Retail Customer Energy Valuation
A White Paper by Peace Software

What Are Your Customers Worth?
The concept that the customer is the asset in a competitive energy market is not always well understood. However, this concept is fundamental to successful energy retailing and of critical importance to Regulated utilities preparing for competition.

By contrast, in a regulated world, an energy company’s number one asset is its franchise territory. Whereas in a deregulated market where the retail function is separate (disaggregated) from the distribution function, the notion of franchise territory is associated with the distribution business and its tangible assets: pipes, wires, poles, transformers and substations. The retail business has neither these tangible distribution assets nor the protection of a franchise territory.

Yet we know from newspaper headlines about recent industry deals that energy retailers carry substantial value. The fact that retail giant Centrica has 44 million customer relationships and a market capitalization in excess of seven billion pounds is further evidence. What makes an energy retailer so valuable is its asset—the customer relationship.

Like any asset, the customer has a value. But how do you calculate that value? A number of valuation methodologies exist for determining customer worth. In this article we examine three such methods—the discounted cash flow model, using organic acquisition as a reference point, and the empirical comparison approach.

The Discounted Cash Flow Model
The Discounted Cash Flow (DCF) model, also known as the Net Present Value (NPV) model, determines customer value by subtracting the cost to Acquire a new customer from the expected margin earned from that customer, at the same time taking into account the time value of money. The assumption is that when you acquire a customer — organically or by bulk acquisition — you pay an initial acquisition cost that puts you into the red at the beginning. This acquisition cost might encompass marketing, sales, enrolment and contract renewal costs.

Over time the customer pays their bills to the retailer, who recoups margin for each billing period. There comes a break-even point along the way whereby the accumulated profit margin offsets the acquisition cost, and any net profit earned thereafter represents positive value.

Customer value can be increased three ways

• Lowering the acquisition cost.

• Increasing the margin per month. This can be achieved by minimizing operational costs to Increase net profit or through offering new products and services to Increase gross revenue.

• Increasing the length of the customer relationship.

The best tactic to use will vary from one retailer to the next depending on business and market circumstances. A new market entrant, for example, may choose to focus on lowering acquisition costs until it gains critical mass. An incumbent with a large customer base is wiser to adopt a defensive strategy around customer retention to Increase the length of customer relationships.

Of course pursuing all three tactics simultaneously is certainly a worthwhile approach for many. The chart lists four hypothetical business scenarios to demonstrate the various valuation drivers at work.

Retailer Black is our control example based on a hypothetical acquisition cost of $200 per customer. Assuming Retailer Black earns $10 margin per period per customer, the break-even point will be reached in 20 months and a customer value of $119 is achieved in the expected three-year customer life cycle.

Streamlining the enrolment process enables Retailer Red to Acquire customers at a lower cost of $100. As a result, the payback period is reduced to ten months and the margin accumulated for the remaining 26 months increases customer value to $219.

Retailer Blue takes a different tack by reducing its operational costs to Increase its margin per period to $15. In doing so, Retailer Blue reduces the payback period to14 months and banks higher margins thereafter to arrive at a customer value of $278.

Retailer Green clocks the highest customer value at $293 because it retains its customers for two years longer.

The global energy industry has many examples of acquisition deals where participants have used the DCF valuation model. A publicized example was new market entrant Infratil, which successfully used the DCF model to determine how much their Trustpower subsidiary should pay to consolidate blocks of customers in the competitive New Zealand electricity market.

A flurry of acquisition activity followed New Zealand’s 1998 Electricity Reform Act as the incumbent power boards scrambled to sell off their customer bases to ambitious new market entrants. Market prices soared as high as NZ $1000 per customer. Infratil, which had determined the value of a customer at around NZ$460 (US$248), declined to pay anything higher and turned down some of the customer bases that were available for sale. Infratil’s lower customer valuation soon became the base comparison for future acquisition deals in New Zealand.

Clues Can Be Found in Organic Acquisition
The term "organic acquisition" refers to signing customers up one by one to achieve "organic growth", as opposed to bulk acquisition of existing customer bases for "growth through consolidation." It has been suggested that the cost to win a new customer organically is similar to the cost to Acquire a customer through bulk acquisition. Therefore your organic acquisition cost may serve as a reference point for valuing your customers.

A 2000 study carried out by CeTurn Limited in the competitive U.K. electricity market determined that new customers cost UK£150 (US$233) to Acquire through direct sales or direct mail. This is only $15 lower than the DCF value used by Infratil to price customers through bulk acquisition.

This similarity is to be expected. If organic versus bulk acquisition costs varied substantially, business logic would be questioned. What would be the point in buying an entire customer base at one price if customers could be acquired individually at a significantly lower cost?

Nor is it surprising that the organic acquisition cost is slightly less than the DCF financial value because of the time to Market factor. It takes longer to win customers one-by-one and therefore acquiring customers in bulk to gain immediate market share will carry a premium value to consolidation-minded retailers seeking rapid growth.

Taking an Empirical Comparison Approach
Another way of establishing customer value is by comparing recently acquired customer bases that have similar characteristics to the company being valued. The table below compares ten acquisition deals signed between 2000 and 2002.

Whereas bulk customer acquisitions in New Zealand, Australia and the United Kingdom exhibit fairly consistent customer valuations over the last two years, it appears that recent events in the United States — namely the Californian deregulation crisis and the collapse of Enron — have led to volatile and decreased customer values in the region.

For example, Centrica acquired the gas customers from the bankrupt New Power Company in July 2002 for the reduced price of US$38 each, compared to the US$200 it had offered for each customer earlier in the year.

