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Coping with the complexities of the energy market

Author: ICAEW Insights

Published: 26 Oct 2022

The rise in energy costs across the UK is in part driven by the way the energy markets work. How should businesses use knowledge of that market, and what role should accountants play?

When you drill down into them, the complexities of the UK and global energy markets can seem overwhelming. The price per unit changes every half an hour in a traded commodity market. The generators are bidding at their price and the suppliers are buying at the marginal cost. Whoever bids last during that half hour sets the marginal price that prevails for everybody who’s supplying for that 30-minute period.

Renewable energy is cheaper to run and is bid on at low prices, but it is still set in line with the commodity price. Jo Butlin, CEO of EnergyBridge and Non-Executive Director at Thrive Renewables, says: “At the moment, it is the scarcity of gas that is setting the high marginal price in the wholesale market. The marginal price, set every half hour, is what ultimately feeds through to all consumers, whether homeowners or businesses.”

There are two markets for electricity: the wholesale market and the retail market. Most businesses buy energy from the retail market and typically agree a contract with a supplier at a fixed price and period. When a contract comes to an end, the new price they face will depend on the current wholesale price. Business energy costs are therefore much more volatile than those for households.

Beside households and micro businesses, which are on fixed-price tariff-based contracts spread over a fixed period, most other businesses are on bespoke, price-per-unit contracts. These tend to be simpler contracts when compared to the more complex agreements that larger companies enter into.

“Despite all the media attention around high prices, many companies haven’t yet faced real pain,” says Butlin. “Most business contracts tend to be either October starts or April starts, and businesses who agreed their contractual prices ahead of the crisis are likely to still be benefiting at least partially from historic prices. Those that have renewed this October will be now feeling the full force of price increases and there will be another big hump in April. The important message is you haven’t necessarily seen the worst yet. And while we have seen prices soften in the last couple of weeks, a cold winter in the UK or Europe could see prices spike again.”

Companies that managed to lock in an energy contract last year that will run to April 2023 will have been somewhat protected from the recent price hikes through the summer, but by next April, those businesses will be exposed and face much higher prices.

Energy contracts for larger companies are usually more complex, but have some flexibility. Butlin says those companies run a risk-management policy where they will buy maybe a five-year contract for 100% of power this winter, 75% for next summer and maybe 50% for next winter. 

“Getting the timing right if buying fixed-price contracts is important. It is worth smaller businesses being aware of wholesale price movements and locking in lower prices when they can, even if for future years.” Butlin says.

In September, the government stepped in to help businesses facing escalating energy price rises with a six-month support package. Although welcomed by businesses and their representatives, companies are still worried about what happens once the six-month term ends and they potentially face a cliff-edge if rising energy costs have still not stabilised. With a new government in place now, the future of this support is uncertain. 

Tim Ross, Commercial Director of energy consultants Advantages Utilities, agrees, saying: “With the delays in tax cuts and a reduction of public spending on the cards, it means probably there’ll be a reduced amount of support from next April and the government is going to be quite selective as to which industries receive help.

“The likelihood is that we’re looking at higher wholesale prices probably until 2024. So that’s going to leave a significant gap in between prices reducing to anything like an acceptable level and the current situation. Therefore, there’s a need for businesses to explore energy efficiency, potentially looking at on-site generation options, to become less reliant on grid prices and more self-sufficient.”

Last summer, the government launched a consultation, the Review of Electricity Market Arrangements (REMA), to enhance the UK’s energy security and future supply. Some of the changes being consulted on include introducing incentives for consumers to draw energy from the grid at cheaper rates; reforming the capacity market so that it increases the participation of low carbon flexibility technologies, such as electricity storage; and decoupling costly global fossil fuel prices from electricity produced by cheaper renewables.

But few of these potential reforms will help businesses as they grapple with securing a new energy contract at a reasonable price. Accountants are uniquely placed to help business owners navigate the potential economic turmoil ahead, helping to lock in savings in other parts of the business through tighter operational resilience, better contingency planning, clearer risk assessments and robust financial viability reviews.

Butlin says first and foremost companies must attempt to reduce consumption and improve insulation. To do that they will need to know how much energy they use and how they use it – as Butlin says: “The cheapest unit of energy is the one that is not used.” But if you are a simple business on a tariff, the best thing to do is to shop around. It’s unlikely that companies will find a bargain, given the current market, but there will be some marginal differences.

For larger companies with bespoke or flexible contracts, Butlin says there are more options. Suppliers will look at a consumer’s demand and the daily shape – the extent to which energy usage is going up and down during the day. They will then give a price for the underlying ‘baseload’ of demand and another price for the shape. Baseload can then be bought in advance, at a known price; but shape, by nature uncertain, has to be bought in short-term markets and comes with a risk premium.

“The more you can get into baseload, the better your price is going to be,” Butlin says. “The suppliers will be protecting themselves against future prices so the better you are at forecasting, the better your price is going to be. It is worth investing time in really understanding how much you’re going to use and when you’re going to use it.”

If a company is on a fixed contract, it can switch to a flexible contract. This does transfer some of the risk to the customer, but it also allows a company to track the market better. It will depend on a company’s risk appetite and available resources.

Accountants can also help advise on investment strategies for more sustainable energy sources such as solar panels. They are also best placed to know what’s available in terms of government-backed funding for investment projects.

For larger businesses there are options for large-scale generation and energy-efficiency measures. One such option is a power purchase agreement (PPA) – a long-term contract between an energy generator to buy their power at a fixed price. That price will be a better price than the market price for a much longer period – at least five to 10 years. This option provides budget certainty, but it’s not risk free because if the market prices fall, you may end up paying over the average cost in a few years’ time.

PPAs also offer larger businesses with external space the option of investing directly, if they have the funds, but a return on investment is typically around two to three years. Ross says: “For businesses what that would mean is no capital outlay, no ongoing maintenance responsibility. You’re still saving money and reducing your carbon footprint.”

If a company wants to own the asset there are various asset finance models, which essentially means that repayments are made as you save. Therefore it can be fairly cash flow neutral, according to Ross. “It’s important to get a handle on your usage, looking at what you’ve done historically, and then trying to make proportional improvements without disrupting your primary business activity. There’s quite a lot that can be done, it’s just a question of doing something proportional to the business and the opportunities that exist,” he says.

Currently, unlike households that enjoy a price cap, it is vital that businesses are in a contract for liquid supply. However, it might be advantageous for companies to have shorter contracts, so they can take advantage when the market price drops. 

Ultimately, it all comes down to energy efficiency, now and in the future. It is likely to be the push needed among businesses to shift to greener energy sources and reach their net zero targets sooner.

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