Supply contracts: Decisions, decisions…

Imagine the scenario: you’re standing at a roulette table with £50 of chips in your hand. You can either go for broke and place all of your chips on a single number in one bet, or spread it around the board, play a few spins and make it last. Most people would opt for the latter because it’s far more sensible, but that logic is rarely applied when purchasing gas and power. Gas and power in the UK can be purchased through a “fixed” or “flex” supply contract. A fixed contract is an agreement between a supplier and a customer that their rate will remain the same for a fixed period of up to five years. A flexible contract enables the customer to make purchases more frequently throughout the length of the contract. For example, rather than buying all of next year’s power or gas today, a customer might only buy for the next quarter, month or even day. Both of these options have circumstance-driven pros and cons; however, it is commonplace for some of these to find their way into the wrong columns. Managing risk The largest misconception surrounding energy contract types is risk. The level of risk associated with energy contracts doesn’t reduce with different contract forms; it moves between the supplier and the customer. Within a fixed contract the customer asks the supplier to undertake all market fluctuation risk by committing to invoice a single static unit rate for the course of the contract. In return for undertaking this risk the supplier will add a risk premium to the price, which is directly proportionate to the level of risk associated with the contract. Typically, the longer the contract or more uncertain the market conditions, the higher the risk premium. In contrast, the unit rate invoiced on a flexible contract is controlled by the customer’s purchases, meaning that an increase in the market price will not impact the supplier. The removal of risk to the supplier therefore results in the removal of a risk premium and potentially lower costs. With a higher level of involvement in purchasing decisions, and a greater exposure to possibly bullish markets, control of risk becomes a significant factor in the debate between fixed and flexible contracts. Historically the perception has been that in order to achieve budget certainty, customers must go fixed and pay the additional risk premium. However, controls can be put in place to mitigate market rises by “locking out” or purchasing for all open positions if the market price hits a specified level. This level could even be set as a fixed market price alternative, ensuring that the customer is never worse off than if the fixed contract was selected. This scenario provides customers with the facility to purchase their own energy, reduce fixed costs such as risk premiums, but also safeguard budgets. An element that should be considered when discussing risk between fixed and flexible contracts is what happens if the market rate falls as it did between November 2016 and May 2017? A 24.29% fall in UK Y+1 base power price was recorded, resulting in a drop of £13.01 £/MWh (1.301 p/kWh). A risk-adverse customer may well have locked into a fixed contract at this point – the highest in the market since March 2014. Other potential inhibitors Risk aside, there are still reasons that property management companies in particular tend to avoid flexible contracts; for example, budget certainty. Annual budgets must be set in advance to enable landlords and tenants to forecast cash flow, and flexible contracts have always been seen as a restriction to achieving this. However, it is now possible for fixed prices to be applied to budget years within a flexible contract based on trades made, giving certainty of billed unit rates for the year ahead with the versatility of trading on flexible contracts. Interestingly, following the debate over whether to pursue fixed or flexible contract options, contract management becomes a whole new discussion and the complexity of managing a flexible contract often causes many customers to remain with a fixed version. Customers are either required to work with a supplier, consultant or internal team to monitor market movements, track trades, identify open positions, and analyse risk positions in real time. Without these functions in place, the nightmare scenario of prices rising and not being able to lock in a trade until it’s too late becomes very real. Whereas many companies have personnel who are capable of working with suppliers or consultants and taking a lead from recommendations received, most don’t have analysts as an internal resource. As a result, customers are reliant on a supplier or consultant to provide independent advice on how to manage a flexible contract. But with little or no regulation in the energy consultancy and brokerage market, customers could be taking advice suited more to the interests of an energy supplier or consultant than their own. Align with business strategy With energy costs rising owing to both fundamentals in the wholesale market and increased non-commodity costs, it remains the decision of an individual company of whether fixed or flexible contracts most align with their business strategy. However, flexible contract customers require not only a strong relationship with their energy provider or consultant, but also a reliable system in place to independently verify the information, commentary and advice being provided. All customers exploring flexible contracts should at least have access to day +1 market pricing and multiple sources of market commentary to ensure that they continue to follow their own strategy rather than that of a third party.  Alex Hill and Joe Warren are two of the co-founders of ZTP, a strategic energy management consultancy that works with businesses and other organisations with multi-site operations to help them manage their energy and procurement requirements more efficiently and cost-effectively Pic credit: ImageBROKER/REX/Shutterstock