« Surgery vs. Drugs | Main | Markets in everything, joys of contradiction edition »
Energy price lock-ins
Trieu, a loyal MR reader, asks:
I've recently received "lock-in" offers from my gas and electricity company. They're offering me the "opportunity" to commit to the current price of gas and electricity for two years, instead of paying the fluctuating month-to-month rates. Naturally, this offers set off my scam alert. Are the energy companies signaling that they think energy prices are too high and will go down? Or do you think there could be something else behind the strategy?
If you draw a standard and supply diagram, you can see that fluctuating prices (with a constant mean) increase expected consumer surplus but decrease expected producer surplus. For instance as a buyer you'd rather have a price of 50 half of the time and a price of 200 the other half of the time, rather than 125 all the time; the opposite is true for the seller. That is one reason why the utility may prefer a lock-in.
There is also a "only the stupidest consumers will respond" effect. It costs the utility very little to make an offer favorable to themselves but unfavorable to the consumers. It's worth doing even if only a few people accept. Given that utilities are regulated monopolies, you should expect conflict of interest to be high and thus decline most of their offers.
The most general response is simply that you should insure only against catastrophic events, and yes that sometimes includes your wife getting mad because you didn't buy a product warranty on your latest purchase of toothpicks.
Posted by Tyler Cowen on November 19, 2007 at 07:40 AM in Economics | Permalink
Comments
"For instance as a buyer you'd rather have a price of 50 half of the time and a price of 200 the other half of the time, rather than 125 all the time;"
This is true only if you have are able to time your purchases to take advantage of lower prices. For residential consumers, this is seldom the case. Nobody has capacity to store natural gas or electric power, nor are people able to defer consumption for a month to wait for lower prices. (Hourly price changes would be a different matter.)
However, in an industrial setting, where gas storage becomes an option (electricity is still too expensive to store), purchase price variablility can be highly advantageous. Even if you can't forecast the future price, you can still build up or draw down reserves to improve profitability.
A while ago, I wrote a hypothetical problem on this subject... I'll dig it up and post it here as a challenge for readers.
Posted by: Russ R at Nov 19, 2007 8:34:58 AM
Here's the problem I mentioned. (Hint... a spreadsheet and Monte Carlo simulation can make this easier.) Enjoy!
The “$1.00 Widget Shop” Purchasing Problem:
You own and operate a widget shop in a small town of x people. Every day, each person in the town visits your store to purchase a single widget. As the name of your store implies, widgets are always sold for exactly $1.00. Your store is not large, but you have enough shelf space to hold exactly 2x widgets.
Each morning at 5am, a widget wholesaler drives his truck to your shop and allows you purchase as many widgets as you like, at the wholesale price, which has always been $0.90.
Rather than wake up so early yourself, you have instructed your nephew, Jack, to meet the wholesaler and purchase exactly x widgets every morning. That way, you sell your entire supply by the end of the day for a daily profit of $0.1x , with no surplus inventory.
But yesterday, the wholesaler informed you that he would be adopting a new pricing model, which would vary each day. His daily price, y, would still average $0.90, but would be normally distributed with a standard deviation of $0.10.
You’d like to pass the variance in costs along to your customers, but alas, you can’t change your store’s name, so you’re stuck selling widgets at a fixed $1.00.
To maximize your store’s profit, what instructions do you give Jack on how many widgets to purchase each morning, z, as a function of daily demand, x, the day’s wholesale price, y, and the previous day’s remaining inventory (initially zero)?
Posted by: Russ R at Nov 19, 2007 8:50:00 AM
Energy prices are in contango over the 2 year term so the company is probably offering to buy futures and lock in the price theirs and yours(lower than you are paying them for fixed prices).
Unless you are a big enough buyer to also buy futures (ideally ~1 contract per month in use) you're probably stuck accepting their markup.
It's not all that different from Freddie and Fannie buying Swaptions and then offering a fixed rate mortgage at a spread to an ARM (they make a spread off the wholesale retail price of interest rate volatility, but their retail price is far lower than most consumers would pay to tap the wholesale market (because of trading costs and contract sizes).
