An Antidote to Energy Sticker Shock: Online Auctions

A larger share of energy buyers in 2013 are seeing something they likely haven’t seen for some time: higher prices when they go to renew their contracts.

While American energy abundance – a development fueled by the shale oil and natural gas boom – initially helped drive down power and natural gas prices to historic lows in many regions, rates have recently been creeping back up. Case in point: the first quarter of 2013 was the first since Q3 2008 that buyers evaluating prices for a 12 month supply contract have seen dramatic year-over-year price increases. In the second quarter of this year the trend was even more marked.

Note the red bar chart below; it displays the percent change of the average 12 month forward contract for the period compared to the 12 months prior. The blue chart shows those historical price trends on a quarterly average basis. As you can see by the swing of the red bars, energy buyers in Q1 2013 would likely have seen over 25% higher prices than when they last shopped in Q1 2012, with Q2 2013 up more than 40% annually.

These changes have big implications on energy buying today. While it may have been easy for a broker to demonstrate year over year savings on energy costs during a period of declining commodity prices, it’s a whole new ball game in 2013. In this more challenging energy pricing environment, companies need to focus on how they buy energy. In this environment, it will be critical for energy managers to ensure they have a defensible sourcing process, something I can categorically say online energy auctions provide.

We recently ran an energy procurement for a manufacturer that had last contracted during the market lows mentioned above. The company fully expected to pay more per kWh this time than last, and in fact solicited our services for that very reason – citing the need for more expertise, more supplier liquidity, and better price discovery than what their prior paper processes had delivered.

The results from this set of auctions were surprising. Even though wholesale electricity prices had risen, with more suppliers in the mix, bidding activity drove down the winning price below their prior rate. And in a subsequent auction, one of the suppliers that had lost the tranche for a traditional “brown” power product lowered their rate even further, beating that winning price while also offering 10% green power “for free.”

One casualty of this process? The incumbent supplier. Despite having offered their “lowest price” in advance of the auction in an attempt to keep the business, the incumbent found their best offer in the auction didn’t finish in the top three. This was an eye-opener for the customer.

As an economics major and MBA, I have several books on auction design lining my bookshelves and have spent hours on the phone with leading auction authorities from Oxford, England to Washington, D.C. I love auctions because of the compelling competitive dynamic they foster and unique economic moment they deliver. Not surprisingly, I can wax on for hours about their design. But for now, following are a few insights I can offer, gleaned from 10+ years conducting 40,000+ online pricing events, about why a well-architected and properly-run online energy auction is superior to the paper-based processes used by the majority of aggregators, brokers, consultants and in-house procurement teams in the US today:

Apples-to-apples comparison. With an online event or auction, the customer fixes the parameters that suppliers must bid on. They can’t bid a different product or parameter. With paper-based RFPs, a supplier will often bid its own product or terms, making apples-to-apples comparison difficult.

Expanding the supplier pool. With an online event or auction, the difference in effort between letting two or 20 suppliers bid on an RFP is nominal; there is no cost to adding another supplier. Experience shows that the more suppliers, the better the competition and the lower the price. On the other hand, each paper RFP requires labor to evaluate. More often than not, a consultant will send the paper RFP to a few suppliers to get a good enough price. In an online procurement, all qualified suppliers are invited in an effort to secure an even better price.

Auction design. Auctions come in many flavors, including forward (where prices are bid up), reverse (where prices are bid down), sealed bid (where prices are not disclosed to the bidders) and multiple to multiple (where both price and terms are part of the bid). At World Energy, we can leverage them all and match the right kind with the customer’s particular circumstances, often relying on an “Anglo-Dutch” reverse-auction approach which is designed to get suppliers to give their best price. The Anglo feature of this type of auction provides suppliers visibility into competitive bids, and the Dutch feature causes suppliers to put a best and final offer in (the poker equivalent of going all in) as the seconds tick down at the end of the auction. Twenty percent of the time, the then-leading supplier outbids itself to win the business, transferring the margin from the supplier to the customer.

One event, many auctions. In an online procurement event, it is possible – even preferable – to run multiple auctions for the customer, testing different terms, products and pricing structures. This segmentation provides energy buyers live information on where prices are settling, enabling them to choose the price and parameters that best meet their risk tolerances and sustainability objectives.

Auction sequence. Because auctions can be run in immediate succession, testing the various parameters, suppliers can quickly react to a loss, sharpening their pencils to win the next round, as illustrated in my prior manufacturer example. The dynamic nature of an online procurement process helps suppliers get the real-time feedback they need to more aggressively pursue the customer’s business, something missing from paper-based procurements.

Closing in real time. Because the underlying commodity in energy is volatile, the amount of time it takes between accepting a supplier’s winning bid and signing the contract ultimately affects the rate. If the anticipated closing period is long, the supplier will typically add a risk premium to protect its position. By running an online, real-time event, where transactions can be contracted in as little as an hour, risk premiums can be lowered, further benefiting the buyer’s final rate.

Audit trail. Automation clearly has its benefits. Along with driving competition, an online procurement process can capture, catalog, and time stamp all bidding activity, providing organizations with a thorough audit trail of their energy procurement.

Now, a traditional consultant may counter that what matters most in energy procurement is market expertise and relationships. Of course those are key elements for success. In our world of online auctions, they are a given, with auctions serving as a powerful tool in the hands of a master mechanic.

Simply put, when energy suppliers compete for your business, you win, and no procurement process comes close to creating the supplier liquidity and competitive dynamics of the online auction. In a rising energy market, this is one advantage you won’t want to leave on the shelf.

Phil Adams is chief executive officer of World Energy Solutions, Inc. (www.worldenergy.com; NASDAQ: XWES), a leading energy management services firm headquartered in Worcester, Mass., and a leading authority on energy auction design and execution. Phil can be reached at [email protected]or 508-459-8100.