Two of the most compelling stories in energy over the past few years have been the rapid growth of competitive electricity supply (“CES”) and rooftop solar. Although the two industries directly compete in some states, we have worked with executives in each industry who know relatively little about the other. However, we believe CES and solar businesses could help one another reduce customer acquisition costs and solar companies could help CES businesses stabilize cash flows over a longer period and increase customer lifetime value.
Both industries have enjoyed rapid growth in recent years. Eleven million consumers in 13 states plus the District of Columbia buy power generation services from competitive suppliers. (For the most part these consumers continue to buy electricity delivery services from a local monopoly utility.) The number of residential CES customers has grown at 16% annually since 2008 and more than half the consumers in some markets buy from a competitive supplier.
Meanwhile, the amount of residential solar capacity installed each year has grown at an annual rate of 56%. One of the key drivers of this growth has been the emergence of third-party-owner financing models, in which consumers spend little or no money up front but agree to host systems at their homes and buy the power produced for 15 to 20 years. Another has been a precipitous fall in the cost of solar equipment.
Note: Both residential and commercial (including non-profit, government, and industrial) customers can purchase CES or solar power. For the sake of simplicity we have focused this paper on the residential segment only, but similar arguments can be made in the commercial segment.
Competitive Electricity Supply
In 2011, nearly 11 million U.S. residential customers spent more than $13 billion with competitive electricity providers (Figure 1). These consumers accounted for almost 10% of the total US residential electric load. Broadly speaking, the competitive electricity supply business is divided into two types:
- Competitive retail, in which providers market directly to consumers. Typically, consumers select a particular supplier or are enrolled with a default (usually their distribution utility).
- Community aggregation, in which providers compete to supply a group of consumers brought together by a local government or agency. Consumers who live in aggregation communities generally receive power from the supplier selected by their aggregator unless they explicitly opt out of the program to stay with the local utility or use another supplier.
Figure 1: Households with Competitive Electricity Supply
Thirteen states and the District of Columbia allow competitive retail electricity and five allow community aggregation (Figures 2 and 3). States have viewed CES as a way to combat high energy prices—12 of the 15 states with some form of CES are among the 25 states with the highest historical electricity prices.
Figure 2: States with Competitive Retail Electricity
Figure 3: States with Community Aggregation
Despite the growth in the number of CES customers, many businesses have found it to be a difficult industry. Many previously independent retail marketers have been sold. Examples include BlueStar Energy (now AEP); Reliant, Green Mountain Energy, and Energy Plus (NRG); GEXA (NextEra Energy); and MXenergy, StarTex Power, and Constellation (Exelon).
The main challenges in the CES business include:
Thin gross margins
Notwithstanding the efforts of some companies to differentiate on service and/or sell green energy, electricity is a relatively difficult product to differentiate other than on cost. Because CES businesses sell a commodity, gross margins are thin and costs must be kept low.
Commodity price risk
The biggest risk in the CES industry is commodity price risk on wholesale power. If a CES company has contracts to provide power for one, two, or three years at a given price and the cost to acquire that power subsequently increases, its profits will be squeezed. Companies can partially hedge this risk, but more comprehensive hedges are more costly. Therefore, CES companies face a constant tension between maximizing profits and minimizing risk.
Customers in this industry have very low switching costs and the products are undifferentiated. As a result, annual attrition (the share of customers that are not carried over from one year to the next) is typically around 30%. To grow their businesses companies must retain and replace existing customers as well as contract new customers.
Customer acquisition cost
A company’s ability to find customers efficiently is one of the major determinants of success. Customer acquisition cost, which typically ranges from $75 to $150, is a key operating metric.
Prevalence of Direct Sales and Network Marketing
Competitive retail electricity firms often use direct sales (including telephone and door-to-door canvassing) and network marketing (also known as multi-level marketing) to acquire customers.
In network marketing organizations, a salesperson’s compensation is partially driven by recruitment of additional salespeople. We estimate companies using network marketing account for nearly 10% of all CES customers and more than 50% of customers of pure retail energy companies (those without significant generation capacity). CES companies such as Ambit Energy, Just Energy (whose network marketing division is called Momentis), Spark Energy (Ampegy), Stream Energy (Ignite), Viridian, and North American Power use network marketing to acquire a significant portion of their customers.
