Hopefully, you are here after reading our previous article, A Brief History of Flexibility. If you’re not? No problem. All we have covered so far is the backdrop to flexible contracts.
In this article, we start getting into the nitty-gritty of it all.
If you would like to read our previous article, you can do so here: https://niccolo.co.uk/flexible-contracts/a-brief-history-of-flexibility
A brief recap – Flexible Contracts
Flexible contracts are a somewhat new contract type that helps to pass on the benefits of the wholesale energy market to consumers, with the price they pay for their energy being dependant on movements in wholesale price.
The profile shape of the customer’s demand (consumption) trend is split into two separate categories. These are the baseload and peak.
The baseload can be thought of as the bulk of demand and is the predictable portion of the customer’s energy. Most businesses will be able to provide very accurate estimations as they have access to much more detailed levels of data. This is usually through combinations of smart meters, sub-meters, and even auditing.
The peak is essentially the spike in demand outside of predictable baseload that nobody foresaw needing. This peak demand makes up the tradeable volume which is able to be traded within flexible contracts.
The wholesale market trades this volume in set blocks, although the match-up between the block and customer profile may not entirely match. As a result of this, customers are able to buy a block of energy that may or may not exceed their total usage. There are actions to resolve any mismatches of demand and purchased volume.
Where the purchased baseload and peak volumes exceed the customers profile the gas can be sold back to the supplier. In addition to this, when purchased baseload and peak volumes fall under actual customer consumption needs, customers are able to ‘top-up’ and purchase extra volume in smaller blocks.
This is where the term ‘flexible’ energy contract really comes from – it allows a much greater degree of freedom to the customer. This is the vector by which the risk and reward of the wholesale market are passed onto customers.
Complicated? Risky? Definitely not…
The hedging possibilities of the clicking contracts have developed a seriously high level of sophistication. This is especially true for North-Western Europe. In less mature markets (Spain and Italy, for example) the products are still rather basic, as many large consumers begin to shift to clicking contracts. On the other hand, in the likes of the Netherlands, Belgium, and Germany, most consumers now have highly individualised approaches to how they fix their prices.
Complicated or not, clicking contracts are still providing significant hedging risk for energy suppliers. There is still a risk for the supplier that the revenue generated by a customer does not match with the costs in the wholesale market – this is due to the sole fact that customers fix percentages of volumes with every time they fix. The supplier still has to apply that price for any volumes consumed between the volume flexibility margins of the contract, regardless of the moment the volume has been consumed.
That is a little wordy, admittedly. So, it makes sense to use a worked example here:
Take for example a client that has a contract to fix 87.6 GWh of 2014 gas consumption in 10 clicks on the TTF Cal14. This contract has 80% to 120% volume flexibility on the annual volume.
Every time that the customer clicks, the supplier can buy a 1 MW block of TTF Cal 14. He will get 87,600 MWh delivered at the price that he fixed at the TTF during 2014. Say the customer consumes 90,000 MWh, the excess will have to be covered in the spot market. If the spot price is higher than the forward price? The customer will lose money.
If the customer consumes only 80,000 MWh but the spot price is lower than the forward price? The customer will lose money again as he pays the forward price for the 7,600 MWh of forward bought gas that then can be sold back, but only at the lower spot price.
In a nutshell, this is why more volume flexibility will cost more money in terms of the add-on on top of the TTF wholesale price. On top of this still, the energy supplier has hedged capacity blocks, 10 MW in total. But the customer will not consume 87,600 MWh in equal 10 MW per hour blocks.
Say for one hour, they consume 12 MW. The supplier will have to buy an extra 2 MW
In the next hour, the customer will consume only 8 MW. The supplier will have to sell 2 MW.
For any capacities per hour that can be forecasted – energy suppliers can buy and sell in the day-ahead market. Compared this to any unexpected diversions of the consumption pattern, which they will have to procure by the within-day market or get balancing system payments or invoices.
This is basically the main problem here.
The fixed price for a customers’ annual volume cannot be perfectly hedged by the supplier in the wholesale market where only capacity blocks are for sale. This creates volume, spot market regulation and balancing risks for the supplier. The supplier will then have to factor this in and add risk premiums to add-on on top of the wholesale price to mitigate this risk. If customers choose to have part of their price indexed to the spot market, the risk is lowered but not certainly eliminated.
The finished product, for now
In North-Western Europe the markets for supplying energy to industrial/commercial consumers have been developed into very competitive markets indeed. In the majority of tenders, the difference between the three best supply offers is less than one percent!
It then makes sense as to why energy suppliers search endlessly for ways to lower any wholesale market add-ons and to offer innovative, new products to customers.
Enter, the full-scale flexible energy contract.
In these contracts, the hedges are no longer on percentages of annual, quarterly, or monthly volumes, but on capacity blocks. Capacity blocks are then regulated over the spot or balancing market.
To make sense of this, we return to our previous customer example.
With a full-flexible contract, the supplier will do just about the same hedges as before but instead of just charging a fixed price for every MWh consumed between flexibility margins, they will also charge/payback to the customer the costs of extra MW’s or lacking MW’s that were consumed or not consumed on an hour-by-hour basis.
If the customer is consuming 12 MW in one hour, they will pay 10 MW at the forward price and 2 MW at the spot price for that given hour.
If the customer is only consuming 8 MW, they will pay 10 MW at the forward price and get back the spot price for the 2 MW.
If by the end of the year they have consumed more than 87,6 GWh then this will mean that the overall volume of energy that was to be bought in the spot market will be larger than the overall quantity that could be cold back.
As is the way with these contracts, the supplier is passing through their volume and capacity regulation risk to the customer. For this reason, such contracts will sometimes have an add-on price that is dramatically better than traditional clicking contracts.
Final verdict? The consumers decide
Honestly, the reactions of customers to full-flexible contracts have been mixed.
Some have been blinded by the lower add-on and sign a full-flexible contract without a full understanding of the added risks.
Others are just scared by the extra risk and are reluctant to sign them without fully understanding the opportunities on offer.
One thing is certain. If you put two clicking contracts next to each other, you can say with 100% certainty which is better.
With full-scale flexible contracts, this is not really possible. You will always have to operate with unknowns, which makes the full-scale flexible contract only better under certain combinations and worse under others.
For this reason, at Niccolo Gas we have created our own approach for judging the risk/opportunity balance of this new contract type. The choice of such contracts should also be based on the broader strategic approach of buying energy.
If you would like to read more about our unique take on the wholesale markets, you can find a link to our piece here: https://niccolo.co.uk/for-customers/risk-in-energy
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