduce this variation to unidimensional convergence are missing out essentials.

This general argument is developed under several labels: business systems (Whitley, 1992), social systems of production (Campbell et al., 1991) and modes of capitalist organisation (Orru, 1994). The essence of this literature is again that industrial development proceeds differently in different countries, as national industrial ‘milieus’ draw on specific traditions and competence in their national surroundings.

Implicitly, and sometimes also explicitly, the national styles literatures draw on a broader path dependency argument that points out that industrial systems cannot develop independently of previous events (David, 1993). Local positive loops serve to propagate traditional patterns into future strategic decisions. This implies a development with several equilibrium points, where small events at one point in time may play an important role for future development by determining the course of a long-term development. The path dependency and national styles literatures thus foresee that institutional, social and organisational factors will continue to reproduce differences in strategic orientations that may reproduce themselves even under international competitive conditions.

Applied to the European electricity market deregulation, we find elements that fit both positions: the Commission’s ambition to develop an internal market with pan-European competition clearly launches a programme with strong drivers towards harmonisation of markets and with strong isomorphic pressures on the competing companies.

However, two major factors serve to make competition in the European deregulated electricity markets very much of a competition under institutional diversity. Firstly, the partiality of the EU deregulation and the subsidiarity in applying this partial market opening to various national contexts implies that market rules and market institutions are extensively shaped to national taste. Secondly, national and even sub-national municipal idiosyncrasy also characterises the players in the electricity markets. The market players are companies with varying mixes of public and private ownership, with varying financial constraints, and with different combinations of political and commercial mandates.

The very cautious pace of market opening spelled out in EU’s electricity directive, and the plurality of models open to national choice, indicated a soft tone vis-à-vis national vested interest. The member states were here clearly given the possibility to limit competition both in generation and supply, allowing them considerable control over the construction of new capacity and the fuel mix. The result has been a variety of regulatory trajectories and energy policies running side by side in Europe:

The Nordic deregulation took a radical, direct and structural approach with an emphasis on full-free trade competition between several decentralised actors.¹ Major parts of the Continental European development, however, seems to take a more gradual ‘contestable market’ path, where market deregulation rather takes the form of gradual market opening under few structural constraints. The English and Welsh reform could be characterised as somewhere in between, with radical change in ownership structure, but without sufficient market deconcentration and consumer participation to fulfil strong free-trade criteria in the first round. However, with the recent opening up of the market to small-scale consumers this has changed.

The analytical possibility-space for a European market-development may be described in terms of a two-dimensional matrix with degree of market opening to competition along the horizontal axis and the geographical expansion of the market along the vertical axis (Fig. I.1). The Continental European development can be seen to follow a path from national monopolistic planned economy (square III) towards a European semi-competitive and semi-integrated market system (between squares I and II). There is reason to expect that this peculiar mixture of competitive and restraining regulation will characterise the strategic context for years to come, even if the European liberalisation project in a longer time-perspective may provide full integration with open trade between national markets (square II). However, even in the case of extensive market opening in Europe, mergers, acquisitions and other forms of strategic integration may limit competition.

Fig. I.1 Market opening and competition.

This is a conceptual model and the rankings are highly judgmental.

As opposed to the Continental development, where the attempt has been to deregulate and internationalise in the same movement, the British and Norwegian deregulation projects were one-country projects, where the move was along the horizontal dimension (from square III to IV) rather than along the vertical dimension. Norway then subsequently moved into a Nordic market, when Sweden and Finland, and gradually Denmark also followed it in deregulation six to nine years later.

From a globalisation and isomorphism perspective it might be argued that this development contains strong convergence elements. Firstly, convergence through internationalisation and institutional harmonisation; but secondly also convergence in regulatory style as all systems have adopted some market elements.

However, from a national styles position, it is easy to point out strong national elements, both in the institutional specification/delineation of competition and in the type of openness that is established between the national market and its environment. In addition to differences in market scope and regulatory regimes, the European scene is also characterised by extensive differences in company ownership and in competitive exposure of companies within their domestic markets.

This again obviously affects mandates, financial positions and conditions for capital accumulation. Municipalistic organisation may typically imply a local focus, where companies are oriented at serving local needs and are influenced by municipal political processes, including local needs to extract dividend to finance other non-commercial sectors. Etatist organisation exposes the company to state policies, where industrial strategy has traditionally been more developed than at the municipal level. Companies in oligopolistic or semi-oligopolistic positions do, of course, have many of the privileges of state companies, without the latter’s political constraints. Companies exposed to free trade, such as smaller and medium-sized private companies in the Nordic market, are obviously pressured to develop high static efficiency and are vulnerable to takeovers.

Nevertheless, one might argue from a global convergence perspective that the commercial forces unleashed by the deregulation are sufficient to establish a dynamic of their own, leading beyond the current institutional restraints.

