Fortnightly
The Efficient Utility: Labor, Capital, and Profit
September 01, 1995By D. Thomas Taylor and Russell G. Thompson
Are utilities working at top productive capacity? A novel look at 19 investor-owned electrics in the Sun Belt.
Major restructuring is expected to hit investor-owned utilities (IOUs) over the next decade. Competitive market forces, in place of rate-of-return regulation, will require many companies to evaluate their resource allocations. No longer will singular adjustments in resource use suffice when both capital and labor resources must be realigned. Realignments may well prove as significant to the electric industry as the triumph of AC over DC current in the late 19th century. Electric utilities must begin now to realign their firms to the market.
Several fundamental questions arise. How do we stand, relative to our peers? Is our production side aligned with the market? How do we move from where we are to where we need to be? What will we gain in profits from such moves? IOUs must gain insight into the answers to these questions before making major decisions.
In this study, we considered data for 19 IOUs located and operating in the southern air-conditioning belt of the United States (see Table 1 on page 26). We have analyzed how each utility, relative to its peers, transformed its labor and capital into gross profit. The results indicate significant opportunities to improve efficiency across this set of firms. Nearly all of the 19 IOUs studied could make more efficient use of their capital and labor. Most of them appear poorly positioned to compete in the forthcoming competitive arena. Several large and prominent utilities must change appreciably to become well-positioned. Otherwise, they may well represent attractive targets for independent power producers (IPPs), since significant profit potential exists.
Frame of Reference
For all 19 IOUs, we focused on the two production inputs of labor (total employees) and capital (total assets) and then on the single output of profit (gross profit), as a surrogate for total productive output. "Total employees" encompasses all of the personnel employed by a utility; "total assets" represents all of the capital employed by a utility. "Gross profit" is a comprehensive measure of a firm's total product.
Within this frame of reference, if one utility's labor, applied to its capital, generates more product than any other utility's, the former receives the highest efficiency rating. This utility lies on the efficient production frontier and is labeled technically efficient. Conversely, if this utility is labeled technically inefficient, then some other utility is obtaining the same level of product with less labor, relative to its capital. Technical efficiency assumes that the there are no wastes (slacks) in resource use either by the firms on the efficient frontier or by the inefficient firms when projected to the efficient frontier.
Beyond technical considerations, we analyzed the alignment between each efficient utility's production and market sides. The Best Practice match was found between the utilities on the efficient frontier and plausible price bounds formed from data approximating a wide range of market conditions. Such a "matched utility" is said to be economically efficient; it has achieved the Best Practice in production and is economically aligned with the market.
Conceptually, the production function is envisioned as
y = f(x1, x2) \(em where y represents gross profits, x1 denotes capital stock, and x2 equals labor employed.
All of the findings follow from the data examined. They were not preconditioned by any behavioral theory or specified mathematical functional forms. Thus, the results should reveal efficiencies and
inefficiencies across the 19 firms for the study periods.
Data publicly reported by the respective IOUs to the Federal Energy Commission (FERC) were analyzed for the four years 1990-93. More specifically, FERC Form 1 pages 111, 114, and 323 supplied the figures for total assets, gross profits (or gross utility), and total employees; gross profits were total revenues less operation and maintenance expenses. Individual utility data were obtained for the utility subsidiaries of Central and Southwest Corp. (4), Entergy Corp. (EC) (5), and The Southern Co. (5). These subsidiary data were summed by category to obtain the respective overall utility totals. Data for 1990-91 and also for 1992-93 were averaged by utility. The first (1990-91) and second (1992-92) periods represents the time periods before and after the 1992 Energy Policy Act became law. (See Appendix on page 29 for data, including data normalized on gross profit.)
Plotting labor per unit of gross profit (x2/y) against capital per unit of gross profit (x1/y) provides a visual perspective for the labor versus capital tradeoffs in the data for the two periods. This type of tradeoff analysis has long been bedrock in concept for production studies in economics (see Figures 1 and 2).
Fixing the Frontier
In Figure 1, the Tampa Electric Co. (TEC) uses less capital than any of its 18 peers; San Diego Gas & Electric Co. (SDG&E) uses more capital than TEC, but less labor than its 18 peers. Relative to the data and the straight lines connecting the plotted positions for these two companies, no other utility is able to produce a unit of gross profits using less capital than TEC or less labor than SDG&E (or any linear combination of these two utilities' plotted points). Two additional lines complete the graph of the frontier, namely, the straight line outward from SDG&E's plotted point and the straight line upward from TEC's plotted point. This data-based determination provided the Best Practice efficient frontier closest to the origin in 1990-91. Hence, TEC and SDG&E were deemed the two technically efficient firms in 1990-91.
In Figure 2, three utilities established the efficient frontier for the 1992-93 period, namely, TEC, SDG&E, and Texas Utilities Co. (TUC). As normalized on gross profits, TEC uses less capital than any of its 18 peers; relative to TEC, SDG&E uses more capital, but less labor; and relative to SDG&E, TUC uses more capital, but less labor.
