One large and obvious benefit of competitive retail electricity markets is that large businesses, small businesses, and government energy users hold the capability to choose how they structure their electricity procurement programmes. The customers in competitive markets are able to select electricity contracts that range all the way from monthly, to annual, to multi-year agreements – and can further choose from a range of electricity procurement structures.
There are multiple available structures to choose from, such as fixed price, index, and blended.
For fixed price structures customers will pay a secure, fixed price for their energy usage. Customers’ energy consumption can sometimes be referred to as ‘load’, and is a term to be aware of.
Index customers will pay a variable index rate for their electricity.
Blended customers will see their structure fix the price for a percentage of energy consumption, while the remaining amount is priced at a variable index rate – a blend of the previous two structures. This structure offers unprecedented flexibility to align their energy cost strategy with budgeting, fiscal calendars, and overall corporate goals.
As is common with all rapidly evolving markets, getting to grips with the different electricity supply choices can be a very tricky task indeed. Because of this, we have decided to see how each procurement choice has performed over the last ten years – which was a period characterised by rising and falling markets. By understanding the relative performance of each will contribute to an overall estimation of which approaches can aid customers in managing budget volatility risk and energy cost.
It is worth remembering that past performance is not necessarily indicative of future results, and there is no guarantee that performance will be repeatable – simply down to the many factors that are important in energy procurement.
However, what the results will offer is an increased customer understanding of exactly what options they have. Which, should lead to more informed energy purchasing decisions.
The Six Purchasing Strategies Considered
It was agreed that in order to provide the broad spectrum of choice that customers would likely face, we would include six entirely different purchasing strategies* from a period of 2003 through to 2012.
We have listed these below with short explanations:
- 100% Fixed Price Point-in-Time (PIT): This strategy is where customers purchase energy at a single point in time, essentially fixing the price that they will pay for the entirety of their consumption for a two-year period, five months prior to power flow.
- 100% Fixed Price Layered: This strategy would be where customers purchase in ‘layers’ over a period of time. Customers would fix the price for 25% of their consumption every six months over a duration of two years.
- 60% Fixed Round the Clock (RTC): This strategy is where customers fix the price for 60% of their load for a duration of two years, five months before their contract start. The remaining 40% of consumption would then be priced at a variable index rate.
- 100% Peak Fixed: This strategy is where customers fix the price for 100% of the peak period load for a duration of two years, five months before their contract start. For the off-peak load, 100% is fixed at a variable index rate.
- 100% Peak Fixed (Summer): This strategy is where the customer fixes the price for the entirety (100%) of the peak period load for the summer months every two years, five months prior to the contract start. The rest of customer load is priced at a variable index rate.
- 0% Fixed (100% Index): This strategy is where the customer does not fix the price for any of their load, and all load requirements are then priced at a variable index rate.
*For the purpose of this paper, it is assumed that all customers did not attempt to modify or deviate from these strategies over the time period. Reasons why customers would attempt to deviate from initial procurement strategy in real-life are numerous, but most likely it would be in response to changing market conditions. The paper also assumes that all purchases are for a percentage of hourly usage at a specific rate over a set period of time.
Figure 1: The Six Energy Purchasing Strategies Illustrated Here we see a matrix of 100% Fixed, Blended and 100% Index options and corresponding risk plotted on the X and Y axis. The Y, or vertical, axis represents both timing cost and volatility risk, while the horizontal X axis shows the continuum of energy strategies running from fully fixed pricing to the left to fully indexed pricing to the right.
Risk and a Fixed Price Point-in-Time Strategy
This strategy appears at first glance to be a massively conservative strategy – but is this assumption true?
Not really, as there is still risk associated with this strategy.
As no one is able to truly predict the markets with complete accuracy, by fixing a price at one solitary point and ignoring any other factors (like price volatility) customers will not know if their decision to fix was truly the lowest-cost one until the term of the contract has played out. As is seen in this paper, in some markets a Fixed Price Point-in-Time strategy can contribute to higher total costs than other strategy types.
Comparing 100% Fixed Price Layered to 100% Fixed Price Point-in-Time
The retail electricity price will rise and fall naturally over time, any glance at market history could tell you that. When customers implement a 100% Fixed Price Layered strategy (where prices are fixed regularly), some of the timing risk is mitigated when making one purchasing decision for all load for a defined period of time (as is the case for 100% Fixed Price Point-in-Time strategy). As such, the 100% Fixed Price Layered Strategy allows for risk diversification by dividing fixing decisions over time, which isn’t possible in a 100% Fixed Price Point-in-Time strategy.
