Table of Contents
THE DYNAMICS OF STRATEGIC ELECTRICITY-TRADING
Patricia Ochoa*, Isaac Dyner*, Carlos J aime Franco*
*Universidad Nacional de Colombia
Idyner@ unalmed.edu.co
AA 1027 Medellin, Colombia
**Interconexion Eléctrica S.A., E.S.P.
ABSTRACT
As electricity markets are turning competitive, uncertainty becomes a major
threat to trading companies. In this environment a single strategic intent seems
inappropriate as important endogenous and exogenous variables are not
predictable and may have important negative impact on the company’s
performance.
In this paper, we undertake Markides’ idea of a portfolio of strategies (2000,
2001) and apply it to the electricity trading industry. We explore the viability of
this approach, that embeds feedback thinking, by using a system dynamics
model for a hypothetical electricity market. We use Porter's competitive
advantage framework and apply it to three generic strategies in order to
examine the idea of a portfolio of strategies. We describe the SD model that was
developed for this purpose and present simulation results.
Key words: The dynamics of strategy, electricity trading, system dynamics.
1. INTRODUCTION
As energy markets around the world are being liberalised since the early 1990s,
intense competition is emerging, bringing important benefits to customers, with
effects on price reductions and the introduction of new types of products and
services.
Under the dynamics and uncertainty of energy markets, companies may find
appropriate to remain flexible by developing a portfolio of strategies that can be
swiftly substituted to respond to the rapid evolving markets (Williamson, 2001).
While companies focus on the implementation of a particular strategy, they may
develop alternative options for the future (Beinhocker, 2001, Hamel, 2001).
As Hamel (2001) notes, successful companies, such as Home Depot, Amgen,
Nike, Intel, Compaq and Gap, grew because they radically change the base of
competition in their industries - they either invented new industries or reinvented
dramatically the old ones.
Dynamics and Uncertainty
According to Elsenhardt (2001), and Hax and Wilde (2001), the dynamics and
uncertainty which are immersed in deregulated energy markets, represent a
challenge for strategic planning. Traditional approaches, which used to define
strategy intents by responding to the questions of where to go, and how to get
there, overestimated managers abilities to analyse and predict which industries
and which competencies or strategic positions would be successful and for how
long. These approaches also underestimated the construction of effective
strategies (Dyner and Larsen, 2001).
The businesses world is less predictable today than what it used to be, and the
human mind has proven not to be an appropriate forecasting aid. However, the
greatest problem, according to Beinhocker (2001) and Williamson (2001) is
people's tendency to identify patterns and interpret situations, associating them
with previously facts, even when there is no connection between them - No one
can predict accurately the evolutions of markets in the long-term.
Modern energy markets are growing fast. They are immersed in an uncertain
world due to price volatility, rivalry intensity, demand fluctuation and regulatory
risk. In this complex world, companies have to deal with imperfect information
and a large number of interrelated variables that exceed the capacity of the
human mind, making management a difficult task.
Strategy and risk management
During the last twenty years, competency has been the centre of strategic
thinking (Kim and Mauborgne, 2001). Managers have been focused on being
competitive, improving operational efficiency trough the implementation of
different strategic intents such as Total Quality Management, Reengineering,
Cost Reduction, Outsourcing, Size Reduction and Focus. However, as Porter
stated in 1996, companies have to find a way of growing by creating competitive
advantages instead of just eliminating disadvantages.
To perform a plan and to achieve a strategic position that allows a company to
reduce risks and benefit from industry’s opportunities, it is necessary to
understand markets and prepare for its evolution. Although strategy would like
to have accurate prediction-tools, most things in the world seemed naturally
unpredictable. This is why businesses might consider not to develop a single
strategy but a number of strategies that evolve through time. In this sense firms
may consider a robust strategic framework that may provide them with
satisfactory, rather than optimal, results under different scenarios.
De Gues (1988) and Hamel (2001), both stated that companies must invest in
experiments that help them understand new markets and motivate the creation
of new strategies, showing new perspectives that allow them to rethink the
industry, their services and the company itself. They should invest more time
trying to understand the preconditions that contribute to emergent strategies, as
company’s survival depends on the management ability to perceive
environmental changes and its prompt reaction.
Moving from one strategy to another one
Flexibility is turning important for companies’ long-term survival. While
companies define and implement one positioning strategy they need to develop
a stock of resources and capabilities that allow them to change fast, which may
help them redefine strategy according to environmental changes.
According to Markides (2000, 2001), traditional strategic thinking fails to
understand strategy from a dynamic point of view; it fails to place the company
into its historical context and to consider its evolution as well as the industry’s.
