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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

mentioned. Useful debate may arise concerning the extent to which such optionality is utilized economically, which again will affect the marginal cost of taking risk. In this light, understanding the costs involved in providing flexibility and balancing is very important, but the lessons learned regarding the marginal costs of serving customers remain.

Pricing the optionality in balancing and flexibility-that is, the right to vary around forecasted quantity, as though every deal were on a standalone basis and as though every customer were going to use their options economically-defies business rationality. Although it is an empirical matter for investigation, customers who are balancing-down (taking less) offset customers balancing up (taking more). Moreover, with sufficient customers across different end-user-categories and different geographic locations, a quantifiable portfolio diversification effect may arise, further reducing the actual cost of bearing such risk. It is difficult to justify attempting to charge a 10 percent balancing cost using option theory and losing the deal, when the actual marginal cost of risk taking, given off-setting take and load factors, may be 2 percent.

The commodity-trading model has many good points, but the challenge lies in how it is applied. Even without movements in forward curves and volatility, changes in the marginal cost of risk-taking will arise. Deals may offset existing positions and therefore reduce risk. When available, savings in the opportunity cost of risk capital should be included, to the extent required, in the marginal cost of pricing gas and power risk to third parties. Such exercises, however, require real-time, dynamic simulation. Such efforts could lead to certain segmentation criteria, wherein deals and exposures below a certain size are inconsequential.


  1. Thomas, S., "The Seven Brothers," Energy Policy, 31 (2003) p. 397.
  2. Stulz, R.M., "Rethinking Risk Management", The Revolution in Corporate Finance, edited by Stern, J.M. and D.H. Chew, Jr., Oxford: Blackwell Publishing, 2003, pp. 367-384.
  3. Some recent interest in this topic includes: Essaye, T. & B. Humphreys, "Portfolio Optimisation," , Vol. 8/No.1, April 2003; and Fronmuller, M. and D. Cobb, "Playing the Asset Optimisation Game," Platts Energy Business and Technology, October 2002, pp. 32-33.
  4. Eeckhoudt, L. and C. Gollier, , London, Harvester Wheatsheaf, 1995. pp. 153-182.
  5. Copeland, T.E. and J. Fred Weston, , Third Edition, New York: Adison-Wesley Publishing, p. 125.
  6. Capital market efficiency should not be confused with the concept of perfect capital markets, as described in the text. Capital market efficiency describes a situation when prices fully and instantaneously reflect all available relevant information. (See, Fama, E.F. "Efficient Capital Markets: A Review of Theory and Empirical Work," , May, 1970, pp. 383-417.)
  7. , p. 331.
  8. Brealey, R.A. and S.C. Meyers, , London, McGraw Hill, 2000, pp. 353-354.
  9. A weak defense for ignoring company-specific differences might be motivated using portfolio theory: Company-specific differences, idiosyncratic risk, may be diversified away, and hence only systematic or market risk is reflected in the prices of securities and commodities. The number of gas and power players may be insufficient to construct a diversified portfolio. Second, creating a diversified portfolio against company-specific differences, such as the cost-of-risk bearing, does not imply immunization from