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Retail Risk-Based Pricing

A new approach to rate design.
Fortnightly Magazine - March 2004

A new approach to rate design.

As energy markets have evolved in the late 1990s away from cost-based transactions to competitive market-based transactions, the exposure to market risks for the variable cost of supply has substantially increased. 1 Reflected in these market risks are the diminishing reserves for North American gas supply, which has created conditions of extreme volatility in gas supply. The added market risk is compounded by the sensitivity of some retail load customers to weather conditions. Through integrating load and price uncertainty, risk-based pricing (RBP) determines the true cost of service and provides a more comprehensive approach to developing retail rates in today's energy markets. 2

Traditionally, retail pricing for regulated entities has been based on the average cost of service, and no factors are associated with the relative volumetric risks and the relationship to prices. 3 The principal concept behind RBP is that customers with greater risk require greater working capital set-asides to address anomalous or unexpected events. RBP provides a structured approach to value the elements of retail supply cost risk and provide a systematic structure to incorporate these risks into retail prices. 4 As a company's stock price carries a beta value with respect to movement in the market average, RBP introduces a method for reflecting the joint relationship of volumetric and price risk that effectively incorporates each customer's beta into retail electric rates. For competitive retail offerings, RBP provides a well structured approach to identify low-risk customers and develop a consistent risk metric for retail offerings.

Utilities are pressed with the challenge of providing service at the forecast cost of supply under highly volatile market and weather conditions that can leave utilities short of the cash required to maintain operations. Over the last three years, utilities have suffered a spate of rating agency downgrades, disabling disallowances related to fuel and purchased power, and, in a few instances, bankruptcy. In most cases, the financial hardship pressed upon utilities has been related to cash flows and the ability to cover current and future liabilities. RBP serves as a defensive mechanism that updates previous rate-making strategies for consistency with current market structures. RBP is a natural extension of real-time pricing initiatives that works contemporaneously with time-of-use pricing and multi-tiered tariffs. 5

Volumetric Risk

Understanding the variability in weather is important for accurate characterization of electricity load, price volatility, and volumetric risk. By producing accurate simulations of spatial and temporal weather patterns, we are able to assess the volumetric risk and weather risk of different retail customers.

For example, looking at Figures 1a and 1b, we have two different customer class profiles in the ERCOT Coastal Zone for July 2004. The first profile, ERCOT "Business High Load Factor" (BusHiLF), is a commercial profile where the daily energy uncertainty is around 16 percent (see Figure 1a). The second profile customer, ERCOT "Residential Low" (ResLow), is a residential profile where the daily energy uncertainty is 26 percent (see Figure 1b). A summary of the annual weather-based uncertainties for the different ERCOT zones and profiles clearly shows large differences between the different