Everything you need to know about hedging strategies18 May 2023
An effective energy procurement strategy requires evaluating the many strategies and contract types available to your company. Each will have its advantages and drawbacks. Choosing the best fit for your business can save thousands of dollars and offer you financial peace of mind. The savings can make it well worth spending time evaluating your options or working with an energy procurement company that can help you understand the available plans. For many organizations, that analysis will lead them to a hedging strategy.
What is a hedging strategy?
With a hedging energy strategy, also known as “layering,” you lock in a fixed energy rate for a portion of your use. This is the first layer, or hedge, of your billing. No matter the current market rate, you pay the set price for that part of your use.
Your remaining consumption is billed at a floating rate, which is tied to current market prices. The cost for that portion of your energy will fluctuate. You will also be able to lock in additional fixed-price layers over the course of your contract so that your overall cost is comprised of multiple layers of fixed costs and some portion of the floating market rate.
Why should I consider a hedging strategy?
A layered approach offers protection against energy price fluctuations. By fixing the price for some amount or percentage of your energy consumption, you avoid huge rate spikes. You may not pay the absolute lowest price for all of your energy all the time. However, you aren’t fully locked into a high rate if prices drop after you sign your contract because a portion of your bill will be at the lower rate. Fortunately, you are still protected from massive increases because the fixed portion of the strategy provides stability. The layered approach balances budget predictability with pricing flexibility, offering you the best of both worlds.
Hedging strategies’ key benefits include:
Energy cost transparency
Your business is not wholly subject to the whims of the changing energy market. By managing how much of your estimated use you choose to hedge, you control how much of your bill you can predict. Think of this like putting guardrails on your energy expenses. You may not know the exact amount every month, but the variations will be controlled. If you want more control, you can move those guardrails in closer. If you are willing to accept more risk, you can leave them further out by fixing the price on less of your overall use.
The ability to leverage price dips while limiting your risk
Without a fixed-price hedge, you may see huge swings in your energy bill. If market rates increase dramatically, you have no protection against massive increases. With a hedged strategy, you have the fixed portion of your contract to act as a ballast by providing stability. The floating portion then allows you to take advantage of rate decreases.
The option to convert to a fixed price at any time
If prices drop enough that you feel confident locking in that rate permanently, your contract will allow you to fix 100% of your energy costs.
Types of hedging strategies
If you want the strategy that provides the most opportunity to react to changes in the energy market, managed hedging might be for you. With an active, managed hedging approach, you establish price and time-based triggers in your contract. That enables you to lock in multiple price blocks in response to pre-determined milestones in either costs or time.
Block and index
A block and index strategy allows you to set a fixed price for a set amount, or “block,” of your energy use. Any use beyond that blocked amount is billed at current market rates. You can start with 100% of your bill at the index rate and set blocks as you move through the duration of your contract. Or, you might start with a hedge in place and execute additional blocks as desired. Prices are down; you can establish a hedge. They drop some more; you can lock in another layer at an even-lower price.
This option is typically best for businesses with stable, predictable load usage.
Load-following block and index
This option is similar to the traditional block and index concept. However, instead of a fixed rate on a specific amount, you fix the rate on a set percent of use. That hedged percentage of your energy use stays at a fixed rate, despite fluctuating consumption. That makes a load-following block and index strategy ideal for organizations with inconsistent use, which might make determining how much energy to hedge a challenge.
Running a business is full of risk; a hedged approach to your energy procurement eliminates one of those stress points by providing stability and predictability to your energy expenses. That allows you to spend your energy and money growing your company instead of worrying about your next electric bill.
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