Margins Dynamic in UK Energy Supply 2001-2004

Table of Contents

• CHAPTER 1 EXECUTIVE SUMMARY
  • This document provides an outline of the margins dynamic between retail and wholesale activities in energy supply over the period 2001-2004. It also discusses the outlook for 2005.
  • The margins dynamic in UK energy supply 2001-2004 is explained through 8 points.
• 1. AN INTRODUCTION TO THE DYNAMICS OF THE UK ENERGY MARKET.
  • Market opening followed privatisation, generation and I&C market opening, SME then retail market opening; it was complimented by a wholesale power market being established in 2001.
  • At market opening there were numerous asset-light electricity supply companies and one, asset rich gas company, Centrica.
  • Competition was introduced by allowing the regional monopolies to discount against each others' regulated tariffs.
  • Price discounting between Tier1 and Tier2 has varied between 5-20%; the discount is designed to protect a Tier1 account in a dual fuel deal.
  • In eight years since liberalisation the number of suppliers in the UK residential energy market has shrunk from 15 to just 6.
  • Although competition has been intense, the regional electricity monopolies and Centrica retain a high level of market power with 60% of the market remaining on the higher tariffs.
  • Three key factors affect whether a customer is supplied on ex-monopoly tariffs (Tier1) or on a discounted tariff (Tier2).
  • 40% of energy accounts are Tier2, with most suppliers replacing lost Tier1 accounts at the expense of Centrica.
  • 58% of the 19m Tier2 accounts are with the original monopoly, protecting an original Tier1 account in a dual fuel deal.
  • 74% of dual fuel customers are Tier1-2, principally because of Centrica's success in the market.
• 2. LONG TERM TRENDS SINCE MARKET OPENING AND THE YEARS 2001-2004.
  • Only the ex-monopoly suppliers remain in the retail market and these companies' focus has been on extracting margin from Tier1 customers, not gaining a significant share of new, Tier2 customers.
• 3. WHOLESALE SUPPLY & HEDGING STRATEGIES DURING 2001-2004.
  • All electricity suppliers now have some form of structural hedge; in gas, only Centrica has coverage, although this has reduced as gas production has diminished.
  • A fluid trading market for wholesale power was introduced in April 2001 for England & Wales, it had the affect of reducing power prices significantly - it has only been extended to Scotland in 2005.
  • NETA is a futures market, based on bilateral power contracts between counterparties; it is not an exchange.
  • Movements in wholesale energy prices, against the retail tariff control whether margins are made in either the retail or wholesale businesses.
  • The two main power generators shed assets as they acquired supply companies; for the remaining supply companies it was necessary to buy power assets to create a structural hedge.
  • All the major retailers, including Centrica have developed a structural power hedge, to protect retail and wholesale operations, thus electricity margin can be protected.
  • There is no major structural hedge in gas, as Centrica's production only accounts for 40% of demand; the ex-power companies do not have any hedge and do not recover retail losses.
• 4. CHANGES IN GAS AND ELECTRICITY RETAIL MARKET SHARES, INCLUDING M&A DURING 2001-2004.
  • The market has been consolidated through M&A of regional electricity monopolies; scale was necessary to compete with Centrica.
  • Even though suppliers have lost a significant number of Tier1 customers, they all remain the dominant player in each of the ex-monopoly regions.
  • Centrica has steadily lost gas customers since its inception, but has moved strongly into electricity and home services.
  • E.ON (Powergen) was the last electricity company to gain 3 monopoly regions; as a result it has been the slowest to align (increase) Tier1 tariffs between old Powergen customers in the TXU regions.
  • Scottish and Southern Energy has a reputation for prudence but has made great strides in the residential sector.
  • RWE npower has suffered because of customer service problems but has a very strong brand.
  • EDF Energy has followed a defensive sales strategy since 2003, after acquiring its 3rd ex-monopoly supplier.
  • ScottishPower has grown rapidly in the last 18 months - it has not been distracted by mergers and has strong retail partners.
• 5. MARKET SWITCHING AND DESCRIPTION OF COMPETITIVE ACTIVITY FOR EACH YEAR DURING 2001-2004.
  • Switching was driven in 2001-2002 through low power prices and Centrica's organic growth; high gas prices and Centrica's margin aspirations drove an increase in switching in late 2004.
  • Switching is driven by differences between suppliers in terms of share positions and structural hedge; it is mitigated by consolidation in the market.
  • 2001 was a year of intense competition as suppliers aimed for organic growth; a round of acquisitions in 2002 slowed this down.
  • 2003 was a period when competition stabilised as there were fewer, far larger suppliers now remaining in the market.
  • Competition became more intense in 2004 as massive wholesale power and gas price rises allowed two suppliers to drive switching.
  • Competition became more intense in 2004 as massive wholesale power and gas price rises allowed two suppliers to drive switching.
• 6. RETAIL PRICING STRATEGIES DURING 2001-2004.
  • Price discounting was evident in 2001-02, as entrants passed on low wholesale power prices to customers; margin aspirations and high energy prices have forced tariffs to narrow.
