EDF: The heads are rolling

The replacement of the CEO is not a great surprise, but it returns the focus onto state intervention and political risk at EDF.

The French government has replaced the CEO of EDF, Mr Proglio, with Mr Jean-Bernard Lévy, CEO of Thales. The ousting of Mr Proglio is not a great surprise. Mr Proglio was close to the previous government, outspoken against the Hollande government policy of reducing nuclear dependency and struck by a scandal.

Nevertheless, I gage the market is seeing this as yet another piece of government intervention at EDF. That Mr Proglio’s contract was not renewed and the new appointment decisions have been taken on political grounds first and foremost.

The event will return the focus onto the malaise with regulation in France, no element of which is particularly favourable for EDF.

Mr Lévy is very close to President Hollande. But he clearly lacks experience in the energy sector. His ability to secure the best deal for shareholders in EDF’s very particular upcoming challenges, must be questioned despite his good track record.

The operational challenge, lifting availability back above 80% for the French nuclear fleet will be another important issue for Mr Levy. The 85% target seems far from reach still.

New nuclear will not be enough to distract from French political risk, and I see further down side.

EDF has underperformed the European utilities sector by 20% ytd. I expect the performance gap to widen as the yield attraction of the quality high payout end of the sector returns to favour amidst broader market uncertainty.

2015 consensus momentum has begun to turn negative, and I see further downwards pressure.

The slippery slope of oil

A 20% oil price decline has upset the directly impacted sectors and broader markets. Below, a short view on impact and action on oil, shale gas, utilities, renewables, and broader energy markets. That view is on the hypothetical case of more protracted weakness rather than just a short term correction. At this stage, there is no indication of that, futures are still up. Energy services are the most leveraged to the impact, look for power and gas exposure within services. Yield names are on the positive side as are gas utilities. I see the limited negative impact on shale gas and lng.

The unhelpful combination of materially increased supply and acute concerns on demand weakness resulting from the reduced IEA expectation has led to a 20% decline in the oil price over the past four months. The inaction by Saudi Arabia has contributed.

Conspiracy theories range from Saudi Arabia looking to hit US production to it looking to harm Russia in the context of the Syria situation.

In any case, there is unlikely to be any OPEC action on production cuts at the next meeting at the end of November. It is a question of discipline enforcement within OPEC.

The oil sector is broadly hedged, so the impact will come with a time delay, most likely one to two quarters.

Negative impact on shale oil, but not the end of it: Industry estimates for break-even for the bulk of projects range from USD 50-85, thus most projects are still viable at the prevailing level. According to IEA estimates, 4% of global shale projects require oil prices above USD 80/bbl. US tight oil accounts for less than 10% of global projects that require USD 80/bbl or above. The US IEA still expects good output growth from the Permian Basin, Eagle Ford and Bakken fields. But, a number of developers have been running on cash flow deficits for development capex. Capex cuts loom, but development is put out not put off. Risk of reserve write downs if the longer term view adjusts to current levels.

Limited impact on shale gas. Focused gas developers are few and far between. Gas activity will not be spared from impact on oil operations as companies consider global budgets. Some wells in the US where gas is a by product to crude as the prime driver might be on shaky grounds. Beyond that, gas has its own price and demand drivers. Henry Hub is down 18% but overall has had a more resilient performance than oil as a whole. Outside of the US, the quest for shale gas will continue on grounds aplenty, first and foremost energy independency. The focused names in the concept story segment will continue to see downside in the absence of uplifting other news flow. Short IGas (IGAS LN). Long Woodside Petroleum (WPL AU).

