- How Much Do Commercial Energy Brokers Get Paid?
Many commercial consumers of electricity and natural gas turn to brokers to line up supply for their operations. In What To Look For in an Energy Broker we discuss what these brokers do. In this article we address how they are paid.
In rare cases brokers conduct their supply services as part of a larger consulting engagement by their clients. In that case they are paid a retainer (e.g., $10,000 per year) to help a client manage their energy usage, confirm that their billing is accurate and they being billed by the utility as part of the correct rate class, explore potential energy savings solutions, and locate supply. In lieu of a flat monthly retainer they may be paid a fee per hour.
Typical Energy Brokerage Fees
By contrast, most brokers are compensated based on a fee per unit of energy purchased. These fees are negotiated and generally range from 2-10 mils per kilowatt hour (kWh) in the case of electricity and $.02-.10 per hundred cubic feet (ccf) in the case of natural gas.
What do most commercial energy consumers pay for their electricity and natural gas supply? It depends on the amount of work performed by the broker on the client’s behalf. Unlike real estate brokers – who often charge identical fees irrespective of the amount of their efforts – energy brokerage fees reflect a wider range.
Note that brokers may not discuss or collude in setting fees for clients. Such coordination of fees would be a violation of federal and state anti-trust laws. If you ever get wind of discussions among brokers you should complain as such discussions can result in chilling competition among brokers leading to unreasonably high fees.
How are energy brokerage fees paid?
In the more common case of volumetric fees, the broker enters into agreements with suppliers under which the supplier commits to supply the broker with quotations and, if the broker’s client accepts a bid, to pay the broker.
The mechanics of paying brokerage fees are these:
1. The broker obtains competitive offers for the client from two or more energy suppliers.
2. The broker advises the suppliers of its fee. The fee is added to the price that is quoted to the client.
3. The supplier quotes are put in front of the client, often with the broker’s recommendation to buy supply from the lowest price bidder. The client decides which supplier to do business with. A bilateral contract is executed between the client and the supplier.
4. The supplier delivers electricity or natural gas and bills the client monthly for the product of (i) the price, including the broker’s fee, times (ii) the volume consumed by the client.
5. Upon receipt of monthly payments from the commercial client, the supplier pays the broker the product of (i) the fee times (ii) the volume. In some cases (see discussion below) a broker may demand this fee be paid in advance for the all or part of the contract term.
Does the Client Know the Broker’s Fee?
The client should always be told the amount of the fee charged by the broker. This amount should be disclosed in the client’s agreement with the broker (see Entering into an Energy Brokerage Services Agreement).
Commercial clients should beware that there are other ways in which brokers can benefit besides volumetric fees. While volumetric fees are often disclosed, these are benefits may not be. Examples of benefits that are often not disclosed are these:
- Advance payments. Some brokers demand that their fees be paid 6 months or 12 months in advance. Not all suppliers agree to make these advance payments as they entail considerable risk: After all, a client may not pay its bill or may terminate its contract early. These advance payments are a significant benefit to the broker but can create a serious conflict of interest. Is the energy broker’s recommendation to the client truly objective if business is being steered to suppliers that pay in advance?
- Special bonuses. Some suppliers offer brokers special incentives to steer business to the supplier. For example, we recently received the following proposal by email from a major supplier:
“I’m excited to announce a Sales Incentive Program for sales occurring July 1 – July 31.
- Each CP [i.e., Commodity Professional or Broker] that sells 5,000,000 kWh (or gas equivalent) we will pay you a cash bonus of $2,500
- For every 1,000,000 kWh (or gas equivalent) above the 5,000,000 kWh, we will pay an extra $500
- Total CP payout capped at $5,000 cash to be paid Aug 15th
- Good on new business only, no renewals”
As with advance payments, how can a commercial client trust this broker not to steer business to this supplier because of the added incentives?
- Gifts. Suppliers often shower their favorite brokers – the brokers who steer to them the most business – with gifts. Gifts include Super Bowl tickets or tickets to other special sporting events; cases of wine; expensive dinner; nights out at strip clubs in Houston and New York. These gifts are rarely disclosed to commercial clients.
