Academic journal article Business Economics

Contracting for Power

Academic journal article Business Economics

Contracting for Power

Article excerpt

Contracts are economic documents as well as legal documents. They specify prices, quantities, quality, and schedules of delivery, and incorporate risk management strategies (see Goldberg, 1989, and McMillan, 1992). However, business economists often are not consulted in the drafting of contracts. As a result, the skills of economists are underutilized and the contract to buy or sell goods and services may overlook some important economic principles. This article will present some economic lessons about contracting, focusing on the management of the risks that contracts present. Our lessons are drawn from good contracts that protect both buyer and seller, from deficient contracts that resulted in the buyer or seller regretting the risks taken on, and from realistic and unrealistic expectations about market transactions expressed by potential buyers and sellers.

The specific types of contracts we review are those concerned with the purchase and sale of electricity, although many of our lessons are of general application. Electricity contracts are rapidly evolving, and it is likely that buyers and sellers will make economic mistakes because there is little experience with these types of contracts. Historically, businesses had one choice in purchasing electricity - buy from the local monopoly utility. However, as we shall explain below, the choices are increasing and businesses have to make economic decisions that could be worth millions of dollars per year.


Instead of having one choice, commercial and industrial consumers of electricity now face an increasing array of power purchase possibilities. They are of two types. First are distributed energy services provided at the consumer's site. Examples are:

1. Generating some or all of your own electricity (self-generation). The industries in which this is most common include the manufacture of paper and wood products, chemical manufacturing, petroleum refining, and mining. One technique that is widely used is cogeneration, defined as the sequential use of energy to produce both electricity and steam or other useful forms of energy such as heat. For example, a business may generate electricity using a steam generator or combustion turbine and use the waste heat or steam from this process to provide heat or steam for the manufacturing process.

2. Conserving energy. A business demands lighting, space cooling, torque, etc. Electricity and energy efficiency are partial substitutes for each other in providing these services, and many businesses have found that more efficient lighting, more efficient chillers, more efficient motors, etc. are cheaper at delivering the desired service than using less efficient measures and more electricity.

Second is direct access, which would allow consumers to shop around among multiple (off-site) generators of electricity, such as independent power producers and utilities in other areas.

Many industrial consumers of electricity advocate a competitive market in place of the traditional regulated electric monopoly to get lower prices. Events are unfolding that may make that wish come true, at least partially.

The California Public Utilities Commission has been active in considering direct access, and many other state utility regulatory commissions are investigating whether and how to carry out direct access. In May 1995, the California Commission issued a proposed policy decision that could allow bilateral contracts between consumers and sellers in a competitive market in 1999. Michigan authorized limited direct access in the future when the affected utilities need to add more generating capacity. In general, there is interest in direct access in many states, and policy may change to allow limited or unlimited direct access.

A variant on direct access is the case where the local utility acts as an agent for the consumer in shopping around for electricity. …

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