Posted by: nelsonal at Nov 19, 2007 8:56:53 AM
First, I would assume that the demand curve for residential power and gas is pretty price-inelastic. Wouldn't that make the consumer surplus argument go away?
Second, I used to work for a regulated gas company so I have some specific knowledge of this. The companies typically hedge a portion of future power and gas needs for their customers whether they like it or not (with the blessing of the state regulatory body). What % they will hedge is highly dependent on the taste of the regulatory body but can be anywhere from 30% to 60%. Sending out these offers to lock in are a way to assign these hedges to particular customers. There are multiple benefits involved:
1. it provides data to the company and regulators as to the demand for a locked in product
2. the company is seen by the regulator as giving customers choice in the face of volatile energy times
3. the regulators are seen by politicians as doing something to protect the customer in volatile energy times
4. the customer (if they want it) gets instant access to the futures market (where they otherwise can't play because they are too small
To answer your question: the futures market for gas actually rises in 2008 and 2009 before slowly falling, so a lock in price isn't a bad idea. In the end, you would expect a small (regulated) margin for the company to offer the product, but a much smaller margin than the bid-ask you would see from a broker in the futures market for a trade of your size.
Posted by: Nate at Nov 19, 2007 8:58:28 AM
Isn't profit function convex in price? Then doesn't it mean producers' are better off with fluctuating prices than fixed?
Posted by: Microecon101 at Nov 19, 2007 9:16:22 AM
"For instance as a buyer you'd rather have a price of 50 half of the time and a price of 200 the other half of the time, rather than 125 all the time;"
This is still true if you can consume less heat when it is expensive and more heat when it is inexpensive, which many households do. However, since gas companies probably charge a relatively higher margin when gas prices are low and a relatively lower margin when gas prices are high in order to give the consumer more consistency, I would think that the producer might not mind.
Posted by: Aaron Fix at Nov 19, 2007 9:28:06 AM
Actually Aaron, consumers are so price-inelastic to heat, that they typically consume more heat when gas prices are high and less when prices are low. (Because cold weather drives price and demand at the same time...)
Posted by: Nate at Nov 19, 2007 9:31:19 AM
Most likely, the company will not be keeping the risk on it's books, but will cover it with the futures. However, the premium you will pay to the company will substantially exceed the one it would have to pay to Lehman, Coral or other major player. I suspect, the risk management component is not a price-regulated product, so I'd think the company is just looking to make a quick buck on it.
Posted by: Sergey at Nov 19, 2007 10:06:13 AM
LOCKED IN, LOCKED OUT
For electricity, take the post-deregulated cost of generation as a ratio
of pre-deregulated generation and multiply it by the cost of consultants
and lobbyists who pushed deregulation through the legislative and
regulatory process.
Subtract out utility executive bonuses and the amount paid by
private equity firms for generation purchased for pennies on the dollar
from vertically integrated utilities, including the salaries of all auction
specialists from FERC and consultants who said price would decline.
Take the amount of new generation induced by deregulation as a ratio of
all existing generation that has changed hands at least once at multiples of the prior purchase price. Multiply
the result by the amount of retail wheeling attempted versus the amount
succeeded.
Multiply the latter by the former to get an index of competitive pressure
at the wholesale level.
Offer lock-in options at the retail level to provide an illusion of firm
service and how current prices were determined in a "competitive" market.
Posted by: barry payne - economist at Nov 19, 2007 10:23:01 AM
Do this strategy raise any concern over antitrust case against tying sale?
Posted by: riverman at Nov 19, 2007 11:42:07 AM
If the price is under a dollar, Jack should buy all he can (subject to the limit on inventory). If the price is over a dollar he shouldn't buy any.
Posted by: John S. at Nov 19, 2007 12:28:29 PM
Does the loyal reader live in an area that offers retail energy choice?
In areas that lack choice, utilities are often forced to pass through energy purchase price costs/benefits to the customer (esp. w/ regards to natural gas). Thus, there would be little profit motive for such utilities in this scenario.
Nate is on the right track I think. Utilities are stuck between a rock and hard place when it comes to hedging. If they fail to hedge and prices increase drastically, the regulator clubs them for imprudent practices. However, if they hedge a lot and prices later fall, the regulator clubs them for buying high when they could have simply waited to buy at lower prices. They aren't damned if the do, damned if they don't (sorry for the 2nd tired cliché). Unfortunately, customers and regulators have trouble understand that reducing price volatility is the goal of hedging.
