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WHY USE POWER MARKETERS?

The Paradox of Saving Money by Paying Intermediaries for Power Supplies

by Scott Spiewak
(originally published by PMA OnLine Magazine: 04/98)

 

The electric power industry is becoming more complex. Two decades ago, there were no real choices for the electric power purchaser. You were served by the local utility at a price which guaranteed them a reasonable return on their investment.

This began to change with PURPA, and the advent of the IPP industry. By the mid-1980’s wholesale customers and large retail customers had the additional option of greenfield development of a new power plant, and falling natural gas prices made that option a competitive one.

Then in 1992, the Energy Policy Act was passed, and transmission access for wholesale customers became a right. FERC’s pro forma tariff requirements under the Mega-NOPR promise to make that right practicably accessible on a broad scale for wholesale customers.

An increasing number of retail customers are also obtaining access to the open market, giving them choices in suppliers of electric power, just as they have a choice of suppliers for virtually every other product they purchase.

Now a new category of company, the "Independent Power Marketer," is offering to become an intermediary between the buyer and the seller, and promising to reduce prices even while making a profit on the transaction.

This appears to be impossible, but as I will demonstrate, it is quite natural and on reflection rather obvious. It explains why marketers have such an important role in other commodity markets.

How Marketers Save the Customer Money

Advantage 1: No assets to protect

The first advantage of a marketer is that it lacks generation assets. This is important because it doesn’t have to favor those assets. To illustrate this advantage, I will hypothesize a competitive bid involving two utilities and an independent power marketer.

Utility one makes an offer based upon its cost of production, which looks like this:

Production Costs: Utility 1


 

Utility 1 has peak production costs of 5/kWh, and off-peak production costs of 3/kWh. It can therefore offer the customer a rate of slightly more than 4/kWh on average to cover its costs and make a profit. (For our purposes I have defined peak and off-peak periods as the highest cost and lowest cost half of each year).

Utility two makes an offer based upon its cost of production, which looks like this:


Production Costs: Utility 2



Utility 2 has peak production costs of 5.5/kWH, but its off-peak production costs are only 2/kWh. It can therefore offer the customer a rate of slightly more than 3.75/kWh, to cover its costs and make a profit.

In a utility-only world, the buyer selects Utility 2.

However, we are no longer in a utility-only world. Now we have marketers to act as intermediaries. And the marketer combines the best parts of each utility’s offering.


Production Costs: Marketer


 

The marketer will combine Utility 1’s peak prices with Utility 2’s off-peak prices to delivery a rate of only 3.5/kWh, beating the offer of either utility standing alone.

This is obviously a simplified example of what a marketer does. The key point is that by virtue of the fact that the marketer is not tied to any set of assets, it is free to pick and choose, combining one utility’s output one day, and another utility’s output the next, to get the best deal possible.

Advantage 2: Risk Management

As we move toward a commoditized electric power market, consumers will increasingly demand something which has been in short supply in the power business: Prices.

Utilities have traditionally offered cost-based service. If their costs vary, so does the bill. In soliciting for power supplies, utilities will rarely even quote a price, except perhaps in the form of a demand charge to reserve the right to certain generation capacity. The customer pays actual costs incurred plus a profit.

This makes it difficult to compare suppliers, much less establish a budget.

However, there is a reason for this. Utilities receive a regulated rate of return on their investment. This means that they are entitled to charge their ratepayers for their costs, and receive a return on their investments. If costs change, prices must change to protect that regulated rate of return. This is why utilities typically charge their customers with a "demand " charge, which provides the return on fixed investment, and an "energy" charge, reflecting operating costs.

Marketer, on the other hand, can give real prices. In response to a request for bids, they can deviate from the traditional cost-plus rate design and offer a dollar figure.

This not only lends itself to easier comparison among marketers, but also permits the electricity purchaser to establish a budget for its electricity purchases -- something which is taken for granted with other commodities.

Interestingly, marketers are able to provide risk management services even for retail customers who as of yet remain captive to local monopolies. Through use of electric rate swaps, marketers are revising local tariffs for discrete customers, providing customized rates linked to the customers products, such as refined oil products, aluminum, natural electricity and orange juice. Customers whose utility-suppliers are heavily dependent upon oil or electricity-fired generation have become able to fix their rates to protect them from the vagaries of their utility’s pricing policies.

These risk management offerings are created using the so-called derivative products:

• options,
• swaps,
• forward contracts, and soon,
• electricity futures.

Risk management is not magic, nor done correctly, is the use of derivative products inherently risky, regardless of what you might read in the press. In fact, failure to use derivative products appropriately, as hedges to reduce risk, is considered imprudent.

