5 strategies for energy market cost and risk reduction

From the May-Jun 2024 edition of Supply Chain Management Review.

May-Jun 2024

In each issue I try to leave you with some of my limited knowledge in this space. Or at least give you something to think about. I think it is our job at Supply Chain Management Review to -- hopefully -- leave you…

Browse this issue archive.

Access your online digital edition.

Download a PDF file of the May-Jun 2024 issue.

“Ben Franklin may have discovered electricity - but it is the man who invented the meter who made the money.”

-  Earl Warren

Electricity and natural gas costs are major factors in the profitability of companies in all industries, but especially in key parts of the supply chain. A recent profitability study by the banking industry indicates that a company’s average expenditure on energy inputs represents 4.1% of total manufacturing industry revenues—ranging from a low of 0.8% to 12% depending on the type of business. So when co-author Mark Trowbridge’s firm (Strategic Procurement Solutions) is asked by corporate clients to find substantial cost savings, energy expenditures are one of the first places they look.

The energy market is very complex. As Mark Twain once wrote: “The more you explain it, the less I understand it.” But hopefully, the techniques in this article can help your company gain a competitive advantage by reducing energy costs; whether through better procurement strategies, greater market pricing visibility, and/or demand reduction enabling less volume acquisition.

At a base level, energy procurement is complicated by the degrees of governmental regulation in each energy-buying region. In regulated markets where little to no choices exist to buy from different providers, some innovative strategies can still be deployed to control the volume, timing, and types of energy consumed. Doing this can generate measurable results—despite your company being handcuffed to a particular source of supply.

In deregulated regions, greater opportunities exist for company leaders to “compete” for electricity and natural gas. For many organizations, electricity represents a larger expenditure than natural gas. However, there can be significant spend on natural gas, especially when it is used as part of some manufacturing processes. When competition can be facilitated, co-author Bob Wooten, executive director of national accounts at Tradition Energy, relates that clients often can save between 10% and 25% of their total energy expense. In North America, a majority of the United States and significant portions of Canada are deregulated giving companies choices of multiple energy providers for electricity and/or natural gas inputs. Globally, deregulation of energy markets exists in Great Britain, across Western Europe, Australia, India, and portions of South America. (See Figure 1.)

Energy is unlike anything else procured by most companies. Co-author Claudette Calder, who directs procurement for the Mitsubishi Chemicals Group in the Americas, has increased profit margins across the enterprise’s 13 manufacturing plants on the continent by using Tradition Energy to compete its regional energy requirements. These efforts have resulted in $10 to $15 million in savings/avoidance for the group. Simultaneously, Calder was able to migrate a higher portion of energy purchases to renewable sources in accord with Mitsubishi Chemical Group’s sustainability program goals, referred to as “KAITEKI”—the sustainable well-being of people, society, and planet Earth.

Recent changes in governmental policies concerning energy production and a push to move from fossil-fuel-generated power are further complicating procurement and utilization. Geopolitical events are affecting energy markets, whether cessation of gas pipelines, hindrance of tanker travel via the Suez and Panama canals, or realignment of Middle East alliances to name a few. Accelerated movement toward renewable energy sources and premature cessation of energy sources (like nuclear, coal, etc.) also stir the mix of challenges. All this at a time when the United States is exporting more and more of its domestically produced natural gas, in the form of liquefied natural gas (LNG), to international markets.

Can company leaders really improve profitability by reducing energy expenses? Absolutely. This article will describe five ways most businesses can reduce expenditures in today’s complicated energy marketplace. They are as follows.

1. Create a formal energy procurement strategy.
2. Understand and follow the wholesale energy market(s).
3. Conduct a thorough pricing process and negotiate agreement terms.
4. Verify account enrollment and invoice accuracy.
5. Never stop monitoring markets; reporting and adjusting.

These techniques are especially meaningful to readers of Supply Chain Management Review who consume energy in support of manufacturing, distribution, warehouse, and logistics activities. Even the increased recharging of electric materials handling vehicles and fleet cars/trucks requires more costly electricity.

Let’s get started in exploring these five techniques.

Technique #1: Create a formal energy procurement strategy

A formal procurement strategy is an energy blueprint that addresses all locations of an organization. In areas where electricity or natural gas is deregulated, the focus is on procuring third-party supply. In regulated regions, the strategy can also address ways to minimize energy usage and ensure accounts are on the right tariff and rate class. Key factors to incorporate into your energy procurement strategy plan begin by summarizing energy exposure by facility (including all hedged and un-hedged contractual positions). That’s our starting point.

