Energy procurement: the bureaucratic versus the entrepreneurial approach

Recently I held a meeting with a customer to define a new strategy for buying energy. The company is a family-owned food producer that has recently witnessed strong growth under the leadership of a new generation of enthusiastic entrepreneurs. In terms of energy procurement we took many excellent decisions in the decade of our collaboration, such as leaving open an increasing part of the pricing to spot indexation in the recent period of price declines. Such decisions were based on the strong risk / opportunity optimization instincts that characterize strong entrepreneurs. However, as the company and its energy spend has grown, the owners feel the necessity of a more formal approach to eliminating risk due to energy market volatility.

During the meeting, we were surrounded by a management team of people trained in larger corporations. Confronted with the question of how much of the volume we leave open to spot price indexation, these professional managers quickly opted for the zero risk solution, meaning in their case that for all production for which sales prices have been agreed with clients the energy price would be hedged, leading to a freezing of the margins. The entrepreneur-owner protested against this, saying that he would feel sorry about the loss of opportunity if markets would go down. This was an excellent example of the tension between entrepreneurialism and a more managerial approach to business and the way it can manifest itself when buying energy.

As companies grow, it becomes impossible to run them based on the enthusiasm and strong instincts of their entrepreneurs. The necessity for more managerial skills grows. In the buying function of a company, procurement professionals are hired and they introduce more structured approaches to buying. Systems are introduced that can track an invoice back to a procurement decision (purchase orders). Decision power is attributed and the authority to purchase is taken away from the users of the goods and services that are bought and delegated to the professional buyers. Formal contract negotiation procedures such as RFQ’s (request for quotations) and RFI’s are introduced. In commodity buying, risk management or other approaches to fixing volatile forward prices are set up. Often, the success of this introduction of professional procurement is measured in terms of savings, which can lead to the introduction of complicated systems for savings calculations.

In many cases, energy is one of the last categories to be brought under formal control. Many companies consider it to be a highly technical category and leave it for a long time with the maintenance or facility management professionals. There is no reason for doing this. Buying energy in an open market is much more challenging from an economic-commercial point of view than technically. I’ve never witnessed a company doing an awful job at energy procurement because its staff members failed to grasp the subtleties of MWh’s versus MW’s. But I’ve seen many companies failing at buying energy because of a lack of understanding of how commodity markets work. Therefore, introducing professional procurement management methodologies can be a blessing for a company’s energy buying practices.

However, too much management techniques can easily derail in a too formalistic approach. Entrepreneurialism, that usage of passion and strong instincts to take the right decisions, disappears and gives way to corporate bureaucracy. I recently had a discussion with the energy buyers of a client of ours, one of Europe’s largest corporations. In this company, a strong procedure for running tenders has been developed that should ensure that the company is always making the best out of the market. However, running this procedure is so demanding that the buyers prefer running bi-annual rather than annual tenders, which would give them better protection in terms of wholesale price hedging. In its worst form, the procurement division becomes a corporate bureaucracy where the instrument of running formal procedures becomes a goal in itself, rather than making the best out of the markets. The system for savings calculations, for example, can easily start to live a life of its own. One client once told us that the first thing their new CEO said in a meeting with the procurement division was: “I want you to stop reporting savings. Why? Well, if all the savings that you guys and girls reported in the last five years had materialized, we would now be paid by our suppliers”.

It’s logic that entrepreneurs that are introducing formal management in their companies revolt against such a bureaucratic approach to procurement. Corporate excellence isn’t founded on “just following the procedures”. A good energy procurement practice will strike a good balance between the professionalism of good procedures and leaving room for talented individuals to take good decisions:

  • Good data management is an indispensable starting point for professional procurement. You can’t be successful at buying energy if your information is stuck in the heads or on the local hard disks of hard-working staff members. However, you should consider efficiency when setting it up. One client once told me that he spends about 70% of his time on internal reporting. Imagine what it would mean for his company if he could bring this down to 40% and actually double the amount of time he has for being informed about the market.
  • Giving some structure to your contract negotiations will make them more effective. However, take into account that energy companies have to produce a lot of offers. If your RFQ procedure becomes too demanding, the account managers might lose their enthusiasm for doing the deal because they have to deviate too far from their standard procedures for making offers. Also, leave some room for good old negotiation. I see many large corporations that go into the market with RFQ’s that are already asking for all the concessions that they want to get. They will get them, but at what price? Negotiating concessions is a much better methodology than writing lengthy, demanding RFQ’s.
  • As a larger corporation, you can’t have the fate of your energy spend determined by the gut feeling of your energy buyer(s). Setting up a good risk management strategy can make sure that nobody will take decisions (or not take decisions) that damage the company. However, within the framework of such a risk management strategy, you should leave room for some opportunistic decision making.

Savings reporting can be a good tool for measuring the success of your energy buyers’ entrepreneurialism when buying energy. However, it isn’t always easy in energy to determine which savings are due to an action by an individual and which are just due to changing market circumstances. But that’s a topic for a new blog article.

Mibgas and its failure to fix the Spanish gas market

On this blog and in conferences, we have repeatedly complained about Spain’s reluctance to fix its gas market. For years now, Spanish end consumers of gas are paying more than consumers in other countries. And we can’t see any good reason for that. Spain’s gas import and transportation infrastructure was drastically expanded in the booming early 2000’s, anticipating a never-ending period of growth of the economy and gas consumption. Instead of that, Spain slumped into a deep recession and in 2015, Spain’s gas consumption was 29% lower than in 2008. As a result, wherever you look in Spain’s gas system, you will find excess capacities. So why on earth doesn’t this result in lower prices?

