Rethinking utilities' service costs

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Utilities are reconsidering traditional business models that rely on revenue gains through rate increases. As demand falls and costs climb, leading companies are taking charge of service costs to generate sustainable growth. Andrew Patterson reports.

US power and utility (P&U) companies are facing weak revenues, significant investment needs, and escalating operating expenses.

As regulators scrutinize allowed returns on equity (ROEs) and grow wary of granting rate increases, companies are faced with a stark choice: cut costs and avoid rate cases or sacrifice earnings. But where to begin?

Top 10 general and administrative cost increases

Three-year compound annual growth rate

1. Communication services (internal and external) 20%—30%
2. Security 20%—30%
3. Insurance 15%—20%
4. Legal 15%—18%
5. Corporate accounting 13%—15%
6. Environmental services 13%—15%
7. IT services 13%—15%
8. Safety 10%—12%
9. HR services 10%—12%
10. Business services 10%—12%
Source: Recent EY client assignments for power and utilities companies

A good place to start is service company costs, for functions including:

  • Finance
  • Insurance
  • IT
  • Supply chain
  • Accounting
  • Legal
  • HR

For some utilities, these costs are increasing two to three times as quickly as field operations and maintenance expenses.

While many of our US P&U clients have already completed one or two waves of cost takeouts in their core service functions – without loss of productivity or business risks – it is time for systemic change in the way these services are delivered.

If you can’t see it, you can’t cut it

In the past, service company costs for support services were allocated across an energy utility’s business lines in a one-size-fits-all manner. This resulted in a lack of transparency between general and administrative costs and end product prices, costs and profitability.

These services have not been line of sight with customer rates or market prices, making them difficult to predict and even harder to control. In many cases, hard targets for service company costs, in the context of end-use markets, are completely absent.

For example, there is a lack of consideration about how services and costs should differ for a merchant power plant compared to that for a regulated distribution region.

Here comes the next generation

Building a next-generation support services model will require P&U companies to develop a more tailored understanding of their cost profile, allowing them to view expenses at a new level of granularity, and take a disciplined approach to cutting excess.

Here are five ways to move forward:

  1. Segment the service company: leading service organizations are aligning service company costs to business segments and profits, taking a hard look at their cost allocation pools to scale back, outsource or eliminate those corporate services they cannot afford. For example:
    • As generators shutter coal plants, what is the corresponding impact on shared services?
    • As rate case increases are denied, what is the balance between reductions in the field versus the corporate center?
    • In a low natural gas market, what is the overhead level or bearable burden that fossil fleets can handle?
  2. Enhance the line of sight between product and service costs: we are working with clients to link service costs more directly to outputs. For example:
    • How much cost is being allocated per customer, kilowatt-hour or megawatts of capacity? 
    • What is this allocation for IT, HR, accounting and legal services?
    • What is the ratio of “line” to “staff” employees?

    This type of transparency reveals how big service company allocations are, how fast they are growing – and where cuts are needed.

  3. Embrace outsourcing and scale economies: an increasing number of our clients are turning to innovative third-party providers, often offshore, in countries such as India, to take on non-operational tasks – and complete them more efficiently at lower cost. The market for many functions, such as payroll, audit services or HR information systems, is mature, and the solutions proven.
  4. Revitalize the organizational structure: as promotions are granted, experienced senior management can end up becoming essentially high-paid subject matter experts. One way to address this is to redesign the management structure so that talent moves consistently toward the top — adopting an “up or out” structure coupled with fewer levels and broader spans of control. Some expensive senior managers should be viewed as candidates for outsourcing – it is more efficient to bring in this talent as needed than employ people full-time.
  5. Review “uncontrollable” costs: companies are reassessing what were previously considered “uncontrollable” costs. Many of our clients are putting a new focus on wellness measures, such as regular health checks and workout facilities to take charge of preventative health care. Ultimately, employees who choose to live unhealthy lifestyles will be required to pay a larger share of their health care expenses.

Talk tough

Shifting their approach to service costs can not only help utilities achieve significant and sustainable cost reductions but also, through reviewing practices, inject innovation and a fresh perspective into the business.

While cost optimization is now firmly embedded in the internal culture of most energy utilities, there is some reticence to engage in the necessary dialogue regarding service functions and their delivery models. Direct conversations are essential to successfully rebuild the service company model and achieve cost reduction while sustaining support levels and quality.

How we can help

In an increasingly complex environment, we are supporting leading utilities as they assess how operations, IT, finance, marketing and other critical business units are executing against their strategic objectives. We work with them to improve the effectiveness of business processes and organizational structures and achieve sustainable long-term value.

For more information

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