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Weighing up the risks of power procurement

Issue 1 and Volume 16.

David Titterton of npower business discusses how a new service is arming major energy users with the tools they need to tackle the risks inherent in energy buying.

By: David Titterton, npower business, UK

In the past five years trends in energy purchasing and use have undergone significant changes. Gone are the days when organizations procured energy by simply buying the best value fixed-price contract and then turned their backs on energy consumption until it came to renewal.

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With the combined pressures of volatility in the energy market, fuelled by global oil prices, concerns over security of supply and uncertainty over the UK’s energy infrastructure, together with the introduction of new regulation to instigate carbon reduction, energy buyers are facing a raft of new decisions in energy procurement.

Our own research, the npower Business Energy Index (nBEI), an annual survey undertaken by npower business that analyzes and monitors business perceptions of the energy market and key energy trends, reveals the type of risks businesses are exposed to in terms of their energy use.

In our latest report, nBEI5, which was launched this year, businesses report that while they are taking measures to control their energy use and are reporting a decrease in costs, they are mindful of future price volatility. Companies report that energy costs are stabilizing and representing a smaller percentage of total operating costs. Whereas, in nBEI4 (published in February 2007) energy represented an average of 12.2 per cent of overall operating costs, this dropped to 9.4 per cent by late 2007.

More respondents say that their energy costs decreased than rose during 2007 – 29 per cent report a reduction; 23 per cent report an increase. This is a marked difference to nBEI4 when only nine per cent of businesses reported a decrease in costs and 61.5 per cent said they had seen energy prices rise. Of those companies that did experience an increase in energy costs in 2007, it is a much lower rise than in any of the previous four nBEIs. The average increase this time was 18 per cent, down from 35 per cent in nBEI4 and 46 per cent in nBEI3.

It Is certain nothing is for certain

While these statistics reveal a largely positive picture for businesses when compared to previous years, they also reveal the potential for volatility in the energy market. The experience from 2006 was completely different to 2007, and it is therefore reasonable to expect that the situation for the coming year will be different again. Exactly how this maps out remains to be seen, but with the prevailing market conditions currently leading to volatility in energy costs, businesses may experience this in their energy purchasing during the coming months.

Energy remains one of the most volatile markets in the world, reflected in the year-on-year experience of the respondents to the nBEI. Yet despite the acknowledgement of volatility and the inherent risk in energy buying, we do not always see this reflected in the way businesses procure energy.

Yes, we have seen energy management improve and businesses keen to control their costs through flexible purchasing arrangements, but not the true application of risk management in the purchasing arrangement.

Businesses routinely manage risks associated with finance, strategy, health and safety legislation, IT, and competition, but many still pay very little attention to potential uncertainties surrounding energy buying. Energy risks often go unpoliced and do not make it on to the boardroom agenda. While exposure to risk will be influenced by the amount of energy a business consumes and by the contract types available to it, for those businesses with energy as a raw material they cannot ignore the risk of the market volatility.

A new dawn for energy usage

As we enter a new phase of energy use, in which it will be influenced as much by carbon regulation as by price, the case for devoting more importance to the risks inherent in energy purchasing becomes stronger.

The Climate Change Levy, the EU Emissions Trading Scheme (ETS) and the Carbon Reduction Commitment (CRC), when it is introduced, are placing new priorities on energy use by incentivising businesses to reduce their carbon dioxide (CO2) emissions. With the cost for carbon predicted to increase in the future there is a very real need for businesses to reduce their energy consumption, and therefore their emissions, and benefit from the additional revenue that comes with trading carbon credits. Conversely, there is also the incentive of reducing emissions so as not to miss targets and suffer financially by having to buy additional credits.

Arguably, corporate social responsibility has never been more important to businesses. Customers, both consumers and business-customers alike, are becoming increasingly discerning in their choice of partners and suppliers and selecting those that show themselves to be most environmentally positive.

