Develop a "SMART" Goal for Your Energy Procurement Plan

October 2008

There's something about commodity markets that brings out the competitive nature in people. Everyone wants to "beat" the market and the rush of doing so can be addictive, much more addictive than the pain of losing to the market. Unfortunately, when a speculative position is taken the likelihood of either outcome is generally the same. In establishing an energy procurement plan, developing a clearly articulated "SMART" goal is a critical first step that many organizations overlook.

Like other plan objectives in an organization, an energy procurement plan should be developed using SMART principles.

1. Specific - Objectives should be specific about what the organization wants to achieve.
2. Measurable -The performance of the hedging program should be measured relative to the stated goal.
3. Achievable - The objectives must achievable. For example, if the annual energy budget cannot be met unless there is a dramatic change in market conditions, the energy procurement plan may be doomed to fail.
4. Realistic - The objectives must be realistic in the sense that they are attainable with the resources available.
5. Time bound - What time frame is being considered? A hedging program can be designed to achieve goals over a single fiscal year, or over multiple years.

A hedge is the pursuit of a known outcome, while a speculation is the pursuit of a potential outcome

When companies consider making a commitment to buy their natural gas at a fixed forward price, they do so for one of two reasons: they want certainty about their energy cost (a hedge against risk), or because they feel the price available now is lower than the price that will be available in the future (a speculative strategy). These two goals are very different and yet companies often find themselves trying to measure their hedges - entered into for risk reduction purposes - against speculative benchmarks such as the ability for the hedge to beat the market price. When an organization undertakes a procurement strategy, it's important to align the measure of success with the intended outcome.

The challenge with measuring a hedge against market conditions is that there are too many uncontrolled variables. At the time that a hedge is put in place, the price for the hedged natural gas represents an expectation of prices given the market's expectations for these variables at that point in time. The price for gas delivered to the market during the time period covered by the hedge reflects the events that actually happened. Establishing a hedge that will be benchmarked against future market prices is an exercise in attempting to accurately forecast supply forces, demand forces, weather, the actions of speculators, regulatory actions, and potentially acts of terrorism. From an energy manager's perspective, this misalignment for assessing success can lead to the perception of a poorly placed hedge, even when the goals of cost stabilization and low variance to the annual budget were met.

A key to effectively measuring the performance of an energy procurement plan is to start with clearly articulated objectives that are set and communicated in advance of plan implementation. Clearly articulated objectives will ensure that everyone understands the purpose of the energy procurement plan and how the program will be measured for success. Developing such objectives can be difficult when a choice must be made between establishing price certainty and waiting for a price that is perceived to be a "good price."

The process of establishing objectives should help the organization determine its priorities. An objective such as "to minimize price and achieve cost certainty" is problematic. Unfortunately, the pursuit of low prices cannot occur if hedges are in place to ensure budget certainty. Some trade-offs are necessary, perhaps leading to a goal of minimizing price while reducing risk to an acceptable level. Working with internal stakeholders, an understanding about the acceptable level of budget certainty can help. For example, a firm that wants to maintain some ability to pursue lower prices may feel that 100% budget certainty is unnecessary. If the organization can accept that they can be 70% certain of meeting their annual budget, a portion of their consumption can be left unhedged to allow for opportunities to capitalize on dropping market prices. An example of a specific objective might be: "we want to be 70% certain that our energy budget will be $1,000,000 or less".

Developing an energy procurement plan that satisfies the needs of the organization starts with clearly articulated objectives. Armed with a clear vision of the end state, the development and implementation of an energy procurement strategy can be undertaken with a much stronger expectation of success.

For additional information about how Aegent Energy Advisors can help you develop both your energy objectives as well as an energy procurement strategy, contact John Voss at jvoss@aegent.ca.