Gifts like these were common on Wall Street for many years until the New York Stock Exchange adopted a rule that prohibited stock brokerage firms from receiving gifts in excess of $50 per year. The rule put a chill into gift giving but it protected the brokers’ clients from the obvious conflicts of interest that were created.
How Can Clients Protect Themselves?
Commercial energy consumers who use brokers should insist that their broker receives no incremental benefits besides the fully disclosed volumetric fee (or consulting fees, if applicable). They can request that the broker add such a provision in their brokerage agreement. An example of such a clause can be found in Solomon’s standard Energy Brokerage Services Agreement.
Of course, even written agreements are often ignored. Therefore a client may take a different approach: They can insist on receiving a minimum of three quotations each time they look for supply. It is unlikely that every supplier will be offering the same incentives. Therefore, barring true skullduggery the multiple quotations will help ensure that the commercial energy client is receiving the best price.
- What Should I Look For In An Energy Broker?
Energy brokers help their commercial clients line up supply in markets that have been deregulated, i.e., permit third party suppliers to offer electricity and natural gas supply contracts as an alternative to utility supply.
Sophisticated consumers could find energy supply themselves, without the help of a broker. See How to Find Supply Without a Broker. However, they may find that working with a broker not only saves them time but provides insight into how other commercial consumers view prices and the timing of energy hedges.
There are hundreds of brokers willing to assist in finding energy supply. They are not equally reliable. Brokers should be evaluated for several important factors:
1. It’s Not Just Price, Stupid.
Good brokers do not simply find the lowest price. That’s the easy part. Brokers should also look for the following:
- An appropriate supply contract structure. Fixed or floating? (See Which is Better: Fixed or Floating Price.) Fixed with a cap? Seasonal fixed (e.g., winter) and floating for balance of year? Option.
- Term of contract. Most brokers routinely price up 6, 12 and 24 month contracts. But these terms may not be optimal. Both forward prices and client volumes vary by month. Prices are based on weighted averages for the term. The weighted average is based on the forward price curve times the volume. A customer with flat volume (manufacturer, pizza shop) will want to take advantage of as many low price months as possible; likewise a customer with electric heating demand in the winter may wish to include a couple summers when the volume and prices are low.
- Contract expiration. A contract that expires in October will mean that on renewal a consumer will be paying winter prices which in some parts of the country are high for both electricity and natural gas.
- Supplier Credit. What good is a fixed price contract from an undercapitalized supplier with a weak balance sheet that may go bankrupt the minute prices spike?
2. Broker Fees
How much are you paying your broker? See How Do Commercial Energy Brokers Get Paid? The fee should be proportionate to the service. If the broker is helping you understand your energy bills, evaluating different contract structures (described above), and assessing the risks of market timing you should be prepared to pay more than if the broker is simply gathering prices.
3. Avoid Conflicts of Interest.
Is the broker’s compensation limited to the fee you are paying? Or does the broker receive additional benefits from suppliers? See How Do Commercial Energy Brokers Get Paid? for a discussion of some of these additional benefits that can create a conflict of interest for your broker.
4. Market Intelligence.
Does your broker provide you with insight into how prices are determined as well as recommendations for when you should lock in prices? No broker has a crystal ball on future energy prices. But your broker should have a basic knowledge of the energy supply industry. Examples of information that can be useful to you:
- Historical data on price ranges in recent years. These will help you assess whether the pricing environment has more upside than downside.
- Factors that drive prices. Does your broker understand the drivers of electricity prices, for example: Natural gas prices, competing fuels, scheduling of nuclear power plant outages, adequacy of pipeline capacity.
5. Understanding of supply business
Does your broker understand how the suppliers quote their prices? Failure to push back against quotes or evaluate alternative pricing structures can result in significant additional costs. Your broker should not just be a “price taker” but should be negotiating with suppliers on your behalf.
6. Multiple supplier relationships.
Some brokers have only a few supplier relationships. Indeed, that is the biggest risk for commercial clients: How can prices be truly competitive if only a handful of people are competing for the clients’ business?
