Public Utilities Reports

PUR Guide 2012 Fully Updated Version

Available NOW!
PUR Guide

This comprehensive self-study certification course is designed to teach the novice or pro everything they need to understand and succeed in every phase of the public utilities business.

Order Now

Betting on Retail Risk Management: Flat Prices for Peak Hedging

Why a risk-hedging product for small customers isn't the gamble you may think.

Fortnightly Magazine - November 1 2002

weather derivatives.

Another financial risk is the change in individual customer behavior. During the first year it is impossible to predict how an individual customer may respond to flat pricing. But the overall average response can be anticipated and distributed evenly into all customers' flat pricing during the first year. When customers renew their offer, however, their actual usage with their demonstrated behavior change could be built into the renewal offer, rather than simply offering a flat price for the average customer. This practice in itself can be expected to reduce inefficient consumption changes.

An additional risk is that a customer might use more electricity during the first year than predicted, and then decide not to renew. This "free-ridership risk" can be measured and forecasted. The predicted impact can then be built evenly into all future customers' flat pricing offerings. Even if participants return to the traditional pricing tariff, they will retain some residual behavioral changes that will generate further profitable sales.

Finally, there is risk associated with the accuracy of the cost variable going into the flat pricing model. That variable includes the predicted base energy price and fuel price, customer usage history, predicted customer behavior, and the accuracy of the weather-normalization model. A risk adder can compensate the supplier for these financial risks. Customers are willing to pay a premium to have this risk transferred to the supplier, so if customer sensitivity to the risk adder is equal to, or greater than, the acceptable risk of these components, then this portion of the risk can be managed.

To manage the portfolio of financial risks, we created a spectrum of potential outcomes based on all risk variables. We tested the severity of these risks by creating a range of worst-case, expected, and best-case scenarios, where the risks can be quantified and therefore managed through the flat price.

The Reality: The financial results of the pilot during the 12-month period supported the hypothesis that the risk could be managed. The actual outcome fell within the risk spectrum and very close to what was predicted, given the actual outcome of each risk variable. That does not mean that the financial results were positive. In fact, during the 12-month period, there was a hot summer, a mild winter, and a fuel price increase. Though that caused Georgia Power to see a negative financial impact for the flat bill customers, it supported the natural hedge theory because the company earned a higher than normal return from weather-sensitive customers not taking the flat pricing option.

Flat pricing programs are not designed to win every year. Rather, they are designed to earn a given return over multiple years. The scenario is similar to the bet a casino wagers. On any given roll, a customer can beat the house, but over a course of multiple rolls, the odds are set so that the house comes out ahead. Most casinos "bet" that few winners will walk away from the table immediately after winning, or act as free riders. The analogy with flat pricing is that even those few who