German nuclear – Can they pay up?

Concerns abound in Germany about the generators’ ability to cover nuclear liabilities. We see nuclear liabilities as well covered, but recognize that there are no dedicated assets. Nuclear provisions are specific in terms of utilisation or reversal, but there is concern about the utilities’ cash generation profile being insufficient. E.ON’s split and the nuclear bad bank debate has increased the worries. We see risk of political action that could lead to additional cost and/or cash outflows for the generators in relation to nuclear. E.ON stands up better than RWE.

A Green Party commissioned study by the Ruhr University concludes that E.ON’s and RWE’s nuclear provisions may be insufficient to cover their respective long term liabilities. It quotes E.ON’s assets of Eur 56bn as just sufficient to cover Eur 55bn of liabilities, and RWE’s Eur 41bn assets as insufficient for coverage of Eur 51bn of liabilities.

The ability to meet nuclear liabilities can vary substantially in function of the underlying assumptions. That begins with the full and true cost of decommissioning and site rehabilitation and ends with discount rates and time frames.

We sense that both RWE and E.ON have always followed a conservative provisioning policy, certainly with regards to cost assumptions and discount rates. There have been times where the market has questioned the discount rates for being very conservative and leading to high levels of provisioning. RWE’s uses market rates, E.ON 4.7% which we find prudent. Like most utilities, both have based their cost assumptions on high profile external estimates that are regularly updated.

The issue that has arisen is the shorter than expected life span. But, that has led to provision re-evaluation at the time the nuclear phase out was passed into law.

Industry precedents and estimates suggests decommissioning costs of USD 200-600/kW to which come site rehabilitation. We recognize that there is risk to the upside. German experts have quantified the costs at Eur 50bn, thus discounted at the utilities’ rates Eur 37bn for the whole of the sector. That is broadly in line with total provisions to date. For the big two, E.ON has Eur 17bn of nuclear provisions and a Eur 57bn asset base including financial assets. Pension and financial liabilities are another Eur 25bn. We estimate discounted liabilities for E.ON’s reactor base to the tune of Eur 15bn. In that sense there should not be a coverage problem. RWE has Eur 10bn of nuclear provisions against an asset base of Eur 41bn of tangible and financial assets, while pension and financial liabilities are Eur 28bn. Again, at this stage coverage is reasonable, even though tighter than at E.ON.

The issue that worries politicians is that there are no dedicated or ring fenced assets, but that provisions are backed by the companies’ generation fleet and financial investments. Recognition has sunk in that asset bases no longer delivers cash generation levels that may be sufficient to underpin provisions and cover associated and financial liabilities. That concern has been heightened by E.ON’s split and the debate about a nuclear bad bank. We (and to our gage investors) share the concern about cash generation, on various levels, not just nuclear provisions coverage.

We see risk of political action and/or legislation that might lead to additional costs for both generators in relation to nuclear as the legislator seeks to ring fence cash. The government is very concerned that the tax payer might have to step in. The Economy Minister has in the past hinted towards placing additional requirements onto the generators. Intermediate and final waste storage provide tangible opportunities for that.

E.ON’s stronger balance sheet and stronger cash generation profile of its asset base make us more comfortable than RWE’s. E.ON’s split might be a catalyst for action by the government, but any action will cover both generators.

French nuclear champion anew

There will be relief on the news: EDF has sheltered itself from the major risks related to Areva’s reactor business. Strong nuclear performance in H1, in line results and reiterated guidance will also contribute to some improvement in sentiment. One of our big concerns, overhang from the Areva deal, is removed. Still, execution risk has increased without a doubt. EDF will need to strongly communicate on execution and also financial and reactor cost benefit and its improved positioning in the global market.

EDF has outlined the terms of the Areva deal. It will acquire 75% of Areva’s reactor business for Eur 2.7bn. As per the previous numbers, this implies a take-out multiple of 0.75x sales. EDF will submit a binding offer in Q4 15 and is looking to close the deal in H1 2016. According to EDF, the deal will be cash flow neutral in 2018. That again will lead to some relief reaction.

