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Long-Term Power Contracts: The Art Of The Deal

Long-Term Cooperative Supplier Relationships
Fortnightly Magazine - August 2004

on shorter duration contracts. However, this does not invalidate the general proposition. It still holds that those suppliers who have a long-term contract in hand will be in the best position to take action in response to moderate shortages and any resulting price swings.

So, what do electricity futures look like? Unfortunately, sources of equivalent information on electricity futures are few and far between. The electricity futures market, though growing, is only thinly traded. However, since natural gas prices currently drive electricity prices, it makes sense to look at natural gas price futures, which are actively traded.

Figure 5 shows that natural gas price futures, though cyclical, currently decline in price as a function of lead time. From this, we conclude that longer-term contracts for gas, and presumably for electricity as well, should not result in higher prices than shorter-term contracts. At times, expected future supply or demand imbalances may overshadow these effects, but the general finding should hold.

As mentioned above, recent run-ups in oil and natural gas prices may create a price premium for longer-term electricity contracts, as occurred in the past when fossil-fuel markets were under pressure. This phenomenon is not expected to be long-lived. One possibility is that fossil-fuel prices may retreat. Alternatively, fossil fuel and electricity contracts may stabilize at new, higher prices. In this situation, any large upward slope in the term structure for electricity contracts would be expected to be replaced by declining or nearly level slopes.

Long-Term Contracts and Financing

Another perspective on buying now for the future is provided by the retail market for cellular phone plans. Anyone who has shopped for cellular phone service knows that a better price is most always offered for a 2-year versus a 1-year contract. The reason is that under a 2-year contract, the supplier locks in a customer for a certain period of time. As a result, the supplier can assure shareholders and financial lenders a more stable revenue stream. Financially and strategically, this is advantageous for the supplier. The buyer, through discounts, is compensated for the risk of locking in to the longer contract. In effect, both parties win. 6

This same argument can be applied to renewable sources of electricity, like wind. Renewables have certain advantages over fossil-fuel generation. For instance, all avoid fossil-fuel price risk, and some are especially powerful at reducing peak prices. 7 However, most types are capital intensive and require project financing. For example, without long-term contracts in place, wind owners do not have a stable revenue source and find it difficult to get financing on favorable terms. This situation would be reversed with long-term contracts in place for the provision of default electric service. The project developer, assured a reliable revenue stream at a level that covers costs and profit margin, can expect to be offered financing on favorable terms. The resulting savings could be shared with buyers, as would be expected in a competitive RFP process. The consequence: Everybody wins. The wind owner builds more wind farms, and buyers get reduced prices.

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