Selling retail electricity in the US

by Judith Waite

A number of states have elected to continue the process of opening their electricity retail markets to competition, albeit slowly. In response, independent marketers have sprung up around the country. While a handful of marketers are very large and compete in several markets for retail customers, most are relatively small and compete regionally. A few offer only non-fossil-fuel power (wind, water, and solar); others sell electricity along with gas, telecom, and other household services.
But all face similar risks: Credit strength of retail customers and energy suppliers, Market risk of volatile energy prices and switching customers, and Operational risk of internal controls.

The experience in Texas reflects these risks. The state, which addressed most of the potential market and credit issues in the legislation that created retail electric competition starting in 2002, has one independent marketer in bankruptcy and another affiliated marketer that will experience a significant loss in 2003.
Both companies, bankrupt Texas Commercial Energy and First Choice Power, a subsidiary of TNP Enterprises, were hurt by the February 2003 gas price spike. Their experience makes it clear that retail electricity marketers can -- and usually do -- share many of the same risks of marketing and trading companies. Standard & Poor's generally views marketing and trading companies as having a "below average" business position, that is, 7, 8, or 9 on a scale of 1 to 10, where 10 is the weakest, or highest risk, profile.

First Choice has the advantage of being a retail electric provider (REP) affiliated with an incumbent utility, Texas-New Mexico Power (TNMP). In Texas, that means that twice per year First Choice may raise rates if the price of gas rises 5 % or more above the average gas price at the Henry Hub, and stays at least 5 % higher for 20 days. (In November and December, the difference must be 10 % or more.)
The legislation lowered the retail rates of all utilities by 6 % for the first five years of electricity supply competition, but provided the safety valve of raising rates to capture higher fuel costs. So, when gas prices spiked in February, First Choice was able to raise rates a second time to assure recovery of the full cost of power from TNMP's traditional customers -- those who have not chosen an alternative supplier.

For competitive customers -- the ones First Choice lured away from other suppliers -- First Choice locked in gas supply that provided a margin over the electricity sales on contracts signed up through early November. However, the gas price was not locked in for contracts that were renewed, or new contracts signed in November and early December, resulting in losses for 2003. How that happened is a case study in the risk of being an electricity marketer.
First Choice started out in 2000 buying fixed-rate electricity in various blocks to match the fairly predictable load of its retail customers, factoring in some customer losses, particularly industrial customers, and to match the contracts signed with new customers. However, the fixed price contracts created collateral requirements when natural gas prices fell below the contracted level, and First Choice had limited credit capacity.

As an alternative way to cap gas price exposure, the company bought gas-purchase options. Unfortunately, the option seller was a shell company created by a former First Choice employee, a fact discovered almost immediately because of a reported transfer of funds. A revised payment approval process is now in place. However, before another options counterparty was approved, a few large competitive customer contracts were renewed with fuel costs at the December 2002 level.
By the time gas price options were purchased, First Choice was stuck with a loss on the renewed contracts. So, in its first year, the company faced two of the major risks associated with retail electricity marketing: lack of the credit capacity needed for fixed-price contracts, and a weakness ininternal credit and risk controls.

Texas Commercial's bankruptcy parallels in certain respects the bankruptcy of Pacific Gas & Electric California. Texas Commercial, like Pacific Gas & Electric, sold electricity to retail customers -- mainly small commercial customers -- at fixed prices, but bought the power from the spot market. Texas Commercial cited the high volatility of electric prices in the Electric Reliability Council of Texas (ERCOT) as the reason for its bankruptcy filing, and has alleged that companies selling in the competitive market may have engaged in improper activities.
Texas Commercial reported its concerns to the Public Utility Commission, which is investigating the matter. Texas Commercial's president points out that barriers to competition in Texas are still very high, and the lack of access to bank credit to provide collateral on fixed-price purchased-power contracts is one key reason.

In fact, this is a major hurdle for most small marketers. GEXA Energy, a smaller, independentretail energy marketer, has 44,000 residential and commercial customers and is adding about 1,000 customers per week. To supply this growth in customers, GEXA buys blocks of power to match the increased demand. An independent generator provides the financial backing that allows GEXA to lock in fixed-price power supply contracts. The CEO points out that for a marketer of this size, the capital requirements are enormous.
That being the case, "It's good to have an 'A' credit rating," according to the senior vice president in charge of the Southern Region-US for Centrica North America. Centrica North America, through various subsidiaries, is a very big independent marketer in Texas. Moreover, Centrica North America is a subsidiary of Centrica PLC, a UK-based multibrand energy supply and essential services company.

In Texas, Centrica buys huge blocks of power to serve retail customers, and buys gas swaps to fix the fuel price, but is not required to post collateral because of its strong credit profile. And,because they have customers in all four of the Texas electricity zones, Centrica has much greater access to electricity pricing information--an important component of being competitive.
For much of its load, however, Centrica has a two-year contract with the generation portfolio that originally served those customers, specifically the customers of AEP Texas Central (formerly Central Power & Light) and AEP Texas North (formerly West Texas Utilities). The rates to those customers are still fixed at the regulated tariff minus 6 %, giving Centrica a fairly good margin on a significant portion of its electricity revenue in Texas.
That is also an advantage for the REPs affiliated with the two other large utilities in the deregulated market within ERCOT, TXU Energy Services and Reliant Energy Retail Services. Customers served by these affiliates will continue to pay the "price to beat" (previous rate minus 6 %) until 2007, or until at least 40 % of the utility's customers have chosen competing suppliers. At that point, the affiliated REP will charge competitive rates, and will have to manage fuel costs without the twice-annual adjustment.

All marketers in Texas have cited the risk associated with non-paying customers, but have noted that this has been partially mitigated by a revision of the rules. The problem greatly increased in the first year of competition mainly due to the operational problems associated with billing through the ERCOT system and with the rule prohibiting marketers from disconnecting non-paying customers. These customers were to be transferred to the provider of last resort (POLR) and only the POLR could disconnect a customer.
Now, the billing problems have been sorted out, and under modified rules, an independent marketer can transfer a non-paying customer to an affiliated REP (but would still have to sue the customer to get paid). In addition, the affiliated REP can now disconnect the customer. So, as the Texas electric market evolves toward full competition, a few of the marketers'risks have become apparent.

On the positive side, from a credit quality point of view, competition is coming slowly. And, importantly, while the structure for deregulating the market is designed to promote customer choice by putting ample "head room" in the rates charged by an affiliated REP, it is also designed to protect the financial integrity of the competitors. An affiliated REP can adjust rates to recover rising fuel costs.
Independent marketers are certified only if they have the financial capacity to buy and sell power. (The Public Utilities Commission is in the process of obtaining additional information relating to whether Texas Commercial is qualified to continue to operate as a retail electric provider.) Plus, non-paying customers can be transferred back to the affiliated REP, which now has the authority to terminate service.
However, the challenges experienced during these first 18 months of competition highlight the importance for electric power marketers of a strong financial profile-- or the backing of an entity with a strong financial profile; a strong risk monitoring and risk mitigation program; and the ability to attract and maintain a large and diversified portfolio of high-quality retail customers.

Judith Waite is analyst at Standard & Poor’s.