The Next German Government Bailout: EON?

For something different and for the first time I have a guest blog on onlyelevenpercent.  An earlier post of mine talked briefly about the problems facing traditional energy suppliers and we have recently seen news of RWE adopting a radical change in strategy.  This excellent piece by Gerard Reid of Alexa Capital goes into detail about Eon’s problems and was first published in Germany.  For obvious reasons it caused considerable comment.   Gerard can be contacted on: GReid@alexa-capital.com.

As stock markets across much of the Western world hover around five year highs it is worth noting that an investment in the Dow Jones European Utilities index would have caused you to lose 50% of your money over that same period. The sector, which was always considered a safe haven for investors with strong dividend payments and solid defensive business models, has been out of favour for many years and the question is whether now is a good time to get back into this sector or not.

At first glance you might say that valuations look very reasonable with Enel, Iberdrola, GDF Suez, EON and RWE all having market capitalisations below the levels of equity on their balance sheets.  However, first glances can be deceiving.

In the world of utilities much focus is put on what are called clean spreads and dark spreads (which are the differences between the wholesale power price and cost of gas and cost of coal respectively). Until recently, utilities have been very good at controlling the wholesale power price. When power prices fell they would simply close capacity to keep prices up. However, this was only possible because they had strong positions in the market with virtually no competition.

The first nail in this coffin was the extra competition caused by the liberalisation of the EU energy market and the interconnection of the continental European power markets. But the real game changer has been the proliferation of distributed renewable generation, owned by millions of individuals across the continent, who unlike utilities are incentivised to produce as much electricity as possible. This additional competition has reduced not only the baseload price, but more importantly the highly profitable peak prices. The impact has been huge, with both baseload and peak power prices currently at seven year lows across the German/French/Benelux region.

Still that being said utilities have been somewhat protected from these falling prices by their power hedges. Power generators generally sell forward a proportion of their power at agreed prices which protect them from the volatility of the market. These hedges enable them to sell power to their customers at prices above that market price.

Utilities can take different views on this. Take for example the Austrian utility Verbund; with its low cost fleet of hydro power stations, it has always taken the view of not needing to hedge its power sales, thereby giving it the flexibility to sell at higher prices if the market price goes up. Verbund has currently hedged 23% of next year’s power volumes. This is in contrast to say, EON, which is close to being 100% hedged. Verbund’s limited hedging strategy means that its average hedged price of €44.9/MWh for next year is well below EON’s €53 which is reflection of EON having signed more customers up on long term contracts when the power price was higher some years back.

The issue for both these companies is that German forward power prices (€36.55 for 2014) do not look like they are going to go up anytime soon which means that anyone signing a new long term contract with these utilities is doing so at much lower prices. The end result will be that, come 2016, the average hedging price will be very close to the current market price. These price falls will hit someone like Verbund first because they are much more exposed to the wholesale market price than a company like EON. This can already be seen playing out in Verbund’s recent results.   Not only did they making an operating loss of €89.3m in the first half of the year but they also announced impairment losses amounting to €659m for their combined cycle gas turbine power plants in Austria and France, as well as a further write-down totalling €371m on an investment in an Italian power business. EON has suffered less so far, but if prices stay low then they will face a much worse situation. Reductions in their average power selling price could mean that by 2015 the company will be generating little or no money from their currently expensive generating fleet. That could be worth circa €1bn in annual lost earnings for the company and would require a much higher asset write-down.

The problem with EON

EON’s problems are larger than most across the European power market. They have made large strategic blunders and have not understood the changes taking place in the wider energy markets, let alone the technology changes, such as cheap solar power, which are directly challenging their business models.

The picture was very different a decade ago. They were on the acquisition trail expanding across Europe with one of the most modern and clean power generation fleets in Europe. They embraced nuclear and invested heavily in new cleaner more efficient gas plants as well as pumped storage power stations and large scale renewables.

