ENVIRONMENTAL CHANGE AND MANAGEMENT STAFFING: AN EMPIRICAL EXAMINATION OF THE ELECTRIC UTILITIES INDUSTRY Ram Subramanian Carol M. Sanchez Seidman School of Business Grand Valley State University Allendale, MI Abstract This paper examines the relationship between environmental change, changes in competitive dynamics, and top management staffing in the electric utilities industry during the period surrounding the passage of the Energy Policy Act of 1992 (EPAct 92). The findings suggest that following the passage of the EPAct 92, competition in the electric utilities industry intensified, placing greater em- phasis on achieving internal, firm-level efficiencies. This external environmental change and the corresponding shift in the competitive context resulted in an ad- justment in the composition of the top management coalition in these firms. The dominant coalition following the EPAct 92 consisted ofolde r manage rs with longer company and industry tenure who had efficiency-oriented backgrounds in opera- tions, engineering, and accounting/finance. Introduction The adaptation research within the organizational theory literature (e.g. Katz & Kahn, 1978; Pfeffer & Salancik, 1978) posits that changes in the external envi- ronment tend to encourage the selection of top-level managers whose backgrounds and skills are more appropriate for the new environment. Using deregulation as a proxy for environmental change, prior studies have empirically examined this relationship in the railroad (Guthrie, Grimm & Smith, 1991) and airline (Thomas & Ramaswamy, 1993) industries. The two studies yielded somewhat inconsistent findings. Guthrie et al. (1991) found evidence to support their contention that following deregulation, railroad companies adopted new strategies that emphasized innovation, risk-taking, and an external, market-focused perspective. Top railroad executives tended to have fewer years of industry and company tenure (i.e. more outsiders were employed at the top level), more years of formal education, be younger, and come with backgrounds in functional areas of marketing rather than engineering, operations, or accounting/finance. In contrast, Thomas & Ramaswamy (1993) concluded that 18 Journal of Business Strategies Vol. 15, NO.1 following deregulation, airline companies emphasized efficiency and cost control. In turn, top airline executives were older, had longer tenures both in the company and in the industry (i.e. more insiders were employed at the top level), and came from functional backgrounds in engineering, operations, and account- ing/finance, rather than marketing. Thus, the same environmental change (i.e. deregulation) produced very dif- ferent adaptive reactions in two different industries. To explain the inconsistency, Thomas & Ramaswamy (1993) argued that the nature of competitive change that results from the change in the external environment must first be identified prior to examining the adaptive response by companies in an industry. These authors used a finer grained analysis to test their hypotheses, by adding an extra method- ological step to their study. They suggested that it is necessary to examine the type of competitive change brought about by a change in the external environ- ment, and its relationship to changes in management staffing, to increase the generalizability of the findings of a study of any specific industry. This paper makes a contribution to the strategic management/organizational theory literature by examining the environmental change-management staffing relationship in yet another industry setting~ the electric utilities industry. Using the finer-grained methodology pioneered by Thomas & Ramaswamy (1993), this study examines the effect of environmental change and the change in competitive dynamics it stimulates on management staffing of firms in the electric utilities industry during the period surrounding the passage of the Energy Policy Act of 1992 (EPAct 92). The paper also makes a contribution to managerial practice by analyzing one of the effects of a significant environmental change ~ industry-level deregula- tion - on the strategic responses of firms. Given the significant impact of any type of regulatory change, firms must be aware that regulation, or the absence of it, can change the intensity and configuration of rivalry in an industry (Porter, 1985). These changes in industry conditions can shift the balance of power among firms in an industry, depending on how firms respond strategically to the new industry conditions. By examining one set of firm level responses - top man- agement changes - this sfudy may shed light on how firms may achieve and sustain competitive advantage under new competitive conditions. The next section of the paper discusses the framework that allows us to iden- tify changes in competitive dynamics as a result of environmental change. We then examine the nature of the competitive change in the industry that was asso- ciated with the passage of the EPAct 92. Next, we develop arguments and hy- potheses that predict how top management teams will be affected by the changed competitive environment. Finally, we test the hypotheses using a sample of U.S. electric utility firms. Top Management Succession and Turnover Organizational theorists (e.g. Aldrich & Pfeffer, 1976; Katz & Kahn, 1978) suggest that top executive succession is a means of adapting the organization to Spring 1998 Subramanian & Sanchez: Environmental Change 19 environmental alterations. Pfeffer & Salancik (1978) argue that environmental changes influence the distribution of power and control in