Is a fixed price product the best approach to energy supply?

Barry Murphy

Barry Murphy

Commercial Director
05/12/2017

Many energy users question whether a fixed or flexible approach is the best value.  There is an answer, and to understand that answer, it is important to recognize that energy commodity prices are driven by global forces and extraneous events;

  • Macro issues such as economic growth or production capacity play a key role in long-term price movement
  • Other factors such as weather disasters, or technological advancements influence price in the short or medium term
  • Local market factors also influence electricity prices

So, this may explain why the cost of a 12-month fixed price contract can move upwards or downwards, year to year, by as much as 25%.

So, what does this mean for wholesale electricity costs in Ireland? 

Firstly, wholesale prices overall have become lower, on average, due to the increasing contribution from renewable technologies, which have no fuel cost. In recent years, many energy users have chosen to avail of products whose pricing gives direct access to the actual wholesale price, known as ‘tracker’ pricing. 

Secondly, notwithstanding changes in the prices of fossil fuels, wholesale prices achieved by conventional energy generation have become higher, due to higher operating costs; big power stations ramping up and down at short notice due to wind intermittency are allowed to recover their (higher) operating costs via the prices that they secure from the market.  

By recognising a few factors…   

  1. Fixed price power contracts are offered by utilities who back them off via their conventional power plants. As the cost of generating power from conventional power stations is higher than renewables, and higher than the market average, the cost to the end user is forcibly higher. 
  2. To offer a fixed price, a utility accepts risk in return. This necessitates a risk premium to be charged as a component of the fixed price. Interestingly, when a utility has a portfolio of fixed price products, they can achieve more margin than the sum of the individual contract risk premiums. This is why Big Utility likes offering fixed price products. 
  3. For an end user moving repeatedly from one fixed price contract to another, the probability of outperforming a tracker product is, statistically speaking, less than 50% in any given year because of the risk premium charged in the fixed price product but not in the tracker product AND due to the utility hedging via higher cost conventional power generation.
  4. When considered over several years, the probability of a series of fixed price products outperforming tracker products falls markedly. For instance, if the probability of a fixed price outperforming tracker in any one year is 47%, then the probability of it outperforming in any 2 years out of 3 is 35%.  The probability of the fixed product outperforming in any 3 years out of 5 years is a paltry 15%.

Certainty is important – am I better off on a fixed tariff? 

Where does this leave the end user facing energy procurement decisions? A few top tips

  • Know the truth:

The single over-riding truth about energy prices is that no one knows where the price of energy is going to be in the future.  Energy consumers must accept that they are price-takers and not price-makers. 

  • Hindsight may be 20/20 – but it’s futile:

It’s futile to compare the consequences of a decision made without hindsight to alternative outcome made with hindsight. There is only decision-making based on latest available information and making sure that you, as decision-maker or buyer, have flexibility and options. 

  • Know the environment:

Consider the ‘energy environment’; prices are unpredictable always, can be volatile in the short-term and yet also cyclical over the long-term. 

  • Flexibility is key:

A solution that affords flexibility to deal with changes in the market gives the end user – the ability to manage energy costs over the long-term, taking a multi-year view as well as a near-term view.

  • Vayu can help:

As energy experts, Vayu’s capability is to provide superior account management and solutions to help our customers manage energy cost risk over the long-term, which, undefined as it is, is also the time horizon for which an energy user requires energy. 

In other words, a large energy user doesn’t need energy for just 12 months; it needs it for as long as it expects to be in business and multi-million expenditure items deserve investment-like timeframes over which to measure value.  

 

ENDS