Defining the customer's buying parameters

Bill Roth is director, national accounts-North America for

Southern Energy, Inc. Prior to this position, Mr. Roth served in

marketing management positions at Georgia Power for 15 years. He holds

a master's degree in economics.

Defining the Customer's Buying Parameters

Many customers are already implementing processes to select suppliers in anticipation offull customer choice, establishing price and risk parameters. Customers are also recognizing that transitional steps on the way to full competition, including such options as buy-through and real-time pricing, can lower costs at reasonable risk.

Bill Roth

tail competition is trans- rming the U.S. electricity

market at a dazzling pace, promis- ing major customers greater choices and better prices--and a lot of new headaches.

Even though regulators have not yet put retail access into gen- eral practice, many customers are working diligently to make sure they are properly prepared to deal with the additional issues and complexities being created by electricity's new world order.

By the time retail competition is officially unleashed, many national buyers of electricity will have: (1) specified their service cri- teria (contract terms and condi-

tions), (2) defined their price risk tolerances, (3) structured their purchasing organization/process, and (4) chosen their national/regional suppliers.

I. Customer Buying Scenarios

Customers will face numerous buying scenarios as the electricity industry moves from its present monopoly supplier model, through a transitional period of market immaturity/uncertainty, and into an eventual efficient retail competitive market. This tran- sition will confront customers with four buying scenarios: (1) bundled monopoly service, (2) commodity "buy-through;"

36 The Electricity Journal

(3) real-time pricing, and (4) unbundled, competitive service.

A. Bundled Monopoly Service

Bundled monopoly service-- the current system generally in place--is causing increasing frustration for many customers. Past experience has lead them to view bundled service as a zero- sum game. Today's utilities establish revenue requirements for customers by summing the utility's costs and allowed profits, then allocating this sum among customer classes: residential, commercial and industrial. Therefore, lowering the price to one customer means raising it for another.

T o address this frustration, some regulators and utili-

ties have begun exploring performance-based regulation. In concept, this approach would provide financial incentives for utilities to be more efficient. The customer would benefit through the resulting lower prices, or steady prices in the face of inflation. Gen- erall~ customers applaud such ef- forts as a first step toward market- based pricing.

B. Commodity Buy-through

An alternative to incentive regulation for bundled service is "buy- through." Buy-through lets customers choose energy suppliers within the traditional franchised utility framework. The customer still takes service at the meter from the existing utility supplier, but the power is supplied by a third-party supplier. Examples can be seen in Illinois' retail corn-

petition pilot and proposed rate structures in Ohio.

1. Buy-through Risks. Buy- through offers the obvious advantage of lower prices, prompted by competing suppliers. However, this scenario can be complex and risky for the customer.

O ne risk is price discovery. Be- cause buy-through prices

are not the product of a fully

Past experience has lead customers to view bundled service as a zero-sum game. Lower- ing the price to one customer means raising it for another.

traded market, determining price offerings of alternative third-party suppliers may be very difficult. In the absence of a central market customers will have to develop bid procedures to simulate a market clearing price.

Reliability is another issue in buy-through. Buy-throughs are typically for uniform blocks of power, or for power during defined time periods. Not unlike the nomination/penalty procedures found in the natural gas industry, buy-throughs can entail substantial price penalties imposed by the existing utility supplier for electricity consumed (or not con-

sumed) in accordance with de- tailed provisions of the buy- through contracts.

A third risk is supplier credit. Most buy-throughs are for a select group of customers. This micro- market provides the opportunity for substantial gaming between competing suppliers. Suppliers-- including the existing monopoly supplier---can "cherry pick" customers using its lower-cost gen- eration by offering prices lower than average embedded cost. In the heat of competition, some suppliers may offer still-lower prices. These lower prices are possible if a supplier is willing to take additional risks--for example, to go "naked" on price exposure in the hopes of normal weather, or by attempting to mitigate risk through a derivative financial instrument.

C ustomers run two potential risks in this scenario. One

is that the supplier does not cover the risk. The customer could face attempted "claw backs," in which the supplier phones just prior to scheduled delivery to re-negotiate price. The other risk is the possibility of "financial settlement" by the supplier, in which the supplier sends the customer a check rather than the actual electricity to cover the position. This approach is acceptable in many commodity markets, but would cause problems for most electricity customers.

Customers confronted with these buy-through issues should not assume "naked" supplier risk, nor should they decline to partici- pate in buy-through opportuni- ties. Rather, customers should try to remedy these risks by develop-

March 1997 37

ing their own buying parameters that assess price goals against supply (and supplier) risks. With such an analysis, buyers can develop mitigation strategies to in- d u d e clearly defined supplier cri- teria, assignment of risk through contractual terms and customer- developed physical/financial hedge instruments.

