One of the first steps for companies in developing a sound energy supply purchasing strategy is to identify their risk tolerance, business objectives, and budget constraints. These components can inform which energy pricing strategy is best for your company.
One strategy that balances budget risk with market risk is the block and index pricing model. To fully understand the appeal of this strategy, let's briefly take a look at two of the alternative approaches at either end of the market-budget risk spectrum: fully indexed pricing versus fully fixed pricing.
A fully indexed energy pricing strategy is one where energy pricing is 100% tied to spot market index pricing. While this method allows more flexibility by enabling the buyer to capitalize on market fluctuations, there is very little budget certainty.
Therefore, this approach is best suited for those customers who have a high risk tolerance and a low need for price certainty during their energy contract. It also requires that a buyer has enough ongoing bandwidth to manage energy pricing as the market moves, so as to fully take advantage of the flexibility of this option.
On the opposite end of the spectrum is the fully fixed energy pricing strategy. In this approach, a buyer locks in a set price for energy for the duration of a contract. In contrast to the fully indexed pricing strategy, fully fixed pricing has absolute budget predictability: buyers know up front exactly how much they will pay for energy costs for the duration of their energy contract.
However, the major disadvantage of this method is the risk that if energy prices fall, the customer pays more for energy use than what he or she would have paid on the open market. Additionally, customers typically end up paying a premium to the supplier to hedge the supplier’s market risk.
This approach is best suited for those customers who have a low risk tolerance and a high need for price certainty. Fully fixed pricing is good for customers whose main objective is reaching a set energy spend.
A compromise between a fully indexed strategy and a fully fixed strategy is the block and index pricing model. With this energy procurement approach, buyers purchase part, or a “block,” of their energy at a fixed price.
The remainder of their energy is purchased at spot market pricing. With this approach, customers have flexibility in what percentage of their energy is purchased in blocks as well as the duration/time of the blocks (specific options vary by market).
The appeal of this method is that it allows the buyer the flexibility to take advantage of market dips and layer in blocks, thereby enabling a certain degree of budget predictability. Furthermore, block and index pricing provides a pass-thru structure to allow customers to take advantage of demand reductions. This approach is ideal for those customers that need or want to mitigate market risk yet would still like to retain some price certainty.
Interested in learning more about block and index pricing? Read the next post in this series.