Many Spanish gas suppliers will point at the limited capacity on the French-Spanish cross-border pipeline. Yes, this means that only small quantities of gas can float directly, through a pipeline, from the cheaper markets in the North to Spain. However, only looking at this pipeline is a very shallow look, especially if you consider that most of Spain (and Portugal’s) gas comes in through LNG ships. As a matter of fact, no other European country has such a large LNG import capacity. Most of the terminals are used at very low percentages of their capacities. And still, lots of LNG ships are sailing past Spain without unloading the gas, taking it to terminals further North to sell it at a price far below what they could get in Spain. They are sailing hundreds of extra, expensive miles to unload at a lower price. In September, the average spot price of gas in Spain was 4,6 euro per MWh higher than in Zeebrugge in Belgium. Why didn’t anyone cash in on that spread by loading gas in Zeebrugge and unloading it in Bilbao? Why isn’t the market with the highest end-consumer price in Europe and the highest amount of unused import capacity flooded with LNG?

Traders answer us: we can get the gas into the Spanish ports, but we can’t get it out. The Spanish government has failed to implement gas market policies that guarantee third party access to the Spanish gas grid. The system makes it possible for incumbent suppliers to sit on unused capacities on key infrastructure just to keep newcomers out. And it creates a lot of risk for traders that don’t have access to huge physical quantities of gas within the country. For a little while we were hopeful that things might change with the introduction of the Hydrocarbon Law in May 2015. It resulted in the launch of Mibgas, a Hub market for gas in Spain. In the middle of this year, we saw prices on this Mibgas drop towards the levels in the North of Europe (TTF). But in the last month, the gap has widened again. Mibgas prices are now trading well above TTF level. In October, the gap was reduced a bit, but that was because of TTF rising, and not Mibgas falling. And, despite the obligation for suppliers to balance their portfolios using the Mibgas spot market since October, volume has picked up only slightly. 

Spain is currently without a government that can fix this mess. On behalf of all gas consumers in the Iberian peninsula, we hope that the first thing a new energy administration will do, is book a flight to the North and see what simple but effective measures are necessary to make a gas market work. It is really very simple:

  • Make the whole country one entry – exit zone and give the responsibility for managing congestions to the transport grid operator (Enagas),
  • Create an hourly day-ahead market (Mibgas) that is adequately aligned with a balancing system (run by Enagas) that is as simple as possible,
  • Implement the use-it-or-lose-it principles that oblige owners of unused capacities to sell it to others.

And while they are there, they might look at power market regulations as well.

In the meantime, the Spanish gas buyers face difficult choices regarding their gas contracts:

  • In April / May / June, when Mibgas and TTF were close to each other, we saw some offers in the retail market that were very attractive, will such periods return? It’s more important than ever for buyers in Spain to follow up intensively what suppliers can offer.
  • When should you switch to Hub-indexed gas buying instead of oil-indexation? With the low liquidity and lack of forward products, financially swapping an oil-indexed formula to TTF is a better choice than Mibgas. Budget risk customers that need long term price stability can focus on the possibilities for savings and more agile price fixing of the new market realities. Market risk customers for whom energy pricing matters in terms of competitiveness should consider whether their competition is in Spain or in countries that have already switched to Hub-indexation. If you face foreign competition, you better consider a quick switch to Hubs. If you’re competing with Spanish companies, you have to decide whether you want to be a first mover or not.
  • Switches to Hub-indexation can come at different add-on costs, depending on the difference between oil-indexed gas and the Hub (TTF) at the moment that you make your contract. From that perspective, you should consider switching an oil-indexed formula in gradual steps towards TTF, which is a complicated hedging operation.

Natural gas is an important input to the economy. It is intensively used by base industries that are the cornerstone of many supply chains. Moreover, it has a lot of impact on electricity pricing. In Spain’s fuel mix, natural gas-fired power stations have the potential of being the marginal power stations, meaning that lower gas prices should result in lower electricity prices. Getting Mibgas fixed should therefore be an important priority for the next Spanish energy minister.

 

Sytuacja na światowym rynku węgla

By Ondrej ZichaEnglish version

W 2016 nastąpiła znacząca zmiana trendu w poziomie cen węgla. Po latach systematycznych spadków ceny węgla odbiły się w marcu tego roku, aby ustabilizować się na poziomie 60 dolarów za tonę (indeks API2, lipiec 2016). Ceny na takim poziomie widzieliśmy ostatnio ponad rok temu.

afb1

Źródło: opracowanie własne

Ceny węgla spadły o 70% od 2011 roku. Węgiel dostał łatkę ‘brudnego’ paliwa i zgodnie z popularną polityką dekarbonizacji został wyparty przez inne źródła energii. W sytuacji, gdy popyt spadał szybciej niż podaż, ceny systematycznie szybowały w dół do poziomu poniżej 40 dolarów za tonę w lutym i marcu br., dochodząc do progu rentowności wydobycia. Cały sektor dopadł poważny kryzys, gorącego okresu nie przetrwało kilka dużych firm m.in. amerykański Peabody Energy.

Co jednak przyczyniło się do odwrócenia trendu i wzrostu cen od marca tego Roku?

Chiny siłą napędową światowych cen węgla

Główną przyczyną odwrócenia trendu są zmiany w polityce gospodarczej Chin, które odpowiadają za ok. 50% światowej produkcji i zużycia węgla. W lutym br Chińczycy zapowiedzieli zamknięcie ponad 1000 kopalni do końca roku. Do likwidacji wyznaczono głównie małe kopalnie, które nie zapewniały odpowiednich warunków pracy. Dodatkowo w kwietniu ograniczono czas pracy w lokalnych zakładach o 16%.

Ograniczenie produkcji węgla powinno iść w parze ze zmniejszeniem zużycia surowca, ze względu na ekstremalnie wysokie zanieczyszczenie powietrza. Jednakże przestawienie się na inne bardziej ekologiczne paliwa to powolny i żmudny proces. Chiny mocno angażują się w rozwój odnawialnych źródeł energii, jednak chińska sieć przesyłowa wymaga dalszych inwestycji, żeby poradzić sobie z transportem niestabilnej energii odnawialnej.

Należy również ostrożnie podchodzić do tego co Chiny mówią i obiecują. Z jednej strony rząd zapowiada ograniczenie wydobycia paliw kopalnianych, z drugiej Greenpeace informuje o budowie kolejnej kopalni o mocy 400 GW, podczas gdy plan redukcji zakłada tylko 70 GW.

