Don't Get Harpooned in a Retail Power Deal

September 2008

In the broad sales world, a "whale" is a customer that yields a high commission or margin. It follows then that one way for buyers (of anything) to minimize costs is to avoid getting harpooned.

In deregulated energy markets, buyers must implement competitive purchasing processes with competitive and otherwise credible suppliers in order to minimize costs.  Aegent works with clients to help them buy in the wholesale market where these goals can be achieved.  Retail suppliers lean more toward mass markets. Sometimes however and because revenue realized is a function of potential margin and the likelihood of realizing the margin, a mass markets energy retailer will get in front of a larger consumer with a retail energy offer.

Almost without exception, the details of these "retail deals" highlight why it's important to have a competitive process with credible suppliers. There are a few things that you should look for in such retail electricity offerings, either in "the deal" or as part of the "story" provided in support of them.

Predicted High Escalation of Spot Market Prices

Fixed-price contracts are a hedge against the risk of higher future prices. Many consumers hold the perception that energy prices only go up. Certain retailers will often in turn paint a very alarmist picture of future prices, to motivate demand for contracts that lock in prices above the current market level. In fact, however, average electricity prices this summer were lower than last year's, the fourth consecutive year-over-year decline in summer electricity prices.

While the replacement of retiring coal-fired generation in Ontario with natural gas-fired generation will put upward pressure on electricity prices in coming years, there are also moderating factors:

• current new-generation contract mechanisms that often take many of the costs out of the market price and place them in the Global Adjustment, and
• a near-term supply picture that appears to be very robust and is likely to stay that way.

In the absence of other signals, forward prices are always the best predictor of future prices, so knowing "where the market is at" is key. One needs to be extremely wary of arbitrary cost-increase assumptions that are out of step with the supply/demand picture.

Low Initial or "Teaser" Rate

It seems obvious but buyers need to beware of being mesmerized by a low initial price that then climbs rapidly afterward. The parallel is low initial-rate mortgages in the US and we know where that ended up. Make sure to take a look at the average price over the whole term of the deal.

Prediction That Smart Meter RPP Will Cause Your Electricity Price to Rise Sharply

If you're a municipality, university, school board, or hospital or consume less than 250,000 kWh per location, then you may be on the Regulated Price Plan (RPP). The Smart Meter RPP is not in broad use but will become more common as more utilities install more "smart" meters. The plan has three time-of-use rates (on-peak = 9.3 cents / kWh, mid-peak = 7.3 and off-peak = 2.7) that apply during different hours of the day, week and year. For customers that may end up on the Smart Meter RPP, a retailer may pitch their price offer against the on-peak price of the Smart Meter RPP rate.

But be sure to compare apples to apples by evaluating the cost of the Smart Meter RPP based on your actual load profile. Smart Meter RPP rates are set using an average load profile for RPP customers - with energy proportions for the three periods / prices being 22 % on-peak, 28 % mid-peak and 50 % off-peak. A typical customer would pay the highest rate on less than one-quarter of their consumption.

So, unless a customer's own, actual load profile is very unfavourable, their true cost picture will be not nearly as bad as often portrayed.

Overly Optimistic Estimate of Rebates

The total cost that consumers pay for electricity includes two regulated price adjustment mechanisms: the Global Adjustment and the OPG Rebate. If a retail offer says "you get to keep the rebate", it means the fixed price of the contract covers only your energy charges, and does not apply to the Global Adjustment or the OPG Rebate.

The Global Adjustment can go either way - it is a charge when the average electricity price is below 6.2 cents / kWh ($ 62 / MWh) or so and a credit when it's above that. The OPG Rebate is always a credit. It is important to note that the net "rebate" that you get to "keep" may in fact be an additional charge, and not always a cost reduction.

In the sales pitches we've seen, this value is projected to be a large credit, which makes the net cost of the proposed deal appear more attractive.

Built-in Over-hedge

Because of the way the Global Adjustment and OPG Rebate work, electricity buyers do not feel the full impact of electricity price increases on their electricity bill. The Global Adjustment, in particular, offsets changes in the market price of electricity. If the market price is high, the Global Adjustment will be a credit and will offset some of the high price. If the market price is low, the Global Adjustment will be a charge and will offset some of the decline. The consumer's net cost is more stable than market prices themselves.

Full-requirements or load-following retail deals provide a fixed price on 100 % of one's electricity consumption, but they don't lock in the value of the Global Adjustment. In such a deal, if the market price is low, the Global Adjustment will still be a charge on the consumer's bill. But the consumer's electricity cost will not have fallen to offset this charge - the net impact will be a higher total cost even though the market price has fallen!

Risk managers call this an "over-hedge". The buyer hasn't achieved a reduction in electricity price risk, they've traded for the opposite risk (the risk of high costs in a low price market) and greater cost uncertainty than they had in the first place.

Balancing Fees

Retail energy offers are "full requirements" or "load following", meaning that on the surface one pays a fixed price for all energy, regardless of one's hourly, daily or seasonal load shape. Still, many such offers have built into their fine print the ability for the retailer to recover costs when there's a mismatch between your load shape and the supply arrangements the retailer puts in place on your behalf. Worst of all, the cost is largely undefined and some agreements allow it to range up to 1 cent / kWh ($ 10 / MWh). If such a maximum charge were applied, your price could rise by an additional 15 % or so!

Exit Fees

When an energy buyer enters into a fixed price arrangement and the market drops or otherwise settles at a lower price afterward, there are often regrets. For all energy deals though, the phrase "a deal is a deal" applies. When a retail deal buyer wants to exit the deal, they can do so but the retail deal gives the retailer the right to charge an exit fee on each unit of energy consumption remaining over the original term of the deal. The unit fee to cover such an occurrence is fixed and can be as much as 1.5 cents / kWh ($ 15 / MWh). This contrasts with non-retail deals, where a premature end to the deal (usually arising from an event of default) can result in a payment to or from the buyer, depending on whether the contract price is above or below the current market price. We're of the view then that the exit fee could give an insight into the deal margin, in which case retail margins are an order of magnitude higher than non-retail margins.

In summary, there are many reasons to steer clear of retail electricity offers or at least treat them with extreme caution. The best way to avoid being "harpooned" by a retailer is to understand the mechanics of how they create their offering. If you have questions about them or would otherwise like to explore issues related to your energy purchasing, please contact Bruce Sharp at bsharp@aegent.ca or John Voss at jvoss@aegent.ca.