5 behavioural biases to avoid for smarter energy procurement

“We can be blind to the obvious, and we are also blind to our blindness.”  – Daniel Kahneman

Behavioural biases typically fall into two different categories: emotional and cognitive. Emotional biases are where our feelings (hopes, fears, desires, etc.) distort our ability to make decisions rationally. Cognitive biases on the other hand are types of thinking that occur when we’re processing information. Together they are the mental shortcuts that quickly help us make sense of the world and make smart decisions. Most of the time these mental shortcuts work just fine, but in the complex world of volatile energy markets they can also lead us astray. In this article we look at five of the most common emotional biases to affect energy procurement participants looking to hedge their electricity and gas needs.

1. Loss aversion

Research suggests that people typically feel the pain of a loss twice as much as an equivalent win. People typically overcompensate, risk seeking in order to avoid taking a loss.

For example, energy procurement professionals whose supply contracts have expired ahead of a strong energy market may decide to wait, hoping that the market turns down. Hedging their energy needs by agreeing to a long-term fixed contract may feel like they have committed to a loss, versus the alternative of taking a risk and waiting for a fall in prices.

2. Endowment effect

The endowment effect is where market participants place a disproportionately high value on those contracts or investments they have already made. An example might be a homeowner that sets an unrealistically high asking price for their property. After all they lived there for decades, loved, and cared for it. It must be worth more! A similar thing happens in energy procurement where you agree to the first offer you receive from your incumbent supplier, even though there may be better value in exploring alternative offers.

3. Status quo bias

People are generally comfortable where they are now. Rather than adapting to changing circumstances they carry on with whatever process has been “the way it’s always been done”. In doing so they miss opportunities that they could benefit from. For an energy procurement professional suffering from status quo bias this might mean that they stick to certain types of contract arrangements even though there are better opportunities for cost savings and risk sharing elsewhere. This bias occurs because people are typically very resistant to change. Worried that they will have to face lots of decisions and fearful of high transaction costs they keep things as they are.

4. Regret aversion

The pain of regret from a poor financial decision is very powerful. For energy buyers, one example of this is the fear of missing out on lower energy prices. Another example is career risk. Instead of pursuing alternative strategies, buyers may stick to what the herd are doing instead. Economist John Maynard Keynes said it best, “Worldly wisdom teaches that it is better for reputation to fail conventionally than to succeed unconventionally.”

5. Overconfidence

One of the risks that we face in the information age is that even if the amount of information is increasing, the gap between what we know and what we think we know is widening still further. As Dan Gardner suggests in his book Future Babble, “In fact, more information makes more explanations possible, so having lots of data available can actually empower our tendency to see things that aren’t there.” An example of this bias in action might be the use of complex analysis to rationalise taking a view on the market, when the prime objective in energy procurement is to control risk.