Evaluating energy price risk
February 1st 2008

Energy is currently a volatile commodity with prices varying daily or hourly, so the key to good procurement is based on 'time to market decisions' and the management of risk argues Gary Worby at EnergyQuote

Any purchasing decision is a choice about how to manage that risk.The risk applies to all contract options, whether energy is bought on a single day,over a number of days or whether 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.

Contract options available

Contract options are numerous but in simple terms they have been split between 'traditional' fixed price contracts and 'flexible' contracts that allow the purchaser to break down the total volume required and purchase requirements in blocks.

These can cover seasons, quarters, months or a proportion of the total requirement for the period.

The main advantage of the flexible approach over the traditional approach is that it offers price management and the potential for financial savings.However, flexible contracts introduce more risk to the purchaser as the additional flexibility and opportunity to take advantage of market conditions is exchanged for the budgetary certainty of traditional fixed contracts.

A relatively new concept that has developed over the past couple of years is energy 'Funds'where customers are grouped collectively.

They allow members to immediately benefit from increased economies of scale, as 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, organisations must ensure that the provider of the 'Fund'fully understands individual members'risk profile, and has a strategy in place that all 'Fund'members have signed up to.

Ignoring the risks that different contract options can entail may lead to a significantly higher energy bill than if the risk had been properly managed.

Greater flexibility in energy contracts allows greater options to control this risk. A balanced strategy ensures a consistent approach to managing energy prices and contracts in order to minimise budget risk.Establishing the strategy requires market expertise and an understanding of the risk appetite of the budget holder – while the level of skills and resource to manage energy risk is uneconomic without aggregation of volume.

So what are the price risks ?

There are four main aspects of risk in energy contracts, which should be covered in a robust risk management strategy: Volume risk is the change in consumption – either planned or unplanned – which will affect budgets.Other considerations, including any minimum or maximum consumption clauses in contacts, should also be taken into account.These can attract high financial penalties and have an impact on the overall costs Purchasing risk refers to the level of authorisation and expertise of the person making the contract decision.

In a volatile market, prices can be missed and any price that is held open for a long period of time attracts a high price premium Operational risk details contingency plans for dealing with problems that may prevent the purchase of energy such as ICT issues or key personnel being unavailable from both the supplier and purchaser side Value risk essentially details the price risk and the measures being taken to minimise 100% exposure to the markets.

Developing a risk strategy

With the market evolving from a wholesale pooling arrangement to a spots and futures market, suppliers are better equipped to offer a wider range of products to customers.The product choice will only grow as the markets continue to develop and this will allow customers to achieve their business objectives as they are more tailored to respond to their risk appetite.

What should a risk strategy look like ?

A typical risk management strategy should set out the following:

A definition of the contract options

Detailed roles and responsibilities

Details of the contingency plans for operational and purchasing risks

Upper budget price and lower budget price

The initial stops and targets or other mechanisms to control the value risk Details for reporting and market updates as required by the budget holder.

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