Electricity Retailing

Abstract

“Electricity” (electric energy) is a homogeneous commodity. In principle, the nature of this commodity is unaffected by scale, i.e., the same product, namely electromagnetic energy carried over a network, is delivered to large, energy-intensive factories and small consumers in other parts of the system.

Every product has some element of service, and every service some element of product.

Aubrey Wilson (UK marketing consultant)

Annex A Retail Processes

This Annex is based on the material prepared by Temboury et al. [45] and expands what is presented in Sect. 9.1.3 of this Chapter. We start from the same Fig. 9.1 in that section, now Figure A.1, which classifies the processes and relationships that constitute the business of retailing.

Fig. A.1

Retail activity processes

In the electricity retailing companies, as a general criterion, these sub-processes are handled by different business areas. Next, based on the different sub-processes, an overview of the scope and nature of these areas is provided.

9.1.1 Sales

The sales area is the marketing “face” of the company towards the customers. Figure A.2 illustrates the tasks that relate to the activity to be developed.

Fig. A.2

Sales sub-processes

Positioning and commercial management

The commercial position of the company is based on the following pillars.

The brand

In every market research, the brand is listed as an essential element. It has to

• be close and credible, transmitting confidence, security, ability to provide good service to consumers,

• allow differentiation of a product (electricity) that is so difficult to differentiate and

• allow to charge a premium over competitors with a weaker brand.

Figure A.3 shows an example of the evolution of the brand positioning of a retailer in an electricity market.

Fig. A.3

Example of brand positioning evolution

Customers’ segmentation

The detailed process of customers’ segmentation has the objective of revealing their values and needs. Not all customers value each service in the same way, which makes it important to categorise the priority of the different subprocesses depending on the considered client. Figure A.4 shows the findings of a study conducted in 2004 that illustrates the diversity of the sensitivities of the different types of customers.

Fig. A.4

Valuation of the product “electricity supply” by customer type

All customers assign a high priority to the quality of supply, in particular to the continuity of supply. In case of a blackout, customers give great importance to a swift recovery, as well as to the availability of information about the causes and the current situation of the service restoration process.

Quality and operations

The care of the quality of service provision and hence the proper management of operations, is a key to boost loyalty and attract new customers.

An important point to keep in mind when investing in improving the quality of service is to know the sensitivity of the customers from any inconvenience that may arise. Figure A.5 illustrates the results of a customers’ survey of an electricity and gas retailer in the Spanish market.

Fig. A.5

Sensitivity of customers to quality of service

Loyalty

The ability of keep the customers’ loyalty to the brand is a key aspect in the smooth running of the retail business since, in most cases, it is cheaper than attracting new customers. By means of specific offers, the company tries to differentiate itself from its competitors, while maintaining its flexibility.

In line with the discussion above, the first and obvious way of strengthening loyalty is the provision of good service. In addition, after-sales service plays a key role. Some further strategies are:

• Personalized attention to large customers. In these cases the ability of the sales agent is very important, when trying to create a relationship or identification of the customers with the brand.

• Provision of energy services and other added values.

• Loyalty programmes: loyalty cards for customers, customers’ club, bonus programmes, etc. They have the additional value of easing the communication between the company and the customer, and of providing additional information on customers. In contrast, the fact that their cost is not negligible has to be taken into consideration.

Communication channels and customer service

The channels to contact with customers must be efficient and adapted to customer requirements. They differ depending on the country’s culture. For example, in the UK “door to door” works for residential customers. In Spain, this alternative does not seem to provide the same outcome (especially considering its high cost). Common channels to reach residential consumers are:

• Advertising (TV and press).

• “Call Center” to conduct direct marketing (more effective if used together).

• Own offices or franchises.

Customer database and new service agreements

Concluding a new service agreement is the process in which consumers cease to pay the default rate, or pay a specific supplier, and start buying their electricity from another supplier. Administratively speaking, this process begins when the customer signs an energy purchase contract with the second supplier and entails a series of subsequent follow-through actions.

Given that one of the key components in this process is the list of all customers and their respective suppliers, there must be an unequivocal mechanism for identifying each point of supply. The first key decision to make when designing a customer database is whether it should be centralised, developed by an independent administrator, or administered by a local body, normally the individual distributor, under terms that ensure that all such lists are duly co-ordinated. In Australia, NEMMCO—the wholesale market administrator—is the centralised agency responsible for customer lists. In England and Wales, the settlement system was wholly centralised between 1990 and 1998, but since 1998, local suppliers have been responsible for compiling and entering customer information. This change was partly prompted by the high costs of the former arrangement. In Norway and PJM (Pennsylvania-New Jersey-Maryland in the USA), the responsibility for customer lists lies with local distribution system operators.

