Energy Risk Management in Food Manufacturing
It will not surprise the readers of this publication that the trade is energy intensive. The BEA reports that the manufacturing of food, beverages and tobacco products (FBT) consumes around 15 percent of the total U.S. manufacturing energy inputs. In particular, food processors are second only to chemical companies in the non-durable goods sector in the use of thermal energy. The share of energy consumption has gone up steadily between 1997 and 2009, with the recent recession breaking this trend.
Energy productivity, the ratio between value-added shipments and total energy cost, is an important indicator for managers of food processing companies. Like all operating indices, managers expect this to be at standard, or even continuously improve. How can this be done without increasing risk?
I’m happy to report good news: In recent years much has changed on this topic, creating new options and strategic opportunities. Most readers will, of course, know about the natural gas boom, and the resulting supply glut has created low-cost thermal supply. Since natural gas and electricity are also closely related, electricity costs have come down for the last few years as well, although these are now going back up. But there’s more.
This year, the Southern Power Pool (SPP) is completing its ‘Integrated Marketplace’ initiative. The SPP is the last of the major Independent System Operators (ISO) to install accessible wholesale electrical energy markets (See Figure 2). These markets serve the preponderance of the populated sectors of the country, and provide structured access to wholesale electricity markets.
Wholesale markets differ from retail access in that there is no other ‘selling’ party. In a conventional energy supply chain, food processors buy the commodity from one company, then pay a local utility to transport the commodity to the point of use.
Figure 2, ISO regions in North America (isorto.org)
This is already an improvement over earlier years, when the local utility monopolized all energy supply. So when ‘choice’ was offered, most took it. Now there is yet another competitive option for cost reduction: transacting in wholesale markets.
Along with this opportunity comes risk, of course. Wholesale markets can be volatile beyond the normal demand-driven pricing cycles. For example, congestion or technical interruptions can drive electricity prices high — very high (see Figure 3). A sustained problem can create very large bills for companies choosing to purchase wholesale without suitable risk hedges.
There are two types of hedges to consider: financial energy hedges, which are essentially fees due to another entity that shoulders the risk, or a structural energy hedge. Structural hedges typically consist of generating assets that deliver energy at a set rate, allowing energy managers to arbitrage markets.
While hedges limit the cost downside, they don’t offer predictable costs. Food processors need to understand their pricing position per pound or gallon when distributing a product. This requires a clear accounting of the energy input cost. When accountants demand predicable cost accounting, energy purchasing managers pursue retail supply contracts at a locked-in price, which would only change every 12 to 18 months. The desired predictability results in higher than necessary prices.
Is it possible to enjoy wholesale price advantages while still understanding forward energy cost inputs? It absolutely is, and as a friend of mine likes to say, it’s simple, but not easy. If cost accountants would be willing to work with energy cost variance accruals, energy managers could deliver costs that are significantly below wholesale.
Structural hedges such as generating assets require a fuel input. Since these are hedges, the generating assets will not operate all the time, but only when wholesale prices exceed the generating asset price. This can be anywhere from 10 to 50 percent of production time.
If one accrues energy cost at the generating asset hedge value, the accrued cost variance will be negative, i.e., the actual energy cost will be less than the standard expected energy cost. Cost accountants must then periodically move this accrued balance into operating profits.
Food processing company managers would then be able to determine a standard unit energy cost derived from the price they pay for the input fuel of the generating asset.
For food processors in particular, that asset is likely to be a co-generator, which creates thermal and electrical energy simultaneously. This means about 80 percent of the energy content purchased creates added value, creating an instant drop in unit energy costs over conventional retail contracts. Make the co-generator a structural risk hedge, and the financial performance of the generating asset dramatically exceeds that of a conventional base load co-generator.
With this approach, a little more planning, and guidance, food manufacturing managers can improve energy productivity with a 15 to 20 percent energy cost reduction over already low industrial retail rates — a result well worth the effort.