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 Direct Energy, they currently 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?

Comments

  1. PatrickMarch 26, 2009 at 12:42 AM

    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. :-)

    ReplyDelete
  2. Michael JamesMarch 26, 2009 at 8:59 AM

    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.

    ReplyDelete
  3. NelsonMarch 26, 2009 at 5:32 PM

    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.

    ReplyDelete
  4. Michael JamesMarch 26, 2009 at 5:50 PM

    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.

    ReplyDelete
  5. NelsonMarch 27, 2009 at 1:09 PM

    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.

    ReplyDelete
  6. AnonymousApril 9, 2009 at 5:45 PM

    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.

    ReplyDelete
  7. Michael JamesApril 9, 2009 at 6:14 PM

    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.

    ReplyDelete

Post a Comment

Popular posts from this blog

Short Takes: InvestorLine’s HISAs, 24-Hour Trading, and more

I recently moved some cash into BMO InvestorLine’s high-interest savings accounts (HISAs) that are structured as mutual funds.  Their designations are BMT104, BMT109, and BMT114, and they purportedly pay 4.35% annual interest (which they can change whenever they like).  However, the way they report the monthly interest payments is so baffling that I wasn’t able to sort it out in my first 15 minutes of trying.  A further complication is the following text in the HISA description: “The Bank may pay, monthly or quarterly, compensation to your Dealer at an annual rate of up to 0.25% of the daily closing balance in the BMO HISA.”  I couldn’t find any evidence of such a charge, but I haven’t been invested for a full quarter, and I can’t yet say that such a charge isn’t buried somehow in the confusing reporting.  I have more digging to do before I can recommend these HISAs. Here are some short takes and some weekend reading: Preet Banerjee explains the dangers of Robi...
Read more

My Asset Allocation

I’ve resisted discussing my asset allocation for some time, but now is finally the time to describe it and the reasons behind it. I’m not holding it out as a model portfolio; I believe it’s suitable for me and not necessarily anyone else. With that warning, enjoy the discussion and feel free to ask questions or take some pot-shots. The main reason why I haven’t discussed my asset allocation in detail before now is that I don’t want readers to treat it like a model portfolio and follow it blindly. Everyone’s situation is different. The need for variation in asset allocation from one investor to the next usually isn’t huge, but there is no one-size-fits-all portfolio. A secondary reason for keeping my asset allocation to myself is that I can’t be sure I’ll never change it. For example, I recently made the minor change of switching from an ETF of small-cap stocks to an ETF of small-cap value stocks . I don’t have any plans to change my current allocation, but I may think differe...
Read more

What to Do About Crazy Stock Valuations

Image
The last time I had to put a lot of effort into thinking about my finances was back when I retired in mid-2017.  I had ideas of how to manage my money after retirement, but it wasn’t until a couple of years had gone by that I felt confident that my long-term plans would work for me.  I had my portfolio on autopilot, and my investing spreadsheet would email me if I needed to take some action. I was fortunate that I happened to retire into a huge bull market.  I got the upside of sequence-of-returns risk.  The downside risk is that stocks will plummet during your early retirement years, and your regular spending will dig deep into your portfolio.  Happily for me, I got the opposite result.  My family’s spending barely made a dent in the relentless rise of the stock market. However, stock prices have become crazy, particularly in the U.S.  One measure of stock priciness is Robert Shiller’s Cyclically Adjusted Price-Earnings (CAPE) ratio .  In the U.S...
Read more

Archive

Show more