Benchmarking European power and utility asset impairments

Transcription

1 Benchmarking European power and utility asset impairments Impairments at a high in 2013 as utility sector transforms Brochure title RR Brochure subtitle RR

2 Contents Executive summary Executive summary This publication aims to help power and utility companies prepare for the 2014 round of impairment exercises. It examines the rationale for write-downs that these companies presented in their annual reports and summarizes the key factors affecting utility asset valuations at present and in the future. To discuss how the power and utility issues raised here may affect your local markets and your business, please speak to your usual EY contact. Alternatively, contact Guillaume Catoire at or guillaume.catoire@fr.ey.com Impairment numbers reach a high in The story behind the numbers 7 3. Looking forward 12 Conclusion 19 The power and utilities sector is undergoing radical transformation, which contributes to the level of impairments booked by leading European utilities in EY has been tracking impairments at 16 major European power and utility companies 1 since In last year s report, we highlighted that complex underlying economics would make the 2013 impairment exercise particularly tough for European utilities. This proved painfully true: with 32b of assets and goodwill impaired (more than the entire period), 2013 represented a major challenge for utilities across Europe. This report analyzes impairments booked by our sample of 16 companies. We have examined their 2013 financial reports, analyzing the five main factors underlying these write-downs and how they rank in terms of relative influence. Difficult conditions persist, particularly in Continental Western Europe Europe s leading utilities wrote 32b off their balance sheets for impairments in Continental Europe was the main region to be hit with impairments. Adverse pricing conditions remained the main trigger for booking impairments, and there were hints from some companies that this pricing environment could become the norm. The competitive environment faced by conventional thermal generation in Europe has also been a big influence on impairment in The trend for closing and mothballing such assets has continued. As mentioned in last year s report, this appears to have become a new normal with no going back to previous assumptions at this stage. Utilities in Europe are calling for new regulation to deal with this issue and secure access to dispatchable capacity. The other external drivers we have previously identified as having an impact on impairment (demand, policy and financing conditions) also played their parts. However, their role was less acute and, in the case of policy and financing conditions, was typically localized in effect. 1. Centrica, CEZ, EDF, Energias de Portugal (EDP), E.ON, Enel, Fortum, Gas Natural, GDF Suez, Iberdrola, RWE, Scottish and Southern, Suez Environnement, Vattenfall, Veolia Environnement and Verbund. 2 Benchmarking European power and utility asset impairments

3 Facing up to a changing world The utility model is being challenged. How energy is produced, who generates it, how it is bought, sold and distributed is all changing and all at the same time. Looking at the magnitude of the impairments posted in 2013, it seems clear that utilities in Europe are facing up to a new economic paradigm. They are affected by energy transition, an ever-increasing amount of data, and new entrants and competition in the market. They are being placed under pressure to become more flexible and innovative with their business models and service offerings. Strong investor communication vital as more uncertainty looms In the context of this new paradigm, we also look forward to consider a number of factors that may influence utilities profitability, and thus impairments. In the short term, risk and uncertainty will undoubtedly prevail and that means we see little prospect of impairments being reversed immediately. However, in the medium term, some factors suggest that there may be a little light at the end of the tunnel. National schemes to remunerate capacity, potential reform of the EU Emissions Trading System market, and the possibility of cheaper European gas prices as LNG is exported from the US could all combine to bring some currently mothballed or retired conventional plants back into the merit order. If that is the case, we would then expect to see utilities reversing at least some of the impairment charges they have taken in recent years. With a pattern of uncertainty and transformation characterizing the sector, utilities will need to communicate clearly and manage investor expectations of impairment. Investor confidence will be a vitally important resource over the next 20 years, given current estimates that US$17t is needed for expansion and refurbishment of global power infrastructure through EY s Power & Utilities Assurance and Valuation teams have deep knowledge of these highly complex issues and challenges. We are dedicated to helping clients assess the consequences of asset impairment for business and accounts. Please talk to your EY advisor or contact one of the authors of this paper to discuss the issues raised in more detail. 2. World Energy Outlook 2013, International Energy Agency, 12 November Benchmarking European power and utility asset impairments 3

4 1 Impairment numbers reach a high in Benchmarking European power and utility asset impairments

