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FR Appendix 9.10: Analysis of retail supply profitability ... · PDF file Appendix 9.10:...

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  • A9.10-1

    Appendix 9.10: Analysis of retail supply profitability – ROCE

    Contents Page

    Purpose of this appendix ............................................................................................ 1

    Introduction ................................................................................................................ 1

    Scope of analysis and principles of economic profitability .......................................... 2

    Adjustments to firms’ financial information ............................................................... 10

    Results of our analysis ............................................................................................. 50

    Annex A: Managing collateral and business risks .................................................... 62

    Supplement 1: Actual trading and collateral arrangements of the Six Large Energy

    Firms ........................................................................................................................ 86

    Supplement 2: Evidence on the trading arrangements and approaches to business

    risk management of independent energy suppliers .................................................. 90

    Purpose of this appendix

    1. In this appendix, we set out our analysis of the profitability of the retail supply

    of gas and electricity in GB. The profitability of electricity generation is

    analysed separately. This analysis forms one part of our assessment of

    whether the prices observed in the retail supply markets are above the level

    that we would expect in a well-functioning market (ie one where competition

    operates effectively so as to allow firms to earn limited, if any, profits in

    excess of the cost of capital). We have had to make a number of assumptions

    and judgements in coming to a view on the level of profits earned by the firms

    that are active in this sector. As a result, we consider our results to be

    indicative rather than precise estimates. This appendix should be read in

    conjunction with the other analyses we have undertaken in order to assess

    whether prices in retail energy are above the level that would be expected in a

    well-functioning market.

    Introduction

    2. On 8 December 2014, we published, and consulted on, a working paper

    setting out our proposed approach to assessing profitability at each stage of

    the energy supply chain in GB, namely in power generation and retail supply.1

    In that paper, we set out our intention to measure profitability using both

    return on capital employed (ROCE) and profit margins for the retail supply

    businesses. On 17 April 2015, we shared our preliminary analysis of the

    1 Approach to financial and profitability analysis working paper.

    https://www.gov.uk/cma-cases/energy-market-investigation#working-papers

  • A9.10-2

    ROCE earned by the retail supply businesses of the Six Large Energy Firms

    with those firms. We invited them to comment on our approach and the

    interpretation of our preliminary results, and we requested some additional

    financial information in order to refine our analysis. On 7 July 2015, we

    published our provisional findings, in which we set out our updated profitability

    analysis and on which we invited parties to make submissions. On 18 March

    2016, we published our (further) updated profitability analysis as an appendix

    to our provisional decision on remedies.

    3. We have received responses on these four consultations from parties and we

    have taken these into account, adapting and refining our approach as

    appropriate. In this appendix we provide an explanation of the analysis we

    have undertaken in order to come to a conclusion on the level of profitability in

    the energy retail supply industry. In Appendix 9.9: Approach to profitability and

    financial analysis, we set out the basic principles that have guided our

    approach to analysing the economic profitability of both the electricity

    generation and energy retail supply sectors. In this appendix, we focus on

    how we have applied those general principles to the specific circumstances of

    energy retail supply.

    4. The structure of this paper is as follows:

    (a) Scope of analysis and principles of economic profitability: briefly

    recaps the proposed scope of our analysis of the profitability of the retail

    supply businesses, as well as the basic principles that we have applied in

    our analysis, including our approach to the recognition and valuation of

    capital employed.

    (b) Adjustments to firms’ financial information: provides an overview of

    the data that we have received from the relevant firms and discusses the

    adjustments we have made in order to ensure that our analysis is

    economically meaningful.

    (c) Results of analysis: sets out our estimates of the ROCE for the supply

    businesses of the Six Large Energy Firms, including sensitivities where

    we consider this to be appropriate.

    Scope of analysis and principles of economic profitability

    The scope of our analysis

    5. We adopted the following scope for our profitability analysis:

  • A9.10-3

    (a) The relevant geographic market was GB, in line with the markets

    referred.2

    (b) The relevant firms were Centrica, EDF Energy, E.ON, RWE, SSE and

    Scottish Power.

    (c) We collected data for the period from 2007 to 2014.

    (d) The relevant activities for retail supply comprised all the activities that a

    stand-alone supplier would need to undertake to compete in the markets.

    These include forecasting energy demand, making decisions regarding

    how and when to buy electricity and gas, managing customer

    relationships, billing, marketing and so on. We note that a stand-alone

    supplier may choose to employ staff directly to execute trades or it can

    purchase these services from a third party. We have analysed the

    profitability of the retailing of energy to both domestic and non-domestic

    customers, including SMEs and large industrial and commercial (I&C)

    customers on a combined basis. However in paragraphs 160 to 162, we

    set out an indicative apportionment of profitability by customer type and

    by fuel.

    Principles of economic profitability analysis

    6. The purpose of this analysis, in the context of the investigation, is to assess

    the profitability of retail energy supply as a hypothetical distinct economic

    activity. Three key objectives may be distinguished; firstly, to assess the

    profitability of retail energy supply on a stand-alone basis; secondly, to identify

    all relevant operating assets, liabilities, revenues and costs whether or not

    shown in the accounts of the firms engaged in energy supply; and thirdly, to

    ensure that amounts are reflected at an appropriate value. Through meeting

    these objectives, we can be confident that the resulting analysis will provide

    an economically meaningful measure of profitability for the activity in question.

    Stand-alone basis

    7. Since the Six Large Energy Firms were all vertically integrated over the period

    of review,3 and we wish to understand the economic profitability of their

    supply businesses, we need to separate the retail arms from the rest of the

    integrated businesses. There are three steps to achieve this:

    2 Terms of reference. 3 As of 1 January 2016, E.ON completed the division of its group into two separate entities, with its retail, grid and renewable generation activities being separated from its fossil fuel generation activities: E.ON announcement. RWE has announced plans to divide its activities along similar lines to E.ON: RWE announcement.

    https://www.gov.uk/cma-cases/energy-market-investigation#terms-of-reference http://www.eon.com/en/media/news/press-releases/2016/1/4/separation-of-eon-business-operations-completed-on-january-1-uniper-launched-on-schedule.html https://www.rwe.com/web/cms/en/113648/rwe/press-news/press-release/?pmid=4014358

  • A9.10-4

    (a) Separating out assets, liabilities and transactions that are attributable to

    retail.

    (b) Measuring transfer prices for services that flow between retail and the rest

    of the group.

    (c) Identifying any additional assets or liabilities that would be incurred by a

    stand-alone retail business.

    8. The first two of these steps can be substitutes. For example, the value of a

    building to a firm can be reflected either as an (appropriately depreciated)

    asset on the balance sheet of the retail business or as an internal transfer

    charge in the profit and loss account (P&L) for the cost of renting the building

    from another part of the business. In our analysis, we have generally used the

    approach adopted by each of the Six Large Energy Firms, ie recognising

    either assets or operating costs depending on the approach taken by the firm.

    9. Our emphasis on ‘stand-alone’ costs implies that costs should be stated to

    reflect ‘arm’s length’ trading between the retail supply business and the rest of

    its parent group.

    10. The approach that we have taken to estimating the ROCE for the suppl

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