Linking Loyalty & Profitability

UNDERSTANDING THE LINK BETWEEN SERVICE, LOYALTY AND PROFITABILITY IN COMPETITIVE ENERGY MARKETS Philip E. Lewis and Juhani Leppänen University of Vaasa, Finland ABSTRACT The vast majority of customers in deregulated electricity markets have remained loyal and incumbent electricity suppliers have frequently managed to substantially increase profits despite uncompetitive offerings.

This paper summarizes international, and especially Finnish, research findings including researches by the authors conducted on over 150,000 residential electricity customers. The paper explores the link between service, customer loyalty and supplier profitability in deregulated electricity markets.

Findings indicate causal links between service, loyalty and supplier profit, but suggest that the dynamics of this inter-causality are more context specific and intrinsic customer orientation is more pragmatic than is commonly assumed.

INTRODUCTION In an industry where pre-deregulation satisfaction has been moderate, where large price differentials between suppliers abound and where customers have been saddled with incumbent suppliers, it would be reasonable to expect large proportions of customers to change their suppliers, assuming the absence of substantial switching barriers. However, despite extensive marketing attempts by prospective suppliers, the vast majority of customers in deregulated European, North American and Asia Pacific electricity markets have remained where they are. Some incumbent electricity suppliers have consequently managed to substantially increase their profits by taking advantage of this paradoxical situation.

The argument that customers do not behave in a rational way would certainly seem to be confirmed within the Nordic (Finnish, Swedish and Norwegian) residential electricity supply market for instance. After more than five years of full deregulation, despite moderate customer satisfaction and price variations between suppliers of up to approximately 300%, only around one in five customers have chosen a new supplier. It is not as though choice does not exist either, since customers can typically choose between around 20-50 suppliers currently offering electricity to non-incumbent customers – and there are no significant structural barriers to switching.

In other markets such as Austria, Australia and the USA for example, experiences have also derived similar conclusions (Hujber et. al. 2002, Olden et. al. 2003, Tschamler 2003). Even in Britain, where proportionately more electricity customers have switched supplier than in any other market, the majority of customers have stayed put and there is now evidence of increased profiteering from suppliers.

After six years of analysis of many deregulated electricity markets, the writers have concluded that the complexities of loyalty are such that we cannot judge rationality, nor predict loyalty or customer lifetime value based on simple indicators (Lewis 2004).

Measurement of these issues requires far more rigorous analysis of more appropriate data than is commonly appreciated, for instance, by CRM-related systems and their operators today.

The research indicates that the behaviour of electricity customers is in fact both explainable and logical if we look at the whole picture.

THE FINNISH MICROCOSM The Finnish residential electricity market is interesting for several reasons. Not only is it one of the most deregulated markets in the world and a frequently cited example of best-practice (IEA 2004), but its three million customers were awarded choice at almost exactly the same time as the nearly ten times bigger British market and its process of deregulation is largely similar to most other deregulated electricity markets, especially those in the Nordic region (Commission of the European Communities 2003, Lewis et. al. 2004, Lewis 2003).

Furthermore, comparative research has indicated that Finnish electricity customers’ willingness to switch is also similar to that in other deregulated electricity markets, as are customer satisfaction levels and opportunities to save money (Commission of the European Communities 2003, Lewis 2003, VaasaEmg and Sener 2001). Even deregulated electricity supplier behaviour can be said to be said to follow broadly similar patterns in Finland and elsewhere (Lewis 2003b). With these similarities in mind, it is perhaps surprising and interesting that whilst competition in the British residential electricity market resulted in net switching levels of 40-50 percent, Finland has only recently exceeded switching levels of 10 percent. Within this context Finnish electricity suppliers have managed to secure good and recently rapidly increasing profits from loyal customers.

It is argued that the Finnish electricity market can therefore be seen as a microcosm and a comparative benchmark by which to investigate customer loyalty and value in deregulated electricity markets in general. This article therefore focuses primarily on research findings from the Finnish residential electricity market, whilst considering those findings within the context of the broader international electricity deregulation experience. Consequently, unless otherwise stated, the following findings relate to, and are supported by, Finnish research conducted at the University of Vaasa, which will be released in more detail in future articles.

