Energy Pricing 101: Breaking Down the Energy Price Tag

Understanding Energy Pricing

Do you do business in a state that has deregulated electricity or natural gas? If you do, you have an opportunity to choose an energy strategy that supports your business. When businesses can choose their energy pricing plan, they can negotiate the inherent volatility of the wholesale market into opportunities for cost control, efficiencies, and other business goals. But to take full advantage of your energy opportunities, you should look beyond a simple comparison of rates and prices.

At first glance, shopping for competitive pricing offers from energy suppliers may seem overwhelming. Not every supplier provides the same information or even explains how they derived their pricing quote, making it hard for you to quickly identify the best offer for your business.

Before you start shopping, you should understand the variables that affect market pricing. The system is complex and continuously changing due to seasonal cycles and sometimes periods of extreme volatility. But if you understand the current and anticipated market conditions that affect energy prices, you'll be able to better choose the right strategy for your business.

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Retail suppliers offer a variety of energy products, so you should become familiar with the choices available in your service area and the configuration of price components. Then consider how these products mesh with your unique business goals, taking into account factors such as risk appetite, financial objectives, and efficiency opportunities.

This article reviews some of the market basics and types of pricing plans, which can help you as you shop for a competitive price. You'll learn the important terms and components that comprise most electricity and natural gas prices so you can better understand what may require clarification and which offers make the most sense for your business.

Understanding market basics, product types, important terms, and price components will empower you as you shop for a competitive price. It's time to take charge of your energy spend by making choices about energy pricing and purchasing that propel your business objectives and ensure you're getting value out of the relationship with your supplier.

What Moves the
Energy Market?

Anatomy of
an Electricity Price

Electricity
Products & Prices

Anatomy of
a Gas Price

Gas
Products & Prices

What Moves the Market?

Like pricing on the financial market, the most basic principles of supply and demand are responsible for price fluctuations in the energy market. The price for electricity or natural gas will vary depending on how much buyers need and how much the market has to offer. The factors that affect available supply are complex, but price fluctuations can impact your business's energy budget. If you have basic knowledge about the variables that drive market changes, you are better equipped to make buying decisions and brace for spikes that could increase your energy bill.

Energy Pricing

Electricity Market Cycles

Unlike other commodities, electricity cannot easily be stored. As a result, the market cannot alleviate price fluctuations by drawing down reserves. So inconsistencies in electricity supply and demand can create more frequent or more dramatic price changes. The electricity market tends to follow two discrete cycles:

The seasonal cycle: Demand for energy rises during winter (peak heating season) and summer (peak cooling season) and drops during spring and autumn.
The energy market cycle: As in other openly traded markets, energy prices tend to rise and fall over the course of four- to eight-year cycles with phases of flat and low, rising, flat and high, and falling prices.

Demand for electricity generally rises during summer (peak cooling season) and winter (peak heating season) and drops during spring and autumn.

Natural Gas Market Cycles

Natural gas prices also follow cyclical patterns:

The seasonal cycle: Homes and businesses rely on natural gas for heating during the colder months, creating higher demand and higher prices during winter. Natural gas is also a popular fuel for generating electricity. So demand for gas also spikes, though to a smaller degree, during warmer months when it is used for electricity generation to satisfy peaks during the cooling season. Demand is generally low during spring and autumn.
The storage cycle: Most natural gas is produced domestically and shipped to customers through transmission pipelines. Production in the United States and Canada is usually enough to meet demand during spring, summer and fall, but may not be enough during colder winter months. Distribution companies store natural gas during off-peak periods (spring, summer, and fall) and draw from that reserve during times of high demand (winter). The amount of natural gas in reserves is published weekly, and prices may jump or fall if the actual amount is different than expectations.

Demand for natural gas generally rises during summer (peak electricity generation season for cooling) and rises further during winter (peak heating season). When demand drops in spring and autumn (off-peak season), natural gas is often injected into stored reserves to be used during times of high demand.

