Managing Director & Senior Partner
Large industrial energy users have traditionally procured electricity under long-term, low-cost, fixed-price contracts. This approach has enabled them to minimize costs and maximize utilization over decades. But in the future, as variable renewable energy (VRE) becomes the main form of power generation, these same large energy users will be exposed to increasingly volatile electricity prices. In this environment, companies will need to find new ways to create advantage and maximize profits from their energy-intensive operations.
How can CEOs best navigate such volatile electricity market conditions? We think they can derive inspiration from asset-backed energy traders.
Asset-backed energy traders make money by operating assets with built-in physical flexibility to create value in markets with volatile input and output prices. Leading companies have started adopting the mindset of these energy traders, creating and accessing flexibility in their production processes to build a competitive advantage out of volatile electricity prices. This approach also has knock-on benefits for the broader electricity system, helping to manage demand peaks and congestion and allowing greater usage of renewable generation.
When we speak to companies about using electricity flexibly, many tell us that this approach is difficult. As well as physical process barriers to flexibility, they must make fundamental changes to their business models to overcome other barriers including organizational, contractual, and informational barriers. By examining how leading companies have solved these problems, we have identified a multistep approach so that other organizations can do the same. In short, they must secure physical flexibility in their assets and processes, expose the business to market fluctuations, rewire the organization to respond to external market signals, and use digital technologies to understand and respond to variability. This journey needs to be driven by the leadership and doesn’t happen overnight: companies start with small changes and over time make more fundamental changes in the way they operate.
Companies in energy-intensive industries have historically gained competitive advantage by sourcing a low-cost, around-the-clock supply of electricity, often from a nearby captive coal-fired or hydro generator. This allowed them to operate continuously and strive for a unit cost advantage by maximizing the utilization of their facility.
However, as electricity systems decarbonize, the penetration of VRE increases, and fossil fuel-powered generators exit, the level of volatility in electricity markets will rise. We are already seeing this effect in markets today. It has been most pronounced in energy-only markets with high renewables penetration like New Zealand, South Australia, and Texas. Other markets, such as those in Great Britain and in the EU, have experienced extreme volatility as a result of the current energy crisis. We expect that volatility will become more common in these markets even during more stable times.
In increasingly volatile electricity markets, companies will no longer have the option of contracts that are both low cost and fixed price. Consequently, the value of using energy flexibly is becoming far higher. Companies that can be flexible about when they use electricity—by using less when it is expensive and more when it is cheap, free, or even negatively priced—will be able to significantly lower their energy costs. South Australia is at the frontier of this trend and provides an example of the benefits of flexibility in the face of rising price volatility. (See Exhibit 1.)
In 2021, if a company located in the state had been able to avoid periods during the year when electricity prices were most expensive (which was about 20% of the time), it could have reduced the average electricity price it paid over the course of the year by more than 65% compared with companies that didn’t vary their electricity usage or were on fixed-price contracts. Taking this example to an extreme, a company in 2021 that used energy only when it was cheapest (about 55% of the time) would have enjoyed free electricity, on average.
Such market volatility changes how companies should operate electricity-intensive assets in order to maximize profitability. When companies treat electricity costs as a constant, they maximize profitability by achieving full utilization. By comparison, companies that operate in volatile electricity markets and use energy flexibly maximize their profit margins by operating plant at the optimal utilization rather than the maximum utilization. (See Exhibit 2.)
Nyrstar, an international producer of critical minerals and metals with a number of zinc smelters worldwide, is a good example of an energy user which doesn’t target 100% utilization. They have a clear view of the “value in use” of electricity in operating their plant and do not run the plant when the cost of electricity exceeds this, participating both in day-ahead and imbalance markets to optimize between electricity price and zinc production. This approach can also be relevant for other companies that operate assets where electricity costs are a large percentage of revenue. (See Exhibit 3.)