This requires some detective work. To act strategically in navigating today’s market, your leadership team must understand its current situation regarding energy procurement at every company site; i.e. energy types used, provider source(s), current contractual commitments and obligations, usage volumes, usage patterns (seasonality, time of day, day of week), etc. Factors to investigate include:

• How has energy procurement been handled in the past and why?
• What is the risk appetite of the organization? Is there any flexibility?
• What are the procurement goals of the company? Budget certainty? Diversification? Lowest cost?
• Are there sustainability goals within the organization?
• What are company perspectives on hedging to mitigate exposure?
• What are the current contract expirations?

With this foundation of knowledge established, we can begin to identify preferred market pathways for bidding and contracting of energy. Four general pathways can be explored, and tailored, in approaching pricing structures for energy contracts (see Figure 2).

A fixed price contract for electricity or natural gas has a single rate to be paid by the customer for the duration of a contract. It’s secure. But that rate is based on a volume commitment, and depending on how the contract is structured can expose the customer to higher rates if the usage goes over or under the contracted volume. Advantages of a fixed price contract include budget certainty and no price volatility. Attention must be paid to negotiating usage bandwidth because this could expose the customer to increased cost if they fail to achieve the committed volume (a real issue if there is a production line shutdown, labor dispute, etc.). The major disadvantage of this method is the risk that if energy prices fall, the customer may pay more for energy use than what he or she would have paid on the open market. Additionally, customers typically end up paying a premium to the supplier to hedge the supplier’s market risk. Fixed price contracts are especially beneficial in increasing market conditions.

A block & index format contract for either type of energy offers slightly less price security but can take advantage of market decreases; whereby the buyer contracts for a portion or “block” of their energy at a fixed price. The remainder of their energy is purchased at pricing “indexed” to the market. With a block & index contract, customers often have flexibility in what percentage of their energy is purchased in blocks as well as the duration/time of the blocks (specific options vary by market). Block & index allows the buyer the flexibility to take advantage of market dips and layer in blocks, thereby enabling a certain degree of budget predictability. It also allows customers to take advantage of demand reductions. This approach lessens the risk of price fluctuations while gaining the advantage of stability.

The utility default approach means that a customer doesn’t contract with a third-party supplier for their energy, but rather just receives their supply from the local utility under its default tariff rate. The utility default approach is usually higher than rates available through third-party suppliers because you don’t have the leverage of competition pushing down on prices. Utilities have their rates approved by the government and are established to keep the utility whole in terms of the energy it buys and then resells to its customers. There is often price risk volatility as well; fluctuating depending upon the utility’s cost to procure pass-through energy from other sources. These rates many times change monthly, meaning there is no certainty of what you will pay
in the future. Although the local utility may seem like the safest option, it frequently tends to be more costly than other procurement sources for the same gas or electricity.

An index approach to energy pricing has rates 100% tied to pricing a particular index—thereby floating with the market. Competition of an index contract with different providers can set the starting point (and the provider’s margins) competitively and drive savings in respect to the open market, but that entry point will be continually adjusted at agreed-upon times (typically monthly) according to movement in the market index to which it is tied. A fully-indexed approach is most-beneficial in a decreasing marketplace over the contract term. But it can perform worse than other formats in an escalating energy market.

Which is the best? It depends. The right energy purchasing strategy will reflect your company’s goals and objectives while considering market conditions. Understanding where the market is going may determine which contract format(s) you deploy in your energy procurement strategy. But how can we determine the future course of electricity or natural gas market movements?

Technique #2: Understand and follow the wholesale energy market(s)

This is where it gets more tricky. Because, in deregulated markets, natural gas and electricity are traded at a wholesale level; a giant step above the commercial retail market where companies contract for their supplies of energy from third-party providers. Wholesale markets don’t just fluctuate every now and then—the wholesale prices of all forms of energy fluctuate many times each day based on large portions of the supply chain being contracted (bought), upstream factors like weather (a subzero cold front is sweeping across the Eastern U.S. as we’re drafting this article, driving large fluctuations in both gas and electricity), geopolitical events, unplanned maintenance (remedial), or planned maintenance (preventive) which ceases production in a generation or transmission facility for a term.

In a competitive market, the timing of a bid is just as important as choosing the best participants (energy providers) to participate in that bid. Whether a company desires a new energy contract to begin next week, next month, or two years from now, the ability to identify a low point in the wholesale market is key. Obviously, no one has a crystal ball to know exactly how a market will move, but one can utilize market intelligence to better understand not just where market prices are, but why they are moving in such a manner. With greater understanding and access to wholesale market data, you can increase the chances you secure energy contracts at the right time in the market.

The following chart from Tradition Energy (part of the Tradition Group) illustrates the degree of market movement of a single energy element over a six-year period.