II. Scale, Scope and Functional Configuration of European Energy Industry

In spite of the institutional diversity and following national regulatory idiosyncrasy, deregulation of European electricity markets has created a basis for new strategic configuration, as traditional limitations on sector, geographical, organisational and economic scale and scope diminishes.

In most European countries, the regulatory regimes are now opening up for sector reconfiguration by allowing electricity companies to take new positions in other sectors or value chains. Therefore, we are seeing integration between oil and gas companies, merging into broader energy companies. We are also seeing joint ventures between telecommunication companies and electricity companies to utilise the electricity grid for transmission also of telecommunication.

By building down national barriers to trade, the deregulation process also encourages expansion of geographical scope. We therefore see European energy companies making new engagements in markets outside their traditional supply areas. Regional and municipal companies have engaged themselves in other regions and areas within their country, but also within other European countries.

Organisationally, European companies have increasingly adopted the shareholder model, although remaining dominantly publicly owned. However, some companies have also been privatised and/or sold out to foreign interests. In addition, companies have developed subsidiaries and a more complex profit-centre structure in order to manage multiple alliances and commercial engagements.

II.A. Scale and scope vs flexible specialisation

There is a large volume of literature on the challenges of industrial configuration. However, this literature includes seemingly contradictory positions, notably in the choice between scale and scope and flexible specialisation. On the one hand, the scale and scope literature argues for large size and complex engagements. On the other hand, the flexible specialisation literature recommends focus and small-scale concentration.

The advantages of scale and scope-argument goes back to classical economics (Ricardo, 1971; Smith, 1933) and includes such arguments as the indivisible input argument, the set-up-cost argument, the division of labour argument, as well as a market power argument (Koopmans, 1957).

The indivisible input argument refers to the case that some specific capital goods are indivisible in the sense that it becomes very costly or even physically impossible to scale it down to a smaller size. Under-utilisation of maximum capacity of the most efficient scale will therefore burden an economic actor with higher production costs than a competitor that is able to scale up to harvest scale advantages. The set-up cost argument implies that initial investments in organisational competencies and material structures dictate a certain volume to minimise fixed costs. This may have to do with designing organisational routines, qualifying personnel, etc. If these activities have scale advantages, there may be considerable advantages for actors capable of applying these resources to large series. The advantage of specialisation-argument, which was pointed out already by Adam Smith (1933), refers to the fact that the ability to fully develop specialised skills may dictate sufficient volume to support the necessary division of labour and the necessary critical mass to maintain an attractive context for creative professional development.

With Ricardo (1971), Smith’s notion of advantages from specialisation of labour is transferred to advantages from specialisation and trade. Assuming systematic differences in productivity for a given commodity between countries, Ricardo showed how both countries might profit from trade (Ricardo, 1971). Transcending Ricardo’s assumption of nationally based industry, and assuming, with modern industrial organisation, that companies may stage international operations and co-ordinate multiple resources and technologies across national boundaries, then Ricardo’s classical trade theories may be transformed into arguments for multinational strategic organisation. A major criterion for scaling and scoping up, for a multinational company, may thus be to internalise Ricardian trade-advantages within the company. Similarly, the later Hecksher Ohlin theory of international trade, based on the comparative advantage of production based on abundantly available resources (1967), may also be internalised within a single multinational company, and thus made relevant in a business strategy context.

With an increasing tendency towards centralisation and oligopolisation of key sectors of the economy, there may be arguments for scaling and scoping up beyond the efficiency arguments listed above. Companies with sufficient size to take dominant market positions may profit from working the markets so as to increase their own profitability on other companies’ behalf.

The classical theories of scale and scope traditionally referred to the production plant, focusing on operative efficiency at the material–technological level. With Alfred Chandler’s analysis of the competitive advantage of US multinationals in the middle of the 20th century, scale and scope issues were systematically also applied at the organisational level (Chandler, 1977). Chandler saw the ability of American companies to build synergy between international market channels, as facilitated by their introduction of the multidivisional structure. Through the development of a professional middle management that linked large systems together through its ‘modern’ organisational models and through its more advanced organisational technology, the US companies were able to integrated large-scale transport systems and large-scale production systems with advanced multinational marketing on a hitherto unprecedented scale.

The classical and Chandlerian scale and scope position has, however, been met by a more recently developed counterposition. Sabel and Piore (1984) have, in their pathbreaking work ‘The Second Industrial Divide’, argued that more craftsman-like modes of production might, through their flexibility and quality, outcompete the large-scale production systems. Today’s demand for highly sophisticated products built on permanent innovation, according to Sabel and Piore (1984), increasingly leads to avoidance of mass production and development of a more flexible production strategy, to reduce production costs while maintaining the flexibility necessary to thrive in economic uncertainty. This means that companies have to organise so that skills and technology can be constantly realigned in order to produce a rapidly shifting assortment of goods and services.