So where did it all go wrong? Well for one thing they did not understand, despite having an oil and gas exploration business within the group, the impact that shale gas would have on their business.  The huge shale gas finds in the US have caused gas prices in the US to fall but have had near zero impact on European gas prices. What is has done is have an impact on coal prices which have fallen as the shift from coal to gas in the US causes the demand for US coal to fall, and in fact Europe has been the major beneficiary of this cheap American coal.  Add to this the fact that most European utilities have long term power purchase agreements for gas with the likes of Gazprom that are tied to the oil price (which has now decoupled from gas prices), meaning that the European utility industry is now paying over twice for their gas than the US.

The results of the above are clear; in the first seven months of the year there was a 19% reduction in gas used for power production in Germany while hard coal usage was up by 8.5%. With the CO2 price collapse and the coal price drops, dark spreads are now positive, meaning the only fuel that companies like EON can make money with is coal. And they are closing plants like the two and a half year old combined-cycle gas power plant in Malzenice, Slovakia which has only operated 5,600 hours since it was opened.

Even pumped storage activities at EON are at best break-even. Their whole business model was based around taking cheap night-time nuclear power, pumping it up the mountain and then letting it down during the day when prices were at their highest. But now with all the extra solar capacity on the grid, peak prices have collapsed, peak power needs are almost all met by solar and the power price is often lower during the day than at night.

But EON did embrace renewables, but what it has not done is embrace the decentralised revolution that we are particularly seeing in Germany but instead large centralised renewable projects. They have thus heavily invested in offshore wind and wind in the US where the projects tend to be on average over 100MW in size. In the US, EON currently owns 2.7GW of wind assets. Meanwhile back in the domestic market, EON owns 196MW of non-hydro renewable power. Whats more they are also reducing their hydro portfolio in Germany which at the start of this year was 1GW in size.  But EON recently sold 8 run of the river hydro assets in Bavaria to Verbund in return for Verbund’s 50% interest in the Turkish utility Enerjisa Enerji A.S.

To add to these issues EON like all other European utilities is dealing with at best flat growth in electricity volumes going forward, when one of their basic business assumptions was that power demand would increase in line with the growth in the economy. This has clearly changed and demand across Europe fell by 4% between 2008 and 2012. Of course it was argued that this was all recession led but the reality is that the two strongest economies in Europe the UK (7%) and Germany (2%) have both seen demand reductions. Energy technologies as well as energy efficiency measures are and will continue to have an impact on demand.

One persistent problem that EON shares with almost all utilities is their relationship to their customers, seeing them as licensees rather than customers.  EON is trying to change but it is a slow process and the customer backlash against the large utilities is clear for all to see. This will probably only intensify as customers begin to engage more with energy be it through having solar on the roof or using energy management systems.

What does it all mean?

The utility business model is dying. Selling electricity at controlled prices is a thing of the past, and the problem is the likely write-downs that are coming the way of many utilities including EON which will weaken already stretched balance sheets, which will then push up the cost of capital thereby making new investments more expensive and the implementation of new strategies difficult.

That said, the financial market is somewhat already assuming that when you look at the valuation of the EON. The market capitalisation of the company is currently €23bn (down from €86bn five years ago) with equity on its books of €37bn so the financial markets are pricing in that the company cannot generate a significant enough return to keep its shareholders happy. It is also assuming a write-down of €14bn in value. Is that too much or not enough? Currently EON’s power generation portfolio is valued in its books at circa €25bn and if it will generate no money on those assets going forward then a very large write-off is a serious possibility. And these write downs are already happening amongst other utilities most notably Vattenfall and Verbund in recent months

Assuming such as write-down, EON would need a new injection of capital and would probably need to restructure some of its debt. Is that something to be afraid of?  In the US, Enron went bankrupt, and the lights stayed on but before that happens the German government is most likely to bail EON out by introducing a capacity payment mechanism which will enable them to generate money from assets they rarely use. But why should German tax and rate payers bailout a company that has made serious strategic mistakes, who has not committed itself to the German government goals of the Energiewende and who has instead committed its future strategy to investing in far off places like South America and Turkey ?