Six tips to manage risk when buying energy

While recent energy prices have been falling, the wholesale energy market is turbulent and buyers need to be wary if they are to avoid becoming stranded against the fast-turning tide of the marketplace, thereby losing out in the business energy purchasing ‘lottery’.

Here are six tips to help in formulating a risk strategy to ensure organisations buy advantageously, while navigating some of the potential pitfalls of flexible energy procurement:

1. Don't dice with volatility. Prices can sometimes move dramatically in response to market information, such as a cold snap or unplanned maintenance. A good risk management system and a trading strategy is essential to limit potential losses. According to Eurostat, it’s not uncommon for total flexible energy bills to vary as much as 20 per cent for medium-sized UK gas and power users.

A risk management process/system needs to be set up to identify the risks to be measured and valued, the company’s objectives and risk limits and the amount the buyer is prepared to lose. The risk limits will also account for unwind time (the time it takes to hedge a position) and other factors. One of the current challenges is to predict when bearish factors, such as the oil price slide, will bottom-out and prices will start to climb.

2. It's complicated, so seek good advice. Risk management is a complex area and it is a good idea to get some expert advice from a broker or consultant. They should be able to highlight risk management options and assess your appetite for risk, as well as carrying out an initial forecast assessment using advanced modelling techniques. It is important to quantify the risk and fully understand how a change in price will impact your energy purchasing costs. From there, an optimum price and risk strategy can be agreed and implemented.

3. Make use of your risk management toolbox. A buyer has many tools in his risk management toolbox. In the case of market risk, forward purchases and sell-backs can be made in months, quarters and seasons via direct negotiation with trading teams at each supplier. Alternatively, transactions can be fulfilled automatically by index pricing and settlement trades, while swaps and options are also available for the very largest clients.

To manage market risk you may wish to purchase a tranche of energy at a fixed price for the duration of the contract, then build up the remaining energy requirement by purchasing fixed-price blocks on the forward market at different points in time. Or you may wish to link prices to a benchmark or index of market levels, but then include a risk management strategy to guard against particularly sharp price moves.

Increasingly, buyers with their own on-site generation can participate in various 'within-day' schemes with network operators. In this way they can earn additional income and limit exposure to high energy market prices, as well as discounting network charges.

4. Keep tabs on your risk management. A risk position is fluid, meaning it can change on a daily basis in line with the market, so ongoing monitoring and analysis of your market position is required. The best brokers are well placed to help with this, and can also ensure quick and direct market access to implement any adjustments to trading positions.

As with other commodities, mark-to-market (MtM) principles allow energy market participants to assess the risk of their market position on a regular basis. A measure of potential deviation in the MtM value, known as ‘value at risk’ (VaR), has been adopted as the standard measure used to manage energy market risk.

Feedback from your market position will influence trading strategy throughout your flexible contract, ensuring you hedge at the right times to maintain energy price risk at satisfactory levels - dependent on your volumes. Re-forecasting can be carried out at various points, helping to adjust forward strategy in line with the latest information.

5. Keep an eye on non-commodity costs too. At the same time as tracking your commodity purchasing, you also have exposure to a range of other charges associated with your supply. These include: network charges, metering costs, and various environmental levies, especially in electricity. With these costs now representing around half of your total bill, it’s easy for increases in these elements to outweigh savings you may be able to achieve on the wholesale side.

While it’s tempting to ask suppliers to fix these costs for a year or more at a time, you will be paying quite a premium for this facility. Most large buyers now opt to take them as “pass-through” charges - just reflecting the prevailing regulated rates. It is therefore important to regularly review your budget assumptions as a whole within your flexible supply framework.

6. Make energy risk management a boardroom issue. To implement a corporate energy risk management strategy, rather than simply managing market risk, an integrated approach needs to be developed at board level. This will not only look at risk appetite and consumption patterns, but also at current and anticipated regulatory and market environments.

Mark Alston is director at ENER-G Procurement

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