Consider the difference if your firm had bid a future 36-month fixed price contract for LNG in August 2022 compared to July 2023 when the average market price dropped by 76%? Over the six years of this energy type charted, market direction changes ranged between 37% and 117% (average delta of 72%). Even more dramatic was a three-month “peak” price near $11/MMBTU (million British Thermal Units), more than 511% higher than the low dip just six months before. While your firm’s commercial pricing agreement won’t be identical to the wholesale price at the time of contract, it will vary commensurately to the wholesale market’s levels. So timing is foundational to success.

Few procurement teams have resources to accurately review forecasts or to confidently predict when a particular market will dip. Too often, a company’s facilities manager or energy buyer just runs a bid three to six months in advance of their current contract expiring. That’s why Mitsubishi Chemical Group’s category managers under Calder rely on insightful wholesale market knowledge to better time their market actions (including moving during a recent market dip to lock in superior rates by extending an existing agreement).

Technique #3: Conduct a thorough pricing process and negotiate agreement terms

To “compete” your energy procurement needs, an understanding of the players in the market is critical. Fewer than half of corporations compete their energy needs, and relatively few do it with a high degree of sophistication using techniques like in this article.

Energy is big business and there are many players representing their own interests. Billions of dollars change hands nearly every day and everyone wants a slice of the pie. Key players involved in energy contracting include:

• companies that buy and use the energy themselves;
• consultants/brokers who help companies identify and contract with energy sources;
• energy equipment (CapX) manufacturers and engineering firms who help customers contract for energy;
• energy utilities/producers who sell direct to customers and are represented by brokers;
• energy producers who sell directly in certain regions but also act as a broker representing producers/sellers in regions they don’t serve; and
• participants in energy markets who help customers evaluate all sources of supply.

The wild card in this group are the consultant/brokers. A theme which should be in every procurement leader’s toolbox is to “follow the money” (The President’s Men). To understand the energy market you must understand the money motivating behaviors.

While good energy advisors can often help a customer find better energy pricing; what is unknown to the customer is that many energy consultants/brokers are aligned with a very limited number of suppliers (sometimes just one). They are acting as a “broker” for an energy supplier and not as an objective representative of the energy buyer. You need to ensure that all fees a broker charges are clear and transparent. Some brokers may bring a very limited number of offers to their customers because they want their connected provider to win the business.

Related Podcast

 

Talking Supply Chain: Managing your energy costs

Traditionally, businesses signed up with their local energy provider to procure the necessary energy to operate their facilities. It was never a procurement function, but rather one of convenience. That has changed in recent years, and now organizations need an energy strategy as part of their procurement process. "Signing with whoever you want to sign with is a fairly recent development,” explains Bob Wooten, executive director of Tradition Energy, which provides energy procurement solutions. “Just over 20 years ago we started seeing the electricity markets here in the U.S. and over in Europe deregulate or liberalize, meaning that [you have a choice].” Wooten, along with consultant Mark Trowbridge, joined Talking Supply Chain podcast host Brian Straight to discuss the energy market, and what companies should look for if they want to “shop” their energy procurement process in search of controllable costs.

Listen

 

Be careful and do your research. Broker payments influence many players in the energy market. If an advisor or CapX solution provider benefits from their customer contracting with a particular provider(s), that is usually not the best for the customer.

Additionally, an unseen rule followed by many suppliers in deregulated markets is that the first consultant/broker to contact them for a bid on behalf of a particular customer is the only channel they will then work through. If a second broker asks for a price quote, the supplier won’t give them a quote because they are now committed to providing pricing through the original channel. So that eliminates true competition from occurring at different entrance points to the market. Just as in the real estate and insurance industries, multiple brokers cannot represent the same client. When a customer tries to engage multiple brokers, it just leads to confusion and reduction of competition because an energy supplier will only work through one broker at a time. To prevent this from happening, we need to ensure that (i) we are not “bidding” energy needs to brokers (only RFP to suppliers); and (ii) if our firm is going to be represented by a consultant/broker we give the energy supplier a letter authorizing only that one representative.

So, how should energy be bid when we are certain the market is in a strategic dip? Several principles are important if you perform the pricing competition yourself.

• Most important is that your firm’s leadership must be “supplier neutral”—open and transparent to all participants.
• Confirm that all suppliers are including the same components in their pricing (for example, a natural gas agreement may not include final pipeline delivery to a site—referred to as the “burner tip”).
• Ensure each supplier is meeting your objectives and all offers and terms are truly comparable; “apples to apples” basis.
• Identify all providers that compete in the region.

But do not allow bids from players who don’t have experience supplying energy to commercial/industrial entities like yourself. Remember that many players in a particular region selling energy are acquiring blocks of energy at different points in the wholesale market—at different cost levels. The same provider is not always the most-competitive every time. That’s why bidding to all key players at the right market timing will be key to your success in securing the best proposal.

