The burning issues

Energy price fluctuation is a major issue for all businesses. For busy manufacturers in particular, the battle to drive down these costs is now taking place in a complex, confusing and ultimately distracting marketplace. Managing this situation has become a board-level issue, as companies come under increasing pressure to handle their overheads while energy prices become ever more volatile. The task manufacturers face in sourcing the best deals is a daunting one, involving detailed preparation and analysis of requirements, tender preparation, gathering of market intelligence, supplier liaison and vetting, and developing a strategy on contract lengths and types. And the possibility of it all going pear-shaped is all too real: opt for a fixed contract and you could be locked in to an agreement that seriously backfires, while those who go for a flexible arrangement could be just as badly burned. So how exactly do you set about successfully managing energy procurement to deliver best-value contracts in a climate of higher and more volatile energy prices? Certainly, what's happened to the economy in the last six months makes a nonsense for many organisations of normal energy purchasing calculations. Julian Denee, one of the authors of last autumn's Deloitte report, 'The Balance of Power', told Works Management last year: "If you're a relatively small business, then I would encourage people to go 'fixed', because then you can do your budgeting. If you're a bigger company, then it does make sense to have a mixture of fixed and floating." Jonathan Page, npower's head of energy marketing, argues that small manufacturers are still well advised to buy on fixed contracts. However, most of the customers that npower deals directly with have energy consumptions of 30GWh a year or more and the majority of these have moved to flexible contracts: "It gives them multiple opportunities to manage their position," he says. Smaller companies don't have the resources to keep tabs on what's happening to energy prices. The choice of fixed contracts is a means of turning a variable cost into a fixed cost, albeit temporarily – they know what the bill will be. But the recession has made the dilemma for those opting for fixed contracts more acute. Six months ago, all they had to worry about was whether they had fixed the price too high, only to find the energy price dropping, leaving them committed to the higher price (see box item, p33). Now, Page concedes, the danger is quite different. Companies in automotive or construction-related businesses may have found that demand has collapsed and, with it, their volumes and energy requirement. If they're in fixed energy contracts, they have to take the hit, because, in a declining market, energy companies such as npower can't easily find alternative customers for that energy. Page says a number of customers are in that kind of fix. If that happens, he says, the energy supplier needs to know about it sooner, rather than later. Of the three sectors npower marketing deals with – commercial, industrial and the public sector – industry has been more affected by shortfalls in its predicted energy consumption, he states. On average, the shortfalls had been 10 to 12%, though some had fallen by 20% or more. If a company only needs 80% of the energy it is contracted to take, the remaining 20% would have to be sold back to the market. "We don't have a font in which we can put it," he explains. The grim likelihood is that other customers will be in the same boat, so the opportunity for reselling is low. Page agrees that some of the falling energy requirement had been planned, and resulted from the purchase of more efficient refrigeration and other industrial equipment. Reducing high carbon-emission activities had brought about other reductions, while some companies are using smart metering and monitoring and targeting tools, such as npower's encompass, a web-based monitoring system. The incentives a year ago had been price, and government regulation and financial incentives. All markets eventually expect carbon to have a higher value placed on it. Overall, the market is still 'in contango', he states; today's spot price is lower than the long-term price the market expects. "Perhaps that's why deals are edging longer: two-year energy deals are not uncommon and some users have entered into even longer contracts. "The best advice therefore would seem to be that, in making energy-buying decisions, smaller companies should include some careful thought, not just about how the future energy price will vary – it's still going up, by the way – but also about how their future production volumes might vary." To benefit from flexible pricing by managing energy purchase carefully, business customers need to have access to the right information at the right time. It is estimated that there are around 200 complex factors driving price fluctuation – be they political or environmental. It isn't about beating the market; it is about understanding it to gain control. Collaboration breeds trust EDF Energy's strategic accounts manager Peter Masterson believes that partnership is key to removing customers' uncertainty regarding pricing levels: "We are seeing more and more that establishing collaborative relationships with our business customers leads to high levels of trust. On larger accounts, service development managers support the customer relationship by providing face-to-face management of service issues, which is really important with such a complicated issue as this. In such a volatile market, we have to consider risk management and react quickly to changing conditions, if we want to support our customers." Tesco, for example, has been an EDF Energy customer since 2003 and the relationship has progressed from a traditional fixed price to a fully flexible arrangement. As James Summerbell, senior buying manager at Tesco, points out: "Taking this step is not for the faint-hearted – buying energy like this is very complex and our scale means it is essential that the organisation dedicates sufficient resources to it." Contrary to popular belief, says EDF, flexible contracts are not exclusively for the benefit of the largest energy buyers. 'Collaborative baskets' created and managed by EDF Energy are consortia of smaller businesses whose individual expenditure is not great enough to seek wholesale pricing. However, when combined, they are able to manage a larger position against the markets. When it comes to adopting a risk management approach to buying energy, Gary Worby of EnergyQuote warns that purchasing risk applies to all contract options, "whether energy is bought on a single day, over a number of days or if a portfolio-based approach is taken. In a complex and volatile market, there are no low risk strategies; fixing on one day can be as risky as being open to all market movements". Another option, he says, is energy 'funds,' where customers are grouped collectively, allowing members to benefit immediately from increased economies of scale. This is because physical volume constraints are removed, which allows smaller energy users to access buying methods normally reserved for organisations typically spending in excess of £5m on energy per annum. "However, the risk here is that an organisation may enter a fund whose purchasing strategy does not match their risk appetite and decisions could be made that would result in higher prices than they could have obtained by themselves." To avoid this scenario, he suggests, organisations must ensure that the provider of the fund fully understands individual members' risk profile and has a strategy in place to which all fund members have signed up. "If an organisation does not have the resources in place to monitor the markets, evaluate contract options and manage risk, they should look to work together with a third-party intermediary energy specialist who is recognised and qualified in risk management practices." The buying strategy employed will largely depend on the risk culture of the organisation. A risk-averse company will usually find comfort with a fixed price approach, while companies with a greater appetite for risk, and the larger rewards that can be accrued, may take a more flexible approach to buying. The success of this flexible approach will be based on the ability of the company to forecast price movements and buy (and sell) accordingly to maximise value. "Funds can be regarded as a sort of hybrid between a fixed and a flexible contract," says Worby. "It is a product that allows you to eliminate the risk of securing your entire power requirement at the height of the market." The common theme seems to be that businesses do not have to be at the mercy of the markets. Through flexible contracts, they can capitalise on fluctuating prices and potentially make major savings on their energy bills. By watching for external events that could affect the cost of energy, businesses can plan ahead and invest at sensible times. Flexible contracts, properly structured and administered, needn't equate to undue exposure either; each portfolio can be managed individually to ensure that businesses are comfortable with the investments they are making and their level of risk. In fact, doing nothing and hoping for affordable rates at the time of fixed contract renewal is widely regarded as a much greater gamble. Ultimately, the difficulty with price fluctuation comes from having to deal with the unexpected. By taking measures such as signing up to flexible contracts – and having a risk management strategy in place – businesses can reduce exposure to price fluctuation and stay one step ahead of the game.