07 Mar Structured Supply Arrangements; Fixed Fee or No Fixed Fee, That is the Question.
By Gianna Schiavone
Entering into a structured credit and supply arrangement or a preferred supply agreement (“PSA”) is a complex, heavy lift for a retailer and is not without a host of important decisions to make. As a retailer, you need to assess your risk tolerance in financing your business as much as you need to decide what kind of contracts to offer to customers and how to manage the price risks inherent in your business.
Given the last few years of relatively low power prices and low volatility, a financing arrangement such as a bank line of credit can easily look like the least-cost option; however in entering a financing arrangement or a PSA with costs that fluctuate with actual financing needs or capital commitments, you are exposed to other variables that are not always readily apparent. When power prices rise, your ISO collateral requirements rise and therefore you have to borrow more to serve the same customer base than you did previously. For example, in this last cold January, a typical retailer in PJM had to post roughly double the collateral to support the same load as they did last January, doubling their borrowing costs and therefore the cost per unit of commodity delivered due to financing (See figure 1).
Alternatively, a PSA could simply have fixed fees per MWhr which can look like expensive money in a low interest rate, low power price environment. However, that structure may be optimal if you are looking to minimize the risk of variable financing costs. Fixed fees can provide insurance from increased borrowing costs in higher price times, although may be higher cost of capital in low price environments. Further, a fixed fee PSA financing cost is easy to build into your cost of goods sold since it won’t fluctuate in any way with the energy markets.
Since many attractive PSAs still may charge you a cost of money based upon capital committed on your behalf by your supplier, all is not lost and there are things you can do to manage financing cost risk. You can buy physical power every day from a supplier in an index-plus price structure that matches your daily fluctuating needs; this would reduce what you buy from the ISO administered markets and therefore minimize ISO collateral calls. Although this provides some protection, it will never be perfect since ancillary services still need to be procured from the ISO and those are more difficult to supply physically from suppliers and those rates could spike alongside energy prices as they did in January—driving collateral requirements higher than expected. Further, buying physical power to meet daily fluctuating needs in addition to baseload needs will likely come with a premium associated with it that is difficult to assess as part of the plan for operating in a non fixed fee PSA or bank line versus a fixed fee PSA.
As stated, the fixed fee versus non fixed fee PSA or bank line structures have their relative benefits and which is a better fit for you depends on your risk tolerance and precise business needs. Either way, price spikes will likely give way to an increase in financing costs to retailers whether it is through increased energy rates in fixed fee PSAs or the cost of operating under a non fixed fee PSA or credit line. Our advice, be sure to stress your financial model and don’t just rely on the current state of affairs when deciding the best course of action for your business.
Gianna Schiavone is a Senior Analyst at GP Energy Management, LLC