Electricity prices are currently low in the National Electricity Market (NEM) as natural gas prices and demand for electricity have fallen, amongst other factors. While these effects were discussed in Energetics’ earlier podcast and subsequent article, “Australia’s electricity and gas markets during COVID-19: know your contract terms, look for opportunities”, here we revisit the fundamentals of risk-managed retail electricity contracting for large energy users. Based on a recent podcast, Energetics’ Gilles Walgenwitz, General Manager, Energy and Carbon Markets and Mark Asbjerg, Principal Consultant discuss the options for balancing short and longer term risks when approaching the market to secure the most advantageous deal.
What are the elements that make up an electricity bill?
Around 40% of the average electricity bill is made up of regulated, network energy and demand charges which essentially equate to the cost of developing and maintaining the infrastructure to transport and distribute electricity. Around 10% is attributable to environmental schemes: the renewable energy target and a number of state-based efficiency targets. 50% is the cost of the actual electricity supply i.e. generation and retail components of the supply chain. This latter component can be managed with different contracting options.
Mark Asbjerg said, “There are two markets for electricity. The first is the spot market. Prices change on a 30-minute basis, driven by demand and the cost of the marginal generator to meet that demand at every single price interval. For example, overnight, base load demand, which is quite low, would typically be met by a coal-fired generator at a lower price point. Conversely, on a hot summer's day when demand surges with the use of air conditioning, we see more costly gas peaking generators engage in the market to meet that demand spike.”
“The second market is the wholesale contract market. It is this market that most retail contracts reference. Futures contracts are traded through the ASX and related traded volumes and prices are therefore publicly listed. The wholesale futures market shows the average expected cost of electricity for future delivery; based on currently expected supply and demand drivers and the market perception of risk. To understand the importance of the futures market, we can look back to the impact of Hazelwood’s closure, formerly Australia’s largest power generator. On 23 September 2016, news articles first appeared speculating that Engie would close their Hazelwood power station in 2017. On this day, the average expected price for electricity in Victoria for the 2017 delivery period, was around $54 per MWh. The day after these articles, the market had a very different view of the average cost of electricity for 2017. With such a large amount of generation taken out of the market, expensive gas-fired generators were likely be needed more often. The average price of electricity futures jumped from $54 per MWh to $62 per MWh in one day. This is the market that customers are exposed to when retailers price electricity supply contract for future delivery.”
Historically, end users have purchased fixed price forward contracts. The level of the peak and off-peak rates is based on the underlying exchange-traded futures market and over-the-counter forward market at the time the retail offer is issued. To the example of Hazelwood, Mark said, “If I secured a retail electricity contract one day before the announcement of Hazelwood, versus one day after, my peak and my off peak prices, quoted in each contract, would have a difference in the order of 15%. If I am a business which uses 100 GWh a year, that jump is around $800,000 overnight. Fixed price contracting exposes customers to that risk.”
Gilles added, “When ‘picking’ the time to engage the retail market for a fixed price forward contract, end-users should form a forward view about the market conditions in the wholesale futures/forward markets: if prices for future delivery are low (leading to an electricity budget reduction for the end-user) and there is limited opportunity for further downward price pressure, then locking in 100% of the volume at a fixed price over multiple years makes perfect sense.”
Alternatives to fixed price contracts
There are alternative contracting methods that large energy users can pursue to avoid the sort of price shocks most vividly seen in the example of Hazelwood’s closure. Those methods include progressive purchasing, which is becoming more of a viable option for smaller customers, block purchasing and managed spot market exposure.
Gilles commented, “Before considering alternatives, it's worthwhile splitting the components that retailers will consider when quantifying the risk premium or contract premium as you may also be able to reduce that aspect of your cost. When we look at the contract premiums that sit on top of the underlying wholesale forward or futures contract prices, these premiums will differ according to the shape of the customer’s load. Typically, peaky loads attract higher contract premiums because of the observed relationship between a peaky load and high prices. There are other factors such as the term of the contact, the liquidity of the market, the credit worthiness of the customer and, in some instances, issues with multiple ABNs, or multiple customers with another customer acting as an agent. This can be very challenging for retailers to manage and such factors definitely impact the formulation of the premium.”
