One of the most important decisions a retail energy buyer makes is whether to sign a contract that locks in the electricity or gas price at a fixed level for a period of time or one that varies based on market factors.
Factors to Consider
When deciding whether to contract for a fixed, variable, or blended price, you need to understand your company’s risk tolerance. Is your goal to minimize risks to your budget and cost structure? Or do you want to speculate on energy price movements in hopes that you can “beat the market” over the long term by signing? If your greatest concern is to ensure you meet a set budget target, fixed energy pricing can be a simple way to control your costs. If your goal is to minimize costs, the answer is more complex.
A second key factor to consider is how much you value a simple contract. To what extent can you devote resources to developing a more complex energy purchasing strategy? Both fixed and variable rates can be relatively simple. Once you perform basic due diligence on your supplier and the terms and conditions they are offering, you can “set it and forget it” until it comes time to renegotiate a new contract.
The complexity arises when you try to predict the future direction of prices. Doing so can prove profitable, but it also requires you to devote time and resources to studying the market – and possibly hiring an external consultant to help. If energy is a major portion of your budget, then it is probably worth expending the resources to develop a buying strategy that predicts price movements and takes them into account. A 2011 article in the MIT Technology Review recommends doing so if energy is among your top three to five costs expenses.
Fixed vs. Variable Pricing: Two Approaches
The Budget Approach
According to a research report from the Energy Research Council, 73 percent of small-to-mid-sized business (SMB) executives want to lock in fixed-rate electricity supply contracts. Whether you take a view on the direction of future prices or simply want to reduce your overall risk, signing fixed-rate energy contracts can help ensure that you meet your annual budget. Many large corporations tie departmental goals to meeting specific targets. Knowing your energy price in advance can go a long way toward providing management with realistic guidance on how much your company needs to spend on energy over the course of the year.
Whereas many firms simply want to limit their energy risk by signing long-term, fixed-rate contracts, many large-scale energy users have extensive insights that help them to predict future energy prices and develop purchasing strategies that meet these long-term forecasts. For example, if you believe local energy prices will rise, you can sign a fixed-rate contract that will protect against future price increases. Conversely, if you believe prices will fall, you can sign a variable-rate contract with a retail supplier that will allow your rates to fall along with the broader energy market. (Retail suppliers often offer more flexibility than utilities in meeting the needs of specific users, though that is not universally true.)
Any analysis should take into account a wide variety of factors that could drive prices over the term of the contract. These may include fuel pricing, transmission constraints, pricing for alternative energy sources, environmental regulations, aging infrastructure and other factors.
Other Factors to Consider
Price Premium for Fixed Pricing
Fixed-rate contracts often carry a price premium compared with market rates, as suppliers need to recoup costs associated with long-term contracts. As PAPowerSwitch explains, “The certainty of getting a fixed rate could cost you a little more money.” When investors buy bonds, longer-term bonds generally offer higher rates because investors take on risk for a longer term. Similarly, suppliers typically demand higher rates for longer-term contracts because they are taking on more risk.
When signing any energy contract, it is vital to consider how long the contract will last before you need to renegotiate – and that there are no hidden fees or renewal terms. This is particularly true if you are predicting the direction of the market. If you believe that market rates will increase for several years, you should lock in pricing for several years. For variable pricing, this may be less important, though you do not want to have to solicit bids and renegotiate retail energy contracts too often.
Other Energy Hedging Instruments
Fixed-price retail energy contracts are not the only way to hedge energy costs. It is also possible to invest in energy futures contracts, options or other instruments. A famous example of hedging is Southwest Airlines. An article from Walden Labs on fixed energy prices describes how Southwest bought futures options that allowed it to enjoy lower fuel prices than its competitors for nearly a decade as fuel prices rose. When fuel prices fell during the Great Recession, the company lost money relative to competitors that had bought fuel based on market pricing, though Southwest probably benefited in the long run.