Global Energy & Materials

Five levers to optimize energy

spent and risks for industrials
Optimizing energy procurement and risk management in a volatile energy market is
key to staying resilient.

by Martin Bohmert, Xavier Bosquet, Alvaro Gonzalez, and Xavier Veillard

© Getty Images

July 2022
 The currently volatile energy market has placed pressure on all sectors of the economy, including
industrials. Managing the associated cost and risk challenges requires a comprehensive approach to
optimizing energy procurement.

This article sets out the case for proactively managing energy costs and considers five key levers to help
achieve energy sourcing optimization and risk management. These could complement companies’ energy-
efficiency measures across their assets. By acting across these levers, industrials could reduce their energy
costs by an estimated 7 to 10 percent and ensure their long-term resilience to energy price volatility.

The case for action

International energy prices have increased significantly and have seen persistent volatility. From 2019 to
present, international prices for both LNG and coal have tripled, while oil prices have doubled (Exhibit 1).

Exhibit 1
Prices surged globally across all major commodities in 2021
Prices surged
with some globally across
backwardation all major
expected commodities
in forward curves.in 2021 with some
backwardation expected in forward curves.

Oil (Brent & WTI) Coal (API2) LNG (JKM) & Gas (HH)
Monthly average oil international prices Monthly average coal international Monthly average natural gas wholesale
as of May-2022, $/barrel¹ prices as of May-2022, $/ton¹ and LNG international prices as of
May-2022, $/mmbtu¹
Brent (Europe) WTI (US) Average API 2 (Northwest Europe) Average Henry JKM Average
2016-2021 2016-2021 Hub (US) (Northeast Asia) 2016-2021

120 400 40

350 35
100
300 30
~2x
80
250 25
~3x ~3x
60 200 20

150 15
40
100 10
20
50 5

0 0 0
2016 2018 2020 2022 2024 2026 2028 2016 2018 2020 2022 2024 2026 2028 2016 2018 2020 2022 2024 2026 2028

¹ Historical data: daily wholesale average prices computed into a monthly basis; forecast data: monthly data as of 2022.05.09.
Source: McKinsey analysis

2 Five levers to optimize energy spent and risks for industrials

In Europe in particular, power and gas prices have seen significant surges and volatility (Exhibit 2). In the
first quarter of 2022, for example, the average month-ahead price for wholesale gas surged above €120
per megawatt hour (MWh)—six times the historical average. As European power prices are heavily linked
to wholesale gas prices, the prices of both commodities tend to increase in parallel.

On top of the uncertainty brought on by increases in energy prices, decarbonized sources of energy
are becoming more competitive as increasing CO2 emissions place an additional burden on fossil-fuel
generation. In this light, contracting renewable energy via power purchase agreements (PPAs) appears to
be a likely mitigation strategy for price increases.

Exhibit 2
In Europe, power
In Europe, power and
and gas
gas prices
prices have
havebeen
beensubjected
subjectedtotounprecedented
unprecedented
volatility.
volatility.

European gas (TTF, NGC, TRS) European power (EPEX FR & GR) European emissions (EUAs)
€/MWh, monthly average wholesale price €/MWh, monthly average wholesale price €/ton, monthly average EU ETS wholesale
as of May-2022¹ as of May-2022¹ prices as of May-2022¹

France Germany Average Germany France Average EUA Average

Netherlands (TTF) 2016-2021 2016-2021 2016-2021

140 600 110

130 100
120 500

100 80
400
80 60
~6x 300 ~4x
60
40
200
40
~4x
20
20 100

0 0 0
2016 2018 2020 2022 2024 2026 2028 2016 2018 2020 2022 2024 2026 2028 2016 2018 2020 2022 2024 2026 2028

¹ Historical data: daily wholesale average prices computed into a monthly basis; forecast data: monthly data as of 2022.05.09.
Source: McKinsey analysis

Five levers to optimize energy spent and risks for industrials

3
 An additional characteristic of the structural changes in the European power market has been the strong
evolution of intraday price amplitudes. Due to the growing share of renewables, the increasing scarcity
of dispatchable power, and peak demand from increased electrification rates in industries, buildings, and
transports, intraday price amplitudes have achieved record highs over the past year (Exhibit 3). For example,
in March 2022, intraday price amplitudes reached over €400 per MWh—nine times that of 12 months prior.

