This article first appeared in The Water Report
Get big, get niche, get out. It is probably not quite the way they teach it at Harvard Business School, but it is a well-respected business adage for the strategic options companies face in new markets. The non-household water market represents such a market and companies are currently considering their strategies. So, how active will the market be and how, and importantly when, do you take this key strategic decision? Are big, niche and out really the only options – what about the in-area retention strategy - and which is the best option for your company?
The Water Act set in place the extension of water competition in water and sewerage services in the Non Household (NHH) Retail market from 2017. This is an extension from the current 5Ml water market, significantly increasing the number of business premises that can switch, from 27,000 to 1.5million, and adding in waste services. This increases the value of the market, which, based on PR14 returns, is worth in the region of £170m pa. Defra, Ofwat and Open Water Market Limited (OWML) have been driving forward the change that will enable the market and, with PR14 resolved, the mood of the industry has seen a distinct change from ‘will this happen?’ to ‘this will happen’.
Predicting market activity
The potential extent of activity in the market, and hence impact on strategy, is not easy to predict. Those who believe it will be a very slow market point to the low early rate of switching in the Scottish market, the low anticipated margins for business and savings for customers.
The Scottish market has been open since 2008 but has seen limited activity (although more than 60% of customers have successfully renegotiated contracts). The average NHH net margin has been set by Ofwat at 2.5% and at an overall size of £170m pa, many argue this does not represent an attractive market for incumbents or new entrants. This in turn, it is argued, will limit potential benefits for customers and so limit activity.
This analysis is leading some companies to adopt a ‘steady as she goes’, or ‘wait and see’ strategy. This is based on a focus on in-area retention, built around current strong relationships, with no, or negligible, activity out of area. There are however predictors of a far more active market, which could make this a dangerous strategy. We have seen an upsurge of activity in the Scottish market, with ten new entrants over the last two years and there is also increasing activity in the English market with a total of 11 licensees now appointed. Companies are privately and publicly declaring their strategies – we talk to many companies aiming at 25+% growth – which cannot be possible in a constrained market. There will inevitably be casualties if these companies are to come anywhere near to success.
Perhaps most importantly, the ‘slow market’ prognosis does not capture the potential disruption and change that may happen in the market or acknowledge transparency that will enable it. Specifically, much of the NHH retail cost to serve is a fixed cost; every time a company loses a customer their cost to serve will hence increase. This will result in reduced profit, assuming tariff increases would not be allowable. Either option is unpalatable and, further, it risks creating a vicious circle that will make your customer base an increasingly attractive target for competitors, that will in turn drive up your cost to serve.
This raises the question of how to decide your strategy. There are very important issues around the value of a customer base, positioning for longer term upstream and potential household competition and what drives value for stakeholders. Firstly, however, it is important to consider that this is an almost unique market in the transparency of data available to help the strategic decision.
A highly transparent market
Through the final determination process, Ofwat has created a highly transparent market. Each incumbent company included a section on NHH Retail, and default tariffs were set for each customer group proposed by the companies. In assessing the deemed tariff, Ofwat considered the cost to serve for each customer group and published this alongside the tariff data. This provides a wealth of information to use in considering retail strategies including the profit margin by customer group, average consumption, number of customers, bill size, wholesale cost and others. The information provided is indicative, prices could change and companies could offer different value added services, reducing margins to ward off competitors. However, the information does show:
The table below sets out the overall number of customers (blue bars) and average Retail cost to serve (green squares).
This shows some very significant differences between companies. For the eight smaller companies, Portsmouth’s average cost to serve is circa £20 per customer, while Affinity’s is nearly treble that at circa £55 per customer. For the large players, Severn Trent Water’s cost to serve is circa £26, while United Utilities’ is circa £42. There is clearly much data behind these figures which helps explain some of the differences. For example Affinity Water also has the highest revenue per customer of the Water Only Companies (WOC), which could be a major reason for the increased cost to serve. However, they do provide a quite remarkably transparent set of information to support strategic decision-making. Among the questions it prompts are: if your company has a very high cost to serve then are you realistically going to compete, what is your target market and how do you drive cost to serve down? Equally, if you have a low cost to serve and want to expand your business, how do you best use the information to target your sales strategy?
The information set out above is valuable, but there is much more detail in the returns. These allow you to break down revenue and margin by service and customer type, to an extent. The example below shows a high level assessment by customer number and revenue by margin. The three red service groups represent about £6m of revenue and 85% of customers. Circa £1.25m of this revenue is in a customer base with margins nearing 50%, a potential prime target with lower cost to serve in these areas.
