Risk hedging against the fuel price fluctuation in energy service business

doi:10.1016/j.energy.2007.05.003

Energy

Volume 32, Issue 11, November 2007, Pages 2051-2060

https://doi.org/10.1016/j.energy.2007.05.003 Get rights and content

Abstract

Energy service business, or energy service company (ESCO), is expanding among industrial users as a means of energy saving. The ESCO business normally tends to become a long-term operation. During the operation, fluctuations of fuel and electricity costs significantly impact on the stability of the profit from ESCO business. Therefore, it is essential to reduce the risk of fuel and electricity cost fluctuations. Generally, a transaction called “financial derivative” is used as a measure of hedging against the fuel price fluctuation. In the case of ESCO business, it is necessary to manage the risk of both electricity and fuel price fluctuations because the variation in electricity price strongly affects the profit from ESCO as that in fuel price does.

In this paper, the stabilization of the ESCO profit using financial derivatives was discussed by quantitative analyses of the actual data from existing plants. Case studies revealed that the appropriate volume of the fuel derivative implementation was less than a half of the fuel consumption at the ESCO facilities, and it ranged from 5% to 50%.

Introduction

Over the past several years, the energy service business, represented by Energy Service Company (ESCO), has been rapidly expanding among industrial users in Japan as a means of saving energy [1], [2], [3]. According to the statistics issued by Japan Association of Energy Service Companies (JAESCO), the energy saving market was estimated as 49.7 billion yen (approximately 400 million dollars) in the fiscal year 2005, including 30.3 billion yen (approximately 250 million dollars) of performance contracts for energy conservation [4]. In Japanese ESCO market, the industrial sector accounted for 74% of the amount of order of the performance contract in FY2005.

The international and regional surveys on ESCO industry have been published elsewhere. Vine [5] conducted a survey of ESCO industries in 38 countries outside the US. The total amount of ESCO activities in those countries was calculated as between 560 and 620 million dollars. The ESCO industry in the US was analyzed by Goldman et al. [6]. The estimated ESCO market in the US was 1.8–2.1 billion dollars in the year 2000. From their analysis of about 1500 ESCO projects, it was found that 73% of the sample was in the institutional sector, such as government, educational facilities, hospitals and public housing. It was also revealed that the improvement of lighting efficiency was the most prevailing measure for energy savings irrespective of sectors. The ESCO activities in Europe were surveyed by Bertoldi et al. [7]. In European countries, cogeneration, or CHP, has been one of the most common ESCO projects. Painuly et al. [8] analyzed ESCOs in developing countries. The barriers to the spread of ESCO and the financial mechanisms were discussed in the paper.

Our research focused on the ESCO projects that install cogeneration systems as one of the main facilities in the industrial sector. About one third of the ESCO project examples of factories, which have been reported to JAESCO, embrace cogeneration facilities [9]. The ESCO contract was assumed as the shared savings type, which accounted for 88% of the performance contracts made in Japan in FY2005. In the case of shared savings contract, the ESCO operator finances the project and owns the energy saving facilities at industrial user's site. The contract period can be as long as 20 years. The Japanese users and ESCO operators, however, prefer to make a contract period as short as possible. In many cases in Japan, the ESCO contracts last around 10 years because of the payback of the investment. Such a long contract involves the risks of fluctuations in fuel and electricity prices as well as in the utilization rate of factories.

Especially in the case of ESCO plans that install cogeneration systems as main facilities, the fuel cost accounts for a large percentage of the total operational cost. Therefore, the mitigation of fuel price fluctuation is essential for the ESCO business to be profitable. The profit from ESCO business also is influenced by the fluctuation of the market price of electricity, which varies concomitantly with the market price of fuels. There is, however, no example of business operations using derivatives that cope with the fluctuations of both fuel and electricity prices.

In the paper, the stabilization of the profit against the fluctuation risks of fuel and electricity prices was investigated by case studies of actual plants currently in operation. Speaking generally, the objective of business is the maximization of profit. Under the volatility of prices, however, the maximization of the profit accompanies a high risk. The stabilization of profit is valuable for users, as well as for ESCO operators, from the viewpoint of the acceptability of the ESCO projects. The strategies to fix the fuel cost using fuel derivatives were quantitatively analyzed, and the optimum amount of the fixed fuel for ESCO facilities was revealed.

Section snippets

ESCO and the fuel price fluctuation risk

ESCO guarantees energy savings for a long-term period to users. The user and the ESCO operator share the cost savings in the case of the shared savings type of ESCO. In addition to that, ESCO itself can provide the mitigation of energy price risk for users because the larger the energy cost reduction is, the less exposure to the fluctuation of energy cost is.

Fig. 1 shows the concept of the shared savings type of ESCO and the constitution of the annual operating cost. In the case of our study,

Fixing the fuel cost by fuel derivatives

Fuel derivatives are measures of risk hedging against the fuel price fluctuation that would cause a shrinkage in the ESCO Merit. It is possible to fix the unit price of fuel in the long term using fuel derivatives.

One of the most popular fuel derivatives in Japan is the Japanese Crude oil Cocktail (JCC) swap. The JCC index is the average import CIF (Cost, Insurance and Freight) price of crude and raw oils. It is published every month by the Ministry of Finance Japan.

An explanation of the fuel

ESCO Merit Analysis Tool

The authors developed the ESCO Merit Analysis Tool to support the determination of the term and the conditions of the swap contract. The tool facilitates the quantitative analysis of the ESCO Merit variations depending on scenarios of future fuel price fluctuations.

Case studies on the fixing strategies of fuel price

Case studies were carried out using actual ESCO operational data. The stability of the ESCO Merit excluding fixed expense in ESCO operating expense, which is equivalent to the first four items in Eq. (1) and hereafter called “Variable ESCO Merit”, was analyzed using the ESCO Merit Analysis Tool. In order to examine the appropriate unit price fixing strategies in different ESCO types, four examples from different business categories, which have different heat to electricity demands ratio, were

Conclusions

The future market price of fuel is not predictable because the fuel market is dependent not only on the supply and demand balance of fuel but also on uncertain conditions such as political and economic situations. Therefore, fuel derivatives are useful to reduce the risk of fuel cost fluctuation.

In the study, the stabilization of the profit from ESCO was discussed and the optimum fixed ratio of fuel for ESCO facilities was found using the ESCO Merit Analysis Tool developed by the authors. The

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Risk hedging against the fuel price fluctuation in energy service business

Abstract

Introduction

Section snippets

ESCO and the fuel price fluctuation risk

Fixing the fuel cost by fuel derivatives

ESCO Merit Analysis Tool

Case studies on the fixing strategies of fuel price

Conclusions

Energy Policy

Energy Policy

Energy Policy

J Cleaner Prod