Most business customers prefer knowing what their electricity rate is going to be for a given contract term. Others prefer to have their electricity rate ride with market. There are several types of market index rates available to commercial and industrial customers. One well-established electricity index product is based on natural gas prices. This product is often referred to as a heat rate product.
Electricity Heat Rate
A heat rate product is a relatively simple concept. For each calendar month, the electricity price is calculated based on a published natural gas index price and a conversion factor (heat rate) specified in the electric service contract. The electricity rate varies each month in a transparent manner with the only variable being the price of natural gas. This approach differs from most residential variable pricing plans where the pricing mechanism is proprietary and not disclosed to the customer. Before contracting for a heat rate product, a commercial customer should understand the mechanics and risks associated with this product structure.
Natural Gas Price Index
First, it is important to understand the natural gas index price ($/MMBtu). The most commonly used natural gas index price is the NYMEX Henry Hub final settlement price. NYMEX Henry Hub natural gas futures are widely used as a national benchmark price. Natural gas futures are defined by delivery in a specific calendar month and are traded until the third-to-last trading day before that month. For example, the final settlement price for May 2015 is set at the close of trading on April 28, 2015. At the end of the last trading day, a final settlement price for the prompt month is set. The trading calendar and final settlement prices are easy to access. Retail electric suppliers may be willing to use other natural gas indices in their heat rate products for large industrial customers. An example of an alternative natural gas index would be the monthly Houston Ship Channel price published in Inside FERC. When contracting for an electricity rate indexed to natural gas, commercial customers should make sure they understand the index and its volatility.
The second part of the electricity rate calculation is the heat rate itself. This is how the the natural gas index price is converted into an electricity price. The simplest, and least common, form is a conversion factor only. For example, say the contract specifies that the electricity price is equal to the natural gas index price multiplied by 12.5 MMBtu/MWh. If the natural gas price is $4/MMBtu, then the electricity price is $50/MWh or 5 cents/kWh. In this example, the electricity price is entirely dependent on the natural gas index price. However, the electricity rate includes ancillary charges and other price components that do not necessarily correlate to natural gas prices. The retail electric supplier would also have their margin tied to the natural gas index price. For this reason, multiplier-only or “all-in” heat rate conversion formulas are rare.
Typically, the retail electric supplier will offer a heat rate formula with a fixed adder. The fixed adder will include electricity price components that do not track well with natural gas prices. The retail electric supplier’s margin will usually be embedded in the adder as well. For example, the contract might specify that the electricity price is equal to the natural gas index price multiplied by 10 MMBtu/MWh plus a fixed adder of $10/MWh. Given the same natural gas index price used in the previous example, $4/MMBtu, the electricity rate for that month would be calculated as follows:
(10 MMBtu/MWh x $4/MMBtu) + $10/MWh = $50/MWh or 5 cents/kWh
Notice that the electricity price is the same in both examples using a natural gas index price of $4/MMBtu. However, if the natural gas index price is $5/MMBtu, the multiplier-only formula yields an electricity price of 6.25 cents/kWh while the multiplier-plus-adder formula gives an electricity price of 6 cents/kWh. The multiplier-plus-adder formula is less sensitive to natural gas price movements because the fixed adder moves some risk away from the gas price.
Electricity Price Risk
Given this basic understanding of heat rate pricing mechanics, a commercial customer should also give serious thought as to whether the risk profile of this product is suitable for their business. Foremost, a customer should be amenable to the higher price volatility associated with this product. Additionally, there are certain business characteristics that may indicate a good fit for having electricity rates tied to natural gas prices. Some of these characteristics include:
- customer revenues or profits correlate to natural gas prices,
- customer is a large consumer of natural gas and already has a program in place to manage natural gas price risk, and/or
- customer has the means or sophistication to hedge the natural gas price risk through financial derivatives such as caps or collars.
Before contracting for a heat rate product, take the time to understand the formula used for determining the monthly energy price. Next, examine historical natural gas price volatility and assess the impact of future volatility on electricity rates. Also, be certain to review the contract provisions as they pertain to converting from a heat rate to a fixed price product. There may be a time during the contract term when it makes sense to lock in the electricity price for the balance of the contract term.