What Drives Energy Prices

During normal market conditions, market cycle transitions are gradual. There may be peaks and valleys, but prices typically remain within an anticipated range. In addition to these cycles, a broad variety of factors affect the market. Changes in one or more of the following can intensify volatility and cause dramatic price changes within a compressed period of time:

Weather: Weather is one of the most influential variables of market pricing because it can be unpredictable and directly affects energy consumption. Of course, weather is predictable to some degree, giving rise to the seasonal market cycles mentioned previously. However, within those seasonal expectations, weather can change unexpectedly and cause unforeseen variances in demand.
Extreme Weather: Analysts closely monitor weather forecasts for catastrophic weather events such as hurricanes, floods and blizzards. These events can create periods of extreme price volatility, particularly if natural gas production or electricity transmission facilities are damaged. These natural gas facilities provide source fuel for electricity generation (limited supply) or to the electricity transmission and distribution infrastructure (reducing demand and limiting the flow of electricity). When forecasters anticipate extreme weather, market prices typically take the probability of such events into account. Prices are also subject to change in the aftermath of extreme weather when actual damage and impact are clear.
Government Regulations: When regulatory agencies propose or introduce changes, the wholesale market may respond with changes in pricing. In addition, regulations affecting process fuel industries may also resonate on the electricity and natural gas market.
Outages: Power plants periodically shut down or slow production to complete facility maintenance. Offshore natural gas wells and inland shale rigs sometimes need to close or slow production due to inclement weather like hurricanes, floods or freezing temperatures. Either scheduled outages or unexpected closures can impact prices.
Source Fuels: The electricity and natural gas markets are swayed by one another and by the supply, demand and pricing in other source fuel markets, including crude oil and coal. The interdependency of these fuel markets is complex and can vary by region. To control costs, many companies seek the cheapest source of fuel to power their business's operations, switching sources based on the cheapest market cost at the time. As a result, a price change for one type of fuel often affects the price of the others. Additionally, because source fuels are used in electricity generation as well as in heating and cooling, dramatic movement in any of these markets also impacts the electricity and natural gas markets.
Geopolitical Events: In regions that import or export natural resources, events such as political unrest, war, and hostage crises, can affect the energy market. Typically, these events impact the market immediately, which can affect short-term prices. Protracted events produce prolonged uncertainty, causing wholesale market prices to escalate long term. Conversely, trade agreements that open a new stream of fuel supply to the global market can create advantageous prices.

Electricity prices can also be driven by regional weather and environmental conditions. In each region of the United States, electricity is generated with a different mix of source fuels. For example, 2005 data shows that more than 40 percent of the electricity produced in Pacific state-controlled waters was generated by hydroelectric power plants on the region's rivers.¹ By monitoring indicators such as snow pack (which will eventually melt and flow into rivers) and salmon spawning (which can limit generator output), analysts can determine a plant's ability to offer electric supply to the market at specific points in time.

Supply and Demand of Natural Gas

Gas is often the price-setting resource because prices have recently dropped and power generation relies on several different fuel sources. Therefore, the many factors that drive gas prices have downstream effects on electricity supply, demand and pricing. Shifts in factors listed below can also happen simultaneously, making it challenging to forecast market shifts.

Imports: Areas that consume natural gas but do not produce it, or do not produce enough of it, must import it from other areas using the available pipeline infrastructure. Demand from imports can create market competition in an area that produces and uses their own domestic source of natural gas.
Exports and Liquefied Natural Gas: If gas prices are high enough to justify exporting overseas, producers may choose to tap into new global markets. These markets (new demand) add competition for domestic customers, increasing prices. For example, liquefied natural gas (LNG) is produced by converting natural gas to a liquid. LNG is easier and safer to store and cost-effective to transport across long distances (such as overseas) where pipelines do not exist. Although LNG production facilities can be costly, global demand and higher prices are incentives for gas producers to convert the commodity. Because the United States just began exporting LNG in 2016, even a very small increase in LNG production and exports represents a large year-over-year change.² Though LNG is currently a modest export for the United States, analysts expect it to grow dramatically over the next several years.³
Infrastructure Constraints: Natural gas is transported using an infrastructure of pipelines. The pipeline network extends across the country like an interstate highway system, taking natural gas from drilling sites to your home or business. When new production sites are built, the necessary pipeline network may not be available in that area to deliver supply to customers. Constructing new pipelines requires regulatory compliance and a great deal of planning. But lack of infrastructure to deliver supply and debates about whether and where natural gas pipelines are located can lead to reactionary price volatility.
Technical Trading: Like many commodities, a large quantity of managed money is invested in natural gas stocks. When traders see indicators of price volatility based on their calculations and market patterns, they may cash in on a strategy to buy or sell. Movements made by large investment groups all at one time can push market prices very easily.

