Why electricity retailers are more like financial institutions such as banks and less like utilities or energy producers

Today, companies that sell electricity (not talking about companies that are vertically integrated into production) operate more like financial intermediaries and less like traditional energy companies. But why is that you might ask? Well in theory they buy something (preferably at a lower price) and then sell it to the end customer (preferably at a higher price). Unfortunately in contrast to selling bananas when it comes to electricity in the process of retail or intermediary there are far more risks involved than in the classical retail business.

What about their business model? Is it really more similar to banks than to other companies from the energy sector e.g. hydro power plants?

If you consider a bank, banks are nothing else than intermediaries that transfer capital from wholesale to retail. For that they are paid a premium a markup but carry credit risk and some more, much like electricity retailers. So in short for a premium you take on a bunch of heavy tailed risks which is true for both retail and banking (and insurance). This is a lot different than is the case for example for hydro power plants, their downside is limited with a lot of upside, in contrast to electricity retailers where upside is limited, whereas downside is for all practical purposes unlimited. So yeah, from the viewpoint of financial payoff electricity retailers are similar to banks.

But why should we care about risk – in the past we didn’t so why should we now?

In the past when margins were high across energy sector risk was not a first order effect. With high profit margins you don’t need to be prudent about risk, since bad years mean just less profit. Also you don’t need to do segmentation based on risk since bad customers are mixed with good customers and, as long as the average margin of the portfolio is good no problems on the horizon.

Sadly, good times have passed and margins have gone down and long term profitability of the company mainly depends on the risk of the portfolio. The aggressive competitive landscape is driving the margins that are already low even lower, creating a risk for the entire economy. If the electricity retailers fail, all of us would feel the consequences and we would be facing the same fate as we did when the banks failed – re-capitalization. Remember risk has a price. Having a portfolio with average rating A (S&P) translates cca. into a cost of 7 cents/MWh per year, whereas portfolio with average rating B (S&P) is 85 cents/MWh, a tenfold difference. Enter market segmentation. If you have the chance to segment your market you will opt for getting low risk and high margin customers, right?

To better understand the consequences of segmenting your customer base (and pricing) based on risk, assume that we have in our portfolio two types of customers, low risk customer with rating A and high risk customer with rating B. There are approx. 50% of each customer type.

There are two types of retailers, retailer 1 and 2. Retailer 1 (lets call him AlesJ) cares about risk and segments between customers based on credit risk and give different prices to customers rated A and B, he gives a price of 45 cents/MWh to customers rated A and 1 euro to customers rated B. Retailer 2 doesn’t distinguish between low and high credit risk customers and gives the same price of 50 cents per MWh to the client.

It is easy to figure out that at the end with rational customers retailer 1 will end up with customers A and client 2 will end up with customers B. Although the price retailer 2 will charge will be higher 50 cents, he will be making a loss on an ongoing concern basis of 35 cents per client, whereas retailer 1 will be making a profit of 43 cents per client. So which retailer do you want to be?

Lessons from the Slovenian market

Here are a few numbers from Slovenian market that will shed some light on the logic presented in the previous section and show that there indeed opportunities to create value added by segmentation.

Reasonable markup amount in relation to the clients’ consumption profiles, credit risk, demand deviations (hourly, contractual, etc.) etc. from 2 to 8 EUR/MWh in the segment of business consumption and above 5 EUR/MWh in the segment of household consumption.

In general customers whose consumption is more unpredictable should be charged a higher markup as the retailer incurs more costs with balancing the expected consumption profile. Additionally, lower predictability of consumption also translates to costs via higher imbalance penalties that the retailer has to pay. Similar conclusions can be drawn about credit risk, portfolio risk etc.

What the results from the market show however is that the margin for the largest companies is low or too low. The markup on the largest customers is 0.5 EUR/MWh over the cost of the profile load whereas it should be between 1.5 to 2 EUR/MWh. Also the markup for the price-sensitive household customers is too low. Their credit rating is often bad and the margins way lower.

So what can a retailer take away from this example? In case of Slovenia if a retailer decides that he will reduce his share on the largest companies and focus more on SME (simply by determining markup via segmentation and price of risk), both his profitability goes up but even more importantly his risk goes down significantly (credit risk especially is heavily codependent) for large companies). Also if the company opts to stay away from marketing actions that attract only price sensitive customers, this additionally improves the risk return profile of the portfolio. Rule of thumb, these two simple actions will for a medium sized retailer with revenue of around 200 mio EUR yield a benefit of cca. 1 mio EUR additional profit and a reduction of 5 mio EUR in Capital at risk.

Where do we go from now regarding risk

Given what was stated it is clear that risk is becoming a predominant effect in solvency and profitability of retailers.

But how to go about it? Here are a few steps that will help any retailer segment his portfolio and make pricing more efficient and profitability higher

  1. Allocate fixed and variable cost per customer
  2. Determine and quantify all the risks associated with retail
  3. Allocate cost of risk per customer
  4. Adopt a pricing policy in line with 1 and 3 to improve the risk return profile of your portfolio

To have a better understanding of how cost and risk (from business) per customer can be incorporated into a common denominator for the purposes of pricing a graph is presented in the figure.

Conclusion

So essentially selling something be it bananas or electricity is long the margin and short at least the credit risk and some more. The business model is thus extremely risky, for a predetermined margin (unfortunately getting lower and lower) you take on your self a lot of codependent (simplifying correlated) risk that can cost you dearly. It is true due to the nature of fat tailed (extreme) risks you can temporarily survive in the short run, but if your goal is to have a sustainable model in the long run, risk is the new paradigm.