Over the last twenty years or so – the energy markets (gas and electricity) have faced intensive deregulation, leading to incredible competition between both buyers and suppliers.
One of the clearest ways in which this can be demonstrated is the opening of the wholesale energy markets for customers to exploit through flexible contracts. Before this, customers would be offered a single unit rate that wouldn’t change for the duration of the contract, even if their supplier was paying a much cheaper price for the energy to supply them with through market changes.
Now – customers are able to access the same benefits of low-cost energy through the extremely price volatile wholesale markets.
In this article, we look to explain a little background of the wholesale market, supplier costs, and how some of the big buyers set rules when delving into the wholesale markets on a customers’ behalf.
The Vector for savings – Flexibility
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 main bulk of demand and is the predictable portion of the customers energy. Most businesses will be able to provide 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. The stuff that nobody foresaw needing. This peak demand makes up the tradeable volume that is able to be traded within flexible contracts.
The wholesale gas 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 gas market is passed onto customers.
What affects energy prices the most?
The wholesale price, and thus, the state of the wholesale market.
The wholesale energy price represents a massive portion of costs for suppliers in providing gas supplies to customers. So, when the price of gas in the wholesale market rises, suppliers have to raise the prices imposed on customers to safeguard profits.
We have included a standard cost breakdown from a supplier point of view for a standard UK customer below. Figures are approximations and there will be variance between customer type, scale, etc.
How do professionals approach the wholesale energy market?
At Niccolo Gas, we have built up a wealth of experience in everything energy.
Now – we are sharing that experience online, for free. We aim to provide a level of transparency for all our customers that simply has never been provided by an energy supplier before.
What better way to do that than by telling you all how we see the energy industry as a whole (with an obvious focus on flexible contracts and the wholesale market.
Approaches to buying energy – charted
As you can see – this is how buyers of large volumes of energy in the wholesale market can effectively be broken down into groups.
We have the staunch predictors, the doubters, and everything in between.
Buyers that believe price can be predicted – 5%
Roughly 5% of buyers in the wholesale market staunchly believe that prices in the energy market can be predicted with absolute accuracy, if they are able to ‘crack the code’ mathematically, that is.
The strongest argument against this operational belief is an incredibly simple one. If those who truly believed that the price of the energy market could be predicted truly believed this, why on earth are they energy buyers!?
If prices could be predicted this easily – why not become a full-time energy trader? The profits you would stand to make are mind-boggling…
This kind of debunks this idea of ‘perfect predictability’.
The wholesale energy markets are incredibly unpredictable by nature. Supply and demand forces are complex, and difficult to understand. There are too many variables to track, let alone quantify.
A huge amount of time is spent analysing past trends through complex mathematics to reveal trends and correlations. But in this market setting, this doesn’t necessarily help you very much. Revealing only that one unknown factor is indeed correlated with another unknown factor.
Buyers that believe you can’t predict price, so should not trade energy – 10%
This small group of consumers fully understand and readily accept the energy market volatility. Most commonly this group will delete deliberate trading decisions from their energy procurement practice, linking energy prices to the spot price, to an average forward price or buy at randomly chosen moments to produce an average price.
This is a bit more of a hands-off approach than others, and it is especially popular with larger energy consumers. This is to do with scale.
Every decision to fix or not is a matter of millions of pounds, if your consumption is high enough, that is. Many businesses decide that they shouldn’t leave this to the energy buyer, and will instead set up a trading desk or automated buying.
Buyers that believe you can’t predict price, but can create business value by actively managing prices – 10%
Active price management should look a little bit like this:
- Analyse the impact of energy market price volatility on your business and find a strategy that helps to minimise risk. The strategy should not determine when you buy, but more-so determine how much you buy and how far into the future. If the main risk for your company comes from financial vulnerability, it is advisable to buy larger volumes for farther into the future. If the main risk is market vulnerability (loss of competitiveness from fixing price higher than the market) then you should buy more regularly and in smaller volumes, at opportune prices. How far you buy in the future is determined by the pace at which prices for your products adapt to changes in energy costs.
- Following the markets to determine when to buy. This type of market analyses doesn’t take future forecasting into the equation, simply what the market is doing at this moment in time. If the markets are in free fall, holding off on purchasing any serious volume. This is the most basic ‘buying the dips’ approach.
- Combining forecasting with ‘buying the dips’ – this takes into consideration the erratic movements in the wholesale market. By looking at forecasting data, it can help to predict any potential upticks (that aren’t just temporary movements).
An energy risk management approach to buying energy means a totally different approach to the false upturn dilemma. When making a price fixing decision a 50/50 approach should be adopted. This stance looks at the problem like a child that doesn’t understand statistical probability – but it works. In a nutshell, it is this – ‘There is a 50/50 chance that I guess the movement right, either going up or down’. An example energy risk management policy allows you to fix up to 50% of an annual volume at a time.
This can be divided into four different buying points, 12.5% at a time. When the market first turns around, the first quarter should be purchased. If it continues to go up, another quarter is fixed. This is continued until 50%. If the market drops again, nothing is purchased and only 12.5% is fixed on a temporary upswing.
You can’t predict energy prices, but I would still like a forecast when making a trading decision – 75%
There is only a tiny proportion of buyers who truly believe in predicting the future price with accuracy. A large majority of this group will still not take purchasing decisions without some kind of forecasting. Why?
The use of forecasts is so deeply imbedded within the business world, and even has its roots based in deterministic economics. Economists make a living trying to create mathematical equations to produce correct predictions time and time again. This service is then sold to businesses looking to bring on a forecasting consultant.
It is difficult to see so many energy buyers in the wholesale market still with an overreliance on forecasting – even though they know it doesn’t work. Not truly. It is far more rational to pursue an active price management approach (as described earlier), instead of entirely trusting forecasts.
For the best of all worlds – contact us today
We recognise that as always, the solution lies in the middle somewhere.
This is why we spend vast amounts of time predicting and tracking movements in the wholesale market, but don’t leave ourselves vulnerable to market changes.
If you would like to hear more about our services then you can get in contact throughout all normal UK office hours at 0131 610 8868 or email us at info@niccolo.co.uk.
Alternatively, you can use our webform here.
We look forward to hearing from you!
Google Snippets
Can I save money on my energy contract any other ways than changing supplier?
Yes, through cutting consumption or speaking to an energy broker. Businesses may be able to utilise flexible energy contracts to exploit further savings.
What affects energy prices the most?
Without a doubt – the wholesale cost of energy holds the most influence over energy contract prices. For suppliers wholesale price can make upwards of 40% of contract costs.