How the global shutdown could impact supply contract terms
How much time do you spend reading the small print of your energy supply contract?
It’s likely that the odds are not very much, but at times of extremes such as we are living in at the moment, the terms in a contract become critical to determine who is exposed to what, and who pays for what. In this article we examine volume risks, how the shift in consumption patterns caused by lock-down may impact future contract terms, and what it tells us about the state of the market.
Domestic contracts contain no volume limits on what customers can consume, and given the regulatory protections in place for these customers its hard to see this changing in the near term; so this article focusses on B2B contracts where there is potential for short term changes. However, the policy questions raised are equally valid for domestic and B2B customers.
The volume problem
Energy supply is unique in the way it is supplied to customers: in that each customer has a direct connection to an inexhaustible grid connection, can take what they want when they want without telling their supplier, and generally pays a fixed price per unit from the supplier for doing so – despite the costs that the supplier pays varying in real time for amongst the most volatile commodity in the world.
Although a core part of a supplier’s business is to manage this risk, and they are paid to do so as part of their pricing; in extreme events it is reasonable for suppliers to have recourse to customers. After all it is the customer that is generally in control of how much it is using.
Contractual volume protection
Most suppliers have contractual volume protection built into B2B supply contracts, providing for recourse to the customer in the event that their volume changes by more than a pre-determined amount in an annual period (typically +/- 15%). The recourse is generally aimed at recouping only commodity price impacts, which as we explore below may be inadequate in today’s market. However, over recent years the fierce competitive pressure of the market has led to some brokers and customers requesting this clause to be widened or removed. A simple action at the time, it is likely to be causing headaches across the market at the moment and exposes risks at the heart of the energy industry.
From a portfolio risk management perspective, volume tolerance is an easy give away as part of a negotiation; after-all in a large portfolio an individual customer generally makes little difference to overall portfolio demand; and risk diversification would generally result in some using more whilst others used less. Would any risk analyst have looked at modelling the shock event of what would happen if all customers stopped consuming at the same time? Whilst it would be an interesting intellectual exercise, the probability would have been so low as to be ignored, and charging customers for the risk would likely lead to no sales.
Contractual enforcement of volume tolerance terms is complex, particularly without explicit detailed drafting, and many contracts don’t have much depth to how any calculation will be made. How suppliers would recover costs in the event of a claim in the absence of such clarity would be fraught with legal challenge.
Volume tolerance and reforecasting
In order to protect themselves suppliers introduced protections giving customers the right to reforecast volumes, a way of managing their exposure to volume tolerance limits. The advantage of this to suppliers is the ability to be forewarned about volume changes for customers. For customers it avoids being exposed to volume tolerance, although for suppliers it does nothing to manage the exposure to price volatility that is associated with volume risks.
The impact of volume on profitability…
a) price volatility
In a world where commodity prices are flat, any change in customer volume compared to expectations carries no exposure to the commodity price itself. From a supplier perspective more volume would mean more margin, less volume would mean less margin.
However, in the real world where commodity prices are incredibly volatile, suppliers are exposed to not only margin impacts but also cost base impacts. In the current downturn, wholesale commodity prices have fallen dramatically in response to global oversupply. This leaves suppliers with a large financial loss on volume that customers would have been expected to consume but are not.
As an example, imagine a customer who took out a 1 year contract starting in October 2019 for electricity supply. During September 2019 when the contract was agreed 1 year baseload electricity was valued at approximately £50/MWh, and current day ahead electricity is trading around £25/MWh. This represents a loss of £25/MWh on each MWh not being consumed by an end user, where a supplier hedged the volume at the time the contract was agreed and is now exposed to selling it back to market in the absence of customer demand.
b) non-commodity costs
Suppliers recover many costs on behalf of other industry parties, and in support of Government schemes associated with low carbon generation and related policy.
Whilst many of these costs are recovered on a volumetric basis, they are in effect financing fixed capital costs, so underlying the calculation is an expected national demand level to smear costs across. In the event of a demand shock of the kind currently being seen, mechanisms exist to push the full cost on to suppliers in future periods. Suppliers face being forced to take costs to support other companies which they are obligated to pay, irrespective of whether the end customer has paid them or not. Having been exposed to various cost mutualisation events in the last 2 years, its looks highly likely that more are coming.
Where next? – volume and risk protection
Recent history has seen suppliers taking more risks from both end users and other parts of the energy value chain for no increase in reward. It would be reasonable to expect at least the terms on which suppliers are willing to contract being reviewed following the current shutdown. Suppliers do not control the obligations to which they are subjected, but they can set the terms on which they contract with customers and what gets passed on. Making contractual terms more solid, including non-commodity costs and minimum consumption levels would seem to be sensible from suppliers, and provide a more sustainable model. Risk committees may be more focussed on contract terms in future, as suppliers protect themselves from the in-direct risks to which they are exposed.
In the wider policy context, the Government mantra of the last decade of passing complex risks to suppliers to manage on behalf of the whole industry, whilst at the same time not allowing them to make reasonable returns has been well and truly stretched.
Suppliers, customers and regulators would be well advised to read the small print, and make sure risk allocation makes sense both now and for the long term as we move towards net zero and all the opportunities (and risks) that will create.