Innogy and SSE: edging towards exit?

For UK energy suppliers, times are tough. It is little surprise therefore that two of the big six – SSE and Npower – want out. But the merger of the two companies which hit the headlines this week has nevertheless created a stir. What’s the strategy behind the move? Is this the spark of a merger spree that will condense the big six into the “big three” and how will the tie-up affect the competitive dynamic of the much-maligned domestic energy market?

In a seemingly snap decision, which caught the industry off-guard, SSE and Innogy have agreed to merge Innogy’s British retail business Npower with SSE’s household energy and energy services business to form a new independent retail energy company – not controlled by either Innogy or SSE.

The merger will effectively turn the big six into the “big five”, and calls have come from concerned parties urging the competition authorities to take a “critical look” at the merger. The trade union Unite’s national officer for energy Kevin Coyne insists that if the big six – which have an estimated 80 per cent market share – were to become the “big five”, then their “stranglehold on the energy market would increase”.

But other market experts are less concerned about negative impact on competition. Former Npower chief executive Paul Massara believes a single merger of this kind can’t do much harm. If more were to follow, coupling up other big six players until the majority of the domestic energy retail market share sat in the hands of three mega-suppliers, that might be a different matter. But Massara, and other commentators, consider such an eventuality unlikely.

The company created by the Npower-SSE merger will still be smaller than British Gas – which will remain by far the UK’s largest supplier with a 33 per cent of the market share of domestic gas customers and 22 per cent of domestic electricity customers. Based on Ofgem figures on the market shares of companies, and assuming customers are not spooked into switching in droves on the back of the merger, the new Npower-SSE creation would have a market share of around 24 per cent in the domestic electricity sector, bigger than that of British Gas. However, its share of the domestic gas market would be around half that of British Gas’s, at 19 per cent.

Domestic market share of UK energy suppliers

Source: Ofgem

Coming so promptly on the heels of government’s publication of a draft bill to implement a market-wide cap on default energy tariffs, it’s hard to believe that Innogy and SSE have not been forced into bed by worries about squeezed margins. Particularly so, given that SSE has the highest proportion of customers sitting on stand variable tariffs out of any of the big six and Npower has become notorious in the market for its struggles with profitability after huge customer losses in recent years.

Doug Stewart, chief executive of independent supplier Green Energy, fervently believes the proposed merger is an “unintended consequence of government intervention”. “I think it’s a shot across the bows of government to be perfectly honest,” he tells Utility Week.

Ian Cain, former managing director of Centrica’s credit energy business agrees. He says the merger is an outcome of the way in which the competitive landscape is shaping up in the energy sector. Speaking to Utility Week, he says: “I see some commentators attaching significance to price caps as a driver in this scenario, though the drivers for me are much wider.”

But despite the timing, Innogy chief executive Peter Terium is adamant that the merger is not a result of the price cap. During a press conference following the announcement, he told journalists the timing is “irrespective of the price cap interference”. Nor is it an “exit before Brexit”, he stated.

However, neither Terium nor SSE chief executive Alastair Phillips-Davies could deny that the decision was driven by a broader climate of government intervention. Terium said the “uncertain political environment” for energy retailers in the UK was the primary reason, and that the price cap news may have “pushed the deal a bit quicker”. And Phillips-Davies said the “scale of change” in the energy market means the deal will enable both entities to “focus more acutely on pursuing their own dedicated strategies”.

It certainly can’t be denied that the UK’s political environment is making life difficult for energy retailers. Rumblings about the potential for a market exit have been building since it became clear the Competition and Markets Authority’s recommendations to root out market failures would be largely ignored by government, in favour of more crowd-pleasing measures.

Warwick Business School professor David Elmes says energy suppliers are justifiably fed-up. “Despite an extensive review of energy markets by the Competition and Markets Authority, the government has chosen to go further than the CMA recommended in requiring changes to how companies supply energy,” he says. “We have just had another government review aiming to “recommend ways to keep energy prices as low as possible”.

Elmes suggests that there comes a point where companies who have the choice of investing in the UK or elsewhere see the UK as “a tough market to compete in”. He insists that the Innogy-SSE announcement should act as a “wake-up call” to those piling pressure on the sector, that they may yet end up breaking it.

This said, it’s an accepted industry truth that Npower has had a “for sale sign” over it for a long time. To say the company has struggled in recent years is an understatement. It made a £100 million loss in 2015, as well as shedding more than 350,000 customers. In the same year, significant problems with the supplier’s new billing system led to a £26 million fine by energy regulator Ofgem. “With that history, it’s not surprising that Npower has looked at selling up and leaving the retail market,” states Elmes.

Market shares of SSE and Npower (2004-2017)

Source: Ofgem

SSE’s motivation for opting out of domestic energy retail (it will retain its industrial and commercial supply unit) is somewhat less clear. But though it has a better record for service and customer retention than Npower, the company has experienced challenges arising from the constraints of a “cumbersome” system of legacy infrastructure. “Both, it is clear need significant investment, focus and pointing towards the radically different energy market of the future,” says Cain.

Massara suggests SSE’s strategic logic for the merger is twofold. Earnings from domestic energy retail are continually subjected to regulatory and government interference. SSE has the largest SVT-base in the country – with roughly 90 per cent of its customers on these tariffs, which are the source of a big chunk of political and consumer dissatisfaction with the market, and which will be subject to the incoming cap.

The other reason is that the risk around returns may not be particularly attractive for domestic retail, and the company may feel it will get a re-rating on the rest of the business if it separates it out. Massara says that, for SSE, the merger creates a new entity which can be floated off, reducing its political risk and leaving a business made up primarily of regulated assets.

Others have speculated that, for SSE, the move could be to protect dividend growth. In its 2017 annual report, SSE said it believes its first responsibility is to give shareholders a return on their investment through the payment of dividends, that are at least equal to RPI inflation. The company has an impressive track record, having delivered a dividend increase every year since 1999. Unite national officer for energy Kevin Coyne insists the merger is a “flagrant example of rampant capitalism designed to solely benefit the shareholders”. The company’s share price spiked dramatically off the back of the merger news. “This is all about placating shareholder demands as the dividend is linked to the retail price index,” says Coyne.

Five-day share price graphs

Source: Google

Details of what will happen to the merged company – “SENpower”, if you will – remain unclear. The press statement issued by the companies says that Innogy will hold a minority stake of 34.4 per cent, while SSE plans to demerge its 65.6 per cent stake to its shareholders upon completion of the transaction.

Stewart suggests that putting the company on the stock exchange will allow Innogy and SSE to get rid of their investment by trading shares over time. “They might change its name, they might carry on holding it, who knows,” he says, suggesting that they may even “run it off”, with serious unintended consequences.

“[The new company] could just not renew any of the contracts for its 12 million customers,” he speculates. “I don’t think the 50 small suppliers would be able to cope with that. I think they’d say they could, but would all run out of cash very quickly.”

Hold all bets for now though. The listing of Innogy and SSE’s new retail energy company is expected to occur in the last quarter of 2018 or the first quarter of 2019. But before that, the merger must pass approval from the supervisory board of Innogy and of SSE’s shareholders and satisfy the scrutiny of the competition and regulatory authorities – be it the CMA or the EU.

While this merger alone is unlikely to compromise the competitive dynamic of the entire energy market, it does show that cracks caused by political upheaval are beginning to show.