Contracting for natural gas and electricity in Ontario: Energy Probe’s advice to household consumers

Tom Adams, Executive Director

January 6, 2002

(The information and forecasts contained here are current only as of the date of publication. Energy Probe in no way guarantees any decisions that might be made after consideration of any of the following statements. Our purpose is only to assist consumers with information that might be useful in considering options.)

Please also see Electricity ‘deals’ deceiving,
‘Direct Energy’ misleading Ontario’s electricity consumers

Many household consumers are receiving solicitations from energy marketers encouraging them to sign up for natural gas (“gas”) and electricity supply contracts of one to five years duration.

Energy Probe supports the right of consumers to choose among suppliers through individual contracts. The value of contracting was demonstrated by customers who contracted for gas on three to five year contracts in the late 1990s, thereby insulating themselves from the all-time high gas prices North America experienced in December 2000 and January 2001. Energy contracting can also assist customers in planning their energy cost.

Notwithstanding Energy Probe’s support in principle for energy supply contracting and the benefits to consumers of some previous contracts, we recommend that consumers able to withstand fluctuations in their energy bills may be best off by buying their gas and electricity without a contract.

Over the long-term, the acquisition strategy likely to minimize your cost of energy commodities may be to buy them from the spot market. Virtually all retail gasoline is purchased this way. Price certainty is a financial insurance service with the insurance premium built into the contract price. Most of the time, spot energy prices are below future prices. This situation currently prevails in the North American gas market, although during the price spike of December 2000 and January 2001 the opposite prevailed. The market for other commodities, such as mortgages, demonstrates the same tendency. See for example, Jonathan Chevreau, “Homeowners’ best bet is to go short – study,” Financial Post (National Post) April 3, 2001.

Gas contracting

Only about 40% to 60% of an average household’s “natural gas” bill reflects the actual cost of natural gas. The rest of the bill recovers the cost of long distance transmission (including the fluctuating cost of gas used by the transmission pipelines), gas storage, and distribution. Rates for these services are determined by regulatory hearings and are charged to you through a “delivery charge” and a “customer charge” whether or not you sign with a gas marketer. The contract you sign will only deal with the cost of natural gas, not the rates for those regulated services.

Gas customers without a contract with a marketer receive gas from their local gas distributor. The distributor – for most Ontario customers it is either Enbridge Consumers Gas or Union Gas – buys gas on the seasonal market, short term market, and the spot market. The utilities then resells it to consumers at cost. (The distributor makes its profit on its distribution and storage rates and in some cases on a portion of the transmission rate.) Your utility’s buying strategy is regulated by the Ontario Energy Board but the costs incurred are not. The purpose of the buying strategy is to utilize gas storage located near consumers as a means of reducing the cost of pipeline services to meet consumer needs and reduce short term fluctuations in acquisition costs. When summer prices are below winter prices and also when the market price is rising, the buying strategy gets gas for consumers cheaper than a buying strategy based purely on the spot price. When winter prices are lower than in summer (which has happened several times in recent years, although not in the winter of 2000-2001) and also when the market price is falling, the reverse is true. The actual price customers are billed for utility-supplied gas is calculated from a forecast of the acquisition price. Forecasts are never perfect, so the billed price is normally either higher or lower than the actual spot price. The difference is tracked in a regulated “purchase gas variance account” and is cleared to customers (with a credit or a charge) when the account reaches some threshold level or at the end of the year. Energy Probe has studied the accounting behind purchase gas variance accounts in the past. We have not uncovered any unfairness to customers, although the accounting is not transparent to ordinary customers.

Unfortunately, if you are an uncontracted gas customer, the price your distributor uses to calculate your regular bill can be a very inaccurate reflection of the spot prices you ultimately pay both because the forecast may be wrong and because clearing the purchase gas variance account can confuse the apparent cost. Neither Enbridge Consumers Gas nor Union Gas even notes the volumetric gas commodity rate on bills to uncontracted customers. The rate used to calculate Enbridge Consumers Gas bills is currently 36 cents per cubic metre whereas the market price is about 18 cents per cubic metre. Again, this overcharge will be refunded in future bills, or used to offset undercharges from earlier or later bills.

As of May 30, the range of gas prices offered by brokers selling to Ontario homeowners is 28.2 cents per cubic metre for three years (Enbridge Home Services) to 32.9 cents per cubic metre for five years (Direct Energy). Signing bonuses apply in each case. One source of information on contract offerings is www.energyshop.com. (Energy Probe recommends caution in using the advice posted to this site. The long-term gas price forecast posted on the Energy Shop web site as of June 6, 2001 expected prices much higher than current prices and higher than the futures market.)

