Procurement 2.0: An Antidote to Energy-Price Sticker Shock
A large share of energy buyers in 2014 are running into something they haven’t experienced for some time now: higher prices, in some cases much higher, when they go to renew their contracts.
While American energy abundance – a development fueled by the shale oil and natural gas boom – recently helped drive down power and natural gas prices to historic lows in many regions, rates have been rising steadily for the last two years. Today’s rates are more comparable to the first half of 2011 than they are to 2012, when the market hit four-year lows. Additionally, there are many factors conspiring to keep energy rates up – an important topic I’ll explore soon in a future article.
Please note the charts below, keeping in mind that power prices are strongly correlated to natural gas prices, the commodity in focus here. The line chart shows the historical price trends of the Henry Hub 12-month forward strip on a quarterly average basis. The bar chart displays the percent change of that forward contract for the period compared to the 12 months prior (with green showing savings, and red showing price increases).
As you can see by the red bars, energy buyers in Q1 2014 would likely have seen 20% higher prices than if they last shopped in Q1 2013, and more than 40% higher if they last transacted in Q1 2012. More than midway through Q2 2014, prices are 10% higher than they were at the same time last year and more than 50% above Q2 2012 levels.
In another significant pricing trend, the ancillary charges on your energy bill, which include capacity, transmission, and renewable portfolio standard (RPS) costs, have been on the rise as well, with many – depending on the state or states in which your facilities operate – poised for significant further increases.
Together, all these changes have big implications on energy buying today. While it may have been easy for any broker to demonstrate value, such as year over year savings on energy costs, during a period of declining commodity prices (H1 2008 – H1 2012), it’s a whole new ball game in 2014. In this more challenging energy-pricing environment, companies need to focus on how they buy energy. In this environment, it is critical for energy managers to ensure they have a defensible sourcing process, something we’re calling Procurement 2.0.
Gone are the days when you can afford to simply let your energy contract “roll over” with the incumbent supplier instead of competing it. Gone, too, are the days when you can settle for using a broker who gets you a price without you knowing how many suppliers bid on your business or how aggressively. In these times, you need the sharpest buying process that brings you the full benefits of the competitive energy marketplace.
Procurement 2.0 is the sharpest process for securing your next energy contract, and it is built on three key principles:
1. Market expertise: Energy is complicated. Now more than ever, you need a team of energy experts on your side.
2. Supplier liquidity: Forget who your broker is “buddies” with, you need to canvass the broadest field possible.
3. Enabling technology: Once you’ve got suppliers ready to bid on your business, you need the right tools and techniques to get them to deliver their best price.
Let me illustrate with an example.
During last year’s run-up in prices, we helped a manufacturer that had last contracted during market lows procure energy. The company came into the procurement fully expecting to pay more per kWh than on its last contract, and in fact had solicited our auction-based services for that very reason – citing the need for more expertise, more supplier liquidity, and better price discovery than what their prior paper process had delivered.
The results were surprising. Even though wholesale electricity prices had risen, with more suppliers participating in the auctions (we helped double the number of suppliers), bidding activity drove down the winning price below their prior rate. And during the course of the auctions, one of the suppliers that had lost the tranche for a traditional “brown” power product lowered its price even further, beating that winning price while also offering 10% green power “for free.”
One casualty of this process? The incumbent supplier. Despite having offered their “lowest price” in advance of the auction in an attempt to keep the business and prevent the competitive event from occurring, the incumbent found their best offer in the auction didn’t even finish in the top three. This was an eye-opener for the customer. In fact, since 2013, we have found that when we run an auction for a new customer, the incumbent supplier retains the business only 10% of the time.
While some of our procurement events in 2014 have helped customers beat their prior contracted rates, getting customers into a new contract at a lower price these days is not the norm. For example, in a market such as New England, where commodity prices surged throughout the winter and have stayed high in the spring, no process is capable of delivering that kind of savings. In these cases, extracting the best available price from the market is the victory customers should be looking for and the reason why they should be leveraging Procurement 2.0 processes and techniques, including auctions.