5 In 2013, impairments in value were 2.5 times higher than in Our sample of 16 European utilities wrote 32b off their balance sheets, compared with 12.8b of impairments posted in 2012, 9.3b in 2011 and 8.6b in From 2010 to 2013, a total 62.7b of value was wiped off, of which slightly more than 50% occurred in To put the 2013 figure into context, it equates to almost 10% of the current market capitalization of our sample. 3 These numbers suggest that companies faced a tough business environment which, if anything, has not shown any real sign of improvement so far in We analyzed the 2013 financial reports of the 16 European utilities in our sample to understand the main drivers of this significant rise in impairment and the lessons we can learn. In 2013 alone, 32b was wiped off utility balance sheets more than the total wiped off in the previous three years ( 30.7b) and equivalent to 63 for every person in the EU. Rise in impairment affecting most companies Similar to last year, the share of impairment is not evenly spread across our sample, and three of the four main contributors remain consistent: GDF Suez, RWE and E.ON. This comes as no surprise as these companies historically have had the biggest exposure in Continental Western Europe. They are in the top quartile of impairment contributors that account for 78% of the total impairments in 2013 and 72% in Most companies included in our sample are seeing an increase in impairment numbers (13 out of 16 companies impaired more in 2013 than in 2012). In 2013, eight companies posted impairments higher than 1b, versus five companies in The rise in impairment is fairly significant in some instances. Two of the companies with impairments higher than 1b in 2013 posted only 0.2b in Aggregated figures tell the same story. Over , 11 companies in our sample posted impairments for an aggregate amount higher than 1b, compared with only 8 companies during No company is now immune to impairments. Over , only two companies posted impairments totaling less than 150m each, compared with four companies during These two companies posted impairments totaling 113m in 2013 compared with 3m over the period. Table 1. Impairment breakdown st quartile 2nd quartile 3rd quartile 4th quartile 24.8b 4.8b 2.2b 0.2b % 77.5% 15.1% 6.8% 0.6% Source: EY analysis. We provide further insight into the rationale companies used to explain their impairments in Section 2 of this report (see page 7). Impairment numbers at a high for both goodwill and assets In 2013, impairment of goodwill reached 9.6b while impairment of assets reached 22.4b or 70% of the total impairments posted in Table 2. Majority of impairment is still assets rather than goodwill Total Impairment of 9.6b 3.9b 1.8b 2.4b 17.7b goodwill Impairment of 22.4b 8.9b 7.5b 6.2b 45.0b assets Total impairment 32b 12.8b 9.3b 8.6b 62.7b Source: EY analysis; figures are rounded. In 2010 and 2011, the largest goodwill impairments were borne by E.ON on its Italian non-regulated business, Vattenfall on its Benelux operating segment and Veolia Environnement on its transport and energy services businesses. In 2012, Enel took the biggest goodwill hit on its Endesa-Iberia cash generating unit (CGU), highlighting the difficult regulatory, operating and financing environment in the Iberian market. In 2013, GDF Suez and RWE were the largest contributors to goodwill impairment, accounting for 75% of the total goodwill impaired for the year. GDF Suez s largest goodwill impairments were on its Energy Central Western Europe CGU and Storage CGU. RWE s goodwill impairment was on its Conventional Power Generation CGU, highlighting the challenges faced by utilities in Europe in the electricity generation sector. 3. Capital IQ market capitalization as at 24 June Benchmarking European power and utility asset impairments 5

6 Indeed, generation assets continue to represent the greatest share of asset impairments. At 22.4b, asset impairments increased 2.5 times in 2013 compared to At 14.8b, generation assets still represent 66% of the total in 2013 compared with 67% in 2012 (see Table 3). Of this 14.8b, we identified that 9.5b specifically relate to thermal generation assets (gas- or coal-fired), 1.5b specifically relate to nuclear generation assets, 2.0b specifically relate to renewable generation assets, and 1.8b is not specifically categorized. Conventional generation assets continue to suffer from the complex business environment we highlighted in last year s publication: stagnating power demand, continuing growth in renewable capacity and ample reserve margins all contributed to reduce conventional thermal plants load factors and even push them out of the merit order. Storage assets also took a heavy hit in 2013 (GDF Suez recognized a total loss of 1.9b on assets from its storage CGU; Centrica and Iberdrola opted to discontinue gas storage projects, recording impairments totaling 0.8b). Companies were affected by a combination of lower demand for gas (with gas-fired power plants running less than the historical average and companies previous forecasts), adequate demand/supply balance and depressed winter/summer spreads. This led to limited arbitrage opportunities and consequently to reduced interest in storage capacity bookings in the short to medium term. Other impairments booked in 2013 were related to a diverse range of assets. Table 3. Generation assets still constitute the greatest proportion of asset impairment Focus is now firmly on Continental Western Europe and the Nordics Impairments posted have increased in every location with the exception of Southern Europe, which was historically the first area to suffer serious impairments and where significant value had already been written off in previous years. In 2013 most of the pain was once again borne by Continental Western Europe, and the magnitude of this area s contribution to total impairments has increased dramatically. In 2012, Continental Western Europe represented 43% of the total impairments posted; its share has increased to reach 66% in As mentioned previously, adverse market conditions for thermal generation assets (particularly gas-fired) are proving a challenge for this region s utilities. Table 4. Impairment four-year geographic breakdown Southern Europe Continental Western Europe and Nordic region UK Eastern Europe Others/ non-specific b 2.4b 1.1b 0.3b 2.3b b 2.7b 1.4b 0.6b 1.2b b 5.5b 1.6b 0.6b 2.2b b 21.1b 2.6b 2.0b 3.8b Total 11.3b 31.7b 6.7b 3.5b 9.5b Total % 18% 50% 11% 6% 15% Source: EY analysis; figures are rounded Total Generation assets 14.8b 6.0b 5.4b 3.3b 29.5b Other assets 7.6b 2.9b 2.1b 2.9b 15.5b Total impairment of assets 22.4b 8.9b 7.5b 6.2b 45.0b Source: EY analysis. 4. Impairments that could not be allocated to a specific region based on the information provided by companies were classified as non-specific. 6 Benchmarking European power and utility asset impairments

