Sunday, March 07, 2010

Five Pitfalls a Commercial Energy User Should Avoid when Making an Energy Procurement Decision

Deregulation of electricity supply began in the late 1990's with Pennsylvania and California becoming two of the first states to offer commercial energy consumers the ability to choose an alternate electric supplier. Since then there have been 16 more states added to the mix that provide an "Electric Choice" program that let competitive suppliers offer alternative rates and energy products to rate payers. Competitive offerings have changed dramatically since the early years of deregulation and commercial customers need to be aware of the pitfalls associated with choosing a supplier and signing an electricity supply contract. The two most common products are fixed rate and variable rate contracts. A fixed rate contract includes a locked-in price per kilowatt-hour for a definitive period: usually a 1 to 3 year term. A variable rate contract allows the energy supply rate to float with the sometimes-volatile wholesale spot market. The wholesale market from which the ultimate rate paid by the customer is derived varies by geographic region. In New York for example, the New York System Operator, ("NYISO"), manages markets including the Day Ahead Market and the Real-Time Market, and in Texas the Electric Reliability Council of Texas, ("ERCOT") manages the Market Clearing Price of Energy, "MCPE") market. This article examines five critical pitfalls commercial energy users may face when choosing an electric supplier and offers suggestions of how to avoid them.

Energy Procurement Pitfall Number One: Energy Users May Not be Aware of All Available Product Options: There are several energy supply products available in the market in addition to the fixed rate and index rate products mentioned above. With regard to fixed rates many energy users will naturally look for the cheapest offer. If fixed rates are the only available offers in a marketplace, then this strategy cannot be faulted. But where product types may vary greatly beyond basic fixed rate fixed term contracts, market conditions play a great role in guiding a smart energy procurement decision. For example, in July 2008 energy markets were at a peak. Examining various fixed rate offers at that peak moment, and selecting the lowest price offer would still result in substantially higher energy costs vs. any other comparable energy consumer that opted instead to enter into an index rate product, and then waited for prices to soften before entering into a fixed price contract. A prerequisite to understanding when index rate or hybrid block plus index rate contracts might be better choices than fixed rate contracts is to have basic knowledge of the existence of those other product types. Contract term is another very important metric to consider. Energy users that sagely entered into long term five year fixed rate contracts at market lows ended up paying less than energy users that signed shorter term fixed rate contracts over that same period, even though the five year contract fixed rate was higher than the shorter term offers presented upon signature of the long term contract. Of course it is impossible to predict the market, and these are really hypothetical scenarios, but armed with a historical perspective of where energy markets have been over the past ten years, and armed with a good understanding of how domestic and world dynamics in economics, weather, politics and war can effect energy market prices, energy users will be best equipped to make the smartest decisions regarding which product type and which product term to select.

Also important to know is that quoted energy rates might exclude one or several components that could have a major impact in the final cost of energy supply. For example, some energy suppliers or brokers offer energy rates that exclude rate components including line losses, ancillary services, congestion, capacity and gross receipts taxes, thereby presenting fixed rates that appear on the surface to be low vs. other offered rates that include those components. The customer may sign such an artificially-low priced contract and then be perplexed why the final rate shown on the first bill is higher than expected. The solution is to be aware of all available product types, and when evaluating offers to be sure to have an "apples-to-apples" analysis of the offers. Ultimately reading each contract carefully, and having a firm understanding of which price components are included or excluded in each price offer is the best first step. Ask your supplier, broker or consultant to show you where the price section is in the contract and what components are included or excluded in the stated fixed rate. If the price components are not explained to your satisfaction, find another supplier, broker or consultant to help you.

Energy Procurement Pitfall Number Two: Picking a Supplier You Know Nothing About: Savvy stock market investors will advise their proteges to make buying decisions only after thorough research into the companies of interest. Because a fixed rate contract serves as a sort of insurance policy against future increases in energy supply costs, the value of the contract is only as good as the strength of the energy supplier. If the energy supplier goes out of business, then the energy contract is void, and the energy user must make a buying decision all over again. If the energy market has increased substantially, then the impact to the energy user’s bottom line could be substantial. Over the past ten years we have seen many energy suppliers come and go. Energy suppliers have shut their doors for various reasons, including failure to hedge their positions. Failure to hedge, (defined in this context as a failure to take an offsetting wholesale market position), can be catastrophic for a supplier if a supplier enters into fixed price contracts with energy users at a market low, and upon upward movement of the market the supplier ends up paying more on the spot market to supply its customers than it is collecting at the low fixed contract rates. When cost of goods sold is higher than gross sales, disaster and business failure is sure to follow for an underfunded energy supplier. We've seen this happen again and again due to cost of credit, the expense of making the hedges and possibly plain old hubris and greed. Don't be afraid to ask a supplier if they are hedging all of their positions in the market. Learn as much as you can about your prospective counterparty. Learn about the financial strength of any parents of the supplier you are considering. Find out if they are a public company and how long they have been in business. Visit your state's Public Utility Commission ("PUC") website and check for the number of PUC complaints against that supplier. Some suppliers have hundreds of complaints, while others have none. Take into consideration the number of customers served when evaluating the relative importance of the number of PUC complaints. It will be easier for you to decide whether you will do business with a prospective supplier after you have taken the time to learn as much as you can about them.

