Published to LuthINformed, Issue 4 (June 3, 2016)
To continue with our discussion of power supply options we will review an indexed price agreement and hybrid product. Furthermore, we will evaluate the risk associated with these options.
An Indexed Price agreement is a contract that ties your cost of power to a market index. Such a structure provides some level of risk mitigation since cost components such as capacity and ancillaries are typically fixed. An ESCO in New York can offer an energy price based upon any of these market price mechanisms; the Day Ahead, Hour Ahead and Real Time Markets. For example, the Day Ahead Market discloses on Monday what the electric prices will be for any given hour on Tuesday. Some ESCOs offer an Index product tied to a utility rate as well. One of the advantages of an Index product is that it allows the buyer to float with the current market until a decision can be reached regarding long term trends.
These deals, if structured correctly, should allow you to move into a Fixed Price contract should market prices decline. It is important that you negotiate into your supply contract the ability to convert to a fixed price deal. Obviously, an Index agreement has more risk than a Fixed Price deal because, should market conditions trend upwards, your price increases. The flexibility of getting out of an upward cycle by locking in a fixed price can control this risk.
An increasingly utilized supply option is a Hybrid Product. This structure provides some of the components of both the Fixed and Index contracts. Customers and their energy providers or consultants will identify some level of a base load which can be fixed in the market. The base load is a block of electric power that will always be used by your facility during any given time. Implementing an energy block hedging approach is a proven strategy that mitigates the risks associated with market timing and eliminates the premiums associated with less transparent structures.
By employing this strategy, customers manage price risk by 1) paying a fixed price for a base load “around-the-clock” block and 2) paying hourly market prices for the power consumed above the block. Generally speaking, customers with high load factors fare best under hourly pricing because they use more power during off peak periods when prices are lowest. Energy blocks can be shaped either seasonally or based upon On/Off Peak times to mitigate risk exposure. A block supply strategy produces good results because the buyer gains price transparency and avoids the risk premiums associated with conventional fixed price supply structures.
This strategy also allows an organization to take advantage of downward price trends for that portion of their load that is not on the fixed price. Contractually, the customer should also be able to convert this structure to a fixed price should the market price increases.
Any customer considering either Index or Hybrid supply should insist the ESCO supply a Value At Risk (VAR) analysis that can be developed to show their best/worst case scenarios using historical prices.
Supply Contracts and Risk…
The assignment and transfer of risk is the basic function of any supply contract. If the energy supplier’s risk is reduced – while your risk increases – the supplier should charge a lower premium. Experience has taught us the myriad ways in which contract language plays a major role in a customers’ final energy cost. Know what your agreement really says..
Next time we will continue or discussion with load factor calculation and demand response programs…
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