Thus, on the development of strategy, companies should be prepared to go
along the following thinking loop, presented by Markides (2000) on his book “All
the Right Moves” (See Figure 1):
Find a unique
strategic position
in the industry
Compete in this position
by trying to become better
than all other competitors
in the industry
Make another
transition from the
old position to the
new
Search for new
strategic
positions
Manage both
positions
simultaneously
Figure 1.Strategy as a Dynamic, Lifelong Process (Markides, 2000, 2001)
No company can perfectly forecast strategic innovation. Most companies fail
when new technology innovations appear on its market, even when they have
adopted them, because they do not have the core competencies needed to take
advantage of the innovation or because they mishandle the transition between
old and new technology.
In the following section, we explore on some likely strategic approaches that
might be undertaken in electricity markets. In section 3 we show the main
components of the model that was built for the evaluation of Markide’s
approach. Section 4 exhibit simulation results for a hypothetical case in order to
show the consistency of the proposed approach. We finish with some
conclusion of our findings.
2. SOME LIKELY STRATEGIC APPROACHES
Porter's Competitive Advantage (1982) seems an adequate approach for
companies to attain a sustainable position in their respective industries.
According to Porter (1982) and Hill and J ones (1995), companies can achieve
competitive advantages by striving for efficiency, Total Quality Management,
innovation and customer satisfaction.
Three Generic Competitive Strategies
According to Porter (1982) and Aaker (1998), the best strategy for a firm is a
unique construct that reflects its particular circumstances; it should be based on
resources and capabilities of the organization and on its abilities for value
creation.
In this sense, Michael Porter suggested three generic competitive strategies to
attain a sustainable long-term position. These three strategies, which could be
used by energy companies as well as by companies in other industries, allow
the firm to stand-out of its competitors.
First_Generic Strategy - Cost Leadership: Overcome competency doing
everything possible to produce or serve clients at a lower cost than competitors
(Hill and J ones, 1995).
The cost-leadership firm gains flexibility because it can stand-out facing price
reductions due to rivalry increase; or cost rising as a result of legal restrictions or
offer reduction, among others.
Cost leadership is certainly a valuable position, although it is hard to sustain in
the long term due to energy prices volatility. However, risk management and
information systems could protect the firm against price uncertainty. Once a
company becomes cost leader, it gains recognition and customer's loyalty,
incrementing its market share, and making possible for the firm to take
advantage of economies of scale.
Second Generic Strategy - Differentiation: To do something the market
perceives as unique in a way that is valuable to customers (Porter, 1982).
Differentiated companies create their own market niche through innovation and
deep understanding of clients’ necessities. This position allows companies to
charge higher prices for its products and services.
Differentiation lowers the effects that higher production costs might have over
companies, because lowering costs is not as important as increasing customers’
perception and loyalty.
Third Generic Strategy - Focus or High Segmentation: This strategy is about
focusing on a specific group of customers - segment - with particular needs.
The best way to attain segmentation, a company seeks for a market niche that
matches the company’s conditions to exploit resources and capabilities; a niche
with almost no rivalry.
Segmentation strategy, as well as differentiation, need a profound customer
understanding and high levels of innovation in order to create new market
segments. This strategy is natural among energy markets, where geographical
zones, demand or types of contracts could segment clients.
Because focused companies have fewer customers than other companies, they
could effectively serve their clients, achieving either differentiation or cost
leadership between their selected segment of the market.
In this context of dynamic and unpredictable energy markets, where strategy
evolution might be indicated, we turn to assess the viability of this strategic
approach with the help of modelling and simulation.
3. SYSTEM DYNAMIC MODELLING
In this section we show a System Dynamics model that represents the pursue of
competitive advantage by trading companies in energy industries through capital
management and investment policies (Figure 2). Competitive advantage
improves the company’s position, in the long term, in comparison to its
competitors’ position, by increasing profits and allowing the company to improve
investment levels to sustain improvement.
INVESTMENTS
PROFITS *
MARKET
POSITION _ SEEKING
COMPETITIVE
ADVANTAGE
Figure 2.Strategic Position through competitive advantage causal loop.
pe
Investment is required for developing resources and capabilities and to improve
the company’s performance. The SD model evaluates three main types of
investment:
Investment_on Process Improvement _& Information Technology (Pl _& IT):
Includes research on contracting alternatives, billing, development of new
complementary services, information systems and communication tools, among
others. This type of investment focuses on research for the improvement of the
company’s processes, with consequences on total quality management, which
increase efficiency (Figure 3) and operational profits, allowing more investment.
Profits
SEEKING
Total A, COMPETITIVE
C Cost ADVANTAGE
+
PIGIT
EFFICIENCY
+
+
TOTAL
QUALITY
SUPERIOR +
PRODUCT
Figure 3. Investment on Process Improvement & Information Technology (P! & IT) causal loop.