Make sure you carefully pre-qualify all energy suppliers. There are hundreds of energy suppliers in today’s markets. With so many suppliers you must apply a rigorous vetting process, continually evaluating each firm against a defined list of criteria, including your prior experience with particular providers, their financial strength and stability, their geographic coverage, competitive prices and terms, and reasonableness of contract terms, and responsiveness of customer service. These conditions, by the way, need to continue beyond initial vetting and be hallmarks of monitoring in a subsequent contractual relationship.

Once pricing options have been identified in the format best-suited to the anticipated energy market, a prudent buyer should conduct a “what-if” sensitivity analysis to compare proposed offers to likely scenarios anticipated in your corporate three to five-year planning. This should include the effect of market movement in cases where the energy supply contract has an index or floating component to it.

Finally, with the best offer chosen and a supplier selected, the energy agreement negotiation process begins. Perform this process knowing that most providers’ agreements do not favor the customer. Remember, we are not too far removed from the days in which all energy supply was regulated, and you had to deal with standard utility monopolies. But there is often room for improvement of key terms like:

• timing and nature of payment;
• termination rights (especially important in light of force majeure events);
• overage/underage pricing;
• usage bandwidths; and
• material business or economic changes.

Most importantly, pricing efforts should seek to maintain solid relationships with a stable of pre-approved suppliers to use in future procurement actions. Tradition Energy has identified and vetted hundreds of energy providers in the firm’s history who participate in its online bidding platform. This has resulted in a large pool of producers competing for business in a truly objective environment, with more than 110 RFPs being conducted each week for customers. That knowledge and activity in the wholesale market gives the firm insights into both the wholesale markets and local commercial retail market pricing, something that has benefitted Mitsubishi Chemical Group.

“Having advanced insights about market movements and the ability to get immediate pricing quotations from all suppliers in a region within several days has facilitated impressive savings for Mitsubishi Chemical Group facilities in the Americas,” Calder says.

Technique #4: Verify service selection enrollment and invoice accuracy

Once the agreement is executed and confirmed by the energy provider, several steps must be taken. These are critical because often energy providers set accounts up inconsistently with the contract. This can result in incorrectly high billings that often are never caught by the customer.

A common mistake is to fail to verify that all the locational accounts are transferred properly into the new agreement. This error means that the beneficial contract rates are not experienced by all locations. If these errors are not caught immediately on the front end, they will grow into very large over-payments over several years. Other errors include:

• incorrect energy rates themselves;
• utility multiplier errors and replacement readings;
• estimated rather than actual readings;
• competitive supplier benchmark misapplications;
• sales tax errors that don’t properly incorporate industry exemptions for firms involved in manufacturing, healthcare, or research & development;
• incorrect energy rates due to overage/underage usage variations;
• index references and formula calculations;
• suboptimal legacy pricing rates; or
• virtual net metering credits misapplied.

Enrollment must be verified and skilled eyes should periodically review ongoing invoices from energy providers. Even billings from a default utility often contain material errors.

Technique #5: Never stop monitoring markets; reporting and adjusting

Ongoing, effective energy procurement requires frequent monitoring of energy markets, reviewing hard data about our energy utilization and costs, and adjusting our strategies to adapt to changing conditions. Obviously, anticipated changes in the cost of natural gas or electricity may offer opportunities to re-contract at preferential pricing…failure to act on market opportunities means missing potential savings.

Many other profit opportunities can also be explored through energy use reductions, self-generation and peak usage timing (demand management), which can add to these procurement benefits. For example, many energy purchase agreements contain rates whichvary by time of day; penalizing the buyer for energy use during peak times (for example 4 p.m. to 9 p.m. when grid usage is highest). So, for a distribution company running a fleet with increasing numbers of electric forktrucks and even semi delivery trucks, put a timer on the recharging stations so electrical recharges don’t begin until after the peak period for instant savings.

If you need help with the five techniques in this article, it can be invaluable to use an expert advisor. But do seize the opportunity to reduce energy expenditures.

Inventor Thomas Edison famously said: “Opportunity is missed by most people because it is dressed in overalls and looks like work.” Business leaders who take time to “work” consistently through the five techniques in this article can secure substantial cost savings in their energy procurement costs—and thus increase their company’s profitability.

About the authors

Mark Trowbridge, CPSM, C.P.M., MCIPS, is president of Strategic Procurement Solutions and leading expert on negotiations. He can be reached at [email protected].

Bob Wooten, C.P.M., CEP, is executive director of national accounts for Tradition Energy, an institutional broker of financial products and  commodities. He can be reached at [email protected].

Claudette Calder, M.B.A., CPSM, is director of procurement for North America at Mitsubishi Chemical Group with expertise in global strategic  sourcing and engineering. She can be reached at [email protected].

SC
MR