Competition Strategies

Competition strategies are designed to increase competition among fuel suppliers in order to lower the supplier’s margin and achieve lower overall fuel prices. There are two major types of competition strategies: calls for tenders and reverse auctions. Competition strategies typically work well with long-term, fixed-margin contracts because they allow suppliers to compete to provide services at the lowest margin. Before we discuss competition strategies, however, it is important to explain the two main components of the supplier’s margin: the supplier’s cost structure and the supplier’s profit. Differences in these components will cause margins to vary from supplier to supplier. Typically, the supplier’s profit is the only component of the supplier’s margin that is negotiable.

Differing cost structures are the primary reason for differences in fuel suppliers’ margins. Given equal profit margins, a more efficient cost structure will lead to a lower supplier’s margin. For instance, a supplier that delivers fuel to a transit agency over a shorter distance will have a more efficient cost structure than a supplier shipping fuel from farther away and will thus be able to supply fuel to the transit agency at lower cost. Larger fuel suppliers are also more likely to have 0.00

Jan-2007 Mar-2007 May-2007 Jul-2007 Sep-2007 Nov-2007 Jan-2008 Mar-2008 May-2008 Jul-2008 Sep-2008 Nov-2008 Jan-2009 Mar-2009 May-2009 Jul-2009 Sep-2009 Nov-2009 Jan-2010 Mar-2010 May-2010 Jul-2010 Sep-2010 Nov-2010 0.05 0.10 0.15 0.20 0.25 0.30 0.35 0.40 0.45 0.50

Margin ($ per gallon)

Retail Margin (mean = 0.23, st. dev = 0.07) Contract Margin (mean = 0.12, st. dev = 0.02)

Source: SAIC, Energy Information Administration: http://www.eia.doe.gov/dnav/pet/pet_pri_dist_dcu_nus_m.htm Figure 7.1. US average ULSD supplier margins by type, 2007 to 2010.

more efficient cost structures because they are able to leverage economies of scale to provide lower per-unit distribution costs. Suppliers’ margins may also be lower in areas that do not require diesel fuel to be blended with biodiesel. Fuel distribution is more expensive when biodiesel blending is required because fuel distributors must make two stops—one at the petroleum product rack and one at the biodiesel rack. Biodiesel cannot be blended in pipelines or in bulk storage tanks due to its corrosive effect on those infrastructures, so before delivery of the finished, blended product to the transit agency, the biodiesel is typically splash blended in the fuel supplier’s delivery trucks while en route to its destination. Identifying fuel suppliers with the lowest cost structures will often lead to lower suppliers’ margins.

The profit margin is a smaller component of the supplier’s overall (cost plus profit) margin, but has a higher potential for negotiation. Competition strategies—those strategies that seek to increase competition to lower prices—are likely to be more successful for large transit agencies that operate in markets with multiple fuel suppliers. These strategies are likely to be less effec- tive for smaller transit agencies with little market power, particularly if the agency is located in a market dominated by one or two fuel distributors. In these areas, market power strategies— strategies that seek to lower prices by increasing the transit agency’s bargaining power—are more likely to be effective (see Section 7.3).

7.2.1 Call for Tenders

A call for tenders (or call for bids) is a contracting practice in which a transit agency invites qualified fuel suppliers to bid for the transit agency’s fuel supply contract. The call for tenders may be an open tender, which is open to all fuel suppliers that can guarantee performance under the contract, or a restricted tender, whereby the tender is preceded by a pre-qualification question- naire in which the transit agency assesses the ability of the fuel supplier to supply the requested quality and volume of fuel and assess the financial stability and overall counterparty risk of the supplier. Public transit agencies are familiar with employing calls for tenders (open or restricted) as it is a common requirement for government entities and entities that receive direct state or local government funding.

7.2.2 Reverse Auctions

Another innovative competition strategy is to hold a reverse auction. Reverse auctions are known by many different names, including: service auction, procurement auction, sourcing event, and e-sourcing. At the federal level, this purchase method has been promoted in several memoranda issued by the Office of Management and Budget (OMB).13,14

The roles of buyers and sellers are reversed in a reverse auction. In a normal auction, buyers bid to purchase a good or service. Competition among buyers drives the price up and the buyer with the highest bid at the end of the auction purchases the item at the highest bid price. In a reverse auction, multiple sellers compete to sell a good or service to a single buyer by bidding successively lower prices. The seller that bids the lowest price must provide the service at that price. In the context of fuel procurement, a transit agency would hold a reverse auction for its fuel supply contract. Among other terms, the contract would specify the type of fuel, the volume

13_{Office of Federal Procurement Policy, Office of Management and Budget, May 12, 2004. “Utilization of Commercially Available}

Online Procurement Services.” As viewed at: http://www.whitehouse.gov/sites/default/files/omb/assets/omb/procurement/ publications/online_procurement_051204.pdf

14_{Office of Federal Procurement Policy, Office of Management and Budget, July 18, 2008. “Effective Practices for Enhancing Com-}

petition.” As viewed at: http://www.whitehouse.gov/sites/default/files/omb/procurement/memo/enhancing_competition_ 071808.pdf

of fuel, and the timing and location of fuel deliveries required by the agency. The fuel supplier that can guarantee performance of the contract at the lowest bid wins. In terms of a fuel supply contract that follows index plus margin pricing, fuel suppliers compete to bid the lowest margin. Because fuel suppliers can bid multiple times and because the bids of other suppliers are known, a reverse auction has the ability to achieve a lower supplier’s margin than a call for tenders. Typi- cally the winner of the auction will be the fuel supplier that has the lowest combination of cost structure and profit margin.

