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The impact of the regulatory environment and corporate level diversification on firm performance.

The strategic choice perspective views adaptation as a process determined by management occurring within a controllable environment (Child, 1972). In response to this view many studies have been conducted investigating the importance of management's role in shaping a firm's direction. Several of these studies suggest that the external environment constrains the range of strategic options (Hambrick and Lei, 1985; Venkatraman and Prescott, 1990). Alternatively, other studies have shown that managers are important variables of firm performance (Day and Lord, 1988; Thomas, et al., 1991). However, while these studies have focused on a variety of settings, research investigating the role of strategic management in regulated industries is sparse (Ramaswamy et al., 1994; Russo, 1992; Shaffer, 1995).

The majority of studies conducted on government regulation have focused on economics or government policy. Issues such as the impact of regulation on market structure (Vietor, 1991) and the role of government in obtaining social objectives (Bryer, 1982) have fallen under these headings. However, this stream of research is dominated by analysis of industry level phenomenon. Thus, very little is known about the influences of government regulation on firm level behavior and performance. While studies of strategy performance relationships have been conducted (Ramaswamy et al., 1994; Snow and Hrebeniak, 1980), the relationship of corporate-level strategy and performance has yet to be examined in a regulated environment.

The extent to which regulation plays a major role in both domestic and international business requires that more research be aimed at understanding the strategic implications of operating in regulated industries (Ramaswamy et al., 1994). Furthermore, research is needed that focuses on what happens when regulated firms diversify outside of the regulated environment. As regulated firms diversify domestically and internationally the relationship between the firm and the environment may change drastically. For example, utilities diversifying into unregulated markets will face competitive forces unlike those within the regulated environment. Thus, the study of how regulated firms perform when diversifying outside the regulated environment is important and may assist managers in choosing strategies at the corporate level.

The present study addresses this gap in the literature by examining the relationship between the regulatory environment, level of diversification outside the regulated environment, and performance of regulated electric utility companies. A review of the diversification literature is provided along with a review of literature regarding how regulation influences a firm's behavior. A research hypothesis based on the relationship between the regulatory environment and corporate strategy, and its effects on performance is then presented followed by the methodology used to test the hypothesis. Finally, results are explained and a discussion is provided to address the theoretical and managerial implications of this study.


Over the past twenty years, beginning with the work of Rumelt (1974), there have probably been more empirical studies of diversification and corporate performance than in any other area of strategic management. Much of this work has focused on the relationship between relatedness of diversification and performance with results being somewhat inconsistent (Dess et al., 1995). For example, Rumelt (1974) found related diversification to be the most profitable, while Michel and Shaked (1984) found unrelated diversification leads to better performance. Other studies by Varadarajan and Ramanujam (1987), Hoskisson (1987), and Simmonds (1990) also found related diversification to be associated with better performance. However, the work of Dubofsky and Varadarajan (1987) suggests that unrelated diversifiers perform better based on market based measures. In addition, studies by Montgomery (1985), Amit and Livant (1988) and Hill et al. (1992) found no performance differences between diversification strategy and performance.

Results from prior research on extent of diversification and performance have also been mixed. Hill and Hansen (1991) found increased diversification to have a negative impact upon lagged-performance and lagged risk, suggesting that diversification is a low risk, low return strategy. Conversely, Chang and Thomas (1989) found that diversification does not have an effect on performance. They suggest that differences in performance may be better explained by size. Other research has shown that diversification has a positive impact on market returns, but no relationship to accounting returns (Keats and Hitt, 1988). However, when controlling for industry effects, Grant and Jammine (1988) found that diversified firms outperformed specialized firms and that no performance differences exist between related and unrelated diversified firms. In addition, the work of Grant et al. (1988) suggests that an inverted U-shaped relationship exists between performance and the degree of diversity. These findings lead Dess et al. (1995) to conclude that while the majority of studies suggest related diversification may be associated with greater performance, a lack of consensus exists in the literature.

One possible reason for this lack of consensus may stem from the fact that the majority of previous studies have assumed a linear relationship between diversification and performance. The work of Grant et al. (1988) as well as Hoskisson and Hitt (1994) suggests that firm performance should improve at moderate levels of diversification, but decrease at higher levels of diversification. In addition, most prior research has also failed to consider the impact of the firm's environment when considering the relationship between diversification and performance (Dess et al., 1995). This is in spite of the fact that numerous studies have suggested the importance of the relationship between the strategy of a firm and the environment in which it operates (Bettis, 1981; Christensen and Montgomery, 1981; Hannan and Freeman, 1977; Hrebeniak and Joyce, 1985; Lawless and Finch, 1989). Because firms in regulated environments face legal and economic constraints not faced by those in unregulated environments, research on regulated firms may provide a unique opportunity for studying the effects of both environmental determinism (regulation) and strategic choice (diversification) on firm performance. The following section defines and discusses regulation and it's influences on firm behavior.


