Facilitating Commercial and Industrial as ‘Asset Backed’ Traders with ETRM
- Jan 9, 2023 9:03 am GMT
The increase in renewables, the surge in demand after the Covid pandemic and the impact on the market from the conflict in Ukraine has forced the Commercial and Industrial (C&I) sector to scramble to manage soaring costs. Energy-intensive industrial companies have choices when procuring energy as well as hedging options to protect against rising market prices. Failure to manage energy costs can lead to exceeding budget, margin erosion and ultimately, losses. Many companies rely on energy suppliers to shoulder the risk, yet as a result of this current volatile market some of the risks are still passed on to them. This means companies can no longer afford to adopt a passive attitude toward energy market risks. Large energy consumers may also look at their production process and consider making their consumption more flexible thereby optimizing cost and profit of those assets without becoming a speculative trader. To help manage these two scenarios is where an Energy Trading and Risk Management (ETRM) system comes in.
Market risk can be defined as “the risk of losses in on and off-balance sheet positions arising from adverse movements in market prices.” Volatility is normal in commodities markets but energy and commodities companies, including utilities, industrial firms, and trading houses, are now dealing with a higher frequency of extreme events. The price of electricity is, in large part, determined by the prices of natural gas. In addition, decarbonization efforts are driving more renewable energy generation and therefore volatility in electricity prices will surge.
Given that energy accounts for a large part of the budget, energy-intensive companies are naturally more exposed to market risk. While some may be able to pass on cost to their customers, others might find it much more difficult to increase prices. For larger C&I businesses, waiting until prices drop and supply increases is a risky path. Entering into a long-term contract via Power Purchase Agreements (PPAs) to reduce the average price may work well if cost can be passed on, and when proactively managing risks shifted from the energy supplier to the C&I, including the supplier counterparty risk. A third option, to protect against extreme market volatility in the future, is a more formal risk management approach.
Large energy consumers faced with the increase of variable wind and solar energy, also face greater price volatility. Traditionally, these energy-intensive industrial companies located themselves close to a dispatchable (not variable) energy source in order to maximize the productivity of their assets. In this new environment however, running their manufacturing process all the time and purchasing from electricity from energy suppliers, could expose them to higher fixed prices. Leading companies are thinking of flexible electricity consumption. Doing this goes beyond demand response programs, often implemented through solutions offered by aggregators or trading-as-a-service solutions to take advantage of flexibility. These large C&Is are now looking at electricity as a tradable commodity, and because this affects their manufacturing processes, they would need to start more direct interaction with power markets rather than relying on a third party.
Apart from electricity as a tradable commodity, the drive for carbon-free energy has also given rise to a mechanism to 'tag' electricity with more detailed attributes such as time (hour, minute), source type, location, etc. of product so consumers can match their consumption with clean energy hour by hour. This is managed by what is called Granular Certificates, which essentially are Energy Attributed Certificates (EAC) such as Renewable Energy Certificates or Guarantee of Origin certificates but now with an added timestamp. This not only is more reflective of the physical availability of clean energy but also improves the credibility of clean energy claims.
In order to adapt to the changing environment, forward thinking C&I companies have created a dedicated energy procurement desk focused on a risk management and purchase strategy in order to better protect themselves against market volatility. Some of them are taking the leap to directly participate in the wholesale energy market with their own trading desk.
Per market research firm Gartner, Energy trading and risk management (ETRM) systems involve commercial decision making and market execution using an integrated system that enables data exchanges among trade floor, operations, credit, contract and accounting functions. Integral to the process are event and trade identification/capture, comprehensive risk management strategies/policies, scheduling/nomination/transportation and settlement execution. The process also provides for price transparency, market monitoring, controlled access and regulatory compliance. For C&I companies this would mean that ETRM systems can:
- Support central energy procurement and streamline the process flow.
- Provide a single source of truth on energy position and portfolio management thereby improving risk management.
- Improve hedging through better information that allows an organization to hedge out further and reduce capital expenditures.
- Achieve operational excellence with a single system that is scalable, reduces risks and mistakes and therefore unnecessary added costs.
The functions in the ETRM system can be leveraged when the overall solution is equipped with:
- Integrated ability to forecast short (and long-term) power prices. For the short term forecast a neural network method will be employed, while long-term forecasting may employ several methods. Under the neural network method, historical data inputs are divided into train and test sets. By taking the train data set, the method performs optimizations in an iterative fashion and provides the optimized model parameters. Those model parameters are used in the test data for model validation. Once the models are validated the optimized, model parameters with new input data are fed in the model for the price forecasting.
- Ability to manage Power Purchase Agreements. Robust settlement functionality streamlines the contract-to-bill process, from capture of all invoiceable trades under complex contracts to creation of accrual entries.
- Ability to support Energy Traceability by automating the end-to-end Energy Attribute Certificates, involving the tracking and management of processes from generation to assignment and retirement or expiration. Specialized ETRM modules provide robust functionality for inventory planning and management.
Variable renewables penetration will have an impact on the energy consuming industries which is further magnified by an accelerated transition due to the natural gas market situation. Energy-intensive consumers will have to deal with the advancement of renewables, prepare themselves for future volatility and their path to net-zero, and adapt their manufacturing profitability based on electricity prices. They will need to transition from buying certificate-backed energy only (or just the off-setting certificates) and engaging in renewable PPAs towards purchasing 24/7 time-matched carbon free energy. They will also need to move from energy procurement and demand response programs to essentially becoming an 'asset-backed' electricity trader.
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