LOYALTY MYTHS One commonly cited factor which might explain loyalty (switching) differences between similar markets is offer-pricing or price-matching. In Finland, unlike Britain, for instance, customers can ask for better offers from their incumbent electricity supplier, rather than switching to another supplier. However, recent research (Lewis et. al. 2004) found that only seven percent of residential non-switchers in Finland stated that their loyalty was influenced by them having negotiated a better offer from their incumbent supplier. Only six percent felt that they were influenced by having received a better offer without asking.

A second factor that might explain switching differences is the initial price restriction that was placed on, for instance, British incumbent suppliers (preventing them from reducing their prices to match those of competitors). No such restriction occurred in Finland. However, once again this is a weak argument when you consider that regardless of these restrictions, opportunities to save in Finland are at least equal to those in Britain. Furthermore, switching in Britain has continued strongly even after price restrictions have been removed, and switching in Norway and Sweden has been far higher than in Finland without the British ‘advantages’.

The evidence therefore suggests that whilst the above mentioned factors may well have reduced Finnish switching levels the primary explanation for differences in switching levels lies not in the pre-determined deregulated environment but in two completely different factors: customer psychology and supplier marketing. To be more precise, the interaction between customers’ minds and suppliers’ actions is at the heart of the switching levels in Finland and arguably also elsewhere.

DEFAULT LOYALTY Research indicates that in recently deregulated markets loyalty is the natural state for a typical residential electricity customer. There is not a single market in the world where the majority of customers have changed supplier. In most markets, including Finland the switching level is low and likely to remain that way in the foreseeable future. This is not to say that the majority will never switch. As habits change and marketing improves, active choice for electricity may become the norm, but as we all know habits change slowly.

In fact recent British and Finnish research (Giulietti et. al. 2003, Lewis et al. 2004) has found that psychological barriers to customer switching are inevitable and therefore even uncompetitive offerings may be accepted by incumbent customers. In other words, incumbent electricity suppliers retain considerable market power due to the impact of the search and switching costs facing customers. Consequently, the likelihood of customers becoming disloyal, whilst not great, depends to a large extent on their perception of the relative costs and benefits associated with switching. If suppliers are to control loyalty they must therefore exert control over customer perceptions through a measured interaction with customers.

THE OVERALL PICTURE Since 1997 detailed research by the writers has analyzed customers’ perceived costs and benefits within the context of electricity customer loyalty drivers, including customer motives, society as well as the marketing and regulatory environment. A simplistic summary of the key drivers suggested by this research is given in Figure 1. This figure is not intended to present a firm theory, nor is it intended to dispute previous theories. Instead it presents a collection of observed influences of residential electricity customer loyalty.

There are very many issues which matter to customers in the context of electricity purchasing decisions, but customers apparently mentally aggregate the complex array of concerns to derive a more simplistic view on the situation. In other words customers ultimately evaluate and are driven by broader issue categories or need drivers which might be simply labeled. The writers have initially labeled these issues lifestyle, predictability and fairness. The consideration of such issues by residential electricity customers influences their perceptions of the costs and benefits relating to their choice of electricity supplier.

Whether or not there is a change in loyalty depends however upon behavioural facilitators, categorized and labeled here as individual, situation, contact and relationship. Except for individual, these behavioural facilitators are largely the responsibility of competitive suppliers, a reality which the Finnish electricity suppliers have largely underestimated or restricted, thus inhibiting customer activity.

Whilst some individuals may be more pre-disposed to switching than others, few could be considered to be actively concerned with the issue of electricity. Furthermore, customers’ generally hectic lifestyles typically preclude the development of sufficiently salient thoughts regarding changing electricity supplier. In most cases, the main individual characteristic which therefore matters to an electricity supplier concerned about customer loyalty is whether a given customer is genuinely open to the idea of changing supplier, or whether their predisposition prevents such consideration on the grounds of for instance risk or change avoidance or concern about saving money.