W krótkim okresie Chiny będą musiały importować więcej węgla (rokroczny wzrost w sierpniu wyniósł 52%), co z pewnością ucieszy wydobywców na całym świecie i ustabilizuje ceny węgla z powrotem na poziomie opłacalności.

Węgiel a sprawa polska

Rosnące ceny węgla to dobra informacja dla Polski, gdzie rodzimi producenci walczą o przetrwanie. W ramach ratowania sektora górniczego Kompania Węglowa, największy producent w UE, została przekształcona w Polską Grupę Górniczą. Wyższe ceny pomogą PGG w podtrzymaniu rentowności.

Z drugiej strony, nową spółkę dalej czekają problemy które obniżają jej konkurencyjność. Przede wszystkim, benchmarkem dla węgla wytwarzanego przez PGG jest polski indeks PSCMI1 (a nie API2 jak w przypadku rynków światowych). I jak możemy zobaczyć na poniższym wykresie, ceny węgla w Polsce jeszcze się nie odbiły, i od czerwca są one poniżej indeksu API2.

afb2Źródło: opracowanie własne

Kolejnym problemem są zbyt wysokie koszty wydobycia. Silna pozycja związków zawodowych nie pozwala kopalniom na redukcję szerokiego pakietu benefitów pracowniczych. Do uzyskania długoterminowej rentowności potrzebne będą bardziej radykalne zmiany niż czasowa likwidacja tzw. czternastek.

Perspektywy na przyszłość

Ograniczenia wydobycia węgla w Chinach doprowadziły do usztywnienia podaży w niektórych regionach co skłoniło rząd w Pekinie do rozluźnienia regulacji. W przypadku niewystarczającej podaży węgla lokalne kopalnie mają pozwolenie na zwiększenie produkcji. Jest jeszcze za wcześnie, aby stwierdzić czy ogólny trend cenowy znów odbije w dół po tej decyzji, jednocześnie mała korekta była widoczna w ostatnich dniach.

Nie ulega wątpliwości, że Chiny są główną siłą napędowa światowych cen węgla i jedną decyzją polityczna potrafią zmienić sytuację na rynku globalnym.

What is moving the coal market?

By Ondrej Zicha – Polish version

2016 could be a year marked by the trend reversal of world coal prices. After years of steady decline, coal prices rebounded in March. In October, API2-prices event hit the level of 65 dollar per tonne, a level last seen one and a half years ago.

afb1

Source: Own study

Since 2011, coal prices lost more than 70%. Coal was marked as a “dirty” fuel and in line with the wide spread policy of decarbonisation, other energy sources were preferred. This made demand decrease faster than supply, so prices continuously went down to reach levels below 40 dollars per tonne in February and March this year. These prices made it difficult for miners to be profitable, endangered the entire sector and even caused bankruptcy of some big players like Peabody.

China drives world coal prices

Changes of the Chinese policy are the main reason for the price rebound. China takes about 50% of both worldwide production and consumption. In February, Chinese officials announced the country will close more than 1000 coal mines before the end of year. The mines on the list were mostly rather small ones and had to be closed because of inadequate working conditions. In April, this decision was followed by another one limiting the number of working days in local mines by 16%.

Limiting the coal production should go hand in hand with decreasing coal consumption, as China is pushed to do so because of extremely high air pollution. However, changing to other more ecologically friendly fuels will take some time while mines will already be closed at the end of this year. China is now investing a lot in renewable sources but these investments need some time to be realised. Additionally, some analysts remark that the current grid system is not prepared for more and potentially unstable renewable sources and therefore requires further investments.

On top, we should take into account that China has proven its statements to not always be 100% correct. China claims it’s abandoning fossil fuels, but according to Greenpeace’s report published in July, the country is currently building another 400 GW of installed coal capacity while the shutdown is only 70 GW.

This means China mainly needs to import more coal in the short term (year-on-year increase in August was 52%), which brought coal prices back at profitable levels and is good news for coal miners all around the world.

Situation in Poland

The rising coal prices are great news for Polish miners as they are struggling with serious problems. Kompania Węglowa, the biggest coal producer in the EU was restructured to Polska Grupa Górnicza (PGG) in order to save the Polish coal sector from bankruptcy. The higher coal prices could help the company to stay alive in a tough market.

On the other hand, the new company is still facing many difficulties which decreases its competitiveness. First of all, the benchmark price index for coal mined by PGG unfortunately is the Polish Coal Index PSCMI1 (not the API2 like on other European markets). However, the Polish index usually follows the European benchmark but this hasn’t happened (yet). As we can see on the graph below, the polish coal prices are even below the API2 index since June.

afb2.png

Additionally, PGG is still struggling with too high mining costs. The unions have a very strong position in the Polish coal sector and generally are not willing to reduce the non-standard benefits of workers in the mining sector. Despite some positive changes in the last months like a temporary suspension of 14th month salaries, further and more radical changes are necessary to make PGG fully competitive.

Outlook for the future

Mining restrictions in China led to tight supply in certain regions. As a consequence, the Chinese government last month decided to ease the mining restrictions. In case of problems with supply, local mines would be allowed to increase production to meet demand. On top, the limited working days in the most efficient Chinese mines could be eased as well. However, this was not confirmed by the Chinese officials and for the time being, the market isn’t taking this into consideration.

Seeing the above, we can only be sure about one thing – China is the main driver of coal prices at this moment and any political decision there can impact the market situation.

Payment day for nuclear addiction in France

French year ahead baseload power ended the day yesterday at 39,9 euro per MWh, backing off from the 42,5 euro per MWh peak that it reached one week ago. The price increases came amid worries over next year’s power supply. Today (12th of October), 37% of France’s nuclear production capacity is shut down due to safety probes. With 76,9% of France’s electricity in 2015 produced with nuclear power stations, it is normal that markets worry when a supply crisis looms. Moreover, the fears are exacerbated by shortages of hydropower stocks due to dry weather. With 9,48% of all power production in 2015, hydro is France’s second source of power production. Stocks currently stand at 68,3%, the lowest level for the time of the year since 2010.

