Debunking the Myths About Long-Term Fixed Pricing of Power
- Dec 3, 2020 4:15 pm GMTDec 3, 2020 4:52 pm GMT
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Debunking Myth #1: Long-Term Fixed Pricing is the Lowest Cost Option
Over the last few years in de-regulated states, there has a been a widespread notion that long-term fixed pricing is the best path to the lowest cost for electricity. This is especially true among large commercial customers and real estate owners across the country.
Commercial landlords are accepting the argument that long-term fixed pricing is the best way to achieve the lowest cost possible. Energy brokers will sometimes call landlords while their contracts still have a year or more left, and ‘blend and extend’ them so that they go out even longer.
A slew of recent studies, however, has shown that over the past six years, fixed pricing was more expensive than index (variable) pricing in virtually every market. Let me say that again: Whenever you fixed the rate since 2014, (any day or month you chose to do this), for 12 months or more, you paid more for power over the next twelve months than had you simply rode the index for real time energy. This analysis includes some of the most volatile power markets in recent memory – and, still, floating was cheaper than fixing for 12 months or more.
The chart below compares the forward 12-month fixed block price for energy in New York City for a given month versus the average index real time energy cost for the same period. Overall, long-term fixed pricing has been on average, 33% more expensive than index.
Looking at the actual monthly (index) energy costs in New York City Zone J since January 2014, the average year of year change in energy prices in the summer months was -1%, the average for the winter months was -11% and the average for the shoulder months was -12%. The results are the same. Pretty much any time a customer bought a fixed block of power since January 2014 – they overpaid.
Recently one of the largest energy suppliers in the country (with more than six million customers) ran a webinar that showed similar results. They took their own 12-month fixed pricing that they offered their large C&I customers since January 2015 and compared it to the index and with only one exception, every single fixed price in every month for the past six years was more expensive than the index. The average forward price was $5.22/mWh higher than the index price. In other words, they admit that index pricing was less expensive that their best 12-month fixed pricing at any time in the last six years.
On January 8, 2014, John F. Kennedy International Airport had canceled about 1,100 flights, Newark Liberty International Airport had about 600 canceled flights and LaGuardia Airport had about 750–850 flights canceled. In New York City temperatures fell to a record low of 4 °F (−16 °C) on January 7, which broke a 116-year record. … with a wind chill of -33 °F. Electricity rates rose - temporarily and energy brokers seized the opportunity to sell fixed pricing to their customers. They locked in rates at about $0.16/kWh (double the previous month’s average rate). That year the average index rate was less than $0.06. Did those 12-month fixed rates save customers money?
The absolute optimal time to buy a 12-month fixed price block was December 2013, just before the January 2014 polar vortex. However, even with that superb hindsight vision and perfect timing, the savings for that period over the index was only 2%.
The reality is that electricity rates have been on the decline since about 2008 in virtually all markets. And the trend is continuing. In the PSEG territory, the average first quarter 2021 rate is lower than any rate since 2015. It is the same in New York.
If one tracks this trend over the last few years, he will notice that there has seemingly never been a ‘bad time’ to lock in rates! When rates increase, customers are told that rates are rising and will continue to rise, so they should “lock in now before it gets worse!” When rates decline, customers are advised to “lock in now at historic lows.” “This may be the bottom”, they say, “so lock in now” before rates start to rise!” Despite the reality of prices, the obvious conflict of interest from energy brokers pitching long-term fixed pricing suggests why customers have been so hard pressed to adopt it.
Debunking Myth #2: Long -Term Fixed Pricing Gives us "Budget Certainty"
The second, and more persistent, myth is that long-term fixed pricing provides “Budget Certainty.”
Let’s unpack this quest by customers.
The reality is that long-term fixed rates for electricity supply does not actually provide the coveted ‘budget certainty’.
First, approximately half the electricity cost is made up of “T&D” (Transmission and Distribution) charges that are billed by the local utility for the delivery of the electricity. These charges are always variable and cannot be fixed or hedged. Second, as we have seen the hard way in 2020, the actual usage or load varies based on occupancy. So, two out of three variables are never fixed. We have shown clients why even if you have a fixed rate for supply, when the T&D charges go up or down (as they have done drastically in 2020), and when the actual usage drops (or increases), the budget is anything but ‘certain’.
The two examples above from 2019 and 2020 demonstrate why long-term fixed supply pricing can result in more of a difference to the budget than variable. We have dozens more examples that show similar (varied) results – where energy usage increases or decreases and where the T&D rates go up and down.
To be sure, all other variables being stagnant, having a fixed supply rate can help in the budgeting process. However, a good energy consultant can assist with budgeting and forecasting (using forward curves and historical usage) even if the rate for supply is variable. We have done monthly budgets for clients who use Block and Index procurement strategy as well as for clients with long-term fixed pricing, and the budget differentials are about the same. To be sure, long-term fixed supply rates do not provide ‘budget certainty’.
What we believe customers really want (and what they can get) is protection from rate spikes. Perhaps that is what they really mean when they say they want ‘budget certainty’. So, is long-term fixed pricing the only way to ensure that they won’t be hit by price spikes? The answer to this question is a resounding ‘no’.
With an intelligent “Block and Index” procurement strategy, the commercial customer buys short-term fixed priced blocks of power specifically and only for the months with historical price risk thereby protecting from spikes ONLY for those specific months in which the building has price-spike risk. This is usually the peak of summer and winter. The rest of the year the building obtains the true lowest cost by buying in the day-ahead wholesale market – in other words, variable index pricing. With Block and Index strategy, customers can obtain the true lowest cost, because the procurement strategy itself, while more work for the energy provider, is smarter. This is the ideal strategy for a customer who is sensitive to consistently obtaining the lowest price and avoiding price spikes in the riskiest periods. Put differently, the customer is, in effect, buying energy with scalpel instead of a sledgehammer – a much more effective pricing strategy is the result.
