Admit it: Sometimes we all need a map.
In this case, we’re not talking about Rand McNally but rather an aid in navigating the unpredictable energy market. If your energy procurement goals include budget stability, recent market trends can be downright terrifying. But take heart! There really are steps you can take to steer your organization away from the dramatic ups and downs in energy pricing by establishing and sticking to a sound risk management strategy.
What does it mean to be “at risk?” Risk means that there is uncertainty that could lead to unfavorable outcomes. The energy market is a perfect example of uncertainty – and one of the reasons why a common term used to describe price movement in the wholesale energy markets is “volatility.”
An energy risk management strategy will help create budget stability, keep costs under control, and achieve savings. Unfortunately, many organizations overlook the importance of their strategy – or neglect key steps that can create serious roadblocks to establishing truly useful guidance.
Key Steps in Creating Your Map
As an energy procurement specialist, you take measures to control these costs to your organization, given the volatility that exists in the energy markets – and achieve savings wherever possible. But combining uncertainty with volatility creates a situation that makes it very difficult to plan and budget for your organization’s energy costs in the coming months or even years.
In order to create a solid energy risk management strategy that effectively controls costs and achieves the savings you’re hoping for, it is helpful to follow five sequential steps that help define the parameters and narrow the focus down to the specific needs of your organization.
1. Identify the Sources of Your Risk
Running almost any kind of organization carries an inherent risk of suffering at the hands of rising energy prices – or of being locked into a high price when the market falls. Let’s consider what it is about energy that leads to your organization’s risk. Key risk factors are:
- Price movement: Changes in price can either be devastating to an organization if they move up or a savior if they move down.
- Changes in your energy usage: Predictable monthly usage makes for a more stable budget, but when your usage is volatile, it makes it more difficult to control costs.
- Contract terms and conditions: It is all about shifting risk. Suppliers look to adjust contract terms to shift the risk over to the buyer.
- Opportunity cost risk; and
- Regulatory changes: As with price movement, you can’t affect regulatory changes unless you lobby your state utility commission. But you must be aware of what is changing and how the changes will affect your costs.
So, what is your current situation? To answer this, you really need to understand your organization’s energy procurement strategy. Knowing exactly what you currently have in place can help you identify the sources that could produce your organization’s greatest risk. Ask yourself these two questions:
- What are our key needs?
- What energy contracts are in place?
For example, if you own a particular property but pass energy costs on to the tenants, “price movement” may not be as big a factor as if you were a school and need to be absolutely certain what your energy costs will be year-round.
2. Establish a Risk Profile
Once you’ve identified the factors likely to generate your risk, you can establish a “risk profile” that will serve as the template through which the strategy will unfold. Essentially, you are taking the sources of risk you named in Step 1 and converting them into an outline that highlights the different factors.
The key is to develop your risk profile to address the factors that are most important to your organization. These could address the following:
- Is there a corporate risk policy in place? Is this open for discussion?
- Is budget certainty most important?
- Is the lowest price most important?
- Can your business handle significant variation in price month-to-month?
- If some risk is allowable, how much exposure is acceptable?
The table below identifies potential energy procurement strategies and accompanying objectives and risks.
Make sure your contract type fits your needs and takes into account how much exposure to price-movement your organization can truly withstand. If, for example, late payment of utility bills would lead to degrading your credit rating, then your profile should address “payment terms” as a key factor of your strategy.
3. Analyze Your Exposure by Portfolio and By Site
It’s critical to review your entire portfolio to determine your organization’s overall strategy.
A portfolio-wide review should include a review of the following elements to determine exposure and areas where you are most at risk:
- Product type
- Contract status
In addition, you must analyze exposure by site by assessing current and future consumption patterns. Evaluate different products to learn whether they fit a certain load shape or if there are load-shifting opportunities.
For instance, you may have one location serviced by a regulated utility while your other locations exist where the market is deregulated. While you are exposed to price movement in both locations, you have the ability to control that exposure at your deregulated sites.
Whether you identified price movement as a key risk or seek “absolute” budget certainty, analyze what areas are controllable (inasmuch as the market can be controlled!) and try to address them above all others.
4. Assess Market Conditions
Assessing the current market is a recurring theme for energy consultants, as we have discussed in many previous articles. If the market is high, you want a price fix for a shorter duration to be positioned to take advantage of future falling prices. When the market is low, you want to lock in a longer-term contract at your fixed cost to protect against future rises in price.
This chart indicates a decline in future prices.
This chart demonstrates volatility in index market prices.
For deregulated situations, align market conditions with the exposure status at each of your locations to determine the best way of approaching contracting. In regulated situations where you have no control over price, you need to understand market movement to better prepare for future budgeting needs.
Remember, even if you can’t do anything about your current contract, simply knowing where your organization stands helps you plan for allocating costs more effectively for your next budget cycle.
5. Quantify Your Exposure
Now that you’ve developed your management template, insert your actual usage to understand the financial impact of all the various options. This is the final piece of the energy risk management equation.
This is often the step that executives jump to first: What’s the real risk in dollars and cents? But don’t be tempted to skip the steps that lead to this determination – you could omit some critical factors.
Honestly describe what is important to your organization from an energy procurement standpoint and how your contract terms and conditions would impact you if you can’t control price. Every company is different, and every organization will assign different priorities. But in our experience, we have found that the risk factor topping most lists is price movement. If price goes up 10% overnight, how financially devastating would that be to your organization?
If your usage is high in a regulated area where you have no control over cost, budget planning is crucial. Meanwhile, high usage in deregulated areas will typically warrant a greater focus than areas where usage is lower. It could be the difference between structuring a fixed price contract vs. floating on the utility rate. Using our example of a school where budget certainty is a key piece of their risk profile and a key area of exposure, a 10% movement in price could increase the annual budget by $500,000. If such an increase is unacceptable, use the risk management strategy to define how you will take advantage of dips in the market to control costs going out many years in the future.
Know Where You’re Going – and How to Get There
Not creating a detailed energy risk management strategy is like taking a trip through uncharted territory. Without a map, you don’t have a clear path before you start procuring and managing energy. Without a developed strategy, you run the risk that the results will not be advantageous to your organization. As the old adage says, “If you don’t know where you’re going, how will you know when you get there?”
The five steps above will help map out your strategy to address the risk your organization faces in trying to plan and budget, given the volatile nature of the energy market. The greatest benefits will be in addressing energy needs long term, as you survive the rocky road inherent in the market. The strategy must be flexible enough to grow and evolve based on changing conditions and goals, but in the end, your map will guide you on the path forward.