June 1 , 2002
Retail Power: Double Down or Fold?
entrants, squeezing through small chinks in the regulated monopoly armor, have made attractive returns and built successful businesses. As the market moves toward full competition, many new entrants are attracted or pulled into the market, driving down whatever margins may be available under the regulatory or market ceilings. Each entrant typically lacks scale but is seeking it in a growing market often with relatively low switching rates, at least when faced with switching away from an incumbent. The cost impact and the customer stickiness are both negatively affected by the lack of uniform market rules from jurisdiction to jurisdiction, leaving even consumers motivated to switch worn out by a tedious switching process. However, the next stages of the market life cycle lead to consolidation, margin stabilization and, dare we say the phrase, even a little market influence, if not market power. Thus, there will be profits in retailing, albeit for those players that make it through the current growth challenges. This long-term view of profitability is supported by extensive research conducted into relative shareholder value creation in the various links in the value chain across a wide variety of industries. Top-tier performers in the retail sector of most industries consistently enjoyed wider margins and stronger and more stable earnings than did players in other vertical parts of their industries.
Short-Term Conditions Favor Retail Success
For markets to be succesful in the future, we must recognize that the restructuring of the energy utility industry has a great distance to go, both in the United States and around the world. (Figure 2 illustrates the concentration of market power in a wide variety of U.S. industrial sectors.) The aggregate market share of the three largest competitors in each of the eleven industry groups vividly illustrates how far gas and electricity retail has to go before it achieves the degree of concentration found in most other industries. This means that energy retailers will be operating in a globally expanding market for at least the next decade. Moreover, the current deregulated retail markets do not appear to have significant price discounting in place, and we do not believe that overly aggressive price discounting will return in most markets around the world over the next few years. This has not been the case in the recent past, where very aggressive, uninformed pricing tactics have been used. In newly opened markets, these pricing tactics were justified on market share grounds and were completely silent on the critical issue of accurately pricing the risk of variable sales volumes. In today's business environment, these tactics have been discarded, replaced by profitability oriented tactics based on much more accurate quantification of retail volume risk. Coupled now with the death of discounting is the potential for a significant move of retained margin from production to retail. Forward wholesale electricity prices have been falling quite dramatically, driven by over-capacity and the slowing demand growth of an uncertain economy. This generation-long environment appears to have staying power, given the volume of new generation on order, in development, and under construction. Indeed, looking long-term, state-sponsored development