Sabel and Piore’s (1984) argument implies that flexible specialisation is in the form of networks of technological sophistication; highly flexible manufacturing firms may in many cases meet today’s demand for permanent innovation better than large-scale multinationals. The flexibility of small-scale networks makes them able to accommodate ceaseless change, rather than seek to control it. This strategy is, as Sabel and Piore state, ‘based on flexible–multi-use–equipment; skilled workers; and the creation, through politics, of an industrial community that restricts the forms of competition to those favouring innovation’. Among the characteristics of flexibly specialised industries is the production of a wide range of products for highly differentiated markets and the constant adaptation of goods/services in response to changing tastes and in order to expand markets. This can be managed by developing flexible and widely applicable technologies, such as general-purpose machines rather than large, dedicated machine systems, so that product innovation is not held back by massive capital investment in rigid technologies, and workers possess the skills to produce and develop a wide range of products. The strategic imperative is a strategy that combines both differentiation and efficiency.

Future prosperity, Piore and Sabel argue, depends on the development of flexible technologies, flexible organisational practices, skilled workforces and management, and economies of scope rather than of scale. Vertical disintegration is important because Piore and Sabel envisage production through flexible specialisation as the sum of the production of many specialised firms in networks that can adapt quickly to changing market demands, rather than of a single firm as is the case in a mass production system. The spread of flexible specialisation, in other words, amounts to a revival of craft forms of production that—according to Sabel and Piore—were marginalised at the first industrial divide at the turn of the 20th century.

Porter’s (1980) discussion of basic competitive strategies can be seen as an attempt to build bridges between the scale and scope and flexible specialisation positions. By distinguishing between a generic cost-based strategy targeted at mass markets and a quality-based strategy targeted at more exclusive market niches (Table I.1), Porter leaves room for simultaneous coexistence between both positions.

Table I.1

Porter’s integrated strategy model.

Source: From Porter (1980).

II.B. Horizontal vs Vertical Integration

At a more specific level, business strategy must address not only the degree, but also the type of scale and scope. Vertical and horizontal integration here constitutes the two major alternatives. Vertical integration involves decisions that define the boundaries of the firm over its generic activities on the value chain from raw materials to the consumer, whereas horizontal strategy aims at identifying and exploiting interrelationships across distinct but related business units in the value chain. Given limited resources, the two strategic orientations are to some extent competing alternatives.

Seen from an existing firm in a given value chain, vertical integration may be directed forward towards the consumer side or backwards towards the supplier side, and it may cover one or several steps in the value chain. Furthermore integration may also occur in many degrees, ranging from full organisational to lighter associational forms. Hax and Majluf (1991) summarise the essential decision criteria for decisions over vertical integration under four main headings: cost reductions, defensive market power, offensive market power, and administrative and managerial advantages.

The benefits from vertical integration include providing autonomy in supply and demand that shields the firm from foreclosure and unequitable exchange relationships; protects retention of exclusive rights to the use of specialised assets; and guards against important attributes being distorted or degraded. Furthermore, vertical integration also raises entry or mobility barriers.

Vertical integration may also enhance the firm’s offensive market power by increasing opportunities for entering new businesses and by providing access to new technology. In addition, vertical integration may also promote differentiation strategy by control of interface with end customers and improvements in market intelligence. Furthermore it may also facilitate a more aggressive strategy to gain market share.

As far as costs and benefits are concerned, the benefits from vertical integration include internalisation of economies of scale, lower transaction costs by integration, and better control with quality and guards against strategic behaviour from suppliers. On the other hand, vertical integration implies increased fixed costs and correspondingly greater business risk, higher capital investment requirements, and the possibility of increased overhead costs.

Up against the pros and cons of vertical integration, the firms will have to also consider possible horizontal strategies. The core issue motivating horizontal integration is the potential synergism across businesses, which could be exploited in order to add value beyond the simple sum of business contributions.

Horizontal integration is traditionally discussed under three basic headings (Porter, 1980): tangible relationships, intangible relationships and competitor interrelationships. Tangible relationships arise from opportunities to share activities founded on the actual sharing of concrete assets or managerial capabilities in one or more activities of the value chain. However, this must be weighed up against costs of co-ordination and compromise. Intangible relationships involve the transfer of management know-how among separate value chains to further competitive advantage. This involves interactions across independent strategic business units that are placed in different industries, but retain generic similarities such as same generic strategy, same type of buyers, similar configurations of the value chain and similar important value activities. However, intangible relationships are more difficult to apprehend and exploit than tangible relationships. Competitor interrelationships stem from the existence of rivals that actually or potentially compete with the firm in more than one business unit. This type of multipoint competition expands the scope for competitive analysis and leads to a focus on retaliatory action to enhance one’s own competitive