Our clients want to lower their utility bills. That is univeral. The question arrises: What are the best ways to do it? What are the best energy supply products and how can they be acquired and put to use?
Most electricity and natural gas consumers consider two basic supply contract options: Fixed and floating price. Like vanilla and chocolate, these two products are so common that consumers ignore the fact that they have other options that may be more suited to their needs.
In this article we describe the different choices available to energy consumers. Note: All utilities and most energy suppliers do not offer some or all of these choices, either because they are not allowed to by law (e.g., utilities) or because they do not have the financial strength or sophistication (e.g., most marketers). Even so, you should insist on discussing with your energy advisors and/or suppliers all of the alternatives to the standard “vanilla and chocolate.”
Note that supply prices cover commodity only, i.e., electricity and natural gas delivered to the consumer’s meter. Utilities charge all customers – whether or not they are served by third party suppliers – for two categories of charges: Distribution charges and demand charges. These charges will appear on all bills to compensate the utility for maintaining its infrastructure.
a. Distribution charges. Distribution covers the cost of delivering the commodity using the utility’s wires or pipelines; all costs associated with maintaining the utility system including labor costs are recovered from this charge. Regulators allow the utility to mark up the costs of maintaining its system. The markup is based on a guaranteed rate of return that is assessed on the utility’s assets or “rate base” and then apportioned to consumers based on rate class and volume.
b. Demand charges. In addition to distribution costs large commercial consumers of electricity are charged demand charges. Demand charges compensate the utility for its maintenance of capacity necessary to meet the highest amount of electricity that might be used simultaneously by a consumer during a given month.
Thus, if a commercial customer turns on its chillers in May there is a spike in demand as the motors draw power. That spike might not be replicated for the rest of the month as the motors start to hum and turn off and on as they are called on by a building’s controls such as thermostats.
However, the utility will charge the consumer for maintaining sufficient capacity to meet that simultaneous demand as if the consumer were using the same amount of electricity all month.
c. Other charges. A few other charges may appear on the bill such as monthly billing costs, environmental surcharges and competitive transition fees. These are generally negligible when reduced to a fee per unit of volume.
Here are the alternative pricing structures available to consumers:
With some exceptions, consumers throughout the country can buy commodity from their local utility. The exceptions are electricity consumers in Texas, natural gas consumers in Georgia, and some natural gas consumers in Ohio and Illinois. In those states regulators have required some or all consumers to purchase commodity from third party marketers who are not the local regulated utility (although remember that the utility still charges for distribution and demand as described above). Note: The third party marketer in these and other states may be an affiliate of the regulated utility using a similar name; although many consumers are confused and think they are buying from the utility, the fact is that the eponymous marketing company is not regulated but a competitive marketer like others.
Utilities pass through the costs of electricity generation or natural gas; they do not mark up or profit from the commodity. In order to collect these costs from consumers the utility uses a three-step process to price its product so that its consumers are paying exactly what it is costing the utility to acquire the commodity for them:
a. First, the utility sets a forward tariff price for the next, say, 3-6 months, based on market prices. It actually buys electricity or natural gas for that period. In some cases the utility will buy, say, half of its annual volumes every six months and blend in the purchase prices so that the six month fixed price reflects the average of the two one-year hedges. The volume that the utility purchases is based on weather and economic forecasts and the price is whatever the prevailing price in the market is at that time (including the price of delivery of commodity in, say, 5 months time).
b. During the period the utility goes into the marketplace to buy additional volumes to meet incremental demand, or goes into the marketplace to sell excess inventory if demand falls. These daily balancing purchases and sales take place every hour in the case of electricity and every day in the case of natural gas. The balancing purchases and sales are necessary because actual usage varies depending on weather and other variables such as the consumer’s own needs. In the case of natural gas the utility may not actually buy or sell incremental volumes but instead may pull or inject more or less gas from storage or into storage.
c. At the end of the period for which it has purchased forward commodity the utility compares the amount it actually spent per unit of electricity or natural gas (i.e., kilowatts or cubic feet) to meet customer needs to what it forecast it would spend. The difference, up or down, is then applied to the forward tariff price for the next period as an adjustment.
Note that utility fixed prices usually do not exceed six months. Utilities do not help their customers fix their prices for longer terms or offer many of the other products described below that are offered by third party marketers. Regulators do not want to see utilities taking risks with their customers’ money. The reason for this can be seen in the following example.
Suppose that a utility hedged three years of forward electricity usage at $.10/kWh. Suppose, further, that during the year the marketplace price for electricity rose to $.15/kWh. Customers would be fortunate; the utility hedge would protect them from the higher marketplace prices and they would be billed for $.10, the utility’s costs.
But suppose that during the three-year period of the hedge the marketplace price for electricity dropped to an average of $.08/kWh. Regulators would want consumers to receive the lower price. They do not want the utility to pass on its actual costs of $.10. The utility would take a loss on electricity it delivered to consumers at $.08 when it had to pay its suppliers $.10. Although the losses occurred in an effort to help consumers, regulators will not allow the utility to pass on the loss. The utility’s shareholders, therefore, would need to absorb the loss.
