You, the Average Western Reader, Directly Determined the Power Sector Strategy Study Priorities
This article explains how seemingly caring and liberal readers in the West indirectly, but clearly, drive painful strategy choices in this study.
In this series of articles we discuss the approach used to help a major power utility develop a corporate level strategy to meet increasing power demand and manage rising blackouts threatening to cripple economic growth and foreign-direct-investment. This is part 3. You can read part 1 here and part 2 here.
For confidentiality reasons, we have modified some of the details in these articles. All >650 power point files and >650 training videos of this complete training program will soon be released as part of our Executive Program.
An Alternative Definition for Corporate Strategy
Corporate strategy is about taking a longer-term view of things. It is about deciding what the company wants to be, the market where it will play in the future and how it will play. These decisions can be made in a month or two but they take years to implement.
Corporate strategy can alternatively be defined as deciding how to allocate pain to your stakeholders. This is because in a world of unlimited limitations there is only so much capital to go around and someone has to be disappointed. Not everyone’s needs will be adequately met. It is about prioritizing needs. In this piece we will discuss the very painful choices required in corporate level strategy.
We will show you how liberal and caring readers in the US, UK, Canada, Germany, Australia etc., directly drive painful decisions in this power sector study. These decisions lead to the very same readers to call for fraud and mismanagement investigations when they see the outcomes of their decisions played out over the media. Those asking for the investigations sometimes forget their actions led to the decision they now want investigated.
What you will see is that in a consumer driven economy, the consumer calls the shots. The consumer is the ultimate shareholder. And consumers have tremendous power which they usually fail to realize can be harnessed for significant change.
This article demonstrates the incredible ripple effects of our investment and retirement choices.
First we need to tie together some concepts.
Corporate Strategy in Times of Crisis
When a crisis comes along, too many companies see their reaction to the crisis as their corporate strategy. They develop an intensely myopic focus. They develop strategy myopia. The reaction to the crisis should not be the corporate strategy. It may very well be the most important item to focus on at the moment, but surviving in the short-term can never be a long-term wealth creation strategy.
For example, when BP was hit with the oil-spill disaster in the Gulf of Mexico, BP’s strategy became one of managing that spill. To a large degree they stopped focusing on other aspects of the business to manage the spill. That is not corporate strategy. To test if they did the right thing here you need to ask yourself one question:
“Is managing this spill the best way to maximize shareholder returns in the long-term?”
It is definitely a way to minimize shareholder losses and it was essential to manage the spill to survive, but focusing on survival is not a corporate strategy. Yes, it was important to contain the spill, but the corporate strategy must focus on what they should do after the spill.
A crisis only helps a company make its corporate strategy decision. The response to a crisis is not a corporate strategy.
Linking the Concepts of Strategy-Myopia and Pain
Let’s go back to the pain part and link the concepts of strategy-myopia and pain.
The country where this power utility is based is going to face severe power outages in the not too distant future. Some would say the current power outages are already too severe and damaging. As true as that may be it will definitely become much worse in the future.
In other words, the country and sector is in a crisis.
Yet, the client does not view the power outages as something that will impact their plans. The client is focused on developing businesses in the unregulated side of the market and a lot of that is about building power assets, refurbishing power assets, maintaining power assets and operating power assets in the country, neighbouring countries and other parts of the world.
Power outages in their home market does not bother them since that is managed by the regulated side of the business.
The client primarily operates across North Africa and the Middle East.
Our client, Empire International (EI) was formed when Empire Energy (EE) spun of all of its design and build capabilities into a separate majority owned subsidiary in the late 2000’s.
EE is EI’s main client and EI has spent the better part of a decade trying to diversify its revenue. EI has been somewhat successful since it now receives 45% of its revenue from other power utilities.
Yet, EI is still heavily reliant on EE where it has lucrative contracts for the refurbishment, maintenance and operation of transmission lines, the power grid and so on.
EE, the regulated part of the business, is the one facing a barrage of problems, government inquiries and media stories about the power outages and failing infrastructure. EE runs all the generation, transmission and distribution systems across the entire country.
While EI thinks they are not linked to these problems facing EE, we think otherwise.