A new dedicated joint venture to be held 80% by EDF and 20% by Areva will be set up for new reactor exports. We see that as a positive for streamlining and efficiency of the international business.

EDF is looking to bring in partners so that eventually it may own 51% of the business. Note, however, that there will be a three way management situation. EDF’s majority ownership gives some comfort in terms of efficiency as far as control goes.

Management has said it has already received indications of interest. We would not be surprised for such interest to come from potential Chinese partners.

The big relief is that EDF is completely immune from all risk relating to the Finnish project. It is also a positive that it will be in full control of the Flammantville and Chinese projects. That should help with execution, which we see as the key element for success in new nuclear.

Along with results in line with guidance (net income Eur 2.5bn, flat y/y) and reiterated guidance (nuclear output 410-415TWh), all of the above should lead to a relief reaction on the share price.

If indeed Chinese partners were to enter the EDF/Areva venture this could bring the global nuclear sector down a path that we have anticipated for a while: Chinese project execution skills could reduce risk and with it the cost of new nuclear. Chinese managers and developers would become more important in the nuclear sector globally. New nuclear might become more viable from a cost perspective.

Asset ownership – What First Utility’s listing plans presage for the sector

First Utility’s potential listing and simultaneous private equity interest in the company are illustrative of changing asset ownership structures in the sector. We can see the business could be appealing to public investors. Both forms of ownership can add value to the company. Our view of the direction that the sector will take supports new businesses and new and flexible forms of ownership.

First Utility, the UK independent electricity supplier, is looking for a London listing in 2016. Its market cap could be around GBP 500m.

There is private equity interest as an alternative. We find both forms of ownership make sense.

The business is very appropriate for an independent listing. Whereas we would have been more hesitant in the old world of energy, the changing sector supports such a view. In the old times, supply would have been characterised by a combination of low growth, regulatory or political risk, negative commodity exposure under a view of long term rising commodity prices and high intensity of competition. Now, independent supply stands on the other side of the regulatory fence to the big six. First Utility targets 1m customers over the next year, ie 25% y/y. There should be potential for growth from new offerings and margin expansion. All of that is appealing to public equity investors.

In our vision on the sector, we see vertical dis-integration as a feature. The E.ON (EOAN GR) split is exemplary, as is – in a circular fashion – First Utility’s potential listing.

Downstream will become a segment of growth and value added. The sector is at the core of change, it has at its doorstep potential for growth from: Packaged services, brand equity, customer recognition and service; smart energy integration; renewables and micro-generation. The borders between sectors in- and outside energy are not always very clear, especially when considering the pro-sumer (small scale generation for own use, particularly solar). Inter- and intra-sector boundaries will move, also with regards to adjacent sectors. See mobile payment, consumer appliance management as some examples. All of this is opportunity for the downstream sector.

Some of these emerging trends may be better exploited under private ownership. Private equity ownership can foster relationships, facility access to new technology and provide nimble yet deep expertise when companies are either in strategic change or rapidly changing sectors. Both is the case here. There is the additional advantage that there may be moves of long term nature that the stock market may not appreciate and that may be easier to execute under private ownership.

Public ownership on the other hand may have the advantage of profile raising, with the added benefit for marketing and communication purposes on all fronts, access to a wide investor base, and last not least potentially larger amounts raised. That last point is of value when considering that by nature a good part of growth may come from acquisitions.

All of this supports our view that there will be changes in structures as well as asset ownership. As a side note, take account of the 8% stake by Royal Dutch Shell (RDSA NA). Irrespective of this case, we see new assets coming to market, and also increasing private ownership. There is positive impact on market- and primary activity, and multiples. Early stage investors will find exit opportunities.

EDF – no heatwave in tariffs

Whilst the heatwave is on in France, there is no risk of overheating on tariffs. The government decision on this year’s tariff adjustment for EDF (EDF FP) will not excite markets. It is slightly better than the previous prospect of a nil increase, but not enough to give meaningful growth. Expect continuation of relief performance on the back of reduced political risk, but only until execution risk on Areva (AREVA FP) take-over.

