Plugging into the European energy market
With only 20%-25% of Iceland’s available hydro and geothermal energy harnessed, the country’s energy potential is vast. The aluminium industry has thus far dominated, but the silicon industry could be the next to come onshore to take advantage of the cheap and plentiful power. Meanwhile, exciting plans to link up to the UK grid are taking shape.
Iceland is blessed with enough renewable energy sources to meet all its electricity demand. Today, just over 70% of the country’s electricity is generated by hydropower, with the remaining 30% accounted for by geothermal sources.
As McKinsey observes in a recent analysis of the Icelandic economy, the country’s extensive natural energy resources give it two very clear competitive advantages. “Firstly, power costs are low in an international comparison,” says the McKinsey report. “Secondly, Iceland can develop along a low carbon trajectory without investing in costly alternatives.”
The bulk of Iceland’s power is produced by the country’s largest electric utility, the state-owned Landsvirkjun, which was established in 1965 to support the build-out of the country’s first aluminium smelter, and which today operates 14 hydropower and two geothermal power stations across Iceland.
Until the passage of legislation allowing for more competition in the industry in 2003, Landsvirkjun was the sole provider of electricity to Iceland’s power-intensive industries. The principal source of demand remains the aluminium production industry, which uses about 70% of all locally produced electricity.
Landsvirkjun, which generated revenue of just over $400m in 2013, is responsible for about 73% of Iceland’s total electricity production, and although this share is expected to decline slightly as competition intensifies, it will remain the dominant player in the sector. “There are a number of companies building new power plants in Iceland which is positive for the market, but we expect to retain a minimum market share of between 60% and 65% for a while yet,” says Hörður Arnarson, Landsvirkjun’s president and CEO.
Today, 96% of Landsvirkjun’s total installed capacity of just under 2GW is accounted for by hydropower, with geothermal plants accounting for the remainder, but Arnarson says that this balance will change. “We started with hydropower, which in our view is the best way to produce electricity, because it is a low-risk and easily controllable resource,” he says. “But parts of our next projects will be in geothermal plants and wind power. Wind is a very interesting resource for us because Iceland has some of the most favourable conditions in the world for wind farms. Wind blows consistently and we have plenty of land with few trees that typically cause turbulence. Therefore windmills don’t need to be built very high.”
Landsvirkjun’s growth over the last 50 years has been closely correlated with the expansion of Iceland’s power-intensive industries in general and its aluminium production in particular, with the bulk of its sales going to leading local producers such as Alcoa Fjardaal, Rio Tinto Alcan Iceland and Norðurál. This customer base provides Landsvirkjun with a solid and dependable dollar-based revenue stream, with S&P commenting that “its long term pay-or-take contracts with customers provides some predictability of earnings.”
However, Landsvirkjun’s relatively high dependence on aluminium producers leaves the company vulnerable to concentration risk and volatility in commodity prices. Its exposure to the global commodities market was especially damaging in 2008, when a sharp decline in the price of aluminium was partially responsible for a loss of $344m. “Landsvirkjun has assumed a commodity risk not seen for other utilities in Europe and outside of Iceland,” Moody’s advises.
While the price of aluminium has stabilised since 2009, Landsvirkjun cautioned when it released its half-yearly results in August that “currently the price of aluminium is low and uncertainty prevails over its development over the coming months”.
All the more reason for Landsvirkjun to intensify its focus on diversifying its customer base, which Arnarson says is at the heart of the company’s strategy today. “We believe the prospects for diversification are good, given that companies in a number of industries that have not previously invested in Iceland are showing an increased interest in the potential here,” he says.
Probably the most striking example is the slew of investments Iceland is seeing in the silicon and silica sectors. “At the moment, all the buzz is around silicon,” says Tómas Brynjólfsson, director general in the Ministry of Finance’s Department of Economic Affairs and Financial Services. “As in the aluminium sector, investors in silicon production are attracted by relatively low energy prices, and at least three new plants are expected to be built over the next three to four years.”
