Retail Electricity Contracts: Do They Reduce Risk?

July 2008

When entering into any fixed-price electricity arrangement, there are two primary factors to consider: price and quantity.

Retail electricity deals are a common offering, often involving paying a fixed price on all of one's electricity consumption. Such deals can assist in managing price risk and possibly lower one's cost of electricity, but only if care is taken concerning the price paid and quantity purchased.

Price

In any retail deal that covers all of one's electricity, the retailer will be very interested in knowing your meter type and consumption profile, both seasonally and time-of-day.  You should be as well. Combining this knowledge with seasonal and time-of-day price behaviour gives insights into how one's actual, weighted price will compare to reference prices, which are based on arithmetic averages.

Competition is then the key for getting the lowest price. It imposes discipline on sellers, that is limited or absent when only a single supplier is involved.

Competition also greatly reduces the likelihood that a single supplier will sell you a deal that on its surface appears to be attractive but in fact is not. Consider the example, not unlike recent, low initial-rate mortgages in the U.S., where a low initial price is offered as part of a multi-year deal. The catch is that a hefty annual escalator will cause the price to rise quickly and the average price paid to be well above the blend of prevailing market prices for the whole period.

Quantity

In a past article on the Global Adjustment ("GA", also called the Provincial Benefit), we discussed how the Global Adjustment essentially provided fixed pricing on a significant portion of one's electricity. The Ontario Power Generation Rebate ("OPGR") also provides price protection. In combination the two mechanisms eliminate as much as 75 or 80% of the electricity price risk that buyers might perceive they face.

Many retail electricity offerings then fall down from a quantity perspective, by offering price protection on 100% of one's consumption. When the cost impacts of the GA and OPGR are factored in, such deals cause buyers to purchase more price protection than they need.  When the entire volume of electricity consumed is purchased at a fixed price, the impact of the GA can result in an unanticipated behaviour in the net price paid..

In our earlier article on the GA, we explained how the amount consumers are charged for the GA increases if the electricity price decreases and vice versa. The GA offsets a portion of the change in price.

If a consumer fixes their energy price in a retail contract, but continues to pay the GA, then they would see their total electricity bill go up when the market price for electricity went down.

The graph below shows how consumer's net price changes with changes in the market price. The X axis shows the spot price while the Y axis shows the net price paid under different scenarios.

The solid black line represents the price behaviour of the spot market, excluding the impact of the GA and OPGR. The dotted black line is the actual spot market impact on a consumer, taking into account the fixed pricing provided by the GA and OPGR.  The GA and the OPGR absorb some of the market price changes, so the consumer's net cost of electricity does not change dollar for dollar with a change in market price.  The solid green line represents the outcome achieved if the proper quantity of electricity is purchased at a fixed price as a result of pursuing a risk management minimization process. The red line shows the net cost that results arising from purchasing 100% of your electricity at a fixed price.

In a nutshell, any resulting line that has a negative slope (down and to the right) is undesirable and the steeper the slope, the worse the result. Such results fail the basic test for price protection appropriateness, the net price achieved drops when the spot market rises and vice versa.  The buyer has not reduced their risk, they've traded it for a different kind of risk. Consequences

Going with a single, uncompetitive supplier can add 10% or more to the price of electricity purchased.

Purchasing price protection on the wrong quantity can cause one to pay risk premiums and retailer margins that add an additional 8% or more to the price paid on the excess quantity.

Purchasing price protection on the wrong quantity can also cause one to unknowingly adopt an inappropriate risk relative to electricity prices. One may then have to explain an unexpected and undesirable net price outcome, namely, why your net cost of electricity went up when the prevailing market price went down.

For more information on how to avoid these additional costs and risks contact us at Aegent Energy Advisors.

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