Copernican revolutions in international (energy) procurement

By Benedict De Meulemeester

By Benedict De Meulemeester on 6/10/2014

One of the main rationales for M&A activity in international business is the search for “synergy effects”. In procurement this means that companies hope to achieve cost savings by buying goods and services in a centralized manner. In the last decades, many international companies have gone through a Copernican revolution in their procurement divisions: buying decisions have been centralized. Buyers are buying goods and services for factories across the globe. Sometimes they carve up the world in zones. It always makes me smile when I see ‘EMEA’ on a business card. It means Europe, Middle East and Africa. That’s quite a big and diversified geographical zone, I would say. Other companies still have their procurement functions organized on a local or even on plant-level. And we have even talked with some companies that are turning their Copernican procurement revolutions back again, scaling down the centralized procurement organizations and bringing back the previously centralized buying decisions to local procurement people.

 

As often, there are no laws written in stone about this topic. Centralized buying has advantages and disadvantages. For some products and services the advantages will be larger than the disadvantages, for others it will be the opposite. In a general sense, the advantages of centralized buying decisions are to be found in the economies of scale that they generate. Bringing together the tons of goods bought in e.g. 20 different factories can lead to serious price reductions on the prices that each of these factories can obtain individually. And in services, things like joint account management or usage of IT infrastructure can make the pricing of centrally procured services cheaper.

The potential for such cost savings is limited by transportation costs. If transport is an important cost component, locally supplied goods and services can be cheaper. Further advantages can be derived from the accumulation of procurement knowledge by the international buyers. Working in different countries in itself can provide a deeper insight into how markets work. And whereas local buyers might have a very broad range of products and services categories for which he has to buy, large centralized procurement organizations will allow for more specialization with category buyers that acquire a deep insight into the specific products and services for which they are responsible.

 These advantages can disappear for goods and services for which local circumstances have a big influence on their value. Country- or even region-specific geographic, legal, cultural or other factors can have an important impact on the pricing, quality and/or service level. For centralization of procurement to be successful, it will be important that a company makes the distinction between the goods and services where the localization have an important impact and those for which they haven’t. A hybrid organization with central and local buyers working together is therefore often a good solution. Another problem of centralized buying can be the distance from the operational practice.

The local buyer often has its office in the factory where the goods and services that he buys are being processed, giving him a better insight into, for example, quality and service levels that are required. Smart central procurement organizations will therefore make sure that there is sufficient travel budget to allow the buyers to go to the factories and see the results of their buying decisions in the operational practice. Unfortunately, we only see too often that in its cost-reduction attempts, companies first decide to centralize procurement and then to cut the travel budget. This will cause further disadvantage for those products and services for which frequent personal contact with the suppliers is necessary.

 Finally, due to their size and their distance from operational reality, centralized procurement organizations can degrade into corporate bureaucracies. They can start to create unnecessary formalistic tender procedures that hamper rather than promote the signing of good deals. Local buyers will often have a more entrepreneurial approach to energy buying, working closely together with plant managers that really care about the budgetary impacts of buying decisions on their factories. Sometimes, local managers complain that the central buyers can take the decisions but they are the ones that get blamed when there is a negative impact on the profitability of a factory.

 A smart centralized procurement organization will make a good combination of central and local decision-making. It will centralize the buying decisions for those categories of goods and services where the economies of scale and knowledge concentration can be beneficial. It will keep the buying decisions local for those categories where local presence is important. It will facilitate collaboration between central buyers and local buyers and plant managers and make sure that taking decisions also means taking responsibility.

 Now, what does this mean for energy?

 When thinking about the centralizing of energy procurement, organizations always think about negotiating cross-border electricity or gas supply contracts in the first place. We have to remark here that the potential for this is still limited at this moment as the electricity markets and to a lesser extent natural gas markets are still largely organized on a national level. Negotiating a cross-border electricity contract is still largely an illusion.