As an economics major and MBA, I have several books on auction design lining my bookshelves and have spent hours on the phone with leading auction authorities from Oxford, England to Washington, D.C. I love auctions because of the compelling competitive dynamic they foster and unique economic moment they deliver. Not surprisingly, I can wax on for hours about their design. But for now, following are a few insights I can offer, gleaned from 10+ years conducting 50,000+ online pricing events, about why this idea of Procurement 2.0 is superior to the paper-based processes used by the majority of aggregators, brokers, consultants and in-house procurement teams in the U.S. today:
Supplier Liquidity. You know the Lending Tree line, “when banks compete, you win?” Well the same holds true for energy procurement. It’s all about competition. Based on more than a decade of successful work with energy suppliers in every deregulated state, we bring maximum supplier participation to our auction events, which fuels competition and drives prices down. Over the last year, customers using our auctions have awarded contracts to 59 unique electricity providers and 93 unique natural gas suppliers nationally.
In addition, with an online event or auction, the difference in effort between letting two or 20 suppliers bid on an RFP is nominal; there is no cost to adding another supplier. On the other hand, each paper RFP requires labor to solicit and evaluate. More often than not, a broker or consultant will send a paper RFP to a few suppliers to get a good enough price. In an online procurement, all qualified suppliers are invited in an effort to secure the best price.
Auction design. Auctions come in many flavors, including “forward” (where prices are bid up), “reverse” (where prices are bid down), “sealed bid” (where prices are not disclosed to the bidders) and “multiple to multiple” (where both price and terms are part of the bid). At World Energy, we can leverage them all and match the right format with the customer’s particular circumstances, often relying on an “Anglo-Dutch” reverse-auction approach which is designed to get suppliers to give their best price. The Anglo feature of this type of auction provides suppliers visibility into competitive bids, and the Dutch feature causes suppliers to put a best and final offer in (the poker equivalent of going all in) as the seconds tick down at the end of the auction. This design works so well that 20% of the time the then-leading supplier outbids itself to win the business, transferring valuable margin to the customer.
RFP architecting and sequencing. In an online procurement event, it is possible – even preferable – to run multiple auctions for the customer, testing different terms, products and pricing structures. This segmentation provides energy buyers real-time information on where prices are settling (something suppliers like, too), what I liken to a ‘topographical map’ of the market, in which the “sweet spots” in the market are identified. This enables the customer to select the price and parameters that best meet their business needs and sustainability objectives.
Additionally, because auctions are run in immediate succession, suppliers can react quickly to a loss, sharpening their pencils to win the next round, as illustrated in my prior manufacturing-customer example. The dynamic nature of an online procurement process gives suppliers the real-time feedback they need to more aggressively pursue the customer’s business, something missing from paper-based procurements, and which can cost customers dearly.
Pristine process. Because the underlying commodity in energy is volatile, the amount of time it takes between accepting a supplier’s winning bid and signing the contract ultimately affects the price. If the anticipated closing period is long, the supplier will typically add a risk premium to protect its position. By running an online, real-time event, where deals can be consummated quickly and precisely, sometimes contracted within an hour of auction completion, risk premiums can be lowered, further reducing the buyer’s final price.
As an added benefit, an online procurement process can capture, catalogue, and time stamp all bidding activity, providing organizations with a thorough and transparent audit trail of their energy procurement, great proof for stakeholders that an organization engaged in a fair, competitive process that maximized market participation and delivered a defensible result.
Further testifying to this process excellence, I am proud to say that over the course of transacting more than $45 billion in energy and environmental commodities there has never been a successful protest of one of our online auctions; our utility customers have a perfect record of public utility rate case approvals when using our auctions to buy energy for their customers; and our auction execution has been called flawless by some of the most exacting customers in the country.
Market expertise. Now, a traditional broker or consultant may counter that what matters most in energy procurement is market expertise and relationships. Of course those are key elements for success. In our world of online auctions, they are a given, with auctions serving as a powerful tool in the hands of master mechanics. Our master mechanics, a.k.a. our market directors, average 18-years’ experience, with many having witnessed or actively influenced the opening of America’s deregulated energy markets firsthand. Transacting every day in every active market, these are the kinds of people you want on your side.
There’s no question that the pressure is on for energy buyers today. When you are sourcing energy in a rising market, it is incumbent on you to secure the lowest price possible. To do so, you’ll need every advantage you can get, and Procurement 2.0 delivers.
Phil Adams is Chief Executive Officer of World Energy Solutions, Inc. (www.worldenergy.com; NASDAQ: XWES), a national energy management services firm headquartered in Worcester, Mass. Phil is a leading authority on Procurement 2.0 and energy auction design and execution. He can be reached at firstname.lastname@example.org or 508-459-8100.
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