By Benedict De Meulemeester on 4/12/2012
Last week, we had another episode in an ongoing discussion with energy suppliers. Suppliers of gas and electricity in markets that have reached an advanced state of liberalization have seen the margins in the retail part of the market all but dissapear. On an industrial consumer, a supplier of energy can make just a few thousands of euro of margin per year. German, French or Belgian gas consumers with an excellent consumption profile, for example, pay as low as Zeebrugge or TTF plus 0,5 euro per MWh. Similar clients in the Netherlands or UK might even pay lower add-ons. From that 0,5 euro add-on price (let’s say times 100.000 MWh, which makes 50.000 euro on a yearly basis), the supplier needs to cover his balancing, volume, trade timing, bid-ask spread, credit and other risks. He also needs to pay for his commercial apparatus, account managers and support staff, their offices, computers & cars, etc. That leaves just a very small amount of money in terms of profit margin. And also, if it goes wrong, e.g. with one of those big clients going out of business with unpaid invoices, the margin is quickly gone.
The erosion of retail market margins was to be expected. In mature energy markets, retail prices are completely aligned to wholesale prices. There is no direct selling from producer to end consumer. If the benchmark wholesale market for power is at 50 euro per MWh, then no producer will sell at 45 to an end consumer (which would be very stupid indeed). As a consequence, all retail prices are aligned to the wholesale price. Also, wholesale markets are monolithic country-by-country blocks. In the Dutch market, everybody is buying electricity at Apxendex and gas at TTF conditions, in Germany EEX, NCG & GPL are the market where everybody buys, in Belgium Apxendex and Zeebrugge or TTF. There is no means of beating your competitor by buying the energy in a cheaper wholesale market. Everybody makes a retail price based on the same wholesale price level. That makes the margin, or the add-on on top of that wholesale level very transparent and susceptible to steady erosion towards a level at which competitors “barely survive”.
Some suppliers blame consultants such as us for these low margins. I think that’s shooting at the messenger. True, energy procurement consultants such as E&C add value to their clients by assisting them to negotiate as sharp as possible and to exploit all possibilities in the markets. We are often the first to find out if a certain supplier can offer real low add-on prices and because we service many clients, we speed up the spreading of this information. But if suppliers claim that without us clients would not get access to those suppliers with low add-on prices, I think they are giving us too much credit. The 0,5 euro add-on in the gas markets is there because a supplier was willing to go that low to win new clients. If margins are low, this is due to the laws of competition. Consultants might facilitate this, but they are not the cause.
Suppliers also claim that these low levels of profitability are unsustainable, that retail margins will rise again. Well, they’ve been claiming that for many years now, they claimed it when the add-on price on gas contracts dropped to 2 euro per MWh also. And the prices dropped lower and they are still in business. Other suppliers threaten to retreat from the retail energy market because of the low margins. “Why do we bother making clients for those few thousands of euros per year”, they ask.
Suppliers of energy would better have a look at the banking business to understand why even at these low margins, it makes sense to continue with their retail outfits. If you make a loan with the bank, and you negotiate it well, you might find out that the retail bank’s margin is minimal. However, the bank is willing to do this, because making loans with end consumers is an essential part of its strategy for making money. The same is true for energy companies. Without their retail clients, energy businesses would make less money and be exposed to larger risks. To understand this, we have to go into the details of how energy companies make money.
The large profits of energy companies are first of all made upstream in their production divisions. Money is made with low marginal cost power production plants, such as ageing nuclear plants. And it is made in the gas fields, to which Europe’s energy companies, unfortunately, have limited access. Another moneymaker for energy companies is the trading desk. Through the buying and selling of futures contracts and through portfolio optimisations in spot and within-day markets, the traders maximize an energy company’s profits. Just have a look at Dutch energy companies such as Nuon, Essent or Eneco. They don’t have any high value production assets, as most of their power is produced in Europe’s marginal gas-fired power plants. The Dutch market is very competitive, so retail margins are more than minimal. And still, these companies manage to make reasonable profit margins, year after year. This is thanks to their trading talent. Some will credit the Dutch mentality for this (I once attended a conference where a Dutch speaker claimed, “we are Dutch, we trade the world”). But I think it is mostly due to the fact that lacking valuable production assets, Dutch utilities were obliged to develop their trading floors faster than others.
Now, for an energy company’s trading floor, having retail clients is a very valuable asset. The end clients take positions in the market. They fix their prices because they sign fix price contracts or “click” in the framework of multi-click contracts or they keep their positions open for the spot market. In any case, the combined position of the clients is something against which the trader can trade. To put it very simply, if the clients have fixed at an average price of 55, and the trading floor manages to fix at 50, than 5 euro’s per MWh have been made for the company. The end client’s position will also serve as a risk limit for the traders. Let’s say that the trading floor has that 50 euro per MWh position, the clients have 55 and the market starts to fall. The trading floor might start unwinding some of its positions, in the hope of fixing them again at a lower level. However, in that unwinding operation, the 55 euro per MWh of the client position will serve as a risk limit. I know that I am oversimplifying, but I’m quite sure that in any energy company, the high-profit trading desk would protest if the low-profit retail business was left out of the profit-making equation.
If you look at the profitability of the sales departments of energy companies in isolation, you could indeed come to the conclusion that the low margins are killing the energy business. But you have to look at the broader picture. Having retail clients is an interesting risk limiting asset for energy companies. Therefore, I don’t believe that sales to end clients will easily be abandoned. And to get hold of that asset, there will always be companies willing to offer at lower add-on prices. And energy companies will continue to complain about low retail business profitability. And blame consultants for it.