The challenges underlying the supply of fixed-price tariffs
Offering to supply power at a fixed price is an inherently risky business. Indeed risk management is very much at the core of the service being provided by the retailer when providing such deals. The vast majority of retailers, therefore, make sure that when they provide fixed-price tariffs, they can offload the risk of rising prices to third parties. Those retailers that did not do this last year have, in many cases, been driven to the brink of bankruptcy.
To manage the risk inherent in fixed-price tariffs, most retailers hedge their expected exposures by buying power in advance in the futures market. That way, if prices do rise, the financial gains on their hedging contracts will ensure that they can still afford the power needed to supply their customers. Indeed, when setting a fixed-price tariff, retailers will tend to calculate the costs involved in hedging the resultant risk. If they do it right, they can pass on the costs of the hedging to the end user and come away with a margin on top. Unfortunately, managing this risk as a retailer is not as easy as one might hope.
Managing volatile prices
The main cause for the withdrawal of fixed-price tariffs in the Spring and Summer of 2022 was extreme volatility in the price of the financial contracts used to hedge power price risk. To put the problem simply, imagine that we are going to launch a fixed-price tariff on Monday. We hope that people will sign up during the week and, by Friday, that we will have enough customers to structure a hedge based on their expected consumption. This business model will work assuming that we can identify the price of hedging on Monday and still be able to hedge at that price on Friday. However, if there is a material risk of prices rising significantly during the week, then we could end up losing a lot of money on all these contracts even if we hedge at the end of the week. Although oversimplified, this was essentially the problem retailers found themselves in, with price volatility being so great that they could not assemble a portfolio of customers before prices changed. Rather than take the risk of losing money on fixed-price tariffs, many retailers simply stopped offering them altogether.
Managing volume risk
Another long-standing challenge for retailers is that fixed-price tariffs generally do not specify the amount that will be consumed or sold. Once you sign up for the tariff, you can consume as much or as little as you wish, within reason. This structure reflects the fact that consumers are often poorly aware of their own consumption needs and not interested in signing deals that offer a complex array of prices for different consumption levels. However, it also presents retailers with a challenge when they come to managing the risk implied by offering fixed-price tariffs. If they hedge a certain volume of power, but it proves to be an underestimate (e.g. due to a cold winter), then when prices rise, they will again be losing money. The retailers, therefore, need to either agree in advance how much power they will supply at a fixed price, or make sure their margins can cover the risks of higher-than-expected consumption.
Securing a hedge
Above, we have assumed that retailers can hedge—that they can observe a price for buying power in future periods and trade at that price. Unfortunately, the financial market underpinning this activity is not very active and even getting an accurate price can be challenging. Part of the problem is that there are effectively separate markets for hedging products in each of Norway’s electricity price areas, so the number of actors in each market is relatively small. With few actors in each market, trades are infrequent and those trades that do happen often occur outside of the public exchange at undisclosed prices. Those parties wanting to use the financial exchange to hedge need to post collateral, which imposes a cost, and the amount of collateral required is higher than otherwise because of the lack of trading activity, since contracts cannot be easily sold to pay off debts. Ultimately, these challenges make the hedging process more difficult and more costly. These costs have to be recouped through the tariff being offered.
What to do to fix the market for fixed-price contracts
Providing support without fixing prices
Traditional fixed-price tariffs, which provide power for a fixed kWh price, are very much at odds with the needs of the future power system. As the system becomes increasingly reliant on variable sources of generation, like wind, it is important that households contribute what flexibility they can to balancing the system, for example by charging EVs when prices are low. Fixed-price tariffs eliminate incentives for households to adapt their consumption to help match the varying availability of power. What is more, you don’t need to fix prices to give end users significant certainty over the total cost of their energy bill. At the simplest level, fixed-price tariffs can be adapted to have different day- and night-time rates. Such time-of-use fixed-price tariffs are already in use in places like for example Finland. Better still, the retail market could offer dedicated products to help insure households and small businesses against increases in the average price of power. That way, end users would still save money when shifting consumption to cheaper hours but receive financial pay-outs when the overall cost of power increases.
Fixing the financial hedging market
The companies providing fixed-price tariffs or commercial insurance, as described above, rely on being able to hedge the risks that they are taking. The more costly it is for them to hedge, the higher the prices that hey charge to end users. Consequently, one of the most important things that can be done to reduce fixed-price tariffs is to make it easier and cheaper for these companies to manage power price risk. As noted above, the financial market that forms the basis for such risk management is not well-functioning. One possibility to improve the market would be to try and break down the barriers to trade between actors in different price areas. That should make for a more active and transparent market and thereby reduce trading costs to everyone’s benefit. Unfortunately, this is easier said than done. ACER and national regulators (notably in Finland and Sweden) have started to discuss how trade across bidding zone borders might be facilitated in the financial market. However, there is a real risk that Sweden and Finland develop a sub-optimal solution to fix an immediate problem in their zones that is ultimately rolled out piecemeal throughout the Nordics. The end result will be a solution that does not work very well and reflects a history of treating the forward market like an afterthought. Given the political focus of securing low-cost fixed-price tariffs for consumers in Norway as well as the prevalence of very many small bidding zones in Norway, Norway should take an active role in this area of market development and try to secure an outcome that will ultimately deliver the lowest costs for consumers.
Strength in numbers
As noted above, the market for fixed-price tariffs proved to be remarkably fragile to price volatility. If we want companies to offer fixed-price tariffs or price insurance even when prices are unstable, we need further innovation in the retail market to close the gap between when end users sign up and when retailers secure a corresponding hedge. One interesting option would be to explore collective purchasing models. The core idea here is that interested consumers will announce in advance their interest in a fixed-price tariff. These interested customers can then be combined by a third-party broker acting on their behalf. The broker will then tender for the supply of a fixed-price tariff for the group as a whole and select a preferred bidder, at which point each individual consumer can choose whether or not to switch tariffs or not. Aggregating small consumers in this way helps to focus hedging activity at key points and enables retailers to avoid lengthy and therefore risky periods during which their exposures are unhedged. The idea of collective supplier switching is also not unprecedented, having been trialled extensively in Great Britain.
A policy that builds on these suggestions would go a long way to addressing some of the fundamental challenges facing the Norwegian market for fixed-price tariffs. In doing so, it would help create a lasting commercial solution for Norwegian households trying to protect themselves against unexpected high power prices.
