How often do we hear comments along the lines of “there is no margin in energy retail” and “the greatest value for energy retailers is derived from large commercial and industrial (C&I) accounts”? The answer is probably “fairly regularly”, and observations such as these could be attributed to energy industry executives and commentators the world over.

Certainly there are statistics to support this conventional wisdom, which is not music to the ears of a mass market energy retailer seeking ways to sustain and enhance margins. There is, however, increasing evidence to the contrary, and for savvy retailers there is both margin in the retail business and generous margin to be made in the mass market.

NO MARGIN IN ENERGY RETAIL ?

Evaluating the bottom lines of energy retail businesses in a number of divergent markets is a good indicator of the current margins available. Take for example Australia, where it is common for energy retailers to report less than 5% net profit after tax (NPAT). In the UK, retail margins are continually reported as ‘paper thin’, though at the end of last year Centrica and Powergen did publish increased margins on turnover of 4.2% and 4.3% respectively for their retail operations. In the US, the average utility net profit figure is much higher – around 15% NPAT – but given that regulated utilities there tend to account for their profitability within their power and gas distribution operations rather than commodity supply, it can be concluded that current retail profitability in US markets is also relatively small.

The very nature of energy retail competition supports this impression. In competitive markets, energy retailers often have to cope with high levels of customer churn that can lead to significant increases in marketing and customer management costs. Add developments and changes in market rules, retail codes and compliance, and costs can escalate. If retailers fail to keep their eye on the ball it can lead to a few surprises, in some cases an expensive lesson or two and an unexpected erosion of margins.

THE MARGIN IS IN A MORE INDIVIDUAL APPROACH

What makes an energy retailer so valuable is its asset – the hundreds, thousands or millions of individual customer relationships that make up its customer base. However, by dealing with this customer base en masse and treating each customer within it as ‘average’, much of the value disappears into an abyss of lost opportunity. The simplistic ‘average’ approach is one of the primary reasons why the ‘no margin myth’ survives.

Recent Peace research into Customer Profitability Analysis (CPA) has emphasised that an energy customer base is made up of widely differing groups of customers contributing dramatically different amounts to an energy retailer’s bottom line. The best customers may represent a significant profit contribution; the largest band of customers may represent a positive but not substantial margin; and other customers may cost so much to serve they are loss-making propositions.

Peace sought to ascertain how customer profitability analytical approaches leveraged in other industries could be applied to the energy retail sector. One such measure is the whale curve of profitability (Figure 1) which depicts the profit contribution profile of a customer base. It shows that 20% of customers can actually contribute 300% of overall customer base profitability. It also shows that another 20% of customers can erode 200% of the bottom line.

Peace’s analysis of utility cost-to-serve factors such as calls to call centres, billing frequency and collection activity, alongside revenue drivers such as energy usage and pricing, shows that substantial margins exist in the energy retail sector. The real business value is to identify which customers are in which profitability segment, in order to focus business resources to increase individual customer value and overall business profitability.

Armed with CPA, utilities are able to implement strategies to pursue profitable customers and segments way beyond the ‘average’ notion, and to take advantage of market opportunities to optimise their customer portfolio.

The goal is to uncover tactical strategies for making each customer more profitable each month, while ensuring a lasting, mutually beneficial relationship. These strategies can include implementing retention initiatives that reward profitable customers, designing acquisition campaigns to target similarly desirable customers, and seeking to change the behaviour of unprofitable customers. With the tools to understand customer profitability, a utility is able to dispense with the myth that there is no margin in energy retail. The margin may be concentrated in certain groups of customers, but the astute retailer knows it is there.

Myth: There is no margin in retail

Reality: Regulated markets and a lack of understanding of individual customer profitability often mask the underlying numbers, when in fact energy retail sits at the top of the utility value chain and can deliver very healthy margins.

The reality that positive and substantial margins are available from the energy retail sector is supported by leading Australian utility Country Energy. The company, which supplies gas and electricity to nearly 800,000 consumers in five Australian states, is focused on finding, keeping and extending its customer relationships. “Our business strategies revolve around the customer as our most important asset,” explains John Adams, Country Energy Group General Manager, Retail. “We invest in our customers and their loyalty keeps us profitable. Sure there is no margin in bad retailing, but there is plenty of margin for the astute retailer.”

HIGH VOLUME OR LOW VOLUME?

With the myth about energy retail dispelled, it is important to evaluate where the vast majority of a retailer’s profits in this sector are derived from. The common assumption is that all the money is in the high volume C&I accounts. Indeed they contribute greatly to both total load and total sales, but the assumption that high volume customers are automatically the major profit contributors is another energy retail myth. Sometimes the largest customers may be contributing little to the customer portfolio other than volume.

Take for instance the price per kWh for the UK’s small, medium and large volume end users in July 2001. The UK’s Department of Trade & Industry states in Energy Trends, March 2002 that the price for small users was £0.0428, for medium-sized users £0.0318 and for the large users £0.0308. It seems the margins in large C&I accounts can be relatively small.

These margins are often driven down by intense competition, the strong negotiating power of high volume end-users and the expenses attributed to some additional services. For example, a large flagship industrial customer is typically a sophisticated energy user, able to drive down prices due to the sheer volume of energy it requires. It might also require daily individual account management and individualised and manual billing interventions that reduce margins even further.

There are certainly highly profitable C&I customers, but what an astute retailer requires is an understanding of when and which accounts are profitable. It is often the case that if a large account is highly profitable there is a strong possibility that it will become a target for competitors, and the margin will eventually be sacrificed or lost altogether.

QUALITY IN RESIDENTIAL

The whale curve shows that much of the value in a customer base is found in the sizeable number of fairly small, but positive margin residential accounts that cumulatively add up to the large positive margin an energy retailer seeks.

For example, C&I customers might on average contribute ten times the total margin, albeit at a lower percentage of revenue, of an average residential customer. Yet given that residential customers often make up 90% of a customer base, and typically represent over 50% of the total margin available in a given market, there is clearly plenty of margin to be made in residential retail. This is supported by market research group Datamonitor. In a report Does residential retail pay? it says: “residential customers provide more secure levels of profits over a C&I customer base.”

The astute retailer also realises that merely targeting the highest margin residential accounts is not the solution to maximum profitability. If an energy retailer can move more customers higher up the customer profit contribution and value curve, whilst at the same time reducing the number of negative margin accounts it serves, its overall profitability will increase. It boils down to a numbers game, and the utility with the added sophistication of CPA tools will be the one able to effectively target every customer with the right strategies aimed at enhancing profitability.

Myth: The real margin is in C&I customers

Reality: While C&I customers have the potential to be highly profitable, not all C&I accounts are profitable to supply and they can represent greater risk. Typically over 50% of the margin available in any typical market is earned from mass market customer relationships.

INDUSTRY MYTHS DISPELLED

CPA not only dispels a number of industry myths – it also provides an energy retailer with information about what it should be doing, with whom, when and how, to increase margins. There is great value in energy retail, and those retailers who measure profitability by individual customer have a distinct advantage over those that do not.

According to Martin Yuill, Utilities Analyst at Datamonitor, the astute energy retailer may understand which of its customers and acquisitions are profitable, but the real challenges and opportunities lie in implementing the necessary processes and structures to effectively target and manage these segments. He adds: “A history of outdated and fragmented legacy systems, coupled with limited customer datasets, have ensured that utilities are a long way from realising the potential that a full scale customer profitability analysis offers.” The solution for the future lies in CPA analysis tools and the new-generation Customer Information Systems (CISs) that power them.