4. Commercial Case
The purpose of the Commercial Case is to introduce and describe a number of key commercial and operating considerations for the Energy Co. In order for it to be successful and meet its objectives of providing low cost energy to consumers in a highly competitive and regulated energy retail market, it will require an operating model which allows it to source low cost energy, operate cost effectively and achieve a sustainable customer base. Developing this model to a greater level of detail, with a particular focus on cost efficiency will be a critical element of the OBC.
In the Commercial Case, we will:
- Introduce and discuss the functions of a typical energy retailer operating model
- Explore a range of potential operating models that could be adopted by the Energy Co.
- Discuss a range of considerations that must be explored and taken to a greater level of detail at the OBC stage when developing the operating model. For example the customer acquisition strategy and the proposed scale and size of the Energy Co.'s customer base
- Summarise the lessons learned from our review of comparable companies in the market
- Discuss potential commercial activities for future phases of the Energy Co.
The legal and regulatory implications of each of the operating models have not been reviewed within the SOC.
4.2 Working assumptions
The review of operating models is based on a number of assumptions, reflecting the objectives and remit of the Energy Co. These are:
- The Energy Co. will be an energy retail business, focussed on the supply of gas and electricity. In the future, however, other commercial activities may be explored, including other energy related services
- The Energy Co. could outsource specific operational functions, however this may exclude the outsourcing of customer service functions as there is a risk that this could have a detrimental impact on the quality of customer services
- For the purposes of some of the operating models, it has been assumed that the Energy Co. would be granted a gas and electricity supply licence.
The working assumptions have been explored in each of the operating models considered for the Energy Co. All of the assumptions may not be applicable depending on the operating model taken forward.
It is worth noting, with reference to both working assumptions and the contingency plans that a switching only service offering could be considered at the OBC stage, in the event that a cost efficient model to supply low cost energy cannot be found in the competitive retail market.
4.3 A typical energy retailer capability model
There are a number of capabilities that a typical energy retail supplier would have and these typically fall into the following main categories:
- Generation and procurement – The commercial functions of buying energy, on a hedged basis and the production of energy (including asset / production facility management)
- Customer management – Full range of customer functions including customer acquisition, customer services (help line) and technical support
- Pricing – Data and analytics based development and management of tariff offerings to energy customers
- Back office – Finance functions, risk and compliance
- Support services – other business support functions covering legal, IT and Human Resources (HR).
The graphic below illustrates a typical energy supply company capability set, including references to the Energy Co. phase 1 and phase 2 required capabilities:
Figure 8 - Typical energy capability model
In line with the proposed remit of the Energy Co., a Full Capability model would not require all of these functions during phase 1. It is expected that the asset management functionality, particularly around renewable energy generation, will be explored during subsequent phases.
The following section explores a number of operating models available to the Energy Co. and sets out the implications for the functions/capabilities illustrated in the figure above for each model.
4.4 Potential operating models
There are three relevant operating models for the Energy Co. to consider. These are:
- White Label model
- Full Capability and a 'Licence Lite' capability
- SG Wholesale Procurement Framework model.
These options are not mutually exclusive, as it may be appropriate to implement a less resource intensive model, for example a White Label model, before transitioning to a Full Capability model. The models are described in the following sections, highlighting the operational requirements and key cost/risk considerations for each. Appendix E sets out the capability models for each option in greater detail.
4.4.1 White Label model
Under a White Label model, the Energy Co. would procure an existing licenced supplier to provide the Energy Co. with its own nationally branded and unique products. It would not apply for, or hold, its own supply licence.
This operating model is currently used in the public sector. For example, Robin Hood Energy, an energy company and licensed supplier operated by Nottinghamshire City Council, has entered into a White Label arrangement with Leeds, Islington and Liverpool Councils.
This model would allow the Energy Co. to exist either as a separate entity or an in-house SG team.
The White Label supplier often has its own core business that consists of suppling energy under its own brand name. Its White Label supply agreements are used to increase its own customer base.