To protect themselves, Utilities work hard to get regulatory buy-off on the decision making process used for hedging. Certainly, one means to put the decision to customers themselves.. i.e. we'll offer you fixed rates at price X. If the customer fails to take it and prices drastically rise, the utility has a nice little CYA going into their next rate case. They are trying to move the choice/responsibility of hedging from themselves over to the customer.
Posted by: Whit Stevens at Nov 19, 2007 12:50:53 PM
My apologies, tired cliché number two was supposed to be: "They are damned if the do, damned if they don't".
This would be a good topic for the folks at Knowledge Problem to contribute to.
Posted by: Whit Stevens at Nov 19, 2007 12:54:17 PM
If people are risk-averse, I do not understand Tyler's unqualified statement that consumers would prefer mean-preserving spreads in the price, since the increased uncertainty, barring the world with complete markets to insure away the resultant income (and consumption) uncertainty, will make them worse-off than in a world with constant prices.
Posted by: Samson at Nov 19, 2007 1:03:49 PM
I work as an energy trader for a company that offers fixed-price energy contracts. These contracts are designed for peace of mind and people on tight budgets. People or businesses on tight or fixed incomes that cannot afford a significant increase in rates (or are unable to pass on costs to customers) should look at these products. When a customer signs, the energy company will hedge their consumption in the forward markets (obviously aggregating volume and risks across multiple customers). The nature of these markets is that customers cannot easily put these hedges on themselves (although investing in the stock of a gas produced or power generator can be a good proxy). Margins in this business are not high (probably under 10% net of risks). As a previous poster noted, purchasing strategies of utilities vary widely. Some buy entirely in the spot market, some hedge significant portions, some run on a price lag.
Posted by: Yannai Segal - Energy Trader at Nov 19, 2007 1:05:11 PM
Does anyone here live in the northeast? If you heat with oil, every summer you are usually given the opportunity to pre-buy and you win even if prices stay flat or decline slightly. Two years is a longer timeframe, but from my experience it sounds like a good offer.
Also, consider the offer from the point of view of energy consumption. Most people are not good at math. Knowing that their electric bill will be roughly the same every month could lead to better efforts at energy conservation. For instance, if the bill went up even though they conserved by adding CFLs, they might have a negative reaction, whereas with the fixed bill their efforts show up every month.
Posted by: 8 at Nov 19, 2007 1:55:35 PM
For the typical consumer living paycheck to paycheck, a 50% increase in natural gas prices (something that has happened in recent history) is a catastrophic event.
Posted by: Tom Hanna at Nov 20, 2007 12:24:29 AM
Tyler said: "The most general response is simply that you should insure only against catastrophic events, and yes that sometimes includes your wife getting mad because you didn't buy a product warranty on your latest purchase of toothpicks."
It is not obvious that to lock-in prices would automatically mean buying an insurance. If most hedgers come from the supply side and want to hedge the risk of lower commodity prices, future prices will be lower than spot prices (normal backwardation), which means that it will be interesting for a consumer to lock-in prices.
Posted by: vic at Nov 20, 2007 4:10:43 AM
Tyler said: "The most general response is simply that you should insure only against catastrophic events, and yes that sometimes includes your wife getting mad because you didn't buy a product warranty on your latest purchase of toothpicks."
It is not obvious that to lock-in prices would automatically mean buying an insurance. If most hedgers come from the supply side and want to hedge the risk of lower commodity prices, future prices will be lower than spot prices (normal backwardation), which means that it will be interesting for a consumer to lock-in prices.
Posted by: vic at Nov 20, 2007 4:11:22 AM
Posted by: 翻译公司 at Feb 25, 2008 9:07:40 AM
Posted by: Alii at Apr 3, 2008 9:06:53 PM
Bvlgari Jewelry
Replica Bvlgari Jewelry
Bvlgari Replica Jewelry
Gucci Jewelry
Posted by: aion kina at Mar 19, 2009 11:27:32 PM
