Investment Research Stranded Assets in the Utilities Sector as Europe Moves to a Low Carbon Society Gary Buesser, CFA, Director, Research Analyst Alistair Godrich, CFA, Vice President, Research Analyst The European Union Emissions Trading System (EU ETS), introduced in 25, is a major directive to reduce greenhouse gas emissions in Europe. A combination of the EU ETS, an increase in renewables generation due to government subsidies, and energy efficiency improvements have all contributed to the decline in carbon emissions. However, from an investment perspective, we believe the increase in renewables generation driven by subsidies has had a much greater impact on utility industry profitability and its behaviour than has the EU ETS. The accelerated shift in power generation has left some of the largest European utilities with stranded assets, as high-cost coal and gas power generation assets are no longer economically viable. Increasingly investors are focusing greater attention on the environmental, social, and governance (ESG) factors that influence the profitability of companies and thus investment decisions. In this paper, we discuss the basics and drawbacks of the EU ETS, as well as recent attempts to incentivise utilities to switch from coal to gas and renewables. We also address how government subsidies provided to increase renewables generation have led to higher consumer electricity bills. Our ongoing engagement with companies provides us with valuable insights into the structural changes happening in the European utilities sector, as the EU transitions to a low carbon society.
2 What Is the EU ETS? The EU ETS cap and trade system started in 25 where emitters of carbon dioxide (CO 2 ) purchase the right to produce a tonne of CO 2 within the EU at a market-determined price. According to the European Commission, a cap, or limit, is set on greenhouse gas emissions by the factories and power plants in the system, and the cap is reduced over time (currently 1.74% annually). Companies receive (from governments) or buy emission allowances, referred to as European Union Allowances (EUA), which they can trade providing them an incentive to reduce their emissions. An EUA is a tradable unit equal to 1 tonne of CO 2. During Phase 1 (25 to 27) the allowances could not be carried over into Phase 2, thus had a fixed life that ended in 27 resulting in the carbon price gradually falling to in 27 once the market realised that allowances were oversupplied. Phase 2 (28 to 212) reflected the EU ETS starting in earnest. Allowances could be banked into the future, and hence always retained at least an option value on higher price expectations. Throughout Phases 1 and 2 utility companies received free permits due to EU concerns of carbon leakage, losing competitiveness to other economies that did not have a carbon price system. Such a system created short-term windfall profits for utilities between 25 and 213. Phase 3 started in 213 and, this time, utilities have to pay for their allowances. Exhibit 1 describes the carbon price trajectory. EU ETS Created Windfall Profits for Utilities in Phases 1 and 2 The electricity price is typically determined by the merit order of power plants within a country, the point at which the marginal cost curve set by each type of power plant meets demand. Nuclear and hydroelectric power plants, with zero or very low variable costs, tend to run whatever the demand level. Gas and coal plants, with higher variable costs, tend to run when demand is higher and their cost base determines the price at which electricity is sold. As shown in Exhibit 2, without any CO 2 costs the marginal power plant for the majority of the day would be a coal plant with a marginal cost of 2/Megawatthour (MWh). For perspective, around 1, MWh are required to power London for a day. At times of peak demand the gas power plant sets the price with a marginal cost of 4/MWh. The introduction of the CO 2 emission price pushed the marginal cost of production up for coal and gas power plants. CO 2 averaged 15 per tonne between 25 and 213, leading to an extra cost of 14/MWh for a coal power station, the cost for a coal station to emit one tonne of carbon while producing electricity (Exhibit 3). The total marginal cost for a coal station rose to 34/MWh and that benefitted hydro and nuclear power stations as they received the extra revenue but paid no CO 2 cost since they do not emit CO 2. However, coal plants also benefitted given that the majority of allowances were allocated free of charge in Phases 1 and 2. This means that the electricity price rose higher even though costs did not increase for the majority of plants because of the free allowances. As a result, utilities received the extra revenues which generated increased profits. Exhibit 1 EU ETS Carbon Price History EU Emission Allowance Price ( /Tonne) 4 32 24 16 8 25 Phase I Phase II Phase III 27 As of 5 October 215 Source: Bloomberg 29 211 213 Exhibit 2 Illustration of Variable Costs of Power Plants without CO 2 Costs 6 4 2 Off-Peak Renewables Hydro Nuclear Coal Gas 215 Peak Capacity (GW)/ As of October 215 Source: Lazard estimates Exhibit 3 Illustration of Variable Costs of Power Plants with CO 2 Costs 6 4 2 Renewables Hydro Nuclear Increased Profit Coal Gas Off-Peak Coal CO 2 cost @ 15/Tonne Gas CO 2 cost @ 15/Tonne Peak Capacity (GW)/ As of October 215 Source: Lazard estimates
