Electricity Procurement Contracts: Fixed, Index, and Hybrid Structures

Load Serving Entities (LSEs), Retail Electric Providers (REPs), and large Commercial & Industrial (C&I) customers use various contract structures to purchase electricity, balancing the need for price certainty with the potential for cost savings by taking on market risk.

Common Electricity Supply Contract Types

Here's a breakdown of frequently used contract structures:

Contract Structure Pricing Mechanism Typical Use Cases & Risk Profile
Fixed Price Contract A single, locked-in price per unit of energy (e.g., ¢/kWh or $/MWh) for the entire contract term. May apply to all usage or a defined volume.
  • Use Cases: Common for residential customers, small businesses, and larger consumers seeking budget certainty.
  • Risk Profile: Supplier bears the market price risk. Customer gains price stability but may pay a premium for this certainty and misses out if market prices fall significantly below the fixed rate.
Index-Based (Floating) Price Contract Price is directly tied to a published wholesale market index (e.g., Day-Ahead LMP, Real-Time LMP at a specific hub or zone) plus a fixed adder or fee covering supplier margin, risk premium, and potentially other costs.
  • Use Cases: Sophisticated C&I consumers who can manage price volatility or have operations that can respond to price signals.
  • Risk Profile: Customer bears the full market price risk (both upside and downside). Benefits from low market prices but is exposed to price spikes. Often paired with separate financial hedges.
Block + Index Contract A hybrid approach. A predefined volume ("block") of energy, often shaped to match expected baseload usage (e.g., 5 MW during peak hours), is purchased at a fixed price. Any usage above or below the block volume settles at an index price (plus adder).
  • Use Cases: C&I consumers seeking a balance between budget certainty and market participation. Allows hedging of core load while retaining exposure (and potential savings) on variable usage.
  • Risk Profile: Risk is shared. Supplier covers the fixed block; customer manages exposure on the indexed portion. Blocks can be customized (e.g., peak vs. off-peak). Requires accurate load forecasting to size blocks effectively.
Heat Rate-Based Contract Electricity price is calculated based on a natural gas price index multiplied by an agreed-upon "heat rate" (a measure of generator efficiency, in BTU/kWh or MMBtu/MWh), plus potentially a fixed adder. Formula: Price ≈ (Gas Index Price × Contract Heat Rate) + Adder.
  • Use Cases: Wholesale bilateral transactions, tolling agreements, C&I consumers whose costs or revenues correlate with gas prices.
  • Risk Profile: Effectively locks in a generation efficiency or "spark spread" rather than an absolute power price. Supplier (often a generator) transfers fuel price risk to the buyer. Buyer's power cost fluctuates directly with the gas market.
Load Following / Full Requirements Contract Supplier provides all the customer's electricity needs, whatever the volume, at a fixed price per unit (¢/kWh or $/MWh).
  • Use Cases: Often used in default service auctions for utilities or for customers who want simplicity but have variable load.
  • Risk Profile: Customer gets price certainty per unit, but supplier bears both price risk and volume risk (uncertainty of customer's total usage). Supplier typically includes a significant risk premium in the price.

The choice of contract depends heavily on the customer's risk tolerance, ability to manage exposure, load profile characteristics, and market outlook.

Physical vs. Financial Settlement

Contracts can be settled in two main ways:

Financial settlement simplifies transactions by avoiding physical scheduling complexities but requires trust that the chosen reference index accurately reflects the buyer's actual energy cost exposure.

Role of Brokers in Procurement

Energy brokers play a significant role, especially for C&I customers:

Brokers typically earn a commission (often included in the supplier's adder) or a flat fee for their services.

Further Reading:

  • Retail electricity provider websites often detail their standard C&I product offerings.
  • Consultant and broker websites often have educational materials on procurement strategies.
  • ISO/RTO training materials may cover how different contract types interact with market settlements.