France is addicted to nuclear power. Only the US produces more energy from atoms and no country comes anywhere near the high percentage of power production through nuclear. This addiction has been a deliberate choice. It was France’s answer to the oil crisis of the 1970’s. Ever conscious about its role in this world, the French prime minister Messmer estimated that nuclear was the safest option to reduce resource-poor France’s dependence on energy imports. This was summarized in the slogan: “France is poor in oil but rich in ideas”. The nuclear ideas were sold to the population by offering them cheap prices, hiding the real costs of nuclear through massive subsidies to state-held nuclear champions EdF, the producer of the energy, and Areva, the builder of the power stations.

Recently, public opinion and politicians, mainly from the currently governing socialist party, have turned somewhat against nuclear power. After the Fukushima disaster, it is clear that nuclear energy isn’t as safe as promised. The exact harm caused to man and nature by Fukushima is a source of intense debate. But if you take into account the 196 billion dollar clean-up bill estimated by the Japan Center for Economic Research in March 2012, it is clear that the risks should not be underestimated. Moreover, it is a myth that nuclear power is cheap. France is currently building a new nuclear power station in Flamanville. On top of massive delays, the project is suffering a threefold overrun of its original budget to 10,5 billion euro. The French government, hoping to build similar EPR-reactors all over the world, is swallowing that bill. But even EdF admits that nuclear power is far from cheap, as it negotiated a 92,5 pound per MWh guaranteed price with the British government to build a new nuclear power station at Hinkley Point. That is more than twice as high as the price paid for year ahead baseload power in the UK at this moment. And three times more than the price paid for year ahead power at its lowest point earlier this year.

Maybe one day we will name Flamanville as the project that killed the nuclear industry. For not only have its overruns of budget and project time proven the flawed economics of nuclear. It also sparked the safety concerns that put serious questions regarding a third pro-nuclear argument: its reliability. Carbon concentrations were discovered in the steel used to build its pressure vessel, and it is feared that these could cause integrity issues that result in nuclear disaster. Alarmed by this, the French nuclear safety authority has ordered probes in 18 reactors causing the shutdowns that currently rattle the markets. This safety issue is a worrying reminder of the situation in the Belgian nuclear power stations in the last years, where similar worries about vessel integrity caused on and off shutdowns resulting in sharp price spikes during 2014 & 2015. Prices were not just higher but also more volatile and unpredictable, causing many Belgian energy buyers to make “mistakes” by panic buying on the peaks. Recently, the French power price has risen high above the German and Belgian prices in similar sharp spiking activity.

afb1

The comparison of German and French power prices is also showing that Germany has become structurally cheaper in the last four years. Anyone that had predicted this in 2011 would have been called a nutcase. Germany announced its plans for a quick shutdown of nuclear power plants. Everyone expected this to result in higher pricing. The contrary happened. Now, I do acknowledge the role of lower coal prices in this. But even now, when coal prices have recently increased by more than 50%, German power is still much cheaper than French. Germany has heartily embraced the renewable energy revolution. This has caused high add-on costs for paying back the subsidies granted to the many windmills and solar panels that were built. But it also resulted in structurally low commodity prices.

The new energy market reality shown in Germany is one of decentralized production spread over a multitude of technologies in small power stations. That contrasts sharply with France’s addiction to large, centralized power production with the one nuclear power technology. Today’s situation is confronting France with the vulnerability and reliability issues of this old market model. Market situations are always changing, so the current situation could reverse in the future, near or distant. But in any case, what happens now in France’s power market should cause politicians in France and other countries to rethink energy policies that bet on nuclear. For consumers of energy in France, difficult times lie ahead. We don’t want to think about what would happen if the carbon concentration issue would turn out to be a genuine safety risk and the current situation becomes permanent. But even if this issue is just the proverbial storm in a teacup, the Belgian situation has proven that due to the scientific complexity surrounding nuclear power, such storms can last a very long time. And as France is an important powerhouse, producing 17,3% of all EU electricity in 2015, surrounding markets will continue to be affected as well.

 

Why you should continue to negotiate your energy contracts

Way back in 2000, when Europe’s continental energy markets were deregulated, I remember how many business clients were thrilled by the prospect of negotiating their energy contracts. After decades of nerve-wrecking non-talks with arrogant monopoly utilities, they would finally get the chance to unleash the power of their contract negotiation skills on the important energy budget. A decade and a half later, we see more and more clients questioning whether negotiating energy contracts makes sense and if it’s not better to ‘just expand your running contract’. Reasons for that disillusion? First of all, in mature energy markets the part of the energy bill that you are negotiating, what we call the retail add-on, is just a tiny part of the overall energy bill. And as it is small, the amount of “savings” you can make by negotiating it is small as well. Moreover, energy companies often run highly standardized contracting procedures, making the room for improvements small. Nevertheless, with every contract negotiation that we as E&C do, we see that improvements can be made. And even if they look like small steps (dots and commas), they often lead to important improvements in the energy procurement practice.

Natural gas and electricity have become highly commoditized products. A product becomes a commodity when standard quality and service characteristics have been defined or developed for it, meaning that it can be bought with “price” as the primary focus. As far as energy is concerned, the quality is standardized. Whether you buy from supplier A, B or C, the natural gas or electricity as a physical product will not be different. Regarding the service, we have to remark that most of the traditional service aspects of a delivery of a product have also been standardized as far as energy is concerned. I’m talking here about aspects such as timing of the delivery, security of supply, responsiveness of the supplier in case of a supply interruption, etc. In the case of electricity and natural gas, it’s not the supplier but the grid operator that is responsible for the delivery at the gate of the client. And this is a regulated company delivering a legally regulated, standardized, one-size fits all service.