This is all good news for Landsvirkjun, although there are inevitably limits to the growth that can be generated from onshore power-intensive industries. As Moody’s comments in its most recent report, “given the very low marginal costs of production associated with its hydro sources, Landsvirkjun has a very attractive generation portfolio. In addition, competition from regional players, primarily Reykjavik Energy and Hitaveita Suðurnesja, is fairly limited. These strengths are, however, somewhat offset by the fact that Landsvirkjun operates in a small and isolated market.”
While growth opportunities for power sales are constrained by Iceland’s size and location, there is still very substantial potential for the country to generate much more power from its extensive renewable resources. According to McKinsey, no more than 20%-25% of Iceland’s available hydro and geothermal energy has yet been harnessed. A number of environmental stumbling blocks inevitably stand in the way of the remaining 75%-80% being developed in anything approaching its entirety. But Arnarson says that Landsvirkjun believes there will be general public acceptance of a doubling of the company’s current production. “The question we are asking is how can we make profitable use of any additional electricity we generate,” says Arnarson.
One answer may be to explore opportunities in the export market, which is why Landsvirkjun has engaged in a feasibility study on the construction of a submarine cable linking Iceland with the UK. This interconnector, known as IceLink, would allow Iceland to sell some of its surplus electricity into the much bigger UK market. “Iceland started to look at the possibility of building a power cable to the UK over 40 years ago,” says Arnarson. “But it is only in the last 10 years that the technology has become sufficiently well developed to make this a realistic proposition.”
Moody’s says that the submarine cable project would be “very significant and strategic” for Iceland. Arnarson agrees, but emphasises that Iceland would not be its only beneficiary. “The cable project is interesting because it would create a lot of value for both countries,” he says. “For the UK, it would provide renewable electricity at a very competitive price. The UK is investing heavily in offshore wind projects which are expensive, but it is essential that the UK finds alternative sources that can deliver when the wind’s not blowing. We can provide reliable and cost-effective renewable power which is an attractive value proposition for the UK.”
This should certainly be music to the ears of the UK’s energy regulator, Ofgem, which warned in a report published in 2013 that the risk of Britain suffering a major power blackout will rise significantly over the coming years as the UK’s ageing generators are retired. Since the publication of the Ofgem report, events in Ukraine have made Europe increasingly twitchy about its imports of gas from Russia, and about the wider issue of energy security.
“For Iceland, the UK cable project would be attractive because it addresses the problem of the isolation of the country’s electricity system,” Arnarson explains. “Because it is a hydro-based system, there is a lot of variation in the amount of energy we can produce depending on the weather. We have to make sure that we have enough electricity to meet total demand even in times when we have very little rainfall, which happens perhaps once every 20 years. We also have to ensure that we have sufficient reserves to cover our requirements in the event of a natural disaster such as a volcano.”
The net result of this contingency planning, says Arnarson, is that Landsvirkun typically spills about 10% of the water it receives into its hydro reservoirs in an average year. “By using this more productively, we can help the UK to address its energy problem, and at the same time reduce our exposure to the aluminium industry,” he says.
Arnarson says that preliminary estimates have suggested that the construction costs of a cable linking Iceland and Scotland would be in the range of €2.2bn-€2.5bn, which would be provided by external investors rather than by Landsvirkjun itself, and that the project would take between eight and 10 years to complete. But he adds that there are still plenty of technical and political hurdles that need to be cleared before construction can begin.
“We are still at the preliminary stage, and detailed cost estimates have not yet been undertaken,” says Arnarson. “We also need to secure political acceptance for the project, both in Iceland and the UK.”
At the same time, says Arnarson, global economic and environmental trends will strengthen the competitive advantages that Iceland enjoys in the international energy market. “We are confident that demand for Iceland’s energy resources will continue to grow as the price of energy in Europe rises,” he says.