Energy
Managing the risk of high energy prices PDF Print E-mail
Written by Vincent Rolland, Head of Major Business Pricing, EDF Energy, July 2005   
With rises in wholesale electricity prices and volatility in the market in 2004, established energy-buying practices from recent years are becoming outdated. As energy buyers look to reduce the price of the electricity they buy, they also need to review the way in which they buy it. Energy prices are a hot topic. In 2004, the UK witnessed the steepest rise in wholesale electricity prices since privatisation, peaking in autumn, the time when the majority of companies renegotiate their energy supply contracts. 2004 also saw considerable volatility in the wholesale market, forcing companies to make their purchasing decisions in much shorter time scales. With the combination of these factors, it's easy to see why the established energy-buying practices that have served companies so well during years of falling prices and relative stability are now less appropriate.

Media coverage showed that many companies were caught off-guard. Organisations coming out of fixed-term contracts in the second half of 2004 were faced with increases of anywhere between 30-50 per cent on their energy bills - which often had not been budgeted for and were even cited as contributing factors in published profit warnings.

A recent article in the Financial Times (16 December 2004) highlighted the very real threat posed to business profitability, citing Center Parcs as an example. In December, the holiday village operator warned that future performance would be hit hard by sharply rising energy costs. The group said like-for-like costs had risen 9.1 per cent in the six months to 7 October and that they anticipated a further rise of 25 per cent by the end of spring 2006. Chief Executive Martin Dalby said: "We have a number of energy contracts that are coming up for renewal. Obviously when we did these contracts a few years ago we got good prices, but they have since risen."

This rise in wholesale energy prices translates into a year-on-year increase of more than 40 per cent on the bills of commercial operators. With further increases very possible, companies need to act now to address this budget-busting risk. In this environment it is crucial for companies to seek to manage their exposure to high prices and the volatility of the energy market. But how? One trend is for customers to work more collaboratively with their energy supplier, committing to the supplier for a longer term in exchange for greater flexibility and transparency in the purchasing of their energy.

Time to retire the annual tender

In today's market the traditional tender process is no longer the best means of managing price volatility. A supplier's management fee accounts for around 2 per cent of the delivered price, whilst energy, which is the part exposed to market risk, accounts for at least 60 per cent. Understandably, while energy prices were falling year after year, customers did not regard the level of the wholesale market as a risk. Yet traditional fixed term one- or two-year supply contracts leave customers totally exposed to the level of the wholesale market at the end of the contract period. In 2002, or even 2003, who could have predicted that market levels would be 70 per cent higher when it came to renewing their contract, and to have budgeted for this?

The energy prices that suppliers offer their business customers are directly related to the electricity wholesale market where prices fluctuate constantly. Given that energy suppliers operate on very slim gross margins - typically around 1-2 per cent - there is very limited room for negotiation there. So a more effective use of purchasing time and effort is to focus on the wholesale market. In today's market the only way to gain any real influence over the price you pay is to get as close to the market as you can and time purchases more carefully. Flexible electricity deals give the customer the ability to manage their exposure to risk by giving them much greater choice of when to buy during the contract.

As energy buyers look to reduce the price of the electricity they buy, they also need to review the way in which they buy it. The traditional tender typically requires the supplier to leave the contract offer open for customers to consider. To cover the daily movements in the wholesale market while the contract is on offer, suppliers have to build a timing risk premium into the price the customer sees. By contrast, flexible electricity deals enable customers to make much quicker decisions and so benefit from substantially reducing, or even eliminating, the timing risk premium element of their delivered price by having a direct access to the wholesale market.

New energy-buying strategies

The casualties of 2004 have shown that companies should think carefully before committing to buying their electricity needs in one go. In today's unpredictable energy market, the secret is to spread risk. It therefore makes much more sense to buy in a calm and measured way, purchasing when the time is right, rather than being tied to fixed contract renewal dates. Yet, very few companies have the expertise, resources or desire to constantly monitor the energy markets, which is essential if you are going to successfully 'play' the markets.

A family of new energy-buying strategies has been developed that have helped create this trend towards flexible deals. These contracts, in effect, give customers direct access to the wholesale market. The level of active involvement by the customer can vary to suit their needs, whilst the amount of risk can be tuned to reflect the customer's appetite. Their transparent nature means they are ideal contracts for obtaining a visibly competitive price without the need to go to tender every year, whilst at the same time building positive long-term supplier-customer relationships.

Flexible contracts can be tailored to meet a customer's purchasing requirements. However, in order to trade on the wholesale market, a customer requires a sufficient volume of energy - over 120GWh annual consumption. This is a huge amount of energy, yet many companies use much less but still have an annual energy spend running into millions. By aggregating their volume with other organisations under basket or framework agreements, companies with an annual energy spend under 120GWh can also benefit from flexible contracts. One of these 'basket' agreements has been set up specifically for the public sector and the energy purchases are managed by OGCbuying.solutions - an executive agency of the Treasury. The other agreement is for the private sector and purchases are handled by utility consultants Inenco.

Case studies

Andrew McMurtie of brewers Scottish Courage chose a flexible contract as a means of "avoiding unnecessary costs". Mr McMurtie said: "We want to control exposure to the wholesale market." He believes that Scottish Courage has a better chance of getting attractive prices by having flexible control. Their energy requirements are divided up so that they have 24 chances to get the best deal rather than just one with a one-year contract. The price last autumn when Scottish Courage was looking for an electricity contract was too high. Mr McMurtie observed that: "It was not sustainable and without a flexible contract we would have been locked into an expensive long-term contract."

Lech Bartoszewski, Specialist Buyer from the fuel and energy team at Royal Mail, believes that flexible contracts provide "the ability to manage price risk". Their choice of a flexible contract was motivated by the desire to keep within budget and not to get caught out by huge price increases. Of course if the price of the electricity is also cheaper, so much the better.

Andrew Jones, Group Energy Manager at Boots, explained that since the 'open book' approach makes charging structures fully visible, it was easy to compare bids and choose the competitive supplier that demonstrated it could best meet their servicing requirements. "Changing supplier is expensive in terms of time and disruption, as well as registration costs, so it makes sense to have a three-year contract," said Andrew Jones. "The contract provided allows us to negotiate the best prices for wholesale energy and build a positive and transparent relationship with them as our supplier."

All change now

Energy is a business overhead that is not going to go away. The recent experience of a 30-40 per cent increase in an overhead cost should be a loud wake-up call for any organisation. Companies urgently need to develop their energy-buying strategies to reduce the very real risks that the volatile wholesale market now poses to their budgets. Flexible, transparent deals are no longer an energy-buying pipe dream - they are the here and now.

Further information
Please visit: www.edfenergy.com
 
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