3 Since the start of Phase 3 in 213 utilities have had to pay for all their allowances, eliminating those profits. Drax, a UK coal power station, received 62 million free allowances during Phases 1 and 2. At the current price of 8.42 per tonne, the additional revenue from the free allowances totalled 522 million, equivalent to 33% of its market capitalisation as of 4th October 215. RWE, a German utility which generates 4% of its electricity from coal, saw a 1.2 billion reduction in its 213 operating profit from this change, compared to an operating profit of 6.4 billion in 212. Going forward, companies with exposure to hydro and nuclear power generation will benefit from a higher CO 2 price since they will see their revenues rise without incurring the carbon allowance costs that coal or gas plants have to pass through to the market price. The EU has seen a 13% reduction in carbon emissions from 25 to 213; hence it could be argued that the cap and trade scheme is achieving its goal of reducing carbon emissions. However, a significant portion of that came during the financial crisis in 29 when carbon emissions fell 7% (Exhibit 4), following which economic activity has remained weak in Europe. The lower level of economic activity has led to lower emissions; EU industrial production is 1% lower than its peak level while carbon emissions have fallen by a similar amount. However, the current carbon price of 8.42 compared to its peak of around 3 in 28 (see Exhibit 1) represents little financial penalty to utilities. We believe the current low carbon price reflects the significant oversupply of carbon allowances seen in the EU ETS, running at around 1.7 billion tonnes or over a year s worth of emissions in the ETS, to the point where the EU is looking to alter the structure of the market in order to increase the price. In February 214, the EU deferred the auctioning of 9 million carbon allowances from 214 216 until 219 22, referred to as back-loading, in an attempt to tighten the oversupply of carbon allowances. In July 215, the EU approved the Market Stability Reserve (MSR) to further defer auctioning the 9 million allowances, until such a time when demand has recovered and the market is tighter. Today, the market remains unconvinced about the success of the EU s back-loading and MSR initiatives. The current EUA December 215 contract price is 8.17 while the forward curve remains relatively flat with the EUA December 22 contract price at 8.85 (Exhibit 5). CO 2 Price and Coal to Gas Switching At the current carbon price of 8.42 we believe it is unlikely that utilities will change their behaviour and switch from coal to gas and renewables. This is because the cost imposed on power plants for emitting a tonne of CO 2 is not high enough to incentivise switching away from using coal power stations towards lower carbon gas power stations. Such activity will only occur when the CO 2 price is at a level where the marginal cost of generating electricity from a coal power station is higher than at a gas power station. At that point plants would switch around in the merit order so that a gas plant would supply electricity at times of off-peak demand and a coal plant would supply electricity at peak time demand; the opposite of today. We believe a 4 carbon price is required to incentivise utilities to switch from Exhibit 4 Carbon Emissions Declined 7% in 29 Due to the Financial Crisis EU Carbon Emissions (million tonnes) 5,2 4,9 4,6 4,3 4, 25 26 27 28 As of 213 Source: European Environment Agency 29 21 211 212 Exhibit 5 EU Carbon Price Forward Curve Remains Relatively Flat Through 22 ( ) 9 8 7 6 215 As of September 215 Source: Bloomberg 216 217 218 219 213 22 Exhibit 6 EU CO 2 Price Estimated at 4/Tonne to See Switching from Coal to Gas Electricity Production 6 4 2 Increased Profit for Low Carbon Utilities Renewables Hydro Nuclear Gas Coal Gas and Coal Switch Order Off-Peak Peak Capacity (GW)/ Gas CO 2 cost @ 4/Tonne Coal CO 2 cost @ 4/Tonne As of October 215 Source: Lazard estimates coal to gas, as highlighted in Exhibit 6. The big beneficiaries in this scenario would be low carbon power plants which would experience higher profits.