Another important database design issue has to do with its contents. If a database, which has been generated with the information provided by local suppliers, contains information on all the customers connected to the system, then, when a customer changes supplier, all that is added is the new supplier’s name. By contrast, if the only information contained in the database is the data supplied by competitive suppliers, the first time that a change of supplier takes place will require a much longer and more complex process, because the customer’s detailed data will have to be compiled and entered into the system first. This results in huge problems when droves of customers simultaneously try to change supplier for the first time, which has been usual in the early stages of liberalisation. However, the key advantage of this second approach is that it minimises the preliminary work required to start up a new market, which may be crucial for effective industry liberalisation.

When a customer concludes a service agreement with a new supplier, the service provider must notify the entity responsible for updating the database accordingly. In some systems customers are required to notify the database administrator directly, primarily to prevent supplier malpractice, such as keeping a list of customers who have not concluded a service agreement with them, potentially causing inconveniences to these consumers. The initial stages of retail market liberalisation are especially susceptible to such abuse, in light of the particularly aggressive campaigns conducted at such times to attract new customers.

Such practices first appeared in the context of the US telecoms business: for the sake of operational efficiency, the regulatory authorities ruled that customer signatures would not be required to initiate the change to another telephone carrier. Therefore, there was no way of informing customers of the change a priori, and substantial abuse was committed in the form of unauthorised changes. Similarly questionable practices have been associated with door-to-door sales. In the United Kingdom, although contracts signed for an unsolicited service can be cancelled without penalty within 7 days of conclusion, such sales are still fraught with a fair amount of fraud. To avoid such problems, suppliers have been mandated to institute confirmation procedures (conducted by a different employee) to ensure that customers actually do want to switch suppliers. In any event, in nearly all systems where retailing has been liberalised, suppliers are held responsible for handling the administrative formalities, to save customers the inconvenience of having to do it themselves.

In some countries, Spain among them, the process of changing suppliers also involves the conclusion of a contract between the new supplier and the respective distributor. The terms and conditions of such agreements, which are regulated, specify that the supplier must pay the respective distribution charges (see billing below). The metering equipment is likewise checked on this occasion, to ensure it is regulation-compliant.

Meter readings may also be a compulsory part of certain supplier change processes. Depending on the meter reading cycle of the country in question, a special reading may, or may not, be required as part of the change process (if not, the change does not become effective until the scheduled meter-reading date).

Once the processes that relate to the customer have been discussed, we shall address the processes that correspond to the acquisition of the energy by the supplier: the estimation of the future demand of the customers; contracting and purchasing in the energy wholesale market—including portfolio risk management, which involves taking hedging positions the medium and long term, usually through financial derivatives—and determining the price to be charged to the client and the format of the corresponding contract (e.g., a constant price, direct pass-through of the wholesale price, etc.).

These processes are developed in the areas of front-, middle-and back-office. The front-office is responsible for the procurement of energy and for portfolio management in the short term (balancing deviations, i.e., the differences between the quantities previously acquired and the actual consumption of the customers’ portfolio). The department of middle-office (which could be the area of risk management) manages the portfolio in the medium and long term, looking at the overall position in the different periods, making the appropriate hedges and giving signals to the sales department on the range of offers that may pose to individual customers and to the front-office area to guide its processes, passing on the positions that remain open (i.e. the energy that has not been previously contracted in the long term). Finally, the back-office department (settlements) is responsible for closing all operations in different markets.

9.1.2 Front-Office Area

The front-office department buys in the market the energy that is necessary to meet the needs of customers (Fig. A.6).

Fig. A.6

Front-office subprocesses

First, the front office has to provide the estimation of the short-term consumption (i.e. 1 week) of the total portfolio. This task starts from the client-to-client estimations previously made by the middle-office department when evaluating the bids made to individual customers. The front-office area refines these forecasts to estimate the purchase requirements in the short term. Both departments must be familiar with the consumer characteristics, which could be very different in volumes and patterns. In the next section we illustrate this process from the viewpoint of the previous calculation to be performed by the middle-office area to calculate the right offers to provide prices to sales managers.

Once the demand for the company portfolio has been estimated, the main task of the front-office area is to manage the purchases in the various markets, preparing and submitting bids for buying and selling, with the purpose of minimising the cost of supply.