Luckily, for the electric power customer, risk management and electric power aggregation need not be a concern. These are the job of the power marketer.


What will I be buying tomorrow?

In the past, a great deal of electric customer attention has been focused on demand side management, time-of-day rates, power storage, cogeneration and other such measures for differentiating service. Some of these will remain available, but will be of relatively little importance in years to come. The reason becomes evident by looking at a graph of the only index we currently have available for electricity-- the Dow Jones California-Oregon Border index.


Role of the Electricity Broker

Now that you’ve been introduced to the power marketer, and have an idea of why you will almost certainly be buying your electricity supplies from a marketer rather than a power producer, the question arises as to how one selects a power marketer.

The power marketing industry is growing rapidly, with well over 100 companies filed for marketer status at the FERC. Marketers are continually experimenting with the form of offers and guarantees to present to their customers, and customers are just beginning to understand the marketing concept.

However, one fact which is true today, and which will be increasingly true in the future, is that marketers will have vastly more experience as buyers and sellers of electricity than their customers-- the producers and consumers of electricity.

An electricity consumer may well enter into only one transaction per year, in which it locks in its prices for that annual period.

An electricity producer may enter into a transaction considerably less often-- selling all or a good portion of the life-cycle output of their power plants to marketers before even breaking ground.

The broker’s role is to represent the customer in its negotiations with the marketer.

Most marketers are not in business to rip off their customers. Particularly at this stage in the industry’s development, it would be very short-sighted to alienate a customer. Nevertheless, because the industry is growing and changing quickly, there are choices and implications to those choices which may not be apparent to the customer faced with a marketer’s offer. Some of the horror stories include:


Some Things to Watch Out for in Power Supply Contracts:

Electric supplies which are less than firm.

Your contract will include a clause entitled "force majeure" which excuses delivery for certain "uncontrollable events." Some suppliers include the inability to obtain transportation, high prices, or a simple failure to contract for electricity supplies. Non-firm electricity is cheaper than firm electricity-- but unless you can stand an interruption in the peak periods, this is not for you.

Short-term electricity supplies.

Your contract may be only for the spring or fall months -- before electricity supplies become tighter. You will have to pay much more for your electricity after your short-term contract expires. Insist on a quote for year-round supplies.

Misleading price guarantees.

Your contract may provide an "estimated savings" in the 20% range, with either no contractual savings guarantee, or a contract which estimates 20%, but only guarantees 5% savings. Make sure you know the difference between an estimated savings and a guaranteed savings.

Incorrect payments to the local utility.

Your contract may show estimated savings based upon lower payments for electricity transportation. Make sure that transportation costs are included in your contract, and not a pass-through item.

Incorrect electricity usage assumptions.

A calculation which assumes greater electricity usage will necessarily result in greater dollar savings-- but not a greater percentage saving. Also, estimates which assume that you use more electricity in the spring and less in the summer will result in lower prices than you will achieve in reality. Review load factor assumptions in your contract.

Math errors.

Your "estimated savings" may include calculations with overt math errors. Some contracts are offering "savings of 18%," based upon savings of 11% in 1995 and 7% in 1996. The real savings here is an average of 9%, but unless you carefully review the calculations, you will not see the math errors.

Fly-by-night companies.

Certification to do business as a power marketer is not an endorsement by the FERC. Beware companies which may not last out the year. Stick with the brand name companies!


When representing a generator, a broker is a seller’s broker. When representing a buyer, a broker is a buyer’s broker.

Brokers work on a fee or commission basis. Today, the fees are relatively extravagant. Buyer’s brokers get about one half mill/kWh for purchases, and upwards of double that for sales (Consumers are always in short supply. It is relatively more difficult to successfully sell power than it is to buy it).

As the market becomes more liquid, and the number of transactions increase, brokerage fees will drop dramatically, as will the margins achieved by power marketers.


Soliciting for Power

In summary, electric power solicitation has changed dramatically. Where once it was simple rate negotiations with the local utility, with perhaps the fillip of an independent power plant, today procurement is done using an experienced broker who will increasingly assist the customer in selecting among power marketers as their suppliers of choice. Of course, for the power marketer, the procurement of electric power and risk management adjuncts becomes a much more complicated business, involving a continual hunt for less expensive generation and transmission paths, and better risk management products. For the broker, the key job becomes making sure that the marketer’s problems remain just that-- their problem, and to insulate the customer from the complexities of the marketplace.


Scott Spiewak is Secretary of The Power Marketing Association, and vice president of business development for CPM Electric & Gas, Inc., an electricity and natural electricity broker. Mr. Spiewak may be contacted at the following address:

CPM Electric & Gas, Inc.