organizations. Through this influence, the environment affects the selection and removal of top execu- tives. Studies of executive or top management succession have generated great interest in recent years. Perhaps the topic has become so important because orga- nizations are often identified by their top managers and the decisions they make (Hambrick & Mason, 1984). After all, top managers are considered to be respon- sible for an organization's strategy, design, and performance (Dalton & Kesner, 1985). As a result, internal and external stakeholders of organizations often inter- pret top management changes as an indication of the future strategic direction of the firm (Beatty & Zajac, 1987). Accordingly, one stream of top management succession research suggests that the most effective changes in top management involve a match between the characteristics of the successor and the strategic needs of the organization (Gupta, 1984; Hambrick & Mason, 1984). These studies by strategic management schol- ars examined succession as one aspect by which organizations aligned themselves with a competitive environment (Kesner & Sebora, 1994). But competitive environments are not static. Competitive environments of- ten adjust themselves to conditions that emerge as a result of external environ- mental change. Thus, environmental changes can influence changes in top man- agement teams by pressuring the organization to select new managers that will better be able to strategically align the organization with its new competitive en- vironment (Pfeffer & Salancik, 1978). For example, Guthrie et al. (1991) argued that the deregulated railroad industry was "unstable and complex," which prompted railroad companies to adopt an innovative, market-focused approach in response. Relative to the regulated industry environment, Guthrie et al. (1991) found that railroad managers in the deregulated era had fewer years of company and industry tenure, were better educated, younger, and came from different func- tional backgrounds, compared with managers in the regulated era. Similarly, Thomas & Ramaswamy (1993) studied deregulation as a surro- gate for environmental change in their study of the airline industry. But their methodology included one important new step. They first determined the type of competitive orientation (a focus on efficiency versus a focus on market orienta- tion) that was dominant among successful airline companies following deregula- tion, and then examined the environmental change - top management staffing relationship. The authors reasoned that one could not assume that all deregulated environments in all industries are, as Guthrie et al. (1991) put it, "unstable and complex." Rather, only by establishing "the changes in critical contingencies" (Thomas & Ramaswamy, 1993: 877) following the environmental change can one predict specific, directional changes in top management characteristics. Other research supports these authors' view. For example, Reger, Duhaime & Stimpert (1992) found that the impact of environmental turbulence varies by industry con- 20 Journal of Business Strategies Vol. 15, No.1 text. Adaptation appears to be contingent on industry-specific factors such as the threat and number of new entrants, market growth rate and capacity utilization (Thomas & Ramaswamy, 1993). Therefore, any hypotheses that predict how firms will adapt to environmental change must be linked to the specific nature of the competitive changes driven by the external jolt. Likewise, the generalizability of the findings of a study of the environmental change - management staffing relationship in one industry context will be in- creased by examining the type of competitive change brought about by the exter- nal environment. This is the approach used in the current study. The two-step process used in the current study is portrayed in Figure I. Regulation as Environmental Change Mahon & Murray (1981) have argued that the transition from a regulated to a deregulated environment involves dramatic environmental changes for firms within an industry. Regulation is the establishment of standards through formal legislation designed to control various aspects of industry activity including prices, entry, and exit (Cohen, 1987). Regulation in the U.S. electric utility industry al- lowed power companies to operate as natural monopolies with entry and prices determined by regulatory commissions. Incumbent utility companies did not have to overly concern themselves with obtaining and sustaining a competitive advan- tage. But the EPAct 92 began the process of deregulation of the electric utility industry. Deregulation, then, can be seen as a significant environmental change, that in the case of the electric utility industry significantly changed the rules of competition for power companies. The EPAct 92 In recent times, market forces have gradually pushed the electric utility in- dustry toward competition. This process was greatly accelerated, however, by the passage of the EPAct 92. According to Grant (1995:15), this legislation promotes competition in the electric generation market and mandates wholesale transmission access. Under the Act, the Federal Energy Regulation Commission is empowered to direct an electric utility to provide wholesale wheeling. Wholesale wheeling refers to the transmission of electric power from any electric generating entity to another utility. The passage of the EPAct 92 created a new class of independent power producers that could either generate power of their own, or, alternatively, buy power from an electric utility and sell it to