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Building a Risky Business

The diversity in customers’ appetites should be considered by more utilities when pricing products.

Fortnightly Magazine - March 2007

risk premium. 4 A number of issues must be addressed to offer this product: 1) historical weather data along with customer-specific usage data must be linked to forecast weather-normalized consumption on a specific customer basis; 2) the change in consumption that the customer is expected to exhibit in the contract period next must be included; and 3) a risk premium must be added to cover extra risk for the utility to offer this type of product. The product is still in its infancy but is capturing 10 to 20 percent market share and experiencing greater than 90 percent renewals. It’s currently targeted to residential and small commercial customers, although interest is growing with moderate-size (100 kW to 500 kW) commercial customers. A new version is being offered both to small to moderate-size commercial customers. This variation sets ceilings on usage at the fixed-bill amount, and provides incremental usage charges for usage above the ceiling. This will be a vital product in providers’ portfolios for an open-access marketplace.

In summary, traditional utility tariffs have shielded customers from most of the direct risks associated with the volatility of electricity costs. The portfolio of pricing products described above explicitly offers customer choices that permit them to accept the level of risk that meets their needs and sets the corresponding price associated with the risk level chosen. These products all consider risk as an essential ingredient in individual tariff pricing. Traditional tariffs have not explicitly recognized risk on a tariff basis. The presumption has been that, in the aggregate, the regulation of all tariffs periodically would provide the necessary backstop (return on equity) or aggregate adjustment when appropriate.

A sound risk-based pricing product portfolio deals correctly with risk on a tariff basis via an appropriate risk premium and lessens the need for the regulatory “backstop.” This does not mean that risk-based pricing will cover actual tariff cost during every event. It means merely that over time, tariff price should cover cost and will do so on an expected basis. To ignore specific tariff risk and rely simply upon the aggregation of the costs of all individual tariffs into one “basket” of revenue requirements, as may have traditionally been the case especially in regulated arenas, means that individual tariff price likely will not match actual tariff cost during many events and over time price may not be expected to do so. It’s time to realign the portfolio upon sound risk fundamentals.

 

Endnotes:

1. “ Building a Better Pricing System ,” Public Utilities Fortnightly , May 2004.

2. “ Real-Time Pricing – Supplanted by Price-Risk Derivatives ,” Public Utilities Fortnightly , March 1, 1997.

3. “ Flat Prices for Peak Hedging ,” Public Utilities Fortnightly , Nov. 1, 2002.

4. “ Flat Bills, Peak Satisfaction ,” Fortnightly’s Energy Customer Management , January/February, 2002.

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