4 Given today s low carbon price such switching behaviour is unlikely to happen. Natural gas generation has seen its share of EU electricity production fall since 25 from 21.2% in 25 to 16.6% in 213 (coal has been more stable, changing from 28.9% to 26.7% over the period), as the higher commodity cost, when compared to a coal plant, has not been offset by a high enough carbon price. As such, frustration within the EU related to the low carbon price has led individual EU members to develop additional carbon emissions programs. The UK has introduced a carbon price floor, with a tax on thermal generation designed to make the CO 2 price up to a minimum of 18 per tonne when including both the permit and the tax. Looking beyond this, by 23 the European Commission targets a reduction of 43% in carbon emissions from sectors covered by the EU ETS from 25 levels, as the carbon emissions cap declines 1.74% annually through 22 and then 2.2% annually from 221 to 23 during Phase 4. Exhibit 7 Share of EU Electricity Generation (%) 6 4 2 199 As of 213 Source: Eurostat 1995 2 25 Coal and Gas Nuclear Renewable Energies Other 21 211 212 213 Renewables Subsidies Are Having a Greater Impact on Utilities Profitability than the Carbon Price The EU s efforts to prop up the carbon price, most recently with the Market Stability Reserve, are indicative of a desire to continue their progression towards a lower carbon society. While the CO 2 price is the most high-profile effort, we believe that government subsidies for renewables generation across various EU countries have had a greater structural impact on utilities profitability and behaviour. We have seen a significant build-out of EU renewable electricity capacity as a result of these subsidies, illustrated in Exhibits 7 and 8, which have created stranded assets in the form of gas and coal power plants. For example, Germany s plan to have 35% of its electricity generation from renewable sources by 22 and 8% by 25, has led to a significant increase in solar and wind installations incentivised by government subsidies. Around 28% of Germany s electricity generation comes from renewable sources, having doubled over the past eight years. Given that the variable cost for solar and wind is zero, these installations run regardless of the market price. This has caused the wholesale power price in Germany to become negative at times, since the subsidy received can offset the cost of paying to generate electricity into the grid (Exhibit 9). The result is that profits at coal- and gas-fired generation plants continue to be squeezed, reducing the average expected lifetimes of these assets faster than previously anticipated. This has resulted in wide-scale closures of thermal power plants in Europe with around 43 GW of capacity (Exhibit 1, page 5), similar to UK Autumn peak demand, and asset impairments worth 44 billion the classic definition of stranded assets. Perversely, this has a negative effect on the carbon price. The closure of coal power stations has reduced demand for carbon allowances, since the (newer) lower carbon plants that have replaced this capacity no longer demand as many carbon allowances. Arguably, this has had a dampening effect on the EU ETS carbon price. The negative impact on utilities profitability has had a significant effect on these companies share prices, as the sector has underperformed European equities in general. Of note, non-regulated utilities have Exhibit 8 Strong Growth in EU Renewable Electricity Generation Electricity Generated (TWh) 9 6 3 (% of Consumption) 27 23 24 25 26 27 28 29 21 211 212 213 Geothermal Biomass & Renewable Waste Solar As of 213 Data for renewables are not available for 23. Source: Eurostat 18 Wind turbines Hydropower Electricity from renewables [RHS] Exhibit 9 Germany Wholesale Power Spot Prices Have Been Negative at Times 8 6 4 2-2 Feb 213 As of 13 October 215 Source: Bloomberg Oct 213 Jun 214 Feb 215 9 Oct 215
5 performed even worse, as is the case of two German utilities in particular, RWE and E.On, both of which have major coal operations (Exhibit 11). Are Consumers Willing to Pay Higher Electric Bills to Support the Transition to a Lower Carbon Economy? While the increase in renewable generation has contributed to the halving of the German wholesale electricity price over the past three years, the subsidy system has simultaneously led to a significant increase in consumer electric bills. The average German customer bill has risen by 15% over this time period and by 17% since 2, 1 and is now more than double that in the United States. This is mainly due to the increased subsidies and grid costs associated with building out renewables, which are passed on to consumers. Such growth in electricity bills is increasingly becoming a concern for the German public and politicians, as evidenced by recent polls, which suggest 88% of Germans are in favour of the principles behind the Energiewende, but the costs for private consumers are too high. 2 Recently we have seen political concerns over rising electricity bills in the United Kingdom, culminating in announced cuts to the subsidy scheme renewable operators receive in the latest UK government budget of July 215. In Spain, in 213 remuneration for renewable generators was cut because the subsidy system was deemed to be unsustainable. Increasingly when analysing the potential growth rate of the utility sector we must consider whether the current pace of renewable investments is financially sustainable because consumers are increasingly concerned about higher utility bills. How Can Utility Companies Respond to a Lower Carbon World? In our opinion, the regulatory timeline designed to transition to a lower carbon intensive economy is more of an evolutionary process rather than revolutionary. Utilities will continue to generate cash flows throughout this period of change, which provide an opportunity for them to reinvest in assets that are more sustainable in a low carbon future. A practical example is E.On, which last year announced plans to split into two companies, one with low carbon renewable generation, distribution grids, and energy supply while the second will retain the thermal electricity generation and oil & gas assets. This restructure is designed to better align towards their goal of offering a cleaner and more sustainable approach to energy. 