Electric Energy Procurement: New Market Dynamics

Author(s):

Bruce K. Moffat
Bruce K. Moffat, Vice President, Duke/Louis Dreyfus L.L.C., Wilton, CT, 06897-0810, 203/761-8076.

82nd Annual International Conference Proceedings - 1997 

Abstract. The deregulating electricity market will bring choices and opportunities as well as risks and complexities for the energy manager. The difference between a successful and unsuccessful power procurement strategy will rest on the energy manager's ability to manage the burdens and extract value from the dynamics of the emerging competitive electric market. The workshop will focus on the changes to be expected, the tools that will be needed, and the opportunities and risks to be managed.

Driving Forces.The U.S. electric power industry is in transition. It is being driven by fundamental competitive market forces on both the supply and demand side, the universal drive by business to reduce cost, and the access to information revealing the un-competitive price discrepancies.

Dramatic differences in the cost of electric power and efficiency of operations exist between various electric utilities (Figure 1 - figure not available in this text-only version). Industrials in the high cost regions are demanding change.

Electric Restructuring. Deregulation of the natural gas, banking, telecommunications, airline, and trucking industry has encouraged demands for changes in the electricity market. The experience in these deregulating markets provides incite as what can be expected in the new electric market. First of all, the highly fragmented supply structure of over 5,000 power producers will rapidly consolidate. At the end of the day there could be as few as three major energy companies with a dominant market share as most all large Industries; automotive, trucking, airlines, telecommunications, etc.

However, unlike the natural gas industry which is in the mature phase of deregulation, the regulation of supply in the electric industry is very strong at the state level making the revamping process very disjointed. The Federal Regulatory Energy Commission (F.E.R.C.) has issued guidelines on restructuring. Each state will determine how and when transition will occur. Rhode Island and California (Figure 2 - figure not available in this text-only version) are in the lead with their legislatures adopting retail access target dates of July 1997 and January 1998 respectively.

Similarly to when Natural Gas was opened to the market, there will be residual, unrecoverable assets (Stranded Assets) that must be dealt with. Utility stockholders will demand full recovery while consumers will want them to take the lumps of restructuring just as many industries have in the past 20 years. The regulators and legislators appear to be siding with the utility which will have which will have the effect of energy tax with broad ramifications the energy manager.

Implications for the Energy Manager. The good news for corporate America is that, for most users, deregulation is expected to result in a general decline in the cost of electricity; by as much as 15-20% by some analysts account. However, lower average prices won't mean prices will be stable. As with prices in other commodities, electricity prices will fluctuate widely with the changes in the balance in supply and demand.

It's likely that the retail electricity prices for industrial and commercial customers will be as volatile as in the wholesale market which is illustrated in the comparison of daily prices for electricity deliveries at the California-Oregon border (figure 3 - figure not available in this text-only version). The likely impact of electric price swings on corporate costs, profits, and competitiveness will be too great to be left to chance for major consumers and producers alike.

In addition to the new requirements of managing electric price volatility, the energy manager must also gain knowledge of, and implement administrative procedures to manage the unique aspect of the delivery market, such as transmission, balancing, load following and other factors that can affect prices and basis differentials.

Strategies for Reducing Costs. The energy manager will want to develop a corporate approach to purchasing energy, aggregating fuels and electric procurement strategies, leveraging the resulting market knowledge and buying power.

While the new products being made available can be used to further reduce costs through reduced consumption/increased efficiency, the increased administrative cost of managing the complexity and volatility of the unbundled supply chain may prove overwhelming and too removed from the companies core business. Fortunately their are options. The energy manager may want to consider outsourcing all of the gas/electric facilities to one whose core business is providing that service; an Energy Service Company (ESCO). Alternatively, she may want to align with an ESCO to develop energy reduction solutions under a performance based contract.

The open market pricing has already begun to spawn a mired of risk managed products such as those listed below:

  • Fixed price products with guaranteed terms and solid credit
  • Indexed products
  • Caps and floors
  • Options
  • Electric products linked to other commodities (e.g., fuels)
  • Financial products (e.g., prepayment)

The energy manager will want to understand and use these products to not only drive toward the lowest total energy cost, but to also manage that cost relative to his company's product cost structure and operating cashflow (figure 4 - figure not available in this text-only version). Heretofore the cost based electric tariffs have had very little real time relevance, and therefore offering no opportunity to margin manage with respect to the electric cost component of the one's product.

Companies that start preparing now to manage their electricity costs in the future will be better positioned to take advantage of the emerging open market. Deregulation will not simply constitute a transfer of wealth between various sectors of the electricity industry but will also increase the power, inclusive of bother producer and consumer, industry's efficiency of operation and allocation of capital.

The Market Driven Energy Supplier. Unbundling and re-bundling of products and services will increase, resulting in more product and supplier choice. Customer specific pricing alternatives will gain momentum.

A rapidly growing number of ESCOs are anxious to supply not just your natural gas, fuel oil, or electric needs, but your total bundled "BTU" needs. In addition, the ESCO will offer you the ability to integrate the demand side of the meter with the supply market to unleash further energy savings.

The ESCO will also be in a strong position to implement the Information Technology advances in metering, billing, and load management, as it will be through their aggregation that an economy of scale may be reached to justify the initial required investment.

Finally, the ESCO will bundle the full scope of energy services with the appropriate risk management tools to deliver total energy at low, stable prices. The ESCO will bring the market to the customer through his wholesale power trading, real-time knowledge. Power Marketing is the bell weather for the emerging ESCO industry (figure 5 - figure not available in this text-only version).

Conclusion. The restructuring electric market is part of a broader convergence of the entire energy market, where electricity becomes the currency for all fuels: natural gas, coal, petroleum, hydro, nuclear, etc. This has broad ramifications for the consuming energy manager. It not only unleashes the opportunities found with price discovery but also the risks and administrative burdens of a volatile, unbundled supply market. The energy manager of tomorrow will have to develop new capabilities to efficiently manage energy cost and volatility.


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