RETAIL COMPETITION: THE TOUGHEST COURSE

Bruce Humphrey is vice president of retail strategy at XENERGY.

As companies compete in the race for customers, the problems of size and cost structure require the greatest attention. In fact, the economics of the retail electricity market limit profitability as much as regulation does.

Even if regulators and legislators designed the perfect transition from regulated electricity to competition, the challenges of operating a profitable retail electricity business are immense. So far, in states with deregulated markets, no company has achieved sustainable gross margins. Neither has any company demonstrated the ability to leverage electric commodity sales into high-margin, value-added services.

On a basic level, the hurdles to vibrant retail markets are regulatory. The highest is the problem of prices set for transition service—that is, the standard service provided by the incumbent utility or other designated provider. Generally known as safety-net service, it has different names and components, depending on the state—provider-of-last-resort, standard offer, default, and so on. To get customers beyond simply sticking with the standard offer, some states have "shopping credits" for consumers who choose to switch to a competitive supplier.

The important point is that in many service territories regulation sets one of the prices available to consumers. This price then becomes a benchmark for new, competitive entrants to beat in order to lure customers away from the incumbent utility. The specific mechanism for this varies from state to state, but the principle is the same. When the wholesale price approaches or rises above the transition price, it forces competitive retailers to accept a low or negative gross margin in order to attract or retain customers. This relationship has prevented the development of retail competition in most states that have restructured.

The transition price problem is large and receives much attention from electricity retailers. But the problem's size also obscures the more fundamental economic realities of the retail power market. Profitability is not just a regulatory challenge but a business one. Companies must come to terms with retail market realities, which can have as powerful an effect on limiting profits as market design.

A Look at the Problems
The retail electric power business has some strong characteristics that will cause market suppliers to compete aggressively. It also has some special risks that can cause any seemingly achieved profits to evaporate quickly. The net effect is fierce competition that can eat away margins, squeeze profitability, and, at the same time, be stymied by the regulatory transition.

The first economic characteristic for retailers is the basic fact that electric power is a commodity. Retailers will certainly try to brand or ascribe specific qualities to their products (e.g., accurate billing, convenience, service excellence, and so on), but the kilowatt-hours provided to a customer are identical. They are traded as a commodity at the wholesale level. They have identical product standards linked to engineering and operating criteria for voltage, reliability, and power quality.

Price is the primary characteristic that suppliers can use to differentiate themselves. In an XENERGY review of the advertising campaigns of 43 competitors in the retail gas and power marketplace, 39 campaigns made cost savings or lower prices the focus of the sales promotion. In the remaining cases the emphasis was on reliability, energy solutions, integrity, and the environment.

Price predominates in advertising also because consumers rank it as the most important factor in choosing an electricity supplier. Since the beginning of competitive restructuring, XENERGY has interviewed more than 15,000 consumers about electric power retail issues. One of the strongest conclusions of this research is that price is king, with 60-80 percent of consumers citing it as the dominant factor. For example, residential customers in Pennsylvania cited price 65 percent of the time as the reason for switching suppliers. Power sold on its environmental attributes scored 12 percent. Among commercial and industrial (C&I) customers, the percentage rises to 81 percent on price with no other factor rising above 1 percent except for financial incentives, which scored 6 percent.

When the question is turned around and consumers are asked why they did not switch, they cite satisfaction with their current utility supplier and the potential savings not being worth the bother. In the new Illinois retail market, the story is much the same. Sixty-three percent of all customers cite price as the most important factor in the decision to switch, compared to seventeen percent citing customer service and eight percent citing reputation. As you can see, consumer views offer a richness that allows a company some brand positioning, but dollars define the market.

At a larger level, price may be king of only a small country. Electricity is typically a small part of a household's budget. In many cases, savings of 10 percent of a small number is perceived to be simply a smaller number. Moreover, the catastrophe in California, the collapse of Enron, price spikes in the Midwest several years ago, and the limited benefits to date for the mass market have all contributed to deregulation anxiety.

On an even larger level, some consumers do not perceive choice as a desired characteristic, but as something that is frustrating, complicated, and potentially expensive. They see competition as a battle between the personal control offered by choice and the simplicity offered by the traditional regulated monopoly structure. As the difficulties of the transition to competition have accumulated, many consumers see neither control nor choice.

The Value-Added Myth
The idea that a retailer can boost electricity sales by selling other types of energy services has remained a mantra in the business, but it is only partially true. Most of the value-added services in the marketplace are not new. Enhanced power quality, energy efficiency services, and cable television were available before electric restructuring began. Also, providing these services is very competitive: Consumers have a choice of suppliers, and they are suspicious of bundled services without itemization. And, whether itemized or not, the evidence from the marketplace is that many consumers will attempt to unbundle your bundle.