According to a recent study, firms that employ reverse auctions as a strategic management technique increased bids by 20 to 30 times the normal number of bids and consistently received price reductions of 12% to 24%.15 _{For fuel procurement, this would equate to a 12% to 24%}

reduction in the supplier’s margin, not a reduction in the overall fuel price (index plus margin). Thus, a public transit agency that pays a fixed supplier’s margin of 12 cents per gallon might expect to reduce the supplier’s margin by 1.5 cents to 3 cents by holding a reverse auction. Recent reverse auction success stories include:

• In 2004, the Baltimore Regional Council Purchasing Committee (BRCPC) achieved a 42% sav- ings in the transportation of 4.9 million gallons of heating oil to nine school districts, reducing transportation costs from 10 cents per gallon to 5.9 cents per gallon.16

• In 2007, the state of Connecticut achieved a savings of more than $20 million for 570 million kWh of electricity for the 2009 fiscal year, a savings of roughly 3.5 cents per kWh hour.17

• FedBid, the company that manages reverse auctions for federal procurement, says its systems can produce savings of up to 15% on commodities.18

There are several types of reverse auction models that a transit agency can employ: out- sourced, consultative, software, and active server pages (ASP). An outsourced model is a fully managed model in which an outside company runs the reverse auction. The company provides this service free to the buyer, but requires suppliers to pay fees of 1% to 2% of the contract price. Presumably, suppliers will pass some this cost to the transit agency in the form of slightly higher bids. A consultative model involves hiring a consultant to set up an in-house system for perform- ing reverse auctions. Consultants charge a fee for this service and will often take a percentage of the buyer’s savings. Other approaches include installing special reverse auction software or using a web-hosted ASP application. The outsourced and consultative models are typically only appropri- ate for high-value contracts ($50,000 to more than $1 million) whereas software and ASP models typically have no limit on contract size. Because the value of annual fuel contracts for public transit agencies is typically large, all models are able to provide effective solutions. Figure 7.2 from sorcity.com compares and contrasts the characteristics, fees, purchases, and total time to establish each of available reverse-auction models.

One potential disadvantage of reverse auctions (or any competition strategy where the sole consideration is price) is that the winning bidder may have been able to bid the low- est price because it reduces its cost structure in ways that may be dangerous or detrimental to the supply operation. For instance, a low-cost bidder may reduce its cost structure by failing to adequately maintain its fuel delivery vehicles or storage tanks, potentially leading

15_{Farris, Ted, et al. “Reverse Auction Case Studies Effectively & Ethically Lowering Supply Chain Costs.” Institute on Supply}

Management. http://www.ism.ws/files/Pubs/Proceedings/JFGuillemaudFarrisRoth.pdf (April 14, 2011).

16_{“eSchoolMall Helps Maryland Schools Save Money: Reverse Auction Provides Significant Reduction in Energy Costs.”}

Eschoolmall.com. July 26, 2004. http://www.eschoolmall.com/customer_feature.asp?pdate=7/26/2004 (April 14, 2011).

17_{“Reverse Auction Yields Savings of $20M.” The State of Energy. CT Office of Policy and Management. Jan/Feb. 2008. http://}

www.ct.gov/opm/lib/opm/pdpd_energy/the_state_of_energy_jan-feb08.pdf (April 14, 2011).

18_{“FedBid Inc. has been awarded a five-year contract to provide online reverse auction services for federal agencies.” AllBusiness.}

to off-spec fuel. For this reason, a transit agency may need to subject fuel distributors to a very thorough prequalification process before allowing them to participate in the reverse auction. Alternatively, the transit agency might evaluate the winning bidder after the reverse auction. If the bidder fails to meet the transit agency’s requirements, the contract can be awarded to the second-lowest bidder (contingent on this bidder also meeting the agency’s qualifications).

Reverse auctions have the potential to significantly reduce the supplier’s margin, but this strat- egy may only be effective in large markets with multiple, qualified fuel suppliers. For instance, a reverse auction with only one bidder would be ineffective. At a minimum, two qualified bidders are needed in order to realize savings from reverse auctions. As a result, competition strategies are often more difficult to employ for electricity and natural gas procurements because these services are frequently provided by local monopolies.