3 Drax, which represents around 8% of the UK electricity generation, has responded to these changes by converting units of its coal power station to become biomass-based electricity generators. This reduces the CO 2 produced by the power station and potentially increases the longevity of the plant, given all coal stations are likely to close in the United Kingdom by the mid-22s, by our estimates. Ongoing discussions with energy companies provide us with valuable insights into our analysis as they respond to the increasingly lower carbon world. Companies are starting to realise that the impact these changes are having on their businesses are structural, thus are looking Exhibit 1 Stranded Assets in Europe Represent Significant Capacity Plant Closures (MW) 21 215E Portugal 1,853 Spain 5,551 United Kingdom 15,53 Germany 7,55 Italy 12,68 Total 42,571 As of October 215 Source: Goldman Sachs Exhibit 11 European Utilities Have Been Weak Performers since 29 Index, 31 December 28=1 2 15 1 5 29 to respond appropriately. We anticipate more changes in the future as companies seek to transition their energy generation mix from higher carbon to lower carbon, establish new business models, and potentially close stranded assets. Conclusion 21 211 212 MSCI Europe Index MSCI Europe Utilities Index 213 214 E.On RWE 215 As of 3 September 215 All data are in EUR and show price returns. The performance quoted represents past performance. Past performance does not guarantee future results. This is not intended to represent any product or strategy managed by Lazard. One cannot invest directly in an index. Source: Bloomberg, MSCI The EU ETS system initially created windfall profits for utilities; however, since 213 these have been eliminated. The current low carbon price and an unlikely major price recovery provide little financial incentive for utilities to switch away from coal power generation. We believe the EU system of subsidies created to encourage renewable electricity generation has had a greater impact on carbon emissions and the profitability of the utilities sector and looks likely to continue. For the time being, these changes have put pressure on the profitability of traditional generation activities and led to stranded assets. Some companies are changing and investors may find attractive investment opportunities by identifying those companies that can thrive in a lower carbon intensive world. By analysing the sustainability of profits, we believe there is an opportunity to offer significant insight into a dynamic market.
6 This content represents the views of the author(s), and its conclusions may vary from those held elsewhere within Lazard Asset Management. Lazard is committed to giving our investment professionals the autonomy to develop their own investment views, which are informed by a robust exchange of ideas throughout the firm. Notes 1 As of March 215. Source: RWE, German Energy and Water Association 2 As of January 215. Source: Trendmonitor from Stiebel Eltron 3 As of December 214. Source: Company conference call Important Information Published on 15 September 217. This document reflects the views of Lazard Asset Management LLC or its affiliates ( Lazard ) based upon information believed to be reliable as of 12 November 215. There is no guarantee that any forecast or opinion will be realized. This document is provided by Lazard Asset Management LLC or its affiliates ( Lazard ) for informational purposes only. Nothing herein constitutes investment advice or a recommendation relating to any security, commodity, derivative, investment management service or investment product. Investments in securities, derivatives, and commodities involve risk, will fluctuate in price, and may result in losses. Certain assets held in Lazard s investment portfolios, in particular alternative investment portfolios, can involve high degrees of risk and volatility when compared to other assets. Similarly, certain assets held in Lazard s investment portfolios may trade in less liquid or efficient markets, which can affect investment performance. Past performance does not guarantee future results. The views expressed herein are subject to change, and may differ from the views of other Lazard investment professionals. This document is intended only for persons residing in jurisdictions where its distribution or availability is consistent with local laws and Lazard s local regulatory authorizations. Please visit www.lazardassetmanagement.com/globaldisclosure for the specific Lazard entities that have issued this document and the scope of their authorized activities. Equity securities will fluctuate in price; the value of your investment will thus fluctuate, and this may result in a loss. Securities in certain non-domestic countries may be less liquid, more volatile, and less subject to governmental supervision than in one s home market. The values of these securities may be affected by changes in currency rates, application of a country s specific tax laws, changes in government administration, and economic and monetary policy. Certain information included herein is derived by Lazard in part from an MSCI index or indices (the Index Data ). However, MSCI has not reviewed this product or report, and does not endorse or express any opinion regarding this product or report or any analysis or other information contained herein or the author or source of any such information or analysis. MSCI makes no express or implied warranties or representations and shall have no liability whatsoever with respect to any Index Data or data derived therefrom. LR25926