The energy crisis requires a short-term reorientation of energy procurement
The prevailing economic situation in Europe, marked by political crisis and economic uncertainties, is causing ongoing changes on the energy markets of historic proportions. The dramatic price hikes and the high volatilities on energy markets cause significant cost increases and fluctuations even with low energy consumption. This also causes a significant increase in capital requirement and liquidity risk from the production and supply chain. Furthermore, the economy faces heightened market price risk for energy and thus for margins. Given these current changes and the high uncertainty about possible future scenarios, it is proving increasingly difficult for companies from almost all industries to continue their energy sourcing with tried and tested methods of the past. Rather, the task at hand is to adapt the energy procurement strategy and its operational implementation to the current situation so as to rise to this this historic challenge.
Design of an optimized procurement strategy
Especially hard hit by the current crisis are those companies that previously did not pay much attention to energy costs, as their know-how, systems and operational processes are simply not equipped to actively manage energy procurement. For instance, where an industrial company has tendered its electricity and gas purchases every two to three years as was customary in the past and is again issuing a call for tenders in the current situation, the energy suppliers' bids will most probably include much less flexibility in terms of purchase quantities and, depending on the timing of the tender, will result in double-digit increases in energy costs and a consequent threat to the company's very existence in some cases. For this reason, besides an operational transformation to save energy consumption, companies must also develop and implement a resistant procurement strategy with a flexible, crisis-proof and corresponding operational design for the new framework conditions on the energy markets. When designing a suitable procurement strategy, companies will need to consider a variety of different aspects, such as their own position in the market and whether they can pass on increased costs to different customer and product groups. The ensuing strategic options for action can vary in many ways. Among the typical strategic target dimensions considered as possible courses of action are the question of securing margins or cost stability, the companies’ s specific ambitions for implementing an energy-sustainable or “green” strategy, the definition of the risk horizon for securing or fixing prices, or the degrees of freedom for an active or strict rule-based price management. Also, the question about a central or decentralized steering of the energy procurement must be defined. In these situations, companies typically turn to their treasury department, especially if the procurement department does not have in-depth knowledge of the energy industry.
Also, when it comes to another much discussed topic, experts quickly turn to the treasury. Power Purchase Agreements (PPAs) are a partial solution and option for action for implementing a new energy procurement strategy, offering a sustainable solution and at the same time enabling price fixing. In this context, the contractual design options are very diverse with regard to
- the term, for example, from 1 to 40 years,
- the pricing in fix vs. float,
- the region or location worldwide and correspondingly also the feed-in or pricing location of the electricity,
- the underlying assets, which means photovoltaic, onshore/offshore wind, run-of-river hydroelectricity,
- the possibility of price caps/floors,
- the agreed delivery quantity as “pay as produced”, “pay as nominated”, minimum and maximum quantities,
- the impact on green ambitions and the sustainability reporting.
Even though contracts tend to be designed in various ways, Treasury is often expected to assess the PPAs both at the outset and at the key dates as well as calculate scenarios with regard to the financial impact and more. That is why Treasury should be involved in the selection and contractual design of PPAs from the very beginning.
Yet it is not only the price fixing strategy that worries companies at the current price level. Especially industrial companies face the challenge that they must pre-finance the production’s energy demand before they can sell their products at the end of the logistic chain. Rising electricity and gas prices mean that, even with steady delivery dates and payment terms, pre-financing is unexpectedly high, causing higher capital requirements and straining liquidity resources at a time when corporate financing is not as easy or cost-effective as it was in the past. For this reason, optimizing one’s liquidity management is once again gaining in importance.
Energy suppliers and municipal utilities are also heavily affected
But not only energy consumers, also major energy suppliers and municipal utilities are struggling with the effects of price increases on various levels. Since electricity and gas contracts are traded on energy exchanges and also bilaterally (OTC), the impacts will vary depending on the contracts used.
Exchange trading, for instance on the EEX, involves standardized trading products with a collateral payment handled by the clearing house. The dramatic rise in electricity and gas prices far beyond the originally traded prices has resulted in the need to pay collateral in the form of variation margins on a scale as yet unheard of. In addition, due to high volatility the initial margin to be deposited increases. And, also for spot trading, high amounts of collateral must be deposited, especially before weekends or holidays.
In OCT trading, however, there is often no agreement on reciprocal provision of collateral, which means that there is a risk that a market participant will default, and substitute purchases may have to be made on unfavorable terms. Most recently, this effect has meant that even major energy suppliers in Europe to call on government assistance.
Due to the very high market prices the energy providers have significant liquidity and counterparty risks that have to be managed very closely. And this is additionally to the regulatory changes and the big challenges in the management of volumes and price risks of their various customer segments.
So, what do we think needs to be done?
Coping with the wide-ranging effects of the energy crisis requires strategic adaptation and optimization in the company-wide energy management and energy procurement, particularly in industrial and commercial companies. Liquidity management and the further enhancing of the risk management methodology are key imperatives in order to secure the company’s continued existence in the long run. Especially for energy suppliers, an improved allocation of counterparty and liquidity risks in procurement as well as a more closely interlinked risk management in sales and procurement will also be crucial.
If you have any questions, please do not hesitate to contact us.
Source: KPMG Corporate Treasury News, Issue 126, October 2022.
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
Director, Financial Risk Management
KPMG i Sverige