Background

The unbundling of the traditional energy company in the face of industry restructuring
has exposed to competition areas traditionally overlooked by utilities, namely
market share and customer satisfaction. As regulated utilities find themselves
threatened with separation from their ratepayers not only by a meter but also
by a third-party supplier, many are attempting to enter the retail market with
unregulated affiliate companies.

The retail energy customer is being pursued by two kinds of entrants. The first
are the unregulated affiliate companies of the incumbent utilities. The second
are “pure” retailers, many of them already selling products and services into
the mass-market home services space, now seeking to expand their business to
include energy commodities. The utility affiliates typically start with a large
installed customer base and an energy brand but without the prerequisite mass-market
retail experience required to protect, grow or make that business especially
profitable. The pure retailers come with a track record of retail success, but
little presence or experience in the energy sector.

While margins on the energy commodity may be attractive in the initial stages
of market deregulation, these soon fall to reflect the nature of the offering
and the liquidity of the underlying market. Energy retailers have therefore
striven to offer commodities (electricity, gas, fuel oil, telecom bandwidth,
etc.) in value-added ways. Practically, this has resulted in numerous attempts
to “bundle” services with the commodity, through sales of appliances, to engineering
and technical support, risk management and non- utility products (home security,
credit cards, etc.).

The Business Model

Although all energy retailers rely on their marketing and sales organizations,
they differ considerably in respect of their target customers. Some focus on
large industrial, commercial and aggregated customers, providing sophisticated
procurement and risk management with cross-jurisdictional and cross-commodity
capabilities. Other retailers focus on the mass market, seeking to exploit established
brands and relationships to sell a wide range of products and services to as
many customers as possible. This article explores the latter group only —
the mass-market retailers.

Figure 1 – Introducing Competition in the Traditional Utility Space

Mass-market
retailers, by definition, seek to maximize the size of their customer base and
then to craft both a broader and more profitable range of products to that customer
base (“cross-selling” of bundled goods and “up-selling” of higher margin goods
and services). Given their mass-market presence, they trade on brand and by
offering standardized offerings. Achieving that position is complex, however,
and requires sophistication in several key areas, including:

• Energy procurement, pricing, and risk management. Mismatched or poorly-priced
contracts can soon lead to huge financial losses.
• Customer contact and relationship management. Maintaining customer contact,
mining the data to increase sales campaign effectiveness and reducing customer
attrition rates are all key contributors to both cost control and revenue enhancement.
• Low unit cost of back-office support (administration, customer service,
billing, etc.)
• Strong business development capabilities, both in acquiring businesses
with large and well-placed customer bases, as well as in forging relationships
with suppliers of goods and services for sale to the customers by the retailer.

The value chain for mass-market energy retailers reflects this as well. As Figure
2 illustrates, the business model is not overly complex, but significant competitive
risks do arise at each stage. The pursuit of growth and profits requires that
the product offering is appealing, the commodity and back-office costs are controlled,
and that customer satisfaction is high.

Figure 2 – The Competitive Retail Value Chain

The core business of mass-market retailing can be summed up quite simply as
a function of customers multiplied by sales. Starting with a low-margin commodity
like energy, however, imposes on the retailer the requirement to either acquire
massive scale (millions of customers) or the need to add higher-margin products
and services to the sales mix very quickly.

One significant hurdle faced by utility affiliated retailers is the management
culture inherited from the utility. Risk-taking, rapid decision-making, the
management of diverse and complex external relationships, and intense customer
management require a different management skill set than that required to manage
a regulated asset base. Managing a mass-market retailer profitably requires
three different functions to be reconciled. These are a cost-controlled call
center, billing and administrative functions (the back office), highly-skilled
and sophisticated commodity risk management, complex business development efforts
(transactions, joint ventures, other external relationships), and most importantly
the revenue earners (sales and marketing).

Scale is critically important to minimizing average fixed costs, both at the
corporate and operating levels. Figure 3 suggests that important back-office
costs decline sharply as the size of the retail base is increased. This provides
significant entry barrier protection to incumbents but also imposes on them
the need to reach critical mass quickly if they are to remain competitive.

