Rethinking Risk: Navigating Energy Volatility in Heavy Industry

Rethinking Risk: Navigating Energy Volatility in Heavy Industry
April 10, 2023 20 mins

Rethinking Risk: Navigating Energy Volatility in Heavy Industry

The rising cost of energy is driving leaders in the heavy industries to rethink their approach to risk.

Key Takeaways
  1. Organizations in the construction and infrastructure industry need to look to include alternative solutions for traditional and emerging risks
  2. Alternative Risk Transfer options such as parametrics can be used to tackle  non-property damage business interruptions and safeguard output.
  3. In order to better understand their exposure, leaders should consider reassessing potential bottlenecks and disruptions. 
Planetary Pressures: Protecting and Powering Business

The global consumption of energy, and its impact on the planet, is being scrutinized. In response to the climate emergency, governments, institutions and businesses across the globe join the United Nations Paris Agreement coalition and take action to limit global temperature within 1.5° of pre-industrial levels and reach net zero carbon emissions by 2050.

As organisations look for new ways to power their business through renewables and lower carbon emissions, they must also continue their production in order to provide for an ever-growing global population. However, a combination of the current inflationary environment, geopolitical challenges and supply chain disruptions has resulted in sharp increases in energy prices as well as continued volatility in pricing.

Exposed to relentless energy volatility, environmental pressures and the need to continue production to generate revenue, organizations in industrial materials and manufacturing sectors face a dilemma: absorb inflated costs or down tools and turn off the lights. Either way, organizations are paying the price for energy.

To navigate energy volatility and associated business risks, leaders must not only identify new ways to power their business, but rethink their approach to protect it. This article explores the factors impacting energy for the heavy industry, and why organizations in the construction, industrial materials and manufacturing sectors can benefit from rethinking their approach to risk.

Energy Volatility Burdens the Heavy Industry

Heavy industry is severely impacted by volatility in the energy industry, where geopolitics and environmental threats are contributing to rising costs. As businesses ramp up production rates post-pandemic, the demand for energy has led market prices to rise. The steady rise in global energy prices has also increased since early 2022, due to supply constraints caused by Russia’s invasion of Ukraine.

European energy market pressures have severely impacted the bottom line for industrial materials and manufacturing organizations who are forced to increase their energy spend. In turn, this causes a knock-on effect to the construction industry through increased price volatility of inputs and construction materials. Between 23rd February 2022, the day before the start of the Russia-Ukraine conflict, and 31st July 2022, European wholesale gas prices increased by 115% and electricity increased by 237%.1

Energy is Powering Political Agendas
Using energy supply as a geopolitical tool, Russia’s dominance in the European oil and gas market means natural gas supplies are predicted to remain constricted in 2023.2

Tensions Restrict Energy Production and Supply
As geopolitical tensions between countries across Asia and Europe continue, some countries look to stockpile their energy, increasing the insecurity of energy supplies. As a result of OPEC’s cuts to oil production, the rising cost of oil3 has disrupted production, distribution and supply across the heavy industries.

Invasion Brings Inflation
The Russian invasion of Ukraine has continued to cause global supply chain disruptions, inflating the prices of essential commodities such as fuel and food across the globe.4

The inflation of fossil fuel prices and insecurity of supply impacts the day-to-day operations of heavy industries across the globe, triggered by the events and responses across the EMEA region. Whether paying upfront to secure and stockpile supply, halting their production and facing financial losses due to less output, or investing in a renewable energy infrastructure, manufacturing and industrial materials organizations are facing stark financial consequences when it comes to energy volatility.

Insecurity Halts Production in Manufacturing and Industrial Materials

In addition to the headwinds of energy volatility, heavy industry also faces the strain of supply chain insecurity. A lack of supply of goods and components hinders the ability to complete projects on time and interrupts business cash flow. Interruptions to material supply chains are caused by a cocktail of geopolitical, environmental and operational events. Although regional stoppages in production can impact the global economy, manufacturing hubs are faced with little option but to halt their output.

