ERM Power- Post the ACCC Inquiry

The ACCC released its report following an inquiry into retail electricity pricing in the National Electricity Market (NEM) in June.  The report made a number of recommendations to try and reduce the retail price of power.  Consequently, there has been a lot of pessimism regarding the prospects of listed retailers such as AGL and of course, ERM Power (EPW).  The main EPW-relevant takeaways I found in the report are:

  • Commercial and Industrial retail margins are a tiny fraction of the retail price.  Excessive retailer margins weren’t one of the areas targeted in the report’s recommendations.
  • Barriers to entry exist in regard to hedging of electricity contracts.  Large generation-owning retailers or ‘gentailers’ such as AGL, Origin etc are able to hedge largely through their own generation capacity.  Large retailers such as EPW hedge mainly through a portfolio of contracts of both ASX-traded derivatives and OTC contracts.  Collateral requirements, minimum contract sizes and contract negotiation costs prevent smaller retailers from accessing diversified, lower cost hedge portfolios.  It seems that any market entrant would need to take a large percentage of sales from one of the few incumbents in order to reach viable scale.  However this is what EPW has somehow accomplished over the last decade.  More on this later.
  • Gentailers generally have generation capacity such that their retail sales are effectively hedged well into the future and have a surplus of generation capacity which can be sold to other retailers.  Large retailers such as EPW have their load fully hedged one quarter into the future.  The degree of hedging declines steadily out to a 2-year horizon.  EPW’s IPO prospectus mentions that they typically sell contracts out to 2.5 years so it seems a portion of each contract is unhedged at the time of signing.
  • Liquidity in hedging markets has decreased in recent years.  Some of the report’s recommendations were to increase the amount of power that gentailers must sell into the hedging market and to increase the transparency of OTC contracts.
  • Generator market concentration is high in some regions.  The report recommendations included measures aimed at reducing this.
  • Construction funding for development of new generation capacity has been hindered by difficulty in securing contracts with large C&I customer more than 5 years into the future.  The report recommends government intervention in the form of contracts for purchase of late-project generation volumes.

I don’t see anything in the report’s recommendations that represents a substantial threat to EPW.  Increased liquidity in hedging markets would make life a little easier for smaller retailers but do little to reduce the collateral and contracting cost obstacles.  Maybe there are some second-order effects from the potential reduction in generator market concentration but they’re not obvious to me at the moment.

What is interesting is the contradiction between the above-mentioned retail market barriers to entry and EPW’s rapid growth in market share (see my previous article here).  EPW’s IPO prospectus shows that EPW started its retail division in 2007, ‘to strengthen the ERM Power business model in a consolidating market’.  Prior to 2007 EPW derived most of its revenue from development of gas-fired power station projects and power generation.  I can see three possible reasons for EPW’s rapid growth:

  • Their development and generation business generated revenue to support the retail division until it reached scale.  Possibly it provided an advantage in terms of access to generation capacity.
  • EPW’s strategy of ‘tailored solutions’ allowed it to complicate the C&I market and take share from the incumbents before they were able to adapt.  If forced to compete on simple pricing the large gentailers would likely have a scale advantage.  By splitting the pricing mechanism into costs for peak, off-peak, renewables etc there is a greater chance of winning customers with demand profiles which benefit from an atypical pricing mechanism.
  • The growth took place during a period of market deregulation.  Customers were exposed to new offerings for the first time.

Finally, the big question for me is whether or not EPW really has a moat in terms of its retail operations in the NEM.  I think the C&I retail market is likely now in a much more consolidated state than it was and I believe the ACCC recommendations are unlikely to change that.  A new entrant could try and win business from EPW and the other retailers but they would need to spend in the order of AUD 45MM each year to match EPW’s SG&A spend and they would need to win around 11 TW.h of business to cover these costs alone out of gross margin (which ignores a whole lot of other fixed costs).  11 TW.h is around 60% of EPW’s 2017 sales into the Australian market.  I think those are the symptoms of a reasonable sized moat.  Obviously this contradicts what I wrote earlier.

A larger threat is that of intensified competition from the other large incumbents.  That’s a harder one to pick but I don’t see any signs of that at the moment.

If you have questions or comments please write to Warwick at oceaniavalue@gmail.com.  I answer every email that I receive.

Disclosure: We currently hold EPW.  This is not a recommendation to buy or sell any securities.  All information presented is believed to be reliable and is for information purposes only.  Do your own research before purchasing any security.

 

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