Options and insurance each has a niche, but price collars are cheaper and more adaptable to market risk and customer behavior.
During the summers of 1998 and 1999, wholesale prices in the Midwest soared to $7,000 or more per megawatt, in comparison to a more typical summer price of $30 to $50 per megawatt. In a competitive environment, electricity suppliers - that is generators, utilities, marketers, etc. - will offer a variety of pricing products ranging from flat rates to real-time pricing (RTP). By varying degrees, price risk will be passed to the end-user. Consequently, consumers will demand risk management alternatives.
A price collar is a way for the electricity merchant and customer to agree on how to share price risk.[fn.1] With a collar, there is a ceiling on the maximum hourly price. In return, the customer accepts a floor on the minimum hourly price. The collar offers an alternative to the extremes of flat rates and RTP.
While customers can use other risk management tools, such as options, to effectively smooth rates, price collars permit the customer to use unlimited quantities at all prices. Options, by contrast, are for fixed quantities. Most customers desire unlimited quantities.
The focus here is on how to establish the floor of a price collar, with particular attention given to price elasticity and the effects of customer response as predicted by economic principles. Accounting for such effects leads to upward adjustments in the floor price needed by the merchant to break even. The key issue is that the merchant who ignores price elasticity will lose money.