A Dose of Common Sense
At this point, one might ask, "How can TUC be technically efficient in the most recent period? It has experienced well-known
profitability problems." The answer lies with economics; TUC appears to represent a striking example of the long-standing Averch-Johnson hypothesis \(em namely, rate-of-return regulation results in far too much capital investment by utilities.
Verification for this hypothesis may be seen in the 1992-93 period, when one looks at TUC relative to its technically efficient peers TEC and SDG&E. TUC employs the smallest amount of labor, but the largest amount of capital. Now consider adjusting TUC's position toward SDG&E's position along the frontier and pricing the compensating adjustments at plausible rates \(em that is, 5%/$/yr -9.5%/$/yr for capital (see utility financial statistics) and $43,000/empl/yr-$45,000/empl/yr for wage and salary compensation (see Survey of Current Business, July 1994, for compensation statistics).
As normalized, TUC's capital-saving gains far exceed its additional costs of labor for all price ratios in the range. If it could, TUC would gain economic value by selling off some of its assets and hiring a commensurate number of employees along the frontier, which would allow it to move effectively toward SDG&E's observed position. Otherwise, TUC is out of economic position except for low capital prices.
Similarly, TEC may gain additional economic value by seeking to move along the frontier toward SDG&E's observed position. TEC needs to cut back its labor, at the expense of adding more capital, in order to improve its economic position. Stated another way, SDG&E was the economically efficient utility, since it is both Best Practice in production and aligned with market prices.
Market Tradeoffs
Just as a utility can trade off labor and capital to move back and forth along the efficient frontier from one point to another, companies can make other adjustments to move from inefficiency to frontier positions and, in turn, to the most profitable position
on the frontier. Making such
adjustments requires first finding the best path to the frontier for each inefficient firm. Some adjustment costs may be involved.
As shown in Figure 3, Duke Power Co. (DPC), Texas-New Mexico Power Co. (TNMP), Public Service Co. of New Mexico (PSCNM), and Houston Lighting & Power Co. (HL&P) made substantial cuts in both labor and capital employed between the two periods. Quite clearly, the competitive stimulus of the 1992 Energy Policy Act had significant effects on the utility structure of some major firms.
Several more utilities have Best Practice potential, if each utility were to make scale adjustments to reach its most productive scale size. In the 1992-93 period, several utilities stood out. The analysis indicates that Central Louisiana Electric Co. (CLE), Southwestern Public Service Co. (SPSC), and TNMP all needed to increase their scale of operations to achieve their most productive scale size and minimize average costs of production. Conversely, SCEcorp. (SCE), The Southern Co. (SC), and Florida Power & Light Co. (FPL) needed to decrease their scale of operations to reach their most productive scale size and minimize average production costs. Notably, some of the large utilities that need to scale back may find it in their best interests to try to sell off some of their operations \(em e.g, assets and employees \(em to some small utilities who need to scale up.
Matrix of Expectations
Several prominent large utilities posted lower efficiency ratings than might be expected \(em namely, Central & Southwest Corp. (C&SC), EC, Houston Lighting and Power Co., and DPC. Notably, as shown in Figure 3, some of these utilities \(em i.e., HL&P and DPC \(em are making needed adjustments; however, the Best Practice modeling results found here indicate that they must do more to be highly competitive in the unfolding market arena.
Relative to the results of this study, the 19 IOUs fell into four classes, as shown in Figure 4. The economically efficient utility, SDG&E, stands out as a best-in-class performer. Six other utilities were classified in the Best Practice quadrant: FP&L, TUC, SCE, SPSC, TEC, and HL&P. Several more utilities \(em SC, CP&LC, APSC, FPC \(em have Best Practice potential if they would place more emphasis on profits. EC could become Best Practice if it placed more emphasis on both efficiency and profits. The seven remaining utilities in the Targets quadrant seem to have formidable adjustment problems: TNMP, South Carolina Electric & Gas (SCE&G), C&SC, CLE, DPC, Oklahoma Gas & Electric Co. (OG&EC), and PSCNM. t
D. Thomas Taylor is principal of Palladian Analysis and Consulting in Houston, TX. Russell G. Thompson is president of The OPCON Corp., and a professor of operations research, statistics, and economic systems modeling at the University of Houston.
This analysis compares profit-ability potential and efficiency at 19 investor-owned electric utilities (IOUs) in the southern air-conditioning belt of the United States. It covers two periods (1990-91 and 1992-93) and compares total assets, number of employees, and gross profit, as reported in FERC Form 1.
This particular method of economic analysis, known as Best Practice, or DEA Best practice (for "Data Envelopment Analysis") has been under development by statisticians and economists for nearly 40 years, and was reviewed in Fortune in October 1994.
Strikingly, most of the 19 utilities examined were very inefficient. However, nearly all these utilities exhibited considerable profit potential.
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