First, EI’s largest client is EE and any changes at EE will directly and quickly hit EI.
Second, the problems at EE relate to the design, build, refurbishment, maintenance and operations of power assets. Our client, EI, was essentially created when EE took all those capabilities above and spun them off, on the assumption those skills were no longer needed in EE. That assumption is no longer valid.
What is the logic of contracting the work to an outside company like EI, with costly middleman markups, if the work EI is doing could soon become EE’s core business?
Third, EI’s largest shareholder is EE and we would need to place the needs of EE’s shareholders first.
Fourth, EE is a state utility so we would need to place the needs of the state first.
So now you can see some of our thinking coming together. This is a unique situation where the crisis actually is exposing a strategic path for the client. This is a rare example where a short-term crisis, legitimately, leads to the long-term corporate strategy.
However, is the immediate short-term focus of keeping the lights on the corporate strategy? Or is the long-term focus of preventing this from ever happening again the corporate strategy?
These two questions look the same but they are very different. They are mutually exclusive and as we will show below, they cannot both be done at the same time. We will also show you how Western investor behaviour makes it very easy to select the right option.
Facing a Difficult Trade-Off
Lets focus more on pain. Since EI is intricately linked to the broader energy issues, we have to make some pretty difficult choices.
This is the part that always saddens me personally on these studies. The blackouts are impacting massive parts of the country. Rural and the poor are most impacted. Schools are being shutdown, hospitals are in the dark and agricultural produce is being spoiled. Whichever way you look at this, we are going to see some kind of stunting in development for a generation of children impacted by this. This will have a generational ripple effect.
If we agree EI will focus on the energy shortfall, because EE is focused on the energy shortfall, we need to figure out where and how EI will focus.
Here is the painful tradeoff we need to make: Knowing that we do not have sufficient resources to do both, do we commit to limiting the blackouts or do we commit to focusing resources on fixing the power infrastructure base for the long-term?
These are mutually exclusive problems. They may appear linked, but they are not.
The blackouts are mainly about fixing existing infrastructure, while the new infrastructure base will primarily look at future demand needs.
The current infrastructure can have some band-aid solutions applied which may limit blackouts for a month or six, but they will not eliminate them. They simply push the problem forward a little.
The rural areas and many urban areas are built on a rickety and outdated infrastructure base.
Applying stopgap measures to keep the lights on diverts limited resources away from building for the future, to investing in an outdated infrastructure base that should be torn up and rebuilt.
In other words, the country will only have the finances to apply band-aid solutions to the current infrastructure or build new infrastructure. It cannot do both.
Think about which is politically expedient?
The stopgap measures will win votes and stop the media barrage. Yet, it will not fix the long-term problems and it will mean that creaky and inefficient infrastructure continues to remain inefficient. However, since the lights are on, the media barrage stops since people complain about what they immediately see on a daily basis.
If the country builds for the long-term it will lay the foundation for an efficient and effective electricity base that can attract businesses and support growth. Yet, the results of these efforts will only be seen in 5 to 10 years. That is a eternity in political circles. Now, going down this route will not win votes, continue the blackouts, continue the media firestorm, cause worldwide headlines and be politically difficult to maintain.
By fixing the long-term problem, the government simply ends up looking incompetent when they are not.
Making the Trade-Off Decision
So, how do we make this decision? It is actually not a rationally difficult decision to make though it is emotionally difficult.
We have to go back to understanding how countries compete. That happens to be the title of a book and the work of Richard H.K Vietor that underpins all our thinking when we do studies for governments. I have personally read this book about 7 times and it sits at the heart of strategy thinking for the work we do for governments. By the way, that very same logic also sits at the core of the McKinsey Global Institute work and at the root of modern economics.
The logic is simple. To succeed and thrive a country must be competitive. To be competitive a country must be productive. Productive countries grow, attract investment and take their citizens to the middle class, and eventually the upper class.
Electricity sits at the heart of productivity. No country is going to be as productive as it could be with high electricity prices and intermittent power eating away at productivity. No investor builds a critical supply chain base in a country unless the price of power is acceptable and that power supply is reliable.
