Your independent energy adviser
0800 051 5770

Hedging and How it Affects Price

We often hear that energy suppliers cannot pass through the falls in the costs of the wholesale market because of a concept known as ‘hedging’ however little is done to explain this opaque and seemingly arcane topic.

Below we will attempt to explain this concept and also provide a practical example to show its effects.

Firstly though we need to establish the first truth.

That is that energy suppliers buy energy at a cost to themselves, whether from the market or a related third party, they then are looking to sell this energy at a cost higher or at very least equal to the amount they paid for it – their margin.

That is pretty standard commercial acumen and a fair example of “buy low, sell high”.

The second crucial truth is:

That the wholesale energy market into which the energy suppliers are making their purchases is influenced by numerous external factors (political, social, climate) as well as simple supply and demand which means that there is significant volatility, certainly more than most regularly traded markets, for which the suppliers need to contend.

As a result the “buy low, sell high” mantra is a relative one.

The point at which the supplier enters the market in a position to “buy” could be the point at which the market is so “high” that it would be next to impossible to “sell” the product, in this instance energy, on to a customer let alone at a “margin”.

Volatility

This state of affairs is worsened by the fact that competitor suppliers could have entered the market at a more benign point and in so doing have bought sufficient product (energy) at advantageous prices that they can sell to the customers with ample margin and yet still be cheaper than our supplier friend who entered the market at completely the wrong time.

We could conclude then that the errant supplier should have done its homework and should have known better, yet we also know the market is very volatile, so in many instances it is, if not pure luck, touched by good fortune to be in the market at the right time.

That however is not the basis that anyone would wish to build a business upon. Fraught with risk (the unknown) and danger (the inability to sell the product on) there needs to be a better way.

That then is where the concept of hedging came in.

Rather than accessing the market all at once and being exposed to the price then on offer, energy suppliers access the market continually and in effect top-up the amount of energy they need at a cost they are willing, and able, to pay.

To do this effectively the energy supplier needs to know the following:

  • When they are buying the energy for
  • How much energy they need
  • How much they can afford to pay and when they can afford to pay it

Forecasting

This means that the energy supplier needs to be well on top of the following:

  • Forecasting not only the size of the portfolio they need to provide energy but also how much energy and when those customers will use that energy.
  • Forecasting when the market will offer the size, shape and timing of delivery of that energy at a price that the supplier can afford, or be willing to, pay.

These forecasts are used as building blocks to create a level of product (energy) capable of fulfilling the demand at a palatable price.

Eggs vs. hedges

Putting “all your eggs in one basket” then was not a viable option once these principles were established, in effect, in doing that you were taking a punt on a single price at a single point in time that could have proven to be a very bad bet indeed.

Instead the energy suppliers adopted a more drawn out strategy based on the idea of “hedging your bets”, in other words still buying for their total demand and the point at which it is delivered, but doing so incrementally so that the risk of being caught out by the volatile market was minimised.

In effect this means lots of ‘little’ transactions at differing prices which are then amalgamated to provide an ‘average’ price of all those trades. This would then become the energy element of the price the customer pays.

Competitive strategy

The beauty of this is that the supplier can adopt unlimited strategies to ‘optimise’ these purchases (right time, right cost, right volume) and in so doing can out perform their competitors and be able to offer a better (more competitive) price to customers than those who fared less well or were left more exposed to a volatile market.

In effect then hedging became an important strategic battle between energy suppliers, with the availability of energy in the market within which they are trading is finite and therefore each was fighting over the same spoils in their efforts to deliver the best costs for their business.

But it isn’t only the supplier who benefits, the customer does too, by not being exposed to a single trade in a volatile market, and thereby being insulated from much of the price movements in the wholesale market.

Fixed term, fixed price

On top of this energy suppliers could developed fixed term, fixed price contracts safe(r) in the knowledge that they had bought the energy well ahead of time, at a known cost that would mean they could offer it to customers for an extended period (anything up to 5 years ahead).

This in itself revolutionised the energy market. Customers could enter long term, fixed price contracts, providing far greater certainty over their energy costs than had ever previously been the case.

Certainty & insulation

However those very benefits of ‘certainty’ and ‘insulation’ had a side effect.

When the energy market is falling, those falls, because of the ‘insulation’ provided by the strategy of hedging, could not and would not be “passed through” to the customer in real time.

This then could, where market dynamics were appropriate (prices falling), make it look as if the energy suppliers were wilfully not “passing through” these falls.

The reality however is bound up in our first truth:

“Energy suppliers buy energy at a cost to themselves…… they then are looking to sell this energy at a cost higher or at very least equal to the amount they paid for it – their margin.”

The energy suppliers therefore have bought the majority of the energy already at the point of a contemporary wholesale market fall and as such the impact of those falls is limited.

Dependent on a supplier’s hedging strategy, for instance how far in advance it is that they purchase, and how much of the final demand they purchase, the falls in the contemporary market can take a corresponding longer or shorter time to filter through.

Of course in a market that has fallen consistently and in a linear fashion over an extended period the ‘hedged’ bets that the suppliers would have made would have been at incrementally lower prices and these could be passed through quicker.