Also, the competitive arena for energy services is already crowded. There are 64,000 energy services companies (ESCOs), heating/ventilation/air-conditioning companies, and related firms in the United States. They range in size from national companies, like Sears, Honeywell, and Johnson Controls, to community-focused, mom-and-pop enterprises. In addition, a number of services are offered through subsidized utility and government programs. Profit margins in energy services reflect the competitiveness and maturity of this market. It is important to note that to include the commodity in an ESCO business offering is not essential to the company's success. The ESCO must compete on its own terms in its own market.

The same is true for the retail commodity. The more that services and commodity are bundled, the greater the pressure from customers to unbundle the offering. It is also not clear that the skills required for retailing a commodity are the same as those needed for selling value-added services. Both the commodity business and the services business can be successful, but no one has yet demonstrated that adding one will lead to the success of the other.

Start-Up Blues
The early stages of a new market have a learning-by-doing quality that typically results in a little chaos, a few surprises, and some expensive lessons. Companies want some experience in serving customers, and they are willing to accept losses in the short run. During the start-up phase of any new business or industry, price promotions (including offers of free samples) are common ways to attract customer attention. The electricity version of free samples has been first-month-free promotions. In Pennsylvania, Columbia Energy offered two months of free electricity. Other examples include guaranteed savings for a fixed period of time, free telephone calling cards, special offers for the first 25,000 customers, and limited-time price offers. It is tough to make money in a market where some companies are willing to lose money, if only temporarily.

Still, companies entering the business are willing to make investments now to generate returns in the future. Startup costs for retail energy businesses range widely. National mass-market start-ups require at least $25 million in the first year and are highly likely to report several years of operating losses thereafter. The leading mass marketers are likely to invest several hundred million and perhaps approach a billion dollars in developing the business. Startups targeting the C&I sector also vary widely in terms of required capital. Small regional players have investments ranging from $5 million to $25 million; aggressive regional players have spent between $25 million and $200 million in the startup phase. National C&I retailers invested $120 to $300 million.

A significant share of these costs has been for customer acquisition—a critical step in entering markets. (See Figure 1.) These costs have been high and diverse, and competitors with deep pockets would appear to have an advantage. But deep pockets can also lead to irrational exuberance and large expenditures that become difficult to recover in a low-margin business. For example, some large companies with market development expenditures in excess of $100 million have left the market or downsized. (See Figure 2.)

The Lowest Gross Margins
The average cost of serving customers is high because of the expenses required to build the platform to acquire customers, acquire power, and then serve those customers. For virtually all retail suppliers in the market today, the average cost exceeds the price they can charge. That is, they are experiencing negative earnings.

At the same time, the incremental or marginal cost is low relative to the average cost: Once the platform is built, the cost of serving one more customer or offering one more kilowatt-hour is minimal. For example, from 2001 to 2002, one active company anticipates growth in revenues of 55 percent and growth in operating expenses of 6 percent. The incremental operating expenses are roughly 1 percent of the marginal revenue. The combination of high average costs and low marginal costs makes for a very difficult business. The two possible solutions are to reduce costs or to increase the number customers or kilowatt-hours served over which to spread those costs, both tricky propositions in the current business environment.

Despite the potentially large cash flow (in excess of $200 billion nationwide), retailing electricity is basically a transaction service. The bulk of the value added is earlier in the energy value chain, as fuel is converted into power. The retailer buys power in its final form. There are no resources applied to transform it into something else the way that steel becomes automobiles or lumber becomes housing: By its nature, retailing electricity is a low value-added industry. For the traditional utility, the cost of the retailing functions accounted for 3-5 percent of the total customer bill. Consequently the gross margins, or mark-ups over wholesale costs, will always be low. (This is also the reason that shopping credits created by regulation should be low.)

Moreover, wholesale price volatility and unhedged retail load can wipe out profit margins that are, at best, typically described as razor-thin. Furthermore, wholesale market design flaws obscure market signals and create after-the-fact financial consequences. Companies incur expenses across the entire value chain. (See Figure 3.) And companies have gotten into trouble because of high costs in a variety of segments. But it is the power acquisition piece that has the most volatility and risk.

Market Participants Are Diverse
Diversity among the competing firms typically makes competition more intense. In mature industries, cost structures and business practices have evolved to a degree of stability and predictability. This has not yet occurred in retail electric power. Varying cost structures and strategies combined with the uncertain regulatory dimension make the business environment more unpredictable and competition more intense. For example, firms with varying mixes of fixed and variable costs react differently to changes in market conditions. Prices in a competitive market typically sink to the incremental cost of serving a new customer. When cost structures differ, so does the price that a competitor is willing to accept. Large and small companies may have a different willingness to invest $25 million in retail markets. Some large companies, such as Shell Energy, America Online, IBM, and Duke Energy, and some very small companies, such as ACN Energy and Woodruff Energy, have entered (and in some cases already exited) the retail power business. Different companies also may have different time horizons on their investments. These characteristics contribute to the turmoil that is part of retail market development.

The conventional wisdom is that companies are more likely to exit than enter this market. It is also true that when a big-name player makes a move, it has usually left a market, such as Enron departing California in 1999 and Shell leaving Texas in 2001. But, beyond the economic demolition derby of the current transition to retail competition, it is likely that strong companies will see some opportunities in a market with such an enormous cash flow. Furthermore, the first-mover advantage may well be of little value in the post-transition market. Major corporate moves lie ahead.

