Procurement Strategies

Each organization has different goals when procuring energy. For some, budget certainty is the chief concern. Others are willing to take a more risky strategy recognizing that, while losses may occur in some years, they pay less in the long run. Often, an organization searches for a middle ground, trying to balance savings (or risk tolerance) with budget certainty and year-to-year volatility. We encourage all of our clients to find an energy product that best matches their goals.

Product Types

FULLY FIXED CONTRACTS

These are the simplest of all products. You pay the quoted rate times your energy usage. Contract language still leaves some room for "change in law" events which may cause cost changes, but these are rarely invoked. These rates also have "swing tolerances" which indicate how much your usage can change before you incur some additional, market-based costs. These fully-fixed rates are simplifications and can mask some of the various bill components. These have the lowest risk to a consumer. These products also mean you buy all your energy at one time, which can lead to higher volatility in price over longer timescales. This remains a very popular product, especially for smaller facilities (annual usage <2,000 MWh, <10,000 Dth).

FIXED ENERGY CONTRACTS

Fixed energy contracts fully fix the energy but pass through many of the other components. For instance, an electric contract may pass through all the capacity charges. In this way, an organization would pay a floating rate for capacity rather than fixing it into the contract price. When energy suppliers fix capacity in the fully fixed product, they add additional (small) risk premiums in order to protect themselves. By passing costs through, the organization takes on this risk and avoids the risk premiums. Fixed energy contracts still involve swing tolerances. They can be purchased at one point in time or in layered hedges. This is a popular product for medium facilities (annual usage <10,000 MWh, <50,000 Dth).

While actual values will vary based on a variety of factors, this conceptual strategy comparison illuminates the differences in expected cost (the height of the combined stack bars) among the different strategies. It also shows what the expected cost range could be (gray line), and the relative amount of costs that are contracted for (blue) and floating (orange).

MARKET (OR INDEX) CONTRACTS

Index contacts are the riskiest an organization can enter into. In these, an organization agrees to a set fee for energy supply, but does not lock in any sort of energy price protection. They pay whatever the market price happens to be plus the contacted supply fee. The market price can vary as much as 200+% month to month, leading to high volatility. Over long time frames, this has been shown to be the cheapest option, but the volatility makes it unpalatable for many organizations.

HYBRID MARKET/FIXED CONTRACTS

In gas, this contract typically looks like a fixed energy contract that only includes a portion (say 75%) of expected energy consumption. In electricity, this contract may be a portion of fixed energy or a slightly different product called a "Block and Index." This is the "Goldilocks" contract for many -- fixed energy is too conservative, market is too risky, and these hybrid contracts are just right. These can be purchased at one point in time, but tend to be executed with multiple hedges being layered in throughout the life of the contract. This is popular product for medium and large sized facilities.

Procurement Timing

FIXED POINT IN TIME

Purchasing all your consumption (Dth or MWh) at one point in time gives one price and a predictable budget. (Click to enlarge)

Contacts fixed at one point in time yield an immediate understanding of budget. Due to the few number of interactions in the market, this strategy can contribute to higher volatility in prices over decade timescales. Still, this requires less active engagement from an organization, making it one of the easiest kinds of contracts to execute and measure against. This makes it a very popular timing option, especially for smaller facilities (annual usage <2,000 MWh, <10,000 Dth).

LAYERED OVER TIME

Purchasing your total consumption in layers (or even leaving some floating) can help lower the cost, but includes a bit more risk. (Click to enlarge)

By layering purchases over time, an organization can lower its price volatility. The downside is that the budget can't be known in advance. However, this is the preferred strategy of many of our clients due to the flexibility this allows in taking advantage of opportunities to layer in hedges as those market opportunities occur. This sort of strategy takes a bit more engagement/time commitment on the purchaser side. Also, this may only be available for facilities above a certain size -- many medium and large facilities find this an appealing option.

Conclusion

Considering pass through charges, product type, procurement timing, and organizational risk tolerance can lead to positive budgeting outcomes for an organization. It is important that each organization match its overall procurement strategy with its internal goals. This alignment is invaluable and a big part of the industry best practices. We work with our clients to customize and optimize procurement and to find the best approach for the given situation.