Part 1 - Traditional Supply Models
Procuring energy is not quite as straightforward as it used to be, especially for manufacturers. Instead of just trying to find the cheapest and most suitable tariff and renewing it every year, it’s now about managing and balancing a wide variety of different elements. Wholesale price volatility is a key contributor to that, but manufacturers now also have emission goals to consider, as well as dealing with complex utilities supplier contracts.
Manufacturer’s energy often accounts for anywhere between 5% and 20% of its operating costs. That means procurement decisions can have a significant impact on costs. But those decisions also take into account any exposure to risk, emissions reporting requirements and even stakeholder perception. That means energy procurement needs a much more strategic approach to get the most favourable outcomes, both in the long and short-term.
There is a wide range of choice available for UK manufacturers when buying energy and other utility services (including electricity, natural gas, hydrogen, water, steam, heat or other input fuels). Choosing the right procurement route shapes cost volatility, sustainability performance, operational resilience and financial and legal risk exposure.
The key energy models available to manufacturers
A specific utility procurement strategy may suit a particular business but not necessarily another. Different organisations are likely to seek different energy and utility procurement models which best suit their requirements, energy and utility buying power as well as strategic goals, including sustainability and/or net zero targets.
There are a few different procurement models available to manufacturers, however each with their own pros and cons, and making the right procurement decision means having a better understanding of what these models are and what they mean. In this Part 1 we have outlined a variety of the more traditional procurement models, however this list is by no means exhaustive.
- Fixed price contracts
For manufacturers looking to obtain a greater degree of budget certainty, a fixed price contract can be a helpful option. This model features a set rate per kWh for a set duration, which is typically 1 to 3 years and is often entered into with a licensed utility supplier. However, these contracts can sometimes be higher in price than flexible options. They are generally more suited to smaller manufacturers, or those who may have tight budget controls. It is important to look out for early termination penalties, volume tolerance and restrictions as well as exclusive supply provisions, any hidden clauses on pass-through costs (such as grid fees) and automatic rollover provisions.
- Flexible purchasing contracts
Flexible purchasing contracts provide a more flexible approach to costs. In this instance, prices can vary over time, depending on market conditions. Those looking to utilise this model will often buy energy in blocks or tranches. Whilst these contracts are more complex than their fixed price counterparts, they can be a source of savings if market conditions are favourable as the price is usually linked to a market index (i.e. wholesale day-ahead/ seasonal products) with varying degrees of buyer optionality and “cap and floor” features. These contracts are a more viable option for high energy users, particularly those with in-house energy managers or external procurement support who are able to lead and implement a more market-led buying strategy. However, it’s important to ensure that any contracts have clear terms around price triggers, volume tolerances, re-forecasting, supplier obligations and dispute resolution.
- Pass-through, blended contracts and hedging
Manufacturers who opt for pass-through or blended contracts will pay utility suppliers who charge a wholesale price as well as a transparent fee (such as management or brokerage). Procurement teams use hedging strategies and wholesale instruments such as futures, forwards, swaps or staged purchases to lock in portions of volumes at different times and for different prices. These types of contracts can be executed directly via a utility supplier at exchanges or over the counter (OTC) or via utility brokers. Such contracts usually suit manufacturers with large predictable energy demand profiles where hedging can smooth cost volatility. Contracts can also feature certain non-commodity costs, such as network charges or levies, that are passed through to the customer. Blended contracts in particular may include hedging or price caps. If these contracts are considered, then it’s important for manufacturers to ensure there is clarity around how non-commodity costs are calculated, as well as how any changes are handled. Manufacturers should also bear in mind that these types of contracts and trades require additional credit support such as additional collateral or parent company guarantees and contracts should clearly define and default events and close out netting rights. It is important that the hedging strategy the manufacturer’s procurement team drives accurately reflects the demand forecast and aligns with actual physical supply requirements.
- Group purchasing/energy consortiums
When manufacturers want to band together to buy energy in bulk, it’s known as group purchasing (or an energy consortium). This is a method often used by organisations such as trade bodies, sector groups or business parks. This approach is beneficial for economies of scale and can provide access to more flexible products. However, there is often less customisation available, as well as having to deal with shared liability or poorly defined governance. That shared liability in particular can present a legal risk, and there can also be problems around exit terms, clarity over collective vs individual decision making and problems caused by conflicts of interest as well as considerations from an energy regulation perspective, for example in cases of on-supply of electricity to other third parties on a business park.
What to consider when choosing your energy procurement strategy
Defining your strategy is a critical part of the process. But it’s important to think carefully about your approach.
- How predictable is your energy use? Is it steady? Is there significant seasonal or batch-based usage?
- Do you have good internal energy expertise? This could include a dedicated energy manager or a utilities procurement specialist.
- Do you know the level or price risk that your business can tolerate? For example, how would a 10% rise in energy prices impact the profitability of your business?
- Are there any green or ESG-linked goals that need to be considered? Some procurement products include renewable energy certificates such as Renewable Energy Guarantees of Origin (REGOs), Renewable Obligation Certificates (ROCs), Renewable Gas Guarantees of Origin (RGGOs) or other types of carbon or emissions certificates or offsets.
These are not the only questions that need to be asked, but answering these questions is important to gain a better idea of what approach to your procurement strategy and energy contracting model might look like to be the most suitable for your business. Knowing the intensity of energy usage, whether you have forecasting capabilities, and ensuring you are able to avoid greenwashing risks, are all crucial factors to the process.
Broker and Third Party Intermediary (TPI) involvement
For manufacturers who use brokers or consultants to arrange deals, there can be further risks. These can include undisclosed commission (which can be up to 30% of your energy cost), conflicts of interest (as some third-party intermediaries are paid more for placing clients with certain suppliers), and a lack of regulatory oversight (currently under voluntary schemes, not Ofgem licensed). That means it’s essential to review all engagement/supplier terms and utility supply contracts to ensure commission fees are transparent and essential terms are clear.
Legal and commercial risks in procurement contracts
As with all contracts, it is important to make sure they are suitable and that they do not present serious problems for your business in a number of situations. There are a number of pitfalls that you need to look out for, including auto-renewal clauses, termination rights and restrictions or excessive break fees, any ambiguity around pass-through clauses, force majeure or change in law clauses (such as to new carbon taxes), exclusive supply restrictions or volume commitment penalties like under consumption or out of tolerance charges. It is also important to ensure that your contracts allow for review or adjustment if any significant energy market reforms occur.
Your legal advisors can help to manage and navigate these risks, as well as helping you to understand your legal obligations under different procurement frameworks. This can help with negotiating utility supplier and broker/ TPI contracts, whilst simultaneously helping you to avoid any hidden risk or unfair contract terms. Greenwashing is also a prominent problem, and your advisors can help to ensure that any ESG or green claims in contracts are both valid and defensible, whilst also futureproofing contracts for your own decarbonisation and sustainability goals.
The right approach pays off
Finding your way through the ever-evolving energy landscape is no easy feat. As we mentioned earlier, procurement isn’t just a back-office decision anymore, and it’s vital to ensure that you’re looking at the bigger picture when defining and executing your energy procurement strategy. The right approach can help you to optimise your assets and save you money, whilst futureproofing your operations against energy shocks and regulatory changes. If you’re thinking about renegotiating your next energy contract, or taking a more effective approach to energy procurement, talk to our Energy, Infrastructure & Projects team to find out how we can help review the legal risks and help structure your strategic utilities procurement approach.