Electricity Supply Markets: Understanding Contracting Methods and Best Practices in Bidding

In today’s energy landscape, striking a balance between efficiency, sustainability, and competitive pricing is imperative. The growing global demand for energy requires businesses, organizations, and governments to ensure a reliable, environmentally sound, and financially viable supply.

In this context, electricity supply contracts become a fundamental tool for navigating the complexities of the energy market. These contracting processes allow companies and organizations to secure the energy supply they need at competitive and stable prices, while simultaneously promoting efficiency, transparency, and innovation in the sector.

This article reviews the fundamental elements that give rise to electricity supply contract markets , addresses the basic characteristics of the main contracting methods, and offers a list of best practice recommendations for electricity supply tenders.

The Contract Markets

While theoretically the wholesale electricity market could operate solely on the spot market (where generators sell all their energy and power and consumers buy all their short-term needs), for both consumers and generators, it is advantageous to establish contracts that, while preserving the economic efficiency of the spot market, facilitate:

Stabilization in transaction prices
Coverage of the average costs of future power generation plants
Risk management between counterparties

Generators selling on the spot market seek to hedge against short-term fluctuations in the spot price, while buyers have a similar but opposite exposure, thus creating a natural hedge against the risks of both parties.

Even in the presence of a well-organized spot market, financial institutions prefer that a generation project have an identifiable buyer with sufficient financial backing to ensure the project’s expected revenues.

By fixing prices for a longer period, the revenues and costs of sellers and buyers become more predictable, facilitating investment decisions for both parties. Furthermore, this contracting mechanism reduces any incentive for price manipulation in the spot market that might exist by the generator in the absence of clear market rules.

This is why these types of contract transactions are prevalent in liberalized markets. Contracts protect market participants from spot market price volatility and serve as a hedging mechanism against price, volume, regulatory, credit, and other risks.

In general, two basic types of transactions can be distinguished in electricity contract markets:

Financial Contracts: These do not affect the scheduling of power generation plants, as their primary purpose is to hedge against future energy price fluctuations. They are settled between the parties involved, and their energy and capacity are withdrawn from the spot market, transforming it into a market for settling deviations from commitments made in the contracts market. This type of transaction is the most common in liberalized markets.
Physical Contracts: The supplier guarantees the origin of the energy injection committed to in the contract by modifying the dispatch schedule of the generation plants. The viability of these contracts is determined by the system operator. This type of transaction is rare and increasingly less common in competitive electricity markets.

These transactions can be carried out using two different contracting methods. Each has its advantages and disadvantages, making one or the other more suitable depending on the characteristics of the supply.

Bilateral negotiation: Direct negotiation between two or more parties.
Tenders: Competitive processes where companies or entities buy or sell energy through bids.

Bilateral Negotiation vs. Tenders

The choice between bilateral negotiation and bidding processes for purchasing electricity depends on several factors, such as the specific characteristics of the supply and the market, and the particular needs of each company or entity. The main factors to consider when choosing one method over the other are summarized below.

Bilateral Negotiation

Bilateral negotiation is characterized by facilitating the development of long-term relationships between the parties, based on trust and collaboration . This type of contract allows for greater flexibility in adapting agreements to the specific needs of each party. In a constantly evolving energy market, where conditions and prices can fluctuate considerably, this flexibility is crucial.

The parties can negotiate customized contractual terms, including prices, volumes, delivery times, payment terms, and other relevant aspects. This flexibility facilitates innovation and the creation of tailored solutions that meet the needs of both parties.

Bilateral negotiation can be a more efficient process than bidding mechanisms , as it does not require the preparation of complex tender documents or participation in lengthy and costly evaluation processes. Furthermore, it allows for cost reductions for both parties by eliminating the need for intermediaries and optimizing the management of the energy purchase and sale process.

Finally, bilateral negotiation offers a greater degree of confidentiality, as the parties can keep sensitive business information private. This allows them greater control over the security of the negotiation process and the protection of their strategic business information.

It is important to note that bilateral negotiations are not without risks. In this type of arrangement, careful selection of business partners with a proven track record of reliability and contractual compliance is crucial to minimizing counterparty risks and ensuring the success and security of long-term agreements.

Public Tenders

Public tenders for electricity supply have become a fundamental procurement method in modern energy markets. Based on competition, these tenders allow distribution companies to acquire the energy needed to meet the demand of their regulated customers, ensuring a transparent and efficient process that benefits both consumers and suppliers.

Key functions:

1. Risk reduction:

Price stabilization: Tenders protect distribution companies from short-term spot market price fluctuations, ensuring a stable electricity price for consumers. For example, spot market prices can experience significant volatility due to weather phenomena such as El Niño or La Niña, temperature increases or decreases, changes in the fuel market, the accidental or planned entry and exit of generation units, and increases or decreases in electricity demand, among other factors. With long-term contracts, these risks are absorbed by the supplier.
Performance guarantees: Tenders mitigate the risk of supplier default by requiring additional contractual guarantees beyond those typically offered in wholesale markets. These guarantees may include bank guarantees or letters of credit.
Investment certainty: Bidding processes reduce the risk of financing investments in power generation plants by providing suppliers with greater security and certainty regarding their future revenues. This can stimulate investment in innovation and new sources of generation.

