The Paradox of Saving Money by Paying Intermediaries for Power Supplies
by Scott Spiewak

The electric power industry is becoming more complex. Two decades ago, there were no real choices for the electric power purchaser. You were served by the local utility at a price which guaranteed them a reasonable return on their investment.

This began to change with PURPA, and the advent of the IPP industry. By the mid-1980’s wholesale customers and large retail customers had the additional option of greenfield development of a new power plant, and falling natural gas prices made that option a competitive one.

Then in 1992, the Energy Policy Act was passed, and transmission access for wholesale customers became a right. FERC’s pro forma tariff requirements under the Mega-NOPR promise to make that right practicably accessible on a broad scale for wholesale customers.

An increasing number of retail customers are also obtaining access to the open market, giving them choices in suppliers of electric power, just as they have a choice of suppliers for virtually every other product they purchase.

Now a new category of company, the "Independent Power Marketer," is offering to become an intermediary between the buyer and the seller, and promising to reduce prices even while making a profit on the transaction.

This appears to be impossible, but as I will demonstrate, it is quite natural and on reflection rather obvious. It explains why marketers have such an important role in other commodity markets.

Advantage 1: No assets to protect

The first advantage of a marketer is that it lacks generation assets. This is important because it doesn’t have to favor those assets. To illustrate this advantage, I will hypothesize a competitive bid involving two utilities and an independent power marketer.

Utility one makes an offer based upon its cost of production, which looks like this:

Utility 2 has peak production costs of 5.5¢/kWH, but its off-peak production costs are only 2¢/kWh. It can therefore offer the customer a rate of slightly more than 3.75¢/kWh, to cover its costs and make a profit.

In a utility-only world, the buyer selects Utility 2.

However, we are no longer in a utility-only world. Now we have marketers to act as intermediaries. And the marketer combines the best parts of each utility’s offering

The marketer will combine Utility 1’s peak prices with Utility 2’s off-peak prices to delivery a rate of only 3.5¢/kWh, beating the offer of either utility standing alone.

This is obviously a simplified example of what a marketer does. The key point is that by virtue of the fact that the marketer is not tied to any set of assets, it is free to pick and choose, combining one utility’s output one day, and another utility’s output the next, to get the best deal possible.

As we move toward a commoditized electric power market, consumers will increasingly demand something which has been in short supply in the power business: Prices.

Utilities have traditionally offered cost-based service. If their costs vary, so does the bill. In soliciting for power supplies, utilities will rarely even quote a price, except perhaps in the form of a demand charge to reserve the right to certain generation capacity. The customer pays actual costs incurred plus a profit.

This makes it difficult to compare suppliers, much less establish a budget.

However, there is a reason for this. Utilities receive a regulated rate of return on their investment. This means that they are entitled to charge their ratepayers for their costs, and receive a return on their investments. If costs change, prices must change to protect that regulated rate of return. This is why utilities typically charge their customers with a "demand” charge, which provides the return on fixed investment, and an "energy" charge, reflecting operating costs.

Marketer, on the other hand, can give real prices. In response to a request for bids, they can deviate from the traditional cost-plus rate design and offer a dollar figure.

This not only lends itself to easier comparison among marketers, but also permits the electricity purchaser to establish a budget for its electricity purchases -- something which is taken for granted with other commodities.

Interestingly, marketers are able to provide risk management services even for retail customers who as of yet remain captive to local monopolies. Through use of electric rate swaps, marketers are revising local tariffs for discrete customers, providing customized rates linked to the customers products, such as refined oil products, aluminum, natural electricity and orange juice. Customers whose utility-suppliers are heavily dependent upon oil or electricity-fired generation have become able to fix their rates to protect them from the vagaries of their utility’s pricing policies.

These risk management offerings are created using the so-called derivative products:

• options
• swaps
• forward contracts, and soon,
• electricity futures.

Luckily, for the electric power customer, risk management and electric power aggregation need not be a concern. These are the job of the power marketer.

In the past, a great deal of electric customer attention has been focused on demand side management, time-of-day rates, power storage, cogeneration and other such measures for differentiating service. Some of these will remain available, but will be of relatively little importance in years to come. The reason becomes evident by looking at a graph of the only index we currently have available for electricity-- the Dow Jones California-Oregon Border index.

Now that you’ve been introduced to the power marketer, and have an idea of why you will almost certainly be buying your electricity supplies from a marketer rather than a power producer, the question arises as to how one selects a power marketer.

The power marketing industry is growing rapidly, with well over 100 companies filed for marketer status at the FERC. Marketers are continually experimenting with the form of offers and guarantees to present to their customers, and customers are just beginning to understand the marketing concept.

However, one fact which is true today, and which will be increasingly true in the future, is that marketers will have vastly more experience as buyers and sellers of electricity than their customers-- the producers and consumers of electricity.

An electricity consumer may well enter into only one transaction per year, in which it locks in its prices for that annual period.

An electricity producer may enter into a transaction considerably less often-- selling all or a good portion of the life-cycle output of their power plants to marketers before even breaking ground.

The broker’s role is to represent the customer in its negotiations with the marketer.

Most marketers are not in business to rip off their customers. Particularly at this stage in the industry’s development, it would be very short-sighted to alienate a customer. Nevertheless, because the industry is growing and changing quickly, there are choices the end user can make in order to save on their energy bill.