He added, “Another consideration is the attractiveness of the overall load shape to a retailer’s portfolio of generating assets and financial hedges, as well as the validity risk factored into the offer. For example, a customer could set an internal approval process with the right levels of delegation of authority to reduce the time taken to accept the offer. So if you had the ability to quickly respond to favourable market conditions and lock in a retail contract within a short period of time, the retailer is less exposed to volatile market conditions which could favourably influence your validity premium. Another option is to refine your estimates of your annual contracted volume and request a lower flexibility allowance on volume. If you have confidence in your future load requirements, you could reduce the load flex so that when the retailer calculates their exposure to the spot market and the covariance between your load shape and the spot price, they are likely to offer a sharper and leaner contract premium. In summary, while there is value in strategically planning your timing to engage the market, there are other components that build a contract premium.”
A fixed price contract locks in volume and requirements on a single date, and the price is driven by the view of the market on the day. With progressive purchasing, different portions of a load are purchased at different points in time. This can benefit the final contract price, and the final peak and off-peak rates, based on the volume weighted average of the purchases. To the example of the Hazelwood closure price shock, and the overnight jump from $54 to $62 per MWh on the wholesale futures market, if half the volume had been purchased before and half contracted later, the contract price would be $58. The price increase would have been somewhat offset.
Gilles added, “Progressive purchasing offers a transparent pricing methodology. You agree on the factors to be used to derive the peak and off-peak rates for electricity based on an underlying wholesale futures or other benchmark price. Some retailers will use a publicly available benchmark or apply one they develop themselves which could include some of their own retail contract risks. You need to understand which benchmark contract price is being applied.”
Mark said, “Depending on the size of your load and different retailers, you can break your volume requirements into chunks - down to 5%, or a single megawatt or five megawatts. Different retailers offer levels of granularity to meet your requirements. Ultimately it is a way of spreading your risk. With progressive purchasing, energy users need to actively monitor the market to have the flexibility to buy more volume when the opportunity presents itself. When market prices are low, they can purchase more.” It naturally fits end-users who want to have a more proactive risk management of their exposure to the retail electricity markets.
“Energetics recommends that clients using progressive purchasing set up a risk management framework, to guide purchase decisions. A framework would include delegations of authority, trigger prices, contract minimum volumes to be bought at different times (which would typically be informed by the time to contract maturity), stop-loss mechanisms, and possible other risk management metrics such as value at risk. It's also important that customers benchmark the pricing they receive from retailers with what they see in the market.”
“It is important to know how the overall pricing methodology will work, especially if you want to implement behind the meter solar generation or if you know your load shape will change over the contract term. The load shape factors or uplift factors that the retailers will apply to determine a peak and off-peak rate, will vary depending on how your load shape changes.”
What can energy users do to optimise their load shape?
The first step should be to reduce demand and minimise demand spikes. Practical measures include ensuring a building or site’s machinery is not operating simultaneously where possible, or using onsite generation, batteries or a backup generator when spikes begin to occur. Another option is portfolio consolidation, grouping sites into a single contract. Where sites operate differently, with some peaking in the morning and others in the afternoon, an energy user could flatten their overall load shape.
Gilles said, “Many would know that a wholesale demand response market is coming. It could be a lucrative market which would substantiate a business case to implement new hardware or software capabilities for demand response management. But there is another benefit to consider. Once you implement demand response capabilities, you develop confidence in your ability to manage your electricity consumption. From there you can assess your ability to take some spot market exposure on your retail contract. Rather than asking your retailer to provide a load following fixed price forward contract or load following progressive purchasing contract, you could buy a block of electricity on the forward market or the futures. You could potentially buy another peak in addition to a flat swap, but then take the spot exposure and use your demand response capacity as a physical hedge.”
Gilles said, “In the future, if the demand response market grows, large customers may not pay retailers a contract premium for a load following arrangement. They could approach retailers with a request for a structured product and request the retailer buy flat swaps, or buy peak swap contracts, or other financial hedges such as options, and then use the physical hedges to reduce their residual spot exposure and reduce the overall hedging costs. We could see in the coming years a move from a market that was fully fixed to progressive and increasingly towards structured products with managed spot exposure.”
Mark concluded, “With COVID-19 there has been downward pressure on market prices. For those customers using fixed price contracting, it's an ideal time to enter the market and extend or renew those contracts. At the same time, progressive purchasing is increasingly used to manage time to market risk. Anyone considering or currently purchasing progressively should actively monitor the market to watch for opportunities and manage any upward movement in prices towards the back end of the year as COVID restrictions are expected to start to ease.”