Supply market failures…why investors should not panic

Two suppliers failing in two days, with 419,000 customers thrown into the ‘supplier of last resort pot’ has the potential to truly shake the energy retail market, and is very sad for all those employees of Extra Energy and Spark Energy who are now going to be looking for new jobs.

As highlighted in my blog last week- this is not an unexpected turn of events, and probably won’t be the last suppliers that fail this winter.

Running an Energy retail business is hard, and getting harder, and this news will undoubtedly mean that investors in the industry have more than a little concern. However, it should not put off those entrepreneurs and industry professionals who still want to offer customers new and innovative propositions and make money!

So where is it going wrong?

Too often, the focus of energy retailers is on the front end ‘glossy’ stuff- Getting the right brand, right products and right marketing are essential to attract and retain customers and this can be where businesses get stuck. It is the part of the business that is emotionally exciting, creative and engaging and does not need technical industry knowledge to come up with and execute brilliant ideas. Naturally, management teams home in and spend their time and energy on getting this part of the business right. Whilst essential however, it is not the part of the business which is causing businesses to fail.

Price competitiveness is essential. However, too often you hear that businesses are setting their price points with reference to the competition, without truly understanding their existing and future cost base. In setting a tariff, the business has to not only ensure that it can cover the cost of the wholesale power, but also ensure that it accurately forecasts future network costs, metering costs and hardest of all, the environmental ‘taxes’ which suppliers collect in order to redistribute in subsidies to new generation. The perverse nature of calculating this last category is such that the actual costs are not known until months after the event, through backward reconciliation. There is material inherent risk in setting a tariff too low without ensuring that sufficient cash is collected in long duration tariffs to meet costs which are both uncertain, and continuously move during the life of that tariff. It is complex, each cost has its own quirky mechanics for calculation, and there are usually at best one or two people who understand pricing properly in the business. By personality, the people who have the skills are rarely the lively sparks in the business, and do not get the profile or air time that they deserve. However, getting the tariff wrong is a major cause of business stress and failure.

Cash is king, and in energy retail, there is a disproportionate amount of cash sloshing in and out of the business, with ultimately very skinny profit margins available to absorb errors in cash management. Sufficient working capital funding, and tight cash forecasting and management are essential ingredients of a sustainable retail business. Sadly, not enough suppliers in the market have sufficient funding reserves or facilities available and are using cash collected for specific purposes eg paying the renewable obligation to provide working capital facilities. This, I am guessing, is what ultimately pushed Extra and Spark over the edge. Perversely, this now means that through the ‘mutualisation’ process, all other suppliers, already straining are expected to fund the shortfall created by the hole left by Extra and Spark. This risk will not have been factored into their tariffs as it is unprecedented in the industry and will add to cash constraints.

All of the cash coming in and out of the business, relies on the ability to collect it in a timely manner from customers. This in itself relies on tightly controlled systems, processes and data management- again not the sexy end of the business. Losing control of customer facing processes results, not only in rising complaints and costs of rectification, but critically cash availability. Often the ‘back end’ of the business is taken for granted and has less focus than the front, but to the peril of financial performance.

Failure to focus on cashflow can quickly kill a business- Far too often in this market, I repeat the age old saying, ‘revenue is vanity, profit is sanity but cash is reality’- it resonates hugely in this complex market.

The good news is that it is all manageable. An energy retail business needs a strong focus on risk management at a holistic level. None of the risks flagged above can or should be looked at in isolation. However, a robust risk management framework, tightly controlled policies and procedures and an experienced team can, and do, manage all the risks and run successful retail businesses.

So whilst this week’s news is dramatic and sad for the market, it should not shake market confidence unnecessarily. OFGEM is now consulting on its plans to strengthen market entry criteria, which can only be welcomed. The market in its widest sense is undergoing true transformation which can only be good for customers and enables new and exciting models to come to market. All investors need to do is make sure the vital ingredients to manage risk are in place- experienced people, tightly controlled policies and processes in all areas of the business, and of course, a killer proposition!