  • The power companies heavily discount gas to allow them to maintain a high Tier1 electricity price; Centrica has to do the same with its gas price; as a result dual fuel prices have generally been in line.
  • Over 2001/02, there was a significant difference between Tier1 and Tier2 electricity prices, driven by low wholesale prices - 2003/04 has seen high wholesale prices and a narrowing of the tier prices.
  • For Gas, the power companies have continually discounted gas against the ex-monopoly, rather than pricing to the wholesale market.
  • For dual fuel, most of the suppliers are in-line; Powergen was aggressively targeting share before it acquired TXU; Centrica stepped out-of-line in 2004 and lost 1m accounts.
• 7. UNBUNDLING RETAIL REVENUE; DERIVING GROSS AND OPERATING MARGINS DURING 2001-2004.
  • Electricity companies have been forced into loss making position on gas by Centrica, due to no gas structural hedge; on the other hand, Centrica benefited from low wholesale power prices in 2001-02 and through buying power assets to cover high prices in 2003-2004.
  • Centrica uses gas production to provide significant protection of overall profit, but has steadily increased retail EBIT margins as this production has reduced.
  • As wholesale power prices recovered, retail EBIT profits were squeezed; Centrica and EDF Energy protected these margins in 2004, whereas the other suppliers traded retail profit for wholesale profit.
  • A recovery in wholesale power prices reduced gross retail margins; EBIT margins have yet to fully pass on these costs to consumers.
  • In 2001-02 Centrica derived more margin in wholesale over retail; as production reduced, Centrica protected overall profit at retail EBIT level, improving retail EBIT margins for all suppliers.
  • Retail EBIT margins are far higher for Tier1 electricity customers, resulting in Centrica making half that of the incumbent electricity suppliers.
  • For gas, Centrica has predominantly made profit on gas production; the electricity suppliers, with no assets, have been forced into loss making positions.
  • Dual fuel has only had a positive retail EBIT margin when one fuel is supplied on a Tier1 tariff.
• 8. FORWARD STATEMENTS ON 2005 - "GAS MARGINS FALL THROUGH THE FLOOR."
  • Centrica aimed to protect retail margin through higher tariffs, as it could not fully recover margin in the wholesale business, but it has now altered this approach, dictating lower margins overall.
  • Centrica's decision to reduce customer losses, by not fully recovering wholesale costs, will damage margins in 2005.
• 9. APPENDIX: METHODOLOGY, RELATED REPORTS AND CONTACT DETAILS
  • Research methodology
  • Report writing team
  • List of Figures
    • Figure 1: Gas market opening
    • Figure 2: Electricity market opening
    • Figure 3: Example of price discounting against Tier1 electricity tariff.
    • Figure 4: Example of price discounting against Tier1 gas tariff.
    • Figure 5: In eight years since liberalisation the number of suppliers in the UK residential energy market has shrunk from 15 to just 6.
    • Figure 6: Breakdown of electricity customer bases (2004)
    • Figure 7: Tier2 accounts gained in relation to Tier1 accounts lost (as at 2004)
    • Figure 8: Dual fuel customer breakdown (2004)
    • Figure 9: Wholesale prices -transfer price to the retail operations (WACO -Weighted average cost of)
    • Figure 10: Changes in capacity 1999-2008, against 2005-2008 fleet excludes oil and renewable capacity.
    • Figure 11: Centrica and E.ON's retail and wholesale balance 2001-04.
    • Figure 12: Centrica's supply and demand balance in gas 2001-04.
    • Figure 13: Reduction in Tier1 customers.
    • Figure 14: Centrica B2C market share by fuel 2001-2005.
    • Figure 15: E.ON UK B2C market share by fuel 2001-2005.
    • Figure 16: Scottish and Southern B2C market share by fuel 2001-2005.
    • Figure 17: RWE npower B2C market share by fuel 2001-2005.
    • Figure 18: EDF Energy B2C market share by fuel 2001-2005
    • Figure 19: ScottishPower B2C market share by fuel 2001-2005.
    • Figure 20: UK annualized residential energy churn rate, 2000-5
    • Figure 21: Total customer accounts, Nov 03-Nov 04.
    • Figure 22: Electricity retail tariffs, Tier1 vs. Tier2 (all regions) 2001-2005.
    • Figure 23: Gas retail tariffs 2001-2005.
    • Figure 24: Tier1-2 dual fuel retail tariffs 2001-2005.
    • Figure 25: Gas EBIT and wholesale profits 2001-2004, by supplier.
    • Figure 26: Electricity EBIT and wholesale profits 2001-2004, by supplier.
    • Figure 27: Electricity gross and EBIT retail margins 2001-2004 [Tier1 Tier2 and all].
    • Figure 28: Gas gross and EBIT retail margins 2001-2004 [Centrica (Tier1) Tier2 and all].
    • Figure 29: Electricity EBIT retail margins 2001-2004.
    • Figure 30: Gas EBIT retail margins 2001-2004.
    • Figure 31: Dual Fuel EBIT retail margins 2001-2004.
    • Figure 32: Flowchart of margins and Tier1 relationship.
    • Figure 33: Customer accounts, Jan 2004 to Jan 2006* [*estimates]