Retail energy providers (REPs) buy electricity future contracts to manage the risk of chaotically fluctuating electricity prices. If a REP signs a large customer, they will buy electricity future contracts to cover the entire contract term. But how large of an electricity future contract should the REP buy to manage the risk on that customer?
Electricity futures contracts are usually separated between peak and off-peak periods. In Texas peak hours are from 7AM to 10PM and the rest are off-peak. So for our first attempt at buying the correct amount of electricity futures, we can just take the average consumption of an example customer from 7AM to 7PM for each month.
This "take the average" strategy works well when the customer has a flat consumption profile. But what if they do not have a flat consumption profile? Should a REP buy the same amount of futures for Customer A:
As customer B:
Customer A and Customer B have the same average usage during peak hours. But Customer B consumes much more electricity during the most expensive peak hours. When a customer consumes more energy during the most costly hours, the expected cost to serve them will be higher. A higher cost to service represents a higher risk, and a REP should buy more electricity futures to cover that customer's higher risk.
I learned a trick from an energy risk manager that solves this issue. This trick uses the interpolation factors from the previous blog post I mentioned. If we multiply the interpolation factor by the customer's volume, we will increase volumes during expensive periods of the day and decrease volumes during cheaper parts of the day. This changes our Customer A's consumption from:
to:
And Customer B's consumption from:
to:
With this new approach, Customer B's average usage during peak hours increases significantly, whereas Customer A's average usage decreases slightly. Our improved "take the average" strategy now properly reflects variations of usage within peak hours and we will better manage the risk of different customers' usage profiles.
Yes, we now have a much better hedging strategy, and this exact strategy is being used successfully by REPs. But some electricity consumers use more electricity as electricity prices rise. Does our hedging strategy protect us from extreme price spikes? To be continued...