From reactors to resistors

From reactors to resistors: Strategies for supplying the global power industry

Executive summary

The utilities industry is navigating crosscurrents of unprecedented change. Demand for electricity is down in developed countries, but rising rapidly elsewhere. Sharply lower long-term natural gas prices, particularly in the United States, are forcing utilities to rethink their future mix of generation fuels. And the emergence of new generation and distribution technologies, combined with new market participants, is complicating how utilities plan for that future.

In turn, these trends are directly affecting the companies that supply the products and services utilities rely on — everything from large boilers to tiny pumps, fossil fuel turbines to wind turbines, and generation to transmission projects. These companies, collectively referred to as power infrastructure and mining (PI&M) companies, must adapt to external changes by rethinking their product and service portfolios, expanding their geographic reach, and improving their efficiency.

Getting there will require a three-step effort. First, they must ensure that their strategy is aligned with the rapidly changing market. Second, they must align their operating model with their strategy, adding the processes, resources, and capabilities needed for success. And third, they must execute against that strategy while remaining adaptive to changing market realities. By doing so, they will better serve their customers, differentiate themselves in the market, and ultimately become more profitable.

Only by carrying out these critical steps can PI&M companies seize the emerging opportunities and position themselves to benefit from the rapid changes in the utilities sector they serve.

The strategic imperative

The electric utility industry, a stable business for decades, is changing rapidly. The trends transforming the industry are making it much more difficult for utilities to manage their assets and plan for capital spending needs. This in turn is complicating the strategies and planning efforts of their suppliers.

Moreover, advances in residential energy technologies, such as distributed solar systems, and easier access to financing for such systems are forcing utilities to spread their fixed costs across fewer megawatt-hours. The fall in fuel prices caused by the U.S. shale gas revolution has, in many cases, been passed straight to customers without benefiting utilities or their shareholders.

Trends are making it difficult for utilities to manage their assets and plan for capital spending needs.

U.S. utilities have grown 40 percent in stock market value since 2009, but the increase lags growth in the broader market. Moreover, European utility returns have fallen 50 percent since 2008, according to index provider MSCI, and that looms as an indicator of what may be in store for utilities in the United States.

While the pace and degree of these shifts are disrupting electricity providers, they have also affected upstream suppliers — fuel and feedstock producers; industrial products and service companies; engineering, procurement, and construction providers; aftermarket parts and service providers — which we collectively refer to as the power infrastructure and mining (PI&M) sector.

These companies represent a diverse set of market players offering a wide range of products and services (see Exhibit 1). From the power generation segment of General Electric down to smaller, specialized companies, these businesses design and manufacture everything from massive capital equipment such as nuclear reactor pressure vessels to routine plant components such as wiring, pumps, and valves. Some of them, like Toshiba and Honeywell International, are highly diversified, while others specialize in particular products, fuel types, and generation technologies; Covanta, for example, focuses on waste management and, in turn, supplying energy from waste.

Exhibit 1: Electric utilities’ product and service needs and sample suppliers

Electric utilities’ product and service needs and sample suppliers

Over the past six years, financial returns in this sector have illustrated the mixed challenges and opportunities for PI&M companies. Between 2009 and mid-2011, Strategy&’s index of PI&M companies outperformed the S&P 500 by 25 percent, and the electric utility index by even more (see Exhibit 2). Since then, however, the index has more closely tracked, and recently lagged, the utility index, as coal companies and some renewables companies have become a significant drag on the overall index.

Exhibit 2: The PI&M sector has endured significant variability since 2009 and most recently under-performed utility and total market indexes

The PI&M sector has endured significant variability since 2009 and most recently under-performed utility and total market indexes

In the developed world, energy efficiency gains coupled with lower energy demand from the industrial base are reducing overall demand for electricity, and these trends are likely to continue — clearly a challenge to utilities and their suppliers. As a result of these trends, utilities will be able to meet electricity needs without building as many new generation plants as previously anticipated. This limits the opportunity to boost utilities’ return on equity and the revenues of their suppliers. Even the reduction in fuel prices as a result of the shale gas revolution in the United States is not benefiting regulated utility shareholders; rather, lower prices are being passed on straight to customers.

Companies that execute against necessary changes will be better positioned for growth and stability.

For PI&M companies, this downward trend in energy usage has created a rapidly changing and uncertain external marketplace, one that differs significantly from the relative stability these suppliers have historically known. For some, these shifts will create new opportunities. Others will find their long-term business models threatened. The PI&M companies that continue to enhance and update their strategic planning and risk management efforts, redefine their organizational models to reflect new strategies, and successfully execute against the necessary changes will be far better positioned for growth and stability than those that do nothing.