Regulation consists of legislation as well as rules issued by administrative agencies such as State Utility Commissions (Reger et al., 1992). A strategic framework is offered by Mahon and Murray (1980, 1981) for evaluating regulation as an environmental force affecting a firm's choice and performance levels. Two types of regulation are identified: social and economic. Social regulation involves noneconomic activities across industries, while economic regulation is aimed at specific industries and firms. For example, the Environmental Protection Agency conducts social regulation while state utility, commissions conduct economic regulation.

Some industries face stern regulation that constricts or eliminates many activities, while other industries face far less regulation. Cook et al. (1983) identified four factors addressing the above issue: scope, stringency, degree of uncertainty and duration. They defined scope as the extensiveness of regulation and stringency as the degree of constraint imposed by regulation. Degree of uncertainty was defined as the degree of change in the regulatory process, while duration was defined as the length of time that regulation has been in existence. The extent to which regulation exists in an industry is expected to affect strategic choices and in turn affect financial performance (Mahon and Murray, 1981).

In a study of the effects of regulation and deregulation on the US banking industry, Reger et al. (1992) combined scope and stringency for empirical analysis and suggested a more general term, "the scope of regulation," to reflect the intensity associated with regulation. Using path analysis, they found significant results that strategic choice and performance were affected by the scope of regulation. Russo (1992) examined the electric utility industry and the effects of regulatory monitoring costs on diversification and vertical integration. His results suggest that regulatory monitoring costs are positively related to diversification outside the regulatory environment and negatively related to integration within the regulated environment. Thus, from a transaction-cost perspective, the cost of monitoring regulatory bodies drives expansion activities into areas that are out of the reach of regulators.

Other studies examining the role of strategy in regulated industries also suggest that regulation impacts strategy and performance. In a study of 20 US domestic certified air carriers Ramaswamy et al. (1994) examined the relationship between business-level strategy and performance. The results of the study indicate that, in the regulated context, a significant portion of performance is explained by the management of strategic resources. The authors suggest that although firms in the regulated airline industry may not have the variety of competitive weapons available to those in an unregulated industry, they do exercise strategic choice by using a limited set of options available. Snow and Hrebeniak (1980) also found the regulated environment to influence performance. In their study, also of domestic certified air carriers, it was found that most firms did formulate focused strategies. However, it was also found that strategy was not significantly related to performance.

Thus, prior studies indicate that the constraints of regulation do affect the strategic choices of firms in regulated environments (Ramaswamy et al., 1994; Reger et al., 1992; Russo, 1992). These findings suggest that regulated firms operate in an environment unique to those in most industries due to legal and economic monitoring activities of regulatory agencies. This presents managers of regulated firms with special problems when evaluating the allocation of resources. It is expected that while considerations of diversification such as improved growth, profitability and market share will likely hold true for most firms, the constraints of regulation should enter the strategic framework for firms operating in regulated environments (Reger et al., 1992). Therefore, firms operating in different regulatory environments should experience different results from diversification outside of the regulatory environment.

Hypothesis Development

Firms operating within a regulated environment are subject to legal and economic constraints not faced by firms in unregulated environments. As such, they are exposed to high levels of determinism which can severely limit the strategic choices available (Murray, 1978). Specifically, regulated firms operate in industries where returns may be limited by regulation. Thus, to maintain shareholder satisfaction managers may find themselves seeking ways to increase the overall returns earned by the firm. Faced with this dilemma, some firms may diversify outside of the regulated environment to avoid the constraints of regulation and earn greater returns (Russo, 1992).

Research has found that industry effects are important when studying the relationship of diversification and performance (Bettis and Hall, 1982). Most research has not controlled for industry effects (Dess et al., 1995) and, thus, it is likely that some of the past research may not do well in explaining the diversification and performance relationship for regulated firms. However, research has shown that diversification away from low performing industries enables firms to increase profitability (Weston and Mansinghka, 1971). In addition, other research has found that diversified firms outperform more specialized firms and suggests that diversification is influenced by industry structure (Grant and Jammine, 1988). It is also expected that, in regulated industries, the extent of regulation affects strategic alternatives (Russo, 1992) and in turn influences the financial performance of the firm (Mahon and Murray, 1981). Because regulated firms operate in more deterministic markets than firms in unregulated environments, it is expected that diversification outside of the regulated environment may provide greater strategic choice and an increase in performance (Russo, 1992). However, as firms increase diversification levels beyond a moderate level it is likely that performance will suffer (Grant et al., 1988; Hoskisson and Hitt, 1994). Thus, it is expected that moderate levels of diversification will increase firm performance, while over-diversification beyond moderate levels will decrease firm performance. This leads to the following hypothesis.

