Will the disruptors be disrupted?

In recent years, new kids on the block have waded into the energy market and have made more than an impact – with the likes of Octopus, Ovo and Bulb taking on the established order. Much has been written about the future of the big six, their flaws and the failings of smaller entrants. But what of the medium sized challengers? Are their business models flawed? Utility Week investigates.

The UK energy retail market in 2019 offers an abundance of choice. Whether a customer is searching for a green tariff or just cheaper bills, there is no shortage of options.

However, this reshaping of the market has led to its fair share of failure – with no less than 13 suppliers bowing out from the retail stage since the start of 2018. This has prompted analysis of why these suppliers failed, with many industry experts pointing to a lack of capital and poor business management as the main reasons behind their demise.

Meanwhile, the long dominant big six have struggled to find their place in a rapidly shifting market, with some dramatic consequences.

While these opposite ends of the market have floundered, the so-called mid-tier challenger brands, especially Octopus, Bulb and Ovo, have thrived, with clear strategies and apparently strong financial backing. Ovo is even eyeing up a game changing acquisition to propel it into the top tier. Meanwhile, Octopus has recently acquired the customers of Co-op Energy in a deal some have suggested could be worth as much as £60 million, showing the company means business.

But how sustainable are these so-called disruptors? Some industry experts have taken the view that their business models expose them to considerable risk from wholesale costs.

One industry analyst Lakis Athanasiou of Agency Partners LLP, goes as far as saying that companies such as Bulb and Octopus would have had problems this year had the costs of gas not collapsed.

“Smaller and medium-sized suppliers have done well this year because energy prices have collapsed. However, if we are to see a year or two of steadily rising prices, even well-backed medium sized companies like Bulb and Octopus will struggle”, he tells Utility Week.

Former Npower boss and chief executive of Electron Paul Massara agrees, saying smaller suppliers’ lack of ability to hedge further than their big six counterparts could place them in danger.

Speaking to Utility Week, he says: “In the short term there are so many new entrants that are all pricing each other out with no margin. So, by the time you do the set-up costs and everything else, I don’t think anyone is making any money.

“It’s about the hedging programme and where they are, the smaller players have less credit capacity typically to hedge further out and therefore essentially they are more likely to be exposed to a rise in prices.”

Similarly Ryan Thompson, a partner at Baringa Partners, argues that while Octopus is well-backed financially, there is still a risk from unusually cold, or mild, winters which can cause major upheaval to the supplier’s hedging strategy.

That being said, Thompson ultimately believes the size of Octopus will allow it to withstand a bad winter.

He says: “You can be perfectly hedged but you suddenly get a warm snap or a cold snap in winter months. And not necessarily just a one-off event – if you have got a generally warm winter and consumption drops by 2-3 per cent, that could sometimes be enough to make or break a year.

“The question is, have you got the buffers to survive? I suspect people like Octopus are now at the size where they probably can.”

It’s clear that a company’s ability to hedge well can be the key to its survival and Octopus’ chief executive Greg Jackson fiercely defends his company’s hedging strategy.

He argues: “A lot of the assumptions made by people from traditional energy backgrounds about challengers are purely based on speculation. For example, one analyst said companies like Octopus and Bulb have only been able to grow or survive because of a fall in gas prices.

“That’s completely wrong, our gas is hedged (and electricity too). Every single customer we sign up, we hedge. We hedge them for the period of the fixed product and on our variable product we hedge them for the period of the price cap. There is no speculative trading, we don’t benefit from a drop in gas prices.”

In financial results published in January this year, Octopus posted a £5.3 million loss in operating profits despite experiencing “rapid growth” in both customers numbers and turnover.

Massara points to the fact that while companies like Octopus do have strong backing, there is a question of how long investors are willing to back loss making enterprises.

He adds: “Octopus made a loss last year, the issue is how long are you willing to put money in to a business if it is loss making unless you have got a sustainable business plan to turn that round?

“If you are an Octopus or an Ovo, which are well capitalised, then I think you are in a relatively strong position but if you are a new entrant without a strong backer, how long are you willing to go through that trough of loss making before you see profitability again?

“That is why I think Ovo and Octopus are getting scale and they’re looking to invest in new technology and EV charging and other areas to both tie in customers and offer them new services.”

Jackson however is keen to highlight Octopus’ financial credentials.

The energy supplier is part of the Octopus Group which, as of 31 March this year, is worth £8 billion across all businesses.

“Companies invest in their first few years of growth to build successful businesses. What is happening in energy is we are seeing this rapid transition from the inefficient, bloated incumbents to technology driven rivals like us”, he adds.

To highlight his point, the Octopus chief executive uses the examples of retailers like Amazon, whose investors backed losses as the company scaled because technology was driving a shift in the way the market works.

Another such retailer with heavy financial backing is London-based Bulb, which was founded in 2015 by Hayden Wood and Amit Gudka.

Last year the renewable supplier, which has 1.4 million customers, announced it received a £60 million injection from two major international investors – DST Global and Magnetar.

Asked about how wholesale costs may affect their business, Baringa’s Ryan Thompson points to the supplier’s single variable tariff.

He asserts: “Bulb’s business model is very different from Octopus or Ovo, with a different hedging approach. Its whole customer base is on a variable tariff and they have a bit more flexibility on moving their tariff up or down. I suspect they are not hedged as far into the market.”

In response Wood tells Utility Week: “Bulb is part of a new generation of suppliers who’ve built a more efficient way to provide energy.

“At Bulb, we’ve developed new technology which means we’re able to supply energy to homes and businesses at drastically lower cost than the big six who are weighed down by inefficient legacy systems.”

Ovo Energy, which declined to comment for this piece, is another success story, so much so that the new player was recently revealed to be in talks with energy giant SSE over the acquisition of the latter’s retail arm.

Yet last year Ovo was one of four companies that Ofgem opened compliance cases into following its bi-yearly complaints handling survey.

The poor handling of complaints was on of the key reasons for the demise of small retailer Iresa last year, according to Energy Ombudsman Matthew Vickers.

Since then however, Ovo has shown itself to take advantage of supplier failures and acquire more customers, building its business in the process.

Furthermore there is the question of the smart meter rollout.

Most, if not all, of the talk regarding challenger suppliers revolves around their ability to sustain a business in a volatile market dominated by well-established large players such as Centrica-owned British Gas.

Yet Thompson further argues that energy retailers’ smart meter obligations may cause them serious issues if they are no fulfilled.

Ofgem has shown it is not afraid to flex its regulatory muscles and has taken enforcement against two big six suppliers, SSE and EDF, which paid over £1 million between them into Ofgem’s consumer redress fund for failing to hit their smart meter targets.

Thompson says: “Challenger suppliers are only really just getting into their smart programmes because their growth has been so steep. They could be exposed to potentially large fines if they haven’t managed to meet the obligations in the next 18 months.

“If they haven’t been building their capability to deliver their smart obligations on the back of that and if they aren’t able to meet those obligations in quite a short time then they are exposing themselves to the regulator.”

He also warns that the renewables obligation payments and capacity market payments could put short-term pressure on cash flows – something which he concedes could be alleviated by substantial financial backing.

While the future for the mid-tier challengers remains unclear, their impact on the market to date cannot be denied. While some are targeting growth there are rumours that others are looking to capitalise on their success so far with a sale. However it pans out, the industry will watch with keen interest the next steps of what we should now perhaps call the Middle Three.

To hear directly from a key player among the disruptors, don’t miss out on a space at Utility Week Congress, where Octopus’ Greg Jackson will be among the speakers.