The standardization of quality and service level is an important step in the development of a wholesale commodity market. Wholesale markets, whether they are exchange traded or OTC, always face the liquidity dilemma. For them to become successful, they need to have sufficient volume traded. If there is a large diversity of products traded, the total volume traded (or the amount of money flowing into that market) will have to be spread out over all these different products, reducing the liquidity per product. With insufficient liquidity, bid-ask spreads will run up, price changes become erratic and it becomes difficult to find counterparties. As far as energy is concerned, it has proven to be possible to sufficiently commoditize energy products for successful wholesale markets, even exchange-traded, to develop. We have first seen this in the oil markets and in the US Henry Hub gas market, the UK’s NBP and Scandinavia’s Nordpool, and recently also in continental Europe’s natural gas and electricity markets with TTF and EEX being the best-of-class examples, but for example Poland’s Polpx recently developing very rapidly as well.

When products become commoditized, a phenomenon called ‘margin erosion’ occurs. The suppliers become retailers in the sense that they buy the product in the wholesale market and then sell it on to end consumers. The basic price reference becomes the wholesale price, which is the same for every supplier – retailer. They have to make their living from the add-on that they charge on top of that wholesale price. As suppliers can no longer distinguish themselves with better quality or service levels, it becomes increasingly difficult for them to charge a price premium for that add-on cost compared to other suppliers. That’s why we observe that as markets mature, the price differences between the suppliers become marginal. This is clear in a very transparent manner in the TTF-based gas markets, where suppliers offer energy at a very simple TTF + add-on in euro per MWh price formula. For consumers above 20.000 MWh per year, we often see at the end of a negotiation that there are three – four suppliers that are offering at TTF + 0,2 or 0,3 with differences of less than 5 eurocent per MWh among them. If you consider that the total value of the natural gas (commodity + other costs) is around 18 euro per MWh, you can clearly see how marginal a phenomenon retail price distinction has become.

Having observed this commoditization of the product, you could easily conclude that the energy supply business is commoditized as well. Hence, comparing energy supply offers is a simple matter of putting prices next to each other. “Negotiation” is even a hyperbole when we speak about commodities, as it’s just a matter of picking the best price, which in the case of many gas markets in Europe has become childishly simple. However, even if their product has become commoditized, the energy supply business hasn’t, on the contrary. As markets mature, energy suppliers have become suppliers of a set of services regarding the delivery of energy commodities that we can subdivide in the following categories:

  1. Profiling services. In the wholesale markets, energy can only be bought on a forward basis in rudimentary blocks. And the physical delivery of the electricity and natural gas goes through a complicated process of balancing. A supplier will buy the blocks for you and perform the complicated day-ahead, intraday and end-of-day financial settlement operations to make sure that you get delivered exactly what you consume. This profiling service constitutes the main economic rationale for buying energy through a supplier – retailer and not directly in the wholesale market. Due to his portfolio effect (he can go through the balancing mechanism on a portfolio-wide basis), the supplier can deliver the profiling at a very reasonable cost.
  2. Volume services. The blocks that you can secure on a forward basis in the wholesale markets come with no or very limited volume flexibility. Energy suppliers can increase the amount of volume flexibility offered to an end-client by using their portfolio effect again.
  3. Price hedging services. As the links between the end-consumer and the wholesale market, the energy suppliers have developed services to perform price hedges. Again, because of their portfolio effects, they can deliver these at a price and with a level of flexibility that is often unachievable for the individual client.
  4. Payment services. Suppliers offer payment terms which are longer than the terms they themselves have to pay to the counterparties in the wholesale markets or the grid companies and authorities in case they offer a single utility bill service. This means that they actually become a credit provider. The amount of credit that they provide and the conditions at which it comes can be more or less strict.
  5. Other services. Suppliers can develop other services in terms of invoicing services, advanced meter reading services, cost monitoring services, energy efficiency services, etc.

Remarkably enough, having a good level of the services described above doesn’t necessarily come at a price premium. It depends mostly on the operational and commercial practices that the different companies have developed. However, the differences in the level of these services makes contract negotiation important. And makes it necessary for clients to have the necessary experience to make a good assessment of the different contractual possibilities. Having a good insight into how suppliers work, e.g. when they perform a price hedge, can be very helpful in getting a better result negotiated. As a consultant, I’m obviously biased, but believing that the suppliers themselves will help you getting the necessary insights into their complicated worlds is somewhat naïve. Not just because of their ill will, but also because the account managers that you talk to often don’t have those insights themselves. As markets mature, we see that energy suppliers’ services in themselves become more standardized, as all the suppliers have to gradually adapt to the best-of-class service standard to stay competitive. However, even then a small difference in wording of e.g. a volume or a price fixing condition can make a very big difference in operational outcome, making it important to carefully check every offer received and negotiate conditions.

But not only such service aspects make it important for a client to have good contract negotiation. Even if the price differences are small, there is still one offer out there in the market that is the cheapest. It’s the responsibility of a professional procurement organization to go out and find that cheapest contract. This importance obviously grows as the consumption grows. 10 eurocents multiplied by 500.000 makes for more money to be made by contract negotiation than for a client consuming just 10.000 MWh. But then the price differences can be larger when the consumption is lower. So it is still worthwhile to go out in the market and negotiate the price conditions. With almost every RFQ we see that we can create value with contract negotiation, that the contract that the client ultimately signs is a better contract than what he would have signed without the negotiation, not just in the conditions but often also in price. The market has come to this stage of low retail add-ons and good service levels thanks to the negotiation efforts of many buyers and consultants. And it’s worthwhile to keep up the effort!

Will the Polish capacity market stimulate new investments?

Read the Polish blog here. Written by Wojciech Nowotnik.

The last couple of weeks there’s been a debate on whether a capacity market needs to be created in Poland. At the beginning of July, the Ministry of Energy published a few suggestions to implement this capacity market. The main question is whether the capacity market as it’s outlined by the Ministry of Energy will stimulate new investments in stable production capacity to increase the energy security in Poland.

Let’s start with a brief recap. Support for investments in conventional power plants in Poland is nothing new. Do you remember how in the early nineties the Polish energy was in need of intensive modernization to reduce greenhouse gas emissions? A relatively simple mechanism was introduced: the long-term contract, called KDT (Kontrakt DługoTerminowy – Long Term Contract). This kind of support was simple and beneficial for the investor. After Poland entered the European Union, the KDT had to be changed because it was seen as unlawful state aid. The KDT became a transition fee as of 2008, a part of the distribution costs.