Exhibit 3
The hourly volatility of electricity prices also increased sharply, driven by
The hourly volatility of electricity prices also increased sharply, driven by
renewables’ outputs and dispatch power shortages.
renewables’ outputs and dispatch power shortages.

EEX day-ahead spot prices 08.03.2022 07.10.2021 30.09.2021 07.04.2021

(selected dates in 2021) €/MWh
Maximum daily amplitude
700

600

500 ~405

400

~210
300
~9x

200

~210
100 ~50

0
12am 5am 10am 3pm 8pm Daytime

Source: EPEX SPOT Market Data; McKinsey analysis

4 Five levers to optimize energy spent and risks for industrials

For industrials, production costs have increased substantially due to rising energy costs (Exhibit 4).
Energy-intensive sectors, such as aluminum and ammonia, have seen an increase in their overall cost base
of more than 100 percent, given the high weight of energy costs. The current energy prices environment
creates new cost- and risk-management challenges, as the share of energy in players’ costs is an essential
threat to their competitiveness.

Furthermore, several industrials face challenges in passing through price increases and the associated
margin-compression effect. For risk management, key challenges for industrials include the ability to
hedge or pass through energy-price risks, the capacity to sustain liquidity requirements for margin calls
(such as initial and variation margins), and the ability to run recurring stress tests on the impact of higher
prices on the balance sheet and treasury. Overall, this calls for industrials to proactively manage risks and
energy costs.

Exhibit 4
Production costs have increased substantially for industrials due to rising
Production
energy costs.costs have increased substantially for industrials due to rising
energy costs.

Sector Typical production cost structure¹, index (historical = 100)

100 +123%
Aluminum
Historical 20 21 22 23 24 2025
2016-2019

100 +166%
Ammonia
Historical 20 21 22 23 24 2025
2016-2019

100 +95%
Glass
manufacturing
Historical 20 21 22 23 24 2025
2016-2019

100 +65%
Iron and potash
mining
Historical 20 21 22 23 24 2025
2016-2019
100 +33%
Copper, nickel,
and zinc mining
Historical 20 21 22 23 24 2025
2016-2019

¹ EU industry average.
Source: US Department of Agriculture; McKinsey analysis

Five levers to optimize energy spent and risks for industrials 5

 Five levers to optimize energy spent
Industrials have an opportunity to optimize their energy spent through five industrial levers.

— Systematic energy-hedging management: Continuously optimizing hedging approach based on,

for example, daily exposure calculations to energy prices, actualized forecasted volumes (including
optionality in consumption profile), and pass-through capacity to clients.

— Structured power-purchase-agreement contracting: Contracting long-term electricity supplies (for

example, baseload or as-consumed PPAs, which can last for seven to 20 years) for part of the power
consumption (virtual or physical).

— On-site generation optimization: Developing on-site generation assets for heat and power—such as
biogas-combined heat and power plants (CHPs) or small-scale photovoltaic (PV) solar—with the option
of having them operated by third parties.

— Contracting optimization: Considering renegotiating gas and power supply agreements (such as the
price indexation formula and markup, flexibility terms, or nominations processes) for all energy supply
contracts across countries.

— Demand-side response: Rolling out peak-shaving schemes and exploring their ability to interrupt
demand to reduce consumption in high-price moments. Grid operator remuneration schemes could also
offer additional compensation.

Case study: A steel manufacturer’s strategy to optimize energy procurement and maximize
renewable energy

The use of these five levers holds the potential to optimize energy spent for industrials. For example, a large steel manufacturer
recently detailed its net-zero strategy in which sourcing renewable energy was a critical lever. Renewable energy currently ac-
counts for 8 percent of its energy matrix, yet the manufacturer aims to achieve 25 percent by 2025. This is equivalent to more
than 7 gigawatts (GW) of solar energy or around 2 GW of offshore wind energy.

Furthermore, the key levers to optimize energy procurement for the steel manufacturer varied geographically. The addition of
the decarbonizing factor led the manufacturer to consider both on-site generation (covering less than 10 percent of its overall
energy target due to the low utilization factor of selected technologies) and the development of tenders for PPAs at main
locations (covering more than 60 percent). For the PPA option, multiple pathways were possible, including investing in projects
to secure PPA access.

