Powered by low-cost state-funded capital

By Leonard S. Hyman and William Tilles:

There has been no shortage of stories recently about looming trade wars and foreign investments with questionable implications for national security. But the business press recently took notice of one particularly large investment number: $452 billion. This is the amount China’s state controlled power companies have invested abroad over the past five years.

The list of actual and potential Chinese utility investment locations includes Pakistan, Russia, Nigeria, Brazil, Chile, Portugal, Philippines, Germany, and the UK.

Roughly one third of this almost half a trillion dollars of investment relates to power transmission projects. The Chinese are exporting their ultra-high voltage transmission technology. This, supposedly, is the secret of China’s technology-export success. Generally speaking, moving bulk electricity at higher voltages reduces line losses, which in turn reduces the cost of transmission.

Transmission expenses, however,  account for slightly less than 10% of end-use electricity costs, a relatively small piece of cost of the final product.  A typical high voltage transmission line experiences losses of about 4% on average. An ultra-high voltage line brings losses down to about 1%. But reducing losses in this fashion requires more capital. Obtaining meaningful savings elsewhere in the power production process should count for far more.

In the semi-deregulated power markets common nowadays, transmission operators run the power grid – somewhat like policemen at a busy intersection directing traffic. Although only minor government functionaries, those directing traffic have a considerable amount power. They decide who proceeds and who shall have extra time to respond to text messages. In the context of the power transmission grid, grid operators as traffic cops have a considerable amount of power and responsibility. For this reason, some local authorities have been reticent about ceding this vital function to Chinese investment and control.

The business press with its penchant for the bright shiny object is focused at present on Chinese technology. We suggest financial considerations matter more. And that goes beyond mere trade subsidies.

China runs a huge trade surplus. It has to make use of the foreign currencies it receives. That is another way of saying that China has a glut of investable savings. Given the law of supply and demand, having big supply and little demand lowers the price (all else equal). But a low return on that capital is still better than no return. And China’s state entities put government policy before profits.

Now let’s consider the financial implications. Electricity is expensive to produce, move, and distribute. The pretax cost of capital for electricity systems accounts for roughly one fifth of the average electric bill. But for low-variable cost businesses, such as nuclear power and transmission, cost of capital might account for as much as half of final costs.

This takes us back to China’s power technology exports. Their state sponsored power companies appear to be content with low single-digit returns on equity – levels way below those considered acceptable by private sector firms. And their cost of debt is also very low.

Western firms in these circumstances pay at least 5% for their debt and a single-digit return on equity is to put it mildly unacceptable. Our contention? Cost of capital here is key. It counts for far more in this so-called competition for new power projects around the world than mere high-tension technological prowess.

The US’s role in the international power sector is receding. European and Canadian firms are more aggressive. Consider, for instance, the price levels exhibited in the recent bidding competition between Italy’s Enel and Spain’s Endesa for a Brazilian property sold by a highly leveraged American firm.

Their low cost of capital advantage, call it cheap money, will keep the Chinese ahead in this technology export race – unless or until there is political or national security pushback. Would the Trump administration continue to pursue its stated intent to sell the US’s power agencies if all the high bidders are foreign domiciled entities? It would be kind of funny in light of recent events if the highest bidders in these proposed asset sales were Trump trade “favorites,” Canada and China.

As pulp fiction aficionados, we love a good hostage situation. Read… Another Nuclear Bailout?  

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