In August last year, the so-called power stages were introduced to significantly relieve the power system in Poland. This revived the discussion on the promotion of investment in conventional generation sources.

afb1

As you can see on the image above, the available capacity and demand are almost at the same level. This is a clear sign that similar problems might occur in the future. Therefore, other solutions need to be introduced in order to have a more stable national power system. Some other European countries are in a similar situation but the risk of supply constraints isn’t that significant as it is in Poland at the moment.

This is exactly why the Ministry of Energy worked on functional solutions for a capacity market in cooperation with experts from PSE SA. The document says they want to ensure the continuity and stability of electricity supplies to all end-users in the country on a long term. The project is largely based on the concept of the capacity market in the UK.

The proposed system assigns one party that is obliged to determine the size of the power demand and needs to organize the purchase of this amount of power based on . The asking price will be gradually lowered and the winner will be the one who offers the lowest rate.

Below you can find the schedule of processes on the capacity market.

afb2

Source: Ministry of Energy

Unfortunately, the example of Great Britain shows us that this solution does not guarantee investment in new blocks. According to the blog of Professor Świrski only 5% of the funds will be invested in new gas-fired units and the vast majority will support the old coal-fired plants to continue to be maintained.

In my opinion, it’s a pity that the solutions were only based on the national system without having a look at the opportunities of cross-border trading. As well, solutions providing Demand Side Response are only marginally treated. I also share the opinion of different commentators that point out that the capacity market as currently proposed might be considered as unlawful state aid. My last and most important remark concerns the cost for introducing the capacity market. ClientEarth’s analysis says that the capacity market based on the current proposal would mean an additional cost of 80 to 90 billion polish zloty (20 to 22 billion euro) between 2021 and 2030. The average energy bill would increase by 30%. The project only shows settlement mechanisms without providing any cost simulations. It seems like the Ministry of energy tries to solve the problems of the Polish energy sector by duplicating the mistakes of other EU countries.

In 2014 Benedict De Meulemeester, founder and owner of E&C Consultants, published an article about the capacity market: Capacity payments: expensive solution for a non-existing problem. At the end of the blog article, a more fair, cost-efficient way without unnecessary increases of energy prices for consumers is proposed:

  1. Continue the climate policy measures aimed at reducing consumption.
  2. Expand cross-border capacities and stimulate cross-border trading initiatives such as market coupling.
  3. Continue to support renewable energy, especially now that its investment costs have dropped.
  4. Support demand side management where it is realistic.

If you analyse both the project above and other legislation on the energy market in Poland (such as the law on the construction of wind farms) it seems like the actions of Minister Tchórzewski are exclusively focussed on supporting the Polish coal industry.

Prior to signing the “Windmills Act”, the Energy Minister said “there is a need for less of this renewable demagogy”. I would say there’s a need of less of this coal and bureaucratic demagogy.

 

 

Is the world ready to grow its economy without increasing energy demand?

It is a strongly imbedded belief in the world of energy analysis that demand for energy can only grow. In terms of energy procurement, this leads many buyers to bullish biases, making them buy too soon or at high price levels, as they believe increasing demand will make prices rise. However, as commented earlier on this blog, we have recently seen a slowdown of the growth of worldwide energy demand. It’s true of course that the last decade hasn’t excelled in terms of economic growth. However, in many parts of the world now, an extra percentage of GDP doesn’t necessarily mean an extra percentage of energy use. In 2015, the world’s primary energy consumption grew by just 1%, whereas GDP, according to the World Bank, grew by 2,47%. Have we cracked the code and can we – as of now – increase our economies without using ever larger quantities of energy? Or will a next phase of strong economic growth come with an acceleration in energy consumption growth again?

afb1

Fig. 1: Primary energy consumption in the world (Source: BP Statistical Review)

The graph on the world’s primary energy consumption is showing us how during 2000 – 2007 strong economic growth came with large extra quantities of energy. The economic crisis of 2008 & 2009 brought that down sharply, only to be followed by a record year-on-year increase in 2010 as particularly China – the world’s largest energy consumer – revived quickly. But then the energy growth started to slow down. Last year, worldwide primary energy consumption grew by just 1%.

It should be clear that not all parts of the world are equally contributing to this reduction in energy voraciousness. As can be seen from the graphs below, the traditional economies in Europe and Northern-America have been in the lead. In the European Union, we even see a clearly declining trend that started in 2006, which is before the striking of the economic crisis. This is the moment that many energy efficiency programs devised in the framework of Europe’s climate policy have come into effect and I believe that there is a clear causal relationship here. In North-America, energy consumption in 2015 was at the same level as in 2000. US primary energy consumption in 2015 dropped 0,9% compared to 2014, despite a 2,4% increase in GDP.

(Regarding Europe, critical observers might remark that there has been an increase in EU consumption in 2015 – to which I would respond that this was a year with cold winter weather.)

afb2

Fig. 2: Primary energy consumption in different parts of the world (Source: BP Statistical Review)

The lines on the right hand side don’t show much slowing-down of the hunger for more energy in the emerging economies. However, in China e.g., energy consumption grew by just 1,5% last year, which is far below the 16,6% and 17% that we saw in 2003 and 2004. On the one hand, this slowdown in hunger for ever more energy can be explained by the mechanics of economic development itself. In the first phase of its economic development, growth in a country like China came from the growth of basic, energy-intensive industries such as steel production, causing energy demand to go up quickly. On top of that, the growing middle classes started to enjoy energy-consuming luxuries such as cars, a larger house, air-conditioning, frozen foods, etc. However, once a certain level is reached, further economic growth comes from less energy-intensive industries and services and the middle class stops to grow, causing the growth of energy consumption to slow down. But could it be a deeper trend, and is the world starting to copy Europe’s example of consciously improving its energy efficiency?