7 2 The story behind the numbers Benchmarking European power and utility asset impairments 7

8 Pricing environment: still key and not improving Movement in wholesale power prices weighed on utility cash flow assumptions, pushing up asset and goodwill impairments for We have taken a closer look at the annual reports of our 16 tracked utilities to assess the relative importance of five drivers we believe are potential impairment triggers (see Figure 1). Similar to last year, the pricing environment remains the main factor driving impairments. However, supply, and in particular the difficulties faced by conventional power generation, is one of the big stories of 2013, with some companies starting to argue that these difficulties should be managed through regulation. The impact of demand is starting to be mentioned on a standalone basis, in contrast with previous years, while regulation itself has gone down in the order of factors that influence utility decisions to book impairment. However, regulation can still have a significant impact on some specific and localized areas or sectors. The push for conventional power generation-friendly regulation, as well as the binding guidelines for reforms in the energy sector that are being contemplated in the EU, could well see regulation increase its influence on impairment in the coming years. Lastly, financing conditions have not been an area of focus in 2013, with only one company in our sample mentioning it as a trigger for booking impairment. Figure 1. Key drivers of impairments posted in 2013 Supply Demand Policy Particularly in a sector that is driven by fixed costs, assumptions made on forward price curves are critical when designing the business plans that underlie investment or impairment decisions. In 2013, utilities in Europe continued to suffer overall from a challenging price environment (see Figure 2, showing wholesale power prices, for example), which remains the key factor in the level of impairment posted. When asked about the main reason underlying the recognition by the company of 4.8b in impairment, RWE s CEO answered: In February 2013, a megawatt hour of electricity traded at 42 on the German forward market. By the end of 2013, this figure had dropped to just 37. In other words, our power plants will earn even less in the coming years than we had feared. We had to take this into account in our financial statements. Later, he states that the solar boom and the steep decline in the price of hard coal and CO 2 emission allowances have put wholesale electricity quotations under pressure. As a consequence, the profitability of our power plants has recently deteriorated significantly. This is reflected in the 2013 consolidated financial statements by lower operating earnings and high impairment. 5 In 2013, Verbund posted impairments for a total of 1.2b. The company highlighted that the main indications of impairment of the generation portfolio in the first half of 2013 were the poor market environment as well as the decline in the wholesale electricity prices below the level defined by Verbund for early pricing in of own generation. 6 Pricing environment Financing conditions Source: EY analysis. Utilities Major driver Important driver Less important driver 5. Annual Report 2013, RWE. 6. Annual Report 2013, Verbund. 8 Benchmarking European power and utility asset impairments

9 Figure 2. Wholesale power prices fell during 2013 across much of Continental Europe, and saw little sign of improvement in H Supply: one of the main stories in 2013 /MWh European power prices (one-year forward baseload) The rapid rise of subsidized renewables has created overcapacity, pushing conventional power generation out of the merit order and partly explaining the large scale of impairments to generation assets Jan 13 Apr 13 Jul 13 Oct 13 Jan 14 Apr 14 Jul 14 Germany Sources: EY analysis; Bloomberg. Italy Nordics Spain There are hints that companies are now factoring in the idea that this adverse pricing environment is becoming the norm in Europe, at least for the foreseeable future. As an illustration, GDF Suez states in its 2013 annual report: The annual 2013 impairment tests carried out on European CGUs take into account these structural developments as well as the lasting decline in electricity prices and seasonal natural gas spread. Finally, the adverse pricing environment has also led to impairments being posted outside Europe. Iberdrola, for example, has totally impaired its gas storage facility construction projects in the US: In view of the potential long-term low margins for natural gas as a result of the eruption of shale gas in the North American energy market, the Iberdrola Group has opted to discontinue its gas storage facility construction projects until this scenario substantially changes. Consequently, it has written down the full cost capitalized in that regard. 7 UK Alongside depressed power prices, adverse supply conditions for conventional power generation are another key element that explains why impairment numbers reached historic highs in In the context of stagnating demand in many parts of Europe, the rapid rise of renewables, which typically benefit from subsidized prices, tends to put conventional power generation out of the merit order and partly explains the large scale of impairments posted on generation assets. The CEO of Vattenfall states in the company s 2013 annual report: The traditional business model, based on large-scale electricity generation in conventional power plants, is being challenged. Much more subsidized renewable power than expected mainly wind and solar power has been added and is putting pressure on conventional gas- and hard coal-based electricity. RWE also underlines the importance of changing supply trends to the impairments posted on its generation and storage businesses. When commenting on the 2.4b impairment it had to book on its Dutch generation portfolio, the company states in its annual report: Here the substantial expansion of German solar power generation capacity comes to bear, which is pushing conventional power plants out of the market not just in Germany, but also in its neighboring countries. In addition, we wrote down our German storage activities by 216 million as the situation worsened: imports of liquefied natural gas (LNG) and the expansion of pipeline infrastructure contributed to a rise in gas supply during peak usage period (winter) resulting in less demand being covered by stored gas. Some companies take the view that a significant proportion of traditional thermal power generation will increasingly be used to cover peak demand, which does not enable them to earn a sufficient return compared to their investment costs overall financial report, Iberdrola. Benchmarking European power and utility asset impairments 9

