Formula, not a game: introducing formula pricing in the public procurement system

10% against formulas

The public procurement system of any country aims to best meet public needs. The best possible cost-to-price ratio is usually regarded as the chief efficiency criterion. It is achieved through the use of tools available in the public procurement system for ensuring the most effective approach to each specific procurement deal by taking into account all of its peculiarities and pitfalls.

One of the important practical aspects of performing the contracts concluded in the ProZorro system is amending their essential terms and conditions in the process, in particular, regarding the cost of the subject of the contract. When creating the ProZorro ecosystem, the legislators provided several grounds for such changes, some of which regulate changes in the price of goods, works or services that constitute the subject of the contract. This brought about an established approach to changing the price of the subject of the contract, which is simple and convenient for suppliers, but usually not so beneficial for customers. Specifically, a change in price within ten percent based on a reference to market price changes. This method has a right to exist. But it is not very suitable for volatile markets, where prices may change by more than 10% during the day. Besides, this method puts suppliers in a better position than customers. Because, as prices rise, suppliers may refuse to deliver the goods without increasing the contract price. And, with prices falling and suppliers refusing to reduce them, customers have to hold a new auction, which entails additional costs. 

For example, natural gas and oil markets, where customers will be able to use the tools allowing for constant supplier competition or “tying” the price of goods to certain objective indicators to determine a fair market price, to their advantage. A clear example of the first tool is framework agreements, with formula pricing being the second. 

Formula pricing in energy contracts

In this article, I discuss the second tool in detail. The grounds for the existence and application of formula pricing are provided by the Law of Ukraine On Public Procurement. The law allows for a change in the price of the subject of the contract if there are reasonable grounds for it. The reasons may be inflation, hryvnia exchange rate fluctuations, changes in price quotes and indices published by Platts, ARGUS, regulated prices (tariffs) and standards applied in procurement contracts, if the latter include a procedure for changing the price.

Formula pricing is based on the idea of ​​creating a transparent ecosystem of interactions between market participants and customers by linking the price of goods to objective indicators – European and Ukrainian exchange quotations and local currency fluctuations. It is thus possible to avoid subjective factors when setting and changing the prices of goods.

This idea is implemented pretty simply by including a formula containing the aforesaid indicators in a contract between customers and suppliers and linking to it a change in the price of the goods to be delivered. 

Therefore, calculation of the actual price of goods is carried out according to the formula that is clearly defined in the contract and includes the quotes provided by Platts and ARGUS. Therefore, any swings in markets, reflected in the quotes, directly affect the price of goods.

Besides legislative rules and regulations on using formula pricing, practical experience with formula arrangements and its use are of great importance. Such organizations as the Ministry of Economic Development with its Reform Support Team, Kyiv School of Economics, the Antimonopoly Committee of Ukraine, Naftogaz of Ukraine NJSC, PJSC Ukrgazvydobuvannia, SE Derzhzovnishinform, the Ukrainian Chamber of Commerce and Industry, and SC Ukrposhta significantly contributed to its practical base. 

Gas price formula

The formula for calculating the price of goods and practical recommendations for its use were provided in information letter No.3304-04/54265-06 of December 11, 2018 by the Ministry of Economic Development and Trade of Ukraine. The letter explains the procedure for entering the formula into contracts and sets guidelines for the gas hubs, whose quotations are considered the most relevant when calculating the price of natural gas, namely the Title Transfer Facility (TTF) and the Net Connect Germany (NCG). The formula consists of three blocks: changes in the price of the national currency, changes in natural gas price quotations at a particular European hub, and changes in natural gas price quotations on the Ukrainian Energy Exchange (UEEX). It is also proposed that the share of prices quoted by the European gas hubs be at 95%, and by the UEEX at 5%. On the one hand, this approach establishes the relationship between the price of gas in the European market and the price of gas purchased via ProZorro, and on the other hand, it takes into account trends in the national market. 

The question may arise as to the reasons for such a proportion of quotations between the European hubs and the UEEX. At first glance, it would seem more logical to use price quotations on the national market. However, the volume of gas trades and the number of participants in the European market are much higher than in Ukraine, making the competition in the European market closer to perfect. It is therefore more profitable for the Ukrainian customers to “tie” the price of gas to European quotations.

Using Ukrainian exchange quotations in the aforesaid proportion makes it possible to take into account the specific features of the national market.

Ukrzaliznytsia as a formula pricing contracts pioneer

Formula pricing was included in the customer toolkit in early 2018. Its development and implementation were based on European experience, aiming to ensure the best interests of customers. Like any innovation, this method was initially met with caution by the market participants.

Today, however, it is widely used by large state-owned enterprises, while being gradually adopted by others. Formula pricing was first used by JSC Ukrzaliznytsia (UZ) to purchase diesel fuel. Using formula pricing simultaneously with framework agreements allows UZ to purchase fuel at a market price when necessary. This brought a significant saving (see Figure 3). 

UZ included in the formula price the quotes provided by the Platts company specializing in the diesel fuel markets. A number of potential suppliers were extremely dissatisfied with the new formula refusing to supply fuel, causing problems for UZ. This is quite understandable, given that formula pricing strengthens the position of the customer compared to the position of the supplier.

The conflict with UZ led to a number of potential suppliers appealing to the Antimonopoly Committee of Ukraine to invalidate the formula. After studying the situation, the AMCU sided with Ukrzaliznytsia confirming the legitimacy of using the formula. The conflict was resolved unblocking the supply of diesel fuel to UZ. This precedent helped other state-owned enterprises switch to formula pricing contracts.

Ukrzaliznytsia’s most valuable experience is that using formula pricing for a considerable period of time makes it possible to assess its economic effects.

Thus, over the 9 months of 2020, the total savings (i.e. the difference between UZ’s procurement costs and average market prices multiplied by purchase volumes) amounted to UAH 187 million, which is 5.83% of the cost of goods at average market prices. Over the whole of 2019, the savings amounted to UAH 110 million, or 1.29% of the cost at average market prices. At the same time, the savings in 2019 were actually generated over the last 5 months of the year (Fig. 3).

Other large companies such as Gas Transmission System Operator of Ukraine LLC and JSC Ukrtransgaz followed in Ukrzaliznytsia’s footsteps, currently using formula pricing to purchase natural gas.  

The market is gradually moving toward formula pricing contracts

Figures 1 and 2 show that in terms of the procurement volume, contracts with formula pricing prevail because this practice has been introduced in large enterprises, while the majority of the contracts are still concluded without using such formulas.

Besides customer savings, another advantage of formula pricing is that it prevents disputes between suppliers and customers after the contract is concluded. With fewer subjective elements in their contracts, the parties have fewer legitimate reasons to review their terms.

Formula pricing is of interest not only to public procurement market professionals. According to ProZorro, any observer can use the ProZorro data to evaluate a customer’s approach to using resources, including public ones. After all, if a state-owned enterprise enters into formula pricing contracts, it means that its leadership is trying to save taxpayers money.