Your broker should have at least 5 or 6 good client relationships. To some extent the number and quality of these supply relationships is a good index of the quality of the broker. The largest suppliers will not approve contracts with brokers they do not trust or do not have experience in the energy markets.
Clients should feel free to ask their brokers who they deal with. A good broker will not hesitate to share the names of his major suppliers.
- Who are the Best Energy Suppliers?
We are often asked by our clients to help them find reasonably-priced electricity and natural gas supply. Even if we help them lower their energy usage with solar, LEDs and other technologies, these strategies never reduce consumption by 100%. Our clients continue to rely on supply from their local utility or a third party supplier.
Besides the utility – which is always a reasonable supply alternative – who are the best retail energy suppliers? What do we look for in an independent marketer? How do we know whether the energy suppliers who want to supply our clients are reliable? And how do we know whether retail energy suppliers are offering the best prices for electricity and natural gas?
One of the functions of a retail energy broker like Solomon Energy is to go out to the energy marketplace and assemble competitive quotes for our clients. In evaluating the bids that come in, price is NOT the only important factor. Over the past 18 years of electricity and natural gas deregulation, dozens of competitive marketers and suppliers have closed their doors, some through bankruptcy, others because state regulators have revoked their licenses, still others through consolidation, merger, or simply liquidation.
Accordingly, all retail energy suppliers are not the same. In this article we first discuss the factors that we use to evaluate who to recommend to our clients. Then we name the retail energy suppliers that we believe are the most experienced, reliable and honest.
Criteria for Identifying Good Retail Energy Suppliers
Before we ask for price quotations we look for a number of factors in a retail energy supplier:
Believe it or not the most important factor in a supplier is the one that is rarely discussed: credit-worthiness. The most frequent cause of supplier collapse is a weak balance sheet.
Suppliers that offer fixed price supply contracts for up to three years must buy long term hedges from the marketplace. Only companies with strong balance sheet can secure such hedges. That is because the financial institutions that offer the hedges will only deal with strong credits; after all, if a supplier buys long term supply from a banking counterparty (in order to hedge against the fixed price supply risk to our client) and prices go down the banker would lose money if the supplier walked away from the contract. Accordingly, the banker will want to know that the supplier has enough money to meet its obligations, even in volatile electricity and natural gas markets.
There are risks even with floating rate or variable rate supply. In that case a supplier can be put under sudden financial pressure if market prices suddenly spike and they must pay more for electricity or gas than they can afford in order to meet their client obligations.
In either case, if a supplier defaults on a contract with one of their customers it could result in unnecessary hardship if the consumer must suddenly go out into the market to buy supply at much higher prices.
Suppliers should have experience with supplying electricity and natural gas to our clients in their specific utility territories. Some suppliers are strong in some parts of the country but not in others. In extreme weather events we want to be confident that a supplier can meet our clients’ needs and get energy to their facilities.
Some suppliers have a reputation for promising to undercut utility prices with a variable rate supply contract. They will often save clients’ money in the first month or two of a new contract. But later they may start to raise their prices in a classic “bait and switch.” Many suppliers have a history of taking advantage of customers who “fall asleep,” i.e., they take their supply for granted and don’t scrutinize their bills to make sure the supplier is setting reasonable prices. See How Do Energy Suppliers Make Money?
We have dealt with some energy marketers who take a week or two to respond to a request for prices. Then, if the customer shows interest, they take their time to “refresh” prices and may even try to squeeze additional markup out of their supply agreement.
We prefer retail energy suppliers who have a pricing desk that will reply quickly to a price request and then will freshen it up when we are ready to do business.
5. Market Research
We like to deal with retail energy suppliers that will supplement their pricing services with information about the markets. Not only does this information demonstrate that a supplier has experience and insight into markets that are important to our clients. It also helps alert us to issues that might affect our thinking about the optimal timing of our clients’ supply decisions.
The best suppliers put our periodic newsletters, similar to the Solomon Energy weekly and monthly newsletter (Watts Up). Even if our clients have no time to read these publications we scan them daily, watching for material market intelligence that we can pass on to our clients.