Disruptive trends

Over the past few years, trends affecting the power sector have forced utilities to adapt, and reverberated upstream to their suppliers as well. Aging fleets of coal and nuclear power plants, evolving domestic and international environmental policy landscapes, shifts in the supply of natural gas, and disruptive technology advances — all are having their effect. These trends come on the heels of a now-aborted, or at least significantly delayed, “nuclear renaissance,” during which many utilities and suppliers began sinking capital into the development of new nuclear plants, only to shelve these projects as cost estimates escalated and declining natural gas prices made traditionally designed nuclear plants uncompetitive.

Suppliers are being forced to broaden their business development efforts and invest in emerging markets.

The challenges that upstream suppliers face have been compounded by a shifting customer base. U.S. utilities are continuing to consolidate, which not only squeezes suppliers’ margins — indeed, the business case for most utility mergers is built in part on supply chain and fuel procurement synergies — but also can weaken critical relationships between suppliers and longtime customers.

More complicating in the long term is the international shift in demand for energy. Despite favorable energy efficiency and intensity shifts, demand for new power plants will pick up in the developed world as aging assets require replacement. But utilities in developing countries where electricity demand is surging will need to add twice as much new capacity as their counterparts in the developed world. That will call for new plants — and the reactors, boilers, and supporting services the supplier industry thrives on (see Exhibit 3).

Exhibit 3: New power generation capacity needs will increase substantially in the developing world over the next 25 years

New power generation capacity needs will increase substantially in the developing world over the next 25 years

Both traditional suppliers and developers of new technologies such as coal gasification and “next-generation” nuclear power will find that their long-term success increasingly requires the ability to sell into less familiar markets like China, Indonesia, and Middle Eastern countries. As a result, suppliers are being forced to broaden their business development efforts and invest in emerging markets, which typically pose higher risks than their traditional domestic markets.

In the U.S., meanwhile, the coal fleet is being downsized. More than 40 gigawatts of coal-fired power plants have been retired since 2004, and we estimate that an additional 25 gigawatts are likely to be retired in the next five years. Low natural gas prices, stepped-up mercury and coal ash regulations, and the aging of assets are driving this transformation. The Environmental Protection Agency’s (EPA) draft rules related to carbon emissions have the potential to further displace coal plants and disrupt utilities’ asset portfolio and capital planning efforts.

Given the anticipated legal challenges and uncertainty surrounding how various states will comply with the new mandates, it’s hard to predict the likely impact of the new EPA rules on suppliers. At the same time, nuclear plants, historically at risk, may regain some value and become less attractive candidates for retirement.

Continuous strategic redefinition and transformation will be critical to PI&M companies’ long-term survival.

Over the past several years, PI&M companies have been making efforts to adapt to these trends. As utilities look to rebalance their portfolios and meet changing capacity needs, there will continue to be opportunities for PI&M players. Net growth in global electricity demand, the ongoing development of new technologies, and the aging of some generation assets will continue to boost demand for the equipment, services, and fuel that PI&M companies supply.

Less certain, however, is how technology choices will change, and thus where PI&M companies can find new opportunities over the next few years, and who the winners and losers will be. Like companies in so many other industries, PI&M companies must recognize that comparative advantage is fleeting, and that continuous strategic redefinition and transformation will be critical to their long-term survival.

Three-pronged response

PI&M companies looking to set themselves up for lasting success need to pursue the emerging growth opportunities available to them but also recognize which products and regions to exit. This will require a three-pronged effort spanning both new strategies and continued operational execution: (1) a market-back enterprise strategy in the products and services they develop and commercialize; (2) operating model realignment to transform resources and processes in response to a changing market; and (3) enhancements to their operations to adapt to new levels of demand and improve their operational execution.

1. Market-back strategy refresh

Utility suppliers exposed to the evolving electric utility industry must rethink their strategy from a market-back perspective if they are to effectively reposition themselves for sustained value creation. In some cases, market and regulatory shifts present threats to their current strategy, and in others they present opportunities. This means companies should frequently reevaluate their portfolios of fuel, technology, and service products, as well as their strategic options, through a scenario-based understanding of future market and regulatory conditions.

Companies should reevaluate their portfolios of fuel, technology, and service products.

Changing product mix. Companies with heavy exposure to the coal and nuclear plant service market, for example, will need to assess their mix of new plant construction and aftermarket businesses, given the potential shifts in regulations and customer preferences.

