Retail Electricity Prices

Part 3

Wholesale Market Contracts

Wholesale contracts for electricity are traded between market participants, either directly (bilaterally) or often anonymously through the Australian Securities Exchange (ASX).  The commonly traded contracts are usually for quarters or years and each of these are either flat (24-7 also called base) or peak, which are from 7am to 10pm working weekdays.  As these contracts are standardised and relatively liquid (traded somewhat frequently) they are what most retailers use to hedge. Off-peak contracts are simply the difference between flat contracts and peak contracts, essentially overnight from 10pm to 7am, and weekends or public holidays.

How Retailers contract

Retailers contract to provide a level of price certainty so that they can offer a fixed price to consumers with the aim of ensuring profitability. Except for a fully load following contract, which are usually too expensive for a retailer to be competitive and very hard to come by, most of the time a retailer’s portfolio of customers will be using a different level of electricity consumption than the contracted level.  Most retailers attempt to minimise their spot price exposure, and many retailers will have strict risk management policies that compel them to hedge in a specific way such as adherence to IASA39/IFRS9 accounting rules, which usually means hedging to between 80-120% of forecast load.  Utilising just peak and flat contracts, retailers will often attempt to get contracts to as close as practical to 100% of the average load.  This means that the average volume of MWs exposed is zero, however these unders and overs usually add additional expense to the retailer’s costs.

It is important to understand that the contracts employed, either swaps or futures are a 2-way contract that is purely a financial contract, only settled against the prevailing spot prices.  This means that whilst an insurance is effectively provided against high prices, the retailer is also insuring the contract seller against low prices, and it does not necessarily match the customer’s energy use.  In practice, customer consumption is usually highly correlated with prices, such that customers use excess energy when prices are high and use less energy than average when prices are low, each of which adds to portfolio costs.

A retailer can then utilise previous consumption data, to assess the level of exposure and estimate the cost of these residual market exposures.  We have performed the calculation here, assuming that customers are managed with contracts matching 100% of their average load in each of peak and off-peak times.

In practice, this means that the customer’s energy purchase costs will be the wholesale contract price plus the cost of the residual exposure.  If a retailer observes that this residual exposure cost has been minimal historically and has had only a small variance annually, then they may offer a cheaper price with greater confidence of profitability.  It is important to note that because these residual measures are based upon a 100% hedged on average position, that these costs are unrelated to the contract price.

Calculating an expected purchase price of electricity

When offering a retail price to consumers, they need to first devise an internal price estimate based upon the wholesale contract price and the anticipated residual market exposure, whether this is based upon historic values or the result of electricity price forecasts.  This applies for all electricity customers not just households.  Retailers will assess larger customer’s load data individually and may likely offer them a peak and off-peak rate under a contract.  For households, and other small customers who are on a flat rate we can calculate their price as follows:

Price(Flat)= [(Price(Peak) + Residual(Peak))*Volume(Peak)+(Price(OffPeak)+Residual(OffPeak))*Volume(OffPeak)]/

(Volume(Peak)+Volume(OffPeak))

Whilst we don’t necessarily know a retailer’s purchase contract prices, they will almost certainly be purchasing at prices reflective of the ASX at the times when they purchase contracts.  Retailers will also acquire customers progressively, such that they need to purchase contracts periodically as their portfolio grows (or in fact, sell down contracts if they are net losing customer load).

This means that the portfolio cost can be heavily influenced by when the retailer does their purchasing. As an example, in February 2022, Russia invaded Ukraine, and subsequently international prices for coal and gas soared.  This impacted Australia’s National Electricity Market (NEM) and flat contracts for the 2022-23 financial year effectively trebled from around 8c/kWh to more than 25c/kWh before the 1st of July 2022, as can be seen in figure 5.  Given most flat retail contract prices offered to consumers were about 20-30c/kWh all inclusive, this would mean retailers would be signing up to significant losses if they were to acquire new customers at that time.

Many of the smaller retailers struggled in 2022 if their portfolio costs exceeded the retail tariff that they were contracted to with their customers.  This resulted in many of them being suspended or choosing to give up their retail licences.  Some may have had sizeable profits if they abandoned their customers and closed out their futures position which may have been deeply “in the money”.

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Note: This information is not financial or investment advice, but solely the opinion of the author.