So Who Are The Best Marketers
We deal with close to a dozen different retail energy suppliers in different parts of the country. Some are strong local or regional players. Others have a national presence. At the risk of omitting some capable marketers (and offending them to boot!), we will list the foremost retail energy suppliers that we have dealt with over the years.
1. Constellation Energy. Constellation Energy and its affiliate, Constellation New Energy, provide a range of retail energy supply services to large industrial and commercial as well as residential and business consumers throughout the country. The company is part of Exelon, the largest utility in the United States, and has grown over the years through the acquisition of a number of strong retail energy companies like MXenergy, Integrys, AES NewEnergy and Startex Power.
In addition to having a strong pricing desk and experience in all major NERC regions and on all major pipelines, Constellation is also familiar with energy efficiency technologies that can help reduce energy usage.
2. Direct Energy. Direct Energy is the North American retail energy subsidiary of Centrica, a large UK-based company that was once known as British Gas. Like Constellation Direct Energy has also grown through acquisitions of other companies and has added numerous other retail energy services including HVAC services. It has a large commercial energy division as well as a residential division and does business throughout the country.
Direct Energy uses a number of direct marketing techniques such as door-to-door which will sometimes be sited for aggressive sales tactics including slamming. (See, e.g., http://wincountry.com/news/articles/2015/jul/24/bbb-warns-of-alleged-gas-service-switching-scam-involving-direct-energy-services/ involving a recent claim in Michigan.) Early in its history Direct Energy was often criticized for such behavior in the Ontario market but we believe that recent management has made bona fide efforts to clean up its sales efforts and treat customers respectfully.
3. Crius; Viridian; Public Power. These companies are all part of the Crius Group whose customers are located in the United States although the company is publicly listed on the Toronto Stock Exchange. The Crius group has grown rapidly in recent years both organically and through acquisitions and has expanded its services beyond its roots in residential marketing to commercial customers throughout the country. We particularly like the fact that its Public Power arm puts out daily pricing to customers, helping them (and brokers like Solomon Energy) keep track of energy market changes.
4. Spark Energy. Spark is a Texas-based company that has grown rapidly in recent years, going public in 2014 and providing strong services to both large commercial as well as small business and residential markets. We have found that Spark has distinguished itself with its rapid response pricing desk which frequently turns customer requests for pricing around within hours. We know how much business Spark does so we know it is not because of a dearth of such requests; rather, the company has made a serious investment in supporting its retail energy supply operations.
In addition to these national marketers we have admired the strengths of several other retail energy suppliers in specific regions. IGS Services, for example, has particular strength in Midwest from its Dublin, Ohio headquarters. Sprague Energy has particular strengths in New England natural gas and electricity markets. Champion Energy has focused on its mid-market commercial clients throughout the Midwest and Northeast. Hudson Energy, a subsidiary of Just Energy, a listed Canadian company with a long history of regulatory problems, has provided strong service to commercial customers in New York, New Jersey and Texas.
It’s All About the People
Ultimately, energy suppliers are only as strong as the people who work there. Over time we and our clients develop relationships with individuals on the pricing desk, in operations, and in sales. They are the ones that ultimately develop our confidence and earn our trust. We thank them in advance for their help!
- How do Utilities and Energy Suppliers Make Money?
Bills for electricity and natural gas can be a very high proportion of a company and household budget. Accordingly, the way in which commodity prices are set is of material importance to most consumers.
In states and utility territories where the utility has a monopoly on energy distribution, regulators determine how much utilities can charge. Consumers can take comfort in such rules, knowing that they will not be gouged because regulators – elected or appointed by elected officials – will protect them from aggressive pricing practices.
What about consumers in the 22 states and the District of Columbia where the utility does not have a monopoly? In those areas most consumers can purchase electricity and natural gas from third party suppliers. Indeed, in Texas for electricity, Georgia for natural gas, and for some in Ohio and Illinois for natural gas, consumers must buy their energy from third parties other than the utility. What protects consumers from price gouging in those utility territories?
