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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

leave the program will maintain higher consumption habits, which have become embedded in their behavior and will be captured in normal tariffs. The trick is managing the risk.

Myth #3: Regulators Won't Approve It.

Even if the potential load growth is manageable, even customers want it, and if the risks can be managed, many suppliers believe that commissioners in regulated regions will be opposed to the program's innovation and risk.

It's easy to understand why regulators would scrutinize this product. The industry norms suggest that there are established opinions against such a product. But we believed that by challenging each of these norms through market research, modeling and risk analysis, this product could be approved and introduced into the regulated electric market. After all, IPALCO's regulated subsidiary, Indianapolis Power & Light, had received regulatory approval for a similar product in 1998, and has offered it ever since. In addition, regulatory concerns could be addressed through standard regulatory accounting to shelter regulated non-participants of the program from flat pricing risk, exposing only utility stockholders.

The Reality: In June 2000, Georgia Power received regulatory approval for a one-year pilot with a maximum number of 500 participants. The utility recently earned approval to expand the offering to 100,000 customers with no cap on participation.

Myth #4: Customers Won't Pay For It.

The commonly held belief is that electricity is a true commodity and consumers will always choose the lowest-cost option. But flat pricing should not be the cheapest pricing package for the customer in the long run, due to the significant cost and quantity risk the programs place on energy retailers.

But would customers recognize the value of an electric service package that provides convenience and "peace of mind," and if so, would they be willing to pay a premium for it?

Reality Check: Survey results showed that many customers valued predictability and convenience, and were willing to pay a premium for that. Because our previous market research predicted that pilot participants would use more energy, the forecasted additional energy was built into the price of the flat pricing offer.

Surveys, however, did not prepare us for the extremely high public interest in the pilot. The day after the pilot was filed, news of it made the front page of the business section. Soon, it was reported favorably on both national radio and television-all for a 500-customer pilot, which hadn't even mailed promotions about the product yet. The mailed offers gained a high penetration rate, indicating that customers opted for the flat pricing option to meet their budgeting needs. In a follow-up survey of pilot participants, 95 percent reported that flat pricing either met or exceeded their expectations.

Managing Flat Price Risk

Energy companies can manage the financial return of a flat pricing program based on its appetite for risk. There are two simple methods to control risk and return.

The first method is managing the number of participants (). The program can be phased in by offering a small pilot, then slowly expanding eligibility to larger markets. A phased approach can give time to