Supplier Risk Premiums in Times of Uncertainty
In New England's deregulated Electricity and Natural Gas supply market fixed price contracts that run between 12 and 60 have become the norm. Most customers spend more time focusing on the fixed price rather than how that price is calculated. This article hopes to provide insight into some of the risk factors that suppliers and customers must consider when comparing fixed prices.
For a supplier to offer a fixed price contract for a fixed term, for example 36 months, the supplier has to make numerous estimates including the customer's expected usage, load profile, and capacity, among others for that time period. To minimize risk, suppliers will lock in some of the costs at the time the contract is signed. The most commonly discussed of these cost components is energy. When a contract is signed, the supplier will go out and purchase the electricity on the customer's behalf based on their estimated usage and load profile to mitigate price risk for the length of the contract.
However, this doesn't remove all price risk for the supplier. What happens in the event that the customer uses significantly more or less electricity on any given month than the supplier was estimating? If a supplier's overall portfolio has purchased too much electricity, they will sell this electricity back into the spot market at whatever the spot price is at the time. On the other side, if a supplier's portfolio is short power, they will go to the spot market and purchase power at whatever the spot market price is.
During an average month or year, suppliers can usually forecast their expected usage extremely accurately. With larger suppliers having thousands of Commercial and Industrial customers, the law of large numbers suggests that some customers will use more while others use less, and they should average around the expected usage. If you look at any publicly traded suppliers quarterly 10-Q you will likely see a note about how their hedging strategy is performing. Although every supplier's strategy is different, they are all utilizing their own internal hedging strategies to minimize their price risk.
Although balancing the usage sounds straightforward during a normal year, what happens during times of significant uncertainty like we are seeing now? With state mandated closures across the country, suppliers could find themselves in situations where they've purchased too much electricity for their portfolio and are forced to sell back into the market. As we've seen with other commodities like Oil, the demand for electricity has drastically fallen making the spot market price very low. This means that any suppliers that are long power for their portfolio are going to be liquidating positions at a loss.
Another problem that suppliers are facing is that capacity, which we've talked about here, can result in additional losses for a supplier. Since capacity is a monthly cost and estimated in terms of a $/kWh cost, a significant reduction in usage leads to a higher cost per kWh for capacity. For example, if a customer uses 100,000 kWh per month and their monthly capacity costs are $1,000 then their capacity costs are approximately $0.01/kWh. If the usage were to drop on a monthly basis to 25,000 kWh per month, the cost would still be $1,000 but the cost per kWh would be $0.04/kWh. These types of losses can have a huge impact on a supplier's overall book.
How are Suppliers Responding?
There are 2 main ways that suppliers help mitigate these risks. They are either through their contract language or the risk premiums they include in their pricing model.
The most common way that suppliers help mitigate their risk is through bandwidth restrictions surrounding monthly consumption, and also bandwidth restrictions on a customer's capacity tag. The monthly bandwidth restrictions are usually fairly straightforward in terms of suppliers offering customers the ability to use something like +/- 25% compared to their historical usage. This means if their usage goes up or down by more than 25%, the supplier could pass through any additional costs they incur as a result of this deviation. Other suppliers include Material Adverse Change (MAC) language to protect themselves. It is a less defined bandwidth, but still allows suppliers to pass through additional costs if they deem a MAC event has occurred.
The same type of language can exist around a customer's capacity tag with similar language. They may allow your future tag to deviate from your current capacity tag by a set amount (+/- 20%) before they pass through these charges. As you can imagine, the risk tolerances that suppliers have to include when they can pass through charges if they are adversely impacted are far less than suppliers offering full-swing contracts for both usage and capacity.
To demonstrate the risk tolerance that some suppliers are having to include as a result of the current COVID-19 Pandemic, I've included a picture below which has been monitoring the weekly renewal pricing for a current customer. This supplier has a contract that is 100% swing and no MAC language. They also have no language surrounding capacity making it on of the most customer friendly contract available in New England.
As you will see in the graph below, there was an increase in price of $3/mWh on approximately March 25th, 2020. This was the day after Massachusetts implemented a stay at home order and closed non-essential businesses. Since this supplier does not have a contract that would allow them to recover any costs if usage or capacity changes, they are including a risk premium in their pricing to account for this.
What does this mean for Customers?
I've stressed the importance of supplier contract for years and how important it is when comparing prices between competitive suppliers. The value of a 100% swing contract with no MAC language has never been higher for those currently under contract. However, given the risk premiums that these suppliers are having to include to offer this product for new customers and renewals, it may not be the best product for every customer.
Customers that are willing to take more risk could consider signing a contract with a tighter usage bandwidth if they don't expect to shut down. They could also pass through capacity altogether which means they would be taking 100% of the capacity risk themselves. These are only 2 of the ways that customers can incorporate today's market uncertainty into their purchasing strategy. There are numerous other considerations, but it is essential that customers understand the contracts of each supplier and how much risk they are taking on with their fixed price.
About Pursuit Energy
Pursuit Energy Solutions is a full-service Electricity and Natural Gas consulting firm that assists Commercial, Industrial, and Municipal customers to navigate New England’s complex deregulated energy markets. Pursuit works with customers to develop customized, long term purchasing solutions that fit within the client’s risk tolerance and budgetary needs.
The views expressed in this article are the author’s own observations and not those of any supplier.