We have numerous case studies of large C&I assets that used the Block and Index procurement strategy over the last few years. It accomplishes everything that customers want: It protects against rate increases; it buys power at the cheapest price during the shoulder months, and it is just as easy to budget for.
Debunking Myth #3: Long-Term Fixed Pricing Provides a True Apples-to-Apples Cost Comparison
Essential to every customer’s long-term fixed price evaluation is the creation of a ‘beauty contest’ (a reverse auction) so that an ‘apples-to-apples’ comparison between vendors can be made to find the lowest cost. Customers are presented with this comparison and assured that this is the only way to obtain the lowest cost.
However, is that true?
No. The ‘beauty contest’ approach followed by long-term fixed pricing does not generate the guaranteed lowest cost.
- It is important to understand that there are hundreds of REPs to choose from. If a customer obtains four or five bids, he will no doubt will miss dozens of others, unless they price out literally every supplier in the country.
- A ‘reverse auction’ (or RFP - ‘Request For Proposal’) of a long-term fixed supply rate is merely an arbitrary snapshot in time and not a true cost comparison. (An RFP done on Monday will miss a rate reduction on Tuesday). It is arbitrary and not indicative of lowest cost. A fundamental flaw of the entire methodology is the susceptibility to a poorly timed auction or ‘lock-in’. By definition, snap shots can never capture the benefits of what the last ten years or more have demonstrated: despite price spikes, power prices drop regularly and the premium and poor timing associated with ‘fixing’ end up costing too much.
- Long-term fixed rates are not ‘risk-free’. Long-term fixed pricing comes with a lock-up and onerous ETFs (early termination fees), so there is no way to take advantage of reduction in rates (which has happened almost every year since 2008).
- With long-term fixed pricing, changes in energy demand, capacity or “ICAP tags” (such as in the year 2020 where energy demand was low due to reduced occupancy) cannot benefit the building (in 2021) because price may have been fixed at a (falsely) higher capacity cost. Any peak-shaving or energy conservation initiatives also will not benefit the landlord (to the contrary, the benefit will inure to the energy supplier because the cost of power will be reduced in the process, but the fixed rate stays where it was before the initiative). Put differently, the dynamics of building operations, tenancy variations, energy efficiency efforts are all wasted when prices are fixed on a long-term basis.
- Long-term fixed pricing with ‘apples to apples’ comparisons may be touted as ‘risk free’ – but they are only risk free to the energy brokers and energy suppliers - not to the customers. In virtually every contract we have examined the energy suppliers will charge the customer more than the fixed rate if anything changes such as the ICAP tag or any other regulatory charge (ZECS, TOTS, RPS etc). We recently witnessed a supplier who sold a fixed rate in NYC of $0.076/kWh last year but was charging $0.10/kWh for the past 8 months. When we asked why they increased the rate by 30%, they replied that the ICAP tag increased and the have the right to pass through the additional cost. These increases in rates due to 'surprise pass throughs' frustrate customers and explain why the retail energy industry may have a bad reputation.
Unfortunately, long-term fixed pricing always benefits energy companies without benefitting customers. When ICAP tags go down, no supplier that we know of has ever given a customer a credit. But if the ICAP tag goes up, the supplier will pass the charge through to them and force them to take the risk. The electricity contracts for long-term fixed pricing allude to this in the fine print and multiple lawsuits have arisen fighting it – all to no avail. Commercial customers are right to wonder: what is the benefit of a long-term fixed price contract during which prices that I pay go up but cannot go down? Answer: none.
So, is there an energy procurement strategy that avoids the pitfalls of today’s common practices? Happily, there is. Customers should have suppliers submit bids for a Block and Index strategy and ask them to bid transparently on the gross margin, or the ‘adder’. Then, to see if they really saved money, customers should retroactively compare the actual cost incurred to what the local utility would have charged. That is the only true apples-to-apples comparison, and the only way to evaluate if buying from an energy supplier has actually saved them any money.
Debunking Myth #4: All the Big Landlords Buy Long-Term Fixed Price
Surprisingly, although, based on the previous points, not surprisingly at all, more and more of the biggest names in commercial real estate are using a Block and Index procurement strategy. These experienced, professionally managed, and successful firms have not procured via long-term fixed price contracts since they were burned by it when they were convinced to try it (any year since 2008). We are aware of more than one billion square feet of commercial real estate (and literally dozens of large commercial real estate companies and funds) who utilize an effective Block and Index procurement strategy. Large commercial real estate owners such as Tishman Speyer are in good company as they buy energy with scalpel instead of a sledgehammer.
For long-term fixed pricing, touted as the ideal way to reduce cost, the disadvantages to this outdated strategy outweigh any seeming benefit. Long-term fixed pricing does not produce the lowest cost. It does not provide customers with ‘budget certainty’. The ‘apples-to-apples’ comparison is prejudiced and fraught with risks. Thankfully, many if not most large commercial landlords are realizing the fallacies of the methodology and moving to a more intelligent process. With a Block and Index strategy and full wholesale cost transparency, customers are finally able to achieve their goals for reduced cost, protection from price spikes and onerous ETFs.
Jack Doueck is a Founder and Principal of Advanced Energy Capital, LLC. He can be reached at JD@AdvancedEnergyCap.com.