6 Five levers to optimize energy spent and risks for industrials

The context of each lever is explored in detail below, as well as the means to approach.

1. Systematic energy hedging management

Three typical hedging strategies are worth considering depending on industrial players’ ambitions. While
risk-averse players tend to follow a “linear” hedge path in line with the market—when applicable—most
players opportunistically hedge a larger or smaller share than their peers. Meanwhile, the most ambitious
players can hedge a large majority of volume four to five years ahead (Exhibit 5).

Exhibit 5
Depending on management strategies, there are several hedging strategies
Depending
to consider. on management strategies, there are several hedging strategies to
consider.

Options for Share of energy-intensive Illustrative hedging corridor, % of estimated

hedging strategy players following the strategy energy spend in year (N = current)
Hedge large majority Approximately 20% 90
of volume 4–5 years 80
ahead

N N+5

Opportunistically Approximately 60%

hedge larger or 85
71 55
smaller share than 57
peers 40
43 25
33

N N+5

Follow “linear” Approximately 20% 80%

hedge path in line 65%
with the market
35%
when applicable 30% 20% 20%

N N+5
Source: Expert energy survey; expert interviews; McKinsey risk practice

Five levers to optimize energy spent and risks for industrials 7

 There are several initiatives that could improve the level of sophistication in hedging management, including:

— Strengthening exposure management: Players could consider shifting to daily actualization of energy
exposures for the next three to four years to drive more frequent contracting and hedging decisions
based on, for example, the actualization of consumption forecasts or review of hedging coverage ratios.

— Adopting risk analytics KPIs and running recurring stress tests: Cash Flow at Risk (CFaR) models could
be implemented to ensure that risk is measured not only based on volumes, but also on the ability to
reflect market prices and volatility. In addition, more “what if” scenarios and stress tests on consumption
or activity levels could be developed based on more extreme price scenarios.

— Enhancing hedging strategies: Industrials could consider defining hedging strategies and hedge
ratios dynamically based on balance sheets or pricing pass-through constraints and available hedging
products. The hedging strategy could derive from management’s strategic ambition for risk tolerance
and return optimization.

— Calibrating hedging instruments used: The optimal mix of instruments to hedge exposure could be
considered through:

• Directly fixing with suppliers to provide operational simplicity via click contracts (due to there being
no margin calls or brokers’ management). However, this option may lack transparency of the markup
embedded in prices (up to 0.2 to 0.4 percent in fixed prices).

• Contracting over-the-counter (OTC) swaps and futures to provide flexibility in terms of timing and
frequency, while being transparent on markups. This option could allow for volumes to be bundled
across suppliers and countries when minimum click thresholds with suppliers are not reached.

• Leveraging financial call or put options to hedge hypothetical consumption that is not yet firm (such
as energy resulting from a large order intake or a potential new factory coming online). However, this
option could cost large premiums.

• Using collar options as a cheaper alternative to call or put options, thereby protecting against
potentially significant cost increases (through a maximum price to be paid) but also limiting large
profits (minimum price to be paid).

8 Five levers to optimize energy spent and risks for industrials

2. Structured PPA contracting
The demand for PPAs has surged in recent years—for example, since 2018, the volume of PPA transaction
announcements has seen an average annual growth rate of more than 45 percent (Exhibit 6). Three industrial
sectors are leading the charge for contracting and securing PPAs—chemicals, mining and metals, and
technology—which account for over half of the PPA volume signed in 2021 in Europe.¹

In Europe, the PPA market hit a new record in 2021 for offshore wind, onshore wind, and solar deal counts
(totaling 196 in 2021 compared to 162 in 2019) and volume (18.8 GW compared to 11.5 GW within that same period).
This increase in demand has likely been driven by a growing share of merchants’ renewables projects needing to
secure production offtakes to acquire financing.

