Why spot contracts are not immune to volume risk

Readers of my previous blog article (in Dutch) will have remarked that I was quite agitated by misleading sales of spot contracts to end consumers. I would want to come back on a specific issue, the volume risk, and write a separate blog article in English on.

 

“No volume risk” is often cited as one of the advantages of a spot energy contract. And indeed, these contracts don’t have “volume conditions” in the sense of minimum or maximum volumes that have to be / can be consumed. Many buyers of energy have gone through agonizing experiences when they ran into the threshold levels of such traditional volume conditions. This was particularly a problem in 2009. Many industrial consumers of energy saw their consumption drop below levels that they hadn’t anticipated even in their worst nightmares. Moreover, many continental European energy contracts at that moment still had minimum volume conditions of a type that we call ‘hard take-or-pay’. It means that any energy that isn’t consumed needs to be paid for anyway at the contract price. But even those consumers that already had ‘soft take-or-pay’ conditions suffered. In a soft take-or-pay settlement, which has become very common, you pay the contract price and get back the spot price. As the reduction of consumption in 2009 struck many consumers, the overall demand for energy was going down. This caused spot prices to drop sharply. Therefore there often was a very big difference between contract prices that had been fixed in the bull markets of 2007 and the first half of 2008 and bearish spot prices for unconsumed levels of 2009. So, even with such soft take-or-pay arrangements, clients still had to pay a lot of money for unconsumed energy.

 

Of course, for anyone that has had to report to his management the payment of a few hundreds of thousands of euros for not consuming energy, the proposal of a contract without any such volume obligations sounds very tempting. And indeed, a spot contract is a ‘you only pay what you consume’ type of contract. Some such contracts really look at what you consume on an hourly basis and multiply that with the spot price for that hour. Most spot contracts look at the monthly consumption and multiply that with the average spot price for that month. So, even if your consumption drops to zero, no problem, no energy will be billed. If your consumption doubles, you’ll pay the spot price for that extra energy. No more thresholds to keep an eye on, just simply pay for what you consume. I can understand why some people call that ‘no volume risk’. But I don’t agree with them. Not at all.

 

First of all, it should be remarked that the zero volume risk proposition only holds as long as you keep everything open for the spot market. Many such spot contracts also have clauses that allow you to forward fix your prices. Such fixings are then always made for capacity blocks. Let’s say you are a client with such a spot contract and you expect you will consume 60.000 MWh next year and you want to fix your price 100%. Your supplier will come back to you with something like ‘OK, your load duration is 6.000 hours on an annual basis, so I’m going to fix a 10 MW Calendar year block for you’. If your contract is then regulated based on monthly consumption times the average spot price for that month, every month that you consume less than 5.000 MWh, you will pay the fix price and get back the spot price for the unconsumed volumes. If your consumption is higher than 5.000 MWh, you will pay the spot price for those extra volumes. If at the end of the year the aggregated volume of the months is 60.000 MWh, the volumes you haven’t consumed and for which you got back the spot price (in certain months) will equal the extra volumes bought at spot price (in certain months). If you’re lucky, you might have consumed less in exactly those months when the spot prices were high and more in the months with low prices. You could actually make some extra money that way. But it could also be the other way around.  The opportunity and risk are even higher when you have a contract that settles on an hourly basis. It should be remarked that in that case, an extra problem occurs of checking such bills based on hourly consumptions, fixed levels and rates.

 

The volume risk of forward fixing a capacity block can be reduced by buying ‘structured blocks’, meaning that you will use calendar, quarter and month products to fix capacities that correspond with your expected monthly volumes. For electricity, such structuring is further complicated by the fact that you have to construct a structure of base and peak-load blocks. However, unless you have a 100% accuracy regarding your volumes forecast, you will never be capable of making a fixing that exactly corresponds with your actual volumes consumed. And it certainly means that you find yourself in real big risk of having a big extra cost due to volume issues when you’ve fixed 100% of your expected volume and your consumption turns out to be structurally lower. If this coincides with a period of low spot prices (like we’ve seen in 2009), you will find your energy costs exceed the fixed price level (at which you probably budgeted) very rapidly. Same thing when a period of larger than expected consumption coincides with high spot prices. In those cases, you will experience that the old contract with its volume conditions wasn’t such a bad idea after all. In such contracts, the volume issue only starts to bite once you’ve hit the threshold volumes. For this reason we recommend any clients that want to have a high degree of certainty over what their future energy prices will be to sign traditional forward fixing contracts, even if they come with volume conditions (nowadays some suppliers offer consumers of smaller volumes forward fixing contracts without volume conditions).  If you want to sign a spot contract, only do it when you are willing to keep the price of at least 20% of your volume unfixed and open for the spot market. And if you have a high volume uncertainty, you should keep the price open for the spot market for even higher parts of the volume.

 

But even if you keep 100% open for the spot markets, this still doesn’t mean that you don’t have volume risk. High prices in the spot market often coincide with high overall consumption of energy, that’s very obvious economic logic. That means that consumers that have typical consumption patterns, e.g. consuming natural gas for heating in the winter or consuming electricity for cooling in the summer, have an increased risk of seeing periods of increased consumption coincide with periods of high prices and vice versa. Moreover, in the electricity markets you should take into account the large differences in hourly pricing. If you have a typical peak-load pattern, for example because you consume the electricity in an office setting, the probability of a large consumption in a particularly expensive hour increases. In a cold winter or a heat-wave summer, the combination of increased consumption and higher spot prices can cause serious derailing of budgets.

 

If you look at it in this perspective, the claim that spot contracts are free of volume risk, actually is true only if you look at it from the suppliers’ perspective. The supplier is sure that he will always get paid for what his clients consume at the exact same price at which he has to buy the energy in the spot market. (Or, if it is a contract settled on a monthly basis, a price very close to it.) No risk of having bought  too much for a client and having to sell it in a bearish spot market. No risk of having to buy more in a bull market. Actually, the volume flexibility conditions of traditional (forward) fix price or tranche model contracts are just that: flexibility, a way of reducing the volume risk. They mean that inside the tunnel or bandwith, you are sure of the price you will pay, regardless of what your exact consumption is. An 80% – 120% volume condition protects you against the negative effects on your prices of unfavorable spot market movements. Forward fixing your prices and accepting volume flexibility on that fixing, protects you against budgetary catastrophe in times of high consumption. In many cases, spot contracts are less expensive than forward fixings with volume flexibility. This clearly illustrates that with a forward fixing contract with volume flexibility, risk is shifted from the client to the supplier and not the other way around. And that makes the claim that spot contracts are less risky absurd.

 

This example clearly shows that as a buyer of energy, you need to be extremely on alert when somebody is proposing you something that has no risk. If I have learned anything in thirteen years in the energy markets, it’s that it is very hard to find ‘no risk at no extra price’. The closest thing to it could be the forward fixing contracts with unlimited volume flexibility that some suppliers currently offer to smaller consumers. But spot contracts aren’t a ‘no volume risk’ solution. Every energy contract negotiation is an act of carefully balancing risks and opportunities between supplier and client. A spot contract means a shift of volume risk from supplier to client. That explains why it often comes at a lower price.

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