Positive impact on utilities and yieldcos: Positive inflation impact will lead to a prolongation of the prevailing low interest rate environment. Utility yields will support ratings. Long National Grid (NG/ LN), Enagas (ENAG SM), note on Abengoa Yield plc: The yield does not offer a high enough premium to the sector in my, when considering the risks of the business on a relative basis. Neutral SNAM (SRG IM), attractive yield stands against negative lng impact (see below)

Positive impact on utilities, II: European gas prices see a degree of weakness, much less than in the past, but still some impact from remaining oil price link. Positive for gas supply names more so than power generators. Power prices will not see a major impact, coal is the marginal driver. Gas will not see a materially higher rate of utilisation, for that over-capacity is still too large in the major European markets. There is no expectation in the pricing for materially improved gas plant profitability, according to my gage. Long E.ON (EAON GR)

Global gas prices: Asian gas prices fall, as a result of the prevailing oil price link. Assuming limited demand elasticity under current economic growth concerns, lng shipments will divert to Europe. Europe will benefit from lower gas prices (see above). Long Centrica (CNA LN).

LNG sees lower volumes and lower returns. Most of the more complex and higher cost projects are conditioned upon an expectation of lng as an enabler. Marginal projects will not make the cut. There is risk for a number of lng projects on the horizon. I retain my long term positive view on lng. Short GDF Suez (GSZ FP). Negative impact on Shell’s (RDSA NA) extensive lng business. Much less impact on Total (TOT FP) which has a higher degree of long term contract protection.

Negative impact on energy services from capex reductions across the board, the consensus view and in my view the correct one over the next quarter. Drilling equipment is worst of as drill rates decrease. USD 80/bbl is a first stop for capex cuts, USD 70/bbl the next. The opportunities lie in yield enhancement, undifferentiated underperformance provides opportunities.

Renewables. Negative headline sentiment from sector performance oil price correlation and perception of deteriorating relative economics. Real impact only in those areas where there is direct competition with gas, ie North America. Suggested pairs trade: long solar/short wind

EDF and UK nuclear: Giveth and taketh

The EU approval for EDF’s Hinkley Point cfd deal with the UK is a positive in terms of progress, but the deal did get worsened in material aspects. Higher profit share and a 400bps in the implied IRR will dampen positive investor sentiment from the clearance news. Hinkley Point in my view is an expensive and inefficient project. EDF still stands to build on its track record and has the risks and inefficiencies covered through the deal guarantees, but the margin has now shrunk. Nuclear is not a high margin low risk business, and profit claw backs are a feature to stay. I expect some positive momentum on EDF, but major political risk in France will come back to haunt at some stage.

The UK has moved a step closer to nuclear new build. EDF’s Hinkley Point C project has won EU approval on the issue of state aid through the CFD scheme. The EU has found the subsidy allowable on the grounds that “no investor would otherwise embark on the project”.

This is one of the last important milestones. It was not a given, the debate and struggle over state subsidy clearance was intense and was an uncertainty that was at best lightly discounted by the market.

There are still some hurdles: EDF has not taken the final investment decision. That can be expected at the end of the year at best. It also has to finalise arrangements with its minority partners to be, as well as waste contracts and overcome remaining resistance by environmentalists and the risk of a legal challenge by Austria

Hinkley Point is in my view an expensive and not very efficient project. It is a pioneer and does not come with a string of simultaneous reactor builds that would have allowed for standardisation, economies of scale and effiency. Cluster build was the original plan by EDF for all nuclear new build, but that is now not looking to come to realisation any time soon.

EDF had built remuneration for the projects inefficiencies into its negotiation and according to my estimate achieved adequate return expectations with the UK deal.

The EU has modified some features of the UK deal, to the advantage of the consumer/taxpayer and to the disadvantage of EDF. The implied allowed IRR is now 11.4% compared to the 15% under the UK deal, through the EU imposing a higher cost of the government guarantee and borrowing rate. That is a material deterioration. I estimate it comes close to a fully risked hurdle rate that EDF has to assume for the project. It does not leave much margin.

Profit share is now in the spotlight: There were profit share provisions in the UK deal, but the profit share issue was not a high profile one. The EU has put in an additional clause of 60% claw back if the IRR exceeds 13%. And, the horizon of profit share was lengthened to 60 years. The topic and its greater profile will negatively impact sentiment towards the entire deal.