The French government has published its decision on the upcoming tariff adjustment for EDF. Tariffs will increase by 2.5% y/y on average in August. This is below the 3.5-8% recommended by CRE, the French regulator. That is not a surprise.

It is a marginal improvement when compared to the prospect of a nil increase that the Energy Minister had previously hinted at.

The increase is below what is required for cost reflectiveness, still. It also means further accumulation of deficit with regards to coverage of costs. It is not sizable enough to bring any upwards pressure to consensus in our view.

A political after taste remains. Some observers may still see the increase as somewhat of a reward for the Areva deal.

There may be continuation of relief performance on EDF. We see this on several grounds: Relief on the fact that there is absolute tariff increase, some recede in political risk as two big items (Areva, ie political intervention in industrial strategy, and tariffs, ie profitability) are now reflected in the price. But we do not see major upside potential beyond short term relief. The next share price driver will be execution risk on the integration of Areva.

….and work…. and keep those German coal plant on

The likely prospect of an absence of the coal levy is a great relief for the German generators. Contrary to previous developments, this time the biggest beneficiary is RWE. We short term relief, but prefer E.ON for longer term exposure.

According to German news source ARD, the Economy Minister will drop the planned coal levy. The Ministry has said it is looking at alternative plans. Reportedly, the government is looking to mothball 2.7GW of old coal plant over a time frame of four years, in order to push forward towards its emissions reductions target. Old hard coal plant under the CHP (combined heat and power) regime would be shut first, in order to substitute that plant with gas CHP. The government would look to cover the 5.5mt shortfall against its emission reductions target through other measures, such as support for heat pumps and unspecified measures at municipalities. The Minister has said he will publish a final decision July 1st. Gaging from the wordings of comments by several senior government and State level officials across the coalition parties on the matter over the past couple of days, we see the likelihood as the coal levy being off the table.

Realpolitik and industrial policy seems to have won the argument. The impact on the domestic lignite industry would have been too important to bear. Further, under energy considerations, especially security of supply and affordability, lignite is a fuel that is abundant and cheaply available from domestic sources. It is clear, that there will be another impact on affordability. The chp repartition will increase end user prices. But so would the coal levy ad power price impact have done.

Mothballing of old capacity would almost certainly hit RWE alone. It has over 7GW of coal capacity that is over 37 years old. 2.1GW is hard coal plant of aged over 30 years. But, on balance it might be a positive. The plant runs on very low load factors. On the other hand, the Minister has said there would be compensation for such reserve plant. RWE and Vattenfall would thus receive capacity payments. On a side note, the part of the mothballed reserve plant invites questions relating to potential capacity payments. The government has several times articulated a less than supportive position for capacity payments. And certainly, if any they might be for gas in the first instance. But these plans could be interpreted as a de facto start of a remunerated capacity reserve.

With that, we see the relief bounce for RWE as justified. But we doubt that there will be any reversal of performance. For that, the structural challenges on the overall profitability of the generation business are too steep (for more detail, see my previous article on www.montpellieranalysis.com – Why RWE remains uninspiring).

The sun shines again on solar – musings on batteries, growth, deals and more

Below, we outline our impressions and views on the key points that stood out at Intersolar in Munich. The message is: growth is back, and storage is the centre point of attention. The Siemens (SIE GR)/SMA (S92 GR) deal was a highlight. 

As a whole, Intersolar suggests substance of the solar recovery. Visitors at the main solar show were stable for the first year since 2012.

The PV Market alliance, formerly EPIA, suggests 50GW of annual installations for 2015, or 25% y/y growth, first and foremost driven by China, but also Japan and the US. China has installed 5GW in Q1, the US 1.3GW.

Storage was as expected the big focus. The storage focused exhibition saw a five-fold increase in visitors.

The BSW li-ion storage price index has fallen by 26% y/y. The combination of falling costs, availability of subsidies and a very strong competitive drive in the sector should provide an acceleration in momentum of availability of solutions, and finally, adoption. As one example, Samsung has presented new residential storage systems of 5.5kW and 8kW based on a li-ion battery and with built-in inverter, specifically targeted at the German residential market.

