Can We Lock in Long Term Electricity Prices and Hedge Against Higher Prices?

U.S. utilities do not provide long term price protection for their customers.  Although prices may be fixed for periods of six months at a time, these prices are place-holders only:  The utility can adjust the prices in subsequent periods based on its actual costs of service.

Since the days of Thomas Alva Edison, regulated utilities do not profit from electricity or natural gas supply.   Commodity prices are passed through to customers.  The utility and its investors make money only from their hard assets and variable costs related to those assets.  Regulators permit the utilities to earn a fair return on capital from their investments in infrastructure:  Generation (although few utilities own their own generating stations today), wires, pipelines, trucks, equipment inventory, and the work crews that deal with emergencies.

How can a consumer lock in long-term prices then?

For consumers in the 20 or so states and D.C. where utilities have faced deregulation, competitive suppliers can offer a fixed price alternative to variable utility pricing.   These long-term hedges can range from as short as 3-6 months to as long as 5 years for large consumers.

Unlike utilities, third party competitive suppliers in the deregulated states can earn a profit margin on commodity supply.  While variable priced supply has little advantage over utility pricing, fixed price supply entails risk and retail energy suppliers are entitled to a markup for their long term supply.

First, in order to offer its customers a fixed rate for a long term the retail energy supplier must lock in its supply costs for terms comparable to those it gives its customers.  The failure to back its customer contracts with long term supply could be lethal to the retail energy supplier in times of market volatility.

These long term purchases are costly.  Whether the supplier hedges its risks in bilateral financial swaps or long term physical supply agreements, the seller will ask for some kind of security or collateral protection that protects it if the retail energy supplier walks away from the agreement.   This collateral is known as margin and can equal as much as 10-15% of the cost of the underlying commodity.  In the case of large consumers this ties up large amounts of capital and can therefore prove quite costly for the retail energy supplier.

Second, while the retail energy supplier can lock up electricity or natural gas supply to meets its customer’s contracted needs, those needs change daily and in the case of electricity hourly.  The retail energy supplier must monitor its consumers’ use closely and balance its actual needs with the supply it purchased.

Supply is often purchased based on historic energy consumption.  But actual consumption does not mirror historical consumption.   The retail energy supplier must be prepared to buy and sell electricity and natural gas daily (or hourly).  A failure to do so will result in penalties to the supplier imposed by the utilities or Independent System Operators that manage the electric utility grid.

Moreover, in the case of small commercial or residential contracts a retail energy supplier faces what is known as “full requirements” risk.  Regulators often require that retail energy suppliers offer these consumers enough supply to meet their needs which could be more or less than historical consumption curves.  In a cold winter – such as the Northeastern United States faced in 2013-14, the so-called Polar Vortex winter – the amount of incremental supply may be far more than planned.

In other words, if prices spike as they did during the Polar Vortex, the retail energy supplier faces two risks:  The risk that supply prices will go up and the risk that consumption will increase.  Price can be hedged in the long term market by buying from other suppliers or by entering into financial swaps or futures contracts with counterparties or the regulated exchanges.

But consumption cannot be hedged.  The retail energy supplier might keep close tabs on the weather and buy incremental volumes (or shed existing supply volumes) as forecasts change.  But these will never simulate exactly the actual changes in volumes.

Accordingly, a retail energy supplier can offer consumers long term fixed price hedges but at a cost that utilities do not face because they do not offer the service.

Each retail energy supplier will charge a different markup for its fixed price supply contracts.  It is rare for two offers to be the same.  Consumers, therefore, are well-advised to shop for long term prices by working with a broker to compare supplier offers.

In this article we have addressed how consumers can enter into long term price hedges in deregulated markets.  Fortunately, these deregulated energy markets cover most of the large population areas in the United States.  For the remaining consumers, despite the absence of formal deregulation of their markets, other strategies may be possible.

For example, although electricity may not be deregulated a large consumer may wish to hedge the price of the prevailing fuel used to generate electricity in its region, e.g., natural gas.  The consumer could purchase long term natural gas supply in order to protect against higher electricity rates charged by the local utility in the event of higher supply costs.

Finally, consumers should be mindful of the fact that commodity prices do not always go up.  A long term hedge protects against higher prices.  But it can also forego lower prices that could have increased profit margins.  A competitor that did not hedge, for example, could enjoy those increased margins and may even be able to lower its prices to consumers whereas the company that hedged would be less competitive.

Consumers who enter into long term hedges should examine closely historical trends in order to assess the risk of these downside opportunity costs.