What do Wrigley Field, Heinz Field and Gillette Stadium have in common? Other than being the sites of major league sports teams, each purchases their electric service from a retail energy supplier rather than the local utility.1
Why the switch? The answer is simple: the potential for lower energy prices and to have greater cost control. The opportunity to reduce a company's spend for electricity exists because more than a dozen states have "restructured" or deregulated the sale of this commodity.2 As a result, electric power, as opposed to the transmission or transportation which still remains regulated, can be purchased at negotiated or market prices, which often are lower than a utility's regulated rate. Also, an unregulated energy supply company has flexibility in tailoring pricing terms (such as fixed and floating prices) that better meet a customer's energy cost risk tolerance.
Although price usually is the overriding motivation to switch from a utility to an energy supply company, the terms and conditions of the contract are just as important, since they also have economic consequences.
The transition from buying under a utility's regulated tariff (which is not subject to negotiation) to entering into a contract with an energy supply company is not necessarily straight forward or intuitive for a legal generalist. This is because a buyer is offered a contract which is laced with terms and conditions that are unique to the electric power industry and often foreign to most contract lawyers' experience.
Preliminary to reviewing an electric supply contract's provisions, knowledge of the basics of retail energy procurement is necessary. Often, the procurement process begins with a formal Request For Proposal (RFP). The RFP process in most corporate settings usually begins within the framework of a management program tailored to a company's risk tolerance and includes a comprehensive evaluation of operational energy requirements. The goal of the final contract is to ensure the operational and legal requirements incorporated in the RFP are translated accurately into the final supply agreement.
Fortunately, the task of negotiating an electric supply agreement has improved as the energy markets have matured and, in the process, the contracts have become somewhat standardized and evenhanded. However, the following are the important contract terms which must be understood in negotiating a contract with an electric supplier:
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Term: The term is the length of time the electricity will be furnished to the customer. Generally, this can be as short as six months or as long as three years. Decisions regarding the appropriate term involve a company's risk tolerance and assessment of market conditions. Often, the term proposed will run to the end from the utility meter reading, which often is different from a contract's end-date indicated in the agreement. Understanding the actual end date of energy supply is important for operational continuity.
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Fixed Price: A fixed price is an unchanging price for all electricity used during the contract period. In most contracts, the price applies to all kilowatt hours (kwhrs). A fixed price provides the highest level of price certainty but does not provide the opportunity for the buyer to benefit from a downward movement in prices.
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Index Price: An index price is a variable price that moves with price changes in the energy markets. With electricity this price is likely to be a Day Ahead Market (DAM) or Realtime Market (RTM) price. An index price provides the lowest level of price certainty and the highest level of price risk.
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Other Pricing Structures: It is not unusual for a contract to contain both a fixed price and an index price, which together form the basis for a physical energy hedge. Within such a contract it is typical to see each price (the fixed and the index) presented in separate attachments to the main Terms and Conditions of the supply agreement.
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Usage Variations: Energy agreements function by applying a price structure to historic energy usage requirements. While it is said that history often repeats itself, it is unlikely that energy requirements will exactly match historic usage. This usage variation must be captured within the terms of the contract (see Bandwidth).
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Bandwidth: Bandwidth refers to a range of energy usage, such as +/- 10% of the contract volume. Bandwidth allows a price to remain fixed even if the usage varies from the historic consumption. Bandwidth shifts price risk to the supplier but increases the cost of the fixed price contract. A contract without a bandwidth provision would have any energy usage under or over the monthly contract volume reconciled, at the current market price. Under-usage creates a credit to the customer, while over-usage results in an additional charge.
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Locational Marginal Pricing (LMP): LMP refers to a commodity price based upon a specific location. The LMP is important as it indicates a specific price that matches a transmission delivery point near a facility's location. LMP prices are also a basis for index pricing.
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Dual Billing: In most markets, customers have the choice of receiving one bill from the utility for transmission service with a supplier's charge for the commodity (electric power) included. In contrast, dual billing provides for separate bills from the utility and the unregulated supplier. To some extent, the choice between a combined or dual bill may depend upon the needs of a company's accounts payable department. For more complicated procurements (like a hedge), dual bills however provide the best transparency of the transaction.