The German Economy Minister has said in a key note speech that he considers solar as the backbone for energy transition. We find that a striking comment, less because of political significance, but because we believe structurally, there are valid points to the assertion.

We do not expect any change with regards to the political climate for solar by the German government. The downward trajectory of subsidies will continue. The government is keen to support SME’s, the Mittelstand, as the backbone of the economy. That is found in sectors that are no longer solely focused on solar. Small trade and services, as well as technology is where the interest lies, rather than manufacturing.

Still, solar is at the heart of structural change. As grid parity becomes the reality, growth will continue and the range of applications widen. As such, solar already offers and will offer more characteristics that are not quite infrastructure like yet, but have similarities to backbone resources. The assets are widely distributed and are close to the point of consumption. They are very flexible. Storage will have a game changing effect and indeed bring solar to something close to the core of the system: Solar can fulfill backup functions, smart energy functions, demand management and market balancing. Solar charged EV’s as means of larger scale energy storage with back into the grid, microsystems and off grid, and solar as technology of choice of the prosumer (producer-consumer) are just some examples.

The battery sector is clearly directly exposed to the paradigm shift. LG Chem (051910 KS) is the global leader in li-ion batteries.  GE’s (GE) strength is in wholesale and grid scale applications. We also highlight ABB (ABBN VX), Sharp (6753 JP), Samsung (005930 KS). Privately held Acquion Energy is a supplier to ABB and a number of other larger battery and storage system suppliers.

Eventually, the manufacturing sector will benefit through demand shift. But we see that point as still further out. In the meantime, we see Jinko (JKS) standing out as the name with the best relationship of multiples vs growth.

The Siemens (SIE GR) / SMA (S92 GR) deal was a highlight. The two companies will partner for a joint large scale bundled inverter and storage product offering. We see the deal as very synergistic for both parties. For SMA, it may be a piece in the puzzle to recovery.

Germany, working on the coal plants…. and work…. and work….

New plans call for certain coal plant to go into a strategic capacity reserve as it transpires the proposed coal levy is politically unfeasible. There would be positive impact on market prices from such a scenario, we estimate to the tune of Eur 2-3/MWh. We gather E.ON would be a greater beneficiary, due to its greater exposure to technologies that would benefit from a resulting merit order switch.

German press suggests that the proposed coal legislation will see further amendments, due to resistance from parts of chancellor Merkel’s CDU, but also parts of the SPD, the party of the Economy Minister in the grand coalition. There are suggestions by DPA that the climate levy on coal plant is becoming unfeasible. Instead there are alternative suggestions, to the effect that certain coal plant, old hard coal or lignite first and foremost should be brought into a strategic capacity reserve.

On the point of any capacity remuneration, investors should probably not hold their breath. Other markets have shown that there is potential for disappointment. Furthermore, coal is not a desired technology under current energy policy, implying any remuneration at very low levels. Security of supply is important to the government, but it is well aware that supply remains ample until the end of this decade. New gas capacity is built very quickly if needed. Lignite is more politically sensitive than hard coal, because of the greater domestic lignite exposure.

Clearly, such a capacity reserve would add costs to the system. There would be aftermath relating to affordability.

The effect of such a new plan would be a net positive: Contrary to the climate levy proposals, through the alternative plant, merit order shift would occur. The impact on power prices could be to the tune of Eur 2-3, according to our calculation. Further, the plant would receive capacity payments of some sort. That could on balance mean profitability improvement for generators. The plant that could go into the stand buy reserve would according to current discussions be particularly high emission reactors, ie old lignite or hard coal plant.

If all of old coal went into the strategic reserve, gas load factors would be practically unchanged on average days. New hard coal would be price setting. But, we estimate short run marginal costs for new hard coal in the order of Eur 31-33/MWh, ie below current market. Gas plant would benefit from slightly higher peak utilization.That would have some positive impact on pricing.

