Why is Electricity Valuable?
Electricity is a set of physical occurrences that produces the flow of electrical power or charge. It is both a naturally occurring phenomenon and one of the most prolific forms of energy used around the world.
People have been aware of electricity for thousands of years. Ancient societies marveled at electric fish and noticed static electricity when they rubbed certain objects.
However, it was only in the last 250 years that scientists made attempts to harness electricity. In 1752, American inventor Benjamin Franklin conducted research on lightning using a kite and a key. This famous experiment demonstrated that lightning is electricity.
However, an even more important breakthrough took place in 1831 when British scientist Michael Faraday discovered the principles of electricity generation.
Faraday’s law of induction describes how an electric current produces a magnetic field and how a magnetic field generates an electric current in a conductor. This discovery of magnetic induction made possible electric motors, generators, transformers and the electric grids that power modern societies.
Prior to the last 100 years or so, most people relied on candles or kerosene lamps for light, iceboxes to keep their food cold and wood- or coal-burning stoves to provide heat. However, Faraday’s law hastened modern advances in electricity.
In the late 1800s, Thomas Edison invented the first long-lasting incandescent light bulb, and inventor Nikolas Tesla pioneered the use of alternating current electricity. Edison’s work made electric lightbulbs an everyday reality, while Tesla’s work reduced the cost of transmitting electricity over long distances.
Today electricity is so prevalent in daily life that we take it for granted. The largest global economies consume trillions of kilowatt hours (kWh) annually to power governments, businesses and home. As the global economy has grown, so too has demand for this vital resource.
How is Electricity Produced?
A common method of producing electricity is through the use of a generator, which is a device that replicates what Faraday described in his law. Essentially, Faraday described how a magnet moving inside a coil of wire produces electric current flow in the wire.
A generator consists of electromagnets (magnets produced by electricity) and a series of insulated coiled copper wire. The wire forms a stationary cylinder, and a rotary shaft made out of electromagnets surrounds this cylinder. As the electromagnetic shaft rotates, it induces a small electrical current in each segment of the coiled wire.
The combination of all of these small currents produces a much larger electrical current. This larger current is the electricity that moves through power lines to reach consumers.
Electric power plants use turbines to power their generators. Turbines are rotary mechanical devices that take fluid and convert it into mechanical energy. This mechanical energy allows the generator to do its work and create electrical energy.
There are many different kinds of turbines – steam, gas, water and wind, for example – but they all require a source of power to operate. In other words, generating large amounts of electricity requires large amounts of energy. Electricity power plants choose energy sources based on their cost, availability and efficiency.
In recent years, about two-thirds of US electricity generation occurred using steam turbines. Steam turbines use biomass, coal, geothermal energy, natural gas, nuclear energy, and solar thermal energy for power. Historically, fossil fuels have comprised the largest energy source for the 4 trillion kWh of electricity generated each year:
Sources of Energy Used in Electricity Production
|Energy Source||Share of Electricity Generation||Description|
|Natural gas||0.34||Natural gas heats water for steam and also produces the hot combustion gases used by gas turbines.|
|Coal||0.3||Some coal-fired plants convert coal to a gas for use in electricity-generating gas turbines.|
|Petroleum||0.01||Petroleum can be used to produce hot combustion gases or steam.|
|Nuclear power||0.2||Nuclear fission creates steam that powers some turbines.|
|Hydropower||0.07||This process uses flowing water to spin a turbine.|
|Wind power||0.06||This source is a growing contributor to electricity generation.|
|Biomass||About 2%||This source uses materials derived from plants, animals, food scraps and paper mills to power turbines.|
|Solar power||<1%||Photovoltaic (PV) and solar-thermal power are the two main technologies for converting solar energy to electricity.|
|Geothermal||<1%||This source uses heat beneath the earth to power steam turbines.|
Steam turbines are surprisingly energy-intensive. For every 100 units of heat energy that go into a power plant, only 33 units are converted into useable electricity.
Electricity is necessary for every facet of a modern economy. Therefore, it is not surprising that the largest electricity producers are also the largest economies in the world.