CES network marketing businesses typically offer two types of compensation to their sales teams:
- Team growth income – Paid when a new associate recruited by a salesperson completes his or her first few sales. Typically $50-250.
- Residual energy income – Paid when customers pay their energy bills. More is paid for higher value customers and for customers brought in by associates deeper in a salesperson’s organization. For example, in Stream Energy’s Ignite program salespeople get $0.25 / month in residual energy income from customers they bring in directly, but $2.00 / month for customers brought in five layers deep in their organization.
The compensation structure, therefore, provides strong incentives for salespeople to recruit other salespeople.
Growth of Community Aggregation
Community aggregation initially developed more slowly than competitive retail but is now growing quickly in most places it is allowed. In many states it has taken years to refine the regulations and for communities to overcome utility opposition. Another catalyst has been a general shift from opt-in to opt-out program design. In opt-in designs, consumers must explicitly choose the aggregation option or they remain with their current supplier. In opt-out designs, consumers are automatically enrolled unless they explicitly choose otherwise. As a result of these developments, more than one million consumers will switch suppliers due to new aggregation agreements in 2012 and 2013.
Synergies with Genco Businesses
Separately, CES companies and power generation companies (“gencos”) each engage in hedging transactions on opposite sides of the same risk. A CES will hedge against increasing wholesale power price, while a genco will hedge against a decrease in the same price. They will each pay third parties for this. Together, a CES-genco business needs less third party hedging because the profits of the two divisions move in opposite ways when power prices move—a natural internal hedge. This natural hedge is one of the primary rationales for purchases of CES companies by large gencos.
Perhaps even more important than the cost of the hedges themselves, a combined company requires less collateral for its hedges. Power companies often need to put up significant cash deposits to engage in futures contracts with third parties. Reducing the need to hedge not only removes the cost of the futures contract but also reduces the capital requirements of the business. For example, at the end of 2011 NRG had $311 million on its balance sheet for cash collateral to support its hedging operations, which was 8% of its annual generation-related revenue.
Despite these synergies, at least some integrated firms still find the CES business to be difficult:
“…both the retail and the wholesale markets have been impacted by aggressive competition and pricing…We also view the current pricing dynamic as unfortunate, but a necessary aspect of what we expect to be consolidation of retail providers.”
Christopher Crane, CEO, Exelon, 3Q 2012 Earnings Call
“…as you know, the trend is competition, no question, and margin pressure…it’s a daily challenge…during this downturn, it’s been tough.”
Paul Koonce, CEO, Dominion Virginia Power, 3Q 2012 Earnings Call
Major CES Companies
In 2011 there were nearly 100 CES brands serving residential customers across the US. In a typical region, there could be 8-12 companies seeking residential customers, but in some states the competition is fierce: 54 companies in Texas, 29 in New York, and 28 in Pennsylvania. At the end of 2011, however, 13 companies accounted for approximately 90% of residential CES customers (although they often have multiple brands):
We estimate the net present value of a new residential CES customer to be $50-450, depending on the value of key variables such as price, gross margin, customer acquisition cost, attrition, hedging cost, and whether or not the company has a natural hedge:
Figure 5: Typical Ranges of Key Variables for CES Businesses
|Price||5.5-9.5 cents / kWh|
|Customer acquisition cost||$75-150|
|Attrition||25-35% / year|
|Cost of hedging||$2-5 / MWh|
|Natural hedge||Yes or No|
The price of CES companies sold over the last two years suggests a similar value per customer (Figure 6), though these should be considered a ceiling on the value per residential customer because the announced customer counts include both residential and commercial customers. Also consider that First Choice Power and Energy Plus had unusually loyal customer bases and that Green Mountain sells green electricity, which carries a price premium. The average price paid per customer among the remaining deals is $454.
Figure 6: Prices Paid in Recent CES Company Acquisitions
Source: company reports
Residential Solar Electricity
The market for residential solar energy systems grew at an annualized rate of 56% between 2008 and 2011, with 297MW of new capacity installed in 2011 (Figure 7). This represents approximately 59,000 new households. 2012 looks likely to continue the trend.
