Forward fixing capacities or percentages of volumes?

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:

1. In regulated markets, these consumers were paying tariffs that had multiple variables. The structures were linked in multiple ways to consumption patterns with capacity and consumption terms, peak, off-peak, weekend or even more periods and seasonal differences. The prices were linked to parameters reflecting underlying cost changes of the utilities, e.g the oil-indexations of the utilities’ long term gas contracts. As a result the energy pricing process was complicated and non-transparent. Especially for buyers that needed budget stability, this caused issues.
2. Therefore, the practice of forward fixing prices became very popular rapidly after the markets were opened up. This spurred the development of exchange-traded and OTC futures and forward markets where the suppliers hedged the fixed prices they offered their clients. As these hedging procedures were streamlined, suppliers passed on the full volatility risk of these markets to their clients. If the wholesale price rose from 30 to 40 euro’s per MWh, e.g., the fix prices that consumers were offered rose by equal amounts, regardless of which supplier was contracted. Large consumers started to realize that the moment of closing the contract was the most important price-setting factor. And more and more of them started to grasp that fixing everything in one moment that you sign the fix price contract, is the win all – loose all option.
3. This gave birth to a new contract type, which is now very widespread among medium-sized and large consumers of energy, certainly in North-Western Europe: the clicking contract. This is still essentially a fix price contract. The client will have a price fixed for all the MWh’s that he consumes before the period of consumption starts. How does that work? Let’s say that you have such a clicking contract for 2014. Your contract has a formula that tells you how your price will be calculated based on the Cal 14 contracts, base and peak (if available). You can keep track of the Cal 14 contracts every day on the exchange. When you think there is a good moment, you can “click”, meaning that you fix that day’s Cal 14 price for a certain percentage of your annual consumption. If you have, for example, 6 clicks of equal portions, the price you will pay in 2014 will be a fix price that is based on the calculation of your price formula using the average of the Cal 14 prices on each of the six days that you chose to do your clicks. This gives you the opportunity of spreading the risk of your price-fixing decisions.
4. As the clients’ needs to hedge their wholesale energy market price risk grew more sophisticated, suppliers started to offer varieties on the basic clicking theme:
   • Very early on, vertical clicks were introduced. Instead of fixing on Cal-products for percentages of annual volumes (i.e. horizontal), clients were offered to fix on quarterly products and for the volumes per quarter.
   • Combinations of vertical and horizontal appeared. In such contracts, clients can for example fix the price for 50% of the consumption with four clicks on the Cal-product and the remaining 50% with one click on each of the quarters.
   • Clients with many clicks, found out how hard it gets to ‘beat the market average’. In some organizations, “making the click” entails a responsibility nobody is eager to take. Therefore, suppliers started to offer contracts where the price is based on the average of a Cal, Quarter, and/or Month product during a certain period. An example could be that your 2014 price will be based on the average of the Cal 14 price for each trading day from the 15^th of January 2013 to the 15^th of December 2013.
   • In recent years, spot markets have quite consistently beaten the forward markets. Therefore many consumers want (part of) their energy price indexed to spot markets. Some of them go all the way to a 100% spot-indexed natural gas or electricity contract. Many stick with the clicking contracts, but build in the possibility of indexing a percentage of the consumption to the spot market. This percentage can be defined at the moment of signature of the contract, but often, contracts allow the possibility of swapping a click for a spot indexation. E.g. a contract with 10 clicks on the Cal-product, if the client doesn’t execute all 10 clicks by the 15^th of December, the remaining clicks are transposed into spot-indexation.

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:

1. Don’t underestimate portfolio-effect. Suppliers can keep the risk premiums of clicking contracts at reasonably low levels because they have several clients. If one client consumes less than the capacity block that has been fixed, another might consume more. Therefore, a full-flexible energy supply contract cannot be that much cheaper than a traditional clicking contract.
2. If you systematically buy part of your energy on the spot market, the risk of a full-scale flexible contract is substantially lowered (but then the risk of a multi-click contract for the supplier also). Especially these clients should really consider lowering their add-on cost by switchting to a full-scale flexible contract.
3. Keep a good eye on correlations of factors determining your consumption and the level of the spot market versus the forward market. If your consume gas for heating buildings, this means that you will see an increasing consumption when it gets really cold. In such cold winter months, there is also an increasing chance of peaks in (spot) gas prices.

Full-flexible energy supply contracts offer important advantages to some consumers of energy. However, careful analysis is necessary before signing them.