Identifying Risks in Energy Contracts

November 30, 2020

The number of energy options available to businesses and consumers expanded dramatically over the last several decades, but those new options also created new risks. Energy contract provisions can limit those risks, but market participants must know where to look.

Credit, Billing, and Renewal Clauses are Key Factors

The first set of risks in energy contracts includes factors that can affect the base level of fees charged, such as credit, billing, and renewal. Customers with better credit quality may be able to secure lower charges. On the other hand, suppliers may require upfront payments from most potential clients. Credit may also affect which billing options are available. Furthermore, choosing consolidated or separate billing from suppliers can also impact the overall cost of energy contracts.

Renewal language in the contracts may create significant risks in some cases. From the customer's point of view, the option to renew at current prices would be ideal. However, an auto-renewal at substantially higher rates that must be canceled months in advance is highly undesirable.

Adjustable Charges Can Pose Risks

Adjustable charges are another area to investigate, especially in fixed-price energy contracts. Although the price of energy itself is constant in fixed-price contracts, capacity and transmission charges may vary in some cases. These charges, which are also known as tags, can account for a significant fraction of energy expenditures in some cases. Fixed-price energy contracts can also fix one or both of capacity and transmission charges but reducing these risks costs money.

Cancellation and Termination Optionality is Vital

The language regarding the cancellation or termination of services is another vital area for managing energy contract risks. If a customer wants to end the contract, there will typically be some type of termination fee. The size of this fee is one of the most decisive factors in the customer's ability to switch suppliers.

On the other hand, the energy contract may also be terminated by the supplier in some cases. Typical reasons include changes in the market, regulations, or the customer's usage pattern. The supplier can cancel some contracts if the customer uses either too much or too little energy, so it is essential to evaluate these terms.

Protections for Suppliers

There are also other protections for suppliers in energy contracts. Rather than outright cancellation, the contract may call for higher fees or renegotiation if there is a material deviation in the customer's long-term energy consumption. Another set of clauses in energy contracts exist to deal with short-term fluctuations in energy usage. Customers may have to pay current market prices during extreme weather conditions, depending on the terms of the energy contract.

Finally, suppliers may attempt to limit their own liability to some preset amount if they choose to terminate the agreement or cannot deliver service for some other reason. A typical strategy is to try and limit their liability to the customer's largest monthly bill during the last year. In some cases, disruptions, and the need to secure energy from other suppliers can be much more expensive for customers.

The Ability to Modify the Agreement

Given that suppliers often have the right to impose charges or even cancel the contract when energy use changes, the customer's ability to alter the agreement is crucial. Most obviously, customers may want to expand or reduce their energy usage. The ability to do this within the energy contract at reasonable prices is far better than being locked in at punitively high rates or facing automatic termination.

Another change that may help some customers is the ability to assign the contract to another party. For example, a firm might sell a particular factory to another company, eliminating their own need for that factory's associated energy contract. If the agreement can be assigned to the factory's new owners instead of being terminated, then the firm can avoid termination fees.

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