2. Buy-through-Strategic Issues. Buy-throughs also give customers the opportunity to strategically in- fluence the direction of future competition. Who the customer buys from may be as important, with respect to long term prices and supplier alternatives, as what to buy and how much to pay in the current buy-through options. Through their selection of buy- through suppliers, customers can introduce new competitors into the market place. Currentl~ many customers select suppliers based on price alone--after all, the only part of the service value chain being opened to competition is the commodi~. However, some customers have begun to think strategically about the type of new en- trant they could introduce into their supply market through selection of a supplier.

C. Real-Time Pricing

Real-time pricing (RTP) is rap- idly being adopted by utilities as a pricing innovation. Initial appli- cation of RTP by utilities is generally for a customer's incremental loads. Often, the RTP structure is a two-part tariff. One part of the RTP structure is the "CBL," or consumer base-line load. This base line of load is priced to result

in the same revenue for the utility as generated by traditional tariffs. Any incremental change from the customer's base load is priced at the utility's incremental cost. Cus- tomers adding loads during low- cost periods, or those with the ca- pability to lower consumption (peak-shave) during high-cost periods, receive tangible benefits from this type of rate.

1. Pains and Gains of RTP. RTP can be extremely important to cus-

RTP offers several positive benefits access

to substantially lower prices and greater clar-

ity in pricing but there are risks as well.

tomers. If RTP is structured to re- flect true incremental cost of electricity (the lower of a utility's "system lambda" or the spot price of wholesale power accessible for delivery to the utility's grid), then RTP approaches an actual market price for electrici~. Further, if RTP is applied to a customer's entire load, rather than an incremental percentage, customers basically have a simulated market price for the entire commodity portion of their electricity service. In effect, RTP lets customers (and utilities) establish a market-price relation- ship without the stress of full de- regulation.

E ven if it is not applied to a customer's entire load, RTP

offers dramatically increased pricing efficienc3a Traditional demand and energy tariffs, or even time-of- use tariffs, are inherently inefficient in matching prices with costs. Lacking time robustness, these tariffs limit utilities' ability to run "sales" when costs are low, or charge prices reflecting the product's economic value when demand exceeds suppl~ Tradi- tional tariffs are highly inefficient for the utility and create higher average prices for customers.

RTP can be a w in / w i n solution for utility and customer. It lets the utility retain customers without competitive threat while gaining practical experience in serving customers in a market-simulated pricing environment. There is even an up side for the utility to the extent that RTP makes electricity supplied by the utility more competitive against other regions or against other fuels.

F or the customer, RTP has several positive benefits. It

offers customers access to substantially lower prices and greater clarity in pricing signals. Because RTP's market-simulated prices are supplied within the franchised regulatory system, the customer's supplier risk is lower than in a competitive system.

However, there are potential down sides to RTR For the utili~, there is the possibility of profit erosion if revenues decline without a corresponding reduction in cost. A potential down side for the customer is that RTP, however closely it attempts to capture in-


cremental costs, is not a pure mar-

ket price. As a result, RTP does

not provide the same level of

price discovery or choice available in a fully competitive market.

2. RTP Customer Implementa-

tion Issues. Customers exploring RTP should be aware that it does require an exponential increase in

the customer's level of buying so- phlsrication. In practical terms, RTP means a customer will receive up to 8,760 different price signals during a year. These signals may be received at any time from one hour ahead to a day ahead.

T his type of hourly pricing

creates several challenges for the customer, the most obvious being the need to react effec-

tively to so many pricing signals.

But customers should not let this increased complexity become a barrier to adopting RTP, as it does

afford the opportuni ty--and incentive--to enhance their infor- marion management systems.

As part of their internal assessments, customers must conduct price risk assessments by facility--

ideally by end use---as well as for their entire business. This price-

risk assessment will define the value of operations against the cost of electricity to the lowest practical level. Even retail stores or continuous-processing industri-

als, both of whom tend to view themselves with rather fixed op- erational characteristics, may find physical or control solutions that can take advantage of RTE

This assessment process should also occur across facilities. Though traditionally RTP has not

been applied as a multiple-ac-

count pricing system, potential ex-

ists for this use. Many customers

have multiple locations within a utility's franchise or within a re- gion's control area. RTP offers

utilities and customers the oppor-

tunity to explore aggregation of energy loads that are delivered to

multiple locations. Another issue for customers is

RTP's inherent price volatility. The difference between the low

Customers exploring RTP should be aware that it does require an exponential increase in the customer's level of buying sophistication.

price and high price under RTP can be as much as a 50-100 times

magnitude (from I cent to $1 per kWh). Currently, most utility ap- plications of RTP offer no price- risk mitigation. Processes for defining and mitigating price risk are well established, however, and the commodities industry offers various forms of price-risk mitigation. However, most utili-

ties have never developed products to mitigate price risk, even though this could be a significant source of new revenue. The opportunity exists for utilities and customers to work together to define price-risk mitigation products

and develop appropriate prices

for the employment of these prod-

ucts. Finally, RTP can be a communi-

cation and billing nightmare, a precursor to market pricing of unbundled products. Most custom-

ers will have difficulty taking ac- tion on price signals that can vary

on an hourly basis. However, hourly pricing may become the most attractive price offering to customers seeking the lowest price available in the marketplace.

