In this article you will learn how renewable energy developers (think solar and wind) determine the price of electricity under a Power Purchase Agreement or PPA.
We welcome comments on this article from both developers and consumers. To date Solomon has been unable to find any articles that answer the most basic question: How is my PPA price calculated? Indeed, the one paragraph the addresses the topic – a section in the Wikipedia article on Power Purchase Agreements — is inaccurate. Not only does it not answer the question but it confuses production with price and goes on to claim that the regulator sets the PPA price “in a regulated environment.” This is not the case.
We tend to disparage monopoly power. But if utility distribution systems were not subject to monopoly power we would have chaotic and unreliable electricity supply: The wires and transformers and meters and engines that transmit and consume this power would blow up constantly at every shift in load.
Throughout the United States utilities have a monopoly on the distribution of electricity through the grid of overhead and underground wires. Every minute of every day these utilities – and the system operators that coordinate them – balance the supply of generators and demand of consumers.
In contrast to the electricity distribution system, the sale of electricity that flows on those wires is a different story. Since the late 1990s, utility monopoly power has been curtailed in some 20 states and the District of Columbia. Most US electric consumers living in those states have a choice. They can buy their electricity from the utilities that serve everybody. Or they can buy the electricity from third party suppliers.
For those consumers who can only buy from their local utility, the utility sets the price. While there are different prices for different classes of customer – for example, large commercial, small commercial, residential — all customers within a class receive the same price. For an explanation about how utilities set their prices, see our article, How Does the Electric Utility Set Its Price?
In contrast to utilities, third party suppliers have more flexibility in pricing commodity or generation charges. Some charge variable prices that can change daily depending on actual costs. Others lock in prices for terms of months or years. For an explanation about how third party suppliers set their prices, see our article, How Do Electricity Marketers Set Their Prices?
In this article we discuss the merits of choosing a variable or floating price – such as that offered by utilities or third party marketers – or a fixed price.
Utility prices are essentially variable or floating: Utilities fix their prices for a limited period of time such as 3 or 6 months. Third party suppliers have more flexibility: They can offer monthly variable prices or prices that are fixed for seasons such as the winter or summer or for periods of 3, 6, 9 or 12 months.
A consumer who chooses a variable or floating price is subject to changes in the market price of electricity. Market prices respond to many different factors which we discuss in our article, Why Do Electricity Prices Change? In choosing a variable price a consumer has probably concluded that there is a greater likelihood prices will decline than rise.
When choosing a variable or floating price from a third party marketer a consumer is probably also concluding that the marketer’s price will be less than the utility’s price. Indeed, many marketers promise “savings” compared to local utility prices. Caveat emptor! Let the buyer beware: Variable prices do not offer guaranteed savings, irrespective of the marketer’s promises. The marketer’s price may be less than the utility’s price in the first month but there is no guarantee against utility prices dropping – or the marketer’s price rising – in subsequent months.
In fact, third party suppliers that offer variable prices will generally not save consumers money compared to their local utility. Third parties only offer commodity supply and charge for electricity generation; distribution and demand charges do not change and are passed through from the utility. A variable price for commodity offered by a third party supplier will generally, over a long period of time, exceed the utility price. This follows from the fact that the utility does not build a profit margin into its generation charge, which is also variable, whereas third party marketers do. The only mitigating factor is local sales tax which in some states is applied to the commodity portion of utility supply but not of third party supply.
Thus, few consumers will obtain any benefit from third party variable prices unless they are willing to watch competitive pricing and switch suppliers monthly and the utility price, in territories where third party supply is not subject to sales tax, is greater than third party supply by at least the amount of the tax.
Consumers should bear another factor in mind: The reason that some suppliers do not offer fixed price supply is because they can’t. In order to offer fixed price supply the third party marketer must have a balance sheet that can support long term hedges in the financial markets. Otherwise, the marketer would put itself – and its bankers, shareholders and personnel – at risk that markets would skyrocket and the marketer would be forced to buy high priced electricity to meet low price contract demand from customers.
Only a handful of marketing firms have sufficient balance sheets to support these hedges. Accordingly, some marketing firms will tout the benefits of variable price contracts because they have nothing else to sell. They will tell consumers that utility prices are going up – despite the fact that there is never any certainty about future prices. Or they will tell consumers that their prices will save money below utility prices, even though (i) the utility prices may go down in the future and (ii) the utility price itself is a form of variable or floating rate contract.
As we noted, utilities do not offer long term fixed price supply to consumers behind their systems. While prices may be fixed for short terms of up to a half year, any changes in the cost of generation during those intervals will be passed along to consumers during a later interval.
Third party suppliers are not prevented by regulators from offering long term hedges. If market prices go down after a consumer locks in a hedge, the supplier is not obliged to offer the lower prices, as regulators insist utilities offer their consumers.
Buyers of long term fixed price supply may or may not save money relative to utility pricing. If fuel prices and thus generation drops in price, a long-term hedge will cost more than if the consumer remained with utility pricing or variable pricing.
To see how hedges can end up costing a consumer money see the chart comparing the forward one year curve of wholesale natural gas prices to the actual wholesale prices for the period. Natural gas pricing drives electricity pricing in the Northeast and much of the United States because the fuel is used by many electric generating stations.
History of 12-Month Forward Strip vs. Actuals
Wholesale Gulf $$/MMBtu
As the chart shows, if a consumer in June of 2011 had locked in one year forward natgas prices at about $5, he or she would have sustained a loss of some $2 per mmbtu or almost 40%. Electricity prices during such period dropped by a similar magnitude.
Perhaps not surprisingly, energy suppliers do not like to speak about forwards vs. actuals. The chart you see here is published by Solomon weekly; to our knowledge, no other energy supplier follows suit. Why? Probably because consumers might be reluctant to lock in any hedges if they knew the risks of getting it wrong were this great.
Term prices can be locked in for periods of months or years. The length of a hedge will vary based on the willingness of suppliers in the market to offer protection. It is rare to find suppliers willing to offer long term hedges for commercial consumers longer than two or three years. A supplier that offers a long term hedge is not gambling on forward prices; it will hedge its supply costs to assure a margin. To hedge supply it much find other willing sellers. Yet liquidity (i.e., sufficient buyers and sellers to quote prices) is limited beyond two or three years.
If market prices increase during the term of a hedge a consumer will save money compared to utility or variable pricing. If prices fall the consumer will lose money. In either case, at the end of the fixed price term prices for a renewal hedge could be higher and the new hedge could be more costly.
Ultimately the decision to purchase fixed or floating should depend on a consumer’s tolerance for risk.