Purchasing Pain
Published : Mar 2006
Energy purchasing is in crisis, with prices at an all time high. How have we been backed into this corner, asks Debbie Giggle
Energy purchasing at the moment is in a dire situation, and manufacturers are bearing the brunt of the onslaught. One expert described the situation as ‘carnage’. Another referred to ‘ballistic’ increases and prices at an all time high.
The impact has been felt for many months within industry, and has worsened over the winter with major manufacturers expressing concern that they may have to shut-down production if gas supply shortages are not eased.
How on earth have we found ourselves in this situation?
Mark Dickinson of energy risk management company Encore International said: “We are seeing the direct results of the UK having a competitive energy market in which gas and electricity are traded as commodities. The sellers have played their cards very cunningly in recent months, while the buyers have, in many cases, been naïve or slow to react. Conditions in the gas market have driven the soaring prices, with electricity prices being dragged upwards at the same time.
“Those with gas to sell have manoeuvred themselves into an extremely strong position. In effect the gas market is cornered. That’s very bad news for business users.”
Chris Bowden of Utilyx – a company specialising in energy procurement and energy risk management – said: “Back in January 2005 many companies were looking at prices and were horrified at what they saw. While companies like ours were warning of further price hikes, there was widespread optimism among energy buyers that the current high pricing levels were unsustainable and were sure to drop soon. As a result, many major consumers moved away from annual renewal and fixed pricing. Instead they moved to flexible contracts and started buying a day ahead or a month ahead, hoping that prices would soon fall and that they could then lock into a fixed contract.
“Unfortunately, the worst case scenario occurred. Prices have continued to rise fuelled by the impact on the market of so many people buying shortdated. In fact, prices are probably around 30 to 40 per cent higher than they were in the summer. So companies that were already paying an uncomfortably high price for their gas have been squeezed even more. We are all entering uncharted territory. Those who have energy risk management companies working for them are perhaps doing better than most, but many companies are completely exposed.”
It appears that, with the gas market cornered, and with so many buyers forced to purchase, the producers and traders who own the gas currently in storage are able to dictate the price they want for it. Those without prior contracts in place have no option but to pay the price – however high that might be. But isn’t it illegal to stitch people up like this?
Dickinson commented: “The traders and producers are doing nothing illegal. They have played their cards cleverly though and many consumers are suffering.”
The situation has been exacerbated by supply shortfalls from Europe. Physical infrastructure exists to transport gas from continental Europe into the UK via the Bacton-Zeebrugge Interconnector. Competition issues arising in the European market however are placing restraints on accessing gas reserves in this way.
Following CBI calls for an investigation into restrictive practises the European Commission has accepted that continental energy markets are not working.
Welcoming the report CBI deputy director-general John Cridland said: “We are encouraged that the Competition Commissioner has stated her willingness to use anti-trust powers and take action against market abuses.
“What is needed now is timely action by the Commission to address the problems it has identified. These include the lack of transparency on access to networks, transit capacity across countries and gas storage, as well as restricted access to monopoly infrastructure across Europe.”
While Cridland urges “timely action” we can assume that change will be very slow in coming. Meanwhile, Dickinson believes that even if continental energy markets are forced to play by the rules, this will not eradicate the problems.
“Supply and demand is not materially worse than it was at this time last year,” he asserted. “But today the rules of supply and demand no longer apply. The gas market is being driven by commodities trading not by traditional factors. When manufacturers warn of winter closures it is rather naïve and counterproductive. Traders just rub their hands.
“You hear stories about there only being enough gas in storage to cover two days demand. In reality you could never empty all the gas from storage in that period of time. The fastest time in which you could free up and transport these reserves would be 80 or 90 days.”
In Dickinson’s opinion this creates an interesting situation. As long as there are more than 90 days of cold winter weather left, sellers are happy to hold gas in storage and demand top dollar. No-one however wants to be left holding the baby. Such is the way with any commodity. So as the spring approaches traders typically examine their positions with a view to selling before a nice warm spring takes the cold bite out of gas pricing.
For manufacturers the vagaries of the commodities market are an unwelcome addition to everyday life. Is it really necessary to be dragged in to all this when we’ve got production schedules to meet?