Top 10 Electricity Producing Countries
|Rank||Flag||Country||(kWh in billions)|
Electricity use across the globe has risen dramatically over the last several decades. In the United States alone, electricity use today is 13 times greater than in 1950. The proliferation of computers, electronics and industrial machinery has played the biggest role in increasing demand.
4 Main Uses of Electricity
|Residential||The residential sector consumed about 38% of annual US electricity demand. Space cooling (air conditioning) was the largest contributor to residential usage followed by water heating, lighting, space heating, refrigeration, and televisions and related electronic equipment. Clothes washers and dryers, computers and related equipment, dishwashers, small appliances, and other electrical equipment combine to use 40% of total US residential-sector electricity.|
|Commercial||The commercial sector consumed about 37% of annual US electricity demand. Refrigeration accounts for the largest component of demand in this sector followed by computers and office equipment, space cooling, ventilation and lighting.|
|Industrial||The industrial sector consumed about 25% of annual US electricity demand. Machines account for about half of this demand, while process and boiler heating comprise the next biggest category.|
|Transportation||Transportation accounts for only about 0.2% of US electricity demand. Most of this use is by public transit systems.|
What Drives the Price of Electricity?
The costs to build, finance, maintain and operate power plants represent the biggest components of electricity prices. According to the US Energy Information Administration (EIA), electricity generation accounts for 57% of the cost of operating a plant, while distribution accounts for 32% and transmission 11%.
Specifically, these factors have the biggest effect on electricity prices:
- Energy Costs
- Power Plant Operations
- Transmission and Distribution System Costs
Natural gas and coal are consistently the biggest fuel sources for turbine power generation. Therefore, electricity traders should pay careful attention to price spikes or drops in these commodities.
Electricity demand is often correlated with fuel demand. When the economy is strong, for example, industries demand greater supplies of electricity and fuel to operate. Similarly, during harsh weather conditions, fuel demand to heat homes rises as does electricity demand (more people stay home and use appliances). As a result, electricity prices often rise when energy prices are also rising.
Power Plant Operations
The construction, maintenance and operations costs of electricity power plants have a big effect on electricity prices. In tight labor markets, for example, construction and labor costs typically rise. These higher costs often get passed on to electricity customers.
Transmission and Distribution System Costs
Transmission and distribution represent more than 40% of the cost of operating an electric power plant. Accidents, harsh weather and wear-and-tear all have the potential to damage these systems and lead to costly repairs. The cost of repairing these systems would generally get passed on to customers either directly through rate increases or indirectly through higher taxes in the affected areas.
Weather has the potential to either increase or decrease the cost of electricity depending on specific conditions. Heavy rain and snow can provide water for hydroelectric power generation, while strong winds can provide a cheap source of fuel for wind turbines used to generate power.
On the other hand, severely cold weather is likely to raise electricity prices. First, severe weather is likely to create higher fuel costs and raise the cost of electricity production. Secondly, such weather usually causes big spikes in electricity demand.
Factors such as electricity demand, availability of generation sources, fuel costs and power plant availability all affect the cost of providing electricity to customers. In the case of electricity demand, the industry shows strong seasonal patterns.
During the summer months, demand for electricity rises as air conditioning systems receive heavy usage. At the same time, many utility companies have to turn to more expensive generation sources to meet demands. The result is higher electricity prices.
Depending on the locality, electricity utilities have different regulatory requirements. In some areas, utility commissions fully regulate prices, while in other areas, generators may be unregulated, while transmission and distribution costs are fully regulated.
3 Reasons You Might Invest in Electricity
Companies that provide electricity operate regionally. Therefore, investments in electricity often depend on the specific economic, political and regulatory factors in a particular country or region.
The most lucrative investments in electricity are likely to occur in regions with high population and industrial growth rates.
In general, these are the reasons traders should consider investing in the sector:
- Emerging Market Demand
- Advances in Alternative Energy Sources
- Portfolio Diversification
Emerging Market Demand
According to the International Energy Agency, by 2035 more than 90% of net energy demand will derive from emerging economies.
Demographic trends across the globe show migration patterns from rural areas into cities. In places such as China, rising industrialization has accompanied these population shifts.
The United Nations forecasts that by 2030, there could be a 36% increase in the number of global cities with populations over 1 million people. New cities will require increasing amounts of electricity to power businesses and homes.
