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Collaring the Risk of Real-Time Prices: A Merchant Strategy for Utilities

Fortnightly Magazine - October 15 1999

would be Pf=$0.07 per kilowatt-hour. (This example is not shown in table 2.) Consequently, a merchant that offers a price floor of $0.05 per kilowatt-hour would attract above-average elasticity customers who would increase hot-hour usage and decrease low-temperature usage more than the average elasticity customer, resulting in losses for the merchant. Furthermore, customers with below-average elasticities would not choose the rate; hence there is no earnings offset to the losses from the high elasticity customers. If the merchant can distinguish these two groups of customers, it may be able to charge each group a different price floor.

Peter Schwarz, Ph.D., is professor and chair of the Department of Economics at the University of North Carolina-Charlotte, and senior economist, energy resource planning, Research Triangle Institute. He specializes in real-time pricing.

Tom Taylor, Ph.D., is a senior economist in the Rates and Regulatory Affairs Department at Duke Energy Corp. He led the development of Duke's hourly pricing program and has focused on pricing for industrial customers.

1 The term "merchant" is used throughout this paper to represent any party who purchases electricity on the spot market and offers, for a fee, to sell that electricity at a rate that reduces or eliminates price risk. Consequently, the cost of electricity to the merchant is equal to the spot price.

2 In Britain, generating companies purchase contracts for differences (CfDs) to manage the risk of buying in the real-time wholesale market and selling at flat rates to customers. See Green and Newbery, "Competition in the British Electricity Spot Market," Journal of Political Economy, Vol. 100, No. 5, pp. 929-953, 1992.

3 Oren, Gupta and Tiesberg and Tiesberg argue that price collars are equivalent to options. See Proceedings: EPRI Conference on "Innovative Approaches to Electric Pricing: Managing the Transition to Market-Based Prices," TR-106232, Research Project 2343, March 1996, for the Oren and Gupta papers. See Tiesberg and Tiesberg, "The Value of Commodity Purchase Contracts with Limited Price Risk," Energy Journal, Vol. 12, pp. 109-135, 1991. The equivalence of insurance and options is in Merton, Robert, "An Analytic Derivation of the Cost of Deposit Insurance and Loan Guarantees: An Application of Modern Option Pricing Theory," Journal of Banking and Finance, Vol. 1, pp. 3-11, 1977.

4 EPRI, "Pricing the Riskiest Retail Electricity Product - Flip-the-Switch," Technical Brief, September 1996.

5 This information is from Restructuring Today, July 15, 1999, and a conversation with Kurt Husar of CIGNA Property & Casualty. Husar also noted that in actuality, the delivery of electricity from an option may take up to two days.

6 Under more realistic assumptions than those of figure 1, contracts are likely to be developed under conditions where there is variability in the number of peak and off-peak hours, spot prices and levels of consumption. The general form of the equation of figure 1 to calculate the floor price under such conditions is

Sh PhsQh - Pc Sl Qh

Pf = S PlsQl + ______________ .

l SQl

l

Note that other aspects of the development of floor prices typically considered in the finance literature may be incorporated,