Utility retail is at a crossroads. Energy executives must decide which path to follow.
There are only two routes to creating or maintaining shareholder value in competitive retail electricity marketing: double down to grow the business significantly or fold and divest the business from its portfolio. Utilities and their competitive retail affiliates should determine today which of these two strategic bearings they wish to follow. The tentative middle ground of hold is simply a way to postpone the inevitable and erode shareholder value.
Despite the problems facing existing players and new entrants to the retail electricity markets, this may actually be the best time to expand operations and influence the retail market development process. There are short-term market conditions that favor aggressive entrants. These are coupled with longer-term structural market forces that we believe will provide aggressive but selective retail players the opportunity to create significant shareholder value.
In terms of its business profile, energy retailing in many regions has undergone a genuine transformation due to the introduction of competition. The concept of energy retailing as a competitive business function has been evolving over the last 15 years. The concept of a competitive retail function within the energy delivery value chain has spread throughout the developed world. The number of gas or electric retail customers served by a competitive supplier has grown to over 35 million worldwide. With over 150 million customers in the United States and Europe still served by regulated suppliers, there is plenty of room for growth. In fact, the North American growth targets of just one company, Centrica, call for more than doubling its number of customer-product relationships to over 10 million customers by the end of 2003. Already, Centrica has nearly 20 million retail gas and electric customers in Europe and North America. With this solid and growing base of business, Centrica is well on its way to becoming the dominant energy retailer globally.
Fundamental Drivers
All of the logic that has been used over the past 15 years to call for the emergence of an energy retailing business remains valid, despite California and the Enron excesses. The benefit of replacing regulated monopoly service with competitive markets has been demonstrated in such industries as banking, telecommunications, aviation, and trucking, so we accept the end state of energy market restructuring will be a much smaller monopoly service-local pipes and wires distribution-and competitive providers of virtually everything else. Despite some issues (such as low-income service in the Georgia natural gas market or fuel adjustments to the price-to-beat in Texas), it is hard to imagine an end state without a vibrant and competitive retail component, given the success of competition in other industries and the success of competitive retail elsewhere in the world. Therefore, we conclude that there will be an energy retailing industry, barring a major regulatory intervention caused by an externality not currently visible. The question remains: Will this segment of the industry achieve sustainable profits? As the retail energy market emerges in each country, the profitability of the business routinely goes through a life cycle. Successful early 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 of renewable generation, and the possible emergence of residential combined heat and power plants over the next five to 10 years, suggest continued long-term downward pressures on generation margins and commodity prices. The variability of gas prices has created periods of time where falling gas prices add to these downward price pressures. Further, during these periods of declining gas prices, the regulatory lag for past under-collections can amplify the gap between market prices and regulated prices. Thus, in some markets, forwards fall much more rapidly than the retail price ceilings, be they default, price-to-beat, or standard-offer tariff rates during specific periods of time. Of course, the opposite is also true when prices move the other way. Therefore, the timing of retail marketing campaigns is crucial. The net result of this price volatility is the creation of marketing windows where, depending on the exact nature of a retailer's supply options, opportunities exist to price deals based on a declining forward market, while competing in the mind of the customer with a lagging price ceiling. It is just this sort of window of opportunity that sparked the rapid transformation of the U.K. gas markets in the 1990s.
This, of course, is an ever-changing situation to which retailers must adapt. The natural gas price-induced cycles may be much shorter in duration and come with greater frequency. With sharp timing of retail marketing activities, retailers can capture the combined value of both. In addition, given the fact that many financially hobbled generators are in need of revenue to cover short-term interest payments and fixed costs, energy retailers are much better positioned to negotiate a portfolio of supply arrangements that can profitably match a growing retail book. Another positive condition is due to the continued expansion of gas infrastructure. This expansion supports more new, creatively located generating facilities that can mitigate congestion costs and ensure reliable delivery of power. Again, this provides a clear benefit to an expanding retailer's book of business. In summary, the pendulum has swung in favor of retail. Generation had a field day in the late 1990s worldwide, but today the pendulum has swung away. Retail electricity prices are unlikely to fall as fast as generation prices for a number of reasons. First, there are far fewer retail competitors than there were just 18 months ago. In addition, there continue to be retail businesses available for sale. Finally, the remaining retailers appear to be committed to much more informed pricing.
For these reasons companies willing to double down are well positioned to reap the substantial profits of savvy retail service providers in a world of cutthroat wholesale commodity competition. Retailers that transform a mass-market retail segment and grow to dominate the new category have created immense shareholder value over time. McDonald's, Home Depot and Wal-Mart have each transformed a portion of the retail landscape, renamed it as their own, and created immense wealth along the way. Each of these retailers serves the basic needs of human existence. Food, clothing, and shelter are at the base of Maslow's hierarchy of needs. These goods are offered by a myriad of retailers worldwide. What has made these three companies so successful? The common threads through these retailing success stories include improved customer convenience and access, at low prices, to good quality products. Add a marketing strategy grounded in developing and leveraging a strong brand name, and an operational plan focused on achieving the lowest operating expenses in the category, and you have a pretty good recipe for shareholder value creation. Gas and electricity are products that also meet basic needs of human existence, such as light and heat. They are commodities that customers do not want to think about, but depend on reliable suppliers to deliver. Given fair prices and dependable service, they also have the potential to be the stickiest of customers, creating a sustainable, long-lasting franchise. However, customer inertia can initially be an impediment to expansionist electricity retailers. As recent experience and statistics have shown, customers will remain with their incumbent utility supplier either by choice or, more often, the lack of a compelling motivation to choose. For the electricity retailer to succeed, the consumer must be motivated to choose.
Time To Choose: Growth or Cash?
As comforting as the slowdown in competitive retail activity in the United States can be for the traditionalist, we believe that this is only a temporary pause in the movement toward competitive retail markets. The evolution of the wholesale sector toward a single, seamless national market is continuing rapidly. Standing still is not an option. Market-facing companies in the retail energy sector should be making and implementing a strategic choice on their role in the retail energy sector soon.
There is a challenging, out-of-favor, but profitable path forward to create a customer-focused retailing business that happens to sell energy-related products. Centrica is the obvious market leader, and while other competitors may appear, unless a major player steps forward soon, Centrica's lead in the market will soon be insurmountable. Alternatively, there is a clear path to exit the retail space and generate meaningful cash along the way. AEP, facing the arrival of competition in Texas, chose this option and generated approximately $150 million in cash by selling its customer bases.
Whichever path is taken, it is very important to make a conscious choice. Failure to choose causes relatively small retailers to face a daunting road, over which the value of the business is almost certain to fritter away. Similarly, failure to choose can sentence retail books of major generators to oblivion, destined to simply be the retail hedge against the forward cyclicality of the wholesale business. Retailing in any industry has never been for the faint of heart, and that is certainly true in the emerging world of energy retailing. Those that grow large enough to achieve retail success will create significant shareholder value. A portion of that future value will be extracted, in cash, by those companies that pursue a thoughtful, timely exit strategy. So which will it be, double down or fold?
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