Dealing With Deregulation: Strategic Challenges and Responses

Published: May 09, 2001 in Knowledge@Emory

Industrial deregulation is a hot-button issue. Ask critics, and they will argue that when the U.S. government deregulated the power and natural gas utilities, for instance, it sold out the public’s interests to those of money-grubbing corporations. Ask enthusiasts, and they will assert that degulating the business was the best way to spur competition and benefit consumers.

While such debates constantly smoulder over matters of public policy, deregulation also poses strategic challenges for companies. Among the most fundamental questions is: If an industry is deregulated, how can companies in that industry make the transition from regulation to deregulation? A related question is: Who is better equipped to survive deregulation – established incumbents who dominated the industry in its heyday of regulation or new entrants who want to take advantage of deregulation to attack the incumbents?

To explore how companies respond to these challenges, Richard Makadok, a professor of Organization & Management at the Goizueta Business School of Emory University, invited a panel of utility and telecommunications industry insiders to speak to students in his Strategic Management class. Makadok observes that immediately following deregulation, incumbent companies usually inherit a high-service/high-cost strategic position, so new upstarts usually choose to compete by entering with a no-frills/low-cost position. Over time, however, incumbent companies struggle to cut costs while maintaining their high service, while new entrants strive to improve service without raising costs.

In the discussion, Makadok challenged the panelists to focused on deregulation’s primary strategic challenge: Which one – incumbent or new entrant – will be the first to reach the ultimate goal of providing high service at low cost? He explained that four key issues surface when analyzing an industry transitioning to deregulation: Which incumbents are most vulnerable? Which markets do new entrants target? What strategies do successful entrants follow? And, lastly, how do incumbents cope with entrants?

Not surprisingly, the most vulnerable incumbents are companies with low profitability, high costs, strong unions, slow and inflexible bureaucracies, lots of excess capacity, and a low investment in marketing. Unfortunately, many of these incumbents do not appear to know how vulnerable they are. The reasons: Corporate culture and the casualties of a competitive process that no longer has rules.

"Large organizations are essentially political coalitions," Makadok says. "What’s best for the organization may not be in the best interest of the management of the organization." While this observation is certainly not new, at a time of disruptive transition to increased competition, it can be fatal.

"Regulation guarantees a steady, predictable profit, so incumbent companies have developed an inward-looking focus, often including a history of in-fighting between constituencies over how to divide the pie," Makadok says. "But when deregulation hits an industry, incumbents have to become market-focused and respond quickly to the challenge of increased competition if they want to survive. As a result, workers and managers who have never had to compete must develop new skills and new mindsets, which may be exactly opposite the mindsets that have enabled them to succeed in the past. But more importantly, if complacent managers and recalcitrant workers stay entrenched in old conflicts over how to slice the pie, their foot-dragging can kill the goose that lays the golden eggs."

For other incumbents, the culprit isn’t internal conflict so much as uncertainty amid a myriad of unknowns. Deregulation "was much more complex and expensive than we ever imagined beforehand," explained panelist Hal Novak, director of rates and regulatory analysis for Atlanta Gas Light, the largest natural gas distribution utility in the Southeastern U.S. and one of the largest in the country. Recently, it was the first gas utility in the U.S. to undergo full deregulation.

Although the deregulation process was originally envisioned to occur over several years, it was accelerated to a 13 month period. According to Novak, this rapid pace of natural gas deregulation in Georgia caused several problems for both the utility and for marketers. For example, as customers migrated from the utility to one of several certificated marketers, Atlanta Gas Light’s rates were reduced while their costs of providing service (call center and customer inquiry costs) actually increased.

In addition, many marketers were suddenly handed the headaches of dealing with large number of customers without having the necessary infrastructure (billing systems) already in place. "A hundred and seventy-five thousand customers is a lot to handle when you’re starting from scratch," he says about a competitor that made an early exit. "The company was just not prepared."

Lack of preparation can also be a problem for incumbents. Under regulation, there was little or no incentive to conduct market research or develop marketing skills. But when competitors enter the market after deregulation, the lack of research and marketing savvy can cripple an incumbent. Makadok notes that incumbents may have a lot of information about customers, but that it might not be the right variety. One company Makadok researched had certain ideas about which sub-markets would be profitable and which ones would not following deregulation. "Their assumptions were all wrong because their information — based on their customer research — was either wrong or misinterpreted," he says.

Not having good information bleeds into other areas of the company as well. Another panelist, Drew Evans, vice president, structuring and market development, for Mirant (formerly Southern Energy) pointed out that in the regulated environment of electricity, a company knows what things cost, but it has "no idea what the value of that [product] is in the marketplace."

More than 450 licensed marketers rushed into the post-regulation electrical energy marketplace which Southern Energy, then a part of Southern Company, had dominated for years. Although just a little more than half those companies survive today, there are still 250 more companies than there were pre-deregulation. This creates two serious hurdles for incumbents and entrants alike: intense price competition and equally intense competition for capital.

