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Long-Term Power Contracts: The Art Of The Deal

Long-Term Cooperative Supplier Relationships
Fortnightly Magazine - August 2004

New Jersey has been quite active in moving toward a laddered approach-basic generation service (BGS)-for the procurement of its default service. To achieve this, New Jersey has phased in longer-term contracts. In 2002, when New Jersey started its auction process, it procured only 1-year contracts for electricity for basic generation service for residential and small commercial customers. Then, in both 2003 and 2004, New Jersey held auctions for the provision of both 1-year and 3-year contracts for default service. 8 The auction design and results are shown above.

The table ("NJ BGS Auction for Fixed-Price Basic Generation Service Contracts") shows the price differences between the 1- and 3-year contracts. Although these were rather small in 2004 for most utilities, the 3-year contracts were indeed more expensive than the 1-year contracts. But can one really compare a 1-year contract directly to a 3-year contract and conclude that the use of the longer contracts for default service will carry a premium over time compared with the use of 1-year contracts? Not necessarily. What one should really be looking at is the price difference between a series of 1-year contracts and one 3-year contract for the same time period.

Suppose, for example, we had started up a 3-year laddering strategy and the available prices for 1-year and 3-year contracts in Year 1 were as shown in Figure 7. And suppose, further, that the 1-year contract prices in Years 2 and 3 happen to have moved as shown in Figure 7, as well. In Year 1, we might have been tempted to choose a strategy of meeting 100 percent of need with 1-year contracts, since their price was less than the 3-year contract price. However, this did not mean that there was necessarily a price premium for the 3-year contract. For example, if the 1-year contracts had followed the hypothetical track shown in Figure 7, their average price over Years 1, 2, and 3 would have been higher than for the 3-year contract signed in Year 1.

It is also interesting to note that even if there is a price premium for the longer-term default service contracts in New Jersey, the premium seems to have diminished to a relatively small amount in the second auction. One might expect this amount to be offset by the financial benefits (price stability) that consumers receive from longer-term contracts.

Migration and Other Volume Risks

If wholesale electricity markets in the '80s and '90s had oil price hikes, nuclear cost overruns, and restructuring as their pivotal risks, perhaps that of default service markets in the early 2000s lies in volume and migration risks. Currently an asymmetry exists. Default service suppliers generally are required to provide a fixed-price offer to all comers, but default service customers can walk away by choosing a competing supplier or can vary their purchase amount at will. Thus, only one of the two parties, the supplier, is truly locking in to a contract. With respect to the issue at hand, this means that default service suppliers (usually incumbent electric utilities) have demanded, in turn, fixed-price, all-requirements bids