end users. The EPAct 92 also loosened the legal restrictions on ownership of generating facilities, and allowed a new breed of generators (e.g. equipment vendors, fuel suppli- ers, municipalities, universities, etc.) to compete with established utilities. Analysts predicted that non-utility generation may capture up to 50 percent of the market for Spring 1998 Subramanian & Sanchez: Environmental Change 21 Figure 1 Study Methodology PHASE I Examine the dimensions of change in the electric utilities industry Step I competitive factors efficiency orientation market orientation statistical test multiple linear regression Step 2 Identify competitive factors related to performance prior to the EPAct 92 Identify competitive factors related to performance after the EPAct 92 Determine the nature of environmental change following the EPAct 92 Time period: 1993-94Time period: 1990-91 Step 3 PHASE II Develop hypotheses predicting change in the dominant coalition consistent with changes in the environment. Step 4 Characteristics of dominant coalition: Age Company tenure Industry tenure Functional area orientation Test hypotheses Statistical test for age, company and industry Step 5 Age, company, and industry tenure Functional area: } MANOVA and univariate analysis of variance chi square Step 6 Explain findings 22 Journal of Business Strategies Vol. 15, No.1 new electricity capacity (Rosemann & Poirier, 1993). The entrance of new providers of electric power significantly altered the competitive landscape of the industry. Electric utilities now have to contend with competitors in their hitherto protected marketplace, with the competition coming from buyers of their electric power that, through whole- sale wheeling, have not invested in capital intensive power generation facilities. Thus, the enactment and passage of the EPAct 92 changed the rules of engagement in the electric utilities industry, similar to the way deregulation changed competition in the railroad and airline industries. The Dominant Dimensions of Competition Important research in business-level strategic management has established that organizations adopt internally consistent strategic postures ranging from an efficiency orientation to a market orientation (Miles & Snow, 1978; Porter, 1980). Firms generally use one ofthese two strategies to position themselves in a competitively advantageous manner (Porter, 1980). Efficiency oriented strategies are characterized by extensive cost controls, a large volume of sales, and the ability to charge lower prices than the competition and still make a profit (Huo & McKinley, 1992). Market-oriented strategies are associated with the ability of firms to create unique, value-enhancing product or service attributes other than low price (Porter, 1985). Another stream of research has suggested that the skills and expertise of top managers reflect the dominant strategic orientations of their organizations. Top managers of efficiency oriented firms are frequently older, have extensive indus- try and company-specific experience, and have backgrounds in efficiency-ori- ented functions such as finance and accounting. Managers of market oriented firms are generally younger, have less industry and company tenure, and bring with them backgrounds in external functions such as advertising, sales, research, and product development (Govindarajan, 1989; Thomas & Ramaswamy, 1993). These two literatures can be combined to create a framework for studying the changes in the competitive dynamics of an industry as a result of environmen- tal change, and how subsequent changes in top management teams are related to such dynamics. This approach is consistent with the Thomas & Ramaswamy (1993) study. The current study ofthe electric utilities industry under conditions of regu- lation and deregulation allow us to characterize the competitive dynamics of the industry under both situations. Then, by examining changes in the top managerial ranks from the first period to the second, we can determine whether or not these changes coincided with the new competitive requirements that resulted as the industry moved into an era of deregulation. The EPAct 92 and the Changing Dimensions of Competition In accordance with the model outlined in Figure 1 and with the work of Thomas & Ramaswamy (1993), we first examined the competitive factors that were related to the performance of the companies we studied both before Spring 1998 Subramanian & Sanchez: Environmental Change 23 and after the passage of the EPAct 92. Based on these findings, we then de- veloped hypotheses that would relate management characteristics to changes in the external environment. Consistent with the Thomas & Ramaswamy (1993) study, we used two contrasting competitive foci - an efficiency orientation and a market orientation - to categorize the competitive factors at play in the electric utilities industry. The two orientations indicated above are consistent with the dominant typologies in the business-level strategy literature, in that an efficiency orientation is akin to Porter's (1980) "cost leaders" and Miles & Snow's (1978) "defenders", while a market orientation corresponds to Porter's (1980) "differentiators" and Miles & Snow's (1978) "prospectors") We first identified factors specific to the electric utilities industry that indicate an effi- ciency focus, and then identified those that indicate a market orientation focus. Power production and power distribution expenses were selected as efficiency indicators, and customer service and sales expenses were the mar- ket orientation indicators (Huo & McKinley, 