Figure 7: Growth of Residential Solar Installations
One driver for this growth has been declining price. In the second quarter of 2012, the national average installed price was $5.46 per Watt DC, which was down 14% from the same period a year earlier and about 20% from the same quarter in 2010. In addition, new financing options have been a significant catalyst for growth. (See “Solar as a Service,” below.)
The majority of demand for residential solar systems is concentrated in a handful of states. California is by far the largest market, but several states that have competitive retail electricity markets are in the top ten: New Jersey, Pennsylvania, New York, Maryland, and Texas. Also, Massachusetts will likely be in the top 10 solar states in 2012.
Figure 8: Size of Residential Solar Market by State
(2011 MW installed)
The market for the sales and installation of solar systems his highly fragmented, with some estimating more than 2000 companies offer these services. However, a few companies have achieved significant regional or national scale (Figure 9). The largest of these, SolarCity, completed its IPO in December 2012.
Figure 9: Major Solar Dealers
|Dealer||States of Operation||Estimated 2012 Residential Installations||Estimated Residential MW / Year|
|SolarCity||CA, AZ, HI, NJ, PA, NY, MD, DE, DC, MA, CT, CO, TX, OR, WA||14,400||72|
|Paramount Solar||CA, AZ, OR, CO||3,600||21|
|Verengo Solar||CA, AZ, NJ||3,600||21|
|Vivint Solar||NJ, HI, MA, CA||3,000||15|
|Sungevity||CA, AZ, CO, NY, NJ, DE, MD||2,500||13|
|REC Solar||CA, AZ, OR, CO||1,800||9|
|Trinity Solar||NJ, NY, CT, DE, MD||1,600||11|
|Real Goods Solar||CA, CO, NJ, NY, CT, MA, DE, PA, RI, VT||1,200||6|
Source: Woodlawn Associates estimates
Solar as a Service
The development of solar leases and power purchase agreements (“PPAs”) has been a major catalyst for the growth of residential solar. These products allow homeowners to go solar without requiring them to have large amounts of investable cash (an average solar system costs about $30,000 installed). In many cases, homeowners can now go solar with no money down and pay less for power under a lease or PPA than they would to their utility. In return for such financing, the customer usually agrees to purchase the power for 15-20 years at contracted rates. Such arrangements now account for over 70% of residential solar sales in major states such as California, New Jersey, Arizona, and Hawaii.
The firms offering these financing solutions are essentially selling power as a service, like competitive retail electricity providers, as opposed to selling hardware, like solar installers. The PPA price (or monthly lease price) typically includes monitoring and maintenance necessary to keep the system operating.
The major firms offering residential solar financing can be divided into three camps:
- Third parties that buy systems from independent solar dealer-installers, such as SunRun and Clean Power Finance
- Vertically integrated installers, including SolarCity and Vivint Solar
- Equipment manufacturers, with SunPower being the dominant player
Figure 10: Estimated Installed Base and Generating Capacity of Solar Service Companies, Year End 2012
|Company||Estimated Installed Base (Households)||Estimated Generating Capacity (MW)|
Source: Woodlawn Associates estimates
Solar service companies have experienced low default rates on their contracts. SolarCity, for example, reports it has a cumulative default rate of less than 0.5% on customers it has had for at least four years.
There are three major challenges and opportunities for residential solar industry participants: customer acquisition cost, installation cost, and financing.
Customer Acquisition Cost
Woodlawn Associates has shown that the average cost to acquire a customer in residential solar exceeds $5000. Because solar sales typically require one or more face-to-face visits with the customer in his home, this is substantially higher than in the CES industry.
Some dealers have done well with superior marketing and sales execution. For example, Vivint Solar and Verengo Solar did well with door-to-door canvassing in 2011. However, it remains to be seen whether companies can create a sustained competitive advantage through execution.
Residential solar installers typically spend 80% of revenue on the cost of installations. It is unlikely a solar installer can create a permanent competitive advantage in installation cost, although there is enough variability among participants today to suggest that for the time being some firms are able to do much better than average through superior execution.
To be a solar service company (rather than only an installer of solar systems), a company requires access to significant capital. SolarCity and SunRun have each raised more than $1 billion in third party capital to finance solar installations. Firms that have access to low cost capital will be most competitive and be able to capture more profits from financing.