When I talk to people around me, I observe that most of them don’t realize at all what a revolution they’ve gone through in their daily lives in terms of energy efficiency. To just name a few examples:

  • Cars have drastically improved their fuel efficiencies,
  • In lighting, we’ve moved from the lighting bulb to energy-saving lighting bulbs to LED-lighting, meaning that we now have the same amount of light using less than 10% of the energy that we used 15 years ago,
  • Insulation regulation has reduced the amount of energy that we use to cool or heat our houses,
  • Walking into electro shops, we are now looking at the energy efficiency labels, inspiring us to buy new fridges, microwaves, vacuum cleaners, etc. that use much less than the ones we throw away,
  • The boilers that we use to heat our houses are now super-efficient top technology,

And not just households have reduced their energy consumption. If I look at our clients, mostly large industrial users, all of them are running energy efficiency programs, inspired by government regulations, demands by clients and other stakeholders or just environmental consciousness. Implementing more efficient technology and practices, they have all reduced the energy-intensity of their production. And many of them are not only reducing energy consumption in relative (MWh per ton) terms, but also in absolute MWh per year terms.

It is true that the effects of more efficient technology, appliances using less energy every time we use them, has partly been undone by the fact that we use them a lot more. We drive our cars more often, take more flights, light up every building with LED’s, etc. This leads pessimists to disbelieve that technological improvements are not a solution to our energy problems. What has happened in the EU in the last decade, has proven them wrong. We can grow our economies and enjoy the luxury of a well-lit building or smoothly-driving car without increasing the overall amount of energy that we use. The next years should show whether this can be imitated and turn the slow-down of energy demand growth in other parts of the world into a decline as well.

You can still subscribe for the second leg of our Transatlantic Energy Conference 2016 in Chicago over here: http://bit.ly/TEC2_US 

A decade of low energy prices?

Written by Benedict De Meulemeester

In March / April of this year, energy prices across the globe hit historical lows. The Brent oil price dropped to 27,88 dollar per barrel, WTI to 26,21. The price of coal for the world markets dropped to 36,55 dollar per ton. Natural gas in the US (Henry Hub 12-month forward strip) traded down to 2,11 dollar per MMBTU, European gas for next year (TTF) dropped to 13,02 euro per MWh. With fuel prices that low, it’s not surprising that power prices hit historical lows as well. The German baseload electricity price for next year dropped to 20,85 euro per MWh. Pricing in the US is very scattered, but the price for Northern Illinois as an example, traded as low as 25,30 dollar per MWh. Since then, prices have rebounded, but they remain at very low levels. Oil is currently trading just below 50 dollar per barrel, less than 11,8 % of the prices seen in the last ten years were better than that.

For buyers of energy this opens up important questions of course. Should you take this historical chance and make long-term fixings? Or are the supply and demand fundamentals supporting this bearishness so strong that we are heading for a decade of low energy prices, so it’s better to stay in the spot market? Some insight into what has been driving prices in the past decade, will teach us that giving a definitive answer to this question is impossible. Hence, the best bet is to prepare for both scenarios.

What on earth happened to peak oil? In the period 2000 – 2008, prices of energy and other commodities increased steadily to reach peaks in the first six months of 2008. An old theory that was popular in the 1970’s was revived. It assumes that production of energy resources follows the path of a bell-shaped curve whereas demand just continues to increase. Once the right-hand side of the bell-shaped curve has been reached, there is an inevitable supply crunch (peak oil). The maker of this theory, M. King Hubbert, was relatively successful in predicting the moment of the crunch in US oil supplies, giving him some credibility. An increasing number of energy market analysts interpreted the energy price bullishness as proof that peaks were occurring (Peak oil! Peak gas! Peak coal!). 8 years later, with prices at these historical lows, the declarations of the peak theorists seem ridiculous. A quick visit to the website of their association http://peak-oil.org/ will make most of us smile, or worse, get annoyed at the lack of empirical backing of what is said, e.g. that the production of oil has been almost flat since 2005, whereas in reality we’ve seen an increase of almost 12%.

Nevertheless, way back in 2008, the peak oil idea had a huge following. Goldman Sachs forecasted an increase of the oil price to 200 dollar per barrel. Many energy buyers fixed prices at the high levels of the first six months of 2008 as they believed the scary stories of ever increasing energy prices. I remember a meeting with the CEO of a big company that said: “we all agree that energy prices can only increase, don’t we”. Why were business people so easily scared into thinking that energy prices could know only one direction: up? First of all, I think that most of us have a hard time not to think in trends. It takes a lot of guts to believe in a decline when for months and months, even years and years, prices have continuously increased. Secondly, when it comes to energy pricing, many of us tend to be pessimist, energy is always too expensive, never cheap. Thirdly, the idea of scarcity was nurtured by environmentalists. When you can’t motivate people to reduce energy consumption for the sake of the environment only, fear of higher prices might be quite helpful. Eight years down the road, and on the other side of the price ranges, it might be tempting to think the other way around, to believe that the decline can only continue. Thinking back about 2008 can be a powerful reminder always to expect the unexpected, to run an energy buying strategy that is ready for the changes in the trends.

If we look at the long term developments in energy markets, we see a pattern of continuously low prices, temporarily interrupted by sharp upticks. This is caused by the way elasticity, the adaptation of supply and demand to price evolutions, works in energy markets. On both sides there is elasticity, but it works slowly, with significant delays. And the delays tend to be longer on the supply than on the demand side.

On the demand side, short term reactions to prices can occur in the shape of fuel switches, e.g. an industrial using fuel oil instead of gas for producing steam. Mid-term, consumers can lower their consumption when prices increase with behavioral efficiency gains, e.g. driving less kilometers with the car or decrease the temperature in one’s house. On the other hand, if prices are low, consumers will become more profligate. Long-term changes in energy demand due to periods of high or low prices can be caused by investments in structural energy efficiency improvements and by the effects of high or low energy prices on the economy. It would be far-fetched to say that the economic crisis that started in 2008 was caused by high energy prices, but it is clear that there was a link. Another example of this can be found in the 1980’s when the high prices of the 1970’s resulted in a sharp economic crisis resulting in much lower energy demand and two decades of low prices.

