Spot price contracts
A spot price electricity contract may be a good option for medium and large electricity consumers, but there is financial risk to consider as well as potential reward.
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About spot price contracts
A spot price electricity contract can be a good option for some medium and large electricity consumers because they can:
- Save money when prices are low - customers can benefit from lower rates when spot prices are low in the wholesale market
- Take responsibility for bills - customers can make decisions about when to use electricity to reduce their costs
- Gain financial rewards - customers can earn a financial reward for actively managing their energy usage.
However, spot price contracts also carry financial risk because spot prices are volatile and can't be known in advance. This page sets out some of the risks that should be considered. We also recommend talking to a financial adviser or an authorised futures dealer for advice on electricity contracts.
The risk of spot price changes
In New Zealand, electricity prices on the wholesale market are set every half-hour. When you buy electricity on a fixed price contract, the retailer takes on the risk of price changes and the risk that you might use more electricity when prices are high. Because of this, retailers usually charge extra to cover these risks.
If you choose a contract linked to spot prices you avoid this extra charge, but take on the risk of price changes yourself. This means if spot prices go up, your electricity bill will go up too. It’s important to be aware of these financial risks and make sure you can manage any cost increases from month to month.
Spot prices are volatile
Electricity spot markets are known to be some of the most unpredictable markets in the world, even more so than stock or currency markets. Spot prices are set every half-hour at about 280 locations across the country. These prices can change a lot over time and in different places.
Spot prices can sometimes jump very high without warning or stay high for a long time. Spot prices are especially unpredictable when looked at every half-hour, and are still very changeable over longer periods.
Understanding why prices are so volatile is important. High spot prices can be caused by droughts that affect hydro power and by shortages of thermal fuel, which can last for months. Another reason for price spikes are periods of low wind when demand is high, or the sudden loss of a large power station or part of the grid. These are known as ‘capacity shortages’, which usually last for hours.
How to manage spot price risk
There are several ways to reduce the risks of spot price changes.
One way to avoid risks completely is to use a traditional contract with a fixed price for all electricity use.
If you choose a spot price contract, there are different tools you can use to lower your risk to a manageable level. You can use insurance-style contracts, also known as hedge contracts, or actively reduce your electricity use when spot prices are high.
Fixed price supply contracts
Fixed price supply contracts can fully or partially protect you from the financial impact of high or low spot prices.
The most common type of fixed price contract is where the retailer buys electricity at spot prices but charges the consumer a fixed price for all their usage. This means you are fully protected from price changes.
Sometimes, the contract might pass some of the spot price risk to you. For example, the contract might have a fixed price for a certain amount of electricity, with any extra usage charged at spot prices, or have different (but still fixed) prices for electricity used at different times of the day, for example peak and off-peak.
These types of contracts may not be available from all retailers.
Financial contracts (hedges)
You can protect yourself from high (and low) spot prices by using insurance-type hedge contracts. These contracts don’t involve supplying or using electricity but provide payments based on spot prices compared to a set contract price. There are many different types of these contracts, some common ones are:
- Contracts for differences (swaps): The most common type. If the spot price is higher than the contract price, you will get a payment. If the spot price is lower, you must pay the difference.
- Futures contracts: Standardised contracts traded on the Australian Securities Exchange (ASX). They help manage spot price changes but require a good understanding of financial markets.
- Options contracts: You pay an upfront fee for the right to a predefined spot price insurance.
Demand-side management
Reducing your electricity use when spot prices are high can lower your costs. If you have your own power generation (solar panels) you can increase your output or switch to backup power during high price periods. Batteries can also be used to store power and this power used when prices are high.
However, to benefit from demand response or backup generation and batteries, you need to be confident you can act at the right times by monitoring spot prices closely or contract an energy management company to do this for you.
What level of spot price risk exposure is for me?
You should consider obtaining advice from a suitably qualified independent financial adviser as the best approach will depend on your specific situation.
Here's some things to consider:
- your ability to absorb spot price risk
- the time period over which you are prepared to act to minimise electricity purchase costs
- the expected costs of the different arrangements
- the risk associated with different arrangements
- how the ability to manage electricity usage affects the choice of different arrangements
- the management time and effort required under the different arrangements.
Assess your spot price exposure
Stress tests are a useful reference if you are considering spot price contracts because it is a simple check you can do yourself to understand your risk.
A stress test requires calculating how much your electricity will cost if spot prices are high due to a market event. Over the long-term, buying on the spot market should be cheaper than purchasing options to mitigate risk, as these options involve a premium to compensate another party for taking on the risk. But market events can result in large losses over the short-term. The results of stress tests can help you compare the costs of different contracts or other risk management options compared to spot price purchases.
For example, if you are a large consumer of electricity, you might compare the risk of buying all electricity at spot prices versus using a contract for 95% of your usage. In a stress test, you may lose $2 million if fully exposed to spot prices, but make a profit of $850,000 with a contract for differences. The choice depends on your risk tolerance and the cost of hedge contracts.
These scenarios just represent potential outcomes. Actual spot prices could be higher or lower than the test levels, and real events could be more severe. For example, a drought could last longer than three months, causing higher and longer-lasting spot prices.