Like any openly traded commodities market, the web of factors affecting energy pricing is complex. However, the shifting conditions are also a source of opportunity for you. The keys to developing a successful energy strategy lie in your knowledge of the choices open to you and your choice of a supplier who can offer you reliable service and good advice.

Anatomy of a Pricing Offer

Please note: Pricing is typically presented as part of a complete contract, with terms and conditions that may be negotiated. Here, we'll touch on the language and components of your quoted price, but not the complete terms of an energy contract. If you previously took electricity or natural gas service from your local utility, you may not have had to sign a contract. All competitive energy suppliers require a signed contract to serve business customers; therefore this is an important element of working with a supplier that you should consider.

When you receive a price quote for electricity or natural gas from an energy supplier, generally there are three core items:

Price of energy supply: quoted in cents or dollars per unit
Amount to be supplied (i.e. "usage"): how much energy you're expected to use. This is generally derived from historical consumption and future consumption estimates.
Duration of the service (i.e. "term" or "delivery period" with start and end dates): indicates the start and end date of the quoted price. The quoted price associated with any particular term or timeframe will vary.

While pricing offers are similar for power and gas, the two fuels are measured and priced in different units, so we will consider each commodity separately.

Electricity Pricing Offers: Cost Components

The price or "offer" is quoted in cents per kilowatt-hour (kWh) or dollars per megawatt-hour (MWh). In order to make an accurate comparison between the offers you receive, you need to know for sure what is included in the price, either by reading through the pricing offer or by asking the supplier to clarify. The following items are the common components that comprise an electricity rate.

Energy: The cost of the commodity itself. This is usually calculated by a supplier as the cost to purchase the amount of power you need in the wholesale market for the specific length of time (term or delivery period) you are seeking.
Capacity: A requirement of the electric system operators in several electricity markets. These charges help guarantee that there will be sufficient generation to meet the maximum energy requirements of the market at all times.
Ancillary Services: Charges for the services required to support and maintain reliable operation of the electric grid.
Losses: Charges covering the electricity losses that occur between the point of generation and delivery to your business.
Transmission: The charges associated with the cost of moving power from the generator to your local distribution company. It can be billed by either your supplier or your local utility, depending on your state and the type of product.
Renewable Portfolio Standards (RPS): If your state mandates participation in a renewable energy program, your supplier is required to procure a portion of your power from renewable sources.

The energy component usually accounts for approximately half of your electricity price. In energy markets with capacity charges, capacity accounts for about a quarter of the price, with Ancillary Services, Losses, Transmission and RPS making up the final quarter.⁴

Why should I know about pricing components?

By understanding the pricing components that go into calculating your price for electricity, you will be better prepared to ask questions about what is and is not included in the quoted price, and therefore be better positioned to make decisions about which product, offer and supplier will work best for your business.

In some cases, components may be included as part of your quote. In other cases, they may be passed through as individual charges. Suppliers may offer different product configurations that are more or less inclusive.

A "fixed all-inclusive product" should contain all of the above components wrapped into one rate – your price. For this maximum price protection scenario, the price will contain a premium to cover the cost components that may vary over the duration of your service. This premium protects a supplier, who must estimate all of these changing cost components in order to provide you with an all-inclusive price for your desired term.
A "fixed product with varying pass-through charges" could include one or more of the above components wrapped into your fixed rate, and several others passed through separately. It could also mean that your energy component is fixed and all of the other charges are passed through at cost.

It's important to clarify whether components are included or passed through because a rate that does not include every cost component will be lower. Sometimes this can be good if your business can benefit from certain cost components being passed through at cost each month. Usually businesses with less risk tolerance choose product configurations that wrap most common cost components into one fixed rate – even if it means paying a slightly higher price premium to do so.

Your Usage

Another factor weighing in on your price is your usage. Suppliers may base their quote in part on your "historical usage," which can be obtained through your local utility or by providing a supplier with a recent invoice from your current supplier. When a quote is based on historical usage, price is customized to your business's unique usage requirements and based on the assumption that you will continue using roughly the same amount of energy going forward.