Human Development Investment (HD): Company invests on personnel by hiring
high quality employees, or when invests on market research, training on system
information, risk management and valuation, or people motivation.
Human Development investment impact is similar to the Pl & IT one, because
they both reduce operational errors while increase efficiency (Figure 4).
Profits gy
SEEKING Ng
COMPETITIVE INV. HUMAN
ADVANTAGE DEVELOPMENT
EFFICIENCY
+
TOTAL gf
QUALITY
#
Figure 4.Human Development Investment impact causal loop
Marketing and Services Investment (MS): Focuses on customer satisfaction
through high quality complimentary-services, consulting, advertising and
corporate image management, improving market product position and lowering
customer price perception (Figure 5) allowing the company to increase its
market share and its profits due to sales rise.
The balance between different investment alternatives is very important in order
to gain sustainable advantages and reach company’s goals on profitability,
market share and strategic position. Over-investment in one of the three main
areas could lead to under-performance.
+
Perceived Sales
Price “YS Revenue
+
Potential
ATISFACTION Mate
a
t *
aS —_— ‘
INE ARKETING Total Cost Profi
& SERVICES
SEEKING + #
COMPETITIVE
ADVANTAGE
Figure 5.Investment in marketing and services impact causal loop.
An adequate combination of investment alternatives leads the company to gain
competitive advantage and strategic position, as represented in Figure 6.
10
Market Niches
SEGMENTATION —_~
+ Sales
Share Revenue
DIFERENCIATION a +
- +
+
€ erceived
SALES ay Pree
PRICE
- < - Profits
INV. MARKET & 3
SERVICES
Purchases
Cost Efficiency
INV. PL & IT
PURCHASES \
a
PRICE of
. 5, INV. HUMAN
DEVELOPMENT
Total Cost
cosT per Unit
LEADERSHIP
mK Sales
(Mw)
Figure 6.Investment impact on strategic positioning causal loop.
Cost leadership is a consequence of an appropriate purchase policy that allows
the company to discover lower prices than its competitors, and of cost reduction
due to efficiency improvement because of investment on human development
and PI &IT.
Marketing and services investment leads to differentiation improving customers’
perception of company’s product, which allows price rising. Differentiation is
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also influenced by segmentation because segmented companies usually offer
particular products for particular clients.
In our SD model, strategic positioning depends on investments: Marketing and
Services, Process Improvement & Information Technology, and Human
Development, which influence the cost structure of the company and customer's
perception. This has an effect on the company’s market share and operational
profits.
Customer perception is modelled through perceived price: This variable
expresses customers’ valuation of the benefit they would attain when acquiring a
product. This perceived price is represented by a function of real price and
investments on marketing and services as follows:
Perceived Price =f(Real Price, MS)
In the following section, we present results for a hypothetical electricity market,
for the purpose of evaluating the viability and consistency of the proposed
approach.
4. SIMULATION RESULTS
Figure 7 shows how the difference between Real and Perceived price is
changing according to Marketing and Services Investment. During the initial
periods there is little investment, thus perceived price is higher than real price,
which means that customers prefer the competitors’ products over ours. During
the following periods, one can observed how perceived and real price are
identical, so there is no difference of perception between the product offered by
competing companies; but by the tenth period, our increasing investment is
reflected on the increasing difference between real and perceived price. Our
product is now positioned and customers perceive it better. However, we
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cannot keep on increasing our investment level for ever and start slowly
reducing it by the end of the planning exercise.
Real_Price
Perceived_Price
+i0
INV_MS
10 20 30 40
Time
Figure 7.Perceived cost variation as a result of MS investment.
Figure 8 presents Market Share and Profits evolution for the former case. At the
beginning, market share and profits are decreasing. This is because the
company is just starting to develop its image and brand position - investment
levels are increasing but company does not have enough clients to cover its
cost. Once its clients recognize company, its profits start to increase and so
does market share.
0.2010.
0.2005.
g 10,000-
a
0.2000.
Market_Share
0 10 20 30 40 0 10 20 30 40
Time Time
Figure 8. Market Share and Profits evolution
Pl & IT and HD investments influence cost structure because of those
investments make company more efficient, reducing errors’ cost. Figure 9
13
shows the impact of different Pl & IT, and HD investment levels on fixed
operational costs. This figure shows how, between the 15-20 period,
simultaneous investment on P| & IT and HD could lead to better benefits than
isolated investments.
INV_HD
50 Operative_Cost
= -
400 sa INVPLIT
30
20
0 10 20 30 40
Time
Figure 9. Operational cost variation as consequence of P| & IT and HD investments.
