Fix or Float? A History Lesson
The question is as old as energy deregulation itself. Is it wiser to fix a price (and thus avoid volatility and possibly rising prices) or to float with the market expecting to eliminate any premium associated with fixing a price?
Proponents of fixing point to price certainty and the historic rise of fuel costs as good reasons to take shelter. Floating advocates point to spot markets that often yield lower prices than do the futures markets (the major component in fixed energy contract prices), despite the fact that they exhibit dizzying volatility and potential ceiling prices of $1,000/MWh or more.
So is it better to fix or float? The answer is yes. Both types of contracts are better at certain times and for various term lengths. As an example, let's look at the spot market in Texas, specifically ERCOT's Market Clearing Price of Energy (MCPE).
This price changes hourly. Customers that choose to float a price using MCPE pay the hourly load-weighted clearing price plus losses, ancillary services, QSE and ISO fees, congestion, and administrative costs plus a margin for the supplier. The exhibit above is a bit complicated, but tells a compelling story. The pink line is the average spot cost of electricity for each month since January 2002. The navy blue line is an estimated indexed (floating) price including all necessary components. The light blue line represents utility default prices, and the yellow line represents the price of a fixed-price contract taken out in January of each year. The red dotted line is a linear regression trend line based on the MCPE, and is useful to illustrate the general rise in the market price over time (the best fit to a constant rate line is about 22% per year). In this case, the average floating price would have been $64.28/MWh. The series of 12-month fixed contracts would have yielded an average price of $66.87/MWh, or $2.59/MWh more than the floating price. The utility Price to Beat (PTB) for the period was ~$86.88, and would have been the most expensive choice by far.
So the float option looks like the best average price compared with a series of 12-month contracts (if you don't mind volatility), but what about longer-term fixed prices? The table below illustrates what might have happened if a buyer were to have taken out three 24-month fixed contracts, or two 36-month contracts. The average cost using 24-month contracts would have been about $63.93/MWh, or less than the floating price, even though the timing of buying in January 2006 would have yielded a price of $115.68 for two years. The 36-month results, however, were much more dramatic, yielding an average of $45.03/MWh, or about half the utility rate and almost $20/MWh better than the fixed rates.
These results do not include any market backwardation, which would tend to improve the fixed position over longer terms, and are highly dependent on the dates on which the contracts were taken out. So it is important to watch trends to decide if a given point in time suggests a float or fix approach, and when a shift in strategy may be called for. The key to floating may be identifying a good time to fix, while a critical issue with fixing may be avoiding lock-in at the peak of an upswing in the market. Having a longer term perspective, a defined disciplined procurement strategy and keeping a constant eye on the markets (as well as regulatory and infrastructure issues) is key to successful energy procurement. History illustrates that a simplistic singular point of view of the markets or strategy can be dangerous; so buyers wishing to avoid repeating past mistakes should take heed, look for balance and diversity, and pick the appropriate tactic at the appropriate time.
Quick Buyer's Tip
When considering balancing your energy portfolio by type of product, remember that facilities located in most regulated markets are on what amount to variable rates, usually due to fuel cost or other increases that change by formula or regulatory timeframe.
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