Best case, you can get some sort of framework agreement under which different electricity contracts per country are brought together but the conditions per country will often be widely different. For natural gas, the negotiation of cross-border contracts has become much easier in the last years. At E&C we have assisted many international companies to negotiate contracts under which natural gas in several North-West-European countries is bought under one and the same (commodity) price arrangement. Other arrangements such as volume regulation, price fixing services or payment conditions can also be brought together for different countries. What advantages should you expect from such cross-border contracts?

 Some economies of scale can be expected, but should not be exaggerated. An energy bill contains three main components:

  1. The wholesale value of the energy
  2. The retail add-on
  3. The regulated component, the grid fees and taxes

Economies of scale can only impact on the second component, the retail add-on, but that component is just a few percentages of the overall energy bill, so you shouldn’t expect miracles in terms of savings on the total cost of energy. Non-price advantages will often be more important. For example the bringing together of volumes from different factories in different countries under one common volume arrangement. Or the reduced time for processing price fixing decisions when this can be done for a collection of factories rather than for each factory individually.

 Accumulation of knowledge can bring important advantages. As the length of some of the articles on this blog illustrates, buying energy is a very knowledge-intensive activity. Local buyers that have to buy a large diversity of products and services often lack the time for acquiring all the knowledge necessary to buy energy. Having a central energy buyer dedicating 100% of his/her time on studying the energy markets is therefore no luxury. We have seen many companies taking large step forwards in e.g. their energy procurement risk management practices when specialized central buyers take over from local buyers.

However, as I have said before, energy markets are organized on a local scale, which can create the disadvantage of a lack of knowledge of local factors of a centralized buyer. Energy markets are organized by regulations, and these are different in every country. As far as the commodity component is concerned (the wholesale value plus the retail add-on), as markets mature the differences between the different countries become smaller. But for the regulated part of the bill, the grid fees and the taxes, these continue to vary widely across Europe.

This regulated part is an important percentage of the overall electricity cost, and to much lesser extent for natural gas. Good energy procurement means that you have a good insight into this non-commodity component so that you can budget it correctly. Moreover, every country has is specific set of exemption rules which you have to know to make sure you’re not missing out on an energy cost reduction possibility. It’s impossible for a central buyer to have in-depth and up-to-date knowledge of these tariffs and reduction schemes in all the countries in which you have to buy energy, moreover since they are written in law texts in a large diversity of languages. Consultants such as E&C with a local presence in the countries can make up for this. But it is also a good idea to work together on this with local buyers or for example technical managers in the plants.

 As far as the commodity part is concerned, the buyer needs to take decisions regarding signing contracts and making price fixings. For contract negotiations, in pre-mature markets the contact of a local buyer with the local suppliers can play an important role in obtaining a good deal. But as markets mature, it becomes increasingly easy for a central energy buyer to negotiate in the different countries. Moreover, the experience from other countries can help a buyer in negotiating good contracts. As an international consultant we have several times negotiated new contract types in different countries by explaining suppliers how their peers in other countries were solving this or that issue. One important aspect to consider is the volume issue. Lack of collaboration between the central and local level can lead to delays in the signature of contracts as the central buyer lacks knowledge of the volumes for which he is to negotiate the contracts.

As far as the price fixing is concerned, the most important advantages of centralized energy procurement pop up. An energy procurement strategy can be defined that covers the whole company, making sure that no local buyer in a distant country is taking too much risk. And the centralized buyer will often have more time available for following up the different wholesale markets leading to more timely decisions at opportunity moments.

 Centralizing energy procurement can have important advantages for international companies. But as with centralizing procurement in general, too much of it can create problems, especially as far as the non-commodity component of the energy bill is concerned. Smart energy procurement centralization will start by focusing on the development of a common price fixing strategy, then gradually get more involved in the contract negotiation process and the budgeting and bill validation. It will set up collaboration with local plant people to facilitate communications regarding expected volumes and local regulations regarding grid fees and taxes.


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