The currently volatile energy market has placed pressure on all sectors of the economy, including industrials. Managing the associated cost and risk challenges requires a comprehensive approach to optimizing energy procurement.
This article sets out the case for proactively managing energy costs and considers five key levers to help achieve energy sourcing optimization and risk management. These could complement companies’ energy-efficiency measures across their assets. By acting across these levers, industrials could reduce their energy costs by an estimated 7 to 10 percent and ensure their long-term resilience to energy price volatility.
The case for action
International energy prices have increased significantly and have seen persistent volatility. From 2019 to present, international prices for both LNG and coal have tripled, while oil prices have doubled (Exhibit 1).
In Europe in particular, power and gas prices have seen significant surges and volatility (Exhibit 2). In the first quarter of 2022, for example, the average month-ahead price for wholesale gas surged above €120 per megawatt hour (MWh)—six times the historical average. As European power prices are heavily linked to wholesale gas prices, the prices of both commodities tend to increase in parallel.
On top of the uncertainty brought on by increases in energy prices, decarbonized sources of energy are becoming more competitive as increasing CO2 emissions place an additional burden on fossil-fuel generation. In this light, contracting renewable energy via power purchase agreements (PPAs) appears to be a likely mitigation strategy for price increases.
An additional characteristic of the structural changes in the European power market has been the strong evolution of intraday price amplitudes. Due to the growing share of renewables, the increasing scarcity of dispatchable power, and peak demand from increased electrification rates in industries, buildings, and transports, intraday price amplitudes have achieved record highs over the past year (Exhibit 3). For example, in March 2022, intraday price amplitudes reached over €400 per MWh—nine times that of 12 months prior.
For industrials, production costs have increased substantially due to rising energy costs (Exhibit 4). Energy-intensive sectors, such as aluminum and ammonia, have seen an increase in their overall cost base of more than 100 percent, given the high weight of energy costs. The current energy prices environment creates new cost- and risk-management challenges, as the share of energy in players’ costs is an essential threat to their competitiveness.
Furthermore, several industrials face challenges in passing through price increases and the associated margin-compression effect. For risk management, key challenges for industrials include the ability to hedge or pass through energy-price risks, the capacity to sustain liquidity requirements for margin calls (such as initial and variation margins), and the ability to run recurring stress tests on the impact of higher prices on the balance sheet and treasury. Overall, this calls for industrials to proactively manage risks and energy costs.
Five levers to optimize energy spent
Industrials have an opportunity to optimize their energy spent through five industrial levers.
- Systematic energy-hedging management: Continuously optimizing hedging approach based on, for example, daily exposure calculations to energy prices, actualized forecasted volumes (including optionality in consumption profile), and pass-through capacity to clients.
- Structured power-purchase-agreement contracting: Contracting long-term electricity supplies (for example, baseload or as-consumed PPAs, which can last for seven to 20 years) for part of the power consumption (virtual or physical).
- On-site generation optimization: Developing on-site generation assets for heat and power—such as biogas-combined heat and power plants (CHPs) or small-scale photovoltaic (PV) solar—with the option of having them operated by third parties.
- Contracting optimization: Considering renegotiating gas and power supply agreements (such as the price indexation formula and markup, flexibility terms, or nominations processes) for all energy supply contracts across countries.
- Demand-side response: Rolling out peak-shaving schemes and exploring their ability to interrupt demand to reduce consumption in high-price moments. Grid operator remuneration schemes could also offer additional compensation.
The context of each lever is explored in detail below, as well as the means to approach.
1. Systematic energy hedging management
Three typical hedging strategies are worth considering depending on industrial players’ ambitions. While risk-averse players tend to follow a “linear” hedge path in line with the market—when applicable—most players opportunistically hedge a larger or smaller share than their peers. Meanwhile, the most ambitious players can hedge a large majority of volume four to five years ahead (Exhibit 5).
There are several initiatives that could improve the level of sophistication in hedging management, including:
- Strengthening exposure management: Players could consider shifting to daily actualization of energy exposures for the next three to four years to drive more frequent contracting and hedging decisions based on, for example, the actualization of consumption forecasts or review of hedging coverage ratios.
