Energy Pricing Explained: What Goes into the Cost of Your Energy
The energy market can be difficult to understand. And navigating all the solutions available for your business can be challenging – especially if you're also managing other responsibilities for your organization.
When it comes to energy pricing, it's important to start with an understanding of the cost components impacting your energy bill.
In this article, we cover the components that influence power and natural gas pricing – and offer insights to help you manage these cost components.
Cost components of your energy bill
There are multiple components that comprise an energy bill. Before you can determine a strategy for your business, it's important to understand these components.
Here are the cost components that make up your energy bill:
- Energy: This is the main cost component of your bill. Prices are subject to significant fluctuation throughout the day, often in response to natural gas prices.
- Capacity: Ensures there is enough generation at a single point in time to meet your peak demand at the highest power-consumption hours.
- Other factors: There are several other components that suppliers have little to no control over – and comprise 5 to 20 percent of your electricity's overall price. These include things like line loss, ancillary services, and state-mandated renewable energy charges.
- NYMEX: The market, or NYMEX, is the main component of natural gas cost, comprising 60 to 65 percent of the overall price. Prices change throughout the day (sometimes abruptly) in response to significant events that impact supply and demand for natural gas.
- Transportation: Ensures there is enough space on interstate pipelines to provide natural gas on the coldest day of the year. Rates vary by pipeline, but typically don't change much annually.
- Basis: This is the price difference between the Henry Hub in Louisiana (a natural gas pipeline that's the official delivery point for futures contracts on the NYMEX) and a given market. If the given market's price is cheaper than the Henry Hub, a credit may apply. These prices are subject to change monthly or even multiple times daily.
- Other facts: There are several components that suppliers have no control over, including line loss, balancing and pooling charges, and BTU conversion.
Managing cost components
As outlined above, energy products are typically comprised of the commodity itself – either electricity or natural gas – plus a variety of other costs. When analyzing strategies for your business, it's important to determine whether you want to lock in the various components or ride the market.
In other words, you need to decide if you want to fix, float or choose a combination of the two.
By choosing to fix cost components, you're choosing to lock into a set rate per kilowatt hour (kWh) for electricity, or per CCF/MCF/Therm/Dekatherm on the natural gas side, for the length of your energy contract. Your monthly bill varies based on your consumption, but the rate you pay remains constant no matter what happens in the market.
By deciding to float your energy or NYMEX cost components, you're using a variable rate strategy. Unlike a fixed strategy, a variable strategy is one where pricing is tied to market rates and is changing constantly based on supply and demand. Your monthly bill varies based on both your consumption and the market rate. Because of the constant fluctuations, it's likely that your bill will look different from month to month, even if you consume the exact same amount of energy.
Fixing cost components
A fixed rate strategy is best for organizations seeking a stable bill each month. This may be suitable for your business if you have a low risk tolerance, seek budget certainty or don't want to take an active role in managing your day-to-day energy costs.
Note that timing is important: You want to lock in when rates are low and flat or falling for the period you're considering, and you must weigh the value of waiting for further price dips against the risk of waiting too long. Long-term price certainty may come with a price premium.
The benefits of a fixed-rate strategy include:
- This product makes it easier to budget for your energy costs.
- There aren't any surprises with your monthly bill.
- You enjoy a rate that remains unchanged for the duration of your term, protecting your business during unpredictable market conditions.
Things to consider about fixed pricing:
- There's less flexibility.
- You may incur early termination fees.
- During a low market, you may pay more for your energy.
Floating cost components
This strategy is beneficial if you want to take an active role in the management of your organization's energy. By actively monitoring the market, the variable rate can help you take advantage of market volatility. This may be suitable for your business if you have a higher risk appetite, can be nimble in adjusting your usage according to market conditions and have a clear understanding of the energy market. If a spike in energy prices presents a significant risk to your business, this plan may not be right for you.
Businesses utilizing a variable strategy often sign a contract but have the option to lock in a fixed price at any time.
The benefits of a variable rate strategy include:
- You experience the flexibility to take advantage of market lows until conditions are right to lock in a long-term fixed price.
- You have the option to participate in programs like peak shaving in the summer, to improve energy profile and reduce other cost components.
- You have the ability to adjust your usage during off-peak hours when prices are low, saving money for your organization.
Things to consider about floating:
- You may assume more risk.
- By riding the market, you're susceptible to potentially large spikes in energy costs.
A hybrid strategy
Of course, you don't have to choose a purely fixed or exclusively variable strategy.
Combination strategies combine elements of fixed pricing with variable pricing under one contract. You can customize a plan for your business by fixing some components, while floating others.
For example, some suppliers may allow you to purchase a block of your energy at a fixed price, while usage that exceeds your designated usage is billed at the market price. You have access to wholesale market pricing and the option to fix or float as much of your energy as you choose, based on your risk tolerance and business objective.
This strategy is suitable for your business if you're seeking to balance budget risk with market risk. It can provide you with some predictability by securing a portion of your load, while still allowing a portion to follow the market. Typically, this makes sense for larger electricity users who do not want to be fully committed to a fixed price and have flexibility to reduce other energy costs through demand management strategies.
The benefits of a hybrid strategy include:
- You can mitigate price spikes (similar to a fixed product).
- You can take advantage of downside market movement (like with a floating product).
Things to consider about a hybrid approach:
- You must assume some price variability and risk.
- Your energy price may vary from month to month.
- You must actively monitor the market to ensure your decisions align with your goals.
Understanding your options
Choosing the right strategy for your organization is a big decision – but the right energy supplier can simplify the process. It's important you work with a supplier that understands your organization's goals – and can help you make the right decisions to meet those goals.
While the cost components impacting your energy bill might be static, the market is always changing. That's why it's important to work with a supplier that offers market experience and expertise.
Learn more about your options for managing your energy costs here.
And for more information on the energy market, sign up for IGS Energy's Market Commentary.