Wholesale power prices declined for 2015 with anticipated softening into 2016. Yet bills are expected to rise and the market to become increasingly volatile. What does that mean for energy procurement strategies? Brendan Coyne reports
Average wholesale prices are currently at multiyear lows. But tighter system margins, more intermittent renewable power and changes to the way the energy industry has to balance supply and demand will make half hourly prices much more volatile in 2016, says Jon Ferris, head of markets at Utilitywise.
That is something major energy users will need to watch carefully: If it is more expensive for suppliers to balance their portfolios they will inevitably pass on the cost to customers. Then there are rising non-commodity costs, which make up about half of the bill.
The non-energy bill
Transmission and distribution elements make about a fifth to a quarter of the total – and they are on the rise. Charges to subsidise renewable energy make up a similar proportion and are also rising. Over the next couple of years other government policies such as the capacity mechanism – which pays generators to be available when needed – will kick in, adding percentage point increases to the total bill (see table below).
The government has agreed to protect energy intensive industries from the impact of rising policy costs. But that means everybody else will pick up the tab, adding more cost to the equation.
The net result is more expense. For mission critical firms, where energy costs are often the single biggest overhead, energy management will arguably become more important than energy procurement.
Procurement: Fix or flex?
It’s tempting for some businesses to lock in current low wholesale prices. But Utilitywise’s Ferris says energy buyers should stay flexible. He thinks the market may fall further.
“We recommend large consumers employ a long-term flexible framework that allows you to buy and sell in response to the changing markets,” says Ferris. “If there is an opportunity to buy, you don’t have to go through a lengthy tendering process – because you have already been through it.”
Deeper and down
Germany provides an example of the impact renewable generation can have on power prices and why fixed contracts may prove expensive.
“Increased renewables on the grid have reduced German wholesale prices for ten years. It is certainly not a given that we will see a bounce in wholesale prices next year,” Ferris says. “With a flexible framework, if you see a bounce in prices, you are in a good position to respond however the market reacts.”
However, he says firms must mull their contract tariff structure and whether they want to fix the policy plus other rising non-commodity costs. To do so carries a premium, says Ferris. “So it may be preferable to fix [non commodity costs] year by year when there is more certainty about what the absolute total will be”.
Then come choices about the tariff structure. There are ‘baseload and shape’ options where for a fee consumption is flattened so that firms do not have to worry about spikes in prices.
Or buyers can choose exposure to the real time cost of consumption, explains Ferris. “But for that you need an understanding of how consumption can be managed and feed that into control project evaluation.”
And there’s the rub. Many businesses cannot easily change consumption patterns. Even those that can may see insufficient incentive to do so. However, that may change as power becomes the smallest element of the bill.
Changing consumption in response to market signals takes many forms, but is known collectively as demand response. Ferris thinks the demand response market is “at a turning point”.
“If you can shift your consumption the rewards are increasing”, he says. “If you can’t the costs are going to grow.” But he feels that the incentives for mission critical industries may be insufficient.
“The problem is that there are so many beneficiaries of demand response that the costs are centralised,” says Ferris. “If organisations bearing the full cost don’t receive the full benefit, it is hard to make a business case for it. The supplier may benefit, the distribution company may benefit, National Grid may benefit and consumers may benefit from less spiky prices… But [for the business investing], in many situations, the cost benefit doesn’t really stack up.”
Perhaps that will change over the next year, as more businesses are moved onto half-hourly metering and settlement. Firms that fail to manage consumption may find power bills far higher then pre-half hourly settlement.
But other policies, such as the capacity market, may end up dampening price signals, which would further fragment signals for demand response, according to Ferris.
Data centres fixing?
Data centres that pass energy costs to their tenants like fixed contracts because they can lock-in low prices, says Bobby Collinson, managing director of consultancy Noveus Energy.
“With wholesale prices at such a low level, fixed priced deals for data centres that are passing through costs will be very attractive,” says Collinson. “They may not get the best price for their energy, but it is low risk.”
But he says “more progressive” data centre operators will consider how to lower operating costs while planning for growth. Fixed contracts, he says, may not cater for big energy increases.
“Volume growth is a big issue for data centres. The majority are not fully occupied and are still growing. If they take on clients and double their volume, their [contract] is not going to allow them to do it,” says Collinson. “Those contracts usually contain a ‘shape clause’, which says if your volume or shape materially affects the commerciality of the contract, they have the right to revisit it – that is their get out.”
For many data centres, “buying a fixed price contract exposes them to a risk they are not even aware of”, says Collinson. “So volume management within a fixed price contract is a risk. Flexible contracts allow them to manage that dynamically”.
Risk and reward
Collinson agrees that the energy market will be increasingly volatile, but says that’s no bad thing.
“At the moment, volatility is the name of the game. But volatility is good, because it creates opportunity for people who are actively managing their energy,” he says. “Overall in the energy market, the active buyer generally gets better results.”
For the last three years, Collinson says the day ahead market has out-turned monthly purchasing by about 5-6%, which has out-turned seasonal (annual) pricing by around 10%.
That is even before risk premiums are factored in and premiums for long-term contracts will rise as the market becomes spikier, says Collinson. “In a volatile world, the risk premium becomes quite expensive, even disproportionate,” he warns.
“To optimise your position you are better off buying flexibly – buying short with a strong risk management policy on when to lock out,” says Collinson. “Take advantage of the market falling but protect yourself from the market rising.”
Matt Osborne, trading risk manager at energy procurement firm Inenco, agrees the wholesale market looks depressed and that opportunity exists for smarter purchasing and risk management.
“There is still potential for prices to come off, so we are not necessarily saying that customers should fix out their energy cost,” he says. “If the market should bounce, then they should start locking out. But for now they should enjoy the low [prices].”
Osborne agrees that procurement and energy management can no longer be separate given pass through charges will soon be the largest bill element. He thinks between 15-20% of the bill is controllable. Such a significant chunk – along with enabling technology – is largely why mission critical sites are waking up to market mechanisms such as demand response, says Osborne.
“The big driver is cost and revenue. Once consumers start to see the market is a lot peakier and NISMS are having a material impact on their costs, they are going to respond,” he says.
When firms see competitors using the balancing mechanisms to generate additional revenues, Osborne believes the incentive to “step up and start thinking actively about how they manage consumption, reduce costs and increase revenue” will be plain.
Why will energy prices get spikier in 2016?
Prices will be volatile for several reasons. Over winter, prices will spike within 24-hour periods because energy supply margins are thin.
National Grid has used conservative methodology to calculate excess power versus expected consumption – and 5% tolerance is lean. Power generators will take advantage of scarcity.
The recent Notice of Insufficient Supply Margin (NISM) was the first in almost four years. It saw power prices soar for a short period of time. National Grid anticipates 7-10 more NISMs over winter. Next winter will be even tighter.
Meanwhile, changes to industry rules, called ‘cash out’ arrangements, mean suppliers must pay more if they generate or consume more or less power then they contracted.
Regulator Ofgem made those changes to create sharper price signals – i.e. make it more expensive – for suppliers failing to accurately forecast customers usage.
Suppliers will pass increased costs both for balancing and more volatile within-day prices to customers. Major energy users may find themselves either exposed or in the black, according to procurement and demand management strategies.
As well, transmission and distribution costs are expected to rise 8-10% (see table below).
This article was first published in the current print issue of Mission Critical Power.