If we are moving to a world of high volatility, we might draw inspiration from organizations that profit in times of volatility: asset-backed traders. These organizations operate assets with physical flexibility in response to market conditions to create value in markets with volatile input and output prices. The “trader mindset” of an asset-backed trader differs fundamentally from the “producer mindset” of a manufacturing company. They treat their operations as a real option rather than just a production facility. This gives them the ability—but not the obligation—to produce depending on whether the market pricing at that time means the output is profitable.
Archetypal asset-backed energy traders include gas-fired power generators and oil and gas producers. Gas-fired peaking generators, for example, consider the decision to operate a particular plant as an option based on the “spark spread”—the difference between the revenue from selling electricity and the cost of burning natural gas to produce it. Similarly, many oil and gas companies have developed a trading business for their products and use the optionality in their physical production, refining, and storage facilities to capture the benefits of volatility. For example, by changing the crudes they process or the products they refine in response to market prices.
The trader mindset of an asset-backed energy trader is very different to the producer mindset of most energy users. Companies that adopt a trader mindset:
In general, the more energy users can become flexible and act like energy traders, the more value they can extract from volatile electricity markets. (See Exhibit 4.) There are two important caveats to this. First, energy users must ensure that any additional investments are justified by the value of the flexibility. And second, energy users should match their exposure to market prices to their ability to physically respond. True asset-backed traders are not taking unhedged bets on price evolution. Rather, their approach is to capture value from volatility using asset flexibility.
Adopting a trader mindset is far more than just providing demand response during critical moments in the electricity market. For example, a flexible aluminum producer with a trader mindset might treat its smelter as an option on the difference between aluminum and electricity prices. Instead of operating the smelter at a constant output independent of the market price for electricity, the company could increase production when electricity is cheap and reduce production when electricity is expensive. To achieve the same output over the long term with a lower plant utilization, the company invests in assets that are flexible and have a higher maximum production capacity.
This approach gives the flexible aluminum smelter the ability to create additional value similar to that of a virtual peaking generator. (See Exhibit 5.)
Like a peaking generator, the smelter can change production levels quickly and sell electricity back to the market. It bases the decision to alter production on the electricity price and its “fuel cost.” In the case of a real peaking generator, the fuel cost is the price of gas; in the case of our smelter’s virtual generator, the “fuel cost” is foregone margin from aluminum production. As a result, the flexible energy user (the aluminum producer) can think about the electricity market in a similar way to electricity generators—as a source of value rather than a cost. The approach also tends to support the broader electricity system: by selling electricity back to the system at times of peak demand, or during congestion, companies can help reduce the impact of these events.
Traditional aluminum smelters are not flexible enough to operate in this way. But German aluminum producer TRIMET is an example of a company that has demonstrated a flexible smelter to manage electricity cost. TRIMET has invested in upgrades to improve the physical flexibility of a part of its smelter in Essen. This has included introducing new heat exchange and magnetic compensation technologies, as well as better process simulation and controls. This combination of technologies allows TRIMET to vary the smelter’s electricity consumption and aluminum production in both directions by up to 25% (whereas typically the limit is less than 5%) for extended periods (targeting up to +/-1000 MWh for a 100MW smelter, rather than the +/-100 MWh capacity for a typical smelter) based on the electricity price.
Companies that we’ve spoken to about flexible energy usage tell us it’s hard. The biggest obstacle to flexibility is, in the first instance, moving away from the producer mindset. But beyond changing the way they think about their operations, there are four practical actions that companies can take to systematically address barriers to flexibility.
Secure Physical Flexibility in Assets and Processes. Constraints arising from asset design, technologies, and processes can restrict physical flexibility. These can be due to inherent limitations in the process or with equipment, which is the case with old, inflexible assets, or the requirement to manage for specific criteria (such as quality and safety). But they can also be due to a lack of understanding about process limits (especially for old equipment) and inflexible upstream or downstream processes (which can lack the ability to stockpile sufficient products and input materials, for example).
To overcome these challenges, leading companies take the following actions:
UPM, Holmen, and Oz Minerals illustrate ways to tackle these barriers. (See sidebar, “Overcoming Physical Barriers.”)