Moreover, industry, processing and resource based economies, like those in the client’s home-country, need cheap power.
Therefore, we need to make a decision that leads to long-term competitiveness. We also need to remember that foreign money will fund this and productivity, therefore, becomes even more important. This is a crucial point. The source of funds matters. It severely restricts the options available for the client.
Foreign investors do not invest in grossly unproductive assets. It would not be possible to get them to invest in keeping the lights on since that business case is weak. The returns from keeping the lights on in the rural areas is small, and on a risk adjusted basis, may even be negative.
Therefore, this study is not about keeping the lights from going out. The study is about sustainably bringing the lights back on.
This decision means, and it is painful to do this, that the areas facing power cuts will probably face deep and severe cuts for many more years as the electricity sector is restructured and new infrastructure built.
That is a conscious decision. We are allowing the rolling blackouts to continue for many more years.
Some form of an energy conservation program must be rolled out to lower the enormous burden on the power grid. But, the short-term problems are not going to be fixed.
A Deep Lesson Here
There is a deep lesson here. We live in a world of limited means and capital flows to where it gets the highest returns. That law of finance is immutable. That is not the lesson though.
The lesson is that a decision you the reader make every month is impacting this power company in some far off land. Let me explain the link.
If this country had massive coffers they could ignore this law for a bit. They could say, we will use our massive financial reserves to bandage the current system while simultaneously building out new electricity infrastructure. Yet, the country does not have deep coffers, partially due to the European crises but also due to their own mismanagement and low revenues. So, the country must borrow money from pension funds, private equity firms and banks.
Imagine you received a note from your pension fund stating they will be lowering their forecasted returns by 5% because they want to invest in a power project that will really help the rural poor in some country you never visited, but the investment will yield very low returns hence the hit to your payout.
What would your reaction be?
I would say everyone would go berserk. There would be rioting. Irate shareholders and fund members, basically you and I, would maul the board of the pension fund. We would demand changes.
We, consumers, want high returns. We make that decision every single day when we force our investment advisors to seek out the highest returns, and then we turn around and want to know why feel-good project x with so little returns was not built. It was not built since our investment decisions directly drive the infrastructure decisions. We call the CEOs of the funds greedy for pursuing higher returns despite our unrelenting pressure to do so.
Financial institutions are among the largest funders of infrastructure projects in the world. And emerging market assets have to play by their rules if they want the money.
This is why all infrastructure plans must be productive and create value. Until a proper business case with decent risk adjusted returns can be developed to stop the power outages in the short-term in the rural areas, it will not receive international funding since capital does not flow to low return projects.
Consumers should not feel bad about this. There is nothing like the fear of poverty to force a country to change. If you think pushing for the highest return is bad, investing in unproductive infrastructure is even worse. It never encourages anyone to change.
In fact, how would you allocate capital if you could not use returns as a measure? One would have to force the capital to be allocated. That is called central planning. The government ends up allocating capital to unattractive investments and there is no incentive to change since returns are not used as a reward tool.
Central planning has never worked. Knowing your lack of productivity may lead to your demise is a powerful incentive.
As Robert Solow once said, fear is the best motivator.
When thinking about high returns on an infrastructure project you need to think about all the management and operating innovations, technical and engineering inventions etc., which drove those returns. That is a good thing. We want people to innovate. It betters society, and the high returns are the reward for the risks of innovating.
So when you read comments in newspapers about people saying that Goldman Sachs is greedy to demand excessive returns from a power project in Africa, remember that by asking for a lower return all the innovation that would have taken place to hit that return target also disappears.
We all lose in this scenario.
To sum up, this is not something the consultants did: this being the decision to not focus on keeping the lights on in the short-term. That is the way most people would look at this.
We are simply following the rules and guidelines “you and I” personally created by pursuing the highest returns from our pension and investment accounts.
In the next article we will look at the structure of the study.
If you enjoyed this piece, please comment below and we will write up follow up articles. Also, remember to visit our iTunes account to subscribe for our podcast and rate us.
To be continued …
QUESTION(S) OF THE DAY: How can we use our demand for high investment returns to encourage more development in poorer countries? Should we? Please share in the comments.
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