Covid has decimated our planet for well over a year now.
It has changed our lives, in some cases for the better, but generally for the worse. All industries and areas of life were affected – only now is it that we can begin to see a light at the end of the tunnel.
How many of these changes will hang around as we enter into recovery is yet to be seen?
One likely change in the energy markets post-Covid will be the return of volume flexibility clauses in energy contracts. As both demand and wholesale price are plummeting, energy suppliers are suffering from contracts where clients pay fixed prices.
About ten years ago suppliers began to offer full-flex contracts where large industrial consumers will fix a price up-front, and then pay for every MWh consumed at that price – regardless of the scale of consumption. If there is a collective fall in industrial demand and the intertwined drop in spot prices, this represents serious danger for suppliers.
Well, guess what Covid has caused…?
Some suppliers are already stating that this situation is pushing them towards bankruptcy. As can be observed throughout recent history, businesses will only ever start to manage risk when risk manifests itself.
In a bit of a reactionary move, suppliers are rapidly withdrawing full-flex product offerings from the market. If you are a commercial energy customer, this should be the sign for you to brush up on how some of the more detailed ins and outs of energy contracts.
Well, you’re in the right place.
Back to Basics
What is the function of an energy supplier?
Well, they are a retailer of energy – commonly in the form of a fixed price contract for customers. At a slightly more abstract level, they simply operate as a link between customers and the wholesale market.
Suppliers will take care of the practical side of things, balancing and performing hedging operations within the wholesale market. This is what allows them to offer fixed prices and not just spot prices:
Suppliers and retailers can fix a price for the future in a three-stage process:
- Buy a forward/future product: Buying/purchasing fixed capacity blocks.
- Adjustments in spot markets: Most commonly on a day-ahead basis, taking care of supply and demand deviations.
- Balancing: The balancing system will take care of any deviations in actual consumption vs what the supplier had bought on a forward and day ahead basis.
If a customer during a certain hour consumes less than the capacity fixed on a forward basis, for argument’s sake let’s say 4MW instead of the fixed 5MW, then they will have to pay the price that was fixed for the full 5 MW and get back the hourly spot price for the 1 MW of short volume on that hour.
However, if the customer consumes 6 MW instead then they will pay the forward price again on 5 MW of energy and the hourly spot price on the remaining 1 MW. The price the customer pays in the retail market is actually very similar to the price the supplier is paying in the wholesale market – minus the risk of discrepancies between the day ahead and the balancing market. Therefore, the risk that the supplier faces is actually incredibly close to zero.
Risk will never be fully removed, simply pushed towards the customer to deal with. In case of a structural drop in consumption plus low spot prices, or if there is a structural increase in consumption combined with high spot prices – the customer will need to put up more money per MWh than the original price at which they fixed at.
Some suppliers have pushed capacity-based contracts as contracts without volume flexibility previously – which is at best disingenuous. Although true that they do not contain traditional volume flexibility clauses, it is also true that they are a take-or-resell contract on an hourly basis with 0% flexibility.
The portfolio effect
Energy markets have traditionally offered fixed price contracts to customers. These operate on a per MWh consumed basis, not on a capacity basis – regardless of the specific moment in time at which energy is consumed. These contracts essentially push the risk for steps 2 and 3 back towards the supplier. This is possible as suppliers aren’t doing wholesale operations for a solitary customer but rather for all their clients. This leads to something dubbed the ‘portfolio effect’.
During a certain hour under normal market circumstances, a customer could be consuming a little bit less than what was secured on a forward basis by the supplier. However, client B may compensate for this by consuming a bit more. With larger well-balanced portfolios these differences find a way of balancing out.
The portfolio effect alongside the supplier taking on the brunt of the risk is a key reason why many customers choose to buy through a supplier still, instead of direct from the wholesale market themselves.
Unfortunately, the effect only really works if the overall consumption volume remains somewhat constant. If spot prices are low and client consumption is dropping (or if overall consumption is up and spot prices are high) then suppliers begin to incur losses from the daily selling/buying of extra volume on a day-ahead basis.
Historically, covering this risk meant that energy contracts with fixed prices on an MWh basis would include volume flexibility rules – meaning that fixed price only applies to volumes consumed within a certain bandwidth.
