Sticky times ahead for UK utilities:
Against a backdrop of falling wholesale prices, UK utilities are posting significant profit growth. While the price discipline that has characterized retail energy supply in recent years will continue to bear fruit in the short term, it also leaves the UK's so-called 'Big Six' exposed to new entrants in a weaker wholesale price climate. MPs, watchdogs and the media alike are clambering to cry "foul" over what they perceive to be bumper utility profits. Chief executives, by contrast, defend the need to protect margins in a rising wholesale environment, and, in a falling market, the right to recoup any losses they have previously absorbed on behalf of their customers. However, transparency of retail margins is the key sticking point here. While Centrica specifically reports how much income it generates from pure retail operations, opaque upstream wholesale margins cloud the picture for the UK's other leading utilities. Regulated network income streams further muddy the water when addressing headline profits. Centrica has played a crucial role in shaping the residential pricing landscape in the past three years. Despite registering significant customer losses, half of all the UK's domestic gas consumers remain loyal to the former incumbent. Centrica has subsequently engaged a strategy of margin maximization, ensuring its British Gas brand remains the premium priced power and gas supplier in the market. Rival utilities E.ON UK, RWE npower, EDF Energy, ScottishPower and Scottish & Southern Energy have all sought to undercut British Gas to various extents and with varying degrees of success. Time lags aside, the price discipline displayed by Centrica's rivals has essentially seen them all legitimately follow British Gas on the way up. A dramatic rise in wholesale prices has, after all, made retail price rises inevitable in the past. Far less certain, though, is what will happen when wholesale prices begin to fall consistently, particularly given the different market exposures that all the major players currently face. According to recent Datamonitor research, the 'Big Six' will all have sufficient power to supply their domestic and SME customer bases in 2007. By contrast, all UK utilities will be exposed to the NBP gas market, where petroleum majors tend to control the upstream means of production. Traditionally, energy retailers have sold more expensive electricity to their in-region customers, known as tier 1, who have yet to switch away. In a rising wholesale market, suppliers with greater supplies of equity gas are better positioned to protect these customers through dual fuel discounts. Going forward, the weaker wholesale prices suggested by the forward curve may challenge this strategy. In a properly functioning market, where asset-light entrants have the opportunity to secure competitively priced wholesale energy, new suppliers should be expected to challenge the 'Big Six.' The greatest threat to the status quo may actually come from existing contenders. Suppliers with greater wholesale market exposure, particularly for gas, will have the strategic advantage should the current forward price curve play out. It will not be lost on some observers that ScottishPower's notable wholesale gas market exposure offers an entry vehicle for an aggressive shipper. With gas-poor Iberdrola the current front-runner, this may go unexploited. In reality, 'sticky' retail prices will inevitably continue to lag the wholesale market - in the short term at least. With wholesale transfer prices falling, this will also mean higher retail margins for the leading UK utilities. It is essential to note that this will also mean lower wholesale margins, particularly for vertically-integrated power generators. Ultimately, it remains unclear exactly how profitable energy retailing in the UK has been in the recent past, and the extent to which 'sticky' pricing strategies will be profitable going forward. If wholesale energy prices fall as they are projected to, however, the UK's leading utilities cannot all maintain their current level of profitability. 22.11.06