5 Simple Steps to Effective Energy Buying

April 2010

• Energy markets are hybrids of volatile commodity markets and complex regulated utility services. But there are five simple steps that energy buyers can take to reduce costs and manage risk in energy procurement.
• Following these key steps can result in a well-founded energy buying plan that leads to cost reduction, greater cost certainty, and better peace of mind.

Buying energy is unlike buying other goods and services. Natural gas and electricity markets are hybrids of volatile commodity markets and complex regulated utility services. Energy is a major operating cost for most institutional, commercial and industrial organizations. What's the best way to reduce costs and manage risks in energy procurement?

5 Simple Steps

Here are five key steps that large energy buyers can take to effectively control energy cost uncertainty in their organization.

Use a buying team: Avoid vesting responsibility for energy procurement in just one person. A buying team with diverse functional representation does a better job of bringing all the important energy procurement considerations to the table, enabling better decisions.

The plant or facilities manager may be primarily concerned with minimizing costs, whereas the financial controller may also value cost predictability. The right strategy for the organization depends on balancing these views, so both functional areas need to be in on the discussion.

Set clear risk management objectives: Each organization has a different tolerance for energy price risk, depending on its organizational goals and the realities of the environment it operates in. Buyers must set explicit, quantifiable, and realistic procurement objectives.

A good way to start is to have the buying team decide on the size of unexpected energy cost variance that would have a material impact on the organization. In the long run, it costs money to hedge your energy price. You want to hedge only as much as you need to in order to contain risks within acceptable limits. Build a strategy that limits the probability of a material cost overrun to an acceptable level.

Create competitive buying processes: Buyers should build a procurement program that ensures access to competitive prices in any energy transaction. That means taking the time to build a supplier portfolio. Prices do vary from supplier to supplier at any point in time, and unless you have a choice, you'll pay too much.

Think about it: if the seller knows you must buy, and that you must buy from him, what impact is that going to have on the price he quotes you? And if the only price you ever hear is from that one supplier, how do you know how competitive it is?

Diversify your risks: Structure your energy supply arrangements to avoid having all your eggs in one basket. In addition to avoiding reliance on one supplier, don't count on one supply path, or one decision day as being the best one. Develop a portfolio.

Quite apart from the price impact of having a single supplier, we've seen circumstances where suppliers have left the market, sometimes on very short notice. If your one supplier disappears, then you may end up in a supply relationship you did not expect.

Prices go up and down, sometimes in unexpected ways. Taking positions by locking in prices from time to time helps you to avoid the situation of being fully exposed when the market takes a nasty unforeseen turn. Similar to the advice we get with our RRSP's, breaking up your purchase into increments is an effective risk management strategy. Making regular purchases over time will reduce the risk of buying all of your supply at the highest point in the market.

Track performance: Measure results to gauge how well your procurement strategies are meeting your organizational objectives. It's the only way to know if you're on track. However, be sure to set up your measurement system when you begin your procurement program and make sure you measure the right things. If price stability is your prime goal, it doesn't make sense to measure whether your price "beat the index". Defining appropriate measures makes sure everyone - right up to senior management - understands the objectives and knows what success will look like when it comes.

It can be a costly mistake to look back on a procurement program and measure it against standards it was never meant to meet. This happens when the measurement criteria are not set at the outset. This vacuum allows someone - usually someone senior - to choose an arbitrary standard at some point down the road and apply it retroactively. Applying performance measures that are not rooted in the risk management goals will simply lead you astray.

By following these five simple steps, you can achieve structure, process, and have a well-founded plan, which will lead to cost reduction, greater cost certainty, and better peace of mind.

Is Now the Time to Buy? - Let's Consider the Question Read more »

Create a Fire Prevention Plan for Energy Buying Read more »