Contract Durations, Potential Risk and Finding the ‘Contract Sweet Spot’
For years now the UK government has been devising new schemes and levies to help fund their de-carbonisation targets. These seemingly ever surmounting fees however are starting to weigh up on the end users bill. In this article we will be discussing how and why different durations vary in price. How you can begin to more fairly assess a suppliers offer and what you should and should not be comparing, in order to manage your bills and counteract these government fees.
In previous articles we have discussed the three core aspects of energy costs:
- Energy Commodity
- Energy Distribution
- Energy Regulatory Costs
Today we would like to add another cost that applies to all three of the above:
- Risk and Margin
When we’re talking about comparing energy providers this is what a tender is trying to hone in on. Depending on the duration you are looking to commit for you may see this fourth element of costs drastically alter the competitiveness of a suppliers offer. This brings us to our next question… why?
Risk and margin varies considerably between suppliers, we have to remember that suppliers do sometimes get these forecasts wrong and are ultimately trying to avoid incurring losses on the energy supplied. We’d like to introduce a concept I refer to colloquially as ‘the contract sweet spot’.
The quintessential sweet spot is essentially what you are looking for during every tender, you are trying to intersect the markets current and forecasted position with durations that do not incur excessive risk or margin from the suppliers bidding. To do this you need to be aware of the following:
- Seasonal market trends
Why? Summer periods generally cost less than winter. If you renewed for 18 months in October, for example, under a fixed contract you would be seeing two winter seasons averaged into your delivered rate. This can have a significant impact.
- Whether the market is in backwardation or not
Why? If the spot or future price of energy is lower than the current price; this means that negotiating a long term price fix with suppliers is more likely to be viable. There is the way of taking advantage of this further to maximise benefit and is something we could talk about in details with anyone who is interested in this option.
- That suppliers have limited information on distribution and regulatory costs beyond 24/36 months
Why? Now if the above two criteria have been met what we need to know is how far in advance is our supplier willing to fix the second and third elements of our contract cost and at what price.
The table below is a really crude example of what suppliers can reasonably forecast without incurring large amounts of ‘risk and margin’ with hypothetical figures:
Let’s look at this table data in graph form and run through points 1,2 and 3…
In summary what this graph is telling us is that 24-month contracts are probably baseline for fixing a price that is pretty free of risk. Now if you are committing for longer, suppliers may counterbalance their margins with their risk in favour of that commitment from you and what you are looking for in their rates is examples of this.
Example: A reasonable assumption for distribution and regulatory costs would look like this…
But if your delivered price fix looks like 16.9625 you can assume something like this is happening:
Remember that these forecasts are being averaged and applied across your whole contract. Price and suppliers are unlikely to bear any additional cost on your behalf when their contracts permit them to recover it. We need to be really careful about how we assess longer-term contracts and what we agree to/recommend. On the one hand distribution and regulatory costs are rising significantly and we do want to secure price stability because of this.
So, exactly where is ‘the contract sweet spot’? At the time of your renewal or acquisition if all suppliers are offering a rate of 14.375 p/kwh on 24 months, this is your default sweet spot.
If there is a 36, 48 or 60 month contract offer of between 14.5 and 15.0 p/kwh then there may be a discussion to be had about timing a long term fix on price. In conclusion, each customer has to determine their own appetite for risk and how much they are willing to take, weigh up the pros and the cons and make an informed decision.
For advice or help with reviewing your energy contract options contact our utility specialists email@example.com or 02476 997 901.
Article written by: James Rant, Business Development Manager