10 GDF Suez s 2013 annual report in particular states that: The Group adopted at the end of 2013 a new reference scenario for the period The vision expressed by the Group in this scenario results in thermal power plants which will be increasingly used to fill the remaining capacity gap and ensure the security of supply within the electricity system by adjusting supply in line with demand during periods of lower renewable energy production. In this context, the Magritte Group (an association of CEOs in large European utilities) is calling for the implementation of drastic measures, including a regulation mechanism that would: remunerate available and qualified capacities as a service provided to ensure security of supply for the energy system. 8 RWE s CEO is also pushing in this direction, stating: We need a system that compensates power plant operators for providing security of supply. So far, no cross-border answer has been implemented. Demand: starting to become a stand-alone driver Sluggish economic growth and improved energy efficiency may continue to dampen demand until 2035: this could be a key driver of future impairments. In 2012, demand did not appear to be the primary justification for impairments reported by our 16 sample companies; it was chiefly considered alongside all the others. In 2013, companies started to point to demand as a stand-alone driver of impairments. In its annual report, GDF Suez explains the rationale underlying the impairments posted for the year by stating: In 2013, the market fundamentals of the countries where the Group operates have again deteriorated with notably new decreases in the demand of gas and electricity. In particular, demand is one of the factors driving the impairment of storage activities as: the volume of unsold capacities in France represented 18.3 TWh in 2013 (12 TWh in 2011 and 2012) or 17% of the total marketable capacity in France. Centrica s annual report stresses that demand could become a key driver in the future: Downstream, UK gas demand is forecast to continue to decline over the next decade with the emergence of smart and connected home solutions. Electricity demand is forecast to decline by a smaller amount or to remain flat. The evolution of demand could well become one of the key factors to affect utility profitability in Europe in the years to come potentially leading to future impairments. Gross inland energy consumption in Europe is forecast by the European Commission (EC) to decline from now until In response, utilities are looking to create new revenue sources by becoming energy services providers. Policy: local impacts only in 2013 Policy alone did not result in any sector-wide impairment but regulatory change in Russia and the US caused sizeable impairments for selected European utilities. National policy clearly did not have sector-wide impact in terms of impairment in However, the magnitude of regulatory impacts in certain localized areas or specific sectors reminds us that regulation remains hugely important in the utility sector. For example, both E.ON and Enel have been hit by a change in Russia s regulatory environment. In its annual report, E.ON states: In the 2013 fiscal year, impairments were recognized on property, plant and equipment in the amount of million. The most significant individual issue in terms of amount, at 176 million, relates to a power plant in the focus region Russia, which was written down to a recoverable amount of 250 million in the third quarter of 2013 because of a changed regulatory framework. Enel recognized a 744m impairment on its OGK-5 CGU (Russia). Its annual report states: The assessment reflects, largely to the same extent as the other parameters used in the determination, the expected contraction in estimated future cash flow as a result of the persistent signs of a slowdown in economic growth and a consequent contraction in forecasts for price increases in the medium term. In particular, in 2013, the local government implemented a number of measures to contain energy spending that have helped heighten uncertainty concerning the timetable for full liberalization of gas prices in Russia, which is considered a key step in making the electricity industry attractive to foreign investors, making it possible to upgrade plants. 8. CEOs of leading European energy companies contribution to the European council, March 2014, 19 March EU Energy, Transport, and GHG Emissions, Trends to 2050, Reference Scenario 2013, The European Commission, 16 December Benchmarking European power and utility asset impairments