If the Energy Co. were to be established under a white label arrangements, its role and responsibilities would be limited. A summary of the contractual arrangements is shown overleaf:
Figure 9 - White Label arrangements
It is important to note, however, that standardised commercial agreements do not exist in the market. As a result, we have identified potential roles and responsibilities for both parties. In any event, the third party licenced supplier would be responsible for satisfying the licence requirements set out by the regulator, such that the roles and responsibilities of the Energy Co. would be limited.
Energy Co. may undertake the following functions:
- The customer acquisition function would be provided by the Energy Co. and in return, the Energy Co. would receive a fee from the White Label supplier for new customers it brings to the supplier
- The Energy Co. could also consider (for an additional revenue stream) providing the customer service function such as billing, metering and customer support functions. This is known as a White Label 'plus' service. This creates the possibility of providing greater benefits to the Energy Co.'s customers and may be considered in particular reference to those in fuel poverty and those customers who would benefit from a bespoke customer service function. However, such services would need to be negotiated with the White Label supplier
- If SG pursues a White Label or White Label 'plus' partnership, limited support services would be required as services such as procurement, hedging and regulatory compliance would be the responsibility of the White Label supplier
- The focus of the Energy Co. services would be customer management and the extent of this would depend on the agreed contracted services that the Energy Co. would provide on behalf of the White Label arrangement
- Under this option, the Energy Co. may also seek to incorporate a switching platform to aid the transition to the White Label supplier tariffs. This could be based on the principles already established by organisations such as Citrus Energy.
Cost and risk considerations
As the Energy Co. would not hold its own supply license, it would be restricted to the prices offered by the White Label supplier. To obtain the best prices possible for its customers, the Energy Co. would look to establish an agreement with a White Label supplier that could agree to low tariffs. The Energy Co. could use its ability to access a large customer base as a negotiating factor in obtaining competitive prices.
Under this model, the Energy Co. would not be able to control retail prices directly, however it would require substantially less working capital to provide energy and operate with reduced overheads.
It is likely that the choice of White Label partner would require a formal Official Journal of the European Union (OJEU) procurement. This is typically a 12 to 18 month process. This would allow the Energy Co. the opportunity to define the specifications and outcomes of the contract.
SG may look to procure this contract for an initial period of three to five years. This period would allow SG to review the ability of the model to make an impact on the wider policy and organisational objectives of the Energy Co.
4.4.2 Full Capability model and 'Licence Lite'
There are two sub-options under this operating model:
- Full Capability model – The Energy Co., would become a licenced gas and electricity supplier and would be responsible for complying with the associated industry regulatory requirements
- 'Licence Lite'- This is an option that helps new suppliers enter the electricity supply market, however it does not apply to gas supply. It allows the new supplier to partner with an existing supplier, where the partner supplier will take on responsibility for providing the capability required to comply with some of the more costly and technically challenging requirements of a supply licence. To obtain a 'Licence Lite' the Energy Co. would be required to enter into a commercial arrangement with a Third Party Licensed Supplier (TPLS). Under this arrangement, the TPLS would carry out the required compliance procedures. This will substantially reduce the burden on the Energy Co. For example, compliance with the Master Registration Agreement, the Distribution Connection and Use of System Agreement, the Connection and Use of System Code and the Balancing and Settlement Code would not fall to the Energy Co. However, becoming a 'Licence Lite' supplier does not remove all of the Energy Co.'s duties as it comes with all the rights and obligations of licensed supply, except those stated.
The Energy Co. could adopt either of these models, or perhaps consider initially adopting the 'Licence Lite' model and progress to a Full Capability model. The following sections discuss each of the options, highlighting the key differences between them.
4.4.3 Capability requirements
Energy procurement and hedging
Under the Full Capability model, the Energy Co. would develop and deploy its own capability to procure and supply energy to consumers.
The Energy Co. will need to purchase energy in order to satisfy its customer demand requirements. In order to balance its supply and demand position, the Energy Co. will need to develop the capability to forecast supply and demand requirements, and be able to hedge any changes in the customer demand profile due to short term events (such as drops in temperature) and longer term events (such as changes to portfolio).
