By Benedict De Meulemeester on 26/01/2017
Procurement savings are often the measure of the performance of procurement professionals. In an earlier blog we commented on the risks inherent to this narrow view on procurement. But reporting procurement savings is an inevitable part of a buyers’ job, and why should calculating procurement savings be avoided? There is nothing dishonorable about saving money for your employer.
However, when procurement savings are used to measure a buyer’s (or a consultant’s) performance, you better get the metrics right. And in a complex knowledge environment like energy markets, it’s not always easy to be sure that the cost reduction is indeed the result of an individual’s good work. In the past few years, wholesale prices for natural gas and electricity have dropped dramatically. Many energy buyers have enthusiastically reported the resulting energy cost reduction compared to the previous year as a cost saving. Now that markets have stopped falling, many are feeling cold sweat about how to report the year-to-year evolutions. Here’s our vision on how energy purchasing cost savings due to energy sourcing should be reported (and how not).
It starts with an analysis of what an energy buyer is doing and what procurement savings he can generate with those activities:
Generating savings by negotiating better contractual conditions (blog) is a traditional activity of professional buyers. It is important to get a clear view on what improvements have actually been made thanks to the buyers’ activities. The energy price consists of three components:
What your wholesale value will be is not decided by your negotiation skills, but purely by the moment at which you are closing it. And grid fees and taxes are in most cases charged on a pass-through basis, meaning that you pay the amount at which they have been set by the regulator and not what you negotiated. Therefore, the only part of the energy bill that you can influence during the contract negotiations is the retail add-on.
Now, if we look at the kind of simple TTF or other Hubs plus add-on contracts that are often negotiated in today’s gas markets, we can easily explain how a saving can be reported. Let’s say that you currently have a contract with a formula TTF + 0,7 euro per MWh and that you negotiate a new contract for 2017 with a formula TTF + 0,4. Then it becomes clear that thanks to your negotiation, your company will save 0,3 euro with every MWh that it consumes in 2017.
However, the calculation of energy savings isn’t always that simple. In a country like Belgium, suppliers are not charging transportation costs on a pass-through basis but apply reductions to the official tariff. In that case the reduction on transportation should be part of the savings calculation. And for electricity, the retail cost is often based on a complicated formula to go from wholesale to retail price. However, by plugging the same wholesale values in the different formulas, the implied add-on costs can be calculated and compared. In the same way, the implied add-on cost of a fix price contract can be calculated by comparing the retail price that was signed to the wholesale value for the relevant period on the day that the fix price contract was signed.
Unfortunately, the performance of buyers regarding their decisions to fix, not fix or unfix forward pricing (white paper) is often judged based on a year-to-year comparison. In the past years, with markets going down, that worked out favorably. But what will buyers report in a bull market?
Moreover, if you acknowledge that the savings metrics should reflect the positive results of a buyer’s work, than you should not report every drop in the wholesale value of your energy as a saving. You can be a very good buyer, but you’re not the one that determines whether the market goes up or down. Moreover, if the wholesale price goes down from 40 to 20 and you fix at 35, you might report a saving, but you’re not doing a very good job. In any case, a worse job than someone who fixes at 25 when the market goes up from 20 to 40.
Some organizations might conclude that no added value can be created with energy trading. That is not true. When we look into the performance of companies that we haven’t advised, we see remarkable differences in the quality of the wholesale price management. You’re doing a good job if you:
If you apply these principles, your price fixing will have good results. These results can be evaluated by measuring them against a market benchmark. Let’s say for example that you are fixing prices in different moments during the year prior to the year of consumption. You could always choose to just buy the average year ahead price, meaning that if your price is higher than that average, the results of your price fixings are negative. You could have better not done any fixings and take the average year ahead price. On the other hand, a price below the average means that you have added value that can be expressed as a procurement saving of the market average minus the price.
You can fine-tune your market average that serves as a benchmark with your global energy strategy goals. Let’s take the example of a client of ours that is a producer of energy-intensive chemical commodities and the pricing of its products is going up and down with spot natural gas markets. Their strategy is to make fixings and unfixings for small volumes, in an attempt to ‘beat the spot market’. In this case we chose the spot market as a benchmark.
Another example is a client in the automotive sector. As prices for its products are fixed for several years, e.g. in seven-year contracts with the car manufacturers, the main goal is to achieve cost stability. Running a diverse portfolio of contracts with car manufacturers, we have chosen to run this cost stabilization strategy in a three-year forward timeframe. When markets reach lows, we make larger fixings for those three years into the future at the same moment. Moreover, we have a strict observance of a maximum year-on-year cost increase of ten percent. In this case, we are using the average three-years ahead price as the benchmark for the performance of this client’s energy trading activities.
The choice of the right benchmark is very important. If the automotive company would choose the spot market as a benchmark, its energy buyers would perform less well. They would be “scared” of making forward fixings, as that jeopardizes the chances of beating that spot market benchmark. Which would mean that they have difficulties achieving the primary goal of cost stability.
You can’t expect to fix prices below market average on every contract for every single year. Sometimes you will fix prices for part of the volume in what was just a temporary uptick, with prices diving even deeper afterwards and your price ending up above the market average. Or you have to take a protective price fixing in a rising market.
The solution for this is to spread your price fixing decisions as much as possible, but that diminishes your chances of having a price well below market average. Therefore, skillful price fixing will strike the right balance between spreading enough to avoid prices high above market average and still make opportunistic (un-)fixings that lead to a price below average.
