Solving the supply-demand conundrum
As the UK's energy market changes to answer a complex set of challenges, how should energy buyers respond? Should they stick with traditional procurement strategies focused on lowest price outcomes, or consider alternative approaches to deliver long-term value-for-money? Sid Cox explains the issues and suggests some answers
Context is always a key consideration for planning any activity and energy procurement strategies are no different. It is an especially important consideration right now as the context within which energy buyers find themselves is undergoing radical change. I am talking about the electricity market arrangements and the nature of the energy challenge facing the UK.
Existing market arrangements were established to support an energy market that enjoyed over capacity in power generation, ample North Sea oil and gas reserves and no decarbonisation imperative. These arrangements encouraged greater efficiency in the electricity industry to drive down costs for consumers. Indeed achieving the lowest electricity price has been the prevailing aim and measure of success for the overwhelming majority of energy supply tenders since the Nineties.
However the energy challenge facing the UK now is very different. How to deliver on agreed and legally-binding carbon reduction goals (reducing our carbon emissions by 80%, by 2050); address the scheduled closure of around 40% of current electricity generation capacity by 2025; and meet an expected doubling of electricity demand by 2050 resulting from the planned decarbonisation of the UK's heat and transportation sectors.
The Electricity Market Reforms currently being developed by Government seek to create the conditions to attract unprecedented levels of investment urgently needed to reduce the risk of disruptions in supply and the likelihood of more volatile and higher energy prices. It is clear that the landscape for energy buyers is going to change in the medium to long term. But we believe that there needs to be a new approach to energy procurement - a move away from price to overall cost - in the short term too.
We are seeing an increasing number of businesses find out the hard way that what appears to be the lowest price, especially when taken at face value, may not be the best solution, nor in fact the lowest overall cost.
One example of the risks facing energy buyers is a change in the treatment of non energy charges, such as distribution and transmission charges, in fixed price contracts. Non-energy charges typically account for around a fifth of the total energy costs in a contract and most businesses prefer them to be fixed within their contract. However, these costs are subject to change within the scope of industry reviews and the outlook for most of them is up. This is to fund the investment required in new infrastructure and meeting environmental targets.
So you should ask yourself: how fixed is your fixed price? The re-opener clause is a relatively new phenomenon gaining favour with some suppliers. It effectively reduces their risk by allowing the supplier to re-price those costs within your contract when they increase above a stated threshold. This can be as little as 5%.
There are clear downsides to this practice. For suppliers like EDF Energy that include forecast increases to non-energy costs in their quotations, it is that they appear more expensive than those that use today's costs with an option to change them in future.
But more importantly for energy buyers, the downside is that what appears to be the lowest price can easily end up representing a higher overall cost to your business.
There are risks present in other forms of contract too. For example, the lowest price approach with flexible or floating contracts often focuses on comparing residual energy costs. That is because it is one of the few easily comparable cost components in flexible contracts as the price of most of the customer's future energy volume is fixed later through block purchases during the contract.
Energy buyers need to keep a keen eye on the blocking strategies (i.e. how the load shape is broken up to be traded) employed by suppliers as these are not always the same. An over-blocking strategy, for instance, can reduce the amount of energy included in the residual energy cost and thereby make this component appear artificially low.
This underlines the importance of making like-for-like comparisons and checking the assumptions built into quotations. It can be a simple matter of asking each supplier how the costs of the contract are distributed throughout the various price components.
There is more to value than price
Considering that much of the market changes are related to reducing emissions and ensuring there is sufficient supply to meet demand, we believe that demand management should begin to be an integral part of energy procurement strategies.
That is not just our opinion. The Green Quadrant Report on Sustainable Power Utilities released in March by Verdantix, an independent analyst firm, shows that the UK electricity market is moving away from price-based competition towards considering demand and price management as an integrated service.
Although the Verdantix analysis in the chart opposite shows the market shift beginning around 2005, it is really only recently that it has begun to achieve a groundswell. The report points to regulations driving this fundamental change in the UK power sector. In addition to familiar regulations such as the Climate Change Levy increasing taxes on business energy use, the more recent CRC Energy Efficiency Scheme requires companies to accurately report their energy-related carbon emissions and purchase allowances to cover them. Add to this reputation pressure and the rising cost of energy and its easy to see there is increasing stress on businesses to know where, when, how and how much energy they use.
This is where we think the real supply industry challenges lie and these will change the nature of customer-supplier relationships away from simple, low-involvement transactions towards closer longer-term partnerships. By increasing the focus given to managing the volume of energy businesses consume, we can deliver greater value to those businesses.
A potential blueprint for energy procurement
The recently announced customer-supplier agreement between EDF Energy and Morrisons is an early example of the integration of supply and demand management services.
The three-year deal comprises an innovative bundled contract, which brings together energy supply and energy demand management services agreements. This provides a guaranteed £1M energy saving each year for the supermarket chain with incentives for EDF Energy to achieve energy savings beyond the guaranteed minimum.
The nature of the deal signals the deepening of a seven-year relationship between supplier and customer and points to what is possible as a result. Our energy services team will work hand in hand with the Morrisons Property and Development Department on project delivery with an aim of saving at least £3.5M during 2011 through new energy saving initiatives with more to be identified and agreed in future years.
As Morrisons' energy team already has an ongoing energy management programme, this is about more than implementing common sense measures. Our in-house energy services team and our parent group's ongoing investment in research and development means we have innovative thinking and solutions to bring to Morrisons.
"With a network of 448 stores, rising electricity costs represent a significant overhead for Morrisons," says Terry Hartwell, Morrisons Group's property director.
"This agreement with EDF Energy offers a guaranteed £1M saving from projects and aims to save at least a further £3.5M during 2011 with more cost savings to be investigated, all of which helps us to ultimately keep prices low for customers."
Morrisons operates in an intensely competitive sector and an energy strategy that looks further than managing the price of energy is even more essential in the current economic climate.
We believe that this more collaborative approach which manages the price of energy as well as the amount needed presents a viable blueprint for energy procurement, one that delivers long-term value for money in a changing energy market.
Sid Cox is EDF Energy’s director of B2B