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Termination Charges: By way of background, an electric supplier buys power for a customer in the futures market. The supplier has to make a financial commitment, and if it has to unwind that commitment because of a customer default, the process can be an unattractive and expensive prospect. Termination charges are costs arising from the unwinding of the energy contract. The method of calculating these charges varies depending on the party terminating or who has defaulted. Look for this provision to have the undelivered energy settled against the current market price in the event the customer is the defaulting party. If the supplier is the defaulting party, the undelivered energy is reconciled against its replacement cost (with reasonable fees and costs).
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Renewal Term: Some contracts provide for automatic renewals sixty days from the end-date as opposed to the last meter read date. This type of "evergreen clause" should be avoided.
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Force Majeure: A Force Majeure clause often encompasses a wide range of events that cause a breach of contract terms and conditions which are beyond the control of either party. This typically includes Acts of God, Acts of War, Acts of the God of War, etc. and supply interruptions at the wholesale and utility level. Often a Force Majeure clause will provide that it does not apply and would be an act of default if a seller can get a higher price for a customer's supply from another customer, or if the buyer can purchase electricity at a lower price from another supplier.
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Creditworthiness: In the post-Enron period, creditworthiness of both buyer and seller has taken on a new importance. In short, a good credit standing and payment history may translate into a better price, while poor credit will result in suppliers adding costs to cover their risk of buyer's default. To some degree the ability to provide (and include in the agreement) a fast electronic payment may mitigate a negative credit standing, or produce a lower price.
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Holdover Rate: This is a rate charged after the contract term has ended. In practice, it can happen that a contract expires but the service from the supplier continues without a new contract. The rate applied for this period needs to be placed into the agreement and is most frequently an index-based price or a price comparable to the utility's regulated rate, which often is higher than the contract's price.
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Capacity Costs: These are charges applied by the supplier to the customer for electricity demand (kilowatts) as opposed to electricity usage (kilowatt hours). Capacity charges are designed inter alia to incent the development of new generation. Capacity costs are presented within the contract as a pass-through or included in the kilowatt hour price. The disposition of capacity charges can vary from state to state.
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Invoicing and Payment: Suppliers should be pre-qualified inter alia on their ability to generate bills on a timely and accurate basis. Payment terms can have some flexibility, but typically range from 10 to 30 days from receipt of invoice with a late fee of 1% to 2% per month.
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Firm Service: Firm service is a guaranteed energy supply that cannot be interrupted absent a Force Majeure event.
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Interruptible Service: Interruptible service clauses provide for service interruptions by the supplier depending upon certain market conditions. A typical example of this would be interuptions at a time of high demand (summer for electricity, winter for natural gas). Interruptible service is cheaper than firm service.
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Delivery Point: The delivery point is the location at which the title of the energy passes from the supplier to the customer, which is usually at the local utility's receiving point for the energy.
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Ancillary Services: Ancillary services are regulatory approved cost components included in an electric price which covers the totality of services required to provide and deliver electricity.
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Attorneys' Fees: Most often suppliers want to be reimbursed for attorneys' fees that may be incurred during litigation or arbitration. Often the provision for reimbursement is mutual.
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Liquidated Damages: Notwithstanding that courts often view liquidated damages as penalties, many suppliers often include these in their contract offers. The law of the jurisdiction needs to be reviewed.
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Warranties: Most sellers' contracts "disclaim allwarranties, express or implied, including any warranty of merchantability or fitness for a particular use."
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Confidentiality: Often a supplier includes an exception to standard confidentiality language so that it may use a customer's name for marketing/advertising purposes. A customer may withdraw its consent to be included in a supplier's publicity.
In addition to these terms that appear in energy supply agreements, corporate lawyers will find more familiar provisions, such as assignment rights, changes in law and/or regulations and remedies for breach. A final word: do due diligence on the seller. The deregulated energy industry has matured along with the practices and ethics of the marketing companies. But, ultimately corporate counsel needs to ensure the bonafides of the counterparty to any energy supply agreement.1 The Power Report (Feb. 23, 2007)
2 As of April 24, 2006. Natural gas also is deregulated in most states and users have the opportunity to contract for this commodity at deregulated market prices. Virtually all of the provisions discussed here would be applicable to an agreement to purchase natural gas.
Published May 1, 2007.