The glib answer is: “The competitive market.” We rely on competition to keep prices reasonable in most consumer markets. Why shouldn’t energy prices be similar? Why wouldn’t suppliers restrain their natural inclination to obtain higher profits from their consumers because of the risk they will lose business to others if they don’t? And if suppliers go too far, aren’t there regulators who will jump in to protect consumers?
In fact, in deregulated markets competition does help to put a brake on unreasonable pricing. However, as this article explains, this is not always the case. Moreover, regulators cannot be expected to step in if and when pricing gets out of control.
It is fair, then, for consumers to ask: How do competitive energy suppliers (e.g., electricity and natural gas marketers) make money? Understanding how energy marketers make money will help consumers understand how there may be times when they are not treated as fairly as they should be. Even if regulators may not act effectively, consumers should be able to take steps to protect themselves.
Energy like electricity and natural gas is bought and sold in an on-line marketplace or in oral transactions over the phone (although oral transactions are immediately confirmed via internet). There are a number of participants in this marketplace:
- Producers. Companies that generate electricity and companies that extract natural gas from the ground. Strangely enough few utilities generate most of their own electricity; almost all is bought in the marketplace from others just like third party suppliers buy.
- Wholesale marketers. A large number of companies buy and sell from the producers in wholesale quantities of, say, 2 mW per hour of load or 10,000 mmbtu (million British Thermal Units) per month.
- Banks. A number of large money-center banks have established divisions or affiliates that engage in wholesale marketers. These affiliates have sometimes been called Wall Street traders. Following the Great Recession of 2008-9 they have recently been the subject of debate over whether they should be able to put bank capital at risk or whether they should be split off from their regulated bank parents.
- Utilities. Utilities are in their regional market buying and selling supplies to balance the needs of their customers.
- Retail marketers. The third party marketers themselves will enter into transactions with utilities and other marketers where they need to balance their supply portfolios during the day to match actual consumption.
- ISOs. In electricity the independent system operators will balance electricity throughout the day, every 5 minutes normally, based on supply and demand. All market participants are effectively buying and selling from the ISO in financial transactions that permit the ISO to bill or pay the counterparties for electricity drawn or provided to the ISO.
- Regulated exchanges. A number of exchanges – all electronic – permit buying and selling of energy products. The most dominant are the Chicago Mercantile Exchange, which lists products created by the New York Mercantile Exchange, and the Intercontinental Exchange (or “ICE”). Members of these exchanges have access to price quotations and can enter trades on their trading platforms.
- Informal electronic platforms. com, recently acquired by Enernoc, offers an online platform for retail suppliers and mostly commercial customers to transact business.
- Speculators. Some traders such as hedge funds may take speculative trading positions that profit if the market moves in a particular direction. For example, they could buy if they think the market is going up and sell for a profit at a later date. Ironically (given the name used by hedge funds), such trading is not “hedging” at all but highly risky.
- Endusers. Consumers are the ultimate buyers of energy and are key market participants. Large industrial and commercial buyers will buy directly from producers or from the intermediaries listed above. Small consumers will not have limited access to the marketplace, being able to buy only from utilities or retail marketers.
Throughout the day players in the marketplace buy and sell electricity and natural gas with each other. These transactions fall into two broad categories:
- Wholesale or standardized trades. This category consists of transactions that are standardized as to volume and frequently other terms and conditions such as delivery point. As noted above, volumes may be 2 mW per hour or 10,000 mmbtu/month. In electricity, the volumes will be either peak or non-peak; peak on the East Coast will be business days only whereas on the West Coast it will include Saturday as well. Delivery will frequently be at a few liquid points (i.e., locations where much trading takes place). Thus, for example, electricity may be delivered at the Palo Verde switching station in Arizona or into the Western Massachusetts Trading Hub. Natural gas may be delivered at the Henry Hub in Lafayette Parish, Louisiana.
- Customized retail trades. Few consumers are located at the delivery points or use energy in wholesale quantities. Accordingly, almost all transactions that involve an end-user require customizing: Odd volumes and specific delivery points are critical components of these trades. In the case of very large consumers the wholesale market players will provide service; for smaller consumers utilities or retail marketers will help with getting the energy the last mile to the customer’s burner tip or meter.