Figure 1

Loyalty Drivers (Source: Lewis 2004) Nature of Utilities

Lifestyle more time, more money, less stress, more fun (requires customization: flexibility, individual treatment, responsiveness)

Loyalty Marketing

The Individual pre-disposition, personality, energy & thought salience

Predictability security, consistency of service, proof of capabilities

Situation opportunity, pressure, environment & time

Loyalty

Contact interaction, awareness & education

Other?

Relationship involvement, perception, structure & strength VS alternatives

Aquisition Marketing

Fairness equality, ethics (genuine), flexibility good intent, individualization

Nature of Regulation / Reg. Reg. Activity

The identification of such negatively pre-disposed customers leads naturally to the identification of potential switchers who should in most cases be viewed as responsive only if led by the hand throughout the switching decision-making process. An interesting, though incomplete, check list to assist this segmentation is provided by Guilietti et. al. (2003).

THE ROLE OF EXPERIENCE AND SATISFACTION Two factors which seem to be relatively minor (though not insignificant) determinants of loyalty are past loyalty relating to other services, and satisfaction. Concerning past behaviour, even though those who have switched electricity supplier in the past seem to be more likely to switch in future, we cannot say that those who have switched in other industries are particularly likely to switch electricity supplier, nor can we say that just because a customer has not switched in any other industry they will not switch electricity supplier.

Concerning satisfaction, whilst satisfaction is closely related to loyalty it does not correlate closely with it and thus increasing satisfaction does not correspondingly increase customer loyalty. In fact dissatisfied customers often remain loyal and many switchers are satisfied (Ofgem 2003, Lewis et. al. 2004). Recent Finnish research (Lewis et. al. 2004) even found that customers who felt the most likely to switch in future were generally very satisfied and

customers who stated satisfaction as a reason for loyalty were generally only moderately satisfied. Furthermore, to limit the role of satisfaction still further, most customers are already satisfied enough and do not feel a real need for greater satisfaction (after all, customer do not buy electricity for the purpose of extreme satisfaction).

What appear more significant than simple satisfaction are factors such as consistency, ethics and flexibility in service. In Finland as well as Sweden and Norway for instance, negative media publicity about prices has been extreme over the past year or two and this has coincided with reduced levels of satisfaction and increased switching levels. Many Finnish customers even state, in research, that they are switching out of principle or because of dissatisfaction due to price rises. It would in fact seem that the emotive issue of fair prices provides a good kick-start to customer switching activity.

When building our check-lists of likely switchers, we must therefore be careful not to fall into the trap of relying too heavily on historical data and simple criteria. We should be mindful of the fact that customer loyalty is complex and for instance heavily determined by directness of marketing, relationship complexities (such as loyalty schemes and other involvement issues), as well as the ease and clarity by which customers are provided information and switching opportunities.

THE DYNAMICS OF LOYALTY Another complication to the understanding of electricity customer loyalty is that satisfied customers’ loyalty decisions appear to work differently to dissatisfied customers’ loyalty.

Whilst satisfied customers seem to become disloyal only if their perceived switching costs are lower than their perceived switching benefits, dissatisfied customers are likely to become disloyal only if perceived switching costs are lower than perceived loyalty costs. In other words, dissatisfied customers often appear remarkably accepting of their situation and aim primarily to reduce dissatisfaction. The historical reality whereby electricity and other utilities customers have often simply put up with monopoly service regardless of the quality and the level of their satisfaction, may have something to do with the prominence of this finding.

In any case the balance of the complex variety of costs and benefits is normally weighted in favour of the costs. Suppliers need to realize not only that costs and benefits are many and varied, but also that there can be no half-way house. Either the balance is right or it is not.

To complicate the dynamics still further, electricity customers often add cognitions to their cost-benefit evaluations with the simple intention of avoiding change. Many customers simply do not wish to switch and if they can convince themselves that switching is pointless (they mostly already feel that it is otherwise uninteresting and un-motivating), then they will do just that. The long list of complications may also include considerations of the predictability of benefits and risks, including variable feelings of risk associated with different tariff formats.

