10 Ways to Respond to the New Reality of Commodity Price Volatility

by Tusahr Narsana and Robert Zabors

Over the next few months, more and more consumers will wake up to sharply higher electricity bills. The primary driver of this increase will not be a populist theme like global warming or deregulation. The root cause will be an aspect of cost that has been traditionally ignored in the context of electric utilities, namely commodity prices.

The cost of commodities represents more than half of the cost structure of a typical utility. Commodities purchased include fuel, metals, chemicals and gasoline for power plants, transmission lines, distribution operations and vehicles.

Traditionally, companies preach a tough stance for their purchasing department to force vendors and suppliers to contain prices. In an environment of tightening global supply and consolidation, there needs to be a paradigm shift in dealing with this challenge. Utilities should form a coherent approach that involves key business leaders across the organization, and in many cases, a discussion with regulators.

With a common approach, there are several available options to control costs. We offer 10 ideas, based on experiences with leading utilities.

Shift from a procurement to a trading mindset

1) As the role of commodities becomes increasingly clear to management, and ultimately to regulators, there will be a variety of responses. Overall, there will be a shift from a procurement mindset to one of active management of costs and volatility. This mindset at utilities today is being applied to fuel and should eventually include higher volume metals and chemicals.

Review product designs and standards

2) Copper and ammonia are two of the commodities vertically integrated utilities purchase in large quantities. Lower-cost substitutes such as aluminum and urea can be considered with modifications to installation and use practices.

3) A re-evaluation of design standards can help identify opportunities and exposures to commodity price escalation and volatility. Typically, design standards are developed in-house with limited external participation. In this new model, suppliers will be equally or more concerned about the impact on their business models, thus opening a new window for collaboration. Utilities generally have internal engineering teams develop design standards. Suppliers are always willing to suggest industry standards with significant scale benefits and engineering teams should collaborate more often with suppliers. Higher and more volatile prices typically lead to innovation in any industry. Teams developing standards will have a wider set of options but also more uncertainty about the lifespan of assets–accelerated innovation can lead to shorter product life cycles.

Implement best-practice operational processes

4) Consortium buying is the collaborative buying of products among multiple companies. By aggregating volume, consortiums help stabilize the flow of goods and services for vendors across the value chain. Consortiums can be formed directly by utilities or indirectly through suppliers. The benefits of consortium-buying versus direct is a discussion with suppliers that should be evaluated.

5) Carrying inventory to maintain a high service level is important to operations. In a stable price environment, higher inventory levels lead to higher carrying costs. In an environment of scarcity and volatility, carrying excess can serve as a hedge against future price escalations. The balance between service levels, inventory carrying costs, and holding inventory on-hand should be identified. There may also be regulatory implications worthy of discussion in advance.

6) Unused materials or commodities removed from the warehouse are analogous to overpaying for a meal and not asking for the returned change. The change adds up over time and there are several innovative ways to recover. One utility saved more than $4 million with minor changes to business practices. (See sidebar.)

Consider a different use of common financial practices

7) Financial markets for major commodities are more liquid today. Hedging against major cost drivers has been successful for leaders in multiple industries. Evaluating futures contracts to mitigate price volatility has the potential to benefit both utilities and consumers. Regulators will need to be involved in the hedging process to ensure costs are recoverable.

8) In today’s historically low interest rate environment, the financial terms for leasing can be evaluated over outright purchasing. Leasing programs are more competitive, easier to administer and provide flexibility in deploying cash. With volatility and technological innovation at work, the flexibility of a lease has option value. For example, with new technologies in development, such as hybrid engines, the future value of cars and trucks is uncertain.

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9) Several utilities are exploring ways to source gasoline, lowering the price through aggregating both company and employee participation. It’s a benefit for employees and also saves money for company vehicles.

Address fuel volumes by reducing internal load/promoting energy efficiency inside the company

10) The equipment used by utilities offers some of the best opportunities for reducing energy use. Procurement decisions should factor in the efficiency (and in some cases the carbon impact) of equipment purchases. This pertains to equipment across the value chain, from large motors used in plants, to transmission and distribution transformers.

Given the global dynamics of these commodity markets, utilities cannot manage this changing environment on their own. The scope of the challenge and cost increases requires the involvement of multiple stakeholders–regulators, customers, shareholders, employees, communities and unions. These ideas often need broad-based support and upfront investment, even with solid longer-term benefits. Fortunately, due to the visible nature of commodities, these areas permit transparent tracking mechanisms that can be established to communicate value to all stakeholders.

Commodity price escalation is an increasingly visible fact of life. Companies that innovate while being pragmatic will succeed in managing their cost environment and in better serving their customers.

Authors

Tushar Narsana is a managing consultant at Bridge Strategy Group in Chicago. He can be reached at tnarsana@bridgestrategy.com or 312-541-8350. Robert Zabors is a director and leader of the energy practice at Bridge Strategy Group in Chicago. Contact him at rzabors@bridgestrategy.com or 312-541-8347.


Asset Recovery and Reclamation

1. Repairing and restocking goods, equipment and material in inventory for reuse. For example, a transformer that is not significantly damaged can be re-wound for later use. The utility used a quantitative computer model to help calculate the “tipping” point between when an asset should be repaired or recycled. Increased repair, net of repair costs, helped this utility offset the purchase of more than 1,000 transformers annually.

2. Recycling and reselling scrap metal. For example, copper and aluminum parts can be recycled through metals brokers. The utility placed several bins across warehouses and storerooms to collect unused equipment. A third party helped sort these bins and the salvaged scrap metal was sold at market prices, generating $250,000+ in annual income for the utility.

3. Reclaiming and reusing unused material. The utility encourages reuse and measures reuse on a separate income statement. Budget owners were given credits for reuse and annual costs avoided exceeded $1 million.

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