In a more general sense, in its energy trading efforts a company needs to strike the right balance between managing risk (i.e. spreading fixing and unfixing) and making savings (opportunistic fixing and unfixing) to be successful. A company that puts too much pressure on its buyers to make savings, might end up in the disaster of having taken too much risk. A company that puts all the emphasis risk management only, might forego interesting opportunities to lower its costs.
The involvement of energy buyers in the controlling of energy costs can differ widely. In some companies, the buyer is responsible for setting up budgets, checking cost versus budget and validating bills. In other companies this is done by the financial controlling department. When buyers are involved, management will often want to see results of the energy controlling in terms of savings.
Defining savings through energy controlling is quite simple. For example: the buyer checks the bills of one of his US plants and finds out that the wrong utility rate is applied. He writes a letter, conducts negotiations and in the end a 350.000 dollar refund is granted and paid to the client. This can be reported as a 350.000 dollar saving.
Some companies might have reservations for calling this a saving. It is a rectification of a mistake, a refund of money that the company shouldn’t have paid in the first place. On the other hand, if the energy buyer hadn’t done his job properly, the mistake might have passed undetected and the 350.000 might have never been returned. For the buyer, reporting the 350.000 might be a great success, especially if he has a bonus arrangement based on savings. On the other hand, he needs to realize that such successes depend on being “lucky” that your supplier or utilities send out wrong bills. For the company’s cash flow, receiving a correct bill in the first place and not getting refunds is the better option.
The buyer and his company should also realize that not all mistakes will lead to a refund, they might also lead to an extra bill. From our energy controlling activity, checking thousands of energy bills every month, we can say that 50% of the mistakes in energy bills are to the advantage of the clients. The 350.000 dollar extra bill sent by the utility that has detected its mistake, will obviously never be accepted as a “saving” … However, if the energy buyer detects that mistake, he’s doing a good job, as he can help his company to put aside the money for when the correction comes in.
Putting too much emphasis on savings through the financial controlling activities can also lead to over-opportunistic behavior. This is a particular danger when such controlling services are delivered by a consultant on a no cure – no pay basis. Of the mistakes that we detect in energy bills, some 60% are “differences in interpretation” rather than real “mistakes”. An opportunistic buyer or consultant might hurry into declaring that difference in interpretation a mistake so that she/he can claim the saving. This leads to the reporting of fictitious mistakes and paying of pay for a cure for a problem that wasn’t a problem in the first place. Moreover, aggressive claiming of mistakes can antagonize suppliers without need.
An example will illustrate this. We once took over a client from another consultant that had been working on a no cure – no pay basis. For its French plant, the client had signed a natural gas contract in which it had agreed to pay a fixed amount every month for transportation of the gas. The agreement stated that at the end of the year, the real cost of transportation, based on the official tariff would be calculated and an invoice or credit note to settle the shortage or surplus amount would be sent.
In July, the consultant calculated the amount that was due according to the official tariff, found out that it was lower than the fixed amounts that had been billed, sent a letter to the supplier to claim back the surplus money that had been paid to the supplier and an invoice to the client for the 50% commission on this so-called “saving”. Needless to say that both supplier and client were not very happy with this behavior. However, in a company where the buyer is receiving a bonus when reporting savings by energy controlling, that buyer might be tempted to work together with the consultant in claiming the saving.
Energy buyers can be involved in many different projects that lead to cost savings, such as:
Calculation of the savings caused by such special projects is to be determined on a project-by-project basis. Such calculus will always be based on a “before” and “after” situation. It should be taken into account that the world of energy markets is very dynamic with all factors changing continuously.
To give a – at first sight - simple example, a PV project. The saving might be calculated by simply saying: “last year we paid 1,5 million euro, now, we pay 1 million, so we made a 500.000 euro saving thanks to the solar panels on our roof”. However, it could be that in the current year, the wholesale electricity market dropped, causing the cost of the remaining power that you consume from the grid to drop by 300.000 euro. Therefore, the saving thanks to the solar panels is 200.000 euro rather than 500.000. A better measurement of savings could therefore be to take the amount of energy produced by the solar panels and multiply that by the price that you paid for the remaining off-grid electricity.
And even that isn’t correct. Due to installing the solar panels, what you pay for add-on cost and usage of the grid will have increased. If you’re very good at interpreting energy cost components, you might be capable of calculating that this means you paid 25.000 euro more for the electricity than you would have paid without the solar panels. Meaning that the real saving is 175.000 euro. As you can see from this example, savings metrics in energy buying is never a straightforward matter.
The involvement of the energy buyer in such special projects might be anything from having initiated them, to be involved in all steps to just getting called in when the contract has to be signed. Too much focus on making savings, can lead to this ‘being called in at the last moment’ phenomenon. Too many companies still consider their procurement professionals as the people you call in to squeeze out a price concession. That’s a pity, as involvement of procurement from the very first steps in a project will lead to much more added value, as they can help to:
Having procurement professionals involved in special projects can increase the savings that they cause. But again, too much emphasis on those savings can lead to sub-optimal results.
Conclusion: be pragmatic when applying procurement savings metrics in the field of energy buying
From the examples given above, it must be clear that the usage of savings in energy procurement is a delicate subject. It is impossible to set up a system for measuring savings that makes sure that every 1 euro savings reported by the buyer results in 1 euro extra for the company’s financial bottom line. Moreover, a good energy buyer will have many added values that are not measurable. Too much emphasis on reporting savings can cause such intangible added values to be neglected.
On the other hand, saving money for their organizations should always be the fundamental driving force of procurement professionals. In this article we have given some ideas of how pragmatic energy procurement savings metrics can be implemented. Applying them will motivate your energy buyers (and consultants!). However, be aware that such measurable savings are not the only added value that they can deliver.