Besides the fact that EDF has to hand over a much larger chunk of profits, the deal it resembles the old model of regulated utilities but upside down (rather than: the utility is set a rate of return, it gets to keep the out-performance, its now: the utility gets a profit cap). The regulator is back and increasingly intervenes in the market. Don’t forget, regulation is addictive. It is very clear that nuclear is not easy money or generous returns with little risk. Profit share as we have seen many times in various permutations over in the recent past (nuclear taxes, life extension vs taxation, windfall taxes etc.) is a distinct feature of the nuclear business. Investors need to build profit share into their expectations when considering the attractiveness of nuclear.

For the UK consumer, I find the profit share deal doubtful. It may win political capital. But the reality is that it creates not enough incentive for cost improvement, which is what the sector really needs.

I estimate EDF has secured a deal that still takes into account the lack of efficiency issue, the corresponding higher cost base and also the considerable execution risk that investors now have to take as a given. The margin with the EU deal is thinner than with the UK deal, but still acceptable.

Investors will not cheer the modifications, rather there could be some upset to sentiment over the profit share and the return numbers that are taking attention much more now than at the time of the agreement on the strike price. But the pure fact that the EU overhang has been removed will be helpful.

EDF’s share price has correctly reflected increased political risk. The Hinkley issue may help momentum for the short run, but major regulatory risk in France still hangs over the share price.

Chinese infrastructure and energy investment in Europe – one more

Chinese investors may be about to conclude another big European infrastructure deal, with the potential sale of a 35% stake in CDP Reti. I do not believe that this will drive up the share prices of SNAM and Terna short term. But I see the deal as attractive for the parties involved. I do see active Chinese investment in infrastructure, energy, utilities and cleantech in Europe. That should support private transaction activity, sector valuations and also operating fundamentals.

The Italian government is in advanced talks to sell a 35% stake in CDP Reti to the Chinese State Grid National Development, a wholly owned subsidiary of the Chinese State Grid. CDP Reti holds a 30% stake in SNAM and will also hold a similar stake in Terna.

The deal would be worth about Eur 2bn. I estimate it could exceed Eur 2bn, on the basis of both companies’ current ratings. But because the stake is in unquoted CDP Reti, a discount can be justified. Terna trades at  P/E of 15.3x 2015E, which is at the high end of the European utilities sector. It yields 5.03%. SNAM trades at a P/E of 14.8x 2015E and a 5.8% yield. The yields are attractive, but I do not see much room for multiple expansion at this stage.

The cash flow attractions of first and foremost Terna, but also SNAM and their strong dividends make them prime investments for infrastructure funds. The Chinese investors will see that as one of the core attractions.

The deal follows a string of Chinese investments in infrastructure globally, in energy in Europe, and in Italian energy, utility and infrastructure assets.

But also, the energy context fits with the investors’ broader strategy: Peoples’ Bank of China’s 2% stake in ENI and Enel (deal of March 2014) and Shanghai Electric’s acquisition of a 40% stake in Ansaldo are intriguing.

SNAM has the particular attraction of gas infrastructure which in my view will get increasingly valuable. It will become the backbone of the broader energy system and an enabler of affordability and system reliability. SNAM also operates LNG terminals which will in my view become highly valuable assets in a world of increasing global gas trade connection and LNG arbitrage. The Chinese interest in that element must be very high.

Infrastructure has partnered with a Chinese connection for a while in a symbiotic way. Chinese investors are looking to gain access to strategic resources. Some of that is achieved through infrastructure investment. That in turn in many cases enables asset or resource development. The many deals in Africa are examples o that.

The Italian government and the companies would achieve stable shareholders. There might still be concerns of strategic asset protection. But the Italian government has been looking for Chinese investment as a help to reduce its budget deficit.

Chinese infrastructure and energy investment in Europe will continue to play an active role, see also UK nuclear and UK water. I can see this as a support factor for large scale private deals. That should also support valuations and interest in the sectors on a broader scale.

 

EU energy efficiency on the slow path

The new EU energy efficiency target of 30% goes in the right direction, but won’t deliver a kick start to the energy efficiency market. It is a tool that could address the big challenges in Europe, climate, affordability and energy security. But its implementation is to weak. I expect energy efficiency to be a very big market, but growth will be on a steady path. Investors should look for building efficiency, solar BIPV, lighting and most importantly demand management and smart features. IT energy efficiency will come up as the next big issue, and there will be big opportunity for the tech sector.