On the supply side, short term reactions occur in the shape of marginal cost decisions not to produce when prices have dropped below production costs. These reactions cause a continuous rebalancing but no structural price movements, as the capacities come back online as soon as prices increase above the production costs. More structural adaptations can be found on the mid-long term when installations are shut down when prices are too low. However, due to the high stranded costs of energy production installations, this shutdown is often rather temporary (the installation is “moth-balled”) and can be undone as soon as prices increase again. In the same fashion, we often see a supply side correction when prices are very high in the shape of bringing very old installations back online. The real structural adaptations of supply to price occur in the shape of production capacity adaptations by investments or lack of it in new production facilities. And the terms can be very long. The construction of a new power station, an LNG export terminal, ships for transporting coal, the development of an oil or gas field, etc., they can take more than a decade before the first energy is available to the market.

Having these elasticities in mind, we can perfectly understand what has happened in the energy markets in the last two decades. The strong global economic growth of the late 1990’s and early 2000’s with the exponential growth of emerging economies and China caused a voracious growth of demand for energy and other commodities. As of the mid 2000s this started to result in supply shortages causing prices to increase rapidly. Many decisions to invest in new production capacities were taken, but most of them only hit the market as of 2010. In the meantime, mid-term demand adaptations started to occur, we saw e.g. Americans choosing more fuel-efficient cars, causing a slow-down in demand growth. As of the second half of 2008, demand was slashed by the economic crisis which, as I’ve said before, was partly linked to the higher energy prices. This resulted in a sharp reduction of prices. When as of 2010 demand started to pick up again, supply extended more rapidly, resulting in a new supply glut that ended in the historically low prices of the beginning of this year. The recent bullish correction can be explained by higher demand and the mothballing of older production capacities.

It is however too early to say whether this is the definitive turnaround. It is clear that investments in new energy production capacities are slowing down, as we can see in this graph from the IEA with figures until 2013:

fig1

Source: Special Report: World Energy Investment Outlook, International Energy Agency, 2014, p. 20.

At some point, this slowdown in investment will result in a supply crunch such as the one that we have seen in 2005 – 2008. Whether that will be next year or whether we will see a decade of low energy prices is impossible to say. A lot will depend on how demand evolves in the meantime. Will we see another period of rapid economic growth or not? Moreover, we are seeing an increasing drive towards higher energy efficiency on a worldwide basis, meaning that more economic growth means less energy demand growth. This efficiency drive in the framework of climate policy started in Europe that has seen its primary energy demand drop by more than 10% since 2006 (although in 2015 it increased again for the first time in nine years). It is now being copied in more and more parts of the world. Will this keep down demand growth sufficiently for prices to remain low?

Slow elasticity sometimes leads some observers to the reasoning that the normal laws of economics (Adam Smith’s invisible hand) don’t work in the energy markets. They are wrong. Trends such as the sharp decrease of energy prices seen in the last five years do end at some point. Whether the recent turnaround is just temporary or the beginning of a longer period is impossible to forecast. Therefore, as an energy buyer you better prepare for all scenarios.

TEC 2016 banner

Go long or go short?

Written by Bart Verest

“I think we should buy all of our electricity and gas needs for next year’s delivery because I’m risk averse and don’t want to miss this opportunity”. It’s a statement I’ve heard quite often in the past few years. Sometimes, it’s followed by the reaction of another stakeholder who, on his end, wants to “take some risk and leave volumes open on the spot market”.
This example brings two important risks to the surface when buying energy.
Sometimes the personal appetite for risk is projected on the company the buyer is working for. In itself this is a natural reflex – people use their personal experiences and vision to perform their job. Nevertheless, it is important to keep a clear line between your personal preference and the interest of the business. Only then will you be able to set up a successful procurement strategy that aligns with the risks and interests of your company. If due diligence matters to you, then you should focus on the interests of your company rather than on your own personal beliefs or risk appetite. Putting your agenda ahead of that of your company can harm both you and the business in a personal and financial way.

We often see that the personal definition of risk is equated with the definition of risk for the company. On one hand, you will have people who see volumes floating on the spot market as a risk because of the unpredictability of spot pricing. On the other hand, you will have people who argue that hedging forward volumes is a speculation on the future price evolution and that a buyer shouldn’t speculate on this. In themselves, both statements are incorrect. Whether or not hedging volumes / leaving volumes open on the spot market constitutes a risk depends on the business model of the company. To explain this a bit further, I can take extremes on both sides of the spectrum as an example. On one side you have company A that makes long-term pricing arrangements with its clients. In order to do this, they look some three years ahead and estimate all costs to determine the final product price they will agree on. Their energy cost is naturally included as part of their calculations and therefore has to remain stable for the next years. If they end up with a price that is higher than the one they agreed upon, they lose margin. In this case, leaving (too much) volumes open on the spot market is rightfully considered a risk because it represents a mismatch between their pricing model and their business model. On the other side you have company B that meets every quarter with their clients to agree on a product price for the next quarter. In these quarterly agreements they have clauses where they pass-through the energy cost. If they fix prices for the next three years and the energy markets drop, they will lose margin as their clients force them to lower the prices they charge for their products. In this case, it’s buying (too much) volumes on the forward market that represents a mismatch between their business and pricing model.

Therefore, answering the question “go long or short” should have nothing to do with the personal convictions of the energy buyer regarding future prices or his/her appetite for risk. It should be based on a long-term energy buying strategy that aims to reduce the impact of energy market volatility on a company’s bottom line. In my presentation at this year’s “Transatlantic Energy Conference”, I will give practical examples of how companies from many different industries managed to take control over their energy costs by setting up such a strategy.

Click here to register for Amsterdam: https://www.eventbrite.com/e/transatlantic-energy-conference
Click here to register for Chicago: https://www.eventbrite.com/e/transatlantic-energy-conference-2-united-states-tickets-21030478728