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August 31, 2006
Hydropower Stocks as an Alternative Energy Play
    by Bill Baue

Phaethon and Creative Investment Research recommend hydro to gain exposure to the energy boom, contending new technologies offer potential for reducing environmental impacts.


The current three-year hot streak of energy stocks places socially responsible investors (SRIs) in a bit of a bind--most traditional energy technologies significantly degrade the environment, while most clean energy technologies are still nascent, and hence carry substantial risk and volatility. Investment research analyst Rich Williams of Phaethon has teamed up with investment advisor Bill Cunningham of Creative Investment Research to make a case for hydropower as a means of gaining exposure to the bullish energy market through a clean energy technology that helps address climate change.

From a universe of ten US and Canadian companies with significant commitments to hydro, the pair has created a model portfolio of six companies that are best positioned to perform well financially. The portfolio includes Avista (ticker: AVA), Brookfield Asset Management (BAM), Idacorp (IDA), PG&E (PCG), Portland General (PGB), and TransCanada (TRP).

At the request of a client, Messrs. Williams and Cunningham back-tested the portfolio, and found significant out-performance of the S&P 500 utilities index for the one-year and five-year periods. Due to above-normal water levels in rivers in the mid-Atlantic states, New England, California, and the Pacific Northwest that have boosted hydropower production up to 170 percent above the norm, the pair expects strong financial performance from hydro in the third quarter and beyond.

1 year performance

5 year performance

However, investing in hydro presents a series of challenges for social investors. Lloyd Kurtz, lead portfolio manager for SRI at Nelson Capital Management and archivist of the SRIStudies database of empirical research on SRI performance, notes that this performance is not peculiar to hydro, but is a byproduct of global demand for energy.

"Every upstream energy stock looks like this," Mr. Kurtz told SocialFunds.com, then pointed out the environmental problems traditionally associated with hydro. "Whatever benefit you get from hydro energy-wise, you have massive land use and conservation issues associated with it."

Mr. Williams readily acknowledges the legacy of hydro's problems.

"Certainly with the old dams, you alter the environment--in addition to impacting plants and animals, such as migratory birds, you may also alter the temperature of the stream," Mr. Williams told SocialFunds.com. "Also, you stop flooding--for instance, by altering the Mississippi River in response to Hurricane Katrina and controlling the floods with damming, you stop the replenishing of marshes, which actually protected the coastline."

Mr. Williams points to new technologies, such as run-of-the-river hydro that submerges turbines that turn with the velocity of the water, which can circumvent these problems. Unfortunately, these turbines can strike and kill migrating fish. Alden Research Laboratory and Concepts NREC conducted a study with a $5 million grant for the Department of Energy of a new turbine design that rotates slower, and found a much lower mortality rate for the 40,000 fish from six species tracked. The new turbine is scheduled to be installed at Brookfield Power's School Street Power Station in Cohoes, New York, outside Albany. He also points to new frontiers for hydro such as ocean and tidal power, as exemplified by the installation of tidal turbines manufactured by Verdant Power in New York's East River as a demonstration project.

The emergent nature of this technology underscores another limiting factor common to the clean energy sector.

"With any new technology, you have to start with the presumption that there's risk embedded in it, and there are so many new technologies, the chance that any one of them will dominate is quite low--the same applies to wind power, the same applies to solar," said Mr. Kurtz. "I can't assign an 80 percent chance that any single technology is going to be the world-changing paradigm--one of them will be, but it's very tough to be smart enough to say, 'That's the one.'"

"When clients ask, 'Should I buy this or that hydro power company?'--my answer is, 'No,'" he added. "I tell them they should buy a basket of alternative energy stocks to try and compensate for the lottery-like nature of returns in any emerging technology sector."

Mr. Kurtz notes that the PowerShares WilderHill Clean Energy Portfolio (PBW), an exchange traded fund (ETF) launched in 2004, plots very closely with oil and gas drillers, allowing social investors to participate in the energy boom while maintaining diversification across clean energy.

Mr. Williams agrees with the need for diversification, and points to wind as a logical counterbalance to hydro.

"Hydro's weakness is that it has year-to-year variability, so wind is the diversification vehicle for hydro, because wind on a year-to-year basis is fairly steady," he said.

The flip side of hydro's weakness is its strength in combining the lowest marginal cost power source at one cent per kilowatt hour with high income potential due to its ability to store energy in the form of impounded water for generating power at higher-priced peak demand times. Hydro is also the most efficient form of power production, delivering 90 percent of the energy generated to favorably compare to fossil fuels which deliver 50 percent efficiency, wind at 30 percent efficiency, and photovoltaic at 12 to 15 percent.

"Given hydro's prominence in the US energy mix, its numerous cost and operating advantages, and its renewable nature, there should be a lot more attention devoted to it," said Mr. Williams.

 

 
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