Bills for electricity and natural gas can be a very high proportion of a company and household budget. Accordingly, the way in which commodity prices are set is of material importance to most consumers.
In states and utility territories where the utility has a monopoly on energy distribution, regulators determine how much utilities can charge. Consumers can take comfort in such rules, knowing that they will not be gouged because regulators – elected or appointed by elected officials – will protect them from aggressive pricing practices.
What about consumers in the 22 states and the District of Columbia where the utility does not have a monopoly? In those areas most consumers can purchase electricity and natural gas from third party suppliers. Indeed, in Texas for electricity, Georgia for natural gas, and for some in Ohio and Illinois for natural gas, consumers must buy their energy from third parties other than the utility. What protects consumers from price gouging in those utility territories?
The glib answer is: “The competitive market.” We rely on competition to keep prices reasonable in most consumer markets. Why shouldn’t energy prices be similar? Why wouldn’t suppliers restrain their natural inclination to obtain higher profits from their consumers because of the risk they will lose business to others if they don’t? And if suppliers go too far, aren’t there regulators who will jump in to protect consumers?
In fact, in deregulated markets competition does help to put a brake on unreasonable pricing. However, as this article explains, this is not always the case. Moreover, regulators cannot be expected to step in if and when pricing gets out of control.
It is fair, then, for consumers to ask: How do competitive energy suppliers (e.g., electricity and natural gas marketers) make money? Understanding how energy marketers make money will help consumers understand how there may be times when they are not treated as fairly as they should be. Even if regulators may not act effectively, consumers should be able to take steps to protect themselves.
Energy like electricity and natural gas is bought and sold in an on-line marketplace or in oral transactions over the phone (although oral transactions are immediately confirmed via internet). There are a number of participants in this marketplace:
Throughout the day players in the marketplace buy and sell electricity and natural gas with each other. These transactions fall into two broad categories:
In this section we discuss how and where prices can be found. Below we discuss how the prices themselves are set.
Before deregulation in the 1990s, all energy transactions were conducted bilaterally with the terms agreed upon by phone or in person. Both electricity and natural gas were highly regulated by federal and state law such that the prices were often prescribed by regulation and the parties had little latitude for customizing their supply contracts.
Exchange Price Discovery. With deregulation came the introduction of exchange-traded mechanisms for transacting business. These exchanges, beginning with the New York Mercantile Exchange, provided a platform for buyers and sellers to find each other easily and buy and sell standardized quantities of electricity and natural gas according to standardized terms.
There were several benefits to exchanges. New market players such as traders, who were neither producers nor consumers, provided quick execution (called liquidity).
More importantly the exchanges provided price transparency: All market participants with access to exchange prices could see where business was being transacted at any given moment.
Exchanges continue to perform an important role in price discovery although all energy exchanges now take place electronically. In 2015 the last floor trading operations were closed by the Chicago Mercantile Exchange.
Off-exchange Swap Markets. Today the standardized exchange contracts have been supplemented by off-exchange mechanisms that call for financial settlement and not physical delivery of the commodity. In these contracts, known as “swaps,” wholesale players will agree to exchange payments based on changes in a price index such as an exchange price or a price published by one of a number of public or private enterprises. For many years the prices reached in off-exchange transactions were known to a handful of market participants but were not transparent like market prices. Recent regulations adopted after the Great Recession have required that these off-exchange transactions be cleared by organizations, known as clearing houses, that must publish the prices just as exchanges publish prices.
Index Pricing. It is important to understand the role of index prices. Most indices used in the swaps market (other than the exchange prices themselves) are found in commercial publications. Examples of these publications include the Wall Street Journal, Bloomberg, Platt’s, and Gas Daily. These publications get more granular than the standardized exchange contracts and list prices at a larger number of specific delivery points that are of interest to consumers.
Index prices are determined based on daily or weekly surveys taken by the publications of industry participants who report on a voluntary basis their transactions according to price and volume. The publications then calculate a weighted average of prices transacted in order to come up with an “index price,” essentially an estimate of where industry participants will do business.
Index prices are used in two ways. First, to determine the financial settlements of swaps described above. Second, to determine prices paid under some bilateral contracts. For example, a contract might provide that a natural gas vehicle pumping station will pay a price equal to the average price of Gas Daily over the course of the month plus $1/mmbtu.