Generation profitability as a whole would improve as a result of both of the above. If old hard coal was going to the strategic reserve, the effect would be stronger on E.ON than on RWE, due to its greater exposure to the benefitting technologies. That would weigh stronger than the impact of capacity payments for RWE, most likely. The contrary would be the case, if the political decision was for lignite going into the reserve, despite its earlier merit order position. In this case, the effect would actually be strongly negative for RWE, as lignite is running on high load factors still. Capacity payments would not make up for volume loss. The problem for profitability above all is hard coal. On average, German hard coal plant was running on load factors below 40% last year.

EDF/Areva or: the big French solution

The French government has decided for the big French solution for the nuclear sector, ie EDF (EDF FP) acquiring Areva’s entire reactor business. As things stand, there does not seem to be a chance of Engie acquiring parts of the business. An expensive multiple paid by EDF ads to compounding financial strain, risk and limited benefits. The impact on market perception is certainly negative. Chances that EDF gets recompensed through a 2.5% pa tariff increase under a three year deal as is being suggested in France now, are limited. Engie will find other productive ways of acquisitive or organic growth and on balance stacks up better, even after a lot of risk has been reflected in EDF’s share price.

The French government has decided, not surprisingly, to execute its plan A, EDF acquiring Areva’s entire nuclear reactor business. EDF’s offer stands at Eur 2.7bn, or 0.74x book. EDF will acquire a majority and Areva retain a minority stake in the business. The potential for the business to be structured in a joint venture, but with the same majority EDF/minority shareholding structure. Areva itself will become a front end and nuclear fuels company.

As things stand, Engie would not be able to acquire any part of the business.

This is still a sell on the news. The take out multiple is expensive for a business with large unknown liabilities. The most important liability is the Finnish project, but there are others, too.

As I have previously argued, reactor construction and export is outside of EDF’s core competencies. EDF will further strain its balance sheet. In addition to the straight outlay for the deal, it will have to take on provisions.

The benefit for EDF, streamlining of its own reactor build and maintenance will be marginal when compared to the risk and financial strain.

The market’s perception that EDF is a political vehicle has just received new substance. EDF would be well advised to put a very strong communications strategy together, in which it addresses the political issue and the benefits of its new reactor build, maintenance and service exposure. Communication would have to address markets, but also business partners and be all comprehensive. It would have to adress risk, finances and quantify long term benefits. Addressing a strong vision by management about the entire integrated business as a whole would be advisable.

At the same time, EDF is asking the government for a 2.5% increase to regulated tariffs over three years. It is the time of the year where the negotiations for the annual tariff increase begin, to be confirmed in August. This increase is particularly sensitive, because it comes after the Energy Minister froze tariffs, and now because of the Areva deal. There are suggestions that a stronger tariff increase might be a reward for EDF’s offer for Areva’s reactor business. The government will tread very carefully, in order to avoid any negative interpretation on the Areva recapitalisation vs consumer vs taxpayer interests. Also, the new formula fixed by the government gives some framework for tariff increases. The government had just devised that formula last year, in order to reduce tariffs, and asked EDF to reduce costs. A u-turn would be difficult.

I maintain the short EDF/long Engie trade on the grounds that risk or downside has not increased for Engie (I have argued before that there was no down side for Engie, almost irrespective of the Areva outcome). Engie has shown it has the ability to source and execute credible growth acquisitions and/or organic growth. The share price has under-performed over concerns over lng margins. That is now a consensus view. Over the longer term, the over-supply will reverse. Meanwhile, all of the other businesses are delivering positive earnings outlooks.

French nuclear sector: Ménage à trois?

EDF has made a Eur 2bn offer for Areva’s reactor business without specifying for which parts.  Engie (GSZ FP) may focus on the international part of Areva’s nuclear reactor business only. That would make sense, but may be politically less desirable. Conversely, the prospect of such an offer may push EDF (EDF FP) to a weaker negotiation position. Engie already shows it holds a strong position in this landscape. There is a lot of upside with very little downside for Engie in this, but a lot more risk for EDF.

EDF has made a Eur 2bn offer for Areva’s reactor business. What parts the offer comprise is not clear at this stage. This an indicative offer and first step for negotiations. Now, there is due diligence and negotiations over risks and liabilities, notably the Finnish project.

