Paper for NZWWA Management Course, Rotorua, June 1999.

 What Business Are You In?

Garry Law

 Being in Business

Participants in the water/wastewater industry often refer to it as a business. Yet at the moment only parts of it is run on business lines. I have explored elsewhere why there has been resistance to operating it as a business (Ref).

I argue below that there are a lot of aspects of the industry where market power does not apply and hence competitive forces can be left to work including capital market forces. The exceptions are the reticulation ownership roles, where admittedly a lot of the capital investment in the industry has been made. An objection often made is that if we allow profit as an objective into the industry we will allow monopoly profits to be made. If this is an argument it can only apply in the areas where monopolies prevail – in the pipe networks.

Yet where is the evidence monopoly profits are not being made already? There is some evidence that they are, at least on the water side under local body ownership – especially where separate water charges are made. The wealth is being captured by their current owners and managers.

Capital has a cost. Not considering its cost is to ensure that poor investments will be made – both too little and too much. The best way to ensure proper investments are made is to account for the cost of capital and in my view to allow private capital markets to operate in assessing the risk and return on investments.

Some consider profits are any return made on capital. In an accounting sense they are. But it is surely legitimate to service debt. That is a return on capital to the lender.

A return on all capital needs to be the expectation to ensure wise overall investment.

What is needed is not a ban on profit. What is needed is where there is market power the return on investment is limited to a fair rate of return. There is a well developed process for determining what a fair level of return is, that has found application before in utility industries. To apply it though, there needs to be consideration of what the equity in the business actually is. What ever this is it needs correction for past contribution of assets by customers. Those that paid for them did not expect to be charged for the use of the assets they donated. Beyond this the level that the equity is set at is a matter of inter-generational equity, one that can be very directly experienced if the current customers become the shareholders – but that is the dreaded "P" word. For the moment we will need the politicians to guard that interest.

Operating the industry on normal business lines is quite compatible with delivering the community needs. There is nothing special about water as a utility which means it needs to be operated in an entirely different way from other utility services. Some argue there are special environmental, health and community needs which are incompatible with operating to a profit objective. An alternative view is that a profit is something the community allows a business to make when it first meets their needs. Meeting environmental requirements, delivering public health outcomes and being a fair employer can all be seen as preconditions of being a successful business. The world at large has ways of punishing businesses which do not meet its expectations.

The primary focus of a business is to deliver value to its shareholders. That value is normally measured in dollars. Investors through a share market will not move too far from that, but beware that there may be other perceptions of value at work as well. Some investors will be prepared to compromise financial return for some other outcomes and may expect those other outcomes from the business.

It may seem that through being the owners and the business operating to maximise their wealth owners come first in the queue. In fact they do not. The company’s employees, its trade creditors and those who lend to it are higher up the pecking order in terms of who gets the cash. As argued above it also has to deliver environmental outcomes acceptable to the community, healthy products and a safe and fair workplace before it can make a sustained profit.

Succeeding in Business

Businesses which succeed usually have a very clear idea about what business they are in. Once they have decided on their field they are rigorous about staying within it – shedding or shrinking aspects of their business which are outside their field, and resisting temptations to move outside it.

Businesses which have very focused strategies invest in them, developing competencies in people and facilities which will strengthen their business.

Having a communicable strategy is important. A strategy that is entirely secret is not one you will share with your staff at large so they will not be consciously working to support it. Moreover your suppliers and support businesses outside your business will not understand it either and cannot then seek to have long term alignment to your interests the way the best suppliers will.

How do we select what business to be in? – Usually it has a degree of self selection – it is part of or closely related to the business we are already in – it has been selected from a field we already know. The principal criteria for selection is that it is a field that we think we can succeed in. Success in this context means more than survival – it means growth. For a business not to be growing usually means it is not competing and if it is not competing it lacks the competitive edge to survive. Standing still is not enough.

Businesses seek to grow where they believe they have a competitive advantage. This is a Darwinist concept – the survival of the fittest. In this case trying to beat natural selection of the fittest by making oneself the fittest – with competencies rather than genes which are the best fitted for the market.

Competitive advantages are not something that grant some permanent advantage. Because they are invented they can be copied. Patents can protect some intellectual property but patents are slow to obtain, expensive to protect and may only confer an advantage for a short time until a competitor finds a superior technology to produce the same result. Many firms believe the competitive advantage of intellectual property is best exploited by a short time to market – getting to the market quickly and exploiting that advantage for as long as possible rather than trying the patent route. The pace of technological change is rapid so even what seems to be a dominant technology may only have a life of a few years.

