This post is the first in a series that delves in to the details of electricity products and pricing. This post covers fixed price products: what they can do for a business, and how suppliers manage risk and exposure when pricing a fixed price product.
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.
- You only pay after you consume.
- 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.
- While it is a physical good, it really only becomes a product through complex markets and financial management.
- In fact, what you pay is really determined by the fact that an electricity product is comprised of many products that are ultimately packaged in to one rate.
Most energy buyers, even the most sophisticated among you, tend to get frustrated and confused about 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. HOW you 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 in to the details about fixed prices. The graphic displayed here 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 on this graphic and seeing the impact of fixing more, or less of their electricity costs. 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”.
This product is the lowest risk product available with respect to market and budget fluctuations. And you will pay a premium for it. A fixed price works exactly as it sounds. Every kWh that flows through your utility meter is billed at the same rate (in cents per kWh). The bill that you pay will vary due to variations in your electricity usage. With this product, all market risk that exists is born by the supplier, for which they will charge you a premium in addition to the regular margin suppliers always add to the commodity cost. In all restructured markets, there are components of a fixed price that a supplier can purchase, and hedge, ahead of time, and there are some components that are impossible to buy in the market. Nevertheless, the supplier will fix that exposure for you, and add risk premiums to the quoted Fixed Price to do so. The premiums that a supplier will charge for those products are usually determined based on historical costs, financial modeling and forecasts of the components that are difficult to purchase in the market ahead of time. If necessary, Megawatt Hour subscribers can view the market costs of each component as determined by our proprietary pricing model, so you can determine how much you pay in basic cost and premiums for each component.
Fixed Price: Components
All electricity products contain basically the same components. What changes from product-to-product is how the wholesale cost of each component is passed through to you in the contract. Here is a list of electricity components and their definitions, along with a graphic that gives you a sense for the financial relevance of each component.
- Electric Energy: Paid to supplier who buys the energy from generators or the hourly ISO (Independent System Operator) electricity auctions. Generators sell “forward strips” which suppliers buy to offset the cost risk of buying hourly/index electricity from the ISO.
- Distribution and Transmission: Paid to utility and/or the ISO to maintain the transmission and distribution systems.
- Ancillaries Charges: Generators are paid to use their facility for system stability and quick response reserves.
- Capacity Charges: Generators are paid to stay operable so that on the peak hour of the peak day of the year, enough capacity will be available.
- Supplier Costs and Risk Premiums: The supplier charges a fee for their service. Credit costs, plus operating fees and the premiums paid to fix prices (and assume risk) on part or all of these costs.
- Fees: A broker or consultant charges a fee for their service.
What should buyers be aware of when selecting a fixed price product?
- The time of year in which your contract starts, as well as its duration will strongly affect the Fixed Price rate you will be quoted by suppliers.
- How much usage variation your facility has? Is your usage predictable and fixed for at least the duration of the proposed fixed price contract? If you plan to sell a facility, you should know about termination restricitions before you sign a fixed price contract. Do you expect big swings in occupancy? You should know that before you sign a fixed price contract with a supplier.
- All the fine print on a supplier contract— about what happens if facility usage changes, or if there’s a regulatory change during the contract term?
While there are other issues to consider, these are the major issues to consider when negotiating a fixed price agreement.
We will be covering these issues and others in an upcoming Webinar titled:
5 Insights about Electricity Products & Contracts
. You can register for the Webinar here.