All these factors are now linked to energy use. A supermarket, for example, is exposed to cost risks by having sizeable energy needs to run its stores; is exposed to regulatory risks by having to conform to the cap-and-trade measures under the EU ETS and the anticipated CRC; and is exposed to societal risks by the expectation of its customers to minimize its impact on the environment.

While in this example, given the high-profile nature of large retail businesses, the risks are clear, such factors may not be as evident for other major energy users. The nBEI5 points to the fact that businesses in other sectors than retail are now also feeling regulatory and societal pressures, alongside traditional cost pressures.

In a mixed response, 75 per cent of intensive energy users surveyed said they thought the combined pressures of the Climate Change Levy, the EU ETS and the new CRC place an undue burden on business. At the same time, a significant majority of respondents (88 per cent) said they support the Government’s commitment to reduce CO2 emissions and 56 per cent also said they thought compliance with climate change agreements had resulted in energy savings or process improvements. Also, 36 per cent said they believed there were commercial advantages to be had from a small carbon footprint – a significantly higher response than in our 2007 report, which revealed widespread misunderstanding of the low carbon economy.

Price volatility needs new business models

At npower business we believe the framework of regulation and the on-going volatility in the energy market will call on businesses to develop new business models if they are to succeed within a low carbon economy. Businesses will have to develop policies to manage all the risks associated with energy use including cost, environmental and societal risks. In this way, decisions on energy buying and investment in efficiency measures which can reduce CO2 outputs can be assessed on a more holistic basis, rather than just cost. This moves away from a quick win scenario in which energy efficiency measures are only made for financial gain to a more progressive strategy in which the approach to energy management and CO2 reduction is aligned with business goals.

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The response to societal and regulatory pressure requires a long-term sustained strategy; taking control of cost risks can be achieved more readily and provide the platform on which to make on-going improvements. In short, make better informed and controlled decisions on your energy purchasing in relation to the energy risks you face, and you stand to benefit from reinvesting the cost savings achieved.

It is with these factors in mind that npower business is working with its customers to understand their business and their risk profile and provide them with the tools to mitigate these risks. This has led to the development of ‘Policy Shaper’ – a new service enabling major energy users that purchase flexibly to make better informed energy procurement decisions and unlock financial rewards.

Shaping up business decisions

A greater number of commercial energy users buy energy in flexible arrangements, but Policy Shaper expands upon this by giving businesses a framework in which to make tactical purchasing decisions.

It provides organizations with the guidance they need to develop the right energy policy by bringing together all the disparate elements that they need to be aware of in a streamlined and accessible solution, rather than view the issues in isolation.

It will help energy users understand their exposure to fluctuating market prices and provide the necessary tools that lead to tactical execution and controlled purchase decision-making. With a detailed understanding of the risks they are prepared to take, energy purchasers can develop a robust energy policy and have a benchmark against which to make purchasing decisions.

This level of detail provides the financial clarity and strategic insight that is needed to make energy a board level decision.

Incorporating Value at Risk (VaR) reporting, the service will enable energy users to measure financial rewards according to the level of risk they expose themselves too. npower business can measure and evaluate the market for the client and then provide a selection of products and services to reflect the customer’s preferred level of risk.

In the flexible arrangement, those who are risk-averse can set a modest upper limit to the price they are willing to pay for their energy per MWh, allowing them to more tightly control and budget their energy expenditure.

Conversely, a business willing to set a higher upper limit has access to potentially greater savings because they can observe longer term trends in the market and potentially buy energy at better rates.

Policy Shaper has been developed on the back of recommendations by the G30 group of international businesses, an international body of leading financiers and academics set up to deepen understanding of economics and financial issues. G30 called on industrial and commercial businesses to establish a framework of overall risk and adopt the same market risk management practices used by large financial businesses.

We have seen an extensive cultural shift in procurement practices over the last few years. Policy Shaper marks the next stage in this evolution, helping major energy users develop a strategic view of their appetite for risk in energy procurement, coupled with subsequent guidance and the relevant services to manage this.

The unpredictable nature of today’s energy market requires a flexible approach and companies can either adapt and make the wholesale and developing carbon regulation market work to their advantage, or do nothing and face the consequences.