Author Gilles Walgenwitz
Date September 2016
The National Electricity Market has been in a state of upheaval over the past twelve months, with far greater volatility in the spot and futures markets, lower liquidity, and uncertainty in future reserve capacity margins. For large commercial and industrial customers purchasing electricity, it has been a challenging time to minimise electricity budget increases.
There are a number of approaches to both electricity procurement and developing a hedging strategy that can be tailored to a business’ specific requirements and tolerance for risk. In our experience, most large energy users seek to avoid any exposure to the spot market, especially given current market volatility. They want budget certainty and to secure one or multiple forward contracts with retailer intermediation.
This article steps through the current market drivers, the two most common procurement options used by Energetics’ clients, and how they are tailored to suit these market conditions.
Forces at work in the market: a perfect storm
Wholesale electricity prices are influenced by a range of factors including weather, local economic activity, global ﬁnancial outlook, international energy commodity prices, resource availability, investment in future resources, government policies and market sentiments. This complicated mix can result in significant price volatility in the electricity futures markets of 5% or more, over a few days. Moves of ± 20% in a single month are possible.
Most recently, extreme volatility in electricity markets has been driven by a combination of supply constraints and increased demand for both electricity and gas.
What happened? A series of planned and unplanned outages in New South Wales, Queensland and Victoria, and complete withdrawal of supply in South Australia, led to significant reductions in the volume of lower priced electricity from coal fired power generators. This was compounded by lower intermittent wind generation across all regions. In South Australia this situation was made worse by the ongoing upgrade program on the interconnectors to the Victorian market which prevented South Australia from receiving the additional supply it needed.
The shortfall in lower priced electricity generation capacity resulted in the frequent dispatch from more responsive, but higher priced gas-fired power stations – which created a price shock. Nowadays the market is increasingly exposed to spot gas pricing rather than long-dated gas supply contracts. Also, this event coincided with the higher domestic gas demand in southern states due to the winter period. Furthermore, CSG to LNG exports have been delivering contract throughput volumes at approximately full design capacity. There have also been upstream production issues at one of the key gas suppliers to AGL and gas transmission constraints on key pipelines from fields to markets. All of which have increased prices for gas-fired electricity.
Such combinations of supply and demand constraints are increasingly likely to occur, making the time-to-market for electricity procurement more critical. This has implications when planning procurement for fixed price, volume-flexible contracts. It is also a key reason why some of our clients have moved to progressive purchasing, spreading the purchase price risk over a longer period of time and over multiple purchases rather than on one speciﬁc day.
Not a good time for an automated bulk-buying procurement process! Consider the market fundamentals when forward contracting
When seeking a fully hedged fixed price contract, Energetics applies a two round Request for Proposals process which is fully independent, competitive and transparent. We have found that having the option of running a second round provides more flexibility and significantly more competitive prices, especially in volatile market conditions.
This procurement approach has demonstrated its benefits when navigating high risk market conditions.
For example Energetics was recently able to rightly advise our clients to defer the request for best and final offers to short listed retailers (in Queensland) and accept a retailer’s offer after the first round (in South Australia) to benefit from a temporary drop in market prices that we anticipated.
The price difference recorded within a few days in the futures markets can be material in the current NEM conditions. This difference multiplied by annual volume leads to a significant budget impact. This is why automating the purchase of electricity retail contracts has its limits if the market fundamentals are not front and centre in the procurement planning and execution process.
Implement a progressive forward purchasing framework: buy in ‘blocks’
A more flexible progressive purchasing approach involves forming a framework agreement under which electricity is purchased in ‘blocks’ at different times, rather than purchasing all electricity requirements at once at a single price. By buying blocks of electricity, a business can secure low prices as they arise in the market, and avoid renewing a contract at ‘the high’ and locking in high prices. It is a variation of the standard purchasing model that spreads the timing risk, allowing the electricity buyer to benefit from ‘averaging in’ or what is also known as ‘portfolio insurance’. With this strategy comes also the ability to buy over a long term. Multi-year blocks can be purchased should market conditions become favourable.
Speed of acceptance is critical to capture price falls with this procurement method, and delegated authority within strict guidelines is necessary.
You need a risk management framework to quantify and manage the risk exposure of unpurchased load and define the optimal trade-off between forward contracting early to provide budget certainty, and keeping the portfolio partially open closer to the beginning of the delivery period to capture low market price periods.
For the large electricity users who applied the governance and purchasing frameworks set by Energetics over the last 10 years, this approach has proven to be a powerful risk minimisation method with good price outcomes, especially under volatile market conditions and for portfolios with peaky loads.
A tailored approach that meets the needs of your business
Our clients’ requirements are varied, their energy price risk exposure differs and applying a simplistic and uniform procurement process, whilst appropriate 24 months ago when markets were flat and down to historical lows, now appears antiquated. Appropriate risk management techniques exist to navigate within this troubled market period for those who understand the underlying market drivers.
Whether a ﬂexible procurement option or ﬁxed price contract, Energetics’ experts receive market information from reputable, independent sources and monitor the commodity markets to build an informed view of market direction and value. We base our advice on a range of technical indicators and oscillators of the energy commodity markets. We combine this technical analysis with the application of Energetics’ unique bottom-up electricity market price model that has been sourced by a number of clients for price forecasting, asset valuation and investment risk evaluation.
Energetics also offers some noticeable differentiators:
• An independent and unbiased view of the markets. Energetics does not have any affiliation to a particular electricity retailer. We have good relationships and are recognised by all market participants. You select the retailers you want to engage with. The default position is to engage with all licenced retailers available in a specific jurisdiction
• Transparency in our fees: we do not receive, and never have received, payments from a retailer when placing large market contracts. None of Energetics’ fees for our proposed consultancy services are paid by any retailer. You will not need to wonder if the energy retail charges in your electricity bill include a percentage brokerage fee!
For further advice on our procurement services and how your business can best manage the risks of buying in volatile energy markets, please contact any one of our experts.