Understanding the free market for buying energy can make a big contribution to a company’s bottom line. But simply knowing when to trade energy is only the tip of the iceberg for a successful energy purchasing strategy. Tim Brown investigates the complexities to overcome when devising a competitive energy contract.
The increasing cost of electricity and gas is of considerable concern for UK manufacturers who, as high volume consumers, are particularly susceptible to the market’s volatility. While all businesses have a range of outgoings to manage, it is important to remember that for most established companies the single biggest cost after manpower is energy. For this reason, managers are continually searching for energy savings: either through consumption reductions; or by manipulating the way in which energy is purchased.
While reducing energy consumption —and, in turn, the carbon footprint of a company — is important and now a legislated necessity, other savings are also available. These may be found simply by market-testing a company’s current energy contract against the raft of different choices that are available.
Within the two primary options of fixed or flexible contracts are a myriad of options that reflect different levels of risk and return. While this engagement with the market is key, it is not the first step towards a less costly energy bill.
A little help can go a long way
Deciding on the level of assistance required to enter into the energy market is the first priority. This likely depends on the size of the operation in question and the level of risk a company wants to undertake.
Some larger companies have a high level of in-house expertise — and the ability to monitor markets and purchase accordingly. Others, with less internal specialisation, may seek the assistance of consultants with the requisite monitoring infrastructure, knowledge of pricing and contractual arrangements. Derek Dixon, CEO of consultancy group Energy Services Partnership (ESP), says his company’s key services are based around “energy procurement, the timing of deals and ensuring the right contract structure so that it fits with a customer’s operation and risk profile.” “The key,” he says, “is to know what to buy and when to buy it. In other words determining what is a good price, when to go to market and for what time duration should you contract.”
According to Mike Beavis, senior plant engineer at Essex-based tractor manufacturer Case New Holland (CNH), an energy consultant is an invaluable resource in the procurement of energy. “If you go it alone and go straight to the energy companies and start buying energy like you would at home, I think you will pay more than you need to. If you get the right consultant with whom you build the right working relationship, then you will get excellent advice.” Although a consultant is certainly not a requirement for a successful foray into energy trading, even the suppliers admit they play an important role. According to Wayne Mitchell, head of corporate clients at energy supplier npower, under the right circumstance a consultant can be an important resource. “We sell both directly to end users and through consultants,” says Mitchell. “For us as a supplier, the consultant is useful and valuable where the end user isn’t certain of what they are doing. In that case we get a better level of data when a consultant is involved and get a better understanding of the customer. In those cases the consultant can actually negotiate a good deal on behalf of the customer and introduce functionality to the end user.”
A matter of choice
When it comes to energy pricing, the ideal would be to secure a long term contract fixed at a rate at which the market never falls below – the bottom of the market, in other words. The tumultuous period of economic decline over the last two years saw the dizzyingly high energy prices of 2008 come crashing down. Those companies savvy enough to have estimated the pricing trough, such as CNH, took the opportunity while prices were low to purchase energy in bulk. “Two years ago we took the decision to move to a fixed contract because our analysis of the market said that the price was going to decrease, bottom out and then take off again,” says Beavis. “Working with a consultant at the time we managed to hit the bottom of the market.” The current view of fixed contracts is strong. The experience of consultants such as Apollo Energy is that a majority of customers are looking to fix at the moment as they are unlikely to gain anything on the flexible market. “Experts in the industry are generally predicting that the energy price is going to rise,” says Apollo Energy director Jackie Gray. “Companies are considering the percentage chance of getting the price any lower is a much greater risk compared to the chance of it increasing. From an accountants perspective a fixed price also makes everything much simpler if they are not aware of how to operate flexible purchasing schemes.” Short of a double dip in the economic cycle or the advent of cold fusion, it would seem that energy prices, over the course of this year, are destined to only travel one way – up. However, on the scale of life’s definitive outcomes with death and taxes at one end, the predictability of a free market is certainly at the polar opposite end of the spectrum. Npower’s Mitchell says the benefits of a fixed contract are obvious, if a company manages to purchase at the right time. He adds, though, that a flexible contract offers the same ability to buy for an extended forward period, but allows a company more time to react.
“If you wanted to fix for two years your price is locked,” says Mitchell. “If you are concerned and your view is that prices are going to go up, then that is a good thing to do. You are, however, removing any possibility of taking advantage of any decreasing movement in price. The majority of the products we sell to the industrial market are flexible: you buy for the period you want when you see fit.” To take full advantage of a flexible product, a company operating independent of a consultant needs a good deal of knowledge and time. Dixon says for many companies “a fixed price structure is precisely what their business risk profile dictates but they sometimes get sold in to a flexible arrangement because people convince them that with such an arrangement they can’t lose irrespective of whether prices go up or down. Very few consultants fully understand traded commodity markets and therefore cannot properly manage the risks such structures present to their customers. It is absolutely key therefore that customers focus on the bottom line impact their energy purchasing strategy could have and then choose which contract structure best fits the bill.”
