Buyers generally acquire a mix of long- and short-term contracts, with the goal of finding the optimal trade-off between price and flexibility.
For both buyers and sellers, forward contracts guarantee the exchange of a known quantity of goods at a known price and for a given time frame. From the buyer's perspective, such a contract not only guarantees delivery of a critical good, at an agreed upon price, but also reduces the costs of procurement operations, as prices do not have to be negotiated continually.
The contract lengths selected generally depend on the lifecycle of the industry and product. For example, in the pork industry, the type of product and product specifications (quality, delivery points, lot sizes, etc.) could be considered constant, and demand easily forecasted. As a result, hog cash contracts typically have durations of 3 to 7 years.1
Companies such as Intel, with products such as CPU processors that have shorter lifecycles and less predictable demand, negotiate contracts anywhere from every quarter to every several years. Multi-year contracts typically are avoided.2
Electricity, as a commodity, has fairly constant quality and definition, and total market demand can be forecasted reasonably well.3 In other words, electricity can be viewed as a commodity with a long product lifecycle, and contract durations of 3 to 10 years seem reasonable.
Long-Term Cooperative Supplier Relationships
One recent trend in industrial purchasing is a decrease in the number of suppliers and an increase in longer-term contracts and cooperative supplier relationships-bolstering the view that buyers benefit by buying for the long term. This trend provides useful insights for default electric service provision.
Honda, Wal-Mart, Harley-Davidson, Toyota, and American Airlines have found that suppliers can contribute creatively to cost reductions, product development, logistics operations, and an improved bottom line. These major firms also have begun to acknowledge that suppliers must achieve profit margins sufficient for them to invest in new technologies, facilities, equipment, and people. To achieve this, both parties are making their cost structures and margins more transparent.
Chrysler Corp. is one of the greatest success stories in restructuring processes and relational contracts with suppliers of key commodities. Traditionally, Chrysler designed products largely without input from suppliers. The company chose suppliers solely on the basis of price through a competitive bidding process. Chrysler dictated the terms of all contracts and limited their duration to two years.
In a major turnaround, Chrysler implemented a program to reduce its costs without hurting supplier profits. Chrysler now deeply involves suppliers in its processes and strives to find ways to lower costs together. Suppliers are now involved in the development stage of vehicles a full 180 weeks prior to volume production, rather than the previous 75 to 100 weeks. Contract times more than doubled to 4.4 years on average. Suppliers are expected to offer suggestions that result in cost reductions equaling 5 percent of the supplier's sales to Chrysler. In return, Chrysler not only gives suppliers 90 percent of the business for the life of each car model through oral agreements, but also a percentage of all implemented savings.
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 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.
Results From the New Jersey Auction
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 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, if a price premium exists for longer contracts, the New Jersey results indicate that the price premium is small and is likely outweighed by the benefits (price stability) that parties receive through use of a laddered approach.
While customer migration risk is a legitimate concern in determining contract prices in the context of a default service auction, the prospects for significant residential switching in the next 5-year time frame are quite small. Furthermore, any risk that this might impose can be mitigated through the use of a laddered procurement approach, wherein for each year, only a fraction of the default service load is procured.
- Wellman, Allen C., "Hog Cash Contracts Advantages and Disadvantages," Nebraska Cooperative Extension NF 96-280, http://www.ianr.unl.edu/pubs/farmmgt/nf280.htm.
- Martha Neustadt of Intel Corporation's Materials Department. Personal communication, 5/21/2003.
- Market rules and definitions of capacity and ancillary products are a concern in this regard, but appear to be becoming more stable; electric energy as a commodity delivered to market is, for purposes of this discussion, reasonably stable in definition.
- Dyer, Jeffrey, "How Chrysler Created an American Keiretsu," , July-August, 1996, 42-56.
- In the rapidly evolving cellular phone market, discount offers that are conditional on a long-term contract may reflect the vendor's strategic expectations about competitive entry and not just the benefits of risk sharing. Buyers in such markets should obtain and use similar strategic intelligence.
- See, for example, William B. Marcus and Greg Ruszovan . JBS Energy, Inc. Dec. 5, 2000. This study analyzed the market price of electricity in the PJM region in order to determine the value of photovoltaic (PV) load reduction. The estimated value of PV load reduction during the on-peak hours during that summer season was over 27 cents/kWh in the PJM (4.8 times the market price calculated) and roughly 8.1 cents/kWh during summer mid-peak hours. PV's summer on-peak load reduction value may very well be equal to or exceed the levelized cost of electricity from PV panels. This effect is thought to be especially pronounced in unhedged markets.
- The 2003 auction contract lengths were 10 months and 34 months to permit synchronization with PJM's power planning periods.
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