Is demand response a commodity yet?


Fruit roll ups logo.

This post has something to do with roll-ups. Incidentally, there are no funny pictures on the internet about roll-ups. Better luck next week.

Two pieces of news broke last week that I thought were pretty significant. One is that Constellation Energy announced on Friday its intent to acquire demand response (DR) provider CPower. The other is that World Energy Solutions (NASDAQ: XWES; TSX: XWE), which runs DR capacity auctions for its clients, announced on Tuesday that it auctioned off a whopping 1.5 GW of DR on behalf of a single customer.

Together, these two announcements scream “commoditization.” What I mean when I say that DR is becoming a commodity is that two vendors selling a unit of DR in the marketplace have nothing by which they may differentiate their respective products, except for price.  When that happens, it’s possible to sell that product through an auction, where price is by definition the only way vendors can compete with one and other.

So, what does this mean for broader demand-side management industry?

First off, commoditization should result in significantly lower margins for DR vendors. World Energy claims this to be the case, with an average of 80% of DR revenue in their auctions being retained by the customer. Interestingly, the poll on their homepage tells a different story:

Survey results from worldenergy.com

I assume these are the results of those who are merely those perusing the website and not yet customers. It’s more of a look into the past than the future, which is pretty dramatic if you think about that 42% mode of vendors moving from the 45-60% bucket to the 76-90% bucket.

Let’s look at the other side of the equation: 100% minus the vendor share is the gross margin of the DR vendor, the best comp for which is EnerNOC (NASDAQ: ENOC). I use a  trailing twelve month (TTM) average gross margin in an attempt to remove the summer peaking seasonality below:

Source: CapitalIQ data

It’s interesting that the TTM average gross margin started to decline after the summer of 2009. Q1-2010’s number was as low as 34%.

So, what should we expect from an industry that’s commoditizing, with potential gross margins in the range of 20-30%, or maybe less? In a word, consolidation.

Consolidation allows companies to leverage synergies and economies of scale to remain profitable at lower gross margins. It’s particularly common in commodity industries, where price swings are cyclical and the best way to protect against their punitive effects is to be big. Rob Day had a nice post about roll-ups earlier this week (of the non-fruit variety), and I (and others) think that the CPower acquisition won’t be the first of these we’ll see in DR.

For others in the demand-side management industry, this consolidation could be a good thing or a bad thing, depending on your perspective. On one hand, commoditization should expand the market significantly and introduce a whole new set of customers to the notion of managing their demand actively. On the other hand, companies like EnerNOC will find it increasingly difficult to find customers who are profitable just on DR revenue. Fortunately for EnerNOC, it has anticipated this change well and has built a portfolio of other products to sell to its customers. This wholeistic approach will be the right way for vendors to approach the commoditization issue, but only the larger ones will be able to execute on it.

Overall, I see the maturation of DR as healthy indicator of progress in demand-side cleantech. New startups can specialize in solving hard problems around the granular management of behind-the-meter assets and will be able to use companies like EnerNOC as channels to market. At the same time, firms like EnerNOC will continue to outsource product innovation and focus on customer acquisition and retention. A healthy big company / small company ecosystem has begun to flourish in demand-side management, and it will certainly be interesting to see how the next five years play out.

Do you agree/disagree with my assessment? Feel free to comment below.

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5 Responses to Is demand response a commodity yet?

  1. Scott Ameduri says:

    RE: World Energy / Alban
    Read the press release at http://www.worldenergy.com/about/newsevents/press/default.cfm?pressID=158 a bit more carefully. It says “an alliance with Alban Engine Power Systems (Alban Engine) that provides World Energy the opportunity to auction over 1,500 MW of load Alban Engine currently has under maintenance service contracts.”
    The key word there being _opportunity_ — they have not in fact auctioned off 1.5 GW of DR yet.

  2. Anuj Mathur says:

    Alex – Really interesting post.

    Another data point: Basic (and attractive ROI producing) DR technology is replicable, and I’ve met with a couple of late-comers who have done so. They’ve had their products adopted, albeit on a small scale. Adoption of their products was a function of price competition, more so than technology differentiation – one company openly stated they compete on price, and target margins below that of EnerNOC.

    What are your thoughts on areas for DR players to target in order to fight margin contraction?

    – Anuj

    • Alex Taussig says:

      Hi Anuj,

      Thanks for reading. Until the market expectation is that DR become 100% automated, you will always have “mom & pop” DR companies that can beat out larger players like EnerNOC on a small scale. However, if they try to grow their businesses beyond a couple million dollars of revenue, they will run into scalability challenges, especially at a price point where they’re basically giving the product away. So, EnerNOC will compete with tiny, local players in lots of markets. This will probably add to the price erosion, but I don’t think these smaller companies will be businesses that you or I would envy.

      It’s similar to the gym business (as my HBS friends will testify too) in that Gold’s Gym is always competing with tiny mom & pop gyms attempting to undermine their pricing. In aggregate, they just drag the overall market price down, but none of them in and of themselves are a good business.

      The best way to fight margin contraction is with technology. If you can do something that allows you to scale quickly or enables you to provide a product or service your customer needs AND can’t get elsewhere, you can capture part of the value you create. Otherwise, margins trend to the cost of capital, which is low here.

      -Alex

  3. dbmees says:

    A very perceptive piece, Alex. One other data point to consider: while World Energy’s auction process, i.e. pitting demand response providers against each other in a real-time competitive event, does transfer margin from DRPs to the customer, the process actually benefits DRPs by bringing them highly qualified customers at virtually no acquisition cost. Just look at the balance sheets of ENOC and others to see how high that customer acquisition cost is, and you can begin to see that providing them an additional channel to market — at no/low cost — could be a positive for the entire ecosystem. Jevan Fox, an analyst at Pike Research who follows demand response closely, has some good perspective on this as well.

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