Usage is an important factor in a pricing calculation because suppliers want to purchase enough power, but not too much or too little, on your behalf, which helps to keep costs in check.

Because your usage is an estimation, you should mention to your supplier any changes you expect would cause noticeable increases or decreases in your usage during the quoted term. It is in your best interest to ensure that your usage profile is as accurate as possible in each quote – particularly if your usage may decrease or increase significantly.

Why should I know about usage?

Ask your suppliers if financial ramifications could result from fluctuations in your expected usage – and within what range. Some suppliers may not include "unlimited bandwidth" in their price quote. So if you need more power than estimated, you could be charged a higher rate; if you need less power than estimated, you could be assigned monetary penalties. Suppliers that offer unlimited bandwidth often build a premium into their fixed price to cover potential fluctuations.

Knowing about bandwidth implications ahead of time can help you make the right decision about your electricity product by preparing you for the possibility of additional charges during your term or paying a higher upfront premium.

Delivery Period

The timeframe for which you are requesting a price will impact your quote. While your bidding documents may clearly outline your desired term, make sure that all of the quotes you receive are for the same term.

For example, a 24-month fixed price contract rate of $0.08 per kWh may actually be a better value than a 12-month contract at $0.07 per kWh because a longer term may protect you from potential rate increases during the second year of the contract. Your sales representative can help you assess current and future market conditions and the timing of your contract length to help you determine if a slightly higher rate over a longer time period could be more beneficial than a lower rate over a shorter time period.

The start and end date of your contract can also factor into your decision to consider a longer or shorter delivery period for pricing. For instance, if your current fixed rate is set to expire during a time of the year when market volatility is common, or if unexpected weather-related events cause forward prices for the following year to rise, you may end up receiving a higher quote for your next delivery period than your current fixed price. In a case like this, locking in for a longer period of time at a particular rate could prove more advantageous.

Common Electricity Products and Pricing Plans

Most suppliers carry standard pricing options such as fixed price and index price electricity. Some will also work with you to develop a customized pricing solution to meet your business's needs. Therefore, it is best to ask for a consultation with the energy supplier and have them review all of their pricing options with you.

With a range of different plans, you have choices.

Fixed Price Products

What is it?

A fixed price product enables you to lock in a set rate per kilowatt hour (kWh) for the generation portion of your electricity bill. Your monthly bill varies based on your consumption, but the rate you pay remains constant no matter what happens in the market. Your utility continues to charge for transmission and distribution, and this may be billed separately or bundled into the bill from your retail supplier. Your options for contract length may vary based on your location, but fixed price contracts are often available in terms as short as six months or as long as 60 months.

What does it offer?

A fixed price can give your business budget stability and predictability of operational costs. If the market price of energy rises, you are protected. However, if the price of energy falls, you are locked into your fixed rate for your contract term and cannot capitalize on market dips. Although a fixed price product may not create immediate cost savings, locking in a low rate at the right time can produce savings over time. Businesses with a low risk tolerance or little budget flexibility often prefer fixed price products.

What should I consider?

Keep in mind that although a fixed rate helps you avoid price spikes, it also prevents you from taking advantage of price dips. Timing is important; you want to lock in when rates are low and flat or falling for the time period you are considering; and you must weigh the value of waiting for further price dips against the risk of waiting too long. Long-term price certainty may come with a price premium.

Index Price Products

What is it?

An index price product is tied to market rates and is therefore changing regularly based on supply and demand. Depending on the market, the reference index may be based on day-ahead or real-time, hourly pricing.

Your monthly bill varies based on both your consumption and the market rate. Your utility continues to charge for transmission and distribution, and this may be billed separately or bundled into the bill from your retail supplier. Businesses on an index price product often sign a contract, but have the option to lock in a low, fixed price at any time.

What does it offer?

Index price products can be advantageous because they enable you to avoid the price premium that may be charged for fixed price products. Index prices provide a greater degree of flexibility to capitalize on market lows until the timing and market conditions are more favorable to lock in a long-term contract with a fixed price. Businesses on index price products can also benefit from "time of use" by scheduling activities during off peak hours when prices are low. This type of plan tends to work better for businesses with a higher risk tolerance.

What should I consider?