We will provide a worked example to help understand the previous statement: An example contract has 80%-120% on an annual basis. This means that in case of a contract with 100.000 MWh of contracted volume the fixed price will be applied to all energy consumption between 80.000 and 120.000 MWh. Once outside of these limits, a special price will kick in. This will be defined in the contract itself:
If below the lower limit average spot price – 0.5 Euros per MWh
If above the higher limit average spot price + 0.5 Euros per MWh
So, what does this mean?
Well, if for the example above the customer consumes only 70.000 MWh during the year, they will simply pay the fixed price for that volume. For the unconsumed volume (10.000 MWh) the customer will pay the fixed price and get back the spot price in return – 0.5 EUR per MWh. If the customer consumes 130.000 MWh instead, then they will pay the fixed price for 120.000 MWh and for the extra 10.000 MWh they will pay the spot price of + 0.5 EUR per MWh.
The contract described above has been dubbed a ‘take-or-resell’ contract, but due to some confusion around terminology (not uncommon for the energy industry), they are often referred to as ‘take-or-pay’ contracts. Take-or-pay contracts are actually something else entirely.
With take-or-pay contracts, there is no reselling of volumes that are not consumed – Meaning that for the previous example, if the customer consumed 70.000 MWh then they would still pay for 80.000 MWh, but not receive anything back for unconsumed volume. This can cause serious strife for businesses not clued up about their energy contracts. In fact, there are many businesses that have had such horrible experiences from take-or-pay contracts that they have been put off of ever taking on a contract with any form of volume restriction.
Crisis and Innovation
During the last world economic crisis (2008) the majority of customers had contracts with take-or-pay or take-or-resell conditions – leading to many large bills for unused volumes. When suppliers introduced full-flex contracts shortly after this, the lack of volume limits and potential payments for unused volumes were a bit of a no-brainer for many.
The suppliers originally opposed to these full-flex contracts were soon won over by the clear and obvious success, so much so that by a year later many of the nay-sayers had added full-flex contracts to their product line-up.
The roaring success of full-flex led to any contracts without full volume flexibility becoming so undesirable that selling one of these contracts became a serious job for even the most hardened of salesman.
Because of this, the product offering of full-flex contracts has been withdrawn.
The burning question for many now is if, and when, will they return?
Therefore, energy buyers are going to have to re-learn how to negotiate good volume conditions into their contracts. To do this, we recommend taking the following factors into consideration:
- Take-or-resell: Take-or-pays are far more beneficial for suppliers than for customers, stick to take-or-resell.
- Negotiate (Period): More specifically negotiate the period on which volume restrictions are applied, in the following order. Year > Quarter > Month.
- Bandwidth: Find a balance between good bandwidth and the period of time it is applied over. Longer periods will grant longer to make up losses in volume.
- Negotiate (Add-ons): Try to get access to some great add-ons for unconsumed or extra volumes.
Fear and Action
Any contract with volume limits should mean that customers should think carefully about the contracted volume within the contract. At a realistic and human level, nobody wants to be the guy that committed on too large a volume, causing the payment in the first place. This fear can lead to decision-making paralysis, letting many good business opportunities pass by.
To counter this problem, consider the following:
- Never just ask someone within your business for the volume to be contracted – often this task is unrelated to their usual day-to-day role and can increase the pressure placed on them.
- Always prepare with data. It can be easy to use too much detail – for annual volumes, there is little sense in going all the way down to quarter hourly data. It may be prudent to try and include some kind of analysis or commentary on the data, as it will help others reach the same conclusions.
- Identify and review the drivers of consumption. If how your energy consumption relates to your operations is known, it is then possible to change the question to ´how many tons of production do we expect next year? ´ from ´how many MWh do we need? ´.
- Estimate lower rather than higher for product driven consumption. If the estimation is too low then the business may end up having to pay a little extra due to high spot prices. The timing of these extra costs will come when the business is doing well, and likely able to cope. On the other hand, if the estimate is too high and the business is under-performing, an annoying take-or-resell bill is the last thing that is wanted. In general, it is easier to negotiate an increase in contracted volume than a decrease.
- Climate-related consumption is a reversal of the above. Consider the effects of a cold winter or hot summer – have you bought enough for both situations? Global warming will only make this assessment harder in the years to come.
Niccolo Gas – Here to Help
If you would like to get in contact with one of our energy experts to see how we can help your business today, you can do so through the following channels.
Phone: 0131 610 8868
Email: info@niccolo.co.uk
Webform: Here
We look forward to hearing from you!