Fixed Electricity Rates - How Do They Work?
Have you ever wondered how energy suppliers can offer fixed electricity rates to end-users? How about the details related to the wholesale and retail electricity markets in general? If you’re like many, deregulated energy markets can seem complex and confusing. Do not worry, we are here to explain!
So, Where Do Energy Suppliers Buy Electricity?
The short answer, from the wholesale electricity market. But it is much more complicated than that! There are electric “grids” that make up each region of the country. New England has an electric grid, New York has an electric grid, Texas has an electric grid, and then there is the PJM grid that covers most of the mid-Atlantic. These electric grids are better known as Regional Transmission Organizations or RTOs. See the map below of the various electric RTOs in the U.S. from FERC.
Each RTO is responsible for balancing supply and demand in its territory on a minute-by-minute basis. To do this, RTOs dispatch various electricity generators to meet consumer electricity demand in real-time. The cost of dispatching a generator determines the wholesale price of electricity for that given time. Most RTOs begin by dispatching the lowest-cost generators followed by higher-cost generators according to what is needed to match consumer demand. The cost of the last dispatched generator each hour determines the wholesale price of electricity for that hour. During times of high demand (air conditioning load on a hot summer day), RTOs may need to turn-on high-cost generators that can ramp-up quickly to meet demand, which in turn, drives up the wholesale price of power. And during times of low demand, lower-cost generators are used causing the price of power to fall. This continual balance of supply and demand causes great volatility in the hourly price of wholesale electricity each day.
Energy suppliers, who purchase electricity in the wholesale market on behalf of their retail customers, pay the RTOs the wholesale cost of power for each hour multiplied by the amount of electricity usage from their customer base.
Then, How Can an Energy Supplier Offer a Fixed Rate?
Great question! It does not make logical sense that an energy supplier would offer a fixed price for electricity to a consumer when they themselves are paying a volatile, floating price on the wholesale market. In order to limit this price risk, energy suppliers hedge their bets in the financial markets. Here is how it works…
- Customer A signs a fixed rate agreement with Supplier A at 5 cents per kWh
- Supplier A needs to pay the RTO for the wholesale price of that power
- Supplier A is afraid that the wholesale RTO price might be greater than 5 cents
- Supplier A makes an agreement with Counterparty B to offset the price risk
- Counterparty B agrees to pay Supplier A the wholesale RTO price each month
- Supplier A agrees to pay Counterparty B 4.5 cents per kWh each month
- Counterparty B limits his risk by purchasing futures contracts on an exchange
This scenario described above looks something like this…
Why is There a Cancellation Fee?
Many consumers wonder why energy suppliers charge early termination fees or cancellation fees to leave a fixed-rate contract early. As described above, because your energy supplier contracts with another party to lock-in your price for electricity, it is hard for them to unwind their positions. Many times customers cancel when the market prices become lower than their fixed rate. In this case, the energy supplier would need to sell the contract made with a counterparty back to the market for a loss. Cancellation fees are included in fixed rate energy contracts to deter customers from leaving and to cover these anticipated costs if they do.
Want more information on electricity prices? Check out this great article here on how electric rates are calculated. If you would like to get a fixed-rate quote for electricity, please contact us today.