Pilot Energy 05/22/2026 Procurement
6 min read

On a napkin

Physical hedge Locks in delivery AND price Retailer delivers MWh to meter No basis risk — settled at your node Counterparty: retail energy supplier Financial hedge Locks in price only No physical delivery Settled vs. hub LMP — basis risk remains Counterparty: bank or energy trader Both achieve price certainty — but through different mechanisms with different residual risks

The short version

A physical electricity hedge involves an actual commitment to deliver or receive electricity at a defined location and price. Your fixed-price retail electricity contract is a physical hedge — the supplier delivers electrons to your meter at the contracted rate and manages wholesale market logistics on your behalf. A financial hedge involves no physical delivery. It is a contract settled against a market price index — the buyer continues purchasing electricity from their retailer while the financial instrument runs in parallel, paying or receiving the difference between the contracted price and the market price.

Physical hedges eliminate basis risk at your meter. Financial hedges settled to a hub may leave residual basis risk — the gap between the hub price the contract settles against and your actual delivery node price. During extreme congestion events, this gap can dwarf the hedge itself.

How physical hedges work in practice

When you sign a fixed-price retail electricity contract, your retailer is making a physical hedge on your behalf — they commit to deliver electricity to your meter at the agreed price and absorb all wholesale market and logistics risk. From your perspective, the outcome is simple: you pay the fixed rate regardless of what wholesale prices do. The retailer manages sourcing, transmission scheduling, and market risk within their own portfolio.

Large industrial customers in some ISOs can execute physical hedges more directly — taking title to power, scheduling their own supply, and acting as their own load-serving entity. This requires a scheduling coordinator relationship with the ISO (in CAISO, for example) and significant operational sophistication, but it gives large buyers granular control over their supply stack and the ability to capture market value directly.

How financial hedges work

A financial electricity swap fixes the price of electricity against a wholesale price index without any physical delivery. The buyer continues purchasing electricity from their retail provider. The financial contract runs as a separate bilateral instrument, typically governed by an ISDA master agreement: each settlement period (monthly or quarterly), the contract pays the fixed-to-floating difference. If the settlement index rises above the fixed strike, the swap counterparty pays the buyer. If it falls, the buyer pays the counterparty. Net of both legs, the buyer's effective electricity cost equals the fixed strike.

Financial hedges are used by sophisticated buyers who want to create price certainty across geographies, customize contract structures beyond what retail suppliers offer, separate energy procurement from price risk management, or hedge renewable project revenues against merchant price exposure.

Basis risk — the gap between hub and meter

Financial hedges typically settle against liquid hub prices — PJM Western Hub, CAISO NP15, ERCOT Houston Hub. Your actual electricity cost is determined by the price at your specific load node, which may differ from the hub price during transmission congestion. This hub-to-node price difference is basis, and the risk of it moving against you is basis risk.

During normal conditions, basis is modest and predictable. During extreme events it can be enormous — during Winter Storm Uri in February 2021, ERCOT hub-to-node spreads in some zones reached hundreds of dollars per MWh for days at a time. A buyer financially hedged at the ERCOT Houston Hub but taking delivery at a load zone that diverged sharply found their hedge provided much less protection than anticipated. Buyers using financial hedges in congested markets should consider adding a basis hedge — a financial transmission right (FTR) or congestion revenue right (CRR) — to close this gap.

Common questions

What is a physical electricity hedge?
 
A physical electricity hedge involves an actual commitment to deliver or receive electricity at a defined location and price. Fixed-price retail contracts are physical hedges — the retailer delivers electrons to your meter at the contracted rate and manages wholesale market logistics. Physical hedges eliminate basis risk at the delivery point because settlement is at the actual meter, not a market hub.
 
What is a financial electricity hedge?
 
A financial electricity hedge is a contract settled against a wholesale market price index without physical delivery. The buyer continues purchasing electricity from their retailer. The financial contract pays or receives the difference between the fixed strike price and the floating settlement index. Net of both legs, the buyer's effective cost equals the fixed strike — provided the settlement index closely tracks the buyer's actual electricity cost.
 
What is basis risk in a financial electricity hedge?
 
Basis risk in a financial hedge is the exposure to price differences between the hub where the contract settles and the actual node where power is physically delivered. If your financial hedge settles against PJM Western Hub but you take delivery at a congested load node, the hub-to-node price difference can be substantial during congestion events — leaving unhedged exposure at your actual delivery point.
 
When should a buyer use a financial hedge vs. a physical contract?
 
Physical retail contracts are appropriate for most C&I buyers — they provide certainty, eliminate basis risk at the meter, and the retailer handles logistics. Financial hedges are used by sophisticated buyers who want to hedge price risk across multiple sites at different nodes, access financial market liquidity for customized structures, separate procurement from risk management strategy, or hedge renewable project revenue streams.
 
What counterparties provide financial electricity hedges?
 
Financial electricity hedges are provided by banks, energy trading companies, and commodity brokers. Most are governed by ISDA master agreements with credit support annexes specifying collateral requirements. Counterparty credit quality is critical — the financial hedge is only as valuable as the counterparty's ability to pay when settlement favors the buyer. Most corporate buyers require investment-grade counterparties for financial hedge transactions.

Want to put this knowledge to work?

Learn about Energy Procurement Talk to an Advisor

Need help navigating this topic?

Pilot Energy’s advocacy team can help you make sense of the energy landscape and build a strategy that works for your organization.

Talk to an Advisor

Tag:

Procurement

Related Articles

It is a long established fact that a reader will be distracted by the readable content of a page when looking at its layout.

Pilot Energy Background

Ready to take control of your energy strategy?

Pilot Energy has spent 25 years helping commercial and industrial organizations navigate complex energy markets. Let our advocacy team put that experience to work for you.

Contact Pilot Energy