The Retail Market Is Fragmented
The rules vary state by state and, in some cases, service territory by service territory. Even within each state and territory, the rules can vary by customer class. The pace of the transition to retail competition is fragmented as well: Each restructuring state is on its own timetable. Retailers have found it expensive to operate across these geographic, political, jurisdictional, and time barriers. The efforts to standardize business practices will go part-way to resolving this difficulty. But as long as state commissions and legislatures set the rules of the game in their respective states, companies will have to absorb the costs of customizing their business to each jurisdiction€€€€including monitoring and influencing evolving public policies. State-by-state customization and state-by-state regulatory expertise are expensive.

Size Matters
In the end, the future of retail markets will be determined by how well companies acclimate themselves to these conditions, how committed regulators are to allowing markets to determine outcomes, and technology.

The new retail power industry will hinge on four questions:

• How large will successful companies be?
• What mix of products and services will they sell?
• How will technology change to facilitate retail markets? That is, will technology change in ways that create new products and services or allow existing products to be produced or delivered differently?
• Will regulatory change create a fertile environment for retail markets?

Although success is relative at this stage of market development, some critical practices distinguish those companies that are doing better than the rest. First, successful companies are careful to scale their retail business units to the size of the market that is achievable. Needlessly large startup costs are the first step toward failure, and numerous companies have had to downsize when they did not realize their market ambitions and had to control costs.

Scale is critical. The current relationship between average cost, marginal cost, and demand reflects the early stages of market development. Average cost is substantially above marginal cost; demand is below where it will be in the future. As the market becomes more mature, average cost will decline, marginal cost will rise, and demand will be more in line with the capacity to bill customers and provide customer service. The scale effect will also drive pricing strategy as competitors strive to accumulate customers and thereby spread the overhead costs across more customers and kilowatt-hours.

Events are well underway in a number of states that begin to answer the scale question. Over the past five years, the number of customer accounts in the states that have begun restructuring has grown from 13 million in 1998 to 55 million in 2002. (See Figure 4.) Although customer switching has been low, these 55 million customers will be the foundation of the retail market of the post-transition period. Even taking California off the table does little to diminish the impact of a growing customer base on resolving the difficult economics of retail markets. As more markets open and consumers are freed to make their choice of supplier, each company will learn whether they are among the ones to recover their investment costs and grow earnings. Industries characterized by small profit margins typically are made up of large firms. All things being equal, if the number of available customers becomes large, then consolidation is likely. However, all things are not equal. Regulatory decisions that continue to balkanize markets will thwart this tendency for large scale.

Other Opportunities
Companies will try to break out of the commoditization of the retail business. The classic strategies for this are to differentiate your company, segment the market, and bundle value-added services. However, the characteristics of the electricity market threaten to turn these popular strategic insights into ineffective bromides.

If a company can bundle a collection of products and services economically and thereby overcome customer tendencies to unbundle those bundles, there are opportunities. But at the mass-market level those opportunities are limited. Residential customers have little interest in purchasing additional services from their electricity provider. (See Figure 5.)

C&I customers are more interested. (See Figure 6.) Further, this interest is being converted into transactions.

Restructuring has created new opportunities, too, especially related to wholesale price volatility, risk management, and energy management. One area worth watching is the opportunity to create physical and financial options around volatile wholesale prices. Conceptually, energy services that can reshape the load profile should have value in competitive markets. But split-the-savings approaches to energy efficiency services are already time-proven without the services company also selling the commodity. What may change is how those services are valued and how the benefits are shared among the customer, the service company, and the retailer or wholesaler. Technology is also creating new opportunities by creating new resource choices and new ways to communicate with and control those resources. Overall, however, the benefits of specialization and bundling will counterbalance each other. After the dust settles, companies choosing each approach will survive and prosper.

Achieving Success
Strong companies also focus on the value chain, emphasizing three areas:

• attracting customers at least cost;
• providing high-quality, low-cost back-office operations; and
• insisting on highly skilled resource acquisition and risk management.

And the best-run companies make sure that they keep their cost structure aligned with the value they offer. Pressures to raise margins to reach profitability cannot outweigh the need to create customer value. If margins are too high, then added value for customers is too low, and they will not let value and margins remain out of balance for long. Misalignment of margins and value opens the door to competitors.

Finally, the most successful electricity retailers work to ensure that the new market structure in general allows excellent companies to deliver the value that competitive markets promise. This means working with legislators, regulators, and other stakeholders to create a system that can provide the benefits to the shareholders who put their resources at risk and to the customers who are the ultimate beneficiaries of an effective market.

The economic fundamentals are inescapable. Although the retail market is new, it is not like most new markets in which companies can jump in, ride the growth wave, and figure out the business along the way. Low-cost operations and targeted implementation are critical right at the start. The Darwinian nature of markets will prove that out.

© 2008 Edison Electric Institute