Ten-year high power prices last week (12-16 September) caused by tight supply margins illustrate the imperative of de-risking your flexible energy procurement strategy.
Towards the end of a turbulent week, prices on the day-ahead over-the-counter market increased to £135 per MWh. This is the highest level in ten years.
The price spike was largely attributed to reduced generation following unplanned outages at key coal and nuclear plants, together with low wind generation and increased air conditioning consumption, due to unseasonal mild September weather. As such, more expensive forms of power generation were required to balance the system during peak demand.
Such price swings underline the importance of managing flexible energy purchasing within the parameters of a robust risk strategy to navigate inevitable market turbulence.
Historical data suggests that, generally speaking, the energy buyer would achieve a cheaper unit rate through purchasing volume on a Day-ahead basis as opposed to annually, but this type of contract is incredibly sensitive to short-term generation and demand issues, and is a perfect illustration that buying volume on a Day-ahead basis can very quickly catch out the energy buyer.
Day-ahead should be utilised alongside other contracts such as, forward-month, quarter, season etc. thus ensuring a more balanced, and ultimately less risky hedging strategy.
What is certain is that last week's supply issues will not be a one off event. There are on-going concerns over the UK power system’s ability to deal with peak demand periods, particularly this winter. National Grid has forecast exceptionally tight margins for the Winter, making it likely that premium price contingency reserves will need to be used to keep the lights on.
Six ways to de-risk your flexible purchasing strategy
Below are six tips to help in formulating a risk strategy to ensure organisations buy advantageously, while navigating some of the potential pitfalls of flexible energy procurement:
1. Don't panic and dice with volatility
It's easy to panic and make 'emotional' decisions in response to price spikes, which can be a a big and costly error of judgement. A good risk management system and a trading strategy is essential to limit potential losses. This will identify the risks to be measured and valued, the company’s objectives and risk limits and the amount the buyer is prepared to lose. The risk limits will also account for unwind time (the time it takes to hedge a position) and other factors.
2. It's complicated, so seek good advice
Risk management is a complex area and it is a good idea to get some expert advice from a broker or consultant. They should be able to highlight risk management options and assess your appetite for risk, as well as carrying out an initial forecast assessment using advanced modelling techniques. It is important to quantify the risk and fully understand how a change in price will impact your energy purchasing costs. From there, an optimum price and risk strategy can be agreed and implemented. They will help devise a balanced risk management system, with multiple inputs, which will ensure a balanced point of view that can be adjusted and won't be susceptible to over correction from short term factors.
3. Make use of your risk management toolbox
A buyer has many tools in his/her risk management toolbox. In the case of market risk, forward purchases and sell-backs can be made in months, quarters and seasons via direct negotiation with trading teams at each supplier. Alternatively, transactions can be fulfilled automatically by index pricing and settlement trades, whilst swaps and options are also available for the very largest clients.
To manage market risk you may wish, for example, to purchase a tranche of energy at a fixed price for the duration of the contract, then build up the remaining energy requirement by purchasing fixed-price blocks on the forward market at different points in time. Or you may wish to link prices to a benchmark or index of market levels, but then include a risk management strategy to guard against particularly sharp price moves.
4. Keep tabs on your risk management
A risk position is fluid, meaning it can change on a daily basis in line with the market, so ongoing monitoring and analysis of your market position is required. The best brokers are well placed to help with this, and can also ensure quick and direct market access to implement any adjustments to trading positions.
As with other commodities, mark-to-market (MtM) principles allow energy market participants to assess the risk of their market position on a regular basis. A measure of potential deviation in the MtM value, known as Value at Risk (VaR), has been adopted as the standard measure used to manage energy market risk.
Feedback from your market position will influence trading strategy throughout your flexible contract, ensuring you hedge at the right times to maintain energy price risk at satisfactory levels - dependent on your volumes.
Reforecasting can be carried out at various points, helping adjust forward strategy in line with the latest information.
5. Keep an eye on non-commodity costs too
At the same time as tracking your commodity purchasing, you also have exposure to a range of other charges associated with your supply. These include: network charges, metering costs, and various environmental levies, especially in electricity. With these costs now representing around half your total bill, it’s easy for increases in these elements to outweigh savings you may be able to achieve on the wholesale side.
Whilst it’s tempting to ask suppliers to fix these costs for a year or more at a time, you will be paying quite a premium for this facility. Most large buyers now opt to take them as “pass-through” charges - just reflecting the prevailing regulated rates.
It is, therefore, important to regularly review your budget assumptions as a whole within your flexible supply framework.
To implement a corporate energy risk management strategy - rather than simply managing market risk - an integrated approach needs to be developed at board level. This will not only look at risk appetite and consumption patterns, but also at current and anticipated regulatory and market environments.
A flexible approach to energy procurement doesn’t mean higher levels of risk.