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Hedging protects against electricity price volatility

Juha Kansikas  ·  02 December 2021

Electricity prices have been volatile this autumn, and the discussion around the causes and effects of the recent price development continues to be active. Affordability of energy is essential for our societies, our industries, and our welfare. Concerns have been voiced about how industry can cope with the high prices – will they wipe out the profitability of industrial companies? The answer is no. Hedging is a widely used and very convenient way for businesses to protect themselves against energy price volatility and manage their energy price risks.

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What an exciting start for me at Fortum. I joined the company and the energy industry in early June; after the hot summer, we have witnessed quite a rollercoaster in the European commodity market. This has naturally offered a wild ride for the Nordic electricity market as well – even though the climb in Nordic prices was relatively mild compared to Continental Europe. When reading the news and talking with people in different contexts, people intuitively see industrial companies as suffering and energy producers as coining money when energy prices are high. However, that is not the case. It is all about hedging – i.e., protecting oneself against energy price volatility.

In essence, hedging means making an agreement that sets the price level for electricity for a selected time frame. For example, current power prices are higher than a year ago; companies that hedged their electricity purchases for this year already in 2020 are shielded from the cost increase. In practice, this means that if the price level is set, for example, to 30 euros/MWh in the hedging agreement, and the market price suddenly climbs to 50 euros during the agreement period, the agreement partner – for example Fortum – pays the difference. Consequently, the increased electricity prices are not reflected in companies’ results, nor do they need to shift the higher electricity cost into their product pricing.

Businesses typically love predictability – also when it comes to electricity pricing. Industrial companies that manufacture goods use large amounts of electricity, and price volatility makes it increasingly difficult to predict operational costs. This naturally affects business planning. Hedging helps companies reduce risks and maintain a clearer, more accurate future outlook.

All electricity retailers that sell electricity to consumers also need to hedge their electricity purchases. They want to keep their sales pricing stable and avoid risks that high price fluctuations can cause. Consumer customers may well switch to a competitor if electricity prices are too high or unpredictable.

Different trading options for different needs

Hedging can be carried out through a direct agreement – with Fortum, for example – or through a marketplace, such as Nasdaq commodities in the Nordics. Hedging through Nasdaq requires cash collateral and entails certain reporting duties, so trading bilaterally between companies tends to be simpler and less costly. Trading costs in the exchanges have recently gone up and liquidity has declined, so a solid counterparty for bilateral trading is often the most efficient way to carry out hedging.

A hedging agreement can be made for a selected time period that aligns with the client’s chosen strategy. It can cover years, part of a year, or even a single month or week. If, for example, an industrial company knows that there will be a peak in its electricity consumption during a certain month, it can prepare for it in advance by securing the price level. When we at Fortum make hedging agreements with our clients, we first make a frame agreement, which enables the client to trade bilaterally with us if and when they wish to do so. Under the frame, we can then make agreements for selected time periods.

Hedging is sensible risk management

Many industrial companies hedge a majority of their electricity purchases, simply because exposing the company to price volatility would be an unnecessary business risk. Of course, there may be times when prices dip and electricity is cheap, but the savings made in such times must be set against the unpredictability brought on by operating with spot prices and the risk of climbing price levels.

From the point of view of the energy company, hedging brings stability. Investments in electricity production are massive; exposing them all to volatile electricity price fluctuations would be risky. Energy companies, too, want to set a certain price level that they are guaranteed to get for their electricity production.

To sum up: although the current volatility of electricity prices understandably causes concern, the vast majority of industrial companies have protected themselves against these fluctuations. Hedging helps companies, including electricity retailers, maintain a balanced and predictable energy cost level.

Juha Kansikas

Juha Kansikas

Sales Manager
Trading and Asset Optimisation
juha [dot] kansikas [at] fortum [dot] com

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