Energy risk: How businesses can reduce costs in a volatile market

The world is facing its most serious energy crisis since the 1970s, putting severe strain on many businesses. Gas prices have soared, electricity costs are up, and even the cost of unfashionable coal reached an all-time high in October 2021. Elevated prices have pushed several UK energy suppliers out of business and raised fears of a long winter ahead, with the situation looking set to persist well into 2022.

The crisis has forced businesses to scramble to manage soaring costs and acted as a stern reminder that the companies that can pre-empt inevitable energy price fluctuations are best placed to weather them.

"We meet CFOs regularly; how you deal with energy cost volatility is a matter of financial management," said Benedict De Meulemeester, owner of Belgium-based energy procurement consultancy E&C. "You don't know whether energy prices will go up or down, but the one thing you do know is that they will always be volatile. We encourage clients to do some deep thinking [about] how their companies' profit and loss are affected by energy cost changes."

But as De Meulemeester noted, the surges in energy prices seen in the second half of 2021 have been considerably larger than those that normally occur in a 10- to 15-year commodity cycle. "The run has been unprecedented," he said.

Companies in more deregulated markets, such as the EU and some US states, have been particularly affected, as have energy-intensive firms such as fertiliser producers, some of which have cut output to reduce costs.

Troy Vincent, a Louisville, Kentucky, US-based market analyst at data, analytics, and technology company DTN, warned that high energy prices are here to stay, at least for the near term.

"Global natural gas and coal prices will remain near record highs, causing electricity shortages for households and industries, with Asia and Europe being the most at risk," Vincent said. "Natural gas to oil switching will lead to higher oil, gasoline, and diesel prices. This trend is likely to sustain through the winter."

Vincent added that surging energy prices are having undesirable knock-on effects throughout the economy, with industries curtailing activity and households seeing their discretionary income reduced by inflation. He expects supply chain issues and shortages to continue to worsen before they improve, persisting through 2022, although there is some uncertainty about when the easing will occur.

Markus Wachter, a Zurich-based energy analyst speaking in a personal capacity, told FM magazine that prices could be sensitive on the downside to positive news coming from supply — or lower demand. "Further developments will depend on the ability and action of Russia to increase gas flows, temperatures and demand this winter, and renewable production," he said. "A huge risk premium has been built up in energy futures which could be eroded quickly by additional gas supplies. Until that happens, there is still a risk that the market stays tight and prices at high levels."

Response strategies

While reducing energy consumption is a reasonable way to reduce energy costs at times of lower volatility, De Meulemeester argued that it should not be regarded as a silver bullet.

"The cheapest megawatt hour is the one you don't consume," he said. "But if you see gas prices go up by 450%, you can't reduce energy consumption by the same amount. I see companies making real efforts to reduce energy consumption, but not doing anything on the energy procurement side, so the budgetary benefits are lost."

Wachter suggested that companies can adopt a range of strategies in the face of higher prices: first, waiting for lower prices in the hope that supply will come onstream and the winter will be mild — "not that unlikely, but potentially risky"; second, securing future energy needs over a longer-term basis to reduce the average price, with gas, coal, and electricity prices currently lower two and three years ahead than spot; finally, protecting themselves against future shocks, if not mitigating the current ones, by setting up a risk management and purchasing strategy for their energy needs in the future.

"This episode emphasises the need to manage energy risk by working with energy risk professionals to understand the potential budgetary impacts of surging energy prices on company operations and balance sheets," Vincent said. "Both financial and physical energy risk hedging would have been beneficial for businesses during this market cycle."

Too many companies "silo" their approach to energy, De Meulemeester said, rather than considering it an essential component of their balance sheet. E&C groups its clients into three categories — those facing budget risk, market risk, or survival risk. The bulk are budget risk businesses, which are not particularly energy-intensive, with energy accounting for up to 5% of overall costs. They often have long-term sales agreements that make offsetting rising costs by passing them on to the consumer more difficult. Such companies range from those in electronics and car manufacturing to those in pharmaceuticals. E&C recommends these companies have a four- to five-year hedging process in place to ensure budget stability; it advised clients to buy energy in spring 2020 when prices hit historic lows, giving them much lower costs for 2021.

Market risk businesses are more energy-intensive and are often found higher in industrial supply chains where the processing of raw materials takes place; for example, cement, glass, or paper production. While hedging helps such firms, they can also pass on the costs to their customers, particularly in the current high-demand environment.

Survival risk businesses, meanwhile, find it very difficult to increase prices, as they have rivals with structurally low energy prices as a result of their location. Examples of this could include petrochemicals competition from firms based in the Middle East, or in Europe from companies in energy-intensive industries in countries such as France and Germany benefiting from major reductions in regulated costs. Such businesses need particularly complex hedging processes.

While many companies do not have the scale or expertise to set up hedging for themselves, energy companies increasingly offer their own trading desks that can execute hedges for customers. Suppliers are willing to offer hedging services to their clients through their physical supply contracts, executing the hedges in the wholesale market, and keeping the hedges on the books, translating this into a final price on the client's invoice. For the energy company, this provides an opportunity to trade on the positions taken by their clients. This model has created issues for energy suppliers in the current environment and led some to shift market risk more towards their clients. De Meulemeester said that the risk can be mitigated by executing hedges several years in advance when prices are historically low, with the aim of stabilising cost at low prices, and putting in place a stop loss defined by maximum year-on-year cost increases, triggering progressive extra hedges as prices rise.

"If you're running a company and not looking into this, you're a sitting duck when markets go crazy as they just did," De Meulemeester said. "Lots of companies are coming to us that are now completely exposed. We have two pieces of advice: Firstly, don't stick your head in the sand, start taking action. And secondly, now is the time to really think about your prices and your profit and loss."

With energy prices likely to remain elevated for some months, the impact on company balance sheets will continue to be felt. Businesses that acted pre-emptively are in the best shape to weather the storm. Others should act quickly to manage the current crisis — and prepare themselves for future volatility.

— Andrew MacDowall is an independent consultant and writer based in France. To comment on this article or to suggest an idea for another article, contact Oliver Rowe at Oliver.Rowe@aicpa-cima.com.