Energy costs often feed directly through to the bottom line with minimal pricing power to pass this volatility on to their customers. Unlike residential energy consumers who may only select between supplier but not choose a precise time to fix wholesale prices, Industrial and Commercial consumers can use flexible supply contracts to separate the timing of placing the physical supply contract from the timing of the purchase of each individual month, or even individual days, wholesale gas or electricity price. Since these flexible contracts are priced identically to traditional fixed price contracts they represent a free option and have consequently been taken up by most I&C consumers over the previous decade.

Whilst flexible contracts offer significant opportunities for energy cost reduction, they also represent a potentially large risk to the business that therefore needs to be effectively and reliably managed.

Flexible supply contracts present the challenge of a real time trading function that few I&C consumers are equipped to deliver from in-house resources. When individual prices, stop loss limits and target prices are being formed in the market and crystallised to your balance sheet in real time, stakeholders need to see the second by second record of market prices otherwise they will be unable to either negotiate the best price themselves or judge how effective any trade done on their behalf was. End of day settlement prices provide little more than an upper of lower bound to the range of prices seen during any trading day, often 2% or more, yet are relied on by most consumers to manage this process.

Perhaps most importantly, the risky activity of real time flexible procurement demands an equivalent real time risk management function separated and distinct from the procurement function. Separation of Duties is an important principle of all risk management since it is essentially a policing function to protect stakeholders and ensure delivery by operational staff of managements agreed trading strategy.

Risk Management cannot be performed by the same people who are doing the actual trading, i.e. the same people that are being policed.

Given the operational challenges outlined above about two thirds of consumers have outsourced the placing of supply contracts and the resulting trading function to specialist procurement consultants. In doing so most have also outsourced the associated risk management function to the same third party. This violates the principle of Separation of Duties and can, in the event of any error or omission on the part of the Procurement Consultant in implementing an agreed Procurement Strategy, create powerful incentives to cover up and/or incur further losses by betting the consumers money that market prices will, in the future, fall within the missed limit.

Nick Leeson infamously created account 888, the start of the demise of the iconic Barings Bank, to cover up the genuine mistake of a colleague he wanted to protect. Nick Leeson was only faced with this temptation to “do the wrong thing for the right reason” because he was tasked with the functions both of trader and risk manager. Exactly the same conflicts are endemic in UK energy procurement today. Even companies that perform the procurement function in-house rarely have separate and effective risk management functions in place.

Is your risk management function formalised and separated from your trading function?

Today with the advent of cloud computing, new software capabilities and high speed mobile internet connections becoming standard, it is for the first time possible to provide the capabilities required for energy consumers to efficiently implement their own in-house risk management business processes separate and distinct from the procurement function, be that in-house or outsourced. The same tools, by aggregating a fragmented and sometimes illiquid market in real time also give consumers the same (or better) tools as are employed by Procurement Consultants, and at a significantly lower cost.

Proposed monthly in depth topics are:

1. The link between global oil prices and your price
2. How do OTC and Exchange markets work
3. How do flexible procurement contracts work
4. What does a “Best Practice” energy procurement business process mean?  What does it look like?
5. Understanding risk – a walk through some of the published material, much of it essential reading in our opinion
6. Statistics 101 – the misunderstood and much maligned Value at Risk and other risk metrics

1. The Black Swan : Nasim Taleb
2. The Quest : Daniel Yergin – I am reading this on my Kindle now