11 In the US, uncertainty surrounding the legislation of wind farms was a trigger for Iberdrola to take a hit of 511m on its wind farm business: At the date of formulation of these Consolidated financial statements, the regulations applicable to US wind farms on which construction commences after 1 January 2014 have yet to be published. Consequently, the Iberdrola Group applied a series of assumptions on the future regulations and US energetic market, causing the Group to considerably reduce the number of projects it intends to carry out and to recognize the impairment allowances reported in Note 11. Financing conditions: very limited impact in 2013 Financing conditions do not appear to have been a big story in Centrica is the only company in our sample to mention a change in the discount rate as an underlying reason for impairing specific assets for a limited amount: We recognized a post-tax impairment of 66 million on our existing gas assets in Canada, reflecting a weaker outlook for North American natural gas prices and an increase in the discount rate applicable to these assets. Table 5 shows that discount rates were relatively stable in 2013 compared to Table 5. Selected examples show no major changes in the discount rates between 2012 and 2013 Company Changes in discount rate parameters from 2012 to 2013 Centrica Pre-tax rates used in 2013 range from 7.4% to 8.4% (range of 7.5% to 8.5% in 2012). Enel Pre-tax rates used in 2013 range from 7.6% to 15.6% (range of 7.7% to 16.8% in 2012). GDF Suez Post-tax rates used in 2013 to measure the value-in-use of the goodwill CGUs range between 5.2% and 15.1% (range of 4.8% and 17.0% in 2012). Iberdrola Pre-tax rates used in 2013 range from 5.38% to 10.29% (range of 5.78% to 10.51% in 2012). RWE Pre-tax rates used in 2013 range from 7.5% to 16.6% (range of 7.7% to 18.8% in 2012). Post-tax rates used in 2013 range from 5.25% to 8.75% (range of 5.75% to 8.75% in 2012). Scottish and Southern Veolia Pre-tax real rates used in 2013 range from 7% to 10% (unchanged from 2012). Rates used in 2013 range from 6.4% to 7.4% (range of 6.0% to 7.7% in 2012). A substantial amount of goodwill remains on utility balance sheets Despite the scale of impairments posted in 2013, the 16 utilities forming our sample still had 100b of goodwill on their balance sheets at the end of 2013 (see Table 6). Within that context, we have looked forward to analyze what factors could trigger more impairment, or a reversal of impairments for certain specific fixed assets, in the future. Table 6. Goodwill on utility balance sheet in 2013 accounts Company Currency Net carrying amount of goodwill in local currency millions Net carrying amount of goodwill in millions GDF Suez 20,697 20,697 Enel 15,015 15,015 RWE 11,374 11,374 E.ON 12,797 12,797 EDF 9,206 9,206 Iberdrola 7,804 7,804 Gas Natural 5,756 5,756 Veolia 3,486 3,486 Vattenfall SEK 23,352 2,792 EDP 3,296 3,296 Suez Environnement 3,184 3,184 Centrica 2,819 3,381 Scottish and Southern Verbund CEZ CZK 9, Fortum Total 100,918 Source: 2013 company annual reports. Benchmarking European power and utility asset impairments 11

12 3 Looking forward 12 Benchmarking European power and utility asset impairments

13 The environment in which European utilities are operating does not appear to have seen any immediate improvements so far in Two recent examples demonstrate the challenges they continue to face in the current year: May 2014 saw reports of a bailout of the 335MW gasfired Elcogas plant near Puertollano in Spain. 10 The three shareholders (Endesa, EDF and Iberdrola) had to provide financial support as a 127m debt fell due, and as a result, Endesa made a 51m provision in its results for Q In the same month, the UK s Centrica announced that it planned to sell its three largest gas-fired power stations (Langage, Humber and Killingholme), with a combined capacity of 2.7GW in order to focus its UK gas-fired generation strategy on smaller flexible peaking plants. 11 When assessing the risks that Europe s utilities face today, we believe five factors will have a particular influence on future impairments: 1. Ongoing expansion of intermittent renewables generation capacity 2. Trajectory of thermal plant closures and mothballing adopted by utilities 3. Introduction of capacity remuneration mechanisms 4. Ongoing evolution of the EU Emissions Trading Scheme (EU ETS) 5. LNG exports from the US Utilities can only directly control the first two factors with their own decision-making; in the case of renewables, a multitude of other players are potentially involved in adding capacity to the market. Our analysis evaluates the current state and the likely impact of each factor. Ongoing expansion of intermittent renewables generation capacity In last year s paper, we highlighted that the expansion of intermittent renewables was a growing source of concern for the sector. It is now widely recognized that intermittent renewables (i.e., solar photovoltaic or PV and wind, in particular) typically displace thermal power plants from the merit order and also lower electricity prices on wholesale markets. 12 The scale of the installed base of intermittent renewables capacity across Europe is significant (see Figure 3). In wind, Germany and the UK made up almost half of the new EU installations in 2013; and at the end of the year, cumulative installed capacity for the EU-28 stood at 117GW. 13 Solar PV capacity was added in 2013 on a reasonably consistent scale, and global cumulative installed capacity for Europe had reached 80GW by the end of This means that, by the end of 2013, Europe s electricity system incorporated a total of almost 200GW of intermittent renewables capacity. Figure 3. Growth of intermittent renewables capacity in Europe GW Wind Solar PV Installed base Net additions Sources: European Wind Energy Association; European Photovoltaic Industry Association. In 2013 the pace at which both solar PV and wind capacity was added to the generation mix across Europe slowed significantly: Wind: 11.16GW of capacity was installed across the EU-28 in 2013, a fall of 8% from 2012 when 12.1GW was added. Solar PV: more than 10GW of PV capacity was grid connected in Europe, compared with 17.6GW in Nevertheless, the installed base of intermittent renewables is set to increase further. For example, by the end of April 2014, Germany had already added 622MW of new solar PV capacity, which is in line with the German Government s expansion target of 2.5GW 3.5GW a year. Across Europe, regulatory and political uncertainty will potentially have a negative impact on the pace of growth of the renewables sector. 10. Spain s Puertollano gas plant losses covered, Platts European Power Daily, 12 May 2014, via McGraw Hill Financial, Platts. 11. Centrica gas plants for sale, under pressure on retail, New Power 64, June 2014, Publishing Energy; Centrica Interim Management Statement, 8 May For detailed analysis of the renewables sector, please refer to EY s latest Renewable energy country attractiveness index available at Renewable-Energy-Country-Attractiveness-Index. 13. Wind in power 2013 European statistics, European Wind Energy Association, February Market Report 2013, European Photovoltaic Industry Association, March Benchmarking European power and utility asset impairments 13