Figure 3 – The Cost Advantage of Scale

There are also diseconomies of scale, however. While the data on these may not
be as clear, the experience of Centrica, with more than 30 million customer/product
relationships, finds that as customer size exceeds the scale manageable by standard
IT systems, costs begin to rise as bespoke solutions are developed, each with
their own additional costs and complexities. In Centrica’s case, this has led
to the development of many parallel businesses with common product/ customer
attributes, rather than the development of
one wholly-integrated multi-product company. Centrica has recently reorganized
its business under its main brands (Figure 4).

The disadvantage of Centrica’s multi-divisional approach is that the use of
common brands, customer information and cross selling is made more difficult.
This is not only an internal constraint, however, but also one influenced by
energy regulators keen to avoid customer information being made available to
parties outside the utility/supplier relationship.

Figure 4 – Centrica’s Product Bundles

Customer Acquisition Paths

Growth in the number of customers served is achievable in one of several ways,
notably organic growth, acquisitions, or through joint ventures. In practice,
most retailers employ a variety of approaches, seeking to reduce the overall
customer acquisition and management costs in each instance.

Organic approaches include brand development and positioning, marketing and
sales, call center-based customer satisfaction management, product development
and placement and regulatory investment (ensuring that the right kind of retail
environment is created in a particular market).

In many markets, organic growth is hampered by the market structure itself in
which customers are given little incentive to abandon the default supply arrangements
provided by their distribution utility. This reflects both inadequate customer
education, the comp lexity of energy contracting and the provisions for rate
reductions and risk management built into default supply arrangements by politicians
fearful of public reaction to price rises and volatility associated with market
liberalization.

The patchwork nature of market reform, with different codes and requirements
in each state and province adds further costs and barriers to the development
of retailers with optimal breadth and scope. Investing in the development of
market rules, as Enron has done in many instances, is more difficult for a retailer
in that the number of retail competitors (and thus beneficiaries from retailer-friendly
market rules) is greater. The benefits of this investment are thus more difficult
for a single company to capture. In fact, the development of particularly supportive
regimes may only lead to the entry of new competitors in that market.

The second route to growth, acquisitions, requires access to capital and management
sophistication. One significant risk in pursuing acquisition growth is the distraction
it imposes on the executive and on the operating staff of the acquiring company.
This is particularly intense in cross-border deals or where the acquisition
includes businesses that are new to the acquirer. The acquirer must also have
a clear view on how the acquired business can be made profitable and how it
will be inte grated, both from a brand and customer perspective, as well as
in terms of administration and information systems.

The third route to growth, joint ventures, holds out the promise of rapid and
inexpensive growth but this impression is often misleading. Finding the right
partner, negotiating a suitable arrangement, managing it well, and knowing how
to exit are all subtle and complex challenges for management. Getting it wrong
may mean that much time, money and brand equity is spent for little return.

Future Trends

The fundamental model of the mass-market retailer is under pressure as the
full implications of e-business are beginning to become clearer. Although pure
e-business retailers such as Utility.com appear unable to succeed in the current
environment, the ease with which energy offerings can be added to existing e-business
relationships suggests that many new competitors will enter this sector in the
coming years.

If managed well, these companies would be able to offer gas and electricity
commodity contracts at little additional cost, rendering energy-only retailers
uncompetitive. Should they succeed in getting customers to use Internet-based
customer service, billing and payment plans, their costs will be reduced even
further.

The difficulties now faced by the New Power Company suggest, however, that success
is not guaranteed and that the pain of many Internet companies also can be felt
in this industry. Until most customers rely on Internet service providers for
a greater range of services, the “feet in the street” approach taken by most
retailers will remain a prerequisite for success.

At the other extreme, utility retail affiliates may yet prove to be more adept
at bundling high-value services, such as load management and home services,
with their commodity offerings. Wrapped in a familiar and accessible brand,
some of these entrants may yet prove to be very hard to displace. They may also
enjoy much lower rates of customer attrition than pure retailers, providing
them with a significant savings in terms of marketing and sales activities.