10 Years of Volatility
Insert graph of median prices
This paper will look at the period of 2003 through to 2012, which is a full 10-year business cycle. A basic characterisation of this period would be dominated by two discrete periods, the economic boom phase in the early and mid-2000s, and the economic recession of the final 5 years.
From Figure 2 it is possible to see the massive year-on-year price fluctuations and how the 10-year time-frame can be largely broken down into two main periods.
From 2003 to 2008: The Booming Economy leads to rising prices
Over this period, the US economy was booming and fuel prices were rising as a result of this. Throughout this time, the median prices of the six strategies rose by just over $40/Megawatt Hour (MWh). This is more than doubling.
From 2009 to 2012: The Receding Economy leads to falling prices
Directly following this booming period was a dramatic recession, characterised by economic weakness, falling demand, and falling natural gas prices. In this period, the median retail price of the six strategies fell by more than $30/MWh – a reduction of about 42% from the peak in 2008. One message from this data is that the competitive market communicates price signals to customers as economic conditions change over time. Like other markets for commodities/services, there is a clear and obvious supply, demand, and price interaction in force.
A Significant High and Low Price Range Over 10 Years
It is clear to see the dramatic market movements over the ten-year period covered by this paper. At this point, we will now see how the six strategies fared.
The median price of the six strategies throughout the 10-year timeframe was $59/MWh, with the highest price strategy in each year averaging $9/MWh above the median price. This is a difference of about 15%.
On the other hand, the lowest price strategy averaged $8/MWh below the annual median price. About a -14% difference. From these two observations, it can be concluded that the overall average price variance between the highest and lowest performing strategies over the course of the ten years was almost 30%.
Figure 3 is the same illustration of the annual median prices of the six strategies but overlays the range of lowest to highest priced strategies in each year (bar graphs). What do we see?
However, the range between the low and high priced strategies varied considerably across the 10-year period, as can be seen in Figure 4.
In four of the ten years observed, the range between the lowest to highest priced strategy did not exceed more than $7.50/MWh. In three of the ten years, the range between the lowest and highest priced strategies exceeded $15/MWh.
Three years were of particular note (2005, 2009, and 2010). These years provided the most variance in terms of price range within the six strategies. Is there a reason for this?
In 2005, Hurricane Katrina and Hurricane Rita ravaged communities along the Gulf Coast region. This included energy infrastructure, either interfering with, damaging, or destroying it entirely. This caused a serious jump in electricity prices.
In 2009 and 2010 the US financial crisis triggered a deep and hard felt national recession that was felt globally for a number of years. As such, it can be concluded that unforeseen events have had their part to play in dictating the markets, and have had a significant impact on the relative performance of the six strategies.
Annual Comparative Price Performance of the Six Strategies
There is a very significant difference between the highest and lowest price programs covered – over $7.50 per MWh in six out of the ten years. But how do each of the programs compare against one another?
No single strategy consistently produced the lowest price over the 10-year period.
In four out of the ten years, 100% Index pricing produced the lowest price. Again, in four out of the ten years, 100% Fixed Price Point-in-Time produced the lowest price. 100% Fixed Price Layered produced the lowest price only once, as did the Blended strategy whereby summer peak-only was fixed.
100% Fixed Price (Point-in-Time and Layered options) and 100% Index fluctuated from the highest or lowest priced strategy in most years.
With the exception of two years in the study, 100% Fixed Price and 100% Index occupied the highest and lowest price positions. To look at this in another way, blended solutions didn’t produce either the highest or lowest prices in most of the years observed, falling somewhere in between 100% Fixed and the 100% Index strategies.
No strategy appears to be without risk and past experience is not necessarily a good predictor of future performance.
The relative ranking of all six observed strategies changed over time, in some cases quite significantly – more than just a slight reshuffling in the middle of the pack. An example of his would be the 100% Fixed Price (Point-in-Time and Layered) maintaining the lowest price position from 2003 through to 2006, to then occupy the highest position from 2007 through to 2012 with the exception of one year (2008).
Managing Energy Price AND Budget Volatility
One other discovery from this comparison is that different procurement strategies can strongly affect two of the main major concerns of energy buyers – Price volatility management and energy cost management. Energy buyers are in a near constant struggle to manage the two goals of achieving long-term cost management, while simultaneously accurately setting budgets by flattening out year-over-year spending.
There is often a trade-off occurring between volatility and price over time.