One of the solar market’s unique aspects is the 30% investment tax credit (“ITC”). The ITC allows a company to deduct 30% of the cost of a solar facility from its federal income tax liability. However, only companies with significant tax liability can use these credits efficiently, so solar service companies are regularly looking for so-called “tax equity” from investors who can take advantage of the ITC.
We estimate the net present value of a new solar customer to be $4000 to $8000, depending on the value of key variables such as installed cost, incentive structure and value, electrical production (which depends on the amount of sunlight), monthly lease (or PPA) payment, and cost of capital (Figure 11).
For the sake of comparison with our CES analysis, we fixed the system size at 6kW, which is not far from the average solar system size and would result in production of around 80% of demand for a typical 10MWh /year residential customer.
Figure 11: Typical Ranges of Key Variables for Solar Business
|Installed cost||$3.50 to $5.50 / Watt|
|Federal incentives||30% rebate or 30% investment tax credit
Bonus depreciation (50% or none)
|State incentives||SREC ($70-200 / MWh, if any)
Capacity ($200-500 / kW, if any)
|Electricity production||1000 to 1600 kWh per kW per year|
|Monthly lease payment||$75-240 / month
(highly dependent on incentive structure)
|Cost of capital||8-15%|
Opportunities for Partnership between Solar and CES Companies
We believe solar and CES companies could partner in ways that benefit both. The best opportunities involve competitive retail suppliers without generation who operate on the East Coast and solar companies operating in the same region.
Solar and Pure-Play Competitive Retail
There are compelling reasons for solar companies and pure-play (non-genco) competitive electricity suppliers to explore partnerships. Solar companies may be able to use some of the sales and marketing expertise of the retail marketers to improve their customer acquisition efficiency. In addition, each type of company could serve as a source of high quality leads for the other. By doing so, solar companies could decrease their customer acquisition costs and increase the NPV of solar and competitive retailers could convert some of their lower-value CES customers into higher-value solar customers.
However, this does not apply in all states with competitive retail or to all competitive retail suppliers. Texas, Illinois, and Ohio are large states for competitive retail, but they are relatively small markets for solar due to a combination of low insolation (amount of sun), low grid energy prices, and/or low solar incentives. On the other hand, several East Coast states with competitive retail electricity are also conducive to solar. Figure 12 shows the major CES companies that compete in six such states.
Solar and Gencos
A partnership with an integrated CES-genco would have benefits for a solar company. A genco’s competitive retail subsidiary could serve as a source of high quality leads for a solar vendor. Depending on the region and the company, a genco may also have a strong local brand that would help the solar company further reduce customer acquisition costs. Finally, a large genco could help a solar company acquire low cost capital.
The analysis for the genco is more complicated. First is the financial question of whether a residential solar customer or competitive retail customer is more valuable to the genco. Where conditions are right (such as in East Cost solar states) a solar customer is more valuable than the retail contract and its natural hedge. However, if one includes the return the genco earns on generation the analysis is more complicated. Strictly speaking we do not think it is correct to include such returns in the comparison since the genco could sell power from its plants on the wholesale market even if it invested in residential solar, but this is not always how companies view it.
Perhaps more important, residential solar is still a very small business compared with large gencos. The largest residential solar service companies have about 100MW of generating capacity, but many gencos operate more than 20,000MW of capacity. Even if one assumes residential solar is a good business for the genco, at its current scale it is not large enough to be material, although it is growing very rapidly. Residential solar could potentially be a piece of a larger renewables program at such companies, too.
One option gencos may want to consider is an investment in solar tax equity. Such an investment would give them an insider’s understanding of the rapidly growing solar market while decreasing their corporate tax burden.
Another possible avenue for partnership would be to help differentiate aggregation bids. While aggregation is a highly competitive business often tightly focused on price, communities have a range of concerns that might be addressed in a bid, and some have chosen to include large amounts of renewable power in aggregation purchases. For example, in early 2012 Cincinnati chose a 100% green offer from FirstEnergy Solutions in an aggregation deal, though they could have reduced price further with traditional power. A solar-genco partnership on an aggregation bid might address community desire for green power and local economic development by including marketing or incentives for the construction of distributed solar.