The EU will set a 30% energy efficiency target by 2030, up from 20% by 2020, according to the latest proposals. The number is controversial, the range that member states were looking for went from 25% to 40%. And, the target won’t likely be binding. At this stage, it is an EU wide target rather than one that will be broken down at country level and legally implemented by state legislations.

Energy efficiency is seen, and rightly so, as a policy tool that could address the big challenges; climate, affordability and security of supply. But there is too little consensus to make the policy effective. The Eastern European states find the burden of transition too high, others would like to push for more, and yet others want freedom for their own policy implementation. That context cannot deliver a strong enough framework for measures that would make an impact.

As a very important element, the EU energy efficiency target is directed towards improving security of supply and reducing energy import dependency. I see the target in its current form as unlikely to deliver that. The incentive is not strong enough to deliver the required investment.

Energy efficiency should address affordability in some countries, namely the UK. Bills in the UK are amongst the highest in Europe, despite tariffs being amongst the lowest. That is a result of high consumption, which in turn is a function of weak energy savings performance. Energy efficiency will be the key to this debate. But, the UK is resisting a binding target as it looks to implement its own policies that are far from clear on the matter at this moment.

In a broader sense, energy savings should ease market balances and with that contribute to improving affordability. But that will be counteracted by other policy costs, such as green levies, system costs and the like.

I do see energy efficiency as a market of growth. But, I doubt that the EU target in its current form will do much to kick off the market. Otherwise, rising energy prices may deliver an incentive. Those will not come through tight markets, but through policy costs. Capacity balances will not justify increasing prices until the end of the decade in Europe, according to my calculation.

The energy efficiency market will with this continue a path of steady but slow expansion. I see continued growth in solar BIPV, building efficiency, lighting, demand management, consumer appliances and smart features. Names that are positively exposed are St Gobain, Siemens, Osram, Aixtron, but not to forget Apple and Samsung as well as Infineon.

I can also see EU directives and regulation coming through on IT. Technology, eg internet, stand by appliances, mobile devices, connectivity and much more has recently been named as one of the major energy demand drivers by the IEA. It is a big growth sector and increasing IT requirement will mean a completely new and yet unaccounted push in electricity demand. Energy efficiency in technology is a great opportunity for investors. I expect the tech sector to lead on this in its own right.

 

EDF and pricing: the big boys

EDF’s price reduction to the Exeltium consortium has a minor impact on earnings, but leaves the door open for more. It also shows the high levels of political risk in France and the fact that EDF’s tariff are a tool of policy. The shares are cheap with a 20% 2015 P/E discount vs the sector, but that is reflective of risk.

EDF has announced it will reduce its tariff for the Exeltium consortium which represents the 50 largest power consuming companies in France. The new price will be Eur 42/Wh, in line with the average annual French wholesale market rice. Exeltium members currently pay Eur 50/MWh.

I can see the commercial rationale of the renegotiation by Exeltium. The level of Eur 50/MWh was out of line with the market. It was derived on the basis that the Arenh price would go out to reach wholesale power prices in excess of Eur 50/MWh. But the market situation has completely changed. At those original levels, energy intensive companies struggle with competitiveness. The adjustment makes sense; still it is negative news. The new price is about covering costs of new build, and that tightly. It is reflective, from EDF’s perspective, of the general market malaise.

The deal also clearly shows the fingerprints of politics. The government is reported to have stepped in with “friendly” intervention. The element of international competitiveness of the largest French companies is highly political. Note the high emphasis in the communication of the deal put on competitiveness with German and North American manufacturing businesses under the angle of energy. It is my view that cost of energy will replace cost of labour as the major factor of distinction in global competitiveness.

The French government did not hesitate to step in in order to safeguard the interest of its wider industrial policy. Energy policy feeds into that. Affordability at the retail level and competitiveness at the industrial level are high priorities of the government. EDF is a tool at hand.

That ads to the recent negative news on end customer tariffs and the formula revision. The news on tariffs continue negative. I estimate a minor impact, less than 0.5% of group EBITDA for 2014, but EDF’s earnings outlook is clearly all but improving.

