Understanding Electricity Rate Structures
First, it’s important to understand different electricity rate structures and how they are billed based on wholesale electricity prices.
Fixed-Rate Electricity Plans
Fixed-rate electricity rates are solely based on forward market prices. Because the retail rate is fixed at a certain price per kWh for a contract term (typically 12 – 48 months), the energy supplier must hedge the underlying wholesale cost in the futures market. When a hedge is in place, the supplier is able to deliver a fixed price for all contracted quantities regardless of movement in market prices during the term of the energy contract.
Fixed-rate contracts can be fully-bundled fixed rates, including capacity charges, transmission, and ancillary costs, or energy-only contracts, which only include a fixed price for the electricity commodity portion of the total retail rate.
Due to their nature, energy suppliers often include hefty early termination fees that are equivalent to their liquidation costs should the contract be canceled before it expires. Furthermore, suppliers often charge a premium for fixed rates, as they must accurately forecast future consumption based on historical usage.
In states without consolidated utility billing and purchase of receivables from local utilities, customer credit also becomes an issue. Under a dual billing system from the electricity supplier, the customer must pass a business credit check in order to obtain a contract.
Fixed rates are ideal for those businesses that are focused on budget certainty and protection from volatile energy markets.
Variable-Rate Electricity Plans
Variable-rate structures, on the other hand, follow the ebbs and flows of the wholesale electricity index market. These rates are often tied to day-ahead market prices, set by Regional Transmission Organizations (RTOs) and Independent System Operators (ISOs). Variable rate plans can be month-to-month or tied to a contract term where the supplier agrees to a set “adder” or profit margin that is added to the total wholesale cost of the market each billing cycle.
Variable-rate electricity plans are ideal for customers who want flexibility and potential upside from lower index prices. In fact, because these rates are based on day-ahead prices, customers do not pay high premiums associated with forward, fixed pricing.
Hybrid Pricing Options
In the middle are hybrid electricity price structures, which combine fixed and variable pricing. These plans include traditional block + index pricing and load-following block + index products. Designed for large energy users who want to take on some market exposure, while hedging costs during traditionally volatile periods (e.g. summer/winter).
Fixed vs Variable Rates: A Side-by-Side Comparison
The chart below is a visual comparison of fixed vs. variable electricity rates, their benefits, and best-fit consumers.
Comparison Table: Fixed vs Variable Electricity Rates
| Factor | Fixed Rate | Variable Rate |
|---|---|---|
| Price Predictability | High – rate locked | Low – fluctuates |
| Budget Certainty | Strong | Weak |
| Market Upside | None | Yes |
| Market Downside Risk | Protected | Fully exposed |
| Contract Length | 12-48 months | Month-to-month, or contracted fixed adder |
| Early Exit Fees | Yes | Sometimes |
| Best Market Conditions | Rising or volatile | Stable or falling |
| Administrative Burden | Low | High (monitoring required) |
Factors That Should Drive Your Decision
If you are trying to decide the best-fit electricity product for your business based on your load, budget goals, and risk tolerance, the outline below can serve as a guide:
Budget Requirements
First, it’s important to assess your budget goals. We recommend utilizing the services of an energy broker or professional who can help you “back into the numbers”. A thorough analysis will include price targets you must hit to achieve your budget requirements. If fixed pricing falls within these targets, you may want to consider locking-in all of your volumes. On the other hand, a detailed analysis can show you what you would have paid historically based on actual index rates and your hourly usage volumes.
Risk Tolerance
Next, it’s important to understand risk. Variable pricing is inherently risky due to the volatile nature of wholesale energy markets. A good historical analysis can show you what you would have paid if prices were to increase or decrease by a certain percentage. On the other hand, there is an opportunity risk associated with fixed pricing as risk premiums are built into fixed rates. Developing a risk management strategy is critical to choosing the right type of power product for your business.