Accordingly, customers who buy from utilities take the risk that the structural changes in supply and demand will drive up electricity prices after the 6 month or one year period that the utility buys forward. For longer-term hedges – or for other pricing structures — they must turn to third party marketers.
With third party suppliers consumers can “lock in” prices for forward supply for terms of as few as 3 months to as long as five years. Most fixed price deals are transacted for 1-2 years. As noted above utilities do not offer long term fixed prices beyond six months because of the regulatory treatment of long term hedges.
A fixed price contract protects a consumer from higher prices during the term of the contract. At the same time, a fixed price contract poses the risk of what is known as opportunity cost: If prices in the marketplace drop during the contract term the consumer foregoes the opportunity to purchase at the lower prices.
Most homeowners are familiar with the risk of fixed price contracts: Some 80% of homeowners lock in the interest rates on their mortgages. These homeowners take the risk that interest rates will go down and not up. Indeed, since 1980 when mortgage rates in the United States peaked at close to 20%, most homeowners who have locked in their mortgages have paid more than those who chose floating rate or variable rate mortgages. Nevertheless, most consumers continue to pay the premium in exchange for the peace of mind they feel by protection from inflation.
For an explanation of how third party suppliers make money from commodity sales see How Third Party Marketers Make Money. This section describes some of the features of fixed price hedges.
Full Requirements. For small commercial customers a fixed price contract will generally cover all of the electricity or natural gas a consumer may use. Such a contract is known as a “full requirements contract.” Suppose a small businessman operating from his or her home were to close its business down and move to Florida for the winter, its usage would probably drop close to zero. Nevertheless, the fixed price would apply to whatever volumes the business used when the owner returned in the spring.
Swing Contracts. Large commercial customers are frequently limited in their ability to lock in fixed prices to finite volumes. If those consumers use more than they bought they will pay market prices. If they use less they will be required to pay for the unused commodity. These contracts are sometimes referred to “take or pay” contracts: You must take and pay for what you contracted for.
To limit the risk of “take or pay,” commercial consumers can buy fixed price contracts that protect them from higher prices for a flat projected quantity of electricity or natural gas that they are confident they will consume during the forward period. They will take the risk that additional volumes they use – if their factory gets more orders, for example, or if their store uses more electricity during a hot summer – will cost more. They will also take the risk that they use less during a period when market prices drop and their supplier will charge them for losses on the unused volumes.
Some suppliers will offer consumers a fixed price that will cover some portion of the difference between projected volumes and actual volumes. These contracts are known as “swing” contracts and will specify the amount of swing around the projected volume. The supplier may cover 25% of the swing, for example. This means that if a consumer hedges, say, 10,000 kWh per month the fixed price will apply for any volumes between 7,500 and 12,500 kWh in the month.
Cancellation Charges. Consumers of fixed rate must be aware that cancellation of a supply contract before the term expires will often come with a penalty. This penalty is reasonable: Suppliers, after all, do not gamble on prices going down but rather buy forward commodity and pass along the hedge prices – with a profit margin of course – to consumers. If a consumer leaves before the hedge expires the supplier would incur a loss if market prices had decreased below the hedge price.
Of course, market prices could increase and the consumer might still walk away in which case the supplier would get a windfall. Most suppliers will charge an exit fee in either event but commercial consumers should make sure that if market prices are higher they should not be charged because the supplier will not lose money in that case.
Automatic Renewal. Many fixed rate contracts will contain an automatic renewal clause that will trigger within, say, 60-90 days before the expiration of the contract. Consumers should make sure that they must be notified and give affirmative asset before renewal. Otherwise they may find they have locked in prices for another long term at prices which are not competitive.
Consumers may choose to let their supply prices float with the market. Variable rate supply agreements are similar to variable rate mortgages: The consumer takes the risk that market prices will go up in exchange for the potential that prices will go down and their bills will drop below the fixed price.
Variable rates are attractive to commercial consumers that can pass price increases on to their customers. Other commercial consumers may conclude that they cannot pass increases on without becoming less competitive; in that case they may prefer to fix their prices.
There are a number of important considerations for consumers choosing the variable rate option:
Bait and Switch. Since utilities deregulated in some 22 states and the District of Columbia, numerous marketers have been accused of so-called “bait and switch” tactics in which consumers have been attracted to variable rates that offered savings below prevailing utility prices in the first month. Often suppliers have counted on consumers “going to sleep” and have taken advantage of them in subsequent months, raising prices above the local utility price.
Unlike mortgages in which variable rates are frequently “capped” on an annual basis or set as a premium to a published interest rate such as the Prime Rate, commodity suppliers rarely offer caps and do not tie their variable rates to any published rate.
Consumers of variable rate contracts must be vigilant during the contract term to make sure their variable rate continues to be attractive relative to the utility “price to compare” and to other competitive supplier rates.
Index Plus Contracts. Commercial customers in some markets may be offered contracts that charge a fixed premium to a specific published index. The “plus” or premium might take into account the pipeline transportation cost for natural gas, for example; this pipeline cost might be volatile and so a consumer may wish to protect itself from sudden spikes in this cost while leaving the underlying commodity price floating.