Advances in Alternative Energy Sources
Advances in the procurement of wind, solar, hydroelectric and biomass sources of power are incredibly positive catalysts for the supply side of the electricity industry.
As these sources become cheaper and more readily available, electricity production costs should come down. At the same time, global demand for electricity should remain strong.
For regulated monopolies such as the utility industry, this could translate to a very favorable profit backdrop.
Investing in a critical resource such as electricity is a way to add diversification to a portfolio. Many of the factors that move electricity prices are different than the factors that affect stock and bond prices. In fact, for many segments of the economy, demand for electricity is inelastic. That is, regardless of prices, people need to consume electricity.
Should I Invest in Electricity?
There are several ways to gain exposure to the electricity, and traders should consider the factors that move each of these investment vehicles.
Electric utilities are one vehicle for investing in the sector. However, while they pay large dividends and have low risk, they probably have less potential upside than investing in electricity futures in high-growth and less regulated regions of the world.
There are three reasons electricity could perform well in the years ahead:
- Emerging Market Growth
- Alternative Energy Industry
- Global Growth
Emerging Market Growth
China, India, Brazil, the Middle East and Africa are among the many fast-growing countries and regions that are becoming more industrial and urban. As populations in these regions migrate from rural areas into cities, demand for electricity is certain to grow.
Alternative Energy Industry
The alternative energy sector is expected to continue to innovate and create efficiencies. As the cost of solar, wind, water and other power sources declines, electricity production costs could fall. This could create a favorable profit environment for utility companies.
Global growth is a positive catalyst for electricity prices. As the world economy expands, electricity demand should grow.
However, traders should also consider the scenarios under which electricity does not perform well. An economic slowdown that affects emerging markets could put a damper on electricity demand.
Expert Opinions on Electricity
One leading expert believes that electric utilities offer safer and more attractive returns than other low-risk investments.
“Although there are some potential risks to that return, historically there have been few, if any, interruptions to the remuneration. Moreover, current regulated rates of return are attractive compared to other low-risk investments, such as bonds. “
Ross Baldick, strategic consultant and professor at the University of Texas at Austin
How Can I Invest in Electricity?
Electricity traders have several ways to invest in the commodity:
|Method of Investing||Complexity Rating (1 = easy, 5=hard)||Storage Costs?||Security Costs?||Expiration Dates?||Management Costs?||Leverage?||Regulated Exchange?|
The physical electricity market is a fragmented market with prices dependent on specific geographies. As a result, electricity is not commoditized globally the way other markets are.
The New York Mercantile Exchange (NYMEX), which is part of the Chicago Mercantile Exchange (CME), offers several electricity futures contracts for various parts of the United States. However, these contracts usually have very light trading volumes.
Futures are a derivative instrument through which traders make leveraged bets on commodity prices. If prices decline, traders must deposit additional margin in order to maintain their positions. At expiration, all of these contracts are physically settled.
Investing in futures requires a high level of sophistication since factors such as storage costs and interest rates affect pricing.
These financial instruments trade as shares on exchanges in the same way that stocks do. There is no ETF that offers exposure to electricity prices. However, there are many ETFs that invest in the utilities sector including the following:
|The Utilities Sector SPDR ETF||iShares Dow Jones US Utilities ETF||iShares S&P Global Utilities ETF||PowerShares S&P SmallCap Utilities ETF||Vanguard Utilities ETF|
Shares of Electricity Companies
There are many publicly traded companies that operate electric utilities. While investing in companies can be a leveraged way to gain exposure to electricity prices, many of these companies can react to other factors such as regional demand for their products, competition, production costs and interest rates.
Furthermore, as regulated utilities, these companies have limitations on their abilities to raise prices. Finally, factors such as company management and the overall stock market can also affect these investments:
Another way to invest in shares of electricity companies is through the use of a contract for difference (CFD) derivative instrument. CFDs allow traders to speculate on the price of companies involved in the electricity industry. The value of a CFD is the difference between the price of the shares at the time of purchase and their current price.
Some regulated brokers worldwide offer CFDs on shares of electricity companies. Customers deposit funds with the broker, which serve as margin. The advantage of CFDs is that trader can have exposure to share prices without having to purchase shares, ETFs, futures or options.
Start Trading Electricity
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