The following company conversely seems in a relatively sound position.
The high volume customers are operating at a low margin and so are arguably less vulnerable to acquisition. The higher margin business is spread across a smaller number of customers who may be harder to target. However, in contrast, the revenues indicate this is a small company and potentially more vulnerable to losses. Furthermore, if the company suffers some losses in its high margin customer base then the overall cost to serve will be driven up.
In addition, some aspects of company sales strategies could cut across the elements above. For example, national deals could take customers from all companies irrespective of margin.
Developing your strategy
The above indicates how, if utilised, this type of information can be invaluable in determining your strategy. What then should that strategy be?
Get Big? This is clearly not an option open to all, or certainly not in the short term. Several of the larger players have set out their stall and are active in the market. They are developing capabilities, sales and marketing strategies and active positions in Scotland and the 5Ml market. Several are starting to consider national deals which could have a significantly disruptive effect on the market. The recent announcement of Anglian Water as the preferred bidder for water and wastewater services to the Scottish public sector showed a strong intent. Although scale is valuable, these large companies are also vulnerable from rivals using the transparent information available above. Targeted sales strategies against them could undermine their cost to serve and lead to a need to focus energies on protecting the home front.
Get Niche? Transparent information again helps companies to develop a niche. This could be by targeting particular types of company, regions, or services. It could be by using a capability as the basis for the offer; the most obvious example would be a digital only service, building on the increasing prevalence of digital markets.
Perhaps the most obvious current incarnation of niche is the ‘in-area’ focus approach. Many companies are pursuing this, aiming to maximise their current relationships, putting in place strong account management and differentiated value added services for key local customers. The lessons from the energy industry on this are not, however, that positive. Local loyalty was frequently rapidly eroded in the face of advantageous deals, particularly for large national or regional players. As noted above, each customer loss will drive up cost to serve and drive down margin.
This is therefore a challenging strategy, but companies can be creative in how they pursue it. One potential approach would be ‘white-labelling’. This is used extensively in energy and other industries; companies outsource the delivery of their products and services through a partner organisation, while they themselves focus on the brand, sales and appropriate aspects of customer service. M&S Energy is delivered through SSE, for example and John Lewis Broadband is delivered through PlusNet. This approach could substantially reduce cost to serve risk and facilitate an in-area strategy, if providers are available. Conversely, a water company could become a provider of white-labelled services itself, if level playing field concerns could be overcome, providing a service to other companies or new entrants to help balance cost fluctuations arising from loss or acquisition.
Get out? The ‘get out’ option would see companies exiting from the provision of water and sewerage services. The viability of this option is not yet clear. The provision to allow exit was introduced at a relatively late stage in the development of the Water Act 2014. Defra has issued a consultation which sets out proposals for companies to seek Secretary of State approval to exit, together with proposed policies for addressing the consequential impacts.
One particular issue is the protection to be provided to customers of the exiting company upon transfer. It is proposed to use Deemed Contracts for all customers who have not negotiated specific contracts with their Licensee. These would include arrangements to ensure customers do not lose price and non-price protection as a result of a transfer. These proposals are based on the principle of equivalence, whereby customers should have access to the same safeguards as they would have had if they had remained with the original company. It is proposed to extend this principle beyond the initial exit and transfer: in effect the customer may have a right to transfer back and the original company remains the default service provider up to two years after the original transfer.
Companies wishing to take advantage of the exit provisions will wish to avoid the need to invest in the new systems, processes, people and infrastructure that would be required to operate a market ready retail business. But the application process itself will not open until October 2016 with the Secretary of State decision following in December 2016. This presents a significant risk to the company in the event that its application is refused. The undertaker would retain the legal responsibility to supply but may not have the infrastructure or capability to do so in the new market arrangements. An undertaker wishing to exit will therefore need to be very sure it can meet the requirements before deciding not to invest. More clarity may emerge in Defra’s response to consultation, but for now this does not provide a low risk strategic option.
Retail strategy is a crucial element in approaching the new market. The backdrop to developing that strategy is challenging. On the positive side, there is a plethora of information; far more than is normally available. On the negative side, the ability to take major decisions, in particular exit, require more certainty. The economics of the market suggest not all will survive and thrive. Get big, get niche, get out – what is the right strategy for your company?
Ted Hopcroft is an energy and utilities expert and John Parsonage is a water expert at PA Consulting Group
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