In this issue:

  • That which is taken for granted is often neglected
  • This is the case with our electrical grid today
  • Investors can profit from a grid upgrade and expansion

When I was young I was fascinated by electricity. I found it just amazing how one could plug a device into a socket and, voila! It would work! But being curious I also wanted to understand how the sockets themselves worked. What magic was this?

And so I would ask my parents what it was that came out of the wall sockets and made things work and they would answer “electricity”. Then I would ask what electricity was and they would try to explain how it was a flow of electrons. Then I would ask what electrons were. And so on…

Eventually the conversation would lead to the power plants that generated the electricity. The circuit was then complete: something in the power plant generates energy. That energy spins a turbine. That turbine spins a generator. That generator spits out electrons.

Those electrons then flow along a cable, which carries the electrons for many miles until they find their way to smaller cables, including the one suspended by poles along our street and then, finally, the cable that leads to our house. Once inside the house, there was a network of wires that led to all the appliances and, yes, the wall sockets, where that energy is consumed.

That was about the extent of my electrical knowledge until high school physics, of which electronics was a part. I was taught about the various components of circuits and how to build them. Finally I knew what “volts” on a battery label actually meant. Or what “amps” were. Or “ohms”. Or the difference between a battery and a capacitor.

At the end of one term we built a simple transistor radio from a kit. As I recall it took less than an hour to assemble, switch on and tune in a local station.

All of the above de-mystified the electrical magic for me somewhat and I felt I finally understood electricity. But in reality everything I had learned was really just electrical theory, rather than practice.

That all changed when I was assigned to a project to assess the value of some power plants.

It was while I was working as a junior member of Bankers Trust’s corporate risk management advisory team. We were available to the bank’s larger corporate clients for strategic consulting projects. If a company was considering an acquisition, or merger, or restructuring or asset disposal, we would help them to determine what the relevant assets were worth, or not worth. Or what the risks of the business were and how those could be at least partially if not completely hedged.

The point was to enable clients to make better-informed strategic decisions. And one of those clients was, at the time, one of the largest utility companies in the US. Located in the industrial Midwest, the company owned and operated some 20 power plants, including the largest coal-fired power plant in the entire US.

The power it generated was essential to the US auto industry, among other major industries. However, during the 1970s and 1980s, the US Midwest’s share of global manufacturing steadily declined. The South and West were taking market share, as were Mexico and Canada. One Midwest factory after another scaled back operations or shut its doors entirely, never to reopen.

And so it came to the point where, for the first time ever, rather than plan for future expansion, this utility had to plan to shrink due to overcapacity. It had too many plants idling, yet these plants still needed to be maintained. My job was to help determine which plants should be shut down entirely to save costs.

This turned out to be far more complex than it sounds. You can’t just take the oldest, most inefficient plant and switch it off. You need to take into account a great many other things.

These include the fluctuating costs of input, which in this case was primarily coal and gas. Then there was the need to always have sufficient excess generation capacity for peak periods.

There was also the prospect of selling excess capacity to other utilities. I had no idea at the time what a big market that was. Some of these excess capacity contracts were long term, some short term; some based on fixed electricity prices, others floating market prices.

The project lasted for months. My colleagues and I were flying back and forth from New York every other week as we worked to build a theoretical “model” of the utility’s entire operations, with fluctuating input prices for coal and gas and fluctuating output prices for electricity generation and excess capacity provision to other utilities.

These fluctuations were based on seasonal models with an underlying long-term trend of declining capacity requirements. Once complete, depending on the choice of specific input assumptions and parameters, one could determine which plant, or plants, should be the first to be shut down and then, going forward, which plants would be next in line if capacity requirements continued to shrink.

The day came when we presented our results to the Board of Directors subcommittee assigned to oversee the project. We had prepared a slick presentation regarding the model, including the methodology used, the input assumptions, parameters and so on.

Finally, the presentation got to the point: the first plants that we recommend it shut.

I’ll never forget what happened next. A hand went up. “You have a question?” asked my boss, who had overseen the project from our side. “No I don’t,” replied the Board member. “I just want to say that you can’t shut those plants.”

An awkward silence followed. “Why not?” asked my boss.

“Those two plants are the core of the entire grid,” he said. “You can shut down one or the other as we do periodically for maintenance, but if you shut down both at the same time, the grid will fail.”

Uh-oh. It appeared we had overlooked a rather important issue. “Could you please explain what you mean?” asked my boss. “Why can’t the other plants take up the slack? They have sufficient capacity. Yet they have lower generation costs so this will save the company money.”

Then the dressing-down came.

“They have sufficient capacity in your theoretical model but not for the actual, real-world grid that they need to support. Those two plants you want to shut are the heart of the entire grid. All that other newer, more efficient capacity has been built around them. The newer plants’ transmission cables draw on their capacity and feed specific points on the grid only. Those new plants are effectively satellites, pushing marginal power into the grid around the edges and stabilising supply and demand at peak times.

“You can’t just take out the heart of the grid and expect the satellite plants and substations to support it. The grid wasn’t designed for that. You switch those two plants off and the grid will fail pronto. Seems your model didn’t take the grid into account now, did it?”

My boss wasn’t quite ready to give up. “Is there no way to modify the grid so that it could operate without those two old, inefficient plants?”

“Of course you could, but that would take years and cost a fortune, which isn’t the point of this exercise now, is it?”

Oh dear. My boss turned pale. We’d been working for months on the huge faulty assumption that the specifics of the grid architecture were not a factor in determining which plants could realistically, or not, be shuttered.

“So you’re suggesting that we adjust the model so that at least one of those two plants remains?” asked my boss in a subdued tone.

“No, they both have to remain. Otherwise, how are you going to shut down the one plant left for routine maintenance without the entire grid going down? You won’t be able to. Either both of those plants remain or you’re going to need to build yourself an entirely new grid.”

The situation was unsalvageable. The model was essentially useless. All that time and money wasted.

We flew home with our collective tail between our legs. And I learned a valuable lesson: don’t take the grid for granted.

Sadly, in recent years, it would seem the government has done precisely that. It’s been so seduced by dreams of net zero grandeur that it’s neglected the grid so absolutely necessary to keeping the lights on regardless of the source of power generation.

The reality is that the unreliable intermittency of wind and solar generation from place to place implies that you need a far more expansive grid connecting far more power sources to one another. There are also higher long-distance transmission costs to consider and the infrastructure needed to support that.

One of my favourite investment styles is to find the “bottleneck”. In any given value-add production chain, in any industry, you want to identify the bottleneck and find a way to invest in it. When it comes to electricity, the grid has become the primary bottleneck. Not wind turbines, not solar panels, nor other power sources. It is the grid itself: cables, substations and all the equipment required to service and maintain it.

James Allen, Southbank Investment Research’s in-house energy expert, specialises in finding energy industry bottlenecks wherever they might appear: fuels in short supply. Refining constraints. Shipping and other logistical challenges. Servicing and maintenance equipment…

Recently, James has identified a company well positioned to benefit from emerging energy bottlenecks. I strongly recommend you take a look at what James has to say about it here.

Until next time,

John Butler
Investment Director, Fortune & Freedom