In many cases, however, there is a tradeoff between volatility and price over time. In Figure 6 we see how a 100% Fixed Price (Point in Time and Layered) compares to a 100% Index strategy, and in Figure 7 we see how a Blended (fixing summer peak only) strategy compares to a 100% Index strategy. The results are quite interesting.
For a 100% Fixed Price Point-in-Time strategy with purchase decisions every two years, the price curve appears to resemble a series of step changes (which are obviously as a result of the point-in-time purchases). For 100% Fixed Price Layered (which has purchases made more regularly over time) the curve smoothed out year-on-year price fluctuations. The 100% Index (Point in Time and Layered) shows great year-on-year volatility. The trade-off with 100% Fixed Price (Point in Time and Layered) and 100% Index is that although they appear to have much lower annual volatility, they also have the highest overall price for the 10-year period.
When comparing the 100% Index to the blended strategy (fixed summer-peak only), the blended solution was more able to take advantage of market movements. However, this strategy also mitigated some of the big year-on-year price swings dramatically affecting the 100% Index, particularly in 2005 and 2009.
Blended Solutions: The “Sweet Spot” of Both Lower Volatility and Lower Price Over Time
When looking at price performance and budget volatility for each strategy of energy buying, there are some interesting results to take away. The annual volatility for each of the six strategies lands in a narrow range, from 22% to 30%.
When we look at the overlay of both price performance AND budget volatility for each strategy, we find some eye-opening results. In Figure 8 we see the average price of each strategy, depicted by the blue bar, and the corresponding annual volatility represented by the red line. As you can see, annual volatility for four of the six strategies landed in a narrow band, ranging from 22% to 30%.
Two strategies, in particular, were outliers:
- 100% Fixed Price Layered option produced the lowest annual volatility from any of the six strategies
- 100% Index option had an annual volatility well outside the range, with a much higher rate of 33%.
This means that over the ten-year period, budget volatility would be largely similar whether a 100% Fixed Price Point-in-Time strategy or any of the three blended options. The 100% Fixed Price Layered approach would have been the best strategy for customers looking to mitigate budget volatility, whereas a 100% Index approach would have left them the most exposed and vulnerable.
Here are some other observations:
- 100% Fixed Price strategy consistently produced the highest prices – averaging between $60/61 per MWh over the 10-year period. Blended approaches on average would be $1-3 per MWh lower than the aforementioned 100 % Fixed Price option, with 100% Index approach also averaging about $4 per MWh below the 100% Fixed Price Option.
- 100% Fixed Price layered option consistently outperformed the 100% Fixed Price Point-in-Time strategy. The 100% Fixed Price Layered strategy produced a considerably lower average price with significantly less volatility.
- 100% Index produced the lowest price but with the most significant volatility relative to the other strategies. The average Index price was shown to be the lowest out of the six options, averaging around $56 per MWh over the ten years, but also with 33% average annual volatility. Blended strategies averaged $1-3 per MWh higher than the 100% Index strategy, with lower average annual volatility.
- Blended strategies have very effectively reduced both price and budget volatility for the period of observation. Blended strategies have had lower volatility relative to Index without sacrificing lower prices compared to either of the 100% Fixed price strategies.
In Conclusion
The main takeaway from this paper is that blended strategies have been shown to effectively and consistently reduce both price and budget risk. Although past performance is not necessarily a concrete indicator of future results, there is enough evidence to suggest that customers may find blended solutions the most suitable strategy to hit their long-term purchasing goals.
Note About Actively Managed Purchasing:
During the period of observation, no effort was taken to modify or deviate from any of the six strategies over time to optimise price or risk in response to changing market conditions. This is not something that real-world customers would do. Any actively managed approaches integrating market intelligence, price alerts, systematic procurement programmes, and other tools that contribute to more informed consumer decisions over time may well produce even lower prices and volatility.
Managing Your Peak and Off-Peak Energy Prices
While in ‘Peak Hours’ the price that consumers will pay for electricity is much higher due to the higher demand from operations like cooling, heating, and commercial and industrial operations that increase the strain on the electricity grid. Conversely, ‘Off Peak Hours’ which are night-time and early mornings, less electricity is used as a whole and the strain on the grid (and price) is significantly lower.
Peak hours are usually during weekdays only, and will mostly exclude specific holidays. The precise times for this window will vary by region and on the particular Peak/Off-Peak convention a supplier chooses to utilise.
Customers are advised to look at the applicable definition when reviewing their contract options from suppliers/suppliers. The price is also massively influenced by the type of generation that is dispatched to cover the grid’s electricity demand. Different generation sources will often be used at different times throughout the day to meet variable load requirements, but will also have different associated costs.