Understanding the New World of Energy Procurement

Volatile energy markets and the de-regulation of gas and electric utilities are forcing industrial energy consumers to adopt energy procurement strategies. Risk is inherent both in the way energy is purchased and consumed, but for a variety of reasons, organizations mostly focus on procurement. Business consumers seek protection from energy price spikes that can destroy earnings and upset budget performance. Management of procurement risk is a necessary component of energy cost control.

Consumers want to be shielded not just from high prices, but also from volatile price movements that complicate fiscal and budget planning. In a deregulated energy market, consider the potential for price movement between the time when a consumer presents an offer to buy and the time when the transaction is fulfilled. Price “risk” describes the degree of market volatility between those two points in time. The techniques used to manage financial investment risks are directly transferable to energy procurement. The key concept here is “hedging,” or structuring a transaction for the express purpose of neutralizing the potential for lost value.

Hedging involves the assignment of risk. In other words, for a transaction with some lag time between contract ratification and actual fulfillment, who will absorb the risk of market price fluctuation—the buyer or the seller? The consumer that wants 100 percent certainty of energy expense must pay the supplier a premium for a contract to receive a commodity at a fixed price on a specified date. Conversely, the consumer that accepts the risk of market fluctuation evades that premium by purchasing indexed contracts, i.e., contracts with prices set to reflect the natural ebb and flow of the market. Many consumers blend their consumption with a combination of fixed and indexed contracts. A related hedging tool is the “option,” which gives the bearer the right, but not the obligation, to procure energy at a fixed price.

A fixed-price contract makes sense for the consumer that anticipates any upward movement in the future price of energy. A contract can lock in a chosen price for a specific quantity of energy. The consumer that purchases 100 percent of its energy this way “assumes a fully-hedged position,” or is shielded against the potential for higher market prices in the future. But by the same token, such contracts—as obligations to buy at a fixed price—prevent the consumer from enjoying market price dips. The opposite end of the risk spectrum is the “fully-indexed position.” This means, for an energy consumer, making all purchases at the market price that prevails at the time of order fulfillment.

In reaction to energy price spikes in the wake of the 2005 hurricane season, many industrial energy consumers aggressively hedged their consumption through 2006. This means they purchased fixed-price contracts that anticipated continued upward movement in the market. However, energy prices dropped during 2006. In effect, the hedged consumers ended up paying higher prices—at least during 2006—than the prevailing market. Does this experience mean that hedging is a bad strategy? To answer, think of it this way: chances are that you paid for homeowner’s insurance in 2006, but you did not need to make a claim against your policy. That doesn’t mean that your insurance expenditure was a waste. Think of energy procurement hedging as a form of insurance—in this case, against the risk of dramatic price spikes.

An important point to remember: by consistently assuming a fully-hedged position, the consumer pays more for a commodity in the long run. This is because of the premium that is paid for the surety of a fixed-price contract. In contrast, by assuming a fully-indexed position, the consumer absorbs the risk of market volatility. This entails enduring the occasional price spike, but consistently avoiding risk premium payments.

Procurement strategies can only be a partial solution to high energy costs. Hedging only stabilizes price risk. Consumers seeking to proactively and consistently reduce energy expenditures must reduce their energy waste. This requires a business plan that employs technologies, procedures, and behaviors for continuous energy improvement.