1992). All indicators were mea- sured as a percentage of total revenues in order to control for the potentially confounding effect of firm size. Return on investment (ROI) was the measure of performance used. Firm level data were obtained from Financial Statistics of Major U.S. Investor-Owned Electric Utilities published by the U.S. De- partment of Energy. An efficiency orientation was identified by measuring total power produc- tion expenses and total distribution expenses. Total power production expense (PWRPRO) was the sum total of operating and maintenance expenses for the utility. Total distribution expense (DISEXP) included all expenses relating to the transmission of power and maintenance of transmission facilities. In a capital intensive industry such as electric utilities, it is important to control expenses relating to both the production of power and its transmission. Utilities focused on reducing these expenses by investing in new equipment and maintaining strict control over the deployment of resources to these activities. As surrogates of a market orientation, total customer service expense (CUSSER) and total sales expense (SALEXP) were used. Customer service ex- pense included expenses for providing assistance to customers and those related to producing and disseminating information and instructions to customers. A utility's sales expenses included salaries of sales supervisors and other sales per- sonnel and advertising expenses. Data on the above measures were collected for two periods. Since the EPAct 92 was passed in 1992, the period 1990-1991, the two years immediately preced- ing the enactment and passage of the Act, was selected as the base period, while period II was 1993-1994, the two years immediately following the Act. We ex- pected significant differences in competitive conditions because of the Act and consequent management changes when comparing 1990-1991 and 1993-1994. A multiple year period was used to smooth unique situations that an utility may encounter in a particular year. While a two-year time period may not be adequate 24 Journal of Business Strategies Vol. 15, No.1 to fully capture the reaction to an external change in the fonn of executive suc~ cession, two reasons were used to justify the selection of this time period. First, in the opinion of the researchers, the nature of the change brought about by the EPAct 92 was significant enough for electric utilities to warrant a quick reaction. Second, a similar time period was used by Thomas & Ramaswamy (1993) in their study of the airline industry. Investor-owned utilities were selected as the population for this study because they represent the largest percentage of electric- ity generated by all utilities and because of the availability of financial and top management demographic data. From the total of 148 investor-owned utilities for which data was available for both periods, a random sample (restricted be~ cause ofresearchers' resource constraints) of 50 utilities were selected. In order to ensure that the sample of 50 companies was representative of the population, we did a chi-square analysis to test the difference in annual revenue between the sample firms and those in the population. The analysis indicated that the differ- ence between the two groups was not significant (X2 = 0.37; p>0.18). Table 1 shows the profile of the target group in terms of average annual total revenue, average annual operating income, the standard deviation and the range. Table 1 Profile of Target Group Average Total Revenue Standard Deviation Average Operating Income Standard Deviation Range of Total Revenue 1990 (in $ millions) 1512.30 791.80 211.66 118.70 334.0 to 3975.8 1994 (in $ millions) 1638.60 835.63 272.00 152.24 351.6 to 4002.1 Data for periods I and II were independently pooled prior to the multiple linear regression analysis. Subsequently, independent regression models were de~ veloped for each period. Such a procedure was used by Thomas & Ramaswamy (1993) who provide the rationale for the methodology. Table 2 reports the results of this analysis. The results of the regression analysis indicated that in period I (immediately preceding the passage of the EPAct 92), superior performance (as measured by return on investment) was associated with lower levels of power production and power distribution expenses. Enhanced efficiency and control of production and distribution costs were the key drivers of competition. Market orientation indica- tors had a non-significant relationship to performance in this period. The dimen- sion of competition did not change following the EPAct 92 (i.e. in period II), in that efficiency once again drove competition and market factors were not signifi- Spring 1998 Subramanian & Sanchez: Environmental Change 25 cantly related to performance. However, the increase in the proportion of vari- ance in ROI explained (i.e. the adjusted r2) which went from 39% before the EPAct 92 to 47% following the EPAct 92 underscores the greater emphasis on efficiency as a key dimension of competition foHowing the environmental change. In sum- mary, following the enactment and passage of the EPAct 92, the competitive en- vironment for electric utilities necessitated a greater focus on efficiency than prior to the regulation. Table 2 Results of Multiple Regression Analysis of Competitive Variables on ROI Competitive Variables Period I (1990.91) Period II (1993·94) Efficiency Orientation PWRPRO -2.125* -3.125* DISEXP -2.872* -2.921 * Market Orientation CUSSER 1.040 1.159 SALEXP 1.349 10417 Adjusted r2 0.39 0.47 F value 6.378** 7.171** • p