Hypothesis 1: In regulated industries, the firm's level of diversification and performance will have an inverted U-shaped relationship.

The extent of regulation plays a major role in the performance of regulated firms (Reger et al., 1992; Snow and Hrebeniak, 1980). Firms operating in a regulatory environment of less constraint would be expected to have greater strategic choice within the industry than those operating in an environment of greater constraint For example, regulatory bodies that require firms to refund all earnings over an allowed rate of return certainly have a greater impact on firm performance than those which allow firms to apply over-earnings toward future projected under-earnings. As such, it is expected that firms operating in an environment of less constraint will have greater performance than those in an environment of greater constraint (Reger et al., 1992). This leads to the next hypothesis.

Hypothesis 2: In regulated industries, the extent of regulation will be negatively associated with firm performance.

While all firms face some type of regulation (Mahon and Murray, 1981), the focus of this study is on electric utility. companies. In essence public utility companies are monopolies. Monopolies of this type are necessary in order to achieve the economies of scale essential in utility operations. However, unrestricted monopoly power is socially undesirable and therefore public utilities are regulated (Crew and Kleindorfer, 1979). In the United States, regulation by commission occurs at the state level and is used to control for the unattractive features of public utilities. Mainly, commissions seek to control the prices of utilities in order to protect the public (Posner, 1974). ff done properly, this should result in utilities pricing at marginal cost and remaining economically efficient (Crew and Kleindorfer, 1979).

Rate of return regulation is used by commissions and, thus, the "fairness" of returns has often been the emphasis of regulation (Crew and Kleindorfer, 1979). The rate of return framework can be illustrated in the following formula:

R = OC + [(RB-AD).sup.*]RR,

where R = revenue allowed, OC = operating cost, RB = value of rate base (assets of the utility used in producing output), AD = accumulated depreciation, and RR = rate of return allowed. based on this formula, utilities file for rates and the commission determines total revenues of the utility. From total revenues, rates are then determined based on estimates such as demand and the number of customers. The allowed rate of return (RR) is used to prevent companies from earning more than a fair rate of return. For example, if a utility is allowed a 12% return on equity and actually achieves a 15% return on equity, the commission may require the utility to refund over-earnings to the customers. Because of the importance of the allowed rate of return, it is usually the most controversial element in the rate making process (Kolbe et al., 1984).

However, different commissions use different procedures to estimate the elements of the revenue framework such as costs, rate base and rate of return (Kolbe et al., 1984). For example, some base their cost estimates in a historical context while others use forecasts when determining costs. Conditions are likely to change during the period in which rates are set and, thus, the firm is likely to earn more or less than the allowed rate of return. If the rates set by the commission do not yield an acceptable rate of return, the company must file for another rate case in order to increase rates and returns. On the other hand, if the rates yield a rate of return that exceeds the allowed rate of return, commissions may require a refund as mentioned above.

Overall, regulators have numerous statutory obligations and face complex political problems. Ultimately, regulators have the responsibility of representing the public interest, consisting mainly of the customers (rate-payers) and the stockholders. They must see that utility companies provide adequate service at reasonable rates, while also maintaining the financial viability of the firm.


Population and Sample

The population for this study is all investor owned diversified electric utility companies in the United States. The sample consists of 55 firms which have diversified businesses outside of the regulated environment. Data were collected from two primary sources, the Goldman Sach's Electric Utility Diversification Survey (1994) and Value Line Investment Survey (1994, 1995). Data were needed from both sources and, therefore, only firms listed in both sources were included in the sample.


Dependent Variable. The dependent variable, performance was measured using the traditional accounting measures return on assets (ROA) as well as return on total capital (RTC). These variables were chosen because of their particular importance to utility companies and their use in many previous diversification studies (Lubatkin et al., 1993; Ramanujam and Varadarajan, 1989). State laws require regulators to allow utilities an opportunity to earn a fair rate of return equal to that of other firms with comparable risks. When done properly, this fairly compensates investors for risks assumed and enables utilities to raise funds for capital projects. The rate of return allowed to regulated utilities is based on ROE (Morin, 1994). Because ROE is sensitive to the firm's level of debt RTC was used. RTC measures the earnings of a firm assuming all capital is equity and, thus, decreases the likelihood of results being sensitive to the debt level of the firm.