There is risk for future adjustments, after this deal has set a precedent. The current wholesale power spot price stands at Eur 24/MWh, and futures are a touch below Eur 42/MWh.

The shares look cheap at a P/E 2015 o 12x vs an average of 14x for the European utilities sector, but the discount reflects political risk that has returned with vigour.

 

E.ON’s Spanish sale

A good bidders list for E.ON’s Spanish assets improves the pricing outlook for E.ON. But the assets will likely go below book value. I estimate a total of up to Eur 1.8bn, vs a book value of Eur 2.7bn. Still, the sale should enable E.ON to come very close to achieving its net debt target. The case is slowly improving, even though investors need patience.

The number of bidders for E.ON’s Spanish assets mentioned in the report by Expansion yesterday is a positive for speed and potentially pricing of the assets. Villa Mir of Spain and EDP are amongst the bidders. Beyond that, there are infrastructure funds on the potential list of bidders.

Given the grid assets, the infrastructure interest is clear. But EDP’s position might also be strong. The combination of trade buyers and infrastructure may overall improve the valuation for E.ON.

Book value of the assets is Eur 2.7bn. But I doubt that that will be achievable. I estimate a realistic fair value in the order of Eur 1.8bn, based on about 6x EV/Ebitda.

At that level, I estimate the company will almost hit its target net debt/Ebitda ratio of 3x. And there will be a reduction in the negative earnings contribution.

The earnings are bottoming very slowly, and investors need patience. But the case is marginally improving.

 

 

 

RWE – a glimpse of sunshine

RWE has entered into a symbiotic marketing partnership with Conergy. It will gain brand equity, whilst Conergy will strengthen its own market position. For RWE, this is a very good deal and a step in the right direction of its strategic reinvention. It will need many more of those.

RWE has entered into a partnership with Conergy for solar roof top system leasing for commercial customers. RWE will market systems of 50-200kw to its customers. Conergy will design and install the systems and components and offer operations and maintenance services.

Solar leasing will see growth in my view, it is a very flexible model. It is already a good part of the US market, and I expect to grow elsewhere.

The deal makes a lot of sense for RWE. It fits with its reshaping strategy towards energy services. The company needs to leverage its customer base to build a portfolio of value added services. Solar is a very important part of that strategy, in my view, utilities will have to have a convincing solar offering within their supply strategy.

With Conergy, RWE has brought on board a very highly recognised brand. That will give it an edge with its German customer base. There has been some taint through the Conergy bankruptcy, but Conergy has recovered. The RWE deal is symbiotic for both parties. It will help strengthening Conergy’s brand again, and RWE will gain brand equity on its own through it.

Conergy is now refinanced and should be able to deliver under the deal with its new structure.

This is a step in the right direction for RWE. In the context of the company’s much larger and long term strategic shift, it is a small step still. Many more need to follow.

Guest comment: Energy Affordability: The Rising Tide on UK Shores

by Dr. Mark Powell, Head of Utilities, AT Kearney

The UK has experienced some of the lowest cost energy in Europe over the past twenty years or so.  Part of the reason for this has been the success of privatization and liberalisation which has driven significant efficiencies in the sector in comparison to the era of state ownership.  This reality has largely been ignored in more recent times as we have increasingly felt the pain of rising costs.  This has placed energy affordability as the centre of the Energy debate.  Everyone us now ganging up to blame everyone else for these rises.  Labour blame the energy companies despite the fact that there is increasing evidence that energy policy and the drive to hit aggressive carbon and renewables targets is also a key reason for costs rising.  Whatever view you hold, one thing is clear, energy affordability is now front and centre as a key issue and is not going to go away and will become a key factor in the future direction the industry takes.

The problem with the debate is that terms like “affordability” and “fuel poverty” are being thrown about without a proper consideration of the facts and figures which surround them.  We thought it was about time we had a proper look at the issue in order to shed some light on this important debate.

