Case

Gas Grogginess

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Problem Definition

As much as monopolists enjoy their monopolistic benefits, they live in outright fear once the market gets liberalized. Your client, GASolina, has decided to take precautious action and asked you to discuss the potential consequences of a market liberalization. You are speaking to the head of sales that anticipates a market opening in the upcoming years. In particular, she has two questions: i) What type of competitors will enter the market? and ii) What will be the level of competition intensity following a market liberalization?


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Short Solution

Market entry of a new competitor is highly unlikely.

Changes in the market regulation and other supplier companies pose a viable threat, though.


Detailed Solution

Paragraphs highlighted in green indicate diagrams or tables that can be shared in the “Case exhibits” section.

Paragraphs highlighted in blue can be verbally communicated to the interviewee.

Paragraphs highlighted in orange indicate hints for you how to guide the interviewee through the case.

I. Structure

Let the interviewee think about a potential structure to answer the questions.

To assess whether potential competitors will enter the market, we need to evaluate the market attractiveness (growth, profitability, risks) for new entrants. Also, key success factors of the market, positioning of other players/ potential competitors and potential competitive advantages would need to be considered…

… (and mentioned!), but the latter are ignored in this case. In this case we will focus on market attractiveness.

Afterwards, share diagram 1 with the interviewee.

II. Background

The company is the (only) German gas provider and its business activities can be generally summed up in sales (to households and firms) and transportation (from border on, includes transportation network, distribution network, storage capacity, equipment,…)

Liberalization has two major implications for GASolina:

  • End of sales monopoly, arrival of new competitors
  • Preservation of transportation monopoly, under surveillance of state authority that ensures equal access to all competitors.

III. Analysis

Growth

We are starting with evaluating the market attractiveness by looking at market growth. The growth levers are the households and firms our client is supplying.

  • Growth in households depends on penetration of the network, share of gas vs. other forms of energy and consumption (climate, improved isolation of houses, …)
  • For firms all growth levers from households apply, plus industry growth and productivity

Having identified the growth levers, we need to give a justified assumption regarding the future of gas consumption:

  • While the penetration of households is expected to increase, consumption is likely to decrease due to global warming and better built houses.
  • For firms, increasing productivity will outweigh industry growth and consumption will most likely decrease as well.
  • Overall growth will be low or even zero. A new competitor will have to lure customers away from the incumbent provider.

If the interviewee finishes this thought, then the next conclusion should be that a new entrant to the market can either compete by offering a superior product/ service or a lower price. Gas as commodity cannot be of superior quality, hence differentiation must be via the price. We will have to know about the cost structure. The interviewee should ask this. If not, direct the interviewee towards this question.

Share diagram 2 with the interviewee.

Profitability

Knowing the cost structure, we can identify areas of cost savings. While this always is a good approach, it can be argued that in the case where the reference value for commercial costs comes from a monopolist, significant cost savings seem possible (since monopolistic firms are usually organized far from cost-efficient).

Gas and infrastructure can be regarded as fix. Neither does a new entrant have the possibility to source the gas comparatively cheaper, nor does it have the opportunity to renegotiate the infrastructure costs that are set by the regulator, i.e. the state.

While the new entrant can reduce the price and save commercial costs, it will also have to significantly spend more resources on marketing. We would need to calculate the potential for a price reduction.

You can tell the interviewee that an analysis for a potential price reduction can be carried out on the basis of the average household’s yearly gas bill of 600€.

From the yearly 600€ bill, 48€ are commercial costs and 12€ is margin. Accepting a lower margin (let’s say 50%) and cost savings in commercial costs of 25% (independent of the value, it should consider the increased resource commitment for marketing), this yields:

25% of 48 € = 12 €
50% of 12 € = 6 €

Total price reduction: 18€ ~ 3%

(Alternative strategy: On top of the fixed 540 € (90% of 600 € gas bill), we would add 48 € - 12 €, which leaves us with 576. Accepting only a 1% margin (~6 €) adds up to 582 €, which is 18 € less than the 600 €. This calculation is more accurate.)

A conclusion can be that margins have to be very low to gain market share from the existing provider.

If the interviewee sticks to the structure built in the beginning, next dimension of market attractiveness was “risks”. First, let the interviewee think of possible risks. After this, the interviewee should ask, if there is any data on this. Yes, there is!

Risks

Naturally, climate is a risk factor for gas retailers. In warm winters, people will heat less and thus need less gas.

If there is a mild winter, the gas consumption will reduce by 10%. While sourcing costs are fully variable, infrastructure consists of a 60% fixed and a 40% variable component. A cold winter is a normal winter, bill and costs as stated before.

Share table 1 with the interviewee. The interviewee can use it for an overview.

The interviewee should carry out the analysis without the potential cost savings!

The results are visible in table 2, which you can, but don’t have to share after the interviewee calculated the correct values.

Sales = 600 - 10 % = 540
Gas cost = 300 - 10 % = 270
Infrastructure cost = (240 x 60% + 240 x 40%) - 10 % = 230,4
Commercial cost = 48 - 0% = 48 (not affected by climate)

Margins are negative in warm winters. This obviously is a very risky business that will not attract new entrants under the given cost structure.

This is the preliminary solution to this case. To conclude it, ask the interviewee why and under which circumstances a new entrant can endanger the business for the current monopolistic provider.

IV. Caveats

We have based our calculations and assumptions on the cost structure of the incumbent provider. However, a new entrant doesn’t necessarily have to be a start-up, but can be an existent energy corporation, which has several implications for our analysis:

  • Synergies can be realized through channel diffusion / delivery cost.
  • Administrative and general costs can be lower through synergies.
  • Brand name and market position in related markets (oil, electricity, water) can have a potential influence on business (e.g. client acquisition).
  • Purchasing price can be lower due to stronger negotiation power (e.g. combined order size of gas and oil).

In addition, rules of the game can change in the course of the liberalization that can influence the composition of the cost structure.

V. Conslusion

Under the current circumstances, a market entry of a potential competitor is very unlikely.

Climate poses a real threat to margins, which makes the business very risky for a new entrant to the market.

However, fairly unpredictable changes to the competitive landscape from the regulator as well as a market entry by other suppliers (e.g. electricity, oil, water suppliers) must not be neglected.

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