Some countries have been particularly active in announcing signed PPA contracts with renewable energy
sources. In 2021, for example, Spain, Sweden, and the Netherlands led the European PPA market with
approximately 60 percent of the volume of PPAs announced in Europe (around 4 GW publicly-announced PPAs in
Spain, around 2 GW in Sweden, and around 1.2 GW in the Netherlands compared to approximately 4 GW in all the
other European countries).² In the United States (US), the market is more established and mature with multiple
sellers; the top ten were responsible for only 3 percent of announced deals from 2018 to 2021.³ This highlights
the wide range of offers available to industrials.

Exhibit 6
PPA
PPA demand hasbeen
demand has been undergoing
undergoing a significant
significant growthgrowth in Europe,
in Europe, accelerated
accelerated
by
by high market
marketprices
pricesand
and decarbonization
decarbonization strategies.
strategies.

Announced European PPA transaction volumes², GW

x # of deals announced Forecast¹ Unknown Utility Corporate

81 162 178 196 195¹

25.0

18.8
+47% p.a.

8.4
11.5 11.1

5.7
5.9 8.1
2.6 9.3
7.5
5.2
3.2 3.1

2018 2019 2020 2021 2022

¹ A pro-rata has been calculated based on YTD 2022 numbers until end of April 2022.
² Only publicly announced PPAs with over five years’ tenure are recorded (Source: PexaPark).

¹ Pexapark, PexaQuote, May 17, 2022.

² Pexapark, PexaQuote, May 17, 2022.
³ McKinsey analysis.

Five levers to optimize energy spent and risks for industrials 9

 Due to their success, PPAs are becoming increasingly sophisticated and structured with more flexibility.
For example, several players, such as Microsoft, are shifting to 24/7 “pay-as-consumed” PPAs to shield
themselves from the risk of intermittent supplies.⁴ Industrials are also increasingly adopting “baseload PPAs”
where the risk to balance the volumes of intermittent renewables is transferred to the utilities or suppliers.
As such, the number of PPA contract announcements is forecast to hit a high in 2025.⁵

Industrials are faced with a unique opportunity to secure long-term supplies of green electricity via PPAs
for a tranche of their needs—this at long-term prices lower than current short-term prices. As a way of
harnessing the potential of structured PPA contracting, industrials could explore new types of PPA offerings
that offer more flexibility (such as pay-as-consumed or baseload PPAs) in virtual formats, which have 24/7
tracking and balancing to secure long-term power purchases for tranches of consumption. They could also
incorporate PPAs as part of their hedging strategies as these could provide an effective means of reducing
risks.

However, the ability to secure optimal PPAs will likely depend on the efficiency of the PPA tenders’ process
management, on optimally structuring flexibility terms, and also on benchmarking long-term prices against
forward curves or specialized PPA benchmark providers.

4
“Microsoft and ENGIE announce innovative renewable initiatives,” Microsoft, September 24, 2019.
5
McKinsey analysis.

10 Five levers to optimize energy spent and risks for industrials

3. On-site generation
The drop in cost of small-scale generation, particularly for on-site PV solar, has helped fuel the adoption of on-site
generation in various countries (Exhibit 7). Given that Germany has one of the highest grid costs in Europe, the
business case for on-site generation can be highly positive in Europe’s largest power market. 

On-site generation offers multiple benefits. First, industrials have the opportunity to develop on-site generation
to avoid escalating grid costs (these are expected to expand rapidly with the need for grid upgrades, flexibility,
and intermittency management). Second, on-site generation can offer industrials relatively good paybacks (within
five to 12 years in the current price environment) at acceptable capital levels on small- or mid-scale assets.

To fully maximize on-site generation and take advantage of these benefits, industrials could consider exploring
a full suite of on-site generation bolt-on systems, such as biogas-CHPs, on-site RES coupled with batteries,
and heat recovery systems, all with the option of being operated by third parties. Furthermore, industrials could
evaluate eligible sites and the associated business cases, with the option to optimize self-use or resale based
on market price arbitrages. They could also look to structure operations and maintenance contracts carefully to
avoid inflation in operation expenses.