From 1978 to 2012, domestic energy prices in the UK have grown by an average of 5% per year for electricity and 6% per year for gas.  These hardly seem excessive although have outstripped the retail price index.  Furthermore, when you compare them to the average gas and electricity prices for Europe as a whole they have been between 20 and 40% lower than the average.  This leads to the first reality of affordability in the UK – we actually pay less for our energy than our European neighbours, the problem is that we consumer more on average than they do so our total bills are, on average, increasingly higher.  The problem, it would seem, is not so much prices as consumption.  We have some of the least efficient housing stock in Europe and, one supposes that our weather does not exactly help either.

We next have to also consider the real income affects as well.  Since the financial crisis households have experienced a decline in real incomes.  This has led to an increase in the proportion of household income spent on energy.  This has risen from an average of 2.8% in 2005/06 to 4.2% in 2011/12. This however hides the more important fact which is that this has affected the lower third of households by a much greater degree with the proportion of their income spent on energy rising from 6.4% to 8.8% in comparison with the top third only experiencing a 1% increase from 1.5% to 2.5%.  The reduction in real incomes has not been experienced evenly across groups such that affordability is much worse at the bottom and this is partly due to real income affects.

It is however the case that energy prices have outstripped most other general costs faced by households.  From 2001 to 2012 the CAGR for RPI was 3.1% while retail gas prices went up by 9.5% and retail electricity by 6.5%.  Interestingly however, despite the ongoing debate about the link between wholesale gas and retail gas and power prices, on average for this period wholesale gas prices increased by 7.2% and so are not that out of step with retail prices across time as many would like to believe. This does support the view that retail prices do largely follow wholesale movements and challenge the automatic assertion that the power companies do not align retail and wholesale prices over time.

Let’s move away from prices for a moment, as I said earlier, prices are one thing, but affordability is also about consumption.  What becomes clear is that affordability would actually be significantly worse had we not experienced a noticeable decline in average electricity and gas consumption which has declined by 2% per year from 2004 to 2014.  If this trend continues then average consumption in 2024 would be 27% less per household.  This starts to demonstrate that consumption reduction will have a greater impact than prices movements over time.

What do we think the picture will be like over the next ten years? Our analysis shows that when price and consumption patterns are taken into account, an average household duel fuel bill will increase from £1,324 in 2013 to £2,012 by 2024.  This is an increase of £680 per household and a rise of 51% over the next ten years.  At an average CAGR of 3.9% this is almost certain to outstrip RPI and lead to affordability becoming worse.

Modelled average residential dual fuel bill – A.T. Kearney base case, 2010-2024 (£/year, Nominal £)

The question is while gas prices have clearly had a large effect on costs in the past few years, what will be driving these increases in the next ten years?  If you break down the bill, what becomes clear is that the single biggest factor driving these costs will be energy policy both at a UK and European level. EU policy costs will drive a CAGR in bills of 7.9% and UK only policy a staggering 16.2%.  This is against wholesale costs which will remain largely static.  If you include all elements of the bill including retail costs and profits and network costs, only 18% of the bill is actually within the control of the individual energy companies.

The projections on bills have assumed that we continue to enjoy the effect of ongoing consumption reductions. What happens if you are unable to enjoy these reductions?  Many household suffer from much poorer housing standards and have less access to new efficient appliances which are driving these reductions.  Our analysis shows that while a dual fuel bill for most would increase by in real terms by 0.6% per year, it would go up by a 6.7% from 2013 to 2024 for those unable to take advantage of ongoing efficiency measures. When you look at all of this across all households, our analysis suggests that without energy efficiency by 2020 up to 80% of All UK households would be spending more than 5% of their household income on gas and electricity.

So where does all of this leave us – there are a few conclusions to draw:

Energy costs are going to continue going up and become less and less affordable with duel fuel bills 52% higher in 2024 than they are today.

The key driver for cost rises over this period is policy costs, at both UK and European level.  Without these costs bills would actually be 2% lower in 2024 than they are now.

There is little that the energy companies can do to change this as only 18% of costs are in their control and very little of the 18% is actually profit.

The real issue for affordability is not prices, it’s the increasing impact of relative efficiency those who are unable to take full advantage of efficiency reductions will see their bills raise massively and the poorest in society will experience a regressive effect as they pay increasingly higher proportions of their income on energy than anyone else.