Give and take
The main focus with most energy purchasing ventures is to secure the best possible energy pricing for each unit purchased. For this reason, many energy contracts are structured as volume purchase agreements which are an integral part of a fixed contract — and are also often applied to flexible contracts. Essentially, the buyer agrees to purchase and use a minimum amount of units within a given time frame. In exchange for this commitment, the seller extends a highly competitive rate per unit.
There is a cost to this agreement, and it comes in the form of what is known in the industry as a volume tolerance — or to the user, a take or pay clause. The concept behind the clause is straight forward and designed to provide suppliers with a level of security. Essentially, it means that you will pay for the electricity you agree to take, within an agreed scope for variation (10-20%), regardless of whether or not you use it. This includes a tolerance for overuse, too, with excess usage charged at a day rate: often double the contacted rate.
Usually tolerances are spread across a company’s annual usage, but monthly take or pay clauses are beginning to emerge.
Having only really come in to force in the last 24 months, there is some disparity in the market place as to whether or not volume tolerances are strictly enforced. “If you had asked me two years ago how common take or pay clauses were and how often they were invoked,” says Dixon, “I would have said they weren’t common and they were never invoked.” He admits that the lenience for tolerances has now shifted, and penalties for veering outside the agreed consumption range are strictly enforced. In comparison, while Gray admits that take or pay clauses are an important consideration for companies, she says that the occasions when the clauses are invoked are still few and far between.
But just how complicated is it to predict how much power a company might need? “The reality with volume tolerance,” says Mitchell, “is that if an end user knows how they use energy at their site and how that energy consumption changes according to the processes that they are running, it is possible to forecast within the volume tolerances. The volume tolerances are there as a protection to us so that if a customer turns off its processes, we are not left stranded with the energy that we purchased on behalf of that customer.” The concern among many companies, even with the most accurate forecasting, is the impact of something that they cannot predict. For instance, a long period of unscheduled downtime due to a strike or the loss of a major contract could vastly impact the ability to consume its agreed quota of energy. Of course, the beauty of the free energy market is that if a company is over supplied it could simply utilise its load management provisions and sell back its excess energy in to the market.
This ability must, however, be a stipulation of the original contract.
Other factors — including the CRC Energy Efficiency Scheme which mandates that companies must improve their energy efficiency — complicate the matter of volume tolerances further. “If you are trying to reduce your usage for CRC, and that takes you down to 80% of your usage, it is unfair if you are penalised,” says Gray. However, she admits that suppliers are open to communication. “If you know something is going to happen to impact on your consumption, the sooner you let your supplier know the more flexible they are going to be about it. This is because some of the suppliers might only buy a portion at a time of a contracted load from the energy producer.” Dixon says that companies that are trying to reduce their energy consumption for CRC purposes could fall foul of take or pay if they are not careful.
“Customers should make sure that when they are putting contracts in place is that they are quite clear as to what the consumption forecasts are based on. For our clients we try and make the numbers as robust as possible by factoring in efficiency savings and agreeing the estimates with suppliers from which the contract prices are then based.” Gray highlights however that when tendering for a contract most suppliers base their offers primarily on historical data may make communicating a change to the forecasted usage slightly more complicated.
According to Nick Grant of British Gas Business, the setting of a volume tolerance should be made in discussion with the customer, and ought to be looking forward primarily. “In absence of data or discussion with a customer, we will use historical data and usually the industry standard 15 per cent tolerances. However, we are not just open, but proactively want to engage with our customers, because that is one element of the cost that the customer can directly influence.”
Electricity Price Index – Day Ahead Baseload Price
In a flat market, it can be better to switch to a floating rate, or combine with some fixed contracts
Gas Price Index – Spectron Day Ahead
The ability to fix energy prices can save a fortune in a rising market
Read the fine print
Over the last two years there has been a large amount of variation in the market, which has been up to 5% week-on-week. Despite this the difference in prices between suppliers on large contracts can be as little 1%. If a company already has a strong relationship and an open communication line with a supplier, focusing on such a small saving could be counterproductive.
The extent to which a strong rapport has been developed is important and, according to Apollo’s Gray, the industry is not renowned as an arena where personal business relationships are particularly common.
The price at which you make the deal in the first instance is only one consideration in comparison to the whole contract with volume tolerances and load management provisions being an important consideration. Like Grant says: “It is a bit like if you are looking for a builder; a cheaper builder may end up costing you more at the end of the day because they are hiding the extras.” If you suffer a take or pay penalty, for instance, because the cheaper contract has a much tighter volume tolerance, it may erode the entirety of your saving. Remember, you often you get what you pay for.
The Nuts and Bolts – What you need to know from this article
● Large energy cost savings can be made by simply market-testing a current energy contract against the raft of different choices available in the market.
● An energy consultant can help negotiate a good deal and better contract functionality on behalf of the customer
● Many energy contracts both fixed and flexible feature a minimum and maximum amount of usage known as a volume tolerance or take or pay clause.
● Volume tolerance penalties can be considerable and are being enforced more frequently.
●Load management provisions such as the ability to sell back excess energy in to the market must be stipulated in a contract.
● Early communication with your energy supplier is vital if a company’s forecasted usage is likely to change.