Exhibit 7
On-site generation has been adopted by many industrials in selected geographies to
On-site
reduce generation has
power-procurement been adopted by many industrials in selected
costs.​
geographies to reduce power-procurement costs.
Retail electricity DG installed in 2020, MWh
$/MWh

180
Australia United Kingdom
160 Germany
Italy
Brazil
140 Japan

120 France
Spain
100 India
Korea
China
80 Malaysia

60

40

20

0
0 10 20 30 40 50 60 70 80 90 100 110 120 130 140 150 160 170 180
Solar decentralized leveraged cost of energy (LCOE)
$/MWh

Source: Enerdata; IRENA; McKinsey analysis

Five levers to optimize energy spent and risks for industrials 11

 4. Contracting optimization

Liberalization and increasing liquidity of wholesale power and gas markets have accelerated the
competition between gas and power distributors to optimize their offerings to business-to-business
(B2B) players.⁶ While not all markets are at the same level of maturity, several industrials have a strong
opportunity to drive prices lower with additional flexibility, thus leveraging the competitiveness of offerings
in the market.

For contract optimization, industrials could consider taking a zero-based approach to energy contracts to
review and optimize all terms, such as:

— price formulations and indexation (the frequency of indexes’ updates).

— flexibility and nominations procedures (such as carry-swings options or virtual power plant options).

— tenure and termination clauses (such as a three-year deal that includes a terminal option without penalty,
or the possibility to have early termination clauses).

— bolt-on options (such as supplies of guarantees of origin [GOOs] or white certificates—for example,
certificats d’économie énergétiques [CEEs] in France) to couple decarbonization to contracting
renegotiation.

— cost breakdown to provide transparency on commodity or molecule prices, marketing costs, and
transport or distribution costs.

— flexibility fixing or unfixing (through click contracts) with a careful assessment of minimal volume,
tolerance, and frequency of options.

— rationalization of contracts in pan-geographies by bundling volumes and consolidating suppliers.

6
McKinsey analysis.

12 Five levers to optimize energy spent and risks for industrials

5. Demand-side response
Demand-side response (DSR) is increasingly being adopted in Europe, as countries such as Ireland, Italy, Belgium,
Poland, and France implemented DSR capacity in a bid to reduce peak power production from gas. Industrial
DSR could provide flexible capacity of up to 160 GW by 2030 in Europe, making DSR a favorable option for
regulators.⁷

For example, DSR has been in place through an annual tender in France since 2017 and is a central tool for
contributing to security of supply, as well as an attractive opportunity for industrials. The DSR revenue for
industrials rose from €24,000 per MW in 2019 to €60,000 per MW in 2022, while awarded volume increased
from 0.8 GW to 2 GW within that same time period.⁸

DSR typically covers 4 to 6 percent of the total reserve capacity requirements with higher rates (more than 9
percent) observed in countries with high grid constraints (such as MISO in the US), and lower rates (less than 4
percent) in countries with high cross-border interconnections—such as Germany and France.⁹

As DSR becomes more popular, industrials could consider exploring how they might fully capture the benefits.
A way to do so may be for large companies to contract services from demand-side players—and sometimes
aggregators—and develop in-house solutions.

Industrials could optimize their energy through DSR by:

— exploring which industrial processes could be flexed with a positive business case, given the large intraday
amplitudes in power prices (ranging from €100 to €300 per MWh within a day).

— running simulations of, for example, changes in the timing of shifts and the effects of machinery interruptions,
given the increasing cost of capacity purchased by industrials during stressed times for the grid.

— evaluating on-site storage options, which could potentially be coupled with on-site generation.

7
McKinsey analysis.
8
Call for tenders for the development of load shedding capacities of electricity for 2019, RTE, September 2018; AOE 2022 Results, RTE, December 17, 2021.
9
McKinsey analysis.

Five levers to optimize energy spent and risks for industrials 13

 The way forward
Managing increasing energy prices requires energy sourcing and risk management optimization. In the face
of the volatile energy climate, industrials will need to manage their energy costs proactively. This requires
a comprehensive approach that could be implemented alongside energy-efficiency measures to reduce
energy consumption. Acting across the five levers detailed above may enable industrials to maintain their
long-term competitiveness and resilience.

Martin Bohmert is a consultant in McKinsey's Paris office, where Xavier Bosquet is a partner and Xavier Veillard is also a
partner. Alvaro Gonzalez is a consultant in the Madrid office.

The authors would like to thank Elise Lu and Romain Tronchi for their contributions to this article.

Copyright © 2021 McKinsey & Company. All rights reserved.

14 Five levers to optimize energy spent and risks for industrials