A long term competitive advantage in a rapidly changing field will not be any one technology or particular piece of intellectual knowledge such as a patent. Rather it is more likely to be a suite of skills in an organisation which combine to make it one which can develop new ideas at the cutting edge, turn them into products, get them to the market quickly and market them successfully. These have been termed by some the core competencies of an organisation.

It is possible to build aspects of a competitive advantage in a variety of ways.

The following is a list of areas other firms have found:

Table 1

These are some generic ones. There are always new ideas arriving because this is the very nature of competition and human creativity. What other people do in other fields though may well be the source of many ideas with potential.

Once businesses achieve a position of competitive advantage their intent is to sustain it. Some of the obvious strategies – vertical integration to control the market, upping the level of regulated standards to increase the entry cost to competitors, brand building, can all work but there is evidence that they are not builders of long term success. Cost management is a basic and with the above can succeed, but a business is always exposed to the market moving more radically and simply displacing the need for the product. Being excellent at building home movie cameras did not stop the rise of home video cameras which quickly displaced film cameras.. The business that made the first home video cameras did not have an established market it was making a step innovation within – it was launching a whole new field which might have failed as easily as succeeded.

Products often go through a life cycle where the competition for the market shifts. In the opening phase there may be a market technical leader which is excellent in new technology and time to market. It will be a price setter, create a strong brand image, will depend on dominating a growing market but may be a relatively high cost producer. It may well have high R and D overheads. As the market emerges, growth is slower, competition emerges and competition is about market share and possibly finding new ways of bundling the product with others. Businesses will be price takers, brand image will be less important, competition will largely be on cost. Such a product can be called mature. Water and wastewater services are certainly in the mature category compared with many other products. The area of commercial innovation is about how it is unbundled within itself and for the public bundled with other utility services.

What Sort of Product is Water/Wastewater

In looking at a water business to work out its characteristics it is sometimes helpful to look at it from a number of perspectives to see what insights might emerge.

The following table sets out some views on what the industry we are in is about delivering:

Table 2

All of the above views of the business give some insights into aspects of the industry for its growth or protection. My view is that the fundamental matter for the industry is public health. Take your eye off that ball and you are at risk. It could be argued that Sydney Water had its eye off the public health ball and was concentrating on improving its environmental performance when it was hit by its protozoa crisis in 1998.

However if the fundamental is public health, it certainly has other outputs which it must be aware of and manage:

• Amenity (swimming pool and garden use)
• Stormwater removal (willing or otherwise)
• Waste disposal (industrial wastewater)
• Community safety (fire supply)
• Environmental protection

All the latter can be viewed as a precursor to doing the other areas of business – something which will be regulated, something which if it is not done to the community expectations will prevent the business from being seen as fit to charge let alone make a profit.

It is interesting to look at the first three dot points above. They are not parts of the water business that it is mandatory to provide. Once provided no-one is required to pay for them whether they use them or not. This would support that they are secondary outputs rather than primary.

How Much Market Power?

But does the sector we are operating in have the potential for competition? It is an oft repeated statement that it is a monopoly. To explore that let us look in a little more detail at the nature of the business.

The most obvious split in the business is between bulk and retail:

Figure 1

This does not occur everywhere. In New Zealand the only places where the split occurs is in Wellington and Auckland. Is there the potential for competition across the border with the bulk operator acting as a retailer – yes it already happens in wastewater tradeswastes in Auckland. Is there the potential for the retailer to act as a bulk supplier – yes, again in Auckland. Auckland City has developed a water source which displaces some of the bulk supplier’s market.

But are the labels bulk and retail as far as division could go?

Looking under to a next level of detail:

Figure 2 Detailed Functional Breakdown

Can there be competition in bulk treatment etc service provider? Yes there can. The Wellington sewerage treatment plant was competed for in its construction and operation. Not ongoing competition when it only arises very irregularly for one particular market but it is competition nevertheless. Anglian will want to defend their reputation in the industry to be able to compete for new work. Hence their service to Wellington will not fall off to the point where they get a bad reputation.

What about the retail box? There is already competition in Auckland to provide the customer interface. MetroWater have structured their business and their costing of the services on the expectation this competition would emerge. The new electricity retailers are already interested in being the interface for non-electricity utilities other than water. Given an access regime, their interest in water may well soon follow.

Many retail network owners already contract out their maintenance and operations. Some contract out their asset management as well.

But the spilt up does not have to be to the smallest fragments. Some contracts and businesses take up larger pieces. The Papakura franchise for instance is a larger package as indicated by the shading below:

Figure 3

It is possible to conceive some competition in the retail asset ownership box with inset reticulators, but in reality this competition is passing and from a customer’s perspective will not be any long term choice. In my view the only two boxes where competition is unlikely – the two reticulation provider boxes.

