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Long-Term Power Contracts: The Art Of The Deal

Long-Term Cooperative Supplier Relationships
Fortnightly Magazine - August 2004

from wholesale suppliers in auctions. This creates a genuine risk for those bidders that may be reflected in their offer prices.

However, no U.S. state currently has more than 15 percent of residential customers switching away from their default service provider, and there is little evidence that this trend is likely to change greatly in the next 1 to 5 years.

Migration risk can and should be managed today by using laddered or segmented procurement, as in New Jersey. Default service auctions, so far, typically have solicited bids for all (or a certain percentage) of the default service load, whatever that amount turns out to be. This approach passes migration and other volume risks on to wholesale suppliers. The cost of that risk (and, hence, suppliers' expected bid prices) can be reduced by laddering the acquisition of contracts. In other words, instead of locking in to a longer-term contract for 100 percent of the current load today, a wholesale supplier would be more secure financially with only one or a few staggered, partial commitments over time, providing a certain percentage of forecasted load in each procurement cycle. Alternatively, a different laddered approach could allow default service providers to eliminate these volume risks for their wholesale suppliers (thereby reducing the expected prices) by soliciting bids for fixed amounts of power, say by using five slices, each for 20 percent of the expected load. Of course, that would leave the default service provider with the volume risk, albeit greatly reduced by the laddering. The default service provider could accept this risk, hedge part of it directly (with weather futures or electricity options where available), or essentially eliminate it by committing to the spot market or short-term contracts a portion of the expected load comparable in size to the uncertainty in the load forecast and by truing up any price fluctuations due to the spot market. Volume risk is low for default service and can be managed in various ways if a laddered, diverse, flexible portfolio approach is permitted.

Individual wholesale suppliers need to (and can) actively manage for migration risks. The suppliers that are good at this are the ones that can charge a small premium for the longer-term contracts. These suppliers will win the competitive bid processes.

There is no support in theory or practice for the notion that longer contract durations systematically result in higher prices. On the contrary, there are reasons to believe that, in many circumstances, longer contracts yield lower prices in real dollars, since through longer commitments, some risks are diminished for both parties.

Empirical evidence in electricity markets fails to demonstrate the existence of a significant and validly comparable price premium for longer-term contracts. One example is the result of the recent New Jersey basic generation service auctions. While the 3-year contracts cost consumers a bit more, this result in no way proves that 3-year contracts are more expensive than 1-year contracts. To make a true comparison, we would need to be able to compare a series of three 1-year contracts to one 3-year contract. In any case,