Procurement strategies for cutting energy costs

By Paul E. Teague -- Purchasing, 11/2/2007 1:25:00 PM

The following are excerpts from an interview by Purchasing Editor in Chief Paul E. Teague with Michael Kagan, CEO of Constellation New Energy, on energy issues and ways to save money:

1. What are the traditional strategies procurement people use to buy energy for their manufacturing companies today?

With crude oil topping $80/barrel in Oct 2007 and global energy markets becoming more volatile than ever, customers are looking for new strategies to manage their energy costs. With the volatility, companies are recognizing that the lowest price on a given day could represent the highest price during a given period. The best strategy is to focus on developing a cost structure that will below a 3-year average or one which tracks company revenues.

Companies in competitive electricity markets that have been opened by deregulation* have been rejecting tariff-based electricity pricing offered by their local utility. Instead, they are building relationships with competitive power suppliers or brokers who offer a wide variety of supply/pricing options to reduce cost and mitigate risk.

Given the unpredictability of energy prices, our customers have recognized that they can’t afford the risk of unmanaged costs on their bottom line. They are moving from a pure fixed-price product to a longer-term strategy for budget certainty. They are asking themselves “How do we manage our total costs?” and “What’s our energy position two to three to five years out?”

We work with companies to apply a risk management approach to how they purchase their energy supply. As a result, our customers are finding that they can insulate their companies from volatile price risk and gain multi-year budget and cash flow certainty by developing a long range energy supply side strategy to manage their costs.

* As a result of deregulation, there are about 15 markets where customers are actively buying competitive electricity supply. They include Maine, Massachusetts, Rhode Island, Connecticut, New York, New Jersey, Maryland, D.C., Delaware, Pennsylvania, Illinois, Texas, California, Alberta and Ontario.

2. What are the issues energy buyers need to consider in planning their procurement strategies?

While cost savings are on the minds of just about everybody, the real question is how to manage your exposure to volatile energy prices. Often it’s acceptable for a company’s cost to vary as long as the variability is linked to changes in revenue (i.e., so profits remain stable). To ensure costs and revenues are linked, many energy managers get the chief financial officer involved in the energy procurement process to help chart the appropriate strategy to meet business objectives.

In many ways, buying energy is like managing a stock portfolio. It requires adopting a disciplined approach that takes into account overall budgetary goals and risk tolerances coupled with energy market insight and analysis. You need to look closely at how, when and why you use energy, plus you need to consider the bottom line impact of your energy program, and your overall tolerance for risk.

To get started, we have our customers complete a risk questionnaire and determine their goals. We then analyze your energy usage data and historical, real-time and future energy prices in the markets where you operate. Using a proprietary methodology, we calculate the optimal risk-reward tradeoff to shape a long-term, forward-looking approach for a comprehensive energy procurement strategy.

To mitigate both the ups and the downs of the market, you need a risk management strategy. We encourage customers to take the long view for how they manage their overall costs and to link energy costs to their business’ revenue plan. We’ve found that companies deploying an energy risk management strategy tend to fair better than those that follow a more a wait-and-see approach to buying in the market.

3. Can companies negotiate energy prices? How? For which energy source is it easiest to negotiate, and for which is it hardest?

The market price for electricity is set through the interaction of supply and demand. (i.e., more demand/less supply = higher prices). Customers should focus on negotiating a supply program that matches their business needs.

For example, a manufacturer under a long-term contract for its output will often want a fixed-price agreement that matches the term of its output contract. In contrast, a firm operating under a cost-plus agreement may choose a pricing agreement that fluctuates with the market within certain specific limits.

What is key is to know the price protection that is right for your business and negotiating this arrangement.

4. What options are available to midsize companies versus very large companies?

It used to be only the largest most intensive industrial energy users who could capitalize on the transparency of price signals in wholesale power markets. However, a growing number of midsize businesses are now actively managing real-time costs through a combination of agreements and demand response. Let me give you some examples.

The most common product is the “fixed price” contract, which offers the customer budget certainty and a fixed cost while the power supplier assumes all price risk. The fixed price product is a simple option for the customer. Although the fixed price contract offers the most price certainty for the buyer, fixed price contracts, alone, may not be the best choice for all customers, since they do not allow buyers to take advantage of price declines.

Instead, some electricity buyers may prefer to opt for a balanced portfolio that combines fixed price contracts with indexed products. With volatile electricity prices fluctuating as much as 10%-25% each month, this procurement strategy offers the risks and benefits of actively participating in energy markets with options to limit exposure.

Demand response programs provide incentives to customers for reducing their electrical consumption in response to high wholesale electricity prices, system resource capacity needs, or system reliability events. The advantage is customers actually earn money for reducing their power during key periods when the system is most strained and prices are highest. 

It sounds complicated, but it really isn’t. Leading energy marketers now provide simple, on-line tools to help energy buyers make informed decisions. Competitive marketers also can help customers with variable loads and/or operational flexibility to lower their energy costs by managing energy usage in response to market price movements (i.e., a “demand response”). For manufacturers looking to site additional facilities, competitive power suppliers can help manage electricity costs by assessing where lower-priced energy zones are located.

5.What can companies do to ensure that they have developed energy-efficient supply chains?

For this you need to look at both the supply and demand sides of the equation.

First, you can maximize the value of your supply portfolio by understanding your load profile and gaining the ability to act on price signals.

Customers can also install demand side management technologies (high efficiency equipment replacements, energy management control systems, etc.), which are often funded by utility run programs.  Other options include the use of alternative generation (e.g., cogeneration), implementing power correction technologies (e.g., capacitor banks), or shifting hours of operation as a part of specific demand response programs.

6. What are the most important tips you can give to buyers on energy procurement?

*     Understand your costs and how they could vary

*     Link your energy costs to other business drivers

*     Take a long term view of your energy management goals