An example of a company that followed this path is Alpha Natural Resources (ANR), a leading U.S. coal mining company. It realized early in this decade that its long-term strategy of relying on domestic coal sales would come under severe stress as stiffer environmental regulations and natural gas supply increases challenged the supremacy of coal. The first step in developing a new strategy involved understanding the magnitude and timing of this evolution in demand, through detailed, scenario-based projections of the coming switch by U.S. utilities from coal to gas. Based on the findings, the company sought to define and evaluate strategic options for strengthening its growth prospects beyond 2020. ANR settled on a diversification strategy to increase its share of thermal coal production, for local electricity generation, and met coal production, for global steel producers.

New markets. Companies selling advanced power generation, transmission, and distribution technology products and services into the evolving utility marketplace face a different set of strategic challenges. For example, the market for the meters and supporting infrastructure needed to build out the smart grid in North America has grown 8 percent annually for the past few years, thanks to the growth in renewable energy and support from the federal government. This has attracted a crowded field of electricity services and software providers, but demand for such products going forward is likely to be less robust and driven more by state and local factors.

Seizing opportunities for growth in the power sector will require reassessing R&D activities.

The case of Siemens AG, a leading global transmission and distribution player, illustrates the challenges. Despite its leading position in other technologies, Siemens had gained only a small share in substation technology, a market dominated by incumbents with well-established customer and partner relationships. To unseat these rivals, Siemens developed an organic growth strategy based on a deep understanding of the North American utility marketplace, and of smart grid and substation automation technologies. Its strategic shift began with a thorough analysis of the market’s size and competitive landscape in order to validate its market entry strategy and then to form a plan to implement it. Once it had determined to take a more aggressive approach, the company devised an execution plan for line managers to follow, as well as a plan for reporting and monitoring the effectiveness of the new approach.

Emerging technology commercialization. As shifts in markets, regulations, and technology speed up, innovation becomes more important, even though prospects for full commercialization of new products and services remain uncertain. Seizing opportunities for growth in the power sector will require that companies reassess their research and development activities to better align them with the needs of their markets. In some cases, companies must also reevaluate how much they spend on such efforts, given their size and the time period over which R&D outlays are typically spread.

Moreover, various hazards — such as a promising new technology being pushed aside by an even better alternative, R&D cost overruns, and financing constraints — often await providers of new technology. Therefore, they must consider creative strategies for managing or syndicating the risks of commercialization. The growth in energy demand worldwide is a critical underlying rationale for any business case for developing new technologies. But rising global demand also creates uncertainty for companies trying to allocate and prioritize business development resources and plan for commercializing new products.

Many PI&M companies pursuing long-term growth have invested heavily in technologies that initially held commercial promise but ultimately proved unviable. For example, several small original equipment manufacturers (OEMs) that focus on nuclear technologies prepared for a “nuclear renaissance” that has not yet materialized.

Rising global demand creates uncertainty for commercializing new products.

Dramatic improvements in solar photovoltaic and concentrated solar commercialization, and the heat transfer fluid and encapsulant products needed to carry out these projects, have drawn several new suppliers to the power sector. One such company, however, was less sure of how to scale its investment strategy for the uncertain future demand prospects. Its legacy business had been built to supply commodity chemicals, a largely predictable market with moderate growth, but the renewables business was still unfamiliar. Not only were energy markets new to the company as a whole, but the wide range of demand forecasts and the role of renewable energy subsidies presented a substantial challenge in planning for long-term manufacturing capacity (see Exhibit 4).

Exhibit 4: Future demand for emerging power technologies remains highly uncertain

Future demand for emerging power technologies remains highly uncertain

Rather than rely on overly optimistic demand forecasts reflecting the upward bias of technology advocates, the company used a more sophisticated, probabilistic model that took into account the market’s uncertainty. The resulting, much narrower, range of plausible demand outcomes helped guide the company to a business plan that was substantially less capital-intensive. The company reallocated or saved 15 percent of its capital budget over five years.

2. Operating model realignment

PI&M companies that take a market-back approach to redefining their strategies and introducing new product portfolios and customer mixes often find their operating models are outdated and in need of realignment. Whether this is the result of regulatory changes, a new focus on products versus services, geographic re-prioritization, or other factors, companies need to make sure their operating model and all its elements fully support the new strategy — including aligning budget and capital allocation plans, refining key execution processes, developing or enhancing critical capabilities, reallocating key labor resources, and updating performance measurement systems.