Hourly price signals also provide the information on price volatility that customers and suppliers need to define costs and create financial instruments that can miti-

gate the risk of price volatility.

C ustomers first need to iden- tify their system for deal-

ing with hourly pricing. The util-

ity can then adapt to the customer's system to enhance the customer's satisfaction. In addi- tion, customers will need access

to circuit pulse data to audit bills against loads, another opportu-

nity for the utility and the customer to jointly develop procedures that meet both parties' needs.

D. Unbundled, Competitive Service

Customers are highly moti-

vated to deregulate electricity so they can buy power from competi- rive suppliers at competitive

prices. But customers' experiences in other deregulated industries have created awareness of some potential disadvantages too.

One such concern is electricity billing in a competitive market.

March 1997 39

Customers with many plant or store locations will desire conjunc- tive billing with customized re- porting. Ideally, this enhanced billing will tie directly into the customer's own bill-auditing a n d electronic data interchange (EDI) accounts-payable system. How- ever, billing has been the great Achilles' heel in the competitive natural gas and telecommunica- tion industries.

Electricity bil ling could become a headache for customers buying unbundled services from numer-

ous suppliers for multiple locations. Customers could be faced with having to correlate, audit and process bills from multiple suppliers for aggregated strips of energ~ ancillary services, financial products and related energy services that cover combinations of the customer's facilities, all stretched over hourly pricing.

B illing-related issues are a key driver for many of the

customers preparing now for retail competition. They recognize the need to specify their own ac-

counts-payable expectations in more concrete detail and to begin evaluating suppliers" ability to im- plement billing systems that can handle increasing levels of billing complexi~.

Customers are also moving to better define their own purchasing processes. Traditionally, electricity purchasing has been a local function. The advent of retail competition will bring about national or regional electricity buys by customers with multiple locations, which most customers are not

There's often a way to meet the needs of one customer without blighting another.


now organized to take advantage of.

E xperience from the natural gas industry has taught

many customers hard lessons about national contracts and local service. Some customers have ex- perienced very real problems with national gas contracts that were not backed up with ade- quate local and back-office retail service operations. This produced considerable tension within the customer organizations and between local operations and corporate energy buyers.

Customers are taking several steps to better prepare to address this situation in a competitive retail electricity market. Many are developing cross-functional buying teams that include corporate and local participants. They are also attempting to more clearly define service specifications, in terms of both corporate price points and local service expectations. This process will be an on- going one, as buying team mem- bers sort out the trade-off between high reliability, customized service and price. The process will evolve as the competitive retail electricity market matures in terms of pricing for unbundled local service supplied through national contracts.

A final area of customer prepa- ration is contract negotiations. Re- tail electricity competition will introduce new business risks not found in today's monopoly structure. The traditional utility contract and regulatory structure is fairly efficient in allocating risk to the customer, counterbalancing

that risk with certainty of supply and supplier-credit integrity.

Competitive markets will allow for much broader negotiation between supplier and customer. From the customer's perspective, competition has the potential to shift risk from the customer to the supplier. But shifting risk to suppliers may increase the risk of supplier default, either on the overall contract or specific contract provisions. In competitive markets, cus-

tomers will face very real contract- default risks tied to potential supplier bankruptcy. Often, the only recourse with such defaults will be costly and time-consuming liti- gation.

M any customers have already begun negotiating

contracts with potential suppliers, providing an invaluable learning process. Customers are beginning to better understand the complexity of supply contract language, exploring incentive clauses for su-

perior supplier performance, craft- ing contract "exit ramps" and defining acceptable liability limits. These relatively unfamiliar con- cepts are putting suppliers and customers on a fairly steep learning curve. But those customers and suppliers already moving up this learning curve will certainly benefit as markets open and full competition arrives.

II. Conc lus ion

Retail competition is beginning toda~ even before being formally enacted into law, as it soon seems likely to be. Many customers are actively implementing the processes for selecting suppliers in anticipation of retail access, establishing buying parameters to define price and risk for individ- ual facilities and overall business units. They are exploring contractual terms and conditions to prepare themselves to take advantage of a complex, unbundled electricity market with numerous suppliers offering negotiated contracts.

Customers are also recognizing that there are transitional steps on the way to full retail competition. Alternative buying scenarios like buy-through and RTP offer customers lower prices and the opportunity to gain experience buying electricity in a more complex pricing environment without the full risk of a competitive market. These experiments in choice and market-simulated pricing offer existing suppliers the ability to learn the new skills they will require to be successful in a future competitive marketplace. •

March 1997 41

Documents

Defining the customer's buying parameters