Because the index prices are based on surveys of market participants there is a risk that those participants may not file honest reports but rather reports that help move the weighted average index in a direction that is favorable to their trading positions. A producer, for example, that wanted higher prices for its product might report that it did a large trade at a higher price than was true. By including this trade in its calculations the index price will be distorted.
Lying on surveys is considered a form of market manipulation and is illegal. Yet sadly it is still practiced by some market participants. Meantime, publishers of indices are becoming more careful about seeing to confirm the legitimacy of survey responses.
Delivered Prices. Because exchange-traded prices are based on wholesale market transactions for delivery at standardized locations, producers and end-users must still enter into customized transactions in order to get their electricity or natural gas from the source of production to the burner tip or meter. In contrast to exchange-traded prices, these transactions are not transparent.
We have examined the market participants, the transactions they enter into, and where prices can be found. Where do those prices come from?
In another article we explain how utilities set their prices. See How Does the Electric Utility Set Its Price? There we explain how even utilities must use the marketplace price to determine one of the three important components of their regulated prices. In this section we discuss where all marketplace participants get their prices.
Except in cases of market manipulation (see section on Index Prices above), prices are determined by supply and demand. Supply and demand, in turn, are the product of a number of factors working independently or together:
Supply and demand factors are being weighed daily to determine current prices. But they also play a role in long term forecasts.
Market participants look at these factors, both short term (e.g., tomorrow’s weather) and long term (e.g., economy), and decide on what they believe is a fair price. Because of the price transparency provided by the exchanges and clearing houses they can see where wholesale prices are being transacted. They can then determine whether those prices are reasonable and whether they fit their risk appetite.
Most people think that the essence of trading is this: “buy low, sell high.” Interestingly, that strategy is the exception, not the rule. There are several ways in which market participants make money:
1. Speculation. Traders with an appetite for risk may take speculative positions on the market depending on their view of market trends. Suppose, for example, a trader believes that electricity prices are going up. He or she can buy electricity and when prices go up sell for a profit. Similarly, he or she can sell if the market looks weak and buy back when prices drop.
This “buy low, sell high” or “sell high, buy low” is highly risky. Suppose that the market does not move in the desired direction. Closing out the position will result in a loss, not a gain. If the market moves fast and far enough the losses could be substantial.
Speculative trading is the least popular method of making money. It requires tremendous reserves of capital to support the business through bad times as well as good.
2. Markup. Most for-profit companies make money by marking up their costs by a competitive profit margin. The size of the markup depends on many things including competitive pricing and the extent of additional services that might be provided to counterparties.
To determine a price, these companies will take the cost of their supply – short term or long term – and add their margin. Note that in the case of long term pricing these companies must also take into account their cost of capital. That is because a long term hedge ties up capital in the form of margin requirements of exchanges or counterparties from whom they buy their fixed price protection. The cost of tying up this capital must be taken into account in addition to the cost of the underlying commodity.
These companies may also want to include a risk premium. Particularly in the case of full requirements contracts, where the supplier will be responsible for supplying at the same price as much commodity as the consumer uses, a premium for this risk should and generally will be added to the costs calculated before applying the markup.
3. Return on Investment. Producers and independent power producers must earn a return on their capital that is sufficient to justify their investment. If a company cannot produce a sufficient return it should deploy its capital elsewhere. Thus, a producer will look at the cost of drilling and a generator at the cost of construction. Tying up its capital comes with a cost, not only for debt service but for foregoing alternative investments.
4. Consolidated Returns. Some energy suppliers may combine the supply with other services, much as an auto dealer might throw a service contract in with a car. The car might look like it’s being purchased at cost; the real profit is in the service agreement.
Likewise, some energy suppliers have begun to offer to finance energy efficiency upgrades in exchange for a supply agreement. Sometimes the efficiency looks inexpensive – the supplier will offer “free” installation – but the profit is in the supply agreement. Alternatively, a supplier may offer to supply electricity or natural gas at “cost” compared to some index. But the supplier may make money from the cost of transportation or balancing services that it is providing elsewhere.
Consumers should understand how their electricity and natural gas suppliers are making money. If it is not readily apparent it is reasonable to ask. Understanding the supplier’s motivation will help clarify whether pricing is reasonable or whether a consumer should spend more time looking elsewhere for alternative pricing.