European utilities focus on regulated business models – a good strategy?
Just lately, on Wednesday, 12/19/2017, Innogy SE has parted with their CEO because the annual results fell short of the expectations of the primary shareholder RWE. Innogy was separated from RWE in 2016. While RWE continued to focus on conventional generation and wholesale markets, Innogy became responsible for network assets, renewable energy and consumer services in the retail sector. From the start, however, it was Innogy’s British subsidiary Npower that faced significant challenges in the UK retail business.
Utilities’ earnings are currently based on regulated business models – but this probably won’t last long
The example of Innogy points at an important challenge for all utilities in Europe: What does the future business case of an energy utility look like? In the recent years utilities have already shifted their core businesses away from conventional generation towards regulated businesses. This movement is nicely illustrated by the following figure from the International Energy Agency.
Figure 1: Aggregated earnings of the top 20 European utilities by business segment (source: IAE, 2017)
The numbers from the IAE illustrate three interesting facts:
- Regulated earnings from renewables and the networks are the current focus of utilities in Europe, while generation only provides 25% of the total earnings compared to 40-50% in 2012.
- Capital expenditure by the utilities has been increasing significantly since 2014, which is a direct effect of the strategic focus on regulated and capital-intensive businesses like network operation and renewables
- While regulated and retail activities provide a bigger share (75%) of total earnings in 2017 than they did in 2015 (60%), the absolute earnings from regulated and retail businesses have decreased from about 85 €billion in 2012 to 75 €billion in 2017.
For the utilities, the strategic shift towards regulated and retail business models can only be a short-term solution. Especially the earnings from the regulated tasks are not likely to increase or even to remain stable.
On the one hand, the networks are regulated by national regulation schemes that only allow a regulated rate-of-return for the investments made by the network operators. Additionally, with increasing decentralized generation and flexibility on the demand side the long-term evaluation of specific network expansion projects gains in complexity. For example, in a rural neighbourhood, private households might invest in a photovoltaic-power plant which will affect the network capacity in that region to a certain extent. Furthermore, new technologies might be applied by network users, e.g. electric vehicles, battery storage or IoT devices. These new technologies increase the uncertainty of network investments, which normally are calculated over a period of 40 years. It is increasingly difficult to estimate how energy consumption will develop in the future due to technological changes. While consumption patterns didn’t change much in the last decade, we must be prepared that in the comming decade consumption patterns might differ from day to day, depending on the adaptation rate of new technologies and the development of new market mechanisms.
On the other hand, the second pillar of regulated utilities businesses is the investment into renewable generation. The fact that renewables still rely on governmental subsidy schemes qualifies them as a low risk and regulated business model. However, again, this situation is already changing today. While renewables were supported by feed-in tariffs schemes in the market entry phase, tendering mechanisms gain importance globally. The tendering mechanisms give rise to competition and reduce the subsidies actually paid to renewable projects. For example, in Germany the average subsidy for onshore wind dropped from 5.71 c€/kWh (May 2017) to 3.82 c€/kWh (November 2017). Similar price levels were reached for onshore wind tenders in Spain and India in 2017. The increasing competition and decreasing subsidies increase the pressure on the regulated earnings of utilities in the renewable sector as well.
While few specialized utilities might be able to operate profitably with conventional generation in the future, this won’t be a future-proof business model for the majority of utilities.
Therefore, utilities need to focus on the retail sector to develop new earnings and develop a sustaining business model. While this conclusion is not new, the data from figure 1 illustrates that utilities struggle to expand their retail business. The example of Innogy and its subsidiary Npower in the UK shows that competition is high in the retail sector and governments are keen on increasing competition further to lower consumer prices. In the UK, the regulator is already discussing to introduce a cap for electricity prices which is likely to reduce the potential earnings for retailers as well. So, what is the utilities’ perspective on retail business? This is an interesting question that was addressed by a recent survey conducted by Pierre Audoin Consultants (PAC) in October 2017.
What Utilities think of retail business and its future
PAC interviewed different utilities’ experts that are responsible for driving innovation strategies in 200 large European utility retail companies. The primary goal of the survey was to get some insights into the utilities’ strategy, i. e. into how they are planning to increase their earnings from retail business.
According to the survey, the primary challenge for retailers is the acquisition of new customers and at the same time utilities face the challenge to keep their existing customers. This shows that while the utilities struggle to attract new customers, some competitors are taking their existing customer base away from them. These competitors are not only other incumbent utilities, but also new market entrants from other sectors or start-ups that provide new services for the consumers.
Figure 2: What are the major challenges facing your business in 2017? (source: PAC 2017)
When asked about the future potential of new digital technologies in the retail sector, the utilities prioritised the application of customer engagement platforms, robotic automated processing and marketing automation as the key areas where digitalization could improve the retailers’ performance. While utilities are currently testing first machine learning or artificial intelligence projects like ‘chat bots’, a majority of the surveyed utility experts (two-thirds) stated that their company sees the identification of a data-based business model as a key challenge.
Earnings from CAPEX-based business models decrease, but retail not ready to fill the gap
The data from IAE from the 20 largest utilities in Europe has a simple but significant message: Networks and renewables, which are the core capital-based business models of utilities besides conventional generation, will not be able to provide enough earnings in the future to compensate the decreasing earnings from conventional generation. So the logical consequence from the utilities’ perspective is to focus on retail and to strive to increase earnings in this business section. However, here again the data from IAE tells us that since 2012 earnings from retail are cut as well. Furthermore, the results from the PAC survey show that retailers struggle to enlarge the customer base and even have problems to protect their current market share. In the PAC survey, the utilities’ experts stressed that they plan to apply digital solutions to existing processes to lower costs and to rise earnings. Thereby, the utilities already do have a clear focus on HOW digital solutions can help them to become more efficient in their existing jobs, processes, services and products. Yet, they neglect the much more relevant question of how data-driven innovations can change WHAT job the retailers do.
How long can retailers avoid to increase investment risks in data-driven business models?
Our general impression of the survey’s results is that European utilities are starting to apply new technologies like robot-automated processing and chat bots to reduce process costs, but that they are still struggling to enter the consumer-side based on data-driven business models. Due to the high competition in the retail sector and increasingly low profit-margins it is understandable that retailers avoid to invest much into new technologies to reduce risks. Still, the question remains how long this risk-averse strategy can survive in a competitive environment that focuses more and more on data-driven innovations. In other words: We are still waiting for a paradigm shift among utilities acknowledging that data-driven innovations do not only change HOW tasks are done but also WHAT tasks are done.
Are distribution network operators in Europe threatened by a potential application of blockchain technology in the energy sector? This seems to be the pressing question that was at least partially the motivation for a recent report on blockchain in the energy sector by eurelectric, which is the European association of the distribution grid operators. From our perspective, this report reads like an attempt by the industry to reassure itself that its core business model – asset ownership and operation of the electricity networks – is not threatened by blockchain. While this might be true for asset ownership, this is different in the case of network operation.