Market Trends and Timing
It’s also important to consider the current market outlook. If prices are expected to rise in the future, a fixed-rate option might be a safer option. If prices are stable or falling, you may want to consider floating all, or some, of your load on the index, variable market. Furthermore, if you have decided to contract at a fixed price, it’s important to work with a partner that has visibility into futures pricing so you can set alerts when market prices are trading within your pre-defined target range.
Load Profile
Your business’s historical energy consumption patterns also play a role in choosing the best-fit product. High volumes of off-peak usage could lend more favorably towards a variable product when prices historically trade lower. For those with consistent usage patterns, a fixed price could be more favorable due to high load factor ratings, which tend to reduce risk premiums charged by suppliers. If you have a large base load that you want to hedge against volatile market prices, you may consider a hybrid block + index product where certain volumes are fixed, and other volumes float on the variable, index market.
Which Businesses Should Choose Fixed Rates?
While there is not a one-size-fits all answer, businesses that value price predictability should consider fixed-rate options. These plans allow you to fix all of your usage at a certain price per kWh and provide budget certainty. Furthermore, if you have high usage patterns during historically volatile periods (such as summer and winter), you may consider a fixed rate plan to mitigate market risk. Small to mid-size businesses often choose fixed rates due to their simplicity. It is often easy to find a fixed rate below your local utility’s price to compare, which results in immediate savings. These businesses often do not qualify for complex hybrid block + index products due to their limited usage.
Which Businesses Should Choose Variable Rates?
Variable rate plans are ideal for those businesses with usage aligned during favorable market periods. For example, a facility that consumes power during off-peak hours (M-F: 11 PM – 7 AM; Sat-Sun) can benefit greatly from choosing an index-based variable product. Other businesses with dedicated energy procurement professionals or market monitoring resources can also benefit from variable plans if they are monitored closely and rolled into fixed positions when prices increase.
Common Mistakes When Choosing Rate Structures
There are several common mistakes made by business owners when choosing electricity rate structures, including:
- Falling for low introductory variable rates that skyrocket one or two months later
- Locking in fixed pricing during high-priced periods
- Overlooking early termination fees associated with fixed-rate contracts
- Paying premiums for fully-bundled fixed rates when you are actively implementing energy efficiency strategies to reduce peak demand.
- Ignoring block + index options for large, flexible loads
- Making decisions without a data-driven approach
6 Steps to Decide the Right Electricity Rate Structure
It’s best to utilize the services of a professional energy broker or consultant who can help you through these steps. Here is what you need to know about choosing the right rate structure for your business:
Step 1: Historical Analysis
Everything begins with a historical analysis of your electricity usage. This data will show you what you would have paid based on various strategies and will help you understand how and when your electricity is being used.
Step 2: Define Risk and Budget Goals
Based on your historical data, you can develop several different pricing models to project annual costs. This will help you to weigh risk vs. reward and decide on the best-fit product for your goals.
Step 3: Assess Market Conditions
After you’ve decided on a strategy, you must then monitor current market prices and conditions to determine if they are trading within range. Your strategy should include target prices based on budget goals. This will help you understand the right time to contract with a supplier.
Step 4: Compare Price Offers
When prices are trading within range, you can then gather price quotes from multiple electricity suppliers. You can do this through a traditional RFP process or by utilizing a reverse auction technology platform.
Step 5: Execute on Strategy
When you’ve received price offers from suppliers, it’s time to execute based on your pricing strategy. Fixed-rate customers will contract all volumes at a specific time, while those implementing a hybrid plan may only contract a portion of their volume and layer multiple hedges.
Step 6: Ongoing Monitoring
Finally, it’s important to implement ongoing market monitoring to identify future price opportunities. These could include prices for your next contract or prices for additional hedges which have yet to be fully implemented.
Need Help Developing a Plan?
Electricity rate structures are complex, and deciding between fixed and variable rate plans can seem daunting for some consumers. At Diversegy, our team of energy market experts has decades of combined experience guiding our clients through these volatile markets. We will help you perform historical regression analysis based on your consumption patterns, model several different price structures, develop a procurement strategy, and execute on that strategy. Contact our team today for a free consultation.