Independent Variables. The independent variable, diversification (DIV), was based on percentage of utility diversified assets outside of the regulated environment. The diversification level of firms was classified based on assets because utility companies are capital intensive and asset levels play a large part in the determination of the allowed returns of firms. This provides a measure that reflects the extent to which utilities have invested resources in the unregulated environment. The use of assets as a basis for diversification has been utilized in previous studies (Daniels and Bracker, 1989; Sambharya, 1995). In addition, business count measures are suggested as an appropriate method for investigating performance differences between diversified firms (Pitts and Hopkins, 1982).

The independent variable, regulatory environment (REGENV), was derived using a readily available index from Value Line referred to as Regulatory Climate. This index is based on judgments made by Value Line analysts regarding factors associated with the adequacy of fairness for returns allowed on overall plant and common equity by state regulatory commissions in which the electric utility operates. Ratings are based on a three-point scale ranging from below average to above average (1-3), where 3 represents the fairest climate in which to operate. Firms operating in below average climates will be subject to less favorable regulatory decisions regarding issues such as cost recovery and allowed earnings (profitability). On the other hand, firms operating in average and above average climates will be subject to more favorable regulatory decision making. Firms are rated as either operating in above average, average, or below average regulatory climates. Thus, firms in a below average environment were scored as 1, firms in an average environment were scored as 2, and firms in an above average environment were scored as 3 in the regression equations.

Control Variables. Higher risk (RISK) firms should be associated with higher performance and, thus, the level of risk should be included as a control variable. Risk was determined using the Value Line Financial Strength Rating. This rating ranges from 1 to 9, with 1 representing the lowest level of financial risk. The rating includes analysis of key risk variables as well as analyst judgments regarding risk factors such as managerial competence. This index was found to have high convergence with the market model measure derived from the CRSP Daily Stock Returns File and therefore is suggested as a good substitute for this accepted method (Lubatkin et al., 1993).

Firm size (SIZE) has been positively related to diversification (Grant and Jammine, 1988) and, thus, should be controlled for in the analysis (Chatterjee and Wernerfelt, 1991). As has been done in previous studies, size was determined using the natural log of total firm revenues (Grant and Jammine, 1988).

Data Analysts

Data on the 55 utility companies were analyzed using multiple linear [TABULAR DATA FOR TABLE 1 OMITTED] regression. This method has been used in previous studies examining the influences of regulation and strategy on performance (Ramaswamy et al., 1994), and is appropriate because of the expected relationship of the dependent variable with the multiple independent variables (Cohen and Cohen, 1983). The curvilinear effect was tested by squaring the diversification variable and adding it to the regression equation. To determine the effects of regulation and diversification on performance, the variables REGENV, DIV and DIV(2) were regressed against ROA and RTC. The relationship between a firm's performance and the independent variables was modeled as follows:

Yi = b0 + b1X1 + b2X2 + b3([X2.sup.2]) + control variables + e,

where Yi is the ROA and RTC for firm i, X1 represents the regulatory environment, X2 represents the level of diversification and [X2.sup.2] represents the quadratic variable. In the regression equation Size and Risk were entered in the first stage, Diversification and Regulatory Environment were entered in the second stage, and the quadratic variable Diversification squared was entered in the third stage. Due to the exploratory nature of this study, an alpha level of .10 was used as the critical value for significance testing.


Summary statistics for all variables are shown in Table 1 and the presentation of the model results is reported in Table 2. As expected, regulatory environment was positively related to performance, while a curvilinear relationship was found between diversification and performance. In addition, risk was negatively related to performance.

The research hypotheses suggest that both diversification level and the [TABULAR DATA FOR TABLE 2 OMITTED] regulatory environment of the firm significantly impact the performance of regulated firms. Specifically, Hypothesis 1 suggests that an inverted U-shaped relationship exists between diversification and performance. As hypothesized the relationship between diversification and performance was found to be curvilinear when regressed on ROA and RTC. For the ROA performance measure the main effect of diversification was positive and significant (p = .05) and the quadratic variable was negative and significant (p [less than] .01), indicating an inverted U-shape relationship. When diversification was regressed on RTC, the main effect of diversification was positive and significant (p[less than] .10) and the quadratic variable was negative and significant (p [less than] .05). These results support hypothesis 1 and, thus, suggest a curvilinear relationship between diversification and performance such that moderate levels of diversification outside the core area of business should benefit the firm [ILLUSTRATION FOR FIGURE I OMITTED].

