How to Manage Risk to Avoid Losing the Energy Purchasing ‘Lottery’
By Magnus Walker, Director of Trading and Risk for Inprova Energy
To increase gains and avoid losses when playing the ‘lottery’ of flexible and volume energy purchasing, businesses must carefully manage risk, says Magnus Walker, Director of Trading and Risk for Inprova Energy.
He sets out a five-step process to help businesses prepare a risk management plan and trading strategy that can ensure resilience in the face of bullish wholesale commodity market conditions and sharp increases in non-commodity charges.
Don’t dice with volatility
The wholesale energy market is incredibly volatile and unpredictable. Prices can move dramatically in response to market triggers – such as a cold snap, geopolitical instability, currency fluctuations or supply and capacity problems.
With professional help, this risk can be contained. It’s often believed that fixed rate contracts are less risky than flexible contracts, which is a fallacy. While fixed rates do provide budget certainty, the odds are 1:365 of picking the day of the year when the market is at its lowest to fix a deal.
In comparison, flexible purchasing offers more opportunity to buy chunks of your energy volume at points in time when the commodity market dips.
The obvious danger is missing the market troughs and then purchasing energy when the market peaks because you’re only watching the market occasionally. This is why any flexible purchasing strategy should be supported by a robust risk management system and trading strategy to limit potential losses by ensuring that you never hit the top of the market. .
A risk management process/system should identify the risks to be measured and valued, the company’s objectives and risk limits, and the amount the buyer is willing or prepared to miss out on. These risk limits or “triggers” should also account for unwind time (the time it takes to hedge a position) amongst other factors.
Seek sound advice and involve your board
To implement a corporate energy risk management strategy – rather than simply managing market risk, an integrated approach should be developed at board level.
Risk management is complex, so it’s sensible to seek expert advice to carry out an initial forecast assessment using established and proven modeling techniques. This will highlight the options available and determine your appetite towards price risk.
It’s important to quantify the potential risk and fully understand how a change in the wholesale energy price will impact your energy purchasing costs. From there, an optimum price and risk strategy can be agreed, implemented and monitored.
Reputable energy advisers, and some energy suppliers, can support you.
Understand risk management methods
There are various methods used to manage risk. In the case of market risk, ‘forward purchases’ of different contracts will help to mitigate the risk of leaving contracts until an inopportune point. For example, you could purchase a proportion of your expected energy requirements at a fixed price for the duration of the contract, then build up the remainder by purchasing fixed-price blocks on the forward market at different times.
Alternatively, you may link wholesale prices to a benchmark or index of market levels, but then include a risk management strategy to guard against sharp price moves.
Some larger energy users may also have their own on-site generation, trading surplus energy on the grid to limit exposure to higher prices.
Get to grips with limits
A risk management plan, in which the trader is only allowed to make purchases within a set range, can limit any potential market losses, but can also constrain gains should the market drop.
Further levels of complexity could be added with automatic triggers and trades, should certain price movements take place and close out against indices near to delivery.
However, complex deals, which require more market monitoring, will be costlier to manage. Sometimes simpler and more straightforward risk management strategies can be equally effective, if professionally managed by experienced teams with access to live market prices.
Risk management is a continuous process
Your actual risk position will change day-to-day in line with the market, so ongoing monitoring and analysis of your market position is required. As in financial markets, mark to market (MtM) principles allow you to regularly assess the risk of your market position. Feedback by your professional manager on your open positions will help to determine the trading strategy throughout your flexible contract, ensuring that you buy at the right times to maintain energy price risk within agreed levels.
What works for you at the start of the contract is likely to change, so regularly review and discuss your buying strategy. A good consultant should offer this as a matter of course for large energy consumers with complex and changeable energy requirements.
Your risks to your overall energy spend will rise with increased market volatility. It can be contained, but only through a properly managed and written risk management solution. This should follow an in depth assessment of your organisation’s appetite for risk and procurement needs.
With an appropriate recorded and agreed trading strategy in place, procurement should be executed by a team with live market price feeds, the right monitoring and reporting systems, and ability to recognise changing market conditions. This team should be proactive in advising customers on the best energy procurement routes, and review and amend the strategy, with the aim of avoiding market shocks.
Inprova Energy is one of the UK’s top ten business energy procurement and management consultancies and manages around 3,000 gas and electricity supply contracts on behalf of clients, including Virgin Atlantic, Hotel du Vin, National Grid, Carlsberg and retail group White Stuff.
Further information: www.inprovaenergy.com, 0330 166 4444