[BETA] Fortnightly

Options and insurance each has a niche, but price collars are cheaper and more adaptable to market risk and customer behavior.

During the summers of 1998 and 1999, wholesale prices in the Midwest soared to $7,000 or more per megawatt, in comparison to a more typical summer price of $30 to $50 per megawatt. In a competitive environment, electricity suppliers - that is generators, utilities, marketers, etc. - will offer a variety of pricing products ranging from flat rates to real-time pricing (RTP). By varying degrees, price risk will be passed to the end-user. Consequently, consumers will demand risk management alternatives.

A price collar is a way for the electricity merchant and customer to agree on how to share price risk.[fn.1] With a collar, there is a ceiling on the maximum hourly price. In return, the customer accepts a floor on the minimum hourly price. The collar offers an alternative to the extremes of flat rates and RTP.

While customers can use other risk management tools, such as options, to effectively smooth rates, price collars permit the customer to use unlimited quantities at all prices. Options, by contrast, are for fixed quantities. Most customers desire unlimited quantities.

The focus here is on how to establish the floor of a price collar, with particular attention given to price elasticity and the effects of customer response as predicted by economic principles. Accounting for such effects leads to upward adjustments in the floor price needed by the merchant to break even. The key issue is that the merchant who ignores price elasticity will lose money.

Adverse selection is another factor that, if ignored, could result in losses to the merchant. If the floor of a price collar is based on the price responsiveness of the average customer and then is offered to all takers, those who have above-average elasticities will opt for the collar and those with below-average elasticities will decline the collar. The result is that the merchant will suffer a loss. In order to break even, the merchant will need to distinguish among customers based on price-response capability and charge a higher floor to customers with above-average price elasticities.

Already, consumers have a number of choices for managing risk. In 1996, trading of electricity options began on the West Coast. It since has been introduced on the East Coast, as well. Puts and calls allow the purchaser to hedge against low and high prices respectively. Electricity insurance recently was introduced. Enron offers derivatives that provide coverage against high electric prices associated with extreme temperatures. CIGNA Property & Casualty, just purchased by ACE Limited, offers insurance against high prices due to generation outages.

Price collars offer a simple alternative, especially for the retail customer. Risk management is accomplished through pricing, rather than turning to a derivative market. Here we compare collars, options and insurance as risk management tools. The remainder of the paper addresses the pricing of collars.[fn.2]

Risk Management Tools: Not Created Equal

Each of the three approaches - options, insurance and price collars - has a niche in the market. No one