14 As we previously outlined, 2012 saw the major generators facing up to this dilemma and accelerating the process of closing or mothballing significant tranches of unprofitable thermal assets. The closure of any thermal capacity, even if it is loss-making, has typically remained a tough decision for European power generators. Nevertheless, in 2013, we have seen this trend continue, with almost all the large European generators having taken further gas- and coal-fired capacity out of operation, as shown in Table 7. Table 7. Closure/mothballing of thermal capacity in 2013 by European utilities in our sample However, the strength of this uncertainty in shaping the sector may weaken over time: solar PV and wind are both believed to be approaching grid parity in many parts of Europe. When that happens, they will be able to compete with conventional forms of generation without subsidy, and the economics of adding such renewable capacity will then see the sector less exposed to regulatory change and political goodwill. Ongoing growth in renewables capacity will continue to put pressure on utilization rates for conventional capacity. There is unlikely to be any respite from an impairment point of view. Trajectory of thermal plant closures and mothballing adopted by utilities Across Europe, utilities remain engaged in an exercise to reshape their generation portfolios that will have consequences for decades to come. In view of the prospect of severely reduced profitability for some thermal plant, an obvious strategy has been to consider closure, or at least mothballing, of some of the worst-affected capacity. By taking capacity out of the market, utilities hope that power prices and profit margins will recover. The major players were arguably slow to adopt this approach, facing a real-life prisoner s dilemma. Closing capacity should help generation spreads to improve but the hope is always that rivals will close their capacity first. Capacity closed in 2013, MW Capacity mothballed in 2013, MW E.ON 584 Coal 465 Coal 718 Gas GDF Suez 921 Gas 1,561 Gas RWE 1,958 Coal 1,410 Gas 968 Oil 742 Coal converted to biomass Vattenfall 874 Gas EDF 1,100 Coal Scottish and Southern 120 Coal 1,515 Gas Iberdrola 1,531 Coal 157 Oil 466 Nuclear Gas Natural 157 Oil Fenosa EDP 946 Oil Total 9,650 6,543 Sources: Company reports; EY analysis. 14 Benchmarking European power and utility asset impairments

15 In 2013, across Europe, 10.1GW of gas-fired capacity, 7.7GW of coal-fired capacity and 2.8GW of oil-fired capacity were decommissioned. 15 Upcoming significant maintenance capital expenditure decisions are likely to have been one key trigger point in determining which plant would be removed from operation and when. Yet, despite this scale of action by generators, power prices across Europe have remained at or near historic lows. Figure 4, showing the net capacity changes, helps to explain why. Indeed, the addition of wind and solar PV capacity as well as new gas-, coal- and biomass-fired capacity means that overall, net capacity was actually added to the system in As a result, generation capacity margins (the difference between installed generation capacity and peak load) have remained healthy for most countries and wholesale power prices have stayed low. Figure 4. Net power generation capacity changes in Europe in 2013 GW Wind Solar PV Hydro Biomass Sources: European Photovoltaic Industry Association; EY analysis. The continuing addition of new capacity does not bode well for the chances of avoiding further impairments in the short term. Take the example of Germany: as well as the ongoing addition of renewables capacity, approximately 8,000MW of coal-fired plant is expected to come online by Most of this relates to legacy projects planned back in Overcapacity should remain a given in the short term. The decision to retire or mothball conventional generation capacity will remain one of the top issues on the utility agenda in Europe. 0.4 CSP 0.2 Other Fuel oil 2.6 Gas 2.7 Coal 5.8 Although utilities have been removing significant levels of capacity from the market, this has not been enough to alter the prevailing pattern of overcapacity. We do not foresee any immediate changes in the pattern of impairment charges already taken. In fact, it is quite possible that we could start seeing further asset impairments but this time of coal-fired plants. Any new coal-fired capacity, be it anthracite or lignite plant, is likely to start squeezing older, less efficient coal-fired plants out of the merit order, drastically reducing running hours and profitability. At the same time, all coal-fired operators will have to cope with a dark spread that is increasingly volatile, as the level of intermittent renewables output continues to grow. Introduction of capacity remuneration mechanisms The scale of closures and mothballing of thermal capacity and more flexible gas-fired capacity in particular now being undertaken across Europe has brought another issue facing the sector into sharp focus. There is growing pressure to ensure a reasonable level of supply security, given the increasing proportion of overall generation capacity represented by intermittent renewables. The answer increasingly adopted by European governments and regulators is to reward generators for the provision of firm capacity, in addition to the delivery of energy. Capacity remuneration mechanisms (CRMs), where introduced, could potentially open up a new revenue stream for assets that would otherwise be facing closure or mothballing. However, this will depend on the specifics of the mechanisms, which are being introduced on a national, rather than a pan-european, basis (see Figure 5). 15. Wind in power 2013 European statistics, European Wind Energy Association, February Benchmarking European power and utility asset impairments 15