- Adopting risk analytics KPIs and running recurring stress tests: Cash Flow at Risk (CFaR) models could be implemented to ensure that risk is measured not only based on volumes, but also on the ability to reflect market prices and volatility. In addition, more “what if” scenarios and stress tests on consumption or activity levels could be developed based on more extreme price scenarios.
- Enhancing hedging strategies: Industrials could consider defining hedging strategies and hedge ratios dynamically based on balance sheets or pricing pass-through constraints and available hedging products. The hedging strategy could derive from management’s strategic ambition for risk tolerance and return optimization.
- Calibrating hedging instruments used: The optimal mix of instruments to hedge exposure could be considered through:
- Directly fixing with suppliers to provide operational simplicity via click contracts (due to there being no margin calls or brokers’ management). However, this option may lack transparency of the markup embedded in prices (up to 0.2 to 0.4 percent in fixed prices).
- Contracting over-the-counter (OTC) swaps and futures to provide flexibility in terms of timing and frequency, while being transparent on markups. This option could allow for volumes to be bundled across suppliers and countries when minimum click thresholds with suppliers are not reached.
- Leveraging financial call or put options to hedge hypothetical consumption that is not yet firm (such as energy resulting from a large order intake or a potential new factory coming online). However, this option could cost large premiums.
- Using collar options as a cheaper alternative to call or put options, thereby protecting against potentially significant cost increases (through a maximum price to be paid) but also limiting large profits (minimum price to be paid).
2. Structured PPA contracting
The demand for PPAs has surged in recent years—for example, since 2018, the volume of PPA transaction announcements has seen an average annual growth rate of more than 45 percent (Exhibit 6). Three industrial sectors are leading the charge for contracting and securing PPAs—chemicals, mining and metals, and technology—which account for over half of the PPA volume signed in 2021 in Europe.1
In Europe, the PPA market hit a new record in 2021 for offshore wind, onshore wind, and solar deal counts (totaling 196 in 2021 compared to 162 in 2019) and volume (18.8 GW compared to 11.5 GW within that same period). This increase in demand has likely been driven by a growing share of merchants’ renewables projects needing to secure production offtakes to acquire financing.
Some countries have been particularly active in announcing signed PPA contracts with renewable energy sources. In 2021, for example, Spain, Sweden, and the Netherlands led the European PPA market with approximately 60 percent of the volume of PPAs announced in Europe (around 4 GW publicly-announced PPAs in Spain, around 2 GW in Sweden, and around 1.2 GW in the Netherlands compared to approximately 4 GW in all the other European countries).2 In the United States (US), the market is more established and mature with multiple sellers; the top ten were responsible for only 3 percent of announced deals from 2018 to 2021.3 This highlights the wide range of offers available to industrials.
Due to their success, PPAs are becoming increasingly sophisticated and structured with more flexibility. For example, several players, such as Microsoft, are shifting to 24/7 “pay-as-consumed” PPAs to shield themselves from the risk of intermittent supplies.4 Industrials are also increasingly adopting “baseload PPAs” where the risk to balance the volumes of intermittent renewables is transferred to the utilities or suppliers. As such, the number of PPA contract announcements is forecast to hit a high in 2025.5
Industrials are faced with a unique opportunity to secure long-term supplies of green electricity via PPAs for a tranche of their needs—this at long-term prices lower than current short-term prices. As a way of harnessing the potential of structured PPA contracting, industrials could explore new types of PPA offerings that offer more flexibility (such as pay-as-consumed or baseload PPAs) in virtual formats, which have 24/7 tracking and balancing to secure long-term power purchases for tranches of consumption. They could also incorporate PPAs as part of their hedging strategies as these could provide an effective means of reducing risks.
However, the ability to secure optimal PPAs will likely depend on the efficiency of the PPA tenders’ process management, on optimally structuring flexibility terms, and also on benchmarking long-term prices against forward curves or specialized PPA benchmark providers.
