A hedging strategy to protect gross margins in a fixed-price mass market.
The retail electricity markets in the United States are set to bloom. Retail power marketers presently must navigate various hurdles, raised by incumbent utilities, before they are able to establish a foothold. Some states, however, including Pennsylvania and Massachusetts, have established a fixed schedule for the recovery of stranded costs, resulting in profit opportunities for new entrants. In addition, alliances of utilities and municipal-owned electric utilities with local brand recognition have further opened the commercial, industrial and residential customers to enterprising power marketers.
A retail business strategy that focuses only on customer acquisition is destined to the red ink. The strategy must be complemented by a judicious management of the risks inherent to servicing electric loads. Power marketing is vastly different from selling electronic microchips where gross margin is clear-cut and inventory control helps manage production flow. Electricity cannot be stored cheaply. Power marketers must, therefore, balance their supply and demand requirements at every point in time or incur heavy energy imbalance penalties. A few hours of $1,000 per megawatt-hour spot prices will, in an instant, wipe out an entire year's worth of profit margins.
While the price and volume risks of retail power marketing are significant, they can be managed with financial and physical instruments already available in the wholesale market. An effective hedging strategy not only reduces risk exposure for the retail power business, but also provides a clearer indication of value.
Risk: The Short and Long of It