However as we established under our second truth:

“The wholesale energy market … is influenced by numerous external factors (political, social, climate) as well as simple supply and demand which means that there is significant volatility”

The market therefore may fall for an extended period but those falls are not linear and as such the insulation from and timing of purchases in the market will directly impact the suppliers ability to “pass through” what from the outside observers see as price falls.

That is not to say that there is not commercial advantage in suppliers using their hedging strategy to hold back additional margin masqueraded as purchase costs but neither is it to say that the retail price offered to customers can in any way reflect the contemporary wholesale energy price without the corollary of exposure to that incessant volatility.

The lesser 'evil'

On balance then the hedging strategies of the energy suppliers benefit both themselves and the customer in most instances.

Of course in an extreme market this very benefit of insulation can be a drawback but without hedging there would be no fixed term, fixed price offers and customers would be directly exposed to the volatile markets and supplier alike would also be operating far more risky commercial models which would inevitably need to be managed through additional risk premiums on the price of energy. Ergo the price a customer would pay would be inflated and crucially far less reflective of the actual underlying wholesale market.

Hedging then is the significant lesser of two evils of managing the underlying volatility in the energy wholesale markets. Whilst the very insulation it delivers is seen by some as inherent unfairness, the alternative is significantly worse from all party’s perspective unless the market conditions are perfectly predictable, linear and falling. If only.

Hedging – A practical example

The background
  • Taking an average business electricity customer, using 43,247 kWh per annum.
  • The customer wants a 1-year contract commencing Summer 2015 through Winter 2015.
Supplier strategy
  • The supplier has already predicted sufficient ‘demand’ for contract volume over that period to have already purchased ¾ of the energy required.
  • Indeed the supplier adopts a formulaic strategy of entering the energy market to purchase ¼ of the energy required every 6 months, with the final tranche being the day that the business wishes to take out their 1-year contract.
Purchases
  • The supplier needs to have bought 43,247 kWh or 43.25 MWH to cover the customer’s demand over the 12-month period commencing Summer 2015.
  • Despite not knowing that this particular customer would want this particular contract, the energy supplier had predicted that it was likely that someone would want it and so bought their first ‘tranche’ of energy for delivery from Summer 2015 as early as September 2013.
September 2013
  • In September 2013 therefore the supplier purchased 25% of the volume, or 10.81 MWH.
  • The supplier predicted that 40% of that volume would be used over the Summer season and the balance 60% would be used over the Winter season.
  • In September 2013, the supplier therefore purchased 4.32 MWH at £52.75 per MWH for the Summer season and 6.49 MWH at £58.85 per MWH for the Summer season.
  • This ‘trade’ therefore for 25% of the final volume, cost the supplier £609.89.
February 2014
  • 6 Months later because the cost of energy had fallen, a similar trade for the next 25% cost the supplier £586.75.
July 2014
  • In the penultimate trade in July 2014 after further falls, the next 25% cost £557.67.
January 2015
  • And so when the customer was ready to take on the contract, the supplier purchased the final tranche of 25% in January 2015 at which point it cost just £477.45. Fully 22% less than in September 2013!
  • But. That January 2015 is only a quarter of the story, literally.
Increment

Our supplier bought:

  • 25% at £609.89
  • 25% at £586.75
  • 25% at £557.67
  • 25% at £477.45
Hedged cost

In total then, to deliver the energy under the contract with the customer the supplier spent:

  • £2,231.76 – the ‘hedged’ cost
Eggs in one basket cost

Of course if the supplier hadn’t “hedged their bets” and bought it all on the day of contracting in 2015 it would have cost just £1,909.79. But conversely if they’d bought the lot in one tranche back in 2013, which would most likely have been the case before hedging, it would have cost £2,439.56.

Retail price

Putting that into real terms. Assuming that the wholesale element of the retail energy price makes up just 42.5%, the resultant retail price would have been:

  • Hedged cost = 12.14p/kWh
  • Non hedged cost, bought 100% on day of contract = 10.39p/kWh
  • Non hedged cost, bought 100% in September 2013 = 13.27p/kWh
Missed opportunity?

So yes, not hedging and waiting would have resulted in a lower end price BUT this is in an (unpredicted and very unusual) falling winter market, following normal market logic the wholesale price would have been rising at this point not falling and so it can be safely assumed that in a non hedged strategy the energy supplier would have purchased further in advance than the day of contract, exposing the customer not to the January 2015 cost but more likely the September 2013 cost.

The difference
  • Hedging delivered a retail price of 12.14p/kWh and therefore an annual cost of £5,251.20.
  • Not hedging and buying well ahead of time would have resulted in 13.27p/kWh and an annual cost of £5,740.15. A premium of 9%.

Hedging your bets

Yes hedging is not perfect, yes it can insulate too much when the market is favourable but bearing in mind that the exact same energy for the exact same customer at the exact same time could have cost 9% more by not hedging underlines the value that such activity can bring.

Of course if the supplier had waited it could have been 14% cheaper still but then that is what “hedging your bets” is all about, mitigating the risk, knowing that you won’t hit the ultimate jackpot but also knowing your losses will be minimised.

Hedging is here to stay for good reason. Without it the market risk businesses would have to shoulder would be significantly worse, paying a relative ‘premium’ for that level of security is a price very much worth paying.