If budget certainty is your top priority, an index price product is not typically recommended as a long-term strategy because of the risk of price volatility. However, it can be a good alternative bridge position to wait out a period of high or rising market conditions. Index price products are generally used by businesses that want to ride the market for some period of time to assess future market conditions or opportunities.

An index price product is not only used as a bridge to a fixed contract. It can also be a specific procurement strategy. While not many businesses use it as a long-term strategy, there are instances when an index price product provides opportunities for cost savings. However, you should carefully consider your risk appetite for price volatility when making this decision.

Combination Price Products

What is it?

Combination products are a hybrid offering of fixed and index price purchased under a single contract. They give you the choice of locking in a portion of your electricity at a fixed price and floating a portion of it at market rates. In this way, your business can manage the risk-cost strategy on an ongoing basis, according to changing risk appetite and electricity cost opportunities. Some retailers may allow you to purchase a block of power at a fixed price, while usage exceeding your block is billed at the market price. Combination products can offer the best advantages of both fixed and index price products.

What does it offer?

Combination products provide ultimate flexibility in energy buying. You get access to wholesale market pricing and the option to fix or float as much of your electricity as you desire, based on your business's risk tolerance and business objectives. Combination products are only available to large electricity consumers – usually an annual consumption of 2 MW (10,000 MWh annually) or if you belong to a group of smaller customers who operate as a pool with the appropriately large aggregated load.

What should I consider?

If you're considering a more complex combination plan, you should first thoroughly assess your business objectives and short and long term risk appetite. Suppliers can devise a custom strategy for you based on a clear understanding of your supply requirements and risk tolerance through the contract duration. This style of procurement requires the time and attention of an energy manager working hand-in-hand with a dedicated, experienced analyst or strategist on the supplier side.

Energy Pricing

With a fixed price for electricity, the generation portion of your price always remains the same, regardless of changes in the market. With an index price for electricity, your price will fluctuate based on supply and demand, including seasonal influences.

Comparing Product Offerings

Many of the products available from retail electricity suppliers may be similar in name, but vary dramatically based on contract terms, included components, pricing structure and service level. You should look at the difference between each offering so you have a clear understanding of how the pricing plan and product will influence your business's operations and financial objectives.

Risk tolerance is an important consideration when choosing a pricing plan. If your business has a higher tolerance for risk, it may be a good fit for a product with lower price certainty. Index price plans provide the opportunity to manage around market changes, including dips and sustained lows, but these plans also come with a higher risk of price uncertainty. Index priced plans may require additional time on your part to remain appraised of market conditions and to actively manage the energy plan. Businesses with lower tolerance for risk may need a plan with higher price certainty. Fixed price plans offer the most price certainty and significantly reduce your exposure to market risk, but may have higher premiums.

The volatility of energy markets and complexity of variables that affect price can make it difficult to feel confident that you are making the right choice at the right time for your business. But you can use market volatility to your advantage when you have a basic understanding of the options and help from a consultant or supplier.

Natural Gas Pricing Offers: Cost Components

The price or "offer" will be quoted in either dollars per dekatherm (DTh), therm (Th) or dollars per million British thermal units (MMBtu). To compare, if you're receiving price quotes in varying units, one dekatherm is equal to one million Btus. In order to make an accurate comparison between the offers you receive, you need to know for sure what is included in the price, either by reading through the pricing offer or by asking the supplier to clarify. The following are the common components that comprise a natural gas rate.

Commodity: The cost of the natural gas itself. This is usually calculated by the supplier as the cost to purchase the amount of gas you need in the wholesale market. Most natural gas contracts are priced through the New York Mercantile Exchange (NYMEX) index for the specific length of time (term) you are seeking.
Basis: The cost difference between the two liquid trading points within the interstate pipeline system. Since most natural gas contracts are priced through the NYMEX but the gas must travel to your business's location, your regional basis price must be added to the NYMEX price.
Fuel or Losses: The costs to replace the gas that is used or lost along the pipeline between your local distribution company and your business. If you receive a bill from both your utility and supplier, fuel or losses may account for a line item difference between the two.

Why should I know about pricing components?

By understanding the pricing components that go into calculating your price for natural gas, you will be better prepared to ask questions about what is and is not included in the quote, and therefore be better positioned to make decisions about which product, offer, and supplier will work best for your business.