Thursday, March 26, 2009

Direct Energy Viewed as an Insurance Company

Direct Energy is well-known for its flat-rate natural gas plans. By guaranteeing rates for a period of time, they are in effect acting as an insurance company. Any time you buy insurance, you need to find out if the other party is financially sound enough to follow through on its promises.

According to the Direct Energy web site, they offer a two-year flat rate natural gas plan in my area at a rate that is about 30% higher than the variable rate that I’m paying right now. This added 30% amounts to a premium for 2 years of insurance against rate hikes.

But what happens if natural gas supplies are interrupted and rates spike up? Will Direct Energy be able to fulfill its promises if variable rates double? I have no idea, but anyone considering entering into a flat rate plan should find out. If Direct Energy isn’t able to maintain promised rates, customers could end up paying the flat-rate premium and then paying the high variable rates too.

Any time we enter into agreements with another party who is promising to deliver something in the future, we must consider the financial health of the other party. AIG employees entered into a bonus agreement with AIG, but it turns out that the company would certainly have gone bankrupt were it not for government intervention. If AIG wasn’t too important to be allowed to fail, the bonus agreements would have been worthless, not because they weren’t legal, but because AIG wouldn’t have been able to pay.

When I left a former employer, I chose to take the commuted value of my pension rather than leave it in the company plan. I didn’t do this because I did the accounting and determined that the commuted value was worth more than the future promised payments. I did this because I doubted the company’s ability to fund the pension plan until I turn 65, and I doubted that the government would step in to protect the full amount of my pension.

It may be that Direct Energy is financially sound enough to honour their fixed rate plans even if natural gas prices spike. But, why would anyone pay the premium for a fixed-rate contract without first investigating the financial backing of the rate promise?

7 comments:

  1. Wow, great post Michael. That's an aspect I hadn't considered -- I've avoided fixed-rate gas contracts merely because a safety margin beats insurance, but now I have an additional reason. :-)

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  2. Patrick: Thanks. Nice reference. If I was inclined to make a list of related posts, I'm not sure I would have remembered that one, but it's definitely relevant.

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  3. Direct Energy just hedges the cost, the same way airlines know what they'll pay for fuel or a gold company knowing how much revenue they'll get per ounce.

    They just enter into a contract that states that a producer provides them with so much natural gas at a fixed cost over the two year term, then sell it to consumers at a premium. Happens all the time really.

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  4. Nelson: If I understand you correctly, Direct Energy lays off the risk of rising costs onto the gas suppliers. So, if there is some major interruption in natural gas supplies, it is the gas supplier who has taken on the commitment to continue delivering gas for 2 years even if they have to do so at a loss.

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  5. Yep. The trade off is that the nat. gas company knows what they're going to get in the next 2 years, but in doing so takes on the risk that prices could go up. So pretty much exactly what you said.

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  6. I work for Direct Energy. We're part of the Centrica group of companies (listed on the FTSE), and have investor-grade credit rating. Part of the value we bring to customers is that we have the financial werewithal to weather economic hardship and volatile markets, and to take on the risk of energy market volatility on their behalf.

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  7. Anonymous: Thanks for your input to this discussion. I would like to think that your customers would take the time to check Direct energy's credit rating, but I doubt that very many customers even consider the financial health of the company that takes on risk for them.

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