Current commodity prices can be found many places including the financial section of the Globe and Mail, the National Post, and at www.ngx.com. Where prices are reported in Canadian dollars per gigajoule (GJ), you can convert the price to cents per cubic metre by using the ratio $1 per GJ = 3.763 cents per cubic metre. Where prices are reported in millions of British Thermal Units (mmBTU), you can convert the energy amount to GJ using the ratio 1.054 GJ = 1 mmBTU.

In natural gas, as in most commodities, traders can buy and sell today for delivery in the future in a “futures market.” You can get information on the prices in the futures market for gas from financial newspapers and at www.futuresource.com.

The futures market reflects a market-based forecast of where prices are going. Consumers can use the futures market to directly lock in or “hedge” their future costs without the services of a gas marketer. Customers who think a futures market price is attractive and have large enough gas bills to make the effort worthwhile can buy the amount of gas they expect to require for specific periods on the futures market. At the same time, customers would buy their physical gas from their distribution utility, effectively paying the spot price. When the contracts mature, customers can sell their financial contract for gas at the spot market price. The loss or gain on the futures market sale will equal the difference between the physical gas purchase and price at the time the futures contract was entered into. With this buying approach, the futures market can be used not as an instrument of financial speculation but rather as an instrument of financial insurance.

The futures market indicates that the price of gas over the next three years is now expected to range between 21 and 24 cents per cubic metre. The May 31 spot price was 18 cents per cubic metre. Customers who lock in at the long-term contract rates offered today – 28.2 cents per cubic metre for three years or 32.9 cents per cubic metre for five years – may end up ahead, but investors on the futures market are betting (heavily) against it. And even if prices stay at today’s value, the extra premium on a contract might still be good value for an individual who wouldn’t get any sleep without being 100% sure about future gas prices.

Electricity contracting

This commentary follows up on other Energy Probe assessments of trends in Ontario’s electricity restructuring including publications in October 2000 and April 2001.

We have studied the contracts that three marketers – Direct Energy (owned by Centrica), Toronto Hydro Energy Services Inc. (an unregulated corporate affiliate Toronto Hydro Electric System Limited), and Ontario Hydro Energy (owned by Hydro One) – have recently offered to consumers. We are suggesting that consumers not accept any of these offerings.

All the contracts offered that we have studied contain financial risks for consumers that ordinary consumers have no reasonable chance of understanding. The contracts assign all future rebates that would normally be paid from Ontario Power Generation (OPG) to each electricity customer (under a program outlined in the Market Power Mitigation Agreement) to be received instead by the marketer.

OPG’s rebate program, which extends for the first four years after market opening, requires the company to rebate customers if the annual weighted average commodity spot market price of electricity exceeds 3.8 cents/kilowatt-hour. The current commodity price, which is buried in consumer bills, is about 4.5 cents/kilowatt-hour. The volume of purchases covered by the rebate declines as OPG’s market share declines, but appears to be about 60% at market opening based on OPG’s actual and planned “decontrol” of generating assets. The net cost of commodity electricity now would be 4.2 cents/kilowatt-hour if the rebate applied but market prices remained at 4.5 cents/kilowatt-hour.

Factors that might cause electricity prices to exceed 3.8 cents/kilowatt-hour include production shortfalls from Ontario’s nuclear plants, a drought in the Northeast region of North America that could cut hydro-electric production, high electricity prices in neighbouring jurisdictions such as New York or Michigan, tougher environmental controls on Ontario’s coal-fired power stations, or little investment in new electric generation capacity due to perceived investment uncertainty. Energy Probe expects that the market price is likely to exceed 3.8 cents/kilowatt-hour and that therefore OPG rebates are likely to be issued in the first couple of years of the market’s operation.

Although Energy Probe expects the market price for power to exceed 3.8 cents/kilowatt-hour, we are guessing that the final price for consumers, at least in the first year or two, is unlikely to exceed 5 cents/kilowatt-hour after taking into account the Market Power Mitigation Rebate. The Ontario Energy Board’s current estimate of the price of power after market opening is 4.2 cents per kilowatt-hour. This estimate may be revised prior to market opening. Toronto Hydro Energy Services Inc. has been offering contracts at 5.79 cent/kilowatt-hour. Direct Energy is offering 5.36 cent/kilowatt-hour for the first year and 5.95 cent/kilowatt-hour after that.