Expose the Business to Market Fluctuations. Many companies have contractual or market arrangements which protect their business from volatility but, in doing so, prevent them from creating value from flexibility.
Electricity supply arrangements or constraints caused by existing market structures can limit companies’ exposure to price variability. These include fixed-rate electricity contracts, the absence of an electricity market in some regions, restrictions on demand-side market participation, or very low caps on prices in wholesale electricity markets (for example, as part of a capacity market arrangement). Constraints can also take the form of barriers to participating in the full range of electricity markets to monetize the value of flexibility, such as restrictions on energy users participating in frequency or reserve markets.
Inflexible offtake contracts and supply contracts for key materials, such as fixed volume or take-or-pay arrangements, can also be a major barrier to flexibility.
To overcome these challenges, leading companies take the following actions:
Holmen, Google, Nyrstar, and Nobian illustrate ways to tackle these barriers. (See sidebar, “Overcoming Contractual Barriers.”)
Rewire the Organization to Respond to External Market Signals. An organization’s existing capabilities, structures and processes can prevent companies with dynamic input costs from using energy flexibly. These limitations can start with not having the required capabilities or expertise in energy markets and trading. In many cases, the capability does exist, but the relevant individuals are not involved in day-to-day decisions regarding operations and product sales. Furthermore, performance incentives tied to production targets rather than profitability and long lead times in the production planning process can hamper flexibility.
To overcome these challenges, leading companies take the following actions:
SA Water and UPM illustrate ways to tackle these barriers. (See sidebar, “Overcoming Organizational Barriers.”)
Use Digital Technologies to Understand and Respond to Variability. Companies without the right information and control systems struggle to make timely decisions or respond to market volatility, exacerbating the other barriers to flexibility they encounter. In short, physical flexibility can be inhibited by needing to use manual processes to control assets. Organizational flexibility can be held back by a lack of visibility over production data or insufficient information about the tradeoffs involved in reducing energy costs. Meanwhile, contractual flexibility can be hampered by a lack of visibility over electricity market prices, and prices and volumes for key inputs and outputs.
Fortunately, new technologies, such as smart meters, advanced analytics, and automated process controls, are increasing energy users’ ability to address these barriers.
To overcome information and control barriers, leading companies use digital tools to:
Nyrstar, Google, TRIMET, and Flexcity illustrate ways to tackle these barriers. (See sidebar, “Digital Enablers in Electricity Planning.”)
Companies that successfully develop a trader mindset transform all aspects of their business to become more flexible, a process that often takes years. UPM is an example of a company that has taken this journey and today embodies the trader mindset. (See sidebar, “Embracing the Energy Trader Mindset in Pulp and Paper Manufacture.”) Although the process starts with small changes, companies move on to make fundamental changes in the way they operate.
What are the initial steps that companies can take? To start with, CEOs should ask themselves these five questions:
As more and more electricity systems achieve high penetrations of VRE, companies are becoming exposed to significant levels of market volatility. Although it is tempting for energy users to maintain a producer mindset toward their electricity supply and contract away the risk from electricity price volatility, this approach comes at a premium. Today, leading companies are adopting a trader mindset to create competitive advantage from volatility while benefiting the broader electricity system. To do this, they are transforming their whole business to overcome barriers to flexibility. This involves not just their physical assets but also changes to their contracts and organizational set-up and the use of digital tools. Adopting a trader mindset is not easy or quick, but the rewards for leaders who are bold enough to transform their business around flexibility are substantial.
The authors are grateful for the exchanges with the representatives from the companies referred to in the article. The authors thank BCG’s Antti Belt, Christophe Brognaux, Jonas Geerinck, Frédéric Geurts, and Marc Schmidt with whom they have exchanged ideas during the preparation of this publication. These rich and engaged discussions have allowed the authors to push their thinking further. The authors also thank James Merabi for his contributions. They are also grateful to Matthew Fletcher for writing support.