Michael O'Sheasy | Apr 18, 2003

Wise business philosophers have repeatedly told us that if we want to be successful in the business world, we must have loyal and highly satisfied customers. Drilling down a little deeper into this truism, we find that the way to engender loyalty and satisfaction from the market is by ensuring value and trust in the partnership between the firm and its customer.

Notice that I have not mentioned price. Price is indeed a critical tool, but only to the extent that it influences value and trust for the customer while providing a reasonable return for the firm.

This article is all about the creation of a new, innovative energy-pricing product that achieves both of these critical goals: value and trust. And, it does so in an industry facing major obstacles to these goals. How can a customer trust a monopoly or a virtual monopoly? How can a customer trust a retail supplier whose bill computations seem arcane and incomprehensible and, worse yet, vary monthly, seasonally, and annually by extraordinary degrees? A retail electric residential customer's bill can vary by 50% from peak month to valley month.

This article is all about the creation of a product that addresses these issues and fills a void in the product offerings for residential customers. A fixed-bill product will enable the development of trust between an energy provider and its customer and, as a bonus, add value to the transaction for the provider much like what has been occurring for years in other industries such as telecommunications and internet services.

Why haven't we previously seen a fixed-bill product in the electric industry? 1
Electricity has some unique characteristics:

  1. You cannot store it to any large degree; it must be produced when requested.
  2. It cannot easily be transported. If New Orleans is running low, you cannot simply load up a tractor-trailer of electricity in Chicago and drive it there.
  3. It's ubiquitous and it's fundamental to daily life.
  4. Buyers expect to be able to purchase as much as they want, whenever they want. A busy signal is unacceptable.

These unique characteristics create an extremely volatile commodity. The price of electricity in the wholesale spot market can change by a multiple of 100 in a 24-hour day. As a result of this underlying cost volatility and the characteristics listed above, the electric industry has feared a fixed-bill product and said it simply cannot be done.

Until very recently, this was the norm. But, a powerful breakthrough has been discovered. A fixed-bill product can be offered if it is based upon sound risk-pricing fundamentals! Suppliers have known of the underlying risks in pricing electricity and have offered various pricing products that transfer risk between seller and buyer. The following charts indicate, from both the customer’s and the supplier’s perspectives, how the fixed bill product compares with more traditional electricity pricing products.

The above chart shows, from the customer’s perspective, how different retail products have different expected bills and different financial uncertainties. The vast majority of residential customers purchase electricity at a per kWh price that doesn’t change by time of day or season. However, the customer still faces bill risk because of the load uncertainty, driven primarily by weather. A time-of-use product may lower a flexible customer’s expected bill, but may also increase the customer’s bill risk.

On the other hand, the fixed bill product costs a little more on average, but it completely eliminates bill uncertainty. Thus, seen in this light, the fixed bill product appeals to a particular customer segment and is a natural addition to a retail product portfolio.

From the provider’s perspective, the fixed bill product requires a larger markup (shown by the height of the rectangle) to compensate for taking on more risk. The provider’s financial uncertainties from each retail product are shown by the vertical lines. Of the three products depicted, the fixed bill has the greatest financial uncertainty and the time-of-use product has the least. However, the fixed bill risk may actually offset some of the existing risk from other retail products. It should also be pointed out that a properly priced retail portfolio will have equal risk-adjusted expected rates of return across products (as shown by the highlighted diamonds within the ranges).

It seems that retail suppliers have not consistently adhered to risk fundamentals. Had they, it would have been clear earlier that a fixed-bill product is not only feasible, but also an important element in a balanced portfolio of risk-diversified products. One merely has to include an appropriate risk premium.

What risks are incurred by a seller who offers a fixed–bill product?
Fixed-bill customers will increase consumption: This is a fact and is well known in the credit card industry as well as by utilities that offer levelized or budget billing. What hasn't been known until now, through intense load research, is just how and when customers will increase their electricity usage. Armed with this knowledge, providers can adjust their product offerings for this expected quantity change.

But what if we’re wrong in a particular year? By modeling the expected change in consumption resulting from a fixed-bill product, we have the necessary tool to produce a distribution of possible outcomes for usage changes. This distribution of possible outcomes can then be used to develop an adequate risk premium for the fixed-bill product.

