Two Major Challenges for Utility IT Organizations:Regulatory Treatment of Shared Services and Managing the Cost of IT

Editor’s note: The information technology (IT) department has become absolutely integral to utility operations. As deregulation continues its slow, often uncertain march across the country, the outlook for IT remains muddy. In this article, Rick Nicholson and Jim Spiers from the META Group’s Energy Information Strategies service discuss the types of IT organization shuffling likely to occur as the industry transforms and the traditional utility unbundles.

By Rick Nicholson and Jim Spiers

For some time, analysts at META Group’s Energy Information Strategies service have recommended a shared services IT structure, which continues to gain ground in the energy industry. This is driven by the “regulatory push” and the “competitive pull” that utility companies are experiencing. However, these centralized, shared service structures are running into resistance as regulators grapple with a mixed market where some lines of business (LOBs) are regulated and others unregulated. This grappling may result in a continuation of shared service structures, regulatory requirements for strictly separating LOBs, or, potentially, development of a totally separate information services business.

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In the latter case, success in other countries could influence U.S. development. In the UK, for example, Vertex (a United Utilities spinoff) and SX3 (a Veridian spinoff) are providing IT and business operations outsourcing for the parents’ electric/water LOBs and other unaffiliated utilities.

Certainly, such an LOB can be a viable pursuit for utilities, but it should be a conscious business choice and not simply the default if regulatory separation requirements continue to increase. It is critical for the utility to carve out its business strategy, including appropriate shared service strategies.

By 2004, META Group expects all U.S. states to have adopted or to have considered different regulatory mechanisms that will require differing degrees of separation between regulated and unregulated service offerings. Those states that were more lax in the early years will stiffen requirements-if necessary-to promote competition in energy services. Regulators have learned lessons while attempting to open telecommunications markets and likely will have less tolerance in the energy markets. Through 2001 to 2003, META Group’s analysts predict shared services IT organizations in an unregulated subsidiary will be the norm for energy companies, particularly for those that have a holding company structure with regulated and unregulated LOBs. Several examples of separate IT businesses will emerge in this time frame.

What Does This Portend?

META Group’s analysts have seen the continuing migration of IT services to the unregulated side of business through second-order unbundling (i.e., IT services outsourcing). As regulators continue to separate regulated and unregulated LOBs, migration of IT and other shared services to unregulated information services companies will accelerate.

Separation rules will put a strain on progressive LOB/IT group partnerships, where IT organizations are part of corporate shared services. The LOB/IT partnership is still a key differentiator. However, an IT organization affiliated with the corporate entity will face increased regulatory barriers to serving both regulated and unregulated energy businesses. Regulators may construe close business/technology partnerships with unregulated energy businesses as implying cross-subsidy, imperiling the sanctity of confidential customer information acquired under the banner of the regulated monopoly and shifting the cost of new IT programs to regulated sister companies.

As the regulatory wedge is driven deeper, IT organizations will focus on developing and delivering standardized IT products and services to regulated energy LOBs with limited needs for customized IT services. Pricing structures for these services will face strict regulatory transfer pricing rules and close regulatory scrutiny. LOB executives will need to consider outsourcing as an additional way to demonstrate separation, and to pass prudence muster in future rate proceedings the pipes and wires companies will face.

Where Is This Likely to Lead?

Regulatory uncertainty over separation of functions, standards of conduct, pricing of services, and confidential/privileged information abounds. Economic regulators are creating business uncertainty by failing to set clear rules for regulated and unregulated services; utility executives are creating uncertainty by hesitating to clearly set out the company’s strategic direction. Each of these events encourages the implementation of broad, sweeping rules that could preclude certain efficiencies by drawing too stark a line between functions.

This separation of functions has been referred to in other quarters as “firewalls,” “Chinese walls,” and “Berlin walls” (see figure). The firewall refers to the most minimal separation, typically protecting against cross-subsidization between regulated and unregulated LOBs. The Chinese wall extends the separation to include functions within employee ranks and certain prohibitions regarding information transfer between regulated and unregulated businesses, often with significant codes of conduct designed to control intercompany activity. The Berlin wall, which typically mandates separate companies, imposes the starkest limitations on the transfer of knowledge, information, and services between regulated and unregulated energy LOBs.

META Group recommends that utilities chart a clear shared services utilization strategy that will support the underlying business direction. This strategy should forestall regulators’ efforts to impose a default strict separation requirement.

