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Improving Energy Costs in a World of Diminishing Returns

The energy side is often overlooked when trying to optimise costs and improve operational efficiency, which is surprising as, in some cases, energy (gas and electricity) constitutes up to 30%-40% of the overall operating costs (e.g. cement industry). In some industries, this is a company’s second biggest cost. The main goal of cost optimisation is, naturally, a margin increase. It will, in turn, increase the ROCE and valuation of your business, amongst other benefits.

I have talked about the significant leverage of savings on energy costs in my previous post. In this post, I will focus on the different layers of your energy budget as it is becoming less relevant to mitigate the commodity component of the energy costs. We will soon see the commodity element reach 30% of the overall energy costs whilst the remaining 70% will be the non-commodity elements (network and policy/green legislation costs). Just a few years ago, this split was 80%/20% (commodity/non-commodity). Your stakeholders, however, are unlikely to be interested in the details around that increase of the non-commodity element and the associated loss of mitigating power of your energy budget. They are interested in savings of the operational costs, increasing margins, returns on assets, and capital employed. I will, therefore, review the dimensions to look at to reach further savings within your energy budget.

Law of diminishing returns

The UK shift to the low-carbon economy is taking place through increasing policy costs with the raft of existing and new legislation. These (non-commodity) costs are regulated. Therefore, the mentioned increases cannot be mitigated and need to be factored in when reviewing the company energy budgets.

The graph provided illustrates the law of diminishing returns and shows that it will become more and more challenging to lower energy costs.

That said, we need to be prepared that non-commodity costs will constitute the largest portion of the energy budget. If in 2015, when the commodity wholesale price dipped by 10%, it translates into a 4.5% saving on your energy budget. This is because the commodity element was 45% of the overall energy cost. In the near future, the share of commodity element is anticipated to fall and constitute 30% of the costs, meaning 3% saving on our overall budget if the commodity market tumbles by the same 10% from the benchmark.

Peeling the onion  

I will now review different angles of your energy budget to scan for the savings’ potential, literally peeling the onion of your costs. Here are three elements we can evaluate

  • Price risk mitigation – smart procurement

In the fixed contract framework, price risk mitigation does not end at identifying the most favourable time to enter the market. The duration of the contract must also be reviewed. For example, in current market conditions, you can enter a 12-month framework and take maximum saving. In this case, with absolute certainty, you will face a cost increase upon renewal. Alternatively, you can strategically extend a renewal for 24 or 36 months, ranging the effect of the savings and hence alleviating the pain of the cost increase. In a flexible contract framework, risk mitigation is used to achieve the best average price.

  • Consumption timing – demand-side management

Paying premium prices during peak hours can be avoided by shifting your production to a different time, hence changing the time of consumption. The potential of the financial savings here is striking, yet this layer is also more complex to analyse and imbued with challenges. For instance, the energy costs might be reduced whilst some payroll costs might go up with more expensive night shifts. A thorough analysis is, therefore, essential.

  • Consumption – behavioural change

This is your chance to contribute to the shift to the low-carbon economy. The motivating factor once again is the financial savings through behavioural change. Here we talk about the volume decrease with the same production output, i.e. investing in more efficient technologies and reviewing the energy consumption patterns with a view of finding and removing inefficiencies.

Pulling all three elements together gives you an overall perspective of your energy costs and documents the space for manoeuvring in a cost-saving world of diminishing returns as the increase of the non-commodity elements lowers your mitigation power. In the unlikely event of not finding additional savings, your stakeholders will have confirmation that your processes are efficient, run to the best standards, and that you are a proud contributor to the emerging low-carbon economy.

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Inese Dose

Senior Analyst at Alfa Energy
Inese has been with Alfa Energy for three years, having been in the industry for five. She has been instrumental in creating and developing the flexible procurement and risk management functions at Alfa. As a Senior Analyst, she regularly provides the business with market briefings as well as managing procurement and risk for Alfa’s pan-European clients. Currently, Inese manages gas and power contracts across France, Belgium, Germany, Spain, and the Netherlands. She is completing her MBA in Global Energy at Warwick Business School.

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Inese Dose

Inese has been with Alfa Energy for three years, having been in the industry for five. She has been instrumental in creating and developing the flexible procurement and risk management functions at Alfa. As a Senior Analyst, she regularly provides the business with market briefings as well as managing procurement and risk for Alfa’s pan-European clients. Currently, Inese manages gas and power contracts across France, Belgium, Germany, Spain, and the Netherlands. She is completing her MBA in Global Energy at Warwick Business School.

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