3. On-site generation
The drop in cost of small-scale generation, particularly for on-site PV solar, has helped fuel the adoption of on-site generation in various countries (Exhibit 7). Given that Germany has one of the highest grid costs in Europe, the business case for on-site generation can be highly positive in Europe’s largest power market.
On-site generation offers multiple benefits. First, industrials have the opportunity to develop on-site generation to avoid escalating grid costs (these are expected to expand rapidly with the need for grid upgrades, flexibility, and intermittency management). Second, on-site generation can offer industrials relatively good paybacks (within five to 12 years in the current price environment) at acceptable capital levels on small- or mid-scale assets.
To fully maximize on-site generation and take advantage of these benefits, industrials could consider exploring a full suite of on-site generation bolt-on systems, such as biogas-CHPs, on-site RES coupled with batteries, and heat recovery systems, all with the option of being operated by third parties. Furthermore, industrials could evaluate eligible sites and the associated business cases, with the option to optimize self-use or resale based on market price arbitrages. They could also look to structure operations and maintenance contracts carefully to avoid inflation in operation expenses.
4. Contracting optimization
Liberalization and increasing liquidity of wholesale power and gas markets have accelerated the competition between gas and power distributors to optimize their offerings to business-to-business (B2B) players.6 While not all markets are at the same level of maturity, several industrials have a strong opportunity to drive prices lower with additional flexibility, thus leveraging the competitiveness of offerings in the market.
For contract optimization, industrials could consider taking a zero-based approach to energy contracts to review and optimize all terms, such as:
- price formulations and indexation (the frequency of indexes’ updates).
- flexibility and nominations procedures (such as carry-swings options or virtual power plant options).
- tenure and termination clauses (such as a three-year deal that includes a terminal option without penalty, or the possibility to have early termination clauses).
- bolt-on options (such as supplies of guarantees of origin [GOOs] or white certificates—for example, certificats d’économie énergétiques [CEEs] in France) to couple decarbonization to contracting renegotiation.
- cost breakdown to provide transparency on commodity or molecule prices, marketing costs, and transport or distribution costs.
- flexibility fixing or unfixing (through click contracts) with a careful assessment of minimal volume, tolerance, and frequency of options.
- rationalization of contracts in pan-geographies by bundling volumes and consolidating suppliers.
5. Demand-side response
Demand-side response (DSR) is increasingly being adopted in Europe, as countries such as Ireland, Italy, Belgium, Poland, and France implemented DSR capacity in a bid to reduce peak power production from gas. Industrial DSR could provide flexible capacity of up to 160 GW by 2030 in Europe, making DSR a favorable option for regulators.7
For example, DSR has been in place through an annual tender in France since 2017 and is a central tool for contributing to security of supply, as well as an attractive opportunity for industrials. The DSR revenue for industrials rose from €24,000 per MW in 2019 to €60,000 per MW in 2022, while awarded volume increased from 0.8 GW to 2 GW within that same time period.8
DSR typically covers 4 to 6 percent of the total reserve capacity requirements with higher rates (more than 9 percent) observed in countries with high grid constraints (such as MISO in the US), and lower rates (less than 4 percent) in countries with high cross-border interconnections—such as Germany and France.9
As DSR becomes more popular, industrials could consider exploring how they might fully capture the benefits. A way to do so may be for large companies to contract services from demand-side players—and sometimes aggregators—and develop in-house solutions. Industrials could optimize their energy through DSR by:
- exploring which industrial processes could be flexed with a positive business case, given the large intraday amplitudes in power prices (ranging from €100 to €300 per MWh within a day).
- running simulations of, for example, changes in the timing of shifts and the effects of machinery interruptions, given the increasing cost of capacity purchased by industrials during stressed times for the grid.
- evaluating on-site storage options, which could potentially be coupled with on-site generation.
The way forward
Managing increasing energy prices requires energy sourcing and risk management optimization. In the face of the volatile energy climate, industrials will need to manage their energy costs proactively. This requires a comprehensive approach that could be implemented alongside energy-efficiency measures to reduce energy consumption. Acting across the five levers detailed above may enable industrials to maintain their long-term competitiveness and resilience.