Michael Athanason

Stock price is a forward looking measure, incorporating both the market's information regarding past performance and its expectation of future performance. Historical earnings performance, book value of assets and liabilities, return on equity, and other traditional financial measures may once have been reliable predictors of future earnings, particularly in a heavily regulated industry, but today, these measures simply do not tell the whole story.

But we all know this old warning to investors to be as true as ever: "In times of transition, past performance is no indicator of future success." Financial statements measure past performance - indicators of future performance are non-financial by definition. For example, the ability to increase market share through product innovation and/or strategic alliances are intangibles that materially affect a company's future profitability. While historical performance is an important measure of a company's health, it is in itself insufficient to create wealth: wealth is created from expectations of how a company will perform. Clearly, non-financial performance is telling investors something about a company that is not contained in its financial statements.

Companies that ignore non-financial performance risk lower valuations, higher earnings forecast inaccuracies and higher hurdles to returning adequate shareholder value. Further, the greater that the uncertainty and volatility is in a sector, the greater the significance of non-financial performance to investor decision-making.

More importantly, only those companies that use times of industry transitions to create superior returns for their shareholders control their own destiny, and only they can be sure to survive the wave of consolidation that is an inevitable consequence of deregulation and increased competition.

The global electric and gas energy industry is undergoing significant change driven by market restructuring, energy convergence and technological innovation. Areas such as environmental sustainability are leading to an increase in global regulatory and social pressures, which, together with the global reallocation of investor funds triggered firstly by the bursting of the Internet bubble, and more latterly as a result of global economic uncertainty, are having a profound affect on the industry. Furthermore, deregulation in a great number of economies has opened up new opportunities for electric and gas energy companies, breaking the traditional model of a geographically focused integrated utility company with earnings linked to the size of the company's asset base.

The once stable platform from which companies in this sector operated is now one charged with new risks and new opportunities. In this changing business environment, it is becoming increasingly important for executives, board members and investors to re-examine the business models that support and drive value.

Managing Risk

Both executives and investors recognised that the ability to manage risk in the changing business environment, while effectively operating in the regulatory environment, was key to success. However the executives consistently rated the key success factors as more important than the investor. This points to an important omission in the current dialogue between energy companies and investors: while energy executives have a dynamic, forward-looking perspective on their business and can appreciate the value of their risk management processes to limit the downside and leverage the upside of uncertain future events, they do not seem to share this perspective with investors, who simply see - ex-post - a successful or failed strategy. Perhaps investors will change following profit warnings from the California Crisis.

For investors, speed of integration and operation in the regulatory environment - the former being easy to quantify while the latter is public by nature - are higher profile issues that they can easily evaluate. The high importance they attach to "strategy execution" raises the question: How do investors measure it and how can company executives communicate it to shareholders?

Our study shows that investors look at the speed with which senior executives integrate newly acquired businesses and assets and at the company's ability to navigate its regulatory environment. Other important factors for investors are the quality of risk management processes, executive compensation and the ability to be an active consolidator.

Executives and investors both agreed that the quality of a company's strategy contributed heavily to overall shareholder value.

However, in this area, there was very little consensus amongst investors and executives as to the best strategic approach for maximizing shareholder value. It would appear that, with the fracturing of the electric and gas energy value chain, each company is trying to leverage its core competencies to maximize value. It is clear that no one approach is the answer for all companies. One of the more interesting observations in this area is that, in the US, investors rated diversification into non-traditional businesses as creating more shareholder value while executives rated diversification into traditional non-regulated businesses as driving more value. If lessons learnt in the UK after it began deregulation were any indicator, it would seem that the executives are focused in the right direction.

In telecommunications, liberalization coincided with great changes in technology. There is evidence that electric and gas energy companies are on the brink of a similar revolution - at least for those companies nimble enough to embrace it.

* Generator engineering: the past five years have seen a 20% increase in efficiency of thermal power plants.
* Digital switching: replacing mechanical switching increases the efficiency of the grid; faster switching means that lines can be loaded to maximum capacity rather than leaving a safety margin.
* Fuel cells: these offer zero emission, and readily available capacity in locations where conventional plant may be unacceptable.
* Convergence with IT: the technology to transmit data over power wires - already run to every room in a house - opens up many business opportunities..

As in the telecommunications sector, the winners may be new entrants to the market. Established utilities are notorious for piloting new technologies for years and never rolling them out. New entrants to the market won't think twice.

Effective Management of the Customer Base

Most of the executives did not rate the quality of the customer base as being very important to creating shareholder value. Given the relative importance placed on customers in other industry segments, this may be an area where first movers that effectively manage the quality of their customer base, could achieve a significant increase in shareholder value.

It would appear that, even in a liberalized market like the UK, the full value of the customer base is not being reflected in the share price. Companies have been too preoccupied with volume rather than quality and need to turn their attention to effective customer relationship management in order to extract full value.

Disparity of importance

In a number of areas investors rated the importance of key factors much lower than executives. This disparity indicates that, in many aspects, executives are more advanced in anticipating the success factors in this industry as it transitions from a heavily regulated market of integrated monopolists to a lightly regulated, open market of specialized energy companies. Therefore, now more than ever, electric and gas energy companies need to be able to articulate to all stakeholders - particularly those outside of the company - simply and with a high degree of certainty, the impact industry transition issues will have on future earnings of the company. Additionally, the expectations of investors and executives of what a winner will look like run the risk of being disconnected. The losers of such a disconnect are investors and executives alike: investors will not achieve the risk / return profile they seek, and executives will not get the support their actions and decisions deserve.

Winning organizations will be those that truly understand where and how value is created (or destroyed) and how performance improvement can be embedded into routine operational financial and non-financial activities.

Managing the Changing Organization

For most electric and gas energy managers, the transition from public to private sector was relatively easy as they focused on cost efficiency and improving customer service standards. Now, electric and gas energy company managements find themselves having to create and manage very different organizations. For example, in a fully deregulated market, customer churn adds a new dimension to earnings stability. In future, managers will need to attach as much importance to the determination and delivery of their trading strategy as they have traditionally given to driving down operating costs and satisfying customer needs.

Electric and gas energy managers need to embrace the changes that are taking place and the opportunities that are presented. While doing so they must ensure that their organizations adopt and maintain world class risk management policies and practices that will truly enable them to ensure that the agreed strategy is being delivered. For European executives in particular, the recent experience of their Californian counterparts provides a dramatic and timely reminder of the real threat to shareholder value of the trading exposures carried by utilities in free markets.

Comprehensive Performance Management is Key

The results of the study suggest that comprehensive performance management is a prerequisite for directing the organization towards future success and winning the investor support needed to be among the winners in a consolidating industry. Electric and gas energy executives should target their communiques to the markets accordingly.

To secure an organization's future, a CEO of today's energy company must have a clear vision of where to create shareholder value and be a master at acquiring and rapidly integrating other entities.

Ernst & Young believes that the results from this study will help electric and gas energy executives and investors align measures for success in their sub-sector, align expectations of the changing risk/reward profile and focus their dialogue on the most relevant indicators for future success.