Increase your profit margins with smarter energy purchasing
12 April 2013
Within the industrial and commercial sector, energy is widely considered to be a top-three spend, along with labour and materials. Of the three mentioned spends, energy is the most volatile, with prices fluctuating up to 100% in recent years. Such swings in price are forcing businesses to consider new and innovative ways of controlling and managing their energy spend.
Ireland Inc is back on the pathway to becoming a more sustainable economy; likewise, Irish businesses are increasing their competitiveness. Profit margins are being squeezed and with energy prices continuing to remain volatile, it is critical that organisations consider the very real risks to their profit margin.
Instinctively, we consider risk to have negative connotations, particularly in the energy sector. However, a well-managed energy portfolio can reward those willing to look beyond the status quo.
If we consider the electricity market in Ireland, the fuel used to generate our electricity is primarily fossil fuel-based, at over 87% in 2011. The dominant fossil fuel in our generation mix is natural gas, at over 55% in 2011. Unfortunately, Ireland does not have an indigenous supply of natural gas. We are highly dependent on our closest neighbours – in 2011, some 93% of our natural gas was imported from the UK.
With this strong dependency on natural gas in mind, many utility companies are now dual-fuel suppliers and offer customers electricity and natural-gas contracts. Within the large energy-using sector, the majority of suppliers offer electricity contracts that are linked directly to the price of natural gas. This, in effect, means that when gas prices move, electricity prices move in the same direction. The price correlation between UK gas prices and Irish electricity prices is very strong.
BUSINESS ISSUES AND CONCERNS
So, what are the issues and concerns that businesses have?
The deregulation of the energy marketplace was welcomed by all. However, with deregulation came complexity (from the end users’ perspective). Traditionally, only fixed-price electricity or natural gas contracts were offered. This was a relatively simple transaction for both the supplier and the end user. As end users became familiar with the key price drivers associated with their energy contract, they became concerned about the complexities and nuances of the energy marketplace. Someone within their organisation had to make a call; someone was responsible for either getting a great deal or a terrible deal. Someone’s head was on the block.
For example, the UK gas price for 2012, which is priced in sterling and takes the format of ‘pence per therm’, has swung by over 30p per therm from September 2009 to September 2011. Prices were at times as high as 72p/therm and as low as 42p/therm.
It is important to put a 30p/therm swing into context and understand the financial implication of such movements in price. Typically, an electricity and natural gas bill consists of three components:
• Commodity component;
• Use of system charges (use of the wires and cables);
• Supplier margin.
This commodity component represents approximately 70% of the final bill. If the commodity component is valued at €1 million per annum, the following rule of thumb applies to the electricity bill:
• 1p/therm movement = €9,000 swing in final energy price.
• 30p/therm swing = €270,000 swing in final price.
If one spent €1 million on the commodity component in 2012, the price would have swung by approximately €270,000.
UK gas prices have a number of quirky characteristics and one of them is the strong correlation between gas price movements for forward years. That is to say, if annual gas prices move upwards for 2013, annual gas prices will also be in an upward trajectory for 2014 and 2015. If we take the previous rule of thumb example, it is plausible that gas prices for 2013 and 2014 will also swing by 30p/therm. With 2012/13 and 2014 combined, the price swing equates to €810,000.
Now have I got your attention?
The purpose of the above example is to stress the value of what is at stake. It also highlights the two sides of the risk conundrum:
a) One side is the risk associated with a fixed price contract. If I fixed prices and prices fall, how much has this lost opportunity cost my business (in terms of lost profit margin?)
b) Another side is the risk associated with a floating price contract. If prices rise, how much extra is this costing my business (in terms of lost profit margin?)
End users have traditionally selected the first option, because a fixed-price contract offers advantages when setting a budget. However, this often comes at a high cost. Is it a case of being either lucky or wrong?
Even in the good old days, getting it wrong to the tune of €810,000 would not be acceptable. The issue for business is that energy contract management is not their core competency. In reality, these complexities can be overwhelming and often result in rash, emotive decision made by end users.
TOOLS AND KNOWLEDGE
Most of us have at some stage made a major purchase in life. If someone was unlucky enough, like this author, to have bought a house in 2006, they would have engaged with a solicitor, engineer and auctioneer to assist them with the purchase. I needed assistance when buying my house because it was not my area of expertise: I did not have the tools or knowledge (especially the knowledge). How professional the experience was, is a debate for another day.
Likewise, large energy users need help. The way in which energy can now be purchased is drastically different to traditional solutions (fixed price or floating price). The marketplace in Ireland has developed considerably in recent years. Suppliers have responded to the needs of the large energy using communities and Ireland now offers some of the most innovative and flexible contracts in Europe.
These innovative contracts enable large energy using organisations to secure a budget (like a fixed price contract), but also enable end users to secure lower prices when these prices become available (like a floating contract). However, the vast majority of end users do not have the tools or expertise to manage these flexible contracts.
Like New York City, the energy market never sleeps. Energy prices and the associated volatility demands full attention; the financial stakes are high. Your profit margin is at risk. Take the airline industry as an example. Fuel prices have a heavy influence on profit margins and as such, airlines view the way in which they purchase fuel as a means to gain a competitive advantage. This type of strategy is now being embraced by large energy users in the Irish industry.
A new way of purchasing and managing energy is here to stay. End users are entering into longer contract terms with suppliers, typically three-year terms. Budgets are protected over this three-year term and opportunities are secured. There is no longer a need to be wishing and hoping that energy prices fall, the tools and expertise are available today. It is through the leveraging of these tools and expertise that businesses can increase competitiveness and increase profit margins.
Ryan O’Neill holds a MBs in Strategic Procurement and BSc in Electrical Power Systems. O’Neill is a corporate area manager (Republic of Ireland ad Northern Ireland) within the professional services division of Schneider Electric. The division is responsible for the purchase of €24 billion of energy globally per annum.