Oh Behave

How Behavioral Economics Applies to Energy Contracting

You can be so irrational at times. But, it’s not your fault, it’s how your brain works. As humans, we are prone to making irrational and downright bad choices because of innate decision-making shortcuts and biases that served us well through our evolutionary existence, but aren’t necessarily helpful for today’s complex world. (Read about Behavioral Economics for additional insight background.)

Fortunately, there is hope. We can make better decisions when we become self-aware and recognize the common thinking traps that lead to unwanted blunders. In this blog, we will explore how some of those key heuristics and biases are creeping into your energy contracting decisions and likely causing you to spend more money on energy in the long run.

Reversion to the Mean

When your Fantasy Football receiver is racking up the points, you are more likely to play him the next game. He’s hot. Go with it, right?  Well maybe not. We routinely give more weight to recent performance or events than they deserve. The data actually shows that performance will almost always revert to the mean, that is, if performance is above the average it is more likely to move down to the average and vice-versa. We are prone to making the same mistake when it comes to energy contracting. When the energy price has fallen well below the historical average, we expect the price to remain low. We get complacent and feel there’s plenty of time to act. We don’t factor in that prices are more likely to rise when they are below the historical average. And when prices are on the rise, we get nervous they will go higher, and this leads us to the mistake of contracting when prices are peaking.

Loss Aversion

If we were economically rational, then we would value an equal chance to gain $1,000 and lose $1,000 the same. But we don’t.  We put much more value on the loss. This can work to thwart a decision to take advantage of low prices. If prices are low we may hesitate to buy because we fear that the market may go lower and we would lose the opportunity to save more money. We don’t put as much value on the gain, that is, prices are low therefore we are gaining all these savings relative to where prices have been historically.  This also works relative to a budget. If prices are up over the amount we have budgeted, then we may wait to see if the prices will drop so we don’t “lock in a loss”. That unfavorable budget variance can be painful, so we may ignore market fundamentals in the hope of recovering ground.

Anchoring

We can also get a particular price stuck in our heads. It may be the last contract price, a budget target, a price someone mentioned, or maybe even subconsciously something unrelated. We all do it; we anchor to a number. If our new contract price is 50% higher than our last contract price, we are inclined to wait and hope that the price comes back down. We may discount the fundamentals that led to the price increase.

How Usource Helps You Avoid These Decision-Making Pitfalls

Usource helps you stay focused on the fundamentals in the market place and avoid gut decisions when analytical insights would serve you better. Our process is grounded in a deep understanding of supply and demand drivers in energy markets.  We utilize data and analytics to help you think more objectively and make fact-based decisions. We take the time to understand your unique business needs and craft a procurement plan that meets your budget and risk management objectives.


About the Author

Scott MacDonald is Usource's Managing Director. Scott has 25 years of experience in the energy industry and is a recognized expert in energy economics and consulting. He has a MS from MIT and a BA in economics from the University of New Hampshire.

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