In this section we discuss how and where prices can be found. Below we discuss how the prices themselves are set.
Before deregulation in the 1990s, all energy transactions were conducted bilaterally with the terms agreed upon by phone or in person. Both electricity and natural gas were highly regulated by federal and state law such that the prices were often prescribed by regulation and the parties had little latitude for customizing their supply contracts.
Exchange Price Discovery. With deregulation came the introduction of exchange-traded mechanisms for transacting business. These exchanges, beginning with the New York Mercantile Exchange, provided a platform for buyers and sellers to find each other easily and buy and sell standardized quantities of electricity and natural gas according to standardized terms.
There were several benefits to exchanges. New market players such as traders, who were neither producers nor consumers, provided quick execution (called liquidity).
More importantly the exchanges provided price transparency: All market participants with access to exchange prices could see where business was being transacted at any given moment.
Exchanges continue to perform an important role in price discovery although all energy exchanges now take place electronically. In 2015 the last floor trading operations were closed by the Chicago Mercantile Exchange.
Off-exchange Swap Markets. Today the standardized exchange contracts have been supplemented by off-exchange mechanisms that call for financial settlement and not physical delivery of the commodity. In these contracts, known as “swaps,” wholesale players will agree to exchange payments based on changes in a price index such as an exchange price or a price published by one of a number of public or private enterprises. For many years the prices reached in off-exchange transactions were known to a handful of market participants but were not transparent like market prices. Recent regulations adopted after the Great Recession have required that these off-exchange transactions be cleared by organizations, known as clearing houses, that must publish the prices just as exchanges publish prices.
Index Pricing. It is important to understand the role of index prices. Most indices used in the swaps market (other than the exchange prices themselves) are found in commercial publications. Examples of these publications include the Wall Street Journal, Bloomberg, Platt’s, and Gas Daily. These publications get more granular than the standardized exchange contracts and list prices at a larger number of specific delivery points that are of interest to consumers.
Index prices are determined based on daily or weekly surveys taken by the publications of industry participants who report on a voluntary basis their transactions according to price and volume. The publications then calculate a weighted average of prices transacted in order to come up with an “index price,” essentially an estimate of where industry participants will do business.
Index prices are used in two ways. First, to determine the financial settlements of swaps described above. Second, to determine prices paid under some bilateral contracts. For example, a contract might provide that a natural gas vehicle pumping station will pay a price equal to the average price of Gas Daily over the course of the month plus $1/mmbtu.
Because the index prices are based on surveys of market participants there is a risk that those participants may not file honest reports but rather reports that help move the weighted average index in a direction that is favorable to their trading positions. A producer, for example, that wanted higher prices for its product might report that it did a large trade at a higher price than was true. By including this trade in its calculations the index price will be distorted.
Lying on surveys is considered a form of market manipulation and is illegal. Yet sadly it is still practiced by some market participants. Meantime, publishers of indices are becoming more careful about seeing to confirm the legitimacy of survey responses.
Delivered Prices. Because exchange-traded prices are based on wholesale market transactions for delivery at standardized locations, producers and end-users must still enter into customized transactions in order to get their electricity or natural gas from the source of production to the burner tip or meter. In contrast to exchange-traded prices, these transactions are not transparent.
Where Do Prices Come From?
We have examined the market participants, the transactions they enter into, and where prices can be found. Where do those prices come from?
In another article we explain how utilities set their prices. See How Does the Electric Utility Set Its Price? There we explain how even utilities must use the marketplace price to determine one of the three important components of their regulated prices. In this section we discuss where all marketplace participants get their prices.
Except in cases of market manipulation (see section on Index Prices above), prices are determined by supply and demand. Supply and demand, in turn, are the product of a number of factors working independently or together:
- Volume produced by producers or electricity generating stations.
- Volume of fuel – e.g., coal, natural gas, nuclear, wind — available to electricity generators.
- Railroad transportation for coal or fuel oil to reach electricity generating stations.