Managing IT Costs

A major barrier to market pricing utility IT products and services is the belief, by most regulated utilities, that rate-making rules require IT costs be charged back to the operating divisions and departments that consume the services. META Group finds this is rarely the case. State and federal regulations require the cost of providing IT services to multistate regulated entities be allocated fairly among the jurisdictions served. For utilities providing service to both regulated and unregulated subsidiaries, regulators require justification that the regulated entity’s customers are not subsidizing services provided to unregulated ventures. These rules are aimed to prevent cross-subsidy between geographic regions or between regulated and competitive entities (e.g., affiliated transaction rules). However, rules for affiliated transactions between regulated and competitive energy businesses owned by a single holding company, or geographic allocation of service costs between multistate utilities, do not require this division of cost be borne in any particular manner by the departments or divisions of the host utility.

META Group recommends pricing IT products and services at market vs. cost for delivery to internal clients. Reasons for this strategy include:

  • Clients pay a market price for their IT products and services, which ensures that IT costs are the result of technology’s role in their business strategies, not an internal price variance.
  • Costs are perceived as controllable and fair by internal clients.
  • IT organizations receive revenue commensurate with what the market would provide a competitive IT entity delivering the same service; hence, IT shops run more like businesses.
  • Discrepancies between revenue earned and the cost of IT products and services can be analyzed for IT resource management, at both the central IT organization and at the consuming LOB.

META Group estimates market pricing of internally provided IT services will increase as competition in energy markets expands. By 2004/05, most energy companies will be market pricing internal IT services, and providing internal clients with a mix of internally generated and externally acquired IT services.

While IT cost chargeback makes life easier for utility accountants, this practice exacerbates friction between central IT organizations and their client LOBs, and retards the migration to competitive readiness at both levels. For central IT, the ability to charge back cost obscures the competitive reality of the service’s cost relative to its market value. Even when current IT products and services are produced and delivered at costs comparable to those of competitive IT service providers, the legacy of prederegulatory IT decisions/actions continues to be charged out, making overall IT allocations incomprehensible and excessive. These “hidden, stranded IT costs” are buried in the chargeback.

LOBs seeking to understand or control IT costs are naturally attracted to obtaining IT products and services from competitive vendors with competitive prices. Internal IT service costs (including legacy utility IT investments) charged back to these LOBs appear high relative to market-priced services. Generation and distribution LOBs are eagerly awaiting full independence from central IT organizations that fail to meet the test of market with internal pricing. Emerging retail marketing organizations in competitive energy markets have demonstrated a preference for outsourcing their IT requirements.

Price Signals

Price signals resulting from the difference between revenue earned from the sale of IT products/services and the cost of producing them reflect the underlying economics of managing IT costs:

  • When total revenue from a market-priced service exceeds the total cost of providing the service (assuming it is measured accurately), one can deduce the service is provided efficiently or market demand for the service exceeds market supply.
  • When total revenue from a market-priced service is less than its cost, one can deduce the service is provided inefficiently, includes services not contained in comparable competitive market offerings (and therefore not reflected in the price), and represents a service for which demand has not yet grown to justify investment in the service.

The information obtained by comparing market-priced IT services, and the range of options this information provides for effectively managing IT, should not be ignored. The quality of this information stands in stark contrast to “guesstimated,” allocated, and self-justified information frequently used to evaluate reasonable IT costs charged back to captive internal customers.

Regulatory vs. Management Accounting

Regulatory accounting driving a just and equitable allocation of cost between jurisdictions or business entities should not be confused with management accounting driving solid information for managing the enterprise and its crucial activities. The former ensures all costs incurred, whether reasonable or not, are fully allocated among entities with total cost drives at a rate collected from captive customers. The latter ensures solid, correct information is available to maximize the value or minimize the cost of the enterprise’s crucial activities. In the critical transition from “product-centered” to “customer-centered,” and from regulated to reregulated (e.g., performance-based rate driven) or competitive markets, energy utilities need to transition even more quickly away from regulatory accounting to management accounting. The cultural and business transitions they must undertake will depend on behaving competitively, not creating the illusion of doing so.

Running IT Organizations as a Business

While technology has never been more important to the execution of business strategy for energy utilities, technology is also under scrutiny to demonstrate its value to the business. The crucial question is whether the execution of business strategy requires more IT, less IT or better IT. If technologists working with their business counterparts cannot answer this question, it likely will be answered by an outsourcer of IT services better aligned/integrated with the IT client’s business strategy. Market pricing IT products and services is crucial to running IT as a business. Market price signals are the source of management information that will enable the effective mix of internal and external IT products and services.

Rick Nicholson is vice president and director of META Group’s Energy Information Strategies (EIS) service.

Jim Spiers is affiliate analyst for META Group’s EIS. META Group’s EIS is a comprehensive advisory service focused on the needs and concerns of the rapidly transforming energy industry.

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