Forward Curves: Why they matter to energy cost managers
Updated: September 27, 2019
Forward curves and the insight they can provide should be an essential decision making tool to any energy manager. Unfortunately, due to the opacity of energy markets and the energy industry, decision makers rarely have access to their own set of pricing and energy cost data. In the following post, we talk about why forward curves are an essential tool for every energy manager.
We originally published this article in 2016. It is just as relevant today and is worth re-posting.
This article is the next in a series in which we answer energy cost management questions asked by customers. You can find other articles in this series here. In prior posts, we’ve answered questions about how index costs compare to fixed costs. We also covered a series of questions about invoicing and billing.
Why do I care about forward curves? How do they impact me and my business? What is a forward curve anyway?
The short answer is that you don’t have to care (much) about forward curves – unless of course you want to either (1) fix the cost of your energy supply over some contract period or (2) if you want to try to get a market-based forecast for budgeting purposes. The long answer is, well, a little longer. Here it goes:
Energy buyers in deregulated markets are making purchases in a specialized commodity market, whether you they know it or not. Your utility can no longer provide you with a fixed supply price, only independent suppliers can. In these markets you — the energy customer — either have to take supply from your utility (which is either at an index or an auction-based price), or you have to navigate the energy commodity market in your state or region. The participants in this market will use forward curves often in determining risk and reward trade-offs over time. The point is, since you are operating in a commodity market, you need to get an understanding of forward curves and how they impact you.
Let’s start with the basics.
Definition of Forward Curve
According to Platt’s article “A Look Forward – Understanding Forward Curves in Energy Markets”
“the term “forward curve” refers to a series of sequential prices either for future delivery of an asset or expected future settlements of an index.”
Take a look at this graph from the MWh’s dashboard. The horizontal axis represents time from (in this case) September 2018 through September 2019. The vertical axis represents wholesale on and off peak power costs in $/MWh. This graph represents the way that a 12 month “strip” of wholesale power has changed between last September and this September. ‘
So each spot on the curve represents the wholesale on peak (blue) or off peak (orange) average cost of energy for the next 12 months (Sept’19- Sept ’20). On this graph, you can think of the “curve” part of the forward curve as the lines you see here connecting a series of fixed (i.e. known, established, agreed-upon) prices for exchange (purchase or sale) of power for Sept ’19 through Sept ’20. The graph is essentially a curve of the curve– showing how those forward prices have changed and moved over time. These lines represent a schedule of fixed prices that you can rely on for future purchases or sales of the asset – hence “forward.”
How do forward curves impact me and my business?
Forward curves are important to you for 4 reasons. (We originally describe 3 reasons to focus on forward curves, then one of our readers added a 4th.)
Price quotes. Your supplier will use a forward curve when providing you with a quote for power or gas. Any fixed component of your power or gas purchase will be based on the supplier’s view of the market cost of that energy supply at different points of time in the future. This view is, in effect, that supplier’s forward curve. Presumably, the curve is an indication of what it will cost that supplier to commit to a fixed purchase on your behalf.
In very active, liquid markets (for example, in certain interest rates and foreign currency exchange) there is so much trading that involves points of time in the future that all market participants share a very similar forward curve. Most energy markets that serve retail customers, however, are not as liquid or as actively traded. There may be meaningful differences between the forward curves of different suppliers. As an energy customer, these differences can result in more or less favorable terms for your fixed price energy supply.
Budgeting. In order for you to develop a reasonable budget, you will need to try to determine the cost to supply any part of your gas or power needs that are not fixed at any given time. Many buyers just use last year’s costs as a proxy for next year. This approach is not a reliable way to determine your costs into the future. Fixed prices, delivered to you by your supplier through their forward curve, can remove some uncertainty from this process.
Risk management. Energy markets impact your operation, no matter where you are in the buying cycle. As you run your operation, it is important to understand forward price dynamics. Looking at forward pricing (based on forward curves!) is the only way to determine the impact of market changes on your operation, even if your energy contracts still have months before they expire. Keeping an eye on the forward curve can signal to you how and whether to change or correct your energy cost management strategy.
And… here’s a fourth reason that MWh friend and colleague Nick Hill mentioned in the original comments on this article:
Power Purchase Agreements for cogeneration and renewable energy. Nick says:
I have seen so many PPA’s that were presented to customers with criminal assumptions regarding energy cost inflation. Too many good plant engineers will scrutinize technical assumptions but then swallow a vendor’s assumption that grid prices will rise by 4.5% annually for 20 years.
MWh Methodology: The MWh uses published indices to develop our proprietary forward curves. We believe, like Platt’s does, that transparency is key. Our methodology is open, transparent and available to clients who want to understand client-specific forecasts. We build our curves using the methodology that suppliers and the broader market also employ. We know because of our experience working with suppliers in our previous careers.
Bottom line for businesses and energy buyers: Make sure you understand the impact of markets on costs and budgets; insist on transparency of methodology and data. Forward pricing will impact your operation. This is true no matter whether you choose to remain on utility services or opt to buy from a retail provider.