Inprova Energy

How to Manage risk in volatile energy markets

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Courtesy of Inprova Energy

In the last year wholesale power prices swung by around 45%, which is twice as volatile as the previous five years. 

Those who fixed their electric bill for the next three years at the height of this market could  end up paying thousands of pounds more than others, who may have pursued a more calculated and less risky approach.

Fixed vs. Flex

It's often thought that fixed rate contracts are less risky than flexible contracts, which is a fallacy. Fixed rates do provide budget certainty, but the odds are 1:365 of picking the right day, when the market is lowest, to fix your deal. Those picking the wrong time in the past 12 months will certainly feel the pain.

In comparison, flexible purchasing offers more opportunity to buy chunks of your energy volume at points in time when the commodity market dips, as it has done over the last 12 months. The danger is hitting the top of the market with all your volume, which is why your energy procurement strategy must be underpinned by a robust risk management system and trading strategy to limit potential losses.

This will provide resilience in the face of bullish wholesale commodity market conditions and sharp increases in non-commodity charges, which now account for around 55% of a total power bill - up from 30% five years ago. From a procurement perspective, there's little you can do to mitigate these third party costs, which is why it's even more important to control wholesale costs and use the professionals watching the energy markets.

If you thought gas might be less volatile- unfortunately not; the electricity and gas commodity markets tend to move in tandem.

Navigating volatile markets

As the past 12 months has indicated, the wholesale energy market is very turbulent. Dramatic price movement can be caused by many market triggers. These include OPEC moving oil markets, and by extension European gas prices;  cold weather impacting demand patterns; geopolitical instability in commodity export markets; currency fluctuations from Brexit machinations; and  supply and capacity problems from Norwegian and continental sources.

The obvious purchasing risk is buying at the peak of the market because you're only watching the market occasionally and panic when prices spike. Do you know if that is a short term price supply related price rise or a long term fundamental change in capacity?

A risk management process/system allied to use of an energy procurement group should identify the risks to be measured and valued, your company’s purchasing objectives and risk limits, and the amount you are 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.

Energy is a major business overhead, so it warrants a corporate energy risk management strategy, requiring an integrated and supported approach – developed and monitored at board level.

Due to the complexity of risk management, it's wise to seek expert advice to carry out an initial forecast assessment using appropriate 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. You can seek help from reputable energy advisers, and some energy suppliers may also offer support.

Risk management methods

There are a number of established methods that can be 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. There may even be an option to sell-back and re-purchase if circumstances or attitudes change.

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, then trade surplus energy on the grid to limit exposure to higher prices.

Know your limits

Limits that only allow the trader to make purchases within a set range, or over a set period of time will reduce potential losses, but they can also frustrate potential savings in the event of a market drop. Such limits can be relaxed by building in further levels of complexity, such as the addition of automatic triggers and trades – should certain price movements take place and close out against indices near to delivery.

However, complicating deals in this way will require closer market monitoring and be costlier to manage. With access to live market prices and the support of experienced teams, simpler and more straightforward risk management strategies can often be equally effective.

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 necessary. As is the case with 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.

Your position is likely to change at various points of the contract, so you should regularly review and discuss your buying strategy.

The essentials of risk management

The risk of market volatility 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 and rationalise 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.

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