The energy market situation and its effects

The current economic situation in Europe, characterised by political crises and economic uncertainties, is causing continuous changes of historic proportions in the energy markets. The extreme price increases and high volatilities in the energy markets are causing significant cost increases and fluctuations even with low energy consumption. This also results in a significant increase in capital requirements and liquidity risk from production and supply chains. In addition, the economy is facing an intensification of market price risk for energy and thus for margins. These current changes and the great uncertainty about possible future scenarios make it increasingly difficult for companies from almost all sectors to continue their energy purchasing with methods that have proven themselves in the past. Instead, the current task is to adapt the energy procurement strategy and its operational implementation to the situation in order to master this historic challenge. 

The current crisis is hitting those companies particularly hard for which energy costs have not played a major role in the past, because their know-how, systems and operational processes are often not geared towards active management of energy procurement. If, for example, an industrial company has put its electricity and gas purchases out to tender every two to three years, as was common in the past, and in the current situation it is putting out to tender again, the offers from the energy suppliers will in all likelihood allow much less flexibility with regard to the quantities purchased and, depending on the time of the tender, will cause energy costs to rise by a double-digit factor and thus in some cases pose an existential threat. Therefore, in addition to an operational change to save energy consumption, a resilient procurement strategy with a flexible, crisis-proof and matching operational design for the new framework conditions in the energy markets must also be developed and implemented. In order to design a suitable procurement strategy, companies must take into account a number of different aspects, such as becoming aware of their own competitive position and thus also of the question of the ability to pass on increased costs for different customer and product groups. The strategic options for action that result from this can vary in many ways. Typical strategic target dimensions that are taken into account in the options for action are, for example, the question of securing margins or cost stability, the company-specific ambitions for implementing an energy-sustainable or "green" strategy, the determination of the risk horizon for securing or fixing prices, or the degrees of freedom for active or strictly rule-based price management. The question of centralised or decentralised control of energy procurement must also be determined. Typically, in such situations, the view goes in the direction of treasury, especially if the procurement department does not have in-depth, specific energy management know-how.

In another currently much-discussed topic area, the view of the experts quickly goes in the direction of the treasury. Power Purchase Agreements (PPAs) are a partial solution and option for action in the implementation of a new energy procurement strategy, which can offer a sustainable solution and at the same time make it possible to fix prices. The contractual options are very diverse in terms of duration, for example from one to several years.

• the term, for example from one to 40 years,
• the pricing in fixed vs. float,
• the global region or location and thus also the feed-in or pricing location of the electricity,
• the underlying assets, i.e. photovoltaic, onshore/offshore wind, run-of-river,
• the possibility of price caps/floors,
• the agreed supply quantity as "pay as produced", "pay as nominated", minimum and maximum quantities
• the impact on green ambitions and sustainability reporting.

The treasury is then often expected to be able to evaluate the PPAs initially and on the cut-off dates, to calculate scenarios with regard to financial impacts and much more, despite all the diversity of the contracts. Therefore, the treasury should be involved in the selection and contract design of the PPAs from the very beginning.

But it is not only the price hedging strategy that worries companies at the current price level. Industrial companies in particular face the challenge of first having to pre-finance the energy needs of production before they can sell their products at the end of the logistics chain. Due to the increased electricity and gas prices, the pre-financing is unexpectedly high, even with constant delivery dates and payment terms, causes increased capital requirements and puts a strain on liquidity resources in a phase where corporate financing is no longer as easy and cost-effective as in the past. Therefore, the optimisation of liquidity management is once again becoming more important.

However, not only energy consumers, but also the large energy suppliers and municipal utilities are struggling with the effects of the price increases on different levels. Since electricity and gas contracts are traded on energy exchanges and also bilaterally (OTC), the effects differ depending on the contracts used.

In exchange trading, for example on the EEX, standardised trading products are settled with a payment of collateral via the clearing house. The sharp rise in electricity and gas prices far above the originally traded prices makes it necessary to pay collateral in the form of variation margins to an unprecedented extent. In addition, the initial margin to be deposited is increasing due to the high volatility. And a high amount of collateral must also be provided for spot trading, especially before weekends or holidays.

In OTC trading, on the other hand, there is often no agreement on the mutual provision of collateral and thus the risk that a market participant defaults and a replacement has to be procured at unfavourable conditions. In the recent past, this effect led to even large energy suppliers in Europe having to resort to state aid.

The very high market prices thus result in significant liquidity and counterparty risks for energy suppliers, which have to be managed very precisely. And this is in addition to the regulatory changes and the great challenges in managing volume and price risks of their different customer segments.

In order to cope with the manifold effects of the energy crisis, a strategic adjustment and optimisation in company-wide energy management and energy procurement is necessary, especially in industrial and trading companies. Liquidity management and the further development of the risk management methodology are important mandatory tasks in order to secure the company's continued existence in the long term. For energy suppliers in particular, an improved allocation of counterparty and liquidity risks in procurement and a closer integration of risk management in sales and procurement will also be necessary.

Active action should therefore replace hoping for a mild winter!

Please do not hesitate to contact us if you have any questions.

Source: KPMG Corporate Treasury News, Issue 126, October 2022.
Authors:
Ralph Schilling, CFA, Partner, Head of Finance and Treasury Management, Treasury Accounting & Commodity Trading, KPMG AG
Bardia Nadjmabadi, Senior Manager, Finance and Treasury Management, Treasury Accounting & Commodity Trading, KPMG AG