9.1.3 Middle-Office Area

As described previously, this area manages the company’s position in all that relates to the quantity and cost of energy for the entire time range. Its goal is to make a first assessment of the costs of providing energy to customers (by calculating the prices and costs of any required processes) and then to optimize the management of the portfolio of energy, by minimising costs and optimising risk.

Load Analysis

Two key issues must be addressed, from the supply-side, when considering the possibility of concluding a service agreement with a specific customer and the terms to be included in the respective contract. The supplier must forecast the most likely price of energy on the wholesale market and must also analyse the characteristics of customer demand—total volume and distribution during the 24 h of the day.

Consumer analysis is generally based on the history of electric power use by the specific customer and other consumers in the same bracket. This analysis is used both to calculate the cost of supplying energy under the terms of the agreement and to analyse its associated risk and secure contracts or other hedging mechanisms to protect the company accordingly. Therefore, any mistakes in this process may occasion hedging errors and lead to undesired risks for the supplier.

The consumption profiles of the customers vary significantly depending on their nature. The Figs. A.7, A.8 and A.9, showing the hourly consumption of three different types of consumers during 25 consecutive days, illustrate this statement.

Fig. A.7

Load profile of a car manufacturer

Fig. A.8

Load profile of paper industry

Fig. A.9

Load profile of a mall

In conducting such processes, a choice must be made between two different conceptual approaches. The first one entails a thorough analysis of the customer’s hourly load curves, followed by the application of exhaustive numerical analysis techniques to obtain reasonably accurate forecasts about future levels of consumption. This includes considering factors such as consumption seasonality, changes in customer behavior during vacation periods and public holidays and, more importantly, the stability of the observed profiles. In other words, the analysis provides a measure of the customer’s demand volatility with respect to some predefined patterns. An estimate of the risk of actual levels of consumption differing from the forecast can be deduced from such volatility and the economic implications associated with the existing contracts. In the second approach a more superficial analysis is conducted, which is based just on the customers’ previous bills. A plot of their expected consumption curve is obtained by simply assuming that their future use will be in line with past patterns.

The choice between these two approaches must be based on an assessment of the required effort, measured in terms of analyst man-hours and computing resources, but also on the judgement about the justification of a very accurate forecast at this stage of the game. Miscalculating a large customer’s demand can be very risky, so methods based on the use of detailed consumption curves are required in this case, whereas previous bills should suffice for smaller consumers.

Suppliers often predefine the demand of these smaller consumers by what is known as market segmentation. On the basis of a few basic values (such as the installed capacity and electricity consumed in the previous year) they estimate a given customer’s consumption profile for the following year or decide just to simply offer a standard contract.

Cost Analysis

Once the total demand of the customers has been estimated, the supplier can project future energy purchase costs. The information used in this process depends largely on the maturity of the market in question.

The simplest case entails predicting the spot market price for the time periods of interest, on the assumption that all the energy will be bought on the spot market. The energy purchase cost curve can be immediately deduced from the price and consumption estimated curves.

Where efficient and sufficiently liquid futures markets exist, another possibility would be to use forward energy prices instead of spot market forecasts for these calculations. In other words, since such organised markets provide a forward energy price, the most obvious way of estimating energy purchase costs would be to determine the cost of forward purchases of blocks of energy matching the customer’s demand profile on futures or over-the-counter markets.

Figure A.10 shows the global process to calculate the energy price/cost in general terms:

Fig. A.10

Estimation of electricity price/cost

• Expected cost of energy: the energy cost of buying in the forward, day-ahead, intraday and secondary (reserves and balancing) markets to supply the expected consumption of the customer.

• Premiums for different risks: risk hedging (insurance) implies a number of additional costs to be internalized in some way when calculating the price of energy. This is not an easy task since, given that these costs are common to the whole portfolio, it is not evident how much to allocate to each type of customer.

• Regulated costs: the regulated costs that the retailer must internalise and pass-through to the customer, such as access charges, should be included in the estimated cost of the service.

• Commercial margin: this margin is intended to pay for the cost of the supplier commercial structure. The calculation of the value to be taken into consideration when analysing the bid for each type of client must be in accordance with the commercial strategy and business segment to which it belongs (there are customers more relevant and strategic for the company than others, what can lead to the convenience of adjusting the threshold).

• Price for the energy supplied: all this leads to a total price of energy. In the process this total price has been structured into the different commercial products.

Hedging

There are several risks involved in this process, which the supplier needs to hedge against.

