Clues emerge for Tesla’s $5 billion battery factory by Kirsten Korosec @FortuneMagazine March 10, 2014, 9:49 AM EDT E-mail Tweet Facebook Google Plus Linkedin Share icons FORTUNE — Tesla Motors, the innovative electric car company, wants to be a bigtime automaker. To achieve that, it needs to produce hundreds of thousands of vehicles more than the 22,300 electric vehicles it made in 2013. Which means it’s going to need a bigger battery factory. A much, much bigger one. On Feb. 26, the electric automaker revealed the first details for its so-called Gigafactory, a massive facility that will be designed to produce more lithium-ion batteries annually by 2020 than were made worldwide in 2013. At 10 million square feet, Tesla estimates that the plant will have the capacity to produce 50 gigawatt hours of battery packs a year, which will be used for its Model S luxury sedan and a cheaper third-generation vehicle intended for the mass market. By 2020, Tesla estimates the facility will be able to make enough batteries to supply 500,000 vehicles a year. The factory, which will employ about 6,500 people, is expected to reduce the per-kilowatt-hour cost of its lithium-ion battery packs by more than 30% by the end of the first year of volume production. It’s nothing less than necessary for CEO Elon Musk’s bid to make a car 50% cheaper than Tesla’s luxury Model S, which starts at $70,000. A possible location Since the announcement, speculation has run rampant about where the facility will be located — and with whom battery manufacturer Tesla will partner. In its initial announcement, Tesla said it is evaluating 500- to 1,000-acre sites in Arizona, Nevada, New Mexico, and Texas. But the company has said little else. (Responding to a Fortune inquiry, Tesla spokesman Patrick Jones declined to comment any further.) But according to Navigant Research analyst Sam Jaffe, there’s one must-have that Tesla’s new plant will need more than any other: a freight train. MORE: Why Google should acquire Tesla “The single-most important aspect is that it’s near a rail line,” said Jaffe, who specializes in the energy storage market. “These batteries are very heavy, and they have to ship them all the way to their plant in California.” Put a rail line toward the top of the factory’s basic requirements, and the list of possible locations narrows. “If you look at the Union Pacific line, they go right through El Paso, cut through New Mexico, through Arizona, and then up through Nevada,” Jaffe said. “And look at their Fremont plant; it’s right next to the rail line.” Potential partners Tesla also said it will partner with a battery manufacturer as well as companies that supply the precursor materials (such as lithium, nickel, cobalt, and electrolytes) needed to make the batteries. Under the plan floated by Tesla, the partners will share the cost of the Gigafactory. Tesla will directly invest about $2 billion. Tesla has not yet named any partners. However, in the company’s fourth-quarter earnings call last month, Musk did say the assumption is that its current battery cell supplier Panasonic would continue to be a partner. MORE: Would you watch an electric-car racing series? Panasonic spokesman Jim Reilly said the company, which also supplies Tesla with automotive electronics components, is looking into a variety of options to further strengthen its collaborative relationship with Tesla Motors. But nothing formal has been decided, Reilly said. Panasonic has had a relationship with Tesla — first as a battery cell supplier, later as an investor — since 2009. The company invested $30 million in Tesla in 2010. Last year, Panasonic agreed to expand its arrangement and supply Tesla with nearly 2 billion cells over the course of four years. The battery cells will be used to power the Model S as well as Model X, a sport utility vehicle scheduled to go into production by the end of this year. Still, Tesla has vetted other battery cell suppliers, Jaffe said. And it has certified other companies, including the Korean firms LG Chem and Samsung SDI and China’s BYD. “Tesla has essentially given the specs of the cell they want built for its battery and have confirmed that [each] manufacturer is capable of doing it,” Jaffe said. Which means Tesla could order battery cells from several suppliers — though it is unlikely that the automaker will choose more than one manufacturer to partner with on the Gigafactory, Jaffe said. Other potential battery manufacturer partners include China’s Lishen, ATL, and Sony — a long shot, Jaffe said. Size is key But the capacity of the factory may be the most clever part of Tesla’s plan to attract a battery partner. Tesla said the factory will have the capacity of 35 gigawatt-hours (GWh) per cell and 50 GWh per pack. The extra 15 GWh is the carrot Tesla is holding out to its potential partner, Jaffe said. Tesla is essentially guaranteeing that while most of the battery cells from the factory will go toward its next-generation model, it will still need to buy more. “Let’s imagine you’re a battery manufacturer and your big buyer comes to you and says, ‘I want you to help me build a factory so I can make a product that you make today and cut you out of the supply chain,’ ” Jaffe said. “Why would you possibly do that?” MORE: Why the Tesla recall matters Even if Tesla sells the 500,000 mass-market vehicles it desires, and continues to make the Model S and Model X, the Gigafactory should still have a remaining 10 GWh of manufacturing capacity left, Jaffe said. That remaining capacity could be used to support — and expand — its burgeoning stationary (as opposed to portable — that is, cars) energy storage business. Tesla already supplies the California energy services company SolarCity with batteries for energy storage systems designed for commercial buildings. SolarCity has worked closely with Tesla for more than three years in its development of a stationary storage product, said Eric Carlson, SolarCity’s senior director of grid systems integration. (Tesla’s Musk is also chairman of SolarCity.) Carlson wouldn’t comment on any future plans with the automaker except to say that he expected the partnership to continue. However, he did say that SolarCity sees significant demand for stationary energy storage and would expect that Tesla would also be excited about its market potential. MORE: Elon Musk’s mom on raising the Businessperson of the Year Nevertheless, if Tesla expects to sell more than 10 GWh per year’s worth of battery packs to the stationary storage market, the packs will have to be priced below $200 per kilowatt-hour (kWh), Jaffe said. Tesla has said that the lithium-ion batteries it buys from Panasonic are between $200 and $300 per kWh, but the current cost of stationary energy storage is much higher — between $500 and $800 per kWh globally. Next steps If Tesla aims to produce a mass-market electric car in three years, it knows it will need to accelerate the rate at which it drives down the cost of producing one. A massive, multibillion-dollar factory that unifies the disparate steps in manufacturing lithium-ion batteries is a step toward that. Will the economics make sense? Like Tesla itself, we’ll only find out in time.