Companies exposed to decreasing demand for coal are a case in point. Equipment and service providers in this space had for years been structured around product lines to address various segments of the coal-fired generation sector, including the design of new coal-fired boilers, auxiliaries, and environmental systems, as well as aftermarket parts and services. Although this model had served these businesses well historically, it was at odds with evolving market realities. As a result, coal market providers are rethinking how to align their organizations to fit with these new realities. The goal: to align business operations with anticipated market changes over the next three to five years.

Companies need to make sure their operating model fully supports the new strategy.

Some coal market providers understand the need to shift from a model dependent on customer service, responsiveness, and high quality to one focused on reliability, low costs, and sustaining quality expectations. To this end, companies are simplifying profit centers and realigning them with their core market segments, supported by centralized operations groups focused on reliable, low-cost delivery. These revised models allow providers to present a clearer face to the market in terms of how and to whom they offer their products and services. These models also enable companies to group similar business lines together, resulting in streamlined decision making and common expectation-setting across business lines. Lastly, these models improve customer alignment, not only with how customers procure products and services but also who within the customer organization controls the purchasing decision (corporate planners vs. plant managers, for example).

3. Operations improvement

Finally, PI&M companies that have established market-back strategies and aligned them with their operating models still need to maintain, if not improve, their operational efficiency. Regulatory and market forces that drive changes in utilities’ cost of goods sold (COGS), and therefore in the economic use of power plants, are complicating such efforts. Shifts in the relative prices of different fuels — most notably natural gas versus coal — have affected COGS, while the need to add pollution control systems has altered the economics of when and how to activate specific plants, and thus utilities’ operational costs. Suppliers of fuel to power plants that have become too expensive to operate economically, for example, might prioritize operating cost reductions to preserve their customer base. The goal of these improvements would be to lower the cost of fuel to their customers enough to offset other potential cost structure threats and avoid plant shutdowns while maintaining acceptable profits at the fuel supplier.

ANR again provides an interesting case. After going through its strategy refresh, the company determined that it needed to focus on operational improvements at its U.S. mines, while maintaining its strong commitment to safety and compliance. So it established an operating performance group composed of former mine superintendents and managers, as well as production, engineering, and safety experts, in order to increase production levels within its existing mines. Since 2012, when it began recasting its operations, ANR has reduced coal production costs by 12 to 15 percent, with more savings potential still to be tapped. That was significant enough to materially improve the economics for ANR and its customers.

Suppliers of fuel might prioritize operating cost reductions to preserve their customer base.

In another case, a global supplier of nuclear fuel and maintenance services had suffered years-long declines in profits and unmet savings targets. To reverse these trends, the company’s management undertook a detailed spending analysis and reassessed its supplier base for technical services, mechanical materials, and other third-party supplies. As a result, the company shifted from a tactical buying approach toward a more structured approach that consolidates spending by supply category and thus makes better use of scale in its purchasing. This effort, combined with improved inventory planning, helped reduce annual supply chain spending by 1.5 percent.

In addition to cost challenges, many companies are struggling to find the craft labor and specialized engineering talent needed to maintain their ongoing operations. The issue has received considerable attention in the engineering and construction marketplace; CB&I, for example, made a point of highlighting its commitment to talent attraction, recruiting, training, and retention in a recent investor presentation.

Be prepared

Although the valuations of PI&M companies have on the whole risen while the power industry has changed in recent years, it is less clear to what extent these companies can continue this trend in the next five years. Opportunities arising from the growth in electricity demand globally, expanded natural gas extraction in the U.S., and increasing demand for renewable energy, among other factors, would appear to outweigh downward pressures on the industry. Still, many PI&M companies have found themselves unprepared for the recent market shifts.

And even as the current trends continue, new ones will arise. PI&M companies need to anticipate and adapt to them as well. The potential for a U.S.-like shale gas revolution in other countries, not to mention the sustainability of low-cost natural gas extraction in the U.S., is far from guaranteed. The likelihood of further innovation in renewable and storage technologies — both the pace and performance of specific new technologies — is just as uncertain. Opportunities in nuclear as a whole, and specifically in next-generation developments such as small modular reactors, will develop to varying degrees on a country-by-country basis.

If PI&M companies are to survive and grow, it’s more important than ever to maintain a disciplined focus on the right market-back strategy, tightly aligned with the operating model and supported by sustained operational excellence. Simply assuming that their competitive advantage can be retained naturally and waiting for change to come to them is a recipe for irrelevance as the sector moves forward.