3 Fairway Lane

Old Tappan, NJ 07675

Tel. (201) 784-5349; Fax (201) 767-1928

e-mail: spiewak1@soho.ios.com


CPM
ELECTRIC & GAS, INC.

ELECTRIC POWER CONTRACTING & PROCUREMENT
3 FAIRWAY LANE, OLD TAPPAN, NJ 07675
TEL. (201) 784-5349 FAX (201) 767-1928




CPM: The Electric Power Customer’s Broker

The energy market has entered a period of the most profound change in over 75 years. This change has already started and is affecting both the way energy is sold and services are delivered. It is anticipated that it will lead to deregulation and a complete restructuring of the utility industry. It is almost certain that most consumers will be buying electric power and natural gas from marketers and brokers in the future. The power marketing industry is growing rapidly, with close to 200 companies filed for marketer status at the FERC. Marketers are continually experimenting with the form of offers and guarantees to present to their customers. However, one fact which is true today, and which will be increasingly true in the future, is that marketers will have vastly more experience as buyers and sellers of electricity and gas than their customers, the consumers of these commodities.

For the very sophisticated purchaser, deregulation is likely to bring large reductions in costs in areas such as the northeast where prices of these commodities are among the highest in the country. However, very few purchasers have all the expertise required to take advantage of this situation and most do not have any expertise whatsoever. The major question for the customer is not only how to select a marketer, but far more important, how does he correct this technical and commercial imbalance between him and the marketer.

The answer is the retention of a Broker. It is the Broker’s primary role to provide this expertise and level the playing field between the marketer and the customer. CPM specializes in the purchase of energy and has developed a purchasing and consultancy program to meet the needs of the newly deregulated environment. Furthermore, CPM, through it’s marketing of natural gas in certain areas has access to gas at marketers’ costs and is willing as part of the program to share the profit with it’s customers as part of the program. The new program and approach discussed below will enable the customer to immediately take advantage of the changing marketplace and substantially reduce energy costs.

The Proposed Purchasing Program

The program proposed by CPM is designed, not only to overcome the technical and commercial imbalances between the marketer and buyer, but is intended to reduce electricity and fuel costs, even as deregulation and the restructuring of the energy industry is evolving.

Provision of Services

CPM will prepare a purchasing program for the customer which would be structured to maximize the individual customer’s purchasing power. Alternative purchasing strategies would also be included as appropriate, for example, oil/gas Btu pricing mechanisms, all with a view to maximize the benefits obtainable in the changing market place. In order to carry out it’s functions the services provided by CPM would include but not be limited to:

Pricing. A complete menu of price options and contracts to ensure the minimum price including fixed price term one month to three years, index based, guaranteed savings, recallable transport pricing, interruptible transport pricing and commodity exchange pricing.

Market Intelligence. Provide market intelligence and commercial and technical expertise to the Buyer to enable him to obtain secure supplies at the best available market price.

Contracts. Provide specialized contracting services to the Buyer, including the evaluation of bid and marketers qualifications and the design and negotiations of procurement and supply Contracts.

Aggregation. Aggregate the loads of the facilities to maximize their purchasing power.

Interstate Transportation. All the interstate transportation nomination, confirmation, tracking, balancing, scheduling capacity utilization and storage services.

Utility Coordination. Coordinate between the facilities and the local utility and the marketer to verify invoices and, ensure correct utility and marketer transport rates and tariffs are being used.

Alternative fuels. Arrange for alternative fuel supplies for interruptible facilities if any, alternative fuel off-site storage and management, advice on fuel oil to natural gas conversion, fuel standby systems and alternative and standby fuel pricing.

Consultancy Services. Energy consultancy services as appropriate would include cogeneration feasibility studies, demand side management and other techniques which would facilitate the reduction in the price of electricity.

Invoicing. Give the customer a choice of standard or levelized billing, single or multi-statement invoices, individually designed and customized invoicing, special credit terms and electronic payment options.

Regulatory Expertise. Provide regulatory expertise to the customer, to assist them through this maze of regulation and enable them to take advantage of deregulation as it happens. CPM has in house legal staff which specializes in public utility law. CPM represents its clients interests in front of the state public utilities commissions. This is very important to ensure that as deregulation evolves, the benefits are passed through to all classes of consumer and in particular the small to medium industrial and commercial user, which has neither the economic power of the very large user or the political power of the residential market.

Should your company be interested, we would be happy to send you a copy of our customer agreement for your review. You can obtain a copy by contacting me at (201) 784 5349; Fax (201) 767 1928; e-mail spiewak1@soho.ios.com. We look forward to doing business with you in the future.

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