Most businesses in Australia purchase electricity as a bundled retail product from a licensed retailer. The retailer takes care of the administration of the customer’s supply service, so that the customer need only turn on the switch and electrons start flowing, and a bill turns up each month.
In the meantime, the retailer is doing a lot of work in the background that the customer never sees, such as:
- Contracting for electricity to supply to the customer
- Purchasing the environmental certificates required to meet the customer’s obligations
- Organising a meter agent to monitor, record and report consumption data from the meter
- Paying the network provider for transmission and distribution charges
- Calculating the bill and sending bills to customers and ensuring that they pay.
The hidden cost
However, retailers provide another service that most businesses don’t even realise they are getting, and it’s an expensive service. Retailers provide a risk management service (insurance service) bundled in with the supply of the electricity, often at high risk premiums.
To some extent the retailer smooths out the risks by aggregating all of the different customers into one or more portfolios, thus reducing the large number of individual risks into one or more portfolio risks. As the retailer is having to wear those risks, it charges a premium to do so, and that premium reflects worst-case scenarios. If the worst-case scenarios do not manifest, then they get to pocket the worst-case scenario premiums that they have charged their customers.
The customers who enter into a straightforward vanilla electricity supply agreement pay the following price for the energy component of their bill:
Retail energy price = Wholesale energy price + Administration costs + Risk premium (volume, load profile and credit risks) + Retailer margin
There are other options
Many businesses don’t even realise that there are other options for purchasing electricity. Negotiating a good price on a standard retail contract might seem like a good approach, but if you understand the intricacies of the electricity market and the electricity requirements of your business, you can achieve huge financial benefits if you get a bit more creative with your electricity purchasing.
Managing your own risk
The risk premium that the retailer builds in assumes that the customer has no ability to manage its own risk. However, there are ways that the customer can manage its own risk through demand side management (DSM) to avoid high prices and achieve very low average prices compared to what is offered by the fixed retail offers.
The first DSM method is load curtailment. By monitoring market half-hour prices, businesses can reduce their load when price spikes occur and avoid the very high prices that sometimes drag the average monthly price above the median price.
The second DSM method is load shifting. By understanding likely price patterns, such as early morning and late afternoon price increases, businesses can often shift their load – to some extent – to maximise the exposure to the very low prices and minimise their exposure to the higher prices. In recent years, middle-of-the-day prices are very low due to solar generation.
Great examples of end users who can apply this are irrigators and water utilities that can schedule pumping at times when prices are historically low, while not running when prices are historically higher. Couple that method with load curtailment to avoid the price spikes and these businesses can achieve average prices well below the fixed retail price offers.
Adopting a pool price pass-through strategy
So, your business carries out an analysis of the electricity spot market, your own load profile and operating constraints, and weighs up the opportunities and risks of adopting a pool price pass- through strategy. But where to from here?
There are two ways you can adopt a pool price pass-through strategy:
The first is to contract with a retailer to supply you on the basis of pool pass-through prices. With this type of supply arrangement, the retailer will charge a management fee to cover their own costs and to make a margin. The cost of the management fee will be an important consideration.
The second way is to become an electricity market participant as an end-user participant. This method is usually only viable for very large users and requires significant management oversight.
The key difference is that the market pool price is not fixed; it fluctuates every half hour, and the average cost will vary from month to month. The other obvious difference is that the customer is not paying the risk premium.
Going directly to the market
A large user may opt not to pay the retailer any management fee and become a market participant themselves. However, inevitably there is still a substantial cost in managing the obligations that a market participant has, whether you outsource this function or employ someone and bring it in house.
In this case of doing it yourself, the electricity cost equation becomes:
Wholesale price = Market pool price + Administration costs (internal and/or 3rd party)
Wholesale Market Pool Price Passthrough Strategy In Action
Historical data analysis has shown that if you adopt a pool price pass-through strategy your average price for the full year is likely to be at or below the best fixed retail price. In South Australia it is likely to be significantly below, depending on your load profile.
However, you can achieve even lower prices by actively managing your electricity usage and avoiding the higher price periods and the price spikes. It is the short-term duration price spikes that drive the average price up. The high price spikes can be largely avoided by adopting a load curtailment schedule.
Developing a load curtailment schedule
So how do you develop a load curtailment schedule that optimises your electricity cost without impacting your customer service and supply of products?
This is where we turn to the Theory of Constraints. The Theory of Constraints posits that with any manageable system – for example, a plant – there is one constraint, sometimes more, but rarely many. This means that there are usually many processes that are not constrained and can be turned off, or curtailed, without impacting the efficiency of the total supply chain.
We need to identify the critical asset or assets that are constrained and then determine the opportunity cost of shutting down the asset, if at all possible. The opportunity cost establishes a break-even point where if that asset were to not operate for a short period of time then the opportunity cost equals the financial benefit of operating.
There are of course other considerations. The customer should see no impact from curtailing load and should be oblivious to the fact that you do curtail as part of your operations management.
Also, some types of equipment – particularly equipment that runs at high temperatures – are not designed to be shut down and restarted for short periods of time. This equipment may experience thermal shock, which will have a deleterious impact on equipment integrity or shorten its service life. For example, equipment that operates at elevated temperatures is usually refractory lined, and thermally cycling this equipment will have an impact on refractory life.
The other non-constrained assets are those that are not required to run all of the time. This equipment is often shut down because the buffer stock after its process fills up or its scheduled operating time is less than the constrained asset run time. It is this equipment that we largely target to curtail in the event of high price spikes.
But, isn’t it risky not to use standard retail contracts?
Going a different way does have risk, but risk does not mean “risky”. Risk is simply uncertainty.
With a pool price strategy, the average annual price is not certain and so there is a risk. A retail price is fixed and so there is no price risk. However, there is a very high risk that the fixed retail price will be higher than the average wholesale market price over a full year.
Tom Adams, a former executive director of Energy Probe, an industry watchdog in Canada, has a great analogy about paying for fixed retail contracts: “Over a lifetime of driving, you know you’ll replace a couple of windshields. But if you insure your windshield, you don’t pay for two windshields – you pay for 10.”
So yes, a spot exposure strategy is “riskier” than a vanilla fixed retail contract, and with taking on that “risk” there is an expectation of a return. History has shown that the worst possible outcome from a pool price exposure strategy has been close to the best retail offer prices, depending on the timing of the retail offer.
The trick for businesses is to understand historical price volatility and annual average prices, overlay your informed view of what is happening in the market structure on the coming years, and then compare that with fixed price offers. If your informed view of likely market price distribution outcomes is at or above a fixed price offer, then by all means lock in the fixed price offer. If your informed view is that market prices are likely to average below the best fixed price offer, then why would you want to lock in high prices?
Post authored by Michael Williams.