Hypothesis 2 suggests a linear relationship between regulatory environment and performance such that firms in the least constraining environment experience greater performance than those in more constraining environments. As hypothesized, the relationship between regulatory environment and performance was positive and significant when regressed on performance in the RTC model (p [less than] .05) and positive, but not significant, when regressed on performance in the ROA model. Thus, partial support was also found for hypothesis 2.


It has been argued in this article that some of the inconsistency in past diversification research may have occurred because past researchers have failed to consider a curvilinear relationship between diversification and performance, as well as the impacts of environmental determinism on firm performance. In their landmark article, Hrebeniak and Joyce (1985) contend that strategic choice and environmental determinism are not opposite ends of a spectrum, but are independent variables which must be studied to explain organizational behavior. However, most previous studies of diversification have not considered the impact of the environment on performance. The purpose of the current study has been to extend the work on diversification and performance by examining diversification in a regulated environment. It was argued that both corporate diversification and the regulatory environment would significantly impact firm performance. Research hypotheses based on this relationship were then tested.

Findings from this study support the research hypotheses and suggest that diversification strategy and regulatory environment both impact firm performance. However, the relationship between diversification and performance is curvilinear. Thus, the results from this study suggest that electric utility diversification increases firm performance but, as firms begin to over diversify, performance deteriorates. The impact of the regulatory environment was also found to impact the performance of the firm. Firms facing the least constraining regulation outperformed firms facing moderate regulation, which in turn outperformed firms facing the most constraining regulation.

Results from this study have several theoretical implications. First, by obtaining significant results when testing the relationship of the regulatory environment, diversification, and performance, further support is offered for the argument that firms in highly deterministic environments are able to impact performance with the use of strategy. While not directly testing Hrebeniak and Joyce's (1985) model, the implications of this study provide further support for the differentiated choice quadrant by showing that firms facing high levels of environmental determinism, such as regulated firms (Russo, 1992), are able to use strategy to impact firm performance. Furthermore, the framework provided in this study suggests that the relationship between diversity and performance can be industry or environment specific and, thus, previous studies which pooled data from numerous industries may have ignored important effects of the environment. This also suggests that while the behavior of regulated firms may be unique and different from unregulated firms, regulation is an important variable of study deserving more attention from the strategic management field.

A practical implication for managers is that the regulatory environment is important and should be considered when evaluating strategic choices. Firms facing the toughest or most stringent regulatory environments may benefit from investing outside the reach of regulators while firms in less stringent regulatory environments may benefit more from growth within the industry due to the higher returns earned within the regulated environment. Managers should also be aware of the level of diversification outside of the regulated environment. Over-diversification could lead to lower performance as firms move from their core areas of business. Thus, managers may be well served to determine the munificence associated with both the current and target environments and base diversification decisions on these differences as well as the current level of diversification by the firm. Future studies examining the relationships proposed in this article may prove useful in confirming these results.

Furthermore, these finding have implications for managers in regards to their approach towards regulators. Firms in all three regulatory environments may receive great benefits from continually investing resources to maintain positive regulatory relations. This is especially true for firms in the poorest regulatory environments. However, as demonstrated by Murray (1978), the process of dealing with regulators often involves negotiating outcomes. Thus, firms less skilled at dealing with regulators may be better off investing resources outside of the reach of regulators. An interesting question resulting from this implication is whether or not some regulated firms are able to outperform other regulated firms based on their ability to negotiate with regulators and, thus, achieve a sustained competitive advantage in a regulated market. Future studies may prove useful in addressing such a question. Also, these findings suggest that in unregulated competitive markets electric utilities are able to perform well. Furthermore, the results also suggest that over-diversification may impact firms negatively. Lastly, these findings indicate that electric utilities may perform well in a deregulated competitive market and that moderate levels of diversification outside of the core area of business should benefit electric utilities. Thus, this study should be useful to managers in regulated or deregulated environments.

Like most research efforts the current study does have some limitations associated with it that provide opportunity for future research efforts. The first limitation concerns the use of a cross-sectional research design. Unfortunately, cross-sectional studies do not provide as rich of information as longitudinal studies. However, the use of 1994 data provides timely information, unlike most studies which are dated and may have limited practical significance in today's business environment. Future studies are needed which analyze these variables from a more longitudinal perspective. In addition, other research efforts in this area should examine the performance implications of related versus unrelated diversification when comparing performance differences among firms.

Overall, it is hoped that this study will serve as a foundation for future research efforts in the area of regulation and diversification strategy. It is also hoped that this study will provide managers of firms with insight regarding the impact of a firm's industry or environmental position on the potential success of diversification strategies.


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Author:Geiger, Scott W.; Hoffman, James J.
Publication:Journal of Managerial Issues
Date:Dec 22, 1998
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