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Long-Term Power Contracts: The Art Of The Deal

Long-Term Cooperative Supplier Relationships
Fortnightly Magazine - August 2004

For their part, suppliers have demonstrated their trust in Chrysler by increasing investments in dedicated Chrysler assets-plants, property, equipment, and people. Results have been impressive. Chrysler has reduced the development, design, and retooling time for its new vehicles from 234 weeks in the 1980s to 160 weeks. Development costs have plummeted 20 to 40 percent. In its first two years, Chrysler's new strategy generated from suppliers 875 ideas worth $170 million in annual savings. As of December 1995, the company had implemented 5,300 ideas worth more than $1.7 billion in annual savings for the company alone. 4

This example of cooperative supplier relationships in manufacturing is relevant to several aspects of default service provision of electricity. While not necessarily involving purchases of bulk commodities, these industrial examples show that buyers can achieve significant savings in direct costs, overhead, and transaction costs by procurement strategies that offer vendors longer commitments. Developers of new renewable generators likely could provide better prices and insulation from fossil-fuel prices over many years in such a purchasing environment.

Consider a renewable energy developer that, based on an agreement with a default service provider, knows a certain number of wind turbines could be ordered every year for five years. That developer could follow Chrysler's example and seek R&D driven enhancements and cost reductions from equipment vendors. Under such an environment, non-renewable generators might be able to deliver power with reduced transmission costs and reduced losses. Even purely market-based wholesale suppliers could afford to invest in a better portfolio, as well as better management tools and practices, in response to such an environment. Upstream opportunities like those mentioned in connection with renewable energy developers could apply here as well.

Commodities and Futures Markets

For many commodities, we see the benefits of long-term contracting in the futures markets: The further away the delivery date, the lower the current contract price.

In Figures 1-3, we see that for milk, the euro, and pork, prices decline as a function of contract start date. Locking in such agreements can reduce risks for both sides. Suppliers are assured that somebody is going to purchase the commodity at an acceptable price, and buyers are assured that demand can be met on the date that it is needed, at an affordable price. For both parties, risk is therefore reduced and prices can be lower.

There are, however, commodities that at times show a pattern of increasing contract prices into the future. For example, both coffee and cocoa currently are priced higher for contracts further into the future. For coffee, this is based on the current expectation of lesser crop volume in top-grower Brazil, slower exports from Central America, and consumption growth forecasts. 5 When looking at such a result, it is important to consider the following: Coffee only grows in a limited number of regions, there is no substitute, and crop success is highly sensitive to weather conditions.

When current events indicate a less favorable future, prices that rise with delivery date are to be expected. In such an instance, it might be better temporarily to rely