Reliance on materials from specific areas and manufacturers puts pressure on supply chains. For example, a factory fire in Japan halted semiconductor production for a month. This resulted in a global chip shortage disabling the automotive industry’s ability to source crucial supplies amidst the already mounting pressures of the pandemic, severe weather and geopolitical tensions.5

  • In the energy-intensive cement, concrete and bricks industry, gas accounts for around 40 percent of production, the rest generally made up of oil and electricity.6
  • British Steel attributes the steep rises in materials prices to the impact of their wholesale energy costs.7
  • According to The Manufacturer’s Organization, energy bills are now business threatening for 60 percent of manufacturers.8
  • UK Government Building Materials and Component Index show material prices increased 24.1 percent in the past year.9
  • Overall sector activity hit a two-year low in June 2022 with a recent survey finding that 90 percent of manufacturing businesses have cash flow issues to some extent.10
Compounding Pressure in the Construction Sector

Companies operating within the construction and infrastructure ecosystem are suffering from increased costs to manufacture and production inputs. In addition, they are also facing the impact of increased energy costs and supply chain constraints on their own operations.

These pressures are having a direct effect on construction projects. Due to increased costs, budgets are coming in much higher than initially estimated during the contract bid phase. Additionally, projects already in execution are suffering as the cost to finish projects are suddenly rising. In many cases, projects are having to pause while parties find ways to finance the new cost, ultimately causing delays in the overall delivery of the project.

Supply chain constraints and bottlenecks continue to add additional challenges to the delivery of construction and infrastructure projects. The flow of construction materials is under threat from trading laws across the globe, where the supply of goods is impacted by geopolitical events. As project-critical materials are locked away in UK and European warehouses due to Brexit’s bureaucratic rules, trading tariffs such as Canadian timber restrictions contribute to material price fluctuations in the construction sector.11 This further exacerbates challenges with increased costs and delivery times for large construction projects, at a time of pressure to deliver more infrastructure assets.

Rethinking Approach Risk to Protect Organizations in Heavy Industry

The construction, industrial materials and manufacturing landscape requires organizations to look towards new solutions relative to the increased volatility it faces. While the challenges are clearly many, businesses who identify, mitigate and manage these factors contributing to this volatility will remain competitive in increasingly turbulent times.

Despite the cascade of disruptions threatening the heavy industry, organizations can develop strategies that are capable of withstanding current energy volatility. But it requires the adoption of alternative solutions with a holistic approach to risk. By reassessing risk solutions and strategy throughout the entire project lifecycle and supply chain, heavy industry organizations can ensure their business is covered for new and emerging risks. The reassessment of risk will also enable them to be more attractive to investors and have a positive impact on sustainability commitments.

Supply Chain Planning and Business Continuity

Business interruptions and delays are escalating. Identifying bottlenecks helps organizations to better understand and assess their exposures. To increase resilience in the face of material shortages, leaders must solve supply chain challenges for the future, not just for today. Assessing the resiliency of contingency planning and identifying supply chain and potential disruptions helps businesses see where they may need alternative funding around critical component pieces.

"Traditional insurance mechanisms are increasingly obsolete relative to the underlying exposures that are driving volatility. We're seeing movement to more customized alternative funding and parametric solutions that are capable of managing volatility and maximizing performance.”

– Sal Perrucci, EVP and Managing Director, Enterprise Client Leader, Global Enterprise Client Group at Aon

Parametric Solutions

Parametric solutions provide an alternative insurance risk financing arrangement that covers a predefined amount when a predetermined condition is met. Once an event happens, this sets off a parametric trigger such as a natural disaster or financial market change, leading to the payment of a pre-agreed amount to the policy holder, rather than a traditional indemnity-based payment.

Parametric solutions provide responsive programs that work for businesses that face both traditional risk and non-traditional emerging risks, such as supply chain disruptions, that require innovation risk financing approaches. Parametric solutions are particularly useful to combat non-property damage business interruptions events. Using alternative risk financing arrangements requires organizations to have people adept at risk preparedness by applying pre-emptive risk mitigation protocols across their enterprise risk profile.

"Aon can play an important role in helping clients to identify a “sweet spot” between risk retained and risk transferred to insurance markets to optimize costs. With alternative structures such as captive or protected cells, clients can build a retention vehicle or self-insure uninsurable risks. These can also serve as valuable data capture vehicles to help organizations better understand their total cost of risk and identify claims trends among other things.”

– Donais Deetz, Director, EMEA Construction & Infrastructure at Aon

Alternative Funding

Heavy industry organizations, especially those that are large and established, are looking towards better alternative funding. Whether they're using a captive insurance company or other types of alternative funding mechanisms to explore non-traditional risks, solutions are being developed by working with the reinsurance market to get the support they need.