This will mean developing (or procuring) the technical capability to predict demand due to changes in market fundamentals. The energy sourced by the Energy Co., which will need to be matched to the demand forecast, can be done through several routes:
- Direct supply from the Energy Co. owned assets (viewed as a potential future phase of activity)
- (a) Power Purchase Agreements and (b) Gas Purchase Agreements with developers
- The wholesale market.
The hedging capability to secure the intended retail tariff end prices can either be built internally, or outsourced to a third party trading desk (which then trades physical wholesale energy on the Energy Co.' s behalf) according to prices and forecasts provided by the Energy Co. If this model is pursued at OBC stage, the hedging options will be further evaluated and explored.
A 'Licence Lite' option only relieves the Energy Co. of its obligation to be a direct party to a number of industry codes for electricity. The Energy Co. would still engage directly with the wholesale market and would therefore require the above procurement and hedging capabilities.
Customer management and back office support
The Energy Co. would require full customer management capabilities, including customer acquisition, services (including billing and helpline services), technical support and any additional services (with respect to the future Energy Co. services). Additionally it would require extensive back office support to maintain the regulatory reporting requirements for a Full Capability model.
Similar to the Full Capability model, the 'Licence Lite' model would require the same customer management capabilities, technical support and other back office functions such as finance, HR, IT etc. However, it would be relieved of some regulatory requirements which can be extensive as these would be contracted to the TPLS provider for a fee. The TPLS would be responsible for these and carry the associated compliance risks.
Cost and risk considerations
The operational requirements to establish the Full Capability model are significant. To comply with regulatory codes will require substantial up-front investment and ongoing resourcing. The 'Licence Lite' model would relieve the Energy Co. of some of these constraints, however, there has been a significant lack of interest from existing industry suppliers to offer this scheme so far. This is evidenced by the low number of 'License Lite' suppliers currently in the market.
Some functions may be outsourced for the purpose of cost efficiency. The Energy Co. would need to weigh up the financial and operational implications of doing this, given the risks associated with lack of direct control. For several functions, outsourcing could reduce cost (and capability requirements) for the Energy Co., however this must be balanced against the time and transaction costs required to procure such services. Additionally, given the objectives of the Energy Co. there may be the requirement to provide bespoke services (e.g. the customer service / help line) for the targeted fuel poor population.
4.4.4 SG Procurement Framework model
SG has two separate national frameworks for supplying energy to the Scottish public sector, one for gas and one for electricity. These are currently available to Central Government, Health, Local Authorities, Universities and Colleges, Third Sector and other Public Bodies.
Under this operating model, the Energy Co. would source its energy through the SG Energy Procurement Framework and effectively act as a customer acquisition agent / re-seller for the Framework suppliers. As the Framework was designed for public sector organisations rather than residential customers it would require substantial changes to allow household customers to purchase energy at the Framework price. Under this model the Energy Co. would not be a licenced energy supplier, but simply a customer acquisition agent for the Framework supplier(s). Additionally, there is a risk that the costs for the current Public Sector customers may increase as residential customers represent a broader spread of credit risk than the current customers.
Energy procurement and hedging
Under this model, the Energy Co. would enter the SG Procurement Framework agreement and sign up domestic retail customers. The intention would be that domestic consumers could access the same wholesale energy charges (subject to limitations on metering) as others on the Framework. Traders in Scottish Procurement would purchase energy on behalf of the customers according to an established Risk Management (Hedging) Strategy.
As the Framework has been designed for public sector organisations rather than domestic users, a review of the hedging strategy for the Framework would be required to incorporate the addition of Scottish non-domestic customers.
Customer management and back office support
The Framework has been designed for the supply of energy to Public Bodies as the needs of consumers would differ to this and the service offering would require significant changes to adapt to this. There would be a requirement to expand the current team managing contracts, additionally a range of different skills would be necessary to effectively manage the different customer service offerings.
As the gas and electricity contracts are tendered separately every 4 to 7 years, consumers would face changing one or another supplier every 2 to 4 years and at any one time may have different suppliers for gas and electricity. This would likely add to the requirements for the customer service team and may be something that is resisted by residential customers.
