Commercial and residential electricity plans can differ significantly in how they are packaged and presented to prospective customers. Commercial electricity offers typically focus on price, customer service, and access to data and reporting. Residential electricity offers appeal to a broader spectrum of customer interests and include value-added services like smart thermostats, appliance warranties, or heating and cooling system maintenance. However, there is a common set of risks underlying electricity plans for both customer groups.
Electricity Price Components
Depending on the location of the customer, the basic elements that make up the cost of electricity include energy, capacity, transmission, line losses, and ancillary services. Energy is the cost of electricity itself. Capacity and transmission are costs associated with the customer’s impact on the power grid during peak demand periods. Line losses are the costs associated with the electricity lost between the point of generation and point of delivery. Ancillary services are required to maintain the integrity of the power grid. There may also be charges associated with state renewable energy requirements, advanced metering, and administration of the power grid and electricity choice program.
For residential and small business customers, energy providers typically approach fixed price electricity plans in the same manner. All price components remain locked in for the term of the agreement. Electricity service agreements often include a little wiggle room if there is a change in law, a change in the allocation of power grid costs, or if the customer materially modifies their usage pattern or quantity of electricity consumption. However, some electricity providers and some commercial customers are not convinced the “everything locked-in” model is the best approach.
Electricity Price Risk
It is important to understand that all electricity pricing components include an element of risk. If the electricity company assumes the risk for a pricing component (i.e., locks it in for the duration of the agreement), it charges a premium. The premium charged is proportional to the risk associated with the particular pricing element. The electricity provider is now on the hook for whatever happens in the market while the customer’s cost remains fixed and stable.
If the customer elects to have a pricing component passed through on their bill, they avoid paying the premium but are at now unprotected from price fluctuations. For example, if the electric service agreement states that ancillary services costs are billed on a pass-through basis, the commercial customer feels the full effect of any price volatility.
Some price components are especially risky and, by passing them through to the customer, the electricity rate looks more appealing. Commercial customers are also known to request certain electric price components be passed through as opposed to being included in the fixed price. These customers often view the risk as being minimal compared to the risk premium the electricity provider would charge for locking it in.
Managing Price Risk
The problem is that commercial electricity customers are not typically in a position to manage the risk associated with pass-through price components. If the customer takes on risk without a means of hedging that risk, it is essentially a pure gamble. Many customers view the risk asymmetrically. They consider the opportunity to benefit outweighs the likelihood of financial loss.
Business owners and managers have the power to choose the type of electricity plan that meets their needs. Before selecting an electricity plan, they should be very clear about which pricing components are locked in and which are passed through. They should also understand the risk associated with pass-through components. In the end, the plan with the lowest electricity rate may actually be the one that costs the most.