Perceived complications may also arise as a result of game changes imposed by competitors.

Non-comparable or un-transparent benefits, including environmental characteristics and inconsistent discounts, all add to the complexity of the switching decision. Finally it should not be forgotten that the lowest risk option is normally associated with the incumbent supplier. All other things equal, customers feel safer where they are. The incumbent supplier is, after all, familiar and usually safe even if it is not perceived as a good service provider. In other words, there is a case of “better the devil you know”.

It is clearly logical therefore, when all is said and done, that attention, interest and desire do not substantially determine loyalty in the electricity industry.

COMMUNICATING A RELATIONSHIP Loyalty should not be taken out of the context of the customer relationship. If suppliers are to achieve loyalty and maximize customer lifetime value, customers must clearly perceive the relationships that they are in. Not only is service, satisfaction and price important in this respect, but customer attraction to differentiated and customized characteristics of the suppliers’ offering, regular positive customer contact, loyalty schemes, successful public relations, billing quality, good service recovery, flexibility, the human touch and other requirements also matter greatly to electricity customers. Nor can suppliers forget that they are essentially perceived as simply energy suppliers and any attempts to broaden the relationship require extensive developments in trust.

STAGES OF LOYALTY Research (Lewis 2003c) has indicated that the Finnish electricity market, including loyalty levels, have passed through several stages of deregulation. These stages indicate that loyalty also has a significant time-element attached to it. For everything there is a right time and place, and the same seems to hold true for loyalty. Suppliers should arguably consider these stages when timing their loyalty-related marketing efforts.

Figure 2

Stages of Deregulated Electricity Market Competition (Source: Lewis 2003c)

LateLate-Attacks

Overlaps

Pre-Full Deregulation

Improvements Improvements in in Price, Price, Service Service & & Marketing Marketing Communications Communications

Early-Full Deregulation

Intensive Intensive Price Price Cutting Cutting & & Marketing Marketing Activity, Activity, Widening Widening Price Price Differentials, Differentials, Learning Learning by by Experimentation, Experimentation, Rapidly Rapidly Increasing Increasing Customer Customer Awareness Awareness

Mid-Full Deregulation

Most-Switching Most-Switching Happens Happens Here, Here, Customer Customer Awareness Awareness & & Intentions Intentions to to Switch Switch Peak, Peak, Suppliers’ Suppliers’ AwareAwareness ness & & Re-Thinking Re-Thinking

Mature-Full Deregulation

Pragmatism, Pragmatism, Balance Balance Sheets Sheets Take Take Centre Centre Stage, Stage, Prices Prices Rise, Rise, Customer Customer Switching Switching Intentions Intentions Pass Pass Their Their Peak Peak

THE VALUE OF LOYALTY One of the strongest arguments for strategies which build loyalty is that greater loyalty can allow higher prices and that smart loyalty related strategies can actually save money.

Research has indicated that by understanding loyalty, it is possible to target spending on factors which efficiently deliver high levels of loyalty. In doing so, customers’ price elasticity can reduce, enabling higher prices and revenue. This super-value scenario may sound idealistic but to a limited extent this approach is already being applied successfully by some electricity suppliers, especially in the Nordic region.

Even if the efficient targeting of service dimensions does not take place, supplier awareness of the loyalty issues and dynamics mentioned within this article can allow pricing which maximizes profit by estimating and predicting customer loyalty within the context of loyalty influencers. Many Nordic electricity suppliers, for instance, whilst generally not particularly scientific in their pricing methods, are fully aware of the fact that so powerful are the barriers to disloyalty (switching) that only monumental prices levels will cause disloyalty on a scale that would significantly harm their economies of scale. Pricing decisions are therefore often more dependent on owners political decisions and on corporate views relating to acceptable disloyalty levels than on fear of disloyalty through high prices. In fact it has been found that in reality, in some cases, the economics of the electricity suppliers are such that even by moving from an average price to the highest price in the market, any realistic loss of customers would not nullify the net revenue and profit benefits derived from the price rise.

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