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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

pilot that metered the participants' actual energy and peak consumption. This information was normalized to account for weather and compared to the previously measured behavior for these customers. The results were measured empirically using test and control groups.

The Reality: With the pilot flat pricing program, there was an increase in both energy and demand consumption. But, the increase was minimal and occurred mostly during off-peak periods. The majority of the growth resulted from customers lowering their thermostat setting during the summer months. The effect of this action was minimal during peak hours because the electric cooling system was running full speed regardless of whether the thermostat was set at 76 degrees or lowered to 74 degrees. But during the off-peak times, when the weather had cooled, the threshold of the thermostat setting had a greater impact of the running time of the cooling system.

Despite the minimal increase in energy consumption exhibited during the pilot, it can be energy-efficient. This program is the only one for residential customers that can accurately measure participants' change in behavior in terms of the financial impact on their annual bills. Typical volumetric pricing used by weather-sensitive residential or small business customers reveals a change in behavior from month to month, or month to the same month of the previous year, but that is less accurate, since weather conditions always will blur the results. Because a flat bill is based on weather-normalized behavior, any change in demand will be accurately quantified in the customers' next-year, flat-price offer. In addition, improved efficiency will be rewarded by a lower offer, regardless of the weather. If the program is marketed correctly to inform customers of how they could be more efficient, and how the program can measure and reward them, it could provide the means for customers to become more energy-efficient.

Myth # 2: Risk Is Unmanageable.

Risk is frightening, and it exists everywhere. But risk also is transferable. With flat pricing, financial risk can be deflected from the customer to the supplier. For flat pricing to work, the key question is whether this risk could be dissected and managed.

The major risk is the weather impact. If the summer is hotter than normal, and the winter is colder than normal, the result is that the amount collected from the flat pricing would be less than the amount otherwise paid by the customer. Conversely, if mild weather occurs, then the amount collected by flat pricing would be greater than the amount otherwise paid by the customer.

In some industries this risk might not be manageable. In the electric industry, however, it acts as a natural hedge. In hot weather years, when flat pricing is under-recovering, the company is generating unusually high returns from its other weather-sensitive customers not on the flat pricing schedule. In mild weather years, at the same time flat pricing is over-recovering, the company is generating unusually low returns from its other weather-sensitive customers. Thus, flat pricing can provide for free a hedge that some energy companies pay for, in the form of weather insurance or