- Natural gas pipeline capacity to gas-powered electricity generating stations.
- Diversion of natural gas supplies through Liquefied Natural Gas exports to Europe and Asia.
- New technologies such as shale gas extraction techniques or more efficiency solar panels.
- Financial strength of producers and generators: For example, a weak economy could reduce the amount of available generation.
- Increases in renewable energy contribution of wind and solar.
- Cumulative usage of consumers.
- Changes in economy that increase or reduce the scope of industrial or commercial businesses.
- Weather (need for heat in winter, cooling in summer).
- Competitive fuel prices that could increase or decrease demand for natural gas whether for consumption or a generating fuel.
- Introduction of new appliances or electronic devices.
- Greater energy efficiency of consumers.
Supply and demand factors are being weighed daily to determine current prices. But they also play a role in long term forecasts.
- Interest rate increases could reduce appetite for building new power plants which could reduce supply in the future.
- New pipelines that take years to build could come on line.
- New generating plants could be introduced
- New technologies could increase supply
- New efficiency technologies could reduce demand
- Industries with major demand could move from region
Market participants look at these factors, both short term (e.g., tomorrow’s weather) and long term (e.g., economy), and decide on what they believe is a fair price. Because of the price transparency provided by the exchanges and clearing houses they can see where wholesale prices are being transacted. They can then determine whether those prices are reasonable and whether they fit their risk appetite.
So How Do People Make Money?
Most people think that the essence of trading is this: “buy low, sell high.” Interestingly, that strategy is the exception, not the rule. There are several ways in which market participants make money:
1. Speculation. Traders with an appetite for risk may take speculative positions on the market depending on their view of market trends. Suppose, for example, a trader believes that electricity prices are going up. He or she can buy electricity and when prices go up sell for a profit. Similarly, he or she can sell if the market looks weak and buy back when prices drop.
This “buy low, sell high” or “sell high, buy low” is highly risky. Suppose that the market does not move in the desired direction. Closing out the position will result in a loss, not a gain. If the market moves fast and far enough the losses could be substantial.
Speculative trading is the least popular method of making money. It requires tremendous reserves of capital to support the business through bad times as well as good.
2. Markup. Most for-profit companies make money by marking up their costs by a competitive profit margin. The size of the markup depends on many things including competitive pricing and the extent of additional services that might be provided to counterparties.
To determine a price, these companies will take the cost of their supply – short term or long term – and add their margin. Note that in the case of long term pricing these companies must also take into account their cost of capital. That is because a long term hedge ties up capital in the form of margin requirements of exchanges or counterparties from whom they buy their fixed price protection. The cost of tying up this capital must be taken into account in addition to the cost of the underlying commodity.
These companies may also want to include a risk premium. Particularly in the case of full requirements contracts, where the supplier will be responsible for supplying at the same price as much commodity as the consumer uses, a premium for this risk should and generally will be added to the costs calculated before applying the markup.
3. Return on Investment. Producers and independent power producers must earn a return on their capital that is sufficient to justify their investment. If a company cannot produce a sufficient return it should deploy its capital elsewhere. Thus, a producer will look at the cost of drilling and a generator at the cost of construction. Tying up its capital comes with a cost, not only for debt service but for foregoing alternative investments.
4. Consolidated Returns. Some energy suppliers may combine the supply with other services, much as an auto dealer might throw a service contract in with a car. The car might look like it’s being purchased at cost; the real profit is in the service agreement.
Likewise, some energy suppliers have begun to offer to finance energy efficiency upgrades in exchange for a supply agreement. Sometimes the efficiency looks inexpensive – the supplier will offer “free” installation – but the profit is in the supply agreement. Alternatively, a supplier may offer to supply electricity or natural gas at “cost” compared to some index. But the supplier may make money from the cost of transportation or balancing services that it is providing elsewhere.
Consumers should understand how their electricity and natural gas suppliers are making money. If it is not readily apparent it is reasonable to ask. Understanding the supplier’s motivation will help clarify whether pricing is reasonable or whether a consumer should spend more time looking elsewhere for alternative pricing.