Sadly the scale of the price increases can no longer be ignored. On publishing its paper Powering the future in November 2005, the CBI said energy costs rising to uncompetitive levels, and concerns over gas supplies during the winter had shot the issue of UK energy needs to the top of the business agenda. And in a survey published in October 2005 conducted among 654 SMEs, the CBI reported that falling output, allied to higher oil and energy prices, had pushed up average unit costs for 29 per cent of respondents over the last quarter. This was despite employers shedding staff for the fifth successive quarter. The situation is also biting into capital expenditure plans. Almost a quarter of respondents plan less investment in buildings compared to the previous 12 months while 18 per cent expect to invest less in plant and machinery. These price hikes are kicking industry where it hurts.
So what can manufacturers do? What protection is there? Utilyx’s Bowden said: “The key reason why so many large consumers, and an increasing number of small users are in trouble is that they have moved to a flexible buying environment, but then failed to manage their levels of risk. You need to lock in to fixed pricing before prices rise and have sufficient flexibility to capitalise on times when pricing falls. That demands a proper energy purchasing policy and continual tracking of the market.”
Energy risk management companies like Utilyx and Encore International handle the procurement process on behalf of their clients. The process is very much like having a stockbroker to manage your investments. The company’s analysts study the market and advise you of the best times to buy. Their aim is to limit your risks and maximise your opportunities.
Back in 2004, specialty chemicals company Solutia faced a potential 30 per cent increase in its energy costs compared to the previous year and recognised that this would hit the bottom line hard. Solutia entered into a relationship with Encore International and now outsources its entire energy buying process. Encore International monitors the situation and sends Solutia a risk report each morning which sets out the company’s position and makes recommendations based on predetermined levels of acceptable risk.
Another client of Encore is Dow Corning Corporation. Energy had been procured by the company on a flexible basis in the USA for many years, and in 2002 it decided to adopt the same approach in the UK to assist in the purchasing of gas. The company’s UK production site uses electricity and steam, but a third party-owned on-site CHP means that the majority of its energy requirement is natural gas. Encore International provides services including contract tendering and negotiation, value at risk, market watch, dispute resolution, European strategy and environmental asset development.
Both Dickinson and Bowden admit that the current trading conditions apply pressure for anyone needing to buy energy – even the experts.
“We have been forced by extraordinary market conditions to accept higher price levels than we would like,” admitted Dickinson. “But our clients are heavily hedged and are in a stronger and more protected position than the majority of the market.”
One manufacturing site that will find comfort this winter however is Ford Dagenham. In 2004 the site moved to on-site generation of energy from renewable sources. Two 85m high wind turbines, with a combined capacity of 3.6MW, generate around seven million kW of clean electricity every year, providing all the electricity needed to power Ford’s Dagenham Diesel Centre. The turbines make a saving of 5792 metric tonnes of carbon dioxide, 67 tonnes of sulphur dioxide and 20 tonnes of nitrous oxide every year.
Oliver Rowe, spokesperson for Ford Dagenham, said: “When the analysis for wind generation was carried out towards the end of 2003, the cost of electricity was comparable with the price we knew we would be paying at that time for brown energy. Our agreement with Ecotricity is for 12 years. On-site generation of our own green power has therefore protected us from the volatility and sharp rises in electricity pricing that have affected the rest of UK industry. In addition it has enabled us to achieve a far higher level of environmental performance.”
Ford Dagenham’s green energy is generated under a merchant wind power agreement with Ecotricity. Under this business model, Ecotricity builds, owns, operates and maintains wind turbines on manufacturing sites, or in the case of Offsite MWP, at a remote location. The manufacturing partner agrees to a 10 to 12 year power purchase agreement and, in return receives its own dedicated supply of green electricity at a competitive price. There is no risk, either financial or developmental, to the manufacturer. Ecotricity absorbs the financial costs of each project and provides the customer with the opportunity to purchase the supply with no additional costs to bear.
Ecotricity sets the pricing of the electricity generated in two ways, either longer term fixed contracts, or variable pricing which tracks the actual market with an agreed level of discount. In either case, the cost of electricity is pegged lower than the market, with greater control and reduced risk.
Regrettably wind power does not solve the problems of rocketing gas prices. It also cannot be an instant solution for the energy buyer trapped in a purchasing stranglehold who needs to buy energy today to be used tomorrow. We are now in uncharted territory according to the experts, and the realities of energy purchasing in the UK will continue to place manufacturers at the mercy of a volatile commodities market. Solutions will have to be found and we can expect manufacturers to look first to the things over which they have greatest control: reducing energy usage, the rethinking of processes and fresh analysis of on-site generation. We are backed into a corner. We need to find the way out.