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. Retailers need to assess their risk tolerance in financing their business as much as they need to decide what kind of contracts to offer to customers and how to manage the price risks inherent in their 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, when entering a financing arrangement or a PSA with fluctuating costs with actual financing needs or capital commitments, you can be exposed to unclear variables. GP Energy Management, an outsourced trading and risk management desk, specializes in providing transparency into these opaque areas.
When power prices rise, your ISO collateral requirements increase, requiring you to borrow more in order to serve the same customer base than you did previously. For example, during January’s cold front, a typical retailer in PJM had to post roughly double the collateral to support the same load as they did in January 2017. This doubled 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 megawatt hour (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 will not 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 ultimately could 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. They are more difficult to physically supply from suppliers and the rates could spike alongside energy prices as they did in January, which drove 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 each have their relative benefits. To decipher what route would be a better fit for you depends on your risk tolerance and precise business needs. Either way, price spikes will likely give way to a rise 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. GP Energy Management’s advice is to be sure to stress your financial model and do not just rely on the current state of affairs while deciding the best course of action for your business.
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GP Energy Management, a wholly-owned subsidiary of Genscape, Inc., is a registered commodity trading advisor (CTA) with the Commodity Futures Trading Commission and is a member of the National Futures Association. GP Energy Management provides a wide range of energy services, including energy management, consulting, and commodity risk and operations support, to its customers.