Demand response auctioning tightens the belt on pure-play providers

We recently talked with World Energy Solutions, an energy management services company that assists with auctioning of electricity and gas supplies, carbon and renewable energy credits. Notably, the company also conducts auctions in which demand response (DR) providers submit bids for government, commercial, and industrial contracts.

While DR providers profit by retaining a share of the revenues from these contracts, World Energy Solutions’ auctioning process motivates them to increase the share of revenue passed on to the customer in order to win the contract.

World Energy Solutions began its DR auctioning program in February of 2010, and it currently has a contract with Alban Engine, a PJM-based Caterpillar dealer, to auction off 1,500 MW of capacity to a number of DR providers. While its service remains in an early stage, increased competition like this can threaten the margins of DR providers that have a narrow market focus. More specifically, it gives the upper hand to utilities that would rather offer DR services directly than work with a third-party DR provider.

Providers with a primary focus on DR currently enjoy healthy gross margins, with EnerNOC and Comverge reporting 45% and 32%, respectively, from DR contracts for fiscal year 2009. However, when competing on price, a DR provider would need to forfeit at least 10% of the contract revenues, given that World Energy Solution’s share of the transaction amounts to roughly 5% of the contract value. This could signify moving from an 80:20 revenue share between customer and provider to a 85:5:10 share between the customer, the auction coordinator, and the provider.

Apply that shift to all contracts, and EnerNOC’s gross margins could drop to about -10%, and Comverge’s to approximately -36%. Meanwhile, more diversified competitors such as Honeywell and Silver Spring Networks, as well as utilities including Constellation Energy and Pacific Gas and Electric, are significantly less dependent on the rates of DR contracts and more capable of undercutting their competition – a concern that EnerNOC has expressed previously (see the September 29, 2010 LRPJ – client registration required). If pricing pressure persists, DR providers without a diversified source of revenues will get edged out. This lesson can be applied to the greater smart-grid industry, where innovative companies once enjoyed the benefits of an early-mover advantage. But as larger competitors enter the maturing smart-grid industry, scale and competitive pricing will determine the victor.