One of the significant risk an electricity company faces in deregulated electricity markets is related to market risks.
Loss in profit can occur because of a significant change in the price of energy commodities. Electricity companies buy energy commodities like natural gas because it is used in creation of electricity power at power plants.
Energy companies don’t just buy these commodities but they also hedge these commodity prices by use of the futures market.
Oil is also used in the process of creating electricity because the large turbines in these plants need oil to run so you could say natural gas and oil play a part in the market risks associated with selling electric power.
Electricity companies in highly volatile markets may not get the best price on these commodities and may miscalculate the demand or price for their electricity rate and plan.
If an electricity company gets any number of these market risk variables wrong they could face bankruptcy because of the thin margin of error available to them from the tight profit margins they work within.
These market risks have a direct impact on profits and because of this it makes more sense for new electricity companies in the market to offer a variable electric rate plan instead of fixed rate plans.
Beyond just the market risks new electric providers are faced with liquidity risks as well and are many times unable to trade in large quantities preventing them from using hedging strategies to even create a fixed electricity rate product.
A customer of one of these electricity companies unable to manage market and liquidity risks will be placed on a variable electric rate that is unhedged.
The electric service customer ends up taking on all the risk instead of the energy provider. Customers are routinely funneled into these variable unpredictable electricity rate plans because it takes most of the risk off of the electric providers shoulders.
By spreading the market and liquidity risks associated with selling power over several thousand electricity customers by one of these providers it allows for easier profits and a generally easier to manage business model.
The variable electricity rate products are less complex to manage and can be framed to the customer as being cheaper and an overall better price plan than a fixed rate.
A fixed rate usually offered by larger more established electricity companies in the market requires that the electricity company take on these risks and still make a profit.
The hedging, energy buying, and credit requirements needed to create and sell predictable fixed electricity rates is costly and therefore is why fixed electricity prices are more expensive the first month than a variable rate plan.
The electricity customer may look at two rate plans side by side. One of these rate plans will be variable one is fixed. The variable price is 8.49 cents per kWh and the 12 month fixed rate is 10.65 cents per kWh.
Many times the customer will choose the 8.49 cent rate because it is cheaper. The next month that variable rate customer will likely see their rate go up to more like 11 cents per kWh and this is when you can see that the variable rate is an easy way for electricity companies to slip one by on many an electric service customer.
The reason the variable rate is so low the first month is a combination of things. For one thing the electricity company has some statistics on exactly how long variable rate plan customers generally stick with them.
On a variable rate plan they can offer a low price the first month knowing that if they take a loss the first month they will make it up on the 2nd, 3rd, and 4th month the customer stays with them.
On those subsequent months the variable price for electricity continues to go up until the electricity company makes a profit. The energy provider then puts a large adder on top of a daily market spot price and it usually follows this market for the length of time the customer stays with them.
A variable electricity rate may also partially follow the natural gas commodities market and whatever profit margin criteria the electric company wants to add to the rate plan.
Also with a variable electricity rate plan there is no hedging being done as with fixed electric rate plans, which is a costly endeavor and requires capital and good credit backing.
To summarize electricity companies have market and liquidity risks associated with selling electricity service but by framing a variable electric rate to appear cheaper overall compared to a fixed electric rate plan they can almost completely drop these risks and allow the energy customer to handle that problem.
For many electricity companies energy risk management is handled by their customers and not the provider.
If you would like to compare commercial or residential fixed electricity rates where the price is predictable and the risk handled by the electricity company please use our compare tool at the top right of this site. You may also call us at 1-800-971-4020