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Contract Terms in a New Financial Climate
In past issues of Energy Insights, we’ve discussed the state of the global financial markets and how credit is much harder to secure in the quantities in which it was previously available and readily flowing. In this issue, we explore how energy suppliers post capital on behalf of their customers and how the terms on energy contracts have changed in response to tighter capital markets.
As a result of the high risk involved with operating in today’s fragile markets, lenders and those entities who post capital on behalf of third parties may act more prudently to reduce their risk exposure and accommodate for the increased cost of lending or extending credit. This has translated to shorter fixed-price contracts for customers.
What’s at Risk?
When a customer buys a fixed-price contract from an energy supplier, like Direct Energy Business, the supplier makes a commitment to its counterparties in the wholesale market on the customer’s behalf for the required load at the agreed-upon fixed price for the length of the contract. The energy supplier is then responsible for posting collateral to its wholesale counterparties to cover the difference (drop) in price—or price stress—if market rates drop lower than the contract price after a commitment is made. Collateral must be posted equal to the price differential, multiplied by the usage (kWh) for the remainder of the contract—and price stress can occur at any time during a contract term for any volume of energy. At the start of a contract—when there are many months of hedged energy that are subject to price stress—a supplier has increased risk exposure, though price stress is transparent to customers who are locked into a rate with their supplier.
When a customer buys a fixed-price contract from an energy supplier, like Direct Energy Business, the supplier makes a commitment to its counterparties in the wholesale market on the customer’s behalf for the required load at the agreed-upon fixed price for the length of the contract. The energy supplier is then responsible for posting collateral to its wholesale counterparties to cover the difference (drop) in price—or price stress—if market rates drop lower than the contract price after a commitment is made. Collateral must be posted equal to the price differential, multiplied by the usage (kWh) for the remainder of the contract—and price stress can occur at any time during a contract term for any volume of energy. At the start of a contract—when there are many months of hedged energy that are subject to price stress—a supplier has increased risk exposure, though price stress is transparent to customers who are locked into a rate with their supplier.
For example, if a customer locks in at 5 cents per kWh for 3 years and their usage is 1,000 kWh per month, their cost per month will be $5,000. If the market price of energy drops to 3 cents per kWh during the second month of the contract however, the energy supplier is responsible for posting collateral to its wholesale counterparty to cover the 2-cent difference multiplied by the usage remaining on the contract (34,000 kWh)—which can necessitate posting a lot of capital ($68,000), especially with many months remaining on a given contract.
Energy service providers also assume a level of risk when entering into a contract with a customer because, like any other borrowing scenario, default by a customer is always possible. Once a contract is secured between an energy supplier and its counterparties in the wholesale market, the energy supplier is ultimately responsible for paying on it for the length of the contract, no matter what happens on the customer’s end. By entering into such contracts, energy service providers extend credit in the form of secured, fixed-price energy to customers. Therefore, if a customer defaults on an energy contract for any reason, the supplier is again exposed to risk because the commitment to purchase the energy has been made and the supplier must fulfill it on behalf of the customer. A default early-on in a contract exposes a supplier to an even higher risk due to the fact that the supplier will then have to sell back the remaining months/quantity of hedged energy left on the contract and assume any losses associated with price stress at the time of resale, in addition to any losses from unpaid receivables on that contract.
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The amount of risk assumed by a supplier in any fixed-price contract is directly affected by the length of the term, the volume of the energy purchase for the term, market prices and fluctuations once the commitment to purchase energy is made, and the credit status/chance of default of the customer. Energy suppliers, like other lenders and creditors, must manage the risk around contract terms more prudently than ever before within the operating standards of today’s financial markets. And, energy suppliers are certainly in no position to be more aggressive lenders than financial institutions, for whom lending is their primary business.
The need for tighter standards has resulted in shorter loan/contract length and less-competitive fixed rates than may have been previously offered, in short due to the higher cost of capital. Since capital costs more today than it ever has, extending it over longer contract terms has become price-prohibitive. This is not unlike the changes that have been seen in the banking/lending and real estate markets whereby the cost to borrow has gone up, the available credit has decreased and the repayment terms have shortened leaving borrowers with less money to work with, higher interest rates and accelerated repayment schedules.
This change in business practices is not necessarily related to the credibility or integrity of the customer/borrower, supplier or the lender, but rather it is more a sign of the times. As a result of the global financial crisis, it has now become mandatory for lenders/creditors to move from “lenient” to “extremely cautious” when it comes to extending credit and managing risk. And, businesses who offer deals that sound too good to be true around credit, loans or contract terms, could be setting themselves up for losses that they are unable to recoup, given the current risks involved.
Analysts predict that at some point in the future, when the economy improves, businesses, lending institutions and the like may well again be able to offer more favorable terms than they are currently. However, like many industries that have felt the pain of hitting the bottom or moving through a major crisis, many believe that credit markets will not be able to bounce back to the glory days of the 1990s when credit was freely flowing at low lending rates over lengthened payback terms. This is therefore an area for customers to understand and manage as another factor in their energy purchasing decisions.
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