Desperately Seeking a Cheaper Kilowatt Hour by Frank Holmes
Let’s imagine that an aluminum manufacturer is eyeing two locations to build a new factory. In location A, an industrial kilowatt hour (kWh) is priced at 4.21 cents, whereas in location B, it goes for 12.67 cents.
The difference is upwards of 200 percent.
It’s fair to assume then that, all other considerations being equal—reasonable taxes, a skilled workforce, modern infrastructure—location A will win out.
So how can electric companies lower their prices to attract businesses and industries? Countless factors make an impact. Research and development. Construction costs. Permits. Securing land. Mining, drilling and refining. Operating and maintenance costs. Taxes and fees. Power lines. The risk of changing laws and regulations.
But let’s keep things simple. Generating electricity is a lot like investing: to get the most efficacious results, diversification is key. That means a combination of energy sources, from natural gas to nuclear to renewables.
A tale of two states.
In the examples given above, location A is actually Washington State, which offers the lowest price per industrial kilowatt hour in the continental U.S. Location B is Connecticut, the most expensive.
To keep prices competitive, Washington diversifies its energy portfolio. The greatest contributor is hydroelectric power, which generates close to 7,700 gigawatts per hour (GWh) annually. Other significant sources of electricity are nuclear (812 GWh), natural gas (290 GWh) and coal (192 GWh). Renewables, which account for 912 GWh, include wind, solar and geothermal. As a result, the state offers electricity at a 35 percent discount from the national average.
Aided by the fact that the Evergreen State doesn’t collect a corporate income tax, cheap power has attracted industries that tend to consume biblical amounts of electricity, from aircraft production to software development to aluminum refining. Major companies in these spaces that are either headquartered or maintain a significant presence in the state include Microsoft, Amazon.com, Expedia.com and Boeing.
Connecticut, on the other hand, is not nearly as diversified as its West Coast peer. About half of its net electricity production last year came from the 2,103-megawatt Millstone Nuclear Power Station (48 percent), the other half from natural gas (44 percent). A negligible amount was derived from coal and renewables.
Any industrial company considering Connecticut as its home base of operations must factor in the hefty electric bill, which is nearly 90 percent higher than the national average. Against all odds, the state has managed to hang on to old stalwarts in the manufacturing and technology sectors such as United Technologies Corporation (NYSE:UTX) and General Electric Company (NYSE:GE).
In the hypothetical scenario above, I used an aluminum manufacturer because aluminum requires a notoriously huge amount of energy to produce. The electricity needed to manufacture just one tonne of the stuff eats up over a third of your entire production costs. Fifteen kilowatt hour makes only a kilo, or 2.2 pounds, of product.
Meaning: the hypothetical aluminum maker headquartered in Washington will spend about 63 cents per kilo, whereas the one in Connecticut will spend close to 2 bucks to manufacture the same amount.
Granted, at only 5,006 square miles, Connecticut lacks the scale and plentiful natural resources found in states as large and spacious as Washington. The same problem can be found in other small, densely-populated states and territories such as Massachusetts, Rhode Island, New Jersey, New Hampshire and the U.S. Virgin Islands.
The Virgin Islands, in fact, has some of the world’s most expensive electricity precisely because it doesn’t have the means to diversify its energy portfolio. The territory depends entirely on imported crude oil to run its petroleum power plants, and as a result, its energy goes for between 50.8 and 54.8 cents per kilowatt hour as of last year. This business-repelling price far exceeds that of countries whose energy is considered steep compared to the U.S. average, namely, Denmark (41 cents per kilowatt hour), Germany (35), Spain (30), Australia (29) and Italy (28). This year the Virgin Islands has tried to reel in businesses with substantial tax breaks, but the savings might not be enough to offset the eye-popping electric bill.
It’s pronounced “nuclear.”
Although people have increasingly distanced themselves from nuclear energy because of catastrophic environmental disasters over the years, there’s still a place for it in a country’s energy portfolio. Nuclear power plants might be expensive to build, but they’re cheap to run.
The question is whether nuclear power helps drive electricity prices down. For some answers, take a look at the following chart.
As the leading producer of nuclear energy, the U.S. has some of the world’s cheapest electricity—which for the industrial sector averages between 6.75 cents and 9.33 cents per kWh. These prices are either trumped or competitive with other nuclear power-producing countries such as Russia (11 cents per kilowatt hour), Canada (10) and China (8). India, which doesn’t quite make it into the top 10, generates 30 billion kWh annually at an average of 8 cents per kilowatt hour.
However, a few of the countries on the chart have pricy electricity. Nuclear power accounts for close to three-quarters of France’s energy, and yet its electricity is on average 7 cents per kilowatt hour more expensive than the U.S. Again, diversification is key. Germany, which already has costly electricity, will soon see its prices soar even higher once it decommissions its nine currently operating nuclear plants, a gargantuan, politically motivated project that’s scheduled to be completed by 2022.
Does Iceland have the answers?
Many people are aware that Iceland has the cleanest energy in the world by far. The island-nation generates 100 percent of its electricity from renewables such as hydroelectric and geothermal sources, and it’s also flirting with wind power. What those same people might not realize, however, is that this results in some of the cheapest electricity in the world.
Landsvirkun, Iceland’s national power company, offers electricity to buyers for as low as 4.3 cents per kilowatt hour, which is nearly on par with what can be found in Washington State. Coupled with 20 percent corporate tax rates, the nation’s low energy prices have attracted not just data centers, methanol producers, silicon metal producers but also aluminum companies—which, again, consume massive amounts of electricity.
Aluminum production, in fact, has in the last few years outpaced fisheries as Iceland’s leading industry.
Alcoa, the third-largest aluminum producer in the world, which we own in our Global Resources Fund (PSPFX), has maintained an aluminum smelter at Reydarfjordur in Eastern Iceland since 2007. Other world-class aluminum producers operating in Iceland include Rio Tinto Alcan and Century.
Diversification in your investment and energy portfolio.
The takeaway here is simple. As is the case in Washington and Iceland, if a state or country has an abundance and availability of natural resources, it should take advantage of them to drive down the price of a kilowatt hour to attract businesses. Diversification is especially essential where possible. Without businesses and industries paying to draw power from the electrical grid, the local economy stagnates.
Savvy investors know the importance of diversifying their portfolios. Electric companies need to learn to do the same.
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Fund portfolios are actively managed, and holdings may change daily. Holdings are reported as of the most recent quarter-end. Holdings in the Global Resources Fund as a percentage of net assets as of June 30, 2014: Microsoft (0.00%), Amazon.com (0.00%), Expedia.com (0.00%), Boeing (0.00%), General Electric Co. (0.00%), United Technologies (0.00%), Landsvirkun (0.00%), Alcoa Inc. (2.42%), Rio Tinto Alcan (0.00%), Century (0.00%).