16 Figure 5. Existing/proposed capacity remuneration mechanisms around Europe CRM operational/decision taken to implement CRM proposed/under construction No CRM (energy-only market) Source: EY analysis. 16 Benchmarking European power and utility asset impairments

17 Many European countries are looking to introduce some form of CRM. It is too early to tell what impact this will have on future impairment testing for generation assets. But energy market revenues could, in fact, fall when the provision of capacity starts to be rewarded because this will remove scarcity value from the market. Notable in 2013 was a growing consensus that energy-only wholesale markets, where the power price is typically set by the marginal plant, are no longer sufficient to ensure that the flexible thermal capacity needed to back up intermittent renewables remains on the system. With gas-fired plants increasingly moving from baseload generation to a more flexible role, lower utilization levels are no longer sufficient to cover fixed costs (or in some cases, running costs). CRMs are seen as necessary means of plugging that gap and enabling flexible thermal capacity (typically gas-fired) to continue in operation, but with fewer operating hours. Marginal pricing is not the solution to a system that is driven by fixed costs, according to EDP CEO Antonia Mexia, speaking at a recent conference. 16 The markets that need new capacity are already introducing these changes [i.e., capacity mechanisms to support firm capacity]. Ongoing evolution of the EU ETS The price signals for carbon generated by the EU ETS potentially could have a significant impact on power markets across Europe. This cap and trade scheme was first introduced in Since then utilities have become familiar with the general principles of its operation. However, 2013 saw a number of significant changes. First, from 2013 onward, the cap on emissions from power stations and other fixed installations emitting carbon started to reduce by 1.74% annually; this will translate into a 21% reduction in greenhouse gas emissions in 2020, compared to 2005 levels. Second, from 2013, auctioning became the main method of allocating allowances (prior to this, they were given away free by governments), so power generators now have to buy all their allowances. But further reform of the EU ETS is now widely expected. Critics of the EU ETS point out that the carbon price signals it has been generating for some years (see Figure 6) are simply not high enough to change the capital investment decisions and operating patterns of utilities. This is largely attributed to the global financial crisis and consequent economic downturn. The slump in industrial activity meant that carbon emission levels fell anyway, and it is argued that the resulting surplus of allowances has undermined the effectiveness of the scheme. Figure 6. EU ETS carbon allowance price /ton Jan 09 Jan 10 Jan 11 Jan 12 Jan 13 Jan 14 Sources: EY analysis; Thomson Financial Datastream. Proposals to reform the EU ETS offer the prospect of higher carbon prices in the future, which would benefit gas-fired plant at the expense of more carbon-intensive forms of generation. This is unlikely to have a significant impact until the latter half of the current decade. Given the recent evolution of EU ETS prices, an immediate impact on the outcome of impairment testing looks highly unlikely. 16. Energy-only no longer fit for purpose, Power in Europe, Issue 676, 12 May 2014, Platts, via McGraw-Hill. Benchmarking European power and utility asset impairments 17

18 As a short-term measure, the EC has postponed the auction of 900 million carbon allowances until (referred to as back-loading ) in the hope that demand will pick up. The EC is also recommending more far-reaching structural reform of the scheme, with the introduction of a market stability reserve. 17 In the meantime, it remains to be seen what impact, if any, the recent EU parliamentary elections may have on the progress of reforming Europe s carbon market. Without reform of the EU ETS, it is currently hard to see (at least in the short term) carbon prices bringing significant financial advantage to gas-fired plant at the expense of rival coal-fired capacity. LNG exports from the US This factor could realign the medium-term prospects and future direction of the European power sector. The US shale gas revolution has already had a huge impact on gas and commodity markets around the world. This has displaced cheaper US coal to Europe, boosting dark spreads at a time when spark spreads have been under consistent pressure. This trend looks set to continue, and it could even intensify if regulations proposed by the US Environmental Protection Agency hasten the declining demand for coal in North America. However, large-scale LNG exports from the US might start to reverse the trend, driving down European gas prices and providing significant support to spark spreads across Europe. European utilities are keen to access gas at prices more closely related to the US Henry Hub indicator. Iberdrola is a recent example: it entered a long-term supply agreement to take US gas from Cheniere Energy at a price linked to Henry Hub pricing. 18 This could end up being a lower price than existing alternatives. The long-term impact of such deals on European spark spreads remains to be seen. Europe has seen a fall in near-term gas prices so far in 2014 following a relatively mild winter, leading to some improvement in spark spreads. This has narrowed the difference between gas-fired and coal-fired power margins. In the UK, this offers some prospect of the more efficient gas-fired capacity starting to come back into the money more often. However, the UK market is arguably more favorable to gas than elsewhere in Europe, due to the existence of carbon price support, the comparative lack of renewables and interconnection, and tighter capacity margins. US LNG exports are a wildcard factor that could improve the profitability of utilities in the medium term. It will be the end of the decade at least before export volumes reach sufficient scale to have a significant impact on the gas/coal fuel price dynamic and thereby encourage switching. As a result, we do not expect this to be a trigger for reversing impairment in the short term. E.ON s CEO of Global Commodities, Christopher Delbrück, has argued that the drop in European spot gas prices has been little more than a temperature-driven event and pointed out that year-ahead prices for gas have stayed relatively consistent. 19 In terms of fuel costs for the German power market, it has been estimated recently that gas prices would need to halve, or European-delivered coal prices would need to double to about US$150 per tonne, to encourage switching For a useful summary, see EC wants 40% carbon reduction for 2030 and scrutiny to boost renewables, New Power Issue 60, Publishing Energy, February Iberdrola agrees to LNG supply deal with Cheniere over 20 years valued at around 4.1 billion, Iberdrola, 30 May Fuel spreads narrow to little effect, Power in Europe, Issue 677, 26 May 2014, Platts. 20. Coal to gas switching point a distant prospect, Vol. XIX, 9, Argus Gas Connections, 21 May 2014, Argus Media Ltd. 18 Benchmarking European power and utility asset impairments

