Retail Risk-Based Pricing

A new approach to rate design.

As energy markets have evolved in the late 1990s away from cost-based transactions to competitive market-based transactions, the exposure to market risks for the variable cost of supply has substantially increased.¹ Reflected in these market risks are the diminishing reserves for North American gas supply, which has created conditions of extreme volatility in gas supply. The added market risk is compounded by the sensitivity of some retail load customers to weather conditions. Through integrating load and price uncertainty, risk-based pricing (RBP) determines the true cost of service and provides a more comprehensive approach to developing retail rates in today's energy markets.²

Traditionally, retail pricing for regulated entities has been based on the average cost of service, and no factors are associated with the relative volumetric risks and the relationship to prices.³ The principal concept behind RBP is that customers with greater risk require greater working capital set-asides to address anomalous or unexpected events. RBP provides a structured approach to value the elements of retail supply cost risk and provide a systematic structure to incorporate these risks into retail prices.⁴ As a company's stock price carries a beta value with respect to movement in the market average, RBP introduces a method for reflecting the joint relationship of volumetric and price risk that effectively incorporates each customer's beta into retail electric rates. For competitive retail offerings, RBP provides a well structured approach to identify low-risk customers and develop a consistent risk metric for retail offerings.