Electricity consumption varies with weather: This too is a fact. However, our predictive equations indicate how consumption is likely to change, and produce a variety of outcomes based upon different weather scenarios. We're not about to propose that we can predict the weather, but we can predict what weather-normal consumption would be and then display a distribution of possible consumption outcomes. This distribution is useful in developing the appropriate risk premium.

The underlying cost of providing electricity will change during the fixed-bill contract year: This may indeed happen. However, our risk fundamentals equations can produce a risk premium component to cover this possibility.

What if only customers who were going to change consumption anyway - even in the absence of this new rate offering - were the only volunteers for the fixed-bill product? What, if abusers were the only takers? This possibility can also be modeled and a risk premium component can be added. In fact, safeguards can be added to the tariff itself to help control for this possibility.

Could the above risk factors be inter-related? Certainly they could. When that is the case, we simply add covariance parameters to properly adjust the risk premium.

In summary, the secret to offering a fixed–bill product is to (1) project the resulting change in consumption; (2) model the risk that actual consumption may be different from the projection, and calculate an appropriate risk premium; and (3) compute the bill offer including the resultant risk premium.

What can a supplier expect from offering a fixed–bill product?
Approximately 10-15% of the target market will immediately volunteer for a fixed-bill offering and gladly pay the required premium in spite of the fact that this new rate is expected to rightfully be the supplier's most expensive pricing product. Customer satisfaction for these volunteers will soar as quickly as their calls to the customer service center for bill questions will decline. Earnings to the supplier will be boosted. Growth in consumption will be induced; appliance conversions may occur. And, a whole new family of additional products will surface, such as prepayments with discounts, now that customers know with certainty their annual bill costs.

Customers who select fixed billing will receive added value. Trust in their supplier will climb as their supplier promises, "No matter what may happen during the contract year, I will not change your monthly bill."

Nothing is as embarrassing as watching someone else do something that you said couldn't be done. For years the electric industry said fixed billing couldn't be done. Today, fixed billing can be done.

1 The remainder of this article will deal with the electric industry, but the discussion is applicable in varying degrees to other energy industries.

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You are right on target! As an unregulated energy marketer in Wisconsin, WICOR Energy was quite successful in pricing and selling this very product to residential and commercial natural gas customers in the late 1990's. The customers initially loved the idea that there would be no true-ups at the end of the contract year. Some signed up for two and three year contracts. The risk was determined just as you outlined in your article, factoring in extreme weather possibilities, balancing fees, and the costs of hedging the commodity as well as a margin for our efforts. We knew it could be done and did it, at a profit, and experienced both warmer-than-normal and colder-than-normal years in the program.

Unfortunately, in the regulated utility environment this type of program has not gained wide acceptance. Regulators are hesitant to allow the appropriate levels of risk premium in order to make this work and the utility shareholders do not receive an incentive to assume any of the price or usage risk in order to gain "value" and "trust" from captive customers. The utilities themselves have valid concerns that, despite their best marketing efforts, customers won't understand why they are paying for energy that they are not consuming in an "off-year", generating more customer calls and complaints. Consumers are probably more forgiving of an unregulated supplier than they are of a regulated utility, even though the consumer is ultimately making the decision to participate in the program. Metering costs can be an issue, too, if the regulator wants to ensure that the program isn't subsidized by other utility product offerings.

All that being said, I agree that fixed pricing programs are possible and should be offered in the customer-focused supplier's portfolio. The ongoing volatility in energy prices can be mitigated somewhat for consumers using a program such as this.

It's all very interesting about fixed bills. Certain steps have been taken in Europe with fixed bills, but only within certain consumption bands. What would be interesting would be to see exactly the effect upon customer satisfaction, and even more important the impact upon customers changing supplier.

For instance, in the UK it will cost a supplier €70 to acquire a customer by doorstep selling, and about €50 for a telesales contract. This is clearly far higher than the returns being made from a fixed bill premium. In a market where we have about 38% of customers changing supplier (of which perhaps 20% changing repeatedly), the fixed bill may be an excellent means of reducing retention costs, and improving acquisition rate. Can anyone tell me what the effect upon customer retention has been in figures?

Comments would be very welcome to apatient@datamonitor.com, +44 20 7675 7889.