Citing research by Joel Bleeke of McKinsey, the consulting firm, Makadok points out that incumbents often underestimate the impact of deregulation because they focus more on how much market share they will lose than on how much pricing power they will lose. According to Bleeke’s study, even when new entrants stay small and take only a modest market share of 10-25% (as they did in the PBX-switching and securities industries), they still force a large price cut of 30-50% on everyone, including incumbents. For this reason, Makadok believes that the real winners in deregulation are almost always the customers. "The lesson for incumbents who are preparing for deregulation," says Makadok, "is to think about the impact of deregulation on both market share and profit margins, and not to underestimate either one."

Again citing Bleeke’s study, Makadok points to a hidden impact of increased price competition in deregulated markets. "Because of their steady and predictable profitability, incumbents in regulated industries grow accustomed to having access to the capital markets on very favorable terms," Makadok says. "But when price competition cuts into their profit margins, incumbents are often surprised to discover that financing becomes more of a challenge."

Ironically, the squeeze on capital comes at precisely the time when incumbents need to invest in upgrading outdated technologies and capabilities in order to compete in the deregulated marketplace. The result is that incumbents end up financing these upgrades by selling off divisions and non-core operations. "Bleeke’s study finds that only a small number of incumbents survive as full-service broad-based competitors," says Makadok. "The result is that the industry winds up becoming much more segmented."

In order for the incumbents to cope with new entrants and make the change to a deregulated marketplace, they must, as Southern Energy’s Evans pointed out, improve their understanding of their cost structure and engage in ruthless cost cutting. Many times, says Makadok, this leads to downsizing.

Lynda Smith, a former manager at BellSouth and now the director of marketing intelligence for communication firm Equant, illustrates Makadok’s point. "If you’re in a company going through deregulation and you can’t embrace change, you will go out of your mind," she says. "Just when you think you’ve got it figured out, you are re-aligned or out-sourced or re-organized or modified. And they’re all words for the same thing — you’re out of here."

Although downsizing takes a toll on morale, it’s often a necessary part of an incumbent’s ability to cope in a deregulated world. If the incumbent can couple cost cutting with improved marketing skills, price-discrimination skills, and continued control over access to customers and information about customers, then the company can survive deregulation and thrive.

For new entrants, the issues are just as complex. Entrants typically target sub-markets very selectively. They often focus on market segments that have paid high prices under regulation in order to subsidize other markets, such as the commercial/industrial segments that subsidize consumer segments. Within these market segments, entrants typically focus most on customers with latent price sensitivity – those who would be most motivated to switch for a lower price if one were offered to them. Indeed, new entrants often attract totally new customer groups who are so price-sensitive that they could never before afford to buy the product under regulation. Finally, entrants seek the path of least resistance and therefore target sub-markets with low barriers to entry.

There are some strategies, according to Makadok, that most — if not all — successful entrants follow. Almost always, new entrants initially attract customers by offering a lower price for the same — or improved — product. Entrants with low cost structures are able to do this. But, says Makadok, it usually doesn’t pay for them to keep competing on price forever. "The most successful entrants are those who move up the service/price ladder while maintaining low costs," he says, referring to the ultimate strategic challenge of deregulation: offering more service for less money.

Successful entrants keep costs down by out-sourcing, eliminating structural costs, avoiding the incumbents’ core markets whenever possible, and focusing on only the most profitable customer segments and markets. In addition, entrants must use innovative marketing techniques to find out what customers want.

Makadok also points out that the deregulation model can be applied to understanding the current shakeout in e-commerce. "The strategic challenge is the same," he says, "ideally offering high service at a low cost." Initially, Makadok argues, the Internet spawned a kind of technological "deregulation" of sorts, by lowering barriers to entry. At first, it seemed like the Internet had eliminated the need for the large capital expenditures to build the bricks-and-mortar operations that had traditionally been necessary for entering many industries. As a result, many virtual entrants took on the brick-and-mortar "incumbents."

"Any time entry barriers fall – whether it’s due to deregulation or technology or anything else – it attracts overconfident new entrants ready to exploit the vulnerabilities of incumbents," says Makadok. "Fairly quickly, the incumbents figure out to best protect those vulnerabilities and fight back."

Offering a telling example, Makadok narrates the story of a small-town barber whose longstanding customers start leaving when a hairstyle chain opens a shop across the street with signs proclaiming "Everything $5! $5 haircuts, $5 styles, $5 perms." The barber responds with his own neon sign announcing, "We fix $5 haircuts."

"The point is that incumbents, in turn, figure out how to exploit the vulnerabilities of the new entrants," Makadok explains. "Not every customer turns out to be as price-sensitive as expected, and incumbents can win them back by playing to their strengths – stability, reliability, high quality, good service. This is now the challenge facing all of those virtual entrants in e-commerce. Only time will tell whether the web-based entrants or the brick-and-mortar incumbents will meet the high-service/low-price target first."

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