Cost and risk considerations
There are a number of challenges with this option. As previously noted there are currently two national Frameworks, one for gas and one for electricity. The changes required to the contracts may not comply with EU regulations, necessitating a re-tender of the national contracts. The electricity contract is currently being re-tendered (submissions are currently being evaluated) and the gas tender will commence late 2018. As the Frameworks are intended for the supply of energy for Public Bodies, including residential customers would require more complex customer requirements than those that are currently provided for. Furthermore, adding residential customers changes the spread of credit risk in the Frameworks which currently have an attractive, reliable customer base. As a result of these changes, Public Bodies may reconsider the national Framework, opting for what may be more attractive rates elsewhere.
4.5 Summary of operating models
Three different operating models have been proposed for the Energy Co. and are illustrated below. The OBC will continue to develop and progress the review of these options. The operating models are not mutually exclusive; the Energy Co. would have the opportunity to select one model and progress to another, for example commence with a White Label model, with the objective to move to a 'Licence Lite' or Full Capability model in the future. The Energy Co. would have the opportunity to outsource some its functions, however any benefits from doing this would have to be considered against the time and transaction costs required to procure such services, as well as the loss of direct control for Energy Co.
Figure 10 - Operating Models explored in SOC
To summarise the discussion of the operating models, the table below highlights the key advantages and disadvantages for each.
Table 9 - Advantages /Disadvantages of Operating Models
Although the SG Procurement Framework model could potentially allow domestic consumers to access low cost energy, in terms of complexity and ability to execute, this operating model presents several fundamental challenges and on this basis should not be considered at the next stages.
The operating models identified provide an overview of the models that could be adopted by the Energy Co., which could all be developed under each of the short-listed delivery structures identified in the Socio-Economic Case. Two of these delivery structures can be addressed specifically regarding the respective operating models, namely the Existing Supplier and "Federal model".
4.5.1 Existing supplier
Under this delivery structure, through an intervention by SG, the Energy Co. would be able to utilise the existing supplier's capabilities, infrastructure and resources, including its customer and back office functions. It could also look to amend and improve some of the existing trading and hedging capabilities. As a result, this option would effectively be a variation of the Full Capability model given the existence of the energy retail supply company. Subject to review, it is possible that certain functions of the existing suppliers could be out-sourced in the interest of cost efficiency.
4.5.2 Federal structure
The Federal delivery structure is based on the premise that the customer service function (including customer acquisition and customer service) could be provided at the LA subsidiary level. This may allow the LA to tailor their interaction with local customers and meet the specific needs of their community. The remainder of the capabilities and services could be provided at SG at a parent company level.
This could be achieved through either of the following operating models:
- White Label: the Energy Co. (Parent company) would contract with a licenced supplier. Customer acquisition and customer services (if the White Model 'Plus' model was selected) would be provided by the respective LA subsidiary companies. There would be minimal intervention from the Energy Co.
- Full Capability: the Energy Co. (Parent company) would be a licenced energy supplier. It would be responsible for the procurement and supply of energy. The LA would provide the back office functions such as customer support, compliance and other services such as HR, Finance, Legal.
4.6 Other operational considerations
We have identified additional considerations which will be critical components of any operating model. These are described in the following sub sections.
4.6.1 Customer acquisition strategy
The customer acquisition strategy of the Energy Co. will need to be developed substantially during the OBC stage. Specifically, the following areas will need to be explored from a cost, risk, capability and time to implement perspective:
- The customer target and acquisition strategy, given the Scottish non-switching, prepayment and fuel poor segments of the customer base
- Routes to customer acquisition and costs: agents such as 'Moneysupermarket' are popular but costly methods to acquire new customers. Social media has also proved to be a useful platform for attracting new customers. Even though this is a cheaper method, the volume of promotion required to reach the correct customers is significant. As a result agents such as 'Moneysupermarket' are often the most effective method
- Current smart technology roll-out and timetable, as well as other switching technology providers (e.g. Flipper, a privately owned company that contracts with household customers and provides a for-profit switching service).