Price risk

Price risk results from the uncertainty in the wholesale market prices, resulting in deviations with respect to the estimated energy purchase costs. For instance, assume that a supplier is purchasing the electricity from the spot market and has concluded a contract with a consumer at a fixed price that matches the supplier’s best pool price forecast. If the pool price subsequently rises far more than anticipated, the supplier’s revenue will remain tied to the contract price, while its energy purchase costs will increase, resulting in a net loss.

The way to hedge against this risk is to conclude agreements with generators that ensure that the energy purchase price remains constant for the estimated volume of demand. In the actual practice of energy markets suppliers are covered by a mix of standardised contracts negotiated on futures markets, bilateral contracts negotiated on OTC markets and generation itself, which may be owned by the company that also supplies the energy. In any event, the supplier must secure cover to reduce the risk of rises in the market price of energy.

Suppliers may also choose not to hedge such a risk and incorporate it instead into their operating costs. Under these arrangements, they charge customers a risk premium,—i.e., a higher price—to compensate for the risks taken. In practice, most of the suppliers’ operations are covered by generation assets or contracts, and only a small proportion remains exposed to price risk.

Another alternative is to pass all or part of this price risk on to the customers. This would involve formalising agreements that stipulate that if wholesale market prices diverge with respect to the estimated amount, the consumer must pay for the deviation. Intermediate arrangements are possible, whereby only part of the actual price is passed through to the consumers. Different variations on this theme and different types of contracts are discussed later in this unit.

Quantity risk

Quantity risk refers to the possibility of substantial differences between actual customer demand loads and the demand forecast, either in volume or in the anticipated demand profile. Since wholesale market prices differ by the hour, changes with respect to the estimated load shape will have an economic impact.

This problem is often addressed by simply designing service agreements that obligate customers to absorb this risk. For example, if the rate structure is designed to distinguish between a specified number of time-of-day segments, each one with a different price, when a consumer’s consumption profile changes, this will be conveniently taken care of. On the other hand, if the supplier decides to charge a flat price without differentiating between time-of-day segments, the contract should include a significant risk premium.

Imbalance risk

This is an additional economic risk that is also derived from deviations between the estimated and actual demand. Depending on the regulation of the specific wholesale market, suppliers may be required to present a balanced declaration of electricity purchased and sold at any moment of time during a prescribed time period (e.g., the next day). Any imbalances are typically penalized or they have to be cleared in short-term expensive ad hoc markets.

Some customers, such as distribution companies with significant amounts of distributed generators, pose higher risks. The most common way of dealing with this is to build a risk premium into the contract, because there is no simple way of handling such risks. Contracts can be designed with built-in incentives to ensure that actual operation conforms to programming, but this sort of agreements are complicated and seldom concluded.

Collection risk

Collection risk is the risk of the customer not paying, a problem that is common to any business and addressed in much the same way as in other markets. Broadly speaking, with large-scale customers the supplier must try to assess the likelihood of non-payment and, in the case of problematic consumers, call for bank bonds or some similar sort of security.

Regulatory risks

Finally, regulatory risk refers to the possibility of changes in the market rules by the regulatory authority. This problem is common to other markets, though in electricity markets—partly because the regulatory experience is still very recent—the risk may be higher. It is, in any event, a risk very difficult to hedge and simply forms a part of the business uncertainties assumed by suppliers when they decide to enter the market.

Types of contracts

Since the most significant of all the above risks is indisputably the price risk, much of a supplier’s business involves optimising its energy purchases and the agreements concluded with both the generators from which it buys energy on the wholesale market and the customers to whom it sells electric power, to protect itself against price risk.

From a consumer’s viewpoint, one of the key services offered by a supplier is the possibility of hedging against price risk. Many consumers simply cannot buy their electricity directly on the wholesale market because they cannot afford to run the risk inherent in market price fluctuations.⁴¹ To avoid such risks, they will try to negotiate a product with their supplier that allows them to reasonably forecast their energy costs.

Although there is a wide variety of commercial formulas in place, the most widespread (and simplest) models are as follows:

• Flat rate: This type of contract stipulates a flat rate per kWh used by customers. In this case, the supplier absorbs the full risk associated with uncertainty in the pool price. This system is particularly suited to small-scale agents or for large customers with a very constant level of consumption, which they are essentially unable to change, who want to avoid highly complex rate schemes. This is very common among smaller customers.

• Time-of-day: These contracts group the hours of the day into several different segments, each of which has a different price per kWh. Customers able to change their load profile in line with prices find this kind of contract attractive because they can benefit from its flexibility. In this case, the supplier shoulders price risk, but not quantity risk. The hours of the day must be grouped into segments, each comprising a time frame during which wholesale prices are likely to be similar.