Engie has been reported previously to want to bid for the international parts only. That makes sense, as the French business is by and large EDF. Engie might not want to take on the service for its biggest domestic competitor. However, there is already some cooperation between Engie and Areva on international projects.

It gives the impression of cherry picking. But, Engie can afford to be selective. It does not need a deal, and clearly, the international part is the most attractive one. It may enable Engie to materially raise its profile as a French nuclear name of reference, ie improving its position for high profile global contracts in the sector.

That in turn might not be desirable to the French government. The policy so far was clearly for EDF (in conjunction with Areva) to be the nuclear champion. EDF will very likely put a lot of effort into retaining that position. That again, may have had some impact on the valuation it has offered for the Areva business. It may contain strategic value, that investors, however, are highly unlikely to find agreeable.

The CEO of Engie has now mentioned the possibility to take a stake in Areva. That would be a less desirable outcome but could still give Engie the parts of the business it is looking for.

Ift Engie succeeded, it would be a master stroke.

There will now be a phase of convoluted negotiations that will likely cloud performance of both share prices, but EDF more so.

Coal fired power generation in Germany: Realpolitik?

The improvements in the draft for coal legislation in Germany could imply a better than expected outcome for the sector. Montpellier Analysis estimates no early closures on the back of the current proposals. The relief is greater for E.ON than for RWE.

The German Economy Minister has presented amended proposals for new coal legislation. By and large, the new proposal is an improvement for the sector, chiefly Vattenfall and RWE: The amount of CO2 reduction from coal has been brought down to 16mt, from 22mt. Further, coal plant would have to pay emission levies after 37 years of operation, rather than 20 years in the previous draft. The levy itself would now be indexed to power prices, as opposed to being decreed according to the old proposal.

The final shape of legislation is far from clear. Chancellor Merkel needs to be seen to take some action, in light of her comments at the Paris climate change meeting. But, large parts of the CDU are against the coal bill sponsored by the junior coalition partner. Emotions on coal, for and against run high, and the mining lobby is strong, it must not be forgotten.

A shut down would have implied the end of operation of all coal plant of RWE and E.ON that is older than 37 years. RWE’s share of coal plant with current operating age of 37 years or more is 7.2GW, E.ON’s 2.8GW.

A levy according to the previous proposal would equate to a shut down. Montpellier Analysis estimates a marginal cost of old coal plant in the region of Eur 28/MWh. A levy of Eur 18-20 Per ton of CO2 as it has been in the early discussions, would bring that to Eur 46-48/MWh, compared to the current power price of Eur 32/MWh.

In the theoretical case of such a shut down, and not considering any nuclear shut down, the big winner would have been gas. There would have been an immediate shift down the merit order, even if some of the demand would have been filled by more renewables.

Adding the nuclear closure would have left the system in perilous undersupply by 2020 already, according to our models, even when building in full achievement of the country’s renewables build and energy efficiency targets. That thought may contribute to the final shape of legislation.

About 5.5GW of plant by E.ON, RWE and Vattenfall would no longer be covered by the emission levy under the new draft.

According to our calculation, the new proposal leaves enough room before the emissions levy kicks in to let coal plant run at load factors of 65-70%. That is a normal utilisation rate for hard coal or lignite plant, but far above the actual runs rates of plant in Germany currently.

The direct implication is that there would be no impact on power prices from the legislation in the medium term.

There is risk of a gradual reduction of the emissions ceiling, in our view.

The chance that upward movement in CO2 prices on the back of political measures will accelerate the process can also not be fully ruled out.
On balance, the near term impact is bearish for gas plant, but there is a marginal improvement to prospects for gas plant profitability over the longer term.

Whilst the immediate relief reaction on RWE shares is intuitive, fundamentally it may be less than commonly thought. RWE won’t de facto lose 16% of its fleet. Still, the underlying problem of low utilisation and weak profitability of conventional generation remains. We gage the impact of all of the above is worse for RWE than for E.ON. E.ON benefits from a more competitive hard coal exposure and stacks up relatively better.