Energy Procurement Pitfall Number Three: Not Understanding the Contract Terms: This is a very important pitfall. Mentioned above is the fact that there are several price components that can be excluded from a quoted fixed rate. There are also contractual provisions that can have adverse effects on your contract rate depending on what changes occur at your business. One provision to consider carefully is known as the "Bandwidth" provision. It is a maximum and minimum limit of how much power you can use in a given period compared to your historical averages before triggering market adjustment. If you go over the maximum limit or under the minimum limit you can be penalized. Make sure you have a contract bandwidth that works for your anticipated business needs. A typical percentage is 90% to 110% or 80% to 120% bandwidth. If your business is seasonal you may want a larger bandwidth during those higher or lower demand periods. To avoid a possible surprise on your bill, know your historical usage, and have a good idea of how usage could fluctuate over the contract period. This will give you a good idea of how much bandwidth the contract should permit. A hotel that may have 100% occupancy for an entire year, will certainly use far less energy in the following year if average occupancy falls below 50%. If a supplier hedges a position to supply the hotel with energy based on 100% occupancy, and the market dips the following year when the hotel is using less power than the supplier expected, the supplier will experience losses associated with having to sell the unused power back into the lower wholesale market. The supplier would then trigger a mark to market calculation to be made whole on those losses by the hotel. Another contract provision that is very important to understand is the penalty for early termination. If you sell your business during the contract term, of if you close one or more locations, and you wanted to terminate all or part of an energy contract early you should have a good understanding of the formula the supplier uses to determine any damages. It may be a specific formula easily deciphered or it may be marked to the spot-market conditions at the time of termination. Ask your broker, consultant or supplier representative to help you get it straight so you are aware of the ramifications of early termination.

Energy Procurement Pitfall Number Four: Not Working With a Consultant or Broker: Suppliers are great to work with directly if you can be assured they have the best price and product for your needs. The real question is how do you know? This is where working with a broker or consultant becomes very helpful to making the smartest energy procurement decisions. Good consultants or consultative brokers have the experience and the insight to explain to customers in layman's terms what all these products, provisions and market trends mean, and can offer numerous supplier options, product types and contract term lengths best suited for your business type. It is very common for the low price offer presented by a broker or consultant to be 10% or more lower than the mean offer. Working with a broker or consultant that knows all of the key suppliers maximizes an energy user's chance of identifying and acting on that low price offer. Before venturing on your own call a consultant that will give you some honest advice on the key points explained in this article. Most good consultants have been around for at least 10 years. A good consultant will assess the situation before they say they can help you.

Energy Procurement Pitfall Number Five: Not Understanding Energy Market Trends: Energy markets are very volatile. It is a good idea to familiarize yourself with the movement of the energy markets. Some energy users sign contracts without knowing where the energy markets have been and without understanding where the markets might go based on local, national and global factors. To rely solely on the biased punditry of sales people who are more interested in timing the close of the sale instead of timing the market can lead to poor buying decisions. Websites such as FutureSource:, CME Group: or Seeking Alpha: offer insight on historical trends, market data, information, and news to track whether the market has been going up or down or staying steady, and if market conditions such as backwardation or contango exist. These market conditions play a role in determining how varying contract term lengths are priced vs. a baseline. Also ask your broker or consultant about the markets and request charts and trend lines of the energy markets so you can make a more informed decision of what products is right for you. Consultants should have a few options to recommend to customers when the market is at a low or if the market is running high. There is no cookie cutter solution for every commercial customer and you and your broker or consultant should understand the needs of your business, the available product types, term lengths, contract terms and market conditions and ask the right questions before moving forward with an electricity supply contract. The possible pitfalls mentioned above and others can be avoided by taking the time to do a little due diligence.


Javier Barrios

Managing Partner

Good Energy, L.P.

212-792-0222 x103

About the author:

Mr. Barrios is an expert in energy cost management and is a Managing Partner of Good Energy, L.P. a national energy consulting firm headquartered in New York City and Dallas.

Posted By Max Hoover