The UK’s biggest energy retailer, Centrica had another bad year. Earnings and operating profits declined. And since 2015 Centrica’s share price has almost halved. So, what is the problem? Selling electricity and gas should be a secure, steady business. For an investor seeking yield plus price appreciation this has been a disaster.
Let’s go back to the heart of the matter. When the British electric industry was privatized, it was divided up into generation, transmission, distribution and supply (retail) businesses. Initially, analysts had serious doubts about the long term viability of the supply business as a standalone entity. It was not clear why any anyone would willingly incur the risks of matching volatile wholesale prices with slow moving, retail prices. And all this business risk for a thin margin that evaporates at the slightest miscalculation.
Eventually power generators in the UK saw value in the supply business. It provided a useful hedge against price volatility in the wholesale generating market. Wholesale prices change quickly. Hourly in fact. Retail prices were steadier. They changed only as the customers’ contracts expired.
When wholesale power prices rise, the generating company's profit margins also rise. But margins fall by a corresponding amount at the supply business. And vice versa. A power generator owning a supplier reduces earnings volatility. And the combined generating/supply business can earn a steady profit. In addition, British power generators thought it advantageous to have a lot of retail customers, to have a guaranteed market for their output. As a result the big power generation companies in the UK merged with big power suppliers.
Related: Peak U.S. Shale Could Be 4 Years Away
Not so with Centrica, which had already established itself as the biggest retailer of natural gas in the UK. Centrica's management assumed that the company already had adequate scale with its millions of customers. The strategy was to cross sell electricity to gas customers and vice versa and perhaps sell other products and services to consumers as well.
Fast forward to the return of the pro-business, pro-market Conservatives to Number Ten Downing Street in 2010. The Conservatives of course, privatized the utility industry in the first place. Shortly after the new Conservative government moved in, retail electric prices shot up (reflecting higher generating costs). Neither Conservatives nor the opposition Labor Party were pleased with that result. They threatened to impose controls on retail prices.
Then when fuel costs dropped and so did wholesale power prices, the politicians wanted to know why supply prices did not immediately reflect the drop in costs. On top of that, they accused the suppliers of issuing confusing tariffs and bills, making it difficult for consumers to figure out how to get better prices.
So back to the hedging concept. The government, via legislation proposed late last year, wants a cap on the so called Standard Variable Tariff (SVT) under which about 4.3 million UK customers are served. The proposed bill would give regulator Ofgem the ability to place price caps on all default energy tariffs. Related: Crucial U.S. Pipeline In Legal Limbo
It looks as if UK politicians wants retail energy price to reflect changes in wholesale costs--at least when they decline. That is, the retailer loses when wholesale prices rise but cannot recover when they decline. What kind of business is that?
Now back to Centrica which just reported last year’s results--not a good showing. Aggressive cost cutting, various asset dispositions including its 20 percent stake in EDF’s UK’s nuclear generating fleet, and a 4,000 employee headcount reduction sort of sums it up.
What does Centrica do that makes a unique and productive contribution to society? It neither produces nor delivers the electricity or gas it sells. It purchases a commodity product, in this case wholesale electricity and gas, in the same national, wholesale power and gas markets as its competitors, from a limited number of sellers. In return for purchasing electricity and gas for customers Centrica adds a margin of roughly 7.5 percent to the average bill. Do customers really care about this service? Does supply still constitute a sustainable business model? We have begun to doubt it. As a result, management claims that the dividend is secure till 2020 must be viewed with some suspicion.
ADVERTISEMENT
By Leonard Hyman and William Tilles
More Top Reads From Oilprice.com:
- Is $65 The Ceiling For WTI?
- OPEC Looks To Dial Back Production Cuts
- Despair In Venezuela: “We Are Dying Of Hunger In The Oil Industry”