Cancellation Charges. Most residential or small commercial consumers of variable rate supply should not be charged if they cancel their contracts and switch to utility or fixed rate supply. This is because suppliers take little or no risk from departing customers.
Some commercial customers may be charged an exit fee if the supplier has locked in a transportation cost or has purchased options to cover the risk in a swing contract.
Some consumers may have greater risks in some seasons than others. For example, a big box store may have high electricity costs in the summer when air conditioners are running at full tilt. To protect itself the store may wish to lock in summer electricity prices.
Likewise, a manufacturer – an asphalt producer, for example — may have a seasonal business and be most exposed to price increases in that period.
In these cases, consumers may lock in prices for seasonal periods while allowing other periods to float.
Options are rights but not obligations. A call option is a right to buy and a put option is a right to sell. A call option would protect a buyer from the risk of higher prices while preserving the opportunity to take advantage of lower prices if prices decline.
Options are attractive in theory but are not practical. Options are priced based on a number of factors; the most important of these is so-called “volatility” which is a statistical measure of price movements over time. See Why Do Electricity Prices Change. The price of an option is proportional to volatility and will be very high for electricity because electricity is one of the most volatile commodities on the planet.
Options are frequently compared to insurance but the analogy is not a good one. Insurance costs are socialized, i.e., they are spread over many consumers that share in risks that will not be borne by all of them. Options, on the other hand, protect against risks that all consumers will share (if prices increase, for example). As a result, insurance costs are far lower as a percentage of the risk than options costs.
An option requires two payments: One for the option and another at the time it is exercised into the commodity. In order for a consumer to recoup the value of a call option that protects against higher prices the cost of the commodity would have to rise higher than the sum of (i) the price of the option and (ii) the commodity price on the day the option is struck. Because the option premium is so high relative to the underlying commodity – often as much as 15-20% for one-year protection – the commodity price would have to rise by 20% or more above the option’s strike price to justify the option cost.
While impractical there may be some cases in which an option makes sense:
Extreme protection. The price of an option declines the farther the strike price is away from the current market. Suppose electricity today is $.08/kWh. A $1/kWh call option will cost a fraction of the cost of a $.20/kWh option.
A commercial consumer might conclude that it could pass on to its customers price increases of electricity up to 10x today’s prices but not more. The high strike price might be cheap enough to justify the outlier protection.
Collars. A call option that a commercial consumer buys can be paired with a put option that it sells in order to keep the price low.
Suppose, for example, that a manufacturer wants to protect itself from higher prices in order to stay competitive. But the cost of a call option is too high. The manufacturer can take the risk of lower prices; indeed, if prices drop its orders will increases and it will want to buy more commodity.
This manufacturer could buy a collar from the supplier: It buys a call option that protects it from higher prices at the same time that it sells a put option that allows the buyer of the put to sell or “put” to the manufacturer more commodity at a lower price. The risk to the manufacturer is that if prices drop below the put option price the manufacturer may buy the additional volumes put to it at a higher price than competitors.
Some suppliers may permit their customers to “trigger” or fix their prices from time to time for all or part of the remainder of the contract term. A consumer may publish a price list every few months, for example. In this industry – say a restaurant that publishes a menu on line — prices change periodically but need to be fixed for at least, say, 3 months.
In this case the consumer may wish to buy its supply on a floating basis with the option to call the supplier and lock in prices for a few months in advance. A long term supply agreement will give the consumer a reliable source of supply (and other things such as billing) while the trigger will give the consumer flexibility in pricing.
Remember the discussion of options? A right to buy or sell can be very valuable. Suppose instead of buying an option a consumer sells to its supplier a put option, i.e, a right to sell additional volumes in the future, say, at the end of its contract term. The option is very valuable and the consumer will receive the benefit. The value of the option can be used to reduce the cost that the consumer will pay during the initial term.
For example, suppose the two year price of electricity is $.10/kWh. At the end of the two year term a commercial consumer would have the ability to buy at market prices. But suppose the consumer is willing to forego the possibility that prices will be lower than $.10/kWh in two years; the consumer is confident that if prices are lower it will still be able to pass on to its customers the $.10 cost.
The consumer could offer its supplier the right to sell the consumer at the end of the two-year contract another two years at $.10. For this right the supplier may pay a lot, say $.02/kWh. If at the end of the two years market prices are $.08 the supplier will be able to get $.10/kWh by exercising the option. Meanwhile, the consumer may lose the potential of buying below $.10; if prices are higher it will pay more but it would have expected to do that anyway at the time it renewed its contract.
The premium of $.02 can be applied today against the current cost of $.10. The consumer could therefore pay $.08/kWh for the next two years, lower than the marketplace (and lower than any of its competitors are paying).
The extendable structure can be very attractive in some industries. Note, however, that there are accounting consequences. The consumer may be required to pay taxes on the $.02 premium since it is receiving the benefit of that payment now even though the supplier might not choose to exercise the put, if at all, for another two years.