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Managing a Volatile Commodity Risk Tolerance Shapes Supply-side Decisions
April, 2008
By Dan J. Pastoric
Talk of energy management tends to bring to mind actions associated with traditional demand-side management (DSM) projects, but energy management also includes supply-side management. That means acting on or reducing cost uncertainty for energy purchased.
Every company decides on a strategy for purchasing energy by its own actions or inaction. Choosing to be on index or hourly pricing is a decision whether that decision is made proactively or by inaction or indecision. Supply-side management brings the importance of risk management to the forefront.
Risk can come from many unexpected places. During the 1970s, when currency exchange rates were freed to float against one another, companies with sales or raw materials purchases from abroad had to worry about shifts in the currency market. In the 1980s, corporate leaders were confronted with a new uncertainty from the unprecedented volatility in interest rates. Rates dropped from above 20% to low single digits, where they remain today.
Since the deregulation of electricity markets in Ontario (May 2002) and Alberta (January 2001), risk now comes in the form of electricity price volatility and uncertainty. Electricity has been shown to be the most volatile commodity in North America.
For example, Ontario's March 2008 monthly average price was 5.82 cents per kilowatt-hour (kWh), but consumers experienced hourly prices ranging from 18.42 cents/kWh to 2.94 cents/kWh. Similarly, Alberta's March 2008 hourly pool prices averaged at 8.49 cents/kWh, but ranged from 99.94 cents/kWh to 1.52 cents/kWh.
In Ontario, the government has provided various rebates, credits and adjustments to provide business consumers with partial protection or natural hedging from swings in electricity market prices. These programs have reduced some price uncertainty, but have not eliminated price uncertainty completely. For businesses that can withstand major swings in electricity prices for the balance of what it consumes, it may make most sense to stay on hourly pricing.
It has been proven that businesses can manage their electricity costs better if they develop an energy strategy to track, assess and reduce their price risks. For those businesses that require more certainty for their annual budgets, additional insurance in the form of hedging may be acquired through energy block priced contracts.
In Ontario, these are typically structured a 7 x 24 - seven days by 24 hours - or 5 x 16 - five days by 16 hours, covering the five business days and traditional on-peak hours of 7 a.m. to 11 p.m. - block contracts.
Contracts do have a cost premium and, generally, the greater the certainty required, the greater is the premium to achieve that certainty. To achieve 100% certainty, a full requirements contract may be purchased, which states that every kWh consumed will be covered at a single contracted price. These contracts have the highest premium.
Yet, there are many historical examples when, over time, the market hourly prices have increased to the point where the average price created by the hedge is below the average price in the market. In these fortuitous cases, the business has achieved both price certainty and a price reduction.
All businesses wish to have both, but only the reduction of price uncertainty can be definitively guaranteed. If everyone had perfect knowledge of where the market prices would be in the future, the suppliers of electricity hedges would also know and adjust their premiums accordingly.
Dan Pastoric, P.Eng., MBA is the Sr. Vice-President of E2 Energy of Mississauga, Ontario, an energy services company specializing in the procurement and ongoing management of natural gas and electricity supplies for industrial, commercial and institutional energy users across Canada. For more information, see the web site at www.e2energyinc.com.
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