Figure 4 Areas With Market Power

This suggests a much more competitive world than our traditional view.

If these shaded boxes are the areas of the industry where market power will lie with the providers where entry barriers for competitors are high and where local ownership of the operations is likely to prevail, we need not assume the same will apply to any of the other unshaded boxes.

There is the potential for national and international providers to be operating businesses supplying those parts of the industry. With multiple contracts they could be much larger operations than the present industry structure. There is the potential then, for horizontal integration and economies of scale within the provider side of the industry. In my view local government owners will have a very small role in this provider industry, or be absent all together. Local government has little interest in operating beyond its own borders, will not take investment risks there and will not select directors of businesses oriented to growth outside the district. The course of Manukau Works away from Manukau City ownership as it expanded its business is entirely indicative.

The Dangers of Monopoly Thinking

Our industry is commonly described as a monopoly, but in reality only part of it is.

There are decided dangers in thinking the industry is a monopoly:

• The threat of competition is dismissed and the need to innovate and be quick to apply innovation is lessened.
• We regard regulation as natural and almost invite regulation. (If regulation is applicable, it is only to the shaded boxes in figure 4).
• We invite Ministry of Commerce intervention (as in the forced entry of competition into connections provision).
• We regard our customers as captive and make some poor investment decisions based on the security of their income. The write-off of hundreds of millions of dollars of electricity generation investments when the electricity retailers were separated from the lines businesses, illustrates this graphically. The old businesses had regarded their customers as tied and made poor investments based on the supposed security of their income.
• We risk having such poor responsiveness to our customers that the price setting in the industry gets put into a regulatory control. (Witness the electricity lines businesses).

My appeal is to stop using the word monopoly. Every time you use it you are affecting your own perception of the world, you are reinforcing others views of the world.

Different views of the business that were expanded on above only apply to bits of the industry as disaggregated here. For instance a business operating at the customer interface only has little control over the public health delivery of the industry overall. That is controlled by others. Hence they would put less emphasis on delivery of this.

The Shape of the Industry

It is my belief that we will see a less vertically integrated business operating in future. The pressures for new parties to come into the different parts of it are already strong. Utility market theorists talk about breaking up vertically integrated industries so as to allow competitive markets to emerge for such parts of the industry as are able to operate competitively. This is normally conceived as applying to separation of physical assets, but the recent innovation in New Zealand of separating electricity retailing from the wire ownership businesses shows disaggregation is not limited to that. This was a disaggregation of functions rather than assets. There is potential for analogous disaggregation of functions rather than assets in the water industry.

Most of us who regard ourselves as being in the industry work directly or indirectly for relatively integrated businesses. I predict a future where most of us will not. We will work in larger businesses with a narrower range.

I will be less didactic over the exact shape of the industry. Government I think, will be less willing to force change than in electricity and certainly the one size fits all approach there will not work in water. Some diversity is a likely outcome.

There is right now an ability to help shape the industry, and an ability to shape your own future careers.

As integrated businesses break up the former internal relationships are replaced by contractual relationships. Building and sustaining these will be a vital part of success. For people used to operating just with construction contracts it is tempting to treat all contracts as being like these. They are not. The quality of the service depends far more on the quality of the relationship than it does with a construction contract. The product is much more difficult to measure as to conformance with a specification. Once the opportunity for good service the first time has passed, then unlike faulty works in a construction contract the opportunity for correction does not exist. The best service only comes with a very positive relationship. Contracts within the industry will be a very important part of the future business.

As horizontal integration builds in the providers we can expect a lot of take-overs, buyouts, displacement of senior executives and emplacement of company wide business systems.

As the asset owning businesses become more commercial we can expect to see more corporatisations, more business in assisting these with valuations, due diligence, re-capitalisation, displacement of executives, short CEO appointment lives, more non-engineers in CEO positions, more people with commercial skills in governance positions on boards and fewer politicians.

Both forms of business will need to be in touch with their local communities and be prepared to respond to the needs of these communities by bargaining community service outcomes with local governments where they are prepared to pay for them.

What sort of people will succeed in our new industry? If we look at our present skills levels – my estimate is below – we are leaving a lot of opportunity for others. To some extent that is fine – let us not individually be expert in everything – that is a contradiction. But as managers we need enough knowledge to be able to manage the experts rather than have them manage us. I think it would be a sad day if the engineers who have been so dominant in the industry in the past became just another sort of expert adviser. With development as managers they can continue to have leading roles. Work on the bottom two boxes!

Table 3 Current Skills Level in the New Zealand Industry

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