If our company’s goal is, for instance, attain cost leadership, then we may invest
on HD, on Pl & IT, or both. Company's operative cost would reduce and
company might achieve its goal. Although, if company’s investment level raises
above certain point, then the firm might be over-investing and increasing cost
rather than reducing it, as can be appreciated on the last ten periods in Figure 9.
Cost leadership is the result of reducing fixed costs and purchases costs. Fixed
costs could be reduced by PI & IT and HD investments, while purchases costs
are more difficult to control because of its dependence on uncertain market
prices. Thus, to attain cost leadership is the consequence of good investment
policy on PI & IT and HD, modified by purchase efficiency. The probability of
being cost leader increases as operative cost decreases (Figure 10).
14
5004
4004
3004
= COST_LEADERSHIP
2004 = Operative_Cost
9 t t t 1
0 10 20 30 40
Time
Figure 10. Operative costs Vs Cost leadership position.
Segmentation is an indicator of sales concentration in different market niches’.
The segmentation indicator is calculated according to the Herfindahl index
(Littlechild, 2001), which has been used as a measure of industry concentration
- adding the square of market shares of all the companies within an industry:
H => [Share iy
In this case, we used Herfindahl index as a measure of company’s sales
concentration among consumers’ type, adding the square of sales percentage
on each segment. Thus, segmentation level relies on sales concentration on
different niches, as shown in Figure 11. When our company sales most of its
products to just one market niche the company is segmented, and the
segmentation indicator will equal one; when company’s sales are equally divided
between two markets, then it is partially segmented and the indicator will equal
? Market niches for Colombian electricity market model: Traders - Residential Consumers -
Industrial Consumers
15
0.5; as the indicator approaches zero, then company is not segmented, which
means that it is serving every available niche on the market.
1.07
0.84
0.64 as Va —y- Sales_Niche_1
ou > 4 4 —z~ Sales_Niche_2
—z— Sales_Niche_3
024 ~4- SEGMENTATION
0.0 —
0 10 20 30 40
Time
Figure 11. Sales concentration and segmentation index.
Differentiation position is gained when customers perceive firm’s product as
unique in the market. That is, company attains differentiation when perceived
price is lower than real price of energy, because of MS investment, which
influence could be seen on Figure 12.
200
aa os
1505
\ [4 =p DIFERENCIATION
—— INV_MS
50+
0-
0 10 20 30 40
Time
Figure 12. MS Investment influence on Differentiation.
16
Segmentation also influences differentiation levels, because competing in just
one segment of the market gives companies the ability to better understand
customer's necessities and differences (Figure 13).
200 |_--Y
150+
DIFERENCIATION
100+ TT”
\ —7- SEGMENTATION
INV_MS
50+ al a 3 ms
0-
0 10 20 30 40
Time
Figure 13. Segmentation influence on differentiation.
Differentiated companies do not pursue cost leadership or segmentation
strategies. A differentiated company may sale its products at a higher price and
still keep its market share and profits. Likewise, once a company becomes cost-
leader, it may reduce its investments. Cost leaders do not need to differentiate
its products, they need to produce as much as possible for the average
consumer So they could maintain its leadership.
However, no position lasts forever. Thus, companies might be able to switch
strategies when required. It is not difficult for a differentiated company to move
into a segment, nor for a segmented company to differentiate. The cost leader
should, however, keep on investing in R&D as it need to be alerted about market
changes.
For a start up company it is difficult to gain a strategic position in a particular
industry. The company might gain competitive advantages and, by properly
managing investments and efficiency, attain cost leadership. This position may
not be sustainable as the introduction of new technologies may result on cost
17
reduction, making the company lose competitive advantage. Thus, the formerly
efficient company may find a niche to focus on. The strategy could be switched
towards segmentation, achieving a new competitive position; in this case, as
shown in Figure 14, chances are high that the company lose its cost leadership,
because they need to increase the level of investment in PI & IT to develop
special products and services for the segment they choose.
=z COST_LEADERSHIP
SEGMENTATION
Figure 14, Switching between strategies
5. CONCLUSIONS
We draw some conclusions from the progress made in our research:
= The development of Competitive Advantage schemes might result
beneficiary to trading electricity companies.
= Markides’ approach to Strategy Dynamics seems appropriate to energy
markets.
= System Dynamics is an appropriate approach for the evaluation of alternative
strategies and evolutionary strategies.
= Core Competences may also be approached by an investment scheme
although we did not evaluate it on this paper.
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ACKNOLEDGEMENT
We especially acknowledge MEM (Interconexidn Eléctrica S.A - ISA) for the
generous financial support to this project and to Professor Erik R. Larsen, City
University, London for his advise. He has not been included as one of the
authors of this paper as he may not agree with everything we expressed here.
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