19 Conclusion Facing up to a new economic paradigm for utilities in Europe With a 32b cleanup from company balance sheets, 2013 has been particularly difficult for utilities in Europe. Currently, we see no signs that indicate a return to previous conditions. Utilities have to adapt to a new world shaped by declining demand for energy and a changing energy mix. Those that do will probably outperform the market and their competitors going forward. Key questions and decisions for utilities In facing up to this new paradigm, companies will need to understand the likely consequences for their individual businesses of the five key factors discussed in Section 3. We believe that these factors will have a major role to play in shaping the profitability of utilities in Europe over the next 5 to 10 years, and we expect to see businesses reorganized and strategies redefined. This may trigger divestments, further mothballing or simply additional closure of assets. In making these decisions, utilities need to consider the following questions: How far can utilities go in thermal generation closure without triggering an adverse impact on the overall balance of the system? How fast will regulatory support mechanisms and new market design be implemented by public authorities and regulators, and what will be their impact on the profitability of thermal generation? What will be the energy mix of the future, and how will energy efficiency efforts and new electricity usage shape the future of electricity and gas demand? Will the global trend toward more stringent CO 2 emission regulation profoundly change CO 2 costs and make plants that are currently out of the merit order economic again? What can we expect in terms of impairments? In the short term, there is little prospect that the conventional gas generation assets that have been hit by impairments will have an opportunity to fare better. Indeed, the current state of grid overcapacity is likely to continue, and we may next see some older coal-fired capacity facing impairment. In the medium term, however, there are reasons to be hopeful as the introduction of a remuneration capacity mechanism, a potential evolution of the EU ETS regulation and LNG exports from the US could all play a part in reviving the outlook for conventional gas generation. If this is the case, it would allow utilities to consider reversing impairments in the future. Managing investor expectations is key in the current environment However, the path to this revival is paved with risk and uncertainty, as utilities cannot control any of these three factors. This uncertainty makes it all the more important for European utilities to manage investor expectations in terms of impairment. Even if, on a short-term basis, there is not systematically a direct correlation between stock market prices and the level of impairments, over the long term unexpected impairments could shake investor confidence. Given the huge scale of investment needed to renew and expand infrastructure, investor confidence is one asset that will be key to utilities as they navigate through a sector in transformation. Benchmarking European power and utility asset Impairments impairments 19

20 Contacts Authors Guillaume Catoire Assurance Power & Utilities Sector Resident, EY Tel: guillaume.catoire@fr.ey.com Duncan Coneybeare Sector Analyst Power & Utilities, Global Markets EY Knowledge Tel: dconeybeare@uk.ey.com Contributor Charles-Emmanuel Chosson Global Assurance Power & Utilities Leader, EY Tel: charles-emmanuel.chosson@ fr.ey.com EY Assurance Tax Transactions Advisory About EY EY is a global leader in assurance, tax, transaction and advisory services. The insights and quality services we deliver help build trust and confidence in the capital markets and in economies the world over. We develop outstanding leaders who team to deliver on our promises to all of our stakeholders. In so doing, we play a critical role in building a better working world for our people, for our clients and for our communities. EY refers to the global organization, and may refer to one or more, of the member firms of Ernst & Young Global Limited, each of which is a separate legal entity. Ernst & Young Global Limited, a UK company limited by guarantee, does not provide services to clients. For more information about our organization, please visit ey.com. About EY s Global Power & Utilities Center In a world of uncertainty, changing regulatory frameworks and environmental challenges, utility companies need to maintain a secure and reliable supply, while anticipating change and reacting to it quickly. EY s Global Power & Utilities Center brings together a worldwide team of professionals to help you succeed a team with deep technical experience in providing assurance, tax, transaction and advisory services. The Center works to anticipate market trends, identify the implications and develop points of view on relevant sector issues. Ultimately it enables us to help you meet your goals and compete more effectively EYGM Limited. All Rights Reserved. EYG no. DX0267 CSG/GSC2014/ ED None This material has been prepared for general informational purposes only and is not intended to be relied upon as accounting, tax, or other professional advice. Please refer to your advisors for specific advice. ey.com