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Pricing Power in Whosesale Markets: A Risky Business

A Risky Business Utilities wrestle with how much to charge for their product.
Fortnightly Magazine - March 2004

resembles a full absorption-cost approach to pricing. This is because rather than purely variable and additional cost of risk taking being utilized, a full theoretic cost is used, as though the entire enterprise were created for this one exposure/deal. Unlike an asset-based business model that may price in a predatory manner, even below marginal cost in the most competitive portion of the market, when the trading model is wrongly applied it results in full-cost pricing of price and market risk on a theoretic stand-alone basis for a specific deal. In contrast to the marginal-cost method of pricing, widely accepted as economically optimal and the preferred transfer-pricing scheme, a full-cost approach to pricing burdens an enterprise with historic assets and cost structures. 11 Full theoretic cost pricing of price and market risk might have some merit if a power company's entire portfolio represented a handful of very large customers, or there were little or no flexible generation to back the marketing or trading activities. However, pricing risk on a full-cost basis defies economic rationality once a risk-spreading base of customers has been created, destroying the many benefits of the commodity-trading model.

Applications

To realize the potential of the commodity-trading model, price and market risk must be priced at the marginal cost to a specific enterprise. The absence of long-run competitive equilibrium implies that the costs of bearing such risks are unlikely to be equal for all enterprises. We examine two common examples of pricing risk-load-shaping premium, as well as volume balancing and flexibility-to take advantage of company-specific marginal cost differences. 12

Looking at load shaping, typically half-hourly prices are priced using option theory. (As high-frequency volatility may be very high relative to day-ahead volatility, such exercises often lead to debates over accuracy and the extent to which non-replicable full-value should be attributed.) Although the use of option theory is correct in the abstract, different customer load profiles, when aggregated, may resemble a baseload or standard-load profile. Although it is critical to price in theory the risk-neutral cost of taking risk on a certain profile, for a large energy utility with a diversified customer base, this does not represent the marginal and forward-looking cost of supplying the additional megawatt-hours. Unless a potential customer is so large that it will systemically alter a utility's embedded cost structure, a marginal cost of serving a particular shape should be used to attract new customers and keep existing ones. Charging for shape may be a valuable source of additional income for utilities with flexible generating capacity, but new business only can be gained and existing ones retained by recognizing the marginal cost of serving the marginal customer.

Balancing and flexibility, important components in the sale of energy, occur because of changes in ambient temperature, cloud-cover, capacity utilization, or other factors. Such volumetric risk also may be highly correlated with prices, thus creating further exposures. As such, balancing and flexibility represent a form of optionality that energy purchasers possess, allowing them to call more than expected or put back less than expected gas and power, depending on the factors