2. Security of supply:

Reliable supply: Tenders ensure the security of electricity supply by guaranteeing that suppliers have the capacity to meet their contractual obligations. This is especially important to ensure supply during periods of high demand.
Diversification of sources: Tenders promote the diversification of supply sources, reducing dependence on a single supplier. This contributes to increased security of supply.

3. Transparency in the market:

Competitive price formation: Tenders facilitate competitive price formation by establishing an environment where multiple suppliers compete to provide the required energy. This competitive process fosters efficiency and price optimization, as suppliers are motivated to offer the best possible deals.
Public information: Tenders reveal relevant information about the supply and demand of electricity in the market, including details about participants, quantities offered, proposed prices, and other key aspects of the procurement process. This information can be used by market participants to make informed decisions about their investments and strategies.

While electricity supply tenders offer numerous benefits to the parties involved, they are not without risks. In this type of process, it is crucial to avoid any practices that could limit the participation of stakeholders, as this could undermine genuine competition among suppliers and ultimately affect the quality of the expected supply, leading to less favorable contract prices.

Best Practices in Electricity Supply Tenders

Electricity supply tenders are a complex process requiring careful planning and efficient execution. To ensure a successful outcome, it is essential to follow a series of best practices that guarantee access to reliable, efficient energy at the best possible price. These best practices include:

1. Transparent, competitive and efficient processes:

Publication of clear, complete and non-discriminatory terms and conditions: The tender terms and conditions must be clear, complete, non-discriminatory and provide bidders with all the information necessary to prepare their bids.
Promote the participation of the widest possible spectrum of suppliers, including companies of different scales, as well as agents from the renewable and non-renewable sectors.
Accurate and accessible information: The information must be accurate, up-to-date, and available in a format accessible to all interested parties.
Reasonable deadlines: The tender specifications must be published well in advance to allow bidders time to prepare their bids.
Question and clarification system: A system must be established so that potential suppliers can ask questions and obtain clarifications about the tender documents.
Impartial and objective evaluation: An impartial and objective evaluation of the bids must be guaranteed.
Evaluation criteria: The tender specifications must include all relevant information for the tender, such as the technical specifications of the supply, the technical and economic criteria for evaluating the bids and the contractual conditions.
Impartial expert committee: The process must be led by an impartial expert committee with no personal interest in the outcome of the bidding process. This committee will be responsible for the technical evaluation of the bidders.
Request for additional information: If necessary, the terms and conditions should stipulate that additional information may be requested from suppliers to clarify or expand upon the information contained in their bids.
Electronic platforms: The use of electronic platforms is always recommended for monitoring the bidding process, and for the economic evaluation and awarding of bids.

2. Guarantees for the fulfillment of contractual obligations:

Technical qualifications and experience: The technical qualifications and extensive experience of the suppliers are key to ensuring compliance with contractual obligations if awarded the contract.
Sufficiency of guarantees: The guarantees must be sufficient to cover any potential damages that may arise from a breach of contract.

3. Dispute resolution mechanism:

Establishment of a clear mechanism: A clear and transparent mechanism must be established to resolve any disputes that may arise during the bidding process.

Conclusions

In today’s complex energy landscape, electricity supply contracts have emerged as a fundamental pillar for ensuring a balance between efficiency, sustainability, and economic competitiveness. This practice not only guarantees a reliable and environmentally responsible supply but also promotes financial stability for both suppliers and consumers. Whether through financial contracts that stabilize prices or physical contracts, the different contracting methods offer solutions tailored to the needs and characteristics of the energy market in which they operate and the electricity demand.

The choice between bilateral negotiation and public tenders for electricity procurement depends on several key factors, ranging from flexibility and confidentiality to transparency and market competition. While bilateral negotiation fosters long-term relationships based on trust and adaptability, public tenders guarantee a transparent and competitive process that benefits both consumers and suppliers. However, it is crucial to recognize that each approach carries its own risks, from limiting the number of participants in tenders to requiring a rigorous evaluation process.

To ensure success in electricity supply tenders, it is essential to follow a series of best practices that promote transparency, efficiency, and compliance with contractual obligations. These practices range from publishing clear and non-discriminatory tender specifications to guaranteeing the technical qualifications and experience of suppliers. By establishing clear dispute resolution mechanisms and promoting fair competition among participants, reliable, efficient, and affordable access to electricity can be ensured, thus contributing to a more robust and sustainable energy market.

If you didn’t have the opportunity to read the previous article entitled ” The Power of Electricity Supply Contracts (PPAs) in the Energy Transition “, I encourage you to do so by visiting the following link:

https://www.linkedin.com/pulse/el-poder-de-los-contratos-suministro-electricidad-ppas-diaz-cohen/

References

New Chilean Law on Electricity Supply Tenders for Regulated Customers: A Success Story.