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Electricity and natural gas are likely the most volatile commodities anyone will ever procure for an organization. Electricity and natural gas price volatility is very apparent when compared to other commodities such as gasoline and the S&P500. Not surprisingly, attempting to purchase energy through a bid or RFP is like playing "Pin the Tail on the Donkey." However, in addition to your being blindfolded, the donkey is also running around the room! Such is how many public procurement professionals feel when tasked with addressing their jurisdiction's energy needs for electricity or natural gas contracts.

As more states deregulate their electricity and natural gas supply, opportunities and challenges increase to control these costs. For the typical jurisdiction, energy accounts for a very large percentage of the overall budget. Energy efficiency is one way to reduce spending on electricity and natural gas. However, the first and foremost method to control energy spend is to focus on the actual cost of the commodity itself. Therefore, the purchasing professional has a huge role to play in controlling and managing the energy budget for his or her jurisdiction.

Make a plan

Energy's volatility makes it crucial that there be a sound plan in place to address how and when to purchase this commodity. The first step in designing a comprehensive energy procurement plan is to understand a jurisdiction's cost exposure and risk tolerance. A starting point is to look at the current contract. Understand how it is structured and how the price affects the organization. For example, you will want to understand whether the price is fixed, meaning you pay this price regardless of market conditions, or if it is an index price that is tied to a moving published index.

Many governmental entities need the budget certainty that only a fixed price contract can deliver. However, these discussions should be held with the entire stakeholder team so that other types of contract structures are understood. If the governing body determines that contracting a certain portion of its energy usage on an index basis will deliver significant savings without jeopardizing the overall budget, then further analysis of such an approach may be warranted.

The second step is to actually develop the procurement plan based on the agreed-upon approach from step one. This initial development is done with the understanding that any plan must have a feedback loop and be structured so that the plan can change constantly and adapt to growing needs in the jurisdiction. All the stakeholders should sign off on the plan, including purchasing, facilities, finance, real estate and others. Only when a plan is agreed upon should you move forward to the next step.

Step three is actually implementing the plan. This is when you will achieve extremely important feedback that should contribute to the continual assessment of the energy procurement plan itself. Implementation means to use the developed strategy to go into the marketplace and procure power needs, resulting in an actual contract with a supplier of electricity or natural gas. Most governmental entities either go through some type of competitive solicitation process or use a pre-procured intergovernmental cooperative contract. Any procurement process must be in sync with the state's applicable procurement laws. As with any other purchase, it is important to maximize efficiencies and effectiveness. There are three key factors a purchasing professional must rely upon to implement an energy procurement plan. The factors are market intelligence, understanding the right price and knowing how to interpret the underlying data.

Market intelligence

To procure and negotiate a contract for energy requires a thorough understanding of the market factors that determine the price and dictate how that price has moved and will move over time. We have already seen that electricity and natural gas are two of the most volatile commodities to procure. The price that a jurisdiction will pay for electricity can change dramatically from one day to another and from one hour to the next. In times of high volatility, a purchasing manager may be prepared to sign a contract at noon, but by the time he or she sends in the signed contract at 3 p.m., the price may have increased. Understanding market dynamics also increases the probability that a price is contracted during a favorable window in the market; that is, when underlying wholesale costs are low, thus leading to a good contract price.

Energy commodities such as electricity and natural gas are first purchased by suppliers on the wholesale market, then sold to actual end-users of the power. If you understand how the wholesale price is determined, you stand a much better chance of negotiating the best rate. It's like going to a car dealership to negotiate the price of a new car. If you know the price the dealer paid for the car, you are better able to determine if you are paying a fair price to buy it. Without this knowledge, you can only spend more time comparing prices from multiple dealers, and in the end you have only determined that you are paying the best price among those three or four dealers.

The same is true with electricity. Even if a competitive bid or RFP is issued, you are only making your decision based on prices from those bidders that chose to respond. You do not know if any of those bidders has really offered a price in accordance with the underlying wholesale costs. So the question arises, "How does someone gain access to this wholesale market information?" True intelligence only comes from direct involvement in the wholesale markets where the institutional players do transactions. Power generators, suppliers, banks and hedge funds are a few of the players that are constantly buying and selling power on the wholesale market. These transactions are the basis for determining the price of wholesale power. There are published indexes that display a small portion of wholesale transactions; however, the majority are done independently of published indexes and are consummated by wholesale brokerage firms.