By Benedict De Meulemeester on 24/09/2012
More and more large and medium-sized consumers in mature markets, are being approached by suppliers offering them full flexible power contracts. The main characteristic of these contracts is that the forward fixing of prices is done on capacity blocks instead of on percentages of volumes. The risk and opportunities of such contracts are very different from more traditional supply contracts. Let me start this blog article with an explanation of this new contract type with a short history of open market energy contracts offered to medium- and large-sized consumers of natural gas and electricity in Europe:
As you can see, the hedging possibilities of the clicking contracts have reached a high level of sophistication, certainly in North-Western Europe. In less mature markets, like Spain and Italy, the products are still rudimentary, as many large consumers are still in the process of making the switch to clicking contracts. But in countries like the Netherlands, Belgium or Germany, most consumers now have highly individualized approaches to how their prices are being fixed (or spot-indexed). It is sometimes questionable whether the level of complexity is still serving risk-mitigating purposes, but that is a topic for another blog article.
For all their sophistication and complexity, the clicking contracts are still creating hedging risk for the energy suppliers. They still create the risk for the supplier that the revenue he generates on his client is not completely matching with his costs in the wholesale market. This is due to the fact that the clients fix percentages of volumes with every price fixing. The supplier commits to apply that price for any volumes consumed between the volume flexibility margins of the contract and regardless of the moment that the volume has been consumed.
Let’s say for example that a client has a contract to fix his 87,6 GWh of 2014 gas consumption in 10 clicks on the TTF Cal 14, a contract with 80% to 120% volume flexibility on the annual volume. Every time that the client clicks, the supplier can buy a 1 MW block of TTF Cal 14. He will get 87.600 MWh delivered at the price that he fixed at the TTF during 2014 (a year has 8.760 hours). If the client consumes 90.000 MWh, he will have to buy the extra volume in the spot market. If the spot price is higher than the forward price, he will loose money. If the client consumes only 80.000 MWh and the spot market is lower than the forward price, he will loose money again, as he pays the forward price for the 7.600 MWh of forward bought but unconsumed gas and he can sell them back at the lower spot price only.
This is why more volume flexibility will cost more money in terms of the add-on on top of the TTF wholesale price. On top of that, the supplier has hedged capacity blocks, 10 MW in total. But the client will not consume his 87.600 MWh (or 80.000, or 90.000, or anything in between the volume limits) in equal 10 MW per hour chunks. One hour, he will consume 12 MW, and the supplier will have to buy an extra 2 MW, the next hour he will consume only 8 MW and the supplier will have to sell 2 MW’s. For capacities per hour that can be forecasted, the supplier can do his buying and selling in the day ahead market, for unexpected diversions of the consumption pattern, he will have to use the within-day market or get balancing system payments or invoices.
This is basically the issue here. The fixed price for the annual volume cannot be perfectly hedged by the supplier in the wholesale market where only capacity blocks are for sale. This creates volume, spot market regulation and balancing risks for the supplier. The supplier will have to add risk premiums to his add-on on top of the wholesale price to mitigate that risk. If a client chooses to have part (i.e. a percentage) of his price indexed to the spot market, the risk is lowered but not eliminated.
The North-West European markets for supplying energy to industrial consumers have become very competitive. In most tenders, the difference between the three best offers are less than 1%. It is therefore not surprising that suppliers search for possibilities to lower their wholesale market add-ons and offer new, innovative products. Hence, the emergence of the full-scale flexible energy contract. In such contracts, hedges are no longer on percentages of annual, quarterly, or monthly volumes, but on capacity blocks. The capacity block is than regulated over the spot and/or balancing market.
If we go back to our 87,6 GWh example, with a full-flexible contract, the supplier will basically do the same hedges, i.e. buy 10 1 MW capacity blocks. But instead of just charging a fix price for every MWh consumed between the flexibility margins, he will also charge or pay back to his client the costs of extra MW’s or lacking MW’s that were consumed, resp. not consumed on an hour by hour basis. If during one hour, a client is consuming 12 MW, he will pay 10 MW at the forward price and 2 MW at the spot price for that hour. If he is consuming only 8 MW, he will pay 10 MW at the forward price and get back the spot price for the 2 MW. If at the end of the year, he has consumed more than 87,6 GWh, this will mean that the overall quantity of energy that was to be bought in the spot market will be larger than the overall quantity that could be cold back. With such a contract, the supplier is passing through his volume and capacity regulation risks to the client. Therefore, such contracts will often have an add-on price that is markedly better than traditional clicking contract with volume flexibility.
Reactions of clients to such full-flexible contracts are mixed. Some clients are blinded by the lower add-on and sign a full-flexible contract without apprehension of the extra risks. Others are scared by the extra risk and shy away from signing them without fully understanding the opportunities. One thing is sure. If you put two clicking contracts next to each other, you can say with 100% certainty: “whatever happens to the markets or our consumption, contract A will always be better than contract B”. With these full-scale flexible contracts, this is no longer possible. You will always have to say, if this and that happens, the full-scale flexible contract will be the better option, if this and that happens, the multi-click contract will be better. Therefore, we have developed a statistical approach at E&C for judging the risk / opportunity balance of this new contract type. The choice of such contracts should also be based on the broader strategic approach of buying energy.
A few more observations for all of those that have this new option in front of them right now:
Full-flexible energy supply contracts offer important advantages to some consumers of energy. However, careful analysis is necessary before signing them.