The following chart displays the acquisition cost range by year. Despite dissimilar market structures, influences and time frames, a common price trend is evident suggesting that on the whole prices have been fairly consistent.

The empirical range for each year spans the Infratil DCF and the CE Turn Limited organic acquisition reference points, suggesting that the three different valuation methods we have described are consistent with each other.

Investing in Your Customers
Leading Australian energy retailer Country Energy has a strong appreciation for the value of its customers. The company, which supplies gas and electricity to750,000 consumers in five Australian states, is 100 percent focused on finding, keeping and extending its customer relationships.

"The customer is king," explains John Adams, Country Energy Group General Manager, Retail. "Our business strategies revolve around the customer as our most important asset. We invest in our customers and their loyalty keeps us profitable."

John Adams continues, "When pursuing new customers, you need to be careful that the total acquisition cost incurred has a definite pay-back period and a quick pay-back period. I heard of a competitor that spent $200 to Acquire a customer who typically has a $40 monthly bill.

Considering that the gross margin on the total bill is likely to be eight percent, half of which covers operational costs and another quarter tends to be a discount incentive, our competitor is looking at a 20-year pay-back period. That’s not good business."

Despite this example, the myth that there is no margin in retail is simply that — a myth. "I would like others to believe that myth," jokes John Adams. "Sure there is no margin in bad retailing but there is plenty of margin for the astute retailer. What you have to understand is that energy retailing is based on hard-won incremental margin. There is no such thing as big chunks of margin. You have to keep your costs low and your customers happy."

Country Energy is attacking operating costs across three dimensions — overhead, cost per task and tasks per customer. The strategy for reducing tasks per customer is simple; keep customers satisfied so they don’t need to contact the call center and empower customers to serve themselves via the Internet.

John Adams explains, "While our competitors may be looking to shave a few cents here and there, we are thinking well outside the box. Say it costs $1.50 to answer a call in the call center.

We could focus on streamlining processes to bring that cost down to $1.40 and save ten cents, or we could take the call out of the call center all together and save the whole $1.50."

Country Energy is doing just that — channeling customers to access their account and energy consumption information, interact with their account manager, enter meter readings and pay their bills online without needing to contact the call center. Last month, Country Energy’s advanced web site was voted one of the best in the Australian energy sector for its interactivity.

The Decision Facing Utilities in Restructuring Markets
Understanding the value of the customer asset is also of great relevance to Regulated utilities as they prepare for competition. Sooner or later they will face the decision — do they invest in the complex new demands of competitive retailing to maintain their customer asset, or do they sell their customer base while it still retains value to a new market entrant seeking rapid market share through consolidation.

Chances are the most profitable customers — commercial and industrial customers — will be lured away first. Unless the utility is fully prepared to invest in its customer asset, it should give serious thought to exiting the retail market and focusing solely on distribution.

New Zealand’s power companies faced this dilemma following the Electricity Reform Act, which made all consumers competitive. Realizing that they didn't have the critical mass to be successful, and that their focus lay with reliability of supply, a few seized the opportunity to sell their customer bases before their customers switched anyway. In doing so, they realized more value per customer for their stakeholders than they would have achieved from continuing to service an eroding customer base as a retailer.

A similar trend could happen in Texas, where municipalities and cooperatives have not as yet exercised their right to participate in the competitive electricity market. Inevitably they will need to make a decision — to sell out or venture forward as a competitive retailer. Relying on the status quo of isolated islands of power supply in a competitive market is unlikely to be sustainable, and they may look to the experience of their counterparts in New Zealand as a guide.

Increasing Customer Value with an Advanced CIS
An advanced customer information system (CIS) can be a key enabler for increasing customer value, and by implication, the value of the core assets of an energy retail business. The right system can streamline acquisition processes, reduce operational costs in order to Increase margin, enable up-selling and cross-selling and support customer retention to contribute to longer customer relationships. Conversely, the wrong system can erode customer value and put your business at risk.

TransAlta New Zealand learned this lesson the hard way. The company operated as one of the largest electricity and gas retailers in New Zealand in the late 1990s. In 1999 it invested in an expensive albeit unsuccessful CIS that resulted in severe billing errors, badly impaired customer service and bad press, all of which contributed to tens of thousands of customers switching away in a period of a few months.

Every lost customer represented a direct erosion of TransAlta’s company value. Using the Infratil valuation of NZ$460 per customer, each ten thousand customers lost represented NZ$4.6 million written off against their customer asset.

Facing further deterioration in brand and customer asset value, TransAlta ultimately exited the energy retail market completely, but not before receiving the 1999 "Roger Award" for being perceived as the worst trans-national corporation in New Zealand.

What an energy retail company needs instead is a CIS that provides a technology platform for accurate billing, improved customer service, streamlined customer acquisition and enhancing customer value. Choosing an advanced CIS that delivers these benefits is a long-term investment in maintaining your customer asset.

The Peace Advantage
Peace Software develops component-based customer management solutions used by utilities and retailers for business innovation in regulated, transitioning and competitive markets. The company’s browser-based Energy suite has been selected to drive efficient operations and provide excellent customer care for millions of mass market and commercial and industrial (C&I) customers in 40 markets around the world. Peace Software’s innovative Energy suite can replace or be phased into existing CIS environments, one component at a time. New version upgrades are available every 12-18 months. Founded in 1984, Peace Software has offices in Australia, Canada, New Zealand, the United Kingdom and the United States.

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