Energy Probe is not aware of any electricity distributor, like Toronto Hydro Electrical System Limited, that has broken out the commodity price from the other regulated charges on the bills it sends to consumers. As a result, consumers have very confusing information in front of them about what they pay for electricity. In Toronto, until June 1, 2001, consumers were charged 6.46 for the “energy charge.” Many customers have been comparing the current “energy charge” with the contract prices offered, and concluded that their cost will decrease. Energy Probe estimates that transmission, dispatch, and debt reduction charges currently billed to consumers but buried in the “energy charge” add up to approximately 2 cents per kilowatt-hour. These charges will be recovered in future from ordinary consumers irrespective of any contracts. The 0.7 cent increase in electricity prices effective June 1, 2001 announced by OPG in March is also not avoidable by contracting. Province-wide, the average cost of electricity directly comparable with the contract offerings is approximately 4.5 cents per kilowatt-hour.

Depending on the price of the fixed term supply, it may be beneficial for consumers to assign away their rebates. And the future has inherent uncertainties which none of us can forecast accurately. It appears to us, however, that the insurance premium embedded in the contract prices is very high relative to current prices.

Some other contractual terms in Direct Energy’s offer may severely disadvantage consumers. Direct Energy has contracted with Bruce Power as a supplier of power. If a failure by Bruce Power to deliver nuclear-generated kilowatt-hours results in extra costs for Direct Energy (Toronto Hydro Energy Services Inc. also buys from Bruce Power), contracted customers will have to cover Direct Energy’s losses. The contract does not set out how consumers will be billed for these losses. The Toronto Hydro Energy Services Inc. contract contains a similar clause. With the opening of Ontario’s electricity market delayed, Direct Energy will have the option to extend the contract but the customer won’t have any choice about whether to continue until the five-year term expires or Direct Energy releases the customer.

Official bodies with a responsibility for customer protection – the Ministry of Energy and the Ontario Energy Board – have done a very poor job of explaining to consumers the implications of the Market Power Mitigation Agreement rebate when contracting for power. Energy Probe has corresponded with the Ontario Energy Board starting in November 2000 asking the regulator to update the information posted on its web site for electricity consumers, with an explanation of the rebate, its administration, and its implications in contracting. In early June 2001, reference to the rebates has been added to the OEB site, although the information provided on the volume of purchases covered under the rebate is inaccurate.

Unfortunately, there is no liquid futures market for electricity yet in Ontario so it is very difficult to predict prices. Without a liquid futures market, consumers have limited hedging options.

In contracting for energy supplies, consumers should be careful to ensure that the marketer is financially capable of meeting its side of the contract commitments. In the past, some gas marketers in Ontario and elsewhere have sold energy to consumers on long-term, fixed-price contracts, but bought the gas to satisfy those contracts on the spot market. When prices rose, the marketers failed to deliver and the customers returned to the distribution utility as a source of supply at higher prices. Energy Probe is not aware of any current energy marketers in Ontario that we believe may be unable to meet their commitments.

Under Toronto Hydro Energy Services Inc.’s first residential electricity sales contract, which has a one year term, the participating customer can get out of the contract with 30 days notice. This provision is potentially valuable and customers with such contracts might be best off to wait and see what happens once the electricity market opens. Unfortunately, the issue of what to do with Market Power Mitigation Rebate in the event that the customer is served for a portion of the year is not clarified in the contract. The current Toronto Hydro Energy Services Inc. does not include any exit provision.

Fixed price, fixed term gas and electricity contracts are purchasing options available to ordinary Ontario consumers that allow consumers to plan their energy costs more accurately than remaining on floating, spot market-based services available to uncontracted consumers from distribution utilities. When shopping for energy contracts, consumers should ensure that they are aware of those components of their energy bills that are regulated and therefore not included in the contract prices. Energy Probe anticipates that in the long run, relying on the spot market for gas and electricity appears likely to yield the lowest costs, although uncontracted consumers must be prepared to accommodate some volatility in the price of energy. Natural gas prices have recently dropped very substantially from the prices seen during December 2000 and January 2001. The gas contracts reviewed here are priced substantially above current spot market and futures market prices. The electricity contracts reviewed here would all have the effect of increasing customer electricity costs significantly above the electricity commodity prices currently embedded in bills. Before contracting, Ontario electricity consumers should also consider the protection from commodity price increases afforded to uncontracted customers by the Market Power Mitigation Rebate program.

 

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