• Pass-through: In this case, the supplier merely charges the customer the wholesale market price for each hour, multiplied by the amount consumed during that hour, plus the access charges stipulated by the regulator. In this case the customer shoulders all the risks, while the supplier merely offers an intermediary service (it represents the consumer on the spot market, deals with billing, handles relations with the distributor and so on). This type of contract may suit very large customers who are well acquainted with how the electricity market works and prefer to handle their energy purchases themselves.

• Contract for differences: This is a standard contract for differences between the end consumer and the retailer, for a predetermined load profile and a strike price, which uses the hourly spot market price as the reference price in the contract. Therefore, if the consumer strictly follows the contracted demand pattern, she is completely hedged and she pays the strike price for the demand. However, any deviations from the contracted load profile will be charged or credited at the current value of the spot market price. This type of contract has the double desirable property of hedging for the totality of the forecast consumer demand and sending the correct real time economic signal to the consumer.

There are, or course, many other types of agreements and much more sophisticated contracts. For example, sometimes the energy prices that consumers pay are indexed to the prices of another market (such as the oil market), so if prices on that market rise, the contract price rises as well. This places part of the risk with consumers. Customers capable of hedging against fluctuations on other markets (because it forms part of their normal business activities, for instance) may prefer to absorb this risk in return for a lower risk premium. Other examples of more elaborate contracts include financial options, pass-through with energy price ceilings and floors and so on.

9.1.4 Back-Office Area

The Back-office area completes the commercial process. Figure A.11 illustrates the sub-processes commonly related to this area.

Fig. A.11

Back-office subprocesses

Metering equipment

The regulatory issues related to metering have been already discussed in Sect. 9.4.

Billing

The billing process is a characteristic feature of supply, as it is in traditional systems. It consists of gathering information about the amount of electricity used by each of a given supplier’s customers and the applicable rates. This information is then used to calculate how much each customer owes and issue a bill, notifying customers of what they owe with payment instructions and information on the amount of electricity used.

Opening up the retail market to competition and, more specifically, enabling all domestic consumers to change suppliers, can make this process far more complicated. For example, if the price of electric power equals the wholesale market price, a different rate must be set for each hour, which entails handling a much larger volume of information for billing purposes. More dramatically, the existence of hour meters would increase this volume of information almost exponentially.

Such considerations aside, the billing process is similar to the traditional scheme and there is nothing especially unique about it. In principle, the supplier and the supplier alone bills the customer and subsequently pays the respective access charges to the distributor, the transmission grid and so on. Some countries have discussed the possibility of a dual billing system, in which distributors would collect all the regulated costs, while suppliers would only charge for the deregulated services. However, for customer convenience, most systems have a single bill scheme, under which suppliers are responsible for subsequently paying both the distribution charges and any regulated charges.

The billing procedure is based on the measures and conditions of the contract and it is built upon the following stages:

• Arrival of the measure to the commercial system.

• Extraction of the data of the commercial contract.

• Disaggregation of the load profiles in block rates (if applicable).

• Block price application.

• Calculation of corresponding bonuses of surcharges.

• Metering equipment renting addition (if applicable).

• Taxes addition.

• Printing and sending the bill.

Collection

Collection management also works along the same lines as in a traditional system. It includes aspects such as different payment options (direct debiting, transfer, check and so on), bad debt processing and debt collection.

9.1.5 Other Services

Finally, another feature of supply is the existence of a range of supplementary products and services that are very commonly offered by competitive suppliers in addition to electric power per se. These services may involve the provision of some kind of energy-related advice on issues such as demand load factor improvements and recommendations about the most appropriate equipment for a specific customer, or energy savings-related consultant services.

Such offerings have been very common in liberalized power systems, where they are used by suppliers to persuade certain customers to move from regulated rates to competitive supply. In the industrial consumer segment, they have often adopted the form of the installation of hourly meters or improvement of metering and control equipment.

Multi-utility offerings are still another approach adopted by some suppliers. For example, bundled electricity and gas products, or telephone service-related offerings can be regarded as additional services designed to add value to the primary product.

A business area that is closely related to retailing and that would require a chapter by itself is energy efficiency and conservation. Most countries have established programmes to reduce the electricity consumption or to make it more efficient. Distribution companies and retailers frequently take an active participation in these programmes, sometimes reluctantly (since in the end these programmes try to achieve a reduction in electricity sales or a shift of demand in time to avoid high prices) and some other times willingly (when the regulatory authority offers an attractive scheme of incentives). The current regulatory issues with the incentive mechanisms for these activities have been discussed in Sect. 9.5.