Europe,Energy and Emissions
August 1st 2007 In this article we consider how changes in the European energy and environmental markets are likely to affect your organisation in the short to medium term. We will briefly examine what these mean for you, before focusing on what you may find yourself doing differently in the future, in terms of managing the price risk of your energy and emissions portfolio whilst reducing the absolute levels of your energy consumption and resulting emissions.
Much has been written about the price risk management of energy procurement and by now your organisation is either already enjoying its benefits or likely to be considering adopting such an approach. Therefore whilst we will address this issue, in this article we shall focus on the reduction of energy consumption and emissions and perhaps more importantly on how many companies who after having agonised over making investments to reduce consumption and emissions, throw away much of the investment value by failing to properly risk manage the associated returns.
It is our firm belief that the consequence of this failure is not just a waste of money and effort, but more generally it threatens the very fabric of any global initiative to make the world's economy more energy efficient and environmentally stable
Impact of the 3 E's The European energy agenda is becoming the hot topic for energy consumers for 2007. As a large consumer of energy you are either managing a European portfolio that now has all of the flexibility of your UK portfolio (in some cases more), or competing against other energy buyers in Europe that now have similar risks and opportunities with regard to their energy and emissions risk management as you do.
What does this mean for the energy procurement and environmental manager in your organisation? Europe is going to have two primary impacts on you: If you are part of a European operation you will need to start to manage your portfolio on a pan European basis If primarily you are UK based, you will need to increase your European awareness to maintain your operational advantage.
There are two primary reasons why it will impact you: We already observe that the energy price differentials between the different European countries change over time and in the new European markets they will change from month to month.
The EU ETS sets a pan European process for harmonising environmental costs which means no company, wherever it is domiciled, can operate in isolation.
It is likely that your competitiveness against your European counterparts or the relative competitiveness of the sites within your portfolio will change more frequently. Eventually businesses are going to need to optimise this as the future profitability of the organisation could depend on it.
What will you have to do differently in the future? There will be essentially two major areas for you to manage in the new European world: The price risk associated with your energy consumption and carbon emissions Reduction in consumption of energy and carbon emissions
Energy and Emissions Price Risk Management Much has been written on this subject already,and many organisations now procure their energy flexibly with the ability to both fix and unfix prices. The importance of being able to optimise your procurement is self evident when you consider the volatility of energy prices across Europe.
Whilst risk management techniques tend to be applied to the procurement of energy, it is fair to say that fewer organisations apply the same discipline to their carbon emissions. If you want to compete on the European stage you will have to start to control this exposure as well and in order to do this you will need to take the following course of action: Create a process for measuring and controlling the value of energy and emissions exposure every day Create a risk policy that determines the parameters under which you can manage this price exposure Create a process for monitoring the markets Execute the right transactions at the right time
Reducing Energy Consumption and Emissions Despite the increasing ethical pressure to 'Save the Planet' and the value organisations are now placing on the marketing potential of being a good environmental citizen, there have been some incredible opportunities to make energy saving and carbon reducing investments in the last 3 years. The problem is that organisations are unlikely to continue reviewing these or take the necessary steps to protect their return on investment.
It is possible that your company looked at making an energy saving / carbon reducing investment and either: It didn't make economic sense based on market conditions at the time so you shelved the idea for at least one year It did make economic sense and you made your investment and lost a lot of return when carbon prices collapsed last year, so your organisation is now unlikely to repeat the experience.
Challenging your experiences to date If we consider a hypothetical investment that you may have considered making in April 2005.
Let's imagine you had a modest gas consumption of 2 million therms (58m kWh) which at that time reflected a commodity spend of about £700,000 and by spending £200,000 you could reduce your gas consumption by 7.5% in 2006 and a sustainable 10% year on year thereafter.
In a pre EUETS world you would look at the economics of this project and assuming that you insisted on a 3 year payback you would see that this investment had an Internal Rate of Return (IRR) of -2.88%; not the best business proposition your company would have looked at that year.
However in a EUETS environment using the cost of carbon in April 2005 the same investment would have had a 3 year IRR of .26%. Still not enough to make your company invest but the carbon effect is significant.
What is more important, is that if you had run the same analysis 50 days later, the 3 year IRR of the same project would have been 17.5% and that starts to become interesting from any perspective. Indeed if you had considered the investment proposition in December 2005 then the IRR was over 30% on a 3 year basis.
The full range of variation in this investment opportunity for 2005 is illustrated in the figure below What do we take away from these observations?
At any point in time you need to consider the commercial impact of both the energy and environmental impact of your investment The projected return on your investment changes over time and often more significantly than you think Those consumers who did their analysis before July 2005, put the project in the drawer and forgot about it. Those who did their analysis between July and December invested in what appeared to be a 'no brainer' project.
The chart below shows how the value of that investment has changed to date.
However this is not the end of the story.
For those who invested during the first year of the project, the good returns just got better, peaking at over 40% IRR on a three year basis.
But today, only half way through the project lifecycle, the %IRR of the project is down to levels lower than they were when it was analysed and rejected back in April 2005 Who made the better the decision? Did the company that analysed and shelved the project when the economics didn't make sense show better business acumen than the company that at a later date could see a pot of gold and made the investment? In reality both companies missed the point, and the worrying thing is that most companies (and most likely your's as well) will continue to miss the point into the future. It was perfectly possible for both to enter into the project and to exit with a return somewhere between 15% and 35% depending on the company's appetite for risk.
How can you optimise your investment? Delivering a significant return from an energy and carbon saving investment is relatively straight forward: Identify the range of projects potentially available to your company Create simple evaluation models that can be updated regularly so that you know when market conditions might make such an investment attractive Once it looks like the investment could meet your company's minimum investment criteria move to a more detailed project evaluation and project plan Continue to evaluate the return on investment based on current market conditions until the investment decision is finally executed At this stage if you have entered into an energy and carbon saving project based on forward markets, it makes sense that you also need to sell some of these commodities at that time, to start to protect your return on investment You should not sell all at once to lock in all of the forward benefit but enter into the transaction in small tranches over time.
In essence you need to risk manage the return on investment of your project in exactly the same way as you manage the price risk of your energy and carbon procurement processes.
The 3 E's in a broader context It's ironic that many companies are considering energy and carbon saving investments now and relying on marketing and public relations benefits to justify them,when during the last two years such investments have been exceptional opportunities in their own right.
They just needed to be risk managed effectively.
The danger is that unless commercial behaviour changes, good investment opportunities in energy and carbon saving are going to continue to be forgone. If they are not risk managed then the pricing signals from those investments are not going to reach the market and the basis for future decisions will continue to be distorted.This will affect not just the bottom line performance of your company, but your company's impact on the world as a good corporate and environmental citizen.
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