Managing Complexity – A Reevaluation of Energy Procurement Strategy
Spend Matters welcomes another guest post from Joel Johnson of GEP.
There are few areas of corporate spend that invites as much fierce debate in strategy as the area of energy. The sheer number of purchasing mechanisms and strategies available can be overwhelming, and the advice of consultancies and subject matter experts is often contradictory. The combination of electricity, natural gas, and fuel oil is frequently one of the top five areas of indirect spend, and some organizations with energy-intensive manufacturing processes build energy expenditures into standard costs. Such a critical and complex category requires a clearly defined management strategy that is flexible enough to evolve with changing internal and external conditions.
The spectrum of options between highly active and highly passive management dictates the time and resources that companies invest in managing their energy spend. On one end of the spectrum, some firms employ teams of 20+ individuals focused on rapidly responding to market movements by using advanced purchasing techniques such as financial hedging. On the other end of the spectrum, some firms establish forward contracts to fix 100 percent of volume and price several years in advance. Other frequently used approaches include outsourcing energy portfolio management and strategic advisement to a specialized, third party organizations. Regardless of the approach, the strategy employed should be clearly in line with corporate objectives.
Internal evaluation – The first step in establishing or reevaluating energy procurement strategy is to define corporate objectives. This typically involves working with a senior leadership team comprised of representatives from finance and operations. This group should provide inputs on their perceived organizational risk tolerance and the importance they give to cost savings versus budget certainty. It is best practice for firms to reevaluate objectives derived from this exercise on a two- to three-year basis. Changes in leadership, corporate strategy, or manufacturing profile can substantially affect these objectives.
External evaluation – Once there is clear internal alignment on the commodity management objectives, the next step is to evaluate the procurement options available in the marketplace. Here are a few key factors to take into account:
- Regulation status – The regulated or deregulated status of a geographic region by commodity type will have a major effect on energy strategy. Deregulated markets present a greater number of purchasing options, while regulated markets require a degree of ongoing monitoring to ensure readiness for any mandated price adjustments or future changes in regulation status.
- Macro trends – There is no purchasing strategy that has consistently produced the lowest cost as compared with spot prices over a period of more than 10 years. Therefore, it is in an organization’s best interest to evaluate strategy within the context of overall market conditions, taking into account macro trends that contribute to long-term increases or decreases in market prices.
- Commodity differentiation – While electricity and natural gas prices are highly correlated, the purchasing strategies for each commodity should be clearly delineated given differentiation in the supply market, distribution networks, and storage options.
It is clear that energy presents a degree of complexity that sets it apart from most other areas of corporate spend. A structured approach to ensure strategic alignment on the front end will help prevent time-consuming and heated debates over strategy on the back end.
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