This past week, one of our subscribers wanted to know if online auctions actually save money over the typical paper RFP process most entities conduct for energy procurement. Reverse online auctions have been popular for several years, with the most notable being municipal bond auctions. The early acceptance by the governmental community may explain why some local municipalities aggregating residential electricity accounts and governmental organizations have adopted the technology readily, while many others have been monitoring these activities. However, with rising commodity prices and outstanding savings levels published by auction providers, auctions warrant some investigation. Are savings being overstated? Is third party energy a commodity that is an equivalent product across all suppliers, thereby making it a good fit for online reverse auctions? Or is there some hybrid process that is the best of both the paper RFP and online reverse auction worlds? What are the nuances and caveats of which you should be aware if you put your toe in the auction pool?
What are Reverse Auctions?
In most auctions, buyers bid up the price of the object being sold. The auctioneers control the process and they (and the sellers) make more money the higher the ultimate selling price. In a reverse auction the roles are reversed in that the suppliers compete by bidding down the price in the hope of securing the sale. The suppliers know the margin they need to make the contract worth their while, and if there are enough suppliers in the mix, the price should be driven down towards the marginal cost of the hungriest suppliers. This is how many municipal bonds are now issued.
Do they save more than the Paper RFP?
In the paper RFP process, suppliers get one chance to offer an attractive price. As suppliers don’t want to “leave money on the table,” they guess what others will be bidding and they adjust their bids accordingly. They try to maximize their profits, while hopefully still offering a price that is competitive enough to get the contract. In an online reverse auction the initial bid prices are usually abnormally high as suppliers test the competitive environment. It is from these initial inflated prices that savings are often calculated and professed. However, if sufficient competition is generated during the auction process, then energy prices are continually bid down as suppliers adjust their margins to secure your business. In an open auction with full information available, the lowest price should be just below the marginal cost of the second lowest bidder.
Extracting more from the suppliers
The open bid process only gets prices down so far. Variations beyond the open auction process (described above) are introduced to secure even lower pricing. For example, the auction time can automatically be extended each time a bid is registered, thereby keeping the pressure on the suppliers to sharpen their pencils even further. Another variation is a final blind bid that encourages suppliers to bid below their last registered bid. In theory this could encourage the lowest bidder to drop their price even further, closer to their marginal cost, to fend off other suitors.
What is the magnitude of Auction savings?
If you look at the websites of the few online auctions that are available, they typically state 30+% savings. Needless to say, savings of this magnitude are vastly overstated for the performance of a reverse online auction over a paper RFP process. It may, however, speak to the inexperience of those offering online auctions. Assuming all is done correctly and an active bidding environment is created, where all lower bids are accepted, a savings of up to 0.3¢/kWh could be reasonably achieved, with very large customers saving a bit less. This isn’t 30% by anyone’s math – but there are savings.
The Auction supplements the RFP Process
Combining the auction process with the current paper RFP process, eliminating overlap and some unnecessary function, is probably the best of both worlds. Third party retail suppliers purchase energy on the wholesale level through a commodity exchange. The clearinghouse ensures the trade and it details a specification for the product being delivered. Energy on the wholesale level is a commodity. Unfortunately, while retail suppliers purchase commodity energy, they go out of their way to sell a differentiated product. While the RFP tries to make an apples-to-apples comparison, there are always adjustments that need to be made to supplier responses to ensure adequate assessment. The current RFP process also ensures the creditworthiness of suppliers and it takes into consideration things such as billing performance and how client problems are handled. These latter issues, which can have a significant influence on which supplier should be chosen, cannot be assessed adequately by way of an online auction process, where all is quantified numerically.
The online reverse auction can be an important adjunct to your current procurement strategy. However, it is not a panacea for getting the best deal and value on energy for your facility. It is a process that has to be carefully navigated and integrated into your procurement process in order to achieve real savings.