What this analysis highlights is that we should not be talking generically about “affordability” without understanding the drivers and the facts and economics that underpin what is actually happening.  The UK has had lower than average prices and higher than average consumption profiles than the rest of Europe.  Affordability is much more about consumption management and the costs of greening our system with more expensive renewables than it is about wholesale gas prices and retail profits.

The time has come to have a proper debate on the best way to handle the issue of energy affordability, not to get into tit-for-tat debates about who is to blame.  Affordability is much more complicated than that but it is clear that this issue is not going away anytime soon.  Maybe when it comes to Energy Policy in the UK we need a new debate and a plan B.

RWE: Lignite and the summer trough

RWE is campaigning for its lignite plant to be considered as back up capacity. I think the likelihood of that successfully resolving the profitability issue of the generation business is low. Meanwhile, the summer trough will provide weak pricing and not much else that could support the share price. The only supportive factor is relative shifts of political risk within Europe. The shares trade I line with the sector and I do not see any premium as justified. There is risk of a short term correction after the recent good performance.

RWE is on the path of campaign for its lignite operations. The head of lignite generation has said that the company’s lignite plant will be as flexible as gas in its ability to serve as back up capacity for renewables.

I agree that lignite plant has become much more flexible, and RWE has particularly focused on improving technology with the goal of flexibility over many years now. That has yielded results, by and large thanks to the BoA technology. On operational grounds, lignite may now come close to gas as far as backup ability is concerned. Management claims it can now ramp up and down capacity by 50% within 30 mins, which is in line with gas. There is still another question though, because RWE’s lignite plant I larger in scale than what would be envisaged average plant size for gas.

If the company is looking to position its lignite operations for the capacity scheme under discussion, I see the chances as weak. Politically, lignite is badly perceived. The high emission profile is one reason. The connected open cast mining is another. There is a lot of resistance against that, and the state government of North Rhine Westphalia is looking to reduce lignite mining. It has recently said it is looking for open cast mining to reduce by 300mt by 2030, from currently 1.3bn.

Back to the emissions issue, for the time being, the company benefits from extremely low CO2 costs. But, that may change at any time a follow on regime from the current EUETS comes in. It is hard to predict if and when that will occur, but the downside risk is big. And, any increase in emissions allowance costs will not get reflected in the wholesale power price as that will driven by the soft capacity balance for the foreseeable future. That makes for operational risk of lignite on the cost basis.

Politically, the emissions profile of lignite will make it unacceptable as back up capacity under the capacity scheme, most likely. The company may achieve a temporary inclusion through skilful negotiation. That could be the case if the back up capacity scheme will be designed very broadly and fuel agnostic. At this stage, there is no clear path of that, and indications are that the scheme will be directed towards gas.

I sense that the company is also looking to improve acceptability of its lignite mining operations in order to counter the threat of output reduction. RWE is diligently highlighting employment and the number of local contracts for business it has handed out. The connection to backup capacity is well brought up from a communication stand point and as said above has value. But the stance of the State government which includes the Green party will likely be tough.

RWE has also said that it cannot cope with any further negative impact from the EEG. I agree with that view in the light of the 25% y/y decline of operating earnings in the generation business and the company’s well over 4x net debt/EBITDA ratio.

The lignite campaign may yield limited results at best in my view on either of the target topics, acceptability as back-up fuel, EEG impact reductions, and lignite mining protection. What RWE needs is a complete reshaping, or a material change in the power price outlook. The latter not in sight with futures standing at Eur 35/MWh, the generation business does not set for any improvement. A complete reshaping will take time.

The shares have performed in line with the European utilities sector, and marginal positive news flow has supported performance. RWE trades on a 14x P/E 2015E, in line with the sector. I cannot see any premium for the business vs the sector. The only potential for relative upside is a shift in relative political risk within Europe away from Germany and towards France and the UK (see my recent post – Political risk, published June 2014). The “summer trough” on pricing will not bring any positive news flow, and a short term correction could occur in my view.