4.6.2 Minimum size and scale
The Energy Co.'s commercial and financial position will be underpinned by a number of operating assumptions. These includes the proposed scale of operations and the number of customers targeted by the business and will need to be considered in the context of:
- Customer meter thresholds for smart technology provision and green levy (200,000 and 500,000 meter points, respectively). There will be significant operational and financial impacts of implementing the requirements associated with the Smart Meter technology and complying with the green levy
- The Energy Co. must consider financial benefits driven by economies of scale versus the limited size of the Scottish market (including market share implications)
- Profitability according to customer characteristics (e.g. potential cost / profitability of acquiring and servicing the target customer segment(s)).
- The scale of business impacting on the choice of delivery model. A White Label model would not require a significant customer base to cover the reduced overheads associated with the model. This analysis will form an integral part of the financial modelling at OBC.
- The size and scale of Energy Co. will also need to be considered in the context of the number of householders in Scotland that are fuel poor. This is discussed further in the Financial Case.
4.6.3 Digital landscape
Suppliers are currently increasing their investment in digital offerings to drive down operating costs. For the Energy Co. their target consumers are those living in fuel poverty, although an innovative digital service could reduce operating costs it may be counterproductive as engagement and interaction with this audience is key to the success of the Energy Co. With an evolving market, digital services will be an area that the Energy Co. will be required to consider to remain cost competitive. The OBC will consider the best solutions to maximise on this whilst still targeting the primary market of fuel poor consumers.
4.7 Summary of precedent companies
We have reviewed a sample of companies with similar objectives to that of the Energy Co. e.g. focusing on renewable energy sources, attempting to alleviate fuel poverty and providing better customer service and engagement.
The analysis performed has highlighted the following key themes:
- It appears that based on this limited sample, established energy companies who both produce and procure energy as well as focus on environmental sustainability are more likely to be profitable. This is exemplified by Ecotricity and Good Energy
- With the exception of Aberdeen Heat and Power Company Limited, which is owned by Aberdeen City Council, the profitable companies are all privately owned
- The size of the energy companies also appears to have an impact on its profitability, as larger companies with more than 500,000 customers have been less profitable. This may be partly due to additional costs relating to the Green Levy and smart meter installation which companies with over 500,000 customer meters must cover.
4.8 Future commercial and operational considerations
SG may also wish to consider other methods of expanding and improving the Energy Co.'s remit. These should be in keeping with the vision and objectives of the organisation, but may also be used to improve the organisation's longer term financial viability.
4.8.1 Expand the range of services offered by the Energy Co.
The Strategic Case identifies a range of factors that contribute to fuel poverty in Scotland, including the prominence of prepayment meters and low quality housing stock.
The Energy Co. may look to expand its operational strategy by entering the energy efficiency market. This would involve providing assistance to customers to minimise their energy bills and reducing their consumption of energy. Through this proposition and subject to further work, the Energy Co. could potentially be rewarded on a gain-share basis (based on reductions in household energy bills) as a result of the Energy Co. efficiency interventions (e.g. improved insulation). This could be implemented in conjunction with any available government grants. The Energy Co. could then enter into a long term arrangement (e.g. 5 years) where the customer pays a fixed yearly fee for their energy (up to a maximum cap) through which the equipment provider can earn back the cost of installing the energy saving measures. The customer would reduce its energy costs, fix its energy bill and the quality of the housing stock would be improved over time.
4.8.2 Renewable energy investment/generation
Consideration will need to be given at the OBC stage with respect to the Energy Co.'s potential participation in energy generation (for later Phases), either through long-term purchase power agreements (PPA's) or direct ownership / participation in generation assets.
The Commercial Case has reviewed the following operating models for the Energy Co. to consider:
- White Label model
- Full Capability and a 'Licence Lite' capability
The analysis indicates that the White Label and the Full Capability Models are the options that should be carried forward to the OBC stage. Both operating models have the potential to deliver the objectives set by the Energy Co. Although the SG Procurement Framework model could potentially allow domestic consumers to access low cost energy, in terms of complexity and ability to execute, this operating model presents several fundamental challenges and on this basis should not be considered at the next stages.