This post is the second in a three- part series that delves in to the details of electricity products and pricing. This first post is found here and covers fixed price products: what they can do for a business, and how suppliers manage risk and exposure when pricing a fixed price product.

This post focuses on another popular electricity product, the index or variable rate product. We discuss index or variable rate products: what they can do for a business, how suppliers manage risk and exposure when pricing and managing a variable rate product, and what to look for when you request a index/variable rate product. If you have already reviewed the first post in this series, you can skip to the next section in this post , which is called Index, or variable rate products.

The Nature of Electricity

When people think about a product, they think of a good, a tangible item, something you can look at, touch, and see–especially before you buy it. Energy products, particularly electricity products, are peculiar in a number of ways.

1. You only pay after you consume.
2. You can’t see or touch it, you only receive the benefits indirectly– through a comfortable built environment, the right light output, motive power for your factory.
3. While it is a physical good, it really only becomes a product through complex markets and financial management.
4. In fact, what you pay is really determined by the fact that an electricity product is comprised of many products that get packaged into a single price, or rate.
5. The element of time! When we talk about quantities of electricity a consumer buys, we have to take into account that it is really a flow of electrons over time. The time element is different from many other goods, but not unlike telecom products, for example.

Most energy buyers, even the most sophisticated among you, can get frustrated and confused by the details and the major determinants of an energy product. Electricity is electricity, right? Right. You can buy electricity on a variable or fixed rate – just like a mortgage. Or, you can buy some combination of fixed and variable rates. Finally, and again, like a mortgage, your purchase covers a set period of time. That time frame (start month and duration of the contract) will have an impact on your costs. HOW you choose to buy that electric power will determine your costs for the year.

Major electricity products

Here is a quick overview of all electricity products, before we get into the details of index, or variable rate products. The graphic displayed below shows you a section of The Megawatt Hour’s proprietary platform. On a daily basis, we update these cost forecasts. Our subscribers can evaluate the impact of an electricity product on their budget by dragging the slider in the graphic to the left and seeing the impact of fixing more, or less of their electricity costs in the table on the right. In addition to viewing an annual cost forecast, subscribers can see how costs vary based on extremely high and extremely low cost environments– that’s what we call “The Stress Test.”

Index, or variable rate products

In contrast to the fixed price product, in which businesses basically ask the supplier to accept all the risk of changes in the market price of electricity over the contract term, the index is supposed to be the opposite end of that spectrum. On an index product, suppliers pass through the actual, market-determined costs to you, the buyer. For energy, the supplier will bill you the day-ahead cost of electricity. Remember (see the first post in this series) that energy is the largest component of your cost, so passing day-ahead energy costs through to you means that you are accepting variable price risk. In theory, if you are willing to accept variable price risk, then you should be willing to accept a similar risk on most aspects of costs: ancillaries, capacity, energy, etc. (See the graphic here titled “Major Components of Electricity Cost” in the first post in this series to refresh your memory about the components of electricity costs.)

When you receive a supplier quote for an index product, you may find that their forecast of expected costs (on a unit basis, or based on total expected dollars spent over the course of the contract) does not differ greatly from that of a fixed price. That is technically accurate– because all of the products that you are quoted will be quoted on the same day. (Note that fixed energy costs for a fixed price contract are determined by the forward curve. The forward curve is the market’s view of where energy costs are headed, where they will end up– essentially this is where you can lock-in future variable prices using hedging products today.) And suppliers will use the forward curve for energy to forecast expected energy costs, the majority of your costs.

Expected costs don’t tell the whole story. In fact, the actual outcome, the delivered costs, may vary greatly during the course of a contract, depending on the type of contract you buy. The following graphic illustrates this point. The bar chart below compares the minimum, maximum and expected costs of a fixed price contract to that of an index contract. On an index contract, energy costs will vary based on the day ahead rate. You will not know how much you will pay until you receive your invoice, and will have no ability to control those costs during the course of the contract (unless you cancel or change to another product type– see more on this below). Seeing the potential risk ranges may help you determine what product works for your business. You have to decide whether you need the full insurance that a fixed price provides, or whether you can accept some market variability. Most importantly, you can begin to think about whether the expected benefit from an index contract (lower expected costs and the ability to benefit from lower prices during the contract) justifies the potential risk (namely that prices could rise during the period of the contracts). Weighing these costs and benefits in an informed and quantitative way is our best advice for reaching a decision that’s right for your business.

In many markets, NY and PJM, for example, customers who buy an index will actually pay a fixed fee, known as an “adder”. The adder is the suppliers’ charge for capacity, ancillaries, and profit margin and, if necessary, a consultant or broker’s fee. So in these markets an index product is not, in fact, a pure pass-through of supplier’s variable costs, but is a kind of fixed AND floating cost product.

What to be aware of when selecting an index, or index with adder product?

Take a close look at your index contract– you should have the ability to switch into other products and/or to cancel without huge penalties. This flexibility is another source of potential value in an index/variable contract.

Also, if you’re looking for an index, do you REALLY need an adder? If you’re already willing to take the variable energy risk, then why not get a full index– instead of paying premiums for fixing a very small component of your cost. Recall that an adder fixes capacity, ancillaries, risk premiums, and adds fees and margins. In fact, we don’t recommend fixing ancillaries for two reasons:

1. 1. Suppliers can’t buy ancillaries in the forward markets, so they will build a premium into the cost. Why pay that if you’re already willing to take index pricing on? and
   2. Why not insist on greater transparency? In fact, if the supplier is taking on less risk, then you shouldn’t have to pay them as much margin. We would advocate for greater transparency around this product.

The next post in this series will cover the hybrid of a fixed and index product, an index with block. In addition, in a future post, we will review the past 12 months of costs and compare the costs of each of the 3 major electricity products.