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Developing Strategies ForDeregulated Markets:

Learning Without Experience

Erik R. Larsenemail: e.r.larsen@city.ac.uk

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Characteristics of Deregulated Mkt

Still heavy regulated

No natural evolution

Difficult transition

Mature market from the first day

Mix of free markets and monopoly

=Artificial Markets

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Why is Deregulation Difficult?

Long time lags

From theory to reality - often a big step

How do you design the best market?

Is there a limit to deregulation?

Political influence and objectives

It is hard to predict - especially the future

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The Electricity Industry

Important industry for all areas of life

Turnover in the US? Turnover in Europe?

The biggest electricity company in the

world?

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Structure of Industry Before

Deregulation

Customers

Customer

Services

Vertical Integrated Industry

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Structure of Industry after

Deregulation

Generation Transmission Distribution

and Sale

Customers

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CustomersGeneration Transmission Power services

Intense competition

Commodity market

Cost-based competition

Entry depends on expected

profit margins

Differentiated

Connected and Organized

Empowered and Protected

Long memory

Convergence to multiutiliy and

multiproducts configurations

Competition based on scale, scope

Emphasis on service value added

Open access

Heavily regulated

Independent

Diversified and International

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Deregulation: Industry Changes

Attribute Mono. Mkt Dereg Mkt.Business Stable, gradual adjustment, Unstable, volatile prices

Environment technical driven cost driven, new stakeholders

Information Full information Gradual less informationRegulatory Concerned with social Balance between customers

Environment welfare, often soft & new entrants, often hard

Market Power Not an issue Central issue for regulator

Public R&D Part of long-term obligation Cannot justify pub. domain R&D

Environmental, Integral part of obligation, Adds one more layer to

DSM, and Other easily integrated into regulatory risk,

Good Causes energy policy needs new incentives

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Deregulation: Company Changes

Attribute Mono. Mkt Dereg Mkt.

Business Focus Best technical solution, Cost efficient solution

Management Technical Commercial

Focus

Customer Not needed, a customer Wholesale & retail competition

Focus has no choice forces customer focus

Planning Classic OR methods used New methods linking strategic

Methods succesfully (hard planning) thinking, uncertainty and limitinformation

Outsourcing Little or none Increasing interest

Business Social optimum Shareholder value

Rationale

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Corporate Risk

From technicalto commercialfocus

Major organizational changes needs to be

implemented

HRM policy might change dramatically

Building new competencies while keeping

some of the existingcore competencies

= Change the mindset of the organization

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UK Electricity Employment Levels

Generation

0

50,000

10,000

20,000

30,000

40,000

89/90 95/96

Employees

Distribution

0

100,000

20,000

40,000

60,000

80,000

89/90 95/96

Employees

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Market Risk

No historyto learn from

Limitedif any idea of competitors

behavior

Competitors for the first time

Noexperience in financial markets

Newstakeholders Fewif any data

Threadof acquisition and take over

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Regulatory Risk

Unpredictablenature of regulation

Principle agent problems in regulation

Political influence

Towards a evolving regulation

paradigm

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Learning

Learning typically requires the existence

of repeated experiences

Small samples trigger processes ofinterpretation

Experience traps

Vicariouslearning

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Learning In Deregulated Markets

Learning by analogy

Buying assets in competitive markets

Learning by doing (at home)

Electricity companies has mainly

applied three ways of trying to learn

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Situation in

Europe 2002

France

Spain

Ireland

Britain

Germany Poland

Italy

Sweden

Finland

Norway

Switzerland

Hungary

Slovakia

Austria

The

Netherlands

Belgium

DenmarkEstonia

Latvia

Lithuania

Czech

Rep.

Portugal Full competition today

Far-reaching liberalization

Partial liberalization

Slow liberalization/no

development

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Situation in USA

2001 (June)

No substantive activity

Inquiry or study continuing

Restructuring plan adopted, but full

implementation delayed

Restructuring plan has been fully implemented

or is on schedule for full implementation

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Average UK Electricity Prices

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Volatility in the Colombian

Electricity Market

1996 1997 1998 1999 2000 2001 2002 2003

Time

100

200

300

400

YearlyvolatilityofdailyP

oolprice(%)

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How Can We Learn in

Deregulated Markets

Creating memory of the futureOur brain does it all the times

Create a history of the future

Using simulation we can create a virtual

history of the future, which can aid thedecision-making of the senior

management team.

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Change in Uncertainty for Utilities

Uncertainty in key planning

i npu t

Plann ing Inpu t MonopolisticMarket

CompetitiveMarket

Price low medium/high

Information low high

Demand medium high

Consumer choice low medium/high

Regulation low high

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Choosing the Right Tool

Environment

ResourcesLow uncertainty High uncertainty

Low risk OptimizationForecasting

Simulation

Optimization

High risk OptimizationFinancial modeling

Forecasting

SimulationFinancial modeling

Optimization

Scenario

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Examples of Resource and

Environment

Environment

ResourcesLow uncertainty High uncertainty

Low risk Monopolies suchas utilities

Deregulated

financial services

High risk

Deregulated rail,

Deregulated water

companies

Newly deregulated

utilities, such as

electricity, gas and

telecom

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The Investment Cycle

Electricity Price

Expected ElectricityPrice

Expected Rate of

Return

Expected Cost

Expected Revenue

Investment

Capacity under

Construction

Capacity

Demand / Supply

BalanceDemand

Retirement

Expected

Demand

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Understand Fragmentation

Fragmentation means

that many companies

take investment

decisions at the same

time to fill the samecapacity gap. This

creates over capacity

the more fragmented

the more volatility in theindustry.

Supply

Supply/demand

balancePrice

Construction

time

NewinvestmentNew

investmentNew

investment

Demand

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Model Structure

Main A reas:

Finance& accounting

Capacity investment

Capacity sale

Capacity management

Market forecast

Incumbent

Main A reas:

Price setting

Demand management

Fuel prices

Imports

Market

Main A reas:

Finance& accounting

Capacity investment

Capacity management

Market forecast

Market Share

BuilderMain A reas:

Finance& accounting

Capacity investment

Capacity management

Market forecast

Economic

Competitor

Main A reas:

Performance evaluation

Possible bankruptcy

Change of managementteam

StockMarket

Main A reas:

Market power (marketshare)

Forced sale of capacity

Change in price

Regulator

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Microworld Interface