Allocation of Risk in Construction

Governments and project developers involved in very complex projects such as civil infrastructure developments often push risk down the supply chain, causing those at the lower end of the chain to face more risk than they can comfortably manage with the tools they have in place. In Design Build and EPC contracts, owners continually contractually allocate more risk downstream. This can result in risk discrepancy, where the party responsible for the risk may not be the best equipped to handle it, which can lead to improper management of risks and result in higher losses.

Organizations can combat this risk through better contractual negotiation or by increasing the project balance toward newer contractual models such as Alliance Contracting or Integrated Project Delivery (IPD).

Time for Heavy Industry Leaders to Take Action

Given the high inflationary environment firms are currently operating in, the valuations for physical property as well as expected incomes are also reflecting the rising pace of inflation.

Whether it’s an operating manufacturing plant or highway or a subway line under construction, organizations need to factor the impact of inflation into their valuations of insured property or expected income revenue streams. Accurate valuation of property and expected revenues, be it business interruption or delay in start-up insurance, will avoid underinsurance and subsequent financial loss. Ensuring that actual property values have been adjusted for inflation will avoid under-valuing and remove the risk of the party not receiving a full pay out in the event of an insurance claim.

Readjust Values

To ensure their business is protected, organizations must assess and readjust their values with cost-effective methodologies. Pinpointing gaps in insurance programs, gaining efficiencies in insurance purchases and negotiating more effectively with underwriters enables organizations to not only gain better value, but to make informed decisions about the deployment of risk management resources. Leaders should look to consistently reassess values in these key areas:

  • Asset valuation
  • Business interruption and contingent business interruption valuation
  • Exposure and supply chain valuation
Rethink Supply Chain Risk

As organizations identify ways to build resilience into their supply chains and reduce their dependence on Russia and East Europe for raw materials, leaders can look to regional, localised sourcing strategies. But to further mitigate supply chain risk, leaders should ask the following questions.

  • Is supply chain risk management integrated into our project risk management approach?
  • Have we fully mapped critical supply chains upstream to the raw material level?
  • Are we maximising our relationships with suppliers and partners throughout the supply chain, have we had the risk allocation conversation?
Adopt Collaborative Practices

Newer models, like alliance contracting or Integrated Project Delivery (IPD) look towards rethinking the risk allocation, getting to a shared outcome that reduces the potential of disagreement and financial loss.

Utilizing collaborative practices and procurement models helps to navigate and improve:

  • Complexity of scale
  • Relationships with multiple sector partners
  • Maturity of business
  • Stakeholder attitude to risk
  • Loss of organizational capital
Heavy Industries Have Much to Gain from Navigating Energy Volatility

When it comes to devising and implementing risk strategies amid rising energy costs, heavy industry clients can benefit from a consultative partner who can anticipate their specific needs. Working with a risk partner across regions enables organizations to assess opportunities and challenges, especially those in production and supply chain, viewing a full picture of risk across their business.

Organizations must aim to reduce risk exposures by taking a holistic approach to risk, increasing their resilience in the face of the volatile energy landscape. Applying the same principles to risk as organizations apply to commodities – where issues are monetized – will enable businesses to have a better control of their capital.

To mitigate mounting pressures and deliver business growth, organizations should work with experienced partners who can help address alternative solutions for traditional and emerging risks – ensuring management across project lifecycles, geographies and supply chains.

1 The impact of the war in Ukraine on energy prices: Consequences for firms’ financial performance, Centre for Economic Policy Research, October 2022
2 Energy crisis prompts ESG rethink on oil and gas, FT, July 2022
3 OPEC defies Joe Biden with a big output cut, The Economist, 2022
4 How the Russia-Ukraine conflict is impacting supply chains, Consultancy Europe, July 2022
5 Verdict, 2021
6 ING, 2022
7 FT, 2022
8 MAKE, 2022
9 CityA.M., 2022
10 Manufacturing, 2022
11 Construction industry hammered by material shortages, Raconteur, August 2022

General Disclaimer

The information contained herein and the statements expressed are of a general nature and are not intended to address the circumstances of any particular individual or entity. Although we endeavor to provide accurate and timely information and use sources we consider reliable, there can be no guarantee that such information is accurate as of the date it is received or that it will continue to be accurate in the future. No one should act on such information without appropriate professional advice after a thorough examination of the particular situation.

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