What it means
Power stations, gas producers and importers sell large volumes to energy suppliers and traders in the wholesale market. Trading can take place on the same day, which is called the spot market, or months and years ahead through forward contracts.
Suppliers then sell to end users such as households, offices and factories. Wholesale prices move with supply and demand.
Weather, fuel costs, the availability of power plants, the amount of renewable generation and international events can all push prices up or down. Because electricity cannot be stored cheaply in large quantities, prices can swing sharply from hour to hour.
For energy suppliers, the main business challenge is matching the cost of buying energy with the price charged to customers. If the supplier agrees a fixed price with a customer but the wholesale price rises, margins shrink or turn negative.
To manage this, suppliers buy in advance through forward contracts and other hedging tools. Large energy users also deal with the wholesale market.
A manufacturer might buy directly or use a flexible contract that passes through wholesale prices, taking more risk in return for a lower margin. Finance teams in these companies must understand the exposure and decide whether to fix some or all of their costs.
Wholesale energy markets are heavily regulated because they are essential to the economy. Rules cover how prices are set, how traders must report their positions and how competition is protected.
Anyone budgeting for energy should check the contract terms to see what part of the wholesale price is passed through. Contract design deserves attention.
Fixed-price contracts give certainty but may include a premium for the supplier's risk, while variable contracts follow the market and can be cheaper on average but more volatile. Many buyers use a blend, locking in a base level of usage and leaving the rest to follow market prices.
In practice
Real-world examples.
Example
A retail energy supplier buys most of next year's electricity in advance at a fixed price. When wholesale prices later rise sharply, its margins stay healthy because most of its costs were already locked in.
Example
A steelworks signs a contract whose price follows the wholesale market. In winter, prices spike and the finance team has to find extra budget, so they consider fixing part of next year's consumption. A fixed share would reduce the risk of a budget overrun, though it could mean paying more if prices fall.
Example
A wind farm sells its output on the spot market. Revenue depends on the wholesale price at the times when the wind blows, and the owners use forward contracts to make income more predictable. Lenders to the project often require this, because stable income supports the loan repayments.
Formula
Calculation
Supplier margin = retail revenue - wholesale energy cost - network and other costs
Suppose a supplier buys 100,000 megawatt-hours (MWh) at a wholesale price of $60 per MWh, so the energy cost is 100,000 x 60 = $6,000,000. It sells the same energy to customers at $95 per MWh, giving revenue of 100,000 x 95 = $9,500,000. Network charges and other costs are $20 per MWh, or 100,000 x 20 = $2,000,000. Margin = 9,500,000 - 6,000,000 - 2,000,000 = $1,500,000, which is $15 per MWh.Case study
Seen in the real world.
Northlight Power Supply is an illustrative, fictional retailer of electricity to small businesses. It sold fixed-price contracts at $90 per MWh for the coming year, assuming a wholesale cost of $65.
Before it had bought the energy, the wholesale price rose to $85 per MWh. On 200,000 MWh of expected sales, the extra cost was (85 - 65) x 200,000 = $4,000,000, which would have wiped out most of its annual margin.
The company learnt to buy energy as soon as it signed each customer contract, and it set a policy of hedging at least 80% of expected demand. The illustrative lesson is that wholesale price risk can overwhelm a thin retail margin when it is not hedged. Northlight also introduced a monthly report comparing hedged volumes with expected demand, which the board reviews at every meeting.
Watch out
Common mistakes.
- Assuming the retail price moves one-for-one with the wholesale price, when suppliers add network charges, taxes and margin.
- Budgeting energy costs on last year's price, when wholesale prices can change quickly.
- Ignoring contract terms, which can pass wholesale costs straight through to the customer.
Questions
People also ask.
What is the spot market?
It is the market for energy delivered immediately or within a day, at prices set by current supply and demand.
How do suppliers manage price risk?
They buy ahead through forward contracts and use other hedging tools to lock in costs.
Why are energy prices volatile?
Energy is hard to store, demand changes with the weather and supply depends on plant availability and fuel costs.
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